Measure what is measurable, and make measurable what is not so.Galileo
Investing using Listed Investment Companies (LICs) is one of the most commonly suggested investment options for Australians interested in pursuing financial independence. Yet it is also one of the least questioned, as well as the least empirically examined and supported approaches.
LIC investment is covered in many beginner personal finance and investment books such as the best-selling Barefoot Investor series from Scott Pape. Discussions of the benefits of LIC-based investing by established Australian financial independence blogs are also common and have been jokingly described as a growing ‘bandwagon’ (see for example, Strong Money Australia, Aussie Firebug and Pat the Shuffler). LIC-based and conceptually similar ‘Thornhill’ approaches are also frequently discussed and compared in Reddit financial independence threads.
A theme of much of this coverage is that LICs are a logical and preferable path for many Australian investors seeking financial independence. The universality of this theme made me curious to examine this popular proposition in more detail. As with all received wisdom it is sometimes worth looking more closely, and seeing if the claims for the position put actually hold water.
This long-read article seeks to start the process of doing that, and provide a more skeptical examination of eight of the common explicit or underlying claims for the use of LICs as an alternative to passive investing though equity index Exchange Traded Funds.
Some caveats to begin. The purpose of the article is not to suggest that LICs can never form part of a sound portfolio, or that an investor that has fully or partly invested their savings in a broad-based dividend focused LIC has made an irredeemable error that will hopelessly compromise their path to financial independence.
Any investor saving a large proportion of their income into reasonably diversified equity based investments should, on average and historically speaking, do well.
Rather, the purpose is to provide some food for thought on the risks and drawbacks of LICs for those either invested, or considering investing in LICs, drawing where possible on relevant academic and hard empirical evidence. This evidence has been either absent, or difficult to consistently spot, in the discussions on the merits of LICs and index ETFs that I have seen to date.
So, to turn to the claims.
Claim #1
LIC managers can skilfully and strategically select reliable dividend stocks
Underpinning any rational choice to invest in LICs is the belief that its management skill can reliably result in at least equivalent risk and return performance as accessible passive alternatives (such as Betashares’s A200.ASX or Vanguard’s VAS.ASX exchange traded funds) through initial and ongoing selection of equities that is enough to at least outweigh the cost of such management. Falling short of this means reducing one’s risk adjusted return with no offsetting benefit.
Importantly, an observation that some LICs may have outperformed a passive equity index even over the long-term does not tell us anything about whether this performance was due to skill or luck. Nor does it tell us, critically, whether this superior performance was identifiable in advance, compared to any other LIC available to investors at the start of the period in question that then went on to deliver below average returns.
Those empirical finance studies just ruin everything
In fact, it is one of the most widely published and replicated empirical findings in finance literature that professional investment managers are unable to reliably outperform relevant passive index benchmarks (see Fama and French “Luck versus Skill in the Cross Section of Mutual Fund Alpha Estimates” (pdf) in the Journal of Finance).
This evidence includes exhaustive studies of unit investment trusts, which are comparable equivalents in the United States to Australian LICs. Unfortunately, recent empirical studies show that unit investment managers typically reduce returns by poor stock selection by between 2.5-2.8 per cent per annum compared to the market index, and even fail to outperform active mutual funds despite having no requirement to hold cash for redemptions (see Comer and Rodriguez “Stock Selection Skill, Manager Flexibility, and Performance: Evidence from Unit Investment Trusts“).
It is difficult to know what to make of a lack of engagement with this established literature and record in the argument sometimes seen that the active management LICs offer the potential for superior risk adjusted returns to the benchmark.
But Australia is different, right?
An accompanying claim sometimes made to discount this clear evidence is that Australia is different, that there is something fundamentally different or special about Australian LIC managers that they are able to achieve results different to those systematically observed across other investment markets. Typically, little clear explanation is given as to why this should be the case, especially in a modern globalised equity market.
In fact, what limited published academic evidence is available suggests the opposite (see Robson “The Investment Performance of Unit Trusts and Mutual Funds in Australia for the Period 1969 to 1978“.
The unfortunate reality is that there is simply no robust evidence that managers in LICs have demonstrated any reliable capacity to select equities, or see trends in advance and act, to the benefit of their investors after costs.
Reviewing the LIC selection pitfalls: a worked example
This same point is evident from comparisons of a Vanguard Australian share ETF (VAS) and four popular Australian-managed LICs (AFI, Argo, BKI and MLT) made recently by Aussie Firebug in a discussion on moving to invest more in LICs. Taken over a recent five-year period, this analysis shows that this underperformance risk is pervasive and not avoidable in advance.
To see this, looking at the four fund and VAS example given in detail it is clear that:
- LIC underperformance risk doesn’t magically disappear if funds are split between different LICs – An investor that split their funds evenly between the four well-established LICs would have received a lower total return than if they had simply invested in the index fund;
- Choosing a single LIC doesn’t help – If an investor chose a single LIC, they faced a 2 in 4 chance of choosing a fund that would underperform on a total returns basis, and just a one in 4 chance of choosing a LIC that went on to outperform by more than 0.1 per cent; and
- Getting it wrong has real consequences – If an investor had had the misfortune to select Argo, a LIC focused on producing highly reliable dividends, they would have received a total return that was 3 per cent lower than the unmanaged Vanguard ETF, with a lower dividend.
Updating the worked example: the problem worsens
Updating this example with Sharesight returns data to 14 January 2019 further demonstrates the potential risks. Using the past 5 years of data a depressing picture emerges in which:
- Performance universally falls short – All four LICs underperformed on a total returns basis by more than 1 per cent, a worse result than chance might suggest;
- Even the claimed dividend performance of LICs is ‘hit and miss’ – 2 out of the 4 of the LICs delivered lower dividends than the VAS, meaning an investor choosing a single LIC fund had only an even chance of keeping up with VAS dividends;
- There was still no help from diversifying between LICs – an investor splitting their fund evenly between the LICs would have received a total return that was 2.3 per cent lower than the index alternative (VAS), and also would have received lower dividends; and
- The laggard performers fell even further behind – with AFI investors receiving a total return around 3.4 per cent lower than the Vanguard VAS ETF alternative, with a lower dividend just adding to disappointment.
The recently published ETF and LIC annual performance report by ETF Watch turns up further anomalies, of commonly discussed ‘established, steady and reliable’ LICs paying lower income, and experiencing higher return volatility than equivalent benchmarks (such a VAS).
Of chance, LIC selection and cognitive dissonance
Of course, some of this could be the result of chance, but this is a knife that cuts both ways – in particular, into frequent objections along the lines that “…but LIC XYZ has outperformed the market over the past 10 years”.
Simply put, a claim that ‘XYZ LIC delivered returns of 7% where the market delivered only 6% during this period’ is not convincing evidence of management skill that an investor should pay much attention to. As noted above, academic evidence consistently demonstrates that most managers destroy value, and those vanishingly few skilled managers who will outperform (by chance or skill) are not identifiable in advance.
It is striking to see investors who willingly and rationally concede their own inability to make individual equity selections – by the very act of considering a LIC or index investment – to go on to act as though they are likely to be able to exercise some value-adding investor skill by seeking to research and make distinctions between even a relatively small range of well-established LICs investing in broadly similar assets.
