ETFs and LICs may appear to be similar products, but they’re very different.
Australian investors, like many investors around the world, are increasingly turning to listed products that give them instant exposure to shareholdings in a large number of companies.
For many, the products of choice are exchange traded funds (ETFs) that invest in every company within a specific market index.
For example, the Vanguard Australian Shares Index ETF (VAS) invests in all of the top 300 Australian-listed companies, mirroring the companies within the S&P/ASX 300 Index.
In other words, through a single market investment in this index-tracking ETF, investors can easily gain exposure to a large number of Australia’s biggest listed companies.
Index-tracking ETFs should not be confused with another class of investments on the Australian Securities Exchange (ASX) known as listed investment companies, or LICs. They are quite different in a number of respects.
Understand the differences
Rather than investing in all of the companies within a specific market index, LICs typically invest in a much smaller number of companies that are hand chosen by their investment team.
In taking an active portfolio management approach, LICs generally aim to outperform the investment returns from the broader share market that index-tracking ETFs aim to achieve.
Yet, outperforming the share market is very hard to do, especially over the long term.
Research from the global index manager Standard & Poor’s released in September shows more than half (55%) of active investment managers underperformed the S&P/ASX 200 Index in the first half of 2023.
The S&P Indices Versus Active Funds (SPIVA) mid-year scorecard shows the proportion of active Australian equity general funds underperforming the broader share market return increased to 81%, 79% and 81% over the 5-, 10- and 15-year time horizons, respectively.
ETFs are an open-ended investment vehicle, which means that the number of units issued in the ETF will change with the demand for the product. If an ETF has a large amount of investors wanting to buy (or sell) it, product issuers can issue new (or redeem existing) units, which helps the ETF trade at a price that is close to its par value, often referred to as its Net Asset Value (NAV).
Investors in an ETF will most commonly transact against investment firms called market makers rather than other investors. Market makers are responsible for creating liquidity in an ETF to help investors efficiently move into or out of the product.
By contrast, a persistent issue for many LICs is that their trading value on the share market is below the actual value of the assets they hold.
The reasons for this is that LICs are closed-ended investment vehicles, which means that the units on issue are set at a fixed number. Because the units on issue can’t change the price that the LIC trades at is subject to change with demand.
Also, in an LIC there are no market makers and each investor will usually transact against other investors on the exchange, if the buying dries up investors are required to discount their price to try and find a buyer.
ASX investment products data shows 82 (91%) of the 90 LICs on the share market were trading below their net asset value as at 30 September 2023.
Another important distinction between LICs and ETFs is in the payment of dividends (income distributions) to investors.
Because LICs are companies, their directors have sole discretion over whether dividend returns from their investments are distributed back to their shareholders.
By contrast, all net investment income that is earned by an ETF is distributed back to its investors.
A LIC trading at a discount to its NAV may not necessarily be a good buying opportunity, as it may continue to trade at a discount for an extended period.
Another key differentiator between LICs ad ETFs is cost. While it’s easy to invest in a broad Australian market ETF with a management cost below 0.1%, the ASX’s data shows the majority of LICs have management expense ratios between 1% and 2%.
Some are also charging additional “outperformance fees” if they happen to outperform their determined market benchmark.
Conclusion
Although the LICs sector in Australia is well established, it is important to know the differences between an ETF and a listed investment company.
There are many, but the main points to consider are that ETFs generally provide much broader market exposures at a lower cost.
Unlike LICs, ETFs are not governed by directors who have discretion on whether company dividend distributions are paid out or accumulated.
ETF investments will generally trade at a price that is close to their NAV – which is not always the case with LICs.
Furthermore, index ETFs provide a high level of transparency in the sense that their investment holdings and weightings are fully disclosed. On the other hand, some LICS do not provide the same level of transparency, especially those invested in unlisted assets.
For investors, it is important to be fully informed and to understand the differences between types of investments.
The above material has been reprinted with the permission of Vanguard Investments Australia Ltd