It is widely believed that low-cost index trackers are a good way to invest in the stock market for most people. This is because they require no effort and guarantee the weighted average performance of the market at low cost. You could put your money in a fund, but the costs are much higher and the problem then becomes choosing the right one, many will underperform the index.
However, listed investment companies (LICs) may offer a viable alternative to an index tracker. Managers generally don't earn performance fees so running costs are low and implied fees are often similar to those of trackers.
I compared the performance of four LICs, Djerriwarrh Investments Limited (ASX: DJW), Diversified United Investments Limited (ASX: DUI), Mirrabooka Investments (ASX: MIR) and Milton Corporation Limited (ASX: MLT) against the SPDR S&P/ASX 200 Fund (ASX: STW), an index tracking fund.
| LIC | 10 year annual compound return | Management expense ratio (MER) |
| SPDR S&P/ASX 200 | 5.23% | 0.28% |
| Djerriwarrh | 7.52% | 0.41% |
| Diversified United | 7.46% | 0.13% |
| Mirrabooka | 9.77% | 0.67% |
| Milton | 6.54% | 0.12% |
The ten-year annual compound returns include both share price gains and dividends adjusted for franking credits and after management fees. For the LICs, management expense ratio (MER) is admin costs divided by average portfolio market value over the year to June 2015.
From the above information, it looks like any one of the above LICs is superior to the index tracker but there are several additional factors to consider before drawing this conclusion.
Most importantly, the share price movements of the LICs do not necessarily correspond to the value of their portfolios. For example, ten years ago Mirrabooka was trading at a 10% discount to its net tangible assets (NTA) and is now trading at a 12% premium. These valuation gains are unsustainable and do not reflect the underlying performance of the company.
The following table is based on gains in NTA per security rather than share price to unwind this effect. Collectively, the LICs still performed better than the index fund using this measure but by a smaller degree.
| LIC | 10 year annual compound return | Current price to NTA ratio |
| SPDR S&P/ASX 200 | 5.23% | |
| Djerriwarrh | 5.94% | 130.5% |
| Diversified United | 7.00% | 96.3% |
| Mirrabooka | 8.53% | 112.4% |
| Milton | 6.61% | 102.1% |
The second column shows how the current share price of each company compares to its most recently disclosed NTA per share value. Although prices follow NTA values over the long-term, if you buy an LIC when it is trading at a premium to its NTA, you are likely to experience lower returns as the valuation gap closes over time. Interestingly, Djerriwarrh commands the highest premium to its NTA yet delivered the worst ten-year performance of the companies.
The next problem is that it is impossible to know if the last ten years' performance will reflect the next ten. Each company has a different investment approach and so a closer look may reveal some clues.
Djerriwarrh Investments holds a portfolio made up of large-cap stocks and uses a small amount of debt, currently $75 million to leverage returns. The company also writes options to enhance returns which are covered by its equity holdings. Based on the performance figures in the tables above, it is questionable whether the use of options and debt enhances returns to shareholders at all. Despite having the worst ten-year performance, administration costs were the highest of the four LICs at $3.8 million in 2015.
Similar to Djerriwarrh, Diversified United Investments primarily holds large-caps and also uses a small amount of debt, currently $85 million. In November 2014, it raised $103 million to diversify into International shares which now make up 9.8% of its total portfolio in the form of unhedged exchange traded index funds. Administration costs were just over $1 million in 2015, the lowest of the four LICs.
Mirrabooka Investments is the smallest of the LICs with a market capitalisation of about $350 million and specialises in holding small and medium sized companies. The company writes options, but this is only a minor part of the operation compared to Djerriwarrh because the options market for small-caps is less developed. Administration costs were $2.2 million in 2015, less than Djerriwarrh, but because Mirrabooka operates the smallest portfolio of the LICs its MER was the highest.
Milton Corporation is by far the largest of the LICs with a $2.7 billion market cap and is also the oldest, having listed in 1958. It operates a diversified portfolio of 95 positions consisting mainly large-caps stocks. Last year administration cost were $3.4 million to manage a $2.75 billion portfolio, giving it the lowest MER.
Foolish takeaway
Overall, there appear to be good reasons to consider LICs as an alternative to index trackers. However, I would avoid buying shares in Djerriwarrh because it is trading at such a large premium to its NTA and recorded the weakest performance over the last ten years.
As a small-cap investor, my choice of the remaining three would definitely be Mirrabooka, as I believe it is no coincidence that it has delivered the best returns through investing in smaller stocks. Even so, I would only buy when its NTA per share is lower than its share price. Often LICs trade at significant discounts to their NTA during a recession, which is the best time to go shopping.
