Fee greed slows LIC stream to trickle - 31st October 2007

John Synnott - The Australian

CORPORATE raiders from overseas are stirring up the cosy world of Australian listed investment companies. Hedge funds have come from the Cayman Islands to muscle in on investment funds trading on our stock exchange at a price discount.

Who can blame them? Buying $1 worth of shares in our mining companies for 80c through a listed investment fund makes good sense. Then they try to get the fund managers to sell the shares or otherwise close the gap between the asset value and the fund's share price, to realise a 25 per cent profit.

Yet the real issue about listed investment companies (LICs) is what is not happening. They were supposed to replace managed funds, because they were were cheaper on the fees, more flexible to trade and had tax advantages.

Somehow that assault has faltered, although a dribble of new LICs keeps popping up. One reason is greed -- the new wave of LICs has boosted fees relative to rival managed fund charges. The other is that financial planners are the distributors for investment products and prefer managed funds because of the commissions they get. The fees charged by traditional LICs are only a tenth of the new breed of LICs (which, to be fair, usually are more active trading managers and don't have massive holdings). For instance, Australian Foundation Investments (AFIC) and Argo Investments, founded in 1929 and 1946, now have assets of $4.2 billion and $4.5 billion respectively.

Their five-year returns are 18.65 per cent and 17.3 per cent from blue-chip Australian share investing, for fees of 0.13 per cent and 0.15 per cent (compared with 1-2 per cent plus for managed funds).

AFIC's better performance is probably because of greater exposure to the resources boom. Argo managing director Rob Patterson says they have been buying more BHP, Oxiana and resource stocks, but one problem is that they pay low dividends -- and fund investors want dividend growth as well as capital growth. Here, low fees have quite a profound effect on the long-term result for investors, Motivated Money consultancy's Peter Thornhill says.

If an LIC and a managed fund both invested $1 million in exactly the same shareholdings, and provide an initial yield of, say, 4 per cent, the dividend income would be $40,000.

The managed fund would deduct fees of 1.5 per cent, or $15,000, leaving $25,000 net. The LIC would deduct its expenses of $1300 leaving a net $38,700. "Which income would you prefer, $25,000 or $38,700," Thornhill asks.

Other low-fee LICs include the Australian United Investment Company, Choiseul investments, Carlton Investments, Djerriwarrh Investments and Milton Corporation.

The most attractive of the established LICs, taking into account premium to NTA, NTA growth and long-term returns, are Argo, Diversified United Investment, Mirrabooka and WAM Capital, according to Tolhurst stockbroking research in a recent review.

An interesting feature of traditional LICs is how little tax they pay. Because they buy and hold blue-chip stocks and don't usually sell much, their capital gains tax is deferred to the never never. That's worth $1 billion for the Argo fund, added to the investible float as a sort of interest-free kick to earn further income.

Another interesting feature is how traditional LICs attract buy-and-hold investors, so when the sharemarket dips they are less inclined to cut and run. Argo dropped only 5 per cent when the whole market was down 15 per cent recently. This was bad luck for sharebuyers -- the best time to buy assets is when markets are down and they are going cheap -- but comforting for holders.

That share price stability is a good environment for gearing. Centric Wealth fund manager Gabriel Radzyminski has exploited this in his Leveraged Investment Companies Fund. It invests in LIC funds and then borrows to buy another 50 per cent coverage. The fund makes money from LIC shares rising in value and when their net tangible asset (NTA) value discount narrows.

The LIC fund's gearing increases the tax credits, potentially reducing the investor's tax bill. So the last dividend to investors of 4.7c per unit was accompanied by a relatively high tax credit of 4.15c. This LIC fund uses positive gearing, whereas the dividend income of the LIC fund's investments exceeds interest costs and expenses of the fund, a conservative gearing strategy.

The returns to the end of June were a healthy 53 per cent, and slightly better than the Morningstar Australian Large Cap Geared Index return over two years. The All Ordinaries Accumulation Index returned 30.3 per cent for last year, while the average LIC portfolio return was 23.3 per cent.

A similar fund of funds that also uses professional investors to pick the best LICs is Select Asset Management's CEF Portfolio, which has returned 38 per cent without gearing for last financial year.

CEF has three strategies. One is to identify the best funds and managers for a long-term investment. Then there's a trading strategy taking advantage of a retail market that throws up opportunities -- such as the Packer family investment company Ellerston Capital's recent float of its Global Equity Managers Fund. Oversubscribed, its shares then dropped from $2.50 to $2 in turbulent markets, making it a buy.


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