Overall AF4 Flashcards
Describe Strategic asset allocation
Strategic asset allocation is a portfolio strategy whereby the investor sets target allocations for various asset classes and rebalances the portfolio periodically. The target allocations are based on factors such as the investor’s risk tolerance, time horizon, and investment objectives
Top Down Method
the process where deciding on asset allocation before stock selection and market timing
Asset allocation
sector selection
stock selection
Tactical Allocation
Ranges are specified around the strategic level to enable market timing adjustments to be made by the manager (e.g fixed interest 40-85%)
the fund manager changes the asset allocation of the fund in order to take advantage of short term market shifts
Fundamental Analysis
process of identifying stocks that are undervalued by looking at underlying investment
Technical Analysis
focuses on the market rather than the stock
Seek to identify trends and by predicting these trends will aim to beat the market (chartists)
Value Funds
Aim to identify undervalued shares.
low price earnings ratio. High Dividend yields
Advantages of Value Funds
Optimal strategy for those with long horizons (pension funds)
Growth Funds
Manager is looking for companies with high growth prospects
High P/E
Mandatory points for Growth Funds
Growth in EPS for at least 4 out of last 5 years
Low P/E relative to growth
Good cashflow (low gearing, high liquidity)
Momentum Investing Advantages
Managers tend to be influenced by momentum because clients like to see investments that are showing good news and results.
Momentum Investing
Momentum investing is a trading strategy in which investors buy securities that are rising and sell them when they look to have peaked. The goal is to work with volatility by finding buying opportunities in short-term uptrends and then sell when the securities start to lose momentum.
Momentum disadvantages
demands a much higher level of trading.
it incurs high transaction costs
highly sensitive to the luck of trading
Contrarianism
betting against the herd
into out of fashion holdings
(Active) EMH Weak form
Active Managers
they believe they can beat the market over the long term
they believe in a weak form EMH
they believe they know more and can act on information to add value to investment return
Weak form demonstrates that all information reflects historic information
past data
Passive - Strong form EMH
Passive investment mangers believe that it is difficult to beat the market - that the market is strong
Liquidity risk
is being able to buy or sell at a fair market price
the liquidity of any market is determined by the number of buyers and sellers at any time.
in a liquid market it is easy to sell and buy and obtain a fair market price
How does Diversification eliminate specific risk (non systematic)
because the positive and negative individual characteristics of each asset tend to cancel each other out.
studies show that approximately 20-30 securities are required in a portfolio to eliminate specific risk
Limitations of CAPM
single period - one year model
only applicable to diversified portfolios
the model assumes that the overall portfolio held is diversified and equates to the market as a whole.
if we were dealing with a small undiversified portfolio then this model would not work.
Difficult to determine Beta
Standard Deviation
takes into account the risk of each share and the covariance of returns when combining them in the same portfolio
the standard deviation is the square root of the variance
Covariance
the extent to which returns vary with another security
how to calculate standard deviation
- calculate the difference between the actual return and expected return
- square the differences to eliminate the minuses
- multiply the squared answers by the probability
- sum the result, this sum is called the variance
the information ratio
compares the excess return achieved by the fund over a benchmark portfolio to the funds tracking error
it is a risk-adjusted return measured to evaluate the funds managers relative experience
the higher the positive IT ratio the better the risk adjusted return based on performance relative to the benchmark
tracking error
gives us an estimate of the risks the manager takes in deviating from the benchmark, The excess return element tells us how well the fund manager did compared to the benchmark.
Sharpe Ratio
adjusts rates of return to take account of the riskiness of the investment or fund.
measures the excess returns for every unit of risk, measured by the standard deviation (total risk)
limitations of the Sharpe ratio
*SD assumes that equity/investment returns are normally distributed when they ARE NOT
*the SR can be manipulated by changing the measurement interval
* It is simplistic, a single figure
*it ignores investment charges and costs
*it uses historic data
Treynor Ratio
similar to the sharpe ratio but uses beta as the divider and measures returns earned in excess of that which could have been earned on a riskless investment per each unit of market risk.
Alpha
is a measure of return that is independent of the underlying market or benchmark - it is a measure if the mangers stock picking skills.
it is the return that is not explained by the CAPM
sometimes called Jensen alpha
Volatility
in the exam we may get a question to calculate the annual volatility, this is simply the variance squared root
When selecting a benchmark with a client, we need to take into account
should be specified and agreed with the client in advance
should priced at suitable periods
how has the benchmark performed in the past
how is it calculated/ has to be transparent
benchmark must be relevant to the investment fund/ i,e you would not place a bond fund against the FTSE 100
Benchmark provides 3 key factors
measure to compare the performance of different types of funds
a basis for reviewing the asset allocation and structure of your portfolio
benchmark for assessing and comparing the performance of your DFM
Benchmark comparison Step 1
choose an appropriate benchmark to compare the portfolio
Not much to do here but check it fits client ATR
Benchmark comparison Step 2
tabulate the asset allocation or check the asset allocation of the benchmark.
Benchmark comparison Step 3
calculate the return that each asset class in the benchmark portfolio would have achieved in line with appropriate index for its sector.
Benchmark comparison Step 4
compare this benchmark performance with the fund mangers performance in terms of asset allocation.
Benchmark comparison Step 5
compare the fund managers % returns in asset classes with the relative index return
The aim is to see how the managers selection of investments within each asset class performance relative to appropriate index
Advisory Management
suggests a course of action
the clients accepts or rejects
usually lower charges than DFM
priority is for maximum return within appropriate risk profile
DFM
once investment objectives agreed
prior consultation with the client is not required to buy/sell investments
usually higher charges than Advisory
priority is for maximum return within appropriate risk profile
4 key investment decisions DFM/Advisory
Investment Style (absolute returns or benchmarking)
Active vs Passive
Management approach
types of asset used
Bespoke segregated portfolio
tailored to the individual client
can be operated on a discretionary or advisory basis
Bespoke portfolio management is offered by stock brokers and private client investment managers
Discretionary Investment Management
client gives discretion to the investment firm to manage their investments on their behalf
regulatory requirement that there is a 2 way client agreement
Advisory investment service
offered by investment managers that recognises that some clients don’t want to give up on the decision making and want to remain actively involved in the management of their portfolio.
Managed portfolios
structured to match particular risk profiles
target at particular set of clients to which the profile applies to
diversified and managed to a known objective
Centralised Investment Propositions
standardised approaches to investment to investment advice
include model portfolios and DFM
without specifically and clearly outlining the advice, why they are suitable to the client
advantages of CIP
removes portfolio drift
removes any adviser/ bias/ behavioural bias
keeps portfolio in line with client ATR via regular rebalancing
Disadvantages of CIP
NOT client specific
May be higher costs
assumptions based on historic data
DFM Reporting and fees
a 2 way client agreement must be entered for a Discretionary investment services between client and adviser
must provide regular reports on investment performance
DFM fees
AMC & Ongoing charges
Dealing commission / bid offer spread
panel on takeover and merger
stamp duty reserve tax
initial set-up fees/ exit fees
one off valuation charges
VAT
custodian/platform/ wrapper fees
Not included in OCF
performance fees
platform/adviser charge
brokerage charges
panel on takeover and merger
stamp duty reserve tax
Investment Mandates
specific instructions that guide the investment manager in the management of a clients investment portfolio
purpose of their objectives
on the other hand it can be seen as the operational detailed instructions to the investment manager on how the portfolio should be managed
Disadvantages of rebalancing
winning investments may be sold that may continue to produce higher returns
losing investments could be bought and continue to fall
there will charges incurred when rebalancing
there may be tax liabilities incurred
Strategic CII
Fixed weighting/ asset allocation
Long term
With occasional/infrequent rebalanced
Little variation from objective
No response to market changes
Tactical CII
Varying weighting/ asset allocation
Short term
Frequent rebalanced
Substantial variation from objective
Take advantage of market movements
Normal yield curve
Rising positive curve
Longer term gilts should produce a higher return/yield to compensate the risks of erosion and longevity of the redemption
Flat curve
When there is no perceived investment risk then the yield will be flat
This occurs in stable economic situations where there are no significant changes expected to interest rates or inflation
Reverse/downward inverted curve
Investors optimism on inflation
Shorter term bonds have a higher yield than longer term bonds
Seen as an indicator of recession
Effectively investors demanding a higher return for the perceived risk to shorter dated bonds compared to long dated bonds
Benefits of CAPM
Easy to calculate/ uses widely available information
takes into account systematic risk/market risk
reflects fact that most portfolios are diversified to remove unsystematic risk
robust/trusted
provides an expected return
Fees included in OCF
Management fee/Annual Management charge
administration fees
Marketing fees
audit/ tax compliance
registration/regulation fees
custody/depositary/trustee
Other Investment Charges
transaction fees/initial fee/spread/stamp duty
performance fees
one of legal/professional charges
interest/gearing costs
adviser charges
Credit Quality
Default Risk/ credit worthiness
credit rating
3 other types of ETF (other than full replication)
Synthetic - uses derivatives
Optimisation - computer model/ algorithm
sampling - uses a sample of the market/index
Undiluted NAV formula
No O/S in issue
NAV Discount Formula
NAV Per Share
x100
Diluted NAV Formula
O/S plus warrant shareholders
Gearing ratio formula
net assets
Over 1 is high
OR
net assets (total assets - total liabilities)
EPS ratio
No of O/S in issue
remember answer is in p
x100 to get 2 decimal places in pence
Why would a company make a rights issue
To fund expansion/acquisition
Strengthen the balance sheet
To refinance company
To reduce share price
4 options regarding rights issue
Take up the rights issue
Sell the rights on the open market
Sell some of the rights on the market and take up the remainder
Do nothing and let the rights lapse/the company will then sell the rights and distribute the proceeds After costs
ROCE formula
Operating profit / capital employed
X100
What Is a Real Estate Investment Trust (REIT)
A real estate investment trust (REIT) is a company that owns, operates, or finances income-generating real estate.
Key facts REIT
A real estate investment trust (REIT) is a company that owns, operates, or finances income-producing properties.
REITs generate a steady income stream for investors but offer little in the way of capital appreciation.
Most REITs are publicly traded like stocks, which makes them highly liquid (unlike physical real estate investments).
REITs invest in most real estate property types, including apartment buildings, cell towers, data centers, hotels, medical facilities, offices, retail centers, and warehouses.
Dividends from the ring fenced element are taxed as rental income with 20% taxed at source.
Can be held in a ISA or SIPP and can be tax free
requirements to qualify as a REIT
Invest at least 75%of total assets in real estate, cash, or U.S. Treasuries
Derive(gain) at least 75%of gross income from rents, interest on mortgages that finance real property, or real estate sales
Pay a minimum of 90% of taxable income in the form of shareholder dividends each year
Be an entity that’s taxable as a corporation
Be managed by a board of directors or trustees
Have at least 100 shareholders after its first year of existence
Have no more than 50% of its shares held by five or fewer individuals
REIT benefits
Liquidity
Diversification
Transparency
Stable cash flow through dividends
Professional management
Partial sale / CGT benefit
Attractive risk-adjusted returns
Reit drawbacks
Low growth
Dividends are taxed as regular income
Subject to market risk
Potential for high management and transaction fees
Patent settlement rules/ Bare trust
A gift from a parent would fall under the parental settlement rules. If annual income exceeds £100 the full amount of income will be assessed against the receiver. Vice versa is less than £100 it will be assessed against the sender
Top down method
Choosing asset allocation
Then geographical areas
Sectors
Style (growth-value)
Individual stocks
Perpetual subordinated bonds
Fixed rate of interest (bonds)
Undated (perpetual)
Low priority on wind up (subordinated)
Interest not guaranteed
Non cumulative
Not covered FSCS
high risk high coupon
High minimum investment
Return on Equity formula
Net profits / Shareholders fund
X100
What does ROE measure
The return on investment made by shareholders
Indication of the firm’s efficiency at generating profits
It is used as a measure of earnings growth
Dividend cover formula
EPS/DPS
EPS formula
Net profit/ number of shares in issue
X100 as pence
DPS formula
Dividend paid/number of shares in issue
X100 in pence
130/30
100% of the fund is invested in long only stocks that are favoured by the manager
30% of the value of the fund goes short
The proceeds from the 30% short selling of unflavoured stocks allows the fund manager to buy an additional 30% of favoured stocks
The end result is 130% long 30% short
Advantages/disadvantages 130/30 fund vs hedge funds
130/30 funds are authorised by FSCS
Hedge funds are not covered under FSCS
short positions which are high risk are limited by the proportion oh short to long holdings
Hedge funds can generally short sell whatever they like
130/30 funds cannot go 100% short
Hedge funds can go 100% short
Leverage in the futures markets
Is exposure to a contract of greater value than the initial payment required to secure it, in expectation of better returns
It is generally acquired by physically borrowing the money or assets to invest or sell back at a later date
Can be achieved by investing in gold mining shares rather than physical gold
Value investor
Research On companies and sectors
To attempt to identify and invest in securities which are trading below their fair market value
Superior growth can be achieved as the market catches up and realises the share is undervalued
How does a bond ETF work
It uses a swap
For a fee
And collateral
An investment bank/ the swap provider will pay the fund the return on the relevant index
The risk is counterparty risk
Which is the risk that the investment bank / swap provider fails in their obligation to pay the return on the Index
What does Bias towards growth stocks mean
This means the fund primarily invests in companies with above market average earnings growth potential.
