1.10 Asset Classes- Collective Investment Schemes (CISs)

Question 0

Unit Trusts

Answer 0

A unit trust is a professionally managed collective investment fund.

• Investors can buy units, each of which represents a specified fraction of the trust.
• The trust holds a portfolio of securities.
• The assets of the trust are held by trustees and are invested by managers.
• The investor incurs annual management charges and possibly also an initial charge.
An authorised unit trust (AUT) must be constituted by a trust deed made between the manager and the trustee.

The basic principle with AUTs is that there is a single type of undivided unit. This is modified when there are both income units (paying a distribution to unit-holders) and accumulation units (rolling up income into the capital value of the units).

If a fund wishes to market the unit trust in other member states of the EU, it may apply for certification under UCITS (Undertakings for Collective Investment in Transferable Securities).

Question 1

What is a Collective Investment?

Answer 1

A collective investment is a way of investing money with other people to participate in a wider range of investments than those feasible for most individual investors, and to share the costs of doing so.

Terminology varies with country, but collective investments are often referred to as investment funds, managed funds, mutual funds or simply funds. Across the world large markets have developed around collective investment, and these account for a substantial portion of all trading on major stock exchanges.

Collective investments are promoted with a wide range of investment aims either targeting specific geographic regions (eg, emerging Europe) or specified themes (eg, technology). Depending on the country, there is normally a bias towards the domestic market to reflect national self-interest as perceived by policy-makers, familiarity, and the lack of currency risk. Funds are often selected on the basis of these specified investment aims, as well as their past investment performance and other factors such as fees.

Question 2

Name 6 characteristics true of a Trustee

Answer 2

1. Trustees of a unit trust must be authorised by the FCA and fully independent of the trust manager.
2. Trustees are required to have capital in excess of £4 million and, for this reason, normally are large
   financial institutions such as a bank and insurance companies.
3. The primary duty of the trustees is to protect the interests of the unitholders.
4. The investor in a unit trust owns the underlying value of shares based on the proportion of the units
   held. They are effectively the beneficiary of the trust.
5. The trust deed of each unit trust must clearly state its investment strategy and objectives, so that
   investors can determine the suitability of each trust.
6. The limits and allowable investment areas for a unit trust fund are also laid out in the trust deed
   together with the investment objectives.

Question 3

What is the Role of the Manager?

Answer 3

The manager must also be authorised by the FCA and his role covers:

• Marketing the unit trust.
• Managing the assets in accordance with the trust deed.
• Maintaining a record of units for inspection by the trustees.
• Supplying other information relating to the investments under the unit trust as requested.
• Informing the FCA of any breaches of regulations while he is running the trust.

Question 4

Buying and Selling Units

Answer 4

Unit trust units can be purchased in a number of ways; for example, via a newspaper advertisement, over the phone or over the internet. These methods will generally require payment with the order, or some form of guarantee of payment. A contract note will be produced and sent to the investor as evidence of the purchase.

Investors can sell their units via the same source that they purchased them, or can contact the fund managers direct, for example by telephone.

Question 5

Unit Trust Pricing

Answer 5

The calculation of buying and selling prices will take place at the valuation point, which is at a particular time each day. The fund is valued on the basis of the net value of the constituent assets and a typical spread between buying and selling prices in the market will be in the range of 5–7%.

Some fund managers use single pricing, in which case there is the same price quoted for buying and selling units, with any charges being separately disclosed.

Question 6

The Charges on a Unit Trust

Answer 6

The charges on a unit trust can be taken in three ways – an initial charge which is made up front, an annual management charge made periodically and an exit charge levied when the investor sells.

Whatever charges are made must be explicitly detailed in the trust deed and documentation. The documents should provide details of both the current charges and the extent to which the manager can change them.

The up-front initial charge is added to the buying price incurred by the investor. Initial charges tend to be higher on actively managed funds, often in the range of 3% to 6.5%. Lower initial charges are typically levied on index trackers. Some managers will discount their initial charges for direct sales including sales made over the internet. It is not unusual for those managers that charge low or zero initial charges to make exit charges when the investor sells units.

