Summary: Martin Luther famously nailed to the door of the Wittenberg Castle church his 95 theses making the case against the Catholic church selling indulgences to get to heaven. In this post, I will compile my reasons why almost all ASX Closed End Funds (CEFs aka LICs or LITs) should be eliminated - and, consequently, why retail investors should avoid (or sell out of) virtually all ASX CEFs, especially LICs.
Note: There are dozens of pitfalls and issues affecting CEFs (primarily equity CEFs), with LICs particularly susceptible. I have little interest in detailing 95, though I may over time bullet point the minor ones. The aim here is to list, in a single post, the most important ASX CEF issues.
No CEF advocate can rebut a single one of the arguments I list here, let alone the top 25. If you simply want to read one thing about ASX LICs and LITs, this is the most critical post on this site. It's the most valuable article published anywhere on ASX Closed End Funds. Once you understand this, you can just avoid/exit equity CEFs and never waste a second of your life on them again!
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| Yes, I really am like Luther pitted against the ASX CEF industrial complex! |
Details:
Summary of the Reasons with a logical question for Closed End Fund (CEF) buyers:
1. No ongoing demand/buyers at NTA. Q: So if you buy in, who's getting you out?
2. CEFs are antiquated, both passive and active funds have superior listed structures (ETFs) for investors. Q: If equity CEFs are destined for the graveyard, why would you willingly leap into the inevitable discount death spiral?
3a. Permanent discounts mean holders want out. Q: So why do you want in?
3b. Closed-end funds reflect their net pros and cons in the discount (or rare premium). Unlike open-end funds that reflect their pros and cons in net inflows/outflows, CEFs have captive capital and thus the discount/premium to NAV becomes the efficient pricing mechanism. Q: Why believe the nonsense that discounts are just sentiment?
4. No continuation votes on the ASX. Q: If you insist on investing in CEFs, why not do so on the LSX where there are periodic continuation votes as a safety?
5. Insider blocking stakes. Q: If just 15-20% of the shares can be used by an insider (e.g. fee beneficiary, founder) to block any vote that benefits most shareholders (e.g. exit at NTA), why trap yourself?
6. Boards and Responsible Entities don't act for most shareholders. Q: Why would you choose to become captive to such perverse governance?
7. Significantly understated Total Expense Ratios. Q: If you're too lazy to use a fee calculator to understand the enormous impact of the actual TERs (often 2-7% per annum!), should you really be investing in anything other than passive ETFs with fees under 0.3%?
8. Appalling exit liquidity. Q: Given a large part of most CEF discounts simply prices horrendous exit liquidity, why would you expect the discount to narrow? (In most CEFs exit liquidity is getting worse!)
9. Management fees are unaffected by discounts or shareholder satisfaction. Q: If fees depend only on fund asset size, and aren't affected by even massive dissatisfaction and discounts, why would you sign up?
10. Performance fee scams are rife. Q: Given there's no way to prevent or eliminate the numerous performance fee scams in a captive capital structure, why would you consider one?
11. Tax leakage is not efficiently returned via franking. Q: Since LICs are flawed tax-leaking vessels, why would you trust their managers to return all franking when their fees are much greater if they don't?
12. True performance against low-cost, passive ETFs is never reported. Q: Seeing as Sharesight enables anyone to easily track Total Shareholder Return performance, why would you choose a CEF given the obfuscation and deception that plagues this underperforming sector?
13. Capital can be raised at huge discounts to NTA. Q: Given CEFs allow 15% to be raised every 12 months at any discount, why would you voluntarily submit to such dilution?
14. Discounts are not opportunities, the long-term trend is a grind downwards. Q: Why believe self-serving fictions about discount opportunities when there are hard facts proving otherwise?
15. Managers switch to unlisted assets despite the adverse impact on shareholders. Q: Why willingly join a captive fund if managers can switch to unlisted assets (without shareholder approval) while knowing shareholders will cop a major discount penalty?
16. Trading CEF discounts is a zero sum game where retail investors donate their capital to sharks and insiders (sometimes acting illegally). Q: Why would you freely decide to be the chump at the poker table?
17. Many CEF managers exhibit contempt for their investors and run the funds for themselves. Q: Given CEF investors are captive and can't exit at NAV, why expose yourself to the many ways CEF managers can extract gains at your expense?
18. The LIC structure is tax inefficient in many, unobvious ways. Q: If you don't understand the many ways LICs are tax inefficient, why pick a structure that is subject to tax?
19. Rare CEF premiums simply invite capital raising or takeovers that undermine the premium. Q: If CEF premiums inevitably result in actions that benefit the fund manager (more fees) but undermine the premium, why play such a one-sided game?
20. The "no forced selling" CEF advantage is a total myth. Q: If CEF fund managers happily abandon the supposedly superior Closed End structure whenever they can make more fees, why do you want to be the last gullible fool at the party?
21. CEF Investment Management Agreements are secret and designed to benefit managers at shareholder's expense. Q: Why would you happily accept such secret agreements that aim to trap shareholders and make funds difficult to wind up even if total failures?
22. Even financial advisors have abandoned the sinking equity CEF ship. Q: A smart economist once said: "When the facts change, I change my mind." Similarly, when the incentives change, why would you ignore the consequences?
23. Reputable fund managers (including all of the largest) don't launch equity CEFs or fight to preserve the few, failed experiments. Q: Why would you ignore the warning signs about equity CEFs among the largest Australian fund managers?
24. Fixed Income products (LITs, Active ETFs) are replacing ASX equity CEFs as they go-to listed income products. Q: If you aren't across the major, recent changes in listed income product options and demand, why would you buy ASX equity CEFs now?
25. Risk-free rates have increased so term deposits, at-call deposits and hybrids offer competitive capital-protected yields. Q: If a retiree can lock in 5.1% to 7% in capital-protected yields why bother with much riskier LICs?
