Exam Questions

Question 1

What is the CGT liable on a Trust?

Answer 1

If the settlor, a spouse or minor child, benefits from the trust then it is the settlor who is liable.

If the trust is an offshore trust any gains may fall on the settlor.

Gains are charged at 20%

The CGT allowance for most trusts is £6,000

Where the beneficiary is vulnerable the allowance is £12,000

It can be less than £6,000 if the settlor established more than one trust, to a minumum of £1,200

Question 2

What is the difference between MWR and TWR?

Answer 2

• MWR is influenced by size and timing of cash flows
• MWR shows average growth rate of money invested
• TWR does no suffer from cash flow impacts
• TWR measures the growth rate of a single unit of currency
• TWR is preferable
• TWR and MWR will vary when cash flows are large relative to the account

Question 3

What is the double taxation relief?

Answer 3

• If overseas income is taxable in both the UK and overseas then may get some relief
• Need to notify authorities and exemption documents filled out and then the income will be exempt in one of the countries
• If no treaty exists then may get unilateral relief

Question 4

Who can claim the personal allowance?

Answer 4

• UK residents
• May be claimed for non-UK residents if they are:
  
  • Citizens of the EEA or commonwealth
  • Resident in the Isle of Man or Channel Island
  • Current of former Crown Servants and their widows
  • Former resident who have left the UK for health reasons.
• Since 2008 individuals who are resident but not UK domiciled will not be able to use both the remittance basis and any of the personal income tax allowance.

Question 5

Onshore investment bonds are likely to be relatively MORE attractive to:

Answer 5

Higher-rate taxpayers where the underling investments generate income rather than capital growth.

Question 6

What is the remittance basis?

Answer 6

• UK residents who are non-doms do not get taxed on income and capital gains until it is remitted to the UK
• Not aplicable to full or part time UK employment but is applicable to non-UK employment and non-UK investment income
• Under £2,000 then no claim is needed
• Over £2,000 then it can be claimed but at a cost:
  
  • Lose use of personal tax allowance
  • If non-dom is resident in 7/9 years then it costs £30k
  • If non-dom is resident in 12/14 then it costs £60,000
  • If non-dom is resident in 15/20 then they cannot claim
  • If retired only 90% of non-UK pension will be taxed if she does not use her remittance basis

Question 7

Explain how correlation impacts the efficent frontier?

Answer 7

At correlation of +1 it is a straight line connecting A and B. Meaning risk and return is completley proportionare to weights

At correlation of -1 the risk has dropped to zero and return will be the weighted

Where there is zero correlation we see the benefits of diversifcation as the risk of the portfolio is less than holding the assets in isolation

Question 8

An investor owns FTSE100 shares with a current value of £550,000 and stands at 7,405.

How many puts does a investor need to buy to protect his portfolio?

Answer 8

The contract size of a FTSE100 option is the index level x £10 per point.

With the put option at say 7,400 each contract hedges £74,000 of shares so the number of contracts needed to fully hedge are:

£550,000 / £74,000 = 7 contracts

Question 9

How would one hedge a portfolio of gilts?

Answer 9

• Gilt futures are based on a basket of deliverable gilts and one will be the cheapest to deliver
• The CTD is the one with the highest implied repo rate
• The Repo rate is a measure of the funding cost implied in future prices which reflects the difference in a cash price and price of a future

Number of contracts = price factor x (nominal value of CTD portfolio/nominal value of the contract)

E.g. you have a portfolio of CTD bonds with a nominal value of £10m and a market value of £11.5m. The price factor is 1.12. The contract size of the long gilt future is £100,000. Number of contracts needed to hedge = 1.12 x (10m/100k) =112.

Question 10

Explain how a split capital investment trust works?

Answer 10

• ITs can have split capital structures by issuing various share classes:
  
  • Income shares: Pay a regular dividend from surplus income and have predetermined maturity value
  • Convertible preference shares: Pay income and can be converted into ordinary shares
  • ZDPs - pay no dividend and the investors return is the difference between the price they pay and the redemption value at maturity.
• ITs use different shares classes so they can appeal to different investors circumstances
• The value of all shares will vary until the trust is wound up

Question 11

What are the different indirect ways of investing in commodities and what are the advantages?

Answer 11

• Shares in commodity companies
  
  • As commodity price rise so should revenues
  • Correlation will depend on operational and hedging activites
• Commodity funds
  
  • More suited for capital growth than income
  • Retail UCITs cannot invest in commodities
  • Has to be non-UCITS or QIS
• ETFs
  
  • Liquid vehicles
  • Exposure to a reange of assets
  • Simple and low cost
• Advantages:
  
  • Lowerr correlation to other assets
  • ETFs have high liquidty
  • Some funds pay dividend
  • Low storage costs
  • Minimum dealing size

Question 12

What are the direct methods of investing in commodities?

Answer 12

• Cash market:
  
  • Buy and sell from commodity broker
  • Not practical because of min quantities, risk of deteriation and storage
  • Can be stored at LME warehouse
  • For immediate delivery
  • Spot price paid
  • Payments made immediately and charges for storage and insurance
• Futures market:
  
  • Agreement to buy and sell a standard quantity of a specifc asset on a fixed future date, at a price agreed today.
  • Generally, requires that a margin account to be set up to make funds available in the case of adverse movements.
  • Futures are generally cash settled daily
  • Standardised quantity:
    
    • Futures contract of led might be for 25tonnes of the metal, or a currency future might be for £20,000
    • Purpose is so that buyers and sellers are clear about the quantity that will be delivered.
  • Homogenous and specifced asset:
    
    • Legal documents set out in detail the size of each contract, when delivery is to take place and what exactly is to be delivered.
  • Fixed future date:
    
    • Delivery takes place on a specific data known as delivery days.
  • Price agreed today:
    
    • Uses futures because they provide certainity or a reduction of risk.

Question 13

What are the different types of commodities?

Answer 13

• Hard:
  
  • Gold, copper, silver ect.
  • Generally relate to metals which require substantial capital expenditure to extract from the ground.
  • Can be used to hedge against inflation
• Energy:
  
  • Crude oil and natural gas
  • Oil and other energy costs and can be extremely volatility and plays a unique role in affecting the outlook for inflation and general economic conditions
• Soft:
  
  • Wool and cottom
  • Usually renewable on an annual cycle
  • Many are perishable and can be highly volatile.

Question 14

Explain what offshore banking is and why someone might use it?

Answer 14

• Banking under a different financial regulatory regime from the one in place from a persons home country
• UK residents might use services in Jersey, Guernsey or IOM.
• Why use it:
  
  • Some have lower cost base so might offer higher rates
  • Many are in jurisdication with favourable tax regimes
  • Deposits might offer some protection
  • More stable regimes
• Usually only available to the wealthy
• Interest earned is paid in gross with no tax deduction

Question 15

What is value averaging?

Answer 15

It is when an investor would buy shares such that the portfolio value increases by at least £500 a month.

A investor focused on increasing their value each period are forced to add how many shares it takes.

Question 16

What is pound cost averaging are what are its merits and drawbacks?

Answer 16

• This is when an investor invests a fixed amount at fixed intervales of time.
• This works well if it means committing yourself to investing a fixed amount of your salary each month.
• However, research has shown that PCA does not provide returns above other strategies.
• Investing a lump sum on average beat PCA by 3% a year but that does come with higher vol.
• PCA is often reccommended to lower-risk investors with a lump sum.
• Benefits:
  
  • It avoids regret if price falls as we are buying more shars.
  • Satisfied our deep-seated need to avoid a loss.
  • More prudent to spread an investment over months than take a gamble on a large one-off investment.
• Drawbacks:
  
  • Only point in adopting PCA is becuase there is an implicit expectation of a fall in prices, and if this is the case then why invest.

Question 17

What does Corner-Fisher do?

Answer 17

• If returns have a negatiev skew or non-zero excess kurtosis then the return distribution will be non-normal and this will not be reflected in VAR
• CF estimates quantiles from a distributions using skew and excess kurtosis to adjust the normal distribution

Question 18

How are investment trusts income taxed?

Answer 18

• Dividends are paid gross of tax
• Overseas dividends may be received net of foreign withholding tax.
• The investment trust is liable for tax on other income at the corporation tax rate applicable.
• Investors dividends:
  
  • Non-taxpayers cannot reclaim this tax
  • Lower-rate and basic rate taxpayers have no further liability
  • Higher-rate taxpayers are liable to a further 22.5% on the grossed-up dividend
  • Additional rate taxpayers are liable to a further 27.5% on the grossed-uo dividend.

Question 19

How are REITS taxed?

Answer 19

• CGT:
  
  • Not subject to CGT on gains made on the disposal of property as long as they distribute at least 90% of their profits each year as dividends.
  • Investors disposing of a holding in a REIT may be liable to CGT on any gains made.
  • Losses may be offset or carried forward
• Income tax:
  
  • REITs are required to pay out at least 90% of the property rental income.
  • These dividends are taxed as property rental income in the hands of the investor.
• Benefits:
  
  • A traditional property company pays both corporation tax and CGT on its property related activities plus the investor pays income tax aon their dividends
  • REITs do not pay corporation taxes
  • Property investment trust companies hold shares in property companies not the direct asset itself.
  • The investor does pay a bit more income tax on their dividend then they would for other sorts of shars as it is classed as rental income. They will pay 20%, 40% and 45% depending on their tax band.

Question 20

What is the non-dom status?

Answer 20

• The rules prevent people born in the UK claiming non-dom status when living in the UK even if they have acquired other domiciles under general law.
• 15-year rule:
  
  • Individuals who have been a UK resident for more than 15 of the past 20 years but are foreign domiciled under general law, will be deemed domiciled for all tax purposed in the UK
• Returning UK dom:
  
  • UK-doms that may emigrate will remain UK-deemed domiciled for IHT purposes for at least three years after they have been non-UK resident.

Question 21

What are the arguements for and against dividend discipline?

Answer 21

• For:
  
  • Dividend payments are a valued and relied on source of income for some shareholders.
  • Dividends are also a source of financial discipline for corporate boards
  • In many markets there is a seperate general meeting resolution to approve the final dividend, so this discipline is real.
  • Companies who have not identifed and justified reinvestment opportunties and who also have low pay-our tations are a cause of investor concern.
  • Low or no dividends might be becuase of a high bonus pool or poor cash flow generation. A fund manager would then wish to oppose unjustifiably low dividend pay-outs.
• Against:
  
  • It is possible for cash dividends to be a drag on investment performance by lowering a funds intended beta and expected return - the portfolio cash level is then unintentionally high
  • It is possible that companies with high R&D, innovation and disovery will have a balance sheet that is less cash generative and therefore more liquid. This could equate to low dividend payments but also to higher expected return.

Question 22

What is an investment objecitve?

Answer 22

An investment objective is set to help achieve the overall objectives of the client and might inlclude:

• Maximise the probability of obtaining an average annualised net return over any period greater than x with vol no greater than Y
• To achieve with 99% probability that the fund covers 100% of the liability within acceptable risk

Question 23

Describe the target replacement objective?

Answer 23

• Common in retirement planning and takes into account both the liquidity needs and totral return to target dates.
• Target retirement funds are becoming increasing popular.
• Key retirment risks are fund shortfall, longevity and inflation.
• Glide path:
  
  • Provide a range of target date funds that gradually move the clients investment from a wealth accumulation phase to a wealth preservation strategy as the client advances towards retirment in their life cycle.
  • During the accumulation phase, asset allocation strategy will be heavily biased towards risk equity markets.
  • Five years before retirement the make up of the portfolio will be adjusted with the debt/equity composition of the managed fund adjusted to a more balanced blend. .
  • Five years after retirment funds will focus even more on income generation and wealth preservation.
• Alternatively this investment objective may be expressed in terms of the amount of money the fund needs to hold in order to be able to buy an annuity.

Question 24

What is a benchmark driven objective, what are the properties of a benchmark and what types of benchmarks?

