Chapter Four

Collective Investments
1. Investment Funds 99

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2. Other Investment Vehicles 115

This syllabus area will provide approximately 8 of the 100 examination questions
 Collective Investments

1. Investment Funds
Investors have a range of investments to choose from, and can buy them directly or indirectly.

Direct investment is where an individual personally buys shares in a company, such as buying shares in
Apple, the IT company. Indirect investment is where an individual buys a stake, or a unit, in a collective
investment vehicle, like a mutual fund that invests in the shares of a range of different types of
companies, including Apple.

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Achieving an adequate spread of investments through holding direct investments can require a
significant amount of money and, as a result, many investors find indirect investment very attractive.

There is a range of funds available that pool the resources of a large number of investors to provide
access to a range of investments that would not be possible to invest in directly – either because of the
underlying investments or monetary value needed to have a directly invested portfolio. These pooled
funds are known as collective investment schemes (CISs), funds or collective investment vehicles, run by
asset management firms, as opposed to private client investment managers running individual private
client portfolios. The term ‘collective investment scheme’ is an internationally recognised one, but CISs
are also known by other names in different countries.

• In the US, the term mutual fund is used.

• In continental Europe, the open-ended version is known as a Société d’Investissement à Capital
Variable (SICAV), but there is a variety of other structures in use, some of them being neither trust nor
corporate, but purely based on contractual arrangements.
• In the UK they take the legal form of unit trusts or open-ended investment companies (OEICs).
Some unregulated schemes are also established as limited partnerships.
• In addition, under the term investment funds, there is another type of unitised vehicle called an
investment trust or an investment company. However, this is set up as a company, listed on a stock
exchange and traded in the same way as other shares. They are very similar to unit trusts in terms
of being invested in a range of different companies but are closed-ended rather than open-ended.

An investor is likely to come across a range of different types of investment fund, as many are now
established in one country and then marketed internationally. Funds that are established in Europe and
marketed internationally are often labelled as UCITS funds, meaning that they comply with EU rules;
the UCITS branding is seen as a measure of quality that also makes them acceptable for sale in many
countries in the Middle East and Asia.

The main centre for establishing funds that are to be marketed internationally is Luxembourg, where
investment funds are often structured as a SICAV. Other popular centres for the establishment of
investment funds that are marketed globally include the UK, Ireland and Jersey, where the legal structure
is likely to be either an open-ended investment company or a unit trust.

The international nature of the investment funds business can be seen by looking, for example, at the
funds authorised for sale in Bahrain, which probably has the widest range of funds available in the Gulf
region, with over 2,700 funds registered for sale. Some of these are domiciled in Bahrain, but many are
funds from international fund management houses such as BlackRock, Fidelity and J.P. Morgan; they
include SICAVs (see section 1.3.3), ICVCs and unit trusts from a range of internationally recognised fund
management companies.

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An open-ended fund, like a mutual or UCITS fund, is one that can create new units or shares to meet
investor demand and cancel shares or units when investors sell and so their capital base can expand or
contract, hence the term open-ended. Unit trusts and OEICs are types of open-ended funds.

1.1 Benefits of Collective Investment

Learning Objective
4.1.1 Understand the benefits of collective investment

Collective investment schemes (CISs) pool the resources of a large number of investors with the aim of
pursuing a common investment objective. This pooling of funds brings a number of benefits, including:

• economies of scale
• diversification
• access to professional investment management
• access to geographical markets, asset classes or investment strategies which might otherwise
be inaccessible to the individual investor
• in many cases, the benefit of regulatory oversight
• in some cases, tax deferral
• liquidity – the ability to join and leave with relative ease.

The value of shares and most other investments can fall as well as rise. Some might fall spectacularly,
such as when Enron collapsed or when banks had to be nationalised during the recent financial crisis.
However, where an investor holds a diversified pool of investments in a portfolio, the risk of a single
constituent having an equally weighted effect on the performance of the fund overall is mitigated
because of the diversification of other holdings in the fund. This is to be compared to an investor holding
their collection of investments. Usually in a directly invested portfolio an investor could have an average
of between 3–5% weightings in the investments. This compares to a fund, where an average holding is a
lot smaller at say 1.5%. Consequently, if both had held Enron, it would be the directly invested portfolio
that would have suffered the most. In other words, risk is lessened when the investor holds a diversified
portfolio of investments. Of course, the chance of a startling outperformance is also diversified away.

Diversification has its limits in reducing risk, however. Correlation between asset classes also tends
to get higher in volatile times – so in major downturns, more asset classes move together; the global
markets which fell ‘across the board’ in 2008 are a good example of this. To monitor this over time it is
important to look at the drawdown ratio of a particular fund to see how well a fund manager performs
in times of falling markets.

An investor needs a substantial amount of money before they can create a diversified portfolio of
investments directly. If an investor has only $3,000 to invest and wants to buy the shares of 30 different
companies, each investment would be $100. This would result in a large percentage of the $3,000 being
spent on commission, since there will be minimum commission rates of, say, $10 on each purchase.
Alternatively, an investment of $3,000 might go into a fund with, say, 80 different investments, but,
because the investment is being pooled with lots of other investors, the commission as a proportion of
the fund is very small.

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 Collective Investments

An investment fund might also be invested in shares from many different sectors; this achieves
diversification from an industry perspective (thereby reducing the risk of investing in a number of
shares whose performance is closely correlated). Alternatively, it may invest in a variety of bonds. Some
collective investments put limited amounts of investment into bank deposits and even other investment
funds. Today a lot more funds are offering investors the opportunity to invest in multi-asset class funds.

The other main rationale for investing collectively is to access the investing skills of a fund manager.
Fund managers follow their chosen markets closely and will carefully consider what to buy and whether
to keep or sell their chosen investments. For those investors who do not have the skill, time or inclination
to do this themselves, investment funds represent a sensible solution. Fund managers’ skill, however,

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varies, and advisers need to be able to assess how well or otherwise a fund manager has performed.
Along with a fund manager’s skill, especially with regard to retail investors, funds allow investors to
access securities and strategies that would not normally be available to retail investors directly, such as
absolute return style investments, hedge funds and private equity investments.

Fund managers do not manage portfolios for nothing. They might charge investors fees to become
involved in their fund (entry fees or initial charges), fees to leave the funds (exit charges) and annual
management fees. These fees are needed to cover the fund managers’ salaries, technology, research,
their dealing, settlement and risk management systems, and to provide a profit. In some countries, the
charges also cover the cost of commission paid to advisers for recommending the fund.

Usually, mutual fund shares can be sold without too much effect on their value. If there could be
an adverse effect on the unit price, then fund managers can delay the sales. In extreme times, this
is referred to as ‘gated’. This means the fund is closed to any new sales/redemptions, until the fund
manager can raise sufficient money to pay out to those wishing to sell their units and not disadvantage
the remaining holders. It is important to watch out for any fees associated with selling, including back-
end load (a percentage of the value being sold). Unlike stocks and exchange-traded funds (ETFs), which
trade any time during market hours, mutual funds transact only once per day after the fund’s net asset
value (NAV) is calculated, which can be at different times of the day.

