Volatility is certainly testing investors’ nerves. The market is see-sawing between the conflicting influences of uncertain economic fundamentals largely brought about by Covid-19 and the unprecedented fiscal stimulus in response. Various geopolitical concerns, including US-China tensions, are adding a twist. This is one reason gold is in vogue. Some investors believe there is a ‘disconnect’ between the stock market and the economy, and are raising cash levels. Yet history suggests there is little to be gained from banking on short-term market predictions.
Instead, as last month’s column emphasised (‘Remaining focused on the long term’, IC, 7 August 2020), investors need to remain invested and use market volatility to their advantage. In focusing on good quality ‘growth’ companies, the portfolios (including those managed on the website www.johnbaronportfolios.co.uk) remain positive about their future and look to add to positions when markets are fearful, where portfolio balance and remit allow – even if timing can occasionally be difficult. It is an approach that has served them well over time.
If comment were needed about the economic scenario, perhaps a key consideration relates to the risk of inflation rising. This belief goes against the broad consensus, including this magazine’s parent company, which believes deflation is the greater threat. The severe decline in economic activity and threat of higher unemployment are reasons why this is plausible. However, perhaps even more powerful counterbalancing forces are at work.
The impact of the pandemic on globalisation and some of the established structures, the gradual but meaningful change in our demographics, likely shifts in the balance between capital and labour, the scale of the fiscal stimuli, the likelihood that this new money will this time reach the real economy, and the political realisation that inflation is now necessary to help deal with the debt (even if pain awaits in the longer term), are just some of the reasons weighing in inflation’s favour. It is also the key reason gold is performing well at a time when the opportunity cost of holding it is negligible.
How should investors react? History suggests equities usually embrace the early stages. But inflation does not always usher in economic growth – ‘stagflation’ is again a real possibility. Economic uncertainty looks set to continue. This environment suggests the portfolios’ focus on quality companies will continue to bear fruit, even if this means occasionally paying less attention to the valuation metrics so beloved of the consensus.
By way of portfolio balance, and given the inflationary outlook, various sectors are worth supporting. Commodities are one example where sentiment trails fundamentals – while offering healthy and sustainable dividends. The portfolios’ exposure to smaller companies and, to a lesser extent, commercial property and emerging markets are also contrarian calls at the moment. There are others.
Replacing the KIDs
Readers will be aware from previous columns and perhaps their own experience of the real concern within the investment trust industry about the introduction of Key Information Documents (KIDs). The EU’s core retail financial services regulations – known as Packaged Retail and Insurance-based Investment Products (PRIIPS) – has had at their heart these KIDs, which are documents that should have been produced for every single investment trust from January 2018 (and unit trusts from the end of this year) in order to help investors better understand what they are buying.
The intention may have been good, but the execution has been poor and perhaps even dangerous. The central problem is that the KIDs can be misleading, particularly when it comes to the assessment of risk, the projection of returns, and the comparison with open-ended ‘sister’ funds. Little wonder the media, consumer champions and the industry generally have been critical, believing them to be potentially harmful to investors. The Association of Investment Companies (AIC), the sector’s respected trade body, has advised investors to “burn before reading”!
I have raised the issue directly with John Glen MP, Economic Secretary to the Treasury, and with Andrew Bailey, the then chief executive of the Financial Conduct Authority (FCA). Both realise the extent of the problem. The FCA launched a 'Call for Input' consultation in July 2018 to seek input from industry and consumers regarding their experience with these regulations. The problem has not been helped by their hands having been tied by EU regulation, which has been, to say the least, unsympathetic to the investment trust cause.
The most dangerous aspect is that these documents ignore the age-old advice that past performance is no guide to the future. The KIDs extrapolate recent returns when detailing information about the future. So KIDs produced in a bull market will suggest higher returns, whereas those produced in a bear market will suggest lower returns. In a recent AIC report, 42 KIDs forecast 20 per cent-plus returns per annum in a ‘moderate performance’ investment trust category. This is grossly misleading. It risks encouraging the sort of investment behaviour that should be discouraged – buying high and selling low.