Claim #2
Relying on LICs that have been around for decades adds safety
Many proponents of LIC-based investing advocate following an investment rule of only investing in older ‘tried and true’ and well-known LICs, for added safety. This rule was recently discussed, for example, in Aussie Firebug’s interview with Peter Thornhill (see 22:00-23:00 of this podcast).
Trusted brands in markets usually exist because past performance of a product or service gives confidence in the ability and incentive of the business to continue to deliver a good standard of service.
This is a reasonable approach to take to purchases of jeans, cars, and many services. It is a potential trap when it comes to actively managed investment products.
Tried and true – or a partial sample overdue for mediocrity?
This is because of two factors:
- Survivorship bias – when investors compare the performance of Listed Investment Companies with alternatives, they are comparing the performance of LICs that have survived the period of comparison, which is only a subset of those investors actually invested in. Active funds and LICs that underperform for substantial periods typically close, leaving the actual comparison being made between those firms that performed well enough to survive and the benchmark. This is not the relevant comparison. Rather, the relevant comparison is: how did the average active fund or LIC that might have been chosen by an investor perform? In many cases, the average fund or LIC is located in the metaphorical graveyard. Some US estimates of this effect are that it leads to the equivalent of an overstating of likely returns from actively managed funds of around 1.5 per cent (see Malkiel, A Random Walk Down Wall Street, p.270); and
- Performance is not persistent – While a LIC may have a strong investment selection process that performs well in one market, past performance does not tell an investor anything about likely future performance. Indeed there is some academic evidence that the performance of newer managers is systematically stronger that those will a long track record:
“Pastor, Stambaugh and Taylor came to another interesting conclusion: The rising skill level they observed was not due to increasing skill within firms. Instead, they found that “the new funds entering the industry are more skilled on average than the existing funds. Consistent with this interpretation, we find that younger funds outperform older funds in a typical month.”
Good managers never die, they just get replaced by average managers
In any LIC operating over decades, the investor is invariably assuming a ‘manager risk’ – i.e. the risk that a given manager will make mistakes that see them lose money against the benchmark.
This is not alleviated by selection of ‘tried and true’ LICs. In fact, there is good empirical evidence that manager risk is not just the risk of current managers making errors, as some studies have shown that investment company owners typically hire managers with good track records, which on average disappear right after appointment (see Goyal and Wahal “The Selection and Termination of Investment Management Firms by Plan Sponsors” (pdf) in Journal of Finance).
Claim #3
LICs are ‘more diversified’ and lower risk than the index
The claim is sometimes made that LICs are superior because they are ‘more diversified’ than equivalent equity indexes.
Often the point being made is that the Australian equity index has significant banking and resource components, and that LICs are investing in a more diversified set of ordinary industrial or other businesses that will exhibit lower risk or volatility over time.
The risks of index departure
This claim is hard to assess on its face because the role of diversification is to lower risk of loss or underperformance. If a LIC has a different make up to the index it is important to recognise that two things are potentially happening. The LIC could be:
- Making sector bets – making a series of active sector bets compared to the market index; and/or
- Assuming lower market risk (or ‘beta’) – in which case expected returns will be lower than the market and the same outcome could be achieved with lower cost through a market index added to a bond or cash position.
If active sectoral bets are being made, the managers are by default making an active assessment that the return from a subset of sectors within the broad market composition will outperform the whole.
The same record of evidence applies here as the broader, incorrect, claim that LICs demonstrate a capability to outperform the market index. Long-term evidence for sectoral outperformance is not strong, and returns data instead tends to show final returns from each sector such as financials, resources and remaining firms are strikingly similar, as the Reserve Bank of Australia recently noted (see graph below).
Risk happens from what is left out of the LIC portfolio, not just what is left in
A further problem for the claim is that LICs often have substantially narrower set of holdings than comparable benchmarks such as the ASX200 (which can be invested in for a 0.07% MER though Betashares A200).
Importantly, these LIC holdings are human selected, meaning that LICs can fail to acquire the critical dividend producing firms of the future, or fail to sell those that persistently underperform.
By contrast, a passive index approach means an investor will always hold those firms that rise to become earnings producers of the future, and have eliminated from their portfolio those firms whose poor returns performance sees them drop out of the index.
This is a critical strength of index investing, because of a characteristic of equity markets that a failure to invest in a relatively small proportion of total firms can mean missing the majority of the strong historical performance of the equity market.
That is because firm earnings are highly skewed, in statistical terms – that is, a small number of firms account for a disproportionate amount of future earnings and growth. Missing those rising stars will inevitably result in underperformance compared to a passive index.
Claim #4
The closed unit structure of LICs provides greater protection investors from panic, and enables bargain hunting
A further claim sometimes made for LIC investment is that the ‘closed end’ structure, where units are traded but not created automatically by new investors joining the fund, is a positive advantage compared to Exchange Traded Funds.
This time, I’m different, or ‘hell is other people’
Typically, so the argument goes, investors are irrational and emotional, and therefore:
- An investor will be able to purchase their LIC’s at prices systematically cheaper than ‘fair value’ (usually assumed to be the published Net Asset Value); and/or
- An investor will be protected from cost or return consequences of the ‘herd’ of investors leaving an ETF fund in response to market falls.
One should always be suspicious of arguments based on assumptions that others will behave – or are behaving – irrationally, whilst one’s own conduct will be guided by a consistently superior temperament or insight. As is commonly observed, far more people similarly consider themselves to be above average drivers than can statistically be the case, and overconfidence is a key contributor to poor investor returns.
There is little evidence to suggest that any investor can systematically buy individual stocks at below their fair market value. In fact, empirical academic evidence such as the classic study by Odean and Barber The Behavior of Individual Investors (pdf) which uses real trading account data consistently show that investors:
- Underperform standard passive investment benchmarks in stock selections;
- Sell winning investments while holding losing investments;
- Unduly weight past returns in purchase decisions;
- Engage in learned reinforcing behavioural loops, repeating actions that brought pleasure in the past (in part this could account for the popularity of the injunction to “buy the dip”).
There is no clear reason typically suggested why this situation would be transformed by the introduction of a LIC structure between the underlying stocks and the investor.
In fact, making a single individual stock purchase decision is arguably a much less complicated analytical decision than buying a bundle of 50-100 equities in one LIC versus another. In such a comparison of bundled products the information disadvantages and complexities faced by the LIC purchaser is multiplied exponentially.
NAV-igation errors?
In a way, the myth of the ‘bargain’ LIC bought ‘on sale’ is understandable. The presence of a published Net Asset Value (NAV) seems to suggest an alluring prospect of the ‘true value’ being on display, opening the gates to the possibility of buying a set of assets below their actual value. Yet, this view ignores a few cautionary facts.
LICs are capable of being valued, and differences between their underlying asset values and prices are subject to arbitrage opportunities by well-informed market participants with greater access to information, trading execution speeds and expertise than any average retail investor.
It is unclear on what basis an individual investor could reasonably be expected to consistently be on the winning side of this grossly uneven contest.
Shallow reefs to port, or a storm to starboard?
Indeed, the situation is worse just than being up against well-informed market players in trying to ‘bargain hunt’ a LIC at below its NAV. It turns out that a buyer faces a difficult choice with ambiguous and incomplete information regardless of whether the LIC is trading at a premium or not.
If the investor purchases at a premium to NAV, they are, all else equal, paying above market prices for a stream of future dividends, compared to buying the same shares and dividend entitlements directly on the open market. This is the equivalent of buying a loaf of bread for $2.20, when the same loaf can be purchased for $2.10 from a shop next door.
