Chapter 5

Question 1

5.1.1 Describe and compare different types of investors.

Answer 1

2 types - institutional and individual
Institutional
Employ professional managers to manage funds on large scale
Internal or external (outsourced management) - depending on the size of the institution
Examples of institutional investors - pension funds, insurance funds, mutual funds, hedge funds, charitable funds and sovereign wealth funds.
Individual (A.K.A Retail)
Limited time and resources
FCA restricts promotions and investments in riskier investments to retail investors
Certified high net-worth investor = annual income > £100K or net investable assets of £250k or more
Certified Sophisticated investor = has a certificate in the required form confirming they have been assessed by a firm and are sufficiently knowledgeable to understand the risk of an investment. Also, have signed statement
Retail can be a self-certified sophisticated investor if they can state at least one of the following:
I am a member of a network of sophisticated business angel and have been so for at least 6 months prior to signature date
I have made more than one investment in an unlisted company in the last two years prior to the signature date
I am working or have worked in the two years prior to the signature date, in a professional capacity in the private equity sector, or in the provision of finance for small and medium-sized enterprises
I am currently, or have been in the two years prior to the signature date, a director of a company with an annual turnover of at least £1m
Promotion of Non-mainstream pooled investments (NMPIs) (inc unregulated collective investment schemes (UCIS) and special purpose vehicles - restricted to high net worth, sophisticated investors or investment professionals.

Question 2

5.1.5 Explain the obligations of a firm to a retails client

Answer 2

Main obligations set out by FCA principles of Businesses (PRIN) specifically principle 6
Treating Customers Fairly initiative (TFC) aims to deliver 6 outcomes
Outcome 1
Fair dealing with customers central to the corporate culture
Key cultural drivers 1. Leadership, 2. Strategy, 3. Decision making, 4. Controls, 5. Recruitment, training and competence, 6. Reward
TFC should be integrated into all levels of operations and driven top down
TFC culture in recruitment policy
And in remuneration - offered bonuses don’t lead to unfair outcomes for customers
Outcome 2
Products and services marketed and sold for retail should meet the needs of consumer groups and targeted accordingly
P&S should be designed to suit the market targeted - care to avoid the risk of mis-selling
Outcome 3
Clients provided with clear information and kept informed during the entire sale process
Clear and easily understood info - Principle 7 of PRIN
Outcome 4
The advice takes into consideration customer circumstance
KYC before giving recommendations
Investment advisory or discretionary portfolio management services also req to assess suitability
Suitability report should be provided
Outcome 5
Clients provided with products that perform as expected and firms service is at an acceptable standard
Firms should communicate clearly with consumers about the characteristics of products
Outcome 6
Consumers don’t face unreasonable post-sale barriers to change product, switch provider of submitting a claim
Firms make consumers aware of complaints handling procedures in communication
Vulnerable clients - Physical disability, severe or long-term illness, mental health problems, low income/debt, caring responsibilities, over 80, young, changes in circumstances - job loss, bereavement or divorce, lack of English language and non-standard requirements or credit history.
Firms must demonstrate a proactive approach to identify and support vulnerable clients.

Question 3

5.1.3 Explain the main needs of retail clients and how they are prioritised

Answer 3

Time horizon
Different time horizons different risk levels
Longer time horizon - less liquidity more risk acceptable
Return Requirement
Calculated based on the desired outcome at the end of the time horizon
More risk better return
Risk Tolerance
Based on investor psychology - assessed in the questionnaire
Other considerations
Liquidity - need generally increases toward the end of the time horizon, some parts may always require liquidity
Tax - tax efficiency will be important
Religious or ethical beliefs - restrict certain kinds of investment (E.G invest in armament manufacturer)
Prioritisation is important as a client’s needs may not be able to be met due to resources over time

Question 4

5.2.1 Explain the importance of establishing and quantifying a client’s objectives

Answer 4

Client’s objectives should be stated in financial terms and clearly defined how much is needed and when
Typical objectives include
Protection - insurance, family in event of death/illness, income in event of illness, long term care
Borrowing - mortgage or remortgage
Savings and investment - School/Uni fees, invest for growth/ income, build capital
Retirement - at a specific age and income
Estate planning - provide for or reduce IHT payable on death
Client’s objectives need to quantified - E.G what level of income in retirement required? Or insurance in the event of a family member dying.
Time horizon needs to be determined to meet the investment objective