1.2 Undertakings for Collective Investment in Transferable

Securities Directive (UCITS)

Learning Objective
4.1.2 Know the purpose and principal features of the Undertakings for Collective Investment in
Transferable Securities Directive (UCITS) in European markets

UCITS refers to a series of European Union (EU) regulations that were originally designed to facilitate the
promotion of funds to retail investors across the European Economic Area (EEA). A UCITS fund, therefore,
complies with the requirements of these directives, no matter in which EU country it is established.

The directives have been issued with the intention of creating a framework for cross-border sales of
investment funds throughout the EU. They allow an investment fund to be sold throughout the EU,
subject to regulation by its home country regulator.

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The original directive was issued in 1985 and established a set of EU-wide rules governing collective
investment schemes. Funds set up in accordance with these rules could then be sold across the EU,
subject to local tax and marketing laws.

Since then, further directives have been issued which have broadened the range of assets that a fund
can invest in, in particular allowing managers to use derivatives more freely. A fourth was issued in
2011 and one of the changes that it introduced is a common format across Europe for a Key Investor
Information Document (KIID) that has to be provided to retail investors who are considering investing
in funds.

While UCITS regulations are not directly applicable outside the EU, other jurisdictions, such as
Switzerland and Hong Kong, recognise UCITS when funds are applying for registration to sell into those
countries.

1.3 Investment Funds

Learning Objective
4.1.3 Know the characteristics of types of investment products: authorised funds and unauthorised
funds; open-ended funds; closed-ended investment companies

In most markets, some collective investment schemes are authorised, while others are unauthorised or
unregulated funds. The way this usually operates is that, in order to sell a fund to investors, the fund
group has to seek authorisation from that country’s regulator. The approach adopted by the regulator
will then depend on whether the fund is to be distributed to retail investors (see chapter 5, section 2.1)
or only to professional investors.

Where a fund is to be sold to retail investors, the regulator will authorise only those schemes that are
sufficiently diversified and which invest in a range of permitted assets. Collective investment schemes
that have been authorised in this way can be freely marketed to retail investors.

Collective investment schemes that have not been authorised by the regulator cannot be marketed to
the general public. These unauthorised vehicles are perfectly legal, but their marketing must be carried
out subject to certain rules and, in some cases, only to certain types of investor, such as institutional
investors.

1.3.1 Open-Ended Funds

An open-ended fund is an investment fund that can issue and redeem shares at any time. Each investor
has a pro rata share of the underlying portfolio and so will share in any growth of the fund. The value of
each share is in proportion to the total value of the underlying investment portfolio, known as the net
asset value (NAV).

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To explain this more fully: if investors wish to invest in an open-ended fund, they approach the fund
directly and provide the money they wish to invest. The fund can create new shares in response to this
demand, issuing new shares or units to the investor at a price based on the value of the underlying
portfolio. If investors decide to sell, they again approach the fund, which will redeem the shares and pay
the investor the value of his or her shares, again based on the value of the underlying portfolio.

An open-ended fund can therefore expand and contract in size based on investor demand, which is why
it is referred to as open-ended.

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1.3.2 US Open-Ended Funds
The most well-known type of US investment fund is a mutual fund. Legally it is known as an ‘open-
ended company’ under federal securities laws. A mutual fund is one of three main types of investment
fund in the US; the others are considered in the section on closed-ended funds (see section 1.3.4).

Most mutual funds fall into one of three main categories:

• Money market funds.

• Bond funds, which are also called ‘fixed-income’ funds.
• Stock funds, which are also called ‘equity’ funds.

Some of their key distinguishing characteristics are shown below.

Main Characteristics
• Being open-ended, the mutual fund can create and sell new shares to accommodate new investors.
• Investors buy mutual fund shares directly from the fund itself, rather than from other investors on a
secondary market such as the NYSE or NASDAQ.
• The price that investors pay for mutual fund shares is based on the fund’s net asset value (value of
the underlying investment portfolio) plus any charges made by the fund.
• The investment portfolios of mutual funds are typically managed by separate entities known as
investment advisers, who are registered with the Securities Exchange Commission (SEC), the US
regulator.

Buying and Selling Mutual Fund Shares

• Investors can place instructions to buy or sell shares in mutual funds by contacting the fund directly.
In practice, most mutual fund shares are sold mainly through brokers, banks, financial planners or
insurance agents.
• The price that an investor will pay to buy shares or receive them when they are redeemed is based
on the NAV of the underlying portfolio. A mutual fund values its portfolio daily in order to determine
the value of its investment portfolio, and from this calculate the price at which investors will deal.
The NAV is available from the fund, on its website, and in the financial pages of major newspapers.
• When an investor buys shares, they pay the current NAV per share plus any fee that the fund
imposes.
• When an investor sells their shares, the fund will pay them the NAV minus any charges made for
redemption of the shares. All mutual funds will redeem or buy back an investor’s shares on any
business day and must send payment within seven days.

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Fees and Expenses
• Operating a mutual fund involves costs such as shareholder transaction costs, investment advisory
fees, and marketing and distribution expenses. Mutual funds pass along these costs to investors by
imposing charges. SEC rules require mutual funds to disclose both shareholder fees and operating
expenses in a fee table near the front of a fund’s prospectus.
• ‘Operating expenses’ refer to the costs involved in running the fund and are typically paid out of
fund assets. Included within these costs are:
• management fees – which are the costs of the investment adviser who manages the portfolio
• distribution and service fees – these are fees paid to cover the costs of marketing and selling
fund shares, including fees to brokers and others, and the costs involved in responding to
investor enquiries and providing information to investors
• other expenses – under this heading are all other charges incurred by the fund such as fees,
custody charges, legal and accounting expenses and other administrative expenses.
• As well as disclosing these costs, mutual funds are also required to state the total annual fund
operating expenses as a percentage of the fund’s average net assets. This is known as the total
expense ratio (TER), and helps investors make comparisons between funds.
• As well as the costs that are involved in running a mutual fund, a fund may also impose charges when
an investor buys, sells or switches mutual fund shares. The types of charges that are levied include:
• sales charge on purchases – this is the amount payable when shares are bought and is
sometimes referred to as a front-end load; it is paid to the broker that sells the fund’s shares. It is
deducted from the amount to be invested so, for example, if you invest $1,000 and there is a 5%
front-end load, then only $950 would be actually invested in the fund. Regulations restrict the
maximum front-end charge to 8.5%
• purchase fee – this is a fee that funds sometimes charge to defray the costs of the purchase, and
is payable to the mutual fund and not the broker
• deferred sales charge – this is a fee that is paid when shares are sold and is known as a back-end
load. This typically goes to the broker that sold the shares, and the amount payable decreases
the longer the investor holds the shares, until a point is reached when the investor has held the
shares for long enough that nothing is payable
• redemption fee – another type of fee that is paid when an investor sells their shares, but this is
payable to the fund and not the broker
• exchange fee – this is a fee that some funds impose when an investor wants to switch to
another fund within the same group or family of funds.
• Where a fund charges a front-end sales load, the amount payable will be lower for larger
investments. The amount that needs to be invested needs to exceed what are commonly referred
to as breakpoints. It is up to each fund to determine how they will calculate whether an investor is
entitled to receive a breakpoint, and regulatory requirements forbid advisers from selling shares of
an amount that is just below the fund’s sales load breakpoint simply to earn a higher commission.
• Some funds are described as no-load, which means that the fund does not charge any type of sales
load. They may, however, charge fees that are not sales loads, such as purchase fees, redemption
fees, exchange fees and account fees. No-load funds will also have operating expenses.

