READ 6.10.6 Chapter 6 – (22 exam questions. 15 standard, 7 multi) Characteristics Risks Behaviours And Tax Considerations Of Investment Products Flashcards
What is the phrase ‘pooled investments’ another name for?
Collective investments
Each investor has direct investment in the scheme that holds and manages the underlying assets within it and owns their proportion of the units (in the case of unit trusts) or shares (for OEICs) within the fund.
The advantages of investing in collective investment schemes are:
No need for investment expertise
diversification
reduced dealing costs
wide choice of options
Tell me about each in more detail
investment expertise: There is no need for the investor to know the market, as the investment company will do this for them.
diversification: The company will spread the client’s money across many different assets, aligning this to their risk profile.
reduced dealing costs: Because a company can buy ‘in bulk’, the individual will have reduced direct costs, such as stamp duty and commissions.
wide choice of options: Most collective investments have several investment options available. The client’s financial adviser will help them choose, and the product can be structured to provide capital growth, income or both.
What are Unit trusts and OEICs
they are both types of collective investment schemes
Definitions to be aware of
What is the general feature that unit trusts and OEICs share by their nature of being collective investments?
What do investors receive in exchange for pooling their money in unit trusts and OEICs?
Who holds the underlying assets in the ‘pool’ for a unit trust?
Who holds the underlying assets in the ‘pool’ for an OEIC?
Who is responsible for the day-to-day buying and selling of the ‘pooled’ assets in unit trusts and OEICs?
What is the general feature that unit trusts and OEICs share by their nature of being collective investments?
Both unit trusts and OEICs involve investors pooling their money together to collectively invest in a diversified portfolio of assets.
What do investors receive in exchange for pooling their money in unit trusts and OEICs?
Investors receive ownership of units (in unit trusts) or shares (in OEICs).
Who holds the underlying assets in the ‘pool’ for a unit trust?
Unit trusts are held in trust so the underlying assets in the pool for a unit trust are held by the fund trustees.
Who holds the underlying assets in the ‘pool’ for an OEIC?
The underlying assets in the pool for an OEIC are held by an independent depositary.
Who is responsible for the day-to-day buying and selling of the ‘pooled’ assets in unit trusts and OEICs?
For both the day-to-day buying and selling of the pooled assets are done by a fund manager.
Both unit trusts and OEICs have an element of investor protection.
Tell me how
Are both products regulated?
With unit trusts, investors are protected by trust deed and the trustees acting on their behalf (remember that unit trusts are held in trust)
With OEICs investors are protected by an independent depository and therefore company law
Both regulated products so are also protected by the regulator
Both are protected by the FSCS for up to 100% of their investment, capped at £85,000, if the fund provider becomes insolvent.
Both OEICs and Unit Trusts are regulated products. What does this mean in terms of investment protection?
Since both are regulated products they are protected by the regulator
Therefore, both are protected by the FSCS for up to 100% of their investment, capped at £85,000, if the fund provider becomes insolvent
Are unit trusts open ended
Are OEICs open ended
What does this mean?
Both are open ended so there is no cap on the number of units (for unit trusts) or shares (for OEICs) that can be created by the fund manager
Due to being open-ended both unit trusts and OEICs always trade at their Net-Asset Value
What does this mean?
It just means that at any one time, the total value of everyone’s shares/units added together must match the total value of the assets the fund holds.
With both unit trusts and OEICs, all deals are conducted directly with the firm that offers the fund and there is no secondary market for them.
True or false
True
How are deals conducted for unit trusts and OEICs, and is there a secondary market for them?
How are funds categorized to help investors easily select them?
How many sectors exist for categorizing unit trusts and OEICs, and what criteria are used for grouping them?
Who determines the sectors for unit trusts and OEICs, and how is this process conducted?
What is the general rule for a fund’s inclusion in a particular sector?
What criteria must a fund meet to qualify as an income fund?
How often are the sectors reviewed, and what factors prompt these reviews?
How are deals conducted for unit trusts and OEICs, and is there a secondary market for them?
All deals for unit trusts and OEICs are conducted directly with the firm that offers the fund, and there is no secondary market for them.
How are funds categorized to help investors easily select them?
Funds are categorized into sectors in a similar way to shares, allowing investors to easily select them based on criteria such as geography and asset distribution.
How many sectors exist for categorizing unit trusts and OEICs, and what criteria are used for grouping them?
There are over 35 sectors for categorizing unit trusts and OEICs, grouped by their geography, asset distribution, and other relevant criteria.
Who determines the sectors for unit trusts and OEICs, and how is this process conducted?
The sectors are determined by the Investment Association (IA)
What is the general rule for a fund’s inclusion in a particular sector?
To be included in a particular sector, a fund must have 80% or more of its assets invested in the relevant sector.
What criteria must a fund meet to qualify as an income fund?
To qualify as an income fund, the fund must aim to produce a yield of not less than 90% of the relevant index.
How often are the sectors reviewed, and what factors prompt these reviews?
The sectors are regularly reviewed in light of new funds and market change
NOTE: When considering fund choice, each sector has its own risk profile, and all the funds within each sector will have slightly different risks when compared with their peers. As mentioned, to be included into a sector the fund must satisfy the IA criteria.
What is the primary goal of index tracking funds?
What does the full replication method of index tracking involve?
Why might full replication not be possible for smaller funds?
There are 3 types of index tracking. What are they?
What is stratified sampling in the context of index tracking funds?
Why do some funds use stratified sampling instead of full replication?
What is the optimisation or synthetic method of index tracking?
How does the optimisation or synthetic method differ from full replication in terms of tracking an index?
What are the cost implications of using the optimisation or synthetic method for index tracking funds?
REMEMBER: A ‘fund’ is just another name for a collective investment scheme
What is the primary goal of index tracking funds?
To align their performance as closely as possible to the performance of a selected index.
What does the full replication method of index tracking involve?
The ‘full replication method’ involves the fund fully replicating the index it is tracking by actually owning the shares in proportion to the index.
Why might full replication not be possible for smaller funds?
Full replication might not be possible for smaller funds because they may not have sufficient assets to own all the shares in proportion to the index.
The 3 types of index tracker are:
Full replication
Stratified sampling
Optimisation / Synthetic
What is ‘stratified sampling’ in the context of index tracking funds?
Stratified sampling is a method where the fund holds a sample of the stocks within an index instead of fully replicating it, due to insufficient assets. It is used by smaller funds
Why do some funds use stratified sampling instead of full replication?
Because they do not have sufficient assets to replicate the entire index.
What is the optimisation or synthetic method of index tracking?
The optimisation or synthetic method involves the fund buying and selling stocks in an index using a computerised model to track a selection of the index’s weightings.
How does the optimisation or synthetic method differ from full replication in terms of tracking an index?
The optimisation or synthetic method differs from full replication as it does not aim to track all the selected weightings of an index but rather a selection, through a computer model, making it less precise but more cost-effective. (Uses computers)
What are the cost implications of using the optimisation or synthetic method for index tracking funds?
The optimisation or synthetic method is the cheapest form of index tracking because it uses a computerised model and does not require the fund to own all the stocks in the index.
There are 3 types of index tracker:
What are they?
Full replication
Stratified sampling
Optimisation / Synthetic
What are the pros and cons of index tracking funds?
One of the theories discussed was the Efficient Market Hypothesis (EMH).
Why would those who believe in the strong form EMH always use index tracking?
I
Individuals that believe in the strong form of EMH would only use index-trackers, as opposed to actively-managed funds, as they believe all available information is reflected in the market and fund prices
Ethical funds are now more popular
Who do ethical funds differentiate themselves?
NOTE: R02 exam questions are common here. Make sure you fully understand these three ethical approaches.
They differentiate themselves through different types of ‘screening’ (how they choose ethical investments)
There is:
Negative Screening
Positive Screening
Neutral approach
When choosing an ethical fund, as well as looking at how the fund is screened, whether positive, negative or neutral, the investor may also look at ESG?
What is ESG?
To be marketed in the UK, a fund must be authorised by the FCA.
There are 3 types of authorised fund What are they?
(The type that they are simply just changes whether they are allowed to marketed in the EU as well as the UK or not).
