Frozen Pension: Who are you KID-ing? Understanding the ongoing charge figure of an investment trust

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%.

Which 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. So 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, apart from a small area of overlap, the AIC says that the two cost calculations are additive. In the case of City of London, for instance, a true indication of its overall costs would be a figure close to 1.26% (0.41% + 0.85%).

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.

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.