Last week in our series on "How to manage your money", we looked at your investment goals and how they may be met by unit trusts in different sub-categories. This week, in the second part of how to choose a unit trust, we look at factors - including how funds are managed, fees and the performance of a fund - that you should consider when you choose a fund within a sub-category.
LOOK AT A FUND'S STRUCTURE
When you choose a unit trust fund, you should look at what kind of fund it is and how it is managed. You need to be comfortable with how the manager will manage the fund, including the risks he or she will take.
Make sure you get a good explanation of the aim of the fund, its benchmark, how the manager intends to achieve these goals and how long it is likely to take for these goals to be met.
The structure of the fund and the way the fund is managed will also affect the fees you pay.
- Passively managed funds
Passively managed funds include index (or tracker) funds, exchange traded funds (ETFs) and quants (an abbreviation for quantitative) funds.
- Index, or tracker, funds
track the performance of a benchmark index by buying the shares in that index at their respective weightings in the index. An index fund can either fully replicate a certain index or it can select specific equities from that index.
Typically, it is cheaper to invest in index funds because they do not require the skills of an investment team.
- An ETF
is a special type of index fund that is listed on a stock exchange and can be traded like a share.
The first ETF in South Africa was the Satrix Top 40, which tracks the top 40 companies listed on the JSE.
You can buy and sell ETFs through a stockbroker or through Satrix's investment plan. If you want to close your investment, however, it will take at least five business days before you receive your money. This is unlike a unit trust, which pays you out within two working days.
- Quants funds
use computer programs and mathematical formulae to select shares, instead of simply replicating the shares in an index.
Quants has been used as an investment tool for years, and is one of the methods used by many funds to select shares. But some unit trusts claim to be purely quants funds, using no other means to select shares.
- Actively managed funds
With these funds, the fund manager has the discretion to make investment decisions that fall within the parameters of the fund's investment mandate.
The fund manager researches shares and watches market movements, and is generally better qualified than you to spot a good investment opportunity.
Actively managed funds may have some restrictions on them as a result of collective investment scheme legislation, the unit trust sub-category in which they fall or their investment mandates.
Styles of active management
Active fund managers may have different management styles, depending on their skills and their underlying investment approach.
- Stock-picking fund managers
focus on the potential of a company to make good profits in the future. This is also known as bottom-up investing.
- Top-down fund managers
start by looking at the economy and then consider which sectors of the market are likely to do well. Based on their analysis, they decide what proportion of the fund to invest in each sector. Only then do the managers consider which shares are likely to fare best within each sector.
- Theme fund managers
look for a market sector or a type of share that will do well in particular circumstances.
- Value fund managers
look for what are called value situations, where a company is deemed to be worth more than its share value.
- Growth fund managers
look for companies which they believe will make good profits in the future. This might mean buying shares at a premium as their future profits will justify the higher price.
Other types of funds
- Multi-manager funds
The management of these funds is outsourced to different fund managers who specialise in different fields.
The management company from which you buy the unit trust identifies suitable specialist managers and decides who will manage the different parts of the fund, be it the different asset classes or the different portions of an equity fund.
Multi-managers often try to choose a blend of managers in such a way that when one manager under-performs, another will perform well. In this way, you, as an investor, can expect more consistent performance.
Fees are generally higher, because you have to pay fees to the principal fund manager and to the specialist managers.
- Funds of funds
These unit trusts invest in a range of other unit trusts. These could be the funds of the company that manages the fund (internal funds of funds) or a selection of funds that includes those of other management companies (external funds of funds).
The advantage of a fund of funds is that even if you have a relatively small lump sum to invest (below R50 000), you can still receive exposure to a wide range of funds.
Your costs will be higher than those of a stand-alone fund, because you have to pay the fees of the fund of funds in which you invest (a first layer of fees) and the management costs of the underlying funds (a second layer of fees). Make sure you are aware of the costs at both layers.
FIND OUT WHAT IT WILL COST YOU TO INVEST
You need to consider the different fees you will pay when you invest in a unit trust to ensure that the fees are line with the returns you expect to earn.
Unit trust companies have to disclose all fees and charges to you upfront.
