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R02 Investment Principles & Risk > 10 Principles of investment planning > Flashcards

10 Principles of investment planning Flashcards

1
Q

How is correlation expressed in a correlation matrix?

A

A decimal fraction e.g. 1.00 or 0.25

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2
Q

What happens if you select assets with low correlation to each other?

A

The portfolio’s overall volatility is reduced

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3
Q

What are the two principal approaches to asset allocation?

A

Theoretical (MPT) and pragmatic

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4
Q

What is stochastic modelling?

A

Models the outcomes of random changes in variables, generates probabilistic assessment

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5
Q

What are some variables used in stochastic modelling?

A

Inflation, interest rates

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6
Q

When considering risk capacity, what is an investment drawdown?

A

Maximum historic loss on proposed portfolio over relevant timeframe

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7
Q

In portfolio construction, what are the 3 essential pieces of data for a potential investment?

A

Return, volatility and correlation

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8
Q

What is top-down investment management?

A

Weight regions -> weight regional sectors -> select individual stocks

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9
Q

What is bottom-up investment management?

A

Managers select stocks based purely on their own criteria

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10
Q

Are top-down or bottom-up portfolios typically more volatile?

A

Bottom-up

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11
Q

What are the four most widely recognised fund management styles?

A
  1. Value
  2. GAARP
  3. Momentum
  4. Contrarianism
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12
Q

What is the ‘value’ fund management style?

A

Use analysis to identify under-valued businesses

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13
Q

What type of funds typically adopt a ‘value’ management style?

A

Equity income; income & growth

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14
Q

What is the ‘GAARP’ fund management style?

A

Find reasonably-priced areas with growth potential

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15
Q

What type of funds typically adopt a ‘GAARP’ management style?

A

Active growth

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16
Q

What is the ‘momentum’ fund management style?

A

Relies on tendency for both good + bad performance to persist

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17
Q

What is an example of ‘momentum’ fund management?

A

Sector rotation: tendency of sectors to do well at different points in economic cycle

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18
Q

What is the ‘contrarianism’ fund management style?

A

Buck trends to achieve high returns, taking advantage of the majority’s excessive optimism/pessimism

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19
Q

What type of funds typically adopt a ‘contrarian’ management style?

A

Hedge funds

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20
Q

What is a structured product?

A

Uses derivatives to limit capital risk in return for a lock-in period of up to 6 years

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21
Q

For a structured product, what is ‘hard protection’?

A

A given return is guaranteed

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22
Q

For a structured product, what is ‘soft protection’?

A

Capital is at risk if a certain threshold is breached e.g. if the index drops 50%

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23
Q

How might an adviser use a structured product within a portfolio?

A

The structured product is low risk so it’s safer for the rest of the portfolio to take on risk

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24
Q

What type of risk is involved with structured products?

A

Counterparty i.e. failure of the institution from which derivatives are bought

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25
Q

What does TCO stand for?

A

Total cost of ownership

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26
Q

What detail does the FCA require if a fund advertises its past performance?

A

Discrete year-by-year performance

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27
Q

Which are more volatile, open or closed-ended funds?

A

Closed, as they may be geared & the premium/discount to NAV can change

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28
Q

Which are better suited to illiquid asset classes, open or closed-ended funds?

A

Closed, as it may not be possible to sell illiquid assets in volumes required to meet redemptions in open-ended funds

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29
Q

What is one place to identify companies with strong ESG practices?

A

FTSE4Good Index Series

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30
Q

How are tracker funds structured?

A

Usually ETFs but can be investment trusts, unit trusts or OEICs

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31
Q

What are the two ways an ETF can track an index?

A

‘Physically’ (by holding stocks) or ‘synthetically’ (using derivatives)

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32
Q

When selecting a passive fund, does it matter which index it tracks?

A

Yes, especially for specialised asset classes like high-yield bonds or private equity

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33
Q

What are the main tax wrappers to consider?

A
  1. Collective investments (OEICs etc.)
  2. ISAs
  3. Personal pensions / SIPPS
  4. Life assurance bonds (UK/offshore)
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34
Q

Who benefits the most, relatively, from tax relief on pension contribitons?

A

Higher & additional rate taxpayers

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35
Q

What tax wrappers often involve little or no additional costs?

A

ISAs

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36
Q

What tax wrappers usually involve additional fees?

A

Life assurance bonds and pensions

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37
Q

Where possible, is it better to hold investments so that they are subject to CGT or income tax? Why?

A

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

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38
Q

What does PCLS stand for?

A

Pension commencement lump sum

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39
Q

What does SIPP stand for?

A

Self-invested personal pension

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40
Q

What happens if a personal pension provider fails?

