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IT geek: ignore your KIDs

KIDs are not a reliable source of information on investment trusts
June 28, 2018

Before you put money into an investment trust you should do thorough research to see if it's a suitable addition to your assets, including scouring as much official literature and data on it as you can find. However, there is one document that you should take with a very big pinch of salt, or in the opinion of some industry participants, ignore.

Since the start of this year investment trusts have been legally obliged to provide a Key Information Document (KID), which aims to provide information such as what the trust invests in, its expected risk and return, and costs.  

But the Association of Investment Companies (AIC), the trade body for listed investment funds, is refusing to host KIDs on its website on the grounds that "the methodologies and disclosures required by KIDs lead to misleading information." And it's not the only critic – the investment trust industry seems to generally agree that KIDs do not provide helpful information.

A key area of concern is the projections of possible investment returns. KIDs don't state investment trusts' past performance – for example, one, three and five year cumulative total returns – as is common on factsheets and data providers' websites. Instead, they give projections of what returns after costs you might make on an investment of £10,000 over one, three and five years under different scenarios: stress, unfavourable, moderate and favourable, as well as a projected average annual return in percentage terms.

However, these scenarios are based on the trust's share price performance over the last five years and at the moment might be providing an overly optimistic outlook.

"These scenarios are inherently based on share price returns over the previous five years, a period that has seen strong market performance, narrowing discounts and falling volatility," explains Charles Cade, head of investment companies research at Numis Securities. "As a result, the scenarios often appear highly optimistic. The KID would be easier to understand if it simply showed historic performance, along with the usual warnings that past performance should not be taken as a guide to the future."

The AIC argues that too many KIDs overstate likely future performance and understate investment risk, so could encourage investors to buy high and sell low. Research it conducted on investment trust KIDs found that 42 of these indicate possible future returns of more than 20 per cent a year in the moderate performance scenario, while 45 indicate possible future returns of more than 10 per cent in the unfavourable performance scenario. "After a sustained bull market KIDs will suggest to investors that they will get higher investment returns in the future," says the AIC. "And after a sustained bear market, they will suggest that investors will get lower future returns."

The Financial Conduct Authority has said that where there is concern that the performance scenarios are too optimistic, investment companies or their managers can "provide explanatory materials to put the calculation in context and set out their concerns for investors to consider." But this is down to the discretion of providers rather than an obligation.

"Investing in financial assets is incredibly difficult as it relies on making judgements about the future which is obviously unpredictable and involves taking risks," says Daniel Lockyer, senior fund manager at Hawksmoor Fund Managers. "A document that relies on the future being similar to the recent past and that seeks to ascribe a precise outcome on a vague set of conditions is very misleading."

 

Scottish Mortgage Investment Trust KID performance projections
Scenario1 year (%)64.683 years (%)5 years (%)
Stress  -64.68-24.78-20.41
Unfavourable-4.246.379.87
Moderate 22.8622.8222.81
Favourable57.3941.7437.23

Source: Baillie Gifford as at 1 June 2018

Scottish Mortgage actual annualised total returns
 1 year total return (%)3 year annualised total return (%)5 year annualised total return (%)
Scottish Mortgage NAV29.126.1425.82
Scottish Mortgage share price26.5626.928.08
Source: Morningstar as at 26 June 2018

 

Skewed risk

A feature of the KIDs that is probably worth totally ignoring is the summary risk indicator - an estimate of an investment trust's risk on a scale of one to seven. The AIC argues that KIDs often understate investment risk. For example, it found that Venture Capital Trusts (VCTs) have the lowest average summary risk indicator of any of the categories of funds among its membership at 3.4. But VCTs invest in small, higher risk businesses which are often unlisted or quoted on the Alternative Investment Market, and have a relatively higher chance of failing than large listed companies.

Numis Securities says that equity trusts with a summary risk indicator of 3, which the KIDs describe as 'medium low risk' include Artemis Alpha (ATS), Aurora (ARR), European Assets (EAT), Herald (HRI) and – perhaps most surprisingly - Woodford Patient Capital (WPCT). But, for example, European Assets Trust focuses on overseas smaller companies, and Herald Investment Trust focuses media and technology companies which can be very volatile. Woodford Patient Capital Trust has a large proportion of its assets in unlisted or early stage companies, giving it some of the characteristics of a private equity fund – arguably a very high risk proposition.

Investment trusts with a summary risk indicator of 2, which the KIDs describe as low risk, include Honeycomb (HONY) which invests in loans to consumers and small businesses. These have the potential to make high returns but are higher risk than developed market government and highly rated corporate bonds.

Yet Capital Gearing Trust (CGT) has a risk rating of 3 despite having over 40 per cent of its assets in government bonds and less than 40 per cent in equities, and making positive net asset value (NAV) returns in every one of the last ten calendar years. And RIT Capital Partners (RCP) which also has a wealth preservation focus, runs a multi-asset portfolio and has made positive NAV returns in eight out of the last ten calendar years, has a risk rating of 4.  

