Looking out for pirates in LIC land

As an investment consultant and Portfolio Manager with a focus on the listed investment fund space (LICs and LITs) one comment/question I sometimes get from advisers and investors is “why wouldn’t I just pick my own LICs/LITs?” After all, isn’t that the point? You outsource the stockpicking and picking fund managers is easy – right?

Well no. I would suggest that choosing fund managers is difficult enough when considering conventional unlisted managed funds, particularly when the investment environment is challenging. I would argue this difficulty is compounded significantly when considering listed funds, for the following reasons;

• Governance and transparency on LICs is generally poorer than retail managed funds (which seems to attract some less ethical operators to LICs).
• Investment mandates can be very flexible and/or allow esoteric investments, leading to unusual return and risk outcomes (although this can sometimes work to the upside).
• Some groups running LICs don’t have any other retail vehicles so less is known about them.
• The pricing dynamics of LICs/LITs trading at a premium and discount can have a major impact on the actual investor return experience over both the short and long term.
• Related to this, unlike unlisted managed funds, it is often difficult to sell a poorly performing LIC for anything near NTA. In some extreme cases you can’t sell them at all (more on this below although this can also sometimes happen with unlisted trusts – think mortgage, property, high yield and certain hedge funds during the GFC)

While many of the funds in the LIC space are well governed and managed, the history of periodic investor losses much greater than that of the broader markets in a few listed vehicles i.e. those that might be labelled “investment disasters”, suggests the above risk factors are real.

Investment success, especially in more trying markets, can be less about what one invests in, and more about what is avoided. While mistakes and losses are inevitable, true investment disasters that result in more permanent capital losses are hard to recover from, especially if investors are overly concentrated in those investments. Still, some of these “disasters” eventually present attractive contrarian investment opportunities.

A Pirate Saga

2018 has perhaps had more than its fair share of disasters in LIC land. Although yet to fully play out, perhaps the ugliest of these will be the experience of investors in two LICs - Henry Morgan Limited (ASX:HML) and Benjamin Hornigold Limited (ASX:BHD), both named after famous pirates. These funds have been suspended from the ASX since June 2017 and July 2018 respectively and are currently subject to scrip takeover offers from their Brisbane based, NSX listed manager John Bridgeman Limited (JBL) – another pirate. The Independent Experts Report on the deal has dubbed the offer “Not Fair but Reasonable” and also highlighted that the manager seems to have issues with the regulator. There are currently no bids on the NSX for JBL stock with an offer at 90cents. Clearly, no easy options exist to resolve the mess that these three vehicles have become but accepting the JBL scrip hardly seems to be the answer.

The two LICs, listed in February 2016 (ASX:HML) and May 2017 (ASX:BHD) commenced as fully liquid, discretionary macro/futures trading funds. The HML prospectus said;

“Henry Morgan Limited will be a listed investment company seeking to achieve moderate to high portfolio returns over the medium to long-term through investment in global markets through products including equity market indices, currency, commodities, equities and fixed income derivatives. The Company's investments will be limited to deeply liquid, high volume global markets to enable ease of entry and exit of positions”.

In October 2016 shareholders in HML approved a broadening of the mandate to unlisted/pre IPO positions. These were allowed in BHD from the IPO but the macro trading and liquidity of the portfolios continued to be emphasized in both LICs. However, they soon morphed into something quite different, purchasing a range of private unlisted assets, many from related parties. The LIC’s NTAs initially benefiting from uplifts in the valuation those assets as transactions (mostly related party) occurred. Large performance fees were paid as a result of these upward revaluations. Some of this uplift in NTAs has now been reversed but more is likely given concerns over the ongoing viability of some of those businesses. Large legal, accounting and other costs have been another big impost on the NTAs. It seems there is little macro trading occurring now given the unlisted asset focus and dwindling cash available in the two LICs.

In any case perhaps continuing to trade in size would only have accentuated losses. On 5th December 2017 JBL released a Business update to the NSX called “Bitcoin futures trading” where the Managing Director and CIO stated “We believe Bitcoin is significantly undervalued despite an approximate 1000% rally.” As we now know Bitcoin is down over 80% from its high near $US20k that month.

Irrespective of whether the current proposed mergers occur, existing investors in HML and BHD are almost certainly going to be hit with major losses compared to the last equivalent ASX traded prices of $1.99 for HML and $0.71 for BHD (and original $1 float prices) when there is finally some sort of market price/exit for their investment. HML also had $1.00 strike price August 2018 options which last traded at 82 cents and have now expired worthless. Some investors are likely to be valuing their holdings/calculating performance and paying platform and/or adviser fees on the basis of the LICs “stale” prices. Investors expecting ASIC to be much more proactive and come to the rescue long before the situation deteriorated to the current extent have been sorely disappointed.

