Spotlight - November 2020
Why investment companies are underused in model portfolios, and how forward-thinking DFMs and advisers are breaking down these barriers?
What a week. As if the release of the sequel nobody wanted, Lockdown II, wasn’t enough to process, we’ve had a US election where the polls have been wrong (again), we’ve stayed up half the night without getting a result and the leader of the world’s biggest democracy has suggested that the counting of votes should stop while he is still ahead.
I’m not sure which is harder to comprehend – the US electoral system or the new lockdown rules. What happens if Trump and Biden win 269 votes each? Can I have a drink with a friend if we’re doing an outdoor activity, stand two metres apart and order online in advance? My head is spinning and I can offer no cogent analysis whatsoever on the big issues of the day.
But you didn’t come to Spotlight for that, did you? You came to hear about the lang cat’s latest paper for the AIC, Practically Speaking: Investment companies within centralised investment propositions.
Let’s start with the good news. It can be done! Scores of advice firms and DFMs run on-platform model portfolios with investment companies. Four advised platforms are “asset neutral” – that is, you face the same platform costs for open-ended funds and investment companies – and a further four are not far off.
There are even DFMs running model portfolios using investment companies for substantially all their equity exposure – a big shout out to Binary Capital and Crossing Point here. And Smith & Williamson also deserves an honourable mention for its long commitment to using investment companies across its models.
The bad news is: most don’t. Now, advisers have various reasons for shunning investment companies that we are quite familiar with – a lack of understanding, for example, or a feeling that they are too complicated or risky. DFMs don’t see things this way. But they still – by and large – don’t use investment companies in their models.
What the lang cat report lays bare is that the reason for DFMs’ reluctance to do this has a lot to do with platforms. All the DFMs the lang cat spoke to who run model portfolios in their own custody – that is, not on a platform – do use investment companies in their models. It is the platform that seems to be acting as the barrier.
This is not an attack on platforms – or on DFMs. It’s an attempt to analyse why people whose job it is to select the best possible funds are building portfolios exclusively out of open-ended funds when those same people may consider investment companies, in some cases, to be a better alternative.
True to its name, Practically Speaking does offer some practical advice for those assessing platforms, including ten questions to ask about the platforms’ capabilities and ability to handle investment companies in a seamless and cost-effective manner. There’s plenty more food for thought in the paper, so I’d encourage you to take a closer look.
One thing that has surprised many about the global pandemic is the efficiency of much of Asia in handling it, compared to Western countries. Having lived for three years in China it doesn’t surprise me quite so much – I’d say the reasons for it are cultural as much as political.
What I hadn’t realised though was how effectively Vietnam has controlled COVID. I did a double-take when I saw the numbers: 35 deaths for a little over 1,000 cases.
Of course under-reporting is always a possibility, but our investment company managers who are on the ground in Vietnam, or stay in close touch with the country, confirm that control of the pandemic has been staggeringly successful. We may have a lot to learn from countries like Vietnam – although rather like our attempt to import Chinese maths teachers to improve children’s numeracy, the jury is still out on how easily these lessons translate to a very different cultural context.
As Vietnam is probably top of my list of Asian countries I would like to visit but haven’t (I love the food in particular) I’m sorry the pandemic means I won’t be going there any time soon. I can, however, invest there thanks to three investment companies that focus exclusively on Vietnam. The views of their managers, and others with exposure to the country, are collated for you in this month’s Spotlight.
Finally, we’re taking a look at the dividend resilience of investment companies this year. COVID-19 has put revenue reserves to the ultimate test – and in the cases of Temple Bar and Edinburgh Investment Trust, boards have preferred to reset dividends to a more sustainable level rather than struggle to maintain increases.
Another option for those whose revenue reserves are running low is to dip into capital profits, but so far not many investment companies have gone for this approach that weren’t using it already. The use of capital profits to top up dividends has been a hot talking point in the investment company world since the rules were changed in 2012 to allow such distributions. We could see more investment companies going down this route in the near future, although at least one, Invesco Perpetual UK Smaller Companies, has shifted in the opposite direction. Kyle Caldwell examines the issues for us this month.
That’s it for now. I hope I have managed to distract you from the mail-in ballots for a bit. Best of luck surviving this second lockdown and we’ll be in touch again before Christmas.
