Collective investment schemes

What Are Collective Investment Schemes?

Collective investment schemes (CIS) are financial structures that pool money from multiple investors to invest in a diversified portfolio of securities and other assets. These schemes are managed by professional fund managers, offering individuals access to broader markets and professional portfolio management that might otherwise be unavailable or impractical for a single investor. They fall under the broader financial category of Investment Management. The core principle of a collective investment scheme is to enable diversification and professional oversight, often with lower transactional costs than if each investor were to purchase individual assets.

History and Origin

The concept of pooling funds for investment has roots dating back centuries. One of the earliest examples of a collective investment scheme, a precursor to modern investment vehicles, is often attributed to Adriaan van Ketwich, a Dutch merchant who created a trust called Eendragt Maakt Magt ("unity creates strength") in 1774, aiming to provide broader investment opportunities for small investors.⁴ In the United States, the first modern mutual fund, the Massachusetts Investors Trust, was launched in Boston in 1924, marking a significant step in making professionally managed portfolios accessible to the public.³

The rapid growth of collective investment schemes and the complexities they introduced led to the need for formal regulation to protect investors. A landmark piece of legislation in the U.S. was the Investment Company Act of 1940, signed into law by President Franklin D. Roosevelt, which established the regulatory framework for investment companies, including most collective investment schemes.² This act, enforced by the Securities and Exchange Commission (SEC), mandated disclosure requirements and set standards for how these funds operate to minimize conflicts of interest.¹

Key Takeaways

• Collective investment schemes pool money from multiple investors for diversified investment.
• They provide access to professional management and diversified portfolios.
• Types include mutual funds, exchange-traded funds (ETFs), and hedge funds.
• They are subject to regulatory oversight to protect investors and ensure transparency.
• Costs, such as the expense ratio, can impact overall returns.

Formula and Calculation

While there isn't a single universal formula for a "collective investment scheme" itself, a key metric used to value many types of collective investment schemes, particularly open-end investment funds like mutual funds, is the Net Asset Value per share (NAV).

The NAV is calculated as:

$\text{NAV per Share} = \frac{\text{Total Assets} - \text{Total Liabilities}}{\text{Number of Shares Outstanding}}$

Where:

• Total Assets: The market value of all holdings within the fund (e.g., stocks, bonds, cash).
• Total Liabilities: All the fund's debts, including accrued expenses, administrative costs, and any outstanding payments.
• Number of Shares Outstanding: The total number of units or shares issued by the fund that are currently held by investors.

The net asset value is determined at the end of each trading day and is the price at which investors buy or sell shares directly from the fund.

Interpreting Collective Investment Schemes

Interpreting a collective investment scheme involves understanding its structure, investment objectives, and fee schedule. For investors, a CIS offers a way to achieve asset allocation goals without individually purchasing every security. The scheme's prospectus, a legal document, details its investment strategy, the types of assets it will hold, and its associated risks. Investors should evaluate a collective investment scheme based on its stated objectives aligning with their own risk tolerance and financial goals. Key aspects to consider include the fund's historical performance (understanding that past performance does not guarantee future results), its management team, and any sales loads or ongoing fees.

Hypothetical Example

Consider an investor, Sarah, who has $5,000 to invest but lacks the time or expertise to research individual stocks. She decides to invest in a diversified collective investment scheme, Fund XYZ.

1. Pooling Funds: Sarah's $5,000 is pooled with money from thousands of other investors.
2. Professional Management: Fund XYZ's fund managers use the aggregated capital to buy a diverse portfolio of hundreds of stocks and bonds across various industries and geographies.
3. Diversification Benefit: Instead of owning just a few shares of one or two companies, Sarah effectively owns a small portion of hundreds of different companies and bonds, significantly reducing her risk compared to investing in individual securities.
4. Returns and Fees: Over the year, Fund XYZ's portfolio generates capital gains and dividends. After deducting its management fees and operating expenses, Sarah's share of the fund increases in value, reflecting her proportional ownership in the scheme's overall performance. If the fund's NAV per share was $10 at the start and grew to $11, Sarah's initial 500 shares (assuming no sales loads) would now be worth $5,500.

