Appendix 12. collective investment

Transcription

1 Appendix 12 Collective investment Collective investment is a complex area, not only for investors and investment professionals, but also for the Compliance Officer. This complexity stems largely from two factors: There are several different types of collective investment vehicle, each with its own structure, modus operandi and suite of operational and regulatory regimes. Collective investment arrangements are vehicles for undertaking investment in another asset. This means that as well as understanding the collective investment structure in question, it is also necessary to have an understanding of the underlying investments in which the scheme is invested. A double dose of information to take on board! This section describes some of the main forms of collective investment vehicle before going on to look at some of the key issues that the Compliance Officer should keep in mind when working in this area of finance. Product Collective investment vehicles Collective investment vehicle characteristics What is a collective Collective investment vehicles may have many different characteristics and investment vehicle? several different structures but all have in common the fact that: the assets of a number of people are pooled together; and the owners of the assets have no day-to-day control over how their pooled assets are managed. Collective investment vehicles may also be referred to as schemes or funds. Purpose? Collective investment schemes are created for a variety of reasons including to: enable expert managers to look after the assets of those less familiar with financial markets; enable investors to gain access to a class of assets that would otherwise be barred from them; enable investors to benefit from economies of scale by pooling a number of small investments into one larger one; reduce the administrative burden on firms looking after the funds of a large number of investors. Who creates collective investment vehicles? Who uses collective investment vehicles? Collective investment schemes are created by a number of different types of entity including: financial services firms creating funds in which members of the public and other institutions can invest; charities who need to manage the funds that have been donated to them; pension schemes needing to manage the contributions that are paid to them; and insurance companies who need to manage the insurance premiums they receive. Almost anyone can invest in a collective investment vehicle although some types are restricted in terms of the type of person who is eligible; child trust funds, for example, are only for children, and hedge funds will generally only be open to experienced (sophisticated), high net worth individuals or institutional investors. 1

2 How does a collective investment vehicle work? Risk profile Regulated status under FSMA (RAO) The mechanics of how each type of collective investment works depends on the type of vehicle that is used, although the basic premise is always the same: funds belonging to a large number of beneficiaries are pooled together and are managed collectively by a third party, as though they were one unit. The risk profile of each collective investment vehicle will depend on various aspects such as: the type of assets in which it invests; the extent to which the fund is diversified; the expertise and ability of the fund manager; whether the fund is regulated or not; general market conditions; and for tradable funds, the liquidity of the investment participations such as units or shares. Most collective investment vehicles are regulated under FSMA, with some notable exceptions, including in-house insurance funds, although clearly insurance itself is subject to its own strict regulatory regime. The FSA draws a distinction between regulated and unregulated funds with regulated funds being deemed the least risky, and suitable for distribution to retail customers. There are four routes for funds to be deemed regulated in the UK: Authorized funds Funds authorized in the UK by the FSA. Recognized funds Funds that have been established outside the UK, but which the FSA considers to offer adequate investor protection. Such funds fall into three categories: o UCITS schemes constituted in an EEA country (s.264 of FSMA); o schemes that are authorized in a designated country or territory, such as Jersey or Bermuda (s.270 of FSMA); or o schemes that are established overseas but which have been individually recognized by the FSA (s.272 of FSMA). It is important to bear in mind that even if a collective investment itself is not regulated by the FSA this does not mean that there is no applicable regulation as the various activities undertaken in relation to the fund, such as fund management and advice, will themselves be regulated. It should also be borne in mind that it is the collective nature of an investment vehicle that determines whether or not it will be a collective investment scheme, not what it invests in. Even vehicles that invest in non-regulated assets such as property or forfaiting instruments will be subject to regulation. This leads to what can appear to be an anomaly providing advice in relation to property, for example, is not regulated, but advice in relation to a collective investment vehicle investing in property is regulated. Shares and units on collect investment vehicles are designated investments making them subject to a wide range of FSA requirements. Tradability Retail collective investment vehicles are generally fairly liquid with certain exceptions such as venture capital trusts, for example. Wholesale funds can be considerably less liquid, with there being virtually no trading in investments in private equity funds for example trading may be prohibited, it may require the prior approval of other investors, or it may simply not be possible to find a buyer. Where funds are tradable, this may take place either via a stock exchange, or 2

