Removing the jargon from your investment goals

Florbela Yates, Head of Equilibrium, outlines the safeguards of financial investments in South Africa, detailing the risks and protections associated with banks, insurance companies, and unit trusts, and the role of LISPs in managing and securing investments.

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Florbela Yates is the head of Equilibrium in the Momentum Metropolitan group. Equilibrium is an independent discretionary fund manager that partners with financial advisors to help them enable their advice outcomes. Equilibrium brings balance to an advice practice by delivering services and investment solutions to help clients achieve their defined investment goals.

Clients encounter a lot of jargon in the financial services industry which may add more anxiety regarding their investments. Some people may use big terms to convince clients to think they have the right answers without first trying to explain the underlying principles.

After seeing an answer a friend received about the security of his unit trust versus that of his bank deposit, my colleague Rowan Burger, head of strategic finance at Momentum Metropolitan Holdings explained the security of a bank, life insurance company and unit trust investment without the jargon.

A bank collects deposits and provides loans. It tries to balance loans with deposits by taking a client’s deposits and issuing them to someone as a loan. The risk to the bank (and the client) is that its deposits dry up or its loan book fails. It then cannot honour the other side of the transaction. A bank fails when there is a loss of faith in its ability to do this, for example, if a large number of depositors want their cash back and the bank cannot cancel loans to effect payment. They hold capital as protection against this, but the write-downs deplete their capital.

An insurance company, however, is fully funded as the investment products underwritten by a life insurer will have all the assets of a life insurer on the balance sheet. In the event of an influx of claims by clients, they can disinvest these assets and make payments. However, a life insurer integrates its investment business with its risk business. The risk in the event of a pandemic, for example, is that the loss on the risk side of the business could leave insufficient capital available to pay out the claims in full. In South Africa, insurance companies have always paid out 100% of their liabilities.

On the other hand, companies that are only asset managers don’t have large balance sheets for protection. Accordingly, South African investments are structured so that the company never holds its clients’ assets. These are held in a trust. The client owns a portion of the trust, broken up into units, hence the name “unit trust”. The trust contracts the asset manager to manage the funds according to the mandate. The trustee is usually a bank or a financial institution not affiliated with the asset manager. This means that if there are any financial concerns at the asset manager, this does not impact the assets invested in the unit trust. If the asset manager goes bankrupt, the trustees have the power to appoint a new manager or arrange for liquidation of the underlying investment holdings and make payments to unit holders. The transaction costs would marginally reduce the value of the investment, for example, the sale of the equities for cash. However, the assets are secure in this trust, governed by the Collective Investment Scheme Control Act (CISCA).

It would be painful to invest your assets across many managers and track these holdings, so investors typically use Linked Investment Service Provider (LISP) platforms to buy, sell and report on their holdings across these multiple unit trusts. This is legislated under the Financial Advice and Intermediary Services (FAIS) Act.

Trusts and asset managers typically have insurance to protect against fraud and loss. The LISP platforms hold capital in the event of a failure to perform their duty or go into financial difficulty. This capital ensures that the fund can continue operating and be wound down if necessary without additional cost to the unit holders.

LISPs were specifically designed to protect investors in the event of failure of the asset manager (or the related companies performing other parts of the investment process). The key risk is measured by the choice of asset manager and their ability to manage the performance delivery.

Cash deposits are considered safer regarding capital protection, while unit trusts offer the potential for higher returns that come with market risk. The security of unit trusts versus bank deposits depends on a client’s risk tolerance and investment goals. In general, conservative unit trusts are less risky than more aggressive unit trusts as they have less exposure to growth asset classes that tend to be more volatile.