Investment funds: The dynamics of growth

Author: | Published: 1 Apr 2008
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Fund investing is one of the most popular and effective methods of investing in today's world. The Ukrainian national collective investment market has shown positive growth dynamics over the past five years of its development. At the same time, Ukrainian investment funds in other saving instruments (bank deposits, investments in real estate) are still not significant.

In Ukraine, investment funds were first created in 1994. They became an important mechanism of the privatisation process start-up, although the funds were not ready for the classic collective investment. The mass machinations with investment resources brought losses and undermined private investors' credibility. But with renewed confidence in the stock market, investment funds have begun to blossom.

Active development of investment funds in Ukraine only started in 2003 when the classic investment funds (in terms of their nature and functions) were created after the adoption of the Law of Ukraine On Collective Investment Institutions (Unit and Corporate Investment Funds) in 2001. The new law replaced the Decree of the President of Ukraine On Investment Funds and Investment Companies Number 55/94, dated February 19 1994. Under the new rules, investment institutions established under the former rules may continue their operations for the term specified in their statutory documents. By the end of 2007 there were already 834 investment funds established according to the rules of the law.

Ukrainian legislation

In Ukrainian legislation, collective investment institutions are investment funds that conduct collective investment activity, which attracts investors' money with the aim of generating profit from investments into other issuers' securities, corporate rights and real estate. Collective investment institutions may be established in the form of unit and corporate investment funds. A unit investment fund is a pool of assets belonging to investors by right of collective partial ownership, managed by an asset management company and accounted separately from the company's business performance results.

We have to take into account that the unit investment fund is not a legal entity. An asset management company establishes it by selling the fund's investment certificates, which the asset management company issues to investors. At the same time, when signing contracts on the purchase or sale of the fund's assets, the asset management company acts on its own behalf. The asset management company performs accounting of the fund's operations separately from its own business operations and those of other investment funds. This is normal practice. In Ukraine the minimal asset volume of the unit investment fund is 1,250 times the minimum wage, which has been equal to Hrn515 ($103) since January 1 2008.

A corporate investment fund is a legal entity established in the form of an open joint stock company that conducts collective investment activity exclusively. The fund forms its statutory capital, which should be not less than 1,250 times the minimum wage, from cash, government securities and other issuers' securities admitted to trading on a stock exchange, or on a trading and information system, and from real estate; statutory capital may be increased by monetary funds only. At least 70% of the average annual value of its assets should be invested in securities. The asset management company manages the fund (and its assets) on contractual basis. However, the corporate investment fund is a joint stock company and has management bodies, which are the same as those of an open joint stock company – a general shareholders' meeting and a supervisory board. It has no executive body (management board).

The division of the investment funds into unit and corporate does not cover the classification of the funds established in practice or stipulated in the law. Depending on how they carry out their activities, investment funds in Ukraine are divided by law into three types.

1) Open-end: if a fund or an asset management company undertakes to perform, on an investor's demand, a buy-back of shares issued by this investment fund (or the asset management company) at any time.

2) Interval: if a fund or an asset management company undertakes to perform, upon an investor's demand, a buy-back of securities issued by this investment fund (or the asset management company) during the time period specified in the issue prospectus, but at least once per year.

3) Close-end: if a fund or an asset management company does not undertake to buy back the fund's securities until the termination of that fund.

As you can see, Ukraine has in general adopted the common principles of establishing and operating collective investment vehicles. Ukrainian legislation also envisages that the investment fund may be limited or unlimited in time. It stands to reason that close-end investment funds will only be limited in time. As mentioned above, securities issued by open-end funds are readily redeemable, while interval funds redeem their securities within certain periods. Securities of closed-end funds are not redeemable until the winding-up of the fund's operations, but are instead transferable in the secondary market. Between the redemption periods, securities of interval funds may also be traded on a secondary market.