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Classes of Shares
• Many mutual funds have more than one class of shares. Whilst the underlying investment portfolio
remains the same for all of the different classes, each will have different distribution arrangements
and fees. Some of the most common mutual fund share classes offered to individual investors are:
• Class A shares – these typically impose a front-end load but have lower annual expenses
• Class B shares – these do not impose a front-end load and instead may impose a deferred sales
load along with operating expenses
• Class C shares – these have operating expenses and a front-end load or back-end load but
this will be lower than for the other classes. They will typically have higher annual operating
expenses than the other share classes.

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For simplification, when looking to purchase on behalf of investors, there are two broad categories of
unit types:

1. retail units
2. institutional units.

Taxation of Mutual Funds

The tax treatment of a US fund varies depending upon its type. For example, some funds are classed as
tax-exempt funds, such as a municipal bond fund where all the dividends are exempt from federal and
sometimes state income tax, although tax is due on any capital gains.

For other mutual funds, income tax is payable on any dividends and gains made when the shares are
sold. In addition, investors may also have to pay taxes each year on the fund’s capital gains. This is
because US law requires mutual funds to distribute capital gains to shareholders if they sell securities for
a profit that cannot be offset by a loss.

The tax treatment of mutual funds for non-US residents means that, in practice, funds domiciled
in Europe or elsewhere are more likely to be suitable. These mutual funds, however, share many
characteristics in common with funds found elsewhere in the world.

1.3.3 European Open-Ended Funds

In Europe, three main types of open-ended fund are encountered – SICAVs, unit trusts and OEICs.

SICAVs and FCPs

As mentioned earlier, Luxembourg is the main centre for funds that are to be distributed to investors
across European borders and globally. The main US fund groups along with their European counterparts
manage huge fund ranges from Luxembourg, which are then distributed and sold not just across
Europe but in the Middle East and Asia as well.

The main type of open-ended fund that is encountered is a SICAV, which stands for Société
d’Investissement à Capital Variable (investment company with variable capital) – in other words, an
open-ended investment company.

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Some of their main characteristics include:

• They are open-ended, so new shares can be created or shares can be cancelled to meet investor
demand.
• Dealings are undertaken directly with the fund management group or through their network of
agents.
• They are typically valued each day and the price at which shares are bought or sold is directly linked
to the net asset value of the underlying portfolio.
• They are single-priced, which means that the same price is used when buying or when selling, and
any charge for purchases is added on afterwards.
• They are usually structured as an umbrella fund, which means that each fund will have multiple
other funds sitting under one legal entity. This often means that switches from one fund to another
can be made at a reduced charge or without any charge at all.
• Their legal structure is a company which is domiciled in Luxembourg and, although some of
the key aspects of the administration of the fund must also be conducted there, the investment
management is often undertaken in London or in another European capital.

Another main type of structure encountered in Europe is a Fonds Commun de Placement (FCP). Like unit
trusts, FCPs do not have a legal personality and, instead, their structure is based on a contract between
the scheme manager and the investors. The contract provides for the funds to be managed on a pooled
basis. This is a popular vehicle for investors in continental Europe.

As FCPs have no legal personality, they have to be administered by a management company, but
otherwise the administration is very similar to that described above for SICAVs.

Unit Trusts
A unit trust is an investment fund that is established as a trust, in which the trustee is the legal owner of
the underlying assets and the unit-holders are the beneficial owners.

As with other types of open-ended investment funds, the trust can grow as more investors buy into the
fund, or shrink as investors sell units back to the fund and they are either cancelled or reissued to new
investors. As with SICAVs, investors deal directly with the fund when they wish to buy and sell.

The major differences between unit trusts and the open-ended funds that we have already looked at are
the parties to the trust and how it is priced.

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Main Parties to a Unit Trust

• The role of the unit trust manager is to decide, within the rules of the trust and the
various regulations, which investments are included within the unit trust.
• This will include deciding what to buy and when to buy it, as well as what to sell
Unit Trust and when to sell it. The unit trust manager may outsource this decision-making to
Manager a separate investment manager in some cases.
• The manager also provides a market for the units by dealing with investors who
want to buy or sell units. It also carries out the daily pricing of units, based on the
NAV of the underlying constituents.

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• Every unit trust must also appoint a trustee. These are organisations that the unit-
holders can trust with their assets, normally large banks or insurance companies.
• The trustee is the legal owner of the assets in the trust, holding the assets for the
Trustee benefit of the underlying unit holders.
• The trustee also protects the interests of the investors by, among other things,
monitoring the actions of the unit trust manager.
• Whenever new units are created for the trust, they are created by the trustee.

Just as with other investment funds, the price that an investor pays to buy a unit trust or receives when
they sell is based on the NAV of the underlying portfolio. The key differences from SICAVs are:

• The underlying portfolio of a unit trust is valued daily at both the bid and offer prices for the
investments contained within the portfolio.
• This produces two NAVs, one representing the value at which the portfolio’s investments could be
sold and another for how much it would cost to buy.
• These values are then used to calculate two separate prices, one at which investors can sell their
units and one which the investor pays to buy units.

For this reason, unit trusts are described as dual-priced. They have a bid price, which is the price the
investor receives if they are selling, and an offer price, which is the price the investor pays if buying. The
difference between the two is known as the bid-offer spread.

Any initial charges made by the unit trust for buying the fund are included within the offer price that is
quoted.

Open-Ended Investment Companies (OEICs)

An open-ended investment company is another form of investment fund found in Europe. They are a
form of investment company with variable capital (ICVC) that is structured as a company with the
investors holding shares.

In the UK their name is often abbreviated to OEIC, whilst in Ireland they are known as a variable capital
company (VCC). They have similar structures to SICAVs and, as with SICAVs and unit trusts, investors deal
directly with the fund when they wish to buy and sell.

The key characteristics of OEICs are the parties that are involved and how they are priced.

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 • When an OEIC is set up, it is a requirement that an authorised corporate director
(ACD) and a depository are appointed.
• The ACD is responsible for the day-to-day management of the fund, including
managing the investments, valuing and pricing the fund and dealing with
investors. It may undertake these activities itself, or delegate them to specialist
third parties.
Parties to
• The register of shareholders is maintained by the ACD.
an OEIC
• The fund’s investments are held by an independent depository, responsible for
looking after the investments on behalf of the fund’s shareholders and overseeing
the activities of the ACD.
• The depository occupies a similar role to that of the trustee of a unit trust. The
depository is the legal owner of the fund investments and the OEIC itself is the
beneficial owner, not the shareholders.
• An OEIC has the option to be either single-priced or dual-priced. Most OEICs in
fact, operate single pricing.
• Single pricing refers to the use of the mid-market prices of the underlying assets to
produce a single price at which investors buy and sell.
• Where a fund is single-priced, its underlying investments will be valued based on
Pricing their mid-market value.
• This method of pricing does not provide the ability to recoup dealing expenses
and commissions within the price. Such charges are instead separately identified
for each transaction.
• It is important to note that the initial charge will be charged separately when
comparing single pricing to dual pricing.

