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The major weaknesses of LICs and managed funds

“He who pays the piper calls the tune.”

To state the bleeding obvious, sales people working for fund managers are biased towards their own product structures. It’s the job of Chief Executives, Chief Investment Officers and Business Development Managers, and anyone working in distribution for a fund manager, to promote their company’s particular structure. Another side of the job description requires them to point out the deficiencies of competitor structures.

So let’s focus on the biggies. What is the main criticism that Listed Investment Company (LIC) folk use against managed funds, and what do managed funds folk say to criticise LICs?

Main weakness of managed funds, as nominated by LICs

Managed funds are open-ended, which means existing investors can redeem (cash out) at times of market stress, forcing fund managers to sell assets into poor markets.

Main weakness of LICs, as nominated by managed funds

LICs are closed-ended, which means the only way existing investors can cash out is by finding a willing buyer on the stock market, and this could be at a heavy discount to the asset backing.

Guess what. Both are correct. The irony is that these are also the strengths in the right markets. Let’s consider each in more detail:

Managed funds are forced to sell in stressed markets

The harsh reality of the way many investors behave is that they invest more into the market when it is strong, expecting it to rise further, and redeem when markets fall, expecting further losses. The doom and gloom in the media prompts unfortunate investor reactions.

In extreme circumstances, managed fund redemptions may be suspended to prevent cash outflow, such as on mortgage funds around 2008 during the GFC. These products had a fundamental weakness. They offered next day liquidity, but their assets were both long-term and illiquid. There is no ready market for five-year mortgages at a time of distressed selling. Faced with a run on their funds, redemptions were suspended, and it was only recently, some seven years later, that the final mortgages were repaid allowing the last instalment to be returned to the investors.

Example of the problem: During the GFC, the only way the demand for cash from managed funds could be met was by selling assets. I remember one frustrated fixed interest manager telling me he could buy seven-year CBA subordinate debt (not hybrids) at over 9%, which he thought was excellent value (and indeed, it turned out to be), but he could not buy because he was desperate to sell anything to fund redemptions. Liquidity has a tendency to dry up when it is most needed.

Similarly, when markets are peaking, new applications are usually at their highest. Since most managers accept as much money as they can, they are either forced to invest when the market is toppish, or hold the money in cash and risk underperformance if the market continues to run.

So the LIC criticism of managed funds can be accurate at market extremes. But the main strength of managed funds is due to the same structure. Managed funds are open-ended, and existing investors can redeem (cash out) at the net asset value (NAV) of the underlying assets every day. They do not trade at a discount.

LICs trade at a discount

LICs are not required to sell assets as investors cash out because the buyer on the ASX provides the liquidity, and the number of shares on issue remains the same. This advantage is balanced by the dependence on the strength of the market bid to support the price, and especially for larger sales volumes, the price can be pushed down relative to Net Tangible Assets (NTA).

For example, assume a buyer subscribes for an initial issue at $1, and the NTA at the start is $0.97 (due to the cost of listing). If the fund manager has a poor start to performance, or the overall market is weak, or the initial issue was not firmly placed with end-holders, then the issue can drift to a further discount to NTA, and sometimes take years to recover, if ever.

The table below shows the weighted average market price to NTA for all LICs in Australia, showing an average discount to NTA of about 5%, but it has been as high as 13%, with no positive average for the last 12 years.

Source: Patersons Listed Investment Companies Report, December 2015.
EMA = Exponential Moving Average, which gives more weight to recent data.

These are averages, and there are some well-established LICs which have performed better, often trading at a premium to NTA. These include Australian Foundation (AFI), Argo (ARG) and some of the Wilson funds, such as WAM Capital (WAM). But since the sector as a whole is at a discount, many are at severe levels of 20% or more, and perhaps up to 30%. Examples of large discounts include Flagship (FSI), Contango Microcap (CTN) and Hunter Hall (HHV). The investor has only two choices in these LICs: hang on and hope the discount is removed, or sell and realise the loss.

