Do Exchange Traded Funds Really Trump Actively Managed Funds?

/ / iMoney

Though known as the new kid on the block, the exchange traded fund, or ETF, has been around since 1993. However, it only started picking up in 2003 and has yet to catch up in Malaysia.

The first ETF in Malaysia launched in 2005, but due to the lack of awareness and education, not many understand how it works much less how to invest in it.

As of 2015, the total ETF market in Malaysia was only valued at over RM1 billion. Currently, there are eight ETFs listed on Bursa Malaysia.

Similar to unit trust fund, an ETF is a collective investment scheme that allows you to invest in diversified underlying assets.

What is an ETF?
It stands for exchange traded funds. This is a collective investment scheme like unit trusts but the difference is that the funds are listed on stock exchanges. You can trade – buy and sell – them throughout the market trading day.
Another key feature of ETFs is that they have an investment strategy that is index-based. For instance, a global emerging market ETF would buy component stocks of a global emerging market index in exact proportions of the component weights.
■ Julian Ng, CFP, presenter/producer at BFM 89.9. He also writes on The Very Long Run.

ETFs are also regulated by the Securities Commission. Much like unit trust funds, ETFs offer investors the opportunity to invest in a diversified list of assets with lower capital requirements.

That’s where the similarities end. A unit trust fund buys and sells assets to drive gains. It’s what we’d call an actively managed fund. Where else the ETF is index based, so it’s comprised of the assets in that particular index in matching weights, hence its performance is tied to that of the index, and there’s no buying or selling or dependence on the skill of a fund manager. The buying or selling only occurs in order to stay on track with the index’s weights. You could say that it’s a passively managed fund.

Here are some other key differences between investing in ETF and investing in unit trust, and why ETF wins in these areas:

1. ETFs have a generally lower minimum investment

With unit trust, you may have a higher minimum investment capital of RM1,000, whereas ETFs entry amount depends on the market price like a unit trust but you can buy it with more flexibility with the minimum being just 1 lot (100 units).

For example, if the reference price for FTSE Bursa Malaysia KLCI ETF is at RM1.725, your minimum investment is one board lot of 100 units. Your minimum investment comes up to RM172.50 for one lot.

This makes it much easier for people to start investing in ETFs.

2. ETFs have lower investment costs

The biggest selling point for ETFs is the low cost of entry. It costs a lot less than investing in unit trust, as long as you have a trading account with a broker, you can buy an ETF. So it’s not just that the minimum amount required is lower but it also has fewer costs associated to getting into it.

Investment cost is an important consideration for investors because fees and charges erode one’s investment earnings. To compare the entry cost for both types of investment, you need to look at the sales charge of the unit trust versus the platform fee of an ETF.

Fees & charges
Unit trust funds
Exchange traded funds (ETFs)
Initial fee
Sales charge
Up to 5.50% of the NAV per unit
Brokerage fee
Up to 0.70% of the contract
value (subject to a minimum
of RM40)
Annual management fee
Up to 2.00% per annum of the
NAV of the Fund
0.60% per annum of the
NAV of the Fund
Annual trustee fee
0.06% per annum of the
NAV of the Fund
0.08% per annum of the
NAV of the Fund

Brokerage fee for ETF can be as low as 0.25% of the transaction amount, while unit trust is often 2.00% to 5.50% of the NAV per unit. Even on a do-it-yourself platform like Fundsupermart, unit trust requires 2.00% sales charge.

This makes a huge difference in your investment in just five years of investment:

RM10,000 investment
Unit trust funds
Exchange traded funds (ETFs)
Yearly return before fees
5.00%
5.00%
Initial charge
5.00%
0.70%
Value in 5 years
RM12,191.91
RM12,743.75

You see an additional RM551.84 in five years with the same initial investment of RM10,000 due to the lower initial fee.

3. ETFs recuperate costs faster

To understand and manage the long-term cost of investments, you need to compare the Total Expense Ratio (TER) for the first year. TER is primarily made up of management fees and additional expenses, such as trading fees, legal fees, auditor fees and other operational expenses.

ETFs have been known to have much lower TER than unit trusts. For example, the Vanguard’s FTSE Asia ex Japan Index ETF only has an expense ratio of 0.20%, while Eastspring Investments Asia-Pacific ex-Japan Target Return Fund has an expense ratio of 2.08%.

There’s a huge difference in cost between these two funds:

RM10,000 investment
Eastspring Investments Asia-Pacific
ex-Japan Target Return Fund
Vanguard’s FTSE Asia
ex Japan Index ETF
TER
2.08%
0.20%
Cost in a year
RM208
RM20

In this example, the long-term cost of the unit trust fund is more than 10 times of the ETF. As such, given positive returns, you are able to recuperate the cost of investment with an ETF much faster.

Note
Investors have to pay brokerage commission every time they buy or sell an ETF. Therefore, it is not encouraged for investors to ringgit cost average with small amounts using ETFs (or any investments that incur transaction cost) because the commissions may stack up and negate its lower investment cost.

4. ETFs have lower trading cost

Active trading does have its cost. According to Investopedia, the more actively managed the fund is, the higher the associated TER will be, due to increases in personnel costs and transaction-based fees. By comparison, a passively managed fund has significantly lower costs of operation, and as a result, has a lower TER.

ETF subscribes to the idea of passive investing, where you buy and hold for long-term. Unlike unit trusts, where the fund managers consistently have to trade the underlying stocks in order to get the highest possible returns, ETFs just have to buy the stocks according to the indices they are tracking once.

This buy-and-hold strategy adds to the low cost feature of ETFs because fund managers just make occasional changes, whenever there are additions or deletions to the indices they are representing.

5. ETFs are more reliable

An ETF investor will be getting returns that is representative of the geography or the asset class that the ETF is represented. For example, if you are investing in the CIMB FTSE China 50 ETF, your returns will mirror the FTSE China 50 index, which consists of 50 Chinese stocks listed and traded on the Hong Kong Stock Exchange. This also makes it easier to understand what the fund does instead of relying solely on the fund manager’s strategy in a unit trust fund.

In unit trusts, the fund manager selects the stocks which he thinks offer the highest possible return as per the fund’s objective. The ultimate objective is to outperform the market. The investor would need to understand the fund’s strategy and then trust that the manager can deliver on the objective.

However, that objective may not always be achieved. According to a study  by S&P Dow Jones Indices, 98.9% of US equity funds underperformed over the past 10 years, while 97% of emerging market funds and 97.8% of global equity funds suffered the same fate.

With ETFs, however, the market returns depend on how the benchmark indices perform, and not on the fund managers, or his forecast of how the market will be over the short-term.

This removes a lot of the opaqueness that tends to shroud unit trust investment.

Which is better?

Though unit trust investment and ETF investment each have their own characteristics and benefits, ETFs offer more advantages to long-term and ultrahigh net worth investors , especially those with a long time horizon. They also have much lower costs associated so it’s easier to see your potential returns accurately.

Just like any other investment products, it is important for one to invest prudently for the long-term – for a period of 10 to 20 years – to allow the market and the respective asset classes to work for him or her.

Of course, which one you choose really depends on your risk appetite as it’s possible to get high returns on a very aggressive  unit trust fund if you can stomach that risk of investing in the fund. ETFs can be a good option to diversify or if you’re confident and comfortable with a particular index’s performance and would like to track it.

It’s a lot easier to be confident with the market as a whole than with the skill of a particular manager though.