In this article the UK's John Baron MP outlines the regulatory problems that beset investment trusts. Despite the £700 million 'split cap' scandal of the noughties, and despite hostility from the European Securities and Markets Authority, he believes that the investment vehicle has a bright future.

John Baron MP delivered a barnstorming speech this month in favour of investment funds at the recent Wealth Management Association annual conference in the City of London. He believes that their time has come, but they face some regulatory hurdles nonetheless. This is what he said.

My intention is to trot through what I see to be the opportunities of one of the City’s best kept secrets - namely investment trusts – and to highlight one or two of the threats and challenges. The facts and figures confirm that investment trusts have performed better than the unit trusts and open-ended investment companies (OEICs) that dominate the United Kingdom’s investment and savings market.

What gives investment trusts the edge?

Research has shown, time and time again, that the average investment trust has regularly outperformed both unit trusts and the relevant benchmarks. Indeed, the annualised outperformance by investment trusts over both open-ended funds and relevant benchmarks in the core regional sectors is around 1.9% and 1.3% respectively over recent decades.

These may not sound like large figures, but such a powerful outperformance can have a significant cumulative effect on a portfolio over time. The investment of, say, £100,000 over 10 years in the global sector in an average investment trust would have produced a net asset value or NAV (an investment company's total assets minus its total liabilities) of £174,100, compared with £140,200 for open-ended funds. This is quite a difference.

These are, of course, average figures. Many good unit trusts and OEICs do beat their benchmarks and those investment trusts that do not perform very well, but the attainment of a better average increases the chances of profit for investors. It is easier to reach your objective if the current is with you.

The reasons for investment trusts’ superior performance are varied – and include their closed-end structure, their ability to 'gear' and, above all, their cheaper fees.

Today's changing investment landscape

So why then, in the past, have so many investors, charities and pension funds not made use of investment trusts? After all, they have been around for a long time. Some are very large, with market capitalisations of more than £2,000 million, and sections of the financial press periodically report on their superior performance. Yet, when I last looked, the amount invested in unit trusts and OEICs has over 10 years risen three-fold to around £600 billion, compared with assets held by investment trusts rising just 50% to around £100 billion.

The answers are varied, but the common thread linking them is a competitive landscape which has been tilted against investment trusts for some time – but this is now changing. The advent of the Retail Distribution Review (RDR) at the beginning of last year is certainly a factor. There can be little doubt that there used to be an in-built bias towards open-ended funds as they paid commission to independent financial advisors or IFAs, whereas investment trusts do not do that. RDR has put a stop to this by banning commission. Investment trusts will now compete on a more level playing field. The gloves are off and the fight is on and investors are set to benefit as a result.

Selling the message

Perhaps RDR is only half the story. Investment trusts have been the 'poor cousin' for a number of other reasons. In the past, they have not always been good at setting out their stalls. They are a slightly more complex than other instruments, and some of their detractors have often exaggerated their complexity. The Association of Investment Companies (AIC), their trade body, has done sterling work in trying to spread the word about them, but it is up against not only the large unit trust management groups, but also a lack of interest among the banks and building societies.

Then there has been the odd bit of bad publicity. The fallout from the 'split-capital' investment trust scandal threw a dark shadow over most of the investment trust sector. It seemed to confirm that investment trusts were a dark art best avoided. Bad perceptions, however, are now changing.

Reasons to be cheerful

There is ever-growing coverage in the financial press of investment trusts' superior performance and cheaper fees – two features that are not unrelated. More investors are coming to appreciate some of their special features. Their ability to 'store' dividends and so produce a growing income in rocky times is helpful for long-term planning. More and more people are realising that their closed-ended structure is better suited to certain asset classes such as private equity and infrastructure. Furthermore, one of the investment consequences of 'globalisation' is that themes and specialist sectors, such as biotechnology, will assume a greater proportion of total returns. Unless one has access to a large research department able to select stocks individually, there can be few better choices than specialist investment trusts and momentum is building up in their favour. The fact that we live in straitened financial times is also important. In the search for more cost-effective and better performance, investment trusts will be one of the key beneficiaries – especially if stock market returns are pedestrian. The City’s best-kept secret is stepping out of the shadows and into the glare of high-net-worth investors.

Opportunity cost

The future is bright for those fund management groups that can strike the right balance between costs, service and performance, but there cannot be reward without risk. Of the threats to the future of investment trusts, regulation is the gravest and, as usual, the story starts in Brussels. As an MP with an interest in this field, I have lobbied the Chancellor and the Treasury and raised questions in the House of Commons in liaison with the excellent work that the Wealth Management Association has been doing, as well as the AIC. Let me briefly touch on three examples – cost transparency, PRIPs and the ‘appropriateness test’.

