How do ETFs compare to LICs and managed funds?

Choosing the right investment tools for your portfolio can be confusing, so we’ve summarised the main technical and other differences in the table later in this article.

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 that 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 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 June 2021 there were 223 ETFs listed on the ASX, up 8% year on year. The market value of the sector pushed through the billion dollar mark for the first time, rising 73% to $113.5 billion as investors rushed back into equities after the COVID sell-off in early 2020. This took growth of the Australian ETF market to 500% in just five years. Close to 90% of ETFs still passively track an index. However, there are growing numbers of 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 fell in number from 111 to 102, but their combined value increased 32% to $58.3 billion.

To confuse matters, some managed funds are 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 June 2021, there were 240 mFunds, up 2.6% year on year, worth $1,744.8 million. 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 big names include Milton Corp and WAM Capital. While Australian shares still account for the biggest share of total LIC assets, global share funds are catching up fast 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, market sector such as global health or technology stocks, or theme such as sustainability. They also offer investments in a wider range of asset classes, from local and international shares to fixed interest, commodities, currency, property, infrastructure and cash.

The most popular ETFs in 2020–21 were Australian and global equities, as sharemarkets rebounded strongly from the pandemic lows. The best-performing ETF were technology sectors and themes such as battery technology, robotics and AI and global cybersecurity.

The rapid growth of ETFs has led to an increase in product providers, but the big players remain Vanguard, BetaShares, iShares and StateStreet.  

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.

On the other hand, ETFs 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. Traditional actively managed funds tend to be more expensive than index managed funds, ETFs and LICs due to 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 0.5–2.0% 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. MERs on mFunds currently range from 0.3–1.7%.

LICs charge management fees that range from 0.3–1.8% 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 1.5% and as low as 0.07%. According to the 2021 Stockspot ETF report, 80% of index ETFs listed on the ASX charge less than 0.5% in fees.

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 exceeding 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.

Why now?

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, in the year to June 2021, the value of global equity ETFs jumped 120% from a combination of new investment inflows and rising stock prices. According to ETF Securities Weekly ETF Market Monitor, the best performing ETFs in the year to June 2021 were geared US shares, battery technology and lithium, crude oil, FANG (Facebook, Amazon, Netflix, Google) and geared Australian shares. The worst performers were Australian and US equities bear funds, US dollar and gold ETFs.

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. However, their simplicity and tradeability have made them popular with younger first-time investors who are comfortable trading on mobile investment platforms.

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