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Unit Trust Basics |
What is a Unit Trust Fund?
A unit trust fund (also known as is a collective investment scheme) is a professionally managed investment fund which pools the financial resources of individual and corporate investors with similar investment objectives. The aggregate sum is then used by the fund to make large scale investments in a selected investment portfolio which comprises stocks, bonds and other assets in accordance with the investment objective of the fund. This includes investments which may not ordinarily be available to individual investors through direct investment such as large commercial properties and corporate bonds.
Unit trusts should be viewed as long term investment vehicles most suited to investors who can tolerate volatile short-term fluctuations in prices in pursuit of potential for long-term capital growth which may be associated with riskier equity investments.
How does it work?
A unit trust is created out of a deed which constitutes a contractual agreement governing the tripartite relationship between the Manager (often referred to as the management company), the unit holders (the investors of the fund) and the Trustee.
As an investor, you subscribe for units in the fund which are equal in value in the unit trust fund. Thus, when you invest, your money buys units in that fund at a price that is struck for that particular day. The price of a unit reflects its total Net Asset Value, commonly referred to as the NAV (the fund's assets less its liabilities, divided by the number of units in issue). Unlike stocks, whose prices are subject to change at each trade, the fund's NAV is calculated only at the close of each business day. Hence the fund's unit price is quoted in major newspapers on the following business day. Over the period in which you invest, the unit trust price will move up and down as the value of the investments comprising the unit trust fund rise or fall. Returns from a unit trust fund are typically calculated based on movements in the buying price of the unit trust fund (that is, the price in which the Manager of the fund will buy back units from unit holders) and assume any income distributions paid to unit holders are reinvested in the fund as additional units.
To protect your rights and interests as investors, an independent Trustee is appointed to ensure compliance of the Manager with the requirements of the Deed, Securities Commission Guidelines on Unit Trust Funds and the Securities Commission Act 1993. The Manager is also required to appoint an approved Company Auditor (within the meaning of the Companies Act 1965) for the purpose of conducting annual audits of the fund's accounts which must be included in the fund's annual report.
The diagram below illustrates the relationship between unit holders, the Trustee and the Manager.
Regulatory Framework for Unit Trusts in Malaysia
The regulatory powers for the establishment and operation of unit trusts in Malaysia is vested with the Securities Commission. The principal legislations governing the establishment and operation of unit trusts in Malaysia is the Securities Commission Act 1993 and the Guidelines and/or Guidance Notes on Unit Trust Funds issued by the Securities Commission from time to time. This requires, inter alia, that the Manager and Trustee execute a Deed, registered with the Securities Commission.
The Securities Commission also grants its approval on the appointment of the management company, the trustee, the manager's directors, chief executive officer, investment committee and the corporate syariah adviser/syariah committee members (if applicable) of the fund, subject to the terms and conditions as it thinks fit.
Comparison of Unit Trusts with Direct Investments in the Stock Market and Fixed Deposits
Unless a person has a very large amount of cash for direct investments in individual stocks, he may not be able to achieve a sufficient level of diversification. Losses in one or more of his stocks may substantially reduce the value of his portfolio. Unit trusts, on the other hand, have a diversified portfolio and losses in some of the stocks held are offset by gains in others. Nevertheless, a person with an undiversified portfolio may reap great returns if one or more of his stocks increase in value. Unit trust prices on the other hand, rise more gradually when some of its stocks' prices increase as the unit prices are based on the total value of the portfolio.
Fixed deposits are generally safe and the returns are guaranteed. However, no single investment in a savings instrument can meet all the investor's needs. Notwithstanding the fact that fixed deposits are liquid and is necessary for your spending requirements, the interest/profits earned may not be sufficient to maintain your purchasing power because of inflation. Unit trust investment which generally aims to achieve returns that are higher, may provide a better hedge against inflation and at the same time may offer better opportunities for capital appreciation. However, this also comes with accompanying risks which may result in losses.
What are the Fees and Charges?
In administering the unit trust fund, there are fees and charges incurred by the fund. Other than the usual Trustee and Manager fees, there are other fees payable such as auditors' fees, custodial charges, other relevant professional fees, cost of distribution of interim/annual reports, tax certificates, reinvestment statements and other notices to unit holders.
Management Expense Ratio (MER)
The MER is a ratio of the sum of the fees and the recovered expenses of the unit trust fund to the average value of the unit trust fund calculated on a daily basis. This includes management fees, trustee fees and expenses incurred for fund administrative services.
The computation of MER is as follows:
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MER |
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Fees of the fund +
Recovered expenses of the fund x 100% |
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Average value of the fund calculated on a daily basis |
The management expense ratio indicates the inherent costs of operating a unit trust fund. The higher the ratio, the more expenses are incurred by the fund when it is compared to other unit trusts within the same category. The lower the MER, the more beneficial it is to the investor.
Portfolio Turnover Ratio (PTR)
The portfolio turnover rate is calculated as follows:
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PTR |
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(Total acquisitions of the fund for the year +
Total disposals of the fund for the year) / 2 x 100% |
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Average value of the fund calculated on a daily basis |
The annual portfolio turnover rate will tell an investor whether a unit trust fund buys and sells securities frequently. A portfolio turnover rate of 100% p.a. means that the fund's portfolio has been turned over once for that particular year.
