Unit Trusts – 80% of Unit Trusts Under-performed the market from May to August 2007

Interestingly enough, an article in The Edge Singapore this weekend (in the pull-out Personal Wealth section) talked about the returns on unit trusts and how they have been battered left, right and centre by the recent market turmoil. Also on Friday, I was having lunch with two friends who expressed their views on the unit trusts market and one of them, incidentally, was heavily vested in unit trusts. I would like to comment on funds in general and also incorporate some of my friend’s personal views on unit trusts and how they have helped her in growing her money.

In the article, nearly 80% of the 700-odd retail investment funds (i.e. mutual funds) have lost money in the past three months up till August 17, 2007 (the day of the big rout and subsequent recovery). That’s about 560 funds in total, no small number by any measure ! The reason for this under-performance can be traced to the fact that during the correction, all asset classes such as equities, bonds, properties and commodities were hit, sparing no one and nothing. Thus, even a well-diversified investor who held on to equity funds, bond funds and real estate funds would be hard-hit. As an example, my friend had a 13% overall gain from her 8 unit trusts before the major correction, but this dropped to as low as 3% (fees inclusive) during the severe correction. Clearly, these funds could not withstand the battering and most were not prepared for this kind of “storm”.

To be fair, to expect mutual funds to consistently out-perform the benchmark index is a little too much to ask. Mutual funds usually show their performance over a stretch of time and this may include periods of under and over-performance; which in the end translate into an average which is then shown to the potential investor. What I would like to add is that funds have a tendency to be a little over-diversified at times, thus eroding any good gains from any particular investment within the fund. After all, owning just 5 excellent companies is much better than 5 out of 30 when the other 25 are just mediocre. But the problem with funds is that the fund manager is forced to (not literally, but in a manner of speaking) make investment decisions on a daily or weekly basis to increase the investment returns for the unit holder. In the end, transaction costs will pile up as the fund manager tries to get into the better investments and bail out of the worse ones. It’s more like fire-fighting in such cases rather than a case of good investment acumen.

Fund managers are trained professionals with a wealth of knowledge in investing, financial products and financial markets. I have the utmost respect for them because after all, it is not easy to handle large sums of money which are not yours and to be accountable to so many people. Herein lies the problem: Warren Buffett mentions that as a fund manager, you are constantly “forced” to make moves in order to grow other peoples’ money; and this is like being a baseball player who is forced to swing at every pitch, even if it’s a bad one. The analogy is apt because in the investment world, there cannot be that many good investments out there for everyone (otherwise, we would ALL be very rich by now). In fact, after doing several months of independent research on the Singapore Stock Exchange, I dare say there are only a handful of truly outstanding companies with capable management, good earnings growth and an endearing product/service. The fact that fund managers have to take action all the time or be labeled as “lazy” or “inefficient” is sad because all it takes is one really good investment to reap all the returns; instead most funds buy/sell constantly (eroding gains through transaction costs) and they also buy/sell into mediocre companies or investment products, further stunting performance. This is why there are only a few truly outstanding funds in this world (which, incidentally, are managed by fund managers who have a value investing mindset).

So I tell my friend: “Why don’t you invest in equities in order to enjoy a higher return ? Fund managers regularly under-perform the index plus you have to pay them an annual management fee even if they fail to perform !” Her reply was that these fund managers “know their stuff” and it was important to “diversify her risk” by investing in a myriad of asset classes. The sad fact is that the entire fund industry likes to convince retail investors that it is difficult and tough to invest on their own and thus the services of such professionals are required. The truth is that even though it is not simple to invest on our own, it is also far from being rocket science ! What most people don’t realize is all it takes is a keen interest in business news, basic accounting knowledge and an understanding of businesses and companies. I have a previous entry on the pros and cons of unit trusts so please refer to that posting for more detail.

For diversification of risk, apparently it also comes with a condition that you also “diversify” your returns ! Wide diversification is necessary if the retail investor does not know what he or she is doing, and even though diversification helps you to “weather” the storm, the flip side is that it cannot guarantee superlative returns. Most of my friends who are heavily into unit trusts report an overall gain of at most 15-20% for their entire portfolio (and that’s for the very outstanding individuals who have picked almost all the out-performing funds). For most value investors who regularly do their homework and research, focusing on just a few excellent companies can help weather storms much better and give much better returns as well.

Note: Kindly feel free to comment on this post as I know the issue is rather contentious (there will be people in strong support of UT, like my friend is). Rather than skew my discussion towards pure equities, I invite views from readers as well.

Also Note: From the feedback of readers, I have organized my blog into sections using labels so that it is easier to navigate and to read up on specific posts (e.g. on Ezra, Swiber or research series). Kindly use the right-hand toolbar called "Categories" to navigate through my blog's older posts. In future, I will "tag" each posting with a label for easier reference. Feel free to leave comments on ANY posting and I will attend to it when I have time.