Unit Trusts vs Exchange Traded Funds (ETFs)

You Have Money To Invest, Now What?

It is very understandable how overwhelming it can be when trying to figure out how and where to invest your hard earned money. Especially for those that don’t necessarily have a financial or investment background.

This article intends to provide some guidance for those who are just beginning their investment journey and have questions around how to invest money. It does not have all the answers, rather it attempts to provide you with the basics so you can make an informed decision and see the forest for the trees.

The Two Basic Investment Options

Please don’t let the heading mislead you. The amount of investment options that exist in the world are endless. For our purposes though, we will discuss the two basic forms that the majority of people use to grow their money.

Namely unit trusts and exchange traded funds (ETFs). The reason for only covering these two is because they are simple to understand and generally very accessible, no matter what your level of investment experience or knowledge.

Unit Trusts Explained

So, what is a unit trust investment? A unit trust is essentially a portfolio of many assets managed by an asset manager, where each asset manager will have different types of unit trusts. You gain access to a unit trust through buying units, and these units represent your share of the underlying assets of the unit trust.

The asset manager takes the money received from everybody who purchases units and pools this money together. This money is then used to purchase the underlying assets of the unit trust- where the underlying assets may consist of various asset classes such as shares, bonds, commodities etc. This results in a unit trust being quite an efficient way to invest.

For example, a specific unit trust may have underlying assets consisting of 50 different shares and 50 different bonds. If you have R20 000 to invest, it would be near impossible to invest in 50 different shares and 50 different bonds directly. However, R20 000 should be more than sufficient to invest in a unit trust, and by doing so you gain exposure to these underlying assets. You would receive units in exchange for your R20 000, and these units would represent the portion of your ownership in the underlying assets.

Each unit trust will have a mandate that describes what it aims to achieve, its investment limits and an indication of the type of investor it is appropriate for. The asset manager responsible for the unit trust generally manages it in an active manner.

There are varying degrees of active management but it basically means that the asset manager will decide which assets the unit trust may invest in. Generally an asset manager will have a team of analysts, whose job is to research the market and specific assets in an attempt to invest in the appropriate assets to achieve the unit trust’s mandate.

For example, consider a hypothetical unit trust for an asset manager called ABC. ABC may have a unit trust that is dedicated to investing only in equity (equity is another word for shares, like those traded on a stock exchange). Let’s call this unit trust the ABC Equity Fund. An example of its mandate may read something as follows:

The Fund attempts to invest 100% in stable, high quality companies with a proven track record. The Fund’s investment universe is all stocks on the Johannesburg Stock Exchange and may invest offshore.

The minimum amount the Fund may invest locally is 70%, while the maximum amount the Fund may invest offshore is 30%. ABC is responsible for managing the local allocation. The offshore allocation is invested in, and managed by, the XYZ International Equity Fund. The Fund’s recommended investment horizon is a minimum of five years or longer.

The Fund is appropriate for investors seeking exposure to high quality companies, are comfortable with a higher degree of risk associated with equities and who require offshore exposure. The Fund’s benchmark is the JSE All Share Index and attempts to at least match the benchmark return at no greater risk.

Let’s dissect the mandate piece by piece to make sense of it.

The Fund attempts to invest 100% in stable, high quality companies with a proven track record.”

This statement tells us that the unit trust only invests in companies – with no other type of asset – which the asset manager deems to be stable and of high quality. This begs the question of course, how good has the asset manager been at selecting these companies in the past? And what criteria do the portfolio managers use in deciding whether a company is indeed stable and of high quality?

There is no hard and fast rule to answering the first question, however you could glean some insight from looking at the past returns of the unit trust as well as which companies the unit trust is currently invested in, and those companies the unit trust was invested in the past.

For example, if the unit trust is invested in a company that’s recently gone through an accounting scandal, the asset manager’s ability to choose appropriate companies according to their mandate comes into question- since the company is probably neither high quality nor stable.

The simplest way to answer the second question is to simply ask. If their website doesn’t provide any insight then send an email or make a phone call asking them how they go about their decision to invest in a company. Most asset managers have an investment philosophy that they stick to, this philosophy is essentially a style of investing that guides their decisions. A good asset manager will stick to their philosophy through time.

