There has been considerable commentary in the media about the “death” of listed investment companies (LICs). This has been driven by the long overdue ban on stamping fees that Treasurer Josh Frydenberg recently introduced, several LICs trading on the ASX at discounts to their intrinsic values, and actions some managers are taking to reposition their LIC or incorporate it into another structure.
In this article, I am going to look at the three biggest LICs and make the case that it is time to sell – not because of the structure – but because their market prices are “too high” and there are better alternatives available through exchange traded funds (ETFs).
But before doing this, let me point out that the LIC structure still carries many advantages over the championed alternative, the ASX quoted managed fund (the structure we use for the Switzer Dividend Growth or SWTZ). Both structures have advantages and disadvantages – neither is perfect.
The main advantage of the LIC is that it is a close ended fund. This means that the pool of capital the manager is investing is finite – and he/she doesn’t have to worry about redemptions or applications. Secondly, LICs are companies. The Board has discretion in paying dividends, so these can be smoothed, and it can make available to shareholders share purchase plans, dividend re-investment plans and undertake capital raisings. The company can also buy back the shares.
The main disadvantage is that a LIC can trade on the ASX at a price that is not the same as its intrinsic value – more conventionally referred to as its NTA or net tangible asset value. Because LICs are investment companies, the only assets they hold are marketable securities and they have virtually no liabilities. So, it is very easy to determine the value of each share by assuming that all the assets are sold at market and the proceeds are re-distributed back to each shareholder. This is known as the NTA. The problem is that the ASX trading price can be different to the NTA. If it is less, then it is said to be trading at a “discount”, if it is more, then it is trading at a “premium”.
The alternative structure, the ASX quoted managed fund (which is also what ETFs use), tries to overcome this problem by appointing “market makers” to provide bid and offer quotes on the ASX either side of the current NAV. The fund is open ended, meaning that the market maker goes back to the issuer to replenish units that he/she sells on the ASX, or to repurchase units that he/she buys on the ASX. Effectively, the fund grows or contracts according to investor action on the ASX.
For the fund manager, the pool of capital they are investing is never constant. In most circumstances, this isn’t too much of a problem, but in a distressed market or where the investor action is one way (wanting to liquidate), the fund could become a forced seller of assets as investors attempt to liquidate, potentially leading to a death spiral.
Also, the unit trust structure that it employs has disadvantages compared to the company structure of a LIC. It must distribute all income received, it is a trust, so the taxation for unitholders is more complicated and it can’t offer share purchase plans or readily raise capital.
Neither structure is perfect.
I don’t think that LICs are a “goner”. But I do think there are times to buy them and times to sell. This is now the case for the major broad based LICs.
The major LICs
There are three major broad market LICs – Australian Foundation or AFIC (AFI), Argo Investments (ARG) and Milton Corporation (MLT). They are big, professionally managed, low cost 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.
While actively managed, 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 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, Argo and Milton 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 boasts a 20 year performance of 8.1% pa compared to the index’s 7.6% pa).
The largest LIC, Australian Foundation Investment (AFI) was also struggling but a little while back, decided to reduce its exposure to the major banks and Telstra, and reposition to more growth orientated companies, such as CSL. Accordingly, it produced a positive return over the last 12 months. It measures its performance by including the benefit of franking credits. Against the S&P/ASX 200 franking credit adjusted index, it has outperformed over the last one year, marginally underperformed over 5 years (8.4% pa vs 9.0%), and matched performance over 10 years.
Argo and Milton do not include the benefit of franking credits in their returns. They are paying on average fully franked dividends of around 4.0% pa. (Argo 4.0%, Milton 4.2%).
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 6.5%. The chair of Milton (Robert Millner) is also the chair of Soul Pattinson.
*Returns to 31/08/20…AFIC’s return is grossed up for franking credits. Source: Respective Managers
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 7.1%, very close to 7.1% 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 August 2020 are shown below, as is the benchmark S&P/ASX 200 accumulation index.
The advantages of an ETF over a LIC are improved transparency and market pricing. ETFs update their NTA every working day, sometimes intraday (A200, 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 pay distributions on a quarterly basis. As they effectively replicate the market, their distribution will yield around 3.5% pa, franked to around 75% (that is 75% fully franked and 25% unfranked). Note: distribution yields in previous years were significantly higher due to several companies paying special dividends.
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 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. But even in 2020, it has swung between a discount and a premium.
Argo’s Share Price to NTA – Relative Premium/Discount since 1991
Source: Argo
At the end of August, AFIC and Argo were trading at premiums ranging from 3.8% to 2.7%. Milton was trading at a discount of 5.1%.
For ETFs, we can be confident that the return will be index less the management fee – nothing more, and nothing less.
So, my basic 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 is actively managed), the flipside is that its return may indeed be better than the index return.
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 paid, 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 premiums/discounts for the major LICs as at the close on Friday, based on a move down in the S&P/ASX 200 accumulation index this month of -2.9%. The prices of the major LICs are often slow to respond to market movements, so it is not uncommon for the premiums to blow out when the market first turns down.
*NTA estimated by The Switzer Report, based on reported 31 August NTA adjusted for the movement in the S&P/ASX 200 Accumulation Index in September of -2.9%.
My view: sell LICs, buy ETFs
I would sell both AFIC and Argo, and switch into index tracking ETFs. Probably Vanguard’s VAS because it tracks 300 companies. Second preference would be IOZ.
Despite still trading at a small discount, I am reluctant to recommend Milton due to its underwhelming performance over 1 year, 3 year, 5 year and 10 year time periods, and governance considerations.
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.
