Two of the most popular investment vehicles for investors looking for diversified exposure to several asset classes are Exchange-Traded Funds (ETFs) and Unit Trusts, which are often referred to as mutual funds in some areas. They differ in structure, trading procedures, fees, and tax consequences, even though they both provide options for asset allocation and portfolio diversification. We will examine the differences between unit trusts and exchange-traded funds (ETFs) in this extensive guide to help investors make well-informed selections that suit their investing goals and preferences.
ETFs vs. Unit Trusts: Structural Variances
Exchange-Traded Funds (ETFs)
ETFs are investment funds that are traded on stock exchanges, much like individual stocks. They are structured as open-ended investment funds, allowing for the creation and redemption of shares at any time. ETFs typically track the performance of a specific index, commodity, bond, or a combination of assets. The shares of ETFs are bought and sold throughout the trading day at market prices, offering investors liquidity and flexibility in trading.
Authorized Participants (APs), usually large financial institutions, play a crucial role in the creation and redemption process of ETF shares. When there is demand for ETF shares, APs create new shares by purchasing the underlying assets and delivering them to the ETF issuer in exchange for shares. Conversely, when there is excess supply of ETF shares, APs can redeem them by returning the shares to the issuer in exchange for the underlying assets.
Unit Trusts
Unit Trusts, or mutual funds, are pooled investment vehicles managed by professional fund managers. Investors purchase units or shares of the fund, and the fund manager invests the pooled capital in a diversified portfolio of assets according to the fund’s investment objectives. Unlike ETFs, Unit Trusts are not traded on stock exchanges; instead, investors buy and sell units directly from the fund at the fund’s Net Asset Value (NAV) calculated at the end of each trading day.
Unit Trusts are also open-ended investment funds, meaning they can issue and redeem units based on investor demand. When investors buy units, the fund issues new units, and when investors sell units, the fund redeems them at the prevailing NAV. This mechanism ensures that the fund’s assets are closely aligned with the number of units outstanding.
Key Differences in Trading Mechanisms
One significant difference between ETFs and Unit Trusts lies in their trading mechanisms:
1. ETFs: Traded on stock exchanges throughout the trading day at market prices, providing investors with intraday liquidity and the ability to execute trades at any time during market hours.
2. Unit Trusts: Bought and sold directly from the fund at the end-of-day NAV, with transactions executed at the next calculated NAV after receiving the order. Unit Trusts lack intraday liquidity, as trades can only be executed at the close of the trading day.
The trading mechanisms of ETFs and Unit Trusts influence investors’ ability to react to market movements and execute trades promptly, catering to different investment strategies and preferences.
Fee Structures and Expense Ratios
Fees play a crucial role in investment performance, impacting investors’ returns over time. The fee structures of ETFs and Unit Trusts differ in several aspects:
Exchange-Traded Funds (ETFs)
ETFs typically have lower expense ratios compared to actively managed Unit Trusts. The expense ratio of an ETF represents the annual fees charged by the fund for managing and operating the portfolio. Since many ETFs passively track an index, they incur lower management fees as they require minimal active management.
Additionally, ETF investors may incur brokerage commissions when buying and selling shares, similar to individual stock transactions. The brokerage commissions vary depending on the investor’s brokerage platform and trading frequency.
Unit Trusts
Unit Trusts often have higher expense ratios compared to ETFs, especially actively managed funds. The expense ratio encompasses management fees, administrative costs, and other operating expenses incurred by the fund. Actively managed Unit Trusts require professional fund managers to actively select and manage the portfolio, resulting in higher management fees compared to passively managed ETFs.
Unlike ETFs, Unit Trust investors do not incur brokerage commissions when buying and selling units directly from the fund. However, Unit Trusts may impose sales charges, commonly known as front-end loads or back-end loads, which are fees paid by investors upon purchasing or redeeming units from the fund.
Tax Implications
ETFs and Unit Trusts differ in their tax implications, particularly in terms of capital gains distributions:
Exchange-Traded Funds (ETFs)
Since ETFs have a different structure and redemption process than Unit Trusts, they are often more tax-efficient. Redeeming ETF shares may allow APs to swap the underlying securities “in-kind,” which eliminates the need to liquidate portfolio holdings and realize capital gains. Because of this, investors often get smaller capital gains from ETFs, reducing their tax obligations.
Moreover, ETF investors have control over the timing of capital gains realization since they can choose when to buy or sell shares. This flexibility allows investors to manage their tax obligations more effectively, such as harvesting tax losses or deferring capital gains.
Unit Trusts
Unit Trusts may be less tax-efficient compared to ETFs, particularly actively managed funds that frequently buy and sell securities within the portfolio. When fund managers realize capital gains from selling securities at a profit, they must distribute the gains to unit holders, subjecting investors to potential tax liabilities.
Additionally, Unit Trust investors have limited control over the timing of capital gains realization since transactions are executed at the fund level. Investors may receive capital gains distributions annually or semi-annually, depending on the fund’s distribution schedule, resulting in less tax planning flexibility compared to ETFs.
Conclusion
Although diversified investment portfolios are accessible to investors through both ETFs and Unit Trusts, there are fundamental differences between them in terms of trading procedures, fee schedules, and tax consequences. Because ETFs have low expense ratios, are tax-efficient, and offer intraday liquidity, they are a good option for investors looking for cost-effective exposure to a variety of asset classes while maintaining flexibility. In contrast, Unit Trusts are designed for investors who would rather take a hands-off approach to investing. They provide expert management, automated diversification, and trading ease. Investors must be aware of the distinctions between ETFs and unit trusts in order to make well-informed choices that suit their investing goals, risk tolerance, and preferences. By evaluating factors such as trading flexibility, fees, tax efficiency, and investment strategy, investors can choose the most suitable investment vehicle to build a well-diversified portfolio and pursue their financial goals.
