Exchange traded funds versus listed investment companies
Learn the difference between ETFs and LICs, and discover which one is the right investment choice for you.
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Thinking of investing in an exchange traded fund (ETF) or listed investment company but aren’t sure which is the right choice for you?
LICs and ETFs are similar in that they allow you to invest in a diverse portfolio of companies in one transaction. However there are some key differences that you need to be aware of.
This guide will help you understand the characteristics and structures of ETFs and LICs with easy-to-understand terminology and examples. We'll also walk you through the advantages and disadvantages of each option, so you can decide which one is best for your portfolio.
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An exchange traded fund (ETF) is a simple and affordable way for you to access multiple assets in a single trade.
In basic terms, an ETF is a collection (or "basket") of tens, hundreds or sometimes thousands of assets, such as stocks, commodities or bonds, that is designed to go up or down in value in line with the index it’s tracking. When you purchase a single ETF, then you’re investing a small amount in every asset which makes up the ETF.
For example, the iShares S&P/ASX 20 ETF is comprised of stocks from the 20 largest Australian companies listed on the ASX. The top 20 stocks are selected by consulting the S&P/ASX 20 Accumulation Index – an index designed to measure actively traded and highly liquid securities that are among the 20 largest securities listed on the ASX. The ETF replicates the performance of the index by purchasing all 20 constituents in a weighting similar to the index. Any movement in the index will result in a near identical movement in the ETF (less a management fee), and you should expect to see a return highly correlated to the S&P/ASX 20 Accumulation Index.
Unlike a managed investment fund, each ETF is allocated a code and can be bought and sold by investors on a stock exchange in the same way that you would buy and sell shares. If you want to exit an ETF, you’ll have to sell your shares on the exchange. The share price for an ETF is based on the net asset value (NAV) of the underlying stocks the ETF tracks.
Broadly speaking, there are infinite types of ETFs which can be formed and traded. The Australian market for ETFs can be categorised into six popular groups:
- Passive ETFs. Also known as indexed ETFs, these funds aim to replicate the returns of a specific index or benchmark. For example, you may want to invest in a fund that tracks the performance of the S&P/ASX 200 or the S&P 500.
- Active ETFs. Active ETFs are those that aim to outperform the market or a particular index to generate higher returns. These are traded on the ASX AQUA market and generally come with a higher level of risk.
- Currency and commodity ETFs. These invest in either the commodities or currency markets through physical assets or futures markets and will allow you to gain exposure to alternative investments such as energy, currencies and agricultural products.
- Leveraged ETFs. This type of ETF uses financial derivatives and debt to amplify the returns of an underlying index. Because it's possible to lose more than you initially invested when using leverage, these types of ETFs are regarded as being more suited to experienced traders.
- Inverse ETFs. These ETFs are designed to move in the opposite direction from the market they are trying to replicate. They use derivatives to profit from a decline in the value of an underlying asset or instrument and are popular for short-term traders looking to hedge longer investments or to take advantage of falling markets.
- Industry ETFs. Industry ETFs are a type of ETF that allows you to gain exposure to a certain industry like pharmaceuticals or agriculture, without having to purchase stocks from individual companies. These types of ETFs generally track a sector index representing a certain industry.
While these six groups are among the most popular, there are additional types of ETFs including bond ETFs, dividend ETFs, international ETFs, smart-beta ETFs and listed property ETFs.
Well-known ETFs listed on the ASX
Major Australian ETF issuers include the following:
- iShares (BlackRock)
- SPDR (State Street)
- Russell Investments
- ETF Securities
- The Perth Mint
|ASX Code||ETF Name||Issuer & Index||Closing price $*||Mgmt Fee %*|
|IOZ||iShares MSCI-Australia 200||BlackRock AM – tracks the S&P/ASX 200 Accumulation Index||24.99||0.15|
|SFY||SPDR S&P/ASX 50 Fund||State Street Global Advisors – tracks the S&P/ASX 50 Index||55.64||0.29|
|VAS||Vanguard Australian Shares Index ETF||Vanguard Investments AU – tracks the S&P/ASX 300 Index||77.53||0.14|
|QOZ||BetaShares FTSE RAFI Australia 200 ETF||BetaShares – tracks the FTSE RAFI Australia 200 Index||13.64||0.30|
*The information in the above table was correct as at 1 February 2018.
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Important: Share trading can be financially risky and the value of your investment can go down as well as up. “Standard brokerage” fee is the cost to trade $1,000 or less of ASX-listed shares and ETFs without any qualifications or special eligibility. If ASX shares aren’t available, the fee shown is for US shares. Where both CHESS sponsored and custodian shares are offered, we display the cheapest option.
