QD view – the right fund in the right structure

I have been working with closed end funds – as an investment manager and an analyst – for almost 30 years – writes James Carthew

 
At times, the sector has felt like the poor relation of the investment industry. It does not attract the vast sums that flow into open-ended vehicles, exchange-traded funds (ETFs), or limited partnership structures, and it has had more than its fair share of scandals and negative headlines, but in my view, it is a much superior product. This is why closed-end funds dominate when it come to my personal savings.

I am not going to properly debate the attractions of active versus passive management here. Index-tracking ETFs suit some markets better than others, come with lower fees, and work well when, as has been the case in recent years, a narrow group of mega caps drive markets. However, I cannot get my head around seeking to own everything, even companies that are obviously in terminal decline. Passive bond funds, where exposure to a company rises when it takes on more debt, are an even worse proposition than passive equity funds in my eyes.

However, in recent years a new product has emerged – active ETFs. Although, as yet, they have not really made much headway in the UK. This structure looks very like a closed-end fund operating a strict zero discount policy. Clearly, they can only really function if the underlying portfolio is highly liquid. In the US, the largest of these is the $29bn JPMorgan Equity Premium Income ETF (JEPI), which is just three years old. It holds a portfolio of about 120 large cap US equities, and it manufactures income by selling options on stocks that it holds. It has an annual expense ratio of about 0.35%. I think that something like that might flourish here too.

That does not mean that the UK closed end fund industry is faced with imminent demise. Clearly the vast majority of investment companies hold assets that are too illiquid to suit active ETFs. Even for more plain vanilla strategies, there are advantages in not being distracted by significant inflows and outflows, and in using gearing.

One element of the closed-end structure that tends to give it an edge over the long run is its ability to borrow money (gearing or leverage). This helps magnify returns, but of course this works both ways and has accounted for some of the more disappointing failures within the industry. Gearing adds complexity and risk to the structure and I appreciate that this puts off some investors. Understanding how an investment company approaches the use of leverage should be a vital part of your due diligence before buying a closed-end fund.

The other main complicating factor is the discount/premium – the separation of the share price from the underlying net asset value. Trading discounts and spotting discount opportunities has been a major part of my career. It is a pain when a discount opens up on something that you hold, but my experience has been that with patience it will often close again, often because someone has intervened to make that happen.

This brings us to one of the great strengths of the closed-end structure, the board of directors working on behalf of shareholders. Their actions can transform an unloved poorly performing fund for the better. Crucially, they can fire the manager and/or change the investment approach (the latter change needs shareholders’ consent). A poorly performing open-ended fund might rejig its management team, but a wholesale rethink about the direction of the fund is almost never going to happen.

The final strength of the structure that I would emphasise is in the name – ‘closed-end’. Unhampered by volatile flows in and out of the structure, managers can take a long-term view and hold more illiquid assets. That strength has underpinned the expansion of the closed-end fund industry into diverse areas such as renewable energy and infrastructure.

Recently, a new structure has appeared on the horizon – the Long Term Asset Fund (LTAF). This is an attempt to drive a square peg into a round hole. It is an open-ended fund that is designed to hold illiquid assets.

Investors were clamouring for a new approach following the prolonged suspension of redemptions from open-ended property funds and the failure of LF Woodford Equity Income, which held illiquid unlisted stocks in an open-ended fund. Within the investment company industry, we lobbied for these strategies to use our structure, but – as I have outlined – for the managers this comes at the risk of getting fired for poor performance. Instead, the idea of an open-ended fund that only lets you get your money back if you give notice many months in advance was born.

On the face of it, LTAFs have few advantages over closed-end funds. However, one crucial difference is that the LTAF will always be valued at asset value. I am sure that is going to suit some investors and it may impact on our industry’s ability to launch new funds. The easy way for us to combat this is to offer investors in closed-end funds periodic exit opportunities – as quite a few investment companies already do. In the meantime, if you are choosing between buying exposure to UK commercial property, for example, at asset value through an LTAF or at a 30–40% discount, I know which I would pick.
 

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