Investment trusts: time for boards to earn their corn

Why boards can't leave everything to the market. Or to the manager.

I had intended to keep my substack for matters cultural and philosophical, but it is such a convenient format for writing longer pieces that it seemed the natural forum for the occasional post about another passion of mine, investing.

Every morning I take the dog on a long walk, and usually listen to a podcast or two. One of my regulars in the Money Makers podcast, which is presented by investment trusts aficionado Jonathan Davis. Every week he has a couple of commentators on the sector, usually a manager and a generalist, often a broker or professional investor.

It has become increasingly clear that the investment trust sector is facing significant, perhaps unprecedented threats. In no particular order, these include:

1.     The rise of passive investments, that offer lower costs than active investment structures can offer;

2.     An unrelenting focus on cost disclosure, applied inappropriately in the case of investment trusts, which discourages wealth managers from investing in the sector;

3.     Mergers between wealth managers, which means they are managing bigger pools of assets, which in turn means they can only consider larger, more liquid assets in which to invest, excluding many trusts;

4.     A number of investment trusts that have become high profile disasters;

5.     The general lack of liquidity and wide spreads on the LSE, which can lead to many of the smaller investment trusts having a spread of up to 10%;

6.     A large number of investment trusts that limp on, at large discounts and with minimal publicity and poor performance.

The list of challenges goes on an on.

The most recent podcast featured Ewan Lovett-Turner, the head of research at Numis, the investment bank, and one of the highest profile investment trust analysts around. He was summarising the first quarter on the LSE and made many interesting observations. There were 2 that particularly stood out.

The first was in relation to a trust that had put a merger to a vote. The number of votes received was very low. Despite improvements from many of the platforms through which people hold shares, there is a very low turnout from retail investors when it comes to voting on company resolutions.  Although Ewan did not mention it, this is particularly important because the proportion of shares in investment companies held directly by retail investors is growing all the time: I’ve heard from 2 managers that it has risen from around 3% to close to 20% over the past 5 years. So retail holds more shares directly but, for whatever reason, doesn’t make its’ voice heard.

The second was in relation to a trust I own, Harbourvest Private Equity (HVPE). Like many private equity trusts, it trades as a huge discount to NAV. As that discount is over 40%, if the company buys back its own shares, it immediately makes a large profit. Spending £600,000 on shares would purchase £1m of underlying assets. Cancel the shares and a profit of 66% has been achieved in a single day. It is very difficult to justify making long term investments when such short turn returns can be achieved.

HVPE was singled out by Ewan as one of the stragglers in the private equity sector, largely because, in his words, it proposed a buyback scheme “grudgingly” and as a result “shot itself in the foot”. The contrast was made with its peer, Pantheon International (PIN), where the chairman, Sir John Singer, set out a radical and ambitious buyback and tender plan which has improved the valuation of PIN materially. Sir John had been a guest on the Money Makers podcast recently, where he made the point that if any investment trust is sitting at a huge discount to NAV, the starting point of the board should be to do everything it can to close that discount, and if that fails, to wind up the trust.

Having had the advantage of seeing the PIN approach, the board and manager of HVPE decided not to follow it. They said a few words about a buyback programme, but the market interpreted them as being grudging, and HVPE continues to be a laggard.

The decision whether to carry out a buyback, and if so, in what size, is always controversial because managers are generally paid a percentage of assets under management. So for some investors, a grudging buyback is a statement from the company that the manager’s fees are, in the short term, more important than the investor’s returns. This is usually tempered by words along the lines that “the investments we make at today’s compelling valuations should provide for strong returns in the future”. They had better, when they could be returning 66% in a single day, tomorrow.

Which sets the scene.

In theory, investment trusts bring together three groups: investors, who provide the money; professional entities, who provide the expertise to manage the money; and a board, who represent the interest of investors and ensure that the professionals do their job properly. For the sake of simplicity, I will treat “professional entities” in this context as meaning just the investment manager, though in reality it includes many more: accountants, lawyers, custodians, brokers, valuation agents etc. There are a lot of city fleas sucking the investor’s blood.

Historically, the pool of investors was dominated by institutions: pension schemes, other investment trusts or funds, and private wealth managers. The latter group in particular, made up of such names as Rathbones, Investec, JM Finn, Quilter Cheviot and all the other names that advertise at cricket matches. However, as mentioned, due to the combination of mergers, inappropriate cost disclosure rules, and the general tide of regulation, these make up a diminishing proportion of the market. Indeed, and this is a crucial point, these entities are more likely to be sellers than buyers.

So now, the most likely buyers in the sector are arbitrageurs – activist investors, often from the US, agitating for corporate action to reduce discounts – and private investors.

But here is the problem. Historically, the marketing of investment trusts has been delegated to the investment manager. Investment managers do not like activist investors, whose ultimate aim is often to either replace the investment manager or to close down the trust. And due to regulation and the dispersed nature of the retail community, the manager struggles to reach private investors. Some managers do use the forums provided by bodies like ShareSoc and Investor Meet Company, but the retail investor market is hard to reach. Regulation (moronic but for some reason unchallengable) in the form of Mifid has reduced the amount of research on investment companies available to private investors. Some investment companies feel they are unable to market directly to punters. And, as Ewan pointed out, retail investors rarely vote, perhaps because they find it difficult to know what is going on at, and hence what is best for the company.

