Summary: Geoff Wilson consistently claims it is straightforward for ASX LICs to trade near or even above NAV: they just need to perform well, communicate effectively, treat shareholders fairly, and pay reliable franked dividends. These are all important factors, but in this post I will reveal the truth about these oft-claimed solutions: Cash franking credits are the only major attraction of LICs, but they aren't a free bonus as many retirees seem to think.
The other factors (fairness, communication, engagement, marketing) only matter because of the unqiue, massive weakness of CEFs: shareholders do not receive the NTA performance and can't exit at NTA whenever they wish. And long-term outperformance (after expenses) by active funds is very rare and can't be found in advance.
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| Wilson's LIC discount factors only matter if you believe the myths about CEFs and active management |
Details:
1. What are the reasons LIC CEFs trade at discounts according to Geoff Wilson?
> AFR: Geoff Wilson sees significant LIC opportunities
> FirstLinks: How can the worst feature of LICs also be the best?
I think what a lot of people forget is for Listed Investment Companies, there’s four things you've got to do.One is you've got to perform for the investors.Second, you need a growing stream of fully franked dividends because a lot of the marginal buyers are the self-managed super funds, trying to get this consistent dividend flow.The third thing is what every listed company has to do and it's treat shareholders with respect.And the fourth thing is … and this is what a lot of the newer investment companies don't necessarily get initially … is you've got to have a really detailed shareholder engagement, communication and marketing strategy. And that is costly.So a lot of the rationalisation that has occurred in the industry recently is where unfortunately, the manager just hasn't got that last bit right.
2. LIC Performance
- I track the Total Shareholder Return (inclusive of franking, dividends not reinvested) of all ASX LICs. Only a few of those older than 10 years have outperformed an alternate, low-cost, passive index ETF (e.g. STW, SPY, VAS, VGS, etc) since inception (typically by trading at premiums to NTA). And only a few of those less than 10 years old have any chance of doing so after 10 years or longer. For periods over 10yrs, if premiums disappear, almost none will outperform in the long run.
- This is true of all the WAM funds too except WMI (inception 2017) and WLE (inception 2016) which are recent. I suspect their Total Expense Ratios (TERs) will eventually lead them to underperformance against broad, low-cost ETFs like: VAS or A200. WAM's published performance figures are misleading: portfolio returns before any expenses, rather than after all expenses. There is also no proportionate relationship between the extent of a WAM fund's under or outperformance and its discount or premium.
- There is no reason to think an active management ASX CEF can overcome its cumulative Total Expense Ratio (TER) handicap and outperform in the long run, especially the greater the gap between its TER and the alternate index fund. WLE is a great example, as to this point it has handily outperformed VAS in portfolio terms. A minority of active managers can outperform before costs, at least for some period. However, WLE's TER is more than 4% higher than VAS, thus over time the cumulative impact of this will overwhelm any alpha or variation in factor exposure.
3. LIC Communication & Marketing
- This matters only because of the inherent flaws when you combine active management and CEFs. Virtually all LICs underperform significantly before they even get to 10 years old. Many underperform straight after launching.
- Open end funds trading at NAV could do the worst possible communication and marketing, or the best, and it doesn't affect the share price discount versus NAV at all. All they need to do is focus on performance after all expenses.
- Perversely, LICs that publish misleading performance figures and falsely claim outperformance could be said to be "communicating and marketing effectively" if this reduces discounts or increases premiums!
- Wilson Asset Management spends a significant amount on staff, events, marketing, lobbying for LIC-friendly policies, and communicating with shareholders and prospective clients. Indeed, in the few times I've been involved, I've found their communication and shareholder engagement to be exemplary compared to many other LICs, especially small ones. However, shareholders pay these costs through the ~2-5% TER for their funds, and this is what drags them to underperform cheap index funds in the long run.
4. LIC Respect & Fairness
- Again, this only matters because of the many and various ways ASX CEF investors can be ripped off: dilutionary capital raisings, performance fees without outperformance, no high-water marks (or inappropriate benchmarks), changing LIC mandates in order to reset performance fee baselines, unnecessarily high Total Expense Ratios (TERs), dividend reinvestment plans at NAV when the share price is at a discount (e.g. OPH), unfair Investment Management Agreements, misleading performance communication, using expensive leverage as it increases fees, invidious related party transactions. It's a long list!