Nick Britton, Head of Intermediary Communications, AIC
The lang cat analyses platforms' treatment of investment companies in model portfolios
The use of investment companies in model portfolios, both directly by advisers and by discretionary fund managers (DFMs), is being restricted by a range of platform-related barriers, according to a new study conducted by the lang cat for the AIC.
A large majority (86%) of advisers surveyed by the lang cat for this paper agree that recent high-profile fund suspensions highlight the importance of looking at a full range of asset types. Yet open-ended funds make up 91% of the assets held in model portfolios, according to the study, Practically Speaking: Investment companies within centralised investment propositions, leaving other fund structures such as investment companies “a minority sport”.
The majority of advisers surveyed (82%) agreed that “there is an inherent bias towards mutual funds within the retail investment sector”.
That bias is illustrated by the fact that all DFMs surveyed by the lang cat who offer own-custody model portfolios include investment companies within them – suggesting that it is platforms that hinder wider investment company use in models.
Trading costs are one of the principal barriers to the use of investment companies in model portfolios on platforms. Although four advised platforms are “truly asset neutral from a cost perspective”, according to the study, these make up only a sixth of total assets on adviser platforms (a list of adviser platforms, and the extent to which their cost structure acts as a barrier to investment company usage, can be found at the end of this article).
Most advisers who use DFMs expect them to take an unconstrained view in investment selection, with 81% agreeing that “part of the reason I outsource to a DFM is that I expect it to make full use of all asset types available in order to generate returns for my clients”.
However, 16% of DFM-using advisers surveyed were unable to estimate what proportion of a typical client’s portfolio was held in investment companies.
Nick Britton, Head of Intermediary Communications at the AIC, said: “This lang cat paper paints a worrying picture of the contradictions within the model portfolio world. While advisers who outsource to DFMs largely expect them to take an unconstrained view of the investment universe, the reality is that structural issues such as platform costs form barriers to investment company use.
“One particularly telling finding is that all the DFMs surveyed by the lang cat who offer an own-custody service (that is, not on a platform) include investment companies in their model portfolios. That suggests that given a free rein, DFMs would use investment companies, and it’s structural barriers on platforms that cause the concentration of models into open-ended funds. It seems valid to question whether clients who are outsourced to DFMs are really getting the DFMs’ first pick of investment choices via their on-platform model portfolios.
“However, the report also points to several reasons for optimism. Several DFMs are running model portfolios with investment companies on platforms, showing that it can be done. Established platforms are seeking to improve their offerings and there are new, innovative entrants to the market.”
Steve Nelson, Insight Director at the lang cat, said: “There’s no doubt in my mind that platforms have changed the intermediated retail sector significantly for the better over the past 15 years or so in terms of open architecture products and technology choice. However, with a few notable exceptions, the sector has largely failed to provide unbiased and unlimited investment choice to advised clients. Our paper explores some fundamental structural issues standing in the way of progress and imagines how things might change in order to unlock true, whole of market investment access.”
DFMs who use investment companies have their say
The lang cat’s report highlights that not all DFMs eschew investment companies in their models, even when those models are run on platforms. Wealth managers Binary Capital and Crossing Point are noted for offering model portfolios that use investment companies for substantially all their equity exposure, while Smith & Williamson has used investment companies since the launch of its model portfolio service in 2012.
Mickey Morrissey, Partner and Head of Distribution at Smith & Williamson Investment Management, said: “Investment companies offer us the opportunity to access sectors, such as the property sector, through a closed-ended structure which we believe is the most efficient way of accessing investments which are less liquid in their nature. In addition some investment managers can only be accessed through investment companies. Finally it is worth highlighting the performance advantages that investment companies offer investors. Statistically it is the case that certain closed-ended funds outperform their open-ended sister funds. We are able to benefit from this outperformance by investing in the investment company option rather than the alternative that is on offer, which is often the route that our peer group might take.’’
