Topic 8: Collective Investment Schemes

Question 1

The main legal forms of collective investment vehicles and products are:

Answer 1

• unit trusts;
• investment trusts;
• investment bonds; and
• Open Ended Investment Company (OEICs).

Question 2

For individual investors, collective investments offer a number of advantages:

Answer 2

• The services of a skilled investment manager are obtained at a cost that is shared among the investors. Individual investors do not need to research particular companies – nor do they need to understand and deal with the decision‐making and administrative work arising from events such as rights issues.
• Investment risk can be reduced because the investment manager spreads the fund by investing in a large number of different companies; thus if one company fails, the investor loses only a small part of their investment, rather than all of it. This is referred to as ‘diversification’. Such a spread of investments could not normally be achieved with small investment amounts.
• Fund managers handling investments of millions of pounds can negotiate reduced dealing costs.
• There is a wide choice of investment funds, catering for all investment strategies, preferences and risk profiles.
• Collective investment schemes enable investors to gain exposure to assets they would not otherwise be able to access due to minimum lot/investment size (eg corporate bonds).

Question 3

What is Diversification?

Answer 3

Diversification is an important concept for investors. It involves creating a portfolio of investments that are spread across different geographical areas, asset classes and sectors of the economy. The aim is to spread risk, in the hope that poor performance of one investment will be offset by better performance in another. It is the opposite of ‘putting all your eggs in one basket’. For example, if you only hold shares in a company that sells sunscreen, you are likely to make more money in a hot summer. If you only hold shares in a company making umbrellas, you will make more money if it rains. By diversifying to hold shares in both companies, you would have the opportunity to make money whatever the weather.

Question 4

How are investment funds categorised?

Answer 4

• location, eg UK, Europe, America, Far East;
• industry, eg technology, energy;
• type of investment, eg shares, gilts, fixed interest, property;
• other forms of specialisation, eg recovery stocks, ethical investments. Many funds are based on more than one categorisation; for example, a UK
  equity fund is categorised by both location and type of investment.
  A further categorisation is possible:
• funds that aim to produce a high level of income (perhaps with modest capital growth);
• those that aim for capital growth at the expense of income; and
• those that seek a balance between growth and income.
  Funds can also be categorised according to their management style:
• Actively managed funds (sometimes referred to simply as ‘managed funds’) use the services of a fund manager(s) to make decisions on asset selection and when holdings should be bought or sold.
• Passively managed or tracker funds will seek to replicate the performance of a particular stock market index, such as the FTSE All‐Share. A manager may be used but it is also possible that asset selection is computerised.

Question 5

What is a Unit Trust?

Answer 5

A unit trust is a pooled investment created under trust deed. An investor will
generally consider a unit trust as a means of trying to produce a better return than could have been achieved elsewhere. They can invest a lump sum in the unit trust, make regular contributions, or a mixture of both.
A unit trust is categorised as an equity trust where the underlying assets are mainly shares, or as a fixed‐income trust where investment is mainly in interest‐yielding assets. An equity trust pays a dividend, while a fixed‐income trust pays interest.

A unit trust is divided into units, with each unit representing a fraction of the trust’s total assets. It is ‘open‐ended’, so if lots of investors want to buy units in it, the trust manager can create more units. (Not all types of collective investment are ‘open‐ended’; investment trusts, for example, which we look at later in this topic, are ‘closed‐ended’.)

Question 6

Unit trusts may offer the following types of unit:

Answer 6

• Accumulation units automatically reinvest any income generated by the underlying assets. This would suit someone looking for capital growth.
• Distribution or income units split off any income received and distribute it to unit holders. The units may also increase in value in line with the value of the underlying assets.