3 Exchange involvement Clearing and settlement Evidence of ownership Trade reporting (to exchange) Transaction reporting (to FSA) Documentation by dealing direct with the manager of the scheme. Participations in pension, insurance and charity funds are not traded. Many tradable collective investment vehicles such as investment trusts and exchange-traded funds are listed on an exchange. Collective investments that are traded on exchange will generally settle through the clearing house associated with that exchange. For example, in the UK, investment trusts are traded on the London Stock Exchange and settle through Euroclear UK & Ireland (formerly CREST) see Appendix 2). Ownership of a right in a collective investment vehicle can be evidenced in several ways, depending on the type of vehicle in question: with unit trusts for example a record of unit holders is maintained by the scheme s registrar (the trustee or their delegate) and units are not physically held, but by contrast, an investment in one of the large wholesale vehicles may be documented in an agreement with other investors. The requirement to submit exchange reports for collective investment vehicles will depend on the type of vehicle: firms must report trades in shares in investment trusts, for example, but becoming an investor in a limited partnership is not reportable. As with trade reporting to exchanges the requirement to make a transaction report will depend on the type of collective investment involved. FSA provides precise guidance in this respect in Chapter 17 of the Supervision Manual. Several pieces of documentation are associated with collective investment schemes: Constitutional and operational documents Collective investment vehicles have a variety of documents setting out the details of the individual schemes. Such documents are mandatory for regulated funds and include: a prospectus full details of all key aspects of the scheme including how the scheme operates, investment objectives and investment policy. Full contents requirements are established by the UCITS Management Directive see Appendix 5; a simplified prospectus used to set out the key features of a collective investment scheme prior to a customer making an investment. Full contents requirements are established by the UCITS Management Directive see Appendix 5; an information memorandum another name for a prospectus but more likely to be used for an unregulated collective investment scheme; articles and memorandum of association used to govern the operation of investment trusts; trust deeds between the trustee and the manager of a unit trust; and instruments of incorporation, used to establish open-ended investment companies. Operators of collective investment vehicles will have numerous agreements in place relating to the operation of each scheme. Such agreements may cover areas such as: investment management; trustee services; registrar services; investment advisory services; 3

4 custodian services; and fund promotion. Customer documents Confirmation notes are issued to investors when a purchase or sale of units or shares in a collective investment is undertaken. For wholesale funds, a record of the investment made may be recorded by way of an agreement. Investors will be sent a periodic report, managers report and accounts, and potentially other information to advise them of how their investment is performing. Pricing The pricing of a participation in a collective investment vehicle will depend on the performance and liquidity of the underlying investments and on the liquidity of the participations themselves. Pricing may sometimes be hard to determine if the underlying assets are illiquid, such as with private equity funds which invest directly in private company shares. The value of other participations, such as shares in investment trusts, may be easier to determine as the instruments are listed on an exchange. More detailed information relating to the pricing of unit trusts and investment trusts is provided below. Duration Collective investment vehicles themselves typically exist for the longer term (5 years plus) though investors are free to sell their participations whenever they choose if this is not specifically prohibited. Sometimes there is a finite lifespan after which a scheme will be wound up. Risks for operators Poor performance either the sector in which the fund is invested, or the individual fund manager, may perform badly, leading to poor fund performance and an exodus of investors. The operators of a scheme may not be able to attract enough investors to their fund, in which case fees will be limited and the fund may need to be wound up. Poor service providers may be employed leading to administrative errors and subsequent complaints from investors seeking redress or compensation. If funds become too large it can be difficult for managers to keep the fund s assets focused on its core investment objectives and performance can suffer. In this situation, fund managers need to split a fund into two in order to regain focus. Risks for investors Poor performance for the reasons listed above a fund may perform badly resulting in a loss for investors. Index funds are designed specifically to track the performance of a specific index such as the FTSE 100, making spectacular performance losses less likely (unless, of course, the relevant index falls massively). On the down side however, as an index tracker is specifically designed to mirror the performance of a particular index, such funds are unlikely to outperform the index. Risk here can be mitigated (or indeed increased) as some index funds employ derivative instruments such as swaps and, in that case, the value of the fund will be determined by the value of the derivative and its liquidity as opposed to the index). A participation in a fund may be illiquid, making it difficult for investors to realise their investment if they need cash. 4

