Investment trusts are a Victorian invention, recently celebrating their 150th anniversary. The first – the Foreign & Colonial Government Trust (now known as the F&C Investment Trust) – was set up by Philip Rose in London in 1868 “to give the investor of moderate means the same advantages as the large capitalists in diminishing the risk by spreading the investment over a number of stocks”. They are therefore part of the group of collective investment funds that includes unit trusts, open-ended investment companies (OEICs) and exchange-traded funds (ETFs).
Interestingly, the term 'investment trust' is rather inaccurate in that they are not actually constituted as 'trusts' in any legal sense of the word, since all investment trusts are established as public limited companies (PLCs) and, therefore, run according to company law. Whilst, investment trusts share many of the characteristics of their 'pooled' investment vehicle cousins, their corporate status means that they also differ in a number of meaningful, but less well-recognised, ways. Of these, arguably the most significant is that, in common with all public limited companies, they are required to maintain an independent board of directors appointed by the shareholders to supervise their activities, to make key strategic decisions about the future direction of the trust and to safeguard the interests of the shareholders. Crucially, the board has the power to dispense with the services of the portfolio manager if they feel they are not delivering adequately; should there be a prolonged period of deteriorating performance, it is the duty of the board to review the manager or, in a worst-case scenario, to wind up the company.
For the majority of investment trust shareholders, the team managing the underlying investment holdings is likely to have been the primary reason for their selection: experience, knowledge of the particular region or sector, expertise within the particular theme being pursued, a distinctive or contrarian methodology, and a reassuring track record of success may all have played an important part. Less likely to have been a factor are the capabilities and skill-sets within the team presiding over the appointed portfolio managers – the independent board of directors. Throughout the 150-year history of the sector, however, there is compelling evidence that the combination of an investment trust’s unique structure, the presence of a skilled and professional investment manager, and its experienced independent board providing a unique additional layer of governance can combine to deliver consistent out-performance over open-ended funds, despite ever-present economic and market turmoil. Indeed, as the asset management world becomes increasingly regulated, the critical governance function undertaken by the board of directors – always with the best interests of shareholders uppermost in their minds – can only grow in importance, thereby enhancing the appeal of investment trusts for investors.
The role of an investment company board is multi-faceted and so, to be optimally constituted, a board will typically comprise individuals with specific experience and expertise in particular disciplines, complementing those of their fellow board members, in order better to ensure that the trust fulfils its mandate. Shareholders therefore benefit from the wide range of talents that directors bring to their role in areas such as investment management, business management, economics, risk and control, sales and marketing, law and accountancy. Moreover, board members are required to stand for election each year and are consequently answerable to shareholders, who can vote to have them dismissed.
Delivering shareholder value
Successful investment trust management is essentially a partnership between the board and the appointed portfolio manager, the board’s key responsibility being the overarching governance of the company, ensuring that those to whom responsibilities have been assigned fulfil those responsibilities in a manner that best contributes to long-term shareholder value. Investment company boards therefore possess the ability to influence policy in a number of profound ways, as we shall see.
First, the payment of dividends. Unlike other types of investment fund, investment trusts are permitted to hold back up to 15% of the income arising in any year, thereby creating a 'reserve' for future years should they prove to be leaner. The level of dividend payout in any year, and the extent to which access to the income reserve is required in order to meet that stated payout, are therefore matters for the board. Through prudent management of reserves, trusts can build up protracted records of dividend increases in this way: The City of London Investment Trust and The Bankers Investment Trust for example – both within the Janus Henderson stable – have grown their dividend payouts in every year for over half a century.
Contrastingly, in its 2020 annual report, the board of Henderson EuroTrust – also within the Janus Henderson investment trust stable – declared its intention to move from targeting a progressive dividend to a strategic policy of paying out substantially all of the dividend income generated by the trust in any financial year. Furthermore, reflecting the fact that the trust has a significant income reserve, it is proposing to smooth the transition to this new policy by paying out the majority of that reserve over the next three to four years.
Next, we turn to the topic of discounts and premiums. A trust's share price is dependent on two key factors: the performance of the assets within the portfolio, and supply and demand for the shares in the marketplace. It will therefore – unlike a unit trust or OEIC – very rarely be the same as the net asset value (NAV). At any particular point in time, the shares could be trading at a discount (where investor demand is low), or at a premium (where investor demand is high) to the net asset value. Trusts typically endeavour to smooth out the swings in their share price rating. If the stock is consistently trading at a premium, the board will determine to issue new shares to meet that demand. Conversely, if there is insufficient demand and the price has been trading at a discount for a protracted period, the board may also buy back some shares to reduce the excess supply. It is a telling issue since buying back shares for cancellation or holding in treasury at a discount is in the shareholders’ interests, but not in those of the investment manager, given that a share buy-back decreases the investment company’s assets under management and thus the manager’s fee.
