LICs vs Index Funds – Which is Better?

 

LICs vs Index Funds

There is a mountain of evidence that supports index funds being the superior investment for stockmarket investing over the long term.

Despite this, in Australia, I’m quite hesitant to plough all my savings into our stock market index.

 

This is because the Australian Sharemarket is extremely top heavy.

The top 10 companies make up nearly 50% of our entire market value.

Almost 40% are in the Financials sector alone!

Over in the US however, it’s a totally different story!

The US stockmarket is very well diversified.

The top 10 companies only make up around 16% of the entire market value.

There is a great spread across different sectors too, with 20% in Financials and 17% in Technology. Then Consumer Services, Industrials and Health Care sectors all have around 13% each.

If I was a US investor, I would use index funds with no hesitation.

 

Why not just buy a US Index Fund then?

You may be wondering why not just invest in the US stockmarket, since their index is more investor friendly.

The simple answer for me is income.

Dividend yields in the US tend to be around 2%.

Very low, compared to the 6% we can get here in Australia.

 

This means 500k in US shares would provide only around 10k of income.

The same 500k in Aussie shares would provide 30k of income.

It’s truly a massive difference!

You would need three times as much savings to be able to retire on this income stream.

Remember, our job is to create a passive income stream to live on.

The more sustainable income we can get from our investments, the less we need to save in order to reach financial independence.

Crunching the numbers and comparing income streams is so critical to early retirement, it can’t be overstated.

Unfortunately, it’s not just a case of ‘investing’ and eventually it will work out.

 

Indexing

Index funds are wonderful, in the sense that you won’t under-perform the market at any stage because index funds match the market index.

The evidence is heavily on the side of indexing, with many professionals failing to outperform the index over time. This is especially true in the US, where fees tend to be higher and a higher percentage of managed funds lose to the index, than here in Australia.

You can be comforted that in 50 years from now, the index will definitely still be around and its value much higher.

You will own all the most valuable companies on the market and your index fund will only keep the surviving companies over the years.

But, by owning every company in the index, you also inevitably own some crappy ones.

This can be fine, since it’s not obvious which companies are going to do poorly in the future.

If a company does do poorly and falls out of the top 300 (in the case of the ASX 300), you will no longer own it.

Owning the index also means owning companies in order of their market size, whether they pay dividends or not.

Index funds are an excellent option, but I think LICs (Listed Investment Companies) are a better substitute for Australian investors wanting to retire early and live on their dividend income stream.

 

Here’s a few reasons why I prefer LICs for investing in Aussie Shares

 

  • Most invest with a focus on dividend paying companies that can provide income that grows faster than inflation. (Of primary importance for early retirees).

 

  • The dividends paid are often more consistent and more stable than the index. ย  (Investing nerd side note – Because the LICs operate as a ‘company’, they have control over how much dividends they pay out so they can smooth the dividends over time. Index funds operate as a ‘trust’ structure which forces them to pay out all earnings, including capital gains from re-balancing the index. This tends to make the income from the index fund quite lumpy and uneven which can also trigger some capital gains taxes).

 

  • Some have shown the ability to outperform the index over the long term.

 

  • You can own multiple LICs, such as ones that focus on small-mid sized companies. This gives you further diversification in the top heavy Aussie Sharemarket. (Our index is dominated by banks and mining).

 

  • There is sometimes the opportunity to participate in Share Purchase Plans, allowing you to buy more shares at a discount with no brokerage fees.

 

But wait there’s more….

 

  • The dividends paid tend to be fully franked, whereas the index tends to be about 75% franked. This can make them more tax effective and means a higher total income from dividends.

 

  • Quality LICs tend to avoid companies that pay very low or no dividends, such as speculative resources companies. This improves the income of the portfolio and generates a higher level of dividends for shareholders.

 

  • LICs usually offer Dividend Reinvestment Plans (DRP) – this gives you the option to reinvest your dividend payment, often at a discount without paying brokerage. You will still receive the franking credits and are still required to declare the income.

 

  • Some LICs also offer a Bonus Share Plan (BSP), sometimes called Dividend Substitution Share Plan (DSSP) – where you are able to forgo your dividend in exchange for more shares in the company, often at a discount and pay no brokerage or tax. This can be a good option for those in a higher tax bracket. No income needs to be declared because no cash changed hands.

