R02

Investment
principles
and risk
2018–19 Study text
 Investment
principles
and risk
R02 Study text: 2018
2018–
–19
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Updates and amendments to this study text

This edition is based on the 2018/19 tax year and examination syllabus which will be examined
from 1 September 2018 until 31 August 2019.
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© The Chartered Insurance Institute 2018

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any investments.

Print edition ISBN: 978 1 78642 367 2

Electronic edition ISBN: 978 1 78642 368 9
This revised and updated edition printed in 2018

Acknowledgement – authors and reviewers

We gratefully acknowledge the contributions of the following to the production of the first edition of this
text:

Derek Darby (author of chapters 1–3 and reviewer)

Jane Vessey (author of chapters 4, 5 and 9 and reviewer)
Chris Gilchrist (author of chapters 7 and 8).

The CII would like to thank the authors and reviewers of other CII study texts in respect of any material
drawn upon in the production of this study text, in particular study texts CF2 and J10.

Updater for this edition

Jane Alford, BA(Hons) ACII FPFS.

Reviewers for this edition

Tessa Roberts, MSc, BA (Hons).
David Smith.

Acknowledgement
The CII thanks the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA) for
their kind permission to draw on material that is available from the FCA website: www.the-fca.org.uk (FCA
Handbook: www.handbook.fca.org.uk/handbook) and the PRA Rulebook site: www.prarulebook.co.uk and
to include extracts where appropriate. Where extracts appear, they do so without amendment. The FCA
and PRA hold the copyright for all such material. Use of FCA or PRA material does not indicate any
endorsement by the FCA or PRA of this publication, or the material or views contained within it.

The CII also thanks the National Savings and Investments (NS&I) for its kind permission to include the NS&I
‘Quick guide for financial advisers’ (available on www.nsandi-adviser.com/) in chapter 1, figure 1.3.

While every effort has been made to trace the owners of copyright material, we regret that this may not
have been possible in every instance and welcome any information that would enable us to do so.

Unless otherwise stated, the authors have drawn material attributed to other sources from lectures,
conferences, or private communications.

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Using this study text

Welcome to the R02
R02: Investment principles and risk study text which is designed to cover
the R02 syllabus, a copy of which is included in the next section.
Please note that in order to create a logical and effective study path, the contents of this
study text do not necessarily mirror the order of the syllabus, which forms the basis of the
assessment. To assist you in your learning we have followed the syllabus with a table that
indicates where each syllabus learning outcome is covered in the study text. These are also
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 5

Examination syllabus

Investment principles and

risk
Purpose
At the end of this unit, candidates will have investigated the:
• characteristics, inherent risks, behaviour and correlation of asset classes, and investment products;
• macro-economic environment and its impact on asset classes;
• merits and limitations of the main investment theories;
• nature and impact of the main types of risk on investment performance;
• performance of investments.

Summary of learning outcomes Number of

questions in the
examination*
1. Analyse the characteristics, inherent risks, behaviour and correlation of 17 standard format/
asset classes. 11 multiple response
2. Understand the macro-economic environment and its impact on asset 6 standard format
classes.
3. Understand the merits and limitations of the main investment theories. 7 standard format
4. Apply the principles of the time value of money. 3 standard format
5. Analyse and explain the nature and impact of the main types of risk on 5 standard format
investment performance.
6. Analyse the characteristics, inherent risks, behaviours and relevant tax 15 standard format/
considerations of investment products. 7 multiple response
7. Apply the investment advice process. 11 standard format
8. Understand the principles of investment planning. 8 standard format
9. Analyse the performance of investments. 10 multiple
response
*The test specification has an in-built element of flexibility. It is designed to be used as a guide for study and is not a
statement of actual number of questions that will appear in every exam. However, the number of questions testing each
learning outcome will generally be within the range plus or minus 2 of the number indicated.

Important notes
• Method of assessment: 100 questions: 72 standard format and 28 multiple response questions. 2 hours
are allowed for this examination.
• This syllabus will be examined from 1 September 2018 to 31 August 2019.
• Candidates will be examined on the basis of English law and practice in the tax year 2018/2019 unless
otherwise stated.
• It should be assumed that all individuals are domiciled and resident in the UK unless otherwise stated.
• Candidates should refer to the CII website for the latest information on changes to law and practice
and when they will be examined:
1. Visit www.cii.co.uk/qualifications
2. Select the appropriate qualification
3. Select your unit on the right hand side of the page

Published June 2018 R02

Copyright © 2018 The Chartered Insurance Institute. All rights reserved.
6 R02/July 2018 Investment principles and risk

Examination syllabus

1. Analyse the characteristics, inherent 7. Apply the investment advice

risks, behaviour and correlation of process.
asset classes. 7.1 Explain the Know Your Client requirements
1.1 Analyse the characteristics and inherent applied to the investment advice process.
risks of the main asset classes. 7.2 Apply asset allocations to different client
1.2 Analyse the behaviour and correlation of risk profiles and requirements.
asset classes and their relevance to asset
allocation. 8. Understand the principles of
investment planning.
2. Understand the macro-economic 8.1 Explain the main approaches to asset
environment and its impact on asset allocation.
classes. 8.2 Explain the portfolio construction process.
2.1 Explain the key economic trends and their 8.3 Explain the basic principles of platforms.
impact on asset classes.
2.2 Explain the key economic indicators, their 9. Analyse the performance of
trends and interpretation. investments.
2.3 Explain the impact of monetary and fiscal 9.1 Analyse portfolio performance using
policy. different benchmarks and other methods.
9.2 Apply an appropriate investment portfolio
3. Understand the merits and review process.
limitations of the main investment
theories.
3.1 Explain the main investment theories, their
benefits and limitations.
3.2 Explain portfolio theory, diversification and
hedging.
3.3 Explain behavioural finance and its impact
on investment markets and individuals.

4. Apply the principles of the time

value of money.
4.1 Apply the principles of the time value of
money.
4.2 Calculate compound interest, discounts,
real returns and nominal returns.

5. Analyse and explain the nature and

impact of the main types of risk on
investment performance.
5.1 Explain the nature and impact of the main
types of risk on investment performance.
5.2 Analyse the nature and impact of the main
types of risk on investment performance.

6. Analyse the characteristics, inherent

risks, behaviours and relevant tax
considerations of investment
products.
6.1 Explain the advantages and disadvantages
of direct investment in securities and assets
compared to indirect investment through
collectives and other products.
6.2 Analyse the characteristics, inherent risks,
behaviours and relevant tax considerations
of the main types of indirect investment
products.

Published June 2018 2 of 4

Copyright © 2018 The Chartered Insurance Institute. All rights reserved.
 7

Examination syllabus

Reading list Ebooks

The following ebooks are available through
The following list provides details of additional Discovery via www.cii.co.uk/discovery (CII/PFS
resources which may assist you with your members only):
studies. Investment risk and uncertainty: advanced risk
Note: The examination will test the syllabus awareness techniques for the intelligent investor.
alone. Steven P. Greiner. Hoboken: Wiley, 2013.

The reading list is provided for guidance only Investment risk management. Greg Filbeck, H.
Kent Baker. New York: Oxford University Press,
and is not in itself the subject of the
2015.
examination.
Investor behaviour: the psychology of financial
The resourcess will help you keep up-to-date planning and investing. H. Kent Baker. Hoboken,
with developments and will provide a wider New Jersey: Wiley, 2014.
coverage of syllabus topics.
Finance: a quantitative introduction. Piotr and
CII/PFS members can access most of the Lucia Staszkiewicz. Amsterdam: Academic Press,
additional study materials below via the 2015.
Knowledge Services webpage at www.cii.co.uk/
knowledge. Portfolio management: a strategic approach. John
Wyzalek, Ginger Levin. Boca Raton: Auerback
New materials are added frequently - for Publications, 2015.
information about new releases and lending
service, please go to www.cii.co.uk/knowledge Factfiles and other resources
or email knowledge@cii.co.uk. CII factfiles are concise, easy to digest but
technically dense resources designed to enrich the
CII study text knowledge of members. Covering general
insurance, life and pensions and financial services
Investment principles and risk. London: CII. Study sectors, the factfile collection includes key
text R02. industry topics as well as less familiar or specialist
areas with information drawn together in a way
Books (and ebooks) not readily available elsewhere. Available online
Financial calculations. Sarah Dingley-Brown. 2015. via www.cii.co.uk/ciifactfiles (CII/PFS members
Totnes, Devon: SDB Training. only).
Mastering financial calculations: a step-by-step • The regulation of retail investment business.
guide to the mathematics of financial markets Kevin Morris.
instruments. 3rd ed. Bob Steiner. Harlow: FT • The regulation of investment intermediaries.
Prentice Hall, 2012. * Kevin Morris.
Investments. 10th global edition. Zvi Bodie, Alex Additional articles and technical bulletins are
Kane, Alan J. Marcus. Berkshire: McGraw-Hill, 2014. available under the Personal Finance section of the
Investments. 10th global edition. Zvi Bodie, Alex website at www.cii.co.uk/knowledge/personal-
Kane, Alan J. Marcus. Berkshire: McGraw-Hill, 2014. finance.
Investments: principles and concepts. Charles P Journals and magazines
Jones. Wiley, 2014. Personal finance professional (previously Financial
Modern portfolio theory and investment analysis: solutions). London: CII. Six issues a year. Available
international student version. 8th ed. Edwin J online at www.thepfs.org/financial-solutions-
Elton et al. New York: John Wiley, 2011. archive (CII/PFS members only).
The basics of finance: an introduction to financial Investment adviser. London: Financial Times
markets, business finance, and portfolio Business. Weekly. Also available via
management. Frank Fabozzi. London, Wiley, www.ftadviser.com.
2010.* Investment week. London: Incisive Financial
The Financial Times guide to investing. 3rd edition. Publishing. Weekly. Available online via
Glen Arnold. FT Prentice Hall, 2014. www.investmentweek.co.uk.
The Financial Times guide to making the right
investment decisions: how to analyse companies
and value shares. 2nd ed. Michael Cahill. Prentice
Hall/Financial Times, 2010.
Winning client trust. Chris Davies. London:
Ecademy Press, 2011.

Published June 2018 3 of 4

Copyright © 2018 The Chartered Insurance Institute. All rights reserved.
8 R02/July 2018 Investment principles and risk

Examination syllabus

Reference materials
Core tax annuals, 6v (Capital gains tax;
Corporation Tax; Income tax; Inheritance tax;
Trusts and estates; Value-added tax). Various
authors. Haywards Heath, West Sussex:
Bloomsbury Professional. Annual.
International dictionary of banking and finance.
John Clark. Hoboken, New Jersey: Routledge,
2005.*
Financial Conduct Authority (FCA) Handbook.
Available at www.handbook.fca.org.uk/handbook.
Harriman’s financial dictionary: over 2,600
essential financial terms. Edited by Simon Briscoe
and Jane Fuller. Petersfield: Harriman House,
2007.*
Lamont’s financial glossary: the definitive plain
English money and investment dictionary. Barclay
W Lamont. 10th ed. London: Taxbriefs, 2009.
Prudential Regulation Authority (PRA) Rulebook
Online. Available at www.prarulebook.co.uk
* Also available as an ebook through Discovery via
www.cii.co.uk/discovery (CII/PFS members only).

Examination guide
If you have a current study text enrolment, the
current examination guide is included and is
accessible via Revisionmate
(www.revisionmate.com). Details of how to access
Revisionmate are on the first page of your study
text.
It is recommended that you only study from the
most recent version of the examination guide.

Exam technique/study skills

There are many modestly priced guides available
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The Insurance Institute of London holds a lecture
on revision techniques for CII exams
approximately three times a year. The slides from
their most recent lectures can be found at
www.cii.co.uk/iilrevision (CII/PFS members only).

Published June 2018 4 of 4

Copyright © 2018 The Chartered Insurance Institute. All rights reserved.
 9

R02 syllabus
quick-reference guide
Syllabus learning outcome Study text chapter and
section
1. Analyse the characteristics, inherent risks, behaviour and correlation of asset
classes.
1.1 Analyse the characteristics and inherent risks of 1.1A–1.1B, 1.2C–1.2E
the main asset classes.
1.2 Analyse the behaviour and correlation of asset 1.1A–1.1B, 1.2C–1.2E
classes and their relevance to asset allocation.
2. Understand the macro-economic environment and its impact on asset classes.
2.1 Explain the key economic trends and their impact 2A–2B
on asset classes.
2.2 Explain the key economic indicators, their trends 2C
and interpretation.
2.3 Explain the impact of monetary and fiscal policy. 2D–2G
3. Understand the merits and limitations of the main investment theories.
3.1 Explain the main investment theories, their 3A–3D
benefits and limitations.
3.2 Explain portfolio theory, diversification and 3A, 9B
hedging.
3.3 Explain behavioural finance and its impact on 3E
investment markets and individuals.
4. Apply the principles of the time value of money.
4.1 Apply the principles of the time value of money. 4A
4.2 Calculate compound interest, discounts, real 4A–4B
returns and nominal returns.
5. Analyse and explain the nature and impact of the main types of risk on investment
performance.
5.1 Explain the nature and impact of the main types of 5A
risk on investment performance.
5.2 Analyse the nature and impact of the main types 5A–5C
of risk on investment performance.
6. Analyse the characteristics, inherent risks, behaviours and relevant tax
considerations of investment products.
6.1 Explain the advantages and disadvantages of 6.2T
direct investment in securities and assets
compared to indirect investment through
collectives and other products.
6.2 Analyse the characteristics, inherent risks, 6.1A–6.1G, 6.2H–6.2S
behaviours and relevant tax considerations of the
main types of indirect investment products.
10 R02/July 2018 Investment principles and risk

Syllabus learning outcome Study text chapter and

section
7. Apply the investment advice process.
7.1 Explain the Know Your Client requirements 7A–7B
applied to the investment advice process.
7.2 Apply asset allocations to different client risk 7C
profiles and requirements.
8. Understand the principles of investment planning.
8.1 Explain the main approaches to asset allocation. 8A–8D
8.2 Explain the portfolio construction process. 8E–8F
8.3 Explain the basic principles of platforms. 8G–8K
9. Analyse the performance of investments.
9.1 Analyse portfolio performance using different 9A–9C
benchmarks and other methods.
9.2 Apply an appropriate investment portfolio review 8L
process.
 11

Introduction
Learning objectives
After studying this introduction, you should be able to:
• state the main investment choices available to investors;
• outline the varying risk/reward characteristics of different types of assets.

Providing investment advice

This introduction is provided by way of background to your studies.
An adviser needs to have a thorough knowledge of the various investment products that are
available in the market place when providing advice. The circumstances of every individual
are unique, and it is essential that an adviser considers which investment products are
appropriate to meet the varying needs of a client before making any recommendations.
An adviser must be able to explain fully to the client, in a way that they will understand, how
each product that is recommended meets the identified financial goals and objectives of the
client. Any options need to be fully described, and the relative advantages and
disadvantages of any alternatives pointed out.

Main investment choices

Types of investment
An adviser has a wide range of investment products from which to choose when making a
recommendation to a client. Each category of asset has a potential role to play within a
client’s overall investment portfolio; however, each has a different risk/return profile.

Table 1: Types of investment

Cash deposits • Practically no risk to the capital value (unless the bank or building
society collapses).
• Inflation can erode the real value of the capital over time and
reduce its buying power.
Fixed interest • Characterised by security of income (unless the issuer defaults),
securities particularly in nominal terms.
• Varying degrees of exposure to capital gain or capital loss.
Equities • Characterised by insecurity of income and capital values over the
shorter term, but offering the potential of rising income and real
capital growth over the longer term.
• Equities tend to perform badly in times of slowing economic
growth or rising interest rates.
Property • Both residential and commercial property have proved to be a
reasonable long-term hedge against inflation.
• Property can also reduce volatility in a portfolio as the property
cycle does not always follow the equity cycle, although both
equities and property suffered from a market collapse in 2007.

These investment categories should not be viewed as being totally separate from each
other. Overall they present a broad spectrum of investments, rather than totally separate
categories.
12 R02/July 2018 Investment principles and risk

Investments can be held in two main ways:

• Collective or pooled investments
investments. Such as unit trusts, open-ended investment companies
(OEICs) and investment trusts. These allow relatively small amounts to be invested in
worldwide stock markets, with stock selection being made by full-time professional
investment managers.
• Direct investments
investments. Such as individual shares. The growth of internet trading has opened
up dealing in shares to the mass market, with many of the high street banks offering share
dealing facilities. To help manage risk it is recommended that a diversified range of shares
should be held in a portfolio.

Investment choices
There are three main investment possibilities:
• making deposits;
• buying fixed interest securities; and
• buying equities.
Each must bear a relatively stable rate of return relationship to the other for the economy to
function.

Table 2: Investment choices

Cash deposits • Deposits generally yield less than fixed interest securities for the
same degree of risk, and rarely achieve much real growth over
time once tax is taken into account.
Fixed interest • Fixed interest securities generally yield lower overall returns than
securities equity investments, but have higher returns than deposits;
however, they will rarely beat inflation by a significant amount.
Equities • Equity investments will generally achieve returns that are higher
than both fixed interest securities and cash deposits over the
longer term. The dividend yield on equities is, however, usually
low compared to the yield on fixed interest securities, but both
dividends and share prices have the potential to grow over time
to compensate.

There is, therefore, a fixed hierarchy of returns that is unlikely to be breached for any
substantial period.
In assessing the choices that are available, the following points should also be considered:
• Investors’ money tends to move to those areas where it will achieve the best results, in
relation to both the risk that is involved and how long investors are prepared to tie up
their funds.
• The rational investor generally assumes that a higher return can be expected if:
– funds are committed to a particular investment for a longer period;
– the risk of capital loss is higher; or
– larger funds are committed.
• There are separate financial markets in each of the main types of investments (cash
deposits, fixed interest securities and equities). However, a change in one market, such as
an interest rate change, is almost certain to have repercussions in the others, i.e. a
reduction in interest rates could encourage a rise in both fixed interest and equity values,
but lower returns from deposits.
 13

Different roles
Each investment has a role to play:

Figure 1: Role of different asset classes

Equities are good for Deposits are good for Fixed interest securities
long-term real growth the protection of capital, are good for secure levels
of capital and/or at least in nominal terms of nominal income, with
income, although the and over shorter periods, some scope for capital
risk of loss is higher and are a safe haven when gains if interest rates fall.
than for either fixed times are bad economically They are usually less
interest securities or (when the value of other volatile than equities.
cash deposits. investments may fall).

These and other issues are dealt with in this text.

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 15

Contents
1: The characteristics, inherent risks, behaviour and correlation of
asset classes
1.1: Cash investments and fixed-interest securities
A Cash investments 1/5
B Fixed-interest securities 1/17

1.2: Equities, property and alternative investments

C Equities 1/38
D Property 1/55
E Alternative investments 1/63
Appendix 1.1: Sample accounts for Green Trees plc 1/69

2: The macro-economic environment and its impact on asset

classes
A Trends in investment markets 2/2
B World economies and globalisation 2/7
C Economic and financial cycles 2/8
D Fiscal and monetary policy 2/10
E Money supply 2/12
F Balance of payments 2/20
G Role of financial investment in the economy 2/21

3: The merits and limitations of the main investment theories

A Modern portfolio theory 3/2
B Capital asset pricing model (CAPM) 3/8
C Multi-factor models 3/11
D Efficient market hypothesis (EMH) 3/13
E Behavioural finance 3/15

4: The principles of the time value of money

A Time value of money 4/2
B Real returns and nominal returns 4/10

5: Nature and impact of the main types of risk on investment

performance
A Main types of risk 5/2
B Diversification 5/7
C Gearing 5/8
16 R02/July 2018 Investment principles and risk

6: Characteristics, risks, behaviours and tax considerations of

investment products
6.1: Indirect investments – unit trusts, OEICs and investment trust companies
A Collective investment schemes 6/4
B Units trusts and OEICs: general characteristics 6/4
C Unit trusts 6/10
D Open-ended investment companies (OEICs) 6/23
E Unit trust and OEIC management services 6/26
F Offshore funds 6/27
G Closed-ended funds/investment trust companies 6/32
Appendix 6.1: Characteristics of retail and qualified investor schemes (QIS) 6/55
Appendix 6.2: Investment trusts, OEICs and unit trusts compared 6/57

6.2: Other indirect investments including life assurance based-products

H Life assurance-based investments 6/63
I Exchange traded products 6/91
J Property-based investments 6/93
K Private equity 6/97
L Individual savings accounts (ISAs) 6/101
M National Savings and Investments (NS
(NS&&I) products 6/109
N Purchased life annuities 6/109
O Derivatives 6/109
P Hedge funds 6/116
Q Absolute return funds 6/118
R Structured products 6/118
S Sharia-compliant investments 6/123
T Direct investment compared to indirect investment 6/124
Appendix 6.3: Treatment of a single £10,000 bond vs. a cluster of twenty 6/131
£500 segments

7: The investment advice process

A Providing investment advice 7/2
B Risk and return objectives 7/12
C Applying asset allocation 7/16
Contents 17

8: The principles of investment planning

A The main approaches to asset allocation 8/2
B Portfolio optimisation 8/3
C Strategic and tactical asset allocation 8/5
D Alignment with client objectives 8/7
E Portfolio construction 8/8
F Fund selection 8/11
G Selection of tax wrappers 8/16
H Platforms 8/19
I Discretionary management services 8/20
J Provider selection issues 8/21
K Recommendations and suitability 8/21
L Portfolio reviews 8/21

9: The performance of investments

A Introduction to investment performance 9/2
B Performance measurement 9/3
C Performance attribution 9/10

Self-test answers i
Legislation xv
Index xvii
 Chapter 1
The characteristics,
1
inherent risks, behaviour
and correlation of
asset classes
Contents
1.1: Cash investments and fixed-interest securities
1.2: Equities, property and alternative investments
Chapter 1
 Chapter 1.1
1.1: Cash investments and
1
fixed-interest securities
Contents Syllabus learning
outcomes
Learning objectives
Introduction
Key terms
A Cash investments 1.1, 1.2
B Fixed-interest securities 1.1, 1.2
Key points
Question answers
Self-test questions

Learning objectives
After studying this chapter, you should be able to:
• analyse the characteristics and inherent risks of the main types of cash investments; and
• analyse the characteristics and inherent risks of the main types of fixed-interest securities,
and the characteristics of yields, yield curves and the bond markets.
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Introduction
An adviser has a wide range of investment products from which to choose when making a
recommendation to a client. Each category of asset has a potential role to play within a
client’s overall investment portfolio; however, each has a different risk/return profile.
Different types of investment are more or less risky in different circumstances:
• Inflation erodes monetary values, so cash and fixed-interest securities are vulnerable to
inflation.
• In an economic downturn, equities are generally losers.
• In periods of declining interest rates, cash deposits are generally unattractive, while fixed-
interest bonds and equities can be more appealing.
• Risk may affect both the capital value and income of investments.

Figure 1.1: Different types of risk

Systematic and
Shortfall
non-systematic

Inflation Currency

Investment capital
and income
Income Interest rate

Regulatory Counterparty Liquidity

Risk is everywhere and in every investment, and yet there is no clear way to measure or
compare the risk of different types of investments. This chapter examines the characteristics
and risks of the main forms of direct investment, i.e. cash, fixed-interest securities, equities,
property and alternative investments such as works of art and commodities.

Key terms
This chapter features explanations of the following:
Bond markets Cash investments Commercial bills Default risk
Fixed-interest Floating rate notes Foreign currency Inflation risk
securities (FRNs) deposits
Interest rate risk Market or systematic Money market funds Permanent Interest
risk Bearing Shares
(PIBS)
Perpetual Reinvestment risk Treasury bills Yield curves
Subordinated Bonds
(PSBs)
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Chapter 1 1.1: Cash investments and fixed-interest securities 1/5

A Cash investments
Cash investments provide a high level of security for an investor’s money. However, they
generally provide little protection against inflation, which, over time, can erode the capital
value and reduce its buying power.

Cash deposits
Although currently offering low returns, it is important for all investors to have some
money in a suitable cash deposit, so that it can be easily accessed in the event of an
emergency.

A1 General characteristics
The major deposit takers are banks, building societies and the UK Government through
National Savings and Investments (NS&I).

Table 1.1: Characteristics of cash investments

The main characteristics of • Investors receive regular interest on their deposit at the
cash deposits are: rate. On some deposits, the interest rate is
prevailing rate
variable, so that the income will generally rise and fall with
interest rates. Obtaining a fixed return usually involves the
investor locking up their money for a fixed term.
• The investor
investor’’s capital is not exposed to investment risk
risk.
It is repaid in full either on demand or at the end of a
stated term. There is, however, no potential for capital
growth, which means that its real value will be eroded by
inflation.
• The return simply comprises interest, with no potential
for capital growth.
• Cash is a liquid asset that can be accessed easily if
necessary.

The interest rate applied to the deposit is usually:

• a flat rate (an annual equivalent rate (AER) is where interest is compounded more
frequently than once a year);
• fixed or variable;
• paid gross of income tax;
• dependent upon the term and/or notice required; and
• subject to penalties on early withdrawal in the case of fixed-term deposits.
Fixed-term deposits can also be made in money market accounts. The term can range from
overnight to one year and the rates are based on those that can be obtained in the money
markets, as measured by the London Interbank Offered Rate (LIBOR).
Many accounts offer higher rates of interest, but require notice periods or minimum balances Be aware of notice
before penalty-free withdrawals can be made. The types of penalty that can be imposed are: periods or
minimum balances
• loss of the interest differentials that were being provided for larger or longer-term to avoid penalties

deposits; and
• loss of interest for the period of notice required on the account.
If a penalty charge is applied on withdrawal, it can greatly reduce the overall return that an
investor earns. This should be taken into account when considering the most appropriate
account to suit their needs and objectives.

A2 Risks
Although cash deposits are relatively simple products, with low risk and no explicit
management charges, it does not follow that they are free of risk.
Chapter 1.1
1/6 R02/July 2018 Investment principles and risk

Figure 1.2: Risks facing cash investments

Default risk

Interest
Inflation risk
rate risk

The risks presented by cash deposits include the following:

• Deposit-taking institutions are of varying creditworthiness
creditworthiness. The possibility of an
institution becoming insolvent and defaulting must be assessed.
• Inflation reduces returns and could mean the real return (after inflation) is negative.
• Interest rates may fluctuate
fluctuate, and the return earned could vary over time.
• Deposits in foreign currencies are subject to exchange rate movements
movements. As a result, cash
investors can often find their deposit accounts earning a lower rate than expected, or
even suffer a capital loss.
When comparing available investment options, it is important to understand the risks that
exist and to consider how they could impact on an investment.

A2A Default risk

Consider credit
Events in 2008 showed that the risk of a bank or building society defaulting on its obligation
worthiness and to repay an investor’s capital is a very real one. The risk associated with a particular
protection from a
compensation
institution therefore needs to be assessed carefully. To judge the level of risk, two things
scheme should be considered:
• the creditworthiness of the bank or building society; and
• the extent to which any compensation scheme will protect the deposits made.
Creditworthiness
One of the ways in which the creditworthiness of a bank or building society can be assessed
is by looking at its credit rating. These are issued by credit rating agencies such as Standard
& Poor’s, Fitch Ratings and Moody’s. Credit ratings principally assess the default risk
associated with bonds issued by governments and companies, but they also give an
indication of a bank’s stability and its ability to repay debts.
Compensation scheme
In the UK, the Financial Services Compensation Scheme (FSCS) is the statutory fund of last
resort that can be called upon in the event of the failure of a bank or other financial firm.
Under the FSCS, the protection provided for deposits is 100% of the first £85,000 per
authorised institution.

Be aware
Key points about the FSCS
• The limits of compensation apply for each investor.
• An investor with several accounts with the same bank or building society cannot
recover more than those investors who hold all of their money in one account.
• Joint account holders can each recover up to the maximum limit of compensation in
respect of the same account.
• If deposit accounts are held at banks and building societies that are subsidiaries of a
larger group, and it is only the parent company that is authorised, only the first £85,000
is protected.
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There are special rules where deposits are held with a UK branch of a bank from the The FSCS scheme
European Economic Area (EEA). However, the FSCS scheme does not cover deposits with does not cover
deposits with
institutions outside the EEA or in the Channel Islands or the Isle of Man. institutions outside
the EEA or in the
It is important to bear in mind that, in the event of a deposit-taking institution defaulting, it Channel Islands or
will take time to resolve the position and return deposits to investors. The time the FSCS the Isle of Man

needs to sort matters out depends on the complexity involved, but they aim to pay
compensation in the majority of cases within seven days of a bank, building society or credit
union failing. More complex claims are paid within 20 working days.
Although the FSCS gives some degree of protection, this should not distract investors from
assessing default risk extremely carefully. Higher than normal returns may mean higher than
normal risk, particularly with overseas banks where the deposit may not be covered by the
FSCS.

A2B Inflation risk

The purchasing power of interest earned on cash investments is undermined by rising prices. See chapter 5,
section A2 for
If an investor is locked in for a considerable period, the final return may be unsatisfactory in more on inflation
real terms if inflation has risen unexpectedly. risk

Activity 1.1
Visit the Office for National Statistics website at www.ons.gov.uk/economy/
inflationandpriceindices to look up the current rates of inflation using the consumer prices
index (CPI), CPI including owner occupiers’ housing costs (CPIH) and the retail prices
index (RPI), and compare the results with the general level of interest rates available on
cash deposits. What conclusions can you draw?

Long-term cash investors, in particular, face the real possibility that the final amount with
interest may buy less than the original sum would have done when invested.

Be aware
Interest rates and inflation
In the 1970s and early 1980s, interest rates were often so much lower than inflation rates
that even shorter-term deposit holders, who reinvested all of the interest they received,
experienced substantial erosion of the real value of their deposits.
This is currently the situation in the UK, with inflation rates running much higher than the
average interest rate on a deposit account.

A2C Interest rate risk

Cash deposits carry the risk that the return earned will vary depending upon movements in
interest rates. This is interest rate risk and is implicit with accounts that earn a variable rate
of interest dependent upon base rate changes. However, fixed-term deposits at fixed rates
of interest also carry reinvestment riskrisk. This is the risk that the original investment may have
been made at a time when interest rates were high but at the end of the fixed term, rates
may have fallen and it may not be possible to secure the same level of interest on
reinvestment.
This was a real issue that many savers faced in 2009. Many retired people had invested Savers faced
money in fixed-rate savings accounts for between three and five years and secured a steady reinvestment risk
in 2009
flow of interest to supplement their pension income. On maturity of those deposits, investors
experienced difficulty in reinvesting the proceeds in accounts that earned similar amounts,
as the comparable rates on offer were often as low as half those previously paid. The
practical result of this was that many pensioners experienced a significant reduction in their
spendable income as a result of falling interest rates.

A2D Offshore accounts

Many people have been tempted to invest in offshore sterling accounts or to invest in Offshore accounts
another currency to earn higher rates of interest. However, chasing higher rates of interest present additional
risks
by investing in accounts that are denominated in a foreign currency or which are provided
by overseas financial institutions carries additional risks over and above those already
discussed.
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Where investment in such an account is appropriate for an investor, particular attention

should be paid to assessing the credit risk of the institution and the arrangements that are in
place in the event of default. The extent of any depositor protection scheme needs to be
assessed along with the reliability of any government guarantee.
Cash investments in a foreign currency provide income and should maintain capital value –
but only in the foreign currency. The actual return to the investor in the home currency
depends on the exchange rate at the time the account is converted back, and currency
exchange rates can change quickly and drastically.
Three common dangers are as follows:
• High rates of interest might seem attractive but they are usually offered by high inflation
countries with potentially collapsing currencies.
• An investor might accept a low interest rate in a ‘strong’ currency in the expectation that
currency gains will always make up for the low return. In fact, strong currencies do not
strengthen continuously against sterling: they fluctuate in value like all financial assets.
Currencies regarded as strong may not rise enough to compensate for their lower interest
rates.
• Some countries do not have the same level of supervisory structure as the UK, meaning
institutional collapse may be more probable.

Table 1.2: Factors to consider when investing in foreign currency

accounts
When investing • what the markets and other investors consider to be the expected
in foreign movement in the currency against sterling over the lifetime of the
currency cash proposed investment, and the range of their opinions;
investments,
investors should • the volatility of the currency’s past value against major currencies;
consider: • if details of the foreign currency are not easily available, the prospect
for sterling generally over the relevant period (if sterling is expected
to appreciate against other currencies generally, the investor should
expect to lose on converting the capital sum back to sterling; whether
the interest earned will compensate adequately for this must be
considered);
• if the investment is being made at a variable rate, the likely changes to
interest rates over the relevant period;
• the ability of the deposit-taking body to repay the capital when it
matures;
• whether there are statutory or industry compensation schemes, the
level of payment and the circumstances in which they are paid.

Despite these risks, foreign currency cash investments can be suitable for people who want
income in a particular currency to meet liabilities denominated in that currency. They can
also be appropriate for investors who specifically want to speculate on exchange rates, while
earning some income in the meantime.

A3 Types of bank and building society accounts

The types of accounts available from banks and building societies have changed little in
recent years, although technology allows people to access their money in different ways.
Banks and building societies provide a range of accounts for investors, with interest rates on
some tiered according to the size of the balance held in the account. These are generally
available as either:
• instant access accounts; or
• restricted access accounts.
Many people have money in instant access accounts earning low interest rates. In general,
the longer a deposit is committed to the bank or the further it is away from the high street,
the better the rates offered.
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A3A Instant access accounts

Instant access accounts give investors immediate access to their funds and are operated
through branches, by post, by phone and online.
Interest rates generally follow the trend of bank base rates, with the best rates usually Interest rates
available from online accounts and the worst from branch-based accounts. One problem for generally follow
the trend of bank
providers is that, in today’s low interest rate environment, cost pressures make it virtually base rates, with
impossible to offer attractive interest rates for branch-based accounts. the best rates
usually available
The main characteristics of instant access accounts are: from online
accounts and the
• an investor can withdraw cash immediately via a branch or by using a cash card; worst from branch-
based accounts.
• rates are variable, almost without exception, and can be significantly lower than other
types of deposit accounts; and
• the highest rates are usually found on postal, telephone and online accounts.
Only accounts where cash can be withdrawn immediately can be described as ‘instant
access’. Many postal, telephone and online accounts have a short delay before an investor
can access their cash because of the time taken to process funds through the bank clearing
system. Unless cash can be withdrawn using a cash card, these accounts cannot be
described as ‘instant access’ and are often called ‘easy access’ accounts.
It is important to be wary of the ‘teaser rate’ accounts from providers which often appear at
the top of league tables. These accounts may:
• offer short-term bonuses;
• have low limits on how much can be deposited and earn the most attractive interest rate
(the headline rate); or
• require parallel investments in other (less competitive) products.
For these reasons, the Financial Conduct Authority (FCA) requires providers to ensure any
communication or financial promotion concerning accounts meets its standards of being
fair, clear and not misleading.

Activity 1.2
Use a web-based savings account comparison site, such as www.moneysupermarket.com,
to review the ‘best’ rates on offer. Compare rates where there are no bonuses with those
that have bonuses but apply some restrictions or conditions on withdrawals or investment
period.

A3B Restricted access accounts

The main characteristics of restricted access accounts include:
• rates being generally higher than for instant access accounts and, for the most restricted
types of account, the rates are among the highest available on cash investments; and
• risks being higher because of the restricted access. This is because many things can
change over time, including the credit rating of the bank or building society, the returns
available elsewhere or the rate of inflation.
Interest rates on many restricted access accounts are variable, but some fixed rates are
usually on offer. The main types of restricted access accounts are:
• notice accounts; and
• term deposit accounts (also referred to as time deposits).
Chapter 1.1
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Table 1.3: Characteristics of notice and term deposit accounts

Notice accounts • A notice account will usually pay a slightly higher variable rate of
interest than an instant access account in exchange for the investor
having less access to their money.
• Some notice accounts work on a very simple basis and require a
period of notice before funds can be withdrawn. Periods of notice
of 30, 60 and 90 days are the most common. The longer the notice
period, the higher the interest rate.
• Penalties may be levied for early access and this is typically
equivalent to the interest for the period of notice on the amount
withdrawn. Many also have much more complex rules, for example,
permitting a limited number or amount of withdrawals without
notice.
• One risk for the investor in the longer notice accounts is that the
deposit taker may offer a higher initial rate to attract funds and
then cut the returns sharply, leaving investors locked in for the
notice period.
Term deposit • Banks and building societies also offer term deposit accounts,
accounts typically from one to five years with a fixed rate of interest, but
with no or limited access to capital before maturity.
• Term deposit accounts provide even higher interest rates for
investors who are prepared to leave money on deposit for a fixed
period.
– Banks tend to offer the widest range of periods, ranging from
seven days to several years, although some require substantial
minimum amounts.
– Smaller banks and building societies tend to offer the highest
rates, but with a more restricted choice.
– Some term deposit accounts offered by banks and building
societies are referred to as ‘bonds’ (not to be confused with
investment bonds or corporate bonds). Interest rates may be
tiered according to the size of the deposit and the term of the
investment.
• Term deposit accounts are suited to investors who want certainty
of income, but are not appropriate for ‘rainy day’ cash. The rates
offered are driven by the money market and may be higher or
lower than variable rates, depending upon the market’s
expectations of future interest rates.
• With interest rates still low (0.5% base rate, as at April 2018), it is
interesting to see that three-year term deposit accounts are
offering rates up to 1.42%. This does indicate a market expectation
that rates may rise further in the near future, but is also an
indication of how banks need to attract cash deposits.

Structured deposits
Most bank accounts pay interest reflecting market interest rates. Structured deposits pay
interest based on the performance of an equity index (usually the FTSE 100). The typical
structure offers the investor a return over a fixed term, which is the greater of:
• their original investment; or
• a percentage (e.g. 110%) of the change in the FTSE 100.
For more These products appear to offer a risk-free way to participate in the rise of stock markets.
information on
structured However, they tend to require a commitment of five years or more, over which time inflation
products, see can take its toll and the only guarantee is the original investment. Structured deposits are
chapter 6.2
offered by a number of high street banks, often with names such as guaranteed investment
account or deposit plan.
 Chapter 1.1
Chapter 1 1.1: Cash investments and fixed-interest securities 1/11

Be aware
Structured deposits
Structured deposits are similar to structured products in that they offer 100% capital
protection and the return is linked to one or more indices, securities or commodities.
Where they differ is how capital protection is provided. A structured product usually relies
on protection provided by a third party who issues debt securities to be held within the
structured product wrapper, and so the investor is exposed to the risk of default by that
counterparty. With a structured deposit, however, the deposit-taking firm has an
obligation to repay the depositor.

A3C Foreign currency deposits

A foreign currency deposit is a savings account denominated in a currency other than
sterling, e.g. a US dollar or euro deposit. Accounts may be instant access savings accounts or
fixed-term deposit accounts. They are available from UK and overseas banks, although the
minimum balance required to open an account is often quite high, e.g. US$ 10,000 to
US$ 15,000.
The interest rate paid reflects the prevailing market rate for the currency in which the
account is denominated.

A3D Offshore sterling deposit accounts

Offshore accounts in sterling are generally available from UK branches of banks and building
societies situated in tax havens such as the Channel Islands or the Isle of Man. The accounts
range from variable rate instant access and notice accounts to term deposit accounts in
much the same way as UK accounts.
These accounts may pay higher interest rates than the equivalent account in the UK.

A3E Individual savings accounts (ISAs)

Individual savings accounts (ISAs) are not an investment but a tax wrapper.

Table 1.4: Characteristics of cash ISAs

Features • Cash ISAs allow savers to receive tax-free interest.
• In 2018/19, the overall annual subscription limit is £20,000
(unchanged from 2017/18). All of this can be invested in cash.
• They are available to individuals who are resident in the UK for tax
purposes, but can only be arranged on an individual (not joint)
basis.
• There is no minimum investment and no minimum holding period.
• Withdrawals can be made at any time without any loss of tax relief.
• Withdrawals can be made and replaced in the same tax year with
no impact on the annual ISA subscription limit for that tax year.
Rules • It is possible to transfer some or all of the money saved in previous See chapter 6.2,
tax years to another ISA manager at any time. section L10 for
more on ISAs
• It is also possible to transfer money saved in the current tax year,
but such transfers must be for the whole amount saved in that tax
year, up to the date of the transfer.
• ISA savers can transfer their cash ISA to another cash ISA or, if they
are aged 18 or over, to a stocks and shares ISA or to an innovative
finance ISA (IFISA). An IFISA allows lenders to enjoy tax-free
returns up to the annual ISA subscription limit.
• A stocks and shares ISA can be transferred to a cash ISA.
• A Help to buy ISA, which is a type of cash ISA, can be transferred to
a Lifetime ISA.
Chapter 1.1
1/12 R02/July 2018 Investment principles and risk

Table 1.4: Characteristics of cash ISAs

Eligible • Bank or building society accounts.
investments • Units or shares in UK authorised unit trusts and open-ended
investment companies (OEICs), which are money market schemes.
• Units or shares in a unit trust, OEIC, undertakings for collective
investments in transferable securities (UCITS) scheme or a life
assurance policy that would be likely to return at least 95% of the
investor’s original capital within five years from the date of
investment.
• The NS&I Direct ISA product.
• Stakeholder cash deposit products.

Cash ISAs are available to 16 and 17-year-olds. However, if the money is given to them by a
parent, and the interest together with any other income from gifts provided by the parent is
more than £100 a year, the income will not be tax free and will be treated as the parent’s
income until the child reaches age 18.

A4 National Savings and Investments (NS

(NS&
&I) products
NS&I products are Government investments that can be bought online, by phone or by post
directly from NS&I. They are secure investments because they are guaranteed by the
Government. At the time of writing, the following products are available:
• premium bonds;
• direct saver accounts;
• investment accounts;
• income bonds;
• guaranteed income bonds;
• guaranteed growth bonds;
• Direct ISAs; and
• Junior ISAs
These products are no longer on sale:
• 65+ guaranteed growth bonds;
• investment guaranteed growth bonds;
• children’s bonds;
• index-linked savings certificates; and
• fixed-interest savings certificates.

Useful website
More information on different NS&I products is available at: www.nsandi.com/our-
products.

A4A NS
NS&
&I Direct ISA
NS&I offer two ISA products, the Direct ISA and the Junior ISA:
• NS&I Direct ISAs (and Junior ISAs) can only be opened and managed online or by phone.
• Transfers from other providers are not permitted.

A4B NS
NS&
&I Savings Certificates
Currently, issues of Savings Certificates are only available to customers who have maturing
certificates. They are not on general sale. Those customers can renew up to the total value of
their maturing certificate, including earned interest, or they can cash in some of the
investment and renew the balance.
 Chapter 1.1
Chapter 1 1.1: Cash investments and fixed-interest securities 1/13

A4C NS
NS&
&I Children
Children’’s Bonds
The NS&I Children’s Bond was a lump sum investment made on behalf of a child with fixed
rates of interest for five years at a time. Since 26 April 2018, the NS&I Children’s Bonds are no
longer available, meaning that new bonds cannot be issued and matured bonds can no
longer be renewed.
• For five years, the NS&I Children’s Bond earns a single annual rate of interest.
• Interest is earned on a daily basis and added to the bond on each anniversary date.

A4D NS
NS&
&I Income Bonds
NS&I Income Bonds pay a monthly income at a variable rate of interest with no risk to
capital. The same rate of interest is paid no matter how much is invested.
For new income bonds, investors must be aged at least 16.
NS&I Income Bonds can be cashed in at any time with no notice period or penalty. Interest is
paid gross but is taxable and therefore counts towards the personal savings allowance.

A4E NS
NS&
&I Investment Bonds
The Investment Guaranteed Growth Bond was available for twelve months (until 10 April
2018) for those over the age of 16 and holding a UK bank account. It had the following
characteristics:
• three-year fixed term;
• fixed rate of 2.20% gross for three years;
• managed online; and
• a maximum holding of £3,000 per person.

A4F NS
NS&
&I Bank Accounts
NS&I have two types of Bank Account:
• an investment account managed by post only; and
• a direct saver that can be opened online or over the phone.

A4G Guaranteed Income Bonds

The Guaranteed Income Bond has the following characteristics:
• fixed terms of one, two, three or five years, with differing fixed rates for each;
• minimum investment of £500 and a maximum of £1m per person;
• interest is paid gross but is taxable so will count towards the PSA;
• interest is paid once a month; and
• they are available by online application only.

A4H Guaranteed Growth Bonds

The Guaranteed Growth Bond has the following characteristics:
• fixed terms of one or three years, with differing fixed rates for each;
• minimum investment of £500 and a maximum of £1m per person;
• interest is paid gross but is taxable so will count towards the PSA; and
• they are available by online application only.

A5 Money market investments

Banks, building societies and other institutions need to hold significant cash surpluses to
meet sudden cash demands (e.g. deposit withdrawals). They prefer to earn a return on these
funds, but need the security of high liquidity, i.e. the ability to encash instantly at relatively
certain prices. The money markets are the wholesale markets where banks, building
societies, the Government and others lend to and borrow from each other. They lend and
borrow for periods ranging from a few hours to several months using short-term debt
instruments.
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The specialist nature of the market and high minimum investment levels means the amount
of private investor involvement is limited. Private investors can, however, gain access to this
market through one of the many collective investment vehicles that specialise in this area.

A5A Characteristics
Money markets play an essential role in the smooth operation of government finances and
the banking industry, as well as providing short-term capital for companies.

Money market
Money market instruments allow issuers to raise funds for short-term periods at relatively
instruments allow low interest rates. The issuers include governments, banks and companies, each of which
issuers to raise
funds for short-
may issue debt instruments to manage their short-term cash needs. Investors in these
term periods at instruments are the banks themselves, companies, local authorities, money market funds
relatively low
interest rates
and individuals who are attracted to the market because the instruments are highly liquid
and carry a relatively low credit risk.
The money markets allow borrowers to obtain funds for a fixed period at a fixed rate, while
the lenders have instant access to the funds at any time by trading (selling) the security in
the money market.

A5B Types of money market instruments

Among the main types of security that are traded in the money markets are Treasury bills,
commercial bills and certificates of deposit.

Figure 1.3: Money market instruments

Treasury bills

Others –
repos, bills of Money Market Commercial
exchange, etc Instruments bills

Certificates
of deposit

Treasury bills
Treasury bills are issued by governments to finance their short-term cash needs.

The issue of UK
In the UK, the issue of Treasury bills is managed by the Debt Management Office (DMO), an
Treasury bills is agency of HM Treasury, which uses the Treasury bill market to manage the Government’s
managed by the
Debt Management
daily cash flow needs. Treasury bills are routinely issued at weekly auctions and can have
Office, an agency maturities of one, three, six or twelve months, although, so far, no twelve-month bill tenders
of HM Treasury
have been held. In addition to the weekly auctions, the DMO occasionally issues Treasury
bills on an ad hoc basis with maturities from 1 to 364 days. Members of the public who wish
to purchase them must do so through one of the Treasury Bill Primary Participants and
purchase a minimum of £500,000 nominal of bills.
Treasury bills do not pay interest. Instead, they are issued at a price that is less than their par
or face value and, at maturity, the Government pays the holder the full par value. The interest
is equal to the difference between the purchase price and the maturity value.
 Chapter 1.1
Chapter 1 1.1: Cash investments and fixed-interest securities 1/15

Example 1.1
If a three-month Treasury bill is issued at a price of £99.876105, it means that a purchase
of £1m of three-month Treasury bills would cost £998,761.05.
At maturity, in three months’ time, this will be redeemed by the Government for £1 million
and the difference between the two amounts (£1,238.95) represents the interest earned.
On an annualised basis, this amounts to 0.497%.

Treasury bills are backed by the UK Government, are short-term and are highly liquid. They
are therefore deemed risk-free cash investments. Their prevailing rate of return is often used
as the benchmark ‘risk-free rate of return’ when measuring the risk premium needed for
other financial instruments.
Certificates of deposit
Certificates of deposit (CDs) are receipts from banks for deposits placed with them. Certificates of
deposit are
The deposits themselves carry a fixed rate of interest, usually related to LIBOR. They have a receipts from
fixed term to maturity and so cannot be withdrawn before maturity. However, the banks for deposits
placed with them
certificates can be traded in the money markets if the investor needs access to the funds
before maturity. The yields on CDs are slightly less than on an ordinary deposit because of
the added benefit gained from being able to trade the CD and so access the capital. Most are
issued with maturities of one to three months, with the interest paid on maturity.
Banks and building societies issue CDs to raise funds to finance their business activities, and
the yield will depend upon market rates and the credit rating of the issuing bank.
Commercial bills
Commercial bills are short-term negotiable debt instruments issued by companies to fund
their day-to-day cash flows. They operate in a similar way to Treasury bills, although the
market is less liquid.
Commercial bills are issued at a discount to their maturity value, with typical maturities of Typical maturities
between 30 and 90 days. They are unsecured and usually issued only by companies with of commercial bills
are between 30
high credit ratings. The yields are typically higher than the Treasury bill equivalent to reflect and 90 days
the higher credit risks involved and their reduced liquidity.

A5C Investment vehicles

The money market is a specialised market where most of the securities trade in very high
denominations and the scope for direct investment by private investors is limited. There is,
however, a range of collective investment vehicles available to both private and institutional
investors, which pool together investors’ funds to invest on their behalf.
Each money market fund can invest differently – some may invest solely in cash deposits in
the money market and others may use a whole range of money market instruments to
achieve their returns. It is important to understand the underlying composition of the
portfolio when assessing returns and risk.
Rules have been implemented across the European Union (EU) so that investors are clear
about what type of money market fund they are investing in. Money market funds must now
meet a set of rules that defines clearly the types of assets, duration and controls that should
be expected from them.

Figure 1.4: Types of money market funds

Types of money
market fund

Short-term Standard
money market money market
fund fund
Chapter 1.1
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Managers must qualify their funds as ‘standard money market funds’ or ‘short-term money
market funds’, according to the maturity and life of the fund assets:
• Short-term money market funds have a weighted average maturity of no more than 60
days and a weighted average life of no more than 120 days.
• For standard money market funds, those periods are extended to six months and twelve
months.

Activity 1.3
Use a website service to identify a list of money market funds. Select one that is offering a
low yield and one that is offering a higher yield. Look at the key facts about the funds and
identify the differences in their underlying portfolios. What are the major differences?

To assess whether a money market fund is suitable for a client, a number of factors should
be considered, including:
• how the returns on money market funds compare with other cash-based investments;
• what charges are made and how this impacts on the returns;
• how long it will take to realise the assets if the client needs access to the funds;
• what assets are contained in the underlying portfolio and the degree of risk to which the
fund is exposed; and
• how experienced the fund management team is.

Table 1.5: Risk and return

Returns • The returns on a money market fund will vary depending upon the
composition of the underlying portfolio.
• A fund that invests in pure cash assets will generate a lower return
than one that uses commercial bills and very short-term debt
instruments. With base rates at 0.5% (as at May 2018), the return on
money market instruments is not competitive.
• The costs of investing in a money market fund will need to be taken
into account when assessing the suitability of the fund and
comparing it with cash investments. While charges will vary from
fund to fund, there would usually be no initial charges and low
annual charges in the region of 0.15%.
Risks • Money market funds carry many of the same risks as other cash
investments. In other words, they have credit risk, inflation risk and
interest rate risk, and may also have currency risk depending upon
their investment objective and the underlying investments.
• Where they differ is in how each fund may be affected by credit
risk.

The starting point for considering the credit risks associated with money market funds
should be to compare the relative levels of risk between a savings account and a money
market investment.

Be aware
Risks of money market funds versus cash investments
A couple of factors to consider:
• Placing funds in a cash investment means that the investor is exposed to the risk of that
bank or savings institution defaulting.
• By contrast, a money market fund will invest in a range of instruments from many
providers. On the one hand, this can diversify against the risk of a single institution
going bust, while, on the other hand, the level of risk will depend upon the types of
instrument into which the fund invests and the credit rating of the issuing institutions.

Question 1.1
Consider the statement ‘cash investments are riskless’. Is this true or false? Explain your
answer.
 Chapter 1.1
Chapter 1 1.1: Cash investments and fixed-interest securities 1/17

B Fixed-interest securities
Fixed-interest securities are issued by governments, companies and other official bodies as
a method of raising money to finance their longer-term borrowing requirements. In return
for lending money to these institutions, the owner of the fixed-interest security is entitled to
receive regular interest payments and usually a repayment of their capital at the end of a
pre-determined period.
They cannot be cashed in before their official maturity date; however, investors can sell
them on the stock market at any time without needing to refer to the original borrower.
Fixed-interest securities can be described as ‘negotiable fixed-interest, long-term debt Fixed-interest
instruments’: securities are
‘negotiable fixed-
• Negotiable
Negotiable: after making the original loan to the borrower by buying a security, a lender interest, long-term
debt instruments’
can then sell the entitlement to the interest and capital repayment to a third party, who is
also free to sell it on to another.
• Fixed-interest
Fixed-interest: the borrower is committed to pay interest at a fixed rate for the duration
of the loan.
• Long-term
Long-term: they typically run for between 2–30 years.
• Debt instrument
instrument: these are financial instruments representing debt.
Fixed-interest securities are also known as bonds, loan stock, debentures and loan notes.
Other names such as gilts and corporate bonds signify loans to particular types of
borrowers: securities issued by the UK Government are called ‘gilts’ or ‘gilt-edged securities’
and securities issued by companies are known as corporate bonds. We will now use the term
‘bond’ to refer to fixed-interest securities.
Companies and other institutions often raise the long-term finance they need by issuing
bonds directly to the capital markets, rather than borrowing from banks, for a number of
reasons, such as:
• Banks may not be able to lend for the particular term (period) or amount that is required.
• The bond market offers a wider range of lenders to tap into; London is the world’s largest
market for international funds.
• Bonds are often the cheapest method of borrowing money.

Be aware
UK trend
There is a clear trend in the UK, following US practice, for companies to go to the capital
markets, rather than to their banks, for large loans.

B1 General characteristics
Bonds have certain common characteristics. They generally:
• carry a fixed rate of interest, known as the coupon;
• have a fixed redemption value, the par value; and
• are repaid after a fixed period, at the redemption date.

B1A Bond titles

The title of a bond will always give three key features:
• issuer’s name;
• coupon; and
• maturity date.
For example: Vodafone Group Plc 5.625% 2025.
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Table 1.6: Features of bonds

Name • This identifies who has issued the bond.
• The issuer is responsible for paying interest and repaying the capital.
These can range from the most secure, i.e. government securities,
through to the most debt-laden company.
• In this example, Vodafone Group Plc has issued the bond.
Nominal • The nominal value of a bond is £100 and is not the same as its market
value price.
• The nominal amount (or par value) is used to determine the interest and
maturity payments and, as a bond nears the end of its life, its market
price will approach the nominal amount.
• At other times, the market price may be higher or lower than the nominal
figure.
Coupon • This is the rate of interest payable on the bond.
• It is set at the time of issue and depends on market forces at that time. It
is usually fixed for the life of the bond.
• It is expressed gross, and is calculated as simple interest on the nominal
value of the bond. In the example above, the coupon is 5.625%.
• Most bonds pay interest twice a year, on dates that are set by the issuer
at the time the bond is issued. Some corporate bonds pay once a year.
Maturity date • This identifies the specific date on which the issuer will repay the
nominal value of the bond to the investor who owns it at the time.
• It is decided on by the issuer of the bond and usually coincides with one
of the interest payment dates in the maturity year. The Vodafone
corporate bond has a redemption date of
4 December 2025.
• In the past, some gilts were quoted with two dates, known as ‘double-
dated gilts’ – in these cases, the Government chose the exact timing of
redemption at a point between two given dates. The final gilt of this type
was redeemed in 2013.
• With an ‘undated’ gilt, there was no stated redemption date. The last
remaining ‘undated’ bonds in the UK gilt portfolio were redeemed in
2015.

B2 Pricing and trading

B2A Pricing
Bonds are traded
Bonds are traded by their nominal value or par value, which is the face value on the bond
by their nominal certificate:
value or par value
• A bond holding of £10,000 would refer to the nominal value of the bond owned, not how
much it cost.
• Bond prices are quoted at a price for £100 nominal value, although any amount can be
purchased.
Before redemption, the market price of £100 nominal will vary; it may be above or below the
par value. The nominal or par value determines:
• the price at which the bond will be redeemed by the issuer at the redemption date; and
• the amount of interest that will be received.

B2B Trading
Prices are quoted in the Financial Times and other major newspapers, but these are not the
exact prices that an investor would pay. There are two reasons for this:
• They are mid-market prices
prices, i.e. the mid-point between the buying and selling prices
quoted in the market. An investor would pay a higher price to purchase a bond, and
receive a lower price on a sale.
• They are clean prices and ignore the value of accrued interest, which is the interest that
builds up between interest dates. The interest on bonds is calculated daily and must be
added to or subtracted from the clean price to arrive at the total purchase price of the
bond.
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In the current low interest rate environment, many bond prices are trading above the
nominal figure. For instance, Treasury 8% 2021 was first issued in February 1996 at a price of
£98.53125. In February 2018, its price was £123.22; the investor who buys this bond now and
holds it until June 2021 will suffer a capital loss of £23.22 for each £100 nominal value
bought. The investor is compensated to some extent by receiving a higher income than is
generally available. Equally, an investor who bought some time ago could lock in the profit
and reinvest in another bond.

B2C Accrued interest

Interest on most bonds is paid biannually, but accrues daily between interest payment dates. Interest on most
bonds is paid
biannually, but
Table 1.7: Cum and ex dividend accrues daily
between interest
Cum dividend • When a bond is cum (with) dividend
dividend, the purchaser will receive the full payment dates
six months’ interest, even though the bond was owned by them for less
than the entire period.
• Consequently, when the bond is purchased, the buyer has to
compensate the seller for the interest to which they were entitled but did
not receive.
• The buyer will pay the clean price plus the interest that has accrued from
the date of the last interest payment up to the settlement date (usually
the business day after purchase).
Ex dividend • Interest payments are usually made to whoever is the registered holder
of the bond seven working days before the interest payment date.
• If the bond is purchased after that time but before the payment date, it is
bought ex (without) dividend, and the full six months’ interest will be
paid to the seller.
• Anyone buying the bond after it goes ex dividend is deprived of interest
from the date of purchase to the interest payment date, and the price is
adjusted to reflect this.
• Interest in respect of the period for which the buyer owned the bond, but
which was paid to the seller, is deducted from the clean price.

The total amount paid by a purchaser, which is the clean price plus or minus any interest
adjustment, is referred to as the dirty price
price.

B3 Bond markets
The arranging and selling of original issues of bonds takes place in the primary market, and
the trading afterwards takes place in the secondary market.

B3A Primary market

The way in which bonds are issued for the first time depends upon the issuer.
Governments are the largest issuers in the bond markets. In the UK, the issue of new gilts is
managed by HM Treasury’s DMO. The DMO issues new gilts weekly to meet the long-term
financing needs of the Government and uses an auction process. The key features of this
process are:
• Large investors put in bids at the price and for the quantity they want.
• Successful bidders pay the price they bid.
• Individuals can submit non-competitive bids for amounts up to £500,000 and, if they are
successful, are allocated stock at the average of accepted prices.
Other organisations or companies issue bonds less frequently. They appoint an investment
bank to manage the issue, which may use a syndicate of banks to market the bonds to
potential investors if the issue is a large one. The key features of this process are:
• The issue and the prospective coupon are marketed to potential investors.
• Potential investors place indicative bids to buy bonds at a certain price.
• The final terms are agreed and issued to the prospective investors, who then have 24
hours to make firm bids.
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B3B Secondary market

Once a bond has been issued, any subsequent trading of that bond takes place in the
secondary bond markets. London is the world’s leading centre for bond trading as most
eurobond trading takes place there.

How it works
Bond trading
The daily value of bond trading is significantly greater than the daily turnover in the
domestic UK equity market. Trading is brisk because holders of bonds are constantly
adjusting their holdings to reflect their changing views on a number of factors, as follows:
• what income they need and when;
• credit ratings of issuers;
• future interest rate trends;
• changes to expected inflation rates;
• conduct of government finances;
• international tensions and the social and political environment generally; and
• relative attraction of other assets.

The trading of bonds after their original issue does not, of course, affect the original issuer or
change the terms of the issue.

There is substantial
There is substantial trading activity in bonds in the UK in four major markets. Three of these
trading activity in are sterling markets that collectively make up the UK bond market:
bonds in the UK in
four major markets • Government sector
sector. The UK Government is the biggest borrower in the UK bond market.
• Corporate sector
sector. UK companies have become major borrowers from the capital markets
leading to subsequent secondary market trading.
• Sterling loans to foreign borrowers
borrowers. The UK markets also manage sterling loans to
foreign governments or companies.
The fourth major market, the eurobond market
market, deals in bonds issued in a wide range of
currencies to a wide range of foreign and domestic companies and governments.

Be aware
Eurobonds
A eurobond is an international bond, denominated in a currency other than that of the
country where it is issued. For example, a British company may issue a eurobond in
America denominated in Japanese yen. This would then be a euroyen bond as Japanese
yen is not the usual currency of America.
Eurobonds are named according to the currency in which they are issued, i.e. a bond
issued in American dollars would be a eurodollar bond, while bonds issued in sterling are
eurosterling bonds.
Multinational companies, national governments and international institutions such as the
World Bank and the European Commission use eurobonds to raise capital in international
markets. The total issue and turnover is high, making this a very liquid market.

B3C Bond indices

As with equity markets, there are a range of bond indices that cover different segments of
the global bond markets. Examples include the FTSE Actuaries UK Gilt Index for the UK or
the Barclays Capital Aggregate Bond Index for global bonds.
 Chapter 1.1
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B4 Bond yields
All fixed-interest securities bear a nominal rate of interest – the coupon – which relates to the
rate of interest on £100 nominal value.
The yields on bonds measure the returns they provide in relation to their market price. Two Yields on bonds
yields are regularly published in the financial press: measure their
returns in relation
• interest yield; and to their market
price
• redemption yield.

B4A Interest yield

The interest yield, which is also referred to as the running yield
yield, the flat yield or the income
yield, expresses the annual income from a bond as a percentage of the price an investor
yield
would have to pay for the bond.
The yield will be different to the coupon, as investors rarely buy for exactly £100.
The formula for the interest yield is:

coupon or nominal yield

× 100
clean price

Example 1.2
If an investor pays £126.85 (clean price) for £100 nominal value with an 8.0% coupon, then
the interest yield would be calculated as follows:
• The return is £8.00 per year (interest is paid on the nominal value of £100).
• The cost to the investor is £126.85.
• Expressed as a percentage return this is:

8.00
× 100 = 6.31
126.85

• The interest yield on this investment is 6.31%.

For an investment of £126.85, the investor receives £8.00 (gross) each year, which is
equivalent to a return on their investment of 6.31%.

Interest yields can, however, be misleading, as bonds may produce a capital gain or loss if
held until redemption, depending on the price at which they are purchased:
• Bonds may trade above or below their par or nominal value. This is because their prices
are not fixed and will alter with the economic climate, responding in particular to changes
in general interest rates and the creditworthiness of issuers.
• If the coupon is above current interest rates and the issuer has a strong credit rating, the
bond will trade above par, as in the example above.
If an investor buys a bond priced at above par and continues to hold it until its redemption
date, they will see a capital loss. However, the bond could be sold to another investor at any
time, and does not have to be held by them until it is redeemed by the issuer.

Question 1.2
An investor buys a holding of £1,000 Gilts – Treasury 5% 2025, which is priced at £125.50.
What is the interest yield?

