Investing in closed-ended trusts
Premiums or discounts to intrinsic value are a normal and inherent part of the successful functioning of listed markets. As with any listed shares, investors in Australian Securities Exchange (ASX) listed closed-end investment funds (commonly known as listed investment companies/trusts) should appreciate the opportunities and risks that this creates.
What happens when an investor buys/sells shares?
Listed Investment Companies and Trusts (LICs and LITs) are ASX-listed closed-end investment funds.
If an investor seeks to increase or decrease their investment in the LIC/LIT, they may buy or sell shares in the LIC/LIT through the stock exchange. This transaction involves an exchange of shares between investors. The capital of the LIC/LIT itself remains unchanged.
In contrast when investors buy or sell exchange traded fund (ETF) units or deposit or withdraw money to or from an unlisted fund, the capital of the investment fund rises or falls and the fund must buy or sell investments to the extent there are more net buys or sells.
LISTED INVESTMENT
The price at which listed closed-end fund shares/units trade is determined in the open market by buyers and sellers.
Buyers and sellers will agree on a price that reflects the underlying net asset value of the fund, any other perceived influences on value and the effect of supply and demand of the fund’s shares/units on the day of trade.
As a consequence, the market price of a listed closed-end fund may be higher (trades at a ‘premium’), the same as, or lower (trades at a ‘discount’) than the net asset backing of the fund.
As with the purchase or sale of any listed share – fluctuations in the open market price are the method by which the volume of buyers and sellers may be matched. This is a normal and integral function of open market pricing on share markets.
This is also the fundamental mechanism that provides investors with the ability to increase or decrease their investment at any time while concurrently allowing the fund to make longer term investment commitments.
As with the purchase or sale of any listed share, the potential to buy or sell a share cheaply or at an expensive level creates a dimension of opportunity and risk that should be appreciated by an investor.
Both history and theory suggest that closed-end fund premiums and discounts may change over time due to:
- Changes in perceived value (examples include a change to investment strategy, personnel, cost structure, taxation, regulation or size);
- Changes in the demand for the underlying assets of the fund (for example, changes in the economic outlook); and
- Changes in the supply of the fund’s shares (examples include a new issue of shares or a buyback of shares).
The price at which investors buy and sell in the open market has no direct impact on the income or gains generated by the fund’s assets.
This means that an investor who has bought their shares at a discount will be receiving the benefit of an investment return on an asset backing that is higher than the price they paid, over the period during which they continue to hold their shares.
OPPORTUNITIES AND RISKS
Similar to an investment in any listed share, an investor in an ASX-listed LIC/LIT may be exposed to the opportunities and risks that stem from:
- Favourable or unfavourable changes in the premium/discount to intrinsic value between the date they purchased and the date they sell their investment;
- The opportunity for added return from acquiring an asset for less than it is worth, and the risk from acquiring an asset for more than it is worth; and
- To the extent (if any) the open market value of the shares may affect the investor – favourable or unfavourable movements in that market value.
Typically, investors in ASX-listed investment funds will seek to adopt an investment strategy that allows them to control the risk and/or capitalise on the opportunities created by open-market pricing.
NET ASSET BACKING
All LICs and LITs disclose their net asset backing to the ASX within 14 days of each month-end.
An investor may compare the net asset backing to the traded share price on that same month-end to determine the premium or discount. In many cases this information will be shown on the LIC/LIT’s monthly asset backing releases.
A LIC or LIT’s monthly net asset backing release can be found as an ASX announcement on the ASX website or in most cases can also be accessed directly from the LIC or LIT’s own website.
Importantly, investors should understand that the premium or discount at which a LIC or LIT trades during a month may differ from the month-end premium or discount.
While generally there is some synchronisation between the movement in the LIC/LITs net asset backing and its share price, the two items can be expected to move differentially and as a result the premium or discount may grow or shrink.
Researchers, stockbrokers or investors specialising in LIC/LIT investment will often estimate the daily asset backing of LICs and LITs. They may seek to calculate these estimates based on the movements in the market values of the LIC/LIT’s major investments, or from movements in an appropriate benchmark index for the LIC/LIT. (For example, the S&P/ASX 200 Accumulation Index return may be used as a guide to the daily return of a LIC investing in a diversified Australian share portfolio).
Investors may be able to access daily or weekly LIC/LIT premium and discount tables from the stockbrokers or research providers specialising in this area.
Investors should appreciate that LICs are tax-paying companies (and are slightly different to LITs). They will often quote their net asset backing on a Before Tax Provision basis, as well as an After Tax Provision basis.
The Before Tax Provision net asset backing is equivalent to the net asset backing of a LIT or managed fund, and is generally considered the asset backing that should be used to determine the fair value for the LIC, and to determine the LIC’s premium or discount.
The simple explanation is that while LICs may make a provision for company tax which reduces their net asset backing, investors will receive the benefit of a franking credit for tax paid when the LIC subsequently distributes its profits as franked dividends. For those more technically minded, a financial calculation properly allowing for the flow through of tax through the franking credit will mathematically illustrate the Before Tax Asset Backing as the more correct measure of value.
PREMIUMS AND DISCOUNTS IN ACTION
Some real-world examples of LIC/LIT premiums and discounts are shown below.
Example A: Australian Foundation Investment Company Ltd [ASX: AFI]
Australian Foundation Investment Company (often referred to as AFIC) is Australia’s largest listed investment company. It holds a diversified portfolio of listed Australian shares. AFIC has traded across a range of premiums and discounts over the last five years. At its most expensive it traded at a 12.6% premium to net asset backing, at its lowest it traded at a discount of (4.0%), and it has traded at a 2.2% premium on average over the five years.
A long-term investor seeking to buy and accumulate AFIC shares, and who was able to acquire shares at the cheapest point will benefit from the company generating investment returns on the asset backing that was 4% higher than their purchase price.
Example B: Future Generation Investment Company Ltd [ASX: FGX]
Future Generation Investment Company provides exposure to a diversified range of Australian share funds, managed by leading Australian fund managers.
The company has traded over the last five years from a discount of (17.3%) to a premium of 7.4%, and at an average discount of (4.6%).
An investor acquiring and accumulating shares at the point of largest discount would have benefited from the company generating investment returns and paying dividends on an asset base that was 17.3% higher than his purchase price.
Angus Gluskie is chair of the Listed Investment Companies and Trusts Association (LICAT).
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