Saftar Sarwar, Chief Investment Officer at Binary Capital Investment Management, said: “Excluding investment trusts results in DFMs excluding a universe of some really exceptional investment products: well run, well managed in a unique capital structure, with persistent performance and excellent transparency. Many companies are not going public as early as before; there’s a growing trend for them to stay private for longer. Many investment trusts offer exposure to private markets which is not otherwise available, or difficult to obtain elsewhere. Clients lose out on performance. Clients lose out on differentiated strategies, clients lose out on some ‘hidden gems’.”
Tomiko Evans, Chief Investment Officer at Crossing Point Investment Management, said: “The majority of UK wrap platforms have the capability to run a model portfolio service for investment trusts. It is fair to say that the costs of buying and selling vary from platform to platform from no dealing charges to an expensive £15 per trade. We find the average platform charges £1 per trade making purchasing investment trusts on platform simple, easy, and competitive. Most of the platforms have the majority of trusts one would expect and will add additional ones if requested. Platform providers are starting to realise the benefits of investment trusts and are seeing increased demand.”
Are trading costs a barrier to investment company use?
The following table from Practically Speaking: Investment companies within centralised investment propositions indicates to what extent costs form a barrier to investment company use on major advised platforms.
Click here to read the full report.
A new Asian tiger?
Reasons to be bullish on Vietnam
With half of its population under the age of 35 and a rapidly expanding middle class, Vietnam is one of the most dynamic frontier economies. It has also been a COVID-19 success story registering just 35 deaths from 1,168 cases. The effectiveness of its short lockdown meant Vietnam began reopening as long ago as April and the Vietnamese economy is forecast to grow in 2020 despite the pandemic.
When it comes to investing in Vietnam, where are the best opportunities and how do they differ from those of other Asian countries? What’s the attraction of accessing them in a single-country fund versus a broader frontier markets strategy? And how could Vietnam’s relationship with China affect the outlook for the region? The AIC has gathered comments from investment company managers investing in Vietnam.
Source: AIC/Morningstar (latest available data at 30/09/2020).
Khanh Vu, Co-Manager of VinaCapital Vietnam Opportunity Fund, said: “The main attraction of investing in Vietnam is that the country is following in the footsteps of other ‘Asian Tiger’ economies that came before it such as Japan, Korea and Taiwan. So the future trajectory of Vietnam's per capita income, consumer spending, and of the general wealth of its citizens is fairly clear. Furthermore, Vietnam is essentially the only Asian Tiger country left to invest in – given how far economic development of other Asian Tigers has already progressed.”
Emily Fletcher, Portfolio Manager of BlackRock Frontiers, said: “Vietnam has been a poster child for frontier markets, having experienced strong economic and social development over the past two decades. The country has seen the benefits of more than $149 billion in foreign direct investment inflows over the past 20 years, supported by accelerating supply chain migration from China – a trend that was established well before trade tensions between China and the US emerged. This has driven huge increases in manufacturing production, such that exports have grown at a compound annual growth rate of 15.8% over this period. Domestically, demographics are in favour of sustainable growth.”
Craig Martin, Manager of Vietnam Holding, said: “Vietnam’s GDP per capita is expected to reach $5,000 by 2025, and by 2035 there could be a further 35 million middle-income consumers in the country. We think this provides exciting prospects for investors. Vietnam is a very open economy from a trade perspective, with more than 200% of its GDP in exports and imports. Over the last three decades it has transformed from an exporter of raw materials, to a producer of finished and semi-finished goods, as well as exporting services – such as information technology."
Ewan Markson-Brown, Manager of Pacific Horizon, said: “So far Vietnam can be considered one of the more successful countries at dealing with COVID-19. It has registered just over 1,000 cases and 35 deaths. The country initially strictly controlled movement internally and externally and reduced cases to zero, however after 99 days of no cases, an outbreak did occur in Da Nang. Given the country’s relatively low level of income it stands out as one of the world’s success cases.”
Craig Martin, Manager of Vietnam Holding, said: “Vietnam’s handling of COVID-19 has rightly won praise and admiration from many other nations. Books will be written on how Asia as a whole dealt with the pandemic versus ‘the West’ and ‘the rest’. It is too early to attribute any one factor as the key success factor, but certainly the cohesiveness of society and the single-mindedness of the people in taking on a threat has been a key part of the resilient response. Let’s not forget that Vietnam was an early victim of SARS in 2003, and regularly faces disease risk from Avian Flu and Swine Flu, so arguably has developed better responses, protocols and communications to deal with emerging infections, and indeed pandemics.”
