LIC benefits missed in a world chasing popularity

Many LICs and LITs have been the quiet achievers over the last 12-18 months. Out of favour in early 2020 among the debate over stamping fees and following some disappointing post listing performance of some funds, LIC total returns since that time have generally been excellent and in some cases spectacular, particularly from the bottom of the COVID crisis. Importantly, despite the volatility of early 2020, the period has demonstrated the inherent robustness of well-run LICs and LITs, particularly their advantages in investment implementation and attractive income characteristics.

Still, LICs have received little attention lately, with the focus on the growth of the number and size of the ETF/Active ETF market that now stands at 221 funds and more than $109B in funds under management. The mainstream media is increasingly covering ETFs and they have become a favourite of the growing tribe of millennial online traders/investors. Investment conferences have dedicated ETF sessions but LICs/LITs are struggling to get coverage.

However, one should be careful in equating growth in funds under management, and investor popularity, to investment success and investor returns. Apart from the fact that much of the growth in ETFs is in funds under management, not investor returns, there are many examples through history where money has flooded into product structures or asset classes only for returns to later disappoint or even collapse. As someone once said, in investments, unlike many other fields, nothing fails worse than success.

In fact, there is a natural tendency for ETF providers to launch funds that have performed well in the past and present an appealing marketing story. Newly launched funds can usually point to attractive historical returns for the index or strategy the ETF is tracking, but such returns from launch date into the future for investors are far from assured.

The LIC/LIT sector has certainly not been immune from occasional overselling, especially at IPO time. However, most LIC vehicles tend to be broad based, active funds, rather than narrowly focused on a certain sector/theme as newly launched ETFs have increasingly become. Investors may have been voting with their feet into ETFs relative to LICs, but this provides no certainty that these investors will experience better future returns. Indeed, such flows are often a good contrarian indicator.

Meanwhile, there have been no new LICs in the last year (in fact a number have closed, merged or converted to other structures). The growth in market capitalisation of its current 101 funds from $40b to $55b in the 14 months from March 2020 to May 2021 is therefore all investor return. In fact, this number understates the return to investors because it excludes most of the dividends paid and is further reduced by the exit of some funds from the category.

Some spectacular returns

Many investors who gave up on LICs and LITs in the first half of last year have missed some excellent returns in the time since.

The table below shows the total return on a selection of LICs from their lows of late March 2020 (a little over 14 months - note returns are understated as I have assumed dividends are received at year end, not reinvested).

Some might say this selection is cherry picking and to an extent it is, focusing on those funds with strong underlying NTA returns but also a significant narrowing of the discount to NTA over the period. However, these 15 equity related LICs represent almost 20% of the ASX equity related LIC universe by number. The table is also not meant to imply that buying at the bottom is easy (although some investors obviously did). The main point is that such deeply discounted, exceptional buying opportunities existed, and subsequent excellent returns were achieved, largely because LICs/LITs are structured as listed, closed end funds.

It is simple maths that a LIC/LIT that moves from trading at a 40% discount to NTA a year ago to a 10% discount today in a year where the market (and fund NTA) returns 35% will return 102.5% over that period (excluding tax differences). This return profile is something that unlevered unlisted trusts or ETFs investing in the same assets cannot provide. Only via significant leverage (with a lot more associated risk) would an unlisted fund/ETF investing in similar assets be able to generate similar above market returns to investors. Of course, investors can also experience the downside of widening discounts in LIC/LITs which is the reason investors need a disciplined approach to these vehicles (more on this below).

Structurally robust

A significant advantage to the managers of LICs/LITs is they are investing a known amount of funds without the risk that money could be redeemed tomorrow. This was particularly valuable around the COVID crisis allowing LICs/LITs to invest as attractive opportunities appeared or retain holdings without fear of the need to sell assets to build cash for redemptions. It is true many LICs/LITs did trade at large discounts to NTA at this time, but as recent years have shown, extremely large discounts are relatively infrequent, usually short-lived and cyclical in nature (and typically a great buying opportunity for investors).

Reliable income

A particular focus for investors recently has been seeking income in a world of near zero interest rates. Many LICs are particularly well placed to provide a relatively consistent, growing stream of franked dividends, something most unlisted funds and ETFs are poorly structured to provide. Many LICs are paying fully franked yields of 4% and above and, after recent strong market gains, have significant profit reserves and accrued franking credit balances to enable them to pay attractive franked dividends into the future. This is particularly important in relation to many of the longer established and lower risk LIC vehicles (less represented in the table above), where reliable income forms a key component of their return.

Meanwhile, it has been Magellan’s new FuturePay retirement product that has been getting the media attention and seeking to capitalize on the demand for secure and growing income. Magellan have certainly launched some innovative products in recent years such as the active ETF and the hybrid listed/unlisted structure. FuturePay targets providing more consistent income through the support of a reserving mechanism that investors contribute to. However, one could argue that a disciplined selection of well-run and sensibly priced (or discounted) LICs, and a sensible overall asset allocation, is a better a solution in this regard, with lower costs. Of course, in both approaches the capital value is still at risk.

Discounts/premiums a benefit if approached sensibly.

The very element that many investors highlight as the biggest disadvantage of LICs/LITs i.e., fluctuating discounts and premiums, can be one of their biggest benefits if approached from the right perspective. This benefit is two pronged,

1. The ability of the LIC vehicle itself to add extra return to investors through sensible capital management. (E.g., Buybacks at discounts are accretive to NTA).
2. The ability for investors themselves to add returns (higher income yields and capital gains) by disciplined buying (and selling) as discounts/premiums change over time.

Approached the wrong way, investors in LICs and LICs can no doubt do poorly if they succumb to a tendency to sell at big discounts and buy at premiums to NTA. However, this tendency creates opportunities for both the vehicle itself and disciplined investors to add elements of return that are simply not available to unlisted funds or ETFs.

Even if discounts never narrow you can still do better in a discounted LIC/LIT than an equivalent unlisted fund or ETF simply because you receive a higher yield from the same level of income on the underlying portfolio. A fund delivering a 4% yield to unlisted investors is a 5% yield to those that bought and hold the same portfolio at a 20% discount to NTA. (Ignoring tax issues for now).

Is an active ETF a better structure?

One LIC recently converted into an active ETF to resolve its persistent discount. The active ETF is a good structure for prominent managers investing in liquid investment areas. However, it is no magic bullet for a manager struggling to perform or attract investors or for a range of more complex investment strategies or those investing in less liquid securities. Not all managers will be successful running a LIC or preventing it trading at a persistent discount, but I suspect some of these managers will struggle in managing and growing other fund structures as well.

Conclusions

There are good reasons LICs have been around for almost a century in this country and longer overseas. The vehicle structure is robust and has some significant advantages over unlisted funds and ETFs. The major “disadvantage”, fluctuating discounts and premiums, can be a significant advantage for both the vehicle itself and disciplined investors if approached sensibly.

The attractions of the LIC sector are highlighted by the fact that the one LIC launching so far this year is the new Wilson Asset Management Fund WAM Strategic Value (ASX code WAR) that targets a portfolio of discounted ASX listed vehicles. (Although perhaps a year on from the best time to launch).

In a world desperate for income, attractively valued investments, and robust investment solutions, LICs and LITs should be receiving more attention from diligent investors. Perhaps the upcoming period of announcements of year end results and dividends will be the catalyst for such greater focus.

Note: The author holds shares/units in a number of the funds mentioned in this article. (I have a small consulting role with LICAT aimed primarily at helping to educate investors about the nature of LICs/LITs - however, the views in this article are my own.)