A

100% of the claim is protected by FSCS, with no upper limit

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41
Q

What happens if a SIPP operator fails?

A

FSCS covers the claim up to £85,000 per person, per firm

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42
Q

What are UK qualifying life policies / maximum investment plans used for?

A

Accumulating funds that are free of higher/additional rate tax after ten years of contributions

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43
Q

What are the drawbacks of a UK qualifying life policy / maximum investment plan?

A
  1. Inflexibility during build-up period
  2. Annual contributions capped at £3,600
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44
Q

How can tax shelter benefits of UK investment bonds be maximised?

A

Arrange for investor to be a basic-rate taxpayer in the year of encashment

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45
Q

What is an advantage of offshore investment bonds?

A

They are not subject to UK tax so should grow faster

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46
Q

What is a disadvantage of offshore investment bonds?

A

There is no tax credit on encashment for the insurance company’s tax

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47
Q

When are offshore investment bonds worthwhile?

A

When the investor expects to become non-resident in the UK

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48
Q

Before 2014, how did platform fees work?

A

The fee was part of the product provider’s ongoing charge, which they rebated to the platform provider

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49
Q

Since 2014, why does the FCA require platform fees to be paid separately & directly?

A

To improve remuneration transparency and help consumers compare platforms

50
Q

What is the exception to the FCA’s platform fee rule?

A

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

51
Q

What is one potential issue with third-party discretionary management services?

A

If the assets are held in the client’s name, the manager’s actions can trigger CGT liabilities

52
Q

In the case of authorised funds, what happens if the fund manager goes bust?

A

The underlying assets are held by an independent custodian, so there is no risk

53
Q

What is included in an investment policy statement?

A
  1. Investment objectives
  2. Constraints on portfolio management
54
Q

True or false: the investment policy statement is required by the FCA

A

True

55
Q

When are legal constraints on investment most likely to arise?

A

When the portfolio is being managed for trustees

56
Q

Why would a defined benefit (DB) pension fund need exposure to real assets (equities, property)?

A

So it can increase in value in line with salaries/inflation over the very long term

57
Q

What are good ways to hedge inflation risk?

A
  1. Index-linked bonds
  2. Inflation swaps
58
Q

True or false: pension funds are subject to corporation tax

A

False

59
Q

What are some reasons to revise an investment policy statement?

A

Changes in:
1. client circumstances
2. regulations
3. taxation
4. market environment (long-term)

60
Q

What are typically the principal items in an investment manager’s report to a client?

A
  1. Purchases & sales
  2. Portfolio valuation & cash statements
  3. Market commentary & comparisons to benchmarks
  4. Recommended strategy changes
61
Q

How often must portfolio reporting to investors be carried out?

A

At least every 6 months

62
Q

In investment management, contract notes…

A

Should be prepared & dispatched immediately after each purchase & sale

63
Q

True or false: individual holdings are itemised in a client’s portfolio report

A

True

64
Q

What is a churn?

A

A switch of investments where the primary aim is to generate income for the adviser

65
Q

If a trust deed has no specific investment powers, what governs the trustees?

A

Trustee Act 2000

66
Q

What powers does Trustee Act 2000 give?

A

Invest as your own provided you have regard to standard suitability & diversification criteria

67
Q

Besides those covered by the investment policy statement, what constraints might a manager have?

A

General house policies e.g. no derivatives, no gearing

68
Q

What are the categories of overall investment objective?

A
  1. Capital growth
  2. Income
  3. Balance
69
Q

What are the general risk classifications?

A
  1. Lower / secure
  2. Medium / balanced
  3. Higher / adventurous
70
Q

What are typical investments for a lower risk / secure portfolio?

A
  1. Cash
  2. Fixed-interest with credit rating at least A
71
Q

What are typical investments for a medium-risk / balanced portfolio?

A
  1. Larger listed UK/overseas companies
  2. Unit trusts, OEICs & investment trusts
  3. Some medium-sized/smaller UK companies
72
Q

What are typical investments for a higher-risk / adventurous portfolio?

A
  1. Smaller / unlisted companies
  2. Alternative investments
73
Q

What are the main factors affecting investment strategy?

A
  1. Legal constraints
  2. Nature of liabilities
  3. Cash flow
  4. Taxation
74
Q

What does a strong positive cash flow into a portfolio mean for a manager?

A

They can take a long-term view & accept short-term uncertainty / losses

75
Q

What should a manager do as a client approaches retirement?

A

Take less risk & focus on income over capital gains (e.g. fixed-income over equity)

76
Q

What affects investment strategy more frequently – changes in regulation or changes in taxation?

