The issues around performance of LICs/LITs, which is impacting the debate on stamping fees, should be addressed fairly and objectively, not by flawed analysis, aggressive lobbying by industry participants or sensationalist media coverage.
Proper returns analysis of LICs/LITs (and LICs in particular), is more complex and nuanced than many perceive and needs to be multi-dimensional. A range of mistakes can easily be made and ASIC’s recent analysis, made available as part of a Freedom of Information (FOI) request by the AFR, and the basis of advice to Treasury/Government, has made most of them.
Simple analysis of share price plus raw dividend returns to 30 June 2019, which has been the basis for ASIC’s case for poor performance of 48 LICs/LITs listed since 2015, is obviously relevant to investors, but is far from the full picture. Further, there are some major errors in ASIC’s raw numbers which significantly distort the results.
The multiple complexities of LIC/LIT performance
There are multiple dimensions to LIC/LIT performance that have been largely or totally ignored in the ASIC analysis and the media commentary surrounding it.
Firstly, share price plus dividend return is driven not just by underlying NTA return (what the investment manager delivers less fees and tax in the case of LICs) but by the starting and ending price relative to NTA (i.e. discounts/premiums) and is very sensitive to ending discounts. Neglecting these dynamics and looking at investor experience at one point to point time period can result in a misleading judgement on longer term investment performance. Indeed, because of this discount/premium factor, past performance of LICs, more so than other fund structures, is typically a poor and usually contrarian, indicator of future performance.
Secondly, because of tax paid and payable, a larger part of a LIC’s return is typically franked dividends so a simple comparison with unlisted funds/ETFs without considering the different taxation arrangements is inappropriate and can understate LICs returns. LICs also usually have franking credit balances reflecting previous tax paid that can benefit investors in the future. This contrasts to unlisted funds that typically have a large unrealised, but largely hidden, capital gains tax liability which will eventually be distributed and taxed in investors hands, lowering after tax returns.
Thirdly, some of the LICs/LITs listed since 2015 involved an initial issue price at a premium to NTA of 3-4% because investors paid all the costs of the issue (stamping fees were part, usually around one third to one half of these initial costs). Investors in LICs/LITs started with this additional drag on performance compared to an unlisted fund or ETF. More recently, managers of LICs/LITs have met this cost, a significant and welcome improvement on prior LIC/LIT investor experience, and this has become the standard model of LIC/LIT capital raising today meaning investors now typically don’t pay any initial costs, including stamping fees, and have the benefit of a starting NTA equal to the issue price. It should also be noted that some recent offerings, MHH and VG8, have provided IPO participants bonus units or shares in the listed manager (as well as paying issue costs) such that investors are effectively buying in at a discount to the issue price/initial NTA.
Fourthly, in the case of around half of the 48 funds listed since 2015 in the ASIC analysis there were listed options attached as part of the IPO. ASIC have ascribed no value to the ability of investors to realise value by selling these options on market or in exercising those options that were “in the money” on or before expiry. Importantly, in cases where options were in the money and exercised, those investors received a return benefit by being able to purchase at a price below market, although NTA would have suffered dilution from these option exercises, which would drag down performance as measured by the share price alone. This has been ignored by ASIC and by other assessments of LIC performance.
Fifthly, in many cases advisers rebate part or all the stamping fees to investors so the effective return since inception has been higher by the amount of this fee rebate. (Stamping fees are typically 1-2%, not the much higher levels some media commentators have been quoting). It is difficult to determine the amount of rebating that goes on but it seems to be significant amongst financial planners and is likely to increase under stronger enforcement of the investor best interest duty and the FASEA Code of Ethics that came into effect from 1 January 2020.
Sixthly, ASIC make a point that LIC/LITs have significantly higher fees than ETFs yet have “underperformed”. Almost all active funds (listed and unlisted) have significantly higher fees than passive funds/ETFs, and in recent years active funds on average, irrespective of the fund structure, have underperformed the market indices and ETFs that track them. This is only part of the picture. Interestingly, despite the importance of judging performance of the LIC/LITs since inception nowhere does ASIC provide ETF or market index numbers that equate to periods since listing for each of the funds. (providing 1-year and 5-year numbers only).
Finally, and related to the previous point, the ASIC analysis of 48 funds simply looks at raw absolute performance and not against their own relevant benchmark. Many of the LIC/LIT funds that have listed since 2015 adopt specialist investment strategies including long/short, market neutral and income focused. These strategies generally aim to have a lower risk profile than equity markets, would be expected to lag in a strong sharemarket and should not be naively compared to equity markets or equity ETFs.
Related to this, risk in listed closed end funds is also partly dependent on the current discount/premium to NTA, and in almost the opposite way that investors perceive. Investors seem to only perceive discounts as an additional risk of the LIC/LIT structure, but once a fund trades at a discount, especially a large one, it’s return profile from that point is more positively asymmetric (all other things equal). A fund that has moved to a discount may show poor returns looking backwards but that bigger discount usually means the risk of further poor performance is reduced and the likelihood of good performance higher. This needs to be considered in any “point to point” performance comparison, especially if the end point is a period of above normal average discounts, as is the case with the ASIC analysis which ended in mid-2019 when LICs in particular were still suffering from earlier concerns of possible franking credit changes and end of financial year tax loss selling.
Rebound in numbers ignored
If ASIC had updated their analysis (according to the FOI material they were still using the same 30 June 2019 figures in PowerPoint presentations dated as late as 27th November 2019) it would be clear that many of the funds that were the worst performers since inception and over 1 Year to June 30, 2019, have actually had particularly strong performance since. The table below shows the subsequent performance of the 10 worst funds as defined by the ASIC analysis (excluding the ASIC errors/exclusions described below) for the 6-month period between June 30 to 31 December 2019. The commonality of funds in ASIC’s worst 10 since inception and the 1-year numbers shows their sensitivity to end discounts. This mean reversion tendency of discounts that contributed to these improved returns is a key differentiating characteristic of listed closed end funds.
Interestingly, at the same time the AFR was breathlessly reporting the ASIC LIC/LIT performance analysis, fund manager Hugh Dive wrote an AFR opinion piece “Shifting through the trash for stockpicking treasure” which opened “The greatest returns on the stock market rarely come from buying the well-loved stocks whose share prices have performed strongly, but rather from unloved companies that outperform expectations.” Many recently discounted LICs fit into the latter category.
