Why Do We Keep Buying Unit Trusts and Investment-Linked Insurance When We Know They Are Overcharging Us?

This Article was first published on 30th July 2018 on our Asia-In-Focus Newsletter. To get the latest newsletters, click here.

Asia In Focus

July 2018 Edition

Why Do We Keep Buying Unit Trusts and Investment-Linked Insurance When We Know They Are Overcharging Us?

“What should we invest in?” 

That is the most common question I get from readers, audience and friends. It is the head-aching challenges of most middle class.

“What do I do with my savings once I have them? Keeping them in the bank doesn’t earn me much interest. Most properties are out of reach of my current budget. And the weak property market isn’t helping.” 

The longer we keep our savings in cash, the more templating it is to just spend it!

“That new car my neighbour just bought looked so slick, I wonder if I can afford it.” 
“The new handbag that my colleague brought to work the other day got the whole office talking about it, if she can afford it, so can I, right?”

At the end of the day, we might just end up buying the next unit trust our bankers is recommending to us, or the next investment-linked insurance product our insurance agents is telling us about. We do that even when we heard from multiple sources and read one too many articles online that fees for such unit trusts and investment-linked insurance products are just too high.

Why do we still continue to buy them?
That question begets another: “What else is there?”

Let’s explore:

  • What do these products do?
  • Why are they expensive?
  • What is the alternative?
  • Under what circumstances should we still buy Unit Trusts and Investment-linked products?

What Does A Unit Trust Do?

In theory, a unit trust is just a trust account to pool money together among a large group of investor, so that they can invest together to create a diversified portfolio that would have been hard for each investor to achieve by him/herself.

Your invested cash will be pooled together with other investors’ fund and the fund manager will choose the stocks to invest in according to the mandate (strategy) of the fund. The fund manager will charge an annual service fee to manage this portfolio for you and you hope they will do a good job.

What Does An Investment-Linked Insurance Policy Do?

An investment-linked insurance policy is basically a combination of two products; the life insurance (maybe with a medical card as well) and the unit trust. So instead of selling you a simple life insurance where you have to pay every year to get a lump-sum payment when you die, the hybrid policy will require you to pay more every year but will allocate a portion of that money into a fund, aka unit trust. Your policy will then have a cash value that gets updated every year based on the performance of that unit trust.

The investment-linked policy will continue to charge you a premium fee for the insurance, a management fee for the fund and other sales charges for your agents.

What Is A Typical Expense Ratio?

A common way to measure the cost of buying a unit trust or an investment-linked product is through an expense ratio. It is basically a ratio that measures how much it cost us a year in maintaining our capital in the fund.
A typical unit trust has an expense ratio around the 2% mark. This means that about 2% of your capital will have to be taken off to maintain the fund, through fund management fee, custodian fee, trustee fee, etc…

On top of that, most of us would have to pay for sales charges, to those who recommended these funds to us. Sales charges can range between 1% to 5% of the initial invested amount. Some funds would also have an exit charge, a fee you have to pay for exiting the fund.

Most of the time, if we are holding these funds for a long time, to be used as part of our inheritance for our kids, we could likely pay more than the sum of our invested capital over the course of the whole investment.

Is It Worth It?

Yet, it has shown that most funds tend to underperform even the passive indices over the longer term. In fact, a study showed that close to 99% of actively managed funds in the US underperformed the market. Although no such studies have been shown here in Asia, I have a feeling that the data should be too far away. Thus, only a small minority of funds in the market would actually be adding value for the investor, by outperforming a passive index without a fund manager.

Thus it means that selecting the “right” fund to invest in is almost as hard as, if not harder, than selecting the right stock to buy. Then, why do we still tend to buy unit trusts instead of spending the time searching for the right stocks to buy and building our portfolio ourselves?

The Price Of Marketing

The truth is we buy investment products similar to how we buy any other products. We buy products that we have heard about, meaning that we buy products that we are being marketed to. All the high fees we are paying for our unit trusts, a large percentage of it will have to go to pay for the marketing and distribution cost of letting you know that such a product even existed. If we want to save on such a cost, then we might have to find products that are not being marketed to us at all.

Can We Create Our Own Unit Trust?

In theory yes!

Since most unit trusts do not outperform the market. If we are able to invest in the passive indices, we should do much better than most unit trusts over the longer term. And if we are able to find passive indices funds with lower expense ratios, then the additional savings would translate to more returns for us in the future. Just a 1% savings in our annual expense ratio on a $1,000,000 investment would give us an additional $350,000 over a 30 year period.

Exchange Traded Funds (ETF) are just the passive investment instruments created for low-cost passive funds. Many of the more popular ETFs are passive funds that merely tracks the performance of indices like the S&P 500 or the Hang Seng Index.

The US market has the most established ETF market, with the passive funds market as big as the traditional active fund management industry. They have some of the lowest-cost passive funds around the world. The famous Vanguard S&P 500 ETF (VOO) is even indirectly endorsed by Warren Buffett himself when he stated in his annual letter that the best choice for his family to manage his wealth after he passed is to just buy this ETF. The VOO ETF has an expense ratio of just 0.04%, talked about low cost!

Hong Kong Exchange is also home to some of the largest ETFs in Asia. You will get a wide selection of ETFs from the HKEx, from bonds to sector-focused to geographical market focused.

Unfortunately, the Singapore and Malaysia markets are still not as developed in term of ETFs. There is a lack of selections of ETFs in these two markets and most of them have relatively low liquidity, making it difficult for investors to buy or sell them. However, looking at the development of ETFs in other markets, it seems that it is only time before ETFs in Singapore and Malaysia will develop as well.

Many of these ETFs not only have much lower expense ratios to unit trusts, they can be traded like stocks, making them easier to enter and exit when necessary.

What Is The Issue With ETFs?

However, as I mentioned above, in theory, we can all create our own unit trust at a much lower cost than most of the active funds out there. However, in practice, it doesn’t mean that everyone should do that.

The advantage of ETFs is also the disadvantage of ETFs. Due to its ease of buying and selling, we might treat it as a short-term investment when it is designed as a long-term investment instrument. We might be tempted to buy more during a bull market, fearing we might lose out on the market rally. Then during a market crash, we might panic and sell out at the worst possible time.

Should We Still Buy Unit Trusts?

If you know you have the tendency to do just that and have a hard time controlling your own emotions when it comes to investing, then maybe buying a unit trusts or investment-linked insurance policy might still be the ideal choice for you.

As such products will separate your investment from yourself and when you come in contact with your investment less frequently, the higher chance you would have to see your money grow in the long run.

In investing, our worst enemy is often ourselves. And if we need to pay a higher price to fund managers and insurance companies to keep ourselves away from our money, then it might be a price worth paying for after all.
However, as most funds do tend to underperform the market, do remember to do your research before buying into any fund. Remember the chance of selecting a good one might be even lower than finding a good stock to invest in.

But If You Want More

But what if you desire more than just being average? What if you are ready to take on the challenge to take control of your own investment, to be the master of your own financial destiny?

Then you are with us, battle on my comrades. The journey is long and volatile, but the fruits on the other side are sweet and wonderful.

Till we meet again.
Happy Investing,

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