M8 Revision

Capital Markets
& Financial Advisory

Services examination
module 8
Collective Investment Schemes

Fourth Edition
COLLECTIVE
INVESTMENT SCHEMES
4th Edition - September 2011
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no relationship to any persons living or dead.
1st Edition published in 2002.
2nd Edition published in 2007.
3rd Edition published in April 2010.
4th Edition published in September 2011.
Capital Markets And Financial Advisory Services Examination Module 8 Collective Investment Schemes
In line with the licensing framework under the Securities and Futures Act (SFA) and
Financial Advisers Act (FAA), the Monetary Authority of Singapore (MAS) has launched
a modular examination structure, known as the Capital Markets and Financial Advisory
Services Examination (CMFAS Examination).
This study guide is designed for candidates preparing for Module 8 Collective
Investment Schemes examination. This examination is for new representatives of
financial advisers who need to comply with MAS requirement to possess the requisite
knowledge to advise or sell Collective Investment Schemes.
[Version 1.3]
Preface
The objectives of the CMFAS Module 8 Collective Investment Schemes examination

are to test candidates on their knowledge and understanding of the features,
advantages, disadvantages and risks associated with the investment of Collective
Investment Schemes, alternative investment assets and other financial assets, as well
as the techniques, strategies to evaluate and invest in the different types of unit trust
funds. It also discusses the different types of financial markets, characteristics and
forms of market efficiency, modern portfolio theory, time value of money concept,
considerations for investment relating to risks, classification and measuring risks,
returns, time horizon, diversification, the various legislation and regulation pertaining to
Collective Investment Schemes.
Organisation Of Study Guide

This Study Guide is divided into eight chapters, each devoted to a specific topic that
the candidates will need to know, in order to pass the CMFAS Module 8 examination,
as outlined below.
Chapter 1: Provides an overview of the nature of a broad range of financial assets,
such as cash and equivalents, money market instruments, fixed income
securities / long-term debt instruments, equity investments, unit trusts, life
insurance, annuities and the advantages and risks associated with
investing them.
Chapter 2: Provides an overview on some of the alternative investment assets, such
as financial derivatives, real estate investment, structured products, and its
benefits and risks associated with investing them.
Chapter 3: Discusses the mechanics of bond markets, equity markets, derivative
markets, over-the-counter market, characteristics of an efficient financial
market, forms of market efficiency and the modern portfolio theory.
Chapter 4: Explains in detail how risk and return of an investment can be quantified,
the various sources of investment risks, the relationship between risk and
return, classification of risks, risk-adjusted investment returns, required
rate of return and Jensens alpha (measure) under the capital asset pricing
model.
Chapter 6: Discusses the important factors to consider when planning for an

investment, the trade-off between liquidity and return, investment
objectives, risk tolerance, time horizon, tax considerations, the Risk
Classification System under the CPFIS, diversification and investment style
of fund manager, and the regulations and legal constraints.
Chapter 7: Explains in detail the nature, fees, advantages and risks associated with
unit trust investments, and the factors that need to be taken into account
when evaluating the suitability of a unit trust. The advantages and pitfalls
of unit trust investment are also discussed.
ii
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Preface
Chapter 5: Discusses the basics of time value of money and the various calculation
methods involved in determining present and future value of a single sum.
Chapter 8: Discusses the various types of unit trusts and the common investment
strategies for unit trusts. It also discusses the innovative unit trust
schemes, such as the capital guaranteed fund and the capital
protected fund, as well as investment trusts, REITs and business trusts.
This fourth edition contains changes to the existing text that will simplify and clarify
key terms and concepts. Additionally, there are new contents on developments in the
industry, as well as new products and services available in the market place.
While every effort has been made to ensure that these Study Guide materials are
accurate and up-to-date at the time of publishing, some information may become
outdated before the next revision of this Study Guide. As such, a new version of the
Study Guide may be issued whenever necessary, to update and reflect any changes to
the information. Such changes will be captured in the Version Control page on the last
page of the Study Guide.
Preface
Please refer to the SCI Website (www.scicollege.org.sg/ebook.asp) for the latest

version of the Study Guide. For examination purposes, the Singapore College of
Insurance (SCI) adopts the policy of testing only those concepts and topics that are
found in the latest edition of the Study Guide.
[Version 1.3]
iii
Acknowledgement
We would like to express our appreciation and gratitude to Mr Andrew Ng, a

representative from the Investment Management Association of Singapore for
reviewing this Study Guide.
Karine Kam
Executive Director
Singapore College of Insurance
September 2011
iv
[Version 1.3]
Study Guide Features
Several study aids have been included in each chapter to help readers to master and
apply the information in the Study Guide.
Chapter Outline And Key Learning Points
An outline of the chapter is provided on the first page of each chapter, after which the
key learning points are listed to help readers gain an overview of the chapters contents
and the expected learning outcomes to be achieved.
Revisions And Updates
With the implementation of the e-book Study Guide, any revisions and updates will
be updated in the Study Guide accordingly. SCI will send an e-mail alert to any
candidate who is affected by the revisions or updates. Please ensure that you have
updated your latest e-mail address with SCI. Do refer to the SCI Website
(www.scicollege.org.sg/ebook.asp) for the latest version of the e-book and the
effective date of the changes before sitting for the examination.
NB:
Throughout this study guide, where applicable, we have used the masculine
gender to represent both genders, in order to avoid the tedium of the continual
use of he or she, his or her or himself or herself.
[Version 1.3]
CHAPTER 1 TYPES OF INVESTMENT ASSETS I ............................................ 1

1. Introduction
2. Financial Assets
2.1 Cash And Equivalent, And Money Market Instruments
2.2 Fixed Income Securities / Long-Term Debt Instruments
2.3 Equity Investments
2.4 Unit Trusts
2.5 Life Insurance
2.6 Annuities
CHAPTER 2 TYPES OF INVESTMENT ASSETS II ......................................... 32
1. Introduction
2. An Introduction To Financial Derivatives
2.1 Options
2.2 Contracts For Difference (CFD) And Extended Settlement (ES)
2.3 Warrants
2.4 Futures
2.5 Swaps
2.6 Summary Of Financial Derivatives
3. Real Estate Investment
3.1 Reasons for Investment In Property / Real Estate
3.2 Disadvantages Of Investing In Property / Real Estate
3.3 Risks Of Borrowing To Invest In Property / Real Estate
4. Structured Products
4.1 Features
4.2 How Structured Products Are Manufactured?
4.3 Benefits Of Structured Products
4.4 Types / Categories Of Structured Products
4.5 Risks With The Structured Products
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Table of Contents
PREFACE ........................................................................................................................ i
ACKNOWLEDGEMENT ................................................................................................. iv
STUDY GUIDE FEATURES ............................................................................................ v
TABLE OF CONTENTS .................................................................................vi
CHAPTER 4 RISK AND RETURN .................................................................. 72

1. Measures Of Return
1.1 Calculating Single-Period Investment Return
1.2 Calculating Multi-Year Investment Return
1.3 Calculating Real After-Tax Rate of Return
2. Measures Of Risk
3. Risk Aversion
4. Risk And Return Trade-Off
4.1 Investor Risk Tolerance Questionnaire
5. Sources Of Investment Risk
5.1 Business Risk
5.2 Financial Risk
5.3 Marketability Risk
5.4 Country Risk
6. Classification Of Risks
7. Diversification Reduces Risks
7.1 Diversification Options
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Table of Contents
CHAPTER 3 FINANCIAL MARKETS .............................................................. 57

1. Introduction
1.1 Primary Market For Newly Issued Financial Assets And Secondary
Market For Others
1.2 Types Of Financial Claims
1.3 Types Of Maturities
2. Bond Market
3. Equity Market
3.1 Singapore Exchange Limited (SGX)
4. Derivative Market
4.1 Singapore Mercantile Exchange (SMX)
5. Over-The-Counter (OTC) Market
6. Characteristics Of An Efficient Financial Market
6.1 Availability Of Information
6.2 Liquidity
6.3 Transaction Cost
6.4 Information Efficiency
7. Forms Of Market Efficiency
8. Modern Portfolio Theory (MPT)
CHAPTER 5 TIME VALUE OF MONEY ........................................................ 104

1. The Basics Of Time Value Of Money
1.1 The Role Of Interest
1.2 The Power Of Compound Interest
1.3 Frequency Of Compounding Or Discounting
1.4 Measuring The Number Of Periods
2. Future Value Of A Single Sum
2.1 Basic Time-Value Formula
2.2 Using A Future Value Interest Factor (FVIF) Table
3. Present Value Of A Single Sum
3.1 Using The Time-Value Formula
CHAPTER 6 CONSIDERATIONS FOR INVESTMENTS .................................... 119
1. Introduction
2. Investment Objectives And Risk Tolerance
3. Liquidity
4. Investment Time Horizon
4.1 Caveats In Investing Over A Long Time Horizon
5. Tax Considerations
6. Regulations And Legal Constraints
6.1 Investment Guidelines Code On Collective Investment Schemes (CIS)
6.2 CPF Investment Scheme (CPFIS)
6.3 CPF Investment Scheme Risk Classification System
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Table of Contents
8. Risk-Adjusted Investment Returns

8.1 Information Ratio
8.2 Sharpe Ratio
8.3 Treynor Ratio / Index
9. Required Rate Of Return And Jensens Alpha (Measure) Under The Capital
Asset Pricing Model (CAPM)
9.1 Risk-Free Rate
9.2 Market Rate Of Return
9.3 Market Risk Premium
9.4 Beta
Appendix 4A
CHAPTER 7 UNIT TRUSTS ........................................................................ 139

1. Introduction
1.1 Investment Fund
1.2 Unit TrustAn Introduction
1.3 Brief Overview Of The Administration And Control Over Unit Trusts
2. Parties Involved In A Unit Trust
2.1 The Trustee
2.2 The Fund Manager
2.3 The Distributor
3. Charges And Fees
3.1 Other Types Of Costs
4. Expense Ratio
5. Bid And Offer Prices
6. Pricing Of Unit Trusts
7. Evaluation Of Unit Trusts
8. Advantages Of Investing In Unit Trusts
8.1 Diversification With Small Capital Outlay
8.2 Professional Management
8.3 Switching Flexibility To Capitalise On Changing Market Conditions
8.4 Liquidity
8.5 Security
8.6 Reinvestment Of Income
9. Pitfalls Of Unit Trust Investment
CHAPTER 8 FUND PRODUCTS .................................................................. 155
1. Introduction
2. Major Types Of Unit Trusts
2.1 Equity Fund
2.2 Fixed Income Fund
2.3 Balanced Fund
2.4 Money Market Fund
2.5 Umbrella Fund
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Table of Contents
7. Diversification
7.1 Dollar Cost Averaging
7.2 Market Timing
8. Investment Style Of Fund Manager
2.6 Feeder Fund

2.7 Index Fund And Exchange Traded Funds (ETF)
2.8 Hedge Fund
3. Innovative Unit Trust Investment Schemes
3.1 "Capital Guaranteed" Fund
3.2 "Capital Protected" Fund
4. Investment Trust, Real Estate Investment Trust (REIT) And Business Trusts
4.1 Investment Trust
4.2 Real Estate Investment Trust (REIT)
4.3 Business Trusts
TABLE 1 FUTURE VALUE INTEREST FACTORS FOR ONE DOLLAR .................... 185
E-MOCK EXAMINATION
Table of Contents
VERSION CONTROL RECORD
[Version 1.3]
1. Types of Investment Assets - I
Chapter
TYPES OF INVESTMENT ASSETS I
CHAPTER OUTLINE
1. Introduction
2. Financial Assets
KEY LEARNING POINTS

After reading this chapter, you should be able to:
understand the following main categories of financial assets:
-
cash and their equivalent bank deposits and time deposits
money market instruments Treasury Bills, Bankers Acceptance and Certificate of

Deposit, Commercial Paper and Repurchase Agreement
fixed income securities / long-term debt instruments
equity investments
unit trusts
life insurance
annuities
Copyright reserved by the Singapore College of Insurance Limited [Version 1.3]
Module 8: Collective Investment Schemes
1. INTRODUCTION
Real assets consist of land, buildings, machines, workers
and commodities that are used to produce goods and
services for the economy. The investment and creation of
real assets lead to improvement in the standard of living,
as there will be more goods and services available for
everyone.
Apart from real assets, investments can be made up of a
whole spectrum of financial assets (also known as paper
assets or capital market securities) consisting of stocks, bonds, etc. They channel
funds from the savings segment of society to the investing segment of society. We
can view financial assets as the means by which investors hold their claim on real
assets. For example, when we hold shares of DBS, we hold a share of all its net
assets.
The value of financial assets should reflect the fundamental value of the real assets
that it would represent over the longer term. However, in the short term, this may
not necessarily be the case. For example, during periods of extreme optimism, the
value of financial assets tends to appreciate much faster than the value of the real
assets that it represents. This is what we call a financial market bubble. On the
other hand, in times of uncertainty when the level of risk aversion rises, the value of
financial assets may collapse. Through this alternating process of boom and bust,
the excesses of financial market are corrected, and the value of financial assets is
brought into alignment with the long-term fundamental value of the real assets.
In general, inflationary pressure will rise if the value of financial assets rises faster
than the true and underlying value of real assets. Hence, in order to enjoy low
inflation and strong growth in real assets, rises in financial assets must be matched
by real growth, rather than excessive expectation about the growth.
2.
FINANCIAL ASSETS
In this section, we will discuss the following main categories of financial assets,
namely cash and their equivalent, money market instruments, fixed income
securities and long-term debt instruments, followed by the coverage of equity
investments, unit trusts, life insurance and annuity products in the next few
sections.
In the next chapter, we will introduce alternative classes of financial assets starting
with financial derivatives. We will then round it off with discussions on real estate
investment and structured products.
2.1 Cash And Equivalent, And Money Market Instruments
To satisfy the need to make transactions and to have readily accessible money
in case of an emergency, many individuals use instruments that are known as
cash equivalent. Typically, cash equivalent either has no specified maturity
date, or has one that is one year or less in the future. The first major purpose
for using cash equivalent is ready access to the investment principal because
of the liquid nature of the investment, which allows cash to be readily
available should the need arise. This may also be due to the investors
overriding concern for the safety of the principal. A second purpose for using
cash equivalent is that it serves as a receptacle for accumulating funds to
purchase other investment assets in an amount that meets the minimum
purchase requirement, or minimises the per unit transaction acquisition cost
(such as buying a round lot of 1,000 shares of a
publicly traded stock, to avoid higher per share price).
Finally, a third use of cash equivalent is when
investors, uncertain about the direction of the
economy or prices of investment alternatives, place
moneys in these instruments until such time as they
can determine, the direction of the economy or prices
of potential investments. This becomes a temporary
instrument and parking place for investors to switch
out from some other investments. However,
investments in this category often provide only a
modest current income and typically have little or no potential for capital
appreciation.
Money Market Securities or Instruments are similar in nature to cash
equivalent. These are debt instruments issued by governments, financial
institutions and corporations with maturities of less than one year. They
include Treasury Bills, Bankers Acceptance and Certificate of Deposit,

Commercial Paper, and Repurchase Agreement.
2.1.1 Cash Equivalent Include Bank Deposits And Time Deposits
(a) Bank Deposits
The most widely known and used type of cashequivalent investments are savings accounts and time
deposits (or fixed deposits) at banks and finance
companies. As all financial institutions in Singapore are
licensed and regulated by the Monetary Authority of
Singapore (MAS), they are generally well managed,
whereby there is very small risk of loss of principal and
interest involved. However, because of their low-risk
nature, the disadvantage with such deposits is that
they are low-yielding in return. Also, time deposits do not provide a
good inflation hedge, as the specified interest offered at inception
generally do not change over the deposit period, and do not
respond to changes in market interest rates.
Since 1 May 2011, the MAS has reviewed the Deposit Insurance
(DI) Scheme with the Singapore Deposit Insurance Corporation
(SDIC) to enhance this Scheme. All full banks and finance
companies in Singapore are members of the DI Scheme, except
those exempted by the MAS. The DI Scheme protects the
depositors in the event a DI scheme member fails. The coverage
limit has been increased from S$20,000 to S$50,000 and the
scope of coverage includes individuals, charities, sole
proprietorships, partnerships, companies and other unincorporated
entities, such as associations and societies. This Scheme is valid
only for deposits placed with a DI member. Some examples of the
deposits include:
Deposits in a savings account;

Deposits in a fixed deposit account;
Deposits in a current account;
Monies placed under the CPF Investment Scheme;
Monies placed under the CPF Minimum Sum Scheme;
Monies placed under the Supplementary Retirement Scheme; and
Murabaha as prescribed by the Authority.
Moneys held in bank deposits under the CPF Investment Scheme

and CPF Minimum Sum Scheme are aggregated and separately
insured up to S$50,000. It should be noted that financial products
are not insured by SDIC, and these may include:
Foreign currency deposits;
Structured deposits and Investment products;
Unit trusts; and
Shares and other securities.
For further details of the DI Scheme, refer to the SDIC website at:
www.sdic.org.sg
(b) Time Deposits
Time deposits are deposits for a specified period of time such as 3, 6,
12 months or even longer (such as 36 months). They tend to provide
a higher return than the savings accounts because of the time
commitment made by the investor.
Generally, the longer the deposit
period, the higher will be the interest
rate. However, there may be the
imposition of a loss of a portion of
the interest earnings as a penalty for a withdrawal before maturity.
Otherwise, there are usually few restrictions placed on withdrawals of
deposits in time deposit accounts. The difference in the return is
referred to as liquidity or duration premium, since tying up cash in an
investment for a longer period of time exposes the investor to more
risk. Therefore, the investor will demand a better (higher) return to
compensate for this risk.
2.1.2 Money Market Instruments
These are debt instruments issued by governments, financial
institutions and corporations with maturities of less than one year.
Owing to their relatively short maturity, money market instruments have
relatively low risks. However, the minimum denomination of money
market instruments is usually relatively large at S$250,000 and above.
They include: Treasury Bills (T-Bills); Negotiable Certificate of Deposit
(CD or bankers acceptance), Commercial Paper, and Repurchase
Agreement.
(a) Treasury Bills

Treasury Bills (T-bills) are short-term government securities (of one
year or less) issued by governments to borrow money from the
investing public to fund government expenditure. They are the
safest type of investments and are generally considered to be riskfree. Investing in a T-bill is equivalent to lending money to a
sovereign government. When the term risk-free investment is used,
it usually refers to T-bills. In this context, risk free means no
possible risk of default on paying interest or principal when due.
These instruments are sold on a discount basis i.e. investors pay
an amount less than the face value, but will receive the face value
at maturity. The difference between the purchase price and the
face value represents the interest earned on T-bills, and is used to
calculate the yield on such securities. The yield on T-bills is usually
used as a benchmark for risk-free rate. They can be readily sold and
converted to cash before maturity at a modest cost to meet client
needs.
GOVERNMENT
TREASURY
BILLS
INVESTORS
LESS THAN
S$ FACE
VALUE
FACE VALUE
AT MATURITY
(b) Bankers Acceptance And Certificate Of Deposit (CD)

Money market instruments issued by financial institutions include
bankers acceptances and certificates of deposit (CDs). Bankers
acceptance is issued to facilitate international commercial trade
transactions, as it represents a claim on the issuing bank for a
specific amount on a specific date. Bankers acceptance is a
negotiable security that is also issued on a discounted basis. CD is
a certificate issued by a bank that indicates that a specific sum of
money has been deposited with the bank. It bears a maturity date
and a specific interest rate generally on a compounding basis. The
interest amount is payable upon that maturity.
(c) Commercial Paper

Commercial paper refers to short-dated unsecured promissory note
issued by a corporation. Like Treasury bill and bankers acceptance,
it is issued at a discount to face value. Owing to the unsecured
nature of this security, only corporations with strong credit rating
are able to issue commercial papers.
(d) Repurchase Agreement
One of the ways in which secondary trading in money market
instruments takes place is through a repurchase agreement
(commonly known as repo). A repo is the sale of a money market
instrument, with a commitment by the seller to buy the security
back from the purchaser at a specified price on a future date. In
short, it is a collateralised short-term loan, where the collateral is
the money market instrument. The yield on repo can be calculated
using the difference between the sale and purchase price.
2.1.3 Why Invest In Money Market Instruments?
In all investment portfolios, there is generally a portion of the funds
placed in money market instruments for liquidity purposes. Liquidity
usually refers to the ability to convert an investment into cash quickly
and with little or no loss in value. Money market instruments are
generally low in risk and their primary function is
to provide a pool of reserves that can be used for
emergencies, or to accumulate funds for some
specific purposes. Money market instruments are
basically viewed as a means of accumulating
funds that will be readily available, when the need
arises.
Investment in money market instruments generally increases when
investors are uncertain about prospects in other classes of investments.
Investors will increase their holding of money market instruments in an
investment portfolio, when stocks and bonds are expected to perform
poorly, such as when interest rates are expected to be on an upward
trend. Conversely, they will hold less cash, when they perceive a bull
(rising) market in the stock and / or bond markets.
2.1.4 Disadvantages Of Investing In Money Market Instruments

In general, professional fund managers try not to hold too much of their
funds in money market instruments in excess of their liquidity
requirements because of the low yield. Although money market
instruments carry almost no risk of principal loss, they are subject to
reinvestment risks. Reinvestment risk refers to the risk that it may not
be possible for an investor, to reinvest the proceeds of his investments
at rates equivalent to those of the maturing investments, because of
possible declines in interest rates.
Money market instruments are subject to reinvestment risk because
they are short-term instruments. The investor has to reinvest his
proceeds from the investment each time that his short-term investment
matures.
2.2 Fixed Income Securities / Long-Term Debt Instruments
Fixed income securities are debt instruments in which the issuer (borrower)
promises to repay to the lender the amount borrowed plus interest over some
specified period of time of more than one year. As the investment term of
fixed income securities tends to be quite long (some may cover up to say 30
years), they are also referred to as long-term debts. These
debts are also referred to as bonds. They can be issued by
governments and / or corporations. Fixed income
securities can be regarded as IOUs (I owe you) issued by
companies or governments to raise funds. The face value
of the fixed income security is known as the principal,
while the periodic interest payment is known as the
coupon payments.
Owners of long-term debt instruments are creditors of the issuing institution,
whether it is a government or business organisation. This status grants the
investors the legal right to enforce their claims to interest income and principal
repayment as contained in the indenture (agreement) that specifies the terms
and conditions of the debt issue. In the case of business debt instruments,
debt claims have priority over any claims of its owners and / or other creditors.
Bond issues of governments and businesses typically are quality rated by

rating agencies, such as Standard and Poors Corporation (S&P), Moodys
Investors Service and Fitch Ratings, to assess the likelihood that the issuer will
default on the timely payment of coupon and / or principal. Based on some
financial analysis of the issuer, a letter grade is assigned to each bond issue.
Bonds rated at the top of the B grade (BBB for S&P, Baa for Moodys) or
higher are considered to be of investment quality. Lower ratings are assigned
for bonds assessed as speculative. These bonds are also referred
to as high-yield bonds or Junk Bond. These rating organisations
evaluate the bond when it is issued, and continue to monitor the
issuer during the bonds life. The lower the quality rating, the
greater will be the risk of default, and the higher will
be the coupon rate (return) that the investor will
expect to earn. The higher return reflects the risk
premium which represents the reward for the higher
risk undertaken by the investor.
Government bonds are used by the government to borrow money from the
public. They are the safest type of investments, carrying almost no default or
credit risk, since interest payments and repayment of principal are guaranteed
by the government because of its unlimited taxing power, and it can just print
moneys. Because of its credit quality, government bond yields are usually the
lowest among fixed income securities of similar maturity period.
2.2.1 Corporate Debt Securities
Businesses are major contributors to the supply of debt securities or
corporate bonds available in the marketplace. These securities have
various characteristics which are detailed in the indenture. Some of the
more frequently encountered characteristics include the following:
Secured a promise backed by specific assets as a further protection
to the bondholder should the corporation default on payment of
coupon and / or principal. The interest is normally quoted as some
percentage (coupon rate) of the principal which is also referred to as
face value or face amount. The coupon payments are normally
payable twice a year, on a semi-annual basis, and the coupon rates
are quoted as such.
Debenture an unsecured promise based only on the issuer's general

credit status, to pay coupon and principal.
Callable an option exercisable at the discretion of the issuer to
redeem the bond prior to its maturity date at a specified price. The
price will include compensation to the investor for the loss associated
with the early redemption. The corporation may find it beneficial to
call the bond, when the market interest rate
associated with the bond of similar risk,
duration and characteristics is lower than
the coupon rate for the bond.
Convertible an option exercisable by the
bondholder to exchange the bond for a
predetermined number of common or
preferred shares.
It should be noted that, apart from the features mentioned above, the
investment return to the investors of bonds ultimately depends on three
factors associated with the bond, namely (1) the face value which is the
payment made by the bond issuer to the investors at the maturity; (2) the
purchase price paid by the investors; and (3) the coupon rate, and hence,
the size of the coupon payments made by the bond issuers to the
investors.
Should the market interest yield be higher than the coupon rate, the
investor would need to pay a price that is lower than the face amount to
achieve the market interest rate. In this case, the difference between the
face value and the purchase price will cover the shortfall (difference
between the market interest rate and coupon rate) over the term of the
bond, on a compounded basis.
Fixed income securities generally stress current income and offer
modest appreciation in value. If there is an active secondary market,
they can be bought or sold at any time before maturity. This
marketability gives the investors the opportunity to realise capital gains,
since bond prices may rise if interest rates fall. However, if the
secondary market is inactive, the investors money may be locked up
for the full life span of the security.
10
Fixed income securities may be classified by the currency in which it is

issued, or by the issuers. Domestic fixed income security is
denominated in the local currency, while foreign-currency denominated
fixed income security is denominated in a foreign currency.
An Eurobond is a bond issued and traded outside the country in which
its currency is denominated, and outside the regulations of a single
country. It is usually a bond issued by a non-European company for sale
in Europe. It is also called global bond.
An Eurobond can be categorised according to the currency in which it is
issued. Eurodollar bond is a Eurobond denominated in US dollar and sold
outside the United States to non-US investors. Euroyen is denominated
in Japanese Yen and sold outside Japan to non-Japanese investors.
Yankee bonds are US dollar fixed income securities sold in the United
States, but issued by a non-US corporation or foreign government.
Apart from the governments, the statutory boards and corporations,
issuers of fixed income security may be supra-nationals1. The yield on
fixed income security is dependent on the maturity of the issue and the
credit rating of the issuer. Generally, the yield on fixed income security
tends to be higher for issues with longer maturity and / or lower credit
rating.
Fixed income securities are exposed to the following types of risks:
BONDS
(a) Interest Rate Risk

As bonds are fixed income instruments, changes in the bond
prices are inversely related to the changes in interest rates.
When interest rates fall (rise), bond prices will rise (fall). The
sensitivity of the bond prices to changes in the market
INTEREST
interest rates depends on the characteristics of the bond,
RATES
such as coupon rate and term to maturity. Generally, bonds
with lower coupon rate and longer maturity are more
sensitive to changes in the interest rates.
Supra-nationals are entities that are formed by two or more governments through international treaties for
the purpose of promoting economic or social developments for the member countries.
11
(b) Default Risk

This is the risk that the issuer will fail to make timely principal and
coupon payments as contracted. Default risk may be reduced if the
bonds are secured, or collateralised that is, or if there is a
guarantee from a bank or an insurance company.
(c) Reinvestment Risk
Reinvestment risk is the risk that the amount of coupon payment on
a bond may have to be reinvested at a lower interest rate than the
market return / yield of the bond at the time that the coupon
payments are received by the investor. Reinvestment risk is higher
for bonds with long maturity and high coupons.
(d) Currency Risk
This is applicable to bonds denominated in
foreign currency. The investor's total return
may be affected by foreign exchange rate
prevailing, when the coupon and principal
payment are received. When an investor
expects the foreign currency to depreciate
relative to his home currency, he can hedge
his foreign currency exchange risk, by using
currency forwards or other currency derivatives (such as currency
swaps), to exchange the foreign currency cash flow to local
currency.
2.2.2 Features Of Fixed Income Securities
The important features common to fixed income securities are:
(a) Par, Face Or Maturity Value
This is the amount of money for which each fixed income security
can be redeemed at maturity. This is usually S$1,000 per security.
If an investor buys five securities, the total face or par value is
S$5,000, which means that the borrower will repay S$5,000 to
the investor when the securities mature.
(b) Coupon Rate
It is the fixed rate that the issuer undertakes to pay the holder at a
periodic interval (annually or semi-annually) on the face (par) value
12
of the bond. When multiplied by the principal or face value of the

fixed income security, the coupon rate provides the basis for
calculating the dollar value of the coupon payment. Payments are
usually made semi-annually, although the coupon rate is generally
expressed as an annual rate. The coupon rate is usually higher for
securities with a longer period to maturity.
(c) Maturity Date
This refers to the final date on which repayment
of the face (par) value of the bond is due.
(d) Price
The market price is often quoted as a percentage
of the face value. For example, a closing price of
95 means that the actual price of the bond is 95 x S$1,000
par value = S$955.00 for each bond.
2.2.3 Return On Fixed Income Securities
Yield refers to the effective interest rate which an investor earns on the
fixed income investment. It is different from the coupon rate, unless the
price is identical to the principal or face value of the security.
Two main yield calculations are used to describe the potential return
from investing in a fixed income security:
(a) Current Yield
This is simply the ratio of the payment to the current price of the
security.
For example:
A bond with a price of 91 (91% of par, or S$910 for a corporate
bond with a face value of S$1,000) and a coupon of 9% has a
current yield of 9.89% (90 / 910 = 9.89%).
The main drawback of this yield measure is that it ignores the
principal sum to be paid at maturity.
13
(b) Yield To Maturity

This is the most important concept of yield because it is the yield in
which most fixed income prices are based. The current yield
measures only todays return, but the yield to maturity measures
the real return that an investor will get based on the purchase price
of the bond, assuming that the security is held to maturity. It also
takes into account the maturity date, the coupon payment, the
frequency of coupon payment, and the face value. The exact way
of calculating this measure is quite complicated and is not covered
within the scope of this study guide.
2.2.4 Considerations When Selecting Fixed Income Securities?
The price of a fixed income security is determined by such factors as
the coupon rate stated on the security, the length of its term to
maturity, the features associated with the bonds (e.g. convertibility and
callability), credit quality of the issuer and the general level of interest
rates. Fixed income securities fluctuate in price, and market value is
largely determined by changes in the general level of
interest rates. As mentioned earlier, when the general
level of interest rate rises, bond prices go down to keep
yields in line with market levels; when the general level
of interest rates declines, bond prices increase.
After taking into account of the general level of interest
rates, an investor will consider two other factors (as
described below) when selecting a fixed income security.
(a) Investment Quality
This is reflected by the probability that a fixed income issue will go
into default. The investor's perception of default risk will determine
the interest rate that he is willing to accept, the price to pay, and
the maturity to take.
(b) Maturity
In addition to quality, investors can control the risk of fixed income
investments through maturity selection. Yields will usually differ for
different maturities giving rise to the yield curve, which defines
the current yield for each possible maturity. It is usually the case
14
that yields increase for longer maturities. The longer the maturity,
the more volatile will be the bond price. Conservative investors tend
to choose securities with shorter maturities, in order to reduce
risks, such as the interest rate risk, default risk and reinvestment
risk. It should be noted that price volatility is not a concern if the
investors intend to hold the bonds till maturity, without trading
them for capital gains, unless owing to emergency needs, they are
forced to sell the bonds before maturity.
2.2.5 Why Invest In Fixed Income Securities?
Bonds and other forms of fixed income securities can be good
investments for investors interested in having the amount of monies at
maturity made known to them and also receive a steady stream of
income. Fixed income securities have long been regarded as good
vehicles for those seeking current income. With fixed income securities,
under normal circumstances, there is a good certainty regarding the
cash flows which an investor will receive. It
should be noted that there is still the presence
of default risks when investing in fixed income
securities, no matter how excellent the credit
rating may be.
In addition, fixed income securities are a
versatile investment vehicle. They can be used
conservatively by those who primarily (or
exclusively) seek high current income to
supplement other income sources. Alternatively, they can be used
aggressively for trading purposes by those who actively seek capital
gains. Since the late 1980s and early 1990s, , bonds have also become
recognised as providing investors with the opportunity to realise capital
gains.
2.2.6 Disadvantages Of Investing In Fixed Income Securities
A major disadvantage of investing in fixed income securities is that the
coupon rate is fixed for the life of the issue and, therefore, cannot move
up over time in response to inflation. Inflation is, therefore, one main
worry for fixed income securities investors, particularly if they are to
creep up to the level of coupon rate, and if the term to maturity of the
15
bond is relatively long. Not only can inflation erode the purchasing
power of the principal portion of the investment, but also can lead to
violent swings and changes in the interest rates, thereby producing
violent swings and changes in the prices of fixed income securities,
which can cause substantial capital losses if they are not held to
maturity, or if such unrealised losses need to be reflected in the
financial accounts.
Unlike ordinary shareholders, buyers of fixed income
securities issued by a company do not participate in the
profits of the company. They also do not have other
shareholder rights, such as that of voting in company
meetings as in the case of shareholders.
Another disadvantage of fixed income securities (particularly in
Singapore) is the inactive and small secondary market. This is not so
much of a concern for ordinary retail investors who tend not to invest in
bonds directly, owing to the large face amounts required for investment
in such instruments. These retail investors invest in fixed income unit
trusts instead, where the initial capital outlay is much smaller.
2.2.7 Housing Loans / Mortgages And Other Types Of Fixed Income
Securities
Apart from the fixed income securities issued by governments and
corporations that we discussed above, there are other types of fixed
income securities which are created through a technique known as
securitisation. A popular instrument that has been securitised frequently
is mortgage loans. In the United States of America (US), the
securitisation of sub-prime mortgage loans during the boom years,
spanning the closing years of 20th century and peaking around 2005 /
2006, was the direct cause of the 2008 / 2009 economic crisis. These
fixed income securities are outside of the scope of this study guide and
will not be discussed.
2.3 Equity Investments
Equity investments represent an ownership position in a business. As such,
they represent a higher risk for the investor than that of the debt investments.
16
Although an equity interest can be the sole owner of a

proprietorship or one of several partners in a
partnership, this discussion will focus on equity as
evidenced by shares of stock issued by a corporation.
Corporations acquire equity funds by selling ownership
shares to either very few individuals or to the public.
When equity shares are sold to the public, a market for
their resale emerges, and the ownership interest can
be readily sold or purchased through some stock
exchanges. Corporations can and often do offer
different types of ownership interests of which the two most popular are
common (ordinary) and preferred stock.
Equities have the same salient features as described below.
(a)
Equity Investors Are Entitled To All Residue Claims On The Income And
Assets Of The Corporation, After All Other Creditors Have Been Repaid
In Full.
Unlike bond investors whose returns are contractual in nature, equity
investors are entitled to all residue claims. Hence, equity investors not
only enjoy the success of the corporation, but also stand to lose their
investments if the corporation does badly.
(b)
Indefinite Tenure
Unlike money market or fixed income securities, equity is assumed to
have a perpetual lifespan. Equity need not be repaid because it represents
the capital that owners invest in a corporation.
(c)
Limited Liability
The maximum amount that an equity holder can lose in the event of a
corporate failure is its paid-up capital. If you have bought the share in the
secondary market, your maximum loss is the amount that you have paid
for the shares.
(d)
Entitlement To Voting Rights

