Don't bother with unit trusts - try these instead

Putting your money into a unit trust is simply suicidal investment - they're expensive and offer measly returns. Bengt Saelensminde suggests an alternative that's cheaper and can offer good returns.

I've never been a big fan of unit trusts. They cost a small fortune in fees. And once you strip out all the expenses that they leach from investors, there is often very little to show for your investment.

As far as I'm concerned, you end up paying a first class price for a distinctly second rate service. And there is no reason to accept this state of affairs.

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You would be far better off investing in exchange traded funds (ETFs). I've taken a keen interest in ETFs since they were introduced over ten years ago. And I think they are a tremendous option for the private investor.

They are simple, they are easy to buy, and best of all, the fees you'll pay are a fraction of what the rip-offunit trustindustry regularly pinches from unsuspecting investors.

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Today I'd like to show you just how superior I think ETFs are to unit trusts. And then I'll explain how to pick the right ETF.

Why unit trusts are so second rate

High unit trustfees are not just about keeping egotistical fund managers in Ferraris. There are plenty of other costs too...

For starters fund management firms spend a lot of manpower and money complying with the various directives heaped on them by the legislators.

And then there's advertising - you know all those posters you see at the train station, or in the weekend press: We've been around since Adam was in shorts - we're the best and most trustworthy guardians of your assets'.

Whose cash pays for all this advertising, supercars and compliance? Unit trustholders of course.

And worse than the high fees (or possibly because) is their poor performance. Success is measured by reference to a benchmark. And guess what? Most funds underperform their benchmarks. Studies show that the only people to consistently make any money in this game is the financial services industry... quelle surprise!

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But you don't have to stand for this. Things are different with ETFs. And if your financial adviser hasn't told you about them it's probably because there aren't any juicy fees on offer to him. So let me fill you in...

A far better option for the private investor

ETFs are like unit trusts in that they offer you a one-stop shop for a diversified investment. But instead of trying (usually in vain) to beat a benchmark, ETFs offer investors the performance of the benchmark - and in this case that's a market index.

ETFs can be based on all sorts of indices from stocks to bonds, commodities or even cash.

The funds will also pay you any income that would be due if you held the securities in the index - ETFs are designed to allow you to hold all the elements of the index. In the old days only massive City institutions would have been able to get this sort of exposure.

But today anyone can. If you want to get exposure to every stock on Brazil's main stock exchange you can. All you've got to do is buy one stock and it's traded on the London stock exchange.

Now there aren't many ways to dress up the fact that what you're getting is the return of an index. So ETF providers don't tend to splash out on the advertising... 'We're distinctly average' probably wouldn't be a great strap line. But that suits me - that's a few quid saved.

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And because there are no fund managers involved and the whole thing is simplified (computers can do most of the admin) the providers save a few more quid. Most ETFs charge between 0.2% and 0.75% a year. And because you buy them through your regular stockbroker, there's no need to shell out for a financial intermediary to pick them up for you.

Better still, as it stands, there's no stamp duty to pay on ETFs - I'm not sure about the logic behind that, but it's welcome nonetheless.

What you're getting here is a first class service, but with a second-class price. Looks like a no-brainer to me. But as you go out ETF shopping, there are some things you should bear in mind...

How to choose the right ETF

Every time I look into ETFs there's more and more stuff available. This is big business now - and I'm not surprised.

I put together some ideas about how you can create a portfolio using just ETFs a little while ago, so I won't repeat it here. The following links will show you what funds are available from each provider. This is not an exhaustive list, but you'll quickly see the breadth of indices you can invest in.

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Apart from deciding which index you want exposure to, there are three important things to consider.

First, the size of the fund. Because ETFs trade in the same way as individual shares, there's a bid/offer spread. And as with shares, generally bigger is better. The bigger the ETF, the more liquid it tends to be. And the more liquid the stock, the smaller the spread.

The second thing to consider is what's known as replication. How does the ETF provider recreate the performance of the index it's tracking? If you want to be safe, you should stick to funds that physically hold all the securities in the underlying index.

Some funds use synthetic' replication. They'll set up contracts with third parties and some clever engineering to reproduce the returns of the index. This may keep fees down, but you could be opening yourself up to counter-party risks. My colleague David Stevenson of MoneyWeek can give you the low-down.

Third is something we always consider and that is cost. Annual fees charged by providers is known as the 'total expense ratio' (TER); you'll see this information on the funds factsheet.- just follow the links I've given. You may think that cheaper is always better, but beware...

Because ETF fees are low anyway, you shouldn't be too tight when it comes to their fees. If you pay a little bit more for a fund that you feel secure with (remember the replication issues) then it's probably worth it.

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This article was first published in the free investment email The Right side. Sign up to The Right Side here.

Important Information

ETF's performance relies on the performance of the underlying investments. Your capital is at risk when you invest in shares - you can lose some or all of your money, so never risk more than you can afford to lose. Always seek personal advice if you are unsure about the suitability of any investment. Past performance and forecasts are not reliable indicators of future results. Commissions, fees and other charges can reduce returns from investments. Profits from share dealing are a form of income and subject to taxation. Tax treatment depends on individual circumstances and may be subject to change in the future. Please note that there will be no follow up to recommendations in The Right Side.

Managing Editor: Frank Hemsley. The Right Side is issued by MoneyWeek Ltd.

MoneyWeek Ltd is authorised and regulated by the Financial Services Authority. FSA No 509798. https://www.fsa.gov.uk/register/home.do

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