The major weaknesses of LICs and managed funds

Thanks Graham

Re LIC's V Managed Funds.
One thing I don't get Graham.... surely the only people who suffer when a Managed Fund is forced to sell at rock bottom prices are the people who are redeeming units. The unit price only suffers long term if the manager sells more than is required for redemptions. With lumpy assets like unlisted real estate this could be a problem, but surely not with shares? In your example, what was stopping the fixed interest manager taking advantage of the CBA bonds yielding 9% for the unit holders remaining in the fund?
I can understand that balancing inflows and redemptions might be tricky, but I don't see how it affects returns.

Hi Neil, thanks for the question. In the example I gave, the bond market was so illiquid that there were few buyers for anything other than government paper. Those willing to make a bid on bank or corporate paper set their prices at very low levels. Portfolio managers were facing heavy redemptions, and so they had to sell almost anything they could just to raise the cash to meet outflows. And so a bond might have been sitting in the portfolio valued at 90 (and this was often a rough estimate because there was no trading), but the manager was forced to sell at 80 because it was the only price in the market. At times of distress, liquidity can vanish and buyers with cash can dictate the prices. The managed fund is forced to sell while the LIC manager can wait. In my example, the fund manager could not buy because he was desperate to raise cash in any way he could to meet redemptions. You would be surprised how often the revaluation of a fund is a best guestimate when many securities have not traded for a while.

Again, during the GFC, listed property trusts (now called A-REITs) had terrible liquidity, and some managed funds fell dramatically as prices collapsed. No buyers other than at fire sale prices, making some fund managers forced sellers. Same in small company equity funds, where bid/offer prices can widen to extremes because there is no liquidity. Obviously, this is less likely to happen with CBA or Telstra, but even there, forced sellers pushed down prices severely during the GFC and some portfolio managers had to sell at whatever price they could find.

Graham, someone who used to work for me is now manager of a seriously large fund. I asked him recently what he does with his own money. The answer is LICs and MICs. I asked why, with his expertise, he let others manage his money? He said: Because I'm too busy to look after it properly myself. If his name were known that would be a great ad for these structures.

The problem of LICs trading at a discount could be largely overcome if the LICs introduced a policy to always buy back shares if there were sell offers say 5% below NTA. This wouldn't necessarily be a great outcome for investment managers (as FUM would decline); however, by definition each buyback that takes place below NTA adds to the net assets per share for the remaining investors and is therefore in the best interests of shareholders.

If there was a genuine commitment to an uncapped ongoing buyback program by the LIC, then the market price would automatically adjust back towards NTA as sellers would cease placing offers below the expected buyback price.

I'd like to see all LICs buy back shares following a sustained period of discount to NTA (Ironbark (IBC) have stated an intent to do this every 3 years), and I'd also like to see new shares only issued at NTA or above, and only when they have traded at a premium to pre-tax NTA (Platinum (PMC) have stated their intent to employ both these measures. That seems sensible policy in shareholders interests.

As for Templeton (TGG), the board has repeatedly shown no respect for shareholders in twice placing shares well below NTA into a saturated market. That action is mostly of benefit to the external fund manager by increasing FUM and the associated fees. I would urge all shareholders to vote against the remuneration report - they received their first strike at the last AGM.

To really undo the damage of their previous actions, the Board ought to offer all shareholders a full buyback at NTA.

Putting all other variables aside (fees, turnover are all valid points but there are high fee/high turnover LICs) if you have two identical portfolios - one in an LIC structure and one in a managed fund structure, with no inflows or outflows to each - there remains one (and only one) difference - an LIC can retain earnings. This is probably great if you are on the top MTR, but not so great if you are a (15%) super fund which pays a lower rate of tax than the LIC and would prefer all earnings paid out with the attached requisite tax credit (which you can then choose to reinvest if you wish) The LIC structure being more tax effective is illusory - just because the LIC pays the tax on gains and dividends before it pays you doesn't mean you aren't paying the tax (most would find a $70 fully franked dividend equivalent to a $100 unfranked dividend - this is no different). Yes - LICs can smooth dividends via retained earnings - however this merely makes the distributions administratively easier to handle from a cashflow perspective.

You can then start relaxing assumptions and start adjusting what works for you - for example my most significant assumption above - zero inflows. A positively performing managed fund in strong inflow will produce a beneficial tax outcome vs a static capital (LIC) equivalent as the realised gains and dividends at the start of the year get diluted per unitholder as the fund grows - so your unit price goes up just as much as you would expect but you get to share the tax liability with your new found friends in the unitholder pool at the end of year distribution. Of course the reverse happens if the fund is in material outflow. But flows are not a strength or a weakness from a tax perspective.

