Measuring Stewardship in Investment Trusts
There are a number of factors one should analyse when investing in investment trusts. Less experienced investors may focus solely on past performance; those with more experience may look into the resources behind the fund, including the skills the team brings and the process the fund manager follows. One area that is often overlooked is the fund firm, or parent—one of the five key areas (alongside people, process, performance, and fees) that we believe are important to understand when predicting the likely future success of funds. We think the parent organisation is of utmost importance in evaluating funds. Although other factors may have a more immediate impact, it’s unlikely they would be sustainable over the long term without the proper backing from the asset manager. Further, the fund firm and its management set the tone for key elements of our evaluation.
Recruitment and Retention of Talent
One of the areas we evaluate is a firm’s hiring policy. There is no definitive model: some firms promote team members from within, others recruit experienced outsiders. We’re less fussed about which approach a firm follows, we’re more interested in its application and results -- turnover among investment professionals and demonstration of a strong working culture. Invesco is a good example of a fund house where managers share a strong investment ethic and the average tenure is nearly 10 years. Likewise Aberdeen and Baillie Gifford boast a low turnover and both fund houses are very team-focused. Aberdeen hires analyst early in their career and trains comprehensively in the group's approach. This helps ensure the group's investment process is applied consistently across all levels. That used to be Baillie Gifford’s approach; the firm used to hire only graduates who they could train in the company mould and, while the graduate intake is still healthy, they now complement this with hires of experienced investors and analysts, particularly following the departure of a few more-senior team members over the years. The two-pronged approach seems to be working well and the integrations into the firm’s close-knit culture have been smooth.
Capacity Management
Although investment trusts have a fixed capital, we believe investors should look at how the fund firm manages capacity if it runs open-end funds, as that speaks of the firm’s culture and its behaviour toward investors. At Morningstar, we look at the firm’s history of closing funds at appropriate AUM levels to protect shareholders money and how they communicated that. We don’t like firms that have a history of leaving funds open until they grow large enough to adversely affect the way the fund is managed.
First State, the fund manager of Pacific Assets (PAC) and Scottish Oriental Smaller Companies (SST), has a history of soft closing their open-end funds due to capacity concerns. They did so last year at several funds—the latest in a longer list of soft-closed funds under their management--and they have introduced front-end charges (credited back to the relevant fund) on some funds that experienced significant inflows this year.
Organisational and Business Strategy
This is a very important pillar that encompasses many aspects including how is the fund firm structured, how it grows its business and what are its plans for future, as well as how transparent it is.
Martin Currie is an example that took the rather unusual step of winding down its UK equities capability in 2011, realising it was unlikely to generate the scale necessary to become a serious player in what is a very crowded investment market. As a result, they changed some of their mandates to make them more relevant and applicable to their skill set. Among others, the firm proposed an expansion of the investment universe at Securities Trust of Scotland (STS) from the UK to global, and to adopt a distinct income remit, changes which were consequently approved by its shareholders.
More recently Scottish Widows Investment Partnership (SWIP) has reorganized its business in a move that shifted some of its strategies from active management to passive. The change has been driven mainly by an increasingly clear divide, in SWIP’s view, between equity investors seeking high-alpha solutions and those preferring a lower-risk strategy through a quantitative-based approach. As a result they shut down and consolidated some small funds and fees for passive funds have been lowered. It’s encouraging to see an asset manager accept they can’t add value in all areas.
We also pay attention to the fund firm’s level of communication and openness. One of the latest companies we have been talking to is Scottish Investment Trust (SIT)—a small boutique running only one investment trust. For companies of this size, administration aspects could be a burden, but not for SIT. We were impressed with its level of openness. The firm's website is informative and easy to navigate; the full portfolio is disclosed quarterly; and the attribution that is included in the annual report and accounts is detailed and of a high standard, which speaks well of how SIT communicates with its shareholders.
Some trusts, such as Finsbury Growth and Income (FGT), take a different approach and delegate non-investment functions to another firm—in this case to Frostrow Capital. That can give comfort against some of the risks associated with self-managed funds and small boutiques (such as administration), but not all. Investors should be still cognisant of a potential owner conflict and increased key-man risk. For example Nick Train, fund manager of Finsbury Growth and Income, is a co-founder and one of the main shareholders of Lindsell Train, the investment manager of FGT. Such a set-up could incentivise him and Michael Lindsell to launch new funds at Lindsell Train, to gather assets and thus grow the business. Indeed, since winning the contract to manage Finsbury Growth and Income, the boutique has launched four other funds; however our concerns here are muted by the fact that all funds have been launched only within their specific areas of expertise. That said, the key man risk remains. The entire investment team at Lindsell Train encompasses two portfolio managers and two analysts, which means that the potential departure of one of the fund managers would have a very significant impact on the business and funds they run.
Alignment of Interests with Fund Investors
We prefer fund firms that structure compensation policies which emphasise long-term investment performance.
Invesco’s remuneration structure is sound in our view--bonuses are based on one- and three-year performance, with more weighting applied to the longer term. We believe this longer-term tilt helps better align managers' interests with those of fund investors.
Likewise, Martin Currie’s sector analysts and investment managers’ performance incentives are split on a 50/50 basis over one- and three-year periods, which we view positively. There is also an entitlement to a share of the annual fee revenue of managed products. This is of some concern as it could encourage higher fees or poor capacity management. However, we’ve seen no evidence of either thus far at Martin Currie.
At Montanaro, although a portion of the managers’ annual bonus is invested in their respective funds, which aligns their interests with fund shareholders', compensation of both analysts and managers is linked to 12-month performance rather than longer periods, which in our view, doesn’t fully align with the team’s long-term investment approach.
Board of Directors
For closed-end funds, our assessment doesn’t stop with the parent. We also consider the board of directors and its role as a steward of shareholder capital. We look to see whether directors are acting in the best interests of shareholders at all times, what skills they bring to the board, how active they are and how they communicate with their investors.
We like to see a mix of longer-serving directors with more recent appointments, as the latter bring a fresh perspective—such as at British Empire Securities, where the tenures range from over 10 years right down to a year and average at six years. The over-riding importance is that the board brings the right skills to the right fund, though.
It’s rare to see the fund manager of an investment trust sitting on his own board these days, but a few instances do still remain. Usually, that person’s fee is waived for the benefit of shareholders and arguably they bring a good understanding and level of access to the fund firm. Nonetheless, we prefer to see fully-independent boards to avoid any conflict of interests.
We also like to see a board’s level of engagement and their approach to discount control—we’re less fussed with a hard rule, we’re after clear guidance on how it will be managed and then whether the board sticks to those commitments at the appropriate times.
Conclusions
The ultimate goal when looking at a parent firm is to understand their objective: sales targets to make quick money or a long-term steward of investors’ capital. While few firms fall to either extreme, we think that determining where a fund company lies across the spectrum should be a key part of fund research.
