LIC Stamping fees are under pressure, with ASIC investigating them and now the Federal Government launching a 4 week consultation into the issue. Steve Bull, Founder of ETF Watch provides his opinion on the matter.
It started as a murmur in 2019, the corporate regulator, ASIC began to raise concerns about the common practice of Stamping fees paid for LIC IPOs, essentially commissions paid to Advisers and Brokers for recommendations for their clients to invest in a new LIC.
In the first few weeks of 2020, the murmur has turned to shouting from the rooftops as market commentators on both sides of the debate about Stamping Fees pitch their arguments for and against the fees. The Labor Opposition, sensing an opportunity has been quick to attack the Federal Government on the issue and now The Government has announced a 4 week consultation into the issue. All this while the country was meant to be still on summer holidays.
We touched on the issue back in July 2019. Today I will unpack the issue a little further and propose a recommendation that should be a winner for all.
For the uninitiated, stamping fees are paid by companies undertaking an IPO (both LICs and normal trading companies) and are paid to brokers for their time to help with capital raising activities. For a LIC, stamping fees are generally in the vicinity of 1.5-3%.
For a LIC who is raising capital, they essentially have a 4-6 week window to raise as much capital as possible that they then can manage into perpetuity. Payment of a 2% fee is small change when the issuer will then receive a management fee, generally of 1-1.5% per annum for the life of the fund.
Stamping fees are good for managers, there is no doubt about that. Brokers are well incentivised to sell their product in the short time available during the IPO window, giving managers more fees into perpetuity. However, it’s rare that what is good for one side of the transaction is good for the other side, even if the stamping fees are paid by the issuer (as is common these days).
Whilst ever there is a volume based incentive on the sell side (ie a commission), there is a chance that investors who are sold into a LIC IPO have been mis-sold by the broker or adviser who made the recommendation.
In my opinion the number one appeal of a LIC to the retail investor is not their company structure, franked dividends or locked away capital. The number one appeal is the ability to access an actively managed investment that can be traded efficiently and quickly through a broker screen.
Unpacking that a little further, an investor who wishes to invest in a traditional managed fund must first find one that is open to retail investors (many are open to wholesale investors only), must meet the minimum investment (often $20,000-$100,000), must complete an application form (even in 2020 many are still paper based) which usually includes complex identify checks (ever tried meeting identity requirements for a SMSF… it’s painful) and must complete more forms to add more or make a withdrawal.
With a user experience so poor, it’s clear why investing in managed funds has such little appeal to most investors. There’s one way investing in managed funds is made easy, and that is by investing through a ‘platform’ or ‘Wrap’ facility, software predominantly designed for financial advisers, that for a percentage based fee provides a centralised place to buy and sell managed funds, essentially what a brokerage account will do for a listed investment (and at no ongoing cost, other than the cost of placing trades).
The good news for investors is that there’s another solution already out there that allows them to invest in actively managed strategies through a trade in their brokerage account. The solution is the Actively Managed ETF or Exchange Traded Managed Fund (ETMF) as they are more officially known. There are now 35 Active ETFs on the ASX, and this is a sector that Australia has been a pioneer on, with the US only now adopting many of the rules that the Australian Active ETF market has been using for a number of years now.
Active ETFs trade in Australia under a unique set of rules, which allow them to maintain their intellectual property, by not having to regularly disclose their entire portfolio holdings, however they will always trade at their underlying Net Asset Value (NAV). They can invest according to almost any mandate, just like a LIC, can pay dividends at a frequency set by the manager and best of all if an investor wants to buy or sell more, they log onto their brokerage account between 10am and 4pm and place their trades, just like they would a LIC or any listed company.
The most common benefits of the LIC structure often discussed are their access to a fixed amount of capital, removing the risk of a ‘run’ on the fund in a market crash, their Company tax structure, the ability to trade at a premium or discount to Net Asset Value (NAV) and their consistency in their dividends (including franking credits). Let me briefly debunk each of these myths and explain how an Active ETF might fill the gap:
There’s no doubt that their known amount of capital is an advantage to LIC managers over Active ETF or traditional managed fund managers. They can make investing decisions without the thought in the back of their mind over liquidity to manage investor buying or selling decisions. This becomes particularly apparent in times of market stress, where the manager is finding great buying opportunities, but investors are panicking and withdrawing their funds.
The advent of the Listed Investment Trust is a solution to this problem. Once an Active ETF attracts enough capital, the manager should be able to convert the fund into a Listed Investment Trust, locking in their capital at that time. Of course investors in the Active ETF must be consulted on this process and given an opportunity to sell prior to the transfer, but if the manager is doing this for the right reasons, this should not be an issue.
We saw a similar situation a few years ago, when Forager Australian Share fund converted from an unlisted managed fund to a Listed Investment Trust. Forager cited the key reason for this transfer was to lock away their capital, giving them the best opportunity to maximise value for investors without needing to worry about liquidity.
Interestingly some LICs that are trading at large discounts to their NAV, are now looking at becoming Active ETFs, essentially the opposite of what is proposed above to solve a slightly different but still relevant problem.
Funds that require large amounts of capital to run, such as fixed income and property funds who are dealing in ‘lumpy’ assets have the institutional market still available to them to raise the funds required to make their offering viable. They can then transfer to an Active ETF or LIT with a higher capital level.
