Unit 1 Topic 8 - Collective investments

Question 1

What are the main forms of collective investments?

Answer 1

• Unit trusts
• Investment trusts
• Investment bonds
• OEICs

Question 2

What are the key advantages of collective investments?

Answer 2

• Investment manager expertise
• Wide choice of funds
• Diversification
• Reduced dealing costs

Question 3

What is diversification?

Answer 3

Diversification involves creating a portfolio of investments that are spread acrodd different geographical areas, asset classes and sectors of the economy.

The aim is to spread risk.

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
• Funds that aim to produce a high level of income (perhaps with modest growth)
• Those that aim for capital growth at the expense of income.
• Those that seek a balance between growth an income.
• Actively managed funds (use the services of a fund manager(s) to make decision on asset selection and when holdings should be bought or sold
• Passively managed or tracker funds.

Question 5

What are unit trusts?

Answer 5

A unit trust is a pooled investment created under trust deed.

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.

Question 6

How can unit trusts be categorised?

Answer 6

Depending on the proportion of funds held in equities and in cash or fixed-interest stock, a unit trust can be categorised as:

• An equity trust (where the underlying assets are mainly shares)
• Fixed-interest trust (invested mainly in interest-yielding assets).

An equity trust pays a dividend, while a fixed-interest trust pays interest.

Question 7

Which unit types do unit trusts offer?

Answer 7

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 8

What is a trust?

Answer 8

In general law a trust is an arrangement whereby one person gives assets to another (trustees) to be looked after in accordance with a set of rules (specified in the trust deed).

Question 9

How are units in a unit trust priced?

Answer 9

The manager will calculate the total value of trust assets, allowing for an appropriate level of costs, and then divide this by the number of units that have been issued.

On a daily basis, managers calculate the prices at which units may be bought and sold, using a method specified in the trust deed.

Unit prices are directly related to the value of the underlying securities that make up the fund.

Question 10

What are the three main prices in relation to unit trust transactions?

Answer 10

Offer price - is the price at which investors buy units from managers.

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 holding.

Cancellation price - is the minimum permitted bid price, taking into account the full costs of buying and selling.

Question 11

Define the bid-offer spread with respect to unit trusts.

Answer 11

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 12

What is forward and historic pricing relating to unit trusts?

Answer 12

Under forward pricing, clients buy or sell in a given dealing period at a price that will be determined at the end of the dealing period.

Previously, there was a system of historic pricing: the price of units was determined by the closing price at the end of the previously dealing period. If an underlying market in which the trust has moved by more then 2% in either direction since the last valuation, the manager must revert to forward pricing.

Question 13

How are units in a unit trust bought and sold?

Answer 13

Unit trust managers are obliged to buy back units when investors wish to sell them.

Units can be bought direct from the managers or through intermediaries. They can be purchased in writing, by telephone or online: all calls to the managers’ dealing desks are recorded as confirmation that a contract has been established.

Question 14

What documents do purchasers receive when purchasing units in a unit trust?

Answer 14

• 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 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 15

How are unit trusts regulated and managed?

Answer 15

Regulated under the terms of the Financial Services and Markets Act 2000.

Must be authorised by the Financial Conduct Authority.

The FCA rules require that a unit trust is suitably diversified and specify that a fund cannot borrow an amount of more than 10% of the fund’s net asset value and, even then, only for a temporary period.

Question 16

What are a unit trust’s manager’s responsibilities?

Answer 16

• Managing the trust fund in line with the trust deed
• Valuing the assets of the fund
• Fixing the price of units
• Offering units for sale
• Buying back units from unit holders

Question 17

What the a unit trusts’ trustees’ responsibilities?

Answer 17

• Setting out the trust’s investment directives
• Holding and controlling the trust’s assets
• Ensuring that adequate investor protection procedures are in place
• Approving proposed advertisements and marketing material
• Collecting and distributing income from the trust’s assets
• Issuing unit certificates (if used) to investors
• Supervising the maintenance of the register of unit holders

Question 18

What charges are applied to unit trusts?

Answer 18

The initial charge covers the cost 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% and 1.5% of the fund value.

Question 19

What are the two main categories unit trusts fall under and how are they taxed?

Answer 19

Fixed-interest trusts are those holding at least 60% of their assets in interest-bearing assets such as gilts and bonds.

Where a trust does not meet this definition it is classed as an equity unit trust

In both cases there is no tax on gains within the fund, meaning that the investor maybe liable to CGT if they make a gain when encashing the investment.

Question 20

How are Equity-based trusts taxed?

