Chapter 6: Collective Investment Schemes (THIS WILL INCLUDE NEW STUFF ONLY, COMBINE WITH R02) Flashcards
There are two main types: open-ended schemes and closed-ended schemes.
It is important for the J12 exam that you understand the difference between how these funds are structured and how you can trade their shares or units.
Unit trusts and OEICs are both a type of open-ended collective investment scheme.
THINGS IN THE CHAPTER TO LEARN OR FIND IN R02 FLASHCARDS
6.2: - Open-ended Schemes (Unit trusts and OEICs)
6.7: Closed-ended Funds / Investment Trust Companies (REITs, Investment trusts)
6.8: Exchange Traded Products (ETFs, ETCs & ETNs)
6.13: Private Equity Schemes -Enterprise Investment Schemes (EISs) and Venture Capital Trusts (VCTs)
6.14: 6.14: Life Assurance-based Investments (with-profits, unitised with-profits, and unit linked.
Units trusts & OEICs are very similar except: WHAT?
Unit trusts are set up under a trust where trustees hold the assets and a manger is responsible for the day to day running
Trustee must be regulated by the FCA and manager must be authorised by the FCA
for an OEIC; it is someone called the independent ‘depositary’( i.e. the person with whom the assets are deposited).
They are FCA-authorised and regulated, as ICVCs.
The OEIC must be incorporated and authorised
What is net asset value?
Unit trusts and OIEC trade at their NAV
Extra:
With a collective that trades at their NAV value, the value of the units you buy directly reflects the underlying value of the investments.
Effectively it is a measure of what each unit or share is worth.
Imagine that the fund were to be wound up and closed today. What would each unit or share holder receive?
We can work this out by calculating:
what each asset of the fund can be sold for.
how much it would cost in fees, etc.
how much money this would leave in the pot.
then divide that amount by the number of unit or share holder.
6.2.1b: What is Unit trusts box management and what is its benefit and risks
Any units that are sold are not cancelled but they are put in a ‘box’. They are then recycled and issued to new investors.
This is more efficient that selling a buying back the same units for new investors
This reduces dealing costs and charges.
There are risks associated with this approach though, particularly in times of high price fluctuation.
EXTRA:
A unit trust is ‘open-ended’. A manager creates new units to sell to new investors and cancels units when investors want to cash them in.
However, it might not always be efficient to cancel units when an investor wants to take funds out, only to have to create them again when a new investor comes along.
Therefore, they use a ‘box’ approach when dealing in their units.
In essence, any units that are sold are not cancelled but they are put in a ‘box’. They are then recycled and issued to new investors
‘Box management’ is the phrase given to the stock control mechanism that is needed to operate a box system
6.2.1c: Types of units
Accumulation Units
Income Units (distribution units)
Accumulation units…
o add all the income produced from the underlying investments back into the investor’s holding.
o the unit price increases to reflect the retained income.
Income units (sometimes called distribution units) …
o pay out the income to the investor.
o distribution funds can split out true income and distribute this, leaving the capital to grow.
EXTTA:
Even if accumulation units and income units in a given fund start off at the same price, as time goes by the income units will have a lower unit price than accumulation units.
This is because each non-distributed income is re-invested back into accumulation units, increasing their price.
To add to the confusion, there also can be income units that reinvest the income produced.
Mixed unit funds also exist. These hold some income and distribute some income.
What is a ICVCs (Investment Company with Variable Capital).
This is another name for an OEIC
Dual priced = Bid/offer spread (how units or shares are priced)
Single priced = Mid market rates
Many people have unit trusts and OEICs and do not know the difference. In fact, many OEIC features are ’as with unit trusts’
The capital is open ended so, (as with unit trusts), there is no secondary market. Shares are bought from and sold back to the provider company.
No stamp duty is paid on their purchase (as with unit trusts).
The investor owns their proportion of the shares within the wider fund (as with unit trusts).
The ACD and the depositary must be authorised / approved persons.
An OEIC is a company but not a normal trading company.
It is self-contained, so is not traded on the stock market like normal listed companies (as with unit trusts).
Most OEICs are single priced, albeit they can operate on a dual basis.
6.2.2a What is an Umbrella fund?
An umbrella fund is where an OEIC is split into a number of different sub-funds. Each sub-fund will have different investment objectives and strategies.
This allows the OEIC to benefit from economies of scale, as they can pool the assets from multiple sub-funds which can lead to lower transaction and operating costs.
6.2.2b Comparing OEICs and unit trusts
LEARN PRIOR TO EXAM
OEIC =
Assets looked after by independent depository
Fund managed by authorised corporate director
Often single priced
Unit trusts =
Assets looked after by trustees
Fund managed by a fund manager
Often Dual priced (bid/offer spread)
6.3: Additional Detail on the Pricing of Unit Trusts and OEICs
Most funds are priced at one point in the day. For unit trusts or OEICs this is done by calculating its NAV, say for example, at 12pm,
What is this part of the day called?
So, if you want to buy a unit in a unit trust or a share on an OEIC what price will you pay? The price from the previous valuation point or the newest one?
WHAT HAPPENS IF PRICES MOVE SIGNIFICANTLY?
valuation point
Both unit trusts and OEICs can be dealt on a forward or historic pricing basis.
