The case for LICs

Many LICs trade at a discount to NTA, enjoy low costs and benefit from the power of compounding over the long term. If you want to improve your core returns, they’re worth a look.

Key Points

  • LICs offer an opportunity to improve your long term index investing returns
  • SMSFs, in particular, can achieve substantial benefits
  • Our financial model enables you to assess the potential benefits

Background

John C. Bogle is the famous proponent of index investing, covered in The ins and outs of index investing—Part I and II. Bogle says, if you want to own growth assets like shares, it’s better to buy a low cost index fund or ETF than to invest in a managed fund.

Managed funds, on average, don’t outperform the index once fees are accounted for. An index fund or ETF will match the index for a much lower cost, creating higher average returns.

Listed investment companies (LICs) might allow the wily index investor to outdo Bogle. LICs are much like managed funds­—they manage a portfolio of shares funded by issuing shares to investors—and many are low cost, like index funds and ETFs.

A feature unique to LICs is that they can trade at a discount or premium to their net tangible assets (NTA). Unlike funds (where units can be created or redeemed as required) LICs have a fixed supply of shares on issue (they are ‘closed-end’). The share price is influenced by the demand for an LIC’s shares, independent of the demand for the underlying assets.

This opportunity won’t be for everyone. And today might not be the ‘right’ time to shift money into Australian blue chips. But for those following a core-satellite approach, or simply wanting to put money into the market via a passive investment, LICs can provide a way to trump the returns on index funds and ETFs.

The opportunity

The benefit of index funds and ETFs is that they provide sharemarket returns at low cost. For instance, the SPDR S&P/ASX 50 Fund (SFY), simply aims to replicate the performance of the top 50 ASX listed companies. It won’t outperform the ASX50, as some fund managers promise, but it only charges 0.3%, not 1-2%, to track rather than outperform the index.

LICs can provide a similar low cost approach to SFY. For instance, Australian Foundation Investment Company (AFI), Argo Investments (ARG), Milton Corporation (MLT) and Australian United Investments (AUI) all invest primarily in large listed ASX shares and charge management fees of less than 0.2%.

A quick glance at their top holdings (see Table 1) shows that these LICs don’t stray too far from the ASX50 and its weightings. Over time they should closely track the performance of the index, which is reflected in their historical performance (Chart 1). The chart also highlights the importance of investing across multiple LICs if index tracking is the objective.

SPDR ASX 50 ETF (SFY) AFIC (AFI) Argo (ARG) Milton (MLT) Australian United (AUI)
Table 1: Top 20 holdings - SFY vs AFI, ARG, MLT, AUI (30 June 2012)
Share % Share % Share % Share % Share %
BHP Billiton  11.5 Comm Bank  9.9 BHP Biliton 7.6 Westpac 11 BHP Billiton 8.7
Comm Bank  10.2 BHP Billiton  9.9 Westpac 5.9 Comm Bank 8 ANZ 7.7
Westpac  8.2 Westpac  8.5 ANZ 5.1 WH Soul Pattison 6.3 Comm Bank 7
ANZ  7.3 NAB  5.2 Wesfarmers 4.5 Campbell Brothers 5.9 Rio Tinto 6.8
NAB  6.2 Wesfarmers  5.1 Comm Bank 4.5 NAB 5.1 NAB 6.2
Telstra  5.7 Rio Tinto  4.5 Rio Tinto 4.2 BHP Billiton 5 Westpac 6.1
Wesfarmers  4.4 Telstra  4.3 Telstra 3.9 Wesfarmers 4.3 Wesfarmers 5.7
Woolworths  4.0 ANZ  4.3 Milton Corp 3.8 Woolworths 3.5 Woodside Petroleum 5.1
Rio Tinto  2.7 Woolworths  3.6 NAB 3.7 ANZ 3.1 Woolworths 4.2
CSL  2.4 Oil Search  2.2 Woolworths 3.3 Telstra 2.2 Diversified United 3.8
Westfield Group  2.4 Woodside Petroleum  2.1 Aust United 3.3 Bank of Queensland 2.2 Orica 3.3
Woodside Petroleum  2.4 Transurban  2.1 Macquarie Group 2.5 Bendigo and Ade Bank 2.1 QBE 2.6
QBE  1.9 Amcor  2.0 Origin Energy 2.5 QBE 1.8 AGL Energy 2.3
Newcrest Mining  1.9 Origin Energy  1.9 Orica 1.7 AGL Energy 1.7 Origin Energy 1.9
Origin Energy  1.5 Aust Infrastructure Fund  1.9 QBE 1.6 Brickworks 1.6 Brambles 1.7
Amp Limited  1.3 QBE  1.9 Woodside Petroleum 1.6 Rio Tinto 1.3 SP Ausnet 1.6
Suncorp Group Ltd  1.3 Santos  1.8 AMP 1.4 Woodside Petroleum 1.2 AMP 1.6
Santos Limited  1.1 AMP  1.7 AGL Energy 1.4 CSL 1.2 Transurban 1.6
Brambles Ltd  1.1 AGL Energy  1.6 CSL 1.4 Suncorp Metway 1.1 CSL 1.6
Amcor Limited  1.1 Orica  1.6 Santos 1.3 Perpetual Trustees 0.9 Telstra 1.5
   78.5    76.1    65.2    69.5    81.0
* SFY holdings as at 23 July