Of course, there are some exceptions to this mean reversion tendency. Some poorly managed funds can continue with even worse performance, higher discounts and very occasionally there are funds subject to fraudulent behaviour that results in total or near total loss (see the pirate funds below) but it’s not as if the unlisted fund space is immune from such problems.
Some of the ASIC data is wrong, and not in a minor way
Even if one totally ignores the range of complex issues around assessing LIC/LIT performance discussed above and accepts ASIC’s simplistic, point to point approach to LIC/LIT returns, there is a fundamental problem that some of its key data is simply wrong, and by major margin. Most concerning is that three of the funds that ASIC data highlight as amongst the worst performers since inception were far from it and using correct figures changes the ASIC result significantly.
Three funds that ASIC got the since inception number wrong in a major way are,
- NGE (NGE Capital Limited) - this was a conversion of an existing company to a LIC in November 2016 and ASIC show it with a return since inception of -42.0% while the fund actually returned +52.6% to 30 June 2019 and has been one of the better performing LICs on the market.
- AYZ (Australian Masters Yield Fund Number 5) is a LIC that invested in Australian corporate bonds and has been in wind down and is shown with a return since of -56.9%. Yet it seems no account has been taken of the capital returns and dividends paid in that period. Conservatively adjusting for these capital returns and dividends (i.e. assuming no reinvestment) results in a return since inception of +11.8%.
- SEC (Spheria Emerging Companies Limited) is a LIC that listed in November 2017 and is shown with a massive negative return of -97.0% since inception and an end price of zero from a $2 issue price. While SEC’s value style has not been in favour, actual returns since inception to 30 June 2019 was just -7.5% including 6c cents in franked dividends and incorporating a move to a mid-teens discount to NTA. (Disclosure - I own this fund currently and believe it is an attractive investment opportunity at the current 15% discount).
One other problem with ASIC’s numbers is it is not clear where the -6.1% average return since inception came from. .Even before any adjustments to their own spreadsheet, it seems the average return since inception on 48 funds is -4.5% not the -6.1% in the ASIC presentations. The -6.3% for 1 year seems consistent.
In any case, correcting returns for just the three funds discussed above changes the since inception number in the ASIC analysis for the 48 LICs/LITs to +0.7% (compared to ASIC’s -6.1% and the spreadsheet number of -4.5%). The 1-year number remains in line with ASIC at -6.3%.
It should also be noted ASIC analysis of LICs/LITs throughout assumes no reinvestment of dividends or capital returns as is usually standard for fund performance calculations. This would generally understate the LIC/LIT returns, especially since inception, but to keep things simple I have adopted the same approach in the adjustments above.
Pirates blast more holes in ASIC analysis
But wait, there’s more. Complicating the analysis further are the two pirate themed funds (HML and BHD) which the ASIC FOI material describes as frauds and which are now delisted.
Being delisted, but still in existence, the ultimate outcomes for these two funds are unclear although it doesn’t look good for investors. ASIC has assumed a zero end value for both funds which, once dividends are included, gives an investment return of -80% for HML and -88% on BHD since inception.
ASIC has also used the same -80% and -88% returns for HML and BHD respectively over one year to 30 June 2019 despite HML not having traded since June 2017 and BHD since July 2018.
There is no doubt that these two funds have been disasters for investors although there were some clear early red flags. (I tried to warn some investors off these funds in mid-2017 and wrote about them in a late 2018 Livewire article “Looking out for pirates in LIC land”. Perhaps if ASIC had been more proactive, HML and BHD wouldn’t have morphed into the pronounced and prolonged shipwrecks they became.
In any case, given fraudulent funds are a rarity in the LIC/LIT space, I believe they should be excluded from the analysis if one is primarily trying to understand returns from legitimate offerings, and the implications of stamping fees, in the LIC/LIT space. Certainly, it seems odd to also include them in the one-year numbers (with the same numbers as since inception) when HML did not trade at all and BHD for only one month of that period.
Therefore, if we now correct for the three major ASIC errors above (NGE, AYZ and SEC) and also exclude the two pirate fund frauds HML and BHD, then under a simple analysis of 46 LICs/LITs that IPO’d since 2015 the returns since inception to 30 June 2019 is actually +4.4% (compared to ASICs original figure of -6.1%) and -3.0% over the one year to 30 June 2019 (compared to ASIC’s -6.3%). These are summarised in the tables below.
The change in the since inception number is very significant given poor returns since IPO is the core tenant of ASIC’s criticism. In a presentation by ASIC Senior Executive Leader Market Supervision, Calissa Aldridge entitled “A fair strong and efficient financial system for all Australians” the only non-redacted slide included only one return related dot point saying, “Poor performance – overall aggregate returns -6.1%.” In my view this should be at least +4.4% and far from the disaster parts of the media have painted.
Some might counter that even the corrected performance numbers are still subdued in absolute terms. However, these numbers don’t include any adjustment for the other complexities of LICs/LITs discussed above (including simple reinvestment of dividends). Moreover, they are still substantially understating/distorting LIC/LIT returns because they are not adjusting for issues including option dilution, different tax structure/higher franked dividends, the change in the IPO upfront cost model from “investor pays” to “manager pays”, stamping fee rebates or properly incorporating the implications of movements in discounts/premiums.
One should also note that the median time since listing of the 46 funds covered is only around 2 years. As I discuss further below this is far from the ideal time period to assess performance of LICs/LITs given the typical, albeit far from certain, move to a discount over the first 1-2 years.
Fortunately, there are few true pirates in LIC/LIT waters
In contrast to the impression from some media commentators, the idea that LIC/LIT IPO are frequently paying high stamping fees of 3% plus and as high as 6% is simply false. Even according to the ASIC analysis of 48 IPOs since 2015, 69% of the funds had stamping fees of 1.5% or less and 92% had stamping fees of 2.5% or less. i.e. only 4 of 48 funds had stamping fees higher than 2.5%. As noted above in some cases these stamping fees were paid fully or substantially to investors via rebates.
