CaptiveCapital's 95 theses on why ASX Closed End Funds should be eliminated

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 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 leakages, pitfalls and issues affecting 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.

Details:

1. CEFs come into existence for the fund manager's benefit, not due to investor demand. There is almost never ongoing demand at NTA (Net Tangible Assets)

As Boaz Weinstein of Saba Capital says: "No-one rings up their broker and says get me the latest Closed End Fund." Most of them only come into existence because a fund wants the perpetual fees from captive capital and 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 discount, all of them suddenly want to exit at NTA. But there are no sweeteners to help retail holders find new suckers to offload to! Many retail CEF owners have to do their own marketing to find new suckers. (Which is why when I add CaptiveCapital blog articles on Hotcopper I often cop flak.)

2. Most ASX Close 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 but this has been hidden from investors!

See the discount graph in Reason #14 below. Only 6 of 90 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 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 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? Embarrasingly for the CEF boosters, this has never happened in any of the dozens of ASX CEFs that have had votes!

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 first attempt at 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 entrenchment (insiders with blocking holdings), the cat is out of the bag. The next step is determining how to validly and most effectively utilise it.

3. 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".

4. Entrenchment. 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 entrenchment and their discounts can only get bigger.

See: > When does CEF "skin in the game" become a blocking stake?

5. 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 no LIC boards are 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?

6. 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 are disclosed but are irrelevant compared to the Total Expense Ratio (TER) before and after any Performance fees. The true TER is so critical to CEF's being worthwhile investments they are actually the most important factor. Yet, no-one else who writes on ASX CEFs, focuses on TERs! I wonder why.

See the impact of TERs on the returns to investors versus managers here: > PE1 - Pengana Private Equity Trust - Cheat Sheet

Also see: > Which CEF Management Fees are most misleading?

See how enormous ASX CEF TER's can be: > RF1 - Regal Investment Fund - Cheat Sheet

7. 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, no matter how small. Virtually all holders are willing to fully exit at prices nearer NTA, but they never trade there!

8. 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 increases their fee revenue.

See: > Which CEF Management Fees are most misleading?

9. LIC managers' fees are 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

10. 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, much 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!

> Which CEFs blatantly advertise misleading expected returns?

> WAX - WAM Research - Cheat Sheet

> PIA - Pengana International Equities - Cheat Sheet

11. CEF performance fees often establish a "heads I win, tails you lose" outcome for investors

ASX CEFs can 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 watermarks (or unjustified reductions 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.

> TEK - Thorney Technologies - Cheat Sheet

> RF1 - Regal Investment Fund - Cheat Sheet

12. 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!

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. Existing shareholders be damned!

See: > TGF - Tribeca Global Natural Resources - Cheat Sheet

In general, CEF managers often raise capital (to generate more fees) in ways that are disadvantageous to existing investors. Apart from raising discounts, there is usually dilution if investors don't participate. And sometimes CEFs create capital raising incentives 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 then dropped from premiums to discounts as these traders sold out.

13. 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. 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

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 2020 ban on CEF selling commissions, only 5 CEFs have launched, and all have been failures and trade at big discounts. Meanwhile, 34 ASX CEFs have wound up or converted due to persistent and growing discounts. And more have announced plans to.

Of the 90 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 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!

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. 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?
> Firstlinks - Why LICs are closing and more should follow

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, Close 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!).
> Which CEF Management Fees are most misleading?

16. The LIC structure is tax inefficient and exposed to more costs

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 also typically higher cost, 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 some limit to the type of expenses that are included. But LICs have the full discretion of a company to include a vast range of actions (thus expenses) that benefit the fund manager at the expense of shareholders. The annual reports are very revealing.
See: > Which CEF Management Fees are most misleading?

17. 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 88 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 no natural demand for WGB, performance has been poor, and the TGG exiting simply drove a substantial discount.

18. Superior, more efficient and attractive structures exist for Actively managed funds

While I consider chasing active management a loser's game, many investors enjoy playing. However, there are now superior Open End Active structures to CEFs regardless of the asset class. One of the newest is Active ETFs (aka Exchange Traded Managed Funds). They have live prices and have unlimited liquidity at small spreads around NAV. 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.

Independent Investment Research in discussing why the ASX CEF sector should shrink, put it this way:

See: > Morningstar list of Australian ETFs

CEF advocates argue that LICs, in particular, 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 simply provide a more efficient, lower-cost structure. Betashares regularly provides updates on the growth of ETFs. They've only been around for 22 years in Australia but dwarf ASX LIC/LITs and are where all the growth is (ASX CEFs are shrinking).