It has been said that we must invest in as “front end load” or “commission”)
Many
order to achieve financial freedom and live
a comfortable retirement. Moreover, we
save and invest so that we can afford to
pay those expensive school fees when our
children enter University. The reasons for
investment are clear.
We leverage on the power of
compounding in order to achieve our
financial goals and usually by investing in
Unit Trusts and Investment-Linked Policies
(ILP). ILPs are actually two products in one
– an insurance product and unit trusts.
However, most investors are unaware that
Exchange Traded Funds (ETFs) are also
available for investment and that it has
many advantages.
Advantages and Disadvantages of
Unit Trusts
Low sales charge for small investment.
Large sales charge for big investment.
The sales charge (or sometimes known
36
advantage of dollar cost averaging.
for purchasing a Unit Trust is typically
expressed as a fix percentage (usually
between zero per cent to five per cent).
This permits you to invest in very small
amount without paying exorbitant sales
charge. Initial investment is often $1000
and subsequent is $500 and the sales
charge is $25 and $12.5 respectively for
2.5 per cent front end load. The sales
charge in absolute amount is small when
the investment amount is small. However,
the sales charge in absolute dollar is large
when the amount of investment is large.
For example, if you invest $10,000 and
assuming a 2.5 per cent sales charge, the
cost to you is $250.
Regular Saving Plans & Exact Investment
Amount
Many distributors permit you to invest in
Unit Trusts regularly and in both small and
large amounts. Better known as Regular
Saving Plans (RSPs), it permits you to take
unit trusts allow you to invest as low as $100
on a monthly basis. This is an advantage for
those who could only accumulate surplus
cash incrementally in small amount.
When investing in Unit Trusts, you
know exactly how much you’ll be paying.
If you invest in $1000, your payment to
the distributors or bank is $1000 net. The
same goes with RSPs. If you setup a GIRO
to deduct $100 from your saving account to
invest in a unit trust every month, an exact
$100 will be deducted every month.
Besides cash, you can purchase selected
Unit Trusts using CPF Ordinary Account,
Special Account and Special Retirement
Scheme (SRS).
Forward Pricing
Most Unit Trusts employ forward pricing.
This means that the day’s Net Asset Value
(NAV) is only known in the future. The unit
price is unknown to both the investors and
fund managers at the time of purchase.

This also implies that the number of units
that you will receive is also not known at the
point of purchase. However, the unit price
and total units purchased are known a few
days after the purchase.
Currency Risk and currency exchange
cost
The fund may invest in shares or bonds
which are in foreign currencies. Therefore,
those who invest in such Unit Trust will
be expose to foreign exchange currency
fluctuations that may result in loses
(or gains) for the fund. If the fund is not
denominated in Singapore dollar, then any
investment using Singapore dollar requires
a conversion that which will incur costs to
the investor.
The investor will pay the most if the
investor’s home based currency, the fund’s
currency denomination and the currency
of its underlying shares are all different
from each other. For example, the Fidelity
Korea fund is denominated in USD. A
Singapore resident purchasing this Unit
Trust is required to convert from SGD to
USD. Cash received by the fund manager
is then re-converted to Korean Won in order
to purchase Korean stocks.
High Annual Expense, Costly Foreign
Exchange and Costly Cash
One pitfall with Unit Trust is its high annual
expense like management fee, Trustee fees,
performance fee, brokerage fees, GST, and
soft dollar commission. These expenses
are charged to the fund and paid by the
investors. In addition, if the currency held
in cash by the fund manager is different
from that of the securities he purchase or
sell, a foreign currency exchange conversion
cost is involved. Therefore, fund managers’
frequent trade may result in significant
forex cost. It is typical for an equity fund’s
turnover to exceed 100 per cent cent. This
means that shares purchased by the fund
manager at the beginning of the year is
unlikely to be held at the end of the year
because it has already been sold. Such
high turnover implies greater brokerage
cost and high forex cost due to frequent
foreign currency conversions.
Many funds hold significant amount
of cash. Often spare cash is needed to
meet redemption without the need to sell
the fund’s securities. Sometime cash is
needed as the fund manager anticipates
significant investment opportunities. Other
times, cash is held simply because there is
no investment opportunity. The presence
of cash in a fund could be costly to the
investor because cash does not earn any
return and cannot participate in any market
upswing. Alternatively, we can hold our own
cash and earn returns in fixed deposits with
no management fee.
Dependence on fund manager’s skill and
the fear of resignation
The performance of a Unit Trust is often
attributed to the fund manager’s skill.
This skill involves market timing, ability to
obtain information, and fast entry /exit in
the market or investment. Any resignation
is a concern. If a fund house uses a team-
based approach to manage its portfolio,
it does not matter if a key staff leaves.
However, if most of the team members
leave, the synergy will be lost.
