Every now and then, a question or comment from a subscriber is likely to be of interest to many other subscribers. In this case, a comment came in asking us to explain the advantages and disadvantages of three different investment fund structures that investors commonly encounter: open-ended investment companies, investment trusts, and exchange-traded funds. This Featured Article is aimed at explaining these common fund types.
Open-ended funds are ones that don’t have a fixed amount of shares in issue. To invest in the fund, an investor must approach the fund manager via an investment intermediary (IFA or Insurance Broker): the manager then creates new shares in the fund, and issues them to the investor. The same process applies in reverse for investors who wish to sell shares in the fund and the manager may have to sell some of the fund’s holdings in order to fund redemptions.
Open-ended funds are known by different names in different jurisdictions:
- In the EU, they are known as SICAVs, and are governed by legislation coming from the European Union.
- In the UK, open-ended funds may come in two forms:
- Unit trusts: Funds which are created by a trust deed and are managed by a trustee. These funds are governed by trust law and are not treated as companies.
- Open-ended investment companies: A new fund structure created in 2000 and which are increasingly replacing unit trusts because of their flexibility and ease of understanding, including the fact that they are treated as investment companies.
- In the US, they are called open-ended mutual funds and unit investment trusts are also available, and are treated similarly to the UK.
Advantages of OEICs
There are some advantages to buying into open-ended funds. The primary advantage is that, investors are able to buy into and sell out of the fund at net asset value (NAV). This differs particularly from investment trusts, whose share prices can trade at a discount or premium to NAV.
Of course, our own opinion is that being able to buy into funds at a discount is one of the primary attractions of investment trusts, but there is nonetheless a comfort in knowing that one’s holdings can be redeemed at NAV which suits some investors’ temperaments better.
An additional benefit of OEICs is that many of them pursue active investment strategies, which gives them the opportunity to outperform their benchmark index if they have sufficiently talented investment teams.
Disadvantages of OEICs
OEICs also come with several disadvantages, which can include:
- Higher fee structures compared to ETFs (and sometimes investment trusts, too), particularly for hedge and private equity funds.
- Potential liquidity problems – if the assets underlying the fund are illiquid and the fund experiences a sudden demand for redemptions, it can be forced to sell its assets into an illiquid market which can cause price declines or even prove simply impossible.
- Funds may impose entry fees and exit penalties, which can be thought of as being required to buy into the fund at a premium and sell out at a discount.
- Open-ended funds, in our experience, tend to be more opaque than investment trusts or ETFs.
- Actively managed OEICs are exposed to “manager risk”, or the risk that a fund manager – through error or intention – makes poor investment decisions which reduce returns or changes the fund’s strategy gradually over time (a phenomenon known as “style drift”).
Tax Treatment of Open-Ended Funds in Ireland
In Ireland, the Revenue treats EU-domiciled open-ended funds differently to companies. For Irish investors, these funds are treated as “gross roll-up” vehicles meaning that any gains are not subject to tax until the investment is sold, or until a period of eight years elapses, whichever is sooner. In this case, a gains tax rate of 41% (currently) is imposed on profits. Losses are not allowed to be offset against gains.
Investment trusts are closed-ended funds that are typically listed on stock exchanges. The term “closed-ended” means that there is a fixed number of shares in issue: Once the fund has listed on the stock exchange any investor who wants to buy into the fund must find another investor in the marketplace who is willing to part with their shares.
Advantages of Investment Trusts
The primary advantage of investment trusts is that they are listed publicly on stock exchanges. Any investor can buy into them in even tiny amounts – there is no cumbersome paperwork, no minimum investment sizes, and no entry or exit fees to pay. In addition, because trusts are closed-ended, they are usually more suitable for illiquid assets because the manager isn’t forced to sell the fund’s holdings to meet redemptions.
Because investment trusts are publicly listed, the share price is decoupled from the NAV (i.e. the two won’t necessarily be the same at any point in time). This gives investors the opportunity to buy into funds at a discount (where the NAV is greater than the share price) or sell out at a premium – while some investors are not comfortable with this added characteristic, we view discounts as potential sources of additional return on top of what the investment strategy can generate.
Several other advantages of investment trusts include (which we summarise in bullet points to save space):
- No distribution costs. OEICs, because they have fluctuating capital, need to spend money on constantly raising new capital to counter redemptions. Investment trusts have fixed capital so don’t need to do this.
