Saturday, July 07, 2007

Unit Trusts – A Candid Discussion on the Pros and Cons

Unit trusts (also called mutual funds in the USA) consist of a basket of stocks, bonds or other financial securities. These are packaged together according to a theme (e.g. industry theme such as property plays, oil and gas plays) or a country theme such as India, Vietnam or Thailand Fund. Unit trusts are marketed and managed by companies such as Aberdeen, and are also “sold” by banks such as UOB Asset Management. This class of assets allows investors to have an alternative to pure equities, which many may see as being uncertain and volatile.

My post today seeks to explore the pros and the cons of unit trusts, and the place it has among different investment products. First, a disclaimer: Please note that all the following comments are personal and are not meant to encourage or discourage readers from investing in unit trusts. Ultimately, we have to rely on our own research and fact-finding in order to make an informed decision. As investors, we all seek a reasonable rate of return on our investment which is higher than inflation (see previous post on research series part 2). Unit trusts, if chosen properly and correctly, have been known to give steady returns over time plus good dividends to boot.

The pros of unit trusts are as follows:-

1) Unit trusts are able to gain exposure to stocks in countries which may not be accessible to most investors. For example, some unit trusts benchmark against shares in the Shanghai “A” shares market which can traditionally only be traded by Mainland Chinese residents. Also, there is a Lion Capital Vietnam Fund which allows investors to gain exposure to the booming Vietnamese economy, as the fund ties its performance to the performance of the Vietnamese stock market indices.

2) Funds also allow investors access to various classes of securities and financial instruments which normally would not be accessible to the retail investor. Some funds are index funds which benchmark against an index, while others are bond funds which allow investors to invest indirectly in the bond market. There are also funds set up for commodities and other classes of assets such as precious metals; thus investors can choose from a spectrum of asset classes to invest in through funds.

3) One aspect of funds which differ from equities is that funds are managed by professionals with good knowledge of the economy and the market. Thus, investors who feel that they are not sufficiently knowledgeable can simply sit back and rely on their fund managers to show results. Fund managers also take care of all aspects of the fund for investors, including giving advice on investment time horizon as well as expected returns depending on whether investors are aggressive or conservative. In fact, I would say fund managers also have a minor role to play as financial advisor to clueless investors.

4) Funds are well-diversified, meaning that the risk of a very large and sharp decline in the price of the fund is minimized as it usually has a basket of 20 to 50 stocks, or is diversified across several industries or asset classes. This helps to buffer the investor against sudden shocks in the system should they arise. Conversely, this could also act as a con in that superior performance is mitigated because the fund may be too diversified, thus eroding gains.

5) Some funds are also tailored to give investors a stake in private equity firms which are poised to go for listing, or which are generating good returns on their own. Investors can thus invest in unlisted companies whose shares are not freely traded on an exchange.

The cons of unit trusts:-

a) There is no chance for an investor to decide on how to alter the constituents of the fund, as the fund is entirely in the control of the fund manager. This means that the investor has no say to dictate what the fund manager should buy or sell, or even how many times he should buy or sell; as long as the fund manager keeps to the original investment objective. This could create a lot of transaction (frictional) costs which eat away at investment returns.

b) Funds are generally too highly diversified to be able to eke out exceptional gains. When I say exceptional, I mean multi-baggers where the you get to multiply your wealth by 3-4x for example. When investing in equities, this is possible due to the fact that the share price is correlated to the earnings and valuations of the company. For well-performing funds, most of the time I hear of good funds bringing in 40 to 80% gain for investors over a year. While this is considered a good (but not great) return, most of the time it is not consistent as the best-performing fund this year tends to under-perform in future years.

c) The costs of owning a unit trust also serve to eat away the gains. Most fund managers charge a flat 3-5% management fee per annum on the value of the fund irregardless of whether it is doing well or not. This literally means that you still have to pay your fund manager even if he under-performs ! Some funds also have also implemented a performance fee which means the fund manager gets paid additional fees if the fund performs over and above a set criteria. These measures all serve to erode the gains for the investor.