26. Even CEF wind-ups often don't return NTA or release all assets (franking credits, tax losses). Q: If CEFs can't even deliver full value when they finally wind up, why would you count on discount reversion?
27. Buy-backs are selectively used to benefit insiders. CEF fee beneficiaries resist shrinking the fund size and claim buy-backs don't reduce discounts anyway. But, when finally forced to do it properly, suddenly they work (see MEC). Even worse, buy-back volumes are often used on specific days to allow insiders or activists to exit at prices unavailable to retail (see VG1, RG8, MEC, any CEF with unusual volume spikes). Q: If the ASX and ASIC don't even care about scams literally documented in ASX announcements, why volunteer to be a victim?
Not a single supposed Closed End Fund expert including Daryl Wilson, Geoff Wilson and Claire Aitchison can rebut these arguments. Indeed, they've spent years pretending they don't exist! Unsurprisingly, their incomes and careers are based on the CEF industry.
1. Closed End funds only came into existence for the benefit of the fund manager or founder, not due to investor demand. There is almost never ongoing demand at NTA (Net Tangible Assets) and no market maker to buy at NTA (unlike Open End funds)
As Boaz Weinstein of Saba Capital says: "No-one rings up their broker and says get me the latest Closed End Fund." They come into existence because a fund wants the perpetual fees from captive capital, and typically brokers and financial advisors got paid commissions to get their clients to participate. Consequently, post-listing, there are rarely natural buyers at NTA. (Note: CEF selling commissions finally got banned in Australia in July 2020).
IPO CEF buyers are typically naive, and when the CEF inevitably falls to a sustained discount, most of them suddenly want to exit at NTA. But there are no sweeteners to help retail holders find new suckers to offload to. And unlike open-end funds, there is no market-maker ensuring liquidity at NAV. Many retail CEF owners have to do their own marketing (Hotcopper, Livewire, etc) to find new suckers to buoy the price or help them exit.
Some CEFs with appalling exit liquidity even use bots on the bid ladder to give the impression there is demand. But when trying to exit, investors will discover the horrendous absence of real buyers, including having to compete with bots on the sell ladder. Even worse, CEF managers/insiders are allowed to exploit the large bid-offer spreads (including with bots) to acquire shares cheaply and sell them expensively. Often this is done with inside information (knowing the live NAV, before price sensitive announcements).
2. CEFs are antiquated; both passive and active funds now have superior listed structures (ETFs) for investors
The first LIC (WHF) started in 1923. The first passive ETFs (STW, SFY) only listed in 2001. The first Active ETF only listed in 2015. Even as of 2016, 83 of 95 ASX-listed investment funds were LICs. 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).
CEF advocates argue that some LICs are worthwhile investments due to their longevity. While the oldest LICs often have lower fees than newer and smaller LICs, the fees of the best alternate passive ETFs are always the lowest. For example, the A200 ETF has a Total Expense Ratio of 0.04% which is five times lower than AFI's at 0.22%. And it's a mistake to think the large, long-established LICs provide outperforming, differentiated active exposure compared to index ETFs. They all underperform after expenses:
See: > Staying ahead of the retiree Income LIC shakeout
See: > AFI - Australian Foundation Investment Co - Cheat Sheet
ETFs provide a more efficient, transparent structure and, among passive/systematic ones, the lowest-cost exposure to asset classes can be found. VAS only commenced in 2009 and now is $15 billion; much bigger than any ASX CEF; indeed bigger than 70% of the CEFs put together!
Betashares regularly provides updates on the growth of ETFs. They've only been around for 22 years in Australia but now dwarf ASX LIC/LITs and are where all the growth is (ASX CEFs are shrinking).
Livewire: How the ETF did we get here? The $150 billion question
And while I consider chasing active management a loser's game, many investors enjoy playing. As of 2015, there are now better-structured Active ETFs (aka Exchange Traded Managed Funds) that are Open End. They have live prices and unlimited liquidity at small spreads around NAV. Unlike with CEFs, when investors decide they want out, they can get out at NAV immediately.
There are 115 Active ETFs out of 368 total ETFs listed on the ASX and they've been growing fast while the CEF sector has been rapidly shrinking. However, be careful, as the advertised fees for most Active ETFs are less than half of their Total Expense Ratios. The smaller the fund size the bigger this issue. Some smaller Active ETFs have TER's over 4% even before performance fees kick in.
Even Independent Investment Research in a rare candid discussion of why the ASX CEF sector should shrink, summarised why Active ETFs (aka ETMFs) are preferable to LICs:
See: > Morningstar list of Australian ETFs
Passive/systematic ETFs are still far superior to Active ETFs: in transparency, tax-efficiency, reliability of asset and factor exposure (thus diversification), buy/sell spreads, and, most critically, the Total Expense Ratio.
See: > VanEck: Active ETFs are not ETFs
3. Most ASX Closed End Funds have traded at large, permanent discounts for years because their investors want out. Over $4 billion in investor capital would be released from captivity by simply converting them to Open End Funds or providing an exit at NAV. Australian Corporations Law allows just 100 shareholders to call a meeting to vote on a wind-up/conversion but this has been hidden from investors!
See the discount graph in Reason #14 below. Only 6 of 89 ASX CEFs trade at a premium; most of the rest have traded at permanent discounts for years, and the discounts are growing. This discount gap has trapped over $4 billion in investor capital.
The vast majority of ASX CEF investors want out of the Closed End Fund structure and this is evidenced by over 34 CEFs winding up already since the July 2020 ban on selling commissions. Only 5 have launched since and they've been abject failures; all quickly dropped to large discounts.
If given an opportunity to vote, the vast majority of ASX CEF investors always vote to exit the CEF structure. The only time such votes (requiring 75%) fail is if the CEF founder or fee beneficiary has a blocking stake. If CEFs actually had advantages, surely enough long-term investors in any of these ASX CEFs would vote to retain the structure? Embarrassingly for the CEF boosters, this has never happened in any of the dozens of ASX CEFs that have had votes!
