I often mention to other investors that looking for opportunities in the ASX Listed Investment Company (LIC) sector has been part of my strategy.

A reaction I have had on several occasions from them is to bring up an example of a LIC boasting great performance figures.

But then they ask me what is the deal with the share price still at the listing price of a $1? For example “hey this LIC supposedly is returning over 15% per annum for nearly 5 years but the share price is flat. I understand a dividend here and there comes out but what is the deal with this?”

This can mean a quoted return from the fund manager may look like for example 16% per annum. But if shareholders exit the investment at the same IPO price then they may only have returned roughly the dividends along the way. Let’s take a hypothetical example where that exciting headline of 16% per annum may have only given the investor more like 6% per annum. To be more positive maybe you can gross this 6% up for franking, but still will be well short of the 16% per annum in the marketing reports.

ASX LIC comparison performance

Where does the discrepancy in reported returns go? A fair bit is to do with some of the weaknesses of some LIC IPOs. That is, a major issue can be a small float size and what this means for fees.

Many investors depart with their hard earned in the IPO only reading about the management fees. Plenty I hope will also be aware of performance fees (although if they don’t read carefully may get confused by the details). They are probably less likely to be aware of the impact of “other” fees. For exampled directors fees, initial listing costs of the float, ongoing admin fees, marketing expenses, accounting fees, ASX fees, share registry fees, custody fees, audit fees, underwriting of placement fees etc. How many investors bother to read the 100+ pages of prospectus details?

Let’s say the LIC only raises an extremely small $20 million, very unusual but not unprecedented.

ASX LICs commissions and conflict of interests

Firstly the NTA can easily lose 3-4% from listing costs. That may not stop some LICs being imaginative when calculating their reported performance numbers. Don’t be surprised if they base their reported returns from the NTA price after listing of around 96-97 cents.

The “other” category of expenses could easily run at $400k a year. On a small float like this, wave good bye to 2% per annum before we even discuss management & performance fees.

If you are a boutique absolute return manager maybe you can get away with charging 1.75% as a base fee per annum. Thankfully though this is now becoming very difficult.

Perhaps a performance fee also. Some like to be cheeky and have a 20% outperformance fee quoted in the media coverage pre IPO, but without the mention of the performance hurdle. Then when reading the fine print you see they have set the benchmark hurdle low at say RBA rate plus a couple of percent. In some cases even the hurdle rate is simply zero, no benchmark! If the manager gets a good 16% per annum at the top level, wave good bye some fat performance fees. In this example maybe you leak another 2-3% per annum.

Let’s say the IPO came with 1:1 options. If these get exercised at a strike price well less than NTA it may dilute the NTA significantly. If you have grown the fund well, e.g. 16% per annum at the headline level this could be a significant dilution. You can exercise the “in the money” options, but that may trap you in the expensive fee structure for a larger investment. That may be uunsuitable for many investors. Any initial sugar hit from exercising the options may not last if a sizeable discount to NTA develops in the share price. Given all the potential issues I have raised above this is quite common.

Selling the options may not give such a great result either. The price is impacted by the shares potentially trading at a sizeable discount to a diluted NTA. Lack of liquidity in the options market can also pose issues. How about then selling your shares but exercising the same amount of options? Perhaps that may work better but maybe not if everyone else has the same idea. Also again beware of fund managers using some imagination when they present their performance numbers. Some may assume you get the full value of the diluted NTA upon exercising. This is overly optimistic if the shares later trade at a consistently large discount. Some may assume the options could have been sold on market at a conservative value. This is a very subjective method.

If an investor changes their mind and wants to exit out of this structure, it is easy to take a 10% hit or more by needing to sell at less than NTA. For smaller less liquid LICs this is quite normal, often the discount is greater. Now the fund manager might also say the discount to NTA can be fickle and we shouldn’t incorporate that into performance returns. There may be some truth in that, but how about in an example like this? What is the likely result when the manager decides to launch a $20 mill LIC, with 1:1 options, and charges a base fee of 1.75% with hefty performance fee? I would argue they are the ones that have brought about the permanent discount to NTA. The odds of such a launch trading at NTA in the long term must surely be very low.

