LICs or ETFs – what you need to know

Co-founder of the Switzer Report
Print This Post A A A

My first (and only) marketing lecturer at Uni said never advertise with an acronym, unless it was funny or another “interesting” meaning could be imagined. Perhaps this explains why LICs (Listed Investment Companies) and ETFs (Exchange Traded Funds) have been so slow in Australia to take off. However, judging by the number of questions subscribers are asking, there does seem to be genuine growing interest in these investment options.

I use the word “options” deliberately because they are valid alternatives to investing directly through individual stocks. Some investors don’t have the time or inclination to select and then manage a portfolio of stocks, and can instead obtain broad market exposure cost effectively by investing in a LIC or ETF.

So the question is – which is better, a LIC or an ETF?

Before turning to this, let me note that we are only going to consider market cap or broad based ETFs/LICs. While there is a plethora of small company/sector/high alpha LICs and some small company/sector ETFs, comparing these is often difficult and they are not necessarily investment alternates.

The major broad market LICs

There are three major broad market LICs – AFIC or Australian Foundation Investment Company, Argo Investments and Milton Corporation. They are big, professionally managed and very credible investment companies. Milton Corporation, for example, was listed on the ASX in 1958 and has paid a dividend to its shareholders every year since.

LICs are actively managed. That said, these broad market LICs essentially invest in the major blue chip companies, placing considerable emphasis on companies that have reliable earnings, pay fully franked dividends and have an ability to grow these dividends. An investment précis is set out below.

As the table demonstrates, each of the funds has performed credibly, marginally outperforming the S&P/ASX 200 over most time periods. While each fund uses a different benchmark, comparison to the same index over identical periods (in this case, the year ending 30 June) allows us to make an informed judgement.

An advantage of LICs compared to ETFs is that they usually offer share purchase plans, which allows shareholders to subscribe for new shares at a marginal discount to their underlying value or NTA (Net Tangible Asset value).

A major disadvantage is that as close-ended funds, where new investors become investors by buying shares from other investors on the ASX, the LIC can at times trade at a significant premium or discount to its NTA. We discuss this in more detail later.

Major Broad Market LICS

Click here to view a larger image.

Returns to 30/6/2014. Source: Respective Managers.

The major market cap ETFs

ETFs are designed to track an index. Due to their low management fees, they should provide a return that closely matches the return of the index. Nothing more, nothing less.

Performances of the major market cap ETFs are set out below. Again, while each ETF tracks a different index, we have compared their performance to the S&P/ASX 200, and used identical periods ending on 30 June 2014.

The major advantages of an ETF over a LIC are improved transparency and market pricing. ETFs update their NTA every working day, sometimes intraday, and due to their fungibility (an investment term for interchangeability) and appointment of market makers, you will buy or sell an ETF within 0.10%/0.20% of the NTA of the fund. The premium or discount should always be small.

Unlike LICs, they don’t offer share purchase plans, although some ETFs pay distributions quarterly. The major ETFs are listed below.

Click here to view a larger image.

Returns to 30/6/2014. Source: Respective Managers

LIC or ETF?

The tables demonstrate that despite their different investment styles, objectives and benchmarks, the broad market LICs can be expected to deliver an index style return plus a fraction, and the ETFs an index return less a fraction. While this is not a “given”, the outcome is not that surprising, given the concentrated nature of the domestic share market and the relatively conservative investment style adopted by the LICs.

So, the answer to the question – LIC or ETF? – comes down to the premium or discount that the LIC is trading at.

The graph below shows how AFIC’s share price has compared to the underlying NTA. At times, it has traded at a discount of up to 10% (typically in bear markets), and at other times, a premium as high as 12% (typically in bull markets). Recently, most of the LICs have been trading at small premiums.

AFIC’s Share Price to its NTA – Relative Premium/Discount

Source: AFIC

Using an assumption that the LIC will outperform the ETF by around 0.40% per annum (or say 2% flat over a five-year period), then the question can be answered as follows:

If the LC is trading at a discount or a small premium (say < 2 or 3%), then invest in the LIC%; otherwise, invest in the ETF.

While there is arguably a little more variability in the return from the LIC than the ETF (because the former it is actively managed), the flipside is that its return may indeed be better than 0.40% per annum over the index. Also, if your time horizon is longer than five years, then you could potentially afford to pay a higher premium.

Calculating the premium or discount

LICs are required to publish their NTA each month (ASX announcement, plus on their website), which are generally available by the fifth working day of the following month.

At other times, you can quite accurately estimate the NTAs for the broad market LICs. Take the last published NTA, and adjust it up or down by the percentage movement in the S&P/ASX 200 since the calculation date (i.e. end of month). To calculate the premium or discount, compare the estimated NTA with the current market price on the ASX.

Which LIC or ETF?

My ranking of the ETFs (based on management fees and index tracked) is:

  1. VAS (Vanguard)
  2. STW (SPDR)
  3. IOZ (iShares)

With the LICs, AFIC has the best performance track record. However, it is also now permitted to borrow money and while the internal gearing is still relatively low, it has yet to demonstrate how it will perform in a bear market. Accordingly, my ranking is:

  1. MLT (Milton)
  2. ARG (Argo)
  3. AFI (AFIC)

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

Follow the Switzer Super Report on Twitter

Also in the Switzer Super Report:

Also from this edition

View More Articles