It is no real surprise that the two pirate funds account for two of the four stamping fee outliers with HML at 4% and BHD at 3%. One of the other two outliers is MMJ at 5% (an existing listed company converting to a LIC in 2018 and holding a collection of cannabis related investments. However, as far as I can see the 5% stamping/selling fee applied to a capital raising before the fund converted to a LIC.
The last outlier is LRT at 5.5% (a small resources unit trust that converted from an unlisted trust and raised a minimal $3.5 in the listing process in early 2018 - that’s a maximum total stamping fee of around $192k).
Given the unique circumstances and small scale of these 4 stamping fee outliers, I believe they should all be excluded from the analysis as not being representative of the standard stamping fee arrangements in the LIC/LIT sector. Clearly, any LIC/LIT raising money today would not have stamping fees anywhere near these levels.
One of ASIC’s conclusions is that LIC and LITs with stamping fees underperform those without them on average. According to ASIC, since inception, funds with stamping fees returned -7.3% while funds without stamping fees returned +3.0%. For one-year ASICs figures were -7.0% and -1.9%.
This is one of the few conclusions from ASIC’s analysis that does stack up, and once ASIC’s error on NGE corrected, on the since inception number, even more clearly than their own numbers suggest. The 6 funds with no stamping fees were OPH, AGM, EAF, FOR, NGE and RYD. When you correct for ASIC’s errors on NGE, the average return since inception for those with no stamping fees since inception jumps to 18.7%.
Having said that, given only these 6 of the 48 LICs/LITs didn’t have stamping fees, and 5 of those 6 were conversions of existing listed entities across widely divergent strategies, I would suggest it is simply too small a sample to draw any sensible conclusions.
Should stamping fees be capped? Perhaps, it would certainly more definitively prevent outliers like the four discussed above but if capped at a level of 1-2% this would be broadly in line with where most of the industry already is.
ASIC’s key charts ransacked by errors and pirates
The core of the ASIC PowerPoint presentation is three charts that purport to show;
- A correlation between the level of discounts and the level of stamping fees. Slide 5 “Conflicted Selling Incentives and Discounts to NTA”
- A correlation between stamping fees and 1-year performance to mid-2019. Slide 6 “Conflicted selling incentives and Recent Year investment outcome”
- A correlation between stamping fees and returns since inception. Slide 7 “Conflicted Selling incentives and Investment Outcomes since Inception”
With performance numbers corrected for errors, and the sensible exclusions I suggested above, I believe ASIC’s charts and numbers prove none of these correlations/conclusions with any conviction.
The first ASIC chart “Conflicted Selling fees and discounts to NTA” attempts to show that higher stamping fees are correlated with bigger discounts to NTA.
However, if you take out the two stamping fee outliers (MMJ and LRT, HML and BHD are already excluded) then it is difficult to see any significant correlation as ASIC suggest. Interestingly, NGE which had no stamping fee, and was one of the best performers since inception, traded at one of the larger discounts to NTA at 30 June 2019.
The second chart “Conflicted Selling Incentives and Recent Year Returns attempts to show a correlation between stamping fees on the Y axis and investment returns on the X axis for the one year to 30 June 2019. However, if you correct for ASIC errors and take out the four outlier stamping fees of 3% or higher there doesn’t seem to be any correlation. Indeed, the worst one-year return outcome came from a fund with no stamping fee, FOR with -39.4%. FOR was a conversion of an Australian unlisted trust to a LIT.
ASIC’s third chart “Conflicted Selling Incentives and Investment Outcomes since Inception” looks at the same relationship since each fund’s inception. “However, again if you correct for the three major ASIC return errors and remove the 4 stamping fee outliers, visibly there is little if any relationship between the size of stamping fees and investment performance.
Clearly, few robust conclusions can be drawn from these charts, even before properly considering some of the other complexities of LICs/LITS raised above.
Discounts/premiums - the waves that complicate the LIC/LIT return story
Clearly, a large part of performance since listing in the ASIC numbers was the move, since inception, of many funds from trading at NTA or a premium to NTA (if investors paid the initial costs) to a discount at June 30, 2019. (Average 10.7% discount on ASIC’s numbers).
It is no real surprise that LICs and LITs typically tend to drift to a discount in the 1-2 years after listing. Irrespective of whether stamping fees are paid or not (or rebated to investors) there is a degree of promotion required to get a LIC off the ground in the concentrated capital raising period required and in this process some investors tend to purchase with only limited understanding of what they are buying. When the initial enthusiasm wanes there tends to be a period where selling pressure overwhelms new buying interest, unless the manager/board does an exceptional job marketing the fund to new potential investors. (As noted above the median period of listing in the ASIC analysis is only around 2 years).
Many investors and commentators, and even fund managers, misunderstand the reasons for, and nature of, fund discounts. On 3 January Chris Joye in an AFR article “Frydenberg faces up to mis-selling crisis” wrote “ Managers regard LICs and LITs as especially attractive because they have very high fees and provide permanent capital that cannot be redeemed which is why they often trade at a substantial discount to their Net Tangible Asset value (NTA)”
High fees may contribute to some funds trading at a higher discount (although ASIC data doesn’t make such a case) but the explanation for discounts more broadly is much more nuanced. Indeed, there is no such thing as “permanent” capital in the LIC/LIT space – “semi-permanent” perhaps. Managers that don’t perform in the medium to longer term, or boards that fail to manage capital well for shareholders, will eventually be replaced or terminated.
While investment management fees on some LICS/LITs could be lower, particularly since investors are locking up capital and taking on the discount risk, the view that LIC and LITs are a near risk free, business gravy train for fund managers is misguided. After 1- 2 years of listing most managers and boards realise that to run a fund well they need to perform from an investment perspective, market the story well and manage capital efficiently. The higher public profile of these vehicles and the tendency of activists to bring reputational risk to managers that don’t deliver on these levels creates considerable challenges that most fund managers and boards seriously underestimate at IPO.
Several funds have recently responded to the pressure of trading at persistent discounts by announcing actions to convert to unlisted trusts or active ETF structures e.g. MA1, EGI, two Watermark funds. There have even been wind-ups such as the case of 8EC. The potential for the introduction of such discount narrowing/elimination measures is one reason why the return outlook for LICs/LITs is more positively asymmetric, and risk lower, once a fund is trading at a large discount.