Question 7

There are four important prices in relation to unit trust transactions:

Answer 7

• The creation price is the price at which the unit trust manager creates units.
• The offer price is the price at which investors buy units from the managers.
• The bid price is the price at which the managers will buy back units from
  investors who wish to cash in all, or part, of their unit holding.
• The cancellation price is the minimum permitted bid price, taking into account the full costs of buying and selling. At times when there are both buyers and sellers of units, the bid price is generally above this minimum level, since costs are reduced because underlying assets do not need to be traded.

Question 8

What is the Bid Offer Spread?

Answer 8

The difference between the price at which a unit is offered to an investor (offer price) and the price at which the fund manager will buy it back (the bid price).

Question 9

How are units bought and sold?

Answer 9

Unit trust managers are obliged to buy back units when investors wish to sell them. There is consequently no need for a secondary market in units and they are not traded on the Stock Exchange. This adds to the appeal of unit trusts to the ordinary investor, because the buying and selling of units is a relatively simple process.

Question 10

Purchasers may receive two important documents from the managers?

Answer 10

• The contract note – this specifies the fund, the number of units, the unit price and the amount paid. It is important because it gives the purchase price, which will be needed for capital gains tax (CGT) purposes when the units are sold.
• The unit certificate – this specifies the fund and the number of units held, and is the proof of ownership of the units.

Question 11

How are unit trusts regulated and managed?

Answer 11

n the UK, unit trusts are primarily regulated under the terms of the Financial Services and Markets Act 2000, and must be authorised by the Financial Conduct Authority (FCA) if marketed to retail investors. The FCA specifies rules aimed at reducing the risks associated with unit trusts. The rules require that a unit trust fund is suitably diversified and specify that the fund cannot borrow an amount of more than 10 per cent of the fund’s net asset value and, even then, only for a temporary period.

The trust deed places obligations on both the manager and the trustees. The manager aims to generate profit for the unit trust provider from the annual management charge and dealing in units. The trustees’ overall role is to ensure investors are protected and that the manager is complying with the terms of the trust deed. The role of trustee is usually carried out by an institution such as a clearing bank or life company.

Question 12

Two types of charges are applied to unit trusts:

Answer 12

• The initial charge covers the costs of purchasing fund assets. The initial charge is typically covered by the bid– offer spread.
• The annual management charge is the fee paid for the use of the professional investment manager. The charge varies but is typically between 0.5 per cent and 1.5 per cent of fund value. Although it is an annual fee, it is commonly deducted on a monthly or daily basis.

Question 13

How are unit trusts taxed?

Answer 13

Authorised unit trusts fall into two main categories:
- If more than 60% of the underlying investments within a unit trust are cash or fixed‐interest securities, such as UK gilts or corporate bonds, the fund will be classed as a fixed‐income or non‐equity fund and all income distributions will be treated as interest payments.
- If less than 60% of the underlying investments are cash or fixed‐interest securities, the fund will be classed as an equity fund and all income distributions will be treated as dividends.
In both cases there is no tax on gains within the fund, meaning that the investor may be liable to capital gains tax if they make a gain when encashing the investment.

Question 14

What are the risks of investing in a unit trust?

Answer 14

The legal constitution of a unit trust helps to mitigate risk of fraud because the trustees have a responsibility to ensure there is proper management.
The risks involved in investing in a unit trust are lower than those for an individual investing directly into equities on their own behalf because a unit trust is a pooled investment. Unit‐trust funds will typically invest in a spread of between 30 and 150 different shares.
The actual risk will depend on the type of unit trust selected. The wide range of choice means that there are unit trusts to match most investors’ risk profiles. A cash fund will carry similar risks to a deposit account, while specialist funds that invest in emerging markets, for instance, are high risk by their very nature. Overseas funds carry the added risk of currency fluctuations.
Unit trusts provide no guarantee that the initial capital investment will be returned in full or that a particular level of income will be paid.

Question 15

What are investment trusts?

