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.
20 thoughts on “Nothing ‘Free’ About LIC Options”
Good article Gareth. Often the listed investment company will find an underwriter to place, for a fee of ~2-3%, all unexercised LIC options at maturity. AWQ.ASX a recent example. This guarantees a cut in the net asset value on a per share basis. No free lunch indeed.
Or the fund manager buys the options himself, exercises and is happy to sell the shares immediately for a small loss in order to grow the permanent FUM.
The guys at NAC.ASX are busy with that at the moment and it remains to be seen whether diluting the NTA for everyone is offset by creating a larger investment vehicle that may eventually cause more investors to want to buy in. A sudden flood of over 100 new buyers today in NCC.ASX where they did a similar thing some months ago has caused the NTA gap to close somewhat……
thanks for the excellent explanation
What if the fund managers pay themselves an annual 1-2% fund management fee, based on funds under management? This big jump in fund size from the exercise of the options is a nice bonus for the fund manager baby-sitting the new cash until it is turned into good stock picks.
Hmmm. Once one is issued with LIC options, why not immediately sell the underlying and retain the options? Eat somebody else’s lunch…
No free lunch. You’ll pay, say, $1.00 in the float for the share and the option. On day 1, all things being equal, you’ll have an option worth, say, 7 cents but a stock nobody will buy for more than 93 cents
Ah, ceteris paribus, but often they are not 😉
Broadly agree, though, Gareth. “Free” options a gimmick at best.
‘on average’ might have been a more enlightening term. There might have been some anomalies, especially with some of the earlier LICs, but the market is not silly enough to consistently get it wrong.
I have done quite well out of free and low cost ‘loyalty’ type options, yes its a cheap way to raise capital/issue shares, but its all up front and known, most of the free options issued by the new LIC’s over the last 2 years or so have expired worthless, so no damage done.
The option does not detract from the value but rather is part of the value. The option is therefore not a liability but neither does it add any value.
When (any) options are exercised they dilute the shareholding, with a company this is usually expressed as earnings dilution, but with LIC’s it can be expressed as NTA dilution, either way dilution is dilution.
Once listed these options can be an excellent and low risk way of investing in the fund. You could buy $10K of shares in the LIC, or for $100 you can get the same number of options. The benefit with the option is the limit in the downside. In this example, the upside is the same but the downside is only $100 as opposed to $10K
the article is technically correct in that the LIC is effectively raising new capital at a discount to NAV, hence the dilution, however as long as you a) participate in the IPO and b) exercise, you will not be diluted. The dilution actually comes through having to sell something else to pay for the option exercise. The guy that is diluted is the aftermarket participant that holds the stock though the exercise period. In actual fact the LIC should be marketed as a 2-part raising, with the IPO stage one, and option exercise stage 2: After stage two is complete you then have an accurate picture of how much capital has been raised and at what average price.
The flexibility for the LIC to retain capital that would normally be distributed in a unit trust structure and compounded over time is one of the most beneficial aspects of an LIC structure
Gareth isn’t arguing that the options detract from the value of the package (option + share). The issue is that they are marketed as “free”. The argument goes that you don’t need to worry about the fact that the NTA is only 97c on day one (or, my favourite, $1.07 for a $1.10 issue price) because you are getting a “free” option. Gareth’s whole point is that whatever value the option has detracts from the value of the shares – the combined package can only be worth $0.97 on day one.
Incidentally, a good way to potentially exploit this phenomenon is to keep an eye on the prices of listed LIC options like PAIO, they sometimes offer very interesting asymmetric payoffs when they are out of the money.
Often, the prices of listed “free” derivatives (e.g., listed rights) become crazily cheap because uninterested investors dump these tiny holdings onto the market without much regard for their price, and their time on the market is so short and their liquidity so low that most sophisticated market participants either don’t bother or are unaware of their existence.