When looking at overall charges of a fund, especially for comparison purposes, it is important to look at
the ongoing charge figure (OCF).

Other Fund Structures

Fund of Funds
A fund of funds comprises a portfolio of retail or institutional CISs which seek to harness what is
considered the best investment management talent available within a diversified portfolio. A fund
of funds has one overall manager, and it invests in a portfolio of other existing investment funds. It is
important to recognise, however, that a fund of funds can be either fettered or unfettered. Most fund of
fund schemes are managed on an unfettered basis, in that the component funds are run by a number
of managers external to the fund management group marketing the fund of funds. However, some are
managed as a fettered product and are obliged to invest solely in funds run by the same management
group as the fund.

Multi-Manager
By contrast, a manager of managers fund does not invest in other investment schemes. Instead, the
fund arranges segregated mandates and appoints fund managers who they believe are the best in
their sector to manage each area. One disadvantage is that the initial investment required is usually
substantially higher than that required for a fund of funds or other CIS. Equally, it also takes time to
change from an underperforming fund manager, as opposed to a fund of funds approach, where the
fund itself is sold within a strategy.

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1.3.4 Closed-Ended Investment Companies

A closed-ended investment company is another form of investment fund.

When they are first established, a set number of shares are issued to the investing public, and these are
then traded on a stock market. Investors wanting to subsequently buy shares do so on the stock market
from investors who are willing to sell. The capital of the fund is therefore fixed, and does not expand or
contract in the way that an open-ended fund does. For this reason, they are referred to as closed-ended
funds in order to differentiate them from mutual funds, SICAVs, unit trusts and OEICs.

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Closed-ended investment companies are found in many countries but, in this section, we will consider
the characteristics of those found both in the US and Europe.

US Closed-End Funds
In the US, they are referred to as a closed-end fund and are one of the three basic types of investment
companies alongside mutual funds and unit investment trusts.

• In the US, closed-end funds come in many varieties and can have different
investment objectives, strategies and investment portfolios. They also can be
subject to different risks, volatility and charges.
• They are permitted to invest in a greater amount of ‘illiquid’ securities than are
Closed-End
mutual funds.
Fund
• An ‘illiquid’ security generally is considered to be a security that cannot be sold
within seven days at the approximate price used by the fund in determining NAV.
• Because of this feature, funds that seek to invest in markets where the securities
tend to be more illiquid are typically organised as closed-end funds.
• The other main type of US investment company is a unit investment trust (UIT).
• A UIT does not actively trade its investment portfolio; instead it buys a relatively
fixed portfolio of securities – for example, five, 10 or 20 specific stocks or bonds –
Unit
and holds them with little or no change for the life of the fund.
Investment
• Like a closed-end fund, it will usually make an initial public offering of its shares
Trust
(or units), but the sponsors of the fund will maintain a secondary market, which
allows owners of UIT units to sell them back to the sponsors and allows other
investors to buy UIT units from the sponsors.

European Closed-Ended Funds

In Europe, closed-ended funds are usually known as investment trusts and more recently as investment
companies.

Investment trusts were one of the first investment funds to be set up. The first funds were set up in the
UK in the 1860s and, in fact, the very first investment trust to be established, the Foreign & Colonial
Investment Trust, is still operating today.

Despite its name, an investment trust is actually a company, not a trust. As a company, it has directors
and shareholders. However, like a unit trust, an investment trust will invest in a range of investments,
allowing its shareholders to diversify and lessen their risk.

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Some investment trust companies have more than one type of share. For example, an investment trust
might issue both ordinary shares and preference shares. Such investment trusts are commonly referred
to as split capital investment trusts.

In contrast with OEICs and unit trusts, investment trust companies are allowed to borrow money on
a long-term basis by taking out bank loans and/or issuing bonds. This can enable them to invest the
borrowed money in more stocks and shares – a process known as gearing.

Also, some investment trusts have a fixed date for their winding-up.

The price of a share in a closed-ended investment company is driven by demand and supply as with
other quoted shares. The share price is therefore arrived at in a very different way from an open-ended
fund. However, the share price is said to either be at a premium to the assets that support that price or a
discount (an investor would be getting more of the assets per £1 invested).

• Remember that units in a unit trust are bought and sold by their fund manager at a price that is
based on the underlying value of the constituent investments. Shares in an OEIC are bought and
sold by the authorised corporate director (ACD), again at the value of the underlying investments.
At the dealing point – units are either created or cancelled and hence always trade at their NAV.
• The share price of a closed-ended investment company, however, is not necessarily the same as
the value of the underlying investments. The company will value the underlying portfolio daily and
provide details of the net asset value to the stock exchange on which it is quoted and traded. The
price it subsequently trades at, however, will be determined by demand and supply for the shares,
and may be above or below the net asset value.
• When the share price is above the net asset value, it is said to be trading at a premium.
• When the share price is below the net asset value, it is said to be trading at a discount.

The NAV gives investors the total value of the fund’s portfolio less liabilities:

NAV = total assets – liabilities

NAV
NAV per share =
total outstanding shares

Example
ABC Investment Trust shares are trading at £2.30. The net asset value per share is £2.00. ABC Investment
Trust shares are trading at a premium. The premium is 15% of the underlying NAV.

Example
XYZ Investment Trust shares are trading at 95p. The net asset value per share is £1.00. XYZ Investment
Trust shares are trading at a discount. The discount is 5% of the underlying NAV.

Most investment trust company shares generally trade at a discount to their net asset value. A number of
factors contribute to the extent of the discount, and it will vary across different investment companies.
Most importantly, the discount is a function of the market’s view of the quality of the management of

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the investment trust portfolio and its choice of underlying investments. A smaller discount (or even a
premium) will be displayed where investment trusts are nearing their winding-up, or about to undergo
some corporate activity such as a merger or takeover.

Many investment trusts have programmes in place to try and manage the extent of any discount by
buying shares and holding them in treasury in an effort to support the price. For those that operate
at a premium, new issues of shares can be used to reduce the premium. (Under certain circumstances,
companies can buy back listed shares in the stock market and they then have two choices – to either
cancel them or hold on to them on the basis that they may subsequently reissue them to other investors.
The latter is referred to as holding shares in treasury.)

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In the same way as other listed company shares, shares in investment trust companies are bought and
sold on a stock exchange such as the LSE.

An investment trust is listed on a stock exchange, where secondary trading takes place. It is closed-
ended as the original share capital stays the same, except when C shares are issued for future investment
opportunities of the fund. This therefore means that the fund managers of the trust do not have to worry
about investing or raising money from investors/unit holders, once the initial seed money has been
invested. As a result, they do not become forced buyers or sellers of assets. This is very different to a
unit trust fund manager, who needs to take account of fund flows and at times could be forced to invest
client money or raise money at the wrong time to meet investment or redemption obligations.

1.4 Exchange-Traded Funds (ETFs)

Learning Objective
4.1.4 Know the basic characteristics of exchange-traded funds and how they are traded

Exchange-traded funds (ETFs) are a type of open-ended investment fund that are listed and traded on
a stock exchange. In London, for example, ETFs are traded on the LSE, which has established a special
subset of the exchange for ETFs, called extraMARK. ETFs represent a natural evolution of investment
funds by combining the benefits of traditional CISs with the ease and efficiency of holding and trading
shares, making these vehicles more liquid and easier to trade in and out of than the traditional OEIC. This
liquidity is provided by market makers to trade (buy and sell) the ETF during each trading day.

