22 January 2018

I am a board director of Scottish Mortgage Investment Trust (SMIT), a £6bn investment fund based in Edinburgh. You can receive material about the trust through its newly published key information document (Kid). But please, please, do not Google or download this document. And if you have received a hard copy, burn it before reading. Above all, keep it out of the hands of widows and orphans. The Kid tells you that if you invest in the shares of SMIT you might in a “moderate” scenario earn more than 20 per cent a year over the next five years, and over 30 per cent in a “favourable” one. Even in “unfavourable” circumstances, you could anticipate an annual return of over 10 per cent. The Kid document does not explain what “moderate”, “favourable” and “unfavourable” mean, but a reasonable person might infer that “moderate” would not be as good for investors as the past few years have been and that “unfavourable” might describe a market downturn — perhaps similar to that experienced in 2000-2 or 2008-9. And the icing on the cake is that these returns can be expected with only moderate risk. The European Securities and Markets Authority has a scale for the risk associated with investment products. Scottish Mortgage is squarely in the middle of a range from one to seven, with a risk rating of four. Irresistible though the prospect might seem, do not on any account max out your credit card to invest. As any but the most inexperienced investor should understand, the Kid’s assessment of risk is thoroughly misleading. In the first part of this article, I describe why this view of risk is misleading and in the second part illustrate what risk really means to the typical retail investor. Scottish Mortgage Investment Trust is the largest investment trust in the UK and, according to intermediary Hargreaves Lansdown, is the most popular such fund on their platform. The assets are managed by James Anderson and Tom Slater of Baillie Gifford. In line with the new European regulations for packaged investment products which came into effect at the beginning of this month, Baillie Gifford has produced a key information document. The objective is to tell potential investors across the EU what they need to know in a short, comprehensible format which they can readily compare with similar documents issued by other funds. Indeed, the required text of the Kid invites you to make such comparisons. Greater transparency, especially about fees, is needed but it seems impossible to prescribe or calculate a standard formula which makes sense for all products. The Kid is the product of well-intentioned endeavour. No one can doubt the desirability of such an objective, though some might question its feasibility. Investment trusts are required to adopt this format from the beginning of this year, and Ucits — the unit trusts and similar funds which account for a much larger share of the retail market — already have Kids but it is proposed to bring their format in line with the investment trust framework in 2019. The concept of the Kid is admirable; unfortunately, its execution is a disaster. The blame for this does not lie with fund managers. Baillie Gifford has produced this information in accordance with detailed guidelines that leave them with virtually no discretion. And none at all in relation to the calculations of risk rating and prospective returns, which must be made in accordance with complex formulas prescribed by the European Securities and Markets Authority (Esma). A small group of consultants has made a lucrative business of crunching the requisite data. Key information documents are misleading because, when you wade through the complexity, the prospective returns are little more than a projection of historic returns over the past five years. The calculations that are required involve fitting a probability distribution to the actual recent experience of returns. The various future scenarios that are presented are not projections of what investment yields might be under various economic conditions, but drawings from that hypothetical distribution of past returns. The recent performance of Scottish Mortgage has been particularly strong, but most investment funds have benefited from bull markets over the past five years. And so you will find a wide choice of funds from which, according to their Kid, you can expect to earn more than 10 per cent a year. In the past, regulators have rightly emphasised to investors that past performance should not be used as a guide to what they can expect in future. Yet it seems that they have not succeeded in persuading themselves of this important truth. Some examples are much more extreme than Scottish Mortgage. The Kid for the Bitcoin XBT tracker fund tells you that over one year, a “moderate” performance will net you a cool 150 per cent return. Some highly leveraged funds apparently lead you to expect even higher returns. At least the Bitcoin XBT tracker fund document has the good sense to warn you that an investment linked to bitcoin is high risk. But this warning does not reflect any recognition of the madness that has inflated the price of an asset without fundamental value. The measure of risk used in the Kid is essentially the historic volatility of weekly returns. Or to put it another way — if the fund managers had been stealing your money, an investment with them would be described as “low risk” so long as they were stealing it at a more or less constant rate. If you are to give advice to retail investors, you need to start by understanding what they mean by risk. And until the dichotomy between what regulators mean by risk and what investors mean by risk is bridged, the risk classification contained in the key information document is as misleading to investors as the prospective returns. Your investment adviser may recently have confronted you with an elaborate questionnaire designed to ascertain your “risk appetite”. He or she is then required to match