Growth stocks tend to retain earnings rather than pay dividends which allows them to reinvest into the company
DFM Charges/fees/taxes
Fund manager fee/OCF
income tax on dividends and other investment income
CGT on any capital gains
Vat
Stamp duty/SDRT
PTM levy
Platform/wrapper charge
Performance fee
Entry/ exit charges
What is crypto currency
A digital commodity/ asset/ currency
Which operates independently of a central bank
It uses encryption techniques/ blockchain
To regulated the issue of new units
And transfer of existing ones
What is a CFD
Contract for difference
Between investor and investment bank
At end of the contract the investor and investment bank will exchange the difference between the opening and closing values of the investment
It allows investors to invest in assets without owning them
Geared investments
Purchase takes place on margin
The investor only deposits an initial outlay (10% or 20% or thr full value of the investment) and borrows the rest of money from the CFD investment bank
Not covered by FSCS
Potentially subject to CGT
Current account
Imports minus
Exports/balance of payments
In goods and services
Plus receipt from overseas income generating assets
Capital account
Movement of all monies / assets
Into country
Out of country
What could cause Current and capital account in a deficit for long period
Rising interest rates
Economy growth falls
Currency devaluation
Unemployment rises
Inflation increases
Drawbacks SRI
Less Diversification
More expensive
Less research available
Higher risk
Screening rules out Growth
Investments that can be held in a innovative ISA
Debt based securities
Bonds and debentures
Loans to companies
Cash
Peer to peer lending
Differences between preference shares and ordinary
Fixed dividend
Higher priority in payment/ wind up
Non voting
EIS subscription rules and tax treatment
Can invest up to £1 million
If excess over £1million up to £2 million but the balance must be in knowledge intensive companies
30% income tax relief
Up to client income tax liability
Can carry back income tax relied to previous tax year
Re investment relief I’d available if invests within 3 years of sale of business
Exempt from CGT upon sale if held for 3 years
Qualify for business relief
Exempt from inheritance tax if held for 2 years
Price to book ratio
Share price ÷ NAV
What are two differences between company warrants and covered warrants
Company warrants is issued by a company and relates to itself
Covered warrant is issued by a financial institution and relates to other companies than the issuer
Company warrant is based on one company
Covered warrant maybe issued on one underlying security, indices, sectors
Company warrants are call options
Covered warrants can be calls and puts
Covered warrants risks are reduced because the issuer must hold the underlying security but the issuer can still fail
Offer for sale
Is where the company sells new shares to an issuing house which then markets the shares to the public based on guidelines in the offering document
This is prepared by the company directors and assessed by an independent sponsor who also confirms the company’s capital adequacy by letter to UKLA
A formal notice will be placed in the paper
The share price will be slightly higher than the price the company sold the shares to the issuing House in order to make a profit
The offer to the public can either be fixed or tender
IPO fixed rate
Is where the shares are offered to investors at a fixed price as a price just below what can be expected for the offer to be fully subscribed
This to encourage an active secondary market
IPO tender price
Investors specify amounts of shares they’d like to purchase and amount they are willing to pay
A strike price is then determined with all successful bidders who bid at/above this strike paying the strike price for the shares
The strike price is generally set low enough to ensure an active secondary market
Offer for subscription
An offer for subscription is an IPO that can be written on either a fixed or tender basis
It involves the issuing house underwriting the offer to ensure any unsold shares are bought
A detailed prospectus is produced and put on the issuers website
Why ROE and ROCE are used to evaluate a shares return
Both ratios measures the efficiency of profit generation
ROE is better for comparing different investments/ Assets but is affected heavily by differences in company capital structure and therefore not suitable as ROCE when comparing companies
Interest cover formula
Profit before tax and interest ÷ interest paid x100
Interest cover explained
The interest coverage ratio is used to measure how well a firm can pay the interest due on outstanding debt.
The interest coverage ratio is calculated by dividing a company’s earnings before interest and taxes (EBIT) by its interest expense during a given period.
Some variations of the formula use EBITDA or EBIAT instead of EBIT to calculate the ratio.
What is sequencing risk and what affect does it have on an investment portfolio
Impact of volaity on the order and timing frequency of withdrawals
And sustainability of future income
Long term impact on capital value and this is greater in early years
Main objectives of rebalancing
Realign portfolio to its original asset allocation / weighting to match attitude to risk and capacity for loss
Review of individual funds/ correct any style drift
Invest cash
Adjust portfolio to deal with any change in their circumstances/ income level/ objectives
Potential issues when rebalancing
Trading costs
Whether to retain or alter benchmark
Potential tax liabilities
Regulatory/ legislation issues
Is rebalancing auto or manual
Frequency of rebalancing
Existing income be effected?
Liquidity / ability to rebalanced EIS etc
Market timing
Suitability of existing funds / allocation
Main conditions for a property fund to qualify as a property authorised investment fund (PAIF)
At least 60% of income must come from the exempt property business.
Value of property assets must be at least 60% of total assets.
Shares must be widely held.
No corporate investor can hold more of 10% or more of net asset value
Tax treatments of the three components of a PAIF (Higher rate tax payer) if PAIF is used to generate income
Dividend income paid gross and taxable at 33.75% once Dividend allowance exceeded
Property income distribution exempt
Paid net of basic rate tax/ 20%
And taxable further at 20%/40% in total once personal savings allowance exceeded
Interest/other income paid gross but taxable at marginal rate
What is meant by growth investment style and good indicator of a good growth stocks
Involves investing in securities with above average earnings potential
Typically growth investors favour smaller companies with the ability to grow more quickly in size reinvesting their earnings back into themselves to deliver capital growth to investors with the share price
It’s higher risk than value investing because growth managers are not relying on investing in undervalued stock
Growth investors need to consider more qualitative measures such as the ability and efficiency of the management team to run the business in the most profitable way
Key indicators of growth stocks
Eps growth for 4 years out of last 5
A low P/E relative to growth
Optimistic annual statement from the company chairman
Strong liquidity (High cash flow low borrowing)
Competitive advantage
Value investment style
Believes that through vigorous research they can discover stocks undervalued by the market which will allow them to profit on the upside
Believe that markets are inefficient and investors under and over react to new information
The value investor aims to take advantage of these reactions
Value investment involves using fundamental analysis in order to identify securities that are undervalued
Investing in them and selling them once thr market has caught back up
Indicator of value stock
Solid value indicators include a low P/E ratio
High dividend yield
Low price to book ratio
Momentum investing
Identifying trends using technical analysis
Going long in investments likely to continue growing
And/or going short in investments likely to continue failing
And selling/ closing out the position before before the security changes direction
It’s a risky strategy as knowing when to sell has proved difficult
Contrarian investment style
This simply involves betting against the herd
They invest in assets which are out of fashion or have recently fallen
They need a fairly accurate valuation of the security they’re investing in (the investment may have fallen for a good reason)
Key differences between fundamental and technical (momentum) analysis
Fundamental analysis uses qualitative and quantitative research into a company and its sector / geography in order to establish the value of an investment- specifically whether it is undervalued or over valued
Research will consider company’s balance sheet: profitability, profit volatility, liquidity, and operational efficiency. It is used predominantly by value investors and contrarians
Technical analysis is most often used by momentum investors
It looks at charts to attempt to identify trends in the market and bases future buy/sell decisions on past share price movements
Tax treatment of REIT
Income from ring fenced lettings element is treated as rental income and paid net 20% tax. But can be reclaimed by non taxpayers including ISAs and SIPPs.
Basic rate and additional taxpayers must pay an additional 20/25%
Income from the non ring fenced element Is a normal dividend. The first £2,000 of dividend income for investors is tax free. Any dividend income in excess of the allowance is taxed at 8.75% 33.75% 39.35%
REIT shares are subject to CGT on any gains in excess of the tax free CGT annual exempt amount at 10 or 20%
No relief is available for IHT / NO business relief
Key differences in EIS vs VCT
Max investment
£200,000 VCT
£1,00,000 EIS
Tax relief
30% for both
Holding period
EIS 3 years
VCT 5 years
One year carry
EIS yes
VCT no
Dividend
EIS taxable
VCT exempt
CGT
EIS gains exempt after 3 years
VCT gains exempt
CGT TAX DEFERAL RELIEF
EIS yes
VCT no
Bottom-up approach
Pay no attention to index benchmarks
they select stocks based on their own criteria (value, GAAR etc)
What are the money markets
they are the markets for short term borrowings.
An original maturity of less than 1 year.
Intuitions borrow funds to help with cash flow problems or deposit if they have a surplus
what is the Inter-bank market
is a market where two-way prices are made between participating banks.
the difference between the two is called the spread
UK Treasury Bills
A way of the government to borrow money
short term - mainly 3 months but can range from 1-6 months
usually minimum investment pf £500,000
Highly liquid
Issued at a discount of £100 nominal
What is Commercial Paper
companies issuing unsecured short dated debt
maturities between 30-90 days
issued via the money markets
What are certificate of deposits (CD)
A CD is issued when an investors places some money for a given term with a bank at an agreed interest rate
but with a discount as they are tradeable
they represent a deposit (not a loan)
pay interest at the end of the term
maturities between 1-3 months
Risks of the Money Markets
Credit Risk
Inflation Risk
Interest rate Risk
Currency Risk
what are debt securities
they are financial instruments that give the owners the right interest and repayment of capital on loan made to the government and companies
Gilts Description
shorts - 7 years to redemption
medium 7-15 years
Long 15 years plus
Interest rate is the coupon described as an annual % of the nominal value £100 which is paid 6 monthly and paid gross of income tax
Index Linked Gilts
have coupons and redemption values (par value) linked to the UK RPI or CPI index
Break even inflation rate
the break-even inflation rate is the rate of inflation that gives the same real net redemption yield for an index linked gilt and a comparison conventional gilt of similar maturity for investors of a given tax rate
above the break even rate the index linked gilt gives the better return
below the break even rate the conventional gilt provides the better return
The strips market
Separate trading of registered interest and principal of securities
these gilts can be stripped into their coupons and final redemption amount, both traded separately.
each strip forms the equivalent of a zero coupon bond. it will trade at a discount to its face value with the size of the discount being determined by prevailing interets rates and time.
The strips market
Separate trading of registered interest and principal of securities
these gilts can be stripped into their coupons and final redemption amount, both traded separately.
each strip forms the equivalent of a zero coupon bond. it will trade at a discount to its face value with the size of the discount being determined by prevailing interets rates and time.
Overseas government bonds
overseas governments bonds and trade vary from country to country
but effectively all operate on the same basic principle
there are 3 major bond markets in the UK;
gilts issued through the treasury by DMO
sterling loans to foreign borrowers
eurobond market which deals with foreign currency loans to UK and foreign governments and companies
The repo market
a repurchase agreement that allows the borrower to use a financial security (gilt) as collateral for a cash loan at a fixed rate of interest.
(think of pawn broker lending money against the collateral of the goods and return at some point in the future)
Eurobond market
Eurobonds are international bond issues outside any particular jurisdiction.
E.G a US dollar Eurobond could be issued anywhere in the world except for the US
Corporate Bonds
are debt securities where the issuing companies promises to repay the capital at the end of the term and interest to the holders throughout the term.
these are very much like a gilt with interest fixed or variable rate and terms of redemption and provisions for early redemption/demand for early repayment or convertibility is set out within the terms of issue.
Domestic Bonds
refers to one in which the nationality of the issuer, the denomination of the bonds and the country are the same.
Foreign Bonds
is one in which the nationality of the issuer is different to that of the denomination of the bond and country of issue
Risks of Foreign Bonds
Credit/ default risk: non-payment of interest or capital at redemption
Economic risk: different countries= different risks (greece vs germany)
Interest rate risk: the inverse relationship between bond prices and interest rates
Liquidity risk: it is possible to sell a specific amount at the price you want and at the time you want
Politcal Risk: political instability can be a major factor
Security of Bond
a debenture is a document which acknowledges a company’s indebtedness to a third party and in particular to a secured debt instruments.
secured corporate bonds would be called debentures
the term loan stock refers to unsecured corporate bonds
Asset-backed securities/Investments
an ABS is a financial instrument secured by a pool of assets such as property or loans.
they are issued by companies specially created for the purpose and are a separate legal entity form the original owner of the underlying assets.
this leaves them unaffected by any bankruptcy risk in the original owner.
Mortgage Backed Securities
is a securitized pool of underlying home loans
they are used by retail banks to securities the cash flows from mortgages that would otherwise be receivable over normally a 25 year term.