B4B Redemption yield

The redemption yield is a more accurate calculation of the yield on a bond. It takes into
account both the income payments from a bond and the capital gain or loss from holding
the bond until maturity. It also adjusts the value of each payment according to when it is
received.
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The capital gain or loss occurs in the last year, while the income payments are usually
received half-yearly over the life of the bond. The redemption yield assumes that the
investor reinvests each interest payment as it is received, by buying more of the stock at the
same redemption yield.

Redemption yields
This involves rather complex compound interest calculations for each half-yearly payment
are readily and is difficult to do without a financial calculator. Fortunately, redemption yields are readily
available in the
financial press and
available in the financial press and online.
online
The following method of calculating the redemption yield ignores the compound interest
calculations. Simply, it combines the interest yield with a measure of the gain or loss that an
investor would incur if the bond is held until redemption.
The formula for the simplified redemption yield is:

gain (or loss) to maturity ÷ number of years to maturity

interest yield + or − × 100
clean price

Example 1.3
Continuing from the previous example and assuming the bond has exactly five years to
run until maturity:
• The bond was purchased for £126.85 per £100 nominal.
• At redemption there will be a capital loss of £126.85 – £100 = £26.85.
• There are five years to redemption.
• The capital loss each year is £26.85 ÷ 5 = £5.37.
• As a percentage of the price paid the reduction in return is:

(26.85 ÷ 5)
6.31 − × 100
126.85

⎛ 5.37 ⎞
6.31 − ⎜ × 100
⎝ 126.85 ⎟⎠

• The income yield calculated earlier was 6.31%, so this gives an approximate yield to
redemption of 2.08% (i.e. 6.31–4.23%).

Where the redemption yield is less than the interest yield, there will be a capital loss if the
bond is held until its redemption date.
While the redemption yield allows bonds to be compared on a common basis, and is often
used to measure the return on a bond, it is not particularly useful to the average investor
since it ignores any tax that a private investor would have to pay.
Capital gains on gilts and on most (but not all) corporate bonds are tax-free to individual
investors. Income, though, is taxable on all types of bond. Thus, two bonds may have the
same redemption yield but very different post-tax returns, as one may be trading near par
with little prospect for capital gain and the other trading well below par with the bulk of
returns coming in the form of tax-free capital gains.

Question 1.3
What is the best measure of a bond’s performance?

B4C Yields on collective funds

When the running yield on a pooled fund, such as a unit trust or OEIC, is significantly higher
than the gross redemption yield, some capital erosion may be suffered in the future to
deliver a high level of income.

Income is rarely
Most gilt and bond fund managers quote both measurements of yield as an average of the
fixed and there is stocks they hold. Unlike direct holdings, the income is rarely fixed and there is no maturity
no maturity date
date.
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B5 Risks
The fall in interest rates during 2008–2017 led to an increased interest in bonds due to the
higher interest rates available. This ultimately meant a substantial increase in the amounts
invested in this asset class through bond funds. While bonds can provide attractive returns,
it is also important to understand some of the key risks associated with them.

Table 1.8: Key risks

Interest rate risk When interest rates fall, investors in fixed-interest securities see the
capital value of their securities rise. Equally, when interest rates rise, the
capital value of fixed-interest securities will fall. Long-term bonds tend
to fluctuate more rapidly than securities with shorter maturity dates.
Liquidity risk Many bonds trade infrequently and so present liquidity risk because it
can be difficult to sell them readily at an acceptable price.
Inflation risk The returns on conventional bonds are eroded as a result of the effects
of inflation, although index-linked bonds provide protection because
the interest and capital is adjusted for inflation.
Currency risk Most bond portfolios include global bonds to provide diversification,
but this carries currency risk. In other words, movements in exchange
rates affect the value of the holding.
Default risk All bonds carry the risk that the issuer will not meet their obligation to
pay interest or capital at maturity.

Diversification across a range of issuers, sectors, countries and maturities is essential for
fixed-interest securities. This can be seen by looking at the number of holdings found in a
bond fund.

B5A Factors affecting bond prices

Bonds have to remain competitive by offering the same yield for the same risks as other
investments. As the income from a bond remains unchanged throughout its life, the only way
its yield can vary is through changes to the capital value. So the yield required by an investor
determines the market price of a bond.
The yields required by investors change for a variety of reasons, particularly related to the
rates that are available from competing investments.
• When interest rates rise, bond prices fall, and when interest rates fall, bond prices rise. When interest
• These price movements will result in investors making capital gains or losses if they opt to rates rise, bond
prices fall
sell before redemption.
Bond prices are affected by a variety of factors, which can be broadly divided into:
• specific or commercial risks that affect a particular issuer; and
• market or systematic risks that affect fixed-interest securities generally.

B5B Specific or commercial risks

The issuers of some bonds are in a better position to meet their interest payments and repay
their borrowings than others.
Government bonds
• Governments are the most secure, because they can always raise additional money
(through taxation, for example) to service and repay their debts.
• The creditworthiness of governments means that the interest payments on government
bonds are the lowest, because investors need the least amount of compensation for the
risk that the borrower will fail to meet their financial obligations.
• However, not all governments have the same rating. Those of some less developed
countries have a history of defaulting on both interest and capital payments, and have
found their bonds priced accordingly.
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Non-government bonds
• Non-government bonds are riskier and pay a higher return to investors than those issued
by governments.
• The greater the default risk associated with the issuer, the more an investor would expect
to be rewarded by a higher coupon or yield to compensate.
The creditworthiness of bond issuers is assessed and constantly updated by credit rating
agencies such as Moody’s and Standard & Poor’s. See Table 1.9.

Table 1.9: Credit ratings

Grades Standard & Poor
Poor’’s Moody
Moody’’s
Highest credit quality – AAA Aaa
virtually no risk of default.
Highest rating, high quality. AA+ Aa 1
AA Aa 2
AA– Aa 3
Adequate capacity to meet A+ A1
financial commitments.
A A2
A– A3
Adequate capacity to meet BBB+ Baa 1
financial commitments but
some speculative BBB Baa 2
characteristics against BBB– Baa 3
changes in economic
conditions.
Non-investment grade. BB+ Ba 1
Moderate capacity to meet
financial commitments – BB Ba 2
credit risk. BB– Ba 3
Weak protection of interest B+ B1
and capital.
B B2
B– B3
Lowest credit quality, lowest CCC Caa (1-3)
protection of investors, a
danger of credit default. CC
Vulnerable category. C
In credit default with little D C
prospect for recovery.

The top rating is

The top rating is AAA/Aaa, which is generally ascribed to governments and other similar
AAA/Aaa organisations. The lowest rating of D/C means that the bond is already in default.
Overall, credit ratings fall into two distinct categories:
• Investment grade bonds
bonds: these have ratings of BBB– or higher from Standard & Poor’s, or
Baa 3 from Moody’s, and are considered to have an extremely low risk of default.
• Non-investment grade bonds
bonds: these have ratings below BBB–/Baa 3 and are considered
to have a significantly higher risk of default. They are also referred to as high yield or junk
bonds
bonds.
The creditworthiness of issuers helps to quantify the risk of holding bonds. When the issuer
of a bond experiences a change in their creditworthiness, the yield demanded by investors is
likely to change:
• if a company’s credit rating is marked down, the market price of its bonds will fall because
they are seen as riskier investments, and investors will require an increased yield to
compensate; and
• conversely, an improved credit rating will reduce the required yield because the
investment risk is perceived to have reduced, and the price will rise.
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B5C Market or systematic risk

Market or systematic risk, such as economic changes or government actions, affect all forms
of fixed-interest security. In particular, market prices will vary with changes in the levels of
interest rates and inflation, and any anticipated future movements:
• If inflation or interest rates rise, bond prices tend to fall. The exception to this rule is an
index-linked bond, where the value will rise with any increase in inflation.
• The yields on bonds take into account a rate of inflation for the currency in which they are
denominated:
– if there is an unexpected change in the expectations for inflation, then there will be a
change in bond prices; and
– bond prices tend to rise if expectations of inflation diminish, and fall if the rate of
inflation is deemed to be speeding up.

Be aware
Economic factors
Other economic factors that result in a movement in monetary policy, causing a change in
interest rates, will also impact on bond prices. For example:
• An increasing balance of payments problem may lead to rising interest rates and
therefore declining bond values.
• Economic growth can fuel inflation, leading to rising interest rates and so declining
bond values.
• In contrast, if an economy is in recession, interest rates may be reduced to stimulate a
recovery, which will boost bond prices.

B5D Volatility of bonds

We have seen that bonds are sensitive to interest rate movements. However, not all bonds The lower the
respond to the same extent; this is determined by a combination of the coupon and the coupon and the
longer the period
period to redemption: to redemption, the
more volatile
• the lower the coupon, the more volatile the bond; and the bond
• the longer the period to redemption, the more volatile the bond.

Consider this
this…
…
Which bonds do you think are:
• most volatile;
• least volatile?
Why do you think this is the case?

The most volatile are those with both long periods to their maturity dates and low coupons,
while the least volatile are short dated, high coupon bonds. The rationale behind this is that a
greater amount of the cash flow from the more volatile bonds is received later in the bond’s
life and is exposed to interest rate movements for a longer period. Points to remember:
• The holder of a bond with a high coupon will receive a return on the bond more quickly
than the holder of a similarly dated low coupon bond, where most of the return is tied up
until the final payment at the bond’s maturity.
• The holder of a shorter-dated bond will receive a return on the bond earlier than the
holder of a longer dated bond with the same coupon, and is exposed to interest rate
movements for a shorter period.
In addition, non-investment grade bonds tend to be more volatile than investment grade
bonds, although they are not as volatile as equities.
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B6 Yield curves
A yield curve provides a means of comparing yields on bonds of different maturities, as well
as giving an indication of the market’s expectations of changes in interest rates and hence
required yields in the future. A couple of points:
• Bonds issued by the governments of developed countries, such as the UK or USA, are
considered to be risk-free and the yield curve gives an indication of the anticipated risk
through economic factors and time.
• Corporate bonds also include the additional risk that the issuer may default on their
obligations.
The yield curve is a graph of the relationship that exists between a bond’s redemption yield
and the period to redemption.

Three main types

There are three main types of curve: normal, flat and inverted.
of yield curve:
normal, flat and
inverted
B6A Normal yield curve
In normal circumstances, investors demand higher yields for holding longer-term bonds to
cover the increased uncertainties over time. The yield curve is then a rising positive curve:
• The higher the degree of pessimism over future inflation and interest rates, the more
steeply the yield curve will rise, as investors will want to ensure that they are getting a
higher yield to compensate. They will want to pay less for the fixed return on longer-dated
bonds.
• For investors who are seeking an income, a positive yield curve means that it will require
more capital to achieve the same income in short-dated bonds than in longer-dated
bonds.

Figure 1.5: Normal yield curve

Yield

Period to redemption

B6B Flat yield curve

When economic factors are deemed to be particularly stable and no radical changes to
inflation and interest rates are expected, the yield curve can become almost flat. Investors
are prepared to accept a lower yield and pay relatively more for longer-dated bonds. They
can buy income at almost any redemption period for much the same price, with no
significant penalty for switching from longer-dated bonds to shorter, lower risk bonds.
 Chapter 1.1
Chapter 1 1.1: Cash investments and fixed-interest securities 1/27

Figure 1.6: Flat yield curve

Yield

Period to redemption

B6C Inverted or reverse yield curve

Occasionally the yield curve can invert, so that the yield on longer-term bonds is less than on
short-term bonds. This can be caused by investor expectations that interest rates will rise in
the short-term while long-term interest rates are expected to be substantially below current
levels. It can also be a result of factors connected with supply and demand that reduce the
yield on longer-dated bonds.

Figure 1.7: Inverted yield curve

Yield

Period to redemption

The Bank of England estimates yield curves for the UK on a daily basis.

B7 Gilts
Gilts are fixed-interest securities issued by the UK Government (via the DMO) when it needs
to borrow money because it has insufficient income to meet its expenditure.
The term ‘gilts’ is short for gilt-edged stock, a name given to UK Government securities ‘Gilts’ are gilt-
because they were first printed on gilt-edged, or gold-edged, paper. They are generally edged stock
regarded as risk free, since they are guaranteed by the UK Government.
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B7A Categories of gilts

Gilts are classified, according to their time to redemption
redemption, into shorts, mediums and longs.
The financial press and the DMO differ in respect of their categorisations, as per the table
below:

Category DMO definition Financial press definition

Shorts Less than seven years Less than five years
Mediums Between seven and fifteen years Between five and fifteen years
Longs Over fifteen years Over fifteen years

The classifications reflect the current life of the bond, rather than the period to redemption
when the gilt was issued; they get reclassified as their date of maturity draws closer.

B7B Index-linked gilts

In addition to conventional gilts, there are also index-linked gilts. An index-linked gilt differs
from a conventional gilt in that the coupon payments and capital repayment are adjusted in
line with inflation, as measured by the RPI, since the gilt was first issued. Those issued before
September 2005 use RPI eight months before each payment date, while all index-linked gilts
issued from September 2005 use RPI three months before each payment date.

How it works
Inflation protection
Investors are protected against the value of their investments being eroded by inflation:
• both interest payments are revised in line with changes in the RPI; and
• capital repayment on redemption reflects changes in RPI from the date of issue to the
date of redemption.
However, if the RPI falls, then the interest and capital payments will also fall.

Investors in index-
The coupons and yields on index-linked gilts tend to be much lower than on conventional
linked gilts are bonds, although the income will rise in the future in line with inflation.
protected against
the value of their Redemption yields for index-linked gilts cannot be calculated in the usual way, as the
investments being
eroded by inflation interest and redemption values are not fixed. Estimates of redemption yields are currently
quoted in the financial press assuming a 3% inflation rate. The DMO website has a report
which allows you to estimate redemption payments using different inflation rate
assumptions.
Any profits on disposals of index-linked gilts are exempt from capital gains tax (CGT),
including any gain resulting from the inflation uplift of the capital amount. The full amount of
interest received will, however, be taxable, including any inflation uplift.

B7C Repo market

The term ‘repo’ is short for sale and repurchase agreement
agreement. In a repo agreement, one party
agrees to sell gilts to another party with a formal agreement to repurchase equivalent
securities at an agreed price on a specified future date.
 Chapter 1.1
Chapter 1 1.1: Cash investments and fixed-interest securities 1/29

Be aware
Repos
Repos usually have the following characteristics:
• The price differential between the sale and repurchase price reflects the interest cost of
raising the funds. The longer the term of the loan, the higher the repurchase cost to
reflect a greater interest cost.
• Although legally, a repo involves a transfer of the assets involved, in practice it often
operates as a form of short-term lending, with the gilts being used as security for the
loan.
• Since the seller is arranging a short-term loan with gilts as security, the interest rate is
competitive. The seller continues to gain exposure to the gilt market and has raised
finance on a temporary basis without the costs of buying and selling the gilts.
• If the original owner does not repurchase their stock on the pre-set date at the pre-set
price, the repurchase transaction is not fulfilled. The stock then becomes the property
of the lender and they can sell it to release their cash.
• The buyback period is usually two weeks, but it can range from overnight to several
months.

In practice, the Bank of England uses the repo market to influence interest rates.

B7D Strips market

Strips is the acronym for Separate Trading of Registered Interest and Principal Securities.
Stripping is the process of separating a conventional interest-bearing gilt into its individual
interest (coupon) and redemption payments, which can then be separately held and traded
in their own right.

Example 1.4
A ten-year gilt can be stripped to make 21 separate securities:
• 20 strips based on the coupons, which are entitled to just one of the half-yearly interest
payments; and
• one strip entitled to the redemption payment at the end of the ten years.

There are two series of strippable gilts; the first pays coupons on 7 June and 7 December,
and the second series pays coupons on 7 March and 7 September.
Strips are referred to as zero coupon instruments, since they pay no regular, half yearly
interest:
• investors receive a payment of the strip’s face value when they mature; and
• before maturity, they trade at a discount to their face value.

B8 Corporate fixed-interest securities

Companies as well as governments often want to borrow money at fixed rates of interest for Corporate fixed-
long periods of time. Just like a government, companies can issue fixed-interest securities. interest securities
are referred to as
Corporate fixed-interest securities are referred to as corporate bonds
bonds. corporate bonds
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Be aware
Corporate bonds compared with gilts
Note that:
• The risk attached to corporate bonds is greater than that attached to gilts.
• Prices are typically more volatile than gilts.
• Corporate bonds issued by the largest companies can be bought and sold easily, but
lower quality bonds may be difficult to trade, particularly in a crisis. The market is
generally less liquid in a crisis, as there are often fewer investors, and it may not always
be possible to trade.
• The spread between the buying and selling price is wider than for gilts.
• The creditworthiness of companies is constantly changing, unlike that of the
Government. Consequently, corporate bond prices can vary, even though interest rates
and inflation are stable.
• Yields on corporate bonds are generally higher than gilts, reflecting their increased
credit risk and lower liquidity.

B8A Types of corporate bond

Corporate bonds may be secured or unsecured, and companies may issue both kinds:
• When the loan is secured
secured, there is a charge on certain assets of the issuing company. If the
company falls into arrears with its interest payments, or defaults on its capital repayment,
the assets can be seized and could ultimately be sold to repay the loan.
• When the loan is unsecured
unsecured, the holder will rank for repayment alongside the ordinary
creditors of the company. All secured loans rank for payment before unsecured loans in
the event of the company being wound up.
For the protection of the bondholders, the terms of the issue usually contain certain
conditions or restrictive covenants:
• there might be an upper limit on the total amount of money the company could borrow;
or
• the company might have to stay within certain financial ratios. These could be a maximum
on total debt in relation to shareholders’ funds, or company profitability compared with
interest payments.

An unsecured loan
There is no obligation for a company to provide security for a loan; however, an unsecured
will usually be loan will usually be more expensive for the issuing company than a secured loan. The yield
more expensive for
the issuing
will have to be higher to attract investors.
company than a
secured loan
B8B Debentures
The term debenture technically means a written acknowledgement of a debt. For
investments, it tends to be applied to bonds where there is some specific security or charge
over assets in favour of the lender.
Debentures are established by trust deed, and usually corporate trustees are appointed to
act on behalf of the lender and ensure that the borrower adheres to the provisions of the
deed. The trust deed will include:
• terms of the issue − the interest rate, payment dates and redemption date;
• assets backing the bond;
• powers of the trustees; and
• any conditions imposed on the borrower, such as restricting the total amount of money
the company can borrow by imposing a maximum ratio of debt to share capital.

Debentures can be
Debentures can be secured by one or both of the following:
secured by a fixed
charge or a • a fixed charge; or
floating charge
• a floating charge.
 Chapter 1.1
Chapter 1 1.1: Cash investments and fixed-interest securities 1/31

Table 1.10: Fixed and floating charges

Fixed charge A fixed charge is a charge over a specified asset or assets of the company:
• these typically include land or freehold property that can be readily
identified and should not depreciate in value over the term of the loan;
and
• the fixed-charge assets cannot be sold by the company without the
consent of the debenture holder.
Floating A floating charge is a general charge over any of the assets of the company
charge that are not otherwise secured in favour of other lenders or banks:
• The company can freely dispose of floating charge assets in the usual
course of its business but, if it defaults on the loan, the assets are
available to be sold to repay the debenture holder.
• A debenture with a floating charge has a lower priority for payment than
a debenture with a fixed charge if the company is wound up.

Consider this
this…
…
Which would you prefer as a lender: a fixed or a floating charge?

B9 Convertible bonds
Convertible bonds are usually unsecured loan stock that offers the holder the option of
converting the bond into the ordinary shares of the issuing company under specified terms
and conditions.

Table 1.11: Characteristics of convertible bonds

• Interest is payable in the usual way until the option is exercised, although they usually
carry a lower coupon than straightforward loans because of the right of conversion into
ordinary shares at some future date. The low interest rate is compensated for by the
opportunity of a favourable return on conversion.
• Conversion rights can vary considerably between different convertible bonds. Some
have a short conversion period, such as one month, in each of a number of consecutive
years, while others have a specified date on which the conversion option may be
exercised.
• The number of shares the holder will receive may also differ between issues. The number
may be fixed throughout the entire conversion period, or may reduce towards the end of
the period.
• If the conversion does not take place by the expiry date, the bond will revert to a
conventional dated bond, although the company usually retains a right to redeem any
stock outstanding once a certain percentage has been converted.

The following example shows the basic calculation that is undertaken to determine whether
it is worth converting.

Example 1.5
Conversion terms
A company has issued a 5% convertible unsecured bond at £100 nominal. This can be
converted into the company’s ordinary shares at a rate of 25 ordinary shares for every
£100 nominal of the bond. At each conversion opportunity, the investor will review
whether it is worth exercising the option to convert. This is assessed by comparing the
respective values of the bond and the shares. Let’s assume that the bond is trading at £110
to yield 4.5% and that the ordinary shares are priced at 400p:

Holding Nominal Price Market value

Convertible bond 100 £1.10 £110
Ordinary shares 25 £4.00 £100
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In this example, the investor would not exercise their right to convert as it is clearly
unattractive. If the share price were to rise, however, to 450p, then it may be worth
converting:

Holding Nominal Price Market value

Convertible bond 100 £1.10 £110.00
Ordinary shares 25 £4.50 £112.50

When considering whether to convert into shares, an investor would also look at the
effect that conversion would have on the income received.

Convertibles fluctuate in value and often reflect the issuing company’s share price:
• a rise in the company’s share price may cause the convertible bond to rise as well; and
• a fall in the company’s share price could mean that the convertible bond is not worth
converting, but the price should never be less than an otherwise identical straight bond.

Be aware
CGT
Bonds that can be converted into shares do not qualify for exemption from CGT. Any
gains on disposals are chargeable to CGT and losses can be set against other taxable
gains.

B10 Floating rate notes (FRNs)

Floating rate notes (FRNs) are securities issued by companies, particularly banks and other
financial groups, which pay a rate of interest that is linked to some relevant money market
rate, such as LIBOR.

Be aware
Coupons
For example:
• The interest rate on FRNs is usually set by reference to the average of LIBOR over a six-
month period and expressed as basis points (hundredths of one percentage point)
above LIBOR, e.g. LIBOR plus 50 basis points would be an additional 0.5%.
• The coupon is usually paid half-yearly or quarterly and the rate for each coupon is
determined at the beginning of each coupon period.

• The price of a FRN is likely to stay quite close to its nominal value:
– changes in interest rates will not cause the market price to alter in the same way as a
fixed-interest security, as it is the interest rate on the security itself that will change;
– the market price is, however, likely to alter if the creditworthiness of the issuing
company changes.
 Chapter 1.1
Chapter 1 1.1: Cash investments and fixed-interest securities 1/33

B11 Permanent interest bearing shares (PIBS) and

perpetual subordinated bonds (PSBs)
Permanent interest bearing shares (PIBS) are a type of fixed-interest investment issued by
building societies, which are listed and traded on the Stock Exchange.
Perpetual subordinated bonds (PSBs) were originally issued as PIBS by building societies
that have now converted to banks.

Table 1.12: Features of PIBS and PSBs

They both have • The issuer has no obligation to redeem them. The only way investors
the following can realise their investment is by selling the PIBS to another investor.
features:
• They are undated stocks, although a number of issues are callable
between now and 2030. This gives the issuer the right to call or
redeem them at par (£100) on or after a specified date in the future.
• Because they are long-term investments, their capital values are
As PIBs and PSBs
particularly sensitive to changes in interest rates. are long-term
investments their
• They do not qualify for compensation under the FSCS. capital values are
very sensitive to
• They rank behind all depositors and other creditors in a liquidation. changes in interest
rates
• If interest payments are missed, they are non-cumulative and will not
be made up in later years. The building society/bank has the right to
pass on interest payments if they are not adequately covered by
earnings, or if interest is due on other shares or deposits.
• Minimum investment limits vary from £1,000 to as high as £50,000;
however, the market is quite small and rather illiquid.
• The yield from PIBS is better than average to compensate investors
for their lack of security.
• Interest on PIBS is paid half-yearly. It is paid gross, but is subject to
income tax.
• PIBS are within the definition of ‘qualifying corporate bonds’ and are
exempt from CGT.
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1/34 R02/July 2018 Investment principles and risk

Key points
The main ideas covered by this chapter can be summarised as follows:

Cash investments
• Cash deposits do not expose an investor’s capital to investment risk. However, there is
no potential for capital growth, which means that over time its real value will be eroded
by inflation.
• Higher rates of interest may be offered on deposit accounts that restrict access, or
impose penalties on withdrawals.
• Any restrictions will need to be taken into account when considering whether the
account is appropriate for an investor.
• Bank and building society deposits are protected by the FSCS if an institution becomes
insolvent.
• NS&I offers a range of products with both variable and fixed rates of interest, some of
which are tax-free.

Fixed-interest securities
• Fixed-interest securities can provide a secure income.
• If sold before redemption, their value can go down as well as up.
• Many factors can affect their price.
• Specific or commercial risk relates to the creditworthiness of the issuer and the
possibility of default.
• Market or systematic risk relates to the possibility of changes in interest rates and
inflation.
• Gilts are guaranteed by the UK Government and are free of default risk.
• Companies issue corporate bonds with differing levels of security.
 Chapter 1.1
Chapter 1 1.1: Cash investments and fixed-interest securities 1/35

Question answers
1.1 False. Although cash investments always produce total returns in excess of the
amount invested – that is, a positive return in nominal terms – they are not free of
risk. Investors can find that the purchasing power of their cash (its ‘real’ value) has
declined over the period of investment due to inflation. There is also the default risk
that the funds deposited are not returned.
1.2 The interest yield would be:

5
× 100 = 3.98%
125.50

1.3 The redemption yield is the most useful measure of a bond’s performance, because it
reflects the returns from both the interest and final redemption payments.
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Self-test questions
1. What are the main risks of holding cash on deposit?
2. What is the maximum compensation payable under the Financial Services
Compensation Scheme (FSCS) to cash depositors?
3. What are the two types of restricted access account?
4. Once a bond has been issued, any subsequent trading of that bond takes place in
which market?
5. What does the nominal or par value of a gilt determine?
6. What does the interest or running yield measure and what is the formula?
7. Which are more volatile: bonds with long periods to maturity and low coupons or
those that are short-dated with high coupons?
8. What is a reverse yield curve and how does it differ from a normal yield curve?
9. Do corporate bonds generally offer higher or lower yields than gilts? Explain why.

You will find the answers at the back of the book

 Chapter 1.2
1.2: Equities, property and
1
alternative investments
Contents Syllabus learning
outcomes
Learning objectives
Key terms
C Equities 1.1, 1.2
D Property 1.1, 1.2
E Alternative investments 1.1, 1.2
Key points
Question answers
Self-test questions
Appendix 1.1: Sample accounts for Green Trees plc

Learning objectives
After studying this chapter, you should be able to:
• analyse the different categories of share, their characteristics, risks and returns, valuation
methods and stock markets;
• analyse the main types of property investment, their characteristics and risks and the
costs of investing; and
• describe the characteristics and risks of alternative investments such as works of art and
commodities.
Chapter 1.2
1/38 R02/July 2018 Investment principles and risk

Key terms
This chapter features explanations of the following:
Alternative Commodities Dividends Earnings per share
investments (EPS)
Indices London Stock Net asset value Panel on Takeovers
Exchange (NAV) and Mergers (PTM)
levy
Price earnings (P/E) Primary market Private equity Property
ratio
Rental yields Secondary market Shares Stamp duty

C Equities
An equity represents a part ownership of a company’s capital and is an alternative name for
a share. Investors buy shares in a company because they expect to receive income in the
form of dividends, and to achieve capital growth. They hope that rising company profits will
lead to increasing dividends and/or growth in the value of the shares.

For shares to be
Every company issues shares but, for shares to be offered to the general public, the
offered to the company must usually gain a listing on a Stock Exchange.
general public, the
company must • When a company is quoted on the stock market, it means that a price for its shares is
usually gain a
listing on a Stock published and it is usually possible to buy and sell them quickly and easily.
Exchange
• Many companies, especially very small companies, are not quoted on a stock market, and
it is generally very difficult to buy and sell their shares or even establish what they are
worth.

C1 Factors that affect share prices

The forces of supply and demand are the main influence on share prices as follows:
• In the long-term, fundamental economic and political factors cause movements in the
market as a whole.
• In the short-term, market movements can be affected by investor sentiment.
• The price movement of individual shares is influenced by a range of factors specific to
that business.
Table 1.13 looks at these points in more detail:

Table 1.13: Factors affecting share prices

External economic • The market is affected by changes in the pattern of economic
and political activity and in particular, by changes in inflation, productivity,
factors growth and in the government’s fiscal and monetary stance.
• Such changes do not affect all companies to the same degree, and
can have a different impact on companies in different sectors.
• For example, a rise in interest rates may depress the price of shares
in house building companies more than the average, because
higher mortgage costs could deter house buyers.
Investor sentiment • Investors may be optimistic or pessimistic about a particular
company, sector or market. If investors become enthusiastic about
a particular company or sector and buy its shares, the price will
rise. This in turn may attract other investors to buy, so moving the
price still further. The process becomes self-fuelling.
• Investors in the London Stock Market are also influenced by the
performance of shares in overseas markets, particularly the USA.
However, with increasing globalisation, this influence may be more
than just sentiment, as world economic events can affect all
markets.
 Chapter 1.2
Chapter 1 1.2: Equities, property and alternative investments 1/39

Table 1.13: Factors affecting share prices

Profit expectations • There may be expectations that a company’s profits will either
grow or decline. Investors usually take into account long-term
trends, and the current share price may reflect their views of how
well the company is expected to perform for some time into the
future.
• When a company realises that its profits are going to be
significantly lower than it had forecast, it will usually have to give
advance warning to investors through the Stock Exchange. When
profit warnings are unexpected, the share price tends to fall, as
investors start selling.
Dividend • A company may increase or reduce dividends, since the amount
expectations paid is at the discretion of the directors of the company. Dividends
usually follow the same trend as the profits, but they can
sometimes rise faster or more slowly.
• Investors prefer a steady growth in dividends, and an unexpected
reduction is likely to lead to a significant fall in the price of the
company’s shares, as investors start selling.
Takeover activity • A company may be considered a takeover target, which could
boost the share price, at least in the short-term.
The quality and • The quality of a company’s management is a difficult factor to
track record of assess and evaluate.
management • The ability of management to recognise changing circumstances
and to respond by taking steps to adapt accordingly will usually be
considered a positive factor by investors, prompting them to buy.
• The past record of management is usually fully taken into account
in the price of the company’s shares. However, the appointment or
departure of an influential member of management may cause an
immediate change in the share price and a rush to buy or sell,
depending on how investors take the news.

C2 Dealing in shares Dealing in shares in

the UK takes place
Dealing in shares in the UK takes place mainly on the London Stock Exchange
Exchange, which serves mainly on the
London Stock
as both a primary and a secondary market for investors. Exchange

Be aware
Primary and secondary markets
market: one in which securities are sold for the first time to investors, to raise
Primary market
money for businesses.
market: a market in which securities that have already been issued can be
Secondary market
bought and sold between investors.

The buying and selling in the secondary market does not directly affect the finances of the
companies whose shares are traded but, if investors were not able to buy and sell shares in
the secondary market, they might be reluctant to invest newly-issued shares in the primary
market.
When shares are first issued on the London Stock Exchange, they must be either admitted to
the:
• official list or main market; or
• AIM (Alternative Investment Market).
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Table 1.14: London Stock Exchange

The official list or • Companies that are admitted or listed on the London Stock
main market Exchange make up the main market.
• Becoming listed, or ‘going public’ as it is commonly termed, is a
demanding and expensive process. The process of floating
companies is regulated by the United Kingdom Listing Authority
(UKLA), which is part of the Financial Conduct Authority (FCA).
(UKLA)
• The UKLA aims to provide a stable and orderly market. Its
requirements govern the ongoing behaviour of listed companies
and the way in which they report to their shareholders.
AIM • The London Stock Exchange launched the AIM (Alternative
Investment Market) in June 1995 to provide primary and secondary
market facilities for companies either too small or too new to apply
for a full stock market listing. The AIM can also be used as an
interim stage to a full listing.
• Although the AIM is properly regulated by the London Stock
Exchange, it has less onerous listing requirements than the main
market, with fewer formalities and lower costs. The objective is to
provide wider accessibility for young and developing companies
that are seeking to sell shares, while maintaining a regulated and
orderly market.
• The shares of AIM companies may be described as being quoted or
traded on the market but, as AIM companies do not fall within the
definition of companies listed on a recognised stock exchange,
their shares should not be described as listed.

C2A Costs of buying and selling shares

Shares can be bought and sold through stockbrokers. Investors can either approach a
broker directly or they can deal through a bank or building society, which either owns or has
links with a stockbroker. The costs involved in buying and selling are:
• commission;
• stamp duty reserve tax (SDRT); and
• Panel on Takeovers and Mergers (PTM) levy.
There will also be a difference between the offer price, at which an investor can buy shares,
and the bid price, at which they can be sold. This spread is the basis of the market maker’s
profit and is likely to vary depending on the shares being traded and market conditions.
Larger company shares that are heavily traded on the market will have quite narrow spreads.
The spread on smaller company shares will be wider, reflecting their reduced liquidity and
the smaller number of market makers prepared to quote a price.
Commission
Commission is the
Commission is the charge made by the stockbroker for executing the deal. There are no rules
charge made by governing commission rates, and it is a commercial decision for firms to set their own
the stockbroker for
executing the deal
charges.
Commission is charged on both purchases and sales at the same rate. The level of
commission will be either a flat fee (possibly going up in stages according to the size of the
deal), or a percentage based on the size of the deal. Charges of traditional stockbrokers are
usually tiered.

Example 1.6
A typical rate for a stockbroker might be:
• 1.25% on the first £10,000;
• 0.25% on the excess over £10,000; and
• a minimum charge of £20 to £30.

Commission charges are usually lower for deals placed online.

Stamp duty/stamp duty reserve tax
Stamp duty (SD) and stamp duty reserve tax (SDRT) are Government taxes charged on the
transfer of UK-registered shares (although not on shares in companies quoted on
recognised growth markets such as AIM).
 Chapter 1.2
Chapter 1 1.2: Equities, property and alternative investments 1/41

SD is charged if the transfer is effected by a stock transfer form and the transaction is over
£1,000. SDRT is charged on paperless share transactions effected electronically through the
CREST system (a computerised register of shares/share owners). The £1,000 threshold does
not apply to SDRT. The rate of tax for both SD and SDRT is 0.5% of the purchase price. They
operate as follows:
• SD and SDRT are paid by the purchaser, not by the seller;
• SD is rounded up to the next multiple of £5; and
• SDRT is rounded to the nearest penny.
Panel on Takeovers and Mergers (PTM) levy
The Panel on Takeovers and Mergers (PTM) levy is a flat rate charge of £1 that is applied to PTM levy is a flat
all trades of £10,000 or more to generate income for the PTM. The panel is the regulatory rate of £1 – it is
applied to all
body that oversees all takeovers and mergers of companies listed on the London Stock trades of £10,000
Exchange. or more

C3 Types of shares
There are two main classes of share capital – ordinary shares and preference shares,
although there are a number of variations on these that companies may issue. They differ
from each other in respect of the rights their holders have in these three areas:
• receipt of dividends;
• control of the company; and
• return of capital if the company is liquidated.

C3A Preference shares

The following features apply to preference shares:
• Preference shares usually pay a fixed rate of dividend half-yearly and, in this respect, are
similar to loan stock. However, the dividend is only paid if there are sufficient after-tax
profits, whereas the interest on loan stock must be paid, whether the company has made
a profit or not.
• The payment of dividends on preference shares has priority over the payment of
dividends on ordinary shares, but comes after all the interest payments on debt have been
made.
• They generally have no voting rights (i.e. no right to vote on corporate policy or issues
such as electing board members), unless the payment of dividends has fallen into arrears.
• In a liquidation, they rank ahead of ordinary share capital, but after loan capital and all In a liquidation,
other creditors. preference shares
rank ahead of
• Since the security of preference shares is lower than that for bonds, their yields are higher ordinary share
to compensate for the risks involved. capital

Different types of preference shares

There are a number of different types of preference share. When a company has issued more
than one type, they may either rank them in a certain order, with one type having priority
over another issue, or on an equal basis.
The ranking usually relates to their priority for the payment of dividends and entitlement to
capital on winding-up.

Table 1.15: Types of preference share

Cumulative • Preference shares can be either cumulative or non-cumulative.
preference shares Unless specifically stated otherwise, they are cumulative.
• This means that if the company has insufficient profits in one year
to pay the cumulative preference share dividend, the shortfall
must be carried forward. It must be paid before other
shareholders of a lower class can receive any payment.
• Even if a cumulative preference share is many years in arrears, all
arrears must be paid before a dividend can be declared on the
ordinary shares.
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Table 1.15: Types of preference share

Non-cumulative • Non-cumulative preference shares lose the right to receive any
preference shares unpaid dividend at the end of the financial year, and no arrears
are due when dividend payments resume.
Participating • Participating preference shares pay a fixed rate of dividend and
preference shares also allow the holder to participate in the profits of the company.
• They receive an additional dividend that is usually a proportion of
any ordinary dividend declared.
Redeemable • They represent a temporary source of finance for the company.
preference shares • Dividends will be paid to the shareholder for a short period and
the share will then be repaid.
• Most preference shares are undated, but some are redeemable at
a pre-determined date or at the option of the company.
Convertible • Convertible preference shares carry the right to be converted
preference shares into ordinary shares at pre-set dates and on pre-set terms if the
holder chooses to. Their prices respond to both the fixed
payment and the convertible element.
• If the ordinary shares increase in value and it becomes likely that
the conversion rights will be taken up, then the convertible
preference share will track the ordinary share price.

C3B Ordinary shares

Ordinary shares usually form the bulk of the share capital of a company and confer an
ownership stake in the company. They represent the risk capital of the company and are the
last to be paid out in the event of liquidation. Holders of such shares have a right to share in
the profits of the company – dividends – and a right to attend and vote at company
meetings.
While most companies only have one class of share, it is possible to create additional classes
with different rights.
Rights
• The ordinary shareholders are generally entitled to a share of the profits that remain after
tax and preference share dividends have been paid. It is usually the case that not all of the
profits are paid out in the form of dividends; profits retained by the company can be used
to reinvest in the business to ultimately increase its value, so generating capital growth in
the value of the shares.
• Ordinary shareholders are entitled to attend and to vote at general meetings of the
company, giving them, among other things, the right to elect the directors who will
control the business on a day-to-day basis. Usually, one ordinary share carries one vote,
giving shareholders with a high proportion of the shares more influence.
• If the company is liquidated, the ordinary shareholders are entitled to share the residual
value of the company’s assets after all debts have been discharged and other
shareholders have received what they are entitled to.
• The holders of the ordinary share capital bear the greatest risks and should therefore
receive a higher rate of return than that accruing to more secure forms of investment.
Dividends
Dividends can only be paid out of the profits that a company has made, and it is up to the
board of directors to determine whether a dividend will be paid and the amount.
Dividends are paid out of profits that have already been subject to corporation tax. The tax
treatment for investors is then as follows:
• Investors do not pay any tax on the first £2,000 of dividends received in a tax year.
• Above this dividend allowance, the tax paid depends on the investor’s income tax band.

Tax band Tax rate on dividends over £2,000

Basic rate (and non-taxpayers) 7.5%
Higher rate 32.5%
Additional rate 38.1%
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Other types of ordinary shares

While most companies only have one class of share, it is possible to create additional classes
with different rights. These are shown in Table 1.16.

Table 1.16: Other types of ordinary shares

Non-voting ordinary • These shares are identical in all respects to ordinary shares,
shares except that they carry restricted or no voting rights.
• They are usually called ‘A’ ordinary shares. They were originally
devised to keep the control of a company in the hands of a few
shareholders, while raising capital from general investors.
• Where these shares still exist, they offer no greater return (they
receive the same ordinary dividend), although the shareholders
are exposed to a higher risk since they cannot influence the
operation of the company. As a result, their market price is
usually lower than that of the voting ordinary shares.
Deferred ordinary • Deferred ordinary shareholders do not usually qualify for a
shares dividend until the dividend on the ordinary shares has reached a
pre-determined level, or until a specific period after their issue.
• To compensate for this deferral, the shareholders may have
greater voting rights, or become entitled to a larger proportion of
the profits after the deferred period.
• Deferred ordinary shares are relatively uncommon today.

C3C Risks
Shares are high risk. The main risks of holding them are shown below.

Table 1.17: Risks

Equity capital risks • The share price depends on supply and demand.
• Investors try to use past performance, immediate and potential
future events to assess the value of a share. If a company performs
badly by producing lower profits than expected, the chances are
that its share price will suffer as a result.
• The causes of poor performance could be based on specific
circumstances of the business, such as poor management.
• Alternatively, there could be market risks beyond the company’s
control, at least in the short-term. For example:
– The state of the economy or technological change can affect
investor perceptions of share values.
– Geopolitical events, such as wars and their aftermath, can have a
very significant impact on share values.
– Markets and shares can be the victims or beneficiaries of fashion.
High technology companies have been both in recent years.
Share dividend • Dividends from shares can fluctuate as companies alter their
volatility dividend payout to shareholders. The trend has generally been
upwards.
Currency risk • Any investment denominated in another currency is subject to
currency risk, whether the investment is in equities or the other
asset classes.
• Investors usually measure returns in terms of the currency they use
and in which they have main assets and liabilities, e.g. a US citizen
thinks in terms of US dollars and a German citizen thinks in terms of
euros.
• Investing outside the UK involves a risk that the chosen currency
will fluctuate in relation to sterling, which increases the overall
investment risk in sterling terms.
• An individual who moves from one currency area to another on a
regular basis (e.g. a UK resident who has a holiday home in Spain,
or who is intending to buy one) might find it worth holding
deposits in the relevant foreign currencies.
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Table 1.17: Risks

Liquidity risk • Investors need to be aware of the potential inability to realise their
investments.
• Some shares in smaller companies or AIM companies may be more
difficult to sell than shares held in FTSE 100 companies.
• Some types of investments cannot be quickly converted to cash,
may have provisions to block redemption (e.g. notice periods), or
have penalties for early encashment.
• This applies to a wide range of investments from fixed-term cash
deposits to some collective investments.
• Property funds in particular are prone to redemption blocks or
deferred redemptions when investors may have to wait six to
twelve months before accessing their funds.
Counterparty risk • This is the risk that the organisation with which an investment is
placed will fail.
• Counterparty risk comes in different forms and has been a major
issue for some time. To better protect consumers, the FCA has
looked to firms to improve their disclosure of the potential risk to
investors.
• The activity in the exchange traded funds (ETF) sector in 2011 to
improve disclosure of counterparty risk for synthetic ETFs and
stock lending risk for traditional ETFs is an example of this.
• Credit ratings and compensation schemes provide some comfort
but counterparty risk remains one of the most difficult to judge.
Fund managers • The structures and legislation governing fund management
and insurance companies and insurance companies should greatly reduce the
companies risks of investing through these institutions, but events such as the
demise of Equitable Life suggest that advisers cannot completely
ignore this risk.
• The Financial Services Compensation Scheme (FSCS) provides
protection up to a maximum of £50,000 for investments.
Regulatory risk • The inadequate regulation of investment markets and commercial
life generally can pose considerable risks to the value of
investments.
• Regulatory risk can cover a range of possibilities and is likely to be
prevalent in countries where government authorities have a more
tenuous control over the markets than in more advanced
economies. Regulatory risk is therefore greater in developing or
emerging markets, but is by no means confined to them.
• Regulatory risks include:
– Investors being misled about companies’ assets, liabilities,
turnover and profitability. In countries where accounting
standards are relatively poor, this might be expected, but it can
happen in advanced countries, as the Madoff fund scandal and
the Enron (US) and Parmalat (Italy) affairs have previously
demonstrated.
– Inefficient market mechanisms leading to difficulties in dealing
or establishing good title to the ownership of securities. Buying
and selling shares can be an expensive and uncertain process in
some emerging markets.
– Market manipulation so that the price of securities can be
artificially boosted or depressed – generally for the benefit of a
few shareholders.

C3D Equity diversification

Diversification can
The risks associated with equities are substantial. Diversification can be used to reduce the
be used to reduce level of risk an investor is exposed to:
the level of risk
an investor is • Diversifying from individual shares
exposed to
By diversifying over a range of shares in different sectors of the market, the investor
reduces the risk of poor or even catastrophic performance by one share. What could be a
catastrophe for one company may be a windfall for another. For example, a jump in crude
oil prices may be bad news for aviation companies, but it would be good for oil
exploration businesses.
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• Diversifying across sectors

Diversification should also be across sectors to reduce non-systematic risk. For example, a
portfolio consisting only of bank shares will offer little protection if bad debt levels rise
generally or the government decides to impose a windfall tax on financial institutions.
• Diversifying across international markets
The next stage up from diversification across different market sectors is diversification
across international equity markets. This has a number of potential risk-reducing
advantages, for example:
– Not all the world’s stock markets move in unison.
– Different markets give investors access to companies operating in sectors that are
unavailable in their home market. For example, a UK investor who wants exposure to
car production has to look to Europe, Japan or the USA for companies in which to
invest.
To a growing extent, globalisation may have reduced the benefits of international
diversification. Some institutional investors now view multi-national companies as a sector in
their own right, regardless of where each company is listed (and listings may be on more
than one market). Many of the FTSE 100’s constituents make most of their profits outside the
UK. However, this is an increasingly narrow view, as it is much easier for investors to get
‘true’ access to markets through ETFs.

C3E Past performance

It has often been stated in the financial services press that equities consistently outperform
all other main asset types – bonds in particular – and have delivered superior real returns
over the long-term. It must be remembered, however, that past performance is not
necessarily what performance will be in the future. Past performance figures should
therefore be used for information purposes only.
During the 1990s, equities generally outperformed bonds, but this pattern changed in the
2000s.

C4 Private equity
Private equity is regarded as an asset class in its own right and involves either taking a stake
in or acquiring companies that are not publicly traded on a stock exchange.

C4A Characteristics
Private equity involves providing medium to long-term finance in return for an equity stake
in potentially high growth, unquoted companies. The term ‘private equity’ is typically used to
refer to the provision of venture capital and management buy-outs and buy-ins.
A private equity firm is looking for its investment to be rewarded by the company’s success
and will generally seek to realise its capital gain through an ‘exit’, which may involve:
• selling its shares back to the management;
• selling the shares to another investor, such as another private equity firm;
• a trade sale, which is the sale of company shares to another company; or
• the company achieving a stock market listing.
An investment in this asset class can be achieved through private equity funds and listed See chapter 6.2,
section K for
private equity investment companies, as well as through an enterprise investment scheme more on EISs,
(EIS), seed enterprise investment scheme (SEIS) or venture capital trust (VCT). SEISs and VCTs
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Table 1.18: Private equity

Private equity • Most UK private equity funds seek to raise money for investment from
funds institutional investors, such as pension funds and insurance companies.
• The funds will typically look to retain their investment in the companies
that they invest in for between three and seven years, and many are
structured as limited partnerships that have a fixed life of ten years.
• Within this period, the funds invest the money committed to them and
aim to return the investors’ original money plus any additional returns
made. This generally requires the investments to be sold, or to be
converted to quoted shares, before the fund is closed.
• Although private equity funds target institutional investors, retail
investors can gain access to them by using a fund of funds, such as a
listed private equity company.
Listed private • There are two types of private equity investment companies: those that
equity invest directly in unlisted companies and those that invest in funds that
investment invest in unlisted companies (funds-of-funds).
companies • Some invest in both direct investments and funds, offering a hybrid of
the two approaches.
• Listed private equity investment companies are a form of pooled
investment where the investment company is established as a closed-
ended vehicle and so is a form of investment trust. They are traded on
the London Stock Exchange and are eligible for inclusion in stocks and
shares individual savings accounts (ISAs).

C4B Returns
Companies backed by private equity have been shown to grow faster than other types of
companies as a result of the capital and experienced personal input provided by private
equity firms.

The rationale
The rationale behind investing in private equity should primarily be that superior returns can
behind investing in be generated. Reports suggest that returns from private equity have outperformed returns
private equity
should primarily be
from publicly quoted shares by around 2% to 4%, but it is important to remember that they
that superior offer only limited diversification benefits.
returns can be
generated
C4C Risks
Private equity can deliver high returns, because companies generally grow fastest when they
are young, but there is a high risk of losses, since some unlisted companies will fail and
others will not grow quickly. Some unlisted companies are one-product firms, which makes
them more vulnerable than more broadly based companies, and all are vulnerable to a
domestic downturn or recession.
Even when they have a stock market listing, private equity securities are less liquid than
other listed securities: they can be sold less readily in large amounts, and the cost of
transactions is higher. The majority of shares are often in private hands, which makes the
share prices more volatile as trading volumes can be very low.

C5 Investment ratios
Investment ratios are used by investors when deciding whether a share should be bought,
sold or held. The factors that are of most concern to the average investor relate to the
returns that they are receiving on their investment and the risks that they are facing. The use
of percentages and ratios allows:
• trends in the company’s performance over a number of years to be identified; and
• comparisons to be made with similar companies and/or with the industry’s average.
Since most investment ratios relate to the current price of the shares, they will vary from day
to day.
The following ratios are illustrated using the sample set of accounts for Green Trees plc,
which are included as appendix 1.1 to this chapter.
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C5A Earnings per share (EPS)

Earnings per share (EPS) is generally regarded as an important consideration in investment EPS is generally
decisions and is one of the most widely quoted statistics in relation to a company’s regarded as an
important
performance since: consideration in
investment
• all listed companies are required to publish EPS in their accounts; and decisions
• EPS enables an investor to see the trend in a company’s profitability.
Earnings per share is calculated as:

Profit attributable to ordinary shareholders

Number of ordinary shares in issue

The profit referred to here is the profit left after tax, minority interests and preference
dividends have all been satisfied. This represents the profit available for distribution to the
ordinary shareholders.
Companies generally retain some of their profits to fund future development and expansion,
and do not usually pay out all of their earnings to shareholders as dividends.

Example 1.7
For Green Trees plc:

1,072 − 63 1,009
EPS = = = 20.18p
5,000 5,000

This represents the amount, in pence, that the company has earned during the year for each
ordinary share.

C5B Dividend yield

The dividend yield measures the dividend as a percentage return on the current share price. Dividend yield
It allows an investor to compare the current return on a share with the return that could be measures the
dividend as a
obtained from bonds or deposits, or from an alternative share. percentage return
on the current
Dividend yield is calculated as: share price

Dividend per share

× 100
Current share price

plc, it is first necessary to calculate the dividend per share. This is:
For Green Trees plc

Dividend 426
= = 8.52p
Number of ordinary shares in issue 5,000

The dividend yield can then be calculated as follows:

8.52
Dividend yield = × 100 = 4.26%
200

The dividend yield is a frequently quoted measure of return on a share, and is readily
available in the financial press. It is, however, dependent on a company’s dividend policy and
the current share price.
Notes
• Some companies distribute a smaller proportion of the profits that are available to
ordinary shareholders than others. Any retained earnings are not lost to shareholders
because they will finance future profits and dividends.
• The yield will fluctuate with the share price, and can look attractive simply because the
share price has slumped.
• It is not necessarily a reliable predictor of future income, as the level of dividend could
change.

Question 1.4
If a company pays a dividend per share of 16.5p and the share price is 292p, what would
the dividend yield be?
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C5C Dividend cover

Dividend cover
The dividend cover measures how many times the dividend could be paid out of the
measures how available current earnings. It indicates the riskiness of the investment and the margin of
many times the
dividend could be
safety the company has in paying the dividend. Dividend cover can be calculated in two
paid out of the ways:
available current
earnings • On an individual basis as:

Earnings per share

Dividend per share

• On a total profit basis as:

Profit attributable to ordinary shareholders
Dividends paid to ordinary shareholders

Again, the profit is that which is left after tax, minority interests and preference dividends
have all been satisfied.

Example 1.8
For Green Trees plc:
• On an individual share basis:

20.18
Dividend cover = = 2.37 times
8.52

• On a total profit basis:

1,072 − 63 1,009
Dividend cover = = = 2.37 times
426 426

Notes
• The higher the figure, the more likely it is that the company will be able to maintain the
existing dividend if profits fall in the future.
• A relatively high dividend cover implies that the company is retaining the majority of its
earnings for reinvestment in the business.
• A company may pay a larger dividend than it has available profits for the year. It would
then draw on its reserves and is said to be paying an uncovered dividend
dividend, although this
could not go on indefinitely.

Question 1.5
If a company has earnings per share of 58p and the dividend per share was 26p, what
would the dividend cover be?

C5D Price earnings (P/E) ratio

P/E ratio is based
The price earnings (P/E) ratio is based on the relationship between the share price and the
on the relationship earnings per share. It is a measure of how highly investors value the earnings of a company.
between the share
price and the EPS
It can be viewed as a reflection of the market’s optimism or pessimism about the potential
for future growth in earnings.
The price earnings ratio is calculated as:

Current market price of share

Earnings per share

Example 1.9
For Green Trees plc:

200
P/E = = 9.9
20.18
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Notes
• P/E ratios should only be used to compare companies in the same sector, rather than
across the market, and should be considered in relation to the average of the sector.
Companies should only be compared with others in the same type of business, since ratios
can vary considerably between industries.
• If a company’s P/E ratio was higher than the average for an industry sector, it would
suggest that the shares of that company were in great demand. The shares will be
relatively more expensive, but investors would expect to be compensated by higher than
average earnings in the future.
• A lower ratio than average would suggest that a company was not greatly favoured by
investors, probably because it had poor growth prospects.
• In general, the higher a company’s P/E ratio, the more highly rated it is and the greater the
expectations for growth. However, a share with a higher price earnings ratio is not
automatically a better buy than a share with a lower ratio. The higher growth expectations
may already have been taken into account in the share price, or it may just be that it is
overpriced.

Question 1.6
What is the P/E ratio of a company if the share price is 410p and the earnings per share
are 38.5p?

Activity 1.4
Look up P/E ratios, either online or in a financial newspaper, and compare the different
ratios allocated to each company.
Compare the P/E ratios for companies in the retail sector. What conclusions can you
draw?

C5E Net asset value (NAV)

The net asset value (NAV) of a company is the value of the tangible assets that are
attributable to the ordinary shareholders. It attempts to measure the amount available to
shareholders if the company were to close down, sell all of its assets, pay all its bills, repay all
of its borrowings and distribute the balance to the shareholders.
It is also known as the shareholders’ funds or shareholders’ interest in the company, and is
effectively the capital provided by the shareholders plus all of the profits the company has
retained in the business, rather than paying out as dividends.
The NAV per share is calculated as:

Net assets attributable to ordinary shareholders

Number of ordinary shares in issue

The net assets attributable to the ordinary shareholders are the total capital employed in the
business minus prior claims, such as secured and unsecured loans and preference shares.
This amount represents the minimum value that the shares would be worth.

Example 1.10
For Green Trees plc:

11,250 − (1,500 + 1,000) 8,750

NAV = = = £1.75
5,000 5,000

Notes
• This is the value of the shareholders’ interest in the company. However, it is unlikely that
the assets would realise their balance sheet value if the company was liquidated.
• The NAV provides a useful guide to the price at which shares should trade for companies
whose assets are generally readily realisable, such as property companies or investment
trusts. However, the share price will be influenced by supply and demand for the shares.
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• It is less useful for companies that are valued on their earnings potential, where the shares
would generally trade above the NAV. This is because investors are willing to pay
something for the goodwill inherent in the business.
• The NAV is a useful valuation figure in key circumstances:
– If a takeover bid is made, shareholders can compare the bid price to a realistic NAV to
check if the assets are being given away too cheaply.
– If a liquidation seems a possibility, the NAV provides shareholders with an indication of
the amount they might receive, and helps them to judge whether to hold onto or sell
the shares.

C5F Limitations of investment ratios

The use of
The use of percentages and ratios can help in the assessment of trends and in comparisons
percentages and with similar companies. In particular, they can highlight aspects of a company that may merit
ratios can help in
the assessment of
closer scrutiny. There are, however, a number of limitations, including the following:
trends and in
comparisons with • Different accounting policies can be used to calculate profits and value assets, making
similar companies comparisons between companies in the same industry difficult.
• The management may decide to change the accounting policy of a company over the
years, making comparisons over time misleading.
• Many ratios have to be calculated using historical data from accounts. This may not be the
best guide to future performance and investment potential.
• When considering trends over several years, periods where there has been high inflation
can produce misleading figures. The reported figures may show an upward trend but, in
real terms, they could be static or even declining.

C6 Indices
Stock market indices bring together the movements of individual share prices and show the
direction in which a market has moved over a period of time. Indices can be used for a
variety of purposes, i.e. to:
• compare the performance of a particular share with its sector or with the market as a
whole; and
• compare the performance of a fund manager with the performance of the market as a
whole.
– Many fund managers aim to beat the market, although an increasing number aim to
track passively the rise and fall of indices.

C6A Variety of indices

Indices are constructed in a variety of ways and reflect many different types of market.
There are indices reflecting most types of investment, including property, art and antiques,
fixed-interest securities, as well as the most commonly used indices measuring equities.
Among equity indices, there are many different types measuring a wide variety of markets
and market sectors.
It is important to choose an appropriate index against which to measure performance.

Example 1.11
Depending on whether the fund is a general or more specialised one, the performance of a
UK equity portfolio may be measured against:
• an index that reflects the whole market;
• just the very largest companies;
• possibly the smaller companies; or even
• particular sectors of the market.
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C6B FTSE Group

The FTSE Group is wholly owned by the London Stock Exchange. It provides a wide range of
stock market indices and associated data services. FTSE maintains a range of indices that
are widely used and quoted, helping investors make informed investment decisions and
benchmark the performance of their investments. FTSE calculates over 120,000 end-of-day
and real-time indices covering more than 80 countries and all major asset classes.
The indices are all arithmetic weighted, where the weights are the market capitalisation of
each company, rather than being based simply on share price movements. Market
capitalisation is the stock market valuation of a company, which is calculated by multiplying
the number of shares in issue by their market price.

Reinforce
It is important to remember:
• the larger the company, the bigger its weighting in the index; and
• the price movement of a larger company (say, representing 5% of the value of the
index) will, therefore, have a larger effect on the index than a smaller company (e.g. 1%
of the index value).

FTSE constituent weightings are adjusted to reflect the free float of shares for each
company as follows:
• the free float of a stock is the proportion of shares that are available for trading on the
stock market; and
• the weightings of companies with less than 75% of their shares available for public trading
are reduced to reflect the available free float.
The free float adjustment is to cope with situations where only a limited quantity of stock is
available for public trading because directors or a subsidiary company own a large
percentage of the shares. This more accurately reflects the available supply, rather than just
weighting by market capitalisation.
The price index is the sum of the market values (or capitalisations) of all companies within
the index, after the weightings have been adjusted to reflect the available free float of stock.
There are eight main UK equity indices relating to different levels of capitalisation, of which
the FTSE 100 is the best known and most widely quoted.
The main indices are as described in the following sections.

Table 1.19: Main FTSE indices

FTSE All-Share • The FTSE All-Share tracks the market value of the FTSE 100, the
Index FTSE 250 and the FTSE Small Cap. It is the widest market index,
consisting of over 600 companies, representing about 98% of the
London Stock Exchange.
• This index:
– represents the performance of all eligible companies listed on the
London Stock Exchange’s main market which pass screening for
size and liquidity;
– is calculated in real time, and the constituent companies are
reviewed quarterly with an annual rebalance in June;
– is divided into sectors representing different market sectors;
– is designed to behave in much the same way as an actual
portfolio and can be used as a reliable indicator of the London
market’s long-term performance; and
– is often used as the basis for index-tracking funds.
• It tends to move more slowly than the FTSE 100, which consists of
just the top 100 companies (the All-Share Index contains some
relatively inactive components).
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Table 1.19: Main FTSE indices

FTSE 100 • The FTSE 100 is the UK’s best-known market index and tracks the
value of the 100 biggest companies listed on the London Stock
Exchange.
• Its membership is revised quarterly in March, June, September and
December:
– changes to the constituents can be prompted by new listings on
the exchange, mergers and acquisitions or an increase or
decrease in market capitalisation; and
– movements by companies into and out of the index can have a
considerable effect on the share value of a company because of
the need for index-tracking funds that use the FTSE 100 as their
basis to rebalance their portfolios.
• It is updated constantly during trading hours, i.e. it is a real-time
index.
• The FTSE 100 represents approximately 81% of the total UK market
capitalisation of all shares listed on the UK market, and is used
extensively as a basis for investment products, such as derivatives
and ETFs.
FTSE 250 • The next 250 largest companies by market capitalisation
immediately below the FTSE 100 make up the FTSE 250. In other
words, the companies are ranked from 101 to 350 by market cap.
• This index represents approximately 15% of the UK market
capitalisation.
• It is a real-time index that is updated constantly during trading
hours. The constituent companies are reviewed quarterly in March,
June, September and December.
FTSE 350 • The FTSE 350 is a combination of the FTSE 100 and the FTSE 250
indices and covers around 96% of the UK market capitalisation.
• It is a real time index and the constituent companies are reviewed
quarterly in March, June, September and December.

Other FTSE indices include:

FTSE SmallCap
This is made up of the companies in the FTSE All-Share that are too small to qualify for the
top 350.
FTSE Fledgling
This index is made up of companies listed on the main market of the London Stock
Exchange, which are eligible for the FTSE UK series but are too small for the FTSE All-Share.
There is no liquidity requirement for companies in this index and constituent companies are
reviewed annually in June.
FTSE AIM index series
The FTSE AIM index series is for young and growing companies traded on the AIM. The AIM
index series comprises the following real-time indices:

Table 1.20: FTSE AIM index series

Index Composition
FTSE AIM UK 50 Index The 50 largest eligible UK companies.
FTSE AIM 100 Index The 100 largest eligible UK companies.
FTSE AIM All-Share Index All AIM quoted companies that meet the
FTSE eligibility criteria.
FTSE AIM All-Share Supersector Indices These are derived from the FTSE AIM All-
Share Index and are based on the Industry
Classification Benchmark (ICB). They
provide an investor with 19 indices with
which to identify macroeconomic trading
and investment opportunities.
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To be eligible for inclusion in these indices, every stock has to be liquid and readily tradeable.
The liquidity of the companies is reviewed annually, and the constituent companies reviewed
quarterly in March, June, September and December.
These are all real-time indices, which are constantly updated during trading hours.
Other FTSE indices
A number of other FTSE indices are also produced, which cover specific areas of the main
market:
• FTSE TMT
TMT: the performance of companies in the Technology, Media and
Telecommunications sectors.
• FTSE techMARK All-Share
All-Share: comprising all of the companies included within the London
Stock Exchange’s techMARK sector for innovative technology stocks.
• FTSE4Good
FTSE4Good: designed to measure the performance of companies that meet globally
recognised corporate social responsibility standards.

C6C Other indices

In addition to the main UK equity indices, there are a range of specialist indices covering
markets other than equities, such as:
• FTSE Actuaries UK Conventional Gilts All Stocks Index – includes all British Government
securities quoted on the London Stock Exchange.
• FTSE Sterling Corporate Bond Index – covering sterling-denominated corporate bonds of
investment grade quality.

C6D Overseas indices

There are widely published indices for all major overseas markets, which provide an
indication of local market performance and can be used to assess the performance of the
overseas element of an investment portfolio.

