By Tony Featherstone, editor

Sharemarket information in newspapers and sharebroker reports typically has a bias towards what and when to buy. Less considered is when to sell stocks or exit the sharemarket because it has become overvalued. Or investors are told that “time in the market” matters most.

Events of the past five years have reminded investors that it pays to keep a close eye on the broader sharemarket. Even the most diversified share portfolio was crunched during the GFC in 2008 and 2009. Those who knew when to exit the market avoided heavy losses.

That does not mean investors, especially those near or in retirement, should jump in and out of sharemarkets and try to time the market – something even professional investors struggle with.

Rather, it is about having a sensible asset allocation plan and knowing when to increase or decrease the weighting of equities based on the market outlook – or using professional investors to do it for you.

For example, investors who thought the sharemarket was undervalued in early 2012 might have increased the weighting of equities in their portfolio and decreased their holding of cash or fixed interest.

Another key step is knowing when to take profits and reallocate proceeds into undervalued assets. Again, this does not mean trading or even being an active investor. Rather, it is about being an informed investor who knows when a stock has run too far or the market in aggregate has become overvalued.

Understanding market “value” is a key theme of this month’s ASX Investor Update. The prominent value investor Roger Montgomery, of Montgomery Investment Management, leads the issue with an excellent review of overall sharemarket value, based on an aggregation of individual stock valuation relative to their market price.

He says: “The market for quality companies is, today, more expensive than it has been at any time since the GFC. But if we extend the analysis to include the period before the GFC, we find that it is not as expensive as it can get and there may be significant upside still to come.”

Another value investor, Paul Zwi, of Clime, considers value in four widely held stocks – Telstra, Commonwealth Bank, Woolworths and BHP Billiton, which together make up about a third of the overall sharemarket.

Zwi says only BHP is trading at a discount to Clime’s intrinsic valuation, but argues all four stocks remain core holdings for long-term portfolio investors.

In another story, Wealth Within’s Dale Gillham considers market value from a technical analysis, or charting, perspective. Using Dow Theory, he gives an excellent roadmap of how bull and bear markets typically unfold.

Investors who are confused by reports about whether a bull or bear market exists, and what happens next, will take comfort in Gillham’s usual no-nonsense analysis. He says current market action suggest the bull market is entering the second of three stages – improving corporate earnings.

The Bull.com.au’s Toni Case rounds out the Market Views section with an overview of Listed Investment Companies (LICs) and Exchange Traded Products (ETP). Toni says both products suit beginner investors who want to enter the market using low-cost, ready-made LIC and ETP portfolios.

I hope you enjoy this issue of ASX Investor Update. As always, do not act on newsletter themes or ideas without doing further research or talking to your financial adviser.

About the author

Tony Featherstone is consulting editor of ASX Investor Update.

By Alon Mizrachi, Citigroup

You might not realise it, but borrowing to invest is an extremely widely-used strategy for Australians. The best illustration is funding the purchase of a residential property. Very rarely can a home-buyer come up with the full purchase price in cash, so typically must borrow. But even in cases where the buyer could fund the property themselves, they may decide to invest less than the full amount, borrow the balance and invest in other assets to diversify their asset base. This concept can also apply to building a portfolio with a mix of your own funds as well as those from a lender.

Let us look at the options for Australian investors seeking to obtain a diversified Australian share portfolio as part of a wider balanced portfolio, and what the options are for those wanting to use both a diversification and leverage strategy.

There is, of course, the option of buying the shares directly through a stockbroker, which often yields great results, especially if the broker is adept at picking stocks. (But it is important to note that your broker is unlikely to closely mimic the S&P/ASX 200 index and thus the performance of your portfolio may be very different to that of the index.)

Another very well-used option is the use of managed funds – that is, investing with a professional fund manager who will either mimic the market by closely tracking the S&P/ASX 200 benchmark index or use their expertise to attempt to beat the market by actively managing the stock selection decisions for you.