The listed closed end structure is different, with different issuance arrangements and unique features and benefits
Discounts and premiums are one of the key distinguishing features of the listed closed end fund structure. This structure comes with a range of benefits not available to unlisted, open ended structures. For example, the closed-end nature provides more certainly of the asset base and a lack of vulnerability to inflows/outflows that allows the manager to invest in ways impossible, or more difficult, for open ended unlisted funds.
LICs/LITs can be fully invested without cash drag, or even geared if appropriate, without
the usual fear of being forced to sell assets at the wrong time. They are a more robust vehicle to invest in less liquid listed assets or in illiquid assets for similar reasons, while still providing the secondary market for those investors who require liquidity themselves.
LICs also provide greater ability of the manager/board to control and smooth dividends, a valued benefit for many shareholders, especially retirees.
There is also the ability of the listed closed end structure to manage capital efficiently and reward patient, long term investors by adding value/return through buying back shares at discounts and/or issuing shares at premiums. This is a tool that is not in the arsenal of unlisted funds.
Of course, there are some disadvantages of LICs. For example, they generally don’t have access the capital gains tax discount (Although LITs may). The tendency to trade away from NTA is another “disadvantage” although depending on your perspective, this can also be an advantage and opportunity.
The listed closed end structure usually can only come into existence however, through the concentrated short-term capital raising arrangements that applies to all listed companies.
A more holistic view of stamping fees/conflicted remuneration on listed investments is required
The costs of new issues of all listed securities have always been paid through a one-off approach given the concentrated capital raising period. Stamping fees are one element of these initial costs. This concentrated capital raising approach puts time and assessment pressures on advisers/stockbrokers considering the investments for client portfolios, whether they be company securities, hybrids or property, infrastructure or investment funds.
Without compensation to meet the costs of groups who operate primarily or totally on a transaction basis, a significant hurdle is erected for quality, specialist managers seeking to access the benefits of the listed closed end investment structure for their investors, in the same way that smaller less well-known companies would have greater difficulty raising capital without stamping fees.
Of course, I suspect there are a few rogue stockbrokers or advisers that are mis-using LICs/LITs and even contributing to larger discounts and poorer short term returns by driving some of the short- term, post IPO selling for irrational and sometimes unethical (churning) reasons. Most of these vehicles are meant to be long term investments, with listing providing a liquidity option for those that need it. ASIC is right to recently flag that it will increasingly conduct ongoing audits of stockbrokers and advisory group assessing the ongoing actions around LICs/LITs beyond the IPO phase to assess the basis for recommendations.
However, ASIC should be thinking a few steps ahead about any proposed structural changes. If LIC/LIT stamping fees were banned yet they remained on a range of other listed securities, those few less scrupulous brokers/advisers that are chasing and abusing such fees will simply change the way they build portfolios and find ways other ways to game the system and exploit clients such as using more securities where stamping fees still apply or simply churning their portfolios more across secondary issues.
ASIC might argue that the client best interest duty should prevent such behaviour as should the recently introduced FASEA Code of Ethics. However, shouldn’t those obligations also be the case whether stamping fees are in place on LICs/LITs or not? i.e. Shouldn’t we allow client best interests duty and commitment to ethical behaviour drive decisions around whether advisers/brokers receive some or all these stamping fees or instead rebate them to clients, particularly with most stamping fees in the 1-1.5% range?
If an investor was paying an annual advice fee to a financial planner or wealth manager and they recommended a LIC/LIT IPO, client best interest would suggest that any stamping fee should be fully or largely rebated to the client. But could a stockbroker whose business relies largely or exclusively on transaction fees and other financial services group groups that are making the fund available directly to clients be justified in receiving a small stamping fee for the work involved in orchestrating the concentrated nature of these closed-end, listed offerings? I find that hard to argue against, particularly while stamping fee arrangement remain in place for all other closed end listed investments and listed companies.
Focusing on the right issues
The intention of the original “carve out’ in the law was to distinguish between companies that pay stamping fees “to secure debt and equity capital for productive companies” that “made goods and provided services”. What about a LIC that only invests in private equity or a LIT that only invests in private debt? Aren’t they providing new debt and equity capital for businesses that “made goods and provided services”?
What about AREITS which along with LICs were originally planned to be excluded from the carve out? or infrastructure funds? or hybrids? What about an internally managed investment conglomerate such as SOL?
If stamping fees around LICs and LITs are now to be reviewed again then perhaps so should stamping fees on all listed securities because they are all used by advisers and stockbrokers to build client investment portfolios.
Where is the ASIC analysis and discussion on these issues? Instead, partly due to lobbying and media pressure, they have pursued a relatively small segment of the investment universe by providing a simplistic, backward looking, flawed analysis that fails to appreciate the unique aspects of the LIC/LIT structure and the origination process that brings them about. ASIC has also failed to provide any forward assessment of how adviser behaviour would change, and consumers be impacted, in a lopsided world where stamping fees are payable on some closed end listed vehicles and companies, but not others.
The listed closed end investment structure exists because it has long term benefits to investors and has stood the test of time. The structure has been around in Australia for almost a century and considerably longer in some other countries.
Meanwhile a range of other conflicted remuneration arrangements remain firmly in place
If ASIC and the Government are truly concerned with eliminating conflicted remuneration in the fund space, perhaps it should re-examine some of the remaining, more pervasive and anti-competitive conflicted remuneration arrangements in financial services. For example, fund manager sponsorship of adviser conferences and “education” programs, some platform arrangements or even the “pay for ratings” research house model.
This fund manager financed, “pay for ratings”, research house model has influence over a much broader array of investment products compared to the $50billion in LICs/LITs. Fund managers pay research houses to research/rate their product and this research/rating is then used by financial advisers to support product recommendations to investors.
Advisers/licensees benefit from this conflicted payment by generating more profit than they would otherwise by relying on fund manager subsidize research rather than either building the in-house resources to do the research themselves or paying an “independent”, non-conflicted party do it. This conflict, along with some others, has been put in the “too hard” basket by ASIC for many years now.
