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A welcome alternative for investors chasing income

Michael Malseed  |  11 Aug 2017Text size  Decrease  Increase  |  

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In today's lower-for-longer global interest rate environment, listed investment trusts present investors hungry for secure income with another income-focused, share-market-listed alternative.


While still somewhat misunderstood and little-known within the Australian market, demand for listed investment trusts (LITs) is set to grow alongside exchange-traded products, listed investment companies, and traditional managed funds.

Ahead of its full-year financial results presentation this week, Magellan Financial Group revealed plans for its Magellan Global Trust offering. Throwing the focus on this lesser-known subset of the market, some commentators suggest this LIT may raise up to $9 billion.

With a cumulative market capitalisation of around $600 million across fewer than a dozen offerings currently on the ASX, the segment hasn't yet gained much air-time. Magellan is likely to change this. Evans and Partners Global Disruption Fund (EGD) is another recent launch within this space.

But what are LITs?

We have written previously about the idiosyncrasies of LICs, and it is a subject that will no doubt remain topical into the future.

Comparing and contrasting

Starting with the obvious similarities, both are listed entities with underlying assets invested by a professional manager into an underlying pooled investment strategy. In this way, they have a similar objective to unlisted managed funds: to generate favourable investment returns from a diversified portfolio of assets.

But unlike managed funds, both vehicles are "closed-ended". Once an initial number of shares or units are created through an IPO, these can only be traded on the ASX between willing buyers and sellers. This invariably leads to the potential issue of the LIC or LIT trading at a premium or a discount to net tangible assets (NTA), depending on the level of liquidity and demand for the asset. Investors also need to pay a broker to transact in the securities, which adds to the cost of investment.

The key differences between LITs and LICs relates to the way income and capital gains are treated, and how investment returns are taxed. A LIC treats the dividends from underlying investments and capital gains--both realised and unrealised--as income on its profit and loss statement. The LIC then deducts operating costs (including brokerage, management fees, directors' fees, listings fees) to derive a profit-before-tax figure. This is then taxed at the company tax rate, which is normally 30 per cent, although from 1 July 2016, this will progressively reduce to 27.5 per cent, depending on annual turnover.

On the other hand, an LIT more closely resembles an unlisted managed fund, in the way all net income and realised capital gains are distributed on a pre-tax basis, and the end investor is liable for any taxation.

As a result, the income stream produced by a LIT can be difficult to predict, and will fluctuate according to the trading activity of the underlying investment manager. However, this is offset by the considerable advantage of discounted capital gains tax concessions for assets held longer than 12 months, for which most individual investors will be eligible.

Corporate entities are generally not eligible for this discount, although some LICs may qualify for a concession from the ATO to pass this benefit on to shareholders.

A LIT may also present the manager with more flexibility in paying distributions, being able to pay over and above the underlying income levels, through a return of capital. This can be useful where a manager wishes to pay out a set proportion of the fund each year, to provide investors with a predictable income stream. On the other hand, a LIC is constrained in its ability to pay dividends, requiring the accumulation of retained profits (in a profit reserve on the balance sheet), before a dividend can be paid.

In rising markets, this isn't a problem for LICs. With a sufficient profit reserve buffer, a relatively smooth and/or rising dividend profile can be maintained. But should markets fall, as occurred during the global financial crisis, the profit reserve can be eroded quickly. This can lead to LICs having to reduce or suspend dividend payments until profit reserves are replenished.

In summary, the differences between LITs and LICs are relatively subtle, and both face the significant challenge of generating sufficient liquidity and demand to ensure they trade near a rate close to their NTA.

But with an ageing demographic of investors who will be increasingly focused on income, we may see more LITs coming to market, given their greater flexibility to pay distributions out of capital, and their tax transparency.


Exhibit 1: Summary of key features by investment vehicle type



Michael Malseed is a senior analyst, manager research, at Morningstar. Any Morningstar ratings/recommendations contained in this report are based on the full research report available from Morningstar.

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