What is an ETF?
An exchange-traded fund (ETF) is simply a “wrapper” around a collection of assets. Often these assets are equities (or stocks), but ETFs can also wrap around other asset classes such as infrastructure, commodities, bonds and even cash.
What is inside an ETF?
Within the “wrapper” of an ETF can be hundreds or even thousands of companies. The makeup of the companies within the wrapper can either be actively selected by a portfolio manager or more commonly determined by the index that it has been built to track. Whilst it may appear that two ETFs are the same there can often be differences inside the ETF.
For example, two common ETFs that invest in companies on the Australian stock market (ASX) are State Street’s STW and Vanguard’s VSO. They’re different in that STW invests in the ASX200 index, which is the 200 largest companies on the Australian stock market, while VSO invests in the small cap segment of the Australian market. Both ETFs own the companies in the same proportion they make up that particular index and when a company falls out of the ASX200 or the MSCI Australia Small Cap Index it is replaced by the new company.
What to look out for when choosing ETFs?
Past performance is not an indication of future performance but you may notice that usually the best performing ETFs available are some form of leveraged ETF. You should also note that the worst performing ETFs are often leveraged ETFs too. The reason being is the leverage simply amplifies the returns or the losses!
While it can be exciting to think how leverage could increase your returns it does come with a higher level of risk. Not only might you be putting all your eggs in the one basket if investing in one leveraged ETF, but you’re kind of borrowing other people’s eggs and putting them in the same basket too.
One of the benefits of ETFs is that they have an ‘open-ended’ structure. What this means is that the ETF can be bought and sold on demand to minimise ‘tracking error’ and maintain its value close to its net asset value (NAV). It does this when required by either creating new shares or removing them out of circulation when required. If you’re putting together your own portfolio of ETFs, look for highly liquid ETFs.
Level of fees
The fee for an ETF is usually referred to as the Managed Expense Ratio (MER). This is one of the big benefits of ETFs as the level of fees they charge can be very low. For example if you invested $1000 in State Streets STW ETF you would be invested in the 200 largest companies in Australia and the annual management fee on the $1000 investment would be just $1.30 per year (or 0.13%).
→ Check out the full guide: Ultimate Guide to Exchange Traded Funds
What is a LIC?
A LIC is a listed investment company that provides exposure to a diversified portfolio that can be traded on an exchange but is constructed in a different way to an ETF.
What is inside a LIC?
A LIC usually contains actively managed investments where a fund manager individually selects a portfolio of investments (such as equities or fixed income). Before the advent of LICs, the process of investing with active fund managers offered a poor user experience involving a lot of paperwork, large minimum investments and significant timing delays. However, unlike an ETF, LICs don’t offer the same level of transparency. You won’t know all the companies within the underlying portfolio of a LIC because their issuers aren’t required to publish their holdings daily.
What’s the difference between ETFs and LICs?
The big difference is the structure. An ETF is open-ended, whereas a LIC is closed-ended, which means that a set number of shares are issued. This can mean the value of shares in a LIC can drift significantly from its net asset value. The fixed amount of capital within a LIC can be a good thing if you have lots of buyers driving the price above its NAV, however the opposite is far more common. After a LIC lists on the stock market the majority end up trading at a discount to their NAV. An ETF is much more likely to closely track its NAV.
So which is better?
In the same way, it can be hard to generalise about the quality of all stocks on the stock market, it can be hard to generalise about the quality of all ETFs and LICs. Be it stocks, ETFs or LICs, some are certainly better than others, and some should be avoided.
In saying that, I am personally of the view that ETFs are superior to LICs. At Six Park we use carefully selected ETFs for our clients, and we use ETFs for a few reasons:
- ETFs usually have lower fees. Fees are among the most important things an investor can control as high fees can erode the power of compound returns.
- ETFs are more transparent in what they’re invested in and contain.
- ETFs are more likely to hold their true value reflected by a low level of drift from their net asset value (NAV).
- LICs are usually offered by active fund managers and the annual SPIVA report shows year after year that most active fund managers underperform their benchmark.
- In the past many LICs have been pushed by professionals within the industry who received ‘stamping fees’ for recommending them. If you are being recommended to invest in a LIC it is worth asking if someone is paid to recommend this option and whether a conflict exists.
So while financial acronyms can be intimidating hopefully this can help you compare an ETF MER and NAV with a LIC on the ASX. LOL!
Main Image Source: Shutterstock (Vintage Tone)
The table below displays some of the International Broad Based ETFs available on our database with the highest three-year returns (sorted highest to lowest by three-year returns and then alphabetically by provider name). Use Canstar’s ETF comparison selector to view a wider range of products. Canstar may earn a fee for referrals.
Ted Richards is Head of Distribution at online investment service Six Park and host of investment podcast The Richards Report. Six Park is one of Australia’s leading providers of online investment management, allowing more Australians to access affordable professional investment management, whether they’re first-time or seasoned investors.