UCITS schemes
They can be marketed across the EU as well as UK. They have an EU passport
Non UCITS - retail schemes
They cannot be marketed across the EU. Can only be marketed in UK
Qualified Investor Schemes
They can only be marketed to professional investors
UCITS = ‘Undertaking for Collective Investment in Transferable Securities’ - This is an EU directive
To be marketed in the UK, a fund must be authorised by the FCA. There are 3 types of authorised funds in the UK. One type can be marketed in the EU, the other can only be marketed in the UK and one can only be marketed to professional investors
UCITS schemes are one of them. This is the type that is allowed to be marketed freely in the EU as well as the UK. To be marketed in the UK however, the FCA state that they must be ‘sufficiently diversified’
To be classed as sufficiently diversified, and therefore be authorised by the FCA, what rules must the fund adhere to? In relation to this question and the rules, why is the minimum number of holdings that a UCITS scheme must have is 16 - what is the math behind it?
LOOK AT IMAGE ON LEFT AFTER LOOKING AT RIGHT IMAGE
SEE IMAGE ON LEFT
In relation to gearing, what are the 3 types of authorised allowed?
Retail UCITS schemes - Can borrow a max of 10% of the value of the fund for a short term and not permanently and only if there is known future cash inflows that can fund it.
Non-UCITS schemes - Can borrow up to 10% as well, but allowed to on a permanent basis.
Qualified Investor Schemes - Can borrow freely, up to 100% of net asset value
As well as there being the 3 types of regulated funds, there are also unregulated schemes.
What are these unregulated schemes called by the FCA?
The FCA call them Unregulated Collective Investment Schemes (UCIS). They can not market themselves in the UK as they do not have FCA authorisation. ( remember there are only 3 types of authorised funds)
DO NOT CONFUSE UCIS WITH UCITS BECAUSE THEY SOUND SIMILAR
UCITS
A scheme that satisfies the EU UCITS directive. Once approved, the fund can market itself across the EU to retail clients as well as the UK.
UCIS
An unregulated scheme. It cannot market itself in the UK or to retail clients.
The FSCS can pay compensation, or order compensation to be paid by a firm, if you lose money because of:
Complete. Do True or false for all statement
Bad or misleading investment advice,
Negligent management of investments
Misrepresentation, or fraud,
The firm concerned has gone bust and cannot return your investment or money owed.
Investments preforming less than desired or anticipated
True for first 4
False for last 1
All the above flashcards were characteristics of OEICs and Unit Trusts
They are very similar but obvs not the same so be careful not to mix up
What are unit trusts?
A collective investment set up under trust.
The fund is split into units, and this is what investors buy. The units represent the underlying investments
They are open ended
The price of each unit depends on the net asset value (NAV) of the fund’s underlying investments. (ie, all units in the fund are at any one point the same value as all the underlying investments)
The trustees holds the trust assets on behalf of the unit holders and a fund manager is responsible for the day to day running of the fund
A unit trust is set up under trust where trustees hold the trust assets on behalf of the unit holders and a fund manager is responsible for the day to day running of the fund
Tell me about both roles in more detail. For example, who they normally are, their responsibilities in more detail and their obligations
LEFT IMAGE IS DETAILS ABOUT THE MANAGERS AND THE RIGHT IMAGE IS DETAILS ABOUT THE TRUSTEES
All unit trusts must hold a register of unit holders. This is an FCA requirement.
What info do the registers contain?
If a unit holder wants to see the unit register can they be refused?
The register contains:
Each unit holder’s name and address, each unit holder’s unit holding and the date on when the unit holder was registered.
If a unit holder asks to see the register, they must be allowed access at any time, free of charge. It can ONLY be refused if the register is closed due to undergoing maintenance. The max it can be closed is 30 days per year.
How are unit holders protected. ie, how can they make complaints, what stops a fund manager going rogue and what statute protected them
Trustees of a unit trust have decided that a fund manager should be removed. Is this allowed?
Yes. Because it is a material change to the fund it must be approved by unit holders before the trustee requests it and
removing a manager must also be approved by the FCA.
How are unit trusts taxed from the unit holders perspective?
Depends on whether the unit trust is classed as an equity fund or a non-equity fund
For equity trusts income is treated as dividends so income tax is payable at dividend rates 8.75%, 33.75% or 39.35% depending on tax bracket. They must also exceed the dividend allowance
For non equity trusts income is treated as interest so income tax is payable at saving rates 20%, 40% or 45% depending on tax bracket that the investor falls in. They must also exceed their saving allowance
Unit trusts can be classed as an equity trust or a non equity trust (interest bearing)
An equity fund is one that has less than 60% of its assets in interest-bearing securities. Income received by unit holders is treated as dividends
If a fund has 60% or more of its assets in interest-bearing securities, it is deemed a non-equity fund. Income received given to unit holders is treated as interest
Therefore, there are tax differences for the unitholders depending on what the fund is classed as
What is ‘franked income’?
Franked income refers to income that has already had tax paid on it at a corporate level before it is distributed to shareholders or investors. This term is often used in the context of dividends paid by companies.
This typically happens in unit trusts
This shows the income tax liability on the unit holders of equity funds (Where the income distributed to unit holder is treated as dividends)
The following table looks at the taxation of this £200 in the hands of various investors. It assumes no dividend allowance is available.
This shows the income tax liability on the unit holder of a non equity fund (where the income distributed to the unit holder is treated as interest)
What are equalisation payments in relation to unit trusts?
When an investor buys units, the price they pay includes the right to income that has accrued in the fund from the previous distribution date up to the date of purchase, i.e. income from the time they didn’t hold the units!
Authorised unit trusts do not pay any internal capital gains. The fund itself is CGT free
However, the unit holder may be subject to CGT when they dispose of their units.
Left image shows how it is calculated
How CGT works
Capital gains sit on top of the investor’s other income.
In this example:
Gain 1 will all be taxed at 10%.
Gain 2 would be part taxed at 10%, part at 20%.
Gain 3 would be all taxed at 20%.
So, an individual with a small amount of income and a large gain could pay CGT at
both rates.
CGT rates
CGT also has an annual exemption of £6000
How to calculate CGT for unit trusts
What is ‘bed and breakfasting’ ?
Where individuals would sell their shares one day, to ‘use’ their CGT allowance, and then buy them back the next day.
This would allow them to dispose of the asset to ‘realise’ gains up to their unused allowance, thereby re-setting the acquisition value at the new purchase price.
Now any sale and re-purchase of shares within 30 days is ignored in a CGT calculation. It’s as if the sale and re-purchase didn’t happen
There are different types of units available in unit trusts. What are they?
1- Accumulation units.
Where all income produced is reinvested back into the investor’s holding. The unit price increases to reflect the retained income.
- Income units/distribution units.
Pays out any income to the investor.
NOTE: If you have two funds starting at the same price but one has accumulation units and the other has income units/distribution units, as time goes by the Income units will have a lower unit price than accumulation units. This is because each non-distributed income is re-invested back into fund which increases the unit price
Can you have unit trusts within an ISA?
Unit trusts are eligible for inclusion in an ISA
The benefit of linking these to an ISA is the exemption of CGT on any realised gains:
The full ISA allowance can be invested in qualifying unit trusts within a stocks and shares ISA.
Virtually all unit trusts qualify for ISA wrapping.
All UCITS schemes qualify.
There are generally no extra charges for investing in a unit trust ISA than in a non-ISA unit trust.
unit trusts can be held in joint names
True but ones but ISA unit trusts cannot
When an investor wishes to sell (dispose of) the units how long does the manager have to action to request and provide the payment
The manager must make payment within 4 days after the receipt of signed documentation.
Each unit in a unit trust represents a proportional share of the property of the scheme. The valuation of units is achieved by:
Taking the value of the underlying assets and then adjusting for income and charges and then dividing this amount by the number of units.
Units are quoted under dual-pricing or single-pricing regulations. Tell me the difference
Dual pricing:
Units have a different price to buy and sell. An investor in a dual-priced scheme buys units at the offer price (which is higher) and sells at bid price (which is lower) - the difference is called the bid/offer spread and represents charges that must be paid back.
Single pricing:
Uses mid market rates. Charges are declared and repaid separately
What is offer price and bid price in relation to unit trusts
This is only applicable to unit trusts that are ‘dual priced’
Offer price - what the investor buys the units for. This is higher than the bid price
Bid price - The price that the investor sells the units for. This is lower than the offer price
Different funds have different Bid/offer spreads as they have different charge amounts that are being accounted for. See image
Remember: ‘offer to buy’ and ‘bid to get rid’.
Unit trusts are open ended. Explain this.
It means a manager creates new units to sell to new investors and cancels units when investors want to cash them in. The number of units that can be created is unlimited
Unit trusts can be dealt on a forward or historic pricing basis
Explain this
Historic pricing is where investors buy at yesterday’s published price
Forward pricing is where investors buy at tomorrow’s ‘yet-to-be-calculated’ price
With historic pricing the investor knows the price they will get, or pay, and with future pricing they don’t.