- Wilson Asset Management avoids exploiting most unfairness opportunities and generally treats shareholders with commendable respect. Indeed, most ASX CEF boards and managers fall way behind Wilson Asset Management - this is a critical issue with the sector that Geoff Wilson doesn't appreciate when he defends it. The issue is that so many ripoffs are legal, most aren't obvious, but in closed end funds you can't escape at NAV when you find out. Wilson Asset Management relies on having some ethics and respect to avoid exploiting the ripoffs, but this doesn't apply to the majority of CEF managers. (Wilson Asset Management does exploit misleading performance reporting, and its older funds have performance fees without high-water marks.)
- Open end funds trading at NAV could be run by unethical charlatans hoping to rip off investors in any way possible, but investors can always fully exit at NAV. Hence, respect and fairness are irrelevant in the long run to open end funds - as soon as any ripoffs start, investors should just exit at NAV. Objective data on TERs and performance is the only thing that matters for open end funds.
5. LIC Dividends and Franking
- Which brings us to the key truth about LICs. They are inferior to passive index ETFs (or if a CEF is absolutely necessary then LITs) in every significant way but have one major difference: Australians not liable for income tax (primarily retirees with superannuation in pension accounts) can still receive franking credits as cash refunds on top of the LIC dividend. On this blog, I refer to this as Cash Franking Credits. In reality, there is no free lunch, as pass-through ETFs/LITs simply pay higher distributions.
- This rort in the Australian tax system means this part of company tax already paid becomes completely untaxed (rather than not double taxed which was the original intent).
- While ETFs can also deliver cash franking credits to Australians not liable for income tax, they cannot generate artifically high fully-franked dividend yields like LICs or smooth this out between years. But LICs are just converting capital gains to dividends, it is not a higher return.
- After performance, most of the movements in LIC discounts and premiums relate to how optimised this single factor becomes: the extent of fully-franked dividends being distributed, how reliably, and even how regularly. If franking credits are insufficient, LICs have an incentive to make more portfolio trades or transaction types that are driven by maximising franking credits (even if this means tax liabilities and inefficiency rises). This often leads to overall longer-term performance being worse.
- Older LICs discovered and settled on generating artificially-high cash franking credits as their main strategy. Some newer "income focused LICs" were established with cash franking credits as the chief strategy and attractor. Some LICs have taken this to an art form (e.g. PL8) which actively jumps around high yielding ASX companies trying to collect franking credits on top of those generated by realised gains. And many LICs deliberately shift their shareholder base to retirees not paying tax (LICs held in superannuation pensions), meaning net company taxes are lower (More Australian retirees own BHP because of LICs than would otherwise own it if they had to invest directly in high yielding ASX companies generating franking credits).
- With the rising pressure on the majority of LICs trading at increasing discounts, almost all of these LICs are now focusing on this cash franking credits strategy too - it's a mythical advantage of LICs that can be used to justify keeping the capital captive.
- One of the reasons Geoff Wilson has avoided discounts for most of the Wilson Asset Management funds is that it genuinely does aim to efficiently return franking credits to shareholders. Wilson's funds are constantly ramping up the franked dividend yield rather than just sitting on the capital (that would be used to pay dividends) to generate fees like several LICs do (e.g. LSF).
- Sadly, the Labor party lost the 2019 federal election and didn't remove franking credits cash refunds or alternatively introduce an inescapable, low level of tax after the age of 60. But we shouldn't forget the obvious rort that needs to be shut down. Chris Bowen's pithy explanation was:
"We can no longer be the only country in the world that provides tax refunds to shareholders who have not paid the income tax to start with. If you pay tax, we will refund it, but if you don't pay tax there is nothing to refund."
- Note: Managed Investment Trusts and Listed Investment Trusts (LITs) are more tax efficient than LICs. Trusts don't pay tax, they are pass-through vehicles, LICs actually convert all types of gains into taxable income. Many LICs are run to maximise franking credits by maximising tax payments. Without Cash Franking Credits, LICs would be replaced by LITs or Active ETFs. Retirees with superannuation pension accounts would still pay no tax by investing in pass-through trust structures (whether listed or unlisted). Ending Cash Franking Credits would just rapidly hasten the end of the LIC investment structure, and there is no good reason for it to exist.
