Australians - Listed Investment Companies (LIC) as investment option?

[bigchrisb]

Hi all,  I'm interested in people's thoughts on this investment option.  I'm not sure how relevant it will be to non-Australians though.

I've got a mixed portfolio of shares, REITs, exchange traded funds and listed investment companies.  The more I look into them, the more merits I see to the LICs over ETFs, and I wanted to see what other people think?  For disclosure purposes, I own forms of both, VAS, VEU, VTS and IVV for ETF's, and AFI, ARG, BKI, CIN and MLT in the LIC court.  I guess I'm having a bet each way.

First up, my understanding is that a listed investment company is a company that invests in shares and securities.  If you own a share in the LIC, you own an interest in its underlying assets.  They are closed end funds - so if you want to redeem your investment, you sell your share on the market, at the price determined by the market.  This may diverge above or below the value of the underlying assets.  Not all that different from a managed fund or ETF yet. 

LICs have been around the Australian market for a long time - indeed, many of the larger ones seem to date from the 1920's - 1940's.  i.e. have survived depressions, world wars and everything in between!

From what I can gather, there are some pros and cons:

- Management expense.  The management expense seems to vary between very low (0.1%) for the larger, internally managed companies, up to several percent for the externally managed ones.  That gives a similar fee base to the Australian listed ETFs, 0.15-0.3% for domestic shares, and 0.07%+ for the US / international ones.  For investing in Australian equities, a slight win to the lower cost LICs.

- Closed end vs open ended.  The LICs are closed end funds, while the ETFs are open ended.  This means that there is the potential for more turnover in the underlying portfolio (and capital gains) in the ETF.  Its also this feature that allows arbitrage of ETFs to keep their price close to the underlying value.  Win for the LIC for lower turnover of assets, win for the ETF for keeping prices closer to net asset value.

- discount/premium to asset value.  This is where is gets really interesting.  ETFs tend to trade close to their net asset value.  Where as LICs can deviate (substantially) from their NAV.  The ASX publishes a list of these discounts every month - see http://www.asx.com.au/products/market-update-managed-funds.htm.  Some of these discounts are pretty significant - for example, Carlton Investments is currently trading for $17.10, where as its NTA is $22.05.  From what I can gather, that means that you are effectively collecting dividends on an extra 29% of your investment!  A win to the LIC if its trading at a discount, a win to the ETF if trading at a premium.

- Distribution of income.  I think ETFs need to distribute all income to unit holders.  Where as I think that LICs have the option to decide their payout ratio.  Most of the larger ones seem to have payout ratios between 70% and 100%.  I guess the payout / retention advantage depends on if you need the cash flow, if your tax rate is higher than the internal tax rate of the LIC, and if you price in a discount for the risk of the LIC not paying out when you need it?  However, the dividend histories of the larger ETFs seems to be pretty progressive - have a look at the dividend history for the likes of AFI, ARG, MLT or CIN.

So, on paper, it would seem that a LIC at a discount to its NAV seems like a bargain, and a clear winner over ETFs.  However, given that markets are "supposed" to be efficient, why does such a large disparity exist? 

Any thoughts from the other members out there?  I think I'm going to keep spreading my eggs between these two baskets, but with a bias towards LICs for new purchases.

What am I missing?  Usually if something looks to good to be true it is?

[englyn]

I've no idea, but I'm very interested in the answer!

[banksie_82]

Bigchrisb, I don’t claim to be an expert on these matters, but I’m happy to share what I know. You probably already know much of this, but I’ll say it anyway for the benefit of others.

LIC’s are a great way to immediately get a diversified portfolio with a small amount of capital. Some have miniscule fees and therefore are more attractive than retail managed funds. They are also a great stock to buy as a ‘set and forget’ and let someone else worry about the investment decisions. Also, for Australians, the dividend structure makes tax time a lot more straight forward, not to mention they are often fully franked.

For the North Americans reading this, I believe Warren Buffet’s Berkshire Hathaway is what we would call a LIC.

You are correct that a LIC is a closed end fund. In fact you can think of them like any other company on the stock exchange, like BHP, banks etc. The only difference is their business is investing in other companies. Like normal companies, the management is mostly concerned with their profit statements, financial performance and the dividends they pay, the actual share price is of lesser concern and is entirely left up to the market.

Conversely, ETFs deliberately manipulate their share price to closely reflect the intrinsic value of the underlying assets, by creating and cancelling shares in the ‘company’.

LIC’s will publish, by law, what the value of their underlying assets (net tangible assets - NTA) is every month… per share. This makes it very easy to judge whether the shares are trading above or below their intrinsic value. 

Some of the older LIC’s have been around since the 40’s or 50’s, as you point out. These tend to be the large ones like MLT, AFI and ARG. Others are more recent and tend to be a lot smaller. The older, larger ones tend to have a very small fee (Management Expense Ratio - MER) in the order of 0.15%, which is insane for an actively managed fund in Australia. The newer ones are usually a lot more and the cynic in me thinks they are only in it to make themselves a profit, and not their shareholders.

