A little cross-investment can cause a large conflict of interest

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The Independent Online
RATHER THAN purely investing in companies' shares, many investment trusts invest in other trusts in the management group's range, or in the shares of a parent company.

This practice could, at the very least, lead to conflicts of interest, and at its worst could lead to the wholesale collapse of funds - as was the case during the 1929 stock market crash, when large numbers of investment trusts were invested in each other.

Among the most affected investment trusts are funds run by Aberdeen Asset Management and Fleming Investment Trust Management, as well as a number of split capital investment trusts.

There are three different issues surrounding investment trust cross-holdings. In simple terms, investment trusts may have large holdings in their parent companies, often making up one of the top 10 biggest holdings in the trust. Experts believe this adds risk to the fund, due to the reliance on a single company, and that the cross-holdings also lead to conflicts of interest. And some trusts repeatedly invest in other trusts run by the same parent investment group. This, again, can potentially lead to conflicts of interest.

More complex still for investors are the split capital investment trusts that invest in each other, creating a "virtuous circle" of investment. Some investment trust analysts have called this the "House of Cards" phenomenon.

They believe that, because these funds are all invested in each other via each other, the collapse of one fund, or the performance of the sector of funds as a whole, could spell disaster, creating a vicious circle of declining performance.

Fleming Investment Trust Management runs a large number of investment trusts and other types of closed-end funds. Four of its investment trusts, in particular, own large stakes in the parent company, Robert Fleming Holdings. This is despite each fund having a distinctly different investment mandate.

For example, Fleming Mid Cap has 3.4 per cent of its funds in Robert Fleming, making the holding its second largest. Fleming Overseas has 2 per cent in Robert Fleming, its second largest holding, while Fleming Continental European has 3.1 per cent (its fourth largest holding) and Fleming American has 1.8 per cent (its fifth largest holding). In the past, the number of funds owning Robert Fleming shares has been even higher. In early 1998, Fleming Income & Growth and Fleming Fledgling funds also held large proportions of shares in the parent company. Fleming Fledgling divested its Robert Fleming shares when it altered its investment mandate to become Fleming US Discovery - the only investment trust in the UK market to invest in the shares of US "microcap" companies.

Ian Overgage, manager of investment trust marketing at Flemings, says many funds hold Robert Fleming shares for historic reasons. "Our Japan fund used to be a general investment trust, so its holdings in Robert Fleming were quite normal for that investment mandate," he says.

"When the fund was converted to just investing in Japan, the board of directors decided it was in the investors' interest to keep some of the shares, as they have performed well.

"All our investment trust boards are independent, and stock choice is made in the interests of the fund and the shareholders," he claims.

Robert Fleming has had problems recently due to its exposure to Asian and emerging markets. Some experts say most other investment trusts, not managed by Fleming, would have sold holdings in Robert Fleming under such conditions.

The performance of these four Fleming investment trusts will be highly dependent on the performance of Robert Fleming Holdings itself, whose performance in turn will be partly dependent on the success of the trusts it runs.

The performance of Fleming Mid Cap, Overseas and Continental European funds have all been below the average for their investment trust sector over the three years to 22 February 1999. The only fund to outperform has been Fleming American, which has returned 118 per cent over that time, compared with a sector average of 30 per cent over the three-year period.

Unfortunately, it is difficult to assess the performance of Robert Fleming Holdings' shares as it is not quoted on any stock exchange and it does not publish its performance to the public. But Mr Overgage claims: "Robert Fleming has had excellent performance over the long term and, in many cases, its shares have been the best performers in the trusts that hold them."

Several of Foreign & Colonial and Henderson investment trusts also used to hold shares in their parent companies, but these holdings have been reduced or eliminated. In early 1998, Foreign & Colonial Investment Trust, F&C Enterprise Trust and F&C Smaller Companies all had shares of Hypo Foreign & Colonial Management in their top 10 holdings. Henderson's Witan and Electric & General investment trusts both had Henderson shares in their top 10 holdings.

Several Flemings, Aberdeen and Foreign & Colonial investment trusts also have holdings in other investment trusts in the same group. For example, Aberdeen High Income has the highest cross-holding of the survey, with 14.8 per cent in Aberdeen Preferred Income investment trust. It also holds 6.4 per cent in Aberdeen Preferred Income Subordinated Unsecured Loan stock 8.25 per cent, the fourth largest holding in the fund.

Aberdeen Preferred Income shares also feature in two other Aberdeen investment trusts, Danae and Jove, bringing the overall cross-holding of Aberdeen Preferred Income shares within Aberdeen trusts to more than 45 per cent.

If the combined value of High Income, Danae and Jove is pounds 122.7m at the time of writing, then the value of the holdings in Aberdeen Preferred Income investment trust shares is approximately pounds 56.2m. This equates to 30 per cent of the value of the pounds 190.2m Aberdeen Preferred Income investment trust.

In theory, if these shares were sold, this would have a dramatic effect on Preferred Income's share price and the discount would widen - not an attractive possibility for shareholders in this fund.

Other examples of cross- holdings at Aberdeen include the Aberdeen Emerging Asia investment trust, which has 13.2 per cent of its money in Aberdeen India, making it the largest holding. Aberdeen New Dawn also has 8.6 per cent in Aberdeen India, again making it the largest holding.

Piers Currie, marketing director of investment trusts at Aberdeen, explains: "We invest in our India fund as it avoids the large capital gains tax charges levied by the Indian government when investments are made direct into Indian shares." He says that the fund managers choose their holdings very carefully.

Katharine Lewis writes for `Bloomberg Money'

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