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Engagement is the key to investment trusts’ success

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I’m a huge fan of investment trusts — I invest in them and I sit on the board of three of them. They have a long-term history of outperforming.

In 2018, Cass Business School produced a study that took into account every issue they could think of that might distort the comparison between investment trusts and open-ended funds and still found that the trusts had outperformed by about 1.4 per cent a year over the previous 18 years. Compound that over a couple of decades and you are talking real money.

They work brilliantly for anyone wanting to hold illiquid assets — this is the way to invest in micro caps, infrastructure, property and renewables. They can use borrowed money to pimp up returns — and history suggests they more often than not add value in doing so.

Possibly best of all, they have active boards of directors charged with representing the long-term interests of shareholders. This appears to make a genuine difference: even after Cass had adjusted for sectoral bias, gearing and share buybacks, the outperformance of trusts was still about 0.8 per cent year, which suggested to them some kind of magic in the structure of investment trusts.

So what’s not to like? A few things.

The first is cost. Until relatively recently trusts were generally cheaper than open-ended funds (and we all know that current costs are one of the main drivers of future returns). No more.

Management fees have fallen for both types of investment but costs have risen for investment trusts. Regulation never stops increasing for listed companies and each new clause and sub clause pushes up the cost of compliance.

As trusts lose their cost advantage, will they also lose much of their performance advantage? The jury is still out on this, though one obvious way to mitigate the cost risk is for smaller trusts to merge and make some economies of scale. They mostly don’t — as in all mergers, it would mean directors losing their jobs and they aren’t mad for that — but perhaps they should.

There’s also tax risk. One of the cornerstones of the trust model is the rule that as long as a trust pays out 85 per cent of the dividend income it receives to its shareholders, it does not have to pay capital gains on share sales made within the trust.

This is to prevent shareholders effectively paying CGT twice — once on the sale inside the trust and again when they sell the shares in the trust.

But Rishi Sunak appears to be having some unsound thoughts on CGT as a whole. If the chancellor is unfriendly enough to suggest it is reasonable for investors to pay their marginal rate of income tax on their capital gains (as the Office of Tax Simplification suggested this week) without rushing also to propose the abolition of the UK’s other wealth taxes (imagine paying CGT of 45 per cent followed by inheritance tax of 40 per cent) what else might he think of?

CGT is going to be “reformed” one way or another, since this fits neatly with the “make the rich pay” political narrative of the moment. The industry needs to be alert to the risk that it could get caught up in that reform.

There are other worries you could add to the list. But the thing trusts need to think most about is their relationships with their small investors.

The past few years have seen a push by the sector to attract retail investors into trusts. I approve of this for all the reasons mentioned above. But if you end up with a shareholder base of lots of small private investors, many of whom will be less experienced than the institutional investors that used to be the mainstay of many shareholder registers, you have to look after them.

That means very good communication around matters of discounts and premiums — investors need to know the risks of buying investment trust shares when they are trading at a premium to their net asset value in particular. It means responding to rising investor demand for more transparency, on ESG issues in particular.

Crucially, it means encouraging interaction. One of the great joys of the investment trust is the annual general meeting. Open-ended funds do not provide an annual opportunity for small unit holders to turn up and directly quiz the directors and fund managers over a cup of coffee (or an actual lunch at the likes of Personal Assets and Alliance Trust, both of which I hold). Trusts provide just that for their shareholders.

This is brilliant for the manager and directors. If I were asked what it is about the structure of investment trusts that makes a difference to performance, I might just single out these meetings.

For the manager to see individual investors and hear their questions face to face is a nice reminder of the point of the whole thing. It is not to bask in the glory of outperformance and prizes. It is to finance the lifestyles (and often the retirement) of people who are not necessarily as well off as the average fund manager or trust director.

One of many miserable side effects of the pandemic has been the cancellation of these events, just at a time when investors need more rather than less engagement. Already voting levels across all companies are low — only around 6 per cent of retail investors vote their shares. That’s partly logistics (not all platforms make it easy), partly because they aren’t interested, and partly because they don’t get enough direct contact from the companies in which they invest to be interested.

Trusts can’t do much about the second of these but they can press the platforms on the first and do more on the third themselves. The more they do those things, the brighter the sector’s future will be — as long as they keep giving us our extra 0.8 per cent a year as well, of course.

Merryn Somerset Webb is editor-in-chief of MoneyWeek. Views are personal. merryn@ft.com. Twitter: @MerrynSW





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US banks could cut 200,000 jobs over next decade, top analyst says

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US banks stand to shed 200,000 jobs, or 10 per cent of employees, over the next decade as they manoeuvre to increase profitability in the face of changing customer behaviour, according to a banking analyst. 

“This will be the biggest reduction in US bank headcount in history,” Wells Fargo analyst Mike Mayo told the Financial Times. If his forecast bears out, this year would mark an inflection point for the US banking sector, where the number of jobs has remained roughly flat at 2m for the past decade.