Table 1.21: Main overseas indices

Country Equity index
USA Dow Jones Industrial
Standard & Poor’s Composite (i.e. S&P 500)
NASDAQ
Japan Nikkei 225
Topix
Germany DAX 30
France CAC 40
Hong Kong Hang Seng
Australia S&P All Ordinaries
South Africa FTSE/JSE All-Share
Spain IGBM (Bolsa de Madrid General index)
Europe FTSEurofirst 300

US equity indices
• The Dow Jones Industrial Average Dow Jones
This is the most well-known US index. The main points to note are as follows: Industrial Average
is the most well-
– It takes the share prices of 30 blue chip companies and measures their movements. known US index

– It is calculated by adding the New York Stock Exchange closing prices and adjusting
them by a ‘current average divisor’ – an adjustable figure formulated to preserve the
continuity of the Dow over time amid changes in its component parts.
– Three specialist indices are also provided, covering home bonds, transport and utilities.
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• Standard & Poor

Poor’’s (S
(S&&P) Composite
This is a composite index consisting of 500 companies listed on the New York Stock
Exchange. The S&P 500 is generally regarded as a good guide to the US market,
representing around 75% of the capitalisation of the New York Stock Exchange. Stocks in
the index are weighted according to their market capitalisation.
The NASDAQ Composite
The NASDAQ Composite is an index of small young companies, which operate in fast-
growing sectors such as information technology and biotechnology. It is often used as a
proxy for the performance of US technology stocks.
Japanese equity indices
Nikkei 225 is the
The Nikkei 225 is the most widely quoted measure of stock movements on the Tokyo Stock
most widely Exchange. The Nikkei 225 is not strictly an index but is based on the average of 225 stocks. It
quoted measure of
stock movements
is not weighted according to market capitalisation, so smaller firms can move the index as
on the Tokyo much as bigger ones. Finally, it may be regarded as a broad benchmark similar to the Dow
Stock Exchange
Jones.
There is a more comprehensive Tokyo Stock Exchange Index (Topix) (Topix), which provides a
better guide to the overall market, but it is not as widely followed as the Nikkei 225. Similarly,
the Nikkei 300, which gives broader coverage, is less popular than its 225 counterpart.
Germany equity index
The DAX 30 consists of the 30 largest quoted German companies, calculated in real time. It
is value weighted, and is the basis of futures and options traded on the Deutsche Termin
Börse (DTB). Unusually for an index, it includes reinvested income.
Hong Kong equity index
The Hang Seng Index is designed to serve as an indicator of the broad movements in the
Hong Kong stock market. It is composed of a representative sample of Hong Kong stocks,
and is value weighted.
France equity indices
The CAC General Index records the opening prices on the Paris cash market.
The CAC 40 is a real-time value-weighted index of the largest stocks.
World equity indices
Other widely used overseas indices are the MSCI World Index series and the FTSE All-World
Index, which covers global equity markets and comprises over 3,000 stocks from 47
Index
countries.

C6E Limitations of indices

Indices are widely
Indices are widely used for comparing the performance of actual portfolios. It is important to
used for understand their construction and limitations to understand how they can be used as a valid
comparing the
performance of
benchmark to evaluate a portfolio’s performance.
actual portfolios
Most modern indices (and all the FTSE indices) are weighted by market capitalisation. This
means that they reflect the relative value of big and small companies on the market. Some
older indices are a crude average of price movements. The modern approach is clearly more
realistic, but investors should remember that a few large companies can have a very
substantial effect on the market.
Most indices only reflect changes in capital values, although reinvested dividend income can
make a substantial difference to long-term performance. Most indices can also be calculated
with an allowance for dividend income reinvested, because they provide a record of yields
from the basket of shares in the index. However, they take no account of tax. The FTSE All-
Share Index and its subsections include a total return index, which is based on reinvested
income.
Other things to bear in mind are that:
• indices do not include the costs of buying and selling, CGT or management expenses; and
• the index assumes that the investor is fully committed to the market and holds no cash
balances. In the long-term, cash holdings tend to lead to underperformance but, in the
short-term, they can improve performance if the market declines.
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D Property
Until the development of the stock markets, property was virtually the only asset-backed Property offers
investment available. Today, property provides a way of diversifying an investor’s portfolio, different
investment
as it offers different investment characteristics from other assets. characteristics
from other assets

Table 1.22: Characteristics of property

Property prices are • The prosperity of an area or an economy can boost or
affected by supply and depress prices. In locations where businesses are flourishing
demand. However, and people wish to live, demand for property will rise, and
demand can fluctuate with it rents and property values.
with changing economic,
financial and • Commercial property values only follow business
demographic profitability in very general terms and the property cycle is
circumstances. likely to be different from the business cycle.
• Tenants of commercial property have to pay their rent even
when they make a loss. Commercial property therefore has
some of the general characteristics of fixed-interest
securities, although, if a property becomes vacant and
tenants cannot be found, the asset can become a drain on
resources.
• There are many different types of property available,
ranging from small flats in the residential sector to retail and
industrial estates in the commercial sector. The returns from
different types of property can vary quite considerably.
• The commercial and residential property markets usually
display very different characteristics, although both tend to
be related to the overall performance of the economy, at
least in the long-term.
• Depending on the wealth of an investor, one of the key
investment decisions is whether to buy property directly or
through a collective investment scheme, which would
usually provide a wider spread of investment.

Property is an asset-backed investment and can, therefore, provide long-term protection

against inflation. It has characteristics that make it different from equities and so offers
investors the opportunity to diversify a portfolio, while offering the prospect of reasonable
long-term returns.

D1 Residential property investment

Over the past few years, residential buy-to-let has become a popular investment, not least Strong capital
when falling yields on equities and bonds make rental yields appear relatively attractive. performance has
added to the
Strong capital performance has added to the appeal of buy-to-let. appeal of
buy-to-let
D1A Drawbacks of property investment
The main drawbacks of property investment are:
• lack of liquidity;
• costs associated with the initial purchase and ongoing management of the property; and
• void periods, when a tenant cannot be found.

Table 1.23: Drawbacks of property investment

Liquidity • Property is expensive to buy and sell, with increased rates of stamp
duty land tax (SDLT) for second properties, legal costs and usually
estate agent fees to pay;
• the sale of a property can be a slow process;
• when the property market is poor, it can be virtually impossible to sell,
except at a greatly reduced price in relation to normal values; and
• it is not usually possible to sell properties in ‘bits’ (unlike an equity
portfolio) to boost income or take advantage of the annual CGT
exempt amount.
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Table 1.23: Drawbacks of property investment

Management • Letting property should be considered a form of business. It requires
issues the administrative, financial and marketing skills that are needed in
most small enterprises. Letting property also involves commitment
and patience with the customers – in this case, the tenants.
• Investors need to decide whether to manage their own properties or
to use specialist letting and management agencies.
• Managing a property without an agent saves fees, but is not
recommended unless the investor has an aptitude for the work as well
as enough time to carry it out. It is also helpful to live sufficiently close
to the property to be able to look after it and deal with tenants
effectively.
• Choosing an effective manager is as difficult as choosing any other
professional adviser or service provider: quality varies between
managers and agency fees vary significantly.
• Some agencies charge fees on the basis of a flat 10% to 15% (plus
VAT) of rents collected; others charge a fee for letting plus a
collection fee. The second option may be cheaper where lettings are
arranged for long periods, but could be very expensive for properties
where the turnover of tenants is frequent.
Void periods • Property investment carries with it the risk of the loss of rent.
• Loss of rent can arise where:
– there is no tenant (for example, when an existing tenant vacates
the property at the end of a lease, and no new tenant can be
found); or
– a tenant occupying a property fails to pay the rent.

Consider this
this…
…
In what circumstances can loss of rent occur and how can landlords reduce the risk of this
happening?

Although a landlord is protected by property law, enforcing the law may involve the services
of a solicitor, incurring additional costs. It may be difficult to find tenants in areas where
there is a surplus of rental property, or in areas that have become unfashionable or
neglected. Investors who have borrowed heavily are most affected by void periods.

D1B Choosing a property

There can be regional variations in both income returns and capital growth, as well as
variations in returns between different types of property. Many different factors need to be
taken into account when choosing property that is appropriate for letting, some of the key
issues are noted below.

Table 1.24: Choosing a property for letting

Location • Where the property is situated is often the most important issue when
buying a property.
• Very small differences in location, from one street to the next, can
make substantial differences to values and prospects for growth.
Tenants • Each type of tenant has advantages and drawbacks. The quality of
tenant in terms of their creditworthiness and likelihood of default can
affect yield. Great care should be taken to investigate the local letting
market before any purchase is made.
Age and • Maintenance costs can greatly reduce or even eliminate the income
condition of the from a property.
property • In a competitive market, where tenants have a choice of properties to
rent, older property may need to be upgraded to make it more
attractive, as good presentation is important at all levels of the rental
market.
• It is usually worth buying newer property for renting.
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Table 1.24: Choosing a property for letting

Diversification • Where an investor has substantial funds, it is generally safer to invest
in more than one property, although buying property in different
locations can increase management costs.
• Diversification can reduce an investor’s exposure to the risks of
defaulting tenants, adverse planning issues and changes in the local
economy.
• If properties are all in the same area, these risks will be concentrated.

D1C Tenure
Property owners should always let under assured shorthold leases, which are for defined
periods. There is no minimum period but it is usually for six or twelve months. However, they
are not usually subject to rent controls.
They do not give a tenant security (beyond the first six months) since, at the end of the
period of the tenancy, the landlord can decide not to renew it.
Residential landlords often avoid long rental agreements, as they tend to depress property Long rental
values. agreements tend
to depress
property values
D1D Prospect for capital growth
One of the main attractions behind property purchase has been the prospect of long-term
capital growth.
Residential property prices in the UK are predominantly driven by the owner-occupier
market. In the long-term, prices tend to follow the growth in average earnings.
Over the past ten years, property prices have risen by considerably more than inflation, but
past performance does not guarantee future success.

D2 Expected yield
Rental yields vary significantly between different properties and different locations. As a The larger the
general rule, the larger the property, the lower the yield. property, the lower
the yield
Currently, the private rental sector has seen a huge surge in demand as first-time buyers
continue to struggle to get on the property ladder.
Certain things, however, are often overlooked when considering residential property
investment and these are:
• the costs of buying the property; and
• the relatively high level of ongoing expenses that are involved.
General expenses, such as the costs of managing agents, maintenance and buildings
insurance, all impact on the overall yield on the investment, reducing it on average by
around 25%. The effect of this can be illustrated by the following example.
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Example 1.12
Rental yield
A property is advertised at £175,000, with potential rental income of £900 per month. The
headline gross yield would be:

Gross rent ⎛ £900 × 12⎞

=⎜ × 100 = 6.2%
Market price ⎝ £175,000 ⎟⎠

In practice, the costs of buying, including legal fees, the survey, increased rates of stamp
duty land tax (SDLT) and basic furnishings, might add another £8,000 to the advertised
price.
General management expenses (for simplicity, 25%) will need to be deducted from the
rent:

Gross rent − expenses

=⎜
( )
⎛ £900 − £225 × 12 ⎞
⎟ × 100 = 4.43%
Market price + costs of buying ⎜⎝ £175,000 + £8,000⎟⎠

If there are void periods between lets of only a few weeks, they can reduce the yield even
further.

D3 Stamp duty land tax (SDLT)

SDLT is paid on
SDLT is paid on purchases of land, property and certain leases in England and Northern
purchases of land, Ireland. The buyer or tenant is responsible for completing the relevant SDLT forms,
property and
certain leases in
submitting them to HMRC and paying the tax. However, this is usually done by the solicitor
England and dealing with the transaction. HMRC must be notified, and they must receive the tax, within
Northern Ireland
30 days of the date of the transaction (this is changing to 14 days from 1 March 2019).
SDLT transactions fall broadly into two categories: buying land or premises and leasing land
or premises.

D3A Buying land or premises

SDLT rates for residential land transactions in England and Northern Ireland are as follows:

Table 1.25: Residential SDLT (2018/19)

Slice of property value Rate %
£0 to £125,000 0
£125,001 to £250,000 2
£250,001 to £925,000 5
£925,001 to £1,500,000 10
Over £1,500,001 12

Note that SDLT is only paid at the rate of tax on the part of the purchase price within each
tax band.

Example 1.13
The SDLT usually payable on a residential transaction of £275,000 is £3,750.
This is calculated as follows:

First £125,000 at 0% 0
£250,000 – £125,000 = £125,000 at 2% £2,500
£275,000 – £250,000 = £25,000 at 5% £1,250
Total £3,750
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SDLT for first-time buyers:

• Since 22 November 2017, a relief for first-time buyers in England raised the threshold for
SDLT to £300,000.
• This means that, for those eligible, no SDLT will be paid on the first £300,000 of the
purchase price.
• However, no relief will be available where the total price paid is more than £500,000.
The revised rates and thresholds for residential property purchases worth £500,000 or less
by first-time buyers are therefore as follows:

Table 1.26: SDLT for first-time buyers

Slice of property value Rate for first-time buyers %
Up to £300,000 0
Over £300,000 and up to £500,000 5

Since 1 April 2016, an additional 3% has been charged on top of the normal SDLT rate(s) on
purchases of second residential properties over £40,000, e.g. a second home or a buy-to-let
property. There are a few exceptions where the charge will not apply; in particular, the
surcharge is not paid if the property being purchased is replacing a main residence, which
has already been sold.
SDLT continues to be charged at 15% on residential dwellings costing more than £500,000
bought by bodies such as companies and collective investment schemes. There are some
exceptions, e.g. SDLT will be paid on the current rates and bands where the property is used
for a property rental business.
SDLT rates for commercial property are as follows:

Table 1.27: Non-residential SDLT (2018/19)

On total Rate %
£0 to £150,000 0
£150,001 to £250,000 2
Over £250,001 5

D3B Leasing land or premises

SDLT is charged on the net present value (NPV) of rent payable under a lease. Broadly, this
is calculated by:
• multiplying the annual rent by the term of the lease;
• then applying a discount, to allow for inflation; and
• finally deducting the threshold figure.
If the NPV of the rent does not exceed the threshold of £125,000 for residential property and
£150,000 for commercial property, no SDLT is charged. Where it is above the threshold, tax
is chargeable at a rate of 1% on the amount of the NPV adjusted rent in excess of the
threshold for residential leases, and at a rate of 1% up to £5m and then 2% thereafter for
commercial leases.

D4 Scotland – Land and buildings transaction tax (LBTT)

Land and buildings transaction tax (LBTT) has replaced SDLT in Scotland since 1 April 2015.
It is applied to both residential and commercial land and buildings transactions, and
operates progressively in the same way as SDLT. However, the property value bands differ
from those for SDLT, as shown in Table 1.28:
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Table 1.28: Scotland – residential LBTT (2018/19)

Slice of property value Rate %
£0 to £145,000 0
£145,001 to £250,000 2
£250,001 to £325,000 5
£325,001 to £750,000 10
Over £750,001 12

Example 1.14
A house transaction in Scotland for £275,000 will result in a LBTT payment of £3,350
(£400 less than in England – see Example 1.13):

First £145,000 at 0% 0
£250,000 – £145,000 = £105,000 at 2% £2,100
£275,000 – £250,000 = £25,000 at 5% £1,250
Total £3,350

At the time of writing, a consultation has been launched in Scotland on a measure which
proposes that first-time buyers will only be subject to LBTT once the value of their property
exceeds £175,000, rather than the usual £145,000 threshold. It is expected that the relief will
be introduced in June 2018, so you should look out for developments in this area.

Table 1.29: Scotland – non-residential LBTT (2018/19)

Slice of property value Rate %
£0 to £150,000 0
£150,001 to £350,000 3
Over £350,001 4.5

D5 Wales – Land transaction tax (LTT)

In April 2018, land transaction tax (LTT) replaced SDLT in Wales.

Table 1.30: Wales – LTT rates (2018/19)

Price threshold LTT rate %
The portion up to and including £180,000 0
The portion over £180,000, up to and 3.5
including £250,000
The portion over £250,000, up to and 5
including £400,000
The portion over £400,000, up to and 7.5
including £750,000
The portion over £750,000, up to and 10
including £1,500,000
The portion over £1,500,000 12
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D6 Letting part of an individual

individual’’s main residence
Individuals who receive rent from letting rooms in their own homes are entitled to a special Rent-a-room relief
exemption from tax. This exemption, known as ‘rent-a-room’ relief, extends to owners and extends to owners
and tenants who
tenants who let furnished rooms in their only or main residence. The relief does not apply to let furnished
a self-contained unit or unfurnished accommodation. rooms in their only
or main residence

Be aware
Qualifying rules for exemption from tax
The qualifying rules are as follows:
• The individual must occupy the property as their main residence at the same time as
the tenant.
• No tax is payable if the gross rent for a tax year, before deducting expenses, does not
exceed £7,500.
• There is only one exempt amount per residence.
• If another individual is also receiving rent from letting accommodation in the same
property, the relief is £3,750 each. This could arise, for example, where an owner lets
part of a property to a tenant, who sub-lets to a sub-tenant. Both the owner and the
tenant may each obtain a maximum exemption of £3,750.
• The rent taken into account is the payment for the accommodation plus any payment
for related goods and services.
• If the rent exceeds £7,500, taxpayers have a choice. They can either:
– choose to pay tax on the excess over £7,500 with no deduction for expenses; or
– be taxed on the gross rent received, less expenses, with no rent-a-room relief.

In 2017/18, a property income allowance of £1,000 was introduced for individuals. If the
allowance covers all rental income received, then the income does not need to be declared
to HMRC and tax is not due.
Where income is in excess of £1,000, there is the choice of deducting the allowance from
gross income to calculate taxable profit, instead of deducting actual allowable expenses.
You should note that the property allowance will not apply to income where rent-a-room
relief is given. It will also not apply where actual allowable expenses are deducted, rather
than the alternative method described above.

D7 Commercial property investment

The commercial property market is divided into three main sectors:
• retail (shops);
• office buildings; and
• industrial properties (factories and warehouses).
The retail sector is often the lowest yielding, while industrial property, with its shorter
lifespan, is the highest yielding.
Investment in commercial property tends to be a specialised part of the overall investment A significant
sector. A significant proportion of investment property is owned by insurance companies proportion of
investment
and pension funds. property is owned
by insurance
companies and
D7A Past performance pension funds

Commercial property values tend to follow a cyclical pattern. They often move in a different
direction to equities and sometimes to residential property.
It is perhaps more relevant to look at the returns in comparison with those earned on
equities and bonds. Commercial property has the potential to diversify the risks of an
investment portfolio and, at times, produce returns that are not correlated to broader bond
and equity market movements.
More importantly, what past performance demonstrates is that commercial property returns
are clearly dependent on the economic cycle and so display periods of growth and
contraction.
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D7B Investment considerations

Consider this
this…
…
An important consideration in all let property investment is the quality of the tenant and
their ongoing ability to pay the rent. A property has intrinsic value as a potential source of
income, even if it is empty, but it is likely to be worth more as an investment with a
financially secure tenant.

Commercial property investors aim to diversify by having properties in each of the three
main sectors – retail, office and industrial – with a geographic spread throughout the UK.
There is now also a trend to invest in commercial property internationally, following the
pattern of equity and bond investment.
Building such a diversified portfolio through direct investment is limited to the richest
investors (mostly larger institutions) because of the cost of individual properties. Less
wealthy investors gain their diversification by using collective funds, including real estate
investment trusts.

Commercial
Commercial property owners prefer long leases as they enhance their property values.
property owners Traditionally, commercial properties are valued as a multiple of the rent they produce.
prefer long leases
as they enhance
However, valuations can change with market expectations of future growth as follows:
their property
values • High multiple, i.e. a low yield, reflects future prospects of strong growth coupled with
reasonable security.
• Retail properties usually have the lowest income yield, while industrial properties have the
highest.
Leases on commercial property usually pass full responsibility for maintenance and
insurance costs onto the tenant, so that the net income from commercial property is
typically higher than from residential property.
The income is also more secure as rental agreements are much longer than residential
property leases. One of the attractions of commercial property in the UK has been the use by
landlords of leases that were often typically for 25 years. However, they have tended to
reduce in recent years and now average less than ten years.
Rental agreements are also becoming more flexible, with break options that allow the tenant
to leave. However, the increased flexibility means that the tenant generally ends up paying
more to compensate the landlord for reduced security of income.

Rents may now be

The rent paid by the tenant is usually reviewed every three or five years, with some leases
linked to inflation including an upwards only review provision. However, there has been political pressure to
or turnover
end this practice and rents may now be linked to inflation or turnover.

D7C Problems with investing in commercial property

In considering commercial property as an alternative form of investment, an investor should
be aware of its shortcomings.

Be aware
Drawbacks of commercial property investment
These are as follows:
• The sale and purchase of commercial property is a relatively slow and often complex
process. Transaction and marketing costs often add around 6% to the purchase price.
SDLT alone is 5% on purchases of properties valued at over £250,000.
• Commercial property traditionally offers the opportunity for good income growth,
linked to rent increases. However, the growth typically takes place in steps, as most
rent reviews take place after specified periods (usually three or five years).
• A property is not easily divided into segments and can usually only be sold as a whole.
This may not meet the requirements of an individual investor.
• The commercial property market is difficult to analyse. It is characterised by a few
transactions involving large sums, with restricted information regarding the prices and
conditions involved.
• There can be a time lag in increasing the supply of property to meet extra demand,
which can result in an over-supply.
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E Alternative investments
Alternative investments can provide diversification to an investor’s portfolio. There have
been certain time periods when they have increased in value, although they often gain in
popularity when other, more traditional, investment areas are depressed.
Alternative forms of investment can encompass a wide range of unconventional Alternative forms
investments. In addition to direct investment in works of art and other collectables, such as of investment can
encompass a wide
coins and stamps, there is an expanding range of funds being offered to investors that invest range of
in commodities, with themes that include agriculture, infrastructure and alternative energy. unconventional
investments

E1 Works of art and collectables

Works of art and collectables cover a wide range of objects, from paintings costing tens of
millions of pounds, to special edition plates or medals. Almost anything can attract the
attention of collectors – however, the returns can vary widely.
Items that may appeal to an investor include paintings, antique furniture, rare books and
manuscripts, memorabilia, vintage wine, stamps, coins, limited edition plates, diamonds,
gold, cars, etc. Most investments in physical assets have certain common characteristics, as
follows:
• they usually do not generate any form of income or financial return;
• they often cost money to keep, and may incur charges in the form of insurance premiums,
specialist storage charges, security costs or maintenance;
• their value is dependent on limited supply and fluctuating demand;
• demand is driven by the tastes of collectors and, in particular by their number and wealth;
• tastes can be conditioned by experts who, in many cases, have been responsible for
increasing the popularity of certain items, which has created demand and increased
prices; and
• authenticity can be very important to the value of an alternative investment and an
interesting provenance, i.e. being connected with a particular historic event or previously
owned by a celebrity, can boost its value.

E1A Investment performance

The performance of collectables has been variable. Although their value generally tends to Performance of
rise in line with inflation, there have been periods when some investments have collectables has
been variable
outperformed inflation, while others have shown substantial underperformance.

Example 1.15
In the 1970s, the British Rail Pension Fund purchased a substantial portfolio of high quality
art and antiques when prices were relatively low. These were disposed of during the 1980s
and early 1990s when prices were at their peak. These investments provided similar
returns to the fund’s equity portfolio. However, other investors have been less fortunate in
their timing and choice of investments.

The basic economics behind a rising alternative investment market is a fixed or declining
supply (e.g. eighteenth-century English furniture) and increasing demand, e.g. private
investors and museums.
One threat is that supply is not fixed because of the manufacture or discovery of Prices may rise,
reproductions. Another danger is that buyers lose interest or the funds to buy. Prices may but often in a
volatile pattern
rise, but often in a volatile pattern. If they fall, there is usually no floor or intrinsic economic
value as there would be with an asset that produced an income.

E1B Investment viability

When considering whether to buy a particular asset as an investment, it is worth taking into
account the following points:
• The difference between buying and selling prices can be much greater than for
conventional investments. It is not uncommon for dealers to have mark-ups of 50% to
100% on antiques and other objects, so that an item bought for £1,000 might only realise
£500 or less when it is sold.
Chapter 1.2
1/64 R02/July 2018 Investment principles and risk

• The state of repair can be very important to the value of an object. Restoration, storage
and insurance can all add to the cost and risk.
• It is not always possible to be totally sure of the genuineness or quality of an article, e.g.
pictures, furniture and diamonds are all assessed according to criteria that are at least
partly subjective. Mistakes can be made.
• Tastes change, e.g. Victorian paintings dropped in value in the early years of the twentieth
century, but have climbed again since the 1960s, although by no means always to their
original real values.
• Some markets are dominated by a small number of buyers and sellers. When they are
buying, prices move upwards rapidly. If they sell or stop buying, prices can fall.
• An investor can obtain pleasure from many types of collectables. Even if a purchase turns
out to be a poor financial investment, it may provide some enjoyment for the investor.
Collectors who know and enjoy the items they collect are probably more likely to invest
successfully.

Specialist
• It can be difficult to diversify and specialist knowledge is needed to buy successfully.
knowledge is
needed to buy
successfully
E2 Commodities
Commodities are raw materials that fall into two broad classifications, hard or soft, as
follows:
• hard commodities are the products of mining and other extractive processes – they
include metals such as gold and silver, crude oil and natural gas; and
• soft commodities are typically grown rather than mined – they include coffee, cocoa,
sugar, corn, wheat and livestock.

Consider this
this…
…
As an asset class, commodities can appeal to some investors as part of an overall strategy
of spreading risk by diversifying their investment portfolio. This is because their prices
tend not to move in tandem with equity or bond prices. In other words, commodities have
low correlation with other assets.

In recent years, commodity prices have risen sharply as demand for raw materials in
developing countries has increased significantly. However, the prices of various
commodities are often volatile and there can be short-term supply-and-demand issues.
These can include exploration and extraction activity and worldwide economic growth rates,
as well as climatic factors and stock levels. There is a higher probability of sudden and
unfavourable price changes in commodity prices than there is of a sudden collapse in share
prices.

Example 1.16
Gold as a safe haven
Gold is one of the most popular of the precious metals, and investors frequently flock to it
as a safe haven when the economy is struggling, as it is seen as useful for hedging against
inflation. Gold prices move to reflect supply and demand just as any other commodity,
often responding quickly to economic events. Many people see long-term value in holding
gold as part of a diversified portfolio.

Direct investment
Direct investment in commodities is not practical for most investors. However, commodity
in commodities is investment can be arranged in a number of other ways, such as investing in:
not practical for
most investors • companies that produce commodities;
• funds that invest in commodities; or
• exchange traded commodities (ETCs).
 Chapter 1.2
Chapter 1 1.2: Equities, property and alternative investments 1/65

E2A Risks
Commodity investment is risky because the markets are dominated by trading interests like
big metal companies and big coffee traders, which are more likely than private individuals to
learn the latest information likely to move prices. Thus, prices will be volatile. There is also
political risk to consider; instability in the Middle East can threaten the supply of oil which
can affect prices – something we have witnessed in recent years. Although commodities
offer useful diversification to a portfolio, private investors need to be aware of the risks
involved in including them within their portfolio through indirect investment vehicles such as
ETCs.
Private investors should also be aware that while commodities offer diversification, they are Commodities are
cyclical, and good timing is essential. cyclical, and good
timing is essential

E3 Cryptocurrencies
There are around 1,300 cryptocurrencies, with an estimated worth of £500 billion. In simple
terms, cryptocurrencies are, as an alternative to notes and coins, a digital currency system
produced by a computer. The first and most famous cryptocurrency is Bitcoin, which was
invented by Saitoshi Nakamoto and released in 2009 following the financial crisis in 2007/
2008; the idea being that it would not be managed by any of the banks.
The payment processing technology that underlies cryptocurrency is a network known as a
‘blockchain’; this is a digital ledger that processes transactions using encryption technology
to keep a secure record of each transaction in one place. Each blockchain is unique to each
individual user. The transaction is known almost immediately by the whole network and,
once confirmed by ‘miners’, it is set in stone and cannot be reversed – it is now part of the
blockchain.
‘Mining’ is computer accounting, attempting to solve complex mathematical problems with a
64-digit solution. It serves two purposes:
• it confirms that the transaction is legitimate – so avoids double spending; and
• it creates new digital currencies by paying the miners with a percentage of the transaction
fee charged to the user.
Features of cryptocurrencies:
• Transactions are anonymous – the system does not record the name of the person who
owns the ‘wallet’.
• They are not backed (or influenced) by governments or central banks.
• They are not regulated by the FCA.
The most common way to buy cryptocurrency is online via a site, such as CoinCorner, where
Bitcoin can be bought using a credit card. It can then be traded online using wallet software
or an online trading service.
A cryptocurrency wallet is a digital wallet (a small personal database stored on a computer
drive, on a smartphone or in a cloud) where private keys are stored, which are used to
receive or spend the cryptocurrency. Each piece of cryptocurrency has a private key, which
is used to write in the public ledger – effectively ‘spending’ the currency.
Because cryptocurrency is anonymous, it is well suited to money laundering and tax evasion,
and there are security risks too, such as the potential for wallets to be hacked.
The market is highly volatile. One view is that as there will only ever be 21 million Bitcoins (by
around 2040), the value should keep increasing.
Chapter 1.2
1/66 R02/July 2018 Investment principles and risk

Key points
The main ideas covered by this chapter can be summarised as follows:

Equities
• Equities offer the potential for long-term real growth, but will not be suitable for all
investors.
• Share prices are influenced by economic and political factors that affect the market as a
whole, as well as by factors that are company specific.
• The two main classes of shares are ordinary shares and preference shares, although
there are a number of variations of both. They differ in respect of their holders’ rights to
receive dividends, control the company and to receive capital if the company is
liquidated.
• Investment ratios allow investors to identify trends in a company’s performance and
compare the performance of similar companies.
• The use of percentages and ratios has a number of limitations. However, they can
highlight aspects of a company’s performance that may merit closer scrutiny.
• Stock market indices bring together the movements of individual share prices and show
the direction in which a market has moved over a period of time.
• Indices can be used to compare the performance of a particular share with its sector or
with the market as a whole, or to compare the performance of a fund manager with the
performance of the market as a whole.

Property
• Property is an asset-backed investment that can provide long-term protection against
inflation.
• Property can add balance to a portfolio, but is not always easily realisable.
• Historically, long-term growth has made property attractive to an investor, but past
performance does not guarantee future success.
• Returns can vary significantly between regions, and between different types of property.
• The relatively high level of expenses can significantly reduce the annual yield on direct
property investment.
• Commercial property generally displays different characteristics to residential property.

Alternative investments
• Alternative investments can provide diversification to a portfolio, but they provide no
income and will incur charges not usually associated with other investments.
• Works of art and collectables cover a wide range of objects, from paintings costing tens
of millions of pounds, to special edition plates or medals.
• Commodities are raw materials that fall into two broad classifications:
– hard commodities, such as gold and silver; and
– soft commodities, such as coffee and sugar.
• Cryptocurrencies are, in simple terms, a digital currency system produced by a
computer.
 Chapter 1.2
Chapter 1 1.2: Equities, property and alternative investments 1/67

Question answers
1.4 The dividend yield would be:

16.5
Dividend yield = × 100 = 5.65%
292

1.5 The dividend cover would be:

58
Dividend cover = = 2.23 times
26

1.6 The P/E ratio would be:

410
P/E ratio = = 10.65
38.5
Chapter 1.2
1/68 R02/July 2018 Investment principles and risk

Self-test questions
10. What two factors tend to influence the price movements of an individual share?
11. Is a rise in interest rates likely to raise or depress the share price of building
companies?
12. To what extent is a preference share comparable to a corporate bond?
13. Which type of share ranks lowest if a company goes into liquidation?
14. A client is considering investing in listed private equity companies. What are the
risks associated with this type of investment?
15. What is a P/E ratio and what does it tell an investor about the potential for growth
in the share price?
16. Why might it be appropriate to include property within an investment portfolio?
17. What are the disadvantages of investing in a work of art?
18. What are the two broad classifications for commodities?

You will find the answers at the back of the book

 Chapter 1.2
Chapter 1 1.2: Equities, property and alternative investments 1/69

Appendix 1.1: Sample accounts for Green

Trees plc

Statement of comprehensive income of Green Trees plc for

52 weeks ending 31 December
£000s £000s
Turnover 27,741
Cost of sales (22,497)

Gross profit 5,244

Distribution costs 1,653
Administration costs 1,903 (3,556)

Net operating profit 1,688

Interest payable 157

Profit on ordinary activities before taxation 1,531

Tax on ordinary activities (459)
Profit for the financial year 1,072
Dividends 63
Preference
Ordinary 426 (489)
Retained profit for the year 583
Chapter 1.2
1/70 R02/July 2018 Investment principles and risk

Appendix 1.1: Sample accounts for Green

Trees plc

Statement of financial position of Green Trees plc at

31 December
£000s £000s £000s
Fixed assets
Tangible assets 8,570

Current assets
Stock 4,095
Debtors 2,462
Cash at bank and in hand 371
6,928

Current liabilities
Trade creditors 3,465
Corporation tax 783
4,248

Net current assets 2,680

Total assets less current liabilities 11,250

Long-term debt
Debenture loan stock 750
Unsecured loan stock 750
1,500

Capital and reserves

Authorised and issued

Ordinary shares 5,000
Preference shares 1,000
Profit and loss account 3,750
9,750

Total capital employed 11,250

Current market price of ordinary shares is 200p

 2

Chapter 2
The macro-economic
environment and its
impact on asset classes
Contents Syllabus learning
outcomes
Learning objectives
Introduction
Key terms
A Trends in investment markets 2.1
B World economies and globalisation 2.1
C Economic and financial cycles 2.2
D Fiscal and monetary policy 2.3
E Money supply 2.3
F Balance of payments 2.3
G Role of financial investment in the economy 2.3
Key points
Question answers
Self-test questions

Learning objectives
After studying this chapter, you should be able to:
• describe the impact of major changes to and trends in investment markets;
• describe the impact of socio-economic issues on investment markets;
• explain how the effects of globalisation impact on investment markets;
• explain how changes in economic growth and business cycles can impact on investment
markets;
• identify the main key economic indicators;
• explain the significance of fiscal and monetary policy;
• describe the link between money supply and inflation, interest rates and exchange rates;
• explain how the effects of inflation, the role of interest rates, exchange rates and
expectations of future changes impact on investments;
• explain the importance of the balance of payments for a country; and
• explain the role of financial investment in the economy.
 2/2 R02/July 2018 Investment principles and risk

Introduction
Governments are in a powerful position to influence economic and financial conditions. It is
Chapter 2

important, therefore, that investors are alert to political developments because of the
potential impact of changes in economic policy on the economy.
This chapter examines the key economic trends and their impact on asset classes, the key
economic indicators and the impact of monetary and fiscal policy.

Key terms
This chapter features explanations of the following:
Balance of payments Business cycles Deflation Disinflation
Exchange rates Gross domestic Inflation Interest rates
product (GDP)
M0 ‘narrow money’ M4 ‘broad money’ Quantitative easing Speculative fashions

A Trends in investment markets

A1 Impact of politics generally
In the financial markets of the USA, the Eurozone, Japan and other countries, it is important
to keep abreast of the thinking of the central bankers. As international financial markets have
grown in influence, there has been a tendency for governments to shed some of their power
by making central banks more independent. However, the financial crisis of 2008/09 has
resulted in governments increasing their role in finance – notably through bank rescues. The
independence of central banks from governments has become less distinct as both parties
have worked together with regulators in seeking a resolution to the problems facing the
markets.
In a world of low interest rates, the central banker’s use of rates to influence the supply of
money and control inflation is restricted. This passes more responsibility for economic
management onto the government, although this may take the form of extending the central
bank’s remit, for example, through quantitative easing (creating new monetary reserves),
which is covered later in this chapter.
In general, government policies can affect:
• interest rates and currencies;
• business and competition; and
• economic cycles and inflation.

A1A Interest rates and currencies

Political developments can have major effects on interest rates and the value of currencies:

Political
• In early 2009, the UK Government agreed to inject money directly into the economy
developments can through quantitative easing
easing. The initial purchases of gilts by the Bank of England
have major effects
on interest rates
increased total demand and pushed up their prices, which in turn led to a drop in gilt
and the value of yields. The combination of low interest rates and quantitative easing was intended to
currencies
provide the economy with a substantial boost and reduce the risk of inflation falling below
the bank’s target of 2%.
• Two weeks after a major earthquake devastated northern Japan in March 2011, the Bank of
Japan intervened in the currency market, spending up to US$6.5 billion in a few days’
trading. The yen had surged by almost 5% against the US dollar in the aftermath of the
resulting tsunami, as speculators anticipated Japanese insurers having to repatriate funds
to meet claims. Other central banks joined the Bank of Japan in selling yen to stem the
rise, which would have added to deflationary pressures in the Japanese economy.
• The effect that politics can have on interest rates and the value of currencies has been
seen in the UK. Since the Brexit vote, the pound has fallen and is trading more than 10%
lower compared with the euro.
Chapter 2 The macro-economic environment and its impact on asset classes 2/3

EU referendum
On 23 June 2016, the UK voted to leave the European Union (EU).

Chapter 2
The UK Government invoked ‘Article 50’ of the Lisbon Treaty on 29 March 2017. In doing
so, the two-year negotiation period which will result in the UK leaving the EU began. This
means that, at the time of publication, the UK’s membership of the EU will cease on 29
March 2019. However, following the meeting of the EU Council in March 2018, an
agreement was reached on the terms of an implementation period that will apply
following the UK’s withdrawal from the EU. The implementation period is intended to
operate from 29 March 2019 until the end of December 2020, during which time EU law
would remain applicable in the UK, in accordance with the withdrawal agreement.
The implementation period forms part of the withdrawal agreement, which is subject to
further negotiations between the UK and EU before it is finalised. Until this final
‘withdrawal agreement’ is entered into, the UK will continue to be a full member of the EU,
compliant with all current rules and regulations, and firms must continue to abide by their
obligations under UK law, including those derived from the EU, and continue with the
implementation of all legislation that is still to come into effect.
The longer term impact of the decision to leave the EU on the UK’s overall regulatory
framework will depend, in part, on the relationship agreed between the UK Government
and the EU to replace the UK’s current membership at the end of the ‘Article 50’
negotiation period.
note: The UK decision to leave the European Union will have no impact on the 2018
Please note
CII syllabuses or exams. Changes that may affect future exam syllabuses will be
announced as they arise.

A1B Elections, economic cycles and inflation

Elections are important because of the way governments use economic policy to create the
most favourable economic conditions in which voting takes place. The time when
governments prefer to rein in the economy is just after the election. This creates the so-
called ‘electoral cycle’ in which booms are generated before elections and an over-heated
economy is then cooled down in the first stage of a new parliament. The ability of politicians
to create a ‘boom’ before an election has been curtailed now that so many central banks
have been granted independence.
Historically, the most important effects on inflation have come from governments through
taxing and spending decisions. However, in the aftermath of the financial crisis of 2008/09,
politicians in most developed countries have used both monetary and fiscal policy to an
unprecedented extent to support their economies. This has led to fiscal deficits that would,
in previous eras, have prompted fears of impending inflation.

Example 2.1
A couple of examples of the banks’ positions in monetary policy:
• From late 1992, the Bank of England was given a greater say in monetary policy and, in
May 1997, the Chancellor handed operational control over interest rates to the Bank’s
Monetary Policy Committee.
• The European single currency (the euro) is run by the European Central Bank, which
has vigorously demonstrated its independence in the face of political pressure from a
variety of quarters, notably from its largest constituent country, Germany.

The removal of interest rate-setting powers from the politicians has been diluted by the use
of Treasury and central bank balance sheets to support asset prices (mainly via quantitative
easing).
 2/4 R02/July 2018 Investment principles and risk

A2 Impact of international relations

Wars or fear of
International political developments can jolt economies, sending shock waves through
Chapter 2

conflicts can lead investment markets. Wars or fear of conflicts can lead to major changes of sentiment among
to major changes
of sentiment
investors and traders. Events such as 9/11 or Russian debt default can also have seismic
among investors effects on economies and markets. International relations have become increasingly
and traders
important as economies and markets have become more globally integrated and
interdependent. Financial markets, and equity markets in particular, have become more
correlated (i.e. they move increasingly in step), so investors must be aware of international
developments when allocating assets.

Example 2.2
Examples of the impact of international events
• The terrorist attacks in New York and Washington on 11 September 2001 created
serious global concerns about a worldwide recession that prompted the major central
banks to reduce interest rates rapidly. While the move cannot be entirely credited with
averting a recession, it probably helped to reduce its length and severity.

Concerns about a
• The build-up to the second Gulf War (Iraq War 20032003––2010) had several effects on
worldwide world markets. The dollar and sterling both weakened against the euro as concerns
recession after 9/11
prompted central
about war grew. Safe haven assets such as gold staged a strong rally, while equity
banks to reduce markets were struggling as investors awaited the outcome of UN resolutions and
interest rates
inspections. Many businesses put their investment plans on hold, adding to a downward
spiral in confidence. To no small extent, the events mirrored those of the first Gulf War
in 1990–1991.
• The rapid growth of the Chinese economy, as its government has embraced autocratic
capitalism, has had major repercussions. In 2007/08, and again in 2010/11, China’s
expansion was blamed for sharply rising commodity prices. The gradual revaluation of
Chinese currency against the US dollar has contributed to a backlash against free trade
in the USA. At the same time, China has become wary about the fate of its huge dollar
reserves and fears that the US government might devalue these by allowing a return of
inflation. These concerns appeared to be validated by the decline in the US dollar
following the Federal Reserve’s quantitative easing in 2010/11. Chinese authorities have
even spoken of the need for a new global reserve currency to replace the dollar. During
2015 and early 2016, the country’s stock market crashed dramatically and there were
fears about a new global financial crisis. The Chinese government introduced a range of
measures to help reverse this major downturn.
• The euro crisis followed the credit crunch
crunch, when states that were too weak to fund
bank bailouts (Ireland) or fiscally over-stretched (Greece, Portugal) required bailouts
from new mechanisms set up by the member countries of the eurozone. As some
commentators predicted, the single currency had, since its formation in 2000, led to
widening disparities in labour costs between efficient Germany, Holland and France
and inefficient Spain, Greece, Italy and Portugal. The latter incurred widening and
unsustainable fiscal deficits, requiring some mechanism for fiscal transfers. This was
unacceptable to Germany, which led to the creation of the European Financial Stability
Facility and the European Stability Mechanism, based on capital guarantees from
Member States. However, a lack of firm proposals to reschedule the debts of countries
too weak to repay them (especially Greece) led to nervousness in the markets, coupled
with a weakness of the euro against the dollar and yen.

A3 Speculative fashions
Financial bubbles happen when investors lose sight of fundamental values and buy shares or
other assets simply because they expect prices will continue to rise. This is often known as
the ‘greater fool theory’, i.e. you rely on a greater fool to purchase the shares at a higher
price.

Reinforce
Crashes occur when investors sell shares because they think prices will continue to fall or
if they are ‘forced sellers’ due to regulations or losses.
Chapter 2 The macro-economic environment and its impact on asset classes 2/5

The forced selling of equities to meet solvency requirements by life assurance and pension
funds added to the severity of the bear market of 2000–03, following the technology boom
in 1999/2000. These speculative episodes are a recurring theme in financial history. They

Chapter 2
generally occur when excess liquidity allows investors to magnify the financial repercussions
of real changes, like technological breakthroughs generating bubbles, or political unrest
generating crashes.

Example 2.3
Examples of speculative fashions
The 1999/2000 boom in technology stocks stocks, which brought several loss-making
companies into the FTSE 100, has been described by some commentators as a modern
version of the ‘tulip mania’ of 17th century Holland (what is thought to have been the first
speculative bubble). While some investors argued that there was a ‘new paradigm’ and
cited how new technology had transformed the US economy, there is no doubt that much
of the buying of high-risk dotcom companies was purely speculative. Investor confidence
peaked in March 2000 and then fell away rapidly as it became clear that valuations were
unrealistic. The recent hype surrounding cryptocurrencies has also led to many claims
that Bitcoin, for example, is a speculative bubble.
The boom in financial services and banking, which ended with the credit crisis
crisis, was fed
by financial innovation that appeared to increase profits while reducing risk. The big idea
was ‘create and distribute’, with banks lending money (creating debt) and then
repackaging and selling the debt as marketable securities. This was followed by exercises
in repackaging the packaged debt, yielding further fees for the banks. It was only when
the underlying debt – most notoriously sub-prime residential loans in the USA – started to
default that it became clear the risk had not disappeared.
The massive expansion in the buy-to-let (BTL) market in the UK between 2004 and 2007
was fuelled by easy credit and a large increase in city centre developments of flats. To
begin with, genuine buy-to-let investors bought flats but, as prices rose, speculators
bought such flats ‘off-plan’, paying in cash only about 10% of the sale price, intending to
use bridging loans to complete their purchases before selling on at a profit. The credit
crunch brought lending in this sector to a halt, and many flats proved unsellable even at
half their original purchase prices.

Some have suggested that loose monetary policy has led to booms as central banks try to
stave off recessions. Investors have noticed that there has been a super bull market every
decade for the past four decades (1960s, US equities; 1970s, gold; 1980s, Japan; 1990s, TMT
(technology, media and telecommunications); 2000s, banking) and that the business cycles
last for approximately ten years. A possible cause is that, in an attempt to revive the
economy in the early part of the decade, rates are cut too far and liquidity rushes into
speculative investments. The mania accelerates towards the end of the decade before
collapsing – requiring rates to be cut aggressively once more.
A good example of an interest rate-driven cycle was seen in the US residential property
market. The US Federal Reserve (‘Fed’) started cutting short-term rates in response to the
fallout from 9/11. The bank then kept cutting until 2003, when rates reached a floor of 1%.
The prolonged spell of very cheap money fuelled a housing boom, which went into reverse in
2006 (with Fed rates peaking at over 5%). When the property bubble burst, and all related
sub-prime lending issues were exposed, the Fed cut rates again. In 2008, they reached a
record low of 0.25%, where they stayed for seven years. In December 2015, the rate was
raised to 0.5% and by December 2017 had reached 1.5%. Interest rate forecasts point to a rise
to 2% in 2018, 2.5% in 2019 and 3% in 2020.

Question 2.1
Why do financial bubbles occur?

A4 Socio-economic issues
Around the world, people are living longer and birth rates are declining, leading to ageing People are living
populations with fewer workers and more people in retirement, issues that can have major longer and birth
rates are declining
long-term effects on investment markets and opportunities. Over the next 50 years, we will
see a significant ageing of the UK population and its workforce.
 2/6 R02/July 2018 Investment principles and risk

According to Age UK, there are 11.8 million people aged 65 or over in the UK, as at April 2018.
This figure is projected to rise by over 40% in the next 17 years to over 16 million. The number
of people aged 85 or over is 1.6 million. This is projected to more than double in the next 23
Chapter 2

years to over 3.4 million.

Population ageing will continue for the next few decades as shown in Figure 2.1.

Figure 2.1: Population age structure 1981

1981–
–2035

100%

90%

80%

70%

60% 80+

50% 65–80

40% 16–64

30% <16

20%

10%

0%
1981 2010

Source: Office for National Statistics

This increased longevity should lead not only to more retirees, but also to higher average
wealth holdings, as working households increase their savings to fund a longer retirement.
This has the following consequences:
• As people become richer, demand for services tends to grow, while the proportion of
wealth that is spent on manufactured goods tends to decline.
• This has contributed to the fact that the services sector, particularly banking, insurance
and business services, now accounts for the largest proportion of gross domestic product
(GDP), while manufacturing continues to decline in importance.
• The ageing of the British population is an important reason why politicians have become
more resolute about combating inflation. As members of the baby-boom generation
(those born from 1946 to the mid-1960s) gather more financial savings, they have become
determined to ensure their value is not wiped out by unanticipated inflation. Elderly
dependants, whose number is increasing because of gains in longevity, are also
concerned to ensure their savings are not eroded by inflation.
Ageing Western populations are having a significant impact on equity markets as baby-
boomers move through the peak years of their lives for investment. This effect is particularly
visible in the USA, where investors now hold more in mutual funds than on deposit. The
ageing of the West should also boost particular sectors catering for a more elderly
population – like financial services, tourism and leisure and health-care products and
services.

A5 Technological change
The development and widespread use of new technology is an important consideration in
relation to economic growth. Over the last 25 years, business has gone through a second
industrial revolution based on the microchip and electronics, which has led to the
development of new products and improved techniques that allow goods and services to be
produced more efficiently. New sectors and industries have been created that offer
investors the potential of high growth, but which can often be quite risky investment
opportunities.
Chapter 2 The macro-economic environment and its impact on asset classes 2/7

Technological change happens as a result of the application of science and technology to

the production of goods and services.

Chapter 2
A country’s capacity for technological change is often measured by the proportion of
national output devoted to research and development. In practice, the key to national
economic performance is not so much the technological innovation of the country, but
rather its ability to incorporate international advances into economic production. This ability
to adopt cutting-edge technology in turn hinges on the overall education and skills of the
workforce.
Inward investment by multinational companies is an important vehicle for technological
transfer between countries. The ease or difficulty of setting up a business is increasingly
recognised as having a major effect on economic development.

A5A Technology and industry

Technological change creates new fast-growing industries and transforms existing ones,
providing the scope and the spur for major cost savings. For example:

Industry Development
Mobile telecoms In the 1990s, mobile telecommunications was a new industry. This
created a lucrative investment opportunity that was exploited by
companies such as Nokia and Vodafone.
Telecoms (data The fast growth of data messages across telecoms as a whole
messaging) (including internet access) shows how an existing industry can be
transformed by rapid technological change.
E-commerce Technology has resulted in significant changes in retailing and
wholesaling via the internet; the biggest bookseller in the world is
now Amazon.com.

The successful incorporation of new technology into all aspects of an organisation’s work,
including product design, production processes, a product’s technical features, the location
of the business and its organisational structure, has led to those firms gaining a competitive
advantage over their rivals.

B World economies and globalisation

International trade and the free movement of technology are creating a global economy in
which consumers can buy goods from anywhere in the world. Developing country producers
can also be assisted with capital and technology from the developed world. This is
enhancing the growth of emerging economies and depressing the prospects of industries in
the West that are exposed to competition from emerging markets.
International trade creates opportunities for emerging economies to sell their products
across the world. This creates efficiencies for their industries and makes them raise their
quality to global standards.
Direct investment by multinational companies in overseas markets has been a powerful Direct investment
driver of globalisation. by multinational
companies in
The effects of globalisation are that: overseas markets
has been a
• investors can take advantage of globalisation by investing in foreign markets or by powerful driver of
globalisation
investing in the shares of multinational companies with large overseas operations; and
• it puts at a disadvantage low-skilled, labour intensive industries in the developed world
that compete with developing countries.
 2/8 R02/July 2018 Investment principles and risk

B1 Political factors
Investors should
When investing, the political (and, therefore, the economic) stability and viability of a
Chapter 2

consider the country needs to be considered, as political and/or government actions or events could
political and
therefore the
have an adverse effect on investment markets. Such actions or events could include the
economic stability following:
and viability of a
country • significant changes in either taxation or spending policies could reduce activities in
sectors that are important to particular businesses, which would reduce their profitability;
• war or major military conflicts could severely disrupt activities in the countries affected, as
well as in nearby countries;
• terrorist attacks can undermine confidence, potentially causing a sharp drop in economic
activity; or
• the leadership of governments could change, or officials could be appointed whose
policies interfere with investment growth.
Many countries have less political stability and less diverse economies than the UK, and
investors need to consider how political and economic upheaval in a country could interfere
with local investment markets and jeopardise investment growth.

Question 2.2
Which types of industries are at a disadvantage because of the effects of globalisation?

C Economic and financial cycles

Economies typically go through regular fluctuations in economic activity called business
cycles. Over the past 20 years, business cycles have lengthened and now appear to last
around ten years. Within these cycles, there may be short-term fluctuations, often caused by
changes in economic policy.

A business cycle
A business cycle can be divided into four main phases, although the economy does not
can be divided into always go through all of the phases.
four main phases

Figure 2.2: Business cycle

GDP growth

Trend
Expansion
growth
0
Acceleration

Contraction Economic
Slowdown
Recovery/

Recession

trough
Boom

Time

The four main phases are:

• recovery followed by expansion or acceleration of economic growth;
• boom;
• slowdown or contraction; and
• recession.
In the expansion phase, there is above average output growth and businesses experience
record sales and profits. Strong customer demand justifies raising prices for many products.
As prices and inflation continue to rise, the economy begins to ‘overheat’ and interest rates
are increased to dampen demand and stop expansion. The period of boom occurs when the
economy is growing at its fastest during the overall cycle.
Chapter 2 The macro-economic environment and its impact on asset classes 2/9

As the economy starts to slow down, output growth slows – but inflation remains high – so
the central bank is reluctant to cut interest rates. Sales start to drop as consumers become
more cautious and spend less. Unemployment rises and some firms go out of business.

Chapter 2
If the slowdown becomes severe enough, it will result in recession. Output growth is sluggish If economic
and company profits are weak; inflation and interest rates are falling. The economy will slowdown
becomes severe
eventually reach its trough. If the trough is deep enough, it is called a depression, typified by enough, it will
high levels of business failure and unemployment. result in recession

The recovery phase is where the economy moves out of recession, people start to spend
more as they become more optimistic and confident about the future. Output growth
accelerates as providers increase production and company profits rise, while inflation and
interest rates remain low.
A business cycle is usually measured either from one peak of economic activity to another,
or one trough to another.
Although cycles typically assume a pattern of recovery, acceleration, boom, overheating,
deceleration and recession, in practice, it is difficult to identify exactly when one stage ends
and another begins and, indeed, to quantify the duration of each stage.
Business cycles occur around trends in a country’s overall economic activity. This is
measured by its GDP, which is calculated by adding together the total value of all goods and
services produced domestically during a calendar year.
To understand where an economy is in the economic cycle, governments undertake
significant efforts to measure the economic activity that is taking place. The most closely
watched indicator of economic activity is GDP:
• When the level of GDP falls compared with the previous quarter, the economy is said to
be contracting.
• After two successive quarters of declining GDP, it is said to be in recession.
• When GDP rises compared with the previous quarter, the economy is expanding.
• The peak of a cycle refers to the point of which GDP is at its highest level before it starts
to fall.

Activity 2.1
Find out the current level of GDP growth at the Office for National Statistics (ONS)
www.ons.gov.uk/economy/grossdomesticproductgdp and consider the trend over the
last twelve months.

A vital component of GDP is government spending on both current and capital expenditure. A vital component
This is in part financed by the taxation of individuals and companies. The difference between of GDP is
government
the government’s expenditure and revenues is known as the public sector net cash spending on both
(PSNCR). Typically, the UK Government has a borrowing requirement, as there
requirement (PSNCR) current and capital
expenditure
is usually a deficit between expenditure and receipts.
The PSNCR indicates the extent to which the public sector needs to borrow from other
sectors of the economy and from overseas, in order to finance the difference between the
expenditure and receipts arising from its various activities.
The state of public finances is in part dependent on the state of the country’s economic
activity:
• if the economy is in recession, tax revenues will be weak and spending on unemployment
will rise, so that the PSNCR is likely to grow; and
• if the economy is expanding, tax revenues will rise and spending on unemployment will
fall as more people find jobs, reducing the PSNCR deficit.
Interest rates tend to rise and fall in line with the level of economic activity: Interest rates tend
to rise and fall in
• If an economy is slowing down, interest rates will be reduced to encourage borrowing, to line with the level
stimulate consumer demand and limit the risk of recession. of economic
activity
• In the subsequent expansion and boom, they will be increased to slow down the economy,
as a way of reducing inflationary pressures.
 2/10 R02/July 2018 Investment principles and risk

The economies of the world are all at different stages in their economic, business and
investment cycles at any given time. However, the increasing globalisation of trade and
investment activity means that changes in the economies of countries around the world,
Chapter 2

particularly the USA, will have an impact on the UK financial markets.

C1 Business cycles and investments

Fluctuations in the rate of economic growth create pronounced cycles in the prices of fixed-
interest securities and equities.

Consider this
this…
…
What do you think is the impact of inflation (high and low) on the price of fixed-interest
securities?

C1A Fixed-interest securities

When the economy is booming, people are prepared to pay more for goods and services.
This pushes up prices, generating inflation and higher interest rates.
The yields from fixed-interest securities will need to be higher to compete with other
investments, so their price will fall.
When inflation and interest rates are low and falling, the income from fixed-interest
securities becomes more attractive. In a recession and the early stages of a recovery, the
prices of fixed-interest securities should increase due to falling interest rates.

C1B Equities
The prices of
The prices of equities in general rise and fall with the upturns and downturns of the
equities in general economy. However, the speed and degree to which they individually respond to changes is
rise and fall with
the economy
varied:
• Typically, prices begin to pick up as the economy moves out of recession, and strengthen
as the economy expands, when interest rates remain low and the operating environment
for companies improves.
• They tend to falter during the boom as interest rates are raised to curb the expansion of
the economy. However, the growing economy should offer companies some
opportunities for enhanced profitability.
• They generally fall as the economy contracts due to higher interest rates and declining
corporate earnings.
• Over the longer term, the prospects for corporate profitability tend to have more
influence on the prices of equities than interest rates.
Government macroeconomic policy is often aimed at smoothing the economic cycle, easing
the pain of recession and applying restraint when the economy is in danger of overheating.
This would typically be carried out through fiscal or monetary policy.

D Fiscal and monetary policy

D1 Fiscal policy
Fiscal policy is the use of government spending and taxation to influence both the level of
demand in the economy and the level of economic activity:
• In a recession or times of low economic activity, the government may increase its
spending or cut taxation to stimulate demand in the economy.
• In a boom, the government may reduce spending or increase taxation to dampen
demand.
An increase in government spending has more impact on the economy than a decrease in
income tax of the same amount. This is because the bulk of such an increase in expenditure
will be spent on domestically produced goods and services.
Chapter 2 The macro-economic environment and its impact on asset classes 2/11

In contrast, a larger part of the extra purchasing power from a cut in taxation will leak out of
the economy in spending on imports, because tax cuts go to richer people who buy more
imports, and part of a tax reduction is typically saved rather than spent.

Chapter 2
Fiscal policy may affect the behaviour of both individuals and companies as follows:

Individual Company
The different tax treatment of the various The tax treatment of a company’s earnings
types of assets will influence investment will affect its dividend policy, and its choice
decisions. of raising capital through debt or equities.

The imbalance between government spending and receipts results in either a budget deficit
or surplus.

D2 Monetary policy
Monetary policy attempts to stabilise the economy by controlling interest rates and the
supply of money. In the short-term, changes in interest rates will have the most effect, while
changes in expectations concerning future interest rates can also be important.
The Monetary Policy Committee (MPC) of the Bank of England has been responsible for The Monetary
setting short-term interest rates since May 1997. The principal rate used is the Bank of Policy Committee
(MPC) of the Bank
England base rate, essentially the rate at which eligible banks can borrow from the bank. of England sets
However, London Interbank Offered Rate (LIBOR), the rate at which banks lend to each short-term interest
rates
other, is a better guide to wholesale money market conditions.

Be aware
Inflation target
Since December 2003, the MPC’s aim has been to meet the UK Government’s inflation
target of 2%, based on the consumer prices index (CPI).

Activity 2.2
Look up the current rate of CPI and compare it with the Bank of England’s target of 2%.

The Bank of England targets future rather than present inflation, as changes in interest rates
have their maximum effect on inflation between eighteen months and two years after they
are changed.
If the inflation target is missed by more than one percentage point on either side of 2%, the
Governor of the Bank of England must write an open letter to the Chancellor explaining the
reasons why inflation has increased or fallen to such an extent and what the Bank proposes
to do to ensure inflation comes back to the target.

Table 2.1: Interest rate changes

Interest rate By reducing short-term interest rates, the Bank of England eases
reductions monetary policy:
• If the financial markets agree with the Bank’s view of the prospects for
inflation, longer-term rates should reduce.
• This will lead to rising asset prices – from fixed-interest securities to
property. This increase in wealth, together with lower interest rates,
will make people more willing to borrow and spend, which will
increase expenditure and stimulate demand.
• People dependent on an income arising from cash deposits will find
themselves worse off.
• Businesses will invest more, since the margin between the return on
investment and the cost of borrowing widens.
 2/12 R02/July 2018 Investment principles and risk

Table 2.1: Interest rate changes

Interest rate By increasing short-term interest rates, the Bank of England tightens
Chapter 2

increases monetary policy.

• This should raise longer-term interest rates.
• This will lead to falling asset prices. The reduction in wealth, together
with higher interest rates, will make people less willing to borrow, so
reducing expenditure and stifling demand.
• Businesses will invest less as they reduce their expectations of
revenues and profitability.

The Bank has to be careful to give only subtle indications of where it wants future interest
rates to go. Expectations, particularly those reached in the financial markets, can intensify
the impact of monetary policy:
• The first reduction in interest rates after a period when they have been rising, may lead
financial markets to anticipate further cuts. This will in itself tend to bring longer-term
rates down further.
• Conversely, when the interest rate cycle turns upwards and rates rise after a period when
they have been falling, financial markets tend to push longer-term rates up further.

Consider this
this…
…
If the markets consider that an easing in monetary policy is unwarranted and will fuel
inflation, the change may have the opposite effect on longer-term interest rates, causing
them to rise.

E Money supply
Money supply is
Money supply is the quantity of money available within the economy to purchase goods and
the quantity of services. The amount of money in circulation in the economy provides information on the
money available
within the
growth of the cash base in the economy, which provides an indicator of the strength of
economy to consumer demand.
purchase goods
and services The rate at which bank lending is increasing gives the MPC of the Bank of England an
indication of the demand for credit at the prevailing rate of interest. As the demand for
money is sensitive to interest rates, an increase in interest rates should reduce the demand
for money, while a reduction in interest rates should increase it.
The most commonly quoted measures of money supply in the UK are M0 and M4:
M0:
• includes notes and coins in circulation, plus banks’ operational deposits with the Bank of
England;
• reflects, but does not cause, changes in the economic cycle – it has little effect on national
output or inflation; and
• is an indicator of consumer spending and retail sales.
– Growth in M0 indicates that consumer spending is buoyant.
– A contraction in M0 suggests that consumers are behaving more cautiously.
M4:
• includes notes and coins in circulation, plus the bank accounts of UK residents with UK
banks and building societies;
• includes deposits created by banks and building societies through their lending activities,
as well as deposits lodged in accounts by people wanting to save; and
• acts as an indicator of the economy.
– Increased demand for loans is reflected in a faster growth of M4.
– Rapid growth in money circulating in the economy is often interpreted as a build-up of
inflationary pressures.
Chapter 2 The macro-economic environment and its impact on asset classes 2/13

Be aware
Other names
M0 is also known as ‘narrow money’.

Chapter 2
M4 is also known as ‘broad money’.

If the quantity of money is increased without a corresponding increase in the volume of

goods and services that can be bought, the value of each unit of money will fall. There will be
an excess of consumer demand over the supply of goods, which will force up the general
level of prices, causing inflation. By reducing money supply, money will increase in value and
so the prices of goods and services will reduce.
The Bank of England can influence the volume of money in circulation by selling and
purchasing Treasury bills and Government stock on the open market. This works as follows:
• Selling securities reduces money supply by removing money from circulation and taking
away excess purchasing power. This reduction in the supply of money will lead to higher
short-term interest rates.
• Buying securities and paying for them by creating money has the opposite effect. It
releases money into the economy, leading to lower short-term interest rates.
In practice, the Bank of England and other central banks use the repo market (the sale and ‘Repo market
market’’ is
covered in
repurchase market in Government bonds) to effect changes in interest rates. chapter 1.1,
section B7C

Consider this
this…
…
Between 2009 and 2011, the Bank of England pumped £375 billion of assets into the
economy through ‘quantitative easing
easing’’. This was a radical new policy of creating money
to purchase Government gilts and corporate bonds in an attempt to increase the UK’s
money supply. The intention was to bring liquidity to the financial markets by increasing
the lending capacity of the banks. This was expected to lead to an increase in spending
that would stimulate the economy, which had stagnated despite the Bank of England
cutting base rate to 0.5%. The introduction of new money into circulation is usually
considered to be inflationary; however, the intended aim of this operation was that
inflation would stay close to the Bank’s target of 2%, rather than undershooting it.
The Bank of England estimates that the first round of quantitative easing boosted growth
by around 1.5% to 2% and helped the UK avoid the worst of the recession. Growth and
lending to business, however, remained sluggish, which led to further rounds. The Bank
estimates that the effect of the programme has been ‘economically significant’ but
independent commentators remain uncertain.

