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Investing basics: How to tell an ETF from a LIC

Emma Rapaport  |  21 Sep 2018Text size  Decrease  Increase  |  
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what is the difference between ETF and LIC investing education

Exchanged-traded funds (ETFs) and listed investment companies (LICs) are both listed on the stock exchange, transparent and cheap. But that's where the similarities end.

Read on to learn how to differentiate between these two acronyms.

What are ETFs and LICs? 

As explored in our Beginner's Guide to ETFs, an exchange-traded fund is a collection of investments that trade just like a stock on an exchange, and is generally used to track the performance of a specific market index. For example, if you want to invest in the overall ASX 100 Index, you can buy an ETF that will mimic its movements. 

State Street's SPDR S&P/ASX 200 Fund (STW) was the first Australian ETF launched on the ASX back in 2001. Since then, Australian ETF market has swollen to $41.5 billion in funds under management.  

LICs, or listed-investment-companies, are also traded on an exchange, such as the ASX. However, rather than invest in the whole of a market a listed company has a fund manager who selects holdings based on a certain criteria.

LICs have a long and established history in Australia dating back to the mid 1920s. Today there are more than 100 LICs on the ASX, with a category market capitalisation of $39.8 billion. 

What do ETFs and LICs have in common? 

Fast and easy execution: ETFs and LICs can be traded at any time during stock market hours, unlike managed funds, which usually are traded only once a day and can have a substantial lag between trading instruction and execution; 

Transparency: Intra-day pricing means LIC and ETF investors can see the market value of their holdings in real time. The ASX also requires ETF portfolio holdings to be disclosed on a regular and timely basis, which means investors can see exactly what they own.

Managed funds, in contrast, disclose portfolios on a lagged basis, or not at all. LICs tend to be more transparent about holdings than managed funds, but not as explicit as ETFs; 

Low trading costs: Low portfolio turnover helps to reduce trading costs. Managed funds can also offer the benefits of low turnover depending on their approach, but a low turnover style is more common among ETFs and LICs.

How do ETFs and LICs differ? 

Active vs passive

ETFs are usually passive investment vehicles that track an index. For example, the SPDR S&P/ASX 200 Fund (STW) tracks the S&P/ASX 200 index. ETFs do not give investors the opportunity to outperform the market. 

Conversely, LICs usually are active, with an investment team that makes calls about the best assets to invest in. For example, the Magellan Flagship Fund (MFF) invests in a concentrated portfolio of global equities and aims to outperform the broader market through clever stock selection. 

However, the boundaries are blurring somewhat. ETFs such as the BetaShares FTSE RAFI Australia 200 (QOZ) use a strategic-beta approach that differs from traditional market-cap-based indexing, while the UBS IQ Research Preferred Australian Share Fund (ETF) uses forecasts from UBS's broker arm, giving it an active flavour. 

Nevertheless, ETFs usually track an index, while LICs, for better or worse, are free to invest in whatever the management team deems appropriate. 

Open-ended versus closed-ended 

ETFs are open-ended. Investors can trade ETF units with each other on the exchange, but when there is an excess of supply or demand, a market-maker steps in to create or redeem units. That means an ETF should trade close to the underlying net asset value (NAV) of its holdings. 

Investors should rarely see a substantial premium or discount in a well-managed ETF, and if there is a gap, it should close quickly. 

In contrast, a LIC is closed-ended. The number of shares is fixed, so when there is an imbalance between demand and supply, the share price may trade at a premium or discount to the NAV of the LIC's assets. 

If you buy at a premium, you may be overpaying for those assets, while selling at a discount means you might not be getting the best price. 

The LIC board may implement measures to close these gaps, such as share buybacks, rights issues, increased marketing efforts, or in extreme cases, winding up the LIC. But these measures take time to implement, which can result in LICs trading at substantial premiums or discounts for drawn-out periods. 

For example, Templeton Global Growth Fund Limited (TGG) traded at a discount from 2009 through to 2013, sometimes exceeding -20 per cent of NAV, while Djerriwarrh Investments Limited (DJW) has traded at a premium for five years to May 2014, sometimes as high as 30 per cent of NAV. The Templeton fund has since narrowed the discount to around 6 per cent. 

Dividends 

ETFs and managed funds pay no tax themselves. They are tax-transparent and must pass on any income, either dividends or realised gains, within the financial year it is earned. 

In contrast, LICs are companies, so they can choose to retain earnings and reinvest them or pay out earnings as dividends. 

LICs pay company tax on their earnings and thus, when they do elect to pass through dividend income, investors may receive franked dividends. 

The ability to retain earnings also allows LIC management teams to smooth out dividend income by retaining some earnings in good years and paying it out in bad years. 

 

More in this series 

 

Emma Rapaport is a reporter with Morningstar Australia, Alex Prineas is associate director, manager research with Morningstar, Jemima Joseph is a former associate analyst with Morningstar. 

 

© 2018 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 ("ASXO"). The article is current as at date of publication 

is a reporter for Morningstar.com.au

© 2019 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782. The article is current as at date of publication.

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