R02 Flashcards
Define the 4 stages of the business cycle
Expansion/ recovery: GDP is increasing
Boom: economy is growing at its fastest
Contraction: GDP has fallen from previous quarter
Recession: 2 consecutive quarters of declining GDP
If the economy is in recession what impact will this have on Public Sector Net Cash Requirement (PSNCR)?
If the economy is in recession, tax revenue will be weak due to unemployment and the PSNCR will grow.
What is an example of government spending that is capital expenditure?
Building new schools, railway lines, bridges, airports etc.
Any spending on physical assets
By what 2 means does monetary policy attempt to stabilise the economy?
By controlling interest rates and the money supply
What is the government’s inflation target?
2%
Outline the 2 quoted measures of money supply in the UK
M0 (narrow money): refers to physical money and the bank’s operational deposits within the BoE. Growth in M0 signals strong consumer spending
M4 (broad money): refers to physical money but also includes bank accounts of UK residents. Growth in M4 signals increased demand for loans
What is the difference between disinflation and deflation?
Disinflation is a slowing in the rate of inflation, prices are still rising
Deflation is when the inflation rate is negative, and prices decline
What does the Real Exchange Rate (RER) measure?
It measures the price of domestically produced goods, relative to the price of foreign goods.
It is a good indicator of international competitiveness
When a country has a strong currency, what happens to the cost of importing and exporting goods?
Cost of importing goods reduces, but also means exports are more expensive which can weaken a countries competitive position
What is the balance of payments?
The record of a county’s transactions with the rest of the world measured in terms of payments and receipts
Receipts represent sterling flowing into the country and payments represent sterling flowing out of the country
What is included in the balance of payments current account?
HINT: 4 things
Trade in good (visible trade)
Trade in services (invisible trade)
Investment income
Transfer payments
What are the implications of an ageing population?
Causes an increase in the demand for services and a decrease in the money spent on manufactured goods
Working households increase their savings to fund a longer retirement
Name 4 risks associated with cash investments?
Default - Institution collapses but consider FSCS
Inflation - Value of cash deposits eroded by inflation
Currency - Value fluctuates with exchange rates
Interest Rate/ Reinvestment - Fixed or variable
What is the Personal Savings Allowance (PSA)?
This allows an individual to earn a certain amount of interest from their savings tax free. It varies depending on your income tax band as follows:
Basic rate taxpayer - £1,000
Higher rate taxpayer - £500
Additional rate taxpayer - £0
Outline the key features of a restricted access account
Usually offer higher rates than instant access accounts
Higher risk due to money being tied in for a set period
Notice Accounts: require 30/60/90 days notice in order to make a withdrawal without penalty
Term Deposit Account: Usually 1-5 years with a fixed rate of interest with no access prior to maturity
What are the taxable NS&I products?
Guaranteed Income Bond
Guaranteed Growth Bond
Income Bond
Investment Account
Direct Saver Account
How can individuals purchase NS&I products?
They can be bought online, by phone or post directly from National Investments.
What are money market investments?
Wholesale markets where banks, building societies and governments lend and borrow money from each other. They are considered short-term (less than 1 year) debt instruments that are traded in high volumes and provide low risk.
What are the 3 money market instruments and who issues them?
Treasury Bills - Debt Management Office (DMO)
Commercial Bills - Companies
Certificate of Deposits - Banks
How do the 3 money market instruments pay returns?
Treasury Bills
No interest payments but issued at a discount to their maturity value
Commercial Bills
No interest payments but issued at a discount to their maturity value
Certificate of Deposit
The deposit carries a fixed rate and term
What is the purpose of a money market fund?
Minimum investments in money market instruments are high which makes it difficult for an individual to gain access to the market. However, a fund is a collective investment vehicle that pools together investors’ funds to invest in the money market.
What are the 2 classifications of money market funds with respect to time?
Standard Fund – 6 to 12 months
Short-term Fund – 2 to 4 months
Who can issue fixed interest securities and what is their purpose?
Issued by governments in the form of gilts, and companies in the form of corporate bonds.
A means of raising money in order to finance their long-term borrowing requirements.
What are the characteristics of fixed interest securities?
Pay a fixed rate of interest, known as the coupon. This is set at issue and is a percentage interest on the nominal value.
A fixed redemption value, known as the par/nominal value.
A fixed redemption date, known as the maturity date. This is set at issue.
What 3 things must a bond title include?
The issuer, the coupon and the maturity date.
e.g., Amazon 3.5% 29/05/2025
What is the difference between secured and unsecured bonds?
Secured – A charge is placed on certain assets of the issuing company. If bond defaults, the assets can be seized.
Unsecured – Only reimbursed once all secured bonds are settled, along with other creditors.
Bonds can be secured by a fixed charge or a floating charge. What is the difference?
Fixed charge – Bond secured against a specified asset(s) that can be readily identified.
Floating charge – Bonds secured against any assets of the company that are not already secured for other lenders. They are a lower priority for payment than fixed charge bonds.
What are the 2 types of Government issued gilts and their key features?
Conventional Gilts
Issued by DMO
Trade at a discount to par instead of offering an interest payment (zero coupon)
Classified according to their time to redemption
Shorts: 7 years, Mediums: 7-15 years, Longs: 15+ years
Index Linked Gilts
Coupon and capital payment adjusted in line with inflation
Measured by changes in RPI
What is a Floating Rate Note?