The typical answer to this is that one is paying a ‘premium’ for the supposed skill of the LIC manager, that is, one is locking in paying an upfront price now in the hope or speculation that any past superior performance was skill-based, and repeatable. As has already been seen under Claim #1 however, evidence for either of these propositions is scant.
A simple rule that suggests itself might therefore be to avoid ever purchasing a LIC at a premium to NAV, and some have adopted this rule. This apparently neat solution runs into a few difficulties though. For example:
- Out of the market – Some LICs trade for quite extended periods above their NAV, meaning the investor will be effectively locked out of some LICs, and be forced to choose a non-preferred alternative;
- Aged NAVs – Given NAVs are not always updated regularly, investors may be making purchase decisions on out of date and non-transparent valuations, and end up paying a premium anyway (note to try to mitigate this recognised problem, Pat the Shuffler recently developed a NTA estimator);
- Discount for a reason – The trading of a LIC at a discount to its NAV could well not be a random opportunity to buy goods at less than fair value, it could instead reflect real price relevant information that trading market participants setting prices have that the ordinary retail investor does not have.
The logic of the argument that LICs provide a special protection against market panic is not readily apparent.
LICs shares themselves are subject to the same herd panic risks as their underlying share holdings, with the added risk that the market for individual LICs may be less liquid than the markets for their underlying holdings or ETF alternatives commonly also used by institutional investors (for a discussion of some of the misconceptions of ETF liquidity, see here). Moreover, the same arbitrage opportunities that keep LICs broadly in line with valuations of their holdings could be expected to expose LICs the same pricing pressures as the equities that make up their holdings.
Claim #5
LICs are just a substitute for low cost index ETFs – which way to go is just a question of taste
Perhaps in recognition of some of the weaknesses in the claims made, a further position sometimes put is that LICs and ETFs are effectively close substitutes, with the choice between them coming down largely to a matter of personal taste.
This is difficult claim to support, when considering that:
- LICs typically have holdings that differ significantly from the capitalisation weighted market index, meaning that a different return and risk package is being purchased;
- If the LIC does happen to be broadly invested in weights that closely reflect an equity index such as the ASX200, then they are effectively charging a mark-up for providing index-like results – a phenomenon so common it has been dubbed ‘closet indexing’
- LICs cannot reliably be selected in advance in a way that will match index return;
- The majority of LICs can be expected to underperform their closest relevant index benchmark, due to a proven inability of investment managers to reliably outperform passive index benchmarks after costs;
- LICs can often have higher management costs than their equivalent benchmark, lowering returns even before an expected underperformance penalty – and if the LIC costs are lower than an unmanaged equivalent, a skeptical investor is at least entitled to wonder about the likely extent of actual value-adding research resources available to management; and
- An investor not willing to pay a premium penalty over the current market value of the dividend flows (intrinsic value) may not be able to purchase their desired LIC at any given time.
These are substantial, and compounding, factors and differences that will have real world effects on a portfolio. They will affect returns, risks, out of pocket costs, the time taken to reach financial independence, and potentially willingness to stay on the journey.
Impacts of differences
As a practical example on costs – even small differences compound over time. This means that over a 25 year holding period a LIC investor paying 0.15% (around the level of many established LICs frequently suggested for consideration) could be paying as much as $27 500 extra on an $250 000 portfolio when compared to a purchase of the low cost Betashares A200 index exchange traded fund.
Note that this example assumes no particular ongoing performance disadvantage, or bad purchase timing with NAV premiums. Paying $27 500 to potentially assume the accumulated manager risks accruing over 25 years, and to obtain index-like or worse results does not sound like a close or effective substitute.
There is a role for personal tastes in investment and everyday purchase decisions between close substitutes. One day, you might prefer lemonade over cola. On another day, you might make the reverse choice.
But the differences between LICs and indexes are more fundamental than such a trivial everyday choice. If either are to form the cornerstone of a journey to financial independence potentially involving the investment of hundreds of thousands of dollars over a decade or more, the differences and risks should be consciously and carefully considered and accepted.
Claim #6
LICs may earn lower returns from their focus on dividend stocks, but still fits with my investment needs
This is not so much a claim, as a position reached by some who either don’t make, or have abandoned, Claim #5 that there is no significant difference between capturing whole of market returns, and the smaller actively chosen portfolios within LICs.
For those taking a conscious choice to accept a combination of lower overall returns, and potentially higher portfolio volatility, from the selection of a LIC, there is no reasonable objection that can made.
This decision should flow, however, from a close and full appreciation of one’s own risk tolerance, and the actual risks of underperformance to an investor’s financial independence goal.
The cost of locking in a persistent below market return should not be underestimated. Compounding will significantly widen the gap between outcomes of an investor earning even 0.5% less over a significant period, and have the potential to result in either higher savings requirements to reach the same outcome, or lower protection against the key risk facing investors of not earning sufficient real returns after inflation.
Claim #7
LICs have special value because they provide a more stable flow of dividends
Another claim made is that LICs provide a smooth and stable flow of dividends, compared to alternative index ETFs. This is due to a policy of many popular listed investment companies choosing to retain some of the dividends they receive for the benefit of their investors, in order to pay out these dividends during future periods of dividend cuts.
Paying another for self-control
The important thing to consider about this service is its value to an investor, versus its price.
In some sense, this dividend retaining approach by LICs is a benevolent act of the same kind as a parent withholding some of a child’s weekly pocket money in case it is spent unwisely. Importantly, however, over any period of investment it is likely to be slightly net present value negative, given than a benefit is being withheld through time, for future payouts. Arguably, if the LIC reinvests this cash, the opportunity cost to the investor is reduced somewhat. What is still lost, however, is the opportunity cost of being able to use the full dividend amount in the way the investor best sees fit at any given time.
There are perhaps some psychological benefits from this ‘dividend smoothing’ service. The same essential function, however, could be replicated by the investor, whilst retaining quarter to quarter to flexibility, if desired, with one option being through simple employment of ones bank account. Again, choosing to accept this externally imposed control may have value to an individual.
Some hidden risks and costs of outsourcing control
But if there are benefits, there are also hidden costs and risks.
In any rapid and sustained change in earnings and dividends payments, LIC distributions will potentially send a false signal of comfort, and not alert an investor that lifestyle or spending adjustments may be justified.
The unhappy fact for investors is that usually a LIC is either withholding part of your owed distributions, or it is paying to you a stream of income that is not sustained by the underlying earnings of its portfolios. Neither outcome appears an unmitigated positive.
Claim #8
But fully franked dividends…there are clear tax advantages inherent in the LIC structure
A final claim sometimes made is that the company structure of LICs confers some special benefit on investors relating to the receiving of franking credits.
In fact, once fully traced through the situation is as you would expect in any rational tax system – the vehicle does not magically alter the total effective liability. Aussie Firebug has ably debunked this claim already.
Summing up – taking their LICs
Many of the claims of benefits of LICs compared to passive equity indexes do not appear to be supported by relevant academic or empirical evidence.
The decision to select a LIC rather than a passive equity index ETF carries with it a range of risks that have been well-documented over past studies, such as taking more risk than necessary, to achieve below average results.
Yet there are a series of other, less visible, risks and costs that also lie in wait for even those investors that seek to mitigate against the weaknesses inherent in relying on actively managed LICs.
