Chapter 1 - Investment Management Process - 5%

Question 1

What is the Investment Management Process?

Answer 1

Investment management is an integrated and continual process designed to meet specific goals and objectives within a set of constraints.
The seven steps are :

1. Determine investment objectives and constraints.
2. Create an investment policy statement.
3. Establish a strategic asset allocation.
4. Select securities.
5. Monitor the markets and the client.
6. Evaluate the portfolio’s performance.
7. Rebalance the portfolio.

Question 2

What information is required by regulation and law?

Answer 2

Advisors are required to obtain certain information from their clients. IIROC licensed asvisors are bound by IIROC’s Client Relationship Model (CRM) and Know Your Client (KYC) Rules as well as PCMLTFA - The Proceeds of Crime Money Laundering and Terrorist Financing Act.

Question 3

How do investment advisors learn about their clients?

Answer 3

1. Client Interviews
2. Client Questionnaires
3. Investor Behaviour

Question 4

How do investment advisors determine investment objectives and constraints?

Answer 4

Two investment objectives -

1. Return
2. Risk

Five Investment constraints -

1. Time horizon
2. Liquidity requirements
3. Tax situation
4. Legal and regulatory requirements
5. Unique circumstances

Question 5

What is an investor’s marginal tax rate? What are the different ways income is taxed?

Answer 5

An investor’s marginal tax rate is the top rate paid on taxable earnings and the rate at which the next dollar of earnings would be taxed. The marginal tax rate includes both federal and provincial tax payable.

Different types of investment income –
- Interest income: originates from investment in debt securities and some managed products. It is added to all other sources of income and is therefore taxable at the investor’s marginal income tax rate. Individuals receive no tax relief of any kind when it comes to interest income.

• Realized capital gains: are effectively taxed at one-half the individual’s marginal income tax rate because only one half of all capital gains are taxable.
• Unrealized capital gains: are not taxable. Taxable gains are generated only when an investment is sold for more than what was paid to buy it.
• Realized capital losses: offset realized capital gains. Therefore, only net realized capital gains are taxable.
• Dividends: from taxable Canadian corporations are subject to a gross-up and credit system.
• Dividends from foreign corporations: are treated as regular income and are taxed at the investor’s marginal income tax rate.

Question 6

What are Registered Retirement Savings Plans?

Answer 6

RRSPs are a type of tax-deferred account. Contributions to an RRSP are tax-deductible directly from the individual’s income in a given year and investment returns earned withing the RRSP are not taxed in the year that they are earned. Withdrawals from an RRSP are fully taxable at the investor’s marginal tax rate.

Question 7

What are Registered Education Savings Plans?

Answer 7

RESPs allow investors to save for a beneficiary’s post secondary education.

Although contributions to an RESP are not tax-deductible, investment income earned within the plan is sheltered from tax until it is withdrawn. When withdrawals are used to pay for the child’s post secondary education, the accumulated income is taxed in the hands of the child.

The lifetime RESP contribution limit is $50,000 per beneficiary. As an additional incentive, the federal govt. provides Canada Education Savings Grants (CESGs). The max. lifetime CESG per beneficiary is $7,200.
- If net family income is >= $43,953 the grant is 40% of the first $500 of contributions plus 20% of the next $2,000 of contributions made this year.

• If net family income is >$43,953 and 87,907, the grant is 20% on the first $2500 of contributions made this year.

Question 8

Which statement(s) is/are true regarding taxation of investment earnings?

I. Dividends from foreign corporations are taxed at the investor’s marginal tax rate.
II. Dividends from Canadian corporations are effectively taxed at a rate lower than the investor’s marginal tax rate.
III.Interest income is taxed at the investor’s marginal tax rate.

Answer 8

I, II and III are correct. In Canada, investment earnings are taxed at different marginal tax rates. Dividends from taxable Canadian corporations are subject to a gross-up and credit system. Dividends from foreign corporations and interest income are treated as regular income and are taxed at the investor’s marginal income tax rate.

Question 9

How can advisors best determine a client’s willingness to bear risk?
A. By referring to the client’s New Account Application Form.
B. By analyzing the historical performance of the client’s portfolio.
C. By asking behavioural questions during interviews and on questionnaires.
D.By comparing the client’s current and expected investable assets to current and expected future spending levels.