Generally, one needs 5% of the shares (votes) to call a meeting. But in Oct 2023, Keybridge Capital managed to get the 100 MGF investors together to use section 252b of the Corporations Act to submit a request for a meeting to wind-up (For LICs it is section 249). A wind-up resolution requires approval from 75% of shareholders who vote. In response, Magellan immediately announced intentions to convert MGF to an Open End structure. This is the first time the "100 shareholders" clause has been used to pressure an ASX CEF to provide an exit at NTA, yet this rule has existed for decades! (Note: Magellan self-servingly blocked Keybridge's attempt at using the "100 investors" rule while continuing with the Open End conversion. I am awaiting details of the Supreme Court ruling as legislation - in this case the Corporations Act - is not meant to be undermined by other rules such as a fund constitution).
The Australian CEF and active management industry has deliberately not publicized this "100 investors" exit method. However, for investors in all ASX CEFs without Blocking Stakes, the cat is out of the bag. The next step is determining how to validly and most effectively utilise it.
4. Most ASX CEFs could be modified to allow periodic redemptions or windups at NTA but aren't as they exist to serve fund managers not investors
The London Stock Exchange has the longest history with CEFs and persistent discounts eventually led to CEFs readily being created or modified to include structures like periodic redemption facilities at NTA or periodic continuation votes (if investors vote not to continue, the whole fund gets wound up at NTA minus costs).
In Australia, the entire financial services industry, that profits off CEFs, pretends that these NTA exit structures do not exist! Search for "investment trusts" (what CEFs are called in the U.K.) and "continuation vote" and you get over 5,500 results. But search for "LICs" and "continuation vote" and you'll get only 10! The same applies with the term "redemption facility".
5. Blocking Stakes. A quarter of voting shares is enough to block any logical change that would benefit most investors like winding up or converting
ASX corporations law enables those with 25% of shares actually voted (and it's not uncommon for only half of investors to vote so this could be ~13% of total shares) to block actions like winding up a CEF at NTA (including by accepting takeovers) or creating periodic exits at NTA for a proportion of shares.
In smaller funds, those benefiting from the captive fees typically build blocking stakes to prevent the majority of shareholders escaping near NTA, and also to discourage larger activist CEF investors from getting involved. The vast majority of ASX CEFs under $150m suffer from Blocking Stakes and their discounts can only get bigger.
See: > When does CEF "skin in the game" become a blocking stake?
6. ASX LIC Boards and LIT Responsible Entities typically don't act for the interests of the majority of shareholders
Australian corporations law and regulatory regimes supposedly require ASX company boards and LIT responsible entities to act in the interests of the majority of shareholders. In practice, for ASX LICs, boards have a majority of directors aligned with the fund manager and typically prioritise the interests of the fund manager. Board Directors would also be losing their fees in any delisting.
For ASX LITs, responsible entities typically want the RE fees and don't want LITs wound up, as well as often being connected to the fund manager. The worst responsible entities (e.g. E&P with the CD funds) actively waste money and pursue actions that are contrary to the interests of the majority of unitholders. There are exceptions (such as where the original responsible entity was replaced) and these may work for the majority of investors (e.g. K2 Asset Management since taking over as RE for the CD Funds).
In the U.K, Closed End Funds (known as investment trusts) have been through boom and bust, and the industry has been forced to evolve toward better governance. There is now clarity in the U.K. that boards and responsible entities should serve shareholders and be wholly independent. In contrast to Australia, where the vast majority of LIC boards are not even majority independent, and most responsible entities are not independent either, thus very few serve the majority of shareholders.
It is worth reading about current standards for U.K. Closed End Funds and comparing to the self-serving norms of the ASX CEF industry. See: > Investors Chronicle: In safe hands?
7. CEF Total Expense Ratios (TERs) are typically multiples of alternate, passive ETFs, yet are undisclosed. CEF TERs inevitably drive most to underperformance
ASX CEF Management Expense Ratios (MERs) are disclosed as nominal percentages but are incredibly misleading compared to the Total Expense Ratio (TER) before and after any Performance fees. The true TER is so critical to whether a CEF is a worthwhile investment, that they are actually the most important factor. Yet, no-one else who writes on ASX CEFs mentions TERs! I wonder why?
MERs are paid on net assets not the share price, so if paying a 1.25% MER on a LIC trading at a 20% discount, the actual MER you are paying is 25% higher!
But the MER is just the first fee. Most ASX CEFs, especially LICs, have many other expenses that sum up to the Total Expense Ratio (TER) - which is never disclosed, you'd need to calculate it from the annual report.
Many CEFs borrow (directly or via convertible notes) to increase the size of the portfolio but for ones with net assets under $150m this leads to blowouts in the TER the smaller the CEF size. CEFs like FPC, GC1, GFL, ECP, FSI, NAC, NCC and NSC are prime examples. All CEFs with small fund sizes should be avoided as they would naturally be forced to close once too small to generate sufficient fees but in a captive fund the fund managers can resort to borrowing to keep the extraction going. Often this isn't even put to a vote (e.g. FPC borrows from its custodian). It's typical for most investors to be unaware as to the extent of borrowing and the massive impact on Total Expense Ratios.
See the impact of TERs on the returns to investors versus managers:
> PE1 - Pengana Private Equity Trust - Cheat Sheet
> Which CEF Management Fees are most misleading?
And see how enormous ASX CEF TER's can be: > RF1 - Regal Investment Fund - Cheat Sheet
8. Most ASX CEFs have terrible exit liquidity, especially when investors wish to de-risk or switch to attractive opportunities in selloffs. This requires a proportionate illiquidity discount
During ASX trading hours, check the exit liquidity (buy ladder) of most LICs and LITs. For over 60% of ASX CEFs, exit liquidity is very poor in normal market conditions. During selloffs, when exit liquidity is most needed to de-risk, re-allocate exposure, or switch to more attractive opportunities, CEF exit liquidity is much worse. ASX CEF holders are forced to either cross large gaps to find sufficient buy-side depth, or are trapped and have to ride it out.
