2.2 Collective Investment Schemes and Funds

2.2 Collective Investment Schemes and Funds

Collective Investment Schemes (CIS) are institutional arrangements that pool capital from multiple retail and institutional investors. The pooled funds are deployed into a diversified portfolio of securities—such as equities, fixed income bonds, money market instruments, and alternative assets—administered by professional fund managers. In the Philippines, the collective investment landscape is bifurcated across two primary regulatory jurisdictions: the Securities and Exchange Commission (SEC) and the Bangko Sentral ng Pilipinas (BSP).

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The Philippine Regulatory Dichotomy

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Mutual Funds under the Investment Company Act (RA 2629)

A mutual fund in the Philippines is legally incorporated as a separate stock corporation under the Revised Corporation Code (RA 11232) and the Investment Company Act of the Philippines (Republic Act No. 2629). Because a mutual fund is a standalone corporation, investors buy shares of stock and become voting shareholders of the investment company.

Minimum Capitalization and Governance Requirements

Under RA 2629 and SEC implementing rules:

• Minimum Paid-Up Capital: An investment company must possess a minimum paid-up capital of Php 50,000,000 (fifty million pesos) upon initial registration.
• Board of Directors: The investment company is governed by a Board of Directors elected by shareholders. Under corporate governance standards, a significant proportion of the board must consist of independent directors to resolve potential conflicts of interest with the external fund manager.
• Asset Segregation and Custodianship: The assets of an investment company cannot be held directly by the fund manager. Section 26 of RA 2629 mandates that all cash and securities must be placed in the safekeeping of an independent, SEC-approved Custodian Bank (typically a universal bank with trust authority).

Operational Roles in a Mutual Fund

1. Fund Manager / Investment Adviser: An SEC-licensed corporate entity hired under an investment advisory contract to make day-to-day asset allocation and trading decisions.
2. Principal Distributor / Underwriter: An entity contracted to market, offer, and sell mutual fund shares to the public through SEC-licensed Certified Investment Solicitors (CIS).
3. Transfer Agent: An SEC-registered transfer agent that maintains the official registry of shareholders, tracks share subscriptions and redemptions, and distributes corporate notices.

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Unit Investment Trust Funds (UITFs) under BSP Regulation

A Unit Investment Trust Fund (UITF) is an open-ended pooled trust fund established, administered, and maintained by a licensed Trust Entity (such as the trust department of a universal or commercial bank, or a stand-alone trust corporation) pursuant to the Manual of Regulations for Banks (MORB) and BSP Circular No. 447 (as amended).

Key Structural Characteristics

• Trust Relationship: A UITF is not a corporation. There is no board of directors and no corporate capital stock. Investors enter into a fiduciary trust arrangement governed by a master Declaration of Trust (Plan Rules).
• Units of Participation: Participating investors do not hold shares; they hold units of participation, evidenced by a Confirmation of Participation (COP). Investors are trust beneficiaries, not stockholders, and have no corporate voting power.
• No Deposit Insurance: UITFs are trust products, not bank deposits. Consequently, UITFs are not insured by the Philippine Deposit Insurance Corporation (PDIC) and do not guarantee principal preservation or fixed yields.

Mandatory Investor Protection Protocols

Before admitting an investor into a UITF, BSP regulations require the trust entity to administer:

1. Client Suitability Assessment (CSA): An objective profiling tool evaluating the client's financial sophistication, investment horizon, net worth, and risk tolerance (categorizing investors as Conservative, Moderate, or Aggressive).
2. Risk Disclosure Statement (RDS): A standardized disclosure explicitly warning that past performance is not indicative of future returns, that the portfolio is subject to market risks, and that potential losses are borne entirely by the investor.

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Open-End vs. Closed-End Investment Companies

The Investment Company Act recognizes two primary corporate classifications:

Open-End Investment Companies

An open-end company (commonly referred to as an open-end mutual fund) is an investment company that is offering for sale or has outstanding any redeemable security of which it is the issuer.

• Elastic Capitalization: The fund continuously issues new shares whenever an investor subscribes, and retires/cancels shares whenever an investor redeems.
• Direct Redemption: The company is legally obligated to redeem outstanding shares upon demand at the prevailing Net Asset Value Per Share (NAVPS), subject to reasonable settlement windows (typically within seven business days under RA 2629).
• Off-Exchange: Open-end mutual funds do not trade on the stock exchange. All subscriptions and redemptions occur directly with the fund company or its authorized distributors.