Answer 20

• For equity-based trusts, the tax treatment is the same as for shares.
• Income is paid without deduction of tax.
• Where an investor’s total dividend in a tax year is less than the dividend allowance (DA), there is no income tax on the dividend.

Where dividend income is in excess of the DA, then the income is taxed at rates of:

• 7.5% for a basic-rate taxpayer;
• 32.5% for a higher-rate taxpayer;
• 38.1% for an additional rate taxpayer.

Question 21

How are Fixed-interest trusts taxed?

Answer 21

• Interest from a fixed-interest trust is classed as savings income.
• The income is paid gross, without deduction of tax.
• Where the interest is received by a non-taxpayer, falls withing the starting-rate band for savings, or falls within the PSA of a basic or higher-rate taxpayer, then no tax is payable.
• Taxpayers who have used their PSA are taxed on the excess income and are required to declare the income to HMRC through self assessment.

Question 22

What are the risks of investing in a unit trust?

Answer 22

• The legal constitution of a unit trust helps to mitigate risk of fraud.
• The actual risk will depend on the type of unit trust selected. (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).
• 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 23

What are investment trusts?

Answer 23

• Investment trusts are collective investments but, unlike unit trusts, they are not unitised funds or even trusts.
• They are public limited companies whose businessis 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.
• An investment trust must meet FCA requirements to gain a stock market listing.
• Shares are sold to investors, the number remains constant (closed-ended by nature).

Question 24

How to invest in an investment trust?

Answer 24

Shares are purchased through:

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

Question 25

What fees are associated with investment trusts?

Answer 25

Shares trade at a single price but dealing fees are added to any purchased and deducted from any sale.

An annual management charge is also payable typically between 0.5% and 1.5%.

Question 26

What factors affect the share price of an investment trust?

Answer 26

The share of an investment trust depends to some extent on the value of the underlying investments, but so so directly as in the case of a unit trust.

The price can also depend on a number of other factors that affect supply and demand.

Question 27

Define Net asset value per share relating to investment trusts?

Answer 27

Total value of the investment fund divided by the number of shares issued.

Question 28

Define Gearing relating to investment trusts

Answer 28

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 29

How are investment trusts taxed?

Answer 29

• At least 85% 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 broadly the same as that described for equity unit trusts.
• Tax on amount exceeded CGT annual exempt amount.

Question 30

What is a split-capital investment trust?

Answer 30

Fixed-term investment trusts offering two or more different types of share.

Most common 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

Question 31

What is a real estate investment trust?

Answer 31

Tax-efficient property investment vehicles that allow private investors to invest in property while avoiding many of the disadvantages of direct property investment.

One particular advantage is that stamp duty reserve tax is charged at 0.5% on purchase.

REITS pay no corporation tax on income or growth provided they meet specific criteria.

Question 32

What are the qualifying features of REITS?

Answer 32

• At least 75% of their gross income must be derived from property rent.
• At least 90% of their profits must be distributed to their shareholders.
• Dividends can be paid in cash or as stock dividends, it the allocation of further shares.
• No individual shareholder can hold more than 10% 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, Child Trust Funds and self-invested personal pensions.

Question 33

What is an OEIC?

Answer 33

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.

Question 34

How do investors invest in an OEIC?

Answer 34

• The investor buys shares in the company.
• There is no limit to the number of shares that can be issued, which is described as open ended.
• Depending on whether new shares are being issued, the fund can expand or contract.

Question 35

What is the key difference between OEICs and investment trusts?

Answer 35

An investment trust can borrow money to finance its activities but an OEIC can only borrow for short-term purposes.

Question 36

How are OEICs regulated?

Answer 36

Unlike an investment trust OEICs must be authorised by the FCA.

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.

Question 37

How is an OEIC managed?

Answer 37

An authorised corporate director, whose role is much the same as the manager of a unit trust, manages the OEIC.

Question 38

What are the roles of an OEIC corporate director?

Answer 38

• 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 39

What is single pricing?

Answer 39

In many unit trusts, the units have a different bid and offer price. Shares in an OEIC are single priced.

Question 40

What are the charges levied, when investing in OEICs?

Answer 40

In addition to the cost of buying the shares, the OEIC will levy:

• an initial or buying charge - which is added to the unit price and is normally in the region of 3% to 5% of the value of the individual’s investment;
• annual management charges - based on the value of the fund the range of annual management charges is typically between 0.5% for indexed funds and 1.5% for more actively managed funds
• a dilution levy - this may be added to the unit price on purchase of shares or deducted from the price on sale of shares in situation where there are large flows of funds into or out of the OEIC.

Question 41

How are OEICs taxed?

Answer 41

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-interest or equity based.