Putting aside all other discount factors (performance after expenses, Total Expense Ratios, tax leakage, etc), ASX CEFs deserve to have a discount added that is proportionate to the extent of their exit liquidity risk. For the ~60% of the ASX CEFs with significant exit liquidity risk, this discount factor alone should be significant (5% to 15%). This puts the lie to the idea these 60% of ASX CEFs can ever trade near NTA, let alone premiums.
Unsurprisingly, if you search for "exit liquidity" and ASX LICs / LITs or review content from those promoting ASX CEFs, you'll never hear of this term elsewhere. At best, the liquidity (buying and selling) of smaller ASX CEFs is sometimes discussed, but not with the intent of quantifying appropriate discounts to apply. The truth is there is never a shortage of sellers for almost all ASX CEFs. Virtually all holders are willing to fully exit at prices nearer NTA, but they never trade there!
9. Unaligned fee incentives mean discounts have little financial impact on CEF managers
CEF managers could be paid fees on the market cap of the fund, then managers would be aligned to try and get CEFs to trade at NAV. Instead, ASX CEFs charge fees on net assets, and some even charge fees on gross assets (including leverage).
As their fees are based on maximising assets, CEF fund managers often use unnecessary leverage and conduct dilutionary capital raisings that disadvantage investors (and expand discounts) but increase their fee revenue.
See: > Which CEF Management Fees are most misleading?
10. CEF performance fees often establish a "heads I win, tails you lose" outcome for investors
Many ASX CEFs use multiple tricks in applying performance fees to tilt the returns of CEFs such that the fund manager is the major beneficiary. These include: no high-water marks (or unjustified reductions or resets in them), resetting performance periods every 6 months, and either no benchmark return to outperform or using an inappropriate benchmark like the risk-free rate.
Some CEFs charge performance fees on gross returns (before even deducting fees, costs and the benchmark return). Other CEFs charge performance fees on outperformance of negative returns! So if the benchmark has a negative period but the fund delivers a zero return, it can still claim 20% of the loss the benchmark made!
Not a single ASX CEF out of 89 publishes actual calculations of its performance fees. Apart from the incredible lopsided nature of them, I suspect there are also unjustifiable reductions of the high-water marks that funds wish to keep hidden.
As an example, consider LRT which selectively touts its outperformance but has a classicly lopsided performance fee every 6 months with no high-water mark. Below are compiled figures from its annual reports showing its Total Expense Ratio without performance fees are already high at 2 - 3.9%.
When performance fees are included, the TER rapidly escalates (8 - 9%) whenever Net Income allows (see highlighted cells below). Due to the lopsided structuring, performance fees alone took out 45% of Net Income in FY2021-22 (despite an advertised rate of 17.5% of outperformance) Thus, Total Expenses have chewed up the majority of Net Income in the last three years.
Further analysis of extractive performance fees below:
> TEK - Thorney Technologies - Cheat Sheet
> RF1 - Regal Investment Fund - Cheat Sheet
11. LIC managers' fee revenue is higher if they don't efficiently return tax via franked dividends
The LIC structure doesn't simply pass through tax consequences like LITs/ETFs and is horribly tax inefficient. Thus LICs are subject to massive tax leakage, yet the decision on returning it via franked dividends is totally up to the manager! Dividends reduce the assets on which fund managers charge fees, so LIC's have a perverse structural incentive baked in.
Indeed, some ASX LIC managers have never returned tax leakage by simply never paying dividends (e.g. GFL, TEK, NGE, ZER). But even very large and profitable LICs can be extremely reluctant to efficiently return the tax leakage as it means reducing the capital they charge their fees on. Unsurprisingly, some of the worst offenders like the L1 Long Short Fund (LSF), have enormous fee loads, so this practice is hugely profitable for the fund manager.
See: > LSF - L1 Long Short Fund - Cheat Sheet
12. ASX CEFs fail to report their true performance figures against low-cost, passive/systematic ETFs. In the long run virtually all underperform!
Not a single ASX CEF out of the 84 I track reports its performance accurately against the lowest cost passive/systematic ETFs that are relevant alternatives. In fact, most of the reporting of CEF performance is inflated, deceptive or misleading.
In my blog posts, I provide objective Total Shareholder Returns (TSR) and NTA returns (both including franking credits) using Sharesight. Almost all ASX CEFs underperform after all expenses. Yet, most fund managers claim outperformance! And most CEFs with "performance fees" have charged considerable performance fees despite significant underperformance in the long run.
> Which CEFs blatantly advertise misleading expected returns?
> WAX - WAM Research - Cheat Sheet
> PIA - Pengana International Equities - Cheat Sheet
13. ASX CEFs under Listing Rule 7.1 can increase shares up to 15% every 12 months without shareholder approval via a Placement capacity. Some CEFs do so at significant discounts to NTA! In general, capital raising is often done at the expense of shareholders
It's not permitted for any Open End Funds (listed or unlisted, active or passive, ETF or not) to issue new shares at anything other than NAV. Yet, just because CEFs have captive capital and are listed on stock exchanges, capital raising latitude, that is wholly unnecessary for investment funds, is legal and exploitable.
For example, on 22 Feb 2023, TGF announced a Placement and Entitlement Offer to raise up to $51.66m. It actually seemed quite proud to advise all new shares would be issued at a 21.6% discount to post-tax NTA (and over 23% to pre-tax).
Tribeca could have sought to raise as much capital as it can (deserves) at NTA. It could have sought to let shareholder's vote on this dilutionary raising given it was supposedly for their benefit. It didn't. Instead, it just ruthlessly pursued its own interest of earning more fees from a larger capital base. There was a huge fall in the share price but existing shareholders be damned!