Advocates of LICs argue that for pooled investing, this is a better structure than managed funds because investment decisions can be made independent of the flow of applications or redemptions. This provides maximum flexibility to the manager and reduces perverse incentives and an overly short term focus. Other benefits are the lower administration costs and the ability to add value from corporate actions such as share buybacks.

What attracts us is the fact that many LICs (including these) currently trade at a discount to their net tangible assets (NTA)—the value of the underlying shares they own. Table 2 shows the discounts as at 30 June 2012 (NTA data is reported monthly).

  AFIC (AFI) Argo (ARG) Milton (MLT) Aust United (AUI)
Table 2: NTA discount at 30 June
Price  4.16  5.15  15.21  5.55
Pre-tax NTA  4.35  5.50  16.42  6.26
NTA discount (pre-tax) 4.37% 6.36% 7.37% 11.34%
Post-tax NTA  3.84  5.12  15.46  5.69

The discount doesn’t necessarily provide a margin for error or give you a chance to get in before the gap closes. The NTA discount of LICs has tended to be remarkably persistent in recent years. There might be some upside if SMSFs and financial advisers start to take more of an interest (with the removal of trailing commissions on managed funds) but there may not.

The key benefit for long term investors is the chance to buy the market on a higher yield than the market itself is paying. With reinvestment, and the power of compounding, each year’s extra yield adds up to a very large number over the long term—particularly in the hands of SMSFs.

The result is much better when NTA discounts are around 10% (the large LICs were trading at these levels not that long ago, and many smaller LICs still trade on this discount or more). However, even with NTA discounts between 5 and 10% the benefits are worthwhile.

The maths

As Table 1 shows, there is not a great deal of difference in the portfolios of SFY or the four LICs. Each are dominated by the larger miners, the supermarkets and the big four banks. The dividends earned on their underlying assets will therefore be about the same.

The difference is that our four LICs allow you, on average, to get roughly a 7.5% discount to buy this income stream. So, if the market pays a 6% yield (grossed up), the LICs will give you almost 6.5% (in practice, a range of factors will affect each actual LIC dividend but, over time, the NTA discount should be reflected).

Over the long term—20 to 30 years or more—this difference in yield really adds up. Not only do you get the extra yield each year but, if the NTA discount remains, you reinvest the extra with the 7.5% discount—a virtuous cycle of yield pick-up, discounted purchases and compounding.

For a 15% SMSF that holds a $100,000 investment through to pension mode, this can add over $100,000 to the final investment balance (based on 2%pa capital growth over 30 years). This is the equivalent of having an extra $10,000 to invest in the first place.

For your benefit we have included an excel model which enables you to assess this opportunity across different time frames, tax rates and levels of NTA discount. By changing the inputs you can see the impact on your final investment balance and your after-tax return. Remember, in practice, your results will depend on exactly what your LICs are invested in and how well their portfolio tracks index performance.

Who should consider it?

This strategy works for investors looking to hold a passive, managed share investment over the very long term. The term is critical as it determines the extent of the compounding effect and reduces the risk of movements in the NTA discount: Changes in the NTA discount have a greater impact on returns over, say, five years then they do over 20 to 30.

Whether you’re an individual, company or SMSF, you will benefit from this approach. But, like all yielding investments, SMSFs get a better result. They get to reinvest a much larger amount after-tax, compounded. SMSFs also help reduce the risk of capital gains being realised in the company (refer ‘Potential pitfalls’ below).

The possibilities

We have focused on large cap ASX listed shares but the principle applies anytime you have two comparable investments—one being an LIC, which can be purchased at a discount. The extra yield received by investing through a discounted LIC gives you substantially more savings over the long term, without changing your underlying asset exposure.

Equally, while we have focused on AFI, ARG, MLT and AUI as a proxy for the ASX 50, you could substitute any other LIC trading at a NTA discount. We picked these four as our example simply because they are well known, focus on blue chips and have a track record that extends back more than fifty years.

Other LICs benchmark the major Australian indices—All Ordinaries, ASX 50, ASX 200 and ASX 300—and some focus internationally. Platinum Capital Limited (PMC), for instance, benchmarks the MSCI World Index like its unlisted brethren, Platinum International Fund, but at a discount of roughly 10% to NTA (although international shares tend to have a lower yield, making the strategy less compelling).

