The funds and trusts that can’t be replaced with an ETF

Passive funds have plenty of appeal, but there are some areas they are poorly suited to. Sam Benstead explains why, and names the active funds that stand out from the crowd. 

When it comes to sales, there has only been one winner in the active versus passive fund battle over the past decade, with the latter cleaning up.

In 2007, before the financial crisis struck, the amount held in tracker funds was a mere £29 billion, which at the time represented 6.3% of the total.

Today, there’s around £300 billion invested in total. This is about 20% of the funds industry, according to trade body the Investment Association (IA), and there are no signs of its share falling as active fund manager performance fails to keep up.

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A simple way to understand the difference between active and passive is to think of active managers as trying to uncover needles (good shares) in a haystack (the market). Passive funds, such as exchange-traded funds (ETFs) meanwhile, buy the whole haystack, knowing that the needles are in there somewhere.

Active funds are generally more expensive as the fund manager’s salary and his or her resources cost money. A typical active fund will charge somewhere between 0.75% and 1% a year (known as the ongoing charges figure), which is higher than most passive funds, where 0.1% to 0.2% a year is typical.

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Low passive fees generally give them an edge over the average returns of active managers, with the most widely followed markets, such as the US, generally hardest for active managers to consistently beat tracker funds.

Interactive investor customers are big fans of passive investments, with eight of the 10 most-bought funds in June passive strategies. Just Fundsmith Equity and Royal London Short Term Money Market fund made the most-bought list.

Our research also showed that there were some passive funds that active managers consistently failed to beat, including the L&G Global 100 Index Trust, the Vanguard LifeStrategy range, and US market trackers, such as the iShares Core S&P 500 ETF and Vanguard S&P 500 Ucits ETF.

Investment trust ideas

However, there are some investment areas that passive funds are poorly suited to and going active is the best way of investing. Investment trusts, which have a permanent pool of capital and can therefore invest in tricky to trade assets, are particularly well suited to active management.

Emma Bird, head of investment trust research at stockbroker Winterflood, said trust managers are therefore able to make truly long-term investment decisions and access illiquid assets easily.

Bird says: “Many equity investment trusts have very high active shares and their performance will therefore differ notably from their benchmark and the representative tracker fund. These investment trusts have the potential to deliver strong outperformance of the benchmark index over time, as a result of the stock-picking ability of the fund managers.

“In addition, closed-ended funds allow investment into illiquid and real assets, including property, infrastructure and unlisted equities and debt, resulting in portfolios that cannot be replaced with a tracker fund.”  

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Bird highlights JLEN Environmental Assets, a trust which owns physical renewable energy assets, such as wind and solar farms.

Bird said: “JLEN has proven its ability to invest in less competitive areas of the market and evolving areas of environmental infrastructure, which we expect will offer higher returns. The fund also has good cash flow visibility, with a high proportion of portfolio revenue contracted and/or linked to inflation.”

For exposure to direct lending debt, she recommends BioPharma Credit (LSE:BPCR), which provides venture debt to biotechnology firms, guaranteed by royalty streams from approved drugs, devices and diagnostics.

Bird says: “Given the frequency of prepayments and the specialist nature of counterparties, the fund relies on the expertise of the investment adviser to assess credit risk, royalty valuation and ongoing deal sourcing. We rate the managers highly, and the quality of credit selection is illustrated by the fact that the fund has experienced no defaults since its launch in 2017. The fund targets a net asset value total return of 8% to 9% a year over the medium term, including a target dividend of 7 cents per annum, equivalent to a 9.8% yield at present.”

David Johnson, investment analyst at research firm QuotedData, says there are three themes that are “difficult, if not impossible” to achieve via open-ended funds and ETFs.

These are activism, diversified funds that include unlisted shares, and low liquidity small cap. His trust ideas for these three sectors respectively are AVI Japan Opportunity Trust, RIT Capital Partners, and Herald Investment Trust.

Johnson says: “AVI Japan Opportunity Ord (LSE:AJOT) is the best example of a truly activist fund. Many Japanese fund managers tout the benefits of the countries improving corporate governance, but AJOT takes this a step further by proactively being part of this transition.

“By taking substantial positions in Japanese small-cap companies, the AJOT team are afforded the opportunity to directly approach company management and address what they believe are resolvable issues which are suppressing their investments’ share prices. Such issues can include excess cash held on balance sheets, inefficient corporate structures, or poor shareholder alignment.”

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He adds that each company the trust invests in is also a high-quality business in itself, so a successful engagement campaign can lead to substantial increases in shareholder value.

Johnson says that RIT Capital Partners Ord (LSE:RCP), which is the investment vehicle for the family interests of Jacob Rothschild, gives investors access to two hard to come by things from tracker funds: unlisted investments and truly diversified capital growth.

He points out: “Both of these factors are linked to the notion that investment trusts do not need to sell their underlying holdings, allowing them to hold assets which are impossible to liquidate daily, and thus cannot be held by open-ended funds (be they tracker or otherwise).

“Private equity strategies are the poster child for this and given RCP’s 40% allocation to private investments it too is an example of the potential of unlisted assets."

Johnson notes its exposure to private equity means that RIT Capital Partners offers greater diversification than a multi-asset tracker that just holds a mixture of shares and bonds.

He adds: “This diversification advantage has led RCP to have low historic volatility and beta to global equities, which may make it particularly attractive to cautious investors.”

His final active fund ideas is Herald Ord (LSE:HRI), which owns small companies from across the world.

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“With its small-cap focus, this is an excellent example of the kind of investments that are better held within a closed-ended structure, rather than say open-ended funds or ETFs,” Johnson said.

He argues that by not having to worry about the need for daily liquidity, the manager is able to pick up the most illiquid of small-caps, capturing the most under-researched areas of the small-cap universe that the majority of open-ended funds and ETFs are unable to fish in.

“For example, when open-ended funds, be they trackers or actively managed, are required to be forced sellers of small-cap companies, strategies like HRI can fulfil such trade requests and pick up companies at uniquely depressed prices,” Johnson said.

At a 16% discount, Johnson argues that HRI also offers investors a more aggressive way to potentially play the tech rebound.

Open-ended fund ideas

It’s not just investment trusts that offer investors something that tracker funds cannot. Highly concentrated open-ended funds also give access to parts of the stock market, while maintaining a degree of sector diversification that ETFs do not.

ETFs can be concentrated, but these trackers are generally not diversified. For example, the SPDR MSCI Europe Technology ETF, which owns European tech stocks, has just 21 positions, but all are tech stocks and therefore the ETF is very volatile. Tracker funds picking other niche themes, such as artificial intelligence or clean water, can also be concentrated funds, without being diversified.

On the other hand, active managers can build portfolios of around 30 shares while maintaining a balance of investment sectors. This means that they have a good chance of consistently outperforming the market if they pick the right stocks, while also being less volatile than some tracker funds.

Two concentrated portfolios on interactive investor’s Super 60 investment ideas list are Lindsell Train UK Equity, managed by Nick Train, and Fundsmith Equity, managed by Terry Smith. The duo own just 21 and 26 shares respectively, across a range of sectors including technology, consumer staples and luxury goods.

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While such funds may underperform their benchmarks over certain periods, they do offer something different than an ETF and the managers have proven that they can outperform over long periods.

Since launch in 2010, Fundsmith Equity has delivered 525% total returns compared with 289% for the MSCI World index.

Lindsell Train UK Equity is up 422% since 2006 compared with the 151% return for the FTSE All-Share index.

This shows that human judgement when picking “quality” shares, as Train and Smith do, can give investors something that a passive fund cannot.