About

Update Sep 2023 - New Site: I now run a site dedicated to eliminating almost all ASX Closed End Funds. I maintain posts on HM1 on that site. See: > Captive Capital

See: > CaptiveCapital: Why HM1 shareholders should vote to convert it to an Open End fund

What: An independent blog with insights into the Hearts and Minds Investments Limited LIC listed on the ASX as HM1. (As of Sep 2023 this site is on ice unless/until I'm involved in a major campaign on HM1).

Who: Adrian Lobo. I have a significant holding in HM1 and am also a specialist in ASX closed-end funds.

Contact: See: > Captive Capital

Why: As of May 2023, HM1 has traded at 15-25% discounts to NTA for over a year due to a massive drawdown in NTA from Feb 2021 to June 2022. A proper assessment of this drawdown and how to prevent it happening again has not been done or communicated to shareholders. This blog will fill that gap, and also provide details of the various actions HM1 Directors and management can take to improve outcomes for shareholders (and thus medical research beneficiaries).

Recommended Actions:

1. Effective Risk Management
- Properly explain the 2021-22 NTA drawdown of ~40% and TSR drawdown of ~50% and detail exactly what risk management changes have been made that will prevent this happening again.

- Properly explain the "Risk Overlay" that was introduced. Is this a hedge to reduce beta exposure? If so, how much? Is it consistent or varied in whether on/off and the proportion hedged?

- I will analyse this drawdown and whether effective preventative mechanisms have actually been implemented. For example, just because a Conference stock may now be exited before 12 months is up doesn't mean those that turned out to be disasters would have been exited, let alone never made it in. Hindsight is 20/20. Effective risk management is mostly about what gets in the portfolio and stays in. Perhaps I'll start with Block Inc, as it's a current top 10 holding.

Feb 2024 Update: No explanation of the mistakes and corrections has ever been given. Claims of improvements to risk management are belied by the regular drawdowns in Conference stock picks. See: > CaptiveCapital: Why HM1 shareholders should vote to convert it to an Open End fund

2. Continual 10% Buyback when the discount > 15%
- If up to 10% of shares are actually bought back every 12 months, buybacks are effective in: capping the extent of discounts, being accretive to NTA, and providing exit liquidity to shareholders who really need to sell. The excuse of not wishing to reduce the fund size doesn't apply to HM1 as it has Net Assets over $650m and its main expense (donations) is set at a fixed percentage of 1.7%. Even if HM1 was a small fund, the share count reduction excuse is readily addressed by issuing free, tradeable options to existing shareholders.

Feb 2024 Update: HM1 Directors continue to insist that shrinking the fund sacrifices donations and is not desirable. See: > CaptiveCapital: Why HM1 shareholders should vote to convert it to an Open End fund

3. Quarterly Dividend
- A major irrational factor in ASX LIC discounts or premiums is the frequency of fully-franked dividends. This is because ASX LICs are heavily favoured by Australian retirees who decide to depend on the simplicity of investment income rather than selling shares. I will use investment return facts to demonstrate that many LICs have their discount or premium driven in large part by the frequency and reliability of their franked dividend (e.g. PL8, PGF). The HM1 discount would drop significantly if it moved to reliable, fully-franked quarterly dividends.

Sep 2023 Update: After my feedback to HM1, a shift to bi-annual dividends was made. However, the appalling risk management record detracts from attempts to be an Income LIC or try and emulate the high, stable dividend of a global fund like PGF.

4. Effective Return of Tax (franking credits)
- Except for some alternative or illiquid asset classes (e.g. private equity), the closed-end LIC structure is not superior to ETFs for shareholders; it just provides captive funds for managers to charge fees on. One of the major downsides is that there is no way to ensure the highly variable amounts of tax paid are returned efficiently to shareholders via franking refunds or credits paid with dividends. HM1 is a chief example of this. It's high risk investments briefly boomed and generated a massive tax bill but then in the bust this ended up as a large franking credit balance reliant mostly on dividends to be released back to shareholders. HM1's franking credits are not included in its NTA and I will explain how they can be better managed for shareholders and more transparently communicated to them.