Then there is the use of exchange-traded funds (ETFs). An ETF is, in effect, a listed managed fund that holds securities with the intention of closely tracking the performance of a broad index such as the S&P/ASX 200, a segment of the index such as the financial sector, or even a pre-defined strategy. In many cases, ETF providers claim to provide “low-cost beta”, or a low-cost method of obtaining exposure to the market. The most popular ETF in the Australian market is State Street Global Advisers’ issued SPDR S&P/ASX 200 that seeks to closely match returns of that index.

Leveraged options

As for leverage, there are several avenues a potential borrower can follow to secure financing. These include the use of a margin loan, borrowing against the equity in your home, unsecured lending and the use of investment vehicles such as CitiFirst Instalment MINIs.

CitiFirst Instalment MINIs may provide the investor with a unique investment proposition in that they combine the concepts of diversification and leverage. First, we will explore the anatomy and features of an instalment MINI.

CitiFirst Instalment MINIs offer a straightforward and cost-effective way to gain medium to long-term exposure to the performance of shares in Australia’s leading companies and ETFs. For a small portion of the up-front price of the underlying shares or ETFs, investors benefit from dividends, franking credits and capital appreciation as if they owned the shares outright.

Unlike traditional instalments, there is no put option and hence no put option cost. There is a stop-loss feature that ensures the investor cannot lose more than their initial investment no matter what happens to the underlying shares or ETFs.

At maturity, investors have the flexibility to pay the final instalment and receive the underlying shares, roll into another series of instalment MINIs, or walk away from the investment, receiving the residual value remaining in the investment.

An investment in instalment MINIs will typically involve two separate payments: the first instalment (which confers the benefits of share ownership) and the second instalment (which is the loan amount plus interest on the loan). Instalment MINIs have an embedded stop-loss feature that ensures the final instalment, or loan amount, is non-recourse in nature, which means you are unable to lose more than your initial investment amount.

Depending on individual circumstances, interest expenses and borrowing fees related to the purchase of CitiFirst Instalment MINIs may be eligible for tax deductions (you should obtain independent tax advice before making any investment decision).

Here is an example of an investment in STWJOB.AXW – a CitiFirst Instalment MINI:

An investor who purchases STWJOB.AXW will obtain a beneficial interest in the STW.AXW units – the STW.AXW underlying security will be held on a one-for-one basis in trust for the benefit of the investor. Hence the investor will be entitled to all the distributions as well as any associated franking credits (assuming the investor is generally entitled). STWJOB.AXW can be viewed as a way to obtain your market “beta” (a return similar to the market) using a moderately geared investment vehicle.

So what can the investor expect from their STWJOB.AXW investment? Assume that after a month the STW.AXW has appreciated in value by $1.00 (or 2.1 per cent) to $48.25 – in this case, the instalment MINI value would have increased in value to $19.50 (or 4.42 per cent), being the $1.00 move in the STW.AXW less the interest cost of $0.175 incurred in holding STWJOB.AXW for that month.

CitiFirst Instalment MINIs are leveraged products and it is important to note that leverage can be a double-edge sword, so we need to consider a scenario under which the STW.AXW had depreciated by the corresponding amount. Under this scenario, the STWJOB.AXW would have fallen by $1.175, or 6.30 per cent, to $17.51 (being the $1.00 move in the STW.AXW plus the funding amount of $0.175 over the period.

Under all scenarios, the investor will be paid the distributions on the STW.AXW and considering the STWJOB.AXWs are limited recourse in nature, there is the certainty that no matter what happens to the price of the STW.AXW, there will be no more to pay by the investor.

Before investing in CitiFirst Instalment MINIs, investors should read and understand the Product Disclosure Statement at citifirst.com.au or asx.com.au.

About the author

Alon Mizrachi is a director within Citi’s Markets team in Australia.

From ASX

The free ASX online Warrants and Instalments course is a great way to learn about the features, benefits and risks of these products.

From Morningstar

Imagine you have applied your toolbox of strategies to a number of companies and found one or two that appear to fit the bill. They are in attractive industries, have solid core businesses, good track records, sound management, strong earnings growth and the outlook for continued growth looks reasonably positive.