ETFs typically track the performance of an index and trade very close to their NAV. Some ETFs are more
liquid, or more easily tradeable, than others, depending upon the index they are tracking. Some of their
distinguishing features include:

• They track the performance of a wide variety of fixed-income and equity indices as well as a range of
sector- and theme-specific indices and industry baskets. Some also track actively managed indices.
• The details of the fund’s holdings are transparent so that their NAV can be readily calculated.
• They have continuous real-time pricing so that investors can trade at any time.
• They will generally have low bid-offer spreads depending upon the market, index or sector being
tracked, for example just 0.1% or 0.2% for, say, an ETF tracking the FTSE 100.

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• They have low expense ratios and no initial or exit charges are applied. Instead, the investor pays
normal dealing commissions to his stockbroker. An annual management charge is deducted from
the fund, typically 0.5% or less.
• Unlike other shares, there is no stamp duty to pay on purchases in the UK.
• ETFs can be used by retail and institutional investors for a wide range of investment strategies,
including the construction of core-satellite portfolios, asset allocation and hedging.
• In Europe, they are usually structured as UCITS III-compliant funds.

ETFs usually track equity or fixed-income market indices, and, in order to achieve their investment
objectives, ETF providers can either use physical or synthetic replication. The risks of the latter have been
the subject of intense regulatory scrutiny by regulators around the world.

Index Replication Methods

Full • Full replication is an approach whereby the fund attempts to mirror the index by
Replication holding shares in exactly the same proportions as in the index itself.
• Stratified sampling involves choosing investments that are representative of the
index. The expectation is that, overall, the ‘tracking error’ or departure from the
index will be relatively low.
Stratified
• The amount of trading of shares required should be lower than for full replication,
Sampling
however, since the fund will not need to track every single constituent of an index.
This should reduce transaction costs and therefore will help to avoid such costs
eroding overall performance.
• Optimisation is a computer-based modelling technique which aims to approximate
the index through a complex statistical analysis based on past performance.
• The optimised sampling approach is more common for indices with a large
Optimisation
number of components, in which case the provider would only buy a basket of
selected component stocks reflecting the same risk-return characteristics as the
underlying index.
• The alternative is to use synthetic replication. This involves the ETF providers
entering into a swap agreement with single or multiple counterparties. The
provider agrees to pay the return of a predefined basket of securities to the swap
provider in exchange for the index return.
• Synthetic replication generally reduces costs and tracking error, but increases
Synthetic counterparty risk. For markets not easily accessible, swap structures do have an
Replication advantage over physical replication.
• The maximum exposure to any swap counterparty for a UCITS fund is limited
to 10% of the fund’s net asset value, so that an ETF will have to have multiple
counterparties and will look to hedge its exposure by requiring collateral to be
posted with an independent custodian. Most providers disclose the composition
of the collateral taken daily on their websites.

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Although ETFs generally track an index, the latest types are described as ‘smart beta’. Instead of tracking
just an index, they will take into account other factors such as value or growth when creating an index
that they will track. This encapsulates factor and fundamental-based indices that are constructed
through approaches other than free float or price-weighted capitalisation. It can be both active and
passive; it follows an index, but is active because it also considers alternative factors.

The legal structure of an ETF varies between jurisdictions. In the US, many ETFs are structured as unit
trust investment funds, while in Europe ETFs can be seen as OEICs (eg, in Ireland) and SICAVs and FCPs in
Luxembourg. The underlying structures they adopt, therefore, follow along traditional CIS lines.

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In Europe, many ETFs are structured as UCITS III funds and are domiciled in either Dublin or Luxembourg
so that they can be marketed cross-border. For example, iShares is established as a Dublin-domiciled
open-ended umbrella fund, and the FTSEurofirst 100 Fund is listed on the LSE, Borsa Italiana, Deutsche
Börse, Euronext Amsterdam, Euronext Paris, the SIX Swiss Exchange (formerly known as SWX).

In summary, the main advantage of physical replication is its simplicity. This, however, comes at a cost
which brings about greater tracking error and higher total expense ratio (TER). The main advantage
of synthetic replication tends to be lower tracking error and lower costs, but with the downside of
counterparty risk.

When investing in an ETF, it is important to understand the tracking error if tracking an underlying index
or sector. However, a high tracking fund just refers to the amount of deviation from the tracking index
and hence should be accompanied by a higher performance than the underlying.

1.5 Commodity Funds

Learning Objective
4.2.5 Know the characteristics and application of commodity funds

Commodities have always had a place in the portfolios of private clients, especially where they are
managed by discretionary investment managers.

Within the asset allocation of a portfolio, a percentage would usually be allocated to commodity
exposure. This exposure has usually been obtained by holding the shares of companies involved in one
aspect or another of the commodities world. For example, an investment manager might determine
that they want to achieve exposure to gold or other minerals and would therefore include the shares of
companies quoted in the mining sector or an investment fund that specialised in the sector.

Achieving exposure to commodities in this way has never been an optimal solution, as the share
price of the company would be influenced both by the prospects for the movement of the underlying
commodity and by the prospects for the company itself. Investors have been able to buy futures and
options on commodities, but this has not always been an appropriate solution for retail investors or
for those managing investment funds who are looking for an alternative risk and return profile of asset
class.

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1.6 Exchange-Traded Commodities (ETCs)
Exchange-traded commodities (ETC) are an investment vehicle that tracks the performance of an
underlying commodity index. There are two main types of ETC, namely single commodity ETCs such as
gold and oil, and ones that track an index, such as exchange-traded notes (ETNs).

ETCs are open to all investors and can be used for a number of purposes where commodity exposure
is needed, such as exposure to a single commodity, like gold, or as part of an asset allocation strategy.
They are an open-ended collective investment vehicle and so additional shares are created to meet
demand. They are similar to ETFs in that they are dealt on a stock exchange in their own dedicated
segment. They have market maker support so that there is guaranteed liquidity during market opening
hours, and are held and settled in the same way as any other shares. However, ETCs vary in construction,
from being fully backed (full replication) to partial replication, to being made up of derivatives/swaps
(synthetic ETCs). It is therefore important for investment managers to understand the true risk profiles
of these structures.

1.7 Exchange-Traded Products (ETPs)

An ETP is an investment fund with specified objectives which is traded on many global stock exchanges
in the same manner as a typical stock for a corporation. An ETP holds assets such as stocks or bonds and
trades at approximately the same price as the NAV of its underlying assets over the course of the trading
day.

In general, ETPs can be attractive as investment vehicles because of their low costs, tax-efficiency, and
stock-like features.

Among the different kinds of ETPs, the best known are ETFs, which will often track an index, such as
the S&P 500 or the FTSE 100. Other versions include more bespoke exchange-traded contracts (ETCs)
and ETNs. ETCs are derivative-based contracts that can include futures. ETNs are a type of unsecured,
unsubordinated debt security that was first issued by Barclays Bank plc. This type of debt security differs
from other types of bonds and notes because ETN returns are based upon the performance of a market
index minus applicable fees, no period coupon payments are distributed and no principal protection
exists. Both ETCs and ETNs are more commonly used in institutional and wealth management than by
retail investors.

