Observing Evolution

This is the text of my keynote address to the Portfolio Adviser Expert Investor conference on Investment Trusts in June.

My thesis today is that a number of environmental forces in the investment trust sector are combining (some might say finally combining) to produce a change of attitudes in the boardrooms of the investment trust industry. However, this change is not yet widespread, nor has it been particularly rapid, nor is it well-established. We can say that we are seeing change but it is change of an evolutionary nature rather than a revolutionary nature. Hence my title – “Observing Evolution”.

I will first look at the catalysts that are forcing this evolution, second note the evidence of the change that is occurring and finally consider where and how rapidly the industry will evolve, in the light of this.
First, the catalysts.

I observe three in recent years – RDR; the recent changes in pensions regulation; and the market’s response to activist investors.
RDR brought with it the requirement that independent, retail investment advice should be based on a “whole of market” analysis of suitable investment products. This opened the door for investment trusts to get into the minds and investment processes of retail advisers offering independent advice. For most of them, who had historically only considered open-end funds, this was a new requirement. In general across the sectors, investment trusts stack up well against open-end funds and there has been some incremental demand from retail advisers for investment trusts, arising from this development. However the retail investment platforms were not well prepared for this change and were either very slow or have not yet been able to incorporate into their systems the ability to deal in real time in listed securities. This difficulty in accessing and trading listed securities is still an issue for many advisers, that has hampered progress.

RDR has meant that the bias of advisers to open-end funds that paid them commission over closed-end funds that did not has disappeared. It has brought transparency and the “whole of market” requirement has meant that advisers now need an answer to the question “why are you recommending Fidelity European to me rather than Fidelity European Values, when the latter has performed better?”

What RDR did achieve though, was to create a wake-up call to Investment Trust boards, and indeed asset managers more broadly, that they were missing an important source of potential new investors, and an opportunity to demonstrate relevance in the marketplace in the post-RDR world. RDR planted the seeds for a new strategic direction for boards seeking to attract investors and build their shareholder base.
Second, the changes to the UK pension regime that were announced fifteen months ago. The abolition of the requirement to purchase an annuity has, at a stroke, created huge demand for a new type of retail investment product in the UK – decumulation products are now desired in contrast to the industry’s previous heavy reliance on accumulation products. The announcement in 2014’s budget was a surprise to almost everyone and again provides an opportunity for both investment trusts and open-end funds alike to create new products to meet this new demand. In particular the very long term unbroken record of some investment trusts in not only paying dividends, but also paying increasing dividends each year, could have strong marketing appeal to decumulation investors. However this is only a catalyst, it requires board level dynamism for it to lead to change.

The final catalyst has been the return of the activist investor to the investment trust sector. The general trend, fuelled by QE, toward tighter discounts in recent years may have argued for less of this than in previous cycles, but activist pressures in this cycle have occurred at lower levels of discount than previously. A tendency too for greater concentrations of shareholder registers by the wealth management community in the larger trusts is also leading for greater pressure from these mainstream investors for boards to be seen to be taking action.

Electra Private Equity and Alliance Trust have been the clearest examples of activist pressure over the last eighteen months, and, given their size and status within the industry, should have shown to most boards that almost any trust can be vulnerable to such pressures, and that trust directors can quickly come under the public spotlight.

These then are, I believe, the key forces in the investment trust landscape that are creating boardroom discussions and shaping changes in the sector.
So what evolutionary change in the investment trust sector is visible today?

I believe evidence of change can be seen in fee levels, in mandate changes and the approach to dividends, in the type of funds being launched and finally in board dynamism.

Perhaps the most obvious is in the realm of management fees. Over the last eighteen months 80 investment trusts have reduced their fees, either by scrapping performance-related fees, reducing their base fees or capping costs – in 2015 alone six investment trusts have announced the scrapping of performance fees. This can be attributed largely to RDR, but also to Morningstar’s influence in discussing and highlighting the need for greater simplicity in fee structures.

