Why LICs are a good fit for SMSFs

Photo of Nathan Umpathy, Bell Potter By Nathan Umpathy, Bell Potter

min read

Need for greater control and transparency driving interest in listed investment companies.

A Listed Investment Company (LIC) is an ASX-listed company established to invest in a portfolio of securities, managed by a fund manager. The LIC raises a fixed amount of capital through an initial public offering (IPO) and new capital can only be raised through a corporate issue. Shares in LICs are traded on ASX like any other share.

Over the past few years there has been a resurgence in popularity of the LIC market. At the end of 2017, the total number of LICs listed on ASX increased to 107 with 14 LICs coming to market throughout the year.

It is no coincidence that the popularity of LICs has coincided with the rise in the number of self-managed super funds (SMSFs). There were 600,700 SMSFs at the end of last year. This represents $704 billion in funds under management and accounts for a third of Australia’s total superannuation assets.

An increasing number of investors are looking for greater control over their superannuation. Combined with effects of the introduction of Future of Financial Advice regulations and a prolonged low interest rate environment, it has resulted in a level playing field for managed funds and investment vehicles such as LICs.

Table 1: Comparison between LICs and other investment vehicles

  Listed Investment Companies (LICs) Exchange Traded Funds (ETFs) Exchange Traded Managed Funds (ETMFs) mFunds Managed Funds
Structure

Company, Closed-ended fund

Regulated Unit Trust, Open ended Regulated Unit Trust, Open ended Regulated Unit Trust, Open ended Regulated Unit Trust, Open ended
Investment Strategy Actively managed Passively managed, rules based, index based Actively managed Actively managed Actively managed
Buy/sells On market via ASX On market via ASX On market via ASX Direct with manager via ASX With manager via platform or direct
Transperancy Weekly or monthly NTA reports. Top 10 or top 20 portoldio disclosure Daily NAV. Full portfolio disclosure daily Daily NAV. Lagged portfolio disclosure quarterly Top 10 portfolio disclosure Top 10 portfolio disclosure
Liquidity Subject to vagaries of supply and demand on ASX Issues and redeems units daily. Market making provides liquidity on ASX Issues and redeems units daily. Market making provides liquidity on ASX Issues and redeems units daily. Does not trade on ASX Issues and redeems units daily. Does not trade on ASX
Pricing Price can trade at Discount or Premium to NTA Generally trades at tight spread around NAV Generally trades at tight spread around NAV Entry/exit price not known until T+1 Entry/exit price not known until T+1

Source: Bell Potter

Key LIC attributes appealing to SMSF investors include:

A consistent distribution of fully franked dividends
LICs are structured as companies. Management can therefore choose to retain earnings and reinvest them or pay out earnings as dividends. LICs also pay company tax on their earnings and can choose to pass through franking credits along with dividend income.

The LIC manager has a degree of flexibility in the timing of distributions, allowing them to smooth out the distribution of dividends. This assists LICs to pay a consistent and growing dividend stream throughout the cycle. It is advisable that investors review profit and franking credit reserves to gauge if the LIC can maintain its dividend yield over time.

Conversely, managed funds and exchange-traded managed funds are not able to retain earnings. This means these vehicles must pass on any income earned (dividends or realised gains) in the financial year it is earned. Hence, distributions tend to be inconsistent year on year.
In addition to franking credits, LICs can also provide shareholders with additional deductions in their income tax if they pay a dividend that includes a LIC capital gain amount. SMSFs can deduct 33.3 per cent of the attributable part advised by the LIC.

Diversification and variety
Australians typically have non-diversified portfolios, with the 2017 ASX Investor study suggesting that 75 per cent of investors only hold Australian shares. Diversification is important because it helps to spread investment risk, which means investors are less exposed to negative effects of specific events or market trends.

SMSF investors can utilise LICs as a simple and effective way to diversify their portfolio. Bell Potter’s LIC coverage broadly breaks up LICs into three main categories – domestic mandates, international mandates and specialist mandates.

