How to Invest in the Stock Market: ETF vs Index Fund vs LIC

It is easy to become confused and overwhelmed whilst learning how to invest. The terms ETF vs index fund are often used interchangeably, and inaccurately. Meanwhile, Scott Pape advises Listed Invested companies (LICS) in the Barefoot investor (the book anyone with an interest in finance has read!)

Investors can sometimes delay getting into the market for YEARS due to hurdles like deciding between an ETF and an index fund. Working out how to actually purchase the investment (and which broker to use) stops others!

Time in the market is the most powerful wealth building tool. We must end the procrastination!

This How to invest in the stock market series aims to tackle the confusion in working out what to invest in, and how to do it!

A clear strategy and some confidence is required. Beginner investors need to prioritize fee minimization. Also, they need to decide whether to start with Exchange traded Funds (ETFs), an index fund or Listed invested companies (LICs).

Before actually starting to invest you need to:

Once you have decided you want to invest in the stock market without a financial advisor you will want to decide on:

  • DIY or start with robo micro-investments if you don’t have much money, time or both. If you are overwhelmed by options, signing up with a robo-advisor will get you into the market (in a sensible portfolio) in minutes.
  • Passive vs Active investments
  • ETF vs Index funds vs LICs
  • How to purchase your investment
  • Rebalancing and reviewing
  • Behaviour in stock market volatility
  • Tax

Passive Vs Active Investing

Passive investing has become increasingly popular in recent years. Very few professional investors (in Australia or the US) can outperform the index on a long-term basis.

It is very difficult for professional investors to compensate for the fees they charge.

Enthusiastic amateur investors perform, unsurprisingly, worse. Attempting to compete with professionals working full time with access to far more data, computer algorithms and experience, seems foolish.

Passive investing is a good place to start for the vast majority of investors. If you want to actively pick shares, consider the “Core and satellite” approach. This is where the majority of your portfolio is in passive funds, with small amounts invested actively by “stock picking”. You need to have undertaken plenty of self education and research into stock analysis before starting.

The amount of effort involved in attempting to outperform the index by a small amount is disproportionate to the returns.

Listed investment companies are actively managed. As the fees for older style LICs are comparably low (AFI is 0.14%), these are included in this article.

ETF vs Index Fund vs LICS

Index Funds

An index fund is a type of managed fund. They are passively managed and designed to own every share included in the relevant index. An index is a collection of shares, such as the top 300 Australian shares (ASX 300).

Index Funds Are Brought Directly From the Investment Company

Index funds are usually brought directly via the company website. No brokerage is required, but there is usually a minimum initial investment.

Index Funds Purchase is Processed at the End of the Trading day

Index funds can only be brought or sold only at the end of the day. This means the exact price you are purchasing at is unknown.

This may not be important to automated dollar cost average investors, but may be undesirable for those investing with a lump sum.

Index Funds are Ideal for Automated Investing

Automation is generally helpful for investors. It reduces impulsive investment strategy changes, and so will usually improve returns.

Dividends are automatically reinvested in index funds. This saves brokerage, tine and the risk of non-compliance with your own plan.

Index Funds Have Minimum Initial Investments

Until recently, Vanguard offered multiple index funds with a $5000 minimum initial investment.

Fees were slightly higher than the ETF, but the funds could be brought and sold without brokerage fees.

The absence of trading fees made the index fund appealing to those wanting to dollar cost average small, regular investments.

I hoped research for this article would help me decide whether the index or ETF was most fee efficient.

Index Funds Have Higher Fees than ETFs

Unfortunately Vanguard have stopped offering these managed funds to individual investors outside of their new “Personal Investor” service (at an additional 0.2% management cost on top of the fund fee).

This is disappointing! I am not willing to pay the additional fee (that now makes the ETF easily more attractive).

Blackrock offer index managed funds, but minimum initial investment is $500,000 . This is unattainable for most without a Self managed super fund, and is clearly aimed at institutional investors.

I have been unable to find another index managed fund with an acceptable management fee and minimum investment.

Index Funds are Less Tax efficient than ETFs.

Because of the need to liquidate stocks when investors cash out, capital gains tax is paid within the funds.

ETF vs Index Fund vs LICS – Exchange Traded Funds

An ETF is also a type of Managed fund. ETFs can be active or passively managed.

Passive ETF’s can be based on an index fund, such as an ETF tracking VAS (containing the largest 300 shares in Australia).

ETF’s can also be narrow, such as a Marijuana ETF, purchasing only marijuana stock.

ETFs with the words “Synthetic”, “Inverse” or “Leveraged”, or covering only a narrow sector of the stock market, are an active, and higher risk strategy.

Most early investors are looking at a broad, passively managed index ETF.

To find this kind of ETF you are looking for the words “Index”, along with “Australian shares” or “World / international shares” depending on whether you are looking to invest domestically or internationally.

ETFs Are Purchased on the Stock Exchange

You need to open a brokerage account to purchase ETFs. Brokerage fees are charged on purchase and selling of ETFs, just as they are with individual shares, or LICs.

You will need to sign up to one of the many online brokerages (or full service brokerage if you want advice at a price).

