This article was originally published by Stockspot, an online investment adviser and fund manager based in Sydney, Australia, and is posted on TEBI with their permission.
Listed investment companies (LICs) used to be one of the best ways for an investor to gain access to a broad range of shares in one transaction.
Throughout the 1900s, ASX listed LICs became more popular with everyday Australians because of the diversification they offered across sectors and countries.
Fast forward to 2019 and the case for LICs no longer stacks up for investors when you compare them to exchange traded funds (ETFs). Our analysis reveals ETFs are superior in every measure; transparency, liquidity, certainty, fees, tax efficiency and most importantly, returns.
When you look at the data, this becomes even more shocking:
- 95% of Australian share LICs failed to beat a market index over 5 years. You would have 20% more money had you invested in an Australian index ETF 5 years ago rather than one of the 3 largest Australian share LICs.
- Not one LIC tracking broad global markets was able to beat a global market index ETF over the past year.
- The average management fee of a LIC is over 1% p.a. (5x a typical ETF). This doesn’t even include performance fees and the tax drag of a LICs higher portfolio turnover.
- LICs regularly trade at a discount to their asset value (on average 7%). Investors have no certainty they’ll be getting fair value when they buy and sell. LICs can also issue new shares which dilute existing investors, making this even worse.
Why are LICs still popular?
Unfortunately for investors, many stockbrokers and financial advisers continue to recommend LICs instead of lower cost index ETFs. This baffles us since ETFs have clear benefits over LICs, not least their lower fees, greater transparency and better performance.
As with most aspects of the finance industry, the motivation is largely self-interest. Stockbrokers and financial advisers are paid a healthy commission to recommend new LICs to their clients via a ‘stamping fee’.
Once the LIC is listed and the stockbrokers and advisers have collected their commissions most LICs trade well below their net asset value (NAV).
LICs are another excellent example of a loophole in the Aussie investment industry that puts financial remuneration of the people selling investments over the financial wellbeing and best interest of their clients, everyday Australians.
Stockspot has long campaigned about unfair fees in superannuation and managed funds. LICs are no different.
Given there is now $45 billion trapped in LIC products we think government needs to urgently act to ban commissions on all new LIC issuances so Australian consumers start to get better advice from their advisers and stockbrokers.
What is a LIC?
A listed investment company (LIC) is an actively managed fund listed on the Australian Securities Exchange (ASX). Like a managed fund, LIC money is pooled together from investors to buy a range of investments.
Unlike managed funds, LICs have a company structure, so shareholders own shares in the company (as opposed to units in a fund). Investors buy and sell shares in the LIC to each other. This means no one can sell shares in a LIC unless someone is willing to buy them at the offered price.
LICs pay company tax (currently 30%) on earnings and can choose to pay distributions to investors in the form of dividends, including any attached franking credits.
There are 114 LICs on the ASX, worth $45.1b. The LIC market has grown by 10% over the past year, much slower than the 30% growth in ETFs over the same period.
Nearly two thirds of LICs invest only in Australian shares, with the remainder investing in global shares and bonds, and a small number in infrastructure and property.
Most LICs trade at a discount to their Net Asset Value or NAV (average discount is 7%). For example if the investments inside a LIC are worth $1, a typical LIC would trade on the ASX at $0.93.
Here in lies one of the main problems with LICs: investors rarely get what they pay for as they rely on other investors in the same LIC to buy off them when they decide to sell.
This discount has increased over the last few years which has hurt their overall performance. These discounts may never close, trapping investors in LICs that have both underperformed and trade at a discount to their asset value.
Why is the share value of a LIC different from the underlying value of its assets?
One reason for this difference is the shareholders’ view of the additional value brought by the fund manager. If LIC shareholders think that the fund manager will provide no additional value the LIC will trade at a discount to the value of the underlying assets.
The size of the discount depends on the management fee – which is a drag on future returns. For example, if the underlying assets are expected to produce a 10% p.a. return and the management fee is 1% p.a. the shares are likely to trade at a 10% discount (given the total return after fees is 9%).
If shareholders think that management can deliver an additional 1% p.a. return and the management fee is 1% p.a. then the shares will trade at the value of the underlying assets.
Most LICs trade at a discount to their Net Asset Value (NAV) as shown in the following table of all the LICs listed on the ASX. Note that the average discount to NAV is around 7%.
However, many LICs trade at discounts much greater than just taking into account their management fee. This is partly because investors have formed the view that management will underperform the market and partly because of the liquidity of the LIC itself. A seller of an unloved and ignored LIC may have trouble finding buyers at any price.
Comparing LICs vs ETFs
We recently discussed the key differences between ETFs and LICs and also provided some context as to why ETFs have been growing faster.
Tax differences between LICs and ETFs
LICs pay company tax on their income before distributing it to shareholders. This means LIC investors are entitled to receive fully franked dividends.
However, LICs tend to have much higher portfolio turnover than index ETFs, which creates an ongoing ‘tax drag’ from realising more capital gains each year.
