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Last week, the Board of Ellerston Global Investments (ASX:EGI) announced that it would convert the company to an unlisted trust structure. This caused an immediate rally in its share price, and the media to speculate that other listed investment companies (LICs) could follow suit. Some more excitable commenters prophesized that “LICs were dead in the water”.
Ellerston Global is a small LIC that offers investors access to global investment opportunities with “compelling risk reward profiles”. Capitalized at around $110m, it invests in companies that are typically not well known to Australian investors. It has been dealing with a discount to NTA (net tangible asset value) challenge – that is, it has been trading on the ASX at a price that is about 17% lower than its NTA (the price per share that would be realized if all the LIC’s assets were sold, liabilities discharged, and funds then repaid to shareholders).
The investment performance of EGI has been quite strong, exceeding its benchmark over the 12 months to 31 October and over the last 5 years, and marginally underperforming over the shorter 3-year period. EGI has also had an on-market buyback in place to lend support, and is currently paying a fully franked dividend of 5 cents per share giving it a yield of more than 4.5% pa.
However, none of these strategies has yielded much success in helping to close the discount to NTA, so it has elected to cancel its listing on the ASX and revert back to a unit trust.
Is EGI’s move a forerunner of what might happen to other LICs trading at a material discount, and are alternatives structures such as unlisted unit trusts or exchange traded managed funds ultimately going to be better for investors? And, which LICs potentially offer “$1 of value for just 80c”?
Before answering these questions, let’s look at why so many LICs are trading at a discount.
Premiums or discounts with LICs are not a new phenomenon, as the graph for one of Australia’s largest LICs, Argo Investments (ARG), shows. Over the last 28 years, it has traded in a range between a discount of 15% and a premium of 18% to NTA, with multiple cycles in between. As at 31 October, Argo was trading at a discount of 0.9%
Argo Investments – Premium/Discount since 1991 (source: Argo)
Source: Argo Investments
But the issue of discounts has become more acute recently due to three important factors. Firstly, the market has yet to recover from Bill Shorten’s retiree tax, which caused some investors to take fright and dump their LICs in the expectation that franking credits would be less attractive. LICs are primarily owned by retail investors, so a proposed change to the laws around franking credits had a disproportionate impact on the LIC market.
The second factor has been an abundance of new supply of LICs and LITs (listed investment trusts), combined with some shocking issues such as the L1 Long Short Fund Limited (ASX: LSF) and suggestions that some advisers have put “their interests” ahead of their clients. Many advisers and financial planners are paid a placement fee (also called a ”stamping fee”) for new issues, and the suggestion is that clients have been “churned” from one issue to the next.
Finally, towards the end of a market cycle (which some argue that this mature bull market is nearing), the share prices of LICs typically lag the market, thereby increasing discounts to NTA.
Because LICs and LITs are traded on the ASX, this provides a ready, timely and easy liquidity facility for investors looking to exit their holdings, or new investors looking to come on board. New investors don’t need to fill in an application form or produce certified identification documents. The downside, of course, it the potential premium or discount.
But there are other advantages of the LIC structure. Firstly, it is a close-ended investment structure of finite capital. This means that the Manager has a fixed pool of funds to invest, and doesn’t have to worry about new monies coming in from applications or monies going out for redemptions or withdrawals. Further, the company doesn’t need to keep a whole lot of money with the Bank (effectively not invested) to cater for the possibility that there may be a flood of redemptions.
The LIC is also a company, giving the Directors the power to declare and pay a dividend or not. They can smooth the dividend form one period to the next, frank it directly if the company has paid sufficient tax, and in some cases, pay it out of reserves and boost the income return that shareholders receive. Dividend re-investment plans and regular share purchase plans (up to the $30,000 limit) are other features.
Alternative structures include the traditional managed fund and the exchange traded managed fund.
The traditional managed fund is typically an open-ended fund, meaning that it grows in size as new investors purchase units directly from the manager or contracts in size as existing investors redeem units and these are cancelled. The manager provides a buy/sell price at a small margin to the fund’s NTA. This is the form proposed by Ellerston (an unlisted trust structure). Some of the traditional managed funds are also available through the ASX’s mfunds service – although only a handful of stockbrokers make this service available to their clients.
But this model does not guarantee investors liquidity. While it works in a stable market environment, in stressed market conditions, redemptions are sometimes frozen or suspended. Funds that hold illiquid assets can be particularly vulnerable. If requests for redemptions become overwhelming, there can also be the challenge of the “death spiral”.
Another consideration is that the pricing is not particularly transparent, and if investors have to lodge applications to withdraw, the process can be quite clunky. Settlement is often 7 days, rather than the two days on the ASX.
Recently, a number of investment managers have developed open-ended exchange traded managed funds. Quoted and traded on the ASX, they also utilise a unit trust structure. They engage a market maker to provide the liquidity such that the fund can trade on the ASX at a price close to its underlying NTA. Magellan Global Equities (MGE) is probably the best known example, others include the Switzer Dividend Growth Fund (SWTZ) and eInvest (EIGA).
Actively managed, these exchange traded managed funds employ the same structure as passively managed index tracking ETFs (exchanged traded funds) such as IOZ, IVV or VAS. The difference between the two is that whereas the market making for exchange traded managed funds is typically internalised, index tracking ETFs that publish their portfolios daily engage external brokers to provide this service. The latter take the risk on any transaction, whereas with the internal market making model, the fund takes the risk. ASIC has recently put a stop on the listing of new exchange traded managed funds while it further considers some of the issues with this structure.
Whether the fund is a traditional managed fund, an exchange traded managed fund or index tracking ETF, all are trust structures. As pass through vehicles, there is no discretion about the distribution of income, and while distributions can be re-invested, the fund can’t offer share purchase plans or their equivalent. Further, the distributions are clunkier – the investor must wait till the end of the financial year to find out about the different tax components including any imputation credits, deferred tax and pass through capital gains.
I don’t think LICs are “dead in the water”, particularly with the most likely alternative structure (the exchange traded managed fund) not currently available. There are many LICs that have proven themselves over the long term, such as AFIC, Argo, Milton Corporation and WAM to name but a few. The simplicity of the company structure managing a finite pool of capital is intrinsically appealing. Going back to the “bad old days” of unlisted managed funds is a retrograde step.
However, small LICs with large discounts that can’t or won’t be closed will be very vulnerable. Shareholder activism will force many to consolidate, merge or commence an orderly wind-up of their assets.
There are several reasons why LICs trade at a discount, including performance, size, manager support, marketing and issue history. So, care should be taken before “buying $1 of value for 80c”. Based on the latest NTA and market price as at 31 October, here are some LICs with big discounts.
Discount to NTA – as at 31 October 2019
As at 31 October 2019
Finally, for full disclosure, I am a Non-Executive Director of listed investment company WCM Quality Growth Limited (ASX: WQG). I am also a member of the Investment Committee of exchange traded managed fund Switzer Dividend Growth Fund (ASX: SWTZ).