Measure what is measurable, and make measurable what is not so.

Galileo

Investing using Listed Investment Companies (LICs) is one of the most commonly suggested investment options for Australians interested in pursuing financial independence. Yet it is also one of the least questioned, as well as the least empirically examined and supported approaches.

LIC investment is covered in many beginner personal finance and investment books such as the best-selling Barefoot Investor series from Scott Pape. Discussions of the benefits of LIC-based investing by established Australian financial independence blogs are also common and have been jokingly described as a growing ‘bandwagon’ (see for example, Strong Money Australia, Aussie Firebug and Pat the Shuffler). LIC-based and conceptually similar ‘Thornhill’ approaches are also frequently discussed and compared in Reddit financial independence threads.

A theme of much of this coverage is that LICs are a logical and preferable path for many Australian investors seeking financial independence. The universality of this theme made me curious to examine this popular proposition in more detail. As with all received wisdom it is sometimes worth looking more closely, and seeing if the claims for the position put actually hold water.

This long-read article seeks to start the process of doing that, and provide a more skeptical examination of eight of the common explicit or underlying claims for the use of LICs as an alternative to passive investing though equity index Exchange Traded Funds.

Some caveats to begin. The purpose of the article is not to suggest that LICs can never form part of a sound portfolio, or that an investor that has fully or partly invested their savings in a broad-based dividend focused LIC has made an irredeemable error that will hopelessly compromise their path to financial independence.

Any investor saving a large proportion of their income into reasonably diversified equity based investments should, on average and historically speaking, do well.

Rather, the purpose is to provide some food for thought on the risks and drawbacks of LICs for those either invested, or considering investing in LICs, drawing where possible on relevant academic and hard empirical evidence. This evidence has been either absent, or difficult to consistently spot, in the discussions on the merits of LICs and index ETFs that I have seen to date.

So, to turn to the claims.

Claim #1

LIC managers can skilfully and strategically select reliable dividend stocks

Underpinning any rational choice to invest in LICs is the belief that its management skill can reliably result in at least equivalent risk and return performance as accessible passive alternatives (such as Betashares’s A200.ASX or Vanguard’s VAS.ASX exchange traded funds) through initial and ongoing selection of equities that is enough to at least outweigh the cost of such management. Falling short of this means reducing one’s risk adjusted return with no offsetting benefit.

Importantly, an observation that some LICs may have outperformed a passive equity index even over the long-term does not tell us anything about whether this performance was due to skill or luck. Nor does it tell us, critically, whether this superior performance was identifiable in advance, compared to any other LIC available to investors at the start of the period in question that then went on to deliver below average returns. 

Those empirical finance studies just ruin everything

In fact, it is one of the most widely published and replicated empirical findings in finance literature that professional investment managers are unable to reliably outperform relevant passive index benchmarks (see Fama and French “Luck versus Skill in the Cross Section of Mutual Fund Alpha Estimates” (pdf) in the Journal of Finance).

This evidence includes exhaustive studies of unit investment trusts, which are comparable equivalents in the United States to Australian LICs. Unfortunately, recent empirical studies show that unit investment managers typically reduce returns by poor stock selection by between 2.5-2.8 per cent per annum compared to the market index, and even fail to outperform active mutual funds despite having no requirement to hold cash for redemptions (see Comer and  Rodriguez “Stock Selection Skill, Manager Flexibility, and Performance: Evidence from Unit Investment Trusts“).

It is difficult to know what to make of a lack of engagement with this established literature and record in the argument sometimes seen that the active management LICs offer the potential for superior risk adjusted returns to the benchmark.

But Australia is different, right?

An accompanying claim sometimes made to discount this clear evidence is that Australia is different, that there is something fundamentally different or special about Australian LIC managers that they are able to achieve results different to those systematically observed across other investment markets. Typically, little clear explanation is given as to why this should be the case, especially in a modern globalised equity market.