Risk Management Main Risk (Bonds)
credit risk - interest payments and repayment of the bond may not be made
market risk - inverse relationship between bond prices and interest rates
inflation risk - real value of bond coupon & redemption repayment
liquidity risk: bonds not easily traded
Exchange rate risk - bonds denominated in different currencies
Bond Credit Risk
credit rating agencies make an assessment when first issued (and throughout the term of the bonds) and are divided into investment grade or non investment grade
Bond Market Risk
the income/coupon from a bond remains unchanged throughout the term
Yields vary to reflect interest rates rising or falling by a fall or rise in its capital value
Bond Volatility/Sensitivity
Bond prices will not all change by the same amount when interest rates or yields change
they are all made up of different coupons and terms #
the measure used to calculate how sensitive the bond is to changes in interest rates or yields is known as duration or modified duration
When the bond is trading above par will the GRY be less or more than the flat yield
LESS because there will be a capital loss
Are Gilts exempt from CGT
Yes
Difference between the clean price and dirty price
the actual price paid in the market for a bond is called the dirty price
the difference between the clean price and the dirty price is the accrued interest that the bond holder becomes entitled to on the distribution date
OR the seller is losing by selling before the distribution date and the dirty price compensates for this loss
The dirty price is?
clean price (what you pay for it) + accrued interest at point of sale
Bonds Coupon Sensitivity
the smaller the coupon the more the bonds price will move for a given interest rate change :
low coupon bonds are more volatile than high coupon bonds
Bonds sensitivity to redemption date
for two bonds with the same coupon, it will be the longer dated that is most volatile
Long dated and low yield bonds are the most volatile or sensitive to price movements
Duration
reflects the time it would take for the investor to get back his purchase price in present value money
Modified Duration
estimates how much a bonds price will change if there is a change in interest rates/yields
it quantifies the sensitivity of the bonds price to changes in GRY
Flat Curve
where there is no perceived investment risk the yield curve can be flat,
this occurs in a stable economic situation where no significant changes are expected to interest rates or inflation
Reverse/downward curve
investors optimism on inflation
a falling ‘reverse’ or inverted yield curve is where shorter term bonds have a higher yield than longer term bonds
and is seen as an indicator of recession with investors effectively demanding a higher return for the perceived higher risk of short term bond compared to that of a longer term bond
Preference Shares
Do not normally carry the right to vote
but carry an expectation of a dividend
payable after interest payments (bondholders)
but before O/S
Cumulative preference shares
where the company does not pay a dividend the right to receive that dividend is rolled into the next period
O/S cannot be paid until ALL cumulative preference shares have been paid
Participating preference shares
where additional dividends could be paid,
over and above the fixed rate
then participating preference dividends (extra dividend) could be paid
Convertible preference shares
rights to convert into O/S
Redeemable preference shares
they carry a specified redemption date when the company will refund the nominal value
Zero dividend preference share
have a fixed maturity date and also provide a fixed return
they get paid out before O/S
often referred to as low risk
have no voting rights
subject to CGT
American Depositary Receipts
used by British companies
to encourage US investors
to buy an equity stake in a UK company
gives them opportunity to buy into a UK company but receive dividends in dollars
AIM features
launched in 1995
currently lists circa 1,000 companies with a total market capitalization of £93billion
many AIM companies lack true liquidity
lower listings standards and lighter touch regulation than LSE markets (major critism of AIM)
lower listing fees and ongoing costs than for the main LSE
advantages of investing in an IPO
the shares may be priced at an attractive level to ensure good take-up
transaction costs will generally be lower
disadvantages of investing in an IPO
no track record for the company’s commericail (business)/ investment (share price) performance
less stringent reporting requirements at the time of IPO
investors in a IPO may get less shares than they applied for
Offer for sale
involves the compnay issuing the new shares, selling the issue to a company called an issuing house
the issuing house initially buys up new shares from the issuing company before re-selling them
the issuing house will buy the shares from the company at a lower price than it intends to sell them
Fixed price Pricing
a fixed price is stated and offered on that basis
sometimes this initial price is set low to encourage take-up
tender pricing
investors make bids for amounts of stock and the price they’re willing to pay.
based on the bids, a strike prices et
with anyone who bid above the strike price paying the strike price for the stock
Offer for subscription
involves a company issuing shares directly to the general public
and offering them for sale direct
this method involves an issuing house underwriting the offer, meaning they’ll agree to purchase any unsold shares for a fee
Placement/selective marketing
the shares are marketed directly to preferred, specially selected institutional investors
these include pension funds, investment banks and life funds
Introductions
involve a company already listed on one exchange the ability to seek an introduction to sell shares on another exchange.
Gordons growth Model formula
most recent dividend/
investors required return-
growth rate of dividend
FTSE 100
top 100 uk companies based on market capitilisation
FTSE 250
The index provides a benchmark for the next 250 biggest companies in the UK
FTSE 350
combination of ftse 100 and ftse 250
FTSE All-Share
a weighted arithmetic index covering approximatley 800 companies
Rights Issue
Is an invitation to shareholders to buy new shares in proportion to their existing holding of shares
A rights issue ensures that existing shareholders are always given first refusal on new shares.
rights issues are often not good news and are typically done in order to repay a debt or refinance the company
Theoretical ex-rights price
is the price of the shares after the rights issue has taken place
Theoretical nil paid price
is the price an investor would (theoretically) pay for the right to buy a discounted share (in the rights issue)
It is the difference between the new price and old price
Swallowing the tail
some investors may want to sell some of their rights and take up the offer with the money they make.
Bonus Issue
is a method of issuing new shares to the existing shareholders where new shares are issued without cost
the effect of a bonus issue is to dilute the existing market price of a share and has the effect of reducing the price and making it more attractive to investors
Share splits and consolidations
a share split is where shares in issue are split into a greater number, each with a smaller nominal value
i.e one £2 O/S split into two £1 O/S
Share Buy - Back
the purchase by a company of its own shares is called share buy back.
Regulatory as well as shareholder approval is required before a company is allowed to buy back its shares
Business protection policies on director/shareholders for company share buy back can be put in place
Equity Warrants
give the owner the right but not the obligation to purchase shares at a fixed price in the future
Equity warrants vs Options
one major difference is the expiry date
equity warrants expiry date id sometimes months or years
Options are traded on the exchange
Warrants are issued by a company to raise money
Gearing ratio formula
Long term debt + preference shares
÷
Shareholders fund + capital reserves
Interest cover formula
Profit before interest and tax
÷
Gross interest payable
ROE VS ROCE
ROE is ideal for comparing Equities with other assets
ROCE is better for comparing between individual companies//efficiencefficiencof
Mechanism by which a synthetic ETF secures its returns
Uses a swap contract
Where counterparty (investment bank) agrees to pay the index return
In exchange for a fee
Main risks of synthetic ETF and how to reduce the risk
Counterparty risk
The risk that the investment bank may not be able to return the agreed index
Buy/hold collateral
Review collateral periodically
What do ETF managers typically engage in to increase returns above that of the index they track
Stock lending
In exchange for a fee and collateral
What Alpha measures and what it indicates
measure of risk adjusted return
above expected market return
return not explained by the CAPM
the managers ability to add value
through stock picking
What is meant by value fund management style
An active management strategy
where a manager selects shares trading at low valuations
that he considers undervalued or under-priced
compared to its sector - market or fundamentals
potential for re-rating
low PE, low price to book, low price earnings to growth ratio
Covered Warrants
issued by financial institutions
such as investment banks
listed on the stock exchange
classed as derivatives
Are issued by someone other than the company
and they cover the warrant by owning shares in the company
EPS explain
The profit that could have been paid as an ordinary dividend
calculated after all expenses including preference shares
The trend of the EPS over time is probably more useful for company comparative performance measure
but must be companies in the same business
EPS Ratio
Profit attributable to O/S / No of O/S in issue
Price earnings ratio - Facts
provides an indication of the markets expectation of the company’s earnings growth potential
it is the time in years, it would take the current EPS to repay the share price
a high P/E indicates a greater perceived ability grow EPS compared to to competitors
The P/E ratio measures how highly investors value a company as a multiple of earnings
it is calculated by dividing the market price by the EPS
investors pay more for shares if they expect the earnings to rise
Drawbacks of P/E ratio
based upon historic data
only one number and rather simplistic
must be relative to the sector and company competitors
PE ratio level should be compared to past levels and trends within industry sector
P/E ratio calculation
Share Price / EPS
PEG ratio explained
shows the projected growth in earnings per share in relation to a company’s share price
What might a high PEG ratio indicate
a share is expensive
the share has limited growth potential
PEG ratio higher than 1 are generally considered unfavourably (overvalued)
PEG ratio lower than 1 are generally considered favourably (undervalued)
what are the disadvantages of using PEG ratio
it is based on projected date
forecasts
opinions
PEG ratio calculated
P/E ratio / earnings growth rate
state the principles functions of a central bank
use interest rates to meet inflation target
to act as bank of last resort
banker to the government and other banks #
control money supply
supervise banks and other financial institutions
Limitations of using simple ratios to analyse a business
Accounting policies change over time.
uses historic data
need to look at trends over time
only uses one piece of information, need to use a more comprehensive analyse of the company
What is the Efficient Market Hypothesis
it hypothesises that the investment markets are efficient and that it is impossible to beat the market long term
and any outperformance is due to luck rather than skill
EMH weak form
believes that
all current market prices are fair
it is impossible to consistently and accurately predict future share prices movements based on past movements
the only thing that can significantly impact share prices is new information
and this happens randomly
no one knows what it is or when it will happen
EMH Semi strong
share prices reflect all public information available
it is not possible to gain an advantage by either fundamental or technical analysis
because share prices adjust to new information within an incredibly short amount of time
EMH Strong
Share prices reflect all information possible
both public an private
this is unlikely true for many markets as insider trading laws prevent insiders from trading on private information
this would undermine investor confidence in the markets
Describe Growth Investment management style
Involves investing in securities with above average earnings potential
Growth investors favour small companies
with the ability to grow in size more quickly
they look for companies that reinvest their profits which in turn will be passed onto the share price in terms of growth
This investment style is typically more risky than value investing
Growth investors need to consider more measures such as the efficiency and management of the company
Key indicators of Growth Investor
EPS growth for 4 out the last 5 years
a low P/E relative to growth
an optimistic annual statement from the company chairman
Strong liquidity
Describe Value Investment style
Values investor believe that by undertaking intensive research they can discover stocks that are undervalued by the market which will allow them to make a profit on the upside
Value investors believe that the market is inefficient and investors under and overreact to new information.
the value investor aims to take advantage of these reactions
Main indicators of a good value stock
Solid value indicators include low P/E ratio
high dividend yield
low price to book ratio
explain momentum investing
identifying trends using technical analysis
going long on investments that are likely to continue to grow
short on investments likely to fall
selling/closing out the position before the security changes direction
risky strategy knowing when to sell
Explain Contrarian investing
Basically going against the trend
betting against the herd
invest in assets that are out of fashion
or have recently fallen
similar to a value investment style
although the asset may have fallen for a very good reason - contrarians need accurate information
What is the security markets line
The expected return as predicted by the CAPM for any given beta
Investments above the SML have alpha
and are therefore undervalued
Investments below the SML have negative alpha
and therefore, over valued
the higher the alpha in the portfolio, the more additional return has been achieved by the fund manager
Four ways that a passive investment manager may track an index
Physical replication - fund manager physically buys and holds the stocks in the index
Synthetic replication - the fund manager enters into a swap contract with an investment bank - the investment bank will pay the return on the index
Sampling - Stratified - representative sample of the index is chosen and is tracked rather than that of the full index
Optimisation - uses computer programs to trade automatically on the index
What is fundamental analysis
It uses qualitative and quantitative research into a company and its sector/geography
in order to establish the value of an investment
specifically, to attempt to identify if the asset is undervalued or overvalued
what is technical analysis
it is the most often used my momentum investors
it looks at charts to attempt to identify trends in the market
and bases future buy/sell decisions on past share price movement
What is the income tax treatment of the income payment that can be made by a REIT within a GIA
*Exempt/PID/Ring fenced
Paid net of 20%
Subject to further 20%/marginal rate tax
PSA not available/ non savings income
*Dividend
Paid Gross
Taxed at marginal rate (8.25/33.75/39.35)
Dividend allowance available £2,000
Tax benefits of holding a REIT within an ISA
ISA manager
can reclaim 20%
income/PID/dividend/ not subject to income tax
gains are tax free / not subject to CGT
List 4 types of fund structure that a retail client can gain access to the commercial property sector
PAIF
UCITS
ETF
Investment Trust
Pension / Life fund
Unit Trust
main stages of the top-down investment process
Asset allocation
Geographical allocation
Sector weighting
Stock selection
Explain GAARP Growth at a reasonable price
Pay a premium/ higher price for
stock with specific advantages / qualities
mix/combination of value and growth
longer term
Momentum investing
Trend/ price movement
likely to continue / further gains to come
sell before trend ends / reverses
ignores fundamental/ intrinsic value
shorter term
What does the EMH believe
Stock picking does not work
Not possible to outperform market/ generate alpha
Market is efficient / market prices in all information
technical analysis does not work
transaction costs offset performance /outweigh benefit
what are two types of bonus for a with profits policy
*Annual / reversionary
regular
variable
once applied cannot be removed
*Terminal/ Final
one-off
paid on maturity
death
surrender/ redemption
not guranteed
Differences between Conventional & Variable unitised with profits funds
UWP has units
CWP does not
UWP bonus is in advance
CWP is in areas
UWP bonus can be changed
CWP cannot be changed
UWP bonus applied to unit price
CWP bonus added to sum assured
UWP easier to switch fund
UWP easier to calculate current value/ more transparent
State the main money market funds
Short term
Upto 60 days maturity
Upto 120 days life
Standard
Upto 6 months maturity
Upto 12 months life
What is CAPM?
single factor
financial model
which projects an expected return for an asset
as the combination of return of a risk free asset
plus the risk premium of a risky asset
Limitations and problems with CAPM
Market risk can be difficult to establish
what to use as risk free asset? is there an actual risk free asset?
What is the market portfolio?