Historic pricing is where investors buy at the last published price.
Forward pricing is where investors buy at the ‘yet-to-be-calculated’ price.
IMPORTANT:
If prices move by more than 2%, it will have to be calculated on a forward pricing basis
6.3.2: Dual priced basis
Tell me more about both the BID and OFFER price
BID TO GET RID
Investors buying units in the fund will pay more than investors selling units back to the fund
The higher price paid by investor buying units in the fund is the offer price
The lower price received by investors selling their units in the fund is the bid price.
The amount of the spread between the bid and offer price will be published in the fund prospectus.
two NAV-related prices that we need to consider:
One based on the bid prices of the underlying securities.
One based on the offer prices of the underlying securities.
Explain how dual priced funds set the price to buy or sell each unit/share
LOOK AT EXAMPLE 6.2 IN 6.3
The starting point will be the NAV, but there are two NAV-related prices that could be used
One based on the bid prices of the underlying securities. (used if the fund has more sellers than buyers to discourage further selling and encourage buying)
One based on the offer prices of the underlying securities. (used if the fund has more buyers than sellers to discourage further buying)
6.3.3: Single priced basis
Most OEICs operate on a single-priced basis, with the total value of all the shares matching the NAV of the fund.
Because of this, what do most single priced funds charge when someone sells their investment
A single priced fund with £30million portfolio of shares and £10million shares in existence will have a price of £3 per share
If an investor withdraws a large proportion of an OEIC’s funds, to the extent that the fund needs to sell some of its underlying assets a dilution levy is charged
This ensures fairness to all its shareholders. REMEMBER, WITH single priced funds there is no bid offer spread to absorb any losses on the fund. The levy, which is based on the actual costs involved in processing the deal, is charged directly to the ‘large’ investor or seller, whenever a trade is conducted that is so large that it adversely affects other investors.
Any dilution levy charge is usually factored in when calculating the buying or selling price of the specific large deal in question. The levy is received by the fund.
6.4: Charges
It is important that potential investors have these charges explained to then in a clear and comprehensive way.
Some funds such as UCITs funds (again, more on these later) are required to publish an Ongoing Charges Figure (OCF) so that investors are aware of the likely costs they will be incurring. This figure includes the annual management charge plus all other costs associated with running the fund and holding investments except initial and exit charges, transaction costs and performance fees.
Some funds still publish a Total Expense Ratio (TER) which includes the same items as the OCF plus performance fees. Costs included in both are: custodian fees, depository fees, audit fees, registration, regulatory fees and legal fees.
Are investments in unit trusts/OEICS tradeable?
No, you cannot trade unit trusts and OEICs, HOWEVER they can be transferred from one person to another e.g. as a gift or on death.
When you decide you want to sell the shares or units, the shares are cancelled by the fund provider, and they send you your money. You cannot sell them to anyone else or trade them on a stock market.
Unit trust/OEIC taxation
Main considerations:
Reporting or Non reporting (if offshore)?
Equity fund (less than 60% of its assets in interest-bearing securities) or non equity fund (60% +)?
At a fund level =
At the investor level =
If a collective has a UCITS designation, what does this allow it to do?
UCITS designation allows a fund to be marketed across the EU.
This is because the regulator considers there are sufficient protections available for the fund’s investors
Why do most UK residents prefer to invest in reporting offshore funds?
Most UK resident or domiciled people who invest offshore prefer reporting funds. That way, they are taxed like UK funds with dividends being paid gross, AND they can use their CGT exemption to cover / reduce gains.
REMEMBER: Non-reporting funds gains are known as roll up funds and are taxable to income tax rates on any capital gains. The investor CANNOT use their CGT allowance
Investors who are non-resident in the UK will only pay tax at the rates of the country they reside in, and will not pay any UK income tax or CGT.
Remember: DONT CONFUSE OFFSHORE FUNDS WITH OFFSHORE BONDS
The main closed-ended fund type that you need to understand for J12 is Investment Trusts.
An investment trusts shares are typically dual-priced with purchases at the higher offer price and sales at the lower bid price.
What is this known as?
(Clue: It is not the BID/OFFER spread as seen in dual priced Unit trusts or OEICs
With investment trusts, the difference is known as the ‘market makers spread or turn’.
because investment trusts are closed ended, this varies, depending on supply and demand of the shares. Ie, investments trusts DO NOT trade at their NAV
If investors see a value in the company over and above the sum total of its assets, then the capitalised share value will exceed the NAV.
Given that investment trusts DO NOT trade at their NAV, why can it still be useful for an investor to calculate its NAV when assessing the value of the investment trust as an investment?
This will give investors an indication of how any ‘intangibles’ such as faith in the fund manager is affecting share prices. Therefore, you can and should still calculate the NAV of an investment trust, although its actually share value may be higher or lower.
If shares trade above NAV, shares are at a premium
If shares trade below NAV, shares are a discount (paying less for the shares than what the underlying asset is worth)
As a reminder, simplistically the NAV is its assets minus its liabilities. Once calculated, this can then be expressed as an amount per ordinary share, which allows the investor to see if the trust is trading above or below its NAV.