In fact, what limited published academic evidence is available suggests the opposite (see Robson “The Investment Performance of Unit Trusts and Mutual Funds in Australia for the Period 1969 to 1978“.

The unfortunate reality is that there is simply no robust evidence that managers in LICs have demonstrated any reliable capacity to select equities, or see trends in advance and act, to the benefit of their investors after costs.

Reviewing the LIC selection pitfalls: a worked example

This same point is evident from comparisons of a Vanguard Australian share ETF (VAS) and four popular Australian-managed LICs (AFI, Argo, BKI and MLT) made recently by Aussie Firebug in a discussion on moving to invest more in LICs. Taken over a recent five-year period, this analysis shows that this underperformance risk is pervasive and not avoidable in advance.

To see this, looking at the four fund and VAS example given in detail it is clear that:

• LIC underperformance risk doesn’t magically disappear if funds are split between different LICs – An investor that split their funds evenly between the four well-established LICs would have received a lower total return than if they had simply invested in the index fund;
• Choosing a single LIC doesn’t help – If an investor chose a single LIC, they faced a 2 in 4 chance of choosing a fund that would underperform on a total returns basis, and just a one in 4 chance of choosing a LIC that went on to outperform by more than 0.1 per cent; and
• Getting it wrong has real consequences – If an investor had had the misfortune to select Argo, a LIC focused on producing highly reliable dividends, they would have received a total return that was 3 per cent lower than the unmanaged Vanguard ETF, with a lower dividend.

Updating the worked example: the problem worsens

Updating this example with Sharesight returns data to 14 January 2019 further demonstrates the potential risks. Using the past 5 years of data a depressing picture emerges in which:

• Performance universally falls short – All four LICs underperformed on a total returns basis by more than 1 per cent, a worse result than chance might suggest;
• Even the claimed dividend performance of LICs is ‘hit and miss’ –  2 out of the 4 of the LICs delivered lower dividends than the VAS, meaning an investor choosing a single LIC fund had only an even chance of keeping up with VAS dividends;
• There was still no help from diversifying between LICs – an investor splitting their fund evenly between the LICs would have received a total return that was 2.3 per cent lower than the index alternative (VAS), and also would have received lower dividends; and
• The laggard performers fell even further behind – with AFI investors receiving a total return around 3.4 per cent lower than the Vanguard VAS ETF alternative, with a lower dividend just adding to disappointment.

The recently published ETF and LIC annual performance report by ETF Watch turns up further anomalies, of commonly discussed ‘established, steady and reliable’ LICs paying lower income, and experiencing higher return volatility than equivalent benchmarks (such a VAS).

Of chance, LIC selection and cognitive dissonance

Of course, some of this could be the result of chance, but this is a knife that cuts both ways – in particular, into frequent objections along the lines that “…but LIC XYZ has outperformed the market over the past 10 years”.

Simply put, a claim that ‘XYZ LIC delivered returns of 7% where the market delivered only 6% during this period’ is not convincing evidence of management skill that an investor should pay much attention to. As noted above, academic evidence consistently demonstrates that most managers destroy value, and those vanishingly few skilled managers who will outperform (by chance or skill) are not identifiable in advance.

It is striking to see investors who willingly and rationally concede their own inability to make individual equity selections – by the very act of considering a LIC or index investment – to go on to act as though they are likely to be able to exercise some value-adding investor skill by seeking to research and make distinctions between even a relatively small range of well-established LICs investing in broadly similar assets.

Claim #2

Relying on LICs that have been around for decades adds safety

Many proponents of LIC-based investing advocate following an investment rule of only investing in older ‘tried and true’ and well-known LICs, for added safety. This rule was recently discussed, for example, in Aussie Firebug’s interview with Peter Thornhill (see 22:00-23:00 of this podcast).

Trusted brands in markets usually exist because past performance of a product or service gives confidence in the ability and incentive of the business to continue to deliver a good standard of service.

This is a reasonable approach to take to purchases of jeans, cars, and many services. It is a potential trap when it comes to actively managed investment products.

