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10 May 2014

Investment Trusts

Tag(s): Business
I recently retired from the Board of JP Morgan Japanese Investment Trust (JPMJIT) after serving as a Non-Executive Director for eleven years. I had agreed to step down the year before rather than seek re-election as nine years is now seen as the guideline for maximum service. After that a director is no longer considered as independent, he or she has to seek re-election every year and if too many of the board are no longer independent then major shareholders may start to vote against them. But shortly before the AGM in 2012 the Chairman phoned me at home. I thought he was going to discuss where we held my retirement dinner but instead he asked me to stay on another year as he was having trouble finding a replacement. I think this was the first time in my life that anyone had said I was irreplaceable but of course they subsequently found an excellent replacement in Sir Stephen Gomersall KCMG, a former ambassador to Japan. Sir Stephen is not only a fluent Japanese speaker but can even write in Japanese and is also on the board of Hitachi. I was pleased to serve the extra year as in that year the Japanese stock market advanced by 30% and we out performed it by a further 15% delivering an increase in the return to shareholders of 57.8%.

An investment trust is a listed company whose business is to invest in financial assets. This usually means shares in other listed companies, but it can also include assets from private equity to infrastructure. As with any other listed company, an investment trust has a board. That board appoints a manager to run the firm’s investments. Unlike other listed companies the directors of an investment trust are all non-executive. There are no executive directors. In law there is no difference between an executive and a non-executive director. But in practice there is a key difference. The non-executive directors are all independent. That is they are so deemed until they have completed nine years. After that, under the combined code, they are seen to have become dependent. That is why I had to retire.

Investment trusts (also known as closed end funds) generally perform better than open-ended competitors, such as unit trusts. In fact according to some recent research over the past ten years investment trusts have beaten unit trusts in all nine major areas of investment. There is one very good reason for this. They generally have lower costs. Unit trusts rely on aggressive advertising and recommendation by so-called Independent Financial Advisers (IFAs) who of course receive substantial trail commissions, not paid by investment trusts.

Most unit trusts charge a standard 1.5% annual fee but the equivalent costs on investment trusts are closer to 0.6%. As a general guide the larger the trust the lower the costs as most of the costs are fixed. Some boards agree performance fees with their manager in which case there could be something of a sliding scale but it will rarely approach the cost structure of the open-ended funds.

The point of both kinds of trust is the same; a manager raises money from a large group of investors, and invests it on their behalf in a range of companies, or other assets. The big difference is in their structure. Investment trusts are listed on the stock exchange. Therefore the price of the fund is not dictated by the face value of the underlying portfolio but by demand for the shares. As a result, investment trusts often trade at a discount to their net asset value. This means that you can buy the underlying portfolio for less than it’s actually worth. Some canny investors trade in and out of the same investment trust to take advantage of movements of the discount.

Over the last few years the average discount has been coming in. In the bad old days of 2008 it went out to 17% but that has gradually come in to 12% in 2009, 9% in 2010, 10% in 2011, 8% in 2012 and just 3% in 2013. Thus we can see that investment trusts are coming back into fashion. Some trusts are so popular that they trade at a premium to net asset value. In such events boards can usually issue new shares. Investors in such companies like the reliable income streams. I was short listed for the board of one investment trust which has increased its dividend every year for 45 years.

Another key difference is that investment trusts can also borrow money to invest, or ‘gear up’ to take bigger bets in bull markets. In other words, if the manager believes his portfolio is set to gain ground he can increase the size of his investments by the margin allowed by a decision of his board. In 2013 JPMJIT was geared up at 13.7% and this contributed strongly to our out-performance against the index. Clearly this strategy adds risk and if the market turns down a heavily geared investment trust will probably lose more ground. But as the long term record is so good it would seem that the great majority of investment trust managers manage this risk well.

I think that the demand for investment trusts will rise even further as the Retail Distribution Review regulatory changes kick in. In future IFAs will have to charge upfront fees for their advice rather than taking commission payments. In that environment more investors will take charge of their own finances and so are likely to be attracted to the lower cost structure of the investment trusts. In response some open-ended funds have already taken a sharp pencil to some of their costs but once investors look at investment trusts they will see a host of other advantages. One investment trust lists these as follows:

“As an investment trust, the Company offers a number of advantages over other kinds of savings.

For example:
• No capital gains tax is suffered on transactions within the portfolio.
• Charges to investors are typically well below those for comparable OEICs or unit trusts.
• Management of the portfolio is not complicated by regular redemptions and subscriptions.
• The ability to enhance net asset value per share by buying back or issuing our own shares.
• The freedom to borrow money to invest on behalf of our shareholders”
In my opinion the most important advantage is the governance. The independent board holds the manager to account. In our case at JPMJIT we had a very experienced and expert board. Three of the directors had highly regarded investment management experience themselves and could both challenge and coach the manager. As audit chairman we had a former top four firm partner who sat on other investment trust boards. My role was as an industry specialist who had visited Japan dozens of times both to buy and to sell and I would ask the slightly innocent questions at which at least one director should be adept. In fact I thought it one of the best boards I have worked with and I have been privileged to work with some very distinguished board directors. These include people who had been or were then the Deputy Chairman of Marks & Spencer, the Dean of the London Business School, the CEO of Marconi, a Director of Fairchild, the CEO of Cable & Wireless, a minister in Margaret Thatcher’s cabinet, the CEO of Reckitt Benckiser and the Strategic Affairs Director of Guinness plc.   Oh, and the retirement dinner was excellent!
Copyright David C Pearson 2014 All rights reserved

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