Structural revolution in the wealth management industry

(Are Unit Trusts an anachronism?)

(LICs into the next decade)
Boyd Peters
December 2014
Its too late. The structural shift has already occurred.

Chart 1: Source ATO data December 2014

SMSFs and high net wealth investors prefer to invest directly in blue-chip equities, LICs and ETFs over
managed funds, while an ever growing number of financial advisers are using these to build client
portfolios. The Traditional fund managers- while still giants by size- are losing the market share
they once took for granted and now search for ways to remain desirable to the higher-end investor.
This is an exciting time to be a part of the wealth management industry. I have not seen such a
structural shift in financial planner behaviour since the 1990s when Master Trusts and Wraps gained
widespread acceptance.
In terms of the dollars managed the unit trust are still the 900 pound gorilla and offer quality
products that satisfy investors needs. Theyre just fighting more competitors, some of whom are
growing very quickly and inflicting significant wounds. Few people on the front line are ignoring
the threat this represents.
As SMSFs become simpler to manage and cheaper to operate, more investment is flowing into direct
equities, ETFs and LICs where the discounts to NTAs are moving into (in some cases significant)
premiums. My observation is that this is a structural shift based on the ability of LICs to offer reliable
franked dividend streams. These satisfy investors needs for reliable income.
The preferred vehicle
Industry research shows that self-directed investors prefer direct equities
to unit trusts, and the wealthier you are the more you prefer them.
Investors needs are typically similar- beyond the obvious of seeking
capital growth they want dividends, franking, control, transparency, low
cost and tax efficiency. Being well educated and typically hands-on they
also expect engagement from those managing their money. Each of these features are what LICs are
renowned for.

Did I mention they want Dividends and Franking? At conferences and investor days where I man a
booth the questions I am now asked from attendees are consistent: Who are you? Reply: Were
an LIC that invests in MicroCap stocks. Which is immediately
followed by Do you pay dividends, followed then by and are
they franked? (The answers to that are essentially yes- LICs
are regarded as a machine for providing smoothed franking
dividend streams).
Having spoken to investors in such forums for over 15 years I
cant ignore the shift that has occurred over the last 3-5 years. It
is not going away. It is not a cyclical trend.

Chart 2 shows assets held by SMSFs as reported to the ATO. Even thought the market has risen
considerably since 2008, assets invested in Listed and Unlisted Trusts have only increased in 2014
(be keen to see where this went and how much went into International Funds, ETFs, Utilities, LITs
and REITS?), while Investments in Listed Shares (blue) have increased substantially. The opportunity
of course is the money sitting in cash, looking for a home. There wouldnt be a broker in Australia
who isnt looking at that Red column measuring the odds of lasting long enough to see some of that
cash come their way.

Chart 2: Source ATO data December 2014

Other than where the only way to access a specific investment type, unit trusts simply are not highly
desirable to SMSFs and high net wealth investors (HNW). Research by Investment Trends and
Wealth Insights amongst other providers confirms this. In general term they are regarded by many
as another costly, tax inefficient layer that underperforms the higher returns they believe they can
get elsewhere. While their perception may misunderstand the value these vehicles have, the
numbers in Chart 2 speak for themselves.
Desire for reliable, franked income
With the aging population more investors have income planning needs. LICs have educated investors
that as a company they can have specific dividend policies which will help investors manage their
income streams and lifestyle planning. This compares to the unit trust which relies on income
received and realised gains to be able to pay a distribution. In many instances, even as late as June
each year the fund manager themselves wont know if or how much of a distribution might be paid
that year.

With the certainty that can come from the LIC structure its hardly surprising many advisers are
increasing their clients exposure to LICs and ETFs. In the showdown between dividends and
distributions it appears there already is a winner- never mind the benefits in cost, transparency,
franking and tax.
Table 1 summarises some of the key structural changes I have observed which contribute to the shift
in allocation patters for financial advisers.

It is no surprise to see the Research houses now providing research reports on LICs for their
subscribers. Only a few years ago there was only broker research available. Now we have
Morningstar, Independent Investment Research (IIR) and Zenith amongst others. Zeniths and the
Australian Fund Manager Association annual awards also now having categories for LICs. Daily
industry e-newsletters routinely cover LIC news in their content, investor newsletters cover them
widely. LICs have clearly crossed into the consciousness of the financial professional and their
approved funds lists, and recommendations.
LICs of the future?
More fund managers are offering an LIC and even more will. Some will be responding to internal
pressure of boards asking why arent we doing what our competitors are doing? and others
because they recognise LICs are a structurally superior vehicle and satisfy the needs of many
investors. A few will simply be focussed on the revenue available from managing more money.
Financial adviser offices/ groups could one day create and issue their own LIC with specially designed
asset allocations and dividend policies. That's still a few steps away due to the need to manage
liquidity for bulk applications and redemptions, but eventually there will be a solution to
this. Potentially this could be a blend of a unit trust and LIC. With individual adviser groups managing
hundreds of millions and in some instances billions of dollars for thousands of clients, creating a
$100m LIC that invests in blue chip Australian equities is imaginable. Interesting is that irrespective
of whether the investor eventually sells their shares or even leaves the adviser/ dealer group/
stockbroker with their money, that investment remains in the LIC vehicle for as long as it is still listed.
Managing an LIC requires total commitment
One important issue for fund managers entering the space is whether they actually understand LICs
and are genuinely committed to supporting them. LICs have specific nuances and unique features. If
the LIC does not engage its shareholders properly it will not be successful and stagnate.