A

Changes in taxation

77
Q

True or false: investment strategies should respond to short-term changes in market environment

A

False. Long-term strategies only respond to long-term changes

78
Q

What are examples of changes in the market environment?

A

Changes to risks of & relationships between asset classes

79
Q

What causes new products & services to emerge?

A

Regulatory & tax changes

80
Q

How can an advisor decide if complex new products & services are appropriate investments?

A

3rd-party advice or external services

81
Q

True or false: means & frequency of client reporting must be agreed in writing

A

True, usually in business letter given to clients

82
Q

What is included in a contract note?

A
  1. Bargain date & settlement date
  2. Who purchase was made for
  3. Number & price of shares
  4. Full name of share
  5. Charges including stamp duty/SDRT
83
Q

How often are summary portfolio evaluations usually issued?

A

Quarterly

84
Q

What does a summary portfolio evaluation include?

A
  1. Value at date of last report
  2. Addition of cash/stock
  3. Reduction by each withdrawal
  4. Appreciation or depreciation
  5. New value & date
85
Q

What tiers of reports do clients receive?

A
  1. Regular report (at least every 6 months)
  2. Summary portfolio evaluation (usually every 3 months)
  3. Contract notes (after every purchase / sale)
86
Q

What are some legitimate reasons for switching an investment?

A
  1. Change in client circumstances / objectives
  2. Clear instruction from client
  3. Change in market conditions
  4. Medium/long-term underperformance
  5. Value of investment is returned in takeover / capital restructuring
87
Q

What is one implication of cashing in an investment bond?

A

CGT implications for higher- and additional-rate taxpayers

88
Q

What is one way to avoid/reduce CGT liabilities?

A

Transfer asset to spouse before disposing of it

89
Q

Which is longer, a KID or a KIID?

A

KID

90
Q

What is the main difference between a KID and a KIID?

A

A KID includes forward-looking performance scenarios

91
Q

Do KIDs include the OCF or the TER?

A

OCF only

92
Q

What is the difference between OCF and TER?

A

The TER includes the OCF plus performance fees, trustee fees etc.

93
Q

Are performance fees included in OCF or TER?

A

TER only

94
Q

Are entry & exit fees included in OCF or TER?

A

Neither

95
Q

Are dealing costs included in OCF or TER?

A

Neither

96
Q

Are brokerage charges included in OCF or TER?

A

Neither

97
Q

Are annual management fees included in OCF or TER?

A

Both

98
Q

Are legal & audit fees included in OCF or TER?

A

Both

99
Q

Which is newer, KID or KIID?

A

KID

100
Q

What sort of investments can be cum/ex dividend?

A

Bonds

101
Q

When does a bond become ex dividend?

A

7 working days before distribution

102
Q

What does the xd in xd period stand for?

A

Ex-distribution

103
Q

What does xd period mean in practice?

A

Simply that the investment’s price is likely lower than it would usually be

104
Q

What kid of investment might involve a dilution levy?

A

OEIC

105
Q

What are the FCA rules about dilution levies?

A

None

106
Q

Who decides when to apply a dilution levy?

A

The ACD

107
Q

When are dilution levies applied?

A

During unusually large inflows or outflows of funds

108
Q

How is a dilution levy applied?

A

Added to purchase price or deducted from redemption price

109
Q

What are the three basic types of life insurance?

A
  1. Endowment (pays out on maturity or if you die during term)
  2. Term (pays out only if you die during term)
  3. Whole-life (pays out whenever you die)
110
Q

True or false: annuity income is exempt from income tax

A

False

111
Q

True or false: drawndown withdrawals are exempt from income tax

A

False

112
Q

What happens to unspent drawdown when you die?

A

It can be passed on free of IHT

113
Q

What does standard deviation measure?

A

Volatility i.e. how widely the actual return varies around its average / expected return

114
Q

What is the designation for standard deviation?

A

Sigma (σ)

115
Q

When data is normally distributed, how often do returns fall within 1 σ?

A

68% of the time

116
Q

When data is normally distributed, how often do returns fall within 2 σ?

A

95% of the time

117
Q

When is σ an acceptable measure of risk?

A

When the returns form a “normal” (symmetrical, bell-shaped) distribution

118
Q

What is the market’s ß?

A

1

119
Q

What is an aggressive security?

A

It has ß > 1

120
Q

What is a defensive security?

A

It has ß between 0 and 1

121
Q

What does CAPM stand for?

A

Capital asset pricing model

122
Q

What does CAPM calculate?

A

Expected return = risk-free return plus a risk premium based on ß

R02 Investment Principles & Risk (11 decks)

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