Studies from Fama and French show that actual returns have no relation to those predicted by CAPM
The suitability of beta, Betas need to be stable
Explain diversification rules a retail UCITS
Minimum 16 holdings
Maximum up to 10%;
in four companies
Maximum/ up to 5%
in twelve/ rest/ others
limitations of beta as a measure of risk
Measure of market risk alone;
ignores others factors/ risks
assumes risk-free rate is correct/ suitable
not stable or accurate predictor of future beta
explain briefly the main investment related factors that you would take into account when choosing either active or passive strategies for collective’s funds
Active
Fund objective/ mandate/ strategy
manager experience/ reputation
Alpha/ IR/ Share/ performance/ track record
Passive
Replication strategy/ tracking error
is market efficient?
counterparty risk
Either
Diversification/ asset allocation
costs/ charges
choice / use of benchmark
Four stages of the investment process
Client objectives - risk and or return
Investment strategy- active passive or both
Stock selection
Performance analysis
What is a top down approach
When focusing on asset allocation rayher than stock selection and market timing
Asset allocation
Geographical areas
Sector selection
Stock selection
Bottom up approach process
Some managers avoid making a conscious decision on asset allocation and move straight into choosing individual shares and bonds that suite thier investment needs. This is called a bottom up approach
Tactical allocation
Is where ranges are specifies around the strategic level to enable market timing adjustments
Example fixed interest 40-50
Disadvantage of Value Investment style
The remit of the fund manager to beat the market
this index may have moved ahead
may have a bigger weight in certain shares
the manager has to keep up with the market regardless of value
Momentum advantages
tend to be influenced by momentum because clients like to see good news and results favored by the news, TV and press
conversely, they are disappointed to hold those that are criticized
Momentum disadvantages
demands a much higher level of trading
a typical funds annual turnover could be 100% plus
high transaction costs
Momentum investing is highly sensitive to luck of timing
whether going into the trend or exiting
Explain Contrarianism investing
Betting against the herd
investing in out of fashion holdings
in 2014 George Osborne famously quoted that no one will need to buy an annuity again
thereafter share prices in Just Retirment fell
This was a good buying opportunity for contrarian investors
who could profit from the market’s overreaction
similar to value investing
Present Bias
Present bias is the tendency to rather settle for a smaller present reward than to wait for a larger future reward, in a trade-off situation
Overconfidence
Ones belief to ah e the ability to pick winning stocks
Reference dependence and
loss aversion
where a real or potential loss is perceived by individuals as psychologically or emotionally more severe than an equivalent gain. For instance, the pain of losing $100 is often far greater than the joy gained in finding the same amount
Regret and other emotions
Less willing to sell investment at a loss
Over-extrapolation
extrapolating from just a
few years of investment returns
to the future
Projection bias
taking out a payday loan
without considering payment
difficulties that may arise in the
future
Framing, salience and
limited attention
overestimating the value
of a packaged bank account
because it is presented in a
particularly attractive way
Mental accounting and
narrow framing
Mental accounting refers to the different values a person places on the same amount of money, based on subjective criteria, often with detrimental results. Mental accounting is a concept in the field of behavioral economics. Developed by economist Richard H. Thaler, it contends that individuals classify funds differently and therefore are prone to irrational decision-making in their spending and investment behavior
Decision-making rules
of thumb
investment may be split
equally across all the funds
in a pension scheme, rather
than making a careful
allocation decision
Persuasion and social
influence
following financial advice
because an adviser is likeable
Arbritage pricing theory
Measures the expected return on a security like the CAPM
but takes account of all risk specific to the security
its an alternative theory to the CAPM
CAPM measures prices that are determined solely by market risk
APT takes into account a series of risk premiums that can be specific to that particular security
APT takes into account systematic ris as well as unsystematic risk
Explain non - systematic risk
Nonsystematic risks are specific to a particular business
all businesses are unique and have their own specific risk factors
explain systematic risk
Systematic risk is the risk that affect the financial system as a whole
Explain Active fund management
The strategy is exact opposite to a passive one
aim is to outperform a benchmark
described as beating the market
actively managed portfolios are either constructed using a top down or bottom up method
What are ETFs
ETF often hold a portfolio of shares
or derivatives
that are selected to track the performance of an index
they offer exposure to many other markets
ETFs are usually open - ended
traditional ETF are available in hundreds of varieties, tracking nearly every index, commodity, currency or exchange you can imagine
low turnover, low cost, broad diversification
expense ratios can be significantly lower
Disadvantages of tracker funds
no opportunity to design a portfolio specific to client requirements
no opportunity to outperform the benchmark
the benchmark/index can be influenced by a small number of stocks/sector
tracking error can and will occur
advantages of tracker funds
many active managers fail to beat the market
tracker funds generally have much lower costs than active funds
simple to understand
Why a close ended fund is potentially more volatile than an open ended fund with similar underlying investments
Units are cancelled, and underlying investments sold in proportion to the disposal, unless inflow us received when cash can be withdrawn
Possible difficulty in disposing of underlying assets/liquidity
Doesn’t trade at net asset value
Trades at a discount/premium which will widen/narrow
The effects of gearing/increased sensitivity to interest rate changes
State 5 advantages and 5 disadvantage of investing in commercial property via an open ended investment company ra5her than directly
Advantages
Liquid investment
Greater Diversification than investing directly
Lower risk
No responsibility for maintenance/ insurance/ health and safety
Professional management
Accessibility to smaller investment funds/ economies of scale
Enables greater control of CGT planning.
Disadvantages
Don’t fully own the underlying investments
Reliant on fund manager to make right investment decision
Lack of control over fees and costs
Can impose a deferment period
Less scope for gearing
No tax relief on borrowing
State the three main ways in which a stock market index is weighted
Value/ market capitalisation
Price
Equal / unweighted
Identify four events that can cause a constituent company to enter or leave the FTSE 100 at a periodic rebalancing
New listing/ IPO
Delisting / switch to another market / becomes ineligible
Merger / acquisition takeover
Change in share price / market cap
Explain briefly what is meant by free float and how it affects a company’s weightingin FTSE UK indices
Proportion/ percentage of shares
Traded on market
Companies with less than minimum free float;
Have weighting reduced
State three main metrics that would be used to measure the risk adjusted return of an actively managed fund and outline two distinct purposes of each metric
Alpha
Stock picking/ value added by manager
Excess return not explained by Beta
Sharpe ratio
Excess return for every unit of risk/ risk free rate
Excess return over standard deviation
Information ratio
Consistency of manager
Excess return over benchmark
State the maximum FSCS limits that would apply to ETF’S, pensions and shares
ETF
£85,000
Per firm
Shares.
No protection
Pension
100%
Without limit
Per provider
SIPP
£85,000
Per operator / firm
What does a strong pound mean
Exports are expensive for other currencies
So consumers and businesses in other countries are not as inclined to buy goods and services from the Uk
However this would also make imports cheaper so UK consumers and businesses will be inclined to import goods and services from abroad
What does a weak pound mean
Imports are expensive into the UK
so they’re more than likely to buy goods and services domestically
Exports are very cheap for other currencies
So consumers and businesses in other countries are more inclined to buy goods and services from the UK
Explain briefly the concept (process) of dilution in respect of the exercising
Of warrants
A company issues new shares.
Existing shareholders;
Subsequently own less of company/ shares worth less.
Unless they buy additional/new shares
Identify the main differences between conventional and index linked gilts
Conventional
Coupon fixed
Fixed capital redemption value 100p
Index linked
Coupon variable
Linked to inflation/ RPI
three / eight months before payment
Capital repayment / redemption linked to inflation
Explain briefly what is meant by the term breakeven inflation rate and state what it measures
Difference/ gap / spread between
Nominal yield
On conventional gilts
And real yield
On index linked gilts.
Expectation of inflation / future inflation rate
To breakeven on purchase price
Describe two main differences between investment grade and sub investment grade bonds
Investment grade rated BBB- / Baa 3 or higher
Investment grade lower default risk
Investment grade lower Coupon/ yield
Investment grade longer issue
Investment grade lower correlation with Equities
State three investment based actions that the manager of a UK strategic bond fund would most likely take in anticipation of a sustained economic recovery
Increase high yield / sub investment grade
Move down credit spectrum/ sell gilts / increase credit risk
Reduce interest rate risk / shorten duration
Reduce inflation risk / buy index linked
Increase equity correlation/ buy convertible bonds
Increase Beta/ Reduce cash
State the main risk that a client would be exposed to if they invested in a synthetic ETF rather than a physical ETF and how the manager could reduce this risk on an ongoing basis
Counterparty risk
Hold collateral
Review collateral on an ongoing basis
Explain briefly what activity ETF managers typically engage in to increase returns above that of the index they track
Stock lending in exchange for a fee and collateral
State and explain briefly the two central principles of the CAPM.
• Non-systematic/specific risk can be eliminated/diversified;
• is not rewarded.
• Sensitivity to systematic/market risk;
• dictates expected return.
State four benefits and four drawbacks of using the CAPM.
) Benefits
• Easy to use/calculate.
• Robust/proven/trusted.
• Allows for systematic/market risk.
• Ignores non-systematic risk/assumes it has been removed.
• Output is the expected return/easy to compare.
Drawbacks
• Risk-free rate may not be suitable/correct.
• Assumptions can be unrealistic/the market return may be different.
• Assumes beta as the correct/suitable measure of market risk.
• Beta is unstable.
• Doesn’t include costs and charges.
• Assumes single holding period/one-size fits all.
• Theoretical/single factor/simplistic.
Describe briefly what is measured by Macaulay duration.
Weighted
• average term;
• in years;
• for purchase price to be repaid;
• by cash flows/coupons
• and redemption value.
Describe briefly what is measured by modified duration
• Sensitivity;
• of bond’s price;
• to changes in interest rates/yield to maturity.
State three factors you should be aware of when assessing Macaulay duration figures across different bond funds.
Macaulay is relative/can be used to compare funds.
• Affected by coupon/price.
• Becomes less accurate as change in yield increases.
• Assumes linear relationship between interest rate and bond price.
• May not reflect fund style/mandate.
List three Investment Association (IA) sectors that may be suitable benchmarks to use solely for the UK sterling fixed interest asset allocation of the portfolio.
Assume there is no exposure to gilts.
• Sterling Corporate Bond.
• Sterling Strategic Bond.
• Sterling High Yield.
Identify five main economic factors that may result in an increase in interest rates.
• Business/economic cycle.
• Expansionary fiscal policy.
• Tightening monetary policy.
• QT/unwinding QE.
• Rising inflation.
• Currency weakness/economic imbalance.
• Market forces/credit spreads widening/UK downgraded.
Comment on the alpha of the UK Opportunities OEIC fund and state four likely reasons to explain the figure.
• Manager has not added-valued/active management not justified/better off
passive.
• Investment style/underlying stocks out of favour/poor stock selection.
• Annual/short-term measure/calculation period for alpha.
• High PTR/transaction charges.
• One-off event.
• Smaller companies/sector has higher volatility.
Comment on the correlation figure for the two OEIC funds and its impact upon the equity component of the portfolio.
Correlation is strong;
• positive.
• Will increase returns in rising market.
• Will increase volatility/market risk;
• as betas are more than 1.
• Will reduce diversification.
Identify three main risks specific to investing in equities on a passive basis using ETFs and state one reason for each risk identified.
) • Market/Systematic Risk.
• Limited protection in falling market/will follow market down/cannot hold cash. or No ability to outperform in rising market/will only deliver market return.
• Style Risk.
• Replication strategy may cause underperformance/tracking error/drift from index return.
• Counterparty Risk.
• Failure of counterparty provider.
State six fund-related factors that you would consider when deciding whether to invest solely on an active basis.
Costs/charges.
• Fund/ style/objective/mandate.
• Alpha/outperformance/past performance.
• Volatility/standard deviation.
• Sharpe/Information ratio.
• Investment house reputation/financial strength.
• Manager experience/track record.
• Dividends/yield.
Identify five potential economic consequences of the current account and capital account being in deficit over the medium to long-term.
• Rising interest rates.
• Economy growth falls.
• Currency devaluation.
• Capital flight out of UK.
• Unemployment rises.
• Increase borrowing/debt-dependence/reliance on foreign currency reserves.
• Inflation increases.
State the main conditions that must be met for a property fund to qualify as a property authorised investment fund (PAIF).
• At least 60% of net income;
• from exempt property business/ringfenced.
• Value of property must be at least 60%;
• of total assets.
• Must pay 3 types of income.
• Shares widely held.
• No corporate investor;
• holding 10% or more of NAV.
Describe briefly the investor biases of;
(i) herding;
(ii) the endowment effect.
(i) Herding
• Follow others/crowd.
• Fear of missing out.
• Ignore price/greater fool theory.
(ii) Endowment effect
• Greater value as inherited/already owned.
• Retain unsuitable investments/emotional attachment.
• Fear of selling.
Identify three benefits of investing in a thematic-based specialist fund.
*Potential higher returns.
• Expertise of fund manager/scope for alpha/outperformance.
• Invest in early-stage companies/start of trend/long time horizon.
• Lower/negative/non-correlation to other equities/diversification.
Identify five likely reasons for the level of fall in value of the NextGen Payment Solutions fund over the most recent statement period.
Economic/business cycle downturn.
• Increase in interest rates/inflation/discount rates.
• Higher beta/volatility/standard deviation.
• Poor stock-picking by manager.
• Tech/growth out of favour/sector rotation.
• Exposure to unlisted companies/deemed illiquid.
• One off event causes write-down/devaluation of underlying assets.
Calculate, showing all your workings, the compound annual return of NextGen Payment Solutions for the period from Martim’s original investment into the fund until the latest end valuation.
Assume Martim made a £5,000 initial investment 4 years ago
(£11,780 / £5,000) = 2.356
∜ 2.356 or 2.356 ^1/4 or 0.25 = 1.23892159
-1 x 100 = 23.89%
List four main types of socially responsible investing. Exclude environmental, social and governance (ESG) from your answer.
• Positive screening/engagement.
• Negative screening/ethical.
• Impact/microfinance.
• Sharia-complaint/religious.
State two examples within each category of the Environmental, Social and Governance (ESG) criteria for investing. Exclude the terms environment, social and governance from your examples.
) Environmental
• Reduction of Pollution/waste/recycling.
• Climate Change/decarbonisation/ renewable energy use.
• Conservation/treatment of wildlife.
Social
• Human rights/education.
• Employee working conditions/benefits/diversity.
• Charities/community/affordable housing.
Governance
• Accounting practices.
• Board diversity/gender equality.
• Conflicts of interest/bribery/corruption.
Calculate, showing all your workings, the Sharpe Ratio for NextGen Payment Solutions fund for the period shown in Table 1.
[(£11,780 - £19,000) / £19,000] x 100 = -38%
(-38% - 0.9%) = -38.9%
(-38.9 / 10.4) = -3.7403846 = -3.74
State two benefits and two drawbacks of using the Sharpe Ratio in investment planning.
Benefits
• Compare different funds/managers.
• Shows risk-adjusted return.