Demand for Henderson Far East Income Limited, for example, continued unabated throughout its most recent financial year, ended August 2020. As a result, the trust issued a total of 10,815,000 new shares, all at a premium, raising £37.3m for further investment, and thereby enhancing the net asset value for existing shareholders whilst enabling the costs of the company to be spread over a wider investor base.1
Next, we come to gearing. Unlike most other types of investment fund, investment trusts are able to borrow money, which can be invested alongside the capital injected by purchasers of the trust's shares. This facility provides the trust with leverage, known as 'gearing'. Whilst it gives the portfolio manager freedom to take advantage of a long-term view, or to react swiftly in terms of a favourable situation without having to dispose of any existing investments to raise the necessary cash, there needs to be a level of confidence that they can generate a higher return than the cost of borrowing the money.
Not all investment trusts take advantage of gearing, however, and it is very much a decision to be made by the board albeit in collaboration with, and on the recommendation of, the manager. Bankers Investment Trust has a three-year gearing low/high range of 0% and 4% respectively, for example; by contrast, Henderson High Income Trust, also managed by Janus Henderson, has a three-year low/high range of 24% and 49%.2
Third, we have the issue of fees. Trust boards have also been widely credited for negotiating competitive management fees for their shareholders, and at levels typically lower than those of their open-ended counterparts. Moreover, trusts are more likely than open-ended funds to have adopted a tiered fee structure, allowing investors to benefit from economies of scale as a trust’s assets grow. A number of trusts have also dispensed with performance fees. For example, City of London Investment Trust enjoys the lowest ongoing charge in its sector, at 0.36% pa, and this is also one of the lowest in the investment trust industry.
Finally, given that investment trust boards exist largely to fulfil a governance role, one would naturally expect that they have been active in shaping the environmental, social and governance (ESG) policies of the trusts they represent. The rise in the popularity of ESG-focused investing has been meteoric over recent years, the acceleration in interest being almost entirely attributable to deepening public and corporate interest in matters of societal importance: climate change, sustainability, the environment and conservation, for example. A recent study by PwC predicts that by 2025, in Europe alone, ESG funds could represent a higher value of assets under management than their non-ESG counterparts, with the former accounting for 57% of the market – a staggering 28.8% compound annual growth rate from 2019 to 2025, and representing a revolutionary, all-encompassing shift in the investment landscape of proportions hitherto unseen in the European fund industry.3
With Europe established as the sustainable capital of the world at present, and therefore leading the way on ESG issues, it's perhaps unsurprising that Henderson EuroTrust, a Europe (ex-UK) investment trust focusing on high quality, predominantly large cap equities, has consistently ranked as one of the leading trusts on Morningstar’s sustainability rankings. Its Janus Henderson portfolio manager, Jamie Ross, has been an enthusiastic advocate of ESG as an integrated stock selection methodology, his investment process being so focussed on governance and sustainability that it naturally aligns with ESG. The proprietary process has been shaped with the full involvement and support of the board, firm in the belief that companies with a robust ESG approach will consistently produce better and more consistent returns over time, thus attracting a lower cost of capital.
To conclude …
Having an investment trust board is not entirely without its disadvantages. Needless to say, any team of highly skilled and experienced professionals needs paying appropriately for its time, and that bolsters the ongoing costs of running the trusts. However, few industry commentators would take issue with the observation that the many profound benefits they bring markedly compensate for the cost.
Indeed, open-ended funds are now obliged, to an extent, to follow suit. In April 2018, the Financial Conduct Authority announced a range of measures to improve fund governance, protect investors and ensure that investment products deliver demonstrable value. One of these measures required the boards of Authorised Fund Managers, with effect from 1st October 2019, to be comprised of a minimum of two independent non-executive directors, representing at least 25% of the board. Imitation is, as they say, the sincerest form of flattery!
1Source: Henderson Far East Income Limited, Annual Report 2020
2Source: Association of Investment Companies, 23.03.21
3Source: PricewaterhouseCoopers, 2022 – The growth opportunity of the century, November 2020