Question 5

5.2.2 Explain the need to prioritise objectives to accommodate a client’s affordability

Answer 5

Not always possible to meet all of the client’s objectives; therefore, prioritisation required of client financial goals
Affordability is the real constraint - can be established through cash flow statement
May require assistance in financial priority

Question 6

5.3.1 Explain the importance of the fact-find process in establishing a client’s current financial circumstances and requirements

Answer 6

As well as goals - a comprehensive understanding of the current situation (both linked - iterative process)

Hard Facts
Personal info
Financial info
Income, earned, savings and pension
Investments and other assets
Liabilities, mortgages and credit card balances
Financial dependents
Soft Facts
Open-ended questions and listening to the client from an understanding of their preferences and aspirations
This info only collected face to face
No specific regulatory requirements regarding the form a fact-find take

Question 7

5.3.1 Explain the importance of the fact-find process in establishing a client’s current financial circumstances and requirements

Answer 7

Fact-find may require details a client cannot answer from memory or records
An advisor can collect the info from third parties through a ‘letter of authority’
Client authorises the third party to release the info

Question 8

5.3.2 Identify the factors shaping a client’s circumstances

Answer 8

Important for an advisor to understand the client’s history and background
Attitudes to risk and financial issues are shaped by experience
May have strong views on ethical issues

Question 9

5.4.1 Analyse the main types of investment risk as they affect investors

Answer 9

Retail generally has a one-dimensional understanding = investment worth less in future than today (capital risk)
Cautious attitude to capital risk can expose them to the following:
Inflation Risk
The future purchasing power of both the capital base and its income will be eroded by inflation
Interest Rate Risk
BoE base rate is likely to change over time, feeds through to the rates of interest paid on deposit accounts.
The interest rate set by the Monetary Policy Committee (MPC) of BoE
Rate increases during times of inflation (not always)
Shortfall risk
Investment return will fall short of the amount required to meet investor objectives
Response = reduce target, increase the amount invested or extend the time horizon
Other risks that may be relevant:
Credit Risk - loss of value of a debt investment due to default - corporate bond investments
Market Risk - loss of value due to fluctuation in market determining prices, interest rates or exchange rates. General risk when investing in securities traded in markets.
Operational Risk - failure of an institution due to poor operating systems or procedures

Question 10

5.4.2 Explain the role of diversification in mitigating risk

Answer 10

No single asset is low risk in all regards
Diversification of a portfolio between different asset classes is central to investment management
Reduces various aspects of risk
Asset allocation must be appropriate to the client’s objectives and risk profile

Question 11

5.4.3 Analyse the factors affecting a client’s risk profile

Answer 11

Risk profile made up of three factors:
Risk required - the level of risk associated with return required IOT achieve the client’s objectives
Risk capacity - the client’s ability to absorb financial losses
Risk tolerance - the level of risk the client is comfortable with
Key factors that affect a client’s risk profile are
The timescale of the investment - Different objectives with differing timescales may alter the risk profile of investors which will affect the asset allocation of their investment capital
Amount of risk capital - Risk capital = money that can be invested with effecting client lifestyle
High net worth has more risk capital and therefore can have a higher risk tolerance
Investment experience - greater experience = greater risk tolerance
Psychology - some client find loss distressing others are more relaxed
Regulatory criticism of the advising process:
Failure to collect and properly account for info assessing customer risk tolerance
Relying on risk-profiling and asset-allocation tools
Poor descriptions of attitudes to risk
Regulator expectation of how risk profiling should be performed:
Customer needs conflict with the level of risk a firm has established is suitable for the customer - the firm must have detailed discussion with customer highlighting mismatch in objectives, financial circumstances, risk tolerance and capacity for loss
If the customer doesn’t have the capacity to sustain loss - the firm should explain customer needs for higher return cannot be met
If the customer able to sustain greater losses and is willing - the firm should document that the customer is willing and able to take this level and reasons why
The firm must take care to establish the suitability of any investment selection that requires a customer to take on a higher level of risk than originally identified

