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Babble deflated the UITF bubble

(Article published in the June 21, 2006 issue of Manila Standard Today)  

To the industry players, the surprise was wonderful. To the Bangko Sentral ng Pilipinas (BSP), it was a flashing yellow light, but, at the moment, still not a reason to step on the brakes.  In both cases, the growth of the UITF was surprisingly phenomenal.

At the end of March last year, funds invested in UITFs amounted, in value, to just around Php 26 billion.  After one quarter, the volume went up by about 39% to Php 36 billion, and then by 70% to Php 61, after two. When 2005 ended, UITFs  had a quarterly growth of 98% with the value of Php 120 billion. And in the first quarter of 2006, the funds were at Php 262 billion.   

Then, by the end of April, 2006, the UITF, like Daedalus and Icarus, raced to the sun at just short of Php 279 billion.  But suddenly its wings appeared to be of feathered wax melting in the summer heat. By the end of May, the UITFs were down to Php 175 billion.  Both industry players and the BSP now fear that, unless some modern parachute blooms for it in mid-air, the UITF just might end up, like its Grecian prototypes, in the open sea.

 It is easy to see, from the 20-20 vision of hindsight, what caused the wax to melt.  Interest rates abroad were going up but local rates were steady, if not going down.  Hence, foreign instruments became more attractive than local ones.  Then a spate of negative news relentlessly spewed out from the media. In no particular order: tax collection targets were not met, rating agencies were not willing to grant us upgrades, VAT on oil, it was floated about, was planned to be lifted, coups were said to be about to be in the offing, and, closer to home, some things with the UITF itself needed some fine tuning (thus suggesting to the paranoid something must be seriously amiss).

 It was a month of all bad news, even if, thank God, it was not in May that the still President have her diarrhea, after having dinner with the First Gentleman.  No one luckily was reported to have had dinner with Mike A. that month. 

 When the local interest rates moved up as the month entered its second half, the you-know-what hit the fan.  And everyone ran for cover.  With the mark-to-market rules requiring UITFs to report the decrease in the market value of their holdings, nervous investors in UITFs primarily invested in fixed income instruments withdrew their units.  Fund managers had to sell their assets.  The sale of bonds further cheapened the commodity, lowering Net Asset Value per units of the fixed-income UITFs.The more the UITFs sold, the more the price of their remaining assets went down and the higher the interest rate went up.  Investors became more jittery and so forth and so on. 

 The withdrawal wave appears to have subsided, but, prudentially, the trust industry and the BSP are talking of what lessons to learn from the Fall and what to do to keep the UITFs in steady flight.  Some suggest intensifying the efforts to educate the investors, upgrading the training of the marketers, adjusting the product features so as to insulate the investor from the dangers of being waylaid by short-term developments from his long-term objectives, allowing the UITFs access to similar liquidity facilities, primarily from the BSP, available to banks when they experience extraordinary problems, etc.

 Without detracting from the curative as well as palliative value of those measures, permit me to suggest that the problem of the UITF last month was not that the heat melted its waxen wings; the problems is that the UITF took flight with wings of wax.

 At root, the UITF bubble burst because, I submit, of the loose articulation of what a UITF was.  Like its predecessor, the common trust fund, the most important word in its name is what is represented by the “T”, namely, trust.  “Trust” is its principal driver.  The “U” and the “I” in UITF, like “common”, in common trust funds, are supporting casts.  Somehow sometime, we forgot that only because clients have funds entrusted with trust entities  that the need arose for a vehicle for collective investment of those funds.  And the legal journey from the former to the latter is worth recalling at this time.

  The primary obligation of a trustee who has in his hands some funds, under ancient but still controlling equity law, is, negatively, not to keep it idle, and positively, to make it productive.  The servant who buries the talents in the ground, as the Gospel says, is not a good steward.

 The reality of the modern financial market, however, is that size matters.  It is the big funds that get the discounts in costs and the premiums in prices.  “Economies of scale”, my economists friends always say to introduce some voodoo mystery into their mundane descriptions of the obvious.

 The obvious solution was to allow a narrow exception to the rule that trust funds cannot be commingled with other funds, whether trust or non-trust, to permit, small trusts and excess funds of big trusts, to be placed in one big fund and managed as one.

 Unfortunately, from its humble rationale of being a facility to enable trust departments to fully comply with their duty, the UITF (and its predecessor, the common trust fund) acquired, in practice, the status of an investment outlet in itself.  Thus, clients who had no trust relations with a bank were convinced to acquire units in a UITF, primarily, as an investment outlet, like a deposit, a certificate of stock, or mutual fund share, on the basis of the prospect of fruits of successful investment of the collective fund.  In short, a client opens a trust, not because he needs a trust, but only in order to avail himself of a UITF’s prospects.  What became primary is the investment aspect, the “I” in UITF, and only secondary is the decision to set up a trust.

 Remember those good old days when being able to make a call while on the go and unable to use a land line was the reason for having a cellular  phone?  Today, of the many functions of your cell, such as texting, e-mailing, picture-taking, sound-blasting, news taking, how often do you use it to make a voice call?

 The same reversal happened, in the Philippines, to collective trust investment facilities.  The tail is now wagging the dog. The UITF has become an investment instrument on its own and the trust relation was relegated to a mere formal requirement, if not, an annoying inconvenience, like your appendix.

 Loose talk about its nature, I submit, is at the root of many difficulties regarding the UITF.

 Failing to see that UITFs are essentially limited to trusts managed by trust entities in the exercise of their fiduciary function, the mutual fund industry appears batting for similar rules in order to, pardon the tired expression, “level the playing field.”  Prescinding from the merits of specific proposals, I submit that the promulgation of identical rules is a mistake.  The UITF is essentially governed by the rule of homo prudens; the mutual fund transaction is a matter of caveat emptor.  Obviously, the emptor who has to be prudent is under more caveats than one who need not.  These caveats explain why UITFs, from the outside, seem preferred.

 The amnesia about the motive force behind UITFs is not limited to the private sector.  Last year, the Commissioner of Internal Revenue responded to the National Treasurer’s query on whether common trust funds investing in government securities with maturities of at least five (5) years were exempt from the 20% final withholding tax.  In BIR Ruling No. 003-2005, the BIR made a distinction between “the Funds themselves” and “the investors in those Funds” and pointed out that the tax-free privilege granted to long-term individual investors under Sec. 24(B)(1) of the Tax Code is available to individuals only and not to the funds.

 The fact, however, is that a common trust fund (now a UITF) like a co-ownership, or a professional partnership, cannot be considered a taxing personality separate and distinct from the trusts that compose it.  Hence, the BIR ruling ought to have resolved the Treasurer’s question on the basis of the nature of the individuals’ trust relation as defined in his trust agreement with the trust entity on which is dependent the common trust fund arrangement.  Not on whether the fund was an individual or not.

 The way UITF is defined under the BSP Circular No. 447-04  appears similarly based, impliedly, on the premise that the funds have lives of their own.  Thus, Section  1, amending Section UX410/U4410Q of the Manual of Regulations defines  UITFs as  “open-ended pooled trust funds denominated in pesos or any acceptable currency, which are operated and administered by a trust entity and made available  by participation…”

 The sense of the definition is that “participation” is the means and the UITF is the end.  That, I submit, is erroneous.  I submit that the primary end is to establish a trust (which is effected by the execution of a participating trust agreement) and the collective investment in the form of the UITF is just one of the many means of executing that trust. 

 Only if we are to return to the original idea behind a UITF can we hope to keep it in flight with wings of steel.  More about this in subsequent issues of this column.