There is strength is unity, without doubt. It is said that a solitary tree can be broken by the wind. A forest, however, is able to withstand strong winds by sharing the load of the wind strength among all the trees. Collective investment schemes operate on this basis. Both the good things and the bad things in investment are shared. Whether they are profits, losses, fees or expenses of a scheme, they are equitably shared amongst all investors of the scheme.
A collective investment scheme (CIS) is a pool of funds for investment that are managed by a professional fund manager on behalf of the investors of the fund. In Ghana, a CIS is either a mutual fund or a unit trust. Mutual funds could be either open-ended or closed ended. In other jurisdictions, CISs include exchange-traded funds (ETFs). The major distinction between a CIS and an ETF is that the former can be traded only at the end of the working day, typically Monday to Friday, whereas an ETF can be traded throughout the trading period of an exchange on which it is listed. The funds are invested in a portfolio of allowed securities and other investment assets. Beneficiary interests in the schemes are divided into shares (for mutual funds) or units (for unit trusts).
The benefits of CISs are significant. Mutual funds and unit trusts provide a very affordable and less risky path to investing. CISs employ economies of scale to get good investment deals for their investors. A prospective investor with a small amount of money for investment can still partake of a large fund and have access to professional fund management services because there are very low barriers to entry. Quite a number of funds, at their launch, set as low as GHS 0.10 as the share price, with a minimum of GHS 5.00 required to own shares of the fund or trust. Expenses per investor can be considerably low, compared to solitary investment accounts (single or a couple of investors). Additionally, an important feature is they offer diversification across several asset classes of securities, or across several characteristics of the same type of security (eg. bonds with different durations, shares of companies with different categories of capitalization).
In Ghana, CISs consist of mutual funds and unit trusts. The difference between these two lies in corporate structure. While unit trusts are not separately incorporated entities, mutual funds are incorporated, with their own corporate governance structures. Every mutual fund therefore has its own board of directors, auditors and bank (custodian), for instance. A unit trust, however, does not have a board of directors but a board of trustees who oversee investment decision-making and set strategy. A unit trust is established under a trust deed and the investors are the beneficiaries. All unit trusts are open-ended, as per the Securities Industry (Amendment) Law, Act 590.
A mutual fund can be open-ended or close-ended. The commoner are the open-ended funds. All mutual funds in Ghana outside the stock exchange are open-ended. Mutual funds do not trade on the exchange if they are open-ended. The fund managers make available shares of the funds for purchase or absorb any shares that are sold, to provide liquidity. They can issue an unlimited number of shares directly for subscribers (investors) to purchase. New subscribers and subscriptions can therefore be added to the fund with little money and at low expenses. This helps to grow the fund’s assets under management. These characteristics have made them very popular among both the investing public and fund managers.
Close-ended Mutual Funds
Close-ended mutual funds raise a fixed amount of capital through an initial public offering (IPO). The Securities Industry Law requires all close-ended mutual funds to be listed on a recognized exchange for trading. After the IPO, the fund does not issue additional shares and the fund itself does not redeem shares of subscribers who intend to exit the investment. The shares of the fund can only be traded on a secondary market (exchange) by investors. This means that a prospective investor can only buy when someone is selling his/her shares, and vice versa. By inference, this makes investing in close-ended mutual funds a bit riskier than doing same in an open-ended mutual fund.
Many close-ended funds pay dividends periodically- monthly or quarterly. They can therefore be an attractive source of regular income for income-seeking investors. Some funds slowly self-liquidate over a period of 20 to 30 years. Income distributed as dividends paid out could include a small portion of the principal invested, in that case.
Where the objective of the fund’s strategy is to increase the fund’s return or the amount of income it pays out, it may use leverage, that is, borrowing against the fund to increase securities invested in. This would make the share price highly volatile- share prices would go down when interest rates rise. Close-ended funds may therefore give consistent income but their principal value may swing to extreme highs and lows.
Open-ended Mutual Funds
Open-ended mutual funds are quite different, though they also aggregate investor funds to invest in securities per their strategy. The number of shares that can be issued by an open-ended mutual fund company is without limit. Whenever an investor buys shares of the fund, the shares are newly issued. Whenever an investor liquidates their position, the shares they held are bought back by the company. Liquidity is ensured by the fund company. Open-ended mutual funds are, thus, typically known to be ‘easy to enter, easy to exit’. To be able to do so, the fund company usually holds a significant cash balance, which could have otherwise been invested to add to overall returns. The fund return potential is, thus, lowered.
Unit Trust Funds
Whereas mutual funds are incorporated entities, unit trusts are unincorporated. Under the Securities Industry (Amendment) law, Act 590, unit trusts are open-ended funds. This means their managers stand ready to issue new units or redeem outstanding units continuously. The investors are referred to as unitholders. The beneficiary interests in the fund are divided into and represented by units. A unit trust does not have a board of directors; instead, it has a trustee or a board of trustees, and a trust deed to govern the funds. The trustee is the legal owner of the assets of the fund. They hold them in trust for the investors of the fund. The trustee oversees the management of the fund manager in respect of the unit trust to ensure compliance of the trust deed. A trustee can also be a unitholder but not the sole unitholder. The trust deed is a contract document between the trustee and the fund manager which outlines the purpose of the trust, the rights and obligations of the trustee(s) and unit holders, powers of the trustee, and identifies various parties such as initial unit holders & Trustee(s).
