A lot is being written right now about LICs. We’d like to put in our two cents worth. As an investor, we were initially attracted to the LIC sector by the quality of LIC managers and the ability to make additional returns by buying at above-average discounts.
Those positive features haven't changed. In fact, they've improved. But the sector does have some issues right now, as many commentators have pointed out. Here’s what we think needs to change for LICs to continue to be an attractive, long-term investment proposition.
We discuss LITs vs LICs, why the IPO market is dead, LIC discounts, debt-based LITs and our take on the current stamping fee debate.
All LICs should become LITs
In our opinion, the company structure traditionally favoured by LIC managers is sub-optimal. They should all convert to Trusts (LITs) where the initial tax consequences are not prohibitive. It's much more tax and cash flow efficient. An LIC pays tax and gets no (meaningful) CGT concessions. The pass-through of franking credits for the tax paid is delayed until the LIC decides or can afford to pay dividends. In the meantime, these franking credits are locked in the Company, and in some cases (e.g. windups) lost altogether.
ETF’s and managed funds, which number in their thousands, use the trust structure for good reasons. It works better and allows much more flexibility to pay out consistent distributions. LIC boards and managers need to fix that problem fast. It would be helpful if treasury and the ATO worked with industry to provide a form of rollover relief to smooth the transition. But perhaps that’s too much to hope for.
The IPO market for LICs is dead (for now)
And that's a good thing. The only recent deals that have gotten away well are from Magellan (MHH) and VGI Partners (VG8). Both have not only paid the costs of the IPO (as they should) but have also paid sizeable “loyalty bonuses” away to shareholders in the form of additional shares in the manager/LIC. That's what it takes to get an IPO away right now. Which is fair enough. When there are a wide range of quality managers trading at 10-20% discounts there probably should be no IPOs.
Don't complain about LIC discounts
LICs and LITs have one compelling feature that differentiates them from other pooled investment vehicles. They trade at discounts and premiums to NTA throughout the investment cycle. That is both a key risk and an opportunity, depending on when you buy or sell. If you bought an LIC without understanding that there is a risk it might trade at a decent discount at some stage, then that is mostly your fault. The one thing we suggest everyone who invests in LICs does is understand what price you are paying before you buy, and make sure you're happy with that.
Current discounts are an opportunity.
The causes of the current discounts include the recent success of debt LITs, the short term underperformance of active/benchmark unaware LIC managers and the franking credits debacle of 2019, all exacerbated by tax loss selling up to June 2019. Since July 2019, discounts have been reducing on average, as IPOs have dried up, the franking credits issue has gone away, and markets have risen strongly.
Since there’s no new issuance, demand is returning for existing LICs, which will probably help to continue to close the discount gap. Recently we saw AFIC (the largest LIC) trading at a historically significant premium to NTA. Many others will follow if no new money enters the space. It may take 2-3 years, but we expect anyone buying now will do relatively well over that time frame.
Debt-based LITs are not all that they seem
The big success story over the past few years has been the addition of the debt-based LITs. They have filled an investor need for higher yield and are mostly trading at NTA or a small premium. And in principle, we think it's a welcome addition to the space. There are some very good offerings from local fund managers. But quality is variable, and risk is not well understood. We think some debt LITs with an offshore fund manager have the potential to disappoint over time, as we do not believe the returns necessarily reflect the inherent risks of the underlying investments.
Some of the desired reforms have already happened.
LIC managers, not investors, are now paying upfront costs. The initial options, which never really worked, are no more. The restructuring and wind up of some underperforming managers is underway or has happened. Manager quality (measured by the long term track records of LIC managers) and investment choice have never been better. The LIC market is not the same as it was three years ago. It's better. Sometimes markets do an OK job of sorting out inefficiencies and bad product features by themselves.
ASIC needs some help
Our financial services regulator has shown themselves to be incredibly poor at analysis, based on the recent FOI information release covered in detail by the AFR and others. If the work done by Dom McCormick in this article is correct, and it seems to be, it doesn't reflect well. The quality of analysis and the level of understanding displayed from our financial regulator leaves a lot to be desired. Notwithstanding that, the conclusions they reach are probably accidentally correct. Which leads to the big issue of the moment…
Stamping fees must be dealt with
It's time for the Government to act on stamping fees. It’s a tough one. We've seen all the arguments for and against. Chris Joye probably captured the key point best, when he suggested the original intent of Government was that stamping fees should not be paid for a listed investment entity (as opposed to a company that makes things or provides services). I think that’s broadly correct, although it may be worthwhile considering a % limit with a cap per investor on Listed Investment Entities as a workable solution.
