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.
Differences between ETFs and Low turnover LICs
Low Turnover LICs
To be allowed to call itself an ‘ETF’ on the ASX, the fund has to track an identified index. It will be what is known as an ‘index fund’ or a ‘passive fund’.
The LIC applies investment expertise to construct a portfolio that may be held for the long-term without needing high turnover. Some LIC’s are a fund-of-funds.
The choice of index will result in a diversified portfolio with particular characteristics, usually starting with a choice of the country or the industry being invested in. There is a wide range of choice.
The LIC will typically be a broad portfolio of Australian shares or a fund-of-fund structure.
When investors buy and sell an ETF on the ASX a Market Maker takes the other side of the trade. A Market Maker ensures that buys and sells of ETF units are done close to the fund net asset value per unit (NAV) by taking the other side of each trade. The NAV is published each day on the ETF issuer’s website and an estimate is available via the ASX and is updated at least every 15 minutes during the trading day. This is called an indicative NAV or iNAV.
The price that the LIC trades at on the ASX is set by the market. The net value of the LIC’s assets is only published once a month after the end of the month. The LIC price may trade at a discount or a premium to its NAV.
ETFs are open-ended meaning that units are created and redeemed in response to demand. This facilitates market prices remaining close to NAV without premiums or discounts driven by demand.
The LIC are closed-ended. There is no regular creation or cancellation of shares. If and when the board of a LIC considers it appropriate, there can be a rights issue, placement or buy-back. This can result in LIC shares trading at a premium or discount depending on demand and market sentiment.
ETFs distribute all of their income each year. Some ETFs do this annually, some six-monthly and some quarterly. For any ETF, the distribution amounts will vary from period to period because they reflect the dividends received from the underlying portfolio.
The LIC only distributes income when its board declares a dividend. Typically this will be done six-monthly. Investors will typically receive a smooth stream of franked dividends.
Differences in Tax Outcomes
Low Turnover LICs
The open-ended structure means that portfolio turnover can be increased by withdrawals. However, only the Market Maker (also known as the Authorised Participant) may withdraw from the ETF. If it does, all capital gains in the ETF can be diverted to the Market Maker rather than being left behind for remaining investors.
This turnover therefore does not impact remaining investors.
The closed-ended structure means that there are no redemptions of shares creating portfolio turnover and capital gains.
Tracking an index generally creates lower portfolio turnover and consequential capital gains than an actively managed fund.
The investment style of these LICs keeps the portfolio turnover and any consequential capital gains low.
Franking credits from the portfolio flow through to investors.
Franking credits from the portfolio flow through to investors.
There is no tax payable by the ETF. See the example below.
If the LIC receives unfranked dividends or other income, the LIC pays tax and that tax is passed on to investors as a franking credit. See the example below.
The distribution for the ETF will be divided into many components as though the investor held the portfolio themselves.
The dividend will typically be fully franked, possibly with a component that is entitled to the CGT tax discount.
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:
- ETFs are transparent; LICs are not;
- 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
- 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 email@example.com 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.