|Index Investment Funds
- new possibilities of the schemes of collective investments and exchange technologies.
А.Е. Abramov, NDC deputy director.
| The present article contains the analysis of a new investment product fast-growing in Europe and the USA, and also of the perspectives of the registration of this experience on the Russian stock market, which, unfortunately, is not yet characterized by the flexibility of its response to the inquiries of the investors, issuers and its targeting at the advantages of new exchange technologies.
It will discuss the so-called investment funds, the portfolio of which is oriented at one of the conventional fund indexes, issuing Exchange Traded Funds. Further in the article we shall call such investment funds Index Investment Funds, or "IIF".
The dynamics of the IIF assets in the USA for the past 7 years is presented in fig. 1 in accordance with the data supplied by Morgan Stanley Dean Witter.
As follows from the diagram in fig. 1, since 1994 the total market cost of the IIF assets in the USA was annually doubled and increased from 0.5 bln. dollars in 1994 up to 56.1 bln. dollars in November, 2000.
According to the forecasts presented by the same organization, during the nearest 5 years the cost of IIF assets in the USA can increase 4 times more to exceed 200 bln. US dollars. At that the share of IIF assets in the total cost of the portfolios of the American investment funds will increase from the present 8-10 % up to 27 %.
In Great Britain the first IIF, the composition and structure of the portfolio of which reproduce the FTSE 100 stock index, began to operate since April 2000. In a few months of the past year the cost of assets of such investment funds reached 11 bln. pounds, or 5 % of the total cost of assets of the unit trusts. Taking into account the obvious advantages of IIF as compared to the current UK schemes of collective investments, a number of experts forecast that IIF can become the dominant form of collective investments on the British stock market. 1.
What is an IIF??
IIF are an extension of the traditional collective investment schemes.
In the USA IIF are formed on the basis of the Act of 1940 "On investment companies", as a rule, in the form of a unit investment trust or mutual fund.
The first steps in the creation of the IIF industry were made in the USA in 1993 in the course of implementation of the joint project of the American Stock Exchange (hereinafter referred to as AMEX) and State Street Bank (hereinafter referred to as SSB) to organize the trading on AMEX of the depositary receipts issued by the unit investment trust "SPDR Trust", managed by State Street Bank and Trust Company, being a part of the SSB holding2. The composition and structure of the unit investment trust portfolio managed by SSB corresponded to the composition and structure of the shares portfolio used for the calculation of the S&P500 stock index, therefore the securities issued by the fund received the title of depositary receipts for the S&P500 stock index (Standard & Poor's Depositary Receipts).
Let's consider the organization and mechanism of the IIF operation using the example of the first unit investment trust "SPDR Trust". .
Main organizations providing the IIF operation
(using the example of the "SPDR Trust" investment fund)
||Unit investment trust - investment company founded under the laws of New York, issuing depositary receipts (SPDR)
||Listing and organization of secondary trading in the depositary receipts issued by IIF.
Services LLC (100%-я daughter structure AMEX)
||Depositing of the securities and money resources in the capital of IIF at its establishment, transfer of the management of the said assets to the Trustee, receiving of the license for the right to use the S&P500 stock index during the IIF activity.
Street Bank and Trust Company
||1. IIF Trustee
||Management of IIF assets, issue and redemption of the depositary receipts in the name of IIF through the Distributor, control over the conformity of the IIF portfolio to the composition and structure of the securities included in the calculation of the S&P500 stock index.
IIF assets Custodian
||Keeping of the securities and other assets forming the IIF portfolio.
||Calculation of the net asset value (NAV) of IIF. Accounting and reporting of IIF
Mutual Fund Services, Inc.
||Distributor of depositary receipts issued by IIF
||Collecting of applications for acquisition and redemption of the depositary receipts and their transfer to the Trustee, issue of instructions to the Trustee to make a credit/debit entry in the accounts of securities on registering the rights to the depositary receipts.
||Receive applications for the redemption and placing of the depositary receipts and participate in their placing and redemption on the basis of the Participant Agreement with the Distributor.
