One of the golden rules of investing is diversification, but that can be difficult to achieve when you are just starting out, have limited funds, or simply feel that you don’t have the time or expertise to select your own investments in a crowded global market.
That’s why managed funds have long been popular, to provide diversification across and within asset classes in a single purchase. Problem solved. Except now investors have a new problem.
The range and variety of managed funds has grown exponentially as new technology has allowed for new types of managed funds. Traditional unlisted managed funds now compete with exchange-traded funds (ETFs) and an upsurge in interest in an old stalwart, listed investment companies (LICs).
Choosing the right investment tools for your portfolio can be confusing, so we’ve summarised the main technical and other differences in the table below.
What are the similarities?
ETFs and LICs are like managed funds in that your money is pooled with other investors to create a large portfolio of assets which is professionally managed.
All three allow individual investors to achieve greater diversification than they could alone and plug holes in their portfolio through exposure to sectors of the global market they could not otherwise access.
What are the differences?
Not only do ETFs and LICs they provide diversification, but they can be bought and sold on the Australian Securities Exchange (ASX) as easily as shares and have lower fees than traditional managed funds.
According to the latest ASX figures, as at April 2019 there were 194 ETFs listed on the ASX, up 7% year on year and worth $47.7 billion. Most of these are traditional ETFs that passively track an index. However, the figure also includes some actively managed ETFs, some that use derivatives to mimic an index and some, like hedge funds, that use borrowing, options and short selling.
At the same time, LICs numbered 113, up 6% and worth a combined $42.9 billion.
To confuse matters, some managed funds are now available via the ASX mFund service. This allows you to buy and sell units in selected unlisted funds through a stockbroker. Unlike ETFs and LICs where pricing is ‘live’, investors in mFunds must wait until the close of trading each day to know the price of units that have been bought and sold. (Managed fund investors wanting to redeem units will not know their exit price until the following day.)
As at April 2019, there were 222 mFunds, up 12% year on year, worth $898.8 billion. For more information on mFunds go to the ASX.
Infrastructure funds and Real Estate Investment Trusts (REITs) are also popular listed funds available on the ASX, but they are not included in this article.
What are LICs and ETFs?
LICs are the great grandfathers of the listed managed investment scene, with a history going back almost 100 years. Trailblazers such as the Australian Foundation Investment Company (AFIC) and Argo Investments have provided investors with steady returns for decades, mostly from a portfolio of Australian shares selected by the fund manager.
These days the biggest LIC is Wilson Asset Management’s Australian share fund. While Australian shares still account for the lion’s share of total LIC assets, global share funds are increasingly popular through well-known fund managers such as Magellan and Platinum. Newer LICs also offer exposure to micro-caps, infrastructure, private equity and absolute return funds.
By contrast, ETFs invest in a basket of shares or other investments that generally track the performance of a market index such as the ASX200 Index or the US S&P500.
You can buy an ETF to give you exposure to an entire market, region such as emerging markets, or market sector, such as global health or technology stocks. They also offer investments in a wider range of asset classes, from local and international shares to fixed interest, commodities, currency, property and cash.
Structure and tax
As the name suggests, LICs use a company structure while ETFs, like traditional managed funds, are unit trusts.
Like other companies, LICs are governed by the Corporations Act. This means 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.
By contrast, ETFs are not required to pay tax on their income or realised capital gains. Instead, they pass on all tax obligations to investors who pay tax at their marginal rate. Despite these differences, the after-tax position for investors is similar.
Another key difference between the two is that LICs are closed-ended investments, which means they have a fixed number of shares on issue and new shares can only be created or cancelled via a rights issue, placement or buyback.
This structure means LICs tend to trade at premium or discount to the value of their net tangible assets (NTA). Like all companies trading on the ASX, it’s the market that determines the share price, not the value of the company’s underlying assets.
ETFs, on the other hand, are open-ended which means units in the fund can be created or redeemed according to investor demand without the share price being affected. As a result, ETFs always trade close to their NTA.
Fees and costs
One of the drivers behind the growing popularity of ETFs is their low fee structure. Actively managed funds tend to be more expensive than index managed funds, ETFs and LICs, because of their teams of researchers and fund managers and higher administration costs.
Index funds are lower cost than active funds because the fund manager is simply mirroring their chosen index. That means there is no need for investment analysis or selection and generally lower turnover of investments.
Managed funds may charge a range of fees including an entry fee, additional contribution fee and a fee to cover the ongoing costs of managing your investments called the Management Expense Ratio (MER) which is typically 0.5-2.5% of net asset value a year deducted from your account balance. There may also be a performance fee if the fund manager exceeds their target or benchmark above a certain percentage threshold.
LICs charge management fees which are typically 1-1.5% of net assets and a performance fee of up to 15-20%.
ETFs are generally the cheapest, with MERs of index funds typically well below 1% and as low as 0.07%.