A type of bond often issued by banks, that pays a coupon biannually or quarterly linked to a money market rate such as LIBOR.
N.B. Cash products linked to LIBOR will end by Q3 2020 and the transition from LIBOR to SONIA will be completed by the end of 2021.
What is the difference between ‘clean’ and ‘dirty’ prices?
The difference between these prices is the inclusion of accrued interest
Prices quoted in the FT are ‘clean’ prices. This price does not include the value of accrued interest
Interest is accrued daily, so gets added to the price from the last interest payment date to the selling date, known as ‘dirty’ price
Bonds can be bought cum dividend or ex-divined, what is the difference?
Cum dividend: This is where the buyer receives the full 6 months’ interest – even though they didn’t own the stock for the whole period
Ex dividend: This is where the full 6 months’ interest is paid to the seller
The total amount paid by the buyer is called the ‘dirty price’, which is the clean price +/- any adjustments for interest payments
What is the difference between non-systematic risk and systematic risk?
Non-systematic risk is a specific risk that occurs as a result of the issuer, it can be eliminated by diversification
Systematic risk is a market risk (interest and inflation rates) that is unavoidable, it cannot be eliminated by diversification
What are the 2 main credit rating agencies and what is the minimum classification for an investment grade bond?
Standard & Poor’s: BBB-
Moody’s: Baa3
Name 5 factors that can affect bond prices
Interest rates
Inflation rates
Credit worthiness of issuer
Time to redemption
The coupon
How does a change in interest rates affect bond prices?
If interest rates increase, investors will demand a higher yield from their bonds. As bond coupons are fixed the prices of bonds must fall so that the yield increases.
What does the Bank of England use the repo market for?
To influence interest rates.
If an investor holds a 15-year gilt, how many individual securities can this be stripped into?
It can be stripped into 31 securities (30 based on the biannual interest payment and a final redemption payment).
How do you calculate the interest yield?
𝑐𝑜𝑢𝑝𝑜𝑛 𝑜𝑟 𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑦𝑖𝑒𝑙𝑑
𝑐𝑙𝑒𝑎𝑛 𝑝𝑟𝑖𝑐𝑒 𝑋 100
What is the interest yield also known as?
Running Yield, Flat Yield or Income Yield.
What does the redemption yield consider that the interest yield does not?
Like the interest yield, it considers the income of the bond; however, it also factors in any capital gain/loss.
How do you calculate the redemption yield?
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑦𝑖𝑒𝑙𝑑+/−(𝑔𝑎𝑖𝑛 𝑜𝑟 𝑙𝑜𝑠𝑠 𝑎𝑡 𝑚𝑎𝑡𝑢𝑟𝑖𝑡𝑦 ÷𝑦𝑒𝑎𝑟𝑠 𝑢𝑛𝑡𝑖𝑙 𝑚𝑎𝑡𝑢𝑟𝑖𝑡𝑦
𝐶𝑙𝑒𝑎𝑛 𝑝𝑟𝑖𝑐𝑒 ) 𝑥100
What are the risks of holding fixed interest investments?
Inflation - Erodes the purchasing power of interest
Interest rates - Generally bond prices move in the opposite direction
Credit risk - Issuer may not be able to pay interest or capital at maturity
Currency - Movements in exchange rates affect the value of holding
Liquidity - May be difficult to sell at an acceptable price
Under what circumstances would you expect to see an inverted yield curve?
This happens when the yield on longer term bonds is less than shorter term bonds. This occurs when investors expect that the interest will rise in the short-term but fall in the long-term.
How can investors expect to receive income from equities?
Investors expect to receive income in the form of dividends and also hope to achieve capital growth on disposal.
What are the transaction costs involved in purchasing shares?
Stamp Duty Reserve Tax (SDRT) is charged on electronic transactions at 0.5%, rounded to the nearest 1p
Stamp Duty is charged if a stock transfer form is used and the value is over £1,000. Also charged at 0.5% but is rounded to the nearest £5
Panel on Takeovers and Mergers Levy is charged on trades over £10,000 at a rate of £1
No rules governing stockbroker commission
What shares are exempt from SDRT?
Alternative Investment Market (AIM) shares.
How can an individual investor gain access to private equity?
Investments can be made through private equity funds, listed by private equity companies. Other methods of investment include: Enterprise Investment Schemes (EIS), Seed Enterprise Investment Schemes (SEIS) and Venture Capital Trusts (VCTs).
What is the primary and secondary market?
The primary market offers new securities on an exchange, once the initial sale is completed further trading is carried out on the secondary market.
When shares are first issued in the primary market, what must they be admitted to?
Official List, Main Market or Alternative Investment Market (AIM).
What are the benefits of being listed on AIM?
Less formalities
Lower cost
Can be described as ‘quoted’ but not listed
How much is the dividend allowance and what is the subsequent tax treatment?
Investors can earn up to £2,000 of dividend income tax free. After this, the rate paid will depend on the investors income band:
Basic rate taxpayer: 7.5%
Higher rate taxpayer: 32.5%
Additional rate taxpayer: 38.1%
What is a participating preference share?
A share that receives a fixed income as well as a proportion of the ordinary dividend declared.
What are the 4 types of ordinary shares?
Ordinary shares
Non-voting ordinary Shares (A)
Deferred Shares
Redeemable ordinary Shares (B)
Why might stock market indices be of use?
