Listed investment companies continue to be included in portfolios by SMSFs, which make up the large bulk, if not the majority, of the shareholders in these structures. Krystine Lumanta reports on the evolving popularity of the structure and what’s to come in the listed investment universe.
Listed investment companies (LIC) have been providing SMSFs with two desirable outcomes: tax-efficient income streams and franked dividends.
Of the 95 listed investment entities on the Australian Securities Exchange (ASX), 83 are LICs.
As at 30 December 2016, the ASX funds monthly update reveals the LICs and listed investment trusts (LIT) segment had a total market cap of $31.3 billion.
The wave of LIC initial public offerings continued in 2016, including the Watermark Global Leaders Fund, one of the latest added on 21 December.
Bell Potter’s “LIC September Quarter 2016” paper says owing to their closed-ended structure, LICs are not exposed to daily inflows or outflows of funds, which is viewed as one of the main strengths of their structure.
“They are not beholden to taking in new funds in buoyant market conditions or exposed to redemptions when the market is soft,” the report says.
“Despite this, LICs can and do attract new capital through a variety of levers.
“The three methods used this quarter to attain new capital were via issuing share purchase plans, placement issues, option and hybrid conversions.”
These methods helped the Australian LIC sector raise over $500 million during the third quarter of 2016.
According to the Investment Trends “September 2016 Investor Product Needs Report”, the number of LIC investors has continued to grow, reaching 170,000 investors in 2016, up 15 per cent from 148,000 in 2015.
“At a high level we’ve been seeing a move from investors from unlisted products to listed investments whether it be LICs, ETFs (exchange-traded funds), REITs (real estate investment trusts), et cetera,” Investment Trends senior analyst King Loong Choi tells selfmanagedsuper.
“Diversification, long-term performance and active management are the top reasons investors gave for using LICs. But what we’re seeing at the moment is that they’re growing more cautious in their investment approach in the current environment of low growth expectations and low interest rates.
“Investors are favouring managed investments over direct shares, so the use of investments products like LICs, ETFs and unlisted managed funds has seen growth over the past year.”
Affluence Funds Management chief executive and portfolio manager Daryl Wilson says the reason LICs are interesting is because unlike a managed fund, they trade at premiums or discounts to the value of their net assets depending on how the market feels, which potentially creates a lot of opportunity.“That’s really what we try to do as much as anything in that space,” Wilson says.
“About 15 per cent to 20 per cent of our portfolio is in LICs and we’re really trying to get good returns, but we’re supplementing that by buying cheap and selling perhaps if they come up and become a bit more expensive.”
Investment Company Services chief executive Boyd Peters recalls the global financial crisis, which brought on dissatisfaction with the market and the performance of fund managers. At the same time, LICs were popping up with transparency.
“That was something the explosion in SMSFs walked into,” Peters says.
“This is also part of why there have been new LICs over the last two years and the savvier fund managers have recognised that there are SMSFs with cash out there, they need to invest, so more are offering a differentiated product.”
Of those trustees who set up their SMSF for control and to lower costs, Peters says the LIC is in the middle of their equities investment sweet spot, and they generally know more about LICs than most advisers out there.
“SMSFs have grown to a level of sophistication where they’re able to trade the LIC at discounts – they can decide if an LIC is at a discount deeper than it should be, and if the LIC is at a premium deeper than it should be,” he says.
“So they can see good opportunity in assessing LICs on a value basis.”
The good, the bad and the ugly
Commenting on what makes a good LIC, Watermark founder and chief investment officer Justin Braitling explains a high-quality LIC will have an experienced investment manager, preferably with a successful track record in managing assets according to the company’s investment strategy.“Also of vital importance is the quality of the board,” Braitling says.
“LICs are different to other operating companies in that they are comprised solely of a portfolio of assets.
“An experienced board of a LIC will understand and make full use of the range of capital management options available to it, in order to ensure that the company’s shares trade at fair value, normally represented by the company’s net tangible assets (NTA).”
Given the value of the portfolio is generally marked to market regularly and published at least monthly, it’s up to the board to manage the company’s capital such that the shares do not trade persistently at a discount to the NTA, he notes.
But not all LICs are immune to such problems.
In July last year, investors voted to close the AMP Capital China Growth Fund following issues around conflict of interest, significant discounts and high fees, as well as underperformance compared to its benchmark.
Perpetual senior investments specialist James Holt says ultimately there is no one-size-fits-all approach.
“But LICs that are too much like the market index will struggle longer term as the cost of replicating the index will keep on falling and there are many forms of competition in index funds and ETFs,” Holt notes.
“Our view of a good LIC is one which offers investors unique exposure and a high-conviction active investment style to deliver better returns than market indices with lower risk.”
He reveals the most challenging aspect for the Perpetual Equity Investment Company, listed in 2014, has been operating during an extended boom in growth stocks.
“Our value investment style avoids the expensive growth stocks and bond proxies that have been popular over the last two years,” he says.
“We have been carefully investing the portfolio into a range of unloved, overlooked value stocks that are yet to be fully rewarded.”