The UK has not been alone in pursuing a policy of quantitative easing. The USA has had a
number of rounds of quantitative easing and the European Central Bank also resorted to
quantitative easing when the sovereign debt crisis in Europe threatened economic stability.

Activity 2.3
Find out more about quantitative easing at www.bankofengland.co.uk.

Question 2.3
How do you think the Bank of England creates money or reduces the supply of money?

E1 Inflation
Inflation is a major consideration for investors. Rising prices reduce the real value of future Even over
interest and dividend payments, together with the real value of the original investment. Even relatively short
periods, the
over relatively short periods, the cumulative effect of inflation can have a serious effect on cumulative effect
the value of money. of inflation can
have a serious
There are a number of different measures of inflation. For many years, the retail prices index effect on the value
of money
(RPI) was the UK’s most familiar general-purpose measure of inflation. It measured the costs
of goods and services purchased from month to month by most households in the UK. Its
designation as a national statistic has been cancelled but it is still used by the Government as
the measure of inflation for index-linked gilts.
 2/14 R02/July 2018 Investment principles and risk

In December 2003, the main measure of inflation for macroeconomic purposes changed
from the RPI to the consumer prices index (CPI). The CPI is constructed according to EU
regulations so reliable comparisons of inflation rates can now be made across all EU Member
Chapter 2

States.
The CPI, like the RPI, measures the average change from month to month in the prices of
consumer goods and services bought by consumers within the UK.
In 2017, the CPI including owner occupiers’ housing costs (CPIH) became the UK’s lead
measure of inflation. This is the most comprehensive inflation measure as it includes owner
occupiers’ housing costs (OOH) along with council tax. Both of these are significant
expenses for many households and are not included in the CPI. Other than including OOH
and council tax, CPIH is identical to CPI.
People whose incomes are fixed in money terms suffer most from inflation because a given
sum of money will buy less than it used to if prices have risen. However, low inflation is
generally good news for people in employment.

Be aware
Average earnings trends
Average earnings in the UK have historically tended to increase faster than price inflation,
so that the incomes of those with earned incomes should at least keep pace with rising
prices. However, according to the ONS, comparing the three months to December 2017
with the same period in 2016, nominal total pay grew by 2.5% whilst the CPIH increased by
2.7%.

E2 Disinflation
Disinflation occurs
Disinflation occurs when there is a decrease in the rate of inflation. With disinflation, the
when there is a prices of goods and services are still rising, but at a slower rate. Typically, this can occur
decrease in the
rate of inflation
during a recession, as sales drop, and retailers are not able to pass on higher prices to
customers.
Disinflation should not be confused with deflation, which is an overall decrease in prices.

E3 Deflation
Deflation is the opposite of inflation and occurs as prices decline over time and the inflation
rate becomes negative. If the supply of goods rises faster than the supply of money, the
purchasing power of money increases and the general price level of goods will fall.
Consumers become reluctant to buy expensive items such as cars and homes because they
know these will be cheaper in the future. Borrowers are committed to making loan
repayments that represent more and more of their purchasing power while, at the same
time, the asset purchased with the loan is declining in nominal price.
If the prices of goods continue to fall, then manufacturers will reduce output, because of
difficulties in recovering the costs of production. This will lead to a reduction in profits:
• Once deflation occurs, it is self-perpetuating, as reduced output and profits will lead to
businesses reducing their workforce, creating unemployment.
• This will lead to further reductions in sales, so that production has to be further reduced.

E4 Effects of inflation on investments

Although the UK has, in the past, experienced periods of price stability, an adviser needs to
be aware of the effects of rising and falling inflation on the various types of asset.

E4A Cash deposits

Savings accounts that offer variable rates of interest tend to rise and fall in line with
increases and decreases in the rate of inflation. If inflation is reducing, then interest rates will
tend to fall, as investors will not require such a high return to keep up with inflation.
Chapter 2 The macro-economic environment and its impact on asset classes 2/15

Investors need to distinguish between nominal interest rates

rates, that are actually paid or Interest rates on
received by the individual, and real interest rates
rates, which take inflation into account. deposits can give a
positive real rate of

Chapter 2
Interest rates on deposits can give a positive real rate of return if they exceed the rate of return if they
exceed the rate of
inflation. inflation

Example 2.4
When the rate of inflation is 2.4% and interest rates are 4%, the approximate real rate of
return is 1.6% (4% – 2.4%).

• Deposits have, in the past, generally provided a positive return, thanks to periods of low
inflation, although the real return has been relatively low.
• Currently, the rate of inflation is higher than interest rates, providing a negative real
return, even for non-taxpayers.
Inflation also has an effect on the value of the capital invested. If there is any inflation over
the investment period, the real value of the capital will be eroded.

E5 Fixed-interest securities
Inflation is particularly significant for investors in fixed-interest securities: Inflation is
particularly
• Investors receive the same fixed income whether prices rise or fall. The purchasing power significant for
of the income will therefore fall by the rate of inflation, so a reduction in the rate of investors in fixed-
interest securities
inflation will result in the investor being better off.
• Any inflation over the term of the security will also result in the real value of the fixed
capital repayment at maturity being eroded.
• If there is an unexpected change in the expectations for inflation, there will be changes in
the values of fixed-interest securities. Their prices tend to rise if expectations for inflation
rates diminish, and fall if the rate of inflation is deemed to be speeding up.
Index-linked gilts have both income payments and redemption values adjusted in line with
the rate of inflation, and can protect against inflation over the longer term. But their short-
term value is driven by market sentiment and the inflation-proofed redemption value is only
guaranteed at redemption.

Be aware
Redemption yields
In the UK, the redemption yields on index-linked gilts are used by investors to estimate
the level of interest rates in the future.

Question 2.4
How and why do you think that expectations regarding inflation affect fixed-interest
securities?

E5A Equities
Equities are usually seen as a good hedge against inflation because efficient companies will
increase their profits in line with inflation:
• Rising company profits will lead to increasing dividends and/or growth in the capital value
of shares.
• Historically, equities have consistently grown in real terms.

Consider this
this…
…
Care should be taken to stress the long-term nature of equity investment. In the shorter
term, equities can lose value, and there is no guarantee that any income will be paid.
 2/16 R02/July 2018 Investment principles and risk

E6 Interest rates
Interest rates play a key role in the real economy and in investment planning. In the UK, as in
Chapter 2

the Eurozone and the USA, the raising or lowering of short-term interest rates is the main
tool used by central banks to control inflation, stimulate spending and encourage or
discourage savings and investment in the economy.
Changes in interest rates have important effects on the economy and affect the relative
attractiveness of different investments:
• Falling interest rates usually signal that the economy will expand in the medium term as a
result of the lower costs of borrowing.

Be aware
Falling interest rates
In the UK, their effect in boosting output reaches its maximum after about 18 to 24
months.

• Demand for products and services rises because consumers and businesses can afford to
borrow more to make purchases. Consumers find they have more disposable income, as
interest payments on their borrowings are lower.
• Interest rate movements can be of critical importance in recommending appropriate
investments for different clients.

E6A Cash
The return on cash-based investments will fluctuate broadly in line with the prevailing rate of
interest. Falling interest rates will, however, make cash deposits less attractive to investors
as they will be worse off. Investors may be tempted to switch to investments that are not
suited to their risk profile.

E6B Fixed-interest securities

The relationship
The relationship between the prices of fixed-interest securities and interest rates is an
between the prices inverse one – as one goes down, the other goes up.
of fixed-interest
securities and • Fixed-interest securities are in competition with other investments for investors’ funds,
interest rates is
an inverse one and their yield, as a percentage of their market price, must remain competitive.
• As the income from a fixed-interest security remains unchanged throughout its life, the
only way its yield can vary is through changes to its capital value.
• When interest rates rise, the price of fixed-interest securities falls so that the yield adjusts
to reflect the higher general interest rates.
• When interest rates fall, the price will rise so that the yield reduces.

E6C Equities
Equities generally
Equities generally benefit from low interest rates, because company profits are usually
benefit from low higher as a result of the reduced cost of borrowing and higher demand for the company’s
interest rates
goods and services.
• Increased profits might lead to an increase in the dividend paid to investors.
• Future dividend streams become more valuable and this pushes up share prices.

E6D Interest rates and inflation

Be aware
UK Government policy
An adviser needs to be aware that the policy of the UK Government is fixed on
maintaining low inflation with correspondingly low interest rates.
The MPC sets monetary policy to meet the 2% inflation target in a way that helps sustain
economic growth and employment. Currently, inflation is expected to remain at around
3% at least for the short-term.

Table 2.2 summarises the relationship between interest rates and inflation for the main
classes of investments.
Chapter 2 The macro-economic environment and its impact on asset classes 2/17

Table 2.2: The relationship between interest rates and inflation

according to investment class

Chapter 2
Asset class Interest rates Inflation
Rising Falling Rising Slowing
Cash – income Those with Those with fixed Accounts that If inflation is
variable rate rate accounts offer variable slowing, then
accounts benefit benefit by rates of interest interest rates will
from greater maintaining their tend to rise in tend to fall, as
returns. returns. line with investors will not
increases in the require such a
Existing fixed Variable rate rate of inflation. high return to
rate accounts accounts keep up with
become less become less inflation.
attractive – attractive. It may
better rates can be difficult to
be obtained obtain better
elsewhere. rates elsewhere.
However, exit
penalties may
make switching
unbeneficial.
Cash – capital N/a N/a If inflation rises The real value of
over the the capital takes
investment longer to erode.
period, the real
value of the
capital will be
eroded.
Fixed-interest Existing bonds Existing The purchasing The fixed-
(bonds) – become less bondholders power of the income investor
income attractive – benefit by fixed income is better off in
newer bonds maintaining their falls. real terms.
may be issued at returns.
higher rates. Interest yields Interest yields
Interest yields rise as investors fall as investors
Interest yields fall as investors need to be are less
rise as investors are prepared to compensated concerned with
will not pay as pay more for for the loss of inflation risk.
much to higher incomes. real income.
purchase.
Fixed-interest Capital values of Capital values of Capital values Capital values
(bonds) – existing bonds existing tend to fall as tend to rise as
capital fall as the investments rise fixed-interest fixed-interest
income they as the income investments investments
provide is they provide is become less become more
unattractive in attractive in attractive in attractive in
comparison with relation to new general. general.
new issues. issues.
Equities Rising interest Lower interest Equities are Company
rates lead to rates mean usually seen as a profitability
higher debt borrowing is good hedge slows, although
servicing costs cheaper for against inflation over the longer
and lower companies, and because efficient term, those who
demand as consumers have companies remain invested
consumers more disposable should increase are still likely to
struggle with income. This can their profits in see their returns
higher mortgage result in higher line with exceed those of
payments. This profits which inflation. other asset
can lead to can lead to an classes.
lower increase in
profitability and dividends and
smaller dividend rising share
payouts, prices.
resulting in
falling share
prices.
 2/18 R02/July 2018 Investment principles and risk

E7 Exchange rates
Trade between various countries involves the use of different currencies. The foreign
Chapter 2

exchange markets allow the currency used by one country to be purchased and paid for
with the other country’s currency.
• UK exports create a demand for sterling by foreign buyers and the satisfaction of this
demand increases the supply of foreign currencies in the foreign exchange market; while
• UK imports create a domestic demand for foreign currencies with which to pay for the
imports and meeting this demand decreases the supplies of foreign currencies in the
foreign exchange market.

An exchange rate
An exchange rate is the price at which two currencies trade on the foreign exchange market.
is the price at For the UK, the dollar exchange rate means the number of dollars ($) one pound (£) can buy.
which two
currencies trade on • Real exchange rates are the effective exchange rates between countries’ currencies (the
the foreign
exchange market rates quoted daily on the currency markets) that have been adjusted to take account of
differences in their rates of inflation. In other words, the real exchange rate measures the
price of domestically produced goods relative to the price of foreign goods, taking into
account the exchange rate.
• The real exchange rate is a good indicator of a country’s competitiveness. If the real
exchange rate rises, domestic goods become more expensive relative to foreign goods,
adversely affecting domestic production. If the real exchange rate falls, however, then
domestic goods become relatively cheaper and so demand for them increases.

Most developed
• Exchange rates can be fixed to one another at rates set by the government, or there can
nations use be a floating exchange rate regime, where currency exchange rates are determined by the
floating exchange
rates
foreign exchange markets and are based on the supply and demand for currencies. In the
UK, the exchange rate has floated since September 1992, when Britain left the European
Exchange Rate Mechanism (ERM).
• Most developed nations use floating exchange rates, but developing economies usually
try to manage capital flows using either fixed exchange rates or capital controls or both.
There is an important link between a country’s economic performance, interest rates and
currency values, although the exchange rate is essentially a price at which different
currencies trade on the basis of their supply and demand. The value of a currency is partially
determined by the health of the national economy, especially the balance of payments
current account. For instance:
• If there is a surplus on the current account, i.e. a country exports more goods and services
than it imports, then buyers must acquire the currency to pay for the goods.
This adds to the country’s foreign reserves and strengthens the currency. If the pound
strengthens against the dollar, the number of dollars that one pound would buy will
increase. There will be a decrease in the price paid for dollars.
• Conversely, a current account deficit implies the need to sell the local currency in order to
acquire foreign goods.
This would lead to a change in the demand for that currency, which would cause a change
in the exchange rate, with the currency weakening in value. If the pound weakens against
the dollar, the number of dollars one pound would purchase will decrease. There will be an
increase in the price paid for dollars.
A strong currency can have beneficial effects, such as reducing the cost of imported goods.

Consider this
this…
…
In a country like the UK, which imports much of the raw materials that it needs, the lower
cost of imports helps keep domestic inflation down. Conversely, a weak pound means
higher import costs and faster rising prices.

• However, if a currency becomes too strong, it can wreak havoc with the domestic
economy.
– a higher currency value will make exports more expensive, weakening the country’s
competitive position and potentially reducing exporters’ profits; and
– manufacturers find that their products become too expensive to compete with those of
other countries in both export and home markets, so domestic manufacturers suffer.
Chapter 2 The macro-economic environment and its impact on asset classes 2/19

• Foreign investment into a country also has an influence on currency value.

Successful countries that run a current account balance of payments surplus (sell more
goods and services to other countries than they buy from abroad) and which keep

Chapter 2
inflation at a low level will usually see their own currency strong or rising in value over
time.

Example 2.5
If a US manufacturer wanted to set up a new factory in the UK, they would need pounds to
purchase land and develop the site. The company would need to sell dollars and buy
pounds in the foreign exchange markets. The supply of dollars would increase and the
supply of pounds would go down, which in turn would cause the pound to appreciate and
the dollar to weaken.

Foreign investment does not have to be in tangible goods such as land, as an investment in
the UK stock market by US investors would lead to the same situation.
Foreign investors may also be attracted if interest rates are higher than those paid in other
currencies:
• If US bonds had a higher interest rate than UK bonds, investors would be more interested
in purchasing US bonds and less interested in purchasing UK bonds.
• To purchase US bonds, they would need to buy dollars on the foreign exchange market,
causing a reduction in the supply of dollars and a rise in their value relative to other
currencies, such as the pound.
• If UK investors were buying US bonds, they would need to sell pounds, which would lead
to an increase in the supply of pounds and a decline in their value.
Changes in exchange rates have a direct impact on the value of investments in overseas
securities, and also affect the profitability of domestic businesses. In the past, the current
account (the trade balance) was regarded as significant in relation to exchange rates but,
today, flows of capital (often ten times greater than trade flows) are seen as the major factor
affecting exchange rates.

Question 2.5
What do you think are the benefits or otherwise of a strong currency?

E7A Effect on foreign investments

Exchange rates also have an impact on investment returns. When interest rates on foreign Exchange rates
investments are higher than on domestic products, overseas investments appear more also have an
impact on
attractive. However, if exchange rates are not favourable, then any profit may be lost when investment returns
the money is exchanged into sterling.

E7B Effect on domestic shares

Movements in the pound have two main effects on domestic shares, as follows:

Indicator Rise in the pound Fall in the pound

Profitability of exports Reduces Increases
Share price of major exporters Marked down Rise
Value of profits earned overseas by Cut (dollars earned in the USA, Increases
UK companies when translated into for example, will buy fewer
sterling-based profits pounds if the pound strengthens)

In summary:
• UK firms that benefit from a rise in the value of the pound are those that rely on a
substantial level of imports, for example, raw materials or components.
• Those that benefit from a fall in the pound are those that export to other countries.
 2/20 R02/July 2018 Investment principles and risk

F Balance of payments
The balance of payments for a country is a record of the country’s trade transactions with
Chapter 2

the rest of the world, measured in terms of receipts and payments

payments:
• a receipt represents sterling flowing into the country, or any transaction that requires the
exchange of foreign currency for sterling; and
• a payment represents sterling flowing out of the country, or any transaction that requires
the conversion of sterling into some other currency.
The balance of payments can have important consequences for exchange and interest rates
and, therefore, can impact on the economic growth of a country. A country with a surplus is
accumulating money within the economy. How this money is spent is an important indicator
of the financial strength of a country on a global basis.
The balance of payments consists of two offsetting components:
• current account
account, which deals with imports and exports of goods and services; and
• capital account
account, which deals with foreign investments in the UK and UK investment
abroad, as well as loans.
Bringing together the current account and the capital account provides a complete
statement of the UK’s trade and financial transactions with the rest of the world.

F1 Current account
The current
The current account consists of transactions in goods (visible trade) and services (invisible
account consists of trade):
transactions in
goods (visible • Visible trade includes exports and imports of goods such as oil, agricultural products,
trade) and services
(invisible trade) other raw materials, machinery and transport equipment, computers, white goods and
clothing.
• Invisible trade includes exports and imports of services such as international transport,
travel, tourism, financial and business services.
The current account divides into four parts, each of which comprises flows of income in and
out of the country (see Table 2.3).

Table 2.3: The current account

Trade in goods The exports and imports of products, ranging from commodities to
manufactured products.
Trade in services The exports and imports of services, such as tourism, transport and
banking.
Investment Comprises the earnings on investments held by Britons overseas
income (which credit the balance of payments) and the earnings on
investments held by foreigners in Britain (which debit the balance of
payments).
Transfer Items such as overseas aid or payments to and from EU institutions.
payments
Chapter 2 The macro-economic environment and its impact on asset classes 2/21

Be aware
Current account balance

Chapter 2
A country’s current account balance is the net balance of trade in both goods and
services, plus net receipts from income generating assets flowing into the UK from
overseas countries:
• a deficit in the current account means that more goods and services have been
imported into the UK than have been sold abroad; and
• a surplus in the current account means that more goods and services have been
exported than imported.
For many years, the UK has imported more goods than it has exported, which has resulted
in a trade gap
gap. This need not cause particular concern if it is offset by surpluses elsewhere
on the balance of payments, such as invisible items.
However, a persistent deficit puts pressure on the country’s currency, encouraging
devaluation to increase price competitiveness of exports and decrease that of imports.

Reinforce
Can you recall the list of ‘invisible trade’ items? Why not make a note of them before you
proceed?

F2 Capital account
The capital account of a country’s balance of payments records all movement of money into The capital
and out of the country for investment. This may be investment in real assets, such as land account records all
movement into
and buildings, or financial assets, such as shares, bonds and loans. This works as follows: and out of the
country for
• Sales of assets earn foreign currencies, while purchases use up foreign currencies. investment
• The UK has a capital account surplus if overseas investors invest more money in the
country than UK investors invest overseas.
Any deficit in the current account balance must be made up by the capital account in the
overall balance of payments through net investment into the country or loans from abroad. If
there is a net deficit in the combined current and capital accounts, the official reserves,
which consist of foreign currencies owned by the Bank of England, will have to be used to
finance it.

G Role of financial investment in the

economy
Financial investment has a major impact on a country’s economic development. This is
because it will stimulate demand by contributing to aggregate demand, and improve
productivity through the introduction of the most up-to-date production technologies and
methods.
Investing in industrial plant and machinery, social infrastructure, research and development
and in human potential through education and training requires current output to be
diverted from consumption. A portion of national income must be saved and devoted to
expenditures that will only pay-off in future.
In any market economy, well-functioning financial institutions and markets, such as
commercial and investment banks and stock exchanges, play a central role in moving funds
from where they are available to where they can be best used.
 2/22 R02/July 2018 Investment principles and risk

G1 Primary and secondary markets

The principal capital market that exists for buyers and sellers of fixed-interest securities and
Chapter 2

shares in the UK is the London Stock Exchange. The London Stock Exchange serves two
purposes:
• a facility for companies, governments and other organisations to issue new securities to
raise money, through the primary market
market; and
• a facility for investors to buy and sell securities that have already been issued, through the
secondary market
market.
The buying and selling in the secondary market does not affect the finances of companies or
the Government. There is, however, a close relationship between the two markets, as
follows:
• without the primary market, the secondary market would be deprived of a stream of
quality new stock; but
• without the secondary market, investors would be reluctant to subscribe to new issues in
the primary market, as they would be unable to easily dispose of those securities if
necessary.
It is the secondary market in shares that has promoted the acceptability of investment in the
equity share capital of public companies. This, in turn, has helped to fuel the growth of the
UK economy.
Chapter 2 The macro-economic environment and its impact on asset classes 2/23

Key points
The main ideas covered by this chapter can be summarised as follows:

Chapter 2
Trends in investment markets
• Governments can influence economic and financial conditions, such as interest rates,
currency alignments, inflation and economic cycles, which can impact on investment
markets.
• Political and other developments can have long-term effects on investment markets.
• People are living longer, which leads not only to more retirees, but also to higher
average wealth holdings.
• Technological change is a key determinant of higher productivity and has had an impact
on all aspects of an organisation’s work, with firms that have successfully incorporated
technology gaining a competitive edge over their rivals.

World economies and globalisation

• Globalisation is leading to rapid economic growth in many developing countries, and this
is creating new (but risky) opportunities for investors.

Economic and financial cycles

• Economies go through business cycles, fluctuations in the level of activity, which in turn
generate cycles in investment markets.

Fiscal and monetary policy

• Fiscal and monetary policies are, in theory, used to smooth the economic cycle and, in
practice, used to respond to crises and market developments.

Money supply
• Changes in money supply provide an indication of the strength of consumer demand
and determine short-term interest rates.
• Inflation is a major consideration for investors because rising prices erode the value of
savings. Changes in expectations can alter the course of the economy. Investors need to
consider the real rate of return on an investment by taking inflation into account.
• Interest rates affect the relative attractiveness of different investments.
• The exchange rate is essentially a price at which different currencies trade on the basis
of supply and demand for them.
• The value of the pound affects the profitability of exporting companies and the returns
made in overseas markets by domestic investors.

Balance of payments
• The balance of payments provides a statement of a country’s trade and financial
transactions with the rest of the world.

Role of financial investment in the economy

• A stable and well-functioning financial system can contribute positively to investment,
economic growth and employment.
 2/24 R02/July 2018 Investment principles and risk

Question answers
2.1 Financial bubbles are often associated with a genuine technological breakthrough,
Chapter 2

like railways in the 19th century or the internet at the end of the 20th century.
Typically, investors overestimate potential returns and underestimate competitive
pressures. The bubble swells as more and more investors are lured into buying
equities because they have risen rather than because they offer reasonable value.
2.2 Low-skilled, labour-intensive industries in the developed world that compete with
developing countries.
2.3 The Bank of England can create money by buying Government securities; it can
reduce the money supply by selling Government securities.
2.4 If inflation is expected to diminish, then the price of fixed-interest securities will rise.
If inflation is expected to speed up, then their price will fall.
2.5 A strong currency reduces the cost of imported goods – useful in a country like
Britain that imports much of its raw materials. The lower cost of imports helps to
keep domestic inflation down.
However, it makes exports more expensive, reducing a country’s competitiveness
and its exporters’ profits. Products are more expensive and so less competitive
compared with those from elsewhere, both at home and abroad, and this damages
domestic manufacturers.
Chapter 2 The macro-economic environment and its impact on asset classes 2/25

Self-test questions
1. Why should investors pay attention to political developments?

Chapter 2
2. Why are international developments increasingly important for investors?
3. What are the four main phases of the business cycle?
4. How can the business cycle affect the stock market?
5. How may a government’s fiscal policy affect the behaviour of individuals and
companies?
6. What are the two main measures of money supply, and what do they comprise?
7. What are the effects when the Bank of England reduces short-term interest rates?
8. How does a country’s balance of payments current account affect currency values?
9. How do exchange rates impact on investments in the domestic and foreign
markets?

You will find the answers at the back of the book

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 The merits and
3

Chapter 3
limitations of the main
investment theories
Contents Syllabus learning
outcomes
Learning objectives
Introduction
Key terms
A Modern portfolio theory 3.1, 3.2*
B Capital asset pricing model (CAPM) 3.1
C Multi-factor models 3.1
D Efficient market hypothesis (EMH) 3.1
E Behavioural finance 3.3
Key points
Question answers
Self-test questions
*see also chapter 9, section B2

Learning objectives
After studying this chapter, you should be able to:
• discuss the merits and limitations of the main investment theories;
• describe the principles of investment risk, including standard deviation, systematic and
non-systematic risk;
• explain the principle of risk reduction through diversification;
• outline the principles of the capital asset pricing model (CAPM) and its limitations;
• describe how multi-factor models can be used to forecast security returns;
• explain the implications and limitations of the efficient market hypothesis (EMH); and
• discuss how behavioural finance helps explain market and investor behaviour.
 3/2 R02/July 2018 Investment principles and risk

Introduction
In this chapter, we examine the merits and limitations of the main investment theories,
looking at modern portfolio theory, the capital asset pricing model (CAPM), multi-factor
models and how these theories consider the balance of risk and return. We then turn to the
efficient market hypothesis and finish with an introduction to behavioural finance.

Key terms
Chapter 3

This chapter features explanations of the following:

Arbitrage pricing Behavioural finance Beta Capital asset pricing
theory (APT) model (CAPM)
Correlation Diversification Efficient frontier Efficient market
hypothesis
Fama and French Hedging Modern portfolio Multi-factor models
model theory
Non-systematic or Prospect theory/loss Standard deviation Systematic or market
investment-specific aversion risk
risk

A Modern portfolio theory

MPT is concerned
Modern portfolio theory (MPT) is concerned with the way in which portfolios can be
with the way in constructed to maximise returns and minimise risks. According to this theory, we cannot
which portfolios
can be constructed
simply consider the potential risks and returns of an individual investment; it is important to
to maximise consider how each investment changes in price relative to the other investments in the
returns and
minimise risks
portfolio.
Essential to portfolio theory is the assumption that investors are risk averse and would
choose a less risky investment if they were offered the choice of two that offered the same
return. The higher risk investment would only be chosen if it offered a higher return. The
implication is that a rational investor would not invest in a portfolio if an alternative portfolio
existed with a more favourable risk–return profile.
The foundations of modern portfolio theory were laid down by Professor Harry Markowitz in
1952, when he demonstrated that portfolio diversification could reduce risk and increase
returns for investors. The conclusion is that a diversified portfolio of imperfectly correlated
asset classes can provide high returns with the least amount of volatility.

A1 Risk
The most commonly used measure of risk is the volatility of returns, which is called the
standard deviation of returns.

Be aware
Standard deviation
Standard deviation measures how widely the actual return on an investment varies
around its average or expected return. The greater the standard deviation, the greater the
volatility and therefore, the associated risk:
• An investment with returns staying close to its expected return is said to be low risk
and has a low standard deviation.
• An investment with returns fluctuating wildly may have the same expected return, but
is described as high risk. It has a higher standard deviation of returns.
• The greater the standard deviation around the expected return, the more volatile and
hence risky the investment.

Be aware
Designation for standard deviation
The standard deviation is usually designated by the Greek letter sigma, σ.
Chapter 3 The merits and limitations of the main investment theories 3/3

The standard deviation is calculated by considering the differences between the average or Standard deviation
mean return and actual returns, based on past experience. It is a useful tool to identify the is a useful tool to
identify the range
range of returns investments are likely to generate in the future. of returns that
investments are
As a rough rule of thumb, the return can be expected to fall within one standard deviation of likely to generate
the average return 68% of the time and within two standard deviations 95% of the time when in the future

the data is normally distributed – as shown in Figure 3.1.

For example, if the mean is 8% and the standard deviation is 5%:
• roughly 68% of returns or events will fall between 3% and 13% (i.e. 8% ± 5%); and

Chapter 3
• roughly 95% of returns will fall between –2% and 18% (i.e. 8% ± 2 × 5%).
Standard deviation is an acceptable measure of risk if the distribution of returns forms what
is called a normal distribution. This means that the distribution of expected returns is spread
symmetrically around the mean in a bell shaped distribution. Investment theory often
assumes this to be the case and standard deviation is generally accepted as a suitable
measurement of risk.

Figure 3.1: Standard deviation

Frequency

3% 8% 13%

–2%

18%

Return
–2σ –1σ mean +1σ +2σ

Question 3.1
If the returns from a market are normally distributed and the average return is 10% per
annum, with a standard deviation of 10%, approximately what percentage of returns will
be negative?

You should note that recent research has discovered that financial data is not always Standard deviation
symmetrically spread around the mean: it can be skewed, which means it is lopsided with a is an acceptable
measure of risk if
long tail on one side or it can exhibit fat tails (called excess kurtosis). This increases the the distribution of
probability of extreme events. returns forms a
normal distribution

A2 Reduction of risk
One way to construct a low-risk portfolio is simply to buy low-risk assets, but this will usually Investors buying
lead to low returns. A more attractive way is to buy risky assets, which on average will give riskier assets can
reduce the risk by
higher returns, and then reduce the risk in one of two ways: either diversifying
portfolio holdings
• either by diversification of the portfolio holdings
holdings; or or hedging
• more specifically by hedging out risk
risk.
 3/4 R02/July 2018 Investment principles and risk

A2A Hedging
Hedging means protecting an existing investment position by taking another position that
will increase in value if the existing position falls in value. One way that this can be achieved
is by using derivatives.

Example 3.1
The value of a portfolio of UK equities can be hedged by:
• selling FTSE 100 futures contracts; or
Chapter 3

• buying FTSE 100 put options.

A2B Diversification of risk

Investors can reduce the risk on their portfolio by holding a range of different types of
assets. Each type of investment tends to perform well in certain market conditions and by
broadening the portfolio’s exposure across a range of asset classes, the fluctuations caused
by most economic and financial events can be smoothed out.

Be aware
Diversification
It is clearly riskier to invest in a single security than in a collection of securities. When a
portfolio is made of a number of securities, the problems associated with one particular
security will not have such a major impact on the overall value of the portfolio:
• Diversification reduces risk because combining different asset classes or securities in a
portfolio reduces the overall risk to less than the average risk of the individual
securities. The downside risk of one investment would be offset by the upside potential
of another investment.

Diversification
• This offsetting would not occur if the investments all moved in the same direction at the
within a market same time. Diversification is effective where individual stocks move in opposite
can remove
specific risk but
directions.
not market risk

You should note that diversification within a portfolio can remove investment specific risk
but not market risk.

A2C Correlation
The effectiveness of diversification depends on the degree of correlation, or covariance,
between the returns on investments within the portfolio. Correlation is a number between +1
and –1.
Positive correlation
The profits and share values of many companies move up and down together. They are
affected by the same things: for example, the overall level of consumer demand or interest
rates and the overall market performance.
Negative correlation
The profits of some companies move in opposite directions and therefore have negative
correlation. For example, companies with a substantial level of imports may benefit from a
rise in the value of sterling, while exporters may be hit by the same factor and will need to
cut margins to sell the same volumes. The share prices of such companies may or may not be
negatively correlated; this is because most shares, if anything, tend to move in the same
direction as the market.
No correlation
The profits and share values of some companies are not related to each other in any way. For
example, there is probably little or no correlation between UK retailers and Japanese banks,
unless they are both affected by the same world events.
Chapter 3 The merits and limitations of the main investment theories 3/5

Example 3.2
Correlation of returns
Suppose an investor buys shares in two companies, an ice cream manufacturer and an
umbrella manufacturer. Like all businesses, these two companies have risky returns in that
their profits vary from year to year. For the sake of this example, we will assume that the
profits of the two companies are only affected by the weather and nothing else. In
particular, the weather affects profitability in opposite ways:
• In good weather, the demand for ice cream increases and the profits of the ice cream
manufacturer rise but in bad weather, the demand for ice cream falls.

Chapter 3
• In contrast, in bad weather, the demand for umbrellas increases and the profits of the
umbrella manufacturer rise but in good weather, demand for umbrellas falls.
• One prospers when the other does badly.
By investing equally in both companies, the variability of their returns is reduced or
eliminated, because they are affected by changes in their environment in opposite ways.
The risk has been diversified away because the returns are negatively correlated.
Return

Umbrella manufacturer
Combined return
Ice cream company
Dry Wet Dry
Time

The most effective diversification comes from combining investments that are negatively
correlated, but these investments are not always easy to find.

Be aware
Diversification in practice
In practice, investors may have to choose investments that are not correlated or where
the correlation is as low as possible.

Diversification can additionally be achieved by:

• Holding different asset classes within a portfolio
portfolio. Not all assets respond in the same way Not all assets
to changes in the economic cycle. As a general rule: respond in the
same way to
– equities are more likely to do well as the economy grows; changes in the
economic cycle
– fixed-interest securities tend to outperform equities as recession looms; and
– residential property values are related to people’s real earnings, although in the
previous downturn, property prices generally fell in line with equities.
• Choosing companies from different sectors. Diversification within sectors is limited,
however, as most shares move up and down in line with the sector as a whole.
• Including overseas companies. In order to provide a greater diversification, it might be
beneficial for some clients to invest in non-domestic markets.

A3 The efficient frontier

A key concept of modern portfolio theory is the efficient frontier
frontier, which describes the The efficient
relationship between the return that can be expected from a portfolio and the risk of the frontier describes
the relationship
portfolio as measured by the standard deviation. between the return
that can be
The efficient frontier plots the risk-reward profiles of various portfolios and shows the best expected from a
return that can be expected for a given level of risk, or the lowest level of risk needed to portfolio and the
risk of the portfolio
achieve a given expected return. The inputs to the models are the: as measured by
the standard
• return of each asset; deviation

• standard deviation of each asset’s returns; and

• correlation between each pair of assets’ returns.
 3/6 R02/July 2018 Investment principles and risk

Figure 3.2: The efficient frontier

Expected returns

The efficient
E
frontier
C D
Chapter 3

A B

Risk (standard deviation)

What we can say about the five different portfolios represented in the graph is:

Comparison Observation
Portfolio A v Portfolio A is a better choice because it offers the same return as
portfolio B portfolio B, but at a lower level of risk.
Portfolio B v Portfolio C is a better choice because it offers a higher return for the
portfolio C same level of risk as portfolio B.
Portfolio C v Portfolio C is a better choice because it offers the same return as
portfolio D portfolio D, but at a lower level of risk.
Portfolio D v Portfolio E is a better choice because it offers a higher return for the
portfolio E same level of risk as portfolio D.
Portfolio A v It is difficult to choose between these portfolios. Portfolio A offers a low
portfolio C v risk, low return strategy, while both portfolios C and E offer higher levels
portfolio E of risk but with higher returns. The portfolio selected will depend on the
risk preference of the individual investor.

A rational investor
The efficient frontier represents the set of portfolios that have the maximum rate of returns
will only ever hold for every given level of risk, with each portfolio lying on the efficient frontier offering the
a portfolio that lies
somewhere on the
highest expected return relative to all other portfolios of comparable risk. A rational investor
efficient frontier will only ever hold a portfolio that lies somewhere on the efficient frontier. However, it is not
possible to say which portfolio an individual investor would prefer, as this is determined by
the maximum level of risk that the investor is prepared to take.

Be aware
Objective of portfolio management
The objective of portfolio management is to find the optimal portfolio for an investor. The
more risk averse an investor is, the lower the optimum portfolio on the risk–reward
spectrum will be, as defined by the efficient frontier.
Chapter 3 The merits and limitations of the main investment theories 3/7

A3A Limitations to using an efficient frontier

The limitations to using an efficient frontier include:
• It assumes standard deviation is the correct measure of risk and assumes assets have
normally distributed returns.
• It is difficult to say which portfolio investors would prefer based solely on their attitude to
risk, as investors may be concerned about other factors in addition to risk and have
constraints on how their portfolio is invested.
• Inputs for risk and correlation between assets often rely on historical data, which may not

Chapter 3
be stable. Correlations usually rise in a financial crisis, meaning that less risk will be
diversified away than indicated by the model.
• The model does not include transaction costs and investors may not be willing to change
their portfolios as often as the model might recommend.
• It assumes that the underlying portfolios in each asset class are index funds with the same
characteristics as the input data.

A4 Systematic and non-systematic risk

MPT suggests that the variance for individual security returns has two components: MPT suggests that
systematic and non-systematic risk. the variance for
individual security
Systematic risk or market risk returns has two
components:
This is risk that affects the markets as a whole and cannot be avoided. It is the risk that systematic and
markets generally will go up and down as a result of news or events. For example: non-systematic
risk
• changes in interest rates, inflation or other economic factors;
• tax changes made by the government; and
• terrorist attacks or wars.
Some securities will be more sensitive to market factors than others and will have a higher
systematic or market risk.

Be aware
Systematic risk
This type of risk is measured by beta, which indicates the volatility of a stock relative to
the market.

Non-systematic risk or investment-specific risk See section B1 for

more on beta
This is risk that is unique to a particular company and relates to unexpected pieces of good
or bad news concerning the company. It is independent of economic, political and other
factors that affect share prices in a systematic way. Examples of non-systematic risk are:
• a new competitor begins making essentially the same product;
• technological breakthrough makes an existing product obsolete; or
• a change in a company’s credit rating.

Be aware
Non-systematic risk
This is risk that can be eliminated by holding a diversified portfolio.

While all shares have a similar exposure to market risk, investment-specific risk will vary from
company to company. Therefore, it is unlikely that the prices on all shares will move in
exactly the same way at the same time. This means that in a portfolio containing a diversified
range of shares, it is likely that as some of the prices are falling, the prices of others will be
stable or rising. The result is a steadier overall return when a portfolio of shares is held, with
the losses on one being cancelled out by gains on another.

Consider this
this…
…
No matter how many securities are held in a portfolio, the systematic (market risk)
remains.
 3/8 R02/July 2018 Investment principles and risk

Non-systematic
The risk reduces as the number of securities in a portfolio rises. Various academic studies
risk reduces as the suggest that 15 to 20 securities selected randomly are sufficient to eliminate most of the
number of
securities in a
investment-specific risk in a portfolio. However, as Figure 3.3 shows, the rate of reduction
portfolio rises diminishes as more securities are added. This is because, although the specific risk relating
to the individual securities can be diversified away, the risk relating to the market remains.

Figure 3.3: Portfolio risk reduction

Risk of portfolio
(standard deviation of return)
Chapter 3

Total risk

Investment-specific risk

Market
risk
10 20
Number of different companies in portfolio

Activity 3.1
Compare the systematic and non-systematic risks that affect share prices with those we
looked at in chapter 2 that affect bond prices. What conclusions can you draw?

B Capital asset pricing model (CAPM)

The concept of MPT derives a relationship between the risk and return of financial assets. To
invest in a risky asset, an investor requires a return that is equal to the risk-free return plus a
risk premium for taking on the additional risk of that asset.
As we saw in the last section, the total risk of a security can be divided between systematic
or market risk and non-systematic or investment-specific risk. The non-systematic risk
relates to risks that are unique to the security and which can be diversified away as
increasing numbers of securities are added to a portfolio. However, no matter how many
securities are held in the portfolio, systematic risk remains. Some securities are more
sensitive to market factors than others and will therefore have a higher systematic or market
risk, while others will not be as sensitive and will have a lower systematic risk.
CAPM says that because non-systematic risk can be eliminated by diversification, it is not
rewarded. It is the sensitivity of the security to the market that is the appropriate measure of
risk.

Be aware
Sensitivity of the security relative to the market
This sensitivity of a security relative to the market is expressed in terms of its beta ß.
Chapter 3 The merits and limitations of the main investment theories 3/9

B1 Beta
By definition, the market has a beta of one, and the beta of an individual security reflects the The beta of an
extent to which the security’s return moves up or down with the market. According to individual security
reflects the extent
CAPM: to which the
security’s return
• A security with a beta equal to one is expected to move up and down exactly with the moves up or down
market. Therefore, if the market moves by 10%, the security’s price will be expected to with the market

also move by 10%.

• A security with a beta of more than one exaggerates market movement, and is more

Chapter 3
volatile than the market. If the market goes up, the security will go up more (how much
more depends on its beta). If the market goes down, the security will go down more. Such
securities are often referred to as aggressive securities.
• A security with a beta of less than one and more than zero is usually more stable than the
market (unless it has a high level of specific risk), and will move less than the market but in
the same direction. These securities are often referred to as defensive securities.

Activity 3.2
Compare the current betas for different UK shares. Which sectors have low betas and
which have high betas?

B2 CAPM equation
The CAPM is a model that derives the theoretical expected return for a security as a
combination of the return on a risk-free asset and compensation for holding a risky asset, i.e.
a risk premium.
The CAPM is usually expressed:
E(Ri) = Rf + ßi (Rm – Rf)
Where E(Ri) is the expected return on the risky investment;
Rf is the rate of return on a risk-free asset;
Rm is the expected return of the market portfolio;
ßi is the measure of sensitivity of the investment to movements in the overall
market;
(Rm – Rf) is the market risk premium, the excess return of the market over the
risk-free rate; and
ßi (Rm – Rf) is the risk premium of the risky investment.

Consider this
this…
…
The CAPM provides the relationship between a security’s systematic risk and its expected
return, so that securities with high levels of systematic risk (high betas) can be expected
to provide high returns in a rising market.
 3/10 R02/July 2018 Investment principles and risk

Example 3.3
The expected return according to the CAPM
The expected rate of return for a security is equal to the return on a risk-free investment
plus a risk premium.
Calculate the expected return from Pro-power plc using the following assumptions:
• the expected return on a Treasury bill is 3%;
• the expected return on the market portfolio is 7%; and
• Pro-power plc has a beta of 1.3.
Chapter 3

From this information, using the CAPM formula, we find the expected return for Pro-
power would be:
E(Ri) = 3 + 1.3(7 – 3)
= 3 + 5.2
= 8.2%
This tells us that on average, the market expects Pro-power to show an 8.2% annual
return. Because Pro-power has more systematic risk than a typical security in the market,
its expected return is higher.
If we now consider a defensive security, Safe Services plc, with a beta of 0.8. Its expected
return would be:
E(Ri) = 3 + 0.8(7 – 3)
= 3 + 3.2
= 6.2%
Because this security has less systematic risk than a typical security in the market, its
expected return is less.

Question 3.2
What is the expected return for Southern Research if it has a beta of 1.4, if the expected
return on a Treasury bill is 3.5% and the expected return on the market portfolio is 8%?

B3 Assumptions for the CAPM

The CAPM is based on a set of assumptions which include:
• Investors are rational and risk averse, making decisions on the basis of risk and return
alone.
• All investors have an identical holding period.
• The market comprises many buyers and many sellers and no one individual can affect the
market price.
• There are no taxes, no transaction costs and no restrictions on short selling.
• Information is free and is simultaneously available to all investors.
• All investors can borrow and lend unlimited amounts of money at the risk-free rate.
• The quantity of risky securities in the market is fixed, and all are fully marketable (this
means the liquidity of an asset can be ignored).

Be aware
Validity of these CAPM assumptions
Some of these assumptions are more valid than others. However, what matters is not how
realistic or reasonable the assumptions are, but how well the model helps us to
understand, explain and predict the expected return on an investment with a particular
level of risk.
Chapter 3 The merits and limitations of the main investment theories 3/11

B4 Limitations of the CAPM

In addition to the assumptions made by the CAPM, there are other limitations. These are
listed below:
What to use as the risk-free rate?
Finding a totally risk-free return is difficult. Common practice is to pick the return on UK Common practice
Government Treasury bills as a representation of a risk-free asset. These are 91-day money is to pick the return
on UK Government
market instruments issued by the UK Government; there is virtually no default risk and, Treasury bills as a
because of their short life, the interest rate and inflation risks are minimal. representation of a

Chapter 3
risk-free asset
What is the market portfolio?
In theory, the CAPM market portfolio includes all risky investments worldwide, while in
practice, this is usually replaced by a market index of shares relating to a particular national
share market, e.g. the FTSE All-Share or FTSE 100. However, depending on which index is
used, the betas are significantly different. This has brought into question whether these
indices represent the true market portfolio, since if the true market portfolio is not used, the
correct beta for a security cannot be determined.
The suitability of beta
In order for the CAPM to be useful, the beta of a security must be stable or predictable. In order for the
Betas are calculated from past experience and do not seem to be stable over time, which CAPM to be useful,
the beta of a
brings into question their reliability as a guide to estimating future risk. security must be
stable or
The CAPM suggests a direct relationship between the excess return on a security over the predictable
risk-free rate and its beta, but some studies, particularly in the USA, have not found this
relationship. There does, however, appear to be more support for the model over longer
periods of time, with some studies seeming to imply that low beta securities earn more than
the CAPM would predict, while high beta securities earn less.
Despite this, the CAPM is the foundation of many risk-adjusted measures of investment The CAPM is the
performance. The fact that the model has been criticised because its assumptions are foundation of
many risk-adjusted
unrealistic (there are some studies that show the market does not perform as the theory measures of
suggests) does not invalidate its ability to provide relative data that illustrates expected investment
performance
returns and their relationship to risk.

Consider this
this…
…
The CAPM can be viewed as a flawed ruler – just because the scale is wrong, it can still be
used to evaluate whether one line is longer than another.

C Multi-factor models
The CAPM expresses a simple relationship between risk and return. It indicates the expected
return on a security as the return on a risk-free asset, plus a risk premium. This risk premium
is simply determined by the level of the security’s systematic (non-diversifiable) risk relative
to the average level of systematic risk on a stock market. Hence, the model is often referred
to as a single factor model – it is concerned with only one factor, the security’s sensitivity to
the market, as measured by its beta.
However, as we have seen, there are some problems with this theory. The relationship
between risk and return can be far too complex to describe by the relationship with a single
market index, as other factors may also determine the return on a security.
Different securities have different sensitivities to different types of market wide shocks:
inflation, business cycles, interest rates, etc. Multi-factor models allow for different
sensitivities to different factors and the identification of each factor’s contribution to the
security’s return.
 3/12 R02/July 2018 Investment principles and risk

Example 3.4
A two-factor model
If we believe the only macro-economic sources of risk are business cycles (gross domestic
product, GDP) and interest rates (IR), the rates of return should then respond to
unanticipated changes in both factors. The formula would be:
E(Ri) = Rf + ßGDP (risk premium GDP) + ßIR (risk premium IR)
= minimum return + risk premium
The expected return on a security should be:
Chapter 3

risk-free return (Rf)

plus
a risk premium based on the security’s sensitivity to unanticipated changes in GDP
plus
a risk premium based on the security’s sensitivity to unanticipated changes in
interest rates.

A multi-factor
A multi-factor model attempts to describe security returns as a function of a limited number
model attempts to of factors. However, when constructing a multi-factor model, it is difficult to decide how
describe security
returns as a
many and which factors to include.
function of a
limited number of The Fama and French model expanded the CAPM by adding factors for company size and
factors value in addition to the market risk factor of CAPM. Fama and French identified two types of
company securities that tended to do better than the market as a whole, they found that:
• small cap stocks tended to outperform large cap stocks; and
• value stocks (those with a high book value to price ratio) tended to outperform growth
stocks.

Be aware
Fama and French model
The securities favoured by the Fama and French model tend to be more volatile than the
stock market as a whole, and the higher reward should be considered as the
compensation for taking on higher risk.

One of the best known multi-factor asset pricing models, based on arbitrage pricing theory
(APT), was developed by Stephen Ross. He suggested a more general multi-factor structure,
which is based on the idea that there are a few major macro-economic factors or indices that
influence security returns. Additional factors can be added that relate to the fundamentals of
the company being analysed, such as earnings growth, return on equity, dividend yield, etc.
Multi-factor models are able to make a more detailed prediction of risk and return, and
improve our understanding of security returns.

Be aware
Multi-factor models
Although there are differences between multi-factor models, they all share two basic
ideas:
• investors require extra return for taking risk; and
• they appear to be predominantly concerned with the risk that cannot be eliminated by
diversification.
Chapter 3 The merits and limitations of the main investment theories 3/13

C1 Arbitrage pricing theory (APT)

APT is a general theory of asset pricing that has become influential in the pricing of
securities. It is based on the idea that a security’s returns can be predicted using the
relationship between the security and a number of common risk factors, where sensitivity to
changes in each factor is represented by a factor-specific beta. The model-derived return
can then be used to correctly price the security. If the price diverges, arbitrage activities
should bring it back into line (arbitrage is the practice of taking advantage of security
mispricing to make a risk-free profit), so that it is not possible for a security to yield better
returns than indicated by its sensitivity to the various factors.

Chapter 3
Like the CAPM, it argues that returns are based on the systematic risk to which a security is
exposed, rather than total risk. Unlike the CAPM, however, the APT is based on the belief
that asset prices are determined by more than just one type of market risk.

Consider this
this…
…
No matter how well a portfolio is diversified, these risk factors cannot be avoided,
although different securities will have different sensitivities to each of those factors.

According to APT, the expected return on a security is determined by adding the risk-free
rate to figures representing the risk premium for each of the risk factors. As in the CAPM, any
diversifiable risk is unrewarded, because it can be avoided. However, the APT differs from
CAPM in that it assumes that each investor holds a unique portfolio with its own particular
degree of exposure to the fundamental economic risks that influence asset returns, as
opposed to an identical market portfolio.
The APT therefore has more flexible assumption requirements than the CAPM.
One difficulty with the APT is its generality, as the model does not tell us which factors are One difficulty with
relevant. In addition, the number and nature of those factors is likely to change over time the APT is its
generality
and between economies.

Be aware
Influences on security returns
Research suggests that there are four important factors that influence security returns:
• unanticipated inflation;
• changes in the expected level of industrial production;
• changes in the default risk premium on bonds; and
• unanticipated changes in the return of long-term government bonds over Treasury bills
(shifts in the yield curve).

The inclusion of multiple factors does, however, mean that more betas have to be calculated, Multi-factor
and there is no guarantee that all of the relevant factors have been identified. Multi-factor models are widely
used by
models are widely used by quantitative model-driven investment managers and in risk quantitative
management. model-driven
investment
managers

D Efficient market hypothesis (EMH)

The efficient market hypothesis (EMH) was developed by Eugene Fama in the 1960s. He put
forward the idea that in an open and efficient market, security prices fully reflect all available
information and prices rapidly adjust to any new information. For this reason, market prices
are always the correct price for any given security and reflect the best estimate of their true
intrinsic value. It is therefore not possible to outperform the market by picking undervalued
securities, since the EMH indicates that there are no undervalued or overvalued securities.

Origins of the EMH

The EMH was developed from the random walk theory, which suggests that security price
movements are random and are therefore unpredictable. Thus, new information is
unpredictable and so are future security price movements.
 3/14 R02/July 2018 Investment principles and risk

The crux of the

The crux of the EMH is that it should be impossible to achieve returns in excess of average
EMH is that it market returns consistently through stock selection. Only new information will move
should be
impossible to
security prices significantly, and since new information is presently unknown and occurs at
achieve returns in random, future movements in security prices are also unknown and so move randomly. The
excess of average
market returns
only way an investor can possibly obtain higher than average returns is by purchasing riskier
consistently investments. If markets are efficient and current prices fully reflect all information, then
through stock
selection
buying and selling securities in an attempt to outperform the market will effectively be a
game of chance rather than skill.
Chapter 3

D1 Three forms of the EMH

There are three forms, or levels, of the EMH, which differ in respect of the information that
they consider:
• weak form efficiency;
• semi-strong form efficiency; and
• strong form efficiency.
Weak form efficiency
This states that current security prices fully reflect all past price and trading volume
information, and future prices cannot be predicted by analysing this type of historical data.
Therefore, technical analysis, which charts historical trading data and looks for trends, is of
no use in determining future prices, and will not be able to consistently produce market-
beating returns.
Semi-strong form efficiency
This states that security prices adjust to all publicly available information very rapidly and in
an unbiased way, so that no excess returns can be earned by trading on that information.
Public information includes not only past prices, but also information reported in a
company’s financial statements, company announcements and economic factors.
This indicates that a company’s financial statements are of no help in forecasting future price
movements and securing excess returns.
Semi-strong form efficiency implies that neither fundamental analysis, which looks at the
historical financial performance of a company, nor technical analysis, which charts historical
trading data, will reliably be able to help identify whether a security is over or undervalued.
Strong form efficiency
This states that security prices reflect all information that any investor can acquire. In this
form, all information includes not only public information, but also private information,
typically held by corporate insiders such as officers or executives of a company, or their
advisers.

Consider this
this…
…
Corporate insiders could make abnormal profits by trading on information before it is
made publicly available. However, insider-trading laws make this activity illegal, which
means that a company’s management and their advisers (insiders) are not able to make
gains from inside information they hold.

D2 Evidence to support the EMH

The debate about
The debate about the efficiency of markets has resulted in hundreds of studies, attempting
the efficiency of to determine the validity of the different forms of the hypothesis:
markets has
resulted in • Generally, strong and consistent evidence supports the weak form of the EMH. The vast
hundreds of
studies, majority of studies have found that technical analysis (buying and selling securities based
attempting to on trends in historical market data) does not lead to out-performance after transaction
determine the
validity of the costs are taken into account.
different forms of
the hypothesis
• The semi-strong form of the EMH has strong factual support, although it is not conclusive.
Research shows that for most types of information, the markets are semi-strong form
efficient, although some anomalies indicate they are not completely semi-strong form
efficient.
Chapter 3 The merits and limitations of the main investment theories 3/15

• Tests of the strong-form of the EMH have focused on looking at investors who have
access to non-public information or an ability to react to new information before other
investors. There is evidence that company directors and their advisers can outperform
other investors. However, investment managers on average do not. It would therefore
appear that the market is not strongly efficient in the strictest sense of the definition.
The bulk of the evidence supports the EMH. However, in reality, markets have varying
degrees of efficiency, with some markets being more efficient than others. In markets that
are less efficient, more knowledgeable investors can outperform less knowledgeable ones:

Chapter 3
• Government bond markets are considered extremely efficient.
• Most researchers consider large capitalised stocks to be very efficiently priced, while the
prices of smaller capitalised stocks, or ones which are not widely followed by analysts, are
considered to be less efficient.
• Venture capital, which does not have a liquid market, is considered less efficient because
different participants may have varying amounts and quality of information.
The efficient market debate plays an important role in the decision between active and
passive investment. If the EMH is correct, instead of picking stocks, it makes sense to invest
in tracker or index funds, which will mirror the overall performance of the market. On the
other hand, where markets are less efficient, there is the opportunity for outperformance by
skilful, knowledgeable investors.

Reinforce
Which UK markets do you think would be most the most efficient, and which might be the
least efficient?

The EMH was widely accepted until the 1990s, when behavioural economists began to
question its validity. They argued that markets were far from perfect in terms of processing
information and that other factors, such as investor confidence, must be taken into account.

Question 3.3
Does the EMH support active stock selection or passive investing (e.g. index funds)?

E Behavioural finance
Behavioural finance is a relatively new area of research that explores how emotional and Behavioural
psychological factors affect investment decisions. It attempts to explain market anomalies finance is a
relatively new area
and other market activity that is not explained by traditional finance models, such as modern of research that
portfolio theory and the EMH, and offers alternative explanations of the key question of why explores how
emotional and
security prices deviate from their fundamental values. psychological
factors affect
Much of the traditional financial theory is based on the assumption that individuals act investment
rationally and consider all available information when making investment decisions. The key decisions

argument of behavioural finance is that psychological factors or behavioural biases affect

investors. These limit and distort their information and may cause them to reach incorrect
conclusions, even if the information is correct.
Behavioural finance highlights certain inefficiencies caused by the irrational way in which See chapter 7 for
more on
investors react to new information as causes of market trends and, in extreme cases, of behavioural
speculative market bubbles (the dotcom bubble in 1999) and stock market crashes, such as finance in the
investment
in 1987 and 2008. By looking at bubbles and crashes, it becomes clear that psychology can advice process
be as important as finance and economics for the explanation of such phenomena.

E1 Psychological factors or behavioural biases

Psychological factors and behavioural biases can be categorised in many ways, although
these often overlap and can be indistinguishable from one another. The following section
considers some of the principal theories within behavioural finance that often contradict the
basic assumptions of traditional financial theory.
 3/16 R02/July 2018 Investment principles and risk

E1A Prospect theory/loss aversion

Prospect theory
Prospect theory deals with the idea that people do not always behave rationally, in particular
deals with the idea in respect to their risk tolerance when they are facing a loss or have made a profit. The
that people do not
always behave
theory suggests that there are persistent biases which influence people’s choices under
rationally different conditions of uncertainty.
Research has shown that investors place different weights on gains and losses, and on
different ranges of probability. Individuals are much more distressed by prospective losses
than they are made happy by equivalent gains, and responded differently to equivalent
Chapter 3

situations depending on whether that situation is presented in the context of a loss or a gain.
Research has also found evidence that people play safe when protecting gains, but if faced
with the possibility of losing money, they often take riskier decisions aimed at loss aversion.
This may include a reluctance to realise losses, so people hold on to losing investments
longer than they should in the hope that, given time, the loss will be recouped. If they were
to sell they would realise the loss, otherwise it is just a paper loss.

Consider this
this…
…
Consider your own behaviour in this regard – and that of your clients and/or other
investors you know.

E1B Regret
Investors may be
Investors may be less willing to sell a losing investment because it is showing a loss. People
less willing to sell a tend to feel sorrow and grief after having made an error of judgment. Investors deciding
losing investment
because it is
whether to sell a security are typically emotionally affected by whether the security was
showing a loss bought for more or less than the current price. Investors therefore avoid selling stocks that
have gone down to avoid the pain and regret of having made a bad investment.
It is the fear of regret which causes investors to hold losing positions too long in the hope
that they will become profitable, or sell too soon to lock in profits in case they turn into
losses.

E1C Overconfidence and over and underreaction

A key behavioural factor, and perhaps the most robust finding from research that explains
market anomalies, is overconfidence
overconfidence. Extensive evidence shows that people have a
tendency to overestimate their own skills and predictions for success, and underestimate the
likelihood of bad outcomes over which they have no control.

Investors tend to
Investors tend to be more optimistic when the market goes up and more pessimistic when
be more optimistic the market goes down. They typically give too much weight to recent experience and
when the market
goes up
extrapolate recent trends that often run contrary to long run averages and statistical odds.

Be aware
Effect of overconfidence
Overconfidence has been found to cause investors to overestimate the reliability of their
knowledge, underestimate risks and exaggerate their ability to control events, which can
lead to excessive trading volumes and speculative bubbles.

E1D Criticisms of behavioural finance

The theories of behavioural finance, incorporating behavioural and psychological factors,
are now beginning to challenge existing efficient market models in terms of explaining
market anomalies. However, they do not appear to be able to predict the effect on the
market of human behaviour.
There is little doubt that various psychological and behavioural factors impact on
investment decisions and can affect the market significantly. However, some believe they
have little use in forecasting the markets, since the many factors of human behaviour cannot
be quantified and so will not enable an individual investor to earn abnormal returns.
Critics of behavioural finance, who typically support the existing efficient market models,
contend that behavioural finance is more a collection of explanations of anomalies than a
true branch of finance and that these anomalies will eventually be priced out of the market.
Chapter 3 The merits and limitations of the main investment theories 3/17

On the other hand, an understanding of behavioural finance can help investors avoid
common mistakes, such as holding on to loss-making positions for too long, and help
advisers, who understand their clients’ behavioural biases, to communicate with these
clients more effectively.

Chapter 3
 3/18 R02/July 2018 Investment principles and risk

Key points
The main ideas covered by this chapter can be summarised as follows:

Modern portfolio theory (MPT)

• MPT suggests that portfolios can be constructed that maximise returns and minimise risk
by carefully choosing different investments.
• The most commonly used measure of risk is volatility measured by standard deviation.
The greater the standard deviation, the greater the volatility and therefore the
associated risk.
Chapter 3

• The overall volatility and risk of a portfolio can be reduced by diversification. This can be
achieved by:
– combining different types of assets within a portfolio, and
– holding a variety of investments of each asset type.
• The effectiveness of diversification in reducing a portfolio’s risk depends on the degree
of correlation between assets.
• The risk for individual security returns has two components:
– systematic or market risk, which cannot be diversified away.
– non-systematic or investment-specific risk, which can be eliminated by diversification.
• The sensitivity of a security in relation to the market as a whole is expressed in terms of
its beta (ß).
• The efficient frontier represents the set of portfolios that have the maximum rate of
returns for every given level of risk. Each portfolio lying on the efficient frontier offers
the highest expected return relative to all other portfolios of comparable risk.

Capital asset pricing model (CAPM)

• The CAPM is a model that derives the theoretical expected return for a security as a
combination of the return on a risk-free asset and compensation for holding a risky
asset.
• The CAPM is based on a number of assumptions, some of which are more valid than
others.

Multi-factor models
• Multi-factor models allow for different sensitivities to different macro-economic and
fundamental factors and the identification of each factor’s contribution to the security’s
return.
• Arbitrage pricing theory (APT) is based on the idea that there are a number of major
macro-economic factors that influence security prices.

Efficient market hypothesis (EMH)

• According to the EMH, in an open and efficient market, security prices fully reflect all
available information and prices rapidly adjust to any new information.
• Buying and selling securities in an attempt to outperform the market will effectively be a
game of chance rather than skill.
• There are three forms or levels of the EMH, which differ in respect of the information that
they consider: weak form efficiency, semi-strong form efficiency and strong form
efficiency.
• If the EMH is correct, instead of picking stocks it makes sense to invest in tracker or
index funds, which will mirror the overall performance of the market.

Behavioural finance
• Behavioural finance is an area of research that explores how emotional and
psychological factors affect investment decisions.
• It attempts to explain market anomalies and other market activity that is not explained
by the traditional finance models.
• It highlights certain inefficiencies caused by the irrational way in which investors react to
new information, as causes of market trends and in extreme cases of speculative market
bubbles and crashes.
• Although the theories are able to explain market anomalies, they appear less able to
predict the effect of human behaviour on the markets.
Chapter 3 The merits and limitations of the main investment theories 3/19

Question answers
3.1 Approximately 68% of returns will fall between 0% and 20% (i.e. 10% ± 10%).
Therefore, since a normal distribution is symmetric, 16% will be above 20% and 16%
below 0%, i.e. negative returns.
3.2 E(Ri) = 3.5 + 1.4(8 – 3.5) = 9.8%
3.3 The EMH indicates that all information is reflected in market prices. Therefore, if the
hypothesis holds, stock picking will not lead to persistently outperforming the

Chapter 3
market, so it supports passive index investing.
 3/20 R02/July 2018 Investment principles and risk

Self-test questions
1. What does standard deviation measure?
2. What does beta measure?
3. What type of risk can be eliminated by holding a diversified portfolio?
4. Why, in theory, should investment managers construct portfolios that lie on the
efficient frontier?
5. What is usually used as representing a risk-free asset in the CAPM equation?
Chapter 3

6. How does APT differ from CAPM?

7. What are the three forms of the EMH, and what information do they consider?
8. How does behavioural finance explain market anomalies?

