Just because it is in fashion - doesn't mean it fits.

Brown dress shoes for men are back. Are brown suits next?

Recently, there have been a number of high profile Listed Investment Companies (LICs) launched or announced to be launched.  Promoters of these vehicles have been quick to point out the liquidity and tax benefits of these vehicles.  These benefits LICs share with ETFs, given that they are both traded on the ASX.  Some LIC promoters go further saying that LICs offer more franking credits.  This is a myth.  It is useful then to understand the differences between LICs and ETFs as there are significant differences between the two as well as understanding the tax outcomes for both.

It is easy to understand why LICs and ETFs are in vogue with investors.  As both trade on the ASX they are quick and convenient to transact and trade as cheap as the cheapest broker you can find. However there are important considerations in determining which investment fits you best.

LICs have been around for decades.  They are like men’s suits – they have been around for a long time and haven’t really changed much.  One of the big LICs advertises that it has been investing for over 80 years.  The newer LICs offer new investment classes and structures – the suit has more pockets - but ultimately they operate the same way. In Australia, ETFs are a newer phenomenon that investors are still discovering.

LICs cover a wide spectrum of investment styles. ETFs are passive investments. This means they track an index by investing in the securities that make up the index.  Consequently some LICs may have higher management costs similar to active managers, particularly the latest ones to come to market. It also means LICs involve a higher degree of manager risk than ETFs. It is worth your while to understand what is included in the management costs and determine if the extra price represents value for money, given the extra risk

To keep things simple, the analysis below is restricted to that subset of LICs with an investment style that has low turnover in their portfolios. These are also the LICs with the lowest costs and the best ones to compare to ETFs.

Probably the biggest difference between LICs and ETFs are how the shares price on the ASX.  If the underlying investments of an ETF rise 5%, then the price of the ETF rises 5%.  The same cannot be said for LICs.  The share price may rise 10%, or even fall.  LICs often trade at a discount or at a premium to the value of their underlying holdings. This is mainly due to transparency. 

The underlying holdings of ETFs are published each day.  For this reason investors can calculate the value of the underlying portfolio.  ETFs are like wearing sandals, you can see your feet when you put them on.  When a man puts on his new brown dress shoes he cannot see his feet, likewise when you buy a LIC you cannot see the underlying investment.  LICs are not required to continuously disclose their holdings. Some LICs may provide end of month holdings, but this will be well after month end so investors cannot accurately calculate the value of the underlying assets.  As a result the price of the LIC trades at a premium or at a discount to the value underlying portfolio.  It is not uncommon for this to be in the range of /-10%.

The other big difference is structure.  When you invest in a LIC, you are buying a share in a public company.  Like other public companies, they will have costly annual general meetings and are subject to the same requirements as other listed companies.  ETFs on the other hand, while listed on the exchange, are subject to more efficient ASX rules.  ETFs are trusts registered with ASIC and operated by a responsible entity that has a trustee board of directors with equivalent duties and obligations to a LIC board.  Investors in an ETF have equivalent rights to shareholders in a LIC under the Corporations Act. 

Because ETFs are a trust rather than a company, the tax law forces them to pay out all underlying dividends received. A LIC on the other hand may choose to retain these as earnings and not distribute them to investors - one example of a LIC manager’s power to influence the value of the LIC. LICs will do this to officially smooth their dividend pattern.  There are practical implications for this and they are worth understanding. 

Below are a series of tables highlighting differences that may influence an investor’s choice between ETFs and LICs.

The trickiest part of the table above is the franking credits and tax payments but it is useful for understanding why the claim that LICs offer more franking credits is a myth. Here is a simple example.  A fund receives $100,000 in fully franked dividends and $100,000 in unfranked dividends. Harry the Investor owns 1% of the fund.

If the fund is an ETF everything flows through. The ETF distributes to Harry $2,000 made up of $1,000 in franked dividends and $1,000 in unfranked dividends.

If the fund is a LIC, the LIC needs to pay 30% tax on the unfranked dividends. It then declares whatever dividend its board deems appropriate. If we assume it chooses to pass on all of the dividends it receives, Harry is only going to receive $1,700 in cash because of the tax that had to be paid. The offset to this is that the $1,700 dividend from the LIC is fully franked.

After Harry receives credit from the Tax Office for the franking credits, he is in the same position whether he invested in an ETF or LIC. The steps are different but the final outcome is the same.

In summary, the key differences are:

1. ETFs are transparent; LICs are not;
2. ETFs trade at or close to the NAV of their underlying portfolio; LICs trade at a premium or at a discount to their NAV; and
3. ETFs pay out all of the distributions received, but it could be bumpy; LICs may choose not to pay out all distributions received in order to pay similar, predictable amounts each distribution.

There are liquidity and tax benefits of investing in ETFs and LICs but it is a myth that LICs investors receive more franking credits.

If you would like to speak to one of our ETF specialists about our ETFs please email us at info@marketvectors.com.au or call 02 8038 3300.

Disclaimer: This announcement is issued by Market Vectors Investments Limited ABN 22 146 596 116 AFSL 416755 (‘Market Vectors’) as Responsible Entity of the Market Vectors Australian ETFs (‘Market Vectors ETFs’). This information is general in nature and is not financial advice.  It does not take into account your objectives, financial situation or needs (‘your circumstances’). Before making an investment decision in relation to a Market Vectors ETF, you should read the applicable Product Disclosure Statement (‘PDS’) and with the assistance of a financial and tax adviser consider if it is appropriate for your circumstances. The PDSs are accessible from  www.marketvectors.com.au or by calling 1300 68 3837. Past performance is not a reliable indicator of future performance. The Market Vectors ETFs are subject to investment risk, including possible delays in repayment and loss of capital invested. No member of the Van Eck Global group of companies guarantees the repayment of capital, the performance, or any particular rate of return from the Market Vectors ETFs. Market Vectors® and Van Eck® are the registered trademarks of Van Eck Global.