Careful thought is warranted about the risks, costs and tradeoffs being assumed in investing in a LIC, particularly if it forms part of a plan to achieve financial independence.
To learn more about my own choices and investment path start here, review my goals and investment plans or browse all posts here.
Further reading
Barber, B and Odean, T. “The Behavior of Individual Investors” in Handbook of Economics and Finance, Vol 2, Part B, 2013
Comer, George and Rodriguez, Javier Stock Selection Skill, Manager Flexibility, and Performance: Evidence from Unit Investment Trusts May 19, 2015
Ellis, C. Winning the Losers Game: Timeless Strategies for Successful Investment, McGraw-Hill, 1993
Fama, E. and K. French, 2010, “Luck versus Skill in the Cross Section of Mutual Fund Alpha Estimates,” in Journal of Finance, 65, 1915-1947
Goyal, A and Wahal, S. The Selection and Termination of Investment Management Firms by Plan Sponsors in Journal of Finance, August 2008
Kohler, M. ‘The Long View on Australian Equities’ Presentation to 31st Australasian Finance and Banking Conference, Sydney – 13 December 2018
Malkiel, B. A Random Walk Down Wall St, W W Norton, 2003
Robson, G. The Investment Performance of Unit Trusts and Mutual Funds in Australia for the Period 1969 to 1978 in AFAANZ Journal of Accounting and Finance, November 1986
Thanks for the thoughtful article mate. One reason you left out was the possible tax advantage during accumulation phase for investors in the highest tax bracket of using a lic with a bsp such as whf. This benefit of capping the effective tax rate at 30% combined with a never sell plan and the fact one can’t invest in an industrials focused index (ethically people may not be a fan of minning) may be enough to include a lic like this in there portfolio despite the underperformance risks.
Thank you for the feedback Jace! I agree. I did think about opening the tax can of worms, but my thought was: the article is already long, and I don’t understand all the intricacies and risks of how these might play out for an individual in th future, compared to the good evidence we have on the overall performance gap issue. The other issue in play would be the benefit of the capital gain discount on capital growth, likely to help an ETF index approach.
Completely accept the point that individuals might knowingly choose LICs for other reasons. Just wanted to set the counter view for consideration! 🙂
Thanks for the great article. I had wondered myself about how LICs seem so popular despite the lack of consistent empirical data.
Thanks J. D.! I am glad you liked it. The Aussiefirebug podcast I link to has Peter Thornhill claiming that LICs were systematically ignored by the advisory/broking sector, but my perception was the same as yours. I remember the first ever Making Money Made Simple book from Noel Whittaker I read in the 1980s had a section giving them as a good option. My limited data skills were applied to other more important tasks then though, like tracking pocket money! 🙂
This is total quality.
Australian content has really stepped up it’s game in the last few months.
I will be keenly following all your future content from now on.
Well done and thank you
Thanks so much for those kind and motivating words David, I’m very glad you liked it, and to have gained a reader! I agree, some of the HiFIRE and Ordinary Dollar blog pieces have been outstanding.
Thanks for the great explanation! Really appreciate the time it must have taken to put this together.
Thank you indeed Victoria! I’m so pleased you find it useful. It was a bit of a long-term exercise to slowly pull all the links and evidence together. I really appreciate you stopping by to comment! 🙂
Great article and good timing for me. I’m currently invested in VAS and am still considering the possible positives of choosing 2 – 3 LICs to supplement it. I have to admit I’m a firm believer in the inability of anyone to outperform the Index but the love LICs get around the place has gotten me interested. Something has always had me hesitating though and I think your article does a great job of summing up everything that’s been rolling around in my head.
Thank you, I’m so glad – you were the exact target audience I had in mind then! 🙂 It’s great being able to put some personally relevant material in front of you. Another reader directed me to this repot as well, which has some good Australian small mid cap performance vs the index numbers (p.2). In summary, 70% underperformed over 3-5 year periods. https://us.spindices.com/documents/spiva/spiva-australia-mid-year-2018.pdf
My first introduction to investing in shares was through a forum where LIC’s are discussed endlessly as the bees knees, but the arguments for using LICs have holes so big that an elephant could walk through.
I believe that most people that follow it, do so because lots of other people follow it, therefore it must be good, and they are not adept at finding logical holes in arguments, which is why religion continues to have massive numbers of followers.
Changing the momentum of a huge group of people who believe something despite logical flaws is a monumental task, and rather than try to continue to explain some of the holes, I just decided to save myself and leave to bogleheads where their reasoning is firmly based in logical reasoning. The most fundamental of which is – accept that you don’t know more than the market and that you are unable to choose someone who does and instead buy the haystack, and build your strategy around that as a premise. The evidence is now there consistently supporting this.
This doesn’t even get into the other problems by Thornhill which have enormous holes.
1. As per your graph, he has a graph starting at the time where the cyclical mining period was at a peak onwards as “proof” mining has lower returns going forward. It is as blatant a lie as an active management company showing the returns of their funds from date Y to date Y as “proof” that they can out perform.
2. Complete lack of international diversification. He uses the argument that Australian companies sell a lot to overseas customers, completely ignoring that this offers some currency diversification but does not diversify your holdings. It’s like saying it is ok to buy only apple and not Samsung because they both sell phones to customers around the world, as though they will either both go out of business or they will both do well so there is no help with diversifying.
3. Saying Indexing is crap because you can’t pick tomorrows winners..
4. Saying diversification is bad, by using a catch-phrase “di-worse-ification”…
At this point I just gave up on responding to people that follow him.
Anyway, great article. Good luck fielding the masses of people who have been indoctrinated into the logical fallacies of Peter Thornhill. I just gave up, but it is people like you who point out these fallacies that help people question why they are blindly following. The great Jack Bogle spent his life doing this and in the end has helped hundreds of millions of people. In the face of mass resistance it is an uphill battle, but one man can make a difference, and even one piece such as this is a great step forward.
Thank you, I’m really glad it appealed to you, though your last para has me wondering what I have put myself up for! 🙂 On 2, I completely agree, when I heard Peter Thornhill say this on the podcast I link to I had to shake my head. It doesn’t make sense. Australian companies offshore sales are simply not significant or diversified across enough sectors to represent any useful level of global diversification. They would be either neutral or reinforce domestic holding risks in many large cases.
Really appreciate the comment! 🙂
waiting to see a response from firebug and sma
In a timing twist, SMA actually wrote a long piece today on different options for trying to deal with the issue of paying over the NAV. There was no coordination! 🙂
I enjoyed reading your post and appreciate it would have taken a while to put together. The end result is very worthwhile as gives a lot of food for thought for investors that have quickly embraced one method or the other.
One thing that comes to mind with this debate is that investing is a long journey and for most this involves at least subtle changes to your style over time. This occurs as you tend to read more and more about various strategies. For that reason the plan for many to confidently say they will invest in a particular LIC and never sell (for tax efficiency) may make sense in theory, but I wonder in practice how many end up sticking with it. Even if you are still happy with the investment logic, life will often throw up events that you never imagined. Some may require liquidating some investments. So I wonder if some around 30 years of age now for example, may be over estimating the likelihood that they will stay in the same LIC say in the year 2050. Who knows what the government will be doing tax wise by then also.