Nowadays unit trusts are dealt with using a ‘historic pricing basis’
What happens if prices of the units move by more than 2% due to some unforeseen event?
If the unit trust is dealt with on a historic basis and prices move by more than 2%, the fund manager must move to a forward pricing basis
There are a number of different charges that are payable if you invest in a unit trust
What are they?
For context, the reason unit trusts have all these charges is because running a unit trust is never going to be cheap. Most are based in the city, with expensive property and staff costs, fund managers don’t come cheaply and that’s before you deal with all the trading costs and taxes.
An initial charge.
Most funds now no longer charge this but it can still be payable.
An annual management charge.
Cover fund manager’s costs, and are typically between 0.5 and 1.5%.
Exit charges.
Only a feature when no initial fee is taken. These are usually paid if the investment is sold within a given period of time.
Performance-related fees.
Performance-related fees are very uncommon but are allowed.
What is an open-ended investment company?
It is a collective investment set up as a limited company.
Investors buy shares in the OEIC (note: OEICs do not trade on the stock exchange)
The price of each share depends on the net asset value (NAV) of the fund’s underlying investments meaning, by buying the shares in the OEIC the investor is exposed the fund that the OEIC invests in
The fund manager is called the Authorised Corporate Director (ACD). They buys the bonds or shares in companies on the stock market on behalf of the fund.
There is a depository who oversees the management
It also has a scheme operation who issues reports twice yearly and deals with most administrative tasks.
It is open ended
They are FCA-authorised
They are often single priced (no bid/offer prices etc like with unit trusts that are usually dual prices ). They just have one price based off the mid market
Can be equity based or income based
Tell me the similarities of OEICs to unit trusts
Funds can be UCITS, non-retail UCITS and QIS, (as with unit trusts).
The capital is open ended so, (as with unit trusts), there is no secondary market.
No stamp duty is paid on their purchase (as with unit trusts).
The investor owns their proportion of the shares within the wider fund (as with unit trusts).
Trading can be on historic or future basis (as with unit trusts).
It is self-contained so is not traded on the stock market like normal listed companies (as with unit trusts).
Can be equity based or income based
OEICs operate on a single-priced basis, with the total value of all the shares matching the NAV of the fund. See image
Because they are single priced the shares are based off the mid market value and charges are paid separately
OEICs operate on a single-priced basis, with the total value of all the shares matching the NAV of the fund.
What happens if an shareowner decides to sell tons of shares or an investor decides to buy a ton of shares?
The OEIC will charge the seller/buyer a dilution levy if they buy/sell a substantial number of shares
This is because the dealing costs of this transaction will severely impact on the value of the OEIC’s remaining portfolio, and therefore, unfairly impact the other shareholders
The levy is paid back into the fund
Since OEICs and Unit Trust are extremely similar besides their structure, what is the advantages of investing in a OEIC over a unit trust?
Full comparison of OEICs and Unit Trusts
Read over before exam
Nowadays most funds offer multi-manager products.
What is this?
This allows investors to spread their money between different managers or different funds. Such arrangements further diversify investments.
Two main types of multi-manager product exist: one to spread investments across different funds and the other to spread investments across different managers
To spread investments across funds a ‘funds of fund’ (FOF) fund is used
To spread investments across different managers a ‘managers of funds’ (MOF) fund is used
For context: This was introduced because collective investments became more popular, and more understood by investors, so investors started to ask for more from their investments and therefore demand arose for access to the expertise of ‘star’ fund managers and more diversified portfolios, hence multi-manager products were introduced
There are two main types of multi manager models products. What are they?
Fund of Funds (FOF) funds.
A FOF fund will either be fettered or unfettered
Manager of Managers (MOM) funds.
There are two main types of multi manager models products
Fund of Funds (FOF) funds.
Manager of Managers (MOM) funds.
A FOF fund will either be fettered or unfettered. Tell me about this
Fettered - Only the ‘hosts’ funds are used
Unfettered - Funds from other companies can be used
REMEMBER:
To spread investments across different funds a ‘funds of fund’ (FOF) fund is used. This is a form of multi manager model this spread of investments across a single providers different funds are not possible overwise
There are two main types of multi manager models products
Fund of Funds (FOF) funds.
Manager of Managers (MOM) funds.
Tell me how the MOM fund works
An overall ‘manager’ is appointed, whose job it is to find the best fund managers in each sector.
A big innovation of collective investments has been in wrap and platform services buoyed by the digital revolution.
Basically, a platform provides access to a wide range of collective investment schemes, exchange traded funds (ETFs) and pensions. These can be fettered or unfettered.
They are wrapped up into one investment for the investor. This widens choice, and also makes it easier to value your investment for tax purposes.
A big advantage is the ability to monitor the investment online using the platform
REMEMBER:
If a fund is Fettered - Only the ‘hosts’ funds are used for the investments
If a fund is Unfettered - Funds from other companies can be used to invest in
What are offshore funds?
They are treated in two ways in relation to taxation. What are they?
Collective investment schemes, established outside of the UK
For tax purposes they are either a:
Reporting fund
Non-reporting fund
In relation to taxation offshore bonds are treated as either being a reporting fund or a non reporting fund
What is the difference?
What are they also both known as?
Why do most UK resident or domiciled people who invest offshore prefer reporting funds
Reporting =
Income is reported to HRMC whether distributed or not. Dividends or interest are paid and taxed in same way as onshore funds. CGT also applies in same way. (basically the same as onshore funds)
Non- reporting =
No income is paid (why they are called ‘roll up funds’) so only CGT is applicable. CGT is payable on gains at income tax rates (20%, 40% or 45%)!!!! And no CGT exemption can be used!
NOTE: Most UK resident or domiciled people who invest offshore prefer reporting funds, as dividends are paid gross, and the CGT exemption can be used to cover/reduce gains. SEE LEFT IMAGE
Reporting funds are also known as distributor funds
Non-reporting funds are known as
non distributor funds
Comparison of onshore and offshore funds
Use before exam
What are investments trusts?
They are a collective investment
They are Public Limited Companies (PLCs) and they are listed (its share are on the stock exchange)
They are closed-ended because they have a fixed number of shares
Therefore, supply and demand greatly effect prices
They can use gearing with no restriction
The shares are dual priced with purchases at the higher offer price and sales at the lower bid price. This varies, depending on supply and demand. The difference is known as the ‘market makers’ spread or turn’. NOT bid/offer spread!
Shares trade at a premium (where shares are worth more than the underlying assets) or a discount (where shares are worth less than the underlying assets)
Why are investments trusts useful for adventurous investors?
They are very flexible in their investments when compared to other collective investment schemes. For example, they can invest in emerging markets, provide venture-capital to new firms, invest in any country in the world and so on
They are higher risk though because of this
FOR CONTEXT:
When buying and selling closed-ended fund shares like from investment trusts, they are issued on the primary market and then traded on the secondary markets. This is unlike a unit trust or OEIC that creates and destroys units/shares.
Investment trusts do not trade at NAV because they have a fixed number of shares and therefore supply and demand can impact prices
It is still useful to calculate the NAV of the shares in an investment trust though to figure out if shares are trading at a premium or a discount. To do this you must also factor in any gearing/liabilities that the investment trust has
See both images for examples
With the left image it is unlikely to be the share price you would pay as the shares are traded and listed on the stock market and therefore Supply and demand principles take over due to the fixed number of shares. Therefore you may be purchasing the shares at a premium or a discount. See image
This shows how discounted shares can lead to a higher returns
What is a close company?
A company owned and controlled by five or fewer individuals. This usually relates to small, family run companies.
There are two main types of investment trust
Tell me what they are and explain both
The two main types of investment trust:
- Conventional
- Split Capital
Conventional trusts = Issue one main type of share which are ‘ordinary shares’.
Split Capital Trusts = Multiple classes of shares, entitled to different returns, with different priorities on wind up. Useful for an investor looking for a particular type of return e.g. high-risk income or low-risk growth. Often have a fixed term
What are limited life trusts.
A conventional Investments trusts with a limited term, rather than indefinite
On maturity, the fund is wound up and the NAV is distributed if investors vote to do so. They can also extend the term if they want too. Therefore, they can be good if the investor bought the shares at a discount as they can make a good gain on maturity due to the distribution of the NAV if it is wound up
For context:
There are two main types of investment trust:
- Conventional
- Split Capital
Limited life trusts are a sub type of conventional investments trusts
What is ‘hurdle rate’
Hurdle rate -
the rate an investment trust’s investments must grow at to repay each share at the wind-up date of the investment trust
What is asset cover?
