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What’s the Difference Between a LIC and an ETF?

What’s the Difference Between a LIC and an ETF?

Jack Fyfe

What’s the Difference Between a LIC and an ETF?

Listed investment companies (LICs) and Exchange Traded Funds (ETFs) are assets frequently traded on stock exchanges such as the ASX. Investors may often choose to invest in either asset as a way of diversifying their portfolio instantly, tracking the market or a particular index via a passive ETF, or they might choose an LIC or an active ETF as they believe the managers can outperform the relative benchmark. There is no uniform fund that suits all investors’ needs and expectations, therefore understanding the characteristics of each asset is essential before you make an investment choice.

What is a LIC?

A LIC is a company that is listed on an exchange and actively invests in other companies to make up a portfolio. LIC’s operates similar to a managed fund, where an internal or external fund manager composes and manages a portfolio for the LIC to invest in. The asset classes which fund managers may choose to invest in are diverse and not limited to the four traditional asset classes: stocks (equities), bonds, real estate and cash. Fund managers use expertise to make an assessment on the asset allocations and weightings in these assets to balance a competitive portfolio, attempting to “beat” a designated benchmark. This benchmark could simply be the market, a particular sector, or a particular data point.

The Australian Foundation Investment Company (ASX ticker code AFI.ASX) is an example of an LIC with the primary aim of providing investors with long term returns and dividends that grow faster than the rate of inflation.

The money that funds these investments is raised via an IPO (Initial Public Offering), where the LIC offers a fixed number of shares on an exchange and investors buy these shares for ownership in the company. Investors buy and sell these shares as they wish, however the supply of these shares are “close-ended”, meaning the LIC does not issue new shares or cancel existing shares in response to rising or declining investor demand. Post IPO, only existing shares are bought and sold between investors, and this supply-demand force is a strong determinant of the share price.

What is an ETF

What is an ETF?

ETFs are a class of managed funds that are available to be traded on exchanges. This fund often tracks a basket of securities such as: an index (the ASX 200 or S&P 500), sector (securities-based sectors e.g., Healthcare or Technology), commodity (such as gold and oil) or another other asset classes that may be tracked (such as property).

Most ETFs are passively managed (where they track an index) and changes in the unit price is reflected by general performance of the index it is aiming to track. Alternatively, active ETFs are operated under the guidance of a fund manager that manages a portfolio of securities. Fund managers can actively alter the weightings of securities as they choose, in response to market changes and performances, as they attempt to beat the market index – subject to fund mandates. Historically, active funds have not outperformed the market benchmark long term, thus they have the potential for greater returns and the risk for potentially greater losses.

Common Types of ETFs

While some ETFs fall into different categories or indeed, spread themselves across several of the common categories, the majority of ETFs can be defined under the following categories:

Bond ETF

This is often used as an income generating ETF. Distributions are dependent on the bond performance and varies dependant on the characteristics of the bonds that the ETFs track. Bonds may include Corporate Bonds, Government Bonds and State / Local Bonds. The Vanguard Fixed Interest Index ETF (VAF.ASX) seeks to track the return of the Bloomberg AusBond composite, with significant holdings comprising of Australian Government Bonds.

Stock ETF

These ETFs combine a collection of stocks that are common to a particular exchange or region. The BetaShares Australia 200 ETF (A200.ASX) seeks to track the ASX 200 index, hold shares in each constituent company. These ETFs are a great option for investors who want to see their returns largely track the market.

Sector ETF

These ETFs combine a collection of stocks that are common to a particular industry or sector. The Beta shares Australian Financials Sector ETF (QFN.ASX) tracks the performance of stocks found in the Australian Financial Sector. These ETFs are a great option for investors who want to gain a diversified exposure to an attractive sector.

Commodity ETF

As per the name, these ETFs invest in commodities such as silver and oil. Perth Mint Gold (PMGOLD.ASX) is an ETF that gives investors the opportunity to trade in gold via a brokerage account. Holding a commodity ETF is cheaper than physical possession of the commodity and makes the investment more liquid. They are useful in assisting investors with diversifying their portfolio beyond traditional stocks and bonds.

Currency ETF

These ETF’s track the performance of currency pairs, consisting of a domestic and a foreign currency. Commonly, investors use these to hedge a portfolio against volatility in ForEx markets by importers and exporters. The BetaShares Strong Australian Dollar (MF) ETF (AUDS.ASX) tracks the change in value of the Australian dollar relative to the US. Investors tend to be subject to macroeconomic risk when investing in these ETFs, such as interest rate hike risk and geopolitical risks.

