AIC interview on investment trusts

AIC interview on investment trusts
We spoke to the industry body about London-listed funds.
David Kimberley
August 27, 2021

Investment trusts can trace their history back all the way to the Victorian era. Unique to the UK, these listed funds have long provided a simple way for regular investors to get exposure to an actively managed, diversified portfolio.

But the rise of ETFs and concerns about high fees and underperformance have left some people sceptical as to their utility. To understand this dynamic, and whether or not those views are totally justifiable, we spoke to Elmley de la Cour, who is part of the communications team at the the Association of Investment Companies (AIC). The AIC is an industry body that represents investment trusts and their investors, as well as providing a wealth of data and information on the funds listed on the markets today.

We chatted in-depth about what investment trusts actually are, how they function, and why they could play a role in an investor's portfolio today. You can watch a video of the interview below or read the transcript.

What are investment trusts?

Dan Lane: Hello and welcome to another executive interview here at Freetrade. I'm Dan Lane. A quick reminder to sign up to our daily market newsletter, Honey, for everything that's going on in the markets every day, you can do that using the link below.

Today I'm joined by Elmley de la Cour from the Association of Investment Companies to talk all things investment trusts — many thanks for coming in. I think there's no better place to start than, can you tell us, what are investment trusts?

Elmley de la Cour: Of course. So investment trusts are funds. So they pull together lots of individual investors’ money to be spread across a diversified portfolio of different assets. And they are actively managed. So a fund manager or team of fund managers works to beat a benchmark index rather than just match the performance of that index.

What makes trust a little bit different is that they're actually companies in their own right. So trusts are listed on a stock exchange, just like Amazon, Apple, Tesco. So you invest in an investment trust by buying their shares on the stock exchange, but investment trusts are actually one of the oldest forms of funds available. Their history goes back over 150 years.

And some of the first investment trusts are still available to be invested in today. But today, despite having this history, they provide exposure to some of the most cutting edge investment opportunities possible. So there's this nice kind of track record, but also looking to the horizon. There's about 400 investment trusts in total and they're listed on the London Stock Exchange.

Why are investment trusts different to ETFs and open-ended funds?

Dan Lane: So yeah, you've described it better than I ever did there. I think, you know, keen Honey watchers will have seen we actually had Paul Niven from the F&C investment trust, which is just, you know, the granddaddy of them all. And I think, more broadly, when it comes to kind of a single product that invests in a basket of stocks, a lot of people will be more familiar with ETFs or even open-ended funds for that. What is specifically different about a trust?

Elmley de la Cour: The biggest difference is the investment trusts have what's called a closed-ended structure. So that's opposed to ETFs or open-ended funds, which have an open ended structure. And what that really means is that investment trusts have a fixed number of shares which investors buy and sell between each other on the stock exchange rather than an open ended fund, which gets bigger and smaller as investors move money in and out of the fund.

So what this really means is that when you buy shares in an investment trust, it has no impact on the underlying portfolio of the trust because you're doing the trading on the stock exchange between all of the investors. So that might sound like a sort of technical difference, but actually it has a huge impact because the trading has no impact on the underlying portfolio. It means an investment trust can invest in a much wider range of assets. So particularly things that are quite illiquid, it can take a long time to buy and sell.

If you're investing in an open-ended fund or an ETF, if you want to redeem your money, the manager will have to sell the assets to then give you your money back. So they have to be invested in things which are quite liquid and things that they can kind of liquidate very quickly. Investment trusts, there's no such restrictions. So investment trusts can provide you access to a huge range of other assets, which we'll probably come on to in more detail a bit later. So closing the structure is one of the really big differences.

The other one is the fact that the companies in their own right, because they're PLCs and they have an independent board of directors just like Amazon, Apple, Tesla, any single stock company you can think of. But what that really means to you as an investor is that you have an independent board of directors who have a legal duty to represent your interests in the trust for an investment trust. It is the board that actually then hires the asset manager to run the fund on a day to day basis, you know, so people like Baillie Gifford or J.P. Morgan. And so the board can hire and fire the fund manager if performance is poor. They can hold the manager to account. They can lower fees and negotiate on behalf of shareholders. This is very different to investing in an ETF or an open-ended fund, which ultimately is a product provided by an asset manager.