Tax issues
According to IRAS, with effect from January
1, 2004, dividends from Unit Trusts are
not taxable (excluding distributions out
of franked dividends or derived through
partnership in Singapore). This is good
news but this does not mean Unit Trusts
INVEST APR/MAY 2008 37
 do not pay tax at all. As most securities are
invested in foreign countries, there are tax
liabilities paid to foreign governments and
of course these are paid by the fund itself
and have already been priced into the Net
Asset Value (NAV), calculated on a daily
basis.
Liquidity Risk
The underlying securities of a Unit Trust are
bonds, shares or both. Fund managers face
the same kind of liquidity risk as an investor
that invests directly with these shares. In
the event which the shares stop trading for
some reason or are delisted, the fund house
will write off these shares as having little or
no value. Thus the NAV of the unit trust will
drop due to this write off.
In the event of massive redemption
by unit holders, cash holdings in the
fund may not be sufficient to meet these
redemptions. As a result, the fund manager
will sell securities to raise cash. However,
not all securities can be sold immediately
as it depends on market liquidity. In order
manage cash flow, several funds have a
provision which allow the fund manager to
provide partial redemptions spread across
a few trading days rather then a lump sum
redemption in a single day. This means that
under market shock conditions, you may
not be able to get out of the market fast
enough.
Advantages and Disadvantages of
Index Funds Exchange Traded Funds
(ETFs)
Exchange Traded Funds are traded on the
stock exchange like shares. However, the
underlying securities of the ETFs are basket
of shares. ETF fund managers do not trade
directly with retail investors. In fact, retail
investors trade with fellow investors in the
stock exchanges. Should there be a price
discrepancy between share price and the
Net Asset Value (NAV), institution investors
may trade directly with the fund manager
so as to use the price differential for a
profit. Institution investors trade with the
fund managers by using basket of shares
in exchange for ETF share.
They may also use ETF shares in
exchange for the basket of shares. This
38
will deplete or increase the number of
ETF shares in the market place and thus
influence the demand and supply of the ETF
shares thereby narrowing the discrepancy
between the ETF share price and the NAV.
Due to this arbitrage mechanism, the share
price of an ETF is normally very close to
the NAV.
For the case of an index fund ETF, the
underlying basket of shares are the same
as those by its benchmark. An independent
company normally decides the composition
of the benchmark.
Good for large trade. Not good for small
trade. Do not trade frequently
As an ETF is traded like share, any purchase
or sales are subjected to a broker fee.
Broker fees are normally expressed as
a percentage subjected to a minimum
charge. For example, lets assume a broker
charges US$29 or 0.35 per cent of trading
principal whichever is larger. For a small
amount of investment this will incur large
broker fee. For a US$500 investment,
the broker fee is 29/500 = 5.8 per cent.
However, for larger amount say US$2000,
the broker fee becomes 29/2000 = 1.45
per cent which is cheaper than the broker
fee for Unit Trust. Of course for even larger
amount, you could go down all the way to
0.35 per cent. The larger you invest the
cheaper the broker fee. Note that broker
fee applies for both buy and sell so don’t
trade frequently.
Estimating the optimal amount to trade.
Suitable for “buy and hold”
To better estimate the minimum amount of
ETF shares you may buy without incurring
exorbitant broker fee, you should compare
the cost with an alternative Unit Trust. If
a Unit Trust charges 2.5 per cent, then
purchasing an ETF is worth your money
when the broker fee is less then 2.5 per
cent. Using the above example, if your
investment is more then (US$29/(2.5 per
cent) = US$1160), your broker fee is less
then 2.5 per cent. Do remember that selling
will also incur a similar broker fee and
therefore ETF investing is suitable for those
who employ a “buy and hold” philosophy.
Lack of RSP & Restricted Source of Cash
for Purchasing ETFs
Due to the manner which broker fees are
structured, dollar cost averaging using
small purchases cannot be done like
Unit Trusts without exorbitant broker
fee. Still it is possible for you to employ
dollar cost averaging by cumulating your
surplus cash in a money market unit trust
(normally 0 per cent sales charge) until
it reaches a sufficient amount to invest
without exorbitant broker fee. However, the
disadvantage in this method is that money
not invested may lose an opportunity to
participate in market upswing and therefore
could be costly.
Unlike many Unit Trust, foreign listed
ETFs can only be purchased with cash.
Forex cost due to purchase/sales
decreases with less frequent trades
If the ETF is denominated in US dollars,
there is a forex cost when you purchase
such shares using Singapore dollar
currency. Similarly any sale of the share
requires a conversion from US dollar back
to Singapore dollar and hence this invoke
another conversion cost. The forex cost is
over and above the broker fee that is already
paid. (No forex cost is incured if you are
paying or redeeming in US dollars.) Frequent
buy/sell trades increases additional forex
cost. Therefore the less you trade, the less
the forex cost of conversion.
Low expense and forex cost. Low/no
brokerage fee paid by fund
Index funds are better then active managed
unit trust because of its low expense. In
the long run, an active unit trust has a
high expense and the erosion of its fund
caused by its expenses becomes highly
significant.
Unlike Unit Trust, there is little of forex
cost incur by the fund because institution
investors trade with the fund managers not
with currency but through an electronic
exchange of basket of shares certificates.