They bring together movements of individual share prices and shows the overall direction of the market.
Can be used to compare the performance of an individual share with its sector or full market.
How do you calculate market capitalisation?
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 𝑖𝑛 𝑖𝑠𝑠𝑢𝑒×𝑚𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒
What is included in the FTSE All-Share index?
It brings together the FTSE100, FTSE250 and FTSE Small-Cap
FTSE All-Share currently accounts for 98% market capitalisation
What are the main indices used in America?
Dow Jones Industrial Average
Standard and Poor’s Composite
NASDAQ
How do you calculate earnings per share (EPS)?
𝑃𝑟𝑜𝑓𝑖𝑡 𝑎𝑡𝑡𝑟𝑖𝑏𝑢𝑡𝑎𝑏𝑙𝑒 𝑡𝑜 𝑜𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑠ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠
𝑁𝑜.𝑜𝑓 𝑜𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑠ℎ𝑎𝑟𝑒 𝑖𝑛 𝑖𝑠𝑠𝑢𝑒
What does the dividend yield measure and what is the calculation?
Measures the dividend paid as a percentage return on the current share price:
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑠ℎ𝑎𝑟𝑒 𝑝𝑟𝑖𝑐𝑒 𝑋 100
If a company has a dividend cover of less than 1, what does this mean?
The dividend in ‘uncovered’
A company does not have the required profits for dividend payments, but they can draw this from reserves.
When must Stamp Duty Land Tax (SDLT) be paid on a property?
HMRC must receive the tax within 14 days
For first time buyers, how is SDLT calculated?
They do not have to pay SDLT on the first £300,000
£300,000 to £500,000 is charged at 5% and anything over is normal SDLT rates
What considerations should an investor make when choosing a buy-to-let property?
Location
Tenants
Investigate local market
Age and condition of property
Diversification
If a company or collective investment scheme purchases a residential property what is the SDLT treatment?
Over £500,000 SDLT is charged at 15% on whole purchase price
What are the SDLT rates on commercial property?
Up to £150,000 - Zero
The next £100,000 (the portion from £150,001 to £250,000) - 2%
The remaining amount (the portion above £250,000) - 5%
What are the conditions to qualify for rent-a-room relief?
Applies to homeowners who let furnished rooms in their only/main residence, and they must occupy the residence at the same time
It does not apply to self-contained units or unfurnished accommodation
What are the conditions to qualify for rent-a-room relief?
Applies to homeowners who let furnished rooms in their only/main residence, and they must occupy the residence at the same time
It does not apply to self-contained units or unfurnished accommodation
How do you calculate yield on a rental property?
𝑔𝑟𝑜𝑠𝑠 𝑎𝑛𝑛𝑢𝑎𝑙 𝑟𝑒𝑛𝑡−𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠
𝑝𝑟𝑜𝑝𝑒𝑟𝑡𝑦 𝑚𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒+𝑏𝑢𝑦𝑖𝑛𝑔 𝑐𝑜𝑠𝑡𝑠 𝑋 100
What is an example of a hard commodity?
Oil, gold, gas
Anything that is a product of mining or another extraction process
How can an individual invest in commodities?
Direct investment is not practical but indirect investment can be achieved by investing in companies that produce commodities, funds that invest in commodities or exchange traded commodities (ETCs)
What type of correlation is needed for maximum diversification?
Negative correlation
What is a financial bubble?
Bubbles occur when investors lose sight of fundamental values (prices are inconsistent with inherent value) and they continue to buy assets expecting the price to increase
The bubble ‘bursts’ when there is a sudden drop in price
How does quantitative easing work?
Bank of England (BoE) creates new money electronically which is used to buy gilts from large financial institutions. Large purchases of gilts push down interest rates, which promotes borrowing and spending.
How can the capacity for technological change be measured in a country?
Can be measured by the proportion of national output devoted to research and development.
How are equities impacted by economic expansion and contraction?
During expansion prices strengthen.
During contraction equites generally fall as interest rates remain higher.
Why is inflation important with regard to fixed interest securities?
With rising inflation capital values of fixed interest securities tend to fall. Purchasing power of fixed interest reduces.
When inflation falls, interest yields fall, and capital values tend to rise.
Why would equities benefit from low interest rates?
Lower interest rates mean cheaper borrowing and higher profits. This generally increases dividends and strengthens share prices.
Modern Portfolio Theory states that you can achieve the best portfolio by the balance of which 2 factors?
It shows investors the best possible return they can expect from their portfolio, given the level of risk they are willing to accept. The higher the level of risk, the higher the level of returns.
What does standard deviation measure?
Measures how much the actual return on an investment varies around its average expected return. The higher this is, the greater the volatility.
What Greek letter is used to denote standard deviation?
Sigma
If the return from an investment is normally distributed, with an average return of 7% per annum and a standard deviation of 2%, what are the probabilities of:
(i) The investment achieving between 5% and 9%
(ii) The investment achieving between 3% and 11%
(i) 68%
(ii) 95%
What type of risk does diversification reduce?
It reduces non-systematic/specific risk.
If two assets have a correlation of 0, what does this mean?
There is no degree of correlation.
Name 2 asset classes that have a negative correlation
Cash and Property. If interest rates are high the returns on cash deposits become attractive, but property investors will be hit by the increased cost of borrow.
Is the Capital Asset Pricing Model (CAPM) a single-factor or multi-factor model?