General Benefits of Investing in Unit Trusts
Unit trusts offer investors a simpler, more convenient and less time-consuming method of investing in securities through the expertise of experienced fund managers as compared to investing on their own.
A summary of the key benefits of investing in unit trusts are:
1. Professional Management
Having investment professionals manage money for you, even if you only have a small amount of money to invest is probably the key benefit to investing in unit trusts. Most of us do not have the time nor expertise to research the companies in which we might invest and as such, may be making decisions that are not well informed. Professional unit trust fund managers however, devote all their time to conducting full-time regular investment research and analysis of the various investment markets and companies, monitoring investment markets and the way economic developments affect these markets, and managing the assets of the Fund. By virtue of its research facilities, information network, investment experience and skills, the unit trust manager is in a better position to make sound investment decisions. Furthermore, as they usually have large sums to invest, fund managers have a far greater access to quality information including company contacts, competitors and customers than do individual investors. This allows them to gather a better understanding of the company before making the decision whether to buy, sell or hold the counter.
2. Minimisation of Risks
Risk is minimised through diversification. Diversification is the spreading of risk over a wide variety of securities positions in different companies. The size of unit trust fund portfolios generally means that fund managers can more easily reduce risk through greater diversification. They can also reduce risk by implementing sophisticated risk-management techniques involving the use of derivatives.
3. Liquidity
Unit holders may redeem all or part of their units on any Business Day and the unit trust manager will purchase them. This means that should you need cash, you can easily sell the investment without having an impact on the current market value of the investment. Most unit trusts will allow you to redeem your investments on any given day. In fact the Securities Commission requires that investors must receive their monies within 10 days of making the request, and the value of the redemption will be based on the unit trust price determined at the close of the Business Day in which the request for redemption is received.
4. Hassle Free
Unit trusts do not require any active participation on the part of the investor. All administrative work is conducted by the manager. Unit holders will be relieved from the tedious task of keeping records on managing investments, investment research and market analysis.
5. Affordability
Only a small amount of money is needed to participate in a professionally managed portfolio of investments. Investors can then enjoy the same benefits accorded to others when investing in high priced securities and reduced expenses through lower transaction costs as fund managers have the benefit of economies of scale. For example, fund managers generally pay much lower commissions to stockbrokers.
6. Diversification Opportunities
Whether you want to invest in shares or across a broad range of asset classes, unit trust funds provide you with one benefit that can be very hard for individual investors to achieve - diversification.
Ø Diversifying across asset classes
One way of reducing risk over short periods of time is to spread your investment over a number of asset classes. Or, as the saying goes, "don't put all your eggs in one basket". Why? Simply because different asset classes tend to experience good performance at different times. By avoiding having all your money in just one investment, the high returns you may receive from one investment can help you offset any poor performance that might be occurring in another, thus enhancing the consistency of returns.
Ø Diversifying within asset classes
The benefits of diversification do not just occur if you are investing across asset classes- diversification should also occur within asset classes. For example, you may decide to diversify within shares by investing in some companies in the construction, properties, industrial and finance sectors. Alternatively, you may decide to diversify within fixed income assets by investing in corporate and government bonds with varying maturity dates.
In order to achieve true diversity of investments, an investor must have a substantial amount of money to buy a sufficient spread of investments. Unit trust funds facilitate this process by providing small savers with an excellent opportunity to pool their savings to invest in a diversified portfolio of investments.
7. Flexibility
Unit trust investments are not simply a means of investing in the capital markets. Unit trusts can be thought of as an investment package with a number of options available. One of the most useful product options is the availability of regular investment plans. Regular investment plans allow the investor to commit to a series of regular investments over a long period of time by investing an initial sum of money, followed by subsequent investments at regular intervals. By committing to an ongoing stream of investments you not only benefit from slowly accruing large sums of money with small regular investments, but also benefit from Dollar Cost Averaging.
Risks of Investing in Unit Trusts
All investments involve varying degrees of risk. There are many possible outcomes associated with an investment and there are a multitude of factors, many beyond the control of investors that affect investment returns. Below is an outline of the major risks faced by investors in general, and our approach to managing these risks within the funds.
1. General Risks
Ø Management Risk
Poor management of the fund or the non-adherence to the investment mandate of the fund will jeopardize the investment of unit holders and may result in the loss of their capital invested in the fund. However this risk is greatly reduced by the presence of the Trustee whose duty is to ensure that the fund's investment mandate is complied with.
Ø Inflation Risk
Inflation is the potential loss of purchasing power of unit holders' investment due to a general increase of consumer prices. Inflation risk therefore, is the risk that unit holders' investment gains will be reduced by inflation. Thus, inflation erodes the real rate of return (that is, the return less the inflation rate) from an investment.
