Occasionally a new investment comes along that deserves discussion to caution investors and to emphasise that a brightly coloured prospectus (in this case appropriately red), advertising in The Australian Financial Review, support of the Australian Stock Exchange (ASX) and an Australian Securities and Investments Commission (ASIC) sign-off does not necessarily indicate a good investment.
The fund I am talking about is the Aspyre Capital Investments Listed Investment Company (LIC).
Aspyre is looking to raise $30 million from investors for an option based strategy.
Of course, I have had some concerns with the rash of LICs that have come out in the last couple of years with 25-year management contracts, lack of independent boards, high fee structures, and option arrangements.
The jury is still out on some of these issues. For those few managers who perform well, the above issues will be ignored and they will be well perceived.
Others are likely to eventually languish at significant discounts to NTA as disappointed investors sell out.
However, my concerns about most of these previous LICs are relatively insignificant compared to Aspyre.
Now it is true that Aspyre has been structured such that it offers the chance for quite exceptional returns with little or no downside.
Unfortunately, it seems to me it offers these prospects primarily to the manager/directors rather than investors.
Let’s first see what the manager earns. We’ll talk about what investors can expect later.
Firstly, there is a 2 per cent per annum management fee (for the management contract term of 25 years).
Then there is a performance fee of 25 per cent of the amount above 150 per cent over the first 5.5 years. A total return of 150 per cent would be quite a high performance fee benchmark.
However, the formula actually provided on page 50 of the prospectus seems to imply on my calculation that this 25 per cent performance fee is earned above a total 5.5 year return of just 50 per cent (or less than 9 per cent per annum compound). Which is it?
In addition to these fees, the three executive directors have also issued themselves with a total of five million 10-year options exercisable at the IPO price of 50 cents.
On the day of the float these options could be worth as much as $1 million depending on your assumptions on the factors that influence option prices such as share price volatility.
Thus, if the float raised the minimum $15 million, on day one effectively as much as $1 million or almost 7 per cent of this value may have been transferred to the directors.
In addition, two of the executive directors have been paid consulting fees of $20,000 each while the other lent the company $200,000 at 20 per cent per annum interest and will be repaid this money out of the proceeds of the float.
Perhaps I am being a bit harsh. After all, I have always believed that fund managers who truly deliver returns can be worth paying more for. Perhaps the Aspyre team is particularly talented or doing something so special that it deserves to be so well rewarded.
A closer look at its prospectus and the investment strategy does not provide much comfort.
Specifically, its core strategy for 70 per cent of the funds raised is essentially to buy well out of the money five-year call options on five ASX leading stocks and generally hold these to expiry with initial leverage of about 10 times the underlying share price. The group calls this strategy “maximum leverage defined risk call options”.
What can investors expect from this strategy? Graph 7 on page 18 of the prospectus is probably the most instructive. Applying their strategy to the S&P ASX 20 Index (therefore assuming no stockpicking skill) over rolling five-year periods since 1993 produces some interesting outcomes.
Specifically the graph suggests the strategy would have lost money in around half the rolling five-year periods and if it had started any time after late 1997, the five-year returns until today would be minus 100 per cent.
In other words, all the funds committed to the core strategy would have been lost.
We are told this graph “highlights the importance of applying the manager’s key criteria”.
What are those criteria? The prospectus lists return on equity, low PEs, high dividend yield, strong earnings growth and so on. In other words, those factors that every investor learns in Investments 101 but that often don’t quite work so well in the real world.
Using perfect hindsight their “current favoured stocks” are NAB and CBA, Woolworths, Telstra and Wesfarmers.
And to no surprise, back-testing these stocks and assuming that 40 per cent out of the money call options could have been bought for each stock at 10 per cent of the underlying share price throughout the period (we doubt it since there have been several periods of much higher volatility), the strategy did not have a loss over the period.
Still, even with this hypothetical record it admits that five-year historical returns are “currently around 16-year lows”, although it says “this could indicate that the current market may provide a favourable opportunity for implementing the strategy”.
Then there is the manager’s “timing expertise”. This seems to simply amount to buying the options over time (basically, dollar cost averaging from Investments 101 again) and maintaining the ability to exercise those options whose underlying share prices rise more than the 35 to 45 per cent required to be ‘in the money’.
There is no doubt there are scenarios where this strategy could work well as is normally the case with highly leveraged, speculative investments. It’s just that the probability of this scenario is, in my opinion, quite low.
Here is another way of looking at it simply and somewhat roughly.
Assume all funds were invested at once in the core strategy and 40 per cent out of the money calls on the five favoured stocks were held to expiry. The dividend yield on these stocks averages about 5 per cent per annum. How much do the shares have to rise to make money (assuming they rise by the same amount)? For these options to be worth anything at the end of the five year period, it is my assessment that the underlying shares have to rise on average by more than 50 per cent (the additional 10 per cent is needed to cover 2 per cent per annum fees). This amounts to growth of just under 9 per cent each year.
Therefore, if you are confident that a selection similar to these two banks, a telco, a grocery retailer and a conglomerate are going to produce a total return above 14 per cent per annum (dividend plus growth) in the next five years, then this investment strategy could be for you.
Remember, however, if they return equal to or any less than this 14 per cent per annum, investors have lost their total investment based on the assumptions above.
With the 30 per cent of the portfolio not in the core strategy, Aspyre will implement a couple of other strategies (including ‘buy and write’).
The prospectus also informs us that the “manager has not previously managed funds for third parties or invested its own funds on the basis of the core strategy”.
If it hasn’t invested in its own strategy, why should you, let alone pay it an exorbitant amount for doing so?
Selecting investments is mostly a difficult job full of uncertainty, subjectivity and self doubt.
It is actually quite rare to come across investments where one can justifiably be convinced that strong absolute returns will be made or even at the other extreme, that investors are highly likely to lose money. The former are the investor’s Holy Grail, but little can usually be done with the latter.
In my last article I expressed concerns that investors were getting out of their depth by moving into various option strategies such as buy and write, and suggested they should instead consider using professionals for this area. Clearly, I was not talking about this type of fund.
Dominic McCormick is chief investment officer for Select Asset Management.