Answer 24

• Expresses the required return relative to an appropriate benchmark
• Essentially this is a passive strategy where the managed portfolio matches as closely as possible to the benchmark portfolio
• Deviation from the benchmark can be measured by the tracking error
• Properties of a benchmark:
  
  • Unambigous - natures of the benchmark must be clearly defined
  • Investable and owned - must be available for investment purposes so that a suitable benchmark can be constructed
  • Measureable - returns must be easy to measure with a timely and high quality data
  • Appropriate - must be consistent with the investment style and strategy adopted by the managed fund for the client.
  • Specifced in advance - specifc in advance in the policy statement and known to all parties involves in the investment agreement signed off by the client and the advisory firm.
• Types of benchmark:
  
  • Peer of managed universes – The managed fund was compared to a median of grouping.
  • Broad market indices – FTSE All-Share
  • Style indices – large cap, small cap and value and growth
  • Factor model-based – takes one or more of the systematic sources of return and calibrate these to the overall returns obtained from the managed fund, single index model, Fama-French three-factor
  • Custom – tailored to match closely with customised investment approaches taken by the manager.

Question 25

Explain the investment objecitves of relative return, absolute return, best efforts or lump-sum?

Answer 25

• Relative return:
  
  • Minimise tracking error risk and aim to construct the portfolio that adopts the same risk factors in the benchmark but will have some flexibility to modify composition to beat the benchmark.
• Absolute return:
  *

Question 26

What are money market funds?

Answer 26

Collective investments that buy and sell short-term cash deposits and money market securities. Funds offers investors with modest amount of capital, acess to high-yielding money market instruments.

Question 27

Given the below circumstances what would your recommendation be?

• Retiring at age 65 and will have £70,000 after taking her 25%
• She wants income flexibility and not run out of money before she dies
• Comfortable taking limited risk in the portfolio and happy to use assets if needs be

Answer 27

• Portfolio circumstnaces:
  
  • Amanda faces longevity risk and inflation risk
  • Need to see some growth, need to manage on a total return basis and over time Amanda will use-up the capital and income
  • Amanda intends to make flexibile withdrawals so needs high level of liquidity and flexibility
  • There is no particular income requirement, fixed income should be short dated to provide liquidity
  • Encourage Amanda to not drawdown when funds NAV has dropped, drawdown same percent of NAV rather than actual £ amount
  • Keep costs down and use collective funds
• Portfolio structure:
  
  • 50% fixed income
    
    • Index-Linked
    • Conventional government and corporate bonds
  • 40% equity
  • 10% property/alternatives and cash

Question 28

Given the below circumstances what would you recommend?

• Plans to retire at 67 and will have £128,000 after taking 25%
• George would like to draw £3,600 per annum in real terms for the rest of his life
• He also has an £8,000 income per annum from a DB pension
• Needs to have significant proportion of the capital left to hand when he dies.

Answer 28

• Portfolio Circumstnaces:
  
  • Can have less asset liquidity
  • Use collective funds
  • Can invest for yield but achievable without capital erosion
  • Happy to take more investment risk
  • More-equity and growth assets
  • More of a decline income requirments
  • Inflation + 3% = total return of about 5% on average.
• Portfolio Structure:
  
  • 50-55% equity
  • 25-30% fixed income
  • 10% cash
  • 10-15% alternatives

Question 29

What rate of inflation matters most to the investor?

Answer 29

• The inflation rate that matters is the investors domestic rate
• The selection of an overseas inflation rate is arbitrary becuase it is not the inflation rate that the client is trying to protect his purchasing power against.
• If nominal returns are deflated by the inflation rate in each country invested in, it is not clear what the real return presented to the client indicates.
• Overall, it is better to show overseas nominal returns because the foreign inflation rate is not relevant to the domestic investors.
• If the exchange rate is moving in step with differences in overseas/domestic inflation then converting local market returns to the clients domestic currency will already take account of inflaiton.

Question 30

What is the order of taxation?

Answer 30

1. Non-savings income is first, i.e. salary and then non-salary income e.g. interest, dividends
2. Dividends are taxed as the top slice of income
3. Capital gains are not treated as income but are related to income
4. Capital gains only paid each tax year with tax return

Question 31

Explain what a SEIS is, the tax benefits and the criteria to be one?

Answer 31

SEIS complements the EIS and hopes to stimulate entrepreneurship and to help small, early stage companies to raise equity finance that may face barriers to raising external finance.

Applies to smaller companies that are under two years old with fewer than 25 employees and assets of up to £200,000.

Scheme makes tax relef available to investors who subscribe for shares and have a stake of less than 30% of the company

• Tax benefits:
  
  • Investors can get up to 50% tax relief in the tax year the investment is made
  • SEIS investors can place a maximum of £100,000 in a single tax year, which can be spread over a number of companies
  • A company can raise no more than £150,000 in total via SEIS investment
  • Investors must not hold more than 30% stake in the company in which they invest
  • Investors can receive up to 50% tax relief in the tax year the investment is made, so 50% tax relief on £100,000
• Criteria:
  
  • The company seeking investment must be based in the UK
  • Applies to smaller companies that are under two years old with fewer than 25 employees and assets of up to £200,000
  • Schemes makes tax relief available to investors who subscribe for shares and have a stake of less than 30% of the company
  • Company has to be trading in a approved sector - generally not finance or investment.

Question 32

What is a EIS, the restriction and tax benefits?

Answer 32

EIS’s are designed to help smaller, higher-risk companies to raise finance by offering a range of tax reliefs to investors.

• Income tax relief:
  
  • Will receive tax relief on 30% of the cost of the shars which is offset against the individuals income tax liability for the year in which the investment is made. So tax relief of 30% on up to £1m of qualifying investments.
  • It is possible to carry back or poart of the investment to the preceding tax year.
  • An individual is able to reduce their tax liability to zero through EIS relief, allowing the taxpayer to claim back any repayable tax dedected at source such as PAYE.
• Restrictions:
  
  • Individual cannot be connected two years before or 3 years after to the company
  • Cannot own more than 30% of any share class
  • Must hold the shares for a minimum of three years to get tax relief, if not the relief will not be clawed back.
• CGT Exemption:
  
  • No CGT charges on any gain of EIS shares disposed after the minimum holding period on which income tax relief was given and not withdrawn
  • CGT can be deferred one year before or three years after
  • If shares are dispossed of with a loss it can be used to offset against income or capital gains.
  • Any losses offset against income are limited to the total exposure being 38.5% of the initial outlay.
• Criteria:
  
  • Qualifying trading company
  • Unquoted at time of share issue
  • Gross assets cannot exceed £15m
  • Employ less than 250 people
  • Limit of 12m and 20m for knowledge intensive companies

Question 33

What are venture capital trusts and the tax treatments?

Answer 33

A VCT is a pooled investment company whose shares trade on the LSE. Aims to make money by investing in typically very small companies which are looking for further investment to help develop their business. Can trade at premium or discount to NAV.

• Tax treatment:
  
  • Attracts 30% income tax relief when buying a newly issued VCT but wont get this tax relief if she buys in second market
  • No capital gains tax on profits from selling VCT shares no matter what the period
  • Dividends from VCTs do not attract income tax but dividends are not common however because the comapnies are small private companies
  • If the VCT makes a loss the loss can’t be used to reduce CGT bill
• Criteria:
  
  • Shares have to be held in VCT for at least 5 years to keep the income tax relief
  • Locked i her investment for 5 years
  • 200k pa limit
• Risks:
  
  • No guarantee that investment will keeps its value
  • Can be hard to find a buyer for VCTs so might have to sell at large discount
  • Only covered by FSCS up to 50k per person
  • Not regulated retail investment products
  • VCT charges can be high

Question 34

What is the tax cost ratio?

Answer 34

• Represents the percentage of an investors portfolio that is lost to taxes on a yearly basis due to the assets held in the portfolio and the trading strategy employed by the fund manager.
• Tax cost ratio = (1(1+TAR)/(1+PTR))X100
• TAR represents tax-adjusted return
• PTR is the pre-tax return

Question 35

What is the income tax liability rates?

Answer 35

• Basic personal allowance = 12,500
• Up to 37,500 above the allowance = 20%
• Above 37,501 above the allowance = 40%
• Over 150,000 = 45%
• Over 100,000 for every £2 earned you lose £1 of your allowance

Question 36

What is the dividend income tax rates?

Answer 36

• First £2,000 is free
• Keep below basic rate = 7.5%
• Above basic rate and below £150,000 = 32.5%
• Dividend above £150,000 = 38.1%

Question 37

What are the interest savings allowances?

Answer 37

• Basic rate can earn £1,000 tax free than taxed 20%
• High rate can earn £500 tax free than taxed at 40%
• Additional tax rate payers do not have any allowance then taxed at 45%
  
  • Interest includes from banks
  • Interest from gilts and corporate bonds
  • Purchased life annuities

Question 38

What is the loss days measure?

Answer 38

• Hidden risk is the sequence of risk
• Positve or negative returns can follow one another more than we would expect
• Sequence of returns is the risk of receiving below average investment returns in close order
• Fund with a long sequence of negative returns is higher risk because there is greater risk concentration is that fund
• Absolute measure of fund performance

Question 39

What is the appraisal ratio?

Answer 39

• Used to compare any active management within a portfolio by reference to the performance of a passive tracker fund
• It compares the funds alpha to the portfolios unsystematic risk
• Active portfolio management seeks to achieve a positve abnormal return or alpha, although this is likely to be accompanies by additional unsystematic risk
• Formula:
  
  • Portfolio alpha / portfolio unsystematic risk
• Assesses this abnormal return by reference to the unrelated unsystematic risk carried in the client portfolio and not present in the benchmark portfolio
• If the ratio exceeds the benchmark sharpe ratio then the active performance has provided a superior return performance as the extra return has more than compensated for the additional risk by reference to the CML.

Question 40

What is the sortino ratio?

Answer 40

• This is a variation of the sharpe ratio
• It subtracts the risk free rate from the return and then divides that by the downside deviation rather than the total risk measured in standard deviation
• Formula:
  
  • (Return- Risk free) / downside deviation
    
    • Downside deviation: SQRT ((1/60) X Square of the sum of deviations below the mean)

SQRT ((1/60 X 0.43)) = 0.0846

Annualise = 0.0846 x sqrt (12) = 0.29

Sortino ratio = (0.035 - 0.005) / 0.29326 = 0.1

Question 41

What are the non-indexation techniques?

Answer 41

1. Full Replication:
   
   • Replaces every security
   • Good for when all stocks are highly liquid as it will be low cost
   • Minimised tracking error
   • Is self-balancing so there is no need to trade except to reflect distribution and index rebalancing
2. Optimisation:
   
   • Holds fewer stocks but is not self-balancing
   • More trading is required
   • Over time this will drag on performance
   • Optimisation is better applied with large number of stocks with higher transactions costs
3. Stratified sampling:
   
   1. Covers most market cap with fewer securities while maintaining sector and industry exposures
4. Core-satelite aproach:
   
   1. Is a mx of active and passive management that goes well with stratified sampling
   2. Investors holds a core index tracking portfolio
   3. Assets expected to outperform are slightly overweighted while underperforming assets are slightly underweight.
5. Factor mathcing:
   
   1. Replace the style factors of the original index
6. Commingling:
   
   1. An index fund structured as a commingled fund, building block funds are mixed to give an index fund and close to tracking to the benchmark.

Question 42

What is the VAT charged on pooled services?

Answer 42

VAT is 20% paid on top of the relevant transaction vaue of certain goods and services

• Exempt:
  
  • Investment management services provided through pooled funds and insurance wrappers are VAT exempt, including OIECs, authorised unit trusts, and closed-end investment funds such as investment trusts
  • Due to their use of pooled funds, defined contribution pension schemes will not usually pay VAT on investmnet management services
  • Where the segregated arrangement accrues seperately per transaction for dealing and the seperate trasaction costs can be identified then no VAT is payable on the trasaction costs, only the AMC. Most investment managers who used to onvolve by the formed method now have charged to seperate invoicing.
• Non-exempt:
  
  • Discrestionary, segregated investment management services such as segregated investment mandates managed through external asset managers are not exempt from VAT and AMC
  • Where the AMC and transaction costs are periodically billed together the two elements, the AMC and the transaction costs should be billed together, and VAT added to the whole lot.

