Updated: As if to underline the confusion caused by discussing different charge estimation regimes, the initial version of this article has been re-edited. Even we and the experts at the AIC got our wires crossed! What’s most important is that you have an accurate reflection of the current situation, so I’ve decided to publish the entire tweaked article again. Apologies for the fuss – The Investor.

Many of us retirement-focused investors have been won over by the charms of income-orientated investment trusts.

And when buying such trusts, in recent months we’ve become accustomed to formally acknowledging – via a tick box at our online broker – that we’ve read each trust’s Key Information Document (KID) at the time of purchase.

Some investors, I’m sure, do assiduously read KIDs.

But many more, I suspect, do not – or have briefly skimmed them once.

Personally, I don’t find them to be particularly useful documents, but maybe that’s just me. Read a KID, though, and it’s not difficult for the eagle-eyed to note that trusts’ costs, as disclosed within the KID, differ from the ongoing charges (or OCF) figure quoted in trusts’ prospectuses and monthly returns, and on popular information services such as Morningstar.

For example, the City of London income-centric investment trust has an OCF of 0.41%, recently reduced from 0.42%.

City of London’s KID, though, lists ‘other charges’ of 0.85%, in addition to ‘portfolio transaction costs’ of 0.03%.

So which costs figure is correct? Why are there two very different figures given for seemingly the same lump of costs? Is some sort of investor rip-off taking place?

Monevator reader Tony B e-mailed us about just such a situation. What was going on, he asked.

Apples and oranges

At which point, let me refer back to a little ancient history.

Many years ago, back in the days of the Total Expense Ratio – the forerunner of today’s OCF – I’d encountered something similar in the context of index trackers.

The culprit? A Financial Services Authority-mandated formula for calculating costs, which had specified the inclusion of some costs that the tracker industry had traditionally excluded from its calculations.

Nothing underhand was happening, and the differences between the two calculations showed up in each tracker’s tracking error.

It was possible that something very similar was going on here, I reasoned. But I couldn’t know for sure that this was the case.

For valuable readers like Tony B, we like to go the extra mile to get to the facts.

Call the experts

So I picked up the phone and called the Association of Investment Companies (AIC), which is the trade association representing investment trusts.

I knew it had been running a vociferous media campaign, arguing against the unthinking imposition of KIDs on the investment trust industry.

Where do KIDs come from? Imposed Europe-wide on the collective investment industry at the start of 2018, KIDs caused a number of difficulties, specifically in terms of the measurement of risk and performance. So much so, that open-ended investment funds (OEICS) have now been exempted from the requirement until 2022, by which time it is hoped that the problems with them can be fixed. But closed-end funds – investment trusts, in other words – haven’t been granted equal exemption.

Ever helpful, the AIC provided me with chapter and verse.

Here, thanks to Ian Sayers, the AIC’s chief executive, and Annabel Brodie‑Smith, the AIC’s communications director, is the low-down on what Monevator readers need to know about charges and KIDs.

The facts, and just the facts

• Every investment company1 KID follows a standardised cost disclosure, showing a projection of the impact of costs over the next one, three, and five years. The ‘other ongoing charges’ section of the KID shows the costs of the investment company managing its investments and the costs of running the company, such as accounting charges, but it also includes the costs of borrowing and stock lending.

• On the other hand, the standard AIC-defined methodology used by the industry calculates ongoing charges based on the expenses levied by an investment company over the last financial year. The ongoing charge includes the costs which investors can expect to reoccur each year, so it includes an investment company’s investment management charge and the costs incurred running the company such as directors’ fees and auditors’ fees.

• Importantly, the AIC says the ‘other charges’ figure quoted on the KID already includes the OCF. The two charges are not additive. In the case of City of London, for example, the KID methodology suggests overall costs of 0.88%, made up of ‘other charges’ of 0.85% (which includes the OCF of 0.41%) and ‘portfolio transaction costs’ of 0.03%.

• To compare investment companies and OEICs, investors should use the ongoing charge because this is the same methodology currently being used by open‑ended funds. When comparing investment companies, the traditional OCF will provide a consistent basis of comparison, but KID-derived figure may not, because the KID rules allow for different interpretations and can lead to different outcomes.

• The KID cost figure is best thought of as a set of costs, projected into the future, based on certain assumptions regarding investment company performance. The traditional OCF is best thought of as a set of (mostly different) actual costs incurred in the most recent financial year.

What to make of it all?

The AIC and the investment company managers that it represents are in no doubt: KIDs are flawed, and must go.

“The AIC has argued strongly for KIDs to be suspended as their flawed methodology for calculating risk and potential returns could be dangerously misleading to investors,” its chief executive Ian Sayers told me. “We have repeatedly called on the FCA to protect consumers by warning them not to rely on KIDs when making investment decisions.”