Asset cover is used to calculate the percentage of liabilities covered at any moment for investment trusts
An asset cover of ‘1’ means that investment trust assets exactly match the money required to repay all share classes at trust wind-up.
A figure higher than 1 means that assets are more than liabilities.
A figure of less than 1 means that liabilities are greater than assets.
At the redemption of an investment trust, investors have the choice to take back their cash or ‘roll over’ into another trust, if one is being created.
Investment trusts can have complex structures (particularly split-capital trusts) and have all sorts of different share types.
What different types of shares can investment trusts have
Remember: Conventional investment trusts only offer ordinary shares
Split Capital Trusts can have a variety of different share classes in it
Warrants also feature in investment trusts, mainly found split-capital trust arrangements
What are they?
Are they tradable
They are a ‘right to buy’ shares at a fixed price at a pre-determined date
They are not shares themselves, just simply a ‘right to buy’ some shares
Warrants are tradable on the stock exchange.
When warrants are exercised, this is said to dilute the WHAT. Before they are exercised, the WHAT is undiluted.
When warrants are exercised, this is said to dilute the NAV. Before they are exercised, the NAV is undiluted.
This is a summary sheet of the different investment trust share classes, to help with your last-minute exam revision.
Investment trusts are able to gear
Tell me what this is and why they do this
How do you work out how heavily an investment trust is geared
How can investment trusts borrow money or gear?
What must advisors mention in relation investment trusts that could potentially gear?
Where the investment trust borrows money to capitalise on investment opportunity’s when it doesn’t have sufficient cash to do so
Gearing is expressed using the following formula: Total gross assets ÷ net assets x 100 - (This is used to calculate how much of the fund is geared. This is obvs useful as it indicates how risky the fund is)
Investment trusts can borrow money or ‘gear’ in the same ways as other companies. See image
Advisers must disclose the enhanced risk to investors if they recommend investment trusts that could possible gear, including if the fund invests in other investment trusts that gear.
An investment trust has a gearing figure of 100. What does this mean
An investment trust has a gearing figure of 130. What does this mean?
Figures are published showing the extent to which an investment trust is ‘geared’:
A figure of 100 means there is no gearing,
130 means the company is 30% geared.
What charges are payable if you invest in a investment trust?
With all collective investment schemes, such as unit trusts, investment trusts, OEICs, providers must supply a key features document (KFD) when it is recommended
On the KFD it will show the ‘reduction in yield’ What is this and what is it for?
It will show the effect of any charges on the investment at the end of years 1, 3, 5 and 10.
This simply shows how much less growth the trust could potentially achieve because of charges i.e. how much yield (growth) is reduced by.
This should allow investors to compare costs.
For investment trusts all investors must pay 0.5% stamp duty reserve tax, as with normal share purchases.
True or false
True
NOTE: This is different from that of OEICs and Unit Trusts, where no stamp duty is paid on purchase of shares or units respectively
Investment trust taxation
The internal taxation is the same as other collective investment schemes
And the investor taxation is the same as equity unit trusts
Tell me about this
The taxation of an investment trust is the same as other collective schemes:
Ie:
Schemes do not pay CGT on profits made through their dealings. They do not pay additional income tax on dividends and they do they pay corporation tax on unfranked income from cash or fixed-interest coupons.
All of this results in little internal taxation
Income distributions to investors are taxed in the same way as equity unit trusts:
subject to income tax in the same way as dividends from equities.
treated as the top part of a person’s income i.e. above earnings and interest.
income paid without tax deduction.
£2,000 dividend allowance available.
Dividend income above the £1,000 is taxable:
BRTPs have an 8.75% liability.
HRTP pay 33.75%.
ARTPs pay 39.35%.
Gains made on investment trust shares are also subject to capital gains tax in the same way as unit trust units and OEIC shares.
investment trusts are influenced by supply and demand whereas OEICs and unit trusts aren’t. True or false
True
investment trusts are stock market listed, and are bought and sold with real-time pricing whereas OEICs and unit trusts are not stock market traded and are priced to their NAV once daily (on a historic or forward pricing basis)
True or false
True
Investment trusts have higher risk because of the possibility of gearing and the fact that their share value doesn’t match the NAV and because it has much more flexibility in its investments
True
How do life assurance based investments work?
See both images
Remember that life assurance products will use very similar investment strategies to collective investment schemes
life assurance based investments use very similar investment strategies to collective investment schemes as well as similar charges
What are the two factors that are completely different with life assurance based investments when compared to collective investments
Their structure and Their taxation is completely different to collective investments
Remember:
some life assurance products are often referred to as ‘bonds’ which can cause them to be confused with fixed-interest investments, which are also collectively referred to as ‘bonds’.
What is the other name for life assurance products?
Life assurance products can also be called policies.
Life assurance contracts are split into two broad types:
Those which only have a protection element, such as term assurance.
Those that have a protection and investment element such as an investment bond.
True or False
True
This exam obvs focuses on the life assurance products with an investment element
Life assurance based investments are packaged in 3 main ways
with-profits, unitised with-profits, and unit linked.
Tell me about each
With profits - Where a provider adds regular ‘bonuses’ to the sum assured
The investment may receive a final or terminal bonus at maturity or when cashed in and reversionary bonuses annually
What is sum assured?
The amount payable on death and/or the amount payable on maturity of a policy with an investment element
with-profit products are available in both regular premium and lump sum investment versions.
Most new plans are lump sum versions, with many of the larger insurance companies such as Aviva and the Prudential having highly popular products.
When a single-premium version of a with-profit product is issued, what is it known as?
A with-profit investment bond.
Tell me about the bonuses that can be given in with profit policies
There are several different with profit investment types.
These include:
traditional (also called conventional or full with-profit).
low cost with-profit.
low start low-cost with-profit.
Tell me about each and given an example of how each work
Traditional -
Annual bonuses are added to the full sum assured. This full sum assured increases as bonuses are added. Pays out sum assured death or on maturity. This starts off with a much higher investment
low cost with-profit -
Combines decreasing term assurance with a with profits policy. When the policy’s with-profit element grows, the decreasing term assurance element reduces. This results in lower premiums, and provides a level of death benefit needed by the client, but the overall return at the end of the policy is also lower because the initial investment will be far lower
low start low-cost with-profit -
Same as low cost but the premiums also start off lower, and then increase gradually over a (usually) five-year period. For those who need cover but cant afford it
Example of a traditional with profits policy
What happens if a policy holder days after receiving a number of reversionary bonuses?
And an example of a low cost with profits policy
FULL WITH PROFITS -
a policy may have a sum assured of £100,000. If a 4% simple bonus is declared after year one. The sum assured of the policy increases to £104,000. Next year another 4% simple bonus is declared, so the policy value increases to £108,000 and so on.
If the policyholder dies at any point during the policy term, the sum assured including bonuses, will be paid out into their estate
LOW COST WITH PROFITS -
Using the same example figures, the policy owner has a full sum assured of £100,000 for death benefit purposes but also a basic sum assured, for investment purposes, which is much lower, say £35,000. Annual bonuses are then added to this basic sum assured which then increases each year.
SEE LEFT IMAGE
This results in lower premiums, and provides a level of death benefit needed by the client, but the overall return at the end of the policy is also lower because the initial investment will be far lower
Example of how bonuses are paid in with profit policies
Remember: A key point to be aware of is that bonus payments are at the discretion of the fund manager.
This can affect the end returns, and the attractiveness, of a with-profit fund.
One thing with profits funds use is Market Value Reduction (MVR)
Why is this very important in times of poor investment performance. What is it also called?
Also called a Market Value Adjuster (MVA).
MVR activates when a with profit fund preforms more poorly than expected
MVR is a reduction applied to the value of an holders with-profit fund if they decide to cash it in. This is to keep fairness and prevent other investors loosing out because of another investor cashing in their investment. See example
Had Marcus had an MVR clause he could have applied the MVR to reduce the pay-out to Sachin and Penelope from £12,500 to £9,000, leaving £9,000 in the pot for Mia.
They are a deterrent in many ways because (using our example) Sachin, Penelope and Mia, when faced with a reduction from £12,500 to £9,000, could simply decide to wait until a future date, when the MVR may not be applied, and then cash in their investment at its face value.
What does it mean if a with profits policy is called a ‘closed fund’?
