Chapter 11: Other investment classes Flashcards
What is a collective investment scheme?
What is a collective investment scheme?
- CISs provide structure for management of investments on grouped basis
- Provide opportunity for investors to achieve wide spread of investments, and
- Therefore, lower portfolio risk
- Managers of CISs – likely to have management expertise in underlying investment or asset classes (often available only to largest institutional investors)
- Offer opportunity for indirect investment – investment through investment scheme rather than direct purchase of the underlying assets
- Distinction between direct and indirect – whether investor’s assets are segregated from other investors’ money
- CISs will have stated investment objective
- Provide investment expertise and diversification – so used by individuals with smaller sums to invest and wanting to invest in shares for first time
- Regulations covering CISs vary by country and different types of schemes will have different rules
- Regulations cover:
Categories of assets that can be held Whether unquoted asset can be held Max level of gearing Tax relief available Some schemes may only be available for certain classes of institutional investors – pension funds
What are closed-ended and open-ended collective investment schemes?
Closed-ended schemes
- Once the initial tranche of money has been invested, the fund is closed to new money – e.g. investment trust
- Only way to invest in investment trust, after launching, is to buy units from willing seller
- So, total number of shares or units available to investor via marketplace is fixed
Open-ended schemes
- Managers create or cancel units in fund as new money is invested or disinvested - e.g. unit trust
What is an investment trust, what does its share price look like and who are the main parties involved?
What is an investment trust?
Form of closed-ended fund
Public companies whose function is manage shares and other investments
Capital structure exactly like other public companies
Can raise both loan and equity capital
Is a company not a trust – ability to borrow is a major difference between investment trusts companies and unit trusts
Unit trusts has limited power to borrow
Most investment trust shares are quoted on a stock exchange – bought and sold in similar way to other quoted shares
Share price
They are closed-ended so, investor buys from another investor in same way as for any other share
Price of share determined by supply and demand
Guide to what share price expected to be is net asset value per share (NAV) – value of company’s underlying assets divided by number of shares
The main parties involved
Boards directors – responsible for the direction of the company
Investment managers – responsible for day-to-day investment decisions
Shareholders – buy and sell share in the investment trust company in the same way as they would in any other company
What is a unit trust, what does its unit price look like and who are the main parties involved?
What is a unit trust?
Open-ended investment vehicle
Investors can buy units in an underlying pool of assets from the trust manager
If there is demand for units = managers can create more units for sale to investors
They are trusts in the legal sense
Limited powers to borrow against their portfolio
Unit price
Price paid to purchase one unit = unit price
Calculated daily by the unit trust provider
UNIT PRICE = Market value of underlying asset/Number of units
Complications include:
Whether to use bid or offer prices of the underlying assets
How to allow for expenses incurred in buying and selling underlying assets
How to adjust unit price to apply any charges to investors
How to round the answer
The main parties involved
- Management company
Does all the work,
sets up trust
get authorisation from relevant authorities
advertises trust
carries out necessary admin and invests the funds
Aims to make profit from charges levied
Many life offices act as unit trust managers
- Trustees:
Ensure that managers obey trust deed and hold assets in trust for unit holders
Oversee the pricing of units
Fees to trustees are paid by unit trust managers
Often an insurance company or large bank
- Investors:
Buy units in trusts (become unitholders) hoping that they turn out to be good investment
What is an open-ended investment company?
Open-ended investment company (OEIC)
An investment vehicle similar in corporate governance features to an investment trust BUT with open-ended characteristics of unit trust.
Managers create shares when investors invest new money and redeem shares when shareholders request to sell shares
Difference between OEIC and unit trust – there is a single price to which is added the initial charge for purchase (unit trusts have two prices – bid and offer)
What are the differences between closed-ended and open-ended CISs?