When they apply, exit charges are generally only made when the investor sells within a set period of time, such as the first three or five years. Furthermore, these exit charges tend to be made on a sliding scale with a more substantial charge made for those exiting earlier than those exiting later. Both the set period and the sliding scale reflect the fact that, if the investor holds the unit for longer, the manager will benefit from the regular annual management charges that effectively reduces the need for the exit charge.

The annual management charge is generally levied at a rate of 0.5% to 1.5% of the underlying fund. Like the initial charge, the annual management charge will typically be lower for trusts that are cheaper to run, such as index trackers, and higher for more labour intensive actively managed funds.

Question 7

Open-Ended Investment Companies (OEICs)

Answer 7

Open-ended investment companies (OEICs) are a type of open-ended collective investment formed as a corporation under the Open-Ended Investment Companies Regulations of the United Kingdom.

Pronounced oiks, they are also known as ICVCs, which is an acronym for investment companies with variable capital. The terms ICVC and OEIC are used interchangeably, with different investment managers favouring one over the other.

With the implementation of the FSMA 2000, the range of UK-authorised OEICs was extended to be similar to that of unit trusts, including money market funds and property funds, for example.

Both OEICs and unit trusts are types of open-ended collective investments (see Section 10.3.1). However, with a unit trust, the units held provide beneficial ownership of the underlying trust assets. A share in an OEIC entitles the holder to a share in the profits of the OEIC, but the value of the share will be determined by the value of the underlying investments. For example, if the underlying investments are valued at £125,000,000 and there are 100,000,000 shares in issue, the net asset value of each share is £1.25.

The holder of a share in an OEIC can sell back the share to the company in any period specified in the prospectus.

An OEIC may take the form of an umbrella fund with a number of separately priced sub-funds, adopting different investment strategies or denominated in different currencies. Each sub-fund will have a separate client register and asset pool.

Classes of shares within an OEIC may include income shares, which pay a dividend, and accumulation shares, in which income is not paid out and all income received is added to net assets.

OEICs are similar to investment trusts in that both have corporate structures. The objective of the company in each case is to make a profit for shareholders, by investing in the shares of other companies. They differ in that an investment trust is a closed-ended investment and an OEIC is open-ended. The open-ended nature of an OEIC means that it cannot trade at a discount to net asset value (NAV)

Question 8

Buying and Selling OEICs

Answer 8

OEICs are single-priced instruments. Therefore, there is no bid/offer spread with OEICs. The buying price reflects the value of the underlying shares, with any initial charge reflecting dealing costs and management expenses being disclosed separately. The costs of creation of the fund may be met by the fund. When the investor wishes to sell the OEIC, the authorised corporate director (ACD) will buy it. The money value on sale will be based on the single price, less a deduction for the dealing charges.

Question 9

Investment Trusts

Answer 9

Investment trusts have a long history in the UK. The Foreign and Colonial Investment Trust was the first to be founded in 1868 with the aim of ‘giving the investor of moderate means the same advantage as the large capitalist’. Today, it invests in more than 650 different companies in 36 countries.

In general, investment trusts provide a way for the small investor to have some exposure to investments in very large portfolios of assets, primarily equities, which are impractical for the investor to buy individually. In mid-2009 there were more than 600 investment trusts tracked by Trustnet, with total assets in the region of £60 billion.
Investment trusts are a form of collective investment, pooling the funds of many investors and spreading their investments across a diversified range of securities.

Investment trusts are managed by professional fund managers who select and manage the stocks in the trust’s portfolio. Investment trusts are generally accessible to the individual investor, although shares in investment trusts are also widely held by institutional investors, such as pension funds.

Despite their name, investment trusts are not trusts but public limited companies (plcs) listed on the LSE. However, whereas other companies may make their profit from providing goods and services, an investment trust makes its profit solely from investments. The investor who buys shares in the investment trust hopes for dividends and capital growth in the value of the shares.

Question 10

Comparison between Investment Trusts and Unit Trusts/OEICs

Answer 10

Investment trusts have wider investment freedom than unit trusts and OEICs/ICVCs. Investment trusts
can:

• invest in unquoted private companies as well as quoted companies;
• provide venture capital to new companies or companies requiring new funds for expansion.

The corporate structure of an investment trust gives it a further advantage over unit trusts and OEICs, because it can raise money more freely to help it to achieve its objectives. Unit trusts’ and OEICs’ powers to borrow are more limited. The ability to borrow allows an investment trust to leverage returns for the investor. Such gearing also increases the volatility of returns.