Question 12

5.4.4 Explain the key methods of determining a client’s risk profile

Answer 12

Begins with Fact-Find
Risk tolerance - determined by reviewing the client’s existing investments - gain the client’s level of understanding
Indicates attitude to risk - but cannot be relied upon in isolation
Risk profiling questionnaires - based on psychometric principles and assess factors
Should form the basis of a wider discussion of a clients circumstances and objectives
Used in conjunction with fact-find info
Capacity for risk - reflects clients ability to accept the level of risk identified from the attitude to risk questionnaire
Takes into account the circumstances of the client’s life that could affect risk capacity now and in the future
May indicate high-risk investment strategy but not if all investments represent total life savings
Asset allocation is a major factor in investment performance; therefore, critical in financial planning
The client must agree to appropriate asset allocation

Question 13

5.5.1 Explain why asset allocation always comes before investment or product selection

Answer 13

Asset Allocation - a mix of underlying asset classes held in a portfolio
Cash, fixed interest securities, property and equities - each class behaves differently and have different risk characteristics
Asset allocation single most important factor in determining returns

Question 14

5.5.2 Explain the key roles of charges and the financial stability of the provider as criteria within the fund selection process, and the use of past performance

Answer 14

Fund selection after asset allocation
Fees available dependent on whether the advisor is tied to a specific provider or is independent
One-off Charges - applied at the point of sale and/or exit charges if capital is withdrawn. Can also be a fee for investor advice
Ongoing Charges - Run through the lifetime of the investment. Include investment and administration costs and platform fees if fund administered by a platform.
Some funds quote an annual management charge (AMC) which includes the cost of investment management services - research analysis and portfolio management
Ongoing Charge Figure (OCF) can replace the total expense ratio (TER) as the preferred charge figure
OCF paid annually
Includes ongoing costs to the funds (inc AMC and other charges)
OCF must be displayed in KIID or unit trust or OEIC
Trading costs - buying and selling assets (higher for funds that trade regularly and less for long term holdings)
TCs include a commission to stockbroker and stamp duty (greater of the two)
Ongoing charges can increase over time - create a bigger hurdle for the fund to outperform peers
Typically the range is 0.75% - 1.50% - tracker funds can be a little as 0.15%
MiFID II requires investment managers to disclose additional transaction costs that are charged separately from OCF

Question 15

5.5.3 Explain the importance of stability, independence and standing of trustees, fund custodians and auditors in the fund selection process.

Answer 15

Financial stability of the provider is the most important with-profits based investment managed by a life assurance company
With-profits deliver a smoothed return in the form of bonuses
Capital placed in reserves during strong returns and drawn when the rate of bonus is above what is achieved on the underlying fund
Past performance is an indicator of skill of the fund manager; however, past performance is not a reliable indicator of future performance
Due diligence is highly important on the fund selection process.
A hedge fund typically uses a network of service providers - investment manager, broker and custodian/prime brokers. All should be independent of each other

Question 16

5.5.4 Identify benchmarks and other performance measures

Answer 16

Performance can be measured by absolute return - more meaningful when it’s benchmarked against
E.G similar investment or fund manager
This isn’t meaningful if the manager is small cap vs large index
In this case best to use neutral, unbiased benchmark made up of similar investment types
Market indices most common benchmark used

Question 17

5.5.5 Explain the importance of reviews within the financial-planning process

Answer 17

Reviews should be at least annually - some advisors may agree to more regular reviews
Reviews keep the portfolio in line with client objectives and changing investment perspectives
The review is an opportunity to:
Check for changes in client circumstances, risk profile and objectives. Long-term objectives tend to modify over time
Monitor investment performance against a benchmark - is it performing/ underperforming relevant market if latter change investments?
Rebalance portfolio in line with agreed asset allocation - portfolio drift

Question 18

5.6.1 Describe the need for advisors to communicate clearly, assessing and adapting to the differing levels of knowledge and understanding of their clients

