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Unit Trusts – Pertinent Points To Consider When Investing In Funds (Part 1)
Education | 31 May 2010
By: jason.liew
Articles (66) Profile

Most readers would have seen advertisements or articles on funds with multiple “stars” attached to them. They are typically accompanied with excellent reviews from those mutual fund rating agencies. Notwithstanding their sound reviews, investors would typically do their own research. However, what do they look out for when they do their research?

I have written a fair bit on unit trusts investing – i.e. how they are different from stocks and the reasons for investing in unit trusts rather than stock investing. In the following two articles, I will be writing more on the important points which investors have to consider when they are doing their research on their choice of equity funds.

First of all, understand yourself

As with all investments, you have to know yourself first before you can understand about funds. What do I mean? Let’s start with an example. Given person A, whose risk profile only allows him to withstand a capital loss of around 30% in any fund; he should not be looking into emerging markets funds, as these funds typically have higher risk and may easily drop more than their risk threshold. Furthermore, less risk adverse investors should not put all their assets into aggressive funds which invest in small companies in traditionally more risky industries such as biotechnology or oil exploration industries.

Secondly, I notice that some of my friends are just adverse to companies in China, perhaps from their bad experiences with some of the SGX listed S-chips or due to their business dealings with the Chinese firms. As a result, their investments should not be China funds (even if these are good funds) as the funds are against their beliefs.

Thirdly, some investors abhor stocks in certain industries such as tobacco industry or gambling industry. Therefore, they should choose the funds carefully so as to adhere to their beliefs.

Fourthly, it is also important to know your target rate of return for your investments. This is important as this will affect the time taken to reach your goals, be it to buy a dream house, or for retirement purposes. Knowing your target rate of return would also enable you to rule out certain fund types or at the very least, reduce your allocation in them. For example, if you plan to retire in 35 years time (starting work at 25); your target rate of return for your investments would be significantly different from one who intends to retire in 20 years. The investor who intends to retire in 20 years is likely to have a higher allocation in equities than the investor who plans to retire in 35 years.

After understanding your personal risk profile and preferences, you can consider the following points for your research on unit trusts.

A) Track record of the funds

Although historical performance may not be indicative of future returns, I find that historical returns are quite a good gauge of future returns (barring changes such as abnormal market conditions; fund manager changes etc). Therefore, one of the prerequisites in fund research is to analyse the track record of the funds.

Do not be misled by a fund’s absolute track record. A fund can register 20% return for the quarter and it may still not be a good fund to invest. This is because an absolute return is not sufficiently representative of its track record. The performance should be compared either against a benchmark, or its peers.

Readers should be aware that the benchmark used should be a good comparable against a fund (this is unlikely to be a problem for large recognized funds). For example, an Asia Pacific Ex Japan fund should use a benchmark such as MSCI Asia Pacific ex Japan Index, instead of the S&P 500 Index.

The performance of a fund can also be compared against similar Asian Pacific ex Japan funds to determine which fund is the best fund in the sector.

B) Manager

For active funds, one of the most important points to research would be its fund managers. There are generally three ways in which how funds are managed.

Single manager approach
The fund’s investment decisions are taken by one sole person. Although he may be supported by numerous research analysts, the fund manager will be the only one to decide on the investment choices.

Management team approach

As the name implies, the investment decisions are decided by two or more people. There may be an investment committee (IC) where the fund managers present their ideas across and the IC would be the final body to decide on the investments.

Manager of Manager approach

For manager of manager (MoM) approach, the client gives the assets to the MoM who distributed the assets into the various asset classes (in line with the client’s agreed asset allocation) held by different fund managers. These fund managers work independently of each other and would report their performance to the MoM who would collate at a total portfolio basis and report to the client. The MoM’s role is to track the performance of each fund manager and she is typically empowered to replace any under performing managers on the client’s behalf.

Regardless of how the funds are managed, it is important to ensure that the fund managers who contributed to the majority of the fund’s track record should still be running the fund.

C) Costs

For unit trust investing, there are likely to be fees such as sales charge, redemption fees, annual management fees, performance fees etc. These costs are important because they “eat away” returns from your funds. Thus, investors should understand the type of charges required for the particular fund which they are investing and they should evaluate whether these charges are worth paying. For example, more actively managed funds are likely to incur higher management fees than less actively managed funds. Investors would have to evaluate whether such actively managed funds are “worth” the higher management fees.

I have tabulated the potential costs which may be incurred in investing in an equity fund in Table 1 below.
Explanation of potential costs
Table 1: Explanation of potential costs

Conclusion

Investors should consider the above factors when they are doing their research on their choice of funds. In the next article, I will be discussing on the important risk – reward profile of the fund which investors should look into before they invest in the funds.


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The Shares Investment editorial team welcomes constructive feedback on our coverage and content. We would also be delighted to answer any questions on the above article. Leave us a comment below, and we'll get back to you shortly!

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