Along with credit cards and ATMs, unit trusts are probably one of the best financial innovations of the last sixty years. Unit trusts have been described as 'a breakthrough in financial democracy' because they have enabled ordinary savers to get access to professional financial management at very low cost. Before the development of unit trusts, most of us would have had to buy shares in individual companies if we wanted exposure to stock markets. Unit trusts removed much of the hard work and uncertainty for us as we no longer had to analyse companies' performance or the advantages and disadvantages of different bonds before deciding where to invest - the fund managers and their staff did this for us.
The ease and low cost of putting money into unit trusts has encouraged many people to save. In fact, for possibly the majority of savers, unit trusts have long been the most sensible, productive and efficient way to grow their money. However, what started as a breakthrough which has benefited tens of millions of savers may now have become a huge and immensely profitable colossus that no longer works in our interests.
Mass Mutual
The unit trust industry has seen enormous growth. In the US (where they're called 'mutual funds'), there were only about four hundred mutuals in 1970 managing around billion. Now there are over six thousand funds with more than trillion invested in them. In Britain, another six thousand or so funds manage in excess of 500 billion of our money.
Now we are in an almost ludicrous situation where there are more funds than there are companies for them to invest in. By 2012 there were around 6,300 funds based in the US of which about 3,840 were domestic funds channelling US savers' money into just 2,900 stocks listed on the NYSE. There are around 6,300 funds operating out of Britain. Of these we can choose from more than 3,200 to put money in only about 2,600 companies on the London Stock Exchange, AIM and Techmark markets. Globally there are in the region of fifteen thousand companies which attract unit trust and mutual fund money and yet we have over eighteen thousand funds competing for our cash to invest in those fifteen thousand companies. This means that many funds are forced to buy the same shares. If you look at the prospectuses from, for example, the main UK unit trusts, their top ten investments are mostly in the same companies - HSBC, Aviva, GlaxoSmithKline, Vodafone, Centrica, AstraZenica, Tesco and so on.
At first sight, the unit trust costs of two to three per cent that individual savers pay may appear quite modest. But funds manage such huge sums that their charges aggregate up to massive amounts of money taken from our savings each year. In the US, where charges are slightly lower, savers pay in the region of billion to billion a year to mutuals - 6 million to 4 million a day - to look after their investments. In Britain we cough up 10 billion to 15 billion a year - 40 million to 60 million a day. This 40 million to 60 million a day comes directly from our savings and has a terribly destructive impact on any returns we are likely to get.
Perhaps the most worrying development in the unit trust industry is how it has moved away from being a business where a limited number of funds tried to provide effective, low-cost financial management and has instead become more akin to consumer mass marketing where all that seems to matter for thousands of funds is getting in as much investor money as possible to maximise profits for fund management firms.
Many unit trusts follow a similar life cycle. A fund is started with say twenty or thirty million pounds or dollars or euros. Because it is managing a small amount of money, it can flexibly pursue the best investment opportunities and so tends to outperform older, larger and less flexible funds. Moreover in the early stages of their life, the key priority for most funds is to demonstrate rapid growth as this is what will draw in more savers' money.
Gradually the unit trust attracts more funds as financial advisers recommend it to their clients and its assets grow to maybe a hundred or two hundred million. A year or so later, the management company takes out big press adverts trumpeting the fund's extraordinary success. This attracts a flood of new money as ordinary savers pile in, completely ignoring the legally compulsory warning, 'Past performance is no guide to the future'. Studies have repeatedly shown that most new investor money goes into the top-performing funds, particularly those advertised in the press and investing publications. Soon the fund may have five hundred, seven hundred or even a billion pounds, dollars or euros under management.
Now growth becomes a bit more difficult. It's generally accepted that any new information about a company is known to all the main players in a market within less than an hour. When a unit trust just has thirty or fifty million under management, it can sometimes achieve high returns by spotting the occasional opportunity. But when it has five hundred million or more, there simply aren't sufficient opportunities for such large sums and it increasingly has to buy the shares of the larger companies in each country - exactly the same shares that are held by many other trusts. As a trust grows, its flexibility declines and, if it has experienced high growth in the past, its performance will tend to fall back to the average of its sector. This means we are often putting our savings in the wrong unit trusts at the wrong time and are probably not going to get anything near the returns that we assume from the past performance boasted in the unit trust brochures and advertising.
Moreover, there is a direct conflict of interest between ordinary savers and their fund managers. We would make better returns if our funds remained small and nimble. But managers want to attract as much money as possible to increase their earnings. If unit trusts used their growth to decrease their fees as a percentage of their holdings, then investors would at least get some benefit from their funds' growth. However, most trusts keep their fees constant, or even increase them, as they become more popular. So growth is hugely beneficial for the management company, but does nothing for investors. In a perverse way, unit trust investors end up paying for marketing and advertising which will most likely dampen the trust's performance potential and thus damage their investment returns, while enormously increasing the fund's profitability for the fund management company.
What most savers should do is use unit trust investment managers' knowledge without giving them our money. For example, it's easy to find the best performing unit trusts in any sector. Then you can look on those unit trusts' websites and see which are the main shares they hold. Once you know that, you can buy the same shares directly yourself. You'll save the initial 5% cost of buying into a unit trust. You'll avoid paying 2% to 3% in annual charges. And you'll avoid losing the 5% difference between the price you buy units and the price you can sell them. Over five years you'll have about 20% more than if you'd put your money in a unit trust and you'll probably get the same performance.
Never Put Your Money in a Unit Trust
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