Chapter 18 Summary
Collective Investment Schemes ≡ Mutual Funds
This is an indirect investment method
Investment Trust (total units are fixed) – close ended
Unit Trust- open ended
Regulation of CISs consist of:
Types of assets that can be held (whether any unquoted assets can be held)
Maximum level of gearing
Tax reliefs (if any)
Investment Trusts (known as investment companies in US)
Public companies that manage shares (governed by company law)
The company invests in other equities and government bonds
Investment trust shares are quoted on stock exchange (work similar to equities)
Parties involved in investment trust are:
1. Board of directors
2. Investment managers: manage day to day investment decisions
3. Shareholders
Share price of investment trust companies is at discount to NAV because of:
1. Management charges: Value of ITC share can be thought of as PV of stream of
dividends that investors receive. But dividends are received only after deducting
management charges. Therefore these charges lower value of share.
2. Marketability: ITC shares would be less marketable than equities, therefore they
would have a lower price
3. Quality of management: If investment managers are poorly rated, investors
would prefer to pay a lower value of ITC share.
4. Market sentiment of investor: ITC shares are not much popular
Unit Trusts
Unit price = Market value of underlying assets / Number of units
Unit price is bought at NAV
Parties involved in investment trust are:
1. Management Company (Unit trust managers)
Sets up the trust
Gets authorization from relevant authorities
Advertises the trust
Administrates and invests the funds
Charge investors
2. Trustees (Insurance company / Large bank)
Ensure managers obey Trust Deed
Check calculation of bid and offer price
Check Running of trust in legal manner
Fees to trustees given by unit trust managers
3. Investors: Buy units from the management company
Differences between Investment Trusts and Unit Trusts
Issue Investment Trust Unit Trust
Law Company Law Trust Law
Time Period Cannot buy after Initial Offering Period Can buy after NFO
Borrowing Can borrow Generally don’t borrow
Expected Returns High (because of higher volatility) Lower (but have more price stability)
Marketability Less than underlying assets (no It is guaranteed by managers
obligation on part of investment (managers are obliged to buy back
managers) units from investors)
Gearing Allowed Not allowed (or limited extent)
Volatility More volatile than underlying equity Same as underlying assets
Quotation of price Uncertainty because of questionable Determined without any doubt
NAV per share
Management charges Low High
Diversification Wide Limited
Price of unit Less than NAV Bought at NAV
Tax rates Different from one another
Indirect versus Direct Investment
1. Control: Little control or influence of investors on investment decisions for CISs
2. Diversification: CISs offer readily diversified portfolios (even with a small capital amount)
3. Expertise and Specialization: CISs specialize in researching for high growth opportunities,
which may not be possible in direct investments
4. Expenses: CISs have higher overall expenses (because of layers of expenses)
5. Marketability: CISs more marketable because:
When assets are themselves unmarketable (e.g. Property investments
or shares in small companies), then it would be easier to hold a CIS
than to have a direct holding
6. Taxation: Depends on:
Country regulations
Investor situation
Underlying assets
7. Expected returns and risk:
No difference in expected returns from CISs and Direct investment
Higher expected returns for ITCs than equity investments (because of
gearing and discount to NAV)
8. Discount to net asset value:
Price of shares in ITCs is often less than NAV (underlying value)
Discount varies depends on whether ITCs are in or out of favor:
o Out of favor (bad run): discount is large
o In favor (good run): discount is small
Increasing returns in ITCs is possible due to :
o Buying when discounts are large
o Selling when discounts are small
9. Volatility:
UTs have same volatility as underlying investments
ITCs are more volatile than value of direct holdings since:
o Discount to NAV can widen or narrow
o Gearing adds to volatility
10. Investment Opportunities
Large institutions can afford to hire its own analysts and fund
managers, therefore they could invest in equities directly
CISs are attractive for smaller companies, overseas Investment and
property investment
Advantages of CISs
Special Expertise available – overseas , property (useful for inexperienced investor)
Diversification easily available [access to other markets]
Guaranteed amount offered (but investor would be charged for the cost of guarantee)
Ease of understanding: Published NAV by company would give information on daily
basis regarding value of fund
Lower dealing expenses than if invested directly (Economies of scale for larger CISs)
Divisibility of holdings is possible
Index tracking could be done by CISs
Assets bought cheaply (for ITCs)
Expected returns on ITCs is more than equities
Quoted prices (which makes valuation easier)
Disadvantages of CISs
Loss of control
Management charges need to be paid
Liquidity issue (Penalty on surrender of scheme)
Extra volatility because of gearing / discount to NAV (only for ITCs)
Both aspects
Marketability
o Advantage if underlying assets are unmarketable
o Disadvantage if there is lock in period
Taxes
o Advantage if tax evasion on income & capital gains
o Disadvantage if withholding tax is levied