• Identify if returns are from excess risk/beta or manager/stock-picking.
Drawbacks
• Need to consider other factors/trends over time/do not consider in isolation.
• Can be distorted by fund/manager’s strategy/higher risk.
• Assumes normal distribution of returns/standard deviation as measure of risk.
• Doesn’t take into account trading/turnover/costs.
Describe briefly the definition and objective of a volatility managed fund.
• Target a specified return/maximise returns;
• while limiting volatility/to specified volatility target;
• using correlation/diversification;
• of asset classes/lower risk assets;
• to produce higher risk-adjusted returns.
Outline why a volatility managed fund could be a suitable investment for Martim
In line with AtR.
• Provides diversification within a small portfolio.
• Could reduce market/volatility risk/hedge against market fall.
• Sufficient time horizon.
• Known/target level of volatility.
State five main administration benefits of consolidating existing investment assets onto a platform.
• In one place/single view.
• Access to tools.
Bed to ISA
transfer of products with ease
• Consolidated tax statement/voucher.
• Less administration.
• 24 7/on demand access/view online.
Calculate, showing all your workings, the return on capital employed (ROCE) for Best Guest.
£2,955,000 + £3,735,000 = £6,690,000
(£620,000 / £6,690,000) = 0.09267
x 100 = 9.27%
Best Guest ROCE 9.27%
Comment, based upon the answer above, on the ROCE for Best Guest compared to that of Rockflour Boutique and identify two factors that would contribute to the difference in ROCE figures. Assume that Rockflour Boutique has a ROCE above 20%.
• Rockflour has used capital more efficiently/Best Guest has used capital less efficiently.
• Rockflour has higher operating profit/Best Guest has lower operating profit.
• Rockflour has lower long-term liabilities/Best Guest has higher long-term
liabilities.
Explain briefly the drawbacks of using ROCE as a metric when comparing Best Guest and Rockflour Boutique.
• ROCE is a single metric/single period/need to compare over time/doesn’t factor in when funds are raised over period
• Affected by one-off factors/distorted by high cash/doesn’t account for current liabilities/doesn’t account for depreciation or amortisation.
• If a investor is a shareholder only/ROCE calculates return for all
sources/shareholders and creditors.
Identify two main differences between an interim and a final dividend.
• Interim declared during financial year/before AGM
• Final declared after financial year/at AGM
• Interim declared by board.
• Final declared by shareholders.
• Interim can be revoked.
• Final cannot be revoked.
• Interim only if Articles expressly permit.
• Final not subject to Article/right of shareholders.
Outline the potential tax benefits for an investor if they receive a dividend on their new shareholding compared to receiving a bonus in addition to their salary. Assume they are a higher rate tax payer
• Can use dividend allowance/first £2,000 tax-free.
• Not subject to National Insurance.
• Taxed at 33.75% compared to 40%.
Calculate, showing all your workings, how much of a £120,000 chargeable gain an investor could invest into a new EIS to maximise the Income Tax relief available in the current tax year. Assume the investor has the full personal allowance available and the dividends they receive are less than their dividend allowance.
Assume their salary is currently £70,000
£12,570 x 0% = £0
£37,700 x 20% = £7,540
£19,730 x 40% = £7,892
Total/Income Tax liability = £15,432
Maximum investment = (£15,432 / 30) x 100 = £51,440
Describe the tax benefits and qualifying rules of an EIS, including the time limits for deferral relief. Exclude Income Tax relief from your answer.
Deferral/rollover relief;
• for up to 1 year before;
• 3 years after;
• sale of the business/disposal.
• Can invest up to £1,000,000/if knowledge intensive £2,000,000.
• Original gain deferred;
• without time limit.
• Gain on EIS exempt from CGT;
• if held for 3 years.
• Loss relief available;
• against capital or income.
• Exempt from IHT/qualifies for business relief;
• if held for 2 years.
Outline nine factors that you would take into consideration when conducting the annual review meeting with a client.
Any change in needs/objectives/requirements/circumstances/State of health/
dependents/marital status.
• Any changes in assets & liabilities/income & expenditure/emergency fund
• Any capital gains made/unused gains/use of CGT/ISA allowance.
• Any changes in legislation/Budget/products.
• Review of investment performance against goals/target/benchmark.
• Rebalance of portfolio.
• On-going suitability.
• Any change in ESG/ethical considerations.
• Re-establish AtR/CfL.
• Level of service/advice proposition/adviser charges.
• Market/economic outlook/sentiment.
Calculate, showing all your workings, the money-weighted rate of return (MWR) for the global managed fund.
£700 + £38,200 - £25,000 - £10,000 = £3,900
£25,000 + (£10,000 x 7/12) = £30,833.33
(£3,900 / £30,833.33) x 100 = 12.648648 = 12.65%
State the Income Tax treatment of the two types of income payment that can be made by a real estate investment trust (REIT) if held within a GIA.
Exempt/PID/Ring-fenced
• Paid net of 20%/BRT.
• Subject to further 20%/marginal rate tax.
• PSA not available/non-savings income.
Dividend
• Paid gross.
• Taxed at 32.5%.
• Dividend allowance/£2,000 available
Outline the tax benefits and an investor were to hold a REIT within their stocks and shares ISA compared to within his GIA.
• ISA manager;
• can reclaim 20%.
• Income/PID/dividend/not subject to Income Tax.
• Gains is tax free/not subject to CGT.
List four types of fund structure with which a retail client could gain access to the commercial property sector. Exclude open-ended investment companies (OEICs) and REITs from your answer.
• Unit trust.
• Investment trust.
• PAIF.
• UCITS/SICAV.
• Exchange traded fund.
• Life/pension funds.
Identify four main types of investment risk that would be relevant to open-ended direct commercial property funds and describe briefly each of these main types of risk.
• Accessibility
• Unable to withdraw funds/dealing gated/suspended.
• Liquidity/pricing
• Fund unable to sell assets at fair price/bid price/dilution levy/hard to sell.
• Valuation
• Material uncertainty/unable to provide NAV.
• Void
• Loss of tenant/property empty.
• Income
• Loss of yield/unable to collect rent/reduction in rental income.
• Economic
• Assets cyclical/sensitive to business cycle.
State the main stages of the top-down investment process of a global managed fund.
Asset class allocation.
• Geographical allocation.
• Sector weightings.
• Individual stock/security selection.
Explain briefly the momentum investment style.
• Trend/price movement;
• likely to continue/further gains to come.
• Sell before trend ends/reverses.
• Ignores fundamental/intrinsic value.
• Shorter term.
Explain briefly the growth at a reasonable price (GAARP) investment style.
• Pay premium/higher price for;
• stock with specific advantages/qualities.
• Mix/combination of value and growth.
• Longer term.
Identify the three main forms of the efficient market hypothesis (EMH).
• Weak.
• Semi-strong.
• Strong.
State whether an active or a passive investment strategy would be most effective for an equity-based investor if EMH is deemed to be correct and explain the reasons why.
• Passive.
• Stockpicking does not work.
• Not possible to outperform market/generate alpha.
• Market is efficient/market prices in all information.
• Technical analysis does not work.
• Transaction costs offset outperformance/outweigh benefit.
State the two types of bonus for a with-profits policy and describe briefly each type, including when they can be applied.
Annual/reversionary
• Regular;
• variable.
• Once applied cannot be removed.
• Terminal/Final
• One-off;
• paid on maturity;
• death;
• surrender/redemption.
• Not guaranteed.
Explain briefly the main differences between conventional and variable unitised with-profits funds.
UWP has units/CWP does not.
• UWP bonus in advance/CWP bonus in arrears.
• UWP bonus can be changed/CWP cannot.
• UWP bonus applied to unit price;
• daily/over course of year.
• CWP bonus added to sum assured.
• UWP easier to switch fund.
• UWP easier to calculate current value/more transparent.
State the two main types of money market fund and identify the key differences in the maturity and life of their respective assets.
• Short-term
• Up to 60 days maturity.
• Up to 120 days life.
• Standard
• Up to 6 months maturity.
• Up to 12 months life.
State five investment-related factors that an adviser would take into consideration when assessing a sustainable withdrawal rate.
• Initial yield/natural income.
• Expected return/growth rate.
• Taxation.
• Asset allocation.
• Charges.
• Inflation/interest rate outlook.
• Sequencing/volatility risk.
• Time horizon.
Identify four client-related factors that would be relevant when considering an investment strategy.
• Age/state of health.
• Marital status/any dependants.
• Any other assets/liabilities.
• Any emergency fund.
• ESG/ethical preferences.
• AtR/CfL.
Describe briefly four changes that Damba may consider when constructing a portfolio designed for an outlook of a sustained rise in inflation, compared with Trevor’s current asset allocation.
• Reduce/hold less cash.
• Diversify into real asset classes.
• Hold inflation-linked bonds.
• Own equities with rising/sustainable dividends.
• Set aside initial income requirement in cash/take profits/use gains to support
income.
Identify five benefits of using collective funds, compared to holding direct equities. Assume that the funds would be held within an ISA and exclude taxation from your answer.
• Access different asset classes.
• Reduction in systematic risk.
• Minimisation of non-systematic risk.
• Access to different sectors/styles/niche.
• Professional management.
• FSCS/investor protection.
• Less admin/involvement.
Explain the diversification rules for a retail Undertakings for the Collective Investment of Transferable Securities (UCITS) OEIC, based upon the minimum number of permissible holdings and the relevant percentages.
• Minimum 16 holdings.
• Maximum/up to 10%;
• in four companies;
• Maximum/up to 5%;
• in twelve/rest/others.
Calculate, showing all your workings, the beta for the multi-factor fund.
Beta = 4.7 - 0.2 /(5 -0.2)
Beta = (4.5 / 4.8)
Beta = 0.9375/0.94
Alternative:
4.7 = 0.2 + Beta (5 - 0.2)
4.7 = 0.2 + Beta (4.8)
4.5 = Beta x 4.8
(4.5 / 4.8) = Beta
0.9375/0.94 = Beta
State the two common principles that apply across multi-factor models.
• Investors require extra return;
• for extra risk.
• Focus on risks that cannot be eliminated by diversification.
Explain briefly the limitations of beta as a measure of risk
• Measure of market risk alone/ignores other factors/risks.
• Assumes risk-free rate is correct/suitable.
• Not stable or accurate predictor of future beta.
Explain briefly the main investment-related factors that an investor would take into consideration when deciding whether to choose active or passive strategies for the collective funds.
Active
• Fund objective/mandate/strategy.
• Manager experience/reputation.
• Alpha/IR/Sharpe/performance/track record.
Passive
• Replication strategy/Tracking error.
• Is market efficient?
• Counterparty risk.
Either
• Diversification/asset allocation.
• Costs/charges.
• Choice/use of benchmark.
Explain briefly the concept of dilution in respect of the exercising of warrants
- Company issues new shares.
• Existing shareholders;
• own less of company/shares worth less;
• unless buy additional/new shares.
Calculate, showing all your workings, the diluted net asset value (NAV) per share.
Assume all of the warrants are exercised.
(49,000,000 – 8,500,000) = 40,500,000
720,000 x 0.7 = 504,000
40,500,000 + 504,000 = 41,004,000
36,000,000 +720,000 = 36,720,000
(41,004,000 / 36,720,000) = £1.1167/111.67p
List three types of preference share and state one principal characteristic of each type.
• Cumulative/non-cumulative;
• Missed payments carried / not carried forward.
• Participating/non-participating;
• May / may not pay additional dividend.
• Convertible
• Right to convert to ordinary shares
• Redeemable/non-redeemable;
• Repaid at a set date or by company / no redemption date/undated.
Calculate, showing all your workings, the operating profit margin for Cantilever Growth Trust.
(26,200,000 – 9,600,000) = 16,600,000
(16,600,000/ 26,200,000) = 0.63359
x 100 = 63.36%
Calculate, showing all your workings, the dividend cover for Cantilever Growth Trust prior to the conversion of any warrants
5,450,000 – 2,100,000 = 3,350,000
36,000,000 x 0.08 = 2,880,000
(3,350,000 / 2,880,000) = 1.163194 = 1.163x
Alternative:
5,450,000 – 2,100,000 = 3,350,000
(3,350,000 /36,000,000) x 100 = 9.30556
(9.30556 / 8) = 1.163x
Identify the main differences between conventional and index-linked gilts.
Conventional
• Coupon fixed.
• Capital repayment/redemption at par/100p.
Index-linked
• Coupon variable;
• linked to inflation/RPI;
• three/eight months before payment.
• Capital repayment/redemption linked to inflation
Explain briefly what is meant by the term ‘breakeven inflation rate’ and state what it measures.
• Difference/gap/spread between;
• nominal yield;
• on conventional gilts;
• and real yield;
• on index-linked gilts.
• Expectation of inflation/future inflation rate;
• to breakeven on purchase price
Describe two main differences between investment grade and sub-investment grade bonds.
• Investment grade rated BBB- /Baa 3 or higher.
• Investment grade lower default risk.
• Investment grade lower coupon/yield.
• Investment grade longer issue.
• Investment grade lower correlation with equities.
State three investment-based actions that the manager of a UK strategic bond fund would most likely take in anticipation of a sustained economic recovery.
• Increase high yield/sub-investment grade.
• Move down credit spectrum/sell gilts/increase credit risk.
• Reduce interest rate risk/shorten duration.
• Reduce inflation risk/buy index-linked.
• Increase equity correlation/buy convertible bonds.
• Increase beta/reduce cash.
Calculate, showing all your workings, the price earnings (P/E) ratio for Submersh plc.
£35,400,000 / £28,000,000 = 1.264285 = 126.43p
448p / 126.43p = 3.54
Compare the P/E ratio of Submersh plc (3,54), to its sector average and explain briefly the possible reasons for the difference.