See: > TGF - Tribeca Global Natural Resources - Cheat Sheet
In general, CEF managers often raise capital (to generate more fees or stave off delisting) in ways that are disadvantageous to existing investors, especially retail. Apart from increasing the discount, there is usually dilution if investors don't participate. And retail investors can't participate in placement raisings as they need to be a certified sophisticated investor.
CEFs also create capital raising incentives through discounts or other mechanisms that bring in short-term traders with no interest in the CEF itself. E.g. VG1 and VG8 (now RG8) raised capital by offering incentive shares in the VGI Partners manager. Both LICs then dropped from premiums to discounts as these opportunistic traders sold out.
14. ASX CEF boosters perennially claim discounts are opportunities. The truth is virtually all are on an inexorable downward trend
Every part of the financial services industry (funds, brokers, advisers, research firms, media), that makes money in some way from the myth of active management outperformance, has argued that CEFs swing between discounts and premiums and this presents an opportunity for investors. You shouldn't trust any of these liars!
The truth is that since the July 2020 ban on CEF selling commissions, only 5 CEFs have launched, and all have been failures and trade at big discounts. Meanwhile, 35 ASX CEFs have wound up or converted due to persistent and growing discounts. And more have announced plans to.
Of the 89 ASX CEFs left that I track, only 6 now trade at premiums: PL8, PGF, WAM, WMI, WAX, WLE. Even the Wilson Asset Management LICs (with its massive marketing and shareholder engagement machine) are not immune. In the last 5yrs: WAM's premium has been as high as 34% and is now ~17%; WMI's premium has been has high as 32% and is now ~10%; WAX's premium has been as high as 52% and is now ~15%; WLE's premium has been as high as 16% and is now ~5%. WGB, WAA and WMA all trade at discounts, as do FGX and FGG that Geoff Wilson helped establish.
Eventually, everyone else will see the bus coming toward them. I'll point to it again: Active management after all expenses virtually always underperforms passive/systematic asset exposure in the long run. Without a steady stream of new CEF entrants, it's simply inevitable that long-term underperformance will come to dominate. But due to the 2020 ban on selling commissions, new CEFs of any scale will be rare, and thus the ASX CEF sector is doomed (the higher the TER, the quicker the implosion). New investors will almost always find ETFs are better alternatives. Existing CEF investors better keep an eye on the exit, it's narrowing!
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| Bell Potter Discount/Premium trend |
See: > Did the end of CEF selling commissions signal the slow death of the industry?
See: > Tracking the elimination of ASX Closed End Funds
15. Some ASX CEFs focus on unlisted assets (or shift allocations toward them) despite the normative discount penalty this entails in a CEF structure
In every CEF market (UK, U.S. Australia, Canada), all other things being equal, the greater the proportion of unlisted assets, the higher the discount of the CEF. Boaz Weinstein's Saba Capital has collected the data to prove this.
Apart from the uncertainty regarding valuations and concerns about liquidity, investors have learned the hard way not to trust most fund manager's timeliness and accuracy in marking their unlisted asset valuations.
Even though this phenomena is well known, ASX CEFs continue to shift into unlisted assets without consulting their shareholders (e.g. HM1). After all, it allows them to charge fees on valuations they control themselves; the greater NAV discount doesn't affect them. Particularly susceptible, are CEFs with performance fee scams that have no high-water marks and even reset every 6 months. When major writedowns finally come (e.g. TVL), the excess fees are naturally never refunded!
Goldman Sach - Global Macro Research - Aug 2023
See: > Bloomberg - Another Casualty of the Everything Bubble’s End
16. Trading CEF discounts is a zero sum game where retail investors donate their capital to sharks and insiders (sometimes acting illegally)
CEF boosters like Affluence Funds Management dishonestly argue that trading CEF discounts offers retail investors considerable extra gains on top of the fund returns. However, all trading is zero sum, the net gains of winners are offset by losers.
The truth is that the sharks (including myself, Affluence Funds Management, other professionals) make the trading gains and consequently retail eats the trading losses. For example, see my CD3 returns documented here: > CD1, CD2, CD3 - CD Private Equity Funds - Cheat Sheet
While I try and warn retail investors to stay away from the poker table, dishonest professionals are always trying to lure retail to take a seat and have a crack. See: > Myth vs reality in the long-run performance of ASX LICs and LITs
17. Many CEF managers exhibit contempt for their investors. They run the funds for themselves
In writing about ASX LICs and LITs that have traded at persistent, significant discounts for years, Graham Hand rhetorically asks:
It’s not that the managers have weak governance, little marketing or even poor reputations, but how are they balancing their own desire for fees against the ability of investors to realise full value?
But Graham Hand knows the answer: in the Closed End Fund sector the capital is captive and decisions are purely about the fund manager's self interest. Obviously, there's the fees, but he points out that many ASX CEF managers (e.g. NAOS) have no other open end funds at all, or of sufficient scale. Such managers would be out of their jobs if they let captive investors exit via winding up or being taken over. Even if they convert to an Open End structure (unlisted or Active ETF), their underperformance will lead to the new Open End fund shrinking, and the high TERs (typically 2.5% to 7% before performance fees) will escalate and crush the fund anyway. These managers will be most desperate in fighting off attempts to wind up their CEFs!
Open end fund managers are forced to focus on performance (after all expenses) as investors can typically fully exit at NAV whenever they like. (There are exceptions to open end fund exit freedom, but investors are aware upon entry). Consequently, the many tricks that CEF managers play that extract gains for them at shareholder's expense are counterproductive for open end managers - they either expand the Total Expense Ratio or undermine NAV performance.
Meanwhile, Closed End Fund managers like NAOS instigate self-serving changes like taking on debt as their CEFs shrink. NAOS's fees expand but the Total Expense Ratio (TER) blows out.