The graph above is very misleading. Note the label on the vertical axis-the graph compares apples and oranges by omitting the option/warrant value and seems to imply the “LIC share with option” produces inferior performance. In fact, it does not when evaluated in totality. The returns are identical.
Tremendous confusion seems to reign about the definition of “NAV”. “NAV” must always be NAV PER SHARE, fully diluted, and must ALSO include option/warrant value. Ignore “headline NAV”, yes, but do NOT ignore option/warrant value. The graph omits option/warrant value: NAV per share in the example is $1.25 fully diluted NAV + $0.25 warrant value, and the latter value is realized upon exercise at $1, enabling the capture of the additional $0.25.
The proper conclusion/headline here is: “Free Options/Warrants: You Get What You Pay For. Nothing.”. Options/Warrants are a complete wash-they are free and shareholders gain zero value from them. Yes, the fund manager gains additional assets. But so what? Maybe it’s good, maybe it’s not. Caveat emptor-investors should factor options/warrants into their investment decisions.
Yes, “headline NAV” may be misleading, but so is this article. Forager seems to be trying to disparage LICs which issue such Options/Warrants (I am not in that LIC camp, let me assure you). Instead, Forager maybe should just have presented its analysis better and more neutrally as an educator. I hope Forager’s stock analysis is not as biased and muddled!
To me, seeking LIC status and gaining “permanent capital” as Forager is now seeking to do, is much more self-serving and detrimental to investors (by removing the right to redeem at NAV) than issuing options/warrants.
P.S. For the smarter of you/us reading this, I am sure you know where the opportunity lies in this confusion…
I don’t think we disagree on anything substantive re LIC options, Maurice. You clearly understand it – that the option isn’t free and that the value comes from somewhere else (the stock). But my experience is that not everyone gets it – I don’t think it’s an exaggeration to say that I’ve talked to more than 100 subscribers in my 11 years at the Intelligent Investor newsletter that didn’t grasp it intuitively like you have, many felt they were getting something free. This article was written with them in mind. That chart was intended to show them where their ‘free’ option came from, and why we don’t intend to pursue that strategy. The value of the option is clearly marked in the shaded area – apologies if it doesn’t make the example clearly, it wasn’t designed to obfuscate.
We believe we’re doing the right thing by unitholders in closing the fund to additional money and listing it. But I’ll leave it to those unitholders to decide whether we’re being self-serving, it’s their vote. I’ll pass on your feedback to Steve and the team. There are a lot of good and frank comments around both the pros and cons in this blog post – https://foragerfunds.com/bristlemouth/fixing-future-forager-australian-shares-fund/ . We’ve tried not to hide from the negatives. But we think the positives clearly outweigh them.
If you still want to redeem at NAV I’d gladly give you some money.
I think this article is a little misleading.
The price of the LIC in the secondary market reflects owning the underlying assets and short a higher strike call option (or warrant which ever term you prefer) on them. Derivatives (in this case Calls) purpose is to move the return profile around to something different and that some investors may find preferable. There is no free lunch but that does not make it a bad product if sold correctly so that the buyers understand what they are getting.
In this case one forgoes some of the upside as the article highlights but importantly one has an implied yield income on top so out performs in flat to down markets. Why? Because in a flat to down market the call option one is short loose a little bit of value each day.
For example if the LIC is worth 100 but trades at 80 cents because of the sold warrants struck at say 110 then overtime all else equal (i.e a flat market) the LIC will drift towards 100 as the maturity on the calls approaches, i.e the probability of them being exercised falls a bit everyday.
If the market is efficient then the LIC will trade at a discount to NAV that fairly reflects the option that one has implicitly sold.
As is the case of any investor that is selling calls then by definition their aim is to add extra yield income to an equity product. This is not good or bad, it is dependent upon the investors requirements or views of the world. Through the range bound markets of the last few years economically it would have been a good trade.
This counter argument is just wrong.