Ø Liquidity Risk
Liquidity refers to the ability of a fund to honour requests for redemption or to pay back unit holders' investments. It is subject to the fund's holding of adequate liquid assets. For example, where a fund invests in bonds, it is exposed to liquidity risk given the fact that the Malaysian bond market is not as liquid as its sharemarket. As a result, it may not always be possible to immediately sell its fixed income securities investments at the prevailing market price so as to fund unit holders' redemptions.
In order to mitigate this risk, the Manager actively manages the maturity structure of its portfolios. Investment in illiquid private debt securities will only be considered when commensurate with attendant risks. Factors such as the issue size of the bond, the issuers' total debt outstanding and sector limits are also taken into consideration to mitigate liquidity risk.
Ø Loan Financing Risk
Borrowing to invest can multiply the effect of an increase or decrease in the value of an investment. If the value of a unit holder's investment falls below a certain level, his financial institution may require him to provide additional collateral or to reduce the outstanding loan amount. A unit holder also runs the risk of an inability to service loan repayments as borrowing costs vary depending on the fluctuations in interest rates. Also, an increase in interest rates on the loan repayments may eat into any gains that the investment makes.
Investors should carefully assess the inherent risk when taking a loan to invest in unit trusts in light of your investment objectives, attitude to risk and financial circumstances.
Ø Risk of Non-Compliance
Failure of the Manager to follow the provisions set out in the deed, the law that governs the fund or its own internal procedures, or simply the lack of fiduciary care by the Manager to uphold the interests of its unit holders all pose a risk to unit holders' investment. In order to manage this risk, the Manager has sufficient internal controls in place and dedicated compliance procedures to ensure compliance with all applicable requirements at all times to protect the interests of the unit holder.
Ø Fund Management Risk
The selection of securities which make up the assets of the fund is a subjective process. Securities selected by the investment manager may perform better or worse than the overall market, or as compared to portfolios selected by their competitors.
Ø Returns are not Guaranteed
Except in the case of capital guaranteed funds, there is no guarantee on the investment returns to unit holders. Unlike fixed deposits which carry a specific rate of return, unit trust funds generally do not guarantee the investment returns or dividend payout to unit holders. In addition, the past performance of a fund is not indicative of its future performance.
2. Investment Risks
Ø Market Risk
Negative movements in the capital market caused by changes in the economic, political and social environment, and the broader investor sentiment affecting the stock market as a whole, will affect the price of units in unit trust funds. Even a well-diversified fund cannot avoid these fluctuating market factors when they are such as to simultaneously affect the prices of all securities irrespective of their sectors and prospects. In cases where market factors affect only selected sectors, investment in a unit trust offers some measure of protection.
Ø Particular Security Risk
There are risks which are unique to the securities or the individual companies that issued the securities. Not all companies are successful. The success or failure of the companies will cause their value to rise or fall. These specific risks can be associated with management errors, shift in consumer taste, advertising campaign, lawsuits, competitive industry conditions or the possible effect on a company of losing a key executive. Other risks which apply to individual bond and fixed interest securities include the potential for a company to default on the repayment of the coupon and /or principal of its fixed interest securities, or the implications of a company's credit rating being downgraded. Valued collectively, the performance of individual securities will cause the unit price to rise or fall accordingly.
The Manager seeks to identify potential risks, prior to investing. All investments are then monitored closely to enable its fund managers to assess changes in circumstances and, where necessary, alter the Fund's exposure. It is not possible to anticipate all company or security specific risks. However, this risk can be minimised by diversifying the fund's investment over more companies in various segments of the economy which operate independently from one another.
Ø Interest Rate Risk
Interest rate anticipation is the most critical factor in any active fixed income portfolio management strategy because it involves relying on forecasts of uncertain future interest rates. Interest rates are inclined to fluctuate over time. This risk refers to the effect of interest rate changes on the market value of a fixed income portfolio. A rise in the general level of interest rates will result in a decrease of the prices of bonds and fixed interest securities, and vice versa. Meanwhile, debt securities with longer maturities and lower coupon rates are more sensitive to interest rate changes. This risk will be mitigated via the management of the duration structure of the fixed income portfolio.
Ø Credit/Default Risk
Credit/default risk refers to the possibility that the issuer of a fixed income security/debenture will be unable to make coupon payments and/or repay the principal in a timely manner, or perhaps even defaulting in the payment of principal and interest. This lowers the value of the fund's investments and subsequently the value of unit holders' investments.
Ø Liquidity Risk
Liquidity risk is faced by a fund which trades in thinly traded or illiquid securities. This risk refers to the ease with which such securities can be sold at or near its fair value depending on the volume traded on the market. Should the fund need to sell a relatively large amount of such securities, their selling price would be greatly lowered due to the selling pressure. This would naturally lower the value of unit holders' investments.
Ø Currency Risk
Where a percentage of the value of the fund is invested in foreign currency or assets denonminted in a foreign currency, the fund may be exposed to currency risks. Fluctuations in foreign exchange rates will affect the value of the fund's foreign investments when converted into local currency and subsequently the value of unit holders' investments. In addition, the value of the assets of the fund may also be affected by uncertaibties such as currency repatriation restrictions or other developments in the law or regulations of the countries in which the fund may invest.
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