Equity investors are entitled to vote at annual general meetings or
extraordinary meetings.
17
Equity investments have higher price volatility as compared to that of money

market or fixed income securities. This is because the cash flow associated
with the former is more volatile than the latter. The cash flow accruing to
investors in money market or fixed income security is contractual. In the
absence of default, investors in money market or fixed income security will
receive the contractual cash flow nothing more, nothing less. However, the
cash flow pattern associated with equity investment is volatile, and depends
on the financial performance of the corporations and, ultimately, the decision
of the Board. It should be noted that investors are only entitled to residue
claims.
There are two main kinds of shares (preferred shares and ordinary / common
shares) and investors should be familiar with both of them.
2.3.1 The Concept Of Sector
Stocks are often grouped into different sectors depending upon the
company's business. A sector is a distinct subset of a market, society,
industry or economy, in which the components share similar
characteristics. Standard & Poor's breaks the market into 10 sectors.
Two of these sectors, namely utilities and consumer staples, are said to
be defensive sectors, while the rest tends to be more cyclical in nature.
The other eight sectors are industrials, information technology, health
care, financials, energy, consumer discretionary, materials and
telecommunications services. Other groups break up the market into
different sector categorisation, and sometimes break them down further
into sub-sectors.
2.3.2 Preferred Shares
Preferred shares are a hybrid security. This is
because a preferred share has features of fixed
income security and equity. Preferred shares are
shares which give the holder a right to a fixed
dividend, provided that enough profit has been
made to cover it. Investors of preferred shares rank
after the investors of fixed income security and
other creditors, but ahead of equity investors in
terms of priority of payment of income, or assets in
the event of a corporate failure.
18
Preferred shareholders usually have two privileges that provide them

with a preferential position relative to ordinary shareholders. The first
privilege is the right to receive dividends before any dividends are paid
to the ordinary shareholders. This preference is usually limited to a
specified amount per share each year (which is generally expressed as
some dividend rate of the face amount of the preferred share). As
previously stated, dividends are payable only if declared by the board. If
the preferred shares are non-cumulative and no dividend is paid to the
preferred shares in any year, the dividend is skipped and does not ever
have to be paid. In the following year, the corporation can pay the
specified annual preferred dividend and then pay a sizeable dividend to
the ordinary shareholders. To prevent this from happening, many
preferred stocks have a cumulative provision associated with the issue.
This provision requires the corporation to pay all the unpaid preferred
dividends accumulated to the current date, as well as the current years
preferred dividend before any dividend can be paid to the ordinary
shareholders.
The second privilege of preferred shareholders is the right to receive up
to a specified amount for each share (plus current or cumulative
dividends) at the time of liquidation. This liquidation value must be paid
to the preferred shareholders in full, before anything can be paid to the
ordinary shareholders. In exchange for these two preferences, preferred
shareholders surrender the basic rights of ordinary shareholders.
(a) Why Invest In Preferred Shares?
The benefits of investing in preferred shares are similar to those of
bonds. Preferred share dividends are usually paid at a fixed rate.
However, they differ from bonds in that, although the income is
fixed, it is not coupon and may not be paid if
the company does not make any profit. They
differ from ordinary shares in that the dividend
will never be more than the fixed rate as
specified for the preferred shares, even if
profits are more than enough to cover it. As
preferred shares carry reduced risk when
19
compared to ordinary shares (owing to the provision of dividends

particularly on a cumulative basis), they typically offer only modest
potential for capital gains when compared to ordinary shares.
In general, preferred shares appeal to investors who do not want to
take as much risk as ordinary shareholders. Unlike ordinary
shareholders, preferred shareholders are more likely to be interested
in receiving current income than enjoying future capital gains.
(b) Disadvantages Of Preferred Shares
Unlike ordinary shareholders, preferred shareholders do not enjoy
the benefits of rising dividends and capital appreciation as the
company prospers.
2.3.3 Common / Ordinary Shares
Companies that go public (meaning they go to the public financial
markets to raise funds for the business) issue ordinary shares to the
investing public. When an investor holds an
ordinary share of a company, he is a
shareholder. As a shareholder, an investor
owns part of the company and he is entitled
to a portion of the profits (after payment of
debts, corporate taxes and other business
expenses) in the form of a dividend.
Investors in common / ordinary shares have the ultimate ownership
rights in the corporation. They elect the board of directors overseeing
the management of the firm. Each common share receives an equal
portion of the dividends distributed, as well as any liquidation proceeds
if the company becomes insolvent.
The current income distributed as dividends to the shareholder is at the
sole discretion of the board of directors. The board is under no legal
obligation to make dividend payments and may instead retain the profits
within the business. The owners of ordinary shares also vote on major
issues, such as mergers, name change, election of members of the
board, sale of a major part of the business, or liquidation.
20
(a) Class A Shares Versus Class B Shares

Class A shares are typically, the most preferred tier of classified
stock, offering more voting rights than Class B Shares. Class A
shares are designed to insulate management from the short-term
swings of the stock and financial markets, by allowing those in
management to control a small amount of the equity of the
company, but still maintain voting power. These type of shares are
not sold to the public and cannot be traded. Supporters say that
such dual-share system will allow the management of the company
to focus on long-term goals. In some cases, a company will
designate shares to be Class A shares, even though they have less
voting rights, and designate the shares with more voting rights to
be Class B shares. Such the decision is left up to the individual
company. This practice is done in US and China, but not in
Singapore.
(b) Why Invest In Ordinary Shares?
Ordinary shares have certain characteristics that make them
attractive as investment instruments as described below.
(i)
Dividends
Shareholders earn income from the investment in the form of
dividends. Dividends are paid to shareholders out of the
companys profits that are decided by the board of directors.
There is no certainty that the company will make profits and,
thus, no certainty that there will be a dividend. The amount to
be paid will vary with the profits made by the company and the
need of the company for additional
funds. Unlike fixed income securities
whose major drawback is that
inflation reduces the purchasing
power of a fixed stream of funds,
dividends from owning shares on the
other hand, have the potential to
increase as the companys sales and
profits grow.
21
(ii) Capital Appreciation

Ordinary shares can provide attractive returns on investment in
the form of share price appreciation or capital gains.
Theoretically, there is no limit to the extent of price
appreciation that may be enjoyed by the shareholder. The price
of a listed share will fluctuate daily according to the investors
assessment of general economic conditions, as well as the
companys progress and prospects of future earnings power.
(iii) Part Ownership
Ordinary shares offer the public a chance to own part of the
company through ownership of the shares. As the company
grows and profits increase, the share value rises, and
conversely, if the company fares poorly, the price of the share
will follow suit.
(iv) Subscription Right
This is a privilege allowing existing shareholders to buy shares
of an issue of common stock shortly before it is offered to the
public, at a specified and usually discounted price, and usually
in proportion to the number of shares already owned. This is
used by corporations to raise additional capital.
(v) Liquidity
Most shares traded on stock exchanges
can be quickly bought and sold. Closing
share prices are available from the
financial press / stock exchanges or via
the Internet. Investors can usually realise
their investments by selling the shares
with relative ease, as compared to
alternative investments, such as physical
real estate or even corporate bonds.
(vi) Inflation Hedge
Ordinary shares, together with real estate investments, have
proven to be an excellent inflation hedge in the past, especially
when compared to other investments. The average rate on a
22
one-year deposit varies from time to time. However, the rate

tends to be quite low. Taking into account taxes and inflation,
the real return is near zero or even negative. Interest rates on
longer-term debt instruments range from 3% to 4%. Again,
after adjusting for inflation and taxes, the real return is low.
The total return of MSCI US Stocks Index (a loose
representative of World Markets), on the other hand,
appreciated by an average annual compounded rate of 11.13%
over the 40-year period from 1969 to 2009. While future
returns may or may not match the historical one, a welldiversified portfolio (to minimise company specific risk) of
carefully selected blue chips and other shares promise to yield a
long-term rate of return for investors well in excess of inflation.
Based on the MSCI US Stocks Index, the
average annual compounded rate of return
of the stock market was 11.13% over the
40 year-period of 1969 to 2009. The US
average inflation rate over this period of
time is approximately 4.7%. Hence, US
stocks would have produced an annual return of 6.4% after
adjusting for inflation. This compares better than the US longterm government bond yield after adjusting for inflation.
(c) Risks Associated With Investing In Ordinary Shares
Despite the obvious attraction of ordinary shares as an investment
vehicle, investors ought to be fully aware of the risks as well. Since
ordinary shares are subject to fluctuations in terms of income and
price, there is a higher degree of risk associated with them than
with other forms of investments.
Share investors are exposed to both market risks (refers to factors
external to the investments that cannot be influenced to any extent
by the company, such as the general level of interest rates) and
specific risks (refers to company specific uncertainties, such as
losses, changes in top management, etc).
23
The value of a share fluctuates according to investors perception

of the above risks. A share price can rise very fast, giving huge
capital gains to shareholders of say, a company
which has discovered a miracle drug for cancer.
The share price can also fall rapidly. In the
extreme, a share can become worthless if the
company becomes insolvent and all its assets are
used to pay off its creditors. A shareholder must
therefore realise that he can lose all his money
through careless stock selection, particularly if he
invests in only shares of a limited number of companies. A welldiversified portfolio of shares from different sectors will help to cut
down such specific risks.
(i)
Risk And Return

As previously mentioned, ordinary shares have, on average,
proven to be good long-term investments. The average annual
compound rate of return of the US stock market was 11.13%
over the 40 year-period of 1969 to 2009. Ordinary shares have
therefore substantially out-performed corporate bonds,
government securities and money market instruments.
However, investors have to remember the risks associated with
stock investments that are linked to rather high returns. The
volatility, as measured by standard deviation, was 18.3% over
the same period. Given the fluctuations of the market, the
investor may suffer losses in their investments on a short-term
basis.
Any investment involves a trade-off between risk and return.
The stock market is no different. An investors share portfolio
will fluctuate in price over a substantial range if held for several
years. Historical data have shown that the share market is an
excellent long-term investment vehicle, providing a rate of longterm capital appreciation, that is well in excess of the rate of
inflation, as well as other asset classes, with the possible
exception of investment in property. However, it should be
cautioned that past performance is no guarantee for the future.
24
(ii) Diversification
In view of the many risks faced by share investors, it cannot be
stressed enough that diversification of share-holdings is a
better strategy than just investing in a limited number of
stocks. Diversification reduces the risk of loss and the volatility
of an investors share-holdings.
Diversification may mean that a share portfolio includes growth
stocks, income-oriented stocks, blue chip stocks and some
speculative stocks. It is also possible to gain some
diversification by buying shares of a company that is itself
widely diversified in its manufacturing and holding activities.
The investor may also wish to diversify across countries to
reduce the vulnerability of the share portfolio to the economic
fortunes of any one country. A prudent investor may also
diversify his investments over time, so as to offset ups and
downs of the market. One good avenue for diversifying the
investments in equity markets is through the purchase of unit
trusts.
2.4 Unit Trusts
A unit trust is a professionally managed investment fund that pools together
money from investors (called unit-holders), with similar investment objectives
to invest in a portfolio of stocks, fixed income securities or
other financial assets, or some combination of them. It is
also known as Collective Investment Scheme (CIS) locally.
A unit trust investor owns units in the funds being
somewhat similar to shares in a company. Each unit
represents a proportionate ownership in the underlying
securities owned by the unit trust. For example, if there are
1,000,000 units in a unit trust that owns 200,000 shares of Singapore
Airlines and 1,000,000 shares of Venture Corporation, among others, then
each unit will represent 0.2 shares in Singapore Airlines and one share in
Venture Corporation. Unit holders redeem their investment by selling units
back to the fund manager.
25
The Securities and Futures Act (Cap. 289) will provide for the MAS to
authorise all collective investment schemes to be offered to the public in
Singapore, for example, the approval of trust deeds and schemes. This deed
enables a trustee (usually a bank) to hold the pool of money and assets in trust
on behalf of the investors. The pool is managed by a third party, namely the
fund manager. The fund manager solely manages the portfolio of investments
and operates the market for the units (i.e. administers the buying and selling of
shares in the unit trust) itself. The unit trust is essentially a three-way
arrangement among investors, the fund manager and the trustee.
Investors who are interested in receiving the benefit of professional portfolio
management, but who do not have sufficient funds and / or time to purchase a
diversified mix of securities will find investing in unit trusts
attractive. They can invest in unit trusts to generate income
in the form of dividends and capital gains.
Investors in Singapore can choose from a wide variety of unit
trusts with different investment objectives. A unit trust may
aim for high income or high capital growth, or a combination.
Some unit trusts invest in specific countries and regions.
It is important that the investment objectives of the unit trust chosen match
those of the investor. Unit trusts are required to state their investment
objectives clearly on the prospectus which every investor should acquire
before buying. The types of assets, which may be bought by the fund
manager, are also specified in the objectives of the unit trust as contained in
the trust deed.
The advantages of investing in unit trusts, the characteristics of unit trusts,
and different types of unit trusts are discussed in detail and in-depth in
Chapters 7 and 8 of this study guide.
26
2.5 Life Insurance

Some life insurance products can also serve as savings / investment
instruments. These include the following two main and different types of life
insurance policies:
Whole Life Insurance; and
Endowment Insurance.
2.5.1 Whole Life Insurance Policy
The premiums payable for a Whole Life Insurance
policy, provide a mixture of life cover and
investment and, as such, have cash or surrender
values. In the case of a Whole Life Insurance
policy, the sum assured will be payable on the
death of the life insured, whenever this takes
place. Policy owners pay fixed monthly or annual
premiums and beneficiaries receive fixed death
benefits. Meanwhile, reserves / assets backing up
the future liabilities of the policies earn interest and
grow, building up cash values that can be
withdrawn or borrowed. The cash values of a Whole Life Insurance
policy can be withdrawn at any time by the policy owners surrendering
(cancelling) of the policy, subject to the terms of the policy.
Alternatively, if policy owners do not want to surrender their policies,
they have access to accumulated policy savings. Policy owners
normally can obtain loans from the life insurance company under their
policies for any amount up to, for example, 80% (the limit being
dependent upon the policy of the insurer concerned) of the cash value.
2.5.2 Endowment Insurance Policy
The premiums payable for an Endowment Insurance policy also provide
a mixture of life cover and investment. However, in the case of an
Endowment Insurance policy, the sum assured is payable on a fixed
date (the maturity date) or on the life insureds death, whichever is
earlier. As such, similar to a Whole Life Insurance policy, the payout by
the insurer is certain at some stage.
27
2.5.3 Whole Life And Endowment Insurance Policies As Investment Media

Both Whole Life and Endowment Insurance policies are thus effectively
an investment that becomes payable at a future date, either on death or
earlier. Such policies may be deemed to be structured to provide a fixed
amount of death benefit (sum assured) only. In this case, the policies
will provide for a guaranteed return. As such, they are known as nonprofit (non-participating) policies, in contrast to the with-profits policy
as explained in the sections that follow below.
The return of the policies can be linked to the insurers investment
performance - either by having a with-profits policy, where benefits are
indirectly affected by investment performance; or by having an
Investment-linked Life Insurance policy, where the link with investment
performance is direct. Both Whole Life and Endowment Insurance
policies can be either with-profits or investment-linked.
(a) With-Profits Policies
Every year, the insurer will carry out a valuation of the assets and
liabilities of its life fund. This will normally reveal a surplus, part of
which can be allocated to the with-profits policy owner in the form
of an addition to the sum assured. This addition, called a bonus or a
profit, is usually reversionary. This means that it is payable only at
the same time, as when the sum assured is paid on death or
maturity.
With such a with-profits policy, the link between the policy benefits
and the investment and operating (such as mortality experience and
level of operating expenses) performance of the insurer is not direct
and depends on the annual valuation of the fund assets and
liabilities, where many factors are taken into
consideration. The allocation of the surplus in
the form of reversionary bonus will ultimately
depend on the decision of the board of
directors,
in
consideration
of
the
recommendations made by the appointed
actuary of the life insurance company. As such,
the bonuses added to the policy tend to follow
the investment and operating performance only
28
in a distant fashion. Allowance must be made for the guarantees

underlying the basic sum assured, and so the bonus system does
not directly reflect the value of the underlying assets of the life
fund. In addition, bonuses are generally declared on a yearly basis.
Therefore, they cannot possibly match and reflect the daily
fluctuations in the value of assets.
(b) Investment-linked Life Insurance Policies
Investment-linked Life Insurance policies offer investors policies
with values directly linked to the investment performance of the
underlying instruments. This is usually done by formally linking the
values of the policies to units in a fund run by the insurer or by
external fund managers. Such a fund usually consists of a mixture
of equity funds, fixed income funds, managed funds and other
types of funds. The investment element of Investment-linked Life
Insurance policies varies according to the underlying assets of the
portfolio, and fluctuates daily according to the performance of
those investments.
2.6 Annuities
2.6.1 What Is An Annuity?
An annuity is a series of payments guaranteed for a number of years or
over a lifetime of the annuitant receiving the payments.
2.6.2 Types Of Annuities
There are two main types of annuities as described below.
An immediate annuity is a contract under which payments to the
annuitant begin as soon as it is purchased. An immediate annuity is
always purchased with a lump sum (single premium).
A deferred annuity, in contrast, is one in which
the payments to the annuitant begin at some
future date. The date is specified in the contract
or at the annuitant's option. The amount that
the annuitant will periodically receive depends on
his contributions, the interest earned on them,
the annuitant's gender, and the annuitant's age
29
when payments begin. Deferred annuities may be purchased with

either single premium or periodic premiums.
2.6.3 Uses Of Annuities
(a) Annuities As An Insurance Against The Possibility Of Outliving
One's Income
In its pure form, a life annuity may be defined as a contract,
whereby for a cash consideration, one party (the insurer) agrees to
pay the other (the annuitant) a stipulated sum (the annuity)
periodically throughout life (lifetime). However, the consideration
paid for the annuity will be fully earned by the insurer immediately
upon the death of the annuitant. As such, the purpose of the
annuity is to protect against loss of income arising from excessive
longevity. Hence, this is exactly the opposite of the purpose of a
life insurance policy that furnishes protection against loss of income
arising out of premature death.
(b) Annuities As An Investment Vehicle Or A Savings Instrument
Most annuities are savings instruments designed to first accumulate
funds and then systematically liquidating the funds, usually during
the retirement years of an annuitant. The annuitant can put in a
lump sum (single premium) or set aside a series of regular premiums
over a period of years. At the annuity starting date, the annuitant
receives a guaranteed income for the rest of his life. The amount of
the income depends on the cash value in the annuity and the
payment option selected.
As such, annuities are an attractive option for any individual person
who has not yet accumulated an estate, but wants to achieve
financial independence in his old age. Professional people,
entertainers and athletes who enjoy a very large
income for a limited period of time will find annuities,
particularly attractive as a savings medium. Under
such circumstances, annuities are an appropriate
investment, because they can be purchased through
flexible periodic premiums or through singlepremium, when the annuitant comes into possession
of large amounts of money.
30
Therefore, in short, annuities can be used as a savings instrument

which provides protection against loss of income arising out of
excessive longevity through liquidating a principal sum.
(c) Annuities As A Hedge Against Adverse Financial Developments
Wealthy individuals who have already accumulated an estate either
through inheritance or by their own personal efforts purchase
annuities as a hedge against adverse financial developments, that
is, as a form of security. Large estates can be wrecked through
business reverses and unwise investments. As such, individuals
who once were wealthy would have to depend on the payments
from annuities purchases in their more affluent days as their sole
source of income.
2.6.4 Comparing Life Insurance And Annuities
While Life Insurance products are intended to guard against living too
short, Life Annuity products are intended to provide a vehicle to support
the living expenses required after retirement, for
so long as the annuitants live. Hence, the Life
Annuity products provide protection for annuitants
who live longer than expected. Again, as in the
case of Life Insurance products, there are many
different variations of the Life Annuity products. In
achieving the aim of providing sufficient retirement
income, Life Annuity products are often structured
as savings and investment products before the
annuity payments begin. The savings / asset building phase is an
extremely crucial part of retirement planning, and an integral part of
many Life Annuity products, where regular premiums are paid into the
retirement savings fund for investment and growth.
31
Chapter
TYPES OF INVESTMENT ASSETS II
CHAPTER OUTLINE
1.
2.
3.
4.
Introduction
An Introduction To Financial Derivatives
Real Estate Investment
Structured Products
KEY LEARNING POINTS

understand the following alternative classes of investment assets:
32
financial derivatives Options, Contracts For Difference, Extended Settlement,

Warrants, Futures and Swaps
real estate investment
structured products
2. Types of Investment Assets - II
1.
INTRODUCTION
Besides traditional investment assets as mentioned in the previous chapter,
investors have the option of investing in alternative classes of assets. They are
financial derivatives, real estate investment and structured products.
2.
AN INTRODUCTION TO FINANCIAL DERIVATIVES

In this section, we provide a basic introduction and discussion of financial
derivatives, the roles that they play, and contributions that they make. These
financial derivatives include the following:
Options;
Contracts for difference (CFD) and Extended Settlement (ES);
Warrants;
Futures; and
Swaps.
Simply put, financial derivatives are financial assets in which the values are derived
from, or depend on some other assets (such as equity, foreign exchange,
commodities, bonds and others). These financial derivatives have attained
overwhelming popularity and rapid growth in recent years for a number of reasons,
including (a) helping to make the financial market more complete; (b) allowing
speculators and risk managers to use these assets to pursue their goals; and (c)
attracting traders to these markets because of their trading efficiency, and the low
transaction costs and liquid markets.
(a) Market Completeness
In a complete market, any and all identifiable payoffs
be obtained by trading the securities in the market.
availability of financial derivatives helps to move
market to completeness. A more complete market
increase the welfare of the agents in the economy.
can
The
the
will
(b) Speculation
Financial derivatives have a reputation of being risky. They can be tremendously
risky in the hands of un-informed traders. However, their risks are not
necessarily evil, because they provide very powerful instruments for
33
knowledgeable traders to expose themselves to calculated and well-understood

risks in pursuit of payoffs.
In the hand of a knowledgeable trader, a position in one or more financial
derivative can present a careful and artful speculation on a rise or fall in interest
rates, or a change in riskiness of the entire stock market, on changing values of
Euro versus the Japanese Yen, or on a host of other propositions.
The precision and speculative power of the financial derivatives stem largely
from the fact that financial derivatives help to make the financial market more
complete. Although serving as a speculative tool is not the only use (and
probably not the most important use) of financial derivatives, they are ideally
suited for this purpose.
(c) Risk Management
Financial derivatives provide a powerful tool for limiting risks that individuals
and firms face in the ordinary conduct of their business.
For example, a corporation that is planning to issue bonds faces considerable
interest rate risk. If the interest rate rises before the bond
is issued, the firm will have to pay considerably more over
the life of the bond. Such a firm can use interest rate
futures to control its exposure to this risk.
Similarly, a pension fund with a diversified holding in the
stock market faces considerable risk from general
fluctuation of the stock prices. The fund manager can use
options on a stock index to reduce the risk exposure.
Even though financial derivatives are risky in the sense that their prices are
subject to substantial fluctuations, they can be powerful tools in limiting the
risks as well. However, successful risk management with derivatives requires a
thorough understanding of the principles governing the pricing of the financial
derivatives.
34
2.1 Options
In general, an option is a formal contract between a seller (the optioner) and a
buyer (the optionee) on the right (but not the obligation) to buy-and-sell (or to
buy-or-sell) a specific property or a fixed-quantity of a commodity, currency, or
security, at a fixed price (called exercise price) on or up to a fixed date (called
expiration date). Optionee generally pays a small sum of money (called
premium or option money) for the contract, thus
obtaining an investment leverage.
In other words, instead of buying a security outright, an
investor can buy a right to purchase or sell a security at a
future date. This is called an option. Note that option is
not issued by the company, but by investors seeking to
trade in claims (buy or sell) on the asset / security.
An option to buy (called call option) is purchased when prices are expected to
rise, an option to sell (called put option) when prices are expected to fall, and
an option to buy-or-sell (called double option) when prices may go either way.
Option prices are directly tied to the prices of the security which they apply.
The life of an option may vary, but the common duration adopted are three,
six and nine months. Over-the-counter options can also be bought by
institutions for longer periods, from one to five years.
The most popular types of options are named American option (exercisable any
day up to the expiration date) and European option (exercisable only on the
expiration date). Any option that is not exercised before the expiry date is
automatically cancelled, and the optionee loses the premium. In practice, only
a few options are exercised and most are bought from or sold to other
optioners or optionees before the expiration date. Since options are legally
binding contracts, they have intrinsic values (which is the difference between
market price and strike price of the option) and are freely traded on the futures
exchanges. A futures exchange refers to a central marketplace where futures
contracts and options on futures contracts are traded.
35
2.1.1 Why Buy Options?

The most significant advantage of options is the effective management
of risk. Options limit the investors exposure to risk, since the only
amount of money to be lost is the purchase price of the option. For
instance, if an investor anticipates the price of the underlying security
to rise, he will buy a call option. If the price of the underlying security
increases, then he can exercise his option to reap a profit. However, if
the price of the underlying security declines, he does not need to
exercise his option, in which case, he will lose only the price that he
has paid for the option. Another major advantage of buying options is
the leverage that options offer. As options are leveraged on securities,
their values respond more than proportionately to changes in the
underlying security value.
With a good knowledge of the principles involved, sophisticated
investors can use stock options to protect profits, to create liquidity,
and as an additional avenue for investing their funds.
2.1.2 Disadvantages Of Investing In Options
Investing in options is inherently risky. Hence, an investor must be
prepared to lose all his moneys in the option premiums, as options that
are not exercised before the expiry date become worthless after that
date. Share options do not provide voting privileges, ownership interest
or dividend income. However, it is noted that option contracts are
adjusted for stock splits and stock dividends.
2.2 Contracts For Difference (CFD) And Extended Settlement (ES)
This section gives a brief description of two
derivative products that are traded and are fairly
popular in Singapore via the Singapore Exchange
(SGX), as well as Over The Counter (OTC)
Markets. These are (1) the Contracts For
Difference (CFD) and (2) Extended Settlement
(ES).
36
2.2.1 Contracts For Difference (CFD)

CFD is a derivative on some asset price (normally on stock / equity
asset). It is a contract between two parties, typically described as
buyer and seller, stipulating that the seller will pay to the buyer the
difference between the current value of an asset and its value at
contract time (If the difference is negative, then the buyer pays to the
seller instead). For example, when applied to equities, such a contract is
an equity derivative that allows investors to speculate on share price
movements, without the need for ownership of the underlying shares.
Contracts for difference allow investors to take long (ownership) or
short (sale) positions, and unlike futures contracts, they have no fixed
expiry date, standardised contract or contract size. Trades are
conducted on a leveraged basis, with margins typically ranging from
1% to 30% of the notional value for CFDs on leading equities.
(a) Risks with CFD
Being a derivative, CFD can result in big losses to the investors if its
risks are not properly understood and managed. Investments in CFD
can be highly leveraged, meaning that the initial amount invested may
be much less than the underlying value of the assets (stocks)
involved, as a start. The gains and losses are thus magnified with the
leveraging effect, and can have severe demand / strain on the cash
balance of investors, when margin accounts are required to be topped
up and brought up-to-date, and marked to the market with the
changes in the market value of the stocks.
This is especially so, when there is or has
been high volatility in the stock market, or
when the market is moving southward, with
poor economic news and development /
prospects.
Another dimension of CFD risk is the
counterparty risk; a factor in most over-thecounter
(OTC)
traded
derivatives.
Counterparty risk is associated with the
financial stability or solvency of the counterparty to a contract. In the
context of CFD contracts, if the counterparty to a contract fails to
meet their financial obligations, the CFD may have little or no value,
37
regardless of the underlying instrument. This means that a CFD

investor can potentially incur severe losses, even if the underlying
instrument moves in the desired direction.
OTC CFD providers are required to segregate clients funds protecting
clients balances in event of a companys default. Exchange-traded
contracts traded through a clearing house are generally believed to
have less counterparty risk. Ultimately, the degree of counterparty
risk is defined by the credit risk of the counterparty, including the
clearing house, where applicable.
2.2.2 Extended Settlement (ES)
ES is another derivative product launched by SGX in early 2009, that
has also gained some popularity. In short, it is a contract between two
parties, to buy or sell a specific quantity (e.g. 1,000 shares) in a specific
underlying share (e.g. DBS) at a specific price (e.g. S$14.20) for
settlement at a specific future date (e.g. last business day of the month)
when the contract matures or expires.
ES contracts have fixed expiry dates (about 35 days from the listing
date) and there is no need for daily settlement, as the contract is
settled on maturity. ES contracts are listed and traded on the SGX. The
investor can buy and sell ES contracts in the
same way that he buys and sells shares
through the stockbroker.
However, note that ES contracts are classified
as contracts under the Securities and Futures
Act (Cap. 289). Before an investor can trade
ES contracts for the first time with his broker, the investor must sign a
Risk Disclosure Statement. In addition, when an investor buys or sells
an ES contract, he must use a margin account.
ES contracts are flexible instruments that offer the investor numerous
advantages, such as capital efficiency, ease of taking short positions
and longer view of the market. In addition, it can be used as a hedging
tool, taking advantage of stock spreads, as well as arbitraging.
38
(a) Risks Of Trading In Extended Settlement (ES) Contracts

The risks associated with ES include (i) leveraged nature of ES
contracts; (ii) margin calls; (iii) liquidity; (iv) volatility; and (v) buy-in
by clearing house.
(i)
Leveraged Nature Of ES Contracts

As in most investments, trading in ES contracts can lead to
losses for investors if the price in the underlying security moves
against the investors. ES being a leveraged product, the losses
suffered from trading ES contracts will be greater in percentage
terms of the initial cost or capital outlay needed to enter into an
ES position i.e. the margin deposit put up by the investors,
against the price movement in the underlying asset. Trading a
contract value several times larger than the margins deposited
means that the risks and returns are similarly magnified
accordingly, as opposed to the same amount of capital placed
for a position directly in the underlying asset. For example, if
the initial margin required for a particular ES contract is 10% of
that ES contract value, then the leverage is 10 times, and the
risk and return are magnified 10 times.
The small initial outlay required may work against the investor.
He may be tempted to over-extend himself by buying too many
ES contracts with the sum which he has to invest. For
example, while an investor may be able to buy only one lot of a
companys shares for S$5,000, he may be able to buy 10 lots
of ES contracts for the same amount of S$5,000 if the margin
of those contracts is 10%. He should bear in mind that, when
the ES contracts are due for settlement, he would have to pay
the balance of S$45,000.
(ii) Margin Calls

