Chapter 11: Other investment classes

Question 1

What is a collective investment scheme?

Answer 1

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

Question 2

What are closed-ended and open-ended collective investment schemes?

Answer 2

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

Question 3

What is an investment trust, what does its share price look like and who are the main parties involved?

Answer 3

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

Question 4

What is a unit trust, what does its unit price look like and who are the main parties involved?

Answer 4

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

1. 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

2. 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

3. Investors:

 Buy units in trusts (become unitholders) hoping that they turn out to be good investment

Question 5

What is an open-ended investment company?

Answer 5

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)

Question 6

What are the differences between closed-ended and open-ended CISs?

Answer 6

Differences between closed-ended and open-ended CISs

1. 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)

2. Marketability of units in open-ended fund is guaranteed by managers
3. 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

4. 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

5. 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

6. Increased volatility of CE funds means should provide higher expected return
7. 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
8. May be uncertainty as to true level of NAV per share of CE fund – especially if investments are unquoted
9. CE funds may be able to invest in wider range of assets that unit trust
10. May be subject to tax at different rates

Question 7

CISs vs direct investment, what are the advantages and disadvantages?

Answer 7

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

Question 8

What is a derivative and how are they used to control risk?

Answer 8

• 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

Question 9

What is a forward contract?

Answer 9

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

Question 10

What is a futures contract?

Answer 10

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

Question 11

What are the main risk for a futures contract and how is that managed?

Answer 11

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

Question 12

What is an option ?

Answer 12

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

Question 13

What is the strike price and option premium for an option?

Answer 13

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

Question 14

What is a warrant?

Answer 14

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

Question 15

What are derivatives used for?

Answer 15

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

Question 16

Is investment in overseas markets justified?

Answer 16

 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

Question 17

What are the main reasons for overseas investment?

Answer 17

Reasons for overseas investment

 To match liabilities in foreign currency

 To increase the expected returns

 To reduce risk by increasing the level of diversification

1. 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

2. 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

3. 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

Question 18

What are the main problems of overseas investment?

Answer 18

Problems of overseas investment

1. A different market performance to home market and associated mismatching risk
2. 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

3. 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

4. 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

5. 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

6. Different accounting practices
7. Less info may be available then in the home market
8. Language problems
9. Time delays – problem in the past but advances in communications have this less of a problem
10. Risk of adverse political developments
11. Liquidity – less developed markets not very liquid
12. Restrictions on ownership of certain shares

Question 19

How do you invest overseas indirectly?

Answer 19

Ways of achieving indirect overseas exposure

1. 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

2. Investment in CISs specialising in overseas investment
3. 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

Question 20

What is an emerging market and what factors should you consider before investing?

Answer 20

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

Question 21

What are the attractions of investment in emerging markets?

Answer 21

 With prospects of high growth rates and possible market inefficiencies, opportunities exist for profitable investment – but with corresponding higher level of risk

1. 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

2. 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

3. 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

Question 22

What are the drawbacks of investment in emerging markets?

Answer 22

Drawbacks of investment in emerging markets

1. 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

2. Marketability

 May be less marketable and this will be concern to many investors

3. Political stability

 Governments of some emerging markets lack stability – can increase volatility of investment returns

4. 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

6. 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