The Sterling Repor   With Kevin Richard   Sunday, July 26, 2015

NEW YORK, United States — In this Oct. 8, 2014, file photo, American flags fly in front of the New York Stock Exchange. Asian stock markets were rattled Friday by a slump in Chinese manufacturing to a 15-year low and cautious earnings outlooks from US companies. European benchmarks rose as talks began in Athens for Greece’s bailout. (PHOTO: AP)

THE local financial sector has had more than its fair share of upheavals over the last 20 years; crises range from high interest rates and the collapse of major financial institutions, to multiple debt exchanges, outright debt defaults and the rise and fall of Ponzi schemes.

There is really never a dull moment in the financial sector.

The latest local market investment trend is the move towards Collective Investment Schemes or CISs. This move is expected to reduce the capital adequacy shortfalls that are currently facing many financial institutions.

Investment managers have been promoting these products as a way of shifting the risk of holding local assets from their balance sheet to the client’s portfolio. It is important to understand that when an investor buys a share in a unit trust or a mutual fund, he/she ultimately owns a proportional share of the underlying assets within the portfolio. Thus, it is very important for investors to understand what types of assets are held by the mutual fund or unit trust in which they are investing.

Let’s explain how this happens:

Step 1: Institution A purchases a government bond yielding 12 per cent per annum.

Step 2: Institution A approaches prospective client and offers said client 4.0 per cent per annum, for example, to keep their money for a term ranging from 30 days to 365 days or even longer. The government bond will act as “collateral” for the client’s funds. This common structure is known as a “repo” — short for “repurchase agreement”.

Effectively, Institution A is ‘selling’ the client the government bond for a pre-determined tenure and agreeing to buy it back (that is, ‘repurchase it’) at a price that yields the investor 4.0 per cent; hence the term “repo”. Institution A is essentially giving the client the asset (that is, the government bond) in exchange for his/her cash and taking a spread on the rate differential between what the client is paid and what the asset earns.

Institution A therefore earns the difference between the income from the asset (12 per cent) and the price paid to the client (4 per cent). In the event, the government bond matures and re-investment interest rate falls, the spread for the financial institution will narrow. The effect of changes in the value of the repo “collateral” or the changes in the interest rate is borne solely by Institution A.

Alternativley, if a client invests in a CIS, he/she owns a stake in that “government bond” described above. Technically, the client owns a stake in a vehicle (that is, a unit trust/mutual fund) that in turn owns the asset. This means that the client will share in both the upward or downward shift in value of the bond and the risks that may exist with reinvesting in a new asset.

The move is certainly one that should bring more stability and diversity to financial institutions, reducing their exposure to price volatility of funded assets. However, this could create a prolonged period of adjustment for clients who have only been schooled in the art of the Repo and know nothing of price risk. In such an instance, a client would no longer be able to precisely predict their returns and there will no longer be any fixed repurchase dates and total return rates as there are with repos.

This shift has already begun as some institutions have dropped the axe on repo rates, leaving clients scampering in the hope of purchasing unit trusts or mutual funds.

What is certain, is that the era of ‘guaranteed’ rates of returns on fixed income investments with ‘minimal risk’ is part of the past, particularly so for larger financial institutions that maintain large repo portfolios. Institutions will now have to focus on being more efficient and nimble in order to meet this new paradigm shift.

How will your investment manager sustain attractive returns?

Currently, we see the market engaging more actively in the sale of CIS to reduce their own balance sheet risk. However, what are the implications for the investor and how aligned are the incentives of the investment manager?

We expect that more efficiently run organisations with strong track records of managing a variety of portfolios, may still be able to offer some sort of fixed period, short-term fixed income investment. Investors will now have to review the track record of some investment houses to determine which CIS is worthy of their investment.

In this new era, return of capital and return on capital will rank equally.

Kevin Richards is Vice-President, Sales and Marketing at Sterling Asset Management Ltd. Sterling is a licensed securities dealer and provides investment management and advisory services to the corporate, individual and institutional investor. Feedback: If you wish to have Sterling address your investment questions in upcoming articles, please e-mail us at: info@sterlingasset.net.jm or visit our website at www.sterling.com.jm. Like our page on Facebook and follow us on Twitter.

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