Answer 15

Investment trusts are collective investments but, unlike unit trusts, they are not unitised funds. In fact, despite their name, they are not even trusts. They are public limited companies whose business is investing (in most cases) in the stocks and shares of other companies. As a company, an investment trust is established under company law and operates as a listed plc; its shares are listed on the stock exchange. A unit trust and an OEIC (see section 8.4) must be FCA authorised. An investment trust, by contrast, must meet FCA requirements to gain a stock market listing, and it is governed by rules in its memorandum and articles of association.

Question 16

Investing in an investment trust involves purchasing shares in the investment trust through:

Answer 16

• a stockbroker;
• a financial adviser; or
• direct from the investment trust manager.

Question 17

What is the Net Asset Value Per Share?

Answer 17

Total value of the investment fund’s assets less its liabilities, divided by the number of shares issued.

Question 18

What is Gearing?

Answer 18

The level of debt as a percentage of a company’s equity. It is a way of measuring the extent to which a company’s operations are funded by borrowing rather than by shareholder capital.

Question 19

How are investment trusts taxed?

Answer 19

At least 85 per cent of the income received by the fund managers of investment trusts must be distributed as dividends to shareholders. As it is constituted as a company, an investment trust pays income in the form of dividends. The taxation situation is the same as that described for equity unit trusts.As with unit trusts, fund managers are exempt from tax on capital gains. Investors are potentially liable to CGT on the sale of their investment trust shares, in the event that their gain, when added to the value of their other gains realised in a tax year, exceeds the CGT annual exempt amount

Question 20

What is a split‐capital investment trust?

Answer 20

Sometimes known as split‐level trusts or simply as splits, split‐capital investment trusts are fixed‐term investment trusts offering two or more different types of share. The most common forms of share offered are:
- income shares – these receive the whole of the income generated by the portfolio but no capital growth;
- capital shares – these receive no income but, when the trust is wound up at the end of the fixed term, share all the capital growth remaining after fixed capital requirements have been met.
Most companies will also offer shares with differing balances of income and growth, so as to meet different investor objectives.

Question 21

What is a real estate investment trust?

Answer 21

Real estate investment trusts (REITs) are tax‐efficient property investment vehicles that allow private investors to invest in property while avoiding many of the disadvantages of direct property investment (see Topic 7). One particular advantage is that stamp duty reserve tax is charged at 0.5 per cent on purchase; the rates of stamp duty for direct property purchase are much higher.

Question 22

Qualifying features of REITS?

Answer 22

• At least 75 per cent of their gross income must be derived from property rent.
• The remainder can come from development or other services but corporation tax is charged on income and gains made here.
• At least 90 per cent of their profits must be distributed to their shareholders net of basic-rate tax. Higher- and additional-rate shareholders will have to pay additional income tax.
• Dividends can be paid in cash or as stock dividends (ie the allocation of further shares) and are taxable at dividend rates.
• No individual shareholder can hold more than 10 per cent of the shares.
• Single-property REITs are only allowed in special cases – such as, for example, a shopping centre with a large number of tenants.
• They can be held in ISAs, Junior ISAs, Child Trust Funds and self-invested personal pensions.

Question 23

What is an OEIC?

Answer 23

n OEIC is an ‘open‐ended investment company’ – a limited liability company that pools the funds of its investors to buy and sell the shares of other companies and deal in other investments.
To invest in an OEIC, the investor buys shares in the company; there is no limit to the number of shares that can be issued, which is why it is described as ‘open‐ended’. The open‐ended nature of an OEIC means that the fund can expand or contract, depending on whether new shares are being issued in response to demand, or being redeemed if investors wish to sell. The value of the shares varies according to the market value of the company’s underlying investments. An OEIC may be structured as an ‘umbrella’ company that is made up of several sub‐funds. Different types of share can be made available within each sub‐fund.
OEICs share a number of characteristics with unit trusts and investment trusts. For instance, as with unit trust and investment trusts, investments can be made by lump sum, regular contribution or a combination of both. One difference to note, however, is that while both investment trusts and OEICs operate as companies, an investment trust can borrow money to finance its activities but an OEIC can only borrow for short‐term purposes.

