Comparing exchange traded funds with unit trusts

Exchange Traded Funds (ETFs) have been in existence for around a quarter of a century, but they really took off in popularity over the past 10 years.

Its popularity largely grew from disappointment with some mutual funds or unit trusts’ performance, in other words, “active fund management”. The basic idea of the mutual fund (as they are called in the United States) or “unit trusts” (as they are called in Singapore) is investors who don’t have the skills or time to actively manage their own portfolio of stocks can pay a professional manager to do the stock selection and stock switching for them to generate better returns.

But unless these fund managers generate better returns than the benchmark index, it does not make sense for investors to pay front-end, back-end and annual management fees for “active management”. That led to the idea of a lower cost “passive investment” instrument that simply (“passively”) tracks the index of any chosen asset, investment geography or sector.

One argument sometimes raised in favour of ETFs is that sometimes unit trust or mutual fund managers hold so many stocks in their portfolios that they end up “hugging” or closely tracking the underlying market index anyway, due to the diversification. If that’s the case, why not just pay lower fees for an ETF that simply replicates that same index?

So, for example, if you want to invest in Singapore stocks, you could search for a unit trust that outperforms the Straits Times Index (STI). But if you can’t find a manager that achieves returns above the STI to justify the fees, then you could consider an ETF that simply seeks to replicate the index. And you can do the same for other investment objectives – e.g. US stocks (your benchmark might be the S&P500 index), Asia ex-Japan stocks (benchmarked against the MSCI Asia ex-Japan index) or Emerging Market stocks (benchmark: MSCI Emerging Market Index).

ETFs are traded on stock exchanges, which means you have the ease of exit.

When choosing between etfs, consider the following:

When choosing between ETFs, consider the following

  • Which market do you want to invest in? There are ETFs now for most significant markets – from individual countries to regions to industry sectors. There are even ETFs for non-equity asset classes such as broad commodities, industrial metals or even gold.
  • The tracking error – how much does the performance of the ETF diverge from the underlying index? You want the ETF that tracks the index most closely.
  • Fees. ETFs charge lower fees than unit trusts but they do charge fees. In general, favour the ETF with a lower fee, but of course, you have to also offset that against how well the ETF tracks the benchmark index.

Finally, whether you choose a unit trust or an ETF comes down to whether you think it is possible for good asset managers to “beat” (meaning perform better) than the chosen market index through active security/stock selection. Indeed, you do get managers who can do better than the market. But are they managing funds in your chosen market? If you don’t think it is possible for managers to outperform the underlying market index over the longer term, then your choice might be the passive investment approach of buying the underlying index through an ETF, and holding for the market to build value over time.

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