Investment trusts: how to benefit from the RDR effect

Since 1 January 2013, commission payments to independent financial advisers (IFAs) selling a financial product have not been allowed, following the financial regulator's Retail Distribution Review (RDR). Instead, the IFA has to charge a fee. Previously, if you went to a commission-taking adviser you got what seemed like free advice, but it was actually being paid for via commission to the adviser.

This only applied to products that paid commission, such as unit trusts and open-ended investment companies (Oeics). Investment trusts and exchange traded funds did not pay commission. This change theoretically puts investment trusts on a level playing field with unit trusts and Oeics in terms of adviser preference, especially as the regulator also says that independent financial advisers (IFAs) should have to consider products across the market.

If more of these start using investment trusts and the shares of these funds are in greater demand, discounts could tighten and share prices could rise, benefiting trusts' existing shareholders.

And it is also anticipated that some investors who once used an IFA will no longer do so as they have to pay an upfront fee, resulting in more self-directed investors who might also favour investment trusts.

A year ago we looked at what the effects of these changes might be, and at the time nothing was especially obvious. A year later there are still no clear answers but some trends are starting to emerge.

The Association of Investment Companies (AIC) reports a rising interest in financial advisers taking investment trust training, with more than 1,400 in 2013 compared with about 800 in 2012.

Meanwhile, purchases of trusts by advisers and wealth managers from six of the main IFA investment platforms (Transact, Nucleus, Ascentric, Raymond James Investment Services, Elevate and Novia) in the fourth quarter of 2013 reached a record high of £86m, up 70 per cent on the same period in 2012, and total purchases for 2013 were £328.4m, up 67 per cent on the £196.6m figure in 2012.

And a hundred more firms purchased each quarter than in 2012, adds the AIC.

Financial advisers who feel unable to meet the new criteria post RDR are outsourcing their clients' asset allocation to wealth managers, many of whom use investment trusts. This is likely to create further demand. There is also consolidation among wealth managers so they are becoming larger with more clients.

The market share of investment trusts held by private client stock brokers and fund managers is rising, with these holding nearly a quarter of investment trust market share, up from less than 20 per cent in 2011, according to research by Richard Davies Investor Relations.

These private client and fund management firms tend to run model portfolios and have lists of funds they invest in for all the clients these apply to. It means they cannot consider smaller funds, as they might not be able to buy as much as they need. For this reason, traditionally wealth managers have largely not invested their clients' money in investment trusts with market caps of less than £100m. But as the size of wealth managers and their interest in investment trusts grows, they need to look to even larger trusts so now generally do not consider ones with a market cap under about £200m, according to Nick Greenwood, manager of fund of investment trusts Miton Worldwide Growth Investment Trust (MWGT), and in some cases under £250m.

He says that wealth managers are not keen to own more than 10 per cent in an investment trust, and funds larger than £2bn are considered particularly suitable.

While this is positive for larger trusts that could form core holdings in investors' portfolios, it could cause discount widening in investment trusts that fall off brokers' buy lists, and where this is most likely to happen is among those with market capitalisations of between £150m to £200m, says Mr Greenwood.

However, the trusts to which it could happen are not necessarily doing anything wrong, so while this would not be beneficial for existing shareholders, it could provide opportunities for new investors to buy into good trusts at a discount.

But others disagree. "There is a loose relationship between the size of a company and the discount," says Annabel Brodie-Smith, communications director at the AIC. "But there is demand for smaller trusts offering something different and discretionary wealth managers are only one element of the market – some other types of investor will accept smaller trusts."

She says an example of this is IC Top 100 Fund Capital Gearing (CGT) which has a market cap of only £94m but is trading at a premium of 4.7 per cent compared with its underlying net asset value (NAV). The trust is fairly defensive and consistently makes positive NAV returns, an attraction for some investors. It aims for absolute returns by mainly investing in other investment trusts and bonds.

"Smaller funds will need to offer a unique proposition or have a strong performance," adds Charles Cade, head of investment companies research at Numis Securities. "More and more wealth managers are making buy lists and the big beneficiaries will be larger funds. I believe the long-term winners from RDR will be the larger investment companies with limited discount volatility, attractive fee structures and good performance records that are differentiated from open-ended funds and ETFs."

But he says exact size may depend on what area, for example, Global sector trusts over £500m should benefit, but among smaller companies trusts it could remain that those over £100m continue to be well regarded.

