13th January 2023
You may know that I, along with a few other intrepid campaigners, have been working hard behind the scenes for a fairer and more transparent cost disclosure regime. The good people at the Investment Association are sensibly trying to ensure fund managers follow FCA recommended best practice, and want us to disclose the “costs” of investing in investment trusts within our own OCFs (in the same way we do if we invest in open-ended funds). The motivation is to bring fund cost disclosures into line with MIFID/PRIIPs rules (which govern private client portfolio cost disclosure incidentally). Hitherto, under UCITS rules (which remain the same), investment trust costs haven’t needed to be disclosed.
Sounds sensible, right? Unfortunately, the whole issue is utterly farcical. Whilst every act has the underlying investors’ best interests at heart, the unintended consequences are hideous. It’s time for these issues to be given the airtime they deserve.
Problem 1): the IA has issued guidance, but there is no obligation for ACDs (the entities which calculate fund OCFs) to follow it.
Some large fund managers, with internal ACDs, currently interpret MIFID/PRIIPs rules differently to our own regulator in the UK. They are excluding investment trust costs from their OCFs and they no doubt have well-reasoned and principled arguments which lead them to this conclusion.
Further, Consumer Duty rules put the onus firmly on fund distributors to consider whether they should be offering access to funds to retail investors. For example, it has been widely reported that Fidelity has recently blocked access on their retail platform to two funds of investment trusts because their OCFs are too high. They are only too high because of the new IA guidance requiring disclosure of investment trusts costs. Were, however, these funds to be run at other asset management houses with different interpretations of regulations, these funds would not be in breach of the platform’s OCF limit. This is patently absurd.
Problem 2): there is no proper definition of what a “cost” is in the investment context.
I have spoken to so many people about this issue – almost all of whom are financial sector specialists. It often takes me a while to get these people to understand what has changed and what the problem is – because it is so nonsensical. When I tell them that fund OCFs are going up, they immediately ask, “who is paying the higher cost.” The answer is of course: “no-one.” This is purely a change in disclosure rules. Transparency campaigners argue this is a step forward for retail investors; finally, this group of investors, who they argue, are often misled by fund managers on the true cost of investments, can finally see what they are paying. Before, it was not disclosed; QED: rip off.
The point is, investors are not “paying” anything when it comes to investment trusts! There is no direct cash cost in the way there is when one invests in an open-ended fund that charges an AMC. An investment trust has a NAV (net asset value) and a share price. The costs of running the investment trust (e.g. the AMC charged by the investment advisor managing the trust’s capital) come off the NAV. The investor pays the share price. It’s not much different to investing in traditional equities. Companies have running costs, but do the equities of listed companies have to have cost numbers next to them? Do fund managers have to disclose that they’ve chosen to invest in a higher cost (lower margin) company? Of course not. Moreover, the “cost” of investing in an investment trust is stated as a percentage of NAV. As soon as this cost is published it is wrong: it bears no relation to the cost the investor pays given that the investor pays the share price not the NAV. In addition, unlike with open-ended funds which have largely static OCFs, investment trusts have higher fixed costs, which means as the NAV rises and falls, so does its cost ratio!
The situation is brought into even starker relief when many investment trusts are often performing the same function as operating companies but have chosen to structure themselves as investment trusts for perfectly legitimate reasons. Just take one look at the REIT sector, or almost any alternative asset housed in an investment trust wrapper. Many REITs are not required to publish costs, while others are. Without going into the legalese (we’d have to talk about the three different pieces of regulation determining this!), in almost all cases, the business models are identical, but the legal structure is different. In any case, there are universally accepted cost ratios for REITs that can be worked out from the accounts (and are often referred to by REITs themselves as performance indicators in their published accounts – look for “EPRA cost ratios”). It is often the case that REITs that aren’t required to publish “costs” have higher accounting cost ratios than those that are! This is patently absurd.
Problem 3): there is little trust between investors and fund managers and the consequences are dire.
If you have read any articles on the OCF calculation subject – see, for example, those published in Citywire on the back of interviews or editorials with James de Bunsen and myself, you will see scores of comments from retail investors, who miss the point because they think this is yet another example of evil active fund managers trying to rip off retail investors and hide costs.
I have engaged with transparency campaigners and met the same wall of distrust. It’s utterly exhausting and completely dismaying. If you knew anything about the people campaigning to highlight the fallibilities of the new disclosure regime you will know that we are motivated by the following:
- Fairer and more transparent disclosures
- Greater and better-informed consumer choice
- The health of the investment trust sector
- A level playing field for all funds
The third point above is so important. The investment trust sector is one of the UK’s finest financial innovations and success stories. Over recent years it has enabled the retail investor to access asset classes that ordinarily only wealthy investors with access to private funds would have access to. The requirement to disclose investment trust costs in OCFs creates a perverse incentive for fund managers not to invest in investment trusts because it pushes the OCF too high without any room for context. In turn, this will starve the UK economy of much needed private sector investment in many vital areas of the economy. People that care about the environment should be appalled. Investment trusts have enabled the build out of vast swathes of the UK’s renewable energy infrastructure, from wind and solar farms to energy storage facilities. This is not to mention the social infrastructure that has been built out.
