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Are undervalued LICs a bargain or a danger sign?

Listed investment companies (LICs) are some of the most popular investments available on the ASX. Many Australians hold managed funds, such as the Australian Foundation Investment Company Ltd (ASX: AFI), in their ASX portfolios, given their strong dividends and solid history. Even The Barefoot Investor himself has been an advocate for LICs over an extended period of time.

But, while popular, many investors don’t understand the mechanics of LICs and how they differ from an exchange-traded fund (ETF). Let’s take a look at when you should buy and when you should leave the ASX LICs.

When are LICs undervalued?

It has often been a profitable strategy to purchase LICs at a discount to their net asset value (NAV). The idea here is that if the assets of the LIC are valued at more than its market price, they should eventually converge and net you a tidy profit. However, times appear to be changing with a new raft of LICs listing on the ASX in recent years.

An article in the Australian Financial Review (AFR) is warning investors about the potential dangers of ASX LICs. Structuring issues could potentially be to blame as advisors are being incentivised to recommend risky LICs to potential investors. 

What are the risks with LICs?

One big disadvantage of LICs over a simple ETF is the high fees that they attract from active management. ETFs are passively managed, meaning the manager tries to replicate the benchmark index such as the ASX 200 and then leaves the portfolio be.

In contrast, a LIC might try to outperform the benchmark through variations in risk factors relative to the index. In doing so, more trades are required to pivot the portfolio as well as a higher management fee to compensate for the extra work.

LICs may be undervalued when they trade at a discount to NAV but it could also be that the value just isn’t there. Particularly for LICs that involve private equity or private debt, asset values can be hard to accurately estimate. In times of distress, market liquidity tightens, which means the liquidity benefits could be lost in a big sell-off.

As noted in the AFR article, Stockspot‘s analysis found that 95% of LICs invested in Aussie shares failed to beat the market over the last 5 years. Similarly, not one global equities LIC beat their equivalent global market index ETF over the same period.

Is there any upside for LICs?

It’s not all bad for LICs and investments such as AFIC can offer a great, high-yield dividend investment. The liquidity offered on the ASX is a great benefit, as well as gaining access to otherwise wholesale-only money managers.

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Motley Fool contributor Kenneth Hall has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.