d) Even though the prices of funds are publicly available on websites such as Fundsupermart.com and publications like the Business Times, it somehow still puzzles me that when one sells his unit trust, the transacted price is always 2 working days late. This means that even though you place a sell order today (say, at the spot price of S$1.00), the order only gets executed at the spot price 2 trading days later (which means the transacted price may be higher or lower than S$1.00, or even S$1.00 itself). The point is that one will not know if markets may crash the next day, thus I find this T+2 rule very disturbing and inconvenient for investors. Why is there a need to settle the price only T+2 days later ? For shares, the transacted price is simply the price entered for buy or sell, even though the actual payment or receipt takes place T+3 days later.

Conclusion

The reason why I don’t invest in unit trusts is mainly due to the cons mentioned above. I do not see a need for me to expose myself to other markets when I can make a good return investing in SGX. Furthermore, value investing works better for me as it allows better gains to be obtained through a concentrated portfolio. In addition, I don’t have extra costs such as Management fees and performance fees to erode my gains when I invest in equities. As for researching which company to buy, I use simple industry analysis and financial statement analysis to determine this, as well as a knowledge of business conditions. This approach has worked for me so far, and I am comfortable with it.

Please feel free to post comments on how you feel about unit trusts versus equities. A more balanced view is desired as I know my views are rather biased towards equities.

16 comments:

Aragorn said...

I generally agree with the points mentioned above.

Aragorn said...

With regards to the "management fee", the "3-5%", as mentioned, in your article is on the high side. Actually 1-3% is more common. Many funds charge only 1-2%.

musicwhiz said...

Hi aragorn,

I see, thanks for the info on Management fees, I guess my info must be a little outdated ! 1-2% sounds reasonable, but ultimately the fund has to perform, otherwise I feel as though I am paying for under-performance.

fishman said...

Just to share...

I'm currently fully invested in Unit Trusts for the simple reason of "not doing what I don't know" and "keeping to my circle of competence". Hence I'm willing to accept the cons of UT in return of its pros. But that's the short to mid term plan. Sort of to dip my toes into the market and understand my investment temperment.

Principle here is very simple, the money should start working to ensure it beats inflation while I seek knowledge and build my equity investment know-how for the long term.

Hence UT serves as a good short and mid term role in my investment journey!

musicwhiz said...

Hi fishman,

Hey thanks for the sharing ! I see your point of being invested in unit trusts as you build knowledge about equities. At least the money isn't rotting away in some bank account collecting 0.5% interest per annum. If the fund actually manages to beat inflation consistently, then I would say it's a good fund to be invested in !

What I didn't mention on my blog is that most of my friends who are in unit trusts are female, while most of the males are dabbling in equities (though their investment profile and horizon differ somehwat significantly as well). I wonder if there is a similar gender role to play in determining which asset class to invest in ?

Anyone care to share their thoughts on this too ?

Anonymous said...

UT are not popular with savvy investors here is because of high charges: mgt fees, sale charges etc. In developed countries, these charges are easily halves. Even the "sure-win" index funds have higher charges. However, it seems that funds from SRS or CPF are attracted to UT, not sure if regulations have anything to do with it? Some UT, though few, have beat their benchmark continuously, such as the one managed by Peter Lynch. Thus choosing the correct UT is the Key.

Anonymous said...

Reason there is 1 T+2 is becoz each unit trust's protfolio consist of alot of equities and there's also a cash component which all unit trust will hold. At the end of every trading day, the price of the fund will be tabulated by taking into account the prices of the entire portfolio and this happens on T+1. normally on t+1 evening after trading hours, the new price is already available. That explain the T+2 pricing.

musicwhiz said...

Hi,

Thanks for explaining the T+2. Helps to clear up a bit of the mystery, but I still think it's a rather inconvenient point for investors who may be getting a worse deal because of this rule.

