New investment trust factsheets giving potential return figures in favourable and adverse markets have provoked criticism.
There has been pushback from providers and financial experts who believe recent buoyant markets have skewed the potential performance figures and could end up misleading people.
We take a look at what the investment trust ‘key information documents’ or KIDS provide to investors, and why they are under attack – notably from leading fund house Baillie Gifford.
Trading trends: Financial experts say recent buoyant markets have skewed the potential performance figures
Fund managers have already had to publish a more bare bones version of these documents for several years, but must switch to the new format from the start of 2019, which could spark more protests along these lines (unless markets tank by then, of course).
Why have investment trust KIDs proved controversial?
KIDs have to provide detailed information about potential performance if you invest £10,000 under different market scenarios – stress, unfavourable, moderate and favourable.
But these figures are compiled on the basis of past performance, which investing experts always say should not be used as a guide to future outcomes.
On top of that, markets have clocked up enormous gains over the past few years, and a correction is widely expected, especially in the US. This means investment trusts have to produce ‘favourable scenario’ performance figures that, frankly, look too good to be true.
What are investment funds and trusts?
Funds pool investors’ money to put in shares, bonds and other assets.
Trusts are listed companies with shares that investors buy and sell on the stock market.
They invest in the shares of other companies, or assets like property. Read more about how trusts work below.
Edinburgh-based fund partnership Baillie Gifford says basing calculations on past performance could lead to investors receiving poor information that is potentially misleading.
‘We have had to comply with the strict requirements of the new rules, notwithstanding that some of the outcomes produced are inappropriate. I would struggle to suggest that these new disclosures meet the clear, fair and not misleading test,’ said Graham Laybourn, partner for compliance and legal matters.
He said a number of boards of Baillie investment trusts had written to the Financial Conduct Authority to point out the performance scenarios could set unreasonable expectations among investors.
James Anderson, joint manager of Scottish Mortgage investment trust, chimed in to say he was ‘extremely disturbed’ by the KID requirements. See the box below.
Influential economist John Kay, a Scottish Mortgage board member, wrote in the FT earlier this year that he regarded it as ‘irresponsible’ to make claims before ‘neophyte investors’ of a 30 per cent return over five years from a mid-range risk ranking investment trust.
He took issue with the volatility risk calculations that underlie the performance figures, saying: ‘This is a triumph of pseudoscience over common sense.’
Scottish Mortgage IT manager hits out at KID requirements
‘We are extremely disturbed by the requirements of the key information document,’ says joint manager James Anderson.
‘We do not believe that reliance on past performance data is ever a sufficient guide to the many possible future outcomes in stocks and markets.
‘The persistent and steady rises characteristic of the last five years seem especially questionable as a guide. We consider the most important risks in markets to be intrinsically unpredictable and unmeasurable.
‘We would also highlight that the emphasis on the short-run demanded in the KID, seems to us to be acutely misguided.
‘We continue to stress to retail shareholders that we focus, as we believe they do, on building capital in the long-term. We believe that an undue preoccupation with short-term volatility undermines this commitment – and indeed the ultimate purpose of financial markets.’
Gavin Haynes, managing director of financial adviser Whitechurch Securities, said: ‘I think Baillie are totally right. Using £10,000 is fine, it’s performance that needs much more thought.
‘On first look at a snapshot of past performance it can certainly provide a misleading outcome.’
Adrian Lowcock, investment director at Architas, an investment management firm owned by AXA, agrees that past performance is not a guarantee of the future, and doesn’t tell you anything about what will happen going forward.
He reckons Baillie has bent over backwards to emphasise its concerns to investors in its Scottish Mortgage KID, with strong risk warnings in the relevant section and again at the end of the document.
What does the FCA say?
The FCA put out a response to industry concerns about the performance scenarios in KIDs here. This explained the calculations were set out in something called the ‘PRIIPs Regulatory Technical Standards’, which is part of European legislation.
‘We understand some firms are concerned that, for a minority of PRIIPs, the “performance scenario” information required in the KID may appear too optimistic and so has the potential to mislead consumers,’ it said.
‘There may a number of reasons for this: the strong past performance of certain markets, the way the calculations in the RTSs must be carried out, or calculation errors.
‘Where a PRIIP manufacturer is concerned that performance scenarios in their KID are too optimistic, such that they may mislead investors, we are comfortable with them providing explanatory materials to put the calculation in context and to set out their concerns for investors to consider.’
How do investment trusts work, and what is NAV?
Investment trusts are listed companies with shares that trade on the stock market.
They invest in the shares of other companies and are known as closed ended, meaning the number of shares or units the trust’s portfolio is divided into is limited – unlike unit trusts or open-ended investment companies (OEICs) where investors’ money is pooled to invest in shares, bonds or other funds.
In an investment trust, investors can buy or sell shares to join or leave the fund, but new money outside this pool cannot be raised without formally issuing new shares.
Investment trusts can be riskier than unit trusts/OEICs because their shares can trade at a premium or discount to the value of the assets they hold, known as the net asset value.
NAV is calculated by dividing the total value of assets (what it owns) minus liabilities (what it owes) by the amount of shares existing.
A trust’s price can fall below the total value of its holdings if it is unpopular and people do not want to invest but do want to sell. This pushes down demand and drives up the supply of its units for sale.
This gives new investors the opportunity to buy in at a discount, but means existing investors’ holdings are worth less than they should be.
An investment trust trading at a discount to NAV may be regarded as cheap because the shares cost less than its overall value – although there might be good reasons why, such as investors being justifiably pessimistic about its prospects.
When a trust trades at a premium to NAV it is more expensive than its net worth.
Investment trusts tend to be a lower-cost option than funds, with no initial charge and lower annual fees. However, buying them incurs share-dealing charges. A good DIY investment platform will cut these.