Magellan: mitigate LIC mis-selling risks

Today I write about an interview this week with one of Australia's most successful and innovative funds management pioneers, Magellan's Hamish Douglass, who says he would have no issue with ASIC applying the Future of Financial Advice (FOFA) laws to the burgeoning listed investment company/trust (LIC or LIT) space to address the huge mis-selling risks whereby fund managers are circumventing FOFA's ban on the payment of conflicted sales commissions to advisers pushing (often complex, leveraged and/or illiquid) fund products to mums and dads. Douglass reckons that at the very least there should be a cap on conflicted commissions, which he proposes should be no greater than what a broker earns on a normal secondary share purchase or sale (click this link to read online or AFR subs can try here). Excerpt enclosed:

"“A lot of LICs are free gifts to fund managers that look at them as a permanent source of management fees,” Douglass warns. “Magellan would have no issue if the rules changed and FOFA applied to LICs and listed investment trusts (LITs).”
Magellan oversees Australia’s largest LIT, the $2.1 billion Magellan Global Trust (ASX: MGG).

There has been a huge increase in fund managers using LICs and LITs to circumvent the FOFA rules and quickly raise vast volumes of capital from retail investors by paying advisers enormous conflicted sales commissions of up to 2.75 per cent. Under the FOFA laws, these commissions are banned when sourcing money from mums and dads via normal unlisted managed funds or exchange traded funds (ETFs).

Since September 2017 there have been 17 new LICs and LITs listed on the ASX, raising almost $8 billion through paying sales commissions in excess of $160 million.

Many of these products involve advising retail investors to shift out of safer asset classes (like cash, bonds and equities) into higher risk products (including leveraged hedge funds and illiquid high yield, or junk bond, portfolios), which consumers would ordinarily find difficult to understand and/or value properly.

Because LICs and LITs are “closed-end” investment vehicles, they also often price at a significant disconnect to their underlying net asset values (NAV). This contrasts with standard managed funds and ETFs, which as “open-ended” vehicles are always priced at NAV.

The worry is that when the cycle turns and these LICs start performing poorly, retail investors will have to exit at huge discounts to the portfolio’s NAV, thereby severely exacerbating their losses.

During the week CEO of the independent wealth adviser Koda Capital Paul Heath questioned how advisers could possibly act in the best interests of their clients when they are being paid conflicted sales commissions to push funds.

“Any payments of sales commissions to promote a product that contaminates clear-eyed and independent advice should be seen as just that,” Heath wrote. “This sort of ‘advice’ is completely compromised and utterly incompatible with the intent of FOFA.”

Read the full column here.

Separately, it was fascinating to read this story in the SMH today on the Senate blocking the ALP's franking proposal, and requiring it to be grandfathered, which would be a huge boon for existing equities and hybrids holders. There are going to be some very, very red faces if Labor does not have control of the Senate, which is likely, or, heaven forbid, if they lose the election. All the folks who have advised mums and dads to sell these securities to buy the other assets they are spruiking could be quite poorly judged by history:

"The party emerging as Senate kingmakers will punch a multi-billion dollar hole in a Labor government budget, after declaring its opposition to raising the top income tax rate and two of Labor's signature policies. Centre Alliance - formerly known as the Nick Xenophon Team - will block franking credit changes worth $5 billion a year unless they are grandfathered...In a Senate race that will define Labor’s ability to govern effectively if it wins the May 18 election, analysts believe the South Australian party is likely to have the balance of power in the 46th Parliament."