Ican foresee considerable disappointment ahead in the listed investment company (LIC) area over the next one to two years. After years of little activity, the plethora of new floats in recent months (with more in the pipeline) indicates this area is as close to a bubble as it ever gets.
My concern is many of those investing in LICs do not understand what they are buying. They think they are just buying another managed fund, but there is more to LICs than this.
Overlaying a standard managed fund are additional complicating elements including the premium/discount to net tangible asset (NTA) cycle, a company tax structure, the nature of the management contracts and option dilution. These vital considerations seem to be largely ignored by most commentary and the minimal research available covering LICs and the new floats.
There is no doubt the LIC structure has some significant advantages over unlisted managed funds, particularly for less liquid investment areas such as private equity, smaller companies and hedge funds.
As closed end funds, managers need not be concerned about uncertain fund inflows and outflows, and the structure enables the smoothing and deferral of dividends which can be particularly useful for high tax payers. In addition, some of the well-known, larger LICs have successfully provided low cost access to the Australian share market for many years.
Indeed, purchased at significant discounts to NTA backing, well selected LICs can be outstanding investments. Some of the best investments I have made have involved what I call the ‘closed-end fund double whammy’. That is, buying well-run but out of favour LICs or pooled development funds at significant discounts to NTA, then benefiting from the effect of good underlying asset performance (and franked dividends) combined with a marked reduction or even elimination of the discount.
The problem is such spectacular ‘double whammies’ are rare and finding and executing them requires more than just filling out a prospectus application form. The more common investor experience in LICs is to buy in a new float at say $1; initial NTA after commission and costs might be 97 cents (let’s ignore the free options for the moment). For the post-company tax NTA to be $1.10 after the first year requires a total pre-tax return of about 20 per cent, a big ask in the current environment. (For simplicity I have ignored imputation credits earned, any discount capital gains and also the future effect of option dilution.)
If performance is anything less than stellar in the first year, investors tend to become disappointed and some begin selling their shares. The shares are likely to drift under NTA and perhaps below 90 cents if performance is poor.
The key point is that unless performance is excellent from early on, the fund will eventually move to a discount in a self-feeding cycle, where investor disappointment breeds a bigger discount and further selling. A select few LICs may manage to avoid this cycle. The vast majority have not done so in the past and are unlikely to do so in the future. The costs of the issue, high management fees and corporate taxation are tough hurdles to surpass given high initial investor expectations.
Some may argue that LIC floats are attractive because investors get a free ‘bonus’ option. However, the now seemingly standard practice of issuing options one-for-one with the strike price at the float price is a gimmick heavily dependent on investor irrationality and greed. It is also a practice that weakens the aftermarket support and longer-term viability of the fund.
While such options clearly have value on day one, they heavily dilute the upside to any prospective on-market investors. Why would anyone pay NTA when they know they are only going to effectively receive half the gain in the first 18 months because of option dilution? There are occasional free lunches in the stock market but LIC options of this type are not one of them.
While LICs now can pass through the capital gains tax (CGT) discount that unlisted trusts and direct investors receive, there is some uncertainty over the eligibility to this entitlement and whether all the new LICs will receive it. The tax issue is also complicated by the differing way that LICs report NTA. Some emphasise the figure providing for tax on both realised and unrealised gains, while others emphasise tax on realised gains only.
One of the other features of many of today’s new LICs is long-term (25 year) investment management contracts. I find it amazing that this feature is so accepted by investors.
A decade ago it was extremely difficult for an LIC to float with long management contracts or without sunset clauses that provide for meetings to be called to consider a wind-up at periodic intervals if the fund trades at a persistent discount. The long contracts mean it is extremely difficult, if not impossible, for a manager to be removed. So what, you might say? If the manager does a bad job I can just sell my shares, as I would redeem from an unlisted managed fund.
Perhaps, but the key difference is that with an unlisted managed fund you can definitely sell out at NTA. In an LIC you are likely to be forced to sell out at a significant discount. Management could be removed by an EGM and special resolution but these require 75 per cent shareholder approval and often result in the payment of large ‘break’ fees to the manager. Some managers suggest they will buy back their own shares if discounts get too large. Perhaps, but when this effectively reduces management fees it is hard to see many doing it aggressively.
I suspect money can be made in the short-term in some of the LIC floats by selling out immediately on listing both the share and the option. However, this cannot be done at scale and is a trading strategy, not an investment strategy.
Looking further out, I expect the majority of the LICs coming to market now will trade at discounts of 10-20 per cent within the next one to two years. Even with the low hurdle strike price, many of the attached options are likely to expire worthless. I also suspect the rigidity of the management contracts and lack of sunset clauses will mean some discounts could become even larger. Obviously, how markets and the specific managers perform will affect the severity of this phase for most. Only the exceptionally performing funds are likely to avoid this pattern.
Because of the inherent strength of the LIC structure, I believe the industry will get through this more difficult phase, and in one sense, I welcome the attractive longer-term discount opportunities the current and imminent floats may eventually present.
However, I suspect many of the current investors, financial planners and brokers clamouring to invest in the current floats will become disappointed and disillusioned.
A key problem is that the only research on LICs is being provided by those brokers who have a vested interest in promoting the new floats. As for the financial planning research houses, research on LICs has been almost non-existent. In fact, the research firm with the biggest market share of the financial planning market is launching its own LIC, so it is perhaps not best positioned to provide objective research as to the role of these new floats in client portfolios.
It is a case where most of the gatekeepers are biased and investors and advisers are once again flying blind or with a distorted view. Then again, perhaps it is just ‘business as usual’ in the investment business.
Dominic McCormick is chief investment officer withSelect Asset Management .
