Who's next? Discounts on LICs force managers to pivot

Just as ETF suppliers are not the only winners from issuance, same too for Closed-end investors.

Closed end structures bestow benefits on patient long term investors;
a. Allows the manager greater certainty for counter-cyclical investing and certainty of capital. Studies show on-average out-performance from the LIC structure.
b. Reduces the Manager's footprint from trading, on having a negative impact for continuing shareholders/investors.
c. Accretion benefits from any Buybacks below NAV.
d. Access to semi-regular Share Purchase Plan / Rights / Options / DRP, to allow for easy and cheap investment adjusting.
e. Complete control over exiting, via precise and known price, no buy/sell spread, and same-day dealing; with as little as $20 brokerage per $30k.
f. Certainty of tax outcomes!!! (Buy an ETF / Unlisted Fund, and depending on the situation and time of the year, you could be up for a rude shock, with plenty of examples seen during the GFC of people losing large $$$ on their Unlisted Funds, and then being slogged tax from prior cohorts gains distributed to them). Further, Lendlease only got their tax statement out to investors 15 September 2020. All ETF’s beat LLC, but a small number of unlisted funds have their tax statements outstanding. Thus paperwork, and delay in lodging tax returns exists for unlisted trusts and ETF’s, whereas a 100% only LIC investor could lodge their tax return 2 July.
g. Voting rights attach to shares, being vitally important to correct "problem" situations; but also the voting-right feature can command a premium in certain situations. (i.e. we don't always need a successful activism result for many shareholders to get the opportunity to sell at/near NAV, in a recovery/contest scenario).
h. Company structure provides a simple and easy vehicle for the efficient compounding of capital, while also allowing for optimisation decisions to be made around; Profit-Reserve type, Dividend-Policy, Franking, Rights/Options issuance. Ideally, the accrual of net-asset and share price gain via the LIC share price will allow access to the CGT-discount for the underlying shareholders. Furthermore, in a world where Franking Credit are refundable (and interest rates are 0%), tax-paid by the LIC retains near full-value to the average and marginal investor (even when the tax-paid falls outside of the NAV).
i. ALSO, the structural benefits for LIC’s (today) are rarely over-hyped (given general hostility to asset-genre). Thus there is far greater capacity for positive-surprise (from the LIC structure), given everyone has curbed their enthusiasm. I.e. no-one enters an LIC expecting that every day there will be a market-maker dealing near-nav, and thus no capacity to get a rude negative shock when liquidity disappears (think March 2020, and generally 1 freak-day every 2 years where VOL spikes). An informed LIC investor/buyer comes with low expectations for any consistency in daily bids/liquidity.
Overall, its horses for courses. There are pros and cons on both sides (LIC, ETF, Unlisted).
Mis-selling, or over-hyping new IPO's/strategies = some of the bigger problems for some of the past LIC-damage. LIC-bashing and attacking the structure is also unhelpful, especially when most of the voices attacking the LIC structure are self-serving, and ignoring the positives.

Hello .
If you run an analysis of trading the top ten stocks of any given reasonably successful LIC , you will find that your performance will outstrip the performance of the relevant LIC !

Why anyone would pay exorbitant fees to LIC managers is beyond me .

Take care , Ramon .

Surely the ultimate matter of importance is: why am I investing in this type of asset?
Well, for me at least, this is a long term dividend play, pure and simple. Many of the better LIC's are paying 5+% even before franking and with low betas. If held for 7-10+ years, even allowing for a NTA discount, these are profitable investments for the patient investor.
If one is inclined to be a trader, it might be better to speculate on the mining boards as I do with a small proportion of available funds. As with all things, it's horses for courses.

You, as a passive investor, rely on the skills of the underlying manager to steer the fund through thick and thin. You then decide if and in which port you make your exit. Also, it is very important not to jump aboard at the start of the journey. Wait for the LIC to find its market priced comfort zone and then make your move. As some wise wag once said: the market is a mechanism for the flow of money from the impatient to the patient.
Choose wisely which you want to be.

