In recent years investors have been increasingly drawn to the diversification benefits offered by listed investment companies (LICs) and exchange-traded funds (ETFs). Despite this, many investors are seemingly unaware as to the nuances between the structures and the impact they may have on portfolios.
Fundamentally, the variance between the two stems from the difference in their structures. ETFs are open-ended unit trusts, meaning they incur unlimited daily in-flows and out-flows of funds. While this does provide investors with certainty regarding liquidity, it also means units are regularly created or redeemed as investors buy and sell an ETF.
Alternatively, LICs are closed-ended listed companies - meaning, for the most part, investors looking to buy an LIC must do so on a secondary market, purchasing shares off an existing holder.
This structure allows managers to invest for the long term, as they are not affected by daily fund flows and hence rarely find themselves to be forced to buy or sell holdings. This is a luxury not enjoyed by ETFs, which are required to sell underlying shares to fund redemptions and purchase shares in order to deploy newly invested capital.
Further, LICs have the ability to retain capital gains and income earned. This allows them to evenly spread dividends, across a range of market conditions, a benefit not afforded to ETFs, which are forced to pay out all returns each year. Additionally, the structure of LICs and the imputation credit system allows tax paid to be paid out to investors in the form of franking credits.
While the benefits of LICs are compelling, specific attributes of ETFs are favourable. ETF units are easily created or redeemed by "market makers" subject to fund inflows or outflows. The positive impact of this is ETFs trade very closely to their underlying net asset value and provide investors with a high level of liquidity.
Conversely, as shares in LICs can only be bought and sold by third parties, liquidity is solely reliant on investor appetite. Further the market price can deviate from the underlying net asset value to trade at either a discount or premium to the LICs true value. An important consideration for any investor thinking about purchasing an LIC is its true value compared to its market value, as buying an asset at a considerable premium may impact ongoing returns.
Additionally, ETFs typically offer superior transparency as they are required to regularly publish the entire contents of their portfolio and intra-day pricing on units. Conversely, many LICs only provide investors with an update of their underlying net asset value and largest investments on a monthly basis, limiting transparency and making it difficult for investors to accurately assess the true value of the underlying portfolio.
The advantages and disadvantages of both investment structures should be considered alongside the objectives of each individual investor.
Daryl Dixon is the executive chairman of Dixon Advisory. firstname.lastname@example.org
The story Investment basics: the difference between ETFs and LICs first appeared on The Sydney Morning Herald.