Comparing index funds and equity unit trust funds

USUALLY, AN index fund invests in the securities that make up the index it imitates in the same proportion that these securities are weighted in the index.

The performance of the index fund closely mirrors the market index.

An equity unit trust fund invests in equities in many industries and sometimes in more than one market, and its performance, based on changes in its net asset value, may be better or worse than the performance of the markets in which it invests.

The index that the index fund tracks is weighted by the market capitalisation of the stocks that make it up. Therefore, the manager of the index fund is not required to do much to rebalance or manage it once it has achieved alignment with the index. This is why it is described as a ‘passively managed’ fund.

Rebalancing is, nevertheless, required when the composition of the index changes due to the addition or removal of companies or increases in the issued shares of others. When rebalancing makes it necessary to sell, this may result in capital gains, which are distributed to investors. Additionally, when dividends are paid, they are distributed to investors in the fund.

As we have seen in the case of the Sagicor Select Funds, described as listed equity funds rather than index funds in the local market, the level of diversification varies, and this influences how a fund responds to developments in the market.

The Sagicor financial fund includes several different types of financial companies, but it is less diversified than the manufacturing and distribution fund, which includes more companies and a wider range of types of companies.

Being passively managed, thereby using a buy-and-hold strategy, an index fund does not have the capacity to adjust strategy to take advantage of developments in the market and the wider economy and does not track fully the index it mimics because of the management fees and other expenses that it incurs. This means that over time, the net return of the fund is less than the return of the index it tracks after the deduction of such expenses. Indexing a portfolio, nonetheless, reduces the cost of running it.

An equity unit trust fund aims to maximise returns to investors and is not constrained by the need to track an index. In fact, it is not reasonable to compare the performance of a unit trust with that of an index fund because they are not alike.

Whereas index funds are passively managed, unit trusts are actively managed and are more likely to incur more transaction expenses in addition to the management fees that they incur.

Unit trust managers do not buy and sell in order to bring the fund in line with an index. They trade primarily to increase the returns of the fund and are free to use their discretion in their buysell decisions. To maximise returns, they reinvest realised capital gains and dividends.

MORE SCOPE FOR DIVERSITY

An equity unit trust fund has more scope for diversification than an index fund. It is not restricted to investing in stocks in a particular sector or industry, so its risk is spread across several sectors or industries in contrast to an index fund, which is exposed to risk in one industry or sector, which may cause greater price fluctuations. It is worth observing, though, referring to the Sagicor funds, that the more diversified manufacturing and distribution listed equity fund has so far fared better than the financial fund in the recent decline in the performance of the Jamaica Stock Exchange.

An equity unit trust fund has another advantage in that it is not limited in terms of what portion of its funds it can invest in a particular security – because it is not tracking an index.

To the investor concerned with establishing a balanced portfolio, investing in an index fund creates the need to add securities outside of the sector to the portfolio in such a way that the portfolio achieves its desired objectives. Although there is scope to invest in a wide range of equities in several sectors of the economy by investing in an equity unit trust, it is still necessary to invest in other types of investment instruments to establish a balanced portfolio.

An equity unit trust fund and an index fund that tracks an equity index are similar in several ways in spite of the differences we have identified. We have noted the scope they offer for diversification but not to the same degree.

They are liquid, the unit trust fund more so, because it is not an exchange-traded instrument, but an open-end instrument, meaning that the unit trust readily redeems units just as it readily creates and sells new units. They both satisfy the ease-of-management investment objective, and although their prices rise and fall from time to time, offer potential for long-term growth.

Here we have two investment instruments that can both fit into the same investment portfolio. What is important is that they are treated as the equity instruments that they are, which means that they should be counted as a part of the equity portion of the portfolio. Failure to do so will likely cause a distortion in the asset mix of the portfolio.

■ Oran A. Hall, principal author of The Handbook of Personal Financial Planning, offers personal financial planning advice and counsel. finviser.jm@gmail.com