Just wondering if there was any way that things could be sped up to at least make it T+1, so as not to disadvantage investors too much.

beano said...

Hi musicwhiz,

With regards to the fund prices, it is technically possible to have "live" prices for funds but the infrastructure to do this may be too expensive. Imagine you will need a system which is able to track all the movements of the securities the fund has a stake in and revalue it in its accounting system at real time. the amount of computing power required is huge. Such costs will ultimately be passed on to unitholders.

I used to work with UTs, the following are my peeves on UTs.

If u read the UT's mandate, there is usually a clause to exempt the fund manager from any liability from negligence of its employees. Which to me is utter nonsense because here we are paying the fund manager a management fee and we have to agree to exempt the fund manager from negligent acts.

Upfront charges, although these have reduced significantly (Fundsupermart and Philip Securities have upfront charges between 1-2%) it still irks me when some bank staff or financial planner promote UTs and charge a ridiculous 3-5% upfront fee.

Soft commissions, the fund manager will get a cut of the brokerage fee charged by the broker to the UT. (Note: This practice may be stopped now.)

Numerous costs incurred in implementing checks and balances. To ensure the fund manager is complying with the mandate, a custodian(usually another financial institution) has to be engaged. The custodian is the "gatekeeper" of the fund. All deposits and withdrawals have to be approved by the custodian. A separate entity called a fund administrator also has to be engaged to keep the books and compute the unit value.
Now all these parties do not perform the service for free, the fund is charged based on a percentage of the value of the fund subject to a minimum fee per year.

The above information may be outdated due to changes in the industry as i have no contacts with it for the past 5 yrs. I stan to be corrected..

musicwhiz said...

Hi Beano,

Thanks so much for sharing your insights on UT. I did learn a lot more now on how the fees work and how these fees can seriously add up to reduce returns for the average investor. If you look at it, equities is much "simpler" in that it does not involve complex NAV computations, does not require a custodian, and has no management or performance fee required. Also, the only person you can blame is yourself if you screw up in equities, but blaming the fund manager won't do much good as he is acting in his own interests as well as yours (not entirely altruistic if you know what I mean).

Keep your comments coming ! Cheers !

Anonymous said...

Thanks for the useful info. I just have a question, if I switch more often will I be able to get better returns?

I had a debate with one of my financial advisor who claims that it is possible but must time it well. he mentioned the study in this website:

http://www.freewebs.com/positivefeedbackinvesting/strategyperformance.htm

What is your opinion on this? thanks.

musicwhiz said...

Hi Anonymous,

Sorry for the later reply as I usually don't "flip" back to older posts to check for more comments. My apologies.

I think the way studies go, there are alway some examples of people who succeed in certain strategies. However, as you said, timing is important and I personally don't believe much in timing the markets. Thus, I won't recommend it. But perhaps there are others out there who have tried it and succeeded.

Cheers....

mooncake said...

Hi, egg-yolk lover
Thanks for taking the trouble to update your blog and to include detailed info about co etc.

I'm new and have been reading up on shares only recently. I have been buying UT for several years now. I never thought of buying shares as they seemed a closed book to me with all their charts and graphs, and I knew there are many people who lost lots of money during market crashes.

With the bank interests so low, I decided to buy some unit trusts from a very 'on' officer from a local bank with good reputation. He would switch funds, depending on the performance. Most funds yielded higher than 20%. This may be a very low figure for those into equities, but I was very happy as it was much higher than bank interests.

It's not like what a reader said--that people who buy UT are lazy people. Why would people not want to invest in shares if they knew it could bring high returns? It's because they don't know how to and they are just afraid of having their hard-earned savings wiped out with a sweep. They'd rather earn less and pay some fund manager who at least are greater experts than they.

In February I bought some UT that was launched Sept 06. Within 1 year, it had grown 30%. But because I bought in Feb and because of the sales charge, for me it grew only about 10%. At the same time, the market was still reeling from the subprime crisis and shares were cheap. That's why I decided to redeem my UT last month.