Feb 2024 Update: The elevated franking credit balance continues to drag on returns. HM1 Directors are reluctant to efficiently return franking credits as they prioritise fund size and donations over Total Shareholder Returns and minimising discounts for investors. See: > CaptiveCapital: Why HM1 shareholders should vote to convert it to an Open End fund

5. Cash Weighting
- According to the HM1 prospectus, it can hold 100% cash at times and there is no requirement for it to always be fully or mostly invested. In practice, HM1 has not used its cash weighting discretion as a risk management tool or communicated this to shareholders. Fund managers that choose to be mostly invested all of the time often argue that shareholders can manage their exposure by selling and buying, but when the NTA discount is 15-25% this is not a defensible justification for a LIC. I will explain how HM1 cash weightings have changed and what options exist to better manage and communicate this to shareholders.

6. Unlisted Investments
- Without consulting shareholders, HM1 management decided to make a major change to the original mandate and suddenly allow unlisted investments and then promptly invested in Guzman y Gomez and Rokt. The justification being that if the highest conviction ideas of its chosen fund managers were unlisted then it should follow along. However, this is a very significant change. The fund manager fees are being redirected to medical research so the fund managers can exert influence over HM1 management and some of the relationships may be a bit too cosy. Also, there are conflicts of interest given fund managers now have HM1 as a vehicle to add liquidity to marked-up rounds of capital raising in their private investments. Even more so if the fund manager is reducing its ownership proportion of a private investment while HM1 is taking a stake or increasing a stake. I will investigate this substantial issue further.

- For some larger investors allocating to the original HM1 mandate, unlisted investments are prohibited by rules, not desired, or not desired to be mixed with listed investments. This can lead to a forced selldown and the discount being wider than otherwise until asserted benefits are proven and attract investor demand.

Feb 2024 Update: HM1's unaapproved, unlisted adventure continues with all of the pitfalls I've flagged as important as ever. See: > CaptiveCapital: Why HM1 shareholders should vote to convert it to an Open End fund

7. Concentrated, High Conviction Stocks
- Part of the HM1 LIC rationale is that retail investors can access the highest conviction picks of multiple outstanding fund managers in a single, concentrated fund. However, no analysis has ever been provided as to whether the highest conviction picks that become the HM1 portfolio outperform or underperform the fund manager's other funds. Generally, HM1 provides no transparent accountability for the performance of the investments, so there is no discipline against fund manager's swinging for the fences with high risk, volatile, trendy and overvalued stocks. If they get lucky the fund manager takes the credit, if they fail dismally, they put it down to the general market (growth stocks tanked, it's not our fault).

Feb 2024 Update: No evidence for the outperformance of the high conviction strategy has ever been provided. It doesn't exist. See: > CaptiveCapital: Why HM1 shareholders should vote to convert it to an Open End fund

8. Style Drift (e.g. from 3 concentrated picks to 20 or more)
- The original rationale was that HM1 provided only the top 3 picks from the 6 Core fund managers. But it seems the 2021-22 shocking underperformance has led to various changes to try and reduce drawdowns and this included switching one Core fund manager's top 3 picks to be an investment in one of its global equities funds instead. But if one Core fund manager can switch, perhaps others will also? This is known as style drift. More stocks means less underperformance, but also less outperformance. A switch away from concentration also detracts from the uniqueness of the HM1 offering. And for investors who wish to know (and possibly research themselves) the portfolio stocks, such a change adds opaqueness.

9. Portfolio Transparency
- When outperforming, few investors care about portfolio transparency. When underperforming, a lack of transparency is a significant factor in closed end fund investors exiting at deep discounts and an inability to attract new investors. Indeed, after the 2021-22 NTA drawdown of ~40%, why would investors take anything about portfolio composition on trust? Unless there were overwhelming adverse consequences (there aren't!), HM1 should fully disclose its Core and Conference portfolios each month.

May 2023 Update: After my feedback to HM1 significant improvements to portfolio transparency in monthly reports have been made, but there is more that can be done.

HM1 Ratings as of Dec 2023:

1. Risk management (inc. transparency and communication of it)
4/10

2. Buyback and share issuance
2/10

3. Dividend frequency and reliability
6/10

4. Tax efficiency (inc. return of franking)
3/10

5. Cash weighting management (inc. communication)
4/10

6. Unlisted investment inclusion (inc. communication)
2/10

7. Concentrated, high conviction style (inc. drift, communication)
4/10

8. Style drift
4/10

9. Portfolio transparency
7/10

Disclaimer: I do not have an AFSL and no content on this blog constitutes personal advice (financial or otherwise). The content of this site is general information only. I am not liable for any loss suffered, whether due to error, negligence or otherwise arising from the use of, or reliance on, the information provided directly or indirectly, by use of this website.