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Introduction to collective investments

Introduction to collective investments

Introduction

It is no accident that collective investments have become increasingly popular. They are transparent, well regulated and easy to understand investment vehicles. Furthermore they are well- suited to a wide range of investment objectives.

Unit trusts and exchange traded funds (most of which are registered as both collective investments and listed entities) provide an economical way for investors with relatively small amounts of money to obtain the same professional management and diversification of investment as wealthy individuals or financial institutions.

What is a collective investment?

The definition of a collective investment scheme is a 'scheme, in whatever form, including an open-ended investment company where members of the public are invited to invest money or other assets in a portfolio, and in terms of which two or more investors contribute money and hold a participatory interest in a portfolio of the scheme through shares, units or any other form of participatory interest. The investors share the risk and the benefit of investment in proportion to their participatory interest in a portfolio of a scheme or on any other basis determined in the deed'.

Which legislation governs collective investments?

The Collective Investment Schemes Control Act, Act No. 45 of 2002 regulates the administration, management and sale of collective investments. The 2002 legislation replaced the Unit Trust Control Act of 1965 and makes provision for various types of collective investments, including hedge funds, open ended investment schemes, exchange traded funds and others. It is expected that the long awaited regulations for the sale and administration of hedge funds to retail investors will be published in 2013.

What is the difference between unit trusts and collective investments?

The Collective Investment Schemes Control Act, Act No. 45 of 2002 effectively changed the name of 'unit trusts' to 'collective investment schemes'. The Act refers to 'a participatory interest' in a scheme, as opposed to 'a unit' in a unit trust fund. However, despite the fact that the terminology was changed ten years ago, investors continue to refer to 'units' and 'unit trusts'.

PSG Securities Ltd refers to 'unit trusts' in order to differentiate these investment vehicles from other types of investment also governed by the Collective Investment Schemes Act.

What are the advantages of unit trusts?

Unit trusts offer several major and other potential advantages to investors. The weight attached to each advantage will obviously vary according to different investors and their individual objectives.

They include professional portfolio management, the ability to diversify a portfolio cost effectively, relatively low transaction costs and the ability to buy and sell at will. Unit trust investors are provided with statements of unit holder accounts, information on fund investments and earnings, and quarterly annual reports. Prices of unit trusts are available on a daily basis.

One of the catalysts for the enormous growth in the number of unit trusts over the last ten years was the introduction of Capital Gains Tax. Capital Gains Tax (CGT) was introduced by the Taxation Laws Amendment Act, 2001 that was promulgated on 20 June 2001.This legislation exempted investors in collective investment schemes from CGT within a portfolio. The shares in a unit trust portfolio held over a ten year period, for example, can be bought and sold many times, but CGT is only triggered when the investor sells a unit or units. The CGT is levied on the difference between the 'buy price' and the 'final sell price' of a unit trust in the case of lump sum investments or the average acquisition price in the event of debit order investments.

This tax increased the popularity of collective investments relative to other investment vehicles. Investors in bespoke share portfolios, for example, could be liable for capital gains tax on each trade.

Fund managers of unit trusts are permitted to use a range of sophisticated mechanisms to protect their portfolios in downward markets. These strategies usually fall outside the skill set of small investors. Used judiciously by a fund manager they provide a powerful portfolio management tool.

What are the disadvantages of investing in unit trusts?

The performances of unit trust are not guaranteed, unless they are housed in a policy provided by an insurance company. This means that investors take on the market risk for the performance of the underlying holdings of unit trusts.

It follows that unit trusts should be carefully matched with investor risk appetite, and that unit trust investors should be well informed of the range of potential investment outcomes, particularly in the short term.

What is the legal structure of a unit trust?

Unit trusts were designed to give maximum protection to investors. There are three separate legal entities that jointly take responsibility for the management, sale and safe guarding of collective investments. These three inter-related but legally distinct entities, namely the unit "trust fund", the "trustee" and the "management company" work together to provide protection for investors.

The fund does not have a separate legal personality and can therefore not be declared insolvent. The fund may be discontinued in which case the net proceeds of total assets after realisation are paid into a trust-controlled account. The units in the account are then divided under the authority of the trustees and paid out to the unit holders.

The trust deed : Each unit trust is governed by a trust deed which falls under the authority of the registrar at the Financial Services Board (FSB). The registrar has the authority to inspect the work of the trustee and the manager of the fund. The trust deed is a contract between the trustee and the management company which sets out the relationship between the fund, the management company, the trustee and the unit holders.

It sets out the investment philosophy and mandate to be followed by the fund manager as well as the fees and charges of the unit trust. A fund manager is bound by the mandate set out in the trust ahead of the Association of Savings and Investments South Africa (ASISA) fund classification. If for example the trust deed stipulates that a fund should be 100% invested in South Africa, and the ASISA Domestic Equity General rules permit a fund manager to invest 30% of the portfolio offshore, the trust deed mandate will apply.

The trustees: Each unit trust is legally obliged to have a separate institution as trustee to act as independent arbiter. The trustee acts as a safeguard for the fund's assets against potential mismanagement by the management company. The most recent disputes between trustees and unit holders have concerned trustees not performing their duties with respect to monitoring the mandate of the fund.

All assets of the fund are held in the trustee's name and it is the trustees who issue certificates to the unit holders (not the managers). The trustees ensure that daily transactions are conducted in accordance with the trust deed and that the investment aim is adhered to. If the trustees have any suspicion that the manager or management company is not acting in the unit holders' interests, they have the power to replace management.

The management company: The management company is a separate legal personality that acts as an agent on behalf of unit holders. The manager is responsible for all aspects of the management of the fund, including marketing, creating and selling units, repurchasing units, keeping records and making investment decisions. The management company is reimbursed for its professional portfolio management services by charging administration (service) fees and portfolio management fees as stipulated in the trust deed.