Question 43

What is the VAT on investment services?

Answer 43

• Exempt:
  
  • Global custody
  • Stock lending
  • Clearing and settlement
  • Foreign exchange
  • Underwriting services
  • Nominee services
• Non-exempt:
  
  • Registrar services - unless supplying your service to an authorised unit trust or an open-ended investment company
  • Advisory, research and evaluation services - unless supplying your service to an authorised unit trust or an open ended investment company
  • Discretionairy fund management
  • Safe custody services

Question 44

Why would an investor use annuities?

Answer 44

1. Stability of principal
   
   • A good way of ensuring a guaranteed income
   • Can also deliver inflation protected income
2. Growth of income
   
   • An annuity with inflation protection may be another way of meeting a growth of income objective
3. Other constraints
   
   • Some of the regular payment can count as a return of capital and tax is only payable on the interest elemetn of the annuity
4. Target replacement income
   
   • Amount of money the fund needs to hold
   • Income stream generated will depend on prevailing annuity rates at the time of retirments as well as the type of annuity needed
5. Deferred annuity
   
   • If there is a target replacement income objective may obtain better and known rate by purchasing deferred annuities today to guarantee future income later in retirement
   • Overcomes later life mortality risk without the need to buy immediate annuity - helps averaging the price of annuities and not risking low annuity yields at point of retirment.

Question 45

What are the different types of ESG strategies?

Answer 45

1. Screening:
   
   • Testing a portfolio against a set of criteria
   • Negative screens remove bad ESG
   • Positve screens selection company that have good criteria
2. Best in class:
   
   • Looking at best company in industries might be the least bad
   • Focus on industry with sustainable profits
   • Provide incentive for company to be the leader in the sector
3. Portfolio tilting:
   
   • Using data providers to find ESG data
   • O/W or U/W to carbon production
   • Still would allow exposure to bad but could make up else where
4. Integration:
   
   • Into valuation process
   • When issues are material they are part of the ESG
   • Natural capital is often not valued or reflected
   • More complete evalution of risks
   • Greater focus on intangibles
5. Responsible involvement influence
   
   • Encouraging corporate directors to improve ESG
   • Support director in balance between risk and return
   • Communication with management

Question 46

What are the 6 Myers Principles?

Answer 46

The Myers report is a report for pension funds to encourage them to follow on a voluntary basis

1. Effective decision making
   
   • Sufficent in house as well as external support
   • Send greater time and resources on asset allocation decisions
2. Clear objectives
   
   • Clear investment objectives for the funds that should relate to liabilities and no relative performance
3. Risk and liabilities
4. Performance assessment
   
   • Formal process to assess performances of managers and trustees
5. Responsible ownership
   
   • Use shareholder powers to actively intervene and use voting rights are used
6. Transparancey and reporting
   
   • Informed and regulated communication

Question 47

What are some well know ESG indices and benchmarks?

Answer 47

• 250 ethical indivies such as FTSE4Good and Dow Jones Sustainable
• FTSE4Good applies negative screening to FTSE All Share
  
  • Tobacco, nuclear power and arms are excluded
  • Remaining are then ranked on ESG factors
  • Dow Jones use best in class approach

Question 48

What are the ESG impact on the investors portfolio?

Answer 48

• Negative screening reduces the amount of securities in a diversified portfolio
• Might exclude utility and energy companies that may provide some protection in a downturn
• When doing positive screening likely that only large cap stocks have the data so unlikely to get smaller companies
• Lower number of stocks means that risk might be higher
• However, risk might be reduced due to lower litigation risk, reputational damage and being shunned by customers

Question 49

What is the performance of ESG investments?

Answer 49

• Only 1.6% of funds in the UK are invested in ethical funds mainly due to assumption that funds have weaker performance
• Data from Morningstar has showed that recent performance has increased but a longer-term study from Bauer showed that longer term performance is not conclusive out-performance of ESG

Question 50

What are enviromental swaps?

Answer 50

Debt swaps which allow the debtor country to have the amount of its debt reduced by the amount that is spends on key envirmental projects

Question 51

What are social impact bonds?

Answer 51

• Raise funds to achieve social objectives
• Investors receive pay-outs based on specific social criteria being met
• They operate over a fixed time but do not offer a fixed return
• More akin to an unusual structured products
• Pay for success financing
• First one was to finance a prisoner rehabilitisation progrem in 2010
• Others might be homelessness, youth unemployment and long-term health issues
• In 2019 there are 32 SIBs

Question 52

What are green bonds?

Answer 52

Conventional debt to raise funds for projects with positive benefits.

Green bonds have some additional transaction costs because issuers must track, monitor and report on use of proceeds but this cost might be offset by:

• Highlighting their green assets
• Positive marketing story
• Diversify their investor base

Issue with them is a lack of standardisation as to what constitutes a green bond

• ICMA has developed the Green Bond Principle to provide issuers guidance on the key componenets involved in launching a credible green bond
• They define green bonds as any type of bond instrument where the proceeds will be exclusively applied to finance or re-finance for eligible green projects

Different types of bonds:

• Green use of proceeds from bonds
• Credit exposure in the bond is to the pledged cash flows of the revenues streams whose proceeds go to treated green projects
• Green project bond which is a single or multiple green project
• Green securitised bond which is collateralised by a green project

Question 53

What of the following would be correct in support for the zero Beta version of the Capital Asset Pricing Model(CAPM)?

Answer 53

• The intercept of the SML is empirically higher than the CAPM risk-free rate
• The zero beta CAPM can explain returns at least as well as the conventional CAPM
• Empirically many investors hold money market funds rather than cash deposits or risk-free Treasury

Question 54

What is the tax on income within the fund for equity funds and bond funds?

Answer 54

• Tax on income:
  
  • Equity:
    
    • Tax charge on 20% of taxable income less allowable expenses
    • Dividend income exempt from tax, so in practice very few funds have net taxable income
  • Bond Funds:
    
    • Tax charge on 20% on taxable income less expenses, less distributions.
    • As funds are required to distribute all net income, these funds should not have net taxable income

Question 55

Which of the following is true for a basic-rate taxpayer with a portfolio of equity and fixed-interest unit trusts and OEICs?

Answer 55

• Any losses from the portfolio are allowable for CGT calculations
• The taxation of share buybacks on the OEICs held will be treated the same way as the unit trusts
• All dividends received are subject to 10% tax credit

Question 56

Which of the following is true for a basic-rate taxpayer with a portfolio of equity and fixed-interest unit trusts and OEICs?

Answer 56

• Any losses from the portfolio are allowable for capital gains calculations
• The taxation of share buybacks on the OEICS held will be treated the same way as the unit trusts
• All dividends received are subject to 10% tax credit

Question 57

What is the income tax treatment for fixed interest funds?

Answer 57

• 20% tax credit no longer applies
• Non-taxpayers can reclaim the 20% tax deduction
• Lower income can reclaim 10%
• Basic rate have no liability
• Higher rate have further 20% to pay
• Additional rate have a further 25% to pay

Question 58

What is the income tax treatment for equity funds?

Answer 58

• Paid gross so no 10% tax credit
• Non-taxpayers and basic pay nothing and cannot reclaim the tax credit
• Higher rate pays a further 22.5% of the gross dividend so total liability of 32.5%
• Additional rate taxpayer needs to pay a further 27.5% so total liability of 37.5%

Question 59

What is the tax treatment of OEICs, unit trusts and ETFs?

Answer 59

• Investors are liable for income tax on dividend and interest distribution and liable for CGT
• Dividend are not paid gross of tax
• CGT is exempt within the fund
• But the investor may have a liability

Question 60

Jennifer has been a basic rate taxpayer in her working years and expects to be a basic rate tax payer when taking a pension in retirement. If Jennifer makes pension contributions of £10,000 and ISA contributions of £10,000 into equitybased funds each year, which one of the following statements is true?

Answer 60

Taking income from the ISA is not taxed and taking income from the pension pot is taxed at 20%

Question 61

What happens on receipt of interest from a corporate bond?

Answer 61

• Basic rate taxpayers have no more tax to pay
• Higher rate taxpayers have a further 20% tax to pay
• Additional rate taxpayers have a further 25% tax to pay

Question 62

UK Gilt Treasury 4.5% 2034 was priced at 127.33. What is the net income yield for a basic-rate taxpayer?

Answer 62

(4.5/127.33) *(1-0.2) = 2.83%

Question 64

What are Treasury bills, their maturities, min lot size, key risk and how do you find their yield?

Answer 64

• Treasury bills are zero coupon eligible debt securities
• Issues with maturities of 28, 91, 182 and 364 days
• Minimum lots sizes of 500,000
• Pose virtually no risks to a portfolio and serve as the risk-free rate for many portfolios
• The key risk is based on them being quoted in nominal terms
• Yield of Treasury bill = (100 - discounted value) / (Discount value x (days to maturity / 356))

Question 65

What is a pickup yield swap?

Answer 65

• Trading out of a low-coupon bond and switching into a comparable high-coupon bond
• If done correctly there is an instantanerous increase in the current yield and YTM contribution to a bond portfolio
• Does not require a forecast but is based on a temporary imbalance in the yield spreads between two comparable bonds

Question 66

What is a child trust fund?

Answer 66

• Is a long-term tax free savings account for children
• Were replaced by Junior ISAs and in 2015 anyone with money in a child trust fund has been able to transfer it into a junior ISA

Question 67

How is dividend taxed?

Answer 67

• The dividend allowance is £2,000 and individuals pay tax on any dividends they receive over £2,000 at the applicable rate
  
  • Dividend income below the basic rate = 7.5%
  • Dividend income above the basic rate and below £150,000 = 32.5%
  • Dividend income above £150,000 = 38.1%
• Tax is no longer applied at source and all savings income is paid gross, which means that once the personal allowance is applied, all income is subject to the clients income marginal tax band.

Question 68

Which types of funds are potentially exempt from CGT?

Answer 68

• VCTs
• EIS
• SEIS
• Gilt Funds

Question 69

What assets are non-chargeable from a CGT POV?

Answer 69

• Nominated main residnece
• Gilts and corporate bonds
• Jewellery worth lass than 6k
• Savings certificates and premium bonds
• ISA
• Betting lottery
• Persional Injury
• Wasting Challets

Question 70

What assets are chargeable to CGT?

Answer 70

• Shares in a company
• units in a unit trust
• land and buildings
• Higher-value Jewellery, painting and antiques
• Assets used in a business, such as goodwill

Question 71

Using Treasury bill yields rather than Treasury bond yields for estimating the equity risk premium will MOST likely result in?

Answer 71

A higher risk premium

Question 72

Using Treasury bond yields rather than Treasury bill yields for estimating the equity risk premium will MOST likely result in

Answer 72

A smaller risk premium

Question 73

Compared to the arithmetic return of a security, the geometric return for the same security is:

Answer 73

Less or the same but never higher

Question 74

What is the geometric mean?

Answer 74

• Referred to as compound return
• Add 1 to every return and then multiple together
• Take the nth root of the result
• Will nearly always be less than the arithmetic mean and the difference between the two increases as the sample variability of return increases

Question 75

What is statistical arbitrage?

A security has a recent historical beta of 1.4 which is above its own long-run beta. A statistical arbitrage strategy is most likely to forecast that beta in the next period is

Answer 75

• Bottom-up, beta-neutral that is based on a belief of mean reversion.
• Relative value strategies
• Ofter very short term
• Usually in an automated fashion

A: Is greater than 1 but would be mean reverting

Question 76

What is a multi-factor model?

