Shares versus ETFs, managed funds and LICs
When most people think of share market investing, they probably picture someone buying shares in an individual company, such as Commonwealth Bank of Australia (ASX: CBA), or Telstra Corporation Ltd (ASX: TLS).
But the reality is that owning shares in individual companies is just one way an investor can invest in shares. By now, you might have heard of the exchange-traded fund (ETF), an increasingly popular option. But there are also managed funds and listed investment companies (LICs).
All of these vehicles offer the same outcome – owning shares in an individual entity that entitles the owner to a share of the profits. But these differing vehicles certainly provide wildly divergent paths on how to get there.
No one vehicle is inherently better than the others, but one might suit the risk tolerance, goals or aptitude of an individual investor better than another. So, let’s take a deep dive into ETFs, managed funds, LICs, and individual shares investing to see what each can offer an investor today.
Why buy individual shares?
Let’s start with buying individual shares. As we discussed above, this is what most people think of when it comes to ‘investing in shares’. In most cases, it involves a person owning a number of shares in a number of companies in their own name.
Most shareholders who invest this way accumulate these shares over time, building up a diversified portfolio of different companies across a range of sectors. Hopefully, they’re all balanced out with consideration to the individual’s diversification requirements, risk tolerance and goals.
So, why buy individual shares? Quite simply, this is the investing method that offers the most control over your capital. Other investment vehicles involve you accepting the choices of either a fund manager or an index provider when it comes to the shares you are investing in.
All of these providers also charge a fee for this privilege too, of course. Doing the hard work yourself means the only cost you will pay is brokerage. No fees to fund managers or ETF providers to eat away at your potential returns. And no unwanted investments that come with an index or a fund manager.
Thus, many investors prefer the control and simplicity that this investing method provides.
However, that’s not to say individual shares don’t have pitfalls. Investing in individual companies usually demands a lot of time and dedication. You don’t want to just pick any old company. So, most investors that employ this method will spend hours reading earnings reports, looking at business fundamentals, and just generally following what their companies are up to.
Failure to put adequate time and effort into an investing portfolio can have dreadful consequences for your wealth, and those who don’t take these steps may find that they might have been better off paying someone else to do it.
It can be more costly, too. If you are starting out with only a small amount of capital, it can be costly to immediately start a diversified portfolio of 10 or more shares. Brokerage is generally cheaper the more capital you invest with, so this might not suit someone who has just scraped together their first $500.
It’s for these reasons that many investors choose to go with other investing vehicles.
Why invest in a managed fund?
Managed funds are one such alternative to individual shares. A managed fund is just what it sounds like – an investment fund managed by a fund manager. If you put your money into a managed fund, you are essentially giving your money to them to invest on your behalf. You will have very little say over what they can do with your money, only the hope that they will invest it wisely.
One of the most defining traits of a managed fund is its unlisted structure. Unlike an ETF or LIC, managed funds don’t usually trade on a share market, and will conduct all transactions with you privately. Thus, you will usually have to wait until the end of the trading day if you want to buy or sell your units.
An advantage of a managed fund is it allows investors to effectively ‘pool’ their money with other investors. By doing so, opportunities that may not normally be available to retail investors can be opened up. Many managed funds will invest in assets like property, government and corporate bonds, or private equity that is out of reach for many individuals.
Another benefit of managed funds is the fund manager’s expertise. If you like the track record of a particular fund manager, then go with them. You won’t have to do the hard work of researching, identifying, and tracking high-performing companies that might provide outsized returns because you’ll be paying a manager and their team for that. Thus, managed funds can be a great way to invest, especially if you just want to ‘set and forget’.
But managed funds also have their disadvantages. The first one to consider is the cost. Unlike investing in individual shares, or ETFs, a managed fund is… managed. Each fund will usually employ a fund manager and a team of analysts. They don’t come cheap. Thus, managed funds normally charge management fees that are far more expensive than an ETF.
You’ll want to ensure that your fund manager is justifying their fee by delivering consistent market-crushing performances. Otherwise, fees will significantly eat into your long-term returns.
Speaking of market-beating, many funds will also take a performance fee as high as 20% for anything above their target benchmark. This may appear to be a win-win for both parties, but it does limit an investor’s upside.
Another disadvantage is the unlisted nature of managed funds. This makes them relatively illiquid compared to exchange-traded products. Many managed funds require minimum investment amounts. These can range from $5,000 to $100,000, or even higher. As such, this will exclude many investors right off the bat.