5 Benefits for operators With some funds money has to be invested for a set period of time in order to benefit from preferential tax treatment, or to avoid paying additional charges. If an investor needs his cash before such a period has come to an end he will be financially penalized. The charges associated with investing in a collective investment vehicle can be high see below, Benefits for operators. Fees can be reduced by investing in tracker funds. A particular risk with investment trusts is that they may trade at a discount or a premium to the value of the shares they represent. Loss of choice If there is a particular share or other investment that a participant wishes to invest in, he has no power to influence the individual investment decisions of the scheme manager. Lack of transparency Unregulated collective investment schemes are often accused of lacking transparency in respect of what is actually happening to the money invested and how valuations are arrived at. In this respect, hedge funds are currently under the spotlight. Finally, for the individual investor, collective investment vehicles can be seen as boring as they take away the fun of stockpicking! The operators of collective investment schemes benefit from the fees that they charge for their services and this can be extremely lucrative! Such fees include: initial charges a percentage of the amount invested; annual management fee a percentage of the total value of an individual s investment; switching fees a fee payable when an investor decides to switch from one sub-fund to another in an umbrella structure; exit charges percentage of the amount of an investment that is liquidated; and for limited partnership general managers, there is a specific form of income called the carried interest see below. The operators of a collective investment scheme may also benefit from the fact that establishing a collective vehicle for investment may be the only way they could raise enough funds to invest in a particular area. This is true of private equity, for example, when the funds that one individual firm has to invest may not be sufficient on their own to make an investment attractive for the investee company. Benefits for investors Expertise Investors hope that fund managers will be more successful at generating profits than they are themselves (alas this does not always go according to plan!) Save time Investors do not have to take the time to follow individual investments, and the markets in general, in order to decide how to invest their money; they are employing someone to do this for them. Capital appreciation It is to be hoped that the value of their participation will be higher when the investor sells it than it was when the investment was made. Regular income Investors will also benefit from any ongoing income from the investments in the pool, such as interest from bonds or dividends from shares. Access to otherwise inaccessible assets Professional fund managers have 5

6 much easier access to some of the more unusual assets such as obscure overseas stocks than the average investor. Diversification - For people with small amounts of money to invest, collective investment offers much greater possibilities for achieving a diversified portfolio than does investing on their own. Diversification also helps to reduce risk by exposing investors to a number of investments instead of just relying on one. Economies of scale The shared cost of investing among all participants may be less than for a person investing on his own. Pound cost averaging It is possible to set up a regular investment plan through which money can be invested each month in a particular scheme. This can be advantageous as the overall average price at which a person invests will be kept relatively low: if he invested all his cash when the market was at a high he would be able to buy fewer shares, units, etc. than spreading the cost throughout the year to benefit from times when the market value, and therefore the cost, of a unit has been low. As well as the generic benefits of collective investment, clearly insurance and pension funds each offer their own distinct advantages. Key parties involved with collective investment vehicles Investor A person who has invested in a collective investment vehicle. May also generically be called a participant. Different types of collective investment have different terms to describe their investors, for example with: limited partnerships investors are called limited partners; unit trusts investors are called unit holders; investment trusts investors are called shareholders; pensions - investors are called members; and insurance schemes investors are called policy holders. Participant An investor in a collective investment scheme. Fund This comprises the assets that have been pooled for collective investment. Investment manager This is the entity responsible for the discretionary management of the assets that Investment advisor have been pooled for collective investment. The entity responsible for advising the investment manager in relation to his investment decisions. Trustee With unitized funds and pension funds, this is the legal owner of the pooled investments, who has title of the assets on behalf of the beneficial owners, the investors. Responsible for ensuring that the investment managers invest the fund s assets in accordance with its investment objectives. Must generally look after the interests of the investors. The trustee will be a regulated financial institution, typically a bank, that can satisfy strict regulatory capital requirements. For regulated unit trusts the trustee must be a separate legal person to the fund manager or scheme operator. Often referred to as the fiduciary. Custodian The entity that has custody of the assets of the scheme on behalf of the 6

7 Sub-custodian investors and that provides administrative services in relation to these assets, such as the processing of corporate actions. With unitized funds and pension funds the trustee is legally responsible for the custodian role although the function is generally delegated to a third party. The custodian may delegate some of their activities to a sub-custodian, particularly in jurisdictions where the investment infrastructure is limited. Administrator With unit trusts and open-ended investment companies ( OEICs ), responsibility for administrator activities rests with the unit trust manager and authorized corporate director respectively, although the function is often delegated to a third party. Typical activities include fund pricing and valuation, and the preparation of financial statements. Depositary Depositaries are used with OEICs and they perform the same role as the trustee for unit trusts. Registrar The entity that keeps a record of unit holders with a unit trust, or the shareholders of an OEIC or investment trust. Responsibility will have been delegated, respectively, from the trustee, depositary or board or directors. Unit trust manager Also called the scheme operator. This is the authorized fund manager of a unit trust and as such, it invests the assets of the fund. Responsible for promoting the fund. Buys and sells units using a process called box management which allows managers to hold some units on a proprietary basis to facilitate customer demand, thereby reducing the need for calls on the trustee to create or liquidate units to match purchase or redemption requirements. Authorized corporate director General partner The investment manager of an open ended investment company performing the same sort of role as a unit trust manager. Often referred to as the ACD. The person responsible for the management of assets held by a limited partnership. Limited partner An investor in a limited partnership. Does not have any direct say in how the partnership s assets are managed although he may be able to influence this through having a representative on the investment committee. Auditor Funds will appoint an auditor in order to confirm to investors the soundness of their operation. Main characteristics of collective investment vehicles Collective investment vehicles can be characterized in many ways apart from how they are structured. Some of the main differentiations are described in the table below. Characteristic Description Open-ended fund Both the size of the fund and the number of units changes according to the amount invested. When a fund is popular and lots of people want to invest then the manager creates more units, and when more people want to sell than buy, the manager redeems/cancels units. 7