As it only considers beta, it is a single-factor model.
What does it mean if a security has a beta greater than 1?
If the beta is greater than 1, the security is more volatile than the market and is referred to as an aggressive security.
How can you calculate expected return according to CAPM?
𝐸(𝑅𝑖)=𝑅𝑓+𝐵𝐼(𝑅𝑚−𝑅𝑓)
𝐸(𝑅𝑖) = the expected return on risky investment
𝑅𝑓 = The rate of return of risk-free asset
𝐵𝐼 = Beta
𝑅𝑚 = The expected return of market portfolio
What are the assumptions of CAPM?
Investors are rational and risk averse
Investors only make decisions based on risk and return
Investors all have the same holding period
No individual can affect market price
No taxes
No transaction costs
No restrictions
Information is free and available to all
All investors can borrow and lend unlimited amounts at the risk-free rate
What 2 types of stock tend to beat the market, as discovered by Fama and French?
Small cap stocks tend to outperform large cap stocks
Value stocks tend to outperform growth stock
Why does the Efficient Market Hypothesis suggest it is impossible to beat the market?
Share prices always reflect all the relevant information, they always trade at their fair value, making it impossible for investors to buy undervalued shares or sell shares for inflated prices.
What does the ‘weak form’ of the Efficient Market hypothesis state?
That current share prices fully reflect all past price and trading information and future prices cannot be predicted by technical analysis of the data.
What is the underlying assumption of prospect theory/ loss aversion?
Investors do not act rationally in respect to risk tolerance. They may be much more distressed by a prospective loss than they would be made happy by an equivalent gain.
Give 3 examples of behavioral finance?
Prospect Theory/ Loss aversion: People are more distressed by a prospective loss than their gains make them happy
Regret: Holding onto losing stocks than you should because you don’t want to sell at a loss
Overconfidence: People overestimate their own skill and underestimate bad outcomes
What is the basis of the Arbitrage Pricing Theory (APT)?
Based on the idea that a security’s return can be predicted using the relationship between the security and the number of common risk factors. Each factor is represented by a factor specific beta.
What are 3 limitations of CAPM?
It can be hard to find a totally risk-free return
Beta must be stable for CAPM to work
Beta is calculated using historical data which is not stable over time
The calculation for compound interest is:
𝐹𝑉=𝑃𝑉(1+𝑟)𝑛
What does each component of the calculation represent?
PV – Present value: the amount of capital invested today
n – is the number of time periods that the capital is invested for
r – is the amount of interest earned for each time period
FV – Future value: is the accumulated amount of money
A sum of £11,500 is invested for 9 years, with an interest rate of 8%. The interest is reinvested each year. Calculate the future value.
FV = £11,500(1 + 0.08)9
FV = £22,988.55
When are the terms APR and AER usually used?
APR normally used for loans and AER normally quoted for deposits.
What happens to the EAR if the interest is compounded monthly as opposed to quarterly?
If the interest is compounded quarterly the EAR will be higher.
If a loan has an interest rate of 22%, what would the APR be if interest is applied monthly?
24.36%
An investment had a real rate of return of 5.5% and inflation was 3%. What nominal rate of interest did the investment generate?
8.5%
How can non-systematic risk be eliminated?
Through diversification.
Name 2 examples of systematic risk
Interest rates, inflation, terrorist attacks or war
Anything that that will affect the whole market
What does the CPIH include that the CPI doesn’t?
Owner occupiers’ housing costs.
Investors who hold what type of assets are hardest hit by inflation?
Those with deposit backed investments
Normally cash investments or fixed interest securities (unless the product is index-linked)
What investments tend to provide protection from inflation?
Asset backed investments, i.e. shares in property, infrastructure and commodities.
Known as ‘real assets’
What is the name of the formula that explains the change in the price of a bond in response to a change in interest rates?
Modified duration
e.g. a bond with a duration of 5 years, will move approximately 5% in the opposite direction when interest rates move by 1%
When interest rates rise, what happens to the capital value of fixed interest securities?
They will fall.
What are the 4 types of credit risk?
Default – the risk that an institution will not be able to repay capital or keep up interest payments
Downgrade – when credit rating agencies downgrade an issuer/bond
Counterparty – risk that a 3rd party involved in the transaction will default on their obligation
Credit spread – reflects the difference in yield between a gilt and a corporate bond of the same maturity
Describe bail-in risk
Instead of governments or central banks bailing out financial institutions that are in trouble, it falls on the shareholders and depositors.
What type of risk might private equity be exposed to?
Liquidity risk
An administrative error would be considered what type of risk?
Operational risk
What is the definition of stagflation?
Combination of stagnant growth and inflation
What is the Investment Association (IA) responsible for?
They categorise funds into sectors. These sectors are divided into broad groups with different investment focuses.
What percentage of a fund’s holdings must be in a particular sector for it to be a sector fund?
80%
What are the 2 FCA Sourcebooks called that cover collective investments?
COLL – Collective Investment Schemes
FUND – Alternative Investment Funds
Who can non-mainstream pooled investments (NMPI) be marketed to?
Sophisticated investors and high net-worth investors.
What are the diversification rules for unit trusts and OEICs?