The "closed-end fund puzzle" has caught the interest of finance scholars for many years (just put the search text into Google Scholar). The article and the comments above make interesting points. The principal point I would make is that the LIC investment structure is mainly directed to the retail investor. To attempt to understand the 'puzzle' it is necessary to examine the investment/trading behavior of this type of investor(e.g. the current interest in millennial "Robinhood/no brokerage" account holders trading stocks on their phones! - I imagine there is zero demand for LICs from this investor cohort).

As a retail investor I started my interest in investing by buying units in four unlisted managed funds in the early 1990s on the advice of a financial planner. All four funds were terrible although I stuck with them for a number of years with regular contributions - poor returns, high costs, unexpected tax liabilities despite the poor returns. It was from that experience that I got much more serious about investing, in both direct shares and LICs. The advantage of the LIC structure to me as someone trying to save for retirement was compelling. Over time my investment strategy evolved into a hub and spoke approach with the hub built on the old style LICs such as AFIC, ARG, etc. I have certainly made more than my share of investing mistakes over the years, but I have so far survived serious market disruption events based on my understanding and confidence in the LICs in the portfolio; and although I would construct my portfolio differently if I were start over from the beginning, LICs would still certainly be factored in the portfolio construction mix despite the plenitude of investment structures now available.

LICs, like any investment, require their due diligence and clear understanding of why the investment is being made. There have been periods of 'irrational exuberance' in the floating of LICs . During these periods the offerings seem more about the benefits to the manager than the retail investor, with the inevitable later disappointment and shake-out.

I clearly like and am comfortable with the LIC structure. I see a significant discount to NTA of a LIC as more of a potential opportunity as long as I can convince myself of the investment case and the bone fides of the investment manager.

I'm more concerned about 10y+ management contracts to fund managers assigned to the LIC's that can't be thrown over than the discounts, and when underpeformance or other issues arise the shareholder has little leverage to make change given the legal structures. And then to have to sell at a discount to get out.

I manage the Monash Absolute Investment Company (MA1) which has been trading at a discount. The discount opened up about 6 months after it was listed and we have been trying to fix it ever since, initially along the lines suggested by Daryl Wilson above, without success.

Additionally we undertook an on market buy back, and an off market buy back. Neither the buybacks nor our very good NTA performance of the last 3 years have solved the issue.

The discount is disappointing for our investors who may need to sell and can't get a fair value for their holding, and it puts off potential investors, because they are worried that they won't be able to get out at a fair price either.
It also attracts "activist" investors who would be happy to wind the LIC up to make a 10% turn, again to the disadvantage of people who have invested in good faith and want to get access to the strategy.

We are going to fix the problem by being the first LIC to turn into an ETMF - that is, a listed trust that has a small spread around its NTA set by a market maker. This is a great solution for our investors because they will be able to retain a listed exposure to the strategy, knowing that they will always be able to trade in and out in size.

We expect the restructure will be achieved in the new year. For more information see our ASX disclosures.

Impressive effort and persistence by MA1 to address the discount but the root cause seems obvious, market cap < $50m (or $100m for that matter) is simply subscale. Costs too high and liquidity/profile too low to sustain a LIC.

Be careful what you ask for.
Within reason i would prefer to pay 83 cents for something worth a dollar any day.
Don't invest if you do not understand.

Issn't that the problem? Paying 83 cents for something worth a dollar seems fine, but when trying to get back that mythical one dollar might fetch less than 83 cents. Unless the investor can access the underlying investment in specie to realise the NTA, the investor feels trapped.

