Since announcing the closure of the Forager Australian Share Fund to new and additional monies, and proposing to list the trust on the ASX, we’ve received a few questions from investors about whether each listed unit will come with a one-for-one option to acquire more units at a later date. I’ll explain the concept of ‘free’ LIC options more fully in a second but first, an answer.
The official company line is:
My more complete answer is:
No. No, no, no, no. Nein. Damn no. We’ll never pull that crap on our investors.
To give some background to the questions, many Listed Investment Company (LIC) floats – starting about 12 years ago with a crop of new wave LICs – came with so-called ‘free’ LIC options. You’d pay, say, $1.00 for a stock that had $1.00 of net asset value (NAV) – and I’m being generous here because, as most floats tended to pass off most of the floating costs on the new investors, NAV’s were typically 97-98 cents. But who’s counting?
In addition to every share you bought for $1.00, the manager generously gave you an option over an additional share, at no additional cost. Sometime down the track, usually up to three years later, if the stock was trading above $1.00, you’d be able to buy a bunch more shares for just $1.00, locking in an instant capital gain. Milton Friedman busted—free lunches all round.
Unsurprisingly, investors ate it up. For a while. But then a funny thing happened. The shares of all these new LICs soon traded at sharp discounts to underlying NAV. Perplexing? No. It happened for a very valid reason.
That reason, repeat after me:
There is no such thing as a free LIC option.
Tails you lose, heads you win half
The simple reason why is that anything you gain on the option, you lose on the stock.
Just putting the LIC options to one side for a moment, think about how the market should price the shares once they come to market. It’s best illustrated by example.
Let’s say that over the three years following the float, the market tanks 50%. And let us generously say that the stock still trades at NAV. So you’re down 50% on your initial investment. Sort of matches everything else in your portfolio.
Now consider a situation where the market rises 50% over three years. Other stocks you own are up an average of 50%. Other LICs you own that don’t have attached options are also up 50%. The headline NAV of the LIC discussed here similarly rises from $1.00 to $1.50. You think you’re going to be up 50% on this stock too, right?
Then bang. Everyone exercises their options to buy additional shares for $1.00. The company gets flooded with new cash, and issues a bunch of new shares that dilute the value of the existing shares. Because of the one-to-one ratio between shares and options, the fund’s NAV drops to $1.25.
So the stock itself becomes a sucker’s bet. If it fails, you’ll feel it in full. But every percent gained is shared equally with option holders (see the diagram below).
The logical response is for investors to mark down the value of the shares immediately after float, to the point where the combined value of the option and the stock add up to the underlying NAV (it is perhaps a blog for another day, but the more volatile the likely investment results and the longer-dated the option, the more value should be attributed to the options vis-à-vis the shares).
While the options are marketed as free, they quite clearly have a cost. There is, after all, no such thing as a free lunch.
The only free option is for fund managers
Or is there? Look at the above example but now from the fund manager’s point of view.
There’s one future that sees the LIC options expire worthless. No skin off their nose.
But there’s another future that sees the LIC options ‘in the money’, with the stock trading above the option subscription price. In that case, there will be a flood of subscription cheques and the fund manager will double their funds under management, almost overnight.
Tails I lose nothing, heads I win big.
Turns out that this Friedman fella was wrong after all. He couldn’t spot a free lunch if a fund manager slapped him across the face with a smoked salmon baguette. The trick is to understand that the only real beneficiary of these free LIC options is the fund manager themselves, not their investors.
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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.