LICs rise again

Australian listed investment companies (LICs) were forced into the investment shadows for years, but finally they’re back in the spotlight, and delivering some impressive returns to their shareholders.

In the face of stiff competition from unlisted managed funds and exchange-traded funds, the 60 or so LICs on the Australian Securities Exchange were in grave danger of fading into obscurity as investors parked their capital into other areas. Not so, anymore.

Easily accessible via the stockmarket, and cheap in comparison to managed funds that often charge their investors high fees, LICs are being rediscovered. That has been great news for the likes of Australian Foundation Investment Company, Australia’s oldest LIC. Listed more than 80 years ago, AFIC is also the largest – with a market capitalisation of more than $5.6 billion. It’s followed closely by another LIC veteran, Argo Investments, which was formed in the 1940s and has a market cap of around $4 billion.

But the renewed investor interest is also spurring a new wave of LIC floats.

William Spraggett, head of listed managed investments at Bell Potter, says LICs have become increasingly popular among investors.

“I definitely think there’s been a huge uplift in the last 12-18 months. You go back 18-24 months and I used to get phone calls from people saying the LIC industry was dead and buried. But the reality is these are closed-end funds and there’s no horizon clause on these vehicles. The industry was never finished.”

Closed-end funds raised a fixed amount of capital on their listing, and then trade like an ordinary share on the stockmarket.

“[LICs] have been around for a very long time and I think market conditions are very supportive for a new product that is being delivered by proven managers.”

The Future of Financial Advice (FoFA) reforms that came into effect on July 1 have played a big part in changing the fortunes of LICs.

Prior to the reforms, financial advisors favoured unlisted investment trusts over LICs due to the hefty commissions they received. With such commissions now banned and advisors legally bound to act in the best interests of their clients, LICs are finally operating on a more level playing field.

This has in turn given rise to an increase in the number of LIC initial public offerings. Watermark and NAOS were two that listed earlier this year. Sandon Capital Investments will shortly list on the ASX, while PM Capital is rumoured to be planning its own LIC IPO in the near future.

Suddenly, the industry is alive and kicking.

“I definitely think it will support LICs this year and going forward,” Spraggett says. “Over the last 12 months I’ve been receiving a lot of phone calls from people looking at the idea of [listing LICs). Whether they all execute, your guess is as good as mine. But I’d be pretty surprised if we didn’t see a few more come to market.”

The growing interest in LICs has also been partly fuelled by the attractive dividend yields on offer. As you can see from the table below, not only have LICs performed strongly in recent years, but they’ve also rewarded investors handsomely.

Click to enlarge

Source: Bell Potter

For the first time in a long time, the future looks bright for LICs. But prospective investors should be aware that a lot of the discounts LICs were trading at have evaporated over the past 18 months. In fact, a number of the bigger names are even trading at slight premiums right now.

Comparing the structures – Managed funds and LICs

Scott Francis adds:

Perhaps the biggest historical difference between managed funds and LICs has been in the area of distribution. As noted above, managed funds have paid both upfront and trailing commissions to investment advisors, creating a potential bias towards these as an investment approach.

There are other issues within the structure of LICs and managed funds that investors should think about. The first of these relate to the way managed funds have to treat capital tax, a problem exacerbated by the flows of money into and out of managed funds.

Managed funds and capital gains tax

If you are an investor in a managed fund, you are negatively impacted by the trading that goes on as other investors enter and exit the fund.

If trades are made, for example, as investors leave the fund that lead to capital gains tax, then you will receive a taxable distribution of capital gains. This is a negative, and is a large part of the reason why managed funds are tax ineffective, and don’t publish after-tax returns. This is most commonly seen in large end-of-year distributions.

In LICs, by comparison, no tax event is created as investors come into or leave the company. As investors exit or join an LIC, they trade their shares on-market. The amount of money that the fund manager has to manage stays constant.

The size effect and managed funds

Both academic research and practitioners like Warren Buffett talk about the fact that as a fund gets bigger (through inflows), it becomes harder and harder for a fund manager to outperform the market.

This is a large problem with managed funds. If they are successful they attract inflows, inflows reduce future performance (because a bigger fund has to own more companies, and has greater market impact costs as they trade), and the fund becomes increasingly ‘average’ in terms of performance.

An LIC gets around this problem by having a closed investment structure. The LIC manager knows exactly how much capital they have to deploy (a fund manager does not even know this as applications and redemptions change the size of the fund all the time), and they can deploy this money strategically.

However, LICs can grow by continually offering new share placements.

Premium/discount to NTA

While a managed fund always trades at its net tangible asset (unit price), an LIC can trade at a discount or premium to the value of its portfolio. This offers opportunities (to purchase assets at a discount) and challenges (what if the share price of an LIC falls relative to the NTA - reducing shareholder return?).

Some time ago I looked at the example of Argo Investments trading at a discount to its NTA, and the investment opportunity that posed. Returns since then have been attractive for investors.

Overall though, the premium/discount is transparent. Importantly, it includes details of the tax position of an LIC. Each month LICs report their ‘net tangible asset position’ (value of the portfolio per share) in an ASX statement made before the middle of the month and include the capital gains tax position of the LIC.

This information is rarely available for managed funds. Sure, the value of assets of the managed fund is reflected in the unit price that is usually calculated and published daily. But I have never seen accessible information for investors published on the unrealised capital gains in a managed fund portfolio.

Conclusion

In considering the structural differences between managed funds and LICs, it is hard not to come to the conclusion that there is a lot to like about the LIC structure.

The possible exception is its ability to trade at a discount or premium to the per share value of its portfolio (NTA), which makes returns somewhat less predictable.

The attractive commission structure of managed funds may have seen them being disproportionately used in portfolios, but the fading of commissions is creating renewed interest in LICs.

Scott Francis is a personal finance commentator, and previously worked as an independent financial advisor.