[Editor’s Note: Do not read the following information as an investment strategy for new investors or a recommendation to use direct shares, exchange traded funds or listed investment companies. All investment products have potential benefits and risks. Do further research of your own or talk to a licensed financial adviser before acting on themes in this article.]
 

A young couple wants to invest in the sharemarket for the first time. Their goal: to build an investment portfolio over the next five years and use it as a house deposit.

After saving hard, the couple has $20,000 to invest. They don’t have a financial adviser or stockbroker and plan to invest the money themselves. 

So, what should they buy on ASX?

Another important question is: how should they buy? Should they use direct shares, an Exchange Traded Fund (ETF), a Listed Investment Company (LIC) or a combination?

Direct shares means buying shares in a listed company. If you’ve bought or sold shares in an ASX-listed bank, miner or another listed company, you’ve invested directly. 

An ASX-quoted ETF typically seeks to track the performance of an Australian or international equity index, currency, commodity or other assets. Investors mostly use ETFs to achieve the return of an underlying index through a diversified portfolio of securities.

An LIC is an ASX-listed company that manages a fund of shares or other assets. Unlike ETFs that usually aim to provide an index return, LIC managers aim to outperform the benchmark index against which their fund is compared.

The ASX website has information on the features, benefits and risks of shares, ETFs and LICs.  There are also free ASX online courses to help investors, particularly those new to the sharemarket, understand the different investments. The ASX Sharemarket Game is another way to learn about the market through simulated trading.

But back to that question: How should the young couple invest their $20,000?

The answer is “it depends”. Although that seems like a cop-out, it’s not. Every investor is different. The young couple should tailor an investment strategy to their needs. 

That’s why it’s good idea to seek financial advice early in your investing journey. An adviser at a wealth-management firm, bank or through some superannuation funds, could help the couple understand their investment needs now and in the future. 

Their adviser could set things up correctly at the start for the couple; build and maintain a portfolio tailored to the couple’s needs; and advise on whether to use shares, ETF, LICs or other products. 
 

Going it alone

For now, the young couple in this hypothetical example decides to invest their $20,000 on their own. Like many new investors, they grapple with what to buy.

The couple feels they must choose either shares or an ETF or an LIC. However, rather than think about investment products in black-and-white terms, they should recongise that different products can potentially serve different goals in a portfolio. 

That’s not always obvious. Understandably, product issuers often promote their investment style at the expense of others. An active fund manager might promote the merits of LICs and highlight challenges with ETFs. Meanwhile, an ETF issuer might promote the benefits of index investing and the potential challenges of active investing or buying shares. 

Clearly, the couple above would benefit from independent financial advice that is genuinely product agnostic and chooses the best investment tool for their needs. 
 

Getting started

[Editor’s note: Do not read the following information as a strategy for new investors or a recommendation to invest in ETFs. The hypothetical example in this article is purely for educational purposes. Like all investment products, ETFs have risks, including company, market and currency risk, depending on the ETF chosen]. 
 

After learning about market basics through ASX online courses, the couple invests their $20,000 in an LIC and ETF. They put half in an LIC that invests in some of the top 200 Australian shares (by market capitalisation) and half in an ASX-quoted ETF over international shares. In doing so, their $20,000 investment is exposed to more than 1,500 Australian and international companies [1].

The couple chose funds instead of direct shares for a few reasons. The first was diversification. With $20,000 to invest, they could only buy a handful of ASX-listed companies (due to brokerage costs). That wasn’t enough diversification. They also don’t know enough yet about individual shares to feel confident choosing them.

Over the next few years, the couple adds an ETF that holds technology shares to their portfolio. As their savings grow, they buy shares directly in three ASX-listed companies they believe have good long-term prospects, and plan to add more.

Without realising it, the couple is starting to sketch out a core/satellite portfolio strategy. Most of their investment is in a lower-fee ETF that provides an index return and in a lower-fee LIC that has active management (the portfolio core). Then, they have a thematic ETF (in tech stocks) and some shares that they believe can outperform (the portfolio satellites). 

