Mutual funds (also known as unit trusts) are often discredited for their supposedly high costs and more active investing approach. In contrast, exchange-traded funds (ETFs) are often viewed as lower cost, and generating higher returns due to a more passive investing approach.
Do these generalisations of ETFs and mutual funds paint a complete picture and how should investors think about choosing between the two? Let’s take a deeper look and what it means for investors in Hong Kong.
What are ETFs and mutual funds?
Both ETFs and mutual funds (or unit trusts) are pooled investment products or collective investment schemes. The key difference between ETFs and unit trusts is how investors buy and sell units/shares.
Mutual funds generally have an open-ended fund structure. The fund manager can increase or reduce the number of units daily, based on investors' requests to invest or redeem units. As long as there is a request to buy or sell units, the fund manager will facilitate the transaction. The transaction value of the units is determined by the value of the underlying holdings, or net asset value (NAV).
In contrast, the order to buy or sell ETF units is facilitated by the stock exchange during trading hours. There is a finite number of ETF units in the market, with buy and sell prices (or the bid-ask spread) determined by market players. As such, part of the prices may be dependent on market sentiments.
Higher costs — a common generalisation about ETFs vs mutual funds
There is an ingrained impression of the high costs of mutual funds (also called unit trusts) in Hong Kong, which makes them less attractive than ETFs.
The higher costs of mutual funds can be distilled into two key elements.
Firstly, mutual funds tend to charge higher fund management fees which form the bulk of the funds' total expense ratio (TER). TERs of mutual funds are typically between 1% to 2% p.a., while for ETFs they can be below 0.5% p.a..
Secondly, buying funds through traditional channels such as banks will usually incur upfront subscription fees and/or redemption fees.
Combined with the preference for passive investing with ETFs, few people would consider investing in mutual funds over ETFs. But does the above generalisation of higher costs always apply?
Do unit trusts really mean higher costs?
Low-cost mutual funds can have equally low TERs as ETFs especially when factoring into dividend withholding taxes
While most mutual funds have higher management fees, this is largely due to trailer fees or small fund size, this may not apply to all unit trusts.
Mutual funds with larger fund sizes generally have lower costs, allowing fixed costs to be spread across a large pool of investors. Through a platform such as Endowus, Individual investors can now have access to institutional share class products that do not have trailer fees. For example, the institutional share class of PIMCO GIS Income Fund’s total expense ratio is 0.55%, as compared to 1.45% of its retail share class.
There are platforms that don’t charge subscription fees
Upfront subscription charges at traditional channels can go as high as 5%, which effectively translates to an upfront 5% loss on investments.
Platforms such as Endowus and other online brokerages have largely offered 0% subscription fees, which by extension, means more returns for investors.
Mutual funds can also be passively managed
While most mutual funds in Hong Kong are actively managed, there are passive funds such as the HSBC US Equity Index Fund which tracks the S&P 500.
There are also systematic passive strategies that are managed cost-efficiently, with cost structures equivalent to low-cost ETFs by Dimensional Fund Advisors available to Professional Investors in Hong Kong via Endowus.
Why unit trusts can be better than ETFs for Hong Kong investors
Defying conventional misconception, mutual funds could be a more cost efficient option for Hong Kong investors when taking into account dividend withholding taxes and foreign exchange (FX).
30% Dividend withholding tax on US-listed ETFs for Hong Kong investors
As a Hong Kong-based investor, there is a dividend withholding tax of 30% on US-listed ETFs, even if its underlying assets are not in the US. For example, if you would like to obtain exposure to emerging markets. One of the “lowest” cost options would be Vanguard’s VWO, an emerging market index ETF that has an expense ratio of 0.08% (as of December 2023).
However, VWO currently has a dividend yield of ~3.5%, a 30% withholding tax would add on an additional cost of 1.05% (=3.5%*30%). The low-cost US ETF option is suddenly not as “low-cost” as it seems. On the other hand, UCITS funds are not subject to such dividend withholding tax.
Read more: An inconvenient truth: Taxes on US-listed ETFs
Diversified ETFs are denominated in foreign currency
Most of the ETFs with overseas underlying holdings listed on the Hong Kong stock exchange are often denominated in US dollars (USD) or Chinese Yuan (CNY) and are often with little liquidity and low daily turnover. For Hong Kong investors to invest in globally diversified portfolios, they have to buy USD/EUR to be able to invest in ETFs listed in foreign exchanges in the US or Europe.
When buying foreign currencies, investors may incur both a transaction charge and an implied cost through the bid-ask spread between the Hong Kong dollar (HKD) and USD/EUR.
As your financial advisor, we often remind clients to focus back on their investment goals and objectives. If your investment portfolio is for long-term general wealth accumulation or retirement planning, and not short-term speculation, we would generally advise against layering foreign currency risk on top of your portfolio risk. The role of currencies should be focused on managing asset-liability matching.
Read more: Managing and thinking about currency exposure for your portfolio
Working with a financial advisor to help you plan and manage your investment portfolio
In the end, the only fundamental difference between unit trusts and ETFs is that ETFs are traded intraday in the stock markets, whereas mutual funds are traded once a day at its per share market value, the net asset value (NAV). This difference only matters for day traders who want to enter and exit the market within the day.
The narrative around why unit trusts perform poorly is centred on high costs arising from management fees and one-off subscription and/or redemption fees. At Endowus, we work with world renowned fund management companies to screen and bring in Best-In-Class funds and portfolios for Hong Kong investors at low, fair costs. This is done either by helping them subscribe directly to institutional share class funds or providing 100% rebate to trailer fees.
To get started with Endowus, click here.
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