As participating parties there can be:
1. Brokers/dealers and other participants of the Continuous Net Settlement System (CNS) created by the NSCC clearing organization;
2. DTC Depositary participants.
Depository Trust Company (DTC)
Depository registering the rights to depositary receipts issued by IIF
||Keeping the global certificate of the depositary receipts of IIF, certification of the rights to the depositary receipts of IIF on the accounts of the securities of the holders and nominee holders
||Keeping the securities from the IIF portfolio on the account of the nominee holder opened in the name of the IIF asset Custodian, nominee holder of the IIF shares in the registers of the security holders, entering / writing off of the IIF depositary receipts from the said account of the securities on their placing / redemption
National Securities Clearing Corporation (NSCC)
||Delivery / writing off of the securities package corresponding to the composition and structure of the stock index, in accordance with the results of transactions on the stock exchanges from / to the security accounts of the Participating parties with DTC to / from the IIF securities account with DTC on placing / redemption of the depositary receipts.
McGraw-Hill Companies, Inc.
||Calculation and disclosure of information on the S&P500 stock index (The Standard & Poor's 500 Composite Stock Price Index), issue of the license to the Fund Sponsor for the right of using the S&P500 stock index in the course of IIF operation
The unit investment trust SPDR Trust was founded in accordance with the legislation of New York for the period of 25 years. The Sponsor of SPDR Trust paying the initial capital of the unit investment trust was the subsidiary company of the AMEX stock exchange - "PDR Services, LLC".
This decision, rather unconventional from the point of view of the Conflict of interests rules on the stock market, has quite reasonable explanations. First of all, the sponsor of the unit investment trust does not play an active role in the disposal and management of the assets of such fund, transferring all its assets since the very first day of the unit investment trust existence to the Managing company (authorized representative). Secondly, the function of the sponsor of the unit investment trust subsequently allows the stock exchange to define the rules of its operation, including the regulation of exchange trading, placing and redemption of the depositary receipts issued by the unit investment trust using the clearing organization and settlement depository. Besides, the stock exchange gets the possibility of encouraging a more active usage in the investment process of the generally accepted composite stock indexes. And, finally, the stock exchange more than anybody else is interested in the creation of new attractive investment products fully supported by the advantages of exchange technologies and their advance on the stock market.
In the scheme of the unit investment trust, including SPDR Trust, depositary receipts are emission (or, according to the American legislation - "investment") securities certifying the indivisible property rights to the portfolio of securities held by the unit investment trust.
The depositary receipts of unit investment trusts in the USA are issued in the form of non-documentary securities with a centralized form of storage of their global certificate kept in the settlement depositary of the stock exchange (The Depository Trust Company). The rights of the holders of the depositary receipts are certified as records on the accounts of securities opened by the market participants directly with DTC or with the depositories (brokers-dealers, banks-custodians), having the accounts of nominee holders in DTC.
The rights to vote vested in the securities included in the portfolio of the unit investment trust belong solely to the Managing company of the fund, the holders of the depositary receipts having no such right.
Composition and structure of the IIF portfolio.
A distinctive feature of unit investment trusts in the USA is the presence of a fixed structure and composition of the investment fund portfolio during its whole life time established in the prospectus and agreement between the sponsor of the fund and the Managing company (in case of the unit investment trust "SPDR Trust" - 25 years). It is this circumstance that makes the form of a unit investment trust more convenient for the IIF organization than, for example, that of mutual funds.
The composition and structure of the unit investment trust SPDR Trust portfolio should correspond to the composition and structure of the portfolio of securities used in calculating the S&P500 stock index (The Standard & Poor's 500 Composite Stock Price Index). The ensuring of the indicated conformity is the duty of the authorized representative - Managing company of the unit investment trust, the control over the proper discharge of this duty by the authorized representative being realized by the sponsor of the unit investment trust - AMEX stock exchange. At that the unit investment trust on the basis of the relevant license and special agreement has received the right to use the S&P500 stock index from the holder of the given investment product - The McGraw-Hill Companies, Inc., a subdivision of which is the Standard & Poor's agency.