Investment trusts must have a board that can act independently of its management and it cannot control any of the assets within the portfolio. True or false
True
Thee FCA will lay down several principles for any company wanting to be listed as an investment trust above the standard Memorandum and Articles of Association that normal companies need.
the investment managers must have adequate experience.
there must be an adequate spread of risk.
the company cannot control any of the assets within the portfolio.
the trust must have a board that can act independently of its management.
the company must seek Income and Corporation Tax Act (ICTA 1988) approval from HMRC (all investment firms must do this. It means that no CGT or Corporation tax is payable on gains made within the fund).
Investment trusts must comply with regulations laid down by the Companies Act, the FCA and HMRC.
6.7.1: Investment Trust Types
There are 2 main types of investment trust
Conventional Investment trusts
Split capital
Tell me the differences
6.7.1a: Conventional investment trusts
Issue one main class of equity share (ordinary shares) .On wind up, the NAV is distributed.
6.7.1b: Split capital investment trusts
These can have multiple classes of shares, entitled to different returns, with different priorities on wind up.
Redemption yields and the hurdle rate are an important measure for split capital trusts. Different types of shares could be ordinary, preference, split-capital, warrants
What are limited life trusts?
A variant to a Conventional investment trust
They have a fixed initial term (hence limited life)
With these, on maturity investors vote whether to wind up the trust or continue it, typically for another three years.
NOTE: Most investment trusts have indefinite terms
Redemption yields and the hurdle rate are an important measure for split capital trusts
What is the hurdle rate?
the rate an investment must grow at to repay each class of share at the wind-up date.
The price has to ‘get over the hurdle’.
Hurdle rates are calculated and advertised in the Association of Investment Trust Companies Monthly Information Service.
EXAMPLE:
Vanguard Investment Trust has a hurdle rate of -3%. This means the investment could fall no more than 3% annually and still be able to repay the NAV at the windup date.
What is the asset cover in relation to investment trusts?
Asset cover can be used to calculate the percentage of liabilities covered at any moment.
An asset cover of ‘1’ means that investment trust assets exactly match the money required to repay all share classes at trust wind-up.
A figure higher than 1 means that assets are more than liabilities.
A figure of less than 1 means that liabilities are greater than assets.
EXAMPLE:
BTS investment trust has asset cover of 1.2. This means the investment trust has 20% excess assets over liabilities
As well as ordinary shares, or preference shares a split capital investment trust can also offer split capital shares. What are these?
Partly income shares, partly capital shares give holder entitlement to income of investment trust and capital which give entitlement to any remainder of trusts assets on wind up respectively
0 dividend preference shares give the holder first call on assets on windup, ahead of holders of capital shares (subject to CGT)
The following are all things that investment trusts can offer
Ordinary shares
Preference shares
Split capital
Zero dividend preference
Warrants
Income
Capital
LOOK AT PAGE 6.7
Managers of investment trusts can borrow money to buy shares and other assets, for example if they see a good investment opportunity but do not have sufficient free capital to take advantage of it. Investment trusts can borrow money in several ways:
Long term bank loans
Short term bank loans
Issuing debentures
Issuing loan stock
Issuing preference shares
Investment Trusts are bound by the PRIIPs regulation ((Packaged Retail Insurance-based Investment Products)
True or false
True
Because of this, investment trusts must include interest charges on their borrowings and transaction costs in their ongoing charges figure whereas unitis trust/OEICs that are subject to UCITS rules do not.
6.7.2e: How are investment trusts taxed?
At the funds level = similar to other collectives. No CGT on profits, no additional income tax on dividends, no corporation tax on franked income for cash/fixed interest coupons - little taxation
At the investors level =
Most deals through stockbroker so 0.5% SDRT on shares (no SD is paid on unit trusts or OEICs)
Taxed whether it is an equity fund or non equity fund
Subject to CGT on any gains
REMEMBER:
Zero dividend preference shares are taxed as capital gains, NOT INCOME
What are 6.7.2: Real Estate Investment Trusts (REITs)?
To qualify as a REIT, the conditions that must be met are:
At least 75% of the company’s total gross profit must be from the ring-fenced tax-exempt element.
At least 75% of the entire assets must be in the ring-fenced element.
Interest on borrowings must be at least 125% covered by rental profits (they cannot borrow heavily).
At least 90% of the profits from the ring-fenced element (income, not gains) must be distributed within 12 months of the end of any accounting period.
Property development is allowable but must be intended to generate future income. If it isn’t, then it will be classified as non-ring-fenced activity and liable to corporation tax.
REITs:
REITs are closed-ended companies, set up as investment trusts. When they are set up, they must be listed on a recognised stock exchange, which can be the AIM market. They must be UK resident for tax purposes and have only one class of share. only becoming available in 2007.
Has a ring fenced element (pays out PID income, 20% net of tax)
Has a non ring fenced element (pays normal dividend income)
‘No Corporation Tax on the part of the collective that really is about property investment’.
Remember:
Ring fenced element of REIT is not subject to Corpotation tax
It also pays out PID income
- This is 20% net of income tax
Non tax payers can reclaim
BRTP, HRTP & ARTP Cannot reclaim
Ring fenced element (pays out PID income ie 20% net of tax). Not subject to corporation tax
Non ring fenced element (pays normal dividend income), but is subject to corporation tax
What are ICVCs?