Hi Steve
I could not agree more! The same sort of issues were bouncing around my head as well. For example, In 2000, I was paying MERs of 2.0% on a series of low balance actively managed funds, and little wonder, was getting nowhere, until I adjusted my approach to a passive low cost focused approach.
I see so many debates along the lines of ‘should I have 5 or 10% in AFI or Milton’, and to me as well, I just wonder at the materiality of all that finely crafted portfolio design, compared to inherent uncertainties in life and potential cash needs for under 30s.
True also on tax, leveraging plans to future treatments of various LIC share reinvestment plans seems to involve some regulatory risk as well. Typically, there is grandfathering of old arrangements, but not always in a way that preserves value. Thanks for raising those issues, well said.
Hi FI Explorer,
Really great post about LICs summarising the points that have been bugging me for a long time!
The 2 genuine benefits I can see from LICs are:
1) Ability to use DSSPs to defer tax liabilities to accumulation phase (but this was already mentioned in a previous comment, which you had responded to
2) Not “having” to take capital gains due to not being a unit structure (as opposed to ETFs). I have recently read that in some circumstances ETFs will pay out capital gains (mentioned in the AFB interview with Sharesight) due to people cashing out of the ETF . It is also something that Peter Thornhill mentions in the AFB interview (although I believe he was referring to mutual funds in general). It would be very interesting to read some analysis on how big an impact this can have, as I’m not sure how concerned I should be. My initial logic would be that this is mainly an issue if you have lots of redemptions in a rising market (since this is when capital gains materialise), but it would be awesome to hear someone who actually understands this topic properly and do a though experiment of what would happen to the tax liability of the remaining ETF owners in VAS e.g. if the market falls 50% and spooked investors withdraw 50% of their holdings
All the best on your journey!
Thank you very much for the thoughtful points Szilveszter.
Yes, I agree, I can see 1), noting the regulatory/legislative risk as well as any costs of abandoning it mid way through, as discussed in the comment above.
And 2 is potentially a good point, like you, I just don’t have the records that would allow me to say much about it systematically at an ETF level. Many of the sadly late Jack Bogle books discuss the tax efficiency of passive ETFs, but it is mainly in the context of comparing to actively managed funds, which LICs are to various degrees.
Have a look at my passive income updates to get a sense of how much capital gains can lead to variations in Vanguard retail distributions. I’ll see if I have enough to write further on it, but it has meant big swings and movements. Thank you again, you too!
Hey FIExplorer
A great piece that has really got me thinking about how I invest my money. For the record I have a hybrid ETF and LIC approach.
I can have a tendency to agonise over investing decisions just like this, which is why I often opt to try to keep things as simple as possible.
Like Silvester above I would really like to see the effect of redemptions on remaining ETF holdings value, thou I suspect that this data may prove too elusive.
Also something I ponder about is the argument that ETFs may get too large one day (I may have 50 more years of life for this to occur after all) creating market inefficiencies and a highly irrational market that automatically bids up rubbish stocks. Though this isn’t actually an argument that LICs would be able to take advantage of that situation, it is possible they will balls it up even worse. I was wondering if you have any thoughts on this? Or if it worries you also?
Thanks Pat, that’s really generous and I value hearing your thoughts on this piece.
I’ve seen that concern. My initial thought is that this is a self-correcting problem, even if it occurs. My view is if it ever got close to a position where indexing was driving irrational outcomes, natural counter arbitrage opportunities would emerge and drive values back to efficient levels.
That is, active trading would become attractive, to exploit any simple predictable index/algorithmic trades. There is a small documented ‘index’ effect in the US, but this has not been significant enough to impact the first-order effect of removing the risks and costs of active management.
The other question would be the realistic duration of the inefficiency or anomaly, given again there would be clear market forces driving ETFs back to the fundamentals of their holdings.
I think some of the more low probability event issues would worry me more if I was entirely exposed in ETFs that did not have the backing and track record of Vanguard, which has been operating ETFs going all the way back to terrible bear markets in the US in the mid-1970s.
And if the world goes completely off-centre I still have Bitcoin, right? *crosses fingers the internet still works* 🙂
Pat on the issue of ETFs getting too large and setting the price for stocks it has to be kept in mind that active managers are (as the name suggest) much more active in their turnover than index managers. It’s hard to come up with an average figure for active turnover but investopedia is quoting 85%, whereas most index managers will have turnover ratios well below 10%. Currently index funds are much smaller than active funds anyway, but even if they were twice the size of active managers or four times they would still be much less involved in setting prices. Particularly given that a large portion of their turnover actually only occurs when the index rebalances at the end of each quarter.
As you say though it could eventually happen in which case as FI Explorer says you would expect active management to make a comeback.
A fascinating article and clearly you’ve put in a tremendous amount of work which has shown up in the quality here. This article is definitely getting bookmarked for future reading as there is a lot to take in and I want to make sure I’m getting all of it. Thanks very much!
Personally I tend to believe in a weak form efficient market hypothesis working enough of the time that index funds make more sense for me than LICs, although I do think there are times EMH doesn’t work. Funnily enough I once went a lecture by Eugene Fama and even he admitted it didn’t work all the time for all assets, but for me it works well enough that it makes sense to invest in index funds. About 97% of my invested money is in index ETFS so my money is currently mostly where my mouth is!
I agree that LICs can have a place in a portfolio, and much of the pushback from others seems to centre around point 7 in my experience with smoother dividends being worth it. As you’ve articulated and I’ve done the same in the past, this means that either part of the earnings of the underlying investments is being withheld or the dividend is unsustainable. If it’s the former then I would rather decide what happens to my money than a fund manager, and if it’s the latter then I’d rather know about it than being lulled into a false sense of security.
Great work, thanks again!
Thanks AussieHIFIRE for reading and commenting – it’s good to deliver some value back to you for all your excellent SWR and sequence posts!
I agree, I sometimes see people attacking EMH (or economics in general) when what they actually disagree with is just the extreme ‘strong’ form of EMH. Like you, I think the weak form is most realistic, implying that after costs it will just be very hard to reliably beat the index. If you haven’t already seen, there are some really great long-form interviews with Fama on Youtube on these types of issues.
I can truly see the intuitive psychological appeal of a slow and steady delivery/build up of dividends, but as we agree, it’s not quite as simple as that all the time. For some, though, that might be what keeps them motivated and on course, and if so, best of luck to them. Agree, I’d rather self manage something as important as this.
A very good article.
One of the main issues with active investing is fees, most of the recent press around retail versus industry super is the exorbitant fees charged meant no progress for investors. Some LICs however have comparable fees to the cheapest ETFs, a small price to pay for a diversified portfolio.
Many of these same LICs are investors for tax purposes maintained with a low turnover that provides tax advantages.
These LICs also pay a better dividend than the index ETFs that is fully franked and smoothed for consistency and reliability. For an investor living off dividends it is a good trade off by having diversification with yield, as one may prefer not to risk selling down my assets at low prices to pay income.
Labor’s franking credit policy is a good lesson in making assumptions about change. It will impact LIC investors but the LIT structure will be an available alternative.
Your article makes completely valid points but an investment in LIC(s) will be much more diversified than a portfolio improving a few different companies, better than trading for 90% of the population, and has advantages in yield and tax for long term investors.
LICs have their place in certain portfolios. With ETF fees getting lower (a200), changes to tax on franking credits and recent performance it may make LICs less attractive, but a buy and never sell strategy for some of the old school ASX LICs will exceed the median performance of ASX investors.