 

More info for DRP and BSP can be found down the page here

 

A warning though…

It’s not all roses and rainbows!

With LICs there are more risks.

There are plenty of fund managers out there that have delivered poor results for shareholders and in many cases you’d be better off with an Index Fund.

The manager may start making poor investment decisions or some talented team members may leave. They could also increase their fees unexpectedly. Realistically, fees are much more likely to be lower in the future. Still a risk though.

Some of the risks are manageable though, by owning multiple LICs and those run by managers with a great long term track record, that is more reliant on their investment process, rather than the magic skill of one individual.

 

Low fee LICs

The fees of different LICs vary wildly and usually depends on their strategy and turnover.

The older style LICs such as Argo, Milton, BKI and AFIC are very ‘index’ like – being weighted towards larger companies. They tend to be very long term holders of their investments, so do very little selling. Their fees are very low – around 0.17% or less per annum. I think of them like a ‘improved index’ for reasons listed above.

 

Higher fee LICs

Something to remember here is, all LICs are not equal…

Many of the more active LICs charge high fees, so this puts them at an instant disadvantage when trying to deliver out-performance for shareholders.

Some LIC portfolio managers have still managed to deliver good out-performance, over time, despite charging higher fees and/or performance fees.

This is true more-so in the LICs that focus on the small-mid sized companies, where the companies tend to be less researched and there is a greater chance to outperform the market. These LICs tend to be much more active. Fees for this type of LIC tend to be around 1% per annum. Some (not all) charge performance fees too.

Many high fee LICs are rubbish, so it pays to be careful and only invest with a LIC or manager who has proven themselves by delivering good performance over the longer term.

There are still quite a few good ones out there. So it can pay to find the good fund managers by doing some research.

A couple of LICs I like in this space (small-mid cap shares) are QV Equities, which is managed by Investors Mutual (1% fee) and WAM Research (WAX), managed by Wilson Asset Management (1%, plus 20% out-performance fee, if applicable).

These two managers have both proven themselves by delivering consistent out-performance in the small-mid cap space for around 20 years, despite their higher fees.

Like anything though, there is no guarantee this will continue.

Summary

I’m obviously a big fan of Listed Investment Companies and clearly biased, but not without reason.

Don’t get me wrong, index funds are great too!

There is no rule that says you can’t have both, if that’s what you’d be more comfortable with.

I just feel that in Australia, the index is a bit too concentrated in one or two sectors to rely on indexing alone.

So here is my answer to the question “which is better?”…

I would say in the US, indexing is the best option for long term returns, low fees and low fuss.

But it’s my opinion, that in Australia, investing in good quality and proven LICs, are a superior option to index funds.

My favourite LICs are the older style breed with super low fees. I use small-mid focused LICs, like the ones listed above to help achieve more diversification away from the top heavy nature of our sharemarket.

By using LICs, we can achieve a more diversified and well balanced portfolio, without sacrificing that all important income we need for financial independence!

 

ย 

Note – All LICs listed in this article have links to their websites. Check them out for further research.

Disclosure – I am a fan of these companies and own shares in many of them.

10 comments

  1. I agree – LICs in Australia are awesome, they certainly offer more consistent dividends. The American index is hard to beat when it comes to diversification etc.. We will look to add lots of both to our portfolio over time ๐Ÿ™‚

    Mr DDU

    1. Thanks for stopping by MR DDU. It’s hard not to get excited about Aussie LICs, that’s for sure.
      Sounds like a mighty fine plan! We’re happy just to keep the overseas exposure to our super fund.

  2. So how do LIC’s differ from Managed Funds? And what kind of fees are you looking at? They sound like actively managed investments, which generally means higher fees eating into your returns.

    1. LICs are very similar, being a managed portoflio of shares. Some small differences – A good overview here on AFIC website. The fees vary and generally LICs can be split into 2 groups. The older style LICs that are much less active and have very low fees – around 0.15% – such as Argo and AFIC, they’ve been going for 70+ years and are much more ‘index’ like. The more active style LICs – fees tends to be around 1% pa, some have performance fees also. Many of these are rubbish but the fund managers I have listed have provided above market returns, importantly after fees – which is what counts to us. Otherwise what’s the point! ๐Ÿ™‚ I’ve updated the text to include the fee figures – thanks.