Dien Vu Huu, Portfolio Manager of Vietnam Enterprise Investments Limited, said: “Having dealt with SARS in 2003, Vietnam responded quickly to COVID-19. From early March air, land and sea borders were all but sealed to human traffic though not to trade. Formal lockdowns have been few, brief and localized, which has limited the economic impact while monetary and fiscal easing have been aggressive, with local government bonds now bearing negative real yields. Hospitality and tourism have been affected of course, but domestic consumption has rebounded and stabilised and exports continue to grow. The unfreezing of infrastructure spending has added another driver of growth which is being reflected in the local market.”
Opportunities in Vietnam
Gabriel Sachs, Manager on Aberdeen Standard Asia Focus, said: “We are bottom-up investors of course but from a macro perspective we are very positive on Vietnam and have been building positions in a couple of companies over the past two years or so. At the moment we have almost 4% of the portfolio in Vietnam. The two companies operate in very different sectors – Nam Long is an affordable housing developer primarily based in Ho Chi Minh City and the other, FPT Corp, is a conglomerate which operates primarily in the IT services industry but has fast-growing telecommunications and education businesses. It is by far the leading tech company in Vietnam hiring a third or more of all computer science graduates in the country, many of whom study in FPT’s own campuses.”
Khanh Vu, Co-Manager of VinaCapital Vietnam Opportunity Fund, said: “Currently, the manufacturing sector accounts for less than 20% of Vietnam's economy, but manufacturing contributed over 30% of GDP in each Asian Tiger economy at the peak. This is an indication of the extent to which Vietnam's future economic growth will be driven by the further development of the manufacturing sector – and the COVID-prompted relocation of factories from China to Vietnam will accelerate this development.”
Emily Fletcher, Portfolio Manager of BlackRock Frontiers, said: “The young, relatively well educated, and increasingly connected population has helped steer change in how businesses interact with consumers. With over 51 million smartphone users, representing 80% of the population aged 15 years and older, awareness of mobile internet and usage has increased, sparking further evolution of retail services. Similarly, the global trend of improving health and wellness has not been lost on Vietnam, leading to shifts in nutritional preferences and the way people shop for food. Seen through this lens, consumer related industries remain preferred areas for investment.”
Dien Vu Huu, Portfolio Manager of Vietnam Enterprise Investments Limited, said: “An innovator worth mentioning is Mobiworld Group. It is Vietnam’s top retailer, with 3,600 stores nationwide, selling mobile phones and consumer electronics, and is now moving into small supermarkets. Management has proven adept at deploying technology and systems to roil up fragmented industries, leading Vietnam into the modern trade era.”
Craig Martin, Manager of Vietnam Holding, said: “Vietnam is likely to be the largest constituent of the MSCI Frontier Market index by the end of 2020, and already has many characteristics of an emerging market opportunity (100 million people, $180 billion market capitalisation). Along with China it is one of the few growth stories in 2020 and is positioned for a strong 2021. The manager of Vietnam Holding, Dynam Capital, has a Vietnamese team on the ground, who are able to research and react to market developments in a nimble fashion.
“We also have the ability to build and manage a concentrated portfolio – we have around 25 positions in the Vietnam Holding portfolio currently – and this focus enables us to deliver on our ESG strategy. Vietnam Holding has been a signatory of the United Nations Principles for Responsible Investment for over a decade – one of the first firms in Vietnam to chart a course of responsible investing.”
Dien Vu Huu, Portfolio Manager of Vietnam Enterprise Investments Limited, said: “As a frontier market, Vietnam remains off the formal radar for most large investment firms who have no on the ground presence or ability to investigate opportunities in this rapidly evolving market. By contrast we have close to 20 analysts able to do this. Our main shareholders are global institutional investors which reflects this asymmetry in access to information. They can simply buy Vietnam Enterprise Investments Limited on the London Stock Exchange and thereby access stocks at their foreign ownership limits at a discount to NAV and without having to open a local trading account.”
