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In the beginning, there were LICs. Where are they now?

While exchange traded funds, or ETFs, are a relatively recent innovation in the investment universe, Listed Investment Companies, or LICs, can trace their origins in Australia to the 1920s. Of the roughly 100 LICs currently listed on the ASX, a handful have seen a half-century or more of market activity, with the five oldest companies boasting an inception date prior to 1972.

Growth in the last decade has been influenced by many factors:

  • investor demand for listed vehicles
  • the popularity of SMSFs
  • demand for predictable fully-franked income
  • a desire from fund managers to raise long-term capital
  • the availability of stamping fees (a commission paid to the adviser for their ‘work’ on capital raising) on new LIC listings (banned from 1 July 2020).

Exhibit 1 below shows the growth in the LIC market by number and assets under management, or AUM, since 2012.

Traditional versus Trading LICs

For our purposes, the Australian LIC universe can be broadly split into two camps: Traditional and Trading.

Traditional LICs, largely the domain of incumbents such as Australian Foundation Investment Company, or AFIC (ASX:AFI), with its $9.4 billion AUM, embody a long-term buy-and-hold ethos, which grants them the ability to pass on Capital Gains Tax, or CGT, concessions to investors.

Trading LICs tend to be more actively managed, with higher average annual turnover. Trading LICs forgo the CGT concessions available to traditional LICs, instead paying the company tax rate on trading profits. This gives them the freedom to trade in and out of positions which provides greater scope to outperform a relevant benchmark and peers. It also enables them to generate franking credits over and above those received from underlying portfolio holdings. This cohort is dominated by the likes of Magellan Global Fund (ASX:MGF), with its AUM of $3.4 billion and WAM Capital (ASX:WAM) at $1.7 billion.

For the purposes of our analysis, we have defined Traditional LICs as those that account for investments on the capital account rather than on the revenue account.

Benefits and drawbacks

LICs provide investors with a few key benefits.

Traditional LICs tend to be a low-cost entry point to an actively-managed investment, especially when compared with the broader actively-managed fund market. The average annual total cost ratio, or TCR, for Traditional LICs is 0.29% compared with 1.13% for Morningstar’s Australian Equity Large Blend Category.

Trading LICs, though, tend to be more in line with the broader actively-managed market, at an average annual TCR of 1.29%.

Additionally, LICs provide convenient access to a diversified portfolio through an ASX vehicle. An argument can also be made that a closed pool of capital can be more effectively invested for the long term without the concern of managing inflows and outflows.

While those features are advantageous for investors, there are some downsides. Chief among them is the tendency for their share prices to trade away from the underlying net tangible assets, or NTA. This is due to the closed-end nature of the investment whereby investors are buying and selling a fixed pool of shares, unlike a unit trust, where new units are issued or cancelled on application or redemption.

A LIC’s share price is influenced by underlying demand and supply dynamics, rather than being strictly pegged to its NTA. Given the relative youth of the Trading LIC cohort, they are generally smaller in scale, and the market of natural buyers and sellers is not as deep. This relative liquidity can have a large impact on price volatility and results in larger premiums or discounts.

Notwithstanding their scale benefits, Traditional LICs are not completely immune to this problem. Exhibit 2 above shows the range of share price premiums and discounts of the LIC cohort from June 2006 to September 2021. The darker bars represent the interquartile range, while the lighter lines plot the fifth to 95th percentile.

Difficulties removing discounts

The difference between share price and NTA is a significant obstacle to consider when surveying the LIC landscape. Prolonged discounts have led to attempts from company directors to close the gap, with share buybacks a primary lever in the battle. Nearly 25% of the market has announced buybacks in the last 24 months, each intent on reducing the trading discount to appease shareholders as well as to ward off internal and external activists.

Nevertheless, the impact has been muted. Over the 24-month period to 31 August 2021, the median discount only shifted by 1.4%, from negative 10.9% to negative 9.5%, with some in the cohort trading even further from NTA.

The issue for directors is share buybacks don’t create demand from new buyers. Rather, the process only creates liquidity for sellers in the present, further reducing liquidity in the future. Effectively, directors can only kick the metaphorical can down the road. Despite colossal efforts from LIC directors across the market, discounts remain ever-present and are once again in the spotlight as competitors seek to capitalise on investments that can provide a margin of safety.

