Questions Flashcards
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.
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.
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 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 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 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.
Describe briefly what standard deviation measures.
- Volatility/dispersion of returns;
- through variation in;
- actual return;
- against mean return.
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 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.
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
- To finance/fund;
- a current account;
- deficit.
Describe briefly what is meant by the term ‘Beta’ according to CAPM
Beta measures the sensitivity to market risk of a share or portfolio
The market has a beta of 1.0
According to CAPM, the average beta of shares in the market is 1 and would be expected to move exactly in line with the market
A share with a beta of less than 1 will rise and fall more slowly than the speed of the market
A share with a beta of more than 1 is more volatile than the market
Outline the assumptions that CAPM is made on
Investors are rational and risk averse
All investors have the same holding period
The market comprises of many buyers and sellers and no individual can affect market price
Information is free and simultaneously available to all investors
Unlimited amounts of money can be borrowed or lent by investors at the risk free rate
All investments are liquid
There are no taxes, no transaction costs and no restrictions on short selling
Outline why investors sometimes behave irrationally as explained by behavioural finance
Loss aversion/prospect theory
Investors take profits
Reluctance to realise losses
Made more distressed by prospective losses than they are made happy by equivalent gains
Reluctance to accept an error of judgment has been made
Tendency to believe current trends will continue indefintely
Fear of missing out/the herd instinct
Over confidence/under reaction
Emotional reasons/attachment
Unit Trust assets held by? and managed by?
Held by Trustees and invested by managers
OEIC assets held by?
Independent Depositary
Describe the four main stages of the business cycle and the effects of these on businesses and unemployment.
Recession
Unemployment is near its peak as businesses have contracted
Entrants to the labour market find it hard to find jobs.
Expansion or upswing
Sales start to rise
Unemployment falls.
Boom or peak
Businesses are operating at full capacity
Unemployment is at its lowest
Contraction or slowdown
Sales are falling
Unemployment is rising
State and briefly explain the three different types of unemployment
Frictional - caused by changes in the economy that lead to qualified jobseekers being
temporarily unmatched with jobs because of lack of knowledge, time needed to arrange
interviews etc.
Structural - caused by structural changes to the economy such as declines in industries
leaving people unemployed and not qualified for other jobs.
Cyclical - caused by changes in the overall level of economic activity and often associated
with the business cycle.
State four ways a company can return money to investors other than paying an annual dividend.
Special dividends
Share buy backs via the market
Tender issue to repurchase shares
Wind up/sell company
Explain the purpose of using a benchmark in the investment process
Sets asset allocation
Independent agreed basis
To manage risk expectations
To measure relative performance to benchmark/performance or added value by the fund manager
Describe briefly four main elements of fundamental analysis and technical analysis
Fundamental analysis
Analyse company.
Analyse industry.
Analyse accounting ratios.
Calculate whether share is over or under valued.
Technical analysis
Analyse past share prices.
Identify trends /patterns in share prices.
Using charts or mechanical trading rules.
Make decisions independent of other information about company.
Explain why the Bank of England may not raise interest rates even if inflation exceeds their target
Future economic uncertainty
High levels of debt, both corporate and personal
Exchange rate concerns/effect on trade
Increase in inflation deemed to be temporary
Explain the longer-term effects on the economy if the Government eased monetary policy to reduce short-term interest rates.
