There are some folks who post here that seem to have a good understanding of LIC/ETF/Managed Fund structures. I hold a few LICs that trade at persistent discounts to NTA so I'd be interested in your thoughts on this article.
The author suggests that it'd be relatively easy to fix by converting to an unlisted trust or an active ETF. Is it really that simple (and if so, why wouldn't all of them just do it tomorrow?). If you have an LIC with an NTA of $1.00 that's trading at 80c and you move it to an unlisted trust then everybody now has units worth $1.00 - awesome. If you move to an ETF then you wake up the next day and your investment has a different stock code and increased 20c a share? What am I missing?
Some listed investment companies and trusts (LICs/LITs) are taking initiatives to remove long-standing discounts to net tangible assets (NTA). This has recently transpired either by way of converting to an active ETF (such as Monash's MA1) or an unlisted unit trust (such as Ellerston's EGI). Alternatively, the dual structure of an unlisted unit trust and active ETF was pioneered by Magellan and Mainstream and launched last week with the Airlie Australian Share Fund (AASF).
While some other boards have announced share buybacks, such buying has proven largely ineffective in closing discounts to NTA over the medium to longer term.
Time for boards and managers to act
With the precedents now set for all three avenues to permanently eliminate discounts to NTA, there is additional impetus for boards, investment managers (those acting in the best interests of investors) and investors to take action. Potentially, activist investors may seek arbitrage opportunities to convert or possibly wind up LICs and the sector may well now or soon be ‘in play’.
For some LIC investment managers, conversion to an active ETF presents the opportunity to grow funds under management (FUM), notwithstanding arbitrage-related divestments upon conversion. Many such LICs have been precluded from growing FUM due to the persistent and material discounts to NTA. The potential for growth in FUM for solid managers is likely to be facilitated by the ongoing growth in the active ETF segment, a dynamic that is being facilitated by the structural decline of the platform space.
Given these dynamics, investment managers, whether of LICs or unlisted unit trusts, would be well placed to review their go-to-market strategies. A manager can sink the costs, time and resources now and benefit from being early to market or they can, should these dynamics come to pass, be ‘forced’ to do so at a later date (incurring the same costs) and be late to market.
In fact, we suggest all boards and investment managers of LICs that:
* have not shown an ability to capitalise on the single greatest benefit of a closed-ended vehicle, that is, captive capital, and
* have traded at a persistent and material discount to NTA, which is the vast majority
... initiate a review towards potential conversion.
Managed investments, in some regards, represent the peak of capitalism. If you live by the sword, then you must die by the sword. Running a fund is not some sort of gravy train for boards and investment managers.
A discount to NTA can of course be viewed as an opportunity, over and above the prospect of solid returns from a strong investment manager. If the sector is now or soon to be in play then the likelihood of crystalising a gain through a share price reversion to NTA may increase materially.
The rise of active ETFs
The rise of active ETFs (sometimes called ETMFs or Exchange-Traded Managed Funds) will likely occur based on a combination of:
1. the fragmentation of the financial adviser sector post the financial services royal commission leading to the ongoing structural decline of platforms and unlisted unit trusts
2. the increasing use of listed investments
3. the launch of the dual ETMF and unlisted unit trust single-pool structure
4. the precedent of the first conversion of a LIC to an active ETF
5. the stamping fee ban (the irony is that the active ETF fund managers that pushed for a ban on stamping fees have just bought themselves a lot more competition), and
6. the likely resurgence of active investing versus passive investing.
With the Magellan/Mainstream dual structure now launched, every new fund managers should include in its constitution the ability to go down this route. Existing fund managers will need to carefully consider their strategic position, given the secular decline of the platforms.
The three roads to remove the discount
As described briefly above, there are at least three routes a struggling LIC or LIT could take in these examples:
1: Conversion of MA1 into an ETMF
Monash Investors is expected to change its name to Monash Absolute Active Trust and the likely listed code is MAAT. To do so, the manager will require at least 75% of votes cast in support of the resolution. The conversion, should the vote pass, is expected to be finalised by September 2020 and in which case investors will benefit from MA1 trading at parity to NTA (in contrast to the current 8% discount).
