By Peter Rae

K2 Asset Management reduces Small Cap Fund fees

K2 Asset Management is changing the fee structure on its K2 Australian Small Cap Fund (Hedge Fund) (ASX: KSM) from 3 July 2017. The investment management fee falls from 2.05% p.a to 1.31% p.a and the performance fee falls from 20.5% to 15.38% p.a. All fees are inclusive of GST and RITC. A new performance fee hurdle of 6% p.a absolute return will apply, as opposed to the previous arrangement, where the manager received the fee simply for increasing net asset value above its previous high.

We believe these changes are a step in the right direction, although the investment management fee is still on the high side. The Fund was established as an unlisted trust in December 2013, but converted to a listed active ETF in December 2015. Whilst KSM has underperformed the ASX Small Ordinaries Accumulation Index since listing, it has performed strongly since inception of the Fund in December 2013, outperforming the benchmark index (S&P/ASX Small Ordinaries Accumulation Index) by 5.2% to 30 April 2017. Our current rating for KSM is Recommended, however, we will be undertaking a full review given the changes to the fee structure.

Industry fees under pressure

Whilst, in our view, K2’s fees for the Australian Small Cap Fund were high, we believe the reduction in fees is indicative of a trend to lower fees for actively managed funds. Platinum Asset Management also recently announced it was lowering its management fee on its eight Platinum Trust Funds and Platinum Global Fund from 1.5-1.35% p.a. At the same time, it announced a dual fee structure option, with investors having the ability to choose between the new management fee of 1.35% p.a (and no performance fee) or a performance fee option which has a lower management fee of 1.10% p.a and performance fee of 15% p.a. The performance fee option is the same fee structure as Platinum’s two LICs, Platinum Capital (ASX: PMC) and Platinum Asia Investments (ASX: PAI).

Over the past few years, there has been significant growth in the number of passive investment strategies available to investors. Added to this, there has been considerable growth in the number of actively managed products, including unlisted funds, active ETFs and a growing number of LICs. New managers keep emerging given there are few barriers to entry in this industry. This creates new choices for investors and, in our view, investors will be become more discerning when looking at fee structures and be reluctant to pay high fees, particularly for poor or average (index hugging) performance, or poor product structures.

Contango MicroCap resolves manager arrangements

Contango MicroCap (ASX: CTN) announced it will return to being a one manager listed investment company, with OC Funds Management (OCFM) ceasing to provide investment management services to the company. Management of the entire CTN investment portfolio reverts back to Contango Asset Management (ASX: CGA). There will be a 60 business day period to allow a smooth transition of the OCFM managed portfolio to CGA.

We placed our CTN rating under review in December 2016 following the announcement that it would add an additional manager and change the LIC name. We saw this as a highly unusual step that would add new risks for shareholders. In our view, and without making any judgement about OCFM’s portfolio management capabilities, we see the reversion to a single manager as a good outcome for CTN shareholders. It removes much of the uncertainty that has surrounded the LIC since the December announcement and removes the risks and administrative complications of the two manager arrangement. Whilst we are familiar with the single manager, CGA, there have been changes at the Board level since we suspended our rating, so we will need to undertake a new review before reinstating our rating.

Hunter Hall shareholders agree to Pengana merger

Hunter Hall International (ASX: HHL) shareholders have voted in favour of the merger with unlisted fund manager, Pengana Capital. This brings to an end the instability that has surrounded HHL since the sudden departure of Peter Hall in December 2016. We outlined the details of the merger in our March 2017 LMI Monthly Update, but in broad terms, the merger will see HHL change its name to Pengana Capital Group, with Pengana Management and directors and Washington H. Soul Pattinson owning a combined 83% of the listed fund manager.

We see the resolution of the corporate action surrounding HHL as positive for its listed investment company, Hunter Hall Global Value (ASX: HHV), given that the structure of the combined investment team can now be finalised. We will be undertaking a detailed review of the new management team, which will include highly experienced HHL Interim CIO, James McDonald, who will continue to manage the HHV portfolio. However, for the time being, our rating remains suspended.