8 The process of determining how many units are required, creating or cancelling units as needed and then holding on to some units in anticipation of future demand is referred to as box management. An example of an open-ended scheme is a unit trust. Closed-ended funds The number of shares remains static no matter how many or few investors there are. The amount of money available for investment does not generally change once the fund has been launched. An example of a closed-ended scheme is an investment trust. UCITS funds/ schemes Non-UCITS retail schemes (NURS) Qualified Investor Schemes (QIS) Actively managed fund Collective investment vehicles that comply with the requirements established by the EU s Directive on Undertakings for Collective Investment in Transferable Securities (UCITS see Appendix 5) and can therefore be marketed to the general public across the EEA. The status of such vehicles is also recognized in several jurisdictions outside the EEA. For a fund to be a UCITS scheme it may only invest in the type of asset covered by UCITS, with notable exclusions being commodities and property. Recently, the range of permitted investments has been extended under UCITS III. NURS are collective investment vehicles that are suitable for retail investors but that invest in assets, such as property, that are not specifically covered by UCITS. QISs are collective investment vehicles that are only open to qualified (expert and institutional) investors they are not UCITS schemes and cannot be marketed to the general public. QISs have very broad investment and borrowing powers and are therefore deemed to be too risky for ordinary retail investors. Funds in relation to which fund managers actively select what they consider to be the best performing shares in a particular sector. These funds generally have higher costs as investors are paying the fund manager to extensively research the market. Index tracker fund A fund that comprises the components of a particular index such as the FTSE 100. Usually cheaper than actively managed funds as they are less expensive to manage for example, extensive research about which shares should be purchased is not required. Also called index funds or passive funds. Passive fund Another name for an index tracker fund. Indexed fund Another name for an index tracker fund. Mutual fund Strictly speaking a mutual fund is the US version of a unit trust. However, the term is often used as a generic way to describe collective investment vehicles. Individual Savings Accounts (ISAs) Personal Equity Plans (PEPs) Child Trust Funds (CTFs) Many funds can be held in an ISA which is a tax free wrapper allowing investors to benefit from income and capital gains tax relief. The forerunner to ISAs. CTFs are established by money given to children at birth by the government with subsequent payments when the child reaches 7 years of age. Profit generated on the investment is tax free, with friends and family able to contribute funds on top of those provided by the government if they wish. 8

9 CTFs can only be provided by entities that have been approved to do so by the Board of HM Revenue and Customs. The framework of the operation of CTFs is set out in Child Trust Funds Act 2004, the Child Trust Fund Regulations 2004, and the amended regulations, also of Not all CTFs are collective investment schemes parents can choose to simply open a savings account with the cash received. Roll up funds A way of describing an offshore fund that accumulates income rather than distributing it to investors. No income tax is payable in the accumulated income until it is actually distributed to investors at some point in the future. Used for tax planning purposes. Distributor funds These are offshore funds that distribute most of their income to investors, rather than reinvest it. Income fund A fund invested in assets providing a high yield rather than capital growth. Growth fund A fund invested in assets providing high capital growth but limited short-term Balanced fund income. A fund invested in a mix of assets to provide a balance between income and capital growth. Hedge funds Despite now having become such an integral part of the financial services industry there is no legal or even commonly used and accepted definition for the term hedge fund. It is, however, possible to describe a set of characteristics that are more often than not present in a hedge fund. Some of these are listed below. Lack of regulation Most hedge funds are based off shore in locations where they benefit from preferential tax treatment. This means that the funds themselves are not regulated and thus do not have to comply with the constraints imposed by the FSA, or UCITS for example (note, however, that a hedge fund manager based in the UK and performing discretionary management services for third parties should be regulated by the FSA). Due to the lack of restriction in terms of investment and borrowing powers, hedge funds are able to act opportunistically, rapidly moving their money from one investment to the next. Hedge funds pursue a total/absolute return strategy, meaning that they aim to make a profit no matter what the prevailing market conditions are, through devising often complex trading strategies, rather than selecting specific assets to buy and hold for their short- or long-term growth potential. In order to achieve these ambitious aims, hedge funds generally make extensive use of derivatives and are highly geared, leading many to describe them as ultra high risk investments. There are however others who would argue that the careful use of such strategies lowers risk as investors should theoretically be protected from market down turns. Hedge funds are very actively managed and therefore charge very high fees, based on returns. Because of the perceived risks and complexities of hedge funds they are generally only open to institutional investors and experienced high net worth investors, they should not be marketed to the general public. 9