An investor may sustain a total loss of
the funds placed for initial margin and
any additional funds deposited to
maintain a position in the ES contract.
If the market moves against the
investor or margin levels are increased,
39
the investor may be required by his broker to pay additional

funds on short notice to maintain the position. If the investor
fails to comply with a request for additional funds within the
specified time, the broker may liquidate the position, and the
investor will be liable for any resulting deficit in his account.
Therefore, the potential loss from trading ES contracts is not
limited to and can be several times the initial margin paid
originally to support the position.
(iii) Liquidity
Similar to ordinary shares in the ready market, there is no
assurance that a liquid market will always exist for an ES
contract. An illiquid market can occur if there
are few willing buyers and / or sellers for the ES
contract. This may increase the risk of loss, by
making it difficult or impossible for an investor
to liquidate a position in the ES contract.
Two useful indicators of liquidity are the volume
of trading and the open interest of the contract
(the number of ES positions still remaining to be liquidated by
an offsetting trade or satisfied by delivery).
In addition to an illiquid market, the ability of an investor to
liquidate his ES position may be affected by the operation of
certain rules, e.g. the suspension of trading in any ES contract
or the underlying security owing to unusual trading activity or
news events involving the issuer of the underlying security.
(iv) Volatility
Since the stock market can be volatile at times, the prices of
ES contracts are similarly affected. The investor must be aware
of the impact of volatility on risk and return.
(v) Buy-In By Clearing House
If you hold a short ES position until expiration, you have an
obligation to physically deliver the underlying security for
settlement. If you do not have the required securities in your
40
account on the settlement day, the Central Clearing House will

buy-in shares on your behalf to satisfy your delivery obligation.
You are required to pay for the bought-in securities and any
associated costs.
2.2.3 Comparison of CFD and ES
It is noted that both CFD and ES are financial derivatives and, as such,
they can be quite risky if the exposure is not properly managed, and the
risks are not properly understood and contained. Both instruments can
be highly leveraged. They can both be used for shorting and speculation
on the price trend of the underlying assets. One key difference is that
ES has a relatively short expiry date (like 35 days),
while CFD technically can be held for a much longer
period of time.
2.3 Warrants
Warrants, also known as Transferable Subscription Rights
(TSR), are a special type of call option issued by a
corporation that gives the holder the right to acquire equity
at a specified price and within a designated time period,
typically several years.
Warrants are seldom issued on their own, but are often provided free as an
added attraction to rights or loan stocks (which are unsecured stock delivered
to an entity that has furnished a loan for a company. Loan stock earns interest
at a fixed rate) issued by a company to raise extra capital. Warrants, in the
form of a certificate, are usually issued along with a bond or preferred stock,
entitling the holder to buy a specific amount of securities at a specific price,
usually above the current market price at the time of issuance, for an extended
period, anywhere from a few years to forever.
2.3.1 Why Buy Warrants?
Warrants offer some attractive features:
An investor can buy a warrant as a way to establish an exposure to a
share, without a large initial capital outlay. The investor will buy the
warrant, pay the exercise price at a later date, and convert the
warrant to the underlying share.
41
An investor may benefit from capital gains by selling the warrants

given to him in the first instance. When the price of the underlying
share goes up, the investor may profit by selling the warrant, or
exercise it to buy and then sell the stock to reap the capital gain.
Note that capital gain is not taxable in Singapore.
2.3.2 Disadvantages Of Investing In Warrants
The main drawback is that on expiry, warrants, which are not
exercised, lose their value completely. Unlike ordinary shares, there is
no chance for price recovery. Once the warrant has expired, it is
worthless. Another disadvantage is that warrant holders do not receive
any income in the form of interest or dividends. They also carry no
voting privileges.
2.4 Futures
In general, futures is a standardised, transferable, exchange-traded contract
between two parties that requires delivery of a commodity, bond, currency, or
stock index1, at a specified price, on a specified
future date. Unlike options, futures convey an
obligation to buy. The risk to the holder is unlimited,
and because the payoff pattern is symmetrical, the
risk to the seller is unlimited as well. Dollars lost and
gained by each party on a futures contract are equal
and opposite. In other words, futures trading is a
zero-sum game. Futures contracts are forward
contracts, meaning they represent a pledge to make
a certain transaction at a future date. The exchange
of assets occur on the date as specified in the contract. Futures are
distinguished from generic forward contracts in that they contain standardised
terms, trade on a formal exchange, are regulated by overseeing agencies, and
are guaranteed by clearing houses. Also, in order to ensure that payment will
occur, futures have a margin requirement that must be settled daily.
The Initial Margin is the sum of money (or collateral) to be deposited by a firm
to the clearing corporation to cover possible future loss in the positions (the
set of positions held is also called the portfolio) held by a firm. The Mark-to1
42
Futures contracts are cash-settled when the underlying assets are intangible, such as stock index.
Market Margin (MTM margin) on the other hand is the margin collected to
offset losses (if any) that have already been incurred on the positions held by a
firm. This is computed as the difference between the cost of the position held
and the current market value of that position.
In summary, a futures contract is one, where a buyer and seller are obligated
to buy or sell an asset, within a specified time period, at a specified price.
They differ from options in that there is an obligation to transact, regardless of
future price movement. In contrast, futures contracts cannot lapse, and their
holders have to sell them before their expiration date, or take delivery of the
underlying item.
2.4.1 Why Buy Futures?
Index futures enable investors to protect their investments, by taking
positions in the futures market to protect the gains that they have made
in the cash market. An investor may also wish to engage in speculative
trading. The investor takes on price fluctuation risks in order to have a
chance at making large gains. However, before an investor ventures
into investing in future contracts, he must have a clear understanding of
the concept of hedging, and of the amount of gain or loss that can
result from any change in the price of the index futures contract.
Finally, by making an offsetting trade, taking delivery of goods, or
arranging for an exchange of goods, futures contracts can be closed.
Hedgers often trade futures for the purpose of
keeping price risk in check. Speculators on futures
price fluctuations not intending to make or take
ultimate delivery must take care to "zero their
positions" before the expiry of the contracts. After
expiry, each contract will be settled, either by
physical
delivery
(typically
for
commodity
underlyings), or by a cash settlement (typically for financial
underlyings).
The contracts ultimately are not between the original buyer and the
original seller, but between the holders at expiry and the stock
exchange. As a contract may pass through many hands after it is
43
created by its initial purchase and sale, settling parties generally do not
know with whom they have ultimately traded.
2.5
Swaps
A swap is a derivative in which two counterparties exchange certain benefits
of one party's financial instrument with those of the other party's financial
instrument. The benefits in question depend on the type of financial
instruments involved. Specifically, the two counterparties agree to exchange
one stream of cash flows against another stream. These streams are called the
legs of the swap. The swap agreement defines the dates when the cash flows
are to be paid and the way they are calculated. Usually at the time when the
contract is initiated, at least one of these series of
cash flows is determined by a random or uncertain
variable, such as an interest rate, foreign exchange
rate, equity price or commodity price.
The cash flows are calculated over a notional principal
amount, which is usually not exchanged between the
counterparties. Consequently, swaps can be used to
create unfunded exposures to an underlying asset, since counterparties can
earn the profit or suffer the loss from movements in price, without having to
post the notional amount in cash or collateral.
Swaps can be used to hedge certain risks, such as interest rate risk, or to
speculate on changes in the expected direction of prices of underlying
securities. The first swaps were produced in the early 1980s. Today, swaps
are among the most heavily traded financial contracts in the world.
It is noted that with swaps, exchange of cash flows can happen between a
number of different asset classes. Also, the cash flows can arise from asset,
some liability, or some payment streams.
Common types of swaps include:
Currency swap: simultaneous buying and selling of a currency to convert
debt principal from the lender's currency to the debtor's currency;
44
Debt swap: exchange of a loan (usually to a third-world country) between

banks;
Debt to equity swap: exchange of a foreign debt (usually to a third-world
country) for a stake in the debtor country's national enterprises (such as
power or water utilities);
Debt to debt swap: exchange of an existing liability into a new loan, usually
with an extended payback period; and
Interest rate swap: exchange of periodic interest payments between two
parties (called counterparties) as means of exchanging future cash flows.
2.6 Summary Of Financial Derivatives
The following tables provide a summarised comparison of the different types
of financial derivatives as discussed above. The tables bring out the
differences among them, in the areas of definition, right / obligation,
management of risk, leverage and expiry, voting privileges, ownership interest
or dividend income, use, margin account, trading and settlement of contracts.
Table 2.1 Definition
Options
Warrants
A formal contract Special type of
between a seller
call option issued
and a buyer to
by a corporation
buy or sell some
that gives the
stock in the
holder the right to
future at some
acquire equity at
pre-set price
a specified price
(strike price).
and within a
designated time
period.
Futures
A standardised,
transferable,
exchange-traded
contract between
two partiesfutures contract
giving the holder
the obligation to
make or take
delivery under the
terms of the
contract.
Swaps
A derivative in
which two
counterparties
exchange certain
benefits (cash
flows) of one
party's financial
instrument for
those (the cash
flows) of the
other party's
financial
instrument.
45
Table 2.2 Buy / Sell: Right Versus Obligation

Options
Warrants
Futures
Equity call option Right / no
Obligated to buy
gives the right
obligation to
or sell within a
(not obligation) to acquire the
specific time
buy at strike
equity.
period at a
price; put option
specific price.
gives the right
(not obligation) to
sell at strike
price.
Table 2.3 Management Of Risk
Options
Warrants
Limited exposure Exposure to a
for option buyer
share without
maximum
huge capital
capital loss for
outlay (warrant
option buyer is
premium or free).
the purchase
For warrant
price of the
issuer, the
option (option
maximum loss is
premium). For
the difference
option issuer, the between the
maximum loss is
market value and
the difference
strike price of the
between the
stock less the
market value and warrant premium.
strike price of the This magnitude
stock less the
turns out to be
option premium.
the maximum
This magnitude
gain for the
turns out to be
warrant buyer.
the maximum
gain / profit for
the option buyer.
46
Futures
Clear
understanding of
hedging and
amount of gain or
loss owing to
change in price of
futures contract
is necessary;
cash flows
needed to
maintain margin
account under
volatile market
conditions.
Swaps
Obligated to carry
out the terms of
the contract till
completion.
Swaps
Failure of
counterparty to
carry out the
exchange of cash
flows owing to
failure or
insolvency; can
be hedged by the
use of credit
default swaps.
Table 2.4 Leverage And Expiry

Options
Warrants
Leverage: Yes
Leverage: Yes
Expiry: Yes, if the
right is not
exercised by the
expiry date.
Futures
Leverage: Yes
Expiry: Yes, if not Expiry: Yes, the

exercised before
expiry date is
the expiry date.
known as the
delivery date or
final settlement
date.
Swaps
Leverage: Yes
Expiry: Yes,
when the term
for the exchange
of cash flows is
completed.
Table 2.5 Voting Privileges, Ownership Interest Or Dividend Income

Options
Warrants
Futures
Swaps
No
No
No
No
Table 2.6 Use
Options
Leverage / hedge
against the price
fluctuation.
Warrants
By corporations /
issuers to
promote the sale
of preferred
shares or
issuance of
bonds.
Futures
Financial futures
are extensively
used in the
hedging of
interest rate
swaps; also by
speculators who
seek to make a
profit by
predicting market
movements.
Swaps
Used to hedge
interest rate risk
(interest rate
swaps), credit
default risk
(credit swaps),
speculate on
changes in
expected
direction of prices
of underlying
securities:
(commodity
swaps and equity
swaps).
47
Table 2.7 Margin Account

Options
Warrants
Not Applicable.
Not Applicable.
Table 2.8 Trading

Options
Warrants
Via stock
Via stock
exchange or
exchange or
OTC.
OTC.
Table 2.9 Settlement

Options
Warrants
Normally by cash By cash for
(representing the acquisition of
difference
stocks.
between the
market value and
strike price of the
stock) or transfer
of security (rare);
same for
warrants.
48
Futures
Yes, to minimise
credit risk,
traders must post
an initial margin
or a performance
bond, typically
5% to 15% of
the contract
value; and
marked to market
daily by
maintenance
margin.
Swaps
Not Applicable.
Futures
Mercantile
exchange /
futures exchange.
Swaps
OTC or
mercantile
exchange /
futures exchange.
Futures
By physical
delivery (common
with commodities
and bonds) or
cash settlement.
Swaps
By proper
exchange of cash
flows until the
completion of the
term.
3.
REAL ESTATE INVESTMENT

Investment in real estate has been a part of the investment
portfolio and activity for many investors, the main reason
being that ownership of real estate and properties are very
much tied to the housing and sheltering need for the
individuals and families. The housing and sheltering need
may be fulfilled through renting or purchasing of properties.
In many other parts of the world, renting has been and is a
key way of addressing the need for sheltering. Besides
housing and sheltering needs, ownership of real estate is a
popular investment activity / strategy.
There are many forms of real estate ownership available to investors. One such form
is the purchase of property directly, either as an individual, or as a managing partner
in a partnership. Another way that requires less active management by the investor
is to own shares in a Real Estate Investment Trust (REIT). A third way is by owning
a limited-partnership interest in a general partnership. This limited-partnership
interest has no active role in the firms management.
Real estate investments usually involve more complexities than the other investment
categories because of:
the uniqueness of each property;
the differing rights associated with ownership of each property; and
the absence of organised markets for the ready sale and purchase of the property
or ownership interest.
Most individuals purchase their homes to provide shelter for oneself and family. At
the same time, they hope to enjoy a current return or capital appreciation in the
propertys value.
Over the recent years, investments in real estate and housing have produced fairly
high and good returns for many investors. As with all investments, market
conditions can change. If expenditures for the primary residence are being made,
because the major objective is to achieve the benefits from an investment, then the
property must be examined from that perspective.
49
3.1 Reasons For Investment In Property / Real Estate

Property is a good investment for the following reasons:
(a) Inflation Hedge
It has been the past experience that, on the average,
in most countries, real estate has been a very good
hedge against inflation, because property values and
the income from properties tend to rise to keep pace
with inflation.
(b) Capital Appreciation
Real estate values tend to appreciate over time, although this is not
guaranteed. When an investor buys a property, a down payment of at
least 20% is normally paid, while the balance is borrowed through a loan
(set up as a mortgage) arranged with a commercial bank. The investor
gets the benefit of all 100% of the investment. This means that the
investor maximises his return with other peoples money. The use of
mortgages and leverage enable the investor to use small amounts of cash
to gain control of large investments and earn large returns on the money
invested.
(c) Pride Of Ownership
An investor may find great personal satisfaction in owning a property
rather than other forms of investments.
3.2 Disadvantages Of Investing In Property / Real Estate
Of course, investing in real estate is not free from problems. Some of such
problems are highlighted below.
High transaction costs, such as brokerage commissions, legal fees and
stamp duties. These costs eat up short-term profits. For an investor who
may need liquidity, investing in real estate is not advisable.
Real estate is usually not as liquid as other types of investments, such as
stocks, bonds, etc. The lack of a central market or exchange makes it
difficult to develop liquidity in real estate transactions. Property investments
must be seen as long-term investments.
Management headaches when the investor encounters unreliable tenants.
50
Negative cash flow for highly leveraged investors. This is due to the fact that
rentals can be lower than mortgage servicing costs.
3.3 Risks Of Borrowing To Invest In Property / Real Estate
Highly leveraged property investing, which makes it possible for investors to
earn big gains on a small amount of capital, also has many pitfalls. Property
values can go down, as well as up, very quickly over a relatively short period
of time. It is important for the investor to select the property carefully. He
must be able to anticipate a rising market owing to lower interest rates, or
high inflation rates, before engaging in highly leveraged property investing.
4.
STRUCTURED PRODUCTS
A structured product is generally a pre-packaged investment strategy involving
derivatives, a single or a basket of securities, options, indices, commodities, debt
issuances and / or foreign currencies, and to a lesser extent,
swaps. The variety of products just described is demonstrative of
the fact that there is no single, uniform definition of a structured
product.
These products have a fixed maturity, and have two components,
namely a note and a derivative. The derivative component is often
an option. The note provides for periodic interest payments to the
investor at a predetermined rate, and the derivative component
provides for the payment at maturity. Some products use the
derivative component as a put option written by the investor that
gives the buyer of the put option the right to sell to the investor
the security or securities at a predetermined price. Other products
use the derivative component to provide for a call option written by the investor that
gives the buyer of the call option the right to buy the security or securities from the
investor at a predetermined price.
4.1 Features
A feature of some structured products is a "capital guaranteed" function, which
offers return of principal if held to maturity. For example, an investor invests
51
S$100; the issuer simply invests in a risk-free bond that has sufficient interest to
grow to S$100 (at the end of the maturity period). This bond may cost S$80
today, and over the product term, it will grow to S$100. With the leftover funds,
the issuer purchases the options and swaps needed to perform the necessary
investment strategy. Theoretically, an investor can just do these themselves, but
the costs and transaction volume requirements of many options and swaps are
beyond many individual investors.
US Securities and Exchange Commission (SEC) Rule 434 (regarding certain
prospectus deliveries) defines structured securities as "securities whose cash
flow characteristics depend upon one or more indices or that have embedded
forwards or options or securities where an investor's investment return and the
issuer's payment obligations are contingent on, or highly sensitive to, changes in
the value of underlying assets, indices, interest rates or cash flows." What this is
saying is that such structured products are quite complex, and are generally
speaking, not for the ordinary investors, nor the faint-hearted.
4.2 How Structured Products Are Manufactured?
Combinations of derivatives and financial instruments create structures that have
significant risk / return and / or cost savings profiles that may not be otherwise
achievable in the marketplace. Structured products are designed
to provide investors with highly targeted investments tied to
their specific risk profiles, return requirements and market
expectations.
CDO
These products are created through the process of financial
engineering, i.e., by combining underlyings like shares, bonds,
indices or commodities with derivatives. The value of derivative
securities, such as options, forwards and swaps, is determined by (respectively,
derives from) the prices of the underlying securities.
The market for derivative securities has grown quickly in recent years. The main
reason for this lies in the economic function of derivatives. It enables the transfer
of risk, for a fee, from those who do not want to bear it, to those who are willing
to bear risk.
52
4.2.1 An Example Of The Working Of A Structured Product

The investor provides the capital. The capital is used by the issuer to
purchase a basket of AA rated credit-linked notes [often termed as
synthetic Collateralised Debt Obligations (CDOs)]. This is called the
underlying securities. Therefore, the investor has exposure against credit
default of the underlying securities. Note that a Note is a short-term debt
security, usually with a maturity of five years or less.
A CDO is an investment-grade security backed by a pool of various other
securities. A CDO is a type of asset-backed security (ABS). CDOs can be
made up of any type of debt, in the form of bonds or loans, and usually
do not deal with mortgages. CDOs are generally divided into slices, each
slice is made up of debt which has a unique amount of risk associated
with it. CDOs are often sold to investors who want exposure to the
income generated by the debt, but do not want to purchase the debt
itself.
To produce the series of payments to the investors, the issuer will
normally engage some investment bank to swap the coupons on the
notes into local currency. Hence, coupons on the
notes are paid to the swap counterparty. In
return, the swap counterparty pays the investor
the promised periodic payouts under the product.
In general, the swap counterparty will insure itself
against the credit default risk of the reference
entities which may comprise of several
companies (names). This is generally executed
with the set up of credit default swap, with premiums paid by the swap
counterparty. In the event of a default by any of these companies, the
swap counterparty will take over the underlying securities and pay the
investor what is left of the defaulted notes of the reference entities minus
costs, etc.
If nothing happens up to maturity, the proceeds from the underlying
securities will enable the product to pay back the original capital to the
investor. More details of CDOs can be found in Chapter 8 of this study
guide.
53
4.3 Benefits Of Structured Products

(a) Return of initial capital on maturity;
(b) Enhanced returns within an investment;
(c) They can be used as an alternative to a direct investment;
(d) They can be used as part of the asset allocation process to reduce risk
exposure of a portfolio;
(e) They can be created to take advantage of the current market trend; and
(f) They can be created to meet specific needs that cannot be met from the
standardised financial instruments available in the markets.
4.4 Types / Categories Of Structured Products
Structured products are by nature not homogeneous as a large number of
derivatives and underlying can be used. However, the more popular ones can be
classified under the categories as described below.
(a) Interest rate-linked Notes and Deposits: These are
structured products designed to be linked to interest
rates such as Libor or Euribor.
(b) Equity-linked Notes and Deposits: These refer to
investment securities that combine the characteristics
of zero or low-coupon bonds or notes with a return
component, based on the performance of a single equity
security, a basket of equity securities, or an equity
index.
(c) FX and Commodity-linked Notes and Deposits: These involve investment
instruments linked to the performance of a specific commodity, a basket of
commodities, some foreign exchange rate, or a basket of foreign exchange
rates.
(d) Hybrid-linked Notes and Deposits: These are structured notes, sometimes
called "hybrid debts. They are intermediate term debt securities, in which
54
the interest payments are determined by some type of formula tied to the
movement of interest rate, stock, stock index, commodity, or currency.
Although structured notes are derivatives, they often do not include an
option, forward or futures contract.
(e) Credit-linked Notes and Deposits: They are a form of funded credit
derivative. They are structured as a security with an embedded credit default
swap, allowing the issuer to transfer a specific credit risk to credit investors.
The issuer is not obligated to repay the debt if a specified event occurs. This
eliminates a third-party insurance provider.
(f) Market-linked Notes and Deposits: These are structured products linked to a
certain or a basket of market indices.
4.5 Risks With The Structured Products
Structured products tend to be quite complex owing to the fact that financial
derivatives and swap arrangements / counterparties are involved.
The risks associated with many structured products, especially those products
that present risks of loss of principal owing to market movements, are similar to
those risks involved with options and financial derivatives. The potential for
serious risks involved with options trading are well-established, and as a result of
those risks, customers must be explicitly approved for options trading. In the
same vein, FINRA (the Financial Industry Regulatory Authority, Inc, which is a
private corporation that acts as a self-regulatory organisation in the US) suggests
that firms "consider" whether purchasers of some or all
structured products be required to go through a similar
approval process, so that only accounts approved for options
trading will also be approved for some or all structured
products.
In the case of so-called "principal protected" products, they are
not insured by the government authority. They may only be
insured by the issuer, and thus have the potential for loss of
the principal in the case of a liquidity crisis, or other solvency problems with the
issuing company (the problems with the Mini Bond series, etc. in the 2008 /
2009 global recession could not be a better example of how risky such
55
structured products could be). The term capital protected and principal
protected had been prohibited by the Monetary Authority of Singapore (MAS)
under the Revised Code on Collective Investment Schemes.
56
3. Financial Markets
Chapter
FINANCIAL MARKETS
CHAPTER OUTLINE
1.
2.
3.
4.
5.
6.
7.
8.
Introduction
Bond Market
Equity Market
Derivative Market
Over-The-Counter (OTC) Market
Characteristics Of An Efficient Financial Market
Forms Of Market Efficiency
Modern Portfolio Theory (MPT)
KEY LEARNING POINTS

After reading this chapter, you should be able to understand:
bond market
equity market
derivative market
over-the-counter (OTC) market
characteristics of an efficient financial market
forms of market efficiency
modern portfolio theory (MPT)
57
1.
INTRODUCTION
A financial market provides a mechanism for the trading of financial assets. It
facilitates the means for the segments of the economy with surpluses to invest
these surpluses in corporations or governments requiring funds. It
is the heart of the global financial system, attracting and allocating
savings and setting / influencing interest rates and prices of
financial assets (stocks, bonds, etc.).
In terms of what it does / achieves, a Financial Market is a market
that facilitates the exchange of capital and credit. It includes the
money market and the capital markets.
A Money Market is a market for short-term debt securities, such as banker's
acceptances, commercial paper, repos, negotiable certificates of deposit, and
Treasury Bills with a maturity of one year or less (often 30 days or less). Money
market securities / instruments are generally very safe investments which return a
relatively low interest rate. Hence, these are most appropriate for temporary cash
storage or for short-term time horizon. The spreads between bid and ask yields on
the securities are relatively small owing to the large size and high liquidity of the
market.
Capital Market is a market where debt or equity securities are traded.
Financial markets may be classified in the following three ways depending on how
the securities are traded. They are Primary Market, Secondary Market and Over-TheCounter (OTC) Market.
1.1 Primary Market For Newly Issued Financial Assets And Secondary Market For
Others
The primary market is one where new issues of financial assets are sold.
Examples of new issues include initial public offers for equities, tender of
government bonds and offers of new fixed income securities. The issuers of
these securities receive funds from investors who then become owners of the
newly issued financial assets. In the primary market, the security is purchased
directly from the issuer.
58
The secondary market is one where trading takes place for financial assets. It
is a market where an investor purchases a security from another investor
rather than the issuer, subsequent to the original issuance in the primary
market. It is also called aftermarket. The secondary market provides the
liquidity necessary for the proper functioning of the primary market. Investors
will be more hesitant to purchase financial assets in the primary market if they
cannot divest them readily in the secondary market. If the financial assets can
be easily traded in the secondary market, it encourages a vibrant primary
market. When trading takes place, the ownership of these assets changes
hands. However, no new funds are raised for the original issuers of these
assets. Hence, the secondary market serves a very important function, in that
it allows and facilitates the orderly and timely transfer of assets and wealth
between different segments of the investment community.
Examples of secondary markets include formal centralised
exchanges and Over-The-Counter (OTC) markets. OTC can be
used to refer to stocks that are traded via a dealer network as
opposed to on a centralised exchange. It also refers to debt
securities and other financial instruments such as derivatives,
which are traded through a dealer network.
1.2 Types Of Financial Claims
Claims in financial assets may be a fixed amount, a residual amount or may be
dependent on an underlying asset. If the claim is for a fixed amount, the
financial market in which such assets are traded is known as a debt or fixed
income / bond market. Financial assets with fixed amount of claims on the
issuers, such as money market instruments and fixed income securities are
traded here. Equities are assets with a residual claim on the issuers. The
financial market in which equities are traded is known as an equity market.
Finally, the derivative market is where trading of derivatives takes place. The
claim of derivatives is dependent on the value of an underlying asset.
1.3 Types Of Maturities
The financial market for short-dated financial assets is called the money
market. They have maturities of less than one year. The financial market for
longer-dated financial assets is called the capital market. Assets traded on the
59
capital market have maturities of more than one year. Thus, the debt market
can be considered a money market or capital market depending on the
maturities of the assets. Equities are perpetual assets and are thus traded in
the capital market.
2.
BOND MARKET
Bond market (also known as the debt, credit, or fixed income market) is a financial
market where participants buy and sell debt securities, usually in the form of bonds.
Nearly all of the US$923 billion average daily trading volume (as at early 2007) in
the US bond market takes place between broker-dealers and large institutions in a
decentralised, over-the-counter (OTC) market. However, there is a small number of
bonds, primarily corporate listed on the stock exchanges. The New York Stock
Exchange (NYSE) is the largest centralised bond market, representing mostly
corporate bonds.
References to the "bond market" usually refer to the government bond market,
because of its size, liquidity, lack of credit risk and, therefore, sensitivity to the
interest rates. Because of the typically inverse relationship between bond valuation
and interest rates, the bond market is often used to indicate changes in the interest
rates or the shape of the yield curve.
Owing to its status as the worlds reserve currency, the US$ bond market is the
largest in the world. Both the US government, its corporate and non-US entities
regularly issue bonds to refinance maturing bonds or to raise new funds. As at
2010, the amounts outstanding on the global bond market is estimated at US$95
trillion, and the US was one of the largest market in terms of the value of bonds
outstanding.
The US government is the worlds largest issuer of bonds. These
are usually issued through an auction where dealers submit
competitive bids. Trading of bonds is typically done over the
counter through bond dealers, comprising mainly commercial banks
and investment banks. US government securities are the most
liquid fixed income securities in the secondary market.
60
The Eurobond market is a very important source of funding for issuers raising
foreign currency debts. Eurobonds refer to bonds denominated in any foreign
currency issued to the investors. Owing to the global distribution of investors and
dealers, the dealing and settlement procedures for Eurobonds are governed by an
international association, which is known as the International Capital Market
Association (ICMA). [Note: ICMA was formed in July 2005 following the merger of
the International Securities Market Association (ISMA) and the International Primary
Market Association (IPMA)]. ICMA is a self-regulated trade association that plays an
active role in the capital markets by influencing the
financial regulations in Europe. Based out of Zurich,
Switzerland, ICMA now has grown to include more than
400 members across 50 countries.
The Singapore dollar bond market is relatively less
developed as compared to other more developed
countries. This is due to the restrictions imposed on
trading of Singapore dollars, the lack of issuers, and the
small financial market. However, the authorities have been working to change this.
They have relaxed certain rules to vitalise the Singapore dollar bond market. The
public sector, including the statutory boards (such as the Housing & Development
Board, Jurong Town Corporation and Land and Transport Authority), is now a
regular issuer of bonds. The restrictions on internationalisation of the Singapore
dollars have also been relaxed to allow some foreign entities to issue bonds under
certain conditions. For example, in 1998, the MAS revised its guidelines to allow
foreign entities of good credit standing to issue S$ denominated bonds, provided
that they swapped the S$ proceeds into foreign currency. This has boosted the
development of the Singapore bond market.
3.
EQUITY MARKET
An equity market or stock market is a public market for the trading of securities,
including company stock and derivatives listed on a stock exchange, as well as
those traded only privately. A stock exchange refers to any organisation, association
or group which provides or maintains a marketplace, where securities, options,
futures, or commodities can be traded. It specialises in the business of bringing
buyers and sellers of securities together. The major stock market in the United
States is the New York Stock Exchange, while in Canada, it is the Toronto Stock
61
Exchange. Major European examples of stock exchanges include the London Stock
Exchange (largest in Europe), Paris Bourse, and Deutsche Brse. Asian examples
include the Shanghai Stock Exchange, Tokyo Stock Exchange, Hong Kong Stock
Exchange, and Bombay Stock Exchange. Shanghai has just overtaken Tokyo in
2009 as Asia's biggest and busiest stock market by value of shares traded, after
activity doubled there year on year.
Equities and other equity-linked derivatives, such as warrants and preferred stocks
are traded on the equity markets. Equity markets can be differentiated by their size,
liquidity, trading and settlement system, and the restrictions on foreign participation.
The worlds largest equity market is the US stock
market, accounting for about half the total market
capitalisation of the total world equities. The size of the
world stock market was estimated at about US$36.6
trillion at the beginning of October 2008. The total world
derivatives market has been estimated at about US$791
trillion face or notional value at 11 times the size of the
entire world economy. The value of the derivatives
market, because it is stated in terms of notional values, cannot be directly compared
to a stock or a fixed income security, which traditionally refers to an actual value.
Moreover, the vast majority of derivatives cancel each other out (i.e., a derivative
bet on an event occurring is generally offset by a comparable derivative 'bet' on
the event not occurring). Many such relatively illiquid securities are valued as
marked to model, rather than an actual market price. Note that the notional value is
the value of a derivative's underlying assets at the spot price. In the case of an
options or futures contract, this is the number of units of an asset underlying the
contract, multiplied by the spot price of the asset.
Liquidity is the trading volume of equities in the market. It is related to the size of
the market, as well as the percentage of free-float shares. A free-float share is the
portion of the corporate total issued shares that is not locked up by strategic and
long-term investors. Liquidity is an important criterion for large funds when deciding
if the particular equity market is investable.
The trading and settlement system differs from one market to another. Most equity
markets today have an electronic settlement system. This is a more efficient system
when compared to the previous scrip-based settlement system. In some markets,
62
such as Taiwan, the use of electronic settlement also allows trades done to be
settled by the following day.
Some equity markets, such as Thailand, still maintain a system of restricting foreign
participation in the market by imposing a shareholding limit on foreigners. In
Thailand, the Foreign Board, set up in 1987 is to serve as an alternative board for
foreign investors seeking ownership of the securities which they invest in and to
register such shares under their own names. There are foreign ownership limits as
set forth in the Articles of Association of each listed company.
In other markets, such as Taiwan, Korea and India, foreign investors wanting to
trade in the equity market have to obtain prior approval before trading can begin. For
example, investors belonging to foreign countries other than few neighbouring
countries are barred from investing through the Indian Stock Exchanges in India.
However, there are ways to get around it, through the use of say, ADRs (American
Depository Receipts) and GDR (Global Depository Receipts) issued in foreign markets
by companies operating in India, and through investment in mutual funds.
Like several emerging stock markets, the Taiwan stock market historically set
several limitations on foreign investment. However, with the growth of the Taiwans
stock market and the development of sounder systems, the government has
gradually relaxed these limitations on foreign investors. Since 1 October 2003, the
review process for investment by foreign investors in the stock market has been
changed from the permit system to the registration system.
This has consequently simplified the application procedures for
foreign investment in the Taiwans stock market.
Under the registration system in Taiwan, foreign investors are
required to register with the Taiwan Stock Exchange so as to
obtain an Investor ID and Tax ID simultaneously, before
opening a trading account with a local securities firm.
For South Korea, foreign portfolio investors now enjoy good access to the Korea's
stock markets. Aggregate foreign investment ceilings in the Korean Stock Exchange
(KSE) were abolished in 1998, and foreign investors owned 32.9 percent of KSE
stocks and 10.3 percent of the KOSDAQ as of 2010.
63
3.1
Singapore Exchange Limited (SGX)

SGX is the first demutualised, integrated securities and derivatives exchange in
the Asia Pacific. Formed on 1 December 1999 by the merger of the Stock
Exchange of Singapore (SES) and the Singapore International Monetary
Exchange Limited (SIMEX), the SGX has since built up a presence and
prominence that extends beyond the borders of Singapore.
SGX owns and operates the only integrated securities exchange (SGX
Securities Trading Limited or SGX-ST) and derivatives exchange (SGX
Derivatives Trading Limited or SGX-DT) in Singapore and
their related clearing houses.
SGX-ST operates the first fully electronic and floorless
exchange in Asia. Besides facilitating the listing of leading
companies in Singapore, it has also attracted listings of other
companies from other countries.
SGX-DT over the years has expanded its range of
international products and trading activities, making it one of
the leading derivatives exchanges in Asia. It has also
developed a reputation for being committed to an innovative
and pro-market approach.
SGX-DT offers the widest range of Asian derivatives in the world and also the
widest range of international derivatives in the Asia Pacific. These instruments
include futures and options on interest rates, stock indices, energy and
commodities.
Together, the securities and derivatives exchanges serve a wide array of
international and domestic investors and end users, including many of the
worlds largest financial institutions. They are also among the most innovative
exchanges in the world in technological and new product development.
On 23 November 2000, SGX became the first exchange in the Asia Pacific to
be listed via a public offer and a private placement. Listed on the SGX itself,
the SGX stock is a component of benchmark indices, such as the MSCI
Singapore Free Index and the Straits Times Index.
64
Aside from equity investments (stocks) and derivatives, other classes of

products that can be traded through the SGX include Exchange Traded Funds
(ETFs), Real Estate Investment Trust (REITs), Global Depository Receipts
(GDRs, which are certificates representing an issuers underlying shares),
Company Warrants, Structured Warrants, Certificates (which are issuer-led
structured financial products that offer investment opportunities, based on
different market themes and expectations), Extended Settlements, and Equity
Index Futures / Options.
4.
DERIVATIVE MARKET
The derivative market relates to the trading of options, futures and other derivatives.
It is experiencing tremendous growth as more derivatives are being introduced.
Futures exchanges, such as Euronext.liffe and the Chicago Mercantile Exchange
(CME) in the US, trade in standardised derivative contracts. These are options
contracts and futures contracts on a whole range of underlying products. The
members of the exchange hold positions in these contracts with the exchange,
which acts as a central counterparty. When one party goes long
(buys) on a futures contract, another goes short (sells). When a
new contract is introduced, the total position in the contract is
zero. Therefore, the sum of all the long positions must be equal
to the sum of all the short positions. In other words, risk is
transferred from one party to another. The total notional amount
of all the outstanding positions at the end of June 2004 stood at
US$53 trillion. That figure grew to US$81 trillion by the end of
March 2008.
Tailor-made derivatives not traded on a futures exchange are traded on over-thecounter markets (the OTC market). These consist of investment banks which have
traders who make markets in these derivatives, and clients, such as hedge funds,
commercial banks, government sponsored enterprises, etc. Products that are always
traded over-the-counter are swaps, forward rate agreements, forward contracts,
credit derivatives, etc. The total notional amount of all the outstanding positions at
the end of June 2004 stood at US$220 trillion. By the end of 2007, that figure had
risen to US$596 trillion.
65
Established in 1973, the Chicago Board Options Exchange (CBOE) is the largest US
options exchange. With annual trading volume that hovered around one billion
contracts at the end of 2007, CBOE offers options on over 2,200 companies, 22
stock indexes, and 140 exchange-traded funds (ETFs).
In the US, apart from CBOE, another established exchange for the
trading of futures and options is the Chicago Board of Trade (CBOT).
As of July 2007, the CBOT merged with the CME to form the CME
Group. Futures and options are traded on the floor of exchanges,
such as using a system of open outcry. Under this system, a pit
trader offers to buy or sell futures contracts at a certain price, while
other pit traders are free to transact with him if they wish. The
clearing house acts as an intermediary between the buyers and the
sellers. It guarantees that all contract obligations will be honoured. In
Singapore, the derivative exchange is the SGX Derivatives Trading
(SGX-DT).
4.1
Singapore Mercantile Exchange (SMX)

