Open-ended vs closed-ended funds
The ongoing coverage of the suspension of dealing in Neil Woodford’s Equity Income Fund has seen frequent discussion of ‘open-ended’ and ‘closed-ended’ investment funds – but what do these pieces of industry jargon mean, and is one approach preferable to the other for investors when they are selecting a fund?
Both types of vehicle offer the benefits of pooling capital with that of other investors, giving simple access to a diversified portfolio and the services of professional asset management firms. There are, however, a number of differences – some obvious, but others more nuanced.
What is an open-ended fund?
Open-ended funds are collective investments which do not have a fixed size or number of units/shares in issue. Instead, an open-ended fund will expand or contract in line with investor demand. As investors subscribe to the fund, new units/shares are created; when investors redeem their units/shares, they are cancelled.
Open-ended funds have two important features.
- Investors have the right to redeem their units or shares on demand by selling them back to the fund manager. This means that an open-ended fund will ensure a certain level of liquidity for investors.
- The price of units or shares is determined by the net asset value (NAV) of the underlying portfolio of assets held by the fund. This value will vary in line with the portfolio’s performance and the level of investor inflow and outflow.
There are various types of open-ended investment fund in the UK. The following are the most popular.
Authorised Unit Trust (AUT) – a type of collective investment where the assets of the fund are held in trust for investors – known as unit-holders – by a designated trustee. The trustee provides oversight of the activities of the fund manager, who is responsible for investment strategy and portfolio management. The trustee has legal ownership of the fund’s assets, but the beneficial ownership of the portfolio lies with unit-holders.
Open-Ended Investment Company (OEIC) – these funds are sometimes referred to as Investment Companies with Variable Capital (ICVCs). They are different from authorised unit trusts in that they are constituted under company law rather than trust law. Instead of a trustee, an OEIC has an Authorised Corporate Director (ACD) who is responsible for its day-to-day running and administration, and a depositary that holds the fund’s assets in safe custody and provides independent oversight of the ACD’s operations. Investment management is usually delegated by the ACD to a specialist fund manager.
Legal ownership of the fund’s portfolio resides with the depositary or delegated custodian; beneficial ownership is held by the company (the OEIC itself). Investors hold shares in the OEIC rather than holding the portfolio directly.
At the level of the fund, AUTs and OEICs are taxed in the same way, being generally treated as if they are UK-resident companies: investment gains from assets held within the funds are not subject to Capital Gains Tax. Certain types of income receivable by the fund are subject to Corporation Tax but, in general, income from dividends is not taxable. At the level of the investor, tax treatment will vary according to individual circumstances.
Authorised Contractual Scheme (ACS) – in contrast to an AUT or OEIC, an Authorised Contractual Scheme has no legal personality. Instead, it is a collection of assets managed on behalf of various co-owners, who are either considered tenants in common or limited partners, depending on the precise structure of the ACS. A manager is responsible for day-to-day operations of an ACS, and a depositary must be appointed to provide custody and oversight in the same manner as with an OEIC. One significant distinction with an ACS structure is that it is treated as tax-transparent – that is, investors are taxed as if they owned the underlying assets of the ACS directly, rather than through a fund vehicle. The ACS itself is not subject to Capital Gains, Income or Corporation Tax.
Although ACSs can be marketed to retail investors in the UK, there is a £1 million minimum investment which makes them impractical for widespread use – as such, they are typically used by larger, professional investors.
What is a closed-ended fund?
In contrast to the vehicles described above, a closed-ended fund has a fixed number of shares, issued on launch via an Initial Public Offering (IPO). These shares are issued in accordance with company law. Investors are not entitled to redeem their holdings on demand. Rather than trading with the fund manager, as with an open-ended fund, investors in closed-ended vehicles trade amongst themselves on the secondary market in a similar way to a standard company share.
This means that the prices of shares in a closed-ended vehicle are determined by market demand and supply factors, rather than with strict reference to the net asset value of the underlying portfolio of assets in the fund. Therefore, a closed-ended vehicle can trade at a discount (below net asset value) or premium (above net asset value).
Closed-ended fund structures are not used as frequently as open-ended vehicles in the UK, even though they have a much longer heritage – the world’s first collective investment fund was a closed-ended scheme launched in 1868!
The most popular type of closed-ended fund is the investment trust. The name ‘trust’ is somewhat of a misnomer here, as the structure is technically not a trust at all, but in legal terms is established under company law. The responsibility for the day-to-day running of the fund is vested in the board of directors of the company, however in practice this is usually delegated to a specialist fund manager. Legal ownership of the assets of the investment trust is generally held by a depositary or custodian but, unlike with an OEIC or AUT, this firm does not need to be independent of the fund manager.
At the level of the fund, investment trusts are not subject to Capital Gains Tax (in the same way as an AUT or OEIC), however they are treated like any other UK company in respect of Corporation Tax. Individual investors are taxed in much the same way as if they held shares in any other company.
Two other features of investment trusts often make them attractive to investors.
- The manager of an investment trust has the ability to borrow in order to finance the purchase of assets within the fund’s portfolio. This facility allows the manager to increase the size of the investment trust’s assets beyond the amount initially raised from investors. This can significantly amplify returns but can also cause greater losses depending on investment performance.
- Investment trusts can retain earnings (up to 15% in each accounting period), which open-ended funds cannot do. This means that an investment trust can smooth income payments by retaining earnings during better years, in order to make up payments in weaker times.
There are also some other, more niche types of closed-ended vehicle such as the European Long-Term Investment Fund (ELTIF), European Social Entrepreneurship Fund (EuSEF), European Venture Capital Fund (EuVECA) and some forms of Limited Partnership, however these are relatively rare in the UK and so not looked at in depth here.
Interestingly, the Investment Association is currently working on plans for a ‘Long-Term Asset Fund’ (LTAF), which is proposed to be a hybrid structure – an open-ended fund but designed to hold illiquid investments such as property or unquoted companies, traditionally the preserve of investment trusts. Unlike most other open-ended vehicles, LTAFs will not offer daily dealing – with the aim of managing liquidity risk.
It is also worth noting that Exchange-Traded Funds (ETFs) already offer a somewhat hybrid structure – they are traded like a closed-ended fund, on an exchange, but there is an ability for shares to be created or cancelled, which gives an element of open-endedness and ensures prices do not deviate significantly from the net asset value of the underlying assets, as an investment trust might.
Comparing the approaches – which is better?
Open-ended and closed-ended funds have different characteristics and neither is intrinsically better than the other – rather, it is a question of ‘horses for courses’. The key differences are summarised in the table below.
Open-ended funds are one of the most widely available types of investment vehicle in the UK. As we have seen, they generally offer daily dealing, but to support this the assets in the fund’s portfolio may need to be sold quickly, which could prove extremely difficult if they are illiquid. Therefore it is important to understand not just the overall fund structure, but the nature of the underlying investments.
Closed-ended funds are often more suitable for holding illiquid investments, and have the ability to smooth income payments. They can also add gearing to amplify returns, but this can add risk. Prices are set by market supply and demand, so it is possible that a closed-ended fund may be priced at a significant discount or premium to the underlying value of the assets in the portfolio, unlike an open-ended vehicle.
In isolation, these and other differences are not necessarily advantages or disadvantages, but they should be considered in the context of an investment strategy and as one part of any rigorous fund selection process. Importantly, an investor does not need to choose one approach for their entire portfolio – it may well be that a mixture of the two types of vehicle is the optimal choice.