In fact, the overall picture looks so good that you are starting to ask the big question: should I buy? Of course, the answer is just another question: how much does it cost?

Finding great companies and great investments is not the same thing. If years of expected future earnings growth has already pushed a company’s share price to very high levels relative to other stocks, you may have to look elsewhere.

Fortunately, there is no shortage of independent research and brokers’ reports to help you work out how much is too much to pay. These are a useful rough price guide, but the fact that they are printed in black and white draws some investors into giving them a legitimacy they do not always deserve.

No one can truly say what a stock is worth. The ultimate judge is Mr Market, given enough time.

In the textbooks, the value of a company is the net present value of its future free cash flows (cash that is not required to be invested back into the business). This basically means that a company is theoretically worth all of its future profits added up, expressed in today’s dollars.

An investor’s job is to identify a price at which the company’s earnings will produce an acceptable return on investment.

If a company continues to generate earnings and produce acceptable “internal returns”, this should eventually be recognised by the sharemarket, although it may take some time, and the price will rise – as will dividend payments.

What return is acceptable?

An “acceptable” return means different things to different people, but generally it starts with the rate of return you would earn if you put your money into government bonds – the so-called risk-free rate of return or the current yield on 10-year government bonds. (It is known as risk-free because in the unlikely event of a government default, an investor is guaranteed to get their capital back).

Analysts may then add a risk premium of perhaps 3 or 4 per cent, sometimes more, for what they consider an acceptable reward for holding the stock. Anything lower than the risk-free rate and there is obviously no incentive to take the extra risk in buying shares.

Analysts typically run these calculations through complex mathematical modelling procedures and apply various filters to weed out companies with undesirable or “risky” characteristics before arriving at their interpretation of a company’s “true value”.

Every analyst does this in their own way, making their own assumptions, allowing their own margins for error, and so on. Under its methodology, Morningstar considers risks to a company and assigns an Uncertainty Rating to it in order to determine the cost of equity.

There is no point pretending the average private investor can go through processes like these; even estimating future earnings growth is fraught with difficulty. But rather than worrying about this, you should take advantage of all the legwork that has been done on your behalf by experienced professionals, such as those as Morningstar.

There are also some relatively straightforward approaches you can take to estimate at what price a stock is worth buying.

Assessing when to buy

Despite its imperfections and limitations, the price-to-earnings ratio (PE) is still the most useful starting point for working out whether or not a stock is cheap or expensive. After putting the company through a rigorous analysis, you can start by comparing its current PE to:

• The historical trend in its PE
• The market average PE
• The sector average PE
• Competitor company PE.

This brief check should already give you some idea of the company’s current value relative to other stocks.

You can then take forecasts of growth in earnings per share (EPS) for, say, the next three years, and work out a forward or prospective PE for each of those years.

This will give some guide to the potential for share price appreciation, although the accuracy will obviously depend on the earnings growth forecasts, as well as the market’s reaction to them.

A worked example

Bogan Steel Limited is trading at $1.00 a share with earnings per share (EPS) of 5 cents, so its current PE is: 100 cents per share / 5 cents per share = 20.

In most markets, such a PE would be considered roughly fully valued for a company with reasonable earnings growth (in a bull market it would probably be considered quite cheap). But let us assume in this case that Bogan Steel’s PE is well-justified by current earnings growth.

Suppose your assessment of Bogan’s earnings prospects, management and so on, combined with reports from Morningstar, suggest the company will grow its current earnings (5 cents a share) at 15 per cent compound per annum for the next three years.

Assuming its share price stays at $1.00, by the end of year one, its PE will have fallen to 100 cents per share / [5 + (0.15 x 5)] cents per share = 100 / 5.75 = 17.

By the end of year two, its PE will be down to 100 cents per share / [(5 + 0.15 x 5) + (0.15 x 5.75)] = 100 / 6.61 = 15.

By the end of year three, its PE will have fallen to 100 cents per share / [(5 + 0.15 x 5) + (0.15 x 5.75) + (0.15 x 6.61)] = 100 / 7.60 = 13.

