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.

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.

This move is expected to reduce the capital adequacy shortfalls that are currently facing many financial institutions. This shortfall has resulted from the sizable reduction in the prices of local assets that collateralise the large repo portfolios issued by these institutions.

Let’s explain how this happens in plain English:

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 four 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 tenor and agreeing to buy it back (i.e. “repurchase it”) at a price that yields the investor four per cent; hence the term “repo”. Institution A is essentially giving the client the asset (i.e. 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 (four per cent). In the event the government bond falls in value or if the interest rate is reduced, the spread for the financial institution will narrow and the amount of the asset needed to collateralise the repo will increase. It is useful to compare this structure to a bank loan; if the market value of the loan collateral falls below a specific amount, the borrower may have to put up more collateral to satisfy the conditions of the loan. Similarly, the effect of the fall in value of the repo “collateral” and the reduction in the interest rate is borne solely by Institution A . The client still earns his 4 per cent when Institution A is only earning, say, six per cent.

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 (i.e. a unit trust / mtuual 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. Ostensibly, the spread of eight (8) percentage points is what Institution A requires to maintain its operations on a day to day basis.

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. We have observed rates below two per cent on significant sums of Jamaican dollars. In the context of inflation and 14.4 per cent devaluation in 2013, an investor would have been better off purchasing USD and stuffing the cash at the back of his/her closet. What is particularly unfortunate is the fact that despite rising local Treasury Bill and inter-broker interest rates, client repo rates have been moving in the opposite direction. This has resulted in increasingly negative real rates of return for investors; their life savings are being whittled away in real terms. The most recent Bank of Jamaica Treasury Bill tender saw six-month rates averaging approximately 9.11 per cent per annum compared with 6.22 per cent per annum one year ago. The central bank is also offering a new security with yields of 9.03 per cent for the first six months, again affirming higher prevailing local interest rates that are not being passed on to the investor.

What is certain is that the era of “guaranteed” rates of return 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 protfolios, 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 an era of negative real returns on investments, return of capital and return on capital will rank equally in the scheme of things.

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.