Investment trusts have faced a lot of selling pressure in recent years, partly due to “opaque and misleading” cost disclosure regulation. That headwind was removed last week when the Financial Conduct Authority (FCA) exempted trusts from European rules.
The UK Regulator’s interpretation of the EU rules was making trusts look artificially more expensive by requiring them to publish costs as an ongoing charges figure. This is misleading because costs do not detract from share price performance as it does for open-ended funds, Gravis managing director William MacLeod explained.
“Costs were captured and paid by the company within the NAV [net asset value] and then published again,” he said.
“In the hands of the investor, a valuation statement coming from a wealth manager would show all of those charges as if they were being deducted from the value of the investor’s holding, which they are not.”
Unlike open-ended funds (where investors receive returns minus fees, which are deducted on an ongoing basis) after an investor purchases shares in an investment trust, there are no further charges.
In conversation with Trustnet, MacLeod proposed a new disclosure framework, the Statement of Operating Expenses, and explained how the previous regulation muddied the waters.
Can you explain the cost difference between investing in funds and trusts?
Let’s say today, you buy £1 worth of a trust that seemingly has an ongoing charges figure (OCF) of 1%. In 12 months’ time, if that share price hasn't moved, your share price is still £1 – the value hasn't changed. Whereas if you bought a unit trust today for £1 and there was a 1% charge, in 12 months’ time (if performance was flat), it would be worth £0.99 because 1% would have been removed from its value as a charge to the investor.
This was our contention – we had no problem at all with going an extra mile to talk about the company expenses, but let's not present it in such a way that it looks like it's a detractor from the value of the investor’s holding.
What other problems did this cause?
If investors only make decisions based upon cost, which they often do (a bit myopically), and something looks synthetically expensive, they may well avoid it and miss out on the returns they were hoping to achieve.
Not only did trusts look more expensive themselves, but other strategies with trusts in their portfolios, such as funds-of-funds or model portfolios, also appeared to be more expensive.
The authorised corporate directors of those portfolios have been grabbing the ongoing charges from investment companies, calculating them pro-rata, and then adding them to an Excel spreadsheet called the European MiFID template (EMT). Therefore their own funds had this additional synthetic charge.
Practically, how large were the synthetic costs added to trusts?
At Gravis, we have a UK Infrastructure Income fund that invests in the UK-listed infrastructure sector through investment trusts and listed companies.
There are two share classes, both of which are capped, so no investor pays more than 0.75% or 0.65%. However, the published figure for those two share classes has been 1.62% and 1.52% – an extreme difference.
What happens now after the FCA exemption?
Investment companies no longer have to publish an ongoing charge or the reduction in yield calculation in their key information documents (KIDs), so the cost of owning an investment company will be a blank figure – effectively zero.
Once all those trusts put a blank in their KIDs, their portfolio costs will drop to the accurate figure rather than the synthetic figure.
My expectation is that it will probably take until the end of October for everyone to update their materials, for the zero to penetrate the system and for that then to be reflected on what's published elsewhere.
The database for costs, the EMT, is updated monthly, so to may take a few weeks to be cleansed.
What legislation will apply then?
Following the announcement made on Thursday last week, investment companies will fall within the UK retail disclosure framework for consumer composite investments (CCI), whereas industry participants have been calling for the exclusion of investment companies from CCI.
The issue with CCI is that it is premised on what is returnable to the investor in the event of wind up. If you have an investment company, nothing is necessarily returnable because it's a company – you get back whatever can be salvaged from the decline of that business.
We must be very sure that in the excitement of the news on Thursday, we aren't just rolling on our backs and having our tummies tickled. There's a lot at stake here and we must ensure that we don't slip back into a regime where we are required to disclose costs which aren't actually applied to the investor.
What is your proposal for showing costs and what information would you include?
The proposal we came up with is a document which is easy to understand called the Statement of Operating Expenses or SOE.
As an investor, I want to know at a glance that the board is being paid an appropriate sum of money to manage the operations of that company. I also want to know that a renewable energy company doesn't have a private jet – that would also appear in the SOE.
The regulation that we've just come out of was completely opaque and utterly misleading, and what we're hoping to do is to have something which is completely transparent and totally clear for everybody, be they really sophisticated investors or people who are just saving for their long-term future.
Might some sectors benefit more than others from this change?
Yes, renewables and infrastructure companies will benefit, and listed companies will benefit too. That’s because, given a bit of time and settling as people absorb the effects of this, they should be able to raise additional capital.
When investment companies are trading at a discount, it's impossible to convince investors to buy shares that are more expensive than their value. When trading at a premium to NAV, you can offer shares to new investors or existing investors in the gap between the NAV and the price, which is a good way to raise capital.
The hope and expectation is that with base rates coming down, the macro environment improving and a true cost being published, investment trusts should return back to par, and hopefully beyond that up to a premium. At that point, they can start capital raising from the wider market.
That means that they can raise capital to deploy into areas such as renewables and infrastructure that the government would like to see further investment going into – and it comes at zero cost to the government.