So you've got an extra level of governance representing your interests because they're companies as well, with an investment trust, you're a shareholder so you can vote on issues affecting the trust. You can attend AGMs, you can ask questions of the board and manager. There's much more of a kind of two way relationship when you're a shareholder of s trust.

What is gearing and why do investment trusts use it?

Dan Lane: I guess one of the things that we’ve focused on in recent years is that accountability actually, you know, you go the open-ended side, there have been accusations that maybe some managers are resting on their laurels or just trying to fit in with the crowd. You can't do that in the trust space, because you've always got someone looking out for shareholder's interests and maybe looking to move you along if you're not doing that.

I guess one of the things I wanted to touch on, and it's actually probably a good segue into the pros and the cons, because, you know, we have to provide balance. I was going to ask you about downsides. And then I thought, well, actually, gearing is something that can be a pro and can be a con, but a lot of people won’t be familiar with that process. I wonder if you could shed some light on it?

Elmley de la Cour: Yeah, so gearing is investment companies' ability to borrow money to make further investments. It's known as leverage in the US. It's essentially borrowing money to make investments. It's something investment companies have the structural ability to do. It's something that seems to be fairly well known as one of a trust's attributes.

It is something that contributes to investment companies' long-term performance. So just to sort of put a few numbers on it, over the last 10 years, the UK All Share has returned 91%. The average open-ended fund has returned 103%. But investment trusts, the average investment trust has returned 119%. So gearing provided, along with the closed-ended structure and ability to invest in a wide range of assets, is definitely one of the things which makes long-term returns one of investment trusts strengths.

But there's no two ways around it. Gearing does add risk and it does make investment trusts more volatile than other types of funds, which is why we always say that an investment trust is suited particularly to long-term investors. Five years as a minimum, but preferably 10 or more, when these structural benefits really, really do come into their own. I think just the last thing I'd say is that each trust uses gearing in different ways. In some sectors they tend to be more highly geared than others. Around half of investment trusts currently have no gearing at all. And across the whole investment trust industry, the average level of gearing is 8% of the average trust's portfolio. So it's relatively modest, but it's just one of the tools that investment trusts can use.

Are investment trust fees expensive?

Dan Lane: Yeah, thanks. And I think fees tend to get a lot of attention in the space. I think with any pooled vehicle, they tend to dominate the headlines a lot of the time, and there can be throwaway comments about trusts being expensive relative to just buying the shares yourself. Do you think that's justified?

Elmley de la Cour: I think that investment trusts are actively managed, so you will always pay for active management compared to passive products. You know, there's just no two ways about it, but there's no real one size fits all approach to fees for the entire investment trust industry. They really do vary between trusts. Several investment trusts are very large companies.

And when you're operating at significant scale, the economies of scale mean that you can actually bring down charges for shareholders. Many large investment trusts operate a tiered fee structure. So as the assets grow, the charges fall for investors. So there's many large investment trusts with actually quite modest fees, considering you're getting active management and, in some cases, exposure to unlisted companies. But there are no two ways about it, if the trust is providing access to a very specialist area, something that is more resource intensive takes more time, you know, something like specialist property, private equity, it is just a bit more expensive, but you'll be getting something back for that. That's specialism and expertise.

Investment trusts and dividends

Dan Lane: Yeah, I guess I think people forget what they're actually paying for. You know, you're paying for that background analysis. Sometimes these trusts have huge analysis teams. You've got the board of directors that you've talked about. Is there anything else that you'd be paying up for? Because I think the notion is that you're just lining the managers' pockets, which isn't always really true.

