Understanding Listed Investment Companies
28 Jun 2016
By Shadforth Financial Group
Listed Investment Companies (LICs) offer exposure to a professionally managed portfolio of securities, which in turn offer exposure to a range of asset classes depending on the strategy employed. These can be domestic equity, international equity, alternatives, fixed income or a combination of asset classes.
It is important to note that, like a managed fund, an LIC is also backed by a tangible pool of assets. However unlike a managed fund, an LIC’s structure is closed-ended, where its shares trade on an exchange similar to any other listed security. This means that any new shares cannot be created or redeemed at the net asset value. Only existing securities can be bought and sold at market prices. LICs in aggregate now account for approximately two to three per cent of market capitalisation when compared to the S&P/ASX 200.
Unlike open ended managed funds, the investment manager has access to a stable pool of capital that can be invested for the long term without being impacted by capital inflows and outflows that in turn impact investment decisions and strategy. The money remains fixed for the investment manager as clients buy and sell the fixed amount of shares available. Whilst the buying and selling of these fixed shares has no impact on the investment manager, it will result in the LIC trading at a premium or discount to Net Tangible Assets (NTA) or Net Asset Value (NAV). It is this premium or discount that the investor buying or selling the LIC should be aware of.
Pre-tax or post-tax NTA - what is it?
NTA represents the total assets of a company minus any intangibles such as liabilities and goodwill. LICs are required to disclose their pre-tax (before tax) and post-tax (after tax) NTA per each share every month. Some do this more regularly than others but the norm is that they release this information 14 days after month’s end.
So what is pre-tax NTA? Pre-tax NTA implies the net tangible asset less any taxes incurred. This means the NTA pre-tax excludes any tax liabilities on unrealised positions.
Post-tax NTA includes consideration of the potential tax on all unrealised positions in the portfolio. In effect, the post-tax NTA provides the after tax value of the portfolio as if all the positions were to be exited.
Compare this to managed funds, which only disclose the NAV. NAV is the value of an entity’s assets less the value of its liabilities and is disclosed on a per unit basis. With managed funds being unit trusts, all tax liabilities pass through to unit holders at their top marginal rate. Most unit trusts will not disclose NAV or performance on an after-taxation basis given that the trust is generally not taxed at the vehicle level but at the unit holder level.
Therefore when comparing LICs to managed funds on an after tax basis, the LIC is taxed at the company rate with any distributions thereafter being franked, while the distribution from a managed fund is taxed at an investor’s rate with no franking. Importantly, for every $100 of realised gain (including any franking for an LIC) passed through to the investor there is no difference on an after tax basis.
It is important to understand that pre-tax NTA is the most relevant measure for an LIC. This is because unrealised gains may take many years to realise and the tax impact will not affect the portfolio until that occurs. Another supporting factor for this is that portfolios with a high turnover strategy tend to unlock capital gains more frequently. Another analytical measure is the price to NAV, which gives a historical track record of the LIC’s pre-tax value.
Being listed on the exchange as a closed-ended structure means that an LIC does not necessarily trade at the portfolio’s true pre-tax NTA. In most cases, an LIC will trade at a premium or discount to pre-tax NTA for the simple reason of imbalances of supply and demand of its shares. This is usually influenced by the popularity of the LIC and its:
- underlying strategy
- historical performance
- effectiveness of communications made
- track record of dividends
- fee structure
- management’s reputation and quality
- size, liquidity and regulation of the LIC
- market conditions
LICs are designed to be actively managed. There are a number of strategies aiming to outperform their prospective indices. Every LIC has a unique objective and strategy that is usually reflected in their portfolios and underlining assets. Another factor to consider is the investment managers. Each investment manager has a unique style and strategy that impacts the underlying portfolio performance. Where the market is confident of sustained outperformance, the LIC would tend to trade at a premium.
What to do? Are premiums/discounts a valuable measure?
It seems intuitive to buy an LIC at a discount and sell at a premium to its pre-tax NTA. However this may not be the most effective method for investing into LICs. LICs can trade at large discounts, or indeed large premiums, which can potentially harm investment returns.
It is important to look at an LIC’s price to NAV, relative to its history. This provides the opportunity to work out any average trading ranges an LIC may possess over its history. The level of the premium or discount relative to its history can be used for entry and exit decisions. We believe that discounts and premiums need to be managed in a proactive manner, especially when entering into an LIC.
With all things being equal, LICs have the tendency to return to long term trading premiums or discounts. Subsequently, using this analysis as a measure may be useful to effectively improve your returns and mitigate the potential risks involved with the underlying LIC strategy.
Investors should look at the pre-tax NTA information and work out the average premium or discount to pre-tax NTA over the long term. Once this is done it should be compared to the average historical (discount and premium) pre-tax NTA. This method coupled with analysis on the strategy and its underlining investments would provide a good grounding when considering LICs.