Tried and true – or a partial sample overdue for mediocrity?

This is because of two factors:

• Survivorship bias – when investors compare the performance of Listed Investment Companies with alternatives, they are comparing the performance of LICs that have survived the period of comparison, which is only a subset of those investors actually invested in. Active funds and LICs that underperform for substantial periods typically close, leaving the actual comparison being made between those firms that performed well enough to survive and the benchmark. This is not the relevant comparison. Rather, the relevant comparison is: how did the average active fund or LIC that might have been chosen by an investor perform? In many cases, the average fund or LIC is located in the metaphorical graveyard. Some US estimates of this effect are that it leads to the equivalent of an overstating of likely returns from actively managed funds of around 1.5 per cent (see Malkiel, A Random Walk Down Wall Street, p.270); and

• Performance is not persistent – While a LIC may have a strong investment selection process that performs well in one market, past performance does not tell an investor anything about likely future performance. Indeed there is some academic evidence that the performance of newer managers is systematically stronger that those will a long track record:

“Pastor, Stambaugh and Taylor came to another interesting conclusion: The rising skill level they observed was not due to increasing skill within firms. Instead, they found that “the new funds entering the industry are more skilled on average than the existing funds. Consistent with this interpretation, we find that younger funds outperform older funds in a typical month.”

Good managers never die, they just get replaced by average managers

In any LIC operating over decades, the investor is invariably assuming a ‘manager risk’ – i.e. the risk that a given manager will make mistakes that see them lose money against the benchmark.

This is not alleviated by selection of ‘tried and true’ LICs. In fact, there is good empirical evidence that manager risk is not just the risk of current managers making errors, as some studies have shown that investment company owners typically hire managers with good track records, which on average disappear right after appointment (see Goyal and Wahal “The Selection and Termination of Investment Management Firms by Plan Sponsors” (pdf) in Journal of Finance).

Claim #3

LICs are ‘more diversified’ and lower risk than the index

The claim is sometimes made that LICs are superior because they are ‘more diversified’ than equivalent equity indexes.

Often the point being made is that the Australian equity index has significant banking and resource components, and that LICs are investing in a more diversified set of ordinary industrial or other businesses that will exhibit lower risk or volatility over time.

The risks of index departure

This claim is hard to assess on its face because the role of diversification is to lower risk of loss or underperformance. If a LIC has a different make up to the index it is important to recognise that two things are potentially happening. The LIC could be:

1. Making sector bets – making a series of active sector bets compared to the market index; and/or
2. Assuming lower market risk (or ‘beta’) – in which case expected returns will be lower than the market and the same outcome could be achieved with lower cost through a market index added to a bond or cash position.

If active sectoral bets are being made, the managers are by default making an active assessment that the return from a subset of sectors within the broad market composition will outperform the whole.

The same record of evidence applies here as the broader, incorrect, claim that LICs demonstrate a capability to outperform the market index. Long-term evidence for sectoral outperformance is not strong, and returns data instead tends to show final returns from each sector such as financials, resources and remaining firms are strikingly similar, as the Reserve Bank of Australia recently noted (see graph below).

Risk happens from what is left out of the LIC portfolio, not just what is left in

A further problem for the claim is that LICs often have substantially narrower set of holdings than comparable benchmarks such as the ASX200 (which can be invested in for a 0.07% MER though Betashares A200).

Importantly, these LIC holdings are human selected, meaning that LICs can fail to acquire the critical dividend producing firms of the future, or fail to sell those that persistently underperform.

By contrast, a passive index approach means an investor will always hold those firms that rise to become earnings producers of the future, and have eliminated from their portfolio those firms whose poor returns performance sees them drop out of the index.

This is a critical strength of index investing, because of a characteristic of equity markets that a failure to invest in a relatively small proportion of total firms can mean missing the majority of the strong historical performance of the equity market.

That is because firm earnings are highly skewed, in statistical terms – that is, a small number of firms account for a disproportionate amount of future earnings and growth. Missing those rising stars will inevitably result in underperformance compared to a passive index.

