As a beginner investor, the thought of getting started in the share market can be intimidating. Well at least it was for us. So what did we do to drive away that fear? We procrastinated!
Every day we would find a new reason to delay making a decision. Those reasons ranged from market volatility to not having enough cash to invest in a diversified portfolio. But the king of them all, the one that we would whip out when all else failed was ‘Research’. Research on the ideal portfolio, which assets, which geographies, etc. Followed by which types of investment instruments and then eventually research on individual shares or units. With so much to learn, it was easy for us to get carried away…
But while we were jogging on our analysis-paralysis treadmill, we forgot the most important thing. That time and tide (of the share markets) wait for no one! There is an oft used and maybe overused saying that the best time to invest was 20 years ago and the second best time to invest is now.
One of the questions that we spent considerable time evaluating was around Exchange Traded Funds (ETFs) vs Listed Investment Companies (LICs) vs Managed Funds. We hope to answer that here. So hopefully you don’t have to waste tons of your time doing research and can start investing more confidently.
Financial Investment Instruments
As a newbie investor, you would think that only shares of companies trade on the share market. You know, companies like CBA & Westpac, BHP & Rio Tinto, Coles & Woolies. But the field of finance has been more innovative than it lets on. Not only can you buy shares on the exchanges, you can also buy units in Bonds, Commodities, Real Estate (through REITs) along with more exotic things such as futures, derivatives, etc. For investors who don’t like to go share picking through these options, ETFs, LICs and MFs can provide an excellent alternative. That is because they already come with a pre-constructed portfolio.
What are ETFs, LICs and Managed Funds?
Before we delve into the nuances, the baseline is this. All three, ETFs, LICs & MFs comprise of either one or many different assets such as shares, bonds, commodities, etc. All three are typically thematic which determines the types of assets they would invest in.
Given that they are all quite similar to each other, it’s best to start with a description of Managed Funds.
- Managed Funds (MFs): As the name suggests, Managed Funds are managed by a fund manager. Investments are pooled in from many investors. These are then invested in the underlying assets as per the investment theme with a view to beat the market. Units of the fund are allocated to the investors, in turn for their investments. Managed Funds do not trade on stock exchanges. So if you want to invest, you have to go directly to the Fund Manager. Examples of MFs are Hyperion Australian Growth Companies Fund, Tribeca Alpha Plus Fund.
- Exchange Traded Funds (ETFs): ETFs are similar to Managed Funds, except that these are traded on a stock exchange and track an index such as the ASX 200 or the S&P 500. Therefore ETFs do not involve active management by a fund manager. Examples of ETFs include Vanguard Australian Shares Index ETF, SPDR S&P/ASX 200 FUND.
- Listed Investment Companies (LICs): LICs are incorporated as companies. Their business being to invest in other companies and assets, with a board to oversee their performance. Managed Funds and ETFs on the other hand are set up as Trusts. Similar to MFs, these are actively managed by fund managers with a long term investment view to beat the market. Examples of LICs are Argo Investments Limited, Australian Foundation Investment Company Ltd
Here’s a simple flowchart to help you determine what financial instrument you’re dealing with.
There are some key points that are common to all three instrument types that are worth highlighting.
- Provide Access to Professional Investment Management: For investors who do not have the time and energy to go stock-picking (like most of us!), each of the three instruments provide access to professional investment and fund managers. When you invest in any of these instruments, you provide your money to the fund managers. They, in turn, charge you to then invest and grow it on your behalf.
- Based on Underlying Assets: Money invested in these instruments is further used to buy shares of companies, bonds, physical gold and even physical real estate. For example, an ETF tracking ASX 200 actually holds shares of the companies comprising the index and in the same ratio. And a Gold ETF will actually hold physical gold! Similarly, a MF and an LIC will have bought shares in these underlying assets based on their respective investment strategies.
- Inherently provide diversification: All three, Managed Funds, ETFs & LICs, will actually hold shares in multiple companies, often providing exposure to different sectors and asset types. Hence, they inherently provide diversification. Again taking the example of an ETF tracking the ASX 200, buying into such an ETF spreads the investment over the 200 companies in the ratio of the contribution to the index.
It’s not the similarities but the differences that determine which of these instruments would be better for your requirements.
Here are some of the features that these instruments differ on:
- Strategy: This is one of the biggest differences that determines other features that the investment instrument will have. LICs and Managed Funds target to beat the markets, whereas ETFs only match the markets.
- Costs: ETFs generally have the lowest cost as they are passive investments. This is because ETFs typically track an index and are not actively managed by fund managers looking to beat the market, as is the case in Managed funds. Therefore managed funds have the highest cost among this cohort. LICs fall in the middle as they have a long term buy and hold strategy.
- Listed on the exchange: ETFs and LICs are listed on the exchanges and can be bought and sold in the same way as shares, through a broker. Managed funds on the other hand are not listed on the exchange and have to be bought directly from the fund manager or through a financial advisor. This means orders to buy and sell “units” in the managed funds are executed at the end of day at the “Net Asset Value (NAV)” of the underlying shares.
- Structure: LICs are closed ended. Which means only a fixed number of units are available for a particular LIC. So if a buyer wants to buy a unit, this will happen from the already available units. MFs and ETFs on the other hand are open ended, meaning more units can be created depending on the demand.
- Distributions: All income in ETFs and MFs is paid out to the unit holders as distributions including franking credits. For LICs however, the board decides the payout amount out of the retained profit and it has the ability to pay franked dividends.
- Transparency: Buyers can actually see what the composition of an ETF is, along with the weightage of the companies and industries the ETF is made up of. This detail is not available as comprehensively for the other two types of instruments. For example, LICs will only mention top 10 investments.
ETFs – Our Investment Instrument of Choice
Full disclosure first. We love ETFs and this is why we invest in them.
We chose ETFs majorly because of:
- Low cost
- Transparency and ease of transaction
It has been proven time and time again that index funds outperform actively managed funds. The biggest differentiating factor has been the management fees. Thus, again outlining the importance of low cost investing.
Importance of Low Cost Investing
To drive home the point we take an uncomplicated example of $10,000 invested in 2020 for 20 years with an average of 5% return every year.
- The Blue line shows a return of average 5% every year, resulting in $26,533
- The Red line shows the return for an average of 4.75% where we can assume 0.25% as the management fees, as $25,298
- The Yellow line shows the return for an average of 4.50% where we can assume 0.50% as the management fees, as $24,117
So you see, there is a difference of $2,416 between the 5.00% and 4.50% average annual returns cases. Meaning that a 0.50% management fee would reduce your returns by 10% over a 20 year time period vs if you paid no management fee at all. That’s a pretty big chuck of your pie! Therefore it is not just a matter of 0.5% management fees but also a partial loss of compounding, as compounding works both on actual profits and profits that could have been.
Step off the Analysis-Paralysis Treadmill & Just Do It!
We were first time investors and in many respects still are, we are learning as we progress on our investing journey. If there would be a single piece of advice which we could give anyone still considering to start investing, is to just start! Learn on the job, it is both exciting and fun to see how the investments behave on a day to day basis and as the corpus increases with regular investments, capital growth and dividend income, you will wonder why didn’t you start earlier!
Disclaimer: This blog is based on our understanding of financial instruments and anyone reading is recommended to do their own research.