The management company responsible for the investment and administration of the unit trust must be a public company with issued share capital and non-distributable reserves of at least R2 million. The management company must be registered with the executive officer of the FSB before it may commence operations. Although a management company may have more than one unit portfolio under its control, each portfolio must be approved by the FSB.

What are the rules governing foreign domiciled unit trusts?

If foreign-based unit trust managers wish to solicit business from South Africans they have to apply to the Financial Services Board (FSB) to be registered and approved.

Any person who solicits business for a foreign domiciled scheme that is not registered is guilty of an offence and is liable for a fine and or imprisonment.

The words ' solicit business' are important. South African investors are free to buy any foreign domiciled unit trusts they wish; however only those registered according the rules and guidelines of the FSB may be promoted, marketed and advertised in South Africa.

How does a unit trust work?

Owners of unit trust are unit holders in a fund that in turn invests the money of the fund in a range of assets, including shares, bonds (gilts) and/or money market instruments, depending on the mandate of the fund. A professional portfolio manager makes the decisions of which investments to buy and which to sell, according to the mandate and risk level of the fund as described in the trust deed.

The pool of funds is known as the fund's portfolio. Unit trusts may only invest in listed securities or in derivative instruments in the manner and on the conditions prescribed by the registrar.

The fund is then divided into identical units, each with the same value. An investor in unit trusts becomes an owner of units in the fund just as he or she might own ordinary shares in a listed company. The value of each unit reflects the combined value of the entities in the portfolio, plus any performance of the underlying investments from the previous working day, less allowable administration expenses. See more on allowable expenses below.

Unit trusts are 'open ended'. This means that new units for purchase by the public are created by the management company on an ongoing basis. This is in contrast to a listed company or investment trust which has a fixed number of shares in issue. When an investor buys shares in a listed company, the process of buying requires a willing seller, selling at an agreed price. Conversely, a unit trust investor buys units from the management company.

When new investors invest in a unit trust, more units are issued and added to the fund. Fund managers have to manage their fund's assets according to set rules. Two rules that apply to all unit trusts are that fund managers may not be sold short, (but they can short an index) and they may not borrow money to buy shares.

Investors in unit trusts share in the fund's gains, losses, income and expenses on a proportional basis.

The value of each unit within a unit trust can be calculated by dividing the value of the portfolio by the number of units that have been issued. The Net Asset Value of the portfolio is the market value of investments, plus cash held, dividends accrued and interest accrued less the liabilities due by the fund. The permitted liabilities include actual costs incurred by the trust itself, and not costs of the management company.

Management company costs are paid for by way of the annual management fee, which is calculated separately from the Net Asset Value of the portfolio. Under the rules of the Unit Trust Control Act, unit trust management companies were prohibited from selling units to pay their fees, but under the Collective Investment Scheme Act (CISCA) rules, fees can be taken from the portfolio.

Managers of unit trusts are permitted to loan their scrip (proof of share ownership) to other fund managers for a fee. As the shares are the property of investors, fees generated in this way remain the property of the fund and are treated as income.

What happens to the income generated by unit trusts?

All money received by the unit trust as dividends from ordinary shares held in its portfolio, fees generated by scrip lending or as interest earned on its holdings of cash and other interest bearing assets is either paid out to unit holders as interest or dividends or reinvested in the fund, according to the wishes of the unit trust investor.

Each unit holder receives a payout proportional to the number of units owned. The relationship between the unit price and the dividend is known as the 'yield' and noted as a distribution on unit holder statements. The distribution is calculated by dividing the total dividends paid over the past year into the latest unit price.

The PSG Securities Ltd system displays dividends and interest together as 'interest' but investor accounts separate income derived from shares (dividends) and income derived from cash yields (interest) as income from these different sources is treated differently by the South African Revenue Service.

PSG Securities Ltd and PSG Asset Management Administration Services, like most Linked Investment Service Providers re-invest all interest and dividends paid by management companies into client accounts on a proportional basis. If clients wish to receive the income in cash, they simply sell the equivalent number of units.

Are unit trusts guaranteed?

Under normal circumstances, no. Performances of stand-alone unit trusts are not guaranteed. Investors in unit trusts take on the market risk associated with the investment objective of the unit trust. Most market risk is ameliorated or reduced over time.

However, some asset management companies (those with an insurance license) sell 'insurance' or 'guarantees' on unit trusts. The most common vehicle for this is the endowment policy. In simple terms, investors pay a premium over and above the Net Asset Value of the unit trust for a guaranteed pay out over a pre-agreed timeframe. In such cases the insurer may impose contractual conditions that commit investors to paying a recurring premium for a predetermined period, normally a minimum of five years.

Are there any investment restrictions that apply to all unit trusts?

In terms of the Collective Investment Schemes Control Act (CISCA):

  • Unit trust funds are not allowed to invest more than 10% in the shares of unlisted companies.
  • They are also not permitted a weighting of more than 5% in any one listed share, unless
    * the market capitalisation of the company concerned is in excess of R2 billion.
    * the company concerned has a weighting of more than 5% in the index against which that the unit trust is benchmarked.
  • Unit trusts fund managers may not borrow money to invest; neither may they short the market (sell shares they do not own) except in the case of shorting indices as described below.

Since November 1993 fund managers have been permitted to hedge up to 20% of their portfolios against a stock market decline by selling futures against the portfolio. They may also buy options in anticipation of a stock market rise, should they decide not to commit the full costs of the share investment when making a buy decision.

How are unit trusts classified?

The Association of Savings and Investments South Africa (ASISA) is the industry body which assists the Financial Services Board with the regulation of the industry. ASISA (and its predecessor the Association of Collective Investments) has designed a classification system to help investors choose funds and to enable industry players to compete for industry awards on even terms.

