Aussie Firebug

Financial Independence Retire Early

Okay, so if you’ve been following me for any length of time you probably know that I’m a big fan of ETFs.

You know, those little exchange-traded funds that grant instant diversification with rock-bottom management fees to provide a great return for extremely little effort. It’s no wonder that famous investors like Warren Buffet and Mark Cuban (US billionaire) are also big fans.

Buffet has been quoted as saying:

“Consistently buy an S&P 500 low-cost index fund. I think it’s the thing that makes the most sense practically all of the time.”

I wrote about the benefits of index investing briefly in ‘Our Investing Strategy Explained‘ post.

I’ve been a big fan ever since reading the Bogleheads Guide to Investing about 3 years ago. And I put my money where my mouth is and currently have over $160K invested in ETFs.

 

“So if ETFs are so great, what the hell are LICs and why should I care? “

 

I’m so glad you asked.

Let’s begin.

 

Listed Investment Companies

GuideToLICs2

FYI when I refer to LICs, I’m referring to the older ‘granddaddy‘ LICs like AFI, ARGO, Milton etc. 

 

Listed Investment Companies (LICs) are first created by an initial public offering (IPO). Money is raised and a fixed number of shares are created for each investor. The money raised is then used for investing in assets such as a basket of shares which together make up the net asset value (NAV) of the LIC.

The shares of the LIC are traded on the stock exchange where investors are able to buy and sell when the market is open.

Sound familiar?

It should because, in a nutshell, ETFs are essentially doing the same thing. But there are key differences.

 

 

Key Differences

There may be more differences than what I’m about to go over, but the ones below are the key differences in my eyes and the ones that reflect my investing decisions.

Same but different

 

Management Fees

ETFs tend to have a lower MER than the equivalent LIC but it’s not as bad as it sounds. If you stick to the older LICs (Argo, AFI, Milton etc.) the highest MER is around 0.18% which is not that bad. It’s still more than double that of an Australian index ETF such a BetaShares A200 (0.07%) though.

The management fees reflect the investment style of the two structures.

ETFs track an index or benchmark whereas LICs try to outperform the index. But given the low MER of the older LICs, some active management is acceptable in my view. I only have issues where the fund managers charge > 1.0% for their services.

WINNER: Generally ETFs

 

Legal Structure/NAV

ETFs are a trust structure whereas LICs are a company as the name ‘Listed Investment Company‘ would imply.

This has some semi-big ramifications.

I’m going to try to keep to as simple as possible because we’re about to get technical here for a second.

To truly understand the differences between ETFs and LICs we must first understand how they operate and what’s the difference between Open-End and Closed-End

Closed-Ended

LICs are closed-ended.

This means that when the LIC had its IPO and raised the capital to start the company, a certain number of shares are issued. Once the company has been established and begins investing the capital on the behalf of shareholders, no more shares are issues. New investors wanting to join the LIC have to buy already issued shares on the exchange. The LIC does not create new shares to deal with demand.

Imagine a new LIC that has started with 4 investors each putting in $1. The LIC currently has a Net Asset Value (NAV) of $4 and there are 4 shares issued to each investor.

Fake LIC

Those four shares that own the LIC are each worth $1 according to the NAV. But those shares are bought and sold on the market. And depending on how bullish or bearish the market is on Fake LIC, will determine how much the share price will drift away from its NAV value either up or down.

If someone offers 1 unit of Fake LIC for 80c, this is what’s called trading at a discount. If someone offers the same unit for $1.20 it’s known as trading at a premium. LICs can drift away from the actual NAV quite a bit.

Can LICs ever increase the number of shares? Yes, they can raise capital and issue new shares just like any other company but this only happens every so often and not something that’s done daily like ETFs.

 

Open-Ended

ETFs, on the other hand, are open-ended and can create or redeem new shares in accordance with the market demand. If someone wants to enter the fund, they don’t need to trade with a current shareholder of the fund (like the LIC does). The fund can create a new share.

Conversely, if someone wants to cash out their share. The fund has to come up with a way to get the cash which may mean selling assets within the fund to give the investor their money.

But who sets the price of each unit? 

When an Investor wants to buy or sell their units on the exchange, there is a market maker on the other side of the trade. The price they offer is generally very close to the Net Asset Value of the fund.

This is why you can’t really trade an ETF at a discount or premium to the NAV.

WINNER: LICs. The ability to trade at a discount is desirable but the company not having to sell assets during a crisis to meet demand is a big plus. 

 

Investment Style

Traditionally ETFs track an index or benchmark whereas LICs try to outperform the index.

If you actually look into what is in the portfolios of Australian ETFs such as A200 or VAS and compare them with the old LICs, there is a lot of crossover. The whole active vs passive debate is more of a debate when the active fund managers are charging big fees (>1.0%).

I’ve got no issues with a little bit of active management as long as the MER is low. In fact, I like that most of the ‘Grand Daddy’ LICs have a focus on income. This is important to me and something that is reflected with historic returns for those LICs (more on that later).