Any forex cost due to the purchase of foreign
shares by the institution investors are paid
by them, not by the ETFs funds. Similarly
there is little brokerage fee charged to the
fund because the ETF fund manager does
not purchase or sell shares directly with
the market.
Unlike Unit Trusts counterparts, retail-
investors trade with fellow investors is
independent of the fund manager. The
fund manager does not interact with retail
investors. Thus the frequent trades by
retail investors do not increase the fund’s
expenses. In addition, forex conversion cost
is not propagated into the fund. This is unlike
Unit Trusts which multiple conversion cost
is propagated to the fund if the Unit Trust’s
currency denomination and the underlying
shares’ currency are not the same.
Currency Risk (not the same as currency
conversion cost)
Similar to the Unit Trust counterpart,
investors are exposed to currencies
fluctuation risk if the ETF’s underlying
shares native currencies are not the same
as investor’s own home based currency.
Please note that there is a different
between foreign exchange conversion
cost (mentioned above) and currency risk.
Investors are often confused between the
two.
In addition, any difference in currency
between the home based currency and
the ETF’s denominated currency is not
an additional risk. For example, if an ETF
is listed in US dollars but its underlying
shares are denominated in Yen, then any
depreciation of the US dollar against the
Yen will result in an increase in the ETF NAV
which is in US dollar assuming all things
stay constant. If your home based currency
is in Singapore dollar, your currency risk
exposure is the SGD/YEN pair and has
nothing to do with the US dollar.
But there is a cost involved when
converting from your home based currency
to the ETF’s denominated currency and vice
versa and this happens when you make a
purchase or sale.
Based on Benchmark returns. Low fear in
resignation and low dependence on fund
manager
The fund manager’s duty is to ensure
that its shares are of similar composition
as its benchmark. Normally the shares
composition of a benchmark is determined
by an independent company. Therefore the
management of the fund is administrative
and does not require the employment of
top-notch and expensive managers. There
is little fear of any staff resignation. As its
obligation is to maintain similar composition
as its benchmark, any returns of the ETF
will be similar to that of its benchmark.
Tax issues
30 per cent of dividends derived from US
listed ETFs are taxed by the US government.
There is no capital gain tax for non-US
residents.
For Singapore’s side, similar to Unit
Trust, resident individuals are not required
to declare any foreign sourced income,
including foreign sourced dividends,
received in Singapore on or after January
1, 2004 as they are tax exempt. The tax
exemption, however does not apply to
foreign sourced income received through
partnerships in Singapore.
As for estate duty, while Singapore has
abolished estate duty, it does not mean that
there is no worry about estate duty. Many
serious ETFs investors preferred offshore
ETFs such as those traded on AMEX, NYSE
Acra and London Stock Exchange. As US
government imposes a long-term death tax
of 55 per cent above the exemption limit of
US$60,000, it is important for investors
to seek assistance from their financial
advisers on how to avoid this hefty estate
duty.
Watch out for Price/NAV deviation
It is important to ensure that the share price
of an ETF does not deviate too much from its
NAV. Most index fund ETFs share price does
not deviate too far from its NAV but there
are some that is persistently trading at a
premium (when share price is above NAV)
or at a discount (when share price is below
NAV). Investors should avoid such ETF if the
share price is persistently far from the NAV.
Such a fund could indicate arbitrageurs’
difficulties in taking advantage of the price
differential. These difficulties could be due
to underlying shares’ liquidity problems.
Liquidity Risk and market shock
As ETF are traded like shares, it faces
similar liquidity risk. An ETF that has low
trading volume should be avoided since you
will have to buy at a higher price or sell at
a lower price in such a situation.
During market shock situation, it is
possible for the share price of the ETF
to deviate away from its NAV because
arbitrageurs may face liquidity issues with
its underlying securities and hence unable
to quickly take advantage of the price
differential situation.
Share Price known. No need to wait a few
days later. Forex rate adds to excitement
One advantage for an ETF is that its share
price is known during the entire market
opening hours. This is unlike Unit Trust
which its price is only calculated once a
day and made known one or two days later
(popularly known as “forward pricing”).
Like all shares, you can specify a
maximum price which you are willing to
buy when making your buy order for an
ETF. Similarly you can specify the minimum
price which you are willing to sell when
making your sell order. However, as most
ETF are denominated in US dollars and if
you are paying in Singapore dollar, then
the actual amount which you will be paying
is also dependent on the foreign exchange
rate at the time of transaction (which could
occur hours or days after your order). This
problem does not exist if the settlement
currency is the same as that of the share or
if your broker is able to freeze the exchange
rate at the time of order.
Wilfred Ling is an investment adviser with
Promiseland Independent. He is licensed
by the Monetary Authority of Singapore to
provide investment advice.
Email: wilfred.ling@promiseland.com.sg
Telephone: 6294-2461.
Website: http://articles.wilfredling.com
INVEST APR/MAY 2008 39