Thank you Elephant!
You make a very good point, but just to emphasise, my basis for comparison is passive equity ETF and LICs.
Compared to stock trading, an undiversified stock holding of 2-3 companies, or a standard actively managed fund, of course low turnover LICs are preferable.
As discussed in the caveats, to be clear, the issue is not ‘are LICs better than a median ASX personal investors record, day trading, or a very actively managed high turnover fund?’. Those are both low bars to pass, given the record.
The issue is, for someone seeking FI over the long term, a goal which is will be highly influenced by getting the highest expected total return over a long period, what will be the most empirically reliable path to go. That will not be LICs.
For investors wanting to live off dividends, they will have other drivers, and the article is not targeted at that. I think this might be where some of the confusion arises, views from those living on dividends that it works for them, and they value LIC characteristics is not the same thing as good evidence of the most reliable and efficient path to reach FI based on evidence.
From the example, you can see that whether LICs actually pay a higher dividend differs on a case by case basis. The dividend smoothing and reliability is a timing issue as discussed in the article, there is nothing in a given LIC that is going to make its dividends inherently more reliable than a broader index that captures new emerging dividend producing businesses more systematically.
ETFs also have low turnover, (circa 3%) so this is not a benefit compared to LICs.
Am I correct in assuming that when you say ETF, you’d have no problems with buying through a wholesale fund instead of an ETF if the fees were the same? I.e. Vanguards International Shares Index fund is 0.18% for both the ETF and their wholesale fund.
Yes, correct, in that case for me, there would not be that much to choose between them. Unfortunately buying into the wholesale fund to get those cheaper fees has a high minimum ($500 k?).
Vanguard do let you into the wholesale fund with 100k if you contact them and ask.
Thanks – yes, I had heard this. Note I understand this is for entry with a new $100k, or for someone who sells their retail funds of at least 100k one day and buys into the wholesale fund the next, though.
I followed this route up a few months ago. So if someone has $100k to invest in a lump sum (gulp), this would be a good option to consider. For myself, however, it would mean selling the retail funds, realising capital gains, and that would probably outweigh the MER savings at this point, especially when I can access similarly low fees on new investments in ETFs.
Out of curiosity, how much money did you have invested through the GFC and where was it invested?
Hi Cam, thanks for reading, this is one I get asked commonly, so I do have an answer on the FAQ page on it, from which some of this is drawn. The rest is taken from some rough reconstructed records of investment contributions.
It was relatively early in my FI journey, about seven years or so. In total, the portfolio went from $152 000 in July 2007, to $228 000 in July 2009, and probably the worst of it was reflected in the portfolio only increasing $10 000 from January 2008 to January 2009. I was saving and investing fairly intensively though the period. At that time I was mainly investing into the Vanguard high growth retail fund, contributing about $70 000 over that 2008-2009 calendar year period, and some smaller additional contributions to the balanced and diversified bonds funds too.
Without new contributions the portfolio would have gone backwards, but I did continue to invest.
The portfolio was around 60% equities during that period. On reflection, I’m glad that it happened while I still had a relatively low portfolio level compared to today.
Hope this helps!
I admire the effort that has gone into this article, well done. It’s somewhat perplexing that there seems to be a LIC vs ETF attitude. Both vehicles have advantages and disadvantages. Despite LICs disadvantages as outlined in this article, they will continue to make up the majority of my portfolio.
In my humble opinion, LICs are considerably more cost effective than the Vanguard Lifestrategy funds, Raiz, BrickX, Spaceship Voyager. They are certainly more conservative and lower risk than Bitcoin, Ratesetter, a Gold ETF or individual stock holdings in the telco/insurance sectors.
This message isn’t to defend either LICs or ETFs (I own both). However, what is important is that we are all investing for our future. Hopefully in a low cost product that has considered each individuals SANF.
Keep up the great work on this blog. I have followed it with interest for some time.
Thanks for the comments and constructive thoughts.
If people come to a view that they still want to invest in LICs, as I note in the caveats paragraph, that’s fine. I have no issues with decisions taken with eyes open. For example, it may suit some in the draw-down, phase.
I think you might have misunderstood the basis of the article if you think I am saying that my own (very eclectic!) portfolio is superior in cost effectiveness terms to LICs. I made no such claim. The comparison as noted in the introduction, is to low cost passive equity ETFs.
In that arena, the lowest cost Australian ETF is below any LIC cost, and VAS is at or below many popular LICs. I believe a focus on ‘cost effectiveness’ as you term it in any case may be missing a critical piece of the evidence, i.e. the record of comparative returns.
The article gives data and evidence around repeatedly established poor performance of 200-300 basis points (i.e. 2-3 per cent per year). Paying about the same cost (say 15 basis point) for a LIC which on average in expectation could be expected to underperform by 200-300 basis points is not cost effective in any dimension for someone seeking to build towards FI.
It is buying into, year on year, a performance penalty that grind down the performance of the portfolio, will harm compounding and extend the journey.
Just to make the example even clearer, if if I take the argument as put about LICs being more cost effective than some of the alternatives in my portfolio you mention, one of the highest is what some of the small Vanguard funds cost, 0.90% or 90 basis points (the fees are tiered). Say a LIC average might be 0.15%, or 15 basis points. So the ‘cost effectiveness benefit’ of the LIC is 0.75% or 75 basis points.
You will notice that the size of this ‘savings’ goes absolutely nowhere near making up for the large expected performance penalty of 2-3%, or 200 to 300 basis points. This is what I mean about framing cost-effectiveness narrowly.
In any case, my example does not really apply to my current portfolio choice of investing in A200, with a 0.07% fee, or 7 basis points.
These types of findings aren’t really matters of opinion, or not. They’re a question of replicated academic findings from multiple studies of actual investment funds, versus the benchmark. If anyone has a reputable academic study or two from a Nobel prize winning finance professor showing LICs can on average outperform a benchmark over a 20-30 year period, then it would be a question of opinion.
What I am seeking to point out is that where a primary goal is building wealth to achieve FI, empirical evidence from finance tells us that maximising total return, and minimising known and avoidable underperformance risk from LICs, will be critical to the time taken, the risks taken, how much is needed to be saved, and ultimately probability of success.
Thoughtful piece. Just a question on the numbers.
Over 20 years (to 31 Dec 2018), I get ARG with CAGR 8.13% (dividends reinvested, assuming zero discount on the DRP) versus All Ords Accumulation (AOA) Index with CAGR 8.11%.
Over 25 years, I get WHF with CAGR 8.40% (same assumptions on reinvested dividends) versus AOA 8.26%.
Except over the recent 10 years, and especially the last 1-5 years, I am not seeing AFI, ARG or WHF underperform AOA by more than a few tens of basis points (over or under), and as the time frame gets longer, they appear to converge closer.
None of which counters your skepticism about the inability of stock pickers to beat the market; no argument there. But the 200-300 basis point difference in CAGR you allude to (and based on the US research) I am just not seeing, certainly over longer horizons. It is easier to distinguish the US research because of the breadth and depth of that market: unit fund managers, unless they are going to basically track the index (and many do) are more likely to be concentrated in a few stocks (like say BKI, in the Aus context), and in such instances, it’s well established that most will underperform a market-tracking ETF.
