10 Principles of investment planning Flashcards
How is correlation expressed in a correlation matrix?
A decimal fraction e.g. 1.00 or 0.25
What happens if you select assets with low correlation to each other?
The portfolio’s overall volatility is reduced
What are the two principal approaches to asset allocation?
Theoretical (MPT) and pragmatic
What is stochastic modelling?
Models the outcomes of random changes in variables, generates probabilistic assessment
What are some variables used in stochastic modelling?
Inflation, interest rates
When considering risk capacity, what is an investment drawdown?
Maximum historic loss on proposed portfolio over relevant timeframe
In portfolio construction, what are the 3 essential pieces of data for a potential investment?
Return, volatility and correlation
What is top-down investment management?
Weight regions -> weight regional sectors -> select individual stocks
What is bottom-up investment management?
Managers select stocks based purely on their own criteria
Are top-down or bottom-up portfolios typically more volatile?
Bottom-up
What are the four most widely recognised fund management styles?
- Value
- GAARP
- Momentum
- Contrarianism
What is the ‘value’ fund management style?
Use analysis to identify under-valued businesses
What type of funds typically adopt a ‘value’ management style?
Equity income; income & growth
What is the ‘GAARP’ fund management style?
Find reasonably-priced areas with growth potential
What type of funds typically adopt a ‘GAARP’ management style?
Active growth
What is the ‘momentum’ fund management style?
Relies on tendency for both good + bad performance to persist
What is an example of ‘momentum’ fund management?
Sector rotation: tendency of sectors to do well at different points in economic cycle
What is the ‘contrarianism’ fund management style?
Buck trends to achieve high returns, taking advantage of the majority’s excessive optimism/pessimism
What type of funds typically adopt a ‘contrarian’ management style?
Hedge funds
What is a structured product?
Uses derivatives to limit capital risk in return for a lock-in period of up to 6 years
For a structured product, what is ‘hard protection’?
A given return is guaranteed
For a structured product, what is ‘soft protection’?
Capital is at risk if a certain threshold is breached e.g. if the index drops 50%
How might an adviser use a structured product within a portfolio?
The structured product is low risk so it’s safer for the rest of the portfolio to take on risk
What type of risk is involved with structured products?
Counterparty i.e. failure of the institution from which derivatives are bought
What does TCO stand for?
Total cost of ownership
What detail does the FCA require if a fund advertises its past performance?
Discrete year-by-year performance
Which are more volatile, open or closed-ended funds?
Closed, as they may be geared & the premium/discount to NAV can change
Which are better suited to illiquid asset classes, open or closed-ended funds?
Closed, as it may not be possible to sell illiquid assets in volumes required to meet redemptions in open-ended funds
What is one place to identify companies with strong ESG practices?
FTSE4Good Index Series
How are tracker funds structured?
Usually ETFs but can be investment trusts, unit trusts or OEICs
What are the two ways an ETF can track an index?
‘Physically’ (by holding stocks) or ‘synthetically’ (using derivatives)
When selecting a passive fund, does it matter which index it tracks?
Yes, especially for specialised asset classes like high-yield bonds or private equity
What are the main tax wrappers to consider?
- Collective investments (OEICs etc.)
- ISAs
- Personal pensions / SIPPS
- Life assurance bonds (UK/offshore)
Who benefits the most, relatively, from tax relief on pension contribitons?
Higher & additional rate taxpayers
What tax wrappers often involve little or no additional costs?
ISAs
What tax wrappers usually involve additional fees?
Life assurance bonds and pensions
Where possible, is it better to hold investments so that they are subject to CGT or income tax? Why?
CGT, because:
1. The annual exempt amount is high (£12,300)
2. Rates are lower (especially for higher & additional rate taxpayers)
3. Losses are easier to offset against gains
What does PCLS stand for?
Pension commencement lump sum
What does SIPP stand for?
Self-invested personal pension
What happens if a personal pension provider fails?
100% of the claim is protected by FSCS, with no upper limit
What happens if a SIPP operator fails?
FSCS covers the claim up to £85,000 per person, per firm
What are UK qualifying life policies / maximum investment plans used for?
Accumulating funds that are free of higher/additional rate tax after ten years of contributions
What are the drawbacks of a UK qualifying life policy / maximum investment plan?
- Inflexibility during build-up period
- Annual contributions capped at £3,600
How can tax shelter benefits of UK investment bonds be maximised?
Arrange for investor to be a basic-rate taxpayer in the year of encashment
What is an advantage of offshore investment bonds?
They are not subject to UK tax so should grow faster
What is a disadvantage of offshore investment bonds?
There is no tax credit on encashment for the insurance company’s tax
When are offshore investment bonds worthwhile?
When the investor expects to become non-resident in the UK
Before 2014, how did platform fees work?
The fee was part of the product provider’s ongoing charge, which they rebated to the platform provider
Since 2014, why does the FCA require platform fees to be paid separately & directly?
To improve remuneration transparency and help consumers compare platforms
What is the exception to the FCA’s platform fee rule?
The product provider can pay a rebate to the platform provider IF it is passed on to the consumer in the form of additional units
What is one potential issue with third-party discretionary management services?
If the assets are held in the client’s name, the manager’s actions can trigger CGT liabilities
In the case of authorised funds, what happens if the fund manager goes bust?
The underlying assets are held by an independent custodian, so there is no risk
What is included in an investment policy statement?
- Investment objectives
- Constraints on portfolio management
True or false: the investment policy statement is required by the FCA
True
When are legal constraints on investment most likely to arise?
When the portfolio is being managed for trustees
Why would a defined benefit (DB) pension fund need exposure to real assets (equities, property)?
