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Mark LaMonica: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general nature. It does not take into account your personal situation, circumstances or needs.

So, Shani, we are just talking about this. I'm listening to a new podcast, and I've listened to a lot of them, even though one of the headphones or one of the ear things on my headphones doesn't work.

Shani Jayamanne: This actually is a part – not the headphone part – but you continue to listen to it because I sent you an episode of this podcast called RedHanded and it's a true crime podcast. They had one that was set in Greenwich, which is where you grew up.

LaMonica: Yes, the Martha Moxley murder. So, you sent that to me when I was in France. I listened to it, and I actually had some problems with that episode just because I feel like I'm very familiar with the crime and I thought there were some inaccuracies.

Jayamanne: Are you too familiar with the crime?

LaMonica: Okay. Well, it happened before I was alive, Shani.

Jayamanne: Okay.

LaMonica: So, I'm not the…

Jayamanne: You're not a suspect. Okay.

LaMonica: I'm not a suspect, but the two suspects and they were these two brothers, the Skakel brothers, went to my high school, obviously way before me and the teacher who was babysitting them that night was a teacher at my high school.

Jayamanne: That's crazy.

LaMonica: Yeah. So, there you go.

Jayamanne: So, you've continued to listen to these?

LaMonica: I have. And so, it's these two British women that do this and yeah, I think they're actually pretty amusing. One of them brings their dog to the podcast.

Jayamanne: I think it's just – we normally have these podcast reviews every year where we talk about what could we improve with Investing Compass. So, if you guys have any ideas, please let us know. But maybe I could bring Priscilla along and maybe we could both be British.

LaMonica: Okay. I'm not great with accents. And you've got some problems with the British and their history of colonialism. So, what could possibly go wrong?

Jayamanne: What could possibly go wrong? So, tell me what your favorite episode was.

LaMonica: I don't know. I just listened to the two-parter that Gilgo Beach murders.

Jayamanne: Oh yeah. Okay. And you enjoyed it?

LaMonica: I mean, I thought it was kind of interesting. I didn't know anything about it really. I saw when the guy got arrested, but I didn't know anything about it and it's crazy.

Jayamanne: Okay. Well, I refuse to listen to the ones that are unsolved. I need a resolution.

LaMonica: What about this? They've arrested the guy, but he's not been convicted.

Jayamanne: No, I don't like that. And I say this because I think about JonBenét Ramsey every day because I need a solution.

LaMonica: We're well aware. Although you've solved the crime in your head.

Jayamanne: Yeah.

LaMonica: The brother did it.

Jayamanne: Yes. I feel like that's the answer.

LaMonica: Okay.

Jayamanne: Anyway, we should talk about something to do with investing.

LaMonica: Yes. Although I will say the advantage that these two British women have is I feel like their topics are more interesting than our topics. But today, we're going to talk about LICs and ETFs, Shani.

Jayamanne: Wow.

LaMonica: Yeah, exactly. A real page-turner.

Jayamanne: All right. So why don't we go through a question that we received because it is a listener-requested episode.

LaMonica: Okay. The question began by asking about the advantages and disadvantages of each structure and the listener wants to know why you would choose one or avoid one structure over the other. And the question follows up – it was a long question. It was a whole email. The listener follows up by asking about the premiums and discounts to NTA for LICs – don't worry. We'll explain what that means – and when to invest in them, and then asking if there is a danger that LICs will go away.

Jayamanne: So, lots of questions. So why don't we start at the beginning? But it's worth acknowledging this is a timely episode, as the day before we actually record this, Magellan announced that they would convert their LIC to an ETF. And those, of course, are the two types of securities that we're talking about today. An ETF is an exchange-traded fund. A LIC is a listed investment company. And the similarities between ETFs and LICs are both captured in their names. Exchange-traded and listed makes reference to the fact that they both trade on exchanges. That makes it really easy for investors to access both investments. You can buy and sell both ETFs and LICs in your brokerage account.

LaMonica: And they are also both baskets of securities. You can easily get access to a diversified portfolio in a single trade. And of course, those baskets of securities will fluctuate in price as markets move. And it is that very movement in price that leads us to our first big difference. How the prices of the ETF and LIC react to those price changes of the baskets of securities and how they reflect the value of those baskets of securities?

Jayamanne: On the surface, anything that trades on an exchange is influenced by the forces of supply and demand. If more investors want to buy something, they will bid the price up and it will increase. If there are more sellers than buyers, the price will go down. And we talk about this a lot with shares that also trade on the exchange. There are times where those shares prices don't reflect the intrinsic value of the shares.

LaMonica: But ETFs have a mechanism in place to keep the price of the ETF close to the basket of securities that they own. This mechanism isn't perfect and there can be small differences between the value of the basket of securities or net tangible assets, the NTA we referenced earlier, and the ETF price. But these mechanisms work pretty well. The differences are mostly small.

Jayamanne: A LIC does not have any mechanism in place to prevent differences between the NTA and the price of the LIC. So substantial differences can exist between the two. The LIC can trade at a premium when the price exceeds the value of the NTA or a discount when the price is lower than the NTA.

LaMonica: And we will get back to that point. But there are a couple of other differences. The first is that an ETF can be both actively and passively managed. All LICs are actively managed, meaning that somebody is making a decision on the makeup of that basket of securities and making decisions on what to buy and sell.