Bargain! That’s assuming, remember, that its share price has not changed over the period, even though its earnings are rising. If its share price does stay flat at $1.00, you will be holding Bogan Steel three years later at a much lower PE, having achieved zero capital growth.

If, however, investors feel much the same way about the stock in three years’ time as they do now (investors are, on average, neither more nor less confident about its future), Bogan Steel may preserve its PE of 20 on year-three earnings of 7.6 cents per share.

That gives us two parts of the PE equation.

Now we fill in the third to see what the company’s share price would have grown to:

Price-to-earnings ratio = current share price / earnings per share. So share price = earnings per share x PE ratio = 7.60 x 20 (remember the PE has not changed this time) = $1.52.

Preserving a PE of 20, which indicates that investors are expecting reasonable growth for years four, five and so on), the share price has risen from $1.00 to $1.52, or 52 per cent, in three years.

Chances are that Bogan Steel has also increased its dividend payments pretty much in line with the increase in earnings.

If Bogan pays out 50 per cent of its earnings as dividends, its dividend per share will have increased from 2.5 cents at the start, to 2.9 cents at the end of year one, 3.3 cents in year two, and 3.8 cents in year three – the same 52 per cent increase.

The potential return from Bogan Steel is obviously well above the risk-free rate of return from government bonds, and theoretically well worth the additional risk.

But don’t buy the stock just yet

Ignoring broader market conditions, which no one can confidently predict over a period of three years, the answer to whether to buy depends on two key factors: the alternative opportunities available at the time (can you do even better than Bogan?), and the probability of the company achieving those earnings forecasts.

How likely is it that the company will meet or exceed its earnings growth forecasts? Are those forecasts conservative or aggressive? And how significant are the risks to the outlook implied in those forecasts?

Although 52 per cent growth in share price and dividend over three years is obviously nothing to sneeze at, nor is it the upper limit to the stock’s potential.

Imagine that during the three-year holding period it becomes obvious that Bogan Steel will easily achieve 15 per cent compound earnings growth for three years, followed by 20 per cent compound earnings growth for some time after that. (We are being a little optimistic in this example, of course. In real life, remember, the vast majority of stocks will not do this well.)

There is every chance that other investors will now become much more interested in the stock and push its PE above 20. Investors may in fact decide that Bogan is such a terrific growth story that they are prepared to pay 25 times current earnings, which means the share price after three years will be:

Bogan’s share price = earnings per share x new PE ratio.

Bogan’s price-to-earnings ratio = current share price / earnings per share.

So, Bogan’s share price = earnings per share x PE ratio = 7.60 x 25 (remember the PE has been upgraded) = $1.90.

Checklist

Let’s draw together the threads of this conversation into some more precise guidelines about when to buy a long-term investment stock.

• There is no point buying a stock if you do not expect it to generate an “acceptable” return, which in most cases should be a reasonable premium to the risk-free rate.
• Although PE ratios are a useful starting point for assessing value, share price growth over the long term depends on growth in earnings per share over time. Mathematically speaking, PEs reflect current earnings, and stocks currently trading on high PEs may outperform low-PE stocks if they have superior earnings growth.
• Every decision to buy or not to buy is relative to the alternatives, and you should try to compare one stock’s potential to another’s to gauge the best possible place for your investment.
• Regularly question the resilience of the earnings growth forecasts provided and the likelihood of the company achieving them.
• There is no “best time” to buy a stock because things can change overnight in the markets. If you find a good company trading at a reasonable valuation, there is usually no better time. If you wait for perfect conditions, they may never come.
• Remember to buy stocks that suit your personal investment objectives. Always be clear in your own mind about whether you are looking for a long-term investment or a speculative trade.

About the author

Morningstar is a leading investment research house.

The free ASX online shares course is a great way learn the basics of share investing.

