Professional investors have urged the FCA for a consultation on misinterpreted regulation regarding ‘complex investment products’ by platforms, following fears that mandatory ‘test taking’ before buying into some investment trusts is dealing another blow to the already-ailing sector.
They add that hampering the democratisation of investing through reducing retail access to real assets – which use investment trusts as vehicles for liquidity – could have negative consequences for both the UK stockmarket and the UK economy, warning that test-taking suggests the industry will go “back to the dark ages” of having to use a financial adviser before executing any trade.
Some DIY platforms in the UK – although not all of them – profess that regulation prohibits them from selling shares in certain alternative and specialist investment trusts without requiring investors to take a knowledge test. This is investment trust-specific, and is not required in order to invest in any other main market-listed company or AIM stock. Platforms known to enforce this include Hargreaves Lansdown, AJ Bell and Barclays Smart Investor.
The trusts affected vary from platform to platform, with some being determined as complex vehicles by the platforms while others are branded ‘complex’ by the trusts themselves.
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A spokesperson for AJ Bell said: “It is correct that our investors have to take a test to invest in complex instruments. It only takes them a couple of minutes, so it isn’t a major hurdle for those who want to invest in these assets.
“It is a regulatory requirement for us and something we’d keep under review were the regulations to change.” The spokesperson added that the regulatory requirements fall under Mifid II, EU regulation first introduced in the UK in 2014.
However, not every platform requires test-taking before buying certain trusts, which calls into question the regulatory nature of the tests. While this is because some simply don’t offer specialist trusts, others cite ‘choice’ and ‘freedom’ as reasons to allow investors to buy products without test-taking.
A spokesperson for Bestinvest said: “We provide access to an extensive range of investments trusts and investment companies on Bestinvest and we also include a number on ‘The Best Funds List’, our list of rated funds, ETFs and trusts, chosen by our research teams.
“We believe in giving our clients choice and the freedom to make investment decisions that align with their attitude to risk and financial goals. Choosing which investment trusts they want to invest in should be their decision and not ours.”
When asked about Mifid, they concedes the regulatory environment “has evolved in recent years”, in conjunction with the recent rollout of Consumer Duty – a standard introduced by the FCA last year which aims to protect consumers.
“This is why investment companies need to be flagged as suitable for retail investors, be made accessible and provide key information documents under the Priips regulations.”
Meanwhile, Fidelity chooses not to offer ‘complex investments’ through its platform at all, having taken the decision to remove certain trusts from its investable universe altogether – a list of which is published on its website. These include MIGO Opportunities, AVI Global, RIT Capital Partners and CT Global Managed Portfolio Income.
A spokesperson said: “Investments that are considered ‘complex’ by the regulator trigger a requirement for non-advised investors to undertake an appropriateness assessment before they are able to buy them. This is a regulatory requirement, rather than a platform-led decision.”
Phone a friend
If there is indeed a regulatory requirement for investors to take tests before buying into some trusts, then it could pose a problem.
Issues were brought to light recently after a sophisticated investor wrote that he had attempted to buy more shares in Bluefield Solar Income on AJ Bell – a renewable energy trust he had held since IPO. However, he failed the test.
Elsewhere, long-time investors have been prevented from buying into Digital 9 Infrastructure on Hargreaves Lansdown for failing one or more questions. The questions asked in the test have been criticised on social media – both by retail and professional investors – for using overly complex language and for being difficult to understand.
“Requiring investors to undergo such tests of understanding is a curious approach and doesn’t withstand much scrutiny,” Richard Parfect, portfolio manager at Momentum Global Investment Management, said. “It is likely to be driven by the platform’s own commercial desire to mitigate the risk of blame of facilitating an investment in case it subsequently turns sour. However, no such tests are required of an investor if they buy any operating company that is listed on FTSE 100, FTSE 250 or FTSE Small Cap.
“Companies of all shapes and sizes go bust all the time – just ask former RBS and Marconi shareholders. Given platforms require tests to buy an investment trust but do not require any such test to buy a speculative operating company, such as a small-cap oil explorer, suggests these tests are not primarily driven by investor protection – especially as there is no specific regulation requiring such a test.”
James Carthew, head of investment company research at QuotedData, said: “There is a very reasonable case to make that if a consumer is judged to have sufficient knowledge to buy any AIM share, they must be able to comprehend the generally lower risks associated with buying a fund with a diversified portfolio. This seems to be the way that Mifid looked at the issue.”
Sheridan Admans, head of fund selection at Tillit, said that while Mifid regulation “strives to ensure investors grasp investment risks”, it is “frustrating to consider that a single company’s stock on AIM could incur a 100% loss, while trusts usually spread investments across a much greater number of instruments, diminishing the risk of complete failure”.
