Unit Investment Trust Fund Classification

UITF CLASSIFICATION – Easing the Challenge of Selection

As financial markets evolve, investment choices multiply. In the Philippines, nothing exemplifies this better than the number of unit investment trust funds (UITFs) available to the local investor. While certainly a sign of progress and, arguably, of increasing financial sophistication, the proliferation of choices could also be a challenge to someone who simply wants to earn some money on his investment. Recognizing this, the trust industry, through the UITF Council of the Trust Officers Association of the Philippines, set its eyes upon the task of helping the investor through this challenge by introducing the UITF Fund Classification.
The UITF Council’s basic concept was to categorize the UITFs according to the assets they are invested in. By doing so, the Council is enabling potential investors to differentiate the Funds by the respective risk-return characteristics of their underlying assets. UITFs invested principally in equity securities or stocks are called Equity Funds. UITFs invested in a mix of equity and fixed-income securities are called Balanced Funds. UITFs invested in fixed-income securities have four (4) variants distinguished by a parameter called the Macaulay Duration: Money Market Funds, Intermediate-, Medium-, and Long-Term Bond Funds. Funds that are benchmarked against specific indices are called Index Funds.
Equity Funds
The objective of Equity Funds is to maximize returns by investing in equities or stock investments that bear the potential of delivering higher returns from capital appreciation, as well as dividend earnings. However, this potential for earnings carries with it the potential for losses, not only of income, but of principal. Clients investing in this type of fund should be aware of this. They should be risk takers and should be willing to take the risk or volatility associated with investing in equities. A long investment time horizon is recommended when investing in equity funds.

Balanced Funds

The objective of Balanced Funds is to provide its investors with capital appreciation over the medium-term through a portfolio mix of equities and fixed-income securities. For uniformity of standards, the TOAP UITF Council has mandated that the fixed-income investments of Balanced Funds should comprise 40% to 60% of the total Fund. The equity component is aimed at spicing up potential returns through gains on stock investments. The allocation of investments between equity and fixed-income securities is a product of how the fund managers read market conditions, as long as they stay within the prescribed range set by the TOAP UITF Council. The Balanced Fund is for investors who are risk takers. These investors should be aware that the potential for high yields from a portfolio that includes stock market investments also carries with it a higher probability of capital losses that equity investments entail.

Fixed-Income Funds

The UITF Council of TOAP has classified fixed-income UITFs according to a parameter called Macaulay duration. Macaulay duration, expressed in time units, is a technical term in finance that measures the average time to receipt of all the cash flows of a security weighted by their present values. A portfolio’s Macaulay duration may be derived by getting the average of the Macaulay durations of all the securities that make up the portfolio, weighted by their market values.
In simple terms, Macaulay duration reflects a security’s or a portfolio’s sensitivity to changes in interest rates. For example, a bond with a Macaulay duration of three (3) years will roughly behave similarly to a bond with a maturity of three (3) years in terms of sensitivity to changes in interest rates. Since Macaulay duration is a measure of the average time to receipt of cash flows, it follows that bonds that have long maturities have high Macaulay durations, which in turn translates to higher interest rate sensitivity. By simple deduction then, longer-term bonds are more sensitive to interest rate changes than shorter-term bonds. Therefore, a class of funds with a high Macaulay duration will be highly sensitive to interest rate changes and will exhibit high volatility. Corollarily, a class of funds with a low Macaulay duration will be less sensitive to interest rate changes and will exhibit low volatility.
Using Macaulay Duration, the TOAP came up with the following classifications of fixed-income UITFs:
Type of UITF
Portfolio Macaulay Duration
Money Market Funds
Up to a maximum of one (1) year
Intermediate-term Bond Funds
Up to a maximum of three (3) years
Medium-term Bond Funds
Up to a maximum of five (5) years
Long-term Bond Funds
About five (5) years
MONEY MARKET FUNDS
The objectives of Money Market Funds are capital preservation and income generation from low risk investments. These funds are invested principally in fixed–income securities and have a portfolio duration of less than a year, These are suitable for risk averse investors who are looking for safe and liquid investments with yields that are relatively modest due to lower risk exposures. The returns on these funds, however, are usually higher than the returns on savings accounts or time deposits.

BOND FUNDS: INTERMEDIATE-, MEDIUM- and LONG-TERM BOND FUNDS

The objectives of Bond Funds are capital appreciation and higher yields over the intermediate, medium or long-term, as the case may be. These funds are invested in higher yielding bonds and are suitable for risk tolerant investors who have a longer investment time horizon and who are willing to take on the risk of a more volatile portfolio in exchange for higher yields due to the longer term nature of the fund’s investments.
By now, the practical importance of classifying fixed-income UITFs is evident. Notice in the above table that as we move from Money Market Funds to Long-term Bond Funds, the portfolio Macaulay duration, and therefore, interest rate sensitivity and portfolio volatility, increase. Thus, a client with a low tolerance for volatility, and therefore risk, should invest in a fund that has a low duration. Corollarily, a client who has a high tolerance for volatility, and therefore risk, should invest in a fund that has a high duration.
There is, however, a caveat to this classification. Although a number of UITFs may belong to the same UITF classification, it does not follow that all these funds will deliver the same returns over a given period. Fund management is a complex undertaking and there are a multitude of other factors that affect a fund’s performance other than duration, such as amount of management fee, other charges, etc. The investor is therefore advised to be cognizant of this fact. He is also advised to scrutinize, among other things, the quality of and the proportionate exposure to the securities that make up a specific UITF. It may serve an investor well to first study the monthly or quarterly reports of the UITF he is interested in. These are readily available in the websites of the particular trust entities. The NAVpUs of the UITFs are likewise available in www.uitf.com.ph.
Index Funds
A Fund category that will soon be launched is the Index Fund category. The funds that would fall under this classification could be equity funds or fixed-income funds. Essentially, these funds would aim to shadow the performance of existing equity or fixed-income indices. As such, their portfolios would attempt to mirror those that make up the chosen indices. For example, the Phisix is an index of the Philippine equity market. An investor whose objective is to have the same return as the Phisix may therefore invest in an Index Fund that is “indexed” to the Phisix. Proponents of Index Funds point out the following advantages: a) Index Funds generally have lower management expenses compared to other types of funds and b) Index Funds have better returns as majority of actively managed funds fail to beat broad indices in the long run.
Ultimately, what investors should bear in mind is that while the reward for taking risk is a high return, the cost of taking risk may be loss of principal. The correct investment is thus one that is suitable to an investor’s tolerance for principal loss primarily and desire for returns secondarily. In this light, the TOAP classification helps investors identify the fund that is best suited for them. (Article contributed by the Trust Officers Association of the Philippines)

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