Unit trusts have always been perceived and marketed as suitable investments for small investors with scant knowledge of investments markets. In return for transparency, flexibility and good returns over time, investors have paid relatively high initial and annual fees. But the unit trust environment is changing: it is becoming more competitive and investors are being offered greater choice of funds. These changes as well as changes in pension fund legislation are causing investors who had previously eschewed unit trusts, to give them a second look.

What is a unit trust?
The fundamental premise behind a unit trust fund is simple: a large group of investors pool their money in order to get a spread of professionally managed investments. The average investor does not usually have sufficient money to buy a spread of quality shares (and a range of shares is important to reduce risk). Via a unit trust, an investor can own part of a diversified, blue–chip portfolio by investing a modest amount of money.

How does a unit trust work?
A unit trust pools the money of many people and invests it in shares, bonds, money instruments and other investments. This pool is then divided into identical units, each unit containing the same proportion of the assets in the fund. Funds set a minimum investment amount – investors can choose to invest a lump sum or a monthly debit order. Lump sums typically start at R1 000 and minimum monthly debit orders at R100 a month. Investors share in the fund’s gains, losses, income and expenses on a proportional basis.

Unit trust management companies are required to operate their investments within certain requirements or mandates, laid down by the Association of Unit Trusts (AUT) and the Financial Services Board (FSB). The primary purpose of these mandate requirements is to protect the investments of the unit trust holders. Critics of unit trusts point to the fact that some of these requirements have the effect of limiting the up side performance of unit trust.

Investments Restrictions of Unit Trusts
An equity-based unit trust has to maintain between 5% and 25% of its investments in cash (no less than 5%; no more than 25%). The balance of the funds under management should be invested, according to the mandate of the fund. Some fund managers use the liquidity range to protect their funds during times of market volatility, while other fund managers take the view that they have been mandated to be as fully invested as possible. The upper limit of cash in a fund has been a contentious issue for some time, but in July 1999, after industry consultation, it was set at 25%. Prior to this date, funds with liquidity had a relative advantage over funds with low liquidity when liquidity the stock market was falling. The Collective Investment Schemes Bill, which is expected to be passed by parliament in the third quarter of 2000, propose that the 5% cash requirements should be scrapped. The 5% minimum was originally written into the Unit Trust Control Act to ensure that unit trusts could pay out investors who wished to redeem their units immediately.

A unit trust fund may not own more than 5% of the share of a listed company (or 10% in the case of shares in companies with a capitalisation of more than R2-billion). There are two exceptions to this rule: in the case where any excess is due to the appreciation to the value of each share, and in the case of gold funds. Gold funds re exempted from the 5% rule on the grounds that there are a limited number of gold shares on the market. The purpose of this requirement is to ensure diversity of investments within a fund, and to ensure that a fund is not overexposed to the management or trading conditions of a particular company.

Income, bond and money market fund have to meet special requirements in terms of the maturity of their investments. Specialist equity funds must hold investments exclusively in that sector. There are special limitations imposed on the derivative component of funds. No fund’s exposure to derivatives can exceed 20%.

A unit fund may invest in an unlisted company, but only if the company intends to list on the JSE within a year. In order to qualify pension fund or provident fund investments, unit trusts are subject to conditions. Regulation 28 of the Pension Fund Act requires that unit funds may not have more than 75% of their portfolio invested in equities. Prudential funds, bond funds and income funds would qualify in terms of these requirements.

In addition, all management companies must hold an investment of at least 10% of the total amount of the units in each unit portfolio, but this can be limited to R1-million, subject to the approval of the executive officer of the FSB.

Some features of unit trusts
Every type of investments has advantages and disadvantages, and unit trusts are no exception. Unit trusts have many advantages as investment vehicles, and this has led to their enormous popularity both here and overseas. But there have many, far–reaching changes in the industry over the last five years, and investors owe it to themselves to keep abreast of change in legislation, products, and management company practice. In this section we highlight some of the advantages of unit trusts – and some of the changes taking place.

Investments safety
For the past 30 years, unit trusts have provided small investors with a way to participate in the stock and bond markets. The founding fathers of the unit trust industry were mindful of their primary obligation: the protection of small investors. And their groundwork has paid off, there have been no major scandals in the unit trust industry

Unit trusts are statutorily entrusted to the Minister of Finance and controlled by the executive officer of the Financial Services Board (an independent, regulatory body established by the government) in terms of the Unit Trusts Control Act. The original Act (No 18 of 1947) made provision for the introduction of unit trusts in South Africa. The shortcomings of the Act, however, led to it being changed several times and finally being replaced by the Act No 54 of 1981. An impressive series of provisions to protect the investor have been implemented over the years – most of these provisions relate to the activities of the management companies.

To ensure that dishonest fund managers or management companies could not steal their clients’ money, units trusts were divided into three separate legal entities: the fund, the trustee and the management company. The unit, Trust Control Act has become very outdated and is about to be replaced by the Collective Investment Schemes Control Bill. Martus Classen, chairman of Collective Investment Schemes steering committee, expects that the Bill will be passed by Parliament in the third quarter of 2000.

The new legislation will allow local companies to design investment products such as open-ending investments company schemes, which are the norm overseas.

The act will provide for new levels of disclosure and will make the unit trusts industry transparent.

Written by Nic Oldert and originally published in Profiles “Understanding Unit Trusts”