Long-term interest rates should reduce
Asset (bond, equities & property) prices should increase
Lower interest rates will mean more people are willing to spend and borrow
People dependent on interest income will become worse off
Borrowers will become better off
Businesses will invest more as the margin between their investment returns and interest rates payable widens
Explain what is meant by inelastic demand
Changes in price have little or no effect on the levels of demand
Explain the implication of elastic demand for the profitability of goods
When goods have elastic demand a small price decrease would lead to a large increase in demand
Assuming adequate supply for the product and a reasonable profit margin
Then profitability should increase substantial with a small price decrease
Or should decrease substantially with a small price increase
List five characteristics of perfect competition
All firms in the market produce identical products
Large number of firms in the market
Each firm is small in relation to the market
No exit or entry barriers
The market is transparent and all transactions are known
Explain how the Bank of England generally sets short term interest rates
The BoE raises interest rates by selling Treasury Bills and Gilts via the repo market
this withdraws physical money from the financial system
They cut interest rates by buying back bonds and bills
This injects money into the financial system
Describe how the BoE eases monetary policy and the effect this has on the economy
The BoE reduces short term interest rates to ease monetary policy
This should bring down long term interest rates
This will lease to rising asset prices, increasing wealth of people and increasing their willingness to spend and borrow
The result of this is increased economic activity
Describe the four main performance measures used when analysing company accounts
Profitability - measures the rate of profits being earned in relation to sales, assets and equity invested
Volatility - measures how sensitive profits are to change in markets
Liquidity - measures wether the company can easily pay its way
Operational efficiency - measures weather the management are making efficient use of the company’s resources
Explain the term capacity for loss
The ability/degree/level/scope;
to absorb/withstand;
any negative investment event.
Adverse effect/materially detrimental;
on lifestyle/standard of living.
List the non financial factors that can influence an investors attitude to risk
Previous experiences.
Time horizon/age/state of health/dependants.
Client objectives/ethical/religious views.
Investor psychology/perception.
Framing.
Society/collective mood/political/economic environment.
Describe the key principles of Modern Portfolio Theory, in respect of the construction of an investment portfolio.
A diversified portfolio;
of non/un/imperfectly correlated.
Investors are risk adverse.
Maximum return;
for given/set risk.
Efficient frontier;
uses expected return of each asset.
Standard deviation/normal distribution (of each asset);
to produce optimal portfolio.
Systematic risk cannot be removed/can be reduced.
Non-systematic risk can be removed.
Sensitivity to the market is expressed by beta is market risk.
Five benefits and five drawbacks of transferring assets to a platform compared to holding directly
Benefits Everything in one place/consolidated valuations/reporting. Less admin/paperwork. Income flexibility. I pre-funding/cash account. Access to institutional/clean share classes. Access to tools. Discounted/lower fund charges.
Drawbacks
May pay exit charges.
Additional platform charges/pay for services not used.
Unnecessary functionality/too complex solution.
May have to sell assets.
Time out of market.
Risk of platform failure/outage.
Unable to hold alternative income products.
Identify the three main categories of benchmark used by fund managers
Constraint
Target
Comparator
Key differences between M0 and M4 as measures of money supply
M4 includes deposits created by lending/all bank accounts.
MO includes operational deposits at the Bank of England
M4 is broad money.
MO is narrow money.
M4 is indicator of economy.
MO is indicator of consumer spending/retail sales.
Describe the general limitations of using investment ratios when analysing a company’s financial performance
Credibility of the source of information/manipulation.
Use different accounting policies/conventions/company may change accounting policy.
Masked by exceptional/one-off items.
Data may be obsolete/historical/not reflect current/future trading.
Affected/masked by macro trends.
Not considered in isolation/other factors.
Can’t compare across sectors.
Identify factors that could affect a companies share price
Economic outlook. Political/changes in legislation/tax/regulation changes. Investor sentiment/broker or credit rating change/demand & supply. Takeover activity. Profit/earnings expectation. Capital event. Dividend expectation! Quality/change of management. Competitors. Fraud. Inclusion/removal from index.
Describe what a momentum investment style is
Identify trend. Trend accelerating/continuing. Sell before trend ends. Ignores intrinsic value/fundamentals. Generally, short term.
Describe what a contrarian investment style is
Consensus usually wrong.
Returns from going against the herd/ market sentimen
Positive when outlook negative/out of favour.
Price less than intrinsic value/undervalued.
Generally, long term.
Explain three main differences between 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 the main rules 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.
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.
Identify three implications to a company paying out an uncovered dividend
May have to cut/reduce dividend;
unless one off/bad year.
