Bill Shorten’s  proposed “franking credit grab” is still impacting the listed investment company (LIC) market. This was one of the drivers behind a “premium crunch” earlier this year when many LICSs moved from trading at a premium to NTA (net tangible asset value) to trading at a discount. Almost four months after election night, discounts for LICs are the norm.

This includes Australia’s biggest LICs –  Australian Foundation (AFIC), Argo Investments (ARG) and Milton Corporation (MLT). Managing a combined $16 billion in assets, these LICs invest broadly across the market in well-diversified portfolios and offer investors an “all in one” way to establish and maintain core Australian equity exposure.

That same exposure can also be secured by investing in index tracking exchange traded funds (ETFs).

So if you don’t want to manage a portfolio of direct share holdings, or perhaps prefer to invest directly in satellite holdings for the “alpha” and let a professional manage the core, investing in broad-based LICs or ETFs can be an attractive option. The obvious question is: which is better? And which is the best managed investment?

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 7.9%, 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 recently introduced a new ETF, the A200, which tracks an index of 200 ASX companies. This index is produced by Solactive rather than S&P. The new ETF charges a management fee of just 0.07% pa. In response, iShares and Vanguard lowered  their management fees to 0.09% pa and 0.10% pa respectively.

Performances (after fees) to 30 August 2019 are shown below, as is the benchmark S&P/ASX 200 accumulation index.

Major Exchange Traded Funds

Returns to 30/8/19 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 3.9% 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 three major broad market LICs – AFIC or 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.

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 8.9% pa compared to the index’s 8.8% 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. LICs 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), reports performance that includes the benefit of franking credits and compares it to a benchmark that also includes franking. However, it has still underperformed this benchmark by 2.2% over the last 12 months and 2% pa over the last five years. Over 10 years, it is marginally behind at 9.9% pa, compared to the S&P/ASX 200 franking credit adjusted benchmark of 10.2% pa.

Milton Corporation (MLT), the smallest in size at $3.3billion, boasts the best performance over 5 years and 10 years.

One concern with Milton Corporation is that it holds a way overweight (although reducing) position in W H Soul Pattinson (SOL). SOL is Milton’s third largest investment at 5.8%. The Chair of Milton (Robert Millner) is also the Chair of Soul Pattinson.

Major Listed Investment Companies

*Returns to 31/8/19. 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 allow 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 and will typically be higher than that paid by the ETFs. They are currently yielding about 4.1% 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, 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 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 discount.

Argo’s Share Price to NTA – Relative Premium/Discount since 1991

Source: Argo

Over the last 12 months, these LICs have moved from trading at a small premium to trading at a small discount. At the end of August, each of the major LICs was trading at a discount ranging from 1.8% for Argo to 4.4% for Milton.

Discount/Premium (as at 30 August 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 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 5^th 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 quite accurately estimate the NTAs for the broad market LICs. 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 on Friday, based on a move up in the S&P/ASX 200 accumulation index this month of 1.5%.

Estimated Discount/Premium (as at 13 September 2019)

*NTA estimated by Switzer Report, based on reported 30 August 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:

1. VAS (Vanguard)
2. IOZ (iShares)
3. 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. I have excluded the new 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, 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 W H Soul Pattinson, it gets the gong. On the basis of a stronger track record in recent periods, AFIC comes in second.

1. MLT (Milton Corporation)
2. AFI (AFIC)
3. ARG (Argo)

Buy LICs

Overall? While the recent performance of LICs has been disappointing, market investment styles tend to be cyclical and there are signs to suggest that investors are looking again at value style stocks and are more favourably disposed to the major banks. There really isn’t that much difference between LICs or ETFs, but on the basis of a small discount, long term investors (particularly those with an income bias) should consider LIC.