Answer 9

C is correct. The best way to determine a client’s willingness to bear risk is by asking behavioural questions during interviews and on questionnaires. Attitudinal questions, such as those found on most firms’ NAAF, tend to be ineffective.

Question 10

Which of the following can be included in an Investment Policy Statement?

I. Advisor-Client agreement.
II. Client summary.
III. Portfolio restrictions.
IV. Investment objectives and constraints.

Answer 10

I, II, III and IV are correct. The Investment Policy Statement is the link between the client’s investment objectives and constraints and the work of the advisor. The statement can include not only the investment objectives and constraints, but also a client summary, portfolio restrictions, asset allocation, investment philosophy, and an advisor-client agreement.

Question 11

Which of the following dictates the relevant time horizon for a client's investment policy?
A.	The use of funds.
B.	The risk tolerance.	
C.	The return objective.
D.	The ease of management.

Answer 11

The use of funds dictates the relevant time horizon for a client’s investment policy. Time horizon means the length of time expected to elapse before one of the client’s significant goals must be met, at which point the client will either withdraw some of the portfolio’s assets, or enter a new stage of investment planning that requires an update to his or her investment policy.

Question 12

What is the maximum lifetime Canada Education Savings Grant per beneficiary?

Answer 12

The maximum lifetime Canada Education Savings Grant per beneficiary is $7,200.

Question 13

What is the tax treatment of dividends from foreign companies?

Answer 13

Foreign dividends are treated just like regular income.

Question 14

Which skills are most required of an advisor for effective communication?

Answer 14

Investment advisors who carry out questioning sensitively and thoughtfully come across as caring, competent professionals who are guided by the highest ethical standards. Effective communication skills include the specific skills of attending, active listening, and empathy.

Question 15

How is rebalancing accomplished in a client’s portfolio?

Answer 15

Selling some well performing assets; buying some poorly performing assets. Rebalancing reallocates assets back to their originally intended portfolio weights by selling some of the ones that have performed well and buying the ones that have done poorly.

Question 16

Which term describes the potential decline in the price of an investment caused by selling it?
A.	Market impact.
B.	Market drift.
C.	Market risk.
D.	Market bias.

Answer 16

Liquidity requirements represent the actual and potential cash needs of the client. They may dictate the need for the client to own investments that can be converted to cash quickly, at minimum cost. Cost includes not only commissions and transaction fees, but also implicit costs such as the bid-ask spread and the potential decline in the price of an investment caused by selling it. This latter cost is known as market impact.

Question 17

Which is true regarding the ‘Square One’ approach of calculating the periodic cash flow required during retirement?
A. It assumes that a certain percentage of pre-retirement income is an acceptable estimate of the income required during retirement.
B. It ignores current income and expenses and focuses on the client’s objectives.
C. It deducts pre-retirement expenses from current after-tax income to calculate after-tax retirement living expenses.
D. It deducts post-retirement expenses from current after-tax income to calculate after-tax retirement living expenses.

Answer 17

Itemizing all expected periodic expenses in line with the lifestyle needs identified through discovery is the most precise method. It ignores the current reality of a client’s expenses and income and focuses on the client’s dream. In this respect it can be called the Square One approach.

Question 18

Which of the following is not considered a portfolio trade cost?
A.	Commissions.
B.	Leverage fees.
C.	Market impact.
D.	Bid-ask spreads.

Answer 18

Trade costs represent the costs involved with money management, and include commissions and transaction fees, bid-ask spreads, and market impact costs.

Question 19

A new client wants to earmark 5% of his portfolio for investment in the shares of small-cap biotechnology companies. In which section of the client’s Investment Policy Statement should this be disclosed?

Answer 19

A desire to invest a portion of a portfolio in a particular market or sector of a market should be noted in the unique circumstances section of the client’s Investment Policy Statement.

Question 20

What does the field of behavioural finance say about investor’s attitudes toward risk?

Answer 20

A major tenet of behavioural finance is that, when dealing with gains people tend to be risk-averse, but when dealing with losses they tend to be risk-seeking.