 

Key Differences Between LIC and ETFs

Structure

The legal structure of an LIC is a company (a separate legal entity), hence buying shares in an LIC grants the investor ownership in the LIC itself rather than its investments. Contrary to this, ETFs are a unit trust, so investment in ETF’s will translate into units in that fund which are entitled to all dividend earnings that the ETF makes on a pro–rata basis. In comparison, dividend payouts in LIC’s will be determined by a board of directors each financial year, and shareholders are not necessarily entitled to dividend earnings, unlike ETF’s.

Tax Implications

ETF tax obligations lay with the investor, meaning all dividend income and capital gains are taxed in accordance with the personal investor tax code. Investments within ETF’s incur low CGT compared to active funds such as LIC, which trade more frequently and lead to higher CGT payable. On the contrary, LIC’s are tax paying entities that pay dividends. The investors tax obligation is dependent on the dividend and franking credit policy as well as realised capital gains (like ETF’s).

Management Costs

Depending on whether an ETF is actively or passively managed, the management fee/cost can vary. Passive exposure carries lower management fees, whilst active ETF exposure are attributed to higher fees. LIC’s carry higher management fees, as the investment portfolio is always actively managed by a fund manager.

Open/Close Ended

ETFs are open-ended Investment vehicles where units can be created in response to investor demand. LIC’s are close-ended and do not offer new shares/units – only existing units that can be traded. In addition, the price of these shares is heavily dictated by the supply demand relationship, where increase in demand (for LIC shares) can drive the price of these shares upwards beyond their real market value.

While LIC’s do not frequently offer new shares/units, an exception is when an LIC decides to issue new shares (increasing funds under management), or if they decide to pay dividends or engage in a share buyback program (decreasing funds under management).

Transparency

ETF’s release information regarding their portfolio composition at a fixed time every day – usually at end of each trading day completed. LIC’s are only subject to disclosing their portfolio with reporting deadlines (which are far more infrequent). As these are actively managed, asset allocations and weightings are transient, meaning and accurate overview of the portfolio composition is difficult to ascertain.

Key Similarities Between LIC and ETFs

Diversification

Transaction into either of these exchange traded products gives the investor exposure to high diversification. ETF’s often gain exposure to potentially hundreds of stocks from select asset classes. An LIC’s fund manager selects individual stocks and assets which usually gives the investor access to a multitude of asset classes and different securities. Therefore, investing in either product dramatically increases investors reach in the market, hence reducing the risk and total investment costs.

Liquidity

Both LICs and ETFs are traded publicly, which enable investors to alter their investment position (buy and sell) frequently, meaning funds are liquid. High liquidity gives investors the freedom to immediately alter their position in accordance with their portfolio needs.

How does the size of the LIC market and ETF market compare?

Since inception, the Australian ETF industry has exploded, with double the amount of ETF products currently offered on the exchange to LIC products. The growth in ETF’s is not only impressive, but unprecedented considering the first ETF in Australia was launched in 2001 (65 years after the first LIC).

Growth Strategy ASX

Performance of the largest Australian Market LIC’s v ETFs

Following the Global Financial Crisis (from 2009), active ETF accounts have compounded at an annual growth rate (return) of 39% compared to the more subdued growth that LICs experienced, of 11.5%. In trading, past performance is not a reliable indicator of future performance, so this trend of returns is of course not guaranteed. However, over the short period that both funds have been active, ETF’s have convincingly outperformed LIC’s.

What should you Invest in?

Your choice of investment will vary depending on a range of factors. Both ETFs and LICs give you access to a product low in volatility, risk and volume compared to other alternatives. For beginner investors, ETFs and LICs require adequate understanding of asset classes and securities which the fund invests in, which could be an easier task for you than doing due diligence on a company level and building a portfolio out of individual stocks. Picking an individual ETF/LIC depends on your investment horizon, financial objectives, financial literacy and risk tolerance – along with personal views on particular sectors or other asset classes. Financial advice can be sought out to help familiarise you with this process and by extension, tailor your portfolio to directly meet your needs and expectations.

Conclusion

ETF’s and LIC’s make up a huge proportion of fund products available on the exchange. LIC’s have performed well, but predicting the performance of fund managers is impossible, and often their performance is inconsistent, therefore carrying more risk. In comparison, ETF’s have been introduced as a low-cost option, with stable long-term performance and high liquidity, even through various market downturns. Both funds have advantages and disadvantages, and it is ultimately up to you to make out which exchange-traded product best serves your investment goal

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