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2. Other Investment Vehicles

2.1 Structured Products

Learning Objective
4.2.1 Know the characteristics and application of structured investments

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‘Structured products’ is a term that is used to describe a series of investment products that are more
commonly known as guaranteed growth bonds, stock market-linked growth bonds and a whole variety
of other marketing names.

These types of structured product have been around for some time and their features and terms differ
markedly from product to product. There are ones designed for the mass retail investment market, ones
that target the high net worth market only, ones that are for the customers of a single private bank and
even ones designed around individuals for the ultra-wealthy.

Structured products are packaged products based on derivatives which may feature protection of
capital if held to maturity but with a degree of participation in the return from a higher-performing, but
riskier, underlying asset. They are created to meet the specific needs of high net worth individuals and
general retail investors that cannot be met by standardised financial instruments that are available in
the markets.

These products are created by combining underlying assets such as shares, bonds, indices, currencies
and commodities with derivatives. This combination can create structures that have significant risk/
return and cost-saving advantages compared to what might otherwise be obtainable in the market.
Below is a simple example of how such a product might work.

Example
• A simple structured product might have a fixed term of five years, 100% capital protection and offer
participation in any growth of an index up to a specific limit, such as 60% of the return on the FTSE
100 Index provided the index finishes at or above its starting level. An investor chooses to invest
£1,000 into the product.
• Within the wrapper of the product may be two underlying investments – a zero coupon bond and a
call option.
• The zero coupon bond pays no coupon, but is instead sold at a discount to its par value and so can
provide a known amount at its maturity. For example, £1,000 nominal of the bond may be bought
for £800 and as it is repayable in five years’ time it provides the guaranteed return of capital at the
end of the term.
• The remaining £200 of the amount invested goes into a long call option on the FTSE 100 Index
which will provide the return on the index if it finishes above its starting level.
• If the index is at or above the starting level at the end of the term, then the investor receives the
return of their capital (provided by the repayment of the zero coupon bond) and the return on the
index from the payout on the call option.
• If the index is lower, the investor will receive the return of their capital only as the call option will be
worthless.

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The benefits of structured products can include:

• protection of initial capital investment

• tax-efficient access to fully taxable investments
• enhanced returns
• reduced risk.

Interest in these investments has been growing in recent years, and high net worth investors now use
structured products as a way of achieving portfolio diversification. Structured products are also available
at mass retail level, particularly in Europe and Asia, where banks and other financial institutions sell
investments on to their customers.

Structured products have their base in the guaranteed bonds marketed by insurance companies from
the 1970s onwards. In recent years, the providers of these products have explored ever more innovative
combinations of underlying asset mixes which have enabled them to offer a wider range of terms and
guarantees.

Structured products have offered a range of benefits to investors and generally have been used either
to provide access to stock market growth with capital protection or exposure to an asset, such as gold
or currencies that would not otherwise be achievable from direct investment. Their major disadvantage
has been the fact that they have had to be held to maturity to secure any gains. The gain that an investor
would make on, say, a FTSE 100-linked bond would only be determined at maturity, and few bonds offer
the option of securing profits earlier. Newer products have overcome this by including ‘kick out’ options
where the product matures early if the index reaches a certain level.

There is a wide range of listed structured products, and the terms of each are open to the discretion
of the issuing bank. They are known by a variety of names including certificates and investment notes.
They do, however, fall into some broad categories that are considered below.

Structured products can be categorised into three main types:

• structured deposits
• structured capital protected products, and
• structured capital at risk products.

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Types of Structured Products

• These are essentially fixed-term deposit accounts where, instead of
interest being earned at a set or variable rate, the return is fixed but
depends on the performance of the underlying asset, such as the
FTSE 100 Index or the S&P 500. The term may be anything from three
to six years and the return a proportion of any growth in the index.
• For example, such a product might offer a return of 15% if the index
is at or above the set level at the end of a three-year fixed term. If the
index is higher at the end of the three years, then you receive your
Structured Deposits

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initial capital back plus interest of 15%. If the index is lower, then
you only receive back the amount invested.
• The advantage of such products is that the investor can potentially
earn higher returns than can be achieved from standard savings
accounts. The investor is, however, exposed to the risk that there
may be no return if the index is below its starting level.
• In the event of the potential default of the provider, they may benefit
from protection under a country’s deposit protection scheme.
• These are similar to structured deposits in that they are designed to
return the original capital at maturity as a minimum.
• Typically, the return offered will be greater than that available on
structured deposits and may have other features not found in a
structured deposit.
Structured Capital • For example, a product might offer a return of 30% if the index is
Protected Products above the starting level at the end of a five-year term. If it is higher,
you get back the initial investment plus the return; if it is lower, then
you get back your initial investment but nothing extra.
• They are, however, loans to the bank or other financial institution
that create the product and so the investor is exposed to the risk if
that organisation goes bust.
• These generally offer the highest return on investment because as
well as the potential returns, there is a risk that some or all of the
capital invested may be lost.
• They may have partial capital protection. For example, a product
may offer a set return if the index is at or above its starting level at
the end of a five-year term. If the index is lower but not less than
50% of its starting level, then the capital is returned in full; if it is
Structured Capital at
below that then the investor loses some or all of their capital.
Risk Products
• Others may offer no capital protection at all and instead offer 100%
exposure to the movement of the underlying index.
• The returns, including the return of capital, are dependent upon
the counterparty remaining financially solvent for the full product
term. This is because these products do not have the benefit of any
investor compensation scheme in the event of the insolvency of the
counterparty.

Within these three broad categories, there are then many variations on the theme.

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It is important that investors understand the risks of structured products before deciding whether to
invest in one, particularly with structured deposits where there is a risk that an investor may see it as
an alternative to a bank savings account that is just as safe. Some of the key risks to be aware of are as
follows:

• Investors must be prepared to leave the amount uninvested for the full fixed term otherwise they
may get back less than they paid in. Many structured products do not permit early withdrawals and
those that do may charge an exit fee.
• There is a risk that they will receive no return at all if the index is below the anticipated level. With
structured deposits and structured capital protected products, the initial capital is returned but with
a zero return. In such cases, the investor would have been better off simply investing in a savings
account where they would have at least earned some interest.
• There is a risk with structured capital at risk products that they will receive not just no return on their
investment, but that they will lose some or all of the capital invested as well.
• Inflation can erode the value of any return achieved on the product. Of course, this risk also applies
to other savings and investment products that are not inflation protected.
• Any investor compensation scheme or deposit protection scheme may not protect the investment if
the provider of the product were to fail.

2.2 Hedge Funds

Learning Objective
4.2.2 Know the characteristics and application of hedge funds
4.2.3 Know the characteristics and application of absolute return funds

Hedge funds are reputed to be high-risk. However, in many cases this perception stands at odds with
reality. In their original incarnation, hedge funds sought to eliminate or reduce market risk. That said,
there are now many different styles of hedge fund – some risk-averse and some employing highly risky
strategies. It is, therefore, not wise to generalise about them: they can no longer be typified and are best
treated as complex securities most suitable for experienced investors.

The most obvious market risk is the risk that is faced by an investor in shares – as the broad market
moves down, the investor’s shares also fall in value.