The jobs most at risk are those in branches and call centres as banks prune their sprawling networks to match the new realities of post-pandemic banking, Mayo’s report found. That is consistent with Department of Labor statistics that predict a 15 per cent decline in bank teller jobs over the next decade.

Historically, lay-offs, particularly for lower-paying jobs, have been a contentious issue for the banking industry, which is often held up by progressive politicians as an example of a wealthy industry prioritising profits over people.

But the threat of technology companies and non-bank lenders chipping away at the business of payments and lending, which have traditionally been dominated by banks, has intensified over the past year, making job cuts necessary, Mayo said.

“Banks must become more productive to remain relevant. And that means more computers and less people,” he said.

Most of the reductions can be achieved through attrition over the next 10 years rather than cuts, reducing the risk of a backlash, Mayo said.

The new research, reported first by the FT, comes on the heels of disappointing jobs data that showed the US economy added just 266,000 jobs last month, sharply missing estimates of 1m. Structural elements of unemployment like accelerated automation that took place during the pandemic could pose stronger than anticipated headwinds to a recovery in the labour, economic officials said following the report. 

Pandemic activity pushed headcount up roughly 2 per cent last year as banks hired staff to meet the sudden demand for labour-intensive mortgages and government-backed small-business loans. But that trend is likely to be reversed in the near-term as lenders refocus on efficiency to compete more effectively with technology companies that increased their share of business during the health crisis. 

Increased competition from unregulated companies such as PayPal and Amazon entering financial services was one of the principal concerns JPMorgan Chase chief executive Jamie Dimon outlined in his annual letter to shareholders last month. 

Mayo estimates that banks currently represent just a third of the overall financing market.

“Digitisation accelerated and that played to the strength of some fintech and other tech providers,” Mayo said. 

Many of the bank branches that were closed during the pandemic will probably stay that way, and even those that remain open are likely to be more lightly staffed as branches become more focused on providing advice than facilitating transactions. A large amount of back-office roles also stand to be automated but those numbers are harder to quantify, the report said. 

Mayo said his team 20 years ago was twice as large and responsible for half as much. Doing more with less was the new norm across the industry.

“If I was giving advice to my kids, I’d say you probably don’t want to go into the financial industry,” Mayo said, adding that technology and customer or client-facing roles are probably the only areas that will see growth. “It’s likely to be a shrinking industry.”



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Inflation wild card unsettles markets

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Regime changes usually take a while to fully register among investors. The big talking point in markets at the moment surrounds the potential return of a more troublesome level of consumer price inflation and what protective action investors should take.

The underlying trend of inflation matters a great deal for financial markets and investor returns. The rise in both equity and bond prices in recent decades has occurred during a long period of subsiding inflation pressure and from recent efforts by central banks to arrest disinflationary shocks since the financial crisis. 

A year after the global economy abruptly shut down, activity is duly picking up speed. The logical outcome has been a surge in readings of inflation and this week, a measure of US core prices recorded its largest annual gain since 1996, running at a pace of 3 per cent*.

Core readings exclude food and energy prices and are deemed a smoother gauge of underlying inflation pressure, a point that many people outside finance find baffling when budgeting the cost of groceries and petrol.

So the significant jump in the core measure, and even accounting for the base effect of the pandemic’s brief deflationary shock a year ago, has understandably generated plenty of noise.

This will remain loud in the months ahead as activity recovers from lockdowns with a hefty tailwind of fiscal stimulus working its way through the broad economy.

But muddying the waters for investors is that the outlook for inflation is still difficult to judge at this stage.

“There is so much dislocation in the economy from the reopening and base effects from a year ago that it will take at least six to 12 months before we get a clear view of the underlying inflation trend,” said Jason Bloom, head of fixed income and alternatives ETF strategies at Invesco.

Investors who are now worried about an inflation shock face a dilemma. Some assets seen as traditional hedges against such a risk, like inflation-protected bonds and commodities, have already risen appreciably. Effectively a period of inflation running hot has been priced in to some degree.

And history does provide a cautionary note for those moving late to buy expensive inflation protection.

Past inflationary alarms, as economies recovered in the wake of the dotcom bust in the early 2000s and the financial crisis of 2008, proved false dawns. After a mercifully brief pandemic recession, the powerful and well entrenched disinflationary trends of ageing populations and falling costs associated with technological innovation are by no means in retreat.

For such reasons, a number of investors and the US Federal Reserve expect inflationary pressure this year will prove “transitory”. But stacked against deflationary forces is the immense scale of the monetary and fiscal stimulus of the past year.

The effects of monetary and fiscal stimulus means “inflation may settle into a pace of 2.5 per cent (annualised) and that would be different from the average of 1.5 per cent before the pandemic”, said Jason Pride, chief investment officer of private wealth at Glenmede Investment Management. “Inflation will be higher. At a dangerous level? No.”

In an environment of firmer growth and moderate inflation pressure, equities will benefit, led by companies that have earnings more influenced by the economic cycle. Investors also will seek companies that have the ability to pass on higher prices to customers in the near term and offset a squeeze on profit margins.

