As an investment consultant and portfolio manager with a focus on the listed investment fund space, one question I sometimes get from advisers and investors is, “Why wouldn’t I just pick my own LICs/LITs?” After all, isn’t that the point? You outsource the stockpicking and picking fund managers is easy – right?
Well, no. Choosing fund managers is difficult enough when considering conventional unlisted managed funds, particularly when the investment environment is challenging. And I would suggest that when incorporating listed investment companies (LICs) and listed investment trusts (LITs) into client portfolios, the difficulty is compounded, for the following reasons:
- Governance and transparency on LICs is generally poorer than at retail managed funds, which seems to attract some less ethical operators to LICs.
- Investment mandates can be flexible or allow esoteric investments, leading to unusual return and risk outcomes, although this can sometimes work to the upside.
- Some groups running LICs don’t have any other retail vehicles, so less is known about them.
- The pricing dynamics of LICs/LITs trading at a premium or discount can have a major impact on the actual investor return experience over both the short and long term.
- Related to this, unlike with unlisted managed funds, it is often difficult to sell a poorly performing LIC for anything near net tangible asset value (NTA). In some extreme cases, you can’t sell them at all (more on this below), although this can also sometimes happen with unlisted trusts – think mortgage, property, high yield and certain hedge funds during the GFC).
While many of the funds in the LIC space are well governed and managed, the history in a few listed vehicles – those that might be labelled ‘investment disasters’ – of periodic investor losses much greater than those in the broader markets, suggests the above risk factors are real.
Success, especially in more trying markets, can be less about what one invests in and more about what one avoids. While mistakes and losses are inevitable, true investment disasters that result in more permanent capital losses are hard to recover from, especially if investors are overly concentrated in those investments. Still, some of these ‘disasters’ eventually present attractive contrarian investment opportunities.
A pirate saga
The year 2018 has had more than its fair share of disasters in LIC land. Although yet to play out fully, perhaps the ugliest of these will be the experience of investors in two LICs – Henry Morgan (ASX:HML) and Benjamin Hornigold (ASX:BHD), both named after famous pirates. These funds have been suspended from the ASX since June 2017 and July 2018, respectively, and are subject to scrip takeover offers from their Brisbane-based, NSX-listed manager John Bridgeman (JBL) – another pirate. The Independent Expert’s Reports on the deals has stated that the offer is “not fair but is reasonable” and also highlighted that the manager seems to have issues with the regulator. There are no bids on the NSX for JBL stock with an offer at 90 cents. Clearly, no easy options exist to resolve the mess that these three vehicles have become but accepting the JBL scrip hardly seems to be the answer.
There were numerous red flags that led sceptical investors, including us, to avoid investing in these funds. These included a somewhat awkward meeting with the pirates in late 2015, which provided no clarity on any process around, or edge in, their macro trading, which was backed up by a stellar but somewhat short, small funds under management and a difficult to assess track record. However, even for sceptics, it was hard to envisage a disaster of this extent and the disdain with which management and the board have treated shareholders. Any normal fund manager presiding over such long ASX suspensions and large investor losses would be forced out of financial services and quietly eating humble pie. Yet in this case, the fund managers have gone on the offensive, treating shareholders with contempt and threatening legal action against commentators raising perfectly valid concerns (usually a warning sign that something is seriously wrong).
More is likely to be written about this “pirate saga” in coming months, although without much good news for investors. Perhaps the most valuable things investors will take out of this are the lessons on being sceptical about something seemingly too good to be true, the risk that even in supposedly liquid, listed securities, your ability to exit easily may disappear, and that regulators are usually of little help in such situations, at least until most of the damage is done.
More to selecting LICs than the discount
Contrarians and value investors are generally attracted to a heavily discounted LIC and there is the old saying “there is a (buying) price for everything”. But when it comes to a certain class of LICs, I don’t believe this is true. I’ve learnt through harsh experience over decades that some LICs are better to avoid no matter how large their discounts to NTA become. Why? Because some vehicles are run heavily or primarily for the benefit of the manager or board, costs are likely to be excessive as a percentage of the typically small fund size AND leakage of investors’ funds occurs in other, less direct, ways. These various imposts will probably largely outweigh any underlying returns and deplete investors’ capital over time.
For example, one small LIC has employment costs for four people equivalent to 4 per cent of the fund NAV, even though half the fund is outsourced to other fund managers. Some of the directors or management of such funds have often had a colourful corporate history, sometimes including periodic issues with the regulators. You only get to know who these people are over time and through (sometimes bitter) experience. In such cases, investors generally lose trust eventually and discounts remain large and persistent.
Discerning between an investment disaster you should look to avoid and one that may provide an attractive opportunity is crucial, and getting the timing right is extremely difficult. Investors in L1 Long Short Fund Limited, Blue Sky Alternative Access Fund and the three Watermark funds that floated this year might agree. Investing in the three Watermark funds might not have been disastrous but it is fair to say might have perhaps disappointed investors’ performance expectations.
The LIC/LIT opportunity set
Too often, investors look only at the recent track record or current reputation of a fund manager in selecting an LIC/LIT. Instead, many elements should go into the mix, including a view on the market environment and strategy employed, governance, quality of manager and team turnover, fees and costs, fund size, liquidity of the underlying strategy, the current discount/premium and catalysts that will affect the size of the discount.
Certainly, investors could point to other LICs that have performed poorly in 2018, in addition to those I have discussed. Alternatively, I could have discussed those funds that have held up or performed well in a difficult 2018. But this is not meant to be a complete review of the LIC sector in 2018; rather, it’s a focus on the most interesting cases and particularly those that provide valuable investor lessons.
The L1 float in April 2018 probably represented the high-water mark of the recent LIC boom. This boom has resulted in an expanded range of interesting listed fund vehicles that broaden the investor opportunity set considerably. There are signs that the boom in new issuance is now fading. Two managers, Firetrail and Cadence, pulled initial public offerings in recent months. Several funds trading at large discounts are under pressure to restructure and funds have merged. There are still some LICs/LITs slated for early 2019, including from reputable managers such as Regal and Pengana but the near-term behaviour of investment markets could determine if these proceed or if they do, constrain how much they raise. There is also the threat of a potential Labor Government limiting access to franking credit refunds, which would reduce the appeal of LICs for some investors, and favour LITs (and unlisted funds) over LICs.
A version of this story was published this week on Livewire.
Dominic McCormick is an investment consultant and observer with a focus on listed investments. He will pick up his coverage of listed investment companies aimed at financial advisers for Professional Planner early in the new year.