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New ways for listed funds to fix their price discounts

Some listed investment companies and trusts (LICs/LITs) are taking initiatives to remove long-standing discounts to net tangible assets (NTA). This has recently transpired either by way of converting to an active ETF (such as Monash's MA1) or an unlisted unit trust (such as Ellerston's EGI). Alternatively, the dual structure of an unlisted unit trust and active ETF was pioneered by Magellan and Mainstream and launched last week with the Airlie Australian Share Fund (AASF).

While some other boards have announced share buybacks, such buying has proven largely ineffective in closing discounts to NTA over the medium to longer term.

Time for boards and managers to act

With the precedents now set for all three avenues to permanently eliminate discounts to NTA, there is additional impetus for boards, investment managers (those acting in the best interests of investors) and investors to take action. Potentially, activist investors may seek arbitrage opportunities to convert or possibly wind up LICs and the sector may well now or soon be ‘in play’.

For some LIC investment managers, conversion to an active ETF presents the opportunity to grow funds under management (FUM), notwithstanding arbitrage-related divestments upon conversion. Many such LICs have been precluded from growing FUM due to the persistent and material discounts to NTA. The potential for growth in FUM for solid managers is likely to be facilitated by the ongoing growth in the active ETF segment, a dynamic that is being facilitated by the structural decline of the platform space.

Given these dynamics, investment managers, whether of LICs or unlisted unit trusts, would be well placed to review their go-to-market strategies. A manager can sink the costs, time and resources now and benefit from being early to market or they can, should these dynamics come to pass, be ‘forced’ to do so at a later date (incurring the same costs) and be late to market.

In fact, we suggest all boards and investment managers of LICs that:

* have not shown an ability to capitalise on the single greatest benefit of a closed-ended vehicle, that is, captive capital, and

* have traded at a persistent and material discount to NTA, which is the vast majority

... initiate a review towards potential conversion.

Managed investments, in some regards, represent the peak of capitalism. If you live by the sword, then you must die by the sword. Running a fund is not some sort of gravy train for boards and investment managers.

A discount to NTA can of course be viewed as an opportunity, over and above the prospect of solid returns from a strong investment manager. If the sector is now or soon to be in play then the likelihood of crystalising a gain through a share price reversion to NTA may increase materially.

The rise of active ETFs

The rise of active ETFs (sometimes called ETMFs or Exchange-Traded Managed Funds) will likely occur based on a combination of:

1. the fragmentation of the financial adviser sector post the financial services royal commission leading to the ongoing structural decline of platforms and unlisted unit trusts

2. the increasing use of listed investments

3. the launch of the dual ETMF and unlisted unit trust single-pool structure

4. the precedent of the first conversion of a LIC to an active ETF

5. the stamping fee ban (the irony is that the active ETF fund managers that pushed for a ban on stamping fees have just bought themselves a lot more competition), and

6. the likely resurgence of active investing versus passive investing.

With the Magellan/Mainstream dual structure now launched, every new fund managers should include in its constitution the ability to go down this route. Existing fund managers will need to carefully consider their strategic position, given the secular decline of the platforms.

The three roads to remove the discount

As described briefly above, there are at least three routes a struggling LIC or LIT could take in these examples:

1: Conversion of MA1 into an ETMF

Monash Investors is expected to change its name to Monash Absolute Active Trust and the likely listed code is MAAT. To do so, the manager will require at least 75% of votes cast in support of the resolution. The conversion, should the vote pass, is expected to be finalised by September 2020 and in which case investors will benefit from MA1 trading at parity to NTA (in contrast to the current 8% discount).

2: Conversion of EGI to an unlisted unit trust

Ellerston Global Investments (EGI) released a door stopper 408-page Scheme of Arrangement booklet regarding the proposal initially announced on 17 January 2020 to restructure EGI shares into unlisted units into the Ellerston Global Mid Small Cap Fund. This initiative is to close the sustained discount to NTA in EGI.

Our understanding is the course Ellerston Capital has pursued was viewed as the quickest route to conversion. However, converting to an unlisted trust is contrary to a key reason why many investors may have invested in the EGI vehicle in the first place, being a listed investment vehicle.