The Financial Services Council admitted this tight link between LICs and franking credits in its submission on refundable franking credits:
6. WAM Strategic Value Webinars: Geoff Wilson's arguments about LICs and discounts
You can find audio recordings of webinars on the Wilson Asset Management SoundCloud page.
In sharp contrast to all of the other 88 LICs/LITs, Geoff Wilson does proper Q&As and endeavours to address all shareholder questions. In recent times, he's even allowed Q&A sessions to extend till all questions have been answered.
Most LITs don't have AGMs or spend any significant time taking questions at webinars. Most LICs either don't have Q&As, or artificially limit questions, or don't answer publicly inconvenient queries, or say time has run out. It's revealing how this single issue (publicly answering all questions) shows how most CEFs are so clearly run for insiders not shareholders.
In the recent WAM Strategic Value webinars, Geoff Wilson has responded to increasing shareholder concerns about the future of LICs, the persistence of discounts, and the futility of current actions to resolve them. Below I provide some brief responses to the arguments he's made.
Geoff: Morgan Stanley research published 30 years ago stated Closed End funds outperform Open End funds by 2 to 2.5% per annum. So I chose to set up LICs
If this outperformance was true Geoff would be able to provide a link to it and recent research backing it up. He never has because it's false. Many ASX CEFs have had open end and closed end versions and no CEF outperformance has occurred. Instead of the closed end versions becoming more popular, the reality is that only the CEFs have been shut down and merged into the open end fund.
In Australia, there are over 3000 open end funds yet none are converting to closed end or launching closed end versions. The equity CEF sector is dying off for the reasons I cover on this site.
Geoff: LICs are not dead and one or two new LICs will launch each year
Since the ban on selling commissions in July 2020, only 5 ASX CEFs have launched and, apart from WAR, none raised significant capital. Only 1 - HCF in Oct 2022 - launched since Dec 2021. In over 3 years no more have launched. Meanwhile, 35 have delisted and, of the remaining 88, 41 will be delisted soon or are uninvestable.
There is no chance of 1 or 2 LICs launching each year. This is pure fantasy. And the number of CEFs continues to shrink. Many of the ones remaining are abject failures but insider blocking stakes mean an exit can't be forced, so they are just spiralling to deep discounts.
This CaptiveCapital site will campaign against any new equity CEF raising money from retail investors. Equity LIC IPOs are particularly unlikely as the structure is so tax inefficient and takes years to build up reserves to pay sustainable franked dividends that are competitive.
See: > Tracking the elimination of ASX Closed End Funds
Geoff: ETFs will not replace LICs. Investors often start with ETFs, progress to LICs and then to direct stock picking
Wilson Asset Management has been getting shareholder queries about LICs being replaced by ETFs but Geoff argues there will always be a place for LICs and there is a logical progression from ETFs to LICs and then direct stock picking as investors become more knowledgeable.
I think what Geoff is arguing is that investors start with passive exposure via ETFs and, as they become more knowledgeable, move to actively managed Closed End funds (LICs and LITs), and then some even decide to try and beat the market themselves.
I put this myth to bed in CaptiveCapital's 95 theses on why ASX Closed End Funds should be eliminated - Reason #2: CEFs are antiquated; both passive and active funds now have superior listed structures (ETFs) for investors.
Previously, investors who wanted to directly buy and sell a listed diversified fund had to buy LICs. Now investors can buy superior Open End ETFs (active or passive) in almost all asset classes (and Open End unlisted funds for the few asset classes that are illiquid like private equity). The first Active ETF only launched in 2015. Now 122 out of 388 ETFs are Active. The Active ETF sector has been growing fast while the CEF sector has been shrinking. Geoff can afford to have his head in the sand, equity CEF investors can't, as discounts grind downwards.