This graphic is a screen shot of an investment commentary provided quarterly to shareholders in an

LIC. Compare to the standard 180 word, 2 sided information sheet most fund managers provide to
unitholders. Sometimes conscious that I am writing too much in these commentaries I ask
shareholders if they
read them. In every
instance the reply is
clearI read every,
single, word.
One only has to
spend time talking
with the actual
HNW and SMSF
investor to identify
they are absorbed
with and participate
in their investments.
They also want real time information and updates. Not stories 6 weeks later. Not from underlings.
Key people- Portfolio Managers, Directors, the Chairman. Real time, readable, comprehensive,
transparent- pushed to their phone via an App.
LICs also manage multiple distribution channels in shareholders, media,
stockbrokers, financial advisers, investors associations and regulators. These
require very different strategies from the fund managers existing distribution
channels for their unit trusts which are primarily financial adviser, research
house, investment platform and industry media.
LICs require experienced and skilled personnel who fully understand the
intricacies of the LIC as both an investment portfolio AND a company listed on
the ASX.
Fund managers anticipating that their BDMs or BDAs will spend a few hours a
week on the LIC and take the occasional phone call from an investor or shareholder completely
misunderstand what is required. (As an aside, I remember watching BDMs play Im not here when
a retail client would call the fund manager instead of the unit registry. After a useless conversation
of not answering any of the clients questions and referring them to websites that the client had just
come from, the BDM then confirms such by sending a note to compliance asserting that they spoke
to such and such client but didnt say anything and certainly didnt provide any financial advice.)
LICs require full time experts that are not only portfolio specialists with interpersonal
communication skills, but are experienced in dealing with such stakeholders and know how to
operate inside of the corporate, legislative and continuous disclosure framework.
They need to personally
know their shareholders,
and work hard to ensure
they
understand
and
accept the companys
vision.
Shareholders are very different from Unit Holders. They are buying into the company as much as an
investment portfolio. They own the company, they know they own it, and they will vote. For many
their natural inclination is to vote against unless convinced otherwise. One shareholder,
irrespective of whether they own 1 share or 100,001 shares has an incredible amount of power- and
rightly so. An LIC neglects or takes their shareholders for granted at very great risk.

Market Cap positive- not cost negative

It is probably fair to say that the fund managers entering the LIC space are doing so because they
desire the consistency of the revenue stream that can be derived from the management fee.
Perhaps there are other factors such as being envious of competitors with their own ASX listed
product or pressure from a Board trying to be relevant to SMSFs and direct investors.
Whatever the reasons the manager must understand that investor relations and shareholder
communications are not a cost-drag to their revenue but are essential to maintaining after market
support and share price parity.
The LIC can also provide more profile, brand and presence for a fund manager than a spend of
multiple times that could provide through traditional industry channels. In a congested marketplace
with over a hundred fund managers vying for attention this is incredibly valuable. By the same token,
failure to successfully manage the LIC may damage the fund managers brand and reputation in
addition to its share price and ability to raise capital.
Beyond ego and responding to Board room pressure, their objective is quite transparent. Get the
options into the money and exercised to doubling the management revenues and expand the
multiples value of their business. Keep that going by growing the size of the LIC through capital
actions such as Rights Issues, Placements and Share Purchase Plans.
From my own observations I have doubts as to the ability of most fund managers to successfully
operate an LIC. So far we have yet to observe a clear distribution strategy from them or hear much
post-listing.
Over time the magnitude of new entrants will clarify what degree of structural change they believe
has occurred, or validate that they are struggling to find growth from their existing distribution
channels.
Whether they do have the ability to operate them will be apparent during the next negative phase of
the LIC premium/ discount cycle. If they are successful then the multiples that fund managers
operate on would mean it was a very good decision. Some careers could be made out of this.
The engagement party
Motivating relationship managers/ BDMs to promote and support the LIC is another vital
consideration. Management cannot assume that because they train their BDMs they are actually
talking about the LIC. Where BDM KPIs and bonus are primarily linked to net inflows the LIC- being
closed ended- will not be a priority for them and they will instead focus on their open-ended funds
when speaking with financial advisers.
This will happen because this is what already happens. Most BDMs bonuses are capped to ensure
that BDMs cant earn more than management, which results in BDMs not selling product once
theyve hit their annual targets. BDMs know this only increases next years budget hurdles.
Risk of marginalising client base
Ancillary to fund managers entering the space is that the LIC communicates directly with the
investor because they are a shareholder. Those financial planners who frame any of their value
proposition around being the intermediary between fund manager and investor will be marginalised
by the LIC doing this. With brands, reputations and distribution networks at stake the impact on
funds invested in these managers unit trusts will certainly be monitored.
The good thing is that where undertaken for the right reasons and properly managed the LIC can be
rewarding for all parties involved, including of course the shareholder who is the singularly most
important consideration. It can be offered as a complementing product into other channels. It does
not have to cannibalise or threaten existing distribution strategies and product suites and can
enhance brand and reputation.