They stop accepting new money
For this reason, a second-hand market has sprung up with investors offering to buy with-profit plans from the original investor.
They offer slightly more than the insurance company surrender value and take on the risk that they may benefit from future gains.
BECAUSE OF THIS Most insurance bonds are now unit-linked rather than with-profit
investors can benefit from Pound-cost averaging for any unit-linked policy by paying a regular premium
Tell me how this works
Pound-cost averaging is where if you buy lots of something whilst the price is low then when you come to sell it again at the end you get back more than you paid, if prices eventually rise.
Applying this to a regular premium unit linked contract; as prices fluctuate you get a different number of units for your same regular contribution.
IT CAN ALSO INCREASE THE OTHER WAY IF PRICES KEEP INCREASING
NOTE: It does not work for any single premium nor with-profit type of investment.
i
Life insurance investment products can be qualifying or non qualifying
If a policy can meet certain rules, it can be deemed ‘qualifying’ and will get some favourable tax treatments. One example is that proceeds on maturity or after 10 years are tax-free, as long as the qualifying status has been maintained throughout. If a policyholder breaks the qualifying rules, their policy becomes non-qualifying.
What are the qualifying rules
Qualifying rules:
When an investor buys a bond, they will decide on which of the provider’s funds they wish to invest in. For example, depending on the provider’s limits, the investor may choose a bond that is invested:
For example:
100% in a UK balanced fund or 50% in equities, 25% in with-profit, 10% in cash and 15% in property.
In relation to its underlying investments, bonds are usually set up as ‘segments’. What is this?
This means that rather than have different parts of the bond allocated to the different fund choices, the bond is split up into lots of individual policies with each segment being split across the funds chosen by the investor.
This makes them identical in terms of asset allocation. The number of segments can be any figure and varies from life office to life office.
So, a £10,000 investment could be ‘segmented’ into 40 different investments of £250.
Be aware that art surrenders and surrenders of segmented bond in the wrong way can lead to large chargeable gains.
This is known as segmentation
SEE LEFT IMAGE
When an investment bond is marketed, it will often have specific investment objectives. For example, a provider may market bonds that aim to produce income, protect capital or smooth out investment returns.
Bonds have different names depending on their objectives: SEE IMAGE to see how bonds can be marketed differently
See image for all the different bond types
Tell me about guaranteed growth bonds
Why are they popular with basic rate tax payers?
Investor pays single premium
Bond provides a guaranteed income each year for a specified term
At the end of the term, the original premium is guaranteed to be returned to the investor
If the gain does not push an investor into the higher or additional rate band , there is no income tax liability, so they tend to be popular with basic rate taxpayers. Not popular with non tax payers as they have to pay Basic rate tax no matter what
This shows how tax liability is calculated for investment bonds. The example shows no tax liability because they remain as a BRTP
Basically:
Calculate the chargeable gain
Check what tax bracket they fall in when adding the chargeable gain to their income
No tax if they remain as a basic rate but tax is payable if they become a HRTP or an ARTP
This shows how tax liability is calculated for investment bonds.
The example shows a tax liability because they are a HRTP or ARTP
NOTE:
Nick’s earnings are £39,875 minus the threshold of £37,700 = £2,175. With normal tax calculations it will just be the higher rate tax applied to the 2175 (the amount that he exceeds the basic rate by) However this is not the case with investments bonds as this would be deemed unfair since the income is being added to the calculation is from previous years, outside of the tax year where the chargeable event occurred. Therefore Top Slicing is used
On the face of it you would think that the calculation for the extra tax is simple, i.e. Nick’s earnings are £39,875 minus the threshold of £37,700 = £2,175 on which there is additional tax to pay.
However this is not the case with investments bonds as this would be deemed unfair since the income that is being added to the calculation is from previous years, outside of the tax year where the chargeable event occurred. Therefore Top Slicing is used
A holder of an investment bond takes out more than the cumulative 5% allowed during the life of the bond.
What happens next?
Basically, Any withdrawals that exceed the 5% annual limit are added to the investors income in the tax year where the withdrawal took place
Because these withdrawals have had tax on them already they are deducted from any chargeable gain in the future
High Income Bonds are another type of investment bond
What are they?
Why are they useful and how are they taxed?
High income bonds have no capital guarantee but in return can have higher returns
They are based on ‘packages of derivatives’.
How it works:
A high level of income is declared, say 10% annually over a 5-year term. The capital value increases/decreases in line with an index just as the FTSE 100. If index is on target, then the capital is returned but if the payment at maturity will be less than originally invested.
They are good when interest rates are low
They are taxed the same as guaranteed income bonds
What are guaranteed Equity Bonds?
What are guaranteed protected bonds?
What kind of investor are they both ideal for?
For cautious investors
They offer a guaranteed return of capital at the end of the term
The guarantee is 100% for guaranteed equity
Protected bonds are the same except the guarantee is a range. For example, 90% to 140%
Investment is linked to a stock market index, such as FTSE 100
So it is good for investors that want to invest in the stockmarket but dont want their capital at risk. No income is paid. The investment only goes up if the index goes up
The max growth they can receive is capped for example 20% so even if the index goes up by 25% theyll only receive 20%
SEE RIGHT IMAGE FOR A guaranteed equity bond
Questions about Guaranteed Equity Bonds
What is the primary feature of guaranteed equity investments that appeals to cautious investors?
How does the capital protection in guaranteed equity investments typically work?
What stock market index is commonly used for linking the growth potential of guaranteed equity investments?
How is additional growth in guaranteed equity investments determined?
What does a ‘cap’ mean in the context of guaranteed equity investments?
Can you explain the term ‘Hard Protection’ in relation to guaranteed equity investments?
How does the final year averaging method benefit the investor in guaranteed equity investments?
What mechanism do firms use to provide the capital guarantee in guaranteed equity investments?
What is a ‘zero-coupon bond’ and how does it relate to the guarantee in guaranteed equity investments?
How would an investor’s returns be affected if the linked index drops over the investment period in a guaranteed equity investment?
What is the primary feature of guaranteed equity investments that appeals to cautious investors?
100% capital protection.
How does the capital protection in guaranteed equity investments typically work?
The capital protection ensures that the investor will receive back the full amount of their initial investment (principal) at the end of the investment term, regardless of market performance.
What stock market index is used for linking the growth potential of guaranteed equity investments?
The FTSE 100 index
How is additional growth in guaranteed equity investments determined?
Additional growth is determined by the performance of the linked stock market index. If the index rises, the investor earns the value of their investment rises, subject to a cap.
What does a ‘cap’ mean in the context of guaranteed equity investments?
A ‘cap’ is the maximum limit on the return that the investor can earn. For example, if the cap is 20%, the investor can earn up to 20% of their principal in returns, even if the index rises more.
Can you explain the term ‘Hard Protection’ in relation to guaranteed equity investments?
‘Hard Protection’ refers to a capital guarantee that is firm and unconditional. It ensures that the investor will get back their entire principal amount regardless of market conditions. A protection that is not a guarantee, or is subject to conditions, is known as Soft Protection.
What investments do firms use to provide the capital guarantee in their guaranteed equity bonds?
Firms use zero-coupon bonds to secure the capital guarantee. These bonds mature at the same time as the investment term, ensuring the principal is available to repay investors.
What is a ‘zero-coupon bond’ and how does it relate to the guarantee in guaranteed equity investments?
A zero-coupon bond is a bond that does not pay periodic interest but is sold at a discount to its face value. At maturity, it pays the full face value, which is used to guarantee the return of the investor’s principal.
How would an investor’s returns be affected if the linked index drops over the investment period in a guaranteed equity investment?
If the linked index drops, the investor will still receive their principal amount back due to the capital protection, but they will not earn any additional returns so potentially an investor could make 0% return if the index preforms badly enough but never less than 0%
Questions about Guaranteed Protected Bonds
What distinguishes protected bonds from guaranteed equity in terms of capital protection?
How does the capital protection mechanism typically work in protected bonds?
What is meant by a spread of 90% to 140% in the context of protected bonds?
How is additional growth determined in protected bonds?
What does a ‘cap’ mean in the context of protected bonds?
Can you explain the term ‘Soft Protection’ in relation to protected bonds?
How does the final year averaging method benefit the investor in protected bonds?
What mechanism do firms use to provide the capital protection in protected bonds?
What is a ‘zero-coupon bond’ and how does it relate to the capital protection in protected bonds?
How would an investor’s returns be affected if the linked index drops over the investment period in a protected bond?
What distinguishes protected bonds from guaranteed equity in terms of capital protection?
