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Is RDR killing the investment trust?

Some managers warn that policies intended to make investment trusts more retail-friendly could work against the interests of private investors.

Thomas McMahon

By Thomas McMahon, News Editor, FE Trustnet
Tuesday March 18, 2014

The boards of investment trusts are in danger of destroying one of the greatest advantages of the products in the bid to make them retail-friendly, according to FE Alpha Manager James Henderson.

Many trusts have implemented discount control mechanisms to keep their share prices trading around NAV, which usually involves buying back shares when their price falls too far from the value of the portfolio’s assets, usually as a way of placating major shareholders.

Henderson (pictured) says that this is the wrong way to go. By buying back their own shares with their cash the boards of investment trusts are denying themselves the chance to back their best ideas and limiting future returns, he warns.

ALT_TAG “Some people in the investment trust industry are going the wrong way [by implementing discount control mechanisms] because it gives away your freedom to buy things when you think they are cheap,” he said. “You have to buy back and can’t get on the front foot.”

“With investment trusts people have to put up with this swing between discounts and premiums but you have to make it count.”

Monica Tepes, investment trust analyst at Cantor Fitzgerald, says Henderson has a point.

“The rationale for buying back shares from an investment perspective is that you can say if you have a good portfolio at NAV if you buy back shares it’s equivalent to buying your portfolio on a 10 per cent discount.”

“But you might not want to buy back your portfolio – there might be some stocks you hold that are more attractive than the portfolio as a whole.”

Narrowing discounts is one of the features that allows investment trusts to outperform over the longer term. By removing this factor from play boards risk limiting the advantages it can bring to investors.

Another factor in their outperformance is that unlike open-ended funds, trusts don’t have to sell their stock when investors want to sell down their position, meaning they are immune from the need to sell their best ideas at a time and a price they don’t like.

By committing to buying back stock boards are limiting the manager’s freedom in this regard to ignore market sentiment and buy what they want at the prices they find attractive.

Henderson says that his freedom to invests his cash in the market rather than use it to buy back shares is one of the reasons the Henderson Opportunities Trust has done so well in the five-year rising market.

The fund is up 443.79 per cent over five years as the sector is up 155.34 per cent and the FTSE All Share 120.84 per cent.

Performance of trust versus sector and index over 5yrs
ALT_TAG
Source: FE Analytics

“One of the reasons for my trusts having good period was I was able to buy recovery situations, knowing no money was going to go out,” he said.

“Where the real value was was in companies people said were selling out of illogically, people were scared of, particularly smaller companies.”

Henderson says that Senior is a good example of an unloved stock he bought in the depths of the 2009 crisis.

Data from FE Analytics shows that the stock is up by more than nine times since March 2009, way ahead even of the FTSE 250 which has tripled in value.

Performance of stock versus index over 5yrs
ALT_TAG
Source: FE Analytics

“We bought Senior when it hit 60p, it fell to 40p and we bought more, it fell to 25p but it’s £2.90 now and our largest position,” he said.

RWS is another stock that the manager bought in the market trough and has paid back his faith handsomely: the stock is up 314 per cent over five years.

Henderson’s co-manager Colin Hughes said: “It was completely clattered. It was entirely inappropriate for that business to be significantly de-rated during that period.”

Tepes says that buybacks are often ineffective anyway, and when a trust is on a discount because of underperformance a board and the manager should focus on turning around NAV performance rather than buying back.

“When a trust is on a discount there’s a reason,” she said. “If the sector is out of favour it won’t do anything.”

The danger is that the trusts are reducing the differences between them and their open-ended peers, Tepes agrees.

By limiting the effects of discount movement boards could be effectively working against the interests of long-term private shareholders, it could be argued.

The impetus behind buybacks comes largely from institutional shareholders such as wealth managers, which are taking greater notice of investment trusts after the retail distribution review.

“Share buybacks are suggested by the largest shareholders who want to sell their shares and are shorter term shareholders,” Tepes said.

“When you have investors going in to see you all the time asking will you be narrowing the discounts you won’t say you are doing what is good for your investors whether they want it or not,” she said. “Often the managers and the boards will only meet with the largest shareholders. It’s not easy to access the smaller investors and find out what each one thinks.”

Similarly, wealth managers are behind much of the impetus to remove performance fees from investment trusts, which some managers suggest could also harm the interests of small shareholders.

Performance fees offer managers a significant incentive to outperform and ensure that they are paid less if they achieve worse results. A number of managers have told FE Trustnet in recent months that they would personally much prefer to buy funds with performance fees and lower standard charges.