Singapore is looking to further develop its commodity markets, with the entry
of SGX and the Singapore Mercantile Exchange (SMX) into the commodity
markets in the first quarter and mid 2010 respectively. The SMX was launched
on 31 August 2010.
In view of the fact that commodities have become important investment
vehicles worldwide, and Singapores unique geographical location, SGX is
looking to tap on commodities trading to drive growth, and planning to expand
its product base under the Singapore Commodity Exchange Limited (Sicom).
SMX products currently include selected precious metals, base metals, energy
and currency pairs. As of 2010, Singapore is the worlds third largest oil
trading centre after New York and London. For the currency markets, it is the
fifth largest foreign exchange trading centre in the world, and the second
largest in Asia closely behind Tokyo. For the OTC markets, Singapore is the
eight largest OTC derivatives centre in the world.
With an objective of implementing the best clearing and settlement practices,
SMX has incorporated its clearing corporation, Singapore Mercantile Exchange
Clearing Corporation (SMXCC) which will perform the role of being the clearing
66
house of SMX and will handle clearing, settlement and risk management
functions. SMXCC will be a Central Counterparty for trades executed on the
SMX trading platform between the buyer and the seller. In order to protect
market participants from counterparty credit risk, SMXCC will have in place a
Settlement Guarantee Fund. Non-performance by any one party will not affect
the other party, as SMXCC will step in and fulfil obligations of the defaulting
party through the Settlement Guarantee Fund. Guaranteed performance on
SMX products will provide immense confidence to market participants as
counterparty risk will be eliminated. This process ensures market integrity.
As a significant milestone, SMX announced on 2 December 2009 that it had
received in-principle regulatory clearance from MAS to operate the first PanAsian, multi-product commodity derivatives exchange.
5.
OVER-THE-COUNTER (OTC) MARKET

Most financial assets are traded in an organised market, where there is a centralised
order flow. In a centralised order flow, there is only one price in the entire market,
and every participant in the market is a price-taker. This makes it very efficient
because market participants do not have to hunt for the best price. The prevailing
market price is the best price. In an organised exchange, there is only one
monopolistic market maker in each security, and that is the exchange itself.
An over-the-counter market is a way of trading financial assets other than in the
organised exchanges. The brokers and dealers who make up the participants of
over-the-counter markets are connected by a
network of telephones and computer systems
through which they deal directly with one
another and with customers. Unlike an organised
exchange, an over-the-counter market does not
have a centralised order flow. Thus, prices are
arrived at through a process that takes place between two parties. If any one of the
parties is not satisfied with that price, he can approach another counterparty.
Fixed income securities are commonly traded over the counter, which is the case in
Singapore. Stocks with small market capitalisation, which are tightly held, or which
are unlisted are also commonly traded over the counter.
67
Instruments such as bonds do not trade on a formal exchange. Therefore, they are
also considered as OTC securities. Most debt instruments are traded by investment
banks making markets for specific issues. If an investor wants to buy or sell a
bond, he must call the bank that makes the market in that bond, and asks for
quotes.
6.
CHARACTERISTICS OF AN EFFICIENT FINANCIAL MARKET

In finance, the Efficient Market Hypothesis (EMH) asserts that financial markets are
"informationally efficient", and that prices on traded assets (e.g. stocks, bonds or
property) already reflect all known information, and instantly change to reflect new
information. Therefore, according to this theory, it is impossible to consistently
outperform the market by using any information that the market already knows,
except through luck. Information or news in the EMH is defined
as anything that may affect prices unknown in the present, and
thus, appears randomly in the future. The hypothesis has been
attacked by critics that blame belief in rational markets for
much of the 2008 / 2009 financial crisis, with noted financial
journalist, Roger Lowenstein, declaring "The upside of the
current Great Recession is that it could drive a stake through
the heart of the academic nostrum known as the efficientmarket hypothesis."
However, when not in a recession, an efficient financial market is one that provides
an ideal setting for the trading of financial assets. The following are some of the
characteristics that create an efficient financial market.
6.1
Availability Of Information
It is important to make available all information, such as corporate
announcements, price history and all outstanding bids and offers to all
investors. Such information will enable investors to make informed investment
decisions. The use of the Internet has greatly enhanced the availability of
information.
68
6.2
Liquidity
Liquidity is the ability of investors to buy and sell a security quickly and at a
price that is not substantially different from the prevailing prices. The prerequisites of liquidity are marketability, price continuity and depth.
Marketability is a securitys likelihood of being sold quickly. Price continuity
indicates that prices do not change much from one transaction to the next,
unless there is new price-sensitive information. Implicitly in price continuity is
the existence of market depth, which means that there are numerous buyers
and sellers willing to trade at prices above and below current prices, thus
preventing drastic price movements.
6.3
Transaction Cost
The transaction cost relating to a trade includes
brokerages, clearing fees and the associated stamp
duties. The current trend has been towards a lower
transaction cost. In some markets, stamp duties
have been abolished to foster a vibrant financial
market. A low transaction cost indicates that the
financial market is internally efficient.
6.4
Information Efficiency
This is also known as external efficiency. It means that prices adjust rapidly to
new information. The institutionalisation of the financial market contributes to
this efficiency. Institutionalisation of a financial market refers to the increased
participation in the financial market by institutional investors. Their
participation has greatly enhanced the information efficiency of the markets.
7.
FORMS OF MARKET EFFICIENCY

EMH consists of the three major forms as described below.
Weak Form: In its weak form, historical price and volume data of a security
should already be reflected at the current time, and is of no value in assessing
future changes in prices. No excess return can be generated by using strategies
69
which trade on historical price data or other historical information. The EMH will
in no way imply that the expected return of a security is zero.
Semi-strong Form: The semi-strong form encompasses the
weak form of the EMH. In this form, the price reflects quickly
all publicly known information and data. These data may
include
earning
reports,
dividends,
new
product
development, financing difficulties, etc. No excess return can
be generated by using strategies which trade on such public
information and data.
Strong Form: The strong form encompasses both the weak
and semi-strong form of the EMH. In this form, the price fully reflects all public
and non-public information and data. In this form, nobody should be able to earn
superior returns over a reasonable period of time by using publicly available
information in a superior manner. This also applies to all non-public information,
including information that may be restricted to certain groups, such as
specialists on the exchanges.
8.
MODERN PORTFOLIO THEORY (MPT)

The Modern Portfolio Theory was developed in the 1950s and was considered an
important step in the mathematical modeling of finance. The theory is about coming
out with an overall investment strategy that seeks to construct an optimal portfolio,
by considering the relationship between risk and return.
Technically, MPT is a mathematical formulation of the concept of diversification in
investing, with the aim of selecting a collection of investment assets that has
collectively lower risk than any individual asset. In theory, this is possible, because
different types of assets often change in value in opposite ways. For example, when
the prices in the stock market fall, the prices in the bond market often increase, and
vice versa. Hence, a collection of both types of assets can have lower overall risk
than either individually. By combining different assets whose returns are not
correlated, MPT seeks to reduce the total variance (which is the square of the
standard deviation) of the return of the portfolio. Therefore, an investment portfolio
should not be based on the merits of each of its assets. Rather, it is important to
70
take into account how each of the assets price would change relative to every
other asset in the portfolio.
The theory goes on to state that, given an investor's preferred level of risk, a
particular portfolio can be constructed to maximise an expected return for that level
of risk. MPT assumes that investors are risk adverse, meaning investors will always
select a less risky portfolio, when comparing two portfolios which offer the same
expected return.
71
Chapter
RISK AND RETURN
CHAPTER OUTLINE
1.
2.
3.
4.
5.
6.
7.
8.
9.
Measures Of Return
Measures Of Risk
Risk Aversion
Risk And Return Trade-Off
Sources Of Investment Risk
Classification Of Risks
Diversification Reduces Risks
Risk-Adjusted Investment Returns
Required Rate Of Return And Jensens Alpha (Measure) Under The Capital Asset
Pricing Model (CAPM)
Appendix 4A
KEY LEARNING POINTS

understand and calculate the different types of measuring returns
explain how investment risk can be quantified
calculate standard deviation
know the risk and return trade-off
explain the sources of investment risk and how risks are classified
explain why diversification reduces risks and learn how to diversify
understand and calculate the various measures of risk-adjusted returns
know and calculate the required rate of return and Jensens alpha
72
4. Risk and Return
1.
MEASURES OF RETURN
Investment is the act of postponing present consumption in
order to grow your savings. The higher the growth rate of the
investment, the more successful you are as an investor. In
order to know the growth rate of an investment, we need to
know how investment returns are calculated. The calculation
of investment returns depends on whether it is a single-period
investment or a multi-period investment.
A single-period investment is an investment that is only held for one period, which is
usually less than a year. A multi-period investment is an investment that is held for
more than one period, which is usually defined as a year.
1.1 Calculating Single-Period Investment Return
You invest S$1,000 in a unit trust at the beginning of a period and that
investment paid a dividend of S$50 during your holding period. At the end of
your holding period, the market value of that unit trust is S$1,100. What is
your return for the period in percentage terms?
Single-period investment return (%) =
(Capital gain+Dividend)
Initial investment
X 100
Capital gain refers to the appreciation in the price of the unit trust or any
investment asset. Dividend refers to the distribution made to unit-holders
during the holding period.
When the asset is sold to cash in on the capital gains, the profit achieved
(equal to the excess of the market value sold over the price) is referred to as
realised capital gains. In the example above, realised capital gain amounts to
S$100 if the asset is sold for S$1,100. It should be clear that when the
investment is not sold, the profit is not yet realised, and the return calculated
using the above formula is not meaningful and should be viewed as such.
Capital loss refers to the depreciation in the price of the unit trust. When the
asset is sold for a loss, equal to the depreciation in the price, the capital loss
73
becomes realised. Using the above example, if the price falls to S$900, the
unrealised capital loss amounts to S$100. Now if the asset is sold for S$900,
the capital loss of S$100 is realised.
It should be clear that if the investor has holding power and
does not have to sell the investment when there are
unrealised capital losses, the unrealised capital losses are just
paper loss. If the market were to improve in the future, to the
extent that the unrealised capital loss were fully reversed, the
investor would not have experienced realised capital loss if
the investment were to be sold subsequently.
In the above example, the realised capital gain
Investment return =
= S$1,100 - S$1,000
= S$100
(S$100 + S$50)
X 100
S$1,000
S$150
S$1,000
) X 100
= 15%
Another way of calculating single period investment return (%) is given in
the formula below:
[ (
End Value of Investment + Dividend

Initial Investment
-1
In the same example, the investment return =

S$1,100 + S$50
-1
X 100
S$1,000
[ (
X 100
= 15%
The investment return calculated above is also known as the simple rate of
return over the single investment period. This is different from the compound
rate of return as explained in the following section.
74
4. Risk and Return
1.1.1 Annualising Single-Period Investment Return

In order to compare the returns from two investments of different
holding periods, we need to annualise their investment returns.
Annualising investment returns of the two investments is equivalent to
re-stating their investment returns, as if the two investments were held
for exactly one year, and that the rates of return throughout the entire
one-year period are exactly the same as the returns over the original
investment periods of the two investments.
It is noted that in annualising the investment, we are really calculating
the effective rates of returns for the two investments on the
compounded basis. Therefore, these returns are known as compound
rate of return, as they represent the investment return earned on the
original investment, as well as the intermediate gains / returns over the
course of the investment period.
Annualised return (%) = [(1 + r)1/n 1] X 100
where
r = is the investment return in percentage terms during the

holding period; and
n = is the holding period in number of years.
Note that n may be fractional or integral. For example, if the holding period
is one year, n=1. If the holding period is 5 months, n=5/12; and if the
holding period is one month, n= 1/12.
Assume that the following two funds can achieve the returns during the
holding periods:
Table 4.1 Returns Of Fund A And Fund B During Their Holding Period
Return (%)
Holding Period
Fund A
15
1 year
Fund B
6 months
75
With reference to Table 4.1, the annualised return for both funds can
be calculated as follows:
Fund A = [(1 + 0.15)1/1 - 1] X 100
= (1.15 1) X 100
= 15.00%
Fund B = [(1 + 0.08)1/0.5 1] X 100 = (1.1664 1) X 100

= 16.64%
Hence, Fund B has achieved a higher annualised rate of return, although
its return over the 6-month holding period (8%) is less than that of
Fund A (15%).
1.2 Calculating Multi-Year Investment Return
The calculation of a rate of return for an investment that has been held over a
multi-year period (for example, more than one year) is more complicated,
because of the need to account for the variation / changes in the market
values of the investment during the multi-year period, and in effect, we are
computing the annual effective rates of return on the compounded basis.
Assume that you bought 1,000 units in a unit trust at S$1.00 per unit at the
beginning of Year 1, and that you hold this investment for the next five years.
During this period, the unit trust does not pay any dividend. The price of the
unit trust at the end of each of the five years is shown below:
Table 4.2
76
Price Of The Unit Trust At The End Of Each Year

Year
Unit Trust Price (S$)
Gain / Loss (%)
0.95
(5.0)
1.02
7.4
1.12
9.8
1.10
(1.8)
1.25
13.6
4. Risk and Return
The investment would have appreciated to S$1.25 X 1,000 units = S$1,250

by the end of the fifth year. The cumulative return from this investment over
the five years is:
S$1,250
-1
X 100 = 25%
S$1,000
[(
) ]
The mean rate of return during the 5-year period is defined as the effective
annual rate of return, which when compounded over the 5-year period, gives
us a cumulative return of 25% in Year 5 (in the above example).
One simple way of estimating the mean rate of return would be to add the
yearly returns in the rightmost column of Table 4.2 and divide that by 5, as
follows:
[(-5%) + 7.4% + 9.8% + (-1.8%) + 13.6%]
5
X 100 =
24%
= 4.8%
5
This approach of estimating the mean rate of return is also known as the
arithmetic mean rate of return (AM). However, the AM does not present an
accurate annual compounded rate of return of the investment over the 5-year
period. If we use 4.8% as the compounded rate of return for our investment,
the value will be:
S$1,000 (1 + 0.048)5 = S$1,264
The value of the investment in Year 5 using 4.8% as the compounded rate of
return is S$1,264. This is slightly more than the actual value of the investment
at S$1,250. This shows that 4.8% is not the exact and true effective
compounded rate of return over the 5-year investment holding period.
An accurate and exact calculation of the historical return will be to annualise
the cumulative return of 25% as follows:
[(1 + 0.25) 1/5 - 1] X 100 = (1.0456 1) X 100 = 4.56%
Using 4.56% as the compounded rate of return, the initial investment of
S$1,000 will grow to S$1,250 as follows:
S$1,000 (1 + 0.0456)5 = S$1,250
77
The above example assumes that we are given information on the prices of the
fund at the beginning and at the end of the multi-period. It further assumes
that these prices have not been adjusted for bonus issues or dividends. Hence,
it is more common for us to calculate the (estimated) mean rate of return,
using the yearly change in the fund values in percentage terms (right most
column of Table 4.2). Under such circumstances, we have to geometrically
link each return to obtain the annual effective rate of return. This is known as
the geometric mean rate of return (GM), or the time-weighted mean rate of
return.
GM (%) = {[(1 + r1) X (1 + r2) X (1 + r3) X X (1 + rn) ]1/n 1} X 100
where r1, r2, r3, , rn
n
= return in % term for each period(year)

= number of periods(years)
In the above example, the geometric mean return on this investment is:
{[(10.05) X (1+0.074) X (1+0.098) X (10.018) X (1+0.136)]1/51} X 100
= {[(0.95) X (1.074) X (1.098) X (0.982) X (1.136)]1/5 1} X 100
= {(1.2497)1/5 1} X 100
= (1.0456 1) X 100
= 4.56%
Geometric mean is a better and more correct measurement of historical
investment return. In fact, it is the compounded rate of return of an
investment, assuming that it is held for more than a year, and that
compounded rate of return is earned throughout that
period. Arithmetic mean, on the other hand, is a
measurement of the expected return over the long
term.
78
4. Risk and Return
Some illustrations will make these points clearer. Consider the following
investment, as shown in Table 4.3:
Table 4.3
Year
Beginning Value (S$)
Ending Value (S$)
Return (%)
50
100
100
100
50
-50
where
AM =
100% = 1
- 50% = - 0.5
(1.0) + (-0.5)
2
0.5
=0.25 = 25%
2
GM = {[1 + 1] X [1 + (-0.5)]}1/2 1 = 11/2 1 = 0

The investment has brought no change in wealth. Therefore, there is no return.
Yet, the AM computes a mean return of 25%. GM accurately measures that
the investment has not yielded any return.
AM or
However, if one had to give an estimate of the

expected long-term return from this investment, AM
would have been a better answer.
Note that the geometric mean rate of return which we
have calculated from Table 4.2 (4.56%) is smaller than
the arithmetic mean rate of return. Generally, GM is
smaller than AM for the same set of data. However,
when rates of return for each year are identical, GM =
AM.
79
Example 4.1
Year
Beginning Value (S$)
Ending Value (S$)
Return (%)
100.0
110.0
10
110.0
121.0
10
121.0
133.1
10
AM =
(0.1) + (0.1) + (0.1)

3
0.3
=0.1 = 10%
3
GM = {[(1 + 0.1) X (1 + 0.1) X (1 + 0.1)]1/3 1} X 100

= {(1.331)1/3 1} X 100
= {1.10 1} X 100
= 10%
1.3 Calculating Real After-Tax Rate Of Return
The investment return used in this section relates to the total amount of
current income plus the total amount of capital appreciation to the beginning
dollar value of the investment. The following formula will determine the beforetax investment return for a one-year period:
Before-tax
=
Investment Return
Total current income + Total capital appreciation

Total initial investment
For example, assume that Michael Mok purchased an investment of S$800 on

1 September 2010. It is now 1 September 2011, and he wants to know what
has been the return on his investment. During his one-year holding period, he
has received S$50 of current Income. In addition, the market price of the
80
4. Risk and Return
investment has increased to S$840. Based on this information, the before-tax

investment return for this investment will be as follows:
Before-tax
=
Investment Return
S$50 + (S$840S$800)
S$800
S$90
S$800
11.25%
If an after-tax basis is desired, the marginal income tax rate (MRT) has to be
taken into account, then the investment return formula becomes:
After-tax
=
Investment Return
total current income

total capital appreciation
+
x (1 MRT)
x (1 MRT)
Total initial investment
] [
If Michael is in the income tax bracket of 20%, then his after-tax return will
be:
After-tax
Investment Return
S$50 (10.2) + [(S$840 S$800) (10.0)]

S$800
= 10%
(Note that in Singapore, capital gains are not taxable for individuals. Hence,
there is no tax rate for this investment. For illustration purposes, the current
income refers to a taxable form of dividend and has been reported for
individual income tax)
For holding periods shorter than one year, the investment return as
calculated above requires modification. If, for example, Michael
held the investment for only half a year and achieved the same
results, his after-tax investment return should be multiplied by 2.
This resulted in an annualised after-tax investment return of 20%
(10 x 2). Or, if Michael had achieved his gains in 3 months or in 2
weeks, his annualised investment return would be found by
multiplying the after-tax investment return by 4 or 26, respectively.
81
Inflation has almost been continual over the last 50 years. Therefore any
analysis or recommendation to a client concerning a particular investment
should include inflation as a factor. One useful method adjusts the annual
after-tax rate of return for inflation, and the result is known as the Real Rate of
Return. If the investment return is used, for example, the real after-tax rate of
return can be calculated using the following formula:
Real After-tax
Rate of Return
(1 + after-tax investment return)

(1 + current rate of inflation)
For example, if an investor can earn an after-tax investment return of 8%

during a year when the inflation rate is 4%, the investor's real after-tax rate of
return will be:
Real After-tax
Rate of Return
(1 +0.08)
(1 + 0.04)
= 1.038 1
= 3.8%
Whenever the rate of inflation exceeds the after-tax rate of
return obtained over a holding period, the investor will
realise a negative real after-tax rate of return. This was the
result for many investments during the late 1970s and early
1980s in the United States, when inflation rates was close
to and even exceeded 10%, and the before-tax return on
some investments was 5%. Today, good grade corporate
bonds in Singapore often pay a before-tax rate of return which is less than
4%, while the rate of inflation has been on an average of around 3%. The
resulting real after tax investment return would be approximately 1%.
2.
MEASURES OF RISK
Generally, individual investors perceive investment risk as one or both of the
following:
uncertainty of the outcome of investment return; and / or
probability of losing money, i.e., earning a negative return.
82
4. Risk and Return
From past experience, we know that the returns from stock market investments are
volatile. While stock market returns tend to be quite attractive in the long term,
there is a possibility that an investor in the stock market may suffer financial losses
in the short term. In other words, the outcome of a stock market investment is
subject to great uncertainty, as the volatility in stock market investments is high.
This is an investment risk because an investor who purchases the investment at a
high price may suffer financial losses if the investment declines in value, and
particularly, if the investor has to sell it when the market value is less than the
purchase price.
The poor performance and high volatility of the stock
market as an asset class, since the late 1980s, has led to
increased concerns by many investors about the negative
returns on their investments. The financial market has risen
to this challenge by offering innovative products, such as
capital-guaranteed funds and hedge funds. For more
information on these funds, do read Chapter 8.
Investment risk has been generally quantified and measured by a statistical concept
known as standard deviation. This is the dispersion of all probable investment
returns around its long-term expected / realised return. The more dispersed the
probable investment returns around its long-term expected / realised return, the
higher will be the standard deviation. Higher standard deviation thus implies greater
risk or higher volatility. Owing mainly to the ease with which standard deviation can
be calculated, (at least) apparent reasonableness of the concept, and the lack of
other measures, the use of standard deviation to measure risk has gained popularity
and been widely accepted by the key communities involved in the investmentfrom
investment professionals, economists and academia, to ultimately the investors.
Let us now learn how to compute the standard deviation of the US stock market
between the years 1969 to 2008.
83
Table 4.4 Returns Of US Stock Market Between The Years 1969 To 2008
Year
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
Returns (%)
4.83
13.50
16.56
-16.24
-27.68
35.82
23.25
-8.02
5.97
14.45
30.04
-4.13
22.14
22.02
Year
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
Returns (%)
5.98
32.75
17.53
3.91
15.91
31.36
-2.08
31.33
7.36
10.07
2.00
38.19
24.06
34.09
Year
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
Returns (%)
30.72
22.38
-12.54
-12.03
-22.71
29.11
10.71
5.72
15.32
6.03
-37.14
24.58
Source: MSCI US Stocks
Standard deviation can be calculated by using the following steps:

(i)
Calculate the most likely outcome. This is the arithmetic mean (AM) or the
simple average of the data in Table 4.4.
(ii)
Take the return from each year and subtract from the AM that you have
calculated in Step 1.
(iii)
Square each of the numbers obtained in Step 2.
(iv)
Add all the numbers obtained in Step 3, divide the answer by the number of
data less one (40 1 = 39 in this case).
(v)
Calculate the square root of this number. This is the standard deviation.
A simple table will make this computation very easy.
84
4. Risk and Return
Table 4.5 Calculation Of Standard Deviation Of US Stock Market Yearly Return

Year
1969
1970
1971
1972
1973
1974
1975
Returns (%)
4.83
13.50
16.56
-16.24
-27.68
35.82
23.25
Return AM = A (%)
-6.30
2.37
5.43
-27.37
-38.81
24.69
12.12
A2 (%)
0.40
0.06
0.29
7.49
15.06
6.10
1.47
1976
1977
1978
1979
1980
-8.02
5.97
14.45
30.04
-4.13
-19.15
-5.16
3.32
18.92
-15.26
3.67
0.27
0.11
3.58
2.33
1981
1982
1983
1984
1985
22.14
22.02
5.98
32.75
17.53
11.02
10.89
-5.15
21.62
6.40
1.21
1.19
0.27
4.68
0.41
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
3.91
15.91
31.36
-2.08
31.33
7.36
10.07
2.00
38.19
24.06
34.09
30.72
22.38
-12.54
-12.03
-22.71
29.11
10.71
5.72
15.32
-7.22
4.79
20.23
-13.21
20.20
-3.77
-1.06
-9.13
27.06
12.93
22.96
19.60
11.25
-23.66
-23.16
-33.84
17.98
-0.41
-5.41
4.19
0.52
0.23
4.09
1.74
4.08
0.14
0.01
0.83
7.32
1.67
5.27
3.84
1.27
5.60
5.36
11.45
3.23
0.00
0.29
0.18
2006
2007
2008
6.03
-37.14
24.58
-5.10
-48.26
13.45
0.26
23.29
1.81
Average Return
Total
11.13
Standard Deviation
131.06
18.33
85
Table 4.5 summarises the standard deviation and expected return from investing in
the US stock market between the years 1969 to 2008.
The mean and standard deviation of this series of stock market return figures can be
shown in a graph as follows:
Probability
1 SD*
-7.2%
1 SD*
11.13%
29.46%
* = Standard deviation
The wider the curve, the higher will be the standard deviation, i.e. the more
uncertain will be the returns. Hence, the more risky will be the investment.
In the above example on the US stock market, one standard deviation = 18.33%.
One standard deviation to the left of the mean gives us a negative return of 7.2%
(11.13% 18.33%), while one standard deviation to the right of the mean gives us
29.46% (11.13% + 18.33%).
In statistical terms, there is a 68%, 95% and 99.7% probability that the returns of
any year will fall within one, two and three standard deviations of the mean
respectively. Note that this assumes that the stock returns will follow an important
statistical distribution known as the normal distribution.
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4. Risk and Return
3.
RISK AVERSION
Other things being equal, it is assumed that investors in general prefer a higher
expected return than a lower expected return, and a lower risk than a higher risk.
This means that investors prefer to have:
a higher return for a given level of risk; and
a lower risk for a given level of return.
In general, investors will undertake additional units of risk
additional reward in the form of higher expected return. In
take on higher risk, i.e., to invest in a fund with higher
compensated with higher return. Hence, the maxim higher
additional return is also referred to as the risk premium.
4.
only if accompanied by
order for an investor to
volatility, he has to be
risk, higher return. The
RISK AND RETURN TRADE-OFF

Suppose an investor is indifferent to the investments as shown in Table 4.6 below:
Table 4.6
Investment
Expected Return (%)
Standard Deviation
15
10
20
12
25
15
30
This means that he has no preference as to which of the four investments to

choose. That is, he is risk-neutral to the four investments. Investment A offers him
lower return, but at a lower risk as well. On the other hand, Investment D offers him
the highest return, but with the highest level of risk. This is the risk and return trade
off. Investors need to be offered higher returns in order to take on higher risk.
87
Another important implication of risk aversion is that, at a higher level of risk, the
extra return that is needed to induce them to take on that risk will be higher than
the previous level of risk. Hence, to take on the first 5% higher standard deviation
(Investment B), the investor requires an extra 1% in return. However, to induce him
to take on the next 5% standard deviation (Investment C), he now requires 2%
higher return. This increases to 3% higher return in the next level of risk for
Investment D.
In economics, this means that this investor has an increasing utility
function which is not linear. For this investor to take on increasing
risk, he expects to receive increasing rewards, in that the risk
premium is to increase faster than a linear function.
4.1 Investor Risk Tolerance Questionnaire
The Investor Risk Tolerance Questionnaire (IRTQ) is used
widely by financial institutions to help investors to better
understand their own risk tolerance profiles, so that the
institutions can go on to make recommendations on the
purchase of investment products. Although much research and
tests have been carried out over the years, it is generally recognised and
agreed that there is no perfect or flawless IRTQ. This is also one of the
reasons why the IRTQs that are used in the market are mostly different from
each other and customised to the needs of the different financial institutions.
Though different, most IRTQs seek to address five areas:
risk propensity (tendencies in financial situations) e.g. if market drops
20% , action that a person is likely to take;
risk attitude (willingness to incur monetary risk) e.g. risk tolerance of
change in market value or paper loss in investment;
capacity (financial ability to incur risk) e.g. age, net worth, income, time
horizon, need for cash and timing;
knowledge (understanding of risk and risk-return trade-off) e.g. experience
in trading of certain assets, view and choice for hypothetical investment
portfolio; and
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4. Risk and Return
objectives (investment goals) e.g. philosophy, return requirement, view /

inclination on preservation of capital, preference for steady asset growth,
etc.
We have included an illustration of the IRTQ in Appendix 4A as adapted from
the CPF Boards version to measure an investors risk tolerance.
5.
SOURCES OF INVESTMENT RISK

One way to model or estimate the market value of any risky investment is to
evaluate the present value of its future stream of cash flow accruing to the
investors. This implies that the market value of risky investments is affected by:
changes in the future stream of cash flows; and / or
changes in the discount rate used to convert this stream of cash flow to its
present value.
The more volatile the above factors, the greater will be the fluctuation of the market
value of the investment. In other words, the investment will have greater risks.
In the case of fixed income investments, the stream of cash flows accruing to
investors is more predictable as compared to stock investments. This is because the
cash flows accruing to fixed income investors are contractual. When the company is
doing badly, the fixed income investors are still entitled to coupon payments, unless
the company is insolvent. On the contrary, when the company
is doing very well, investors in fixed income instruments do not
participate in the upside performance of the company, which is
manifested in the increase in the price of the company stocks.
However, it should be noted that the fixed income instruments
do contractually provide the return of face (par) value of the
investment to the investors at the time of maturity.
Furthermore, given that there is a greater degree of certainty
with the stream of cash flows for the fixed income instruments,
the discount rate used to convert them to their present value
will be correspondingly lower. This reflects the lower risk premium required and the
lower investment return demanded by the investors.
89
Stock investors are subject to higher risks because the stream of cash flows
accruing to them is not contractual and uncertain. This stream of cash flows from
stock investments comes in the form of dividend payment and the eventual price at
which the stock is sold. Both are not contractual. Hence, the cash flows are more
unpredictable, and the discount rate used to convert this stream of cash flows tends
to be larger, reflecting the higher risk associated with stock investments.
Generally, uncertainty in the stream of cash flows arises from one or more of the
factors as described below.
5.1 Business Risk
Business risk is the risk that the profits of a company will fall unexpectedly.
This may arise because of cyclical slowdown, intense competition or simply
incompetent management. The level of profitability affects the ability of a
company to pay dividends, to service its debts, which as a
result will affect the share price performance.
The level of business risk inherent in any risky investment
depends on the nature of the industry being exposed. A
cyclical industry has an earnings profile that is more
sensitive to economic growth. During boom years, the
earnings of cyclical industry tend to rise faster than the
broad economy. On the other hand, their earnings tend to
fall more than the broad economy during recession. A
defensive industry has an earnings profile that is not as
volatile as the broad economy. For example, during boom
years, the earnings of a defensive industry tend to rise slower than the broad
economy. However, its earnings also tend to be more resilient than the broad
economy during a recession.
5.2 Financial Risk
This is the risk that interest rate changes may negatively affect the value of
your investment. Rising interest rates tend to negatively affect the share prices
of corporations with high debt levels and poor operating cash flows. This is
due to the fact that higher interest rates lead to higher interest charges, and
hence, higher debt servicing expenses. Also, higher interest rates will result in
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4. Risk and Return
reduction in the market values of the fixed income securities held by the
corporations, weakening the balance sheet and financial position of the
corporations. Higher interest rates tend to be associated with the slowdown of
the economy, which may in turn negatively affect the revenue, and hence, the
income performance of the corporations.
5.3 Marketability Risk
This is also known as liquidity risk. Marketability or liquidity risk is the risk that
a given security or asset cannot be traded quickly enough in the market to
prevent a loss (or make the required profit). It is the risk that an investor will
have to sell his investment at a price below the prevailing price, owing to low
trading activity, and hence, poor liquidity. Investments with higher trading
liquidity tend to have lower marketability risk, as compared to those with
lower / poorer trading liquidity.
5.4 Country Risk
This is the risk that the investment denominated in some foreign currency may
be exposed to volatility in the exchange rate. The volatility may be caused by
financial mismanagement, poor economic development and growth, or political
problems and social instability of the country. Aside from the foreign exchange
risk, country risk is also related to the risk that the country concerned may run
into financial difficulty (for reasons as mentioned above), and hence, is not able
to honour the contractual terms associated with the investmentsfor example,
not being able to make the regular coupon payments under the long-term
bonds issued by the government of a country. This is also known as default
risk.
6.
CLASSIFICATION OF RISKS
It is convenient to classify risks into systematic or unsystematic
risks, depending on whether the risk is pervasive to all securities in
the market or only affects some securities.
Systematic or un-diversifiable risks are caused by macroeconomic,
political and social factors that affect the value of all risky assets in
91
the financial market. There is little the investor can do to protect himself against
such risks, other than to stay out of the market or hedge through futures and
options.
Unsystematic or diversifiable risks are caused by factors that are unique to a
company or an industry that an investor invests in. Hence, it only affects the value
of certain securities in the financial market. They can be controlled and reduced
through diversification by investing in other companies or industries.
7.
DIVERSIFICATION REDUCES RISKS

In a well-diversified portfolio, most of the unsystematic risks have been eliminated,
resulting in lower risk. Unit trust investment is a diversified portfolio, and hence, it is
subject to a lower level of risk compared to investing in the underlying assets
individually.
Combining assets whose returns are out of step with one
another is the whole idea behind diversification. If the returns
on investments move together, we say that they are
correlated with one another. The correlation of returns is the
tendency for the returns of two assets to vary in the same
direction together.
The returns on the two investments are:
perfectly positively correlated (correlation = 1) if their returns vary in the same
direction;
perfectly negatively correlated (correlation = -1) if their returns vary in opposite
direction; or
uncorrelated (correlation = 0) if their returns have no relationship with each other.
The correlation of returns ranges between +1 to 1. Investors can eliminate
unsystematic risk (hence, portfolio risk) by combining assets whose correlation of
return is less than +1. The smaller the correlation (the closer it is to 1), the greater
will be the reduction in the portfolio risk.
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4. Risk and Return
7.1 Diversification Options

Diversification can be achieved by spreading the funds in a variety of ways,
such as (a) in different asset classes; (b) buying securities from different
industries; (c) buying securities from different countries; and (d) buying
securities from different regions:
(a) In Different Asset Classes
Securities offer higher returns in the long term, but are more risky; fixed
income securities offer modest returns, but the risks tend to be more
stable.
(b) Buying Securities From Different Industries
The boom and bust of the technology industry at the
end of the 20th century is an excellent example of the
danger of over concentration in one single industry, no
matter how tempting the short-term outlook appears to
be. This is the infamous speculative "dot-com bubble"
(or sometimes the "IT bubble") that covered roughly
from 1998 to 2000 (with a climax on 10 March 2000
and with the NASDAQ peaking at 5132.52), during
which stock markets in western nations saw their equity
value rise rapidly from growth in the Internet sector and
related fields. There has been a proliferation of sector
funds in recent years, in response to the investors
wishing to diversify their investment holdings in
different industries. Note that a Sector fund is a unit
trust which invests entirely or predominantly in a single
sector.
The following points about the sector fund should also be noted:
(i)
Sector funds tend to be riskier and more volatile than the broad
market because they are less diversified, although the risk level
depends on the specific sector;
(ii) Some investors choose sector funds when they believe that a specific
sector will outperform the overall market, while others choose sector
funds to hedge against other holdings in a portfolio; and
93
(iii) Some common sector funds include financial services funds, gold and
precious metals funds, health care funds, and real estate funds.
However, sector funds exist for just about every sector.
(c) Buying Securities From Different Countries
Country funds represent an interesting asset class when stock market
themes, such as corporate restructuring or rising consumerism are
expected to drive the stock market return. Single-country unit trust is a
type of unit trust that only invest funds in a particular country's securities.
For example, a single-country unit trust may be offered in Switzerland.
Funds received for this unit trust will then be invested in securities that are
specific to that country.
(d) Buying Securities From Different Regions
There are a number of similarities among different political groups or
economic blocks, such as Europe, emerging Asia and other emerging
countries. This is the result of common economic policies or preferential
tariff treatment within the political groups / economic block (e.g. European
Union and ASEAN). Hence, their stock markets tend to
perform in line as a grouping. Regional funds refer to
unit trusts in which the funds are invested in the
securities of some specific region.
It is noted that, when an investor diversifies, his
investment may take on currency risks. These currency
risks can be hedged against if an investor is averse to
the risk of exposure to a certain currency.
8.
RISK-ADJUSTED INVESTMENT RETURNS