Minimum of 16 shareholdings:
4 holdings of maximum 10% of the fund
12 holdings of maximum 5% of the fund
Funds that replicate a tracker fund can hold 20% of the fund in the shares of one company (35% in exceptional circumstances)
Funds that invest more than 35% in gilts must have at least 6 different issues. No single stock can exceed 30% of the fund value
What is the name of the directive that created passporting of securities across EU capital market?
EU Transparency Directive
Who legally protects the assets in a unit trust?
Trustees
What is the capital gains tax rate for a higher-rate tax payer realising a gain from a unit trust?
20% - Consider CGT allowance
If an investor receives a distribution from an equity fund, how is this taxed?
Income is taxed according to their dividend rate. There is a £2,000 dividend allowance. Above this, taxed as follows:
Basic rate taxpayer will pay 7.5%
Higher rate taxpayer will pay 32.5%
Additional rate tax payer will pay 38.1%
How are trustees taxed on dividend income within a discretionary trust?
They are taxed at the highest rate of 38.1% and are not entitled to the £2,000 dividend allowance, but any dividends that fall within the standard rate band for trusts of £1,000 are taxed at 7.5%.
If an investor receives an interest distribution, how is this taxed?
Interest distributions are paid gross, so it is taxed at the investors marginal rate of income tax and they can use their Personal Savings Allowance.
Basic rate taxpayer: £1,000
Higher rate taxpayer: £500
What percentage of a fund’s assets must be in fixed interest securities for distributions to be classed as interest distributions?
60%
What is bed and breakfasting?
Selling units and buying back the next day to avoid changing units, used to realise gains or losses.
How often must the net income of a unit trust be allocated to unit holders?
Annually at minimum
An equalisation payment is included when investors first purchase new units, what is the purpose of this?
The equalisation payment is a partial return on the amount paid by the investor as they bought units at a higher price (the units included accrued income).
What are the 2 types of units available to investors in a unit trust?
Income & Accumulation
What is the ex-dividend (xd) date?
The cut-off point for an investor to be entitled to the next distribution of income.
What must an investor be supplied with before a purchase can be executed, with regard to a unit trust?
Key Investor Information Document (KIID)
What does a share exchange facility allow a new investor to do?
They can exchange existing shareholdings in public companies for an equivalent value in the fund’s units
Fund manager has the option to sell these or absorb theme into the fund
What are the 2 components of dual-pricing?
Investors buy units at the higher offer price
Investors sell them back at the lower bid price
What is the difference between the buying and selling price referred to?
Bid-offer spread
If a unit trust manager deals on a forward basis, what does this mean?
When the price is calculated at the next valuation point.
What’s the difference in marketing rules with retail and non-retail UCITS?
A retail UCITS can be market to all UK investors and EU passport holders
A non-retail UCITS can only be market to UK investors
Who is responsible for maintaining the register of shareholders in an OEIC?
Authorised Corporate Director (ACD)
Name 3 things that the depository is responsible for in an OEIC
Overseeing the management
Ensuring the ACD acts correctly
Collection of income
Authorising distributions
Safekeeping of assets
What price is used if a fund uses single-pricing?
The mid-market price of the underlying investments
What does it mean if a fund of funds is ‘fettered’?
‘Fettered’ fund can only invest in funds ran by the same management group.
What is a manager of manager’s fund?
The fund manager appoints external specialist managers who each have their own management style and have a segment of the portfolio to manage.
The FCA recognises some off-shore funds that can be marketed within the UK. How can these off-shore funds be categorised?
UCITS
Funds in designated territories
Funds from outside designated territories (recognised in their own right by FCA)
What is a reporting fund?
One in which dividends and interest are treated the same as a UK-based fund and normal rules apply for CGT. They do not have to distribute all the income, but it must be reported to HMRC.
What is a non-reporting fund?
Gains on disposal are calculated using CGT principals but the gain is taxed as income therefore the CGT allowance cannot be used.
The fund is not completely tax free, dividends received on equity investment will often be subject to a non-reclaimable withholding tax.
What was the purpose of the European Savings Directive 2005?
Allows for the automatic exchange of information between member states on savings income paid to EU residents.
The main purpose is to stop tax evasion.
Investment trust companies have a fixed capital structure. What is a major advantage of this structure over that of a unit trust?
Investment managers can take a long-term view with their investments and do not have to sell their holdings if investors need their cash back.
How do you calculate the Net Asset Value per Share (NAV)?
Divide the shareholders fund by the number of shares in issue
The shareholders fund is the total of the fund’s assets less any liabilities
What does the diluted NAV figure of an investment trust take into account that the undiluted figure does not?
It assumes that all warrants and convertible loan stock that can be converted into ordinary shares have been converted
What do investment trust companies often do when their shares are trading at a large discount?
They buy their own shares back (a share buy-back) which helps to narrow the discount
What 3 sets of regulations must investment trust companies adhere to?
Companies Act 2006
FCA
HMRC
Investment trusts can have a conventional capital structure and a split capital structure, what is the difference?
A conventional structure: one main class of shares is issued, ordinary shares
Split capital: different classes of shares that are ranked in priority of payment
Why is a negative hurdle rate a good thing with a split capital investment trust?
It means the investments could fall by that amount each year and still be able to repay all classes of shares
What is a warrant and how can they be used to attract investors to a new investment trust?
A warrant is the right to buy shares at a fixed price at a predetermined date, the warrant price may only be a fraction of the share price
Investors in a new investment trust have to pay the NAV and launch costs; however, shortly after the shares often trade at a discount, so the trust may offer 1 warrant for every 5 shares purchased to encourage new investment
How do you calculate gearing?