At 83 cents you are leveraged. You get dividends for $1 worth of securities. Sounds like good dal.

that only works if the discount to NTA closes. but it may remain that large or get bigger, as numerous LICs have shown. don't assume your 83 cents is such a bargain !

why do etf's escape the scrutiny that lic's get? There has been a ballistic promotion of etf's portraying them as safe and low cost. Both claims are questionable to say the least. The closed end vehicles provide a stability to the fund that open end vehicles do not, If an investor buys an lic at a discount and sells at the discount they have only "suffered" by receiving a higher yield than if they had bought and sold at nta! Investors who buy in at a discount expecting a windfall profit by exiting at nta should not be able to alter the structure which all investors have bought into.

not all investors buy at discounts, a fair part of the scrutiny comes from ipo investors of heavily promoted LIC's who got in at NTA or a small premium (due to raising costs if they weren't covered by the manager), and then in short time saw the LIC fall to a 10 or 20% discount. These LIC's over-raised due to the hype created by promoters for commissions and gimmicks such as IPO options. ETF's are not perfect but they are transparent, liquid and trade around the NAV...

And ETFs did survive the market turn down/volatility earlier this year so they look like to be part of the investment world for some time yet.

Meanwhile LICs trade at discount to NTA.

Alot is made of the "tiresome paperwork" for unlisted funds but in my experience they take about 10-15 mins and this is a once-off piece of admin for something that is intended to be a 7+ year investment.

In my opinion, Magellan are now setting the standard in LIC/LIT's with their structures / transparency and rewarding shareholders with partnership options and DRP discounts, etc. They seem to really recognise the benefit to the fund manager of the closed-ended LIC/LIT structure and are willing to invest and share some of this with their shareholders.

Adrian, invest through an SMSF and you invariably need 'certified copies of your trust deed', which means finding a JP or solicitor to certify it. Plus 'certified copies of ID of directors' the same. Plus accountants certificates which expire every two years in some cases. Yes, tiresome.

We have ventured back into the MF world thru our SMSF recently. 2 different managers with 2 different administrators. All done online. 5-10 minutes each. Painless.

You actually do not need certified trust copies of smsfs in covid environment. AUSTRAC have given relief.

Simon, how many fund managers have updated their application forms to allow for this? If they don't change it, then COVID-relief doesn't mean anything. For example, I just jumped on Perpetual's online application process for SMSFs, and it says applicants need to provide certified copies of all identification forms. It remains a long, drawn out procedure.

Fair enough Gary M, i don't have a smsf so wasn't aware of that. I did a paper form the other day though and needed a certified copy of ID which didn't need to be JP/solicitor, a chartered accountant was acceptable and easy enough to find one amongst my regular contacts.

I'm also drifting back to unlisted MF's, I used to like having the portfolio together in my ASX broker account but nowadays I'm thinking there are behavioural advantages of keeping it unlisted and away from regular attention. The time spent on a one-off form for a long-term investment can be negligible compared to the time spent watching screens and micromanaging the portfolio, if you truly have a long-term horizon. I think the same applies to trying to trade around the discount/premium, there can be opportunities no doubt but the market is becoming more efficient and IMHO it is a second order factor versus picking a small group of capable/trustworthy managers and holding them long-term. Of course, if you are switching in and out of funds in the short to medium-term then I can see how this paperwork would be a bother.

I find the obsession to reduce discounts to NTA on LIC's rather curious given the benefits and opportunities availed to investors by them. With only a little trading when prices are at a premium, I have found LIC's to be the most profitable segment of my own portfolio.
NTA (like book value) does not always explain the price or value of an LIC's share: Performance record, sector focus, management quality, broker coverage, market cap., not to mention marketing efforts (sic. the WAM group) are seen to impact significantly on the discount/premium of LIC's. In a small market like Australia's, one can also argue there is surplus supply of LIC's for the demand available, thus adding to low liquidity and unrealised opportunities.
The degree to which share price is at a premium or discount can also be cyclical. When sentiment is positive, premiums are more prevalent while uncertainty and negativity frequently result in discounts.
Of greatest value is the "safety buffer" provided by a discount to intrinsic value. Combined with the cyclical nature of discounts and premiums, and the determination of earnings, dividends and yields against NTA, not share price, a discount offers investors a clear potential for above average returns compared with purchase at NTA or a premium. And aren't "above average returns" what we, both management and investors, all strive for?

