This article is taken from sgfunds.com and is written by Wilfred Ling. It gives a very well rounded view and a thorough look at the advantages and the disadvantages of both unit trust and ETF.
Advantages and Disadvantages of Unit Trust
Low sales charge for small investment. Large sales charge for big investment
The sales charge (or sometimes known as “front end load” or “commission”) for purchasing a Unit Trust is typically expressed as a fix percentage. For example, many equity Unit Trust have a sales charge of 2.5% while bonds tend to have a lower sales charge of 1.5%. Therefore, regardless of the amount of investment, the sales charge is always the same in percentage term. Therefore this permits you to invest in very small amount without paying exorbitant sales charge. Initial investment is often $1000 and subsequent is $500 and the sales charge is $25 and $12.5 respectively for 2.5% front end load. The sales charge in absolute amount is small when the investment amount is small. However, the sales charge in absolute dollar is large when the amount of investment is large. For example, if you invest $10,000 and assuming a 2.5% sales charge, the cost to you is $250.
Availability of Automatic Regular Saving Plans
Many distributors permit you to invest in Unit Trust regularly and in both small and large amounts. Better known as Regular Saving Plans (RSPs), such regular investment permits you to take advantage of dollar cost averaging. Many unit trust allow you to invest as low as $100 on a monthly basis. This is an advantage for those who could only accumulate surplus cash incrementally in small amount. Very often, new money comes in as we work. Thus the use of a regular saving plan is a discipline way of investing this new money as soon as it is available for investment.
Exact Investment Amount
When investing in Unit Trust, you know exactly how much you’ll be paying. If you invest in $1000, your payment to the distributors or bank is $1000 net. The same goes with RSPs. If you setup a GIRO to deduct $100 from your saving account to invest in a unit trust every month, an exact $100 will be deducted every month. No more and no less.
Purchase using different source of cash
Besides cash, you can purchase selected Unit Trust using CPF Ordinary Account, Special Account and Special Retirement Scheme (SRS).
Forward Pricing
Most Unit Trust employ forward pricing. By this it means that the day’s Net Asset Value (NAV) is only known in the future. This means that the unit price is unknown to both the investors and fund managers at the time of purchase. This implies that the number of units that you will receive is also not known at the point of purchase. However, the unit price and total units purchased are known a few days after the purchase.
Currency Risk and currency exchange cost
Depending on the investment mandate of a Unit Trust, the fund may invests in shares or bonds which its currencies are not in Singapore dollars. Therefore, those who invest in such Unit Trust will be expose to foreign exchange currency fluctuations that may result in loses (or gains) for the fund.
If the fund is not denominated in Singapore dollar, then any investment using Singapore dollar requires a conversation which also incurs a cost to the investor.
The worst case currency conversion cost occurs when the investor’s home based currency, the fund’s currency denomination and the currency of its underlying shares are all different from each other. For example, the Fidelity Korea fund is denominated in USD. A Singapore resident purchasing this Unit Trust is require to convert from SGD to USD. Cash received by the fund manager is then re-converted to Korean Won in order to purchase Korean stocks.
High annual expense. Costly foreign exchange. Costly cash.
One pitfall with Unit Trust is its high annual expense. Expenses like management fee, Trustee fees, performance fee, brokerage fees, GST, soft dollar commission are expenses charged to the fund and hence paid by the investors. In addition, if the currency held in cash by the fund manager is different from that of the securities he purchase or sell, a foreign currency exchange conversion cost is involved. Therefore, fund managers’ frequent trade may result in significant forex cost. It is typical for an equity fund’s turnover to exceed 100%. This means that shares purchased by the fund manager at the beginning of the year is unlikely to be held at the end of the year because it has already been sold. Such high turnover implies greater brokerage cost and high forex cost due to frequent foreign currency conversions.