𝑡𝑜𝑡𝑎𝑙 𝑔𝑟𝑜𝑠𝑠 𝑎𝑠𝑠𝑒𝑡𝑠
𝑛𝑒𝑡 𝑎𝑠𝑠𝑒𝑡𝑠 𝑥 100
When would an adviser usually have to issue a risk warning?
When the trust is financially geared over 30%
What are the chargeable events for a non-qualifying policy?
Death
Maturity
Full encashment and some partial surrenders
Assignment for money or money’s worth
When must the life office issue a certificate to HMRC regarding a chargeable gain?
When the gain exceeds half of the basic rate income tax band
How much of the original investment can be withdrawn without attracting an immediate tax liability?
Up to 5% of original investment can be withdrawn each year (for a maximum of 20 years) and works on an accumulative basis
5% withdrawals do not mitigate tax liability, they simply defer it
At maturity or death, how is the chargeable gain calculated?
(final proceeds + previous withdrawals) – (original premium + chargeable excess)
What is top slicing?
Should a gain cause an individual to move from a basic rate band to the higher rates they can benefit from top slicing relief
This divides the gain by the number of years the investment has been held. For partial withdrawals the gain is only divided by the number of years since the last chargeable event. On final encashment/death, the gain is divided by the total number of policy years
What is segmentation of a life policy?
The process of splitting the policy into lots of mini policies, allowing each of the policies to be surrendered individually
If a conventional with-profit policy is performing well how is this reflected onto investors?
Annual bonuses are added to the value of the policy. It is not guaranteed but once paid it cannot be taken away
Outline the process of smoothing with regard to with-profit policies
When profits are rising, the life office holds back some of the profits to boost the profits in bad years
When does a market value reduction (MVR) not normally apply?
On death or maturity
What is a unit-linked policy?
A policy in which a percentage of the premium is used to buy life cover and the rest is used to buy units in a fund of the investor’s choice
Value of the policy is measured by the total value of the units in it, which are determined by the performance of the fund
What is the concept of pound cost averaging?
This only applies to regular premium contracts. When prices are low, the premium paid can buy extra units
The saver will receive a better return if prices are low for a long period then rise before the policy is encashed
What is an investment bond?
This is a non-qualifying single premium (lump sum) life assurance policy
They are primarily investments with only nominal life cover (101% of the value of units)
Single life or joint life
Why do investment bonds work well as trust investments?
Suitable option for long-term capital growth and they don’t create any true income (no taxable income) and reduce the administration burden of the trustees.
What are the 5 main types of investment bonds available?
Guaranteed income bond: guaranteed income, return of capital
High income: derivative based, high level of income, no guarantee of return of capital
Guaranteed growth: no income, guaranteed capital growth
Distribution bond: income reflects income generated by the fund, maximum equity content of 60%
Guaranteed equity bond: guarantee linked to stock market index
How does the tax treatment differ between an onshore bond and an offshore bond?
Onshore bonds pay tax of 20% on income and gains therefore basic rate is deemed to paid in the fund and satisfies basic rate liability. For higher rate/additional rate taxpayers, a gain is taxed at the difference between the basic and higher rate/additional rate (20% & 25% respectively).
With an offshore bond, policy holders are liable to income tax as their highest rate on their whole gain.
If a chargeable gain arises from an investment bond that is held as a trust investment and the individual who created the trust is dead or no longer a UK resident, what is the tax treatment?
If at least one of the trustees is a UK resident, the trustees are liable for the tax charge. They would not benefit from top slicing relief and would be charged 45% on any income above the trusts standard rate band and 20% for income within the standard rate band.
If a non-qualifying policy is sold on the second-hand market within the 10-year period, will there be a chargeable gain?
Yes, if the sale price exceeds the total premiums paid.
What is the tax treatment for Friendly Society Policies?
The friendly society does not have to pay income or capital gains tax on their investment returns; however, premiums are limited to £25 per month or £270 per year if paid annually.
If an exchange traded fund (ETF) uses derivatives, what is this known as?
Synthetic replication
What is the tax treatment on an ETF?
Dividend payments are subject to income tax as normal and CGT applies on any gains
What is an exchange traded note (ETN)?
Unsecured bonds issued by banks, the performance tracks an index using derivatives
List 4 ways of investing in property
Direct investment
Buy shares in listed property companies
Property collective funds
Insurance company property funds
Property Authorised Investment Funds (PAIF)
Offshore property companies
Real Estate Investment Trusts (REIT)
What are the requirements of a Real Estate Investment Trust (REIT)?
Must be a closed ended company
UK resident
Listed on a stock exchange (including AIM)
Must have low gearing (rental income must not exceed 125% of interest borrowing)
75% total profits must come from ring-fenced element
75% total assets must be in ring fenced section
90% of ring-fenced income must be distributed
CGT on sale of shares
What are the tax features of a REIT?
Ring-fenced property business: exempt from corporation tax and payments are paid net of 20% income tax (treated as property income)
Non-ring-fenced activities: subject to corporation tax, produces dividend income for the investor
What are the main ways to invest in private equity?
Venture Capital Trust (VCT)
Enterprise Investment Scheme (EIS)
Seed Enterprise Investment Scheme (SEIS)
What is the income tax relief given on a VCT, EIS and SEIS?
