I was asked recently to explain the differences between Exchange Traded Funds (ETFs) and Listed Investment Companies (LIC’s).
ETFs and LICs are both assets that can be bought and sold on the Australian Securities Exchange (ASX). At the end of 2018, there were over 250 Funds listed on the ASX.
You are investing in a portfolio of individual assets when you invest in an ETF or LIC.
ETFs and LIC’s may invest in a wide range of assets, including cash, domestic equities, international equities, bonds, currency, and commodities. Some funds track an entire share market. In contrast, others allow the fund manager to invest based on their discretion into a basket of assets or commodities.
ETF’s have both a primary and secondary market. The primary market is the means of trading and adjusting the number of units on issue. While the secondary market provides the ability for investors to buy and sell the units already on issue.
Close price parity is necessary for ETFs between the traded unit price on the secondary market and the Net Asset Value (NAV) of the units on the primary market. In contrast, LIC’s share prices can vary widely from the NAV of the underlying investments.
Traditionally, an ETF tracks an index such as the S&P/ASX 200 or S&P/ASX 20 holding the top 200 or 20 (respectively) funds listed on the ASX, and do not try to outperform that index. LIC’s, on the other hand, may use an index as their benchmark but seek to outperform.
The most significant difference appears to be passive management versus active management. However, recently, there has been more crossover with newer ETFs coming to market that are fully or partially actively managed. Other styles of Fund managers have emerged, such as Active Managed, Inverse Index, and Smart Beta. Therefore it’s crucial to understand the investment, costs, and benefits of each style and focus before investing.
The most important difference between ETF’s and LIC’s is the legal structure.
An ETF is a trust, which means there is an open-ended source of funding, where the pool of money can rise and fall daily depending on who buys or sells their units. It also means that the fund does not pay tax on their earnings; instead passes these onto investors who pay tax at their marginal tax rate.
On the other hand, an LIC is a listed investment company, which means the pool of money available for investment is close-ended. With additional capital raised through a capital-raising process. Profits of LICs are subject to company tax rates, the managers of which have discretion as to how much (if any) of those profits they choose to pay as dividends.
Many investors believe ETF’s and LIC’s provide diversification at a reasonably low cost with easy access via a share trading account. Trading and brokerage fees to purchase all 200 shares in the ASX200 individually would likely far exceed the cost of the ETF. Also, Investors can trade ETF’s and LIC’s any time the exchange is open via online brokerage accounts. Compared to traditional Managed Funds, where units must be bought and sold by completing application and redemption forms and undergoing mandatory identity checks on every new fund purchase, online seems easy.
The table below outlines the major differences between ETFs and LICs:
|Description||Exchange Traded Fund (ETF)||Listed Investment Company (LIC)|
|Shares on Issue||Open-ended||Closed-ended|
|Price to Net Asset Value (NAV)||When an investor buys or sells an ETF, there is a market maker on the other side of the trade. The price they offer is generally very close to the NAV which is published daily||Price based on what investors are prepared to buy or sell the share for on any given day may result in trade at premia or discount to the NAV. LICs only announce their NAV monthly.|
|Income Distributions||ETF’s must distribute all income each year in the form of dividends (franked and unfranked), foreign source income, capital gains, and capital losses.||LIC’s only distributes income when its board declares a dividend. As LICs pay tax at the company tax rate, generally, the distributions are fully franked dividends.|
|Income Stability||As ETF’s must distribute all income, the dividend amount can vary substantially from year to year as the underlying performance determines it||As LIC’s have the flexibility of timing and quantum of income returned to investors, most LIC’s aim to provide a steady stream of dividends and attempt to avoid fluctuations.|
|Cost||Generally, ETFs are low cost as they aim to track an index rather than outperform. However, there are now some actively managed ETFs with higher fees.||LIC’s tend to be higher cost as the investor is paying for management’s skill to outperform over the long term. There may also be outperformance fees paid if the manager outperforms.|
- In Australia, a large percentage of ETF’s and LIC’s are bought and sold without the guidance of a financial adviser. According to Peter Mancell of FYG Planners, it is possibly leading to investor indiscipline in volatile markets, a propensity to trade more frequently, and an absence of a regular rebalancing policy.
- Assess the expertise and experience of the LIC Manager before deciding to invest.
- In some markets, the benchmark index tracked may be complex and volatile, which may expose investors to liquidity risk.
- Currency risk is possible if the index (that the ETF tracks) currency is different from that to the dominant currency of the ETF.
- Some ETFs are synthetic, using derivatives to gain desired exposure. By not holding all the names and relying on a third party, this brings a level of counterparty risk to the product.
- Diversification is not a unique feature of ETFs and LIC’s. Many other mutual funds are well diversified and offer the same benefits, sometimes at a lower cost.
- Some ETFs only sample the index they are tracking, leading to fewer names in the strategy. This reduced diversification may increase the risk of not capturing the asset class return.
- ETF Liquidity can disappear during times of market stress as the spreads between the fund NAV and the exchange price widen.
For more information, see our video series. View the six key factors to help you become a better investor. Enjoy greater success with less stress, leaving you to focus on more important things in life.
- Accept the Price
- Beware, Market Gurus,
- Control Your Costs
- Spread Your Risk
- Be Disciplined; and
- Stay Balanced.
Over the past 15 years, ETFs and LICs have had significant growth in the Australian market.
However, investors in ETF and LICs may be missing out on some important benefits and are failing to recognise some equally important risks.