The rules for the classification of unit trusts are constantly being tweaked and modified by the industry body. For an up to date version, please consult the industry website: www.asisa.co.za. The classification system described below has been in place for a number of years. However, ASISA has announced that a new classification system will be introduced with effect from January 2013.

Before January 2013, the classification system described below applies.

Note that the ASISA groups funds by objective and mandate and not by strategy or investment style. For example, a fund with a mandate to invest in the Domestic Equity General category could be an index fund, and exchange traded fund, an actively managed fund or a fund of funds.

First level: Geographic classification

In the first instance, investors must decide whether they would like to invest in domestic assets, foreign domiciled assets or a combination of the two

Domestic Funds must invest at least 70% of their assets in South African investment markets at all times.

Worldwide Funds invest in both South African and foreign markets. There are no minimums set for either domestic or foreign assets.

Foreign Funds invest at least 85% of their assets outside South Africa at all times.

Second level: Asset type

Each of the geographic sectors above is further divided according to the nature of the assets they invest in. Asset types include equities, fixed interest investments, real estate and 'asset allocation' a category that spans the first three categories.

Third level: Sub-categories of asset types

At the third level, there are nine types of equity portfolios, including General, Growth, Value, Large cap, Smaller companies, Resources & Basic Industries sector, Financial sector, Industrial and Varied Specialist.

Equity portfolios are collective investment portfolios that invest predominantly in shares listed on the Johannesburg Stock Exchange. These portfolios invest a minimum of 75% of the market value of the portfolios in equities at all times and generally seek maximum capital appreciation as their primary goal. All equity and derivative investments must conform 100% to the defined investment requirement of each category.

However, a minimum of 80% of the equity portfolio must, at all times, be invested in the JSE Securities Exchange South Africa sector/s as defined by the category, and a maximum of 20% of the equity portfolio may be invested outside the defined JSE Securities Exchange South Africa sector/s provided that these investments comply fully with the category definition.

Equity - General portfolios
These portfolios invest in selected shares across all economic groups and industry sectors of the JSE.

Benchmark: FTSE/JSE All Share Index (J203T)

Equity - Growth portfolios
These portfolios that seek maximum capital appreciation as their primary objective through investment in growth companies. Growth companies can be defined as those whose earnings are on or are anticipated to enter a strong and sustainable upward trend and typically trade on high price to earnings ratios (PE ratios). Determination of a company as "growth share" takes into consideration the company's sustainable earnings growth on the basis of a combination of: (a) The 2 year historical earnings growth and (b) 1-year consensus I-Net forecasts.
Benchmark: FTSE/JSE Style All Share Growth (J331T)

Equity - Value portfolios
The portfolios seek out "value" situations by typically investing in shares with low relative PE ratios as well as shares that are trading at a discount to their net asset value. These portfolios frequently offer a higher than FTSE/JSE All Share Index average level of income.
Determination of a share as "value share" takes into consideration: The current PE trading at a discount to the average PE of the market and the dividend yield of the company significantly exceeding the dividend yield of the market.
Benchmark: FTSE/JSE Style All Share Value (J330T)

Equity - Large cap portfolios
These portfolios invest in shares which fall within the top 40 JSE Securities Exchange South Africa listed shares ranked by market capitalisation.
Benchmark: FTSE/JSE Top 40 Index (J200T)

Equity - Smaller companies portfolios
These portfolios invest in companies in the initial phase of their life. New investment by the portfolios are restricted to fledgling, small and mid-cap shares only and at least 75% of the portfolio will be invested in fledgling, small and mid cap shares at all times.
Benchmark: FTSE/JSE Mid Cap Index (J201)

Equity - Resources and basic industries portfolios
These portfolios invest in companies whose principal business operations involve the exploration, mining, distribution and processing of metals, minerals, energy, chemicals, forestry and other agricultural and natural resources or where at least 50% of their earnings are derived from such business activities and excludes service providers to these companies.
These portfolios invest primarily in securities listed in the FTSE/JSE Resources and Basic Industries economic groups and may be more volatile than portfolios that are diversified across a wider range of FTSE / JSE economic groups.
Benchmark: FTSE/JSE Mining Index (J177T)

Equity - Financial portfolios
These portfolios invest in shares of financial services companies including banks, insurance companies, brokerage firms and other companies whose principal business operations involve the provision of various financial service or where at least 50% of their earnings
Benchmark: FTSE/JSE Financials Index (J580T)

Equity - Industrial portfolios - These portfolios invest in selected industrial companies listed on the JSE Securities Exchange South Africa. Companies listed in the FTSE / JSE Resources and Financial Economic Groups are excluded from the definition of 'industrial' for this purpose.
Benchmark: FTSE/JSE Industrial (J257T)

Equity - Varied specialist portfolios - These portfolios invest in a single Economic Group or Industrial Sector or in companies that share a common theme or activity as defined in their respective mandates. However due to the unique nature of their mandates they cannot be categorised into any of the afore-listed categories. The performance of these portfolios cannot be compared to others in this category. Due to both the nature and focus of these portfolios, they may be more volatile than portfolios that are diversified across the broader market.

Asset Allocation Portfolio

Asset allocation portfolios are divided into six further categories including four designed for retirement investing ( Prudential Low Equity portfolios, Prudential Medium Equity portfolios, Prudential High Equity portfolios and Prudential Variable Equity portfolios), Flexible portfolios and Targeted Absolute and Real Return portfolios.

Asset Allocation - Prudential Low Equity portfolios
These portfolios invest in a spectrum of investments in the equity, bond, money, or property markets. The portfolios have an effective equity exposure (including international equity) below 40% at all times.

Asset Allocation - Prudential Medium Equity portfolios
These portfolios invest in a spectrum of investments in the equity, bond, money, or property markets. These portfolios have an effective equity exposure (including international equity) between 40% and 65% at all times.