Meanwhile, KIDs are also misleading when it comes to the assessment and comparison of risk. They suggest investment trusts are less risky than unit trusts. Courtesy of their closed-end structure and ability to gear, it is generally accepted that investment trusts are more volatile in comparison. But long-term investors are prepared to accept this volatility given their better track record, on average over time, when compared with both unit trusts and the benchmarks.
Last year the FCA announced its findings from the consultation which, in its feedback statement, agreed that both the summary risk indicators and performance scenarios in KIDs can be misleading, and that the regulation could cause consumer harm if these problems are not addressed. It set about pressing the EU to think again, but without success. Despite the industry’s best efforts when lobbying, the EU has simply failed to understand the nuances and unique characteristics of investment trusts.
However, now that we have left the EU and the transition period comes to an end on 31 December, there is reason to believe better news is on the horizon following a recent ministerial statement and further discussions with John Glen MP and Treasury officials. The Economic Secretary confirmed in his letter to me following the statement that he fully understands our concerns about these documents and the urgency required to correct their misleading nature.
By way of background, in preparation for the UK leaving the transition period, a lot of EU regulation is being retained, but brought under Parliament’s control (hence the term ‘onshored’) in order to minimise any disruption given the EU will remain a key trading partner. However, the intention over time is to amend these regulations as necessary so they best meet our requirements.
At the moment, the most damning aspects of the KIDs, including the methodologies for producing the performance scenarios and assessing the summary risk indicators, are set out in the EU’s PRIIPs Regulations and Regulatory Technical Standards (RTS), which will form part of the retained EU law once the UK leaves the transition period.
At the earliest opportunity in the coming months, in response to our concerns, the government will therefore be introducing legislation to amend the PRIIPs regulation. These amendments will enable the FCA to address the key problems with PRIIPs, including the misleading performance information and the issues regarding the disclosure of risk, to ensure that investors are provided with better information. The FCA will be able to make some of these changes through their RTS powers from the end of the transition period, with further changes coming in to scope later next year.
The problem for the government is that the legislative timetable is busy given Covid-19 and the December deadline. However, I have been assured by the Economic Secretary that the Treasury realises the importance and urgency of the required legislation given the significant uncertainty created and that it will be forthcoming as soon as possible.
Meanwhile, there has been criticism of the Treasury courtesy of the impression that it intends to let the regulator postpone KIDs for Ucits funds (including unit trusts) for up to five years once existing regulations come to an end. The minister confirmed that although the Treasury will have the power to exempt Ucits funds, it has not yet decided to do so. This at least in part is because it considers the existing rules – as defined by the EU’s Key Investor Information Documents (KIIDs), which are due to remain in force until 31 December 2021 – are operating satisfactorily. Again, this is something we will be discussing in coming months.
The FCA is obliged to conduct a wide-ranging consultation as to the way forward and has previously promised to work closely with the AIC, other bodies and investors when doing so. However, once empowered, they also have a duty to act swiftly once the UK is through the transition period because the regulations as currently drafted are grossly misleading. There is no reason it could not give notice of its consultation and proposed approach shortly after the government has passed its amendments.
Meanwhile, in its recent statement, and in addition to the proposed legislation in coming months, the Treasury also pointed to a longer-term wholesale review of the disclosure regime for UK investors. This represents a key opportunity to shape the regulatory landscape in favour of investors, as the EU rules are changed and brought up to standard. It is something that needs to be monitored closely, as opportunities such as this do not come along every day.
Portfolio performance (1 January 2009 – 31 August 2020)
Growth (%) Income (%)
Portfolio 311.4 218.9
Benchmark* 163.2 125.8
Yield 2.9 3.7
* The MSCI PIMFA Growth and Income benchmarks are cited (total return)