By Michael Kemp, Barefoot Blueprint

No one likes paying tax, so let’s start with a question everyone asks: how much tax do I have to pay on my dividends? The answer lies in knowing how franking credits work. A July 2012 ASX Investor Update article touched on the concept of franking credits and this month we explore the topic further.

Dividends usually represent a partial distribution of company profits – partial because most companies choose to retain a proportion of earnings to reinvest in the business. The tax you pay on your dividends depends on two things: your marginal tax rate and how much tax the company paid before you received the dividend. Here’s an example.

Karen owns shares in a company that has paid a dividend of 70 cents a share. She receives this after tax has been paid by the company at the company rate of 30 per cent. So for every dollar the company pays out, 30 cents goes to the Australian Tax Office (ATO) and 70 cents to shareholders.

To calculate what tax Karen must pay takes three steps.

First, we notionally add back to Karen’s 70-cent dividend the tax already paid by the company (the 30 cents it forwarded to the ATO), which gives a figure of $1, often referred to as the grossed-up amount.

Second, we apply Karen’s rate of personal income tax to the $1 (let’s say 46.5 per cent), so that gives her a tax obligation of 46.5 cents.

Third, the good news. Because the ATO has already received 30 cents from the company, Karen only has to pay 16.5 cents a share. The additional tax paid by Karen represents the difference between the corporate tax rate (30 per cent) and her marginal tax rate (46.5 per cent).

What of shareholders whose marginal tax rate is below the 30 per cent corporate tax rate? The news is even better. They will receive a partial (and in some circumstances total) refund of tax already paid. The ATO will refund the difference between the personal tax rate and the tax already paid by the company.

This process is referred to as dividend imputation, because the word impute means assign. The ATO imputes or assigns the tax already paid (30 cents) so Karen only has to pay the difference (16.5 cents). The term “franking credits” refers specifically to the tax already paid by the company on earnings before they are distributed as dividends.

A company’s franking account

You will hear reference to a company having a franking account. This is not an account containing money, but simply a record of the tax that has already been paid by the company. Some things add to the account, others reduce it.

When the company pays tax or receives a franked distribution from another company in which it has a shareholding, the company’s franking account increases. If the company pays out a franked distribution to its shareholders, it decreases. There are several other reasons why the franking account can decrease; for example, when the company receives a tax refund from the ATO.

When shareholders receive dividends with franking credits attached, these franking credits are paid out of the company’s franking account. And because franking credits are ultimately only of use to shareholders, companies are usually quick to pass them on.

Why some companies pay higher franking credits than others

Dividends are not always fully franked. This can arise when a company does not generate sufficient tax credits; for example, if it earns income overseas or experiences losses rather than gains. Under these circumstances the franking account might be insufficient to pay a fully franked dividend to its shareholders, which means the dividend could be partly franked or it might not be franked at all.

A dividend that has a franking credit attached is referred to as a franked dividend. Dividends with no franking credits are referred to as unfranked dividends. These dividends cannot be grossed-up; hence the tax payable in the shareholder’s hands is calculated by applying the shareholder’s marginal tax rate to the dividend they receive – with no adjustment. Where dividends are partly franked they are grossed-up only by the franked portion.

It is easy to determine the dollar amount of the franking credit attached to any dividend you receive. Companies supply a dividend statement to shareholders and this shows, as a separate item, the amount of the franking credit.

Alternatively you can calculate it yourself, as shown in the following examples.

An example: IAG vs. AMP

Insurance Australia (IAG) and AMP Limited (AMP) are two companies in similar industries but with different levels of franking attached to their dividends.

IAG is a general insurance group with operations in Australia, New Zealand, the United Kingdom and, more recently, Asia. AMP is an Australasian wealth manager and life insurer with core markets in Australia and New Zealand. IAG pays a fully franked dividend; AMP does not. This means neither their dividends nor their dividend yields are directly comparable (unless adjusted for tax differences).

Here is a worked example to show what adjustments you need to make to compare them. Let’s assume your marginal tax rate is 46.5 per cent (including Medicare levy).

IAG’s most recent full-year dividends totalled 17 cents (fully franked), which means after tax you will have received 13 cents. That’s the all-important figure – how much of the dividend actually ends up in your pocket.