Use reserves/future profits.
May borrow/raise capital.
State the main forms of ethical investment
Positive screening/engagement.
CSR/SRI/Sharia finance/responsible.
ESG.
Impact.
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 income:
from exempt property business.
Value of property assets must be at least 60% of total assets.
Shares widely held.
No corporate investor;
holding 10% (or more of net asset value).
Explain four potential drawbacks of using Socially Responsible Investing other than investment performance.
Less diversification due to avoiding certain areas/fewer investment opportunities.
More expensive.
Approach differs/not consistent/not aligned with John’s Socially Responsible Investment (SRI) view.
Less research available.
Higher risk/higher tracking error/risk not aligned with John’s attitude to risk.
Screening rules out growth/income.
Describe briefly what is meant by current account and capital account
Current account
Imports minus;
exports/balance of payments;
in goods & services;
plus receipt from overseas income generating assets.
Capital account
Movement of all monies/assets;
into country;
out of country.
Identify two aspects of personal taxation that would change if a couple 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 what is meant by the standard deviation of returns
It is a measure of the volatility of returns
It measures how widely the actual return of investment varies around its average return
An investment which stays close to its expected return is said to have a low standard of deviation
An investment which fluctuates wildly has a high standard of deviation
It is a measure based on past experience
And a useful tool to identify the range of returns investments are likely to make in the
Explain the term active investment management and state two advantages and two disadvantages of this type
An investment strategy using analysis
In an attempt to achieve above average or superior risk adjusted returns
Advantages
Informed investment decisions based on expierence and analysis of market
Possibility of higher returns than index which portfolio benchmarked against
Disadvantages
Higher fees and operating costs
Stock/sector analysis may not produce the right selections and portfolio could outperform
The benefits of diversification within a portfolio
Reduces the risk of any one particular investment
Spreads the opportunity for potential return across asset classes
Minimises the risk of the overall portfolio suffering a significant downturn
Increases the possibility of stable returns through all economic cycles
Explain briefly what passive management means
An investment strategy that should not require active intervention but will be self- maintaining.
Passive management does not attempt to outperform the market
Outline the two main methods of passive management
Buy and hold; buy investments and hold them
Indexation; tracks an index (either fully, via a representative sample, based on a computer/statistical model or through derivatives, or a combination)
State four advantages and four disadvantages of index tracking
Index tracking - advantages
Lower cost than actively managed funds
Returns in line with the index
Lower portfolio turnover
Few active investment managers consistently outperform the index
Index tracking - disadvantages
Index trackers should, by definition, underperform the index after charges
Index tracker funds will track the index down (as well as up)
Increased merger activity increases the concentration of the fund
Actively managed funds offer specialism, e.g. catering for different risk profiles, that tracker funds cannot
Explain four advantages of ETFS as a possible alternative to active funds
(iv) ETFs - advantages
ETFs are efficient index trackers used to track the performance of an index
ETFs Generally have lower costs than actively managed funds with particularly low expense ratios
Dividends received by ETFs are reinvested immediately and so suffer no cash drag
ETFs are free of stamp duty for funds registered outside of the UK and since April 2014
UK domiciled ETFs have been treated in the same way.
Describe the tracking method of synthetic replication giving one advantage and one disadvantage of a synthetic fund
Fund manager enters into a swap with a market counterparty to exchange returns on the index for a payment
Unfunded or funded swap
Counterparty undertakes to deliver the performance of the index the ETF is tracking
Responsibility for tracking index performance is passed on to the swap provider and costs are lower.
Downside is investor is exposed to counterparty risk
Identify the reasons why you should not solely rely on a risk-profiling tool to clarify Amanda’s attitude to risk.
Different tools produce different results
may not be able to relate to content of questionnaire
Potential to misinterpret/misunderstand question
Doesn’t allow her to express her views/ethical/does not take into account past experience
Will be unsuitable if she has a zero capacity for loss
Different risk may be in evidence for different objectives/timescales
Outlipe six main reasons why a financial adviser would use an investment trust rather than an open-ended investment company (OIC) 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
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.