Discounts, premiums and the new normal

How this structural evolution impacts discounts and premiums in LICs is already being observed.
Historically, LICs have enjoyed cyclical periods between discount and premiums of around 2-3 years
duration, with LICs that invest in larger cap stocks enjoying a tighter discount or higher premium
than those that invest in smaller cap stocks.

Chart 3 with permission from William Spraggett, Bell Potter Securities

T:+61 3 9235 1733 | M:+61 400 535 577 | wspraggett@bellpotter.com.au www.bellpotter.com.au
Over the last few years discounts have narrowed with many moving into premium. As can be seen in
Chart 4 the extent of premiums in many LICs is quite astounding. We are observing premiums of
10%, 20% and in 2 cases 30% in excess of NTA! That may seem madness but it is what it is, and
investors are clearly prepared to pay to own these stocks.
As this has occurred during the positive phase in the LIC discount/ premium cycle, premiums
would be expected albeit not to such extremes.
As such it is difficult to measure the structural
contribution to premiums. We probably need a
full discount phase in the cycle to observe to
observe how deep and prolonged these may now
go. Further discussion on the structural vs
cyclical aspect is found in the Tony Featherstone
AFR feature on LICs The Comeback Kings which
you can read here.
Notwithstanding, in regard to sustaining (such
high) premiums through any cycle we should not
expect these abnormally high LIC premiums to be
the new normal.
What is reasonable is to believe there to be less
potential for share prices to drop too far into
discount, for too long a period of time. If for no
other reason than where they do their (franked)
yields will be even more appealing to this enormous pool of income seeking investor.
Chart 4: Source: Morningstar November LIC report
http://www.morningstar.com.au/LICs/MonthlyReports

Understanding Premiums and Discounts in LICs

By way of discussion it should be noted that the presence of a Premium or Discount does not
indicate the actual return generated by an LIC
over any time period.
LICs delivering low actual returns for
shareholders could be disguised by their trading
at a low Discount or even a Premium to their
NTA. In 2012 I wrote A discussion paper*on the
relationship between Share Price and Net
Tangible Asset value in relation to market timing
in Australian Listed Investment Companies
(Available upon request).
Investors need to understand the distinction
between Investment Performance, NTA performance and Share Price performance. (Article I wrote
on that can be found here)

Summary
Changes have happened and changes will keep happening to investor preferences and how financial
advisers react to provide cost effective income streams for their clients.
Yield is King, and LICs can provide certainty on Dividends versus the Unit Trust which can only offer
the uncertainty of Distributions. SMSF and HNW investors like equities for the control, transparency,
dividends and franking they provide. Stable revenue streams and the inability to provide meaningful
products to these investors is encouraging fund managers to offer LICs.
This is an exciting time to be part of the wealth management industry as both the cyclical and
structural evolution occurs.
Some will get it right, some will get it wrong and careers will be made. A little bit of effort in
operating an LIC will go a long way. Those who fail to engage their shareholders will find they cant
hide behind the anonymity of large companies. With LICs there is nowhere to hide.

Acknowledgement:
The author works for an LIC and was formerly Head of Business Development for a Fund Manager. This
paper is nothing more than personal thoughts and do not reflect the view of any LIC, Fund manager or
organisation I may provide services for, nor should it be taken as providing advice of any sort.
Fair use:
Anyone is welcome to use any of this content- I simply ask you acknowledge me where you do. If
you would like this document in word format or the charts just email me boydpeters@hotmail.com

The Comeback Kings- May 2014 Australian Financial Review feature where
Tony Featherstone explores whether this is a permanent rerating or a
danger signal for investors
https://www.scribd.com/doc/250804295/AFR-Kings-of-LICs-pdf