Inside listed Investment companies

There are many factors to consider when investing in listed investment companies. Greg Hoffman digs into the details.

This article follows on from Beating the index: LICs vs active unlisted funds, where we promised to delve in to some of the finer points of investing in listed investment companies (LICs).

When considering an LIC, size is a good place to start. The ‘L’ in LIC comes with costs attached and to an extent, those costs are fixed, or at least have a floor. Consider the smallest of Geoff Wilson’s stable of LICs, WAM Active (ASX code WAA).

  $'000
Table 1: Costs of being small (WAM Active)
Net assets 36,431
Directors' fees 70
ASX listing & CHESS fees 45
Share registry fees 36
Other expenses 148
Custody fees 52
Brokerage expense 209
Subtotal (pre-management fees) 560
Management fees 374
Performance fees 1,066
Total costs 2,000
Total costs (excl. Performance fees) 934
   
Total costs (% of net assets) 5.50%
Total costs excl. Perf. Fees (% of net assets) 2.60%

WAM Active had net assets of $36.4m at 30 June 2014, and in the preceding 12 months it incurred the costs you see in Table 1. They came to a nice, round $2m. That’s a whopping 5.5% of net assets. Even excluding the Performance Fee, the year’s costs came to 2.6% of net assets.

The table also gives a guide to the costs of being listed. Directors’ fees, share registry fees and ASX listing and CHESS fees are all unavoidable costs and they can’t be reduced below a certain point. Some portion of ‘Other expenses’ will also relate to annual meetings and investor relations activities that will likely be higher for a listed company than for an unlisted fund.

The defence from smaller LICs (say, those under $200m) would be that their size means they can invest in smaller companies with potentially higher returns. And, in the case of WAM Active, its record has been good. But annual costs of between 2.6% and 5.5% of net assets are a big hurdle for any fund manager to overcome compared to a low-cost index fund or even an unlisted fund with the same assets. As investors, we should think twice before backing a manager with such a hefty handicap.

Scrutinise the structure

Related to the topic of size is structure. Firstly, it’s important to know if a fund is externally or internally managed. Externally managed funds tend to have far higher costs than those with internal management.

Table 2 provides a snapshot of some of the eye-watering fee structures charged by external managers to manage LICs. WAM Active and Thorney Opportunities both take a base fee plus 20% of any increase in portfolio value (at least the others have to beat an index before getting their gravy). Such fee structures are in the ballpark of the rapacious hedge funds of the boom years. They seem out of place in today’s post-GFC world but both arrangements are safely locked in and unlikely to change.

Name ASX code Fee structure
Table 2: Selected externally managed LIC fee structures
WAM Active WAA 1% 20% of any increase above 'high water mark' (plus GST)
Hunter Hall Global Value HHV 1.5% 15% of outperformance over MSCI index
Thorney Opportunities TOP 0.75% 20% of any increase (plus GST)
Cadence Capital CDM 1% 20% of outperformance above All Ords Accum. Index

To illustrate, if the WAM Active portfolio increased by 11% before fees, investors would end up with a return of just 8% after a 1% base fee left them with 10% and then 20% of that disappeared in a performance fee. It’s an astonishing division of profits between those risking their capital and those running it. In that example, more than a quarter of the returns are going to the manager (and that figure climbs higher if returns are lower).

One would need extraordinary belief in a manager’s ability to accept such outrageous terms. Alternatively, investors may seek compensation by pricing the listed shares at a discount to the underlying portfolio value.

Internally managed funds like Argo Investments and Australian Foundation Investment Company (AFIC) have much lower annual costs, at less than 0.2% of net assets. And that figure includes all operating costs as well as paying investment management staff.

Check the capital structure

There’s another aspect of ‘structure’ apart from fees. Some LICs have other types of securities on issue. Sandon Capital, for instance, has options on issue that have the effect of reducing the upside for investors holding the ordinary shares. Clime Capital has Preference Shares which have two effects. Firstly, they act as a form of debt in the period before their second impact, which is converting into ordinary shares.

Investors in Exchange Traded Funds (ETFs) and standard unlisted funds rarely have to concern themselves with other securities muddying the capital structure but, in the world of LICs, it’s important to check and understand the situation before making any investment.

Is the tax system working for you?

One of the advantages of being a long-term investor is that the tax system helps you along. Because tax on capital gains is only paid after an investment has been realised, a long-held profitable investment carries with it a kind of interest-free loan from the tax office.

Imagine you’re sitting on a $10,000 capital gain on which you’d have to pay, say, $1,000 in tax if it was realised at today’s prices (and assume the stock is not so overpriced that selling would still be a rational move). While that gain remains unrealised, then you are effectively investing $1,000 of the government’s money. Over time, you’ll be compounding meaningful gains and dividends on this capital in addition to ‘your’ investment.

You can see this at play with Carlton Investments, a long-term focused LIC. Its pre-tax net assets at 31 December were $32.00 per share while the post-tax figure was $26.83. So Carlton shareholders have $5.17 per share working for them, which would otherwise be sitting in the tax department’s coffers if the company traded more frequently and had realised those gains.

That contrasts with the likes of Wilson Active, where there is virtually no difference between the pre-tax and post-tax net asset figures.

Philosophy and track record

Other key factors to consider are an LIC’s investment philosophy, approach and track record. Is the LIC applying a philosophy that you understand and feel comfortable with? Also ask yourself whether you’re comfortable with an LIC borrowing money and, if so, how much?

Once you’re comfortable with an LIC’s approach and confident in its manager’s ability to apply it successfully then you should check the investment track record. Has the manager been able to beat the market over a realistic time frame (at least three years but perhaps five or seven years for those with a genuine long-term focus)? And have they beaten the market after extracting all management fees and deducting other costs?

In our next article we’ll scan the LIC scene for opportunities and apply the factors we’ve covered in this article.

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