The boom in new listed investment companies (LICs) and listed investment trusts (LITs) has gone on longer than many expected. There are now about 110 LIC and LIT vehicles listed on the ASX, with assets of more than $42 billion. And it seems the boom is not over yet. Neuberger Berman Global Income Trust and Tribeca Global Natural Resources have recently listed, although funds raised have been relatively modest. Firetrail Absolute Return was planning to list but has since decided not to go. Charity-focused Hearts and Minds Investments is proposing a maximum $500 million listing for November. A number of other fund raisings are in the works, too.
Even so, we may look back upon the April 2018 listing of the mammoth $1.3 billion L1 Capital Long Short Fund as the high-water mark for the LIC boom of recent years. (Perhaps along with the late 2017 listing of the $1.5 billion Magellan Global Trust.) Poor initial performance of the L1 fund has led to it trading as much as 20 per cent below its issue price and that is without it even drifting to a substantial discount to net tangible assets (NTA), as often occurs with poor initial performance.
THE TAILWINDS
What explains the strong growth in the number of LICs and LITs in recent years? No doubt, investors’ growing preference for the transparency and access that listed vehicles offer has been a major factor. They allow immediate pricing on transactions and investors can more easily monitor their portfolios on a frequent, even intraday, basis. This preference for listed vehicles has been justified, as sharemarkets have generally performed well for most of the decade since the GFC. A focus on yield and franked dividends as interest rates have declined, and the ability of LICs to smooth this dividend income stream over time, has been another driving factor, particularly for self-managed superannuation funds.
In addition, some specialist managers with capacity limits have seen the structure as attractive from a business perspective, such that it may be the only way retail investors can access them.
Fund managers are attracted to LIC/LIT vehicles because they see them as “permanent capital”. Yet in the real world there is no such thing as permanent capital in listed funds. In certain circumstances, share/unit holders can vote to change boards/directors/responsible entities and replace fund managers. Funds can be taken over or forced to return some or all capital to investors. History shows that complacent fund managers who most adamantly view their funds as “permanent capital” are the ones most likely to lose control of the funds at the hands of disgruntled share/unit holders at some point. They are also the managers less likely to proactively manage issues around their fund trading at large discounts to NTA. They are lazy about promotion and marketing as well; therefore, they have a smaller base of loyal investors.
But perhaps the biggest factor in the popularity of these listed investment structures has been the ability of brokers, dealer groups and planners to earn ‘selling fees’ of 1-2 per cent as part of the IPO process. Financial planners have become a larger component of LIC initial public offerings in recent years, compared with the listings’ historical reliance on stockbrokers and direct investors. While the fees are not particularly large and some rebate them to clients, the ability to earn what are effectively commissions on listed fund IPOs is one of the more obvious Future of Financial Advice (FoFA) anomalies.
Another recent and related factor elongating the boom has been the increasingly standard arrangement in which the manager covers initial transaction costs (including the selling fees) to ensure the initial NTA equals the issue price. This is clearly a welcome development for investors, although depending on the structure it’s not necessarily quite as generous as it first appears.
THE HEADWINDS
It remains to be seen whether the selling fee anomaly will continue to exist, given the current focus on eliminating grandfathered and other previously excluded forms of conflicted remuneration. Greater scrutiny around, and possible elimination of, the ability of some to earn these selling fees following the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry is one potential headwind for growth in the LIC/LIT sector. A number of other headwinds are building, including:
Disappointment with the performance of some prominent recently listed fund vehicles, leading to lower investor appetite for new IPOs
- Proposed changes to franking credit refunds under a potential Labor government that make LICs, which effectively convert realised gains into franked dividends, less attractive (although this policy may encourage more LITs relative to LICs)
- More issuance of active exchange-traded funds as an alternative to LICs/LITs with the perceived benefit that trading is always close to NTA
- Further growth and competition from the exchange-traded fund market for passive and smart-beta investment options
- Greater market volatility or the next bear market, which is likely to reduce appetite for listed vehicles generally.
The listed fund structure and growth in the number of listings has allowed the introduction of innovative asset classes and specialist managers in LICs/LITs. Some quality managers cannot be accessed other than via their listed vehicle. In recent years, there have been floats in areas as diverse as residential mortgage-backed securities, high-yield debt and resources, plus a range of long/short strategies. A private equity LIT is expected in coming months.
CHART THE COURSE
The LIC structure, while flexible, does require close scrutiny of governance issues and asset/ manager quality. The company structure of LICs can also expose shareholders to a greater range of costs and risks than would be the case with a normal managed fund.
One LIC that listed early in 2016, the John Bridgeman-managed Henry Morgan (ASX code HML), has been suspended from the ASX for 16 months as it seeks to satisfy ASX and ASIC concerns around asset valuations and related-party transactions. The manager’s second LIC, Benjamin Hornigold (BHD) has also been suspended for four months. Investors in these vehicles (especially HML) will probably face a bloodbath relative to the last traded prices if these securities trade again in their current form.
Of course, a slowdown in the supply of new LICs/ LITs is no disaster for realistic and patient investors and advisers. Even without more LICs/LITs, there is already a wide variety of funds providing a fertile field of opportunities and risks for investors; however, a period of more challenging investment markets would certainly help separate the “stayers” from the short-term opportunists amongst the funds launched in recent years.
Therefore, while the listed fund space has benefited from specific tailwinds in the latest cycle, the sector has long moved through cycles of expansion and consolidation closely aligned to the cycle of general premiums and discounts to NTA. Issuance is greatest when many funds are trading around or above NTA, while few vehicles are issued (and a number are unwound) when most funds are trading at discounts to NTA. For investors and advisers recommending listed funds, excessive issuance should, therefore, encourage caution, although it increases the universe of attractive (often discounted) opportunities in the future.
Knowing roughly where we are in the expansion/consolidation cycle is crucial to taking advantage of such opportunities and avoiding excessive risks. In that light, the signs that the current boom is waning are growing.
Dominic McCormick is an investment consultant and observer with a focus on the listed investments space.
