The cost trap: why you should not always trust unit trusts

Recently I read a lot about unit trusts, which most of the time are actively managed funds with high expenses. They are well loved by financial advisers trying to earn some commissions, but I would like to explain why you should be very careful when evaluating unit trusts.

The vast majority of actively managed funds fail to beat the market

It is a well-known fact, the vast majority of actively managed funds does not outperform passive index funds in the long term after fees. There are two main reasons for this: first the market is overall very effective and beating the market is difficult in the short term and near impossible in the long term. Second: actively managed funds and unit trusts often have huge expenses which massively drag down performance.

There are some active managed funds which manage to beat their benchmarks for some years, but good luck identifying them. Also remember: past performance is in no way an indicator of future performance!

I do not want to go into too much detail, but I can really recommend the book “A Random Walk Down Wall Street by Burton G. Malkiel  for anyone that wants to learn more.  He wrote:

“Since all the stocks in the market must be owned by someone, it follows that all the investors in the market will earn, on average, the market return. The index fund achieves the market return with minimal expenses. The average actively managed fund must underperform the market as a whole by the amount of the expenses that are deducted from the gross return achieved.”

Another very good article “The Arithmetic of Active Management” on the topic of actively vs. passively managed funds was written by William F. Sharpe from Stanford University. He comes to the conclusion: “Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement”

Unit trusts are expensive

Often when I log out of my Standard Chartered online banking I am greeted by this ad:

No wonder the guy has to work non-stop sitting in his work clothes in some hotel room. He can never ever retire! He is paying a 1.5% sales charge on his unit trusts. If 1.5% seems absurdly high to you I can only recommend you browse the Standard Chartered Fund library, where you will find many funds with charges up to 6.25% and yearly charges of up to 3%! Often you will not only be slapped with a sales fee and yearly high expense ratio, but even with a redemption fee when selling the product.

Be careful! I am not bashing Standard Chartered here. These charges are normal and all major banks have these fees.

Obviously expenses matter. If you already have to take a 5% penalty when buying the fund and you pay 3% in expenses each year the chances that this fund will outperform a passive fund are close to nil.

Let’s look at the costs: Unit trusts vs. passively managed ETFs

Here is a little, simplified scenario:

Let’s assume you would like to invest SGD 10,000 in a fund trading equities from Asia Pacific excluding Japan. You want to hold the fund for ten years and then sell it. We will compare two options from Standard Chartered, a passively managed index fund vs. an actively managed unit trust.

(ad [1],[2],[3]: For details see the note section below the article)

Conclusion: the actively managed fund has huge costs associated with it. These costs will severely reduce the performance of your investment. If you want to play with some numbers you can visit this page at Vanguard: Why costs matter.

Front load or sales charge costs are especially worrying, because they lower the value of your portfolio from the start. If you check the actively managed fund’s fact sheet in our example you will see how closely it follows the benchmark index. Historically speaking you obviously you would have been better off investing in a passive low cost fund than this one.

So why do so many financial advisers recommend unit trusts and actively managed funds?

The main reason is that selling actively managed funds and unit trusts will make them a lot more money. Most financial advisers do not earn anything recommending passively managed cheap funds.

Conclusion:

Actively managed funds are not necessarily bad. There are some good ones around, but the key is to carefully evaluate and to check the associated costs. More often than not they are outrageously expensive and their costs will eat into your returns. Calculate the costs over the total life of your investment!

Before you buy any actively managed fund or unit trust you should:

• Keep the costs in mind: how much is the sales charge? How much will it cost to sell? How high is the expense ratio per year?
• Compare to passive options: are low cost index funds available that are very similar?
• Run the numbers for the total planned life cycle of your investment

If you are not convinced by my article I do not blame you. Advice from the internet is always to be taken with a grain of salt. You could however read some good books on the topic and maybe drop by the Bogleheads page & forum to educate yourself before buying costly unit trusts.

Where actively managed funds make sense

Are all actively managed funds bad? Of course not! There are some very specialized actively managed funds available. Specialized commodity funds, for example agricultural commodities could be an interesting choice. My recommendation is to limit this type of investments to a small percentage of your total portfolio (<5%).

Notes

1. The Index fund is traded in HKD and currency conversion fees are excluded. Similar index funds are available in SGD but they are not traded much, so they do not make a great example.

2. Fund yearly expenses are a % of fund value. For easier calculation I have assumed the markets stay flat. For sake of easier comparison this works.

3. Index fund ETFs do not charge fees to redeem or buy, and you only have to pay the small trading commission. Unit trusts often charge redemption fees, make sure to check.