“Additionally, failing trusts often offer a reasonable chance of redeeming underlying assets at their net asset value in the windup process.”
The truth about Mifid
A majority of platforms cite Mifid as the reason for testing – in particular, its rules regarding ‘complex investment products’.
Article 25(4) of the regulation specifically enables Mifid companies to be bought by an investor without them having to be assessed if certain conditions are met. Specifically, if the investment is considered to be ‘non-complex’.
Under Article (4)(a)(i)-(v), Mifid states “shares in non-Ucits collective investment undertakings” that are “trading on a regulated market or on an equivalent third-country market of on an MTF” will always be classified as ‘non-complex’. Our sister publication Portfolio Adviser has received legal confirmation that investment trusts constitute as “non-Ucits collective investment undertakings” and are therefore exempt.
An additional layer of complexity, however, is that the FCA’s recently-published third consultation on Mifid II is less explicit. It says investment trusts will not automatically be considered complex nor non-complex, stating at paragraph 8.16: “Our view of the Mifid II provisions on complex and non-complex financial instruments is that, as in Mifid, non Ucits retail schemes (Nurs) and investment trusts are neither automatically non complex nor automatically complex.
“They need to be assessed against the criteria in the Mifid II delegated regulation. When firms apply these criteria, they should adopt a cautious approach if there is any doubt as to whether a financial instrument is non complex.”
Baroness Sharon Bowles, non-executive director of the London Stock Exchange and former chair of the European Parliament Economic and Monetary Affairs Committee, said: “This has nothing to do with Mifid. It might have something to do with [platforms’] interpretation of Consumer Duty.
“I haven’t a clue why they are doing it. There is nothing in Mifid that has changed recently – this has appeared from nowhere. I’m toying with whether investors who are finding themselves blocked could complain to the Financial Ombudsman.
“When you’re a bank, admittedly you can categorise clients and choose who you do business with. But is it right that platforms can submit investors to a test, claiming they are required to under regulation, when they aren’t?”
She added: “Platforms have potentially just misinterpreted ‘complex products’ within Mifid. It has to be a misunderstanding because, otherwise, why are they letting investors buy shares in banks or insurance companies? It doesn’t get more complex than that.”
Consumer Duty
The other piece of regulation working in conjunction with Mifid confusion is Consumer Duty. Implemented in July last year, the new rules aim to set a higher standard of consumer protection across the financial services industry. Under Principle 12, which requires firms to “act to deliver good outcomes for retail clients”, they must: act in good faith towards retail customers, avoid foreseeable harm to retail investors; and enable and support retail customers to pursue their financial objective.
These, according to the FCA, fall under products and services, price and value, consumer understanding, and consumer support.
“These well-meaning aspirations have presented firms with a problem with respect how to actually implement them in a way that is relevant to the service they are providing to customers,” Parfect reasons. “For example, to “avoid foreseeable harm to retail customers” – should that extend to preventing those customers from taking risks, even high levels of risk (whether the risk be perceived or real)?
“If the platform does prevent a customer from investing in a ‘high-risk’ investment, how does that fit with them “enabling and supporting customers to pursue their financial objective” especially if they are of the age where they can afford to take higher risks?”
Value and price also raises questions. Bill MacLeod, Gravis managing director, points out that firms have to write ‘past performance is no guide to future returns’ on every document they publish.
“But when it comes to the way value is often assessed, we have to pinch our noses and go with it; because everything about it is at odds with what we say to investors when we’re trying to be helpful.
“All we can do is say we have a process in place, that it’s repeatable, that we have repeated it for a certain number of years and received a certain outcome, that we will carry on repeating it, and that the probability is we will achieve the same outcome.
“However, we absolutely cannot look to the past to inform the future. It’s like putting a car key in your car and turning the ignition; you just have to think, ‘It started up yesterday morning, so I’m hoping the same will happen today’. But you never really know for certain.”
He added that ‘value’ transcends a number printed on a piece of paper, as it is only executed at the point of transaction.
“It’s like buying a house – you could drive down the street, point to a house and say, ‘That must be worth £250,000’. But if the seller is prepared to accept £225,000 for it, it’s therefore not worth £250,000. And then, the house itself could have only cost £100,000 to build.
“That’s how valuations work – they’re a bit of science, a bit of art and a bit of history.”
Assessment of value
Under Consumer Duty, the FCA expects companies – including platforms – to provide evidence of fair value across their products and services.