You will find the answers at the back of the book

 The principles of the
4
time value of money

Chapter 4
Contents Syllabus learning
outcomes
Learning objectives
Introduction
Key terms
A Time value of money 4.1, 4.2
B Real returns and nominal returns 4.2
Key points
Question answers
Self-test questions

Learning objectives
After studying this chapter, you should be able to:
• apply the principles of the time value of money;
• calculate compound interest and discount factors;
• calculate annual interest rates when interest is compounded more than once per year;
• calculate discounted cash flows; and
• differentiate between real returns and nominal returns.
 4/2 R02/July 2018 Investment principles and risk

Introduction
Which would an investor rather have: £10,000 now or £10,000 in a year’s time? The answer
must surely be £10,000 now. A sum of money now is more valuable than the same sum later,
because it can be invested and earn interest over that period. This is the basic meaning of
‘the time value of money’.
In this chapter, we look at the formulas linking present and future value, and how the
calculations are adjusted when sums of money are invested over multiple periods, or interest
is paid at different intervals. Please note that some of the example calculations require the
use of a scientific calculator (although some manual calculators may be able to perform the
functions).

Key terms
This chapter features explanations of the following:
Chapter 4

Accumulation and Annual equivalent Annual percentage Compound interest

discounting rate (AER) rate (APR)
Discounted cash Effective annual rate Future value Interest rate
flows (EAR)
Nominal returns Present value Real returns Time period

A Time value of money

A1 Definitions
It is important to be very clear about the basic definitions used in time value of money
calculations:

Term Definition
Present value (PV
PV)) The amount of capital invested today is called the present value,
denoted by PV. This is sometimes referred to as the principal.
Time period (n) The time for which the capital is invested is split into time
periods and the number of time periods is denoted by n. Time
periods are usually yearly, but can be half-yearly, quarterly,
monthly or daily.
Interest rate (r) The amount paid on the investment for each time period is
usually quoted as a percentage and called the interest rate. It is
usual to express this as a decimal fraction and call it r. For
instance, an interest rate of 7% is written r = 7/100 = 0.07 and an
interest rate of 10% is written r = 10 ÷ 100 = 0.1.
Future value (FV
FV)) The accumulated value of an amount of money invested for n
time periods, at a rate of interest r, is denoted by FV.

In practice, money A2 Linking present value and future value

paid as interest is
usually reinvested, In practice, money paid as interest is usually reinvested, and earns interest in the next period.
and earns interest
in the next period
Interest calculated in this way is called compound interest
interest.

Example 4.1
£1,000 invested at 5% would give rise to £50 interest at the end of the first year. This
would give an accumulated total of £1,050 that at a continuing rate of 5% would give rise
to a further amount of interest of £52.50 at the end of the second year. Interest that itself
earns interest is another way of expressing or defining compound interest.
Chapter 4 The principles of the time value of money 4/3

The basic formula for calculating compound interest is:

FV = PV (1 + r)n
where FV is the future value or accumulated sum, and PV is the present value or principal
invested.

Future value formula

Formula for accumulation of capital sum
The basic compound interest formula is built up as follows:
• It assumes that one unit of capital or money is 1.
• Interest is payable at the rate of r per year, as a percentage figure, which is converted
to a decimal:
rate of interest
100

Chapter 4
so that 5% = 0.05 and 12% = 0.12.
• The unit of capital increases to 1 + r at the end of year one; so that the value at that time
is:
FV = 1 + r
• This is then reinvested at the rate of r for a further year, and becomes
(1 + r) × (1 + r) or
(1 + r)2
• Similarly, for three years: (1 + r)3

Example 4.2
A sum of £2,000 invested at an interest rate of 5% for five years would increase to:
FV = PV (1 + r)n
= £2,000 × (1 + 0.05)5
= £2,000 × (1.05)5
To raise a number to a power, most calculators have the symbol xy, yx or ^. It might require
the use of a shift key to make the function work on some calculators. So 1.05 xy 5 should
give 1.28. Make sure you always calculate the value of the bracketed numbers first and
that you are clear on how your calculator handles this calculation.
= £2,000 × (1.28)
= £2,552.56

Example 4.3
A sum of £1,000 is invested for four years at an annual rate of 3%. How much will be
accumulated at the end of four years?
FV = PV (1 + r )n
FV= £1,000 × (1 + r)n
= £1,000 × (1.03)4
= £1,000 × 1.13
= £1,125.51
Please note that you should use the full values as shown on your calculator when doing
this calculation. The figures shown in this example have been rounded to two decimal
places, where appropriate, for presentation purposes.

Question 4.1
A sum of £5,000 is invested for five years at an annual rate of 4%. How much will be
accumulated at the end of the five years?
 4/4 R02/July 2018 Investment principles and risk

Example 4.4
A client invests £10,000 into a unit trust and after five years it is worth £15,785. What
compound rate of return have they achieved in a year?
In this example, we need to calculate what r is.
FV = PV (1 + r)n
£15,785 = £10,000 (1 + r)5
£15,785 ÷ £10,000 = (1 + r)5
£1.5785 = (1 + r)5
To proceed further we need to isolate 1+ r. We do this by taking the 5th root of each side
of the equation:
5
1.5785 = 1 + r
Chapter 4

The 5th root of 1.5785 is calculated using the x—y key. If your calculator does not handle
this function, it could also be written as (1.5785)1/5, which is the same as (1.5785)0.2. Using
the xy function on the calculator:
1.0956 = 1 + r
r = 1.0956 – 1
r = 0.0956
Always remember to express any interest rate answer as a percentage to two decimal
places:
r = 9.56%.
Please note that you should use the full values as shown on your calculator when doing
this calculation. The figures shown in this example have been rounded to four decimal
places, where appropriate, for presentation purposes.

Example 4.5
It is also possible to change the compounding rate during the accumulation period. For
example, the sum of £5,000 is invested at 5% a year for two years; then the accumulated
capital and interest is reinvested for a further three years at 7% a year. What will the total
sum be at the end of five years? This question calculates the future value using
compounding:
FV= £5,000 × (1 + r1)n1 × (1 + r2)n2
= £5,000 × (1.05)2 × (1.07)3
Always calculate the bracketed parts of the equation first:
= £5,000 × 1.10 × 1.23
= £6,753.05.
Please note that you should use the full values as shown on your calculator when doing
this calculation. The figures shown in this example have been rounded to two decimal
places, where appropriate, for presentation purposes.

A3 Interest payable at more frequent intervals

Interest rates are usually quoted as an annual rate, referred to as the nominal rate, but
interest could be paid over any period, e.g. daily, monthly, quarterly or half yearly rather than
at the end of the year:
• For example, interest could be expressed as a nominal rate of 10%, paid quarterly. This
means that some of the interest is paid sooner and can be reinvested earlier, which makes
the effective rate of interest greater than the equivalent nominal rate of interest.
• The total return depends on the frequency of compounding (known as conversion
periods); e.g. £1,000 invested for twelve months at 10% a year generates £100 interest if
the interest is paid only once at the end of the year.
Chapter 4 The principles of the time value of money 4/5

– When interest is paid half yearly (i.e. two conversion periods), the total interest after
one year is higher and is £102.50. For each half year, the interest accumulation factor is
half the annual rate of 10%, i.e. 5%.
– After six months, the interest plus capital is £1,050, and this earns interest for another
six months, to give an accumulated total of £1,102.50. If interest were payable quarterly,
or with four conversion periods, the interest accumulation factor would be 10% ÷ 4, or
2.5%, compounded quarterly to give an accumulated total of £1,103.81.
• If we express all the above arithmetically, we have the following:
For annual interest £1,000 × 1.10
For half-year interest £1,000 × (1.05) × (1.05)
or £1,000 × (1.05)2
For quarterly interest £1,000 × (1.025) × (1.025) × (1.025) × (1.025)
or £1,000 × (1.025)4

Chapter 4
We can see from Table 4.1 the effect of interest being paid at different intervals:

Table 4.1: Effect of 10% nominal annual interest compounded at

different periods
Interest No. of periods in one Value of £1 after one Effective annual
compounded year year rate %
Annually 1 1.1000 10.00
Half-yearly 2 1.1025 10.25
Quarterly 4 1.1038 10.38
Monthly 12 1.1047 10.47
Daily 365 1.1052 10.52

The formula to find the effective annual rate (EAR) of interest is:
EAR = (1 + r/n)n – 1.
The EAR is used for both loans and deposits.

Example 4.6
What is the effective rate if the nominal rate is 8% per year, compounded on a quarterly
basis?
It is a good idea to get in the habit of writing down the formula when doing calculations,
as it will help you to learn them.
Effective = (1 + r/n)n – 1
rate
= (1 + 0.08 ÷ 4)4 – 1
= (1.02)4 – 1
= (1.0824) – 1 = 0.0824
The effective rate is 0.0824 × 100 = 8.24%.
Please note that you should use the full values as shown on your calculator when doing
this calculation. The figures shown in this example have been rounded to four decimal
places, where appropriate, for presentation purposes.

A3A Annual percentage rate and annual equivalent rate

The EAR of interest is also referred to as the annual percentage rate (APR) or annual
equivalent rate (AER).

APR or AER?
APR is generally used for loans, whereas AER applies to deposits.
 4/6 R02/July 2018 Investment principles and risk

The APR/AER can be found using the same formula as above:

APR/AER/EAR = (1 + r/n)n – 1.
The answer must be multiplied by 100 so that we can express the answer as a percentage to
two decimal places.

Example 4.7
What is the APR on a loan where interest is charged at the rate of 24% a year on a monthly
basis?
This can also be expressed as a rate of 2% a month.
APR= (1 + 0.24 ÷ 12)12 – 1 = (1.02)12 – 1
Always calculate the bracketed part of the equation first.
= 1.2682 –1
= 0.2682
Chapter 4

Multiply by 100 to express as a percentage to two decimal places

= 26.82%.
Please note that you should use the full values as shown on your calculator when doing
this calculation. The figures shown in this example have been rounded to four decimal
places, where appropriate, for presentation purposes.

A4 Present value
We have looked at the calculations for the accumulation of capital sums. We also need to be
able to calculate the present value (PV) or amount that has to be invested now to reach a
required sum at a future date.
The formula is:
PV = FV/(1 + r)n.

Example 4.8
What amount has to be invested to accumulate £1,000 at the end of five years at an
annual interest rate of 5%?
PV = FV/(1 + r)n
= £1,000 ÷ (1.05)5
= £1,000 ÷ (1.28)
PV = £783.53
Please note that you should use the full values as shown on your calculator when doing
this calculation. The figures shown in this example have been rounded to two decimal
places, where appropriate, for presentation purposes.

Question 4.2
If the nominal rate of interest is quoted as 6% per annum and interest is paid weekly, what
is the EAR of interest?

A4A Accumulation and discounting of regular savings

In this section, we will consider how to calculate:
• the sum of money accrued from a series of payments; and
• the present value of a series of payments.
If you set aside £100 a year at an interest rate of 8% (payable annually), we can calculate the
value of the accrued investment at the end of ten years. In this case, we assume that the first
payment is made at the end of year one so, at the end of ten years, the first payment will
have been invested for nine years and will have a value of 100 × (1.08)9.
Chapter 4 The principles of the time value of money 4/7

The next payment is made at the end of year two; by year ten, it will have been invested for
eight years and will have a value of 100 × (1.08)8.
In tabular form, this is as shown below:

Table 4.2: Value of accrued investment

End of year Amount £ Value at end of year 10 £
9
1 100 × (1.08) 199.90
8
2 100 × (1.08) 185.09
3 100 × (1.08)7 171.38
4 100 × (1.08)6 158.69
5
5 100 × (1.08) 146.93
4
6 100 × (1.08) 136.05

Chapter 4
7 100 × (1.08)3 125.97
8 100 × (1.08)2 116.64
9 100 × (1.08) 108.00
10 100 100.00
Total 1,448.66

At the end of year ten, the total value is the total of the final column. However, rather than
calculate the total value in the lengthy fashion shown above, we can use the following
formula:

FV = P ⎨
( )
⎧ 1 + r n − 1⎫
⎪ ⎪
⎬
⎪ r ⎪
⎩ ⎭
where: P = the regular payment.
This formula allows us to calculate an accumulated amount from a regular payment paid in
arrears over a given period. It might look a bit intimidating, but there is no new maths
beyond what we have already done. Example 4.9 below shows you how to use this formula
to work out the value of the accrued investment as shown in tabular form in Table 4.2.

Example 4.9
A sum of £100 is invested at the end of each year for ten years. The interest rate is 8%. The
accumulated or future value at the end of ten years will be:
FV= £100 × (((1 + 0.08) 10 – 1) ÷ 0.08)
FV= £100 × ((2.16 – 1) ÷ 0.08)
FV = £100 × 14.49
FV = £1,448.66
So, the value at the end of ten years will be £1,448.66.
Please note that you should use the full values as shown on your calculator when doing
this calculation. The figures shown in this example have been rounded to two decimal
places, where appropriate, for presentation purposes.

We have now seen how to calculate the future value of an investment if we know certain
information, including the present value. We refer to the process of calculating the future
value as compounding. We can also reverse this procedure and calculate the present value
of an investment if we know certain information, including the future value. We refer to the
process of calculating the present value of cash flows as discounting. Discounting is
therefore the opposite of compounding.
 4/8 R02/July 2018 Investment principles and risk

We use discounted cash flow analysis to calculate the present value of an investment’s
future cash flows to arrive at a fair value of the current investment price. We can then
compare the theoretical present value of the investment against the actual current traded
price of the investment in the financial markets. This will give the investor an indication of
whether the investment is currently under or overvalued in the market and, if it is, then
whether it is worth buying or selling.
Companies may pay dividends from profits to their shareholders. The monetary value of
dividends will be variable and so the present values, after discounting, will be uncertain.
Fixed-interest securities, such as bonds, will pay a constant fixed amount of interest (known
as the coupon) to the bondholders on a regular basis. We can use discounting to calculate
the present values of these fixed cash flows. Example 4.10 shows the discounting formula for
the predicted price of a bond. Fixed-interest securities were covered in chapter 1 of this
study text.
The basic formula for calculating discounted cash flows is:
Chapter 4

FV
PV =
(1 + r)
n

Where PV is the present value of the cash flow, FV is the future value or accumulated sum, r
is the interest rate and n is the number of time periods.

Example 4.10
A bond pays a 6.5% annual coupon and is redeemable at its par or nominal value of £100
in two years’ time. The interest rate is currently 5% per annum. What is the theoretical
price of the bond?
Remember the formula:

FV
PV =
(1 + r)
n

A 6.5% coupon bond paying annual interest will pay a fixed amount of £6.50 at the end of
each year (i.e. 6.5% of the £100 par or nominal value). This bond will therefore pay £6.50
to the bondholder at the end of year 1 (therefore n = 1 for the end of year 1 payment), plus
it will pay another £6.50 at the end of year 2 (therefore n = 2 for the end of year 2
payment). Also at the end of year 2, the bond will be redeemed at its par or nominal value
of £100.
The present value of the bond is calculated as follows:

£6.50 £106.50
PV = +
(1 + 0.05) (1 + 0.05)
1 2

PV = £6.19 + £96.60
Therefore, the theoretical present value of the bond = £102.79
We can then compare the theoretical present value of the bond against the actual current
traded price in the financial markets. For example, if the actual trading price of the bond in
the markets is £104.00, then the theoretical price of the bond calculated at £102.79 would
appear to show that this bond is presently trading above its theoretical price and may not
therefore represent a good investment at this time.
Please note that you should use the full values as shown on your calculator when doing
this calculation. The figures shown in this example have been rounded to two decimal
places, where appropriate, for presentation purposes.

If we can calculate the future value of a series of payments plus interest, we can also use the
formula to calculate the sum of money needed now to make regular payments plus interest
over a fixed term at a fixed rate of interest. This is the present value and it is called an annuity
(A) and the general formula is:
Chapter 4 The principles of the time value of money 4/9

( )
⎛ 1− 1+ r ⎞
−n

A=P ⎜ ⎟
⎜ r ⎟
⎝ ⎠

This again may look complicated, but really the only difference here is the order of the
symbols and the fact that we are now raising the 1 + r to the power of –n (minus n). Let’s look
at an example.

Example 4.11
How much needs to be invested as a lump sum to provide an annual payment of interest
and capital of £100 at the end of each year for ten years if the interest earned is 8% a year?
This is known as an annuity and using the formula above we can insert the figures from
this example. Note that 1.08 is now raised to the power of –10 this time.

( )
⎧1 − 1 + r ⎫
−n
⎪ ⎪
A=P ⎨ ⎬
r

Chapter 4
⎪ ⎪
⎩ ⎭

Remember to calculate the smaller bracket within the bigger bracket first.

⎧ 1 − 1.08
( ) ⎫
−10
⎪ ⎪
A = 100 ⎨ ⎬
⎪ 0.08 ⎪
⎩ ⎭

1.08 to the power of –10 = 0.46

⎧ 1 − 0.46 ⎫
A = 100 ⎨ ⎬
⎩ 0.08 ⎭

Deduct 0.46 from 1 to get 0.54

0.54 divided by 0.08 = 6.71
So £100 × (6.71) = £671
We now know that the present value of £100 a year earning 8% interest is £671.
Please note that you should use the full values as shown on your calculator when doing
this calculation. The figures shown in this example have been rounded to two decimal
places, where appropriate, for presentation purposes.

We also need to be able to calculate the payments that make up an annuity when the capital
and interest are paid monthly. The formula is exactly the same as we have already used but
this time we express everything as months, not years.
 4/10 R02/July 2018 Investment principles and risk

Example 4.12
An individual has £30,000 invested in a building society paying a nominal 3% a year.
Interest is credited monthly and they intend to draw out capital and interest monthly, so
that at the end of six years, the account will have a nil balance. How much can be
withdrawn at the end of each month? Six years is 72 months. The monthly rate of interest
is found by dividing the annual rate by 12; 3% ÷ 12 = 0.25%.
Therefore, using the same annuity formula as above, we can insert the figures from this
example:
3 ÷ 12 = 0.25

⎪
30,000 = P ⎨
( )
⎧ 1 − 1.0038 −72 ⎫
⎪
⎬
⎪ 0.0038 ⎪
⎩ ⎭

⎧ 1 − 0.7638 ⎫
Chapter 4

30,000 = P ⎨ ⎬
⎩ 0.0038 ⎭

£30,000 = P (65.8169)

£30,000
= £455.8103
65.8169

P = £455.81
£455.81 can be withdrawn each month.
Please note that you should use the full values as shown on your calculator when doing
this calculation. The figures shown in this example have been rounded to four decimal
places, where appropriate, for presentation purposes.

B Real returns and nominal returns

As we have seen in previous chapters, inflation can significantly erode the value of assets
and most investors will be concerned about the increase (or decrease) in the purchasing
power of their investments.
Real returns are calculated by adjusting nominal returns to take account of inflation (nominal
returns ignore inflation).
The real return is approximately the nominal return from an investment minus the inflation
rate and the formula is:
RREAL = RNOM – RINF
where
RREAL is the real return
RNOM is the nominal return
RINF is the inflation rate

Example 4.13
An investment generated a return of 11% over the past year and the inflation rate was 3%
over the same period. The approximate real return is:
RREAL = RNOM – RINF = 11% – 3% = 8%
The investment generated an approximate real return of 8%.

Example 4.14 considers expected returns as opposed to historic returns.

Chapter 4 The principles of the time value of money 4/11

Example 4.14
An adviser forecasts that inflation over the next year will be 2.5%. His client has a long-
term target of achieving real returns of 4%. Based on his inflation forecast, the adviser
realises he will need to generate an approximate nominal return of 6.5% to achieve the
target return over the next year. The approximate nominal return can be found by
rearranging the equation as follows:
RNOM = RREAL + RINF
RNOM = 4% + 2.50% = 6.50%

Chapter 4
 4/12 R02/July 2018 Investment principles and risk

Key points
The main ideas covered by this chapter can be summarised as follows:

Time value of money

The relationship between present and future values.
• The formula linking present and future value is FV = PV (1 + r)n, where FV is the future
value, PV is the present value or principal invested, and the principal is invested for n
periods at an interest rate r.
• To calculate the PV of a future sum of money we need to discount, and the FV formula is
rearranged to give:
PV = FV/(1 + r)n.
• To calculate the future value of series of regular payments we use the formula

FV = P ⎨
( )
⎧ 1 + r n − 1⎫
⎪ ⎪
⎬
Chapter 4

⎪ r ⎪
⎩ ⎭
where P is the regular payment.
• The general formula to find the effective annual rate (EAR) of interest is:
EAR = (1 + r/n)n –1, where r is the nominal rate of interest and n is the number of
conversion periods or frequency of interest payments each year.
• The EAR is also referred to as the annual percentage rate (APR) or annual equivalent
rate (AER).

Real returns versus nominal returns

• The real return from an investment is the return after adjusting for inflation.
• Real returns are important for an investor since they represent the increase (or
decrease) in the purchasing power of their investment or portfolio.
• The formula linking real and nominal returns is: RREAL = RNOM – RINF,
where RREAL is the real return, RNOM is the nominal return and RINF is the inflation rate.
Chapter 4 The principles of the time value of money 4/13

Question answers
4.1 FV = £5,000 × (1 + r)n
= £5,000 × (1.04)5
= £5,000 × 1.22
= £6,083.26
Please note that you should use the full values as shown on your calculator when
doing this calculation. The figures shown in this example have been rounded to two
decimal places, where appropriate, for presentation purposes.
4.2 Effective rate = (1 + r/n)n – 1
= (1 + 0.06 ÷ 52)52 – 1
= (1.0012)52 – 1

Chapter 4
= (1.0618) – 1 = 0.0618
Effective rate is 6.18%
Please note that you should use the full values as shown on your calculator when
doing this calculation. The figures shown in this example have been rounded to four
decimal places, where appropriate, for presentation purposes.
 4/14 R02/July 2018 Investment principles and risk

Self-test questions
1. A lump sum of £20,000 is invested at 3% per annum for five years. How much will
be accumulated at the end of five years?
2. Interest is payable monthly at a (nominal) rate of 6% a year. What is the annual
effective rate (AER)?
3. Which of the following building societies offers the more favourable rate?
Building Society A pays 5.70% annual interest, compounded half-yearly.
Building Society B pays 5.65% annual interest, compounded monthly.
4. What amount has to be invested to accumulate £10,000 at the end of three years at
an annual interest rate of 2%?
5. If the nominal rate of return on an investment is 6% and inflation is 3%, what is the
approximate real rate of return?
Chapter 4

You will find the answers at the back of the book

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Chapter 4
 Nature and impact
5
of the main types of risk
on investment
performance
Contents Syllabus learning

Chapter 5
outcomes
Learning objectives
Introduction
Key terms
A Main types of risk 5.1, 5.2
B Diversification 5.2
C Gearing 5.2
Key points
Question answers
Self-test questions

Learning objectives
After studying this chapter, you should be able to:
• discuss inflation and its potential impact on investment values;
• describe other types of risk – including interest rate risk, credit risk and currency risk;
• differentiate between market risks and operational risks; and
• describe gearing and its effect on increasing investment returns and risk.
 5/2 R02/July 2018 Investment principles and risk

Introduction
In chapter 7, we will discuss the investment advice process and the importance of
establishing the risk tolerance of a client as part of this process. However, in this chapter, we
consider the impact of risk on investment performance.

Key terms
This chapter features explanations of the following:
Credit risk Currency risk Diversification Event risk
Gearing Inflation risk Interest rate risk Liquidity risk
Operational risk Political risk Systematic risk Non-systematic risk

A Main types of risk

Risk is an
Risk is an unavoidable part of the investment process and is implicit in all investments; even
unavoidable part so-called ‘risk free’ investments are exposed to some risk. In this section, we consider the
of the investment
process
main types of risk that can affect investments.
Chapter 5

A1 Systematic versus non-systematic risk

Systematic and Risk can be categorised in different ways. The main types of risk are:
non-systematic
risk are also
covered in
• Systematic or market risk – the risk that there might be a reduction in expected returns as
chapter 3, a result of a fall in the stock market generally. For example, virtually all shares in the
section A4
London Stock Exchange fell during the global financial crisis.

Be aware
Market risk
Market risk is also called systematic risk and is measured by beta.

Activity 5.1
Look up the performance of the FTSE 100 and the FTSE All-Share over the last few years
to identify the scale of the fall that took place during the financial crisis and its subsequent
recovery; consider what risk this presents and where it might be acceptable to some
investors and not to others.

• Non-systematic or investment-specific risk – the risk that there might be a reduction in

expected returns as a result of some event or circumstance specific to a particular
company. The problems faced by BP in the Gulf of Mexico oil spill in 2010 is a good
example of investment-specific risk.

A2 Inflation risk
Inflation is a major consideration in the design of any investment plan.
The main measures of inflation that are widely quoted are the retail prices index (RPI), the
consumer prices index (CPI) and the CPI including owner occupiers’ housing costs (CPIH).

Table 5.1: Inflation measures

See chapter 2, RPI • RPI is a long-standing measure of UK inflation that historically has been
section E1 for used for a wide range of purposes, such as the indexation of pensions
more on inflation
and index-linked gilts.
• RPIX is RPI excluding mortgage interest payments and is used to
calculate income-related benefits.
• You should note that while the Office of National Statistics (ONS)
publishes the RPI each month, its designation as a national statistic has
been cancelled.
Chapter 5 Nature and impact of the main types of risk on investment performance 5/3

Table 5.1: Inflation measures

CPIH • CPIH is the most comprehensive measure of CPI, as it includes the
costs of owning, maintaining and living in your own home. CPIH
became the lead measure in ONS publications in March 2017.
CPI • The CPI is the inflation measure used in the Government’s target for
inflation of 2%.
• The CPI is used for increasing benefits and the State Pension.

A2A Cost of goods and services

The inflation rate is calculated each month by analysing changes in prices of over 700
separate goods and services in the UK. This basket of goods is reviewed annually to reflect
changes in the things we buy.
The CPIH twelve-month inflation rate was 2.7% in January 2018, unchanged from December
2017.

A2B Deposit-based investments

Those hardest hit by inflation have usually been investors in deposits and fixed-interest
securities, where inflation erodes the value of the capital and interest payments, in many
cases leading to negative real returns in an inflationary environment.

Chapter 5
The best long-term protection against inflation is thought to be provided by investment in
real assets, such as shares, property, infrastructure and commodities, but only over the long-
term. In the shorter term, inflation creates uncertainty and the potential for governments to
introduce restrictive economic policies, particularly if it is a result of overheating of the
domestic economy. Index-linked government securities can also give protection against
inflation in the long-term, although, in the short-term, their value is driven by market
sentiment and their inflation-proofing is only guaranteed if the stock is bought at issue and
held to redemption. Heavy demand for index-linked bonds can lead to negative real yields,
so investors buying in the secondary market will earn a return less than inflation if they hold
to redemption.

A2C Real asset protection

In theory, the protection offered by real asset investments exists because their values
generally move in line with inflation. In practice, however, the value of such assets can fall,
regardless of inflation. This is because it is usually necessary for someone to buy the asset
from the owner for the profit to be realised. Thus, liquidity and other factors can drive values.

Reinforce
The most obvious example of recent years has been UK house prices.
After surging in the mid-1980s, residential property prices fell sharply from 1989 onwards
in many parts of the country, even though general inflation was rising.
It was not until the mid-1990s that prices began to rise again, helped by lower interest
rates. From then to the financial crisis, property prices seemed to be on an ever-upward
rising trend. Price rises were in excess of inflation and the long period of growth led to an
asset price bubble that eventually burst.

A2D Causes of inflation

General inflation can be caused by many factors. In the past, it has been blamed on rising
demand fuelled by expanding money supply. This then leads to the following:
• bottlenecks in production cause prices to rise and imports to flood into the economy;
• government and the financial markets respond with rising interest rates;
• cuts in public expenditure, as well as tax increases to dampen down demand; and
• economy enters recession and prices steady or perhaps fall as the supply of goods and
services exceeds economic demand.
 5/4 R02/July 2018 Investment principles and risk

Some cycles are further exacerbated by external events such as:

• war or shortages, as occurred in the 1970s;
• prices of imported goods rising as overseas countries experience inflation and commodity
prices also increase;
• currency devaluation; and
• high wage demands, which can be affected by trade union policies.

Investor sentiment
Investor sentiment can also be an important contributor, especially as particular markets
can contribute to reach their peaks. There have been times when investors believed that houses,
inflation
technology shares, commodities, gold, antiques and even tulip bulbs could never drop in
value.

Be aware
Results over time
Over time, the net result of real asset investment has always been positive after peaks and
troughs have stabilised.

A2E Deflation
The reverse of inflation is deflation: a sustained fall in prices. The prospect of falling prices
gives an incentive to consumers to delay spending, because goods will be cheaper
tomorrow than they are today. This leads to lower sales and lower economic output as the
Chapter 5

manufacturers lose the incentive and the profitability in producing goods. This explains why
governments are very keen to avoid deflation and target steadily rising prices.

Reinforce
Deflation had a serious stagnation effect on the Japanese economy, which struggled with
falling prices for almost 20 years. More recent figures, including the latest for 2018, show
that the economy has shown continuing levels of improvement for the past twelve
months. The Japanese experience of deflation has proved a salutary lesson for the world’s
central bankers.

A2F Stagflation
Stagflation is a combination of ‘stagnant growth’ and ‘inflation’. Periods of stagflation have
tended to be short-lived, but they are a painful reminder that inflation is not easily managed.
Stagnant growth is a sign of weak business performance and usually rising unemployment.
The problem of stagflation cannot be resolved by simply raising interest rates (the usual
route to controlling inflation) as the economy is weak and businesses would suffer further
leading to more job losses. In addition, if house prices are falling, rising interest rates would
put further pressure on those already struggling.

Question 5.1
What investments might an investor consider including in their portfolio to give some
protection against inflation?

A3 Interest rate risk

This is a particularly important consideration for fixed income or floating/variable rate
securities.
When interest rates rise, the capital value of fixed-interest securities will fall. This is because
investors can get greater yields by switching to other investments that can reflect the
increase in interest rate.
Conversely, when interest rates fall, as they did during the financial crisis, investors in fixed-
interest securities see the capital value of their securities rise. This is because the bondholder
still receives a fixed return relative to the market, which is offering a lower rate of return
because of the fall in interest rate.
Chapter 5 Nature and impact of the main types of risk on investment performance 5/5

Interest rate risk is measured by duration. Modified duration is the measure of a sensitivity of
a bond or bond portfolio to a move in interest rates; a bond with a duration of five will move
by approximately 5% when interest rates move by 1% in the opposite direction. To reduce
the interest rate risk of a portfolio, a manager would reduce or shorten the duration of the
portfolio, typically by holding shorter-dated bonds or cash.

A3A Causes of interest rate moves

Interest rates can move due to a number of factors; some of these will affect short-term
rates while others will affect rates across the yield curve and the shape of the yield curve.
The key factors are:

The economic cycle Strong demand reflecting strong economic activity will push
up rates, whereas rates will be lower in a recession.
Government fiscal policy When the government plans to issue gilts to fund a deficit, this
will tend to push up medium- and long-term gilt yields.
Government monetary Quantitative easing will tend to reduce short-term rates and,
policy when the government is also purchasing long-dated bonds,
this will also impact on long-term rates.
Inflation expectations If inflation is expected to increase, this will push up longer
term interest rates, typically leading to a steeper yield curve.

Chapter 5
Preference for liquid In times of uncertainty, investors prefer to hold their money in
securities short-term securities, pushing down short-term rates.

A4 Credit risk
Credit risk is particularity important for investors in bonds or those placing deposits with
financial institutions.
There are a number of these types of risk: Types of credit risk
include: default,
downgrade, credit
Table 5.2: Credit risk spread and
counterparty
Default risk The risk that the value of a fixed-interest investment will fall
when other investors decide that the probability of default has
increased. The credit rating agencies issue ratings to assist
investors to assess the risk of a default.
Downgrade risk The risk that the market anticipates that a credit rating agency
is going to downgrade a bond. When a bond is downgraded, the
required return or yield rises to compensate the investor for the
greater risk; this means the price of the bond will fall.
Credit spread risk If investors become nervous, as they did in 2008, there is a flight
to quality. This means that bonds issued by corporates will tend
to underperform bonds issued by governments. This is a result
of a widening of credit spreads; the difference between the yield
of different grades of corporate bonds and government bonds.
Counterparty risk This is the risk that a counterparty will not pay what it is obliged
to on a bond, derivative, trade or other transaction. Any product
or investment that has a derivative counterparty (structured
products, for example, where a third party provides the
guarantees) is exposed to counterparty risk.

A newer type of risk that is becoming increasingly important is bail-in risk

risk.
 5/6 R02/July 2018 Investment principles and risk

Be aware
Bail-in risk
Compared to a bail out, where a government or central bank bails out a financial
institution that is in financial difficulty – as we saw with the UK and US banks in the run-up
to, during and after the financial crisis – a bail in is where the financial assistance comes
from the existing capital base, i.e. the institution’s shareholders, bondholders and
depositors.
This was seen in early 2013, when bondholders in Cyprus banks and depositors with more
than 100,000 euros in their accounts were forced to write-off a portion of their holdings.
Since then, it was seen again with the restructuring of the Cooperative Bank in 2013 and
again in 2017.
With a bail in, those with money in the bank may see their balance reduced, which is at
odds with the basis of a bank account being 100% secure. It also has a potential impact on
the compensation provided by the Financial Services Compensation Scheme.

The concept of bail in has been discussed by the Financial Stability Board and it may be used
in the event of a future financial crisis because the cost of financial assistance may need to
be met by the institution, not the government.

A5 Currency risk
Chapter 5

Where an investment is made overseas by a sterling-based investor, there is the risk that
sterling may appreciate against the overseas currency.

Example 5.1
If sterling is strong against the US dollar, any capital growth can be eliminated from
investment in US markets, and the value of dollar dividends in sterling terms is eroded.

Currency risk can also affect an investment in individual securities. If you invest in a company
that is dependent on exporting its product and the currency where the goods are
manufactured appreciates, it will affect the profitability of the company. Similarly,
depreciation of a local currency will increase the cost of imports.

A6 Liquidity risk
Asset classes such
This is the risk which is faced by investors when they are forced to sell a security at a price
as private equity below its fair value due to lack of liquidity. Asset classes such as private equity and property
and property can
be particularly
can be particularly illiquid.
illiquid

A7 Event risk
Event risk is similar to default risk and refers to the issuer of a security being unable to pay
interest or repay capital due to a major unexpected event such as a natural disaster, a
corporate change such as a takeover or a regulatory change.
It also includes natural catastrophe risk, including earthquakes, hurricanes, floods or
industrial accidents.

A8 Political risk
This describes the risk that a new or changed government will have different fiscal and
monetary objectives, including a decision to make major changes to the taxation system.

Question 5.2
List six other major risks that affect investments, in addition to inflation risk.
Chapter 5 Nature and impact of the main types of risk on investment performance 5/7

A9 Operational risk
Operational risk factors look at risks that arise from the investment process. They include:
• settlement or counterparty risk – the counterparty to a transaction may fail to settle;
• fraud – this can be internal or external fraud including misappropriation of funds;
• misrepresentation – misleading reports and valuations;
• systems failure;
• trading – trading errors and unauthorised trading;
• staff errors; and
• regulatory risk.

B Diversification
No investment is entirely risk free. Index-linked gilts, which offer inflation protection, are
considered to be the safest form of investment, while speculative unlisted shares would be
considered one of the riskiest.
The most important strategy for reducing risk is diversification.

How it works

Chapter 5
Spreading risk
The risk of holding just one company’s shares is greater than the risk in holding shares in
40 companies. In the single-share portfolio, the company’s failure can lead to total loss; in
the 40-share portfolio, the maximum potential loss from the failure of a single company is
2.5% of the portfolio. The single-company portfolio is more common than might be
imagined, mainly because of employee share incentive schemes and privatisations.

The advantages of diversifying a portfolio are:

• it reduces the risk of any one particular investment;
• it spreads the opportunity for potential return across asset classes;
• it minimises the risk of the overall portfolio suffering a significant downturn; and
• it increases the possibility of stable returns through all economic cycles.
Diversification can take place on a number of levels:
• At the highest level, diversification across the main asset classes is looked at first: cash,
bonds, commercial property, commodities and equities. Generally, these do not all
perform in the same way, so a spread of investment within them provides a degree of
protection against the main types of risk and can smooth out overall returns.
• Equity investments can also be spread across world markets. Although the correlation
between markets has risen over the last decade, individual world stock markets do not
necessarily follow each other, and so can offer risk-reducing advantage.
• Investors can also spread their holdings across the UK market to avoid overreliance on a
particular sector. For example, a portfolio consisting of only bank shares will offer little
protection if bad debt levels rise. Diversification across sectors will reduce non-systematic
risk.
 5/8 R02/July 2018 Investment principles and risk

C Gearing
Gearing, or leverage, is borrowing money in a client’s portfolio with the objective of
increasing exposure to other assets, often equities. Gearing will magnify positive and
negative portfolio returns.

Example 5.2
The effect of gearing
An investor has £5,000 to invest in ABC shares trading at £2.50. She is convinced that the
share price is going to rise and decides to borrow an additional £2,500 to allow her to buy
a total of 3,000 shares instead of the original 2,000.
A month later, the share price has risen by 20% to £3.00 and the investor realises a profit
of £1,500 (3,000 shares × £3.00 − £7,500 = £9,000 − £7,500) on her original investment
of £5,000, a gain of 30%. However, if the share price had fallen by 20% to £2.00, she
would have lost £1,500 or 30% of her original investment.
On top of this, there will also be a cost for borrowing the £2,500, which will reduce the
gains and increase the losses.

While gearing may appear attractive to clients who are targeting high returns, the high
potential returns must be balanced against the greater level of risk or volatility of returns. In
many cases, this level of risk will be unacceptable to clients.
Chapter 5
Chapter 5 Nature and impact of the main types of risk on investment performance 5/9

Key points
The main ideas covered in this chapter can be summarised as follows:

Main types of risk

• Systematic risk is market risk, whereas non-systematic risk refers to investment-specific
risk.
• Inflation is a major risk for investors; particularly those invested in cash deposits or fixed-
income investments, which are not index-linked. Real assets such as property, equities
and commodities provide some long-term inflation protection.
• Interest rate risk is measured by duration. Fixed-interest securities will lose value when
rates rise and vice versa. Fixed-interest securities are also subject to credit risk.
• Investors buying securities outside their base currency are taking on currency risk.
• Other risks are liquidity risk, event risk, political risk and operational risk.

Diversification
• Diversification refers to combining investments in a way that reduces the overall risk of a
portfolio.
• Diversification can be carried out at asset class or geographic level or by holding a
diversified portfolio of securities within a single market.

Gearing

Chapter 5
• Gearing increases risk by magnifying losses or gains made in a portfolio when the
underlying security price moves.
 5/10 R02/July 2018 Investment principles and risk

Question answers
5.1 An investor might consider:
• index-linked gilts; and
• assets that can provide long-term growth such as equities, property, infrastructure
or commodities which have generated positive real returns in the long-term.
5.2 The other major risks covered in this chapter are:
• interest rate risk;
• credit risk;
• currency risk;
• liquidity risk;
• event risk; and
• political risk.
Chapter 5
Chapter 5 Nature and impact of the main types of risk on investment performance 5/11

Self-test questions
1. Is inflation usually a major consideration for short-term investment?
2. What are the main risks that an investor should be aware of when investing in a UK
corporate bond?
3. Explain the five different types of credit risk.
4. If an investor borrows 25% of the cost of an investment, how much do they lose, in
percentage terms, if the value of the investment falls by 10%?

You will find the answers at the back of the book

Chapter 5
Chapter 5
 Characteristics, risks,
6
behaviours and tax
considerations of
investment products
Contents
6.1: Indirect investments – unit trusts, OEICs and investment trust companies
6.2: Other indirect investments including life assurance-based products

Chapter 6
Chapter 6
 6.1: Indirect investments –
6
unit trusts, OEICs and
investment trust
companies
Contents Syllabus learning
outcomes
Learning objectives
Introduction
Key terms

Chapter 6.1
A Collective investment schemes 6.2
B Unit trusts and OEICs: general characteristics 6.2
C Unit trusts 6.2
D Open-ended investment companies (OEICs) 6.2
E Unit trust and OEIC management services 6.2
F Offshore funds 6.2
G Closed-ended funds/investment trust companies 6.2
Key points
Question answers
Self-test questions
Appendix 6.1: Characteristics of retail and qualified investor
schemes (QIS)
Appendix 6.2: Investment trusts, OEICs and unit trusts
compared

Learning objectives
After studying this chapter, you should be able to:
• describe and analyse the characteristics, inherent risks, behaviours and tax considerations
of unit trusts, OEICs, offshore funds and investment trusts; and
• explain the advantages and disadvantages of direct investment in securities and assets
compared with indirect investment through collectives and other products.
 6/4 R02/July 2018 Investment principles and risk

Introduction
In this chapter, we will discuss, in detail, the characteristics of a range of indirect
investments, looking at characteristics such as their tax treatment and risks.

Key terms
This chapter features explanations of the following:
Approved securities Capital structure Depositary Dividend taxation
Equalisation Offshore investment Portfolio Reporting and non-
companies diversification reporting funds
Selling/bid price Single pricing Undertakings for Unit trusts
collective investment
in transferable
securities (UCITS)

A Collective investment schemes

Collective
Collective investment schemes are popular with investors for the following reasons:
investment
schemes are • they offer a good way to invest small sums of money, because the investor’s cash can be
popular with ‘pooled’ into a much larger fund;
investors
• professional fund managers make the underlying investment decisions;
• an investor can achieve a balanced portfolio because the fund managers invest in a
spread of investments;
• they offer the ability to pursue particular objectives or specialise in particular markets that
Chapter 6.1

an investor might otherwise avoid, e.g. income or growth funds, Far Eastern funds; and
• the individual investor’s risk is reduced by the wide spread of investments in the
underlying portfolio.

Be aware
Pooling of resources
The pooling of resources enables the scheme to invest in a wide spread of investments at
a lower cost than could have been achieved by individuals acting on their own. Investors
buy units or shares in the scheme and not the underlying investments of the fund.

B Units trusts and OEICs: general

characteristics
Unit trusts and open-ended investment companies (OEICs) are popular collective
investments and are often referred to as funds
funds.

Table 6.1: Characteristics of unit trusts and OEICs

They have the following • they allow the individual investor to participate in a large
characteristics: portfolio of shares with many other investors;
• units or shares are sold to investors, each unit representing
a small but equal fraction of a portfolio of perhaps 50 or 100
different shareholdings;
• the assets of a unit trust are held for investors by trustees
and are invested by managers;
• the assets of an OEIC are held by an independent
depositary; and
• there is generally an initial charge which covers setting up
costs and also an annual management fee. Where a fund
does not have an initial charge, an exit charge may be
applied.
Chapter 6 6.1: Indirect investments – unit trusts, OEICs and investment trust companies 6/5

There are many different types of fund:

• very general funds, covering most markets and types of security;
• very specific funds that concentrate on a particular market sector or type of security;
• some aim for a high income;
• some look for above average capital growth; and
• the many so-called ‘balanced’ funds which may look for a mix of both capital growth and
income.
Unlike investment trusts, unit trusts and OEICs are open-ended
open-ended. Units or shares can be Unlike investment
created or issued when investors invest and cancelled when investors dispose of their trusts, unit trusts
and OEICs are
holdings by selling them back to the fund manager. There is a direct relationship between open-ended
the unit or share price and the value of the underlying investments.

Be aware
Regulation
The Financial Conduct Authority (FCA) regulates the sale and marketing of unit trusts and
OEICs.

B1 Unit trust and OEIC sectors and categories

According to the Investment Association (IA), £1,217.4bn is managed in UK funds. There is a
huge variety of funds on sale (around 3,000) and, to allow investors to select a fund and
make effective comparisons, they are categorised within a fund classification system of over
30 sectors. Each sector is made up of funds investing in either similar assets, the same stock
market sector or in the same geographical region.
IA sector definitions

Chapter 6.1
The IA categories are divided into broad groups, each with a different investment focus:
• capital protection;
• income;
• growth;
• specialist funds; and
• those principally targeting an outcome.

Table 6.2: Investment Association (IA) sectors

• The IA, in consultation with its members, determines the sectors.
• Performance measurement companies such as Standard & Poor’s and Lipper Ltd rank
the performance of funds in each sector. The data is published in a range of weekly and
monthly trade publications.
• In general, the fund must have at least 80% or more of its assets invested in the relevant
sector to be included.
• To qualify as an income fund, each fund in the sector must achieve a yield of not less
than 90% of the relevant index (e.g. MSCI World Index or the FTSE All Share). Funds that
fail to do so will be removed from the sector.
• The criteria for membership of a particular sector are constantly reviewed in the light of
market developments and the launch of new types of funds.

Activity 6.1
Visit the IA’s website, www.theinvestmentassociation.org/fund-sectors/sector-
definitions.html and familiarise yourself with the categories and sectors.

B2 Investment strategy
The IA sector classifications give only a broad guide to a fund’s investment activity and
philosophy. Within each sector, there may be funds which invest in smaller companies,
recovery situations, ‘mid-cap’, blue chip, ethical investments, index-tracking funds and so on.
 6/6 R02/July 2018 Investment principles and risk

Index-tracking funds
‘Index-tracking’
‘Index-tracking’ funds aim to mirror the performance of a particular index as closely as
funds aim to mirror possible. Index trackers may follow the FTSE 100, the FTSE All-Share, the S&P 500, the
the performance of
a particular index
Nikkei 225 or any other index. If the fund is large enough, the managers may be able to
as closely as replicate the component shares of the index exactly; alternatives to this include sampling
possible
(stratification) and the use of a computerised model (optimisation).
Supporters of index-tracking argue that:
• relatively few managers consistently outperform the index against which they measure
their performance;
• outperformance by active managers is generally achieved by taking higher risks; and
• index-tracking funds generally make lower charges than actively managed funds.
Ethical funds
There is no specific IA categorisation for ethical funds, which mostly fall into the UK All
Companies or Global sectors. The funds’ investment strategy has tended to divide between
those that use negative screening criteria, e.g. no arms companies, and those that adopt
positive criteria, e.g. selecting companies in environmentally friendly industries.
The screening process has tended to drive ethical funds away from many large capitalisation
stocks. As a consequence, some funds are now considering a neutral approach, i.e. allowing
investment in companies that are neither positively harmful nor positively beneficial or, more
positively, in what are known as ‘socially responsible companies’.

Activity 6.2
Vigeo EIRIS is a leading provider of independent research into the environmental, social
and governance (ESG) performance of companies. You can find out more by visiting their
website at www.vigeo-eiris.com.
Chapter 6.1

B3 Investment risks
The risks involved vary according to the objectives of the fund:
• A gilt fund is relatively secure because of government backing and because gilts are not
generally volatile, although they can sometimes move sharply in times of changing
interest rates.
• A specialist fund, such as a mining fund, may be considerably less secure because of the
inherent volatility of the underlying shares. However:
– the wide spread of investments held in the fund should mean that investors will be
protected against the consequences of one individual share becoming worthless if a
company fails; and
– the wide spread of holdings also reduces the effect on the portfolio of dramatic gains
being produced by the success of one individual share.

B4 Investment powers and restrictions

A range of rules
A range of rules restrict the investment powers of authorised funds. These are designed to
restrict the ensure that each fund has a proper spread of investments (to spread risk) and that the
investment powers
of authorised
investments are realisable on demand. Their features are outlined below:
funds
• The FCA’s specialist sourcebook – Collective Investment Schemes (COLL) – sets out the
rules for establishing and operating authorised schemes in the UK, including the spectrum
of markets and types of securities in which funds can invest. These rules help in achieving
the statutory objective of protecting consumers by laying down minimum standards for
the investments that may be held. In particular, the proportion of transferable securities
and derivatives that may be held is restricted if those transferable securities are not listed
on an eligible market. The intention of this is to restrict investment in those that cannot be
accurately valued and readily disposed of.
Chapter 6 6.1: Indirect investments – unit trusts, OEICs and investment trust companies 6/7

Be aware
General limits for an individual fund
The general limits for an individual fund may also be laid out in the trust deed of a unit
trust, to be monitored by the trustees, and in the instrument of incorporation of an OEIC,
to be monitored by the depositary.

• The trust deed must contain a statement that the fund may invest in any securities or
derivatives market which is eligible under the FCA regulations. No other investment limits
need be contained in the deed unless it is intended that the fund should be subject to
narrower investment powers than those set out in the regulations.
• The detailed investment limits must be set out in the scheme particulars or prospectus of
the fund and must be no wider than the restrictions set out in the FCA regulations. The
trustee or depositary therefore monitors the investment limits to ensure the fund is being
managed in accordance with the trust deed instrument of incorporation, the scheme
particulars prospectus and the FCA regulations.

B5 Approved securities and eligible markets

Securities that are admitted to an official list in European Union (EU) Member States are
‘approved securities’ and managers may invest in those markets without further enquiry.
At least 90% of a securities fund must be in approved securities. Markets in non-Member At least 90% of a
States, and those in which securities are not admitted to official listing, must meet certain securities fund
must be in
criteria to qualify as an eligible market for a particular fund. The FCA places a duty on unit approved
trust managers and trustees, and on the authorised corporate directors (ACDs) of OEICs, to securities
ensure that the market is liquid and meets four other standards. These are that the market
must be:

Chapter 6.1
• regulated;
• operating regularly;
• recognised (e.g. by a statutory body or government agency); and
• open to the public.
The FCA requires firms to carry out an annual review of the non-EU markets they consider
eligible for each fund and, if necessary, update the fund’s scheme particulars in which the
eligible markets must be listed. Overseas markets may themselves impose restrictions.

B6 Diversification rules
There are rules to ensure that unit trusts and OEICs are sufficiently diversified. The FCA There are rules to
imposes an obligation on authorised fund managers in relation to undertakings for collective ensure that unit
trusts and OEICs
investment in transferable securities (UCITS) schemes. UCITS schemes are investment funds are sufficiently
established in accordance with the EU UCITS Directive and, once authorised, can be freely diversified
marketed to other EU Member States. They must ensure that, taking account of the
investment objectives and policy of the scheme as stated in the most recently published
prospectus, it aims to provide a prudent spread of risk. These diversification rules are
considered in Table 6.3.

Table 6.3: Diversification rules

• A retail UCITS fund investing broadly in securities, but which is not an index tracker, is
prohibited from holding more than 10% of the total value of the fund in the shares of any
one company:
– the fund can invest in only four separate shareholdings to the maximum 10% holding,
i.e. no more than 40% in aggregate;
– any other individual shareholding must not exceed 5% of the fund;
– in effect, the fund must have a minimum of 16 holdings. In reality, most unit trusts have
a pool of between 50 and 100 shareholdings; and
– UCITS schemes that are established as replicating tracker funds can hold up to 20% of
the value of the fund in the shares of one company and, where justified by exceptional
circumstance, up to 35%.
 6/8 R02/July 2018 Investment principles and risk

Table 6.3: Diversification rules

• UCITS funds are also prevented from overexposure to the fortunes of any one company
or group of companies by rules that prevent them from holding more than 20% of the
securities or money-market instruments issued by the same group. Additionally, where a
fund management group runs a range of funds, they cannot aggregate their voting
shares if it allowed them to significantly influence how a company does its business.
• Funds investing more than 35% in government fixed-interest securities (e.g. UK gilts)
issued by a single issuer are required to invest in at least six different issues of stock. No
single stock holding can exceed 30% of the value of the fund.
• UCITS schemes can hold up to 10% of the fund’s value in ‘unapproved’ (unlisted)
securities, and up to 20% can be in units of another collective investment scheme. Non-
UCITS schemes can hold up to 20% of the fund’s value in unapproved securities and
unregulated schemes, and up to 35% can be in units of another collective scheme. Such
schemes must satisfy the same authorised criteria as the scheme making the investment
and, if the former schemes are also operated by the same manager, they must be
constrained to investment in a stated geographic or economic sector.
• UCITS schemes and non-UCITS schemes can hold warrants without limit.
• Other than money market funds, unit trusts hold cash for liquidity and cash flow
purposes only, but may hold cash without limit during the initial offer period. Most fund
managers maintain around 5% of a fund’s assets in cash, although regulations impose no
limit or restrictions. In practice, IA sector rules prevent funds holding more than 20% in
cash.

B7 Borrowing
A retail UCITS
A retail UCITS scheme is not permitted to borrow on a permanent or continuous basis to
scheme is not ‘gear up’ its portfolio in the same way as an investment trust. However, it is able to borrow
permitted to
borrow on a
up to 10% of the value of the fund’s property on a temporary basis against known future cash
Chapter 6.1

permanent or flows, such as dividends, subject to certain conditions.

continuous basis
to gear up its A non-retail UCITS scheme is also allowed to borrow up to 10% of the value of the fund, but
portfolio
on a permanent basis, rather than the temporary basis that applies to retail UCITS schemes.
A qualified investor scheme (QIS) may borrow up to 100% of the net asset value of scheme
property, provided arrangements are in place to make sure borrowings are repaid on
demand.

B8 Authorisation of funds
Collective investment schemes that have been authorised by the FCA can be freely
marketed in the UK. The detailed framework for the authorisation and operation of collective
investment schemes (COLL) is contained within the specialist sourcebooks of the FCA
Handbook called Collective Investment Schemes (COLL) and Investment Funds (FUND).
FUND applies to fund managers that manage alternative investment funds (AIFs) such as
hedge funds and private equity funds. It sets out the requirements for AIF managers
including disclosure of information to investors, reporting obligations to the FCA and
implementation of risk management systems.
The FCA will only authorise schemes that are sufficiently diversified and that invest in a
range of permitted assets. Whilst some collective investment schemes are authorised, others
are unauthorised or unregulated funds. The FCA now refers to all unregulated COLL as
unregulated collective investment schemes. These unauthorised vehicles are perfectly legal,
but their marketing must be carried out subject to certain rules and, in some cases, only to
certain types of investor.
Chapter 6 6.1: Indirect investments – unit trusts, OEICs and investment trust companies 6/9

Reinforce
The terms UCIS and UCITS are very similar and so are easily confused. You should ensure
that you are clear about the difference:
• UCITS is a scheme that meets EU requirements and, once authorised, can be marketed
to retail investors across Europe. For example, the largest fund management groups
have funds that are set up in Luxembourg (or another centre in Europe) and are bought
and sold every day by investors in the UK.
• UCIS is an unregulated scheme and therefore cannot be marketed to retail investors in
the UK.

Useful website
See the FCA Handbook at www.handbook.fca.org.uk/handbook for the COLL and FUND
sourcebooks online

UCIS are described as unregulated because they are not subject to the same restrictions as
regulated schemes regarding their investment powers and how they are run. As a result,
there may be a greater risk of loss to the client and so they are generally considered a higher
risk investment. They may also not be covered by the Financial Services Compensation
Scheme (FSCS).
The FCA refers to UCIS as a type of non-mainstream pooled investment (NMPI) and banned Promotion of these
their promotion to the majority of UK retail investors in June 2013. Instead, promotion of riskier and often
complex fund
these riskier and often complex fund structures is restricted to sophisticated investors and structures is
high net-worth individuals. restricted to
sophisticated
The rules came into effect on 1 January 2014. investors and high
net-worth
individuals

Chapter 6.1
Table 6.4: Non-mainstream pooled investments
Investments The following investments are subject to marketing restrictions:
considered as NMPIs
• units in QIS;
• traded life policy investments;
• units in UCIS; and
• securities issued by special purpose vehicles (SPVs) pooling
investment in assets other than listed or unlisted shares or bonds.
Investments not A number of products fall outside of the marketing restrictions.
considered as NMPIs These include:
• exchanged-traded products;
• overseas investment companies that would meet the criteria for
investment trust status if based in the UK;
• real estate investment trusts (REITs);
• venture capital trusts (VCTs);
• enterprise investment schemes (EISs) and seed enterprise
investment schemes (SEISs), unless structured as UCIS; and
• SPVs pooling investment primarily in shares and bonds.

Firms still need to ensure promotional communications about these products are fair, clear
and not misleading. If advice is given, they must ensure any recommendation to invest is
suitable to the client.
The EU Transparency Directive
The Transparency Directive is EU legislation that was written into UK law in January 2007. It
provides a framework to govern the preparation of prospectuses for public offers of
securities and for the admission of securities to trading on regulated markets.
Its key innovation was the creation of a passport across the EU’s capital markets, allowing a
prospectus approved in one Member State to be valid across the EU. The Transparency
Directive sets out ongoing disclosure requirements that issuers must make once their
securities are admitted to trading. It also sets out rules that impose notification requirements
on both issuers and investors in relation to the acquisition and disposal of significant
shareholdings in companies.
 6/10 R02/July 2018 Investment principles and risk

The directive is designed to promote prompt and fair disclosure of relevant information to
the market and sets out specific sets of circumstances under which an issuer can delay
public disclosure of inside information.
In 2013, the European Council adopted the proposal for a directive to amend the
Transparency Directive to make regulated markets more attractive for raising capital for
small- and medium-sized issuers by simplifying certain obligations. Implementation of the
amended directive took place on 26 November 2015.

Useful website
For more information, visit the London Stock Exchange Group website:
http://bit.ly/2sSFcRN

The Alternative Investment Fund Managers Directive (AIFMD)

The AIFMD is EU legislation aimed to increase investor protection and reduce risk.
The scope of the AIFMD is broad and, with a few exceptions, covers managing and
marketing AIFs in or from the EU.
Its focus is on regulating the alternative investment fund manager (AIFM) rather than AIFs.
An AIF is a ‘collective investment undertaking’ that is not subject to the UCITS regime and
which includes hedge funds, private equity funds, retail investment funds, investment
companies and real estate funds, among others. The AIFMD establishes an EU-wide
framework for monitoring and supervising risks posed by AIFMs and the AIFs they manage,
and for strengthening the internal market in alternative funds. The directive also includes
new requirements for firms acting as a depositary for an AIF.
The aims of the AIFMD are as follows:
• To enhance supervisory practices among European Economic Area (EEA) competent
Chapter 6.1

authorities to prevent market instability and the build-up of systematic risk in the
European financial system.
• To improve investor protection.
• To foster efficiency and cross-border competition.

C Unit trusts
C1 Managers and trustees
The FCA defines the roles of the unit trust manager and the trustee, whose primary objective
is to protect the investor:
• This protection is ensured by a legally binding trust deed, made between the trustee and
the manager. A unit trust can only be constituted by the signing of a trust deed:
– the trustee legally holds the assets of the trust on behalf of unitholders, and
– the manager is responsible for the day-to-day running of the unit trust.
• The manager must be authorised to conduct investment business in the UK.
• The trustee must be regulated by the FCA.
• To be marketed publicly in the UK, the unit trust must be authorised by the FCA.

To be marketed C1A The trustee

publicly in the UK,
the unit trust must The trustee is usually a large bank or one of the major insurance companies. Trustees are
be authorised by formally required to be independent from the management group.
the FCA
The trustee
trustee’’s role
The key role of the trustee is to ensure that the investors’ interests are protected by:
• Checking that the manager’s actions are in line with the regulations, the trust deed and
the scheme particulars.
• Ensuring that the fund manager invests in accordance with the investment objectives of
the fund.
Chapter 6 6.1: Indirect investments – unit trusts, OEICs and investment trust companies 6/11

– The trustee has the ultimate power to replace the manager if the manager goes into
liquidation, insolvency or receivership, or if the trustee believes that the manager is not
acting in the unitholders’ best interests.
– The trustee would have to remove the manager if a majority of unitholders voted for
the removal.
• Holding or controlling the holding of the assets, ensuring that they are safely held by a
competent custodian.
The trustee is the legal owner of the trust’s assets and is often the custodian for the trust’s The trustee is the
underlying securities and cash. The securities are registered in the name of the trustee, and legal owner of the
trust’s assets
all income is collected and held by the trustee. The trustee must report to its regulator if it is
not satisfied that the trust is being managed in accordance with the regulations. In addition,
the trustee’s responsibilities include:
• Arranging the auditing of the trust and issuing financial statements to unitholders.
• Monitoring the calculation of unit prices, both for sale by the managers to the public and
for repurchase by the managers from the public.
• Arranging meetings of unitholders.
• Setting up a register of unitholders and issuing certificates, if appropriate.
• Distributing the income of the trust to unitholders.
• Making any additional provisions necessary for the trust to be recognised as a pension
scheme or charitable scheme.

Question 6.1
Trustees of unit trusts are usually what type of organisation?

Chapter 6.1
C1B The manager
The manager agrees to manage the trust in return for an annual management fee, usually The manager
between 0.5% and 1.5%, depending on the type of fund. agrees to manage
the trust in return
The manager
manager’’s duties for an annual
management fee
The manager is required under the regulations to:
• be an authorised person;
• have adequate financial resources;
• manage the assets of the trust in accordance with the regulations, the trust deed and
scheme particulars;
• supply information to the trustee when requested;
• maintain a record of units for inspection by the trustee; and
• notify the trustee and/or the FCA if it has breached any rules while running the trust.
The manager
manager’’s functions
The manager is usually responsible for promotion, advertising, selecting investments and
fund administration, but other groups may also be involved.

Be aware
Subcontracting
It has become increasingly popular for a manager to subcontract administration to a
specialist third-party company.

The manager may also select a third party to decide how the fund should be invested. For The manager may
example, a building society may promote a fund where the investment management is also select a third
party to decide
contracted out to a separate fund management company, which in turn selects a third party how the fund
to handle day-to-day administration. However, in the interest of investor protection, the should be invested
manager retains responsibility for the actions of such providers, and for their compliance
with the regulations.
 6/12 R02/July 2018 Investment principles and risk

Consider this
this…
…
A manager may switch trustees. The upheaval caused by such a move means that
switches usually take place only when forced, say, by the acquisition of one fund
management group by another.

C2 Registration
It is the duty of the trustee to establish and maintain a register of unitholders, although this is
an activity it can delegate. In practice, the register is usually run by the manager or the third
party administrator, although the trustee continues to be responsible for the delegated
activity and will, in the interest of investors, monitor its maintenance.

Be aware
Contents of the register
The register is conclusive evidence of the investor’s title to the units and must contain the:
• name and address of the unitholder;
• number of units of each type held by the unitholder; and
• date on which the holder was registered.

Under FCA regulations, the manager and trustee must take all reasonable steps to ensure
that the information on the register is up-to-date and complete at all times.
The trustee must make the register available for inspection by unitholders free of charge at
all times during normal office hours, although the register may be closed by the trustee for
periods of not more than 30 days in any one year.

C3 Certificates
Chapter 6.1

It has become increasingly common for the manager and trustee not to issue certificates.
Instead, investors receive a periodic statement detailing the number of units they hold, and
the value. If issued, certificates must show the:
• date;
• name of the scheme;
• names and addresses of the manager and the trustee;
• number and types of units held by the unitholder; and
• name of the unitholder.

C4 Reporting
Unit trusts are
Unit trusts are required to publish annual and half-yearly reports.
required to publish
annual and half- The content of the manager’s report is set out in the Statement of Recommended Practice
yearly reports (SORP) for unit trusts. A statement of total return (capital and income), with details and
charges, must be shown in the notes to the accounts. Managers are allowed to issue short
form accounts, provided full accounts are available for unitholders on request.