ETF Fees are the Lowest but Brokerage Fees are Paid on Purchase and Sale

ETF fees are often very low, often slightly lower than the fees for index funds or LICs.

The basic Vanguard Australian shares ETF (VAS) charges only 0.1% per annum. The international shares Vanguard ETF (VGS) costs 0.18% per annum.

The minimum purchase for ETFs is as small as $500, but small regular investments like this are going to attract lots of brokerage fees.

The same brokerage fee often applies whether you are purchasing $500 or $5000 worth of an investment.

Due to brokerage, it is more cost effective to save up and buy a few thousand dollars of your ETF at a time (eg quarterly). If you want to work out how frequently is the optimum purchasing routine for your situation check out this calculator.

ETFs Can be Brought Any Time the ASX is Open – You Know the Exact Price You Are Paying

ETFs can be brought any time the relevant stock exchange is open, important for traders and those trying to time the market.

If you are buying in large parcels irregularly, your exact purchase price may be important to you.

Automated Regular Investing is Now Possible (eg Monthly / Quarterly)

For many of us, automation is really powerful in helping us stick to our investment goals.

Up until recently, it wasn’t possible to automate ETF investing.

Pearler is a new broker, set up specifically for those wanting to regularly and automatically invest in ETFs.

I have not tried the platform yet, but Captain FI gave a detailed review here. Automation is a powerful tool in keeping your investing consistent.

ETFs are Generally More Tax Efficient

ETFs tend to be more internally tax efficient than index funds or LICS.

An ETF is sold by an investor to another investor, via the stock exchange. When an index fund is sold, the fund manager sells securities to free up cash, incurring capital gains tax for all other investors in the fund.

ETFs, however, can be more complex in their tax treatment due to their trust structure. Sharesight can make tax time far simpler for ETF owners, and is free for the first 10 holdings.

Because ETFs are a trust structure, they have to pay out all dividends each year. Dividends can be irregular, resulting in increased tax burden some years and little control over the income withdrawn.

It also means more brokerage fees need to be paid to reinvest the dividends during the accumulation phase.

ETstF vs Index Fund vs LICS

Listed Investment Companies (LICs)

With LICs, you are buying shares in a company that invests in the stock market.

These are generally active investments, although the older style LICs such as Australian Foundation Investment Company charge fees comparable with index funds.

LICs Are Brought on the Stock Exchange

Similar to ETFs, you will need a broker to purchase LICs. Brokerage fees are paid when purchasing and selling.

LICs are Closed Ended Funds – Meaning they Can Trade Above or Below the Cost of the Underlying Assets

The “Net asset valuation” (NAV) is the value of assets owned by the LIC at the time. Due to LICs being a “closed end structure” (there are a set number of shares at all times), the share price of the LIC can fluctuate above and below the NAV according to supply and demand.

Barefoot investor suggests buying at a discount to NAV. Trying to time purchase at a time when the stock market seems undervalued, and the LIC is trading at a discount to NAV is a recipe for endless procrastination!

Don’t be distracted by trying to time the market, just plan an investing schedule and stick to it.

ETF’s are open ended structures which means there is no limit to the number of “shares” that can be sold.

LIC Dividend Smoothing & Reinvestment

Dividends tend to be more even over time, as LICs are allowed to withhold dividends for a later time. This is often important for investors that focus on income over total return.

There are more options with dividends than in ETFs or index funds.

LIC dividends can be automatically reinvested (saving brokerage). Dividends from AFI or Whitefield can also be substituted, a potentially powerful strategy for for high income earners to defer income until post retirement (and then with a 50% capital gains tax discount).

I feel the dividend substitution (DSSP) is the one big advantage for LICs for high tax paying investors. Tax can be deferred completely until you are in a lower tax bracket (post retirement). Income is also taxed as capital gains rather than income, so qualifies for the 50% capital gains discount after 12 months invested.

There is no Minimum Investment with LICs

There is no official minimum investment with LICS. Brokerage fees mean that most will want to invest thousands of dollars at a time, similar to ETFs.

LICs and Tax

LICs are not as tax efficient within the investment as ETFs, but for high income earners wanting to defer income until post retirement, may save tax. The DSSP gives high tax investors an option for investing tax free, or to be taxed at half the rate.

Summary

Index funds would be great for dollar cost averaging small amounts, but have become far less accessible with $500,000 needed to invest.

Broad index fund ETFs are generally tax efficient. Brokerage costs have to be paid when buying and selling ETFs or LICs, but can be minimized by investing less often, with larger amounts.

Automation is probably the best defense we have against the biggest threat to our investments: ourselves. It is now possibly to automate ETF investing with Pearler.

Dividend income from ETFs has to be paid out, and can be irregular.

The old school LICs are actively managed funds with similar fees to ETFs.

LICs are generally not as tax efficient as ETFs within the fund. LICs do, however, create potential for high income earners to defer all dividend income until post retirement, when they are on a lower tax bracket.

Choose you investment, and set yourself up with a brokerage account this week. Automate investments if you can, to minimize the risk of pulling out of your investing commitment.

What’s your vehicle of choice en route to financial freedom?

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