To derive this figure first calculate the franking credit attached to the dividend:

Dividend x Corporate Tax Rate
(1 – corp. tax rate) x franking proportion

17 cents x 0.3
   0.7 x 1.0
= 7.286 cents

Grossed-up dividend = 24.286 cents (17 + 7.286).
Now apply your marginal tax rate of 46.5 per cent.
Equals an after-tax return of 13 cents per share.

AMP shareholders received two partly franked dividends in the most recent full operating year. Each dividend was 12.5 cents. One was franked at a rate of 55 per cent, the other at 65 per cent. Using the formula above the attached franking credits per share were:

12.5 cents x 0.3          12.5 cents x 0.3
   0.7 x 0.55           +        0.7 x 0.65
= 17.98 cents

And the final after-tax amount you received was:
23 cents per share.

How to tell if a company is capable of paying higher franking credits

You can determine the franking credits your company has accumulated in its franking account by referring to the company’s most recent financial statements. Look in the notes to the financial statements under the heading “Dividends” (easy to find these days with financial statements on line). Find the annual report on Google and search for “franking credits”. The notes will show the balance of the franking account at balance date (the end of the financial year).

There might be additional information, such as how many franking credits are attached to the income tax payment provided for in the current financial statements; and how much the franking credits balance will be reduced as a result of the dividend declared in association with the reported profit result.

This all goes to show how important it is to check the franking credits attached to any dividends that companies pay, particularly those with overseas operations. If you don’t, you might be comparing oranges with apples.

About the author

Michael Kemp is chief analyst at The Barefoot Blueprint.

From ASX

Dividends has useful information on how ASX-listed companies release dividends.

By Toni Case, TheBull.com.au

These days you only need about $500 and five minutes to create a nicely diversified share portfolio consisting of around 200 stocks. Indeed, one-stop-shop investment products, such as listed investment companies (LICs) and especially exchange-traded funds (ETFs) have been all the rage since the GFC.

The chart below shows the rapid take-up by Australian investors in products such as ETFs. This is hardly surprising when you consider the US experience; exchange-traded products (ETPs) are the goliath of the US investment market, with combined assets of $1.6 trillion in January 2013.

In essence, many investors in the US own ETFs rather than, or in addition to, direct shares; it is easier and takes less time to monitor one stock than a dozen or more, and when the underlying market goes up, broadly diversified ETFs ride the wave.

ETP growth – from January 2007 to January 2013

Source: ASX. (Exchange Traded Products include ETFs, managed funds and structured products).

Beginner investors can use LICs or ETFs as an entry point into the sharemarket. Rather than weighing up the merits of BHP Billiton versus Commonwealth Bank, simply log into your online broker and buy one stock that does the rest of the buying for you.

iShares MSCI Australia 200 (IOZ), for instance, is an ETF that invests in the top 200 Australian companies; incidentally, its top two holdings are BHP and CBA, followed by Westpac, ANZ, NAB and Telstra. As the sharemarket has bounced back, IOZ has netted a return of 18 per cent annualised.

Refine your focus

If 200 stocks is a little too diversified for your liking, iShares S&P/ASX 20 invests in the 20 largest Australian companies by market capitalisation. There is also a high-dividend ETF, and an ETF that invests in 200 companies in the Small Ordinaries Index – such as Australian Infrastructure, Perpetual and Mineral Resources.

You can buy ETFs that focus on stocks in a particular sector such as Financials, Energy, Property Securities, Metals and Mining, Industrials, Resources, and even physical gold.

Despite weak global growth, commodity prices have risen by as much as 150 per cent since the GFC – which partly explains why ETFs specialising in commodities are popular. China’s demand for energy, minerals and grains is growing as the country’s wealth increases; demand for commodity-intensive consumer durables – mobile phones, cars and computers – is rising rapidly.

The chart below shows the percentage growth in oil consumption between 2006 and 2011. As you can see, although oil consumption has fallen in countries with slower growth in Gross Domestic Product, such as in Europe, Japan and the US – growth in China and India have more than compensated for the fall elsewhere.