Have there been a lot of complaints about stamping fees on LIC/LIT IPOs from investors? (and not just certain financial services groups and sections of the media). As provided in the FOI material an ASIC Senior Specialist stated via email in August that “we weren’t able to extract complaints due to that level of granularity.” This looks like a case of media (and lobbying) pressure pushing ASIC to conceive and grow a problem that didn’t exist or was much smaller than was being made out. Today that offspring is making a lot of noise but not being constructive for anyone.
Indicative of this pressure from competitors, it is notable that in one of the earlier ASIC presentations, dated 12 September 2019 , there was an additional slide 11 titled “Industry research by Stockspot” simplistically promoting the case for ETFs over LICs. The Stockspot paper behind the points on that slide contained many of the same flaws as the ASIC analysis (e.g. not accounting for tax differences, options or risk etc.).
The ASIC analysis and competitor and media commentary around it has clearly missed the complexities and nuances of LICs and LITs. The same Senior Specialist for ASIC stated via email in August that “It is hard, on the historical data available, to justify maintaining the stamping duty exemption from conflicted remuneration for these products.” However, if a case is to be made for banning stamping fees on LICs/LITs it should be based on analysis that is objective, broad in scope and reliable, not just backward looking, overly narrow and flawed. Proper assessment of LICs/LITs returns is difficult, and errors easy to make, but this means judgements and policy decisions need to be approached cautiously.
Are there some LICs/LITs that will perform poorly in the years ahead? For sure. Do investors need to be cautious buying into LIC/LIT IPOs, particularly “flavour of the month” asset classes or managers? Definitely. Are there some funds whose share price will move from trading at NTA at IPO to 10%, 15%, or even 20% plus discounts in the future, showing disappointing returns, at least in the short/medium term? For certain. Will such moves provide some attractive investment opportunities? Almost certainly yes. Will there be more frauds like the pirates? Hopefully not, if ASIC and the industry do a better job of vetting them out.
Does any of this mean the LIC/LIT structure is flawed and investors generally have been systematically mis-sold the LIC/LIT concept, even with modest stamping fees being paid? No.
Can poor absolute performance occur in unlisted funds and ETFs? Of course. Could LICs and LITs, properly adjusted for tax and other differences highlighted above, significantly outperform unlisted funds/ETFs in the next few years, especially from recent above average discounts and in more difficult market conditions more supportive of the value and specialist/income strategies more common in LICs/LITs? That outcome must be a reasonable probability.
This excessive focus on LICs/LITs raises the chances the industry is neglecting other products where the risks of permanent losses are high. Spare a thought for unsophisticated investors who pass the outdated and feeble hurdles of ASIC’s wholesale investor tests and continue to be drawn into some deeply flawed unlisted products such as IPO Wealth/Mayfair Platinum, whose forward looking risk/return profile and liquidity mismatch is much more concerning than the vast majority of the LIC and LITs listed in recent years (pirate funds excepted) and despite these products targeting conservative investors. See “IPO Wealth/Mayfair Platinum – the scary end of the rush for yield” December 2019.
Rather than a toxic battle between supporters of different fund structures, financial services participants need to better understand and appreciate the unique characteristics and advantages and disadvantages of each, aiming to develop a healthy industry framework for all. This allows for a greater industry focus on creating products that deliver for investors and weeding out poor quality ones, irrespective of the fund structure. In today’s emotive and time-consuming discussions about competing structures (and LICs/LITs in particular) this crucial focus is being neglected, with investors the ultimate loser.
Dominic McCormick is an independent investment consultant. Amongst a range of roles across the investment industry, Dominic has also recently been contracted by LICAT to provide independent commentary and input on issues impacting the closed end listed investment fund space. LICAT has no editorial control over the content of any articles written under his own name and Dominic has not been paid by LICAT or any other party for this Livewire piece.
Good article. Haven't read the ASIC piece, however they do seem to miss far too much. LICs form an important part of my investment strategy, specifically buying decent LICs when at what I consider a too high discount. PGF an example of a good manager, good past returns, overly large discount. Lots of companies perform poorly, and lots do well. LICs really just reflect what we see in the market overall.
Spokesperson for the LIC industry award goes to.... you guessed it. Makes some valid points, but talk about a skewed and biased view. Just as ASIC made fundamental errors, so has this report in glossing over the well entrenched issues of closed funds. Their performance using any scale has been sub-par - even when you account for the benefit of franking and reinvestment. Talk about trying protect stamping fees for the boys... :(
A beautiful piece of thought
Many very good points in this dissertation Dominic but also several that are questionable, not all of which I'll explore here. As you say, advisers generally aren't prepared to do the work or employ capable researchers to do this work for them, which enables all sorts of suboptimal investment results and market misallocations to flourish - it also provides good opportunities for those who are prepared to do so. In contrast, the market in general appears much more complacent and less activist than you suggest and as it should be with respect to holding poorly performing LIC managers to account, of which there appear to be many - this stands in stark contrast to some overseas markets I consider. Furthermore, there are many LIC managers with greater FUM than they deserve to have - and which frankly are pretty ordinary custodians of people's money - which has come about given how they have been sold. One could easily argue the space in general in Australia deserves to trade at a discount to NAV (which strangely enough it often has! - I expect this will continue). Furthermore, I think Chris Joye's arguments are in essence correct, unlike what you suggest, and that he understands some managers' incentives well. You strike me as very supportive of the Australian LIC space, but if considering a global perspective, there appear to be far better opportunities for investors considering LICs and similar vehicles in overseas markets.
its pretty obvious that the vast majority of LIC IPO are a bad idea. doesnt really matter why, but why bu something at NAV when its almost certain to go to a large discount. any finacial advisor that thinks an LIC IPO is a good idea is negligent
The fact is that ASIC and other regulators care nothing about a fair and objective analysis. A commission is being paid by the product provider to the seller and therefore ASIC will stop at nothing to have it banned and that is that.
Jerome, I’m supportive of the LIC structure against invalid criticism and supportive of good quality LICs, especially if available at a nice discount. I’m far from supportive of poorly managed LICs and would like to see more LIC/LIT holders pushing boards/managers to be accountable when they don’t perform or manage capital well over a reasonable time frame. It would be good it you could clarify which of Chris Joye’s arguments you agree with - was that the one about there being a “mis-selling crisis” in the space, that LICs/LITs are paying stamping fees up to 6% or his recent tables “proving” poor performance in 2019 that contained most of the same flaws as the ASIC analysis.