Some say they believe that there is an inevitable psychological bias towards favouring a fund with a performance fee for managers who run a whole suite of funds.

However, recent polling evidence suggests that wealth managers are pressuring boards to remove these fees in favour of fixed ongoing charges.

A recent FE Trustnet poll suggested that the private shareholders who read Trustnet are more well-disposed to performance fees, with a majority saying they preferred them coupled with lower standard charges.

Ultimately, by shifting to standard charges in line with their open-ended peers and limiting discount movements trusts could be removing their key distinguishing features which give them their advantages.

Nick Greenwood, manager of the Miton Worldwide Growth fund, says that the consolidation in the wealth management industry is also having an effect on the market.

Greenwood says that the minimum size that investment trusts need to be for many of these institutional investors is growing, now up to £200m from £100m already, thanks to the large number of funds they are investing at the same time.

This could potentially lead to a situation where the smaller trusts retain more of the flavour of the traditional investment trusts and display more of their differentiating characteristics, while the larger, more liquid trusts become less distinguishable from their open-ended cousins and offer less of the outperformance potential.


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EJohn Mar 21st, 2014 at 04:55 PM

As a small investor, I play the discount narrowing game, so am not keen on share buy backs which reduces my scope to make returns, so I do agree with James Henderson on this.

On performance fees, it is a question of how they are set up and what the incentive is. One of Henderson Managers trusts has (had?, I have not checked recently) a performance fee paid on exceeding Libor. With Libor so much lower than inflation that is ridiculous.

In many industries performance fees don't change the decisions taken, but I do beleive it right that if those are good decisions the manager should share in the success if they have a particularly good set of years. This means performance bars should be set reasonably high and judged over a period of years. They should certainly be well in excess of maintaining the capital value of the investment.

Reply
Nicholas Mar 19th, 2014 at 06:39 PM

Share buy-backs are in the same league as share support schemes. At best it distorts the market. Money spent this way is potentially of no benefit to the shareholders if markets fall. Much better to use the money to develop the business.

Reply
Andy Mar 18th, 2014 at 05:51 PM

A really interesting article. I hold a variety of Investment Trusts and no open ended funds for all the usual reasons.
The very last thing I want is for them to mimic open ended funds.

Reply
Theo Mar 18th, 2014 at 05:10 PM

ITs paying performance fees charge a miniscule less for underperformance and hugely more for overperformance and Henderson is not fooling any one that it is "swings and roundabouts".

Furthermore, it is distasteful for a fund manager on a huge salary, to argue for even more, or he will not do his best. Has greed no limits?

Reply
Nigel Mar 18th, 2014 at 03:22 PM

Trusts that are buying back stock do so in the market. But I recon that there is more stock issued than bought back these days. There are plenty of announcements by trusts to that effect.

Reply
Mo Mar 18th, 2014 at 02:54 PM

Keeping discounts narrowed by buying back shares is extremely annoying. I want to be able to make my choice among trusts on the basis of their investment performance. As a shareholder in the trust I want to make the decision about when it is expensive or cheap - I do not want the Board to play this game, as it simply reduces my own options!

Reply
poulter Mar 18th, 2014 at 01:41 PM

I think it depends on the trust. For large trusts that seek to preserve wealth (eg Personal Assets) discount control makes sense. But for others it may be counterproductive as the article suggests.

Reply
John gallagher Mar 18th, 2014 at 11:33 AM

As an investor i am seeking risk and reward opportunities, so trading discount and permiums are a key part of judging investor sentiment.

Lets not try anf fix something that isn't broken as far as i am concerned.

Reply
Ned Ludd Mar 18th, 2014 at 11:33 AM

Buybacks are also now useless for small shareholders holding investment trusts through Hargreaves Lansdown, which charges £10 for every corporate event. If the trust pays a dividend, I get all of it; if it pays a buyback, I end up handing a quite significant proportion to HL.

Reply
SteveB Mar 18th, 2014 at 02:28 PM

Why would someone have to pay Hargreaves Lansdown £10 if they buy back their own shares. As far as I am aware that would not be a corporate action for any IT shares held in a HL account by an individual investor

Reply
Mo Mar 18th, 2014 at 02:58 PM

Ned, you are mixing up things which are similar but not the same. Most investment trust buybacks are authorised within limits at the AGM, and therefore do not require any further shareholder approval when they happen. Therefore they take place without any explicit cost to individual shareholders.

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