Listed investment trusts are selling at a discount and undervalued but worth considering.
Investors seeking a managed fund offering a combination of solid historical performance, appealing dividend yield and low fees should consider listed investment companies (LICs) - funds on the ASX whose shares can be traded like those of any public company. Though LICs have their drawbacks - most notably a tendency to trade below their true asset value - they not only provide the conservative investor with security but also, in some respects, outshine unlisted funds.
More than 30 LICs specialising in Australian shares are traded on the ASX, led by the venerable Australian Foundation Investment Company (AFIC), which has a market capitalisation of $4.7 billion and was first listed as far back as 1936. Other large funds include Argo Investments (market capitalisation $3.5 billion), Milton Corporation ($2 billion) and Djerriwarrh Investments ($0.8 billion). A further 10 LICs specialise in international shares. (See below.)
The biggest funds tend to specialise in large-capitalisation stocks. Both AFIC and Argo included the four large banks, Telstra, Wesfarmers, Woolworths, BHP Billiton and Rio Tinto among their top-10 holdings, as of September 30.
But go further down the list and you find funds that specialise in smaller and medium-size companies. The Mirrabooka Investments portfolio includes Toxfree Solutions, IRESS Market Technology and Austbrokers Holdings among its leading stocks.
Some also deal in derivatives, or invest in property.
"Right now is a sensational time to be looking at LICs, because a lot of them are trading at reasonable discounts to where they historically trade," William Spraggett, an investment specialist at Bell Potter, says.
"But more importantly, I think they are very good investment structures, and it puzzles me that unit trusts get such great airplay while LICs have been left on the sideline for so many years."
Spraggett says that of the LICs he covers, eight have a management-expense ratio (MER) of less than 0.2 per cent of the value of the fund.
"I am pretty sure I could not give you a unit trust with an MER that low," he says. "I am not sure I could give you an exchange-traded fund [ETF] that is so cheap, although I think there are some that are coming close."
Low fees are one factor behind some impressive long-term performance from the leading funds. Spraggett says the LICs he covers have outperformed unit trusts by an annual average of 1.6 per cent over the past five years, with an "absolutely extraordinary" performance from several of the smaller funds.
"LICs like AFIC and Argo have outperformed the All Ordinaries Index on a 15- or 20-year basis," Yen Koh, a director of the investment strategy department at JB Were, says.
He says that the "No.1 attraction" of an LIC is that it blends an active management style with ETF-style ease of access. The dividends are another attraction. "A lot of them pay very healthy fully franked dividends," investment commentator Matthew Kidman says. "In the last 12 months investors have been scavenging for yield, and the LICs are fantastic in that sense." However, there is a notable drawback. LICs sometimes trade at a price that is below the value of their net tangible assets (NTA), depending on how the market views them.
For example, according to Bell Potter, earlier this month AFIC was trading at a 2.4 per cent discount to NTA. Argo was trading at a 6.3 per cent discount.
This can become a trap for the unwary investor, who notes the discount and perceives the shares as a bargain. Yet the discount may persist or intensify.
Spraggett says an astute investor will try to find out the average discount or premium applying to the LIC over years, to learn whether the current figure is high or low. (See table, above.)
Both AFIC and Argo have in the five years to June 2012 traded, on average, at modest premiums to their NTA figures, suggesting at current prices they could be a bargain. Another drawback is a paucity of available research information, compared with unit trusts.
And, though management expenses for many of the LICs are low, this is not universally the case. Some of the smaller funds, especially the more actively managed ones, may have quite high expenses, including performance fees.
In addition, LICs might offer stability and security but little excitement. In the words of the senior client adviser at Lonsec, Michael Heffernan: "If people want a basic, quiet life, with reasonable dividends and a bit of capital growth, then they are not a bad option."
That is, they can be appropriate vehicles for a plodding market. But when stock prices soar, investors often prefer to focus on the next hot stock.
For investors looking to buy an LIC, the chief executive at data provider Lincoln Indicators, Elio D'Amato, says it is important to check on the style of the fund's managers to ensure it accords with your long-term goals. Some of the funds only invest in large-cap stocks, others for smaller- or medium-cap stocks some for derivatives or property.
In a research note in mid-August, Patersons Securities quantitative analyst Kien Trinh says: "The key criterion in the evaluation of an LIC is its track record. Those with the best long-term performance - measured by total return, dividend and NTA growth - are the ones likely to give the best future returns."
He says the best performers over five years have been three smaller funds: Australian Leaders Fund, Cadence Capital and WAM Capital.
The research director of Intelligent Investor, Nathan Bell, advises acquiring LICs trading at a discount to NTA, after adjusting for fees. "If the stocks in which the LIC is investing seem expensive, even though the LIC itself appears cheap, do not proceed," he warns. Investors should establish whether the underlying stocks held by the fund are reasonably priced.
International funds open the door to overseas markets
Buy foreign shares is the advice from some market experts. In this way local investors can benefit from a rebounding US market, from a possible recovery in Europe and from any slump in our dollar.
An easy way to gain exposure to overseas markets is through one of the 10 LICs that specialise in international shares.
The largest of these is the Magellan Flagship Fund, which, in the words of Bell Potter's Spraggett, has "absolutely shot the lights out" a one-year return of 42.3 per cent and an annual average of 18.2 per cent over three years thanks to a portfolio dominated by US blue-chips.
By contrast, another of the larger funds, Hunter Hall Global Value, holds a portfolio of shares in companies that, according to Intelligent Investor's Bell, "no one will ever have heard of". Its one-year return is 4.8 per cent, with an annual average of 0.4 per cent over three years.
Other leading international LICs are AMP Capital China Growth Fund, Platinum Capital, Asian Masters Fund and Templeton Global Growth.
Bell warns investors to check the foreign currency exposure of each fund before buying.
Most do not hedge their exposure, but some do, meaning that you may not benefit if our dollar falls.