Investors in Australia’s biggest Listed Investment Companies (LICs) have witnessed a fairly ordinary last 12 months. While on paper the portfolio returns of around 9% look reasonable, this masks the fact that they have underperformed the benchmark S&P/ASX 200 accumulation index by between 2.4% to 3.4% over this period. And if share price performance is considered (growth in share price plus dividends), they have fared even worse as any premium to NTA (net tangible asset value) has been crunched and they have moved to trading at a discount to NTA. The second largest, Argo (ARG), has returned just 1.5% on this measure over the 12 months to 31 March.
The move to a discount to NTA is not just related to performance. It’s also a reaction to Bill Shorten’s proposed change to franking credits. I have warned on several occasions that LICs trading at a premium are the most vulnerable group of stocks to any change (more vulnerable than bank stocks or hybrids) because the LIC market is purely a retail market and the premiums defy gravity. Institutional and offshore investors don’t buy LICs. All it takes is a few retail investors to move to the sell side and the premium can crunch very quickly.
If you are holding other LICs trading at a premium, they remain vulnerable to a premium crunch.
The reason for the underperformance of the major LICs is less clear, as the “top part” of the market (the top 50 stocks) have outperformed the broader market over the last 12 months (see table below, which shows that over the 12 months to 29 March, the ASX 50 has returned 14.20% compared to the ASX 200’s 12.05%). The broad based LICs tend to be invested in the major companies because it is hard to invest in microcaps and their investment thesis is deliberately conservative and weighted to established companies. While it is not possible to be definitive, the underperformance is probably a function of an overweight position in the major banks and an underweight position in some of the high flying technology stocks.
Total returns to 29 March 2019
But it is the move from a premium to discount which is most interesting, and leads me to address one of the most frequently asked questions by investors – which is the best managed investment?
While many investors prefer to construct their own portfolio of direct shares, others see the advantages of using a managed investment – particularly if they don’t have a lot of time to follow the market. Some investors use managers to complement a portfolio of direct shares – while others go the opposite way and run a core portfolio with a manager and then invest in individual shares as the satellite component.
Two of the easer ways to gain exposure to the market are through broad based LICs or index tracking Exchange Traded Funds (ETFs). Listed and traded on the ASX, both are managed investments. There are also many other managed investments (ETFs and LICs) that specialise in components of the market (such as mid caps or small caps), sectors, or investment styles (eg. deep value). And of course there is the Switzer Dividend Growth Fund (ASX: SWTZ)) which because I am conflicted, I will exclude from this discussion.
The purpose of this article is to stick with the funds that provide broad based share market exposure and answer the question – “which is the best?” I answer this by saying it largely comes down to the premium or discount.
Exchange traded funds (ETFs)
Most ETFs are designed to track an index. They are on “autopilot” – the manager invests and maintains the investment in accordance with the index. If the index weight for Commonwealth Bank is 7.5%, very close to 7.5% 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 index. Nothing more, nothing less.
The major market cap ETFs are set out below. They track broad based indices, with both iShares IOZ and SPDR’s STW tracking the S&P/ASX 200 while Vanguard’s VAS tracks the broader S&P/ASX 300. Fees are very competitive.
Performances (after fees) to 29 March 2019 are shown below, as is the benchmark S&P/ASX 200 accumulation index.
Major exchange traded funds
Returns to 29/3/19. Source: Respective Managers
The major 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 4.25% pa, franked to around 75% (that is 75% fully franked and 25% unfranked).
The major LICs
There are 3 major broad market LICs – AFIC (Australian Foundation Investment Company), 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.
As the table demonstrates, the funds have roughly kept pace with the S&P/ASX 200 accumulation index over 10 years and longer periods but have underperformed in more recent times. Milton Corporation (MLT), the smallest in size at $3.1bn, boasts the best performance over the last 5 years and 10 years.
The largest, Australian Foundation Investment Company (AFI) has recently stopped reporting total performance consistent with the normal industry benchmark, but now includes the benefit of franking credits in its return and compares it to a benchmark that also includes franking. If franking was excluded, its return for the last 12 months to end March would be approximately 8.9%. On its own measure, it has underperformed the franking adjusted benchmark by 2.5% over the last 12 months, 1.8% pa over the last 5 years and 0.4% pa over 10 years.
One concern with Milton Corporation is that it hold a way overweight position in W H Soul Pattison (SOL). SOL is Milton’s second largest investment holding at 7.7%. The Chair of Milton (Robert Millner) is also the Chair of Soul Pattison.
Major listed investment companies
*Returns to 29/3/19. AFIC includes a gross up for franking credits, whereas Argo and Milton are reported on the normal total return basis. 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 yielding about the same as the ETFs at around 4.2% pa.
A major 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 demonstrate that despite their different investment styles, objectives and benchmarks, the broad market LICs can be expected to deliver over the long term an index style return plus or minus a fraction, 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 sharemarket and the relatively conservative investment style adopted by the LICs.
So, the answer to the question – LIC or ETF – comes down to the premium or discount that the LIC is trading at.
The graph below shows Argo’s share price compared to the 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 discount.
Argo’s share price to NTA – relative premium/discount
Source: Argo
Discount/premium (as at 29 March 2019)
*NTA sourced from Company Reports
The recent underperformance of the LICs over the last 1 year, 3 years and 5 years is making this proposition above harder to sustain. No doubt part of this underperformance was due to the underperformance of the major banks, which have been underperformers for the last couple of years. The major LICs have all been overweight financials because of their focus on dividend paying 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 has been:
“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 some manager risk – so you may want to spread any investment across two 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.
At other times, you can quite accurately estimate the NTAs for the broad market LICs. Take the last published NTA, and adjust it up or down by the percentage movement in the S&P/ASX 200 since the calculation date (ie 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 as at the close on Friday.
Estimated discount/premium (as at 12 April 2019)
*NTA estimated by Switzer Report, based on reported 29 March NTA adjusted for the movement in the S&P/ASX 200 Accumulation Index
Which one?
My ranking of the ETFs (based on management fees and index tracked) is:
- VAS (Vanguard)
- IOZ (iShares)
- STW (SPDR)
There is very 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).
With the LICs, Milton Corporation has the best performance record over most time periods and is trading at the biggest discount. Despite the concern over the holding in Soul Pattison, it gets the gong. On the basis of the discount, Argo comes in second.
- MLT (Milton Corporation)
- ARG (Argo)
Do you buy LICs?
Overall? While there is a risk that the discount could widen further in the short term, LICs are starting to look attractive. Long term investors looking for broad based exposure should consider LICs in preference to index-based 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.
