Managing risks by using collective investment schemes

Collective Investment Scheme (CIS), also known as unit trusts or participatory interests are investments in which many different investors put their money together into a portfolio, and then these pooled monies are managed by professional investment managers.

These professional investment managers invest the pooled money in different asset classes ranging from shares of listed companies to bonds, money market instruments, to property, etc. This way risks that retail/individual investors cannot manage or mitigate given their limited skills in securities analysis, gets managed by professional investors on their behalf.

The total value of the pool of invested money is split into equal portions called participatory interests or units. When you invest your money in a CIS portfolio, you buy a portion of the participatory interests in the total CIS portfolio.

The assets of a CIS portfolio are held by the trustees. A closer example of this structure is the Unit Trust of Tanzania. The unit price of the CIS depends on the market value of the underlying investments in which the pool of money is invested. This unit price rises and falls (fluctuates) according to the value of the underlying investments based on daily calculations. What are some of the advantages of CIS over direct investment? CIS provides an ability to:

• hire professional investment managers, which may potentially be able to offer better returns and more adequate risk management;

• benefit from economies of scale i.e., lower transaction costs; and

• increase the asset diversification to reduce some unsystemic risk.

There are two types of CIS, namely CIS in Securities and CIS in Property, also known as Real Estate Investment Trusts (REITs). I will focus on CIS in Securities – what are benefits of investing in CIS in Securities?

• They are affordable and easy - these collective investments are affordable as an investor can invest small amounts of money. This makes it possible for more people to easily invest in underlying assets that they normally would not be able to afford.

• Diversification of risk - as collective investments may be invested in a range of underlying assets, it means that your eggs are not all in one basket. The risk associated with your investment is therefore spread amongst the different underlying assets. If any of these assets perform poorly, your total investment will not necessarily perform poorly as there are other assets that may have done very well. The more diversified your capital, the lower the capital risk. This investment principle is often referred to as spreading risk.

• Good returns — the longer you leave your money invested, the greater the opportunity for your investment to grow. An investment in a CIS in securities can be repurchased at any time, however, it is advisable that you invest the money for at least 3 – 5 years. The reason for this is that the value of the units of a CIS in securities can go up or down. If invested for a longer period, one can expect to see the benefit of the long-term growth in the market.

• Professional investment management — an investment manager manages your investments for a fee. However, an investment manager must be registered with the capital markets regulator as a financial services provider.

• Your money is accessible — CIS in securities are easy to sell which means that you can sell all or part of your investment at any time.

• Different investment options — CIS in securities offer flexible investment options as you can make: (i) lump sum investments – these can be made at any time once you have opened your collective investment account; (ii) debit order investments – you can make regular payments, e.g. monthly, into your account; and (iii) switching – as there are many different collective investment portfolios, you can switch between different portfolios at little or no cost.

• Reduced dealing costs - If one investor had to buy a large number of direct investments, the amount this person would be able to invest in each holding is likely to be small. Dealing costs are normally based on the number and size of each transaction, therefore the overall dealing costs would take a large part out of the capital (affecting future profits).

A choice of where to invest: It is important that, before you select a portfolio in which to invest, you first understand what you are investing in, and that you carefully consider the amount you commit to invest. A licensed financial advisor should assess the amount of risk that you are prepared to take and advise you accordingly. Factors such as your age, health, income, alternative liquid assets, financial knowledge, appetite to risk, whether or not you have dependents and what your investment goals are will all influence the choice of investment.

Types of CIS in securities: There are two types of CIS in securities: open-end fund: this is equitably divided into units which vary in price in direct proportion to the variation in value of the fund’s NAV.

Each time money is invested, new units are created to match the prevailing unit price and each time units are redeemed, the assets sold to enable redemption matches the prevailing price.

In this way there is no supply or demand created for units and they remain a direct reflection of the underlying assets. These units may be listed and traded in the stock market.

Closed-end fund: this type of CIS issues a limited number of units in an initial public offering (IPO)