Question 24

How are OEICs regulated and managed?

Answer 24

An OEIC is established as a limited liability company under a structural framework set by HM Treasury (not under trust) under the Open‐Ended Investment Companies Regulation 2001 (as amended) and associated FCA rules. Unlike an investment trust (unless it is self‐managed), OEICs must be authorised by the FCA; there is a great deal of common ground between the FCA’s regulations for OEICs and those that apply to unit trusts
The role of overseeing the operation of the company and ensuring that it complies with the requirements for investor protection is carried out by a depositary, who is authorised by the FCA. The role of the depositary is similar to that of the trustee of a unit trust.
An authorised corporate director, whose role is much the same as the manager of a unit trust, manages the OEIC. The role of the corporate director is to:
- manage the investments;
- buy and sell OEIC shares as required by investors;
- ensure that the share price reflects the underlying net asset value of the OEIC’s investments.

Question 25

How are OEICs taxed?

Answer 25

The tax treatment of UK‐based OEICs is exactly the same as that for unit trusts.
In terms of income, an OEIC will be classified as either fixed‐income or equity‐based.
- If it is fixed‐income, the interest is paid without deduction of tax but is subject to income tax as savings. There will be a liability to income tax for basic‐ and higher‐rate taxpayers if total savings income exceeds the investor’s starting‐rate band for savings income (where available) and personal savings allowance. Additional‐rate taxpayers will be liable to income tax on the full amount paid.
- If an OEIC is equity‐based, a dividend is paid, again without deduction of tax. There will be a further liability for income tax for basic‐, higher‐ and additional‐rate taxpayers if total dividend income exceeds the investor’s dividend allowance.
Fund managers are not subject to tax on capital gains, although individual investors may be liable to pay CGT when their shares in the UK OEIC are encashed.

Question 26

What are the risks of investing in OEICs?

Answer 26

The risks associated with investing in an OEIC are similar to those of investing in a unit trust:
- An OEIC is subject to the same FCA rules on diversification and fund borrowing as apply to unit trusts, and these rules help to reduce risk.
- As an OEIC is a pooled investment employing the services of professional investment managers, the degree of risk is lower than it would be for an individual investing directly in equities.
- Risk is also mitigated by the spread that can be achieved for a relatively small investment.

Question 27

What are Endowments?

Answer 27

Endowments are a type of investment based on life assurance. They combine life assurance and regular savings. A lump sum is either paid if the life assured dies during the term or, if they survive to the end of the term, it is paid at maturity.
The introduction of schemes such as ISAs has reduced their popularity but some plans remain in existence

Question 28

What are Friendly society plans?

Answer 28

A friendly society is able to market a tax‐exempt savings plan, effectively an endowment with tax benefits, because the friendly society pays no corporation tax on its investment returns. This can be compared with a conventional endowment on which the life assurance company would pay corporation tax on some income and gains within the fund.
As there is preferential tax treatment, the amount that can be saved is limited to £270 per year (as a lump sum),£25 per month or £75 per quarter. The plan is set up over an initial ten‐year term and there is no tax upon encashment.
Friendly society plans are often marketed as savings plans that enable parents and grandparents to save on behalf of their children and grandchildren.

Question 29

What are Investment Bonds?

Answer 29

nvestment bonds are collective investment vehicles based on unitised funds; although they often appear similar to unit trusts because of their unitised structure, they are actually very different.
Investment bonds are available from life assurance companies and are set up as single‐premium, whole‐of‐life assurance policies. An individual who wants to invest does so by paying a single (lump sum) premium to the life company.
If an investment bond is unit‐linked, the investor then receives a policy document showing that the premium has purchased (at the offer price) a certain number of units in a chosen fund, and that those units have been allocated to the policy. To cash in the investment, the policyholder accepts the surrender value of the policy, which is equal to the value of all the units allocated, based on the bid price on the day when it is surrendered.
Investment bonds are attractive to investors because of the:
- relative ease of investment and surrender;
- simplicity of the documentation; and
- ease of switching from one fund to another – companies generally permit switches between their own funds without charging the difference between bid and offer prices.
The range of available funds is similar to those offered by unit trusts and investment trusts.

