Closed-end funds, also known as investment trusts, are not common in Asia, with the exception of real estate investment trusts (REITs). Such vehicles, however, have a long history in the UK and the US, providing access to asset classes other than real estate.
Andrew Lister, London-based head of closed end fund strategies at Aberdeen Standard Investments, is responsible for the firm’s multi-manager (fund-of-funds) products investing in listed closed-end funds.
Closed-end funds have a fixed number of units that trade only on a stock exchange. In the normal course of business, units are not created or redeemed (unlike open-ended mutual funds). In order to trade a unit, there must be a buyer and seller on each end so the number of units always remains the same.
Relieved of the pressure to provide daily liquidity through redemption of units, closed-end funds invest not only in stocks but in illiquid asset classes such as real estate, private equity, private debt or infrastructure, which would otherwise be unavailable to some investors.
Thus, listed equity and fixed income closed-ended funds offer liquidity for underlying illiquid investments. In Hong Kong, closed-end REITs are the only ones that have developed into a market of significant size.
Managing volatility
Since units cannot be redeemed, market sentiment often exerts additional pressure on them, leading to trading at a discount or a premium with respect to the net asset value of the fund. Despite some arbitrage activity, such discrepancies often persist and may provide additional opportunities for investors.
“Our approach is very contrarian,” Lister told FSA on a recent visit in Hong Kong. “If Chinese equities are seriously out of favour, then we typically get to buy a dollar’s worth of China equities for 80 cents.” As the factors that suppress the sentiment go away, the discount narrows, providing additional gain, on top of the movement in the underlying assets.
This, in a way, amplifies the market sentiment, as discounts widen when the underlying asset class is in disfavour and narrow (or become premiums) when the market is bullish on it.
Managing around such additional volatility, together with liquidity are the main challenges for closed-end fund managers.
Compared to an equivalent open-ended mutual fund, a closed-end product should deliver better performance, Lister argued. One reason is that the manager isn’t pressured to invest new cash when the fund is popular, unlike mutual fund managers who must do so. A mutual fund also must deal with redemptions at the moment when prices of underlying assets are under pressure.
Lister said closed-end funds avoid such problems, and their managers ride out the tough patches. “This is why a lot of these funds have been around for an extremely long time.” (The world’s oldest closed-end fund, the F&C Investment Trust, celebrated its 150th anniversary in March).
Without worrying about redemptions, managers of closed-ended funds “can go further down the liquidity and market cap spectrum” than traditional mutual funds, according to Lister, which should give them freedom to look for opportunities mutual funds may have missed.
Moreover, they can issue debt to leverage their returns. “It is not uncommon for a closed end fund to be 10% geared,” said Lister.
Lister’s team manages both open-ended and close-ended fund-of-fund strategies that invest in close-ended funds. Being multi-manager products, investment decisions for such products revolve around analysis of performance of the managers of the underlying funds.
Liquidity and fee drawbacks
However, liquidity is a risk. If there is no buyer or seller at each end, no units of a closed end fund can be traded.
Investors are also clamoring for lower fees and in fund of funds there are layers of fees. The first layer would be the underlying illiquid investments such as private equity funds. The next layer would be fees from the closed end funds that invest in them. Finally, there is an additional top layer of fees for the fund-of-funds product that represents them all.
Lister is the lead manager for the Aberdeen Emerging Markets Investments, a fund of closed-end funds. Its AUM is £392.0m ($548m). It is not registered for sale to investors in Hong Kong or Singapore, but available to professional or accredited investors in these markets.
Aberdeen Emerging Markets Investment Company Limited vs benchmark and category average.