Answer 76

Answer is X

A factor portfolio has a sensitivity of one to a particular factor and zero to all other factors

The intercept term in a macroeconomic model is usually equal to the risk-free rate and the factors are suprises in macroeconomic variables

Answer 77

Beta = cov bm / market portfolio variance

So

cov bm = beta * market portfolio variance

Question 78

In a covariance matrix, the covariance of the returns of a security on the returns of the same security is equal to:

Answer 78

The variance of the security

Question 79

All of the following about covariance are true:

Answer 79

The units-of measurement are not standardised

A high negative figure may or may not indicate a weak relationship

A low negative figure may or may not indicate a strong relationship

The units are not squared, that would get your to correlation

Question 80

What is the yield curve upward sloping?

Answer 80

The yield curve presents the YTM and the corresponding maturity date for the same income security

Upward sloping for the following reason:

• Uncertainty:
  
  • Increases with maturity and includes risk of inflation, interest rates and purchasing power and so requires high return
• Duration:
  
  • Long dated bonds are more variables to a change in interest rates than a short-dated bond
• Preferred habit theory:
  
  • Investors may prefer different parts of the curve, banks may prefer short end and pension funds and life insurers prefer long. Local supply and demand shortages can lead to bumps and troughs. Most investors are short dated so this part has more competition and fewer investors at long end so less competitive
• Default risk:
  
  • related to time horizon

Question 81

According to the preferred habitat hypothesis, when a portion of the yield curve has excess supply, the slope of that portion of the yield curve is MOST likely to be:

Answer 81

Negaitve

Question 82

According to the expectation theory why is the curve upward sloping:

Answer 82

• Time value of money
• Duration
• Preferred habit theory

Question 83

What are the factor tilt from ESG im EMs?

Answer 83

• EM are likely to have lower ESG ratings due to looser policy on fossil fuel consumption
• Value stocks tend to be dirtier so have to go to growth stocks
• Technological stocks focussed on reducing X02 emissions may be ignored due to their high valuations
• Any tilt toward real assets is likely to include commodity stocks that will deplete enviromental resources
• Small caps will avoid tobacco and oil
• Small growth technology stocks that are helping reduce C02
• Tilt towards developed markets where ESG standards are higher

Question 84

What are the fors and against from SIN stocks and how could one engage with SIN stocks?

Answer 84

• For:
  
  • SIN stocks are only a small part of the global index, although they are large part of the UK market
  • Very little practical difference in performance if replaced with stocks of similiar characterstics
  • Trustees send clear message to companies
  • May avoid future litigation
  • Tobacco companies may cease to perform well due to government discouragement
  • Norms of society of moving on in the developed world
• Against:
  
  • Often consistent dividend payers
  • Staying invested the company can engage
  • Additional charges to manage the index minus tobacco stocks
  • The tobacco industry has consolidated into a small number of large businesses with globally diversified earnings which equates to relatively stable earnings
• Enagement examples:
  
  • Vote against political donations and goverment lobbying
  • Engage to reduce nicotine levels
  • Provide funds to research cures for cancer
  • Diversify the business away from tobacco and towards e-cigarettes
    *

Question 85

What are the benefits of commodities in a portfolio?

Answer 85

1. Commodities have low correlation with other asset classes, therefore they could be used by a fund manager as an effective diversifier to add diversification to a portfolio.
2. Commodities such as gold can be used to add a degree of capital protection to a portfolio as the price of gold and certain other precious metals often increases in times of market stress.
3. Commodities are very often priced in USD (US dollars) therefore they can add a degree of currency hedging or currency risk to a portfolio.
4. Commodities can be accessed cheaply by utilising exchange traded funds or exchange traded commodities. These products can be bought without paying stamp duty and have low management costs. They can be physical – i.e. hold physical gold in a vault to back the price or be synthetic. Synthetic funds use total return swaps so there is a degree of counterparty risk.
5. Commodities may be accessed via the futures or forwards market. Contracts could be closed before delivery to avoid physical delivery of the commodity.
6. Historic safety during down turns

Question 86

What are the governance issues with Private Equity?

Answer 86

Negatives:

PE have a general partners and limited partners. Limited partners have no voting rights, cannot requisition a meeting, and cannot be sure that the general partner has not held back the best investments for their own investment.

It is also hard to develop an understanding as to whether the GP is taking excessive risk, or whether the GPs stated exist strategy is to maximise return or becuase cash is needed elsewhere in the GPs business.

How possible is it to identify a high-quality GP from a low-qualit GP.

These points suggest that governance is more opaque than listed equity.

Positves:

GP screens the universe of investable opportunities for suitablility.

The GP monitors and influences decision making, gets involved in strategy and leadership, refreshment of the board and succession and is incentivised through investment in the firm.

Since private firms have lower levels of disclosure, less regulation and greater accounting discretion, the GP an essential conduit of investment return for the limited partners.

The GP acts as the eyes and ears of the limited partners.

The closer proximity of the GP to the economic heart of the investments, and alignment of their financial interests with those of the limited partners, suggests that governance is better

Question 87

What are the diversification benefits of PE?

Answer 87

• The PE risk premium is based on broad exposure to the asset class i.e. once idiosyncratic risk has been all but diversified away.
• The danger for the investor is that by targeting this risk premium on its own, it ends up looking and feeling similar to the listed equity risk premium plus an amount for illiquidity. This is because both capture growth in GDP and similar changes in the economic cycle. The expected return to PE, while higher than that for listed equity, may therefore offer limited diversification.
• PE should focus on certain types of the market:
  
  • Small firms at the start of rapid growth stage
  • Medium firms seeking scale
  • Large companies that want to be private
  • Distressed companies
• According to the investors holdings of listed equities, as well as need for liquidity and probability, certain types above may be a better fit for the improvement of riks and expected return. The aim is to achieve real ex-post diversification.

Question 88

Why is human capital more equity like?

Answer 88

The reason why human capital may be more-equity like than histroically presumed are based on changing dynamics within the modern workplace:

• Workers have more company shares/options
• A bonus culture is quite common for some levels of staff in some industries
• Public listed employers have directors that are performance-remunerated so motivated to right-size the firm’s resources to the economic cycle - including staff
• Increasing use of contracts, temporary and part-time employment arrangements makes people’s employment and income more tied to the fortunes of companies and the economic cycle
• Workers have acquiesced to new and more flexbile employer practices by permitting the rise of defined contribution pensions. THis now means many people start their earnings career expecting to frequently change employer, which permits employers to also adopt greater flexibility
• If the hypothesis of more equity-like human capital is accepted, then intertemporal portfolio theory indicates that workers should diversify away from equity-like job risk.
• At the start of a person’s earnings career, human capital is high and financial capital typically low. This implies a low exposure to equity investments when young. The usual diversifying asset class to select is fixed income
• A person starting out with a low equity allocation would then increase this allocation as financial capital grows and human capital declines. Moving forward in years, at a certain age lifestyling of asset allocation would commence. Lifestyling involves reducing the variability of returns in the financial portfolio. This usually means reducing the allocation to equities. The combined effects are a distinct hump shape to the life-time allocation of equities
• Of course, clients exhibit a variety of different human capital characteristics, which is when the interaction of wealth manager and client starts to get interesting. Understanding clients and their employment becomes more important.

Question 89

What is the taxation of preference shares?

Answer 89

• The return of profit is dividend to the shareholder and they sit as equity
• This means the usual dividend 10% notional tax credit attaches
• The 10% tax credit is non-reclaimable
• Dividend tax treatment is the same as other shares
• Also subject to capital gains tax
• Can be held in tax wrappers such as ISA and SIPPs
• Buyers pay 0.5% stamp duty
• Zero-coupon preferences shares may be interesting to additional-rate income tax due to large difference in income tax rates and CGT
• Makes them more like equity than bond

Question 90

What is the M2 measure?

Answer 90

Is equivalent to the return which the fund would produce if it had the same risk as the market as a whole.

M2 = Rf + ((STDEV of bencmark - STDEV of portfolio) x (Portfolio Returns - Risk Free rate))

Fund with the highest M2 measure will have the highest return for any level of risk. The same will be the case for the fund with the highest Sharpe ratio

Fund rankings based on the Sharpe ratio will be the same as rankings based on M2

M2 measure is effectively a linear transformation of the Sharpe ratio and does not add any new information

Question 91

All of the following about the Information ratio for calculating a fund manager’s performance are true, that the Information ratio:

Answer 91

• Indicates whether the extra charge for active management was worth it
• Helps to indicate consistency of fund manager performance
• Indicates the active return for the active risk taken

Question 92

The information ratio of a portfolio’s benchmark is

Answer 92

Zero

As the tracking error would be zero

Question 93

A fund manager with an information ratio of 0.8 has recently stated she intends to take a more aggressive, higher beta approach to the portfolio next year. Other things equal, in a relatively efficient market, what is the information ratio MOST likely to do?

Answer 93

Stay the same

Beta is not in the formula so it will not have an impact

Question 94

What is the information ratio, its merits and drawbacks?

Answer 94

Information ratio = (portfolio return - benchmark return)/tracking error

• Use:
  
  • Measure of excess returns relative to excess risk used to produce those returns
  • Shows excess retun divided by excess risk taken
  • Shows how consistent a fund manager has been - the higher the IR the more consistent
  • Shows how active a manager has been
  • Index funds often have a low or even negative IR due to trading costs
• Example:
  
• Merits
  
  • Direct comparison of portfolio and benchmark performance
  • Simple to calculate and widely used
• Drawbacks
  
  • Only allows relative assessment of portfolio performance
  • Difficult to assess statistical signifignace
  • Assumes that portfolio and benchmark have similiar levels of systematic risk

Question 95

Which of the following is correct about the Jensen portfolio performance measure and what are the merits and drawbacks?

Answer 95

• It was originally based upon the CAPM
• It requires a new RFR for each sample time interval
• It calculates risk premium in terms of systematic risk
• It is flexible enough to allow for others models of risk and expected return other than the CAPM
• Measure of risk-adjusted equity portfolio returns used to evaluate performance of a well-diversified portfolio against a CAPM benchmark with the same level of systematic risk as that assumed by the portfolio
• Formula:
  
  • portfolio return – (risk free rate + portfolio beta x (market return – risk free rate))
• Establishes whether the portfolio has performed in line with its CAPM benchmark

Merits:

• Most rigorous risk-adjustments process that separates unsystematic and systematic risk components
• Can be adapted to CAPM or multifactor models of risk-return trade-off
• Permits statistiacal significance test

Drawbacks:

• Difficult to calculate as needs formal regression analysis
• Diversification of portfolio needs to be assessed separately
• Alpha and significance can vary markedly depending on specifciation of model of return generation

Answer 96

Portfolio Sharpe ration x correlation coefficient

Investors should accept assets that has a ratio smaller than its own Sharpe Ratio

E.g. Commodities is 0.7 x 0.5 = 0.35. Its sharpe ratio is 0.4 so it should be accepted

Or the investor should accept a new assets class if its sharpe ratio divided by correlation coefficient is greater than portfolios Sharpe Ratio

Question 97

What is the Sharpe ratio, merits and drawbacks?

Answer 97

Calculates return per unit of risk

Portfolio with highest return relative to risk gives highest ratio

Portfolio theory suggest investing in most efficient portfolio

Formula: (Return - Rf) / STDEV

Merits:

• Simple cost benefit comparison of risk and return trade-off
• Simple to calcualte and widely used
• Largely reflects strength of the underlying market
• Simple cost benefit analysis between risk and return

Drawbacks:

• Only allows relative assessment of portfolio performance
• Difficult to assess statistical signifignace
• Ignore diversification potential of portfolio
• Assumes that investors are fully diversified

Question 98

What is the Treynor ratio, its merits and drawbacks?

Answer 98

Treynor ratio = (return - risk free rate) / beta

• Is the return earned in excess of that which could have been earned on a riskless investment
• Relates the excess return over the risk-free rate to the additional risk taken as measured by the beta
• Ranking of Treynor ratio is only useful if the portfolios are sub-portfolios of a larger portfolio
• Ignores unsystematic risk of the portflio and uses beta

Merits:

• Treynor uses beta for systematic risk and this is suitable for a diversified investor but can be hard for clients to understand
• Treynor can be useful for measuring returns across different sectors and for any portfolio where a client holds a number of portfolios

Drawbacks:

• Only allows relative assessment of portfolio performance
• Difficult to assess statistical significance
• Ignore unsystematic risk in the portfolio

Question 99

What are fundamental Indexes?