All CISs can also be categorized according to what they are set up to do and what they invest in. For instance, there are balanced funds, money market funds, equity funds, fixed income funds, income funds and index funds. These funds may be mutual funds or unit trusts.
Money Market Funds
A money market fund, as the name implies, invests in short-term (up to one year) fixed income securities. These are usually government issues like treasury bills and quasi-government issues like cocoa bills, certificates of deposits of financial institutions like banks and savings and loans companies, commercial papers of corporate bodies and bankers’ acceptances. They are generally safe but with low potential return, compared to other types of funds. Yet still, they may offer liquidity and capital preservation, at the minimum. Investment returns are likely to be always slightly above the rate of inflation so the real return is positive. Investors who have short investment horizons and have capital preservation as a priority over high return may find these funds suitable for their needs.
Fixed Income Funds
These funds invest in securities that offer a fixed rate of return. Securities such as government bonds, corporate bonds and, at times, preference shares that pay out steady dividends and income all qualify for investment by fixed income funds. The objective is to provide income to subscribers on a regular basis from the interest payments of securities the funds are invested in. Though these funds may not necessarily be dividend-paying, subscribers may take advantage of the high liquidity to make withdrawals as and when the need arises.
Income funds are very much like fixed income funds. The difference is that they are not limited to only fixed income securities. They may invest in equities that have high dividend yields or have a history of strong dividend payout ratios. This would include preference shares and common shares. Again, the objective is to provide income to subscribers. Probably all funds may not pay out dividends and are not required to do so. In other jurisdictions, however, all funds are required by law to distribute their accumulated dividends at least once a year. This may be done through the issue of more shares to subscribers or through cash payments.
These funds invest in shares. The funds are susceptible to the volatilities stocks usually experience so are riskier than funds that invest in fixed income securities. The flipside to that is these funds have a higher returns potential to reward investors who purposely take on the additional risk the funds pose. Equity funds may specialize by restricting investments in particular categories of equities. For instance, a fund may be a growth fund- invests in equities with high growth potential, an income fund- invests in equities that regularly pay high dividends, large-cap/mid-cap/small-cap fund- invests in shares of large capitalization/mid-sized/small companies, value funds- invests in shares of companies that appear to trade at a lower price relative to its fundamentals, etc.
These funds invest in a defined mix of shares and fixed income securities. The mix is spelt out in their asset allocation strategy. Some balanced funds may be aggressive (with a larger share of equities) or conservative (with a smaller share of equities) or have equal weighting of equities and fixed income securities. Some balanced funds may initially invest in a conservative mix, then plough interest earnings from their fixed income securities into equities. That way, a significant portion of initial principal investments are insulated from large erosion of value from a bearish stock market.
These are funds that aim to replicate the performance of a specific index. They therefore exhibit market risk only. In Ghana, for example, we could have a fund that tracks the GSE indices: Composite and Financial Stocks Indices. Index funds are passively managed and usually have lower fund manager fees, compared to other funds. Just as there are thousands of indices globally, there are also many index funds that track them. Despite the diversification across the specific market they operate in, these funds may have wide swings of returns, just as the market indices they track. Investors usually invest in different indices to further diversify across different markets.
These funds invest specifically in real estate, commodities or in selective areas like socially responsible ventures. There are three broad types:
- Thematic- Invests in groups of stocks with certain themes, eg. renewable energy stocks, ethical stocks,
- Sectoral- Invests in particular sectors of the economy, eg. energy sector stocks, real estate/construction sector stocks
- Regional- Invests in specific geographical accounts offshore, eg. sub-Saharan stocks, EMEA stocks, Latin American stocks
These are funds which invest, in turn, in other funds. For this reason, their asset allocations are wide and well diversified and their risk profiles are lower than other types of CIS funds. They are also referred to as multi-manager investment funds. The risk inherent in such funds is minimal but they tend to have higher expense ratios. Some fund of funds may invest in funds managed by the same company that manages them and are categorized as ‘fettered’. Others invest in funds managed by companies other than the company that manages them. Those are referred to as ‘unfettered’.
It is important for investors in any CIS to be actively involved in how the funds they are invested in perform or are managed. In our next piece, we shall look at what subscribers of such funds should do to keep an eye on how their investments fare in these funds.
About the Writer
Kwadwo is a Senior Investment Analyst at OctaneDC Limited and heads OctaneDC Research. Prior to joining OctaneDC team, Kwadwo was a Fund Manager at Dalex Capital and has over a decade experience in fund management and administration, portfolio management, management consulting, operations management and process improvement. You may contact him at [email protected] or +233244563530