LICs: making a comeback – but tread carefully

Listed Investment Companies – or LICs – have been making something of a comeback lately with the net number of new LICs on the ASX at levels not seen since 2005, as today’s chart shows. It hit fever pitch when Investors Mutual raised $185m into the newly minted QV Equities – well above their minimum $100m target. In a market that has seen Australian equity managed funds lose $4.1b in net outflows over the last year, that’s a pretty outstanding result.

So could LICs be the saviour of fund managers’ flagging retail businesses? Maybe.

There’s a lot to be said for LICs from the perspective of a fund manager.

• Firstly, brokers provide fund managers with a real chance of targeting the SMSF segment. We know SMSFs have relationships with brokers – and as it happens it’s primarily brokers who sell LICs, which could be the SMSF-friendly vehicle that fund managers have been looking for.
• Secondly, upfront commissions are back. Brokers have a carve-out from FOFA, so paying upfront commissions to a broker as part of an IPO is within the rules. Being able to pay incentives can only be good news for fund managers.
• It would be remiss of me to forget the stickiness of LIC funds under management. Following the big-bang capital raising during the IPO there is not generally an option for investors to redeem their cash – instead, they sell shares in the LIC to another investor. So from a fund manager’s perspective, nothing changes when investors decide to sell– the value of assets under management only changes according to the funds’ asset returns (net of whatever it decides to declare as a dividend). It doesn’t matter how good or bad performance is, the number of shares on issue doesn’t change.

There are some genuine advantages for investors as well:

• Yields are often high and fully franked.
• Liquidity is available all day every day on the ASX.
• After putting in an order, there is no waiting to find out the price you got at the end of the day – trading is done on-screen at the quoted price.
• LICs allow investors in what would otherwise be illiquid investments to sell their shares to other investors – providing a secondary market liquidity option that is not available in most other products.

Of course, there are some potential downfalls for investors.

The upfront commissions clearly dilute an investor’s initial investment. So a $100 investment ends up being around $98 on the day of listing. Managers have wised up to the issue and sought to solve it through providing an option (valued at >$2) to purchase a further share in the LIC at a later date. Whilst this solves the immediate problem in that the investor has a portfolio on listing day that is valued at more than the initial investment, as Graham Hand pointed out on Cuffelinks recently, in a rising market this causes some pretty significant dilution for investors who don’t participate.

But the main downfall – especially if investing at IPO – is that LIC investors are exposed to a risk that managed fund investors simply don’t have: the bet that there will be continued strong demand for the product. Managed funds are valued at NAV. LICs are valued at whatever price investors are happy to trade at. This substantially changes the equation for investors as they are exposed to supply and demand of the LIC as well as the underlying investments.

As at the end of August, about a third of the LICs traded on the ASX were trading at a discount to NAV of more than 5%. This could be seen either as an opportunity to get in (hoping the discount closes) or a sign to get out (the market doesn’t believe in the asset class or the ability of the fund manager to outperform).

Interestingly, this discount to NAV actually causes a headache for brand-name fund managers as well – having your LIC trade at a heavy discount to NAV can be a very public expression of a lack of faith in your investment capability.

In all, the business drivers for fund managers launching LICs are strong – it’s not often that a high margin, near-guaranteed revenue stream opportunity comes along so taking advantage of that is a perfectly rational decision. But there are risks, so a pragmatic and careful product design is going to be really important – to ensure the product delivers a healthy business outcome and also a really strong long-term proposition for investors.