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3: Launch of dual unlisted unit trust and active ETF

On June 4, the Airlie Australian Share Fund (AASF) began trading on the ASX. It brings together the features of an unlisted fund and an active ETF into a single unit in a single fund. The structure provides investors with greater choice and flexibility in how they invest and will deliver efficiencies to fund managers.

Magellan and Mainstream have developed a means for fund managers to offer one fund that can be accessed by investors through the traditional means of applying and redeeming units in an unlisted managed fund. These investors are managed by the registry, effectively on an issuer sponsored sub-registry, and transact using a shareholder reference number (SRN). Alternatively, investors can trade on the exchange (either the ASX or Chi-X) through their broker, using their holder identification number (HIN). IIR notes that there are no adverse taxation consequences for existing unit trust investors through the restructure process.

For fund managers, the development is nothing short of a potential game changer. An investment manager of an unlisted unit trust can now seamlessly add the exchange-listed distribution channel (which a certain percentage of advisors and investors are oriented towards) in addition to the pre-existing unlisted unit trust distribution channel (which a certain percentage of advisors and platforms are oriented towards).

The potential of this dual structure to grow FUM for an investment manager should not be underestimated, particularly in the context of the strong (active) ETF market growth and the progressive changes in financial advisor business models who are in increasing numbers moving off traditional platforms.

A key drawback for unlisted funds has been the excess paperwork required from an investor applying to buy or sell units. Investors have been required to complete 15- to 20-page application forms for each fund and most of these are still paper-based in 2020. This existing system of listed and unlisted funds creates an unwieldy, inelegant landscape for investors, brokers and fund managers alike.

All stakeholders will benefit

In IIR’s view, all key stakeholders benefit from the development of this dual structure.

For fund managers, they are able to offer the same benefits of dual funds to investors without the duplicate cost structures (fund managers can save in the vicinity of $150,000 per annum by consolidating dual funds into a single product). More importantly though, where a fund manager had only offered an unlisted unit trust, they are now given a highly prospective listed distribution channel.

For advisers, the development provides more choice in portfolio construction (as some only use listed, others largely unlisted), it potentially removes the administration burden of unlisted unit trust investments.

For investors, there is a simplified view of their investments. A key feature is ensuring investors can seamlessly move between SRN and HIN and vice versa. Investors will be able to access an investment manager’s pool of assets through different entry points and then have the flexibility of moving their units between their brokerage account and the issuer sponsored sub-register.

For brokers, this product eliminates the need to build a bespoke 14-message system required for the ASX mFunds. By making use of existing messaging tools, the demand to introduce low-return infrastructure is removed and thereby so too are the barriers to adoption. Brokers are able to buy units in the fund for a client as simply as if they were buying any other security listed on the ASX.

The Airlie Australian Share Fund may well be the first offering for this dual structure, but there is nothing stopping other fund managers pursuing this path once they have developed the required infrastructure and expertise to manage the active ETF aspect and adhere to the ASIC guidelines.

We suggest all fund managers closely monitor the progress of AASF with respect to FUM growth and which of the two channels that growth is coming from.

 

Rodney Lay is an Analyst at Independent Investment Research. This article is general information and does not consider the circumstances of any individual.

 

13 Comments
Graham
June 29, 2020

I believe the 2 current issues currently drawing attention re LICs are well woven together. Prior to Financial Advisors being able to claim a fee for recommending LICs to clients, there was no commission issue. But good LIcs traded at a low premium while the few not so good traded at a discount. Once Advisors could get commissions, there was a deluge of new LICs in the market place. They attracted investors with new investment moneys and attracted investment moneys away from established LICs. With new LICs appearing better than moderate established LICs, discounts to NTA appeared more regularly as advisors directed clients to new IPOs. Now, the surfeit of LICs finds many moderate performers and small funds lacking investor support and trading at serious discounts to NTA.
I see the following actions as possibly moderating discounted NTAs.
* Merging or closing down moderately performing funds.
* Investors doing more diligent research to find the good performers who trade at discounts because investors do not understand the product. Particularly I refer here to specialist or sector based funds.
* Fund managers wanting their funds to trade closer to NTA should follow the longer established successful LIC managers and keep the investors well informed about the performance and benefits of investing in their fund. Selling the fund is as important as great investment performance. They go together, not either/or.