The main reasons why some LICs trade at a premium are that the manager or fund is well-known, highly sought-after and communicates well with investors. The flip side is that if the manager loses the confidence of investors, it can take a long time to recover. Investors need to be convinced the manager can add value. There is no mean reversion.

Looking at the graph, it might sound attractive to buy at a discount of 13% and then sell at a discount of 5%, but it is extremely difficult to know which manager’s reputation will improve, or even what caused the discount.

Example of the problem: Templeton Global Growth Fund (TGG) is a long-established LIC from a global brand with a market value of about $280 billion. Until a year ago, TGG had been trading at around NTA, with a 12-month high of $1.50, but is now at $1.13 against an NTA of about $1.30. The share price has fallen roughly twice the market fall. They recently held an investor update where a member of the public criticised the board for twice issuing new shares at a discount to NTA, diluting the value of shares for existing shareholders. The investor argued that the placement had contributed to the discount to NTA. A board member of TGG admitted they had underestimated the consequences of both the issue at a discount and the placement. He said their communication must improve, especially by better explaining their style and in what conditions it might not work (they are deep value, which has underperformed growth recently). It will take a lot of time and effort by TGG to remove the discount to NTA.

As with managed funds, the main weakness is also the main strength. LICs are closed funds, which means the manager is never forced to sell assets on market at times of stress.

Are LICs or managed funds better?

There is a lot more to the overall merit of these two structures than the two main points highlighted here. Consider the quality of the manager and investment team, the time frame of the investment, the asset class and the need for liquidity.

For investors who find high quality managers who put a lot of time and effort into nurturing their clients and who deliver consistent performance, LICs are a good structure. For investors who demand liquidity at market value and trust a large institution with a strong investment management business, managed funds can work well.

But next time you hear the predictable criticism of an alternative structure, ask about their own potential weaknesses.

 

Graham Hand is Editor of Cuffelinks. This article is general information only. Disclosure: Graham holds investments in both managed funds and LICs, including TGG, he is on the Board of a LIC (Absolute Equity Performance, ASX:AEG) and sits on the Compliance Committee of a managed fund business (Lazard Asset Management).

 

15 Comments
Neil
March 20, 2016

Thanks Graham

Neil
March 20, 2016

Re LIC's V Managed Funds.
One thing I don't get Graham.... surely the only people who suffer when a Managed Fund is forced to sell at rock bottom prices are the people who are redeeming units. The unit price only suffers long term if the manager sells more than is required for redemptions. With lumpy assets like unlisted real estate this could be a problem, but surely not with shares? In your example, what was stopping the fixed interest manager taking advantage of the CBA bonds yielding 9% for the unit holders remaining in the fund?
I can understand that balancing inflows and redemptions might be tricky, but I don't see how it affects returns.

Graham Hand
March 20, 2016

Hi Neil, thanks for the question. In the example I gave, the bond market was so illiquid that there were few buyers for anything other than government paper. Those willing to make a bid on bank or corporate paper set their prices at very low levels. Portfolio managers were facing heavy redemptions, and so they had to sell almost anything they could just to raise the cash to meet outflows. And so a bond might have been sitting in the portfolio valued at 90 (and this was often a rough estimate because there was no trading), but the manager was forced to sell at 80 because it was the only price in the market. At times of distress, liquidity can vanish and buyers with cash can dictate the prices. The managed fund is forced to sell while the LIC manager can wait. In my example, the fund manager could not buy because he was desperate to raise cash in any way he could to meet redemptions. You would be surprised how often the revaluation of a fund is a best guestimate when many securities have not traded for a while.

Again, during the GFC, listed property trusts (now called A-REITs) had terrible liquidity, and some managed funds fell dramatically as prices collapsed. No buyers other than at fire sale prices, making some fund managers forced sellers. Same in small company equity funds, where bid/offer prices can widen to extremes because there is no liquidity. Obviously, this is less likely to happen with CBA or Telstra, but even there, forced sellers pushed down prices severely during the GFC and some portfolio managers had to sell at whatever price they could find.