I like your analysis Dominic but I believe it is a little one sided. You have excluded some key facts, particularly around the FoFA conflicted Rem rules that the Liberal Government carved out for LICs. Despite what you say, most of the conflicts have been removed from the industry, prior to FoFA it really was the wild west, with most funds marketed to retail investors having upfront commissions, trailing commissions and paying 'shelf space' fees and volume bonuses to be on investment platforms. The removal of these has created a much fairer playing field for investors, with LICs and their stamping fees the one thorn left in ASIC's side. There's a reason why funds which would take many years to gather $500m in assets in a normal environment can raise $500m in a 6 week marketing campaign, and it's the 1-2% commission (don't call it a stamping fee, its a commission) that is paid to the brokers and advisers who promote it. If most LICs move to a discount soon after launch and stay there for 1-2 years as you mention above, then how can it be in the client's best interest to invest at IPO? In most cases it's not, it's in the adviser's best interest to receive a 1-2% commission. It's a tough one, I am not sure what the answer is. Removing stamping fees will kill the LIC IPO industry overnight, with only the largest and most well known funds likely to have any chance of raising sufficient capital in an IPO. The LIC structure clearly still does have its benefits in its closed ended nature and ability to retain earnings and it would be a shame to see it die, but they need to come up with a solution in raising capital that removes the conflicts of interest.
The sad fact is that, with only a few exceptions, investors over the past 5 - 10 years would have been better off in Aussie and USA broad index ETFs . ASICs lack of action against the HML and BHD fraudsters is an utter disgrace and will destroy their reputation forever as far as I'm concerned.
There seems to be a lot written on this topic of late. I think the key issue is largely summed up in 3 sentences from an earlier comment on this thread from Craig Pickford.
Many excellent points made! Appreciate your strong logic Dominic and pro-LIC arguments. Agree with Dr Jerome Lander's summation in comments below. My view in parallel, today’s FASEA code requirements (from 1 Jan 2020) make the Stamping Fee issue 100% moot on a go-forward, given no-one acting inside the code’s prescriptions can legitimately keep a Stamping Fee bar the end-client in 2020. Meaning cash for comment / cash to influence advice via LIC-issuance has already ended simply via adherence to the FASEA code. Irrespective of the merits of LIC’s, the prevailing Discount-level, or the weak listing environment; in practice we won’t see any more Stamping Fees lining the pockets of advisers; because any Adviser that pockets a Stamping Fee in 2020 is asking for a FASEA-breach notice (unless current code prescriptions are amended). Thus, even if part of the ASIC methodology is wrong, the argument for an end to the Conflicted Remuneration exemption for LIC’s is unassailable. There’s no point fielding a team in that debate. A Stamping Fee/equivalent that finds its way directly into the pockets of investors (a rebated commission, another incentive or enticement) is not under threat from the Media / ASIC scrutiny and is allowable under FASEA. Think MHH and its loyalty bonus. That or a similar raising structure is clearly the future for the LIC/LIT issuance space, as Chris Joye highlighted many months ago. So, even though ASIC may have tripped over themselves on LIC performance reporting (granted near no-one has clean hands on that front, albeit I credit you are the Industry-beacon). And even though ASIC’ grouping/inclusion decisions might be non-representative. Despite these things, the ultimate end-game from the ASIC review and advice remains the same, it is better for consumers to live in a world where LIC capital cannot be raised under the old “Pay the Adviser via Stamping Fee” model, given it’s a conflict, and conflicts matter (now being FASEA-protected). Whether Frydenberg does away with the Exemption or not, post-FASEA (and its implicit ban on Adviser-Stamping Fees) we will see fewer but more discerning new listings ensue. This should enhance quality of strategies brought to market, and durability of demand; given the “new normal” will see far fewer conflicted parties advocating Buy-IPO for any new listing, rather than wait for secondary-discounts.
Dominic, I have written many times about the size of the conflicted sales commissions paid on LICs and LITs, and I almost always quote the range 1.5% to 3.0%. I think, as you note above, ASIC cites some examples of higher commissions, which I referenced following the FOI release. As for my comment on fund managers loving LICs/LITs because they are perceived to provide "permanent capital", that is absolutely a key motivation for issuers across the industry (numerous LIC and LIT managers have stated that to me personally). I don't think anyone would seriously refute that idea. There is nothing wrong with seeking semi-permanent capital (I agree with your comments that there are some risks to retaining it), but the closed-end structure clearly contributes to the prevalence of LICs/LITs trading at a discount to NTA with almost 80% of all LICs and LITs ending 2019 at a discount to NTA, and an average discount of more than 9%. As you say, that is a feature of the industry, and creates both risks and opportunities. I actually agree with many of your technical arguments. And I think there is a valuable role for LICs and LITs - Magellan and VGI I have shown that there are many unique value propositions fund managers can provide investors with LICs and LITs. LITs also offer some unique solutions to the illiquid assets problem, although that does come with the risk that LITs that hold illiquid assets end up trading at enormous discounts to NTA as we have seen historically with the likes of Allco Max, the Adelaide Yield Trust, the Dixon URF disaster, and others...The problem with illiquidity is it creates tremendous uncertainty about what the true NTA is, which is very different to an equities LIC/LIT. I don't think that anyone, again, really rejects the idea that the performance of the LIC/LIT sector has been poor - in 2019 alone, Aussie equity and global equity LICs/LITs massively underperformed the Aussie shares and global shares benchmarks with or without franking credits. But as you say, this point could be made of active managers generally, although the discount to NTA issue is idiosyncratic to LICs/LITs. I think the concern is that these products are raising capital primarily because they are being sold by third-parties motivated by the conflicted sales commissions, which the Future of Financial Advice laws were legislated to ban in 2012. There is nothing ultimately stopping all fund managers shifting their capital raising on to the ASX, and everyone using these conflicted sales commissions to effectively kill FOFA. Asking ASIC to pick-up the pieces after these mis-selling risks have manifest by prosecuting advisers for failing their best interest duties to clients ex post facto is demonstrably not the solution. As the Royal Commission recommended very clearly, the solution is getting rid of the conflict in the first place, as FOFA intended in 2012, especially when it comes to financial advice! It is absurd having adviser sales commissions outlawed for unlisted funds and ETFs, but permitted for an LIT or LIC. The huge impact of these commissions on fund raising is precisely why there are 20-30 local and global fund managers chomping at the bit to raise money from Aussie retail investors on the ASX. Some of these managers will be outstanding, but many are there purely because the conflicted sales commissions make it much easier to raise money from punters. Is it really in Aussie mums and dads' best interests to be buying very expensive leveraged hedge funds or leveraged junk bond funds? Blind freddy can see that is a very dubious proposition. Anyone involved in this industry knows that the commissions are having a huge impact, and driving massive sales. Suggesting they are not is silly. Managers that have never been able to raise volume from Aussie retail are suddenly raising almost $1bn in a few weeks. Yes, there are some advisers who rebate commissions to clients. But many do not. And if there is one lesson from both the Royal Commission and the history of Australian financial services, it is that fund managers paying chunky 1% to 3% sales commissions to financial advisers inevitably leads to big mis-selling crises. Jason Coggins over at Linkedin today has commented on your piece, and I would leave you with his quotes: "Are we still debating the merits of conflict-free advice? 10 years after Storm Financial? 6 years after Banking Bad? Let’s be clear. This is not an anti-LIC crusade. It is calling out ALL conflicts. Conflicts can’t be “managed”. That’s an oxymoron. Yes, most try and do the right thing. But create the option to do the wrong thing and a minority will prioritise their self-interest ahead of others. The industry does not need lobbyists to tell us what is right or wrong. It’s simple. Work actively (and only) for the client."
