Why I do not like to invest in Unit Trusts (Mutual Funds)

One of my readers asked me if I could blog about Unit Trusts or Mutual Funds and this post is a result of being responsive to my readers. :-) Talk about semi-interactive blogging!

What are unit trusts?
Wikipedia defines Unit Trusts as "... a form of collective investment constituted under a trust deed."

It goes further to explain that, "Unit trusts are open-ended investments; therefore the underlying value of the assets is always directly represented by the total number of units issued multiplied by the unit price less the transaction or management fee charged and any other associated costs. Each fund has a specified investment objective to determine the management aims and limitations."

How a unit trust works is that you invest a certain sum of money with a professional fund manager who will take care of buying and selling the underlying assets in order to grow the unit trust. Generally, this is achieved through the fund manager being paid a performance fee should he hit or exceed his performance targets.

Sounds good so far, doesn't it?

The Unit Trust "Catch"
Now the catch of any unit trust or mutual fund (US term) is that regardless of how the fund manager performs, they will continue to earn a management fee from you even if they perform way below their benchmarks. Hence, if you put your money with them, and the benchmark is the STI, and STI has performed, say 20% and the fund manager has only managed 10% return, he would have underperformed his benchmark. He may not be given his performance fee but by golly, he will continue to deduct his management fee for taking care of the unit trust portfolio while you are busy slaving at your job for income and savings to pay for the expenses of the fund.

Most fund managers do not consistently out-perform their respective benchmarks
Statistically, most fund managers under-perform their benchmarks over the long-term. If you believe in the pareto principle, i.e. the 80-20 rule, you will realise that only a small selection of good fund managers are able to consistently outperform their benchmarks. The key here is consistent outperformance. In any given year, there will be fund managers of unit trusts that achieve sterling results. But how many of them can replicate this performance year-in year-out. Most investment books "One Up on Wall Street" by Peter Lynch or "Random Walk Down Wall" Street" by Burton Malkiel all point to one fact, that it is the minority that consistently outperforms their respective market indices after factoring in fund expenses.

I used to invest in unit trusts. I still have some but they form the smaller portion of my investments. Ever since 2003 when I began to learn to manage my own money, I have not invested in any new unit trust since then because I just do not believe in paying for mediocre performance. I can do that all on my own without the management fees and expenses charged by the fund against my investment monies. :-)


Should I invest in unit trusts then?
Unit trusts are not without their advantages. For instance, if you wanted to participate in the China market for the last 5 years, the only realistic avenue for the small investor was to invest in China through a unit trust. The growth of China has seen heady double digit growths in these sectors. Similar for India and other emerging economies. In addition, many of us have a day-job and cannot afford the time to be monitoring the markets all the time.

However, many financial gurus usually advise small investors to buy a low cost index fund and put some money in it through a regular investment plan and go for the long-term of 20-30 years. That is the way to beat money market, inflation and be relatively safe from the fluctuations of specific stocks or sectors.

I feel that investing is a very personal choice and it is up to each person to decide based on their experience, skills and objectives. Most unit trusts perform average and I hate to pay management fees for average performance. Diversification is also overrated to some extent and some funds e.g country or sectoral funds can even be riskier than holding individual blue-chip shares on SGX in my view. Take the example of Technology funds that tanked when the dot.com bubble burst in 2000-2001. Where are these funds now?

Before you decide to invest in unit trusts, at least visit the moneysense website and get information on making sense of unit trusts before you take the plunge.

There are many other investment asset classes to consider, do invest in learning more before parting with your money.

Be well and prosper!