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Posted on 14 Sep 2017 by Alvise Peggion

Australian Fund’s Problematic Premium

Australian Fund’s Problematic Premium

 

Prior to the listing of of the Forager Australian Shares Fund, I invested $200 each month via direct debit. In my mind’s eye I could see my wealth compounding over decades as my regular savings combined with the power of compound interest.

That fund is now closed to new money. Of course, I could always use additional savings to buy more units on the ASX via my broker instead. But the investment decision is muddled due to the fact that the Fund now has two important prices that can diverge. Indeed, they have diverged.

First, there’s the net asset value or NAV. This is calculated by adding up the value of all the Fund’s investments and cash, subtracting any accrued management and performance fees, then dividing it by the number of units on issue. It effectively represents the underlying value of what investors in the Fund own for each unit they hold.

We report the NAV every business day to the ASX – currently it stands at $1.73 per unit. Before listing on the ASX, my monthly investments were added to the Fund at the NAV and hence my future return matched the Fund’s future return, setting aside the impact of tax.

Since listing the Fund late last year on the ASX under the code FOR, we now have a second price, which is the market price for units. That price is set on the ASX like any other stock – by the coming together of buyers and sellers. The market price of the Fund’s units has risen substantially due to there being more demand than supply. As a result the Fund’s market price of $2.02 is approximately 17% higher than the NAV.

On such figures, there is a real chance that any additional investments I make today at the market price earns a lower return than the underlying fund. That potentially upsets my original game plan, so I’ve recently gone back to the drawing board to analyse the impact on future investment returns.

Can I afford to buy at a premium?

The Fund has returned almost 15% per year after all fees and costs since inception in 2009. This is impressive compared the Australian market’s performance of 7.3% per year over the same period. But conditions have been generally favourable and I think it’s prudent to expect somewhat lower returns over the long term.

For the sake of conservatism and working with a nice, round number, I’ve picked an assumed average future return of 10% per year. But now we return to the thorny issue of the current premium on the ASX.

If the premium were to remain constant over time, paying it would make no difference. The black line in the chart below reflects this scenario. Yet if the premium changes, performance will vary. But the effect is most pronounced in the short term. As the years pass, the impact of the premium drops away. This is because the ‘cost’ of the premium is spread out over a greater number of years.

Australian Fund’s Problematic Premium

For example, if I buy units today at a 20% premium, and the premium shrinks to 10% over a five year holding period, my expected return would be 8.1% per year. If the premium were to fall to zero, my return would be 6.1%. On the flipside, if the premium were to increase to 30%, my performance would then be 11.8%.

Increasing the holding period to thirty years would make the returns 9.7%, 9.3% and 10.3% respectively in the three scenarios above. Not much different to the 10% I would expect to average from an investment at the NAV. Given that my investment horizon is rather long, paying even a 20% premium today doesn’t seem to hurt my chances of building wealth through the Fund much.

Reinvestment risk

There is a problem with this analysis though. Internal rate of return (IRR) calculations assume that interim cash flows can be reinvested at the IRR. In other words, the analysis assumes that I will be able to reinvest any distributions at the NAV and therefore earn a 10% return on the distributions. Unfortunately, this is unlikely if the Fund continues to perform well.

The Fund’s ability to invest at the smaller end of the market, where competition is less intense, has been one key to its success. As Alex Shevelev will expand on in a coming post, size kills in funds management. If the Fund continues to generate good returns, it will soon grow to $200m. This is the amount of money Forager estimates we can manage in the Australian market using our current approach without hurting performance. Upon reaching that ceiling, the Distribution Reinvestment Plan (DRP) is likely to be suspended, hence preventing distributions from being reinvested at the NAV.

Australian Fund’s Problematic Premium

With no opportunity to reinvest distributions, an investment at a 20% premium will yield an average expected return of 8.3% over the long term. Even if this is still better than the market return, paying the premium permanently precludes the return approaching the 10% mark.

Patience needed

So there seems no clear answer. Provided the Fund continues to outperform the market, investors might still do well over a long holding period. Nonetheless while such a large premium exists, I’ve decided I will not use my regular savings to purchase more units.

But if the history of closed-end funds is any guide, it’s likely that I’ll get a chance in the future to buy units at NAV. Perhaps even at a discount. While it’s common for new closed-end funds to trade at a premium for a while, over time unit prices tend to fluctuate wildly. Like any stock, funds can go through periods of popularity and its opposite.

While there’s no guarantee that the Fund will ever trade back at NAV, I’m happy to wait for the possibility. In the meantime, I’ve switched my $200 monthly investment to the Forager International Shares Fund. While Forager has a shorter track record in foreign markets, I’m confident the approach which has served us well here in Australia is also valid overseas.