Differences between closed-ended and open-ended CISs
- Marketability of shares of CE funds often less than marketability of their underlying assets
Shares in CE fund may be more marketable than underlying assets if assets themselves are unmarketable (property investment/ shares in small company)
- Marketability of units in open-ended fund is guaranteed by managers
- Gearing of CE funds can make share more volatile than underlying equity
Investment trusts are companies and can borrow – by issuing loan capital
BUT, not all investment trusts borrow
- Most OE funds cannot be geared and those that can may only be geared to limited extent
Unit trusts have very limited powers to borrow – in SA, can borrow an amount equal to up to 10% of fund value
- May be possible to buy assets at less than net asset value in CE fund
Price of shares in investment trusts often less than value of underlying securities (the NAV)
Difference between actual share price and the NAV is source of extra volatility in the return on investment trust company investment
Average amount of discount will vary depending on whether investment trusts are in favour or not
Investment trusts at a discount to NAV give investors opportunity to increase returns:
o Buying when discounts large and selling when narrowed
o By buying investment trust at discount to NAV – investor has benefit of those assets (the income) having paid less if assets had been purchased directly
Concept of discount to net asset value does not apply to unit trusts – unit price fixed by direct reference to asset values
- Increased volatility of CE funds means should provide higher expected return
- Shares in CE funds are more volatile than underlying equity because size of discount can change – volatility of units in OE fund = similar to that of underlying assets
- May be uncertainty as to true level of NAV per share of CE fund – especially if investments are unquoted
- CE funds may be able to invest in wider range of assets that unit trust
- May be subject to tax at different rates
CISs vs direct investment, what are the advantages and disadvantages?
CISs vs direct investment
Advantages – greater for smaller investors than for large ones
Useful for obtaining specialist expertise
Easy way of obtaining diversification
Some costs of direct investment management are avoided
Holdings are divisible – part of a holding in any trust can be sold
May be marketability advantages – but may also be less marketable than underlying assets
Used to track return on a specific index (objective of some CISs is to track an index)
Disadvantages
Loss of control – investor has no control over individual investments chosen by managers
Management charges are incurred
May be tax disadvantages such as withholding tax which cannot be reclaimed
What is a derivative and how are they used to control risk?
- Futures and forwards belong to class assets = derivatives
- Derivative – financial instrument whose values is dependent on or derived from value of another underlying asset
- Derivative can be thought of as a contract between two parties to trade an underlying asset at a future date
- Derivatives can be used to control risk:
Reduce risk – hedging
Increase risk in order to enhance returns – speculation
What is a forward contract?
Forwards
Forward contract is contract to buy/sell an asset on an agreed basis in future
Non-standardised
Details of contract will be tailor-made and will be negotiated between the two trading parties
Not exchange-traded but traded over-the-counter
No exchange on which contracts are traded – so degree of credit risk will depend on creditworthiness of counterparty
What is a futures contract?
Futures
Contract to buy or sell an asset on an agreed basis in the future
Standardised contracts that can be traded on a recognised exchange
Standardised
A standardised contract is one where all of the details surrounding the asset to be traded, with expectation the price at which parties agree to trade, are pre-determined
Lots of identical futures are arranged between lots of different parties – due to futures being standardised
The result is futures market is very liquid
Standardisation also results in ease of administration
Exchange-traded
Functions of the exchange include:
- Setting details of standardised contracts
- Authorising who can trade on exchange and bringing buyer and sellers together
- Operating a sub-institution called clearing house
A clearing house is a self-contained institution whose only function is to clear futures trades and settle margin payments
Checks that buy and sell orders match
Then acts as party to every trade
So, simultaneously acts as if it has sold to buyer and bought from seller
Each party has contractual obligation to clearing house
In return, clearing house guarantees each side of original bargain – removing credit risk to each individual involves
What are the main risk for a futures contract and how is that managed?
Credit risk and margin
Credit risk is the risk than one of the parties to the trade defaults on agreement
The clearing house intervenes to guarantee each side of original bargain
Each party makes small good faith deposit with the clearing house – initial margin
Variation margin – depends on movement in price of underlying – payable during term of contract
Thus, credit risk to each individual party under futures contract is minimal
What is an option ?