The pitfalls

As always, there are potential pitfalls. Leaving aside the general risks associated with making an investment in the sharemarket, the main risks with this strategy are:

  1. Changes in the NTA discount—This is both a risk and an opportunity. If the NTA discount increases at the time you are selling, that’s a negative, but it’s a positive if you are busy reinvesting dividends or buying more shares.

    A fall in the discount (or a return to a premium) will be good for your existing holdings but reduce or eliminate the benefits of this strategy.
     
  2. Slippage—Slippage occurs when your LIC investment doesn’t track the index, or alternative investment, in the manner expected. This is a risk as the portfolio of LICs are selected by a manager rather than ‘pre-set’ in the manner of ETFs.

    But it shouldn’t be a major concern with the large, well known LICs mentioned—they tend to focus on the same large blue chip stocks that make up the ASX 50—or LICs aiming to replicate a particular strategy (like PMC). But if you invested in a LIC specialising in small cap shares as an alternative to the ASX 50, slippage would be a more significant risk.

    Slippage can also occur with the passage of time. AFI may invest in blue chips today, but the strategy or management may change. Whilst unlikely in this case given their long history, it is something you need to monitor. Unlike ETFs, an LIC’s investment strategy is not fixed.
     
  3. Crystallizing capital gains—While many LICs are trading at a discount to pre-tax NTA, they might still be at a premium to post-tax NTA. Post-tax NTA is calculated by making a provision for CGT on unrealised profits—even though the investments may not be sold (and the tax not be payable) for many years from now. LICs pay CGT at the corporate tax rate of 30%.

    LICs often promote themselves as ultra long term investors, and historically they have had low turnover. This makes the CGT rather theoretical. If an LIC never sells the investments, it won’t pay tax.

    However, if something were to happen to change this—a change in strategy, or a series of takeovers that couldn’t be avoided—the CGT bill would fall due now. This would make it a real cost to investors.

    The mechanics of this are that the LIC pays tax on the capital gain and passes the capital gain through to shareholders as part of its dividend payment (together with franking credits arising from the tax it has paid). The shareholder gets the same CGT treatment as if they owned stock directly (or through a trust, such as a managed fund) and gets a tax credit (or refund) for CGT paid by the LIC.

    This process makes the post-tax NTA number calculated by the LIC irrelevant to most shareholders. The shareholder’s net exposure to the CGT is based on their own tax rate. A 0% SMSF won’t end up paying any tax (after franking credits) and other SMSFs will pay very little. Table 3 converts the post-tax NTA disclosed by AFI, ARG and MLT into a ‘shareholder effective post-tax NTA’.
      AFIC (AFI) Argo (ARG) Milton (MLT) Aust United (AUI)
    Table 3: Shareholder 'effective'NTA discount at 30 June
    Price  4.16  5.15  15.21  5.55
    Pre-tax NTA  4.35  5.50  16.42  6.26
    NTA discount (pre-tax) 4.37% 6.36% 7.37% 11.34%
    Post-tax NTA  3.84  5.12  15.46  5.69
    Effective post-tax NTA (23.25%)  3.95  5.21  15.68  5.82
    (Individual on top marginal rate)        
    Effective post-tax NTA (15%)  4.10  5.31  15.94  5.98
    (SMSF)        
    Effective post-tax NTA (0%)  4.35  5.50  16.42  6.26
    (SMSF Pension mode)        
    As you can see, in addition to improving the benefits of this strategy, investing through an SMSF minimizes the risk associated with an early realisation of capital gains. A SMSF’s effective post-tax NTA is much higher than an individual—in this case about the same as, or higher than, the current share price.
     
  4. Dividend strategy—We’ve made the general assumption that LICs will pay underlying income as dividends and pass through any capital gains. This is critical, as it allows shareholders (especially SMSFs) to get a refund or credit for excess franking credits.

    In the unlikely event of an LIC substantially reducing its dividend payout, the refund or credit would be delayed.
     
  5. Management—Dividend strategy is an important example but there other risks associated with the fact that LICs and their portfolios are run and selected by management. For instance, management may take on debt, undertake more active trading, issue new shares or change the investment strategy.

    LICs, especially the ones we mentioned, have typically had no (or very little) debt, kept active trading strategies small and run a consistent strategy over a long time frame. It’s something to be more aware of if you venture into the smaller, more exotic LICs.
     
  6. Law changes—This is a risk with any investment but LICs are a touch more complicated. We would rate an adverse change to LIC rules unlikely—you are more likely to see an adverse change to your SMSF benefits generally. But it can’t be ruled out.

Overall, there’s nothing here to get overly concerned about, especially if you’re investing through an SMSF. If you’re an individual, pay close attention to the unrealised capital gains issue—the magnitude of the exposure will vary from LIC to LIC.

In a nutshell

For those using a core-satellite approach, or who simply prefer a passive index tracking investment, this LIC strategy offers the opportunity to add substantially to your savings over the long term.

Give our model (which can also be found under ‘tools’ on the website) a try. If that prompts further questions, please let us know.

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