But as Ben Conway, CIO at Hawksmoor points out: “One of the big issues is that investment companies don’t have to produce Assessments of Value as Ucits do, so it’s very hard for a platform to demonstrate an investment company represents fair value – especially if the disclosures say the investors are paying costs that they aren’t.”
Therefore, platforms are outsourcing independent assessments of value for the trusts they are making available to retail investors.
This has caused controversy, however, with some assessment providers coming under scrutiny for seemingly failing to understand what an investment trust is. One value assessment report, provided by third-party firm 360 Fund Insight to AJ Bell, compared Bluefield Solar Income Fund directly with the Invesco Global Clean Energy Ucits ETF, on the basis that it also has “exposure to clean energy”.
It also stated: “The fund is too expensive (1.94%) to gather exposure to solar and wind energy with most of the operating plants in the UK, versus a more diversified exposure to global clean energy with other funds or ETFs at a reduced cost (0.60%).”
Baroness Bowles said: “You only have to look at some of the third-party assessments, which clearly show platforms have obtained these from researchers who know nothing about investment trusts.
“It is no good for platforms to blame this issue on their assessors. They chose them – they should have made sure these firms are familiar with UK legislation, regulation, investment funds and how listing rules may differ from those in other countries.”
Conway said: “There is a massive issue with external sources. It is clear [in some instances] the authors are not experienced investment trust practitioners. To be clear, I think investment companies should be treated in the same way as equities are: no tests, and no assessments of value (unless the board requires one from the investment adviser).”
Annabel Brodie Smith, communications director at the AIC, agrees with Conway that current cost disclosure regulation forcing trusts to double-count their costs is adding fuel to the fire.
“The very unhelpful cost disclosure regulation is feeding in here when it comes to assessing trusts’ value,” she says. “What we think – although we don’t know, because no platform has actually told us – is that some platforms are restricting or even denying access to trusts if their charges are above a specific cost cap.
“People are having difficulty buying Chrysalis, for example. For a start, it has now completely changed its performance fee structure so, if this information is based on some kind of cap, it is now based on wrong and outdated information.
“It’s a mess. But we are currently lobbying hard on the cost disclosure issue. The Treasury says it is going to make a decision on this ‘very soon’. But that was last said to us over a month ago.”
Using Chrysalis (ticker: CHRY) as a case study, which failed an assessment of value test, Parfect points out that its shares sit at a 40% discount to its net asset value, while a number of its investments are approaching realisation at higher valuations than they were valued at in the trust’s net asset value (NAV).
“The annual management charge is just 0.5% and the performance fee will not apply unless the NAV is significantly higher than now and has been achieved with cash realisations,” he explained. “A pragmatic assessment of the valuation of CHRY could (and does to many investors) suggest there is compelling value and opportunity for profit from current levels over the next 12-24 months.”
Indeed, the concept of applying a hard cap on fees – which, according to unofficial reports, is what some platforms have decided to do although none have confirmed – has also left investment trusts professionals perplexed.
Kamal Warraich, head of equity research at Canaccord Genuity Wealth Management, said: “Like all things, some platforms are better than others. Introducing a hard cap on fees is nonsensical, as fees are only one component of what constitutes ‘fair value’. If you pay 2% and outperform, it’s better than paying 50 basis points and underperforming, for example.”
Comparing apples with pears
The other factor causing confusion regarding trusts’ value, is the fact that unlike Ucits vehicles, they are publicly listed entities that issue a set number of shares. Trusts therefore have both a share price and an underlying net asset value. The price the market values them at, relative to the value of their underlying holdings, places them at either a premium or discount to NAV. Investors therefore buy shares in investment company at ‘price’, as they have no product costs.
MacLeod said: “There is a difference between permanent capital, which trusts have, and variable capital, which open-ended funds have. The distinction seems to have been forgotten.
“With an open-ended fund, the price is also the net asset value – the manager issues or cancels units to meet supply and demand. An investment company has a finite number of shares in issue and the price is determined by demand for those shares.
“In this sense, you are basing your view on the other people in that market and their demand for those shares, versus yours. So, you buy them hoping people will want those shares more than you do, and that the price will therefore rise. It’s as simple as that. The value of these companies should be treated differently.
“When it comes to how you position these things, and how you think about them from a platform perspective, you cannot apply the same thinking to both.”
Baroness Bowles said: “The thing to stop and think about is, while all of this is going on and investors are worrying about trusts trading on double-digit discounts relative to their NAVs, they should be thinking to themselves, ‘My, that’s a bargain’.
“Why hasn’t the NAV collapsed? Because these portfolios that are supporting vital economic activity, are actually being very well run by exceptionally talented people. So, the proof they are not so risky and in fact jolly good investments, is that the NAVs are still there, despite this awful scenario we’re in. This, surely, has to speak to the regulators as well.”