Assume The sector average price earnings ratio for Submersh plc is 9.8.
• P/E is lower.
• Undervalued/out of favour.
• Bad management/decline in business.
• Event causing a one-off increase in earnings.
Calculate, showing all your workings, the dividend cover for Submersh plc.
16.2p x £28,000,000 = £4,536,000
£35,400,000 / £4,536,000 = 7.804232 = 7.8
Alternative
£35,4000,000 / £28,000,000 = 1.264285 = 126.43p
126.43p / 16.2p = 7.8
Comment briefly on what can be deduced from the dividend cover figure
Dividend Cover = 7.8 times
High coverage/dividend well-covered.
• Retaining majority of profits.
• Company financially stable/dividend secure/sustainable.
• Low growth/ex-growth business.
State the four main types of index replication strategy and describe briefly how each strategy works.
• Physical/Full Replication
• Buys all stocks within index in correct weighting.
• Stratified/Simplified Sampling
• Buys subset/selection/sample of stocks within index.
• Optimisation
• Buys computerised model of index.
• Synthetic
• Uses derivatives/swaps.
Identify five specific investment risks to which Edward may be exposed within his investment portfolio and state one reason for each risk.
• Currency
• Exposed to Dollar/Yen/exchange rate movement.
• Concentration/Overlap
• Composition/market weighting of index/duplication/same stocks held in more than one fund.
• Market/Volatility
• NASDAQ/Japan Small Cap/beta likely to be greater than 1.
• Counterparty
• Failure of ETF.
• Passive/Product
• Replication style causes underperformance/underperforms index.
State the three main ways in which a stock market index is weighted.
• Value/market capitalisation.
• Price.
• Equal/unweighted.
Identify four events that can cause a constituent company to enter or leave the FTSE 100 at a periodic rebalancing.
• New listing/IPO.
• Delisting/switch to another market/becomes ineligible.
• Merger/acquisition/takeover.
• Change in share price/market cap..
Explain briefly what is meant by ‘free float’ and how it affects a company’s weighting in FTSE UK indices.
• Proportion/percentage of shares;
• traded on market.
• Companies with less than minimum free float;
• have weighting reduced.
State three main metrics that would be used to measure the risk-adjusted return of an actively-managed fund and outline two distinct purposes of each metric.
• Alpha
• Stock-picking/value added by manager.
• Excess return not explained by beta.
• Sharpe
• Excess return for every unit of risk/risk-free rate.
• Excess return over standard deviation.
• Information Ratio
• Consistency of manager.
• Excess return over benchmark.
State the maximum Financial Services Compensation Scheme (FSCS) compensation limits that would apply to Edward’s pension and investment assets. Exclude the money accumulated within the cash account from your answer.
Investment;
• £85,000;
• per firm.
• Shares;
• no protection.
Pension;
• 100%;
• without limit.
• per provider.
• SIPP;
• £85,000;
• per operator/firm.
State the options that are open to an investor in respect of generating the income stream that they are considering from their personal pensions. Assume that the provider(s) offers all of the available options.
• Drawdown/FAD.
• PCLS only.
• UFPLS.
• Phased retirement.
• Buy short-term/fixed term annuity.
Describe the actions that an investor could take to mitigate the effects of sequencing risk, if they were to consider drawing the income stream from their overall portfolio over the medium to long term.
• Reduce the level of initial withdrawal.
• Change the timing/frequency of withdrawals.
• Stick to his original retirement plan/date.
• Alter asset allocation/reduce equity/market/volatility risk.
• Invest in fixed interest/diversification across asset classes.
• Increase cash/hold sufficient level of cash/take withdrawals from cash.
• Take natural income/dividends.
• Secure income through annuity.
Calculate, showing all your workings, the Stamp Duty Reserve Tax and any levy that Edward would pay if he used the cash from the accumulated dividends to purchase more shares in Submersh plc. Assume that the number of shares owned by Edward and the
dividend per share have remained unchanged for the past four years.
SDRT
16.2p x 18,000 x 4 = £11,664
£11,664 x 0.5% = £58.32
PTM levy
£1
Total = £59.32
State four areas that the advisory firm would need to consider, in respect of the potential impact of the platform’s change in technology provider on the advisory firm.
• Ownership of technology provider/conflict of interest/financial stability of tech provider.
• Ability to meet existing clients’ needs/expectations.
• Timescale for upgrade/testing/phasing of migration.
• Business continuity plan during upgrade/reliance on sole platform.
• Front/back office compatibility/loss of functionality/tools/reporting.
• Impact on firm’s advice proposition/reputation.
• Time/cost to firm.
State four main risks to the client that could arise during the migration process.
• Loss of service/outage/access.
• Loss of income payments.
• Unable to trade/buy/sell/out of market.
• Data breach/loss.
• Loss of transaction history/legacy data.
• Increase in costs.
State the tax treatment of the income generated from the funds held in the GIA and ISA, based upon the client’s tax position.
Client earns £35,000 only income
ISA
• Dividends;
• and interest/distributions;
• free of personal taxation/not subject to Income Tax.
GIA
• Dividends;
• taxed at 7.5%;
• once DA/£2,000 used.
• Interest/Distributions;
• taxed at 20%;
• once PSA/£1,000 used.
GIA
£110,000 x 2.1% = £2,310
less £2,000 = £310.
£95,000 x 3.5% = £3,325
less £1,000 = £2,325.
Identify three main risks to which a client would be exposed if they invested in high income alternative investments and outline each risk.
• Income
May be unsustainable/cut/not paid.
• Unregulated
Not subject to FSCS/investor protection.
• Accessibility
Unable to sell underlying assets.
• Liquidity
Wide price spread/hard to sell.
• Capital loss/Valuation
Assets may be written down/down-valued.
• Correlation
May not be uncorrelated/may be more correlated with equities.
• Interest rate/Gearing
Sensitive to interest rate rises/cyclical.
Identify three factors that could impact on the potential to hold alternative assets on a platform.
• Asset may not be eligible/not available to retail clients.
• Dealing infrequent/not readily realisable/unable to sell.
• Additional costs of ownership.
• May require third party to transact/may have to trade manually.
• Valuation/price may not show automatically/may have to input manually.
Describe briefly what is meant by the term ‘capacity for loss’.
• The ability;
• to absorb;
• any negative investment event;
• without an adverse/detrimental effect;
• on lifestyle/standard of living.
Outline three ways in which the effects of capacity for loss can be mitigated.
• Reduce portfolio risk/AtR.
• Hold sufficient cash to cover potential loss/event.
• Invest less/only invest what client can afford to lose.
• Discuss and agree CfL with client in advance.
• Establish the actual risk the client is willing to take/not focus on the outcome.
• Avoid overreliance on tools/simplified questions/inappropriate assessment of information.
Calculate, showing all your workings, the information ratio for Risk III fund.
10.7 - 10.4 = 0.3
0.3 / 1.65 = 0.181818 = 0.18
Comment on what can be deduced about Risk III fund’s performance based upon the information ratio 0.18
• Value added by manager/outperformance.
• Low risk-adjusted return/information ratio.
• Similar return could have been achieved through passive/tracker fund/active management not worth the cost.
MO
Narrow Money
the notes and coins in circulation
Banks operational deposits in the BoE
M4
Broad Money
The notes and coins in circulation
Money in savings and time deposits accounts of
UK residents in UK Banks and building societies
What is Narrow Money (M0)
Reflets but does not influence the economy
has limited impact on national output and inflation
Growth in M0 indicates consumer spending increasing;
while a reduction in M0 indicates consumers aren’t spending as much
What is Broad Money (M4)
Influences the economic cycle
Growth in M4 indicates increased lending activity from banks
and that inflation is likely to rise with fast growth in money circling around the economy
What is a financial bubble?
A financial bubble occurs when investors stop paying attention to the fundamental indicators of an investment
and invest speculatively
simply because they think the asset will continue to grow in value
this is what is known as the greater fool theory
Investors overestimate potential returns
and underestimate competitive pressures
What is a crash?
a crash occurs when investors sell investments quickly
because they believe the price will continue to fall
or perhaps because they are forced sellers
Describe briefly the main features of an MPS.
• Collectives-based.
• Low minimum investment.
• Asset allocation/fund selection determined centrally/by external
manager/investment committee.
• Portfolio changes can result in client CGT liability.
• Range of risk-adjusted portfolios.
• Portfolios not bespoke to client/limited choice.
• Low cost.
Identify six main factors that an adviser would take into consideration when evaluating a DIM service
• Charges.
• Overlap with existing/non-DIM assets.
• Regulatory permissions/reputation/financial strength.
• Past performance/track record.
• Investment style/strategy.
• Client’s AtR/use of unsuitable/high risk assets.
• Conflict of interest.
• Basis of agreement.
• Ownership of client.
Identify the main phases of the economic cycle, in the order that they occur, starting with the recession phase.
• Recovery.
• Boom/expansion.
• Contraction.
• [Correct order of phases].
State the main difference between the definitions of the M0 and M4 measures of money supply
• M0 excludes/M4 includes;
• bank/building society accounts;
• of UK residents
Identify which money supply measure best indicates overall economic growth and state two reasons why.
M4.
• Broader/wider scope.
• Reflects borrowing/lending.
• Reflects velocity/transfer of money.
Explain briefly the likely monetary policy response to a sustained increase in money supply in the UK economy.
• Reduce/cease;
• QE.
• Sell bonds back to market/QT.
• Increase interest rates.
State the three main types of benchmark and describe briefly the purpose of each type.
• Target;
• measure/calculate performance/fee.
• Comparator;
• comparison of performance.
• Constraint;
• limit portfolio construction/asset allocation.
From a behavioural finance perspective, identify two biases that relate to Abeo’s view of the potential online investment and state one reason to explain each bias.
• Anchoring;
• fixated on 9%.
• Overconfidence;
• believes own research is best/overreliance on own knowledge.
• Misunderstanding Of Probability;
• too focused on yield at expense of potential risk to capital.
Calculate, showing all your workings, the alpha for the Value Opportunities Fund.
5.1 - [0.1 + 1.3 (4.5 - 0.1)] = -0.72
State four limitations of using alpha to measure a fund’s performance.
• Doesn’t explain source/reason for outperformance.
• Assumes CAPM/market/benchmark/risk-free rate/ is suitable/correct.
• Relative to beta/assumes beta is correct measure of risk.
• Ignores costs/charges.
• Only suited to comparing equity/similar funds.
Identify and explain briefly four main types of investment risk that would be relevant to Clara’s investment in the Value Opportunities Fund.
Exclude market risk from your answer.
• Volatility;
• Greater degree of movement.
• Manager;
• Stock-picking/negative alpha/underperforms.
• Shortfall;
• Returns less than needed/target.
• Style/Concentration;
• Value out of favour/growth outperforms.
• Non-systematic/specific;
• Corporate event.
Identify and explain briefly four main types of investment risk that would be relevant to Clara investing in Tech Trust plc.
• Liquidity;
• Unable to sell/achieve fair price.
• Pricing;
• Trades at discount/premium to NAV.
• Currency;
• Returns affected by currency movement.
• Gearing/Interest Rate;
• Equity returns affected by borrowing/interest rates.
• Sector;
• Lack of information/early stage/speculative investment.
Calculate, showing all your workings, the overall return of Tech Trust plc.
UK 15% x 12% = 1.8%
North America 25% x -9% = -2.25%
Asia 40% x -6% = -2.4%
Frontier 20% x 8% = 1.6%
Total = -1.25%
Calculate, showing all your workings, the relative performance of each of Tech Trust plc’s geographical allocations against their respective benchmark returns.
UK 1.5% vs 1.8% = +0.3%
North America 4% vs -2.25% = -6.25%
Asia 5% vs -2.4% = -7.4%
Frontier 6% vs 1.6% = -4.4%
State the maximum amount that Lucy and Clara could each contribute to a Lifetime ISA in its first year and any Government bonus that may be payable.
Lucy
• £4,000.
• Up to 25%/£1,000 bonus.
Clara £0 - you must make at least one payment into an LISA before you turn 40
Explain the main contribution and withdrawal rules for a Lifetime ISA.
• Part of £20,000/overall ISA allowance.
• Must be 18 or over;
• and under 40/make first contribution before 40;
• can contribute until/must cease at 50.
• 25% withdrawal charge unless/no withdrawals in first 12 months;
• buying first home;
• £450,000 or less;
• aged 60 or over;
• terminally ill/less than 12 months to live.
• Bonus not payable if HTB ISA bonus used.
Outline the options available to Lucy in respect of her existing Help to Buy ISA.
• Increase contribution;
• by up to £100 pm/to £200 pm.
• Stop/decrease contribution.
• Withdraw/close.
• Transfer into a LISA/ISA.
• Transfer into a different rate/provider.
State the information that an ISA administrator would require in order to process an additional permitted subscription (APS) request by a surviving civil partner.
• Deceased’s;
• name;
• address/proof of residency;
• NI number;
• date of birth;
• date of death;
• date of partnership.
Describe the main differences in the structure of an OEIC and an Investment Trust.
OEIC
• Unlimited shares/can create new shares.
• Redeems shares linked to NAV.
• May be standalone or sub-fund of ICVC.
• Must appoint an ACD.
• Assets held by depositary.
• Can borrow on temporary basis/up to 10%.
Investment Trust
• Fixed number of shares/finite share capital.
• Shares bought/sold independent of NAV.
• Listed company.
• Has board of directors.
• Can borrow on permanent basis/unlimited.
• May have fixed life/winding up date.
Describe the main differences in the pricing of an OEIC and an Investment Trust.
OEIC
• Daily pricing/pricing point;
• Based upon NAV.
• Single priced;
• May apply swing pricing/dilution levy.
Investment Trust.
• Real-time pricing;
• determined by market/supply and demand.
