Why this 100-year-old investment structure still has a role in your portfolio

LICs were largely popular in the 90s before exchange-traded funds (ETFs) stole some of their thunder. But this doesn’t mean you should ignore them. Like any investment, LICs have both pros and cons. They can still play a very relevant role in a portfolio.

Currently, there are 95 listed LICs on the ASX, with a total market capitalisation of $50.49 billion (Source: ASX, July 22). So, what are LICs and how do they work?

What is a LIC?

A Listed Investment Company, or LIC (pronounced “lick”) is a specialised type of investing fund that pools together shareholders’ money and invests it under an approved investment strategy. 

LICs are listed and traded on the ASX and other securities exchanges around the world. The majority of these listed active investment vehicles are companies but some are Listed Investment Trusts (LITs).

The main difference between the LIC and the LIT structure is the tax treatment:

• Companies pay tax on their earnings and pay dividends to their investors (which are usually taxable to them but include franking credits).
• Trusts pay no tax directly but instead must distribute their taxable income to investors, who then pay tax on it at their own tax rates. These distributions usually do not include significant franking or other tax credits.

How do LICs work?

Like other companies, an LIC is overseen by a board of Directors, while a trust is overseen by a responsible entity. Specialist investment managers are employed by the Directors or Responsible Entity to carry out day-to-day investing activities.

There may also be an additional fee payable where the performance of the investment portfolio exceeds a certain return benchmark. In most cases where the performance of the investment manager has been acceptable and their fees are reasonable, they will be asked to continue on at the end of the management contract period.

An alternative structure is an internally managed LIC. In this case, investment staff are employed by the LIC directly. Instead of paying an external manager a fee, the company pays the employment and associated costs of the investment staff. Internal management can be a more attractive proposition for a large LIC because the cost of managing the investments can be more efficient and this can improve returns. However, for most LICs external management makes more sense because the size and scale of activities are not sufficient to make it efficient to manage internally.

Why do investors use LICs?

There are many reasons why people invest in a LIC, but the most common are:

• To achieve better diversification in your investment portfolio.
• To access the skills of a professional investment manager.
• To get exposure to a particular market, asset class or investment strategy.
• To access the benefits of an unlisted managed fund with the ease of trading and liquidity of traded shares.
• To receive income from dividends or distributions.
• To profit from the change in premium/discount of the net tangible assets* (NTA) compared to the share price.

*The net tangible assets is the value of all the holdings in the LIC, less any liabilities. We'll delve more into this next week.

How do you invest in LICs?

LICs can be bought and sold daily on the ASX. So long as you have an account with a stockbroker, you can invest in a LIC on the ASX for as little as $500. Brokerage costs usually mean it’s better to buy a larger parcel than this to average out the transaction costs.

Priced to the market

The price at which LICs trade on the ASX is set by market forces and is impacted by many factors. Some of these factors may include:

• The reported NTA for the LIC.
• Market conditions and investor confidence.
• The attractiveness of the investment strategy.
• The asset class in which the LIC invests.
• The level of the dividend yield (this is never the correct method to price a LIC).
• Performance of the investment manager.
• Cost of running the LIC, including fees to the investment manager.
• How large the market capitalisation of the LIC is, and how liquid its trading is.
• How well the LIC markets itself and communicates with current and potential investors
• Whether the directors and investment managers treat their shareholders with respect, and understand that it is the shareholders' money they are investing

There are also many other factors that can impact the price an LIC trades at.

How do LICs generate returns?

1. Regular dividends (or distributions)
   These dividends usually include at least partial franking credits and are generally paid from underlying profits generated by the LIC over time. LITs don’t pay franked dividends, however, they do pass on any franking credits they receive from underlying investments.
2. The share price of a LIC, which increases or decreases over time.

FAQs

What is a listed investment company (LIC) or a listed investment trust (LIT)?

A LIC is a specialised type of investing fund that pools together shareholders’ money and invests it under an approved investment strategy. It is listed and traded on securities exchanges.

What is the difference between a LIC and a LIT?

The key difference is the structure. One uses a company structure meaning it pays tax on its earnings and distributes dividends to its investors. The other uses a trust structure so it doesn’t pay tax directly and distributes its income directly to investors.

Do LICs pay franked dividends?

LICs use a company structure meaning that they pay tax on earnings at the applicable company tax rate and therefore are able to offer franking credits. Most LICs in Australia offer fully franked dividends.

How can you buy LICs?

LICs can be bought and sold daily on the ASX via a broker or your online trading account.

How do LICs generate returns?

LICs can offer returns via any dividends or distributions paid out to investors, or via movements in the share price.

Next week, I'll discuss how to evaluate a LIC. This information is an extract from Affluence Funds Management guide to LICs. You can request a copy via our website.