Russell Investment Group managing director Ed Schuck providess eight issues to consider when investing in an listed investment comany (LIC).
Tuesday, March 23rd 2004, 10:36PM
LICs often trade away from fair value or Net Tangible Assets (NTA)
The prices of LICs deviate from NTA because of market sentiment, the pricing of management fees or variations in short term liquidity.
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 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.
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.
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.
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. 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.
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.
Buying LICs in the Initial Public Offering
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.
