I often mention to other investors that looking for opportunities in the ASX Listed Investment Company (LIC) sector has been part of my strategy.
A reaction I have had on several occasions from them is to bring up an example of a LIC boasting great performance figures.
But then they ask me what is the deal with the share price still at the listing price of a $1? For example “hey this LIC supposedly is returning over 15% per annum for nearly 5 years but the share price is flat. I understand a dividend here and there comes out but what is the deal with this?”
This can mean a quoted return from the fund manager may look like for example 16% per annum. But if shareholders exit the investment at the same IPO price then they may only have returned roughly the dividends along the way. Let’s take a hypothetical example where that exciting headline of 16% per annum may have only given the investor more like 6% per annum. To be more positive maybe you can gross this 6% up for franking, but still will be well short of the 16% per annum in the marketing reports.
ASX LIC comparison performance
Where does the discrepancy in reported returns go? A fair bit is to do with some of the weaknesses of some LIC IPOs. That is, a major issue can be a small float size and what this means for fees.
Many investors depart with their hard earned in the IPO only reading about the management fees. Plenty I hope will also be aware of performance fees (although if they don’t read carefully may get confused by the details). They are probably less likely to be aware of the impact of “other” fees. For exampled directors fees, initial listing costs of the float, ongoing admin fees, marketing expenses, accounting fees, ASX fees, share registry fees, custody fees, audit fees, underwriting of placement fees etc. How many investors bother to read the 100+ pages of prospectus details?
Let’s say the LIC only raises an extremely small $20 million, very unusual but not unprecedented.
ASX LICs commissions and conflict of interests
Firstly the NTA can easily lose 3-4% from listing costs. That may not stop some LICs being imaginative when calculating their reported performance numbers. Don’t be surprised if they base their reported returns from the NTA price after listing of around 96-97 cents.
The “other” category of expenses could easily run at $400k a year. On a small float like this, wave good bye to 2% per annum before we even discuss management & performance fees.
If you are a boutique absolute return manager maybe you can get away with charging 1.75% as a base fee per annum. Thankfully though this is now becoming very difficult.
Perhaps a performance fee also. Some like to be cheeky and have a 20% outperformance fee quoted in the media coverage pre IPO, but without the mention of the performance hurdle. Then when reading the fine print you see they have set the benchmark hurdle low at say RBA rate plus a couple of percent. In some cases even the hurdle rate is simply zero, no benchmark! If the manager gets a good 16% per annum at the top level, wave good bye some fat performance fees. In this example maybe you leak another 2-3% per annum.
Let’s say the IPO came with 1:1 options. If these get exercised at a strike price well less than NTA it may dilute the NTA significantly. If you have grown the fund well, e.g. 16% per annum at the headline level this could be a significant dilution. You can exercise the “in the money” options, but that may trap you in the expensive fee structure for a larger investment. That may be uunsuitable for many investors. Any initial sugar hit from exercising the options may not last if a sizeable discount to NTA develops in the share price. Given all the potential issues I have raised above this is quite common.
Selling the options may not give such a great result either. The price is impacted by the shares potentially trading at a sizeable discount to a diluted NTA. Lack of liquidity in the options market can also pose issues. How about then selling your shares but exercising the same amount of options? Perhaps that may work better but maybe not if everyone else has the same idea. Also again beware of fund managers using some imagination when they present their performance numbers. Some may assume you get the full value of the diluted NTA upon exercising. This is overly optimistic if the shares later trade at a consistently large discount. Some may assume the options could have been sold on market at a conservative value. This is a very subjective method.
If an investor changes their mind and wants to exit out of this structure, it is easy to take a 10% hit or more by needing to sell at less than NTA. For smaller less liquid LICs this is quite normal, often the discount is greater. Now the fund manager might also say the discount to NTA can be fickle and we shouldn’t incorporate that into performance returns. There may be some truth in that, but how about in an example like this? What is the likely result when the manager decides to launch a $20 mill LIC, with 1:1 options, and charges a base fee of 1.75% with hefty performance fee? I would argue they are the ones that have brought about the permanent discount to NTA. The odds of such a launch trading at NTA in the long term must surely be very low.
