Investing Basics: understanding your listed investment company (LIC)
Listed investment companies offer investors exposure to a diversified portfolio of assets in a single trade, but the risks are worth examining.
Listed investment companies (LICs) have been a niche segment of the Australian investing landscape for 90 years. However, in recent years, they have experienced somewhat of a renaissance.
More than 100 LICs were listed on the Australian Securities Exchange (ASX) in July this year, up from 67 in July 2014. The category's market capitalisation is up 53 per cent to $39.8 billion.
This year's largest listing is the L1 Capital Long Short Fund, which was heavily oversubscribed and raised $1.33 billion in April.
In this article, we look at LICs, how they operate and who they cater to.
What is a LIC?
LICs are like managed funds in that they provide investors with exposure to an actively managed diversified portfolio of assets, including Australian and global shares.
A portfolio manager is responsible for selecting and managing the company's investments.
Unlike managed funds, LICs list and trade on the ASX. Investors can buy or sell a LIC as they would a normal share.
LICs are “closed-end”. That means they do not regularly issue new shares or cancel existing ones. Consequently, they are not forced to sell assets to meet the withdrawal demands of investors.
And unlike many managed funds, there is no requirement for LICs to be fully invested at all times. As a result, LICs can hold high levels of cash to hedge portfolios at appropriate times.
How are LICs created?
LICs initially raise capital through an initial product offering (IPO) whereby investors can apply for shares in the company. The funds raised from the IPO are then invested in a portfolio of securities which are managed by a professional fund manager.
The value of the underlying investments forms the basis for the net tangible assets (NTA) of the LIC.
Once a LIC has conducted its IPO the funds raised are "captive," meaning they cannot be redeemed. Instead, investors are free to trade their shares on the secondary market (that is, the ASX).
This makes LICs simpler than a unit trust, as there is less paperwork involved in adding to, or reducing an investment.
However, where the price of a unit in a trust will always reflect the value of the underlying investment, the share price of a LIC is influenced by several factors, which can lead to big differences in the underlying NTA per share.
A crucial factor in the trading of a LIC's shares is liquidity. If there are insufficient buyers or sellers at any point in time then wide divergences can appear between the share price and the underlying NTA, referred to as the LIC's "premium" or "discount".
So, size often matters, with the larger LICs typically trading closer to their underlying NTA than smaller LICs.
Investors should be wary when considering the purchase of a LIC at a premium to NTA, as it means much more risk.
As we mark ten years since the GFC, it’s critical to remember that a big win today can be a huge loss tomorrow.
Likewise, the purchase of a LIC at a discount to NTA is no guarantee of superior returns, as discounts can linger.
Benefits of LICs
Perhaps the most touted benefit of a LIC in the current market is the ability for them to generate a regular passive source of income in the form of fully franked dividends.
This is because a LIC pays tax on its investment returns at the company tax rate and can then distribute dividends out of after-tax profit.
Indeed, if a LIC can generate consistently strong investment returns it can retain a portion of profits each year which can be paid out in future years.
A more passive investment philosophy will generally result in franking credits being generated from dividend income. An active philosophy will tend to generate franking credits from realised capital gains, which are taxed at the company tax rate.
A unit trust, on the other hand, must distribute all income and realised capital gains to investors in the year which they are incurred.
Ultimately, the LIC tax structure offers more simplicity and relative certainty, whereas taxable income from a unit trust can be lumpy in any given year.
That’s why self-managed super funds like LICs. They can be simpler and more tax-effective.
But keep in mind, over the longer term, on a like-for-like basis, the post-tax outcome between a LIC and a unit trust are likely to be similar.
Take a look at 4 Morningstar medal-rated listed investment companies.
Are LICs expensive?
As with unit trusts, the fees charged on LICs vary a lot. Some of the largest, most longstanding LICs have the lowest fees.
For example, Milton Corporation (ASX: MLT) at 0.12 per cent a year. Argo Investments (ASX: ARG) at 0.16 per cent; and Australian Foundation Investment Company (ASX: AFI) at 0.14 per cent.
These funds generally adopt a highly diversified, long-term, low-turnover approach to investing, whereas the newer crop of LICs generally charge much higher base fees for active management, and often charge performance fees as well.
For example, Monash Absolute Investment (ASX: MA1), which listed in April 2016, charges a base fee of 1.5 per cent plus a performance fee of 20 per cent for any excess return over the RBA cash rate.
As always, investors should study the prospectus of any LIC investment where all fees are listed in detail.
Our verdict
As with any investment, the merits and risks must be examined on a case-by-case basis. LICs have a long history in Australia and should be around for a long time to come.
While LICs may appear simpler than unit trusts in terms paperwork, investors must understand the extra market risk they incur, as the shares can trade in a wide range around the underlying NTA.
To that end, investors should also consider exchange-traded funds (ETFs), which provide the simplicity of an ASX tradable entity, but at a price more closely anchored to the underlying NTA.
More in this series
• Investing Basics: small, mid, large cap - does size matter?
Emma Rapaport is a reporter with Morningstar Australia, Peter Warnes is Morningstar's head of equities research and Michael Malseed is a senior analyst, manager research, at Morningstar. Any Morningstar ratings/recommendations contained in this report are based on the full research report available from Morningstar.
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