HMS Investment Trust is facing turbulent waters. Not only are the sharks circling, but the icebergs are proliferating, while the regulator seems determined to put a hole in us below the waterline.

The Financial Conduct Authority (FCA) recently hosted an open panel for industry members, focusing on a critical issue: the fate of the sector under the proposed Consumer Composite Investments (CCI) regime, which includes the future of cost disclosures. Its proposals received a tepid at best/hostile at worst response in the room, but the time is running out to change its mind.

The long-term struggles of investment companies

The longer-term challenges facing investment trusts are well-documented, with considerable column-inches devoted to it on this website alone (click here for some key stories). In addition, the sector has been caught in the broader sell-off of UK equities more recently, with 2024 the worst year on record for withdrawals from UK equity funds.

A major problem for the investment companies sector has been the financial regulation that has encouraged waves of consolidation within the wealth management industry, traditionally significant buyers of investment companies, who need ever larger and larger funds for investment companies to stay relevant within their strategies. This was a factor behind the proposal, announced this morning, to merge the £329m Henderson International Income Trust (HINT) into £3.1bn JPMorgan Global Growth & Income (JGGI), to create a £3.4bn colossus – click here to read more about that deal). At the same time, competition from alternative investment products has intensified. These factors have driven the average investment company to trade at an ever-widening discount over the past decade, as shown in Figure 1.

Despite these headwinds, investment companies still account for one-third of the FTSE All-Share Index, comprising 185 closed-ended funds in a pool of 554 companies as of the end of 2024. They are an ideal vehicle to give ordinary investors access to managers and investment strategies that would otherwise be inaccessible to them. They also provide critical funding for the UK economy, with $36bn in assets held within the infrastructure and renewable infrastructure sectors alone. The permanent capital nature of investment trusts is a vital lifeline for UK small-cap markets, particularly in light of the recent collapse in UK IPOs.

Revitalising the investment company sector, and by extension the UK savings industry, ought to be a no brainer for UK policymakers, especially given the pro-growth mantra adopted by the Labour government. The sector could take the lead on providing much need funds for the net zero agenda and the replacement of the UK’s crumbling infrastructure.

However, it would mean getting trusts to trade at asset value to enable them to issue new shares. To date, no meaningful action has been taken. While financial markets are often cyclical, including the current challenges facing investment trusts, if corrective measures are not implemented soon, the sector may not survive long enough to benefit from the next upturn.

Two pressing concerns

Beyond the structural challenges already mentioned, two critical near-term issues threaten to break the sector:

1. The way investment trusts are presented to retail investors – FCA regulations have turned cost disclosures into a painful millstone around the sector’s neck.
2. A wave of opportunistic attacks on individual trusts – this threatens to strip assets and diversity from the sector.

All pain, no gain: the FCA’s approach to retail disclosures

The FCA’s approach has become a significant burden for investment companies. This stems from complex regulatory issues inherited from European regulations under MiFID II and AIFM frameworks. Investment trusts are being categorised alongside open-ended funds and ETFs for disclosure purposes, despite being companies rather than funds.

There are two key issues that need to be addressed. The first is whether a disclosure of charges at the point of sale is at all relevant – investment companies are companies after all. You don’t need BP’s running costs highlighted to you before you can decide whether to invest in it. The second is the logic behind aggregating layers of expenses into a single figure.

The charges are already reflected in the share price

In the discussion, the FCA said that its intention was to ensure that investment company fee disclosures remain fair, and that the current investment ‘culture’ means trusts need to be compared to the more conventional open-ended funds and ETFs.

One solution to the cost disclosure issue is to simply treat investment trusts as listed companies and remove the need for them to disclose any fees. Proponents of this idea argue that the obsession with fees is irrelevant in the context of listed companies with share prices, as these already reflect projected costs. Investment trusts trade at a premium or discount to their NAV and this should be the primary indicator of value – with a small long-term discount being a rational outcome if investors are discounting the future reduction in NAV due to costs. And if investors find the charges that are disclosed in the regular reporting of a trust unpalatable, they can vote with their feet by selling their stakes and driving the discount out further. This discount should be a rational signal to the market, rather than a consequence of misrepresentation.

Regulators did appear to have embraced that argument, on 19 September the FCA said it would apply ‘forbearance’ for investment trusts if they choose not to put a cost figure in their KID. The AIC guided investment trusts to leave it blank (you can read more about this here).

Now, while the FCA did acknowledge this argument, they still seem set on ensuring that a single aggregated cost figure is produced for investment companies. Which, judging by the tone in the room during the discussion, may bring investment trusts back to square one and leave them at a disadvantage when being presented to investors.

The FCA is still in a consultation period and has invited industry feedback, reactions from the audience suggested that the proposals, so far, fall very short of the mark.

Aggregating fees gives a misleading impression and distorts investor behaviour

This is the genesis of the cost-issue, as it requires the aggregation of fees into a single figure. This figure is usually non-contentious for open-ended funds as their costs are straightforward – management fees, operational costs, and trading expenses for the bulk of it.

