If you are planning to invest, you may puzzle yourself with various investing leaflets in front of your table. Two terms about investment tools always pop up on computer screens or investment brochures: the ETF and Unit Trust.
These popular tools group investors’ money in one place and invest. They invest in stocks, bonds, and other assets. The profits earned by these investment tools pass out to investors at the end.
Indeed, you should examine the differences I shall outline in the following between these two investment tools. Having understood these pros and cons, you may know more about the right choice for you.
What are the key differences between ETFs and Unit Trusts?
- Exchange-Traded-Funds(ETF) are pools of investments mimicking indexes, like the S&P 500 or STI. ETFs also buy securities covered by indexes in specialized sectors, e.g., technology, commodities, energy, and healthcare. Besides, investors can pick ETFs based on geographics like US, European markets, and South East Asia; sectors like staples and non-staples; and asset classes, for example, stocks, bonds, alternative investments to your preferences.
- Unit trusts, like mutual funds, are trusts established to hold specified assets for investments, and the trustee appoints a fund manager to carry out the investing activities. The asset classes are also stocks, bonds, and other high-risk assets. Like ETFs, unit trusts can invest in different markets, asset classes based on their investment objectives.
The following table summarizes the differences between ETFs and Unit Trusts:
|Expense ratios||0.05%-0.7%||Median 1.5%|
|Assets invested||Components from market indexes||Assets designated investment manager based on unit trust’s objectives.|
|Trade channels||Public markets like the New York Stock Exchange(NYSE); the Singapore Stock Exchange(SGX)||Sale and redemption by the trust itself|
|Sales loads||S$10-20 per trade via a broker||3 – 5%|
|Liquidity||Highly liquid||Not liquid(the unit trust is the only channel for trade)|
|Management styles||Passively managed||Actively managed|
|Valuation||During trading hours||After the market close|
|Purchase prices||Market price||Net asset value|
More About ETFs: Price, Fees, and Returns
1. How ETFs work
An ETF is a passively invested fund mimicking investment components from an index. Unlike unit trusts, an ETF fund manager’s job is to rebalance a portfolio reflecting component changes and other currency hedging activities in line with the index he models against.
An ETF aims not to beat the market but to go hand in hand with it in the longer term.
The benefits of investing in an ETF are:
- Your portfolio is more diversified, and you may reduce risk because one company fails.
- You don’t spend more time monitoring and worrying about your investments. The investments grow in line with the market.
An ETF is a highly liquid asset in the market. Like a public stock or bond, most ETFs are tradable on a continuous pricing basis. As such, you have the most updated price quotes from a market during trading hours.
Not unusually, the price quoted from the market may differ from the actual value of an ETF, also called net asset value(NAV). Seeing the discrepancy between them, you will find a premium that is higher than a NAV or a discount that is lower than a NAV. An interesting tip: you may profit from selling from a premium ETF and buying from a discounted ETF.
As an ETF is a passively managed fund, the cost will be lower than other actively managed ones. The table above shows a double difference in annual expense between an ETF and a unit trust. An investor has to pay more sales charges for a unit trust to compensate an investment distributor; nevertheless, he doesn’t pay commission to a broker selling an ETF. Most security transactions are free of commission.
It takes an ETF investor less effort to monitor their portfolio performance. An ETF tracks a market index, and you may see your performance by following the index if your ETF goes in line with it. You may find a minor tracking error because of the timing and cost of transactions. The less the tracking error becomes, the more it matches an index. A 2% tracking error is deemed normal.
More About Unit Trusts: Price, Fees, and Returns
1. How Unit Trusts Work
A unit trust is a collective investment scheme created by a fund management company to manage assets for clients. The legal framework is an investment trust holding clients’ assets and appointing an investment manager for carrying out investing activities.
The investing aims are diverse in the unit trust universe. They have one thing in common: beat the market and outperform peers.
Most unit trusts use an active management style to enhance the trust’s return. The investment manager plays an essential part in selecting securities he thinks may outperform the market and peers.
Fund managers carry more trades than ETFs. They also implement hedge and arbitrage activities to protect and enhance returns from volatile markets.
Differing from ETFs, unit trusts have 2 features in valuations and trade.
Valuation: A unit trust determines its worth by the value of its unit. The total value of assets held by the trust is divided by its units. The unit price measures its worth(net asset value).
Usually, a trustee determines the price per unit at the end of each business day. Therefore, an investor should find the price of a unit on the next business day’s end if he invests in the fund.
Unlike ETFs, unit trusts can have only one price quote every business day. Besides, investors can only buy from or sell to the trustee or through a broker. If you deal with a broker, you may pay a charge.
You may pay 2 types of fees: the annual expenses and the sales/bid-offer charges. From the table above, you can see that unit trusts impose more costs than ETFs.
First, a trust investment manager, like a mutual fund, should outperform the market, and extra compensation is necessary for the work carried out.