But James, your comment "not to mention marketing efforts (sic. the WAM group) are seen to impact significantly on the discount/premium of LIC's" and similar words of praise in the story do not reflect in WAM Global, average discount to NTA in 2020 17%. Anyone buying it at issue is well down and "marketing" has not helped much.

tony l maybe wam global is trading at a discount to nta because it has only made profits since it started up to 30/june 2020 of $23.5M and paid out dividends of $10.5M but shows retained profits at 30/6/2020 of $51M.THIS LOOKS A BIT ODD.also management fees were about $12M to earn $23.5M.

As a long time investor in the LIC space, we welcome the NTA divergences, so long as they are not permanent. It provides opportunities to make money by buying when individual LICs are trading at bigger discounts than they should, and selling again when that discount narrows (or even turns into a premium). But it's not for everybody and it's easy to get caught out.

Buying the bigger LICs doesn't help beause their performance has largely been worse than the market for the past few years. They might trade close to their NTA, but you're probably better off buying an ETF if you're looking for market returns.

What the LIC industry need to do to fix the discount problem is:
- Report monthly, including portfolio updates. And do it within a few days of the end of the month. Don't wait for the ASX deadline on the 14th of the month.
- Report performance both at the investment portfolio (NTA) level after fees, and also on a total shareholder return (share price + dividends) basis.
- Change from LICs to LITs. The company structure is unweildy and tax inefficient. 30% of taxable profits get paid to the ATO and held as franking credits to be distributed as dividends at some future time. That's a big cash flow lag when under the trust structure the tax is not paid by the LIT and the cash could be distributed immediately. Also, companies can't take advantage of the 50%/33% CGT exemption, trusts can pass this through to investors.
- Pay dividends/distributions regularly (at least quarterly).
- ASX needs to fix the listing rule problem that counts deferred tax assets as an asset for NTA purposes. Deferred tax assets are caused by losing money and generating tax losses. That is not an asset.
- And the big one - all LIC need to have a mechanism in place whereby at least every 3 years, if the NTA has not traded close to NTA for a reasonable time, all investors get an opportunity to withdraw at a price close to NTA. If that ends up making the LIC too small, then just wind it up or convert it to an unlisted fund.

Thankfully, we are seeing more LICs like the examples mentioned above, who are doing the right thing by shareholders. But there are still plently who have a way to go. We are now seeing a lot more activist investors enter the space and this may well mean quite a few more LICs wind up/delist in the next few years unless they can get the discounts closed.

"so long as they are not permanent".....but often they are !

Daryl, monthly reporting is not good enough in this day and age.
LICs are holding liquid listed assets that are priced every second.
if PIC ( Perpetual equity ) and LSF can post DAILY NTA figures, why can't the rest of them do it ?

Good extra ideas, Daryl. But looking at the Bell Potter report regularly featured on this website, there are many LICs which never remove their discounts. Consider FIVE YEAR average discounts on PM Global 13%, Bailador 21%, Thorney 13%, Acorn 14%, Flagship 15%. So you can buy a LIC at 10% discount thinking you have a margin of error and then it goes to 20% discount.

"- Change from LICs to LITs. The company structure is unweildy and tax inefficient. 30% of taxable profits get paid to the ATO and held as franking credits to be distributed as dividends at some future time. That's a big cash flow lag when under the trust structure the tax is not paid by the LIT and the cash could be distributed immediately."

Wouldn't changing to a LIT remove two of the primary benefits of a LIC; dividend "smoothing" and fully-franked dividends? If so, why would LIC shareholders deliberately vote to change to a LIC structure and lose the two biggest benefits of an LIC?

Additionally, why would someone buy or hold an ex-LIC LIT which does not have the above benefits when they could simply buy an ETF with a lower MER that could outperform the LIT benchmark?

LIC'c were on the way down well before the Government announcement on stamping in 2020 and before Covid- 19 - so was advisors pushing EFT's the real turning point or was it because most LIC were using value investing strategies ?

The performance of this company CIE has been atrocious.

Good article. I have no real complaint about my fund, Australian Unity, other than the fact the fund manager rips out a huge amount of the money earned by the fund. The ACCC should not allow this but it ignores what is happening. On the positive side the fund does give a good return but this should be multiples high fees were not allowed. I often wonder why we bother to fund a regulator which refuses to regulate.

