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ETF & LIC Guide

Starting with the Basics

Exchange Traded Funds (ETFs) and Listed Investment Companies (LICs) are both assets that are able to be bought and sold on the Australian Securites Exchange (ASX).  Their popularity with investors in recent years has exploded, resulting in over 200 different funds now being available on the ASX.

What do these funds do?

When you invest in an ETF or LIC you are investing in a portfolio of individual assets. Some funds track an entire share market index, for example an ETF that tracks the S&P/ASX 200 will hold the top 200 funds listed on the ASX. Other funds hold smaller porfolios of stocks and allow the fund manager to invest based on their discretion. ETFs and LICs do not need to invest in shares, there are now a wide range of ETFs and LICs that invest in cash, bonds, currency, commodities, etc.

Benefits of ETFs & LICs

Many investors are drawn to ETFs & LICs for their ability to provide diversification in their portfolios at a reasonably low cost.  For example an ASX 200 ETF will provide the investor exposure with around 200 individual shares. The trading and brokerage fees to purchase all of these shares individually would in most cases far exceed the cost of the ETF. They also provide access to assets traded outside of the ASX, which can be difficult for individual investors to access. This includes international shares, bonds, currency and commodities.

Due to the investors ability to buy/sell ETFs and LICs on the ASX, all that is required to invest is a brokerage account, with shares able to be bought and sold at any time the exchange is open.  Compared to traditional managed funds where units must be bought and sold by completing application & redemption forms, as well as the mandatory ID checks on every new fund purchase and minimum investment amounts, ETFs & LICs are much more convenient for many investors.

What are the differences in ETFs & LICs?

Traditionally the biggest differences between ETFs & LICs is ETFs generally track an index return and do not try to outperform that index. LICs on the other hand may use an index as their benchmark but seek to outperform.This is referred to as passive management and active management.  This difference is not always the case however, and in recent times there has been more of a crossover with many new ETFs coming on the market that are fully or partially actively managed (these are generally referred to as Exchange Traded Managed Funds as to be called an ETF the fund must track an index.  For the purpose of ETF Watch we call them all ETFs).

The real difference between ETFs and LICs is their legal structures.

A LIC is a company. The impact of this is that the pool of money the fund has access to is close ended (additional capital requires a capital raising), and all profits are reported at the company tax rate (currently 30% in Australia).  Just like other companies, the managers have discretion over how much (if any) they choose to pay as dividends.

An ETF on the other hand is a trust.  This means that there is an open ended source of funding like a managed fund, where the pool of money can grow and shrink on a daily basis depending on who buys or redeems their units.  It also means that the fund does not pay tax on their earnings, but passes these on to the investor who pays tax at their marginal tax rate.

The table below outlines the major differences between ETFs and LICs:

FeatureExchange Traded Fund (ETF)Listed Investment Company (LIC)
Legal StructureTrustCompany (although Listed Investment Trusts, LITs are trusts)
Investment styleGenerally passively managed, meaning they simply try to replicate an index returns, rather than outperform themGenerally actively managed, therefore try to outperform an index or provide an absolute return to investors.
Shares on issueOpen ended, meaning that units are created or redeemed based on the demand on the share market.Closed ended, meaning that there is a limited supply of shares available unless the manager raises capital.
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 Net Asset Value of the fund. NAV is published daily.As LICs are close ended, the price is based on the price that investors are prepared to buy or sell the share for on any given day. As a result the price of the share may trade at a large premium or discount to the NAV. LICs only need to announce their NAV on a monthly basis, however some LICs provide more regular updates.
Income DistributionsAn ETF must distribute all of its income each year. This will be returned to investors in the form of dividends (franked and unfranked), foreign source income, capital gains and capital losses.A LIC only distributes its income when its board declares a dividend. As LICs pay tax at the company tax rate, generally the distributions are fully franked dividends.
Income StabilityAs an ETF must distribute all of its income, the dividend amount can vary dramatically as it is determined by the underlying index performance.As a LIC has flexibility of when and how much income it returns to investors, most LICs aim to provide a steady stream of dividends and attempt to avoid fluctuations. Listed Investment Trusts (LITs) distributions are more like ETFs.
CostGenerally ETFs are low cost as they simply aim to track an index rather than outperform. However, there are now a number of actively managed ETFs with higher fees.LICs tend to be higher cost as the investor is paying for management’s skill to outperform over the long term. A number of LICs have outperformance fees attached where additional fees are paid if the manager outperforms.

Some more on Net Asset Values

Now that we have ascertained the key differences between ETFs and LICs, you might see one of the main differentiators is the concept of LICs trading at a premium or discount to Net Asset Values (NAVs), also referred to as Net Tangible Assets (NTA).

To explain this, it is best to look at an example.  Lets take a LIC called XYZ company.  Today it is trading for $0.80 per share, however the value of all the underlying investments is worth $1 per share.  In this case the LIC is trading at a $0.20 discount to the value of its assets.  On the flipside would be a LIC trading at $1.20 per share with underlying investments worth $1 per share.  This would be trading at a $0.20 premium to its NAV.

Rationally you might think a LIC would always trade at a similar price to its NAV but the share market is not always rational.  Reasons for a LIC being priced differently to its NAV include a number of factors such as: general market sentiment, out/under performance of LIC compared to its peers, asset class the LIC is invested in and the liquidity of the share.  ETF Watch tracks NAVs of all the LICs that we follow, as well a historic NAVs, which is a useful resource if you are interested in investing in LICs.

LICs must report their NAV on a monthly basis, and must report the NAV of the fund on a pre tax basis and post tax basis.  The post tax NAV is generally lower than pre tax due to capital gains that would be payable with full liquidation of the fund.

As mentioned in the table above, ETFs have a market maker on the other side of the trade, this means they tend to track their NAV very closely.  Sometimes the ETF price can drift from its NAV particularly in times of high volatility but this tends to be resolved fairly quickly.  As a result, ETF Watch does not track the NAVs of ETFs and just reports on the ETF price.

Risks of ETFs & LICs

ETF Watch is an information resource only.  We are not licensed to provide general or personal financial advice.  Therefore you should consider consulting a financial adviser before investing.  As with all investments, certain risks apply when investing in ETFs & LICs.

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