Thursday November 9, 2006

This week, Yeoh Keat Seng discusses the pitfalls of investing in unit trusts and suggests an industry mechanism that would provide investors with greater depth when including this investment instrument in their wealth management portfolio. 

WITH an aggregate net asset value (NAV) of over RM50bil as at mid-2006, unit trusts have become a mainstream form of investment for individual investors.  

Over the last 10 years, the industry’s NAV has grown seven-fold and now represents around 7.2% of Bursa Malaysia’s market capitalisation compared with only 1% previously. 

The pace of the growth of the industry here should not come as a surprise, as it mirrors the experience in the developed markets. Unit trusts offer several advantages which suit the needs of retail investors, namely diversification at an affordable price, access to professional fund managers, assurance of liquidity and convenience. 

Yet anecdotal evidence suggests a gap often exists between what investors expect and what they get from investing in unit trusts. This may be due partly to some investors having unrealistic expectations, or advisers not setting expectations right at the beginning or offering advice that may not be sound, or industry players importing unit trust practices from elsewhere without accommodating these to our market’s structural differences.  

This article focuses on the gap in expectations arising from the peculiarities of investing in unit trusts in our market, and suggests a possible solution to the problem.  

Conventional wisdom says that investors should treat unit trusts as buy-and-hold instruments because by sticking to the same fund, they will enjoy better returns than if they continuously try to time their investments. For many investors though, the theory does not seem to apply in practice.  

There are several possible reasons for this. First, a buy-and-hold approach works only if the factors that have contributed to the fund’s performance remain intact over time. Very often though, they do not always remain so for very long. 

Also, fund managers change. In developed markets, the fund management process is often institutionalised, which means that performance does not usually fluctuate much when there is a change of fund manager. In our case, performance is often highly dependent on individuals rather than a process, and unfortunately, their tenure with a firm often tends to be shorter than the client’s recommended investment horizon. 

Fund sizes change. Many award-winning funds have been unable to sustain their performance as they grow substantially bigger. This is not to say that size is a handicap, but in certain cases where the investment mandate is very narrow, or where the securities are very illiquid, there is often an inverse correlation between size and performance. 

Second, some funds are not meant to be long-term buy-and-hold investments. While there is a diversity of sector and theme-based funds in developed markets, it is debatable whether such funds can serve the needs of the average Malaysian looking to invest passively in a unit trust fund here. 

A technology fund in the US would have an investment universe comprising hundreds of stocks in different sub-segments worth hundreds of billions of dollars. A similar fund here would only have a handful of alternatives, with depth and breadth sorely lacking. Such funds may be good for tactical allocation, but not buy-and-hold. 

Third, a rigid buy-and-hold strategy should not apply blindly regardless of market circumstances. Even within an individual’s recommended asset allocation based on his risk requirement, there is a case for lowering his equity weighing if it becomes obvious that the market is about to go through a bearish phase. 

Another argument in support of a more active approach is that buy-and-hold fails to take advantage of changes in market cycles and investment styles the market favours. Small caps did very well between 2001 and 2003, but under-performed sharply after that. Index funds significantly outperformed others in 2004 and 2005, but were laggards prior to that. 

At other times though, the long-term buy-and-hold approach stems from the conscious decision on the part of investors. In many cases, when advice to switch or cut loss is given, there is no follow through. Whether it is unit trusts or stocks, many investors have a psychological problem with realising losses, even when they agree on the fund’s likely under-performance.  

In my opinion, a fund of funds could provide a timely remedy for the problems faced by many of our unit trust investors.  

A fund of funds is a unit trust that invests in a number of other unit trusts.  

Its advantages are extra diversification and simplicity, but in this context, I believe another critical advantage is the availability of a fund manager to actively manage the underlying funds.  

The value add of a fund of funds manager lies in selecting the appropriate funds, monitoring them for changes which could affect their performance (e.g. fund manager and size), taking advantage of opportunities to make tactical allocations, and being disciplined about cutting losses or switching out when market situations warrant it.  

Just as many investors are better off letting unit trust managers manage their money in individual funds, there are others who are better off letting fund of fund managers manage their unit trust funds as a whole. 

There is, however, a possible downside to this approach if the fund of funds manager does not do his job well. In that case, what the investor risks ending up with is a highly diversified but very mediocre performer at best, or a long-term under-performer at worst because of the extra layer of fees charged.  

Fund of funds are not available here yet, but I believe there is room for them in this market, especially given the circumstances described above.  

Related posts:

  1. Introduction to Unit Trust
  2. Introduction to Unit Trust
  3. Is Unit Trust a good way to invest our money?
  4. Unit trust funds get off to a dazzling start

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