Amid the massive boom in Listed Investment Companies (LICs) and Listed Investment Trusts over recent years, there’s a lot to be said about the advantages of a ‘traditional’ LIC, such as AFIC.
The benefits of an LIC
In general, LICs offer many benefits. Firstly, there’s stability of capital, which enables long-term investment. Investors are not forced to buy or sell shares in the companies they own as market conditions change.
Distributions are simple and fully franked – shareholders benefit from after-tax returns, so there’s no unexpected tax consequences. LICs also have the ability to build reserves over time to fund fully franked dividends, which is important for income-focused investors.
An often-overlooked benefit of LICs is that retail investors get good access to corporate actions through the fund, such as allocations in capital raises.
Furthermore, LICs adhere to the corporate governance requirements of the ASX, which includes continuous disclosure, regular reporting, and an annual general meeting, which provides opportunities for investors to question the company. In addition, many LICs have regular shareholder briefings.
How are traditional LICs different?
Traditional LICs are managed internally. Unlike some of the newer LICs and other funds, there is no external funds management business running the portfolio, charging a portfolio fee or performance fee and deriving a profit from managing the portfolio.
Also, long-standing traditional LICs, such as AFIC, have the advantage of scale, so costs are low, which ultimately benefits shareholders. AFIC actively manages a portfolio of 62 stocks, yet its management expense ratio (MER), which expresses management and administration expenses as a percentage of the total portfolio value, is only 0.13% ‒ close to the cost of an index fund. Over the long term, a low MER can make a big difference to overall returns.
Management incentives are also strongly aligned to the interests of shareholders. There is no incentive to grow the LIC’s portfolio to generate income streams for a separate funds management business. Capital is raised when suitable investment opportunities arise.
Traditional LICs are also likely to have been established for a long time and are viewed by investors as trustworthy and stable given their history.
Another characteristic of traditional LICs is that accounting for realised gains is on the capital account, not income account which is often the case with newer funds. This means realised gains from the sale of holdings at a profit can be distributed as LIC capital gains credits. This puts shareholders in a broadly similar position as if they directly owned the shares. This can be used to further reduce a shareholder’s tax liability. This benefit is not available to LICs that are treated on income account.
The ‘Traditional’ Model
‘Traditional’ LICs, such as AFIC, focus on creating benefits for investors over the long term. They are counter-cyclical in approach, buying in market downturns and participating in capital raisings through difficult times when many other investors are doing the opposite. Traditional LICs look to buy when quality companies get left behind in exuberant sector rotations, that is, when other investors are moving their money into industries that they think will perform best over the short term.
Traditional LICs are also ‘tax aware’. They have a lower portfolio turnover. Higher turnover rates in other funds mean a higher tax cost, which can often reduce overall performance.
Furthermore, where a traditional LIC is concerned, performance is quoted after fees and tax. Many newer funds quote performance before fees and pre-tax.
Another characteristic of traditional LICs is that they are sensitive to the income requirements of their shareholders, so they maintain profit reserves from which they can pay a dividend. For example, during the Global Financial Crisis and the COVID-19 pandemic, when there was a general downturn in dividends, AFIC maintained its dividend. This was particularly important to those AFIC shareholders who are retirees.
Lastly, traditional LICs have independent directors who have strong business experience, which is not only useful from an investing perspective but also ensures strong governance, including consideration of the best interests of shareholders.
Conclusion
The important things to consider when investing in an LIC are the company’s track record of performance relative to the fees payable, the dividend history (especially the distribution of fully franked dividends and how they are generated), the size of the LIC both in terms of portfolio and the number of shareholders, the demand equation in terms of people buying and selling, market communication and marketing, and ongoing shareholder engagement.
Investors also need to consider where the share price is trading relative to the net asset backing per share (the value of the portfolio per share). The share price can quite often swing between a discount or premium to the net asset backing per share. Our observation has been that having the features outlined earlier can mean discounts/premiums are typically transitory over the long term, often depending on broad market conditions.
AFIC has an investment process that is well defined – we are not looking for quick cyclical turnarounds. We invest in quality businesses for the long term and are not second-guessing market cycles. The team manages four funds with different investment objectives and market focus for each. This provides great insights into the investment process and helps generate better ideas, ultimately creating wealth for shareholders over the long term.
