Over-hyped or here to stay? The case for, and against, listed investment funds

Chris Meyer

Pinnacle Investment Management Limited

Listed investment funds, including open ended trusts (ETFs & active ETFs or ETMFs) and closed ended listed investment companies (LICs) and trusts (LITs) are today nearly a $100 billion industry in Australia in terms of funds under management.

While still only 15% of the $600bn retail managed fund industry, listed investment products have grown nearly 300% over the past five years, compared to unlisted managed funds that are up only 20% over the same period (since December 2014).

Is this growth in listed investments a fad or is this a sign of structural growth that is here to stay?

Are listed investment funds only for the ‘pros’?

  • FOR: Stock markets are volatile and high volatility has a tendency to bring out the worst animal instincts of some retail investors and cause them to over trade, buy high and sell low.

  • AGAINST: The transparency and scrutiny of listed investment funds are important safeguards for investors, in much the same way that investors should take comfort investing in listed companies over unlisted companies. The numbers of eyes (market participants and regulators) watching the listed market means that issues are more readily identified more quickly. Market makers and other market professionals are liquidity providers that tighten spreads, as they do with shares.

    Saying that just because a fund is listed causes investors to overtrade is the same as saying that we should all go back to using landline phones as mobile phones are causing us to talk too much. It ignores all the other benefits in much the same way that listed investment funds are an innovation that are for the benefit of the end investor.

Unlisted funds are better than listed funds

  • FOR: Unlisted funds have only one end of day NAV that all investors receive and have a fixed buy/sell spread, providing certainty to investors. They are also lower cost to invest in as there is no brokerage to pay to invest in an unlisted fund.

  • AGAINST: Listed funds have multiple benefits. They are easy to transact (no onerous form filling), accessible (no minimums) and transparent (more regular portfolio disclosure and price discovery) than unlisted funds. In terms of transaction costs, the bid/offer spread on listed funds such as ETFs is very similar and often better than their unlisted fund equivalent.

    Yes, you must pay brokerage to buy or sell a listed fund, but those costs have become very competitive and are comparable to or lower than the platform costs of investing in unlisted funds. The intraday NAV and the traded price of an ETF are almost identical and very ‘visible’ as they are quoted on exchange. The benefit of this intraday pricing is that investors can implement their investment decision at a price when they make the decision rather than only at an unknown price using the end of day NAV (as with an unlisted fund). In finance speak, the implementation shortfall when investing in listed funds is superior to unlisted funds

ETFs are unproven in a crisis

  • FOR: Some people say ETFs are a recent phenomenon and haven’t been tested during a market crisis. It is unknown how the bid/offer spreads, operational robustness and liquidity of ETFs will react during the next GFC.

  • AGAINST: ETFs have been around well before the GFC. So have LICs. Both have survived.
    During the GFC, ETF spreads did widen, as did the spreads on buying and selling shares but they snapped back quickly and the efficiency, liquidity and transparency of ETFs to investors during the GFC (when many other markets were shut) actually put ETFs on the map.

Growth in listed has been too rapid and an ‘accident’ is waiting to happen

  • FOR: Anytime an area of the financial services industry grows too quickly, mistakes are made and an accident happens. ETFs are the most rapidly growing part of the asset management industry in the last decade and are like structured products leading up to the GFC, the next accident waiting to happen.

  • AGAINST: ETFs are growing rapidly as they’re a good innovation for investors. ETFs are not like structured products during the GFC. Structured products had two features that ‘killed’ investors – counterparty risk and leverage. Counterparty risk means you only get paid out from an investment if the counterparty doesn’t default. Leverage amplifies asset price movements. Unlike structured products, ETFs are not derivatives, and carry no counterparty risk to a default of the issuer. The assets inside the ETF are segregated from the issuer and owned by the trust, much like an unlisted trust (managed fund). ETFs also have no leverage.

Active ETFs are opaque and illiquid

  • FOR: Active ETFs are opaque and don’t disclose their portfolio holdings daily like ‘traditional’ ETFs, often only disclosing their holdings quarterly. Some investors consider many active ETFs are illiquid as they have low average daily value traded.

