Avoiding the great 'Labor franking credit grab'

Daryl Wilson

There are now over 100 LIC’s (plus some Listed Investment Trusts, or LITs) on the ASX. The main difference between a LIC and a LIT is tax: LITs help to avoid the great "Labor Franking Credit Grab". In this wire, we examine this theme, as well as four other important themes in the sector right now.

Avoiding the great "Labor Franking Credit Grab"

Labor’s plan to deny franking credit refunds to certain taxpayers is bad policy. It's unfairly targeted, and there are plenty of options to minimise it. This makes it inefficient, and it will likely generate less savings than predicted. In the Listed Investment space, the sudden focus on franking has turned the spotlight on the advantages of the LIT structure, as compared to LICs.

An LIT is a listed managed fund (similar to an ETF or a REIT). Existing LIT’s include Forager Australian Shares Fund (FOR), Magellan Global Trust (MGG) and Metrics Credit Income Trust (MXT). And, there’s more on the way. We believe LITs will eventually outnumber LICs.

LIT's pay no tax directly, and therefore have higher cash earnings. So, instead of a franked dividend, an LIT might just pay a higher cash distribution.

An LIT can still pass through franking credits from dividends the LIT receives on its investments. An investor in an LIT receives an annual tax statement detailing the tax treatment of all distributions paid to them. The taxable portions get included in the investors' tax return.

As well as new listings, we've also recently seen a couple of existing LICs converting to LITs. We may see this happen a lot more if Labor does get their way. This conversion process results in a realisation of the portfolio for tax purposes, so it can lead to a big one-off tax payment (and franking credit) as a result. But after that, it's a lot more tax efficient.

In addition to the rise of the LIT, here's a few more themes that might play out over the next 12 months.

The flood of listings is set to continue

The market for LICs is quite discerning. Those that make it to IPO stage tend to be from well-regarded managers, pursuing a strategy that is differentiated and has been successful in the past. We are selective in the IPOs we participate in, as the post IPO market can quite often result in pressure on share prices. But the quality is very high, and if you're happy to hold for the long term, you can be well rewarded.

Recent developments in the market have also led to more shareholder-friendly structures. Options have largely been dropped in favour of the manager picking up some or all the initial listing costs. This means the starting NTA is roughly the same as the price investors pay, which is positive.

Over the past year, we've seen around 10 new entrants to the LIC space, and another (WAM Global) is listing at the end of this week. We expect this trend to continue. You can monitor upcoming listings through your broker, or on the ASX website.

What about something different

While overall returns haven’t been stellar in the past 12 months, we’ve not seen any major market correction either. The longer this goes on, the higher the chance of a decent market fall in the future.

We try not to get caught up in making predictions, but rather we to try to make our portfolio as resilient as possible against a range of different potential challenges. One strategy is to hold a portion of LICs that can outperform in down markets, or that might weather the storm in better shape than most at least. We wrote about three of them here, and these are all still pretty good value. There are now quite a few LICs that pursue a long/short or market neutral investment strategy. All of them have the potential to be much more resilient in sustained market corrections.

Be careful of the premium.

It's very rare that we buy any LIC at a premium to NTA. There's very little justification for it. By buying at a premium, you're saying you have so much confidence in the skill of the manager to outperform that you're prepared to pay for some of that future outperformance up front. That’s brave, given that both markets and outperformance by a manager tend to be cyclical.

Most LICs trading at a large premium have a combination of good long-term performance, an above average dividend yield and a core of loyal investors. A poor short-term performance period, or a fall in the dividend, makes them very vulnerable. This can then lead to a reduction or elimination of the premium at the same time.

We also expect to see more capital raisings from existing LICs over the next year where they trade at a premium to NTA. We usually reduce our holding in an LIC if it moves from a discount to a premium. This leaves us well positioned to top up again if they do raise capital or suffer through a period of poor performance.

Last year's underperformers, next year’s winners?

Our analysis shows that more than half of all LICs are currently trading at an NTA discount that is greater than their historical average.

Sometimes the laggards in one year can be outperformers in the next couple of years. This is most likely to be the case where an LIC with a good long-term record has had a relatively poor year, leading to the LIC trading at a larger discount than would normally be expected. Sometimes this occurs where the sector or market an LIC invests in has performed poorly.

For example, in the last 12 months, we've seen large Aussie shares and value stocks underperform. So, it's worth looking at LICs that invest in this area to see if there are any potential bargains.