C5 Unitholder rights
Unitholder rights are protected at three levels:
• by trustees − who safeguard the fund’s assets, are the legal owners of those assets and
ensure that the manager is complying with the trust deed, the scheme particulars and
regulation;
• by the regulatory organisations set up under the Financial Services and Markets Act
2000 − to ensure investor protection; and
• by the complaints and arbitration procedures − which enable unitholders to seek redress
either through the regulators or through the independent ombudsman.
Chapter 6 6.1: Indirect investments – unit trusts, OEICs and investment trust companies 6/13

C6 General
The trust deed and the scheme particulars together establish the scope within which a unit Trust deed and
trust can operate. Any material changes a manager may wish to make to the trust deed, e.g. scheme particulars
together establish
a merger of trusts, must be approved at a meeting of unitholders held for that purpose: the scope within
which a unit trust
• The typical trust deed sets out the management charges of a trust. If a manager wishes to can operate
raise charges, unitholders have to be given reasonable notice, which must not be less than
60 days.
• A trustee who considers that unitholders are at risk has the power to remove the
manager, although such an action is extremely rare.
• A manager cannot be removed without the approval of the FCA. The manager must notify
the FCA of any proposal to replace the trustee.
If the management group running the trust goes into liquidation, the assets of the trust are
protected by the trust structure.

C7 Taxation treatment of the unit trust fund

Authorised unit trusts are principally subject to the corporation tax regime, but only in Authorised unit
respect of income. For investors, this has the important effect of allowing annual trusts are
principally subject
management expenses to be offset against income other than UK equity income for tax to the corporation
relief purposes, provided that there is sufficient interest or foreign dividends. tax regime, but
only in respect of
There are a number of important modifications to the usual corporation tax regime that income

apply to authorised unit trusts, mostly for the benefit of individual investors. Unit trusts do
not pay tax on any capital gains nor on income or gains derived from options or futures.
Different tax regimes apply, depending on the composition of the investments in the fund.

Chapter 6.1
Rates
• Funds with less than 60% of their assets in interest-bearing securities, i.e. equity funds
that pay dividend distributions, pay corporation tax at 20% on income received in the
form of overseas income, rent or interest.
• UK dividends are received by a unit trust as franked investment income and flow through
to dividend distributions payable by the unit trust with no tax liability.
• Funds with more than 60% of their assets in interest bearing securities pay an interest
distribution which is deductible for corporation tax purposes, i.e. there is no UK
corporation tax liability.

C8 Equalisation
A unit trust regularly receives income from the underlying investments of the fund, and this Unit trust income is
is usually distributed to unitholders half-yearly. When an investor buys units, the price of usually distributed
to unitholders half-
each unit includes the income that has accrued in the fund from the previous distribution yearly
date up to the date of purchase.
The first distribution a unitholder receives consists of the income that has accrued from the
date of purchase up to that distribution date, together with an equalisation payment, which
represents the income that was included in the price paid for the units.

Be aware
Equalisation payment
The equalisation payment represents a partial refund of the original capital invested and is
not subject to income tax. As it is a return of the initial price paid, it must, however, be
deducted from the purchase price of the units to identify their acquisition value for CGT
purposes.

The aim of equalisation payments is to:

• achieve a broad fairness between unitholders in the apportionment of the income
received by a trust during its accounting period; and
• allow the same pence per unit dividend payment to be made to all unitholders, although,
for the new unitholder, part will be taxable and part will be tax-free.
 6/14 R02/July 2018 Investment principles and risk

C9 Income allocations and distributions

The net income of a unit trust must be allocated, i.e. applied for the benefit of unitholders,
and is usually distributed at least annually. Most funds make distributions twice a year, some
quarterly and income funds often monthly. Income may also be retained in the fund and
added to the capital for the benefit of holders of accumulation units.
Income distribution vouchers detail how an allocation is broken down between franked and
unfranked income and equalisation. Equity funds make a dividend distribution and bond
funds make an interest distribution.

C10 Taxation treatment of the investor

Both the income tax and CGT positions need to be considered.
Income tax on distributions – dividend distributions from equity unit trusts
These are subject to income tax in the same way as dividends from shares. The first £2,000
of dividend income in this tax year is tax free. Sums above that will be taxed at 7.5% for
basic-rate taxpayers, 32.5% for higher-rate taxpayers and 38.1% for additional-rate
taxpayers. Taxpayers must use self-assessment to pay any tax due.
Dividend distributions paid to trustees
When equity funds are held within a discretionary trust, the trustees are liable to pay income
tax at 38.1% on the distribution received (i.e. the same rate as an additional rate taxpayer).
The £2,000 tax-free dividend allowance does not apply to trustees although dividends that
fall within the standard rate band of £1,000 will only be taxed at 7.5%.

Example 6.1
Unit trust position £
Income 100.00
Chapter 6.1

Less corporation tax (20.00)

Distributable income 80.00
The first £2,000 of dividend income in this tax year is tax-free. For investors
receiving more than £2,000, the position is as follows:
Non-taxpayer and basic-rate position £
Dividend 80.00
Tax due at a rate of 7.5% 6.00
Higher-rate taxpayer position £
Dividend 80.00
Tax due at a rate of 32.5% 26.00
Additional-rate taxpayer position £
Dividend 80.00
Tax due at a rate of 38.1% 30.48
You should note that unit trusts and OEICs are subject to a special rate of corporation tax
(20%).

Interest distributions from non-equity unit trusts

Be aware
Interest distributions
To pay interest distributions, a unit trust or OEIC must hold at least 60% of its investments
in interest-bearing investments, such as gilts and corporate bonds.

• These distributions are paid gross (since 6 April 2017).

• A basic-rate taxpayer can earn up to £1,000 in savings income tax free. Higher-rate
taxpayers are able to earn up to £500, but there is no allowance for additional-rate
taxpayers. This is called the personal savings allowance (PSA).
Interest distributions paid to trustees
When gilt and corporate bond funds are held within a discretionary trust, the trustees are
liable to pay income tax at 45% on the distribution received (although those received within
the standard rate band of £1,000 are taxed at 20%).
Chapter 6 6.1: Indirect investments – unit trusts, OEICs and investment trust companies 6/15

Reinvestment of dividends and interest

If the dividend or interest is reinvested in the unit trust or OEIC in accumulation units, it still
counts as income for the investor. It will be subject to the same tax treatment as income that
is distributed.

C11 Capital gains tax (CGT)

Internal capital gains within an authorised unit trust are exempt from tax.

Consider this
this…
…
This means that disposals of investments by the unit trust can usually be made without
any tax liability.

Capital gains tax (CGT) may be payable on any profits made by a taxpayer who disposes of CGT may be
units. The profit is calculated in the usual way: payable on any
profits made by a
• the original acquisition cost is deducted from the sale proceeds; taxpayer who
disposes of units
• any losses can be deducted;
• unrelieved losses can be carried forward indefinitely;
• units held on 31 March 1982 are deemed to have an acquisition cost equivalent to their
market value on that date;
• there is an annual exempt amount of £11,700; and
• the taxable gain remaining after the annual exempt amount has been deducted is taxed at
10% or 20%, depending on other income for the year.

Example 6.2
Anna invested £10,000 in the ABC unit trust in May 1988 and cashes in her holding in July

Chapter 6.1
2018 for £31,522. Her gain is calculated as follows:
£
Disposal proceeds 31,522
Less acquisition cost (10,000)
Gain 21,522
Less annual exempt amount (11,700)
Taxable gain 9,822
The gain will be taxed at 10% or 20% depending on Anna’s other income for the year.

Gains or losses are realised by disposing of units. Usually disposals are made by selling units,
but gifts are also disposals for the purposes of CGT.
You should note that if a unitholder does receive an equalisation payment, this would be
shown on their dividend voucher at the end of the first distribution period. This is treated as
a return of the initial price paid and it should therefore be deducted from the acquisition
price when calculating the chargeable gain on eventual disposal.

Be aware
CGT planning
CGT planning consists of making disposals to use the annual exempt amount or, in some
cases, capital losses.

A ploy used in the past to realise gains or losses without changing the units held was to sell
and buy back the following day – known as ‘bed and breakfasting’. The rules now are such
that a sale and repurchase within 30 days is ignored.
 6/16 R02/July 2018 Investment principles and risk

Bed and breakfasting is therefore no longer effective unless there is an interval of at least 30
days between the sale and repurchase, which would usually involve an unacceptable level of
risk. Some factors to consider:
• Alternatives for investors who want to retain existing investments after realising a gain or
loss include:
– selling units and buying back within an individual savings account (ISA);
– selling units and arranging for a spouse or civil partner to buy them back; or
– selling and repurchasing another very similar unit trust.
• If an OEIC is an ‘umbrella fund’ with a number of sub-funds, a switch from one sub-fund to
another is a disposal for CGT purposes. However, a ‘fund of funds’ unit trust or OEIC is
exempt from CGT on switching its underlying holdings.

C12 Tax elected funds

TEFs are required
From 1 September 2009, AIFs can elect to be treated as a tax-elected fund (TEF). TEFs are
to make two types required to make two types of distribution of the income they receive – a dividend and a
of distribution of
the income they
non-dividend (interest) distribution. The intention of the TEF regime is to move the point of
receive: dividend taxation from the TEF to the investor, so they are taxed as if they had invested in the
and non-dividend
(interest)
underlying assets directly.
Under normal tax rules, income from UK dividends and most foreign dividends is exempt
from corporation tax in the hands of the TEF. Any other income (such as interest) must be
distributed as a non-dividend, for which the TEF will be entitled to receive a deduction up to
the same amount to off-set the taxable income that would ordinarily be liable to corporation
tax. UK investors are then treated as receiving distributions of UK dividend income and
distributions of interest.
Chapter 6.1

C13 Distributions
Unit trusts can pay
One of the most popular reasons for investing in unit trusts is that they can pay an income
an income and and also offer the potential for capital growth. Generally, the income largely comes from
offer possible
capital growth
dividends on shares and interest on stock:
• The unitholder can choose the dates when income may be received by investing in a
range of unit trusts with a spread of distribution dates.
• Alternatively, the income can be used to increase the unitholder’s investment by way of
either accumulation units or income reinvestment plans. However, the income still counts
as income of the investor and is taxable in the same way as income that is distributed.
• Income is paid net of expenses, usually including the manager’s annual charge. The
unitholder is sent a notification of income, including a tax voucher.

Be aware
Changes made to FCA regulation
Following changes made to regulations, some unit trusts now deduct charges from the
capital, thereby enhancing the quoted yield, but reducing capital performance. Unit trusts
that follow this practice must include a prominent statement reflecting this policy in all
scheme documentation. They must also state the risk to the growth of the capital as a
result.
Chapter 6 6.1: Indirect investments – unit trusts, OEICs and investment trust companies 6/17

C14 Income and accumulation units

Many trusts allow the unitholder to choose between receiving income and reinvestment by
offering income and accumulation units.
Accumulation units
These add all the income produced from the underlying investments, net of any tax (if
applicable), into the investor’s holding. Relative to income units, the unit price increases to
reflect the retained income.
Income units
These pay out the income of the unit trust to the investor. The price of income units Income units pay
(sometimes called distribution units) will therefore be lower than that of accumulation units. out the income of
the unit trust to the
For instance: investor

• Income funds may consist solely of income units.

• Equity growth funds may only have accumulation units.
• Mixed distribution/accumulation funds also exist, in which case there will be two unit
prices quoted in the press, one labelled ‘Acc’ or ‘Accum. Units’ and the other ‘Inc’.
• In the absence of accumulation units, the manager may offer a facility to automatically
reinvest income to buy more units, which are then added to the unitholder’s investment.
This has the potential disadvantage that the unitholder may pay all or part of the initial
charge on the new units, but it is increasingly favoured by managers and investors.

C15 Impact of allocations on unit prices

As income comes into the fund and the accounting date approaches, the unit price rises to
reflect this.

Chapter 6.1
• When the accounting date is passed, the price is marked ‘xd’ (i.e. ex-distribution) and then
the price of income units usually falls by the amount of the income.
• The xd period may not be more than four months after the end of each annual or interim
accounting period.
• If unitholders sell their units during an xd period, they still get the allocation attributable to
the previous period, while buyers will not.

C16 Link to ISAs

A unit trust can be held in an ISA. This allows it to benefit from the exemption from CGT on A unit trust can be
any realised gains: held in an ISA

• The full ISA allowance can be invested in qualifying unit trusts within a stocks and shares
ISA, either by lump sum or regular savings.
• Virtually all unit trusts qualify as investments for a stocks and shares ISA. Cash funds also
qualify as investments for a cash ISA.
• All UCITS schemes are qualifying investments for stocks and shares ISAs.

ISAs are covered

C17 Charges in section G16

There are generally no extra charges for investing in a unit trust ISA offered by the manager,
beyond the usual charges that apply to the unit trusts themselves. There may be a reduced
initial charge, but an exit charge applies on the surrender of units within the initial period of,
say, five years.

C18 Process of buying and selling

There is usually a minimum holding requirement of £500 or £1,000 in each fund, which is set There is usually a
by each management group. Holdings can be purchased in single or joint names. minimum holding
requirement of
Many groups also offer monthly savings schemes, often linked to an ISA. Savings schemes £500 or £1,000 in
each fund
usually begin at around £50–£100 per month. There is no maximum investment limit
because unit trusts are ‘open ended’, creating or cancelling units according to demand.
 6/18 R02/July 2018 Investment principles and risk

Investors can buy or sell in several different ways; by phone, online, by completing an
application form (to buy) or renunciation form (to sell), or by dealing through an authorised
financial adviser.

Consider this
this…
…
• A deal handled over the phone is as legally binding as a written deal.
• Once the deal has been made, the management group immediately sends a contract
note. This shows the fund, the number of units involved in the transaction and any other
levies on the transaction.
• Investments made on an application form must usually be accompanied by the
payment.
• Phone and online applications usually require payment once the contract note has been
received by the client or adviser.

Investors must be supplied with a Key Investor Information Document detailing the main
aspects of the fund and the associated charges and expenses, before the transaction to
purchase can be executed.

C19 Selling
To sell units, an order is placed with the management group, which will then issue a contract
note. For instance:
• If the investor holds a certificate, they must sign the renunciation form on the back of the
certificate and forward it to the manager.
• For non-certificated holdings, an investor may be required to sign a separate form of
renunciation if a signed written instruction has not been sent.
Chapter 6.1

• The manager is obliged to make payment no later than four business days after receipt of
the signed documentation.
• Where investors only wish to sell a portion of their investment, the renunciation form
should indicate how many units they wish to sell, or the amount of cash they wish to raise.
• If certificates are issued, then the management group will issue a new certificate for the
holding balance.

C20 Share exchange facilities

Share exchange
Share exchange schemes are offered by a number of unit trust management groups. These
schemes allow allow investors to exchange existing shareholdings in public companies for an equivalent
investors to
exchange existing
value in the fund’s units.
shareholdings in
public companies A share exchange scheme can be a cheaper and simpler way of disposing of a small holding
for an equivalent of shares than selling through a stockbroker, as the unit trust manager may offer
value in the fund’s
units advantageous terms to swap the shares for units:
• The unit trust manager may either accept shares in lieu of payment and absorb the shares
into one of the group’s funds, or dispose of the shares and apply the proceeds to buy units
in a fund.
• Usually a share exchange scheme will have a minimum holding for a share and/or a
minimum total value of a portfolio that it will accept. Most set a minimum at around
£1,000, and prefer blue chip listed stocks to overseas and unlisted stocks.

Be aware
Tax position
A share exchange scheme does not exempt the investor from CGT considerations:
• selling shares by a share exchange scheme is still a disposal for CGT purposes; and
• the investor can expect to pay tax if the gain on disposal exceeds their CGT annual
exempt amount.
Chapter 6 6.1: Indirect investments – unit trusts, OEICs and investment trust companies 6/19

C21 Pricing and valuation

Each unit in a unit trust represents a proportional share of the property of the scheme. The Each unit in a unit
valuation of units is achieved, in broad terms, by valuing the underlying securities and cash trust represents a
proportional share
held by the fund, adjusting for income and charges, and then dividing by the number of units of the property of
in existence. Unit trust managers are required to calculate unit prices in accordance with the scheme
FCA regulations. Under COLL, this means ‘fair value pricing’ on a basis described in the
scheme’s prospectus. Managers may elect to operate under single-pricing or dual-pricing
regulations.
Dual-priced unit trust features:
• For dual-priced unit trusts, the FCA formula determines:
– the highest price at which units can be sold to investors; and
– the lowest price at which the manager can repurchase units from investors.
• The manager may create additional units to satisfy demand or may cancel existing units
redeemed from investors. In this way, a unit trust, unlike an investment trust, is ‘open
ended’ and can expand or contract depending on market conditions.
The manager will value the capital and income property of the scheme on a buying-and-
selling basis, which will produce the creation and cancellation value of the fund. The
manager will calculate the selling or bid price and buying or offer price for investors from
these values. Most unit trust managers quote both prices, and the selling or buying price will
be applied to the deal depending on the type of transaction:
• the investor buys units at the higher buying or offer price;
• the investor sells units back to the manager at the lower selling or bid price; and
• the difference between the prices is known as the ‘bid–offer spread’. This includes the
initial charge.

Chapter 6.1
Single pricing features
Unit trust managers can elect for ‘single pricing’ using mid-market prices for the underlying See section D4
for more on single
investments; incoming and outgoing investors deal at the same price, with any charges pricing
being disclosed separately. It is also possible for a unit trust manager to operate swinging
single prices.

C22 The buying and selling prices calculation

Unit trust managers have to calculate unit prices according to FCA regulations. The Unit trust
following explains the traditional dual pricing basis. managers have to
calculate unit
The buying or offer price prices according to
FCA regulations
To calculate the maximum buying price the managers:
• take the market buying value of the underlying securities at the published valuation point;
• add on the costs of buying securities in the market;
• add on all the other property of the trust, such as un-invested cash and any accrued
income less tax, fees, charges and expenses;
• divide the total by the number of units issued; and
• add on the initial charge and express the price to four significant figures.
 6/20 R02/July 2018 Investment principles and risk

Example 6.3
Buying price calculation Pence
Lowest market dealing offer price
Value of assets per unit, e.g. 50.0000
Add brokerage (0.25%) 0.1250

50.1250
Add accrued income 0.7250

Creation price 50.85

Add initial charge (6%) 3.051

53.901
Express to four significant figures to give the maximum buying or offer 53.90p
price per unit

Selling or bid price

To calculate the minimum price at which the managers will buy back the units, the managers:
• value the underlying securities at the best market selling prices;
• deduct the dealing costs that would be incurred if the securities were to be sold;
• add in any uninvested cash;
• add any accrued income after deduction of any annual management fees, trustees’ fees,
audit fees and outstanding tax;
• divide the total by the number of units in issue; and
• express to four significant figures.
Chapter 6.1

Be aware
Selling or bid price
This is also the ‘cancellation price’ receivable by the manager from the fund if they choose
to cancel units they have repurchased.

Example 6.4
Selling price calculation Pence
Highest market dealing bid price
Value of assets per unit, say 49.0000
Subtract brokerage (0.25%) (0.1225)

48.8775
Add accrued income 0.7250
49.6025
Express to four significant figures to give the minimum 49.60p
selling or bid price per unit (or cancellation price)

Bid
Bid––offer spread
The bid–offer spread is the difference between the buying and selling prices, expressed as a
percentage of the buying price and includes:
• dealing costs; and
• initial charges.
The bid–offer spread will vary depending on the type of assets held within the unit trust, and
can be anything from a few basis points on very liquid assets, such as UK gilts, to 5% or more
on assets that are more difficult to buy or sell, such as property, or equity investments.
Chapter 6 6.1: Indirect investments – unit trusts, OEICs and investment trust companies 6/21

This is usually in the range of 5% to 7% for equity funds, however:

• no-load index trackers (i.e. funds without an initial charge) have a narrow spread – often
less than 1%;
• smaller companies and emerging markets funds have a relatively high spread because of
the underlying market – the spread may be 10% or more, depending on the initial charge;
and
• some cash funds have no spread at all.
There is a range of funds between these extremes. To help the fund manager control
liquidity, the trust deed often gives them the right to vary the bid–offer spread to reflect
market conditions.
Maximum spread
The maximum permitted spread (the difference between the maximum buying price and the
minimum selling price calculated according to the FCA rules) is usually greater than the
spread operated by the managers, although, in practice, it will depend on the demand for
units:
• when one unitholder is selling and another investor wants to buy, there is no need for
managers to sell any of the underlying assets and incur the dealing costs;
• if a unit trust manager is a net seller of units, the units can be priced towards the ‘offer
end’ of the range; and
• if the manager is a net buyer, there will be costs and the units will be priced at the ‘bid end’
of the range.
Offer basis
If demand is high, the manager will set the buying price at the offer end of the spectrum, i.e.
the full price to create a unit plus the initial charge. This is what is meant when a trust is said
to be on an ‘offer basis’.

Chapter 6.1
Investors coming into the fund will pay the maximum price, and investors choosing to
redeem will get a relatively good price for their units, which the manager typically sets at
their normal spread down from the offer price.
Bid basis
Conversely, if demand is low, and more units are being redeemed than being sold, the
manager will choose a selling price at the bid end of the range, i.e. the price of cancelling
units.
In this case, the trust is priced on a ‘bid basis’. Investors choosing to purchase will pay a
relatively low price for their units, which the manager sets at their usual spread up from the
bid price. Sellers will get the minimum price for the units they redeem.
The manager can therefore move the pricing basis of a trust in line with the level of demand. The manager can
It also means that spreads quoted in newspapers are not always followed. For example, a move the pricing
basis of a trust in
large purchase of units could cause a trust to shift to an offer basis when it may previously line with demand
have been on a bid basis.
The box
Investors buy and sell units via transactions with the manager who may hold units in the
‘box’. The box may be made up of created (new) units or units that have been repurchased
from investors.
‘Box management’ is the term used to describe the stock control mechanism applied by
managers in the buying and selling of units. For instance:
• Where a fund is expanding because investors are buying units, the manager will create
units at the creation price.
• Where a fund is contracting, when there are more sellers than buyers, the manager will
cancel units at the cancellation price.
• The decision to hold units in the box is made by weighing up the risk of the market turning
and expected future demand.
The manager can match buyers and sellers in general two-way business. A manager can sell
on units at a price lower than it would be possible to create them and buy back units at a
price higher than it would receive to cancel them. This benefit can be passed on to the
potential buyer or seller.
 6/22 R02/July 2018 Investment principles and risk

Box management was at one time a significant source of profit for unit trust groups, but the
holding of large boxes is now out of favour.
Single pricing
Unit trusts may
Unit trusts may quote a single price in the same way as OEICs. This should not be confused
quote a single with those trusts that have the same bid and offer price, but create and cancel on a dual
price
(as per OEICs)
price basis.
The valuation point
The manager is required to carry out regular valuations of the property of the unit trust
scheme under the FCA regulations.
Most unit trusts are valued daily and the ‘valuation point’ is the time of day that the manager
carries out the valuation. The manager can decide the frequency and the time of day at
which to value the fund. The frequency of the valuation must be detailed in the fund’s
scheme particulars.

Question 6.2
Before you leave this section, can you recall what is meant by the ‘bid–offer spread’?

C23 Forward and historic pricing

Unit trusts may
Unit trusts may be priced on either a forward or historic basis. The manager can decide the
be priced on either basis on which it will deal:
a forward or
historic basis • forward: at the price to be calculated at the next valuation point; or
• historic: at the price calculated at the last valuation point.
Forward pricing
Chapter 6.1

When an investor buys on a forward pricing basis, they will pay the price that will be
calculated at the next valuation point.
For cash investments, the exact number of units purchased will be unknown at the time of
the deal. It is also impossible to predict the number of units that will be sold where an
investor has asked to raise cash by selling units back to the manager.
On a forward pricing basis, the manager must create enough units at the valuation point to
cover any deals taken since the last valuation point.
Managers operating on an historic pricing basis must move to a forward basis if the value of
the trust is believed to have changed by 2% or more since the last valuation, and if the
investor requests it.

Be aware
Usual practice
Most managers deal on a forward basis.

Historic pricing
When working on the traditional historic pricing basis, the manager creates a stock of units
at the valuation point based on the expected level of sales until the next valuation point.
They then sell them at the known historic price.
If they run out of units, the manager must either move to a forward basis or continue on an
historic basis, and risk losing money if the market moves unfavourably. They must create
units to cover the oversold position at the next valuation point, when the creation price may
rise.
The advantage of historic pricing is that small investors can be offered a known price when
they place a deal.
There have been concerns, particularly for overseas equity funds, that a transaction does not
fully reflect the value of the underlying shares, which may have moved substantially since
the fund was last valued. This may be to the advantage or disadvantage of investors buying
or selling. The FCA has addressed these concerns in COLL, with rules that require ‘fair value
pricing’.
Chapter 6 6.1: Indirect investments – unit trusts, OEICs and investment trust companies 6/23

C24 Charges
Investors in unit trusts may incur different types of charges as follows:
• Initial charge – this may be made when the investor first invests in a fund. It is usually a
percentage of the amount invested and varies depending on the type of fund. Many funds
do not now make an initial charge.
• Annual management fees – these are charged to cover the ongoing costs of the
management and administration of the fund.
• Performance fees – some funds have performance fees.
• Exit charges – these are sometimes imposed instead of initial charges and are paid if the
investment is sold within a certain period of time. This can be on a sliding scale over five
years, at the end of which it disappears.
• Other charges can also be made such as legal and audit fees, and fees for specialist For more
information on
advice – these can have an impact on performance and so funds must publish an ongoing charges see
(OCF). An OCF enables investors to have a clearer picture of the total
charges figure (OCF) chapter 8,
section F2
annual management charge involved in running an investment fund, together with other
operating costs such as fees paid to the trustee, auditors and registrar.

D Open-ended investment companies

(OEICs)
OEICs are now the main type of open-ended fund found in the UK. They are also referred to
as investment companies with variable capital (ICVCs).
The underlying legal structure is a company. However, they differ from conventional
companies because they are not established under the Companies Acts but under different

Chapter 6.1
legislation. This allows them to have share capital that can expand and contract to meet
investor demand:
• Individual investors’ assets are pooled together in a centrally managed fund, which is then
invested on a collective basis. The assets are valued on a net asset value (NAV) basis, like
a unit trust.
• Funds can be established as retail and non-retail UCITS, and as QIS.
• The investors’ interests in the fund are represented by shares in the fund company (very
much like units in a unit trust, but without conferring beneficial ownership of the fund’s
assets).
The regulatory structure is broadly as follows:
• an OEIC must be authorised by the FCA if it is to be marketed in the UK;
• the OEIC is operated by its board of directors, which may comprise a single ACD;
• the assets of the OEIC must be held by an independent depositary;
• the ACD and the depositary must be authorised persons, i.e. regulated by the FCA; and
• sales and marketing are mostly regulated by the FCA through the Conduct of Business
Sourcebook, and the non-life disclosure and cancellation rules apply.
In addition to the regulations which govern the establishment and conduct of the OEIC,
further operating regulations are set out in the FCA’s sourcebooks FUND and COLL.

D1 Product structure
An OEIC is not an investment trust or a trading company. It also differs from a unit trust in a
number of ways including:
• It is a self-contained company which has its own constitutional documents and holds an
annual general meeting.
• It can be a stand-alone fund, or it may take the form of an ‘umbrella’ company, with a
number of sub funds, each with its own investment objectives.
• All sub funds of a scheme that is an umbrella must adopt the same pricing basis, i.e.
forward or historic.
 6/24 R02/July 2018 Investment principles and risk

• It issues shares rather than units and different share classes may be issued with different
charging structures and/or currencies.
• It appoints directors, including the ACD.
• An independent depositary is required to safeguard its assets and must be an authorised
person.
• Annual audited accounts are issued.
• The costs of its creation may be met by the fund.

Single pricing is
• Single pricing is usually used, although single or dual pricing can be adopted by the ACD.
usually used in the • Like a unit trust there is a limit on borrowing, which must be temporary (for a UCITS retail
case of OEICs
fund) and not exceed 10% of the fund, so it cannot gear up like an investment trust.

D2 Fund management and administration

The OEIC
The OEIC equivalent of the unit trust manager is the authorised corporate director (ACD),
equivalent of the who is responsible for:
unit trust manager
is the ACD • OEIC’s compliance with investor protection requirements, as set out in FCA regulations;
• maintaining a register of shareholders;
• day-to-day management issues such as valuation, pricing and dealing;
• preparation of accounts; and
• management of investments.
The depositary
The depositary is an independent authorised person who is responsible for overseeing the
management of the OEIC in relation to investor protection. Including:
• valuation, pricing and dealing in OEIC shares;
Chapter 6.1

• collection of income and authorising the payment of income distributions;

• ensuring the ACD correctly exercises the investment and borrowing powers; and
• safekeeping of assets.
Reporting to holders
An OEIC’s scheme operator:
• must report to holders twice a year – once at the interim stage (unaudited) and once at
the annual stage (audited);
• must produce reports that comply with the OEIC’s SORP;
• may issue short-form accounts; and
• must make available full accounts, if requested.

D3 Link to ISAs
OEICs can be held in ISAs in the same way as unit trusts.

D4 Single pricing
Investors buy shares in their chosen fund and the value of each share of the same class
represents an equal fraction of the value of the securities and other assets in that fund. Thus,
each share price reflects the total net value of the fund’s assets related to that share class,
divided by the number of those shares in issue – the NAV per share.

Example 6.5
If the OEIC holds a portfolio of securities worth £25 million and there are 10 million shares,
the NAV per share is £2.50. When a fund uses single pricing, there is no bid–offer spread.

The assets contained in the OEIC are valued at:

• their mid-market price where there is a market dealing spread in the assets themselves
(e.g. shares); and
• the only price if that is all that is available from the relevant market.
Chapter 6 6.1: Indirect investments – unit trusts, OEICs and investment trust companies 6/25

When single pricing of shares is used, the single mid-market price makes no allowance for
market dealing costs and any charges are shown separately (added or deducted) on
investors’ contract notes.
If an OEIC adopts a dual pricing policy, the shares will be priced in the same way as a dual
priced unit trust.
Where single pricing is used, shares are purchased from the ACD at the single price plus an See section C22
for more on the
initial charge to cover sales and management expenses. For instance: buying and
selling prices
• A charge called the dilution levy can be added to the single price on share purchases or calculation
deducted from the price on redemptions at the ACD’s discretion. The dilution levy is paid
to the OEIC to cover dealing costs and the spread between the buying and selling prices
of the underlying investments. It can be applied if there are unusually large inflows or
outflows of funds. The levy goes to the fund, not the managers. There are no FCA rules
about the precise application of the dilution levy and practice varies greatly between
funds, but the policy will be stated in the prospectus.
• Shares are redeemed or issued by the OEIC at the request of the ACD at the single price.

Be aware
Dealing costs
The FCA allows OEICs and single-priced unit trusts to collect dealing costs that have been
incurred as a result of investor transactions from investors when they invest or redeem
funds through a swing (adjustment) to mid-market price. This avoids the need for dilution
levies. Fund managers may choose to adopt the swinging-price mechanism, or continue
to use the existing dilution-levy mechanism.

Dealing and management

Dealing in OEICs is much the same as unit trust dealing. The ACD issues a contract note for Dealing in OEICs is

Chapter 6.1
each trade and may also issue a share certificate. much the same as
unit trust dealing
OEICs are allowed to issue bearer certificates, which are convenient for some investors (e.g.
non-UK domiciled shareholders).

D5 OEIC advantages
There are several advantages to OEICs:
• For the investment industry, the most important advantage is that this type of open-
ended fund structure is the most widely recognised type of collective investment in
Europe: OEICs are capable of being marketed internationally in a way that is virtually
impossible with unit trusts.
• The OEIC regulations permit multiple share classes, which allow more flexible charging
and currency structures than are possible with unit trusts; although COLL allows different
classes of units or shares for all types of funds.
• The OEIC structure allows management groups to offer umbrella funds. These give the The OEIC structure
investor a choice of funds covering a range of investment objectives, each sub-fund allows
management
offering or issuing a different class of share within the company. So switches between groups to offer
funds become a simple matter of share exchange, often at nil cost. umbrella funds

• From the manager’s viewpoint, the umbrella structure also makes it easier to create new
funds, the interest in which is represented by another share class.

D6 Taxation of OEICs
The tax position of OEICs is basically the same as for unit trusts: The tax position of
OEICs is basically
• Corporation tax is payable by the OEIC on income received according to its source the same as for
(interest, dividends or income from overseas), less chargeable expenses of management. unit trusts

As mentioned in the section on the tax treatment of unit trusts, annual management
expenses can be offset against interest or foreign dividends, meaning that annual charges
are effectively tax relieved, provided there is sufficient income.
• Dividends paid by OEICs are treated in the same way as distributions from unit trusts.
Dividends are paid without deduction of tax. Interest payments from fixed-interest funds
are paid gross.
 6/26 R02/July 2018 Investment principles and risk

• Internal gains within an OEIC are exempt from CGT.

• Personal CGT liability can arise on the sale of an OEIC or a switch in the class of shares
held, where this involves a change of sub fund.

E Unit trust and OEIC management services

E1 Multi-manager products
Most fund
Most fund management groups now offer at least one multi-manager product. These allow
management investors to spread their money between different managers or different funds, so that they
groups now offer
at least one multi-
can achieve greater diversification than if they had invested in just one fund.
manager product
The two main types of multi-manager categories are:
• fund of funds
funds, which invest directly into funds managed by other managers; and
• manager of managers funds
funds, which appoint specialist investment managers to look after
different parts of the portfolio to a particular brief.

E1A Fund of funds

A fund of funds
A fund of funds service invests in a selection of funds and the fund of funds can be either
can be either ‘fettered’ or ‘unfettered’:
‘fettered’ or
‘unfettered’ • A fettered fund of funds only invests in funds run by the same management group.
• An unfettered fund of funds is not obliged to invest solely in internal funds and can select
from any fund and management group.
In-house fund of funds may not levy an additional annual charge on top of the fees of the
underlying fund. External fund of funds usually have the additional expense of the charges of
Chapter 6.1

the underlying fund. This additional cost is not added to the initial or annual fees of the fund
itself, but is instead taken from the fund’s assets. Most management groups are able to
negotiate a rebate on these charges, or they may purchase an institutional class of unit or
share that has significantly lower dealing and management costs, and no commission.
The fund of funds provider selects the individual funds and monitors their performance, with
the aim of maintaining a balance between them and maximising returns. If it becomes
necessary to change the exposure within the fund, a manager can do this by selling and then
purchasing a new underlying fund.

Be aware
Fund of funds structure
The fund of funds structure provides a CGT shelter, because switching between funds by
the manager does not create any CGT liability.

E1B Manager of managers funds

Manager of managers funds owe their heritage to the world of institutional investment,
where a fund manager appoints several investment managers, each with a specific
management style, to manage a part of the portfolio:
• the overall fund manager will decide on an appropriate asset allocation for the fund;
• for each asset class, an external investment manager will be chosen to run that part of the
portfolio; and
• the overall fund manager is responsible for identifying competitive managers and
monitoring exactly what each of them is buying and selling.
The overall fund manager, through its custodians, has direct control over the fund’s assets. If
it becomes necessary to replace an existing investment manager, rather than having to sell a
fund and reinvest the cash, responsibility for asset management can be assigned to a new
investment manager. This avoids any difficulties in liquidating large holdings, and is a quicker
and more efficient way of making the transition.
Chapter 6 6.1: Indirect investments – unit trusts, OEICs and investment trust companies 6/27

Be aware
Costs of manager of managers fund
The costs of a manager of managers fund are more transparent than those of fund of
funds. The additional fees for the individual investment managers are not charged
separately to the fund, but are paid for from the annual management charge of the
manager of managers fund.

E2 Platform services
The platform market in the UK has evolved rapidly over recent years from a small and
relatively niche part of the financial planning landscape into a core part of many advisory
propositions.
A core purpose of a platform is to offer access to a wide range of investment funds or
collective investments. Different platforms offer access to different types of collective
investments including ISAs, self-invested personal pensions (SIPPs), pension contracts,
exchange-traded funds (ETFs) and investment bonds. The investor’s holdings are all shown
in a single account accessed online, enabling investors to view their total assets and asset
allocations, and the up-to-date value of their investments in one place.

Consider this
this…
…
From an adviser’s viewpoint, platforms can greatly simplify the administration of clients’
portfolios, as each client’s holdings can be consolidated into one account.

F Offshore funds

Chapter 6.1
Offshore funds are funds established outside the UK – usually in low tax areas. The funds are
collective investment vehicles structured like an OEIC.

F1 Background
Offshore funds, particularly those based in the Channel Islands and the Isle of Man, have a
long history in the UK. They have been sold to UK-resident and UK-domiciled investors, and
to UK expatriates and non-UK-domiciled individuals working in this country.
In recent years, a European element has emerged as ‘offshore’ funds have been established
in the EU tax havens of Luxembourg and Dublin. These can have marketing advantages over
many of their Channel Islands and Isle of Man counterparts, particularly in terms of sales
within the EU.

F2 Classes of recognised schemes

The FCA recognises offshore funds for marketing purposes in the UK. They are generally See section F5 for
information on
categorised under three different sections of the Financial Services and Markets Act 2000: the UK marketing
status
• Funds categorised as UCITS under EU legislation: receive ‘automatic’ recognition from
the FCA.
• Certain funds in ‘designated territories (s.270): a designated territory is one that the
territories’’ (s.270)
FCA is satisfied gives a UK fund investor the same protection as applies to authorised unit
trust investment. In practice, this means the offshore legislation, under which such funds
are authorised by their home states, is similar to the rules applying in the UK, and there is a
compensation scheme that is almost equal to its UK counterpart. Guernsey, Jersey, the
Isle of Man and Bermuda all have designated territory status.
However, not all funds from these countries are covered by the respective regulations and Not all funds from
FCA recognition, and there are generally three layers of fund: these countries are
covered by the
– those approved by the regulator for the territory and FCA recognised (s.270 schemes); respective
regulations and
– those approved by the regulator for the territory, but not FCA recognised; and FCA recognition
– those funds neither regulated by the territory, nor FCA recognised.
• Funds from outside the designated territories but recognised by the FCA in their own
right: this is on an individual basis and they are covered by s.272, the least used section.
right
 6/28 R02/July 2018 Investment principles and risk

Be aware
Classes of funds not recognised by the FCA
The two classes of funds not recognised by FCA are subject to severe marketing
restrictions.

F3 Types of scheme
With so many different offshore centres all with different legislation, there is no uniform
structure to offshore funds. Indeed, the structure of the fund may only become apparent on
close reading of the product literature.

F3A OEICs
Many of the
The basis of most offshore funds is very different from UK unit trusts, which have a similar
offshore funds structure in Europe known as the fonds commun de placement (FCP). Many of the offshore
marketed into the
UK are
funds marketed into the UK are constructed in a format that is similar to an OEIC and so their
constructed as structure is either an OEIC or ICVC. Investors are therefore buying shares in offshore
OEICs
companies, although the actual type of share held may be a participating redeemable
preference share, rather than an ordinary voting share.
The most common type of investment fund in Europe is the société d’investissement à
capital variable (SICAV). This is a type of investment company with variable capital and is
the model for the UK OEIC.
Umbrella funds
The OEIC structure allows management groups to offer umbrella funds. These give the
investor a choice of funds covering a range of investment areas, with each sector fund
offering or issuing a different class of share within the one company. Switches between
funds become a simple matter of share exchange, often at nil cost. This once offered a tax
Chapter 6.1

advantage to UK investors, which no longer exists. A switch between funds is now treated as
a disposal with an immediate potential tax liability for the investor.

Be aware
Umbrella structure
From the managers’ viewpoint, the umbrella structure makes it easier to create new funds,
the interest in which is represented by another class of share. OEICs also allow managers
to operate single pricing (i.e. there is no buying and selling structure), although this should
not be taken to mean that initial charges disappear. In practice, 5–6% is usually added as a
sales charge.

F3B Specialist funds

The more specialist
With fewer restrictions on investment, offshore funds can provide investment opportunities
(and speculative) that are not permitted for their UK unit trust counterparts. For example, some offshore funds
funds are usually
not FCA-
invest directly in commodities, while others are heavily invested in the options and futures
recognised and market. However, the more specialist (and speculative) funds are usually not FCA-
would not satisfy
UCITS rules
recognised and would not satisfy UCITS rules.

F4 Undertakings for Collective Investments in

Transferable Securities (UCITS)
Once an UCITS fund is authorised in its host country, it can be marketed elsewhere within
the EU, subject to the marketing rules of the other country being satisfied. In the UK that
means that an UCITS fund from, say, France, has to register with the FCA, and then wait for
two months before it can start marketing under FCA rules.

F4A UCITS Directives

The original UCITS Directive was issued in 1985 and established a set of EU-wide rules
governing collective investment schemes. Since then, further directives have been issued;
UCITS III broadened the range of assets in which a fund can invest, UCITS IV allowed funds
with authorisation in one country to operate throughout the EU and UCITS V included
amendments to remuneration principles, transparency obligations towards investors and
changes to the regime for depositaries.
Chapter 6 6.1: Indirect investments – unit trusts, OEICs and investment trust companies 6/29

A UCITS fund complies with the requirements of these directives, no matter in which EU
country it is established.

F5 UK marketing status
Funds with FCA recognition can be marketed in the UK in much the same way as authorised Funds with FCA
unit trusts. However, they may not be sold following cold-calling because cancellation rules recognition can be
marketed in the UK
do not generally apply. If the fund manager is not a member of a UK regulatory body, all in much the same
advertisements, including brochures, need to be approved by a member of a suitable way as authorised
unit trusts
regulator. For funds with UK parents, this will mean that the group’s UK marketing company
will provide approval.
Those funds without recognition are severely restricted by the Financial Services and
Markets Act 2000 regulations. In practice, they are primarily used within the UK by
intermediaries for established clients with appropriate discretionary management
agreements. The funds themselves cannot be publicly advertised except to investment
professionals.

See section B8
F6 Taxation treatment of investors for more on the
authorisation of
For UK taxation purposes, offshore funds currently fall into two categories: funds

• reporting funds; and

• non-reporting funds.

F6A Reporting funds

Tax treatment
Most UK resident and domiciled investors prefer reporting funds:

Chapter 6.1
• The main advantages of a reporting fund are that:
– dividends and interest are treated in the same way as UK-based funds, as previously
described in this chapter; and
– any capital gain on a sale is subject to the usual CGT rules.
• For investors to benefit from this CGT treatment, the fund must have retained reporting
status throughout the period of their ownership.
• Dividends from funds constituted as companies are taxed as foreign dividends. These are
subject to income tax in the same way as dividends from equities. The first £2,000 of
dividend income in this tax year is tax free. Sums above that will be taxed at 7.5% for
basic-rate taxpayers, 32.5% for higher-rate taxpayers and 38.1% for additional-rate
taxpayers. Taxpayers must use self-assessment to pay any tax due.
• Where an offshore fund holds more than 60% of its assets in interest-bearing securities,
any distribution will be treated as a payment of interest in the hands of a UK investor and
taxed at the following rates: 0% starting band, 20%, 40% and 45%. This income can be
offset against an individual’s PSA.
• A reporting fund does not have to distribute all of its income, but must report its income
to HMRC.
• The income need not be physically distributed, as the regime allows for deemed
distributions or a combination of physical and deemed distributions.
• A UK investor in a reporting fund will be taxed on their share of the income of the fund,
even if an actual distribution is not received.

F6B Non-reporting funds

Tax treatment
Non-reporting funds are usually roll-up funds, i.e. all income is accumulated and no Non-reporting
dividends are paid. funds are usually
roll-up funds
The gain on any disposal, including the death of the investor, is calculated on CGT principles
and is taxable in the year of encashment. However, the CGT annual exempt amount cannot
be used to mitigate the tax liability and the gain is taxed as income:
 6/30 R02/July 2018 Investment principles and risk

• For the UK resident and UK-domiciled investor, the gain is liable to income tax at the basic
rate, higher rate or additional rate, even though the gain may consist wholly or largely of
dividends.
• Roll-up funds can be used to shelter accumulated income, perhaps allowing the investor
to realise profits when their tax rate has dropped or they have become non-UK resident.
• For investors who are not resident in the UK, offshore income and gains will be free of UK
tax, but possibly taxed in their country of residence.
• Investors who are UK resident, but not UK domiciled, are taxed on an arising basis on all
UK or non-UK income and capital gains as they arise. They are only taxed on the
remittance basis if they fall into an excepted category or they pay the remittance basis tax
charge.
• Non-domiciled investors gain inheritance tax benefits by investing offshore. Their IHT
liability is based only on their UK assets, so offshore funds will escape the UK IHT net.

Be aware
A gain made on a non-reporting fund is calculated using CGT rules but actually taxed as
income.
Income tax rates are higher than CGT rates and the CGT annual exempt amount cannot be
used.

Question 6.3
Do most UK investors prefer reporting or non-reporting funds? Why is this?

F7 Taxation treatment of funds

Chapter 6.1

Although offshore
Although offshore funds are based in tax havens, the funds are not completely free of tax, as
funds are based in the following demonstrates:
tax havens, the
funds are not • If an offshore fund invests in equities, the dividends will usually be subject to a non-
completely free
of tax reclaimable withholding tax. This is a minor inconvenience where investment is in low-
yielding markets, but is a more significant loss in higher-yielding markets.
• Investments in fixed-interest securities will generally yield tax-free income because the
funds will choose securities, such as Eurobonds or gilts, which pay income gross. For the
UK resident investor, offshore fixed-interest funds are generally more tax efficient than
offshore equity funds.

Be aware
Taxation of offshore funds
The offshore funds may also be subject to a small amount of tax. For example, Jersey
funds are subject to a small flat annual corporation tax charge, whilst, under current
legislation, Luxembourg funds are subject to a tax of 0.05% per annum based on the
amount invested at the end of each calendar quarter.

F7A European Savings Directive (ESD)

The European Savings Directive (ESD) has, since 2005, allowed tax administrations better
access to information on private savers. The EU Directive 2003/48/EC was repealed by the
European Council on 10 November 2015, following a strengthening of measures to prevent
tax evasion. An overlap had developed with other legislation adopted at the end of 2014 and
the repeal eliminates that overlap.
Chapter 6 6.1: Indirect investments – unit trusts, OEICs and investment trust companies 6/31

EU Directive 2003/48/EC required the automatic exchange of information between Member

States on private savings income. This enabled interest payments made in one Member State
to residents of other Member States to be taxed in accordance with the laws of the state of
residence. In the UK, HMRC receive information about the savings income that individuals
receive from abroad from the tax authority of the country where the income is paid. They
will then compare that information with the information declared by the investor. Under the
directive, most EU Member States exchange information on savings held by non-residents.
However, a number of territories operate a withholding tax on savings income instead of
exchanging information. For EU residents, the withholding tax is currently deducted at
source at a rate of 35%. Any withholding tax that is deducted under the Directive may be
offset against other tax the individual has to pay, or can be reclaimed from HMRC if it
exceeds their total UK income and CGT liability.
This Directive was last amended in March 2014 to reflect changes to savings products and
developments in investor behaviour since 2005. The repeal meant that the 2014
amendments were not transposed by Member States.
The repeal was as a consequence of the adoption by the council in December 2014 of
Directive 2014/107/EU, amending provisions on the mandatory automatic exchange of
information. This directive implements the July 2014 Organisation for Economic Co-
operation and Development’s (OECD) Global Standard on automatic exchange of financial
account information within the EU with a scope covering not only interest income, but also
dividends and other types of capital income. Directive 2014/107/EU came into force on 1
January 2016 and is generally broader in scope than Directive 2003/48/EU.

F8 Underlying investments
In many ways, the underlying investment spread of overseas funds mirrors that of UK unit In many ways, the
trusts. A quick look through the categories covered in the financial press reveals that many underlying

Chapter 6.1
investment spread
offshore fund sectors are also to be found among authorised unit trusts. of overseas funds
mirrors that of UK
unit trusts
F8A Equities
There is a spread of UK and international equity funds, although UK funds do not generally
play the predominant role they do onshore. Other characteristics are:
• withholding taxes generally means that the investment emphasis of equity funds tends
towards growth rather than income;
• as the funds are targeted at a wide range of overseas investors, the international equity
choice is extensive; and
• as well as the general global international funds, there are single-country funds,
geographical sector funds and specialist sector funds, e.g. technology and commodity.

F8B Fixed interest

Many foreign investors favour bond investments and there is no shortage of offshore fixed- The biggest single-
interest funds. The major currencies (euro, dollar, yen, etc.) warrant a fund sector each, with bond fund sector is
international fixed
sterling being the largest. The biggest single-bond fund sector is international fixed interest, interest
which covers funds investing across the world’s bond markets.

F8C Currencies
An offshore sector that does not have a UK unit trust counterpart is the currency fund An offshore sector
sector. This sector has grown rapidly, offering international investors a tax efficient and cost that does not have
a UK unit trust
effective alternative to currency deposits with banks: counterpart is the
currency fund
• Many groups use umbrella funds for this market, with a range of sub-funds covering each sector
of the major and some minor currencies. Some groups aiming at UK investors offer two
series of funds: one reporting and the other non-reporting.
• Switching between funds is simple, quick and usually carried out at much finer exchange
rates than banks usually offer for small sums of currency. While the funds often end up
depositing money back with the banks, the larger amounts they deposit mean that the
interest rates they receive are typically higher than those most individuals could earn.
• In addition to single currency funds, some offshore groups also run managed currency
funds, which attempt to capitalise on changes in exchange rates.
 6/32 R02/July 2018 Investment principles and risk

F8D Fund denomination

Most offshore
Most offshore funds are denominated in a currency other than sterling. However, the
funds are denomination of the fund may be driven by the target audience, rather than by specific
denominated in a
currency other
currency considerations.
than sterling
For example, whilst one Japanese fund denominated in dollars may always invest directly
into Japan and never hedge currency risk, the other may hedge against the yen falling
against the dollar. For the fund that does not hedge, the currency of denomination is actually
irrelevant, as the investor is directly exposed to the yen. Often, the only way to discover the
fund’s approach to currency risk is to ask the fund managers.

F8E Specialist funds

Beyond these mainstream categories, a number of specialist funds can be found investing in
areas such as physical commodities, derivatives and warrants. These funds tend to fall
outside what the FCA will allow to be marketed in the UK.

G Closed-ended funds/investment trust

companies
Investment trust
Investment trust companies are among the oldest and most widely used types of collective
companies are investment. Investment trusts were first set up over 100 years ago to provide small investors
among the oldest
and most widely
who wanted to invest overseas with an opportunity to do so at a low cost, and to diminish
used types of their risk by spreading their investment over a number of stocks. They still fulfil this function
collective
investment
today, although investment trusts are also widely held by institutions.
They are a collective investment that pools the money of investors, spreading it across a
diversified portfolio of stocks and shares that are selected and managed by professional
Chapter 6.1

investment managers. Subject to any restrictions in their articles of association, investment

trusts can:
• invest in any kind of company, whether its shares are quoted on a stock exchange or it is
an unquoted, private company;
• provide venture capital to new firms or firms that want to expand; and
• invest in any country in the world.
There is a wide range of investment trusts offering exposure to different industries and
regions of the world. They have a variety of investment objectives, ranging from security of
capital with no income, to very high income with low capital security.

Question 6.4
Who do you think runs an investment trust?

G1 Main categories
The Association of Investment Companies (AIC) classifies investment trusts into various
main sectors such as property, specialist and VCT sectors, based on a combination of the
regional and industry focus of the portfolio. Different regions of the world and economic
sectors will have varying levels of risk:
• some areas of the world are more stable than others;
• some economic sectors can be more affected by unpredictable world events, such as
weather patterns; and
• overseas funds can be affected by currency fluctuations.

Activity 6.3
Visit the AIC’s website: www.theaic.co.uk and familiarise yourself with the various sectors.
Find an example of each.
Chapter 6 6.1: Indirect investments – unit trusts, OEICs and investment trust companies 6/33

G2 How investment trust companies work

Investment trusts are structured in the same way as normal companies and have a board of Investment trusts
directors and shareholders. They: are structured in
the same way as
• issue a fixed number of shares, hence they are described as closed-ended funds; and normal companies
and have a board
• are regulated by company law and their shares are traded on the London Stock Exchange. of directors and
shareholders
One of the advantages of their fixed capital structure is that managers can take a long-term
view with their investments. They do not have to sell their best holdings if investors want
their cash back in the way that unit trust managers are sometimes forced to do.
As public limited companies, investment trusts can borrow to ‘gear’ up.
An investment trust is run by an independent board of directors that is responsible for See section G11
for more on
looking after the interests of shareholders: gearing

• The directors may employ a salaried fund manager (or managers) directly, in which case it
is called a self-managed trust
trust.
• Nowadays, however, it is more common for the directors to employ, under contract, an
external management group to undertake the day-to-day investment management and
also to provide other services such as administration, registration and accountancy.

Be aware
Management groups
Management groups typically provide services to a range of different trusts and are
instrumental in setting up new trusts. However, they must appoint a majority of
independent directors to the trusts’ boards and this majority must be maintained under
the FCA regulations.

Chapter 6.1
The day-to-day running of the trust is in the hands of the managers, although they will Day-to-day
usually meet with the board on a regular basis to discuss investment policy. If the board is running of the trust
is in the hands of
unhappy with the progress of a trust, it can move it to another management group. the managers
Sometimes shareholders may also press for such a move to be made.

G2A Share price

Investment trust company shares are traded on the London Stock Exchange and the share
price depends on supply and demand in the market. The share price published in the
newspapers is the mid-market price, although dealers actually quote two prices:
• the higher, buying or offer price is the price at which investors can purchase shares; and
• the lower, selling or bid price is the price at which investors can sell shares.
The difference between the prices is known as the market makers
makers’’ spread or turn
turn. The
spread varies according to the supply and demand for the shares. Large, generalist trusts
have narrower spreads than smaller, specialist trusts, because there is generally more
demand and more stock availability in these trusts.

Consider this
this…
…
Buying and selling shares in investment trusts is exactly the same as buying and selling
any other shares quoted on the London Stock Exchange, although investors can often
deal more easily and cheaply through investment trust managers themselves rather than
having to use stockbrokers.

G2B Net asset value (NAV) per share

In principle, the net asset value (NAV) of an investment trust is equal to the total value of all
of the investments within the trust, less any liabilities that the trust may have.
 6/34 R02/July 2018 Investment principles and risk

Be aware
Calculating the NAV per share
It is calculated by taking:
• the total value of a trust’s listed investments at mid-market prices;
• plus its unlisted investments as valued by the directors;
• plus cash and any other assets;
• less the nominal value of loans, debenture stock and preference shares; then
• the resulting figure is known as the shareholders
shareholders’’ funds
funds.

The NAV of an investment trust is usually expressed as an amount per ordinary share. The
NAV per share is the available shareholders’ funds divided by the number of ordinary shares
in issue.

Example 6.6
If shareholders’ funds are worth £50 million and there are 25 million ordinary shares, the
NAV per share would be 200p. If an investment trust is wound up, shareholders receive
the NAV of their shares, after repayment of prior charges and the payment of wind-up
expenses.

Diluted and undiluted NAV

The simple approach used to calculate NAV can, however, give a misleading figure, as many
investment trusts have issued warrants or loan stocks with options to convert into ordinary
shares. Typically, these give warrant holders the right to subscribe for one ordinary share for
each warrant that is held, at a fixed price, within a specified period of time, and allow the
holders of convertible loan stock to convert into ordinary shares under specific terms and
conditions.
Chapter 6.1

The diluted NAV per ordinary share is calculated assuming that all of the outstanding
warrants and convertible loan stocks are exercised, something that the undiluted NAV figure
ignores. The result of the holders exercising their rights would be an increase in the number
of ordinary shares amongst which the assets are divided, but without a proportional increase
in the value of the trust’s assets.

Example 6.7
If a trust has ten million ordinary shares and two million outstanding warrants that give the
holders the right to subscribe at £1 per share, and the trust’s assets are worth £16 million,
the diluted NAV per share is calculated as:

Net assets plus money subscribed by warrant holders

Number of ordinary shares in issue plus new shares issued to warrant holders

£16m + £2m
= = £1.50 per share
10m + 2m
The undiluted NAV per share would be:

Net assets
Number of ordinary shares in issue

£16m
= = £1.60 per share
10m

G2C Discounts and premiums

Over the longer
Over the longer term the movement in a trust’s share price will reflect the progress of its
term, the investments. However, it is rare for the price to match the NAV per share exactly, since the
movement in a
trust’s share price
price is set by market demand for the shares.
will reflect the
performance of its Discounts
investments When the share price is lower than the NAV per share, it is described as trading at a discount
because shareholders are ‘buying’ the underlying assets at a lower price than they would pay
if they purchased the same investments direct. The discount is the difference between the
share price and the NAV per share, expressed as a percentage of NAV per share.
Chapter 6 6.1: Indirect investments – unit trusts, OEICs and investment trust companies 6/35

Example 6.8
For example, if the share price is 180p and the NAV per share is 200p, the discount is 10%.
Discounts arise when there are more sellers than buyers of the shares. In general, most
investment trust shares trade at a discount.

Premiums
If the share price is higher than the NAV per share, then the investment trust is said to be If the share price is
trading at a premium
premium. If the share price is 210p and the NAV per share is 200p, the premium higher than the
NAV per share, the
is 5%. This is rare, but can occur when there is a particularly high demand for an investment investment trust is
trust. said to be trading
at a premium

Be aware
Premiums and discounts
It is not necessarily a good thing to buy shares when they are trading at a discount, or a
bad thing to buy them when they are trading at a premium. It is the growth of the
underlying assets that will, over time, drive the share price.

G3 Investment performance
The performance of investment trusts is usually measured over various periods on the basis
of share price movements, taking into account reinvested income. This is the return to
shareholders.
An alternative basis for measurement is NAV return, including reinvested income. This shows An alternative
the performance of the trust’s investments and is a more accurate reflection of how skilfully basis for
measurement is
the investment managers have run their portfolio. NAV return,
including
Narrowing discounts

Chapter 6.1
reinvested income
When the popularity of an investment trust increases and demand for its shares rises, the
share price performance figures can show it in a particularly favourable light. Not only can
they reflect the increasing value of the trust’s investments, but the narrowing of the discount
helps to enhance the results. If the discount narrows during the period the investor holds the
shares, it provides a better return on the share price than on the underlying assets.

Example 6.9
If, at the beginning of a period, an investment trust has a share price of 86p and a NAV per
share of 100p, this means that it is trading at a discount of 14%, i.e.:

100p − 86p
× 100 = 14%
100p
Assuming its share price rises to 141p and its NAV to 150p, this means the discount has
closed to 6%, i.e.:

150p − 141p
× 100 = 6%
150p
Whilst the NAV per share has appreciated by 50% from 100p to 150p, the share price has
increased from 86p to 141p; and hence an investor’s return has been enhanced to 64% by
the closing of the discount.

Widening discounts
Widening discounts will have the reverse effect as they can reduce the gain an investor
could potentially receive. Worse still, if the stock market falls and discounts widen as well, an
investor’s losses will be greater than the reduction in the value of a trust’s investments. It
should, however, be noted that if an investor is not a ‘forced’ seller, any loss is only a paper
loss and not a ‘real’ loss until the shares are actually sold for cash.
Wider discounts can be regarded as buying opportunities by professional investors, who
may put pressure on managers to restructure a trust or convert it to a unit trust to overcome
the discount problem. Any such action, which results in the narrowing or disappearance of
the discount, gives investors an automatic gain.
If the discount is wide, then managers may also seek to buy back some of a trust’s shares to
reduce the oversupply and bring about a narrowing of the discount.
 6/36 R02/July 2018 Investment principles and risk

Question 6.5
If a share price is 210p and the NAV per share is 200p, are the shares said to be trading at
a discount or premium? What is the discount or premium?

G4 Regulation and approval

An investment trust company must conform to regulations laid down by the Companies
Acts, the FCA and HMRC.
Investment trusts themselves do not deal directly with the public. However, if a management
company or subsidiary company wants to sell the trust’s shares to the public through a
savings and investment scheme, then it must be authorised to carry on investment business
under the Financial Services and Markets Act 2000.

As a public limited
As a public limited company, an investment trust is formed under (and controlled by) the
company, an Companies Acts. When it is formed, the rules and objectives of the trust have to be laid
investment trust is
formed under (and
down in its memorandum and articles of association.
controlled by) the
Companies Acts The FCA lays down a number of principles for a company seeking a listing as an investment
trust, as follows:
• the investment managers must have adequate experience;
• there must be an adequate spread of investment risk;
• the company must not control, or seek to control, or be actively involved in the
management of the companies in which it invests;
• the trust must not, to a significant extent, be a dealer in investments; and
• the trust must have a board that can act independently of its management.
The FCA also requires that the company must seek HMRC approval under s.842 of the
Chapter 6.1

Income and Corporation Taxes Act 1988 1988. A company will usually want to do this anyway, as
HMRC approval means that a trust will not be liable for tax on the capital gains it makes from
sales of shares. To gain approval, the company must satisfy HMRC that:
• it is resident in the UK and is not a ‘close’ company (basically a company controlled by five
or fewer persons);
• the ordinary share capital is listed on the London Stock Exchange; and
• it does not retain more than an amount equal to 15% of gross income.

Be aware
Regulation and approval
Some investment companies registered offshore are managed in the UK and therefore
can qualify as investment trusts. These companies are listed on the London Stock
Exchange and have s.842 approval from HMRC. However, some companies marketed in
the UK do not have s.842 approval and investors need to check the tax situation with the
managers.

G5 Capital structure
Investment trusts
Investment trusts are generally divided into two types:
are generally
divided into two • conventional; and
types:
conventional and
• split capital.
split capital
These reflect differences in their capital structures.

G5A Conventional trusts

Conventional investment trusts issue one main class of equity share, known as ordinary
shares. These entitle investors to all of the income and capital gains produced by the trust
investments, subject to any borrowing or preference shares that have a prior charge.
Chapter 6 6.1: Indirect investments – unit trusts, OEICs and investment trust companies 6/37

Be aware
Conventional trusts
Conventional trusts are usually set up for an indefinite term and some are now over 100
years old.

G5B Limited life investment trusts

A number of the newer conventional trusts have started off with limited lives, after which
time shareholders are asked to vote on whether to wind up or continue the life of the trust,
typically by extending its life for three years at a time.
The benefit to investors of a limited life trust is that it helps to reduce the discount (the
difference between the share price and the net asset value).
In theory, as the winding-up date draws near, the discount will narrow because investors
could obtain the full value of a trust’s assets (after repayment of any prior charges, wind-up
expenses, etc.) if they voted to wind up the trust. However, there is no guarantee of this
happening. Nevertheless, the possibility of such a vote can help to keep the investment
managers on their toes.

Consider this
this…
…
It should be noted that, as with any public limited companies, shareholders can vote to
wind up an investment trust at any time.