One issue I do have with LICs is that they can and sometimes do change investment style. The fund manager that has a fantastic track record might retire or get offered a higher wage at another fund. I personally like the fact that most ETFs are legally obligated to track an index and can’t diverge from that strategy no matter what the managers are thinking.

Some would argue that being able to see waves in the market and adjust accordingly is a good thing.

WINNER: Tie. I prefer to track an index but don’t mind a little bit of active management as long as the fees are kept to a minimum. 

 

Retained Earnings

ETFs are a trust and they must distribute their income each year to unitholders. The income from assets within the funds such as dividends, get passed directly from the fund to the unitholder.

ETF Income flow

Because LICs are a company, they can receive income from the assets they own (usually dividends from shares), pay the company tax rate of 30% and keep that income in the fund for as long as they want. Then at a later date, the manager can decide to pass it on, usually as a fully franked dividend to the shareholders of the LIC.

LIC Income flow

This means that the income from ETFs are often lumpy and inconsistent because the market may do well some years and bad others. But if the LIC retains some income from the good years, they can distribute it in those bad years to make it more smooth and consistent.

Sounds like a good thing right? 

This one is something that’s been on my mind for a while.

The ‘smoothing’ of income is often touted as a benefit whenever any debate comes up between ETFs and LICs.

I beg to differ.

I personally don’t want the LIC to retain any of my income. I would much rather they pass on every single dollar to me so I can make the judgement call on what to do with it whether that be reinvested or spent.

This might be a plus to some but it’s an annoyance to me and something I really wish they didn’t do.

WINNER: ETFs. This is my personal preference. 

 

DSSP/BSP

Without going into too much detail, Dividend Substitution Share Plan (DSSP) and Bonus Share Plan (BSP) are offered by two LICs (AFIC and Whitefield respectively). It’s basically a plan offered by those two LICs which allow the investor to forgo the dividend in exchange for extra shares.

This means you don’t pay income tax and get more share instead. It’s great for high-income earners.

This is not offered by any ETF and is unique to the two LICs mentioned above.

If you want to read more about it, check out fellow FIRE blogger Carpe Dividendum’s excellent article.

WINNER: LICs

Fully Franked Dividends

This is actually not a difference but I want to clear up a common misconception about the franked dividends that LICs are able to pay out.

Some investors think that LICs can magically produce more income from the same basket of shares because they often pay out a fully franked dividend whereas an equivalent ETF might only distribute a partially franked dividend.

Let’s say for example that a LIC and an ETF both invested in the same company that paid out an 80% franked dividend of $70 dollars.

Here’s how that money would reach the investor using a LIC.

LIC Franking

Note that the end result for this investor who is in the 37% tax bracket is a grossed-up dividend of $59.22 after tax.

 

So how does it play out in an ETF structure?

ETF franking

 

The end result for the investor is exactly the same. A grossed-up dividend of $59.22 after tax.

WINNER: Franking does not matter when comparing LICs to ETFs.

 

In a nutshell, the key differences are:

TypeManagement Fees (MER)Investment StyleLegal StructureNet Asset Value (NAV)DSSP
ETFAs low as 0.04%Passive. Usually tracks an index and does not seek to outperform.TrustTrades on, or very close to NAVNo
LICAlthough slightly higher for an equivalent ETF, the old LICs generally are all under around 0.18%.Active. Seeks to outperform an index over the long term.CompanyCan trade at a discount or premium to the NAV of the fund.Yes

 

So Which One’s Better?

HomerThinking

If you’ve made it this far, I can almost hear your cries.

‘Just tell me which ones better FFS!’

After consuming all that info above, you’ll be rewarded with a clear and concise answer as to which investment is superior and what you should do.

And here comes the most annoying answer…

They are both great.

Both have pros and cons but either ETFs or LICs are suitable for FIRE chaser in Australia looking to generate a passive income. The most important thing is to understand the pros and cons for yourself and then you can make an informed decision as everyone’s needs, investment style, and appetite for risk are different.

The last point is often overlooked, it’s not so much about trying to achieve the maximum return in my eyes. It’s about choosing a strategy that will generate that passive income but more importantly, a strategy that you’ll be comfortable with through thick and thin. Because any portfolio is easy to hold in a bull market (see negative gearing). But it’s when the shit hits the fan that you’ll really appreciate a well thought out strategy that you’ll feel comfortable in when everyone else is running for the exit.

 

Conclusion

Peter loves Homer

ETFs and LICs are similar yet different. They shouldn’t be seen as enemies, more like best friends and depending on your mood, you might want to hang out with one or the other…maybe there’s room in your portfolio party for both?… Which leads me to talk about…

 

Strategy 3?

If you have read ‘Our Investing Strategy Explained‘, I have been thinking more and more about a dividend focussed portfolio which mainly consists of Aussie shares since they offer a great yield plus franking credits. They certainly feel like the ultimate passive investment to fund early retirement. And our end goal, after all, is to create a passive income stream to retire on.