The concept of risk-return trade-off suggests that the measurement of portfolio
return needs to be adjusted for risk. Returns must be higher in order to compensate
for higher risk. Risk-adjusted returns provide a meaningful comparison of the
performance of your investment against the market and within peer groups. A
portfolio manager who has achieved a very high return is not necessarily the better
manager if he has taken too much risk in achieving that return. Such high-risk profile
can potentially lead to substantial under-performance in future.
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4. Risk and Return
There are three commonly used measures of risk-adjusted returns. These are: (a)
Information ratio; (b) Sharpe ratio; and (c) Treynor ratio / Index. Another measure of
risk-adjusted return is known as the Jensens measure. It is related to the Capital
Asset Pricing Model (CAPM), and is covered in Section 9 of this chapter.
8.1 Information Ratio
In general, this is a ratio of expected return to risk, as measured by standard
deviation. Usually, this statistical metric is used to measure a manager's
performance against a benchmark.
Specifically, this is a ratio to measure the consistency of the value added by a
fund manager. It is the value that has been added by the manager per unit of
risk taken relative to some benchmark. Information ratio is calculated as:
Fund Return Benchmark Return
Tracking Error
In brief, tracking error is the standard deviation of the
monthly differences in return between the fund and the
benchmark.
When using some benchmarking strategy, tracking error represents the amount
by which the performance of the portfolio differs from that of the benchmark.
In reality, no strategy can perfectly match the performance of the benchmark,
and the tracking error quantifies the degree to which the strategy differs from
the benchmark, by measuring the standard deviation between the two values.
All else equal, the higher the ratio, the better will be the performance.
8.2 Sharpe Ratio
The Sharpe ratio relates the funds excess return to its total risk. The excess
return is the return above the risk-free rate. The total risk of the unit trust is
the standard deviation of return for that fund during a similar period. This ratio
is a measure of the excess returns per unit of total risk taken. The higher the
ratio, the better the risk-adjusted performance of the fund. The investment
community tends to compare the Sharpe ratio of one portfolio manager against
his peers, as well as the market.
95
Sharpe ratio =
where
(Rp Rf)
p
Rp is the return for the fund;

Rf is the risk-free rate; and
p is the standard deviation of the return for the fund.
8.3 Treynor Ratio / Index

The Treynor ratio / index is a measure of a portfolio's excess return per unit of
risk, equal to the portfolio's rate of return minus the risk-free rate of return,
divided by the portfolio's beta. It assumes that the unsystematic risk can be
eliminated through a portfolio diversification, and hence, the only risk that
matters is the systematic risk. As in the Sharpe ratio, a higher ratio tends to
indicate a better performance in the risk-adjusted return.
Treynor ratio =
where
(Rp Rf)
p
Rp is the return for the fund;

Rf is the risk-free rate; and
p is the beta for the fund.
Difference Between Sharpe Ratio And Treynor Ratio
The main difference between the Sharpe and Treynor performance measures
lies in the definition of risk. The Sharpe ratio uses a total risk concept
(standard deviation of returns of the portfolio), while the Treynor ratio uses a
relative risk concept (beta) of the portfolio. Since the Sharpe ratio adjusts for
total risk, it can be useful for assessing the performance of a portfolio that is
a substantial portion of an investors total invested funds. In fact, both
Sharpe and Treynor Ratios are often used to rank the performance of the
overall portfolio, as well as the Unit Trust managers (sub-portfolios of a
broader, fully diversified portfolio). With the help of investment consultants,
investors can make use of Treynor Ratio to evaluate and rank the
performance of sub-portfolios that make up the overall investment funds, and
see how the total invested funds should be constructed and constituted.
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4. Risk and Return
9.
REQUIRED RATE OF RETURN AND JENSENS ALPHA (MEASURE) UNDER THE

CAPITAL ASSET PRICING MODEL (CAPM)
Under the Capital Asset Pricing Model (CAPM), the required rate of return for any
risky investment, including unit trusts, should commensurate with the risk of that
investment. It is the sum of two factors:
risk-free rate - to compensate for the time value of money; and
risk premium - to compensate for the risk inherent in the risky investment, e.g. for
the risks discussed in an earlier section.
RR = Rf + (Rm Rf)
This required rate of return is also referred to as the expected rate of return. Do
refer to the explanation below for the definition of the terms in the formula.
where
RR
Rf
Rm
is
is
is
is
the
the
the
the
required rate of return of any risky investment;

risk-free rate;
market rate of return; and
beta of the risky investment.
The actual performance or the actual return of the fund (portfolio) is likely to be
different from the required (expected) rate of return. The deviation (difference)
between the actual and required (expected) rate of return, is known as the Jensens
Alpha, or Jensens measure. The Jensens measure is also referred to as the
portfolio's alpha (). In fact, it is a risk-adjusted performance representing the
required return on a portfolio over and above
that predicted by the CAPM, given the
portfolio's beta and the average market return.
In fact, Jensens measure can be calculated as:
= actual return RR
where
RR = Rf + (Rm Rf)
The basic idea of calculating the Jensens measure is to analyse the performance of
an investment manager. One must look at not only the overall return of a portfolio,
but also the risk of that portfolio. For example, if there are two unit trusts that both
97
have a 12% return, a rational investor will want the fund that is less risky. Jensen's
measure is one of the ways to help determine if a portfolio is earning the proper
return for its level of risk. If the value is positive, then the portfolio is earning excess
returns. In other words, a positive value for Jensen's alpha means a fund manager
has "beaten the market" with his stock picking skills.
9.1 Risk-Free Rate
A risk-free rate is the return that you expect from an investment that has an
assured outcome. An investment in 3-month Treasury Bills can be considered
risk-free. This is because the return that you will receive at the end of the
three months from holding this investment is regarded as default-free, and
known with certainty. That is, the sovereign government is deemed to be
default-free, and hence, risk-free.
9.2 Market Rate Of Return
This is the required return for investing in a basket of
securities whose performance replicates the investment
universe of the fund. For example, if the investment
universe of a unit trust is Singapore equities, the market
rate of return is the required return for Singapore
equities. The difference between the market rate of return
and the risk-free rate is the market risk premium (Rm - Rf).
9.3 Market Risk Premium
The market risk premium is the return over and above the risk-free rate, in
order to compensate investors for the uncertainty in the market rate of return.
The market risk premium is directly affected by the risk aversion. If the risk
aversion rises, investors will require a higher return, in order for them to
undertake risky investment. For example, when investors are increasingly
cautious about the level of corporate governance, they become more risk
averse, and will require a higher return. When the level of risk aversion falls,
investors will tend to lower their return requirement when assessing risks. For
example, when they believe that the economy is poised for strong recovery,
their risk aversion will fall, and they may thus require a lower return.
98
4. Risk and Return
When the required rate of return rises, investors must buy risky assets at a
lower price, in order to achieve that higher return. This implies that the market
price for risky assets must fall. Conversely, when the required rate of return
falls, the market price for risky assets will rise such that prices paid by
investors will earn them a lower return.
9.4 Beta
The beta of a fund is the volatility in the return of that asset relative to the
market. A fund with a beta of 1 indicates that its price moves with the market.
Hence, a fund with a beta of more than one means that the fund is more
volatile than the market. The return of this fund is also expected to be higher
than that of the market. A fund with a beta of less than one means that the
fund is less risky than the market. The return of this fund is expected to be
less than that of the market.
99
Appendix 4A
For information only
Risk Tolerance Questionnaire

Please answer the six questions below by clicking the number next to the answer that best
represents your investment goals and circumstances. The total points from all six questions will
determine your score.
1.
Depending on the investment, the value of your assets can remain relatively stable (generally
increasing slowly but steadily) or may fluctuate (rising and falling in response to market
movements). In general, investments that fluctuate have the potential to grow faster;
however, they are more risky than stable investments. How much fluctuation are you willing
to accept for your savings?
I do not want to experience any falls, even if it means my investment returns
are relatively small.
I would be willing to accept occasional falls as long as my savings are in sound,
high-quality investments that could be expected to grow over time.
I am willing to take substantial risk in exchange for significantly higher potential
returns.
2.
Some investments may keep your money safe, but may not earn a high return. (Consider
what S$100 would purchase both 10 years ago and today.) Choose the statement that is
most accurate for your investment savings goal.
My savings should be 100% safe, even if it means my investment returns do
not keep up with inflation.
It is important that the value of my investments keep pace with inflation. I am
willing to risk an occasional fall in the value of my original investment (my
principal) so my investments may grow at about the same rate as inflation over
time.
It is important that my investments grow faster than inflation. I am willing to
accept a fair amount of risk to try to achieve this.
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4. Risk and Return
3.
You understand the value of your investment portfolio will

fluctuate over time. This means it will rise and fall in
response to market movements. What is the maximum loss
of value you could accept in any one-year period?
0%
5%
10%
20%
30%
4.
Consider two hypothetical investments, A and B:

Investment A provides an average annual return of 5% with a minimal potential fall in the
value of the original investment (the principal).
Investment B provides an average annual return of 10% but the value of the original
investment (the principal) may decline 20% or more in any year.
How would you choose to invest your retirement savings in these two investments?
100% in Investment A and
0% in Investment B.
25% in Investment B.
101
5.
The chart on the right represents hypothetical performance of four selected investment
portfolios (A, B, C and D) over a 20-year period. The chart illustrates average annual total
investment returns and the greatest one-year gain and one-year loss that has occurred for
each of the four portfolios. (For example, Portfolio C achieved a 12% average annual return
during the 20-year period, gaining 55% in the best year and losing 40% in the worst year.)
Keep in mind that past performance does not guarantee future performance.
Range of Annual Returns for Any Given Year During the 20-Year Period
140%
150%
125%
100%
75%
55%
40%
50%
25%
0%
-25%
15%
0%
-10%
-50%
-75%
-40%
Portfolio A
17.5%
12.0%
5.5%
3.5%
Portfolio B
Portfolio C
Among these investments, would you prefer your

primary investment to be:
-60%
Portfolio D
Portfolio A
Portfolio B
Portfolio C
Portfolio D
6.
The number of years you have

to save and invest is your
investment time horizon. This
is the amount of time between
when you invest and when you
need to spend the proceeds of
your investments.
What would your investment
time horizon be?
102
Less than 3 years (short-term)

Less than 10 years (short to
medium-term)
4 or more years (medium to longterm)
10 or more years (long-term)
4. Risk and Return
Results
Your risk tolerance score is XX, and your investment time horizon is XXXX-term.
Look at your Risk Tolerance Score and your Investment Time Horizon to help you decide what type
of Equity Risk Category under the Risk Classification System may be right for you.
Equity Risk is related to exposure to the riskier types of investments in the unit trust. The greater
the proportion of assets invested in stocks, the higher is the Equity Risk, and vice versa.
Risk Tolerance Score
Investment Time Horizon
Equity Risk Category
5 to 19 points
Short-term (less than 3 years)
Lower Risk
20 to 29 points
Short-to-medium-term (less than 10 years)
Low to Medium Risk
30 to 37 points
Medium-to-long-term (4 or more years)
Medium to High Risk
38 to 45 points
Long-term (10 or more years)
Higher Risk
RISK TOLERANCE
Equity Risk
Category
Cash Equivalent
Bonds
Stocks
Higher Risk
Medium to High Risk
Low to Medium Risk
Lower Risk
TIME
HORIZON
short-term
Source:
medium-term
long-term
Adapted from CPF website as of August 2011.
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Chapter
TIME VALUE OF MONEY
CHAPTER OUTLINE
1. The Basics Of Time Value Of Money
2. Future Value Of A Single Sum
3. Present Value Of A Single Sum
KEY LEARNING POINTS

Understand the concept of time value of money
Calculate the future value of a single sum
Calculate the present value of a single sum
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5. Time Value Of Money
1.
THE BASICS OF TIME VALUE OF MONEY

Some people erroneously believe that a dollar is a dollar regardless of time. The fact is
that dollars to be paid or received in different time periods have different values. A
person would prefer to collect rent from the tenant at the beginning of the month than
at the end of the month. A company would choose to maximise the credit period given
by paying the supplier later. This is because people and companies have an opportunity
to earn a return on any money that they have in hand, and generally, the longer they
hold the money, the more they expect to earn on it. So
receiving money earlier or keeping it longer gives an
additional opportunity to earn more.
Earning a return on money can be done in many ways,
including depositing it with a bank or investing in a new
business or buying shares, although of course, some
methods are riskier than others.
The above examples illustrate the time value of money
(TVM). TVM is the concept that a sum of money will
increase over time as a result of earning a return on the
money while it is being held. This also implies that to pay a sum of money in the
future, less than that sum needs to be held now, because of the return that can be
earned on the money being held now.
The TVM concept is used by financial institutions such as insurance companies to
make decisions daily. Insurers use it to calculate the cost of claim benefits, determine
the premiums and invest the premiums. Insurance involves a legal promise of a
financial benefit in the future in exchange for a policy owners payment of a premium
now or at regular intervals in the future. It is important for insurers to price the
premiums correctly as the premium cannot be changed once a policy is issued, and the
contract cannot be cancelled by the insurer if the policy owner fulfils his obligations.
Representatives of financial advisers need to understand the TVM concept as it is used
in many financial products, such as traditional life insurance policies, investment-linked
life Insurance policies, etc., so that they can then better explain these products to
their clients.
105
Do note that normally for more complex time value of money problems, a financial
calculator or a spreadsheet would be used to obtain the various values. For simple
problems, a mathematical formula can be directly applied to the data. For the purpose
of this study guide, only the application of the formula would be discussed. A
calculator would still be useful for this purpose.
The TVM concept can be used to calculate present and future income streams of a
plan, e.g. the value of a series of monthly premium payments. Complex problems that
involve uneven cash flows or payment frequency can also be analysed using the TVM
concept. You should be able to apply this concept into the various investment
decisions or the planning for your clients.
1.1 The Role Of Interest
Interest can be viewed as the cost of renting money, and is paid by the
borrower to the lender. We are all familiar with the idea that if you borrow money
from a bank, you will have to pay interest on the loan. When we deposit money
with a bank, we are actually lending our money to the bank, although we do not
usually think of it in this way. In this case, since we are the lender and the bank
is the borrower, the bank pays us interest.
Suppose an investor puts S$5,200 in an account that pays 6% interest per year.
The interest earned will be derived by multiplying the principal by the interest rate
as shown below:
Interest earned
= S$5,200 x 6%
= S$5,200 x 0.06
= S$312
1.1.1 Simple Interest Versus Compund Interest

There are two ways of computing interest. Simple
interest is computed by applying an interest rate to
only an original principal sum. Compound interest is
computed by applying an interest rate to the total of an
original principal sum and interest credited to it in
earlier time periods.
106
To illustrate the difference, assume S$100 is deposited in an account that

earns 6% simple interest per year. At the end of each year the account
will be credited with S$6.00 of interest. At the end of five years, there
will be S$130 in the account (if no withdrawals have been made), as
shown in Table 5.1.
Table 5.1 Accumulation Of S$100 In Five Years At 6% Simple Interest
Per Year
Year
1
2
3
4
5
Principal Sum
100.00
100.00
100.00
100.00
100.00
Simple Interest (S$)

Interest
6.00
6.00
6.00
6.00
6.00
Ending Balance
106.00
112.00
118.00
124.00
130.00
If instead, the account earns 6% compound interest per year, it will grow
to a larger amount, as shown in Table 5.2. The extra S$3.83 in the
account when it is credited with the compound interest is the interest
earned on previous interest earnings.
Table 5.2
Year
1
2
3
4
5
Accumulation Of S$100 In Five Years At 6% Compound

Interest Per Year
Principal Sum
100.00
106.00
112.36
119.10
126.25
Compound Interest (S$)

Interest
Ending Balance
6.00
106.00
6.36
112.36
6.74
119.10
7.15
126.25
7.58
133.83
For the account which was credited using simple interest, the balance
grows by a constant amount at S$6.00 per year.
For the account which was credited using compound interest, the balance
grows by an increasing amount each year, because interest is being
earned on the interest being accumulated. Assuming no withdrawal and
107
given the same interest rate, it is clear that compound interest will result
in a higher balance over the end of a period of time than simple interest.
Note that, in this compound interest example, the interest is compounded
yearly. Interest can also be compounded at shorter intervals, such as
quarterly, or monthly.
For the purpose of this study guide, we will only look into compound
interest, as this is used far more commonly than simple interest.
1.1.2 Compounding Versus Discounting
The process by which money today, a present value, grows over time to
a larger amount, a future value, is called compounding. The process by
which money due in the future, a future value is reduced over time to a
smaller amount today, a present value, is called discounting.
Figure 5.1
Dollar
Amounts
(S$)
Compound Interest As The Link Between Present Value And

Future Value
Future Value
Present
Value
Number Of Periods (n)
Figure 5.1 shows how compound interest acts as a link between the
present and future value. Compounding may be viewed as a movement
up the curve, while discounting may be viewed as a movement down the
curve. The relationship is a curve rather than a straight line, reflecting the
application of compound interest, rather than simple interest. When
compound interest is used, the future value rises each year by an
increasing amount of money, as one moves up the curve (or the present
108
value declines by a decreasing amount of money, as one moves down the

curve).
As the number of periods increases, the difference between the present
value and the future value also increases. This is reflected in the curve
constantly moving higher, as it moves to the right. Also, although not
illustrated, the greater the interest rate, the steeper the slope of the curve
will be. Thus, if the interest rate increases, the difference between the
present value and the future value, for the same time period, also
increases.
These relationships among the number of periods (n), the interest rate (i),
the future value of money (FV), and the present value of money (PV) are
the main variables, when considering problems involving the time value of
money and may be summarised as follows: In compounding, FV moves in
the same direction as n and i (it increases as they increase); In
discounting, PV moves in the opposite direction from n and i (it decreases
as they increase).
1.2 The Power Of Compound Interest
The effect of compound interest is extremely powerful,
especially in cases involving high interest rates, or over a
long period of time.
Imagine one had deposited S$10 in a bank account 500 years ago, as shown in
Table 5.3. Assuming the bank pays a 3% compound interest per year, the
account would have grown to about S$26 million at the end of 500 years!
Table 5.3
Accumulation Of S$10 In 500 Years At 3% Compound

Interest Per Year
Year
1511
1611
1711
1811
1911
2011
Approximate Ending Balance (S$)

10
192
3,693
70,985
1,364,237
26,218,772
109
1.3 Frequency Of Compounding Or Discounting

So far, it has been assumed that the interest rate is applied once per year or, in
other words, interest is compounded annually. However, interest can be
compounded at shorter intervals, and this must also be taken into consideration,
in addition to the interest rate and the length of time.
In many cases, interest rates can be applied semi-annually (twice a year,
quarterly (4 times a year), monthly (12 times a year), or even daily (365 times a
year).
1.3.1 Effective Interest Rates
Nominal interest rates are quoted when the effects of compounding is
not taken into consideration. Nominal actually means in name only.
For example, when a bank quotes you an interest rate, it quotes a
nominal interest rate, say 6% per annum.
The interest rate that includes the effects of
compounding is known as the effective interest rate.
The effective rate of interest is greater than the
nominal rate of interest because of the effects of
compounding.
To illustrate, assume you have borrowed S$500 at a 10% nominal
annual interest. You may expect to pay S$50 in interest. However, the
bank may say that the interest is payable twice a year. This means
that, after six months, you are charged 5%, and then, after another six
months, you are charged the remaining 5%. However, since the interest
is compounded, the calculation is as follows:
Loan repayable after first six months:
S$500 x 1.05 = S$525
Loan repayable after second six months:
S$525 x 1.05 = S$551.25
The loan is repayable in a lump sum of S$551.25 at the end of one
year.
110
Interest = S$551.25 $S500 = S$51.25

Effective interest rate = S$51.25 / S$500
= 0.1025 or 10.25%
Notice that the effect of compounding is to make the effective interest
rate a quarter percentage point greater than the nominal interest rate.
The greater the frequency with which compounding or discounting
occurs, the greater is the effect on the growth of a future value or the
decline of a present value. For example, a S$1,000 principal sum that is
credited with 8% compound interest will grow to a future value of
S$1,166.40 in two years if compounding occurs annually. If
compounding occurs semi-annually, on the other hand, it will grow to
S$1,169.86; and if compounding occurs
monthly, it will grow to S$1,172.89.
Conversely, the present value of S$1,000 due
two years from now is S$857.34 if an 8%
annual interest rate is applied once per year.
However, if the discounting is applied semiannually, the present value is only S$854.80.
1.4 Measuring The Number Of Periods
The number of periods has to be accurately reflected for the compounding or
discounting process. It greatly depends on the period when the process started;
whether it is at the beginning or the end of the period.
Refer back to Table 5.3. In that illustration, the account balance for year 1511
was S$10. It was assumed that S$10 was deposited at the beginning of year
1511 and the account balance was computed at the end of year 1511.
Therefore, the first year would have produced S$0.30 of interest.
On the other hand, if the initial S$10 was deposited at the end of year 1511, the
ending account balance would have been S$10. No interest would have been
earned in that year.
111
Referring back to Table 5.3, imagine if the compounding was to start one year
later, the amount available on 2011 is only S$25,455,118 as compared to
S$26,218,772. That is a difference of about S$763,654!
To assist in counting the number of periods (n), it is useful to draw time lines
such as those in Figure 5.2. The timing should be marked with vertical arrows
along the time line and the timing of unknown dollar values to be marked with
question marks.
For example, the upper time line depicts a case where you need to calculate the
future value (FV) as of the beginning of the sixth period (which is the same as
the end of the fifth period) of a deposit made at the beginning of the first period.
The lower time line depicts a situation in which you need to compute the present
value (PV) as of today (the start of period one) of a series of payments that will
occur at the end of each of the next four periods. Time lines are useful for all
types of time value of money calculations.
Figure 5.2
Time Lines As A Help In Counting Number Of Periods Of

Compounding Or Discounting
?
10
S$
S$
S$
S$
S$
10
112
2.
FUTURE VALUE OF A SINGLE SUM

The simplest form of time value of money problems involves obtaining the future value
(FV) from a present value (PV) of a single sum. Determination of this future value
entails a process of compounding a present value with an interest rate (n) for a certain
number of periods (n).
We refer back to Table 5.1, where a S$100 deposit made today (present value) will
grow to S$133.83 (future value) at the end of five years at 6% compound interest.
This can be related to a common interest-bearing account with a financial institution.
2.1 Basic Time-Value Formula
The basic formula for computing the future value of a single sum of money is as
follows:
FV = PV x (1 + i)n
where:
FV
PV
i
n
=
=
=
=
the
the
the
the
future value of a single sum

present value of a single sum
compound annual interest rate, expressed as a decimal
number of periods during which compounding occurs
We will next discuss a simple problem to recognise the need to understand both
conceptually and mathematically, in order to come up with a solution.
For example, assume that S$5,000 is placed on deposit today in
an account that will earn 9% compound annual interest. What
will be the future value of this sum of money at the end of year
7? The problem is depicted on a time line in Figure 5.3.
For purposes of consistency among the time lines used to depict
various types of problems, present values will be depicted below
the line, as will periodic cash outflows. Future values and
periodic cash inflows will be shown as above-the-line factors.
113
First, we would come up with the time line, indicating a present value of
S$5,000, a period of seven years, and a question mark (future value) at the end
of year 7.
FV = S$5,000 x (1.09x1.09x1.09x1.09x1.09x1.09x1.09)
= S$9,140.20
Typically, shorthand notation is used to express the multiplied interest rates. For
example,
1.09x1.09 = (1.09)2
1.09x1.09x1.09 = (1.09)3
1.09x1.09x1.09x1.09 = (1.09)4
1.09x1.09x1.09x1.09x1.09 = (1.09)5
and so on. The superscript the small, raised number at the end means the
power of. In the example above, 1.09 is multiplied by itself the number of times
indicated by the superscript, so that 1.09 to the seventh power is written as
(1.09)7 and means 1.09x1.09x1.09x1.09x1.09x1.09x1.09.
The basic time-value formula can also be used to compute the solution as
follows:
FV =
=
=
=
PV x (1 + i)n
S$5,000 x (1.09)7
S$5,000 x 1.828039
S$9,140.20
Figure 5.3 Time Line Depiction Of FV Problem

?
10
S$5,000
114
The time line also illustrates the basic trade-off present in all time value of money
problems. Here, the trade-off is a cash outflow today (the deposit shown below
the time line) for a larger cash inflow later (the account balance at the end of the
seventh year, shown above the time line).
Using the formula, what would happen to the FV if the value of i or n were to be
increased? In either case, (1 + i)n would be larger than 1.828039 and when
multiplied by S$5,000 the FV would be larger than S$9,140.20. That is, future
value increases as the interest rate or the number of years increases, and it falls
as either of them is lowered. Graphically, it had been shown earlier in Figure 5.1.
For instance, if the interest rate in the above example is increased to 10%:
FV
=
=
=
=
PV x (1 + i)n
S$5,000 x 1.107
S$5,000 x 1.948717
S$9,743.59
However, if the interest rate in the above example is decreased to 5%:

FV
=
=
=
=
PV x (1 + i)n
S$5,000 x 1.057
S$5,000 x 1.4071
S$7,035.50
2.2 Using A Future Value Interest Factor (FVIF) Table

A future value interest factor (FVIF) is a factor equal to the
future value of a S$1 sum after a given number of
compounding periods at a given interest rate. You can multiply
the present value of a sum by these factors to determine the
future value. The method of finding the right factor to use in a
FVIF table is fairly simple. For example, the future value interest
factor for a 2% interest rate compounded for two periods is
1.0404 This is found as follows:
Refer to the Table 5.4 below which shows a section of the FVIF table. Notice the
shaded number in Table 5.4. It is at the point where the two periods (n=2) row
intersects the 2% column. It can be seen that the FVIF is 1.0404. The FVIF table
115
is available at the end of this study guide as Table 1 Future Value Interest
Factors For One Dollar.
Table 5.4 Future Value Interest Factors For One Dollar
FVSS Factor = (1 + i)n
i=
n=1
2
3
0.5%
1.0050
1.0100
1.0151
1%
1.0100
1.0201
1.0303
where i = rate and n = periods

1.5%
1.0150
1.0302
1.0457
2%
1.0200
1.0404
1.0612
3%
1.0300
1.0609
1.0927
We will look at another example. Assume that you have placed S$100,000 in a
single premium policy with a maturity value of S$103,000 at the end of Year 3.
Calculate the annual compound interest rate.
Using the Time Value formula:
Initial Single Premium (1 + i)n
S$100,000 (1+i)3
(1+i)3
= Maturity value at end of Year 3

= S$103,000
= 1.03
Using Table 5.4, the closest factor is 1.0303. Hence, the interest rate is close to
1% per annum.
3.
PRESENT VALUE OF A SINGLE SUM

We now reverse the question to find out the sum of money needed today if we were
able to assume the future amount needed.
For example, assume that in four years time, you will need S$100,000 as a
downpayment for your new house. How much money should you have today in an
account which earns 4% compound interest in order to reach S$100,000 in four
years?
116
3.1 Using The Time-Value Formula

You learned earlier that FV can be calculated using the formula:
FV = PV x (1 + i)n
By rearranging the formula above, the formula for present value (PV) is as
follows:
1
(1 + i)n
PV = FV x
FV
(1 + i)n
Figure 5.4 Time Line Representation Of PV Problems
S$100,000
10
?
Figure 5.4 shows a problem in which you are asked to determine the present
value of a S$100,000 single sum due in four years.
If you can earn 4% compound interest, you should set aside today an amount of
S$85,477.39 as calculated below:
PV = S$100,000
(1.04 )
S$100,000
(1.04 )
S$100,000
1.1699
= S$85,477.39
This amount, accumulating at 4% compound annual interest, will grow to the
S$100,000 needed in four years.
117
Note the effect of a change in i or n on PV. If either of these is increased, the

denominator of the formula increases and the resulting PV declines. In the
example above, if the interest rate is increased to 5%. the present value
decreases to S$82,270.67 as calculated below:
1
PV = S$100,000
(1.05)
S$100,000
(1.05)
S$100,000
1.2155
= S$82,270.67
On the other hand, a decrease in either i or n, will cause PV to rise. For instance,
if the S$100,000 is needed in three years time instead of four years, and the
interest rate remains at 4%, the present value increases to S$88,896.79 as
calculated below:
PV = S$100,000
(1.04)
S$100,000
(1.04 )
S$100,000
1.1249
= S$88,896.79
We can see that this is logical: If we can earn a higher rate of interest, then we
do not need as much money now. Similarly, if we have a shorter period over
which we can earn interest, we need to start with more money.
118
6. Considerations For Investments
Chapter
CONSIDERATIONS FOR INVESTMENTS
CHAPTER OUTLINE
1.
2.
3.
4.
5.
6.
7.
8.
Introduction
Investment Objectives And Risk Tolerance
Liquidity
Investment Time Horizon
Tax Considerations
Regulations And Legal Constraints
Diversification
Investment Style Of Fund Manager
KEY LEARNING POINTS

know and understand the issues and factors which an investor should consider when
establishing and planning for his investment
explain liquidity and returns
explain investment time horizon
understand the tax effects of investment
know the regulations and legal constraints
explain diversification
understand the investment style of a fund manager and how it affects selection of a unit
trust
119
1.
INTRODUCTION
The most important step that an individual investor should take before
contemplating any unit trust investment scheme is to establish an investment policy.
The purpose of an investment policy is to provide useful guidelines for investing that
are appropriate to the investors investment objectives and personal situation.
A good investment policy should consider both the external and internal aspects of
investment. This means that the investment policy should ultimately reflect and be
in line with the investment style of the investor. The investment style of an investor
is about the approach, mindset, and / or philosophy under the influence of which
investors frame their expectations and choose the means to achieve their
investment objectives. The investment style of an investor is largely determined by
the amount and type of available resources, time constraints, level of risk tolerance,
and the extent of his freedom in choosing from the alternative means. The external
aspect of investment refers to the risks involved and returns achievable in various
market conditions. It is important to set realistic expectations about market
performance, in order to meet the investment objectives of investors. The internal
aspect of investment considers the investment objectives of investors and their
attitudes towards risks. Having a clear understanding of the internal aspect of
investment keeps investors focused on their investment objectives, and avoids adhoc revisions in asset allocation caused by short-term distress in the marketplace.
Such ad-hoc revisions may lead to buying at the top of a speculative
bull market, or selling at a time of extreme market pessimism. Both
actions often lead to poor investment returns in the long term.
By considering both the external and internal aspects of investment,
the individual investor will be able to design an investment plan
appropriate to his investment objectives and within his risk tolerance.
The external aspect of investment has been discussed in the earlier
chapter on risk and return. This chapter will discuss the internal aspect
of investment.
Investors should consider the following issues when planning for investment:
investment objectives and risk tolerance;
liquidity;
investment time horizon;
tax considerations;
120
regulations and legal constraints;

diversification; and
investment styles of fund managers.
2.
INVESTMENT OBJECTIVES AND RISK TOLERANCE

Every investor has different objectives to meet, depending on his age, income,
planned activities and attitudes towards risk.
When defining the investment objectives, some important factors as described
below are to be considered by the investors.
(a) Goals And Needs
The most common goals are retirement, education and
emergency reserves. In considering retirement, investors
should consider the proportion of their final income that
they need when they retire, in order to maintain a
comfortable lifestyle and the length of time before they
retire. Investing for the education needs of children should start at very young
age, so that the investment time horizon will be lengthened considerably.
Emergency reserves are assets that investors may need at short notice to meet
unexpected needs. Money market funds or other short-dated bond funds are
appropriate to meet this objective.
(b) Age
When starting to invest early, the investment time horizon is longer. An investor
will be able to take on higher risk investments to earn a higher return. With a
longer investment time horizon, he can ride out the short-term volatility of risky
assets, while another investor who is close to retirement should invest a greater
proportion of his funds in money market funds and fixed income funds. This will
help to reduce the potential negative and devastating impact of the volatile
market movement that can cause the loss in asset value and / or assets, making
them unavailable to meet the objectives of retirement.
121
(c) Wealth And Income

The better the financial position of the investor, the higher will be the risk that
he can afford to take. Even if the investment suffers temporary losses, he will
still be able to maintain his lifestyle, or even contribute additional capital to his
investments. On the other hand, if he needs the income from his investment to
supplement his lifestyle, then he may need to allocate a greater proportion of his
funds to income-generating funds.
Risk tolerance is a very personal decision, and a very difficult one
to assess. It is important for an investor to be honest with
himself in assessing whether he is comfortable with market
volatility, as well as the financial losses which he can tolerate in
the short term. Many investors make the mistake of looking at
recent market performance to define their own risk tolerance.
Instead, they should take a more realistic view and look forward
at the risk that could occur in the future.
The degree of risk aversion varies among investors. For those with a lower level
of risk aversion, the emotional distress associated with investment loss is lower.
These investors have a higher level of risk tolerance. For other investors with a
higher level of risk aversion, it is recommended that they seek investment with
a lower risk profile. This is because the effects of investment loss can be
devastating to their personal life.
The questions to ask the investor include:
(i)
Can he stand to see the fluctuation / volatility in the market value of my

investment, or afford the loss in some invested asset should the whole
economy and markets head south?
(ii) Does he have a fallback position / plan should things turn very wrong with
the investments that he has made?
(iii) Realistically, how far can he extend himself? All these will say something
about the level of leverage and the extent / depth of speculation that he can
go into.
122
3.
LIQUIDITY
Liquidity is the ease with which an investor can convert his investments into cash at
prevailing market prices. In general, greater liquidity will tend to lower and reduce
the returns of investment assets. Hence, it is necessary to bear in mind the tradeoffs between liquidity and returns. Once the investment is chosen, it should be
maintained until the investment objective is met, or any change in the market
condition necessitates a change in the investment strategy. Selling an investment
based purely on liquidity needs can compromise the long-term return from the
investment plan. Investors should commit only funds that they could reasonably live
without in any investment scheme.
4.
INVESTMENT TIME HORIZON