Claim #4

The closed unit structure of LICs provides greater protection investors from panic, and enables bargain hunting

A further claim sometimes made for LIC investment is that the ‘closed end’ structure, where units are traded but not created automatically by new investors joining the fund, is a positive advantage compared to Exchange Traded Funds.

This time, I’m different, or ‘hell is other people’

Typically, so the argument goes, investors are irrational and emotional, and therefore:

• An investor will be able to purchase their LIC’s at prices systematically cheaper than ‘fair value’ (usually assumed to be the published Net Asset Value); and/or
• An investor will be protected from cost or return consequences of the ‘herd’ of investors leaving an ETF fund in response to market falls.

One should always be suspicious of arguments based on assumptions that others will behave – or are behaving – irrationally, whilst one’s own conduct will be guided by a consistently superior temperament or insight. As is commonly observed, far more people similarly consider themselves to be above average drivers than can statistically be the case, and overconfidence is a key contributor to poor investor returns.

There is little evidence to suggest that any investor can systematically buy individual stocks at below their fair market value. In fact, empirical academic evidence such as the classic study by Odean and Barber The Behavior of Individual Investors (pdf) which uses real trading account data consistently show that investors:

• Underperform standard passive investment benchmarks in stock selections;
• Sell winning investments while holding losing investments;
• Unduly weight past returns in purchase decisions;
• Engage in learned reinforcing behavioural loops, repeating actions that brought pleasure in the past (in part this could account for the popularity of the injunction to “buy the dip”).

There is no clear reason typically suggested why this situation would be transformed by the introduction of a LIC structure between the underlying stocks and the investor.

In fact, making a single individual stock purchase decision is arguably a much less complicated analytical decision than buying a bundle of 50-100 equities in one LIC versus another. In such a comparison of bundled products the information disadvantages and complexities faced by the LIC purchaser is multiplied exponentially.

NAV-igation errors?

In a way, the myth of the ‘bargain’ LIC bought ‘on sale’ is understandable. The presence of a published Net Asset Value (NAV) seems to suggest an alluring prospect of the ‘true value’ being on display, opening the gates to the possibility of buying a set of assets below their actual value. Yet, this view ignores a few cautionary facts.

LICs are capable of being valued, and differences between their underlying asset values and prices are subject to arbitrage opportunities by well-informed market participants with greater access to information, trading execution speeds and expertise than any average retail investor.

It is unclear on what basis an individual investor could reasonably be expected to consistently be on the winning side of this grossly uneven contest.

Shallow reefs to port, or a storm to starboard?

Indeed, the situation is worse just than being up against well-informed market players in trying to ‘bargain hunt’ a LIC at below its NAV.  It turns out that a buyer faces a difficult choice with ambiguous and incomplete information regardless of whether the LIC is trading at a premium or not.

If the investor purchases at a premium to NAV, they are, all else equal, paying above market prices for a stream of future dividends, compared to buying the same shares and dividend entitlements directly on the open market. This is the equivalent of buying a loaf of bread for $2.20, when the same loaf can be purchased for $2.10 from a shop next door.

The typical answer to this is that one is paying a ‘premium’ for the supposed skill of the LIC manager, that is, one is locking in paying an upfront price now in the hope or speculation that any past superior performance was skill-based, and repeatable. As has already been seen under Claim #1 however, evidence for either of these propositions is scant.

A simple rule that suggests itself might therefore be to avoid ever purchasing a LIC at a premium to NAV, and some have adopted this rule. This apparently neat solution runs into a few difficulties though. For example:

• Out of the market – Some LICs trade for quite extended periods above their NAV, meaning the investor will be effectively locked out of some LICs, and be forced to choose a non-preferred alternative;
• Aged NAVs – Given NAVs are not always updated regularly, investors may be making purchase decisions on out of date and non-transparent valuations, and end up paying a premium anyway (note to try to mitigate this recognised problem, Pat the Shuffler recently developed a NTA estimator);
• Discount for a reason – The trading of a LIC at a discount to its NAV could well not be a random opportunity to buy goods at less than fair value, it could instead reflect real price relevant information that trading market participants setting prices have that the ordinary retail investor does not have.