Unlike unit trusts which are normally open-ended funds, investment funds are closed-ended. In the case of an open-ended fund, the trust can create new units when new investors subscribe and it can cancel units when investors cash in their holdings. In the case of a closed-ended fund, new investors buy investment trust shares from existing holders of the shares who wish to sell.

Because investment trusts are closed-ended investments, the number of shares in issue is not affected by the day-to-day purchases and sales by investors, which allows the managers to take a long-term view of the investments of the trust. With an open-ended scheme such as a unit trust or an OEIC, if there are more sales of units or shares by investors than purchases, the number of units reduces and the fund must pay out cash. As a result, the managers may need to sell investments even though it may not be the best time to do so from a strategic and long-term viewpoint.

Being closed-ended also means that the price of shares of the investment trust rises and falls according to demand for and supply of the shares of the investment trust, and not directly in line with the values of the underlying investments. In this way, investment trust prices can have greater volatility than unit trusts and OEICs, whose unit prices are directly related to the market values of the underlying investments.

Because prices are dependent on supply and demand, the price of the shares can be lower than the net asset value (NAV) of the share (see Section 10.3.3).

When the prices of the trust’s share are below the NAV investors can buy investment trusts at a discount, while the income produced by the portfolio is based on the market value of the underlying investments. The income yield is therefore enhanced.

Charges incurred on investment trust holdings can be compared with the alternatives. Some unit trusts and OEICs have initial charges of around 5%. Initial charges may be much lower than this (at around 0.25%) for some investment trust savings schemes. However, there may be charges on selling investment trust holdings.

An investment trust is also subject to FCA rules.

Question 11

Investment Trust Prices

Answer 11

The quotation of the price of investment trust shares is similar to that for equities generally, and a dealer will give two prices.

• The higher price is the offer price, at which an investor can buy the shares.
• The lower price is the bid price, at which a holder of the shares can sell.

In a price quote in the financial media, a single price may be given: this will typically be the mid-market price, between the offer and bid prices.
The difference between the offer price and the bid price is the spread.

Question 12

Dealing in Investment Trusts

Answer 12

Shares in investment trusts can be bought through a stockbroker, who is likely to charge the same level of commission as for other equities. If a broker is not providing any advice and is providing an execution only service, then commission may be as low as 0.5%, or £10 per deal.

Stamp duty will be payable at 0.5% of the purchase consideration. If the broker is providing an advisory service, commission will be higher, for example, 1.5% or 2% of the purchase consideration.

Some brokers provide discretionary investment trust management services for individuals with larger sums to invest. The broker will select trusts that meet the investor’s investment objectives and will charge an annual management fee in addition to dealing charges.
An investor can usually deal directly through the investment trust managers instead of through a broker, and may incur lower charges by doing so.

Small investors who do not have an account with a broker may prefer to deal through the managers. However, the managers may only deal on a daily basis, while a broker will be able to quote an up-to-the- minute price and a deal can be made instantly by telephone.

Question 13

Name the 4 aspects of Investment Trusts that affect performance

Answer 13

An investment trust share is similar to any other equity, except that the specific objective of the company is to invest rather than to transact other forms of business. The past performance of the trust can be measured against standard benchmarks of performance, such as market indices most closely covering the market sector in which the trust invests.

Aspects of investment trusts influencing the assessment of performance are:

• dividend growth and gross yield (calculated in the same way as for other shares);
• net asset value (NAV);
• levels of discount/premium to NAV;
• gearing.

Question 14

How is NAV calculated?

Answer 14

The NAV is essentially the net worth of an investment trust company’s equity capital, usually expressed in pence per share, and is calculated from adding together the following:

• the value of the trust’s listed investments at mid-market prices;
• the value of its unlisted investments at directors’ valuation;
• cash and other net current assets.

The company’s liabilities are deducted from this figure, including any issued preference capital at nominal value. The resulting figure is the asset value or shareholders’ funds of the company. Dividing by the number of shares gives the NAV per share. The valuation may be carried out monthly, weekly or daily.

