ETFs versus LICs

There is no doubt that exchange traded funds (ETFs) have become more popular in Australia in recent years. But with global risks raising the prospect of a market correction, I think it is important that investors become aware of the challenges that ETFs (and therefore managed funds) can face in difficult markets.

I think an investment portfolio strategy should include ETFs for trading, but also listed investment companies (LICs) for investing.

An important difference

Most investors think of ETFs solely as index-tracking vehicles listed on the stock market. But I am also seeing growth in ETFs that cover managed funds. (It's important to note that I am comparing long-only equity-based ETFs and LICs.)

ETFs are ‘open-ended' funds: the number of units isn't limited. When you sell an ETF, you sell the unit at or around the fund's net tangible assets (NTA). But if there are a large number of sellers of an ETF then the underlying fund will need to liquidate assets to meet the withdrawals.

LICs by contrast are ‘closed-end' funds with ‘permanent' capital. When you sell a share in a LIC, you may or may not get NTA, but the underlying capital of the investment company doesn't fall and the manager will not be forced to sell assets.

ETFs are great in rising markets. But …

This structural difference between ETFs and LICs becomes crucial to investors in tough markets.

When markets pull back and people want to shift money out of the market, the ETF must meet redemptions. Rather than buying when the market is cheap, the ETF fund manager has to sell in a sharply falling market.

So an ETF fund manager is arguably constrained in making long-term investment decisions or investing in illiquid value propositions because they are never sure when money will be directed to them, or withdrawn.

When the market falls, the value of LICs will also fall, but the fund manager isn't hit by redemptions. They can take a longer-term view and steadily buy shares in a weak market. Ultimately, it is weak markets that present the best entry points to equity markets.

LICs also have greater flexibility and can hold cash at market peaks; ETFs/managed funds usually have to be almost always fully invested pursuant to their mandates.

Franking implications

There are also tax and franking benefits to LICs' company structure. They can hold or distribute franking credits received, but also from the franking credits generated from the tax the LIC pays.

ETFs generally have a trust structure, so all of their income needs to be distributed each year and franking credits will only come from the companies they invest in.

Franking distributions to ETF holders can also be diluted if lots of investors buy units towards the end of the financial year and expand the unit base. Further franking may be lost if the trust has realised losses greater than dividend income.

LICs: A long-term proposition

I think the impact of market movements on the underlying fund and capital is key to the choice between LICs and ETFs.

ETFs do have a place in rising markets and particularly for traders; they give you quick access to market performance.

But problems start when markets are weak and as fund managers face a number of cycles.

I believe that investors should be in the stock market for the long term, and the LIC structure with its greater stability and flexibility is a more suitable structure for investors through market cycles.

John Abernethy is a leading Australian fund manager and the chairman of Clime Capital. Clime Capital is a LIC (CAM:ASX) that has delivered 13.1 per cent per annum in total shareholder returns since early 2009 to March 24, 2015.