IIR Rates Contango Global Growth recommended plus

IIR has published a pre-IPO report on Contango Global Growth (expected ASX code: CQG). We have assigned the LIC a Recommended Plus rating. The company is seeking to raise between $55m and $330m, including oversubscriptions, through the issue of shares at $1.10. Investors will receive one free option for each share subscribed to, with an exercise price of $1.10. CQG has already received its minimum subscription of $55m. The offer closed on 8 June 2017.

CQG will invest in a concentrated portfolio of quality global growth equities, typically comprising 20 to 40 stocks. While Contango Asset Management (ASX: CGA) is the Investment Manager, it has delegated the management of the portfolio to an Investment Adviser, WCM Investment Management, an independent international equities asset management firm based in California. WCM will manage the portfolio in the same manner as the existing WCM Quality Global Growth strategy offered in the US, which was established in March 2008. WCM has met all its objectives since establishment of the strategy and has consistently outperformed the benchmark index, MSCI ACWI ex-Australia (AUD). The strategy has also offered downside protection. We are of the view that over the long-term, WCM will continue to outperform the benchmark index and provide downside protection.

WAM Microcap offer open

WAM Microcap (proposed ASX code: WMI) released its prospectus for an initial public offer to raise up to $154m through the issue of 140m shares at $1.10. The majority of shares under the offer are reserved for investors in existing Wilson Asset Management LICs, with a priority offer of up to 110m shares. The priority offer closed on 5 June with the general offer expected to close on 14 June.

WAM Microcap will invest in undervalued ASX listed companies with a market cap less than $300m at the time of investing. The Manager, Wilson Asset Management, will use its proven research-driven and market-driven processes to select stocks for the portfolio. The investment objectives are to deliver a stream of fully-franked dividends, provide capital growth over the medium-to-long term and preserve capital. There are a limited number of LICs in the micro-cap space and many of the current offerings are sub-scale and have low market liquidity.

WAM Microcap will provide investors with a new offering in this space from a manager with a proven track record of outperformance over a long period of time. IIR has not undertaken any research on WAM Microcap and we make no recommendation as to whether investors should subscribe. However, we note that with WAM Capital (ASX: WAM) and WAM Research (ASX: WAX) trading at significant premiums to NTA, WAM Microcap provides investors with access to a proven investment strategy and experienced investment management team at NTA, ignoring IPO costs.

Market under pressure after strong 12 months

Australian equities rose again in April with the S&P/ASX 200 Accumulation Index up 1% giving it a solid gain of 6.7% for the three months to 30 April 2017. For the 12 months to 30 April, the index was up 17.8%. Large caps continued to perform well and have been a key driver of the strong market performance over the past 12 months, with the S&P/ASX 50 Accumulation Index up 18.2%.

Resource stocks have come off the boil in recent months, with the S&P/ASX 200 Materials Accumulation Index down 3.0% over the past three months. Still, for the 12 months to 30 April, the resources index rose 21.5% and was one of the best performing sectors over this time.

Since the end of April, the market has struggled and has given back some of its recent gains. With many of the large cap stocks looking fully priced and the banks under pressure on a number of fronts, the next few months could be difficult for the market.

Is there value in Small Caps?

Small caps again underperformed during April, and for the three months to 30 April, the ASX Small Ordinaries Accumulation Index rose 3.7% versus the 6.7% rise for the S&P/ASX 200 Accumulation Index. This sector also underperformed over the past 12 months, with a return of 10.0% versus the 17.8% return for the top 200. This prompts the question as to whether there is value starting to emerge in the small-cap sector of the market.

One LIC manager we spoke to believes that small-cap PEs are at a 10-15% discount to larger cap PEs, implying some value. However, we note that some of the falls in small-cap share prices have been driven by earnings downgrades. A number of companies, particularly those exposed to consumer spending, are coming under revenue pressure. Some of the small-caps that have disappointed the market on the earnings front have seen significant reductions in their share prices and may take some time to regain market confidence.

