Wednesday, August 16, 2006

What you should know about UITFs?

UITFs have recently received a lot of media mileage, notoriously, because of the large drop in market value suffered by its holders. But other than this notoriety, there is surprisingly a lot of misinformation about this product.

What is a UITF?

UITF stands for Unit Investment Trust Fund. The product is fairly simple on paper: the funds of several people are combined by an administrator and collectively invested into particular assets. As the assets gain or lose in market value, the individuals who pooled their funds either accrue the gains or absorb the loss. In exchange for structuring the fund, fees are charged to the individuals by the administrator.UITF is literally a collective fund. The nature of this instrument is that of a “trust” product. This means that the entity offering the UITF (i.e., the trustee) administers the fund in behalf of the individuals (i.e., trustors) whose resources have been combined into the fund. There is no guaranteed return for this product because the underlying investments of the fund can make or lose money.

UITFs are what we call “open-ended funds” which means that the institution offering the fund can continue to pool the resources of as many investors who may be interested to invest in the fund. Redemptions — individuals selling off their UITF holdings — are allowed anytime. To keep track of these inflows and outflows, participation into the fund is conveniently measured in “units”. The current value of each unit is referred to as Net Asset Value Per Unit (NAVPu). This makes it easy for investors to know the market value of their investment since they only have to multiply the number of “participation units” they purchased by the NAVPu.

UITFs are regulated by the Bangko Sentral ng Pilipinas (BSP, the Manila central bank) under Circular 447. Only BSP-accredited trust entities are allowed to offer and administer UITFs. There are several types of UITFs from which the interested investor can choose. There are UITFs that invest in shares of stocks only, bonds only or money market instruments only. There are also “balanced funds” which invest into a more diversified portfolio of assets. Investors can also pick whether the fund restricts itself to assets that are denominated only in either Philippine Pesos or US Dollars.

So on the whole, investors are faced with three levels of choices in purchasing a UITF: [a] from which trust entity do they purchase the UITF, [b] what instruments they want the UITF to buy and [c] in what currency.
Appreciating the risks involved

It is important to emphasize that UITFs are not deposit instruments. The BSP does not treat them as deposits and does not impose reserve requirements. UITF investors also do not enjoy the insurance cover that the Philippine Deposit Insurance Corp. provides on bank deposits.

Think of a UITF as a portal that allows several investors to invest into several underlying assets. The investment risk of this portal is then dependent on two things:

(1) the volatilities and nuances of the particular assets the fund has invested into and

(2) how these individual assets behave as a group.

The first point just talks about the basic nature of the underlying assets. Movements in interest rates affect bonds directly and will just as easily affect a UITF bond fund. Equity funds, on the other hand, are sensitive to what affects the equity market in general (systemic risk) and the specific companies covered by the fund (business risk). Investing through a UITF does not change the nature of the risks of the assets that underlie the fund. No matter how you do it, you still won’t get orange juice by trampling upon grapes.

The second point is a bit tricky. You really do not want a fund to be investing in several assets that behave exactly the same way. Otherwise, this is like investing in only one asset and your financial fortune is hit-or-miss. What would be nice is something akin to fraternal twins who share the same set of basic values but are still different in key respects and their day-to-day moods. For a fund, these differences are important because they tend to offset possible extreme occurrences.

The point is that UITFs are subject to both the nuances of market volatilities and the composition of a specific fund. These risks are clearly borne by the investor. It is these risks that make UITFs an “investment”, not a “saving” instrument.

As a result, UITFs have to offer higher indicative rates: the possibility of higher returns comes from the fact that UITF investors are also exposed to more risks. But there are no guarantees as UITFs can take a hit (like last May) from time to time. Safer instruments, like bank deposits for example, command a lower rate of return because of the implicit reduction in risk brought about by deposit insurance.

What Prudential Regulations are in place for UITFs?

Under current regulation, UITFs may only invest in instruments that can be easily traded. As defined by the Bangko Sentral ng Pilipinas, Manila’s central bank, this essentially means bank deposits and a slew of securities that are either readily tradeable or listed in an organized exchange or traded in an organized market.

The emphasis of all these is the availability of a price at which buyers and sellers can readily consummate a transaction. That means there is cash for those who want to sell at a price that would-be investors consider fair value to buy into the UITF.

Regulations require that the prices of the underlying instruments in a UITF are revalued everyday. As a result, NAVPu changes daily and the resulting gains and losses are for the investor’s account. This frequent re-valuation gives investors the chance to re-assess their position as daily market conditions evolve. This is especially helpful in preventing losses to accumulate which will surely surprise the unknowing investor.
Because the UITF is revalued daily then the NAVPu is also calculated daily. This should be made available to UITF investors and interested parties upon request. Current regulation also requires the trust entity managing the UITF to publish their NAVPu at least on a weekly basis.

The upside of UITFs

There are lots of good things going for UITFs. For one, pooled resources magnify the investment possibilities while dividing the financial burden across many investors who would otherwise have only smaller sums of money to invest. The “unitized” nature of the fund gives investors the benefits of these investments without diminution, limited only by the number of participation units actually purchased by the investor.

UITFs also allow its investors to tap into their specific preferences. They can choose to limit their investments to only peso or dollar-denominated assets. They can also choose between equities or bonds or money market instruments or go for a more diversified fund.

Having a UITF is itself a move forward for the development of the financial market. It taps into the supply of smaller parcels of investable funds and then induces a demand for other market instruments. This is possible because the investment risk is essentially diversified across several investors, several portfolio options and several specific assets.

Are UITFs for you?

All these benefits come at some cost because UITFs are not risk-free instruments. They can generate gains but only with the possibility of losses. UITFs are suitable for “investors” who have the patience to parlay their excess funds into some gains and have the financial capability to absorb losses. If your foremost objective is to protect the principal amount you have already set aside, UITFs are not for you.

Because of the nature of the underlying instruments, UITFs are not generally structured for those with a short investment horizon. Those who have the patience and resources for medium-to-long term investments can ride out the day-to-day volatilities without eroding their overall investment view. This gives added stability to UITFs.

But it also does not mean that UITF investors should always disregard a declining NAVPu. The responsibility of monitoring the performance of a UITF is still on the investor with the added burden that she/he must understand what is causing the NAVPu to change (for example, interest rate changes or credit standing of assets etc). Since the investor can always redeem the investment from the UITF, the burden of deciding whether evolving market changes are temporary or systemic enough to warrant redemption still rests with the investor.

At the end of the day, UITFs do serve a particular investment purpose for particular investors. In considering it as an investment option, two things are worth remembering:

1. The information hurdle is set higher for UITFs since its investors need to continually monitor and process market information; and

2. Investors do not invest money that they cannot afford to lose.

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