Chris, just time for one comment/question - for Jason also - how does getting rid of stamping fees on LICs/LITs solve for the potential conflicts of stamping fees on AREITs, infrastructure funds, hybrids, investment holding companies, operating companies etc when all of these are also used by advisers/brokers to build portfolios? Either they should all stay (perhaps capped) or should all go. Although, the free market view would be that they could all stay (given unique capital raising process) but are usually rebated to clients unless advisers /brokers can demonstrate that they are still acting in clients best interest by not doing so.
Hey Dom, yes, this is a key question. In its advice to government, ASIC stated clearly that sales commissions are permitted when companies are issuing debt or equity capital to fund their productive businesses (either on the ASX or in the unlisted market) and that this is generally true globally. In contrast, best practice is not to allow fund managers seeking to raise capital for speculative investment products (as opposed to companies) to pay sales commissions to financial advisers who are meant to be paid by their clients, not by product manufacturers. I agree that you could take the view that all equity and debt capital issuance, and issuance of investment products, should be subject to the same regime when it comes to financial advisers...I suppose the question is really, Are you a sales person or a financial adviser?
Well written Dominic and some of the responses are worthy as well. There are some points I would like to make as the Chairman of Clime Capital Limited - a ASX LIC. Therefore my perceived conflict is made upfront. First, there is no excuse for a Government regulator like ASIC to produce flawed analysis and then to put it into the public domain. The glossing over of this point by some of the writers in this blog is not justified. ASIC needs to and should consult more widely with industry participants when it researches or investigates into either a financial sector or indeed a significant issue. ASIC should investigate conflicts but it needs to fully understand them and the extent to which they exist. They need to acknowledge that the closing of some perceived conflicts can create more significant adverse anti competitive outcomes (see below); Second, the cost for the formation of and the distribution of investment products is significant. Whilst large fund managers can absorb this cost it is clear that smaller managers are restricted in this endeavor. Is that good or bad? Is the restriction on the creation of a diverse range of investment products by a diverse range of asset managers desirable? Given the Royal Commission findings regarding the behavior of large banks, do we really want to put barriers in place for smaller fund managers in coming to the market and potentially the offering superior products? Third, there are lots of bad investments and the overwhelming majority are not LICs or LITs. Indeed to some extent a good LIC/LIT manager will avoid bad investments in their portfolios and protect a self directed investor whom does not have the information, time or experience. Any analysis of returns without an understanding of risk is flawed in itself; Fourth, I believe that Dominic makes a very compelling point, not yet picked up by others in this blog (I wonder why?) as to why the conflicted remuneration created by the "paying for ratings" in the unlisted fund space is not investigated by ASIC or indeed the ACCC. Anti competitive outcomes can occur in the ratings of products or the placement of products on platforms; Fifth, there is a ongoing and concerted covert campaign by parties to force self directed retirees into a default position of falling into Industry or Retail Funds. The attack on franking (strongly supported by large superannuation funds) was a clear example. These same parties certainly do not want a diverse, liquid, vibrant and well regulated LIC industry which is available to self directed retirees. And lets ask the difficult question - who pays for their advertising? I suggest that we develop fair solutions to actually grow the LIC market, to support the trustworthy and experienced custodians of investment capital. If changes are required then please do it fairly, do it widely and at least understand all the issues. Most importantly understand the real significant conflicts that do exist - many which are sitting in front of the regulators whom are blind to their existence.
Hi Dominic. So you have been contracted (aka paid) by Listed Investment Companies and Trusts Association (LICAT), which represents the interests of LICs, to provide "independent" commentary in the media? Just as financial advisers are required to disclose conflicts of interest *before* providing financial advice, perhaps you should follow the same standard and state your conflicts of interest at the start of the article (and within the body of the article itself). This would save people the time (and danger) of reading further.
