Unit trusts (or mutual funds, as they are known in the US) are often discredited for their supposedly high costs and more active investing approach. By 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 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. You can also think of them as a basket of stocks, bonds, or other securities. For example, the S&P 500 ETF has 500+ of the largest publicly traded companies in the US.

Investors in unit trusts or ETFs enjoy the advantages of diversification, convenience, and security. The securities are held separately in a custodian account and kept apart from the fund managers' operational 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, upon investors' requests to invest or redeem units. That means, the number of units can increase or decrease based on investor demand and the fund manager will facilitate the transaction. In terms of trading, unit trusts are typically traded at the end of a trading day at the net asset value (NAV) price, which represents the value of the underlying holdings.

By 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.

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, forming the bulk of the funds’ total expense ratio (TER). Unit trusts usually have a TER of between 1.5% to 2% per annum (p.a.), whereas ETFs often have a TER below 0.5% p.a.

Secondly, buying funds through financial advisers or banks will incur one-off sales charges and/or redemption charges.

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Combined with the preference for passive investing with ETFs, few people would consider investing in unit trusts over ETFs. But the above generalisation of higher costs don’t always apply.

Four facts about unit trusts and ETFs

Low-cost unit trusts can have as 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 Global Core Equity Fund that is used to make up the Endowus Flagship Portfolios for Cash and SRS monies has a track record of lowering its total expense ratio as its fund size grows. 

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 iShares Core MSCI World UCITS ETF (IWDA), at 0.20% p.a. TER.

An overlooked cost for ETF investors

While commissions and expense ratios are straightforward, ETF investors often overlook a third cost: the bid-ask spread. 

The bid-ask spread refers to the difference between the highest price a buyer is willing to pay (bid) and the lowest price a seller is willing to accept (ask) for a particular security or asset. 

In the context of ETFs, the bid-ask spread represents the cost of executing a trade. This cost for ETFs listed on the Singapore Exchange (SGX) is exacerbated due to a limited daily trading volume. During times of low liquidity, especially when markets fall, bid-ask spreads can widen by a huge margin, resulting in higher transaction costs for investors, as they may need to pay a higher price to buy shares or receive a lower price when selling shares.

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, that means 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.

Read more: Other potential fees for investing in unit trusts in other platforms

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 tracking indices such as the S&P 500 index passively. Also, there are systematic passive funds such as Dimensional funds that are managed cost-efficiently, with cost structures equivalent to low-cost ETFs.

On Endowus Fund Smart, there are more than 20 index-tracking unit trusts managed by top fund managers such as Amundi, iShares, Lion Global and more. A handful of them are exclusive on Endowus platform, charging a fund management fee as low as 0.05%. 

Read more:  Passive index unit trusts and passive index ETFs

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. Here are four potential pitfalls for ETF investors in Singapore. 

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 real estate investment trust (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.

Dividend withholding tax makes US-listed ETFs pricey

For non-US residents, there's another hidden cost to consider: dividend withholding tax. US law typically imposes a 30% tax on dividends distributed by US-listed ETFs to foreign investors. This applies even if the ETF itself invests in companies worldwide. 

For instance, a low-cost ETF way to get exposure to the S&P 500 is by buying Blackrock’s iShares Core S&P 500 ETF (IVV), which has an expense ratio of 0.03%. IVV has a dividend yield of 1.36%, but here comes the catch. 

As a Singapore-based investor with no US tax treaty, there is a dividend withholding tax of 30%. 

Therefore, the tax-adjusted dividend yield falls to 0.95% (70% of 1.36%), with 0.41% going to the US government. This means that the seemingly cheap IVV ETF has now grown to an annual cost of 0.44% (0.03% + 0.41%), suddenly becoming pricey. 

One way to get around this issue is to buy UCITS (Undertakings for Collective Investments in Transferable Securities) ETFs or funds, giving investors a tax-efficient way of investing. 

Using the same example from Blackrock, there’s an Irish-domiciled version – iShares Core S&P 500 UCITS ETF (CSPX) – with a reduced dividend withholding tax of 15% due to a US-Ireland tax treaty. The ETF is also “accumulating” in the sense that the dividends are reinvested back to buy more units in the ETF. 

Did you know there’s a way to get the dividend withholding tax down to zero? And that’s through Blackrock’s low-cost iShares index funds found on the Endowus platform. In many cases, the iShares range of funds can also be cheaper than SGX-listed ETFs and UCITS ETFs. 

The US Index Fund that tracks the S&P 500 index uses an index futures-based approach with no US withholding tax and a low total expense ratio of just 0.08%. The fund is accumulating as well and is denominated in SGD, mitigating FX risks. 

Let’s summarise what we have discussed below: 

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Hefty estate tax for US-listed ETFs

If you hold US-listed ETFs, even if you're not a US citizen and live in Singapore, you could be on the hook for a hefty estate tax of up to 40% when you pass away. The tax applies to the total value of your US assets exceeding a very low exemption amount of US$60,000. 

For example, if you own a $1 million US-listed ETF (even if it invests in China), it could mean owing the US government up to $400,000 in taxes! 

However, when you invest in funds through Endowus, you don’t face this issue. 

Read more: What happens when an Endowus account holder passes away?‍

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. Find out the list of funds on Endowus Fund Smart.

Next on the Endowus Fin.Lit Academy

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