Let's remark that the composition and structure of the unit investment trust portfolio not always precisely corresponds to the composition and structure of the portfolio of the securities included in the calculation of the base stock index. Some deviations, in the event that they correspond to the interests of the investors of the unit investment trust or have an enforced character (for example, in case of a temporary absence of non-liquid securities included in the calculation of the index in the market), may be allowed by the decision of the authorized representative of IIF.
Listing and trading in depositary receipts.
The depositary receipts of the unit investment trust SPDR Trust are included in the listing and traded on the AMEX stock exchange. The transactions are concluded and settlements under the transactions with depositary receipts on the "delivery against payment" terms are effected in the order established for the shares and other securities traded at the above stock exchange.
According to the rules of security trading at AMEX the following main terms for including the depositary receipts in the stock exchange listing are established:
1. The IIF portfolio or the relevant stock index should consist by at least 90 % of the issues of shares, each of which should correspond to the following criteria:
- the market cost of the securities issue constitutes not less than 75 mln. US dollars;
- during 6 months the minimum monthly volume of the shares traded at the stock exchanges constitutes not less than 250 thousand pieces.
2. The specific gravity of any issue of shares in the structure of the IIF portfolio or stock index should not exceed 25 %, and the specific gravity of five issues of shares having the greatest specific gravity in the structure of the IIF portfolio or stock index should not exceed 65 % in this structure.
3. The composition of a portfolio investment fund or stock index consists of not less than 13 issues of shares.
4. All securities issues in the composition of the IIF portfolio or stock index should be included in the listing on the national stock exchange or in the NASDAQ trading system.
5. The stock index forming the basis for the IIF portfolio should meet the following requirements:
- the index should be calculated pursuant to market capitalization, modified market capitalization or another generally accepted methodology;
- the index should be calculated by a person not being a broker-dealer, and if the information about the stock index is disclosed by a broker-dealer, the latter should hold on to the "Chinese wall" principle with respect to the personnel having access to the unpublished information on the changes and current updating in the given stock index calculation;
- the base stock index should be re-estimated and disclosed every 15 seconds.
6. The minimum number of the placed depositary receipts for their subsequent secondary negotiation should be not less than 100 thousand pieces.
7. The payment of remuneration to the stock exchange for the listing of the depositary receipts in the amount of 5 thousand US dollars.
8. The granting to the stock exchange of the right of supervision over the depositary receipts negotiation procedures.
The depositary receipts of a unit investment trust are traded on the AMEX stock exchange at the prices as close as possible to their value calculated on the basis of NAV of the trust. Large institutional investors are able to enter into arbitrage transactions with the depositary receipts, using minor deviations of the prices for the depositary receipts in the exchange market and the acquisition and redemption price for the said securities in the primary market.
The secondary market also allows uncovered transactions with depositary receipts resulting in the appearance of "short" positions for the market participants. The depositary receipts can give rise to the issue of derivative financial instruments.
Redemption and placing of depositary receipts.
The placing and redemption of the IIF depositary receipts may be allowed only in the form of large packages, which limits the ability of small and medium-sized investors to acquire and redeem the depositary receipts directly from the unit investment trust.
The issue prospectus of SPDR Trust provides that at placing or redemption of the depositary receipts of the said unit investment trust the minimum package of securities which the investor has the right to acquire or present for redemption shall constitute 50 thousand pieces. Taking into account the fact that the market quotation of the depositary receipts of the trust constitutes about 128 dollars, the minimum value of the transaction to acquire or redeem the said securities in the primary market shall amount to 6.4 mln. US dollars.
РThe settlement with the investor on redeeming from him the depositary receipts is mainly effected by transferring to him a portfolio of securities corresponding to the composition and structure of the IIF portfolio. Under such conditions small and medium-sized investors prefer to acquire the IIF depositary receipts in the secondary market, instead of the primary market directly from the trust and its distributor.