John
March 18, 2016

Graham, someone who used to work for me is now manager of a seriously large fund. I asked him recently what he does with his own money. The answer is LICs and MICs. I asked why, with his expertise, he let others manage his money? He said: Because I'm too busy to look after it properly myself. If his name were known that would be a great ad for these structures.

Brad Matthews
March 18, 2016

The problem of LICs trading at a discount could be largely overcome if the LICs introduced a policy to always buy back shares if there were sell offers say 5% below NTA. This wouldn't necessarily be a great outcome for investment managers (as FUM would decline); however, by definition each buyback that takes place below NTA adds to the net assets per share for the remaining investors and is therefore in the best interests of shareholders.

If there was a genuine commitment to an uncapped ongoing buyback program by the LIC, then the market price would automatically adjust back towards NTA as sellers would cease placing offers below the expected buyback price.

Simon
March 20, 2016

I'd like to see all LICs buy back shares following a sustained period of discount to NTA (Ironbark (IBC) have stated an intent to do this every 3 years), and I'd also like to see new shares only issued at NTA or above, and only when they have traded at a premium to pre-tax NTA (Platinum (PMC) have stated their intent to employ both these measures. That seems sensible policy in shareholders interests.

As for Templeton (TGG), the board has repeatedly shown no respect for shareholders in twice placing shares well below NTA into a saturated market. That action is mostly of benefit to the external fund manager by increasing FUM and the associated fees. I would urge all shareholders to vote against the remuneration report - they received their first strike at the last AGM.

To really undo the damage of their previous actions, the Board ought to offer all shareholders a full buyback at NTA.

Matthew Webb
March 18, 2016

Putting all other variables aside (fees, turnover are all valid points but there are high fee/high turnover LICs) if you have two identical portfolios - one in an LIC structure and one in a managed fund structure, with no inflows or outflows to each - there remains one (and only one) difference - an LIC can retain earnings. This is probably great if you are on the top MTR, but not so great if you are a (15%) super fund which pays a lower rate of tax than the LIC and would prefer all earnings paid out with the attached requisite tax credit (which you can then choose to reinvest if you wish) The LIC structure being more tax effective is illusory - just because the LIC pays the tax on gains and dividends before it pays you doesn't mean you aren't paying the tax (most would find a $70 fully franked dividend equivalent to a $100 unfranked dividend - this is no different). Yes - LICs can smooth dividends via retained earnings - however this merely makes the distributions administratively easier to handle from a cashflow perspective.

You can then start relaxing assumptions and start adjusting what works for you - for example my most significant assumption above - zero inflows. A positively performing managed fund in strong inflow will produce a beneficial tax outcome vs a static capital (LIC) equivalent as the realised gains and dividends at the start of the year get diluted per unitholder as the fund grows - so your unit price goes up just as much as you would expect but you get to share the tax liability with your new found friends in the unitholder pool at the end of year distribution. Of course the reverse happens if the fund is in material outflow. But flows are not a strength or a weakness from a tax perspective.

As to whether or not a company structure pays tax and decides whether or not to retain it vs a trust structure that is forced to pay everything out - only the individual can choose what works best for them - there is no clear winner.

As to the "forced seller" problem - this only occurs when managers are offering their investors more liquidity than the underlying assets offer them (which typically ends badly in any case) - otherwise they can just re position the portfolio with outflows in the same way they would with inflows.

Jerome Lander
March 17, 2016

Investors often fail to understand certain facts about LICs:
(1) LICs can be of great value to an investment manager as they represent a source of annuity income from captive money.
(2) Furthermore, LICs all too commonly have a nasty habit of issuing more equity, often in a dilutive fashion to existing investors.
These are legitimate reasons for why LICs routinely trade at a discount to net asset value, and why institutional investors don't want to buy LICs at IPO.

With respect to the point about managers being forced to sell assets from a managed fund at times of stress, it is important to note that at times of stress, LICs often trade at an even bigger discount to their NAV - which is already simultaneously lower due to this same stress. Hence if I needed to sell at a time of stress, I'd typically rather be selling a managed fund (at a depressed NAV) than an LIC (at a deep discount to a depressed NAV).