Depending on the asset structure, investment funds are divided into two types: diversified and non-diversified. Diversified investment funds are funds that meet the requirements of their monetary resources to be invested in different capital market instruments. According to the law, monetary funds can be invested exclusively in securities, placed in bank deposit accounts, or in other assets permitted by legislation (not more than 5% of the total asset value). On the other hand, non-diversified investment funds are investment funds that meet no strict requirements to asset diversification. They can invest in real estate and in the statutory capital of a limited liability company. Close-end investment fund may be either diversified or non-diversified, but an open-end and interval investment fund may only be diversified.

More detailed specification of the investment funds based on the asset structure (index funds, equity and bonds funds) is adopted in the practice of asset management companies but is not specially regulated by the law. However, since legislation expressly prohibits collective investment institutions from investing in securities issued by other collective investment vehicles, the establishment of a fund of funds, which is a well-known type of fund in several jurisdictions, is not allowed in Ukraine.

There are also venture investment funds – corporate or unit non-diversified investment funds which should have no less than 50% of assets invested in corporate rights and securities. They are not listed on stock exchanges. Such funds perform only private placements of their securities, and implement a fairly risky investment strategy, often investing in innovation-related projects. Out of 834 investment funds registered in Ukraine, 650 are venture funds. Natural persons may not participate in the venture funds.

Asset management companies

Under Ukrainian legislation, an asset management company is a legal entity that conducts professional activity on the management of assets of collective investment institutions through the licence issued by the Securities and Stock Market State Commission of Ukraine.

Asset management companies establish unit investment funds. Regarding corporate funds, a group of initial investors establishes the fund in the form of an open joint stock company (OJSC) and transfers its assets under the management of the company by a special agreement. Then the asset management company places the securities of the fund and engages agents to place securities among the investors. The company manages the fund's assets: after the money has been transferred to the fund's account, the company directs the managers to purchase assets with the aim of creating a portfolio with the structure of the given investment fund specified in its investment declaration.

The asset management company's reward (except for venture fund asset management companies) shall be set as a ratio to the value of net assets of the respective fund. By contrast, the reward of a venture fund assets management company shall be set as a ratio of the value of distributed issue of investment certificates at their nominal value and the difference between expenses for acquisition of fund assets and income from their sale.

Benefits

Only about 80 investment funds are oriented to attract financial resources from private investors. Most investment funds in Ukraine are used in financing schemes, in particular in the realisation of construction projects. The special tax regime is one of the most significant benefits of using the investment funds not just as special investment vehicles in private projects, but in general.

Ukrainian investment funds are subject to a special set of regulatory, accounting, and tax rules. Unlike most other business entities, the funds are not subject to corporate income tax on income from operations with their assets (for example, on gains from selling the portfolio securities at a profit). Thus the funds provide substantial and straightforward tax incentives for portfolio investment because they enter the market directly. Pursuant to the Ukrainian Law On Corporate Income Tax the income of collective investment institutions from operations with their assets is not subject to corporate income tax. A fund investor's profit is taxable on selling the fund's shares or receiving dividends from the fund. By contrast, any income on or from selling individual securities is taxable in Ukraine. It is worth mentioning that these exceptions do not cover situations when investors sell the securities of the funds to any other person except the fund that issued the securities. The taxation of non-resident capital gains after selling the securities of the fund back to the asset management company has certain specifics. The taxation of each investor should be considered separately. It depends on whether investor is a legal entity or an individual and if there is a Treaty on Avoiding a Double Taxation between Ukraine and the investor's country of tax residence.

The Ukrainian Parliament created another serious motive for developing investment funds (especially venture funds) in December 2005 when it amended the law and established an absolute range of ways to invest in and finance the construction of residential real estate. Since the amendments came into force in January 2006 there are only four safe, mechanisms of investing in construction of residential real estate from the viewpoint of legality. Investing through collective investment institutions is among them.