Answer 99

A fundamental index is constructed by taking into account more general economic movements that may reflect the broader economy and economic growth

May favour stocks based on fundamental characteristics that can reveal stocks ability to generate wealth

The fundamentals may be attractive because they are reflective of a client’s own investment thesis and may be the most overvalued

Some countries a few large stocks tend to dominate the index, so what appears to be a market trend is driven by a small number of companies, perhaps in one or two sectors only

Question 100

What are stranded assets?

Answer 100

When input costs required to exploit and produce the asset rise significantly or when the value of the output falls significantly

Exposure to carbon and climate change pose risks to long term investors

Scientific consensus expects significant effects of climate change caused by mandate emissions which will impact investment portfolios

The investor will need to manage this portfolio risk proportionately and over the appropriate timescale

Time horizon is relevant because market discounts and securities are valued based on their NPV

There is an empriical questions concerning how far ahead markets do actually disocunt

Regulations, legislation and voluntary initiatives might change in the short term which can alter prices, for example taxes and subsides might alter in the short term to encourage new market and deter more CO2 emitting markets.

Forecasts are valuing some assets stranded as share price of global coal companies are essentially worthless

Uncertainty about the path of climate chagne and the materially of neww arrival about this create security price volatility

Question 101

What considerations might and ESG investor have for cash and equity and their subsequent returns?

Answer 101

Cash:

• Lent in ways that meet the ethical policy of the client
• Will have neglibible impact on cash returns as rates are so similar
• Leave capital assumptions unchanged at 0.5% above inflation

Equity:

• Not all wil meet ethical policy of the client
• Switching the investment to ethical developed indicies, FTSE4Good
• Index is less representative of the world so might have higher risk and lower expected return but evidence of this is limited
• Slightly lower estiamte for ethical equity return so drop 0.2% and increase the voliality
• Do not know the size of the long run ethical equity risk premium

Question 102

What is global systematic risk?

Answer 102

• Outlook which is orientated to the home market and include inflation, the interest rate, exchange rate and goverment stance
• Some of these factors exhibit idiosyncratic variation which is to a degree diversificalbe
• Factors such as the price of oil, water and other essentials commodities for which there are no substitutes
• Event-specific common factors also make good examples such as millenimum bug

Question 103

Hoe quickly does diversifcation reduce?

Answer 103

• Risk falls to systematic risk and is often reach at aroun 15-30 stocks
• Holding more securities raises transaction costs for no extra risk reduction
• The portfolio risk is around 34.5%
• Recent empirical research finds that the co-movement of financial markets have increased over time making diversifcation hard to achieve
• Unsystematic risk is harder to remove when low positive zero or negative correlation are in practice difficult to find
• Doesn’t explain why institutional portfolios most often hold 70 lines of stock, a persistent anomaly to the story

Question 105

What is kurtosis?

Answer 105

Implies that for much of the time the market moves very little, much less predicted by a normal distribution

So a perfectly normal distribution would have kurtosis of 0

A positve kurtosis shows that there is greater severtiy of large negtive returns than predicted by a normal distributiom

Question 106

What is leptokurtic?

Answer 106

A distribution with a flatter central peak than the normal distribution

Question 107

What is Platykurtic

Answer 107

A distribution with a flatter central peak than the normal distribution

Question 108

What is skewness?

Answer 108

Perfect normal distribution would have skewness of 0

Negative skewness shows that the mean is to the left of the median

Negative implies that a large negative return occurs more frequent and the severity of negative returns are larger than predicted by normal distribution

Question 109

What are the restrictions placed on unit trusts and OEICs?

Answer 109

• Cannot hold more than 10% of the fund value in shars of any one quoted company
• Only four shares which represent maximum 10% holding
• Other shareholding must not exceed 5% of the fund
• Minimum holding of 16
• Not allowed to gear up
• Can borrow on a temporary basis against known cash flows

Question 110

What is socially responsible investment?

Answer 110

Means investing on the basis of ethical principles and traditionally means screening out companies that are involved in unacceptable practices

What might be adopted:

• Positive or negative screening
  
  • Based a % of company sales
  • Often outsourced
  • Or outsource to eithical fund
  • Each fund has own criteria and degree of rigor
• Tilts
  
  • Emphasis on progressive, smaller growth companies and screens out those with potential liabilities
  • Can restrict option for yied
• Geography
  
  • SRI is strong in UK but much less in EM as hard to find information
  • Usually much easier to use a fund that is global

Question 111

What are the merits and drawbacks of collective investments?

Answer 111

Merits:

• Obtain diversification cheaply
• Lower cost of trading due to sharing investment with others
• Share in pools that contain similar minded asset owners with similiar investment goals
• Some funds may be exempt or use instruments that do not incur stamp duty
• Some fund managers are not charged VAT on fund management charges

Drawbacks:

• Not bespoke or tailored
• Lack or transparency on unit pricing method, commision charging
• Principal-agent problems concerning poor investment decisions mismanagement and even fraud
• Pooled fund experience inflows and outflows that the manager does not control. Inflows impact cash levels and outflows will force sales.

Question 112

An individual investing in a UK company will pay stamp duty reserve tax (SDRT) on all the following types of investment

Answer 112

• Share options
• Convertible loan stock
• Uncertificated shares
• Do not pay an ADR of a UK company

Question 113

SDRT is paid on what?

Answer 113

• Shares in UK companies
• Shares in foreign company with a share register in the UK
• Options
• Rights arising from shares already owned
• Interest in shares
• Not charged on unit trusts or OEICs on purchases but fund manager does and this comes in management fees
• Flat rate of 0.5% on consideration of shares

Question 114

What is the SDLT rates?

Answer 114

SDLT at £125,000 for residential and £150,000 for non residential

• Up to 125k = 0%
• 125-250k = 2%
• 250k-925k = 5%
• 925k-1.5m = 10%
• Above 1.2m = 12%
• Over 500k for corporate = 15%
• 3% if residential property is second home
• New leases:
  
  • If ground rent over you pay 2% instead of 1%

Question 115

What is classified as non-residential properties?

Answer 115

• Commercial property
• Agriculture land
• Forest
• Any other land not used as residence
• 6 or more properties bought in a single transaction

Question 116

What are the exemptions from SDLT?

Answer 116

• No money changes hand
• Left in will
• Divorce or settlement
• Freehold less thank 40k
• Lease holder
  
  • No notified of lease grand or surrender of lease
• Short lease
  
  • Less than 5 years
• Alternative property
  
  • Such as islamic finance

Question 117

What is the IHT if we transfer to charity?

Question 118

For the inheritance tax disposition exemption to apply, all the following statements about normal expenditure out of income are correct

Answer 118

• It is made as part of the normal expenditure of the transferor
• Taking one year with another, it was made out of income
• It leaves the transferor with sufficent income to maintain their usual standard of living

Question 119

What is the nil rate band?

Answer 119

• First £325,000 is taxed at 0%
• Additional nil-rate band when a residence is passed on to direct decendent at £175,000
• Tappered withdrawals at additional rate band over “m withdrawal rate 1 for every 2”

Question 120

What is the transfer of nil rate?

Answer 120

• Married couples and civil partners
• On death of second spouse nil rate will increase by % of nil rate not used on death of first spouse
• E.g. if first spouse dies leaving £130,000 there is no IHT and £195,000 as unused
• Upon second death the first £520,000 (£325,000+£195,000) will be exempt

Question 121

What are the annual exemptions to lifetime transfers?

Answer 121

Small gift:

• 250 or less to as many as want
• If over 250 all is taxed
• Cannot gift into trusts

Annual exemption:

• 3000 in taxyear is exempt
• Cannot give same period 3000 plus gift
• If several gifts i year 3,000 is applied to past gifts
• Any unused exemption can be carrier forward one year

Normal expenditure out of income:

• Transfer of value if:
  
  • Normal expenditure of transferrer
  • Taking one year with another, made out of income
  • Sufficient income to maintain usual living standard

Question 122

Stock lending may occur for all the following reasons?

Answer 122

• Dividend taxation
• To cover delivery against payment
• In order to vote at company general meetings
• It will not occur to favilitate naked short selling

Question 123

Explain stock lending?

Answer 123

• All voting rights are transferred from the lender to the borrower for period of loan.
• Lender is reimbursed by the borrower for any dividends or distributions
• Lender is not reimbursed any votes
• Lender of shares retains full financial interest but losses opporunity to vote
• As borrowers are not financial participants this can reduce incentives to monitor the firm and vote in an informed way
• Institutional investors should disclose their approach to stock lending and recalling lend stock
• Might allow manager to increase revenue but creates a conflict between the additional earnings and the aboloty of the manager to exercie its share voting rights

Question 124

What are callable bonds?

Answer 124

• Have a call feature where issuer has the right to call the bond back and redeem it early
• Has two dates, first one is the first date that it can be called, and the last date is the last date it can be called
• Likely to call the bond back when the cost of replacement finance is cheaper than yield on the bond
• Promised yield to call is a measure used for callable bonds and is expected rate of return for a bond held to first call date

Question 125

What is the FCA’s operational objectives?

Answer 125

• Securing an appropriate degree of protection for consumers
• Promoting efficiency and choice in the market for financial services
• Protecting and enhancing the integrity of the UK financial system

Question 126

What is a zero beta portfolio?

Answer 126

• Borrowing large sums is not possible nor is borrowing and lending at single risk-free rate. Proxy of 3m T-bill is used
• Relax the assumption so neither risk free lending nor risk free borrowing is possible
• So now an only invest in portfolios on efficient frontier
• There is pairing of efficent sets that have zero correlation between them
• So for the efficent portfolio M there is another portfolio on other half efficient boundary or Z. Z has zero covariance with M, Z is a minimum variance zero beta portfolio for M
• Since Z has zero risk with M it has a zero beta so risk at Z will be zero when compared to M
• The intercept of the SML is empirically higher than the CAPM risk-free rate
• The zero beta CAPM can explain returns at least as well as the conventional CAPM
• Empirically manny investors hold money market funds rather than cash deposits of a risk-free treasury

Question 127

What is horizon matching?

Answer 127

Mixutre of immunisation and cash flow matching

Cash flow matches the liabilities for the next four quarters but is then immunised for the remaining investment horizon

At the end of the four quarters the portfolio is rebalanced

Question 128

What is a bullet portfolio?

Answer 128

Portfolio from bonds with durations close to the liabilities

10 year might have a 50/05 9 and 11 year

Question 129

What is a laddered portfolio?

Answer 129

• Has a range of different maturities say, three, five, seven and ten years
• As each matures funds become available for the investor to withdraw or can be reinvested in later maturites
• Reduces the portfolios sensititivity to interst rate risk by not concentration the funds on the maturites that have the higher than yields at the price of a lower overall yield
• The return would be higher than if only short date securites were bought and the risk would be less than if just long dated
• If interest rates fall then it would be necessary to reinvest the proceeds from the stock that matures soonest at a lower rate
• If rates rise then the portfolio will be paying a below market return but investment into higher rates as maturity happens

Question 130

What is immunization?

Answer 130

• Insulate portfolio from interest rate risk altogether
• Many defined contribution funds are concerned with protecting future values of portfolios
• Ability to meet future liabilities will fluctuate with interest rates
• Value of assets will then track the value of liabilities whether rates risk or fall
• Done by matching duration and liabilities
• If rates fall coupons can only be reinvested at lower rate but would be offset by higher capital value
• If duration is chosen correctly then two should balance out
• Netting off quarnetees the GRY and so helps match the liability
• Managers must rebalance to realising durations with duration of obligation. Duration generally decreases less rapidy then does maturity so passive in sense doesn’t aim to pick undervalued names

Question 131

What a bond index funds?