Relationship with China and long-term outlook
Ewan Markson-Brown, Manager of Pacific Horizon, said: “Vietnam has had a long and tumultuous relationship with China stretching millennia. Today China sees it as an export market, a cheap manufacturing hub, a place for real estate investment and a potential gateway into South East Asia. It is also a geopolitical rival with claims on the South China Sea among other territorial issues. Managing this relationship will be critical to Vietnam’s rise over the next few decades.”
Gabriel Sachs, Manager on Aberdeen Standard Asia Focus, said: “The country has been one of the fastest-growing markets in the region and we don’t see that changing. The government has handled COVID-19 very well which means the economy is operating rather normally now and the consumer is in reasonably good shape. The intensifying US-China trade spat will likely only improve the attraction of Vietnam as global corporates look to diversify their supply chains away from China.”
Craig Martin, Manager of Vietnam Holding, said: “China is an important trading partner for Vietnam. As China develops and grows, there is likely to be a demand for agriculture and aquaculture products from Vietnam, as well as processed food products. As the US rallies support for a bipartisan ‘us versus them’ approach to China, Vietnam is positioned to be an increasingly important alternative destination for manufacturing – which would further increase its foreign direct investment and hasten infrastructure development."
COVID-19 versus dividends
Kyle Caldwell on the resilience of income-paying investment companies
The coronavirus pandemic has led to scores of UK companies cutting or suspending dividend payments, but the good news for income seekers is that the majority of investment companies have so far managed to buck the trend.
Research by analyst Winterflood to 8 October found that from the beginning of March investment companies made a total of 45 dividend announcements to the effect that income payments to shareholders would be cut, suspended or cancelled.
To put this figure into context, AIC data in March showed that 254 investment companies were paying income, so the number of dividend cuts or suspensions by investment companies equates to around 18% of those that pay dividends. In contrast, the FTSE 100 index has seen more than half its members (52 in total, according to ETF provider GraniteShares) make changes to dividends that have negatively impacted income investors.
Another piece of good news is that when looking under the bonnet the majority of companies that have taken dividend action either invest in property (17 in total, including REITs) or adopt a specialist focus, such as debt and leasing. Investors are therefore likely to only have a relatively small holding, as such investment companies are not typically used as core holdings in a portfolio.
In terms of more mainstream sectors that have seen dividend payments cut, suspended or cancelled, six invest in UK equities, and two in other developed market equities. But all in all, investment companies have so far largely proved resilient in the face of this dividend drought, just as they did in the global financial crisis. And history has repeated itself for the same reason: one of the key structural advantages of investment companies – their ability to retain up to 15% of gross annual income within revenue reserves – has again served them well.
Research by Numis published on 13 October found that “on the whole equity income investment company boards have used (or indicated that they will use) reserves to support dividends and dividend growth records. Revenue reserves have been accumulated in order to smooth dividends in a ‘rainy day’ which the current crisis certainly appears to be.”
Some investment companies also have shareholder approval to fund part of their dividend distributions from capital profits if needed. But of the 41 companies Numis analysed that invest in equities, only two companies adopt this approach: Scottish Mortgage and Manchester & London. They may soon be joined by Murray Income, which is seeking to pay some of its dividends from capital profits in the future as part of its merger with Perpetual Income & Growth.
One investment company that did use capital profits to prop up its dividend yield has changed tack. Earlier this year the board of Invesco Perpetual UK Smaller Companies removed its 4% target yield. It said such a target was “no longer appropriate since it might require a material distribution out of capital which would not be consistent with the board’s approach to paying out a small amount only from capital.”
There are both pros and cons to companies paying some dividends out of capital profits. On the one hand, the ability to enhance a dividend through capital profits is arguably a good thing, as it gives fund managers more freedom in meeting their yield target. They can have freer rein in stock selection, rather than having to potentially ‘chase yield’ to generate the amount of income required. But clearly the trade-off for having a dividend yield enhanced by capital profits is that net asset value performance will suffer, especially if there is a sustained fall in profits and dividends continue to be partly funded through them.
According to Numis, investment company boards need to be clear how the dividend is being funded, in terms of spelling out “the extent to which any dividend is uncovered and thereby funded from revenue or capital reserves”.
Time will tell whether in 2021, if the dividend drought continues, more boards consider taking the capital route to partly fund dividends – particularly those that have seen their revenue reserves start to dry up.