The logic of the argument that LICs provide a special protection against market panic is not readily apparent.

LICs shares themselves are subject to the same herd panic risks as their underlying share holdings, with the added risk that the market for individual LICs may be less liquid than the markets for their underlying holdings or ETF alternatives commonly also used by institutional investors (for a discussion of some of the misconceptions of ETF liquidity, see here). Moreover, the same arbitrage opportunities that keep LICs broadly in line with valuations of their holdings could be expected to expose LICs the same pricing pressures as the equities that make up their holdings.

Claim #5

LICs are just a substitute for low cost index ETFs – which way to go is just a question of taste

Perhaps in recognition of some of the weaknesses in the claims made, a further position sometimes put is that LICs and ETFs are effectively close substitutes, with the choice between them coming down largely to a matter of personal taste.

This is difficult claim to support, when considering that:

• LICs typically have holdings that differ significantly from the capitalisation weighted market index, meaning that a different return and risk package is being purchased;
• If the LIC does happen to be broadly invested in weights that closely reflect an equity index such as the ASX200, then they are effectively charging a mark-up for providing index-like results – a phenomenon so common it has been dubbed ‘closet indexing’
• LICs cannot reliably be selected in advance in a way that will match index return;
• The majority of LICs can be expected to underperform their closest relevant index benchmark, due to a proven inability of investment managers to reliably outperform passive index benchmarks after costs;
• LICs can often have higher management costs than their equivalent benchmark, lowering returns even before an expected underperformance penalty – and if the LIC costs are lower than an unmanaged equivalent, a skeptical investor is at least entitled to wonder about the likely extent of actual value-adding research resources available to management; and
• An investor not willing to pay a premium penalty over the current market value of the dividend flows (intrinsic value) may not be able to purchase their desired LIC at any given time.

These are substantial, and compounding, factors and differences that will have real world effects on a portfolio. They will affect returns, risks, out of pocket costs, the time taken to reach financial independence, and potentially willingness to stay on the journey.

Impacts of differences

As a practical example on costs – even small differences compound over time. This means that over a 25 year holding period a LIC investor paying 0.15% (around the level of many established LICs frequently suggested for consideration) could be paying as much as $27 500 extra on an $250 000 portfolio when compared to a purchase of the low cost Betashares A200 index exchange traded fund.

Note that this example assumes no particular ongoing performance disadvantage, or bad purchase timing with NAV premiums. Paying $27 500 to potentially assume the accumulated manager risks accruing over 25 years, and to obtain index-like or worse results does not sound like a close or effective substitute.

There is a role for personal tastes in investment and everyday purchase decisions between close substitutes. One day, you might prefer lemonade over cola. On another day, you might make the reverse choice.

But the differences between LICs and indexes are more fundamental than such a trivial everyday choice. If either are to form the cornerstone of a journey to financial independence potentially involving the investment of hundreds of thousands of dollars over a decade or more, the differences and risks should be consciously and carefully considered and accepted.

Claim #6 

LICs may earn lower returns from their focus on dividend stocks, but still fits with my investment needs

This is not so much a claim, as a position reached by some who either don’t make, or have abandoned, Claim #5 that there is no significant difference between capturing whole of market returns, and the smaller actively chosen portfolios within LICs.

For those taking a conscious choice to accept a combination of lower overall returns, and potentially higher portfolio volatility, from the selection of a LIC, there is no reasonable objection that can made.

This decision should flow, however, from a close and full appreciation of one’s own risk tolerance, and the actual risks of underperformance to an investor’s financial independence goal.

The cost of locking in a persistent below market return should not be underestimated. Compounding will significantly widen the gap between outcomes of an investor earning even 0.5% less over a significant period, and have the potential to result in either higher savings requirements to reach the same outcome, or lower protection against the key risk facing investors of not earning sufficient real returns after inflation.

