IAD Level 2 - Mock 4

Question 1

Which of the following is not a measure of risk-adjusted performance?

A. Sharpe ratio
B. Standard deviation measure
C. Jensen measure
D. Treynor ratio

Answer 1

B. Standard deviation measure.

Standard deviation is a measure of total risk but does not measure return or risk adjusted return.

Question 2

Which of the following is an assumption of Modern Portfolio Theory?

A. Investors are loss averse
B. Investors are risk averse
C. Investors are risk takers
D. Investors are risk avoiders

Answer 2

B. Investors are risk averse.

MPT assumes investors are risk averse meaning they need to be compensated with return for taking on risk.

Question 3

Which of the following would be a consequence of investing in a regulated scheme rather than an unregulated scheme?

A. Lower overall costs
B. Higher management fees
C. More market activity
D. Higher potential return

Answer 3

A. Lower overall costs.

Unregulated funds tend to be more aggressive in the market causing more market activity, higher fees but a potentially higher return (or bigger loss!), such as hedge funds.

Regulated funds have more restrictions placed upon them including how much they can charge. This tends to lower overall cost of investment, but also potentially give lower returns.

Question 4

Marital status is important in calculating various tax liabilities. Which of the following is least likely to be affected by the marital status of the client?

A. Capital gains tax
B. Income tax
C. Inheritance tax
D. National insurance

Answer 4

D. National insurance.

Of the four taxes listed, national insurance liability is the least likely to be affected by the marital status of the client.

Question 5

Which of the following is/are associated with investment trusts?

I. Closed-ended
II. May borrow money for gearing purposes
III. If an investor sells a share, the net asset value of the portfolio of the fund is affected
IV. They are approved by the FCA

A. I only
B. II only
C. I and II
D. I, II, III and IV

Answer 5

C. I and II.

Shares in an investment trust are sold in the secondary market - as such the net asset value of the fund will NOT be affected.

Question 6

Jimi, a fund manager, was instructed by his manager to increase the systematic risk of his fund’s portfolio. Which of the following actions would BEST achieve this goal?

A. Shifting the portfolio’s weight TOWARDS assets that have low positive correlation with the existing portfolio
B. Shifting the portfolio’s weight TOWARDS assets that have low negative correlation with the existing portfolio
C. Shifting the portfolio’s weight AWAY from assets that have a negative correlation with the existing portfolio
D. Shifting the portfolio’s weight TOWARDS assets that have a high negative correlation with the existing portfolio

Answer 6

C. Shifting the portfolio’s weight AWAY from assets that have a negative correlation with the existing portfolio.

A perfectly hedged portfolio can be achieved by adding investments with a correlation coefficient of -1 to the portfolio. This would eliminate the market or systematic risk of the portfolio.

Increasing the weight of assets with negative correlations with the existing portfolio would reduce systematic risk. Doing the opposite would increase systematic risk.

Question 7

Which of the following risks is least likely to be mitigated through diversification?

A. Management risk
B. Business risk
C. Industry risk
D. Interest rate risk

Answer 7

D. Interest rate risk.

Diversification can help to mitigate (reduce) non-systematic or specific risks such as those shown in the other answer options by combining a number of assets that are not perfectly positively correlated. Interest rate risk, however, is a systematic risk and affects all areas of the market and cannot be mitigated through diversification.

Question 8

A socially responsible investor wishes to avoid investment in alcohol products and companies related to these products. By what process would an advisor recommend investment opportunities?

A. Negative screening
B. Positive screening
C. Stock picking
D. Mutual exclusion

Answer 8

A. Negative screening.

Negative screening would eliminate all of the investment opportunities involved in a specific activity: in this case, alcohol.

Question 8

An investor notes that the income on a collective investment product requires tax to be paid to HMRC by investors at either 20%, 40% or 45%. Which of the following collectives could the investor be looking at?

I, Unit Trust that invests primarily in bonds
II. OEIC that invests primarily in equities
III. OEIC that invests primarily in bonds
IV. REIT

A. I & IV
B. I, III & IV
C. II & IV
D. IV only

Answer 8

D. IV only.

This question tests the different tax treatment between property income and savings interest. Property Income is taxed as non-savings income, and the rates for non-savings income are 20%, 40% and 45%.

Savings interest has the starting tax rate of 0% as well as 20%, 40%, and 45%.

Distributions from an equity OEIC will be taxed as dividend income: 8.75%, 33.75%, 39.35%

Question 9

An investor wishes to directly hold a property through a trust. Which of the below investments will allow this?