Many funds hold significant amount of cash. Often spare cash is needed to meet redemption without the need to sell the fund’s securities. Sometime cash is needed as the fund manager anticipates significant investment opportunities. Other times, cash is held simply because there is no investment opportunity. Whatever the reasons, the presence of cash in a fund could be costly to the investor. As cash does not earn any return, it means this portion of the fund is not invested and hence cannot participate in any market upswing. Besides, management fee has already been paid to the fund manager to invest and not to hold cash (we can put our spare cash in fixed deposits with no management fee)
Dependence on fund manager’s skill. Fear of resignation
The performance of a Unit Trust is highly dependent on the fund manager’ skill. Such a fund relies on the manager’s market timing skill, ability to obtain information that is not available to others so as to enter and exit a particular investment faster then all other competing fund managers. Due to the high dependency on fund manager’s skill, any resignation is of concern. It is being said that if a fund house uses a team-based approach to manage its portfolio, it does not matter if a key staff leaves. However, if most of the team members leave, there goes all synergy that the team had build up over the years. Obviously for such a case, it will take the new team a long time to build up any synergy. Moreover, there is no guarantee that the new team will be as effective as the previous. As we know, this had happened to a fund house, which lost two thirds of its fixed income team and this had caused great distress to many investors.
Tax issues
According to IRAS, with effect from 1 Jan 2004, dividends from Unit Trust are not taxable (excluding distributions out of franked dividends or derived through partnership in Singapore). This is good news. However, this does not mean Unit Trust do not pay tax at all. As most securities are invested in foreign countries, there are tax liabilities paid to foreign governments and of course these are paid by the fund itself and have already been priced into the Net Asset Value (NAV), calculated on a daily basis.
Liquidity Risk
The underlying securities of a Unit Trust are bonds, shares or both. Fund managers face the same kind of liquidity risk as an investor that invests directly with these shares. In the event which the shares stop trading for some reason or are delisted, the fund house will write off these shares as having little or no value. Thus the NAV of the unit trust will drop due to this write off.
In the event of massive redemption by unit holders, cash holdings in the fund may not be sufficient to meet these redemptions. As a result, the fund manager will sell securities to raise cash. However, not all securities can be sold immediately as it depends on market liquidity. In order manage cash flow, many funds have a provision which allow the fund manager to provide partial redemptions spread across a few trading days rather then a lump sum redemption in a single day. What this means to you as an investor is that under market shock conditions, you may not be able to get out of the market fast enough. This is in contrast to holding shares directly, which you may be able to get out of the market faster.
Inferior performance
The most serious disadvantage of an Unit Trust is its poor performance when compared with its own benchmark. In the next few articles, we shall examine the performance of common Unit Trust in greater details.
Advantages and Disadvantages of Index Funds Exchange Trade Fund (ETF)
ETF are traded on the stock exchange like shares. However, the underlying securities of the ETF are basket of shares. ETF fund managers do not trade directly with retail investors. In fact, retail investors trade with fellow investors in the stock exchanges. Should there be a price discrepancy between share price and the Net Asset Value (NAV), institution investors may trade directly with the fund manager so as to use the price differential for a profit. Institution investors trade with the fund managers by using basket of shares in exchange for ETF share. They may also use ETF shares in exchange for the basket of shares. This will deplete or increase the number of ETF shares in the market place and thus influence the demand and supply of the ETF shares thereby narrowing the discrepancy between the ETF share price and the NAV. Due to this arbitrage mechanism, the share price of an ETF is normally very close to the NAV.
For the case of an index fund ETF, the underlying basket of shares are the same as those by its benchmark. An independent company normally decides the composition of the benchmark.
Good for large trade. Not good for small trade. Do not trade frequently
As an ETF is traded like share, any purchase or sales are subjected to a broker fee. Broker fees are normally expressed as a percentage subjected to a minimum charge. For example, lets assume a broker charges US$29 or 0.35% of trading principal whichever is larger. For a small amount of investment this will incur large broker fee. For a US$500 investment, the broker fee is 29/500 = 5.8%. However, for larger amount say US$2000, the broker fee becomes (29/2000 = ) 1.45% which is cheaper then Unit Trust. Of course for even larger amount, you could go down all the way to 0.35%. The larger you invest the cheaper the broker fee. Note that broker fee applies for both buy and sell. Therefore, it is not advisable to trade frequently.