The 'appropriateness test'

The so-called "ESMA-proposed advice on MIFID 2" suggests that the European Union's regulators should deem all investment trusts to be "complex instruments." If they were to do this, they would have to subject them to heavy regulation. For example, before a HNW retail client could buy an investment trust on an 'execution-only' basis, the relevant investment firm would have to conduct an ‘appropriateness test’ to ensure that he had enough knowledge and experience to understand the risks he faced. Today's appropriateness test typically applies to an HNW client who wants to invest in derivatives – a far cry from your average investment trust.

Mainstream investment trusts are one of the safest investment vehicles around. In each one, an independent board of directors monitors an experienced fund manager as he/it runs a spread of investments. The EU’s wish to classify these trust as "complex" is confusing. The AIC has been particularly active on this issue, with the WMA providing support. We now await the European Securities and Markets Authority’s "final advice," to use an EU term.

PRIPs

Just before the European Parliament dissolved in time for the elections of May, it had plenty of proposals for financial regulation in the pipeline. These included new rules about Packaged Retail Investment and Insurance-based Products – PRIPs to you and me. Without going into the detail, let us say that the EU considers an investment trust to be a PRIP.

Right up to the last minute of its life, the last EU Parliament wanted every purchase of a PRIP by or for an HNW investor to be preceded by that investor signing a Key Information Document (KID) similar in style to the existing KID that is used in the UCITS market (including Unit Trusts). The politicians wanted each KID to contain a description of the PRIP in question. In large part because of lobbying from the WMA, they removed this silly requirement at the last minute.

That was a good day, you may think, and so it was. But the long-term concern remains: the EU still considers investment trusts as funds rather than equities. Because of this, the UK is going to have to keep asking for 'special treatment' as investment trusts are almost unique to Britain.

The EU's folly

This is nonsense. As every fund manager knows, investment trusts are fundamentally different from UCITS in two respects. Firstly, they are equities that have market-makers and operate with real-time pricing throughout the trading day. Secondly, being closed-ended companies in the same vein as BP and M&S, they are not the same kind of investment vehicles as unit trusts at all, and they perform better than unit trusts as a consequence.

The EU is, once again, being foolish in trying to impose 'one size fits all' regulation on very different products. Moreover, it is clear that HM Government supports the EU’s categorization of investment trusts as ‘funds’ rather than ‘equities.’ Regulation is likely to remain a big problem.

Cost disclosure

A further regulatory challenge stems from the fact that investment trusts, and others providing PRIP KIDs, will have to meet these obligations in the autumn of 2016. The ESMA proposal, however, calls for an exemption of five years for UCITS providers. This difference in time-scale raises problems because the PRIP KID is expected to include a more complete disclosure of costs than the current requirement for UCITS KIDs.

Investment trusts bear, on average, fewer costs than unit trusts. However, there is now a risk that, when the products are compared, a UCITS KID will appear to have a more favourable cost profile than a PRIP KID because of the need for more complete disclosure, even if it gives the onlooker a false impression in the process. Nobody knows how this story will end. It will depend in large measure on the specific details that go into the PRIP KID. Once again, investment trusts stand to suffer from EU regulation because they are classified as funds rather than equities.

Education by the industry

People still have to be educated about the characteristics of investment trusts. This is especially true when it comes to the ‘discount’, or more relevantly the ‘premium’, and the effect that it can have on the price of shares, particularly when markets are volatile. As you all know, movements in the discount or premium can accentuate investment trust share price movements which, unlike unit trusts, are not anchored to the underlying NAV.

The risk is perhaps greatest when investors buy trusts on premiums – and I, for one, do not think that this is automatically wrong – and then markets have a shake-out. Prices can fall very quickly as sentiment turns negative.

Investment trusts are obviously still capable of generating bad headlines in the press – the split-cap affair is still seared into certain investors’ minds. I think, however, that the industry is not doing enough to educate HNW investors about the mechanics of these trusts and should raise its game. By and large, it is failing to get its message across, even though it has plenty of opportunity to do so.

The is one thing that the industry should do. As you can imagine, I come across numerous trust factsheets and websites, Report & Accounts, and various announcements. Some fund management groups are better than others, but most fail to include enough details in their literature. For example, when you next look at a trust factsheet, the chances are it will simply contain a ‘disclaimer’ and the top 10 or 20 holdings. It should, instead, contain a succinct text approved by the whole industry that explains:

• what discounts and premiums are;
• how they influence the share price; and perhaps
• where that investment trust lies in its one-year range.

The challenge, as ever, is to get the balance right. It is in the industry’s long-term interest to highlight the risk of premiums or narrow discounts, while at the same time not scaring investors away from investment trusts' many good points, which include superior performance. I think that the future is bright for investment trusts, but we have to be alive to the threats to them if we are to enjoy their full potential. With the help of organisations such as the WMA, which has done such sterling work on behalf of investors in defending investment trusts against the tide of EU regulation, I am hopeful that we shall succeed.