I received the following email from a subscriber this week;
“I would love if you could discuss the pros and cons or what we might expect in investing in LICs (listed investment companies) if the refunding of franking credits to pension phase SMSFs were to stop.
This is serious issue for me and I am sure for many of your subscribers.
The idea of LICs has been very appealing to me, but I now desperately need some more advice as to whether to add or continue as an LIC investor.”
The email was timely, firstly because at the Switzer Investor Strategy Day this week, there were many questions on the impact of Bill Shorten’s proposed changes, and secondly, Perennial Value Management CEO John Murray introduced his new exchange traded managed fund, the eInvest Income Generator (you can watch John’s presentation here [1]). With exchange traded managed funds set to take over from LICs, it is probably opportune to review how they compare and whether they also could be impacted.
LICs vs Exchange Traded Managed Funds
There are more than 100 listed investment companies (LICs) quoted on the ASX, including the broad-based equity gorillas such as AFIC (AFI), Argo (ARG) and Milton Corporation (MLT), all the way through to specialist LICs focussed on offshore investment (an example is Ellerston Asia Investments, ASX: EAI). Actively managed exchange traded funds (ETMFs) are a newer structure and include funds such as Magellan Global Equities (MGE), Switzer Dividend Growth Fund (SWTZ) and the soon to be listed eInvest Income Generator (EIGA). They differ in three essential ways.
Firstly, LICs are a close-ended structure, whereas EMTFs are open-ended. LICs have a finite pool of funds that can only grow if more shares are issued via raisings like share purchase plans. Having a finite pool of funds means that the investment manager has certainty and doesn’t have to worry per se about market movements or investor withdrawals impacting how much he/she has to invest. The downside is that if they are sub-economic when established (too small for the fixed costs), it is very hard to grow. There is also an argument that managers can become complacent because they don’t have to “work” to retain the funds.
On the other hand, ETMFs can grow, or contract, depending on investor appetite. They do this because the fund creates, or redeems, new units each day based on flows occurring on the ASX. Market makers appointed by the fund offer to both buy and sell units on the ASX. At the end of every trading day, if they have sold more units than they have bought, the Fund creates new units, which are then used to settle the market maker’s trades. If the market maker has purchased more units than he has sold, the net amount is redeemed by the fund.
The market maker acts as an agent of the fund and this leads to the second main difference. EMTFs should trade on the ASX very close to the Fund’s NTA (net tangible asset value), whereas a LIC can trade at a discount, or premium, sometimes considerable, to the LICs NTA.
With a LIC, the price at which shares trade on the ASX has nothing to do with the company, it is just buyer demand and seller supply. If the sellers are keener than the buyers, then the traded price will tend to be at a discount to the NTA and vice versa.
Discounts or premiums of up to 15% are not uncommon, and sometimes they can be sustained for years. Although there are many variables, including overall market tone and direction, better performing LICs will tend to trade at a premium, while weaker performing or smaller LICs tend to trade at a discount. Investor communication and support by the investment manager also plays a role.
The market maker’s job is to ensure that units in EMTFs change hands on the ASX as close as possible to the NTA. The market maker doesn’t take part in every trade, but by providing a tight bid/offer spread either side of the NTA, they can ensure that trades are occurring at the “correct” price. To help buyers and sellers, the manager publishes an indicative NTA that updates in real time as the market moves. Called an iNAV, this is usually available on the manager’s website.
Importantly, the market maker is acting for the fund and profits or losses on these trades belong to the fund. Over the long term, these aren’t expected to be that material, but it does mean the fund is wearing the risk. As the fund needs to be fair to all participants – current investors in the fund, new investors purchasing units, and existing investors selling units – it tries to ensure that trades occur close to the fund’s NTA.
Market making is not a fool proof concept. In a severely stressed market, it will be interesting to see how the market makers respond and how wide the spreads become. One thing that is for sure – it will work better for funds that are bigger and have more liquid assets.
The third important difference is the accounting treatment. LICs are companies that pay tax on their investment income (dividends and interest) and realised capital gains at 30%. If they invest in shares paying franked dividends, they won’t pay that much net tax. Further, they get a credit to their franking account, allowing them to pass those credits onto their shareholders via a franked dividend.
Because the payment of any dividend is discretionary, LICs can choose to “smooth” their dividends from one period to the next by withholding some of their net income and paying this out at a later period.
EMTFs on the other hand aren’t companies, but a managed fund employing a trust structure. They are pass through vehicles that don’t pay tax directly. Rather, the income, franking credits and realised capital gains received by the fund are distributed in full to the unitholders, who are then responsible for paying the tax. Most EMTFs don’t have any discretion to withhold income, so distributions can sometimes be uneven and lumpy.
How does Bill Shorten’s plan impact LICs or ETMFs?
Well, the short answer is it doesn’t. Some LICs or ETMFs may adjust their investment strategy marginally by reweighting to assets or shares that don’t pay franked dividends, such as property trusts, but only if they consider the risk adjusted return to be interesting. Consider also that the fully franked “high yielders” may cheapen marginally to make them more attractive.
Shorten’s proposal to end cash refunds of excess franking credits on share investments will have absolutely no impact on taxpayers whose tax rate is the same, or higher, than the company tax rate because they don’t get cash refunds. This includes individuals paying tax at 47% or 39%, and companies paying tax at 30%. A LIC pays tax at 30%.
Taxpayers whose tax rate is less than 30% could be impacted. Super funds (SMSFs) in accumulation mode paying tax at 15% will be impacted if they have a substantial proportion of their assets in Australian shares. If they have less than 35% of assets invested in Australian shares, they are unlikely to be impacted (they don’t get cash refunds). SMSFs in pension mode, and other low rate taxpayers not receiving government support, such as a non-working spouse with share investments, will probably be impacted.
EMTFs, as pass through vehicles, won’t be directly impacted.
Two other points to consider. Firstly, the ALP needs to be elected. And then, it will need to legislate the change. While this shouldn’t be a problem in the House of Representatives, getting this through the Senate could be a real challenge, particularly if he has to deal with a cross bench of “populist” senators. I think the odds of this change starting in 2019/20 (the tax year he has nominated) are low.
The big LICs – are they cheap?
Finally, let’s have a look at the major broad based LICs – AFIC, Argo and Milton Corporation. While performance over the longer term has been sound, they have underperformed relative to the index over the last one and three years. This is true of most funds that are weighted to the top 50 stocks.
Performance to 31 March
Premiums to the NTAs have narrowed. The tables below show the NTA and premiums to the share price as at 29 March, and an estimate of how these stand as at the close of trade on Friday. The estimate is calculated by adjusting for the performance of the S&P/ASX 200 in April, which has returned 1.92%.
Premium/Discount at 29 March 18
Estimated Premium/Discount at 20 April 18
The broad based LICs are now trading close to NTA. While they are not cheap, they represent better value than they have for some years. The following graph from Argo shows the premium/discount on ARG since 1991.
ARG Premium/Discount
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.