РCalculation of the net assets value and pricing of the depositary receipts.
The scheme of IIF operation does not make use of the conventional methods of pricing in establishing the cost of the securities released by the investment funds, namely, the methods of forward or historical estimations.
Taking into account the fact that the composition and structure of the IIF portfolio, the same as the base stock index, are fixed, the calculation and disclosure of information on NAV and the cost of the depositary receipts in the primary market is performed through generally accepted news agencies practically in the real-time mode.
It has already been mentioned that small and medium-sized investors acquire depositary receipts for the prices having been formed in the secondary market. Institutional investors acquire or redeem the depositary receipts in the primary market for the prices formed at the moment of receiving their application.
Other organizational and legal forms of IIF.
The experience of IIF operation in the form of unit investment trusts in the USA is given in the present article as an example of IIF organization and activity. Alongside with unit investment trusts in the USA there are also IIF formed and operating as mutual funds.
In Great Britain IIF are formed as unit trusts or mutual funds created on the basis of the European legislation and operating on the territory of Great Britain (so-called "OEICs"). The stocks or shares issued by IIF in Great Britain are included in the listing of the London stock exchange (LSE) and circulate in a special trading system "Extra Mark" created by LSE. The settlements under the transactions with stocks or shares of IIF in Great Britain are effected through a centralized clearing organization - "CREST".
The composition and structure of the IIF portfolio in Great Britain corresponds to the composition and structure of the generally recognized stock indexes and, first of all, the FTSE 100 index.
The principles of creation and organization of activity of the indicated IIF are in many respects similar to the principles of organization and operation of unit investment trusts in the USA.
Main advantages of IIF as compared to other schemes of collective investment.
IIF allows the investor to use to the full the advantages of the current collective investment schemes, namely:
- high diversification level of the investment funds portfolios permitting to limit investors' hazards;
- focussing on the potential of the existing stock market infrastructure at placing, negotiation and redemption of the securities issued by investment funds;
- high liquidity level of the securities issued by open type investment funds;
- high degree of protection of the rights and interests of the investors due to the introduction of rigid legislation requirements, creation of a special risk management system for the investors and providing strict supervision on the part of regulatory bodies.
At the same time, IIF have additional benefits as compared to the current collective investment schemes, which explain their advanced growth on the stock market.
Low transaction costs.
According to the data of some studies, during the past 10 years the general profitability level of the financial instruments oriented to stock indexes, steadily exceeded the average profitability level of actively controlled investment funds. With all ambiguity of arguments advanced to explain the given paradox, in particular, by the fact that large investment funds in the USA, with the assets often exceeding dozen billion dollars, may be themselves considered as stock indexes, it shows that IIF by their profitability can well compete with actively controlled investment funds.
At that IIF can provide an additional essential benefit to the investors due to saving on the payment of remuneration to the managing companies, agents for the placing and redemption of the shares (stocks, depositary receipts) issued by IIF, and also on the payment for the services of intermediaries (for example, brokerage) when performing operations with the investment fund securities portfolio.
The table below allows to compare the investors' expenses on the payment for the services to manage some IIF and other varieties of investment funds in the USA.
Average annual management costs for IIF and other categories of mutual funds in the USA4
||Ordinary mutual funds
||0.12 % + commission 5
It follows from the table that the expenses incurred by the investors in the payment for the management services and costs of IIF issuing depositary receipts (SPDR), constituting 0.12 % from NAV of the fund per year, are almost 4 times less than the relevant expenses of the investors placing their assets in generally recognized mutual funds with the portfolio structure oriented to the S&P500 stock index.
Besides, IIF do not make use of collection of extra charges and discounts to the cost of the shares (stocks, depositary receipts) at their acquisition or redemption in the primary market, which all together quite often "devour" up to 5 - 10 % of the cost of the financial investments using the generally recognized collective investments schemes.
Availability of the securities issued by IIF for the unsophisticated investor.