2: Conversion of EGI to an unlisted unit trust
Ellerston Global Investments (EGI) released a door stopper 408-page Scheme of Arrangement booklet regarding the proposal initially announced on 17 January 2020 to restructure EGI shares into unlisted units into the Ellerston Global Mid Small Cap Fund. This initiative is to close the sustained discount to NTA in EGI.
Our understanding is the course Ellerston Capital has pursued was viewed as the quickest route to conversion. However, converting to an unlisted trust is contrary to a key reason why many investors may have invested in the EGI vehicle in the first place, being a listed investment vehicle.
3: Launch of dual unlisted unit trust and active ETF
On June 4, the Airlie Australian Share Fund (AASF) began trading on the ASX. It brings together the features of an unlisted fund and an active ETF into a single unit in a single fund. The structure provides investors with greater choice and flexibility in how they invest and will deliver efficiencies to fund managers.
Magellan and Mainstream have developed a means for fund managers to offer one fund that can be accessed by investors through the traditional means of applying and redeeming units in an unlisted managed fund. These investors are managed by the registry, effectively on an issuer sponsored sub-registry, and transact using a shareholder reference number (SRN). Alternatively, investors can trade on the exchange (either the ASX or Chi-X) through their broker, using their holder identification number (HIN). IIR notes that there are no adverse taxation consequences for existing unit trust investors through the restructure process.
For fund managers, the development is nothing short of a potential game changer. An investment manager of an unlisted unit trust can now seamlessly add the exchange-listed distribution channel (which a certain percentage of advisors and investors are oriented towards) in addition to the pre-existing unlisted unit trust distribution channel (which a certain percentage of advisors and platforms are oriented towards).
The potential of this dual structure to grow FUM for an investment manager should not be underestimated, particularly in the context of the strong (active) ETF market growth and the progressive changes in financial advisor business models who are in increasing numbers moving off traditional platforms.
A key drawback for unlisted funds has been the excess paperwork required from an investor applying to buy or sell units. Investors have been required to complete 15- to 20-page application forms for each fund and most of these are still paper-based in 2020. This existing system of listed and unlisted funds creates an unwieldy, inelegant landscape for investors, brokers and fund managers alike.
All stakeholders will benefit
In IIR’s view, all key stakeholders benefit from the development of this dual structure.
Forfund managers, they are able to offer the same benefits of dual funds to investors without the duplicate cost structures (fund managers can save in the vicinity of $150,000 per annum by consolidating dual funds into a single product). More importantly though, where a fund manager had only offered an unlisted unit trust, they are now given a highly prospective listed distribution channel.
For advisers, the development provides more choice in portfolio construction (as some only use listed, others largely unlisted), it potentially removes the administration burden of unlisted unit trust investments.
For investors, there is a simplified view of their investments. A key feature is ensuring investors can seamlessly move between SRN and HIN and vice versa. Investors will be able to access an investment manager’s pool of assets through different entry points and then have the flexibility of moving their units between their brokerage account and the issuer sponsored sub-register.
For brokers, this product eliminates the need to build a bespoke 14-message system required for the ASX mFunds. By making use of existing messaging tools, the demand to introduce low-return infrastructure is removed and thereby so too are the barriers to adoption. Brokers are able to buy units in the fund for a client as simply as if they were buying any other security listed on the ASX.
The Airlie Australian Share Fund may well be the first offering for this dual structure, but there is nothing stopping other fund managers pursuing this path once they have developed the required infrastructure and expertise to manage the active ETF aspect and adhere to the ASIC guidelines.
We suggest all fund managers closely monitor the progress of AASF with respect to FUM growth and which of the two channels that growth is coming from.
Rodney Lay is an Analyst atIndependent Investment Research. This article is general information and does not consider the circumstances of any individual.
