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Unit trust: An investment alternative

31 October 2016 12:00 am - 0     - {{hitsCtrl.values.hits}}


What is a unit trust?
It is a pool of funds collected from many investors with an objective of investing these funds in various types of assets in order to provide a return to the investors. Investors are not expected to invest a particular sum of money; they can invest whatever amount they are comfortable with. 

What is the necessity to invest in a unit trust when people can directly make investments?
In a unit trust, funds collected from many investors are invested by a professional fund manager. These fund managers have a wealth of knowledge and experience and they could select the best investments available in order to provide an attractive return to the investors. Investments are not confined to just savings or fixed deposits, it comprises various types of fixed income securities and equity securities. One needs to have a thorough knowledge when investing in these different types of securities as some of them involve very high risk. So, by investing in unit trusts, an investor gets an opportunity to earn a return from various types of securities or instruments unfamiliar to him or her.

Who are the parties involved in a unit trust?
In a unit trust, you will find a fund management company (FMC), a trustee and the investors, who are called ‘unit holders’. 

What is the role of the fund FMC in a unit trust?
The FMC plays a major role in the unit trust. Primarily, it obtains a licence from the Securities and Exchange Commission of Sri Lanka (SEC) to operate the unit trust. Having obtained the licence, it starts looking for investors who are willing to invest in the unit trust. In other words, it does the marketing function of promoting the unit trust among prospective investors. Secondly, the FMC takes investment decisions as to where the funds raised from the investors should be invested. Thirdly, the FMC is responsible for maintaining accounts and a register of all investors.

Can anyone start an FMC?
In order to start a FMC, one needs to have the minimum capital required by the regulator (SEC) and sufficient number of people with relevant qualification and experience to run an FMC. 

Who can be a trustee and what is the role played by the trustee in a unit trust?
A trustee has to be an independent financial institution with good financial standing and reputation. The trustee must have the systems and people in place to operate the unit trust. In a unit trust, the trustee plays an important role. The main role of the trustee is to protect the interests of the investors who have invested their money in the unit trusts. In order to fulfil the above role, all funds collected from the investors (unit holders) should be under the custody of the trustee. That means the FMC needs to send all the funds collected from the investors to the trustee. 

As we mentioned earlier, the FMC will be making the investment decisions as to where these funds should be invested. As the funds are with the trustee, the FMC conveys all investment decisions taken by it to the trustee in order to disburse the funds to such investments. The trustee will disburse the funds to such investments only if those investments are in conformity with the objectives of the fund. In this way, the trustee ensures that funds collected from the investors are not misused in any way and it is utilized only to fulfil the purpose for which it was collected. 

What are the rules and regulations that govern the unit trusts?
The SEC Act, Unit Trust Code, Trust Deed, Explanatory Memorandum and any directives issued by the SEC. The provisions of the SEC Act and Unit Trust Code govern all unit trusts that operate in Sri Lanka. In addition, there is a trust deed for every unit trust signed by the FMC and the trustee. This specifies every aspect of the unit trust and how it should be operated. The trust deed will state the responsibilities of the FMC and the trustee, the rights of the unit holders, permitted and prohibited investments, how units are created and redeemed, how the income is distributed to the unit holders, etc. Investors can always request for a copy of the trust deed from the FMC. The trustee will ensure that the operation of the unit trust conforms to all the provisions of the SEC Act, Unit Trust Code and trust deed. 

The explanatory memorandum is a simplified version of the trust deed. This will give the investors a general idea about the unit trust fund. It will specify the objective of the fund, the risk and return of the fund, the types of assets the fund will invest in, the fees and charges levied by the FMC and trustee, the frequency of the dividend distribution, how units are created and redeemed, etc. 
In addition to the above, the SEC issues directives to the FMC and trustee as and when the necessity arises for such directives. 

Can the unit trust meet my need?
The needs of the investors could be diverse. One investor may want to receive a regular income from his investment, another does not require a regular income but wants to grow his investments and yet another may require a regular income as well as growth. The unit trusts can fulfil all these needs through an array of unit trust funds in operation. We will look at the different types of unit trust available in the market in detail to clearly understand the types of unit trust that may meet your need.
The two main classifications of unit trust funds are income funds and equity funds. 

Income funds
The main objective of income funds is to provide a regular income (return) to the unit holders. Hence, these types of unit trusts will invest their funds in different types of fixed income securities that provide a definite income. These securities may include, fixed deposits, treasury bills, treasury bonds, debentures, commercial papers, securitised papers and repurchase agreements. These instruments carry varying degrees of risk. For example, the fixed deposit that you place with a bank will carry a lower risk as against a fixed deposit placed with a finance company. Accordingly, the finance company will offer a higher rate of interest for fixed deposits in order to compensate for the higher risk associated with it compared to the bank. 

Similarly, a treasury bill may provide you a lower return compared to fixed deposit as it has no default risk, it is guaranteed by the Government of Sri Lanka. If you take a treasury bond, it provides you a higher return than the treasury bill because the treasury bond is a long-term instrument ranging from two to 30 years, whilst the treasury bill has a maturity ranging from three months to 12 months. Although the treasury bond too carries the guarantee of the Government of Sri Lanka, there is a possibility that the price of the treasury bond may move up or down during the tenure of the bond due to fluctuations in the interest rate. This is perceived as risky and hence it provides a higher return than the treasury bills.  

When it comes to debentures, commercial papers and securitised papers, these are issued by companies and carry a default risk. That means the companies that borrow funds from investors by issuing these instruments may fail to honour their obligations. Hence, these instruments carry a higher risk compared to fixed deposits, T-bills and T-bonds and provide a higher return. 
Within the income fund category, the FMCs have structured different types of funds based on the instruments and the tenure of the instruments. For example, there are Funds called ‘gilt edged funds’, which invest only in government securities such as T-bills, T-bonds and repurchase agreements. There is another category of income fund called ‘money market funds’, which invest only in short-term investments with maturity of less than one year. 
Investors can therefore select a suitable income fund that meets their risk profile and return requirements. 

Equity funds
The main objective of equity funds is to provide a growth in the value of investments in the medium to long term. The equity funds invest in the shares of the companies listed in the Colombo Stock Exchange.  Investments in equity securities carry a very high risk as the price of the securities fluctuate on a daily basis based on the demand and supply of such securities in the market. FMC generally carry out a thorough research on the companies in order to identify shares that are undervalued. 
When you make an investment in an undervalued share the possibility is there for you to make a significant capital gain in the medium to long term when the price of the share goes up in the market. When the performance (profitability) of the company improves, the demand for that share will improve in the market and the share price will increase. Further, the FMC continuously monitors the factors that may have an influence on the profitability of the companies in order to decide whether the investment should be retained or disposed. 
Within the equity fund category, the following funds operate: growth funds, balanced funds, indexed funds and sector-specific funds. 

Growth funds
The main objective of the growth fund is to provide a growth to the investor’s money in the medium to long term. This is achieved by investing in shares of the companies with strong growth potentials. As the major part of the investments is made in the shares of the listed companies, these funds carry a very high risk. At the same time, these funds can provide an extra ordinarily high income in the medium to long term. Given the high risk attached to these funds, these are ideally suitable for young investors who are prepared to take a high risk for a higher return. Usually these funds do not pay a regular dividend and investors can sell their investments when the prices go up and realize a capital gain. 
(To be continued next week)

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