You also must consider that a very small size float like this will likely always be on the lookout to raise extra capital. Be prepared for them saying “we felt it is in shareholder’s interests to conduct a raising at a discount to NTA in order to attract new sophisticated investors on board. This will lower the management expense ratio and allow us to pursue attractive opportunities in the market“. Apart from dilution this also is likely to encounter placement fees. Also when a small LIC desperately needs all of the options to get exercised to become a reasonable size, this can add costs. They may also pay significant underwriting fees to ensure this occurs and tolerate further dilution to NTA.
Adding up all the above issues can easily turn the a 16% per annum gross return displayed into far less. We are talking potentially 10% per annum less over a period of a few years.
So if you see a LIC boasting great pre fees and expenses performance numbers, it may pay to consider many other factors before diving in quickly. A great stock picker may not necessarily provide you with great returns by buying their LIC.
LICs vs managed funds
The closed end fund structure does have many benefits. Stable AUMs for the manager help in managing the portfolio, and they can also work to smooth out dividends for shareholders. Some better LICs boast a long track record of growing fully franked dividends. But with LICs trying to start out with less than $50 million there can be many challenges with using this structure.
If you choose the open end fund structure you may be rightly concerned about the effect redemptions from the fund can have on the manager’s performance. This is certainly a risk. But if a small boutique fund can run with lower fixed operating expenses it may still be a better alternative. The key is that the manager communicates their strategy well with their clients, and the money is “sticky”. If investors perceive they are getting a fair deal with the fee structure (unlike perhaps the above example), that may also encourage them to stay in the fund for the very long term.
As would believing the manager has real “skin in the game”. Some LIC managers claim they have skin in the game by controlling 20% of the company. This could be true, but such a stake can also be used to trap investors inside the LIC and keep management fee revenue high. It is a great gravy train to be on if you can get away with a high base fee. IMAs of LICs in recent times often come with 10 year terms. An open ended fund where the manager only gets paid if they outperform a fair benchmark can be preferable. In that case assuming the manager also has significant wealth in the fund, then to me that means real skin in the game.
Another point about the more old fashioned unlisted open end structure I would like to make is around investor behaviour. What if you apply for units the “old fashioned” way in an unlisted fund? Maybe you are more likely to stick with it for longer now that the price is not flashing on the screen every day. Could that be a good thing?
Perhaps an increasing number of smaller boutique fund managers that are much fairer with what they charge will become more prevalent in the future. I am thinking of ones starting up with an open end unlisted structure, where fixed costs can be less. Managing portfolios less than $50 million can be fruitful as you can hunt for smaller companies where arguably pricing inefficiencies are more common. The recent trend of money flows favouring large passive funds should help keep that the case. Maybe it will be the case that less broker research on small caps in the future may also favour more inefficiencies to exploit. It’s just important to keep fees fair.
I think innovative performance only fee structures could become more common. I also don’t mind the concept that a fund manager could maybe use a loyalty incentive. Perhaps reward a unit holder in later years with lower fees. Investors are often impatient with sticking with a fund manager during some lean years. Some encouragement for them to stick with things over a full investment cycle may help both fund manager and their investors. In some ways a high watermark for a performance fee only manager already kind of achieves this. I will perhaps explore more of this in another post sometime in the next few months.
I won’t go into specific details of shareholder returns from many of the sub $50 million LICs that have come to the market in recent years. However I shall list the tickers that came up on a quick scan of mine. Readers can have a look themselves at some of the results. I think it is safe to say in general if you had participated in all of the very small LIC IPOs over the last few years you may not be jumping for joy about your returns achieved. Some of the new ones that came up on my scan include 8EC, FPC, GC1, MA1, MEC, RYD. I should point out that RYD has got out of the blocks well and where I think IPO investors would be well satisfied.
Please note that by mentioning those LICs just above I am not suggesting that from this point in time they will underperform. Investing with a large discount to NTA can sometimes compensate for other factors. I don’t have a strong opinion on the future prospects either way for those mentioned above. The stock picking from the above LICs has been fine in some cases. Often it is other factors I mentioned earlier like costs, dilution from raisings, discount widening etc. that has hurt investors.
