9 August 2019
The suspension of the Woodford Equity Income Fund in June shone a spotlight on several different aspects of the investment management industry.1
Among the talking points was the Fund’s open-ended structure, with investors effectively trapped when trading was suspended in order to stem a surge of outflows.2
The challenge for open-ended funds
Where open-ended funds - such as unit trusts and open-ended investment companies - aren’t able to support redemption requests from the cash they hold back for this purpose, they need to sell investments to cover them.
In the case of Woodford, pressure from redemption requests had been growing in the run up to the suspension, raising the risk of forced sales that would not have been in the best interests of the Fund’s investors as whole. A compounding issue was the level of relatively illiquid – harder to sell - investments in the Fund’s portfolio.3
Illiquidity of holdings is a particular and established challenge for open-ended funds facing redemption requests. Stock markets recovered quickly from post-EU referendum falls in June 2016, but trading in several open-ended property funds was suspended for a period as firms put a block on withdrawals to ensure they didn’t have to sell properties to meet redemptions4. The same happened when property prices crashed during the 2008/9 financial crisis.5
How closed-ended funds compare
In contrast, the closed-ended status of investment companies – such as investment trusts - means they don't have to sell assets to cover redemptions. As listed companies, they issue a fixed number of shares which are tradeable in their own right, meaning investors wanting out should be able to sell their holdings on the secondary market.
Investment companies can therefore be particularly useful for investing in sectors with low liquidity, such as private equity and property.
There are other features that potentially count in their favour too. For instance, investment trusts have the ability to hold back up to 15% of annual earnings in reserve during the good years so that they can continue to pay dividends during leaner times.
Open-ended funds are popular
Yet open-ended funds still attract the bulk of investors’ money and remain popular with advisers. While there was £192bn held in investment trusts as at the end of June 20196, that was dwarfed by the £1.2 trillion held in open-ended funds run as at the end of May 20197.
There remains a school of thought among advisers that investment trusts are too complex to be suitable for many clients, while there’s also a practical issue with their availability on certain platforms.
Understanding adviser views
Research conducted last year by the lang cat, on behalf of the Association of Investment Companies (AIC), presented advisers with six potential barriers to using investment trusts and asked them to select those that applied.8
Half said trusts lacked the ease-of-use factor that funds have, while the next biggest barrier was the suitability of investment companies from a client perspective, followed by availability on platforms.
Another 2018 report, by Cicero, found that 57% of advisers were discouraged from recommending investment trusts because of a lack of knowledge and 36% because of perceived complexity.9
While some concerns are valid, others appear to arise from misconceptions. For instance, the lang cat report noted that although advisers suggested the investment trusts sector did not help to identify trusts with gearing, such information is in reality easily accessible.
On the other hand, adviser concerns about a lack of correlation between price and value of assets are clearly based on fact. As investment company shares are listed and traded on an ongoing basis, their price is influenced by supply and demand and not just their net asset value (on which the pricing of open-ended funds is based alone). So their shares may trade at a premium or discount to their NAV, depending on market sentiment at the time.
Suitability is what really matters
Both fund structures have their pros and cons and when you are giving advice your emphasis will always be on suitability for individual clients. The 2018 implementation of the product intervention and product governance sourcebook (PROD, updated when MiFID II came into force) underlines the obvious need for advisers to understand their clients and create and manage their investment propositions accordingly.10
Against the high profile background of Woodford, and depending on your own preferred investment approach, you may now find explaining the basics of how open-ended and closed-ended funds compare, and what each can be helpful for, becomes an increasing feature of client conversations.