Elmley de la Cour: I think the other thing I'd say is that because investment trusts have a closed-ended structure and because they're companies, they can invest in a much wider range of assets than other types of funds. So particularly illiquid things like I mentioned. So they can provide access to a whole world of unlisted companies, unquoted companies and some really, really exciting areas. So, you know, space technology, fintech, emerging biotech, renewable energy, infrastructure, things like wind farms, solar parks, battery storage, you know, there isn't a way to access these actual assets. You know, listed investment companies offer that.

So your being able to access these things, which otherwise would be very, very difficult, if not impossible, for an individual investor to actually access. So there's definitely those benefits and also income benefits, as well as providing access to a wider range of assets. Investment companies are really, really well suited to investors who are looking at income. Unlike other types of funds, they can save up to 15% of the income they receive from their portfolio holdings each year. They put that away into a revenue reserve. So if you're buying an investment trust, the dividends....this is a huge advantage because it means that investment trusts can put income away in good years to then pay up when times are more tough.

So take an example of last year. The pandemic hit the entire world, the entire business world, the entire economy, extremely badly in the UK. Dividends fell 41%, but investment trusts, because they had built up revenue reserves over many, many years, almost nine in 10 investment trusts were able to increase or maintain their dividends to shareholders despite what was going on in the wider world. So definitely structural benefits that you pay for with trust.

Who invests in investment trusts and what are some of the benefits?

Dan Lane: Yeah, you're picking up on that, I was going to ask you but I may as well ask you now about, you've got access to these private opportunities and then that really important income element that you mentioned there. And who then buys trusts? Is there a certain type of investor that takes advantage of these things? Do you see a certain type of persona that will opt for trusts over something else to take advantage of these rules?

Elmley de la Cour: Well, what we see is that when investors begin investing in trusts, they tend to really like them, and then they tend to sort of become advocates. So your typical investment trust investor will have been investing in trusts for a while and probably has a portfolio of trusts. But we're seeing younger investors become more and more interested in trusts. You know, they could well have had parents that have recommended trusts to them.

But also, I think it's the fact that they provide access to these exciting areas, you know, things that you see around you, apps that you're using, energy, infrastructure that's contributing to a net zero future. And also because they're companies, you have the opportunity to actually vote and take part and be of sort of a member or shareholder of this company. So I think for younger investors who want to get involved with their investments, I think that's why it's attracting younger investors as well.

Dan Lane: Yeah, and I mean, I think your point about the income reserves is really quite important, as you said, anyone who's relying on the consistent income stream, I'm thinking about maybe someone in retirement. And, you know, last year would have given them heart palpitations with all those dividends just dropping left, right and center. Whereas just if I think about a few trusts in the sector, it didn't actually stop any dividends and they just kept on paying because they were able to use that reserve. So I think that's I mean, that's kind of handy for retirees as well.

Elmley de la Cour: Yeah, since 2008, when interest rates have pretty much just been nailed to the floor, investors have had to look elsewhere for income. And, you know, with more and more investors having to take control of their own pensions rather than sort of, you know, work providing a defined benefit scheme, more and more investors are taking control of their financial future and their pension.

So investment trusts' income advantages have been hugely popular over the last sort of 10 years or so. We have a group investment trusts called the Dividend Heroes. They are trusts which have consistently grown their dividends to shareholders for 20 years or more. So 20 years might sound like quite a lot, but actually it's just the price of entry to become a dividend hero investment trust. There are six which have raised dividends consecutively for more than 50 years.

So, you know, the trust that's actually raised dividends the most consecutive years is called City of London Investment Trust. It's probably well known to many of your investors. The last time it didn't raise a dividend was when the Beatles released Sgt. Pepper. So, you know, if you've been a shareholder in the City of London Investment Trust, your dividend has been going up every year. And you think about what's happened over that time. You know, we've had huge market setbacks. You've got the crash, you've had the global financial crisis but investment trusts have been able to keep raising their dividends, you know.

So, you know, not all do. It's up to the board of an investment trust to decide on the dividend policy that's in the best interests of shareholders and dividends are never guaranteed. But it's just such an extra benefit having this structure that enables trusts to do that if they decide to.

What is the AIC?