Jayamanne: And the last important difference is tax. An ETF is a pass-through vehicle, meaning that all dividends and capital gains generated from the portfolio and from changes to the portfolio will be immediately passed on to investors. The investor will then pay the applicable taxes based on his or her tax circumstances.

LaMonica: A LIC can keep those capital gains and dividends and distribute them to investors when the manager decides. And this may seem like a small difference, but it means that the LIC can build up a reserve that can be used to smooth these distributions out so that an investor gets more steady income, something that is very attractive to investors who are using income generated by this investment to pay for their life.

Jayamanne: So those are the basics, but we need to get back to the discount and premium issue with LICs because it was part of the question and because this characteristic of LICs is having a huge influence on the current state of LICs in Australia.

LaMonica: So many people, including Firstlinks' Graham Hand, have declared that the heyday of LICs is in the past. In a recent article, Graham provides some facts about the state of LICs. According to the Australian Securities Exchange, otherwise known as the ASX, there are 89 LICs with a market capitalization of $49.4 billion in August of 2023. The rival exchange, the CBOE, offers 20 listed managed funds. The number on the ASX is down from a peak of 115 in 2019, so a reduction of 26 LICs in four years.

Jayamanne: According to Bell Potter, LICs are close to their widest discounts to NTA in history, with smaller LICs, so those are less than $100 million at around 25%. Even the large LICs, which have traditionally traded around NTA due to decades of investor support and large shareholder bases, are currently at discounts.

LaMonica: And this can of course be frustrating for investors. As the discounts have widened, investors have either lost money or failed to adequately capitalize on the growth in value of the underlying assets.

Jayamanne: And this is why LICs have started to be converted into ETFs to close that discount, but it is worth noting why LICs were attractive for managers in the first place. LICs are known as permanent capital. That means that when a LIC starts, an IPO is performed, and a certain amount of money is raised by the investment firm. After that, the manager no longer needs to worry about the sentiments of investors putting money into or pulling money out of the LIC.

LaMonica: And this is important because if you run a managed fund, the inflows and outflows of investor money does influence the way that you invest. If lots of money is pulled out of a fund, the manager will have to sell assets. Lots of money is put into the fund, the manager will have to buy assets.

Jayamanne: And the problem is that at extremes of the market, this can be quite detrimental. If shares fall significantly, investors tend to pull money out right when shares are cheap. Managers will have to sell those cheap shares. And when the market is overheating and shares are expensive, investors tend to pile in, and the manager will have to buy these overvalued assets.

LaMonica: So, in theory, a LIC provides independence from the impact of investor behavior on a manager. But the interests are still aligned because if the NTA goes up in value, the manager can collect more fees.

Jayamanne: But the problem is that at a certain point, a stubborn and increasing discount makes this whole thing untenable. And if this discount is thought to be permanent, it is no longer in the best interest of investors to maintain that structure.

LaMonica: So, this of course gets us back to the question posed by our listener. Is a good strategy to buy LICs when they are trading at large discounts? And the answer, like so many things in life, is maybe. One could argue that if the discount is permanent and continues to widen, that is a bad choice for an investor. But if one thinks it will shrink, that would obviously be a good strategy.

Jayamanne: But there is another problem in buying a LIC at a discount. The manager receives a fee, which is a percent of assets, the same as any other. The problem is that figure used to calculate this fee is a net tangible asset of the LIC or NTA. So, let's say you buy a LIC at a 20% discount. Well, the fee doesn't take that discount into account. So, if the discount never closes, the investor will end up paying a higher fee than they normally would.

LaMonica: So, let's say that the fee is 1%, just to make things easy. If the 20% discount is permanent, it means the investor is paying a fee effectively of 1.25% on their investment. So that isn't great news.

Jayamanne: So, it's hard for any of us to tell an investor what to do. There are certainly attractive qualities of LICs, and they may make sense for investors who are looking for active management and who find the tendency for LICs to smooth income attractive.

LaMonica: However, those investors will have to grapple with the unpredictability of the discount to NTA and the fact that it might continue to widen. It just introduces another factor that an investor will have to take into account.

Jayamanne: All investments have advantages and disadvantages. The important thing is for investors to understand those advantages and disadvantages and decide which vehicle works best for them, given their particular circumstances. Then stick with that vehicle. Trying to gain a premium or a discount is not a long-term strategy for success.

LaMonica: All right, that is our episode on LICs and ETS, but I have one more thing to say about that podcast, RedHanded.

Jayamanne: Okay.

LaMonica: So, did you know that they wanted their listeners to vote for them for a British podcasting award, like a listeners' choice award? And each year they came up with a way to reward those listeners for voting, I guess, induce them to vote. One of the hosts got a tattoo with a listener name on her. Next year, they jumped out of a plane. And if they win three years in a row, they're going to go spend the night in a haunted house.

Jayamanne: Okay.

LaMonica: So, would you get a tattoo of a listener?

Jayamanne: Depends what their name is.

LaMonica: Well, I guess there's nothing else I can say to that without you insulting somebody. So, there we go. If Shani likes your name, she will get it tattooed on her. Thank you very much for listening.

(Disclaimer: Any advice in this podcast is general advice or regulated financial advice under New Zealand law prepared by Morningstar Australasia Proprietary Limited and/or Morningstar Research Limited without reference to your financial objectives, situations or needs. You should consider the advice in light of these matters and any relevant product disclosure statement before making any decision to invest. To obtain advice for your own situation, contact a financial advisor.)