ETFs distribute income on a pre-tax basis and pass on any franking credits received by Australian companies they’ve invested in. Distributions from the Vanguard Australian Shares Fund (VAS) are about 80% franked.
The creation and redemption process for ETF units is also tax efficient since there is no asset sale and no capital gains when units are created or redeemed. The ETF issuer can select which shares to use, so it will pick those with a low cost base, reducing the ETF’s tax burden.
The reason most LICs underperform is high fees
On average LIC costs are 5x more than a typical index ETF and that’s before the LICs costs of buying and selling shares, performance fees, tax impacts of high portfolio turnover and the dilution impact of LICs issuing more shares.
The impact of high costs becomes more apparent with each passing year as LICs find it more and more difficult to generate sufficient returns to make up for the drag of their costs.
The below chart shows that $10,000 invested in one of Australia’s largest LICs 5 years ago would be worth roughly $12,500 today including dividends and capital growth. That same amount invested in the Vanguard Australian Shares Index ETF (VAS) would be worth over $15,000.
This is one reason why we have advised clients since 2014 to invest in the Vanguard Australian Shares Index ETF (VAS) rather than use LICs that invest in Australian shares.
Performance of the largest Australian share market LICs vs ETFs
Many Aussie investors would be familiar with the Australian Foundation Investment Company Limited (AFI), which is by far the largest and most popular LIC with $7.5b in FUM. It’s also the oldest LIC in the market having listed in 1936.
Argo Investment Limited (ARG) comes in a close 2nd in popularity after building up FUM of $5.8b, listing over 70 years ago. Milton, WAM and BKI are also all over $1 billion in size.
Research by S&P/SPIVA that shows that 80% of active Australian share funds have underperformed over 15 years and this is also evident with LICs with almost all of them underperforming the index and ETFs.
89% of Australian share LICs underperformed the Vanguard Australian Shares Index ETF (VAS) over the last year. The figure is even worse over the long term, with 95% (19 in 20) of broad Australian share LICs failing to beat the ETF over 5 years.
Performance of the largest global share market LICs vs ETFs
It’s similar story for global share LICs. Not a single one of the 18 broad global share LICs beat the Global 100 ETF over the last year. Worse still, 62% of global share LICs had negative returns while the Global 100 ETF had a positive year returning +14.6%!
We’ve published articles in the past about Australians preference to invest in Australian shares. For investors wanting exposure to shares in global markets like the USA, Europe and Asia, ETFs have more consistent performance and are a better, transparent way to access these markets.
Sometimes a LIC will perform well but performance tends to come and go. According to S&P, only 1 in 10 U.S. share funds have beaten the index over 15 years.
This is why we advise clients to invest in the iShares S&P Global 100 Index ETF (IOO) rather than use LICs that invest in Global shares.
Best performing LICs in 2019
Only one third of all LICs on the ASX had a positive 1 year return to 30 June. The average LIC return was -4% compared to the average ETF return of +8%. The returns within asset classes tell the same story.
The best performing LIC was the Bailador Technology Investments Limited (BTI) delivering a return of 42% return over the year. The LIC invests in a range of tech startups and private equity deals.
A strong year for assets like infrastructure meant Argo Global Listed Infrastructure Limited (ALI) and URB Investments Limited (URB) returned a total of 29% and 20% respectively.
High dividend yielding strategies such as Clime Capital Limited (CAM) rounded out the top performers over 1 year but have underperformed the market benchmark over longer periods with a 5 year return of just 5.9% p.a.
Worst performing LICs in 2019
The worst performing LIC was the 8I Holdings LTD (8IH) which lost 52% over the year. Its fellow value manager, the Forager Australian Shares Fund (FOR), also had a poor year, falling 39%. Forager was previously a star fund with top quartile returns.
Lowell Resources Fund (LRT) lost 39% over the year, despite many resource ETFs being up almost 15%. Cadence Capital Limited (CDM) was the fourth worst performer declining 36% over the year and -6.4% p.a. over the last 5 years.
Finally, the HHY Fund (HHY) lost 35% and may soon be shutting down after a proposed change of investment manager and responsible entity. A fund closure or merger due to poor active performance is another risk of owning a LIC.
Every year a couple of LICs perform well, but fund manager performance is inconsistent and almost impossible to predict. Of the top 25% of active Australian share funds in 2014, only 1.3% remained in the top quartile by 2018. Zero active Australian small cap fund managers remained in the top quartile from 2014 to 2018.
LICs served a purpose about 20 years ago but the investment world has moved on. In a country like Australia it is incomprehensible that stock brokers and financial advisers are not regulated to act in the best interests of their clients. If this were the case LICs would no longer continue to operate or be forced to modernise.
We urge the government to ignore the loud voices and deep pockets of the LIC lobby groups. It should move to act in the best interest of investors and close the LIC loophole by banning stamping fees and commissions.