• Dual pricing/bid/offer spread.
• Can trade at discount/premium/independent of NAV.
Identify three advantages and three disadvantages of using a GIA for retirement planning, compared to a workplace pension, to meet Lucy and Clara’s needs.
Advantages
• Accessible at any time/before age 55.
• No limit on contributions/not part of Annual Allowance.
• No limit on future investment value/not part of Lifetime Allowance.
Disadvantages
• No Income Tax relief.
• No employer contribution.
• Taxation within GIA/funds/subject to CGT.
• Part of estate/subject to IHT.
Identify six main benefits of an investor consolidating their existing collective funds onto a platform
• Single point of access/all information in one place.
• Multiple tax-sheltered products.
• Less/easier administration.
• Income flexibility/consolidated payment.
• Access to planning tools/bed & ISA, etc.
• Transaction/account history.
• Migration to cheaper share classes/lower fund charges.
State the time limits within which CGT deferral relief would be available to a investor on a new investment into an EIS. Assume that the sale of the shares completes in May 2022.
Assume current date October 2021
Up to 3 years;
• after/following/May 2025.
• Up to 1 year before/from now/October 2021.
Explain briefly the CGT rules of any new investment into an EIS, if the investment were made with the proceeds from the sale of the shares.
• Existing gain;
• deferred until disposal;
• without limits/unlimited;
• can be deferred again.
• New gain;
• exempt from CGT;
• after 3 years;
• if Income Tax relief obtained.
• Loss relief available;
• offset against income or gains.
Calculate, showing your workings, the Income Tax and CGT reliefs that could be claimed by Anshul if he invested the maximum amount into a new SEIS.
Income Tax relief
£100,000 x 50% = £50,000
Carry back = £50,000
CGT reinvestment relief
£50,000 x 20% = £10,000
CGT deferral relief
£50,000 x 20% = £10,000
Identify two factors that are relevant to Anshul, from a behavioural finance perspective and give one reason for each of these two factors.
Anchoring;
• 7% yield/£500,000 capital sum.
• Endowment effect;
• ‘His’ company/emotional attachment/retains shareholding.
• Mental accounting;
• Compartmentalising capital for income/used to receiving income.
Describe briefly the objective of Stochastic modelling.
• Estimate/forecast/predict the;
• probabilistic/potential/likely;
• range of;
• returns/outcomes and;
• volatility/standard deviation.
• Under different outputs/scenarios/simulations
State the three main inputs required to generate an optimal portfolio via a Stochastic modelling tool.
• Returns.
• Volatility/standard deviation.
• Time period.
Identify four drawbacks of using a Stochastic modelling tool.
• Assumptions/inputs not correct/unrealistic.
• Ignores sequencing risk.
• Over-reliance/over confidence.
• Difficult to understand/too complex.
• Output is unrealistic/unattainable/expected return not accurate.
• Doesn’t factor in client circumstance.
Calculate, showing all your workings, the return on equity (ROE) for Forest View plc.
£18,500,000 - £2,000,000 - £4,200,000 = £12,300,000
£35,000,000 + £9,700,000 - £22,600,000 = £22,100,000
(£12,300,000 / £22,100,000) = 0.556561 x 100
= 55.66%
Describe briefly what is measured by the ROE metric.
• Ability to generate;
• profit.
• How efficiently it uses;
• shareholders’ funds/capital.
• Relative performance within sector/against peers.
Calculate, showing all your workings, the quick ratio for Cloud Formation plc
(£3,800,000 + £2,150,000) = £5,950,000 / £1,400,000 = 4.25
Explain briefly what the ratio shows about Cloud Formation plc’s current financial position,
Based on Cloud Formation quick ratio 4.25
• Company in strong position.
• Can easily repay short-term/current debts from cash/most liquid assets;
• without use of other assets/external resources.
State the two main Asset headings within the balance sheet of a company’s accounts and list two categories of assets that would be found under each heading.
• Fixed/non-current assets
• Tangible (plant, buildings etc.).
• Intangible/goodwill.
• Investments.
• Current assets
• Stock/inventory.
• Cash.
• Trade receivables/debtors/prepaid expenses.
State the three main components of the UK’s capital account.
Investments/assets.
• Loans/borrowing.
• Foreign currency reserves.
State the principal purpose of a capital account surplus within the UK’s balance of payments.
• To finance/fund;
• a current account;
• deficit.
Explain briefly the macro-economic role of financial investment within the economy.
• Stimulates demand/spending;
• by increasing aggregate demand.
• Increases productivity/output;
• and business investment.
Describe briefly what is meant by the OCF in respect of a collective fund.
• Single;
• percentage figure;
• that shows the;
• annual cost of;
• investing in/owning a fund.
Using the Capital Asset Pricing Model (CAPM) equation, calculate, showing all your workings, the expected return for the client’s portfolio.
(3.3-0.2)
0.91 x (3.1)
0.2 + 2.821 = 3.021 = 3.02
Explain why UK Government Treasury bills are a suitable measure of risk-free return to use in the CAPM equation.
• Minimal/no default risk;
• Short duration/less than 3 months;
• minimal inflation and;
• interest rate sensitivity.
State seven main assumptions upon which the CAPM equation is based.
• Investors are rational and risk averse.
• Single/identical holding period.
• No individual can affect the market price.
• Ignores charges/tax.
• Market is liquid.
• Information is fully available to all investors.
• Risk-free rate/treasury bills are suitable to use.
• Investors can lend/borrow;
• unlimited amounts.
• Beta is correct measure of risk.
Describe briefly Macaulay duration.
• Weighted;
• average term/number of years;
• discounted/present value of;
• all cash flows/coupons + redemption value;
• from a bond.
Explain briefly what is measured by modified duration.
• Measures sensitivity of;
• a bond’s price;
• yield to maturity/redemption yield/interest rates.
State one reason why a fixed interest fund manager would use Macaulay duration and one reason why a fixed interest fund manager would use modified duration within a bond fund.
Macaulay
• Portfolio immunisation/liability matching/hedging out interest risk/predict returns.
Modified
• Reduce duration/interest rate risk.
State the technical definition of a recession in the UK economy.
• Two;
• consecutive;
• quarters of;
• negative/declining/falling;
• GDP growth.
Describe briefly the four main factors that cause UK interest rates to reduce.
• Fiscal surplus/reduction in gilt issuance.
• Monetary policy loosening.
• Reduction in inflation expectations.
• Quantitative easing (QE).
• Credit crisis/safe haven appeal/demand for sterling
State four changes that could be made within the client’s fixed interest portfolio in the event of an anticipated recession.
• Increase duration.
• Decrease high yield.
• Increase investment grade/gilts/cash/short dated bonds.
• Use derivatives.
State the main product features of NS&I Income Bonds.
• Minimum £500;
• Maximum £1 million.
• No minimum term/Instant access/no notice withdrawal/penalty.
• All/100% protected without upper limit.
• Backed by Government.
• Can use personal savings allowance/taxable but paid gross.
• Pay monthly/income must be paid out.
List three benefits of investing in NS&I Income Bonds.
• Provides diversification.
• Could invest more than £85,000/higher level of investor protection.
• No volatility/default/market/investment risk.
Identify two limitations on the use of NS&I Premium Bonds within the client’s portfolio.
• Maximum deposit £50,000.
• Interest rate notional/may not win any prize/erosion of money in real terms
Calculate, showing all your workings, the portfolio’s standard deviation using the returns data for the past two years.
(-0.4 + 7.3)/2 = 3.45
(-0.4 – 3.45) + (7.3 - 3.45)
(-3.85)2 + (3.85)2
14.8225 + 14.8225
29.645/2 = 14.8225 = 3.85
Describe briefly what standard deviation measures.
• Volatility/dispersion of returns;
• through variation in;
• actual return;
• against mean return.
State the percentage of returns that fall within one and two standard deviations, based upon the normal distribution of returns of a bell curve.
• 65-70% for 1SD.
• 94-98% for 2SD.
Describe the semi-strong form of efficient market hypothesis (EMH).
• Prices adjust/reflect/respond to;
• all;
• public information;
• rapidly and;
• unbiased.
• No excess return/cannot outperform market;
• Includes past prices and;
• company information.
State how the semi-strong form of EMH considers technical analysis and fundamental analysis.
• Fundamental analysis ineffective;
• technical analysis ineffective.
• Neither adds outperformance.
Identify five factors that should be taken into consideration if it is agreed at the meeting to rebalance the portfolio.
• Cost.
• Potential tax liability.
• Impact/interruption to existing income.
• Attitude to risk/capacity for loss.
• Suitability of funds/asset allocation.
• Retention/change of benchmark.
• Time out of market.
List seven additional pieces of information relating to a clients financial situation that a financial adviser would consider when determining a clients objectives and needs.
• Marital status/dependents/children.
• State of health.
• Other assets.
• Liabilities.
• Provision of emergency fund.
• Ethical/socially responsible investments preferences.
• Capacity for loss.
Calculate, showing all your workings, the most recent dividend Fenna received, net of any tax, from her technology company shares.
Assume this is the only dividend Fenna receives and that she is a higher rate tax payer (2021)
22,000 x 12.5p = £2,750
£2,750 - £2,000 = £750
£750 x 32.5% = £243.75
£2,750 - £243.75 = £2,506.25
Explain the tax treatment of any investment that an investor might make into a new VCT.
• For investment of up to £200,000;
• 30%;
• Income Tax relief;
• up to investors tax liability;
• if held for 5 years.
• Gains exempt from CGT/CGT-free;
• with no minimum period.
• No loss relief/deferral relief.
• Dividends tax-free.
State two potential drawbacks that Fenna’s financial adviser would draw to her attention in respect of the proposed level of investment, if she wanted to invest £95,000 in a new VCT at issue.
• Not covered at all by Financial Services Compensation scheme/£95,000/all capital at risk.
• May not receive full Income Tax relief/level of tax relief may exceed tax paid.
Identify four additional risks to which Fenna would be exposed if she invested into a VCT in comparison to her AIM shareholding.
• Accessibility/unable to sell underlying assets.
• Liquidity.
• Manager breaches qualifying rules.
• Manager risk/change in gains or income profile.
• May hold cash/not invest for a while.
Compare the main differences in the tax treatment of the gains and withdrawals from onshore and offshore investment bonds, based upon Fenna’s investment needs.
Onshore
• Corporation Tax paid;
• on capital gains made/investment income;
• deemed UK basic rate tax/20% tax paid.
• Chargeable gains subject to 20%.
• Taxed as top part of income/after dividends.
Offshore
• Withholding tax;
• not subject to UK tax internally/gross roll-up.
• Subject to 40% on gains.
• Taxed as savings income.
• No chargeable event on death if on capital redemption basis.
State whether strategic or tactical asset allocation would be more suitable for Fenna given her objectives and give two reasons for your choice.
• Strategic
• Investing for the long-term.
• Objectives known at outset/future target income.
Calculate, showing all your workings, the redemption yield for Gilt X. You should
use the simplified method in your answer.
£132.56 – £100 = £32.56
£32.56/12 = £2.713333333
(2.7133/132.56) x 100 = 2.0468718%
£1.45 x 2 = £2.9
(£2.9/£132.56) x 100 = 2.1876885%
(2.1876885% - 2.0468718%) = 0.14%
Calculate showing all your workings, the difference between the running yield and the redemption yield 0.14% of Gilt X
2.19 - -0.14 = 2.05%
Explain what can be identified about Gilt X from the information contained in Table 1 and your answer from part (a)(ii) below.
(difference in redemption yield and running yield is 2.05%)
• A medium.
• Trading above par.
• Capital loss;
• if held to redemption/maturity.
• Running yield lower than annual coupons/issue yield.
• Running yield higher than redemption yield.
Identify the main benefits of owning a gilt-based collective fund in comparison to a single gilt on a direct basis.
• Active management.
• Diversification;
• across yield curve/maturities/durations.
• Can invest in new gilts at issue.
• Access to market participants
Identify the main drawbacks of owning a gilt-based collective fund in comparison to a single gilt on a direct basis.
• Exposed to duration risk/manager gets it wrong.
• Loss of known redemption date/yield/coupon.
• Investor protection limited to £85,000.
• Subject to CGT upon disposal.
• Daily dealing.
• Fund charges.
State the three types of credit risk that apply to owning direct gilts.
• Default.
• Downgrade.
• Credit spread.
Calculate, showing all your workings, the theoretical ex-rights price of the client’s holding in Garden Finch, assuming that the client exercises their rights in full.
(9,500/5) x 2 = 3,800
3,800 x 71p = £2,698
£8,284 + £2,698 = £10,982
(£10,982/13,300) = 0.82571428 = 82.57p
State the two options available to the client other than taking up the rights issue in full.
• Do nothing/ignore the issue.
• Sell the rights.
List four main smart beta strategies that may be suitable based upon the client’s objectives.
• Earnings growth.
• Dividend cover.
• Style (growth/value/momentum/quality/low volatility).
• Weighting.
Calculate, showing all your workings, the Sharpe ratio for the REIT.
8.5 - 0.35/1.97 = 4.137055 = 4.14
Explain three main differences between the Sharpe ratio and the Information ratio.
• IR uses benchmark;
• Sharpe uses risk-free return.
• IR is relative/can compare funds;
• Sharpe is absolute.
• IR measures consistency over time;
• Sharpe does not.
• IR uses tracking error;
• Sharpe uses standard deviation.
State four drawbacks of using the Sharpe ratio in investment planning.
• Need to consider other factors/trends over time/do not consider in isolation.
• Can be distorted by fund/manager’s strategy.
• Assumes normal distribution of returns/reliant upon standard deviation.
• Can be distorted by illiquidity/volatility/trading frequency/costs.
State the main rules that a fund must adhere to in order to qualify as a REIT.
• UK resident/listed.