ETF’s, I believe, tend to be a lot newer and have a much higher MER. Again, I think they are there to make themselves money, not the unit holder. But I confess to not know a lot about ETF’s. I too have heard that they leave themselves open to adverse capital gains events, due to having to buy and sell assets more regally. This of course gets passed onto the investor at tax time but isn’t shown in the official performance tables.

As a result of letting the market set the share price of LIC’s, it will often not reflect the value of the NTA. This can be both a good thing and a bad thing. Contrary to what some people will have you believe, the market isn’t all that efficient and everywhere you look you can find examples of this, LIC’s are just another case. It isn’t perfectly efficient because the ‘market’ is lots of individual people, and people aren’t rational creatures.

The share price will sometimes trade quite a lot higher or a lot lower than the NTA.  I guess you could read into this and think the market knows more than you and there is something else going on, but to be honest, the people who buy these funds are in for the long hall and so not looking for an arbitrage.

Don’t expect the gap between the NTA and share price to close quickly though. I purchased some MLT about a year and a half ago for a discount of about 12%. This has somewhat narrowed since then, but it has been slow and is still not fully there. As a result, the share price has done better than the NTA and the overall market in that time, but it defiantly isn’t a sure fire way to make a quick buck.

If you are simply looking for a high yield dividend, then look at the dividend the LIC has historically paid compared to the current share price, much like you would with a normal stock. If you are looking for growth, then look at the underlying companies and make a decision based on them.

The risks of course, in addition to the general stock market risks, is the discount to NTA could be quite large when you need to sell, bigger than when you purchased it. So you will need to factor this into your considerations. The longer time frame you have, the less it matters.

My suggestion would be to stick to the bigger LIC’s, such as MLT, AFI and ARG because they have much more liquidity, a lower MER and better stability of share price. Try to buy when they are trading at a discount to NTA but be prepared to stick with them for the long term.

[bigchrisb]

Agree with all you have said! 

I hold shares in the larger LICs that I've accumulated over the last few years, and all purchased at a discount to NTA.  The big two (AFI and ARG) seem quite liquid, and at the moment are trading broadly in line with NTA at the moment.  I'm also not interested in the newer, small LIC's - I agree with you that these seem to be structured to reward the manager rather than the investor.

It's really the second tier of LICs that I'm curious about at the moment - for example BKI and CIN.  They are trading at bigger discounts to NTA (10-20%), and seem to have broadly blue chip holdings.  Both have low MER - 0.18 for BKI and 0.12% for CIN.  I struggle to see why they trade at such a comparative discount.  The only theories I can see are:
- Both have a core holding that isn't a big blue chip - BKI has 10% in NHC, while CIN has 35% in AHD.  For both, the rest of the portfolio is the usual large cap blue chip stuff.
- Both seem to have fairly complex cross-ownership structures, and are old family money - the Milner family for BKI (they are also the folks behind MLT), and the Rydge family behind CIN. 

I'm invested in both.  I've been building a greater position in CIN (now about $50k) recently, because of how substantial the discount seems to be.  When you look at the underlying dividends that the LIC is receiving (based on their stock holdings in their annual report, plus franking credits), they are getting a gross dividend yield in excess of 10% on their market cap, paying out about 70% and re-investing the balance.  They seem to have a seriously progressive dividend to boot.

However, I put this post up because of that old adage of "if it seems too good to be true, it usually is", and I see the MMM forums being a fairly astute audience.

[happy]

I've no idea, but I'm very interested in the answer!

+1

[banksie_82]

My personal opinion…

I would be comfortable with BKI, and probably classify them closely with MLT, but the liquidity problem with CIN would make me think a little harder.

I think the discount to NTA that you see is probably largely due to the liquidity risk being priced into the stock price.

I haven’t looked at the historical values for CIN, but perhaps you could make a decision based on the long term average discount to NTA that the LIC experiences. I think it would be safe to assume that it will tend towards average over the long term.

Just a thought though, CIN have an overweight position in Amalgamated Holdings (AHL), 35% of the fund, then another 25% in the big 4 banks. All of which have quite a hefty dividend yield at the moment. But would you be happy with this type of concentration? And if so, why not just invest directly into these companies yourself (ignoring the current discount to NTA of CIN)?

[bigchrisb]

Good points about both the liquidity and the exposure to AHD.

The exposure to the banks doesn't worry me, CIN at 26%ish is not much different from the other alternatives - 34% for VAS, >20% for ARG and >30% for AFI.  If I'm going to have these assets, having an exposure to them at a significant discount seems like a good thing.

The concentration to ADH is a different story.  While it doesn't look like a bad company per se, I'd be hesitant about having a lot of dollars tied up in it, as it is isn't exactly a large cap stock (market cap of about $1Bn).  That said, combined with the discount to NTA, holding this inside CIN has an effective gross dividend of over 10%.