For the second, unlike an available market for an ETF, investment companies use distribution channels like investment brokers or banks to promote the sales. A trustee deducts the cost from a client’s portfolio.
One distinguishing feature distinguishing a unit trust from an ETF is a unit trust manager uses a pro-active approach to beat the market. In contrast, an ETF uses a passive approach following the money. They believe active managers can profit from picking and actively trading over undervalued assets rather than being passive in awaiting asset growth.
Why invest in ETFs
If you consider investing in ETFs, you should consider the following factors before pouring money into them.
You may know that most ETFs’ expense ratios and sales charges are low. One of the low-cost investing benefits is that the savings from the reduced costs help increase the fund’s return. The greater the savings, the greater the return(others constant).
2. Passive investing style
Investing billionaire Mr. Warren Buffett says if you don’t know about investing, you should invest in an S&P 500 fund. He believes few can beat the market in the long term and should invest in the stock market itself instead. The S&P index has returned about 10% for the past 20 years.
ETFs are tradable on a stock market. You can buy or sell an ETF in an open market without liquidity issues. Though investing experts do not encourage short-term trading for ETFs because of their long-term investing nature, ETF is still a valuable and liquid investment tool.
4. Hassles free investing
No time to build up your portfolio, strict budget for financial advice! ETF may be a good choice for busy and tight-budget investors. When you buy a share of an ETF, you invest in a portion of an entire market represented by an index. You shouldn’t be worried about portfolio balancing, or some market reverses.
Also, you can set up an automatic investing plan using the cost of averaging approach to fend off investing risks.
5. Long-term investing
ETF investing is a long-term job for investors. You may reduce the short-term fluctuations you hold on for mid-to-long-term. Seeking sound financial advice should be the first step towards investing.
6. Currency risk
If you invest in foreign ETFs like the US or Europe beyond the Singapore market, you may encounter a currency depreciation problem even though your portfolio value has been up. Some ETFs have return protections by using currency hedges. You may look carefully and talk to your financial advisor.
7. Tracking Errors
An Exchange-Traded-Fund may lag in performance behind an index they are modeling, and tracking error is an excellent indicator of how an ETF performs relative to an index.
How many types of ETFs are there?
An ETF, like a stock, can be listed in many stock exchanges like New York Stock Exchange and the Singapore Stock Exchange. Many of them are index-tracking ETFs. Like many individual stocks, you can follow an ETF symbol in exchange to find out the news and performance of the fund.
You may notice two types of ETFs: Physical ETFs and Synthetic ETFs. They seek to track and replicate the returns from an index.
- The ETF is a straight product as it is a cash-based investment vehicle. The cash in the fund is the only source for investing.
- It charges limited management and transaction fees.
- The ETF has no counterparty risk as it only invests in the components from an index.
- It has a highly transparent mechanism and open operating procedures.
- An ETF holds securities and cash only.
- It uses derivatives to replicate the return in line with an index’s. Due to market transparency, access, liquidity, and timing issues, an ETF fund manager may use derivatives like swaps to keep pace with an index.
- Besides derivative costs, fund management collects transaction and management fees.
- It may have the counterparty default risk as a third party may not honor the pledge if changes occur in the market.
- As it involves complex transactions with other parties, the operating procedures are less transparent and open.
- An ETF may hold a proportion of derivatives apart from securities and cash. The risk from the combination may increase.
Investors for an ETF
To summarize: If you are a busy investor intending to grow your portfolio without sparing too much effort, ETF investing is a good choice.
Why invest in Unit Trusts
1. Aggressive growth
If you are looking for high growth and betting on an investing manager’s ability to outperform the market, a unit trust investment may be your choice. Besides, you may profit and diversify individual risks for individual assets by holding various assets. A professional manager is actively growing the holdings in your portfolio.
2. Clear investment objectives
A mutual fund has clear investment aims, like beating an index or a percentage target within a period. It also states the investment methodologies and sector and target requirements, so investors know what a unit trust will invest.
Unit trusts have higher running costs than ETFs because investment managers spend more on research and trading. A share charge may eat into your portfolio. If your portfolio performance cannot outweigh the costs, you may lose money.
4. Investors for Unit Trusts
Unit trusts are your favorite choice if you aim to outperform the market. But you should look into the unit trust’s investment objectives, track records, and investment manager’s background. You can only increase your chance of success by carefully reviewing a unit trust performance.
If you cannot tolerate regular market fluctuations or monitor your investments closely, invest in ETFs to diversify your assets and grow your portfolio. If you want to beat the market and play an active part in investing, then Unit Trust Investing is your choice. But you may risk losing because of higher costs and market ups and downs. Know more on how to start your investing in Singapore here.
- ETF investing makes you hands-free because they grow with the market.
- Unit Trust investing aims to outperform the market but carries higher risks.
- They both diversify market risk as they hold numerous securities.
- Risk-cautious investors are prone to ETFs while risk-tolerant investors like unit trusts.
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