G6 Split capital investment trusts

Like a conventional trust, a split capital investment trust has one portfolio of investments
that can produce both growth and income. However, it may have two, three or even four

Chapter 6.1
different classes of shares, which are entitled to different returns and are ranked in a
particular order of priority for repayment on a winding up. The different categories are
useful for investors looking for a particular type of return – growth or income, high risk or
lower risk.
Some split capital investment trusts also offer ‘units’, which are packages of its different
classes of shares that produce equivalent returns to an ordinary share in a conventional
trust.
Split capital investment trusts have a limited initial life span, which is typically five to ten
years. They can then be wound up and the different classes of shares repaid in order of
priority, assuming sufficient assets are available.
Shareholders are not locked into a split capital investment trust until the end of its life. They Shareholders are
can buy and sell the shares of splits at any time, just like conventional trusts. However, it is not locked into a
split capital
important to bear in mind a trust’s winding-up date, as this will influence the behaviour of its investment trust
share prices. until the end of its
life

G6A Redemption yields

The redemption yield measures the capital and income return on a particular share until
wind-up. It is expressed as an annual percentage, so that it can be compared with returns on
other forms of investment, such as building society deposits or gilt-edged securities.
A redemption yield of 7% on a share means that if the investor bought it at the quoted price,
and held it until the company is wound up, the value would have grown by 7% each year
between purchase and redemption.
Redemption yields for income, capital and other variable shares are based on assumed
growth rates of –2.5%, 0%, 2.5%, 5%, 7.5% and 10%.
The redemption yield shows the total return as an annual percentage. It assumes that the
shares are bought at the current price, held until redemption, and that the assets and
dividends payable (for share classes entitled to dividends) grow at the rate assumed.
The equity redemption yield shows a similar annual percentage rate, but bases the return on
growing only the equity portion of the portfolio, holding any cash and fixed-interest holdings
constant.
 6/38 R02/July 2018 Investment principles and risk

G6B Hurdle rates

The hurdle rate indicates the annual growth rate at which the company’s investments must
grow each year in the future, if they are going to be sufficient to repay each class of share at
the wind-up date at either the current purchase price, the pre-determined redemption value
(if applicable), or just repay the prior charges ranking before each share class. The
calculation takes into account any classes of share that rank for prior payment. A variation
on the hurdle rate is the ‘wipe-out’ rate, which measures the annual rate of decrease in gross
assets that would lead to no capital payment on wind-up.
These hurdle rates can be found for each class of share in the Association of Investment
Trust Companies’ monthly information service. They have the following implications:
• a hurdle rate of 2%, for example, means that the company’s investments must grow by 2%
each year to pay either the current purchase price, the pre-determined redemption value
or just wipe out the value at wind-up; and
• a negative hurdle rate means there are already surplus assets and that total investments
can decline in value by that amount each year and still leave enough to pay either the
current purchase price, the pre-determined redemption value or nothing at wind-up.

Consider this
this…
…
It should be possible by looking at a trust’s investment portfolio to make a judgment
about whether the hurdle rates will be met over the remainder of the trust’s life. A high
hurdle rate may be difficult to achieve if the trust has a heavy weighting in fixed-interest
securities or has expensive borrowings.

G6C Asset cover

Asset cover is another way of measuring the company’s ability to meet or cover, from
current assets, the liability to share classes with a pre-determined redemption price.
Chapter 6.1

It is the ratio by which the pre-determined redemption value for a class of shares is currently
covered by those assets of the company that are available for them. Any shares ranking for
prior payment are taken into account first.

Be aware
Asset cover
A cover of 1 means that the assets exactly cover the redemption price. A cover of 50% or
0.5 means that half of the redemption price is covered.

G6D Redemption
In practice, when a split capital trust reaches its redemption date, rather than winding it up,
managers will generally offer investors a ‘roll-over’ investment vehicle. This will usually be a
new investment trust of a similar nature into which they can transfer their investment
without incurring an immediate CGT liability.
However, a cash alternative will almost always be offered to those investors who do not wish
to continue.

G7 Classes of shares
Some investment trusts have complex structures, with various classes of shares offering
different types of return to investors.

G7A Ordinary shares

Ordinary shares
These are the main type of conventional investment trust share. Generally, these shares are
are the main type entitled to all of the income and capital growth from the trust’s investments, subject to any
of conventional
investment trust
borrowings with a prior charge that the trust may have.
share
Chapter 6 6.1: Indirect investments – unit trusts, OEICs and investment trust companies 6/39

G7B Preference shares

Conventional investment trust preference shares pay a fixed dividend, which must be paid
before any income is distributed to ordinary shareholders. They also have a prior claim to the
assets of a company in the event of a winding up. Nowadays, zero dividend preference
shares are a common feature of split capital trusts.

G7C Split capital shares

Split capital trusts were originally designed in the 1960s with two classes of shares:
• income shares
shares, which are broadly entitled to all of the income received by the investment
trust, with a pre-determined capital return when the trust is wound up; and
• capital shares
shares, which have no entitlement to any income, but receive the remainder of the
assets on wind-up.
This structure has evolved over the years to include other classes of share, offering different
combinations of income and capital.

Table 6.5: Split capital shares

Zero dividend Zero dividend preference shares (zeros) are found in virtually all
preference shares newly-launched split capital investment trusts. They have the
following characteristics:
• Limited life
life, with a capital return from the assets of the split
capital fund.
• Fixed redemption dates which coincide with the end of the
trusts’ lives. This is typically no more than ten years. As their
name implies, zeros have no entitlement to income, instead they
participate in the capital performance of a trust. They have
preferential rights over the distribution of capital at the end of a

Chapter 6.1
trust’s life, subject to any borrowings with a prior charge.
• Issued at an initial value which, in effect, rises at a pre-
determined compound annual growth rate until it reaches the
final redemption value. The market price may not reflect this
progress exactly. Prices and redemption yields will be influenced
by general interest rates and the security of the underlying
portfolio. The shares have no entitlement to any of the residual
capital value of the fund.
• Taxed under capital gains and not income tax rules (as no
income). They are especially attractive for investors not using
income)
their annual CGT exempt amount because they can obtain tax-
free returns. In the past, they have been regarded as low-risk
investments, as trust assets at the outset are often sufficient to
cover their repayment. However, this is not guaranteed because
a trust’s assets may fall in value. Investors will need to check how
well a trust’s zeros are covered to ascertain the risk and the
nature of the trust’s investments.
 6/40 R02/July 2018 Investment principles and risk

Table 6.5: Split capital shares

Income shares There are several types of income shares that are entitled to income
paid in the form of dividends. However, there can be significant
differences in their capital entitlement at wind-up. It is important to
distinguish between these when advice is given, because certain
shares can give rise to substantial capital losses at redemption. The
characteristics of income shares are as follows:
• The traditional income share gives a right to income with a fixed
redemption price (often equal to its issue price), subject to
sufficient assets remaining after repayment of debts and other
preferred classes of share. However, the redemption price may
be well below the current market price.
• Some split capital issues have included income shares closer to
an annuity in form, with a high income level, but only a nominal
redemption amount that is far less than the issue price. For
example, 1p for a 100p share.
• A third, and increasingly common, type of income share is the
ordinary income share. These are often found in trusts in
combination with zero dividend preference shares. They have no
pre-determined capital value, but receive all the income and all
the surplus capital available, if any, after the holders of the zeros
and any borrowings have been paid. They may also be described
as income and residual capital shares
shares. There is no guarantee how
much capital, if any, will be available after the zeros and any
borrowings have been paid off. These shares may be attractive to
investors who want an above average income and are prepared
to take risks with their capital.
Capital shares In general, holders of capital shares are entitled to any capital that
remains once a trust has been wound up, and after all other classes
of shares and borrowings have been repaid. They have no pre-
determined capital entitlement or any rights to receive income but,
Chapter 6.1

because of the gearing effect of the other classes of shares, they

provide the possibility of superior capital returns. However, gains
are not guaranteed. Indeed, investors could suffer a total loss. These
shares are only suitable for investors prepared to take a high risk for
a potentially high return.
Packaged units Some split capital investment trust issues have bundled together
‘packages’ of capital, income and zero dividend preference shares.
This creates what is the equivalent of an ordinary share of a
conventional trust.

G8 Warrants
Warrants are not shares but are a right to buy shares at a fixed price at a pre-determined
date or within a specified period in the future. They produce no income and are an
investment with a potentially high level of risk and reward. The price of a warrant is only a
fraction of the share price, but movements in the price of the warrant tend to magnify
changes in the share price.

Warrants can be
Warrants can be bought and sold on the London Stock Exchange at any time until their final
bought and sold exercise date. They are usually worth exercising if the holder is able to buy the shares at a
on the London
Stock Exchange at
discounted price. If they are held beyond expiry and not exercised, then they have no further
any time until their value.
final exercise date
Warrant holders have no income tax liability, as they receive no dividends. They are
therefore taxed under capital gains rules, with any gain in excess of the investor’s annual
CGT exempt amount being subject to tax.
Most investment trust warrants are issued as ‘sweeteners’ with new investment trust share
issues. Typically, one warrant is given away to investors for every five shares purchased. The
difficulty with new investment trusts is that investors have to pay the NAV, plus the launch
costs, for the new shares issued to them. However, the investment trust will usually trade at a
discount very soon after launch, creating an instant loss. The aim of the warrant is to
enhance the return to the investor by offsetting the reduction in the share price.
Once issued, investors have the choice of selling the warrants separately from the shares or
of retaining them to buy extra shares by exercising the warrants at a future date. However,
this will not be worthwhile until the market price of the shares exceeds the ‘exercise price’.
Chapter 6 6.1: Indirect investments – unit trusts, OEICs and investment trust companies 6/41

Be aware
Prospective investors
Prospective investors in a trust which has warrants in issue need to be aware that if the
warrants are exercised and more shares created, there will be a dilution in the NAV per
share of existing shares. The exercise of warrants will result in a greater number of shares,
without a proportionate increase in the value of the trust assets. In the past, some trusts
have repurchased their warrants to reduce the dilution effect.

G9 Suitability for investors

Split capital investment trusts provide investors with the opportunity to invest in different
share classes to fulfil different financial needs, i.e. investors who:
• require a very high income, and who are prepared to erode their capital, can purchase
annuity income shares;
• require income with some capital protection can purchase traditional income shares;
• require a combination of income and the potential for capital growth and who are
prepared to accept a relatively higher level of risk can purchase income and residual
capital shares;
• do not require income, but are looking for capital growth at lower risk, can purchase zero
dividend preference shares; and
• are seeking the possibility of higher than average capital growth and are prepared to take
a higher risk can purchase capital shares.

G10 Share buybacks

Chapter 6.1
A share buyback is where an investment trust company buys its own shares. They can be
used to return money to shareholders, but are more often used to tackle a company’s
discount. Boards of investment trusts with large discounts can initiate a programme of share
buybacks to reduce the oversupply of shares.
This gives the board a greater ability to balance supply and demand and help prevent the
discount widening or even reduce it.
Trusts have to first seek the permission of their shareholders to carry out a buyback.

G11 Gearing
Investment trust managers can borrow money to buy shares and other assets if they see a
good investment opportunity, but do not have sufficient free capital available to take
advantage of it. This is known as financial gearing.

Gearing
Gearing is expressed as an investment trust’s total gross assets divided by the net assets
(shareholder’s funds), multiplied by 100:

total gross assets

× 100
net assets

• A figure of 100 means that there is no gearing.

• A figure of 120 means that the fund is 20% geared (20% of the total assets are
borrowed funds).

Financial gearing can be implemented in a number of ways. Investment trusts can arrange Investment trusts
long- or short-term bank loans in sterling or foreign currencies, or issue debentures, can arrange long-
or short-term bank
unsecured loan stock or preference shares. loans in sterling or
foreign currencies
The ability of trusts to gear can work to the advantage of shareholders, if the investment
returns achieved with the borrowed money exceed the cost of servicing the loan.
However, if they do not exceed the cost, the trust’s performance will suffer. A bank may call
in its loan if the assets of the trust fall too far in relation to the loan. A trust may then be
forced to sell shares to repay its borrowings.
 6/42 R02/July 2018 Investment principles and risk

This can badly damage its performance, and trusts with high levels of gearing are thus
generally regarded as a riskier investment than those without borrowings.

Be aware
Use of gearing
Not all investment trusts use financial gearing, and many of those that do use it to very
modest levels. The decision on whether or not to use gearing is taken by the fund
manager and the board of directors. Other investment vehicles are unable to borrow to
the same extent as investment trusts.

Trusts with different share classes

Split capital investment trusts may be financially geared, but they will also be geared as a
result of their capital structure. The different share class priorities and their pre-determined
entitlements can provide a type of gearing called structural gearing, with the different
classes of shares having varying levels of risk. This has the following effects:
• returns on each class of share are affected by the entitlements of other share classes that
rank for prior payment;
• number of share classes and their particular entitlements determine the level of structural
gearing involved; and
• classes of shares that are lower down the order of entitlement are higher risk as a result of
the capital structure.
Structural gearing is inherent in the nature of split capital investment trusts, but some also
have borrowings (financial gearing).

Be aware
Structural and financial gearing
Those split capital investment trusts with high levels of financial gearing, in addition to
Chapter 6.1

their structural gearing, will be even higher risk.

Question 6.6
If an investor borrows money to invest in equities in an investment portfolio, what is likely
to happen to the size of any gains or losses?

G11A Risk warnings in respect of geared investment trusts

The FCA Conduct of Business rules state that advisers need to provide an enhanced risk
warning to clients if they recommend or buy significantly geared investment trusts. The rules
state that the enhanced warnings must be given if:
• an investment trust uses or proposes to use gearing as an investment strategy;
• it invests or proposes to invest in other investment trust companies that use or propose to
use gearing as an investment strategy; and/or
• the overall result of the exposure to gearing is likely to subject the value of the investment
trust company share to significant fluctuations compared with the underlying investment.
The definition of gearing is broad and relates to financial gearing (i.e. bank loans,
debentures), structural gearing (in the case of splits) or investing in other types of geared
instruments (e.g. warrants or other derivatives). It also covers additional exposure to gearing
that arises if the company invests in other investment trusts, which themselves use gearing.
It is therefore necessary to look at gearing in its totality, both in the investment trust itself
and in its investments, and determine whether the total effect of gearing is ‘significant’.

Consider this
this…
…
There is no precise definition of ‘significant’ but, typically, a conventional investment trust
with no underlying or structural gearing, and with effective financial gearing in place
below 30%, should not be subject to the risk warning rules. Where the enhanced risk
warning is required, an adviser must bring the risks to the customer’s attention before
recommending a particular transaction.
Chapter 6 6.1: Indirect investments – unit trusts, OEICs and investment trust companies 6/43

G12 Investment trust charges

The main charges that are made within an investment trust are detailed in the following
sections.

G12A Annual management charge

The annual management charge pays for the external management of an investment fund, or
the staff costs of a self-managed fund:
• management charges tend to be lowest on the older, general trusts, where they are still
typically under 0.5%;
• on newer, more specialist trusts, annual management charges of 1%–1.5% have become
usual; and
• some trusts also have performance fees, with managers receiving an extra fee if they
outperform certain stock market indices. However, some providers are now removing
these.
Management charges are generally scrutinised periodically. They may be renegotiated and Management
are usually subject to one year’s notice of termination. They can be taken from a trust’s charges can be
taken from a trust’s
income or capital or both. income or capital
or both
While average charges have risen with the launch of new trusts, they still tend to be lower
than annual fees on unit trusts and OEICs.

G12B Other expenses incurred within the fund

Some expenses are incurred separately by the trust. These include items such as custody
and auditors’ fees, directors’ remuneration, marketing, promotion and secretarial costs.
These expenses may add another 0.2%–0.5% a year to the costs of the fund.

Chapter 6.1
The resulting figure is known as the ongoing charges figure (OCF). The OCF is a single
percentage figure that shows the proportion of a fund’s assets which are consumed by the
annual management charge and other operating charges incurred during the period under
review, usually a year.
The OCF takes into account the annual management charge and all of the other expenses of
running the fund. It is a fairer and more accurate indicator of the charges and their effect on
a fund’s performance than the quoted annual management charge.
Some funds still, however, publish a total expense ratio (TER)
(TER).
Table 6.6 highlights the difference between the OCF and TER.

Table 6.6: Measurement of fund charges

It is important to understand what is comprised in the various charges made by funds so
that meaningful comparisons can be made.
OCF • UCITS regulated funds must provide a Key Investor Information
Document to investors, which displays an OCF rather than the
TER, as part of European regulation.
• The OCF is similar to the TER but does not include performance
fees, as these can vary depending on how well or badly a fund
performs.
• Neither the TER nor the OCF include entry or exit charges paid
directly by investors, interest on borrowing, brokerage charges
or dealing costs.
TER • The TER consists of the annual management charge (AMC) and
other charges, such as the fees paid to the trustee, depositary,
custodian, auditors and registrar.
• It also includes any performance fee, although this may be shown
in a separate field.
 6/44 R02/July 2018 Investment principles and risk

G12C Extra charges made outside the fund

These are charges that usually occur at the time of the transaction, and include:
• The spread
spread. The difference between the price at which an investor can purchase and sell
shares.
• Dealing charges
charges. Stamp duty on purchases.
• ISA charges
charges. An additional charge to cover administration costs, or a withdrawal, switch
or transfer fee when a trust is held in an ISA.
• Charges for advice
advice. A fee paid to a professional adviser by the client.

G13 Disclosure requirements

Providers of
Providers of investment trust savings schemes and ISAs have to supply investors with a Key
investment trust Investor Information Document (KIID). This contains essential information about their trusts
savings schemes
and ISAs have to
and includes a table showing the effect of charges and expenses at the end of one, three,
supply investors five and ten years. This will include any extra charge made for the savings plan or ISA
with a KIID
wrapper.
As future investment performance is unknown, managers are required to base their
projections on reasonable assumptions of future growth, supported by objective data.
The KIID allows investors to compare costs with those levied on similar investments, such as
unit trusts and insurance products, which must show their charges in the same way.
Since 1 January 2018, where an adviser is arranging packaged retail and insurance-based
investment products (PRIIPs), a key information document (KID) is required. These provide
key facts and important information that will enable customers to make meaningful product
comparisons.
The form of the KID is prescribed, so it must be:
Chapter 6.1

• a short document of no more than three sides of A4; and

• written in a concise manner using non-technical language that avoids jargon.
Essential information includes:
• the identity of the product and its manufacturer;
• the nature and main features;
• the product’s risk and reward profile;
• costs and past performance where applicable;
• any compensation or guarantee scheme; and
• any other information necessary for a specific product.
To avoid confusion, KIDs will eventually replace KIIDs.

G14 Dealing in investment trust shares

Investment trust shares can be bought and sold either through a stockbroker, like any other
share, through online investment platforms or via regular savings schemes.
Execution-only
Investors who know which investment trust they want to buy can deal through a
stockbroker on an ‘execution-only’ basis. Many will have a minimum fee and there is also
stamp duty of 0.5% to pay.
Discretionary investment
Some stockbrokers offer discretionary investment management services for larger investors
with, say, £25,000 or more to invest. They will select and manage a portfolio of investment
trusts to meet different needs, e.g. capital growth or income. Investors are charged an
annual management fee plus the costs of dealing.
Chapter 6 6.1: Indirect investments – unit trusts, OEICs and investment trust companies 6/45

G15 Savings and investment schemes

For investors with modest sums, savings and investment schemes are convenient and low For investors with
cost. They cater for regular savers contributing as little as £50 per month and for investors modest sums,
savings and
with lump sums starting at £250. For investors who do not want income, dividend investment
reinvestment facilities are available. schemes are
convenient and
Charges low cost

Charges vary between managers. Initial purchasing costs typically range between 0.2% and
1%, but some managers charge nothing at all for buying or selling shares through their
schemes. All the investor has then to pay is stamp duty of 0.5% on a purchase.
Managers usually keep their costs down by dealing in bulk, pooling investors’ money and
buying shares just once a month or once a week, although daily purchases may be made for
larger lump sums.
Share exchange
As well as accepting cash into their savings and investment scheme, some managers offer
attractive low cost share exchange services. They will take holdings of UK shares, realise
them for cash and provide investors with investment trust shares in return.
Documentation
When purchasing shares through an investment trust manager, an advice note will be sent to
the investor after an application and funds have both been received. This will confirm the
purchase and show the number of shares purchased and their price. To keep costs down,
shares purchased in this way are usually held in a nominee account, so the investor will not
receive a share certificate. Investors investing monthly receive six-monthly statements.
Investors who buy shares in new issues or deal through a stockbroker will receive a contract
note. Stockbrokers also tend to operate nominee accounts unless a share certificate is
specially requested.

Chapter 6.1
G16 Individual savings accounts (ISAs)
Most investment trust managers offer a stocks and shares ISA linked to one or more of their ISAs are covered
in more detail in
trusts. While some managers do not make any charge for the ISA wrapper, most levy a small chapter 6.2
initial and annual charge. This can be at a flat rate or at a percentage of the investment value,
to cover the additional administration costs. All approved investment trusts can be held in
an ISA.

Be aware
Appeal of investment trust ISAs
Investment trust ISAs are likely to be of most appeal to higher- and additional-rate
taxpayers and those who need the CGT shelter which ISAs provide. For others, a
straightforward savings scheme is likely to be a better option, unless the ISA is free of
additional charges.

G17 Dividends and taxation

Investment trust dividends are paid by direct transfer into an investor’s bank account or can
be paid by cheque. If investment takes place through a savings and investment scheme,
investors can opt to have dividends reinvested in more shares. However, the charge for this
facility should be investigated to make sure it is worthwhile.

G17A Taxation of investment trust companies

The taxation situation is as follows:
• Investment trusts that have been approved by HMRC are not subject to any tax on gains
made from the sale of shares or other holdings in their portfolios.
• They are not subject to any additional tax on franked income (franked income is the
dividend income that investment trusts receive from their shareholdings in UK
companies).
 6/46 R02/July 2018 Investment principles and risk

• They do have to pay corporation tax on unfranked income, which is income from sources
such as foreign share dividends, interest from gilts and bank deposits, and underwriting
commission. However, trusts can reduce their tax liability by offsetting their own
expenses – interest paid on borrowings and management fees – against the unfranked
income. This means they often end up paying little or no tax.

G17B Taxation of the investor

Income and gains from investment trusts are taxed in the same way as income and gains
from other shares. Their tax position is as follows:
• The first £2,000 of dividend income in this tax year is tax free.
• Sums above that will be taxed at 7.5% for basic-rate taxpayers, 32.5% for higher-rate
taxpayers and 38.1% for additional-rate taxpayers.
• Investors are also liable to CGT on any profit.
• Tax is only chargeable if total gains on all disposals, after deduction of losses, exceeds an
investor’s annual CGT exempt amount.
• If an investment trust is held within an ISA, all dividends and capital gains are tax free.

G18 Offshore investment companies

Investment companies established in countries outside the UK are not subject to UK taxes,
although they may be subject to low levels of local tax in the country in which they are
established.
They are also usually subject to lower levels of regulatory scrutiny and there are less onerous
demands on the board of directors if the company is registered offshore.
Chapter 6.1

G19 Investment trusts vs. unit trusts and OEICs

Unit trusts, OEICs and investment trusts have much in common, but there are certain
differences that give each of them advantages and drawbacks.
See appendix 6.2 The costs of purchasing shares in investment trusts are often lower than investing in unit
for a comparison
of investment trusts. For instance:
trusts, OEICs and
unit trusts • A unit trust or OEIC may have an initial charge of up to 5%. With investment trusts, if you
invest directly with the provider, then buying often carries no charge, but selling may
incur a flat fee. Initial charges are heavily discounted on both, often to zero, when
investment is made through online fund platforms.
• The AMC of older investment trusts are generally considerably lower than those of most
unit trusts and OEICs; but with more modern investment trusts, the annual charges are
often very similar ranging from 0.5% to 1.5%.
• On balance, although investment trusts can be cheaper to invest in than unit trusts, each
one should be looked at individually.

The risk (and

The risk (and reward) of investing in investment trusts is often said to be greater than the
reward) of risk (and potential reward) of investing in unit trusts. There are several reasons for this:
investing in
investment trusts • Investment trusts frequently trade at a discount to NAV. The risk is that the discount
is often said to be
greater than the might get wider. However, if the discount narrows, the shares may outperform the trust’s
risk (and potential assets. In the case of unit trusts and OEICs, on the other hand, the price of units cannot
reward) of
investing in unit rise or fall any further than the rise or fall in value of the underlying investments.
trusts
• Discounts can widen if the market does not like the way an investment trust is being
managed and there are more sellers than buyers. However, shareholder pressures may
produce an improvement in performance or even a change of manager. Investors in unit
trusts have no power to bring such changes about.
• Investment trusts can borrow to invest (gearing). Unit trusts and OEICs have much tighter
restrictions on their borrowing powers. In certain cases, borrowing can increase the
volatility and risk profile of an investment trust. At other times, it can reduce the risk if the
managers use borrowings to finance the hedging of their positions, either in the market
generally or in particular securities, or in currencies.
Chapter 6 6.1: Indirect investments – unit trusts, OEICs and investment trust companies 6/47

Be aware
Income from investment trusts
Investment trusts can provide higher levels of income than the equivalent unit trust or
OEIC because of the discount to NAV. The same amount of money buys exposure to more
securities within an investment trust with a discount to NAV and, as a consequence, a
greater annual income.

There are several different types of investment trust securities which have specialist uses,
such as shares in split capital trusts and warrants:
• Split capital shares divide out the investment returns from the trust to different classes of
shareholders. The shares also involve different degrees of risk from lower-risk zeros to
higher-risk capital shares.
• All investors in a unit trust or OEIC, on the other hand, have an equal entitlement to any
income and capital gains, and bear the same amount of risk.
• There are some types of unit trusts and OEICs that do not exist in investment trust form,
such as guaranteed/protected funds, where derivatives are used to protect investors
against falling share prices. There are also some investment trusts that do not exist in unit
trust and OEIC form, such as private equity trusts, which offer access to unquoted
companies.

Chapter 6.1
 6/48 R02/July 2018 Investment principles and risk

Key points
The main ideas covered by this chapter can be summarised as follows:

Collective investment schemes

• In a collective or packaged investment scheme, such as a unit trust or open-ended
investment scheme (OEIC), investors participate in a large portfolio of securities or other
assets with many other investors.
• With collective investments, such as investment trusts or with-profit policies, the link is
less direct.
• The pooling of resources enables the scheme to invest in a wide spread of investments
at a lower cost than could have been achieved by individuals acting on their own.
Investors buy and sell units or shares in the scheme and not the underlying investments
of the fund.

Unit trusts and OEICs: general characteristics

• Unit trusts and OEICs are popular collective investments – often referred to as funds.
• They are categorised within a fund classification system of over 30 sectors. Each sector
is made up of funds that invest in similar assets, or the same stock market sectors, or in
the same geographical region
• A range of rules restrict the investment powers of authorised funds, and these are
designed to ensure that each fund is sufficiently diversified.
Chapter 6.1
Chapter 6 6.1: Indirect investments – unit trusts, OEICs and investment trust companies 6/49

Unit trusts
• The trustee ensures that the investors’ interests are protected:
– they check that the manager’s actions are in line with the regulations, the trust deed
and the scheme particulars; and
– they hold or control the holding of the assets of the fund on behalf of the investors.
• The manager manages the assets of the fund in accordance with the fund’s investment
objectives. They are responsible for the day-to-day running of the fund, including the
promotion, investment and administration.
• Unit trusts are required to publish annual and half-yearly reports.
• Authorised unit trusts are principally subject to the corporation tax regime.
• A unit trust regularly receives income from the underlying investments of the fund, and
this is usually distributed to unitholders half-yearly. The first distribution a unitholder
receives consists of the income that has accrued from the date of purchase up to that
distribution date, together with an equalisation payment, which represents the income
that was included in the price paid for the units.
• Net income of a unit trust must be allocated (i.e. applied for the benefit of unitholders)
and is usually distributed at least annually.
• Tax position needs to be considered:
– Investor: income tax on distributions.
– Dividend distributions paid to trustees.
– Interest distributions from non-equity unit trusts.
– Interest distributions paid to trustees.
– Reinvestment of dividends and interest.
– CGT payable on profits made by a taxpayer who disposes of units.
• Since 1 September 2009, AIFs can be treated as a tax elected fund (TEF).
• One of the most popular reasons for investing in unit trusts is that they can pay an

Chapter 6.1
income and also offer the potential for capital growth.
• Many trusts allow the unitholder to choose between income receipt or reinvestment by
offering income and accumulation units.
• As income comes into the fund and the accounting date approaches, the unit price rises
to reflect this.
• There are generally no extra charges for investing in a unit trust ISA offered by the
manager, beyond the usual charges that apply to the unit trusts themselves.
• There is usually a minimum holding requirement of £500 or £1,000 in each fund, which is
set by each management group.
• Most unit trust groups have now switched to non-certificated units, as it has become
increasingly common for the manager and trustee to no longer issue certificates.
• To sell units, an order is placed with the management group, which will then issue a
contract note.
• Share exchange schemes are offered by a number of unit trust management groups.
These allow investors to exchange existing shareholdings in public companies for an
equivalent value in the fund’s units.
• Each unit in a unit trust represents a proportional share of the property of the scheme.
The valuation of units is achieved, in broad terms, by valuing the underlying securities
and cash held by the fund, adjusting for income and charges and then dividing by the
number of units in existence.
• Unit trust managers have to calculate unit prices according to FCA regulations.
• Charges cover most of the costs of managing and administering the fund, such as
investment management costs, marketing costs, registration and other administration.
 6/50 R02/July 2018 Investment principles and risk

Open-ended investment companies (OEICs)

• An OEIC is a diversified collective investment vehicle similar to a unit trust. Like a unit
trust, the underlying investment area will be specified, e.g. UK equities. It is an
investment company with variable capital (ICVC).
• An OEIC is not an investment trust or a trading company.
• The OEIC equivalent of the unit trust manager is known as the authorised corporate
director (ACD).
• The OEIC’s scheme operator must report to holders twice a year and is responsible for
issuing the accounts.
• ISAs are able to hold OEICs.
• An OEIC is like other open-ended funds, such as unit trusts. Investors buy shares in their
chosen fund and the value of each share of the same class represents an equal fraction
of the value of the securities and other assets in that fund:
– The price of each share therefore reflects the total net value of the assets of the fund
relating to that share class, divided by the number of those shares in issue – the NAV
per share.
• Advantages of OEICs:
– For the investment industry, the most important advantage is that this type of open-
ended fund structure is the most widely recognised type of collective investment in
Europe. OEICs are capable of being marketed internationally in a way that is virtually
impossible with unit trusts.
– The OEIC regulations permit multiple share classes, which allows more flexible
charging and currency structures than are possible with unit trusts, although COLL
allows different classes of units or shares for all types of funds.
– The OEIC structure allows management groups to offer umbrella funds. These give
the investor a choice of funds covering a range of investment objectives, each sub-
fund offering or issuing a different class of share within the company. Switches
between funds therefore become a simple matter of share exchange, often at nil cost.
Chapter 6.1

– From the manager’s viewpoint, the umbrella structure also makes it easier to create
new funds, the interest in which is represented by another class of share.
• The tax position of OEICs is essentially the same as for unit trusts.

Unit trust and OEIC management services

• Most fund management groups now offer at least one multi-manager product to help
investors achieve greater diversification. Main types are:
– fund of funds, which invest directly into funds managed by other managers; and
– manager of managers funds, which appoint specialist investment managers to look
after different parts of the portfolio to a particular brief.
• Fund platforms offer a variety of funds from a number of different management groups,
but the decision of which funds to buy is generally left to the investor or their adviser:
– They usually offer their own ISA wrappers, allowing investors to hold funds from a
range of providers which would otherwise only be possible at additional cost, e.g. via
a self-select plan.

Offshore funds
• The FCA recognises offshore funds under various sections of the Financial Services and
Markets Act 2000 and this has a bearing on how they can be marketed in the UK.
• For a UK resident and UK domiciled investor, the tax benefits of holding offshore funds
are marginal and based mainly on possible tax deferral.
• Offshore funds can be very useful for non-UK domiciled investors, or UK domiciled
investors who are non-residents, as income is only taxed in the UK when it is remitted to
the UK.
Chapter 6 6.1: Indirect investments – unit trusts, OEICs and investment trust companies 6/51

Closed-ended funds/investment trust companies

• Investment trust companies are listed on the London Stock Exchange with a number of
independent market makers.
• They have independent boards, and are regulated by company law.
• As closed-ended companies, they have a fixed capital structure, which has its
advantages and disadvantages:
– It means the share price is influenced by supply and demand, so it does not always
exactly reflect the value of a trust’s assets, which adds somewhat to the risk and
potential rewards. When a trust is trading at a discount, this can provide a buying
opportunity.
– The advantage of a closed-ended company is that the investment managers can take
a longer-term view of their investments. They can invest in more illiquid securities and
markets because they know they will not be forced sellers.
• Unit trust and OEIC managers must be prepared to liquidate holdings if investors want
their money back. However, if they are doing well, they will have the benefit of regular
new inflows of money for investment.
• An investment trust manager does not necessarily have to sell existing investments to
purchase new investments, as they can borrow money for investment or can organise an
additional share issue.
• Investment trusts offer smaller investors easy, low-cost access to a wide range of stock
markets around the world.
• Unit trust managers, on the other hand, can offer cash funds and derivative-based funds.
• Different types of investment trust shares are available to meet different investment
objectives.
• Some zeros can provide low-risk capital growth, while income shares can pay an above
average yield.
• Most investment trust managers offer cost-effective savings and investment schemes

Chapter 6.1
and ISAs.
• The differences between investment trusts, unit trusts and OEICs should be considered
carefully when assessing an investment portfolio.
• The investor’s objectives and attitude to risk must be taken into account.
• The effect of narrowing discounts, lower costs and the ability to ‘gear’ an investment
trust should mean that an investment trust performs better than a comparable unit trust
or OEIC in a rising market.
• Investment trust managers can borrow money to buy shares and other assets if they see
a good investment opportunity, but do not have sufficient free capital available to take
advantage of it. This is known as financial gearing.
• Providers of investment trust savings schemes and ISAs have to supply investors with a
KIID.
• Investment trust shares can be bought and sold either through a stockbroker, via a
platform or through direct investment.
• Investment trust dividends are paid either by direct transfer into an investor’s bank
account or by cheque.
• Investment companies established in countries outside the UK are not subject to UK
taxes, although they may be subject to low levels of local tax in the country in which they
are established.
 6/52 R02/July 2018 Investment principles and risk

Question answers
6.1 Major banks and insurance companies.
6.2 The bid–offer spread is the difference between the buying and selling prices
expressed as a percentage of the buying price.
6.3 Most UK resident and domiciled investors prefer reporting funds. The main
advantages of a reporting fund are that any capital gain on a sale is subject to the
usual CGT rules.
6.4 The board of directors runs an investment trust; this may be either as a self-managed
trust or by the directors employing an external management company.
6.5 If the share price is 210p and the NAV per share is 200p, the shares are trading at a
premium of 5%.
6.6 The profits or losses will be increased in proportion to the gearing ratio: for example,
a gearing level of 20% will result in a 20% increase in profits or losses.
Chapter 6.1
Chapter 6 6.1: Indirect investments – unit trusts, OEICs and investment trust companies 6/53

Self-test questions
1. For an OEIC, who is responsible for establishing and maintaining the register of
shareholders?
2. What percentage of a securities fund must be in ‘approved’ securities?
3. What must the unit trust register of unitholders contain?
4. What does a UCITS certificate permit the fund manager to do?
5. What does an equalisation payment represent?
6. What is an investment trust?
7. List the principles laid down by the FCA for a company seeking a listing as an
investment trust.
8. Name the two types of investment trusts.
9. What does the redemption yield measure?
10. What are the main characteristics of zero dividend preference shares?
11. What is ‘financial gearing’?
12. Summarise the tax position of investment trusts.

You will find the answers at the back of the book

Chapter 6.1
 6/54 R02/July 2018 Investment principles and risk
Chapter 6.1
Chapter 6 6.1: Indirect investments – unit trusts, OEICs and investment trust companies 6/55

Appendix 6.1: Characteristics of retail and

qualified investor schemes
(QIS)

Fund attributes Retail QIS

UCITS Non-UCITS
Permitted All UK investors and All UK investors. Institutional and
subscription. EU passport holders. expert investors.
Different share Yes. Yes.
classes.
Investor relations
Investor approval. Fundamental changes (extraordinary Fundamental
resolution). changes (ordinary
resolution).
Notification to Significant changes to be notified pre-event. Significant changes
holders. Other important changes to be notified pre- to be notified pre-
or post-event. event.
Investment and borrowing powers
Assets. Transferable As UCITS plus gold, As non-UCITS plus
securities, deposits, property and a wider other financial assets

Chapter 6.1
derivatives, money range of non-UCITS (precious metals and
market instruments, CIS. commodities
collective investment contracts on
scheme (shown here regulated markets).
as CIS).
Prudent spread of UCITS limits apply. Other specified Spread of risk per
risk. limits. fund documents.
– 10%.
• Unapproved – 20% (aggregate
securities. with unregulated
CIS).
• Unregulated CIS. – None. – 20% (aggregate
with unapproved
securities).
• Regulated CIS. – 20% (in any one – 35% (in any one
CIS). CIS).
• Index replicating – 20–35%. – 20–35%.
funds.
Concentration. 10% (securities/ n/a n/a
debentures) 25%
(CIS units).
Borrowing. 10% (temporary). 10% (permanent). 100% of NAV
(subject to adequate
cover).
Operating duties and responsibilities
Deferred redemption. Yes (for daily-priced schemes). Yes.
Limited redemption. No. Yes (per fund Yes (per fund
documents, and documents, and
subject to reasonable subject to reasonable
basis) – six months basis).
maximum.
Limited issue. Yes. n/a Yes.
Price calculation. NAV single or dual pricing (swing price NAV (per fund
mechanism allowed). documents).
 6/56 R02/July 2018 Investment principles and risk

Appendix 6.1: Characteristics of retail and

qualified investor schemes
(QIS)

Fund attributes Retail QIS

UCITS Non-UCITS
Frequency of price At least twice At least twice As per fund
calculation. monthly. monthly (or monthly, documents.
if limited redemption
arrangements).
Chapter 6.1
Chapter 6 6.1: Indirect investments – unit trusts, OEICs and investment trust companies 6/57

Appendix 6.2: Investment trusts, OEICs and

unit trusts compared

Feature Investment trust OEIC Authorised unit trust

Legal structure Listed public limited Limited liability Legal trust governed
companies governed company governed by a trust deed.
by a memorandum by an instrument of
and articles of incorporation.
association. (Not a
trust in the legal
sense.)
Stock Exchange Yes. Optional. No.
listing required?
Introduction FCA listing Prospectus. Scheme particulars.
particulars.
Nature of fund Closed-ended, i.e. Open-ended, i.e. fund Open-ended, i.e. fund
fixed number of expands by the issue expands by the issue
shares in issue at any on demand of on demand of
one time. additional shares or additional units or
contracts by the contracts by the
redemption on redemption on
demand of shares. demand of units.
Management May be self-managed Has directors who Has a manager

Chapter 6.1
or management may may be individuals or (usually an
be provided under companies but must authorised
contract by an include an authorised investment
external authorised corporate director management firm).
investment (ACD). The directors
management firm. are responsible for
Has independent managing the
board of directors. company’s business
by the contract with
the ACD as the
manager of the
company. The ACD
may obtain the
assistance of any
third party to
perform its functions.
Taxation Exempt from tax on Exempt from tax on Exempt from tax on
capital gains made capital gains made capital gains made
within the company. within the company. within the fund.
Unfranked income Unfranked income Unfranked income
charged to charged to charged to
corporation tax at corporation tax at corporation tax at
20%, after deducting 20%, after deducting 20% after deducting
management and management and management and
other administration other administration other administration
expenses and expenses (no expenses (no
interest cost of corporation tax is corporation tax is
borrowing. Expenses payable where payable where
cannot be offset income is paid out as income is paid out as
against franked an interest an interest
income. distribution). distribution).
Expenses cannot be Expenses cannot be
offset against offset against
franked income. franked income.
 6/58 R02/July 2018 Investment principles and risk

Appendix 6.2: Investment trusts, OEICs and

unit trusts compared

Feature Investment trust OEIC Authorised unit trust

Capital structure Can issue different Can offer different Can issue income and
classes of shares, classes of ordinary accumulation units
including preference shares subject to and different classes
shares and also approval of the FCA. of units in the same
debentures and (In the case of an way as an OEIC, e.g.
warrants. Can have a umbrella OEIC, the retail and
split capital. assets of one sub- institutional.
fund cannot be ‘ring-
fenced’ from the
liabilities of other
sub-funds.)
Regulation • Companies Act. • Structural • Unit trust
• FCA listing rules. framework authorised by
provided by FCA.
• Income and Treasury
Corporation Taxes • Manager and
regulations. trustee authorised
Act 1988, s.842.
• Authorised by the by the FCA.
• External FCA.
investment • Marketing
manager and • Operational issues regulated by the
investment trust and special FCA.
savings scheme corporate code
Chapter 6.1

(ITSS)/ISA administered by
operator the FCA.
authorised under • Manager (ACD)
the Financial and depositary
Services and authorised
Markets Act 2000. by FCA.
• Marketing
regulated by the
FCA.
Investment Almost unlimited Acceptable Acceptable
restrictions range of investments, investments investments
subject to company’s specified by the FCA. specified by the FCA.
articles and approval
of board.
Method of valuation Listed investments at Defined by Defined by
market price; unlisted regulation. regulation.
investments at
directors’ valuation.
Frequency of Usually monthly, Usually daily, though Usually daily, though
valuation although weekly and may be more than may be more than
daily valuations are once a day. once a day.
increasing.
Investors
Investors’’ holding Shares. Shares. (Shareholder Units.
has no beneficial
interest in the assets
of the OEIC.)
Chapter 6 6.1: Indirect investments – unit trusts, OEICs and investment trust companies 6/59

Appendix 6.2: Investment trusts, OEICs and

unit trusts compared

Feature Investment trust OEIC Authorised unit trust

Pricing A function of Single pricing reflects Prices are usually set
demand and supply the valuation of daily by managers,
for the shares: the assets in the portfolio based on FCA
price of the shares is (NAV) with charges regulations. Dual
not directly related shown separately. pricing with initial
to the value of the Funds can adopt charge incorporated
assets in the single or dual pricing. in offer (buying)
portfolio. Dealing prices. A number of
charges are separate. trusts now have
Share prices usually single pricing.
stand below NAV.
Prices are quoted at
any time by a number
of different
independent market-
makers.
Purchase/sale • Through a • Through the • Through the
stockbroker; or manager for lump manager for lump
sums and regular sums and regular
• through an savings; or savings; or
investment trust

Chapter 6.1
manager; or • through a financial • through a financial
adviser, via a adviser, via a
• through a financial platform. platform.
adviser who has
access to a
manager’s dealing
service, via a
platform.
Chapter 6.1
 6.2: Other indirect
6
investments including
life assurance
based-products
Contents Syllabus learning
outcomes
Learning objectives
Introduction
Key terms

Chapter 6.2
H Life assurance-based investments 6.2
I Exchange traded products 6.2
J Property-based investments 6.2
K Private equity 6.2
L Individual savings accounts (ISAs) 6.2
M National Savings and Investments (NS
(NS&&I) products 6.2
N Purchased life annuities 6.2
O Derivatives 6.2
P Hedge funds 6.2
Q Absolute return funds 6.2
R Structured products 6.2
S Sharia-compliant investments 6.2
T Direct investment compared to indirect investment 6.1
Key points
Question answers
Self-test questions
Appendix 6.3: Treatment of a single £10,000 bond vs. a
cluster of twenty £500 segments
 6/62 R02/July 2018 Investment principles and risk

Learning objectives
After studying this chapter, you should be able to:
• Describe and analyse the characteristics, inherent risks, behaviours and tax considerations
of:
– life assurance-based products;
– exchange-traded funds (ETFs) and exchange-traded commodities (ETCs);
– real estate investment trusts (REITs) and other property-based products;
– venture capital trusts (VCTs);
– enterprise investment schemes (EISs) and seed enterprise investment schemes (SEISs);
– the various types of individual savings account (ISA);
– National Savings and Investment (NS&I) products;
– purchased life annuities;
– derivatives;
– hedge funds;
– absolute return products and structured products; and
– Sharia-compliant investments.
• Explain the advantages and disadvantages of direct investment in securities and assets
compared to indirect investment through collectives and other products.
Chapter 6.2
Chapter 6 6.2: Other indirect investments including life assurance based-products 6/63

Introduction
In this second part of chapter 6, we will continue to examine a range of indirect investments
and finish by discussing the advantages and disadvantages of direct investment in securities
and assets compared to indirect investment through collectives and other products.

Key terms
This chapter features explanations of the following:
Absolute return Derivatives Direct and indirect Enterprise
funds investment investment schemes
(EISs) and seed
enterprise
investment schemes
(SEISs)
Exchange traded Futures Hedge funds Market value
products (ETP) reduction (MVR)
National Savings and Offshore bonds Options Real estate
Investment (NS&I) investment trusts
products (REITs)
Second-hand policies Unit-linked policies Venture capital trusts With-profit policies
(VCTs)

H Life assurance-based investments

Life assurance contracts are split into two broad types:

Chapter 6.2
• those which provide protection only, such as term assurance; and
• those which have both a protection and an investment element, such as a whole of life
policy or an endowment.
This chapter is concerned mainly with considering life assurance as an investment rather
than as a protection product.

H1 Insurance vs. investment

Across the broad category of insurance products that have an investment element, the level
of protection compared with the level of investment can vary.

H1A Higher protection

Certain products, e.g. mortgage endowments, incorporate a substantial element of
insurance and this aspect is important where protection is required in the event of death.
Policies that have a higher insurance element carry the risk that on the death of the life
assured, the life office must pay out a greater sum than the total of the premiums they have
received, plus the investment return made up to the date of death.

Be aware
Policies with a high insurance element
If a policy has a high insurance element, more of the premium must be paid to cover this.
The life office is carrying a greater risk, and consequently it expects a greater reward in
the form of higher premiums.

H1B Higher investment Life office policies

that have the
In contrast, life offices have developed many other products where the element of insurance minimum life cover
is low, and the product is designed primarily as an investment, e.g. single premium bonds. carry little risk in
the event of death
Life office policies that have the minimum life cover, perhaps 101% of the premiums paid,
carry little risk in the event of death.
 6/64 R02/July 2018 Investment principles and risk

H2 With-profit policies
Virtually all with-
With-profit policies are available in both regular and single premium contracts, although, in
profit policies recent years, the bulk of new investment has been in single premium bonds. Virtually all
currently available
are written on a
with-profit policies currently available are written on a unitised basis. The traditional with-
unitised basis profit contract, whilst still an important part of the traded endowment policy market, has all
but disappeared in terms of new business.

Be aware
Industry reviews
There have been a number of industry reviews of with-profit policies and a recurring
criticism has been their lack of transparency. To look at the Financial Services Authority
(FSA)’s 2010 ‘With-profits regime report’ go to www.fca.org.uk/your-fca/documents/fsa-
with-profits-report.

H2A Bonuses
Investment
Investment performance is reflected in bonuses that attach to the policy:
performance is
reflected in • Bonuses, if declared, are added to the value of the policy annually. The bonuses are based
bonuses that on the company’s profits from its investments and are not guaranteed but, once they are
attach to the
policy added, they cannot be taken away.
• Annual bonuses are generally set at a rate that the insurance company’s actuary believes
represents the long-term returns from the funds. They tend to reflect the income yields on
investments in a smoothed, long-term fashion. However, financial pressures have limited
the scope for companies to take a long-term view.
• Final bonuses are paid when the policy matures or on death and also upon surrender by
some insurers. Generally, they tend to represent more of the capital growth that the
insurance company has made on its funds. Final bonuses are therefore more volatile, are
Chapter 6.2

more directly affected by changes in the investment markets, can vary and are not
guaranteed.

Be aware
Final bonuses
Some companies suspended final bonuses when stock market conditions were difficult.

• Insurance companies usually reserve the right to reduce the amount paid on the surrender
of a policy during times of adverse market conditions. A market value reduction (MVR) is
applied to unitised with-profit funds, whereas, for traditional policies, this will be achieved
by changing the surrender value basis.

H2B Market value reduction

All offices operate an MVR to protect the interests of investors remaining in the unitised
with-profit funds:
• The MVR is applied at the life office’s discretion to reduce the amount payable on
surrenders or switches and operates in times of adverse investment conditions, for
example, a stock market crash.
• Usually, the MVR does not apply on death or maturity.
• The aim of the MVR is to prevent the value leaving the fund from exceeding the value of
the underlying assets.

Be aware
Financial Conduct Authority (FCA) requirements
When these products are being sold, the FCA requires the bonus system and MVR to be
explained properly and forbids the presentation of with-profit products as guaranteed.
They should, therefore, be sold as long-term investments.
Chapter 6 6.2: Other indirect investments including life assurance based-products 6/65

H3 Conventional and unit-linked with-profit

With-profit policies are available in two main types:
• unitised with-profit
with-profit; and
• conventional with-profit
with-profit.

H3A Unitised with-profit policies

These are with-profit investments expressed as a unit-linked policy, where the premiums
buy units in the unitised with-profit fund. The main difference from other unit-linked funds is
that the unit price is guaranteed not to fall. There are two basic types of unitised with-profit
funds, operating with either a fixed or variable unit price, as follows:
• Under the fixed-price system, the unit price never varies. When a regular bonus is added, Under the fixed-
extra units with the same price are allocated to the policy. These extra units cannot be price system, the
unit price never
taken away by the life office: varies
– Usually, the number of units is increased daily throughout the year by a percentage of
the annual bonus rate.
• Under the variable price system, the unit price is increased through the addition of regular
bonuses and is guaranteed not to fall.
– The most common method of allocating the bonus is by daily increases in the unit price
throughout the year.

Be aware
Advantages of unitised with-profit investments
The advantages for the investor are that:
• the bonus rate is declared annually in advance (but investors should be aware that this

Chapter 6.2
could be amended later on in the same year);
• it is easier to understand the current value of the investment;
• switches can be made to and from other unit-linked funds, although an MVR may apply
to switches out;
• unitised with-profit policies involve the insurance company in less initial commitment of
reserves than traditional with-profit policies; and
• final bonus may also be paid on death or maturity, in addition to the value of the units.

H3B Conventional with-profit policies

A conventional with-profit policy has an initial sum assured that is increased by the addition A conventional
of bonuses. Annual bonuses and final bonuses are declared as a percentage of the sum with-profit policy
has an initial sum
assured, or the sum assured plus attaching bonuses. assured that is
increased by the
The characteristics of conventional with-profit policies are that: addition of
bonuses
• bonuses are declared annually in arrears;
• the investor can see the build-up of the policy in terms of the eventual proceeds, which
are secured each year by the bonus declaration;
• however, investors cannot easily calculate the current value of their policies.

Example 6.10
An endowment has a basic sum assured of £6,000, bonuses declared to date are £2,500
and this year’s bonus is 3% compound, i.e. £255 added to the claim value. Sometimes,
there is one bonus rate on the sum assured and a different rate on existing bonuses.

Unitised with-profit policies have now almost entirely taken over from their conventional
counterparts. However, past performance results usually refer to conventional contracts and
the traded endowment market is dominated by traditional contracts.
 6/66 R02/July 2018 Investment principles and risk

H4 With-profit performance
Performance of
The performance of with-profit funds depends on:
with-profit funds
depends on the • the underlying performance of the investments, which is the most important factor; and
underlying
performance of the
• for some companies, the profitability of their other businesses.
investments and,
for some The strength of the company’s reserves is often measured by the size of the free asset ratio.
companies, the This can allow reserves to be maintained, even in those years when the value of investments
profitability of
their other and the income from them have fallen. The companies generally try to maintain a balance
businesses between:
• retaining enough of the profits in particularly good years to smooth out the bonuses in
years when investment returns are poor; and
• providing each generation of policyholders with the appropriate returns from their
investments.

H5 Advantages of with-profit
With-profit policies can be seen as having the following advantages:
• They provide investors who are relatively risk-averse with some exposure to the equity
markets.
• Bonuses are not directly linked to investment performance in the same way as with unit-
linked policies, because it is possible for a life office to use its reserves. This produces a
‘cushioning’ effect which irons out the sharp rises and falls that characterise unit-linked
investments.

Over the last ten

• Over the last ten years, most with-profit policies have outstripped inflation.
years, most with- • In some cases, they allow investors to participate in the profits of the insurance
profit policies have
Chapter 6.2

outstripped company’s trading activities.

inflation
• Ownership of a mutual life office’s with-profit policies represents ownership rights in the
life office itself. These should generate either additional profits or shares if the company is
demutualised.

H6 Disadvantages of with-profit
A growing number of companies do not offer with-profit policies and their popularity has
declined, particularly for regular savings and mortgage repayments. This is partly because
they have the following disadvantages:
• They are difficult to understand and lack transparency.
• Returns depend to some extent on the insurance company’s subjective judgment of long-
term returns and their marketing objectives. For example, in the past, some companies
have increased bonus rates (especially final bonus rates) to boost past performance
where the underlying investment performance might not have justified that bonus level.

With-profit
• They may be inflexible and generate poor returns on early surrender or during periods
policies may be when the MVR applies.
inflexible and
generate poor
returns on early
surrender or
during periods
when the MVR
applies
Chapter 6 6.2: Other indirect investments including life assurance based-products 6/67

H7 Closed with-profit funds

A number of with-profit funds are now closed to new business, although they have not all
closed for the same reasons, and not necessarily because the insurer is financially weak.
Some have closed when the life office was taken over, or through competition from other
offices. Some closed funds have performed better than open funds, while some have
performed worse.
Most closed funds hold a relatively high proportion of their funds in fixed-interest securities,
with only a small proportion invested in equities. However, the allocation to equities is
primarily dependent on the financial strength of the insurer. This has the following
consequences:
• funds with a relatively high weighting in fixed-interest securities are not as likely to
perform as well over the longer term as funds with a higher equity content;
• this will restrict the fund’s ability to pay future bonuses; and
• where a fund is paying no annual bonus, the charges of the fund will eat into the
policyholder’s investment.
The position of policyholders in these funds is complicated and it is extremely difficult to
generalise about what they should do. Each client’s circumstances are different and any
decision needs to be made on an individual basis. Policyholders should consider the:
• financial strength of the insurer;
• current asset allocation of the fund;
• current bonus rate;
• long-term performance of the fund;
• current surrender value of the policy;
• penalties (if any), i.e. an MVR, for exiting the fund; and

Chapter 6.2
• length of time until the end of the policy or an MVR-free encashment date.
The problem for policyholders remaining in a closed with-profit fund is that the
policyholders who incur no exit penalties on policy anniversaries (i.e. MVR-free dates) will be
taking more than their fair share of the fund. This leads to the fund becoming considerably
weaker.
Where exit penalties are at the less punitive end of the scale, policyholders have to weigh up
the option of exiting the fund and reinvesting the money to get a better return.

Be aware
Traded endowment market
Policyholders with regular premium endowment policies may be able to obtain a higher
amount by selling their policy on the traded or second-hand endowment market as an
alternative to taking the surrender value offered by the life office.

Question 6.7
State four advantages of with-profit funds.

H8 Unit-linked funds
The value of a life assurance policy can be linked to the performance of units in life company The value of a life
funds. assurance policy
can be linked to
With a unit-linked policy, the premiums buy units in the fund of the investor’s choice. This the performance of
units in life
might be run by the life office itself, or it might be a unit trust run by the life office or another company funds
institution. It has the following characteristics:
• The value of the policy is measured by the total value of the units allocated to it.
• As soon as a policy is set up, its surrender value is lower than the premium paid. This will
be because of the difference between the buying and selling price of the units, usually 5%,
and/or because there is an early termination penalty.
• From then on, a policy’s value depends on the performance of the fund, or funds, to which
it is linked.
 6/68 R02/July 2018 Investment principles and risk

H9 Investment funds
Most offices have a variety of funds on offer, with different risk and growth prospects. The
funds most usually available are as follows:

Table 6.7: Choice of investment funds

Cash fund • A cash fund is invested in the short-term money markets, such as
bank deposits and Treasury bills. This should produce steady (but
secure) growth, and is often used to provide capital protection at a
time when the outlook in other investment markets may be
uncertain.
Building society • This is invested in building society accounts, aiming to offer a return
fund in line with the building societies’ rates. The interest rate will vary
from time to time but the unit price is usually guaranteed not to fall.
Gilt or fixed- • Invested in UK Government gilts and other readily marketable fixed-
interest fund interest securities. Some offices may also invest in listed marketable
stocks of overseas governments and companies. These funds are
relatively secure, owing to the underlying guarantee on government
stocks, but capital values can fluctuate.
Index-linked gilt • Invested in index-linked securities issued by the UK Government. The
fund income element and redemption value of these bonds are linked to
the rate of inflation and returns are likely to be higher in times of high
inflation.
Equity fund • Invested in shares listed on the UK stock market and maybe also in
convertible loan stock and overseas securities. Prices can fluctuate
considerably, reflecting the fortunes of the underlying shares and the
economy as a whole.
International • Invested in securities listed on foreign stock markets. Some offices
Chapter 6.2

fund might also include shares in UK companies if they earn a large

proportion of their profits from overseas earnings. Prices can
fluctuate substantially because there may be a currency risk as well
as an investment risk.
Property fund • Invested directly in freehold and leasehold interests in commercial
and industrial property, such as warehouse buildings, shopping units
and office blocks. This should provide reasonable long-term
performance but prices can still go down substantially. There is often
a proviso that encashments or switches can be delayed for a specific
period. This would be in times of difficult market conditions because
of the relative illiquidity of the underlying investments. Smaller funds
may invest in property company shares rather than in direct property
investments.
North American • Invested in securities on US and Canadian stock markets. Prices can
fund fluctuate substantially because of currency and investment risks.
Far Eastern fund • Invested in securities on Far Eastern stock markets. Prices can
fluctuate substantially because of currency, investment and political
risks.
Chapter 6 6.2: Other indirect investments including life assurance based-products 6/69

Table 6.7: Choice of investment funds

Managed fund • Invested in a balanced spread of equities, both in the UK and
overseas, fixed-interest investments, property and cash either
directly or through the other funds. The life office’s investment
managers vary the distribution of the investments according to the
relative current attractiveness of the various markets. Usually, the
objective is steady long-term growth, while avoiding undue risk. The
spread of investment should reduce risk, but prices can still fluctuate.
• The Association of British Insurers (ABI) classifies these funds as
follows:
– Mixed Investment 0–35% Shares.
– Mixed Investment 20–60% Shares.
– Mixed Investment 40–85% Shares.
– Flexible Investment.
• The definition for each sector shows how much flexibility the fund
manager has over the range of investments in a fund. The sector
name shows the minimum and maximum amount that funds in that
sector may invest in shares. Funds in the Flexible Investment sector
are expected to have a range of different investments, although the
fund manager has significant flexibility over what to invest in. There
is no minimum or maximum requirement for investment in shares, so
there is scope for the manager to invest up to 100% in shares if they
so wish.
Ethical funds • Most life companies offer ethical or environmental funds. The equity
investments underpinning these funds are screened on various
criteria. For example, some ethical funds will exclude companies
involved in arms, tobacco and alcohol, whereas environmental funds
may use positive selection criteria and invest in companies
producing electricity from renewable energy sources.

Chapter 6.2
External • Most life companies offer links to funds managed by external
manager funds investment managers. These may be specialist sector funds, e.g.
Japan, or fall within the managed fund category. Often, the life funds
represent no more than a wrapper for the external manager’s unit
trust or OEIC.
Manager of • These funds are a variation on the external manager approach. The
managers funds life company, or sometimes a third party asset allocation adviser,
select specific fund managers for each investment sector within a
class of funds. For example, a managed fund may have different
external managers for its UK, European, US and Far East equity
holdings.

H10 Unit-linked returns

The returns available on unit-linked policies depend on two main factors: Returns available
on unit-linked
• investment performance of the funds to which they are linked; and policies depend on
the investment
• exact days on which the policy is set up and cashed in. performance of the
funds to which
they are linked and
H10A Performance the exact days on
which the policy is
There is a significant difference between the performance of the best and worst offices, and effected and
the best and worst funds within offices: cashed in

• The more specialised the fund, the greater the chance of spectacular rises in value and
also spectacular falls.
• The more broadly based a fund, the more likely it is to conform to an average return and
the less likely it is to suffer a disastrous fall.

Be aware
Performance of new funds
There is some evidence to suggest that new funds tend to perform better than average in
their early years because their small size tends to make dealing easier.
 6/70 R02/July 2018 Investment principles and risk

H10B Cashing-in – pound-cost averaging

Pound-cost
Pound-cost averaging only works for regular premium contracts. The yield obtained from
averaging only the policy depends mainly on the bid prices of units on the day the policy is cashed in:
works for regular
premium contracts • If unit prices are low at times during the term of the policy, this can work to the saver’s
benefit. When prices are low, the premiums buy more units than they would if prices were
higher.
• The saver will receive a better return if prices are low for a long period and then rise just
before the policy is encashed, than if the prices rise to the same eventual height but at a
consistent gentle growth rate. This is because units will have been bought, on average, at
a lower cost during years of low prices. This factor is known as pound-cost averaging. An
example of how this could operate is shown below, using a ten-year policy for £300 a
year.

Example 6.11
Case A – Prices rise at a constant rate for ten years from £1.00 to £1.90.
Year Investment Unit price Number of
£ £ units bought
Year 1 300 1.00 300.00
Year 2 300 1.10 272.73
Year 3 300 1.20 250.00
Year 4 300 1.30 230.77
Year 5 300 1.40 214.29
Year 6 300 1.50 200.00
Year 7 300 1.60 187.50
Year 8 300 1.70 176.47
Year 9 300 1.80 166.67
Chapter 6.2

Year 10 300 1.90 157.89

Total units 2,156.32
Total unit value 2,156.32 @ £1.90 = £4,097.01
Case B – Prices fluctuate, going down and up for ten years between £1.00 and £1.40.
Year Investment Unit price Number of
£ £ units bought
Year 1 300 1.00 300.00
Year 2 300 0.50 600.00
Year 3 300 0.70 428.57
Year 4 300 0.60 500.00
Year 5 300 0.90 333.33
Year 6 300 1.10 272.73
Year 7 300 0.90 333.33
Year 8 300 1.20 250.00
Year 9 300 1.10 272.73
Year 10 300 1.40 214.29
Total units 3,504.98
Total unit value 3,504.98 @ £1.40 = £4,906.97

All charges, etc. have been ignored for simplicity, but the cases clearly show that fluctuating
prices need not damage the overall return and may well enhance it.
Chapter 6 6.2: Other indirect investments including life assurance based-products 6/71

H11 Investment appeal of life assurance

Many of the funds are broadly equivalent to those that are available from unit trusts and
OEICs. Indeed, some funds are unit trusts or OEICs that are held by life assurance offices.
Nevertheless, there are several types of funds that are more or less unique to life assurance
policies:
• with-profit funds;
• guaranteed income and growth bonds;
• property funds with asset holdings of property rather than property shares; and
• mixed or managed funds, which provide a balance of equities, fixed-interest investments,
unit trusts, property and cash.
Switching Switching tends to
Switching tends to be more frequent on bonds than on regular premium policies. An be more frequent
on bonds than on
attraction of unit-linked policies is that switches can be made between funds at little or no regular premium
cost and without the policyholder incurring any personal tax liability at the time of the policies
switch. Most offices offer two free switches with any subsequent switches chargeable.

H12 Saving from income

The number of people using qualifying life policies as a means of saving from income has
steadily declined. The decline reflects regulatory pressure to recommend tax efficient
alternatives, such as individual savings accounts (ISAs).
Nevertheless, the choice of investment funds and the inclusion of life assurance can make life
assurance policies attractive for certain investors.
In theory, life assurance policies can be held in a stocks and shares ISA. In the past, there was

Chapter 6.2
even a life assurance ISA, but they did not prove popular.