There were numerous red flags that led sceptical investors, including us, to avoid investing in these funds. This included a somewhat awkward meeting with the pirates in late 2015 which provided no clarity on any process around, or edge in, their macro trading which was backed up by a stellar but somewhat short, small FUM and difficult to assess historic track record (albeit given what the portfolios look like today this has become largely irrelevant). However, even for sceptics it was hard to envisage a disaster of this extent and the disdain with which management and the board have treated shareholders. Any normal fund manager presiding over such long ASX suspensions and large investor losses would be forced out of financial services and quietly eating humble pie. Yet in this case they have gone on the offensive, treating shareholders with contempt and threatening legal action against commentators raising perfectly valid concerns (usually a warning sign that something is seriously wrong).

More is likely to be written about this “pirate saga” in coming months, although without much good news for investors. Perhaps, the most valuable thing investors will take out of this is important lessons in being sceptical about something seemingly too good to be true, the risk that even in supposedly liquid, listed securities, your ability to easily exit can disappear and that regulators are usually of little help in such situations, at least until most of the damage is done.

More to selecting LICs than the discount

Contrarians and value investors are generally attracted to a heavily discounted LIC and there is the old saying “there is a (buying) price for everything”. But when it comes to a certain class of LICs, I don’t believe this is true. I’ve learnt through harsh experience over decades that some LICs are better to avoid no matter how large their discounts to NTA become. Why? Because some vehicles are run heavily or primarily for the benefit of the manager and/or board, costs are likely to be excessive as a percentage of the typically small fund size, leakage of investors’ funds occurs in other less direct ways and these various imposts are likely to largely outweigh any underlying returns and deplete investors’ capital over time.

For example, one small LIC has employment costs for 4 people equivalent to 4% of the fund NAV even though half the fund is outsourced to other fund managers. Some of the directors/management of such funds have often had a “colourful” corporate history, sometimes including periodic issues with the regulators. You only get to know who these people are over time and through (sometimes bitter) experience. In such cases, investors generally eventually lose trust and discounts remain large and persistent.

Discerning between an investment disaster you should look to avoid, and one that may provide an attractive opportunity is crucial, although getting the timing right is extremely difficult.

L1 – “Peak LIC?”

Perhaps, one positive in the pirate saga is that the absolute scale of losses in the two LICs is modest in dollar terms and in the number of shareholders affected. Unfortunately, this can’t be said of the many more investors who have been seething about the 30% losses (mostly unrealised) experienced in the massive $1.3 billion L1 Long Short Fund Limited (ASX:LSF) float since it listed in April this year (that’s close to $400m at the current share price).

Some elements around the LSF float provided the basis for concern that kept investors like us away. Key amongst these were the taking on of much larger amounts of FUM compared to that held through much of the long short/strategy’s unlisted fund history and the decision to invest all the funds almost immediately. The overhyped nature of the float – meaning a lot of “weak handed investors” took stock also increased the chances of it drifting to a discount irrespective of performance, as we have seen recently. Certainly, the ability of some brokers and advisers to earn a “selling fee” of 1-2% in a financial services industry where commissions have already been, or will likely be., banned in a post Royal Commission world, no doubt contributed to the enthusiasm for the float.

Investment disappointment since has been accentuated by the perception that the long/short approach was presumed to carry lower than normal market risk. The LSF investment “disaster” is a very different animal from the pirate saga above. The L1 team have good long-term reputations as stockpickers and there is a good chance performance will improve, perhaps significantly, at some point in coming months or quarters. Although the pre-tax NTA is down around 25% from the IPO, LSF is now trading at a double digit discount to that NTA and with no performance fees payable for some time, given the high-water mark, it looks increasingly attractive. Of course, this doesn’t rule out an even larger 20% or even 30% discount if performance continues to struggle, but at those levels there would likely be significant pressure to introduce measures to narrow the discount and I would expect the Board in this case to be proactive in that regard.

Blue Sky turns Red

Blue Sky Alternative Access (ASX:BAF) is an example of a LIC whose 2018 “disaster” has already provided an attractive opportunity. Following the late March revelations by Glaucus about its manager Blue Sky Alternative Investments (ASX:BLA), BAF had, by early June, fallen almost 45% from its recent high. (Of course, this is still modest compared to the almost 95% peak to trough loss in BLA). BAF, which had traded relatively close to NTA for much of its life, offered an attractive opportunity when its discount blowing out to as much as 40%, even after there had been an independent assessment of the value of most of its assets. (I bought a small BAF position in the fund I oversee at this time). At the current discount of sub 20%, the outlook is a little more nuanced with Wilson Asset Management proposing to take over as manager. While this may narrow the discount further, some of the underlying assets held may face some headwinds. (I have since largely exited).

