by Damon Riscalla
While both exchange traded funds (ETFs) and listed investment companies (LICs) are exchange traded products, there are some important differences. These differences can be a source of frustration for investors who can confuse the two, and the expected performance profiles of each.
Let’s take a closer look.
What are ETFs? What are LICs?
An ETF is simply a wrapper around a collection of assets – often listed investments. This wrapper can encompass hundreds of securities and provide diversification in one trade.
Most ETFs are passively managed funds that aim to track an index. Many aim to track a market capitalisation-weighted index – such as the BetaShares Australia 200 ETF (A200). Smart beta ETFs seek to track indices that use a rules-based system for portfolio construction, often targeting a specific investment factor, such as ‘quality’ – for example the BetaShares Global Quality Leaders ETF (QLTY), which invests in 150 of the world’s highest ‘quality’ companies.1
There are also active ETFs, where an ‘active’ manager manages the underlying basket of securities, though these are in the minority.
LICs are companies that are listed on the ASX and that invest in other companies. They typically adopt an active approach, with an investment management team that is responsible for deciding upon the companies they invest in.
Similar to ETFs, LICs can provide substantial diversification and cover different asset classes.
How are they different?
ETFs are open-ended investment vehicles which means units can be created or redeemed according to investor demand, without this demand causing changes in the value of the unit price. In essence, the driving factor of change in an ETF’s unit price is the movement in the price of the underlying assets.
In contrast, LICs are closed-ended vehicles. This means they do not issue new shares or cancel existing shares in response to rising or declining investor demand.
This is a critical point of difference.
Because the number of shares on issue in a LIC is fixed, the forces of supply and demand can drive prices above or below the market value of the underlying investments. LICs often trade at a – sometimes significant – discount, or premium, to net asset value (NAV). In contrast, ETFs typically trade at or very close to NAV.
As a result, the performance of a LIC is determined not just by the performance of the underlying assets, but also by the LIC’s share price premium or discount to NAV (which may change over time). This can add a layer of complexity to the decision-making process for potential investors, as it is very difficult to assess the likely discount or premium to NAV that the LIC will trade at in the future.
How does the size of the LIC market and the ETF market compare?
Since the launch of the first Australian ETF in 2001, the rate of growth in ETF assets under management (AUM) has been over four times that of LIC AUM. Tellingly, since the abolition of commissions or stamping fees paid to brokers by LIC sponsors in May 2020 there has been a net reduction of 10 LICs in the Australian market.
Source: BetaShares ETF Review May 2021.
How do LICs and ETFs report their performance?
Reporting obligations for ETFs and LICs stand in stark contrast.
Both ETF and LIC performance are reported on the basis of NAV. However, the NAV of an ETF is available on a daily basis on the issuer’s website. Most ETFs also publish an indicative NAV (iNAV) throughout the trading day.
In contrast, LICs only have an obligation to report their underlying NAV monthly, within two weeks of the end of the month, meaning investors typically must wait around 30 days between NAV updates.
Furthermore, while the performance of both ETFs and LICs is reported on the basis of NAV, the fact that the share price of a LIC can be at a discount/premium to NAV, which discount/premium can vary significantly over time, means a LIC’s reported NAV performance can vary materially from the actual performance that a LIC holder receives from their investment.
For example, in January 2020 when the pandemic first hit, average pre-tax discounts in the LIC space moved out to around 10.5%, meaning investors wanting to exit their LIC received on average 10.5% less than the quoted NAV.
The chart below shows the average premium/discount to NAV of LICs over the period July 2018 to February 2020.
Source: https://www.etfwatch.com.au/lic-nav-discounts-rise-as-fear-grips-markets/
It can be a source of significant frustration for LIC investors to receive updates from their LIC manager touting ‘performance’ or ‘returns’ of x%, when the investor has in fact experienced returns of y%, due to the level of premium or discount to NAV.
For example, consider a purchase of a LIC with a NAV of $1, but trading at $1.05, a premium to NAV of 5%. Assume that over the next 12 months, the NAV rises by 10% to $1.10, but the LIC now trades at a discount to NAV of 10% – a unit price of $0.99.
While the LIC manager cites a ‘performance’ of ‘+10%’ over this period, the investor’s actual return is a loss of 5.7%, the change in the share price.
ETFs, in contrast, will typically provide a return to unitholders that is at or very close to the NAV performance over the given period of time.
Summary
The table below sets out key differences between LICs and ETFs.
1. Stocks in the index are selected on ‘quality’ based on a combined ranking of four key factors: return on equity, debt-to-capital, cash flow generation ability, and earnings stability.