For example, I demonstrate from its 2021-22 Annual Report, that the debt NAC took on alone added ~2.36% per annum in expenses! And actual NAC management fees were over 3.4% of final net assets. In totality, NAC advertises a management fee of 1.75% but its true TER for 2021-22 was over 7% (not including performance fees had they applied). I explain some of the sheer extraction tricks in the full post:
For example, NAC charges 1.75% plus 10% GST which is 1.925% - an extremely high Management Fee given Performance Fees also apply. But this is charged monthly on the gross value of the portfolio. As ASX CEFs never detail these calculations it's uncertain what this gross value means, but it could well include the ~$17m in borrowings (an extra 42% of the Net Assets I calculated at 30 June 2022!).
18. The LIC structure is tax inefficient and exposed to more costs and risks
69 of the 89 CEFs left on the ASX are LICs, including virtually all those investing in equities. Yet, the LIC structure is far more tax inefficient than ETFs or LITs (trusts distribute returns before tax and any tax liable is paid later by the holder). The LIC structure is exposed to a greater range of costs, especially versus ETFs.
- Unlike the trust structure, LICs pay company tax but can only return it via franking dividends. Some LICs never pay dividends, while most others choose to keep buffers for "smoothing" dividends. Either way, the tax leakage earns nothing while sitting as a franking balance and often builds up.
- Some LICs choose to sit on large franking credits because the level of dividends required to return them would significantly reduce their fund size and thus the fees they charge. See details in Reason #9 above.
- With the exception of a handful of the large, buy-and-hold LICs (AFI, ARG, WHF, etc) that are eligible for CGT concessions, most LICs do not benefit from the 50% capital gains discount for holding an investment longer than 12 months. This tax leakage accumulates into a major difference over the long run compared to structures (ETFs, LITs) that pass through tax consequences to the individual (who can claim the 50% discount).
- In wind-ups, and even some conversions, the tax leakage (franking credits balance) can be completely lost.
- LICs can only pay dividends (thus release franking credits) if they have sufficient accounting profit reserves. This means there is a delay before dividends start and a limit on the flexibility to return all franking if the profit reserves are not kept high enough. Trust structures (ETFs, LITs) have full flexibility in making distributions.
- Trust structures (LITs, ETFs) are simpler and there is a limit to the type of expenses and actions that are permitted. But LICs have the full discretion of a company to include a vast range of actions (expenses, related party transactions) that benefit the fund manager (or founder, insiders) at the expense of shareholders. Only the annual reports contain the details (variety of leakages) but they are rarely read and properly understood by retail owners.
- Note that CEF advocates claim that LICs protect investors from the capital gains tax liabilities of other investors who've sold. But that tax pitfall relates to unlisted managed funds and does not affect ETFs (including Active ETFs).
- Like all Active management funds, LICs turn over their portfolios more than Passive funds and generate taxable capital gains. It is hugely beneficial for investor total returns in the long run to defer realising capital gains (active managers never discuss this). At least Active ETFs don't pay tax directly and suffer less tax leakage than LICs, but the major advantage is for Passive ETFs. Many LICs that trade actively hide the long-term tax leakage effects from investors (e.g. by not including it in their performance comparisons). Because LIC performance is more confusing to compare than for Active ETFs, many LICs are less discouraged from creating tax leakage (e.g. from over-trading or to generate franking credits).
See: > Which CEF Management Fees are most misleading?
19. LICs and LITs at premiums to NTA are always at risk of fund manager's increasing the supply of shares to increase their fees
The CEF boosters promote the myth that virtually all LICs and LITs fluctuate between discounts and premiums and thus there is the potential for any of them to trade at premiums, especially if they outperform. The reality is that only 10 out of the 89 left ever trade at premiums and only 6 trade at consistent premiums of any significance.
However, even when a CEF trades at a premium to NTA, the unjustified nature of premiums prompt self-serving actions by fund managers to increase their fee revenue at the expense of existing investors.
(a) Capital raising near NTA
Most CEFs conduct capital raisings if the fund trades at a premium. In a capital raising, no-one ever willingly invests at a premium, so they all occur at the justifiable price: the NTA. Below you can see how PL8's share price crashed 10% when a capital raising at ~$1.04 was announced but the share price was $1.23.
(b) Scrip takeovers
When CEFs trade at premiums or even at NTA this also provides an opportunity for fund managers to increase their fund size (thus fees) by takeovers or mergers with other CEFs - often those trading at persistent, substantial discounts where investors were trapped. Below you can see how WGB's takeover of TGG led to most TGG investors exiting via dumping their WGB shares.
As mentioned above, CEF managers charge their fees on the NTA not the market cap, so Wilson Asset Management continues to reap the fee rewards from this takeover. Meanwhile, WGB shareholders are fuming as there is little natural demand for WGB, performance has been poor, and the TGG exiting simply drove a substantial discount.
20. CEF Fund Managers assert that Closed End Funds are better structures than Open End due to key differences like no forced selling. But they abandon the CEF structure whenever there are more fees to be made!
CEF managers always harp on about a supposed key advantage of Closed End Funds: not being a forced seller during market selloffs. Geoff Wilson summed up the argument thus:
I have been passionate about the LIC structure since reading a mid-nineties Morgan Stanley report that found closed-end funds outperformed open-end funds over a 50-year period.
The logic is clear: open-end funds buy and sell in line with investors’ inflows and outflows and this leads to them being a forced buyer when asset prices are high and a forced seller when they are low.
Even worse, all the bluster about the Closed End structure benefits goes out the window as soon as the circumstances mean fund managers will raise more capital (thus generate more fees) via an Open End structure. Since the July 2020 ban on selling commissions, there's no easy way to raise massive amounts of capital in Closed End Funds. So CEF fund managers now opportunistically launch Open End funds when it suits.
Wilson Asset Management demonstrated this by launching an Open End version of WAM Leaders (WLE) to target raising $1 billion extra. CEFs are on the nose, and it couldn't raise anywhere near this much in the existing WLE Closed End structure. If Geoff Wilson truly believes the Closed End WLE will outperform the Open End version, he should be advising retail investors not to buy the new Open End fund. Yet, the Open End version is continuously marketed to retail investors.