10 The most common way for a private investors to gain access to a hedge fund is through another sort of investment vehicle such as an OEIC which is itself regulated but invests in hedge funds; a lower risk strategy, but one that brings with it a double dose of fees the OEIC pays the hedge fund fees which will then be indirectly passed on to the investor in the OEIC, who also has to pay for their investment. Many are concerned about a lack of transparency in relation to how hedge funds invest their money and in how they value their portfolios. Hedge funds are generally open-ended investment vehicles often using the limited partnership or unit trust structure. Pensions Funds specifically established in order to invest pensions contributions. Benefit from generous tax advantages. Feeder fund A fund that invests only in another fund. Master fund Common investment funds Insurance funds Alternative investment funds Fund of funds Fund of alternative investment funds (FAIFs) Mixed fund A fund into which a number of feeder funds invest. A type of collective investment vehicle used by charities. Similar to unit trusts. They have the same tax benefits as charities. Insurance companies offer many different types of collective investment that may also provide life insurance. Some of the most common types include: unit-linked policies; insurance bonds; endowments; and annuities. An alternative investment fund is an umbrella term largely used to describe unregulated collective investment vehicles that invest in non-mainstream asset classes. Common types of alternative investment funds include: hedge funds; unregulated unit trusts; limited partnerships; investment companies. A fund that invests in other funds, normally with no direct investments. At the time of writing the FSA is proposing to introduce FAIFs into the NURS regime. It is proposed that FAIFs will be subject to regulation by FSA but will be able to invest up to 100% in other funds (such as hedge funds) which are not (at present the threshold is capped at 20%). Fund that invests in other collective investment schemes, and other direct investments. Collective investment vehicle structures As indicated above, collective investment vehicles may have many different characteristics although there are only a few basic structures that may be used. The main structures for collective investment are described below. 10

11 Unit trusts Structure Open/closed Investment instrument Different classes of investor Trust enabling investors to participate in an underlying fund. Open ended Units Units may only be bought or sold directly from the manager and may be of two types: Income/distribution units Any income from the underlying investment in the fund is distributed to unit holders. Accumulation units Any income from the underlying investments in the fund is automatically invested in new units on behalf of the unit holder. Units may also either be group one units or group two units, depending on where they were created in the fund s income distribution cycle: Group one units Units in existence since the most recent distribution. Group two units Units created since the most recent distribution. Buyers will have to pay an additional amount to take account of the distribution they will receive covering the period between the last distribution and the date the unit was made. The process of managing distributions as described above is called equalization. There are now different types of unit class available with differing characteristics. Pricing The value of a unit is based on the value of the assets in the fund. There is a single valuation point each day for units. The fund is generally valued once a day and the units may be valued on either a forward or historic basis: Forward basis The price paid will be set at the time of the next valuation. Historic basis the price paid will be as determined by the previous valuation. A different price is usually charged depending on whether a person is buying or selling units (i.e. there is a market spread). Units may also be created and redeemed at different prices. Pricing may also be said to be on a bid basis or an offer basis: Bid basis There is little demand for the units and therefore the manager will only be prepared to pay a low price for the units. Offer basis There is heavy demand for the units and therefore the manager will demand a higher price for the units. The FSA lays down rules on how the maximum offer and minimum bid prices are determined. Borrowing Advertising Regulated unit trusts are not permitted to borrow except in very limited circumstances. Advertising is permitted although only retail funds may be freely marketed to the general public. They are not exchange listed. Trust deed between the trustee and the fund manager. Exchange listed Founding documentation Responsible bodies Unit trust manager. Trustee. 11