So it can increase in value in line with salaries/inflation over the very long term
What are good ways to hedge inflation risk?
- Index-linked bonds
- Inflation swaps
True or false: pension funds are subject to corporation tax
False
What are some reasons to revise an investment policy statement?
Changes in:
1. client circumstances
2. regulations
3. taxation
4. market environment (long-term)
What are typically the principal items in an investment manager’s report to a client?
- Purchases & sales
- Portfolio valuation & cash statements
- Market commentary & comparisons to benchmarks
- Recommended strategy changes
How often must portfolio reporting to investors be carried out?
At least every 6 months
In investment management, contract notes…
Should be prepared & dispatched immediately after each purchase & sale
True or false: individual holdings are itemised in a client’s portfolio report
True
What is a churn?
A switch of investments where the primary aim is to generate income for the adviser
If a trust deed has no specific investment powers, what governs the trustees?
Trustee Act 2000
What powers does Trustee Act 2000 give?
Invest as your own provided you have regard to standard suitability & diversification criteria
Besides those covered by the investment policy statement, what constraints might a manager have?
General house policies e.g. no derivatives, no gearing
What are the categories of overall investment objective?
- Capital growth
- Income
- Balance
What are the general risk classifications?
- Lower / secure
- Medium / balanced
- Higher / adventurous
What are typical investments for a lower risk / secure portfolio?
- Cash
- Fixed-interest with credit rating at least A
What are typical investments for a medium-risk / balanced portfolio?
- Larger listed UK/overseas companies
- Unit trusts, OEICs & investment trusts
- Some medium-sized/smaller UK companies
What are typical investments for a higher-risk / adventurous portfolio?
- Smaller / unlisted companies
- Alternative investments
What are the main factors affecting investment strategy?
- Legal constraints
- Nature of liabilities
- Cash flow
- Taxation
What does a strong positive cash flow into a portfolio mean for a manager?
They can take a long-term view & accept short-term uncertainty / losses
What should a manager do as a client approaches retirement?
Take less risk & focus on income over capital gains (e.g. fixed-income over equity)
What affects investment strategy more frequently – changes in regulation or changes in taxation?
Changes in taxation
True or false: investment strategies should respond to short-term changes in market environment
False. Long-term strategies only respond to long-term changes
What are examples of changes in the market environment?
Changes to risks of & relationships between asset classes
What causes new products & services to emerge?
Regulatory & tax changes
How can an advisor decide if complex new products & services are appropriate investments?
3rd-party advice or external services
True or false: means & frequency of client reporting must be agreed in writing
True, usually in business letter given to clients
What is included in a contract note?
- Bargain date & settlement date
- Who purchase was made for
- Number & price of shares
- Full name of share
- Charges including stamp duty/SDRT
How often are summary portfolio evaluations usually issued?
Quarterly
What does a summary portfolio evaluation include?
- Value at date of last report
- Addition of cash/stock
- Reduction by each withdrawal
- Appreciation or depreciation
- New value & date
What tiers of reports do clients receive?
- Regular report (at least every 6 months)
- Summary portfolio evaluation (usually every 3 months)
- Contract notes (after every purchase / sale)
What are some legitimate reasons for switching an investment?
- Change in client circumstances / objectives
- Clear instruction from client
- Change in market conditions
- Medium/long-term underperformance
- Value of investment is returned in takeover / capital restructuring
What is one implication of cashing in an investment bond?
CGT implications for higher- and additional-rate taxpayers
What is one way to avoid/reduce CGT liabilities?
Transfer asset to spouse before disposing of it
Which is longer, a KID or a KIID?
KID
What is the main difference between a KID and a KIID?
A KID includes forward-looking performance scenarios
Do KIDs include the OCF or the TER?
OCF only
What is the difference between OCF and TER?
The TER includes the OCF plus performance fees, trustee fees etc.
Are performance fees included in OCF or TER?
TER only
Are entry & exit fees included in OCF or TER?
Neither
Are dealing costs included in OCF or TER?
Neither
Are brokerage charges included in OCF or TER?
Neither
Are annual management fees included in OCF or TER?
Both
Are legal & audit fees included in OCF or TER?
Both
Which is newer, KID or KIID?
KID
What sort of investments can be cum/ex dividend?
Bonds
When does a bond become ex dividend?
7 working days before distribution
What does the xd in xd period stand for?
Ex-distribution
What does xd period mean in practice?
Simply that the investment’s price is likely lower than it would usually be
What kid of investment might involve a dilution levy?
OEIC
What are the FCA rules about dilution levies?
None
Who decides when to apply a dilution levy?
The ACD
When are dilution levies applied?
During unusually large inflows or outflows of funds
How is a dilution levy applied?
Added to purchase price or deducted from redemption price
What are the three basic types of life insurance?
- Endowment (pays out on maturity or if you die during term)
- Term (pays out only if you die during term)
- Whole-life (pays out whenever you die)
True or false: annuity income is exempt from income tax
False
True or false: drawndown withdrawals are exempt from income tax
False
What happens to unspent drawdown when you die?
It can be passed on free of IHT
What does standard deviation measure?
Volatility i.e. how widely the actual return varies around its average / expected return
What is the designation for standard deviation?
Sigma (σ)
When data is normally distributed, how often do returns fall within 1 σ?
68% of the time
When data is normally distributed, how often do returns fall within 2 σ?
95% of the time
When is σ an acceptable measure of risk?
When the returns form a “normal” (symmetrical, bell-shaped) distribution
What is the market’s ß?
1
What is an aggressive security?
It has ß > 1
What is a defensive security?
It has ß between 0 and 1
What does CAPM stand for?
Capital asset pricing model
What does CAPM calculate?
Expected return = risk-free return plus a risk premium based on ß