Protected bonds typically offer partial capital protection, often around 90%, compared to the 100% capital protection in guaranteed equity investments.
How does the capital protection mechanism typically work in protected bonds?
The capital protection in protected bonds ensures that the investor will receive back a certain percentage of their principal (e.g., 90%) at the end of the investment term, potentially risking a small amount of capital.
What is meant by a spread of 90% to 140% in the context of protected bonds?
This spread indicates that the investor is guaranteed to receive at least 90% of their principal, with the potential to earn up to 140% if the linked index performs well.
How is additional growth determined in protected bonds?
Additional growth is linked to the performance of a stock market index. The investor gains a return when the index’s rise, subject to a specified cap.
What does a ‘cap’ mean in the context of protected bonds?
A ‘cap’ sets the maximum return the investor can earn. For example, if the cap is 20%, the maximum return is 20% of the principal, regardless of higher index performance.
Can you explain the term ‘Soft Protection’ in relation to protected bonds?
‘Soft Protection’ refers to capital protection that is conditional or not fully guaranteed, potentially subject to certain market conditions or other factors. Hard Protection’ refers to a capital guarantee that is firm and unconditional
What mechanism do firms use to provide the capital protection in protected bonds?
Firms use zero-coupon bonds .
What is a ‘zero-coupon bond’ and how does it relate to the capital protection in protected bonds?
A zero-coupon bond is purchased at a discount and matures at face value. It is used to ensure that a portion of the investor’s principal (e.g., 90%) is available at the end of the term to provide the capital protection.
How would an investor’s returns be affected if the linked index drops over the investment period in a protected bond?
If the index drops, the investor will receive the protected portion of their principal (e.g., 90%). They may lose a small percentage of their initial investment but will not lose more than the unprotected portion. With guaranteed equity bonds the portection is typical 100% so they wont lose anything but there returns and cap tend to be lower
-Guaranteed/Protected Equity Bonds:
What is the return structure for guaranteed/protected equity bonds?
How do protected bonds lock in growth?
What is the range of protection available for guaranteed/protected equity bonds?
What is the difference between Hard protection and Soft protection in these bonds?
-Guaranteed Income Bonds:
What type of contract is a guaranteed income bond?
What is the typical term for guaranteed income bonds?
What happens to the investor’s capital upon maturity of a guaranteed income bond?
Why are guaranteed income bonds attractive to basic rate taxpayers?
- Guaranteed Growth Bonds:
How are guaranteed growth bonds similar to guaranteed income bonds?
What do guaranteed growth bonds provide at the end of a set term?
How are returns from guaranteed growth bonds treated in terms of capital gains tax and basic rate income tax?
What additional tax liability might higher and additional rate taxpayers face with these bonds?
- High Income Bonds:
What level of income do high income bonds provide and what are their capital guarantees?
On what does the return of high income bonds depend?
What happens to the original capital if the chosen index meets or does not meet the pre-set performance level?
Why are most high income bonds now issued as offshore bonds?
Guaranteed/Protected Equity Bonds:
What is the return structure for guaranteed/protected equity bonds?
The return is the original capital plus a percentage of the rise in a selected, well-known index, such as the FTSE 100.
How do protected bonds lock in growth?
Protected bonds lock in growth at pre-set dates.
What is the range of protection available for guaranteed/protected equity bonds?
The protection ranges from 95% to 100%.
What is the difference between Hard protection and Soft protection in these bonds?
100% protection is known as Hard protection, whereas less than 100% protection is known as Soft protection. Basically guaranteed or not guaranteed
Guaranteed Income Bonds:
What type of contract is a guaranteed income bond?
It is a single premium contract that provides guaranteed income for a specified term.
What is the typical term for guaranteed income bonds?
The term is typically up to five years.
What happens to the investor’s capital upon maturity of a guaranteed income bond?
The investor’s capital is returned upon maturity.
Why are guaranteed income bonds attractive to basic rate taxpayers?
They are attractive because there is no further tax liability on the income received for BRTP.
Guaranteed Growth Bonds:
How are guaranteed growth bonds similar to guaranteed income bonds?
Both are single premium investments, but guaranteed growth bonds do not pay regular income; instead, they provide a guaranteed capital return at the end of a set term.
What do guaranteed growth bonds provide at the end of a set term?
They provide a guaranteed capital return.
How are returns from guaranteed growth bonds treated in terms of capital gains tax and basic rate income tax?
Returns are free of capital gains tax and basic rate income tax, as these taxes are accounted for within the fund.
What additional tax liability might higher and additional rate taxpayers face with these bonds?
They might face further income tax liability if they are higher or additional rate taxpayers in the year of maturity.
High Income Bonds:
What level of income do high income bonds provide and what are their capital guarantees?
They provide high levels of income but do not have capital guarantees.
On what does the return of high income bonds depend?
The return depends on the performance of the chosen stock market index.
What happens to the original capital if the chosen index meets or does not meet the pre-set performance level?
If the index meets the pre-set performance level, the original capital is returned in full. Otherwise, less than the original capital may be returned.
Why are most high income bonds now issued as offshore bonds?
They are issued as offshore bonds due to challenges by HMRC over tax treatment.
NOTE: All of these are UK based
- Unit Linked Bonds:
What is the term structure for unit linked bonds?
How can income be taken from unit linked bonds?
What options do investors have for encashment with unit linked bonds?
How do unit linked bonds provide flexibility compared to guaranteed bonds?
- With-Profit Bonds:
How do with-profit bonds determine investment performance?
What is the purpose of the Market Value Reducer (MVR) in with-profit bonds?
Under what circumstances can the MVR be applied to with-profit bonds?
Is the MVR applied on the death of the bondholder?
-Distribution Bonds:
What distinguishes distribution bonds between income and capital?
How is income paid to investors in distribution bonds?
What happens to the capital in distribution bonds after each income distribution?
Unit Linked Bonds:
What is the term structure for unit linked bonds?
There is no set term for unit linked bonds.
How can income be taken from unit linked bonds?
Income can be taken tax-deferred, following the rule that allows taking 5% of the original capital per year like most bonds where income can be taken
What options do investors have for encashment with unit linked bonds?
Investors can partially or totally encash their bonds at any time, with units being cashed in to provide withdrawals.
How do unit linked bonds provide flexibility compared to guaranteed bonds?
Unit linked bonds are more flexible as they allow for partial or total encashment and have no set term.
With-Profit Bonds:
How do with-profit bonds determine investment performance?
Performance is determined via bonus additions, including annual (reversionary) and terminal bonuses.
What is the purpose of the Market Value Reducer (MVR) in with-profit bonds?
The MVR protects remaining investors if bond holders switch or encash funds early by reducing the amount paid out to reflect the current market value of underlying assets. MVR is controversial and can make with profit bond returns look unclear
Under what circumstances can the MVR be applied to with-profit bonds?
The MVR can be applied if the bond holder switches or encashes funds early.
Is the MVR applied on the death of the bondholder?
No, the MVR is not usually applied on death.
NOTE: All of these are UK based
In relation to offshore bonds how are they taxed different to onshore bonds?
The fund itself has very little taxation, which improves growth
From the individuals perspective because no tax has been paid by the fund already they pay tax at their highest marginal rate on any growth
This obvs differs with onshore bonds where 20% is already deemed to have been paid internally (but this obvs affects the investment growth)
SEE BOTH IMAGES
The Personal Savings Allowance can be used for offshore bonds as it can for onshore bonds.
In examples 6.27 and 6.28, both Gordon and Nishma were basic rate taxpayers. but the Personal Savings Allowance was ingored. If it was taken into account Nishma would have a higher gain than Gordan
This shows that whether you choose onshore or offshore it is down to personal circumstances
Comparison of onshore and offshore Bonds…
Do not confuse with onshore and offshore FUNDs
Unit linked bonds, like other bonds, have the 5% rule. Unit bonds however do allow partial or total encashment and have no set term unlike other bonds. Dont confuse these two things. if someone encashed more than 5% in a year a tax charge will be payable but with unit linked bonds you do have the option to do this with no issue which is why they are seen as being flexible
Why must investors who have segmented bonds be careful when cashing or part cashing in their bonds
Part surrenders and surrenders of segmented bond in the wrong way can lead to large chargeable gains.
In the event where a gain is ‘wholly disproportionate’ due to a part/full surrender, an investor can ask for this to be reviewed by HMRC within 4 years to have it revoked
What is the Traded endowment policy market?
Why do people use this market and how is the buyer taxed?
