FINANCIAL MARKETS

11 Investment instruments

Investment is the commitment of money or capital to purchase an instrument that provides

the possibility of generating returns over a period of time within certain levels of risk. An array
of investment instruments with a variety of maturities, risk-return characteristics and cash-flow
patterns are available to the investor. In this chapter we examine some of these instruments.

The chapter starts by explaining the need for the development of different investment products.
The chapter proceeds by describing the features of the different investment instruments and the
different risks associated with them.

Learning outcome statements

After studying this chapter, a learner should be able to-

• understand how different needs lead to the development of different investment

instruments and products
• describe the different investment products available to investors.

11.1 Introduction

The characteristics of investors and the circumstances that confront them are diverse and complex.
Each investor’s financial profile and attitude to return and risk are unique. Each has a different set of
constraints related to liquidity, taxes and time horizon and a set of preferences in respect of social
and environmental responsibility. To meet the varied risk/return objectives, requirements and
preferences of investors a wide array of investment products have been developed and are
available to retail and wholesale investors.

11.2 Cash
Cash can be held as notes and coins or deposited with a bank.

Holding cash has the advantage of immediate liquidity. However there are two problems with
holding cash. Firstly cash earns no interest and its real value will be eroded by inflation and secondly
large cash holdings may attract criminals.

11.3 Deposits
Cash deposited with a bank will be held in non-interest-bearing or interest-bearing accounts.

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Non-interest-bearing accounts such as cheque accounts are used to meet immediate expenditure
requirements. Cash can be withdrawn by cash or cheque at any time without notice. Since cheque
accounts generally do not pay interest they are not strictly-speaking investments. Rather they are a
convenient way to store cash and make transactions.

To choose an interest-bearing account such as a demand deposit, fixed deposit, money

market account or notice deposit account, an investor should consider the following factors:

• Interest rate: Interest rates may be fixed or variable and may be paid at different times e.g.
monthly, quarterly, semi-annually or annually. Investors should ensure that when evaluating
interest rates offered, these are comparable

• Term to maturity: Term to maturity indicates the set period of time for which the cash is to
be invested. The longer the term to maturity, the higher the interest rate

• Period of notice: Period of notice is the amount of time that must be given by investors to
withdraw the invested funds in an account. Some accounts can be withdrawn on demand;
others require a notice period for example 30 days’ notice

• Cost: Some accounts attract fees such as monthly maintenance fees. Since these eat into the
return and perhaps capital of the deposit, investors should ensure they are receiving value
for money.

• Security: Security relates to the risk of default by the bank. Investors should consider the
financial strength of the bank before placing their funds with it. In addition they should consider
diversifying i.e., having accounts with several different banks. Some countries have deposit
insurance, which provides compensation to small retail depositors in the event of a bank failing.
Deposit insurance has been proposed in South Africa but has not yet been introduced

There are a number of deposit accounts. These include the following:

• Savings accounts: Deposits that pay interest and can be withdrawn on demand. The amount
of interest will depend on the balance in the account. The higher the balance, the higher the
interest rate

• Notice deposit accounts: Deposits that pay interest and are subject to a period of notice to
withdraw the funds. The longer the period of notice, the higher the rate of interest. Immediate
access to funds is generally available on the penalty of forgoing the interest

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• Money market accounts: Accounts that pay interest rates closely related to money market rates
such as JIBAR. Generally such accounts have a relatively high minimum balance and upfront fees.
These accounts can be withdrawn on demand

• Negotiable certificates of deposit (NCDs): Negotiable certificates of deposits are issued by banks
for a specific period at a stated interest rate. They are negotiable but have a minimum balance
of R1 million.

11.4 Equities
Equity instruments are discussed in chapter 8.

11.5 Bonds and long-term debt instruments

Bond and long-term debt instruments are addressed in chapter 7.

11.6 Retail savings bonds

In 2004 securities for the retail savings bond market were introduced. The main objectives of the
issues were to create awareness amongst the general public of the importance to save, diversify the
financial instruments on offer to the retail market and target a different source of government
funding.

The government has on issue two series of RSA retail savings bonds:
• 2-year, 3-year and 5-year fixed-rate retail savings bonds
• 3-year, 5-year and 10-year inflation-linked retail savings bonds
In terms of security, retail savings bonds are backed by the full faith of the Government.

Retail savings bonds have a minimum investment limit of R1 000 and maximum investment limit
of R5 million.

11.7 Money market instruments

Money market instruments are dealt with in chapter 6.