In this example, they are using a combination of investments to achieve their goals (and being mindful of any stock duplication). Their portfolio also has a combination of investment styles: active management (the LIC and shares) and passive management (the ETFs).  That further aids diversification.

The couple’s portfolio is invested entirely in equities (they also have some savings in a cash account). Over time, they plan to add fixed interest and other asset classes to improve their long-term portfolio diversification. 

For now, they want more exposure to growth assets, to build their house deposit. Due to their age and employment status, they are able to take more calculated investment risks – and recover from the odd setback. They believe it will take at least five years to build a decent house deposit, so they have a longer time frame to invest. 

They also plan to seek financial advice as their portfolio takes shape and as they become more confident about sharemarket investing. 

Here’s a few other things the couple might have considered when choosing between direct shares, ETFs and LICs. More comprehensive information is available here. 
 

Direct shares 

• Pros: Investing directly in ASX-listed shares can potentially provide higher returns - if your view is correct. Unlike investing in a fund where you get a return based on lots of securities, investing directly allows you pinpoint stocks that you favour. Investing directly also provides more control. You can buy or sell as you choose rather than rely on a fund manager to make decisions. Also, there’s no annual fees with direct shares (the main cost is brokerage).
  
  
• Cons: Two key issues are diversification and risk. Holding a small number of shares directly, particularly if they are concentrated in certain sectors, may reduce portfolio diversification. There is more concentrated company risk if you have a small portfolio of shares, compared to holding dozens or hundreds of companies through a fund. Your losses could be larger if your view is wrong. Direct share investing also involves a lot more paperwork and monitoring.

ETFs

• Pros: The main features of ETFs are diversification, index returns (depending on the ETF), lower fees, simplicity and transparency. Investing in an ETF usually means gaining exposure to hundreds of securities in that fund, thus providing instant diversification. Many investors are happy with the index return, knowing that the majority of active managers underperform their index over long periods [2].  ETF fees, on average, are lower than active funds. Also, ETFs are bought and sold on ASX like shares, making them convenient to use. ETFs are more transparent than unlisted funds: investors know exactly what the ETF holds and its real-time price.
  
  
• Cons: The main one is index or “passive” investing. The majority of ETFs aim to provide a similar return to an underlying index, positive or negative. Unlike actively managed funds, index tracking ETFs don’t aim to outperform their index (some smart-beta ETFs and active exchange traded products have forms of active management). Exposure to an index through an ETF means exposure to company winners and losers. In a market downturn, the index (and ETF) could potentially have a negative return. Unlike actively managed funds, an ETF doesn’t have a fund manager trying to preserve your capital if the market falls or an investment sours.

LICs

• Pros: The main benefit is the company structure of LICs. As an ASX-listed company, LICs have a board, governance and shareholders. When you invest in an LIC, you are buying shares in that LIC, not units in the fund it manages. Due to their company structure, some LICs can potentially smooth dividend flows and franking (through their retained earnings) over longer periods. That is not true of all LICs (dividends can also fall or be deferred), but some income investors use LICs for their franked dividends, which might be paid quarterly.
  
  
• Cons: The main downside is discounts to Net Tangible Assets (NTA). As a close-ended fund, an LIC can trade at a price different to the value of its underlying portfolio. For example, an LIC portfolio (NTA) might be worth $1 a share. But the LIC’s share price is 90 cents. Thus, the LIC trades at a 10% discount to its underlying value because the market is concerned about the LIC’s manager’s performance, dividend outlook or other factors. Low share liquidity in the LIC or its underlying portfolio could also affect the size of the discount. Persistently large discounts to NTA are a problem for LIC shareholders and LIC managers. Conversely, some LICs trade at premiums to NTA because the market is willing to pay more for their shares than the value of the LIC’s underlying portfolio. LIC premiums/discounts can be an investment threat or opportunity, depending on your perspective. But they add a consideration not apparent in ETFs or other open-ended funds that trade at or near their NTA. 

-----------------------

[1] The couple chose an ETF over the MSCI Index International Shares Index, which has 1,500 company constituents. The number of shares held in their Australian LIC is unknown.

[2] S&P Global (2023), “SPIVA Australia Year-End 2022”. 13 March 2023.