But the broad market ”old” Aussie LICs over the longer term seem to track the market reasonably well. Couple that with the fact that LICs earnings are a lot cleaner to report at tax time than are ETF earnings, and the LIC’s ability to smooth dividends (which undeniably has value to many investors) and you can see why some investors – especially long term buy-and-hold retail investors – might choose one of those LICs over a broadbased market ETF.
(I used price histories from Yahoo finance, AOA data from MarketIndex, Dividend histories from IRESS)
Thanks Peter for the comment and thoughts.
The numbers I used were from Sharesight’s data. I used this in order to use exactly the same data source that AussieFirebug had in his original example that I link to in the article, and to extend using the exact comparable data.
As I discuss in the second paragraph under Claim #1, an observation that this or that fund, chosen after the event, came close to or marginally exceeded the passive benchmark does not tell us anything about whether this arose through chance or skill. With scores of LICs operating over the period (around 60), probabilities are almost certain that some will keep up with, or outperform the index. The issue is that which these are are not identifiable in advance. Identifying this or that LIC that met or marginally exceeded the benchmark over a time period is not relevant to the question: should an investor now, hoping to maximise expected returns and portfolio target success, pick an index equity ETF, or one or a combination of LICs?
Addressing this question by noting that one or several LICs have a record of keeping up with, or marginally beating the index, is akin to seeking to prove that betting on the Melbourne Cup is rational and consistently profitable, by reciting the names of past race winners, and counting up potential winnings. The problem for punters is that they are betting their own money, before the race, on a field of 20 or so horses, and they don’t know the outcome.
This is relevant to your point that ‘old funds’ seem to track the market well. As discussed in the article, this is a logical consequence of survivorship bias, which overstates the returns available to investors from active management by about 1.5%, by some empirical estimates. This is the focus of the discussion in Claim #2.
The underperformance of 200-300 basis points is based on US studies, but the article also links to an Australian empirical survey of the underperformance of Unit Trusts, which you do not mention. It concludes “the results were similar to overseas research with the funds unable to earn positive abnormal returns”. In addition, the S&P Globals 2018 research report on active management finds:
– Australian mid and small cap funds disappeared at the highest rate of any funds, reinforcing the risk of an investor making an investment ending up in a fund that underperforms and is eliminated quietly
– On a risk adjusted return basis, over the longest period measured, 15 years, an investor in a small-mid cap had a 52% chance of being outperformed by the index
– For a general equity fund, this risk rose to 80%
– Over shorter period, which could be argued to better reflect the competitive opportunities to outperform in the future given greater efficiency in the Australia market over time, investors in LICs faced a 70% chance of getting lower than benchmark returns (3 & 5 years)
(https://us.spindices.com/documents/spiva/spiva-australia-mid-year-2018.pdf)
A little unclear on the tax ‘cleanliness’ point – most ETFs provide a simple one page tax summary indicating exactly where to type in values, and they may well pre-fill. Compared to the cumulative compouding expected underperformance penalty over decades, this, and dividend smoothing, seems non-material in the case of someone targeting FI, which is the stated focus of the article.
I assume that most people invest in LIC for income. But I guess, dividends could also work against an investor especially those who are high income earners and has to pay higher tax on dividends for the entire duration of their journey towards FIRE. So if one high income earner has 10-15 years before retiring, that means that 4-5% or more dividends will be tax higher for all those 10-15 years of accumulation, compared to receiving as little dividend income as possible in the accumulation stage. In this scenario, is it more beneficial that a given investor to invest for growth instead? I assume investing for growth requires some level of international diversification e.g. investing in IVV or VGS for example.
I hope to hear from you about your thoughts on investing for growth versus investing for income possibly during the beginning of the accumulation stage and mid to a third of the way before reaching retirement if there such a phase.
LICs are good if you need a stable income stream such as in retirement. Fully franked dividends are icing on the cake.
Note that AFI and WHF are LICs with DSSP that give you bonus shares instead of dividends, but you lose the franking. This means you could accumulate under DSSP and then switch back to receiving dividends when you need income.
I’ve been looking at AFI, but it’s always trading at a premium. WHF is not good either because of the higher expense ratio.
Thanks for reading and stopping by. The above is a good practical example of the complications and compromises that seem to arise in LIC investment. Note also, their holdings will differ, so buying one LIC as an alternative to another selling at a premium is not a clean process of substitution.
Thanks Elephant. Agreed, however not the focus of the article was on best reaching FI, not living at FI/RE. To be honest, relying on the DSSP schemes, tax rulings, etc over a decade or two is outside of my ‘legislative’ risk tolerance.
Thanks for your thoughts and comments.
Yes, you’re right, and I toyed with including this in the article, but decided ultimately that I didn’t want the conclusions of the piece to rest on complicated tax examples. You’re getting at the central point of the article though, that for people relatively early on the FI journey, or mid way through, maximising the total after tax return will be crucial. This means eliminating underperformance risk, maximising returns for your risk appetite, and also, I’d argue, taking advantage of capital gains discounts arising from index ETFs higher growth potential than a dividend focused LICs. Compounding good total returns over time will be the best assistance toward a FI number. Someone at FI saying LICs suit me because I don’t mind not maximising returns, and I’m not in a high tax bracket doesn’t really address the point about how best to reach FI.
A thoughtful and well written article. I’d just like to add a few contrarian points of view.
The reduced volatility in share price and more consistent dividend payments of LICs are important for some investors, in particular retirees who rely on dividend income. It is worthwhile remembering that the not all investors are focused on long term growth. Capital preservation and dividend income are also important to many.
There are arbitrage opportunities in LICs trading at a discount to NTA. These are not easy to take advantage of and require an active, well informed investor. An example of this is to reduce holdings in LICs trading at a premium and switching to those trading at a discount. This can’t just be applied to any LIC, but it is a reasonable strategy for switching between large LICs like ARG, AFI, BKI, etc. that have similar holdings closely linked to the ASX 200.
FTR, my portfolio currently includes both LICs and ETFs. I am now planning to reduce the holdings of LICs over time while increasing my investment in ETFs. The reasons for this are quite similar to the points in your article.
Thanks David, I appreciate you stopping by and commenting!
You raise good points, and I don’t think we potentially disagree on any point but one.
The article as mentioned in the introduction and summary is really focused on those seeking FI, not those at FI who may well value the LICs higher income payment. My point in the example is that investors should be conscious they are giving up some long term total return performance for this, and in many cases, not even getting higher income. As discussed under Claim #6, if this is a choice made with eyes wide open, there’s no reasonable objection. My point under #7 is that if the dividend smoothing service is really valued, bear in mind that it can also be replicated oneself, whilst avoiding the underperformance risk inherent in LICs. Again, if that risk is accepted for those at FI, no issue.
There may well appear to be ‘arbitrage’ opportunities for the active well informed investor. Just be aware that repeated empirical studies shows that retail investors fail to capture even the passive market return by large margins because they active trade, buy and sell at the wrong time, and are overconfident.
My question about these proposed trades would be: who do you consider is likely to be on the other side of these trades, and what evidence do you have that they are less informed than you about the true underlying value? How confident are you of getting both the buy and sell decision right?
If the portfolios are genuinely interchangeable and ‘closely linked’ to the ASX200, the variances from VAS performance in the example seem to represent evidence of managerial incompetence. Rather, I suspect the holdings do differ materially, and thus any trading between them is not actually a true arbitrage at all, it is a purchase of one bundle of shares for another with different performance characteristics (positive and negative). That is, it is just active trading of active funds, in large bundles, potentially a very high cost pastime.
