Are investment trusts the best option in an RDR world?

Investment trusts can give clients good value for money without impacting on potential investment returns.

The law of unintended consequences can be defined as follows: ‘Any intervention in a complex system may or may not have the intended result but will inevitably create unanticipated and often undesirable outcomes’. The Retail Distribution Review is without doubt an intervention in a complex system. Fundamentally, RDR is designed to improve the lot of intermediate investors. It looks to give IFAs’ clients access to the complete set of products offered by the investment marketplace.

These products will have to come with transparent pricing commensurate with effort and expertise taken over their selection. To reach these goals intermediaries are being asked to charge fees, research the whole market for the most suitable investment opportunities and pass a series of testing exams. This sounds simple, but as has been debated ad nauseam, RDR is littered with opportunities for unanticipated and undesirable outcomes.

Move to fee-based

Consider then the following experience of an imaginary client and ask whether it strikes a chord in terms of possibility or indeed probability. The client visits his IFA for an annual review. Hitherto, their arrangement has been commission rather than fee-based. But today that will change. The IFA says to his client, there is bad news and good news. He says the bad news is he will be charging fees from now on for his advice and service, but the good news is his client will not have to pay any more than he did before. The IFA intends to sell his client’s actively managed unit trusts and invest the proceeds into a portfolio of ETFs and tracker funds. The saving will mitigate the new upfront cost to the client.

So is this an undesirable outcome directly emanating from the imposition of RDR? Who is happy? The IFA could be because they are offering their client a better price and delegating investment choice to ‘Mr Market?’ The client may be because they are getting equity exposure at the cheapest possible price. Perhaps neither party will be better off after this initiative? The client will be swapping an actively managed portfolio of funds for a collection of passive strategies that by definition will never outperform. Fund selection is being made on the basis of price and the safer haven (for the IFA but not necessarily for the client) of the index. The client will be worse off in the future, assuming that carefully chosen actively managed funds outperform.

One can have some sympathy with the IFA, because if it were not for RDR the client would still be invested in active funds that at least have the opportunity to outperform. RDR is pushing IFAs to charge a fee rather than accept commission, which may have suited his client well in the past. This seems unfair. In addition, the concept of having to justify each investment decision on the basis of whole market analysis is a tall order in practical terms. While accepting that some investors will wish and require suitable exposure to stock markets via passive funds, does our client here not deserve the best fund choice particular to his needs? The investor may have wanted a portfolio designed to beat the index and requested one chosen for him on the basis of the judgement, expertise and experience of their IFA. They may wish to invest passively direct, then they have lost the benefit of advice and the IFA has lost their fee.

AIC versus IMA

Perhaps a happy compromise might have been reached if the IFA had considered switching from unit trusts to investment trusts in an effort to give their client value for money without impacting on potential investment returns. Many studies over the years have shown the propensity for members of the AIC to outperform members of the IMA. This is not true for every sector all of the time, but past performance does offer a pretty convincing case for the closed ended sector. Within the investment trust sector IFAs can seek exposure to some of the brightest names in investment, such as Woodford, Mobius, Young, Tulloch and again Bolton to name but a few. Many of these managers consistently outperform the index.

Variation

Investment trusts come in many varieties investing across countries, sectors and asset classes. The Global Growth sector is the largest, and its constituents are the best-known investment companies listed on the London Stock Exchange. The big ones are all FTSE 250 stocks and as such offer accessibility and liquidity and long-term performance (see Table One). They offer a variation of investment objectives, which does not stray onto the tracker’s patch. For example, Monks takes a pragmatic approach to global investing whereas Scottish Mortgage has a devout long-term bottom-up stock-picking style. Witan takes a multimanager route, while F&C employs talent both from within and outside its management company. These funds also do not cost the earth. For the most part Global Growth Investment Trusts offer exceptional value with total expense ratios well below 1% per annum (see Table Two).

Corporate governance

Another (sometimes maligned) advantage enjoyed by investment trusts is corporate governance. In a world dominated by regulation and compliance, it is an extra comfort to know each trust has a board of directors independent of the investment manager and working on behalf of the shareholder. A unit trust is the creature of its manager.

Indeed, investment trusts stand up well to the proposed rigours of RDR analysis as investment options. They should take their place alongside the historically more popular open ended funds in the post-RDR brave new world. Many have been around for over a century, so perhaps another unintended consequence of RDR will be their long-awaited return to mainstream popularity in 2012, if not before.