11.8 Commodities
Commodity instruments are dealt with in chapter 10.

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11.9 Products made available by long-term insurance companies

There are two kinds of insurance – short-term and long-term insurance. Short-term insurance
insures possessions such as household goods or vehicles against events such as fire, theft, personal
liability. Long-term insurance covers major events in life such as death, retirement and disability.

Life insurance companies offer a variety of life policies and variants thereof. A life policy is a
contract between the insurance company and an individual or individuals, where payment by the
insurance company in return for premiums paid, depends in some way on the duration of the
life/lives of the individual/individuals.

There are essentially three classifications of life policies: term insurance, whole-life insurance
and endowment.

A term insurance policy is a policy for a specified number of years in terms of which, in return for
premiums paid, a fixed benefit is payable on the death of the policyholder any time before the
specified term of the contract. The policy provides no further protection if the insured person lives
beyond the specified term of the contact. It has no surrender or cash-in value.

Whole-life and endowment policies, in return for a premium paid, provide a mix of life cover and
investment. Such policies have a surrender value and can be with-profit policies i.e., the return
on the investment portion of the policy is linked to the investment performance of the insurance
company. In the case of a whole-life policy the benefit is paid out on the death of the insured
regardless of the date of such event. The endowment policy will pay out the benefit after a fixed
period or on earlier death.

11.10 Annuities

Insurance companies offer annuities to investors. An annuity is a contract to pay a set amount every
year while the person on whose life the contact depends – the annuitant - is alive. Annuities may be
immediate or deferred.

An immediate annuity provides, in return for a single premium, an annual payment starting
immediately and continuing for the rest of the annuitant’s life. The contracts are often purchased
by retired people who want an income that is guaranteed to last the rest of their lives. The income
received depends largely on prevailing interest rates and life expectancy.

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A deferred annuity is a contract that provides for an annuity to be payable commencing at some
future date. The period between the date of the contract and the date of commencement of the
payments (also known as the vesting date) is referred to as the deferred period. Regular premiums
are payable throughout the deferred period. If the annuitant dies during the deferred period, the
insurance company will return the premiums paid. The annuity is payable from vesting date until
the annuitant dies.

There are a number of types of annuities including a compulsory purchased annuity (CPA), a
voluntary purchased annuity (VPA), a living annuity and a composite annuity.

A compulsory purchased annuity (CPA) must by law be bought with a portion of the funds received
from a matured retirement annuity or pension fund. A CPA is paid to the annuitant for life.

A VPA can be purchased by anyone wanting guaranteed income. It can be taken for life or for a
fixed term e.g. 10 years.

The biggest disadvantage of a CPA and VPA is that the income dies with the annuitant unless
insurance cover is taken out for the capital (at a cost) or a guarantee is placed on the annuity.

In terms of a living annuity, the annuitant’s capital is invested in equities or bonds to achieve growth,
and an income of between 5% and 20% of the investment value is withdrawn annually. The
annuitant bears the risk of a capital loss on the investment if the equity or bond markets weaken.
The advantage of a living annuity is that when the annuitant dies, the balance of the investment
goes to the heirs.

Composite annuities are a combination of CPA/VPA annuities and living annuities. Composite
annuities offer flexible income from the living annuity part and a guaranteed income from the
conventional annuity part.

11.11 Retirement funds

A retirement fund is an independent non-profit legal entity that collects, invests and administers
funds contributed to them by individuals and companies. The exclusive purpose of a retirement fund
is to finance retirement plan benefits i.e., provide an income for an individual after retirement.

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There are three basic types of retirement funds: government pension schemes, personal retirement
funds and occupational retirement funds.

11.11.1 Government pension schemes

Government pension schemes pay a state pension to elderly citizens. The pension is funded out of
taxes. In South Africa it comprises a social old age grant to elderly people (men over 65 and women
over 60) who do not have sufficient income from other sources. About 75% of South African elderly
rely on the old age grant.

11.11.2 Personal retirement fund

Personal retirement funds are funds entered into by individuals to provide for their retirement. Such
funds are funded by contributions from the individual. Retirement annuities can be used for this
purpose.

11.11.3 Occupational retirement funds

Occupational retirement funds (or simply retirement funds) are run by employers for the benefit of
their employees. They are funded by contributions from the employee or employer or both. The
main role-players in a retirement fund are the sponsor (the employer or a group of employers), the
beneficiaries (the employees who participate in the fund), the fund manager (who manages the
assets in the fund) and the trustees who govern and monitor the retirement fund on behalf of the
beneficiaries.

Retirement funds in South Africa are categorised as provident funds or pension funds. A pension
fund provides for at least two thirds of the final retirement benefit to be paid as a life-long pension
after retirement. One third of the final benefit may be taken in cash, subject to tax. A provident fund
provides for the full amount of the final retirement benefit to be taken in cash, subject to tax.

