How To: Make Sense Of Funds
Funds can be a great way to gain exposure to shares and other different kinds of investment vehicles as part of your Asset Allocation plan. In this article, we briefly describe the different types of Funds available and how they might fit into your portfolio.
Unit Trust: A pool of money from different investors which are managed by a Fund Manager. The Fund Manager will use that pool of money to invest in different kinds of investment instruments such as shares and bonds. When you contribute a sum of money to that pool, you are in effect, an owner of a small slice of all the different investment instruments that the Fund owns. The term Unit Trust is used predominantly in Singapore and other Commonwealth Countries while Mutual Fund is a term used commonly in the USA. For all practical purposes for a retail investor like you, the two terms can be used interchangeably.
It is important to note that the performance of an investment made in Unit Trusts would be largely dependent upon the skill of the Fund Manager in picking winning investments. Unit Trusts also have a Mandate, whereby a description of the types of investments that the Trust is allowed to make is given. For example, if a Trust has a Mandate such as ‘Singapore-listed Food & Beverage Companies’, then it is only allowed to invest in Singapore-listed companies that operate in the F&B industry, such as BreadTalk (5DA.SI).
Due to the dispersion of skill among Fund Managers, investors in Unit Trusts can achieve results that range from doing much better than the overall market (usually measured against a broad market Index) to performing way worse than it. Before attempting an investment in Unit Trusts, you as an investor should already have a basic understanding of the share market and should have a very good grasp on the signs distinguishing a competent Fund Manager from an incompetent one – you are choosing Unit Trusts because you are too busy with other aspects of your life but would still want superior results from share picking. Furthermore, if you think your portfolio needs more exposure to shares of companies from a certain industry or market-cap, you could also choose Unit Trusts that have investment mandates that fulfil your needs.
Now, before you rush off to purchase Unit Trusts thinking you can get above average results while putting in next to no-effort, bear in mind that it is very tough for professional Fund Managers to beat the market and in 2012, only 31% of Fund Managers in the USA managed to beat the USA broad market index (S&P500). So, please bear in mind the very important qualifying statement that an investor in a Unit Trust should have a very good grasp on the signs that distinguish a competent Fund Manager from an incompetent one before investing in Unit Trusts.
Index Fund: A special type of Unit Trust or Mutual Fund that buys shares in different companies such that it matches and tracks a Market Index at the lowest possible cost. There are many different kinds of Market Indices and some of the more well-known ones in the Asian region include the Straits Times Index (the Singapore Share Market Index) and the Hang Seng Index (the Hong Kong Share Market Index).
The performance of an Index Fund is dependent upon the movement of the Market Index that the Index Fund is tracking. If you want exposure to the broad share market as part of your Asset Allocation plan, an Index Fund would be a good addition to your portfolio for you. There are market-cap Index Funds, industry-sector Index Funds and many more and these can also be included in your portfolio as part of your Asset Allocation plan instead of investing in individual shares or Unit Trusts.
As we mentioned earlier, it is extremely tough for Fund Managers to beat the overall share market and so, it becomes doubly tough for an investor to know how to pick a Unit Trust with a competent Fund Manager. In that regard, we think it would be best for most investors to stick with an Index Fund for exposure to the share market if individual share-picking is not their cup of tea. An Index Fund allows investors to participate in the overall wealth-building capabilities of the share market while removing the risk that comes from individual share-picking.
ETF: An ETF, or Exchange Traded Fund, is similar to an Index Fund for all practical purposes to a retail investor like you. The main difference, though, between an Index Fund and ETF is that an ETF is traded on the Stock-Exchange, just like the shares of publicly-traded companies while an Index Fund does not. An ETF would also probably cover a wider range of more exotic Market Indices than those covered by Index Funds. As an investor, if given a choice between an ETF and Index Fund, the important consideration in choosing one over the other would be the total annual expenses associated with them – we would certainly prefer the one with the lower total annual expense. ETFs and Index Funds usually have annual expenses ranging from 0.1% to 0.65% and 0.1% to 3% respectively.
So there you have it, a brief description of Mutual Funds, Unit Trusts, Index Funds and ETFs and how they can all be a part of your portfolio in your Asset Allocation plan!