18 December 2019

PAUL HEATH

For investors who poured over $900mln into the listed KKR Credit Income fund (KKC) during October, the opening weeks of trading would have provided a sobering insight into the pitfalls of a LIT structure.

The experience has also laid out an important ethical question for the wealth advice industry to answer.

KKC upsized the deal to $925mln following a flood of demand, however since listing the shares have consistently traded below the $2.50 issue price. And when the shares sank to $2.43, the 2.8% decline in capital value had eaten into nearly half of the expected 4% - 6% total annual income return.

One of the major challenges of a LIT structure is that the underlying shares can trade away from the value of the units in the trust. Occasionally – very occasionally – the shares trade at a premium to the underlying value. More regularly, the shares trade at a discount. Of the 122 LICs/LITs trading on the ASX today, 72% trade at a discount to NTA and the average discount is 12.6%. True, there is always a risk of capital loss when investing, but the possibility of a discount to NTA amplifies that risk significantly.

The risk of variance to NTA is just one of the pitfalls of investing via a LIC/LIT structure. Another major risk for investors is the lack of liquidity. Since listing less than three weeks ago, only around 3% of KKC has changed hands. The total value of KKC bid for in the market is a mere $270k. The harsh reality of a LIT such as KKC is that even if an investor decided to exit their investment, it will be almost impossible to do so without driving the price down further.

The toxic pairing of a discount to NTA and a lack of liquidity is a value destroying combination that is unique to LIC and LIT structures.

So why do so many investors line up to participate in these issues?

Depending on the specific LIC/LIT there can be a variety of reasons, however our view is that a loophole in FOFA regulations that allows fund managers to pay incentives to advisers who sell LICs and LITs to their clients is a major contributor.

Under the 2012 Future of Financial Advice (FOFA) regulatory reforms, fund managers are banned from paying sales commissions to advisers who sell their products. But in 2014, listed funds were exempted from this rule - and the extent to which that exemption has been exploited is eye-popping. Nearly $45 billion of capital is now invested in LICs and LITs – mostly on behalf of mum and dad investors. And advisers are being paid very lucrative incentives, called “stamping fees” by fund managers, to sell their clients these funds. Initially these structures were used to buy portfolios of listed shares. However more recently, as in the case of KKC, the structures have been used to acquire portfolios of unlisted, high yield, fixed income securities that are often difficult to value. We can now add another risk into the mix – opaqueness. The already toxic combination just got a little more dangerous.

Worryingly, there are several more of these strategies queued up to come to market in 2020.

Good advice is always important, and that importance is only increasing as the risks keep rising.

The key question to consider is how can an adviser who is receiving a significant fee for selling a product be in a position to offer good advice to their client? The truth is, they can’t.

As Kenneth Hayne noted in his final report of the recent Royal Commission, “Experience shows that conflicts between duty and interest can seldom be managed; self-interest will almost always trump duty.”

The advice industry in Australia has evolved around the idea that it is acceptable for an adviser to have an interest that is in conflict with the interests of their client. For some time now there has been a view that the conflicts could be adequately managed, or adequately disclosed. The case studies of the Royal Commission graphically revealed why the current situation cannot be allowed to continue.

At Koda Capital, we have taken a public position against the exploitation of the stamping fee loophole. You can read the article we published (There Are Still Dangerous Loopholes In Financial Advice Rules) on the topic earlier this year here

When we built the foundations for Koda in 2014, we understood that good advice meant conflict free advice. We took a stand that we would only accept fees that were paid by our clients in order to ensure our advice would never be compromised. This thinking stood in stark contrast to the conventional wisdom of the time.

Importantly, conventional wisdom is slowly shifting for the better. The Financial Adviser Standards and Ethical Authority (FASEA) code of conduct comes into force on January 1, 2020, and standard 3 states clearly “you must not advise, refer or act in any other manner where you have a conflict of interest or duty”. The guidance notes attached to the code specifically call out stamping fees on IPOs.

That’s great news for clients. At Koda, we fully support the intent and application of the FASEA code of conduct and view it as a necessary step on the pathway to an advice profession.

The Code comes into effect from January 1, however the disciplinary body charged with monitoring and enforcing adviser’s adherence to the code has not yet been established. Whilst ASIC have provided relief for the requirement that advisers are registered with a compliance scheme, they have also stated that “AFS licensees will still be required to take reasonable steps to ensure that their financial advisers comply with the code from 1 January 2020, and advisers will still be obliged to comply with the code from that date onwards. ASIC may take enforcement action where it receives breach reports”.

So it is at this point that we reach the fundamental ethical question for the industry.

We know today where the regulator stands on this issue. Will the fund managers follow the lead of Magellan and voluntarily call time on the practice of paying lucrative incentives to advisers to place private investors into risky structures? Will advisers voluntarily call time on accepting fees that compromise the advice they give to the clients who trust them?

Or will the industry continue the rush to exploit the loophole before it finally closes?

1 January is a moment of truth for the wealth advice industry. How the industry responds will say a great deal about integrity and intent.