The minimum amount the Fund may invest locally is 70%, while the maximum amount the Fund may invest offshore is 30%. ABC is responsible for managing the local allocation. The offshore allocation is invested in, and managed by, the XYZ International Equity Fund.”

This statement tells us two things. Firstly, there is both a local and offshore allocation. The difference between local and offshore is that local will be the allocation to South African companies on the JSE. While offshore includes companies on stock exchanges outside South Africa. Secondly, the offshore allocation is managed by a different asset manager, namely XYZ, and the portfolio managers use the XYZ International Equity Fund to achieve its offshore allocation.

Essentially, the fund is investing into another fund. This is a common practice, and what you’ll often find is that XYZ is affiliated to ABC in some way- possibly ABC’s international sister company. Further, the XYZ fund should have the same mandate as the ABC fund, the only difference is that the XYZ fund can invest across the world.

The reason for the ABC fund to invest in another fund to gain offshore exposure is simply because ABC may not have the resources to analyze companies across the world. So they outsource this to XYZ.

Because the allocation to the XYZ International Equity Fund could be as much as 30%, it’s very important to get information on this fund. Again, this can be done by checking the asset managers website, sending an email or making a phone call asking for information on the XYZ International Equity Fund.

The Fund’s recommended investment horizon is a minimum of five years or longer. The Fund is appropriate for investors seeking exposure to high quality companies, are comfortable with a higher degree of risk associated with equities and who require offshore exposure.”

The first sentence above is often misleading. A minimum of five years does not mean you can only access your money after 5 years. The majority of unit trusts are open-ended, which means you can add and withdraw money from the unit trust as and when you see fit.

There are some instances though where you may only be able to access your money after a predetermined period of time. This is generally due to the type of account that houses your investment vehicle (rather than the investment vehicle itself i.e. a unit trust), which is governed by specific legislation (more on this later). If you’re uncertain, it’s best to check with the asset manager to verify.

With regards to our example above though, the recommended investment horizon is stated to manage expectations. Essentially the asset manager is saying that in order for the fund to achieve its mandate, you need to give it at least five years to do so.

Generally, unit trusts that invest 100% into equity will recommend an investment horizon of at least five years. This is because the equity asset class tends to fluctuate quite significantly over the short-term, and requires a decent length of time to realize its return potential. This is also why it states that the fund is appropriate for those investors who are comfortable with a higher degree of risk.

The Fund’s benchmark is the JSE All Share Index and attempts to at least match the benchmark return at no greater risk.”

Each unit trust will have a benchmark of some sort. This benchmark is used to compare the performance of the unit trust against, and in some cases may determine the amount of the asset management fee the asset manager charges. It’s important to take note of a unit trust’s benchmark for two reasons.

Firstly, it provides insight as to what the asset manager is targeting in terms of the unit trust’s performance. Secondly, it simplifies your expectations for the unit trust. For example, an asset manager may offer a seriously complicated unit trust that invests into assets you didn’t even know existed.

If the unit trust’s mandate then states that the benchmark is the JSE Top 40 (i.e. the top 40 biggest companies on the Johannesburg Stock Exchange), it helps clarify what the unit trust is targeting and allows you to determine whether the unit trust is appropriate for you. In this case if you don’t want returns similar to the JSE Top 40, you wouldn’t go into this unit trust.

The part where it states “at no greater risk” is also important to consider. This refers to the manner in which a unit trust actually achieves its return. As an example, consider two different unit trusts, Red and Blue, with the same mandate and benchmark and both make the exact same return of 10% for the year. At face value, you’d be indifferent as to which one you’d invest in.

However, closer inspection reveals that at one point during the year the Red Fund was down -15%, while the Blue Fund was up 3%. At another point during the year the Red Fund was up 17% while the Blue Fund was up 6%. While at the end of the year they both made an equal return of 10%.

