For investors who poured $925 million into the listed KKR Credit Income Fund (ASX:KKC) during October 2019, the opening weeks of trading would have provided a sobering insight into the pitfalls of a Listed Investment Trust (LIT) structure.
The experience also highlighted an important ethical question for the wealth advice industry to answer.
KKC upsized the deal to $925 million following a flood of demand, but since listing, the shares have consistently traded below the $2.50 issue price. And when the shares sank to $2.43, the decline in capital value had eaten into nearly half of the expected total annual income return.
Problem of trading at a discount
One of the major challenges of a LIT structure is that the underlying shares can trade away from the value of the units in the trust. Occasionally, the shares trade at a premium to the underlying value, but of the 114 Listed Investment Company (LICs) and LITs trading on the ASX at the time of writing, 72% trade at a discount to Net Tangible Asset (NTA) value. The average discount is 12.6%.
While there is always a risk of capital loss when investing, the possibility of a discount to NTA amplifies that risk significantly.
The risk of variance to NTA is just one of the pitfalls of investing via a LIC/LIT structure. Another major risk for investors is the lack of liquidity. In the first three weeks of listing, only around 3% of KKC changed hands. The total value of KKC bid for in the market at time of writing is a mere $270,000. The harsh reality of a LIT such as KKC is that even if an investor decided to exit their investment, it will be difficult to sell volume without driving the price down further.
The toxic pairing of a discount to NTA and a lack of liquidity is a value-destroying combination that is unique to LIC and LIT structures.
Why do so many investors line up to participate?
Depending on the specific LIC/LIT, there can be a variety of reasons for the massive demand. However, our view is that a loophole in FoFA regulations that allows fund managers to pay incentives to advisers who sell LICs and LITs to their clients is a major contributor.
Under the 2012 Future of Financial Advice (FoFA) regulatory reforms, fund managers are banned from paying sales commissions to advisers who sell their products. But in 2014, listed funds were exempted from this rule, and the extent to which that exemption has been exploited is eye-popping. Nearly $45 billion of capital is now invested in LICs and LITs, mostly on behalf of mum and dad investors.
And advisers are being paid lucrative incentives, called 'stamping fees' by fund managers, to sell their clients these funds. Initially these structures were used to buy portfolios of listed shares, similar to a managed fund. However more recently, as in the case of KKC, the structures have been used to acquire portfolios of unlisted, high yield, fixed income securities that are more difficult to value. We can now add another risk into the mix: opaqueness.
There are several more similar strategies queued up to come to market in 2020.
Can an adviser be impartial when paid to sell a product?
Good advice is always important, and that importance is only increasing as the risks keep rising. The key question to consider is how can an adviser who is receiving a significant fee for selling a product be in a position to offer good, impartial advice to their client? The truth is, they can’t.
As Kenneth Hayne noted in his final report of the recent Royal Commission,
“Experience shows that conflicts between duty and interest can seldom be managed; self-interest will almost always trump duty.”
The advice industry in Australia has evolved around the idea that it is acceptable for an adviser to have an interest that is in conflict with the interests of their client. There has been a view that the conflicts could be adequately managed, or adequately disclosed. The case studies of the Royal Commission graphically revealed why the current situation cannot be allowed to continue.
We have taken a public position against the exploitation of the stamping fee loophole. You can read the article we published (There Are Still Dangerous Loopholes In Financial Advice Rules) on the topic earlier this year here.
Good advice means conflict-free advice. We took a stand that we would only accept fees that were paid by our clients to ensure our advice would never be compromised.
A shift in what is acceptable
Importantly, conventional wisdom is slowly shifting for the better. The Financial Adviser Standards and Ethical Authority (FASEA) Code of Ethics came into force on 1 January 2020, and Standard 3 states:
“You must not advise, refer or act in any other manner where you have a conflict of interest or duty.”
The guidance notes attached to the Code specifically call out stamping fees on Initial Public Offerings. However the disciplinary body charged with monitoring and enforcing adviser’s adherence to the code has not yet been established. Whilst ASIC has provided relief for the requirement that advisers are registered with a compliance scheme, they have also stated that:
“AFS licensees will still be required to take reasonable steps to ensure that their financial advisers comply with the code from 1 January 2020, and advisers will still be obliged to comply with the code from that date onwards. ASIC may take enforcement action where it receives breach reports.”
So it is at this point that we reach the fundamental ethical question for the industry.
We know where the regulator stands on this issue. Will fund managers follow the lead of Magellan and voluntarily call time on the practice of paying lucrative incentives to advisers to place private investors into risky structures? Will advisers voluntarily call time on accepting fees that compromise the advice they give to the clients who trust them?
Or will the industry continue to exploit the loophole before it finally closes?
1 January 2020 is a moment of truth for the wealth advice industry. How the industry responds will say a great deal about integrity and intent.
Paul Heath is a Founding Partner and Chief Executive Officer at Koda Capital. This article is general information and does not consider the circumstances of any individual.