Investment Company with Variable Capital
It is just an OEIC
What are Exchange Traded Funds (ETFs)
What are they also known as?
What are the benefits are using ETFs?
What are the negative?
Exchange traded funds (ETFs) are a type of collective investment that track a chosen index.
Often known as index funds or tracker funds,
They are listed and traded on the stock market.
Most are OEICs
Benefits: Trading in ETF shares incurs the costs that normal share dealing does, but the investor does not pay stamp duty on purchases. They have low costs
Unlike OEICs and unit trusts, they can be traded at any point during the day, like normal shares.
Negatives: Tracker funds often have tracking errors
What do ETFs have such low costs?
Because the fund manager is copying the changes made within the tracked index, rather than using their expertise to select their own portfolio of investments.
Remember, they are tracker funds
What methods do ETFs (tracker funds) use to track an index?
What are the differences?
Full replication
Stratified Sampling
Optimisation / synthetic
Is it possible for any tracking fund (ETF) to beat the index it is tracking?
No. Trackers often experience a ‘tracking error’. This is the distortion between the fund performance and that of the index, caused by factors such as always being ‘1-step behind’ the index, and the fact that the fund will have charges over and above the ones incurred by the index.
Full replication funds have lower tracking errors than synthetic funds
Who creates ETFs?
What is the process?
ETFs are created by major financial institutions known as authorised participants (AP).
The AP buys a backet of shares. They deposit the basket to the ETF provider. The ETF provider converts the backet into creation units
What is arbitrage?
Arbitrage is the process of taking advantage of a security’s mispricing in the market to make a risk-free profit.
6.8.5: Exchange traded notes (ETNs) & 6.8.4: Exchange traded commodities (ETCs)?
Fund type summary (at end of 6.8)
Unit trusts
OEICs
Investment Trusts
ETFs
6.9: European Funds
As we said, in Europe trusts are not recognised. This means that all funds are structured as companies with variable capital. There are several types of funds, which depend on where they are established. The different types are:
SICAVs
FCP
UCITS funds
6.9.1: Societé d’Investissement à Capital Variable (SICAV) =
6.9.2: Fond commun de placement (FCP) =
6.9.4: UCITS funds
What are 6.9.3: Offshore centres?
Offshore centres such as the Isle of Man, Dublin and the Channel Islands create funds for investors to invest in. They will use either trust or company structures, as per the UK.
UCITS funds benefit from passporting
What is this?
If the fund has been authorised by their home state they do not need authorisation in the country they are being sold in (the host state) in the EU. This is an EU directive
NOTE:
UK UCITS funds = comply with the UCITS investment rules but cannot be passported across Europe.
EEA UCITS = schemes can technically no longer be marketed to the UK. (After 2025, UCITS funds must comply with the UK Overseas Fund Regime to be marketed in the UK)
6.10: What are Multi-Manager Funds?
Way of managing funds that allows fund managers / investors to spread money between different managers or different funds
For example, Saltus might choose multiple different funds with multiple different managers
6.10: Multi-Manager Funds
Tell me the difference between:
Funds of fund, funds
Manager of managers funds
Funds of fund, funds = fettered or unfettered
Manager of managers funds = Overall manager is appointed, who finds best managers to have within the MOM fund (Example = Let’s assume it’s AXA.
Their job is to source the best fund managers in each sector.
They then select Jupiter for their Gilts fund, Henderson for their Equity fund, Aviva for their property etc.
AXA can ‘hire and fire’ these managers if they underperform.)
A Fund of Funds can take one of two forms.
It will be either a fettered or unfettered arrangement:
What is the difference?
Fettered = Only host funds are used
Unfettered = Funds from other providers are used
How do Manager of Mangers, funds charge fees? Is it individual fees for each respective manager?
MOM funds charge a one-stop fee rather than individual fund manager’s fees.
NOTE = The costs of FOF funds can be accused of being somewhat opaque, when compared to the transparent MOM charging.
It is easier to see the cost and performance of a MOM.
What is a big benefit of FOF funds?
Provides a good CGT shelter, as fund switches do not produce a chargeable gain.
6.11: Hedge Funds and Funds of Hedge Funds?
Hedge funds are pooled investments, whereby a number of investors entrust their money to a fund manager, who invests in various traded securities.
They are mainly actively managed investments that are far from traditional and aim to make the investor money even at times of turmoil and general downturn.
They seek to:
hedge against market downturns.
invest in currencies or shares they believe are trading cheaply.
use derivatives, arbitrage and gearing to move money quickly, cheaply and easily.
There are over 14 different types of hedge fund strategy. Fortunately for this exam you only need to know 4:
Long/short funds
Relative Value Funds
Event Driven Funds
Tactical Trading Funds
What is a Fund of fund hedge funds
Seek to spread investors’ money over a range of hedge funds to minimise the risk through diversification. These often provide access to hedge funds for lower-level investors but are typically more expensive, as they will charge an extra fee of up to 2% on top of the underlying fund fees.
6.12: What are Absolute Return Funds
Absolute return funds can be set up in the UK as part of the UCITS III regime. The aim is to try to make a profit regardless of market conditions.
