What you need to know about listed investment companies
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The older we get the less active we become. The body slows down and in many cases so does the mind. We tend to become more passive.
This overall slowing in both physical and mental activity can also be reflected in the way we wish to manage our financial affairs, particularly our superannuation funds set aside to finance our lifestyle in retirement.
It is not unreasonable to see an increasing number of older investors choosing more passive investment alternatives and becoming less active, particularly in the direct equities segment of their financial assets.
Morningstar is in a unique position with extensive independent research on listed investment companies, managed funds and exchange-traded funds (ETFs).
To address the change in investor behaviour we intend to provide regular research in Your Money Weekly on all three passive alternatives.
This week we introduce listed investment companies (LICs). Here's a thumbnail sketch of their operating structure, suitability and information investors need to know before making a commitment.
The managed investment universe for Australian investors has never been broader. Not only is there a vast array of unitised managed investments available through numerous platforms, but there is an increasing number of ASX-listed ETFs available for purchase.
LICs have been around for a long time, occupying a niche segment of the market. However, in recent years, they have experienced somewhat of a renaissance, with 20 new LICs focused on Australian equities coming to market since 2013, and a number still in the pipeline.
Exhibit 1: Total capital raised by Australian Equities Focused LICs*
* Includes IPOs, Exercise of Options, Secondary Issues and DRPs, excludes Buybacks.
Source: Morningstar DatAnalysis
The investment appeal of LICs is not altogether straightforward. On an underlying basis they are similar to other managed investments in that they provide investors with exposure to a diversified portfolio of assets.
However, there are substantial differences in the way new funds are raised and subsequently traded on the secondary market, as well as the way investment returns are taxed.
Investors should take the time to be fully aware of the various complexities of LICs to make an informed decision regarding their investment merit and suitability.
A LIC is a corporatised managed fund which is listed and traded on the ASX. The LIC initially raises capital through an IPO whereby investors can apply for shares in the company.
The funds raised from the IPO are then invested in a portfolio of securities which are managed by a professional fund manager.
The value of the underlying investments forms the basis for the net tangible assets (NTA) of the LIC.
Investors should be aware when a LIC undertakes an IPO there are costs associated with the offer which are deducted from the NTA on day one. As such, new investors are typically paying an initial premium to participate in the IPO, over and above the value of the underlying portfolio.
For example, in early 2016 WAM Leaders (ASX: WLE) raised $394 million via an IPO with a corresponding $5 million in costs. Investors who subscribed for shares in the IPO at $1.10 had an initial underlying investment worth $1.086 on day one.
Sometimes shares issued in an IPO will come with a corresponding option to buy additional shares at some date in the future, which can also be traded on market. In the case of WLE, the option traded at 4.4 cents on day one.
Investors need to consider if they sell their option, or do not exercise, their initial investment could be diluted, if others exercise and new shares are issued.
Once a LIC has undertaken its IPO the funds raised are "captive," meaning they cannot be redeemed. Instead, investors are free to trade their shares on the secondary market (that is, the ASX).
This makes LICs simpler than a unit trust, as there is less paperwork involved in adding to, or reducing an investment (albeit this paperwork can be avoided by using the ASXs mFunds platform).
However, where the price of a unit in a trust will always reflect the value of the underlying investment, the share price of a LIC is influenced by a number of factors which can lead to sometimes substantial differences to the underlying NTA per share.
Of principal importance for the efficient trading of a LIC's shares is liquidity. If there is not an adequate number of buyers or sellers at any point in time then wide divergences can appear between the share price and the underlying NTA, referred to as the LIC's "premium" or "discount".
In this respect, size often matters, with the larger LICs typically trading closer to their underlying NTA than smaller LICs.
Investors should exercise due caution when considering the purchase of a LIC at a premium to NTA, as it presents an additional layer of investment risk.
History has shown premiums can unwind, and swing to discounts quickly, particularly during times of market stress such as the GFC.
Likewise, the purchase of a LIC at a discount to NTA is no guarantee of superior returns, as discounts can remain for extended periods of time, or indeed continue to widen.
Perhaps the most touted benefit of a LIC in the current market is the ability for them to generate fully franked dividend streams. This is because a LIC pays tax on its investment returns at the company tax rate, and can then distribute dividends out of after-tax profit.
Indeed, if a LIC can generate consistently strong investment returns it has the ability to retain a portion of profits each year which can be paid out in future years, effectively smoothing the dividends to investors.
A more passive investment philosophy will generally result in franking credits being generated from dividend income. An active philosophy will tend to generate franking credits from realised capital gains, which are taxed at the company tax rate.
This compares to a unit trust, which must distribute all income and realised capital gains to investors in the year which they are incurred.
Ultimately, the benefit of the LIC tax structure is more around simplicity and relative certainty, whereas taxable income from a unit trust can be lumpy in any given year.
This has perhaps led to the strongest demand for LICs coming from self-managed superannuation funds seeking simple and tax-effective investment solutions.
However, over the longer term, on a like-for-like basis, the post-tax outcome between a LIC and a unit trust are likely to be similar.
As with unit trusts, the fees charged on LICs vary substantially. Some of the largest, most longstanding LICs have the lowest fees such as Milton Corporation (ASX: MLT) at 0.12 per cent per annum, Argo Investments (ASX: ARG) at 0.15 per cent and Australian Foundation Investment Company (ASX: AFI) at 0.16 per cent.
These funds generally adopt a highly diversified, long-term, low-turnover approach to investing, whereas the newer crop of LICs generally charge substantially higher base fees for active management, and often charge performance fees as well.
For example, Monash Absolute Investment (ASX: MA1), which listed in April 2016, charges a base fee of 1.5 per cent plus a performance fee of 20 per cent for any excess return over the RBA cash rate.
Investors should take the time to study the prospectus of any LIC investment where all fees are disclosed in detail.
As with any investment, the merits and risks must be examined on a case-by-case basis. LICs have a long history in Australia, and the captive nature of their funds should mean they continue to be around long into the future.
While LICs in some respects appear simpler than unit trusts in terms of less paperwork, investors need to be aware of the additional market risk they incur, as the shares can trade in a wide range around the underlying NTA.
In this respect investors should also consider ETFs which provide the simplicity of an ASX tradable entity, but at a price which is more closely anchored to the underlying NTA.
In addition, investors now have access a wide universe of unit trusts on the ASX's mFunds platform for added trading simplicity.
Peter Warnes is Morningstar's head of equities research and 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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