  3. Congratulations on what you’ve achieved. Great blog too and excellent write-up on LICs.

    It’s always great to see others as passionate as myself about investing in Shares for income, especially LICs. There’s no better way to invest in my mind.

    An important point you raised:
    “Quality LICs tend to avoid companies that pay very low or no dividends, such as speculative resources companies. This improves the income of the portfolio and generates a higher level of dividends for shareholders.”

    Investors so often focus on whether a LIC consistently outperforms the index. But I’m more concerned with consistency and reliability of dividend income. If a LIC underperforms for a period because it avoids those stocks you mentioned above then that’s fine by me.

    I look forward to following your journey.

    Cheers
    Gordon

    1. Thanks Gordon!

      Glad the write-up was to your liking. I know for a fact you know more about LICs than I do ๐Ÿ˜‰

      I have really been won over by dividend investing, that’s for sure! Even Mr Bogle himself has suggested that is what investors should focus on.

      Yeah, completely agree mate. Income reliability is more important than constant outperformance. I’m happy even if we just receive index-like returns, but with a more predictable income stream. It’s actually preferable if they underperform at times, because we know there is sometimes rubbish that gets hyped up in the market.

      Good to have you here, hope you stick around ๐Ÿ™‚

  4. So how you you allocate your portfolio or Index fund (or ETF) and LIC? Currently I’m in all index ETF of 30% VAS, 30% VTS, 40% VEU.

    1. Thanks for your commend BlackPinoy. You have a nice spread there! Much more diversified than I am.

      Currently more than half our wealth is still in property, and we are transitioning to shares. We have a basket of individual shares and the rest is LICs.
      So how I plan our portfolio is having majority in LICs for simplicity, and some individual shares. All with a dividend focus. The portfolio will be ASX only, as this will give a much higher level of income (around 6% gross). Later I plan on adding international index funds. such as VGS for diversification, but that will be after the main dividend focused portfolio is built.

      The LICs are a mix of large cap and small/mid cap for diversification. Such as Milton, Argo, BKI, AFIC for large cap and QVE & WAX for small/mid cap. The blended yield of this mix comes out to around 6% incl. franking credits. For allocation levels, equal weight would probably be fine. What I am likely to do is have a higher weight in the LICs that have a longer/better track record of consistent dividend payments, dividend growth and performance. Or the ones I consider lower risk. Like anything, it can be as complicated or as simple as you want to make it!

      There is no way I could achieve that level of dividend income with index funds, and I’m not a fan of selling shares for income, so this is the approach that fits best for me. Build ASX dividend income first to retire ASAP, diversify into international index funds afterwards. Will write more about this soon.

      Hope that helps ๐Ÿ™‚

  5. I have just come across your blog as only recently started taking a look at some of the other Australian investing blogs out there.

    Have just read the posts on your journey, the rent v buy, and now this one on LICs & Index funds. Very refreshing to read some well-balanced discussions on those last two topics I mentioned.

    I can never get my head around the fact that I rarely run into people who use the strength in Australian property, particularly Sydney & Melbourne, to consider reducing the property exposure in favour of an investment structure that will give your more cash flow and financial freedom.
    I like this article also, I come across too many articles that donโ€™t address the issue of lack of diversification in the Australian index when discussing LICs & Index Funds.

    I can certainly relate to the post about you and your journey. I shall try and read your other posts and check back now and then. Looks like some interesting topics you have tackled, so I am not just here stalking Austingโ€™s posts ๐Ÿ˜Š.

    1. Thanks for stopping by mate.

      Glad you’ve enjoyed a few of my posts ๐Ÿ™‚ I do try to keep somewhat of a balanced view, even though we each have our preferences.

      Yeah, I think a lot of people would benefit by considering reducing their capital city property exposure, in favour of more cashflow from shares. Many people are equity rich and cashflow poor.

      I much prefer the LIC approach since we can create a more balanced portfolio, and receive dividend income from a larger variety of businesses. Not to mention, some of the LIC managers here have also delivered excellent returns over time.

      Haha, hope to see you and Austing around here in the future!

Leave a Reply

Your email address will not be published. Required fields are marked *