Before RDR retail investors in open-end funds typically paid an AMC of 150bp of which 50bp went to the adviser and 25bp to the platform. It was not hard for investment trusts to appear to be good value at those prices. However the new world transparency ushered in by the FCA’s changes to the industry has typically reduced the AMC to the 75bp which the asset management company earned previously; that same charge has made investment trusts appear relatively expensive. The price advantage held by investment trusts was eliminated almost overnight. This has certainly stiffened the backs and boosted the negotiating power of trust boards in their discussions with asset managers.

The launch of Woodford Patient Capital Trust was unusual in two regards, the first was in its eponymous nature – there are very few modern-day trusts with an individual’s name within the name of the trust, and the second was its zero AMC structure (though with relatively high administration charges but a not unreasonable performance fee structure).

The changes wrought by the board at British Assets Trust were also stark. They took the opportunity of a sluggish long-term record and the new demand for decumulation products to re-engineer their investment objectives and approach, for the deregulated pensions world. A multi-asset approach aimed at reducing portfolio volatility (a key requirement for decumulation products) and a focus on maintaining a 5% dividend yield. The previous traditional, equity-focussed manager was given his marching orders at fairly short notice and, following shareholder approval, BlackRock were appointed to manage a completely new mandate.

The discretion that boards have in the payment of dividends, greatly enhanced recently by the ability to pay dividends from capital reserves as well as income reserves has also been seen as a potential advantage in an income-seeking decumulating world. Open-end funds do not have the ability to manage or smooth their income payments to investors, and long track records of ever-increasing income payments can weigh heavily in the minds of investors seeking sustainable investment income. The move by some trusts to the payment of dividends each month, though not an advantage over open-end funds, is a further example of the flexibility that boards are showing in their efforts to appeal to investors.

New fund launches have generally come from one or both of two themes. The first theme has been income and the second theme has been investment into rather illiquid asset classes, both alternative assets and micro-cap equities. These both play to the inherent strengths of investment trusts and demonstrate some strategic thought going into the mandates for new trust launches. The clear trend toward multi-asset investing should in theory be of benefit to investment trusts – since the structure allows for efficient investment into illiquid assets such as infrastructure, alternative energy plays and loan investments – both traditional and alternative forms – such as peer-to-peer and speciality lending, bringing the benefits of greater diversification into investors’ portfolios.

I think it is becoming more evident that boards are responding to shareholders’ desires for greater board involvement in their trusts.

Certainly the boards at Electra and Alliance Trust have been kept very busy. I think it can be said that both have sought out the views of their shareholders in response to the activities of Messrs. Bramson and Elliott respectively and have sought to reflect those opinions in their decisions. With Electra, Bramson has not really made clear where and why he believes that better performance or a better approach can be generated, and the board have reflected shareholder views that not much needs to change. In contrast, at Alliance Trust, it appears that the consultation with shareholders following the attempt by Elliott to add directors to the board, told the board that shareholders were not happy and that there was a degree of support for Elliott’s stance that major changes should be considered.

Elsewhere, the Monks and the Fidelity Asian Values boards have also been seen to be on the front foot with their decisions to change managers, though in both cases they stayed with managers from the same house rather than take the bolder and possibly more costly decision to move the trust to an entirely new asset manager. The AIC noted this week that 18% of investment companies had changed a manager in the last 18 months.

I have sought to demonstrate that within the investment trust world, the changes we have seen over the last few years are meaningful – they have already affected a good number of trusts and the direction of travel is, I believe, very clear. Boards are noting the changes in the external landscape, they are assessing their own relevance within the investment industry and they are seeking to adapt to these new pressures. This is both necessary and healthy for the sector.

Based on these trends, my expectation is that, in the next few years, we will see:

  • Pressure for change in underperforming general UK and global equity trusts, either from activists, or from shareholders or from the boards themselves. This may finally mean some mergers in order to reach critical mass.
  • More emphasis on income and a steady stream of dividend payments as a solution for investors post pension deregulation.
  • Mandates becoming more multi-asset focussed to produce less volatile performance
  • New launches focussed on income streams from alternative assets.
  • Continued downward pressure on fee structures – boards should see themselves as a very large institutional client of the asset manager, and negotiate fees on that basis, in which case there is still a fair way for fees to fall. In the low return world that we all now expect, cost is the only certainty and it has negative alpha!