Whatever the outcome, they cannot continue as they are. Most LIC IPO’s (excluding the debt-based LITs) are dud short-term investments. We have participated in very few over the past 3-4 years, preferring mostly to wait 6-12 months for the almost inevitable 5%-15% discount to occur. Those we did participate in were hit and miss in terms of success rates. It has almost always been this way.
This being the case, I would have thought that makes it very difficult for a financial adviser to recommend an LIC IPO. So, what was the thinking behind the statements of advice that accompanied their recommendations? On average, LICs have traded at discounts most of the time. Knowing that, how do you recommend buying a new one at NTA? In most cases, there were already a range of comparable LICs trading at reasonable discounts. Why not buy one of those instead?
Right now, our LIC Fund is sitting on a portfolio of over 30 LICs. They have an average discount of nearly 15% and manager quality has never been better. To my knowledge, not a single financial adviser or broker who has taken commissions in an LIC IPO in the past 3 years, has invested, or even expressed interest in investing in our fund. That tells you all you need to know about stamping fees.
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.
Fair points raised and balanced perspective. I genuinely feel the LIC/LIT structure has run its course. The emergence and continued growth of ETFs and ETMFs (for active management) is largely removing the need for investors to buy into closed funds in order to access listed funds. There seems to be a concerted effort to downplay the liquidity issues affecting closed funds in the Australian market. I think the assessment that given the risks associated with LICs, that is locked in capital and lack of liquidity in many cases, a circa 10% discount is justified when buying these vehicles.
Well done, I find this comment absolutely remarkable: "Whatever the outcome, they cannot continue as they are. Most LIC IPO’s (excluding the debt-based LITs) are dud short-term investments. We have participated in very few over the past 3-4 years, preferring mostly to wait 6-12 months for the almost inevitable 5%-15% discount to occur. Those we did participate in were hit and miss in terms of success rates. It has almost always been this way. This being the case, I would have thought that makes it very difficult for a financial adviser to recommend an LIC IPO. So, what was the thinking behind the statements of advice that accompanied their recommendations? On average, LICs have traded at discounts most of the time. Knowing that, how do you recommend buying a new one at NTA? In most cases, there were already a range of comparable LICs trading at reasonable discounts. Why not buy one of those instead? Right now, our LIC Fund is sitting on a portfolio of over 30 LICs. They have an average discount of nearly 15% and manager quality has never been better. To my knowledge, not a single financial adviser or broker who has taken commissions in an LIC IPO in the past 3 years, has invested, or even expressed interest in investing in our fund. That tells you all you need to know about stamping fees."
I agree with most of this article, but am perplexed by the statement in support of LITs over LICs that, ".... use the trust structure for good reasons. It works better and allows much more flexibility to pay out consistent distributions." This would appear to be totally back to front. LICs can 'smooth' dividends by retain profits from strong years and using that to to bolster the dividend in weak years. LIT distributions are the ones that are all over the place due to the legal requirement to distribute all profits each year. Hence it is quite common to have a large distribution one year followed by nil the next. In my view the tax planning implications of this is actually the main advantage LICs have over LITs.
Hi Graeme H, your question is a good one. We plan to do a future article on this topic because the issue always generates a lot of interest. In short, LITs are more tax-efficient because they can commence distributing immediately, they can distribute higher cash (pre-tax) amounts and, very importantly, they can pass through capital gains tax concessions. The fact that they must distribute all taxable earnings as a minimum in any tax year can cause a bit of "lumpiness". However, not as much as you would expect, as it only really captures realised gains, which tend to occur in a smoother pattern than unrealised gains/losses. In the long term, it is also possible that companies can deliver very consistent dividends, but trusts do not have any limits on when they can distribute. For example, the concept of a "profit reserve" for LICs which can limit the ability to pay dividends is not a constraint for LITs. Also, the type of assets being invested in will also have a bearing on how consistent dividends/distributions can be, regardless of structure.
I vehemently disagree with your assertion that if a LIC that I bought into drops into a discount, then it is my own fault. Nor do I agree that LIC discounts are an opportunity, as many can remain in discount for years or seemingly forever. I am yet to be convinced that the LIC structure is the best format for newer, high turnover, active funds. I much prefer an ETMF such as Magellans MGE and MICH funds. I know I'll always buy and sell at NAV with a ETMF. I can see advantages in a LIC structure only for low turnover, index hugging conservative funds, not active funds whose portfolios differ markedly from the index. The latter are extremely prone to wander far and wide from NAV often for no good discernible reason but sometimes as excessive punishment for a period of underperformance which all active managers encounter sooner or later. I feel a lot of investor confidence in LICs has been harmed by discount fiascos. I doubt I'll ever again buy a LIC at IPO.
Carlos if you bought into EGI about half a year ago, you will be sitting pretty on +30% now with more upside when they convert to an open-ended structure. That's an example of a buying opportunity in LICs.