VAS vs AFI: Which is right for your portfolio?
We explore the key differences between exchange-traded funds and listed-investment companies.
At first glance, Vanguard Australian Shares Index ETF (VAS) and Australian Foundation Investment Co (AFI) are remarkably similar. They're both listed on the ASX. They both offer investors exposure to a diversified portfolio of large Australian companies. And they both charge rock-bottom management fees. However, there are key differences investors need to know before they invest.
To help you make more informed decisions, let’s examine how these two investments invest your money.
Key comparison information
Source: Morningstar. AFI Portfolio Date: Mar 31, 2021 VAS Portfolio Date: Jul 31, 2021
Structure
VAS
Vanguard Australian Shares Index ETF (VAS) is an exchange-traded fund (ETF). ETFs are listed funds that own a basket of assets like stocks, bonds and commodities. In it, investors pool their money with lots of other investors, in exchange for fund units that represent the assets chosen by the manager.
ETF are open-ended. This means they're always open to daily inflows and outflows. Practically, this means that if an investor wants to leave the fund, the manager may be forced to liquidate some assets to finance the redemption.
AFI
Australian Foundation Investment Co (AFI) is a listed investment company, not a fund. When investors purchase AFI, they are buying shares in a listed company whose business it is to invest in a range of other companies (and other assets).
LICs are closed-ended. When an asset manager creates a LIC, they raise capital via an initial product offering (IPO). When the IPO is fully subscribed, they list the company on the ASX and issue shares to the participants.
The funds are “captive” in the sense that they are closed-in for the manager to invest and cannot be redeemed by investors. For investors who didn't participate in the IPO, they can buy and trade shares in the LIC with other market participants on the ASX. Investors who want to get out must find someone else to buy their shares.
Management style
VAS
Most ETFs passively track the performance of an index. Managers who oversee passive ETFs are hands-off, simply ensuring that their ETFs track their designated indices. ETF investors won't outperform the index, nor will they underperform it (before fees). They will receive the average return. As such, investors should understand the index, its methodology, and the companies, countries and sectors it’s invested in.
VAS tracks the S&P/ASX 300 Accumulation Index, which includes the 300 largest Australian listed companies (by market capitalisation—share price multiplied by the number of shares outstanding). VAS holders are indirectly investing in those companies, weighted according to size.
AFI
AFI is actively managed. This means an investment team is responsible for selecting and managing the company's investments. Investors are betting that team can beat the index and so should be comfortable with the company’s investment philosophy and management team. For this, we turn to Morningstar's manager research team:
"David Grace leads this strategy, and established CEO and CIO Mark Freeman and small-cap leader Kieran Kennedy are important figures," says Tim Wong, Director, Manager Research, Morningstar Australasia says.
"AFI's process has a value and quality orientation. The strategy seeks stocks with superior value and long-term sustainable earnings growth.
“The bottom-up approach incorporates traditional valuation metrics such as price/earnings multiples and dividend yield, as well as a qualitative assessment of balance-sheet, management-strength, and business-strategy soundness."
Portfolio
Where VAS investors are buying into the bank and resource-heavy ASX 300, AFI distinguishes itself with a smaller portfolio and a quality bias.
VAS
While the S&P/ASX 300 Index is dominated by giant- and large-cap companies, it also has exposure to small caps, with an approximate weighting of 7.5%. The portfolio is top-heavy, with about 29% of the index in the top five companies.
Financial services and basic materials—banks and miners—make up X% of the portfolio. The technology and healthcare stocks that dominate the global stage are underrepresented in the Australian market. Technology and to a lesser extent healthcare (thanks to the share price rise of CSL) only make up around 17% of the index—a lower proportion than the equivalent US and European indexes.
AFI
AFI's buy-and-hold approach favours companies with higher levels of franked dividends and taxes are a major factor behind investment decisions. Trading is consequently limited, and AFI's conservative and valuation-sensitive roots refrain from more speculative businesses.
AFI's current portfolio has a somewhat higher allocation to larger companies than VAS. More than 86% of the portfolio is in large or giant-cap stocks like Commonwealth Bank, CSL and Wesfarmers. Australian companies dominate (86.49%), but six months ago the company decided to put a small portion of the portfolio in international equities – US (4.15%), NZ (6.03%), Switzerland (2.2%) and Papua New Guinea (0.91%).
"We've employed some additional fund managers to help us to test the waters around process and back-office procedures," AFIC general manager Geoff Driver told Morningstar.
"This has worked well for us and we’d hope down the track to launch a low cost, tax-aware LIC for international equities."
Concentration is similarly skewed to the financial services sector, which makes up 29% of the portfolio. Compared to the S&P/ASX 200 index, the fund is overweight industrials and healthcare.
The portfolio has been reducing its holdings, from 103 in mid-2016 to around 62 holdings today. Driver told Morningstar that the board has made the decision to "go up the quality curve in these difficult times". "We want to put money behind our best ideas rather than play around the edges," he said.
Premiums and discounts
VAS
The share price for an ETF is based on the net asset value (or NAV) of the underlying assets. Its value is determined intraday by dividing its total assets by the number of units on issue. An ETF typically trades at prices that match this NAV closely. ETFs can trade at prices outside the NAV. However, these variations are usually minor and short-lived because they create arbitrage opportunities for institutional market participants. You can view VAS's NAV and its estimated intraday NAV on Morningstar or the issuers website.
AFI
As LICs are closed-ended, the number of shares is fixed. When there is an imbalance between demand and supply, the share price may trade at a premium or discount to the NAV. If you buy at a premium, you may be overpaying for those assets, while selling at a discount means you might not be getting the best price.
The LIC board may implement measures to close these gaps, such as share buybacks, rights issues, increased marketing efforts, or in extreme cases, winding up the LIC.
Morningstar's Wong says AFI’s heft ($ 8.8 billion at 31 May 2021) helps with secondary market liquidity, though it has still traded at substantial premiums or discounts to net tangible assets over time, depending on underlying market sentiment. AFI traded at a modest premium at the time of writing (mid-2021).
Australian Foundation InvesCo Ord AFI
Source: Morningstar Premium
Dividends and distributions
VAS
ETFs are tax-transparent and must pass on any income, either dividends or realised gains, within the financial year it is earned. The end investor is then liable for any taxation at their marginal tax rate. This may result in a difficult to predict income stream. But the biggest advantage is the investor is likely to be eligible for the discounted capital gains tax concession on assets held longer than 12 months.
AFI
LICs pay the company tax rate of 30 per cent on dividends and realised capital gains. The board can keep profits in reserve and choose how much to distribute as dividends out of its after-tax profit to shareholders. This structure is particularly beneficial to investors in pension phase for two reasons:
- If a LIC can generate consistently strong investment returns it can retain a portion of profits each year which can be paid out in future years. The smooth income stream helps those in retirement. Since 2010, regulatory changes mean that LICs can pay a dividend even when they post a loss.
- Income distributed to shareholders can be franked because it is subject to tax before it is distributed. Therefore, shareholders may be entitled to a credit for the tax the company has paid. For individuals with a marginal tax rate of zero, they can receive the credit in a cash refund.
Investors should study a LIC’s board and what their policy and history are regarding distributions. It’s also important to look at the LIC’s operating cost. The older ones, like AFI, tend to have lower operating costs so most of the dividends are passed onto shareholders.
AFI is a capital account LIC—also known as ‘Buy and Hold’ LICs. These types of trusts are low turnover and trade rarely. Capital gains from these LICs are eligible for the CGT discount. Capital account LICs generally pay fully franked dividends by passing on the franking credits received from their underlying investments.
