However, not all LICs are alike, and investors need to understand these differences as they may have a bearing on their returns. 

In this article, Argo outlines five key factors to consider before investing in an LIC:
 

1. Internally managed or externally managed

The first factor is whether the LIC is internally or externally managed. 

Many of Australia’s largest and oldest LICs, such as Australian Foundation Investment Company (ASX: AFI) and Argo Investments (ASX: ARG), are internally managed. These LICs employ their own in-house investment and management teams and therefore operate as both the manager and the investment vehicle. 

Externally managed LICs, which have made up most of those listed since the early 2000s, are managed by an external fund manager under a management agreement.

The main differences are outlined below.

Source: Argo Investments
 

The distinction between the two may be relevant when considering alignment of interests, fees or costs, investment behaviour and shareholder returns over time.   
 

2. Fee structure

Another distinction between internally and externally managed LICs is their fee structure.
 

Internally managed LICs

For an internally managed LIC, all operating costs (wages and administrative costs such as rent, regulatory costs, research tools and brokerage) are captured within the management expense ratio (MER). The MER is expressed as a percentage of the LIC’s assets and is accounted for in the reported net tangible asset (NTA) performance.  

As the internally managed LIC grows, its relatively fixed operating costs tend to reduce as a proportion of assets.

For large, long-established LICs, the MER is usually between 0.1% and 0.2%. (The ASX Investment Products monthly report shows the MER for every LIC on the ASX).

Externally managed LICs

In addition to its own administration costs, an externally managed LIC also pays a management fee to its external manager, based on a percentage of the LIC’s assets. The management fee is often between 0.7% and 1.0%, sometimes as high as 2.0%, depending on the investment strategy, based on Argo’s analysis.  As the LIC’s assets grow, the management fee increases. 

These LICs will often pay a performance fee on top of the management fee, typically between 10% and 20% of returns above the LIC’s benchmark or hurdle [against which their portfolio’s investment performance is compared].

Fee structures differ and may create different incentives for external managers, such as more active investment strategies with higher turnover or that are focused on short-term performance[WH5.1]. For LICs with high portfolio turnover, brokerage expenses and tax liabilities may be considerable, potentially eroding capital over time (see point 3, Dividend Sustainability, below). 

Investors may be attracted to some externally managed LICs because they offer access to specialised strategies, managers or less accessible asset classes, like international markets, private equity, or private debt, with a small minimum investment via ASX. 

In Argo’s opinion, it is important to understand whether an LIC’s reported portfolio performance is calculated before or after fees. 

For an externally managed LIC, NTA performance returns can be markedly lower than portfolio performance returns after management, performance and administration fees are deducted.     

Note: Purchasing, selling, or holding LICs involves no direct fees for investors, aside from brokerage costs. The expenses associated with managing an LIC are deducted from its assets and income. 
 

3. Dividend sustainability 

An LIC typically generates income in two main ways: dividends received from its underlying portfolio and from realising capital gains. It can then pay this income to shareholders as dividends. 

An important and distinguishing feature of LICs, particularly compared to exchange-traded funds (ETFs) and other investments using a trust structure, is their ability to accumulate earnings from multiple periods in retained earnings or a profit reserve. 

LICs may then use those reserves to distribute dividends during weaker years, which may reduce variation in dividend payments between periods; however, future dividends are not guaranteed.

Although an LIC’s future dividend cannot be guaranteed, its capacity to maintain or grow its dividend can be assessed by looking at several factors, including the LIC’s dividend record and the retained earnings or profit reserve in its financial accounts.

LICs may sell assets from their portfolios to fund dividend payments to shareholders. They may do this to maintain a higher level of dividends or to distribute excess franking credits. 

Over time, this practice may reduce the LIC’s capital base, from which it derives dividends and generates gains. This can restrict potential future dividends to shareholders.     
 

4. Franking credits 

Because an LIC is an Australian corporate taxpayer, when it realises gains on investments in its portfolio and pays corporate tax, it generates imputation (franking) credits, even on overseas assets. 

Additionally, an LIC can receive franking credits on dividends from its investment portfolio if those investments pay Australian corporate tax. 

These credits accumulate in a franking account and are distributed with dividends, 

Investors can refer to an LIC’s Annual Report for its franking account and LIC capital gain account. If the franking balance is insufficient or trending lower over time, the LIC may not be able to fully frank its future dividends.   
 

5. Premium or discount to NTA 

Because an LIC is a closed-end structure, buyers and sellers on the ASX set its share price, which can trade above (a premium) or below (a discount) its NTA[WH7.1] per share. 

Some investors see these discounts as an opportunity to buy the underlying assets below market price, hoping the shares will trade closer to the NTA in time. 

A range of factors can influence premiums and discounts, some specific to the LIC such as portfolio performance and  dividend track record, as well as external factors, such as the interest rate environment and market trends. 

Smaller or less liquid LICs may trade at wider discounts, although this varies across products and market conditions.
 

Conclusion

No single factor will determine if an LIC is a worthy investment. However, taken together, these five factors provide a more fulsome picture of the key features and risks of LICs.
 

From ASX

Listed Investment Companies and Listed Investment Trusts has information on the features, benefits and risks of LICs and LITs, and is a good place to start for investors who are new to this market and want more information.