OTHER ARTICLES ON THE LIC PERFORMANCE REPORTING TOPIC.
https://cuffelinks.com.au/lic-performance-reporting-inadequate/
https://cuffelinks.com.au/trust-why-not-all-lics-created-equally/
Great article – I haven’t looked at the smaller cap LIC’s in any great detail – generally into the large ones (ARG, AFI, MLT etc)
Thanks mawermoney. You may not have missed out on much by overlooking them. Playing around with LICs sub $50 mill in size can be riskier. I think eventually there will be a time the discounts get large enough to be tempting. Generally speaking though I don’t think we are at that stage yet.
A belated and very long comment containing my experiences with <$50m LICs. A few years back, based on my observations of new small equity trusts, I considered there was a possibility that small LICs could perform very strongly from the word go. The plan was to buy a part holding in selected IPOs (FOMO?) then, assuming of course that I was still happy with the way the LIC was being run, buy more of the same ones later if they became available at a pre-determined (from historical data) price to post tax NTA discount (‘the discount’). Didn’t matter if this was due to NTA rising or price falling. Using post tax NTA meant all the numerous fees and costs were already taken into account. I have in this category bought GC1, MA1 and SNC. The Pohl siblings, BST and FSI were bought only under ‘the discount’ rule, I having not been aware of the IPOs. More on the success or otherwise of this plan in the conclusion. Note that the end point for all performance figures is the current NTA plus divs, not the current share price. More on this also in the conclusion.
GC1 has only now reached ‘the discount’ level. Yes, the gross performance basis for performance reporting was poor and I’m fairly certain that GC1 was the unnamed subject of an ex LIC manager’s tweet on “puff reporting”. They have since gone to NTA change plus dividends, which of course is much lower. I make it 6.9% pa, all from dividends. However, I think Michael Glennon is one of the better small company analysts and have bought more.
MA1 Original holding only. No dividends yet and down a couple of percent over 26 months. There has been, and currently is, opportunities to buy at ‘the discount’, but the jury is still out on the manager’s ability. Performance is quoted as + 0.5% pa pre-tax since inception, though without the ‘before everything’ figure for comparison, one doesn’t know what the fees and costs really are.
SNC Sold out of them and got my original dollar back. Dividends made it 3.9% pa so I guess I can’t complain too much. They were available at ‘the discount’ a couple of years back, but even then I had become sceptical that their activist strategy was working. The sell was prompted by the repeated option issues. At one point I was amazed at how a reported 29.1% return became 7.1% after ‘everything’ by their own admission.
BST was bought at ‘the discount’. My return is 15.0% pa comprising mostly capital growth. In the last two years there has additionally been full attributable dividend deduction. BST only report performance quarterly and then as that of the underlying portfolio. Their three year figure to 31/3/18 is 10.1% pa. My post NTA plus dividends for the same period comes to 4.0% pa. At $19m this would be one of the smallest LICSs.
FSI is a bit different in that it contains generally larger cap stocks, but is still (just) under $50m. Again bought at ‘the discount’. As one would expect, dividends are higher than BST, but still mostly capital gain making up to the same 15.0% return to me. It reports on the same basis as BST. I haven’t held it as long so can only compare their one year figure of 9.4% with my 6.9% calculation. FSI may be unique in that they charge a performance fee but no management fee. I haven’t checked the financials to see whether it is this or its larger size, or both, that accounts for the difference with its smaller brother.
CONCLUSIONS.
The buy some in the IPO part did not work for me. All companies discussed could have been bought at both a significant discount to NTA and subsequently cheaper price. Further investigation of an admittedly low number of small equity trust suggests that their outstanding performance occurred very early when they had less than $10m FUM, so was not applicable to any LICs.
The buy at ‘the discount’, not surprisingly, worked well. It would even have provided a good return for SNC a fund that I considered was not well run. The downside is that some LICs never reach ‘the discount’ and so would never be bought using only that part of the strategy. WMI comes to mind, though that is a larger entity. FGG and FGX likewise, though they are a different kettle of fish altogether. As a sideline, I wonder if Radzyminski (SNC) has taken on too much with his activist strategy and Future Generation responsibilities.
It should be apparent that ‘the discount’ figure is critical and that I have not stated it. Sorry, but I spent a lot of time back testing to determine one figure that could be used for any small LIC. There may not be a lot of time to get set, so I don't need any competition. I’ve no doubt that, like most mathematical strategies, at some point in the future it will cease to work.
