Chapter 4 · Collective Investments

Collective Investment Schemes (CIS) let many investors pool money into a single fund managed on their behalf. Three core benefits:

• Diversification — a $5,000 investor can get exposure to hundreds of securities; on their own, they could only afford a handful
• Professional management — access to specialist expertise the individual investor probably can't replicate
• Economies of scale — lower per-investor dealing costs, custody fees and administration costs

Plus practical conveniences: simpler administration, easier diversification across asset classes and geographies, regulated structures provide protection.

The Net Asset Value (NAV) per unit is the per-unit value of the fund's net assets at the valuation point. It's the price at which open-ended funds transact:

Open-ended funds trade at NAV (creation/cancellation absorbs any discrepancy). Closed-ended funds DON'T — their share price is set by supply and demand and can deviate from the NAV of their assets:

• Premium to NAV — share price ABOVE NAV. Buyer is paying more than the assets are worth.
• Discount to NAV — share price BELOW NAV. Buyer gets the assets at a discount but bears the risk it never closes.

Persistent discounts are common in closed-ended trusts, especially in unfashionable sectors or for trusts with weak governance.

Investment trusts (UK-style) are closed-ended COMPANIES whose shares trade on the LSE. Distinctive features:

• Permanent capital — manager isn't forced to sell holdings when investors want out
• Can use gearing (borrowing) to invest, amplifying gains and losses
• Independent board of directors overseeing the manager — extra layer of accountability
• Can hold illiquid assets (eg, private equity, property) without liquidity-mismatch problems
• Often trade at discounts; share buybacks can be used to manage this

Both are open-ended. OEICs are the more modern UK structure (introduced 1997). Continental Europe uses SICAVs, which are similar to OEICs.

UCITS (Undertakings for Collective Investment in Transferable Securities) is the EU regulatory framework for funds that can be marketed to RETAIL investors across all member states under a single rulebook.

To gain UCITS status, a fund must comply with strict requirements: diversification limits, restrictions on borrowing, derivative-use rules, daily liquidity, transparent disclosure. In return, it gets the EU passport — sell across borders without separate authorisation in each country.

The key diversification rule for UCITS funds:

• No single issuer may represent more than 5% of the fund (raisable to 10% in some cases)
• The sum of all 5%+ holdings must not exceed 40% of the fund

This forces broad diversification — concentrated bets are not allowed.

An ETF is an open-ended pooled fund whose shares trade INTRADAY on a stock exchange, just like ordinary shares. Most ETFs track an index (passive); some are actively managed.

How prices stay close to NAV: AUTHORISED PARTICIPANTS (large institutions) can create new ETF shares by delivering the underlying basket of securities to the fund, or redeem ETF shares for the basket. If the market price drifts from NAV, APs arbitrage the gap — pushing prices back in line.

Compared with traditional index funds:

• Intraday trading at market prices (vs daily NAV)
• Often lower total cost than equivalent OEIC index trackers
• Can buy in small amounts via a brokerage account — no separate fund-platform needed

ETCs let investors get commodity exposure through exchange-listed instruments. Two types:

• Physically backed — the issuer holds physical commodity (eg, gold bars in a vault). Each ETC unit represents a claim on a fixed amount.
• Synthetic — uses futures or swaps to track the commodity price. Exposed to roll yield and counterparty risk.

A structured product is a hybrid instrument that combines a debt component (eg, a bond) with a derivative (often an option on an index). The payoff is engineered to specific outcomes:

• Structured deposit — capital returned at maturity + index-linked return. Often FSCS / deposit-protection eligible. Return capped or formula-based.
• Structured capital-protected product — capital returned by the issuer at maturity + index-linked upside. NOT typically deposit-protected; bears ISSUER CREDIT RISK.
• Structured capital-at-risk product (SCARP) — capital can be LOST if a barrier is breached. Returns linked to an index but with much higher risk.