“The implementation of KIDs for UCITS funds has recently been delayed by two years to January 2022. We believe the KIDs rules should be suspended because they are systematically flawed due to their reliance on past performance as a basis for future projections. We need time so the rules can be fixed once and for all: if KIDs are not good enough for open‑ended investors, then they are not good enough for purchasers of investment companies.”

My take? Not for the first time, we see – doubtless well-meaning – financial regulators muddy the waters.

Whatever fix eventually emerges the likely impact will be deleterious.

With an investment industry repeatedly and loudly calling for KIDs to be fixed — and to be dumped until they are fixed — the result is that the KID brand is in danger of being irreversibly tarnished.

That’s not good for investment trust investors. It’s not good for the investment trust industry, either.

Read all of The Greybeard’s previous posts on deaccumulation and retirement.

1. The AIC talks about investment companies, and I have retained that usage here. For most purposes, and most investors, investment trusts and investment companies can be thought of as being the same thing. All investment trusts are investment companies; not all investment companies are investment trusts. And although this isn’t the only difference between the two, investment trusts are UK-domiciled, while investment companies need not be UK domiciled. [↩]

What caught my eye this week.

Investing blogs – especially in the UK – are updating much less frequently than they used to.

Perhaps as ever more of us go passive, there’s less to write about?

Index fund-focused blogs like us are typically trying to find new ways to say the same thing (as Jack Bogle quipped about himself). It’s just not as exciting as blogging about Facebook shares crashing or small cap story stocks. Readers invariably find Monevator, read a lot and comment a little, and then vanish. Perhaps that happens with most websites. But a strategy that says “set your portfolio and forget about it” isn’t the best way to keep ’em coming back for more.

Sometimes I think about going full-time with Monevator (oh the luxury) and about what else I’d like to write here. (Apart from all the follow-up articles I’ve promised you over the years I mean!)

I’d like an excuse to dig deeper into unlisted/angel investing, for example, but the tumbleweed festooning my article this week suggests this isn’t the right venue.

Similarly I’m interested in all the new fintechs coming to market. I went to a pitch event last night featuring seven, all aiming to make the world a better place. I even chatted to the founders of Monevator reader favourite, Money Dashboard!

This area is appealing to me because it’s not well-covered elsewhere. But perhaps it’s not covered much because few other people are curious about it.

Going back to blogs, I do think the years of seeing their traffic drifting to Facebook and Twitter has eventually encouraged a lot of bloggers to throw in the towel or jump ship. I see people who used to write copiously on blogs and forums now throwing off a couple of tweets about the same thing. It has its place, but nobody is learning about investing on Twitter.

Similarly I was happy to support a financial freedom Facebook group a few years ago that has since ballooned with lots of interesting comments most days. It’s very easy to post a question or a link and to press a like button. Far harder to blog every week for year after year.

Finally, several interesting bloggers – especially in the US – have moved most of their focus to podcasts. I followed a few for a while, but podcasts are time-consuming fare to get through. For me, nothing beats the written word.

The golden age of investment blogging seems to be over. If that’s reflected in the quantity or quality of links to blogs in our Weekend Reading, now you know why.

We’re still standing though. Have a great weekend! 🙂

Am I overlooking some great UK investing blogs that are consistently posting quality content? If so let me know in the comments below. (Not so much people posting about their coupon clipping or matched betting, or personal stuff that doesn’t lend itself to sharing in a single article. Nothing wrong with any of that, but it’s not our thing here.)

[continue reading…]

Note: While as ever this article is not personal investment advice, know that do I own a few shares in Seedrs. Also if you follow my links to Seedrs and try their platform, you can get a £50 investment credit and I may receive a small marketing fee.

Over the past 15 years, advances in technology – smartphones, Cloud-based storage and processing, and low-cost software development – have enabled entrepreneurs to scale up massive companies with little outside capital.

In 2014 Facebook paid almost $20 billion for WhatsApp, a messaging service only five-years old.

WhatsApp had just 55 employees at that time, and most of the momentum that took it to 400 million users came from seed capital1, and some later venture capital (VC) funding.

That was enough to grow it to a valuation of c. $20 billion!

WhatsApp is not unique. The current implied valuations of unlisted start-ups like Uber and AirBnB make the billions Facebook paid for WhatsApp seem stingy. These disruptive giants – again just a few years old – have made their early seed investors rich and delivered stellar returns for VC firms.

Previously it would have taken a couple of decades for a new industry to grow into the $20-billion deal bracket.

Along the way, at least some of the leading companies would probably have floated on the stock market.

But these new behemoths achieved scale without us ordinary stock market investors getting a look in.

It’s not unprecedented, but it is a conundrum.

When capitalists don’t need capital

Of course the initial money for startups has always come from friends, family, and angels (wealthy individuals).