Advantages of holding gilts in an OEIC
Greater diversification
Smaller minimum investment level
Professional fund managers will make the underlying investment decisions
Explain tax position if holding gilts directly or via an OEIC
Gilt tax position -held directly
Interest received from Gilts is normally payable gross but taxable at a rate of 20% for a
basic rate taxpayer (can be set against the PSA).
Capital gains on gilts are tax-free to individual investors
Held via an OEIC
•
Sarah will receive interest payments from fixed interest funds gross but will be liable tr
income tax at basic rate (can be set against the PSA)
Internal gains within an OIC are exempt from capital gains tax (CGT)
Sarah will incur a personal liability to CGT, if the gains are in excess of her CGT annual
exempt amount, in the event of the sale of the OIC or a switch in class of fund
Explain briefly what a derivative is and the key difference between investing in derivatives and investing directly in an asset
A derivative is a financial instrument based on some other asset
The key difference in buying a derivative rather than the asset itself is that the cost of buying the derivative is a fraction of the cost of buying the asset
Describe five uses of derivatives within portfolio management
Asset allocation
Capturing volatility
Anticipating cash flows
Increasing returns by investing in cash
Portfolio insurance using a put option
Currency and interest rate plays
Writing options
Increasing returns by increasing risk
Describe briefly three benefits and three drawbacks of investing directly in derivatives
Derivative benefits
Leverage - potentially high return for low outlay
Futures specify a specific grade / quality
Daily returns locked in through daily calls
Derivative drawbacks
Risk of losing more than initial investment
Must honour on expiry of contract
Risk of physical delivery
Very high risk - increases and falls in underlying assets are fully reflected
Describe a unit trust equalisation payment and state its income tax treatment.
An equalisation payment is part of the first distribution received after an investor has bought a unit trust.
It is a partial return of capital which enables a proportional income payment to be made.
It is not subject to income tax.
Describe forward pricing within a unit trust and the implications of this
The unit price which applies to a purchase is the next one calculated after the transaction is made. They will not know the number of units bought or the price at the
time of dealing.
List four factors which influence the size of discount in an investment trust
Supply and demand
The reputation/past performance of the fund manager
The provision of warrants
Whether there is currently a share buy-back
Explain what is meant by gearing and how it affects the risk to the investor
The investment trust borrows money to fund further investment opportunities.
If the cost of borrowing is greater than the investment return, then the performance is reduced.
If the market falls, gearing exaggerates the loss.
Highly geared investments are more volatile.
State four ways in which an open-ended fund structure could respond to a liquidity crisis following substantial redemption requests.
Open-ended/OEIC/ETF
• Dilution levy/exit penalty.
• Switch pricing/swing-pricing/offer to bid price/fair value price.
• Borrow to fund redemptions.
• Gated/limited redemptions/change dealing frequency.
• Suspend redemptions.
• Forced sale of property(ies).
State four ways in which a closed-ended fund structure could respond to a liquidity crisis following substantial redemption requests.
- Borrow.
- Move to discount/widen spread/match buyers and sellers.
- Suspend dealing.
- Rights issue.
- Sell property.
Explain the effects of the higher level of cash within the direct property OEIC.
- Drag on performance.
- Reduces risk/protects in falling market.
- Dilutes yield.
- Reduces risk of forced sales/buying opportunities.
State the three inputs required to produce an efficient frontier curve.
- Expected return.
- Standard deviation/level of risk.
- Correlation.
Explain how the efficient frontier is used in investment planning.
- To set (optimum) asset allocation.
- To show best/highest return;
- given level of risk.
State five limitations of using the efficient frontier.
- Assumes standard deviation as measure of risk.
- Does not take into account attitude to risk/capacity for loss.
- Uses historic data to predict expected returns.
- Excludes impact of costs and charges.
- Assumes portfolio uses passive funds/cannot factor Alpha.