There are two broad fund structures: defined benefit funds and defined contribution funds. In a
defined benefit fund the retirement benefit is determined according to a formula linked to the
beneficiary’s final salary. This means that the employer is exposed to the investment risk of the
fund i.e., if the investments of the fund are insufficient to fund retirement benefits, the employer
must contribute the shortfall. If the fund’s investments perform better than expected, the employer
may contribute less to the fund and may even make no contribution i.e., take a contribution
holiday.

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In a defined contribution fund the retirement benefit is the sum of the total contributions made plus
the net (i.e., after costs) return on investment. This implies that the employee is exposed to the
investment risk of the fund. If fund investments perform worse/better than expected, the
beneficiary’s retirement benefits are reduced/increased. Retirement benefits are dependent on the
investment return of the fund.

11.12 Collective investment schemes

Collective investment schemes (CISs) is a generic term for any scheme where funds from various
investors are pooled for investment purposes with each investor entitled to a proportional share
of the net benefits of ownership of the underlying assets. A CIS consists of the following:

• Pooling of resources to gain sufficient size for portfolio diversification and cost-
efficient operation
• Professional portfolio management to execute an investment strategy.

CISs can be categorised as open-end funds or closed-end funds.

Open-end funds publicly offer their shares or units to investors. Investors can buy and sell the shares
or units at their approximate net asset value. The shares can be bought from or sold to the fund
directly or via an intermediary such as a broker acting for the fund.

Closed-end funds offer their shares or units to the investing public primarily through trading on a
securities exchange. If closed-end fund investors want to sell their shares, they generally sell them
to other investors on the secondary market at a price determined by the market.

In South Africa CISs are governed by the Collective Investment Schemes Control Act 45 of 2002
(CIS Act). The CIS Act became effective on 3 March 2003 replacing the Unit Trusts Control Act and
Participation Bonds Act.

The CIS Act makes provision for five different types of CIS:

• CISs in securities: Schemes where the portfolio consists of shares, preference shares, bonds,
futures, options, warrants and / or money market instruments

• CISs in properties (CISPs): Schemes where the portfolio consists of property shares, immovable
property and units in CISs in property in a foreign country. CISs in property are listed on the JSE

• CISs in participation bonds (CISPBs): Schemes where the portfolio consists mainly of participation
bonds. CISPBs pool funds received from investors and lend them out by granting first mortgage

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 bonds over commercial, industrial or retail properties. The interest paid on these loans is
passed on to participants in regular payments. Thus CISPBs offer security and an interest
income on a regular basis, which is why they are attractive to investors such as retired persons,
charities and pension funds

• Foreign CISs: CISs established outside South Africa. A Foreign CIS invites or permits members of the
public in South Africa to invest in its portfolios. To carry on business in South Africa a Foreign CIS
must obtain approval from the Registrar of Collective Investment Schemes. Only once it is approved,
may a Foreign CIS solicit investment from members of the public in South Africa
• Declared CISs: CISs deemed by the Registrar of Collective Investment Schemes to be CISs

CISs make it possible for investors, including small savers, to obtain diversified investment portfolios
with professional management at reasonable cost and to execute a widening range of investment
strategies. In other words, the main benefits of CISs are:
• Diversification i.e., spreading the risk of investing over a range of investments
• Professional expertise to manage investors’ portfolios

• Reasonable cost due to reduced dealing costs due to bulk transacting and cost-effective
administration
• Choice in that there are increasing numbers of alternative funds from which to choose.

In addition CISs generally exist in a set of legal, institutional and market-based safeguards to protect
the interests of investors.

The disadvantages of investing in CISs are generally held to be as follows:

• Costs in respect of funds management and advice could be avoided if investors managed their
own investments. This assumes investors have the expertise to so self-manage their investments

• Although investors have a large variety of funds to choose from, they have no control over
the choice of individual holdings within their portfolios

• Investors have none of the rights associated with individual holdings e.g. right to attend the
annual general meeting of a company and vote on issues impacting the company.

11.13 Hedge funds

Hedge funds like other CISs, pool investors' money and invest those funds in financial instruments in
an effort to make a positive return. Many hedge funds seek to profit in all kinds of markets by

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pursuing leveraging and other speculative investment practices that may increase the risk of
investment loss.