However, other factors drive premiums and discounts, for example, performance, whether the trust is in a popular sector and individual circumstances relating to the trust. And trusts' income profiles in recent years have been particularly influential on discounts and premiums.

Read more on the relationship between high yields and discounts/premiums

Investment trusts have been popular due to the plunge in interest rates following the financial crisis because of their ability to provide a good income. They can hold back 15 per cent of their income each year to hold in reserve for tough times, when they can use it to maintain or continue raising dividends. A number of trusts have raised their dividends every year for decades (read more on this).

Looking at the AIC UK Equity Income sector, which is largely in favour and according to Winterflood data on an average discount to NAV of 1.6 per cent as of 11 April, one of the trusts on the highest premiums is IC Top 100 Fund City of London (CTY) on 2.5 per cent. This is one of the largest with a £1.06bn market cap.

But the largest in the sector at £1.163bn, Edinburgh Investment Trust (EDIN) (also an IC Top 100 Fund), is on a discount of 2.5 per cent. This trust used to trade at a premium and has widened out because it is no longer run by star fund manager Neil Woodford. The trust moved out to a discount last autumn when Mr Woodford announced his departure, and although it has been taken on by a manager with a very strong record, Mark Barnett, there is uncertainty about how he will manage going forward.

Read more on this

Read more on the prospects for the Invesco trusts

Meanwhile, the smallest trust in the sector, BlackRock Income & Growth (BRIG) which has a market cap of £45m trades at par. A reason for this is because BlackRock, which took over the trust in 2012, formerly known as British Portfolio Trust, has been committed to discount control and amended the trust's policy in January 2013 to allow share repurchases at any discount, whereas previously they were only allowed at discounts greater than 4 per cent. "The revised buyback policy should increase attractiveness to new shareholders and benefit existing shareholders as liquidity improves," commented Numis Securities.

Since BlackRock took over, the trust has also increased its dividend two years in a row – before this it had not raised it for three years. Investors may also be hoping for improved performance over time from the new managers and that the trust will grow in size.

Value and Income (VIN) is the trust with the widest discount in the sector at 17.5 per cent even though its share price performance has done well against the sector. It has a market capitalisation of £121m. But reasons for the wide discount include that it has a very different portfolio to the other trusts in the UK Equity Income sector holding a mixture of shares, particularly medium and smaller sized companies, and UK commercial property. There is also very little trading of the trust's shares and illiquidity can contribute to discounts to NAV.

UK Equity Income sector

Source: Winterflood as at 11 April 2014

Other concerns

Another area Mr Greenwood is concerned about is the alternative income space, which accounts for many recent investment trust launches. This includes sectors such as debt or renewables infrastructure.

With ongoing low interest rates higher yielding investment trusts have been particularly popular with investors. Many higher yielding trusts trade at premiums, with for example, some infrastructure funds on double digit premiums. However, Mr Greenwood is uncertain if alternative income funds will continue to trade at premiums in the long term. "Interest rates are now 0.5 per cent but when there is a normalisation demand could evaporate for these trusts," he says.

Beneficiaries

Last year industry experts predicted that the investment trusts which would benefit from increased demand were likely to include large, well-managed and low-cost generalist investment trusts. Examples include Foreign & Colonial Investment Trust (FRCL), Bankers Investment Trust (BNKR) and Witan (WTAN).

They also thought UK Equity Income trusts could benefit, for example, City of London (CTY) and Perpetual Income & Growth (PLI).

This seems to be the case to a certain extent, as the most popular investment trust sectors for advisers using platforms in 2013 were UK Equity Income (18 per cent) and Global (17 per cent).

Also popular were income focused sectors Property Direct – UK (6 per cent) and Infrastructure (5 per cent).

Discounts across the board have tightened, however, this has been put down to a mixture of factors as well as RDR, such as a strong period of performance, the dividend track record, access to specialist asset classes and the hunt for yield.

Read more on historically tight investment trust discounts

Investment trusts have benefited since the financial crisis in 2008 from rising markets. "Investment trust managers can take a long-term view and position themselves for recovery, so have bounced back faster after the downturn," says Ms Brodie-Smith.

James Henderson, manager of both open-ended funds and investment trusts such as Henderson Opportunities (HOT) and Lowland (LWI) which have strong long-term performance records, says that in 2009 he was able to buy recovery situations with these funds because he knew that no money would have to be returned to investors seeking redemptions. "There was real value in small illiquid companies that we had the freedom to buy," he says. "You always have that worry (of having to meet redemptions) in open-ended funds which you don't have in investment trusts."