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Do You Know What You Are Buying Into? (A Closer Look at Unit Trusts & ETFs)
Education | 28 October 2011
By: Andy Chiok
Articles (1) Profile

In a recent survey by the Singapore Asset Management, assets under management (AUM) of professional money managers has risen to SGD 1.4 trillion*, a 12 percent increase from the same period a year ago. Even then, unit trust is one of the most mis-understood collective investment schemes amongst Singaporean, judging by the questions that even Financial Advisor’s Representatives are asking at Continuing Professional Development (CPD) sessions.

Other than buy low sell high and unit trusts being very good diversification instruments, what do you, as the investor, understand about relative vs absolute returns or ‘cheap’ and ‘expensive’ unit trusts, for that matter?

Top of the list of misconception is returns. Performances of unit trusts are, generally, reported on a relative basis. The unit trust will hold a portfolio of stocks and shares in accordance to its mandate. The Net Asset Value (NAV) of this portfolio is then calculated and matched against the NAV of its benchmark. Out-performance or under-performance is thus determined.

This can result in the absurd situation where the unit trust has out-performed its benchmark and yet loses money. During a market correction when the benchmark is down 10 percent, for instance, the fund manager may boast that the fund has outperformed the market if it is down merely 6 percent, regardless of the fact that the fund is in the red. This is one of the reasons why more and more ‘absolute return’ funds are making their appearances in the marketplace.

“When a fund is managed on a relative return approach, it is highly likely that the fund’s performance will mirror its benchmark. The composition of the fund in terms of stocks is likely to mimic the breakdown of the index with minor “over-weightings” or “under-weightings,” says Gan Eng Peng, Head of Equities at Hwang DBS Investment Management.

So what is this over/ under-weightings? A lot of FA Reps and even some analysts are using such jargons without really understanding the meanings of the words. First of all, in order to over or under-weigh something, one needs to have a ‘control’, what we at New Independent (NI) refer to as the NI Model Portfolio. This is the weightage of allocation to countries and sectors in the ‘most ideal’ situation.

As time passes and markets fluctuate, financial advisors may be overweight Emerging Markets, for instance, and underweight Europe. What the Financial Advisor is saying is that The House is recommending a 5 (sometimes 10) percent increase in allocation to Emerging Markets and the same in the opposite direction for Europe. It does not mean “putting all your money in Emerging Markets while cutting all positions in Europe.” This is tactical asset allocation, an ‘active’ strategy as compared to a static asset allocation strategy with periodic rebalancing.

The model portfolio (in the above illustration) defines the broad long-term investment (portfolio) guidelines. Asset (tactical) allocation defines the short-term, generally minor, variations that The FA will employ to enhance returns or manage risk by taking advantage of market pricing anomalies or strong market sectors. Under/Over weighting illustrates how the tactical overlay manifests itself across the various asset classes.

*Source: 2010 Singapore Asset Management Industry Survey; MAS

How many FA Reps or investors really understand this? Alarmed at the number of financially-illiterate investors purchasing complex instruments from banks and FAs, The MAS is stepping in to arrest this problem. In a policy consultation on regulatory regime for listed and unlisted investment products, it has proposed that “intermediaries formally assess a retail customer’s investment knowledge and experience before selling investment products to the customer. Customers who do not have the relevant knowledge or experience in specific unlisted investment products must be given financial advice before being able to purchase the product.” By 1 Jan next year, it is mandatory that FA Reps ensure that clients are proficient in investment before products can be sold. Investment-linked insurance will also be included.

This is jumping the gun a little if FA Reps are the ones who need the training in order that they don’t punt clients’ investment monies. After all, what is wealth management if it is not asset allocation?

Finally, Is there such a thing as an expensive unit trust (not referring to management and other miscellaneous fees)? This is the most misunderstood concept that investors have. When a unit trust is bought at $12, is it a ‘more expensive’ unit trust than one at $1.20?
A unit trust is not like shares. Forces of supply and demand do not affect its price. Rather a unit trust is priced when front-end fees are added to its NAV. The fund manager, Aberdeen for instance, can create as many units as it wants to if the unit trust is heavily subscribed. Furthermore, the investor is purchasing a unit of the entire portfolio, not the shares of a company which are limited at its initial public offering (IPO). These shares are priced according to their forward P/E and the fact that the authorized capital of any company is limited means that prices will go up if demand is heavy.

Also, the performance of a unit trust depends on the performance of its underlying holdings of stocks and shares, not on the price of the unit trust.

To raise an example, say an investor has purchased $1000 worth of units each from two unit trusts focused on China, one at $1 and the other at $10. At the end of the day, he is invested $1000 in unit trust A and another $1000 in unit trust B, both focused on China. So which unit trust is more expensive?

Simply put, an investor is invested in the NAV of a portfolio of stocks and shares. He is not purchasing the shares of a company with the hope that others will chase up its price.

Exchange Traded Funds (ETFs) work the same way except that it is a tracker fund that tries to mirror the index that it is designed to track through the use of derivatives and borrowed shares. The ETF manager, or the sponsor, will then create or redeem ETF shares over the counter. These shares can be bought and sold just like stocks and shares. As tracker funds, ETFs are not actively managed.

Currently a communications specialist, Andy has also spent 15 years in banking & finance dealing with derivatives, FX, Equities, and Wealth Management. He is a Certified Financial Planner (CFP) and holds an MBA from South Australia. Andrew also has a professional diploma in banking & finance from the Institute of Banking & Finance.

Please click here for more information about this author.

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