Investment time horizon refers to the length of time during
which an investor expects to stay invested. Investment time
horizon has major implications on the risks and returns.
As the investment horizon lengthens, the risks associated with
investing in risky assets tend to fall. However, the expected
returns remain quite constant. This suggests that investors with very long
investment horizon should focus on equities for higher potential returns. The risk
associated with investing for longer time horizons is lower than the risk associated
with investing for shorter time horizons.
The yearly data for the US stock market returns between the years 1969 to 2009
illustrate these conclusions. In the table below, the 1-year, 5-year, 10-year, 15-year
and 20-year returns are computed. For example, for the 5-year period ending
December 1969, the return was a negative 3.42%, while the next 5-year period for
the period ending December 1970 was a positive 1.7%.
123
Table 6.1
USA MSCI Index
Dec
Dec
Dec
Dec
Dec
Dec
Dec
Dec
Dec
Dec
Dec
Dec
Dec
Dec
Dec
Dec
Dec
Dec
Dec
Dec
Dec
Dec
Dec
Dec
Dec
Dec
Dec
Dec
Dec
Dec
Dec
Dec
Dec
Dec
Dec
Dec
Dec
Dec
Dec
Dec
Dec
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
1-year
100.000
104.830
118.980
138.680
116.160
84.010
114.100
140.630
129.350
137.070
156.870
204.000
195.580
238.890
291.500
308.920
410.100
481.980
500.820
580.520
762.580
746.710
980.630
1,052.830
1,158.850
1,182.010
1,633.380
2,026.290
2,716.980
3,551.720
4,346.660
3,801.780
3,344.370
2,584.930
3,337.410
3,694.970
3,906.350
4,504.770
4,776.320
3,002.600
3,740.560
Highest Return
4.83%
13.50%
16.56%
-16.24%
-27.68%
35.82%
23.25%
-8.02%
5.97%
14.45%
30.04%
-4.13%
22.14%
22.02%
5.98%
32.75%
17.53%
3.91%
15.91%
31.36%
-2.08%
31.33%
7.36%
10.07%
2.00%
38.19%
24.06%
34.09%
30.72%
22.38%
-12.54%
-12.03%
-22.71%
29.11%
10.71%
5.72%
15.32%
6.03%
-37.14%
24.58%
5-years
-3.42%
1.71%
3.40%
-1.38%
3.37%
13.30%
12.32%
6.82%
13.05%
16.29%
14.51%
14.99%
19.77%
15.96%
14.77%
19.81%
12.73%
15.26%
16.02%
14.83%
9.16%
16.95%
15.62%
20.88%
25.11%
29.75%
18.41%
10.54%
-0.99%
-1.24%
-3.20%
0.54%
6.14%
13.07%
-2.09%
0.25%
10- years
15 -years
20- years
3.20%
4.11%
5.54%
3.50%
7.48%
13.25%
10.47%
11.30%
14.06%
13.83%
13.98%
14.09%
14.34%
15.17%
13.70%
14.13%
11.17%
12.98%
15.00%
16.69%
16.63%
19.26%
14.51%
12.25%
8.35%
10.94%
8.51%
6.78%
5.19%
3.01%
-3.63%
-0.16%
7.39%
7.47%
8.60%
8.66%
10.23%
13.75%
13.50%
11.77%
14.46%
14.56%
14.26%
12.43%
15.20%
15.32%
16.05%
17.68%
17.04%
14.76%
13.49%
10.47%
10.34%
11.25%
9.65%
10.18%
9.90%
6.41%
5.68%
9.19%
10.43%
9.62%
10.27%
11.65%
14.02%
12.40%
13.04%
14.75%
16.11%
16.88%
16.53%
15.99%
14.11%
11.53%
12.64%
11.62%
11.03%
11.61%
11.11%
7.09%
8.39%
38.19%
29.75%
19.26%
17.68%
Lowest Return
-37.14%
-3.42%
-3.63%
5.68%
16.88%
7.09%
Arithmetic Return
11.13%
11.27%
10.30%
11.87%
12.27%
Standard Deviation Of Return
18.33%
8.46%
5.42%
3.31%
Source: MSCI US Stocks
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We can see from Table 6.1 above that the range between the highest and lowest
return narrows progressively as the investment horizon lengthensfrom the
difference of 75.33% for 1-year to 9.79% for 20-year time horizon). In fact, for the
longer time horizon, such as 15-years and above, the lowest annualised returns are
positive. It follows that the standard deviation of return also reduces progressively,
as the investment time horizon lengthens. This suggests that the risk associated
with longer investment time horizon is lower. However, the expected return as
represented by the arithmetic mean ranges from 10.3% to 12.3% for all investment
time horizons. This suggests that the expected return is relatively unaffected by
different investment time horizons.
4.1 Caveats In Investing Over A Long Time Horizon
While the above analysis and statistics do illustrate that investing over a longer
time horizon show certain plus points and benefits (e.g. smaller standard
deviation, and hence, lower volatility in returns; the gap between highest and
lowest returns declines as the investment time horizon is lengthened; etc), it
should be emphasised that the above analysis on the investment time horizon
has been made with reference to the changes specifically to the US MSCI
market index. The progression / changes of returns over the different
investment time horizons (from 1-year, to 5-year, 10year, and so on) has therefore implicitly incorporated in
them the benefit of diversification of the different market
segments and sectors of the stock market. In this sense,
the reduction in standard deviation, and the narrowing
spread between highest and lowest returns over the
different investment time horizon might be due in some
way (and perhaps in large part) to the diversification of the
market, as the data of the entire market had been used.
Additional analyses involving, for example, segmentation of data into different
sectors will be needed, if we want to make the statement and conclusion that
lengthening investment time horizon will, for sure, lead to lowest volatility and
higher return overall. This will entail separate and different study and research,
which will be outside the scope of this study guide.
Having pointed out the limitation of the analysis above, it may be worth just
highlighting the benefit of diversification. The statistics suggest that, when the
entire market is involved, the volatility and risks can be much reduced, and it
125
appears that lengthening investment time horizon is a good thing to do. The
eggs are spread out over the market!
In short, the arguments and points raised above suggest
that the pitfalls of putting all your bets in a particular
sector like technology, especially when the intention is
to hold the investment over a long time horizon. The
financial crisis of 2008 / 2009 and some other earlier
ones gave a lot of examples of stocks losing much of
their values over a short duration of timewho would
have thought that Lehman Brothers could go down so
quickly! In fact, one argument against investing over a
long time horizon is that, given all the changes and
developments, new risks may pop up along the way; and
these may not have been foreseen or known when the
investments being first made (case in point: excessive
over-leveraging and financial engineering in the financial markets leading to
cheap liquidity and the sub-prime mortgage and housing asset bubble). In fact,
one possible strategy may well involve taking a middle roadlocking in the
profits and gains at or close to the top of the economic cycle, and switch to a
safer investment with lower risks / volatility or with assets which the investor
is more familiar and comfortable. That is to say, divide the investment time
horizon up in segments, in line with the economic cycles. Obviously, it is
easier said than done. It involves good understanding of the market, and
sensing and seeing the trends, and having strong discipline knowing when to
stop and let go, and restart!
5.
TAX CONSIDERATIONS
Investors should consider the tax effect of investing.
In Singapore, capital gains from stock market and unit trust investments are nontaxable. Income from bonds and savings accounts have become exempt from tax
since 11 January 2005.
For longer-term investors in the higher tax brackets, they can consider the
Supplementary Retirement Scheme (SRS) which offers attractive tax benefits.
126
Contributions are eligible for tax relief, while investment returns are accumulated
tax-free (with the exception of Singapore dividends) and only 50% of the
withdrawals from SRS are taxable at retirement. In general, the personal income tax
laws and regulations in Singapore are pretty straightforward, and not complicated.
There are really not much tax angles and tax-saving schemes that the individuals
can look to reduce the income taxes. So the key really is to come up with an
investment strategy / plan, coupled with proper execution, so as to achieve a good
return over time.
With the rising popularity of online trading and the globalisation
of the finance industry, more investors are carrying out offshore
investments. Investors typically have to take note of the tax
issues in the respective jurisdiction as they may be taxed on
capital gains. Investors should consult their respective tax
advisers to have a clear picture on tax issues before carrying out
any offshore investments.
6.
www
online
REGULATIONS AND LEGAL CONSTRAINTS

The Monetary Authority of Singapore (MAS), is responsible for regulating the unit
trust industry, formulating guidelines on unit trust operations and supervising fund
management companies in Singapore. These are achieved through legislative
frameworks and non-statutory guidelines on best practices in collective investment
schemes. Central Provident Fund (CPF) Board is involved in ensuring that the funds
included under the CPF Investment Scheme (CPFIS) comply with the various CPFIS
investment guidelines.
6.1 Investment Guidelines Code On Collective Investment Schemes (CIS)
This Code on Collective Investment Schemes was issued by MAS pursuant to
Section 321 of the Securities and Futures Act (Cap. 289) (SFA). The Code
sets out best practices on the management, operation and marketing of such
schemes that managers and trustees are expected to observe.
The Code was first issued on 23 May 2002 and was last revised on 30
September 2011. In revising the Code, MAS considered public feedback
127
received from its public consultation on proposed amendments to the Code

released in May 2010.
The revised Code will take effect from 1 October 2011 and will apply to all
authorised schemes, except structured product funds. In view of the industrys
feedback that structured product funds have customised
structures which require time and potentially higher costs to
unwind, MAS will allow such funds to comply with the
revised Code by 1 April 2012 or be grandfathered
(exempted) on condition that they do not take in new retail
investors after that date. Investment-linked life insurance
policies will have to comply with similar guidelines on 1
October 2011.
Details of the revised Code are specified in the MAS website which should be
visited for guidance from time to time at: http://www.mas.gov.sg/Regulationsand-Financial-Stability/Regulations-Guidance-and-Licensing/Securities-Futuresand-Funds-Management/Codes.aspx. The revised Code is also covered in
CMFAS Module 5 Rules and Regulations for Financial Advisory Services
published by the Singapore College of Insurance.
6.2 CPF Investment Scheme (CPFIS)
Profits made from investments under the CPFIS-OA and / or CPFIS-SA are not
withdrawable, as the purpose of investing is to grow the savings for
retirement. However, the profits can be used for other CPF schemes, subject
to the terms and conditions of these schemes.
All CPF members who satisfy the following requirements can invest and
participate in the CPFIS:
are at least 18 years old;
are not un-discharged bankrupts; and
have more than S$20,000 in their Ordinary Account (for investment under
CPFIS-OA) and/or more than S$40,000 in their Special Account (for
investment under CPFIS-SA).
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6.2.1 Instruments Included Under CPF Investment Scheme (CPFIS) 1

Below is the table that shows the instruments available for investment
under the CPFIS-OA and CPFIS-SA:
CPFIS - OA
Ordinary Account savings can be
invested in:
Fixed Deposits
Singapore Government Bonds
Singapore Government Treasury Bills
Statutory Board Bonds
Bonds Guaranteed by Singapore
Government
Annuities
Endowment Insurance Policies
Investment-linked Insurance Products
Unit Trusts
Exchange Traded Funds (ETFs)
Fund Management Accounts
CPFIS - SA
Special Account savings can be invested
in:
Fixed Deposits
Singapore Government Bonds
Statutory Board Bonds (Secondary
Market only)
Bonds Guaranteed by Singapore
Government
Annuities
Endowment Insurance Policies
Selected Investment-linked Insurance
Products 2
Selected Unit Trusts 2
Selected ETFs 2
Up to 35% of investible savings3 can be

invested in:
Shares
Property Funds (or real estate
investment trusts)
Corporate Bonds
Up to 10% of investible savings3 can be
invested in:
Gold
Gold ETFs
Other Gold products (only UOB
offers these new gold products)
1
Source: www.cpf.gov.sg as of 20 May 2011.
Refer to the risk classification tables for unit trusts, investment-linked insurance products and
exchange traded funds in which Special Account savings can be invested.
Investible savings will be the sum of the Ordinary Account balance and the amount of CPF
withdrawn by CPF members for investment and education.
129
The first S$60,000 in a members combined CPF accounts earns an

extra 1% interest. To enable members to earn extra interest, only
moneys in excess of S$20,000 in the Ordinary Account and S$40,000
in the Special Account can be invested.
However, CPF members can continue to service their regular premium
insurance policies (but NOT recurring single premium insurance policies
or regular savings plans for unit trusts) and agent bank fees even if the
Ordinary Account balance falls below S$20,000.
All investments made under CPFIS must be in Singapore dollars except
where otherwise stated. Investments under CPFIS cannot be assigned,
pledged or used as collateral.
(a) Fixed Deposits
Must be placed with a CPF Fixed Deposit Bank.
(b) Singapore Government Bonds
Can be bought from the primary and secondary
markets.
Can be traded through bond dealers.
(c) Statutory Board Bonds 4
Can be bought from the primary and secondary markets.
Can be traded through bond dealers or brokers.
(d) Bonds Guaranteed by Singapore Government 4
Can be bought from the primary and secondary markets.
Can be traded through brokers.
Under the CPFIS-SA, members can currently invest in Statutory Board Bonds and Bonds
Guaranteed by the Singapore Government only in the secondary market.
130
(e) Annuities
Endowment Policies
Investment-linked Insurance Products 5
Must be offered by Insurance Companies included under CPFIS.
Life insured must be the member himself.
Only single premium or recurring single premium policies are
allowed (new regular premium policies are not allowed from 1
January 2001).
For endowment policies, maturity date must not be later than the
member's 62nd birthday.
(f) Unit Trusts 5
Must be managed by Fund Management Companies included
under CPFIS.
Fund managers are required to invest according to the Investment
Guidelines as set by CPF Board.
(g) Exchange Traded Funds 5
Must meet guidelines as set by CPF Board and be listed on the
Singapore Exchange-Securities Trading (SGX-ST).
(h) Fund Management Accounts 5 (CPFIS-OA only)
Fund managers are required to invest according to the Investment
Guidelines as set by CPF Board.
(i)
Shares of Companies, Units of Property Funds

or Property Trusts and Corporate Bonds (CPFISOA only)
Must be offered by companies incorporated
in Singapore.
Must be fully paid ordinary or preference
shares or corporate bonds as listed on the
Singapore
Exchange-Securities
Trading
(SGX-ST).
Can be denominated in non-Singapore dollar currencies.
131
(j)
Gold (CPFIS-OA only)

Gold ETFs 5
Must meet guidelines set by CPF Board and be listed on the
Singapore Exchange Securities Trading (SGX-ST).
Other Gold products
Only UOB offers these gold products. If you wish to invest in
gold, you need an investment account with UOB.
6.3 CPF Investment Scheme Risk Classification System

In 1999, the Central Provident Fund (CPF) Board engaged an international
investment consultant, William M Mercer, to approve, review and classify
funds approved under the CPF Investment Scheme. The aim was to provide
sufficient information to CPF members, so that they could make informed
investment decisions when investing in such funds. CPF members are still
responsible for making their own investment decisions,
and for understanding the risks that they are taking.
Mercer has developed a risk classification system to help
CPF members understand the nature and types of risks
associated with each unit trust, so that they can make
informed judgement on a suitable investment.
Mercer classifies investment risks into two major types
equity risk and focus risk.
Equity risk is related to the exposure of the riskier types of investments in
the unit trust. Risky investment refers to equities. Generally, where the unit
trust has a higher proportion of equities, the equity risk will be higher. The
longer an investor's investment time horizon, the more likely he can
comfortably take on more equity risk and vice versa. Over the long term, a unit
trust with high equity risk may reasonably be expected to outperform a unit
trust with lower equity risk. However, in the shorter term, a unit trust with
high equity risk may substantially under perform, as compared to a unit trust
with low equity risk. This is due to the volatility in stock prices connected to
5
Can be denominated in non-Singapore dollar currencies.
132
changes in economic forces (e.g., changes in interest rates, monetary and

fiscal policies, etc). Occasionally, it will not hold true even for some fairly long
periods (as long as a decade or more).
Focus risk reflects the focus of unit trusts in one particular geographical
region, country, or industry sector. The purpose of providing information on
focus risk is to make CPF members aware of certain types of risks associated
with a given investment which may not be readily apparent at the first glance.
Investments within each equity risk category are further classified into either
broadly diversified or narrowly focused.
Broadly diversified unit trusts tend to have investments that are spread across
relatively more geographical regions, countries, industry sectors and individual
securities. This portfolio tends to contain more securities and is less
concentrated.
Narrowly focused unit trusts tend to have investments
that may be focused in particular geographical regions,
countries, industries or individual companies. This
portfolio tends to contain fewer securities and is more
concentrated. In general, a narrowly focused unit trust not
only will have the potential to produce higher returns in a
short-term period, but also will have more downside risk
than a broadly diversified unit trust, i.e. a narrowly
focused unit trust within a given equity risk category
tends to have greater volatility. However, they will not necessarily be
associated with a higher level of long-term expected results.
Since July 2002, Standard & Poors (S&P) has replaced William M Mercer to
provide quarterly evaluations of the performance of insurance-linked
investments and unit trusts under the CPFIS.
Starting from 2005, with the aim of improving the value and return to the CPF
members investing in unit trusts and investment-linked life insurance policies,
the CPF Board stipulated certain guidelines for unit trusts, in order for them to
be continually included under the CPFIS. These include the investment
performance of the unit trusts, as well as meeting certain expense ratio
criterion. The expense ratio refers to the operating cost of unit trusts and
133
investment-linked life insurance products, including investment management

fees and other administration costs, expressed as a percentage of the fund's
average net assets for a given time period. The expense ratio does not include
brokerage costs and various other transaction costs that may also contribute
to the total expenses of a fund.
In February 2008, the CPF Board appointed Morningstar Research Pte Limited
(Morningstar) as its investment consultant under the CPFIS with effect from 7
March 2008. Morningstar assumes the role of evaluating suitable product
providers such as fund management companies and insurers, as well as their
products such as unit trusts, investment-linked life insurance products, and
exchange traded funds, etc, seeking to be included under the CPFIS. The
contract with the CPF Board will be for a period of three years from the
commencement of the consultancy services, with the option by the CPF Board
to extend for two additional one-year terms.
In August 2008, the Investment Management Association of Singapore (IMAS)
and the Life Insurance Association, Singapore (LIA) entered into an agreement
with Lipper, a Thomson Reuters specialist fund subsidiary, to be the provider
of fund performance data for the Central Provident Fund Investment Scheme
(CPFIS) of Singapore.
With the appointment, Lipper is to work with IMAS and LIA to enhance the
CPFIS Performance & Risk Monitoring Report, and the fundsingapore.com web
portal, to better meet the needs of the investing community.
7.
DIVERSIFICATION
The purpose of diversification is to reduce investment
risk. Simply, it is not putting all your eggs in one basket.
By doing so, the volatility of your investment returns is
reduced. Diversification can be achieved by combining
assets in your portfolio which have a correlation of return
that is less than one.
In assessing the appropriate level of diversification, the
factors as described below should be considered by the
134
investors. These include: (a) the asset class the portfolio is invested in; (b)
concentration of investments; (c) concentration of sector exposure; and (d)
concentration of geographical exposure. In addition, dollar cost averaging reduces
the timing risk in investment, and is a very important and effective tool in
diversifying the investment over time.
(a) The Asset Class The Portfolio Is Invested In
Generally, the higher the proportion of equities, the higher will be the risk of
that fund. After taking into account other considerations such as risk tolerance
and investment time horizon, investors may want to diversify their funds to
include some money market or fixed income securities.
(b) Concentration Of Investments
A concentrated portfolio is one that owns a smaller number of investments, but
each investment has a sizeable weightage in the unit trust. Hence, a portfolio
with 20 investments is more concentrated than one with 50 investments.
Hedge funds usually have higher concentration of bets than traditional funds.
(c) Concentration Of Sector Exposure
A portfolio that concentrates its investments in one particular sector is generally
more risky than one that is diversified in its sector exposure.
(d) Concentration Of Geographical Exposure
A portfolio that concentrates its investments in one geographical region is
generally more risky than one that is diversified geographically. Hence, generally
a country focused portfolio is more risky than a regional focused portfolio, while
a globally diversified portfolio is, in general, the least risky among them, as the
exposure is spread over a larger number of countries and / or regions.
Another way to achieve diversification is to have a regular savings plan, where
you invest a certain amount into a unit trust for example, regardless of market
conditions. This is also known as dollar cost averaging.
7.1 Dollar Cost Averaging
This is a practice adopted by investors who do not want to undertake markettiming risks. The risks of market timing are discussed in the next section.
Investors invest in steady, equal amounts over a period of time. It has the
135
effect of making their average cost of purchases lower than the average price
during that period.
Example 6.1: How A Dollar Cost Averaging Works
You decide to invest S$1,000 in a stock fund at the end of every
month.
Month
January
February
March
April
May
June
July
August
September
October
November
December
Price
(S$)
1.02
1.00
1.15
0.98
1.10
0.95
0.90
0.88
0.75
0.95
1.10
1.00
Total units purchased

Total investment (12 X S$1,000)
Average price
Quantity Purchased
(Units)
980.39
1,000.00
869.57
1,020.41
909.09
1,052.63
1,111.11
1,136.36
1,333.33
1,052.63
909.09
1,000.00
12,374.61 units
S$12,000.00
S$0.9697 per unit
The average purchase price of S$0.9697 per unit is lower than the
average of the monthly closing price over the one-year period of S$0.9817
(add up the monthly closing price during that one-year period and divide by
12). Dollar cost averaging has the advantage of buying more when the
market is low, and buying less when the market is high (expensive). This is
consistent with the concept of buy low and sell high.
136
7.2 Market Timing

Market timing is a technique of shifting your investments in
and out of risky asset classes, to capture the upside for risky
asset classes during bull markets, during bear markets.
Empirical evidence suggests that most investors fail to use
market timing to make a positive impact of their investments
on a sustainable basis. Not only are the odds against them,
but also the punishments inflicted on investment returns can
be devastating if the best trading days are missed.
To illustrate the impact of missing the best trading days on portfolio returns,
we shall use the daily MSCI index return for Singapore stock market over the
three-year period between 5 April 2007 and 5 April 2010. The cumulative
return for the MSCI Index during the 3-year period was a negative 3.68%.
However, missing the best 5 and best 10 trading days reduced the MSCI Index
return to a larger negative return of 30.03% and 47.8% respectively.
There are two further risks in trying to time the market. Best trading days
usually occur immediately after some of the worst trading days. Hence, the
chances of missing on the best trading days are high as investors sell on panic.
Furthermore, best trading days tend to occur within close proximity of each
other. This further heightens the risk of missing out on most, if not all, of the
best trading days. It should be noted that it is almost impossible to spot the
best and worst trading days in the market. This is because the daily
movements in any market are affected by many events that are beyond the
guess and prediction of even the best investment managers in the world.
Thus, the best and worst days are usually only identified on hindsight. In this
sense, instead of trying to pinpoint the good and bad days, the best strategy
may well be to use the dollar cost averagingthat is, follow and attain the
average performance of the markets.
137
8.
INVESTMENT STYLE OF FUND MANAGER

It is important that an investor in unit trust investments selects a fund manager
whose investment style that he (the investor) appreciates and fully understands. In
this way, the investor will not be disappointed, so long as the fund performs in line
with the selected style.
The two most common investment styles are growth and
value. In growth style, the fund manager typically holds stocks
with high earnings growth rates (either shown by historical
record and performance, or projected and judged to be so
potentially in the future, given the nature of the industry,
economy, expectation and outlook on the company
performance). Even though the valuation of these stocks may
be high, a growth fund manager believes that strong earnings
growth rates will result in the increased market / real value of
the asset, proving that the valuation is justified and in line with the original
assessment. Consequently, the valuation metric, such as price (valuation) to
earnings (P/E) ratio, will be brought down to a level that is in line with the market.
The risk to the growth style lies in the company not being able to deliver the strong
earnings growth rate that is expected of it.
In value style, the fund manager typically holds stocks with cheap valuation. The
value fund manager believes that, over time, the market will re-rate these stocks at
a higher valuation. The risk in value investing lies in the market not giving a higher
valuation to the asset / investment over a longer period of time.
Funds with different styles may perform rather differently at any one point of time.
Thus, an investor who opts for value style should not expect his fund to perform as
well as growth funds in a market environment, where growth stocks are doing much
better.
138
7. Unit Trusts
Chapter
UNIT TRUSTS
CHAPTER OUTLINE
1.
2.
3.
4.
5.
6.
7.
8.
9.
Introduction
Parties Involved In A Unit Trust
Charges And Fees
Expense Ratio
Bid And Offer Prices
Pricing Of Unit Trusts
Evaluation Of Unit Trusts
Advantages Of Investing In Unit Trusts
Pitfalls Of Unit Trust Investment
KEY LEARNING POINTS

describe the benefits of a unit trust and the parties involved in it
list the charges and fees related to Collective Investment Schemes
understand and calculate expense ratio and the types of unit trusts with high expense
ratio
know the bid and offer prices and how unit trusts are priced
evaluate the suitability of unit trusts
know the advantages and pitfalls of investing in unit trusts
139
1.
INTRODUCTION
1.1 Investment Fund
An investment fund is a fund managed by some firm / investment manager
which pools the investments by retail investors for a fee. By aggregating the
funds of a large number of small investors into specific investments (in line
with the objectives of the investors and detailed in the prospectus), an
investment company gives individual investors access to a wider range of
securities (such as corporate securities, commodities, options, etc.) than the
investors themselves are able to access. Also, individual investors are not
hampered by high trading costs, since the investment company is able to gain
economies of scale in operations. They can be classified as open-ended and
closed-ended funds.
1.2 Unit Trust An Introduction
A unit trust is a professionally managed investment
fund that pools together money from investors (called
unit holders) with similar investment objectives to
invest in a portfolio of stocks, fixed income securities
or other financial assets or some relating combinations.
Unit trust, also know as collective investment scheme
(CIS) locally, is typically set up as a trust where there is a trustee. In other
countries, similar structures called mutual funds may be set up as an
investment companies with no involvement of a trustee.
A unit trust investor owns units in the funds, which are somewhat similar to
shares in a company. Each unit represents a proportionate ownership in the
underlying securities owned by the unit trust. For example, if there are
1,000,000 units in a unit trust that owns 200,000 shares of Singapore
Airlines and 1,000,000 shares of Venture Corporation, among others, then
each unit will represent 0.2 shares in Singapore Airlines and 1 share in Venture
Corporation. Unit holders redeem their investments by selling units back to the
fund manager.
140
7. Unit Trusts
1.3 Brief Overview Of The Administration And Control Over Unit Trusts
The level of a unit trust's income from its portfolio, and the market values of
the underlying investments determine the daily market value (called net asset
value) at which its units are redeemable on any business day, and the
dividends paid to its unit holders. Unit trusts are of two main types, namely (1)
open-ended fund, where the capitalisation of the fund is not fixed, and more
units may be sold at any time to increase its capital base; and (2) closed-ended
fund, where capitalisation is fixed and limited to the number of units
authorised at the fund's inception (or as formally altered after that).
Unit trusts usually charge a management fee (typically between 1% and 2% of
the fund's annual earnings) and may also levy other fees and sales commission
(called load) if units are bought from a financial adviser.
Hence, a unit trust is a pool of co-mingled funds contributed by many
investors, kept in trust by a trustee, and managed by a professional fund
manager.
The Securities and Futures Act (Cap.289) will provide for MAS to authorise all
collective investment schemes to be offered to the public in Singapore, for
example, the approval of trust deeds and schemes. This deed enables a trustee
(usually a bank) to hold the pool of money and
assets in trust on behalf of all the investors. The
UNIT TRUSTS
pool is managed by a third party, namely the
investment fund manager. The fund manager
manages the portfolio of investments and operates
the market for the units (i.e. administers the buying
and selling of shares in the unit trust) itself for the
benefit of unit-holders. The unit trust is essentially a
Investors
Trustee
three-way arrangement made up of the investors,
Fund Manager
the fund manager and the trustee.
Investors who are interested in receiving the benefit of professional portfolio
management, but who do not have sufficient funds and / or time to purchase a
diversified mix of securities will find investing in unit trusts attractive. They
can invest in unit trusts to generate income in the form of dividends, interest
and capital gains.
141
Investors in Singapore can choose from a wide variety of unit trusts with
different investment objectives. A unit trust may aim for high income or a high
capital growth, or a combination. Some unit trusts invest in specific industry
sectors, countries or regions.
It is important that the investment objectives of the unit trust chosen match
those of the investor. Unit trusts are required to state their investment
objectives clearly on the prospectus which every investor should acquire
before buying. The types of assets which may be bought by the fund manager
are also specified in the objectives of the unit trust as contained in the trust
deed.
The coverage of unit trust investments is divided into two chapters. This
chapter covers the: (a) parties involved in a unit trust; (b) charges and fees; (c)
expense ratio; (d) bid and offer prices; (e) pricing of unit trusts; (f) evaluation
of unit trusts; (g) advantages of investing in unit trusts; and (h) pitfalls of unit
trust investments. Chapter 8 covers: (a) major types of unit trusts, (b)
innovative unit trust investment schemes, and (c) investment trust, real estate
investment trust and business trust.
2.
PARTIES INVOLVED IN A UNIT TRUST

The operation of a collective investment scheme involves three main parties,
namely: (1) the trustee; (2) the fund manager; and (3) the distributor.
2.1 The Trustee
The trustee is the watchdog to safeguard the rights and
interests of the investors. To fulfil this objective, the trustee
must perform the following key roles to:
ensure that investments in the unit trusts comply with the
trust deed which is a legal document drawn up to govern the aims and
objectives of the fund, as well as its investment guidelines;
assume legal ownership of all assets (securities and residue
cash) belonging to the unit trust and holds them in trust for unit holders this is to ensure that all assets belonging to the unit trust are protected from
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7. Unit Trusts
the other operational and financial risks of the fund management company;
and
maintain proper accounting records for the unit trust and have them audited
yearly.
To perform these roles effectively, the trustee must be an independent body
from the fund management company. For these services, the trustee earns a
fee, known as trustees fee. This is usually 0.1% to 0.15% of the asset value
in the unit trust.
2.2 The Fund Manager
The fund manager is responsible for the performance of the fund, and
manages it in accordance with the objectives as set out in the trust deed. To
fulfil these objectives, the manager must perform the following key roles to:
invest all assets in the unit trust to meet its objective as set out in the trust
deed;
create or redeem units in accordance with the stipulated methods of
calculating the unit price; and
prepare and send to unit holders semi-annual and annual performance reports
of the unit trust.
For its services in managing the assets in the unit trust, the fund manager is
paid a management fee. This is usually between 0.5% and 1.5% of the asset
value in the unit trust, depending on the types of unit trusts (and hence, the
types of investment assets) involved.
2.3 The Distributor
The distributor has assumed greater importance in recent years owing to the
proliferation of unit trusts available locally, as well as
the strategic marketing reach of the distributor. The
distributor has been largely responsible for marketing
unit trusts through publicity in the media, investment
seminars and mail.
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For these services, the distributor earns a one-off sales charge (also known as
front-load fee). This is typically between 3% to 5% of the initial investment.
The distributor may also earn a portion of the recurring annual management
fee, known as trailer fee. This is usually pegged at a quarter of the annual fee.
However, in recent times, increased competition from local banks with strong
branch network and online investing websites have exerted downward
pressure on the sales charge.
3.
CHARGES AND FEES

The charges and fees related to a collective investment scheme are broadly divided
into initial charge and recurring charges. Initial charge refers to the sales charge that
is payable when the fund is first purchased. It is the single most substantial portion
of the total fees paid by investors in a collective investment scheme.
Type Of Charges
Quantum
Payable To
Sales charge
3% to 5%
Distributor
Management fee
0.5% to 1.5% per annum
Fund management company
Trailer fee
25% of annual management

fee. (May vary across the
various funds or distributors).
Distributor
Trustee fee
0.1% to 0.15% per annum
Trustee
3.1
Other Types Of Costs

These are described below.
(a) Switching Fee
This may be imposed when the unit holder switches from one fund to
another fund under the same umbrella. Thus, constant switching of funds
can be an expensive affair for unit holders because most fund
management companies allow free switching only once a year.
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7. Unit Trusts
(b) Custodian Fee

This is levied by a custodian for safe custody of securities in a unit trust.
The fee structure is typically transaction-based. This means that there can
be a fixed transaction charge for each trade, regardless of fund size.
(c) Audit Fee
An annual audit is mandatory for unit trusts.
(d) Marketing Costs
These costs are incurred when promoting the unit
trust at a new launch or at a re-launch. However,
marketing costs are not allowed to be charged to
the fund.
(e) Redemption Fee
This is usually levied on investors who liquidate
their investments within a specified time. However,
this fee is applicable only in the case of a no-load
fund (a unit trust without sales charge upfront).
From the above descriptions, it should be apparent that a unit trust should be
held at least as a medium-term investment, or at best as a long-term
investment, since the charges and fees involved are quite prohibitive for shortterm trading.
4.
EXPENSE RATIO
This is the ratio of expenses incurred by the unit trust to its net asset value.
Expenses to be included in the calculation of the expense ratio include:
fund management fee;
trustee fee;
administrative fee;
accounting and valuation fees;
custodian fee;
registrar fee;
legal and other professional fees;
audit fee;
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printing and distribution fees; and

amortised expenses.
Note that expenses NOT included in expense ratio computation are:
interest charges;
performance fee;
brokerage; and
sales charge.
High expense ratios can affect fund performance negatively, especially when they
are compounded over the longer term. For example, over a 5-year holding period,
the fund performance can be worse off by more than 10% points if the expense
ratio is 2% higher.
In general, the expense ratio ranges from between 1% and 2%. However, some
types of unit trusts have higher expense ratios (> 3%). These include:
(a) Unit Trusts With Small Fund Size, Particularly If The Fund Is
Actively Managed
A transaction fee is usually a flat fee levied on each transaction
done by the fund manager. Hence, an actively managed fund
has high transaction charges. The effect on expense ratio is
compounded on funds with a small size or net asset value.
(b) Feeder Fund
Such funds have two layers of expenses one incurred in
Singapore and the other incurred at the level of the parent
fund.
5.
BID AND OFFER PRICES

The standard quotation of most unit trusts has a bid and offer price (although there
are now fund houses who practise single pricing and impose a back-end charge at
surrender). This is the price at which the fund manager will buy and sell units in the
fund respectively. The bid and offer prices are usually quoted in three to five
decimal points. The bid price is the net asset value per unit of the fund, while the
offer price includes the sales charge.
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7. Unit Trusts
For example, as at a certain date, the Singapore Index Fund appears as S$1.7466 /
S$1.7815. The bid price of S$1.7466 is the net asset value per unit of the fund. It
is the price that investors in the fund will receive if he decides to redeem his
investment. The fund manager will buy back units at this price.
The price of S$1.7815 is the offer price of the fund. It
incorporates a 2% spread over the bid price as its sales charge
payable to the distributors. New investors wishing to come into
the fund will have to pay S$1.7815 for every unit purchased. In
other words, they are paying the net asset value per share plus a
sales charge. In short, an investor pays offer price when buying,
and receives bid price when selling.
Net Asset Value (NAV) is commonly used to quote unit trusts in recent times. NAV
of a unit trust is actually calculated by dividing the sum of the values of all the
underlying securities, less liabilities, by the total number of outstanding units.
Example a fund size is at S$100 million with 100,000 outstanding units, the NAV
will be at S$10 per unit.
6.
PRICING OF UNIT TRUSTS