- Strong regulatory protection as they are required to obey the Companies Act in their relevant jurisdiction.
- Investment trusts are actively managed which gives them the chance to outperform their benchmark indexes while not necessarily taking on higher levels of risk.
- The ability to use borrowing to boost returns (although OEICs can also do this).
Disadvantages of Investment Trusts
The flipside of buying at a discount and selling at a premium is that investors may be forced to buy in at a premium and sell at a discount, which can act as a drag on returns. For this reason, some investors prefer ETFs and open-ended funds because the risk of having to buy in at a premium or sell at a discount is eliminated.
In addition, fees tend to be higher for investment trusts compared to ETFs, particularly for funds that follow hedge fund or private equity strategies. These fees are charged because it costs money to attract investment talent to actively manage the fund; this, in turn, can be an additional disadvantage. Funds that pursue active strategies run the risk of underperforming their benchmarks through poor security selection or asset allocation.
Finally, investment trusts are exposed to “manager risk”, which we explained previously.
Tax Treatment of Investment Trusts in Ireland
The Irish Revenue has never provided any clarification on the tax treatment of investment trusts and these fund types are not defined in the Revenue’s guidelines. The UK Revenue treats them as securities (shares) and capital gains tax rules apply. Our own view is that, if push came to shove, the Irish Revenue would have a hard job justifying applying any other tax treatment than that for shares (securities). One principal reason is that there is no direct link between the share price of an investment trust and the underlying net asset value. A second reason is that investment trusts are companies and are governed by the Companies Act and not regulators. Thirdly, the introduction of REIT legislation has made it clear that at least one type of investment trust will not be treated as an open-ended fund and will be treated like a company.
Hence, it is our view that investors can assume that dividend income on investment trusts is taxed at your marginal rate of income tax, gains are taxed at the CGT tax rate of 33%, losses can be offset against gains and losses can be carried forward.
Exchange-traded funds (shortened to ‘ETFs’) are publicly listed funds that are passively managed (i.e. they attempt to match a benchmark’s performance). The innovation in ETFs is that they act like open-ended investment companies – investors can buy and sell shares in the fund at NAV – while being publicly listed on a stock exchange. We won’t get into the details of how that works here.
Advantages of ETFs
Exchange-traded funds have significantly expanded their presence in the investment universe because they have several advantages that appeal to investors – particularly retail investors. The first advantage is that ETFs can be publicly traded without having to interact directly with an investment intermediary which reduces administration work. In addition, investors can buy and sell shares at NAV without having to worry about discounts or premiums because of the way that ETFs are structured.
ETFs also charge low fees because they don’t have to pay higher salaries to retain investment talent: the funds simply seek to replicate the performance of a particular index or “benchmark”. Because the funds are passively managed, ETFs also don’t run the risk of underperforming their particular benchmark – as more and more academic and industry research has demonstrated that active investment managers struggle to outperform their benchmarks over long periods of time, this particular advantage of ETFs has contributed strongly to their growth in assets.
Disadvantages of ETFs
One particular disadvantage of ETFs is that in some instances they provide an illusion of liquidity where there may be none. Investors assume that, because ETF shares are publicly traded, there will always be a liquid market for the shares. However, ETFs are in essence open-ended funds and are thus subject to the same liquidity problems that can disadvantage open-ended unit trusts or OEICs – if the ETF is holding assets in illiquid areas of the market, then a sudden increase in investors selling shares can cause a liquidity crunch which drives the price of the underlying assets (and thus the ETF’s share price) down significantly.
Finally, we also believe that ETFs inability to deliver outperformance can be a disadvantage. We hold to the belief that carefully researched investment managers can produce superior returns without higher risk over time if one possesses the proper tools and temperament. With ETFs, this potential for superior returns is lost which we view as disadvantageous.
Tax Treatment of Exchange-Traded Funds in Ireland
ETFs are treated differently in Ireland depending on whether the fund is domiciled in the EU (and governed by UCITS legislation) or outside the EU.
Non-EU-domiciled ETFs are treated as securities: dividends are taxed at the marginal rate of income tax, gains are taxed under capital gains rules and losses are allowable for CGT purposes.
In the case that an ETF is EU-domiciled, it is treated as an open-ended fund: gains are taxed at 41% upon disposal or after an eight-year period, whichever is earlier, and losses are not allowed to be offset against gains.
Note: There are separate fuller notes on exchange-traded funds and investment trusts in the Learning Centre area of the subscribers’ website.