Later and more substantial financing comes from VC funds (especially in the US tech sector) and strategic partners such as big firms in adjacent sectors.

But most founders with global ambitions previously had to tap the public stock markets for the booster fuel needed to achieve multinational escape velocity.

A wider range of funds – and even ordinary punters – could then buy into these still relatively small firms when they floated on the stock market, via an IPO.

And after that, anyone could buy their shares.

In today’s low-capital startup world, however – where it takes takes barely a Love Island villa’s worth of talent to create companies worth billions – we might wonder whether we’re missing out on growth that has previously made up part of the reassuring historical returns seen from owning equities.

Most startups amount to nothing, but the best become the giants of tomorrow. They grow from small winners into middle-sized companies, and some into stock market titans.

True, Uber and AirBnB will probably float some day. (If only so their employees can easily offload the shares they’ve earned.)

But given the vast scale they’ve already achieved as private companies, how much growth will be left for ordinary folk when they do?

I don’t know the answer, but I think it’s worth asking – especially given how important the tech sector has been in driving global market returns.

Imagine if the next wave of Amazons, Googles, Microsofts, Apples, and Netflixes all came to the market years later – and far bigger – than they did?

Trillions in valuation growth might never be seen by stock market investors.

The best VC funds don’t want our money, either

If you think this is a problem – I’m undecided, but wary – then the obvious answer is to invest in private (i.e. unlisted) companies for yourself.

This has long been possible, but it’s not a straightforwardly good decision.

Studies paint a mixed picture about the returns from venture capital as an asset class, and it’s hard to get clear data.

Industry promotional material – such as this overview from Barclays – tends to be short on return information.

The picture is complicated by how venture capital goes through feast and famine, wildly influencing the performance of funds of different vintages that raised money at different times.

For instance the FT reported in 2017 that a representative subset of European VC funds that took money at the height of the dotcom boom in 2000 on average paid back just 39% of the money put into them!

Some did much better. But this only raises the perennial question of knowing which funds to put money into.

And while the UK and European VC sector is becoming more established, the biggest and best funds are still based on the West Coast of the US.

These US funds get the pick of company founders and ideas. In the hit-driven game of venture capital, that’s crucial.

US funds would also argue they’re best-placed to help the startups they invest in via their own long-established networks – by introducing them to managerial talent, other investors, potential acquisitions and so on – and so creating a virtuous circle.

You might decide the solution is to invest in these US funds, but the elite ones are usually closed to all but the richest investors and institutions – and some even to them.

Yet the return from these top outfits will skew higher any return figures you see from the VC asset class – even though oiks like us can’t buy into them!

Ways to invest in venture capital

For these reasons and others (notably a lack of liquidity and high fees) most of the writers we rate – Hale, Kroijer, Swensen, and the lazy portfolio creators – do not see a place for VC in everyday investor portfolios.

But what if you disagree?

There are ways to put money to work in private companies if you’re keen. You don’t even have to move to San Fransisco and fill your wardrobe with chinos.

However all come with challenges – and you’ll need to do a lot of research.

Here’s a summary of the main routes you could explore.

Invest via venture capital funds

The venture capital firms are out there – there’s even a growing seed investing scene in London – but whether you can judge the best funds in advance – or as I say put money into them – is extremely debatable. VC investing is brutal, at least for the investors. (The managers enjoy some fees either way.) If you’re a high net wealth type, you’ll find private banks may include VC (or at least private equity) funds in their managed portfolios. Such a relationship might get you access into better funds that would otherwise be unavailable – but you’ll need to don your shark-proof armour!

Investment trusts

There are a bunch of investment trusts that operate in the unlisted space. The majority are private equity rather than VC-focussed. This means your money will be funding things like management buy-outs, expansion at more established companies (including debt raises), and perhaps buying into a portfolio of companies that your trust owns outright. You’ll need to dig deeply to look for trusts with a growth perspective, if that’s your bag. You could even look at something like Neil Woodford’s Patient Capital Trust, or other idiosyncratic trusts that have a relatively high allocation in unlisted firms. Expect a rocky ride – with market conditions and the business cycle playing a big role – and understand that failures happen early in VC investing, so it can look pretty dark before any dawn.

Venture Capital Trusts (VCTs)

Going by the label on the tin, you’d think your hunt would stop here. VCTs come with tax breaks (albeit watered down in recent years) and many do put significant sums into start-up firms. However as a class they are definitely not all focused on high-growth minnows.2 VCTs mostly aim to return money to shareholders via relatively high (and tax-free) dividends rather than in multi-bagging your initial investment. Their high fees make are also a big problem, as I’ve discussed before. I’ve wealthy chums who’ve maxed out their SIPPs and ISAs who love VCTs for the tax-free dividends, but for most of us these probably aren’t the venture capital vehicles we’re looking for.