Answer 131

• Creats a portfolio that mirrors composition of an index
• Many issues can be illiquid so can be hard to purchase each security in proportion to its market value
• Also face rebalancing issues as bonds fall out of the index as maturities fall below 1
• Stratified sampling is practiced
• Characterstics in terms of maturity, coupon rat, credit risk and industrial representation all match so performance should follow.

Question 132

The convexity of a bond is influenced:

Answer 132

Positvely by maturity and inversely by coupon

Convexity is higher for longer and lower bonds

Question 133

What is the convexity of a bond?

Answer 133

• The relationship between bond prices and yields is not linear because duration changes as yield does
• Convexity measurees this by making an adjustment to the Macaulay duration to arrive at new bond price
• Bonds wth greater convxity have more curvature in the price-yield relationship
• Duration is a good measures for small changes in bond yields but always understates the value of the bond, it underestiamtes the increase in bond price when yield falls and it overestimates the decline in price when the yield rises.

Question 134

Which type of duration is computed by discounting cash flows using the yield to maturity of the bond?

Answer 134

Macaulay Duration

Question 135

What is the duration of a bond?

Answer 135

• Weighted PV of all future cash flows of a bond and measures sensitivity of a bond to changes in interest rates
• Same as volatility in equities
• Macaulay duration equals weighted averaged of the flows until payment received
• A high coupon with short duration will not vary in price as much as a low coupon long maturity bond
• Duration is shorter than maturity for all bonds except ZCBs
• Duration is equal to maturity for ZCBs

Question 136

The policy effect when measuring bond portfolio performance refers to the:

Answer 136

Differences in portfolio duration and index duration

Question 137

What is duration switching?

Answer 137

• If bullish and expect fall in rates than he should increase duration of portfolio
• If bearish and thinks rates will rise he should reduce duration of the portfolio
• If yield curve is upward sloping the manager can by bonds with greater maturity and sell at the end of his horizon, if curve has not shfited then he will generate higher returns this is so becuase as maturity declines the YTM fall and price of bonds rises creating a capital gain

Question 138

What is anomaly switching?

Answer 138

• Switch between two bonds with very similar characterstics but whose price are out of line with each other
• The expensive bond will be sold and the cheaper one purchased
• Alternatively the bonds could be exchanged on the basis of yield differentials
• Involves switching out of a bond below or at the yield curve into another bond above or at the same point on the yield curve

Question 139

What is portfolio dedication?

Answer 139

• Designed to service a prescribed set of liabilities
• A pure cash matched approach is the most conservative strategy
• By timing the coupons in a manner that they generate funds in advance of the scheduled payment
• The same strategy can also deploy a series of zero-coupon corporate bonds that matures at different points in time corresponding to the liability payment date
• Exactly £500,000 in 91 days time, then in 180 days and again in 270 days could be delivered through T-Bills or bonds. The manager will purchase low coupon or zero coupon bonds at discount with maturites slightly less than 91 days, 180 days ad 270 days. This will ensure that the amount invested in each case pays a principal of £500,000 each time and the funds mature in advance of the liabilities so that payments can be made in time

Question 140

What is policy switching?

Answer 140

• Switching between two types of bonds, purchasing a higher yield bond and selling a low yield bond
• Bridge swap when you sell a correctly priced bond and purchase high yield bond meaning duration remains the same while expected return is increased
• Switch between two dissimilar bonds designed to take advantage of changes in interest rates, yield curve, credit rating or sector
• If an investor expects interest rates to fall, he should move towards the longer end of the yield curve. Longer dated gilts and more volatile and therefore response more in a price risk to a fall in interest rates
• If interest rates are expected to rise the investor should move towards the shorter end of the yield cruve in order to minimise losses.
• Predicting changes in the yield curve is very hard and so this is a risksy strategy.

Question 141

What is riding the yield curve?

Answer 141

• Curve is usually smooth showing the relationship between yield and maturity but at times dip can occur
• Depends on how investors think these dips will move
• On hump price of bonds can rise and yield fall
• On dips the price of bonds can be expected to fall and yield rises

Question 142

What are the active bond strategies?

Answer 142

• Interest rate anticipation
• Relative value
• Duration matching

Question 143

Which is likely to be a reason why the tracking error of an index fund following a full duplication approach is likely to differ from zero?

Answer 143

• Change in price due to entering or leaving an index. The fund may trade after constituents enter or leave the index
• Dividends reinvested may be gross when in the fund they are reinvested net. Some dividend payments may be too small to be amenable to reinvesment
• Round-lot purcahses - stocks may only be able to be bought in a minimum lots causing mismatch in the weight that a stock has in the index and the weight allocated in the tracking portfolio

Question 144

What is tracking error?

Answer 144

Measures the risk taken against an appropriate benchmark

It is the standard deviation of relative returns. A tracking error 5% indicates that 68% of returns will lie within 5% of the average relative return

Shows how actively managed a fund is. An actively managed fund has a higher tracking error

Is a standard deviation, take each fund return minus the return of the benchmark which gives the active risk. Once you have the active risk take the STDEV of it

Is a starting point of the riskiness of a fund relative to an index

Need to have a good benchmark

Question 145

What is MOMO investing, its benefits and drawbacks?

Answer 145

• Buying stocks that have had high returns over the past
• Should not be easy to exploit in efficient markets
• MOMO investors bear risk or are exploiting behaioural biases
• Fourth factor in Carhatt Model

Merits:

• Managers tend to be influenced by Momo because clients like to see investments which are showing good news and resilts, favoured by the press and investment community. They are disappointed to hold those which are criticised by the press. Frequently reporting of portfolio performance discourages a contrarian view

Drawbacks:

• It demands a much higher level of trading as investors latch on to the latest winners. Reflecting its more widespread use, a typical funds annual turnover has risen to about 100%, with average holding periods of 12 months or less.
• MOMO investors are always strating behind the game line, because they’re buying shares that have already risen and selling those that have already fallen.
• Means selling shares that disappoint, even though the lower price may now make them look better long-term value

Question 146

What is growth investing, its merits and drawbacks?

Answer 146

• Rapid growth prospects often at early stage of development
• Tend to focus on small-mid cap stocks
• Or in large cap if market has underestimated growth prospects
• Have a lower book to price and usually higher beta which should make them riskier

Merits:

• Usually wins in the medium and long run. Even moderately successful attempt to buy cheap and sell dear can enable investors to exploit the mispricing created by momo traders. It is the optimal strategy for those with long horizons, such as pension funds
• “Value Investing” was established by Benjamin Graham in the 1930s and concentrated on balance sheet ratios such as price to book-value. This developed to discounted cash flow, P/E ratios and yields to adapt to industries where assets are less important or are intangibles such as patents, designs and “people-skills”.
• “Growth” or “Growth at a Reasonable Price” is a belief that a steadily growing company will provide a good overall return even if its shares appear highly rated.

Question 147

What is value investing and what are its disadvantages?

Answer 147

• Identifying efficient firms that are inexpensive
• Such stock offer a margin of safety to IV
• Evidence over long run shows relative value stocks outperform
• Usually high book value and low beta making them less risky
• Low beta should mean low returns so disconform to EMH

Disadvantage:

• One criticism of Value Investing is that it can mislead investors, who see a significant fall as an opportunity, but it could be due to a fundamental long-term change in the company’s financial health.
• A common problem is the standard remit for the manager to beat an index return subject to risk levels. The index, weighted by market value channels fund flows towards the shares which have moved ahead and have a bigger weight in the index due to a high rating.
• To comply with the risk constraints, the manager has to keep up with the fads of the market regardless of value. As Keynes pointed out, “Markets can remain irrational longer than you can remain solvent.”

Question 148

What are the similarities between the styles?

Answer 148

• MOMO is a short-term strategy
• Value and growth are longer-term
• Value and growth involve developing understanding of company
• MOMO and growth are directional strategies
• Value and growth rely on fundamentals
• MOMO relies on behavioural

Question 149

What type of investment style would be MOST expected to outperform if the bond yield curve is between flat and steep?

Answer 149

Value investing

Question 150

What is smart beta?

Answer 150

This is when incremental returns are attributed to a given factor that will persist.

Investment vechile tracking non-standard indivies have become increasing popular

Vast majority suggests the existence and persistence of an anomaly in a market and systematically exploit them

Question 151

Relative to market cap indicies why it smart beta a good move?

Answer 151

Merits:

• Opportunity to follow a long run investment anomaly such as high dividend paying stocks, low P/E or MOMO
• Not procyclical so potentionally lower risk in market downturns
• Can have a lower and more stable correlation to other assets
• May U/W largest cap stocks so if they fall market beta outperforms

Drawbacks:

• Higher fees and charges
• Higher and unknown annual turnover
• Unclear when to rebalance
• It becomes anomaly then might get exploited and priced out
• Anomaly only exists in back-test
• Liquidity may be a concern
• Index provider has little incentive to refine approach

Question 152

For EM why might smart beta be good?

Answer 152

Merits:

• EM are generally considered less efficient than developed markets which means that active management approaches have potentially greater opportunties to succeed
• Need to be wary of market cap approaches as EMs tend to be more concentrated
• Active management can mean greater concentration and less diversification than index tracking portfolio
• Can be spikes in money flows that can drive up correlation and active managers provide more opportunity to respond and adjust
• Lower cost
• Active manager in EM tend to be expensive and are generally at or close to capacity

Drawbacks:

• Smart beta U/W large cap stocks so can underpefrom when they do well
• Liquidty
• No incentive to stop growing funds
• Based on histroical norms and may not remain
• Back-tests do not factor in turnover and cost

Question 153

What are the merits and drawbacks of off-the-shelve smart beta?

Answer 153

Merits:

• Costs are reduced relative to single factor
• Investor may not have time or knowledge to manage single factor portfolios

Drawbacks:

• Relatively new and might not include ESG
• No control of how factors are weighted within the fund and may be misaligned with their own values
• Diversification will be in hand of managers and may be hard to manage
• Construction of portfolios has no consideration to asset allocation or geographical weighting
• No track record over number of economy cycles

Question 154

What are single factor smart-beta products?

Answer 154

• SIngle factor afford more control and may fit better with the wider asset allocation and desired timing of tilts
• Single factor allocation can help tilt away from other portfolio exposures
• May be more transparent more liquid but involved more cost and resource involvements
• The risk of being wrong is higher

Question 155

What other factors should be considered with smart beta?

Answer 155

1. Increased risk
   
   • Any smart beta outperformance may be compensation for increased risk, for example, Fama and French documented that value stocks outperform more expensive stocks over time but this may just be that cheap stocks ar more volatile than expensive stocks so it is simply a reward for bearing the incremental risk of at the time correct low valuations
2. Persistence
   
   • Whether the incremental returns attributed to a given factor will persist is impossible to answer. Investors must ask themselves if a particular vehicle is well-designed to exploit the anomoly and if the anomaly is expected to persist
3. Blended approach
   
   • Hard to determine what certain factors will perform and when is best to be switched into and out of based on market timing
   • There is a problem that some stocks may be classified within more than one factor, stock that have been rising in price may have MOM and low vol and so be double weighted in the index
4. Market cap indices
   
   • This strategy will not outperform market indicies in every enviroment
   • Look different to market cap indicies
   • U/W largest stocks in the market cap universe and so will lag if there is a big performance
5. Risk budget
   
   • Smart beta provides an alternative that frees up a portion of the risk budget and allows for more diversifcation
   • It may be an attempt to seek alpha or to gain exposure to certain risk premiums or to manage specifc risks
6. Data mining
   
   • Could just be data mining, back testing and whether smart beta claims are believable
   • A lot of data mining is involved in developing smart beta strategies
7. Beyond single factor model
   
   • Far beyond simply identifiying the potential of value of small cap factors. Recent developments include multi-factor equity indicies utilising combinations of value, low value, MOM, size, quality and others
   • Not limited to equities, current efforts include building multi-asset indices based on factors across different asset classes
   • Since cycles in both factors and asset classes are no coincendent, mixing multi-factor and multi-asset classes can provide better risk management through diversifcation
8. Liquidty:
   
   • Bigger concern for smart beta, while some are liquid there is no incentive for managers to stop growing assets
9. Based on mean reversion:
   
   • Many are based on mean reversion, historic valuation, histrotical correlations and so will not pick up market developments, e.g. tapering and flows

Question 156

What is hyperbolic discounting?

