The Investment Case for Listed Investment Companies
by John Abernethy, August 2012
The LIC is an excellent investment structure for retail investors who seek long term gain and stable income flows from the share market. The recent tumultuous history of the markets, when properly put into perspective, supports investments in LICs over many managed funds.
LICs and the GFC
Take your mind back to the investment markets 2008 and you will recall a period of immense turmoil and fear. Then consider this question: Would you have been better off to have invested in an equity trust fund structure or to have been a shareholder in a LIC?
The year of 2008 saw the onset of the GFC. There were cracks appearing in equity markets in late 2007 but things really got worrisome for investors when Bear Stearns collapsed and was sold in early 2008. During this period the Federal Reserve of America (FED) cut interest rates aggressively and on 22 January 2008 made the following release:
“The Federal Open Market Committee has decided to lower its target for the federal funds rate 75 basis points to 3-1/2 percent.
The Committee took this action in view of a weakening of the economic outlook and increasing downside risks to growth. While strains in short-term funding markets have eased somewhat, broader financial market conditions have continued to deteriorate and credit has tightened further for some businesses and households. Moreover, incoming information indicates a deepening of the housing contraction as well as some softening in labour markets.”
The cut of 0.75% to overnight rates was extraordinarily large and it clearly indicated that the FED had serious concerns with the economic and financial outlook for the US. It was clear that if the US had problems, representing as it did at that point 25% of the world’s GDP, then this would impact the whole world. Indeed it did, and by February 2009 the Australian equity market had collapsed by nearly 60% from its peak in 2007.
Challenges of managed funds (open end funds) during a market downturn
Periods such as these put stress on investment managers and investors alike. The investment manager has to consider his investment exposures. If the manager is controlling an equity fund that is absolutely mandated to be fully invested in the equity market then there is little he can do. He is like the captain on the Titanic and will be compelled to ride the market down with his fund. His investors will progressively jettison his fund with their life boats, through redeeming units. The equity fund will decline in value and he will also lose capital as it is withdrawn by investors.
This feature of what is called an “open fund” (number of units equals the amount invested) is both desirable and destabilising. During the market meltdown of 2008 there was much panic redemptions by unit holders in managed funds. This can cause chaos for a trust structure, which might be unable to invest. Think about that point carefully. At the exact time that an equity fund should be buying in a depressed market, it may not be able to do so if it has to meet cash redemptions!
Of course, not all equity funds are strictly mandated to be fully invested. Indeed, recent history shows that investors who invested in equity unit trusts that allowed the manager to lift cash levels were partly protected in the 2008 market.
The case for LICs (closed end funds)
On the other hand, when we consider LICs in 2008 we see a different investor perspective and arguably a better outcome. A LIC is a listed company capitalised by share capital. It is known as a “closed end” fund because the investment capital is permanent. The manager of such a company has a distinct advantage over an “open fund” manager because there is no requirement to meet redemptions. The buying and selling of shares does not impact the underlying investment. Further, the LIC manager generally has no requirement to be fully invested and so can adjust their cash weighting to match economic circumstances. But note that this is more likely the case for a smaller LIC than a larger traditional LIC.
The ability to raise cash and have a stable balance of cash to invest gave the average LIC manager a massive advantage in the turmoil of 2008/09. To the dismay of shareholders, the share price of most LICs was crunched in this period and most fell well below their NTAs (net tangible asset backing). However, the underlying investment business was able to continue to operate with some certainty.
In the case of Clime Capital Limited (of which I am the Chairman), the manager responded to the market conditions by taking the portfolio towards 60% cash in early 2008 and then started investing capital back into the market in the second half of 2008 and early 2009. Permanent capital, without the risk of redemption, allowed our managers to make rational decisions which ultimately led to some substantial gains in 2009/10/11.
There are other advantages with an LIC. In particular, the ability of the LIC to gather and to stream franking credits to their owners. So long as the LIC is solvent and has retained earnings, dividends can certainly be declared. In the case of Clime Capital, we have adopted a quarterly dividend strategy that ensures a steady flow of dividends throughout the year. In contrast, the ability of some trusts to make distributions is more convoluted and can be affected by realised losses and gains generated by redemptions.
Points to consider
Finally, it should be remembered that not all LICs are the same and the investment style of individual managers needs to be understood. Then again, there is significant transparency offered to investors and shareholders through ASX monthly NTA reports. This transparency is significantly better than the average managed fund.
- The tax status of the LIC
- Available franking credits
- Retained earnings
- Investment outlook
- The portfolio structure
- The NTA per share
This last point is often jumped upon by advisors and investors. The LIC share price be trading below NTA, and it may be claimed that this is a drawback for a LIC investment. However, look at it another way: a discount is always to the advantage of a buyer, particularly if they have an investment rather than trading mentality.
Clime Capital Limited
An extract from his article was featured in the ASX newsletter in August 2012