Another factor that develops collective investment is the legislative requirements aimed at providing investors with a level of safety. Even with the most liberal investment declaration, any fund or asset management company must be registered with the State Securities and Stock Market Commission of Ukraine. There is no unregistered and unregulated fund concept in Ukrainian investment legislation. Besides, in contrast with those investing in individual securities directly, investors of funds are additionally protected by the State Securities and Stock Market Commission of Ukraine, independent property appraisers, auditors and custodians that check all the aspects of the asset management company's actions for prudence, fair and consistent valuations and pricing. Whether it is a corporate or unit fund, the fund's assets are kept and accounted for by a custodian independent from the asset management company, which also ensures that the company adheres to legislative requirements, by-laws and the rules set out in the investment declaration. Asset management companies must give the State Commission periodic reports on the fund's activities, portfolio, asset value, and expenses.

Room for improvement

In trying to make investment through the collective investment institutions safer, the legislator has introduced mandatory rules of diversification of the fund's assets, which have had also negative consequences for the management of assets. Tough rules on diversification of assets make Ukrainian investment funds awkward and non-profitable in crisis conditions. That is why many experts in the investment sphere recommend transforming legislative requirements to the structure of assets into an investment declaration for each particular fund and also expanding the list of permitted financial instruments. The country has about 14,000 open joint stock companies, while as a rule there are shares of less than 20 joint stock companies in portfolios of investment funds. It also seems strange that there is a ban on investments into precious metals, which are a liquid instrument capable of supporting profitability in the event of sharp dips on the stock exchange.

Non-regulation of free migration of investors between investment funds poses another threat: an investor could acquire tax liability during the exchange of securities of one fund for the securities of another fund. There is also a legal conflict. According to the Law On Collective Investment Institutions (Unit and Corporate Investment Funds), there are no provisions for investment funds investing in the securities of foreign issuers.

Taking into account the growth in collective investment institutions in countries with developing stock markets, first of all in Ukraine, we can assume that investment funds sector will also grow in the next five to 10 years. The tendency of deposit interest rates to decrease will be an additional stimulus to redistribution of investment costs in favour of the collective investment market. Investment managers will propose more investment strategies to investors. The state will support these tendencies, which will bring the legal environment up to the standards of world investment practice. This in turn will make investment funds still more popular and attractive, especially for those investors wishing to avoid big risks on the stock exchange.

Author biographies

Iryna Marushko

Lavrynovych & Partners

Ms. Iryna Marushko is a world-renowned lawyer, recognized as a leading expert in corporate law and corporate finance. Prior to becoming a partner at "Lavrynovych & Partners", Iryna practiced law at "Andersen" ("Arthur Andersen"), "Magister & Partners" and White & Case London, holding several senior positions throughout her extensive career.

With over four years at "Andersen", Iryna's practice covered a diverse range of areas such as financial and banking law, international and domestic tax legislation, corporate law, securities law, currency regulation, privatization and real estate. Iryna featured prominently as one of the top lawyers specializing in syndicated lending, structured commodity financing, securities issues (issue of CLN, eurobonds) and other "international market" transactions.,

Iryna has managed and coordinated numerous large-scale tax and legal inspections in the discourse of due-diligence procedures and acquisitions, and has analyzed a range of projects, such as joint activity, as well as establishment, takeover and restructuring of companies.

Iryna holds a summa cum laude degree in law from the Kyiv National Economy University as well as a Master of Laws from the University of London.

Iryna Marushko has held an Attorney's Bar Certificate since 2000.

Konstantin Pilkov

Lavrynovych & Partners

Konstantin Pilkov is a senior associate with Lavrynovych & Partners Law Firm. His main practice areas are corporate law, M&A, foreign investments, real estate and land law. Mr. Pilkov is an author and co-author of several publications on tax law issues, corporate governance, financing, due diligence practice, etc.

Mr. Pilkov graduated summa cum laude degree from the Kyiv National University of Trade and Economics in 2004. Prior to joining Lavrynovych & Partners he worked as a senior associate at a Ukrainian law firm and held position of the head of legal department at a state enterprise.

Konstantin Pilkov has held an Attorney's Bar Certificate since 2007.