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Disclosure – Non-substantive Research
This is not substantive investment research or a research recommendation, as it does not constitute substantive research or analysis. With this commentary, Kepler Partners LLP does not intend to influence your investment firm's behaviour.
Closed-ended funds have outperformed open-ended funds in the major equity sectors since 2000. Unlike the latter, investment trusts have outperformed their benchmarks net of fees too, according to research from academics at Cass Business School.
According to research recently published by Andrew Clare and Simon Hayley, one major reason for trusts outperforming was that they hold more illiquid assets, namely smaller companies. They stripped out this effect in order to calculate the alphas generated by the two types of investment (because overweighting higher beta areas of the market should lead to extra returns irrespective of manager skill). However, they found that investment trusts still showed significant outperformance over their benchmarks and open-ended peers. Interestingly, gearing was not a reason for the outperformance, on their analysis, although market timing and share buybacks did contribute.
In our view, the fact that closed-ended funds held significantly more in smaller companies is no accident: the structure allows managers to take larger positions in less liquid parts of the market and be truly long term about investment, both of which favour investing more in small and mid caps. While it makes sense to exclude a higher small cap weighting from the alpha attributed to a set of managers, as Clare and Hayley have done, when comparing the relative merits of open and closed ended funds it is clearly relevant. This is particularly true given that one cannot invest passively in small caps due to precisely the same liquidity issues.
We drill into the details of the research before asking whether closed-ended funds will retain their advantages in the future. We find reason to be optimistic they will, and consider some trusts which display the key characteristics the research highlights.
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