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Unraveling The Unit Trust Mystery
Education | 22 December 2010
By: jason.liew
Articles (66) Profile

Although practically an everyday word, unit trusts are a very misunderstood class of asset. Other than it being a diversified investment tool, many – including accredited investors – have no idea what it really is, how it is priced, or what to do with it.

Simply put, a unit trust, like a hedge fund, is a collective investment scheme. Monies from investors are pooled to purchase a basket of stocks and shares. This, in turn, is managed by a professional fund manager appointed by the fund. In other words, the fund – say Aberdeen Pacific Equity Fund – is a separate entity that can own assets, sue, and be sued. The fund manager, Aberdeen Asset Management, is appointed by the fund to manage it, and therefore charges a management fee.

The Most Misunderstood: The Fund Is Too Expensive

When a fund is retailed at SGD 3, does it mean that it is too expensive? To start off, a fund is priced based on its Net Asset Value (NAV). NAV is the difference between the assets of the fund less all liabilities. This is, in turn, divided by the number of units being held by subscribers. Unlike the pricing of stocks and shares, forces of demand and supply do not come into play.

Shares that a company issues during an initial public offering (IPO) are finite. When these shares are traded in the secondary market (i.e. the stock exchange), supply and demand will determine what prices these shares will be bought at or sold. This is not the case with unit trusts. Units that investors subscribe to are indefinite. The manager can create as many units as he wants if there are many subscribers (e.g. a popular fund like the UBS Asia Consumption Fund). Therefore if a fund is priced at $1.5 per unit, it simply means that there are a lot of units for the NAV to be spread over while one priced at $5 means that there are less – ceteris paribus. THE NET ASSET VALUE WILL ALWAYS REMAIN THE SAME.

Second On The List: Returns

Most unit trusts are benchmarked against an index that the manager will try to beat. The Aberdeen Pacific Equity Fund, for instance, is benchmarked against the MSCI AC Asia ex-Japan Index. Should the benchmark collapse, the fund will inevitably suffer a loss regardless of whether the manager has done his job beating the benchmark. For instance in the 4th quarter, the MSCI Asia ex-Japan Index has dipped 23.8 percent during the 1997 Asian Currency Crisis. Even if the manager of a fund benchmarked against this index should outperform it by 5 percent and has justified his management fee, it doesn’t cancel out the fact that investors are sustaining a loss of 18.5 percent. Investors have to understand that the returns of most unit trusts are relative, not absolute.

Relative return, then, is the difference between absolute return and a market index. If the absolute return of a fund is 20 percent and the benchmark index has risen by 10 percent, then the relative return is only 10 percent.

So why the fuss over relative and absolute returns? This is because an investment does not exist by itself. It has to be compared to the next best alternative to make sense. If a fund manager boasts an absolute return on his fund of 12 percent, it really means that for every dollar invested, the return is 12 cents – a pretty decent return. But if the index has appreciated by 15 percent, then the fund is not so hot.

Staying Invested…Does It Still Work?

Advice from financial planners has always been to stay invested and not get distracted by the noise. After all, investment is for the long term. But does this maxim still work?

View Full-sized Image

The above is a 30-year chart of the S&P 500. There have been numerous crises during this period: The Cuban Crisis, Bay of Pigs, the oil crisis, collapse of the Japanese market, default by Russian and Argentinean governments, the Asian Financial Crisis, and most recently, the CDO debacle in the US, the mal-function of credit creation, and the sovereign issues in Europe. If a retirement plan consisting of investment in passively-managed funds is executed in 1971 and has stayed invested for the next 30 years – regardless of what has been happening around the world – it would have risen by *1274.83 percent. This is the reason why Warren Buffett is a billionaire.

On the other hand, if someone is to be invested prior to the Tech Bubble burst in 2000, no amount of dollar-averaging can save the situation. After the bubble has burst, the tech-heavy NASDAQ Composite has fallen by 78.4 percent from the peak of 5,132.52. Similarly, the S&P 500 has dipped about 50 percent from a peak of 1,553.11. Does ‘buy and hold’ still work in these situations?

Selling The Winner, Buying The Loser”

Rebalancing the portfolio can improve the risk of the portfolio as well as limiting losses. A portfolio’s asset allocation determines its risk/ return characteristics. This allocation will change as the assets produce different returns over time. Rebalancing is bringing the portfolio back to its original allocation. Over-weighted funds can be sold to purchase under-weighted ones.

Constant mix rebalancing is the strategy to keep asset allocations in their original mix. For example, an original portfolio of 60-40 in favour of equities may end up as 70-30 at the end of the year. Rebalancing the portfolio to its initial target allocation will ensure that the portfolio’s risks remain constant over time.

An Example

Abu and Baba are two investors with $100,000 portfolios. These portfolios are allocated 70-30 between equities and bonds. While Abu practices rebalancing at the end of each year, Baba is happy to let his portfolio run its course. Equities will rise every year at 30 percent before collapsing 70 percent at the end of year 4. Bonds will pay a return of 10 percent per year.

Baba


Abu

Portfolio is 'brought back’ to 70-30 allocation
Portfolio is ‘brought back’ to 70-30 allocation

As Abu’s equities grow at 70 percent, he’ll rebalance his portfolio yearly by ‘transferring’ profits to the debt section, keeping his 70-30 allocation intact. When the stock market finally collapses at the end of year 5, Abu’s equity portion suffers a loss of 15.66 percent but his capital has grown!

Baba, on the other hand, has to sustain a 34 percent loss on his equity portion.

Portfolio balancing is a vital part of investment. Constant Mix Rebalancing is a simple mechanism that ensures that the portfolio is ‘buying low and selling high’. More importantly, it reduces risks and provides for adequate diversification.


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