A. Property investment trusts
B. Property company shares
C. Property unit trusts
D. Property fund of funds

Answer 9

C. Property unit trusts.

The investor has a direct interest in a property held in a property unit trust, so that would be the best answer here.
Property investment trusts can not hold property directly.
Property company shares are shares of property development companies.
Property fund of funds is where a fund has invested in other property funds, so this would be indirect investment.

Question 10

Rupert is adopting a passive bond strategy. Which of these is the MOST likely explanation for Rupert’s actions?

A. Rupert believes interest rates are going to rise quickly in the near future, and wishes to take advantage of current rates
B. Rupert thinks the equity market is efficient
C. Rupert wishes to match some liabilities he faces over the next decade
D. Rupert suspects that the spread between the yield of bonds of different levels of issuer risk is going to narrow

Answer 10

C. Rupert wishes to match some liabilities he faces over the next decade.

Liability matching is a passive bond strategy.
Choices A and D are examples of active bond strategies. Choice B states equity markets are efficient and the question is about a bond strategy.

Question 11

An authorised firm receives a complaint from a customer on 1 March. Which of the below is the latest for them to inform the customer about the FOS, assuming no bank holidays?

A. 8 March
B. 29 March
C. 2 April
D. 26 April

Answer 11

D. 26 April.

An authorised firm has eight weeks to resolve the dispute, otherwise they should provide the customer with an update and advise them of the FOS.

Question 12

After a prolonged period of falling markets, the markets rise substantially over the next three years. Assuming all investments were made at the same time, investing in which of the following investment vehicles is most likely to give the best return?

A. Exchange Traded Fund
B. Investment Company with Variable Capital
C. Investment Trust with gearing
D. UCITS Unit Trust

Answer 12

C. Investment Trust with gearing.

The investment trust is highly geared which magnifies both the upside and the downside.

Question 13

Which of the following is NOT true regarding equity warrants?

A. They can be issued with a bond in a detachable form
B. On exercise warrants raise funds for the company
C. The issuer can exercise the rights on the exercise date
D. The holder of the warrant has no right to vote

Answer 13

C. The issuer can exercise the rights on the exercise date.

The holder exercises the warrant, not the issuing company.

Question 14

A two-year 5% bond is trading at £100. Based on this information what will be the price of a two year 3.5% bond?
Assume the bonds have annual coupons.

A. 102.84
B. 97.21
C. 98.41
D. 93.88

Answer 14

B. 97.21.

As a two year bond with a 5% coupon is trading at par, 5% is the effective discount rate.
The bond cashflows will be discounted as follows:
T1 = £3.50 / 1.05
T2 = £103.5 / (1.05)^2

£3.50/1.05 + 103.50/1.05^2 = £97.21

Question 15

Which of the following is/are correct of unit-linked and with-profit bonds?

I. Unit-linked bonds have no basic sum assured
II. With-profit bonds have a basic sum assured
III. Unit-linked bonds can contain no extra life cover
IV. Unit-linked bonds attract bonuses

A. I & II
B. II & IV
C. I, II & III
D. II only

Answer 15

A. I and II.

With-profit bonds do have a sum assured, whereas unit-linked bonds do not.
The sum assured is a guaranteed amount payable on death.

Question 16

Which of the following is most accurate in describing the diversification effects of modern portfolio theory?

A. Systematic risk is reduced and non-systematic risk remains
B. Non-systematic risk is reduced and systematic risk remains
C. Both systematic risk and non-systematic risk are reduced
D. Both systematic risk and non-systematic risk remain at the same levels

Answer 16

B. Non-systematic risk (specific risk) is reduced and systematic risk remains.

Question 17

Harry needs to find a bond with a real return of 3.3% to fit the risk/return target of his customer. Inflation is currently running at 3.7% per annum. Below is the nominal rate of return of four bonds:
Bond A: 1.1%
Bond B: 3.5%
Bond C: 7.0%
Bond D: 7.1%

Which bond should Harry recommend for his customer?
A. Bond A
B. Bond B
C. Bond C
D. Bond D

Answer 17

D. Bond D.

The nominal return is made up of the compounded effect of the real return and the inflation rate.
(1 + nominal return) = (1 + real return) x (1 + inflation rate). (1 + nominal return) = (1.033) x (1.037) (1 + nominal return) = 1.0712

So, Harry requires a bond with a nominal return of 7.12%. At 7.1%, Bond D has the closest nominal return to this.

Question 18

Michael is a small private investor who has been watching the markets for some time now. He has noticed that the day after snow disrupted transport links to the city, the markets tended to rise. At the end of the next snowy day, Michael invests in an exchange-traded fund (ETF) that tracks the FTSE 100 index.