When you first buy a unit trust, you will be charged initial fees, which are used to cover administration costs and broker commission. You will also have to pay ongoing or annual fees to the management company that administers your units and manages your investment (see "How to ... invest in a unit trust", published on March 7, 2009).
Unit trust companies have to give you three months' written notice of any increase in fees, additional fees or changes to the way fees are calculated.
However, you should not decide to invest in a unit trust on the basis of its fees alone. It may be worth paying a higher fee for a good fund manager.
You may also find it worth your while to pay a fee to a financial adviser if you are new to investing and if the adviser is going to give you good ongoing advice on your investments.
You generally pay higher fees for equity funds than you would for fixed-interest funds, because investing in equity markets is riskier and requires more research by the fund manager.
The annual management fees a unit trust management company can charge you depend partly on the "class" of units you buy. In June 1998, unit trust fees were deregulated and, as a result, there are now two main classes of units: "A" and "R".
- A class units
are those units purchased after June 1998. The service fees on these funds are not regulated, which means the management company can set its own fees.
- R class units
are those units purchased before June 1998, and fees on these funds are regulated. The annual management fees on R class units can range from 0.25 percent to two percent, excluding VAT.
Other costs on R funds include an initial charge, usually up to five percent.
Unless you purchased unit trusts before June 1998, you will generally not be able to access R class funds.
ASSESS A FUND'S PERFORMANCE
When you are considering in which unit trust to invest, it is important that you consider a fund's performance track record.
It is unwise to choose a fund simply on the basis of its short-term performance. For example, a fund may have been the top- performing fund in its sector this year, but if you look at its medium- to long-term history, you may find that it did not perform well and that it may have achieved its recent good returns as a result of risky investment decisions or even luck.
For the same reason, you may find it pays to choose a fund with returns that, on average, consistently put it among the top funds in the performance tables rather than one that has been the top performer for just one quarter or one year.
Ideally, when you evaluate the performance of a fund, you should look at nothing less than its three-year performance.
You should also assess a unit trust's performance on the basis of both its straight and its risk-adjusted performance.
Straight performance rates a fund simply on the returns it achieves. With risk-adjusted performance, the fund manager's risk of under-performing either a benchmark or inflation is also taken into account.
The PlexCrown Ratings, which are included in Personal Finance's unit trust performance table each week, combine four different measures of risk-adjusted returns. The ratings also measure the consistency with which funds have achieved good risk-adjusted returns over periods up to five years.
The PlexCrown Ratings of each fund can also be used to determine how consistent a manager is in managing all its funds. Average ratings of each managers' qualifying funds are calculated each quarter to determine the leading managers.
This kind of data can help you choose a manager and/or a fund that has a track record of consistently performing well.
However, remember that past performance is no guarantee of future performance, and the returns you earn could be very different and even negative.
How we can help you
Personal Finance regularly reports on the performance of unit trust funds. Apart from our weekly prices and performance table, the quarterly Personal Financemagazine and our website (go to the Unit Trust Results section) carry performance results over longer periods. These tables enable to you compare a fund's performance relative to the other funds in its sub-category and against a benchmark, where applicable.
ACCEPT A LEVEL OF RISK
Investment risk refers to your chances of losing all or part of your money or of earning a return that is below an investment target - for example, beating inflation. Different fund managers take different levels of risk, and the risks they take may or may not be compensated for in the returns they earn.
Before you invest, make sure you know the risks of investing in a fund, particularly the risk of losing your money.
You can reduce the risks you face when you invest in a volatile unit trust fund, such as an equity fund, by using what is called rand-cost averaging.
This means you phase your money into the fund by moving small amounts at a time from a cash investment, such as a money market fund.
The benefit of rand-cost averaging is that, as the market rises and falls, you buy some units in the fund at a higher price and some at a lower price. In this way you avoid the risk of buying all the units when the price is high only for the price to fall dramatically thereafter.
Your circumstances, including how long you plan to invest, the purpose of your savings and their importance to you, will determine your tolerance for the risk of a particular fund.
A financial planner can help you determine your risk profile, which will help you decide the level of risk you can tolerate.