Investment trusts face no statutory limit on how much they can hold in a single stock, while open-ended funds are hamstrung by European UCITS rules carried over by the Financial Conduct Authority (FCA). Is this fair?
As we covered this week, active funds (and some passives) are only allowed to own companies within certain limits, under the so-called 5/10/40 rule.
Anna Macdonald, investment strategy director at Hargreaves Lansdown, said: “If the rules are here to promote diversification and to ensure that holders aren't too weighted into something, which I assume is the idea, there are no such rules in investment trusts.”
She noted that the FCA “is very happy for retail investors to buy” investment trusts with few restrictions but does not extend the same courtesy to open-ended UCITS funds.
Yesterday, Matt Tagliani, head of EMEA ETF product at Invesco, explained why he believes active funds have more punitive rules, with the freedom to invest in anything paired with restrictions on how much can be invested in any one particular stock.
He said that, although trusts are an area he “know less about”, they provide a “precedent for the argument of giving full flexibility [to funds too]”.
However, the argument that “trusts have full free rein and they've never had a problem” is unlikely to resonate with the regulator, as there are significant regulatory differences between the two and other reasons why they are st up that way.
Below, Trustnet looks at the key differences that allow investment trusts to operate differently, including their structure, and how the rules of companies’ law differ here from the FCA’s restrictions.
Different structures
UCITS funds are open-ended, meaning investors can withdraw their money at any time with the fund obliged to return their money. Conversely, investment trusts are closed-ended. They are listed on the London stock market and therefore to sell, investors must find a buyer for their shares.
Richard Stone, chief executive of the Association of Investment Companies (AIC), noted that, as a result, trusts “do not offer redemption and so a statutory limit on the size of their investments is not required”.
Withdrawals have been an issue in the past for open-ended funds, particularly during the Neil Woodford debacle in 2019 and among property funds, many of which closed in the late 2010s due to liquidity issues. Open-ended funds investing in difficult-to-trade assets were forced to sell some of their holdings to meet withdrawals. First out of the door tend to be the most liquid assets, such as large stocks.
However, after these have been sold, more time is needed to arrange the sales of illiquid assets, resulting in ‘gating’ – the temporary closure of a fund. This can lock investors’ money in a fund until such time as asset sales could be made.
What rules do investment trusts have to follow?
Trusts aren't rule-free, far from it. Under FCA Listing Rules, they must publish an investment policy demonstrating how they “spread investment risk” and maintain that policy on an ongoing basis.
Stone added that, as well as the FCA, any material change to a trust’s investment policy “needs to be approved by a shareholder vote”.
“Many investment trusts do set a limit to their single-stock exposure at purchase and boards review this regularly,” he added, although this is not compulsory.
There are exceptions, however. Venture capital trusts (VCTs) and real estate investment trusts (REITs) are not subject to a spread-of-risk test but have other diversification requirements.
VCTs are subject to a 15% maximum in any one company at time of investment – similar to the current UCITS rules – while a REIT must have at least three properties, and no single property can represent 40% of the total value.
A true long-term approach
Because investment trusts do not offer daily liquidity in the same way as open-ended funds, they can take a much longer-term approach. As a result, they can invest in illiquid assets that can balloon in size should they perform well.
This recently became a live issue for Scottish Mortgage, for example, ahead of the SpaceX IPO. The unlisted tech stock had rocketed higher and accounted for more than a fifth (21%) of its total holdings ahead of the IPO. That figure still stands at 18.1% since the listing, almost double the amount an open-ended fund can own.
Stone said: “Unlike open-ended funds, trusts are also well suited to long-term investing in illiquid assets, the valuations of which can change significantly. This would make a limit impossible to manage,” he said.
“For example, it would be impossible for investment trusts to invest in exciting unquoted companies such as SpaceX if they had to follow the same rules as open-ended funds.”
Boards
Investment trusts use an independent board of directors, employed and voted on each year by shareholders to ensure the trust aligns with their interests.
“The oversight provided by boards is another reason why there is no regulatory limit on the concentration of an investment trust’s investments,” said Stone.
Conversely, open-ended funds use authorised corporate directors (ACDs), which is only required to have a minimum of 25% independent directors – or at least two.
“Independent boards of directors who look after shareholders’ interests are an important advantage of investment trusts,” added Stone.