Options
An option is right, but not obligation, to buy or sell an asset
Options are contracts agreed between investors to trade in an underlying security at given date at set price
Difference between options and futures is that holder of option is not obliged to trade
Option writer sells options
The writer is obliged to trade if holder of option wants to
Price paid to writer for an option is the option premium/option price – for giving holder the right to exercise (or not) option
This represents difference between futures and options – costs nothing to enter into futures contract (exception of margin payment)
Call option is right, but not obligation, to BUY a specified asset for a specified price on a set date or dates in the future
Put option is right, but not obligation, to SELL a specified asset for a specified price on a set date or dates in the future
Exchange-trades or OTC
Traded options are option contracts with standardised features actively traded on organised exchanges
Timing
European call – option that can only be exercised at expiry
American option – option than can be exercised on any date before expiry
What is the strike price and option premium for an option?
Exercise (strike) price
Price at which underlying security can be sold to (for a put) or purchased from (for a call) the writer or issuer of an option
Not the same thing as the option premium
Option premium or option price is price that option holder pays to option writer for right to exercise (or not) option
Exercise or strike price is the price at which they agree to trade the underlying asset
What is a warrant?
Warrants
Option issued by a company over its own shares
Holder has right to purchase shares at a specified price at specified times in the future from the company
May be issued by any company
Most warrants are equity warrants – give right to subscribe for ordinary shares of issuer however bond warrants also exist
Exercise price or strike price – may be very different from current market price
Holder of equity warrant does not have rights associated with ordinary share ownership
No right to dividends or to voting rights
BUT, warrant holder protected from changes in ordinary share capital such as rights issues and scrip issues
Often issued as add-ons to other benefits
What are derivatives used for?
Uses of derivatives
- Futures contracts can be used to set price in advance
- Financial institution can trade in futures but needs to be sure of being able to sell long positions before delivery
- Investors trading in futures rarely want to actually receive delivery of underlying asset
EXAMPLE:
Investor who wants to speculate on price on sugar over next 3 months
Investor buys sugar future now for deliver in 3 months when price of X paid
Investor has agreed to receive a specified quantity of sugar in 3 months for price X
3 months later just before delivery, investor sells an identical sugar future (standardised) at then price Y
So, investor has agreed to deliver same specified quantity of sugar on same date for price Y
By taking out an equal but opposite contract – investor has closed out their position
Neither receive or deliver any sugar – make profit/loss of Y-X (speculated on price movement of sugar)
- Options give financial institutions opportunity to alter structure of their portfolio without needing to trade in underlying assets
- BECAUSE, option gives buyer/seller economic exposure to underlying asset without having to actually buy or sell that asset (or index)
Derivative transactions not cheap – cost of derivative and any collateral counterparty may require may need to be included in calculations
Is investment in overseas markets justified?
Overall objective of investment strategy is to strike the correct balance of risk and reward
Investment in overseas assets is justified as it can help reduce level of risk – by diversification or by matching the liabilities and/or increase expected returns
BUT there are additional investment and management problems associated with overseas investment
What are the main reasons for overseas investment?
Reasons for overseas investment
To match liabilities in foreign currency
To increase the expected returns
To reduce risk by increasing the level of diversification
- Matching liabilities in the foreign currency
Investor with liabilities expressed in overseas currency will be exposed to risk of adverse currency movements unless liabilities are matched with investments in appropriate currency
Investors with only domestic liabilities need to consider effect that overseas investments have on expected risk/return performance of whole portfolio
- Increasing expected returns
Returns on overseas investment can be higher than domestic returns:
- Either because, they are fair compensation for higher risk
- Or if inefficiencies in global market allow fund managers to find individual countries whose markets are undervalues
Over long term, the actual returns have been similar – this suggests that matching and diversification may be more important for overseas investment than increasing returns
Argument of increased returns is more likely to apply in case of emerging markets
- Diversification
Investing in different countries or economies with low degree of correlation helps diversify risk – a fund that invests in more than one country is less vulnerable to downturn in economic fortune of any single country
Also achieved by investing in industries that are not available for investment in home market
What are the main problems of overseas investment?