An absolute return fund seeks to make positive returns in all market conditions by employing a wide
range of techniques including short selling, futures and options, derivatives, arbitrage, leverage and
unconventional assets.

In the fixed-income space – an absolute return fixed-income strategy may be attractive as it can provide
an income, but with the flexibility to target the most attractive areas of the fixed-income market and
protect against rising interest rates to also preserve the underlying capital.

Innovation has resulted in a wide range of complex hedge fund strategies, some of which place a greater
emphasis on producing highly geared returns rather than controlling market risk.

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Many hedge funds have high initial investment levels, meaning that access is effectively restricted to
wealthy investors and institutions. However, investors can also gain access to hedge funds through
funds of hedge funds.

The common aspects of hedge funds are the following:

• Structure – hedge funds are established as unauthorised and therefore unregulated collective
investment schemes, meaning that they cannot be generally marketed to private individuals
because they are considered too risky for the less financially sophisticated investor.
• High investment entry levels – most hedge funds require minimum investments in excess of

4
£50,000; some exceed £1 million.
• Investment flexibility – because of the lack of regulation, hedge funds are able to invest in whatever
assets they wish (subject to compliance with the restrictions in their constitutional documents and
prospectus). In addition to being able to take long and short positions in securities like shares and
bonds, some take positions in commodities and currencies. Their investment style is generally aimed
at producing ‘absolute’ returns – positive returns regardless of the general direction of market
movements.
• Gearing – many hedge funds can borrow funds and use derivatives, potentially, to enhance their
returns.
• Liquidity – to maximise the hedge fund manager’s investment freedom, hedge funds usually
impose an initial ‘lock-in’ period of between one and three months before investors can sell their
investments on.
• Cost – hedge funds typically levy performance-related fees, which the investor pays if certain
performance levels are achieved, otherwise paying a fee comparable to that charged by other
growth funds. Performance fees can be substantial, with 20% or more of the net new highs (also
called the ‘high water mark’) being common.

2.2.1 Hedge Fund Strategies

Fixed-income Arbitrage (FIA)
Fixed-income arbitrage (FIA) seeks to exploit inefficiencies in interest rate yield curves, corporate
spreads and/or pricing of government bonds, swaps and other derivatives based upon interest rates. For
example, if the yield curve is expected to steepen, with the yields on long-term bonds moving up more
than short-term yields, the strategy would be, for example, to buy a two-year government bond (known
as gilts in the UK) and sell a 20-year government bond.

Non-Directional Strategies
The expected returns from these strategies may be limited, but owing to their relatively low volatility
and low correlations with traditional markets (at least during non-critical periods) they are often
implemented with high leverage, which magnifies the returns (and losses). When the money markets are
behaving erratically, as in the second half of 2008, drawdowns can be very substantial.

Market Neutral
Known as equity arbitrage. The strategy is to combine long and short positions, while balancing the
beta exposure (the degree to which the movements in prices of the security will track movements in the
overall market) to ensure a zero or negligible market exposure.

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The emphasis is on stock-picking as opposed to having a single directional view of the market. One
favoured strategy is pairs trading, in which one takes converse positions in correlated securities, such as
going long on a major oil company such as BP and short another oil company such as Shell.

Convertible Arbitrage
Another relative value strategy focuses on those securities which have convertible features. The objective
is to profit from mispricing of a convertible security and/or expected trends in factors influencing the
price of a convertible security.

Typically, the strategy will involve a combination of a long position in the convertible security and a
short position in the underlying stock.

Statistical Arbitrage (StatArb)

Any strategy that is bottom-up, beta-neutral in approach and uses statistical/economic techniques in
order to provide signals for execution. Signals are often generated through a belief in the notion of
mean reversion. This relates to the discussion of the notion that if a security has strayed a long way from
its mean performance, eventually it will tend to revert back towards its mean performance. Also involved
in StatArb trading are ways of investing in securities which have favourable momentum characteristics
that can be determined by statistical measures such as rate of change and other technical characteristics
of the price behaviour.

StatArb considers a portfolio of many stocks (some long, some short) that are carefully matched by
sector and region to eliminate exposure to beta and other risk factors. Because of the large number of
stocks involved, the high portfolio turnover and the fairly small size of the mispricings the strategy is
designed to exploit, the implementation is usually in an automated fashion and there is much attention
placed on reducing trading costs.

Event-Driven
• Special situations – typically an attempt to profit from a change in valuation as a result of a
corporate action or takeover and is generally not a long-term investment. An example would be a
large public company spinning off one of its smaller business units into a separately tradeable public
company. If the market deems the soon-to-be-spun-off company to have a higher valuation in its
present form than it will after the spin-off, an investor might buy shares in the larger company before
the spin-off in an attempt to realise a quick price increase.
• Distressed securities – such as when corporate bonds, bank debt and sometimes the common and
preferred stock of companies are in some sort of distress. When a company is unable to meet its
financial obligations, its debt securities may be substantially reduced in value. Typically, a company’s
debt is considered distressed when its yield to maturity is more than 10% or 1000 basis points above
the risk-free rate of return available in government securities. A security is also often considered
distressed if it is rated CCC or below.
• Merger arbitrage – seeks to profit from the spreads in announced mergers and acquisitions or
takeovers. The approach is to buy the stock of the target company in a mergers and acquisitions
(M&A) deal and sell the acquiring company’s stock. Profits are realised when the deal is consummated
and the stock prices converge. Such strategies are usually considered to be low-risk, but there can be
substantial risks if the M&A deal falls through.

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Directional Strategies
These cover all of the numerous styles of investing when the manager expresses a view as to the future
direction of a particular asset class and/or the overall market. Directional strategies require the manager
to speculate as to the absolute values of the securities that will be included in a portfolio.

Directional strategies can be subdivided into two categories: equity hedge and tactical trading.

Equity Hedge
• Long/short equities

4
The portfolio will consist of securities that are on both the long and short sides of the market.
The decision as to which securities to invest in will be based on individual judgements about the
future direction of each security, rather than the top-down approach which uses a beta valuation
designed to achieve a market-neutral portfolio from being long and short beta in the appropriately
engineered, correct ratios.

In essence a long/short equity strategy is to identity securities that are mispriced relative to the
manager’s internal valuation models.

These strategies differ from the non-directional (relative value, event-driven) strategies in that they
typically take the market direction risk (either long or short) as part of their investment approach.

Market exposures may be net long, net short, or neutral at any given time. The strategy should
outperform in bear markets by aiming to deliver absolute returns, but they will tend to
underperform in sharply rising markets.

Tactical Trading
• Global macro
George Soros’ successful strategy was to seek out profits from opportunistically trading global
markets using financial instruments such as global stock index futures, commodities and large-scale
bets in the foreign exchange market.

The broad philosophy behind global macro investing is to find large-scale themes in the global
capital markets, identify trading opportunities and to take large positions on broad indices and
currencies.

• Systematic strategies
Systematic strategies use mathematical models to evaluate markets, detect trading opportunities
and generate signals and investment decisions. The systems used in this category can be classified
as trend-following, which means essentially that the models seek out trends and then ride out
those trends; or there are other systematic strategies which, for example, look for trading markets
at extremes or are based on intermarket tactics such as alignment between certain key foreign
exchange rates such as the Japanese yen and the Australian dollar and global equities.