This example illustrates how a collective investment scheme provides an accessible and professionally managed path to market participation for individual investors.

Practical Applications

Collective investment schemes are widely used across various facets of finance:

• Individual Investing: They are a primary vehicle for retail investors seeking professional management and liquidity. This is especially true for retirement accounts like 401(k)s and IRAs, where mutual funds are a staple offering.
• Retirement Planning: Pension funds and other institutional investors frequently invest in collective investment schemes to manage large pools of assets for their beneficiaries, aiming for long-term growth and stable income streams.
• Wealth Management: Financial advisors often recommend collective investment schemes as core components of client portfolios, tailoring allocations based on client objectives and risk profiles.
• Regulatory Oversight: Regulatory bodies globally, such as the SEC in the U.S. and organizations like the International Organization of Securities Commissions (IOSCO), play a crucial role in overseeing collective investment schemes to ensure investor protection, market integrity, and transparency. IOSCO, for instance, publishes principles for the valuation of collective investment schemes to promote fair practices.

Limitations and Criticisms

While beneficial, collective investment schemes are not without limitations and criticisms:

• Fees and Expenses: Investors in collective investment schemes incur various fees, including management fees, administrative costs, and sometimes sales loads. These fees, particularly for actively managed funds, can erode returns over time. Research, for example, suggests that many actively managed funds tend to underperform their passive counterparts after accounting for these higher fees.
• Lack of Control: Investors cede control over investment decisions to the fund manager. This can be a drawback for investors who prefer to select individual securities or employ specific tax-loss harvesting strategies that are not part of the fund's mandate.
• Dilution of Returns: While diversification reduces risk, it can also dilute potential returns. A collective investment scheme designed to mirror a broad market index, for example, will generally not outperform that index, even if a few individual holdings within it perform exceptionally well.
• Tax Inefficiency: Depending on the fund's trading activity and distribution policies, investors may be subject to capital gains taxes on distributions even if they do not sell their shares, which can be a concern in taxable accounts.

Collective Investment Scheme vs. Mutual Fund

The terms "collective investment scheme" and "mutual fund" are often used interchangeably, but it is important to understand their relationship. A collective investment scheme is a broad category encompassing various pooled investment vehicles. A mutual fund is a specific and common type of collective investment scheme.

The confusion arises because mutual funds are perhaps the most widely recognized and accessible form of collective investment scheme for individual investors, particularly in the United States. However, other structures, such as exchange-traded funds (ETFs) and hedge funds, also fall under the umbrella of collective investment schemes, each with distinct operational characteristics and investor accessibility.

FAQs

What is the primary benefit of investing in a collective investment scheme?

The primary benefit is gaining access to professional money management and a diversified portfolio, which helps reduce the specific risk associated with investing in individual securities. This allows investors to achieve broader market exposure with a smaller capital outlay.

Are all collective investment schemes the same?

No. While they share the common principle of pooling money, collective investment schemes come in various forms, such as mutual funds, exchange-traded funds (ETFs), hedge funds, and unit investment trusts. Each type has different structures, liquidity features, fee structures, and regulatory requirements.

How are collective investment schemes regulated?

Collective investment schemes are typically subject to strict regulation by government bodies to protect investors. In the U.S., the Securities and Exchange Commission (SEC) regulates mutual funds and other investment companies under the Investment Company Act of 1940, mandating disclosures, operational standards, and oversight.

Can I lose money in a collective investment scheme?

Yes, investing in a collective investment scheme carries investment risk, and you can lose money. The value of your investment will fluctuate with the performance of the underlying assets held by the fund. While diversification aims to mitigate risk, it does not eliminate the possibility of losses.

What fees should I be aware of when investing in a collective investment scheme?

Investors should be aware of various fees, including the expense ratio (which covers management fees and operating expenses), and potentially sales loads (front-end or back-end) or redemption fees. These fees directly impact your net returns, so understanding them is crucial before investing.