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ETFs (Exchange-traded Funds) and Unit Trusts (also known as Mutual Funds) often get confused because they both offer diversified exposure to the market. But, there are fundamental differences with significant implications that you should consider when deciding where you should invest your money.
Before we understand the implications of these differences, let’s first understand the key differences between these investment products.
An ETF, or an Exchange-traded Fund, is an index-tracking investment tool that is traded in a public market. Indices are composed of asset classes, such as stocks or bonds, typically focused on a particular segment of the market, such as technology, energy, or real estate, or on a particular geography such as Japan or Emerging Markets. ETFs follow these indices to track the market’s volatility. ETFs are traded on the stock exchange just like a security and they are very popular: in 2016, 14 out of the 15 most active securities were ETF, and only one was a stock: Apple.
An example of an ETF is the SPDR S&P500 ETF (ticker: SPY), that tracks the S&P500 index. Buying shares of SPY, an investor gets exposure to the performance of the S&P 500.
A Unit Trust, or Mutual Fund, is an actively-managed investment tool. Like an ETF, it has many securities beneath it, but the two differ in how the funds are created. With a Unit Trust, individual investors pool their money into a Unit Trust, and then the fund manager oversees the fund by investing in individual securities, such as stocks or bonds. In turn, the investors of the fund earn proportional ownership of the fund. Investing in a Unit Trust is betting on the manager’s ability to pick the best securities, the “winners”, and therefore perform better than the market. Because of their higher cost structure, Unit Trusts need to return 1% to 2% more per annum in order to match net-of-fees returns of passive funds. Unit Trusts are bought and sold through private channels.
The table below summaries the key sources of differences for these investment products: how they are sold, and how they are managed. In practice, these differences typically lead to dissimilar overall returns. How? It comes down to their structure, how they’re managed, and the associated costs.
Figures refer to pure, plain-vanilla equity funds. Balanced and fixed-income funds tend to have lower annual management fees.
Data for “Unit Trust” come from The Cerulli Report - Asian Distribution Dynamics 2015.
The price of an ETF reflects the price of the underlying securities within the ETF. Because ETFs are traded on the stock market like a security, they are easily sellable, which can give you almost immediate access to your cash.
Unit Trusts, on the other hand, are only available to buy and sell after the market closes each day. Additionally, Unit Trusts usually have associated entry and switching fees for buying and selling, which makes the investment tool less liquid-- and more costly-- than an ETF.
ETFs track indices of specific asset classes, whereas Unit Trusts can have great diversity in the included asset classes in a particular fund. This is not to say that an ETF cannot be in a portfolio with other asset classes-- it can!
Most major and minor asset classes, markets, and geographies are covered by one ETF or another. Plus, with the introduction of smart beta ETFs and alternative ETFs, such as the IQ Merger Arbitrage ETF, investors will start seeing more and more ETFs with multiple factors of exposure to various asset classes. When selecting an ETF, though, it is very important to check its size, liquidity, and tracking error, as some of the more “niche” ETFs lose their liquidity feature by being too small and not achieving good trading volumes.
Unit Trusts provide the flexibility to build a portfolio of your choosing without being constrained to a specific tracking function. So, if you are looking to invest in a specific niche that no liquid ETF covers at a given time, a Unit Trust may be the best way to create a portfolio that has the unique underlying securities you want.
Ultimately, an ETF offers diversified exposure to a particular asset class at a low cost, and Unit Trusts still can achieve the exposure, but at a high cost. Unit Trusts are better suited to help an investor get exposure to a particular market niche where more liquid and cost-effective products are not available.
Due to the Unit Trust management’s focus on costly securities selection, fees are inherently higher with these types of investment products. Unit Trust management requires significant resources, which translate to higher fees that are passed on to the customer investing in the managed portfolio. These management fees include the frequent fees of buying and selling the securities within the Unit Trust. Additionally, Unit Trusts usually carry distribution costs, as they’re not available on public markets. Part of these costs are usually included in the management fees, while part of them are charged as “entry” or “exit” fees these fees are often referred to as “loads.”
Because ETFs trade like a security, they do not have loads; the cost of distribution may be charged directly by the distributor itself, for instance as trading costs by the broker. By avoiding active selection of securities, portfolio managers can charge management fees that are significantly lower than their Unit Trust counterparts that require fund managers to trade stocks continually, also known as active management.
Unit Trust managers deploy an active investing strategy, which focuses on choosing which securities to buy and sell at any given time based on a point of view on the future prospects of a specific asset (e.g., will Apple’s stock increase in price or decrease?). This is what’s is commonly referred to as “stock picking.”
Recently, active fund management has come under scrutiny for its ineffectiveness at outperforming major indices, such as the S&P 500, over a long-term period, resulting in overall lower returns for investors. According to the mid-2016 SPIVA US Scorecard, 94.58% of US domestic equity fund managers who participate in active fund management have underperformed the relevant passive index benchmark in the past 5 years. Active fund management also is quite costly, as it comes with frequent transaction costs that are deferred to the investor as a fee deducted from his or her investments.
Investors who build portfolios with ETFs are more concerned with the broader picture of long-term returns for an asset class, and less concerned with beating the market by picking the best stocks. Because an ETF tracks an index, its investment strategy is very clearly laid out by the choice of index and the execution is very cost-effective, as no decision making is needed. This long-term strategy is referred to as “passive investing.”
Unit Trusts were once very popular because they offered similiar diversified exposure to the markets, but it turns out that there are other options, such as ETFs, that can more efficiently achieve desired levels of diversification, and enable investors to apply passive investing strategies effectively. As such, ETFs are increasingly gaining popularity amongst portfolio managers who apply passive investing strategies to their portfolios.
At StashAway, we use ETFs in every customer's portfolio. Their low costs don't cut into returns, their diversified exposure to the markets maximise returns at any given level of risk, and their liquidity and versatility give us the flexibility to face any economic environment. All of this ultimately helps our customers achieve their financial goals faster than with other investment products.