She added that there is more scepticism from platforms and the regulator regarding trusts simply because they are regulated in a different way from their open-ended counterparts – despite the fact trusts are listed entities, while investors can buy ever-increasing ‘units’ in a fund.
“Various people hear ‘open-ended’ and ‘closed-ended’ funds, and the fact closed-ended funds are not regulated in the same way as Ucits. Therefore, they don’t see them as transparent. But – not appreciating that they are listed companies with all the transparency and reporting that brings. The shorthand usage of ‘trusts’ and ‘funds’ rather than the mouthful of ‘listed closed-ended investment companies’ isn’t educating people. When actually, investment trusts have been in existence for more than 150 years and they are more transparent,” she argued.
“You can have equivalent types of transparency, but you can’t have exactly the same rules in place, because the closed-ended listed funds are a different structure from the open-ended unlisted funds – the latter do not have market price-setting mechanisms taking account of expense and indeed risk. Platforms cannot compare apples with pears.”
A tough world for platforms
Despite widespread criticism in terms of mandatory test-taking for investment trusts – as well as questionable sources for third-party valuations – a majority of investment professionals interviewed by Portfolio Adviser sympathise with the challenging position platforms find themselves in.
“What is happening with platforms is that they are open architecture – they are trying to provide a whole-of-market service,” Gravis’s MacLeod said. “This comes with quite a lot of compliance risk. I completely understand the perspective they have on this – they can’t cover all of the bases themselves.
“This is why they outsource some of their functions to other parties, and why they exercise regulatory caution.
“Platforms don’t want to impinge on our rights. What they want to do is stay within the law and deliver a good service.”
Baroness Bowles said: “I can see what they’re trying to do. They’re trying to make sure people have a level of understanding or the right kind of warnings, without removing the freedom to choose.
“I think they have a duty to do that, in a way that enables non-financial services people to understand the questions. Lots of investment trust professionals I know can’t pass the tests by one of these platforms.
“For example, the person on the street might not understand what a ‘counterparty’ is. But they would understand a platform saying to them, ‘There are other people that might expose you to risk within this trust, because there might be borrowing and loans, or exchange rate risk’. And yet, people have to resort to jargon-wrestling.”
Brodie Smith added: “If platforms choose to take this action to meet their regulatory obligations, then they must be transparent about it. Otherwise, we’re all going on guesswork.
“It ends up becoming a whispering campaign where nobody quite knows what’s going on. I can understand they are trying to follow Consumer Duty and that is what they are obliged to do, but they must be transparent.”
QuotedData’s Carthew agrees with the platforms that investors need to ensure they understand what they are buying – this, he says, was one of the reasons his company was founded – to produce free and easy-to-understand research into investment trusts.
“If a platform has a reasonable expectation that an investor won’t understand a product, they should not sell it to them. However, that degree of understanding will vary from end-consumer to end-consumer, and it would be wrong to put a blanket ban on a product. Rather, it makes sense to try to work out how much knowledge they have and treat them accordingly.”
Some commentators support the implementation of questioning prior to buying trusts. However, they say it has to be executed in the correct way.
Alan Ray, investment trust analyst at Kepler Partners, doesn’t think there is “anything wrong with a platform with its own Consumer Duty obligations making its own assessments of complexity”. However, he said clearer explanations of the reasons for those designations would first, “help investors understand why they may be asked additional questions and help explain why the investment may not be right for them”; and second, “give the investment trusts themselves the right to reply and, potentially, address any concerns the platform may have”.
“For example, while investment trusts are not, from a regulatory perspective, generally complex, it could be that a particular trust is difficult to deal in and a platform may see this as a factor in its designation of the trust as complex, as it may be more difficult for an investor to exit their investment than they anticipated,” he points out. “As it stands, there doesn’t seem to be much transparency about why some things are deemed complex and transparency is probably the best solution.”
Canaccord’s Warraich concurs that test-taking before buying trusts is, in theory, “a good idea”.
“But as with all these things, tests need to be accurate, the methodology consistent and the questions posed, clear,” he says. “The reality is that appropriateness tests on different platforms will be structured differently and therefore lead to different outcomes. There is a risk that certain questions, including knowledge and experience type questions, may be too vague.
“There needs to be a balance between enough regulation to protect investors (which introduces high-quality and sensible measures) and regulation that is too binary, which could prevent people from reaching their financial goals.”
Baroness Bowles, meanwhile, believes there are alternative solutions which don’t require creating an additional layer of “tick boxes”.