Absolute return funds can be set up in the UK as part of the UCITS III regime. The aim is to try to make a profit regardless of market conditions.
They are different to hedge funds tho altough the above sounds similar. What are its differences?
The main difference to hedge funds: Cant gear in the same way as hedge funds; the only way they can gear is through using derivatives e.g. buying a futures contract to increase exposure.
Hedge funds, on the other hand, can borrow cash using the securities they already own as collateral, and then use that cash to invest in more securities
6.13: Private Equity Schemes -Enterprise Investment Schemes (EISs) and Venture Capital Trusts (VCTs)
What happens if someone invests more in an EIS than is needed to get the full 30% tax reducer?
They just wont get any tax reduction on the excess and will have more shares in an EIS
What do EIS allow in relation to CGT?
CGT relief
There is no CGT to pay on gains from the EIS shares as long as the EIS is held for 3 years and income tax relief has been given.
CGT deferral relief
You can also defer a capital gain by reinvesting it into an EIS company. If you are only claiming this relief, there is no upper limit.
note: EIS CGT
The reinvestment (into an EIS) must take place in the period beginning one year before, and ending three years after, the disposal giving rise to the gain (the sale of his property shares).
CGT will eventually be payable, and at the rate of CGT at that time, not the rate now.
VCT CGT =
No CGT deferral relief is available.
You get immediate CGT exemptions on any growth in the VCT without the need to wait 3 years. It is instant. Due to this, no losses are allowable or claimable.
6.13.1c: EIS risks
EISs are risky. Young or expanding businesses have a habit of failure and, whilst you may well be in control of the business in some part after you invest, there are no guarantees of its success.
You must keep your shares for three years and after that they may be difficult to sell.
Tax relief is only given on new issues. Someone brave enough to want to invest in an EIS may be hoping for some tax relief, so they may not want to buy yours off you ‘second hand’ as they will get no tax relief.
This makes the shares pretty illiquid.
Tax relief is only given on first issue of shares
VCTs are similar in structure to Investment Trusts, in that both are limited companies, run by fund managers, who are generally members of larger investment groups.
VCT tax relief
ncome tax relief, as a tax reducer, is at 30% up to a maximum investment of £200,000 in new issues of ordinary shares in VCTs.
Dividends received are tax free, as long as the original investment was within the permitted maximum of £200,000 per year.
Tax relief is withdrawn if shares are not held for 5 years.
No CGT deferral relief is available.
You get immediate CGT exemptions on any growth in the VCT without the need to wait 3 years. It is instant. Due to this, no losses are allowable or claimable.
6.14: Life Assurance-based Investments
6.14: Life Assurance-based Investments with-profits, unitised with-profits, and unit linked.
With profit policies
What is a Market Value Adjustment (MVA)?
To protect the interests of other with-profit product investors, a provider may apply a deduction to the value of an investor’s with-profit product on early surrender. This is known as a Market Value Adjustment (MVA).
DO NOT CONFUSE WITH A Dilution Levy which is what is applied to someone who pays in a large amount or withdraws a large amount from a fund that trades at its NAV to protect other investors
6.15: Taxation of Life Assurance-based Investments
A policy is deemed to be qualifying or non-qualifying
Qualying rules:
The main qualifying rules that you need to know for the J12 exam are:
the policy must have a minimum term of 10 years.
the maximum premium is £3,600 per year.
the policy must not be surrendered or assigned earlier than three quarters of the way through its term.
Non qualifying life assurance policies:
All gains on non-qualifying policies are potentially taxable, however tax is only paid if a chargeable event occurs and a chargeable gain arises.
Chargeable event = DAMPS.
6.16: How much can a investment bond withdraw?
LOOK AT R03 QUESTIONS AND CALC BOOK!!! ALTHOUGH ON BASICS OF TOP SLICING IS NEEDED FOR J12
To confirm the basics of bond taxation:
Non-taxpayers cannot reclaim the 20% already paid by the fund.
Basic-rate taxpayers have no further income tax liability unless the gain makes them a higher-rate taxpayer.
Higher-rate taxpayers will pay an additional 20% and additional-rate taxpayers will pay an additional 25%.
Top-slicing may apply.
note:
Offshore bonds are structured in exactly the same way as onshore bonds, for everything other than tax treatment. As an example, offshore bonds don’t pay enough tax for HMRC to say that they have effectively paid 20% basic rate tax.
One of the reasons that people choose offshore bonds is something known as ‘gross roll-up’.
An investor can take 5% per policy year of their original investment out of the bond (This is deemed a return of capital, so not a chargeable event)
The 5% withdrawal is cumulative (5% per year)
- Any withdrawal of more than the ‘unused, cumulative, 5%s’ of the investment, in any one year, must be added to the investor’s income for that tax year to establish whether they are still a basic rate taxpayer. (for onshore bonds, 20% is deemed to have already been paid, so if HRTP or ARTP there may be a further 20% or 25% liability)
If they pay tax higher than basic rate, they will pay additional income tax on the chargeable gain.
- The 5% withdrawals are not tax-free, they are tax-deferred. When the investor is deemed to have withdrawn 100% of their original investment, any gain will be potentially chargeable in the tax year the funds are taken.
- The Personal Savings Allowance (PSA) can be offset against gains made from investment bonds.