12 Duration Secondary market Normally perpetual but some specialist funds may have a defined life span. No secondary market purchases and sales of units take place directly with the fund manager. Other An authorized unit trust is one that is regulated under FSMA. Shorting is prohibited for authorized unit trusts, i.e. the short selling of the fund s assets is not permitted. An Unauthorized Exempt Unit Trust is a specific type of unit trust open for investment only to tax exempt investors such as charities and pensions. Many unit trusts have converted into OEICs. Investment trusts Structure Open/closed Investment instrument Different classes of investor Despite their name, investment trusts are actually companies, not trusts. Closed ended A participation in an investment trust is represented by a shareholding. Split capital investment trusts have several different classes of share, each with varying degrees of risk that should be carefully explained to investors. Some of the most common include: Income shares The shareholder receives income from the underlying investments in the fund but a limited return on the actual redemption of the share at the end of the life of the trust. Capital shares The shareholder receives most of the value of any increase in value of the underlying portfolio at the end of the life of the trust. Zero dividend preference shares pay no income but offer a fixed value for shares held at redemption Stepped preference shares Predetermined dividend payable during the life of the trust but return at redemption of the shares is limited. Pricing The price of shares in an investment trusts depends on two factors: the value of the underlying assets; the demand for the investment trust shares themselves. There is a single price for buyers and seller of shares: the net asset value. Because demand for investment trust shares may be limited, this can reduce the value of the shares far below the value of the assets that actually comprise the fund. When this happens, the shares are said to be trading at a discount. Conversely, when the value of shares in an investment trust is above the value of the assets in the fund, the shares are said to be trading at a premium. Normally valued daily. Borrowing Advertising Exchange listed Founding documentation Responsible bodies Duration Secondary market Investment trusts are permitted to borrow so they may be quite considerably geared. Not permitted to advertise except for issues of new shares, so investment trusts are not as well known as unit trusts and OEICs, which are permitted to advertise. Investment trusts are listed on an exchange. Articles of association. Memorandum of association. Board of directors Split capital investment trusts have a predetermined duration. There is a full secondary market unlike with unit trusts where dealing must take 12

13 place directly with the manager. Other Rarely pay commission to independent financial advisers who are therefore not incentivized to promote them. This is another reason that investment trusts are not particularly well known. Investment trusts are not covered by UCITS. Not directly regulated by the FSA in the same way that units trusts and OEICs are, although as investment trusts are listed, they must comply with the rules of the UK Listing Authority which is in fact a specific division of the FSA. As companies, investment trusts are also governed by companies law. Different types of investment trust Venture capital trusts (VCTs) Venture and development capital investment trusts Real estate investment trusts (REITs) Property investment funds (PIFs) Lloyds investment trusts Enterprise zone property trusts Umbrella fund VCTs are a type of investment trust designed to encourage investors to invest in newer companies that are higher risk as they do not have a track record. As an incentive to invest, and in compensation for the higher risk, VCTs offer a range of tax advantages for investors in relation to income and capital gains tax relief. Similar to VCTs but without the tax advantages. Investment trusts investing in property. There are some tax advantages (e.g. no stamp duty) to investing in property through a REIT as opposed to making a direct investment. Also known as property investment funds. Another name for a REIT. A type of investment trust whose strategy is to underwrite insurance risk through Lloyd s. Invest entirely in property located in specially designated enterprise zones so designated by the government due to the area s need for inward investment. As an incentive to invest, a number of tax benefits are offered. A fund that has a number of different sub-funds investing in different asset classes. Notes Some people exclude investment trust from the definition of collective investments due to their closed-ended structure and simply consider them to be a specialized type of company. The term investment trust refers specifically to investment companies listed on the London Stock Exchange. Equivalent companies set up elsewhere are referred to as investment companies. Open ended investment companies Structure Company established with the sole purpose of acting as a collective investment scheme. Open/closed Similar to a unit trust in that they are open ended. This means that the number of shares in circulation increases and decreases Investment instrument with demand (unlike other companies that have a finite number of shares). Shares. 13

14 Different classes of There may be different classes of shares for different classes of investor and with investor different charging structures. Pricing Typically valued once a day like unit trusts although there may be a longer interval weekly, monthly or even yearly. Borrowing Not permitted to borrow except in very limited circumstances. Advertising Permitted Exchange listed OEICs are not quoted on the stock exchange. Founding Prospectus. documentation Responsible bodies Depository. Authorized corporate director. Duration Normally perpetual but may have a limited life span. Secondary market There is no secondary market: investors have to trade directly with the fund manager. Other OEICs are also known as investment companies with variable capital (ICVCs). Many unit trusts have converted into OEICs due to the attraction of single pricing which means that there is no bid/ offer spread. On the sale of an OEIC share a dilution levy may need to be paid to the fund, at the discretion of the fund manager. Limited partnerships (LPs) Structure Partnership. Open/closed Closed an LP will set out to raise a certain amount of money and before any additional funds can be raised the partnership documentation will need to be amended. Investment An investment in a limited partnership is represented by contractual agreements instrument rather than by shares, units or certificates. Different classes of There are two types of investor in a limited partnership the limited partners investor and the general partner. The general partner (GP) is responsible for managing the fund as well as being an investor. The GP is normally the entity that has established the fund and marketed the investment idea. There is normally only one GP although there may be more. The limited partners (LPs) are investors in the fund who do not have any direct say in how their assets are managed. GPs will try to attract a number of LPs to the partnership. LPs pay management fees to the GP. Pricing and Generally people do not refer to the pricing of this type of investment as there valuation is a very limited, if any, secondary market. The partnership s assets are frequently illiquid, property or private equity for example, so it is hard to determine the value of the fund. Borrowing Limited partnerships may be permitted to borrow, depending on the contractual terms of their establishment. Advertising The advertising of limited partnerships is likely to be restricted as these vehicles are generally classified as QISs. Exchange listed No exchange listing. Founding The founding documentation for a limited partnership is the partnership 14