State five main risks you are exposed to if investing in high yielding alternative income products
Liquidity risk Accessibility risk Interest rate risk Default risk Diversification / correlation risk Valuation risk
State the information you would have to provide when requesting an Additional Permitted Subscription ISA
NI number Date of birth / birth certificate Date of death / death certificate Proof of marriage Full name Address
State the qualifying investments that may be held within an Innovative Finance ISA.
Debt based securities / bonds and debentures / loans to companies
Cash
Peer to peer lending
State five factors that should be considered before accepting or rejecting the rights issues.
Why is the ompany making a rights issue?
What is the discount on offer - is it attractive?
Does David want more shares/will his personal circumstances impact any decision?
How will the market react?
What are the future prospects for the company?
Describe what might happen to a post-rights share price after a rights issue.
The pre-rights share price is likely to fall towards the rights-price.
The post-rights price is likely to rise towards pre-rights share price.
Both prices are likely to become the weighted average price, (although in reality, this depends on market reaction).
Explain to Louise what is meant by a normal yield curve and what it means for an investment in fixed-interest securities.
The yield curve shows how the yield of bonds vary with periods to redemption
In normal circumstances investors demand higher yields for longer term bonds to cover the increased risk and uncertainties over time
The yield curve in normal circumstances is a rising and positive curve - the more pessimistic the future prospects are for inflation the steeper the curve is.
A normal yield curve means more capital will be needed to get the same income in short dated bonds than for longer dated bonds.
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.
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.
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 OIC 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
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.
Differences between ROE and ROCE
ROCE considers all assets used in business/return for all sources of capital;
including debt/borrowings
profit measured as earnings before interest and tax/operating profit.
ROCE useful to compare individual companies and their efficiency.
ROE based on equity investment only/shareholder return/funds.
Main differences between strategic and tactical asset allocation
Strategic Fixed weightings/allocation; long term; with occasional/infrequent rebalancing. Little variation from objective. No response to market changes.
Tactical Varying weightings/allocation; short term; with frequent rebalancing. Substantial variation from objective. Take advantage of market changes.
Outline what would cause a normal yield curve to invert
Expectation that; long term interest rates will fall; short term interest rates will rise; long term inflation will fall. Economic outlook pessimistic/low growth/recession.
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.
Cash / fixed interest / bonds subject to what risks?
Interest Rate - when interest rates fall capital values rise and vice versa
Liquidity - trade infrequently
Inflation - erodes capital values (bond prices tend to fall if rate of inflation is speeding up)
Currency - exchange rate movements for global bonds
Default - Issuer may not pay interest or capital at maturity (Governments are most secure due to
creditworthiness and ability to raise money to pay debt)
Credit ratings: investment grade (S&P BBB- or higher /Moody’s Baa3 or higher)
Sub-investment grade (junk bond) (volatile)
Market/Systematic Risk - economic factors or government actions
Type of preference shares
Cumulative
Non cumulative
Participating
Redeemable
Convertible
Risks of hedge funds
Gearing
Hedge fund of fund
Manager risk
Liquidity risk
Encashment risk
Regulatory risk
Behavioural finance types
Regret
Over confidence
over and under reaction
Mental Accounting
Herd Behaviour
Emotional Gap
Anchoring
Self Attribution
Confirmation Bias
Experential Bias
Loss Aversion
Hindsight Bias
Familiarity Bias
Explain four benefits of using the Capital Asset Pricing Model (CAPM) in
assessing the potential suitability of a fund.
Easy to calculate/uses widely available information.
Takes account of systematic/market risk.
Reflects fact most portfolios are diversified to remove unsystematic risk.
Robust/trusted.
Gives an expected return/benchmark.
List four fees that are included within the OCF figure
Management fee/ Annual Management Charge.
Administration fees/secretarial/directors fees/insurance
Marketing.
Audit/tax compliance fees.
Registration/regulatory fees.
Custody/depositary/trustee.