Asset Allocation - Prudential High Equity portfolios
These portfolios invest in a spectrum of investments in the equity, bond, money, or property markets. These portfolios have an effective equity exposure (including international equity) above 60% at all times.

Asset Allocation - Prudential Variable Equity portfolios
These portfolios invest in a spectrum of investments in the equity, bond, money, or property markets. These portfolios have an effective equity exposure (including international equity) between 0% and 75% at all times.

Asset Allocation - Flexible portfolios
These portfolios invest in a flexible combination of investments in the equity, bond, money and property markets. These portfolios are often aggressively managed with assets being shifted between the various markets and asset classes to reflect changing economic and market conditions to maximise total returns.

Domestic - Asset Allocation - Targeted Absolute and Real portfolios
These portfolios invest in a combination of equity, bond, money market, property or derivative instruments. The underlying risk and return objectives of individual portfolios may vary as dictated by each portfolios mandate and stated investment objective and strategy. These portfolios tend to display below average short-term volatility and are mandated to manage towards a predetermined, explicit benchmark. These portfolios may not conform to legislation governing retirement portfolios, (Regulation 28 of the Pension Funds Act) and do not necessarily offer capital or performance guarantees.

Fixed Interest Portfolios
There are four types of Fixed Interest Portfolios including funds with special mandates to invest in bonds, Income portfolios, Money market portfolios and 'Varied Specialist', a category that invests across the yield spectrum.

Fixed Interest - Bond portfolios
These portfolios invest in bonds, fixed deposits and other interest-bearing securities. These portfolios may invest in short, intermediate and long-dated securities. The composition of the underlying investments is actively managed and will change over time to reflect the manager's assessment of interest rate trends. These portfolios offer the potential for capital growth, together with a regular and high level of income.
Benchmark: BEASSA All Bond Index

Fixed Interest - Income portfolios
These portfolios invest in bonds, fixed deposits and other interest earning securities which have a fixed maturity date and either have a predetermined cash flow profile or are linked to benchmark yields, but excluding any equities. To provide relative capital stability, the average modified duration of the underlying assets is limited to a maximum of two years. These portfolios are less volatile and are characterised by a regular and high level of income.
Benchmark: BEASSA All Bond 1 to 3 year split Index

Fixed Interest - Money market portfolios
These portfolios seek to maximise interest income, preserve the portfolio's capital and provide immediate liquidity. This is achieved by investing in money market instruments with a maturity of less than one year while the average maturity of the underlying assets may not exceed 90 days. The portfolios are typically characterised as short-term, highly liquid vehicles.
Benchmark: Money Market Index

Fixed Interest - Varied Specialist portfolios
These portfolios invests in bonds, fixed deposits, structured money market instruments, listed debentures and other high yielding securities, provided that not more than 5% may be invested in ordinary equities. They seek to maximise income with either preservation and stability of capital, or an offer of potential growth of capital. The underlying risk and return objectives of individual portfolios may vary as dictated by each portfolios mandate and stated investment objective and strategy. However, in terms of the investment mandates of these portfolios, they fall outside the existing sub-categories of the Fixed Interest sector. Should it be considered appropriate, where five or more portfolios have a similar focus, a new category will be created and the funds transferred.

Real Estate Portfolios
There is only one type of fund mandated to invest in the Real Estate sector; the Real Estate - General category.

The Real Estate
General portfolios invest in listed property shares, collective investment schemes in property and property loan stock. The objective of these portfolios is to provide high levels of income and long-term capital appreciation. Due to liquidity constraints in the Real Estate sector on the exchange these portfolios must maintain a minimum effective exposure to real estate securities of 50% and may include other high yielding fixed interest and other securities from time to time.
Benchmark: FTSE/JSE SA Listed Property Index (J253T)

After January 2013

After January 2013 investors will be able to choose from South African (previously Domestic), Worldwide, Global (previously Foreign) and Regional (new category) portfolios. Each of these categories will be sub-categorised into Equity, Multi Asset (previously Asset Allocation), Interest Bearing (previously Fixed Interest), and Real Estate portfolios.

The third tier of classification will categorise funds according to their main investment focus, for example Equity - Large Cap, Multi Asset - High Equity, Interest Bearing - Money Market, or Real Estate - General.

In terms of the new ASISA Fund Classification Standard, fund names must be a true reflection of the mandate of the fund. For example:

  • Fund of funds must have the wording "fund of funds" included in their names.
  • Index portfolios must have the word "index" or "tracker" included in their names.
  • Money market portfolios must have the wording "money market" in their names.
  • Feeder portfolios must have the wording "feeder funds" in their names.
  • Portfolios may only use the word "institutional" in their names if they are exclusively available to retirement funds, long-term insurers, investment managers or collective investment schemes.

DIFFERENT TYPES OF UNIT TRUSTS

  • Funds of Funds
  • Multi-managed funds
  • Index funds
  • Feeder funds
  • Shari'ah compliant funds
  • White label funds
  • Hedge funds
  • Exchange Traded Funds
What are Funds of Funds?

A 'Fund of Funds' is a unit trust fund that invests in other unit trust funds. Current rules stipulate that fund managers may invest in other unit trust funds or exchange traded funds up to 80% of the first portfolio. The maximum exposure of a fund to any underlying fund may not exceed 20% of the market value of the first portfolio. If a fund manager elects to invest in foreign portfolios, the underlying foreign funds have to comply with certain restrictions. In addition, the stated investment portfolio of the fund must provide for the inclusion of other unit trusts or exchange traded funds.

Funds of funds have a range of advantages. When the timing of an investment decision is critical, the fund manager of a unit trust fund who wishes to sell shares in the resource sector and buy small caps, for example, might find this trade easier and quicker using exchange traded funds and other unit trusts.