To start the value of the call in the example can’t reach anywhere near 20 cents (hence a LIC fair value 80 cents) unless you make the option three years long, use an implied volatility of 30% and the LIC doesn’t pay any dividends yet accumulates profits. These are all terrible assumptions to get to a 20 cent call value and I don’t believe them anywhere near realistic. But even if these assumptions could be used the time decay argument is a fallacy because for a three year option time decay is so negligible it isn’t noticeable, even one year time decay is minimal. The option risk is all in vega and delta i.e. the value of time (implied volatility) and the direction of the stock…but its not time decay.
A fair value of a $1.10 call option is likely around 5 cents if 12 months long or under 9 cents if stretched to 24 months (20% volatility assumption), so in theory 95 cents or 91 cents is the price of the LIC after the option is considered if the market is efficient.
Now to the idea that an investor should be thinking they are receiving the value of the LIC’s call they sell as income and then sit on the LIC and ride it up. This is similar to the ‘covered call’ concept where you own a stock and then sell a call option against the stock. The sales pitch is you make some money from selling the call even if the stock doesn’t go up and even more money if the stock does go up to the call and get exercised. This is a net loser’s game. Yet the simplicity of the explanation appeals to anyone who doesn’t have an understanding of derivatives or probability….which is understandably a lot of people.
What determines whether you are better off selling versus keeping/foregoing selling an option is the amount of volatility that occurs in the LIC’s share price versus the amount that was expected. If there is more price volatility than expected (which happens just as much as it doesn’t) then selling the option is an opportunity cost and sometimes huge. Of course nobody involved actually goes back and measures these opportunity costs, they get ignored but they are very real. Does anybody really believe the people buying all these unwanted options lose all the time and they are everyone’s bunny? Even worse for call option sellers is that there are usually many more natural sellers of certain call options than buyers – especially as in a LIC situation. The effect is to subdue the call option price even more than is justified hence increasing the sellers opportunity cost. But who is counting?
Nope, this counter argument is likely false economy and the only winner remains the fund manager picking up cheap FUM while over complicating their client’s investment.
Hi Justin, I agree with a lot of what you say here. I will cover some of the points individually:
1. I agree with your numbers as being more realistic. The numbers I gave were hypothetical to illustrate the example but I would like to add that does not change the point I was trying to make.
2. Option price of 1.10 strike for 12 months, 20 vols. Agreed and this is more realistic number set.
3. Decay at 3 years. Agreed it is low but then by definition so is the change in ones expected dilution (gamma) hence one is less exposed to increasing levels of dilution as prices rise – the change in expected dilution level is much more sensitive to the underlying price move at 1 year and 6 months etc. as you comment but it is then that one earns more decay. You cannot earn decay without being short gamma.
4. “Covered calls” analogy – agreed we are on the same page. The sweet spot is the underlying moves up to the strike.. thereafter one does not participate in the upside, at which point it was a bad strategy. That’s what I meant by forgoing the upside. I have no experience on how the covered call idea is sold but would totally agree that if they are sold as win win then that is both deceiving and wrong. The covered call strategy is a defensive/income strategy not outright growth exposure.
5. Implied versus realised vol. By definition it is a bad idea to sell options/vol if one thinks vol is under-priced. If the options are cheap then buy them don’t sell them.
6. Natural sellers: if the market is a wash with options sellers then yes it depresses the price. This is a good point and if this is the case time after time it is good support for the argument that investors do want them.
Happy to chew this out over a few charts if you ever in Sydney.
The worst aspect of this ripoff is the fact that managers charge performance fees on the “base” without allowance for the dilutive aspect of the options. Imagine a 1-1 scenario (no need to imagine, they’re everywhere) where the manager does 10% on the base portfolio NAV and the benchmark does 5%. The manager will collect their 0.75% or so extra fee (assuming 15%>bm) but when the options are exercised, the pre tax NTA has only gone up 4.625% – worse than the index. When the LIC is $100m thats $750k for free. The currently marketed Morphic LIC certainly has this structure, but so do a number of others. Egregious in my opinion. .