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This article appeared in the March 2015 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

These versatile low-fee products have differences but many common benefits.

Photo of Michael Kemp By Michael Kemp, Barefoot Blueprint

Have you ever been chatting to someone when they lowered their voice to a whisper, flicked their gaze nervously left and right like a spy in an old black-and-white movie, and asked: "Do you know any shares I should be buying?"

They are on the hunt for a "stock tip" and it happens to me. I find it easy to answer: take a look at the larger Listed Investment Companies (LICs) such as AFIC, Argo and Milton. Or look to invest in one of the growing number of exchange-traded funds (ETFs) offered on ASX.

The answer satisfies most people. This article addresses the questions that often follow.

(Editor's note: To learn about the features, risks and benefits of exchange traded products, take the free ASX online course, ETFs and ETPs).

What are LICs and EFTs and how do they differ from each other?

Listed Investment Companies are created by an initial public offering (IPO). A fixed amount of money is raised from the issue of a fixed number of shares. The money is used to buy shares in lots of other listed companies (Woolworths, Telstra and BHP, for example).

Once created, the LIC trades on the sharemarket just like any other listed company. LICs are, in effect, managed funds, although investors do not buy units, but shares, in the fund. And because LICs are listed on a stock exchange, investors are able to buy and sell shares in the fund any time the market is open.

Exchange-traded funds are also investment funds that are bought and sold on a stock exchange. But they are not the same as LICs and sometimes the differences are significant:

  1. LICs do not aim to track specific sharemarket indices, but rather to outperform them. ETFs usually do track indices. For example, they might track a broad-based market index such as Australia's S&P/ASX 200 or the S&P 500 in the United States. Or they might track a narrow and specific index such as Healthcare or Real Estate Investment Trusts. Some overseas ETFs do, however, undertake active management in an attempt to outperform benchmark indices.
  2. ETFs cover a broader range of asset classes than LICs. For example, there are ETFs that invest specifically in domestic shares, international shares, fixed-income products, foreign currencies, precious metals, commodities and agricultural products.
  3. ETFs are open-ended, which means the number of shares on issue is not fixed but can increase or decrease in response to demand from investors. LICs are closed end, so the number of shares on issue is not impacted by investor demand.
  4. LIC portfolios are constructed using physical stocks (actual shares). So too are ETFs, but not always. Some ETFs (referred to as synthetic ETFs) use derivatives in their portfolios. These simulate the returns that would have been achieved by a portfolio constructed purely from physical securities. The use of derivatives introduces an additional layer of risk, which is discussed below.

What are the benefits from investing in LICs and ETFs?

The following benefits are common to both:

1. Diversification

LICs and ETFs enable investors to achieve broad diversification of their equity holdings, even from the purchase of a single LIC or equity-based ETF. Diversification across different asset classes can also be achieved by the purchase of non-equity-based ETFs.

For example (and to name just two), a single investment in Australia's largest LIC, Australian Foundation Investment Company (AFIC), means your investment covers nearly 90 listed companies operating across a wide range of industry sectors. And an investment in the Vanguard Australian Fixed Interest Index ETF means you are investing in around 360 fixed-interest securities (bonds) issued by state and federal governments and investment-grade companies.

2. Low management fees

The management fees charged by LICs and ETFs are typically much lower than traditional non-listed managed funds - and an investment in a traditional managed fund does not guarantee higher returns to compensate for higher fees.

Management fees charged by ETFs are low, at about 0.15 to 0.3 per cent each year. For the larger LICs (AFIC, Argo, BKI and Milton) they are around 0.15 per cent. That might not sound like a big deal, but even slightly lower management fees can provide a significant boost to long-term investment returns.

There are, however, a couple of extra costs that need to be considered.

First there is the (usually) small penalty of the bid/ask spread, the difference in the market price between what buyers pay and what sellers receive when shares change hands. The bid/ask spread is highly dependent on the market liquidity of the ETF or LIC, but for the large and deeply traded ones the spread is tight, hence the cost is not much.

Second, there are broker's commissions. To reduce their impact on overall investment returns, use a low-fee broker, trade in sizeable parcels (preferably $10,000 or more), and purchase these securities as part of a long-term investment plan, rather than trading in and out.

3. Transparency

Because both ETFs and LICs are traded on ASX, there is clear price visibility. Also, their managers are required to regularly disclose to the market what securities they hold.

4. Liquidity and access

Trading on ASX provides the ability to buy and sell your holdings whenever the market is open.

5. Broad range of asset classes

ETFs (more so than LICs) provide small investors access to asset classes they would not otherwise be able to tap into. For example, emerging markets, government and semi-government bonds, corporate bonds, currencies and commodities.

What are the main risks?

1. Systematic risk (or non-diversifiable risk)

Although investing in an LIC or an equity-based ETF delivers company diversification, there is one type of risk this diversification does not avoid. Referred to as systematic risk, it is the risk of the entire sharemarket suffering a significant downward correction.

Ironically, ETFs also help in reducing the impact of systematic risk. By using non-equity-based ETFs (such as those based on precious metals, property, and government and corporate bonds) broader diversification is provided across different asset classes.

2. Exchange rate fluctuations

ETFs based on an overseas market index or benchmark, and traded and settled on ASX in Australian dollars, potentially carry exchange-rate risk. If the ETF is not hedged against currency risk, fluctuations in the exchange rate can affect the value of the portfolio.

3. Counterparty risk

This is the risk that the other party to a contract into which you have entered fails to meet its financial obligation. It is a risk to which synthetic ETFs are exposed. Synthetic ETFs use derivatives in order to simulate the returns that would have been delivered had the portfolio been constructed purely from physical securities.

Derivatives rely on the counterparty to that derivative agreement delivering on their contractual obligation, and because that is not always certain, failure to do so would cause the synthetic ETF to incur losses. This risk is further heightened for ETFs that use over-the-counter (OTC) derivatives, because they are not subject to central counterparty clearing arrangements.

ASX acknowledges this risk and requires synthetic ETFs to limit OTC derivative exposure to no more than 10 per cent of their net asset value. In addition, ASX has mandated that all derivative counterparties for synthetic ETFs on ASX must meet certain eligibility requirements.

How do you assess LICs and ETFs?

LICs and ETFs provide plenty of useful information on their respective websites. Look at them and make sure you understand how your money will be invested. Read the product disclosure statement (PDS) and if you have any questions seek professional advice.

Before investing, you need to understand the structure, investment objectives, principal investment strategies, risks and costs.

About the author

Michael Kemp is chief analyst at The Barefoot Blueprint.

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The views, opinions or recommendations of the author in this article are solely those of the author and do not in any way reflect the views, opinions, recommendations, of ASX Limited ABN 98 008 624 691 and its related bodies corporate ("ASX"). ASX makes no representation or warranty with respect to the accuracy, completeness or currency of the content. The content is for educational purposes only and does not constitute financial advice. Independent advice should be obtained from an Australian financial services licensee before making investment decisions. To the extent permitted by law, ASX excludes all liability for any loss or damage arising in any way including by way of negligence.

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