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 weakness of CEFs shareholders can't escape at NAV at any time. And long-term outperformance of 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 raising, performance fees without outperformance, no high water marks, 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, unfair Investment Management Agreements, misleading performance communication, etc.
- Wilson Asset Management avoids exploiting most unfairness opportunities, but the CEF problem is that so many exist, most aren't obvious, and in CEFs you can't escape at NAV. 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 major 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 flowthrough 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 flowthrough 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:
Links:
> Firstlinks: Why LIC discount harvesting is a buy-and-hold decision
> Firstlinks: In the beginning, there were LICs. Where are they now?