You also must consider that a very small size float like this will likely always be on the lookout to raise extra capital. Be prepared for them saying “we felt it is in shareholder’s interests to conduct a raising at a discount to NTA in order to attract new sophisticated investors on board. This will lower the management expense ratio and allow us to pursue attractive opportunities in the market“. Apart from dilution this also is likely to encounter placement fees. Also when a small LIC desperately needs all of the options to get exercised to become a reasonable size, this can add costs. They may also pay significant underwriting fees to ensure this occurs and tolerate further dilution to NTA.

Adding up all the above issues can easily turn the a 16% per annum gross return displayed into far less. We are talking potentially 10% per annum less over a period of a few years.

So if you see a LIC boasting great pre fees and expenses performance numbers, it may pay to consider many other factors before diving in quickly. A great stock picker may not necessarily provide you with great returns by buying their LIC.

LICs vs managed funds

The closed end fund structure does have many benefits. Stable AUMs for the manager help in managing the portfolio, and they can also work to smooth out dividends for shareholders. Some better LICs boast a long track record of growing fully franked dividends. But with LICs trying to start out with less than $50 million there can be many challenges with using this structure.

If you choose the open end fund structure you may be rightly concerned about the effect redemptions from the fund can have on the manager’s performance. This is certainly a risk. But if a small boutique fund can run with lower fixed operating expenses it may still be a better alternative. The key is that the manager communicates their strategy well with their clients, and the money is “sticky”. If investors perceive they are getting a fair deal with the fee structure (unlike perhaps the above example), that may also encourage them to stay in the fund for the very long term.

As would believing the manager has real “skin in the game”. Some LIC managers claim they have skin in the game by controlling 20% of the company. This could be true, but such a stake can also be used to trap investors inside the LIC and keep management fee revenue high. It is a great gravy train to be on if you can get away with a high base fee. IMAs of LICs in recent times often come with 10 year terms. An open ended fund where the manager only gets paid if they outperform a fair benchmark can be preferable. In that case assuming the manager also has significant wealth in the fund, then to me that means real skin in the game.

Another point about the more old fashioned unlisted open end structure I would like to make is around investor behaviour. What if you apply for units the “old fashioned” way in an unlisted fund? Maybe you are more likely to stick with it for longer now that the price is not flashing on the screen every day. Could that be a good thing?

Perhaps an increasing number of smaller boutique fund managers that are much fairer with what they charge will become more prevalent in the future. I am thinking of ones starting up with an open end unlisted structure, where fixed costs can be less. Managing portfolios less than $50 million can be fruitful as you can hunt for smaller companies where arguably pricing inefficiencies are more common. The recent trend of money flows favouring large passive funds should help keep that the case. Maybe it will be the case that less broker research on small caps in the future may also favour more inefficiencies to exploit. It’s just important to keep fees fair.

I think innovative performance only fee structures could become more common. I also don’t mind the concept that a fund manager could maybe use a loyalty incentive. Perhaps reward a unit holder in later years with lower fees. Investors are often impatient with sticking with a fund manager during some lean years. Some encouragement for them to stick with things over a full investment cycle may help both fund manager and their investors. In some ways a high watermark for a performance fee only manager already kind of achieves this. I will perhaps explore more of this in another post sometime in the next few months.

I won’t go into specific details of shareholder returns from many of the sub $50 million LICs that have come to the market in recent years. However I shall list the tickers that came up on a quick scan of mine. Readers can have a look themselves at some of the results. I think it is safe to say in general if you had participated in all of the very small LIC IPOs over the last few years you may not be jumping for joy about your returns achieved. Some of the new ones that came up on my scan include 8EC, FPC, GC1, MA1, MEC, RYD. I should point out that RYD has got out of the blocks well and where I think IPO investors would be well satisfied.

Please note that by mentioning those LICs just above I am not suggesting that from this point in time they will underperform. Investing with a large discount to NTA can sometimes compensate for other factors. I don’t have a strong opinion on the future prospects either way for those mentioned above. The stock picking from the above LICs has been fine in some cases. Often it is other factors I mentioned earlier like costs, dilution from raisings, discount widening etc. that has hurt investors.

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