Keep your costs low (OR: Why past performance does not predict future performance)
One of the reasons why I have a soft spot for listed investment companies is that their overall fee levels are usually quite reasonable, and in some cases, extremely reasonable!
Recently, the ASX has seen a number of new LICs hit the boards, some with some pretty aggressive fee structures. Investors should consider the fees in light of what they ultimately receive – in some cases, paying larger fees for better performance can make sense. I argue that you should default to lower cost options, and below I outline why.
Listed Investment Company raisings at levels not seen for 10 years
Zenith Investment Research indicated that LIC capital raisings have now reached $5.8b over the past five years, a huge amount for what is generally considered a sleepy little backwater of the market. Notably, we saw one of the biggest LIC raisings I can remember in the form of the Magellan Global Trust, which pulled in $1.55b.
A number of these new LICs have quite aggressive fee structures, comprising of management fees (generally around 1%) and a performance fee, which can be anywhere from 12.5% of outperformance of a relevant index to 20% of any positive performance! Without providing calculations, aggressive performance fees lower returns to investors substantially, and I would classify these as in the favour of managers, not investors.
Typically, large raisings and management favourable terms are things that you see at the end of sustained bullish markets – Australian investor Steve Greeny (sorry Steve – count find the link!) provided an interesting tweet noting the number of raisings being similar to the behaviour that was seen in 2006.
The reason why I believe you should be cautious of these investments is as follows: one of the best indicators of future performance is fund fees.
Fund Fees Predict Performance
Russel Kinnel, director of research at Morningstar, recently updated one of the most important pieces of research of all time (in my opinion). As a director of a company that makes its money rating funds, most would expect Kinnel to indicate that the best predictor of future performance was a proprietary measure, delivered by Morningstar, that could be all yours for a low, low price!
Instead, he released a report that shows that the best indicator of future fund performance is fees, specifically, the expense ratio.
This research is so important, I would encourage everyone to read it themselves. Download it here.
The lower the fees the better the future total returns for investors. Simple.
Five Star Ratings do not predict performance (Past Performance is not a guarantee of future results).
Part of the reason why I wrote the post up is because the WSJ wrote an interesting article last week about the predictive nature of Morningstar’s research. Specifically, the WSJ highlighted that 5 star Morningstar funds do not perform any better than others.
Morningstar star ratings are driven specificallty by historical performance. A fund with excellent historical performance gets five stars. Unfortunately, reversion to the mean asserts itself over time, and these funds are on average only 3 stars five years later, indicating that their performance has fallen.
Whats the takeaway?
Some of these new LICs have excellent long term track records. They also have extremely high expense ratios.
The combination of the research above indicates that these track records are, on average, likely to mean revert.
The question becomes this – are you confident in being able to pick the fund that outperforms the averages, and flies in the face of the above research?
For the investor who wants less hassle than monitoring LIC disocunts and premiums, and doesn’t want to pay away their investment gains to large fees: stick to those old, Australian LICs with incredibly low expense ratios. Simple.