Week 1 - Investment Background

Question 1

What is capital?

Answer 1

Capital is the buffer between assets and liabilities (C=A-L)

Question 2

List two concerns around management of capital

Answer 2

1. Capital needs to be in excess of regulatory minimum
2. Need to minimise the volatility of capital
   Var(C)=Var(A)+Var(L)-2Cov(A,L)
   Reduce the variability of assets and increase the covariance of assets and liabilities, i.e. price matching

Question 3

What is the difference between defined benefit and defined contribution superannuation?

Answer 3

DB: employer takes on investment risk and payments to customer are set (e.g. fixed % of final wage)
DC: customer takes on investment risk and payments to customer are variable dependent on profit/loss on investment

Question 4

Describe the difference between superannuation systems domestically and internationally

Answer 4

1) Australia uses DC system, while the rest of the world uses a DB system
2) Australia invests more aggressively than the rest of the world (more equity and less bonds/cash)

Question 5

What is the role of financial markets?

Answer 5

1) Makes it easier for good investment opportunities to access capital relative to poor ones
2) Provide investment options for different risk appetites
3) Provide a way to defer consumption

Question 6

What is continuous disclosure?

Answer 6

If a company is listed on the stock exchange it has an obligation to inform the market of important information, with an objective of minimising insider trading

Question 7

What are ESG investment considerations?

Answer 7

The Economic, Social and Governance principle indicates that there are objectives other than financial ones which must be upheld, e.g. environmental and social objectives

Question 8

What do the United Nations Principles of Responsible Investment seek to uphold?

Answer 8

They seek to encourage ESG in investment processes across the industry, cooperating and monitoring progress to enhance effectiveness of implementing the principles.

Question 9

What is corporate governance?

Answer 9

The framework of rules, relationships, systems and processes within and by which authority is exercised and controlled in corporations

Question 10

What is the “two-strikes” rule?

Answer 10

When a company’s remuneration report receives 25% or more ‘no’ votes cast twice, a spill resolution is voted on. If 50% of shareholders vote in favour, new directors will be elected.

Question 11

Who regulates banks, institutional super funds, LI and GI? How?

Answer 11

APRA - institutes capital requirements sensitive to asset mix and reduced by matching. APRA criticised by Royal Commission for not being intrusive enough

Question 12

Who regulates companies, investment managers and brokers?

Answer 12

ASIC - told by Royal Commission to take the legal route more often in cases of misbehaviour

Question 13

Who regulates listing rules for companies and brokers?

Answer 13

ASX

Question 14

Who introduces accounting and auditing standards?

Answer 14

AASB and Auditing and Assurance Standards

Question 15

Who regulates competition? How?

Answer 15

The Australian Competition and Consumer Commission regulates competition to prohibit unconscionable business actions, contracts that diminish competition and abuse of market power

Question 16

Who regulates self-managed super funds?

Answer 16

ATO

Question 17

Describe the Australian superannuation environment?

Answer 17

Compulsory saving, currently 9.5% rising to 12% by 2025. Employees have choice of super fund and within the fund, members have choice of risk level, and in some cases can contribute portfolios at individual level.

Question 18

What is the relationship between capital structure and residual claim on asset/income (return for ordinary shareholders)?

Answer 18

Capital structure magnifies profitability and volatility of residual claim on assets and income. They are a characteristic of ordinary shares.

Question 19

What is the level of taxation on superannuation investment?

Answer 19

1) 15% on short term net realised cap gains (<12 mths) and 10% on long term net realised cap gains (two thirds included in assessable income, taxed at 15%)
2) Imputation credits are included in taxable income then rebated - NOTE: pension assets are typically tax exempt and earn the full benefit of imputation credits

Question 20

Explain the concept of dividend imputation

Answer 20

Idea is to “only pay the tax that your situation calls for” - i.e. paying your level of income tax on dividend earnings, not the tax rate of the company.
Dividends charged based on company earnings, then income tax applied to the pre-tax amount in form of imputation credit, then income tax applied. This could cause an additional benefit to investor

Question 21

Outline 3 features of the Australian investment market in relation to the rest of the world

Answer 21

1) Australia is heavily reliant on events in the US financial system - 54% of all international investments are in the US, bringing strong contagion effects
2) The franking credit system is unique in Australia, and we have a higher dividend yield (4.25%, 5.7% when fully franked - much higher than the world average of 2.44%)
3) Compared to the rest of the world, we have a substantial focus on financials (33% vs 17.5%) and materials sector (18.5% vs 5%). Significantly less in information technology

Question 22

What is the current situation surrounding monetary policy in the last 20 years? [3 main points]

Answer 22

1) Cash rates and yield curves have fallen substantially in the last 20 years (need to account for these differences in modelling)
2) Quantitative easing (injecting money in economy by buying back CGS) has been decreased significantly, particularly in the US. It was used to combat the GFC (ineffectively)
3) Market expects the RBA to drop cash rates once more at the start of next year and for further downward trends to occur

Question 23

Explain the relationship between bond yield and sub-investment grade borrowing spreads and recessions.

Answer 23

As the sub-investment grade credit spread expands, recessions are likely to occur, causing them to drop drastically. Also, as the yield curve spread drops and nears rock bottom, a recession is likely occur.

High sub-investment grade credit spread flags a recession is pending. A rock bottom yield curve spread flags a recession.

Question 24

What are Australia’s two main problems regarding savings?

Answer 24

1) High levels of household debt - level of household debt is higher than during GFC and places a constraint on growth
2) Flat income growth - real disposable income is not growing and to increase consumption, individuals are thus in need of dipping into their savings, running down the savings accumulated during the GFC.

Question 25

What is the impact of geopolitical factors (give examples)?

Answer 25

US-China trade tensions have the potential to further slow economic growth as the demand and supply for goods, particularly intermediate goods will be massively impacted. Already a reduction in merchandise trade by 16%/13% (imports/exports).
Brexit has also caused tensions and diminished investor confidence in the European sector. This has been compounded by an inability to settle the deal and a potentially chaotic Brexit.

Question 26

Which is the best measure to assess price earnings?

Answer 26

Use the Cyclically Adjusted Price-Earnings ratio (CAPE) - a measure which takes the average of the last 10 years of inflation adjusted market earnings