The problem with unit trusts 4 comments

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I may have recommended buying unit trusts for investors who see great potential in other countries' economies and want to participate in their growth (my blog on "Advantages of being a small investor"). However, it makes no sense to buy unit trusts that specialise in the local market. This has been my investing approach towards allocation of my stock purchasing funds.

The first problem is well-known to everyone who has bought unit trusts, and that is the substantial frictional costs. One has to pay 2.5-5% sales charge upfront on initial purchase, plus annual management fee of about 1-2% (buy through Fundsupermart to get the cheapest sales charge). For a capital sum of $10k one pays $250-500 even before making a single cent, and pays another $100-200 every year. Assuming a generous 5% dividend yield that is possible given the blue chips that these funds typically herd towards, effectively the dividends (and slightly more) flow to the fund managers while investors reap any capital gains. So, the model is: the fund managers get the income (steady) portion, the fund investors get the capital gains (volatility) portion. You take the risk and hope for proportionate reward, they take the steady money.

The second problem is one of helplessness in a fund encashment crisis. Fund managers usually try to discourage their holders to sell big chunks of their holdings because, given that they usually invest nearly all their cash holdings into stocks and bonds (or whatever their fund is mandated to buy), any large-scale cash redemption has to be met with partial liquidation of selected holdings to obtain the cash to pay the unit holders. Yet this is exactly what happens in a crisis (say Oct 1987 Black Monday) when panicky retail investors rush for the exits. The fund managers will be forced to sell stocks, at prices which have already plunged, to meet cash requirements for fund redemptions. A unit trust investor who refuses to panic is nonetheless dragged down because his fellow investors have forced the liquidation of his unit trust's holdings nonetheless. Note that this is different from the investor trading in his own account: he doesn't sell, he doesn't lose in real cash terms; he can wait for the inevitable rebound. The unit trust investor suffers the fate of seeing his stocks (which are held in the unit trust) being sold at rock-bottom prices regardless of whether he wants to sell or not; fund redemptions depend on the proportion of panicky fellow investors. And then, when the crisis is over, the fund receives new fund injections and repurchases the same stocks at much higher prices. The overall effect is that the same investor who held on through the crisis, instead of being rewarded for his steadfastness, is punished by effectively being diluted in his unit trust holdings.

The third big problem is that unit trusts will typically buy "discovered" stocks, or blue chips. For example, most funds put a third of their money into finance/banking stocks, the bluest of the blue chips in any economy. These stocks are safe, no doubt, but they rob the unit trust investor of one of my favourite strategies: the "spot what stock the fund manager is going to accummulate next" strategy. Besides being fun, this is also extremely lucrative. It is surely better than investing in unit trusts which are going to invest in stocks which have already been ramped up by peers' accummulations. The efficient market hypothesis is surely exerting a powerful influence in this category of stocks that are so widely covered by professional investors, such that the hope for any future gains is as good as the proverbial game of darts.

All being said, my point remains that unit trusts, nonetheless, remains the best method of investing in overseas markets. Investing overseas on a personal basis requires tremendous frictional costs, not just of brokerage commission and foreign exchange risk, but also substantially higher information risk and time risk (of having to keep in touch with the less accessible overseas news). Furthermore, it makes sense to buy unit trusts with your CPF: they allow the individual to utilise 100% of his CPF, compared to only 35% if he does his own purchases.