An LIC can usually claim the benefit, as does a managed fund with a more infrequent redemption policy, of being able to take a longer term view with respect to its positioning. courtesy of its more captive capital.

Peter Thornhill
March 18, 2016

Sorry, forgot the issue of an annuity income for the manager. This is not an industry wide issue. The reason we require a 50 year plus history is that all the recent entrants to the market have a separate management company with unconscionable fee levels, 1% or more plus performance fees. I'm happier with the older lic's where the company and management are one with a management fee of, say, 0.12% like Milton.

Peter Thornhill
March 17, 2016

Managed funds being a trust structure must distribute all profits to avoid double taxation. This means that any trading profits have to be returned to unit holders each financial year end.
This creates extremely lumpy distributions that are very tax ineffective.
I have experienced quarterly distributions from one fund that varied from $800.00 to $13,000.00 leaving me to pick up the tax bill on thousands of dollars of unwanted capital gains.
Repeated time and time again over a number of years I ended up with a fund, the unit price of which hadn't moved at all and paying unnecessary tax each year. This also meant that the 'dividend income' was often only partially franked as most of the distribution was capital.

My rules of thumb for choosing lic's are, 1. they must have been around for at least 50 years, and have a robust investment philosophy that doesn't rely on a hot shot personality.
2. They must be a single entity and not have separate management company.
3. The management expense should be 0.5% p.a. Or less and there should be no performance fee.

Steve
March 17, 2016

This is the problem I've had with managed funds in the past. Given managed funds report their returns on a pre tax basis they seem to have no care about portfolio turnover. If you're in a low tax environment (and reinvesting divs) it doesn't matter so much but if you are invested in your own name or rely on distributions for income it is hugely problematic. At least LICs must report their returns after tax (at company rate), and then can control their distributions to keep it consistent. Of course the added benefit is that the tax paid is returned to the investor if they are on a low tax rate thanks to our overly generous dividend imputation system.

Peter your rules for LICs are interesting and limit you to about 4 options, all of which are trading well above their NTA. Do you have any concerns about buying LICs above NTA?

Peter Thornhill
March 18, 2016

Not at all Steve. Having taken up the rights issues and share plans over the last 20 odd years for the 4 lic's we hold the whole issue of discount/premium is of no interest or consequence. As we never sell our children and the charities that will benefit can agonise over whether we could have tweaked the performance by frigging around with our holdings.

I love the ‘nasty’ habit the lic’s have of issuing new shares. As we take them all up we are never diluted and it is a zero cost way of topping up for children and grandchildren.

Carlos
April 10, 2017

"they must have been around for at least 50 years"

that is silly.
If you look at the performance figures for AFIC, Argo and Milton over the past 1, 3, 5, 7 and 10 year periods they are usually no better than and sometimes worse than the ASX200 index. They have far too much ( 30 - 35% of portfolios ) in banks plus other boring mediocre companies such as Telstra and BHP whose share prices are lower now than they were 10 years ago.
There are far better LICs out there performing far better such as those run by Geoff Wilson ( WAM, WAX, WLE ), Mirrabooka, Magellan, Amcil, Forager, Watermark.
I don't need to pay a fund manager to invest in the index, banks and Telstra for me.

Gary M
March 17, 2016

If managed funds were any good they should have limited the downside in 2008 and fewer unit holders would have wanted out.

LICs trade at a premium or discount depending on whether investors as a whole believe they will add value or detract value in the future from their active management of their assets.

If they trade at a discount, investors are effectively saying “stop wasting my time. Just liquidate the thing and distribute the assets to the shareholders.”

robert
March 18, 2016

being a contrary person i love buying LICs at a discount ( but only after perusing the portfolio held and management style and assured they are 'unfashionable ' rather than struggling )

although BE WARNED your LIC manager may change adjust the management style as they deem wise ( not totally bad or good just affects my 'balancing attempts ').

 

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