Australian Fund’s Problematic Premium
Australian Fund’s Problematic Premium  Australian Fund’s Problematic Premium  Australian Fund’s Problematic Premium  Australian Fund’s Problematic Premium

11 thoughts on “Australian Fund’s Problematic Premium

  1. Thanks Alvise,
    you’ve over-thought matters.
    The low hanging fruit here is your last few paragraphs – patience needed and buy at a discount.
    Crikey, you guys are great at this stuff!
    It’s frustrating but in the next five years, likely in some crisis, this LIC will trade at a discount. Buy some then.
    Are you allowed to?

    • Hi Craig. Yes I am allowed to but I would have to fill in a trade form first and then get approval from management before purchasing the units.

  2. Great article Alvise.
    I’m in the same boat , brought an initial parcel at listing.
    Waiting for premium to go down.

    Got money split between Vanguard and AFI in the interim.

    Thank you for your thoughtful article!

    Dylan

  3. Hi Alvise,
    One thing that I don’t think you have taken into account is that if you have purchased at a premium to NAV, you have less money working for you so your returns necessarily will be lower. For example, if you buy in at a 20% premium, say $2.40 vs $2.00 NAV, and the fund earns 10%, i.e. 0.20 per unit, your return is only 8.3%, assuming that the premium doesn’t change.
    Leo

    • That’s true if you’re thinking about the underlying dividend yield of the portfolio. e.g. if the shares held have a dividend yield of 4% at NAV 2.00. Then based on the SP paid of 2.40 your actual underlying dividend yield is only 3.33%

      However if you’re purely looking at it from a capital growth perspective and the premium remains unchanged at 20%, then your new NAV of 2.20 (=2.00+0.20) would have a corresponding SP of 2.64 (=2.20*120%). So your SP return is 0.24 or 10%.

  4. You also skip over that if the NTA slips from say 17% to -5% – which is possible if there is an ordinary quarter or two, say a -3% return – you can get hurt quite a bit more than if the fund say dropped by 3%.

    I really find it hard to like these listed entities compared to the original fund where you had a pretty clear understanding that you were backing a manager. Not a manager and the fickle market.

  5. Yes, but can we not invert our thinking? It might be terrible for the investor but an opportunity for the fund/fund manager. Before the GFC, CVC Limited (CVC) (the listed Australian venture capital company), had a rights issue when it’s share price was trading at a decent premium to it’s NTA. It held the capital it raised until the GFC hit and the stock then traded at a significant discount to NTA. This is when CVC got busy and bought back a significant amount of stock at a hefty discount to NTA. How ingenious is that? And what creation of shareholder value!! Mr Market is the friend of the patient investor.

  6. The other factor that isn’t really mentioned is that the low daily liquidity/turnover results can result in a significant buy/sell spread which only increases with the order size.

    A quick look just now showed just 4 trades today, with a total value of only $40k.

    The lowest sell price was $2.01 but there were only around 3600 units available – want a few more and you would be paying $2.08 – want more than 35,000 units and you would clean out both these levels and be up to $2.10.

    The highest buy price was only $1.965 but, again, only for a small parcel (<4k units) – if you wanted to sell the same 35,000 units you would clean out the top 6 levels and be into the seventh level down at $1.92.

    So, even though the apparent spread of $1.965 to 2.01 is already 2.3%, the spread on 35,000 units (only around $70k) at $1.92 to $2.10 takes you up to 9.4%.

    It is easy when talking about the NTA premium, generally based on the last traded price, to forget that you can't actually buy or sell even a modest parcel of units at or near thatprice, due to the low liquidity.

    I realise that this is a problem common to any low liquidity security but, I would imagine, it is generally down to this, coupled with an underlying demand, that gives rise to the size of the premium.

  7. To quote this blog post: “For the sake of conservatism…I’ve picked an assumed average future return of 10% per year”

    To quote Darryl Kerrigan: “Tell him he’s dreaming.”

    Preserving the purchasing power of money (i.e., a 0% real return) will be an impressive feat once the ZIRP, NIRP and governmental fiscal-idiocy chickens come home to roost.

  8. Great article, I think many investors will find it valuable, I know I did.

    Do you have a view on the idea that LICs should generally trade at a small discount to NTA to account for mgmt and operational fees?

  9. The decision by Forager management to convert to a LIC was self-serving. Shareholders have gotten what they deserved by approving the conversion. Illiquidity. Inability to reinvest at NAV.

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