As to whether or not a company structure pays tax and decides whether or not to retain it vs a trust structure that is forced to pay everything out - only the individual can choose what works best for them - there is no clear winner.

As to the "forced seller" problem - this only occurs when managers are offering their investors more liquidity than the underlying assets offer them (which typically ends badly in any case) - otherwise they can just re position the portfolio with outflows in the same way they would with inflows.

Investors often fail to understand certain facts about LICs:
(1) LICs can be of great value to an investment manager as they represent a source of annuity income from captive money.
(2) Furthermore, LICs all too commonly have a nasty habit of issuing more equity, often in a dilutive fashion to existing investors.
These are legitimate reasons for why LICs routinely trade at a discount to net asset value, and why institutional investors don't want to buy LICs at IPO.

With respect to the point about managers being forced to sell assets from a managed fund at times of stress, it is important to note that at times of stress, LICs often trade at an even bigger discount to their NAV - which is already simultaneously lower due to this same stress. Hence if I needed to sell at a time of stress, I'd typically rather be selling a managed fund (at a depressed NAV) than an LIC (at a deep discount to a depressed NAV).

An LIC can usually claim the benefit, as does a managed fund with a more infrequent redemption policy, of being able to take a longer term view with respect to its positioning. courtesy of its more captive capital.

Sorry, forgot the issue of an annuity income for the manager. This is not an industry wide issue. The reason we require a 50 year plus history is that all the recent entrants to the market have a separate management company with unconscionable fee levels, 1% or more plus performance fees. I'm happier with the older lic's where the company and management are one with a management fee of, say, 0.12% like Milton.

Managed funds being a trust structure must distribute all profits to avoid double taxation. This means that any trading profits have to be returned to unit holders each financial year end.
This creates extremely lumpy distributions that are very tax ineffective.
I have experienced quarterly distributions from one fund that varied from $800.00 to $13,000.00 leaving me to pick up the tax bill on thousands of dollars of unwanted capital gains.
Repeated time and time again over a number of years I ended up with a fund, the unit price of which hadn't moved at all and paying unnecessary tax each year. This also meant that the 'dividend income' was often only partially franked as most of the distribution was capital.

My rules of thumb for choosing lic's are, 1. they must have been around for at least 50 years, and have a robust investment philosophy that doesn't rely on a hot shot personality.
2. They must be a single entity and not have separate management company.
3. The management expense should be 0.5% p.a. Or less and there should be no performance fee.

This is the problem I've had with managed funds in the past. Given managed funds report their returns on a pre tax basis they seem to have no care about portfolio turnover. If you're in a low tax environment (and reinvesting divs) it doesn't matter so much but if you are invested in your own name or rely on distributions for income it is hugely problematic. At least LICs must report their returns after tax (at company rate), and then can control their distributions to keep it consistent. Of course the added benefit is that the tax paid is returned to the investor if they are on a low tax rate thanks to our overly generous dividend imputation system.

Peter your rules for LICs are interesting and limit you to about 4 options, all of which are trading well above their NTA. Do you have any concerns about buying LICs above NTA?

Not at all Steve. Having taken up the rights issues and share plans over the last 20 odd years for the 4 lic's we hold the whole issue of discount/premium is of no interest or consequence. As we never sell our children and the charities that will benefit can agonise over whether we could have tweaked the performance by frigging around with our holdings.

I love the ‘nasty’ habit the lic’s have of issuing new shares. As we take them all up we are never diluted and it is a zero cost way of topping up for children and grandchildren.

"they must have been around for at least 50 years"

that is silly.
If you look at the performance figures for AFIC, Argo and Milton over the past 1, 3, 5, 7 and 10 year periods they are usually no better than and sometimes worse than the ASX200 index. They have far too much ( 30 - 35% of portfolios ) in banks plus other boring mediocre companies such as Telstra and BHP whose share prices are lower now than they were 10 years ago.
There are far better LICs out there performing far better such as those run by Geoff Wilson ( WAM, WAX, WLE ), Mirrabooka, Magellan, Amcil, Forager, Watermark.
I don't need to pay a fund manager to invest in the index, banks and Telstra for me.

If managed funds were any good they should have limited the downside in 2008 and fewer unit holders would have wanted out.

LICs trade at a premium or discount depending on whether investors as a whole believe they will add value or detract value in the future from their active management of their assets.

If they trade at a discount, investors are effectively saying “stop wasting my time. Just liquidate the thing and distribute the assets to the shareholders.”

being a contrary person i love buying LICs at a discount ( but only after perusing the portfolio held and management style and assured they are 'unfashionable ' rather than struggling )

although BE WARNED your LIC manager may change adjust the management style as they deem wise ( not totally bad or good just affects my 'balancing attempts ').