Index funds and unit trusts often sound very similar, especially on paper. Investors are often confused between the two and struggle to even differentiate them, let alone know how to make the smarter choice between index fund and unit trust.
Here are four tips to help you discern the two and decide which is a smarter investment choice for you.
Definition: Index fund vs unit trust
Index fund refers to either an exchange traded fund (ETF) or mutual fund that tracks the performance of an index. Investors like you and I will pool our money together in the fund, and the fund manager will manage the fund based on its investment mandate. When investing in a variety of assets, the fund manager will aim to match as closely the constituent of the index that the index fund is mandated to track. Index fund ETF can be traded during market trading hours while index tracking mutual fund can only be traded at the end of the day based on the fund’s net asset value (NAV).
Unit trust is similar to an index fund in most ways. It also pools money together from multiple investors (regardless of size) into a portfolio of assets. But unlike an index fund, the constituent of the portfolio is dependent on the investment objective and investment approach of the unit trust. Although it can, a unit trust doesn’t have to be tracking the performance of an index. Furthermore, unit trusts can only be bought or sold at the end of the day based on the closing NAV of the unit trust.
1. Index fund vs unit trust: Fees and expenses
There are four types of fees that are chargeable whenever you invest in unit trusts: Subscription fee, redemption fee, switching fee and recurring fee. While most unit trusts charge similar types of fees, the amount of each type of fee can vary from unit trust to unit trust. Thus, it is important to read the percentage fees of each type of fee if you are looking to invest in a unit trust.
Unit trust: Subscription, redemption, switching, and recurring fees
Subscription fee is also known as sales charge. Like the name suggests, you will need to pay a fee whenever you buy a unit of unit trust. The subscription fee can range from 1.5% to 5% of your investment.
Redemption fee, or realisation charge, is a fee that is payable when you want to redeem (read: encash) your investment in a unit trust. The redemption fee can be anywhere between 1% to 5% of your total investment. Most
One thing to note is that unit trusts typically charge one or the other. Funds that charges you an initial sales charge generally do not charge a redemption fee.
The other fee that is often associated with unit trust is switching fee. Imagine if you want to switch from one-unit trust to another during your investment period. This will incur a switching fee that typically costs you around 1% of your investment.
Apart from the cost of switching and initial cost of investment, unit trusts also have recurring fees. There are three typical types of recurring fees that you need to keep a lookout for: Management fee, trustee fee and other miscellaneous fees. These recurring fees are charged by the fund for providing their services.
Management fee is an annual fee that is usually 0.5% to 2% of the unit trust’s NAV. On top of management fee, a trustee fee is also charged for providing custodian services to safekeep the assets. This adds another 0.1% to 0.15% of the unit trust’s NAV to your total expense ratio. The total amount of recurring fees can go as high as 2.15%!
Index fund: Expense ratio, brokerage and custodian fee
Unlike a unit trust, index fund has much lower fees and expenses. For a start, index funds do not charge any sales charge or subscription fee. Secondly, instead of categorizing its fees into individual components like unit trusts, the fees are lumped into a single expense ratio. If you invest in an index fund, the typical annual expense ratio of an index fund is around 0.11%. This is much lower than the fees incurred when you invest in a unit trust.
An expense investors often neglect when they invest in index funds is the brokerage fee. Instead of investing with the fund directly, index fund investing involves buying and selling through a broker on the exchange. The broker will charge a brokerage fee for offering the service to buy and sell your index fund for you. For local brokerages, the brokerage fee is S$25 for each transaction (i.e. a buy or sell transaction). This sums up to S$50 for a complete buy AND sell transaction.
For an initial investment of S$1,000 in an index fund, this translates to 0.5% of your NAV. Instead of making multiple transactions, you can accumulate your capital and make a single investment transaction to lower the ratio of the brokerage fee to your NAV. If you prefer a dollar cost averaging strategy, you can choose to invest in index funds through a regular savings plan instead.
Given the limited options of index funds in the Singapore market, you might be considering investing overseas index funds. An extra expense that comes with investing in an overseas index fund is the custodian fees if you purchase it through a local broker like UOB Kay Hian or OCBC Securities. Your broker will levy a custodian fee of S$2 per counter per month, which translates to an annual fee of S$24 per annum. For an investment of S$1,000 in an index fund, this translates to 0.24% of your NAV.
Verdict: Cheaper is always better. Index fund.
2. Index fund vs unit trust: Investment objective
Index funds are designed for simplicity. The aim of an index fund is to track the performance of a market index (e.g. Straits Times Index, S&P 500). Thus, the only choice you have as an investor is to choose which type of index you would like to track.
On the other hand, unit trusts were designed with more financially savvy investors in mind. Thus, unit trusts have a wider range of investment objectives compared to index funds. You can choose to invest in unit trusts that specialize in different financial instruments, from money market to bond to pure equity to specialised funds, or even a balanced fund. Apart from different investment assets, you can also choose from different geographical region, investment style, investment themes and sectors.
Note: There are also unit trusts that tracks the performance of indices. It will be more cost effective to invest in an index fund rather than index tracking unit trusts.
Verdict: Unit trust (For investors who prefer more investment options). Index fund (For investors who prefer simplicity).
3. Index fund vs unit trust: Investment returns
If you choose to invest in an index fund, your investment will always track the market performance. Thus, your investment return will be dependent on the market performance. Apart from tracking error, your index fund return will never outperform the index. After all, they were designed to track the market index performance. The beauty about index fund is that your returns are led by the market without any potential concern about underperforming or outperforming the market.
On the other hand, (most) unit trusts aim to outperform their benchmark index. Unit trust managers are actively seeking investment opportunities to try and outperform the benchmark index. There is a chance that your investment return will be higher than index funds. However, the higher potential return also indicates that you will need to take on higher risks for unit trusts, compared to index funds. You might significantly under or over perform against index funds, depending on the constituents’ performance in your unit trust.
Verdict: Unit trust (for the more risk loving). Index fund (for the risk averse)
4. Index fund vs unit trust: What do you really need as an investor?
This is the most important step in deciding whether an index fund or unit trust will suit you better as an investor. If you want to make a smart choice between index fund and unit trust, this is THE determining step. This step will help you make a holistic decision between fees, investment objective and investment return.
For example, if you have a moderate-to-low risk tolerance, it makes more financial sense to pursue an index fund. This is because it has lower associated investment risk. Likewise, you can also choose to invest in a bond-focused unit trust with lower associated risk. Then, you need to consider whether the fees and expenses of unit trusts outweigh the returns of a bond-focused unit trust. You also need to consider whether the additional risk associated with unit trust is something that you can accept and still sleep well at night.
To summarize, what you need to consider is how an index fund or unit trust fit into your financial plan. It also needs to fit your personal investment objective and risk profile. Now, are you ready to make a smart choice between unit trust and index fund?