In many articles over the past few years, I have expressed frustration that investment company share price discounts seem to be divorced from reality. Initially, this was centred around private equity funds, but over the past 12 months or so the problem has widened to encompass much of the closed-end fund sector.

Investment companies have not only seen their share prices fall further behind their underlying asset values, but their discounts have also been more volatile than usual. In addition, private investors frequently complain to me that bid-offer spreads on their shares have increased dramatically, making trading in the stocks more expensive.

There is a real underlying problem here but one with a very simple solution. Please bear with the technical aspects – they are important – and the length of this – there is a lot of ground to cover.

To uncover it, we must go back a decade to the introduction of the Alternative Investment Fund Managers Directive (AIFMD) in 2013. Ahead of this, investment companies had been regulated as companies – subject to listing rules, companies acts, their fund managers regulated, required to comply with accounting standards and watched over by directors with fiduciary duties.

AIFMD was an EU law designed to protect investors in lightly regulated funds. However, in typical fashion, the UK decided to ‘gold plate’ this by bringing listed investment companies into its scope, making them ‘alternative investment funds’ (AIFs). Other EU countries did not – the handful of EU-listed private equity funds are not covered by it, for example. In the UK, the immediate result was some added complexity and cost (typically £50,000–100,000 per fund, but sometimes much higher). However, there have been some more pernicious effects that have created today’s problems.

In 2018, the advent of the EU’s Mifid II regulations introduced the principle of aggregating all costs that impact on the value of an investment into one figure. There was a seductive simplicity to this idea. Investment companies were caught because they were designated as AIFs. However, open-ended funds were not because they are covered by other ‘Ucits’ legislation.

Many of us have complained about the unlevel playing field this created, but we were promised that changes to packaged retail and insurance-based investment products rules would bring Ucits funds into line in January 2023. However, this did not happen, as the PRIIPs directive is to be scrapped.

The most obvious impact of this from about 2018 onwards was the lack of wealth manager interest in listed private equity investment companies. Because these were obliged to aggregate the fees that the fund manager charged with the fees charged by underlying private equity managers, the costs looked too high to stomach.

As a result, single manager private equity funds such as Oakley Capital Investments (OCI ) have been preferred to multi-manager funds such as Pantheon International (PIN ). Many of the multi-manager funds are going down the route of increasing their exposure to co-investments as these do not come with extra fees. The legislation is distorting the market. Investors that shunned private equity missed out on returns that were well ahead of equivalent public equity funds.

Funds of funds investing in investment companies such as MIGO Global Opportunities (MIGO ) were also caught up in this and the regulatory blight was a contributing factor in the loss of Aberdeen Emerging Markets which merged with Aberdeen Thai two years ago.

In the Ucits world, because the legislation did not apply, the managers could get away without aggregating charges. However, from about 2020, the Investment Association – conscious of the impending PRIIPs rule changes – began to ask its members to change the way that they reported on these. From about January last year, the authorised corporate directors (ACDs) that oversee these funds began to insist on it. This triggered a wave of selling of investment companies by Ucits funds of funds.

Wealth managers are sellers too. The costs and charges figures that they must report to their clients are also aggregated. For small pension funds, who have a 0.75% cap on fees that they are allowed to incur, most investment companies are completely off limits. IFAs, who generally try and keep the total cost to their clients below 2%, are turned off too.

To underline the absurdity of this, the managers of exchange-traded funds (ETF) are still not aggregating fees. Any ETF based on the UK market, especially those focused on mid-cap FTSE 250 stocks, has a big exposure to investment companies. They ignore the underlying fees when disclosing their charges and so they are a more attractive option for wealth managers, pension funds, IFAs and Ucits funds of funds.

It has been suggested that the solution to this is more disclosure and more education – but everyone likes simplicity, and the charges figures that the Ucits funds use in their fee aggregation calculations are and will always be the aggregated numbers because the European Mifid template (EMT), that everyone uses to report charges, requires it.

The latest blow is the UK consumer duty rules. At every point in the chain of creating and selling a fund, there is an obligation to ensure that the end consumer is getting value for money. The cost element of this is the aggregated fee, and often it seems as though the value bit – the net return generated – is ignored. The result is that some investment platforms are blocking private investors from buying some funds, and this is only going to get worse.

The problem with spreads also goes back to AIFMD. The banks that own the brokers are subject to Basel rules that govern the amount of capital that they are required to hold. Under these rules, AIFs – which everywhere else other than the UK are things like hedge funds and baskets of stocks and derivatives – are designated as collective investment undertakings (CIUs).

For regulatory capital purposes, brokers are required to hold 8% of the value of their equity positions as capital, but for CIUs the figure is 32%. This has massively shrunk the amount of capital that brokers are prepared to commit to making markets in investment company shares. Again, to illustrate the absurdity of this, if a broker holds 100 individual equities, its capital requirement is four times lower than if it has exposure to the same equities through an investment company structure.

And it gets worse, from 2025, with Basel 3.1, the capital requirement to hold CIUs will rise to 70%.

There is a simple solution to all of this. Scrap the EU red tape, take investment companies out of AIFMD, and everything sorts itself out. Here is a clear potential Brexit benefit, albeit solving a problem that the EU rules never intended to create.

Let me clear, there is no question that keeping costs down and investors informed of the impact of fees is of paramount importance. However, the fixation on costs rather than outcomes, needs to change.

To illustrate the effect that this is having, investment manager Gravis has highlighted the difficult choice it faces with its Ucits fund investing in renewables. It holds companies like SSE which are investing in wind farms alongside Greencoat UK Wind (UKW ) which does the same thing. The cost disclosure rules are putting pressure on it to sell the latter. UKW has dropped to a wide discount and is now planning to shrink through a £100m share buyback, diverting cash that should be driving down energy bills and improving the UK’s energy security. Unfortunately, if the investment companies market is not fixed, £100m will probably prove insufficient. Billions of pounds of much needed UK infrastructure investment might be lost.

James Carthew is head of research at QuotedData.

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