Funds of funds fund managers are able to trade underlying unit trusts without incurring capital gains tax on behalf of clients.

In the past, the downside of funds of funds was the opaque cost structure. It was very difficult for investors to get an accurate picture of the costs. However, since the introduction of the 'Total expense ratio' many of the more expensive, lower performing fund of funds have been closed down, leaving the more robust, competitively priced funds of funds.

'In-house' fund of funds aim to keep costs low by combining specialist unit trusts managing different asset groups from one asset management company in one fund.

What are multi-managed funds?

Multi managed funds are a sub-type of fund of funds. Multi-manager funds transcend the ASISA classification system in the same way as Funds of Funds. The theory of multi-management has its roots in analysis that shows that different fund managers seeking the same outcomes perform differently under different market conditions. Most multi-managers claim that the process of multi-management decreases risk and improves performance over the longer term.

On the down side, investors should establish that the cost of reduced risk does not outweigh the benefit of possible out performance. Some multi-managers seek access to either unit trusts with institutional price structures, or segregated funds in an effort to control costs. Like funds of funds, multi managed funds do not incur capital gains tax when trading unit trusts within a portfolio.

What are index funds?

Index funds are mathematically driven funds that seek to replicate or track the performance of a pre-selected index. Obviously, they are very cost effective as no money is spent on researching individual shares and other fund manager expenses. Some index funds have lower annual fees than exchange traded funds.

The rationale behind index funds is that the performance of a growing economy is usually correlated with upward trending stock markets. However, in developed markets, very few active fund managers outperform an upward trending market. Often quoted figures suggest that only 25% of United States fund managers outperform the S&P 500.

The difficulty is that not all markets and indices are the same. Generally, one could make a case that traditional equity markets in the larger developed countries are evenly weighted across different sectors. This is not the case in many emerging economies such as South Africa's. In South Africa between 35% and 40% of the total value of listed companies is connected to the resource sector.

It follows that an investor who chooses to invest in an index fund that tracks the FTSE/JSE All Share Index would by definition be inordinately exposed to the resource sector. To counteract this, many new index funds have been designed around more evenly weighted indices.

What are Shari'ah compliant funds?

Shari'ah compliant funds are structured in accordance with Islamic law. There are a number of registered Shari'ah compliant unit trusts in South Africa servicing the needs of our Muslim population.

Shari'ah compliant equity unit trusts are prohibited from investing in businesses associated with the production and sales of alcoholic beverages, pork products, tobacco, gambling and pornography.

The payment or receipt of interest, debt, and investing in highly leveraged companies is not permitted. Funds are not permitted to pay a fixed or guaranteed return on capital. Islamic finance relies on sharing the ownership of the assets and therefore risk and profit/loss.

Board Notice 80 of 2012, gazetted by the Financial Services Board in May 2012 extended the universe of collective investments to include more Shari'ah compliant instruments.

The ASISA classification system provides for the separate classification of funds with restricted mandates, such as Shari'ah compliant funds and social responsibility funds, under the catch-all category 'varied specialist'.

However many of the fund managers and /or unit trust management companies that administer some of funds with restricted mandates sometimes choose to be included in the general equity category. This is because they wish to demonstrate that fund performance does not necessarily suffer due to a relatively more restricted mandate.

What are 'white label' funds?

White labelling is a practice where a third party, usually a new asset manager who does not have the capacity or administration capacity to register a Collective Investment Scheme with the Financial Services Board requests a registered CIS manager to register a portfolio in the name of the third party.

In return for a fee, the 'host' CIS contracts to do the administration and legal compliance for the start-up fund manager.

White label funds enjoy a wide range of performances; some are at the bottom of the rankings while others are perennial prize winners. To date, the FSB has been tolerant of white-labelling unit trust portfolios, regarding the practice as a mechanism to enter the market.

MET Collective Investments is the biggest facilitator of white label funds in South Africa, and PSG Securities Ltd has a number of this company's white label funds on our platform.

What are hedge funds?

Hedge funds use a wide range of trading strategies to hedge or protect the assets in their portfolios from downside risk. Hedge funds are regulated in terms of the Collective Investment Schemes Act, the same legislation that regulates unit trusts. For many years there has been a stand-off between regulators and the proponents of hedge funds on whether or not they should be made available to the retail public.

ASISA has announced that draft legislation on the sale and advertising of retail hedge funds will be released for public comment in the first quarter of 2013. It is anticipated that hedge funds will be classified as either 'light' (transparent and deemed fit for retail consumption) or 'heavy' (and reserved for experienced, financially literate traders).

What are exchange traded funds?

Exchange traded funds or ETFs pool investor funds in cost-effective instruments that give investors access to a large basket of underlying holdings, which can include equities, interest bearing securities or physical commodities such as gold or wheat. They are generally mandated to track a well-known index but in the case of 'smart ETFs' track composite indices.

All exchange traded funds are listed instruments, and most are also registered as collective investments. This means that investors can either buy them as shares or through investment accounts, as a collective investment. PSG Securities Ltd offers investors both methods of investing in ETFs.

How do you buy unit trusts?

There are three different ways you can buy unit trusts. Investors should find the distribution point that best suits their needs.

You can invest directly through a unit trust management company such as PSG Asset Management. This works well if you restrict your choice of funds to one unit trust management company. It can be more cost effective to approach a unit trust company directly. However not all unit trust management companies have the capacity to deal with members of the public and they may refer you to a Linked Investment Service Provider or to a financial adviser. In the case of the PSG suite of companies, investors are able to invest directly with PSG Asset Management. PSG Asset Management manages a full range of unit trusts.

