Listed Investment Companies, commonly referred to as LIC’s, are a way for the average investor to gain exposure to professional investment managers. Having said this, not all professional investment managers do a good job of outperforming the market. Due to the structure of these investment vehicles there are also some drawbacks that can arise. Because LIC’s generally invest in listed stocks, it is usually possible to obtain a reasonably accurate measure of the net tangible assets (NTA) of the fund. Theoretically then, the share price of the LIC should trade very close to the NTA of the fund. In practice, however, this often isn’t the case.
The difference between the NTA and the share price is known as the discount (when price is below NTA) or premium (when price is above NTA) and the discount/premium can vary quite significantly over time. As a general rule, LIC’s that are performing well, with strong management, will trade at a premium to NTA. This is because investors are willing to overpay to gain exposure to the good investment performance of the fund. On the other hand, poorly performing LIC’s will often trade at a discount to NTA. Logically, this should create an arbitrage opportunity. One could simply buy the LIC and wait for the share price to catch up to the NTA. Unfortunately, it isn’t as simple as this. Some LICs will continue to trade at a discount to NTA for a very long time, and the discount could even increase over time. In order for such a trade to work, there would need to be some sort of catalyst to push the share price and NTA back in line.
Such a catalyst can sometimes come from activist shareholders. These shareholders buy significant stakes in the LIC and then push for a vote to have the company wound-up. If successful, the proceeds from the wind-up can exceed the price paid for the shares, thus realising the value of the NTA discount. There are risks in this strategy, however, as the costs of exiting the portfolio in a relatively short time frame can yield proceeds that are less than the NTA. Although as long as the discount is large enough there should still be a profit to be made.
Another catalyst might come from the management of the LIC themselves. In some cases, management will buy back shares (either on or off market) to push the share price back in line with the NTA. The reason this isn’t done very often is that it reduces the total amount of funds under management for the LIC and ultimately decreases its size. This produces a sort of conflict of interest for the LIC managers who are generally incentivised to keep the assets in the LIC as high as possible. Unfortunately, this can mean that some LIC’s trade at a discount for an extended period of time which doesn’t allow investors to exit their investment at a fair value. Nevertheless, when buybacks do happen they can be good for the opportunistic investor who is trying to make a low risk profit.
The structure that allows a fund to trade at a significant premium or discount is that of a closed end fund. This means that a certain number of shares in the fund are issued upon inception and then that number only really changes when new capital is raised. New investors to the fund have to find an existing investor to sell them their shares. Effectively, the supply/demand balance of the shares determines the market price which could be significantly different from the NTA. There is another type of fund structure that exists, an open end fund, where new shares can be bought (sold) from (to) the fund when a new investor wishes to enter or exit the fund. The trade price of these shares will be very close to the NTA and therefore guarantees that the price and NTA of such a fund cannot diverge very far.
Rivkin currently holds a LIC as part of its income portfolio and we are currently performing research on how to make a low risk profit from the premium/discount anomaly of LIC’s. Rivkin local members will be the ultimate beneficiaries of this research so consider signing up today.
