Updated Apr, 2020

What are ETFs, LICs, index funds, and managed funds

It is easy to get confused since there are two separate dimensions –

  • The Stock selection style (index-tracking vs actively managed); and
  • The Investment vehicle/legal structure that can hold a basket of underlying shares and offer them to be purchased as a single unit (managed fund vs ETF vs LIC).

Index tracking Actively managed
Managed
fund
tick tick red
ETF tick tick red
LIC tick red

tick Index tracking
tick red Actively managed
[empty] Option doesn’t exist

Stock selection style — index-tracking vs actively managed

An index tracks a market.

For example,
The S&P ASX200 index tracks the 200 largest Australian publicly traded companies.
The MSCI World index tracks the largest 85% of publicly traded companies in 23 developed countries.
The MSCI Emerging Markets index tracks publicly traded companies in 23 emerging countries.

They track them by ‘market capitalisation’ (what the market collectively has priced each company at), which means if one company is valued at double another company, then that company will be weighted at double the proportion.

For example, if you purchase a share in an ASX200 index-tracking fund, you own a piece of all of Australia’s largest 200 companies in their valuation proportions. So if CBA is currently valued at double BHP, there will be twice as much CBA as BHP within your index fund in dollar value.

There is more than one investment vehicle that can be used to invest in index funds, which we will go through in a moment, but the important thing to understand is that an index fund (a fund that tracks an index) has no risk of a fund management company selecting a subset of stocks that will underperform the market. You’re guaranteed the returns of the market.

The opposite of an index fund is an actively managed fund – where a fund management company selects a subset of stocks.

The 3 vehicles/legal structures that allow you to invest in a basket of shares with a single purchase

A fund’s investment vehicle/legal structure doesn’t tell you anything about what assets the fund invests in.
The shares held can be stocks, bonds, real estate, infrastructure, commodities, cash, or any combination.

1. Managed funds

The company holds the underlying shares, and you purchase directly through that company.
When you buy or sell a share in the fund, the fund goes and buys or sells the underlying shares of each company in the fund. This ensures that the underlying shares’ value will match what they’re worth if you bought them individually.

Both actively managed funds and index-tracking managed funds are available.

An index tracking fund will often have the word index in the fund name, and if not, it will mention it early in the product’s main web page (usually the title or at least the first paragraph) or else in the PDS.

Examples of – Index tracking managed funds
Vanguard Australian Shares Index Fund
Vanguard International Shares Index Fund

Examples of – Actively managed funds
Colonial First State FirstChoice Wholesale Australian Share
Colonial First State FirstChoice Wholesale Global Share

2. ETFs – Exchange Traded Funds

ETFs are simply listed versions of managed funds. Instead of purchasing directly through the fund management company, you buy a share of the fund on the stock exchange. As per the name, it is a fund that is ‘exchange-traded’. Again, there are both index-tracking ETFs and actively managed ETFs.

Examples of – Index tracking ETFs
VAS – Vanguard Australian Shares Index Fund
VGS – Vanguard International Shares Index Fund (VGS)

Examples of – Actively managed ETFs
INIF – InvestSMART Australian Equity Income Fund (Managed Fund)
MGE – Magellan Global Equities Fund

3. LICs – Listed Investment Companies

The above two types of investment vehicles are called open-ended funds, in that, as an investor buys or sells shares of the managed fund or ETF, the fund will go and buy or sell more of the underlying shares, so the price tracks the actual value of the underlying shares it holds.

LICs are closed-ended funds which means that the company purchases or sells the underlying holdings at their discretion. When investors buy shares, no additional shares are created. If there is a high demand for an LIC’s share, the price goes up above the value of the underlying basket of shares within it (called trading at a premium to NAV – Net Asset Value). Conversely, if there is low demand, the LIC’s share price falls below the value of the underlying basket of shares (called trading at a discount to NAV).

Buying at a premium is generally not a good idea – why would you pay more than the value of the underlying assets?

