Unit trusts have their disadvantages

By David McEwen

Thursday 6th June 2002

Unit Trusts have their part in any portfolio. This is particularly the case for smaller portfolios that would otherwise find it difficult to diversify adequately or for people who want to invest internationally.

However, investing in the local share market through unit trusts is less appealing.

One of the few advantages we have in New Zealand is that we don't pay capital gains tax on shares we buy and eventually sell, provided we are not traders.

That is not the case with unit trusts, which pay the corporate rate of tax on all their gains.

Why invest in a unit trust that has to pay capital gains, on the same shares that offer tax-free benefits if you own them in your own name?

On top of that tax, many unit trust holders have to pay a stiff entry fee then annual trustee, administration and management charges.

The inference, of course, is that the people who manage funds are so smart at choosing a portfolio, and deciding when to buy and sell, that gains will more than make up for costs and taxes.

This might be the case in some instances but most funds managers are unable to generate such attractive returns consistently.

To be fair, there are a handful of trusts that have performed exceptionally well over the past few years, after deducting fees and taxes.

However, on average, fees gobble up most of a fund's gains. A recent survey of unit trust performances found the average net one-year return for active equity funds in New Zealand in the past year was a modest 1.78%. Over three years, the figure is only slightly better at 2.1% per year compounding.

Such results are not necessarily the funds managers' fault. Unit trusts are run by highly educated professionals, but they are saddled with a system that does not function very efficiently.

In general, funds are obliged to stick close to the biggest companies making up a market index, such as the NZSE40, because there is not enough liquidity in smaller companies. Unfortunately, the largest companies tend to be very mature and slow growing relative to many others, contributing to modest unitholder returns.

Times have also changed.

Traditionally, the investing power of the funds was seen as a major advantage. While the private investor had to buy and sell shares through a full service broker, which charged a minimum fee on every trade, big funds got a much better deal.

These days, any individual can trade shares over the Internet for a relative pittance.
It's not all bad, of course.

International managed funds play a very important role in allowing New Zealanders to invest in overseas markets that are not so accessible. The importance of this diversification partly compensates for higher costs, especially as an investor can gain access to faster growing markets than New Zealand's.

Those with the capital, the time and the interest should consider making their own trades in the New Zealand market. Owning shares directly will cost much less than by buying the same ones through a unit trust.

Those that feel more comfortable in a trust should:

- Choose those with consistent records over a long period (ideally several years).
- Ignore those that only perform as well as the market - index funds can do the same job at a fraction of the cost.
- Make sure you get in writing exactly what fees you face when you buy into a managed fund.

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