The second option would be to approach a financial adviser. Most financial advisers use Linked Investment Service Providers to manage their clients' accounts. Many people are reluctant to make investment decisions without the guidance of financial advisers. PSG Konsult, the parent company of PSG Securities Ltd has over 300 advisers geographically spread across South Africa who have access to a wide range of unit trusts. Investors who choose this route would obviously be liable for broker's fees, which would include an ongoing trailer fee.

The third option would be to invest directly with a unit trust platform such as PSG Securities Ltd . This route is a good choice for those investors who wish to invest in a range of unit trusts managed by different asset management companies, as well as those who feel qualified to make their own choice of unit trust.

One of the benefits of using PSG Securities Ltd is that investors get consolidated unit trust statements which calculate consolidated returns across the different unit trusts for Capital Gains Tax purposes.

One of the often cited disadvantages of using a platform is the extra level of costs incurred. However PSG Securities Ltd has negotiated reduced annual fees, or rebates, with a number of leading unit trust management companies which ensure that the costs of the platform fees are reduced and in some cases, negated entirely. The rebated fees are displayed on our Portfolio Selection List.

Which types of unit trusts are designed for different types of investors?


The graph shows the relative performance of equities, bonds and cash in South Africa between 1959 and 2012. Source: PSG Asset Management.

There are a few points to notice about this graph.

  • Over the longer term, equities have outperformed both bonds and cash by significant margins.
  • However, readers should note that the equity line, the blue line is more jagged than either the red bond line or the green cash line. This indicates that the performance of equities has been more volatile than bonds or cash between 1959 and 2012.
  • It must be pointed out that although equities have outperformed both bonds and cash for the past 50 years, there is no certainty that this outperformance will continue.
  • Current wisdom has it that investors should start investing in equities as soon as possible when they start earning a salary, and remain invested, reinvesting dividends as long as possible. As investors retire, they have (theoretically) built their capital assets to such a level that they are able to live off the dividends of their portfolios, without having to draw on the capital.
  • The flaw in this argument is that most investors have other financial obligations, including a home mortgage, school fees and medical expenses. Most people leave saving too late. They then find it difficult to catch up. The later investors start investing, the less the time frame available to them, and the more vulnerable they are to the normal rises and falls of the stock markets.

It follows that the later investors start investing, the more cautious they have to be with their limited 'nest eggs'.


What is it?

Who would be ideal investors?

Equity

Equity based fund invest in companies on the JSE or other stock exchanges around the world.
Over the last 50 years equities have been the most volatile, but the highest performing asset class in many countries. This is not to say that this trend will continue. Japanese investors have seen 20 years of sideways trending equity markets.

Ideally, if you started investing 100% of your savings in equities from the day of your first pay check, you would not need to dabble with any other type of investment. At retirement age, the equities would produce dividends, which would allow you to live off the income, and not the capital.
Younger investors should aim to have as much of their savings in the equity markets as they possibly can.

Interest bearing

Interest bearing investments include bonds, property and other 'fixed interest' securities. It is vital that the yield provided by interest bearing investments, less costs, is higher than the rate of inflation.

The rule of thumb used to be that investors should transfer 'risky' equity investments to 'safe' interest bearing investments as they got older. The logic behind this was that older investors would have to preserve their capital, and could not afford to lose money in the periodic downturns of the stock exchange. However, the fear of loss of assets has to be balanced with increasing longevity.

Property or real estate unit trusts

Investments in listed property could be described as 'hybrid investments' as they produce both capital growth, like equities, and income, like interest bearing assets, in different proportions through the property cycle. Up till recently, pension funds have been the major investors in property. However, as the listed property sector on the JSE has become more robust, and offered more choice, it has become more attractive to clients seeking both income and capital growth.

Property unit trusts represent a relatively small proportion of the assets under management in the unit trust industry as whole. However, property unit trusts have proved to be relative outperformers over the last five years and are attracting a growing number of investors.

Multi-asset unit trusts

Multi-asset unit trusts have become the biggest category of unit trusts. 'Prudential funds' which are a sub-set of multi-asset unit trust specifically designed for funds earmarked for retirement, are now 25% of the assets invested in unit trusts, up from 17% in 2006.

Multi-asset class unit trusts invest in a range of asset types, including equities, property and interest bearing assets, depending on the mandate of the fund. More aggressive funds have a higher proportion of their portfolios allocated to equity, while less aggressive funds have a higher percentage allocated to interest bearing assets

The table above should be understood as a rough guide to the mandates and ideal investors in different types of unit trusts. It should not be construed or understood as personal advice.

Can you combine unit trust investments with investments in exchange traded funds?

The 'core and satellite' investment philosophy, designed to extract the maximum performance out of a range of investors at the lowest possible cost, is becoming more popular with investors on PSG Securities Ltd .

The rationale of this approach is to put the bulk of an investment into a low cost, passive investment such as an index fund or exchange traded fund, and then add to the portfolio with 'satellite' investments designed to add performance.

PSG Securities Ltd is very well placed to help investors with this strategy. PSG Securities Ltd sells a wide range of investment vehicles including shares, unit trusts and exchange traded funds as well as financial products aimed at more sophisticated investors. Many Linked Investment Service Providers are not in favour of selling exchange traded funds because they do not offer the same commission structures as unit trusts.

Lump sums or debit order?

Unit trust investors can choose whether they wish to save up lump sum investments to invest or invest a recurring amount every month by debit order. Investors with a large lump sum could also opt to enter the market in a number of stages. This strategy would be particularly advised during periods of market volatility.

Debit order investments are very popular for good reasons. Debit orders encourage a saving habit and discipline, which is essential for good investing. Secondly, debit orders that invest across and through an investment cycle benefit from rand cost averaging. By virtue of a standing arrangement, investors cut themselves off from the prevailing market sentiment.