It’s the company tax structure of a LIC that allows it to pass on often fully franked dividends to investors. However, companies are not eligible for the capital gains tax discounts that individuals and Super Funds are. As a result, for many investors a trust structure that an Active ETF employs is more tax efficient even though it might feel like it is not, as the tax liability falls on the investor rather than the company. Franked dividends might decrease, but the franking credit is just a refund on the tax already paid by the company.
The Company structure also offers a level of corporate governance that is not available to a trust facility. In theory this means investors can vote on resolutions to provide better outcomes. The reality however, is that a retail investor’s voting power matters little. With an Active ETF investors can easily vote with their feet if they do not agree with how the fund is run, being able to exit at the fund’s NAV between 10 and 4 every day, without having to be concerned about discounts to NAV that a LIC in a similar situation has likely drifted to.
A feature of a LIC is its ability to trade at discounts and premiums to its underlying Net Asset Value (NAV). Investors can make great money by buying a LIC at a discount to its NAV and riding the reversion back to the mean, or lose great money by buying a LIC at a premium that then falls to a discount.
Investors in a LIC IPO are buying the investment at the underlying NAV. It’s then a roll of a dice as to whether it stays there or moves to a premium or a discount. The evidence shows that the dice has more chance of landing on a one than a six, as most new LICs move to a discount not long after they IPO.
Given LIC IPO investors are happy to invest at NAV, I’m going to assume they’d be happy to invest at NAV in an Active ETF. Discounts and premiums are a feature of the secondary market only and are a risk that many investors would rather avoid.
The company structure of LICs allows them to retain earnings and pay dividends at a rate set by the company. This is different to an Active ETF, which is a trust structure and therefore must pay all earnings each year. The results of these differing tax structures tend to mean consistency of LIC dividends and lumpiness of Active ETF dividends. Investors who rely on these dividends to fund their living expenses clearly prefer the former.
However, if targeting income focused investors, an Active ETF can easily make investing choices that aim to limit variability in their income each year, providing their investors with regular and consistent income. In fact, many are already doing this.
Innovation in dividend reinvestment plans would also help this cause, allowing investors to elect to reinvest dividends received beyond a certain amount. This innovation would need to be supported by the ASX, registries and brokers, and we expect it is low on their priority list.
Australia’s funds management industry Is one of the largest in the world. Thanks to compulsory Superannuation, there are thousands of managed funds fighting for a small slice of what is an incredibly large pie (the Superannuation industry alone is closing in on $3 Trillion in assets). So whilst 35 Active ETFs is a good start, it’s a tiny, tiny percentage of all the funds out there. Investors deserve access to many hundreds of Active ETFs like a Financial Adviser has access to through their menu of managed funds on an investing platform.
I believe there’s a couple of reasons behind this.
Firstly, the ASX has not been a strong supporter for Active ETFs. Prior to the ETF revolution, the ASX launched their mFunds product, aimed to make buying and selling managed funds easier for investors. The mFunds product was not well supported by the broker industry and has limitations compared to Active ETFs, such as its inability to trade in real time like you can with an Active ETF.
Reportedly it costs at least $200,000 per annum to run an Active ETF, predominantly through the ASX fees. This is an extraordinary cost for a small fund, and until significant investor capital has been invested will mean new funds trade at a loss for a significant amount of time. The ASX are using their monopoly like pricing powers to starve the market of more Active ETFs.
Challenger exchange the Chi-X has recently launched their ETF proposition, supporting both Active and Passive ETFs. We applaud them for supporting the industry, however, they are a secondary player to the ASX, and to really move the dial the ASX must better support the Active ETF space.
Secondly, ASIC’s concerns about Active ETFs, raised in July last year have put a fright amongst the industry. Why spend all the time and effort getting an Active ETF to market when the industry can be killed overnight with the stroke of a pen?
ASIC’s primary concern was the bid/ask spreads charged by Active ETFs. When we reported on this issue, the Bid/Ask spread of Active ETFs was 0.52%, more than double that of index ETFs at 0.23%. However, comparing the bid/ask spreads of active and index investments are a bit like comparing apples to oranges, just as management fees for actively managed products are higher, we would expect bid/ask spreads to also be higher.
These funds are often performing their own market making to protect their intellectual property, which will never run at the efficiency of a professional market maker. Buy/Sell spreads of 0.25% for each side of the transaction (0.50% in total) are common in the traditional managed funds world, which is in line to that of the Active ETF averages.
Of course there were some outliers who ASIC had a right to be concerned about, however dealing with those outliers individually would be a better approach than blanket bans.
The above comments may look like I detest LICs. This is certainly not true, I have invested in LICs myself, and support a thriving LIC industry. The reality is the arguments to support the continuation of Stamping Fees are weak, and I expect the Government who has had a summer they would like to forget will support their banning, with the changes pushed through parliament as quickly as possible in order to deflect any more mud slinging from the opposition.
Of course this will result in a reduced number of LIC IPOs, particularly in the short term. However we’ve already seen some recent LIC IPOs innovate their approach to their IPOs, including Magellan who offered bonus units to IPO investors and VGI Partners who offered investors a stake in the managing company. There’s an opportunity for a thriving LIC IPO market that benefits both managers and investors if their interests are aligned.
I’d love to see a world where the Active ETFs available to investors are in the hundreds, not tens. To support this, a couple of things need to happen:
The Treasury consultation into the stamping fee issue is open for the next few weeks. Submissions can me made to firstname.lastname@example.org. Whilst we’d love to see our recommendations around Active ETFs supported, we expect the Government to just deal to the immediate issue. Regardless, we can still hope for a more accessible funds management industry for all!