The pricing of a unit trust is based on the principle of dividing the net asset value of
a fund into equal portions referred to as units. For example, if the net asset value of
a unit trust is S$10 million, and if there are 5 million units in issue, each unit will be
worth S$2. This is the net asset value of each unit. It is also the bid price as
described in the earlier section.
Most unit trusts are open-ended funds. This means there is no limit to the number of
units that can be created. New units can be created as and when there are
demands. Similarly, units may be cancelled when investors redeem their
investments. The fund manager must be given sufficient time to rebalance his fund,
whenever there are changes in the total number of units. For example, if S$100,000
worth of new units is to be created, this sum of money will be represented by an
increase in the cash holding of the fund. A fund manager has to decide on the
deployment of this amountthe security to purchase (if the increase in the units are
not linked to any specific security). On the other hand, if S$100,000 worth of units
is redeemed, this will be represented by a cash outflow in the fund. The fund
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manager has to decide on which securities to sell (if the redemption is not linked to
any specific security), in order to raise the cash to meet the redemption request.
Hence, a unit trust is priced on a forward basis. This means that, at the point of
application or redemption of his unit trust investment, investors will be given an
indicative price, based on the closing price of the previous dealing day. The actual
dealing price will be determined at the close of the current dealing day. As such, the
fund management company can calculate the bid / offer price for the unit trust after
the financial market is closed, and all the underlying investments in the unit trust
can be priced, in order to arrive at the current market valuation for the unit trust.
Investors will not be able to determine their transacted prices of the units until the
next dealing day, and this is known as forward pricing.
Despite being priced on a forward basis, a unit trust is a highly liquid investment,
because the underlying securities of the fund are relatively liquid in nature. Most
trust deeds also allow unit trusts to borrow up to 10% of the net asset value to
meet redemption, whenever there is any cash flow mismatch. The latter may
happen because trade settlement on the sale of securities and redemption payments
may be mismatched.
7.
EVALUATION OF UNIT TRUSTS

When evaluating the suitability of a unit trust as part of their long-term investment
plan, investors should take into account the factors as described below.
(a) Risk Appetite
Investors should understand their risk appetite or risk tolerance level, and
choose the right unit trust that fits into this risk profile. Risk appetite is affected
by their investment time horizon, personality and financial
background. If their risk appetite is high, they can consider higher
risk investments or unit trusts with higher risks. These also offer
prospects of higher investment return over the longer term. On
the other hand, if they cannot afford to suffer price declines in
the short term, then a fixed income fund is probably more
suitable for them.
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7. Unit Trusts
(b) Investment Time Horizon

The investment time horizon is the expected length of time during which
investors will stay invested in the fund. If the investment time horizon is long,
investors may have a higher tolerance for risk and may consider riskier assets,
because they offer potentially higher expected returns.
(c) Diversification
While unit trusts are already a diversified portfolio, investors should also
diversify their holdings in the various types of unit trusts. At the very first level,
they should divide their funds between various asset classes, such as fixed
income and equity funds. Within each of the equity and fixed income funds,
further diversifications should be made in industry sectors, geographical regions
and countries. For some investors, diversification into hedge funds may also be
appropriate, provided that the risks associated with them are well understood.
(d) Regular Investment Plans
While the initial outlay for a unit trust may be affordable,
investors should also consider regular investment plans, in
order to take advantage of dollar cost averaging. Some fund
management companies have regular investment plans that
allow investors to invest minimal amounts of a hundred
dollars each month, subsequent to the initial investment.
(e) Transaction Costs
Other than the one-off sales charge and annual management fee, investors
should also look at the expense ratio. This is calculated by taking all the
expenses like the unit trust's operating expenses, such as custodian fees,
management fees and other fees for shareholders' services, and divided by the
total asset value of the fund. As mentioned above, everything being equal,
funds with small net asset values and feeder funds tend to have high expense
ratios. Generally, funds with low transaction costs and lower expense ratios are
preferred.
(f) Availability Of Switching Options
While most fund managers offer a variety of funds, it may be desirable to
switch from one fund to another, in order to take advantage of the changing
investment environments and to adjust ones investment plans. Investors should
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enquire from the distributor or the fund management company on the costs
associated with switching.
(g) Style Of Fund Manager
The two major investment styles, namely growth and value, have different
fortunes at different phases of the economic cycles. Investors should
understand and be comfortable with the professed style of the fund manager
before investing in any unit trust. Only by doing so will they have a better
appreciation of the performance of the unit trust which they choose. For
example, if an investor believes in value style, he will have a better appreciation
of a unit trust managed using the value-style. In times when the fund is not
performing as well as the other style, he will have the conviction to ride out the
cycle.
(h) Consistency Of Performance
Other things being equal, a fund management company that
demonstrates consistent superior performance on a riskadjusted basis is preferred. When measuring fund
performance, investors should also consider its investment
objectives, selected style, and the risks taken to achieve
those returns. Finally, investors should remember that past
performance is no guarantee of future performance.
8.
ADVANTAGES OF INVESTING IN UNIT TRUSTS

8.1
Diversification With Small Capital Outlay

With a small sum of money invested in unit trusts, investors are able to invest
in a sufficient number of companies to achieve effective diversification. By
pooling investors' money, investment companies enable unit holders to hold
fractional shares of many different securities. A diversified portfolio of
securities, as we have seen, can reduce investment risks. Most unit trusts
require relatively small capital outlay ranging from S$1,000 to S$5,000.
Investors can continue to invest more of their funds into the same unit trust at
a smaller outlay, as low as a few hundred dollars, using the regular savings
plan. This is generally quite affordable to most investors. Unit trusts also allow
investor to invest in certain markets and sectors which they may find difficulty
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7. Unit Trusts
in accessing on his own. For example, investments in the stock markets of

India, Taiwan and Korea require an investment licence, which is typically
available only to institutional investors, such as a fund management company.
8.2
Professional Management
All else being equal, investment professionals devote
full time to analysing market trends in order to make
sound investment decisions. With their training and
qualifications, they are aware of changes in the
investment environment and are thus able to react to
them promptly. Furthermore, they have access to the
vast research capabilities from major international
brokers, by virtue of the commissions which they pay
on the larger pool of funds that they manage. With
such advantages, they are in a better position to make
better investment decisions.
8.3
Switching Flexibility To Capitalise On Changing Market Conditions

The choice of unit trusts need not be restricted to the initial purchase.
Investment companies typically allow investors to switch within a family of
funds. Investors can switch from one fund to another conveniently and with
minimal costs. Switching between funds provides investors the benefits of
flexibility, as they can respond easily to changes in their investment plans and
market movements. For example, if the investment plan of an investor
necessitates a change from one of moderate risk to higher risk, he may
consider switching from a balanced fund to an equity fund.
8.4
Liquidity
Investors can sell their investments to the investment managers who are
required to buy back the units, based on the net asset value of the unit trusts.
They can do so at relatively short notice with no prior notice.
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8.5
Security
The unit trusts in Singapore are subject to certain rules, regulations and
guidelines imposed by the Monetary Authority of Singapore, and the Central
Provident Fund Board in the case of CPF-approved investments. The assets of
a unit trust are always legally held on the investors behalf by an independent
trustee, and not by the fund manager, in order to safeguard the interests of
unit holders. The trust deed regulates the actions of fund managers to ensure
that they act within legislated boundaries. Fund managing companies hold
investment advisory licences approved under the Securities And Futures Act
(Cap. 289). Trustees will also have to abide with the Trust Companies Act
(Cap. 336).
8.6
Reinvestment Of Income
Usually, the manager will automatically reinvest the
dividends or interests received by the unit trust. This
is an advantage versus personal investing, because
the dividends or interests collected by an individual
are usually too small for any capital investment.
9.
PITFALLS OF UNIT TRUST INVESTMENT

Unit trusts are very effective in achieving risk diversification with minimal outlay.
However, each unit trust should be selected after considering the factors as
mentioned in the earlier chapters and Section 7 Evaluation Of Unit Trusts of this
chapter. Nevertheless, there are some pitfalls that investors should avoid in unit
trust investments:
(a) Performance Of Unit Trust Is Closely Linked To Fund Manager
While all fund management companies have an investment process to ensure
that all its funds are managed using similar philosophy and approach, it is
common for a fund which has performed very well in the past to under-perform
its peer group, after the departure of the fund manager who was previously
managing the fund. This can be due to the unique skills that the fund manager
brings to the fund, in addition to the investment process adopted by the
company. Investment consultants regularly enquire if there has been any change
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7. Unit Trusts
in the fund manager managing a particular fund during their performance

review. Investors should also attempt to keep track of changes in the fund
manager, to alert themselves that future performance of the fund may be
affected by such changes.
(b) Investors Cannot Influence The Way A Unit Trust Is Managed
The management of a unit trust is at the complete discretion of the fund
manager. Investors will not be able to influence the way in which it is managed.
For example, investors cannot insist that the unit trust raises more cash to
protect its net asset value, even if they are convinced that the stock market is
going to weaken further. (If that being the case, the investors should sell their
units). Similarly, investors cannot influence the sector allocation or the stock
selection of the unit trust. Therefore, it is important that they choose a unit
trust that shares their investment philosophy and investment approach.
(c) No Guarantee Of Profits
All unit trusts carry investment risks. Even capital guaranteed unit trusts is subject
to investment losses if it is redeemed before the end of its maturity. The level of
risk associated with each unit trust is dependent on its underlying assets. Hence, a
technology fund is exposed to the volatility of
technology stock prices in general. A globally
balanced fund is exposed to the volatility of both
global equities and global bonds.
There is no guarantee that the unit trust investment
will result in profits, even if held over a long term.
Investors should regularly evaluate their unit trust
investments to assess if the risk and return profile is
still relevant to meet their investment needs.
(d) Past Performance Is Not A Reliable Indicator Of Future Performance
Investors should be careful not to consider the recent success of an investment
strategy as being sustainable indefinitely into the future. For example, following
the phenomenal success of technology funds in the late 1990s, many investors
invested heavily into such funds, as they believed the bull market for the
technology sector will continue forever.
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Investors should be wary of this pitfall as fund management companies and

distributors tend to promote new funds or re-launch existing funds that have
experienced recent success. Such funds are much easier to sell, and hence, more
moneys can be raised.
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8. Fund Products
Chapter
FUND PRODUCTS
CHAPTER OUTLINE
1.
2.
3.
4.
Introduction
Major Types Of Unit Trusts
Innovative Unit Trust Investment Schemes
Investment Trust, Real Estate Investment Trust (REIT) And Business Trusts
KEY LEARNING POINTS

understand and explain the major types of unit trusts and funds
know the innovative unit trust investment schemes
understand investment trusts, REITs and business trusts
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1.
INTRODUCTION
As mentioned in the previous chapter, the coverage of unit trust investments is
divided into two chapters. This chapter covers: (a) major types of Unit Trusts; (b)
Innovative Unit Trust Investment Schemes; and (c) Investment Trust, Real Estate
Investment Trust (REIT) And Business Trusts.
2.
MAJOR TYPES OF UNIT TRUSTS

Depending on the types of underlying assets involved, unit trusts can be classified
as any of the following types:
2.1 Equity Fund
An equity fund invests predominantly in equities. A unit holder in an equity
fund is a part owner of each of the securities in the fund. The total return from
an equity fund comes from the dividend paid by the underlying securities in the
fund, as well as an appreciation in their share price. An equity fund is the most
common type of unit trust. It can be further classified into:
Single country fund, where all the investments in the fund are placed in one
specific country;
Regional fund, where the investments are spread out over the countries in
some geographical region (Asia-Pacific, Middle-East, or South America), or
some economic / political grouping (e.g. ASEAN,
European Union);
Global fund, where the investments are spread out or
diversified over the world; and
Sector fund, where the investments are concentrated in
certain sector or industries (such as finance, technology,
automobile, etc).
In general, owing to the risks associated with investment in equities, an equity
fund tends to have a higher level of investment risk as compared to other
types of unit trusts, such as fixed income fund or a balanced fund. However,
the risks associated with each sub-classification of an equity fund vary
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8. Fund Products
depending on the nature and concentration of the underlying securities. Unit

trusts invested in a cyclical industry and highly concentrated unit trusts have
higher risks. A cyclical industry is one whose earnings are more sensitive to
changes in the economic condition and cycles. A highly concentrated unit trust
has fewer securities, but each security has more significant weighting.
For example, the technology sector is considered more cyclical
as compared to the consumer sector. Hence, a technology fund
will have higher risks as compared to a consumer sector fund.
A global equity fund tends to have more stock holdings as
compared to a single country equity fund. This means that the
global equity fund will own more listed companies, but the
individual weighting of each company in the fund may be
smaller. Hence, it may be more diversified than the single
country equity fund, and therefore, it may not be as risky. Note
that, in understanding / assessing the riskiness of any fund, it
is important to see (a) number of companies (investments)
selected, which says a lot about the diversification; and (b) the
riskiness of individual companies selected. The interaction and
co-relation of these two factors will affect the overall riskiness
of the fund.
While an equity fund has a higher risk, it has historically performed better than
other types of unit trusts in the long run. In general, the investors will expect
to receive higher return for investments with higher risks. The additional return
represents the premium for the additional risk undertaken by the investors.
Hence, this type of unit trust is typically more suited to investors with longer
time horizon, being able to withstand short-term volatility, as owing to their
higher volatility nature, the unit trust may perform negatively during certain
periods. As illustrated in Chapter 6, on the returns of USA stocks from 1969
to 2009, the risks associated with stock investments have decreased as the
investment time horizon increased. However, the reader should take note of
the caveats in investing over a long-term horizon, as explained in Chapter 6.
2.2 Fixed Income Fund
A fixed income fund invests predominantly in fixed income securities. An
investor in a fixed income fund is a part owner of the underlying fixed income
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securities in the fund. The total return from a fixed income fund comes from
the coupon payments, as well as appreciation in the prices of the underlying
securities. The prices of the underlying fixed income securities will change
(increase or decrease) in response to the changes (decrease or increase) in the
market interest rate. As fixed income securities tend to involve bonds, the
fixed income funds are also referred to as bond funds.
As in an equity fund, the risk level associated with
each fixed income fund may vary, depending on the
risk and concentration of fixed income securities
that it owns. The risks of fixed income securities
are dependent on the credit quality of the issuers
and the duration of the underlying securities, as
well as the economic environment, which will affect
the level and movement / trend of market interest
rate.
Issuers of fixed income securities may be classified into corporate and
sovereign issuers. International credit rating agencies such as Moodys,
Standard & Poor and Fitch IBCA usually have credit rating for major issues.
The credit rating is assigned based on the risk of possible default. Issuers with
lower credit ratings are considered more risky than those with higher credit
ratings, while corporate issues are generally considered to be more risky than
sovereign issues (owing to the default risk of corporations). Fixed income
securities with longer duration are also considered to be more risky as
compared to those with shorter duration, because their prices are more
sensitive to changes in interest rate. Also, the longer duration will imply
increased exposure to the risk of changes in interest rates and default risk.
Duration is the cash-flow-weighted average term to maturity of the fixed
income security. Other things being equal, a lower coupon fixed income
security has a longer duration than a higher coupon fixed income security,
because more cash flow is paid out further into the future (note that the face
amount is paid out at maturity of the fixed income security). A diversified fixed
income fund, such as a global bond fund, has in general a lower level of
investment risk, because the fund is more diversified over different countries /
areas and different industries / sectors, when compared to a fixed income fund
invested in emerging markets.
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8. Fund Products
Major risks of fixed income funds include the following:

(a) Interest Rate Risk
This is the risk that rising interest rates may lead to a fall in the market
price of the fixed income security. Duration is a
measure of a fixed income securitys market price
sensitivity to interest rate movements. Prices of
fixed income securities with a longer duration are
more sensitive to changing interest rates. In
general, fixed income securities with longer
maturity dates and with lower coupon rates (and
hence, coupon payments) tend to have a longer
duration.
(b) Credit Risk
This is the risk that the issuer may default on coupon payments and / or
principal repayments. It is directly related to the credit-worthiness and
business risks (nature of business and quality of management, etc.) of the
issuer.
(c) Reinvestment Risk
This is the risk that the coupon income can only be reinvested at lower
yields when the coupons are received, owing to the changing interest rate
and economic environment.
In general, a fixed income fund tends to be less volatile in terms of its market
prices, when compared to an equity fund. Hence, its relevance to investors
overall investment portfolio tends to become more important as their time
horizon becomes shorter (e.g. approaching retirement), since investors will
need to cash out on some of the investments to cover the needs for cash and
living, as well as other expenses.
The following chart is the yearly return on the G7 government bonds over a
25-year period (from 1985 to 2009). During this period, the geometric mean
rate of return is 7.54%. Note that negative return occurred only in one out of
the 25 years. However, it is interesting to also note of the number of months
where there was a drop in bond index, and hence, negative return (not shown
in chart) over the 25-year period is 78, or 26% of the time (78 / 300 months).
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Although bond returns are typically not measured on a monthly basis, the
statistics serve to illustrate the potential volatility in the bond return over the
months owing to changes in the economic environment / market and interest
rates.
In view of this volatility in month-to-month return, the price of fixed income
funds may still be subject to fluctuations, albeit not as much as equity funds.
On the other hand, if the unit holders have holding power and do not intend to
trade the units on a fixed income fund regularly to realise gains or losses, this
will be of a lesser concern.
Source: Citigroup
2.2.1 Collateralised Debt Obligation (CDO)

Collateralised Debt Obligation (CDO) is a form of financial instrument
which may provide income to its investors. It is a form of asset-backed
security (ABS) which consists of many layers or tranches. These are
typically being issued by special purpose entities (SPE). An ABSs value
and income is derived from its underlying assets. By pooling these
underlying assets into financial instruments, and in turn, selling these
instruments to general investors, allow the risk of investing in the pool
to be diversified. This is because each security will now only represent
a fraction of the total value of the diverse pool of underlying assets.
These underlying assets may include payments from credit cards, car
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8. Fund Products
loans, residential mortgages, commercial mortgages, cash flows from

aircraft leases, royalty payments, movie revenues, etc. Some of these
assets may even include small or illiquid assets that are unable to be
sold on an individual basis. CDO may vary in structure and underlying
assets, but the basic principle is the same.
SPE plays the role of creating and selling these underlying assets. SPE
will normally bundle these assets to market and suit the risk
preferences or other needs of investors who may want to buy the
securities, example for the purpose of managing credit risk. The sale
proceeds will be paid back to the financial institution that created or
originated the respective underlying assets. By bundling and selling to
many investors, the credit risk of the underlying assets is transferred to
another holder. The originating financial institution therefore removes
these underlying assets from their balance sheet and receives cash for
it. This transaction may potentially increase the financial institutions
credit rating, which is advantageous in various ways. In this case, the
credit rating of the ABS will be based only on
the assets and liabilities of the SPE, and this
rating can be higher than if the originating
financial institution issued the securities. The
risk of the ABS will no longer be associated
with other risks that the originating financial
institution may bear once it goes through a
SPE. A higher credit rating will also allow the
SPE to pay a lower interest rate (or charge a
higher price) on the ABS than if the
originating financial institution borrowed
funds or issued bonds. In short, the originating financial institution
removes risky assets from their balance sheets by having another party
to take on this credit risk. The originating financial institution receives
cash in return and is able to channel more of their capital to new loans
or other assets and investments. It may also have a lower capital
requirement due to a good credit rating.
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CDOs will pay the cash flow to investors by tranches / levels. This cash
flow depends on the amount the CDO is able to collect from its
underlying assets. If the amount collected is less than then amount to
be paid to the investors, the CDO will pay the
higher (Senior) tranches / levels first. In this
manner, the investors in the lower (Junior)
tranches / levels will not receive any cash flow
and may suffer losses.
CDOs were very popular between 2000 till
2006, and the demand volume was growing
very fast. However, during the subprime
mortgage crisis in 2007, this demand declined
dramatically largely due to the fact that many of
the CODs underlying assets were subprimemortgage-backed securities. With a drop in
demand, the CDOs are no longer funded and this lead the collapse of
certain structured investments held by major investment banks.
Bankruptcy of several subprime lenders also took place, and Lehman
Brothers was one of them.
Valuation of a CDO is on a mark to market basis. When the subprime
market collapsed, the value plunged as the banks had to write down the
value of their CDO holdings. In some structures, the assets held by one
CDO consisted entirely of another tranche of an existing CDO in the
market. This explained the domino effect at that period of time and
why some CDOs became entirely worthless. This was because there
was no sufficient cash flow from the underlying subprime mortgages
(many of which defaulted) to fund even the first tranches.
The risk and return for a CDO investor depends directly on how the
tranches were defined, and only indirectly on the underlying assets. The
investment depends on the assumptions and methods used to define
the risk and return of the tranches. CDOs, like all asset-backed
securities, enable the originators of the underlying assets to pass credit
risk to another institution or to individual investors. Thus, investors
must understand how the risk for CDOs is calculated.
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8. Fund Products
2.3 Balanced Fund

A balanced fund invests in both equity and fixed income securities. The
relative weighting between equity and fixed income securities may vary
according to the strategy employed by the fund manager. If they are bullish on
the equity market, the proportion invested in equities will be higher and vice
versa. A balanced fund attempts to strike a balance between long-term capital
growth (equity) and recurrent income generation (fixed income security). It has
more limited capital appreciation potential as compared to an equity fund, but
provides a higher degree of safety (in terms of lower default risks and lower
volatility, and lower chances of losses in assets / unit values) and moderate to
high income potential. The risks associated with balanced funds are
proportionately related to the weighting in equities and fixed income securities.
2.4 Money Market Fund
Money market fund invests in short-term fixed-income instruments that have
less than one year of maturity, such as bank certificates of deposit,
commercial paper, and Treasury bills. Some of these instruments have a
minimum lot size of at least S$250,000. Thus, some retail investors will find
that investing in each of them individually is prohibitive. A money market fund
provides an avenue for retail investors seeking higher rates through money
market instruments, as compared to the fixed or savings deposit rates.
Investors in money market funds normally do not pay a sales charge or a
redemption charge, but they do pay a management fee. A money market fund
provides investors a low-risk investment alternative to cash rates.
In general, the risk associated with a money market fund is quite minimal,
owing to the fact that its underlying securities have less than a year to
maturity, and in general, the relatively better credit
quality associated with the underlying security. Also,
because of the short duration and lower yield level as a
start, these securities are not very sensitive to interest
rate changes. However, they are still subject to credit
risk of the underlying securities.
The money market fund has grown in popularity recently owing to the
historically low interest rates, and the relatively lower returns on bank
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deposits. It is appropriate for investors seeking capital preservation, while

looking for a better rate of return as compared to bank deposits.
2.5 Umbrella Fund
An umbrella fund refers to a set of funds with different
investment objectives offered by a single fund
management company. Umbrella funds generally permit
their investors to switch from one fund to another within
the family, at little or no cost. This feature allows the
investor to change his investment strategy as the need
arises, without incurring high transaction costs.
An umbrella fund may be a combination of equity, fixed
income and money market funds that are managed by
that fund management company.
2.6 Feeder Fund
These are unit trusts that invest directly or feed into existing offshore unit
trusts (known as the parent fund) established elsewhere. This fund has two
layers of fees - one for the feeder fund and another for the parent fund. If the
feeder fund charges a management fee of 0.75% per annum and the parent
fund charges 1.5%, the unit holders end up paying 2.25% in total. Like any
other unit trust, a feeder fund has a Singapore-based manager and a trustee.
Previously, some foreign funds in Singapore were not offered directly to the
public, because they did not meet the requirements of the Companies Act
(Cap. 50). This requirement was put in place, so that the funds would be
subject to jurisdiction of the Singapore courts. Investors could seek legal
recourse locally in the event of a legal dispute. Hence, feeder funds were
offered as an alternative to gain exposure to these foreign funds.
To cut down on the additional layer of fees, the authority has allowed funds
denominated in foreign currencies that are regulated and supervised in a
manner comparable to Singapore to be offered locally. These funds may be
included under the CPF Investment Scheme, so long as they meet the criteria
as set by the CPF Board. These include the fund manager being included under
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8. Fund Products
the CPF Investment Scheme, and the foreign fund passing an evaluation by the
investment consultant appointed by CPF Board. With the changes, existing
feeder funds may continue as they are, or they may be wound up and the
units held by investors in the feeder fund exchanged for units in the recognised
foreign fund.
The most common type of feeder fund is equity fund. Hence, this is subject to
similar risk and return characteristics as any other equity fund. However, there
are also feeder funds that feed into hedge and / or fixed income funds.
2.7 Index Fund And Exchange Traded Funds (ETF)
An index fund is designed to track the performance of a specific market index.
The fund is passively managed in a fairly static portfolio and is always fully
invested in the securities of the index that it tracks. If the overall market
advances, the index fund will match the market appreciation. When the market
declines, so will the index fund. The attractions of such a fund are its low
management fees and low transaction cost in managing
the fund. The management fees of index funds are
significantly lower than those charged by active
managers for other types of funds.
An index fund is usually an equity fund. Hence, this is
subject to similar risk and return characteristics as an
equity fund. Examples of the index fund include
Exchange Traded Fund (ETF) and Exchange Traded
Note (ETN).
2.7.1 Exchange Traded Fund (ETF)
Exchange Traded Fund is an investment fund that tracks an index of
markets and sectors, or a fixed basket of stocks. It can be traded like a
stock on an exchange. Most ETFs are bundled together with the
securities that are in an index. Some ETFs known as synthetic ETFs
will hold financial derivatives instruments to replicate the index rather
than the actual securities that are in the index.
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Investors can do just about anything with an ETF that they can do with
a normal stock, such as short selling (however, see note at the end of
this section]. Since ETFs are traded on stock exchanges, they can be
bought and sold at any time during the day (unlike most unit trusts).
Their price will fluctuate from moment to
moment, just like any other stock price. An
investor will need a broker in order to purchase
them, which means that he will have to pay a
commission.
On the plus side, ETFs are more cost-efficient
than normal unit trusts. Since they track indices,
they have very low operating and transaction
costs associated with them. There are no sales
loads or investment minimums required to purchase an ETF. The first
ETF created was the Standard and Poor's Deposit Receipt (SPDR,
pronounced "Spider") in 1993. SPDRs gave investors an easy way to
track the S&P 500 without buying an index fund, and they soon
became quite popular.
ETFs offer investors the benefit of diversification as investors need only
to buy an ETF share to gain exposure to a diversified portfolio of
domestic or international stocks. ETFs have low annual management
fees. Investors may buy or sell ETFs at prevailing market prices during
trading hours in the relevant stock exchange. Besides cost efficiency,
ETFs also provide the benefit of transparency and flexibility. Investors
can access and monitor information on the ETF prices, and trade ETFs
throughout the trading day. Moreover, they can employ the traditional
techniques of stock trading, including stop-loss orders, limit orders,
margin purchases, etc. Investors are also able to see what stocks that
they are buying, as ETFs offer transparency in its composition.
Investors can track the ETF's performance by monitoring the particular
underlying index's performance. In this sense, ETFs provide an efficient
way for investors to invest in the stock market.
It should be noted that, in Singapore, some brokerage houses have
recommended that ETFs be bought by investors using margin accounts
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8. Fund Products
(that is, without paying for the full cost upfront). ETFs can be short sold
with the use of CFDs (contracts for difference).
In considering using CFD and margin account,
investors should exercise care and be aware of
the risks involved. CFD is a complex financial
derivative, and margin account can be highly
leveraged. The investors can be caught and may
be short of cash if markets move in a somewhat
erratic fashion.
Other risks associated with ETFs are (a)
Investing in ETFs with longer than the Intended
Tracking Period; (b) Market Risk; (c) Counterparty Risk; (d) Tracking
Error Risk (The risk that the ETFs performance is markedly different
from the index that it is tracking); (e) Market Price not reflecting NAV;
(f) Foreign Exchange Risk; and (g) Liquidity Risk.
2.7.2 Structuring Of ETF
Investors should first of all note that not all ETFs have the same
structure and level of complexity.
ETFs can be structured differently to track the same underlying index,
and they may not invest directly in the assets or components of the
indices that the ETFs track. For example, some ETFs replicate the index
by investing in the indexs component stocks. Others may invest in a
representative sample of stocks from the index that they are designed
to track. In view of this, the ETFs may not be able to replicate the
returns of the underlying asset or index as closely as others.
Consequently, some ETFs may be exposed to more risks than others.
Some ETFs come with more complex structures. They may even use
swaps and participatory notes, in addition to holding a basket of
representative stocks or collateral. Depending on the structure of the
ETF, the risk elements may differ greatly among ETFs. Hence, the use
of swaps and notes exposes the ETF to counterparty risk from the
swap counterparty or participatory note issuer.
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2.7.3 Examples Of ETF

The objective of an ETF is to track a specific benchmark, such as a
stock or commodity index or commodity price. Here are some examples
of assets or indices tracked by ETFs that are available on the Singapore
Exchange (SGX): (a) commodity and commodity index; (b) bond index;
and (c) equity.
(a) Commodity and commodity index - These ETFs are intended to
provide exposure to only one type of commodity or a basket of
closely related commodities. As such, they may not be as
diversified as ETFs linked to a broad-based equity index.
(b) Bond index ETFs can also track a specific bond index, and
provide exposure to the fixed income market.
(c) Equity - There are two types of equity ETF, the long stock index
ETFs and inverse (short) index ETFs. Long index ETFs track
closely the movement of some indices and is expected to gain by
the similar margin as the gain in the index. On the other hand,
inverse (short) index ETFs track the movement of a short index.
The short index moves inversely to its
corresponding long index on a daily basis.
Note that these ETFs are generally not
intended for long-term investments and are
generally not suitable for retail investors
who plan to hold them for longer than one
day, particularly not in volatile markets.
2.7.4 Exchange Traded Note (ETN)
Although similar to ETFs, ETN is actually a type
of structured product and issued as a senior
unsecured debt security, combining features of an ETF and a bond. It is
linked to and tracks the total return of a market index. ETNs are not
only traded on an exchange such as SGX, but also can come with a
maturity date, like bonds. The returns for an ETN is based upon the
performance of a particular market index, and its value is affected by
many things, including changes in the credit rating of the party that
issued the ETN.
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8. Fund Products
ETN is issued by a third-party financial institution over a wide range of

assets. It combines both the benefits and risks common to investments
in bonds and exchange-traded funds (ETFs). Like an ETF, ETN returns
are meant to track the performance of the underlying assets, such as an
equity index, commodity price, currency exchange rate, etc, minus
investor fees. Like a bond, the value of the ETN depends on market
factors, as well as the credit rating of the issuer. Hence, it gives retail
and institutional investors a chance to gain exposure to a broad range
of commodities.
The ETNs are suitable for investors who seek
to invest in a debt instrument, where the
returns are linked to the performance of the
index underlying the ETNs. Investors should
be aware that an investment in ETNs will
subject them to the issuers credit risks.
The benefits of ETFs include (a) Ease of Access; (b) Intraday Exchange
Liquidity; (c) Transparent Performance Tracking. The risks of investing
in ETNs include (i) Credit Risk of issuer; (ii) Liquidity Risk; (iii) Market
Risk; and (iv) Foreign Exchange Risk.
2.8 Hedge Fund
A hedge fund aims to achieve absolute returns in any market condition. It is
different from traditional funds as described above in the following ways. The
investment objective of a traditional fund is related to the benchmark that it
has adopted. Hence, the returns tend to be highly correlated with the returns
of that benchmark.
In general, a hedge fund is open to a limited range of investors or wealthy
investors (hedge funds are restricted under the USA law to less than 100
investors who typically put in a minimum of US$1 million each).
It also pays a performance fee to its investment manager. Every hedge fund
has its own investment strategy that determines the type of investments and
the methods of investment that it undertakes. Hedge funds, as a class, invest
in a broad range of investments, including shares, debt, real estates, and
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commodities (that are unlikely to all) move in the same direction. The goal of
diversification is to reduce the risk in a portfolio. Volatility is limited by the fact
that not all asset classes or industries or individual companies move up and
down in value at the same time, or at the same rate. Diversification reduces
both the upside and downside potential, and allows for more consistent
performance under a wide range of economic conditions.
This provides them with an exemption in many
jurisdictions from regulations governing short selling,
derivatives, leverage, fee structures and the liquidity
of interests in the fund, in comparison to the
investment and trading activities of other investment
funds. This, along with the performance fee and the
fund's open-ended structure, differentiates a hedge
fund from an ordinary investment fund.
As the net asset value of a hedge fund can run into many billions of dollars,
and the gross assets of the fund will usually be higher due to leverage. Hedge
funds dominate certain specialty markets, such as trading with derivatives,
with high-yield ratings and distressed debt. As the name implies, hedge funds
often seek to hedge some of the risks inherent in their investments using a
variety of methods, most notably short selling and derivatives. However, the
term "hedge fund" has also come to be applied to certain funds that do not
hedge their investments, and in particular, to funds using short selling and
other "hedging" methods to increase rather than reduce risk, with the
expectation of increasing the return on their investment.
2.8.1 Hedge Fund Characteristics
(a) Investment Objective
Hedge fund employs a variety of investment strategies, asset
classes and financial instruments to achieve absolute returns in all
market conditions. The investment objective of a traditional fund is
related to the benchmark that it has adopted. Hence, the returns
tend to be highly correlated with the returns of that benchmark.
(b) Fee Structure
It is common for a hedge fund to have a performance fee of up to
20% of the excess return of the fund over a specified absolute
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8. Fund Products
return. This is in addition to the usual annual management fee of

