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Why LICs have a built-in advantage over unlisted managed funds.
By John Abernethy, Clime
Take your mind back to the investment markets of 2008 and you will recall a period of immense turmoil and fear. Then consider this question - were you better to have been an investor in an equity trust fund structure (unlisted managed fund) or a shareholder in a Listed Investment Company (LIC)?
That year saw the start of the global financial crisis. Cracks were appearing in equity markets in late 2007 but things really got worrisome for investors when Bear Stearns collapsed and was sold in early 2008. During that period the US Federal Reserve cut interest rates aggressively and on January 22, 2008 made the following statement:
"The Federal Open Market Committee has decided to lower its target for the federal funds rate 75 basis points to 3.5 per cent. The Committee took this action in view of a weakening of the economic outlook and increasing downside risks to growth.
"While strains in short-term funding markets have eased somewhat, broader financial market conditions have continued to deteriorate and credit has tightened further for some businesses and households. Moreover, incoming information indicates a deepening of the housing contraction as well as some softening in labour markets."
The cut of 0.75 per cent to overnight rates was extraordinarily large and clearly indicated the Fed had serious concerns with the economic and financial outlook for the US. From an Australian perspective it was clear that if the US, representing at that time 25 per cent of the world's GDP, had problems, then it would spread around the world.
Indeed it did and by February 2009 the Australian equity market had collapsed by nearly 60 per cent from its peak recorded in 2007.
Periods such as these put stress on investment managers and investors alike. Managers have to consider their investment exposures. If a manager is controlling an equity fund that is absolutely mandated to be fully invested in the equity market, there is little that can be done.
The manager is like the captain on the Titanic and will ride the market down with the fund. Investors will progressively jettison the fund, whose lifeboats are in redeeming units (to pay out departing investors). The equity fund will decline in value and will also lose capital as it is withdrawn by investors.
The catch in liquidity
This feature of the equity trust fund structure, or what is called an "open fund", is both desirable and destabilising. We can only speculate on how much of the market meltdown of 2008 was caused by panic redemptions by unitholders in managed funds.
Although it is desirable that investors have liquidity, it can cause chaos for a trust structure if it cannot undertake investment. Think about that point. At the exact time an equity managed fund should be buying in a depressed sharemarket, it may not be able to do so because it has to sell stock to meet cash redemptions.
Of course, not all equity funds are strictly mandated to be fully invested. Indeed, recent history shows that investors who invested in equity unit trusts that allowed the manager to lift cash levels, were partly protected in the 2008 market.
When we consider LICs in 2008 we see a different investor perspective and arguably a better outcome. A LIC is a listed company capitalised by share capital. It is known as a "closed end" fund because the investment capital is permanent. The manager has a distinct advantage over an "open fund" because there is no requirement to meet redemptions.
Further, the LIC manager generally has no requirement to be fully invested and so can adjust their cash weighting to match economic circumstances. I note this is more the case for a smaller trading LIC than a larger traditional LIC.
The ability to raise cash and have a stable balance of cash to invest gave the average LIC manager a massive advantage in the turmoil of 2008 and 2009. To the dismay of shareholders, the share price of most LICs was crunched in this period and most fell well below their net tangible asset (NTA).
However, the underlying investment business was able to continue to operate with some certainty. In the case of Clime Capital Limited (of which I am the chairman) the manager took the portfolio towards 60 per cent cash in early 2008 and started investing capital back into the market in the second half of 2008 and early 2009. Permanent capital without the risk of redemption allowed our managers to make rational decisions which ultimately led to some substantial gains in 2009-2011.
LICs have other advantages, in particular their ability to gather and to stream franking credits to their owners. So long as the LIC is solvent and has retained earnings, then dividends can certainly be declared. Clime Capital has adopted a quarterly dividend strategy that ensures a steady flow of dividends throughout the year. In contrast, the ability of some trusts to make distributions is more convoluted and can be affected by realised losses and gains generated by redemptions.
To summarise, the LIC is arguably a better investment structure for retail investors who seek long-term gain and stable income flows from the sharemarket. The recent tumultuous history of the markets, when properly put into perspective, supports the investment in LICs over many managed funds.
It should be remembered that not all LICs are the same and the investment style of individual managers needs to be understood. However, there is significant transparency offered to investors and shareholders through ASX monthly NTA reports. This transparency is significantly better than the average managed fund.
These reports need to be analysed in conjunction with LIC annual reports and investor briefings, because they will also outline the following key important investor issues:
- The tax status of the LIC
- Available franking credits
- Retained earnings
- Investment outlook
- The portfolio structure
- The NTA per share.
This last point is often jumped upon by advisers and investors. The LIC share price may be seen to be trading below NTA and it may be claimed this is a drawback for a LIC investment. This obviously depends upon your perspective, as a discount is always to the advantage of buyers and particularly if they are investing rather than trading.
About the author
John Abernethy is chairman of Clime Capital, a well-performed LIC.
Listed Investment Companies provides a wealth of information on LICs. Use ASX Market Update information to review LIC premiums and discounts to NTA since 2004. View the monthly sector update to see overall LIC performance. Examine quarterly performance returns to gauge a LIC's investment performance against others.
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