TOP SLICING CAN BE USED
Offshore bonds are structured in exactly the same way as onshore bonds, for everything other than tax treatment. As an example, non reporting offshore bonds don’t pay enough tax for HMRC to say that they have effectively paid 20% basic rate tax.
One of the reasons that people choose offshore bonds is something known as ‘gross roll-up’.
This does mean that, in the hands of the investor, tax is due at the investors’ highest marginal rate on the entire growth achieved. There is no allowance for tax paid in the bond, as there hasn’t been any tax paid.
So, a basic rate taxpayer will pay 20%, a higher-rate tax payer 40% and an additional rate tax payer 45% on the gains from offshore bonds.
Offshore bonds
What is time apportionment relief.>
Not everyone who invests in these will be UK residents. For anyone who changes their residence, the tax is apportioned for time spent outside of the UK. This is known as time apportionment relief.
It means that UK income tax is only applied to the gain for the period that the individual was a UK resident.
when we looked at offshore funds earlier, we mentioned ‘reporting or non-reporting’ funds.
Offshore bonds are not subject to the reporting considerations that affect other offshore funds.
6.18: What are Structured Products
There are three main types of structured product
100% capital protection
Partial Capital Protection (The investor gets their money back unless it has fallen below a set amount)
No capital Protection
Investors seeking capital protection with an exposure to the stock-market often find that there are very few alternatives to these. They have been widely sold through banks throughout the last ten years.
There are two component parts to structured products:
What are they?
A zero-coupon bond provides the guarantee. The return is in the form of a capital (no income).
A call option
In structured products that have no capital prtection, this zero coupon bond element is gone
What are Structured Capital at Risk Products (SCARPs)?
Simply a structured product that where the capital is not 100% protected
Are structured products tradable?
No
Tell me the difference between active/passive fund management
Active management is where the fund manager is actively seeking to select investments that will outperform an index or chosen benchmark for the fund (decided according to the investment objectives of the fund).
Within equity funds there are two types of active style: top-down and bottom-up
Within equity funds there are two types of active management style: top-down and bottom-up
This is a common question in the J12 exam so ensure you know the difference between them.
Top down = Asset allocation - Sector allocation - Stock selection
Bottom up = Stocks selected first, which then decides the rest
IMPORTANT - Different Bottom-up strategies to active management. Tell me about each and what type of fund strategy (growth, capital protection etc) that it is most appealing to.
Value
Growth at a reasonable Price (GAARP)
Momentum
Contrarianism
IMPORTANT : It is highly likely you will get a question on these in your exam.
Value =
fund manager believes you can find undervalued shares if you look hard enough and find out enough about a company. Once found, they buy and keep hold. For growth managers
Growth at a reasonable Price (GAARP) =
Find firms with proven track records. Dont mind paying shares even if at a premium. Appeals to active growth managers
Momentum =
React to investor sentiment and markets. depending on trends etc. Rotate often from bubble to bubble. Used most by average managers
Contrarianism =
Goes against trends as it is believed most analysis is wrong. Opposite to momentum. Often used by hedge fund managers
Indirect investment products
Investors’ money is pooled in a large portfolio of assets. Examples include OEIC and unit trusts.
With investment trusts and with-profits bonds, the link to the assets’ value is less direct.
The pooling of resources allows for a diversified spread of investments, at a lower cost than could be achieved by direct means.
Unit trusts and OEICs – general characteristics
Often referred to as ‘funds’ and very popular investments.
They are classified into 30+ sectors.
Each sector is made up of funds that invest in similar assets.
Investors buy units or shares in the scheme, not in the underlying assets.
Rules ensure that authorised funds operate within the scheme particulars.
Unit trusts
The trustee ensures that the investors’ interests are protected.
The manager controls the assets and trades them, within the trust deeds rules.
The trustee monitors the manager’s actions and holds the assets within the trust.
The manager is responsible for the investment of the fund.
They must publish half-yearly reports.
They are subject to the corporation tax regime.
Income is received and distributed half-yearly or re-invested.
Investors pay income tax on distributions and capital gains tax on gains.
The trust pays income and provides the opportunity for growth.
Most unit trusts can be placed within an ISA wrapper, often without additional charges.
There is no secondary market. The investor deals with the unit trust provider who creates units for each new investment and cancels units when investors cash in their holdings.
Units are identical for all investors.
The trust’s unit price must reflect the Net Asset Value (NAV) of the fund.
The trust’s price is governed by FCA rules.
Charges are made to cover the running and management of the trust, such as initial charges, annual management charges, and ancillary fees.
OEICs
A diversified collective investment vehicle: similar to unit trusts.
An OEIC is not an investment trust or a trading company.
The OEIC equivalent of the trustee is the Depository.
They employ a manager, who manages the fund in return for an annual management fee.
The OEIC publishes reports half-yearly.
OEICs can be held in ISAs, exactly as per unit trusts.
Investors buy shares rather than units, but these are shares in the scheme not in the underlying investment(s).
Like unit trusts, the OEICs value is linked to its NAV.
OEICs are more EU-friendly than unit trusts, and can be marketed throughout the EU, once approved in the UK.
Likewise, EU funds once approved by their member state, can be marketed throughout the UK.
