At our Switzer Webinar last month, and again last week in meetings, a question that was raised by several investors was “What is better, an ETF or a LIC?” and then followed up by, “Which one?” If I have lost you already with the acronyms, I am talking about Exchange Traded Funds (ETFs) and Listed Investment Companies (LICs).
While many investors prefer to construct their own portfolio of direct shares, others can see the advantages of using a managed investment – particularly if they don’t have a lot of time to follow the market. Some investors use managers to complement a portfolio of direct shares – while others go the opposite way and run a core portfolio with a manager and then invest in individual shares as the satellite component.
Two of the easiest ways to gain exposure to the market are through broad based LICs or index tracking ETFs. Listed and traded on the ASX, both are managed investments.
There are different types of ETFs – some that track the broad market, some sector based and others that follow a part of the market like small caps. Similarly with LICs, where there is an even greater variety. So that we can make meaningful comparisons, we are only going to consider broad-based LICs and market cap ETFs in regard to the first question – “an ETF or a LIC?”
Exchange Traded Funds
ETFs are designed to track an index. They are on “autopilot” – the manager invests and maintains the investment in accordance with the index. If the index weight for Commonwealth Bank is 9.80%, very close to 9.80% of the ETF will be invested in Commonwealth Bank shares. The manager doesn’t try to beat the market – all he/she does is try to reduce the index tracking error.
With 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. While each ETF tracks a different index, they are all broad based indices and we have compared their performance to the S&P/ASX 200 accumulation index over periods ending on 31 March 2015.
Major Exchange Traded Funds
[1]Click here [2] to view larger image
Returns to 31/3/2015. Source: respective managers
The major advantage of an ETF over a LIC is improved transparency and market pricing. ETFs update their NTA every working day, sometimes intraday (IOZ and VAS), and due to their fungibility (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.
The major 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.
Major Listed Investment Companies
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Returns to 31/3/2015. Source: respective managers
As the table demonstrates, the funds have, in the main, marginally outperformed the S&P/ASX 200 accumulation index over longer time periods. Over the last 12 months, the funds have marginally underperformed. While each fund uses a different benchmark, comparison to the same index over identical periods (in this case, the year ending 31 March) helps us 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.
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 or minus 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 sharemarket 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 AFIC’s share price 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).
AFIC’s share price to NTA – relative premium/discount
[5]Source: AFIC
Over the last 12 months, most of the LICs have been trading at premiums, although this has narrowed considerably over the last month or so. At 31 March, Argo was trading at a very small premium while AFIC and Milton were trading at tiny discounts.
Current Discount/Premium (as at 31 March 2015)
[6]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 LIC 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 is actively managed), the flipside is that its return may indeed be better than 0.40% per annum. There is also some manager risk – so you may want to spread any investment across two LICs.
Calculating the premium or discount
LICs are required to publish their NTA each month (ASX announcement, plus on their website), which is 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 one?
My ranking of the ETFs (based on management fees and index tracked) is:
1. Australian Shares ETF VAS (Vanguard)
2. SPDR S&P/ASX 200 STW (SPDR)
3. MSCI Australia IOZ (iShares)
There is very little in this assessment – any of these ETFs could be selected. It is heavily influenced by fees and a longer-term view that smaller companies will in time do better and hence a preference to opt for a broader index.
Australian Foundation (AFIC) is the largest LIC and has the best performance record. It is also trading at a small discount to NTA, and although it is permitted to borrow money and gear internally, this is still relatively low. Accordingly, my ranking for the LICs is:
1. AFI (Australian Foundation)
2. MLT (Milton)
3. ARG (Argo)
Overall? With the LICs trading so close to NTA at the moment, it’s LICs over ETFs. If I had $100 to invest and wanted broad-based exposure to the market through a managed investment, I would invest $50 in Australian Foundation and $50 in Milton Corporation.
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.