VCT: 30% on first £200,000
EIS: 30% up to £1,000,000 (£2,000,000 for knowledge intensive companies)
SEIS: 50% on first £100,000
How long must an EIS or SEIS be held to qualify for 100% business relief inheritance tax?
2 years
Income tax relief will be withdrawn from an EIS if the shares are not held for how long?
3 years
Name 5 conditions that must be met for an EIS
Investor must not be connected with the company
Qualifying company must be unlisted
Fewer than 250 employees or 500 if knowledge intensive company
Gross assets must not exceed £15,000,000 before the issuing of shares or £16,000,000 after
Company must not have raised more than £5,000,000 under a Venture Capital Scheme in the previous 12 months (£10,000,000 if KI) and no more than £12,000,000 in the company’s lifetime (£20,000,000 if KI)
What is the purpose of an Individual Savings Account (ISA)?
Officially classed as a tax wrapper, that allows investment products to be held within it. Gives the investor tax free income and gains
What are the ISA rules for a 16-year-old UK resident?
They can pay the maximum into a JISA (£9,000) and a cash ISA (£20,000), giving them an annual limit of £29,000.
What is the £100 rule with regard to young investors?
If an investor is aged between 16-17and the deposits made with the parent’s assets, any interest arising from this that exceeds £100 per year is classed as the parent’s income for tax purposes.
Between what ages can you invest in a Lifetime ISA?
18-40 capped at £4,000 per year
What happens to an ISA if the investor becomes a non-UK resident?
They can keep the ISA and the tax benefit; however, they cannot make any further investments into it.
Name 5 eligible investments in an ISA
Listed shares
Corporate bonds
Gilts
Unit Trusts/ OEICs
REIT
Investment Trust
Shares from employee schemes
Life policies
How long should an ISA transfer take?
15 working days for a cash ISA and 30 working days for any other type of ISA.
What are the two elements of a purchased life annuity?
Capital element: tax free (return of original capital)
Income element: taxed as savings income
What is a financial future?
A legally binding contract to buy or sell an asset at a specified future date at a price that is agreed when the contract is made.
What is meant when buyers of futures are said to have the ‘long position’?
They expect prices to rise
They have an obligation to buy the asset at the agreed price
What is the variation margin?
An initial trade of a purchase or sale opens a client’s position and the contract is made. An initial margin is deposited with an independent 3rd party, this acts as collateral.
Open positions are revalued daily, this takes into account any movement in the price of the contract. Any profits or losses are paid and received daily within the depository account. These profits and losses are referred to as the variation margin.
What is a financial option?
Contracts that give the buyer the right but not the obligation to buy or sell the underlying asset at some future time at an agreed price.
The option fixes the price.
What’s the difference between a call option and put option?
Call options give the owner the right to buy the underlying share at a predetermined price, known as the exercise/strike price (this will not change no matter how high the shares subsequently go)
When will a call option and a put option be ‘in the money’?
Call options will have an intrinsic value if the value of the underlying asset is above the strike price.
Put options will have intrinsic value in the value of the underlying asset is below the strike price.
When the strike price is equal to the asset price, what is this referred to?
‘At the money’
How can a fund manager who expects the market is about to drop offset any losses?
They could sell FTSE 100 futures and any profit can offset the losses on the fund.
What is the tax treatment of derivatives?
Profits of both future and options are chargeable to CGT unless the investor is classed as a trade, then their profits will be classed as income.
There is no CGT to pay if the underlying asset is a gilt or a qualifying corporate bond.
What are the 4 categories of hedge funds?
Long/short funds
Relative value funds
Event driven funds
Tactical trading funds
What is the objective of an absolute return fund?
To make a positive return in all market conditions by using derivatives.
What 2 components might a structured product typically contain?
Zero coupon bond: capital guarantee element
An OTC call option: provides a potential return on an index
What are the benefits of using a structured product?
Wide range of underlying asset combinations available.
No exposure to a fund manager’s style or ability.
The amount an investor can lose, or gain will be explicitly stated.
What is the difference between a hard and soft fact?
A hard fact is a verifiable fact (e.g., name, age salary, marital status)
A soft fact is opinion based (e.g., ethical views, family values)
What is strategic asset allocation?
Strategic asset allocation is creating an asset mix that will provide the optimal balance between risk and return for a long-term investment horizon and will only be adjusted in extreme conditions or if the client’s circumstances change.
What is tactical asset allocation?
Tactical asset allocation works on the basis of having asset allocation models that give a range for the amount of capital in each asset class. If the range given for equities is 40-50%, then any deviation from the central 45% is seen as a tactical move by the adviser to take advantage of short-term movement in the market.
What are the 3 elements that need to be considered when establishing a risk profile?
Attitude to risk: what is the client’s understanding of risk
Tolerance to risk: a client’s willingness to accept fluctuations in their investments
Capacity for risk: ability to absorb any financial losses
What is positive screening?
Involves investing in companies that have a responsible approach to business practices, products or services, e.g. companies that only use renewable energy.
What is negative screening?
Involves not investing in companies that do not meet certain ethical criteria, e.g. companies that carry out animal testing or are involved in arms manufacturing.
What is meant by mental accounting?
When a client might have different attitudes to risk in respect of each of their objectives.
What is the next step in the advice process after establishing a risk profile?
