ETFs vs Unit Trusts: Which is better?

There is a multitude of investment products readily available to retail investors such as you and I today, ranging from financial assets such as stocks and bonds to physical assets such as property and commodities like gold and platinum.

However, there is a certain amount of complexity that is associated with investments, and many who do not have any financial knowledge or experience might lack the confidence to begin investing.

If you are someone who does not know much about investments, does it mean that you shouldn’t be investing?

No!

Fortunately, there exist a sub-class of investments called Collective Investment Schemes (CIS), such as ETFs and Unit Trusts, which make it easier for beginner investors to begin investing.

Rather than personally investing in a variety of securities directly through a broker, a CIS does all the financial analysis and management to create a portfolio that is available to investors to invest in.

Risks

Before diving deeper into choosing between ETFs and Unit Trusts works, we should understand why choose a Collective Investment Scheme in the first place?

As the saying goes, the higher the risk, the higher the return. As such, one would only reasonably take up riskier investments if they have the potential to generate higher returns.

However, to the layperson that is unable to decipher complex financial statements and economic jargon, distinguishing the risk a certain investment is associated with may not be possible.

For those seeking modest returns with a tolerable level of risk, lowering of risk can be achieved via diversification, which simply means to avoid “putting all your eggs in one basket”.

To achieve diversification, professional portfolio managers will assess different asset classes and allocate them in such a way that avoids exposure to any single asset.

However, this often requires skill and larger capital outlays in order to create a diversified investment portfolio.

Collective Investment Schemes (CIS) were therefore created to tackle these problems.

More on Collective Investment Schemes

Exchange-Traded Funds (ETFs) and Unit Trusts (Mutual Funds) are both examples of a CIS, as money is pooled together from a number of investors into a portfolio that is professionally managed by investment companies.

This money is held in trust by an independent trustee for the purpose of investment under a professional fund manager.

The trustee simply safeguards the funds of the investors to ensure that the fund manager carries out their role based on the fund’s objectives.

Benefits of a CIS:

– Investments are managed by a professional fund manager.

– Diversification of assets reduces concentration risk.

– Different types of funds allow for a wide variety of CIS with different objectives.

Shortfalls of a CIS:

– Investment decisions are made solely by the fund manager. Individual investors have no say.

– Multiple layers of fees lower the investor’s real returns.

Unit Trusts

 In Singapore, the most common type of CIS is Unit Trusts. In other countries, unit trusts are known as mutual funds.

The money from investors is pooled together in a Unit Trust, with the fund manager using the pooled money to invest in a variety of assets based on the fund’s investment objectives.

The investment objectives of the fund, together with the management charges and rules are written out in an agreement called a trust deed.

Types of Unit Trusts

There are many different types of Unit Trusts available, that comprises of different kinds of assets.

Each type of fund has different financial objectives and will cater to various types of investors.

Eg:

Equity Risk Type of Fund
Low Cash Fund
Low-Medium Bond Fund
Medium Balanced Fund (Equity bond mix)
High Equity Fund

To determine the type of Unit Trust fund, investors should look to a document called the Prospectus, which outlines the objectives, focus, performance and fees of the Unit Trust.

Buying into unit trusts

The total value of a Unit Trust is known as the Net Asset Value (NAV), which is the value of the UT’s (Assets-Liabilities). The fund can be divided into units, which refer to equal portions of the fund. For instance, for a 20-million-dollar fund which issues 20 million units, each unit will be worth $1.

Often, Unit Trusts are front-end load funds, which means that the fund is sold to investors at the NAV together with an initial sales charge. This initial sales charge is the commission for the brokerage distributing the Unit Trust and can be up to 5% of the NAV.

Often, this is hidden in something called the bid-offer spread.

– Bid price = Prices that investors sell their units
– Offer price = Prices that investors pay for their units
– Bid-Offer spread = Difference in Bid and Offer prices.