While there may be some value starting to emerge in the small-cap space, investors need to be cautious given a backdrop of earnings weakness across a number of sectors.

In our view, LICs are one of the best ways for retail investors to gain exposure to small-caps. A LIC gives exposure to a well-diversified portfolio across numerous market sectors, with the benefits of a professional investment manager. Most small-cap LIC managers have hundreds of meetings with companies and industry contacts and are in a strong position to identify likely long-term outperformers. Still, professional investment managers don’t always get it right for each stock, and this where the benefits of a well-diversified portfolio come into play.

In the above performance table, we highlight a number of LICs that have generated the highest returns over a five-year period. The three Australian small-cap focused LICs in this table, WAM Research (ASX: WAX), Mirrabooka Investments (ASX: MIR) and WAM Capital (ASX: WAM) have all delivered five-year returns above the ASX All Ordinaries Accumulation Index (10.6%) and the Small Ordinaries Accumulation Index (2.4%).

Unfortunately, all are expensive, trading at premiums to pre-tax NTA. We would prefer to be patient and look to acquire these LICs closer to pre-tax NTA. Hunter Hall Global Value (ASX: HHV) invests in both Australian and international small-caps. Its performance has suffered over the past year, due to significant falls in a number of its largest holdings, especially Australian-listed Sirtex Medical (ASX: SRX). HHV has a stronger five-year performance, but despite beating the Australian market returns, its performance is below the MSCI World Total Return Index, AUD five-year return of 16.3%. Given a high conviction, concentrated portfolio, tracking error tends to be much higher than peers. At 30 April, HHV was trading at a discount of 8.4% to pre-tax NTA. However, as we noted on page 1, our rating remains suspended pending a review of the new management team following the merger of its Investment Manager, Hunter Hall International (ASX:HHL) with Pengana Capital.

(Note: Global Masters Fund (ASX:GFL) invests primarily in the shares of Berkshire Hathaway and is not a small-cap focused LIC).

An alternative option for Small Cap investors

There are few LICs with a long track record in the small-cap space and many of the offerings are sub-scale. We believe this is one of the reasons why those with an established track record of strong performance are trading at significant premiums to pre-tax NTA. As we noted on page 1, the new Wilson Asset Management LIC, WAM Microcap, will give investors another option in this space. It may well prove to be an opportune time to launch a micro-cap LIC given valuations of small and microcap stocks are looking more reasonable. Given the lack of opportunities in the pure small-cap LIC space, we look at an alternative option for investors seeking exposure outside the large-cap sector of the market.

Contango Income Generator (ASX: CIE)

Contango Income Generator invests in a portfolio of stocks primarily outside the large caps with a mandate to invest in ASX ex-30 stocks. At 31 March 2017, the portfolio had a weighting of 29% to small and micro-cap stocks, 43% in mid-caps and 20% in large-caps. While CIE has a short history, listing in August 2015, its Investment Manager, Contango Asset Management (ASX: CGA) has a track record in managing a portfolio with a similar strategy. One of the key objectives of CIE is to generate an above-average yield for its shareholders, so the portfolio has a high weighting to financials (32%), although it does not own the major banks and insurers as they fall outside its mandate.

CIE paid an unchanged interim FY2017 dividend of 3 cents per share, 50% franked, and is guiding for a FY2017 final of at least 3.4 cents per share. This points to a yield of around 6.5%, although franking is likely to be 50% for the full year. For the 12 months to 30 April 2017, CIE delivered a portfolio return (pre-tax NTA plus dividends) of 13.4%%. Whilst this was below the ASX All Ordinaries Accumulation Index return of 16.6% for the same period, it reflects the absence of the major banks and underweight positions in materials and energy, all sectors which performed strongly. This portfolio positioning is consistent with its strategy to invest outside the ASX top 30. Our rating for CIE is Recommended Plus. At 30 April 2017, the shares were trading at a 5.2% discount to pre-tax NTA, a reasonable entry point for investors seeking exposure to a portfolio of Australian shares outside the top 30 companies. However, we think the discount is likely to remain until the company can establish a track record of outperformance.

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Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.