Macro

Today I interview Paul Moore, founder of the $2bn PM Capital, which runs two LICs, who sensationally calls on Treasurer Josh Frydenberg to finally close the loophole that allows listed fund managers to pay enormous 1% to 3% sales commissions to advisers to push their products as ASIC has repeatedly advised the Coalition to do. Moore says these selling fees are creating enormous distortions in retail behaviour and believes the new wave of illiquid junk bond LITs are "toxic time bombs". I go on to interview the patriarch of the LIC industry, Geoff Wilson, who says he will not defend commissions and, like Moore, strongly believes in a level playing field. Read the full column here or AFR subs can click here. Excerpt enclosed:

“Listed and unlisted funds are the same product being sold to the same client profile and should have the same rules,” says Moore, founder of PM Capital, a $2 billion equities and fixed-income fund manager that runs two listed investment companies (LICs) worth over $500 million.

Moore says the Coalition’s 2014 decision to grant LICs and listed investment trusts (LITs) a bizarre exemption from the 2012 Future of Financial Advice (FOFA) laws that ban payments from fund managers to advisers to push products is “distorting rational decision-making”.

“When you have an anomaly in capital markets, it gets exploited and it only takes a few rogues to destroy the credibility of an industry where the vast majority of players are very conscious of their duties as custodians of other people’s money,” Moore says.

He believes all fund managers should be governed by FOFA’s consumer protections, as was the case between 2012 and 2014, to ensure advisers are not corrupted by the conflict of interest that arises when they are paid real estate agent-like commissions of 1 per cent to 3 per cent to push funds to mums and dads.

“There should be no payments allowed from fund managers to the distribution system,” Moore says.

Moore has found an unlikely, and indirect, ally in the form of LIC patriarch, Geoff Wilson, who during the week told this columnist that he too is a “big believer in level playing fields” and “does not want to defend LIC/LIT commissions”.

The founder of Wilson Asset Management, which offers six LICs, argues the current debate has incorrectly mixed-up “two separate issues”. “At one end is the commission and conflicts debate while at the other end is the LIC/LIT sector,” he says.

In 2013 ASIC advised the Coalition government not to grant LICs/LITs a carve-out from the FOFA ban, finding that doing so would create a non-level playing field between listed and unlisted funds, and precipitate mis-selling crises.

For some reason the Coalition ignored this advice and in 2014 excised LICs and LITs from FOFA’s consumer protections. Interestingly, Wilson says he cannot recall any impact on LICs/LITs when the FOFA ban was in place between 2012 and 2014.

After Frydenberg sought ASIC’s counsel on the subject in July 2019, the regulator wrote to his department and advised that it could not rationalise “maintaining the exemption from conflicted remuneration for these products”.

Since the Coalition created the 2014 loophole, there has been an explosion in LICs/LITs with more than $20 billion raised from retail investors. And brokers are forecasting an “avalanche” of listings in 2020 from fund managers desperate to exploit the loophole for as long as Frydenberg allows it to stay in place.

Most of these products have been risky equity hedge funds, often with high levels of leverage, and illiquid high yield, or “junk bond” funds, containing unrated loans and sub-investment grade debt, which the fund managers are increasingly starting to leverage to further spike yields at a time when credit spreads on corporate bonds are lower than they were before the global financial crisis.

On Thursday, Labor’s shadow minister for financial services, Stephen Jones, wrote to Frydenberg asking the treasurer to “take a bipartisan approach to ending the obsolete exception to conflicted remuneration” for LICs/LITs.

Jones said Labor had deep concerns that commission-based selling of LIC/LITs was “creating a real risk for ordinary investors” and that there was an “urgency to the issue” because this week another “junk bond” LIT raising had been launched by US fund manager Neuberger Berman.

Neuberger will pay selling/transaction fees of 2.45 per cent to five different financial advice groups, totalling $18.35 million, to source $749 million in a few weeks. Combined with other ASX fees, Neuberger will pay-away more than three years’ worth of its management fee to secure this capital. It has already raised over $900 million since late 2018 using this commission structure.

Defenders of LICs/LITs claim these products are not being sold, but are demand driven because low rates are creating an appetite for income. They blame the LIT tsunami on the “search for yield”.

