A question of trust

Investment trusts are often viewed as more volatile than open-ended funds. This is largely due to their use of gearing and the fact that the share price can trade at a discount - or premium - to the net asset value (NAV) of the portfolio at different stages of the market cycle.

But does that mean investors are worse off in a closed-ended investment trust than an open-ended equivalent?

I would argue not. Both have a place in a well-diversified portfolio and each will lead to different results at different points of the cycle.

While the volatility of investment trust share prices may mean they are not always suitable for investors with a lower risk appetite or a shorter investment horizon, on the flip side, I believe they can present interesting opportunities - even in volatile markets - and provide excellent value over the longer term.

Dealing in the underlying portfolio

The key structural characteristic of investment trusts which sets them apart is their closed-end nature. At a portfolio level, this is a great advantage to the manager as they do not have to deal with daily inflows and outflows of capital.

He or she is therefore not forced to sell shares from the underlying portfolio at a disadvantageous time. It also allows greater flexibility to target attractive opportunities in less liquid, smaller - even unlisted - stocks, as well as using gearing and derivatives to amplify returns.

In contrast, open-ended funds have to carefully manage flows as shareholders trade in and out of a fund. This is often magnified during periods of market weakness, when uncertainty and speculation can lead to heightened volatility.

As investors elect to sell holdings rather than ride out the storm, the portfolio manager of an open-ended fund may be forced to sell stocks at a lower price than they would otherwise have accepted.

They may also be forced to dispose of individual stocks that they still like - selling more liquid names first to meet the redemption request when other less attractive stocks are harder to trade out quickly. All this trading also carries additional costs which must be shared between the remaining shareholders in the fund.

In contrast, an investment trust portfolio manager is not forced to sell shares when markets are weak. This thereby limits dealing costs, while the portfolio retains the potential to capture any future upside of a stock in the future.

Discounts and premiums

It should be noted, however, that short-term trades do impact investment trusts as sellers can drive down the share price both in absolute terms and relative to the NAV of the portfolio.

Clearly, investors able to ride out periods of volatility are not negatively impacted by this. Indeed, a depressed share price can be an attractive entry point for new investors - and investors making regular monthly contributions or reinvesting dividends will actually end up being able to buy a larger number of shares as a result of the weakness.

Investment trusts can therefore be an attractive new investment when the stock market is depressed, although there is no guarantee how quickly, or if at all, the discount will narrow.

Finally, if we look at the return trajectory of closed-ended investment trusts versus open-ended funds over a 12-month view, market data shows that the average investment trust tends to underperform the average open-ended fund in most Investment Association sectors.

However, when the same analysis is conducted over three years, it shows that investment trusts have generally a superior total return for shareholders.

This trend is also apparent when we take a 10-year time horizon - highlighting to good effect that those investors willing to take a long-term view and ride out periods of volatility may well be better off in a closed-ended vehicle once calm returns.

Nicky McCabe is head of investment trusts at Fidelity Worldwide Investments.