ETFs and LICs are two popular investment vehicles that provide access to diversification at a relatively low cost. However, there are significant differences between the two, particularly in terms of structure and management. In this post, we’ll explore the differences between ETFs and LICs to help you make informed investment decisions.
Exchange traded funds
ETFs (Exchange Traded Funds) are managed funds that you can buy or sell on an exchange such as the Australian Securities Exchange (ASX) or Cboe Australia (CXA). EFTs will usually track a particular index, sector, commodity, or other asset.
Understanding ETF structures and mechanics
When you invest in an ETF, you don’t own the underlying investments; you own units in the ETF, while the ETF provider owns the shares or assets. EFTs hold multiple underlying assets, while stocks only hold one.
All ETFs in Australia are ‘passive’ investments, typically tracking markets or assets but not trying to outperform them.
Comparing ETFs across different asset classes
There are many types of ETFs available to cater to all investment goals and risk appetites. Some common types of ETFs include:
Equity funds
Equity funds pool money from investors to invest in stocks in different companies. The aim of this type of ETF is capital appreciation as stock values rise. Equity funds can focus on specific sectors, market capitalisations, or geographical regions, allowing investors to achieve diversification cost-effectively.
Fixed-income funds
Fixed-income funds invest in bonds and are an effective way to reduce your portfolio’s volatility while providing an additional stream of income. For this reason, many financial professionals recommend that you invest part of your portfolio in fixed-income securities.
Commodity funds
Commodity funds invest in physical commodities such as gold, oil, or agricultural products. While some commodity funds focus on specific commodities, others track a diversified basket of commodities.
When you purchase a commodity ETF, you typically don’t own the physical asset but instead own the set of contracts backed by the commodity itself.
Currency funds
Currency funds invest in foreign currencies and allow investors to benefit from exchange rate movements. These currency funds also allow investors to engage in speculative trading based on anticipated movements in exchange rates, with the goal of capitalising on volatility to receive profits.
However, the high volatility associated with currency funds poses a significant risk, and currency funds should only be a small part of your investment strategy for this reason.
Real estate funds
Real estate funds involve investing in income-generating properties, allowing investors to access real estate without direct property ownership. You can choose a fund that invests in a specific type of real estate or one that is broader in nature.
Real estate funds are particularly popular because they must pay out 90% of their taxable income to shareholders.
Pros and cons: Is an ETF right for you?
ETFs allow you to buy a basket of shares or assets in a single trade, helping you to diversify within an asset class. Since your money is automatically diversified over specific indexes, you can save time, reduce your risk, and even make money without thinking about it.
ETFs are generally cheaper than traditional managed funds as they involve lower fees.
However, as with any kind of fund, ETFs come with downsides. For one, the return on your ETF investment won’t exactly match the index the ETF tracks due to management fees. The buy and sell price of your shares in the fund can also differ from the net asset value of the underlying index, lowering your return.
If the ETF invests in international assets, they also face currency risk, which may impact your returns.
Listed Investment Companies (LICs)
Listed Investment Companies (LICs) are similar to managed funds. However, unlike managed funds, investors can buy and sell LIC shares on the ASX. LICs also have a fixed number of shares and the capital is not actively traded.
Demystifying the structure of LICs
LICs are typically managed by professional fund managers, who make investment decisions for the company and its shareholders. Their investment strategies may be focused on a particular sector, region, or investment style, such as growth or value investing.
These fund managers charge a management fee, typically a percentage of the company’s net tangible assets (NTA). They may also charge a performance fee if the management company achieves higher results than the benchmark it measures against.
Exploring LIC strategies in diverse market conditions
Your investment strategy is typically based on a wide variety of factors, including your age, goals, appetite for risk, available capital, and expected returns. There isn’t a one-size-fits-all approach to investing, and you may find yourself adjusting your strategy over time to suit your changing situation.
Typically, LIC strategies involve focusing on long-term investments and investing in a diverse portfolio of assets. Since LICs are managed by experienced professional investment managers, you get access to a wide range of investment styles and strategies.
Assessing risk and returns: The LIC investor’s guide
Investing in an LIC allows you to diversify your portfolio across asset classes, sectors, and geographies that may otherwise be difficult to access. For example, if your portfolio is composed mainly of Australian shares, adding an LIC that covers international shares allows you to diversify your portfolio.
Despite the advantages of LICs, there are also risks associated with these investments. Although investment managers try to outperform the market, you still face the risk of the fund underperforming or declining in value, which will affect your return. LICs that cover international shares are also subject to currency risk.