ETFs vs LICs – the Big Picture

There’s no doubt that Exchange Traded Products (ETPs) including ETFs have taken off in popularity over the past few years. Between January 2017 to December 2022, the number of ETPs listed on the ASX has grown from 202 to 294, with the number of issuers more than doubling in that period from 16 to 38. The market cap value of ETPs has likewise grown from $25.234 billion to $130.528 billion in that same period.

Over the same period, LICs and LITs (Listed Investment Trusts) have seen a slight contraction in the number of listed entities, and modest growth in market cap value.

There are a few reasons that account for these relative movements in funds.

Cost

ETFs

A key driver for the uptake in ETFs as a favoured investment is cost. Most (but not all) ETFs are designed as passive portfolios, requiring little management by the provider. ETFs were originally created to track well known stock market indexes such as the S&P 500 etc. The first ETFs brought to the Australian market in 2001 were much the same, tracking the SPDR S&P/ASX 50 index (ASX:SFY) and the SPDR S&P/ASX 200 index (ASX:STW). These were low-cost products, with initial management fees sitting under 1%. As more and more ETFs were listed, the breadth of available indexes grew significantly, covering sectors such as property, global equities, infrastructure, fixed income, commodities etc. All offering a typically low-cost product to gain exposure to these differing asset classes.

LICs

Listed investments entities such as LICs and LITs tend to have a higher management fee due to the active management style employed by most of these fund managers. Depending on the LIC and the fund manager, management fees typically tend to range between 1% – 1.5%. Having said that, there are also some very low cost LICs such as Argo Investments Limited (ASX:ARG) at 0.16%, Australian Foundation Investment Company (ASX:AFI) at 0.14%, and BKI Investment Company Limited (ASX:BKI) at 0.17%. These particular LICs are well established (Australian Foundation Investment Company celebrated its 100th year this year) and employ a more passive approach to managing the portfolios. The fees on these LICs are comparable to many ETFs.

Diversification

ETFs

With the growth in exchange traded products such as ETFs came a broad range of options to easily diversify across multiple asset classes. ASX share indices, property indices, global indices, and commodities are all covered by different ETF products. Over the last 5 years or so we have seen an increase in so called ‘thematic’ ETFs, offering exposure to current trends in investing. Examples include the US tech sector (ASX:TECH), Australian tech sector (ASX:ATEC), cyber security (ASX:HACK), robotics (ASX:ROBO), cloud computing (ASX:CLDD), and so on. A current full list of ETFs covering all available categories can be found here. If there’s a new hot theme in the investment universe, you will eventually see an ETF listed to provide exposure to that theme. As to the actual value and performance of such thematic ETFs, that’s for another post.

LICs

Diversity is also available in the LIC universe, with similar asset classes covered – ASX equities, global equities, alternative assets, global infrastructure etc. Whilst there is some overlap in the availability of diverse assets between ETFs and LICs, so called ‘thematic’ LICs in the same vein as thematic ETFs are not really a thing. A current full list of LICs on the ASX can be found here.

Income

ETFs

Most (but not all) ETFs provide income in the form of distributions. These are not the same as dividends. In Australia, ETFs listed on the ASX use a trust structure. That means that dividends and/or distributions from the underlying assets as well as any capital gains are fully distributed to unit holders of the ETF. Depending on the underlying assets, franking credits may or may not form part of those distributions. Usually when ETF distributions are received, the level of franking is less than 100%. This is often due to these distributions including a capital gains component. Many ETFs that are based on an index will see some level of rebalancing due to changes in asset values changing the relative weightings in the tracked index. When certain assets are sold down in order to rebalance, any capital gain is passed on to the unit holders who are then taxed on that capital gain at whatever their marginal tax rate is. Because ETFs are structured as a trust, all income of the trust is fully distributed to the unit holders.

LICs

All LICs on the ASX provide income in the form of a dividend. Because an LIC is a company that generates a profit (hopefully!), those profits are paid out to shareholders as dividends. When an LIC makes a profit, the company pays tax on that profit at the standard company rate of 30%. This generates franking credits that can then be passed on to shareholders as part of the dividend payment. Any capital gains realised on sale of assets within the portfolio form part of the income of the LIC who pays any relevant capital gains tax. Shareholders are still taxed on their dividends at their personal marginal tax rate, but have the advantage of franking credits than can reduce the overall amount of tax payable. Where the shareholders marginal tax rate is less than 30% (such as superannuation), they may find themselves fortunate enough to receive a tax refund on any excess franking credits received.

Liquidity

ETFs

Because of the open ended nature and trust structure of ETFs, liquidity should never be a problem for investors wishing to either buy or sell in these funds. New units are created as needed to meet demand from investors wishing to buy into the ETF. Likewise, the fund manager will always buy back units offered for sale that exceed the number required to meet buyer demand.

LICs

As LICs are a closed-ended fund (ie, limited by the number of shares issued), liquidity can sometimes be a problem. Some LICs are less liquid than others, and factors such as the size of the LIC and it’s appeal to investors can play a part in determining the liquidity of the stock. Small ’boutique’ LICs as well as some of the large well established LICs can both be less liquid, albeit for different reasons. Factors that can lead to less liquid LICs will be covered in a future post.

Conclusion

These are a few of the standout differences between ETFs and LICs. Whilst there are other differences, those discussed here are the ones that are key to many investors. In future posts I will look at some of the nuances to be considered when investing in LICs that make them different to ETFs.

Whilst reading the above differences may lead one to think that ETFs have a clear advantage over LICs especially when considering both cost and liquidity, there are other reasons why LICs may be considered a better choice. In the next post we will start looking at those reasons in more detail.