Are unit trusts the best investment vehicle for Singapore investors?
8 May 2001

On 4 May 2001, The Straits Times reported that for the first quarter of 2001, 82 percent of unit trusts approved by the Central Provident Fund (CPF) for investment by members suffered negative returns. This was the fourth quarter in a row of negative returns. Furthermore, out of 113 approved unit trusts and 76 investment-linked insurance products as at 31 March, 62 percent failed to outperform their benchmarks in the first quarter. These findings emerged from the latest analysis by William Mercer, the consulting firm that tracks the performances of CPF-approved investment instruments.

The poor performance of unit trusts would not have surprised WallStraits.com. WallStraits.com has never been a fan of the unit trust industry. And understandably so. This internet-based investment advisory service depends mainly on small investors for its business. And small investors are more likely to turn to it if they are investing their money directly in individual stocks, not unit trusts.

Back in 1999 -- in response to the plans by the Singapore Government to limit the amount of CPF funds that can be invested directly in stocks while removing the limit on the amount that can be invested in unit trusts -- it urged the Government to review its decision, which favoured investment in unit trusts over direct investment in stocks for CPF funds. It argued that unit trusts historically gave returns that are below the general stock market, using the following table as illustration.

Investment Choice Historical Returns $20,000 for 20 years
Government Bonds 3.0% $36,000
Average Unit Trust 7.5% $85,000
S&P 500 broad index 11.2% $167,000
Select Stock Portfolio* 25.5% $1,791,000

*Select Stock Portfolio return is based on a systematic formula called the "Dogs of the Dow", where an investor adjusts a 5-company stock portfolio only once per year based on the performance, price and dividend yield of the 30 dow stock components.

That the average unit trust fails to beat the S&P 500 broad index is not surprising, professional management notwithstanding. After all, unit trusts tend to be big and -- to a large extent -- are the market. But the fact that they underperformed the market, and to the degree shown in the above table, is highly significant.

However, it needs to be pointed out that the relative performance of unit trusts vary from period to period. The last 20 years have been a difficult time for unit trusts to beat the major market indices for the simple reason that large stocks have collectively outperformed small stocks during this period, the relatively recent and short-lived internet binge notwithstanding. And since the major market indices like the S&P 500 consist mainly of large stocks, the average broadly diversified unit trust would tend to underperform it.

Other studies show that equity funds do not always underperform their benchmark indices, or at least not as badly as in the figures quoted by WallStraits.com. The following table shows two examples.

    Average annual return
Comparison Period Funds average Benchmark index
General US equity funds vs S&P 5001 1960-1997 11.3% 11.6%
General UK equity funds vs FT All Share2 1973-Jan 1990 14.4% 14.6%

Notes:
1. Data from Lipper Analytical Services, Inc.
2. Data from Expatriate Advisory Services plc.

Last month, WallStraits.com launched another attack on unit trust investing. This time, it concentrated on the fact that funds committed by Singapore investors to unit trusts tend to be sucked out of the Singapore market and invested overseas. It also made mention of the "high fees [that] prohibit even achieving market performance".

Now, these two grouses deserve more sympathy. First, let us look at the diversion of funds overseas.

WallStraits.com pointed out that the diversion of funds drains liquidity from the local economy. This is obviously not good. But let us look at it from the individual investor's point of view. It may be a good idea under normal circumstances to diversify your investments. But while diversification reduces your risk, it also reduces your potential gain. And it seems clear to me that the potential gain from the Singapore stock market is higher than most other major markets. As I elaborated in greater detail in my article on 4 May 2001, the Singapore stock market is currently trading at a lower valuation while the Singapore economy is expected to post better economic growth this year than most developed countries, where global unit trusts tend to be invested in. So, based on the two most important factors affecting stock market performance, the Singapore market comes out as the better buy.

As for fees, most unit trusts charge a front-end fee of 5 percent - or 2.5 percent (usually) if bought through an internet dealer - as well as an annual management fee of between one to two percent. Now remember: all these just to equal or even underperform the market. Of course, for the investor with limited funds but who needs diversification, there may be little choice but to pay these fees. However, investors with enough funds to buy a diversified portfolio of stocks directly would probably be better off doing so. After all, investment expertise is not even needed; a well-diversified portfolio -- even a randomly-selected one -- should theoretically match market returns -- in other words, match or beat the average unit trust performance.

All these bring us back to the implication of the first quarter performance of CPF-approved unit trusts and WallStraits.com's original point back in 1999: That the Singapore Government's preference for investment in unit trusts for CPF funds might be misguided. True, the fund management industry needs to be beefed up. True, some CPF members were using CPF funds for speculation in stocks rather than long-term investing. The new CPF ruling helps in the former and discourages the latter. But as a result of it, many CPF members may have to pay a price in the form of reduced wealth in their retirement.

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Disclaimer: The commentaries posted here represent the opinions of the author at the time of posting and should not be taken as investment advice. Readers who wish to take any investment action based on information obtained from this site should seek appropriate advice from a qualified financial adviser.