Unit trusts vs. Exchange traded funds (ETFs)

Tracy Jensen, Chief Product Architect at 10X Investments,

What investors should compare these investment products

With the increasing popularity of passive investment strategies over the last decade, investors are faced with the question whether they should rely on unit trusts or rather go for an Exchange Traded Fund (ETF). 

According to Tracy Jensen, Chief Product Architect at 10X Investments, this underlies a common misconception that unit trust investments are actively managed and that Exchange Traded Funds are index trackers. Although this may often be the case it is not necessarily so. But as these are the most commonly used investment vehicles today, it is important that investors understand the differences between the two, as well as their underlying risks and benefits. 

Trading 

Both types of investments fall under the Collective Investment Schemes Control Act. “From a practical perspective, the main difference between unit trusts and ETFs, is how you buy or sell units. With an ETF, you need a ‘middle man’ to buy or sell on your behalf and to hold the investments on your behalf. You buy or sell units in the same way an investor would buy or sell shares, either via a stock broking account or trading platform.” 

For unit trusts, however, it is not necessary to have a stock broking account or trading platform. Jensen says that this makes unit trusts a more accessible type of investment. 

Another difference is that investors can trade an ETF intraday, but can only buy or sell a unit trust at a set time of day. For most investors this difference is irrelevant. 

Fee structures 

With any investment, it’s critical that investors pay close attention to the costs and fees associated with each vehicle. Jensen points out that both ETFs and unit trusts have explicit and implicit fees and expenses. 

Explicit fees include an investment manager fee (which is a percentage of the assets invested) and performance fees, in the case of most actively managed funds. 

“In South Africa, this fee ranges from around 0.2% pa to a few percent of the investment value. Typically the lower end of the fee spectrum is occupied by passively managed unit trusts/ETFs and the higher end by actively managed unit trusts/ETFs,” adds Jensen. 

Both unit trusts and ETFs types also incur implicit expenses such as brokerage, auditor’s fees, applicable taxes, custodian fees, bank charges and trustee fees. These are deducted from the fund as and when they are incurred. 

Jensen says that in addition, ETFs investors would incur additional fees as they need a ‘middle man’ to buy or sell units on their behalf and to hold units on their behalf. “In order to trade and hold an ETF, you also need a stock broking account or alternatively apply to be part of an investor plan, both of which typically have an ongoing cost attached to them. Furthermore, the investor may also incur debit order fees, stock brokerage fees, Strate fees and investor protection fees. Therefore, all else being equal, an ETF with the same explicit fees, will be more expensive than a unit trust.” 

She says the total expense ratio (TER) of the fund should give you an indication of the costs incurred. “However, this will exclude any advice fees, should you have an advisor, and any ETF transaction and holding costs, such as stock broking account or investor plan costs. Therefore, you need to account for these additional costs when comparing an ETF to a unit trust. Many investors do not account for this and wrongly assume that ETFs are a cheaper alternative to unit trusts.” 

Investment risks 

All investments have a level of risk and this depends on the investment strategy employed. Jensen says that when comparing ETF and unit trusts, ETFs may face some additional investment risks. 

“For example, a number of ETFs do not buy physical securities, but instead buy derivatives that aim to generate similar returns. For example, if you want to track the JSE Top 40 you can either buy all 40 shares or you can buy a single instrument (called a derivative) that aims to give you a similar return to holding all 40 shares. However, the returns may not be exactly the same and the person who sold you the derivative may not be able to pay you the return when it falls due. This is called counterparty default risk,” she explains. 

Further, ETFs seldom trade at the value of the investments which they are invested in. This means you may pay more to buy into the fund than the actual investments are worth, or alternatively you sell out of the fund below the value of its underlying investments. “If the ETF is not traded frequently these differences can be quite significant.”

Conclusions 

Before assessing whether and ETF or unit trust is the right product for you, you need to determine what you want to achieve with your investments. In other words, what your goals are and the type of investment that is best suited to these goals e.g. time period, active vs. passive, etc. Only after making these decisions should an investor assess whether a unit trust or ETF is preferable. 

“When deciding between a unit trust or an ETF, it is imperative that investors consider all of these factors, to ensure that they choose one that is most appropriate,” concludes Jensen. 

In November this year, 10X Investments launched a simple, low cost unit trust alternative. Promising diversity over a number of asset classes, each asset component tracks an index, making it ideal for investors with a time horizon of five years or more.