Three ways the investment trust industry is changing

It’s likely you’ll have a certain image in your head of investment trusts, or investment companies as we tend to call them. But the pace of change in the industry is picking up. The investment companies of today are significantly different to those of 10 or 20 years ago.

This should be no surprise. Investment companies celebrated their 150th birthday this year, and nothing survives for 150 years without change. To quote Paul Niven, manager of the original investment company, Foreign & Colonial, they have gone from investing in the Amazon to investing in Amazon.com.

The last 20 years have thrown up both challenges and opportunities. On the challenge side of the equation, there’s been the rise of passive investing, and the consolidation of traditional investment company buyers into larger and larger groups, with ever greater liquidity demands.

Then there’s the opportunities. The income advantages of investment companies, such as the ability to smooth dividends, have come to the fore in an era of ultra-low interest rates. New, illiquid asset classes have sprung up that can only be held in a closed-ended structure.

There are three changes in particular that are shaking up the investment company industry at the moment, which industry professionals need to be aware of.

1. Alternatives have gone mainstream

In 1999, less than a fifth of investment company assets were invested in alternative asset classes. By 2006, it was around a quarter. Today, it’s nearly half.

Entirely new asset classes and AIC sectors have sprung up, such as specialist debt, direct property, infrastructure, leasing and ‘flexible’ investment.

Most of these focus on illiquid assets, where investment companies have a clear advantage. The perils of holding such assets in open-ended funds were laid bare in 2008 and 2016 when property funds were forced to suspend trading.

Average yields for ‘alternative’ sectors

Source: AIC/Morningstar

The biggest driver of the growth of ‘alternative’ sectors is, without doubt, the hunger for income that comes from a decade of near-zero interest rates. Yields of 5% or 6% are naturally attractive, especially for assets whose income streams are not correlated to the business cycle.

That said, track records in some of these asset classes are short, and they need to be better understood. The AIC is increasing the quantity of training it is providing in these areas.

2. Discount controls are now the norm

When innovations work, they can soon become standard practice. The change in tax law in 1999 that allowed investment trusts to buy back their own shares is a case in point. Now about three-quarters of investment companies have some form of discount control policy.

Discount control policies provide a kind of safety net when there is a lull in demand for an investment company. As the discount widens, the investment company buys back its own shares, thus adding demand, raising the share price and reducing the discount.

Some investment companies are fortunate enough to have the opposite problem: persistent premiums. A gradual issue of new shares can keep this under control.

If you’re thinking that this ability to buy back or issue shares makes investment companies a bit more like open-ended funds, you’re probably right. But discount control policies have their limits, and won’t be operated in extreme market conditions (for example, a sudden collapse in demand). They are exercised at the discretion of the company’s independent board, who need to seek shareholders’ authority to buy back or issue shares.

Only a handful of investment companies have set themselves the challenging task of eliminating discounts or premiums altogether through so-called ‘zero discount policies’. Most investment companies with such policies merely want to keep the discount within an acceptable range, reducing volatility and giving shareholders a smoother experience.

Most investment company investors and analysts agree that the wider use of discount control policies has been helpful for shareholders, and most new investment companies are launched with such arrangements in place.

3. Fees are falling

By knocking commission off the fees of open-ended funds, the Retail Distribution Review (RDR) set investment companies a challenge. In response, 41% of investment companies have changed their fees since 1 January 2013 – a total of 176 changes, or 32 a year.

The most common fee changes are a reduction in base fees, the removal of performance fees and the introduction of tiered fees.

Most common types of fee change since 2013*

*Source: AIC. Fee changes in period 1/1/13 to 10/4/18 inclusive

All these fee changes are negotiated by the investment companies’ independent boards, who are tasked with getting the best possible deal on shareholders’ behalf.

Fee changes, discount control policies and the rise of alternatives may be the most noticeable changes in the industry, but there are others: a move towards mainstream investment companies investing in unquoted companies, for example. All of these changes aim to keep investment companies fresh, competitive and relevant as this 150-year-old industry seeks to reinvent itself for the 21st century and beyond.