I'm interested in their distribution policy too - they have tended to have a payout ratio of about 70%, compared to close to 100% for the other LICs.  Means that there is some income compounding inside CIN at company tax rates.  While my tax rate is above 30%, that's a bonus.  But if it isn't, its a negative?

I'm going to hold this one in the long term and see how it goes.

For reference, my (stock) investments are currently 18.5% LICs, 29.6% ETF (all international shares) and 51.8% direct Australian shares.

 

[AdrianM]

Interest thread, I have two thoughts.

1. How many people in between you and the actual investment.
    - Why not just own the assets outright and be done with the extra layer

2. AFI & ARG are both heavily invested in the 6 largest companies of the ASX.
    - what happens when the boom ends and the bubble bursts?

3. Your international investments are they priced in AUD or USD?
    - If the AUD collapses do you get the currency benefit?

[bigchrisb]

Good questions!  I guess I'll answer 1 and 2 with a tangent - I try to have a foot in each camp with the individual stocks vs managed funds debate.  However, with the managed funds, I'm only interested in the lower cost options.  From my tinkering to date that basically boils down to a choice between ETFs and LICs.  Both of these have the middle man issue.  And lets face it, Australian stocks by their very nature are highly concentrated - for the all ords, the big four banks comprise about 24% of the index, and the big two miners another 11%. 

The level of sectorial concentration in the Australian economy brings us to point 3 - I don't want to be totally beheld to the Australian economy or the Australian dollar, hence the 30% of assets in international shares - all currency un-hedged.  With the rise of the AUD over the last few years the return on these has not been great, but I'd rather have it that way as an insurance policy against the Australian economy, its mining and housing focus, and its political risks. 

Interested in what other Australian's do for a bit of international diversification. I've been using the Ishares and Vanguard ETFs (IVV, VTS and VEU).  I looked briefly at direct ownership of international shares, but the custodial fees put me off and I didn't really look further.  Anyone looked into it further?  What do you do to spread your domestic risk?

[AdrianM]

They way I have structured my investments is 30/30/40 AUD/INT/PM

Everything I buy is direct. No ETF's or funds.
This is a personal preference because I like researching and investing
All Stocks must pay a dividend for me to hold them.

Aussie
TRY - Gold miner
MLB - IT
WHG - Financial services
Cash - Aussie Dollars

International
PLL - Water
STO - Oil (not in the middle east)
Cash - US Dollars

PM
Gold and Silver bullion

I don't hedge currency risk as the only real risk I see, at this stage of the game, is the AUD tanking, and if that is the case then I am set to profit.

The heavy PM content is because I think all the Muppet's that are running the show don't have a clue, and that is putting it politely.

Also I don't try and chase Alpha. I aim to buy an asset when it is cheap/undervalued and then sit on it. So I spend a lot of time just waiting and stockpiling cash as I wait for the opportune moment to strike. I may get one or two opportunities a year but when I strike I load up.

How I spread my domestic risk is to avoid the big end of town. To many funds with lots of cash to splash are restricted to the ASX200 and of that the most of it goes to the ASX20. So that means finding the smaller companies that punch above their weight so to speak.

When you said "custodial fees", Did you try opening a trading account in an overseas jurisdiction or just use what was offered by Australian brokers?

Think of things this way, you want to put your money outside of the Australian governments reach. If you use ASX listed funds it is not truly international as your money never leaves the country. The Australian government can call a bank holiday and you are screwed. With it outside of the country you may lose a portion of your wealth but you have access to funds and can take steps to profit.

[bigchrisb]

To date, just by looking at domestically listed international funds.

Tell me more about the direct overseas shareholding of yours?

Does that mean you have opened a bank account in another country and opened a brokerage account in another country?  Does that mean two sets of tax returns etc?

One of the ideas in the back of my mind is to have a small investment (say $250k) domiciled in another country, to provide a bit of a disaster hedge should Australia go belly up.  But I haven't really investigated the logistics to this.

[AdrianM]

I am going to tell you to do your own homework, Just so you are making an informed decision and not just copying mine.

Bank account
http://www.hsbc.com.sg/1/2/personal/deposits/foreign-currency-current-account

E-trade account in Singapore.
https://global.etrade.com/sg/en/products-services/open-an-account

Tax, what tax.....
 http://www.iras.gov.sg/irasHome/page.aspx?id=8502

You are on the right path with the home and account but take it further with a second passport.
http://www.sovereignman.com/

[bigchrisb]

Interesting take on the foreign tax approach.  I think I'll do a bit more research, and think about setting up a holding company in another country  (Singapore looks good on the surface, but I want to do some more research), and fund it with say $250k.  Then just let it sit there  compounding.

In the interim, I'm going to keep building up my investment company here in Australia, and stick with a mix of direct stocks, ETFs and LICs.  I've taken a reasonable sized position in CIN ($53k), so will watch this one with interest to see how it goes.

For now, back to working, saving and maximizing that savings rate, so that I do have a surplus to invest!