1% to 2%. On the other hand, a traditional fund rarely has a
performance fee as part of its fee structure.
(c) LockIn Period
There are no rules governing a certain level of liquidity
in a hedge fund. In fact, most of its investments may
be invested in securities that are highly illiquid. Hence,
a hedge fund has guidelines on redemptions, such as
requiring advance notice to be served, before hedge
fund investors can redeem their investments. This is to
allow the manager time to liquidate his investment to
meet redemption needs. Traditional funds are usually
invested in securities that are highly liquid.
(d) Use Of Leverage
Unlike traditional funds, a hedge fund has provisions to use
leverage in order to gear up the portfolio.
(e) Specialisation
Most hedge funds specialise in some narrowly defined investment
strategies. A description of some of the common strategies is given
below. As a result, the underlying securities tend to have
concentrated bets in the direction of the market one way or
another.
2.8.2 Some Common Investment Strategies Used By Hedge Funds
The common investment strategies used by hedge funds include the
descriptions below.
(a) Long / Short Equity
This is a relative strategy that involves going long on a segment of
the market that is likely to perform better than another market
segment. There are many ways to define market segments, such as
value versus growth, USA market versus European market,
technology sector versus healthcare sector, emerging market banks
versus developed market banks. A long / short strategy may be
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implemented by using stocks (where facilities exist for shorting) or

by using index derivatives.
(b) Event-Driven
The managers take significant position
in companies undergoing special
situation, such as mergers and
acquisitions, corporate restructuring or
companies whose share price is trading
at distressed level without fundamental
justification.
(c) Fixed-Income Arbitrage
This is a fixed income strategy, whereby the manager strives to
arbitrage on price anomalies between related fixed income
securities. Such anomalies may include large / unusual spread in the
yields between government and corporate bonds, emerging and
developed market bonds, etc.
(d) Global Macro
The manager takes long or short position in the financial market to
reflect his views on economic trends or events. The shorting of
emerging Asia equities and selling of Asian currencies, following the
devaluation of the Thai Baht in 1997, is an example of a global
macro strategy. The strategy can be executed using equities,
bonds, currencies or commodities.
(e) Convertible Arbitrage
This strategy involves taking a position in a convertible security and
an offsetting position in its underlying equities. An example of a
convertible arbitrage is buying the convertible bond of UOB Bank
and simultaneously shorting (i.e. selling) its underlying equities.
Such a strategy can generate profit from the relative spread
between the price of the convertible and the underlying equities.
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8. Fund Products
2.8.3 The Risks Of Hedging Fund Investing

It should be emphasised that investing in a hedge fund can be
exceptionally risky. It employs aggressive leverage to multiply gains (or
losses) from fluctuations in the prices of financial instruments (bonds,
notes, securities, etc). In Singapore, hedge funds
are quite well regulated. For example, the
Monetary Authority of Singapore (MAS) regularly
surveys the hedge fund industry in Singapore to
evaluate the Singapore banking sectors
exposure to hedge funds. It has also regularly
reviewed and revised the guidelines for retail
hedge funds.
In general, Singapore's approach to regulating hedge funds is riskfocused and differentiated, balancing the potential benefits with the
risks that hedge funds can pose to the financial system. Also, hedge
fund managers are regulated like any other fund manager that manages
third-party funds. MAS's regulatory oversight of the marketing of hedge
funds is focused on retail investors, as retail investors may not be
familiar with the differences between a hedge fund and a typical
collective investment scheme, especially so, when funds of hedge
funds and other hedge fund-linked products are increasingly being
marketed to the retail market.
Although heavily regulated, hedge funds may still suffer from huge
losses, when the market turns against it owing to the reasons as
mentioned below. This is all the more obvious when the value of hedge
funds has dropped by a huge percentage, since the global recession got
underway in 2008 / 2009:
highly concentrated bets taken by the manager;
holding of illiquid securities may further aggravate losses, when there
is no orderly asset-clearing prices;
requirement of lock-up period suggests that investors cannot redeem
their investments at short notice, even when they are convinced that
the market has further downside;
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use of leverage subjects the hedge fund to greater risk; or

lucrative performance fee encourages excessive risk-taking, without
adequate coverage of the risks by the fund manager, as seen in the
2008 / 2009 recession that is linked to the sub-prime mortgage crisis
in the USA.
2.8.4 Fund Of Hedge Funds (FOHFs)
A fund of hedge funds is where the portfolio is constructed by selecting a
number of other hedge funds to invest in. How the underlying hedge
funds are chosen can vary. A fund of hedge funds
may invest only in hedge funds using a particular
management strategy. Or, a fund of hedge funds
may invest in hedge funds, using many different
strategies in an attempt to gain exposure to all of
them.
The benefit of owning any fund of fund is a team of
experienced
management
and
diversification
between funds. A portfolio manager uses his
experience and skill to select the best underlying funds based on past
performance and other factors. If the portfolio manager is talented, this
can increase return potential and decrease risk potential, since putting
your eggs in more than one basket may reduce the dangers associated
with investing in a single hedge fund.
Given that most hedge funds have prohibitively high initial minimum
investments, a fund of hedge funds can theoretically provide investors
access to a number of the countrys best hedge funds, with a relatively
smaller investment. For example, investing in five hedge funds with a
minimum subscription amount of S$100,000 per fund will require
S$500,000. Investing in a fund of hedge funds that invests in those same
underlying funds may require just S$100,000.
In fact, it may even require less. Sometimes a fund of hedge funds will
invest in only one hedge fund, but offer shares at a much lower initial
minimum investment that the underlying hedge fund does. This gives
investors access to an acclaimed fund with less cash than normally
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8. Fund Products
required. The minimum subscription amount can at times be as low as

S$20,000.
One disadvantage of investing in a fund of hedge funds is the fees. These
funds generally charge a fee for their services in addition to the fees
charged by the underlying hedge funds. In other words, each underlying
hedge fund will charge a fee of 1% to 2% of assets under management
and a performance fee of 15% to 25% of profits
generated. On top of that, a fund of hedge funds
will typically charge its own fees.
In summary, funds of hedge funds may be
appealing to investors seeking the high return
potential of hedge funds, along with some
diversification to help manage risk and lower
investment minimums. Just like any other
investments, do make sure that you know the
risks and fees before investing.
3.
INNOVATIVE UNIT TRUST INVESTMENT SCHEMES

During the unpredictable and volatile market conditions that characterised the late
1990s and early 2000s (low interest rates, and dismal performance of asset
classes, such as equity and fixed income securities), investors increasingly sought
out new approaches to investing that offered both security and potential growth. It
was under this background that financial engineering and innovation in the fields of
finance and investment brought about new product features, such as capital
guarantee and capital protection.
These innovative unit trusts aim to preserve the capital of investors and at the same
time enhance the returns that they would have otherwise earned from keeping their
money in bank deposits. Consequently, there had been a number of new products
being created, packaged and pushed into the market, often with fanciful names, like
Principal Protected Notes and Guaranteed Linked Notes.
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3.1 Capital Guaranteed Fund

Under the capital guaranteed fund, the principal amount invested in the fund
is guaranteed by a financial institution at the end of a three to five-year period
or longer. Investors who cash out before its maturity will not be entitled to
capital guarantee. A substantial portion of the underlying assets in a
guaranteed fund comprises mainly good quality fixed income securities known
as zero-coupon bonds (which are essentially bonds
that do not have coupons). The remainder is
invested in long-dated derivative instruments that
provide higher return to the fund upon its maturity,
assuming the derivative instrument is in the money
(i.e. profitable) by then.
Take for instance a capital guaranteed fund with a
fund size of S$100 million and matures in five years.
Further assume that the yield on good quality fixed income securities is 3%
per annum over the next five years. The minimum amount of principal that
needs to be invested today to generate S$100 million in five years time will
be:
S$100m
(1 + 0.03)5
= S$86.26m
Assuming that the projected fees (such as custodian, trustee and management
fees) aggregated to S$5m over the 5-year period, the remaining amount that
can be used to buy into some derivative instruments to provide for potential
upside to the fund is up to S$8.74 m (S$100m S$86.26m S$5m =
S$8.74m). The derivative instrument may be an option on the STI Index that is
customised by an investment bank to suit the maturity profile of the fund. If at
the end of the 5-year period, the STI Index is higher than the strike price of the
option, investors in the fund will enjoy higher return. If the STI Index is lower
than the strike price of the option, the option will expire worthless. In this
case, investors will still get back their principal from the portion invested in the
fixed income securities.
The risk of such fund lies in credit default in any of its holdings. However,
such a risk can be reduced by diversifying the underlying securities, going with
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8. Fund Products
underlying securities of very good quality, or investing more than the minimum
amount needed to generate the principal at the end of the guarantee period.
However, the latter is usually not advisable, as this will be costly and make the
economics and return on the product not as attractive. The final protection to
investors will be to call on the guarantee.
The guaranteed fund trades at its Net Asset Value (NAV) before its maturity.
Investors who cash out before the end of the maturity of the fund will do so at
the prevailing NAV. This can be above or below the principal amount. At
maturity, if the NAV is above the principal, investors will cash out at the NAV.
On the other hand, if the NAV at maturity is less than the principal, the
investors will receive the principal amount as guaranteed.
3.2 Capital Protected Fund
This is similar to a capital guaranteed fund, except that the principal amount
is not guaranteed. Instead, the fund is protected by its investment in high
quality fixed income securities (e.g. sovereign bonds). In the event that the
NAV of the fund is below that of the principal at maturity, investors will still
get back their principal, unless there is a default in one or more of the fixed
income securities that the fund is invested in.
The return profile of capital protected fund is similar to that of
the guaranteed fund, so long as the NAV is above the principal
amount. However, when the NAV is lower than the principal
amount, the investors in a capital protected fund may face
some downside risk, depending on how the fund is structured.
There are also products in the market protecting only a portion
of the principal (e.g. 90%), but not the full amount.
There are many innovative features on such funds. Such features usually
revolve around the pattern of cash flow accruing to the investors during the
tenure of the fund. For example, some funds pay a pre-determined rate of
return during the tenure of the fund. Others attempt to lock-in some capital
gains, if any, on the derivative instrument on a yearly basis.
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3.2.1 Prohibition On The Use Of The Term Capital / Principal Protected

Having explained the concept of capital protected fund above, it
should, however, be noted that with effect from 8 September 2009,
the use of the term capital protected or principal protected or any
other derivative or form of this term in all disclosure documents, and
sales and marketing materials would be prohibited.
In the process, MAS has solicited definitions for capital protected and
principal protected. Unfortunately, the suggested definitions tend to
be quite lengthy and not easily understandable by the investors.
Furthermore, investors may not understand that a number of conditions
need to be satisfied, before they may receive in
full their principal at maturity. In view of the
lack of an agreed definition of such terms that
could be clearly and easily understood by the
investors, MAS had proceeded with the ban.
This was also specified in the April 2011
release of the Code on Collective Investment
Scheme.
Having made the above decision, MAS stressed
that the prohibition does not intend to
discourage the selling of products structured
with the objective of returning full principal to the investors at maturity.
However, issuers and distributors should highlight to the investors that
these products would not unconditionally guarantee the return at
maturity of their principal amounts invested.
Details of the revised Code are specified in the MAS website which
should be visited for guidance from time to time at:
http://www.mas.gov.sg/Regulations-and-Financial-Stability/RegulationsGuidance-and-Licensing/Securities-Futures-and-FundsManagement/Codes.aspx. The revised Code is also covered in CMFAS
Module 5 Rules and Regulations for Financial Advisory Services
published by the Singapore College of Insurance.
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8. Fund Products
4.
INVESTMENT TRUST, REAL ESTATE INVESTMENT TRUST (REIT) AND BUSINESS

TRUSTS
4.1 Investment Trust
Investment trust is a company formed for the purpose of investing in
securities. In that respect, it is similar to a unit trust in that the funds are
professionally managed. However, it differs from a unit trust in the following
ways:
(a) It Has No Independent Trustee
The legal title of all its assets is vested in the company. The board of
directors safeguards the interests of shareholders in an investment trust.
(b) The Capital Fund Of The Trust Is Fixed
In other words, an investment trust is a closed-ended fund, as compared
to a unit trust which is usually open-end. In the case of a closed-ended
fund, the capital fund is fixed. For every buyer in a share of the
investment trust, there must be a seller. Buying and selling of investment
trust are done just like in any other shares as listed in the stock exchange.
An investment trust usually trades at a discount to its underlying assets.
This can be due to any of the following reasons:
the trading in the shares of investment trust is
illiquid;
the investment trust may not be managed in a
way in which the risk-return of the fund is
maximised. This can happen, for example,
when the investment trust is used to invest in
companies related to the trust; or
the investment trust is tightly held. Hence,
minority investors cannot seek to break up the trust, in order to realise
the value of the underlying assets.
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4.2 Real Estate Investment Trust (REIT)

A REIT is a specialised form of investment trust. It is an investment vehicle,
where the funds of individual investors are pooled together to invest /
purchase and manage income property (equity REIT) and / or mortgage loans
(mortgage REIT). A REIT can thus be classified as equity, mortgage or hybrid.
REITs are traded on major stock exchanges just like stocks. They are also
granted special tax considerations. REITs offer several benefits over actually
owning properties. First, they are highly liquid, unlike traditional real estate.
Second, REITs enable sharing in non-residential
properties as well, such as hotels, malls, and other
commercial or industrial properties. Third, there is
no minimum investment with REITs. REITs do not
necessarily increase or decrease in value along with
the broader market. However, they may pay yields
in the form of dividends, when the underlying
property and loans generate net income or profits. REITs can be valued based
upon fundamental measures, similar to the valuation of stocks.
In many respects, a REIT is similar to any unit trust, like in providing the
benefits of diversification, professional management, affordability and liquidity.
Yet, a REIT can be different from a typical unit trust in the following ways:
(a) It requires a wider range of specialists to manage. A REIT manager has to
be more hands-on and knowledgeable, as he is involved in the actual
running and operation of the properties which he buys into;
(b) Its market value is determined by the demand and supply of its shares in
the stock exchange. Unit trust, on the other hand, trades at its net asset
value; and
(c) It pays a substantial portion of the surplus to investors. This surplus is
determined after deducting the income generated from its underlying
properties, and all relevant expenses necessary to maintain the property.
There are different types of REITs. They can be sector-specific. For example,
they are invested only in office properties. Alternatively, it can be a hybrid
with investments in different sectors of property, such as offices, retail and
industrial warehouses. REITs are long-term investments and are subject to the
180
8. Fund Products
ups and downs of the property cycle. Like other corporations, REITs can be
publicly or privately held. Public REITs may be listed on stock exchanges like
shares of common stocks in other firms. Equity REITs invest in and own
properties (thus responsible for the equity or value of their real estate assets).
Their revenues come principally from their properties' rents. Mortgage REITs
deal in investment and ownership of property mortgages.
These REITs loan money for mortgages to owners of real
estate, or purchase existing mortgages or mortgage-backed
securities. Their revenues are generated primarily by the
interest that they earn on the mortgage loans. Hybrid REITs
combine the investment strategies of equity REITs and
mortgage REITs by investing in both properties and
mortgages.
There are 22 REITs listed on the SGX since 1 June 2011,
starting with CapitaMall Trust in July 2002. They represent a
range of property sectors, including retail, office, industrial,
hospitality and residential. These REITs hold a variety of properties in
countries, including Japan, China, Indonesia and Hong Kong, in addition to
properties in Singapore. REITs also enjoy tax-advantaged position in Singapore.
In return, they are required to distribute 90% of their income, which may be
taxable in the hands of the investors. From the above description, it can be
seen that the REIT structure is designed to provide a similar structure for
investment in real estate, like unit trusts provide for investment in stocks.
4.2.1 Factors Which Affect Returns On REITs
Unit holders of REITs are subject to similar risks as holders of other
diversified asset portfolios. Some of the factors which affect returns on
REITs are:
(a) A rise or decline in the general level of real property prices can
adversely affect the value of a REIT. The overall depth and liquidity
of the real estate market and other assets in which REITs are
invested may fluctuate and can correspondingly affect the depth
and liquidity of trading in REITs;
(b) A rise or decline in rental income will affect the distribution that the
REITs are able to return to the investors, and this will affect the
value of the REIT;
181
(c) The overall performance or expected performance of the real estate

industry and other related industries;
(d) The general economic climate and outlook;
(e) Wear and tear, and disasters which damage
physical real estate assets owned by the
REITs;
(f) Substantial increase or fall in interest rates,
making a listed REIT less or more attractive
as an investment instrument;
(g) Professionalism and experience affecting the performance of the
property management firm;
(h) Quality of assets owned by the REITs, essentially affecting
sustainability and stability of revenues; and
(i)
Laws and taxation changes affecting real estate property prices

which may impact returns on the REITs. REITs participating in
properties or investments outside Singapore may be subject to the
risks of fluctuations in currency values, differences in generally
accepted accounting principles, or local economic or political events
in the countries in which those properties or investments are
located.
4.3 Business Trusts1

Business trusts offer investors a new way to invest in cash-generating assets.
Business trusts are business enterprises set up as trusts, instead of
companies. They are hybrid structures with elements of both companies and
trusts.
Like a company, a business trust operates and runs a business enterprise.
However, unlike a company, a business trust is not a separate legal entity. It is
created by a trust deed under which the trustee has legal ownership of the
Source: www.sgx.com
182
8. Fund Products
trust assets and manages the assets for the benefit of the beneficiaries of the
trust.
Purchasers of units in the business trusts, being beneficiaries of the trust, hold
beneficial interest in assets of the business trust.
While REITs are regulated as property funds under the Code on Collective
Investment Schemes, business trusts are governed by the Business Trusts Act
(Cap. 31A) under a different regime.
One of the key differences between business trusts
and REITs is that business trusts are premised on a
single responsible entity, namely the TrusteeManager. Whereas in the case of REITs, while the
assets are legally owned by the trustee, they are
managed by a separate asset manager, more like unit
trusts and mutual funds.
The shares in the trustee-manager will likely be owned by the sponsor of the
business trust, which is likely to sponsor the trust by injecting assets into the
business trust. The trustee-manager will raise funds from public investors, by
issuing business trust units in an initial public offering. The proceeds from the
initial public offering, together with any borrowings will be used to acquire the
trust assets.
The trustee-manager of business trusts thus has dual responsibility of
safeguarding the interests of unit holders and managing the business trusts.
This stems from the difficulty in apportioning the fiduciary responsibility
between two roles given the nature of business trusts as active enterprises.
To address any potential conflict of duties of the trustee-manager to the
shareholders of the trustee-manager and to the unit holders of the business
trust, the Business Trust Act (Cap. 31A) stipulates higher requirement on
corporate governance.
Another key difference is in taxation. While REITs with Singapore assets are
tax-transparent investment structure focused on real estate assets, business
trusts are like companies, subject to the Income Tax Act (Cap. 134). However,
183
certain assets or businesses that enjoy tax benefits under the Income Tax Act
(Cap. 134) will continue to enjoy these benefits.
4.3.1 Benefits And Risks Of Investing In Business Trusts2
Business trusts allow investors to have a direct exposure to cash flowgenerating assets, such as utilities, shipping or aircraft. The structure
unitises big ticket assets into liquid and affordable units which are
traded on the Singapore Exchange, giving investors a new alternative to
existing yield plays.
Business trusts typically have high payout ratios because of its ability to
distribute cash flows in excess of accounting profits. This imposes
discipline on the trustee-manager when considering acquisitions.
In addition to maintaining the payout, trustee-manager as the
responsible entity is also expected to actively manage the business for
growth via acquisitions and expansion, to enhance returns to the
investors. The incentives of the trust-managers are typically structured
to align their interests with the unit holders.
The risks of investing in business trusts will largely
depend on the kind of assets and investment focus
that the business trust has. These include, but are
not limited to, risks that the value of the units may
fluctuate and that the projected distributions may
not be achieved, as well as other risks. Investors
should carefully read the prospectus and seek
advice from the relevant professionals in evaluating
any potential investments in business trusts.
Source: www.sgx.com
184
Table 1: Future Value Interest Factors For One Dollar
Table 1
Future Value Interest Factors For One Dollar
FVSS Factor = (1 + i)n where i = rate and n = periods

i=
0.5%
1%
1.5%
2%
2.5%
3%
3.5%
4%
4.5%
5%
n=1
1.0050
1.0100
1.0150
1.0200
1.0250
1.0300
1.0350
1.0400
1.0450
1.0500
1.0100
1.0201
1.0302
1.0404
1.0506
1.0609
1.0712
1.0816
1.0920
1.1025
1.0151
1.0303
1.0457
1.0612
1.0769
1.0927
1.1087
1.1249
1.1412
1.1576
1.0202
1.0406
1.0614
1.0824
1.1038
1.1255
1.1475
1.1699
1.1925
1.2155
1.0253
1.0510
1.0773
1.1041
1.1314
1.1593
1.1877
1.2167
1.2462
1.2763
1.0304
1.0615
1.0934
1.1262
1.1597
1.1941
1.2293
1.2653
1.3023
1.3401
1.0355
1.0721
1.1098
1.1487
1.1887
1.2299
1.2723
1.3159
1.3609
1.4071
1.0407
1.0829
1.1265
1.1717
1.2184
1.2668
1.3168
1.3686
1.4221
1.4775
1.0459
1.0937
1.1434
1.1951
1.2489
1.3048
1.3629
1.4233
1.4861
1.5513
10
1.0511
1.1046
1.1605
1.2190
1.2801
1.3439
1.4106
1.4802
1.5530
1.6289
11
1.0564
1.1157
1.1779
1.2434
1.3121
1.3842
1.4600
1.5395
1.6229
1.7103
12
1.0617
1.1268
1.1956
1.2682
1.3449
1.4258
1.5111
1.6010
1.6959
1.7959
13
1.0670
1.1381
1.2136
1.2936
1.3785
1.4685
1.5640
1.6651
1.7722
1.8856
14
1.0723
1.1495
1.2318
1.3195
1.4130
1.5126
1.6187
1.7317
1.8519
1.9799
15
1.0777
1.1610
1.2502
1.3459
1.4483
1.5580
1.6753
1.8009
1.9353
2.0789
16
1.0831
1.1726
1.2690
1.3728
1.4845
1.6047
1.7340
1.8730
2.0224
2.1829
17
1.0885
1.1843
1.2880
1.4002
1.5216
1.6528
1.7947
1.9479
2.1134
2.2920
18
1.0939
1.1961
1.3073
1.4282
1.5597
1.7024
1.8575
2.0258
2.2085
2.4066
19
1.0994
1.2081
1.3270
1.4568
1.5987
1.7535
1.9225
2.1068
2.3079
2.5270
20
1.1049
1.2202
1.3469
1.4859
1.6386
1.8061
1.9898
2.1911
2.4117
2.6533
21
1.1104
1.2324
1.3671
1.5157
1.6796
1.8603
2.0594
2.2788
2.5202
2.7860
22
1.1160
1.2447
1.3876
1.5460
1.7216
1.9161
2.1315
2.3699
2.6337
2.9253
23
1.1216
1.2572
1.4084
1.5769
1.7646
1.9736
2.2061
2.4647
2.7522
3.0715
24
1.1272
1.2697
1.4295
1.6084
1.8087
2.0328
2.2833
2.5633
2.8760
3.2251
25
1.1328
1.2824
1.4509
1.6406
1.8539
2.0938
2.3632
2.6658
3.0054
3.3864
26
1.1385
1.2953
1.4727
1.6734
1.9003
2.1566
2.4460
2.7725
3.1407
3.5557
27
1.1442
1.3082
1.4948
1.7069
1.9478
2.2213
2.5316
2.8834
3.2820
3.7335
28
1.1499
1.3213
1.5172
1.7410
1.9965
2.2879
2.6202
2.9987
3.4297
3.9201
29
1.1556
1.3345
1.5400
1.7758
2.0464
2.3566
2.7119
3.1187
3.5840
4.1161
30
1.1614
1.3478
1.5631
1.8114
2.0976
2.4273
2.8068
3.2434
3.7453
4.3219
35
1.1907
1.4166
1.6839
1.9999
2.3732
2.8139
3.3336
3.9461
4.6673
5.5160
40
1.2208
1.4889
1.8140
2.2080
2.6851
3.2620
3.9593
4.8010
5.8164
7.0400
45
1.2516
1.5648
1.9542
2.4379
3.0379
3.7816
4.7024
5.8412
7.2482
8.9850
50
1.2832
1.6446
2.1052
2.6916
3.4371
4.3839
5.5849
7.1067
9.0326
11.4674
185

i=
5.5%
6%
6.5%
7%
7.5%
8%
8.5%
9%
9.5%
10%
n=1
1.0550
1.0600
1.0650
1.0700
1.0750
1.0800
1.0850
1.0900
1.0950
1.1000
1.1130
1.1236
1.1342
1.1449
1.1556
1.1664
1.1772
1.1881
1.1990
1.2100
1.1742
1.1910
1.2079
1.2250
1.2423
1.2597
1.2773
1.2950
1.3129
1.3310
1.2388
1.2625
1.2865
1.3108
1.3355
1.3605
1.3859
1.4116
1.4377
1.4641
1.3070
1.3382
1.3701
1.4026
1.4356
1.4693
1.5037
1.5386
1.5742
1.6105
1.3788
1.4185
1.4591
1.5007
1.5433
1.5869
1.6315
1.6771
1.7238
1.7716
1.4547
1.5036
1.5540
1.6058
1.6590
1.7138
1.7701
1.8280
1.8876
1.9487
1.5347
1.5938
1.6550
1.7182
1.7835
1.8509
1.9206
1.9926
2.0669
2.1436
1.6191
1.6895
1.7626
1.8385
1.9172
1.9990
2.0839
2.1719
2.2632
2.3579
10
1.7081
1.7908
1.8771
1.9672
2.0610
2.1589
2.2610
2.3674
2.4782
2.5937
11
1.8021
1.8983
1.9992
2.1049
2.2156
2.3316
2.4532
2.5804
2.7137
2.8531
12
1.9012
2.0122
2.1291
2.2522
2.3818
2.5182
2.6617
2.8127
2.9715
3.1384
13
2.0058
2.1329
2.2675
2.4098
2.5604
2.7196
2.8879
3.0658
3.2537
3.4523
14
2.1161
2.2609
2.4149
2.5785
2.7524
2.9372
3.1334
3.3417
3.5629
3.7975
15
2.2325
2.3966
2.5718
2.7590
2.9589
3.1722
3.3997
3.6425
3.9013
4.1772
16
2.3553
2.5404
2.7390
2.9522
3.1808
3.4259
3.6887
3.9703
4.2719
4.5950
17
2.4848
2.6928
2.9170
3.1588
3.4194
3.7000
4.0023
4.3276
4.6778
5.0545
18
2.6215
2.8543
3.1067
3.3799
3.6758
3.9960
4.3425
4.7171
5.1222
5.5599
19
2.7656
3.0256
3.3086
3.6165
3.9515
4.3157
4.7116
5.1417
5.6088
6.1159
20
2.9178
3.2071
3.5236
3.8697
4.2479
4.6610
5.1120
5.6044
6.1416
6.7275
21
3.0782
3.3996
3.7527
4.1406
4.5664
5.0338
5.5466
6.1088
6.7251
7.4002
22
3.2475
3.6035
3.9966
4.4304
4.9089
5.4365
6.0180
6.6586
7.3639
8.1403
23
3.4262
3.8197
4.2564
4.7405
5.2771
5.8715
6.5296
7.2579
8.0635
8.9543
24
3.6146
4.0489
4.5331
5.0724
5.6729
6.3412
7.0846
7.9111
8.8296
9.8497
25
3.8134
4.2919
4.8277
5.4274
6.0983
6.8485
7.6868
8.6231
9.6684
10.8347
26
4.0231
4.5494
5.1415
5.8074
6.5557
7.3964
8.3401
9.3992
10.5869
11.9182
27
4.2444
4.8223
5.4757
6.2139
7.0474
7.9881
9.0490
10.2451
11.5926
13.1100
28
4.4778
5.1117
5.8316
6.6488
7.5759
8.6271
9.8182
11.1671
12.6939
14.4210
29
4.7241
5.4184
6.2107
7.1143
8.1441
9.3173
10.6528
12.1722
13.8998
15.8631
30
4.9840
5.7435
6.6144
7.6123
8.7550
10.0627
11.5583
13.2677
15.2203
17.4494
35
6.5138
7.6861
9.0623
10.6766
12.5689
14.7853
17.3796
20.4140
23.9604
28.1024
40
8.5133
10.2857
12.4161
14.9745
18.0442
21.7245
26.1330
31.4094
37.7194
45.2593
45 11.1266
13.7646
17.0111
21.0025
25.9048
31.9204
39.2951
48.3273
59.3793
72.8905
50 14.5420
18.4202
23.3067
29.4570
37.1897
46.9016
59.0863
74.3575
93.4773
117.391
186
Table 1: Future Value Interest Factors For One Dollar

i=
10.5%
11%
11.5%
12%
12.5%
13%
13.5%
14%
14.5%
15%
n=1
1.1050
1.1100
1.1150
1.1200
1.1250
1.1300
1.1350
1.1400
1.1450
1.1500
1.2210
1.2321
1.2432
1.2544
1.2656
1.2769
1.2882
1.2996
1.3110
1.3225
1.3492
1.3676
1.3862
1.4049
1.4238
1.4429
1.4621
1.4815
1.5011
1.5209
1.4909
1.5181
1.5456
1.5735
1.6018
1.6305
1.6595
1.6890
1.7188
1.7490
1.6474
1.6851
1.7234
1.7623
1.8020
1.8424
1.8836
1.9254
1.9680
2.0114
1.8204
1.8704
1.9215
1.9738
2.0273
2.0820
2.1378
2.1950
2.2534
2.3131
2.0116
2.0762
2.1425
2.2107
2.2807
2.3526
2.4264
2.5023
2.5801
2.6600
2.2228
2.3045
2.3889
2.4760
2.5658
2.6584
2.7540
2.8526
2.9542
3.0590
2.4562
2.5580
2.6636
2.7731
2.8865
3.0040
3.1258
3.2519
3.3826
3.5179
10
2.7141
2.8394
2.9699
3.1058
3.2473
3.3946
3.5478
3.7072
3.8731
4.0456
11
2.9991
3.1518
3.3115
3.4785
3.6532
3.8359
4.0267
4.2262
4.4347
4.6524
12
3.3140
3.4985
3.6923
3.8960
4.1099
4.3345
4.5704
4.8179
5.0777
5.3503
13
3.6619
3.8833
4.1169
4.3635
4.6236
4.8980
5.1874
5.4924
5.8140
6.1528
14
4.0464
4.3104
4.5904
4.8871
5.2016
5.5348
5.8877
6.2613
6.6570
7.0757
15
4.4713
4.7846
5.1183
5.4736
5.8518
6.2543
6.6825
7.1379
7.6222
8.1371
16
4.9408
5.3109
5.7069
6.1304
6.5833
7.0673
7.5846
8.1372
8.7275
9.3576
17
5.4596
5.8951
6.3632
6.8660
7.4062
7.9861
8.6085
9.2765
9.9929
10.7613
18
6.0328
6.5436
7.0949
7.6900
8.3319
9.0243
9.7707
10.5752
11.4419
12.3755
19
6.6663
7.2633
7.9108
8.6128
9.3734
10.1974
11.0897
12.0557
13.1010
14.2318
20
7.3662
8.0623
8.8206
9.6463
10.5451
11.5231
12.5869
13.7435
15.0006
16.3665
21
8.1397
8.9492
9.8350
10.8038
11.8632
13.0211
14.2861
15.6676
17.1757
18.8215
22
8.9944
9.9336
10.9660
12.1003
13.3461
14.7138
16.2147
17.8610
19.6662
21.6447
23
9.9388
11.0263
12.2271
13.5523
15.0144
16.6266
18.4037
20.3616
22.5178
24.8915
24 10.9823
12.2392
13.6332
15.1786
16.8912
18.7881
20.8882
23.2122
25.7829
28.6252
25 12.1355
13.5855
15.2010
17.0001
19.0026
21.2305
23.7081
26.4619
29.5214
32.9190
26 13.4097
15.0799
16.9491
19.0401
21.3779
23.9905
26.9087
30.1666
33.8020
37.8568
27 14.8177
16.7386
18.8982
21.3249
24.0502
27.1093
30.5414
34.3899
38.7033
43.5353
28 16.3736
18.5799
21.0715
23.8839
27.0564
30.6335
34.6644
39.2045
44.3153
50.0656
29 18.0928
20.6237
23.4948
26.7499
30.4385
34.6158
39.3441
44.6931
50.7410
57.5755
30 19.9926
22.8923
26.1967
29.9599
34.2433
39.1159
44.6556
50.9502
58.0985
66.2118
35 32.9367
38.5749
45.1461
52.7996
61.7075
72.0685
84.1115
98.1002
114.338
133.176
40 54.2614
65.0009
77.8027
93.0510
111.199
132.782
158.429
188.884
225.019
267.864
45 89.3928
109.530
134.082
163.988
200.384
244.641
298.410
363.679
442.840
538.769
50 147.270
184.565
231.070
289.002
361.099
450.736
562.073
700.233
871.514
1083.66
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Module 8: Collective Investment Schemes (4th Edition)

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Capital Markets

& Financial Advisory

Collective Investment Schemes

Photocopying or reproducing this study guide partly

2011 by Singapore College of Insurance Limited. All rights reserved.

The objectives of the CMFAS Module 8 Collective Investment Schemes examination

Organisation Of Study Guide

Chapter 6: Discusses the important factors to consider when planning for an

Please refer to the SCI Website (www.scicollege.org.sg/ebook.asp) for the latest

We would like to express our appreciation and gratitude to Mr Andrew Ng, a

Study Guide Features

CHAPTER 1 TYPES OF INVESTMENT ASSETS I ............................................ 1

CHAPTER 4 RISK AND RETURN .................................................................. 72

CHAPTER 3 FINANCIAL MARKETS .............................................................. 57

CHAPTER 5 TIME VALUE OF MONEY ........................................................ 104

8. Risk-Adjusted Investment Returns

CHAPTER 7 UNIT TRUSTS ........................................................................ 139

2.6 Feeder Fund

VERSION CONTROL RECORD

1. Types of Investment Assets - I

TYPES OF INVESTMENT ASSETS I

KEY LEARNING POINTS

cash and their equivalent bank deposits and time deposits

money market instruments Treasury Bills, Bankers Acceptance and Certificate of

fixed income securities / long-term debt instruments

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Module 8: Collective Investment Schemes

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1. Types of Investment Assets - I

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Module 8: Collective Investment Schemes

include Treasury Bills, Bankers Acceptance and Certificate of Deposit,

Deposits in a savings account;

1. Types of Investment Assets - I

Moneys held in bank deposits under the CPF Investment Scheme

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Module 8: Collective Investment Schemes

(a) Treasury Bills

(b) Bankers Acceptance And Certificate Of Deposit (CD)

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1. Types of Investment Assets - I

(c) Commercial Paper

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Module 8: Collective Investment Schemes

2.1.4 Disadvantages Of Investing In Money Market Instruments

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1. Types of Investment Assets - I

Bond issues of governments and businesses typically are quality rated by

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Module 8: Collective Investment Schemes

Debenture an unsecured promise based only on the issuer's general

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1. Types of Investment Assets - I

Fixed income securities may be classified by the currency in which it is

(a) Interest Rate Risk

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Module 8: Collective Investment Schemes

(b) Default Risk

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1. Types of Investment Assets - I

of the bond. When multiplied by the principal or face value of the

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Module 8: Collective Investment Schemes