Michael could be said to be suffering from:
A. Loss aversion
B. Confirmation bias
C. Hindsight bias
D. Cognitive bias

Answer 18

C. Hindsight bias.

Michael is relying on hindsight bias. Creating a link and an explanation based on probably unrelated events simply through observation.
Loss aversion is the tendency for people to get a greater loss of satisfaction from losses, than they would gain satisfaction from the equivalent gains.
Confirmation bias is the tendency to look for information or returns that confirm your beliefs.
There are many forms of cognitive bias.

Question 19

Frank is filling out his annual tax return. He has earned £45,000 in salary and £10,000 as a bonus. He has been granted the use of a company car as a benefit-in-kind assessed at £5,000. How much should he declare as earned income?

A. £45,000
B. £50,000
C. £55,000
D. £60,000

Answer 19

D. £60,000.

Income includes salary and wages, bonus, commission and fees and benefits in kind.

Question 20

In what circumstances may the liability for CGT fall upon the settlor?

I. When payment is made to a beneficiary
II. If the settlor is eligible to become a trustee
III. If the trustees own the trust monies
IV. If the settlor’s spouse benefits from the trust

A. I and IV
B. II only
C. III and IV
D. IV only

Answer 20

D. IV only.

If the settlor’s spouse or family benefits from the trust monies then the settlor is liable for any CGT due on gains made by the trust.

Question 21

Which of the following is not one of the four theories of behavioural finance?

A. Prospect theory
B. Regret theory
C. Anchoring
D. Framing

Answer 21

D. Framing is not one of the four theories. The four theories: Prospect Theories, Regret Theory, Anchoring, Over-and-Under reaction.

Question 22

Elzbieta is studying investing styles that combine both passive and active management strategies; this includes smart beta funds. Smart Beta funds may be considered an “active” strategy since it:

A. Uses active strategies to manage most of the portfolio allocation
B. Aims to outperform the market benchmark using passive strategies
C. Aims to match the customised benchmark created to capture above market performance
D. Uses active weights in its allocation in comparison to the market benchmark

Answer 22

C. Aims to match the customised benchmark created to capture above market performance.

Smart Beta funds have become more popular in recent years due to the combination of passive and active strategies by the manager. The main objective is to overcome the disadvantage of passive funds, which track market losses as well as gains, including holdings that a manager may not think worthwhile. Therefore, smart beta funds create their own benchmark containing assets with desired attributes (e.g. value, income, growth), this is the active approach required. The manager then tracks the index, which is the passive approach.

Choice A in incorrect, as smart beta does not use active strategies once the benchmark has been created.
Choice B is incorrect as active beta does use active strategies to adjust away from the market benchmark.
Choice D is incorrect, as active beta funds do not simply tilt their weighs (active weight) away from the benchmark.

Question 23

Which of the following statements regarding unit trusts is FALSE?

I. Unit trusts are incorporated as unlimited companies
II. Unit price is based on NAV
III. The manager can remove the trustee
IV. Units are bought and sold through the manager

A. II and III
B. I and III
C. II and IV
D. I and IV

Answer 23

B. I and III.

Unit trusts are trusts, NOT companies.
It is not possible for the manager to remove the trustee.

Question 24

Marcus is a higher rate taxpayer who wishes to invest in a well-diversified fund and gain some tax efficiency but wants to take control of the timings of his purchases and sales. He has an internet share-dealing account with his retail bank. Which of the following would be the best investment?

A. He should invest in an authorised unit trust held in an ISA account
B. He should invest in an investment trust company held in an ISA account
C. He should invest in a unit-linked investment bond
D. He should invest in an EIS-qualifying company via his share-dealing account

Answer 24

B. He should invest in an investment trust company held in an ISA account.

Marcus wants to gain tax efficiency, and all of the investments provide a certain tax benefit. All gains and income within an ISA account are tax-free. Investment bonds allow a deferral of tax until encashment, when Marcus’s tax liability may be lower. Enterprise investment schemes offer income and capital gain tax relief. However, Marcus also wanted a diversified fund: this eliminates the EIS-qualifying company.

Marcus also wanted control over his purchases and sales. This definitely eliminates the unit-linked bond, which is a fixed-term investment with early encashment penalties, and, to a lesser extent the unit trust, which is likely to have dilution levies charged on purchases and sales. The unit trust will also have less clarity on the pricing of purchases and sales, because of the, typically, forward-pricing. Investment trusts, as they trade on the secondary markets, have a more immediate pricing available and can be traded through his share-dealing account.

Question 25

What two types of tax will a FUND receiving overseas income suffer?

I. Withholding tax
II. Underlying tax
III. Income tax
IV. Capital gains tax

A. I and III
B. I and II
C. II and III
D. III and IV

Answer 25

B. I and II.

Withholding tax and underlying tax are suffered on overseas income.