When an investment trust is performing well, its directors are almost invisible. An investor will probably skim through the chairman’s statement in the report & accounts before focusing on the manager’s report.
Few investors attend annual general meetings, and if they do, they aren’t there for the directors.
So what, exactly, do the directors do – and why does it matter for investors like you and I?
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How investment trust directors hold managers accountable
The directors of an investment trust, all non-executive, look after the trust’s relations with counter-parties such as registrars, custodians and auditors – all the things that investors take for granted.
They examine reports from internal audit, compliance and risk controllers which are invisible to investors. They scrutinise the parts of the report and accounts that nobody reads.
They shouldn’t – except on rare occasions – tell the investment managers what shares to buy or sell, because that undermines the accountability of managers for performance. They do, however, influence performance in more subtle ways.
They quiz the managers on holdings to ensure the investment rationale remains sound. They ensure the managers stick to the agreed investment mandate and that investments are compatible with it.
They set limits to ensure individual holdings are not disproportionately large and monitor the number of holdings.
They scrutinise unlisted investments, if allowed, and set the gearing policy, which allows the manager to borrow money to enhance performance on the basis that the likely returns exceed the cost. This also means approving the terms and provider of any loans and keeping an eye on its usage.
Most importantly, the directors should be supportive in difficult times but puncture over-confidence when things are going well; markets may be down or the trust’s area or style of investment out of favour.
All investors go through rough patches, make mistakes or get unlucky – investments are made on the basis of probability, not uncertainty, so rational investments or strategies don’t necessarily perform well. At the other end of the scale is the old maxim “don’t confuse brains with a bull market.” Good performance isn’t necessarily clever.
If poor performance persists, directors need to decide whether the manager is at fault. If so, they can ask for an internal replacement (if the management company hasn’t already suggested it), move the management contract elsewhere, or change the mandate.
These decisions may require consultation with the larger shareholders if they have not made their views known already. They can agree a merger with another trust or, in extremis, wind up the trust and return the proceeds to the shareholders.
The advantages trusts have over open-ended funds
That highlights a key difference with open-ended funds. The trust may carry the name of the fund management company, but the managers are just the hired hands under the terms of a contract of limited duration. The managers can be changed at the directors’ discretion, though the directors are accountable to investors.
If an open-ended fund performs poorly and the management company fails to take action, the investor can only sell, perhaps triggering a tax liability. A change of investment manager, though, can give a trust a new lease of life.
A change of manager can also give the directors an opportunity to negotiate fees lower, a consistent trend for at least 20 years. Directors also have leverage on fees if they issue new shares, requiring lower fees in return for the additional funds managed. Given that the corporate costs of a trust are likely to be higher than for an open-ended fund for regulatory reasons, lower management charges are a useful compensation, and a way for directors to add value.
They can add value by growing the trust, thereby spreading the costs that are fixed over more assets but also by calling a halt to expansion, thereby preventing any dis-economies of scale. These dis-economies can arise from having too large a pool of funds for an illiquid asset class.
As well as growing a trust, directors can shrink it through share repurchases, adding value if these are made at a discount to net asset value (NAV). This is rarely effective in reducing a discount if the underlying performance is poor and, if taken too far, can make the trust too small to be economic – but there are plenty of trusts that have bought back equity at a discount and then reissued it when the shares have risen to a premium.
Open-ended funds are obliged to distribute substantially all their net income each year, but investment trusts have the discretion to retain up to 15% in reserves, enabling directors to smooth dividends by holding back income in the good years and releasing it in the bad. This is why many trusts have such a long record of increasing dividends.
Directors are also able to distribute realised gains, allowing their trusts to pay a higher dividend than the asset class could otherwise finance. This enables trusts to offer an attractive yield without compromising total returns by investing in higher-yield equities.
The freedom of manoeuvre of directors may be limited by the impracticality of changing managers. They may give a failing manager the benefit of the doubt for too long, or jump out of the frying pan into the fire with the wrong change. They may fail to restrain an over-optimistic manager or force divestment at the wrong time. Boards of directors are certainly not infallible – but they are much better than having no independent sounding board at all.
The actions of directors are a drip-drip of positive actions, dwarfed by the underlying investment performance; but they accumulate over time. That investment performance is itself the consequence of a well-chosen manager, restrained in the good times, supported in the bad. Good managers readily accept that the scrutiny of directors, especially those ready to ask awkward questions, adds value. It is an important reason why, almost without exception, investment trusts out-perform open-ended funds, even those with the same manager and mandate.
Max has an Economics degree from the University of Cambridge and is a chartered accountant. He worked at Investec Asset Management for 12 years, managing multi-asset funds investing in internally and externally managed funds, including investment trusts. This included a fund of investment trusts which grew to £120m+. Max has managed ten investment trusts (winning many awards) and sat on the boards of three trusts – two directorships are still active.
After 39 years in financial services, including 30 as a professional fund manager, Max took semi-retirement in 2017. Max has been a MoneyWeek columnist since 2016 writing about investment funds and more generally on markets online, plus occasional opinion pieces. He also writes for the Investment Trust Handbook each year and has contributed to The Daily Telegraph and other publications. See here for details of current investments held by Max.
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