Closed-End Investment Companies

A closed-end company issues a fixed number of shares through an Initial Public Offering (IPO), after which its capital stock is closed to further subscriptions.

• Fixed Capitalization: The fund does not continuously issue new shares nor does it redeem shares upon shareholder demand.
• Exchange Trading: Investors seeking liquidity must sell their shares to other investors in the secondary market on an organized stock exchange, such as the Philippine Stock Exchange (PSE).
• Pricing Dynamics: The trading price of closed-end fund shares is determined by secondary market supply and demand. Consequently, closed-end shares frequently trade at a discount or a premium relative to their underlying NAVPS.

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Exchange-Traded Funds (ETFs) under SEC Rules

Governed by SEC Memorandum Circular No. 10, Series of 2012, an Exchange-Traded Fund (ETF) is an open-end investment company that tracks the performance of a specific underlying benchmark index (such as the PSE Composite Index / PSEi, as exemplified by the First Metro Philippine Equity Exchange Traded Fund / FMETF).

The Dual-Market Structure

ETFs combine the diversification and open-end redemption features of mutual funds with the intraday trading flexibility of individual stocks:

1. Primary Market (Creation and Redemption):
   • Operates exclusively between the ETF issuer and designated institutional entities known as Authorized Participants (APs).
   • Transactions occur in large aggregated blocks called Creation Units (typically 10,000 to 100,000 ETF shares).
   • Conducted primarily on an in-kind basis: The AP delivers a designated basket of underlying equity securities to the fund custodian and receives newly created ETF shares in return (or vice versa during redemption).
2. Secondary Market (Continuous Exchange Trading):
   • Retail and institutional investors buy and sell individual ETF shares on the PSE throughout the trading day at live market prices.
   • Trades execute in standard board lots through any licensed stockbroker, settling on the standard rolling cycle.
3. Arbitrage Mechanism: If the secondary market price of ETF shares drifts above or below the intraday NAVPS of the underlying portfolio, Authorized Participants step in to execute arbitrage by creating or redeeming Creation Units, driving the secondary market price back into close alignment with the fund's fair value.

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NAVPS and NAVPU Valuation Mechanics

The fundamental pricing benchmark for collective investment funds is calculated at the close of every business day:

$\text{NAVPS / NAVPU} = \frac{\text{Total Portfolio Assets (at Fair Market Value)} - \text{Total Accrued Liabilities}}{\text{Total Number of Outstanding Shares or Units}}$

Valuation Process

• Asset Valuation: Equity holdings are marked to market using the official closing prices reported on the PSE. Fixed income assets are marked using official benchmark yield curves (such as the PHP BVAL rates published by the BTr and PDEx).
• Liabilities: Deducts accrued management fees, custodian fees, auditing expenses, and administrative liabilities.
• Cut-Off Times and Forward Pricing: To prevent speculative market timing, funds enforce a strict daily cut-off time (e.g., 12:00 PM or 2:00 PM). Subscription or redemption orders received before the cut-off receive that day's closing NAVPS. Orders received after the cut-off receive the next business day's NAVPS (forward pricing).

Fee Architecture and Expense Ratios

• Front-End Load: A sales commission deducted from gross subscription capital before shares are purchased (reducing the effective initial investment).
• Back-End Load / Contingent Deferred Sales Charge (CDSC): A redemption charge deducted when shares are liquidated within a prescribed holding period (typically scaling downward from 2% to 0% after 2 to 3 years).
• No-Load Funds: Funds that charge zero entry or exit sales fees, compensating managers solely through ongoing operational fees.
• Total Expense Ratio (TER): The annualized percentage of average net assets consumed by operational and administrative overhead: $\text{TER} = \frac{\text{Management Fees} + \text{Custody Fees} + \text{Audit Fees} + \text{Other Operating Costs}}{\text{Average Net Asset Value}} \times 100\%$

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Practical Exam Traps

• PDIC Insurance Trap: UITFs and mutual funds are never insured by the PDIC. A test question suggesting that bank-administered UITFs enjoy PDIC protection up to ₱1,000,000 is false.
• Ownership Status Trap: Mutual fund investors own shares of stock and have corporate voting rights. UITF investors hold units of participation under a trust agreement and have no shareholder voting rights.
• Redemption Price Trap: Open-end mutual fund redemptions are processed at NAVPS, whereas closed-end funds and ETFs are bought and sold on the secondary market at market price, which can deviate from NAVPS based on supply and demand.