  • AGAINST: Yes, some active ETFs only disclose their portfolios quarterly as they value the intellectual property of their portfolio decisions and don’t want the market to easily replicate their portfolio (after all that’s what their investors are paying for). While this portfolio disclosure may be less regular than the daily disclosure of passive ETFs (that track an index and thus don’t need to protect their IP), it is still more disclosure and the disclosure requirements are more heavily regulated than with unlisted managed funds. Unlisted funds have no standard disclosure requirements and, in most cases, only disclose their top 10 holdings monthly (active ETFs do this as well) and never disclose the entire portfolio on any frequency to the market.

    On liquidity, ETFs have three layers of liquidity. The ‘on screen’ liquidity (like the daily value traded), unlike with shares or LICs is only one layer of this liquidity. Ultimately, an ETF is as liquid as the securities underlying the ETF (e.g. global equities). Given ETFs are open ended, any sale of an ETF can always be funded, as a last resort, by the sale of securities in the ETF portfolio, if there are no buyers on the other side at the time of the sale (as with a redemption in an unlisted managed fund).

In a ‘winner takes all’ scenario, ETFs (that trade at NAV) must win out over LIC/LITs (that can trade at premiums or discounts to NAV)

  • FOR: The LIC market will dwindle as investors don’t like the fact that LICs can trade at a discount or premium to their NTA. Investors like the certainty of NAV trading that you get with ETFs. ETFs will be the ultimate winner.

  • AGAINST: Not all asset types can be inside an ETF. If the asset class is illiquid or where the underlying asset price of the security inside the ETF is not readily observable, it’s not suitable for the daily liquidity of ETFs and thus are not allowed under the ASX’s AQUA rulebook (governs the issuance of ETFs).

    LICs and LITs, due to their closed end nature, can house asset classes that are less liquid and with prices that aren’t quoted on a stock or bond exchange. This provides the retail investor with the opportunity to access asset classes such as private equity, unlisted infrastructure and corporate loans via a LIC or LIT that aren’t available in an ETF. These asset types, that have both return and diversification benefits over traditional listed equities and bonds, provides additional choice to investors to complete their portfolios.

    In addition, the LIC market has come a long way and become more investor friendly over the past few years as issuers improve their alignment with LIC shareholders (e.g. issuer paying for the upfront capital raising costs). This should, over time, help to close the gap between the share price of an LIC or LIT and the NTA of its underlying assets. For income investors, LICs are also able to smooth their distributions received, and amplifying their franking credit when compared to a trust structure like an ETF, LIT or unlisted unit trust (managed fund) that must pay out its income as received.

All fund types are here to stay but the outlook for ETFs looks brightest

Much like how the debate on active versus passive investing has moved on to a point where most would agree they both have a future, we believe the debate on ‘listed vs unlisted’ funds or ‘ETF vs LIC’ should also move on to a different debate: what’s best for the end investor.

When looking at it through the eyes of the investor, the answer becomes a lot clearer: all of these fund types have a future.

The first layer of an investment decision is ‘what do I want to invest in’. The second layer of the investment decision is ‘how do I want to invest in it’. If you like the ‘one click to trade’ nature of investing in listed funds, chances are you will like ETFs and LICs over unlisted funds.

If you don’t like investments that can trade away from their NAV/NTA, chances are you will prefer ETFs and unlisted managed funds over LICs. If, however, you like NTA discounts as they provide an opportunity to buy a portfolio below its value or if you want access to more alternative asset classes or a more stable dividend stream then you could look at LIC or LITs.

The growth of the listed investment market is because of the innovation and investor choice provided by ETFs and LICs, a structural benefit to investors that is here to stay, not because the industry is getting carried away with an overhyped fad.

Looking overseas at the US and Canadian markets suggests that the prospects for the ETF industry look the brightest as they’re much larger than their LIC market counterparts and in each market, the ETF industry is closing in on the size of their unlisted funds markets as the ETF industry continues to see strong net inflows while the unlisted fund market is in outflow. Investors are voting with their feet.

Chris Meyer
Pinnacle Investment Management Limited

Chris is part of the Pinnacle executive management team and responsible for driving the listed products business. Pinnacle’s mission is to establish, grow and sustain a diverse and complementary stable of world-class, specialist investment managers

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