Three ways trusts are trying to lose ‘City’s best-kept secret’ tag

Investment trusts have historically been less popular than funds. We explain why and outline how boards are broadening their appeal to private investors.  

Investment trusts have a reputation for being the City’s best-kept secret, reflecting the fact that over the long term they typically outperform funds but historically have been less popular.

There are three main reasons why the value of fund sales vastly outstrips investment trust purchases. First, prior to a rule change in 2013 financial advisers received commission for fund sales but not for selling investment trusts. Second, there is a perception that investment trusts are more complex and difficult to understand. And finally, the investment trust universe is much smaller than funds, with only around 400 investment trusts versus more than 3,000 funds.

In recent years, though, helped by the banning of commission on fund sales, investment trusts have seen a notable uptick in demand. According to the Association of Investment Companies (AIC), at the end of June industry assets amounted to £201.7 billion, a new all-time high. Seven years ago, the sector’s assets were £100 billion.

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While investment trusts have formed the bedrock of many private investor portfolios for decades, various investment trust boards are consciously trying to broaden their appeal by attracting new investors.

Here are three key ways in which the boards of investment trusts have been working to reach a wider audience.

Boards being more proactive

The investment trust industry has faced criticism from various investment trust commentators and analysts over the years for having too many small, sub-standard trusts with assets worth £100 million or less.

This is starting to change, with boards becoming increasingly proactive, whether by replacing an underperforming fund manager or fund management group, changing the trust’s strategy to broaden its appeal, or winding up the trust altogether.

Analyst Winterflood notes that there are 88 trusts with a market capitalisation of less than £100 million and most trade on discounts of 10% plus, but that “the process of rationalisation across the sector is gaining momentum”. It adds: “Different factors may be at play, but some of the themes are more proactive boards preparing to seek out and listen to shareholder feedback and also long-term shareholders who are prepared to be more critical.”

Rival analyst Numis agrees that it is “likely that the number of wind-ups and reconstructions increases in coming years as investors again reassess the relevance of mandates following a significant economic shock caused by Covid-19”.

But Numis also cautions: “There have been numerous examples of funds continuing when a more obvious route would have been winding-up, but boards appear reluctant to be ‘turkeys voting for Christmas’ in voting themselves out of a job.”

Five high-profile management changes over the past year have taken place at Edinburgh Investment Trust (LSE: EDIN), where management moved from Invesco to Majedie; Baillie Gifford European Growth Trust (LSE: BGEU), which moved from Edinburgh Partners to Baillie Gifford; Baillie Gifford UK Growth (LSE:BGUK) which dropped Schroders for Baillie Gifford; Woodford Patient Capital, which was renamed Schroder UK Public Private (LSE:SUPP) and is now run by Schroders; and Jupiter UK Growth (LSE: JUKG), where fund manager Steve Davies was replaced by Richard Buxton following Jupiter’s takeover of Merian Global Investors.

In addition, at the end July a rare merger was announced, with the board of Mark Barnett’s former Perpetual Income and Growth trust opting to merge the company with the Murray Income Trust (LSE:MYI). 

More often than not, a change in management group leads to a change in strategy in order to improve performance, which in theory leads to greater levels of investor interest.

The board of Witan Pacific (LSE: WPC), for example, proposed to shareholders in mid-July that Baillie Gifford should take over management of the investment trust and invest solely in China stocks. This would result in a big shake-up, as Witan Pacific currently invests across the whole of Asia.

Susan Platts-Martin, chair of Witan Pacific, says the shift in focus to China should help performance. In the proposal she notes: “The board believes that China provides a compelling investment opportunity that is currently underrepresented in global portfolios. China's domestic stock market and economy have grown to become the second largest in the world and we believe that China will be one of the most important markets of the next decade.”

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Eliminating wide discounts to boost share price performance

One of the attractions of an investment trust is the opportunity to pick up a bargain, when there is a mismatch between the value of the underlying assets held by the trust and the value of its share price.

But care needs to be taken, as discounts can widen further rather than narrow, which negatively impacts returns. Some trusts, particularly those that hold only a small value of assets, persistently trade on a wide discount of 10%-plus due to a lack of investor demand for the shares.

To boost demand for a trust’s shares and in turn improve its liquidity, boards have a few options: they can issue or buy back their own shares to reduce the discount, or alternatively remove discount risk entirely by putting what is known as a “discount control mechanism” in place. Those trusts with a discount control mechanism commit to keeping the discount within a certain range, typically anywhere from a zero discount to -10%.

In theory, a discount control mechanism makes a small trust more appealing, as discount volatility risk is removed. In other words, investors know they are buying a trust that is not likely to persistently trade on a wide discount, and that the discount is likely to reduce rather than increase if it does drift to a notable discount.

Peter Spiller, manager of the Capital Gearing investment trust (LSE: CGT), which as part of its portfolio invests in the shares of other investment trusts, explains: “The great advantage is that, if properly implemented, [a discount control mechanism] transforms the liquidity of investment trusts as well as removing discount risk. It does so while maintaining the advantages that investment trusts have over open-ended funds, namely independent boards and the power to gear modestly.

“Another key plus is that it allows even a small trust the chance to grow to a relevant size. Of course, if shareholders do not rate the manager, it can also shrink. However, if the starting position is an investment trust that shareholders no longer value then shrinking and ultimately restructuring is the best path forward.”

At the start of 2020, Winterflood estimated that 62 trusts have explicit discount controls in place, up from 51 trusts three years ago.

Cutting charges

Another trend that has been playing out over the past couple of years to help widen the appeal of investment trusts is the reduction of annual management fees.

In the first half of 2020, a total of 18 investment companies cut charges, whether by simply reducing their yearly fee, dropping their performance fee or introducing a tiered fee structure.

Under a tiered fee structure, which various high-profile trusts have moved to over the past couple of years, the annual charge reduces as the trust’s assets grow. As a result, economies of scale can be passed back to investors.

Notable names that have made this change since 2017 include Scottish Mortgage (LSE: SMT), Lowland (LSE: LWI) and Templeton Emerging Markets (LSE:TEM). Boards that have made the move in the first half of 2020 include Aberdeen Asian Income (LSE: AAIF), Edinburgh Investment Trust and European Opportunities (JEO).

In 2017, a total of 36 investment trust companies made changes to their management fee arrangements, while a further 43 made tweaks in 2018.

When it comes to open-ended funds, most fund management firms toe the line and quote an ongoing charges figure (which does not include transaction costs) of around 0.8% to 1%. Some charge slightly less, others a bit more, but in general there is a serious lack of competition on the charges front. Although, a positive recent trend has been some fund managers reducing charges on some funds in response to regulatory pressure.

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