Financial acronyms can be intimidating. Even so, exchange-traded funds (ETFs) and listed investment companies (LICs) are two that are worth taking the time to understand. This is because they are popular vehicles for people interested in regular, long-term, passive investing. Or more specifically - incremental amounts in diversified portfolios, for the long term. This investment style is what we founded Pearler to promote, and so ultimately, we’re avid supporters of both ETFs and LICs.

When it comes to ETFs vs LICs, both can typically be good options for long-term investing. This is because they are both cost-effective ways to invest in diversified portfolios. A diversified portfolio is one where your funds are spread across many companies. Diversification is important, because having all your eggs in one basket can leave you vulnerable to market fluctuations and random one-off events, whereas diverse portfolios spread risk and invest in different types of businesses at the same time.

You build a diversified portfolio by investing in many individual shares. An even easier way to do this is by investing in a single exchange-traded fund (ETF) or listed investment company (LIC). This is because LICs and ETFs are baskets of shares, which means that you invest in many (usually hundreds) of shares by investing in any ETF or LIC.

Before we explore whether ETFs or LICs are better for you, know that choosing between them is a matter of personal preference. Both offer their strengths and drawbacks, and the right decision for you will depend on your goals and preferences. With that said, let's dive deep into the differences between the two!

ETFs: An overview

Exchange-Traded Funds, or ETFs, are investment funds that track indices, commodities, bonds, or a basket of assets. They are traded on stock exchanges, much like individual stocks. The primary allure of ETFs is their ability to offer diversification, lower fees, and the ease of trading.

Pros of ETFs

1. Diversification: ETFs provide instant diversification, reducing the risk associated with holding individual stocks. For instance, an ETF tracking the ASX 200 gives investors exposure to 200 different companies in a single transaction.
2. Lower fees: Generally, ETFs have lower management fees compared to actively managed funds. This is particularly true for passive ETFs that track an index.
3. Liquidity: Being traded like stocks, ETFs are highly liquid. Investors can buy and sell shares throughout the trading day at market prices.
4. Transparency: Most ETFs disclose their holdings daily, offering a high level of transparency about where your money is invested.
5. Tax efficiency: ETFs are usually more tax-efficient due to their unique structure and lower turnover rates compared to actively managed funds.
6. Access to various markets: They offer access to a range of asset classes and international markets, allowing for a more global investment approach.

Cons of ETFs

1. Market risk: ETFs are subject to market volatility. A broad market downturn can negatively impact an ETF that tracks a particular index or sector.
2. Limited active management: Passive ETFs don’t attempt to outperform the market. For investors seeking active management, this could be a downside.
3. Over-diversification: Some argue that excessive diversification can dilute returns, especially in ETFs that cover too broad a range of assets.
4. Tracking error: There can be a difference between the performance of the ETF and its underlying index, known as tracking error, which can sometimes be significant.
5. Liquidity variability: While generally liquid, some niche or smaller ETFs may have lower trading volumes, leading to wider bid-ask spreads.

LICs: An overview

Listed Investment Companies (LICs) are a type of investment fund structured as companies and listed on a stock exchange. They typically have a closed-end structure, meaning the number of shares in the company is fixed after the initial public offering. LICs are managed by professional investment managers who actively select and manage the investments.

Pros of LICs

1. Active management: LICs are usually actively managed, potentially offering higher returns if the manager can outperform the market.
2. Stable investment pool: The closed-end structure means managers have a stable pool of capital to invest, unaffected by investor redemptions.
3. Dividend stability and franking credits: Many Australian LICs focus on delivering consistent dividends, often with franking credits, which can be appealing for income-focused investors.
4. Discounts to NTA: LICs can trade at a discount or premium to their Net Tangible Assets (NTA). Purchasing at a discount can offer additional value to investors.
5. Long-term investment approach: With stable capital, LIC managers can adopt a long-term investment strategy, potentially leading to better risk-adjusted returns.