Question 30

How are investment bonds taxed?

Answer 30

The funds in which the premiums are invested are an insurance company’s life funds and their tax treatment is different from that of unit trusts. In particular, they attract internal tax at 20 per cent on capital gains (whereas unit trust funds are exempt) and this tax is not recoverable by investors even if they themselves would not pay capital gains tax.
The taxation system for policy proceeds in the hands of the policyholder is complex. Policies may be qualifying or non‐qualifying with tax consequences, particularly for higher‐ and additional‐rate taxpayers as 20 per cent tax is deemed to have already been paid within the fund. Investment bonds are non‐qualifying policies.

Question 31

What are Non‐mainstream pooled investments?

Answer 31

Collective investment schemes may only be sold to the general public in the UK if they adhere to regulations relating to investment and promotion set out in the FCA Handbook (the content of the FCA Handbook is covered in Topic 17).
Schemes that do not fulfil the criteria for regulated collective investment schemes are classified as non‐mainstream pooled investments (NMPIs). The FCA Handbook defines an NMPI as:
- a unit in an unregulated collective investment scheme (UCIS);
- a unit in a qualified investor scheme;
- a security issued by a special vehicle, unless an excluded security; „ a traded life policy;
- rights or interest in any of the investments listed above.
NMPIs may invest in non‐traditional assets. Such investments carry a higher risk. Also, if the provider is based abroad, an investor may have limited recourse to the Financial Ombudsman Scheme and the Financial Services Compensation Scheme (see Topic 25). For these reasons, NMPIs are only considered suitable for a very small group of high‐net‐worth individuals. The FCA does not generally permit the marketing of NMPIs to retail customers.

Question 32

What are Structured Products?

Answer 32

The defining characteristic of structured products is that they offer some protection of the capital invested (up to 100 per cent in some cases), while enabling investment in underlying assets that have the potential for higher returns but are also higher risk (such as ordinary shares). They appeal to investors who are cautious about direct exposure to the possible downside of stock markets but who would like to share in the growth possibilities

Question 33

What are Structured capital‐at‐risk products (SCARPs)?

Answer 33

A SCARP is defined as a product other than a derivative that provides an agreed level of income or growth over a specified investment period and displays the following characteristics:
a) Thecustomerisexposedtoarangeofoutcomesinrespectofthereturnof initial capital invested.
b) The return of initial capital invested at the end of the investment period is linked by a pre‐set formula to the performance of an index, a combination of indices, a ‘basket’ of selected stocks (typically from an index or indices), or other factor or combination of factors.
c) If the performance in b) is within specified limits, repayment of initial capital invested occurs. If it is not, the customer could lose some or all of the initial capital invested.

Question 34

What are Non‐SCARP structured investment product?

Answer 34

A non‐SCARP investment is one that promises to provide a minimum return of 100 per cent of the initial capital invested as long as the issuer(s) of the financial instrument(s) underlying the product remain(s) solvent. This repayment of initial capital is not affected by the market risk factors in b) above.

Question 35

There are a number of risks associated with structured products including:

Answer 35

• counterparty risk;
• market risk;
• inflation risk.

Question 36

What are Wraps and Platforms?

