Never have we seen so much negative media attention on LICs and LITs (unless specifically mentioned, we will refer to both as LICs for convenience). There have been passionate and brutal attacks from those with and without vested interests, on both sides of the argument, with enough noise made to evoke a snap sector consultation from the federal government!
The scrap has now combined a number of different issues into one message; LICs have underperformed and therefore investors should focus on ETFs, unlisted managed funds and everywhere else but here. Below, we set out why we think now is a fantastic time to invest in LICs.
To disclose our own interests, one of the unlisted funds we manage invests solely in LICs. To be clear, we don’t operate an actual LIC listed on the ASX. Rather, a portfolio that invests just in LICs. No one forced us to start this strategy. We just believed that there is inherent long term alpha available in the sector over an investment cycle. And while it has been a difficult 14 months for LICs as discounts to NTA have increased, we believe the current opportunity available in the sector is better than it has been for a long time.
The following is our view of the LIC sector as professional active investors. We don’t get paid any stamping fees or give personal advice. We get paid solely based on the returns we generate for our unitholders. We hope to inject some rationality into the debate.
Separating the Issues
The attack on LICs has descended into a bit of a free-for-all, so let's separate out the issues and handle them one by one.
- LIC stamping fees.
- Buying an LIC IPO that is now trading at a discount.
- The LIC sector trades at a discount.
- The LIC sector charges high fees and underperforms the index
This is probably the main issue at present and relates to advisors/stockbrokers receiving a 1-3% commission from the LIC manager for their clients investing in a new equity raising. For us, it’s a non-issue, as anytime we have received a stamping fee for participating in an equity raise, the fee has been paid directly to our Fund for the benefit of all unitholders. Thus, the stamping fee has just added a small amount to the overall investment returns of the Fund.
We do see the inherent conflict in stamping fees, and have no doubt that it has contributed to the massive increase in FUM in the sector over the past 5 years. To be fair to the LIC managers, they have made sensible commercial decisions to raise FUM this way and can hardly be blamed for taking advantage of the opportunity.
And while the investing public may take issue with a financial advisor recommending a new LIC IPO to a retail client while receiving a stamping fee, we don’t believe the LIC sector can be blamed for some advisors potentially providing conflicted advice.
Reading between the lines, it appears likely that stamping fees for LICs are likely to be severely curtailed or banned altogether. This is likely to be a good outcome for existing LIC investors. The probability of new LICs getting away is very low in the short to medium term, which means the existing LIC universe should get more attention. This will help push up share prices and narrow discounts over time.
Buying an LIC at IPO that is now trading at a discount
We have selectively participated in a small number of LIC IPOs in the past, mostly where we believed there would be strong demand and a strong aftermarket. But we knew we were taking a risk by paying NTA for a new product rather than buying an existing LIC at a discount. We generally did ok out of these IPOs, but it was always a very small part of the portfolio. Mostly, we could never understand why someone would want to pay NTA (or even a premium to NTA) to invest in a new LIC when there was a whole sector trading at a discount to NTA. It didn’t make sense then, and it makes even less sense now.
We can’t comment on why other investors (or their financial advisers) participated so heavily in LIC IPOs. It does seem very plausible that the availability of stamping fees may have acted as an extra incentive. The investment lesson from this is not that because recent LIC IPOs are now trading at discounts, that the entire LIC sector is bad. Rather, the investment lesson is that buying LIC IPOs is probably not a good investment strategy for the average retail investor.
The LIC sector trades at a discount
It is true that LICs can trade at a discount to NTA for a long time. It is also true that LICs can trade at a premium for a long time. Based on our data, WAM Capital has traded at a premium to NTA since August 2013, at times up to a 30% premium. To us, buying an LIC at a 20-30% premium to NTA is completely unjustifiable. However, WAM Capital is a very large and liquid LIC with a very good long term track record. For those reasons, many investors appear happy to purchase and own it at these sorts of premiums.
The fact is, there is no “one” correct discount or premium for all LICs. We would never assume that the equilibrium discount for all LICs is par. Some may average around par, some may average a 5% discount, and some may average a 15% plus discount. The most important decision is what discount you purchase that LIC relative to its average.
For example, someone might buy an LIC at a 15% discount, thinking they have bought well. But if that LIC has historically traded on average at a discount of 20%, then chances are that they have actually paid too much. On the other hand, buying an LIC at a 10% discount that traditionally trades on average at around par, could be a very good purchase, even though it was purchased on a smaller discount.
The media articles that just state “the LIC sector is trading at a 10% discount to NTA”, miss the point. If all LICs naturally reverted to par, and it was normal for the entire sector to trade around par, then that would be a very easy investment process. But it’s just not that simple.
Even more importantly, when LICs are trading at far greater than average discounts, as they are now, it’s not the time to be encouraging investors to get out. Unless we have this the wrong way around, the idea is to buy low and sell high. This means buying when discounts are greater than average and selling when discounts are smaller than average. That would indicate that now is a pretty good time to buy.
LICs charge high fees and underperform the index
Some LIC do charge very high fees. But in many cases, the fees charged by LICs are less than the manager would charge in the same strategy in an unlisted fund. Perhaps the point people are trying to make is that active management fees are higher than passive management fees. This is true.