It is an alternative for endowment policy owners
The only way an endowment is surrendered is to cash it in with the life company that issued it but this could be an issue if their is a MVR at the time (if a with profits policy) or the policy may be receiving a large terminal bonus which would be lost due to the surrender
The Traded endowment policy market allows the original owner to permanently assign their policy (Note: In all but name) to someone else, in return for a cash payment that will probably be higher than the surrender value. The bond remains in the policyholder’s name (life assured) but the benefits are assigned to the buyer
Most Friendly Society’s investments
use life assurance bonds.
What is the maximum amount that can be invested into friendly society investment
bonds that is fully exempt from tax?
Do Friendly Society’s investment bonds pay internal tax? If no or yes, what does this mean in terms of fund growth
Are they FSCS protected
The R02 examiner appears to like these products, so it is important to learn the tax limits on as seen in the image
For friendly society investment bonds the max that can be invested without paying tax is/that is tax exempt is:
-£270 if annual premium OR
-£300 if premiums are paid monthly (£25 a month)…
These limits apply to to total amount investment, not per policy
They can obvs invest more than that but it wont be exempt from tax
Also with friendly society investment bonds there is no internal tax and they are FSCS protected
Obs these investments cater for low level investors because you cant invest much without it being subject to tax
Exchange Traded Funds (ETFs) as well as well as ‘tracker funds’ (collective investments) match the performance of the index by either holding the actual assets within the index or using derivatives to replicate the index’s performance (known as synthetic funds).
Is this replication 100% accurate?
No
Any fund that is replicating an index can experience tracking errors
synthetic funds have more tracking errors than funds that hold the assets
What are Exchange traded commodities
Work in the same way as Exchange Traded Funds but track commodities
It is a type of exchange traded product
What are Exchange traded notes
Work in the same way as Exchange Traded Funds but they track a currency
It is a type of exchange traded product (etp)
This type of etp has the highest level of counterparty risk because it uses fixed-interest security (loan stock specifically) issued by banks, in order to track the currency. because this is not full replication this means they are always synthetic
For context:
Exchange traded notes, Exchange traded commodities and Exchange Traded Funds are all types of Exchange traded product. They just track different things either synthetically through derivatives, or by owning and replicating the assets themselves
ETF track index’s, ETN track currency & ETC track commodities
The main ways you can invest in property indirectly is the following
See image
Tell me about the option of buying shares in property companies and tell me some of the risks
One option for indirect property investment is buying shares in listed property companies
- Property firms own and build many properties across the UK
Risks = Housing companies can have periods of losses when they build houses, then gains as they sell them so short term investing may not be viable
Even though the property company may own 100s of properties which increases diversification, the investor ultimately only has shares in that single property company which reduces diversification
The main ways you can invest in property indirectly is the following
See image
Tell me about the option of investing in property unit trusts and property investment trusts. Also mention the risks involved and explain why property investment doesn’t suit unit trusts as well
It is where you invest in a unit trust or investment trust, that have bought shares in a property company
All the same respective drawbacks of investment trusts and unit trusts apply
Why it doesnt suit unit trusts - Many property companies build a clause into their rules stating that they have a right to restrict investors’ access to their money for a period of up to six months so this removes all flexibility that unit trusts have
See image for some differences between property unit trusts and property investment trusts.
The main ways you can invest in property indirectly is the following
See image
Tell me about the option of investing in Insurance company property bonds
‘Insurance company property bonds’ are investment bonds that invest in property
All same features that apply to investment bonds apply here such as tax treatment
Just remember for this:
The value of the units is directly linked to the value of the property held.
The main ways you can invest in property indirectly is the following
See image
Tell me about the option of investing in offshore property companies
They are unauthorised investment trusts, specifically to allow them to hold 100% of their assets directly in property, rather than property company shares.
The main ways you can invest in property indirectly is the following
See image
Tell me about the option of investing in Real Estate Investment Trusts
When shares in a REIT are sold is CGT is payable?
THESE WILL LIKELY BE TESTED ON IN THE EXAM
They are a type of investment trust for indirect property ownership
It is separated into two business areas. A part that is ring faced specifically to ‘property letting’ (this makes up most of the RIET) and another part that deals with all other business ventures such as property management services.
Both elements have different tax treatment (SEE IMAGE)
The ring fenced element -
The property letting part of the REIT. This must be where most of the REITs income comes from and makes up most of the RIET. At least 75% of the company’s total gross profit and 75% of the companies total assets must be held within this element. For investors income from this part is paid 20% net of income tax (reclaimable ONLY for non tax payers)
A non ring fenced element -
Deals with any other activity outside of the property letting side of the business. For example, property management services. For investors income from this part is treated as dividend payments
What rules must RIETs satisfy?
Cues -
Where must most of the RIETS assets and gross profit come from
Since RIETS are investment trusts they can borrow. What is the rule regarding this?
How quickly do REITs have to distribute profits to investors for the property letting side of the business?
Property development is allowed but what is the rules regarding this?
Both elements of a REIT are taxed differently. Tell me how it differs specifically
REITS are a type of investment trust for indirect property ownership
The following rules must be satisfied in order to be classed as a REIT
At least 75% of total gross profit and at least 75% of assets must be from property letting
Interest on borrowing must be at least 125% covered by rental profits (they cannot borrow heavily).
At least 90% of the profits from the ‘property letting’ element (income not gains) must be distributed within 12 months of the end of any accounting period.
Property development is allowable but must be intended to generate future income. If it isn’t, then it will be classified as non-ring-fenced activity and liable to corporation tax.
The main ways you can invest in property indirectly is the following: See image
Tell me about the option of investing in a Property authorised investment fund (PAIFs)
Only OEICs can qualify as PAIF
NOT FINISHED
READ OVER 6.10.6
An Enterprise Investment Scheme has met all qualifying rules so the investor (venture capitalist) will be given tax breaks. What are the tax breaks offered under Enterprise Investment Schemes?
An investor qualifies and receives the tax relief saving lots in tax, but then deposes the shares within 3 years after the purchase. What effect does this have on the tax relief?
The major benefit of this type of investment is the tax relief that is available:
30% Income tax relief on investments up to a max of £1,000,000 or £2,000,000 in ‘knowledge-intensive companies’ (£300,000 and £600,000 respectively)
Relief is taken back if the shares she buys are disposed of within 3 years, except to a spouse or on death.
Enterprise Investment Schemes offer the best tax breaks (by way of a ‘tax reducer’) to investors when they invest in EIS companies that are classed as a ‘knowledge intensive company’
What classes a company as being ‘knowledge intensive’ and what extra tax relief is offered?
See image to know what classes a company as knowledge intensive
For ordinary qualifying EIS investments you get 30% Income tax relief on investments up to a max of £1,000,000
For qualifying EIS investments in ‘knowledge-intensive companies’ you get 30% income tax relief up to £2,000,000!!!
For context:
The relief given by enterprise investment schemes is a ‘tax reducer’ i.e. you must have a tax bill equal to that of the relief (see image)
In this example, no income tax relief would be given if Grace were to buy more than 30% of the EIS capital issued because this would be higher than her tax bill of £150000 and relief is only given equal to the tax bill up to a max of £300k or £600k (if its a knowledge intensive company)
Another tax benefit of investing in Enterprise Investment Schemes is it can be used to defer capital gains. Tell me about this
SEE EXAMPLE
Note:
The reinvestment (into an EIS) must take place in the period beginning 1 year before, and ending 3 years after, the disposal giving rise to the gain (the sale of his BP shares).
CGT will eventually be payable, and at the rate of CGT at that time, not the rate now.
Do unquoted companies qualify for business relief?
What are unquoted companies?
Unquoted companies = Unlisted companies = companies NOT listed on the stock exchange meaning their shares can only be bought privately
DIFFERENCES BETWEEN EIS, SEIS & VCTs
APS is where the value of the deceased ISA-holder’s ISAs can be added to the recipient’s (spouse of civil partner) current standard annual subscription of £20,000..
APS is an additional allowance given to the surviving spouse or civil partner. The value of APS given depends on things such as when the ISA holder died, whether there has been any loss or gain since death, and what the funds are being used for.
This is Additional Permitted Subscription being applied in different examples
See both examples
MAIN BIT TO REMEMBER: the APS value used is the value of the ISA when the APS is activated, which can be after death if the accounts remain open, unless the value of the ISA falls following death or it is used for funeral costs, which is where the value of the ISA on the date of death is used instead. see examples
What investments are allowed in Stocks and Shares ISAs?
Cash
Authorised collective funds.
Shares listed on recognised stock exchanges around the world, including AIM.