Cons of LICs

1. Management fees: LICs usually have higher management and performance fees compared to ETFs, especially those tracking an index.
2. Market price vs. NTA: The share price of a LIC can deviate significantly from its NTA, influenced by market sentiment and demand for the shares.
3. Less transparency: LICs may not disclose their holdings as frequently as ETFs, making it harder to understand where your money is invested at any given time.
4. Less liquidity: Shares in smaller LICs can be less liquid than ETFs, with wider bid-ask spreads and lower trading volumes.
5. Active management risk: The success of a LIC heavily relies on the skill of the manager, and there is a risk that the manager’s decisions may not always yield the best results.

ETFs vs LICs: Key Differences for Australians

Here are the key differences between ETFs and LICs, accounting for our Australian context.

Investment strategy

ETFs are often favoured for passive investors who are content with market returns and seek broad exposure to various asset classes. LICs, meanwhile, often appeal to investors who prefer active management and are willing to pay higher fees for the potential of outperforming the market.

Cost considerations

ETFs typically have lower expense ratios compared to LICs, making them a potentially cost-effective option for cost-conscious investors. The higher fees of LICs are attributed to the active management and stock selection expertise they offer.

Dividend preferences

Australian LICs are known for their focus on regular dividend payments, often accompanied by franking credits, which can be attractive for income-seeking investors. While some ETFs also provide regular dividends, the focus is usually more on capital growth than income.

Market timing and pricing

ETFs offer real-time pricing during trading hours, allowing investors to respond quickly to market changes. LICs can trade at a discount or premium to their NTA, requiring investors to consider timing and valuation when buying or selling.

Taxation aspects

ETFs can often be more tax-efficient due to their structure and passive management style. LICs, depending on their structure and the portfolio turnover, may have different tax implications, especially regarding capital gains and dividend distribution. However, if you have any queries about the tax implications of either choice, speak to a licensed tax professional.

Comparing ETFs vs LICs for long-term investors

As we mentioned earlier, the right choice between the two will depend on the preferences of each investor. Having said that, for long-term investors who employ a dollar-cost averaging strategy, our opinion is that ETFs typically offer several advantages over LICs. Here's a summary of why we believe ETFs emerge as the better choice in this context:

• Lower costs: ETFs generally have lower management fees compared to LICs. When you're investing regularly over a long period, even a small difference in fees can add up to a significant amount. Lower costs mean more of your money stays invested and has the potential to grow. To be sure the costs are right for you, always check a fund's Product Disclosure Statement.
• Market price vs. NAV consistency: ETFs usually trade very close to their Net Asset Value (NAV), providing more predictability for investors who dollar-cost average. In contrast, LICs can trade at a premium or discount to NAV, which can introduce an additional layer of price variability not directly tied to the underlying assets' performance. This variability can potentially impact the efficiency of dollar-cost averaging.
• Greater transparency: ETFs typically offer higher transparency regarding their holdings, allowing investors to know exactly what they are investing in at any given time. This transparency can be beneficial for long-term investors who want to ensure their regular investments align with their risk tolerance and financial goals.
• Broader diversification: ETFs often provide more extensive and immediate diversification across various asset classes and global markets. This diversification can be invaluable for long-term investors using dollar-cost averaging, as it helps spread risk and can lead to more stable returns over time.
• Liquidity: ETFs are generally known for their liquidity, making it easier for investors to buy and sell shares at market prices. This is particularly important for dollar-cost averaging, where the ability to make regular purchases without significant price impact or liquidity concerns is crucial. Tax efficiency: ETFs are often more tax-efficient due to their unique creation and redemption process and lower portfolio turnover. For long-term investors, this can mean fewer tax liabilities over time, allowing more of their investments to compound. Again, though, always confer with a licensed tax professional to understand the tax implications of an investment.

Conclusion

Both ETFs and LICs can serve as suitable long-term investment options. However, the combination of typically lower costs, comparative price predictability, transparency, diversification, and liquidity can make ETFs a more compelling option for long-term investors who invest incrementally. These factors can contribute to more predictable, cost-effective, and efficient investment growth over time.

While financial acronyms can be intimidating, hopefully this article can help you compare an ETF MER and NAV with a LIC on the ASX.

Happy investing!