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.