Estimating the optimal amount to trade. Suitable for “buy and hold”
To better estimate the minimum amount of ETF shares you may buy without incurring exorbitant broker fee is to compare with an alternative Unit Trust. If a Unit Trust charges 2.5%, then purchasing an ETF is worth your money when the broker fee is less then 2.5%. Using the above example, if your investment is more then (US$29/(2.5%) = ) US$1160, your broker fee is less then 2.5%. Do remember that selling will also incur a similar broker fee and therefore ETF investing is suitable for those who employ a “buy and hold” philosophy.
Lack of RSP but Internet trading saves the day
Due to the manner which broker fees are structured, dollar cost averaging using small purchases cannot be done like Unit Trust without exorbitant broker fee. Still it is possible for you to employ dollar cost averaging by cumulating your surplus cash in a money market unit trust (normally 0% sales charge) until it reaches a sufficient amount to invest without exorbitant broker fee. However, the disadvantage in this method is that money not invested may lose an opportunity to participate in market upswing and therefore could be costly.
With the exception of Philips’ Share Builders Plan that can be use to purchase STI ETF and other selected shares regularly and automatically, no broker could arrange for an automated investment on ETF on a monthly basis. With the wide spread use of Internet share trading, purchase of any shares is just a matter of clicking a few buttons on the web browser and hence the lack of automated investment facility is not a significant deterrent.
Restricted source of cash for purchasing ETF
Unlike many Unit Trust, foreign listed ETF can only be purchased with cash. The local STI ETF can be purchased using cash, SRS and CPF Ordinary account.
Forex cost due to purchase/sales decreases with less frequent trades
If the ETF is denominated in US dollars, there is a forex cost when you purchase such shares using Singapore dollar currency. Similarly any sale of the share requires a conversation from US dollar back to Singapore dollar and hence this invoke another conversation cost. The forex cost is over and above the broker fee that is already paid. (No forex cost is incured if you are paying or redeeming in US dollars.) Frequent buy/sell trades increases additional forex cost. Therefore the less you trade, the less the forex cost of conversion.
Low expense. Little forex cost incured by the fund. Low/no brokerage fee paid by fund
The main attraction of index fund ETF is its low expense. It is being said that index funds are better then active managed unit trust because of its low expense. Active unit trust has such a high expense that on a long run, the erosion of its fund caused by its expenses becomes highly significant.
Unlike Unit Trust, there is little of forex cost incur by the fund itself because institution investors trade with the fund managers NOT with currency but through an electronic exchange of basket of shares certificates. Any forex cost due to the purchase of foreign shares by the institution investors are paid by them, not by the ETF funds. Similarly there is little brokerage fee charged to the fund because the ETF fund manager does not purchase or sell shares directly with the market.
Unlike Unit Trust counterpart, retail investors trade with fellow investors is independent of the fund manager. The fund manager does not interact with retail investors. Thus the frequent trades by retail investors do not increase the fund’s expenses. In addition, forex conversion cost is not propagated into the fund. This is unlike Unit Trust which multiple conversion cost is propagated to the fund if the Unit Trust’s currency denomination and the underlying shares’ currency are not the same.
Currency Risk (not the same as currency conversion cost)
Similar to the Unit Trust counterpart, investors are exposed to currencies fluctuation risk if the ETF’s underlying shares native currencies are not the same as investor’s own home based currency. Please note that there is a different between foreign exchange conversion cost (mentioned above) and currency risk. Investors are often confused between the two. In addition, any difference in currency between the home based currency and the ETF’s denominated currency is not an additional risk. For example, if an ETF is listed in US dollars but its underlying shares are denominated in Yen, then any depreciation of the US dollar against the Yen will result in an increase in the ETF NAV which is in US dollar assuming all things stay constant. If your home based currency is in Singapore dollar, your currency risk exposure is the SGD/YEN pair and has nothing to do with the US dollar.
