What are the key differences between exchange-traded funds (ETFs), managed funds (MFs), and listed investment companies (LICs)?

Exchange-traded funds (ETFs) are enjoying their time in the spotlight when compared to their older counterparts: unlisted managed funds (MFs) and listed investment companies (LICs).

With the Australian ETF market having just surpassed A$109 billion in AUM in May, ETFs are moving into the mainstream with both investors and advisers.

While we don't see MFs and LICs dominating headlines as much, all three remain popular SMSF investment options that share some similarities but also some important differences that could make them more or less suitable for particular investors.

 

1. Investment Style and Structure

A key difference between LICs, ETFs and MFs is how they are structured and managed.

LICs are set up using a company structure so they are governed by the Corporations Act and a board of directors. LICs are listed on the stock exchange via an IPO, whereafter shares are then issued to its subscribers. The capital raised by the IPO is then invested in a portfolio of securities chosen by the LIC's fund manager.

ETFs and MFs on the other hand use a trust structure, where investors pool their capital with other investors. This combined capital is then invested on their behalf by a fund manager.

LICs are actively managed, whereas managed funds and ETFs offer both styles so it's important for investors to understand the underlying investment approach particularly if you are seeking an opportunity to outperform the market.

LICs are also close-ended funds, which means there's a set number of shares available to trade, determined by when the LIC is first listed or through any subsequent capital raisings. As such, new shares are not issued, or existing shares cancelled when investors join or leave.

ETFs and MFs on the other hand are open-ended so the number of units on issue is not fixed. This means new shares can be created when investors buy the fund, or existing shares taken out of circulation if investors redeem funds, which overall contributes to strong liquidity.

This is a fundamental difference between LICs and ETFs. Both trade daily on the ASX but because of the closed ended structure of LICs, they will typically trade either at a discount (sometimes heavy) or at times, a premium. ETFs in contrast typically trade around their net asset value so you are paying the total of the prices of the securities within the portfolio.

Investors should be wary of LICs trading at discounts to the actual dollar value of their holdings. While it may seem like an opportunity to gain access to a portfolio of securities at less than their value, it may also mean investors could see losses if they intend to sell their LIC shares in the future and the discount has widened even further.

It's also worth noting that in recent years, many LICs have changed their structure from close-ended funds to ETFs or other open-ended funds in a bid to increase liquidity and address the issue of LICs trading at persistent discounts.

 
2. Access

As their name suggests, LICs and ETFs can be bought and sold on the ASX through an online broker or trading account.

MFs however cannot be traded but instead, accessed directly through the fund provider or through financial advisers.

All three types of funds can provide SMSFs exposure to sectors, both domestic and international, that may otherwise be too costly or risky to access using direct investments.

 
3. Diversification

All three products provide strong diversification benefits to SMSFs as they offer access to hundreds or thousands of securities across, or within, a wide range of asset classes in just one investment vehicle.

Considering the generally low risk tolerance of many SMSFs, ETFs, MFS and LICS help mitigate portfolio risk because of their diversified nature.

 
4. Income and tax

Income and tax implications are important considerations for most, if not all, SMSFs.

ETFs, MFs and LICs can all provide a steady income stream dependent on the type of product selected (for example, high yield funds), but where they differ is how the distributions from these funds are paid out to investors.

Because LICs are incorporated companies, they pay a company tax of 30 per cent and how they distribute dividends to shareholders is determined by its directors. This means LICs can also retain profits if they've generated particularly strong returns and steadily pay them out over future years.

This approach may be particularly beneficial to SMSFs who are looking for a smooth, predictable income stream that they can plan and budget around, particularly during periods of heightened market volatility. Additionally, the income distributed by LICs can be franked which can subsequently reduce a SMSF's own tax liability depending on their applicable rate.

ETFs and MFs pool together the dividends they receive from their underlying assets and then periodically pay them to investors in the form of distributions (typically quarterly or semi-annually). Unlike LICs however, ETFs and MFs do not have the ability to decide how much of the distribution to pay out – they must pay in full on the stated distribution dates. This means market movements can have an impact on both the size and nature of the distribution that ETF and MF investors receive.

For example, during the first half of calendar 2020, many companies reduced dividend payments reflecting reduced profits and greater economic uncertainty. This in turn lead to many funds and ETFs paying lower distributions in the financial year ended June 2020.

But in recent months, most equity markets have recovered to pre-pandemic levels, with some even reaching all-time highs. This might mean distributions from ETFs and MFs tracking the underlying performance of these equity indexes may notably increase.

Both situations can affect the income stream and tax position of SMSFs, and it's best for trustees to consult a licensed financial adviser if they are unsure of the impact.

 
5. Pricing and Costs

Managed funds and ETFs tend to be lower cost than LICs because they are not actively managed. LICs typically charge higher management fees than MFs and ETFs to compensate its fund managers who select which investments to include in the portfolio.

For example, SMSFs can invest in a broad Australian-market ETF for a management cost of just 0.1 per cent, while many LICs covering narrower segments are charging 10 times that. Some LICs may also charge additional fees if they outperform their target market benchmark.

Being mindful of how costs will add up over time is a key determinant of long-term investment success. With actively managed funds on average underperforming over the past three decades when compared to index funds, SMSFs should carefully assess if the extra fees they're required to pay for LICs is worth it.

 
So which one is right for you – strategy before structure

Ultimately, selecting between ETFs, managed funds and listed investment companies should be determined by the SMSF trustee's goals, time-frame and risk tolerance.

An iteration of this article was first published in Firstlinks on 5 July 2021.

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