David Stevenson’s recent article on the rise of ‘active’ exchange-traded funds (ETFs) has stirred debate about the future of investment trusts. Proponents argue this evolution unites the strengths of active management with the strengths of passive ETFs, offering investors some of the benefits of investment trusts, but at a potentially lower cost and most importantly with no discount risk.

For a small number of strategies, this may indeed be the case. However, for the majority of strategies run within investment trusts currently, this oversimplifies things and, in our view, ultimately misses the mark.  

Active ETFs can certainly play a useful role for investors: providing lower-cost access to highly liquid investment strategies, with no discount risk, and certain tax advantages, particularly in the US. But ultimately, investment trusts offer advantages that active ETFs simply can’t replicate. They have endured since 1868, weathering financial crises, wars and economic shifts.

If the managers of a trust employ some of the unique features outlined below to deliver their strategy, it’s hard to see how the structure could be replaced, or improved on, by an active ETF. At times the risk (or reality) of a discount widening is frustrating. However, over the long term, the unique features of investment trusts remain valuable, and time-tested from the perspective of investors and managers alike.   

The more sensible view is to consider both trusts and active ETFs as complementary structures, rather than standalone solutions – both offering different advantages. Ultimately, we believe it is incontrovertible that the unique structure and distinctive qualities of investment trusts allow them to stand above the parapet in their ability to enhance diversification, smooth dividend streams and support long-term returns.

What do trusts bring?

The closed-ended structure of investment trusts allows portfolio managers to invest with a long-term view, free from the pressure of forced liquidation of assets during market downturns, or meeting routine day-to-day redemptions. This stability has helped trusts endure. Even when structural demand for a trust drops – usually the case for smaller trusts or those in more niche sectors – the presence of an independent board means consolidation can occur, creating larger entities with improved liquidity, reduced costs and broader investor appeal.

Another distinct advantage is gearing, which is not permitted within open-ended funds or ETFs. This enables managers to borrow capital to potentially enhance returns during favourable market conditions. Long-term, low-cost gearing can also serve a purpose in boosting income. The downside of course is that gearing can amplify losses in down markets. Gearing is not one size fits all.

There are many diverse strategies for gearing employed across the trust sector, including the likes of Fidelity Emerging Markets (FEML ) which employs effective gearing through derivatives to take long and short positions which express their views on a company or market.

Trusts are also celebrated for income consistency – a feature hard to match in open-ended funds or active ETFs. Being able to set aside up to 15% of each year’s income in a reserve, trusts can offer investors a much smoother dividend trajectory, a feature much appreciated during turbulent market conditions, such as those we saw in 2020. City of London (CTY ) for example, boasts a 58-year record of consecutive dividend increases, exemplifying the potential for trusts to provide investors with a stable and consistent income. 

Finally, each trust is backed by an independent board accountable to shareholders, providing oversight to ensure managers and trusts continue to meet objectives. Boards can replace managers if necessary and negotiate fees, aligning managers’ interests with that of investors. Open-ended funds, including active ETFs, benefit from an active manager but they generally lack the added oversight, protection and focus on shareholder interests that an independent board brings.

The benefits of an active ETF

Active ETFs represent an evolution of the traditional passive ETF, aiming to outperform an index rather than simply track it. In our view, as long as the underlying investment strategy suits the wrapper, active ETFs can validly add a new dimension to an investor’s portfolio.

Compared with investment trusts, active ETFs are generally more liquid, owing to the creation and redemption mechanism, and may be lower cost. In the ETF world, designated brokers (or market makers) are provided with daily updates on an active ETF’s underlying portfolio. This enables them to provide narrow dealing spreads for those who wish to buy or sell units, and assuming the underlying portfolio is highly liquid, in almost any volume. Discount risk is therefore eliminated.

Active ETFs also typically have a fixed ongoing charge, which can give investors reassurance and predictability, especially when the ETF’s assets under management are relatively small.

Looking forward, certain strategies currently using an investment trust structure might adapt well to an ETF structure, potentially forming rollover vehicles that could eliminate discount risk altogether.

That said, while active ETFs quickly gained traction in the US, largely due to favourable tax implications and transparency rules, uptake in Europe has not been as fast.

Firstly, the tax advantages in Europe aren’t as compelling. Secondly, many European regulations require ETFs to publish full portfolio holdings daily, meaning a level of transparency that can deter some managers fearing others could replicate their portfolios, losing the impact of their secret sauce.

However, we understand that the Central Bank of Ireland, which regulates most of Europe’s ETFs, is reviewing these rules and if changes similar to the US materialise, it could trigger greater uptake across Europe.

Striking a balance 

Overall, we believe both active ETFs and investment trusts hold the potential to add value in an investor’s portfolio. However, while active ETFs may appeal strongly to certain investors due to their liquidity, transparency and cost advantages, investment trusts ultimately provide distinct benefits that are hard to match.

Trusts have long distinguished themselves as vehicles built to navigate the market’s ebbs and flows, often providing investors with exposures and return profiles that differ significantly from open-ended funds.

Despite challenges in recent years – such as persistent discounts – their distinctive qualities remain important features for investors of all types. In our view, the rise of active ETFs is unlikely to diminish the relevance of investment trusts, most especially those that use the unique tools at their disposal for the benefit of investors.

Josef Licsauer is an investment trust research analyst at Kepler Partners.

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