So after much research, learning from other dividend focussed investors such as Peter Thornhill and Dave at Strong Money Australia and much toing and froing, I have decided to direct all future capital into high yielding Aussie shares in the form of ETFs and LICs.

We currently have nearly $100K in international securities which makes this decision a little bit easier. We are basically accepting the risk of lesser diversification in order to gain a higher dividend yield through Aussie shares.

I completely understand the risk and acknowledge that an internationally diversified portfolio will most likely outperform an all Aussie one in terms of total return. However, I’m confident in saying that the international portfolio will not offer the same level of dividend yield that the Aussie one will.

I wrote a little bit more about my reasoning to move to strategy 3 in our September 2018 Net Worth Update.

 

Historic Returns

I would like to take a second to illustrate just how similar the returns are between most of the older LICs and Australian Index ETFs.

I’m going to be using the historical data of Vanguards VAS ETF because the A200 was only created this year and VAS has been around nearly 10 years. Since they are so similar it should be a fair comparison. And I’m choosing 4 of the most common older LICs for comparisons.

Below are the returns for investing $1M on the 21st of May 2009 (creation date for VAS) in each of the LICs and VAS.

LICs VAS Returns Historic

It’s no surprise that the majority of the LICs returned more dividends than VAS. This is their main focus after all and a primary reason I’m investing in them.

Argo was a surprise returning significantly less than the others in terms of capital gains and dividends.

Maybe even more surprising is that VAS is smack bang in the middle of the pack for total returns. I guess that this just further illustrates that it’s hard to beat the index consistently over a long period of time. Some LICs might be able to do it (in this case MLT and BKI) but others won’t.

 

ETFs AND LICs?

Yes, I’m utilising a combination of an ETF and LICs for the Aussie portion of my portfolio which is what I have decided to focus on for the foreseeable future.

Here’s how it’s gonna work.

I will be purchasing either one of two LICs or one ETF once a month to the tune of around $5K.

 

Why 1 ETF and 2 LICs?

I have already been into why I think ETFs are so great if you’re looking to get exposure into the Aussie market and want to invest in an index style. BetaShares A200 or VAS are the obvious choices in my opinion and with the A200’s MER being half the price of VAS, it’s a clear choice for me.

One of the biggest pros for ETFs for me is that they do not try to pick winners and divulge from an indexing strategy.

LICs, on the other hand, can and do suffer from a fund manager change or investment style redirection.

This scares me.

To mitigate this risk, I’ll be spreading our capital out between two LICs even though what they’re investing in is incredibly similar and might look silly from a diversification point of view. But I don’t really care if others think it’s silly, if it helps me sleep at night then it’s all gravy baby!

The other reason I’m buying multiple LICs is to have a greater chance to be involved in a Dividend Substitution Share Plan.

So what am I buying and how am I deciding what to purchase? 

ETF

A200
MER: 0.07%
Benchmark: Solactive Australia 200 Index

Why it’s in our portfolio:
BetaShares A200 made it’s way into our portfolio last month after Vanguard failed to respond and lower their management fee for VAS which is currently double that of the A200.

Given that the returns for the last decade between the ASX200 vs ASX300 (pictured below) were incredibly similar.

A200vsA300

Source: https://au.spindices.com/indices/equity/sp-asx-300

I’m choosing the ETF with the lower management fee every day of the week.

 

LICs

AFI
MER: 0.14%
Benchmark: XJOAI (ASX:200)

Why we will be investing:
Other than being a dividend focussed LIC with a MER of 0.14%, AFI is only one of two LICs that offer DSSP. The other LIC is Whitefield (WHF) and that has a MER of 0.35% which is too high for my liking.

A very good detailed review about this LIC can be found by the ever so insightful SMA. Check it out.

 

MLT
MER: 0.12%
Benchmark: XOAI

Why we will be investing:
Milton’s very low MER of 0.12% was attractive and we needed to spread our risk across another LIC so after much research, Milton it was. Milton also seems to be a bit more on the active side compared to the other older LICs which is another hedge against something happening with the index.

Full SMA review if you’re interested.

When To Buy?

So if I’m going to be directing all future capital into Aussie shares through LICs and A200 ETF. When do I know which one to buy since they are all essentially the same investment (Aussie shares)?

Here’s what I’ll be doing each month when we have saved up $5K and are ready to invest:

  1. Check both AFI and Milton’s NAV compared to their share price on the ASX to see if they are trading at a premium or discount (currently developing a web app to make this easier)
  2. Invest in whichever LIC is trading at the biggest discount
  3. If both LICs are trading at a premium, buy A200

 

That’s It…For Now

As of writing this article, for my circumstances and goals, I believe that an Australian based portfolio consisting of ETFs and LICs is the best strategy to produce a passive income for me to achieve financial independence so I can have the freedom to retire early.

But as I’ve always said, if I come across something that’s better than what I’m doing, I’ll make the switch.

My mind is always open to new ideas and strategies.

But that’s it for now… until strategy 4 rears its head 😈

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