State four costs that may be paid when investing in a fund
Transactions fees/initial charge/spread/Stamp Duty.
Performance fees.
One off legal/professional charges.
Interest/gearing costs.
Adviser charge.
Explain briefly what is meant by a deep value investment strategy
Investing for long term;
in undervalued/out of favour stocks.
Price less than net asset value/book value.
Contrarian view/buying what others are selling.
Buy and hold/low turnover.
Limited downside/greater upside/mean reversion.
Bottom up investing
Stock selected purely on basis of own criteria
Usually dependent on style or approach of fund manager
Focuses on how individual company performs
Looks at financial ratios
o Value/buy & hold strategy to earn higher return than market average o Growth At A Reasonable Price/find companies with lorg-term sustainable advantages o Momentum/uses analysis to be ahead of latest swing in opinions, e.g., sector rotation o Contrarianism/high returns can be achieved by going against trend (found most often in hedge funds)
Top down investing
- focuses on bigger picture
- overall economy and macroeconomic factors
- performance of sectors and industries
- looks at monetary policy and GDP
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 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 main product features of NS&l Income Bonds.
Minimum £500;
Maximum £1 million.
No minimum term/Instantaccess/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&l 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&l 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.
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.
Offshore funds - reporting / non reporting
Reporting funds
- income declared to HMRC, investor taxed as income arises
- taxes like UK dividends or interest for UK investor
Non reporting funds
- mainly rolls up funds, no income distributed
- gain calculated using CGT principles
- however, gain taxes as income @ 20,40,45
- PSA available at £1000 or £500 on savings income
Types of risk
Market risk Equity risk Accesibility Interest rate risk Currency risk Liquidity risk Concentration risk Credit risk Reinvestment risk Systematic/unsystematic Inflation risk Horizon risk Longevity risk Political risk Counterparty risk
Weak form efficiency
- current security prices fully reflect all past price and trading volume information
- future prices cannot be predicted by analysing this type of historical dates
- technical analysis is of NO use in deterring future prices and can’t produce returns
Strong form efficiency
- security prices reflect all information that any investor can acquire
- includes all information such as public and private information
Drawbacks of money weighted return
Strongly influenced by timing of cashflow
Outside fund managers control
Difficult to distinguish performance from manager or cashflow input
Explain briefly the potential causes for an ETF tracking error
Inaccuracy of tracking Management fee. Other expenses/costs. Currency hedging. Cash drag/uninvested cash. Dividend reinvestment lag. Tax/withholding tax. Securities lending.
Duration (Macaulay)
Period of time it will take to repay initial outlay (in terms of
interest and capital)
Used to measure sensitivity of fixed interest investment to changes in interest rates
Modified Duration estimates the change in a bond’s value if there is a change in interest rate (and thus yields)
Active management strategies
Top down
- Asset allocation (strategic and tactical)
- Geographical distribution
- Sector selection
- Stock selection ( fundamental and technical analysis)
Bottom up
- Value
- GAARP
What is the CAPM?
- model that shows relationship between expected return and risk of a security
- helps investors understand the returns they can expect with a given level of risk
Arbitrage Pricing Theory
APT states risk premium is based on a number of independent factors i.e. multi factor
Can be market or industry related
Can include macroeconomic variables e.g. Interest rates, inflation
industrial production
Each factor taken into account and extent risk will affect that security.
Thematic investing explained
- investors can invest in long- term ideas and trends
- aims to identify macro-level trend
- aims to generate long term growth
Growth vs Value
Growth stocks are those companies that are considered to have the potential to outperform the overall market over time because of their future potential.
Value stocks are classified as companies that are currently trading below what they are really worth and will thus provide a superior return.
Three main ways in which a stock market 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
Describe 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.
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.
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 put perform an equity based non ethical 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
Appropriateness of benchmark.
Ethical criteria/mandate of the fund/UnitedNationsSustainableDevelopment Goals.
Manager’s skill/track record/experience.
Ethical stance of management group itself.
Is it aligned with client’s ethical views?