By way of illustration, the NAV of an investment trust with assets worth £10 million, with liabilities of £4 million and 12 million ordinary shares is 50p per share, ie, (£10 million – £4 million) divided by 12 million shares. However, this figure is an undiluted figure. It does not make any allowances for any warrants in issue (see Section 7.2).

Most investment trusts operate at a discount to NAV. The level of premium or discount relates to the demand for shares, and any factor that influences demand will affect it. For example, if investment in emerging markets becomes unpopular because of a global recession, share prices for investment trusts which focus on that sector may fall and, if the values of the underlying assets have not fallen so much, the level of discount to NAV may increase.

Question 15

Split Capital Investment Trusts

Answer 15

A split capital investment trust is like other investment trusts, in that it has a single portfolio of investments. A split capital trust, however, involves a number of different classes of share, with holders of the different classes having different entitlements to returns of capital or income from the trust.

A split capital trust has a limited life. The period of time remaining to the planned winding-up of the trust is usually very significant to how the prices of the different classes of share move.

Split capital investment trusts allow trust managers to tailor returns to appeal to different investors with different strategies, circumstances and attitudes. For example, if a low-risk but rising income is required, stepped preference shares may be suitable. If an increasing income is required but high risk is acceptable, an income share may be more appropriate.

The capital value of all classes of share will vary up until the trust is wound up. At that stage, the amount of capital returned will depend on the class of share and the order of priority in which the trust is wound up.

Question 16

Exchange-Traded Funds (ETFs)

Answer 16

An exchange-traded fund (ETF), also known as an exchange-traded product (ETP), is an investment fund traded on many global stock exchanges in the same manner as a typical stock for a corporation. An ETF holds assets such as stocks or bonds and trades at approximately the same price as the NAV of its underlying assets over the course of the trading day. Most ETFs track an index, such as the S&P 500 or MSCI EAFE, and European Australasia and Far East ETFs can be attractive as investment vehicles because of their low costs, tax-efficiency, and stock-like features.

Only authorised participants (typically, large institutional investors) actually buy or sell shares of an ETF directly from/to the fund manager, and then only in creation units – large blocks of tens of thousands of ETF shares – which are usually exchanged in kind with baskets of the underlying securities. Authorised participants may wish to invest in the ETF shares long-term, but usually act as market makers on the open market, using their ability to exchange creation units with their underlying securities to provide liquidity of the ETF shares and help ensure that their intra-day market price approximates to the NAV of the underlying assets. Other investors, such as individuals using a retail broker, trade ETF shares via a secondary market such as the NYSE/Arca exchange in the US.

Closed-ended funds are not considered to be ETFs, even though they are funds and are traded on an exchange. ETFs have been available in the US since 1993 and in Europe since 1999. ETFs have traditionally been index funds, but in 2008 the US Securities and Exchange Commission (SEC) began to authorise the creation of actively managed ETFs.

Question 17

Trading Features of an Exchange-Traded Fund (ETF)

Answer 17

The selection of ETFs available is now very diverse and provides investors with a real alternative to some of the more traditional funds. One of the key features of ETFs is that, since they are listed securities and trade in the same manner as shares, the pricing takes place in real time and the funds can be bought or sold during all times when markets are open. This is unlike the position with many types of collective investment vehicles, such as unit trusts and other investment funds, where the pricing of the fund based on the NAV of the constituents is computed at the end of each day and where the ability to transact is also limited to certain prescribed times. For investors and traders who want to be able to react quickly to market movements and have immediate pricing and settlement for their positions (subject only to the normal settlement period for any listed share), the variety of ETF products is preferable to the more traditional structured investment products.

One can purchase an ETF which has been designed and constructed to track a general stock index, such as the S&P 500 (SPY) or the NASDAQ 100 index (QQQQ), or indices for market sectors (eg, industrials, financials), geographical regions, currencies, commodities such as gold, silver, copper and oil, and even certain managed funds with objectives and management criteria laid out in an offering prospectus.

Another factor which has led to the increasing popularity of ETFs is that many of them are constructed in a manner which enables an investor to buy or take a long position with an ETF with a view to benefiting from a downward movement in a particular sector or index. This feature makes it easier for many investors to take a short position than having to borrow stock from a brokerage. In addition, it is also possible to purchase from a variety of ETFs if leverage is built in to the position taken.

