The low cost, transparency and liquidity of ETFs with the outperformance potential of an actively managed strategy, has led to a surge in their popularity amongst investors, leading some to realise the uncomfortable reality that the traditional investment trust model is under severe pressure from structural changes in the market.

Changing Landscape

Investment trusts once served a clear purpose. They provided access to illiquid markets, allowed patient capital deployment without redemption pressures, and offered a closed-end structure that made sense when macro-economic developments caused market volatility and could trigger devastating outflows from open-ended funds. But the competitive environment has fundamentally shifted.

The emergence of low-cost ETFs has altered the calculus dramatically. An investor can now buy broad beta for roughly 25 basis points, compared to 100 basis points or more for actively managed trusts. When a traditional trust runs 60-plus holdings, it essentially offers actively managed beta and beta can be bought far more cheaply elsewhere.

The mathematics are stark. A diversified portfolio might outperform by 50 to 100 basis points annually, but after fees, the net value proposition becomes questionable. Investors can achieve similar exposure through passive products with dramatically lower costs and perfect liquidity.

High conviction

This reality is forcing a fundamental reconceptualisation across the industry. Investment trusts that want to remain relevant are moving aggressively toward high conviction portfolios typically 30 to 40 names or fewer. This isn’t a marginal adjustment; it represents a complete rethinking of what active management means.

High conviction portfolios create genuine differentiation from passive alternatives, but they cut both ways. A concentrated portfolio that makes correct calls can significantly outperform. But mistakes show up clearly in returns.

There’s no hiding in a 70-name portfolio anymore. Every position matters, and this level of accountability, while uncomfortable, is what the market demands from active managers.

Structural Advantages and Disadvantages

The closed-end structure does provide one genuine advantage: trusts aren’t forced sellers during market stress. When market volatility spikes and sentiment turns negative, open-ended funds face redemptions that force managers to sell their best ideas at the worst prices. A trust structure can maintain conviction and wait for markets to stabilise.

This matters particularly with certain markets, like emerging markets, which are inherently cyclical and prone to sentiment-driven volatility. Being able to look through volatile periods without forced selling has value, though not enough to justify the structure alone.

However, this advantage comes with a significant cost: discounts to net asset value (NAV). When sentiment sours, the share price can trade significantly below underlying asset value.

This creates a dual-layer problem not only does the NAV need to perform, but the discount needs to narrow for share price returns to match. Open-ended funds don’t face this issue.

Specialisation as differentiation

Even within the investment trust universe, specialisation matters. Investment trusts with a broader universe compete primarily on manager skill and track record, directly competing with ETFs.

More focused sector trusts – whether on specific markets, regions or countries – compete on offering expertise and access that passive products don’t provide.

This creates a natural hierarchy. The more specialised and niche the focus, the stronger the case for the trust structure, assuming the manager delivers the promised expertise.

The broader and more benchmark-like the approach, the harder it becomes to justify the structure and fees against passive alternatives.

Future

For investment trusts to remain relevant in, several shifts are necessary:

• High conviction is mandatory. Investors can get diversified exposure cheaply elsewhere. Active managers must demonstrate genuine differentiation through concentrated positions in their highest-conviction ideas.

• Focus on absolute returns. While boards and managers discuss benchmarks, investors care whether their capital is growing. Patient capital deployment through volatility only matters if that patience translates into positive outcomes.

• Genuine specialisation. Whether regional focus, sector expertise, or a particular investment approach, trusts need something that justifies their existence beyond active management. That specialisation must be deep enough that it cannot be easily replicated.

• Fee scrutiny. If the value proposition is genuine alpha from specialised expertise, fees need to be demonstrably worth paying versus passive alternatives. This might require performance-based structures, lower base fees, or creative approaches that align manager and investor interests.

To find out more about the Investment Trust sector, and the challenges it faces, check out the Missing Lever: A Blueprint Beyond Buybacks

Robbie Lawther and McKinley Sadler are Account Director and Account Manager at Quill PR.