Answer 18

Comments in fact find
Should have interrogated Darren’s objectives, such as provisions for dependants on his death
Didn’t find out enough details on mortgage
The advisor ascertained that he had sufficient emergency funds - good practice
The advisor ascertained the risk profile of Darren
Carol should have been present if she was to be involved in investments

Question 19

5.6.2 Identify and apply suitable investment solutions to suit different needs of retail clients

Answer 19

Comments in recommendations
Recommended investments do not match Darren’s risk profile
Carol was not interviewed and risk profile not determined - potentially unsuitable investments
Recommendations consistent with objectives and circumstances in fact-find; however, fact-find was not wide enough to determine best recommendations
Written report sent quickly; however, there was not enough justification why the investment funds were of a higher risk than Darren’s stated
Use of ISA allowances for both D and C is sensible

When recommending a designated investment to a retail client - the firm must provide the client with a suitability report
No minimum period for Capital Gains relief on Venture Capital Trust investments
Income tax relief on an EIS investment is 30% of the investment, i.e. £100,000 x 0.3 = £30,000

Question 20

5.7.1 Explain the features and objectives of the following funds in the UK: Pension funds (defined benefit (DB) and defined contribution (DC)), life assurance and general insurance

Answer 20

Defined Benefit (DB) scheme - the sponsor agrees to pay the members benefits equal to a pre-determined percentage of their salary at retirement or close to retirement, subject to the members years of service
Defined Contribution (DC) scheme - contributions are used to buy investments and the return on these investments determine the pension benefits
Occupational pension schemes = DB or DC
Personal pension = DC
Pensions schemes benefit from tax reliefs - accumulated interest and capital gains not liable for taxation and part of the proceeds are available as a tax-free pension commencement lump sum (PCLS)
Pension income is liable to income tax
Investment managers must focus on long-term assets for pension schemes
To determine the average length of time that an employee will draw a pension and calculate fund liabilities for DB schemes = actuaries take into account mortality tables
Pension fund maturity - determined by employees close to retirement
Pension fund managers may look to chose dividends over capital gains
Capital gain is achieved through the buying and selling of securities - this incurs transaction costs
If the fund can be rebalanced using dividend or coupon income, transaction costs only incurred on the purchase of that security
Assets are selected by the PF trustee
PFM take advantage of regular income flow - pound cost averaging = buying and selling during market peaks and troughs FM pays an average price for assets
Life Insurance Companies:
Term assurance policies = cover the life of an individual over a specific period
Whole life policy = insures the life of the individual and pays capital upon the policyholder’s death
Life assurance involves long-term liabilities based on insurance contracts sold by the company
Long term portfolios
Detailed performance of unit-linked life funds can be found in the Financial Times managed funds service
Subject to CGT and income tax
Life assurance FMs will adjust their investment strategy to avoid tax on their funds
Premiums are paid by policyholder post-tax income
Different to pensions which are paid gross and is taxable
General Insurance Companies:
Insurance against specific contingencies - E.G Fire, theft, storm damage ETC.
In return for a premium, a company can insure the property for a period of a year.
Liabilities are short-term in nature - capital required immediately after a claim
To meet this requirement, premiums are pooled into reserves, usually in the form of securities which are highly liquid

Question 21

5.7.2 Identify and contrast the risks of defined benefit versus defined contribution pension schemes for the sponsor and beneficiary

Answer 21

DB valuable for the holder as they have certainty of how much they will be paid at retirement
Dependent on how many years they have contributed into the scheme
E.G 1/80 scheme with 40 years contribution and a final salary of £50,000: 50,000 x 40 / 80 = £25,000 PA until death
Risk of meeting this benefit lies with sponsoring employer
In contrast, DC schemes built from invested contributions over the members working life and the final accumulated fund is then used to generate an income at retirement.
Risk of meeting benefit lies with the member
Payable benefits depend on investment return during the fund build-up
In the UK DB schemes have declined and DC schemes increased
DB schemes are reducing because:
Increased longevity = scheme costs more
Disclosure of the schemes’ funding position in accounts - actuarial deficits leading to shareholder and regulatory pressure to meet that deficit by increasing employer contributions
Increasing pension deficits, due partly to increasing longevity, but also a consequence of falling returns on assets held by schemes
DB schemes switching from equities to bonds
Adopting liability-driven investment (LDI) strategies - not just bonds but also swaps to more accurately match asset to liabilities