Debit order investors thus invest when the market is low (when other investors have been scared off by bad news), when the market is fairly priced as well as when the market is overpriced. Research has shown that this strategy benefits investors in the longer term.

What taxes are payable on unit trust investments?

Unit trusts fall into two categories

  • Category 1. Those that are 'voluntary' investments, where investors are free to buy and sell when they wish.
  • Category 2. Those that are housed within retirement portfolios

The tax treatment of unit trusts depends on which of the two categories applies.

Category 1

Most voluntary unit trust investors are liable for income tax on the interest paid out by unit trusts, dividend tax paid on dividends received and capital gains tax if the unit trust is sold for a profit.

Income tax on interest: Voluntary investors are liable for tax on interest earned by unit trust investments, payable at their marginal rate of tax. The exemption on interest income for the 2012/13 tax year was R 22 800 for tax payers under the age of 65 and the first R 33 000 of interest income for tax payers over the age of 65.

Interest is exempt where earned by non-residents who are physically absent from South Africa for 183 days or more per annum and who are not carrying on business in South Africa.

Dividends tax: With effect from 1 April 2012, where an individual holds less than 10% of the equity share capital of a foreign company, which distributes a dividend, the dividend will be taxed at a maximum effective rate of 15% as determined by a formula. There are a number of categories of investors who are exempt from dividends tax. These categories include, but are not limited to retirement funds and foreign investors.

Capital gains tax: One of the reasons for the growing popularity of unit trusts is that the buying and selling of the underlying assets by the portfolio manager do not count as 'CGT events' for either Unit Trust Management Company or investors.

Under most circumstances unit trusts investors can defer the sale or transfer of unit trusts to a time which is most tax efficient. Capital gains or losses are incurred under any of the following circumstances:

  • Regular and once-off withdrawals
  • Switches between funds
  • In the event of a fund merger, unit holders in the merging fund are liable for CGT
  • Change of ownership of unit trusts
  • The divorce of an investor if assets jointly owned are sold to divide the proceeds between the two parties
  • Sequestration, emigration or death of an investor (unless provision for units transfer to a surviving spouse have been made)
Calculating your capital gains and losses

The method for the calculation of capital gains tax ain is described in the rules contained in the Eighth Schedule of the Income Tax Act and is determined by calculating the difference between the original cost ('base cost') and the market value of the units at the date of sale. The base cost of an asset is the cost of acquiring it. A capital gain or loss is determined by deducting the base cost from the market value of the units at date of sale. If the unit trusts were acquired before 1 October 2001, the base costs as published by the industry should be used. These prices are available on the ASISA website ( www.asisa.co.za)

For unit trusts acquired on or after 1 October 2001, the actual cost incurred in acquiring the units should be used to calculate the base cost. Industry practice is to make use of the Weighted Average Unit Cost (WAUC) method for the calculation of the base cost.

Any capital gains may be offset against any losses or assessed losses for income tax purposes. Gains in one unit trust can therefore be netted against losses in another. This is one of the reasons for the popularity of using trading platforms like PSG Securities Ltd for the buying and selling of unit trusts. Unit trust platforms are able to calculate the capital gains or losses across different unit trust investments.

Unit holders are permitted to take costs of investment into account when calculating the base cost of units. There are certain costs that may be added to the original cost if they were incurred as expenditure directly related to the acquisition of the assets. Initial costs (levied by either the unit trust management company or the adviser) may be taken into account, but not ongoing costs.

CGT is applicable to offshore investments. Capital gains on offshore investments should be calculated and declared in Rands. Taxpayers are offered a choice; they can either use the average exchange rate over the year to do this, or to use the rate on the day of the purchase or sale. Fluctuations in the exchange rate can therefore be used to best advantage.

Rate of tax

Investors do not pay tax on the total gain in value of the investment. Only 40% of the gain is included in taxable income in the case of a natural person, while 80% of the gain is included in the case of companies, close corporations and trusts. In addition, there is an annual exclusion R40 000. The exclusion amount on death is R300 000.

Type of taxpayer Inclusion rate % Statutory tax rate % Maximum effective rate of tax

Individuals & special trusts

40% 45% 18%

Companies

80% 28% 22.4%

Other trusts

80% 45% 36%

Source: SARS Pocket guide Budget 2017

Category 2

The tax treatment of unit trusts held in retirement portfolios is more favourable than the tax treatment of 'voluntary investments'. Retirement portfolios include all retirement assets held in pension funds, provident funds, preservation funds and retirement annuity funds.

Retirement portfolios are granted tax exemptions on dividend and capital gains tax as well as tax on interest income. Tax levied on interest and property rental income within retirement funds was abolished in 2008.

In the case of dividend tax, the full 10% on dividends is passed on to fund members, where previously STC would have been paid.

What are the advantages of housing unit trusts within a retirement fund structure?

The primary advantages are the favourable tax regime as described above.

In addition, retirement fund savings are ring fenced in the event of insolvency. This means that retirement fund savings cannot be listed as assets in the case of an insolvent estate. However, there are exceptions; a judge may award one party of a divorcing couple half of the benefit of a retirement fund and the South African Revenue Service has the right to attach assets from a retirement fund.

Thirdly, estate law provides for the exemption of retirement assets from an estate for estate duty purposes.

What are the disadvantages of using a retirement fund to house unit trusts?

The government's objective in allowing a favourable tax regime for pension fund savings is to encourage workers to save for their retirement and ultimately pass any savings on to their dependants.

It follows that it would be in the government interest to ensure that the assets in a retirement fund should be invested prudently, and the ultimate beneficiaries should in fact be the workers' dependants. Retirement fund members are required to nominate their beneficiaries and to ensure that this information is kept updated. Retirement fund assets may not be bequeathed to beneficiaries that would not be considered as 'dependants' by the Pension Funds Act.

