Last week we sent an email to investors in the Forager Australian Shares Fund (“FASF” or the “Fund”) notifying them that we will soon be closing the Fund to new and additional investments. We are also proposing two unitholder meetings to, initially change the responsible entity of the fund, and then to consider converting the fund into a closed-ended vehicle and listing it on the Australian Stock Exchange (ASX). Here is an explanation of what we are proposing and some common questions we have been answering.
Please note that the following is my explanation of what’s happening. Investors in the FASF will receive documentation from the Fund’s Responsible Entity in the coming weeks.
Why are you capacity constrained?
The Forager Australian Shares Fund has found the odd large company to invest in but most of our returns have come from the smaller end of the market. There is a limited universe of investment opportunities in this space and, because liquidity in these stocks is nothing like the largest stocks in the market, we need to carefully consider the size of our investments in each.
I have previously said that I thought the natural limit to what we could effectively invest in Australia was $150m-$200m. Nothing has changed our thinking on this.
Thanks to good performance and inflows, our funds under management is rapidly approaching the bottom end of this range. Last week we told investors that we will not be accepting any new investments into the FASF after Friday 7 October 2016.
Why can’t you close it to new investments and leave it as is?
But, while contemplating the necessary steps for an orderly close of the Fund to new investments, we have also been considering how else the Fund might be improved. The Fund has been well served to date by its unlisted unit trust structure. We have had relatively consistent net inflows and the vast majority of investors have an appropriate long-term investment horizon. But is this the best vehicle for the type of investing we practice?
The Fund owns a lot of small, illiquid companies, yet it offers investors the ability to redeem on a weekly basis. Investors expect us to be buying in times of market distress, taking advantage of others’ forced selling. But is that actually feasible in an open-ended fund?
The problem with redemptions
The problem is a mismatch between the liquidity offered to investors – weekly redemptions – and the liquidity of the underlying investments the Fund owns. Roughly half of the portfolio is currently invested in stocks where it would take more than one month to liquidate (in an orderly fashion) the investments. Selling them in a hurry could have a significant impact on prices, which then impacts performance, which could lead to more redemptions.
We could be faced with a situation where, rather than being opportunistic and buying stocks in times of market distress, we might be selling into illiquid markets simply to satisfy redemptions. We’d become a forced hand. That has the potential to affect me as the manager and every remaining investor in the fund.
Can’t you manage this liquidity risk?
Yes. As I write some 30% of the Fund’s assets invested in cash or highly liquid stocks. We have capacity to meet plenty of redemptions and we could make sure it stays that way.
That is not what most of the Fund’s investors want. Including me. If history is a guide, there will be another market meltdown like 2008/9 at some point over the next 30 years. If this happens, we want to be able to be as fully invested as possible. If we need to manage the portfolio for liquidity, it is going to severely hamper our ability to do that.
Why an ASX listing?
The solution we are proposing is to close the fund to redemptions (as well as applications) and list it on the ASX as a closed-ended fund. This would mean that there are a fixed number of units on issue and that, instead of being able to redeem units and draw liquidity from the Fund, investors can only buy and sell units on the ASX.
This is the ideal investment vehicle for our investment style. We know exactly how much money we have to invest, rain, hail or shine, and can get on with the job of investing it for decades to come, free from the spectre of redemptions.
An ASX listing also allows investors to continue adding to their investment by buying units on market.
What is the downside for investors?
There are obviously trade-offs for investors, or every fund would be a closed-ended listed vehicle. The most obvious being is that many closed-ended funds trade at a discount to their underlying net tangible assets. At the moment FASF investors can send in a redemption notice and get their share of the net asset value with less than a week’s notice.
If it becomes a closed-ended vehicle and an investor decides they want to cash out, the price they receive will depend on the pricing and liquidity available on the ASX.
It is clear what should be done to keep the discount to a minimum (the good ones trade at a premium). Costs need to be kept low relative to the vehicle’s assets. The manager needs to provide consistent communication to potential investors. Performance needs to be good. And the manager needs to always put investors’ interests first. That means not issuing dilutive units and buying them back when it makes sense (ideally adding value in the process).
Forager should be able to tick all of these boxes, but it remains a fact that, on the day you wish to sell units once it is listed, the price you receive will dependent on the market. And that will likely be disadvantageous at times. For the reasons outlined above, we think the long-term performance advantages outweigh these issues, but each investor will have to weigh up the pros and cons.
What would it cost and who pays for it?
Our aim is to get the FASF onto the ASX at no cost to investors. Forager Funds Management is going to bear the conversion and listing costs.
The ongoing fee and recoverable expense regime is not changing.
Would it change the way the portfolio is managed?
There would be no change to the investing strategy or concentrated nature of the portfolio. With less liquidity concerns, we could possibly be more fully invested but you should expect similar types of opportunities to crop up in the portfolio.
Why a LIT and not LIC?
We investigated the option of converting the trust into a listed investment company (LIC) but formed the view that the current trust structure is better for our investing style and existing investors. Most of the historical returns have been in the form of discounted capital gains (held for more than 12 months) and it is our expectation that this will also be true in future.
We believe a trust is more likely to be able to be able to pass those tax advantages through to investors than a company.
What does that mean for distributions?
Most LICs try to pay consistent and regular dividends. As a trust, the FASF will still have to distribute all of its taxable income every year, including realised capital gains. As the timing and amount of realised gains is irregular, distributions will probably be highly variable (as they have been historically). The availability of a distribution reinvestment plan will depend on capacity constraints and will be considered on an annual basis.
What happens next?
Investors and potential investors have been informed that the final date for accepting applications will be Friday 7 October 2016.
Unitholder meetings will be held shortly thereafter to consider resolutions that, assuming they are passed, will enable the Fund to be listed. If successful, we would hope to have the units trading on the ASX before Christmas.
What about investors who don’t want to be invested in a listed vehicle?
The redemption facility will be available until listing.
Where do I learn more?
You can ask questions on this blog, call us on (02) 8305 6050 or send an email through to [email protected]
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Forager Funds is a boutique fund manager specialising in a value investing approach. We offer an ASX listed Australian Shares Fund as well as an International Shares Fund both aimed at delivering returns for long term investors.