Like me, you may have been looking at your portfolio of investment companies over the past 18 months or so and swinging between despair and puzzlement. I keep asking the question, how can so many ostensibly good companies be so out of favour?
Take Greencoat UK Wind, for example, which I bought for my portfolio in May 2022 and topped up in June this year. It passed the tenth anniversary of its IPO in March and so it has been drawing attention to just how successful it has been. I talked about this on this week’s show so, rather than regurgitate that, here is a link to it.
My conclusion on the show was that the market is broken, and I promised to explain why in this article and the one that should be published in Citywire next week.
There is a long, complicated and rather technical history to this that goes back as far as Greencoat UK Wind does. Various factors are combining to lock funds of funds, wealth managers, IFAs, pension funds and now – in some cases – even private investors, out of investment companies.
I am grateful to a number of people that I have talked to over the past week or so who have guided me through the issues – here is my go at explaining at least some of these to you.
The main problem boils down to the presentation of costs. In a world where we are repeatedly reminded that past performance is no guide to the future and that attempting to forecast short-term market moves is a mug’s game, one of the few things that investors can latch onto is how much will this investment cost me? The problem is that the way that costs are disclosed on investment companies is not the same as for open-ended UCITs funds.
Back in 2013, the EU implemented a piece of legislation – the Alternative Investment Fund Managers Directive (AIFMD). It was designed to bring in greater protection for investors in things like hedge funds. Here in the UK, a decision was made to ‘gold plate’ the legislation by bringing investment companies within its scope. No other EU member did this and we did not have to.
Then another piece of EU legislation – MiFID II – introduced in 2018, set out rules around how funds including alternative investment funds (AIFs) should disclose their charges. This required AIFs to aggregate all of the costs that impact on the value of an investment, which results in one number, the total cost figure and this is input into a system used by all professional investors. That number includes the cost of running the fund, plus – if it holds other funds – the cost of running those funds too.
One big problem for the investment companies’ industry was that UCITs open-ended funds did not have to do this cost aggregation as UCITs funds had an exemption. So immediately, a whole raft of investment companies looked more expensive than equivalent open-ended funds.
That weighed on the sector for a long time, but a move last year by the open-ended fund industry to get their members to fall into line – ahead of a planned rule change that has since been scrapped – has actually made things worse. Suddenly those open-ended funds of funds that are complying with the request are looking much more expensive to run. They have been shrinking and switching out of funds, including investment companies, into ‘normal’ companies where they can.
There is a clear illogicality to this. There are quite a few funds that do very similar things to ‘normal’ companies. For example, The Renewables Infrastructure Group (which I will be talking to on the show in two weeks) holds a diversified portfolio of onshore and offshore wind, solar and energy storage projects. It could give up the tax benefit of the investment company structure and become a ‘normal’ company. It is likely that either way it would have a similar level of overheads.
When an investor buys a ‘normal’ company, there is an acceptance that its net returns after costs drive share price performance. Yes, it is important to keep an eye on what management are spending (and nobody, especially me, is suggesting that costs can be ignored), but overheads are only a small part of the consideration. Why should investment companies be any different?
But I don’t base my entire investment decision on charges, I can hear you saying. Well, while you may not, the path of least resistance for the many professional investors that have to report on charges to their clients is to remove investment companies from their portfolios, regardless of how well they are doing.
I have been saying this for ages about private equity funds like Pantheon International and HarbourVest, which have great track records but trade on enormous discounts. Now that extends to funds like those in the infrastructure and renewables sectors too.
The new UK Consumer Duty rules have compounded the problem again by putting an onus on dealing platforms to ensure that their customers are getting value for money. The unintended consequence of this is that retail investors are being blocked from buying some investment companies on cost grounds, based on misleading cost figures and I suspect in some cases just based on costs not the return after cost.
There is an easy fix to this, turn the clock back to 2013, cut the red tape, and reverse the ruling that investment companies are AIFs. That is what a number of industry participants are hoping for. It will not be a panacea for all of the sector’s ills, but it might halt the current buyers’ strike that has caused share prices to collapse.