L1 Capital has had a major performance turnaround with its Closed End vehicle LSF providing the opportunity to raise more capital for new funds. However, it also concluded there was little interest now in CEFs and opted for an Open End structure for its new international fund.
So much for the structural benefits of CEFs! As usual, fund managers want to have their cake and eat it too. CEF fund managers are delighted to launch Open End funds to generate more fees when it suits them, and market the benefit of being able to achieve the NAV performance and exit at NAV whenever you like. But Wilson Asset Management won't convert its Closed End funds trading at persistent discounts (WGB, WMA, WAA) to Open End. L1 Capital won't convert LSF to Open End either despite the massive tax leakages I have exposed.
The simple truth is CEFs exist to keep capital captive for as long as possible, and are run for the fund managers or insiders benefit.
21. ASX CEFs have Investment Management Agreements for 10 years, automatically renewing, high termination fees, and terms that frustrate any wind-up, takeover or conversion
Haven't heard of an Investment Management Agreement (IMA)? Why would you, CEF boosters never reveal the dirty secrets.
- IMAs are secret agreements between the CEF and an external fund manager (which most CEFs have). Neither ASIC nor the ASX appear to require disclosure of even the critical elements like termination fees or contract terms that would interfere with any wind-up, takeover or conversion.
- ASX listing rules say the maximum initial term should be 5yrs but every ASX CEF appears to have sought and got a waiver for 10 years.
- Within the initial 10 year term it is extremely difficult for even 75% of shareholders to wind-up, convert, merge or consent to a takeover for a CEF, unless the fund manager is also in favour (which they almost never are, as they'd lose their ongoing fees). Most IMAs contain termination fees of 1% of NAV for each year remaining (terminating a CEF 3yrs into a 10yr agreement may cost 7% in fees).
- When the 10 year term is due to expire, shareholders have a brief window to organise to vote to block an extension, which is usually for another 10 years. Yet, CEF Boards (for LICs) or Responsible Entities (for LITs) almost never seek to widely engage shareholders to make them aware of this opportunity to change the fund manager or wind-up/convert the fund (which is very feasible if shareholders have voted to block extension). Nor are unjustified termination fees or other unfair mechanisms removed from future agreements. Shareholders are never consulted by CEF Boards or Responsible Entities.
- Advocates of investing in CEFs due to their significant discounts and chance of structural resolution (like Affluence Funds Management) never mention IMAs, how far into their term the CEF is, or termination fees.
- How do IMAs for Open End funds compare? Who cares; all of these hidden pitfalls and complexities don't really matter. Capital isn't captive in an Open End fund. Everything that affects performance is in the NAV, there is only one measure of performance (which is easy to compare in Sharesight), and you can fully exit at NAV at any time if unhappy with performance or future directions of the fund.
22. The financial advisors and superannuation platforms that pushed the CEF boom are now part of the CEF bust. It's all about incentives and delivering value
Since the July 2020 ban on CEF selling commissions there are no benefits to financial advisors (or other intermediaries like super platforms and managed portfolios) pushing equity LICs and LITs. They understand that passive ETFs (VAS, VGS, etc) outperform virtually all equity CEFs long-term, and if clients want listed active management it can be had with Active ETFs that can be fully entered and exited at NAV at any time. High fees and persistent discounts guarantee a negative experience for their clients. And advisors all know what happens post-IPO to virtually all equity CEFs, so, absent incentives, why recommend any new IPO?
After numerous scandals and a Royal Commission, conflicted remuneration has been much more constrained, and Closed End funds are on the nose due to the intractable discounts plaguing the sector:
Credit and private equity are somewhat defensible as Closed End structures, and financial advisors continue to offer them for diversification benefits or income purposes. But they are exceptions that prove the new rule: where there's no ongoing demand for the CEF structure, the LIC/LIT will die.
In a context of rapidly expanding, low-cost access to passive ETFs and active ETFs (or managed funds) in all asset classes globally but with asset allocation tools, financial advisors are also migrating from LICs (liquidity issues, discounts, higher fees, tax leakage, opaqueness) to online platform alternatives like Separately Managed Accounts (SMAs). SMAs allow for much greater control, transparency, reporting and implementation. Financial advisors de-risk responsibility for LIC fund selection and entry/exit prices and focus on asset allocation, implementing client requirements and reporting.
See: > Exploring Zenith’s managed accounts and their unique value for advisers
See: > Vanguard: Why asset allocation is key to investment success
23. The biggest Australian fund managers never got into CEFs. The few experiments are being ended or inevitably will be. No reputable manager will launch an equity CEF
CEF boosters like Daryl Wilson (Affluence Funds Management) claim that an advantage of ASX Closed End LICs and LITs is that the "quality of managers is tremendous"! Indeed with hundreds of fund managers operating in Australia and only ~40 in ASX CEFs, boosters claim that CEFs are like cream rising to the top. But this is pure baloney, offered up without even a slice of evidence. Most equity CEFs simply reveal the scummy underbelly of the active management industry!
The reality is that the vast majority of Australian fund managers steered clear of the Closed End experiment. Below is a table of the Top 25 Australian fund managers by Assets Under Management (AUM). They typically have dozens of funds across many asset classes but most don't have a single CEF:
- Out of 89 ASX CEFs remaining, only 9 are managed by a Top 25 Australian fund. And of these, MGF and SEC are on their way out leaving only 7.
- Wilson Asset Management is the giant of the ASX Closed End fund manager domain but has less than $5 billion in AUM. The entire ASX CEF sector (all 89) is only $50 billion. Yet, the Top 25 Australian funds have AUMs in the tens of billions but typically not a single CEF!