On the WARpath

The LIC market has seen a flurry of consolidation activity in the past few years, with Geoff Wilson and WAM Capital Limited (ASX:WAM) in acquisition mode. Further cementing Wilson’s position as a consolidator is WAM Strategic Value (ASX:WAR), which was launched in June 2021, intent on targeting LIC and LIT peers trading at a discount to NTA. WAM will seek to close the discount gap by driving investor engagement and creating new buyers or taking an activist approach through corporate action.

Elsewhere in our LIC universe, Washington H. Soul Pattinson acquired Milton Corporation in October 2021, bringing a total of nearly $11 billion under management for the group and removing a significant player in the sector (Milton represented roughly 6.5% of the LIC market).

With WAM’s acquisition of Templeton’s ASX:TGG, the consolidation process is in full swing, thinning the ranks of the LIC market. Since January 2019, the number of ASX-listed LICs across all asset classes has declined by roughly 20, with the likes of Australian Leaders Fund ALF, Contrarian Value Fund CVF and CBG Capital CBC all subject of takeover or liquidation activities. While some LIC managers across the country nervously wait for hostile approaches, others are learning to adapt and survive.

Open-ended solution

This persistence in the trading discount has also seen several LICs convert into active ETFs, otherwise known as exchange-traded managed funds, or ETMFs. ETMFs are open-ended vehicles, meaning that supply and demand for units won’t push the price far from the NTA. It is a better structure for investors, with the same benefits that come from a listed access point.

Several fund managers, such as Magellan (ASX:MHH), and Monash Investors (ASX:MA1) have taken the leap from closed-ended to open-ended structures in search of a solution to the discount problem. At the time of writing, Antipodes (ASX:APL) has a scheme meeting scheduled to vote on a transition to AGX1 (the ETMF vehicle of Antipodes' long-only strategy).

While the active ETF structure will largely resolve the NTA issue, investors should remain vigilant for occasional spread and liquidity issues. Volatility can lead to spreads widening materially for short periods, and it has the potential for market makers to reduce their orders. Intraday indicative NAVs, or iNAVs, are published on each manager’s website and should be referred to before trades are placed (though this is not without fallibility).

Exhibit 4 below shows the average bid-ask spreads over time for the Global Equity Large Cap and Australia & New Zealand ETF categories.

You can have your cake and eat it too

Another innovation emerging in the managed investment universe seeks to cover all bases and extend the reach of unlisted managed funds.

Magellan, Hyperion, Antipodes, and Fidelity are among a growing number of fund managers to launch product structures that are tradable both on and off market, at the investor’s discretion. The Hyperion Global Growth Companies Fund (ASX:HYGG), for example, gives investors listed access to the Global Growth Companies Fund through the ASX. Here, though, unlike our LIC-to-ETMF conversions above, investors still have use of the unlisted access point.

This hybrid structure provides an interchangeable product that can theoretically remove liquidity risk from the equation. When liquidity is poor, as was the case in March 2020, investors can trade off market through the unlisted vehicle at a price much closer to NTA (albeit without price transparency at the time the order is placed). The on-market bid-ask spread purely represents the cost of securing intraday liquidity, if needed, and relative price certainty during volatile periods.

All things considered

Progressive iterations of access points for investments continue to whittle away at the pricing inefficiencies driven by product structures. While this may limit arbitrage opportunities for those seeking to capitalise on historical pricing variations, more-efficient markets are a positive for most investors.

Today there are more choices than ever as markets and products continue to evolve. So, while this round of LIC consolidations looks to be far from over, there will be more active ETF launches and LIC-to-ETMF conversions from managers and directors who want to close the discount to NTA, appease shareholders, ward off would-be activists and secure their piece of the exchange-traded pie.

 

Callan Maclennan is an Analyst and Michael Malseed is an Associate Director for Manager Research at Morningstar, owner of Firstlinks. This article is general information and does not consider the circumstances of any investor.