Formulating the investment strategy for asset allocation. This sets out the proportion of capital to invest in each asset class to generate a portfolio that needs the needs of the client.
When an adviser is selecting funds, what different things should they consider?
Funds objectives
Costs and charges
Management group
Performance of fund manager
Type/ structure (unit trust/ OEIC etc.)
What is a ‘churn’?
Involves rebalancing a client’s portfolio with the sole intention of generating fees. This is highly prohibited.
Outline the difference between passive and actively managed funds
Passive funds tend to track an index whereas actively managed funds require a ‘hands on’ approach with frequent buying/selling decisions in order to try and beat the market.
Active funds usually have higher management fees.
What are the three main types of Sharia-compliant funds?
Ijarah funds
Equity funds
Commodity funds
MiFID II requires firms to provide investors with a full breakdown of costs. What 4 sections are these broken down into?
Ongoing
One-off
incidental
Transaction
What is a discretionary management service?
As part of the investment proposal the adviser can recommend the placement of some/all the client’s capital to be invested in a 3rd party service. This means that buying/selling decisions are made by a portfolio manager on behalf of the client.
At what stage should the tax wrapper be chosen?
Investments should be chosen on the basis of risk and return, tax should never influence the asset allocation decision. Therefore, choosing a tax wrapper is the final step before presenting recommendations to the client.
Clients can hold their products on a platform, how are they now charged for this service?
Using a platform imposes a single fee across all accounts and has transparent costs. Since 2014 the FCA imposed that charges for platforms should be paid separately and directly to the platform.
Under MiFID II what is the minimum frequency for periodic reporting to investors?
Every 3 months
Advisers must also communicate to their clients if their portfolio falls by 10% over a single reporting period.
What are the reasons for rebalancing a portfolio?
Rebalancing occurs as a result of the review process. It is normally required if variations in returns cause significant changes to the portfolio and the portfolio needs to be brought back to the correct asset allocation mix.
What 4 main categories can investor objectives be summarised into?
Capital preservation
Capital appreciation
Income
Total return (income and capital appreciation)
List the constraints than an adviser must consider when producing recommendations
Timescales
Liquidity
Tax
Legal and regulatory factors
Unique needs and preferences
What did the Barclays Equity Gilt Study 2016 suggest about risk?
That the longer an investor has, the greater the risk they can take.
What are the MSCI WMA Private Sector Indices?
A set of calculations that indicate the returns that an investor might expect from their portfolio. These can be used as a benchmark for comparing the performance of discretionary fund managers and similar funds.
What are the 2 main approaches to asset allocation?
Theoretical
MPT uses mathematic analysis to obtain the desired risk/return trade-off, creating the optimal portfolio based on historical returns and using negatively correlated assets to reduce volatility. It is backwards looking
Pragmatic
Uses subjective forward-looking judgements about what is likely to happen in the future to determine how the portfolio should be weighted. This may be subject to bias
What is stochastic modelling?
Modelling that uses probabilistic methods to establish the ranges within which returns may fall over a future period
It takes an initial set of assets and assumes that their behaviour will be affected in a specific way by a change in one variable (e.g. interest rates)
What is the top-down approach to portfolio construction?
Involves looking at the ‘big picture’ first. Start by determining asset allocation, then allocate geographical distribution and chose sector weighting. Finally select the appropriate funds or stocks considering ethical considerations.
What is the bottom-up approach to portfolio construction?
Involves searching for individual investments based on their own characteristics (e.g. a company is a good takeover target), with less consideration given to the economy and market.
Outline each of the 4 main fund management styles?
Value: fund manager buys shares when their value is greater than the price placed on them by the market.
GAARP: fund manager finds companies that have a longer-term sustainable advantage, and is worth paying a reasonable price for quality characteristics.
Momentum: fund manager uses the theory that, in equity markets, there is a tendency for good and bad performance.
Contrarianism: fund manager believes that the common opinion is usually wrong and higher returns can be achieved by going against trends.
What is holding period return?
The total return you achieve from the change in the value of the asset and the income you receive.
What is the difference between Money Weighted Return (MWR) and Time Weighted return (TWR)?
MWR is strongly influenced by the timing of cashflows (when you put money in and when you take money out)
TWR ignores the timing of cashflows and thus eliminates the distortions around the timing of new money; it just considers the performance of the portfolio over time. This can be used to compare fund managers with each other
What are risk-adjusted returns and what is the purpose of using such calculations?
Risk-adjusted return is a performance measure, a calculated number that tells you how well the investment has performed but it also considers how much risk you took to achieve that return.
What are the 3 ways to measure risk-adjusted returns?
Sharpe ratio
Alpha
Information ratio
What is the sharpe ratio used for?
This ratio measures excess returns for every unit of risk and therefore it can be used to compare investments to see which gave the best return for a given amount of risk.
The higher the Sharpe ratio, the better the risk-adjusted performance has been, i.e., the investor has received a higher return for the level of risk.
How is the sharpe ratio affected if the standard deviation increases?
If the level of risk (i.e. standard deviation) increases, that means your risk adjusted return will decrease.
It means an investor has taken more risk to achieve the same return.
What does alpha look at?
It looks at the difference between the return you would have expected from a security, given its beta, and the return it actually achieved.
What is the information ratio?
It shows the consistency with which the manager beats the benchmark.
What 4 factors does performance evaluation asses?
Asset allocation
Stock selection
Market timing
Risk