With regard to the LIC costs, they can only be easily determined if the manger publishes both ‘before anything’ portfolio and ‘after everything’ NTA change figures. Few do. Like most things in the financial industry, I’ve always assumed that fees and costs will be excessive. Using the after everything NTA means I don’t have to worry as much about them. As a long term holder, I also have less concern that these costs will be a factor in keeping the price at a discount for a long time. I tend to think that with a good manager the discount will eventual decrease regardless or that the dividend will grow enough to keep me happy. The theory of getting rich slowly appeals to me. Failing that, in the very long term I assume the LIC will be taken over by another LIC or liquidated. I have had both of these eventualities occur.
Appreciate you sharing these experiences Graeme, some interesting examples there.
It’s a fair point to think that if you buy a manager at a large discount and their performance does well the discount will close. This can power up your returns as you get the portfolio performance and the gains from the discount contracting. The problem is sometimes we pick a manager and their performance doesn’t improve.
That is where the next point you make is also a key. Yes in many of these cases the LIC may get wound up and you receive the NTA anyway. The problem is ones where the ownership structure may trap you in and this never happens or takes a very long time. Long IMAs can be a problem. Pre GFC some old LICs like CAM & HHV had agreements to last decades and couldn’t be wound up easily. CAM still struggles with performance now. Contango might have been another example initially that has a long IMA that Michael Pascoe described as a “hotel California” stock. Ownership structure can be an issue. AMP tried to stop the wind up of their AMP China Fund by planning to use their voting stake initially.
I do share your way of thinking though. Some current battlers of mine ALI & ALF I figure if their performance doesn’t improve I may well receive NTA one day from a wind up. I don’t see too many obstacles. It’s not my base case or preferred case it just might minimise the downside risks on the investments.
When I last checked the expense ratios aren’t as bad now for GC1 as it’s larger than when floated. I can see how they may suit your thinking. I don’t own them but if small caps do ok in the medium term that should do ok I think.
SNC I’ve owned in the past and can understand your concerns. I’d be comfortable though they won’t try too many share raisings from here. They criticise others about capital management so need to be careful what they do themselves. I’m not that bothered about the depth of team, together with Campbell Morgan they come up with some good presentations. Because they have paid out such strong dividends though it’s hard to see it trading at a big discount. If it did I’d probably consider it again.
“Fake News” that’s like “Fake NTA” that’s like the story being spun by VG1 and L1. Do you honestly think that their starting NTA’s are the subscription price?
L1 had a $40m fund they ramped up the returns in. Why are the returns from the Aussie long-only portfolio nothing like the 36% in the baby fund that is now a whale?
Here is a hypothetical, if VGI or L1 closes tomorrow where is the $15m VGI or the $40m L1 owes the LIC going to come from?
Do you think that CDM has returned 520% since inception (after some weird add back for franking)? The share price is $1.27 from a $1.00 start price.
Do you think it’s right that Naos used their client’s funds to buy into Contango asset management and then give the prized asset to themselves?
WAM has a $2.00 NTA after 20 years.
Some great points and questions raised there Amanda!
They are all interesting but personally I find the situation of Naos gaining control over CTN the most fascinating. Selling the old portfolio before shareholders even voting on it from memory? Transitioning alone costing a few percent around October / November last year possibly? When does their performance on NSC start at, December according to their NTA report. Hmm.
Steve, CTN was in a mess long before Naos arrived on the scene. I gather it was initially managed successfully by a guy who was, or ended up on, the board. Switzer / Boubouras somehow got involved and took over the management and performance went south. Eventually the non-Switzer aligned directors woke up and tried to bring in OC as a second manager. In the ensuing ruckus these directors were turfed.
Co-incidentally I had looked at Naos not long before that, but found them rather opaque, in addition to the usual questionable performance reporting.
You are correct and I think OC may have done really well since the board turfed them, rubbing salt in the wounds. Don’t have the exact figures on hand though.
Amanda, I too have long suspected CDM’s real results were nothing like they reported. I’ve just now worked out that I’ve actually had a return of 13% pa for them, but had to buy them at 75c in the second half of calendar 09 to get that. If I’d bought them in the IPO the return would have been half that at a bit over 6% pa. And if you take out one particular stock I wonder if you’d even be ahead of inflation.
I started to work the figures on WAM, but my records don’t go back far enough!