Profit from being a liquidity provider in LICs

BACKGROUND

There was an excellent article on Livewire last week looking at some Listed Investment Companies (LIC) trading at a discount that offer good chances to profit for investors. Today, I offer another way that investors may not always consider: IPO investors to offer liquidity on the stock exchange.

Here at Morphic we recently undertook the listing on the stock exchange of an Ethical version of our Fund called the Morphic Ethical Equites Fund (ASX:MEC). The Fund doesn’t invest in a number of types of stocks, such as tobacco, armaments and coal and also seeks to short those stocks if we think shareholders can profit from the demise of those industries.

But this article isn’t about our Fund, it’s about helping investors understand how they can profit from the way markets work.

LIC OPTIONS – DIVIDING THE MARKET

When we launched, we made the decision to attach options to the issue of shares. Now options and LICs have divided people, with some like Forager Funds, coming out against them and others like Geoff Wilson supporting them.

The reality is that options remain very popular with LIC investors and one thing I have learnt over the years is that markets are pretty efficient so if something exists, there is usually a reason.

UNDERSTANDING THE FLOAT PROCESS, OPTIONS AND LIQUIDITY

So what I want to talk about today is “liquidity provision”. What this means is the role and profit paid to be a “middle man”. The most common example is someone who exchanges foreign exchange on a corner that you may see on holidays. If you want to access the currency you need on holidays but haven’t got enough for whatever reason, they “provide liquidity” to you by acting as a middle man.. at a price of course – that being an exchange rate lower than normal!

If we return to looking at an LIC, the IPO process essentially offers unlimited liquidity. The price, though, is the listing cost of the IPO.

Now once the IPO is complete and the LIC is trading on the stock exchange, there are no new shares available. So if you want to buy some, you have to convince a shareholder to sell to you. For investors who just put money in for the long term, a lot of them may be unwilling to sell just yet. In this case, the price of the shares would then trade to a premium to try and “bring out sellers” to make supply and demand equalise.

This brings me to the second part of LIC IPOs  from above – options. Options provide a valuable role in liquidity provision.

PROFITING FROM PROVIDING LIQUIDITY – HOW DOES IT WORK?

Holders of stocks in most LIC IPOs hold options granted to them on day 1. These options represent the natural providers of liquidity. If you are an owner of options from an IPO, there is a relatively easy way to profit from providing liquidity. The steps of an example are below:

• Step 1: LIC floats and a shareholder paid $1.10 for 1 share and 1 option.
• Step 2: the stock trades up to $1.20 through a combination of rising asset values and more buyers than sellers creating a premium.
• Step 3: The shareholder goes on market and sells the stock on the ASX at say, $1.20 with the NAV being worth $1.12.
• Step 4: The options were issued at $1.10, so the shareholder, who still owns the options, then convert those options at $1.10 and pays for them using the money received from the sale of the shares ($1.20).
• Step 5: The shareholder still owns 1 share trading at $1.20 and keeps the 10c difference as the profit.