Sometimes systematic strategies are known as black-box methods because they contain proprietary
indicators and analytical tools which the creators do not wish to disclose to investors.

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2.3 Private Equity

Learning Objective
4.2.4 Know the characteristics and application of private equity

Private equity is medium- to long-term finance, provided in return for an equity stake in potentially
high-growth companies. It can take many forms, from providing venture capital to complete buy-outs.
This asset class can offer relatively poor liquidity, while giving exposure to strong growth areas on
conservative valuations.

For a firm, attracting private equity investment is very different from raising a loan from a lender. Private
equity is invested in exchange for a stake in a company and the investors’ returns are dependent on the
growth and profitability of the business. Therefore, it faces the risk of failure, just like the shareholders.

The private equity firm is rewarded by the company’s success, generally achieving its principal return
through realising a capital gain on exit. This may involve:

• the private equity firm selling its shares back to the management of the investee company
• the private equity firm selling the shares to another investor, such as another private equity firm
• a trade sale, which is the sale of company shares to another firm
• the company achieving a stock market listing.

Private equity firms raise their capital from a variety of sources but mainly from large investing
institutions. These may be happy to entrust their money to the private equity firm because of its
expertise in finding businesses with good potential.

Few people or institutions can afford the risk of investing directly in individual buy-outs and, instead,
use pooled vehicles to achieve a diversification of risk. Traditionally this was through investment trusts,
such as 3i or Electra Private Equity. With the increasing amount of funds being raised for this asset class,
however, methods of raising investment have moved on. Private equity arrangements are now usually
structured in different ways to more retail-focused CISs. They are usually set up as limited partnerships,
with high minimum investment levels. As with hedge funds, there are generally restrictions on when an
investor can realise their investment.

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2.4 Sukuk Investments

Learning Objective
4.2.6 Know the characteristics and application of Sukuk investments

Islamic finance is the approach used to determine what are acceptable investments and ways to raise
capital under Shariah law.

4
A central element of Islamic finance is the importance of risk-sharing as part of raising capital and the
avoidance of riba (interest) and gharar (excessive risk or uncertainty). Charging or receiving interest is
haram, which means prohibited, as it is considered usurious and exploitative. Financial products where
details concerning the conditions of sale are unknown or uncertain are generally prohibited under
Islamic law. Thus, all contracts should be devoid of uncertainty and speculation and parties must have
perfect knowledge of the terms of exchange. In particular, the identification of the owner of the goods
must be disclosed.

The absence of interest in Islamic finance is one of the key factors that differentiate Islamic finance from
conventional finance. However, there are other important differences as shown below:

• Islamic banking is asset-backed, which means that an Islamic bank does not carry out business
unless an asset is purchased to allow the transaction to be conducted according to Shariah.
• The source of the Islamic bank’s funding, profits and business investments cannot be in/from
businesses that are considered unlawful under Shariah, such as companies that deal in interest,
gambling, pornography, speculation, tobacco and other commodities contrary to Islamic values.
• The whole premise of Islamic banking is to provide a way for society to conduct its finances in a way
that is ethical and socially responsible. Trade, entrepreneurship and risk-sharing are encouraged
and these are the financial principles that underpin Islamic finance and the products offered by
Islamic banks.

Islamic law, the Shariah, bans the payment or receipt of interest and, as a result, rules out the use of
traditional bonds as an investment medium.

Islamic bonds or sukuk are always linked to underlying assets, whether tangible or intangible assets.
Holding a sukuk represents a partial ownership in assets and so sukuk are neither shares nor bonds;
instead, they represent a little of each. This means that the return on a sukuk bond is calculated
according to the performance of the underlying assets or projects.

Characteristics of Sukuk
• It is a participation in the ownership of the company issuing the sukuk.
• Each bond represents an ownership of the underlying asset. The bond holder also bears, as owner,
risks proportionate to his share of the underlying asset.
• Bond holders have the right to profits but also bear losses. They do so, based on the nature of the
underlying Islamic contract and the trend within Islamic finance is that profit and loss in any sukuk
investment should be proportionate to the investor’s ownership of the assets.

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• The maturity of the bond is linked to an underlying project or activity.
• Financial guarantees are not typically allowed in Islamic contracts meaning that the investment is
not guaranteed for investors.

The Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) has specified 14
categories of permissible sukuk and a number of techniques that can be employed to structure a sukuk
transaction. The choice of structure type will depend on various factors, including the character of the
underlying assets, taxation and regulatory considerations, the targeted investor base and the views of
the Shariah scholars who must approve the sukuk issuance.

The most commonly used sukuk structures in the market are ijara, murabaha and mudaraba-wakala.
A sukuk al-ijara is regarded as the classical sukuk structure and has become the most commonly used
one, especially for international issues. It is popular because it is simple and widely accepted and
understood by both conventional and sukuk investors as well as by the international rating agencies. A
straightforward example of such a sukuk is shown below.

Sukuk Al-Ijara
• Ijara is the transfer of the use of a tangible asset to another person in exchange for a rent.
• An Ijara sukuk involves the transfer of ownership of tangible assets such as real estate, aircraft or
ships from an originator to a special purpose vehicle – such as a company specially incorporated for
that purpose.
• The SPV issues sukuk certificates to investors representing undivided ownership interests in such
assets.
• The asset is then leased back to the originator by the SPV for a specified term which is typically
commensurate with the term of the certificates.
• Each sukuk holder is entitled to receive the rentals generated under the lease pro rata to its
ownership interest in the underlying asset.
• On the issue date, the originator will enter into purchase undertaking which gives the right to the
SPV to oblige the originator to purchase the assets at maturity. The money received by the SPV will
be used to pay the repayment amount due to investors under the sukuk.

The use of sukuk bonds has grown substantially over recent years and there is now an active primary
market in the issue of bonds and secondary markets where they can be traded. Equally, a growing
number of investment funds have been launched which are Shariah-compliant and which give investors
exposure to both sukuk bonds and other Shariah-compliant investments.

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 Collective Investments

End of Chapter Questions

Think of an answer for each question and refer to the appropriate section for confirmation.

1. How might the pooling of investments aid a retail investor?

Answer reference: Section 1.1

2. What is the difference between an open ended-fund and a closed-ended fund?

Answer reference: Sections 1.3.1 and 1.3.4

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3. In which type of collective investment vehicle would you be most likely to expect to see a fund
manager quote bid and offer prices?
Answer reference: Section 1.3.3

4. Who is the legal owner of the investments held in an OEIC?

Answer reference: Section 1.3.3

5. How does the trading and settlement of an authorised unit trust differ from an ETF?
Answer reference: Sections 1.3.3 and 1.3.4

6. What are some of the principal ways in which investment trusts differ from authorised unit trusts
and OEICs?
Answer reference: Section 1.3.4

7. Name an open-ended type of investment vehicle that is traded on a stock exchange?

Answer reference: Section 1.4

8. Briefly explain the types of replication methods an ETF could follow?

Answer reference: Section 1.4

9. What type of strategy makes extensive use of short positions?

Answer reference: Section 2.2

10. What is the term for bond type investments that are acceptable under Shariah law?
Answer reference: Section 2.4

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