For a young investor, one of the first decisions to make is not simply which investment to buy, but what type of investment structure makes the most sense. ETFs, unit trusts and individual shares all play a role in a long-term portfolio, but they work in very different ways and involve different levels of risk, cost and decision-making. Understanding these differences is more important than choosing the investment that happens to be performing well today and in this week’s article we will unpack each of these investment options.
An exchange-traded fund, or ETF, is a pooled investment that generally aims to track the performance of a particular index, sector, commodity or group of assets, therefore if you buy an ETF, you are effectively buying a small interest in a portfolio of underlying investments. For example, an ETF tracking the FTSE/JSE Top 40 gives an investor exposure to a basket of large South African companies rather than requiring them to buy each share individually. Many ETFs are passively managed, meaning the fund is designed to replicate an index rather than have a manager actively selecting investments.
One of the biggest advantages of ETFs is diversification, which means a young investor with a relatively small amount of capital can gain exposure to dozens of companies or other assets through a single investment. ETFs also tend to have relatively low management fees, particularly where they simply track an index. However, investors should look beyond the advertised management fee and consider the total cost, including brokerage, spreads and the fund’s tracking difference, which measures how closely the ETF actually follows its underlying index.
Unit trusts are also pooled investments, but they differ from ETFs in how they are structured and traded. A unit trust pools investors’ money and a fund manager uses that capital to construct a portfolio according to a particular mandate. The manager may actively select shares, bonds or other investments in an attempt to outperform a benchmark, although some unit trusts are also passively managed.
The main attraction of an actively managed unit trust is that investors are paying for professional investment management. A skilled manager may be able to identify opportunities, manage risk and adjust the portfolio when market conditions change. The difficulty is that active management comes at a cost, and higher fees create a performance hurdle that the manager has to overcome before investors actually benefit. A fund that charges significantly more than a comparable index-tracking ETF therefore needs to add enough value to justify those additional costs.
Individual shares are fundamentally different because you are taking direct ownership of specific companies rather than buying a diversified portfolio. This gives investors greater control and potentially greater upside, but it also significantly increases concentration risk. If you invest your entire portfolio in five companies and one performs badly, the effect on your wealth can be substantial.
Investing directly in shares can also require considerably more research and investors need to understand the company’s financial statements, competitive position, debt levels, cash flows, valuation and future earnings prospects. A company can be excellent but still be a poor investment if you pay too much for it. This distinction between the quality of a business and the valuation of its shares is one of the most important concepts for a new investor to understand.
For most young investors, the decision therefore does not have to be an either-or choice. A diversified ETF can provide a sensible core holding while individual shares can be used selectively by investors who are willing to research companies and accept greater volatility. Unit trusts may make sense where an investor specifically wants an active investment strategy or exposure to an asset class or mandate that is not easily replicated through a low-cost ETF.
The most important consideration, however, is not whether an ETF, unit trust or share is inherently better, but rather whether the investment matches the investor’s time horizon, risk tolerance, objectives and ability to remain invested through market cycles. A young investor has one major advantage that cannot be bought later: time. That makes diversification, disciplined contributions and controlling investment costs particularly powerful.
Ultimately, the best portfolio is unlikely to be the one containing the investment that delivered the highest return last year. It is the one that an investor understands, can afford to hold through periods of uncertainty and can continue contributing to for many years. For a beginner, that often makes a diversified, low-cost investment a more sensible starting point than attempting to identify the next winning share.