Dan Lane: it's a sign of long-term investing when you measure in decades and centuries. OK, so moving on to the AIC itself. So, I mean, what are you? What do you do? Where do you sit in the industry and what's the purpose?

Elmley de la Cour: So the AIC, the Association of Investment Companies, is the trade body for investment trusts broadly. Our work is to help our member investment trusts deliver the best possible returns for their shareholders. So we have a public affairs team that lobbies for the best tax and regulatory environment for investment trusts. Our members, investment trusts, are the board of directors. So they're non-executives.

They tend to have specialist knowledge, which is why they might be a good director for that particular investment trust. So they might be specialists in science if it's a biotech trust or, you know, Japanese smaller companies if it's investing in Japan, for example. So it will provide events and training to make sure that directors are up to date with what's going on across the whole industry. We have a very active website where a huge amount of data on each of our member investment trusts is available for free. So investors all want to work very hard to make sure that is updated every day with performance data, portfolio information, fees and charges. And it's a huge resource.

So that's to help try and inform investment trust investors' decisions, or bring people who might be new to trusts and sort of help them understand what they are and how they can help them. And then we also have a communications team, which is my team, which works to promote investment trusts to the widest possible audience, journalists, private investors, financial advisors, wealth managers, making sure the benefits of investment trusts are known by as many people as possible.

Investment trusts and ESG

Dan Lane: And I think certainly we've got time for one more, so I'm going to squeeze it in here. I think one really important consideration broadly among investors now is ESG. Those are environmental, social and governance standards. Basically, you know, shorthand for sustainability, really. And I think it's something on private investors' minds. I was just wondering, do you think it's on professional investors' minds, these heads of these trusts? Today, is sustainability something they think about? Is it even something that could add value to for private investors who are looking for their sustainable investment opportunities?

Elmley de la Cour: Yeah, I mean, in one word ‘definitely’ is the answer. I go to lots of investment trust managers' presentations and, you know, almost all of them have an ESG process. It's part of most investment trust....investment trust managers' investment framework. You know, so [things like] how does this potential investment fit with the investment trust's and policy strategy towards ESG? So, yeah, I'd say it's pretty pervasive through, you know, almost all investment trusts' investment processes.

But sort of just moving on from that, there's a huge range of options for investors who want to be involved in sustainable investments. We have an environmental sector which houses investment trusts, specifically investing in green and environmental technology. You know, things like recycling water treatment, reverse vending machines to make the most of materials. We have very, very large renewable energy infrastructure sector. So these are trusts which will invest in solar parks, wind farms, battery storage, you know, the real building blocks that our net zero future will require.

That's been a very, very big sector, but also the social impact opportunities as well. We have an investment trusts, which owns specialist property, care homes, accommodation for the homeless, social housing. Trusts which are investing in associates, doing real social good. So those are specialist opportunities and something which is pretty much impossible for retail investors to otherwise invest in. So there's a whole range of opportunities investment trusts can provide.

Dan Lane: So a definite yes there then.

Elmley de la Cour: And the other thing I'd say is that because it's so diverse, you know, both for individual investors and for investment trusts, you know, everyone's approach to ESG is different. And we have a hugely diverse industry. So thinking about how we could best help investors, we gave each of our member investment trusts the opportunity to publish their policies and approach to ESG on our website. 

So if you go to our website and look at any of our member investment trusts next to all of the information I was talking about, things like performance and portfolio, which will give you how they think about ESG, what their policies are. And our aim is that investors can then use ESG information to help inform their investment decisions. So that's available on our website.

Dan Lane: Excellent. You know, I think I could talk to you about this all day, but I won't keep you as we've run out of time here. Thanks for coming in to join us.

Elmley de la Cour: Dan, great to speak to you.

Dan Lane: Thank you very much for watching. If you'd like to know more about the AIC or just trusts in general, feel free to visit the AIC website or you can visit the explainers on the Freetrade Learn Hub. Thanks for joining, see you again soon.

Past performance is not a reliable indicator of future returns. Source: AIC/Morningstar, as at 1st August 2021. Basis: bid-bid in local currency terms with income reinvested.

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