The sector agrees there’s plenty of space for new companies as well as strong opportunity for further growth in the market, which poses the question of what future LICs may offer.Peters expects LICs under $20 million will struggle due to the challenge of building liquidity, which in turn will result in new names stepping into the market.
“They’re eventually going to become more niche and boutique. It’s still very vanilla so when looking forward, we’re talking about a little bit of topping rather than a completely new flavour,” he explains.
“LICs will still very much be the same thing but with a bit of a twist.
“And I have no doubt in a couple of years that we’ll see a LIC-of-LICs, like a fund-of-fund.”
These new companies will come from brokers and fund managers jumping ship from big name boutiques, he says.
“I also wouldn’t be surprised if we see a couple of LICs listed a couple of years ago by big brand fund managers – some of which are poor performers, poorly conceived, poorly supported and have no point of differentiation – no longer around in 10 years’ time,” he says.
“A LIC can’t be an adjunct to your funds management distribution strategy.
“You’ve got to be a manager who’s emotionally connected to its shareholders, rather than a faceless board.”
He says shareholders who invest in LICs, SMSFs included, form an emotional attachment to the portfolio manager.
Wilson believes LICs will continue to grow substantially over the next couple of years at the expense of managed funds and potentially at the expense of ETFs due to the high quality of managers in the space.
“I think this year we’ll see more income-focused LICs coming to market and we may see some other LICs coming to market which invest in asset classes other than shares,” he says.
“So there’ll be an expansion on the number of managers but also the underlying asset classes you can invest in as well.”
An evolving listed landscape
Wilson reveals Affluence may look at launching a LIT at some point in the future.“From all the work we’ve done, we believe that a LIT could be a much better vehicle than a LIC,” he says, citing the main consideration between the two structures is often franking credits.
“But while investors view franking credits as a positive, LITs also have an advantage – put simply, a LIT doesn’t pay any tax at all and passes the taxable income through to its investors, its shareholders.
“For example, a LIC makes 10 cents, pays 3 cents in tax and gives you a dividend of 7 cents with a franking credit. A LIT doesn’t pay any tax so if it earns 10 cents, it can give you the whole 10 cents in cold hard cash. So you’re actually better off getting the full amount as opposed to getting partly cash and partly franking credits.”
Wilson adds another benefit is that a trust allows for easier payment of regular distribution.
“Even with the taxable part that flows through to the investor, the CGT (capital gains tax) position is easier to deal with and if that trust gets franking credits from its investments, you can still give those through to your unitholders in the same way you would if you were a company. It’s just actually a much more tax-effective vehicle,” he notes.
There are currently 12 LITs on the ASX, with one of the newest arrivals being Forager Fund Management’s flagship, the Forager Australian Shares Fund, which started trading on 16 December at a market cap of $138 million.More than half of its units are held by SMSFs.
“I think LITs will very much become part of the listed investments sector and we’re going to end up with this whole class of listed managed funds, if you like,” Wilson continues.
“At the moment we have LICs, we have some LITs out there and we also have ETFs – all three will evolve because the process for applying for managed funds is still messy, whereas putting something on the stock exchange makes it quite easy for financial advisers and mums and dads to access it.”
2017 and beyond
As more and more investors prefer to access investments via the ASX, LICs look like continuing to be the beneficiary of this shifting trend.According to Braitling, the future for LICs is bright as evidenced by the broad range of new companies coming to market.
“Self-directed investors are an increasingly important segment of the retail investment market and fund managers realise they need to innovate or offer product that is relevant for investors who have an appetite for direct, listed investments,” he says.
“During 2016 we have seen that the typical market for LICs has expanded from broking networks and self-directed investors to financial planning networks, including those affiliated with the big banks.
“Administration platforms – a traditional blockage for financial planners using LICs – have evolved to accommodate LICs and the bonus options that often come with them. A broader spread of investors in LICs will also help with liquidity and provide an ultimate benefit for SMSFs who invest in LICs.”
The number of next wave LIC investors – those who do not currently invest in LICs, but intend to do so in the next 12 months – has grown, reaching 51,000 in 2016, up from 40,000 in 2015.One in four LIC investors say an adviser was involved in their LIC investments. This figure has been steady over the past five years.
Among SMSFs, their use of LICs has grown over the past five years from about 1 per cent of total SMSF assets to 3 per cent currently.
What to look for
Antipodes Partners chief investment officer and lead portfolio manager Jacob Mitchell says investors looking to invest in a LIC should ensure:
- the investment manager is true to mandate,
- the fee structure is priced appropriately for the mandate (some mandates are more expensive to manage than others),
- the management team/board communicates effectively with shareholders, and
- the LIC is being managed for the benefit of shareholders via an independent board.
Mitchell adds larger LICs tend to have greater liquidity and are less susceptible to trading at a discount to net tangible assets (NTA). Other factors helping to minimise the likelihood of trading at a discount to NTA include:
- solid investment performance,
- effective communication with shareholders,
- good disclosure, and
- a board that genuinely works in the best interests of shareholders.