To find out the fees and other costs charged by a managed fund, ETF or LIC you need to check their Product Disclosure Statement (PDS). You should be able to find this on the fund manager’s website.
Of course, cheap is not necessarily best. An active manager who consistently outperforms the market at a level in excess of their performance fee may be worth the cost. The most important consideration where fees are concerned, is the net return after all fees and charges.
And don’t forget transaction and advice fees. To buy an ETF or LIC you will need to pay a broker’s fee. If you purchase a fund via a financial adviser or a platform, there will be charges for each.
The growing interest in LICs and ETFs can be traced back to the growth in self-managed super funds. SMSF investors are not only keen to keep investment costs down, they are also on the lookout for simple, effective ways to create a diversified portfolio tailored to their personal needs.
The expansion of products on offer has also made it easier to take advantage of market trends, such as improving global growth or geopolitical tensions. For example, according to ETF Securities Weekly ETF market Monitor, the best performing ETFs in the five months to May 2019 were geared Australian shares, geared US shares (currency hedged) and crude oil (hedged). The biggest money flows went into Australian high interest cash, international shares and Australian shares.
LICs were also given a shot in the arm following a change in the Corporations Act in 2010 that altered the way dividends can be paid out. This allowed them to pay a regular stream of franked dividends to investors seeking higher yields at a time of historically low interest rates.
LICs, ETFs and managed funds must all meet the requirements of the Corporations Act.
All managed funds have their place
Despite the growing profile of ETFs and the recent resurgence in LICs, all types of managed funds have a role to play in your portfolio depending on your needs. It’s not an either/or – you might hold all three for different reasons.
Some fund managers these days offer the same assets wrapped up in an ETF or LIC as well as a managed fund to attract different types of investors.
Managed funds can suit investors who want a low-cost way to add or withdraw small amounts regularly. This makes them suitable for investors who want to build their investment over time, perhaps taking advantage of dollar cost averaging.
ETF investors can add or sell units at any time, but they will incur brokerage on each transaction. As many online brokers charge a fixed dollar amount, ETFs may suit people making large investments.
Because ETFs are traded on the ASX like shares, they also offer the opportunity for experienced investors to use sophisticated trading strategies like limit and stop-loss orders. However, their easy tradability could prove costly if it encourages you to overtrade or try to time the markets.
Before choosing a fund, it’s important to understand how they work. Also look at their underlying investments, their performance and trading history, their tax status and distribution policy as well as their fees and cost.
Table 1: Managed funds vs ETFs vs LICs
|Structure||Open-ended. Units are created or redeemed by the fund manager based on demand which aids liquidity. Fund manager may need to sell investments to pay out investors in a falling market, or buy investments when demand is high in a rising market.||Open-ended. Market makers provide liquidity by always offering to buy and sell units.||Closed-end. Investors buy and sell shares from each other. This allows the fund manager to concentrate on selecting investments and saves on administration costs. The supply of shares is limited unless the fund manager raises capital.|
|Access||Accessed directly from the fund manager or via a financial adviser or platform.||Bought and sold like shares via a broker (investors must open an account with a broker).||Bought and sold like shares via a broker.|
|Investment style||Generally actively managed to outperform an index or provide an absolute return to investors but passive index funds also available.||Generally passive index funds which track a particular market or market segment.||Generally actively managed.|
|Pricing||Orders to buy or sell units are transacted at the end of the day at the net asset value (NAV) of the underlying securities.||Traded like stocks in real time so price changes continuously. Market maker on other side of the trade so price is generally close to NAV which is published daily.||Traded like stocks, based on price investors are prepared to pay each other. This means the price may be at a large premium or discount to NAV. LICs need only publish their NAV monthly although some provide more regular updates.|
|Income distributions||Must distribute all income and realised capital gains (less realised capital losses) from the underlying investments. Investors pay tax on these distributions at their marginal rate.||Must distribute all income and realised capital gains (less realised capital losses) from the underlying investments. Investors pay tax on these distributions at their marginal rate.||LICs only distribute income when the board declares a dividend. As LICs pay tax at the company rate, dividends are generally fully franked.|
|Income stability||As all income must be distributed, income can vary dramatically depending on the underlying investment/index performance.||As all income must be distributed, income can vary dramatically depending on the underlying index performance.||As an LIC determines when and how much income to pay investors, many LICs pay a steady income stream and avoid fluctuations.|
|Cost||Management fees plus adviser or platform fees. Actively managed funds often charge a performance fee. Management fees lower for index funds.||Generally low management fees plus brokerage. Costs are minimised because most are index funds. Also, there is no need to buy and sell units to meet demand.||Typically charge management fees plus performance fee. Many LICs have a long-term buy and hold strategy, so fees often lower than managed funds with similar assets.|
|Transparency||Actively managed funds often only list their top 10 investments so competitors/investors can’t copy them.||All underlying holdings available on the investment manager’s website.||All underlying holdings generally available on the fund manager’s website.|