The real difference between unit trusts and ETFs

Unit trusts (or mutual funds, as they are known as in the US) are often discredited for their supposedly high costs and more active investing approach. In contrast, exchange-traded funds (ETFs) are generalised as being lower cost, and generating higher returns due to a more passive investing approach.

Do these generalisations of unit trusts and ETFs paint a complete picture? Are there inherent advantages of unit trusts that make them more suitable for Singapore-based investors?

Let us start off by understanding what unit trusts and ETFs are, and the key differences and similarities between these products.

What are unit trusts and ETFs?

Both unit trusts and ETFs are pooled investment products, or collective investment schemes. A group of securities, such as the 500 largest publicly traded companies in the US (S&P500), are pooled together into a fund.

Investors of such funds have the benefits of diversification, convenience, and security, with the securities custodised and segregated from the fund managers' operating assets.

The key difference between ETFs and unit trusts is how investors buy and sell units/shares.

Unit trusts 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, prices are dependent on market sentiments.

Apart from this key difference, there is also an unfortunate generalisation about the high costs of unit trusts in Singapore which has rendered them less attractive.

You may read more about their differences here.

Higher costs — a common generalisation about unit trusts vs ETFs

The higher costs of unit trusts can be distilled into two key elements.

Firstly, unit trusts tend to charge higher fund management fees which form the bulk of the funds' total expense ratio (TER). Unit trusts typically charge between 1.5% to 2% per annum (p.a.) in terms of TER, relative to ETFs' TER which can be below 0.5% p.a..

Secondly, buying funds through financial advisers or banks such as the DBS unit trust platform will incur one-off sales charges and/or redemption charges.

Combined with the preference for passive investing with ETFs, few people would consider investing in unit trusts over ETFs. But does the above generalisation of higher costs always apply?

Do unit trusts really mean higher costs?

Low-cost unit trusts can have equally low TERs as ETFs

While most unit trusts have higher management fees, largely due to trailer fees or small fund size, this may not apply to all unit trusts. Some unit trusts distributed are institutional share class products that do not have trailer fees, and have a huge fund size. The large fund size allows fixed operating expenses to be spread across a larger pool of investors' funds, lowering the cost of operating the fund per dollar invested.

For example, the Dimensional Core Equity Fund used by Endowus Core Portfolios for Cash and SRS monies has a track record of lowering its total expense ratio as its fund size grows. The recent fee revision by Dimensional further lowers the already competitive annual 0.29% to 0.26% TER.

For a Singapore-dollar denominated fund that is tracking the MSCI World Index, a 0.26% p.a. TER is competitive with an equivalent US-dollar denominated ETF, such as IWDA, at 0.20% p.a. TER.

Not all unit trust platforms charge sales and withdrawal charges

Sales and withdrawal charges are charged by financial advisors as well as local banks (DBS, OCBC, UOB), through their fund platforms or relationship managers. These front-end sales charges and redemption charges can go as high as 5%, which effectively translates to a 5% loss on investments - by extension, poorer returns for investors. As brokerages that facilitate ETF investing do not normally charge such exorbitant fees, ETF investors are able to keep more investment returns for themselves.

However, unit trust investing can be as cost-competitive as investing in ETFs when investing through a platform like Endowus, where you pay 0% sales or redemption charge.

Unit trusts can also be passively managed

Most unit trusts in Singapore are actively managed, with fund managers making discretionary investment decisions. There are a handful of unit trusts such as the Infinity US 500 tracking indices passively. Also, there are systematic passive funds such as Dimensional funds that are managed cost-efficiently, with cost structures equivalent to low-cost ETFs.

Read more about passive index unit trusts and passive index ETFs here.

Now that we have addressed the misconceptions about unit trusts, let us explain how unit trusts should be the better investment vehicle for passive investors, especially with robo-advisors.

Why unit trusts can be better than ETFs for Singapore investors

In general, unit trusts distributed in Singapore already take tax and foreign exchange (FX) for Singaporeans into account.

Diversified ETFs are denominated in foreign currency

Most of the ETFs with overseas underlying holdings are often denominated in US dollars (USD) or other foreign currencies. The only few exceptions include the STI ETF and other Singapore Reit ETFs. For Singapore investors to invest in globally diversified portfolios, they have to buy USD to be able to invest in these ETFs.

When buying foreign currencies, investors may incur both a transaction charge and an implied cost through the bid-ask spread between the Singapore dollar (SGD) and USD.

Lack of diversified SGD-hedged bond ETFs

While it is reasonable to bear FX risk for long-term investments by investing in non-SGD denominated equities ETFs, one should not take unnecessary FX risk for shorter-term investment goals.

A study by Vanguard shows that FX volatility accounts for more than two-thirds of fixed income funds' volatility. This volatility does not contribute to additional expected returns, and may offset the diversification benefits of holding bonds in a multi-asset portfolio.

Unfortunately, there is a lack of SGD-denominated diversified bond ETFs in Singapore. While there are two SGD bond ETFs listed on SGX, the ABF SG BOND ETF (A35) and the Nikko AM SGD Corporate Bond Fund (MBH), the underlying holdings are mainly Singapore government bonds and/or Singapore corporate bonds.

Conclusion: Differences do not lead to poor performance

The narrative around why unit trusts perform poorly is centred on high costs arising from management fees and one-off sales and/or redemption charges. While this largely holds true for the unit trusts distributed through financial advisers and fund platforms, it does not apply to digital advisory platforms like Endowus.

The only fundamental difference between unit trusts and ETFs is that ETFs are traded intraday in the stock markets, whereas unit trusts are executed by the next business day. This difference only matters for day traders who want to enter and exit the market within the day.

At Endowus, we work with fund management companies to screen and bring in low-cost, best-in-class unit trusts that are suitable for Singapore investors. We also rebate any trailer fees we receive back to clients to not only lower costs, but also align our interests with our clients. The process of screening and down-selecting appropriate funds allows our clients to be exposed to the markets in the most cost-efficient manner, even relative to ETFs. This effectively translates to higher returns over the long term.

To get started with Endowus, click here.

Next on the Endowus Fin.Lit Academy

Read the next article in the curriculum: The power of diversification in investing

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This article is for information purposes only and should not be considered as an offer, solicitation or advice for the purchase or sale of any investment products. It is recommended that you seek financial advice as to the suitability of any investment. Whilst Endow.us Pte. Ltd. (“Endowus”) has tried to provide accurate and timely information, there may be inadvertent delays, omissions, technical or factual inaccuracies or typographical errors.

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