However you look at it, the old model, where the manager would go out for a series of meetings with the company’s major investors, perhaps accompanied by the Chair of the board, ideally a City grandee, no longer works. The big investors are selling out and there is no way of contacting the retail investors who need to replace them.

In reality, the principle that manager was held to account by board on behalf of investors was a convenient fiction. The big investors held the manager to account directly. If the likes of Schroders or Rathbones or one of the many regional pension schemes held 5% in an investment trust, they had the manager’s number. And the manager would take their call seriously. If approached by retail investors, in my experience most managers are courteous, but an individual investor holding £10,000 worth of shares cannot carry the same influence as an institution holding £20m worth.

The reality was also that the board didn’t really hold the manager to account, and in some ways wasn’t expected to. Fact is the first board was appointed by the manager, and the first investors bought shares on the strength of the manager’s abilities. It was another legal fiction. The manager ran the show, the investors wanted the manager to run the show and the board was there to ensure the manager stayed within the parameters of the company: though in the case of Woodford, it’s not clear that they even managed to do that. The board was naturally comprised of people who felt loyalty to the manager. And finally, most non-executive directors of trusts have a portfolio of such appointments and do not want to be know as “difficult”. When managers are doing the hiring, you want to be known as being manager friendly. That is not to say that non-executive directors are not independent, more that a subtle network of influences make them naturally incline towards giving the manager the benefit of any doubt.

The problem is that model is now broken. It worked when markets were rising, discounts were small, liquidity plentiful, and institutions were net buyers of investment companies. Now, all of that has changed. Many trusts are sitting at big discounts: the average discount is around 20%, and there are many trusts at double that. With very little broker coverage seeping out to retail investors, many trusts see their prices slumber for months, without volume or news.

Competition for capital is also increasing. I mentioned passive funds as the biggest threat facing the sector, but active ETFs are just as significant. One fund I hold, Geiger Counter (GCL) was, a few years ago, about the only way for a retail investor to play the uranium sector. Now, as well as a uranium commodity holding company on the LSE (Yellowcake) there are at least half a dozen ETFs available. The same applies across the board: sector specific ETFs are generating better performance at lower cost than most investment trusts.

There is no easy solution here, but in my view the way forward is through boards reasserting their primacy and being clear that they are in charge. The reality is that the investment trust sector boomed between 2010-2020, particularly in the alternatives area. Anyone launching a fund with yield in any esoteric asset could raise funds and move to a premium. Asset managers were in demand. Capital was freely available. Anyone with a credible plan and a 6% dividend target could raise a few hundred million.

The opposite now applies. There are too many funds, too many managers, and a lot of investors who are sitting on losses and want their capital back. Managers were in demand. Now they are in denial. When companies in areas as diverse as asset backed debt, battery storage and private equity (to name just 3) are trading at discounts of 40%+ to NAV, and yet managers are being paid according to that NAV, investors are rightly furious.

This anger only increases when there seems to be no clear plan to increase shareholder value. Pantheon, Pershing Square and (belatedly) Scottish Mortgage have shown commitment to buybacks, but all too often buy backs are done “grudgingly”.

Managers do not like to see funds wound down or assets under management reduced: it is their fees that are hit. But it is precisely now that boards need to reassert their primacy. They are the custodians in charge of money that belongs largely to an investor base that they are distant from. They need to focus on bridging that gap. That means people on boards who have credibility in the private investor community.

There is also a diversity issue, for though gender and ethnic diversity boxes may often be ticked, too often directors are chosen from a narrow city pool that is not diverse in any meaningful sense. As the investor pool shifts from institutional to private investor, the board pool must reflect this.

Boards need to be more assertive in achieving shareholder value. That means that funds need to reduce both discounts and costs. Buybacks, mergers, tender offers and wind downs must be explored with much more vigour. Outreach to private investors is vital. That also means that regulators need to completely reverse their assumptions, and start to see communication as something to be encouraged, rather than prohibited. I would suggest that if regulators want to protect consumers, the focus should be on prohibiting fees linked to NAV in cases where funds trade at a discount.

Ultimately, much more scrutiny needs to be brought to bear on fund managers: those who have proven unable to generate long term shareholder value must be denied the privilege of managing other people’s money. Just because a manager raised money once does not give them a right to have an annuity from it forever.

Many managers will resist this, but if an investment trust is trading at a meaningful discount and is not consistently outperforming similar ETFs which charges lower fees, then the duty of the board is to bring that trust to an end.

And that will only happen when boards are truly independent.

Notes

It would be remiss to not highlight that many managers do an excellent job for reasonable fees. Baillie Gifford spring to mind, for making every effort to reduce fees wherever possible, but there are others. However, the economies of scale mean that mergers of investment companies will often be needed before fees can be reduced. Another reason to pursue them as a matter of urgency.