- As for the exceptions, Perpetual has over 40 managed funds but only 2 CEFs: PIC, PCI (a credit fund)
- Magellan has ended its CEF experiment with MHH converted to Open End and MGF to follow soon.
- Pinnacle has MXT and MOT via Metrics but these are credit funds for which there is demand. It has SEC via Spheria and PL8 via Plato. SEC is on its way out and PL8 has idiosyncratic demand and trades at a premium.
- Platinum Asset Management manages $13 billion but only 2 LICs: PMC and PAI. PMC is only $440 million compared to its Open End version: Platinum International Fund ($6 billion). PAI is only $350 million compared to its Open End version: Platinum Asia Fund ($2.25 billion). It's inevitable PAI and PMC will ultimately delist and merge into the Open End funds.
- Macquarie Group alone has $542 billion in dozens of managed funds but somehow hasn't discovered the advantages of the Closed End structure for even a single ASX experiment! Meanwhile, the majority of the 89 CEFs left on the ASX are less than $150 million in size with ~20 less than $60 million.
- In a few years, out of more than $1.6 trillion in hundreds of managed funds in the Top 25 Australian fund managers, there will likely be just 5 CEFs left: MXT, MOT, PCI, PIC and PL8. Only the latter two are equity CEFs. I think we can conclude the short-lived ASX equity CEF experiment has failed.
24. Fixed Income products (LITs, Active ETFs) are replacing ASX equity CEFs as they go-to listed income products
Until 2017 the ASX CEF sector was dominated by equity funds, many touting their reliable yield as "Income LICs". From 2017 to 2019, all of the fixed income CEFs listed on the ASX (as LITs): MXT, MOT, GCI, PCI, KKC, PGG, NBI, QRI.
Persistent (though not massive) discounts for PGG and NBI led both to convert to Open End as there actually is demand for these income products (from specialist, large managers earning the yield from the debt asset class). But, for the higher risk segment like PGG and NBI, a signficant proportion of demand was only if structured Open End to trade at NAV. MXT, MOT, GCI, PCI and QRI typically trade close to NAV.
With central bank rates normalising, these listed fixed income funds (mostly floating rate) now offer attractive, more reliable yields across the credit spectrum (from top investment grade to high yield / junk, and asset exposure beyond corporate bonds like residential mortgages and private debt).
The income reliability and diversification benefits of adding these listed fixed income products to portfolios is penetrating further and this has been noted in the sector such as in GCI's recent capital raising:
I'd predict over time the delusion about LIC cash franking credits being a free bonus will disappear and listed fixed income funds will take over this listed income product role in portfolios (as they have in the U.S. and Europe). The majority of ASX Equity CEFs trying to compete will suffer.
The impact of higher yields on fixed income popularity, and a consequent fall in demand for Closed End Funds targeting yield-focused investors, has been noted in the large London investment trust (CEF) market:
See: > Bloomberg: Britain’s £260 Billion Trust Industry Is in Rapid Decline
And because the "income smoothing" aspect of LICs has always been artificial, it can easily turn from a blessing to a curse if the main reason for that LIC's demand. With yields structurally higher, fixed income products now offer actual income stability and, if open end, without the downside of discounts.
25. Risk-free rates have increased so capital-protected products (e.g. term deposits, at-call deposits, hybrids) offer competitive, safer yields
When risk-free rates collapsed from 2012 to 2020, equity LICs boomed as they have the ability to generate artificially high and stable yields (rather than the lumpier but higher Total Shareholder Returns of VAS or VGS). This lazy income stability especially valuable to wealthier retirees following the mantra: "I don't care about share prices, the kids are going to get those."
I wrote about these "Income LICs" and the threat of sustaining competitive yields and performance here: > Staying ahead of the retiree Income LIC shakeout
In the below graph you can see how the collapse in capital-protected yields led to the boom of equity LICs till the ban on selling commissions in July 2020:
Since then risk-free rates and capital-protected yields have normalised higher due to trends in demographics (access to cheap labour, working age ratios), productivity, globalisation (e.g. friendshoring), energy prices and other forces. Meanwhile governments continue to spend beyond their means creating a huge expansion of debt securities to sell.
See:
> Canstar: Term deposits rates comparison
26. Even CEF wind-ups often don't return NTA or release all assets (franking credits, tax losses).
In an Open End fund, all investors enter and exit at NTA, regardless of whether it failed and when they exited. There is no tax leakage and only pass-through franking credits matter. But in Closed End funds there is never a guarantee of receiving NTA in a wind-up or merge. Franking credits can be lost. Deferred tax assets are almost always lost, not just in conversions but even in a merge with another CEF.
Recent Examples:
- CD1 investors have been advised that their fund may wind-up with a whole of portfolio sale at a substantial discount (my estimate is 20-25%)
- EAI investors lost significant franking credits in its wind up.
- QVE investors received a takeover offer from WLE at a discount to NTA.
Links:
> Firstlinks - Why LICs are closing and more should follow
> LMIs In Australia: 3 Ways To Clean Up This Mess
> Hawksmoor - We Need to Talk About Investment Trusts (see all Investment Trust articles)
> Perpetual - Understanding the LIT structure
> Perpetual - Exchanged traded management funds offer a solution to the net tangible asset discount
> Zenith: If you want to be a contender, you need to act the part
> Alder & Partners: Shareholder activism in LICs
> FNArena: LMIs In Australia: 3 Ways To Clean Up This Mess
> AFR: The big discount danger of LICs
> AFR: Why ETFs may be better for self-managed super funds
> AFR: Listed funds could be 'toxic time bombs'
> Morgan Stanley: The Rise of Active ETFs
> JP Morgan Asset Management: Fine-tuning portfolios with active ETFs (YouTube)
> Morningstar: ETFs and tax explained: why 2021 was a capital gains headache for investors
> VanEck: The tax advantages of ETFs (pdf)
> Money Management: Considering a listed vehicle
> Money Management: Who earned the stamping fee exemption millions?