Question 42

How are fixed-interest OEICs taxed?

Answer 42

The interest is paid without deduction of tax but is subject to income tax as savings

Question 43

How are equity- based OEICs taxed?

Answer 43

A dividend is paid 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.

Question 44

How are offshore OEICs taxed?

Answer 44

If the offshore fund reports all annual income attributable to an investor whether the income is distributed or not, it is referred to as a ‘reporting fund’. The investor will be liable for income tax on the income and CGT on any gain on disposable

For ‘non-reporting funds’ the investor will pay income tax rather than CGT, on any gain on disposal.

Question 45

How are risks mitigated in OEICs?

Answer 45

• An OEIC is subject to the same FCA rules on diversification and fund borrowing as apply to unit trusts, and these rules help reduce risk.
• An OEIC is a pooled investment employing the services of professional investment managers.
• Risk is also mitigated by the spread that can be achieved for a relatively small investment.

Question 46

What are Endowments?

Answer 46

Endowments are a type of investment based on life assurance.

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.

Question 47

What are Friendly society plans?

Answer 47

A friendly society is able to market a tax-exempt savings plan, effectively an endowment with tax benefits.

As there is a 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.

Question 48

What are investment bonds?

Answer 48

Investment bonds are collective investment vehicles based on unitised funds.

Investment bonds are available from life assurance companies and are set up as single premium, whole-of-life assurance policies.

Individuals who wants to invest does so by paying a single (lump sum) premium to the life company.

In order 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.

Question 49

What are the advantages of investment bonds?

Answer 49

• Relative ease of investment and surrender
• Simplicity of the documentation
• 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.

Question 50

How are investment bonds taxed?

Answer 50

Investment bonds attract an internal tax of 20% (whereas unit trust funds are exempt).

Basic-rate taxpayers have no further liability.

Higher-rate taxpayers (who are liable to income tax at 40%) pay a further tax of 20%

Additional-rate taxpayers (who are liable to income tax at 45%) pay further tax of 25%.

Question 51

What are qualifying and non-qualifying life policies?

Answer 51

Life assurance policies are designated as ‘qualifying’ or ‘non-qualifying’ policies for tax purposes.

The benefit of a qualifying policy is that there is no tax liability on the proceeds of the plan on death or maturity.

Question 52

What are the qualifying criteria for tax purposes on life policies?

Answer 52

Premiums must be payable annually, half yearly, quarterly or monthly and set up for at least ten years.

If premiums cease within ten years, or three-quarters of the original term if this is less than ten years, the policy becomes non-qualifying.

Sum payable on death must be at least equal to 75% of the total premiums payable

Premiums in any one year must not exceed twice the premiums in any other year, or one-eighth of the total premiums payable.

Question 53

Outline the steps of top slicing.

Answer 53

1) The gain on the policy (surrender value + withdrawals that have not already been taxed - original investment) is calculated.
2) The gain is divided by the number of complete policy years the investment has been in place.
3) This gives the top-sliced gain, which is the average gain for each policy year that the plan has been in place.
4) The average gain is multiplied by the number of complete policy years and added to the planholder’s taxable income in the year of surrender to establish whether or not any tax beyond the 20% taken within the fund is due.

Question 54

What percentage of the original investment in an investment bond can be withdrawn without an immediate tax liability?

Answer 54

5% of the original investment each year regardless of whether the investor is basic, higher or additional rate taxpayer.

These withdrawals are tax-deferred not tax-exempt: when the investment ends, on maturity, death or encashment, a tax liability may arise.

Question 55

What are Non-mainstream pooled investments?

Answer 55

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.

FCA does not generally permit the marketing of NMPIs to retail customers.

Question 56

What are structured products?

Answer 56

Structured products offer some protection of the capital invested, while enabling investment in the underlying assets that have potential for higher returns but are also higher risk (than ordinary shares).

Question 57

What is a SCARP

Answer 57

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.

Question 58

What are the main characteristics of a SCARP?

Answer 58

a) The customer is exposed to a range of outcomes in respect of the return of 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 or other 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 59

What is a Non-SCARP structured investment product?

Answer 59

A non-SCARP investment is one that promises to provide a minimum return of 100% of the initial capital invested as long as the issuer(s) of the financial instruments(s) underlying the product remain(s) solvent.

Question 60

What are the main risks associated with structured products?

Answer 60

• Counterparty risk
• Market risk
• Inflation risk

Question 61

What are wraps and fund supermarkets?

Answer 61

The basic premise of a ‘wrap’ account is that one provider sets up an internet-based platform to hold all of the investor’s investment within one framework.

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).