Do your homework with LICs, advises Russell
Do your homework with LICs, advises Russell
7 things to consider when assessing a Listed Investment Company
Listed Investment Companies (LICs) have attracted some public attention recently in New Zealand and Australia. Investors considering LICs should take the time to research and understand such offerings, says global investment services firm, Russell Investment Group.
Edward Schuck, PhD, Managing Director of Russell Investment Group in New Zealand, states that investors can easily avoid common pitfalls to help ensure their LIC lives up to expectations.
"There's no question that some LICs have recently had a period of strong share price performance, but this has not always been the case historically," Schuck says. "Judging actual performance of underlying investments is difficult for retail investors as the LIC's share price performance is a combination of investment performance and market premium/discount."
Schuck highlights the following seven issues to consider when investing in an LIC.
1. LICs often trade away from fair value or Net Tangible Assets (NTA). LICs often trade at prices well above or below their NTA, while prices of unit trusts always equal NTA. The prices of LICs deviate from NTA because of market sentiment, the pricing of management fees or variations in short term liquidity.
2. Price volatility for LICs is higher than for managed funds. Because of the deviations that can arise between the market prices of LICs and NTA, the tracking error for LICs (a measure of volatility) can be very high compared to managed funds. For example, Russell Australia reports that the tracking error for LICs is typically 12-20% against the S&P/ASX 300 Accumulation Index compared with 3-5% for managed funds. This means that at times, the performance of LICs, in Australia at least, may bear little resemblance to the performance of the share market.
3. Some LICs are structurally superior to others. There are several reasons for this. Many of the older LICs have internal management so profits from the fund manager go to LIC investors rather than an external funds management company. Effectively, the LICs own the fund manager as well as the investments. Older LICs with internal management generally have significantly lower fees than the newer LICs (i.e. an effective MER of around 0.25% with no performance fee).
4. Who's protecting your investment? Investors thinking of buying into a new float should also consider the composition of the LIC's board. Some newer LICs have a number of directors in common with the external fund managers. This puts the directors in a situation where they have a potential conflict of interest and raises questions about independence - or "teeth" - of the LIC's board.
5. What if management turns bad? If you decide you don't like the LIC's management, the only real alternative is to sell your shares. Of course, if other investors share your view on management, the market price for the shares could be well below fair value (i.e. net asset backing). The other alternatives are to wait for the management agreement to expire (up to 25 years for many new LICs) or lobby for a change of fund manager, which will need to be passed by the directors - all the more reason to ensure your LIC board is independent.
6. Performance fees - aren't they a good thing? They can be, but only if they are structured to align the interests of the fund manager and the investor. A well-designed performance fee should be calculated against an appropriate benchmark, and fund managers should have to earn back prior years' underperformance before they are paid a performance fee in the future. Several newer LICs have a performance fee that is reset every year. This is effectively a free option for the fund manager and creates potentially risky incentives to manipulate performance.
7. Buying LICs in the Initial Public Offering (IPO). In Australia, some investors have purchased LIC shares in recent IPOs with the intention of making a quick "stag" profit after listing. This may work while LICs are the flavour of the month; however the reality is that NTA after the IPO for last year's main floats in Australia was around 98c - two percent less than the dollar that the investor paid. The issue of options along with shares also decreases the value of the shares.
Rules of thumb for those keen to invest in LICs:
q Read the prospectus!
q Understand the performance fee structure and how this aligns the manager's interest with yours.
q Look for LICs with independent boards.
q Invest for the long-term, and be prepared to ride out periods where the LIC is trading at a discount to asset backing.
q Don't expect LIC floats to always trade at a premium. It may happen, but this is a punt, not an investment.
About Russell: The Russell Investment Group, a global investment services firm, provides multi-manager investment products and services in more than 35 countries and has been researching investment managers for more than 30 years. Worldwide, Russell manages over NZ$149 billion in assets and advises clients representing approximately $3.0 trillion.
In New Zealand, Russell advises on more than NZ$14 billion in assets and invests around NZ$1.0 billion for New Zealand investors in Russell Funds.
Founded in 1936, Russell is a subsidiary of Northwestern Mutual and is headquartered in Tacoma, Washington, USA with additional offices in New York, Toronto, London, Paris, Amsterdam, Singapore, Sydney, Auckland, Tokyo and Johannesburg.