Question 22

5. 7.3 Distinguish among the typical asset allocations for DB and DC pension funds, life assurance and general insurance funds
6. 7.5 Classify funds by their income/capital growth requirements
7. 7.4 Explain the return objective of the major fund types

Answer 22

Reference table 5.3 (data from 2016) page 227
Pensions funds - equities are suitable for long-horizon PFs, close to 40% net assets are equity investments
Fixed income plays a small role 25% (UK gilts)
Short term assets high - uncertainty about long-term holdings
Life Assurance - second largest institutional investors
Long-term liabilities - 56% in equities
Fixed-income - 30% as they provide a higher degree of certainty of cash flows matching the institution’s annuity liabilities
Short term assets were low reflecting greater certainty in this sector
General Insurance - net assets small in comparison to the above
The pooling of household, motor, personal accident and other short-term risks
Substantial portions of short term assets to match their liabilities
Insurance company business cycles 3-5 years

Question 23

5.7.6 Explain the effects of each of the following on a fund’s asset allocation: time horizons, liability structure, liquidity requirements

Answer 23

Pension funds long-term liabilities - not fall due for 45 years and may last for 20+ years
Analysts prefer to think of this long-term horizon as comprising of a series of shorter, possibly 5-year horizons
Leads to a sensible evaluation of investment objectives
Reasonably foreseeable changes in conditions and circumstance
When economic conditions become more volatile tendency is to focus on shorter periods
Liquidity requirements between DB and DC differ
DB based on the current age of the beneficiary
As PF matures liquidity requirements increase
Liquidity for DC vary depending on the circumstances of the plan
Inc employee turnover rates, withdrawal provisions, projected death and retirement rates and the average age of contributors
New company with high employee turnover will require high liquidity
A decline in fixed benefits and a rise in with-profits policies offed by long-term insurance companies
Liabilities similar to DB and DC pension schemes
Liquidity needs to be similar to but slightly greater than PFs - reflecting shorter term liability structure
Cash flows for general insurance much more uncertain
Liquidity a higher priority for these funds
Short time horizon
Portfolio of short term securities and immediate liquidity reserve to meet liquidity needs

Question 24

5. 7.7 Explain the taxation of the various funds in the UK

5. 7.8 Explain the effect that taxation legislation may have on the stock selection and asset allocation of a fund

Answer 24

Pension funds - exempt from CGT and income tax
Maybe withholding tax on overseas investments
Should be indifferent between high/low- coupon and fixed income securities
However, there are factors affecting pension funds investment behaviour including a preference for cash flows (dividend payouts) which allows it to change stance without selling its securities
Both general and life insurance are taxed on profits
Latter depending on whether it is a (tax-exempt) pension, life assurance with-profits or annuity based
The standard rate of corporation tax on life business unless it relates to investments defined for policyholders - basic income tax
Investment via pension scheme has tax advantages over life assurance-linked savings policies

Question 25

5.7.9 Identify other types of legal requirements that affect pension funds, insurance funds and retail clients

Answer 25

General/life insurance operates within a detailed legal framework - intended to prevent companies from being unable to meet future liabilities and reduce the possibility of fraud
A separation between general and life assurance
General insurers keep solvency margins expressed as a % of net assets to net premiums written
Fund objectives and constraints
Portfolio allocation determined by reviewing the objectives and constraints of the fund
Return objective and risk tolerance are dependent on portfolio constraints that can fall into these categories:
Liquidity needs - cash or near cash for day-to-day operating expenses, payouts and unanticipated changes in those needs - fixed-income instruments (short-term gov bonds)
Time horizon - longer horizon more risk tolerable
Tax - tax status affects return objective - some assets less desirable (investments taxed at source)
Legal and regulatory - may exist and taken into consideration when building the fund
Other constraints may exist that do not fall into the above - E.G trust deed could constrain the manager to certain asset classes or prevents investment in certain types of stock - ethics