The tax position of OEICs is identical to unit trusts.
Unit trust and OEIC management services
Most fund management groups now offer at least one multi-manager option to help achieve greater diversification.
Fund of Funds and Manager of Managers arrangements are commonplace.
Fund platforms and wraps are on the increase, fuelled by ‘the digital age’.
They usually offer their own ISA wrappers, allowing investors to hold funds from a range of providers within one wrapper.
Offshore funds (not offshore bonds)
The FCA recognises offshore funds under various sections of the FSMA 2000.
For a UK resident and domiciled investor, the tax benefits of investing offshore are minimal.
Funds are either reporting or non-reporting.
Closed ended funds / investment trust companies
These are listed on the London Stock Exchange.
They have independent boards and are regulated by company law.
They have a fixed capital structure and a fixed number of shares.
The price is therefore influenced by supply and demand, and does not have to match its NAV.
Trusts trading under their NAV are said to be trading at a discount and those above their NAV are said to be trading at a premium.
There is a secondary market where investment trusts are traded.
This means that fund managers are not forced to sell assets to redeem investments back to investors, allowing them to take a longer-term view.
As with the other collective investments, a wide range of funds, in different sectors, is available.
Investment trusts can borrow or ‘gear’ their fund to increase cash flow in to their scheme.
Over-geared funds add significant risks.
REITs are pooled investments, comprising of a ring-fenced property business and non-ring-fenced management company.
Exchange Traded Funds (ETFs) and Exchange Traded Commodities (ETCs)
ETFs can be bought and sold like other shares listed on the stock market.
They are tracker funds, with low charging structures.
A variety of indices can be tracked across the different asset classes.
They pay no Stamp Duty.
They can be invested in ISA wrappers.
ETCs are the same as ETFs, but with commodities, and allow exposure to different types of investments.
European funds
All European funds are structured as companies with variable capital (i.e. no trusts).
SICAVs are established in Luxembourg and are similar to OEICs.
They can be distributed cross border.
FCPs are tax transparent contracts between investors and the fund manager.
Once authorised in EU home state, UCITS funds can be actively marketed across the EU without the need for authorisation in each member state.
There are prescribed rules that UCITS funds must follow.
UK UCITS funds comply with UCITS rules but cannot be marketed freely across Europe.
EU UCITS funds may be sold in the UK under the temporary marketing permissions regime until 2025; thereafter they must be recognised by the FCA under the UK Overseas Fund Regime.
Hedge funds and funds of hedge funds
Pooled investments, often managed in the Cayman Islands or Bermuda.
Allows for regulation-free trading, which has spawned some unique trading methods not allowed in the UK.
Actively-managed investment portfolios, often for the wealthy.
High charges apply, including performance-related charges.
Fund of hedge funds are similar to normal fund of funds, but offer greater diversity.
Absolute return funds
Aim to achieve positive returns in all market conditions by implementing different investment strategies.
Success is heavily-dependent on the fund manager.
Enterprise Investment Schemes (EIS) and Venture Capital Trusts (VCT)
Private equity investments in small unquoted companies.
EISs often involve a single company which you intend to take an element of control over.
The ‘Dragon’s Den’ of investments.
VCTs are collective schemes where no control is taken and investment will be in many companies that you will not necessarily know.
Both options offer tax relief as a ‘tax reducer’ within certain limits.
Life assurance-based investments
There are many types of life assurance-based and packaged investments available.
Some aim to provide income, some capital growth and some a combination of both.
They offer access to protected and guaranteed products that are often not available to collective schemes.
With-profit investments are some of the oldest on the marketplace.
These offer ‘smoothed’ returns, within lower-risk environments.
Qualifying policies are now rare, particular since the £3,600 contribution limit was imposed.
Distribution funds can split out true income and distribute this, leaving the capital to grow.
Income payments are treated as capital payments.
5% withdrawals (of the original investment) can be tax-deferred until a chargeable event occurs.
Growth in the fund is liable to income tax, not CGT, meaning the CGT exception is of little use.
Structured products
Designed to offer tailored combinations of risk and return.
Many offer capital protection and guarantees.
Often linked to an index, such as the FTSE 100 index.
Investment management styles
Active management can be top-down or bottom-up.
Top-down decides asset allocation, sector selection then stock selection.
Bottom-up is the reverse, and ‘ends up’ with an asset allocation.
Active management will be more expensive than passive management.
Passive management involves tracking an index.
Jay and Jasmine have both received a £1,500 dividend from the non-exempt element of their UK REITs. Jay is an additional rate taxpayer and Jasmine pays higher rate. Ignoring the dividend allowance, how much more income tax will Jay pay than Jasmine on this distribution?
£0.00.
£84.00.
£300.00.
£375.00.
£84.00.
We need to do some maths on this one…
As an additional rate taxpayer, Jay would pay 39.35% of the distribution. £1,500 x 39.35% = £590.25.
As a higher rate taxpayer, Jasmine would pay 33.75% of the distribution. £1,500 x 33.75% = £506.25.
£590.25 - £506.25 = £84.
Alternatively, a quicker method is to calculate the answer using the 5.6% difference (39.35% – 33.75%) in their respective tax rates:
£1500 x 5.6% = £84.
