Sunday, 10 November 2013

Why Unit Trust Expense Ratio Matters

Many investors would have the familiar experience of finding it difficult to make money from unit trusts. My own experience with the few unit trusts that my family and myself bought is the same. In my last post, I charted the price performance of the 2 unit trusts in my Supplementary Retirement Scheme (SRS) account since my first investment 6 years ago. They have not recovered to the initial price which I made my entry even though the Dow Jones Industrial Average is reaching new highs. Why is it so difficult to make money from unit trusts?

There are several reasons for it. Firstly, studies have shown that it is very difficult for fund managers to beat the market indices. So, most actively managed funds actually fare poorer than the market indices. This poorer performance is even before deducting the sales charges and annual expenses of the funds. Secondly, the annual expenses of the funds is a huge drag on the fund performance. The typical equity fund charges approximately 2% of the fund's net asset value (NAV) annually. This goes towards paying the fund manager and trustee and for other expenses such as administration and audits.

At first glance, 2% of NAV might not seem a lot to pay for professional management of the funds. However, what is the annual returns that investors could realistically expect from equity investments? Approximately 10%. So, a 2% expense ratio out of 10% typical annual returns is equal to 20% of the annual profits that investors could expect. That is a lot of money! In poorer years, the equity returns would be lower than 10% or even become negative, but a 2% expense ratio is still charged. So, in poorer years, the fund managers get more than 20% of the profits that investors could earn in that year.

In comparison, hedge funds' fees comprises 2 components, namely, a management fee based on NAV of the fund (same as non hedge funds), at around 1-2% of NAV and a performance fee based on excess returns, at around 20% of returns above a pre-determined hurdle rate. Take for example, a hedge fund that has a fee structure of 1% of NAV and 20% of excess returns, hurdle rate of 2% and the underlying investments return 10% in a particular year. The total fee that the fund manager gets is 1% of NAV + 20% of (10% - 2%) or 2.6% of NAV in total. Although this is higher than the 2% expense ratio that non hedge fund managers charge, a majority of hedge funds have a high-water mark. If the returns of the hedge fund do not exceed the highest value achieved to-date, no performance fee is charged. So, for the same hedge fund, if the return of the underlying investments is 0% or negative in the subsequent year, the hedge fund manager will only receive the management fee of 1%. On the other hand, the non hedge fund manager will continue to receive the 2% expense ratio regardless of the performance of the underlying investments. From this perspective, the variable performance fee component of hedge funds is more palatable than the fixed management fee of both hedge and non hedge fund.

As a final note, the 2% expense ratio can make a huge difference in the total wealth after a long holding period due to the effects of compounding. Assuming the underlying investments earn 10% annually, a $1,000 investment in a typical fund with 2% expense ratio would become $10,063 while the same investment without the expense fee would become $17,449 in 30 years' time. The 2% difference in expense ratio causes a 73% difference in the total wealth.

Thus, do not underestimate the expense ratio of a fund. As far as possible, always select one with a low expense ratio. Index funds are a good choice, with low expense ratios and performance that are better than most actively managed funds.

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  1. Personally i feel anyone who can invest in stock should avoid UT.

    1. Hi Cory,

      Thanks for your comments. While UTs have disadvantages, they also have some advantages. For instance, UTs allow investors with small capital to achieve diversification. Also, UTs allow investors to enter markets that they otherwise have no access to, such as overseas markets. There's still a role for them to play, but we need understand what they can and cannot achieve for us.

      (The) Boring Investor