My larger question would be, unless one actively enjoys taking underperformance risks and spending time working out NAV premiums and discounts every purchase time, why wouldn’t you just save time and lower risk by investing via an ETF in the accumulation phase?
Well thought out article and a great contribution to the community, thank you.
I invest in both, and continually look at my approach – your article definitely helps to keep perspective and not get to seduced to either one side permanently. You should never be too proud / stubborn to adjust as time goes by.
I like you writing style of present different sides of a point, will be subscribing and looking forward to future articles.
Thank you very much John!
Glad to be of help and to give you something to think about and consider.
I know what you mean, keeping an open mind to how you can improve your approach is critical, as no-one starts out with the perfect approach for them. Thanks for stopping by and commenting.
Can you please send Peter Thornhill a link to this article? No seriously, I’d like to get his opinion on this!
Fantastic work, definitely gained a new reader!
Thank you for the feedback, I’m really pleased to have gained a reader.
I’m not sure I’d know how to contact him, to be honest. In a way, as well, his opinion doesn’t matter very much. He’s an individual, with a view. My point is that many of the propositions that are implicit in relying heavily on LICs to reach FI just don’t stack up when consistent, repeated, empirical studies are considered.
Excellent article and one I have been endlessly searching for!
I also read Aussie Firebug & Strong Money Australia blogs and I paid attention when AFB updated his strategy to include LICs. I too used sharesight to study the returns / performance and have the same findings as you in that the numbers are just not there to warrant the added risk in investing in LICs over index ETF for me personally.
As a reader mentioned earlier, I too am curious of the capital gains implications if others sell and I am holding long term. I am researching more about this.
I do not deny that there is a place for LICs in one’s portfolio however as you say for someone trying to reach FI, “The decision to select a LIC rather than a passive equity index ETF carries with it a range of risks…such as, taking more risk than necessary, to achieve below average results”. Well said.
Thank you for writing this article, and sharing it with us.
Jasmine
Thanks Jasmine!
I’m really glad that the article met your needs. Get in contact if you’d like via the Contact page, as I’d be curious about your thoughts and approach to the capital gains issue, I thought about it a bit but didn’t go into it for length reasons.
I really appreciate hearing where an article has been practically useful for someone, so thank you so much for leaving a comment! 🙂
Hi again, I found this video useful to understand the fundamentals of ETFs and thus the turnover / capital gains issue. Although I haven’t fully grasped the payment in kind part, I am more reassured that the risk of avoiding ETFs all together outweigh the risk of paying some capital gains(for me personally looking at VAS).
Video link: https://www.etf.com/etf-education-ce.html (30min video, I watched x1.75 speed). I recommend watching the entire video but see 18:45 for the subject of turnover and capital gains.
I also started this discussion on Property Chat in case you are interested: https://www.propertychat.com.au/community/threads/why-lics-over-etfs.37241/#post-672054
Jasmine
Thank you very much for posting again! Many thanks for the eff link – I’ll take a look at the video. Right now I’m still processing that you watched it x1.75 speed! 🙂 I’m currently listening to an audio book at x0.9 speed, so I need to up my game!
Thanks, I also looked though the thread, and it was interesting. I found it reassuring that the top commento acknowledged that performance is not necessarily the best metric to judge LICs on, and to go for a simpler ETF like VAS instead. My contention is that for those seeking to build a portfolio over a substantial period, performance will matter uppermost in reaching a FI target, due to compounding maths.
Again, thanks for coming back and sharing those, and its great to see you actively seeking out disconfirming viewpoints and evidence in making your choices.
Hi TFE, Great article and very in depth. I currently invest in a split between ETFs (Aussie, US and world ex US) and some australian LICs. I bought the LICs when I was getting started (thanks to the barefoot investor) and have build up a good portfolio now. I have reached leanFIRE but I am still working and every fortnight purchasing $3K of index funds – I was trying to pick the most undervalued LIC (price vs NAV) or if nothing seemed good I went for which ever ETF had dropped the most (or grown the least). I hadn’t really cared about portfolio weighting about AUS vs US vs international(ex US) but I guess this might be something I need to concentrate on. Your review of LICs vs ETFs has definitely made me reconsider buying more LICs in the future, and I think I will be concentrating on just the ETFs from now on. Thanks heaps for the quality article!
Thanks so much for that CaptFI, it’s great to get that feedback!
It’s one of my most read pieces, so glad people are finding it of value. I think your story of being directed by Barefoot in that direction is very common indeed – but reaching LeanFIRE is a brilliant achievement! Well done!
You mention you’re working – have you changed your work situation at all as a result of LeanFIRE, or are you just accumulating faster as a result? 🙂
Another interesting piece below
https://blog.stockspot.com.au/compare-lic-vs-etf/
Thanks for adding, that’s really an excellent piece. 🙂
Great article. Only stumbled across it today. Been doing a bit of Michael Burry, Peter Thornhill, Scott Pape reading in the last few months, so this come along at a good time.
I’ve always created my FI goals based on a 6.5% return, regardless of the underlying equity investments. That way I’m able to focus on my habits, leaving investment choices (without being stupid) to be less relevant in my plan.
The beauty of the Australian investment marketplace is we are able to have a bit of everything, if we choose to. This causes the natural debates of investment X vs Investment Y. No doubt in 10 years something else will be getting played off against another new/trending structure.
Unless you are an investor with a gambling mentality, I found having lower expectations (but naturally working for outperformance) helps to minimise the impact of analysis paralysis (I do this often) and buyers remorse (I get this, too).
Having sat in the financial planning chair in a previous life, boring money habits were never sexy and made clients’ eyes glaze over. They do, IMO deliver the best ‘outperformance’ for the average Joe.
Keep it up.
Thanks Ben, I’m really glad you liked it!
I haven’t heard of that approach before, but given the much higher payoff from starting and saving rates, versus investment return optimisation in the early and mid-part of the FI journey, I can see the logic.
It’s true, we are quite lucky in terms of times and places with the sheer number of options, vehicles and exposures we can access. I think that’s part of the reason for my untidy portfolio – just exploring that is interesting to me.
Completely agree with your point on habits beating a focus on hoped for outperformance every time.
Thanks again for reading! 🙂
That is one of the best finance articles I’ve ever read. Very in depth, well reasoned and well backed up. It articulated many of the issues I have found through being a former LIC investor. Another point which is my only bug bear you didn’t cover, is Arg, Afi and Mlt essentially hug the index – the correlation of the portfolios to VAS is extremely high. So an investor faces all the issues you mentioned for the privilege of owning something that is trying to closely mimic the index. I would just prefer the real thing.
Thank you very much for the kind comment!
Yes, I agree, I briefly mentioned the phenomenon of ‘closet indexing’ under Claim #5 – your point is exactly the issue. Paying for active, while actually mostly getting passive management is a real problem.
Ah, just re read that point! Indeed you did! Faultless.
Interestingly I think Strong Money, Aussie Firebug and Pat the Shuffler now all seem more in the indexing/ETF camp
Thanks for the comment Baz!
Yes, all three have graciously referenced this piece, and it seems to have changed some minds – and you’re right, the tide seems to have gone out on LICs a little since it was first written!