LIC advocates say that you can get a free lunch buying LICs at a discount to NAV, but this is a fallacy. The price of an LIC is at a discount because the market sees a risk (often manager risk) and is pricing-in the risk by valuing it lower than its net asset value, so when it is at a discount, there is no free lunch, you’re paying for the discount with a higher risk. Provided you purchased at a time of discount, you’re at least getting a higher expected return to compensate for the higher risk you’re taking, but you may buy it at a time when it is not at a discount but later on have it face management uncertainty, and then you face the risk without the associated reward. Why take on this added risk at all when you can just buy an index fund and remove this risk entirely.

Examples
AFI – Australian Foundation Investment Company
ARG – Argo Investments Limited

Summary

A fund has two dimensions – the vehicle/legal structure and the stock selection style.

Some funds are index tracking. Some are actively managed. Some hold stocks. Some hold bonds. Some hold gold. Some hold property. The fact that a fund is an ETF or a managed fund, or an LIC doesn’t tell you anything about the investments it holds.

The most important decision is the stock selection style – whether to choose an index fund or an active fund.


Choosing between Vanguard’s managed index funds and their equivalent index-tracking ETFs

For their index-tracking funds, Vanguard offers two managed funds and 1 ETF.

  • Wholesale managed fund
  • Retail managed fund
  • ETF

Advantages of managed funds

The managed funds allow you to BPay directly in, which means there is no brokerage cost to buy and sell, so you can BPay in as frequently as you like. In contrast, for the ETF, there’s a minimum brokerage cost each time you buy or sell, so with ETFs, you want to save up and buy in larger chunks less often to minimise purchasing costs (more on this below). So, if you’re going to invest more frequently, managed funds have an upside. The upside is that your money is working for you sooner, whereas, with an ETF, your money is sitting out of the market while you accumulate enough funds to make your next purchase.

Managed funds have another upside that is rarely mentioned. Since ETF prices move with the market, when news comes out, some people go and check the portfolio. News alert comes out? Check the portfolio. Trump tweets something? Check the portfolio. Sitting on the toilet? Check the portfolio. For many people, it’s not good for their mental health and their ability to remain invested.

Managed fund prices only update once per day (after market close). Transactions only process once per day (after market close). There’s no longer a point or a personal drive to check the portfolio during the day. Some find that the once per day updates allows you to detach your emotional connection from your portfolio.

The managed funds also allow you to set up automated BPay directly in on pay day, which means you don’t need to look at your investments at all. Behavioural risk is one of the major risks and is discussed more in the following article on mitigating risks.

The wholesale managed fund is only a couple of basis points over the ETF, virtually insignificant, but you need at least $100,000 to start investing in them. The Vanguard website says $500,000 minimum but call them up, and they may let you in for $100,000 but note that is $100,000 minimum per fund. [1]

[1] Update 2020 – Vanguard may no longer be accepting 100k for their wholesale funds.

If you still want to invest frequently or set up automated BPay but don’t have at least $100,000 per fund to start with, that leaves only the retail managed fund, but the retail fund has high fees. I would try to avoid that, and either look for a low-cost broker and invest in ETFs but less frequently, or possibly use the retail fund and once you have $5,000-$10,000 over the minimum balance, sell down to the minimum and buy a single parcel of the equivalent ETF to reduce the ongoing costs.

Advantages of ETFs

One advantage of ETFs over the managed funds is that when you purchase a share of an ETF, you pay whatever the price is at that time. In contrast, with managed funds, you put in a purchase order, and the shares are bought after the market closes that day, so you may end up paying more or less per share than you intended. For a long-term investor, this won’t matter because it will even out over time as you buy regularly.

Another advantage of ETFs is when you have plans to buy or sell very large parcels, the cost to buy and sell will be cheaper buying an ETF and using a flat-fee broker compared to the managed fund’s buy/sell spread.

A further advantage of ETFs is that they’re more tax-efficient than their managed fund counterpart.

In managed funds, the entire fund is one pool of assets, so other investors selling their units triggers capital gains for all investors of the fund. So even if you don’t sell any units, you still have to realise gains. This doesn’t occur with ETFs due to their tax structure, and instead, you defer these capital gains until you sell your ETF shares.