With a 5% initial sales charge to buy into the fund, the offer price would be $1.05 if the bid price was $1.00—which gives rise to a spread of 5%.

Thus, if you initially spent $1000 to buy into the fund, you would only receive $1000/1.05 = 952.38 units.

On top of the initial sales charge, there are other charges such as annual management fees, trustee fees and other administrative fees that may add up to an additional 2-3%.

Thus, if you had added up all the fees, you would have spent up to 8% of your initial capital on fees alone! Thus, even if your fund returned 5% on the first year, you would still be down 3%.

Therefore, buying into Unit Trusts are usually a mid to long-term commitment, as in the short run, you would lose out to the fees and charges alone.

When you do decide to redeem (sell) your units, there is another fee called the redemption fee, however, this is often waived after a period of time, as its purpose is to discourage the sale of units shortly after buying them, in effect reducing short-term price volatility.

Exchange-Traded Funds

Unlike Unit Trusts which do trade on an exchange, ETFs are traded on a stock exchange like ordinary equities and bonds.

While Unit Trust comprises of various financial assets to meet the objectives of the fund, an ETF usually comprises of assets that enable the ETF to track a specific Index or specific industrial sectors.

For instance, the S&P500 SPDR tracks the S&P500, and the SPDR STI tracks the performances of the Singapore Straight Times Index.

Tracking of Indexes

Given that the purpose of an ETF is to track the performance of an index, how precise it is will depend on a metric called the tracking error.

The tracking error is simply the deviation between the actual performance of the index and the performance of the ETF. Given various constraints, it is difficult for an ETF to track the respective index 100%.

Reducing the tracking error, therefore, increases the precision of the ETF to the underlying index.

Buying into ETFs

Similar to Unit Trusts, the NAV represents the total value of assets of the fund minus its liabilities.

Given that ETFs are traded on an exchange, units can readily be bought and sold by individual investors during trading hours. For Unit Trusts on the other hand, there will be a delay during unit redemption, as units can only be redeemed by the fund manager at closing.

ETFs also work based on bid and ask prices; however, the spread is often smaller than that of Unit Trusts.

This is because ETFs aim to reduce the expenses and commissions compared to a Unit Trust. Initial commissions, annual fees and management fees are lower than its unit trusts counterparts.

This is possible as ETF’s are passively managed while Unit Trusts are actively managed.

What this means is that for ETFs, there is no investment team making management and investment decisions. Thus, lesser commissions can be charged. The main fees are simply brokerage fees based on the brokerage you use to access the exchange.

This is the main appeal of ETF Index Funds over Unit Trusts, as the amount of fees saved is significant.

Comparison between ETF and Unit Trust

ETF Unit Trust
Differences
Lower fees ( 1% <) Higher fees ( > 5%)
Passively managed Actively managed
Similarities

Diversification of assets

Regular Savings Plans Available

Small Capital Outlay

At the end of the day, the ETFs and Unit Trusts are both medium to long term investment products that you can utilize to grow your money to meet your financial objectives.

Compared to picking individual company stocks on your own and managing your portfolio, buying into CIS will be beneficial to you if you don’t have the time to manage your investments actively.

Personally, I prefer passively managed ETFs that tracks indexes over an actively managed Unit Trust.

This is because I believe that the additional fees associated with active management are simply not worth it.

Moreover, my financial objectives are simply to grow my money in a steady and low-risk way. However, if you are looking for higher returns some actively managed Unit Trusts offer, then perhaps you would prefer investing in Unit Trusts.

At the end of the day everyone’s financial objectives differ, and the decision comes down to your own research and analysis!

Disclaimer: All investment opinions made in this article are based on personal experiences and are meant for informational purposes only. As such, information from this article shall not be taken as investment advice, nor is not a substitute for financial advice provided by a professional. While we strive to provide accurate and up to date information, by engaging in investments, it will be at your own risk.

 

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