Angel investing

It’s hard to get closer to the coal face of backing unlisted companies than to do a bank transfer to the founder of a start-up in exchange for a chunk of their shares. Perhaps you’ll even get a say in how the business develops. Results from angel investing will vary extravagantly, and cause your typical Monte Carlo simulator to reconsider its life choices before having a melt down. Angel investors run the gamut from the founders of hit companies like Skype to big fish in small provincial ponds who fancy co-owning a restaurant. Clearly, if you’re looking for the next globe-conquering Tinder or WhatsApp, don’t give money to your mate who wants to open a craft beer shop. The best book I’ve read on hunting for tech companies that might return 100x your money is Angel by Jason Calacanis.

Equity crowd funding

Not many of us can write the chunky cheques required to be an angel investor without jeapordising our future wealth. If you’ve got £5m to your name then perhaps it’s fine to stick £50,000 into several exciting moonshots to hang around with clever 20-something hipster coders. If you’ve only £50,000 in your ISAs and SIPPS, not so much.

Over the past few years, however, platforms such as Seedrs, Crowdcube, and Syndicate Room have addressed this issue by pooling often very small amounts of money from thousands of individual investors to put money into startups as a bloc.

It works, but there are issues.

In theory these platforms are democratizing venture capital and I applaud that on principle. (I even invested a little in Seedrs).

But in my experience the quality of both the companies listed on these platforms and the investors putting money into them is extraordinarily variable, to put it mildly. This is hugely risky investing, and as the space is so new there’s not return figures available that take into account all the future failures – or at least not figures I find thoroughly convincing.

For the record, Seedrs for instance has claimed a 12% internal rate of return across all-fundraisings on its platform – jumping to over 26% if potential tax breaks are taken into account.

I do judge Seedrs puts a superior cut of companies onto its platform, for what my observations are worth.

But the truth is we’ve not got a long-term to look at with these platforms yet, and barely a medium-term.

Worse, most individuals will likely discover they have a negative edge in assessing small startups. Crowd funding raises are invariably supported by scanty financial details and in a handful of cases what have seemed to me borderline fraudulent business plans. People still back them.

‘Adverse selection’ also looms large. Why are the founders coming to the great unwashed if they could get money from traditional VC funders? Perhaps because they’ve been turned down elsewhere?

On a brighter note you can often meet the founders in person (at least in London) which I believe is far more important with this kind of investing.

I also think there are companies for whom crowdfunding actually makes more sense than traditional fund raising, at least early on. I’m thinking of consumer-facing companies that may benefit from an army of shareholder-promoters.

There are also compelling tax breaks for investors putting money into firms that qualify for EIS and SEIS relief. Most of the tiny startups you’ll come across via fund raising do qualify.

Just remember that however good you are, many or maybe even most of these companies will eventually fail or near enough fail and you’ll lose the money you put into them. Much of that money can be offset by the tax reliefs, but not all of it.

The following graph is typical of the distributions of winners to losers you’ll see quoted:

(It’s based on US returns from professional VC investors, so if anything it is over-stating the chances of amateur angels striking it big.)

The aim of the game is to be in one or two of the few companies that may eventually break out of the crowdfunding morass to achieve ginormous scale. If you manage this it could make up for all your losers and then some.

Financial firms Monzo and Revolut and the brewer BrewDog have all delivered handsomely for early crowd funding investors. There will be others, but they’ll shine beyond a meteor storm of burnouts and crashes. (One irreverent blog specialises in tallying the frequent failures).

Investing in lots of companies rather than betting on half a dozen is probably the best strategy for trying to get a sliver of a future giant.

But I wouldn’t invest so much that it will make a big difference if you never strike gold. This is lottery ticket investing at its riskiest.

Innovation in venture capital investing

For all the downsides, I have put about 3.5% of my net worth into unlisted companies via crowdfunding platforms.

However I have several diverse reasons to get involved, beyond any returns. (Improving my investing chops, for example.)

I’d urge caution in allocating anything more than play money-sized allocations for even most active investors, let alone passive players.

Indeed there seems to be gap in enabling everyday investors to get exposure to venture capital – and to enjoying those generous tax reliefs – without digging through the business plans of hundreds of mostly doomed start-ups.

The Seedrs platform has recently made some interesting moves in this direction, though I do think its solutions raise new issues even as they address others.

Will they offer a way for passive investors to easily get exposure to start-up companies?

More on that next week – subscribe to ensure you see it!

1. Seed capital is the first money that goes into starting a new business. [↩]
2. In the past some VCTs even actively avoided VC-type investments as much as was possible within the rules, in order to offer limited life capital preservation vehicles that milked the tax breaks, though this has now been curbed. [↩]