Still, a troublesome period of elevated inflation cannot be easily dismissed. The “transitory” argument could be challenged if economic growth continues to run hot into next year, accompanied by a trend of higher wages from companies finding it hard to attract workers.

Before reaching that point, expected inflation priced into the bond market may well push past the peaks of the past two decades and enter uncharted territory in the US and also for other developed markets in the UK and Europe.

Bond market forecasts of future inflation pressure over the next five to 10 years have already risen sharply in recent months. But the rebound is from a low level and for now, expected inflation is not far beyond the Fed’s long-term target of 2 per cent.

“It is the change in inflation expectations that drives asset returns,” said Nicholas Johnson, portfolio manager of commodities at Pimco. Assessing almost 50 years of data, a portfolio holding equities and bonds underperforms during bouts of elevated inflation, while real assets including inflation-linked bonds and commodities prosper, according to the asset manager.

“Most investors have not experienced a period where inflation surprised to the upside,” added Johnson. Clients are asking more questions about insulating their portfolios, but their present exposure to commodities and other assets show that in broad terms investors are “not paying much of an inflation premium”.

That can change and the prospect of inflation regime change remains a wild card for investors.

michael.mackenzie@ft.com

*The value of core inflation has been changed since first publication.



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How traders might exploit quantum computing

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If you had a sports almanac from the future as did Biff Tannen, the brutish bully of the time-travelling Back to the Future movie trilogy, how might you be inclined to take advantage of the foresight buried within it?

The obvious temptation would be to place sure bets in the market that make you rich. In Biff’s case, the wealth is then used to change the world into a dystopian reality in which he himself exists as “America’s greatest living hero”.

That sort of thing used to be considered fiction. But the dawn of so-called “supremacy” of quantum computing over conventional technology raises the possibility that one day soon someone might be able to effectively see into the future.

This is because quantum computers, when they become fully capable, are likely to be uniquely good at crunching probability scenarios. They are based on the mysterious world of quantum physics. Quantum bits or qubits are the basic units of information in quantum computers. Unlike the binary bits of traditional computing, which must be either zero or one, qubits can be both at the same time.

This gives quantum computers super powers that will allow them to solve probability-based tasks that would previously have been impossibly hard for conventional counterparts in realistic timeframes. If the problem at hand was a game of football, adding quantum computers to the mix is like allowing footballers to use their hands to get the ball into the net, say quantum experts.

It’s a prospect that poses an entire new set of challenges for market regulators and participants. If super quantum computers really can help institutions see into the future, the information advantage will be unprecedented.

It might also represent an entirely new type of front-running and market manipulation risk, one that regulators can’t necessarily even identify unless they too have a quantum computer at hand.

In Back to the Future, the almanac gave Biff a 60-year insight advantage over everyone else in his home 1955 timeline. With quantum computers, the edge might only be nanoseconds. But in the fast and furious world of high-frequency trading, that could be enough to sweep up.

The reassuring news — at least for now — is that we’re still at least five years away from quantum computers being powerful enough to compete with existing supercomputers on much simpler problems. Prediction might not even be their initial forte.

Goldman Sachs research recently noted, as and when quantum computers are rolled out, they are far more likely to be deployed on crunching options pricing conundrums or running Monte Carlo simulations that value existing portfolios than they are on predicting future movements of asset classes.

According to Tristan Fletcher, of artificial intelligence-forecasting start-up ChAI, that’s because prediction is ultimately about solving a very specific, deep problem by understanding the nuances of the data that matters.

“We are already at the limits of what any system that isn’t actually listening to Opec meetings and five-year plans is capable of,” he said. It’s not the complexity of the calculation that is the issue as much as the breadth of the data sample at hand. That means prediction wouldn’t necessarily get more accurate with quantum power.

The appeal to focus on “brute-force” problems such as optimising portfolio analysis or cracking cryptographic problems such as those that underpin bitcoin, the cryptocurrency, is far greater.

But this poses its own problems. If cryptographic systems can be broken, exceptionally sensitive data held across the financial system could be exposed and taken advantage of in unfair and market manipulative ways.

Rather than being able to better predict the market, the true pay off in the arms race might lie in achieving quantum-level encryption-breaking capability and using it subtly to seize the information that can get a trader ahead. Experts say the chances someone is already up to this, however, are low. If quantum supremacy had been achieved, the news of it would leak pretty quickly.

“We don’t know what we don’t know,” said Jan Goetz, chief executive of IQM, a quantum computing builder. “But generally the community is very small so everyone knows what’s going on. The status quo is clear.”

Nonetheless, the financial sector seems to be waking up to this quantum computing issue. Many banks and institutions are introducing teams to think exclusively about how quantum computing will affect their business. How far ahead they are on making their systems quantum secure is harder to say. It’s a secretive issue. For now, most agree, the threat level is low, not least because — as the hacking of the Colonial pipeline shows — system security is low enough to ensure far cheaper and simpler ways to hijack digital systems.

izabella.kaminska@ft.com



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