A listed investment company (LIC) is a type of investment product that has been incorporated as a company and listed on a stock exchange (usually the ASX). That company will then invest in other companies, typically listed on the stock market. Similar to an ETF, you can buy shares in the LIC, which you can then trade on the stock exchange. Investing in a LIC will give you access to a wide range of assets including shares, bonds and property in a single trade. However, rather than tracking an index, a LIC will have an external and internal management team who is responsible for choosing the company’s investments and managing them.
For example, Argo Investment Limited (ARG) owns a portfolio of listed blue-chip Australian stocks worth over $4 billion. Making an investment in Argo will give you a small portion of almost every major company in Australia. Every month, ARG will calculate the net tangible asset backing per share (NTA), providing you with a regular valuation of their shares based on the underlying value of Argo's portfolio.
LICs are described as “close-ended” meaning they (usually) don’t issue new shares or cancel existing shares as investors leave and join. This allows the managers to place their focus on selecting which investments to make, rather than worrying about money coming into or leaving the fund. Instead, they issue a fixed number of shares on initial public offering (IPO), and investors must buy and sell those shares on the ASX.
Traditionally, LICs will invest in Australian shares or international shares, although newer listed companies offer exposure to a much broader range of asset classes, such as infrastructure and alternatives.
Broadly, there are four main categories of LICs, which are defined by their investment style:
- Australian shares funds. Companies that invest mostly in listed Australian shares
- International shares funds. Companies that invest mostly in shares listed on overseas stock exchanges
- Private equity funds. Companies that invest in unlisted companies, either here or overseas
- Specialist funds. Companies that invest in special assets or particular sectors such as wineries, technology companies, infrastructure or property
Well-known LICs listed on the ASX
Major Australian LICs include the following:
- Argo Investments Limited
- Australian Foundation Investment Co. Ltd.
- WAM Capital Limited
- BKI Investment Co Ltd
- Carlton Investments Limited
- Australian Leaders Fund Limited
- Mirrabooka Investments
- AMCIL Limited
- Milton Corporation Limited
- Flagship Investments Ltd
|ASX Code||LIC Name||Market Cap $*||Last price $*||Mgmt Fee %|
|AFI||Australian Foundation Investment Company Limited||7,375,566,538||6.24||0.14|
|ARG||Argo Investments Limited||5,658,586,755||8.13||0.16|
|AUI||Australian United Investment Company Limited||1,077,645,353||8.70||0.13|
|MLT||Milton Corporation Limited||3,075,659,309||4.68||0.14|
|WAM||WAM Capital Limited||1,572,617,556||2.40||1.0|
|BKI||BKI Investment Company Limited||1,076,452,948||1.74||0.18|
*The information in the above table was correct as at 31 December 2017.
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|Legal structure||Unit trust||Company|
|Management style||ETFs invest in a basket of shares or other investments that generally track the performance of a market index and do not try to outperform that index (passive management)*.||LICs rely on the expertise of an investment manager to select certain stocks or other investments. While they may use an index as their benchmark, they seek to outperform it (in other words, they are actively managed).|
|Investment type||ETFs give you exposure to an entire market, region or market sector such as global health or technology stocks. They offer investments in a wider range of asset classes ranging from local and international shares to bonds, commodities, currency, listed property and cash.||Australian shares account for 83% of total LIC assets while 16% are in global equities. Newer LICs also offer exposure to micro-caps, infrastructure, private equity and absolute return funds.|
|Tax obligations||As ETFs are unit trusts, they pass on all tax obligations to investors.||LICs use a company structure and are governed by the Corporations Act. They pay company tax on their income and realised capital gains which they can hold onto or pay out as dividends plus any franking credits. Investors are then liable for tax at their marginal rate.|
|Cost||Generally, ETFs are low cost as they simply aim to track an index rather than outperform it.||LICs tend to be higher cost as the investor is paying for management’s skill to outperform over the long term. Additionally, a number of LICs have outperformance fees attached where additional fees are paid if the manager outperforms the benchmark.|
|Shares on issue||ETFs are open-ended which means units in the fund can be created or redeemed according to investor demand without the share price being affected.||LICs are closed-ended investments, which mean they have a fixed number of shares on issue.|
*Note: This difference is not always the case, and in recent times there has been more crossover with new ETFs coming on the market that are fully or partially actively managed.
Similarities between ETFs and LICs
- Listed funds. Both are investment funds which are bought and sold on the stock exchange. Your money will be pooled with other investors to create a large portfolio of assets which is professionally managed.
- Diversification. Both provide access to a broad range of assets in a single trade.
- Low fee. Both are low-cost investment vehicles which have lower fees than traditional managed funds.
- Diversify your portfolio. Buying shares in just one international ETF allows you to invest across an extensive range of overseas companies, and thereby minimise your level of risk.
- Enjoy full transparency. The complete list of all underlying holdings of an international ETF is provided to the market each day, while the net asset value of the ETF is also provided regularly. This means you can constantly monitor your risk exposure and invest with confidence.