I didn't know what shares to buy so I bought some from a co in which my unit trust has invested.
I'm learning more about the stock market, but recently, I bought a smaller amount of Fidelity China Focus that has grown 60% in 6 months. This is because, at this stage, I may make some drastic investing mistakes.

As to your comment about more women in UT than men--I think that's because buying shares requires technical skills, so many women don't even think of buying shares themselves. But I know many men who also think the stock market is tough.

I tried reading some articles but they were very technical. Then I discovered Kleer's Stock Alerts section. A newbie can only look for cheap recommendations!

Until I came across an American investing column for women. The writer uses simple language and humourous eg, and simplifies the technical stuff. I've never looked back eversince.

I don't know why broker houses are not trying to target at the women's market. The potential is huge!

Thanks for reading my super-long post! By the way, I've also emailed your blog to a lady friend.

musicwhiz said...

Hi mooncake,

Nice of you to drop by and leave such a long comment. A joy to read about what you think of UT and how you started your investing journey. And, thanks too for visiting my blog and recommending it !

To keep it short, I feel that people are intimidated by shares and think they are complex things when they actually represent just onwership of a company. You do NOT need charts, diagrams and complex data to do proper research into a company; all you need are ratios and some numbers (see my Research Series). The "Buy and Hold" is more effective than trading all the time because of transaction costs, and because many of us do not have the time and energy to monitor markets.

As to your UT experience, I think it is common to see good gains eroded by Management Fees and sales charges. That's why I avoid UT. Fund Manaagers do not always have YOUR wealth in mind; it's more like they are trying to attract as much funds as possible to make money for THEMSELVES. Hard to know the truth, but there it is !

Kleer has a good blog indeed but I think he mainly focuses on IPOs and stock alerts. It's a good read for beginners and I would encourage you to visit there too to learn about how "analysts" write about the stock market and the economy (and how they can be so dreadfully wrong sometimes !).

I would presume you are a lady then ? It's rare to find ladies who are into investing; most of my friends who are female are more into speculating and trading.

Regards, Musicwhiz

Ginger Cat said...

The problem with equities is that it has a low barrier to entry, so anyone who fancies themselves a market expert can go in and treat it like a casino. Thus is it surprising that we hear of devastating losses?

I started out investing in unit trusts. Later on I moved to equities. One key difference besides the passive-active aproach is the level of analysis. Direct equities investing is usually bottom up - you analyse the company's strengths and weaknesses, its competitors and the industry. Unit trust investing is very top-down. You look at global trends, macro market cycles and the broader economy instead of individual companies.

UT investing can be profitable. I would say that multi-bagging UTs are also possible, as common as multi-bagging stocks. I have invested in some profitably. WIth UTs, it is timing that is also important - buy and hold gives poor results because over the long term the results are average. My forays into the following UT sectors over the past 8-9 years have given annualised returns of over 100%: Technology (in and out in 6 mths with 70% profit); Singapore; China. Of course I also made losses in other areas, but my point is that the diversification over 30+ companies doesn't stop UTs from multi-bagging.

musicwhiz said...

Hi ginger cat,

Thanks for the insights, I learnt something from your comments. :)

I must say your UT performance is very impressive indeed ! Some of my friends have not managed very good returns (after fees) at all; but maybe it's because they have not done their research and "paid their dues" ?

Personally, I still think it is harder for a UT with 30 companies to multi-bag due to the diversification. It is easier (for me at least) to identify one company which is going to multi-bag rather than a fund of 30 companies because I will have questions about all 30 ! Perhaps I should just trust the fund manager instead of being so troublesome as to question each company within the fund, but that's my nature - I like to know what I am investing in. Perhaps for this reason, I am not too suitable for UT.

To each his own. I wish you success if getting more multi-baggers from UT !

Regards,
Musicwhiz