Problems of overseas investment
- A different market performance to home market and associated mismatching risk
- Currency fluctuation risk
Significant losses can be made very quickly if currencies purchased fall in value
Similarly, losses in domestic currency terms made if domestic currency rises in value
- Increased expertise needed to assess the market
There are extra variables to analyse e.g. overseas economies and currencies
More work is required to overcome problems with poor information
- Additional administration functions: custodian, dividend tracking and collection
May be necessary to appoint an overseas custodian – safeguard the assets, including holding the stock certificate and take responsibility for activities such as handling rights issues and receiving dividends
- Different tax treatment
Often results in higher overall tax charges for investor
Withholding tax is tax deducted at source from dividends or other income paid to non-resident of country
Could then be liable for further tax in own country
Adverse effect of this reduced when there is a double taxation agreement between domestic tax authorities and overseas country – domestic tax reduced/eliminated as overseas tax already paid
- Different accounting practices
- Less info may be available then in the home market
- Language problems
- Time delays – problem in the past but advances in communications have this less of a problem
- Risk of adverse political developments
- Liquidity – less developed markets not very liquid
- Restrictions on ownership of certain shares
How do you invest overseas indirectly?
Ways of achieving indirect overseas exposure
- Investment in multinational companies based in home market
The advantages are:
Easy to deal in familiar home market
Companies will have expertise and conduct their business in most profitable areas overseas
Disadvantages are:
Company’s earnings will be diluted by domestic earnings
Investor will have no choice in where company transacts its business
- Investment in CISs specialising in overseas investment
- Investment in derivatives based on overseas markets
- In each case, primary advantages over direct investment is that at least some of practical problems associated with direct overseas investment are avoided
- Indirect investment is suitable for small funds
Overseas investment via domestic companies with overseas exposure
Many of the largest domestic companies have significant overseas exposure
Among the 100 largest companies listed on the JSE, more than 2/3 of their earnings are earned internationally
What is an emerging market and what factors should you consider before investing?
Investing in emerging markets
Stock markets in countries with developing economies are known are emerging markets
Offer high expected returns due to rapid industrialisation
Very risky markets
Factors to consider before investing
Current market valuation
Possibility of high economic growth rate
Currency stability and strength
Level of marketability
Degree of political stability
Market regulation
Restrictions on foreign investment
Range of companies available
Communication problems
Availability and quality of info
What are the attractions of investment in emerging markets?
With prospects of high growth rates and possible market inefficiencies, opportunities exist for profitable investment – but with corresponding higher level of risk
- Current market valuation
Inefficient markets: buy cheaply
Pricing of currencies and stock markets of developing economies is less efficient than that of world’s largest markets
May be significant anomalies from time to time – giving investors opportunity to buy cheaply
Perceived to be risky: buy cheaply
Investment in emerging markets is often perceived to be risky
Should lead to lower demand and lower prices
- Rapid economic growth
Some of developing economies will grow at rates that are not attainable by large developed economies
Equity investors in fast-growing economies share in increase in wealth
- Better diversification
Economies and markets of many smaller countries are less interdependent than those of major economic powers
Therefore, investing in emerging markets may provide good diversification
Emerging markets will provide opportunities to invest in range of industries available domestically
What are the drawbacks of investment in emerging markets?
Drawbacks of investment in emerging markets
- Volatility
Markets of small economies can be significantly affected by large flows of money leading to stock markets and currencies of developing economies being very volatile
Best performing and worst performing of world’s stock markets in given period will often be from emerging markets
- Marketability
May be less marketable and this will be concern to many investors
- Political stability
Governments of some emerging markets lack stability – can increase volatility of investment returns
- Regulation of stock market
Because emerging markets are newer and generally smaller – there are more question marks against efficiency of processes for regulating markets
Where markets poorly regulated, foreign investors may lose out through:
- Insider trading by local investors
- Fraud
5. Restrictions on foreign investment
Some emerging markets have tight controls on ownership by foreigners
Developing nations tend to be less stable politically
- Communication problems and availability and quality of information
More difficult for investor to get enough good quality information to substantiate view that investment is worthwhile
Specialist local expertise is thus important