An unusual event occurred in thin post-Christmas trading on the ASX. Australia’s major listed investment companies (LICs), including the giant Australian Foundation Investment Company (AFI), blew out to a premium to their NTA (net tangible asset value). And despite the market rallying 5.7% already in January, AFI is currently trading at a premium and is in sell territory. For investors seeking an easy way to gain broad based exposure to the Australian stock market, there is better value to be had with index hugging exchange traded funds.
I will come back to why AFI is a sell, but firstly, a quick re-cap on the broad based listed investment companies and their competitors, the major exchange traded funds.
Exchange Traded Funds (ETFs)
Exchange traded funds offer an easy way to gain broad exposure to the Australian stock market. While they are suitable for investors who don’t want to manage a portfolio of direct shares, they can also be used by those who utilise a “core and satellite” style investment approach. The ETF provides low cost access to the core, with the investor working on getting the alpha from the actively managed satellite. Active investors can also use ETFs to readily establish a position, potentially only holding the ETF in some cases for just a few hours.
The major ETFs track an index, investing in accordance with the make-up of that index on “autopilot”. If the index weight for (say) the Commonwealth Bank is 7.9%, very close to 7.9% of the ETF will be invested in Commonwealth Bank shares. The Manager doesn’t try to beat the market – all he/she does is to try to reduce the index tracking error.
With their low management fees, they should provide a return that closely matches the return of the underlying index. Nothing more, nothing less.
The major broad market ETFs are set out below. Blackrock’s iShares IOZ and SPDR’s STW track the S&P/ASX 200, while Vanguard’s VAS tracks the broader S&P/ASX 300. Betashares has the A200, which tracks an index of 200 ASX companies produced by Solactive rather than S&P.
Performances (after fees) to 31 December 2019 are shown below, as is the benchmark S&P/ASX 200 accumulation index.
Major Exchange Traded Funds
Returns to 31/12/19. Source: Respective Managers
The advantages of an ETF over a LIC are improved transparency and market pricing. ETFs update their NTA every working day, sometimes intraday (IOZ and VAS), and due to their fungibility and appointment of market makers, you will buy or sell an ETF within 0.10%/0.20% of the NTA of the fund. The premium or discount should always be small. Unlike LICs, they don’t offer share purchase plans.
Each of the major ETFs pays distributions on a quarterly basis. As they effectively replicate the market, their distribution will yield around 3.75% pa, franked to around 75% (that is 75% fully franked and 25% unfranked). (Note: distribution yields in 18/19 were significantly higher due to several companies paying special dividends)
The major LICs
There are 3 major broad market LICs – AFI, Argo Investments and Milton Corporation. They are big, professionally managed and very credible investment companies. Milton Corporation, for example, was listed on the ASX in 1958 and has paid a dividend to its shareholders every year since.
LICs are actively managed. That said, these broad market LICs essentially invest in the major blue chip companies, placing considerable emphasis on companies that have reliable earnings, pay fully franked dividends and have an ability to grow these dividends. An investment précis is set out below.
The major LICs, like many value style managers, have really struggled over the last few years to match the performance of the benchmark indices as growth stocks and momentum investing have played a bigger role in investors’ thinking. As the table below shows, they have lagged over 1 and 3 years, and even out to 10 years, their performance is behind the benchmark. Not shown in the table is performance over a 20-year period, which is roughly on track with the S&P/ASX 200 (for example, Argo (ARG) boasts a 20-year performance of 8.8% pa compared to the index’s 8.4% pa).
To be fair to the major LICs, the performance doesn’t include the impact of franking credits, nor participation in off-market share buybacks. LIC’s will typically frank their dividends to 100% (compared to about 75% for an ETF) and pay higher dividend distributions. The largest LIC, Australian Foundation Investment Company (AFI), also reports performance that includes the benefit of franking credits and compares it to a benchmark that includes franking. It has outperformed the franking benchmark over the last 6 months and marginally outperformed it over the last 12 months, but underperformed over the last five years. Over 10 years, it is marginally behind at 9.2% pa compared to the S&P/ASX 200 franking credit adjusted benchmark of 9.5%.
Milton Corporation (MLT), the smallest in size at $3.3bn, boasts the best performance over the last 10 years. However, it has really struggled in recent periods. In 2019, it returned 16.5%, but this was 6.9% below the benchmark S&P/ASX 200. One concern with Milton Corporation is that it holds a way overweight position in W H Soul Pattinson (SOL). SOL is Milton’s third largest investment at 6.0%. The Chair of Milton (Robert Millner) is also the Chair of Soul Pattinson.