Retirement fund assets are invested according to Regulation 28 of the Pensions Fund Act, which requires that a maximum of 75% of the portfolio should be invested in equities. In addition, a maximum of 30% can be invested offshore. While these restrictions may be acceptable to most investors most of the time, there are times in the investment cycle where South African assets may be considered 'over-valued'. Similarly, it could be argued that a 20 year old investor would be better advised investing up to 100 % of his or her portfolio in equity assets, and should not be limited to the 75% as stipulated by Regulation 28.

Investors should consider the fact that that a lower tax liability permitted by tax rebates might not necessarily translate into a bigger nest egg at retirement. Further, the risk of 'government prescribed assets' should not be ignored. In recent times, the governments of Spain and Portugal have 'nationalised' pension fund assets to provide markets for government bonds.

Unit trust fees

There are a number of different types of charges associated with investing in unit trusts. Unlike the Unit Trust Control Act of 1947, the Collective Investment Schemes Act of 2002 does not regulate initial, ongoing or administrative fees. However the legislation requires that more disclosure from unit trust management companies, Linked Investment Service Providers and financial advisers is required. All service fees, (initial fees, annual fees, financial adviser fees, performance fees, switching fees) are liable for the VAT at 14%.

Upfront, initial or entry level fees payable to unit trust companies: One of the reasons the Linked Investment Service Providers developed a niche in the unit trust industry was that until fairly recently it was the norm for initial fees of up to 5% (2% for the unit trust company and 3% for the financial adviser) to be levied on every new investment. A new investment was also understood to include the 'reinvestment' of proceeds of unit trusts, interest and dividends. Unit trust management companies have responded to the 'threat' of unit trust platforms by steadily decreasing initial fees.

Upfront, initial or entry level fees payable to financial advisers : Many unit trust companies still rely on financial advisers to sell unit trusts. Fees payable to financial advisers should be agreed between the investor and the adviser. The industry has a 'suggested rate' of no more than 3% for an initial investment. Some financial advisers prefer to discount an initial fee in favour of a higher ongoing fee.

Upfront, initial or entry level fees payable to investment platforms : Most investment platforms, like PSG Securities Ltd, have had a zero initial fee for a number of years. However, some platforms still charge an initial or administrative fee of up to 2%.

Annual fees payable to the asset management company: One of the most consumer-friendly acts of the Association of Collective Investments was the introduction of the Total Expense Ratio (TER) in May 2007.

The objective of the total expense ratio (TER) is to measure of the direct costs involved with managing a unit trust. The TER is updated quarterly and indicates the total value of all the expenses and fees (including taxes) of the daily average value of the unit trust portfolio on a one-year basis, expressed as a percentage. TERs don't have to include trading costs, but some fund managers have chosen to include them in their TERs.

The use of the Total Expense Ratio enabled investors to get an accurate idea of the 'look through' expenses incurred by funds of funds, as well as the impact of performance fees levied by asset management companies.

The Total Expense Ratio is designed to capture the actual expenses paid out for the management of the fund and includes management fees (including performance fees) and VAT, administration costs, custody fees, trustee fees, audit fees, bank charges, other than those charged by an investor's bank and taxes.

The Total Expense Ration excludes fees paid to stockbrokers, initial fees, annual fees paid to a Linked Investment Provider, annual fees payable to the unit trust platform, annual fees paid to a financial adviser and switching fees.

Annual fees payable to the Linked Investment Service Provider: Some unit trust platforms, such as PSG Asset Management Administration Services negotiate volume-based rebates with asset management companies, which are passed on to investors in order to reduce the fee of the platform. PSG Securities Ltd clients also benefit from these reduced administration fees.

Annual fees payable to the unit trust platform: Some companies, such as PSG Securities Ltd and PSG Asset Management Administration Services, separate the administration of unit trusts and the call centre and help line services. Depending on the funds chosen, the combined platform fee ranges from 1.1% to 2.4%. Fees are quoted annually, calculated daily but levied monthly.

Annual fees payable to the financial adviser: As mentioned above, investors contract with investment advisers on their own account. It is in the interests of investors to negotiate competitive ongoing fees. Financial advisers charge between 0.5% and 1.25% per annum for ongoing advice.

Switching fees: Some unit trust management companies and investment platforms levy fees for the switching of funds. PSG Securities Ltd and PSG Asset Management Administration Services do not.

Understanding a unit trust platform or linked investment service provider

A Linked Investment Service Provider is defined a "… linked investment services provider approved in terms of section 4(1) (a) of the Collective Investment Schemes Act, and whose business consists of implementing or capturing, or both, instructions given by an investment manager or by a client in respect of the management of investments on the basis that the LISP holds, purchases or sells such investments in bulk".

Linked Investment Service Providers have to be registered with the Financial Services Board.

Providing choice at a reasonable cost is the primary aim of a unit trust investment platform.

Unit Trust investment platforms act like intermediaries between the investors and the unit trust investment fund providers, offering a simple and cost effective way to manage a range of unit trust investments provided by different asset management companies.

Linked Investment Service Providers therefore offer choice, flexibility and transparent access to a range of underlying funds on one administrative platform in varying degrees.

They also offer consolidated reporting and the ability to switch between underlying funds, construct portfolios conveniently and efficiently.

Conclusion

In 1965 unit trusts were designed as a low-risk way of allowing small investors to invest in the Johannesburg Stock Exchange. Today, there are over 1000 registered unit trusts which invest according to an increasingly complex range mandates. Unit trust investors can use unit trusts to get access to bond markets, the money markets, domestic equities, overseas markets and specific sectors. Unit trust investors have to understand how unit trusts work, why different products exist, and how to minimise their risks.

Copyright © PSG Konsult Ltd (1998-2017), All Rights Reserved. FAIS affiliates of the PSG Konsult Group are authorised financial services providers.