Geoff: CEF discounts aren't explained by discounting the net present value of the fees
A WAR shareholder asked if this explanation was valid and Geoff objected and said it didn't account for risk adjusted returns (this simply asserts risk-adjusted outperformance which doesn't exist for over 90% of CEFs). Geoff also went on to argue, that at least with Wilson Asset Management funds, that 80-90% of shareholders are "rusted on" and it's only the remaining marginal shareholders selling at discounts. When they finally transfer their shares to long-term holders, the funds will quickly move to NTA or even premiums.
The above is nonsense. As I explain here, there are various Discount Factors which all add up: Exit Liquidity, Performance (after all expenses), Total Expense Ratio, Blocking Stake, Shareholder Satisfaction, Boards/REs extent of representing shareholder's interests, Tax Leakage, Capital Raising Dilution, Unlisted Asset Proportion.
No other site publishes: true performance comparisons with passive ETFs, actual Total Expense Ratios, Blocking Stake figures, Tax Leakage data, Exit Liquidity facts, or quantifies the other critical factors noted. Thus, discounts are not as deep as they should be for most ASX equity CEFs. But the facts are slowly getting out.
As noted, the only true long-term measure of CEF performance for investors is Total Shareholder Return (TSR). And, using Sharesight, it is ridiculously easy to track and validate: you just choose your Start and End Dates and Sharesight does everything else: share prices, capital returns, distributions, franking credits. Even better, you can compare to any real alternative (typically passive) like VAS, VGS, VDHG, etc. As more CEF holders or potential buyers start doing this, the discounts of funds like WAR can only remain large to reflect the persistent underperformance.
Geoff: Discounts narrow when shares finally end up with holders who understand what the fund does and really want to be invested in it long-term
Geoff spends a lot of time talking about how some WAR shareholders didn't properly understand the strategy (e.g. the medium to long-term approach) and that eventually all good funds "tighten up their share registers" to consist of happy long-term holders, thus forcing the market price to be at NTA or even premiums to NTA - such as with WAX, WMI and WAM.
In my view, only if performance (after all expenses) is considered comparable or better than passive ETFs, do investors pay up for the higher, artificially-stabilised yields and cash franking credits in LICs. WMI and WLE have outperformed over their short histories, and WAX has had periods of outperformance and ended up near passive ETF returns over a 20 year period. WAM has underperformed passive ETFs but Wilson Asset Management's pre-expense performance reporting deceptively suggest it has outperformed too. WAA, WMA and WAR all trade at discounts and WLE trades at NTA.
Inception dates are 2008 for WAA, 2016 for WLE, 2018 for WGB, 2020 for WMA and 2021 for WAR. Geoff is apparently patiently waiting for their share registers to tighten up so that they trade at NTA or premiums too. However, I doubt WAA, WMA or WAR will ever trade at premiums or even consistently at NTA. They are highly unlikely to outperform ETF alternatives after all expenses.
Geoff actually advised all current shareholders feeling frustrated or negative about a Wilson Asset Management fund at a discount to sell out so that their shares would find their way quicker to a long-term holder, and thus move quicker to trading at or above NTA. This is false hope as relative performance trumps everything and outperforming in the long run is extremely rare.
Geoff: WAR's share price should reflect its NTA and even its look-through NTA. There is "easy money" to be made buying WAR at discounts (e.g. over 10%)
This is pure hopium. WAR is subject to the same cons as every other CEF and same Discount Factors. In WAR's case, major discount penalties exist for its "fees on fees" structure (fees are charged at two levels), it's baked-in underperformance of passive index ETFs (VAS, VGS), and the fact its performance fees are charged with no benchmark to beat (let alone a benchmark reflecting equity returns which is what it holds).
I suspect Geoff Wilson's plan is to try and "rust on" shareholders for his funds via storytelling, keep the focus on the franked dividend yields, and hide Sharesight comparisons with VAS, VGS, VDHG. But this won't attract younger, savvier investors used to the superior performance of passive ETFs and simplicity of always achieving the NAV return, and entering/exiting at NAV. Equity CEF holders should worry about where the next generation of buyers will come from.
Links:
> Firstlinks: Why LIC discount harvesting is a buy-and-hold decision
> Firstlinks: In the beginning, there were LICs. Where are they now?