“I think this kind of gating is anti-democratisation in investment. It’s anti everything we want. It has gone too far,” she argued.
“I understand the idea that firms should take care, but I don’t think that fobbing the responsibility off to third parties or to jargon-filled questionnaires is the solution. You already have tick boxes, saying that you’ve read things.
“Why don’t the platforms check whether the investor has downloaded the KID [key information document], for example? Because very few people do.
“I’m not saying KIDs are the solution to the problem because they are not – far from it. But the fact is, if you’re going to establish gating, why not use things that are already in place, rather than put up new fences?”
Baroness Bowles warned that, if retail access to investment trusts that provide vital funding to real assets in the UK is reduced, the UK economy – and indeed its stockmarket – will ultimately suffer.
“The democratisation of investing through retail access to real assets is ever-more important, at a time when the government and most economic commentators realise the power and need for more retail investing in the UK economy – not just playing safe in bonds.
“This is like going back to the dark ages when you had to go via a financial adviser for everything.”
Levelling the playing field
In summary, the problem seems multi-faceted, but seems to stem partially from requiring greater transparency from platforms, as well as more standardised and easier-to-understand questioning – if any at all.
Emma Bird, head of investment trusts research at Winterflood Securities, said: “In our view, it is important that retail investors are well informed and do not face undue risk when allocating to investment trusts. However, we urge platforms to ensure there is not an uneven playing field when determining the risk of investment trusts, which generally offer diversified exposure to a range of assets or companies, versus individual companies, which may pose higher risks in terms of illiquidity or share price volatility.”
Another missing piece of the jigsaw puzzle is ensuring that any third-party research is conducted by analysts that understand the nuances of investment trusts and the purpose they serve within investors’ portfolios.
Admans pointed out that trusts offer “valuable benefits for investors” and are less high-octane than some investors believe them to be.
“Unlike some collective investment schemes, they can provide liquidity even during market downturns. Managed by professional fund managers, they offer diversification across various assets, sectors and regions, including investment types often inaccessible to retail investors.
“Their closed-ended structure ensures portfolio stability, as managers aren’t compelled to sell assets to meet redemption demands. Moreover, they trade at a discount or premium to their NAV, potentially boosting returns. With regular reporting, investors gain valuable insights into the trust’s progress.”
The other part of the problem is regulatory complexity leaving platforms in the dark, and many providers and researchers remaining unsure of the benefits of investment trusts and how they actually operate. The FCA was approached for comment, but did not respond by the deadline given.
Warraich said trusts are indeed more volatile relative to their open-ended counterparts, on the basis that they can swing to big discounts, borrow money to enhance returns, and can be more concentrated due to not being Ucits structures.
“I understand that even the simplest type of trust, say, a plain vanilla equity strategy, can be slightly more complex than its open-ended counterpart. However, complexity does exist on a spectrum and there are relatively effective ways to define trusts.”
He therefore believes the FCA should collaborate with the AIC and the rest of the trust industry to devise a framework to advise platforms on how to categorise investment trusts.
QuotedData’s Carthew agreed that the regulator must issue greater clarity for platforms. “In the absence of firm guidance from the FCA, it is understandable any platform would want to err on the side of caution. In an ideal world, this wouldn’t be open to interpretation.”
Momentum’s Parfect said the recent examples of tests and the quality of the assessment of value reports are “failing all parties”.
“Platforms are clutching at straws to cope with Consumer Duty and the interpretation of how to manage it. This is the result of that. Consumer Duty, tragically, is failing and the FCA needs to give better guidance on how to implement it.”
Alongside calls for the FCA to simplify and better explain its stance on investment trusts, commentators continue to bang the drum for cost disclosure rules – which effectively force trusts to double-count their costs – to finally be resolved.
The AIC’s Brodie Smith told Portfolio Adviser: “It’s frustrating for investors. When the regulation comes into play, we sometimes end up with bizarre situations like this occurring. Which are unintended, but that’s what has happened due to a lack of communication – from multiple parties.
“Presumably [the FCA] will review Consumer Duty at some stage. But cost disclosure reform should help put an end to this platform issue.”
Gravis’s MacLeod said misleading cost disclosure means misleading costs are therefore still in circulation, which have in summary “led platforms to deny investors access on the grounds of Consumer Duty compliance”.
“They are using false data and, guess what, they come to a false outcome. Like maths teachers have said since time began – show your working.
“They also require investors to self-identify as experts to buy these intentionally dull companies. Pooled investments are there to give a spread of risk and return. There is nothing racy about an investment company.”
This article first appeared in Portfolio Adviser’s May magazine