Potential opportunities right now in LICs that invest in large companies include AFIC (AFI), Amcil (AMH) and BKI Investments (BKI) which has just completed a capital raising. More active investors in this large-cap space include WAM Leaders (WLE) and Century Investments (CYA). Both are managed by the talented team at Wilson Asset management, and both are trading at discounts to NTA.

There are also some smaller LICs which are currently trading at substantial discounts. These often invest in more niche sectors and may not have the liquidity of the large LICs, but some that we think look interesting include Bailador Technology (BTI) which invests in unlisted technology companies, as well as small company LICs Glennon Capital (GCI), NAOS Small Cap Opportunities (NSC) and Barrack Street (BST).

Change is constant

We expect the ASX Listed Investment sector will continue to grow and evolve in FY19. With this growth will come a wider range of opportunities. Whether you currently have LIC investments or not, we would encourage you to have a look at the market. There’s a lot of quality here.

A good starting point for education and ideas might be ASX’s investment products monthly report. There are also various LIC research reports available through Livewire Markets and brokers. We’ve also written a guide to LICs which you can find here.

Disclaimer: This article has been prepared by Affluence Funds Management Limited ABN 68 604 406 297 AFS Licence no. 475940 (Affluence) to enable investors in Affluence Funds to understand the underlying investments of the funds in more detail. It is not an investment recommendation. Prospective investors are not to construe the contents of this article as tax, legal or investment advice. Neither the information nor any opinion expressed constitutes an offer by Affluence, its subsidiaries, associates or any of their respective officers, employees, agents or advisers to buy or sell any financial products nor the provision of any financial product advice or service. The content does not consider your objectives, financial situation or needs. In deciding whether to acquire or continue to hold an investment in any financial product, you should consider the relevant disclosure documents for that product which are available from the product provider. Affluence recommends you consult your professional adviser to determine whether a financial product meets your objectives, financial situation or needs before making any decision to invest.


Daryl Wilson

Daryl Wilson has over 25 years’ experience in finance and investing. He formed Affluence in 2015 to give everybody access to the investing model used by the ultra-wealthy. Investors can access over 30 of Australias best boutique investment managers.

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David Yabsley

I don't get this? My understanding of Labor's plan is that they are denying cash payment tax refunds for Franking Credits. That is, retirees like me who pay no tax, will no longer get cash. But normal Franking offsets will remain. So where is the benefit of a LIT to me? The LIT does not pay extra cash, it just passes through the Franking Credit for offset, which I can't use. Please explain.

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Rick Huxtable

We are reading the DRP offers and will probably change our SMSF pension clients to reasonable DRP that basically covers the cash Franking Credits loss. Regards, Rick Huxtable

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Michael Hill

David, my understanding is that whereas an LIC pays tax and incurs franking credits on their trading/selling stocks, an LIT does not pay any tax before distributing all profits and thus no franking credits from trading is attached. So you receive 100c of the profit from an LIT trading vis 70 cents plus 30 cent franking credit from an LIC. Any franking credits received with dividends from companies invested in will be distributed but that is about one third of the franking credits by, for example, the WAM LICs. Arguably, you will receive less than half the franking credits if the structure is an LIT. Geoff Wilson from WAM Funds is on record as saying he will look at converting his funds to LITs if necessary.

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David Yabsley

Many thanks for the updates. I will hold off until we actually see legislation. Suspect that if the ALP does not get this done the LNP at some future point will do exactly the same. Morrison has not be shy to hit pensioners with pension cuts, so this won't be off the books either.

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Roslyn West

Sorry Rick, I dont understand what you mean about DRPs covering the franking credit loss.

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Anthony Connellan

Daryl,who are the LICs that have converted to LITs? Tony Connellan

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Daryl Wilson

Hi Tony. The LICs I referred to were the Asian Masters Fund (EAF) which was previously AUF. The Australian Governance Masters Index Fund (AQF) has also recently approved a similar restructure. Both are part of the Dixon/Evans and Partners stable of LICs.

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Edward Barkes

Amend the quote please: LITs are also closed-ended funds, meaning investors buy and sell existing units on stock exchange, such as the ASX. LITs, however, are incorporated as trusts, rather than companies. LITs must pay out any surplus income to investors in the form of trust distributions. These distributions are received by investors in the same way they were received by the trust from the underlying investments. Franking levels may vary depending on the income distributed from the underlying assets. From the same source.

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