Discounts should come with a warning

Listed investment companies (LICs), like Exchange Traded Funds (ETFs), can offer a good opportunity to buy a diversified portfolio.

The number of LICs and listed investment trusts (LITs) on ASX has risen in the past year, with 113 products listed as at the end of March 2019, up from 107 from a year earlier with the market capitalisation of the sector jumping 11.6% to $42.3 billion.

Christopher Joye recently opined the reason for this growth in The Australian Financial Review on 8 March 2019 entitled, ‘Boiler rooms are back as listed investment companies.’

LICs are often compared to ETFs. But they are different investment vehicles with different risks. Among the risks you need to consider is what we call ‘NAV risk’. The NAV is the ‘Net Asset Value’ of the underlying portfolio. You want your investment to be as close as possible to NAV. The risk that it goes below that can impact an investor’s returns and investors in a LIC have more exposure to NAV risk than investors in an ETF.

There are three reasons for this:

1. A LIC is closed-ended;
2. An ETF has a market maker; and
3. Passive ETFs are fully transparent, publishing their holdings daily.

Closed-ended funds mean higher NAV risk

A closed-end fund issues a fixed number of shares. Just like a listed company, a LIC’s fixed number of shares is determined via its initial public offering (IPO). After the IPO a LIC trades just like normal shares with market demand determining its share price. Increased demand means the share price goes up and the rise may be independent of the value of the LIC’s underlying investments. Most LICs therefore usually trade at a premium or discount to the value of their portfolio. The difference between the LIC’s share price and its underlying value can impact an investor’s returns, this is NAV risk.

When a LIC trades at a 20% discount, investors in theory are buying $1 of assets for 80 cents. A discounted LIC share price has been perceived as a good thing for a prospective investor. Unfortunately it is not that simple.

Sometimes a LIC trades at a discount for good reason. Some LICs trade at big discounts because they have poor underlying performance, or the market has concerns about the manager. The LIC may have a patchy dividend record or it invests in an out-of-favour sector.

Low liquidity in LICs is another factor that increases NAV risk. As with other thinly traded stocks, lack of regular buying and selling creates pricing anomalies. You do not want to be holding a discounted LIC nobody wants to buy.

Poor investor relations programs from smaller LICs, usually because of their tight cost structures, can also hinder their share turnover.

Some LICs trade at a big discount, a phenomenon that has been common on the ASX in recent times, with most LICs trading at discounts, as the chart below shows.

_{Source: ASX/Morningstar, 31 March 2019}

ETFs, on the other hand, are open-ended, meaning the fund manager can create (or redeem) units in the fund on an ongoing basis to match demand. This is one of the reasons ETFs’ prices remain close to the value of the underlying investments. The other reason is the involvement of a Market Maker.

A Market Maker ensures ETFs trade close to NAV

Market Makers do exactly as their name suggests. They make markets by matching buy and sell orders for investors that want to trade on ASX. This means, as an investor, you are not dependent on there being other investors wanting to sell when you want to buy or other investors wanting to buy when you want to sell. The Market Maker will trade with you.

Market Makers stand in the market during ASX trading hours offering to buy or sell at prices either side of the NAV of the ETF shares. The ‘spread’, also called the “buy/sell spread” is to reward them for the service they are providing. 

Like large-cap shares, ETFs with high trading volumes have a deep bench of buyers and sellers on exchange making them highly liquid.  This means that they can trade closer to the NAV of the ETF than the prices the Market Maker is offering. But for ETFs traded less frequently, Market Makers ensure that liquidity is available within spread limits set by ASX to protect investors from the kinds of discounts and premiums seen in most LIC share prices.

Market Makers know the true NAV of an ETF because a passive ETF is fully transparent, publishing its full portfolio holdings each day. This allows the Market Maker to value the underlying holdings independently. Investors can also access this information. During ASX trading hours an ‘indicative NAV’ or iNAV is published for Australian equity ETFs which is updated every 15 seconds throughout the day. iNAVs allow investors to track the fair value of an ETF’s shares during the trading day.

The result is a favourable outcome for investors. ETF investors can buy when they want and sell when they need, at a price very close to the true value of the portfolio of securities held by the ETF, avoiding significant premiums and discounts no matter the market conditions.

LICs, on the other hand do not have Market Makers, rather they rely on random buyers and sellers for liquidity. If you want to sell your LIC you are dependent on there being another buyer who wants to buy it at the price you are offering. As the ASX chart above shows, for many LICs there are no such buyers. Instead investors are being forced to sell at significant discounts to the value of the underlying investment.

Transparency

The other issue with LICs is transparency. We noted above that because passive ETFs are fully transparent the Market Marker can independently value the ETF. This is not the case with a LIC. Prospective buyers and sellers do not know what is in the underlying portfolio because a LIC unlike an ETF, is not required to publish its holdings daily, making them difficult to value during the trading day. This lack of transparency increases the NAV risk of a LIC.

The accurate pricing of an ETF with its transparency is something that a LIC can’t offer.

ETFs eliminate uncertainty

Compared to LIC, ETFs significantly reduce NAV risk because ETFs are open-ended, they have a Market Marker and are fully transparent.