The argument presented by the naysayers has become convoluted and self-serving over balanced. Let’s level the playing field for the debate. Christopher Joye (CJ) is a fund manager, predominantly in the credit/fixed interest space I believe, for Coolabah Capital Investments (CCI). 75% of CCI is owned by its team and 25% owned by Pinnacle Investment Management. CCI also owns 100% of Smarter Money Investments (SMI). Pinnacle owns a number of fund managers, that have LIC’s that trade under NTA and paid stamping fees when they listed. Should we assume the same guilt by association in the argument. Fund managers, like financial advisers, get paid fees by their underlying clients. Will CJ, as a leading vocal critic outline his receipt of stamping fees by CCI, SMI and BetaShares and what’s done with them? To me it seems there are leading critics, in fund manager roles, that are conflicted in their own right if I am to read these comments and press mentioned in the articles. Most of the fund manager critics are not qualified to provide financial advice, so they have no idea why a particular investment may be used in a portfolio, whether an equity, a fund, LIC or LIT or whatever the investment may be. How are they conflicted; well many of these fund managers charge higher fees than advisers, many charge performances fees (even on cash funds) when most advisers don’t, many of them underperform their benchmarks and lots of them keep stamping fees or fees from equity capital market deals and some add these fees back to the funds they run. The majority of these fund managers don’t provide financial advice; however, their opinions seem to indicate they can dictate how others should be remunerated or how the use of an investment is conflicted because it pays fees. It would be naive to think there will never not be confliction anywhere. Is one conflicted when they allocate funds to a fund manager, they are friends with, they may not benefit directly however what about indirect benefits. Common sense must prevail here. Many advisers charge fees for portfolio management and asset allocation advice, to suit clients where they know the client’s financial situation, objectives, goals and needs. Some advisers rebate fees, but charge higher ongoing adviser fees. Some advisers charge lower advice fees and may retain these stamping fees for the ad hoc work they do for the one-off deals. No critic knows the structure of these underlying businesses, the level of work undertaken on these ad hoc deals nor if they have investment committees or external consultants they pay as part of the review process. Of course, all advisers and their businesses carry out different levels of work and types of research. Let’s think about the quantum of the dollars here. If an adviser invested in say 3 of these deals in one year, at $50,000 a deal with stamping fees of at a median of 1.5%, so between the 1% and 2% mention, the total remuneration is $2,250. If adviser A charges the client say 1% per annum or a flat fee of $10,000 per annum for full financial advice and portfolio management and rebates stamping fees or adviser B charges 0.70% per annum or a flat fee of $7,000 per annum who is better off? If both advisers bought the same LIC or LIT then client with the adviser who doesn’t rebate the fee is better off as they pay less out of their pocket. CJ has opined the same opinion about a number of debt LIT’s that offer superior credit ranking above bank hybrids, managed by large teams with impressive long term performance records. CJ also opined the same about hybrids at one stage offering up the below; Westpac's hybrid deal a dud https://www.afr.com/companies/financial-services/westpacs... On 22 July 2015, when this article was first published, Westpac Ordinary bank shares closed the day at $34.35 and they have paid $8.32 of fully franked dividends. The Westpac share price closed at $24.57 on the 14.01.20. This represents a return of negative -4.25% in circa 4.5 years. As per the article, Westpac ended up issuing Westpac Capital Notes 3 at a margin of 400bps (4%) that commenced trading on the 9/9/2015. Investors that purchased that dud deal, “equities for dummies”, as opined by CJ, that the aforementioned now heavily promotes and runs portfolio’s for in the sector, have received the following return; WBCPE were purchased in their IPO at $100 and have paid $17.56 of fully franked dividends. WBCPE closed at $102.25 on the 14.01.20. This represents a return of 19.81%. The differential is 24.06%. Ultimately, it’s the right of the end consumer to find value and determine if the level of fees for the service and returns they receive is warranted. There are pros and cons of all investments. Some of these LIC’s have underperformed how I have seen in the debate when you buy and equity LIC you should have a view of 5-7 years, we can’t be judging this off 1 year performance records.
FASEA relevant passage; "Income derived from ancillary products and services You will not breach Standard 3 if you share in profits generated by the provision of ancillary products and services to clients providing that: • the ancillary products and services are merely incidental to the adviser’s dominant purpose in providing advice, AND • the ancillary products and services recommended are in the best interests of your client – conferring on the client value that is EQUAL or GREATER than ANY OTHER OPTION......" FG002 Financial Planners & Advisers Code of Ethics Guidance, page 17. Seemingly impossible for any Adviser to meet this FASEA standard and also pocket a Stamping Fee. When Option A is client buys Asset at $1.50 (Adviser retains Stamping Fee), or Option B is client buys same Asset at effective $1.47 (Client receives stamping fee). Per above, Option A will always fail the code and its catch-all provision, given its clearly inferior to the near identical alternative (Option B). It will be a “brave” Adviser to accept a Stamping Fee in 2020, unless ASIC guidance on FASEA’ code specifically greenlights Stamping Fee retention in the coming months. Compliance by all practitioners with the current in-force FASEA code, along with ASIC making its position on FASEA clear in the coming months will together help make Stamping Fees obsolete. The coming lull in issuance, over 2020-2022, will likely help the LIC market digest the over-issuance of LIC/LIT supply during 2017-2019. It is great that people like Chris Joye are leading the conversation and Industry in looking to elevate Australian Financial Advice standards (clearly fluid right now). Further, I credit John Abernethy (Chairman of Clime Capital) with penning a piece on the eve of FOFA’s enactment ~7 years ago (just prior to 1 July 2013), correctly foreseeing the large benefit and demand-wave that would flow through to the LIC space. This very prescient piece (written in 2013 by Clime). This piece forecast the large uplift in demand for LIC’s that would likely occur as conflicted unlisted investment options ceased, liberating substantial capital that would look for a better home..... As at mid January 2020, Feels like we’ve come a full 180 degrees now, and there’s likely a long winter ahead for the LIC/LIT space.
Finally, A voice of reason without obvious subjective opinion. Thanks very much for calling these points out Dominic. It also gets very tiring to hear that some sort of 'loophole' has driven growth in outstandings (it is sensible law, not a loophole) - so tiring, when the growth is, like other products (including ETF's) due to historically low returns for cash, increasing equity volatility, and the highly positive structural changes to LIC's & LIT's including the Issuer paying for the IPO costs. On top of this - having a professional expert in diverse asset classes act for an investor that is overly exposed to domestic equities - particularly the expert names that are bothering with the tiny Australian market - is a great opportunity for Australians.
Good article Dominic. One of the important points that has been overlooked in all these is the disclosure practices of LICs. They are often very non-transparent about their holdings information. Most disclose full holdings annually. A quarterly disclosure would be more appropriate. Many funds disclose monthly while ETFs disclose even more frequently. A more transparent approach may help in closing the level NTA discount by allowing investors to have full understanding of the names held in the portfolio.