Distinguishing Between ETFs and LICs

Welcome to week two of a special Daily Reckoning series. Last week you were introduced a new project, led by Guild Chairman Bernd Struben and myself. We answered a number questions sent in to our DR reader mailbox and introduced you to our Australian board members.

This week we’ll examine some more questions from our readers. And Dan Denning will introduce you to our international board on Wednesday.

Today I want to look at an easier, safer way to invest in a wide range of businesses.

Picking individual stocks can be a rollercoaster. First you need to understand the industry and markets that a company operates in. Then you should be confident of the company’s prospects. Even if they have been doing well in past years, you must know whether they can continue to do well next year. How capable is their management team? Will they continue to pay dividends? Will investors lose interest in the stock? There are a lot of unknowns.

This can be a lot of work, even when investing in Australian companies you’re familiar with. But trying to benefit from select opportunities in emerging markets, such as China, India, and Brazil, can be even more difficult.

You may not be familiar with these foreign companies. It’s harder to get hold of the right information you need to make an informed decision. And the volatile nature of emerging market stocks could put you off. And then there’s the hassle and expense of arranging to buy stocks on overseas exchanges.

A simple solution can be found in listed managed investments, in particular exchange traded funds (ETFs). With just one trade, you can invest in an entire market or industry. ETFs offer a low cost, diversified exposure to a range of countries, markets and asset classes.

The popularity of exchange traded products (ETPs) has grown exponentially in Australia in recent years. There are now 96 exchange traded products — mainly ETFs — on the ASX. And their value has grown by 50% over the past year.

ETFs mimic the performance of a particular index. For example, if you held an ETF that mimics the ASX 200, you would have earned 11% over the past year — the same as the ASX 200 Index. Their units are listed on the stock exchange so that they can be bought and sold easily, in any quantity.

They have lower risk than individual shares, especially than individual shares in international markets. They are also cheaper, more transparent, and easier to buy and sell than traditional (unlisted) managed funds.

With low costs and benefits from diversification, they are a great addition to your portfolio.

If you’re a regular reader of the Markets and Money, you may already be familiar with ETFs. A number of the editors have already discussed the benefits of ETFs and other ETPs, such exchange traded commodities.

But listed investment companies (LICs) haven’t gotten the attention they deserve…yet. These have a longer history in Australia. While ETFs have only been trading in Australia since 2001, some LICs have been operating for more than 80 years.

ETFs and LICs have many similarities. Each pools your money with other investors to offer opportunities that you couldn’t access individually.

The management costs in ETFs and LICs are generally lower than unlisted managed funds. And they can be quickly and easily bought and sold on the Australian Stock Exchange for the same fee you’d pay buying and selling regular shares. But there are a few differences that you need to be aware of.

LICs are more actively managed than ETFs. ETFs track an index. They do not aim to outperform it. The LIC’s fund manager applies their expertise, aiming to beat an index rather than match its performance. This means that management fees are often higher. Although the older LICs tend to have lower fees than newer companies.

As I mentioned in Friday’s Markets and Money, the majority of fund managers fail to beat the index that they are paid to beat. But then there are LICs like the Australian Foundation Investment Company [ASX: AFI] and Argo Investments [ASX: ARG]. These have outperformed the market over several decades.

Also unlike ETFs, you can sometimes purchase LICs at a discount. Just like regular shares, shares in LICs can trade at both a premium and a discount to their Net Tangible Assets (NTA). NTA, by the way, is simply the underlying value of the company. This would be the total value if its parts were sold privately.

Take for example, an LIC trading at $1.00 but with assets worth $1.10. This would be trading at a discount to its NTA. In the future, the LIC may return to trade at fair value, or at a premium to its NTA, offering potential for gains above what the index alone may return.

ETFs are more transparent. Their prices are adjusted by a ‘market maker’, who buys and sells units to keep the price in line with the index it tracks. The net asset value (NAV) is the value of all the investments held in the fund. This is available on the ASX, and it’s updated every 15 minutes while the market is open.

LICs provide details of their investments only once a month. And they’re close ended. This means that shares cannot be cancelled or created, so the market determines the price LICs trade for. That’s why you can sometimes buy at a discount.

We’ve created a complete portfolio for Guild members using these products. This is designed to reduce the risk to your portfolio while opening the door to new opportunities.

More on overseas investing tomorrow.


Meagan Evans
Investment Director, Albert Park Investors Guild

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Markets and Money offers an independent and critical perspective on the Australian and global investment markets. Slightly offbeat and far from institutional, Markets and Money delivers you straight-forward, humorous, and useful investment insights from a world wide network of analysts, contrarians, and successful investors.

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