Clearly the Red Fund is more volatile than the Blue Fund. Volatility refers to the degree by which the return of a fund fluctuates over a period of time. As a rule of thumb, the fund with the higher volatility will carry a higher degree of risk. The Red Fund went through some serious return volatility (from -15% all the way up to 17%) to produce a yearly return of 10%, while the Blue Fund worked its way up pretty consistently through the year.

From a practical perspective, imagine you found yourself needing money during the year. If you were invested in the Red Fund, this may have been problematic if you needed money from the fund around the same time as its -15% decline.

Let me be clear though, volatility in and of itself is not a bad thing. In fact, without volatility asset prices wouldn’t move and investments wouldn’t make any capital gains. With that in mind, it’s still important to know when your investment carries an inappropriate amount of volatility. This can be determined by looking at the standard deviation value for the unit trust. Standard deviation is simply the average amount by which the unit trust’s returns fluctuated from the overall average return of the unit trust.

For example, if a unit trust had an average annual return of 10% for the last 5 years (i.e. made 10% per year for the last 5 years on average), with an annual standard deviation of 12%. It means that during any one individual year of the last 5 years, the unit trust’s return for that individual year could have been as high as 22% (10% + 12%), or as low as -2% (10% – 12%).

Back to the ABC Equity Fund. Let’s assume that both the Fund and the benchmark made an annual return of 10%. If the Fund had a standard deviation of 8% and the benchmark had a standard deviation of 9%, then the Fund made the same return with less risk.

If both the Fund and benchmark had the same standard deviation and same return, the Fund would have made the same return with the same amount of risk. If the Fund had a higher standard deviation than the benchmark, with the same return, then the Fund needed to take on extra risk to make the same return.

Obviously in real life this kind of precise scenario rarely happens, and a more realistic scenario is when both the Fund and benchmark make different returns with different standard deviations.

For example, if the ABC Equity Fund made a return of 12% with a standard deviation of 15%, while the benchmark made a return of 9% with a standard deviation of 5%, how would we know which one made the best return according to the amount of risk taken?

Enter the Sharpe ratio. The Sharpe ratio is used as a comparison tool to determine which investment made the best risk-adjusted return, i.e. which investment made its return with the least amount of risk. The ratio is as follows:

Sharpe Ratio = (Investment Return – Risk Free Return) / Investment Standard Deviation

The risk free return is usually the return of a five-year government bond, but you could also use the return on a 5 year fixed deposit at a bank or similar. Although the hardcore finance people would probably shun you for doing so. However, it would work for our purposes.

Let’s assume that our applicable risk free rate is 6%. Therefore, the Sharpe ratio for the ABC Equity Fund is 0.4 ((12 – 6) / 15), while the Sharpe ratio for the benchmark is 0.6 ((9 – 6) / 5)). A higher Sharpe ratio is desirable, so we can conclude that the ABC Equity Fund did not make a better risk-adjusted return than the benchmark and failed to achieve its mandate.

This highlights an important concept, even though the Fund made a higher return of 12% compared to the benchmark of 9%, it had to take on a lot more risk to do so. Blindly comparing returns between investments, without taking into consideration the amount of risk taken to make that return, could have dire consequences for your expectations of the investment.

Exchange Traded Funds (ETFs) Explained

So, what is an ETF investment? An ETF, like a unit trust, is a portfolio of assets managed by an asset manager. There are two significant differences between an ETF and a unit trust. Firstly, while a unit trust is generally actively managed, an ETF is passively managed. Secondly, you would buy shares of the ETF over a stock exchange such as the JSE, while you would buy units of a unit trust directly from the asset manager.

The first difference – actively vs passively managed – requires further explanation. A unit trust is generally actively managed because the inclusion of specific assets is at the discretion of the asset manager. An ETF on the other hand, includes assets according to a predefined index, and attempts to track the index as closely as possible. An index is simply a portfolio of assets that represent a certain factor.

For example, a financial index may include all the shares of banks, insurers, investment companies and other types of financial companies. Another example is the JSE Top 40 Index is probably the most well known and represents the top 40 biggest companies on the JSE. The asset managers responsible for the ETF are obliged to recreate the index as closely as possible, thus they have no discretion as to which assets to include or exclude. People often get confused differentiating between an ETF vs index fund, where in actual fact they are the same thing. An ETF will invest according to a predefined index.