15 documentation agreement, which will be signed by the initial partners. New partners will sign a deed of adherence binding them to the partnership agreement if they join after the original agreement has been completed. Subscription agreements are also used. These documents cover the investment of funds by the partners into the partnership. Finally, the operation of each partnership is likely to be governed by a variety of other documents such as investment management, custody, administration and advisory agreements. Responsible bodies General partner, which acts as the fund manager. Custodian. Duration Limited partnerships have a limited duration frequently years. Secondary market The secondary market for participations in LPs is extremely restricted. Other Limited partnerships incorporated in the UK are subject to the Limited Liability Partnerships Act 2000, but many are established in offshore locations in order to benefit from preferential tax treatment. Often used for investment in private equity and venture capital. The entity in which a private equity limited partnership invests its assets is known as the investee. As well as benefiting from the investment management fees and the profit from their investment, limited partners generally receive carried interest (usually referred to as the carry ). This is a predetermined percentage of any profit received from investment after the limited partners have recouped their initial investment and made a certain amount of profit over and above this. Exchange traded funds (ETFs) Structure Company set up to mirror a particular stock market index. Open/closed Open ended. Investment Shares. instrument Different classes of There may be different classes of share. investor Pricing and The price of an ETF varies throughout the day in line with movements of the valuation value of the index or basket they track. Borrowing Not permitted. Advertising Advertising is permitted but may be restricted for ETFs that are not UCITS. Exchange listed ETFs are exchange listed. Founding Articles of incorporation. documentation Responsible bodies Fund manager. Custodian. Duration Normally perpetual. Secondary market There is an active secondary market. Other Rarely pay commission to independent financial advisers who are therefore not incentivized to promote them. For this reason ETFs are not particularly well known. 15

16 Key Issues for Compliance Officers Collective investment is a very common throughout the financial services industry at both a retail and an institutional level. Despite this, however, it remains a fairly self-contained area you are either involved with collective investment, or you are not. The following table provides only a brief introduction to the Compliance issues of particular relevance to this field; and anyone whose work specifically involves collective investment will have a lot more to learn! Issue Comment Diversity/complexity There are many different variations of the collective investment vehicle structure. Try not to be lulled into a false sense of security just because you personally have an investment in a few unit trusts does not mean to say that you know how collective investment, in all its many guises, works. Regulatory environment Individual fund investment and borrowing powers There is a separate table below that lists some of the sources of legal, regulatory and best practice requirements and guidelines with which the collective investments Compliance Officer should be familiar. Depending on the type of arrangement concerned, collective investments may be either highly regulated, or subject to minimal rules. Each fund will have its own investment and borrowing powers with which the Compliance Officer should be familiar. These set out in detail the investment objectives of the fund, the assets which they may and may not invest in, the extent to which the fund may borrow and how the fund may use derivatives. Regular monitoring should be conducted to ensure that a fund s investment and borrowing powers are being adhered to. Regulated status As described above, some forms of collective investment are regulated under FSMA and UCITS whereas others are not. It is therefore vital for Compliance Officers to understand the sources and levels of regulation for each collective investment arrangement they are responsible for. Also note that investment trusts are not currently regulated by the FSA in the same way as unit trusts and OEICs, although this situation periodically comes up for debate, with this being particularly under the spotlight following the Splits scandal see page 31 in Chapter 2. Regulatory status of staff Front Office staff providing advisory and/or discretionary management services in relation to collective investment will need to be Approved Persons and will be covered by the FSA s training and competence rules (retail clients only). Certain Back Office staff providing administrative services in relation to collective investment for retail clients will also be covered by the training and competence rules. Market abuse The susceptibility of collective investment arrangements to market abuse will depend primarily on two things: the nature of the underlying assets and whether or not the units of participation in the vehicle are listed. Underlying assets Market abuse can be committed much more readily with a fund that invests in shares than with a fund that invests in property, for example. Listing Market abuse can be committed in relation to listed investments (e.g. investment trust shares) but not in relation to non-listed investments 16

