Much has been made of growth in Exchange Traded Funds (ETFs) that replicate an index return at low cost. Less considered are larger Listed Investment Companies (LICs) that provide active exposure to Australian equities without high fees.
In some respects, a middle ground between active and passive investing is emerging. “Smart beta” ETFs use methodologies to produce a return greater than their index. And some LICs provide a scaled-back active management compared to other funds with higher portfolio turnover.
Done well, this strategy provides the best of both worlds: active management that lifts returns and low fees that make a big difference to portfolio returns over years or decades.
The market’s three largest LICs – Australian Foundation Investment Company (AFIC), Argo Investments and Milton Corporation – are portfolio staples for many investors. Brokers historically recommended them to small clients who benefited from investing through a fund.
The LICs were promoted as a simple way to gain exposure to Australian blue-chip shares. Rarely were they considered as a tool to gain modest active exposure, without the fees, for long-term conservative investors. Or an alternative to smart-beta ETFs.
The three LICs have performed consistently over long periods. The market’s largest LIC, AFIC, has a 5-year annualised total return (capital growth and dividends) of 10.5 per cent, Morningstar data shows. Argo has delivered 12.2 per cent; Milton 11.8 per cent.
Chart 1: AFICSource: The Bull
The LICs have been particularly useful for income investors seeking diversified exposure to a reliable stream of fully franked dividends from Australian shares. Greater scope to manage dividends is a strength of closed-end LICs that have a fixed pool of capital.
My interest in the big LICs has been tweaked by the latest discount/premium information. LICs typically trade at a discount or premium to their portfolio’s underlying value (measured by pre-tax Net Tangible Assets). Some see this is as a flaw in LICs; others an opportunity.
A discount to NTA means the LICs can theoretically be bought for less than the market value of its assets. But LICs often trade at large, persistent discounts for a reason: poor performance, unreliable dividends, management uncertainty or low liquidity in the LIC’s shares.
Do not view the NTA discount or premium in isolation. What matters most is how the figure compares to the average discount or premium over three to five years. Is the LIC trading at a larger-than-usual discount to premium compared to long-run averages?
LIC discounts and premiums have a habit of reverting to their median over longer periods. Not all LICs follow this pattern and relying on a larger-than-usual discount or premium when deciding to buy LICs is no guarantee. Still, it’s a useful guide.
AFIC traded at a 1.7 per cent premium to its latest stated NTA (for August 2017) and Argo and Milton just above pre-tax NTA as this column was published.
AFIC traded at an average 2.4 per cent premium to pre-tax NTA over three years to July 31, 2017, Independent Investment Research data shows. Argo traded at 3.1 per cent and Milton at about 1 per cent. On that measure, the big LICs are slightly undervalued against their long-term averages, although LIC NTA figures can bounce each month in volatile markets.
Chart 2: ArgoSource: The Bull
Dividend performance is a key metric. In the recent reporting season, AFIC held its dividend in FY17 and Argo and Milton had modest dividend increases. AFIC paid a 24-cent full dividend for the past three financial years; the trailing yield is 4.1 per cent, fully franked.
Chart 3: Milton CorporationSource: The Bull
Low management fees are another attraction. AFIC and Argo had a management expense ratio (MER) of 18 basis points (plus brokerage when buying and selling its shares). Milton’s MER was only 14 basis points, ASX data shows.
That is less than most ETFs, despite the big LICs providing active portfolio management rather than index exposure. Unlike many smaller LICs, none of the big three have outperformance fees when the LIC returns a certain amount above its benchmarket index.
Although attractive, the big LICs are hardly screaming buys. Active investors who want to buy LICs trading at a larger discount to pre-tax NTA – and hope the discount narrows through better portfolio performance and a rising share price – should look elsewhere. Plenty of small LICs trade at larger discounts to NTA, usually because they have poor performance.
The combination of modest discounts to long-term premiums at the current price; solid dividends; low fees and share prices well below recent highs strengthens the case to buy the big LICs for Self-Managed Superannuation Fund that want conservative Australian equities exposure in the portfolio core.
The big LICs once again prove that boring can be beautiful. The key is buying them when they trade at small discounts to NTA and have a long-term investment horizon. Such discounts rarely last for long and their reversal can boost the total LIC return.
• Tony Featherstone is a former managing editor of BRW and Shares magazines. The information in this article should not be considered personal advice. The article has been prepared without considering your objectives, financial situation or needs. Before acting on the information in this article you should consider its appropriateness, regarding your objectives, financial situation and needs. Do further research of your own or seek personal financial advice from a licensed adviser before making any financial or investment decisions based on this article. All prices and analysis at September 20, 2017.