Answer 156

• People have a much higher discount rate for now compared to the future
• Initially at time 0, large future reward has a higher value but as small reward nears closer preferences shift to small reward. Financial models to not predict preferences reversals
• Immediate and concreate concerns rewards outweight fund the distant and abstract
• Implies that people act impulsively in the short term and people avoid waiting more as the wait nears the end
• Leads to concern in terms of accessing retirment fund and approopriate spending rates
• Present bias can influence retirment age decision, choose to have less and retire earlier than continue working for later
• Average retirment is 3-4 years before state pension age
• Way to devase it is by saying your pension fund is now growing at is maximum each year

Question 157

As IMs how do we try and avoid loss aversion?

Answer 157

Show the client different periods of drawdown and understand how the client would react to these losses

Shows that losses have been made back

Question 158

What are noise traders?

Answer 158

• An investor who makes trading decisions without the use of fundamental data, relying instead on trends, sentiments, anomalies and momo
• More likely to buy high and sell low
• EMH suggests over time noise traders will lose wealth compared to informed traders
• In the long run the investment behaviour of noise traders can be ignored as they will have negilibile effects on prices
  
  • Internet has made information spread faster but this does not mean it is high quality info

Question 159

What is the prospect theory?

Answer 159

It is a theory that people value gains and losses differently

DK found losses relative to a current wealth point are disliked about twice as much as equal size gains. Rationally a person combines net effect of gains and losses involved with each choice to present an overall evaluation of whether a choice is desirable net. But when presented equal return choices they favour not the loss.

People tend to settle for a reasonable gain even if they have a reasonable chance of earning more but are willing to go to much greater length to engage in risk-taking to which people are averse to have a possibility but not the probability of limiting a loss

In other words people have greater aversion to losses than expected

This is loss aversion, fear of regret and noise trading

Question 160

How can quant funds be used to combat some biases?

Answer 160

Investors are retionality bounded, and this can lead to overreactions and underreactions. Shiller has found from a DDM that variation of the return on US market exceeds that predicted by asset pricing models. He put forward the view that mass psychology is a driver of this and economist outght to factor this into their models.

Knowing this, there is scope for the use of quant funds in investment design, unemotional models have generated abnromal returns based on these to take advantage of overreactions and underreactions to news by market particpants

Question 161

What are heuristics?

Answer 161

Refers to the fact that we as individuals are overwhelmed with sheer amounts of information that we are unable to process perfectly. This leads to short cuts and following rules of thumb through the belief that the present may be reprsentative of the past

Faced with this, it is crucial that clients are not overloaded with options in terms of investment design as this could lead to procrastination and lower utility. The wealth manager should present fewer, clearly thought-out and defined investment strategies for the client to choose from.

Also is inertia where investors prefer to stick to the status quo and not make changes, this is also linked to regret aversion. As a result, investment design could focus on developing a glid path construction where the asset allocation is de-risked over time to mitigate risks prior to retirment. This is a target replacement investment objective.

Other insights from BF show that investors are regret averse and sensitive to early stage loss. This should place a low risk start in investment to avoid dissatisfaction if there are early interim losses. Throughout the investment process, the wealth manager shoukd keep the client informed to increase understanding and mititage regret avoidance.

Question 162

What is the endowment effect?

Answer 162

A bias which people value an asset more when they hold rights to it than when they do not.

Tom demonstrates the endowment bias by considering his shares in his fathers company a source of family pride and worth every penny and refusing to consider selling or diversifying

Question 163

What is base rate neglect?

Answer 163

• Paul gets investment ideas from stories from others and adverts, he invests in companies that remind him of his most succesful corporate clients since they are well informed. He doesnt consider fundamanetals.

Question 164

What is conformity?

Answer 164

Believes others are better informed. Herd instrinct, Paul gets investment ideas from companies that advertise more and that are more in the news

Question 165

What is the availability bias?

Answer 165

• If something comes to mind when asked to consider a question or make a judgement, then what has come to mind must be relevant and important
• People tend to rate more newsworthy events as more likely because they can more readily recall an example from memory
• Decision-makers tend to over-weight more memorable facts and evidence
• Tend to place more weight on decision information that is presented in a format consistent with the choice format

Question 166

What is the gamblers fallacy?

Answer 166

• There is discernible sequences or patters observable in repeated independent trials of some random process such as the repreated spinning or a roulette wheel
• Echoes the widespread belief in mean reversion

Question 167

What is anchoring?

Answer 167

Suggested refernce point which can be likended to an anchor and then make small adjustments to it each and eventual basis for deciding on a particular course of action of judgement

If asked where the FTSE100 will be one year from now some forecasts tend to take the current value and add or subtract a nominal amount

Whether people sell shares is influenced by what they paid for them

Question 168

What is overconfidence?

Answer 168

People are found to be correct in their judgements far less often than they think they are. People tend to be overconfident about their ability to forecast and make correct decisions. Overrate their skills by drawing far to strong influences from small amounts of data.

Overconfident investors trade more and take more risks which can explain the high amount of trading activity in equity markets.

Financial analusts can be slow to rvise their previous assessment of a companys likely future performance even when there is notable evidence that their existing assessment is incorrect. Often is the case that even establising the clients risk profile the risk profile extracted may suggest great risk tolerance than is actually true. Individuals investors may interpret medium investment risk as meaning a lowish chance of loss

Question 169

What is representativeness?

Answer 169

• Tends to see patterns and similiarities to previous context where perhaps none exist
• Often people will draw inferences about probabilities without considering important issues such as sample size and tend to extrapolate beliefs from isolated occurrences
• The fallacy of representative arises from assuming that similiarity in one aspect leads to similarity in other aspects
• Assume that a recent pattern of events in financial markets will continue into the future

Question 170

What is the reason of home bias?

Answer 170

• Overseas transactions may be greater than those at home
• Investing at home involves no explicit risk and helps with payment of UK liabilities
• UK assets are a good match for UK liabilities which helps defined benefit pension schemes liabilities which will be indexed to UK inflation
• Investors may be using a peer group benchmark rather than a market weighted benchmark
• A large amount of UK companies earns revenue from overseas
• UK investors may have familiar and expertise about their own economy
• Good corporate governance, regulation and disclosure standards
• UK has dividend paying culture

Question 171

How do you combat bias?

Answer 171

• Chair of asset allocation meeting to carefully manage debate - ask for previews - not everybody is natural orator in the moment of the meeting.
• Manage the loudest or the person who loves to go first or last
• Dont let most senior person speak first
• Control the group size, need to be small and informed. Making sure the right people are involved strong cognitive diversity.
• Create the right atmosphere, have a deviles advocate to ecourage strong contrary perspectives to challenge confirmation bais.
• Rotate roles periodically to remove thought silos
• Wise crowds or madness of crowds. Which have been nutrered
• Undertake due dilligence based on independent facts. Dont allow people to make impulsive investment decisons
• How do you evaluate
• Manage the debate, set an agenda, set boundaries, devise a voting system, have clear goals.

Question 172

Why do investors have low capacity for risk yet high risk tolerance?

Answer 172

Low income people are close to state benefits and his provides a floor to downside risk or a guarantee, and potentially limitless upside.

People on low income with low financial wealth are close to the value of the guarantee and this can, quite rationally, lead to a high-risk tolerance despite low capacity for risk taking when their total wealth is considered

This option-like characterstics can explain high risk tolerance and so there is little to lose from investment risk taking

People with greater financial wealth have more to lose in aboslute terms for they are further away from the guaranteed floor of state benefits

Question 173

What is a multi-factor model, the merits and drawbacks?

Answer 173

Explains security returns by looking at a number of factors. FAMA and French built a three factor model by adding the factors value and size to the CAPM model and later extended to include price momentum. Models can incorporate economic factors such as the oil price of inflation or fundamental factors.

Merits:

• Adds more factors to CAPM so easy to understand
• Improves understanding and explanation of total return
• Adds persistent anomalies from EMH
• Factors can be useful when taking factor allocation approach

Drawbacks:

• Not sure what specifc metric is best proxy
• Fiddly and harder to calculate
• Unsure if factors are rewards for other risk, e.g. shares of small shares might just have higher risk

Answer 174

As the stocks were not sold there is no tax adjustments for stock A

Required return for Stock A = 0.5% + 0.9 x (5% – 0.5%) = 4.5%. The expected return for Stock A is 5.2%. Stock A is undervalued. This is above the SML.

Stock B pays dividend so need to find after-tax return

1) 10% dividend tax paid at source, so gross-up the dividend = 4% x 1.1 = 4.4% and then reduce by the dividend tax of 32.5% = 4.4% x 0.675 = 3%. The required return for stock B is therefore 2% capital gain + 3% dividend return = 5%.

Question 175

Which is a limitation of the traditional Capital Asset Pricing Model (CAPM)?

Answer 175

• Estimation of beta
• Poor predictor of returns
• Homogentity in investor expectations

Question 176

What are the review of CAPM assumptions?

Answer 176

1. In equilibirum and no one can impact the market
   
   • Major institutions do impact the market
   • Algo trading programms allege that they have created a playing field which is tilted in favour of a few large banks with rapid access to exchange trading platforms.
2. No tax
   
   • UK basic taxpayer would pay income tax at a rate of 7.5% on dividends and on CGT about their allowance
   • Elton and Gruber tried to build a model under taxation and found that investors would tilt portfolio to benefit their tax position
3. Dealing cost and price of illiquidity
   
   • 2008 put questions to the issue of perfect liquidity
   • Less liquid assets have higher dealing spreads
   • illiquidty has a cost
4. Homegenity of investor expectations
   
   • Where investors do not have the same expectations that have their own unique frontiers
5. Free lending and borrowing
   
   • Spread between deposit and borrow rates shows this is wrong
   • However, this just slightly alters the slope of the SML reducing the gradient
   • It will just change the efficient portfolio
6. Unlimited short selling
   
   • Has proved to be un-needed as all own he market
   • 2008 there were partial bans on short selling to calm market volatility
7. Normal distribution of returns
   
   • Fat tails and black swan events the high amount of six sigma rules
8. Single period model
   
   • Common single period of all investors

Question 177

What are the assumptions of the CAPM?

Answer 177

• Mean and variance are sufficent to describe the distribution of future returns in a portfolio and investors are indifferent about upside and downside variance
• Investors prefer higher expected returns to lower expected returns for a given portfolio risk and prefer lower volaitlity to higher volaility of portfolio returns for a given portfolio expected return
• All investors can borrow and lend at a risk free rate
• Investors have the same expectations about means, variances and covariances of security returns

Question 178

Which is a similarity between the Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Theory (APT)?

Answer 178

• Both use the risk free rate as their intercept
• Beta in the CAPM is a composite factor which is equivalent to the weighted average of the betas of the relevant factors in the APT model
• In equilibrium, there is no unsytematic or idiosyncratic return. All expected returns derive from systematic or common factors.

Question 179

In equilibrium APT?

Answer 179

• There is no under or overvaluation
• No abritage opportunities exist
• Return is explained by a multifactor model
• Non-systematic risk is not priced as all returns derive from systemic risk
• The intercept term in APT is the risk-free interest rate

Question 180

What are the reasons to not choose efficent portfolio?

Answer 180

• Correlations to other stocks already in the portfolio
• Beta of a security might be too high or too low for the risk objecitve of the portfolio
• Liquidity may be low, increasing transactions costs and ability to rapidly sell at quoted prices
• Ethical reasons
• Yield could be a requirment and stock may not pay dividend
• Not followed in the benchmark
• Less information availability and greater uncertainity

Question 181

What risk free rate to use?

