Unit trusts can track an index in a passive, low-cost way — learn how they stack against ETFs

What is a passive index fund?

A passive index fund provides exposure to a defined market by tracking an index that represents the underlying market. For example, investors can get exposure to the broad global equities market by investing in an index fund that tracks the MSCI World Index. As such, the performance and risk of the passive index fund is expected to follow very closely those of the tracked index. 

There is no active investment decision involved in a passive index fund and the fund manager just needs to make sure that the underlying investments follow the composition of the index that the fund tracks. The composition of the index is often defined by the external index provider in order to represent and measure the performance of a certain investable market. If a stock is added to excluded to the index, the passive index fund would follow suit. 

One of the largest contributors to the difference in performance between a passive index fund and that of the underlying index is the level of fees charged. As fees pulls down the relative performance of the passive index fund, the higher the fee, the larger the drag on performance. Successful passive index managers have kept fees and other frictional costs much lower than other comparable index funds, or even active funds that benchmark against the same indices. 

As such, passive index funds can be an attractive option to investors as they provide a low-cost and efficient way of gaining access to many different markets. Investors, however, need to be aware of certain inefficiencies — including fees, tracking error, broad exposures, and low active management — when making such investments.

What's the difference between a passive index unit trust and a passive index ETF?

While unit trusts and ETFs are both funds, and can invest passively into an index, there are some important differences to note.

A fund is essentially a vehicle that pools investor money to invest in a basket of underlying assets. Put simply, the only difference between unit trusts and ETFs is their listing status – as the name suggests, exchange-traded funds (ETFs) are open-ended mutual funds that are listed on a stock exchange, while unit trusts are open-ended mutual funds that are not listed. The number of ETFs listed in the markets now has surpassed the number of stocks in the world. Both ETFs and unit trusts can be either passive or actively managed. 

The listing status has a significant impact on liquidity and pricing, which in turn may bring about significant differences between unit trusts and ETFs. 

ETFs listed on a stock exchange trade like stocks, which means that investors who trade these instruments are subject to volatility in the bid and ask price. If an ETF has low liquidity — reflected in low trading volume or a small market cap — the bid-ask spread can actually be quite large, even exceeding the expense ratio of the ETF itself. In such cases, investing in such an ETF can be extremely costly. Investors need to assess the total cost of trading when investing in ETFs.

Unit trusts do not face the same issue as they are not priced based on bid-ask spreads — they trade once a day, and at a specific net asset value (NAV) rather than at intraday market prices. If larger trading costs from significant inflows or outflows are being recorded, fund managers can use something known as swing pricing to apportion such costs to the investors behind the significant subscription or redemption flows. That means these specific investors are to pay or be paid at adjusted NAV levels. The swing pricing mechanism is an anti-dilution tool meant to protect existing long-term investors from footing the excessive transaction fees that impact shareholder value, which is a different situation altogether from ETFs trading at a wide bid-ask spread caused by low liquidity.

For further elaboration on the difference between unit trusts and ETFs, click here.

‍How does Amundi replicate market indices?

Endowus has worked strategically with Amundi to bring a new series of passive index funds that are priced at the lowest cost into Singapore. We now exclusively offer three equity Amundi Index Funds — the Amundi Index MSCI World Fund, Amundi Prime USA Fund, Amundi Index MSCI Emerging Markets Fund — and one fixed income index fund — the Amundi Index Global Aggregate 500m Fund. 

For equity funds, Amundi will typically use a full physical replication methodology to track the performance of the Index. This means that they will own almost all the securities in the respective index with the same weightings stipulated by the index. This differs slightly from the sampling replication methodology used for most fixed income funds. In sampling replication, the respective bond index is broken down into sections each representing key risk factors such as duration, currency, country, rating and sector. The investment team then picks bonds included in the index that mimic the risk profile of each section. The aggregate result is a portfolio that represents the index’s overall risk profile and duration. For example, the Bloomberg Global Aggregate (500 Million) Index has over 19,000 bond holdings but the Amundi Index Global Agg 500m only has slightly over 6,000 bonds with a modified duration similar to that of the index.

For more details on the funds, click here.

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