We do not need new investment structures, we need fewer, better managed LICs acting for and respecting their current and future clients. And if commissions to misunderstanding advisors causes fragmentation of the product sector, cease commissions to poor salespersons.

Tim
June 28, 2020

I’d like understand how the dual unlisted unit trust and active ETF structure is different from the ASX mFunds service?

Are they not the same thing - investment managers expanding their distribution channel by offering access to unlisted managed funds via the ASX? Are there particular benefits to the investment manager through the dual structure compared to mFunds?

Graham Hand
June 30, 2020

Hi Tim, there is one important difference, at least. mFunds is an order service. You don't know the price at which you will transact. You place an order at say 10.00am for $20,000 worth of units in an unlisted fund. The market may rise 5% over the day and your order is sent to the fund manager at the end of the day, and you pay the extra 5% (or 5% less if it falls). It can be a bit messy as the paperwork comes a few days later, saying you bought 10,651.8923 units (to match your $20,000).

With ETFs and LICs, you know the price when you transact. It is the same as with any other share.

Possum
June 28, 2020

Please stop attacking LIC's, they are a great product. Being able to buy them at a discount is GOOD because you are paying less for the same dividend amount, thus magnifying the yield.

The company is able to retain earnings in good years to smooth out dividends in bad years, and at the end of the financial year you already have all your statements and can put in your tax return straight away instead of waiting, sometimes for months, for the company to send a tax statement. They also are closed end, so they don't need to sell investments at the bottom of the market to pay out to nervous investors who want to redeem their units.

If you are upset by the discount to NTA then don't buy LIC's in the first place, they are obviously not for you. There are plenty of trusts and ETF's available for those who don't like LIC's. At least leave some choice available for those investors who prefer the LIC structure.

I personally don't like the company buying back shares to try to reduce the discount, I would far prefer they used the funds to buy more investments if they are good at what they do, leaving the discount in place so investors can buy more of the discounted LIC shares if they want to.

James
June 27, 2020

Great article Rodney, but you fail to answer the fundamental question being, what’s in it (ie.a change to an active ETF structure) for the manager whose LIC is trading at a material discount to NTA, has under-performed the market over recent years, but has a sizeable pool of invested capital which is “locked in” under a long term management contract. Changing structure to one which allows investors to exit at NTA whilst absolutely in the best interests of investors, is fundamentally not in the best interests of that manager. I fail to see how this dichotomy can be resolved, based on your analysis & real life experience, investing in LICs over the past 20 years...

Bob Jarvie
June 26, 2020

It is important to relate the discount / premium to NTA with the market. Buying at a premium at a market low could be better value than buying at a discount at a market high !

Kerry
June 26, 2020

I’m not a regular investor in these products, but lately the discounts to NTA and competitive distributions look inviting. Seems to me, is not to buy into new offerings, but wait to see if a discount developes. 10%, 20% or 30% sure looks juicy.

Damo
June 25, 2020

I like buying at a discount too, but as a last resort, these options make sense. Does making it an ETF change it from the closed-end fund approach which I prefer as it gives the fund manager certainty in regard to available funds.

I actually have an investor call tomorrow from an LIC with a hefty discount tomorrow. They do make significant daily buybacks and management purchase shares regularly, so I'm guessing the above isn't on the cards, but interesting to see.

Graham
June 25, 2020

The discount is not an issue for me with LICs Managements competence is the key issue and applies regardless of structure. Other key issue is liquidity. As a retiree, I need to be able to raise cash and some cash is better none due to long-term withholding of funds by a fund manager or market-maker decision. LICs allow this but there is less certainty in other structures to my limited knowledge.

John
June 25, 2020

As a long term holder I prefer to buy at a discount.

Carlos
June 25, 2020

Bring them on !!
Utterly sick to death of LIC discounts.

Simon Taylor
June 25, 2020

Who cares about NTA discounts? Do you check the NTA of other shares you hold? Gives me comfort that the shares are backed by more assets than what I paid for them. It is the long term growth and return which really matters. And chance to buy well at bigger than the usual discount.

Carlos
June 25, 2020

not when you buy close to NTA and then watch them drift lower and lower below NTA and remain at a large discount for an eternity !!!!

 

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