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7 Comments
Harry
December 01, 2021

If LIC’s price meanders away from NAV, so what? It’s discounted when you buy and discounted when you sell. If LIC managers are moving to ETF, maybe find one currently trading at a discount to NAV, lob in there and wait. As for trading vehicles outside of SMSF, trusts are useful. Franked dividends to a company beneficiary and capital gains to your kids. Happy daze. No worries how they pay. The joys of breeding!

Garry B
November 29, 2021

Why would you be worried about an LIC trading at a discount, of say 10%? Unless the managers mess up it will likely stay about that level, or reduce. The worriers ought to be the holders of LIC's trading at a premium of 10% or more. Long term, the prices will trend to a normal level of about nta. This will be modified by the perceived ability (and cost) of managers, and artificial factors like high dividends, information meetings, publicity, etc. Just accept that LIC's are boring investments, but with good conservative managers, who will probably avoid obvious errors, it is a reliable income source.
How much extra should you pay for an LIC paying dividends with the special LIC capital gains? If it is an SMSF in pension mode-NOTHING. Sell and buy something else. The stock probably is already at a premium. At least my accountant told me to do so.

Adrian
November 28, 2021

I disagree about LIC's being more tax efficient investing. Just because you don't see the capital gain distribution doesn't mean the CGT doesn't occur and is being paid inside of the LIC, without any 50% discount for long-term holdings (unless you're in one of the traditional LIC's who may still be eligible to pass it on).
I do agree LIC dividends are simpler (although not necessarily more tax efficient) but these days the managed fund/ETF statements nearly always pre-fill so not really an issue for me. Also agree about the pre-planning although the better fund managers are communicating this and providing estimated distributions, surely this will improve further over time. 2020-21 was an outlier due to the huge market movements, most years don't have such potential for capital gain distributions. By researching your fund manager's style/turnover you can also mitigate this issue

The LIC sector generally is still riddled with too much lack of transparency (e.g. NTA's published monthly 14 days in arrears) and potential conflict of interest (.e.g reluctance to buy-back to address discounts as it reduces FUM). Agree with Joey, LIC's will be in slow decline as the baton slowly passes from the SMSF generation to millenials.

CC
November 28, 2021

I fail to see how a capital gains distribution, which is simply a liability on my tax return of no benefit to me, is as good as a fully franked dividend.

Two of my largest LIC holdings PIC and LSF both announce daily NTAs.

Buy backs have been tried by various LICs again and again with minimal effect on reducing discounts because they don't address the problem of insufficient buyer -seller liquidity, if anything it can make liquidity worse as fewer shares are left on issue. But buying at a discount and selling at a discount doesn't mean you can't don't make a profit. AUI has almost always traded at a 5+% discount for decades but if the share price goes up, whilst still trading at a discount, and franked dividends are paid, investors are still ahead.

Joey
November 25, 2021

Let's not dress this up. LICs have had a bad couple of years, only one new issue by Wilson and that's because he can place his own paper without relying of brokers. The reason the balance are up is because the market is up. Manager now use active ETFs not LICs, which are in a slow decline. There are still dozens of names at big discounts who would switch to ETFs if they cared for their investors.

CC
November 25, 2021

The trouble with active ETFs is that they can distribute annoying capital gains tax liabilities each year that are a burden on investors. I recall one year I received an $8000 capitals gains distribution from a fund whose unit price had barely gone up in the 12 months. Also these capital gains are distributed to people who buy into a fund at any stage before June 30. Even if buy on June 27, you get hit with capital gains distribution from the whole previous 12 months activity !!
With LICs you get only franked dividends, no capital gains distributions. Much better at annual tax time and much more tax efficient investing.
I use both , as they both have Pros and Cons.

Geoff D
November 25, 2021

I agree with CC. Because of the CGT considerations for ETF's, of which you only become aware AFTER the financial year end, it is very difficult to do adequate pre year end tax planning. Same with managed funds. As a result I have seriously reduced my holdings in ETF's and managed funds as an individual. Instead, I use my SMSF for such investments to take advantage of the tax free situation on capital gains. It then doesn't matter when you become aware of the capital gain. Until the government changes the rules for SMSF's of course, which may well be inevitable.

 

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