Even if you do invest in a managed fund, you will usually have to wait until the right time if you want to add or take money out, as we flagged earlier. Even then, issuance or redemption of managed fund units can often take several days and involve paperwork. It’s also difficult to pull money out of a managed fund during times of market dislocation, such as during a share market crash.
This is especially true if the managed fund itself is invested in illiquid assets, like property or private equity. A fund manager can even ‘close’ the fund for redemptions, in some cases. (In other words, lock up your money as you might have seen in the 2015 film The Big Short).
If this is likely to be a significant concern for you, then a managed fund might not be a great investment for you.
What's the difference between a managed fund and an index fund?
Managed funds and index funds have a long history – the first index funds were managed funds, after all.
An index fund is a fund (either an ETF or managed fund) that faithfully tracks an index, such as the S&P/ASX 200 Index (ASX: XJO). Most index funds are ETFs these days, so when people refer to a ‘managed fund’, they are generally referring to one that is actively managed by a fund manager.
Actively-managed funds do not attempt to track an index, they instead aim to outperform it. And this is the main difference between the two. An index fund doesn’t usually have a fund manager or management team. Because of this, its fees are usually significantly lower than its active counterparts.
Why invest in an ETF?
So, why would an investor choose an exchange-traded fund over another option? Most ASX ETFs are index funds, tracking the performance of a share market index. ETFs offer a few advantages in this light.
They are listed on a share market, for one. This results in high liquidity, ease of access, and transparency that a managed fund can’t match.
Another big advantage of an index ETF is its fees, which are usually among the lowest you will pay for an investment vehicle. The lowest fee index ETF on the ASX charges just 0.03% per annum. That represents roughly $3 a year for every $10,000 invested.
An ETF also ‘rebalances’ itself over time in order to accurately reflect the index it is tracking. This reduces the need for an investor to manage their investments and makes an ETF a great ‘bottom drawer’ investment for those unable – or unwilling – to dedicate significant time to managing their portfolio.
Remember, not all ETFs track share market indexes. The ASX hosts ETFs that mirror indexes tracking oil futures, platinum prices, healthcare shares, bank shares, gold, and much more. These ETFs can provide easy access points for otherwise tough sectors for individuals to invest in.
What indexes can an ETF track?
So, there are index funds available on the ASX that cover most of the world’s most popular indexes. There’s plenty of choice for Australian shares, for one. There are many ETFs covering the ASX 200 Index, such as the iShares Core S&P/ASX 200 Fund (ASX: IOZ), the BetaShares Australia 200 Fund (ASX: A200), and the SPDR S&P/ASX 200 ETF (ASX: STW).
There is also the most popular ETF in Australia, the Vanguard Australian Shares Index ETF (ASX: VAS), which instead tracks the ASX 300 Index.
Outside the ASX, there are still plenty of index funds to choose from. The US markets are well covered. You can either choose an S&P 500 ETF, like the iShares S&P 500 ETF (ASX: IVV), or the Vanguard US Total Market Shares Index EFT (ASX: VTS).
There’s also the popular BetaShares NASDAQ 100 ETF (ASX: NDQ), which covers the tech-heavy NASDAQ 100 Index.
There are obscure options, too. For example, the iShares MSCI South Korea ETF (ASX: IKO) tracks an index that holds purely South Korean shares. The Vanguard MSCI International Shares Index ETF (ASX: VGAD) tracks an index that follows multiple share markets across the advanced economies of the world.
What about actively-managed ETFs?
Most, but not all, ETFs are index funds. Any ETF that doesn’t blindly track an index is usually referred to as an ‘active ETF’. Active ETFs can look a lot like managed funds, with the exception of being traded on the ASX, rather than being unlisted. The VanEck Vectors Morningstar Wide Moat ETF (ASX: MOAT) is a good example.
In fact, more and more managed fund providers are offering clients either a listed or unlisted version of their funds. These include the Magellan Global Trust (ASX: MGF) and the Hyperion Global Growth Companies Fund (ASX: HYGG).
Because they share many of the characteristics of a managed fund, these active ETFs also share some of the drawbacks, including higher fees and the potential for market underperformance.
Why invest in a listed investment company (LIC)?