Corporate bonds listed on recognised stock exchanges around the world.
Gilts from EEA countries.
Individually-owned life assurance investments.
Units in a stakeholder medium term product.
Difference between help to buy ISAs and LISAs
Stakeholder products were launched to a fanfare in the late 1990s promising low charges, easy access, and flexible terms.
What stakeholder products can be held in ISAs
There wont be many questions on JISAs and CTFs so dw
Tell me the differences and similarities between Junior ISAs and Child Trust Funds
The major differences between the two, are:
The JISA has no government contribution and never has but CTF’s do. (CTF’s gave parents ‘vouchers’ to choose where they wanted it paid in)
The contributions period on a JISA is ‘per tax year’ but, for CTFs it’s ‘per birth year’.
Beside this they are very similar:
A £9,000 limit
Full access to the money is given at age 18.
There are several different types of annuities that have different tax rules.
One of the most common used types are ‘Purchased Life Annuities’ (PLA). What are they and what is their tax treatment?
What type of annuity is used in pension funds?
Income is split into a ‘capital’ and ‘interest’ element where the capital element is a return of capital of the lump sum paid and the interest is the additional amount (where the actual benefit comes from)
Capital element is tax free (it would be stupid of this wasn’t the case) and an interest element (taxed as savings income)
A ‘lifetime annuity’ is used in pension funds
Info about derivatives that might help understanding
What is the technical definition of a derivatives?
A derivative is a ‘Financial contracts whose value is derived from the value of an underlying asset.’
A derivative itself is the right to buy or sell the asset. This right can be sold to others and the value of this right will fall/increase depending on the value of the asset (look at example).
In this example, your right to buy the car had a value attached to it. You could trade it to someone else. The same can be said of derivatives. If you buy a right to buy or sell an asset, then you can sell that right to someone else for a profit (or loss).
What are futures & options?
They are 2 different types of derivative
USES: Typically, futures are used for hard commodities such as oil, gas, cocoa etc. and options are used in financial planning.
A future is established. What stops either the buyer or seller not sticking to the agreement if they don’t achieve what they want?
Both the buyer and seller provide a deposit called an ‘initial margin’ when the contract made
This initial margin is given to the London Clearing House (a 3rd party) whose job it is to ensure the contract is honoured
At the expiry of the contract, each side would have already been credited with their profit or debited their loss. They then get back their initial margin and the deal is concluded.
What is an option?
There are two types of option. What are they?
A type of derivative
Gives one party (the option holder) the right (not the obligation) to perform a specified transaction with another party (the option issuer or option writer) according to specified terms.
Ie, the buyer pays a premium to the seller for the right to buy or sell something owned by the seller at a set price in the future. They don’t have to exercise this right if they don’t want to.
An option can either be a ‘call option’ or a ‘put option’
The two parties in an option contract are known as what?
The option holder = Who bought the option
The option issuer/option writer = Who sells the option and originally owns the asset
In this example, the option holder is Jason and the option issuer is ABC bank
Options can either be a call option or a put option
What is the difference?
Call option:
Gives the Optionholder the right to buy the underlying asset from the seller. The seller must sell the asset when the contract is exercised.
A put option:
Gives the buyer of the option the right to sell the underlying asset from the seller. The seller must buy the asset when the contract is exercised.
The seller (the option issuer/writer) of the option is obliged to meet the obligation placed upon them by the buyer; their obligation depending on whether it is a call or a put option
In the example, Jason bought a call option because he has the right to buy the shares
What is ‘in the money’, ‘out of the money’ or ‘at the money’ in relation to option contracts and a typical exam question regarding this.
Note that the example in the left image is a ‘call option’ as Jason has a right to buy the shares
This is because with call options to be ‘in the money’ the option holder wants the asset’s market price to be higher than the strike price (so they can buy the asset less than market value)
And with put options to be ‘in the money’, the option holder wants the assets market price to be less than the strike price (so they can sell the asset higher than market price)
Remember: If a put option is ‘out of the money’ it means if it was a call option it would be ‘in the money’ and vice versa. they are the opposites in this respect
An option is ‘in the money’
An option is ‘out of the money’
An option is ‘at the money’
Tell me what each mean at a high level
In the money = The option holder will make profit if they exercise at the option price (the strike price/the pre agreed price)
out of the money = The option holder will lose money if they exercise the option price
At the money = The option holder will gain or lose nothing if they exercise the option price
Remember: If a put option is out if the money it means that if it was a call option it would be in the money and vice versa. they are the opposites in this respect
Options can be traded on an exchange by the option holder as an alternative to letting the option expire worthless or exercising it at the options strike price
If they decide to trade it, the more ‘in the money’ they are, the better, as this means the option has higher intrinsic value and therefore can be sold to other investor for more. Another aspect that adds value to a option contract when trading, is ‘time value’. What is this?
Time value
The buyer will look at the time left on the option and add or take away value from there
This is speculative from the buyers perspective as their assessment is based on the underlying’s asset price and this can never be fully known for future dates, especially shares
Generally, the longer the period left on the option, the greater the chance that it will end up ‘in the money’ which means higher value when trading
Futures and options can be used for a variety of purposes. In the financial world, they are mainly used for hedging and speculation.
What is hedging?
What is speculation?
Hedging is trying to protect your position against future adverse market movements. Hedging is a defensive strategy
Speculation is to try and profit by correctly forecasting future market movements.
Speculation is a positive strategy
COTEXT: The phrase ‘I’m hedging my bets’ comes from this concept.
Sellers of options face almost unlimited risk for the premium they receive because in the case of put options the market price could rise indefinitely but they still have to sell the assets at the option price
Most sellers of options are banks and not individuals. However, on occasions, fund managers will sell options
A fund manager can either be subject to limited risk or unlimited risk. Tell me how?
The biggest risk would have been if Marcus’s fund did not own XTA PLC shares. (SEE RIGHT EXAMPLE)
What are hedge funds?
There are 4 main hedge fund strategies
Hedge funds are pooled investments, whereby a number of investors entrust their money to a fund manager, who invests in various traded securities.
They are very high risk and are expensive. They are often found in the Caymen islands too
They seek to:
hedge against market downturns.
invest in currencies or shares they believe are trading cheaply.
use derivatives, arbitrage and gearing to move money quickly, cheaply and easily.
The 4 strategies are: SEE IMAGE
What are structured products?
A structured product has 2 parts that allow it to do what it does. What are they?
A structure product does the following:
Provider takes investors money and links it to the FTSE 100 index.
If it goes down, the provider returns the money to the investor.
If it goes up, the investor receives the growth
If it goes up a lot, the provider will keep some back for themselves and return some of the growth to the investor
Investors seeking capital protection yet an exposure to the stock-market often use structured products
They are structured with two component parts:
A zero-coupon bond: provides the capital guarantee as the return is in the form of a capital return (with no income).
A call option (gives the fund the option to buy at roughly the price at investment, and will provide the growth if the index rises.)
What are Sharia-compliant investments?
These are savings and investments aimed at complying with Islamic law.
Under Islamic law you cannot:
Pay or receive interest (Riba).
Invest in anything against Muslim values e.g. alcohol, gambling companies, pork products, tobacco.
What are the advantages/disadvantages of direct investment
What are the advantages/disadvantages of indirect investment
People tend to directly own their own house and own shares, have bank accounts and occasionally hold GILTS. Indirectly they have stocks and shares ISAs, with-profit bonds and maybe some structured products.
Jay and Jasmine have both received a £1,500 dividend from the non-exempt element of their UK REITs. Jay is an additional rate taxpayer and Jasmine pays higher rate. Ignoring the dividend allowance, how much more income tax will Jay pay than Jasmine on this distribution?
In relation to the questions, the ‘non exempt element’ refers to the non-ring faced part of the RIET. It is non exempt because this part of the RIET at the business level is subject to corporation tax. The ring faced part is exempt from corporation tax at the business level so this could be referred to as the exempt element. This is obvs at a corporate level. The investors tax liability is different for both respective parts of the RIET which is what you need to know to answer this question. SEE BOTH IMAGES
£84.00
Explanation:
As an additional rate taxpayer, Jay would pay 39.35% of the distribution. £1,500 x 39.35% = £590.25.
As a higher rate taxpayer, Jasmine would pay 33.75% of the distribution. £1,500 x 33.75% = £506.25.
£590.25 - £506.25 = £84.
Alternatively, a quicker method is to calculate the difference in their respective tax rates:
£1500 x 5.6% (39.35 – 33.75) = £84.
