Collective investments training guide part 1

Introducing Collective Investments.

Since investors began to invest in shares century ago, investors have been perplexed over the complexity of individual share investments. (For more history on the Johannesburg Securities Exchange, visit www.jse.co.za). Indeed, successfully investing in individual shares requires extensive research and considerable expertise.

If there were ever such things as perfect investments, then FUND investments, such as unit trusts. Unit trusts or Collective investment schemes and open-ended investment companies, would be them. The way a unit trust works is as if several of you and your friends clubbed together (collective), threw a bunch of money into a pot (investment), hired a professional to manage it for you (scheme).  This is why we call them Collective investment schemes or CIS. Unit trusts are called mutual funds in the United States.

How do they work?

The fund will buy more shares and other investments to spread the risk of one share doing badly. The theory is that not all shares and investments will do badly at the same time. We call this diversification, and it is where we spread the risk of bad investment performance. Of course the result of diversification is you also lose out on the positive return because as one asset class or share does well the other may bring it down with a bad performance. That being said diversification is still better than putting all your eggs in one basket of a single share. Any CIS is a collection of individual shares divided up into units of equal value. The price of each unit, known as the net asset value (NAV), is calculated by taking the overall value of the portfolio (which includes income that has not been reinvested or distributed), deducting expenses (taxes and investment costs), and dividing that amount by the total number of units in the fund.

You can then add money into that pot, buying more units and share in the growth or contraction of that money. The skill of the professional should limit the losses, which is why you pay them administration and management fees.

There are two main sources of income for unit trust funds: interest from interest-bearing investments, such as money-market instruments and bonds, and dividends from shares which will be taxed before you receive it, unless the dividends are from overseas investments. Interest is taxed as income. You have to declare this interest on your tax return. You may also receive Capital gains tax on the capital gain when you disinvest, subject to exclusions. This is also declarable on your tax return.

CIS structures can provide all the benefits the stock market has to offer, e.g. high returns, while limiting the risk you face as an investor by diversifying (looking at various) stock and type of asset holdings. Plus, because of all the competition among investment companies over the last few years, they’ve become downright cheap to administer. The down side is there are so many CIS to choose from but this series will help you with that

The upside is you get exposed to very expensive shares at a cost you can afford. If, for example, you invest in ‘blue chip’ shares, on your own, you’ll effectively try to own shares in such names as Anglo American, Liberty Life, Old Mutual, Sanlam, etc., but you would own the individual share and be exposed to the risk that one type of share poses.

Safety features of the CIS funds

All funds marketed to South African investors must be approved by the Financial Sector conduct Authority (FSCA) and they are subject to ongoing monitoring by the FSCA.

Collective investment Schemes or CIS have strict consumer protection under the Collective Investment Schemes Control Act of 2002. 

To dampen stock market volatility, and ensure you can withdraw from the fund at any time, CIS funds are required to keep a minimum in cash to meet redemption needs. This is in line with International Standards. Additional capital  is required for certain risk positions taken.  Funds are allowed to borrow up to 10% of their portfolio to pay out investors. If this is not sufficient the fund manager would have to sell shares to generate the cash to meet his redemption obligations.

The fees and costs…

Fees and charges are all expenses that get taken out before your money starts working for you. This from a man who built one of the largest fund companies in the world!

We’ve heard salesmen say: “What does it matter if charges are 1% or 2%, when you’re rolling in so much gravy anyway?” That is true but returns on all investments are no longer in the double digits.  The 2020  equity market is expected to trend lower still as growth slows down until 2021.  So a percent or two a year, compounded over five or ten years, could really eat into your returns and could even turn your return negative for short periods.

The total investment charge is the sum of the total expense ratio (TER) and the transaction cost (TC). The TER is the unit trust’s total expenses calculated over the past three years expressed as an annualised percentage of the average value of the unit trust. Where funds hold a significant amount of assets and don’t trade that often, transaction costs will be low (0.1% or less). The TER includes all those expenses related to managing the fund (the base fee, performance fee and VAT) The Transaction Cost (TC) is the cost incurred by the portfolio in the buying and selling of underlying assets. This is expressed as a percentage of the daily NAV of the CIS and calculated over a period of 1 year.

An additional performance fee is sometimes charged and is the fee active managers’ charge if they generate a return that is higher than the benchmark used for the fund and should not be charged if the base fee is high or if the fund has failed to perform. Index-type unit trusts or exchange-traded funds (ETFs) should have charges that are below 1% per annum.

Financial advisors may also charge advice fees for selling you the fund. Many financial advisors work on a commission basis which entails the generation of income or part thereof from selling specific financial products. There’s nothing evil about this. If a financial advisor does the research, completes the paperwork, visits you, evaluates your financial situation, and proposes an investment commensurate with your risk profile and situation, they should be compensated. They may also charge on-going management fees. Some advisors charge an upfront fee for doing a financial needs analysis. You should negotiate fees with your advisor and ensure they are working sufficiently for what they charge.  It is unlikely a good financial advisor will add more than 3% to your return in a year. Certain companies deal with you direct and others insist on a financial advisor.

If you do the research,  fill in the paperwork and determine the best fund yourself (as you’ll shortly learn how to do), you shouldn’t have to pay the full advisor fee or any on-going fees.

When investing in a CIS product, your money’s invested in a single product, the fund or in multiple funds. Multiple funds includes a number of underlying financial instruments managed by different fund managers. All fund managers need to be paid, so certain funds will have higher administration charges than others.

You buy units at the ruling price of the day which may be determined by either a historic pricing or a future pricing method. Historic pricing is when prices are set at the end of the day and all transactions for the next day are at this price. Future pricing occurs when the value of the fund is calculated at the days close and that value applies to that days’ transactions. The price for the units is published daily in the newspapers and online and that will be the selling or buying price you pay without the transaction fees.

You can chose between local or offshore equities, bonds, property and money unit trusts as well as some that are invested in multiple asset types even  hedge funds are offered under this banner.  The funds may be passive funds, tracking an index or actively managed seeking to outperform the chosen index. In essence you can buy a wide variety of wealth generating products in speciality types or as general investments across a range of assets. Some are more risky than others.

In our next article we will look at the different funds you can buy.