• Issuer credit risk — usually the biggest risk
• Complexity — payoffs can be hard for retail investors to understand
• Liquidity — usually meant to be held to maturity; early exits may be costly or impossible
• Limited upside — returns often capped at a maximum level
• Tax treatment — can be unfavourable and complex

A hedge fund is a lightly-regulated pooled vehicle, typically structured as a limited partnership, aimed at sophisticated/professional investors. Hedge funds enjoy investment flexibility unavailable to regulated retail funds: leverage, short selling, derivatives, illiquid assets, concentrated positions.

"Hedge" originally referred to hedging market risk (eg, long/short equity), but the term now covers a vast range of strategies.

• Unregulated / lightly regulated structure — usually a limited partnership in a tax-friendly jurisdiction (Cayman, Delaware, Luxembourg)
• High minimum investment — typically $100,000+; often $1m+
• Restricted to qualified investors — high-net-worth / professional
• Limited liquidity — lock-up periods (eg, 12 months) + notice periods (eg, 60-90 days) + possibly gates
• 2 and 20 fee structure — 2% annual management fee + 20% performance fee above a high-water mark

Absolute return funds aim to deliver positive returns in ALL market conditions, regardless of benchmark performance. They use the full hedge-fund toolkit: long/short, derivatives, leverage.

Why they often underperform in bull markets: their hedges (short positions) drag on performance when everything's rising. Their value shows up in bear markets and choppy periods.

Private equity (PE) is medium- to long-term equity finance provided in exchange for a stake in PRIVATE (unlisted) companies. PE houses raise capital from institutional investors (pensions, endowments) and high-net-worth individuals through closed-ended limited partnerships with fund lives typically of 10 years.

Types of PE investment:

• Venture capital (VC) — early-stage companies, often pre-profit. Higher risk, higher potential return.
• Growth equity — established but expanding businesses
• Buyouts (LBOs) — mature companies, often with leverage to amplify returns
• Distressed — struggling businesses bought at low prices for turnaround

PE returns are realised primarily on EXIT — not through ongoing dividends. Routes:

• Trade sale — sell to another corporate
• Secondary sale — sell to another PE firm
• IPO — float the company on a stock exchange
• Sale back to management — management buyout

Until exit, holdings are illiquid. Investors commit capital for years.

Two main routes for commodity exposure in a fund:

• Physical holdings — only viable for storable commodities (gold, silver). Fund holds the metal in a vault.
• Futures-based — fund rolls a portfolio of futures contracts. Exposed to ROLL YIELD (gain or loss when rolling expiring futures into new contracts).

Why futures-based funds can underperform the spot price: in contango (futures above spot), each roll converts a cheaper near contract into a more expensive longer-dated one — a negative drag. In backwardation, the reverse — a positive drag.

Islamic finance follows Shariah law. Four key prohibitions:

• Riba (interest) — payment or receipt of interest is forbidden. Rules out conventional bonds and savings accounts.
• Gharar — excessive uncertainty or speculation. Rules out most derivatives and gambling.
• Haram industries — investments in alcohol, tobacco, gambling, pornography, conventional finance, pork are prohibited
• Risk-sharing — both parties to a financial transaction should share both profits and losses (vs interest-based lending where lender gets paid regardless)

A sukuk represents PARTIAL OWNERSHIP of an underlying asset (tangible or intangible). The investor's return derives from the asset's economic performance — rentals, profits, lease payments — NOT interest.

Sukuk are neither pure shares nor pure bonds — they're hybrid instruments backed by real assets.

Key features:

• Linked to underlying assets (not pure debt)
• Returns depend on asset performance
• Investors share PROPORTIONATE losses if the asset underperforms
• Financial guarantees not typically allowed

Ijara means lease. A sukuk al-ijara works like this:

1. A Special Purpose Vehicle (SPV) is created
2. The SPV issues sukuk certificates to investors and uses the cash to buy an asset (real estate, aircraft, ship) from an originator
3. The SPV leases the asset BACK to the originator for a specified term
4. Lease rentals from the originator flow through the SPV to the sukuk holders as periodic distributions
5. At maturity, the originator buys back the asset under a pre-agreed purchase undertaking, repaying the sukuk principal

This is the most common international sukuk structure — simple, widely understood, and accepted by both Islamic and conventional investors.