17 Conflicts of interest Conduct of business rules (COBs) (e.g. units in a unit trust). A key risk for collective investments in terms of market abuse relates to market timing : discrepancies between the valuation point of a fund and the closing/valuation times of the markets in which it invests. Fund units should not be traded at values that do not reflect movements that investors would have been able to benefit from in the underlying market. Further information about market abuse can be found in Appendix A of the main text. There is plenty of scope for conflicts of interest to arise within a collective investment scheme structure, for example: Poorly performing assets held by a firm on a proprietary basis may be offloaded into a fund managed by another section of the company or group. Where a firm is trading in the same assets on a proprietary basis as well as for managed funds it might delay the allocation of aggregated trades so that more profitable trades can be allocated to the firm, and less successful ones can be allocated to the managed funds. Brokerage services may be exclusively sourced in-house in order to bolster group commissions instead of using the services of a third party offering better terms. Brokerage services may be obtained from a third party not because this serves the clients best interests but because there is a soft commission arrangement in place that is beneficial for the fund manager. The FSA s detailed conduct of business rules apply to collective investmentrelated activities where these activities constitute designated investment business. This is not totally straightforward as there is such an array of different methods to engage in collective investment. In general terms, the COBS rules will apply in the following situations: providing custody services for the assets in the fund; undertaking fund management activity; and advising and dealing in relation to participations in collective investment vehicles. It is important to remember that even if the COBS rules would not apply in relation to transactions in a non-regulated asset, this will have no bearing if that asset is held by a fund, for example, advising on a property purchase is not covered by COBS, but advising in relation to a collective investment vehicle that invests in property is covered by COBS. It is also important not to be misled by the term unregulated fund. A fund itself may not be subject to FSA rules because it is incorporated overseas for example, but anyone in the UK who is advising clients to participate in that scheme, or who is acting as an investment manager for it, will be covered by COBS (and indeed all other relevant requirements under FSMA). Some of the main conduct of business rules that should be complied with in relation to collective investment include: suitability; switching; risk disclosure; advertising of unregulated collective investment schemes; confirmation notes; provision of simplified prospectus. 17

18 Personal account dealing arrangements Trade and transaction reporting Compliance with relevant COBS requirements should be kept under regular review. Compliance Officers should decide on the stance they will take regarding fund managers investing in the funds they manage. There are two opposing points of view in this regard: Some say that managers should be able to invest in their own funds as it means that their interests are fully aligned with those of the fund, and that it is a good selling point as it shows manager commitment. Others think that this practice should not be permitted as it provides far too much scope for the fund manager to take advantage of privileged information about his funds. Also note that staff personal investments in collective investments may be excluded from a firm s PA dealing procedures because of the lack of employee discretion. Underlying assets Where the underlying assets in a collective investment scheme are listed on an exchange, a trade report to the relevant exchange is required. Transaction reports will also be required for the FSA if transactions in those assets are reportable under FSA rules it is best to refer directly to the FSA rules under SUP 17 here as the reporting rules are quite complex, depending on the asset concerned and the person who undertook the trade. Participations The requirement to make trade and transaction reports for participations in collective investment schemes will depend on the type of fund; for example, units in unit trusts are not reportable, whereas shares in investment trusts must be trade reported to the stock exchange and transaction reported to the FSA. Again, it is best to refer directly to the exchange and FSA rules in this regard. Client assets Prospectus rules Simplified prospectus Listing rules The trade reporting function will generally be undertaken by Front Office and transaction reporting by the Back Office and should be subject to periodic review to ensure that they are working in accordance with relevant regulatory requirements. The client assets rules may apply on various levels in relation to collective investment schemes: Underlying property of the fund the assets will be subject to the protections of the FSA custody rules if they constitute designated investments. Participations/subscriptions held on behalf of investors if in the form of shares the custody rules will apply. Monies held pending subscription or distribution to investors FSA client money rules will apply. The essential features of each FSA-regulated scheme must be described in a prospectus which should be reviewed by a Compliance Officer (in conjunction with a lawyer) before distribution to investors to ensure that it does not contain any inappropriate material and that it meets the minimum contents requirements. Minimum disclosure requirements for FSA-regulated schemes that are meant to be easily understood by the retail investor and contain far less technical information than the full prospectus. See Appendix 19. Compliance officers whose work involves investment trusts should be familiar 18