Major Listed Investment Companies
*Returns to 31/12/19.. Source: Respective Managers
An advantage of LICs compared to ETFs is that they usually offer share purchase plans, which allows shareholders to subscribe for new shares at a marginal discount to their underlying value or NTA (Net Tangible Asset value). Dividends, while only paid twice a year (compared to the quarterly distribution cycle offered by ETFs), are usually fully franked. They are currently yielding about 3.75% pa.
A disadvantage is that as close ended funds where new investors become investors by buying shares from other investors on the ASX, the LIC can at times trade at a significant premium or discount to its NTA.
LIC or ETF?
The tables above demonstrate that despite their different investment styles, objectives and benchmarks, the broad market LICs can be expected to deliver over the very long term close to an index return, and the ETFs an index return less a fraction. While this is not a “given”, the outcome is not that surprising given the concentrated nature of the domestic share market and the relatively conservative investment style adopted by the LICs.
So, an answer to the question – “LIC or ETF, which is better?” – comes down to the premium or discount that the LIC is trading at.
The graph below shows Argo’s share price compared to its underlying NTA over the last 30 years. At times, it has traded at a discount of up to 15% and at other times a premium as high as 17%. More recently, this range has narrowed to around 5% either way, with the most recent move to a small premium.
Argo’s Share Price to NTA – Relative Premium/Discount since 1991
Source: Argo
At the end of December, each of the major LICs was trading at a premium ranging from 7.2% for AFI to 0.4% for Milton.
Discount/Premium (as at 31 December 19)
*NTA sourced from Company Reports
The underperformance of the LICs over recent periods is making the proposition of “close to an index return” harder to sustain. No doubt part of this underperformance is due to the underperformance of the major banks (where the LICs have typically been overweight), and the market’s interest in growth stocks. But it is also probable they have become too big and this is encumbering performance. So, a safer assumption for long term performance may be “index minus.” For ETFs, we can be confident that the return will be index less the management fee – nothing more, and nothing less.
So, my rule of thumb is:
If the LIC is trading at a (not immaterial) discount, then invest in the LIC;
otherwise, invest in the ETF.
While there is arguably a little more variability in the return from the LIC than the ETF (because the former it is actively managed), the flipside is that its return may indeed be better than the index return. There is also manager risk – so you may want to spread any investment across 2 LICs.
Calculating the premium or discount
LICs are required to publish their NTA each month (ASX announcement, plus on their website), which is generally available by the 5th working day of the following month. They publish two NTAs, one that is done on a pre-tax basis, and the other that provides for tax on unrealised gains/losses in the portfolio. As LICs are long term holders and won’t be wound up, use the pre-tax NTA.
Outside the monthly publication, you can estimate their NTAs. Take the last published NTA, remove the impact of any dividends, and adjust up or down by the percentage movement in the S&P/ASX 200 since the calculation date (i.e. end of month). To calculate the premium or discount, compare the estimated NTA with the current market price on the ASX.
Listed below is my estimate of the discounts for the major LICs as at the close last Friday, based on a move up in the S&P/ASX 200 accumulation index this month of 5.7%.
Estimated Discount/Premium (as at 17 January 2020)
*NTA estimated by Switzer Report, based on reported 31 December NTA adjusted for the movement in the S&P/ASX 200 Accumulation Index in January
Which one?
My present ranking of the ETFs (based on management fees and index tracked) is:
- VAS (Vanguard)
- IOZ (iShares)
- STW (SPDR)
There is little in this assessment – any of these ETFs could be selected. It is heavily influenced by fee, and a longer term view that smaller companies will in time do better and hence a preference to opt for a broader index (the S&P/ASX 300) rather than the S&P/ASX 200. I have excluded Betashares A200 from this ranking as I want to see a track record and in particular, how closely the Solactive index matches the S&P/ASX 200.
With the LICs, AFI is trading at almost a 4% premium and is a sell on this basis. Milton on paper looks interesting given the discount, but its underperformance in recent periods is concerning. So right now, Argo gets the gong. If AFI comes back to a discount at about the same level of Argo, I think it would marginally preferred.
Right now, my order is:
- ARG (Argo)
- AFI (Australian Foundation Investment Company)
- MLT (Milton Corporation)
Buy ETFs, sell AFI
For those looking to establish or increase exposure to the market, exchange traded funds represent better value than broad based LICs. Australian Foundation (AFI), on the basis that it is trading at a premium is a sell (potentially, buy VAS as a substitute).
Premiums and discounts can change quickly, so always check these before investing in LICs or ETFs.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regard to your circumstances.
