Investment Trusts: Good but Could Do Better?

Key Points

• Investment trusts can offer smaller investors access to liquid, long-term returns from assets that have traditionally been the reserve of larger institutional investors.
• Despite some recent progress, we believe the sector still has several issues to address to improve transparency and governance.
• Our responsible investment team and portfolio managers work in tandem to relay our concerns to boards and managements of companies where we feel there are considerable governance concerns.
• Our view is that it is crucial for the managers of investment trusts to be stewards of the capital that they oversee and to fulfil their role in line with the mandate given to them by investors.
• We believe greater diversity of background and deeper levels of operational knowledge, as well as the addition of independent trustees, could help decision-making on investment trust boards.

We believe investment trusts can offer smaller investors access to liquid, long-term returns from assets that have traditionally been the reserve of larger institutional investors. As such, we view them as having a useful role to play in any long-term investor’s toolkit.

However, despite some progress in recent years, we believe the sector still has several issues to address to improve transparency and governance, to ensure that trusts ‘behave’ more like conventional companies and are thus better aligned with all their shareholders.

We address these concerns below, but first, it is useful to explain why we view the sector as a useful addition to some of the portfolios that we manage for our clients. At Newton, we have long been investors in investment trusts, and currently have exposure to them across approximately 60 strategies, including absolute-return, multi-asset, income (via property real-estate investment trusts, known as REITs) and sustainable portfolios. In total, we have around US$1.36 billion invested in investment trusts as of September 30, 2023, with a split of roughly 70% in UK investment trusts and the remainder in other jurisdictions.[1]

Advantages of Investment Trusts

We like investment trusts as their unique structure affords retail and other smaller investors the opportunity to access a range of otherwise illiquid private assets, because trusts are traded on exchanges, which provide daily liquidity. This is important because it means investors can access their capital when needed, rather than being locked in when their circumstances, or the investment backdrop, changes.

Unlike large institutional investors, who need to exceed a substantial minimum threshold to invest, smaller investors can adjust investments in small increments via these listed exchanges.

For us, this combination of liquidity and increased accessibility affords trusts (and their investors) access to more stable investments, thus making investment trusts an attractive strategic option for smaller investors.

Long-Term Investments

A further advantage of trusts is that managers can invest in long-term projects without the need for regular cash-flow management. For example, REITs provide a more efficient property investment option compared to open-ended property funds, where the manager is required to set aside cash to deal with large cash outflows and inflows. By contrast, investment trusts enable a more prudent capital management option, allowing managers to raise or return excess capital (through share buybacks), which helps to ensure optimal value for investors.

In the UK, specialized investment trusts also play a significant role in financing the energy transition and helping to develop clean-energy capabilities, for example by investing in solar or wind farms or capabilities such as battery storage.

Structural Challenges

Despite the potential for compelling and sustainable long-term investments, we believe the sector has several challenging aspects to address. Our responsible investment team and portfolio managers are working in tandem to relay our concerns to boards and managements of companies where we feel there are considerable governance concerns which we believe require actionable change. We lay out our suggestions for how practices could be improved below.

One example of where we believe our efforts have been effective is our engagement throughout 2022 with a UK-based renewable energy investment trust. We have continued to engage with the company in 2023 and encouraged the new board chair to address the share-price discount to net asset value (NAV) and showcase operational resilience by undertaking a share buyback program. We were pleased to learn that the trust had recently announced a share buyback program. You can read more about our approach in our latest Sustainability and Stewardship Annual Report.

Governance Issues

An investment trust typically has an external investment manager responsible for making decisions regarding the investment strategy and management of the trust. The board of directors of the trust oversee and hold the manager accountable for the trust’s performance and for delivering value to shareholders.

We believe it is crucial for the managers of investment trusts to be stewards of the capital that they oversee and to fulfil their role in line with the mandate given to them by investors. At the simplest level, this means that the manager must maximize the value of the trust. However, an inherent conflict may arise if the fee structure rewards management based on NAV rather than NAV per share. In some cases, managers may be incentivized to pursue absolute growth as the primary objective at the expense of value maximization, which may lead them to invest in projects that are below their current NAV, and thus misaligned with the best interest of shareholders.

In addition to growing assets, managers also have the duty to correctly value the trust. Critical to this is fair appraisal of the NAV and, with this, transparency and consistent disclosure of the assumptions used. Ideally, changing assumptions to fix the NAV should be discouraged.

In some cases, we have seen an increasing occurrence of perceived misalignment between investment managers and shareholders stemming from concerns such as discrepancies in NAV appraisal, issuing shares at undervalued NAVs, complications arising from related-party interests, and manager contract structures that may not be best aligned with shareholder interests.

We believe it is crucial for boards in this sector to maintain a heightened level of vigilance, and we believe investors should diligently evaluate and hold boards accountable. Furthermore, we expect boards to act primarily in the best interests of shareholders, not the investment managers.

Representing Shareholders First

In our view, boards must keep in mind that they represent the views of their shareholders and must act accordingly on their behalf. On occasion, we have witnessed what we believe to be a ‘cozy’ relationship where boards are too close to the investment management teams of investment trusts, leading to actions being taken which benefit the managers to the detriment of shareholders. This can be through installing long-term contracts which effectively stop shareholders from being able, for example, to replace an underperforming manager, put the management contract out to tender or reduce fees.

Similarly, when considering capital-allocation decisions, we believe investment trust boards often need to be more transparent in demonstrating to shareholders why a particular acquisition offers more value to existing shareholders than buying back existing shares.

Importance of Cognitive Diversity and Expertise

We believe greater diversity of background and deeper levels of operational knowledge could help decision-making on investment trust boards, as well as the addition of independent trustees. We believe greater levels of transparency and expertise are required, especially given that the asset mix of investment trusts can evolve over time, and many investment trusts are becoming increasingly specialized in nature. In our view, such attributes should better position boards to assess the overall strategy and scrutinize whether an acquisition or a share buyback is the best option for shareholders.

Continuing the Engagement Journey

At Newton, we conduct our own due diligence when we invest in investment trusts. We have been key investors since launch in a number of investment trusts in areas where we believe we can make a positive impact, such as renewable energy. 

Based on our continuing due diligence and active engagements with many companies in the sector, there are a few areas where meaningful change is still required. Below is a summary of the key areas where we are focusing our engagement efforts to help drive the further governance improvements we think are necessary. By improving them, we believe we can help to make investment trusts an even more compelling investment option for a broader range of investors as well as for existing stakeholders like us:

• The importance of well-rounded skills on the board – we believe boards need to be better positioned to assess the overall strategy and best options for shareholders
• Aligning compensation with share price and not with assets under management
• Tendering of contracts and annual rolling contracts for managers
• Clear succession planning of managers
• Proper analysis of continuation votes by shareholders (for example, fewer long-term contracts for the manager, the implementation of processes for winding down where necessary, and a focus on sensible use of cash flows if the vote seems risky)
• A more thorough analysis around related-party involvement

While the sector has made strides to improve its corporate governance and transparency around fee disclosure, we believe that more still needs to be done. We need to ensure that we continue to engage to challenge management teams and investment trust boards to act in the best interests of all their shareholders. We will continue to engage on these topics and update you with our progress.

[1] Source: Newton, October 3, 2023.

Authors

Paul Flood

Head of Mixed Assets Investment

Anchit Sharma

Responsible investment stewardship analyst*