To further illustrate why the trust issue is so important, let us briefly look at what goes into the OCF:
- the AMC of the fund manager
- any admin costs of running the fund, not paid for by the fund manager
- ‘synthetic costs’
‘Synthetic costs” are the look-through costs when a fund manager invests in another open-ended fund or, per IA guidance, investment trusts. Leaving aside the notion that investment trust costs aren’t “cash costs” at all, I argue it would be so much simpler and fairer to disclose synthetic costs outside of the OCF. They are costs the fund manager incurs in the course of the investment decision. There is an active decision to do so instead of investing directly into a “zero-cost” security like an equity. There is nothing intrinsically “ongoing” about these costs at all. In addition, the fund manager doesn’t benefit commercially from incurring these higher “costs.”
Campaigners who are worried that retail investors might get ripped off, are really worried about the nefarious practise of “double-dipping;” i.e., a fund-of-funds manager earning an AMC on their fund and again on any underlying funds run by the same management company that are invested in as part of the portfolio. Aside from the fact that a modicum of research could uncover this practice, it could be easily dealt with by disclosing synthetic costs but not including them in the OCF. Ultimately, we believe that investing in actively managed specialist funds run by on-the-ground experts in their given market or asset class will result in superior returns for our investors, even if the decision to do so has negative commercial implications for our business, given the impact an optically higher OCF has on potential fund flows. If there was more trust between investors and fund managers, the OCF number would have far less importance and we wouldn’t be where we are now: striving to arrive at one number to compare all types of funds. We have to stop the horrified Pavlovian reaction that occurs when an investor learns of an OCF being above a certain level.
Bringing this all together
At the risk of hyperbole….. actually, no, this isn’t hyperbole. This matters more than anything else in my 22-year investment career. First, the current situation benefits large asset managers with internal ACDs that are prepared to go against IA guidance. This group includes the many passive fund providers, who are members of IA sectors, who aren’t disclosing investment trust costs. It makes these managers seem even lower cost than other managers for no good reason. Typically, those fund managers that rely on independent ACDs (like Hawksmoor) will be disclosing these costs. In the wake of the Woodford scandal, ACDs are understandably loathed to be accused of engaging in regulatory arbitrage. But larger asset managers, including passive providers, are large enough and have enough clout to take a different (justified) view.
This results in a situation where retail (and indeed any type of) investor cannot usefully compare OCFs, and if they are taking the OCFs at face value, they do so without the right information. And now, with new Consumer Duty rules, we now have a situation where retail investors are being barred from investing in certain funds for the wrong reasons!
The key over-riding point leading these outcomes is the importance of the OCF number. It is used to compare the costs of ALL funds. A high OCF is immediately taken a sign that somehow a retail investor must be being ripped off. This is a nonsense. Without context, a single OCF is meaningless – and is even more meaningless when fund providers are not applying regulations consistently.
Away from retail investors, we have a huge amount of sympathy for the financial adviser client base (which make up the core unit holder base of the multi-asset funds most affected). When recommending investments to their clients in the wealth planning stage, they have to make assumptions on future returns and future costs. You can clearly see the incentives to invest in lower cost funds and not have the hassle of justifying the extra “expense” of investing in a “higher cost” fund. We meet so much opposition from this constituency of investors who simply will not consider funds above a certain OCF.
The obsession with the OCF is leading to worse, not better consumer outcomes. Lower cost funds are not always better. In addition, we will see crucial areas of the UK economy being starved of capital. We need a regulatory environment that fosters choice and proper cost disclosures. In the midst of all of this we must not forget that what really matters is performance after costs. Fortunately, that is impossible to be manipulated without fraud – but we must have a cost disclosure framework that creates a level playing field for all types of funds to play on.
What can we do about it?
Before Christmas, Jeremy Hunt announced his “Edinburgh Reforms.” Within these comprehensive proposed reforms looking at the UK financial services sector, there is a consultation on PRIIPs and UK Retail Disclosure. This is an opportunity for us to demand a much fairer and consistently applied cost disclosure regime. I would urge everyone reading this to consider engaging with this consultation.
Alternatively, if you are a fund manager, please speak to your ACD, who should in turn engage with the Investment Association. If you are the Board member of an investment trust, please engage with the AIC. Both the IA and the AIC care about this issue and are keen to hear from you. If you are an investor, please carefully consider the issues and please don’t rush to the conclusion that all fund managers are trying to hide costs. Most of us are good people, invested in our own funds alongside you at the same cost, with no incentive to hide costs or double-dip or mislead you in any way. I’d be happy to engage with you directly to discuss these issues.
This is our chance to improve the lot of literally every single stakeholder: from the fund manager to the retail investor to the UK economy to the environment.
Ben Conway – Head of Fund Management
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