The term ‘hedge’ is generally associated with the practice of covering an investment position (long-
bought position) with an equal and opposite position (short sale position8), thereby neutralising
the market risk of the original investment decision. The degree to which a fund is ‘hedged’ in the
traditional sense varies substantially across funds. A fund is said to have a net short position or bias
when it takes a larger bet on short positions versus long positions. A fund is said to have a net long
position or bias when it takes a larger bet on long positions versus short positions.

Hedge funds are notoriously difficult to define. The Basel Committee on Banking Supervision sees
hedge funds as financial institutions that generally have the following characteristics (none of which
individually is unique to hedge funds): (i) hedge funds are subject to very little or no direct
regulatory oversight because they are structured as limited partnerships; (ii) investors are either
institutions or sophisticated high net worth individuals and the securities issued take the form of
private placements; (iii) hedge funds are generally subject to limited disclosure requirements, and
(iv) hedge funds take on significant leverage, which increases hedge funds exposure to large
movements in market prices.

Hedge funds achieve leverage through conventional means, such as unsecured or partially secured
debt, but in reality much of the leverage of hedge funds is created through the types of trading
strategies undertaken. For example, a hedge fund uses leverage when it sells government bonds
short and uses the proceeds to establish a long position in corporate bonds.

An investor has several options for accessing hedge funds. One is to directly invest in one or several
hedge funds. Alternatively the investor can purchase an interest in a fund of hedge funds, also
known as a multi-manager fund. The investment manager of a fund of hedge funds selects and
invests in a number of hedge funds, often through an offshore corporation or similar privately
placed vehicle.

8
A short sale is a sale of a security that the seller does not own at the time of trade. Short sellers believe
that the price of the security will fall. If the price of the security falls, the short seller buys back the security
at a lower price and makes a profit. If the security price rises the short seller will incur a loss. Short selling
allows arbitrageurs and dealers to profit from going short of the ‘overvalued’ securities.

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11.14 Property

Property comprises buildings including offices, industrial warehouses, shopping centres, factories,
residential homes, apartment buildings and land. Property is a tangible asset rather than a financial
asset such as shares or bonds. In addition it is an immovable asset comprising the land and
permanently attached improvements to the land.

Property offers an attractive way to diversify an investment portfolio. Property can be classified
into two investment categories income property and speculative property.

Income property includes residential and commercial properties that are leased out and expected to
deliver returns primarily from rental income. Income properties have a number of sources of return:
increasing rental incomes, appreciation in the value of the property and possibly tax benefits.

However such properties have risks: losses from tenant carelessness or negligence, excessive supply
of competing rental units or poor property management.

Speculative properties include land and investment properties that are expected to provide returns
primarily from appreciation in value due to location and scarcity rather than rental income.
Speculative properties give their investors the opportunity to make excessive profits from increases
in value or heavy losses due to uncertainty resulting in failure to achieve price appreciation.

Investors can either invest directly in property through individual ownership or joint
ventures/partnerships or indirectly by investing in a property entity. Property entities in South
Africa include listed property entities namely property holding and development companies (called
property loan stock companies) and collective investment schemes in property (CISPs) or property
unit trusts (PUTS) as well as unlisted property holding and development companies (or property
syndications).

11.14.1 Property loan stock companies

Property loan stock (PLS) companies (also known as property holding and development companies)
are listed on the JSE under Real Estate Holding and Development. PLS companies invest solely in
property. As with all other listed companies PLS companies are subject to the Companies Act, JSE
regulations and are governed by their memorandum of incorporation.

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The main difference between PLS companies and other companies is that PLS companies issue linked
units rather than shares. A unit in a PLS company is part share and part debenture (called a dual-
linked structure), with most of the value of the unit attributable to the debenture. The debenture is
not redeemable and earns interest at a variable rate. The interest comes from income that the PLS
company earns from rental incomes received from the properties in which the company invests, the
sale of properties in which the company has invested and that have appreciated in value since
purchase and fee income from property management services.

PLS companies usually distribute all their net profits, mainly through debenture interest with the
balance being paid out as dividends. Distributions are paid quarterly, semi-annually or annually.
These regular distributions provide investors with a steady cash flow.

11.14.2 Unlisted property holding and development companies

Unlisted property holding and development companies are more commonly known as
property syndications. These are unlisted investment schemes that enable a group of investors
to buy property and become part owners of it, either directly or but more usually, indirectly.

Property syndication is typically structured in one of the following ways:

• A public company owns the property directly
• A private company owns the property and is itself wholly owned by a public company.

The units (shares and debentures) in the public company are sold to investors. The investment can
either be solicited with a prospectus registered with the Registrar of Companies or by way of private
placement with catalogue.