The second difference – shares vs units – simply means that your ownership in the underlying assets is represented by the amount of shares you have in the ETF. While ownership in a unit trust is represented by the amount of units you own.

Unlike a unit trust, an ETF is traded on the stock exchange such as the JSE through which you would buy shares. A unit trust on the other hand, is not traded on the stock exchange and you would need to purchase units through the relevant asset manager.

Apart from those two differences, a unit trust and an ETF are very similar in that both are an efficient way to invest and both provide exposure to a wide range of assets.

Unit Trust or ETF?

So it begs the question, which one should you invest in? Well there are a few things to consider. If you would like your money to be professionally managed according to a defined mandate, a unit trust may be appropriate. If you prefer knowing exactly what your money is going into without question, an ETF may be appropriate.

Another consideration is that the management fees for a unit trust are quite a bit higher than the management fees for an ETF. This is because an actively managed unit trust has a team of analysts that need to be paid, while a passive ETF simply tracks a predefined index without the need for analysts.

This is probably a good time to comment on the active vs passive debate. There is a long standing argument in the investment industry, with some evidence supporting the notion, that active management does not outperform the general market over the long term due to higher management fees. If such is the case, there’s no point in going into an actively managed unit trust if it’s just going to make the same return as a passively managed ETF. However, I personally don’t believe it’s as cut and dry as that.

Firstly, I believe that there are appropriate times as to when you should invest in a unit trust or an ETF. When the market is doing incredibly well and everything is going up in value, it makes more sense to invest in an ETF because it’s generally cheaper than a unit trust and the whole market is increasing in value anyway.

On the other hand, if the market is flat or even declining, the flexibility that active management offers may result in superior returns even after fees. This is because the active asset manager may redeploy money in the unit trust to other assets that carry less risk or less chance of declining significantly. An ETF would have no choice but to take the hit that comes with a declining market since the asset manager does not have the ability to deploy appropriate defenses.

Secondly, the market structure makes a difference. What I mean by this is the size of assets in the market relative to each other. For example, consider the JSE Top 40 Index where Naspers makes up 20% of the index. That’s one fifth of the index being made up by one company. As an extreme example, an investor with R20 000 in a JSE Top 40 ETF essentially has R4 000 invested in Naspers.

Should Naspers go bankrupt and the share price plunge to zero, the ETF investor would lose R4 000. An actively managed unit trust on the other hand, could limit the amount they invest into each company and avoid the risk of being significantly exposed to one single company.

The choice between either a unit trust or ETF is entirely a personal one with various factors influencing the decision. Some people may really appreciate a specific active asset manager’s investment philosophy.

On the other hand, some people may think that an active manager can make mistakes, and prefer knowing their money will be invested in a predefined index. One investor may be happy with a unique unit trust that caters for their goal. While another is content with building a portfolio of different ETFs to achieve theirs.

Advantages and disadvantages of unit trusts

  • Advantages
    • Managed according to a defined mandate
    • Flexibility to change asset allocation, subject to the mandate, to take advantage of or defend against market movements
    • Efficient way to gain access to a portfolio of many assets
    • The choice of which assets to invest in have gone through a rigorous research process
    • The specific asset manager may have an investment philosophy you agree with
  • Disadvantages
    • Generally have relatively higher fees which could be a fixed fee or performance based
    • Reliance on the asset manager to make the right investment decisions
    • Reliance on the asset manager to stick to the mandate which moved you to invest in the unit trust in the first place
    • Not always clear as to why the asset manager invested in a specific asset

Advantages and disadvantages of ETFs

  • Advantages
    • Relatively lower fixed fees
    • Efficient way to gain access to a portfolio of many assets
    • Clear description of what the ETF is tracking, providing asset allocation certainty
    • Ability to target specific market sectors
  • Disadvantages
    • Asset manager is unable to change the asset allocation to take advantage of or defend against market movements
    • Subject to the market structure risk (especially in the case of South Africa)
    • May require a more hands-on approach to create a portfolio of ETFs that meet the investor’s requirements

Next: The General Types of Investment Accounts

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