Why LICs Find Favour In Times Like Now

To make profits in this market you need darn good stock picking skills combined with a modicum of good luck – or else, you need a well-diversified portfolio, and listed investment companies (LICs) are one way to achieve this. They’re well diversified, cheap, and the oldest LICs have track records spanning back to the early 1900s.

And there’s even been some talk that LICs could experience a comeback of sorts due to regulatory changes in the financial planning industry. But we’ll talk more about this later.

Firstly, for those who don’t know much about LICs, here’s a quick rundown. Listed Investment Companies (LICs) trade on the ASX just like any share such as Telstra, which means that they sport a three-letter stock code, as well as a bid and ask. But LICs are companies that invest in other stocks on the ASX and the stock selection is actively managed by a professional manager (either in-house or outsourced externally); so the LIC may hold shares in Telstra, as well as shares in Westpac and Woodside Petroleum, for example, and will actively manage the portfolio in an effort to outperform the index. Most LICs will own shares in as many as 70 ASX listed companies, meaning when you buy shares in a LIC you are indirectly buying shares in a whole host of ASX-listed companies.

LICs work in the same manner as any company listed on the ASX; the LIC raises capital from investors via its IPO and its shares trade on the ASX. When investors wish to sell their shares in the LIC they do so on the market by selling to other investors who want to buy in. This feature of LICs is very handy in nervous sharemarkets, and is one reason why LICs find favour in times like now.

You see the problem with unlisted managed funds, such as the majority of retail managed funds, is that when investors wish to redeem units in the fund, the assets of the fund must be sold down to meet these requests. This can be troublesome in bear markets when share prices are falling, and a flood of redemptions cause a fund manager to sell out at lows.

On the contrary, the manager of an LIC is never under pressure to sell assets to meet redemptions. They can invest with an eye on the long term, as well as in less liquid assets such as microcaps. The manager needn’t worry if investors suddenly pull out.

Another plus is that unlike managed funds, LICs do not charge entry or exit fees, there are no buy or sell spreads, or upfront and trail commission to financial advisers – basically, the only cost is brokerage to buy shares in the LIC in the first place and a comparatively low management expense ratio (MERs).

So what happens in the event that investors’ do exit an LIC in tranches? Well, what happens when investors sell BHP shares in droves? Indeed, its share price drops and this is exactly what happens to an LIC from time to time. If its popularity wanes, its share price can sink below the value of its investment portfolio. This is probably the most talked about criticism of LICs – the problem when LICs trade significantly above or above Net Asset Value (NAV), which is simply fund assets less fund liabilities expressed on a per share basis.

For contrarian investors, the opportunity to buy an LIC for less than its worth and sell for more than its worth is a bonus. Other investors feel ripped off when they purchase shares in an LIC that is temporarily trading above its NTA (LICs publish their NTA values as regularly as weekly so investors should check this out before buying).

A comparable investment to LICs is the exchange traded fund (ETF) which offers the broadest possible diversification by investing in the entire index of shares. While LICs are actively managed, ETFs are passive. They simply buy the index in totality and ride the highs and lows of the overall market. (LICs in contrast, aim to beat the market by selecting the best shares to achive this end).

ETFs tend not to experience the problem of trading above or below its NTA, because they are open ended. If an ETF experienced a surge in demand for units, the ETF provider can simply issue new units without the share price being affected. Similarly, if the ETF is trading at a discount, market makers can come in and buy ETFs, closing any gap in market price to Net Asset Value (NAV).

The popularity of LICs tends to move with the cycles. LICs tend to come into favour in bear markets, but often get lost in the wash when bull markets turn everyone into an avid stockpicker. Some LICs are perennially popular because of the manager’s track record, and enjoy strong demand such as the country’s largest LIC, Australian Foundation Investment Company, and the second largest, Argo Investments; both often trade around a 4-6% premium to their NTA.

The good news for LICs is the Federal Government’s regulatory changes that should come into effect by 1 July 2012. The proposed changes mean that financial advisers will be prohibited from receiving commissions and payments from investment product providers, fund managers and investment platforms in exchange for recommending particular products. Happily for LICs, it means that financial advisers will be less inclined to favour commission-based products like unlisted managed funds compared to listed products that do not pay commissions – such as LICs.

The user-friendly nature of LICs – in that you access a diversified portfolio of stocks via the purchase of single share – would be a handy for advisers monitoring multiple client portfolios. Rather than managing individual share portfolios for each client, a once-off investment in an LIC can do the job.

For these reasons, we could witness a rise in popularity for LICs – which as we’ve already discussed may overcome the major investor gripe over recent years, which is the problem when LICs are permanently trading at a discount to NTA.

Another growing market segment for LICs are private client businesses advising to self-managed super fund investors. Since LICs are structured as a company, they are required to pay company tax on income and realised capital gains made in the portfolio; management have the choice of either retaining profits or paying them out to investors as dividends. Investors pay tax on any dividend income, and franking credits can be used to offset the tax already paid. Self-managed super funds benefit from franked income as it helps to reduce tax in their SMSFs.

When researching LICs to buy, the best LICs tend to beat the market indices over the medium to long term, are liquid, have a solid management track record and a history of increasing dividend payments. Riskier LICs are newer, smaller in size (measured by market capitalisation) and are less liquid. LICs that use gearing can heighten both share gains and losses, and LICs that invest in microcaps or Asian markets, for example, more probably trickier to research than those invested in popular Aussie industrial stocks.

If you’re looking to buy an LIC for yield, then an LIC in large, Aussie industrial stocks will be more appropriate than one invested heavily into Aussie microcaps. LICs will list individual stock holdings on their website, so take a look at the types of stocks chosen as well as investment objective behind their stock choice.

You also want to compare LICs against management expense ratios (MERs). Some LICs will outsource portfolio management to an external fund manager, which tends to increase costs. And lastly, compare the market price of the LIC to its underlying asset value, preferably its pre-tax figure as the post-tax figure measures the fund’s value if all investments were sold and all capital gains paid, in other words if the fund was wound up.

Every month the ASX publishes reports detailing all LICs, including current share price, market size as well as NAV, both pre and post tax. The reports also calculate whether the LIC is currently trading at a discount or premium to NTA. As at August 2011, out of a total of 63 LICs, just 9 LICs were trading at a premium to pre-tax NTA, with the rest trading at a discount. The report can be found here.

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This article is of a general nature only and does not take into account your individual circumstances. For advice, TheBull recommends that you employ the services of a qualified financial adviser.