Great article Graham, I think there is really one fundamental truth that needs to be acknowledged. A closed ended structure which houses liquid underlyings such as equities benefits no-one other than the fund manager raising the trust. The closed ended structure is actually very suitable for and therefore should be relegated to housing illiquid underlyings such as alternatives and some form of credit instruments.

All other arguments are pure and simply self serving.

Maybe a naive question, but has there been a comparison between post-tax NTA and share price? I'm wondering whether the discount is in fact rational?

Hi Deo, not as easy to answer as it seems. Chris Cuffe wrote this in an article: https://www.firstlinks.com.au/lic-performance-reporting-inadequate

How do you calculate LIC performance before tax payments?

Each month, most LICs report their NTA before tax (that is, their NTA excluding any tax liabilities or tax assets). However, whenever company tax is paid to the ATO by LICs this causes their NTA to fall by the amount of the tax. So, it is necessary to add back the impact of such tax payments to the movement in NTA to arrive at performance numbers which exclude tax. While this sounds easy in theory, the reality is that the bulk of LICs do not provide this information to the public.

Some LICs do report actual tax payments as a dollar amount in their monthly NTA releases. The raw data allows the performance calculation to be made, although investors will need a spreadsheet to work out performance after fees and before tax. It would be far easier if all LICs did the performance calculations and reported it as unlisted managed funds do.

Is there another way to measure LIC performance?

There is another way to measure the performance of LICs other than the movement in NTA adjusted for tax payments (as outlined above). It is the movement in the share price after taking into account dividend payments (which, because we want to measure performance on a pre-tax basis, need to be grossed up for franking credits paid).

The problem here is that LIC share prices are influenced by factors other than the NTA, such as demand for the stock, scarcity value, marketing initiatives, LIC size, sizable undistributed profits, franking credits, etc. The share price performance is not totally in the control of the LIC, and there is often a premium or discount to the NTA.

A further problem is this ignores the stored franking credits, being those generated from tax actually paid but which have not yet been paid out, although franking credits are of no use to shareholders unless they are paid out.

If share price and dividend data is all we have to work out LIC performance, then so be it, provided we put appropriate disclaimers around such numbers.

Excellent point Deo, whilst there is good analysis above on the many reasons for the discount to NTA, the size of the discount is often being incorrectly measured by reference to pre-tax NTA rather than post tax NTA. Most commentators confuse the measurement of LIC investment performance with the measurement of LIC value at any point in time. Investment performance of LICs should be measured as the change in pre-tax NTA after fees (as Graham points out below) so that performance can be compared to trust vehicles such as Managed Funds and ETFs. LICs should also disclose the change in post tax NTA plus any franking credits reserve so that investors can determine their post tax investment return.

However, when measuring the point in time value of a LIC, it is post tax NTA that should be compared to the share price. Tax liabilities (both current and deferred) represent real cash outflows that will be paid in the short to medium term on most investment portfolios (given average portfolio turnover rates). Given the current low discount rates the book value of these tax liabilities are a good approximation of the future cash outflows. It is simply incorrect (when calculating the value of a LIC) to include the market value of assets in an investment portfolio and not deduct the accompanying tax liabilities that will be paid on realised and unrealised gains in the market value of the investment portfolio. Some analysts make the point that pre-tax NTA is a better measure of value because the future stream of franking credits offset the payment of tax liabilities. However the timing of these future cash flows for most LICs have different time profiles and therefore don’t neatly offset each other. Current and deferred tax liabilities generally have a much shorter duration than the distribution of franking credits which are generally tied to a dividend policy. One exception to this approach is LICs with very long investment holding periods and a consistent high franked dividend yield.

Notwithstanding the measurement of share price discounts, most sub scale or poor performing LICs do trade at a discount to post tax NTA. I would argue that scale, sustained investment performance and good disclosure practices are the main ingredients to ensure that share price discounts are minimised over the long run.