• Closed-ended/only one share class.
• At least 75% of profits;
• at least 75% of total assets;
• relate to property rental/ring-fenced business.
• Interest/borrowing coverage;
• at least 125%.
• At least 90% of profits;
• paid out/distributed;
• within 12 months/one year.
Irma receives an income payment of £2,950 from the REIT, consisting of £750 property income distribution and a £2,200 dividend.
Calculate, showing all your workings, her Income Tax liability on this payment.
Assume Irma is a higher rate taxpayer and this is the only dividend she receives.
(2021-22 Tax rates)
PID
£750/80 x 100 = £937.50 x 20% = £187.50
Dividend
£2,200 - £2,000 = £200
£200 x 32.5% = £65
Total £187.50 + £65 = £252.50
Given their previous experience of equity-based investing, Irma and Christopher decide to invest the £190,000 equally across three UK equity funds.
Identify four main risks relating to the achievement of their objective to which Irma and Christopher would be exposed.
• Market/systematic/volatility.
• Shortfall.
• Inflation.
• Concentration/all in UK equities/lack of diversification.
• Accessibility/liquidity.
• Fund specific event.
Given their previous experience of equity-based investing, Irma and Christopher decide to invest the £190,000 equally across three UK equity funds.
From a behavioural finance perspective:
State three main biases that may have influenced their investment decision and provide one justification for each bias.
• Hindsight
• UK equites have done well in the past.
• Mental accounting
• Their money for their objective/known target value.
• Endowment effect/divestiture aversion
• Already own equities/why change.
• Overconfidence
• Market timing/they know best/UK equities will be best asset class.
Outline six main reasons why a financial adviser would use an investment trust rather than an open-ended investment company (OEIC) when investing in the same sector of the market.
• Charges likely to be lower.
• Gearing/borrowing.
• Discount/price arbitrage/higher running yield.
• More flexible/less diversification.
• Ability of board to change/select manager.
• Greater accessibility/liquidity/do not have to sell underlying investments.
• More suitable structure to hold specialist/niche investments/wider range of investments.
• Dealing frequency/real-time pricing.
List four open-ended fund structures that could be used to invest in UK equities. Exclude OEICs from your answer.
• Unit trust.
• Undertakings for Collective Investment in Transferable Securities
(UCITS)/Société d’Investissement à Capital Variable.
• Exchange-Traded Fund.
• Non-UCITS Retails Schemes.
• Life fund/investment bond.
Explain three relative differences between what is measured by alpha and beta.
• Beta measures market risk;
• alpha measures difference between actual return and expected return (implied by Beta)/not explained by CAPM.
• Beta explained by movements/correlation/in relation to market;
• alpha not explained by movements in market.
• Beta measures volatility;
• alpha measures manager value/stock-picking.
Calculate, showing all your workings, the time-weighted rate of return (TWR) for the GIA over the twelve-month period shown in Table 1.
Period 1
(£15,470 - £5,000 - £10,000)/£10,000 = 0.047 = 4.7%
Period 2
(£16,800 - £15,470)/£15,470 = 0.08597 = 8.6%
(1 +0.047) x (1 + 0.08597) - 1 = 0.13701 x 100 = 13.7%
Explain briefly why an adviser would use the TWR, rather than the money-weighted rate of return (MWR), when evaluating the performance of an investment.
• TWR not influenced by money added/new investment.
• TWR focuses on individual manager skill/performance.
• TWR compounds multiple periods/shows change over entire period.
Identify two aspects of personal taxation that would change if 2 clients were to get married and state how each could result in potential tax savings
• Inheritance Tax;
• unlimited spousal exemption/transferable nil rate band.
• Capital Gains Tax;
• inter spousal disposal exempt.
• Income Tax;
• marriage allowance/transfer of £1,250/10% of Personal Allowance.
Explain briefly the main drawbacks of holding a fund that invests on a single theme or thematic basis.
• Smaller investment universe/fewer managers with experience.
• Costs likely to be higher.
• Dealing frequency of fund/illiquidity of underlying holdings.
• Lack of common terminology/inconsistent application.
• Higher volatility/beta.
• Lack of diversification/greater non-systematic risk.
• Risk of fund closure/short lived/implementation risk/theme being closed.
Identify the due diligence factors solely relating to meeting Catherine’s income needs that the adviser would consider when assessing a potential platform.
• Ability to hold existing assets/equities.
• Ability to continue existing income uninterrupted.
• Cash account minimum balance/interest rate.
• Charging structure.
• Range of income yielding funds available.
“Catherine has sufficient money in her current account to cover her short-term expenditure but may require occasional capital from her portfolio to meet unplanned or discretionary expenditure.”
Identify the main income options available via the cash account that would enable a platform to meet Catherine’s income needs
• Ability to pay natural income.
• Ability to pay regular income/fixed income.
• Ability to pay ad-hoc/one-off withdrawals.
Calculate, showing all your workings, the shortfall in Catherine’s target income based upon her current pension and ISA income.
£90,000 x 4.2% = £3,780
£3,780 + £19,500 = £23,280
£25,000 - £23,280 = £1,720
Describe how the investment bond could be used to generate the shortfall of £1,720 and state the basic tax treatment of this figure.
• Take withdrawals;
• of up to 5%/£2,000 per annum;
• of original investment.
• Tax deferred/no immediate Income Tax liability;
• up to initial 10 years/up to 20 years/surrender/death.
Briefly describe sequencing risk.
• Effect of volatility/fluctuation;
• on the order;
• and timing/frequency of withdrawals;
• and sustainability of income;
• and impact on capital value.
• Effect greater in early years.
State five actions that could be taken to mitigate the effects of sequencing risk.
• Reduce/suspend the level of income.
• Change the frequency/order of income.
• Take only natural income.
• Extend time horizon.
• Secure proportion of income/purchase annuity.
• Diversification/change asset allocation/buy higher yielding assets.
• Hold more/at least 6 months in cash.
Identify the main differences between an interim and a final dividend.
• Interim declared during financial year/before AGM.
• Final declared after financial year/at AGM.
• Interim declared by board.
• Final declared by shareholders.
• Interim can be revoked.
• Final cannot be revoked.
• Interim only if Articles expressly permit.
• Final not subject to Articles/right of shareholders.
Describe briefly what it meant by the term ‘correlation’ in relation to investment planning.
• Covariance/relationship between;
• a pair/two assets;
• adjusted for the risk.
Identify the four components of an economy’s current account.
• Goods.
• Services.
• Investment income/overseas earnings.
• Transfer payments/capital and asset movement.
State the main forms of ethical investment.
Exclude negative screening from your answer.
• Positive screening/engagement.
• CSR/SRI/Sharia finance/responsible.
• ESG.
• Impact.
Identify which other non-equity asset classes could be used for the new money, to diversify the existing portfolio while maintaining an overall ethical approach.
• Fixed interest/green bonds/charity bonds.
• Infrastructure/renewable energy.
• P2P/social impact.
• Property/social housing/education.
Explain three reasons why an equity-based ethical investment strategy could out-perform an equity-based non-ethical investment strategy.
• Small cap focus shown to outperform.
• Greater concentration.
• Invest at the start of a trend/increase in demand.
• Government subsidies/support/less political/legal risk.
State four fund-specific factors that an adviser would consider when researching ethical funds for potential inclusion in the portfolio.
• Appropriateness of benchmark.
• Ethical criteria/mandate of the fund/United Nations Sustainable Development Goals.
• Manager’s skill/track record/experience.
• Ethical stance of management group itself.
• Is it aligned with client’s ethical views?
Gilts description
Shorts <7 years to redemption, Medium 7-15 and Long >15
Nominal (par) value (=£100 on redemption)
Interest rate (coupon described as an annual % of nominal value £100 paid semi-annual
6 months apart and paid gross of income tax)
Redemption date (year £100 capital is repaid) with undated/irredeemable gilts effectively
being cashed in by the government at any time.
Eurobond market (Government Issue)
Eurobonds are international bond issues outside any particular jurisdiction.
For example, a
US dollar Eurobond could be issued anywhere in the world, except for the US.
They are a way for an organisation to issue debt without being restricted to their own domestic market.
Foreign bonds
A foreign bond is one in which the nationality of the issuer is different to that of the
denomination of the bond and the country of issue, for example, a sterling bond issued in London by a US company (known as BULLDOGS on the UK market).
the principal risks associated with buying foreign bonds (from the perspective of a UK
investor):
Credit / default risk: non-payment of interest or capital at redemption
Economic risk: different countries = different economies = different risks (Greece
versus Germany?)
Foreign exchange / currency risk: negative currency exchange movements
Interest rate risk: the inverse relationship between bond prices and interest rates
Liquidity risk: is it possible to sell a specific amount, at the price you want and at the
time you want to?
Political risk: political instability can be a major factor (Venezuela?)
Mortgage backed securities (MBSs)
A mortgage backed security (MBS) is a securitised pool of underlying home loans. They are used by retail banks to securitise the cash flows from mortgages that would otherwise be receivable over, normally, a 25 year term.
The main risks associated with holding either government or corporate bonds are:
Credit risk: interest payments and repayment of the bond may not be made
Market risk: inverse relationship between bond prices and interest rates
Inflation risk: real value of bond coupon & redemption repayment
Liquidity risk: bonds not easily traded
Exchange rate risk: bonds denominated in different currencies
Credit Risk
Relating to a Bonds Price
Credit rating agencies make an assessment when first issued (and throughout the term of the bond) and are divided into Investment Grade (various grades) or Non-Investment
Grade (junk bonds). For example, using S&P ratings, anything less than a BBB is junk.
Market Risk
relating to a bonds price
The income/coupon from a bond remains unchanged throughout the term. Yields vary to reflect interest rates rising or falling by a fall or rise in its capital value (par=100).
Volatility/Sensitivity Risk
relating to a Bonds price
Bond prices will not all change by the same amount when interest rates or yields change –
they are all made up of different coupons and terms. The measure used to calculate how sensitive the bond is to changes in interest rates or yield, is known as duration or modified duration
How the coupon affects the Sensitivity of bond prices:
The smaller the coupon the more the bond’s price will move for a given interest rate change:
low coupon bonds are more volatile than high coupon bonds.
How the redemption period affects the sensitivity of bond prices
For two bonds with the same coupon it will be the longer dated that is most volatile.
Long (dated) and low (yield) bonds are the most ‘volatile’ or sensitive to price movements.
Think long and low for bigger swings, more volatility and more sensitivity to change (or the see-saw movements).
Modified duration (MD)
This is the most important and often quoted (MD), used to quantify sensitivity.
The modified duration (MD) of a bond estimates how much a bond’s price will change if
there is a change in interest rates/yields; it quantifies the sensitivity of the bond price to
changes in GRY:
Reverse/downward (inverted) curve:
investor optimism on inflation, a falling ‘reverse’ or
inverted yield curve is where shorter-term bonds have a higher yield than longer-term bonds, and is seen as an indicator of recession, with investors effectively demanding a higher return for the perceived higher risk of a short-term bond compared to that of a longer-term bond.
Hurdle Rate (to Redemption):
Is the annual growth rate required in the assets
To cover the zeros
Thus, a Hurdle Rate of 9% means that the assets need to grow by 9% and the zero would still be repaid.
Hurdle Rate (to Wipeout):
At what point will zero dividend preference shareholders receive NOTHING?
Thus, a Hurdle Rate (to Wipeout) of 90% means that the assets would have to fall by 90%
before zero holders received nothing.
Negative Hurdle Rate:
This is the amount that the assets can fall each year and still be sufficient to repay the zeros in full.
Statutory rights for shareholders in the UK
o companies must hold AGMs at least once per year
o shareholders with more than 10% of voting rights can call EGMs
o shareholders with more than 5% of voting rights can propose resolutions
o any shareholder can petition the court on grounds of the affairs of the
company that are unfairly prejudicial to the interests of some or all of
shareholders.
Principal features of AIM are:
Launched in June 1995
Currently lists circa 1,000 companies with a total market capitalisation of £93bn
Many AIM companies lack true liquidity (sometimes ANY liquidity!)
Lower listing standards and “lighter touch” regulation than for the main LSE market –
which has been a major criticism of the AIM
Lower listing fees and ongoing costs than for the main LSE market
The Share price and valuation
Shares have a nominal/face/par value shown on the face of the share certificate.
This is the par value and is virtually irrelevant in normal trading conditions.
The market value is the trading price of the share on the market. This is the capital value of that share in the market and used to provide the total ‘capitalised’ value of the company:
shares issued x market value = capitalisation.
Gordon’s Growth Model
(GGM) is recognised, widely used and simplified model for
calculating a share price:
It calculates the (ex-dividend) price of a share, assuming constant dividend growth and
dividend payments made at the end of each period.
It helps place a price on value of an ordinary share with reference to the dividend. But, it is simplistic and only really suitable for mature shareholdings with track record.
Most recent dividend / investors required return - growth rate of dividend
Some of the problems with GGM include:
- If the required return is less than the growth rate of the dividend, the model gives a
negative share valuation. - If the required return is equal to the growth rate of the dividend, the formula collapses
as the result approaches infinity. - It’s only valuing the share based on dividend, which is a single fundamental, and any
value investor worth their salt will tell you that fundamentals need to be considered as
a whole rather than in isolation. What if the company is very profitable, but it’s retaining
its earnings and using them to invest back into the company?
Market indices:
The markets use a range of indices to track the performance of the stocks and shares traded on a daily basis across the world. For example, in a weighted-index a 1% change in the price of a large company (higher market capitalisation) will have a proportionately greater effect on the index than a 1% change in the price of a smaller company.
Current account vs Capital Account
The current and capital accounts represent two halves of a nation’s balance of payments. The current account represents a country’s net income over a period of time, while the capital account records the net change of assets and liabilities during a particular year.