Answer 181

Treasury bills:

• Treasury bill can be used so the Treasury bill has zero systematic and unststematic risk, its default risk, and this is an important factor even though it may sometimes not be risk free in real, inflation adjsuted returns

Money market funds:

• Money market rate has zero systematic risk and the zero beta CAPM which better reflects actual practive and empiracally predicts better

Question 182

What are money weighted returns?

A client has a £10m at start, after 5 years it had grown to £14m. At end of year one the initial investment another 0.5m was invested and at the end of year 3 £1m was redeemed.

Answer 182

Measures the final value return of a fund and the begining value. Includes only intermediate cash flows.

MWR is the IRR of the opening and closing values of the portfolio, taking into account any deposits into and withdrawals from the fund

The fund has roughly grown from £10m to £14m over a five year period, this is a growth of 40% over 5 years and 8% per year.

Question 183

Which of the following methods of measuring a portfolio’s performance would provide the MOST accurate measure for a portfolio that has had several large inflow and withdrawals?

Answer 183

The time weighted rate of return since its return is based on a series of sub- periods between each cash flow.

Question 184

What is the time weight returns?

Answer 184

Computed by calculating holding period returns between each point that a fund is valued. Funds should be valued each time there is a signifcnat cash flow. The returns are then compounded to give the overall TWR.

This eliminates any distortions created by the timing of cash inflows and outflows.

Time

Q1

Q2

Q3

Q4

Fund Value

107

110

115

120

Cash Flow

• 4
• 3
• 8
• 2

NAV

103

107

107

118

Return

107/100

110/103

115/107

120/107

Relative Return

1. 07
2. 068
3. 0748
4. 1215

Return = (1.07)(1.068)(1.0748)(1.1215) – 1 = 37.75%

The average quarterly return is then calculated as the geometric mean of the individual quarterly sub-period returns

Quarterly = 4Sqrt(1+Return) = 4SQRT(1+0.3775) = 8.34%

Question 185

What is the IRR?

Answer 185

Is the internal rate that makes the NPV of an income stream return equal to zero.

The IRR is the annualised compound rate of return earned by an investment.

Investment is potentially good if the IRR > than the rate of return earned on an alternative investment of equal risk. If the IRR > cost of capital then investment is potentially good.

Question 186

Which of the following is true of the holding period return on a bond?

Answer 186

Holding period return is the rate of return over a particular investment period and depends on the bonds price at the start and end of the period.

If the bond is held to maturity and there are no coupon payments the holding period return will be known in advance

Question 187

What is reinvestment risk?

Answer 187

YTM has reinvestment risk because the YTM computation assumes that 1) all coupons can be reinvested and 2) that all coupons will be reinvested at the promised YTM.

Reinvestment will occur at interest rates that prevail when coupons are paid, and these are subject to uncertainty.

Question 188

Which of the following is true of a bond’s yield to maturity?

Answer 188

• It is the average return if the bond is held to maturity
• It depends on the bond’s coupon rate
• It depends on the bond’s maturity and par value
• It does not rely on the bonds duration

Question 189

A high probability of default on a bond can be expected to result in a promised yield to maturity

Answer 189

Greater than the expected yield

Question 190

A company has a current share price of £16 a share, a growth rate in perpetuity of 9% and an expected dividend payment of £1. You have a required rate of return of 14%. What return do you expect, and do you invest? Show all workings.

Answer 190

A: Using Gordons growth model

P = D1/ R-g

16 = 1/ R- 0.09

So rearranging the formula:

R – 0.09 = 1/16

R – 0.09 = 0.0625

R = 0.09 + 0.0625

R = 0.1525 or 15.25%

This is higher than your required rate of return of 14% so yes, you would invest.

Question 191

What is the equity risk premium?

Answer 191

• Risk premium = forward looking dividend yield + long run earnings growth – current long run gilt yield

Or

• Expected return = risk free rate + equity risk premium

Question 192

What is the concept of fundamental value?

Answer 192

• Fundamental value is based on all information, public and private.
• Share prices are meant to reflect on unbiased estimate of fundamental value but private information is not known.
• No all public and private info is expected to be incorporated into prices which allows company value to fluctuate above or below fundamental value.
• Prices reflect estimates which is subjective and leads to differing in view which drives supply and demand.
• If share prices exceed fundamental value, then the firm is overvalued and if below it is undervalued.
• Difference in price vs value is based on error or interpretation or because only limited information is known.
• Those that most closely follow information are best at interpreting information should reach most accurate stock valuation.
• So long as people do not have systematic biases then subjective valuation will be normally distributed about fundamental value. This should ensure only minor departures from value.
• If people have systematic biases, then subjective valuations may not be normally distribute then expected returns can prevail – efficient market anomalies.

Answer 193

The tax rate quoted is personal and so the valuation is unaffected by tax D1/r-g = 5 x 1.02 / 0.05-0.02 = 5.1 / .03 = 170

The tax rate quoted is corporate and the dividend paid after tax taken off. If analysts feel that tax rates may change in the future they may wish to input a different number, for example 10% or even 0%. Assuming 10% the valuation is D1/r-g = 5 x 1.1 x 1.02 / 0.05-0.02 = 5.1 / .03 = 187 Assuming 0% D1/r-g = 5 x 1.2 x 1.02 / 0.05-0.02 = 5.1 / .03 = 204

Question 194

What is the DDM, its merits and drawbacks?

Answer 194

The DDM calculates the IV of a stock index based on future series of dividends that grow at a constant rate.

The assumption is that dividends growth at a constant rate in perpetuity, the model solves the PV of the series of future dividends.

Merits:

• Very simple to understand
• Focuses on the most visible form of returns to shareholders
• Relies on a few parameters, requiring only the observation of the current dividends, the required rate of return and some projection of the future

Drawbacks:

• Does not work well when required rate is equal or lower than growth rate
• Does not allow us to value firms which do not pay dividends
• Concentrates on a very narrow range of parameters

Question 195

What are the merits and drawbacks of using nominal returns?

Answer 195

Merits:

• Shows the actual performance of assets
• Grossing up inflation component can flattern the return obtained by the risk taken and present an inaccurate picture of asset returns and risk relative to the SML
• Real numbers show risk attached to producing real retursn. If the investors seeks inflation exposure, there may have been safer ways of achieving this, for example via cash instruments in the same market offering a compensating higher interest rate.

Drawbacks:

• Risks associated with currency, interest rate and inflation are part of international investing. The active manager should include all active decisions
• The inflation rate that matters is the investors domestic inflation rates as this is the purchasing power that the investor is trying to protect against
• If the exchange rate is adjusting, then adjusting for inflation in local currency terms and the converting to the investors domestic currency is double counting
• Real performance numbers can be hard to interpret for clients

Question 196

What are the drawbacks and merits of annualised returns?

Answer 196

Merits:

• Standardises performance over long periods so indicates what an investor can expect to achieve over a longer time period

Drawbacks:

• Smoothens performance figures and does not reflect the bumpiness of the journey so client may not full understand volatility inherent in investment
• Risk aslong the way may be too high for clients risk tolerance

Question 197

What is the international fisher equation?

Answer 197

It is the difference in nominal interest rates between two currencies which wil determine the movement of nominal exchange rates between their currencies

Country with lower nominal interest rates is expected to have lower inflation and so value of currency should rise

Question 198

Why would an investor want to hedge?

Answer 198

• Unhedged positions add extra risk in the form of variance in FX rates and this can be substantial.
• Correlations between FX rates and stock markets may offset the variance and so can have low volatility.
• May be additional diversification benefits from holding currency so we need to know correlation structures.
• Strongly appreciating home currency may warrant unhedged and the opposite is true for a weakening currency.
• Many large companies will earn revenue internationally so are hedge themselves

Cost of hedging, time period and ability to roll over need to be considered.

Question 200

Assume EUR 1 = US$ 1. A Eurozone investor has investment exposure in two currencies: the Euro and the US $. The Eurozone risk-free rate is 3%. The US risk-free rate is 1%. The expected appreciation of the dollar is 5%. What is the foreign currency return? (2 marks)

Answer 200

• If you invested 100 EURO in dollars at the start of the year you would get $100 and at the end of the year you would have $101
• If the dollar appreciated by 5%, the exchange rate at the end of the year would be 0.95 EURO/$
• So if you converted the dollar returns back to EUROs you would get $101/0.95 = 10.6.3 EURO
• So the total return in 6.3%
• The Eurozone investors could have got 3% on his EUROs so the difference is 3.3% is the relative foreign currency return

Question 201

Key empirical results of studies about Beta suggest all of the following

Answer 201

• In some short periods, investors may be penalised for taking on more risk.
• in the long run, investors are not rewarded enough for high risk and are overcompensated for buying securities with low risk.
• in all periods, some unsystematic risk is being valued by the market.
• in the long run, estimated betas are not stable

Question 202

What is the different taxation between off-shore reporting and non-reporting funds?

Answer 202

Reporting funds:

• Any gain is a capital gain subject to CGT
• Income taxed as dividends as if it’s a corporation
• Pay low tax if in low tax jurisdiction
• Report to HRMC and are regulated
• Example:
  
  • Used CGT allowance

Reporting fund has 6% return, 4% capital and 2% income.

All capital taxed at marginal CGT rate: 4% x (1-0.2) = 3.2%

All income taxed at dividend rate: 2% x (1-0.325) = 1.35%

Total return = 3.2% + 1.35%

Non-reporting funds:

• Subject to income tax not CGT
• Aim to penalise by investing in non-reporting funds who report little by way of dividends may be attempting to turn income into capital gains
• Gains is subject to income tax at the investors marginal rate of income tax.
• Example:
  
  • Non reporting funds has achieved 6.5% gross return.

For non-reporting fund tax all as income.

6.5% x (1-0.4) = 3.9%

Question 203

What is the VAT charged on trades:

Answer 203

• EO Transactions:
  
  • No VAT
  • If you supply EO but do not offer advice you are exempt
• Platform of EO plus custody of dematerialsied assets
  
  • No VAT
• A platform offering EO, custody of dematerialised assests plus market data and research for client porfolio
  
  • VAT is applied to market data reseach and serivices
• A platform plus advice
  
  • VAT applied to advice, only in instances where your povide advice and this advice is incidental to transaction will the supply of the advice be exempt.
• Physical safe custody are VAT applicable but nominee services and global custody are not

Question 204

What are the VAT positions of pooled and segregated structures?

Answer 204

• Services through pooled funds and insurance wrappers are exempt
• OEICs, unit trusts and closed-ended are tax exempt
• Defined pension schemes are exempt
• AMC and transaction costs are billed together are charged VAT to whole lot
• If transaction costs can be separated, then no VAT is payable on transcations only AMC

Question 205

Which of the following statements about a strategic long-term asset allocation approach is

Answer 205

• The approach is well suited for an investor with an aspirational investment objective that may be met but who can afford for it not to be.
• The approach presumes that investments mean revert.
• The approach is relatively inexpensive in terms of trading costs.
• The approach is relatively good at capturing market rises following large drops.

Question 206

You are deemed to be a UK resident for tax if?

Answer 206

• Spend at least 183 days in the UK in a tax year
• Only home or main home is in the UK and used for 30 seperate days
• They have sufficent working hours
• Sufficient ties test:Considers the number of ties the individual has with the UK:
• Were UK resident for any of the three tax years before the tax year
• The number of days you spend in the UK in the tax year
• Family ties:
  
  • Spouse, Minor childer live in the UK
• Accomdation tie:
  
  • Accessible accomodation in the UK used for 91 days
• Work tie:
  
  • Work in the UK for more than three hours a day for a total of at least 40 days per tax year on an employed or self-employed basis.
• 90-day tie:
  
  • Has spent 90 days or more in the UK in either of the last two tax years
• Country tie:
  
  • Spent more days in the UK in a tax year than in any other single country.

Question 207

You are deemed non-UK for tax if:

Answer 207

• Present in the UK for fewer than 46 days
• Resident in one or more of the previous three tax years and present in UK for less than 16 days
• Work overseas full time
• Work in the UK for no more than 30 days
• Spend no more than 90 days in the UK