Most Singaporean investors have heard of unit trusts. How are ETFs similar, and what makes them different?
Before we go deeper, here’s a quick definition of unit trusts and ETFs. A unit trust (also known as a mutual fund) is usually an actively managed investment fund overseen by a fund manager who picks what securities to buy and sell in an attempt to “beat the market”.
An exchange traded fund (ETF) is usually a passively managed index fund that trades on a stock exchange. ETFs replicate the performance of the index they track. In short, they aim to own the market (by holding the same proportion of securities as their index), rather than try to beat the market.
The key similarity is that ETFs and unit trusts can provide investors with exposure to a broad range of asset classes, sectors and even geographies. In this regard, both fund types offer retail investors an easy way to build a diversified portfolio with just a single investment.
Besides the difference in management styles, ETFs and unit trusts differ chiefly in terms of investment cost and performance.
ETFs typically cost less than comparable unit trusts. With unit trusts, you pay more for fund management fees, upfront fees, trail fees and miscellaneous fees such as marketing, administration and audit fees.
Source: MoneySense Singapore and CPF Board
When you buy a unit trust, you normally pay a sales charge on top of the fund management fee. This is deducted from your investment amount. This means if your investment is $10,000 and the sales charge is 2%, your actual amount invested will only be $9,800.
ETFs don’t have sales charges. The fees payable are mainly ETF management fees and commission charges if you purchase them through a broker.
Fees are a key determinant of returns
As Warren Buffett said in his annual letter to Berkshire Hathaway shareholders in 2017, “When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients.”
High fees eat into your returns over time. An important figure to look out for when evaluating fees is a fund’s total expense ratio (TER).
A unit trust typically has TER between 1% and 2.5% of its net asset value (NAV). Passively managed ETFs however have much lower TERs due to their significantly lower operating costs.
For instance, the Straits Times Index ETF (STI ETF) has a TER of 0.3% while the Aberdeen Standard Singapore Equity fund, a unit trust which also benchmarks the STI, has a TER of 1.64%.
A 1% difference in TER may seem minimal initially, but it adds up over time. $100,000 invested at an annual return of 5% will be worth $324,000 after 30 years, assuming a TER of 1%. However, your final investment value drops to just $242,000 if your fund TER is 2%.
Many investors who choose to invest in unit trusts often do so for higher potential returns since actively managed funds often contend that they can beat the benchmark.
The reality however is that active fund managers usually fail to beat their index targets over the long term once costs are factored in. For one, all that buying and selling of stocks as they try to chase the market racks up large transaction costs.
According to the S&P Indices Versus Active (SPIVA) 2019 scorecard, 97% of actively managed large-cap funds have underperformed their benchmarks over the last 10-years. Similarly, 80% and 89% of mid-cap and small-cap funds have underperformed their benchmarks over the past decade.
Moreover, beating the market on a consistent basis is highly unlikely. Active fund managers who outperform one year typically fail to maintain that edge next year.
In contrast, passive investments like ETFs don’t try to pick which stock will perform well. Instead, they invest in all the stocks reflected in their benchmark index. By capturing the market’s return at low cost, ETFs typically outperform their active counterparts over the long haul.
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