In South Africa many investors have lost their investments in property syndications for various
reasons including substantial falls in property prices. In addition property syndications, because
they are unlisted and loosely regulated, have been used to fleece investors.

11.14.3 Collective investment schemes in property

A collective investment scheme in property (CISP) also known as a property units trust (PUT), is a
portfolio of investment-grade properties typically held in the form of a trust.

PUTs are approved by the FSB in terms of the Collective Investment Schemes Act. The FSB limits PUTs
to investments in listed immovable property assets, shares in property companies; and liquid

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debt-related investments. The FSB requires a PUT to be listed on the JSE and as such are subject
to all the regulatory requirements imposed by the JSE for listed securities.

The management companies of PUTs are responsible for the day-to-day operation of the portfolio of
properties and for the investment strategy of the property unit trust. The affairs of the management
companies are governed by a Trust Deed between the management company and the PUTs.

PUTs typically derive the bulk of their income from the rental of immovable property. Income (e.g.
rental) received by a PUT is taxed at standard income tax rate unless distributed to holders within a
12 month period. PUT distributions are treated as ordinary income in the hands of investors. PUTs
are free from any capital gains tax, which applies only when investors dispose of their units.

11.14.4 Real estate investment trusts

The current financial regulatory and taxation regime for PLS companies and PUTs is not the same.
Although both PLS companies and PUTs are subject to the same JSE listing requirements, only PUTs
are directly regulated by the FSB. The National Treasury, in its explanatory memorandum to the
Taxation Laws Amendment Bill, 2012, proposes a real estate investment trust (REIT) regime that will
create a unified system of regulating and taxing property investment entities such as PLS companies
and PUTs. The REIT system, which will conform to international standards, should be in place by
2014. National Treasury is in consultation with relevant stakeholders before considering the
inclusion of other forms of property entities such as property syndications into the proposed
regime.

A REIT aims to provide investors with a steady rental income stream while also providing capital
growth from sales of underlying properties. To qualify as a REIT, an entity must be listed on the JSE
as a REIT. To obtain a listing the entity must:

• have a minimum amount of gross property assets (direct interests in immovable property (such
as land and buildings), interests in a lease relating to immovable property, interests in a
property subsidiary or holdings in another REIT
• invest in immovable property assets
• distribute most of its profits on yearly basis

• not have excessive borrowing (i.e. gearing) in relation to the asset value of property held by the
entity.

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The above requirements must be contained within the trust deed in the case of a PUT and in the
memorandum of incorporation in the case of a PLS company.

REITs will be exempt from capital gains. However the holders of shares or participatory interests in
REITS will be subject to tax, typically capital gains.

11.15 Private equity

Private equity is medium to long-term finance provided by investors in return for an equity stake in
potentially high-growth companies. The companies are generally not listed on a stock exchange and
need financing to fund growth, development or business improvement. In addition to providing
capital, the private equity investment encompasses hands-on application of skills, expertise and
strategic vision to the privately owned companies. The investment is often realised through flotation
on the public markets.

Private equity investments take the form of any security that has an equity participation feature.

The most common forms are ordinary shares, preference shares and subordinated debt
with conversion privileges or warrants.

In general investors invest in private equity because the risk-adjusted returns on private equity are
expected to be higher than that on other investments and there are potential diversification
benefits.

The principal ways of investing in private equity are as follows:

• Indirectly through a new private equity fund

• Indirectly through a private equity funds of funds, which is a private equity fund that invests in
other private equity funds
• Directly through in a private equity transaction
• Through a secondary purchase of an existing private equity interest.

The key characteristics of private equity are as follows:

• Private equity investments are privately held as opposed to publicly traded.

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• Private equity investment entails active involvement in identifying the investment, negotiating and
structuring the transaction and monitoring the company once the investment is made. This often
requires serving as a board member of the company.

• Private equity investments are not intended to be held indefinitely. Generally, alternative exit
strategies are evaluated at the time the initial investment in the company is made. One such
strategy would be to take the company public and sell the shares into the public market.

• Private equity investments are high risk and high reward. Private equity investors seek a high
return on their capital when the company prospers as they risk losing most, if not all, of their
investment if the company fails.

11.16 Collectibles

Collectors may collect for profit or the joy of collecting. Collectibles include stamps, coins, jewelry,
art, antiques, books and even Barbie dolls and toy soldiers.

Illiquidity adds to the costs of collectibles i.e., it is difficult to find a buyer at short notice, finding a
buyer who will pay the right price takes time. In addition the costs of buying and selling diminish
profits. These costs include commission, storage, insurance, packaging and shipping.

Real assets such as collectibles and real estate are highly regarded as hedges against inflation.