Domestic mandate LICs invest in a portfolio of Australian equities, often concentrating on a segment of the market, such as large cap, large to medium cap, medium to small caps, and small to micro-cap companies. LICs focused on smaller companies can offer broad market diversification for SMSF investors lacking the time, resources or expertise to invest outside the ASX Top 20.

SMSF investors can also gain access to global markets through international mandate LICs. These are particularly appealing relative to their managed fund peers, as they have the capacity to pay franked dividends over time.

Specialist LICs offer a variety of investment strategies that are too sophisticated for SMSFs to replicate. In the past five years there has been an increased breadth of LICs offering specialist exposure to sectors such as technology, or different investment strategies (income enhancer, market neutral strategies) and alternative asset classes (corporate loan market).

A LIC can allocate a portfolio without an overhang of cash, given no redemption obligations. However, managed funds are required to ensure they have adequate head room to cover redemptions should they occur. Consequently, most unit trusts suffer from cash drag due to a reasonable weighting of cash in a portfolio. Cash has tended to underperform all other assets classes through the cycle.

Closed-end structure
It has been recognised that closed-end vehicles historically outperform managed funds over time. The closed-end structure of a LIC means investors are able buy and sell shares in a LIC, like any other share, without affecting its underlying portfolio.

This means the portfolio manager of a LIC can be purely focused on long-term investment performance. This is a key difference to managed funds and exchange-traded funds and allows a LIC manager to take advantage of weak sharemarket conditions.

Managed funds and exchange-traded managed funds are exposed to inflows and redemptions. This can lead to an overbearing focus on short-term performance that could negatively affect the longer-term profitability of the fund.

Accountability and transparency to shareholders
Given the compliance requirements for SMSFs and their investments, a LIC’s structure ensures accountability of the board and investment manager. LICs are required to comply with the Corporations Act and various governance principles, and the board must act in the best interest of all shareholders.

Various statutory obligations give shareholders the opportunity to communicate and engage with the board and management, including through annual general meetings.

Each month, a LIC regularly publishes its net tangible assets (NTA), top holdings and often additional information, ensuring additional transparency for investors. Furthermore, this process is improving, with several LICs now disclosing weekly NTA reports.

Cost-effective nature
LICs can be a cost-effective way to complement an investment portfolio. Unlike a managed fund, there are no entry or exit fees. The initial cost comes in the form of brokerage paid to acquire the LIC.

A LIC only charges management and performance fees like many active investment vehicles. Management fees are used to cover the cost of running the investment portfolio, while performance fees help align the manager with the profitability of the fund.

Tradeable units (shares) ensure capital is not locked up
The SMSF demographic is one that probably has some significant financial decisions in their future. Whether updating investment strategy or investing in other assets, SMSF investors tend not to want their capital locked up for too long. As noted, LICs can be bought or sold on ASX like any shares – allowing investors to cash out when required.

Trading at a premium or a discount is part and parcel of the LIC structure. Historical analysis suggests that LICs tend to revert to their long-term average premium or discount through the cycle. Investors should therefore be wary of these historical averages when making investment decisions.
While LICs are subject to similar risks associated with other investments, such as market, performance and investment risks, with an increasing array of product choices on offer we believe LICs will continue to be used as foundation blocks to build a robust investment portfolio from a risk-return perspective.

About the author

Nathan Umapathy is a LIC analyst at Bell Potter, where he is responsible for the highly regarded Weekly LIC and Quarterly LIC reports.

From ASX

Listed Investment Companies and Trusts provides information the features, benefits and risks of ASX-listed LICs.

The views, opinions or recommendations of the author in this article are solely those of the author and do not in any way reflect the views, opinions, recommendations, of ASX Limited ABN 98 008 624 691 and its related bodies corporate ("ASX"). ASX makes no representation or warranty with respect to the accuracy, completeness or currency of the content. The content is for educational purposes only and does not constitute financial advice. Independent advice should be obtained from an Australian financial services licensee before making investment decisions. To the extent permitted by law, ASX excludes all liability for any loss or damage arising in any way including by way of negligence.

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