An example of this was during the coronavirus market downturn where VGAD paid no mid-year distribution (due to currency hedging), yet the managed fund version was forced to pay out a distribution due to realised capital gains. This is despite the two funds having the same base fund, because they’re two different pools of money and must be managed according to the fund structure.

Generally, you want to delay your gains until as late as possible because that additional money could be compounded for potentially another 30 years or more otherwise.

Important note – I’d like to stress that there are two distinct tax advantages to be aware of:

  1. The first and most important is the low-turnover tax nature of index funds vs actively managed funds. This advantage of index funds is shared between both ETFs and managed funds. The improved tax outcome is because as companies within an index fund grow or shrink in value, so does the value of their shares within your fund, so the only selling in regards to adjusting holdings in an index fund is when a company drops out of the index.
  2. The second tax advantage is only for ETFs, which is that when other investors sell shares in the same fund, an ETF (and not a managed fund) can delay those gains until they sell their own ETF shares, whereas for managed funds, you realised gain each time any investor sells shares in the fund.

How ETFs are created and redeemed and why it matters – Vanguard
Tax and ETFs: 5 ways ETFs can achieve better tax outcomes for clients – Vanguard
The tax advantages of ETFs – VanEck
Taxing the advantages of ETFs – Morningstar

In summary

The difference comes down to the convenience of BPaying regularly and the associated behavioural aspects vs improved handling of capital gains (and avoiding the retail funds’ higher fees).


How often to buy a parcel of shares

How often to buy a parcel of shares will depend on whether you purchase the ETF version or the managed fund version.

With the managed fund version, you can buy as often as you like without any added cost, but to buy ETFs, you need to buy through a broker, and there is a minimum brokerage cost per purchase.

Investing small parcels means higher brokerage costs, leading to a drag on returns as you lose more of it before it even gets into your investment.

For example, let’s say you decided on investing $1,500 per month split evenly between 3 index funds. If brokerage had a minimum cost of $10, then to make 3 purchases (one of each) every month would cost you $30 or 2% before your money even got into the investment, whereas waiting for 2 months and then alternating between the 3 funds would cost you $10 per $3,000 or 0.33% — one sixth of the cost.

However, waiting too long before investing also means you miss out on market gains.

A good rule of thumb is saving and investing parcels of around 3-5k if you can accumulate that within 3 months, but this calculator is a bit more precise.


Are ETF’s accurately priced?

Managed funds do all their buying and selling after market close, so the price you buy and sell at is exactly their net asset value (NAV).

For the most part, ETF’s are accurately priced because there are market participants called ‘market makers’ that the ETF provider appoints who can convert between a basket of the underlying assets and units of the ETF, and this keeps the price in check. Here’s a good explanation of how this works.

How ETFs Work – Bloomberg

However, there are certain times where it’s more likely to drift from NAV, and I go into this in the following section and how to avoid the problems associated with it.


With ETFs – avoid trading the first and last 15 minutes of the day, and always use limit orders

With managed funds, all the buying and selling of orders are done at the end of the trading day, and they use the actual net asset value of the underlying shares.

However, with ETFs, the price needs to update constantly throughout the day, and the difference between the net asset value (NAV) and the ETF share price can be more volatile during the start and end of the day when price discovery is being established by the market.

You should

  • Never trade in the first or last 15 minutes of the trading day;
  • Never place an order during off-market hours expecting it to be filled at the market open;
  • Always use limit orders. It’s just a matter of eliminating tail risk (those couple of times market makers have suddenly disappeared and spreads have blown out).

When you make a purchase, ignore the last price because, for lower liquidity ETFs, the last price could have been hours of trading earlier or even the day before and no longer reflect the price that people are willing to buy and sell at.

Just place your order a few cents below the bid if selling or a few cents above the ask if buying. It will act just like a market order, but you’ll never have any big surprises.

Being tricky and trying to price it lower when buying and higher when selling doesn’t actually help.

Vanguard suggests this for ETFs and calls it placing marketable limit orders.

More info
Does It Matter When You Buy Or Sell An ETF?
The two times during market day when investors should never trade