For example, if one has a bearish view on the direction of the S&P 500 index, it is possible to purchase an ETF which trades on the NYSE/Arca exchange under the symbol SDS, which is known as UltraShort S&P 500 ProShares fund, and this fund will return twice the inverse return of a long position in the S&P 500 index. In essence, the mechanics for many kinds of inverse ETFs are that one buys (or goes long) the ETF and this will profit as the sector or index goes down.

ETFs are also available to track the performance of various fixed-income instruments such as US Treasury bonds or indices which track high-yield bonds and other corporate bonds. Again, these can be used to take a long position on higher yields, in effect to be short the bond on a price basis. One well-known ETF traded in the US under the symbol TBT tracks the yield on US T-bonds of 20 years plus maturity.

The fund moves in line with the real-time yields of the long end of the US Treasury curve, and therefore the fund moves inversely to the price of such US T-bonds.

Question 18

ETF Charges and Taxation

Answer 18

Many ETF products are managed by large financial intermediaries, including BlackRock and JP Morgan Chase, and the fees and charges are very competitive and often considerably lower than those applied for more traditionally managed funds.

Also, no stamp duty is applied to purchases of ETFs available from UK exchanges.

Question 19

ETF Tracking Methods

Answer 19

While the operation, marketing and construction of an ETF requires skills on the part of the ETF management company, many funds are in effect tracker funds and therefore have to reflect the composition of a reference index or commodity.

The large amounts of funds invested in tracker funds can have a distorting effect on the market, for example if many tracker funds buy a particular share at the point when it is included in the index.

Undoubtedly, inclusion in an index can be beneficial to the price of a share, while exclusion may be a factor causing a share to receive less attention from investors and to fall out of favour.

Question 20

Physical Versus Synthetic ETFs

Answer 20

When tracking an index, the providers of ETFs can use either physical or synthetic replication to ensure their ETFs mimic their designated indices as accurately as possible.

Physical replication means the ETF will buy and own most or all of an index’s constituents in order to replicate the index’s performance. Despite being simple and transparent, since physical replication involves buying and selling index components, this strategy is inherently labour intensive and costly. These additional costs are ultimately passed along to investors in the form of higher charges.

In contrast, synthetic replication involves the ETF provider entering into a contract with a counterparty (typically a bank) to deliver the return of the fund’s benchmark index in exchange for a fee. This swap contract means that, for example, an equity ETF will not actually hold any stocks at all. Instead it will have a contractual relationship with the counterparty bank. This may generally reduce costs and any possibility of tracking error, but it increases risk for investors. This is because there is a danger of the counterparty being unable to honour its obligation under the contract, known as counterparty risk.

Question 21

A collective investment scheme, according to the FCA, is any arrangement that…

Answer 21

• the purpose or effect of which is to enable those taking part (either by owning the property, or part of it, or otherwise) to participate in or receive profits or income arising from the acquisition, holding, management or disposal of the property;
• when persons taking part do not have day-to-day control over the management of the property; and
• whether either the contributions and profits or income are pooled, or the property is managed as a whole by or on behalf of the operator of the scheme, or both.

Question 22

The FCA distinguishes two types of CISs:

Answer 22

• Regulated CISs that are either authorised by the FCA, or, if they are from outside the UK, they are recognised by the FCA. Recognition enables overseas CISs to be marketed to the public in the UK and the FCA will only recognise an overseas scheme if certain specified criteria are met.
• Unregulated collective investment schemes (UCISs) are those schemes that are not authorised or recognised by the FCA. UCISs may be established, operated and/or managed in the UK or in a jurisdiction outside the UK.

Question 23

What are Unregulated Collective Investment Schemes (UCISs)

Answer 23

UCISs are described as unregulated because they are not subject to the same restrictions as a regulated CIS (eg, in terms of their investment powers and how they are run). Although the schemes themselves are not authorised or recognised, persons carrying on certain regulated activities in the UK in relation to UCISs (including providing personal recommendations, arranging deals and establishing, operating and managing schemes) are subject to regulations, particularly from the FCA.

UCISs are deemed to be among a group of investments referred to as ‘non-mainstream pooled investments’ that cannot be promoted to retail investors unless they meet specific exemptions; for example they can be shown to be sophisticated or high net worth investors.