Below the watermark

The Watermark Funds (ALF, WMK, and WGF) have disappointed from an underlying NTA performance perspective, particularly recently, but when compounded with the move from trading at premiums or around NTA to substantial discounts, the investment experience of some holders could rightly be described as a disaster. This perception is accentuated given the funds were expected to hold up much better in market weakness give the market neutral positioning of all three funds. For investors who owned ALF at close to $1.70 in mid-2014 (a near 20% premium to NTA) the near 45% fall to a recent $0.96 cents has certainly been a disaster, even if partially offset by dividends of 32 cents over that period. This example shows the danger of paying high premiums. I currently own all three of the Watermark funds in the fund I oversee (including WGF personally) but fortunately purchased the majority of these at mid to high teen discounts to NTA. Given question marks over the manager’s strategies and the small size of two of these vehicles the manager/Boards are under pressure, and have flagged intentions to introduce measures to deal with these large discounts.

ALF’s experience demonstrates that sometimes the “pirate” resulting in large investor losses in LIC land is not poor underlying NTA performance – or not that alone - but the erosion of a previously unsustainable premium sometimes replaced with a (often growing) discount. After all, a move from a 25% premium to a discount of 15% is an investor loss of more than one third without the portfolio necessarily changing in value at all. Typically, though the move from premium to discount is accompanied by poor underlying NTA performance thereby accentuating investor losses.

The LIC/LIT Opportunity Set

Too often investors only look at the recent track record or the current reputation of the fund manager in selecting a LIC/LIT. Instead many elements should go into the mix including a view on the market environment and strategy employed, governance, quality of manager and team turnover, fees and costs, fund size, liquidity of the underlying strategy, the current discount/premium and catalysts which will impact the size of the discount.

Certainly, investors could point to other LICs that have performed poorly in 2018 in addition to those I have discussed. Alternatively, I could have discussed those funds that have held up or performed well in a difficult 2018. But this is not meant to be a complete review of the LIC sector in 2018 but rather a focus on the most interesting cases and particularly those that provide valuable investor lessons.

The LSF float in April 2018 probably marked the high-water mark of the recent LIC boom. This boom has resulted in an expanded range of interesting listed fund vehicles that broaden the investor opportunity set considerably. There are signs that the boom in new issuance is fading. Two managers, Firetrail and Cadence, pulled IPOs in recent months. Several funds trading at large discounts are under pressure to restructure and funds have merged. There are still some LIC/LITs slated for early 2019 including from reputable managers such as Regal and Pengana but the near term behaviour of investment markets could determine if these proceed or if they do, constrain how much they raise. There is also the threat of a potential Labor Government limiting access to franking credit refunds which would reduce the attractions of LICs to some investors, and a move which would favour LITs (and unlisted funds) over LICs.

A challenging environment for investors

As 2018 ends, in addition to some of the more extreme issues in the LIC space discussed above, it is concerning that we are starting to see revelations or rumours of some other financial services product failures and scandals that smell a little like the pre GFC period of 2007/early 2008. These include the recent Goldsky Ponzi scheme, online broker Halifax going into administration various property scandals being exposed and some questions over some heavily promoted yield/income products.

While the descriptions of these scandals are often entertaining, we sometimes forget the devastating impact that they can have on individual investors’ wealth, lifestyles and health. Indeed, investors heavily exposed to product failures typically suffer much greater individual losses than clients exposed to most of the scandalous issues raised at the Royal Commission (fee for no service, overselling insurance etc.). Yet ASIC’s limited resources now seem clearly focused on those larger institutional issues leaving little resources to investigate or pre-empt smaller scandals/problems. When ASIC does act on these it is often long after the horse has bolted and these issues are usually too small to benefit from class actions. Investors are therefore largely on their own which is another reason it is so important to devote effort to avoid the problem funds and products in the first place.

The impact of investment disasters on real people and their helplessness was highlighted by a post on HotCopper by someone who attended the Henry Morgan Limited AGM on 30 November in Brisbane:

“Never before have I seen shareholders treated with such contempt! We were intimidated, chastised and made to feel stupid for asking perfectly valid questions. The board would blow us off with phrases like "That's not relevant", "That's not an appropriate question for an AGM", "That's outside the scope of what an AGM is for", "We're not legally required to answer that". It was unbelievably frustrating. What was really sad was the number people I noticed in the room were retirees - many of them too scared to speak up in the meeting. If you could have seen the looks on their faces... If I wasn't feeling so insulted, frustrated and angry at the time I would have cried”.

As a tumultuous year ends for investment markets and financial services it would not surprise me if 2019 sees more of the same, although it should provide some excellent investment opportunities for those in a position to take advantage of them. In my view, holding a decent amount of cash and even some “out of favour” gold exposure makes sense as we enter the New Year. Cash and gold – now that’s two things the real pirates of centuries past sought, valued and carried, while unfortunately the struggling LIC vehicles of today’s fake pirates have little, if any, of either.