Investors need to think very carefully about the investment vehicle before making any investment.

Every investment needs to be assessed in terms of liquidity, market impact, fees and premium or discount to (net tangible asset) NTA

One particular vehicle that causes us concern is the listed investment company or LIC.

This is because it fails almost every test.

LICs are generally far less liquid than the underlying securities within the vehicle.

For example, if a LIC holds the top 200 shares listed on the Australian Stock Exchange (ASX), then that LIC is likely to be so illiquid that it makes investing in the LIC a very risky and dangerous proposition.

LICs and Liquidity – Potential Pitfalls

Take the example where the market is experiencing a downturn, for example during the COVID-19 pandemic. If an investor held all the shares in the ASX 200, then he or she can generally sell those 200 shares relatively promptly and without moving the market.

On the other hand, if one invests in an LIC that holds those same 200 shares at exactly the same weights, then the investor is at the mercy of the liquidity of shares in the LIC, usually only a fraction of the liquidity of ASX 200 shares.

So not only does using an LIC in this example guarantee reduced liquidity, but it also introduces two other major detriments.

One, there is no guarantee that the LIC will trade at a price anywhere near the value of the underlying securities. In fact, it is commonplace for an LIC to trade at 10-30 per cent below NTA.

It is commonplace for an LIC to trade at 10-30 per cent below NTA

How happy would you be if you bought an LIC at its public listing for $100 and it instantly fell to $80, a 20 per cent discount to NTA?

(P.S. trading at a discount to NTA is so commonplace for listed investment trusts (LIT), the sister instrument to LICs that managers often have to allocate large sums of money to a reserve that can be used to push the trust price closer to NTA when it inevitably drops)

Additionally, holding those ASX 200 shares in an LIC always adds extra fees. These fees generally outweigh any convenience from being able to hold 200 shares in a neat little bundle, especially when an ASX 200 exchange traded fund (ETF) can be had for the bargain basement price of 4 basis points.

Riding the Gravy Train

And two, we haven’t even dealt with the ‘Hotel California’ nature of LICs, whereby the manager of the LIC has a gig for life. Because no matter how often the ownership of the shares in the LIC are exchanged, the manager’s funds under management remains constant.

No wonder managers love locking investors into LICs; it is a wonderful gravy train that can last forever.

No matter how often the ownership of the shares in the LIC are exchanged, the manager’s funds under management remains constant. No wonder managers love locking investors into LICs; it is a wonderful gravy train that can last forever

If we compare LICs to ETFs, then LICs are inferior by almost every measure, except of course the one that has to do with managers getting fees in perpetuity!

No wonder that Bellmont Securities is currently using ETFs in its managed accounts. We believe that, as well as children, ETFs are the future!

This article was originally published at i3-invest.