Furthermore, UCISs are generally regarded as being characterised by a high degree of volatility, illiquidity or both – and therefore are usually regarded as speculative investments. This means that in practice they are rarely regarded as suitable for more than a small proportion of an investor’s portfolio. The schemes can offer exotic investments – such as golf courses in Mexico or forests in Brazil, off-plan property in Eastern European countries – and some not so exotic, such as wine in France.

Question 24

The Risks of Unregulated Collective Investment Schemes (UCISs)

Answer 24

As with most other investments, a client investing in a UCIS could lose some or all of their principal investment. However this risk is likely to be particularly relevant to UCISs. UCISs frequently invest in assets that are not available to regulated CISs (for example, because they are riskier or less liquid), or are structured in a way that is different from regulated CISs. Unlike regulated CISs, UCISs are not subject to investment and borrowing restrictions aimed at ensuring a prudent spread of risk. As a result they are generally considered to be a high-risk investment and firms should always ensure that clients fully understand the risks before investing.

Question 25

Typical risks encountered in an individual UCIS are likely to include the following:

Answer 25

• Liquidity – most unregulated investments will not offer daily liquidity. It is normal for investors wishing to redeem their investment to serve notice of their intention and for the redemption to take effect at the next available redemption date – typically at the end of the month in which notice is served. The investment will be sold at the price prevailing at the end of the following month and the realisation value returned to the investor approximately 14 days later. It can be seen, therefore, that the elapsed time from serving notice to receiving the proceeds can be up to two and a half months.
• Fixed- or long-term commitment – mainly due to the liquidity constraints set out above, investment must be regarded at outset as long-term.
• Lack of Financial Services Compensation Scheme (FSCS) cover – due to the unregulated status, should the provider of the investment become insolvent, cease trading, or suffer an act of fraud or malfeasance in relation to a UCIS, the investor is not eligible to make a claim under the FSCS. As a result, extra care should be taken by the adviser to satisfy him/herself that the investment is commercially and financially viable. Information must be sought from the fund’s managers and from other institutions representing the fund, such as auditors, accountants, bankers and legal representatives. Much of this information is available in the fund prospectus and/or memorandum.
• There is no guarantee of capital or income return – while this represents a risk, it is not necessarily significantly different to the risk associated with a regulated investment.
• High charges – some unregulated investments may have higher administration charges associated with them. This can only be determined on an individual fund basis. Some unregulated investments include a performance fee for the manager if they hit a level of performance in excess of (say) 20% p.a. It is usual, in these cases, for there also to be a high water mark which means that if the price of the investment falls in a year only to rise again in the next, the manager will not become eligible to receive an additional fee, until the previous maximum fund price is surpassed.
• Gearing – this means that the fund can borrow money to enhance the total funds available to it for investment. If the fund goes up in value (and the capital value of the loan remains static) this can lead to a higher multiple of gains (net of interest charges) being available for distribution to the investors. The risk is that in the event of a loss in the value of the fund’s assets, this can lead to a higher multiple of loss to the investor, because the loan will still require repayment in its entirety before NAV can be attributed to the investors.
• Currency/geopolitical – an offshore investment may have a base currency other than sterling. This means that there is currency exposure in the translation of value back into GBP from whatever the base currency is. If, during the period of investment, the base currency strengthens against sterling, this is advantageous to the investor; and vice-versa. Part of the due diligence process is to establish whether fund management hedges out the currency risk thereby neutralising its effect on underlying fund performance. Similarly, investing offshore may expose the investor to parts of the world which are less politically stable than the UK. If there is the slightest risk that assets might be sequestrated as a result of political unrest and/or government instability, the due diligence process should establish this and communicate the risk to the investor.
• Fraud and money laundering – in the same way as one cannot regulate away completely the possibility of fraud, extra care is required to verify the credentials of fund management and the supporting administration team associated with an offshore investment.
• Conflict of interest – routine due diligence should establish whether any person associated with the proposal, capital raising, management or administration of the fund has an interest in the fund’s success over and above their own role, duty or responsibility. If multiple interests exist, there is no implication of impropriety as long as any potential conflict of interest is disclosed in the fund prospectus and understood by the investor.
• Single asset – an unregulated investment may represent a single project, the success of which is dependent upon certain criteria. This may be deemed high risk.