Portfolio A is invested in FTSE 100 companies and Portfolio B is invested in unlisted shares. Portfolio B will have a greater…
interest rate risk.
inflation risk.
default risk.
counterparty risk.
default risk.
There is a bit of a cross-over from chapter 5 here.
Interest rate risk could affect either of them, but you could not say that it is more likely to occur in smaller firms. The same applies with inflation.
Counterparty risk is the third-party risk generally associated with structured bonds.
Smaller, unlisted companies are more likely to default, so are more susceptible to default risk.
Who is ultimately responsible for the assets within a unit trust?
The Depository.
The Board of directors.
The Trustees.
The Fund Manager.
The Trustees.
Not to confuse unit trusts with OEICs is the key here. The Depositary would be the correct answer to a similar OEIC question.
A trust is not a company, so has no directors and the fund manager, whilst having responsibility for the assets within his remit, answers to the trustees, who are ultimately responsible.
Which of the following investments will have the largest ability to borrow money?
A with-profit bond.
A defined contribution pension scheme.
An OEIC.
An investment trust.
An investment trust.
A with-profit bond cannot borrow, nor can most pension schemes. Even those pension schemes that can borrow have stringent rules attached (SIPPs/SSASs)
OEICs can borrow in exceptional circumstances and only over short terms. Of the options listed, the investment trust is certainly the one with the most scope and ability.
Can OEICs borrow?
OEICs can borrow in exceptional circumstances and only over short terms.
In respect of investment trusts, if the purchase price is said to be ‘at a premium’ this means…
the trust is priced below its Net Asset Value.
the trust has reduced charges at this time.
the trust is priced above its Net Asset Value.
the trust is heavily geared.
the trust is priced above its Net Asset Value.
If it was below its NAV, it would be trading at a discount. It has nothing to do with charges or gearing.
Phil has £20,000 invested in a structured product that he was sold by his bank several years’ ago. He is unsure about how the product produces its capital guarantee and investment return. You correctly explain that it is often a combination of…
a zero-coupon bond to provide the capital guarantee and a future to provide the investment return.
a future to provide the capital guarantee and a call option to provide the investment return.
a zero-coupon bond to provide the capital guarantee and a call option to provide the investment return.
a put option to provide the capital guarantee and an equity fund to provide the investment return.
a zero-coupon bond to provide the capital guarantee and a call option to provide the investment return.
The zero-coupon bond provides the guarantee.
The call option gives the fund the option to buy at roughly the price at investment, and will provide the growth if the index rises.
The Fund Manager of a unit trust is required to…
be independent from the management group.
trade the funds’ assets to try and make a profit.
ensure that the assets of the fund are safely held by a competent custodian.
set up a register of unit holders.
trade the funds’ assets to try and make a profit
All the others are duties of the Trustees.
OEICs and unit trusts have many similarities, but which of the following would you associate with an OEIC, not a unit trust?
It is an investment company with variable capital.
The assets are held in a trust.
It has a fixed capital structure.
It is traded on the stock exchange.
It is an investment company with variable capital.
Explanation:
A unit trust is where assets are held in a trust.
A fixed capital structure and trading on the stock exchange relates to investment trusts.
Peter is considering the purchase of an Exchange Traded Fund (ETF) or a FTSE 100 index-tracking OEIC. He should be made aware that…
the ETF is likely to have lower charges.
the ETF will only use derivatives to track the index, whereas the OEIC will be fully replicating.
Stamp Duty would be paid on both when purchased.
he can only use his CGT exception on the OEIC, as the ETF is liable to income tax on his gains.
the ETF is likely to have lower charges.
Explanatio
ETFs can be fully replicating, in fact, many are.
No Stamp Duty is paid on ETFs, and CGT is potentially payable on both.
When comparing onshore and offshore bonds, Mia, a basic rate taxpayer and UK resident, would be correctly advised that…
charges on onshore bonds are generally lower, due to tax relief being given.
the offshore bond will have no tax advantages.
she will pay more personal tax when a chargeable gain arises for an offshore bond.
top-slicing relief is only available for onshore bonds.
she will pay more personal tax when a chargeable gain arises for an offshore bond.
An offshore bond has no tax deducted at source, therefore Mia, when calculating her own tax liabilities, is liable for basic rate tax. Top-slicing would be available if the gain moves her from the basic rate into a higher rate of tax.
An offshore bond does have slight tax advantages for a UK taxpayer, but these are limited to the gross roll up experienced by the bond, due to it having no internal taxation.
Which type of investment strategy focuses on finding companies that have a long term sustainable advantage?
Value.
Contrarianism.
GAARP.
Momentum.
GAARP.
Value stocks are those that are undervalued by the market compared to their fundamental value.
Contrarianism is where fund managers buy stocks that go against the trend.
Momentum is buying with the trend. GAARP is buying companies with long-term sustainable advantages.
An investment trust is currently trading at a price of 125p. It has a NAV/share of 95p. From this we can deduce that it is trading at a:
premium of 24%.
discount of 24%.
premium of 31.6%.
discount of 31.6%.
Discount or premium = (Share price-NAV/share)/(NAV/share)×100, so
(125-95)/95×100=31.6%
It is positive, therefore it is trading at a premium (share price is greater than the NAV).