- Lower fees. International ETFs tend to have lower fees than traditional managed funds, providing a low-cost way for you to invest in a diversified portfolio. Note: You will have to pay brokerage fees when buying and selling ETFs.
- Easy exit. Unlike some other types of investment that lock you into a contract for a fixed term, international ETFs are open-ended. This means that as long as there is sufficient liquidity available, you can buy and sell international ETFs whenever you choose.
- Liquidity. ETFs offer high liquidity as they can usually be bought and sold in the market at any time. Additionally, ETFs trade very closely to their underlying NAV and the price will often correspond with its true value.
- Tracking errors. ETFs don’t always exactly mimic the performance of the index they’re designed to track, with fees, taxes and other factors potentially resulting in lower-than-expected returns.
- Potential returns. As ETFs seek to replicate an index, they don't offer the potential for above-market returns which come with investing in an actively-managed fund. They also don't have the ability to minimise the effects of market downturns.
- Currency risks. If you invest in an ETF that tracks the performance of overseas assets, fluctuations in the value of the Aussie dollar will have an impact on the value of your investment.
- Company structure. LICs are close-ended listed companies, meaning that they don’t issue new shares or cancel existing shares as investors leave and join. This structure allows managers to place their focus on selecting which investments to make and invest for the long term.
- Tax and dividends. On top of dividends, LICs can pay tax out to investors in the form of franking credits. (see section below on dividends)
- Liquidity. LICs are listed entities that can be effectively valued and liquidated throughout the trading day.
- Lower fees. Fees for LICs are generally lower than unlisted and index managed funds. Note: You will have to pay brokerage fees when buying and selling LICs.
- Corporate governance. Due to the company structure, LICs have a high degree of corporate governance and are required to maintain a board of directors and deliver annual and half-yearly reports.
- Limited transparency. Some (not all) LICs only provide investors with an update of their underlying net asset value and largest investments on a monthly basis, making it difficult for investors to accurately assess the true value of the underlying portfolio.
- Lower liquidity. As shares in LICs can only be bought and sold by third parties, the liquidity of the investment is heavily reliant on investor appetite. Additionally, LICs have a tendency to trade either at a discount or a premium to their true value as the price the market places on them can deviate from the NAV.
- Active management. LICs are actively managed and seek to outperform the market. However, there is no guarantee that the investment manager is able to meet this objective and you may lose money on top of fees.
- Jargon. LICs are notorious for employing confusing terminology and industry jargon which can confuse beginner investors.
ETFs must distribute all their income each year to investors in the form of dividends, while LICs only distribute their income when the board declares a dividend.
ETF issuers are required to pay out dividends collected from the assets held in their funds. When the securities pay dividends, the fund will collect the payments and hold them in a cash account until the fund's official payment date, normally quarterly or bi-annual. Payment can be in the form of cash or a reinvestment in additional fractional shares of the ETF. An ETF dividend may be franked or unfranked.
Note: A dividend ETF is a special type of ETF which consists of dividend-paying stocks and usually tracks a dividend index like the S&P/ASX Dividend Opportunities Accumulation Index. Stocks in the fund are specifically selected because they produce a dividend yield.
A LIC will distribute its income when its board declares a dividend. As LICs pay tax at the company tax rate, generally the distributions are fully franked dividends. (For more information about dividends, view our guide here). Since legislative changes in 2010, LICs can pay a dividend even when the company posts a loss.
Franked and unfranked dividendsA franked dividend is an arrangement that eliminates the double taxation of dividends (company earnings in Australia). Shareholders are able to reduce the tax paid on a dividend by an amount equal to the tax credit attached.
For example, if a company has earned $1 in profit, they will have 70 cents left to pay shareholder dividends (assuming it owes 30% in taxes):
- If the dividend is unfranked, shareholders will pay tax on the dividend – for instance if the shareholder also owed 30% in taxes, their original dividend of 70 cents would be reduced to 49 cents due to double taxation.
- If the dividend is franked, shareholders will not pay tax on the dividend. If the company pays a dividend of 70 cents, a 30-cent franking credit will be attached. The shareholder can claim the dividend, the franked credit and their income. If the shareholder’s marginal tax rate is 15%, they will pay a 15 cent tax on the dividend and receive a 15 cent refund.
Can I reinvest dividends without paying brokerage fees?
Some ETF issuers and LICs offer a “no-fee, no-commission” reinvestment program that will allow you to reinvest your dividends as shares at a predetermined price. In other words, you are issued shares instead of money.
For example, say you own 1,000 shares in a company and have elected for 100% participation in its dividend-reinvestment plan. Instead of receiving your dividends in cash, you receive company/ETF shares, which will increase your total shareholding.
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