IIF fully use the advantages of organized exchange markets and technologies. The investors have the possibility to invest their savings in the shares (stocks, depositary receipts) of IIF mainly by executing the agreements of their sale and purchase on stock exchanges, instead of by acquiring or redemption of the said financial instruments through specialized distributing networks organized by each investment fund separately.
This allows not only to reduce transaction costs, but also to materially increase the liquidity of the securities issued by IIF. At the stock exchanges the said securities, the same as ordinary shares, are traded during the whole operation day for the prices depending on the supply and demand for the said financial instruments. Provided that the values of the stock index defining the quotations of the shares (stocks, receipts) of IIF are disclosed by the stock exchanges and are accessible even to the unsophisticated investor practically in the real-time mode or with minor delays. A more complete and timely disclosure of the information about IIF is another factor boosting their attractiveness in the eyes of the private investor.
IIF attractiveness for institutional investors.
Transactions with securities issued by IIF are attractive for large institutional investors, which get the possibility to execute arbitrage transactions in the primary and secondary (exchange) market for these securities in case of difference of the quotations on the stock exchange and the cost of the shares (stocks, depositary receipts) calculated on the basis of NAV.
Such arbitrage is an essential factor providing the conformity of the exchange quotations for the IIF shares (stock, receipts) and their NAV-based cost. For example, if the exchange quotation of the IIF shares essentially exceeds their cost on the basis of NAV, the institutional investor - market participant can earn additional profit by acquiring the said shares directly through their primary market. After such transaction the stock quote of the shares falls leading to an equilibrium between the price of the IIF shares on the stock exchange and the NAV-based cost.
New ways of pricing for the securities issued by IIF.
In estimating the cost of the shares (stocks, depositary receipts) IIF do not apply the generally recognized methods of forward or historical pricing of the financial instruments issued by collective investment schemes which quite often put various groups of investors at a disadvantage.
Information on the cost of the IIF portfolio, NAV and quotations of the securities issued by IIF are available to the investors, as a rule, in the real-time mode, through news agencies or special Internet web-sites (for example, www.ishare.net).
Can IIF be of interest for the Russian stock market?
In spite of the fact that the Russian securities market has already accumulated significant experience of applying different forms of collective investments, as yet there are no investment funds similar to IIF in the country. Different from other countries, there are no IIF abroad with the portfolios targeted at the Russian issuers and Russian stock indexes.
The draft federal law "On investment funds", which has got stuck in the State Duma, and the drafts of new normative acts of the Federal Securities Exchange Commission mentioned in mass-media provide the possibility of organizing a secondary market of investment stocks for unit investment trusts (UITs). However, the on the whole positive "novations" of the investment stock market embedded in the said documents already today lag behind the development of new technologies and legislation effective in other countries.
In Russia, where the financial crisis of 1998 destroyed the system of private savings, and the operating schemes of collective investments only start to develop, it is necessary to carefully interpret the experience of IIF, as its use can help to efficiently and speedily solve the following problems:
- to make the costs of the investors placing their assets in collective investment schemes several times less with no prejudice to the reliability of the investments;
- on the basis of the existing infrastructural organizations to create a simple and transparent mechanism for collective investments operation, actually accessible to the wide circle of the Russian investors;
- to significantly lower the hazards of private investors;
- to introduce new financial instruments on the stock market and to give a powerful momentum for accelerated development of the Russian infrastructure and recovery of the system of private savings.
Let's hope that on the Russian stock market the new technologies will more actively serve the needs of the investors, issuers and all market participants, and that the period of time from the development to the introduction of new investment products and technologies will be as short as possible.
"A real time world: the death of the unit trust industry?" (London,
23-24 ноября 2000 г.).
2The present article contains the description of the operation pattern for the investment funds of a new type - Index unit investment trusts (hereinafter referred to as "IUIT"), the investment stocks of which can be negotiated at stock exchanges. The purpose of the article is to formulate for discussion the suggestions about a new investment product which could be interesting to the investors and other participants of the Russian stock market, and also to voice a number of wishes concerning the further development of investment fund legislation.
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