Whole books have been written on arguing active versus passive investment strategies. We are firmly on the active management side of the debate. That is, we believe that it is possible to identify active managers who can outperform markets over a full investment cycle. Having said that, we don’t want to try to convince passive investment believers to convert. If you don’t believe in active management, you are probably not going to invest in LICs, which is fine. However, recent underperformance and higher than passive management fees are not unique to LICs. They are issues that have impacted actively managed unlisted funds as well.
There is no doubt that passive investing has worked very well over the past 5 years. But then again, there has been no reward for risk management over this period either as markets have quickly recovered from any short term pull backs to forge new highs. In addition, momentum has favoured the largest stocks and created historically significant divergences in pricing between growth and value stocks. These are not conditions in which active managers generally thrive. But these conditions are cyclical, not permanent, and we don’t believe these trends will continue forever.
Why buy LICs now?
Everyone likes backing winners. Think of punters rushing to buy Sydney houses at the very top of the market, exciting tech companies that have total addressable markets equal to three times world GDP and investing into the share market after a 20% plus year. But it doesn’t normally work out well for investors who jump in near the top.
Likewise, it is human psychology to not want to own an investment when it has gone less well, and everyone is pointing out why it is doomed forever. This would appear to be one of those times.
We agree that the LIC sector is probably better off if stamping fees are banned, which will dampen IPO activity. We feel for investors who have a significant proportion of their portfolios in LICs held since IPO that are now trading at deep discounts and sitting on significant losses. And yes, many LIC managers (as well as many unlisted fund managers) have underperformed the index recently. But we don’t believe this set of circumstances make LICs a poor investment choice.
A few examples
As an example of the opportunities on offer, the following all appear very attractive:
- Future Generation Global (FGG),
- Blue Sky Alternatives Access Fund (BAF), and
- Tribeca Global Natural Resources (TGF)
FGG is a fund of funds that boasts an investment management line-up second to none. The underlying managers forgo all their management fees, and instead, the company charges a 1% fee that is donated to charity. Since inception FGG has traded at an average 1% discount to NTA, however at the moment we estimate the discount is around 17%, making it a very attractive entry point.
BAF is the alternatives fund that was set up by Blue Sky and is in the midst of attempting to change investment managers. This has taken a lot longer to play out than many expected, however, it cannot continue as is, and at some point, major changes will be made. BAF is currently trading at a 26% discount to NTA, and we believe a wind-up proposal is increasingly becoming the most appropriate action to sort this matter out.
Lastly, TGF is a long/short equity strategy plus resources credit exposure that was first listed just over one year ago. The manager has an excellent track record with this strategy, however given investor concerns regarding China and the coronavirus the share price has plummeted recently, and we estimate is now trading at a 25% discount to NTA. While resources could be a rocky sector in the short term, we believe the sector is substantially cheaper than most assets on a medium-term view, and when the reversion potential is realised, we expect the discount to close rapidly.
There are many more LICs like this. Right now, we are invested in a portfolio of over 30 LICs. They have an average discount of nearly 17% and manager quality has never been better. To contrarians like us, that seems like a rare opportunity.
Find out more
We encourage you to do your own research before making any investment. A great LIC, investment fund or manager is only part of the story. We also like to make sure they’re trading at the right price and that the assets they are investing in are not themselves overvalued. We explain how we do this in our LIC Guide and our Managed Funds Guide, but in the end, it’s up to you to make the investment decision that’s right for you, in conjunction with your financial advisor if you have one.
Take care and all the best with your investing.
Nicely balanced article.
I think your estimated discount for TGF is off the mark.
Well written Daryl. I agree about the over emphasis on the stamping fees. Best to get rid of them and allow industry participants and investors focus on more fundamental issues like: how do these significant LIT/LIC discounts and premiums arise? It’s gotten to the point where prospective returns are as much determined by discounts and premiums as performance of the underlying assets. A ridiculous situation the lay investor is scarily equipped to anticipate. This has occurred under relatively benign market conditions. Fear and greed driven market dynamics can ramp way up from here, in which case perverse outcomes for investors will become even more pronounced. Sentiment is always a factor in asset pricing but combined with a shallow pool of unsophisticated buyers and sellers e.g. smaller closed end LIT/LIC’s and the convenience of real time trading and the roller coaster is all set. Best to state I don’t actually think there is anything wrong with these structures theoretically, but a lot of investors have been blindsided by the prevalence of large discounts and premiums. It may create opportunities for those who better understand the double whammy effect of recent portfolio performance on current LIT/LIC pricing, but was that the goal? Seems like an unintended consequence to me. For the average punter this amplified volatility sits well outside of their comfort zone. The industry needs to get on top of this issue in a hurry, otherwise the regulators will.
In my opinion, the vast increase in LIC IPOs in recent years caused 2 effects. 1) New LICs IPOd so that a perceived market demand could be met. The new managers had no established profile or history in the LIC market, so they needed sellers to market them. Quite naturally, the establishment costs meant that some raised funds had to be withheld causing NTA to be less than par. How much less depends on the included costs recovered. 2) When the post IPO share price was discounted to NTA, disillusioned investors exited to participate in the next IPO which promised it would be the best performer, only to become disillusioned again. 3.) Some LICs have performed poorly so that exiting investors have caused their share price seriously discounted, sometimes temporarily, sometimes permanently. Similarly, some LICs have performed consistently well so that knowing investors swarm to them and cause the significant premiums some trade at. So I see the problem as being too many LIC products being sold to investors inexperienced in LICs and LIC managers of varying degrees of competence or luck. Graham