ETFs vs unit trusts as investment option

2015-11-09 11:30
 iStock

Cape Town - A Fin24 is stuck on choosing between ETFs or unit trusts as an investment option.

He writes: "I wish to invest a lump sum of R50 000 and R500 per month. I am stuck between choosing which way to invest - ETFs or unit trusts.

"I would like to know what percentage returns I can roughly expect and how volatile these types of investments are.

"There are so many options, I don’t know how to do it?"

Matthew Chapman, a CFP® Professional, of NFB Financial Services Group responds:

Your question is very open ended in that I would require a lot more information with regards to your other investments; liquidity needs; risk profile; timeframe etc. All of this information will be carefully considered in order to correctly advise you on what the optimal investment solution would be.

I can however generally respond to your questions:

ETF vs unit trust

In essence both ETFs (Exchange Traded Fund) and unit trusts are collective investments schemes in that they pool client’s money in order to allow smaller investors access to asset classes which may be difficult to hold in small denominations.

The difference lies in the fact that an ETF is a publicly traded security (much like a stock on the JSE) and you would thus pay brokerage to trade in and out of it. You would trade these securities through a stockbroking account. Tax would be attributable to yourself in terms of capital gains and interest for fixed income investments (dividends tax is withheld at company level for individual investors).

You are the legal owner of this security (the ETF).

A unit trust on the other hand pools client money and issues units in the fund which will change in price as the underlying securities in the portfolio change in price. Investors buy and sell units of the fund and not the individual securities themselves. Tax is attributable on the gain/loss in the unit price of fund on realisation of such units.

ETFs tend to be more passive in nature – i.e. tracking a broad market index or blend thereof – whilst unit trusts are more active in nature – over/underweighting certain securities in attempt to outperform the index.

That being said, with the advent of smart beta, some ETFs do aim to outperform a basic index such as the JSE ALSI by algorithmically weighting stocks in line with fundamental metrics such as value; quality; momentum etc. These ETFs will therefore also aim to generate alpha (outperformance), although this may be beyond the scope of this article.

Another key difference is that while ETFs fall under the same regulatory framework as unit trusts, they can be traded on the secondary market (between investors) and not only the primary market (direct with the manco) in the case of a unit trust.

To conclude on the difference, unit trusts are typically for retail clients looking for outperformance on the benchmarked index, while ETFs, listed on the stock exchange and tradable on the secondary market, ordinarily aim to track such index.

In terms of risk (volatility) vs return refer to the graph below.

This illustrates the long term points of risk/return trade-off of various assets classes.

What you will notice is that cash and cash like investments are at the bottom left of the graph where low volatility and low expected returns are exhibited. Right at the other end of the scale are alternatives (private equity; hedge funds; commodities etc.) which offer on average the highest long term return but have the largest volatility. Equities are where the typical retail investors allocates the risky portion of their portfolio.

In terms of absolute expected returns and volatility I cannot make predictions but I would refer to the graph for a general understanding of the relationship.

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