By contrast, investment companies face more stringent reporting requirements than the ‘conventional funds’ they are often compared with. As listed companies, they must have independent boards and adhere to extensive regulatory filings, including annual reports. This results in a modicum of additional cost relative to their open-ended peers. Furthermore, marketing and distribution costs often fall upon the trusts themselves rather than being absorbed by the asset manager.

One improvement on the previous position was that the FCA conceded that including the costs of gearing and the maintenance and operation of real assets (like wind farms) is misleading.

However, the FCA still wants to present an aggregated figure to investors that includes costs beyond managers’ control. For example, Hargreaves Lansdown lists Pantheon Private Equity’s average annual charge as 3% of NAV, whereas in reality the running costs of this trust are about 1.3%– a discrepancy arising from Pantheon’s investments in funds managed by third parties.

The greatest inconsistency arises from the FCA’s proposed treatment of ETFs, which it says will not be required to aggregate the fees charged on investment companies that they hold. The FCA’s rationale is that trackers would simply avoid holding investment companies in order to reduce the costs they disclose – effectively admitting that the proposed regime influences investor behaviour.

Why are charges so important?

One cannot underestimate the impact of fees on investment decision making, as it is a known drag on returns (academic literature has demonstrated the negative relationship between fees and performance) and a psychological barrier to investing – as the cost of your investment manager is known but the value it will create is unknown. Overly inflated fees can have, and in many cases already have had, a serious impact on attracting new investors.

The consequences of regulatory misalignment

Regulation and bureaucracy are the cholesterol in the lifeblood of financial markets, and the FCA’s approach seems akin to comparing apples with oranges. The FCA’s stance suggests a fundamental misunderstanding of what the sector represents. Its focus on simplification and a ‘retail-friendly’ approach underestimates the intelligence of the average investor.

This issue is uniquely problematic for UK closed-ended funds. Thousands of REITs exist worldwide, yet the UK’s 29 property investment trusts are singled out to be subjected to retail-focused disclosure rules. Given the additional complexity placed upon this small cohort, it would seem as if the FCA may end up funnelling investors into products which are less aligned with retail shareholders’ needs. For example, into non-investment trust REITS or Long Term Asset Funds that trap investors’ money within them for extended periods.

Another comparison would be to contrast Caledonia Investment Trust (CLDN) with Berkshire Hathaway. Both are listed companies that are invested in listed and unlisted assets, and both retain a substantial ownership by their founding families. Yet because Berkshire Hathaway is a US holding company and CLDN is a UK listed investment trust, it is subject to disclosure requirements that Berkshire Hathaway isn’t. As a result, one may perceive that Berkshire Hathaway’s lack of (disclosed) fees makes it a more attractive investment (with platforms also displaying inflated fees for the Caledonia), despite CLDN paying a dividend and having a board more attuned with the UK investor. CLDN also trades at a 32% discount to its NAV, while Berkshire trades at a 1.6 times premium to its book value.

Without significant industry protest, the FCA will likely implement a revised but still flawed cost disclosure regime that could exacerbate outflows and accelerate the sector’s decline. The FCA’s current stance on retail investing platform fees further underscores its reluctance to drive meaningful change, leaving the onus on the trusts themselves to pressure platforms to fall into line – an ineffective and unambitious approach.

Regulatory complacency has drawn in the sharks

Structural challenges and regulatory apathy have widened discounts, attracting activist investors.

Saba Capital’s recent attempts to take control of seven UK investment trusts serve as a wake-up call. While Saba has thus far been shot down in all shareholder votes, with only Edinburgh Worldwide’s vote left (NB, we believe strongly that investors should vote against Saba in that vote too), the mere fact that it committed substantial capital to profit from widespread discounts should be alarming. Other activist investors may succeed where Saba has not.

Without new demand, the sector is slowly shrinking. The pace of consolidation picked up in 2023 and then again in 2024. This week alone, Henderson International Income has announced a merger with JPMorgan Global Growth & Income, and BBGI Global Infrastructure has received a takeover bid. The BBGI bid neatly illustrates the sector’s problems. A once popular company with an impressive track record drifted out to a discount as new buyers dried up. The bidder was prepared to pay a premium to NAV to get hold of the portfolio and have access to the management team. However, the market was valuing that opportunity on a 17% discount. Remarkably, despite the obvious read across into the renewable energy sector, discounts here barely budged. Andrew McHattie highlighted the wide discounts and high yields on offer on today’s show.

What can be done?

Investors must pressure the FCA to reform cost disclosure rules and recognise investment companies as listed companies rather than conventional funds. The FCA’s consultation period remains open, and industry feedback is essential.

In the meantime, retail investors have a golden opportunity to pick up bargains that cost disclosure rules mean professional investors are ignoring. Many investment trusts offer compelling valuation opportunities – trusts like Polar Capital Technology trade at an 8% discount, providing exposure to global tech stocks at a relative bargain, while Rights & Issues offers an additional 16% discount to its already undervalued UK small-cap holdings.