Lastly, we get to our final type of investment vehicle, the listed investment company (LIC). Much like the managed fund, the LIC structure has been around for a long time and doesn’t quite hold the same sway with ASX investors as it used to.
Again, this is largely due to the rise of the ETF. Still, many ASX investors continue to invest in LICs, and many LICs give their investors spectacular returns.
So, LICs are similar in nature to a managed fund, with two significant differences. Firstly, LICs are always listed on a stock exchange, and so are publicly traded. This removes the liquidity and availability issues facing managed funds.
Secondly, LICs operate under a corporate structure – they are essentially a company in their own right. This is very different to a managed fund or an ETF, which are usually structured as a trust. This has big implications for investors. Trusts are pass-through vehicles that, by law, have to distribute profits and taxable income (or losses) to their investor beneficiaries every year.
A company has no such obligations. It must pay tax itself on any profits (thereby generating franking credits for shareholders), but can hold on to cash and franking credits as long as it deems necessary. This means that LICs have the ability to hoard cash over time, in order to ensure smoother dividend payments and franking credit distributions for shareholders.
This is greatly appreciated by investors in times of market stress. In 2020 after the COVID-19 pandemic struck, many ASX LICs had enough cash on hand to continue paying their dividends at a time when most companies were suspending or cutting their shareholder payouts. This is one major advantage of LICs.
LICs are also what’s called a ‘closed-ended’ investment vehicle. Unlike a managed fund or ETF (which are ‘open-ended’ vehicles) but like an individual company, there are a finite number of shares that a LIC has at any one time.
When an investor sells their shares, the shares pass to the buyer – they are not redeemed by the LIC itself. This can be another advantage of LICs.
Managed funds and ETFs have to sell their underlying holdings when their investors redeem their units. This can spark instability if the fund is processing a large number of sell orders, which is typical in a market crash. A closed-ended vehicle like a LIC does not have this problem.
The drawbacks of LICs are also similar to those of managed funds. Since the company has a corporate structure and employs a fund manager and a team of analysts, LICs usually charge fees that are closer to the managed fund level than an ETF (although there are exceptions).
You are also getting the same possibility that LICs can deliver market underperformance.
A final potential drawback of a LIC is the possibility of a permanent discount. Since a LIC (like a managed fund or an ETF) holds shares within it, each share will have a net tangible asset (NTA) value. This reflects what the LIC would be worth if its assets were valued on a per share basis. But some LICs, for a variety of reasons, often trade below this value with semi-permanent regularity. This can be a problem as it means the LIC’s investors cannot access the liquidity of the shares’ ‘real value’.
Which are the biggest LICs in Australia?
The ASX is home to dozens of LICs, but a few have been around for so long that they have garnered quite a reputation. The most prominent of these is the Australian Foundation Investment Co Ltd (ASX: AFI). AFIC is a $10 billion ASX stalwart, having first opened its doors in 1928. This LIC typically invests in a portfolio of ASX blue-chip shares.
Other prominent ASX LICs include Argo Investments Ltd (ASX: ARG), formerly chaired by Sir Donald Bradman, Milton Corporation Limited (ASX: MLT), and WAM Capital Ltd (ASX: WAM). Milton and Argo tend to follow the ‘AFIC model’ of conservatively investing in blue-chip shares, whilst WAM Capital takes a more active approach.
Verdict: Shares versus ETFs, managed funds and LICs
At the end of the day, each of the four asset classes we have discussed – individual shares, managed funds, ETFs, and LICs – have distinct advantages and disadvantages.
Some of these you can see on this table:
These differences might make some of these vehicles appropriate for some investors, and inappropriate for others. Deciding which one is right for you comes down to your preferences, goals, and expectations for your investment strategy and portfolio.
There’s also nothing wrong with investing across many, or even all, of these four vehicles within your portfolio.
Article last updated 21 March 2022. Motley Fool contributor Sebastian Bowen owns shares of Telstra Corporation Limited and VanEck Vectors Morningstar Wide Moat ETF. The Motley Fool Australia's parent company Motley Fool Holdings Inc. owns shares of and has recommended BETANASDAQ ETF UNITS. The Motley Fool Australia owns shares of and has recommended BETANASDAQ ETF UNITS and Telstra Corporation Limited. The Motley Fool Australia has recommended VanEck Vectors Morningstar Wide Moat ETF, and iShares Trust - iShares Core S&P 500 ETF. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.
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