Growth in oil consumption – from 2006 to 2011

Source: Percentage growth in oil consumption between 2006 and 2011, based on BP’s 2012 Statistical Review of World Energy. Gail Tverberg, OurFiniteWorld.com

The major companies offering ETFs are StateStreet (SPDR), iShares, Vanguard, Australian Index Investments (Aii), BetaShares and Russell Investments. As for the most popular, most investors buy ETFs that broadly invest across Australian shares, followed by ETFs specialising in international shares, then commodity ETFs, strategy-based ETFs (i.e. buy stocks on a “value” investment principle), and Australian sector ETFs.

The top five ETPs by value traded, as at February this year are:

Listed investment companies (LICs)

LICs are a similar investment vehicle – providing a fully-fledged share portfolio with the purchase of a single stock. Unlike ETFs, which tend to track an index or sector closely, LICs tend to be more actively managed. There are LICs that buy Australian shares, and others that specialise in international shares such as Chinese or US, private equity and even global resource stocks.

At present there are 52 LICs and trusts trading on ASX and 90 ETPs, and the list keeps growing. The newest entrant is Naos Emerging Opportunities Company, a LIC that specialises in buying undervalued smaller companies outside the S&P/ASX 100 Accumulation Index. It listed on ASX in February at $1 and currently trades at 94 cents.

Some LICs, such as Argo Investments (ARG), have been listed on the Australian sharemarket since 1946 (distributing dividends every single year). Indeed, there are few companies with such a long trading and dividend history. Argo’s strategy is to buy and hold shares for the long term, rather than trying to get spectacular rewards in the short term from buying high-risk stocks.

The top five LICs by value traded as at March are:

The benefits of buying a ready-made share portfolio using ETFs or LICs is certainly attractive for time-poor investors. But when there are 142 different products to choose from, how do you decide?

The big difference between LICs and ETFs is that LICs are closed-end investment structures (a fixed number of shares are on issue); whereas ETFs are open-ended (new shares can be regularly issued by the ETF provider).

LICs, being closed-ended funds, operate in a similar manner to Telstra or NAB. For example, when you buy shares in the LIC, you are effectively buying the shares from another shareholder. On the other hand, if a large institution wanted to buy $20 million of units in an ETF, the ETF provider can go ahead and issue the units without the share price being affected.

How does this affect you?

In a similar vein to buying Telstra shares – which fluctuate in price according to supply and demand – an LIC may at times trade at a price above what it is worth, and other times lag below the value of its underlying share investments, measured by net tangible assets (NTA).

It is possible, therefore, to buy an LIC at a bargain price – although when it comes to selling you may face the prospect of selling at a loss if the price has dipped in the interim.

ETFs, in contrast, tend to trade around their net tangible assets – meaning in bull markets the price of an individual ETF will advance higher regardless of whether investor demand for the ETF in question is running hot or cold.

At February 2013, LICs including Djerriwarrh Investments, Australian Leaders Fund and Mirrabooka Investments were running at the highest premiums to NTA, one as high as 16 per cent. More than half were trading at discounts one as low as -60 per cent.

As with all investments, be vigilant and pick LICs with independent boards, strong investment credentials and a track record of dividends and performance.

What about cost?

Both LICs and ETFs are considerably cheaper than unlisted managed funds, but ETFs on the whole are a touch cheaper than LICs (largely because of active management of LICs). Management fees for LICs average from 0.13 per cent per annum to 2.7 per cent for the more actively managed. Yearly fees for ETFs range from 0.06 per cent to 1 per cent.

About the author

Toni Case is editor of TheBull.com.au, one of Australia’s leading trading and investing site. Each week TheBull’s free newsletter offers 18 share tips from more than a dozen leading brokers, tailored share portfolios for income and capital growth, plus trading, investing and super strategies.

From ASX

Exchange Traded Products and Listed Investment Companies have useful information on the features, benefits and risks of both products.