But there is a cost involved when converting from your home based currency to the ETF’s denominated currency and vice versa and this happens when you make a purchase or sale.
Watch out for the custodial fees
Many broker impose a custodial fee for holding your foreign shares unless you trade often. Such custodial fees are normally charge as a per counter per month basis and could significantly erode your returns. Fortunately there is still one broker left that does not charge a custodial fee. Custodial fees can be reduced if you hold as few counters as possible. It is possible to construct a globally diversified equity portfolio just with 3 different ETF counters.
Note that Unit Trust does have a “custodial fee” through its annual management fee and expensive expenses.
Low dependence on fund manager. No fear in resignation. Benchmark returns
The fund manager’s duty is to ensure that its shares are of similar composition as its benchmark. Normally the shares composition of a benchmark is determined by an independent company. Therefore the management of the fund is administrative in nature and does not require the employment of top-notch and expensive managers. Due to this reason, there is little fear of any staff resignation. As its obligation is to maintain similar composition as its benchmark, any returns of the ETF will be similar to that of its benchmark.
Tax issues
30% of dividends derived from US listed ETF are taxed by the US government. There is no capital gain tax for non-US residents.
For Singapore’s side, similar to Unit Trust, resident individuals are not required to declare any foreign sourced income, including foreign sourced dividends, received in Singapore on or after 1 Jan 2004 as they are tax exempt. The tax exemption, however does not apply to foreign sourced income received through partnerships in Singapore.
Watch out for Price/NAV deviation
It is important to ensure that the share price of an ETF does not deviate too much from its NAV. Most index fund ETF share price does not deviate too far from its NAV but there are some that is persistently trading at a premium (when share price is above NAV) or at a discount (when share price is below NAV). Investors should avoid such ETF if the share price is persistently far from the NAV. Such a fund could indicate arbitrageurs’ difficulties in taking advantage of the price differential. These difficulties could be due to underlying shares’ liquidity problems.
Liquidity Risk and market shock
As ETF are traded like shares, it faces similar liquidity risk. An ETF that has low trading volume should be avoided since you will have to buy at a higher price or sell at a lower price in such a situation.
During market shock situation, it is possible for the share price of the ETF to deviate away from its NAV because arbitrageurs may face liquidity issues with its underlying securities and hence unable to quickly take advantage of the price differential situation.
Share Price known. No need to wait a few days later. Forex rate adds to excitement
One advantage for an ETF is that its share price is known during the entire market opening hours. This is unlike Unit Trust which its price is only calculated once a day and made known one or two days later (popularly known as “forward pricing”).
Like all shares, you can specify a maximum price which you are willing to buy when making your buy order for an ETF. Similarly you can specify the minimum price which you are willing to sell when making your sell order. However, as most ETF are denominated in US dollars and if you are paying in Singapore dollar, then the actual amount which you will be paying is also dependent on the foreign exchange rate at the time of transaction (which could occur hours or days after your order). This problem does not exist if the settlement currency is the same as that of the share or if your broker is able to freeze the exchange rate at the time of order.
Superior Performance
The most significant advantage of an index fund is its superior performance. Index Funds have superior performance primarily due to its low cost and secondly due to Unit Trusts' own poor performance. In the next few articles, we shall examine the returns of index funds more closely.
Conclusions
There are many advantages and disadvantages in investing in Unit Trust and Exchange Traded Funds. Depending on needs and constraints, Unit Trust may be more suitable for some and ETF may be more suitable for others.
Wilfred Ling is a freelance writer and is an active participant at http://www.sgfunds.com. He can be contacted at wilf_ling@yahoo.com. He is also an independent financial adviser and his website is http://www.wilfredling.com/
Thursday, December 11
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