Claim #7

LICs have special value because they provide a more stable flow of dividends

Another claim made is that LICs provide a smooth and stable flow of dividends, compared to alternative index ETFs. This is due to a policy of many popular listed investment companies choosing to retain some of the dividends they receive for the benefit of their investors, in order to pay out these dividends during future periods of dividend cuts.

 Paying another for self-control

The important thing to consider about this service is its value to an investor, versus its price.

In some sense, this dividend retaining approach by LICs is a benevolent act of the same kind as a parent withholding some of a child’s weekly pocket money in case it is spent unwisely. Importantly, however, over any period of investment it is likely to be slightly net present value negative, given than a benefit is being withheld through time, for future payouts. Arguably, if the LIC reinvests this cash, the opportunity cost to the investor is reduced somewhat. What is still lost, however, is the opportunity cost of being able to use the full dividend amount in the way the investor best sees fit at any given time.

There are perhaps some psychological benefits from this ‘dividend smoothing’ service. The same essential function, however, could be replicated by the investor, whilst retaining quarter to quarter to flexibility, if desired, with one option being through simple employment of ones bank account. Again, choosing to accept this externally imposed control may have value to an individual.

Some hidden risks and costs of outsourcing control

But if there are benefits, there are also hidden costs and risks.

In any rapid and sustained change in earnings and dividends payments, LIC distributions will potentially send a false signal of comfort, and not alert an investor that lifestyle or spending adjustments may be justified.

The unhappy fact for investors is that usually a LIC is either withholding part of your owed distributions, or it is paying to you a stream of income that is not sustained by the underlying earnings of its portfolios. Neither outcome appears an unmitigated positive.

Claim #8

But fully franked dividends…there are clear tax advantages inherent in the LIC structure

A final claim sometimes made is that the company structure of LICs confers some special benefit on investors relating to the receiving of franking credits.

In fact, once fully traced through the situation is as you would expect in any rational tax system – the vehicle does not magically alter the total effective liability. Aussie Firebug has ably debunked this claim already.

Summing up – taking their LICs

Many of the claims of benefits of LICs compared to passive equity indexes do not appear to be supported by relevant academic or empirical evidence.

The decision to select a LIC rather than a passive equity index ETF carries with it a range of risks that have been well-documented over past studies, such as taking more risk than necessary, to achieve below average results.

Yet there are a series of other, less visible, risks and costs that also lie in wait for even those investors that seek to mitigate against the weaknesses inherent in relying on actively managed LICs.

Careful thought is warranted about the risks, costs and tradeoffs being assumed in investing in a LIC, particularly if it forms part of a plan to achieve financial independence.

To learn more about my own choices and investment path start here, review my goals and investment plans or browse all posts here.

Further reading

Barber, B and Odean, T. “The Behavior of Individual Investors” in Handbook of Economics and Finance, Vol 2, Part B, 2013

Comer, George and Rodriguez, Javier Stock Selection Skill, Manager Flexibility, and Performance: Evidence from Unit Investment Trusts May 19, 2015

Ellis, C. Winning the Losers Game: Timeless Strategies for Successful Investment, McGraw-Hill, 1993

Fama, E. and K. French, 2010, “Luck versus Skill in the Cross Section of Mutual Fund Alpha Estimates,” in Journal of Finance, 65, 1915-1947

Goyal, A and Wahal, S. The Selection and Termination of Investment Management Firms by Plan Sponsors in Journal of Finance, August 2008

Kohler, M. ‘The Long View on Australian Equities’ Presentation to 31st Australasian Finance and Banking Conference, Sydney – 13 December 2018

Malkiel, B. A Random Walk Down Wall St, W W Norton, 2003

Robson, G. The Investment Performance of Unit Trusts and Mutual Funds in Australia for the Period 1969 to 1978 in AFAANZ Journal of Accounting and Finance, November 1986