But if these capital raisings were driven by consumer demand, fund managers would be not be paying fees to secure the money. They would be raising it for free without commissions as is the case in normal FOFA-protected channels, such as via an unlisted fund or exchange-traded fund. They could alternatively offer an LIT that pays no selling fees, as Magellen recently did.

The fact LICs/LITs shelled out selling fees of almost $250 million in 2019 to raise money from mums and dads (institutions don’t buy these products) shows this is an unalloyed sales push.

Moore says it is “urgent” the Coalition restores the original 2012 FOFA ban because “I fear—in fact I know—the risk-reward trade-off on many of these new LITs is not at all understood by retail investors (and many so-called “sophisticated” investors)”. “Under the wrong market circumstances there could be real problems down the track—these new LITs could potentially be toxic time bombs,” he says.

Wilson likewise worries that retail investors do not fully comprehend that if they are getting a “significantly better return than cash, they may actually be taking on significantly more risk”. He is particularly concerned punters may not understand the risks they are assuming with illiquid LITs, citing the example of the billions of dollars raised via illiquid LICs from Allco, Macquarie, Babcock & Brown, Hedge Funds of Australia (HFA) and others before the 2008 crisis (and the introduction of FOFA’s protections).

These LICs/LITs invested in private equity, illiquid bonds, and risky alternative assets and initially performed well. But they inevitably traded at huge discounts to their net tangible assets (NTA) and ended-up disappearing or blowing-up. “When an LIC/LIT holds unlisted assets, it is hard to mark-to-market their value and assess their liquidity, which means they often trade at discounts,” Wilson says.

This is different to an LIC/LIT that holds listed equities where investors can transparently observe the value of the listed holdings, which opens up a theoretical arbitrage opportunity if the discount is irrationally large.

“The holy grail of investing is being able to buy an asset worth one dollar for eighty cents, as you can with some discounted LICs,” Wilson says. He currently has more than a dozen LICs in his funds that were bought at discounts to NTA after they listed. Indeed, Wilson specialises in taking-over the management of LIC/LITs that have blown-up, and says he has “four or five in my cross-hairs right now”.

This is, however, cold-comfort for the punters who bought at IPO and suffered poor performance, as most do.

Moore agrees that “history dictates you can almost guarantee most LIC/LIT raisings will sell at a discount to NTA after their listing”. And he questions, as ASIC has pointedly done, how advisers could be putting their clients’ money into new LIC/LIT issues when most end-up trading at an average 9 per cent discount to NTA.

Wilson says one possible driver of the post-listing discount is clients fleeing products when there is a mismatch between their expectations and experience. Another suggested by Moore and others across the industry is that “a small minority of advisers churn their clients from one LIC/LIT IPO to the next in search of the next commission payment”.

Advisers pushing the recent illiquid junk bond LITs counter that they have all traded near or above NTA since listing. But this is true of almost every illiquid LIT initially, with the recent Dixon US residential property LIT blow-up a case in point.

The Australian Financial Review examined the experience of 298 closed-end LICs that hold bonds and loans in the US, where the market is more mature. Like equity LICs/LITs in Australia, 75 per cent of these fixed-income LICs trade at a discount to NTA with the average discount a chunky 6 per cent.

Frydenberg’s advisers privately concede they have yet to hear anyone explain why LICs/LITs should, in fact, be granted an exemption from FOFA’s commission ban.

“The vast majority of advisers actually support restoring the commission ban,” Moore says. “They are genuinely concerned about the damage that may be inflicted on those that are being sold these LICs/LITs and the only real mystery is why the loophole has not been closed”...

Another concern with the recent junk bond craze is that corporate high yield spreads are today less than they were even before the 2008 GFC. Junk corporate bond spreads in the US are currently trading at 189 basis points above the US treasury yield compared to a superior 218 basis point spread in 2007. This is despite the fact that US corporate leverage is now higher than it was in 2007.

These high yield spreads compare poorly with the superior 292 basis point spread investors can currently get on 5 year major bank hybrids, which have a higher BBB- "investment-grade" rating.

Quantitative analysis shows that most global high yield bond portfolios are really equities risk in disguise. The Bloomberg Barclays Global High Yield Bond Index fell more than 40 per cent during the GFC and has consistently displayed equity-like returns and volatility since 2007.

Click here to read the full column.




Patrick Poke

We must've had the same thought at a similar time Christopher. I interviewed Paul last week too and am about to release it! Great choice of guest.