Answer 36

The basic premise of a ‘wrap’ account is that one provider sets up an internet‐based platform to hold all of the investor’s investments within one framework, enabling the investor to see all relevant information in one place. The wrap account allows the investor to analyse and quantify the holdings according to value, tax treatment and product type.
Wraps are generally offered by independent financial advisers, who levy charges in addition to any individual fund management charges that apply to the investments held in the framework. Most wraps are able to hold any class of asset or fund on behalf of the investor.
A fund supermarket is designed to provide access to a wide range of funds, such as OEICS, unit trusts and ISAs, but not investment trusts. The investor has a ‘general investment account’, which is exposed to the UK tax regime (apart from any ISAs that are included, as they are tax‐free). The investors pay a charge for the service: either a flat fee or a percentage of funds held – this is how the fund supermarket makes its money.
Both wraps and fund supermarkets are often referred to as ‘platforms’, but they are different. A wrap offers all the same investments as a fund supermarket, plus a range of other investments, such as investment trusts, offshore investments and direct equities (shares).

Question 37

What is Sustainable Finance?

Answer 37

In short, sustainable finance is about taking into account environmental, social and governance (ESG) material factors when making investment decisions. A material factor is one that is likely to affect the profitability of a firm. For example:
- A material environmental factor could be paper recycling for a publishing house.
- Material social factors could relate to how a firm treats its employees. Are they an inclusive employer? Do they pay a fair salary?
- Governance factors relate to how a firm is run. Does it pay its fair share of taxes? Does it have an ethics code? Is it transparent in its communications?

Question 38

What are Cryptoassets?

Answer 38

Cryptoassets are a digital representation of value, the ownership of which is cryptographically proven (using computer code). Cryptoassets do not generally have equivalent physical manifestations. ‘Coins’, for instance, only exist notionally. Bitcoin was the first cryptocurrency and it remains by far the biggest, most influential and best‐known cryptoasset (GOV.UK 2023).

Question 39

How do cryptoassets work?

Answer 39

The easiest way for a user to conduct a transaction using cryptoassets is to create a digital wallet, similar to an online bank account. This generates a pair of digital keys: one public (essentially the account number), one private (the user’s PIN). The keys are used to send and receive transactions; they are a means of identifying the parties to a transaction and proving their ownership over the assets they intend to transact.
Transactions are recorded using distributed ledger technology (DLT). Distributed networks eliminate the need for a central authority to check for invalid transactions. Participants around the world, connected through a peer‐ to‐peer network, compete to solve complex puzzles to validate transactions. All verified transactions are recorded on an electronic ledger.
Blockchain is the most widely known DLT network. It comprises transaction entries called ‘blocks’ that confirm and record users’ transactions. Each block is cryptographically connected to the previous block in the blockchain through a ‘hash’ (a digital fingerprint). This creates an auditable trail of the transaction. Blockchains are generally publicly available and transparent. Transactions aretime‐stamped on the blockchain and mathematically related to the previous ones; they are irreversible and impossible to alter.

Question 40

Explain the regulation around cryptoassets?

Answer 40

While the FCA has oversight to check that cryptoasset firms have effective anti‐money‐laundering (AML) and terrorist financing procedures, generally cryptoassets are not regulated by the FCA.
The FCA has confirmed that some cryptoassets, such as security tokens, may fall within its regulatory remit depending on how they are structured.
The UK Cryptoassets Taskforce (CATF) report identified three different categories of cryptoasset:
- Exchange tokens – these are not issued or backed by any central authority and are intended and designed to be used as a means of exchange. They tend to be a decentralised tool for buying and selling goods and services without traditional intermediaries. These tokens are usually outside the regulatory perimeter.
- Utility tokens–these tokens grant holders access to a current or prospective product or service but do not grant holders rights that are the same as those granted by specified investments. Although utility tokens are not specified investments, they might meet the definition of e‐money in some circumstances (as could other tokens). In this case, activities involving them may be regulated.
„ Security tokens – these are tokens with specific characteristics that mean they provide rights and obligations akin to specified investments, like a share or a debt instrument as set out in the Regulated Activities Order (RAO). These tokens are within the regulatory perimeter.