Scottish Mortgage Investment Trust (SMT) and City of London Investment Trust (CTY) also have risk indicators of 4. Both are excellent funds in their respective areas but it would be fair to say that Scottish Mortgage is higher risk because of its focus on listed and unlisted high growth companies, and it has been more volatile. City of London Investment Trust, by contrast, focuses on large, stable dividend paying companies mainly listed in the UK. 

 

 

Trust2008200920102011201220132014201520162017
Scottish Mortgage NAV-42.3953.7429.08-15.0225.3832.416.3314.7715.2540.64
Scottish Mortgage share price-44.7752.8733.9-15.1530.0539.821.3613.2916.5441.07
City of London NAV-29.5623.1616.533.1916.226.065.115.769.5112.86
City of London share price-21.3624.1424.682.1216.5624.144.416.069.3312.56

 

Source: Morningstar as at 31 May 2018

 

"These anomalies reflect the fact that calculation of the summary risk indicator relies heavily on historic volatility of a trust's share price rather than the nature of the underlying assets," says Mr Cade. "Low historic volatility is sometimes a reflection of a lack of liquidity or an insurance-style pay-off profile rather than low risk."

 

Incomparable costs

Investment trust analysts have a number of concerns on the cost figures in KIDs, including a lack of consistency in the way that costs are calculated by different trusts. This means that the cost figures in investment trust KIDs cannot be fairly compared to each other.

The cost information in KIDs is also not comparable to that provided by the document which funds such as open-ended investment companies, unit trusts and many exchange traded funds (ETFs) produce - Key Investor Information Documents (KIIDs). Despite the similar name these are very different to KIDs: they do not have performance projections, and the costs they show are possible entry and exit charges, and the ongoing charge.

Investment trust KIDs include several costs which fall into three categories: one off costs, ongoing costs and incidental costs. Ongoing costs include management fees, other expenses, and finance costs in one figure which is more comprehensive than what is included in the KIID ongoing charge. KIDs also include an estimate of the trust's transaction costs – what it spends on buying and selling investments - something KIIDs do not include.

Both documents include details of performance fees, if the fund charges one.

The differences are unhelpful because when you are constructing a portfolio, after you have determined your asset allocation, you should then compare all the types of funds available which invest in the areas you have chosen and try to pick the best available for each – regardless of its legal structure. This means comparing investment trusts, open-ended investment companies and unit trusts, and ETFs focused on the same area to each other.

Open-ended funds which comply with Undertakings for Collective Investment in Transferable Securities (UCITS) legislation do not have to start providing a KID until 1 January 2020. But there are much better data sources to assess and compare investment trusts and other types of fund to each other now - and after 1 January 2020 if KIDs are not improved.

"Given our view that the return scenarios in the KID are misleading and the cost figures are inconsistent, there is a strong argument for the document to be ignored by investors," says Mr Cade.

And in any case, before committing money to an investment you should do a lot more than look at one type of document, especially as there is a wealth of far more useful information.

A great starting point, says David Liddell, chief executive of online investment service IpsoFacto Investor, is the fund fact sheet. This should give the ongoing charge which may not be as comprehensive as what is in a KID document but is comparable with those of other funds.

It should also have one, three and five year total returns which aren't a guarantee of future returns but are real figures, so give an idea of what that trust's investment team is capable of in recent market conditions. Just be aware that these conditions might not continue for the next five years, so consider how the trust might perform going ahead. Know what kind of assets the trust invests in, how they work and what influences them. This can help inform a view on how they might react in different market conditions, and what returns the trust could deliver.

You can find the factsheet on the website of the asset management company which runs the investment trust, which might have further useful information. You should also be able to find its annual report here, which says how the trust invests, what it held at its last year end, what its managers and board have done, and what they are planning to do.

Investment trusts are listed securities so are obliged to provide many reports and updates, which you can check on websites such as investegate.co.uk or londonstockexchange.com.

You should check data such as a trust's premium or discount to NAV via more up to date sources such as theaic.co.uk, or data providers morningstar.co.uk and trustnet.com. This is particularly important as you do not want to buy an investment trust on a historically high premium. Also have a look at the trust's annual report to see what its board's policy is on discounts and premiums – do they try and control them, for example, via share buybacks and issues?

Also check these sites to what a trust's latest gearing figure is – the level of debt it has relative to its assets. Debt invested in more assets in rising markets can boost returns, but debt invested in more assets in falling markets compounds losses. And look at the annual report to see what level of interest the trust is paying for its debt, because servicing expensive debt eats into its returns.

If you want to compare the performance of different types of fund look at their returns on one data provider's site, for example trustnet.com, running to the same date.

theaic.co.uk shows a trust’s ongoing charge and any performance fee separately so you can get a clear picture of these costs. Also look at what your investment platform or broker charges to hold the trust, and to buy and sell shares in it.