H12A Conventional with-profit endowment savings plans

Probably the most basic savings plan is the conventional with-profit endowment: Probably the most
basic savings plan
• many policies have a ten-year term – the minimum for qualifying status; is the conventional
with-profit
• level premiums are paid, usually monthly or annually; endowment:
• the premiums purchase a guaranteed sum assured, payable on maturity or earlier death;
• bonuses are added to the guaranteed sum assured on the fund each year, at the office’s
declared rate;
• when the policy matures, or on earlier death, a final bonus is often added, which is usually
based on a percentage of the total annual bonuses already allocated (some insurers also
pay a final bonus on surrender); and
• the eventual return is the total of the guaranteed sum assured, plus any annual bonuses
and final bonus.
There is virtually no new business in this category, but many standard with-profit plans
remain in force. This type of contract is now most commonly purchased second-hand.

H12B Low-cost endowment savings plans See section H27

for more on
second-hand
Under a low-cost endowment savings plan: policies

• the basic sum assured, on which bonuses are calculated, is lower than the death sum
assured; and
• the amount payable on maturity is the basic sum assured plus bonuses.
Low-start, low-cost endowment savings plans have premiums that start at a low level and
build up over five or ten years to the full premium which, for qualification reasons, cannot be
more than double the initial premium.

Be aware
New business
Like the standard with-profit endowment, virtually no new low-cost endowment business
is written.
 6/72 R02/July 2018 Investment principles and risk

H13 Unit-linked savings plans

Unit-linked contracts, which can include a unitised with-profit fund within the fund range,
now dominate the market. They operate in the following way:
• premiums are applied to buy units in a unit-linked fund run by the life office or possibly in
a unit trust run by the life office or an associated institution;
• most offices offer a choice of funds, such as equity, fixed-interest, property, international,
cash and managed, whilst others have unitised with-profit funds and some have specialist
funds, e.g. a specific overseas area; and
• one of the most common of these contracts is often known as a maximum investment
plan (MIP). These products became popular with higher-rate and additional-rate
taxpayers who had maximised their pension and ISA allowances. However, since 2013,
there has been a cap on contributions into qualifying polices of £3,600, which limits their
effectiveness.

H13A Charging structure

The charging structures of unit-linked policies have varied over the years:
• some policies have ‘initial units’ with a heavier annual management charge (AMC);
• some have an initial non-allocation period;
• some policies deduct charges for expenses and life cover from the premium before it is
applied to units;
• some policies apply the whole premium to investment and the life office cancels units
each month to pay for that month’s expenses and life cover; and
• some offices reduce charges by giving higher unit allocations from the outset and
compensate for this by introducing a surrender penalty for early encashments. A typical
penalty might be 5% of unpaid premiums due up to the tenth anniversary. The aim is to
Chapter 6.2

discourage early surrenders and reward those investors who keep their policies for the full
term.

H13B Purchase of units

When units are
When units are allocated, they are bought at the current offer price. The total amount of
allocated, they are units allocated to the policy increases each time a premium is paid. The eventual value of the
bought at the
current offer price
policy is based on the total bid value of the units.

H13C Endowment or whole life

Unit-linked savings plans can be written as endowment or whole-life policies:
• Endowment policies usually have a ten-year premium payment term (for qualifying
purposes) with a right to extend the policy if required.
• After ten years, the bid value of units can be taken as a lump sum, or premiums continued
for a further ten years, or the units can be withdrawn as and when required.
• Policies can also be written as whole-life assurances. After the initial period of say ten
years, these can be cashed in at any time for the bid value of the units then allocated.
• Increasing premiums are also available.
• Unit-linked savings plans are frequently issued as clusters of small policies for maximum
flexibility.

Be aware
Qualifying policy
Whether the contract is written as an endowment or as a whole life, it is likely to include
enough life cover to ensure it is a qualifying policy. For this reason, unit-linked savings
plans commonly have a guaranteed sum assured of 75% of premiums payable over the
whole term for an endowment, or up to age 75 for a whole life.
Chapter 6 6.2: Other indirect investments including life assurance based-products 6/73

H14 Early encashment of regular premium savings

policies
There are various penalties for early encashment of regular premium savings policies, and
both with-profit and unit-linked policies frequently have no surrender value at all in the first
year. The best return on a fixed-term savings plan is nearly always achieved by letting the
contract run until maturity. Any encashment before maturity can lead to a much lower return
for the reasons as follows:
• The endowment surrender values of most offices incorporate a penalty element. This
reflects the costing of the premium on the basis that the contract will run its full term and
that, if it is cashed in early, they will not be able to recoup the expense loadings from the
unpaid premiums.
• As an alternative to surrender, it may be possible to sell a traditional with-profit policy on
the open market and this will often produce a greater sum than the surrender value for the
policyholder.
• A final bonus may only be payable on maturity or death and may not be applied on earlier
encashment. However, under pressure from a number of sectors, many offices now
include an element of final bonus in their surrender value quotes when maturity is near.
Some offices include an element of final bonus earlier, depending on the number of years
held.

Consider this
this…
…
Fixed-term endowments are generally only suitable where the saver is sure that they will
not want the money until the end of the term.

Segmentation
Increased flexibility can be achieved by writing the plan as a cluster of identical individual

Chapter 6.2
Increased
policies. This is known as segmentation. For example, a £100 per month plan might be flexibility can be
achieved by
written as twenty £5 policies or four £25 policies. The advantages of this are that: writing the plan as
a cluster of
• the saver is not committed to taking all the money at a single time; identical individual
policies
• individual policies can be encashed as required; and
• the remaining policies can be continued independently, either with premiums being
maintained or as paid-up policies.
If policies are made paid-up, no further premiums are payable and the guaranteed sum
assured is reduced accordingly, but bonuses continue to be allocated at a lower rate than on
fully in-force policies.

H15 Lump sum investments

Investment bonds are frequently used for lump sum investments:
• An investment bond is a single premium life assurance policy.
• Most bonds are written as whole-of-life policies, with no specific maturity date.
• Investment bonds are structured primarily as investments and provide only nominal life
cover, which is typically just in excess of the value of the fund on death, i.e. 101% of the
value of the units.
• They can be written on a single-life or joint-life basis and are often used as trustee
investments.
When an investment is made, the premium is used to purchase units in funds of the Bid-offer spread is
investor’s choice at the offer price. When an investor wishes to cash in a bond, or make usually around 5%
of the offer price
withdrawals from it, the units are surrendered at their bid price. Therefore, the price of the
units must rise above the initial bid–offer spread before any gain is made, although the unit
price will vary according to the market value of the underlying investments. The bid–offer
spread is usually around 5% of the offer price.
In addition to the initial bid–offer spread, the fund is subject to an AMC, which is typically 1%
of the value of the units. This is allowed for in the published unit price of the units.
 6/74 R02/July 2018 Investment principles and risk

Some investment bonds have a single pricing system with the same price applying to both
purchases and sales. This means that there is no explicit initial charge, and the manager can
only extract their costs through the AMC. In this situation, an exit charge is likely to be
applied on surrenders within the first five years.
The main types of lump sum life assurance bonds are:
• guaranteed income bond;
• high income bond;
• guaranteed growth bond;
• unit-linked bond;
• distribution bond;
• guaranteed protected equity bond; and
• with-profit bond.

Be aware
‘Income
Income’’ payments
The regular withdrawals taken from an investment bond are considered to be a return of
capital rather than true income.

H15A Guaranteed income bond

A guaranteed income bond is a very simple contract. In return for a single premium, the
bond provides a guaranteed income each year for a specified period. The income is usually
payable annually in arrears and most bonds are for terms of up to five years.

On maturity, the
On maturity, the investor’s capital is returned. The combination of security and good net
investor’s capital is returns make this an attractive investment for a basic-rate taxpayer.
returned
Chapter 6.2

Life offices offer these contracts from time to time, depending on their own internal taxation
position. At any one time, there are usually only a few offices in this market. Most tranches
are for a limited time or for a limited total amount.
The attraction of these bonds is that the income is guaranteed; however, the rate offered at
any particular time varies according to market conditions.

H15B High income bond

High income bonds are based on packages of derivatives. Their characteristics are as
follows:
• Most offer a high level of income, e.g. 10%, for five years, but do not guarantee return of
capital.
• Return of capital will depend on the performance of one stock market index, or possibly
the average of two or three.
• Provided the index meets a pre-set performance target over the period of the bond,
capital is returned in full. If the target performance is not met, the payment at maturity will
be less than the original investment.
Because of the risks involved with these products, the previous regulator, the FSA, issued
strict guidelines on how they should be marketed.

H15C Guaranteed growth bonds

Guaranteed
Guaranteed growth bonds are similar to guaranteed income bonds, except that they pay no
growth bonds are income:
similar to
guaranteed • the investor pays a single premium and is guaranteed a capital sum in three, four or five
income bonds,
except that they years’ time;
pay no income
• the capital sum is free of capital gains tax (CGT) and basic-rate income tax has already
been deducted at source;
• while the bond is held, it generates no income for the investor;
• maturity dates are typically from one to five years and sometimes for longer periods;
• at maturity, the bond can usually be encashed or possibly rolled into another bond;
Chapter 6 6.2: Other indirect investments including life assurance based-products 6/75

• the underlying investments held by the insurance companies are usually gilts and other
short- to medium-term financial investments; and
• the relatively high returns available to investors are based on the advantageous tax
position of the life policies.

Be aware
Availability
Other non-income-producing investments that provide a guaranteed return for investors
are not widely available. Alternatives are zero coupon preference shares in investment
trusts, which provide fixed (but not guaranteed) capital gains and are dependent on stock
market performance to some extent.

The guaranteed income bonds benefit from the underlying guarantees provided by the
Financial Services Compensation Scheme (FSCS).
Encashing
Each of these income and growth bonds is designed to run for a fixed term, and it is not
possible to simply encash them at any time and receive the full value from the investment.
Most bonds allow access to the investment capital before the maturity date, but there will be
penalties that can be significant. Investors need to be made aware of the fixed-term nature
of these products, and the potential costs if they are likely to need access to their capital
before the end of the fixed term.

H16 Unit-linked bonds

Many higher-rate taxpayers invest in single premium unit-linked bonds either for capital Many higher-rate
gains or income. With an onshore bond, any liability to basic rate income tax is covered by taxpayers invest in
single premium
the tax paid within the fund, and the investor may take 5% of the original investment without

Chapter 6.2
unit-linked bonds
an immediate liability to tax. This can be continued for 20 years or until the initial capital has either for capital
gains or income
been returned. The effect of this can be to give the investor a relatively high net return when
compared with fully taxable investments, as illustrated here:
• to receive a net return of 5% on a fully taxed investment, a 40% taxpayer would need a
gross yield of 8.33%; and
• if the underlying funds are growing at a rate of more than 5%, then the capital sum
payable on final encashment will also be growing.

Be aware
Payments
Investors must remember that the payments are capital withdrawals, not income. If a 5%
withdrawal exceeds the growth rate, capital is being drawn as well as investment income.

H16A Encashing
Unit-linked bonds are written as whole-life policies and so can be cashed in at any time or Unit-linked bonds
left until the policyholder’s death. can be cashed in at
any time or left
The investor can take an income from the bond, which can be at regular or irregular intervals until the
policyholder’s
(of any amount) whenever required. The income is obtained by cashing in part of the unit death
holding. If the rate of income exceeds the growth rate of the units, then the bond will decline
in value and may extinguish altogether if this continues.

H16B Advantages and disadvantages of unit-linked bonds

The main advantage of unit-linked bonds is their flexibility – cash can be taken out as and
when required. This is a big improvement over the guaranteed bond, where the dates of
payment are fixed in advance and cannot be altered.

Consider this
this…
…
Guaranteed bonds have the advantage of security because the return is guaranteed for
both capital and income. However, unit-linked bonds may provide a higher return (but
also the possibility of generating losses) depending on the investment performance of the
funds.
 6/76 R02/July 2018 Investment principles and risk

H17 Distribution bonds

Ordinary unit-linked bond funds do not separate income and capital, and the investment
returns from invested income are simply reflected in the unit price. Any withdrawals taken as
a form of income are achieved by cashing in units, which have no particular relationship to
the actual income generated by the fund.
Distribution bonds effectively distinguish between income and capital so that the income
paid reflects the income generated by the fund. This leaves the capital intact, although this
could still rise or fall in value. The ABI classification requires that a distribution fund must
have a maximum of 60% total equity content (and a minimum of 20%), a minimum of 50%
sterling-based assets and a yield of, at least, 110% of the FTSE All-Share yield. All income
must be capable of being paid to the investor. The relatively low equity limit means that
some distributing high-yield equity funds are not classed as distribution funds. The way
these bonds work is as follows:
• The money is invested in a special distribution fund, which pays out the natural accrued
income of the fund, i.e. dividends, interest or rental income, usually two or four times a
year, though some offices can pay monthly.
• Investors can take these payments as income, but there are no unit encashments and the
number of units in the bond remains constant – although the payments look like income,
they are actually capital.

Unit price will fall

• The unit price will fall in line with the payout on each distribution date.
in line with the • The investment managers of the fund have to bear in mind the requirement for income in
payout on each
distribution date the way they manage the fund’s assets, which tend to be well spread, with a high
proportion of gilts and fixed-interest securities to lessen the risk.
• These bonds should be regarded as a medium- to long-term investment because many
offices have early surrender penalties.
Chapter 6.2

• The taxation of distribution bonds is the same as for ordinary unit-linked bonds, i.e. 5%
cumulative allowance rules apply to the income distributions.

Reinforce
A distribution bond could be an appropriate investment for a cautious investor requiring
income. The risk profile in general is fairly low, but there is still a reasonable chance of
capital growth.

H18 Guaranteed/protected equity bonds

These are unit-linked bonds with some form of guarantee, linked to various stock market
indices. They are fixed-term single premium life assurance policies that are usually based on
a combination of an over-the-counter (OTC) call option and a fixed-term deposit.
Guaranteed equity bonds
Guaranteed equity bonds typically guarantee the return of the original cash investment on
the maturity date of the bond, plus a percentage of the growth in the index to which it is
linked. A few incorporate lock-ins, which guarantee returns if the growth in the chosen index
reaches more than a certain set percentage at any time during the policy term.

Guarantee
The guarantee generally operates only on a fixed anniversary date. If the bond is
generally operates surrendered before that date, the normal unit value principle applies.
only on a fixed
anniversary date The guarantee is usually achieved by a fixed-term deposit or zero coupon bond, with the
exposure to the growth in the stock market index being provided by some form of option
(often an OTC option) purchased by the life office.
Protected equity bonds
Protected equity bonds allow investors to select a quarterly guaranteed level of protection.
This is typically between 95% and 100% of the capital at the start of the quarter, although the
actual level of protection varies between providers. The bond will be protected against falls
in excess of this selected level of guarantee, regardless of the performance of the index to
which it is linked.
The greater the level of protection, the slower the bond’s value will rise if the underlying
index rises.
Chapter 6 6.2: Other indirect investments including life assurance based-products 6/77

Assessment
These investments are worthwhile for those who like the idea of an equity-linked product, These are
but who do not want to risk losing money. It is worth keeping in mind: worthwhile for
those who like the
• While receiving 100% capital return on a fully guaranteed fund does not appear as a loss, idea of an equity-
linked product, but
in real terms, a loss has arisen because of inflation. who do not want
to risk losing
• Guaranteed equity bonds must be held for their full term to benefit from the guarantee of money
capital protection and are not suitable as short-term investments.
• Protected equity bonds with a 95% quarterly rolling guarantee can still produce a loss of
nearly 20% over a one-year period, ignoring any initial bid–offer spread.
• The indices chosen follow the price of leading shares. They usually make no allowance for
dividend income, which can be an appreciable part of normal unit-linked fund growth.
• All guarantees involve costs. In general terms, the better the guarantee, the lower the All guarantees
ultimate return when compared with a non-guaranteed equity bond, particularly if stock involve costs
market performance over the period is good.

H19 Bonds as trust investments

Bonds are often appropriate investments for trustees, if they are looking for long-term
capital growth. This is for the following reasons:
• Bonds provide a wide variety of funds to meet the different risk requirements of different
types of trust.
• The policies generate no taxable income and so substantially reduce the amount of
administration, and subsequent expense, for the trustees.
• The underlying life fund pays corporation tax on income at a lower rate than the trustees
would pay on accumulating income. When trust income is below £1,000, the trustees of

Chapter 6.2
discretionary trusts are liable to 7.5% income tax on dividends and 20% on all other
income. When trust income is above £1,000, they are liable to 38.1% income tax on
dividends and 45% on all other income.
• The policies can be assigned to the beneficiaries of a trust and there would usually be no
income tax charge on the transfer. The policies could then be encashed by the
beneficiaries and possibly suffer no additional tax, depending on their tax position at the
time.
• Up to 5% of the original investment can be withdrawn by trustees each policy year and
paid to beneficiaries with no immediate liability to tax for the trustees.
Liability for chargeable gains
If a chargeable event occurs on the investment bond, any chargeable gain is assessable to
income tax. A chargeable event might be triggered by:
• withdrawing more than 5% each year;
• full encashment; or
• the death of the life assured.
Prior to 1998, if a policy was subject to a trust, the person chargeable was the individual who
created the trust, although they could recover the tax from the trustees. If the creator of the
trust was dead and had died in the tax year before the year of the gain, there was then no-
one on whom HMRC could tax the gain. This was known as the ‘dead settlor rule’.
The rule changed in the Finance Act 1998
1998. The situation is now as follows:
• If the individual who created the trust is both alive and a UK resident immediately before
the chargeable event, the gain is treated as part of that individual’s income. They can
recover any tax paid from the trustees.
• If the individual who created the trust is dead or resident outside the UK immediately
before the chargeable event, and one or more of the trustees are resident in the UK, the
trustees are chargeable on the gain but without the benefit of top-slicing relief. The
charge for a discretionary trust is 45% for income above the trust’s standard-rate band
and 20% for income within the standard-rate band. On gains that exceed the standard-
rate band there is, therefore, a 25% liability for a UK policy, due to the basic-rate tax
credit. This tax cannot be reclaimed by the trust beneficiaries, even if they would not have
been liable to it in their own right, because they are well below the higher-rate threshold.
 6/78 R02/July 2018 Investment principles and risk

• If the trustees are not resident in the UK, any UK beneficiary receiving a benefit under the
trust from the gain will be taxable on that amount at their tax rates, but without top-
slicing relief. No credit is given for the basic-rate credit of 20% when a gain arising to non-
resident trustees is assessed on an individual beneficiary.

The rules apply to

The rules apply to chargeable events that occur on or after 6 April 1998. They do not apply
chargeable events to policies effected before 17 March 1998, where the trust was also created before that date
that occur on or
after 6 April 1998
and the creator of the trust died before that date. For these cases, HMRC accepts that there
is no one to tax (the dead settlor rule) as long as the policy is not varied on or after 17 March
1998 so as to increase the benefits or extend the term.
The 25% tax charge referred to above can be avoided if the beneficiaries are non-taxpayers
or basic-rate taxpayers. This can be done by arranging for the trustees to retire and be
replaced by foreign trustees (e.g. in the Channel Islands or Isle of Man) before the
chargeable event. The beneficiaries would then be liable at their personal rates − and there
would be no tax if their incomes were low enough to avoid the chargeable gain putting them
in the higher-rate tax band. However, top-slicing cannot be used for this purpose.
Alternatively, the trustees could assign the policy to a beneficiary, free of the trust, before a
chargeable event occurs. The policy could then be cashed-in by the beneficiary (now the full
owner) and tax would be chargeable on them, rather than on the settlor or the trustees. If
the beneficiary was well below the higher-rate tax threshold, this could eliminate any tax
liability on a UK policy.
The beneficiary would also benefit from full top-slicing relief.

H20 Offshore bonds

Offshore bonds are generally issued by subsidiaries of well-known UK life offices in countries
such as Luxembourg, the Channel Islands or the Isle of Man. Although onshore and offshore
Chapter 6.2

bonds are structured in similar ways, the tax treatment of the two types of bond is different.
The perceived advantage of offshore bonds is that the country concerned imposes little or
no tax on the income and gains of the underlying life fund, thus allowing what is often called
a gross roll-up that is valuable, particularly to a higher-rate taxpayer. This contrasts with an
onshore bond, where the fund pays tax at up to 20% on income and on gains (although
indexation allowance applies: when a capital gain is made on or after 1 January 2018, it will
only be calculated up to 31 December 2017). However, the effect of gross roll-up can be
reduced by the fact that charges are often higher for offshore bonds than for their onshore
competitors, and some investment income may be received after the deduction of non-
reclaimable withholding tax.

Be aware
Taxation of UK policyholders
UK policyholders with offshore policies are liable to income tax at their highest rates on
the whole of their gain, with time apportionment relief for any periods spent outside the
UK during the term of the policy.

Encashment
When an offshore bond is encashed and a gain arises, there is a chargeable event for income
tax purposes, because it is a non-qualifying policy.
The chargeable gain is calculated by multiplying the total gain by the following fraction. As
shown:

number of days policyholder was resident in the UK

number of days the policy has run

Therefore:
• the whole gain is chargeable if the policyholder was resident in the UK for the policy’s
whole term;
• if they were resident, for example, for five out of ten years a policy was held, only half the
gain is chargeable; and
• if the policyholder was resident outside the UK the whole time, the chargeable gain is
zero.
Chapter 6 6.2: Other indirect investments including life assurance based-products 6/79

There is no time apportionment if the policy has ever been held by a non-resident trustee – in
such cases, the whole gain is chargeable.
You should note that time apportionment relief also applies to onshore bonds issued on or
after 6 April 2013.
Taxation of a gain on an offshore bond
When a UK policyholder encashes an offshore bond, two separate calculations are carried
out:
• First, the basic-rate tax calculation is carried out.
For a basic- or higher-rate taxpayer, the whole gain is charged to tax at the basic rate,
currently 20%. If the policyholder’s other income is not sufficient to reach the basic-rate
band, any part of the gain that falls within the personal allowance would not be subject to
tax. As chargeable events are subject to the savings rate of income tax, the starting rate
of 0% will apply. Where the taxpayer’s non-savings taxable income is less than the
starting rate limit for savings (£5,000 in 2018/19), the income is not taxed. The PSA can
also be used to offset the tax due on an offshore bond.
• Second, the higher-rate or additional-rate tax calculation is carried out
The gain is top-sliced and added to the policyholder’s other income. When the tax on the
slice has been calculated (using the 20% and 25% rates in the normal way), it is multiplied
by the number of relevant years to determine the total higher-rate tax payable on the
gain.
If the policyholder was resident in the UK for the policy’s whole term, the whole gain is
chargeable. However, if they had at some time been non-UK resident, the gain is reduced by
a fraction equal to the period of non-residence divided by the duration of the policy.
The number of years used for top-slicing is also reduced by the number of complete years
for which the policyholder was not resident in the UK.

Chapter 6.2
A chargeable gain on an offshore policy is always top-sliced back to the start date of the
policy, even for part withdrawals. This is in contrast to a UK bond where part withdrawals are
always top-sliced by reference to the number of years since the last chargeable event, each
chargeable event effectively rebasing the date of the policy for top-slicing purposes.

H21 Offshore and onshore bonds compared

It might seem that an offshore bond is always preferable. This is not necessarily so for a
number of reasons:
• Gains made by an onshore fund benefit from indexation relief calculated up until 31
December 2017, with the net gain being taxed at 20% or 25% under the chargeable gains
rules on encashment by higher-rate and additional-rate taxpayers. With an offshore bond,
gains for higher and additional rate tax payers are taxable at 40% and 45% respectively on
encashment with no indexation allowance.
• Some investment income received by an offshore fund may be received after deduction
of non-reclaimable withholding tax, thus reducing the effect of the gross roll-up. In
addition, there would be no credit for this in the chargeable gain, leading to possible
double taxation.
• Charges on offshore bonds are generally higher than onshore ones, which will reduce the
final net return received by an investor.
• In an onshore fund, management expenses may be deductible from the fund’s income for
tax purposes. An offshore fund has no tax from which to deduct management expenses,
thus reducing the effect of the gross roll-up.
• On an onshore bond, for a higher-rate taxpayer, 20% tax is charged on the net return of
the fund; whereas, on an offshore fund, the 40% is on the gross return. The difference this
makes is shown by the following example, which contrasts an onshore gain from income
of £100,000 with an offshore one of the same amount.
 6/80 R02/July 2018 Investment principles and risk

Example 6.12
Onshore £ Offshore £
Gain in fund 100,000 Gain in fund 100,000
Less tax at say 20% in fund 20,000 Investors tax at 40% 40,000
Net gain 80,000 Net gain 60,000
Investors tax at 20% 16,000
Net gain 64,000
In this case, the net gain is higher on the onshore bond.

One advantage of
One advantage of an offshore bond is that income can roll-up gross. In theory, over the long-
an offshore bond is term, the compounding effect could make a difference to the eventual overall return, despite
that income can
roll-up gross
the higher tax on final encashment. However, this advantage is generally only gained over
the long-term or where the fund is invested in interest-bearing assets.

H22 Offshore bonds and offshore funds compared

Underlying
The underlying investments of offshore single premium bonds and offshore funds are similar.
investments of In fact, many offshore single premium bonds invest directly into offshore funds. There are
offshore single
premium bonds
significant differences for UK resident investors:
and offshore funds
are similar • within a bond, switches between funds do not give rise to a personal tax liability, which is
not the case for offshore funds, even if they have an umbrella structure;
• depending on their category, gains on offshore funds may be subject to either income tax
or CGT, whereas gains made on offshore bonds are solely governed by the generally less
favourable income tax regime;
• charges on offshore bonds tend to be higher than offshore funds, particularly if third-
party investment management is involved;
Chapter 6.2

• it is generally easier to place and maintain offshore bonds in trust than offshore funds; and
• the ‘5% rule’ allows tax-deferred withdrawals to be taken from offshore bonds, but not
offshore funds.

H23 Personal portfolio bonds

On a normal unit-linked bond, investors pay cash to the life office that is then invested in the
selected funds. Alternatively, they may have used a share exchange scheme to sell shares
and purchase a bond with the proceeds.
Some investors may have a portfolio of shares that they would like to keep and manage
themselves, or would prefer the stocks to be managed by their existing stockbroker, rather
than the life office. A few UK offices allowed this to be done by creating a personal bond,
which, in reality, is the investor’s own portfolio wrapped up within a bond. However, the
Finance Act 1998 imposed tax penalties on deemed gains and so, currently, only offshore
offices provide this facility to non-residents. A few things to remember:
• The deemed gain is 15% of the total premiums paid at the end of a policy year, plus the
total deemed gains from previous years (minus any chargeable withdrawals). This in
effect taxes the policyholder as if the investment was yielding 15%, regardless of any
actual growth.
• In addition, the deemed gain is on top of the normal tax charge that would arise on a part
surrender.
• The usual rules for chargeable gains apply to the deemed gain, except that there is no
top-slicing relief.
• The deemed gain can be deducted from a final termination gain. For an onshore policy,
there is a credit for the basic-rate tax paid by the life fund.

Be aware
HMRC intent
The intent was to extinguish these bonds, which is what has happened, at least as far as
UK residents are concerned.
Chapter 6 6.2: Other indirect investments including life assurance based-products 6/81

H24 Friendly society policies

Friendly societies started as mutual self-help associations in the eighteenth and nineteenth
centuries, and were assisted in this aim by complete exemption from taxation. This has
enabled them to offer tax-efficient savings plans, although legislation restricts their business
by imposing limits on the size of contracts they can offer. Only a few societies, mostly
recently established, actively market tax-exempt savings plans.

Table 6.8: Friendly society policies

Tax treatment • The friendly society does not have to pay any income tax or
CGT on the investment returns achieved on its funds. The
return to the saver is potentially greater than on a policy issued
by an ordinary life office, where the underlying funds are taxed.
Investment choice • In the past, friendly societies were legally confined to investing
at least half their funds in such investments as cash, gilts and
other safe securities. Now, they can invest where they like.
• For investors, the main choice of funds is generally cash
deposits, managed or mixed funds and with-profit.
Investment limits • The limit on annual premiums for tax-exempt business is £270
per annum. If premiums are payable monthly or quarterly, the
maximum permitted premium is £25 per month
(or £300 per year).
• The limit applies to the total of all friendly society policies
owned by an individual. Existing policies can be increased up to
the £270 limit without losing the tax-free status.
• A friendly society can also write ordinary taxable business
without limit.

Chapter 6.2
• Children under 18 can also have a tax-exempt friendly society
policy. Parents can have their own friendly society policies, as
well as one for each of their children.
Investor protection • Friendly societies are covered by the FSCS and supervised by
the FCA.
Regular savings plans • Friendly societies currently market a variety of ten-year savings
plans. Most are unit-linked plans, some plans are linked to
building society deposits and some societies offer with-profit
plans.
Lump sum investments • A number of friendly societies also offer lump sum investments.
• The lump sum buys a capital protected annuity, which feeds
each annual premium under the friendly society policy.
• If the saver dies during the policy term, the life office returns
the difference between the single premium and the total gross
annuity payments already made, and this is paid in addition to
the sum assured under the friendly society policy.
• Some societies use guaranteed bonds or unit-linked bonds as a
funding vehicle. If the bond has any value remaining in it after
the ten-year funding period, it can be encashed or left to grow.

Some advisers recommend investing the maximum permitted premium into a friendly
society savings plan because:
• funds grow tax free;
• there is a fairly high degree of security, although this could change; and
• the return is tax free if taken after at least seven and a half years.
The plans have the minimum amount of life cover to remain qualifying, i.e. 75% of total
premiums. With unit-linked plans, the life cover is usually paid for by unit cancellation. Early
surrender values depend on unit prices.

Be aware
Charges
The tax advantages of many friendly society policies are significantly reduced by the level
of charges made on them.
 6/82 R02/July 2018 Investment principles and risk

Friendly societies can incorporate themselves and undertake other types of business
through subsidiaries. This has enabled them to increase their range of services to include
unit trusts, OEICs, ISAs and mortgages.

H25 Taxation of life assurance policies

One of the main reasons for choosing to invest in a life assurance policy is its tax treatment:
• The tax treatment depends on whether or not it is a qualifying policy, and how the
benefits are drawn.
• The tax treatment of the funds held in the policy is the same – regardless of whether it is
qualifying or not.

H25A Taxation of life assurance funds

The taxation of life assurance funds is as follows:
• Dividends are exempt from tax, whether from UK or overseas companies.
• All other income, such as interest from fixed interest securities and cash, and rental
income, is taxed at 20%.
• Gains on gilts and corporate bonds are exempt from CGT.
• Capital gains on other assets, such as shares and property, are taxed at 20% after
indexation allowance (capped to 31 December 2017).
The expenses of an insurance company can be offset against its unfranked investment
income. An implication of this is that life offices whose expenses are greater than their
unfranked investment income generally pay little or no tax on their investments and can
afford to provide higher returns, e.g. on income and growth bonds. Such companies are
generally fast growing and/or small and/or have a high proportion of UK equity income.
Chapter 6.2

It is, however, the type of policy that determines the policyholder’s tax position.

H25B Qualifying policies

Most regular premium life assurance policies taken out for investment purposes (as opposed
to protection) are likely to be endowments. An endowment policy must pass various tests to
qualify:

Term of an
• policy term must be at least ten years;
endowment policy • premiums must be payable annually or more frequently for at least ten years (or until
must be at least
ten years to qualify death or disability);
• minimum level of life assurance cover is 75% of the total premiums payable;
• premiums payable in any one year must not be more than double those payable in any
other year; and
• no premium is to be more than one eighth of the total premiums payable over the term of
the policy.
Since 6 April 2013, the annual limit for premiums payable under qualifying policies (that are
not exempt) is £3,600 in a twelve-month period. Transitional rules applied to policies issued
between 21 March 2012 and 5 April 2013. Policies issued in this period are restricted so that
relief is only attributable to premiums paid, or treated as paid, in the transitional period, and
for premiums paid up to the £3,600 annual limit thereafter.
Early encashment
A surrender within the first ten years, or three-quarters of the term if sooner, can be subject
to income tax because it is a chargeable event:
• tax is payable only if the surrender value exceeds the total gross premiums (the
chargeable gain) and then only at the saver’s top rate minus basic rate; and
• if the saver is only a basic-rate taxpayer, after addition of the top-sliced chargeable gain,
there will be no tax liability.
A surrender might also result in the loss of the Married Couple’s Allowance (MCA), Child Tax
Credit and Child Benefit. Also, premiums paid to qualifying policies that are in excess of the
premium cap of £3,600 will be subject to the chargeable event rules.
Chapter 6 6.2: Other indirect investments including life assurance based-products 6/83

Tax-free lump sum

The proceeds of a qualifying policy on maturity are completely free of any further annual Proceeds on a
taxes: qualifying policy
on maturity are
• there is no personal income tax or CGT if the policy is in the hands of the person who was completely free of
any further annual
the original life assured, or it has never been acquired by another person for money or taxes
money’s worth; and
• if a policy is surrendered after ten years, it will also be free of further taxes.
Therefore, a 20-year endowment or a unit-linked whole-life policy can be cashed in with no
tax liability at any time after ten years.
The qualifying rules also provide that proceeds are free of further taxes on surrender after
three-quarters of the policy term, if sooner. Therefore, a ten-year endowment can be
surrendered after seven-and-a-half years without any further income tax liability.

Be aware
Underlying life fund
It should be remembered that the underlying life fund has already suffered up to 20%
income tax and CGT.

H25C Taxation of non-qualifying policies

All gains on non-qualifying policies are taxable. However, tax is only payable if: All gains on non-
qualifying policies
• a chargeable event occurs; are taxable
• a chargeable gain arises; and/or
• when the gain added to the taxpayer’s total yearly income, puts it in the higher- or
additional-rate tax bracket.

Chapter 6.2
These factors will now be dealt with in turn.
Chargeable events for non-qualifying policies
The chargeable events for non-qualifying policies are:
• death of the life assured;
• maturity;
• surrender or final encashment of a policy;
• certain part surrenders; and
• assignment for money or money’s worth.
Whenever a chargeable event occurs and a gain arises, the life office has to issue a When a chargeable
certificate to the policyholder. They also issue a copy to HMRC if the amount of the gain event occurs and a
gain arises, the life
exceeds half of the basic-rate income tax band. Policyholders are required to report all office has to issue
chargeable gains on their tax returns. a certificate to the
policyholder
It is important to note that assignments by way of a gift, where the policy has not previously
changed hands for any consideration, and assignments by trustees to beneficiaries are not
chargeable events.
Calculation of a chargeable gain
When a chargeable event occurs, a calculation must be done to see whether a gain has
arisen.
Partial withdrawals
For partial withdrawals, the chargeable gain is determined at the end of each policy year,
when all withdrawals for the year are added together. The chargeable event certificate is
issued to the investor on the policy anniversary date, and the assessment of income tax is
made in the tax year in which the policy anniversary date falls.
Up to 5% of the original investment may be withdrawn each policy year, without attracting a
tax liability at the time, also. For example:
• The potential liability is deferred until final encashment or death.
• If the allowance is not used in any one year, it may be carried forward on a cumulative
basis for future years.
• The allowance is treated as a return of the investor’s capital, and applies until the total of
all withdrawals covered by the cumulative 5% allowance equals the original investment.
 6/84 R02/July 2018 Investment principles and risk

If any withdrawals have been made during the policy year, the amount withdrawn has to be
compared with the cumulative allowance (5% for the current year plus any unused
allowance carried forward from previous years) to determine if there has been a chargeable
event and a chargeable gain.
The chargeable gain is the amount by which the withdrawals exceed the cumulative
allowance that is available.
Provided the total amount withdrawn does not exceed the cumulative allowance, there is no
chargeable gain, and no chargeable event in that year: the amount is, therefore, carried
forward.
If the amount withdrawn, plus the previous withdrawals that have been carried forward,
exceeds the cumulative allowance, a chargeable event has occurred. The excess over the
cumulative 5% allowance will be treated as a chargeable gain regardless of the actual
performance of the bond.
Maturity, surrender or assignment for money or money
money’’s worth
The chargeable gain on final encashment or assignment for money is assessed in the tax year
in which it occurs, and takes into account all previous chargeable events.
The chargeable gain is calculated by adding the final policy proceeds to the total of all
previous withdrawals, and then deducting the original value of the investment (including
increments, if any) and any previous chargeable excesses.
If the final gain on the bond is less than previous chargeable excesses, then the difference
can be used to offset any higher-rate income tax liability in that tax year.
Death
Where the proceeds of a bond become payable on death, the gain is calculated as if the
bond had been cashed on the date of death.
Chapter 6.2

Any additional amount of life cover is excluded from the chargeable gain.

Example 6.13
The following is an example of a calculation involving a single premium bond of £10,000,
which is held for five years.
• Year one
Part surrender of £500.
No chargeable event because it is not over 5% of the single premium.
• Year two
Part surrender of £1,000.
Chargeable event, because the accumulated withdrawals (£500 + £1,000) exceed the
total of the annual 5% allowances for two policy years.
• Year five
The bond is cashed for £14,000.
Final encashment of a non-qualifying policy is a chargeable event.
£
Chargeable gain = maturity value 14,000
plus part surrender in 500
year 1
plus part surrender in 1,000
year 2
Total 15,500
Less initial investment 10,000
5,500
Less previous chargeable gain (excess over 5% 500
allowance)
Chargeable gain on maturity 5,000
Chapter 6 6.2: Other indirect investments including life assurance based-products 6/85

Top-slicing
Since the chargeable gain identified at a chargeable event may have built up over a number Top-slicing divides
of years, it would be unfair to treat it all as having been earned in the year of receipt. the gain by the
number of years
Therefore, a method of relief known as top-slicing is allowed, which divides the excess or over which it built
up to give an
gain by the number of years over which it built up to give an average yearly gain. average yearly
gain
• Partial withdrawals:
For partial withdrawals, the gain or excess is divided by the number of years since the
start of the bond (in the case of the first chargeable event) or since the last chargeable
event (for subsequent excesses).
As the calculations can only be carried out at the end of the policy year (by which time all
withdrawals for the year will be known), the top-slicing calculation for part withdrawals
includes the current year.
• Final encashment or death:
The chargeable gain on final encashment will be assessed in the year in which it occurs
and will take into account all previous chargeable events.
The top-slicing calculation for final encashment or death uses the number of complete
policy years from the start of the bond until final encashment.

Be aware
Chargeable gains
Making partial withdrawals from a bond does not alter the total chargeable gains that may
arise. However, it can alter when any gains will be assessed to tax. The advantage of
deferring as much of the chargeable gain as possible is partly because the investor could
benefit from the investment return on the deferred tax liability, and partly because the
investor’s marginal rate of income tax may be lower when any liability arises, e.g. after
retirement.

Chapter 6.2
Taxation of a gain
Tax is calculated after the chargeable event has occurred and a chargeable gain has arisen. Tax is calculated
Since the investment funds have already borne tax, there is no personal liability to either after the
chargeable event
basic-rate income tax or CGT. Tax is calculated as follows: has occurred and a
chargeable gain
• The top-slice of the gain is calculated and added to the individual’s total income for that has arisen
tax year. The chargeable gain does not have to be grossed up, thereby further reducing
the likelihood of a personal liability to tax.
• Provided taxable income, including the top-slice, is not more than the basic-rate threshold
in the year the bond is cashed, no personal tax is payable. Non-taxpayers cannot reclaim
any tax.
• If taxable income, including the top-slice, is more than the basic-rate tax threshold, then
tax is charged at the difference between the higher-rate and the basic-rate on the amount
falling in the higher-rate band (currently 20%).
• If taxable income, including the top-slice, is more than the additional-rate tax threshold,
then tax is charged at the difference between the additional rate and the basic rate on the
amount falling in the additional-rate band (currently 25%).
• The total tax on the gain can then be calculated by multiplying the tax on the slice by the
number of years used to calculate the slice.
• By cashing bonds when other income is low (e.g. after retirement), it could be possible to
reduce or even completely eliminate the personal tax liability. Furthermore, if the bond is
issued as a series of segmented policies, full policies can be cashed in separate tax years,
which should further reduce the chance of a tax liability.
• A gain from an onshore bond can be included in the personal savings allowance (PSA).
Many investors hold on to these bonds until death. The tax liability may then be reduced,
because total income in the year of death is often less than usual. This is especially true if the
investor dies early in the tax year.

Reinforce
The extreme case would be an investor who died on 6 April, whose other income in that
tax year would probably be negligible, thus avoiding any tax at all on the bond proceeds.
 6/86 R02/July 2018 Investment principles and risk

Joint ownership
If a bond is jointly owned, the gain is split in the same proportion as the ownership,
regardless of the person to whom the money is actually paid. Each owner is therefore
taxable on their share of the gain.

With joint
If the joint owners are married to each other, or in a civil partnership, HMRC considers that
ownership, each each spouse should be taxed on half of the gain.
owner is taxable
on their share of Independent taxation
the gain
There are a number of ways in which independent taxation can be used to reduce the tax
liability on gains on bonds:
• if an investor is a higher-rate or additional-rate taxpayer but their spouse is not, then the
bond could be assigned to them before a surrender is made;
• the assignment is not a chargeable event and is also free of CGT and inheritance tax (IHT),
assuming the spouse is UK domiciled; and
• the assignment puts the money in the hands of someone who will not be taxed on it,
saving 20% or 25% income tax on any gain.
Married Couple
Couple’’s Allowance
The Married Couple’s Allowance can be claimed if a couple are married or in a civil
partnership, are living together and where at least one of them was born before 6 April 1935.

Be aware
Treatment of the gain on final encashment
The total gain on final encashment will be treated as income for Married Couple’s
Allowance purposes. The whole of the chargeable gain is used, as top-slicing does not
apply in MCA calculations. The effect of this will be to restrict the MCA, but only to its floor
(£3,360 in the 2018/19 tax year).
Chapter 6.2

Child Benefit and Child Tax Credit

If someone has adjusted net income of more than £50,000 and claims Child Benefit, a tax
charge will be incurred.
Child Tax Credit is not a tax allowance, but a social security benefit consisting of a number of
elements. It is paid directly to the main carer, but is progressively reduced according to the
joint income of the claimants.
When determining ‘adjusted net income’ for Child Benefit and Child Tax Credit purposes, a
chargeable gain has to be included in the taxpayer’s income without top-slicing, as follows:
• any withdrawals in excess of the 5% cumulative allowance will be treated as income; and
• the total gain on final encashment will also be treated as income.

Be aware
Impact of a chargeable gain on Child Benefit and Child Tax Credit eligibility
A chargeable gain may therefore reduce or eliminate a taxpayer’s eligibility for these
benefits.

H26 Segmentation
Maximum
Maximum flexibility can be achieved if a bond is divided into a number of segments or
flexibility can be clusters. The advantage of segmentation arises from the different tax regimes that apply to
achieved if a bond
is divided into a
full and part surrenders, and may reduce the actual amount of tax that is payable.
number of
segments or Segmentation means taking out a cluster of identical small bonds rather than one large
clusters bond:
• It provides an alternative to repeated part surrenders, since complete segments may be
surrendered.
• This maximises the benefit of top-slicing by ensuring that the period over which gains are
spread dates back to the commencement of the bond.
• In comparison, when a part surrender is made, the period over which the gain is in excess
of the cumulative 5% allowance spread dates back only to the previous chargeable event:
Chapter 6 6.2: Other indirect investments including life assurance based-products 6/87

– In particular, if withdrawals are made for more than 20 years, after all 5% cumulative
allowances have been exhausted, top-slicing on each additional part surrender would
only be based on the period since the previous chargeable event. A segmented bond,
on the other hand, would benefit from top-slicing for the full number of years each
segment had been held from its commencement.
• Although the segmentation of a bond does not alter the total gains that arise, the
advantage of having a choice between making part surrenders and surrendering whole
segments is that they produce different chargeable gains and it is therefore possible to
select the method that provides the more favourable result for the investor:
– In particular, large part surrenders can produce artificially high gains as investment
performance is ignored, whereas a full surrender would usually produce a precise and
lower figure related to the actual gain on the bond.
• There is no disadvantage in segmentation, since part surrenders could be made across all
of the segments of a policy as an alternative to surrendering whole segments.
• It is also possible for some policies to be totally surrendered, while others are part
surrendered, in which case, the dates of the chargeable events would be different and
could possibly fall into different tax years:
– This is because full surrenders are assessed in the tax year in which they occur, while
part surrenders are assessed in the tax year in which the policy anniversary falls.
The example in appendix 6.3 at the end of the chapter contrasts the treatment of a single
£10,000 bond and a cluster of twenty £500 segments, and assumes a unit growth rate of 5%.
In the example, the chargeable gain on final encashment is higher, but the total gains are the
same for each method, i.e. £3,592. However, segmentation is preferable for the following
reasons:
• Most investors prefer gains to occur later rather than sooner, e.g. final encashment after Segmentation will

Chapter 6.2
retirement when the tax rate may be lower. Segmentation will always effectively defer always effectively
defer gains
gains.
• There is a cash-flow effect of deferring gains, and therefore tax, for as long as possible –
tax deferred is tax saved.
• Although total gains are the same in each case, the greater top-slicing relief given by
segmentation can lead to less tax being paid if the investor is on the border of the higher-
rate tax. This will be especially true if frequent withdrawals are taken.
• If the bond is held until death, deferring much of the gain is beneficial because the
investor’s tax rate in the year of death is usually lower, especially on death early in the tax
year. Also, any income tax liability reduces the estate for IHT purposes.

Be aware
Topping up
Most life offices allow unit-linked bonds to be topped up, so that an investor can add an
additional premium to an existing bond at any time instead of taking out a new policy.
This makes no difference to the investment return, but can be beneficial in relation to how
the gain is taxed.

Top-slicing relief is related to the full term of the policy, from the date of the commencement
of the bond, even if some of the gain is produced by a premium paid part-way through the
term.

H27 Second-hand policies

There is much interest in the selling and buying of existing life policies, often called the TEP market is
second-hand or traded endowment policy (TEP) market. This market is attractive for the: attractive to the
original
• original policyholder who needs cash, because the selling price of the policy may be policyholder who
needs cash
better than the surrender value offered by the life office, sometimes by a substantial
margin; and
• buyer, because, although future premiums will have to be paid, the yield on maturity may
be good and there is always a chance of an early profit if the life assured dies.
 6/88 R02/July 2018 Investment principles and risk

The process is as follows:

• the seller has to execute a deed of assignment in favour of the buyer and hand the policy
over to them;
• the buyer should serve notice on the life office to protect their interest and to prevent the
life office paying the original owner by mistake;
• the buyer will be responsible for premiums falling due after the sale and will have to make
arrangements to pay them;
• it is advisable for the buyer to keep in touch with the life assured so as to be aware of any
death claim; and

Some market
• some market makers are willing to buy back policies sold by them. This increases the
makers are willing liquidity of the investment and is, in effect, a tertiary market.
to buy back
policies sold by Participating in this market, whether as market maker, agent or auctioneer, is classified as
them
investment business requiring authorisation by the FCA.
The policies traded are mostly with-profit endowments and some with-profit and
guaranteed bonds. Each firm has its business criteria, usually based on acceptable life
offices, minimum surrender values, and years of the policy left to run.

Policies most popular with buyers

Older with-profit policies with a few years to run to maturity and from established offices
are the most popular. Each firm also has its own scale of charges for buyers and sellers.
The market maker or agent should check that there are no assignments registered with
the life office and that premiums are paid to date.

H27A FCA requirements

FCA rules provide that:
Chapter 6.2

• When an independent adviser is asked to arrange the surrender of a with-profit

endowment policy, the adviser should tell the client, where appropriate, that it may be
possible to obtain a higher cash value through the second-hand policy market;
• Similarly, life offices are now required to inform policyholders considering surrender
about the second-hand market if the policy is marketable.
• An IFA advising buyers must give the buyer a quotation of the life office’s surrender value.
• The IFA must also explain the arrangements for assignment, including notice to the life
office and for keeping the deed and copy notice with the policy.
• The IFA should explain the claims procedures and the arrangements for checking whether
the life assured has died.

The IFA must

• The IFA must also ensure the buyer understands the tax position.
ensure the buyer
understands the
tax position
H27B Taxation on the seller
The tax position is currently as follows:
• If a qualifying policy is sold after at least ten years, or three-quarters of the term if sooner,
the sale is not a chargeable event and there is no income tax.
• If a qualifying policy is sold within the ten-year period, or three-quarter term, the sale is a
chargeable event, and if a non-qualifying policy is sold, the sale is always a chargeable
event. For example:
– If the sale is a chargeable event, the seller will make a chargeable gain where the sale
price exceeds the total premiums paid.
– If the seller is a higher-rate or additional-rate taxpayer, the gain is subject to higher-rate
or additional-rate income tax, less basic-rate tax. The gain is subject to top-slicing
relief.
• There will be no CGT liability on the sellers, provided they are the original beneficial
owners.
Chapter 6 6.2: Other indirect investments including life assurance based-products 6/89

H27C Taxation on the buyer

There are two principal forms of taxation on the buyer, as described below:
Income tax
• If the buyer holds a qualifying policy to maturity, or to a death claim, there is no
chargeable event and therefore no income tax liability.
• If the buyer holds a non-qualifying policy to maturity, or death claim, this is a chargeable
event:
– There will be a chargeable gain if the maturity value (or surrender value immediately
before death on a death claim) exceeds the total premiums paid by the buyer and the
seller.
– The purchase price paid by the buyer does not enter into the calculation.
• If a gain arises, buyers will pay income tax at their highest rate less the basic rate, subject
to top-slicing relief.
Capital gains tax (CGT)
There may also be a CGT liability because the claim is a disposal made by someone who is
not the original beneficial owner and who acquired the policy for consideration. It could also
be because the disposal is of a policy, received as a gift, which has at some stage been
bought second-hand.
The CGT situation takes no account of whether the policy is qualifying or not, although the CGT situation
taxable capital gain is reduced by any amount which is subject to income tax, i.e. a takes no account
of whether the
chargeable gain. Therefore, it is unlikely that the same policy will be subject to income tax policy is qualifying
and CGT. or not

For CGT purposes, the disposal proceeds are the maturity value or death claim value as
appropriate.

Chapter 6.2
To calculate the gain, the buyer can deduct the purchase price and their expenses, plus all
the premiums that they have paid.

Be aware
CGT on the gain
If the gain exceeds the annual CGT exempt amount, taking into account any other gains
that year, the excess is subject to CGT at 10% or 20% depending on other income for the
year.

H28 Evaluation of life assurance as an investment

Many advisers recommend UK life assurance policies to clients for their qualities as
investments rather than for their potential for providing insurance cover.

H28A Single premium bonds

Advantages
The main advantages of investment bonds are broadly as follows: One advantage of
investment bonds
• The investor can switch from one fund to another without a personal CGT charge arising. is that the investor
Therefore, bonds are potentially attractive for investors who want to switch frequently can switch from
one fund to
between funds and who would otherwise be subject to CGT at either 10% or 20%. The another without a
funds underlying the investment bonds are generally those managed by the insurance personal CGT
charge arising
company itself, but an increasing number of insurance companies offer links to funds
operated by other investment groups.
• For higher-rate taxpayers, the rate of tax that they may pay at maturity might represent a
lower charge than the higher-tax rate they might be expected to pay on income or capital
gains. If they expect to pay tax at a lower rate at some point in the future, e.g. after
retirement, the use of an investment bond could be worthwhile, especially if there is
sufficient time to build up enough income and gains at the lower rate within the fund.
• Up to 5% a year of the original amount invested can be withdrawn annually without an
immediate tax charge.
 6/90 R02/July 2018 Investment principles and risk

Disadvantages
The investment and tax features of investment bonds are balanced by certain drawbacks
and limitations:
• UK investment bonds are subject to tax on the underlying funds and this tax cannot be
reclaimed by non-taxpayers. They are therefore not suitable for non-taxpaying investors.
• Very few investors are subject to CGT because of the annual exempt amount. For most
clients, investing in UK life assurance policies will involve paying, within the fund, CGT that
would not otherwise be incurred.
• Investors whose tax rates are likely to rise in the future should be careful about using
investment bonds. They are effectively postponing their tax liability from a period when
they are paying tax at a lower rate to a period when they may be paying tax at a higher
rate.
Married Couple
Couple’’s Allowance (MCA) and Child Benefit
Single premium investment bonds may be both useful and potentially inefficient for
investors, who find themselves with a total income over the level that results in the loss of
some of the MCA or Child Benefit:
• The advantage is that the 5% withdrawals do not count towards total income. So ‘income’
can be taken from these investments in the form of withdrawals − without counting as
income that is subject to tax in the year it is drawn.
• The potential drawback is that any chargeable amount counts in full towards total income,
with no allowance being made for any top-slicing relief.

H28B Regular premium policies

Regular premium
Regular premium policies are taken out largely for investment or savings purposes. The life
policies are taken assurance elements may be of secondary importance or possibly wholly irrelevant.
out largely for
Chapter 6.2

investment or Advantages
savings purposes
The main advantage of investing through a regular premium policy is likely to be that it is a
qualifying policy and is therefore free of personal tax on maturity or early encashment under
the rules. (As long as the £3,600 contribution limit is not exceeded for policies issued after
the 6 April 2013).
Other things to consider are that:
• underlying investments are subject to the insurance company’s tax rates, so the
investment is likely to be unattractive for a non-taxpayer and possibly no longer neutral
for a basic-rate taxpayer with respect to income tax, following the introduction of the
PSA;
• as tax is paid on some internal capital gains, there is a loss of tax efficiency for a person
who does not expect to pay CGT; and
• higher-rate taxpayers, however, should benefit, especially if they pay CGT regularly on
investment gains.
Possible disadvantages
Qualifying policies
Qualifying policies have to fulfil several relatively inflexible rules. These mean that they have
have to fulfil to be maintained for long periods, generally at least ten years, and it is difficult to vary the
several relatively
inflexible rules
level of regular premiums.

Consider this
this…
…
Also, a minimum amount of life cover is required, which could represent an attractive
benefit or an irrelevant expense, depending on the investor’s circumstances.

H28C Offshore bonds

Offshore
Offshore investment bonds are taxed in much the same way as UK bonds. However, there
investment bonds are several differences that may make the tax position of the underlying funds more
are taxed in much
the same way as
attractive for some investors. These include the following:
UK bonds
• The underlying funds are free of UK tax on capital gains. Offshore bonds are therefore
attractive for those who wish to have actively managed portfolios of investments,
especially where there is considerable switching between different funds and types of
assets.
Chapter 6 6.2: Other indirect investments including life assurance based-products 6/91

• The scope for postponing the incidence of CGT is therefore potentially greater than with
ordinary UK-authorised unit trusts, where switches between unit trusts may trigger a CGT
charge.
• However, the ultimate tax charge on the gain may be greater. The capital gains are
treated as income in the year of encashment and so there is no annual CGT exempt
amount to use.
• There is no UK tax on investment income, but the dividends may be subject to
withholding tax from their countries of origin.
– The income tax position of offshore bonds therefore provides little or no tax advantage
over UK bonds for equity investment, but there are some tax advantages for income
derived from deposits and fixed-interest investments held within the offshore bond
funds.
– Where the investment bond is linked to a private portfolio of shares for one investor (a
personal portfolio bond), HMRC will impose the tax treatment detailed in section H23.
• The proceeds of the plan are subject to both basic rate tax and the higher rates of tax.
This could mean that there would be an element of double taxation on the income of
equity investments that have already suffered withholding tax.
• There are often higher set-up and management charges for offshore bonds than for the
equivalent UK investments.

Be aware
Usefulness of offshore and UK bonds
Offshore bonds may therefore be useful where the underlying investment is either deposit
or fixed-interest income or low- or nil-yielding equities that will produce capital gains.
Both UK and offshore bonds are more attractive if the investor’s tax rate on encashment is
lower than their tax rate during the lifetime of the bond. Where the investor can arrange

Chapter 6.2
to be a non-UK taxpayer at the time the bond is encashed, the long-term tax saving from
an offshore bond is potentially greater.

H28D Life assurance investments generally

The adviser must be able to justify the use of investment bonds when they are used in The adviser must
preference to other vehicles. Tax is likely to be an important consideration and is the main be able to justify
the use of
reason why investment bonds are recommended. investment bonds
when they are
Unless there are very good investment reasons for using a bond rather than any other type used in preference
of vehicle, it is usually preferable to invest first in tax-free investments such as ISAs, then to other vehicles

shares, unit trusts, open-ended investment companies (OEICs) or investment trusts, where
the investor has the opportunity to use their annual CGT exempt amount and pay a lower
rate of CGT. Investors should also ensure that they use their dividend allowance before they
decide to invest in onshore bonds.
Life assurance products enable investors to set their own level of ‘income’ withdrawals,
which may be more or less than the true level of income being generated by the underlying
fund. Currently, few unit trust and OEIC providers offer such a service.

I Exchange traded products

I1 Exchange traded funds
Exchange traded funds (ETFs) are index-tracking funds that are listed and traded on major
stock markets around the world in the same way as the shares of publicly quoted companies.
They are similar to an index-tracking pooled fund, as they reflect the diversification and
performance of a chosen index, but they are traded like a single share through stockbrokers
and their prices are updated throughout the day.
The first ETF tracked the FTSE 100, but the range rapidly expanded to cover equity, fixed
interest and property indices in the UK and around the world, providing investors with ways
of achieving exposure to entire asset classes, geographical regions, markets and sections of
a market.
 6/92 R02/July 2018 Investment principles and risk

ETF transactions are subject to broker fees in the same way as share transactions, but there
is no stamp duty to pay on purchases. They have very competitive cost structures compared
with other index-tracking investments, with typical management fees of less than 0.5%.
Like other index-tracking funds, ETFs are designed to match the return on the index they
track, usually by fully replicating that index by buying exactly the same investments as those
in the index and rebalancing whenever the index is rebalanced.
Some ETFs use swaps, a type of OTC derivative, to replicate the returns and so the investor
is exposed to the risk that the counterparty may fail to meet their obligations. This is known
as synthetic replication.
Tracking an index by investing in just a subset of the index (rather than full replication) is
known as sampling or optimisation.
As they are subject to management and trading costs, they tend to experience a degree of
tracking error (the difference between the fund’s return and the index return), although
typically this will be quite small.

Be aware
Performance of an ETF
The performance of an ETF reflects the total returns of a specified market index, including
dividend payments, less the management charges applied by the issuer. The dividends on
each index are accumulated and paid out at regular intervals, usually quarterly.

An investor will be
An investor will be subject to income tax on dividend payments and CGT on any gains
subject to income arising on disposal in the same way as for equities. The majority of ETFs are domiciled in
tax on dividend
payments and CGT
offshore fund centres and so the tax treatment will depend upon where the fund is located
on any gains and whether it has reporting status. Many Dublin-based ETFs directed at the UK market and
arising on disposal
in the same way as
which are quoted on the London Stock Exchange have reporting status, but not all, and
Chapter 6.2

for equities reference needs to be made to the fund’s prospectus to ascertain its tax treatment.
ETFs are eligible for inclusion in ISAs.

I2 Exchange traded commodities (ETCs)

An exchange traded commodity (ETC) works on the same principle as an ETF, tracking the
performance of an underlying commodity or basket of commodities, such as metals, natural
energy resources, agricultural produce or livestock. ETCs may either try to directly track the
performance of a given commodity, or, where there may be complications in tracking the
value of the actual physical commodity, the ETC may track an index that is designed to
measure the value of that commodity.

I3 Exchange traded notes (ETNs)

ETNs share many
Exchange traded notes (ETNs) share many of the characteristics of ETFs. They are traded on
of the a stock exchange throughout the day, their performance tracks the movement of an index
characteristics of
ETFs
and they give access to specialist market niches, such as commodities and currencies. An
ETN is, however, a type of bond issued by a bank. In the same way as other types of debt,
ETNs have a maturity date, but they do not pay any interest. Instead, the returns are linked
to the performance of a market index, less management fees.

Be aware
Difference between ETNs and ETFs
ETNs differ from ETFs as there is no portfolio of investments. ETNs do not own anything
they are actually tracking. Instead, they use derivatives to track the index.

As ETNs are unsecured bonds, they have an additional risk compared with ETFs, which is
that their value will be affected by the credit rating of the issuer. If the issuing bank’s credit
rating is downgraded, the value of an ETN may drop, even though there is no change in the
underlying index. Repayment of the investment is also dependent on the ability of the
issuing bank to meet its commitments and, in the event of default by the bank, investors may
receive nothing at all.
Chapter 6 6.2: Other indirect investments including life assurance based-products 6/93

J Property-based investments
As an alternative to direct property investment, it is possible to invest indirectly through:
• shares in listed property companies;
• property unit trusts and investment trusts;
• insurance company property funds; and
• real estate investment trusts (REITs).
Each of these has different investment characteristics from direct property investment.

J1 Shares in listed property companies

A much more liquid way to invest in property than a direct investment is to own shares in A more liquid way
one of the property companies listed on the London Stock Exchange. to invest in
property than a
Such an investment differs from a direct investment in the following ways: direct investment
is to own shares in
• the investment is diversified over a number of different properties; one of the
property
• share prices are affected by the quality of the management and the level of borrowing, as companies listed
on the London
well as the underlying asset value of the property portfolio; Stock Exchange
• property shares can be highly geared as the companies usually borrow to purchase more
property, making the shares more volatile;
• the share prices will rise and fall independently of the underlying asset values, depending
on the forces of supply and demand:
– they will also be affected by the risks that affect the stock market as a whole, such as
general economic conditions, as well as those that are specific to the company; and
• the company will be liable to corporation tax on capital gains and rental income.

Chapter 6.2
There is a range of different property companies specialising in different areas and with
different investment objectives:
• some hold property as an investment – they are property companies that act like Some hold
professional landlords; property as an
investment, others
• others undertake developments – they are property development companies that are undertake
more like construction companies; and developments and
many do both
• many do both.

Be aware
Risk and returns
Different companies provide different returns, with varying levels of risk:
• the returns from a development company that sells buildings on completion can
fluctuate quite widely, since its profits from sales can be erratic; and
• a company that holds onto a property it has developed usually has a secure income,
since its revenues come mainly from the regular rent paid by tenants.
It should be possible to select property companies that match the requirements and
investment objectives of individual investors.

J2 Property unit trusts and investment trusts

A convenient way of investing in the property market, for an investor with limited funds, can
be through an authorised unit trust or investment trust. Both give a wide exposure to the
property market, providing diversification, with sufficient liquidity to ensure that investors
can realise their holdings, in whole or part, when needed.
Authorised unit trusts are permitted to invest in the shares of property companies, or Authorised unit
directly in property itself: trusts are
permitted to invest
• unlike property companies, they cannot borrow money as easily to invest; and in the shares of
property
• the price of units is directly linked to the value of the investments held in the fund. companies, or
directly in property
Funds that invest substantially in property are allowed to delay redemption to raise money itself

to pay investors. The maximum period permitted between redemptions is six months.
 6/94 R02/July 2018 Investment principles and risk

Investment trusts are required to invest primarily in the shares and securities of property
companies and can hold only a relatively small percentage in direct property:
• they can borrow money for investment purposes, which is riskier; and
• the share price will move independently of the net asset value (NAV), depending on the
level of demand.

Be aware
Capital gains tax
As with all unit trusts and investment trusts, there is no CGT on investments within the
funds. The investor is only subject to CGT when gains are realised on disposal and only if
they are in excess of the annual exempt amount.

It is possible to hold funds that invest directly in property in an ISA, provided they do not
restrict an investor’s ability to access their funds.

J2A Property authorised investment funds (PAIFs)

A property authorised investment fund (PAIF) is an FCA-authorised OEIC that invests
mainly in property (including UK and non-UK REITs). The point of taxation moves from the
fund to the investor, in the same way as would apply to a direct investment in property.
Under the PAIF regime, rental profits and other property-related income are exempt from
taxation in the fund.

The property
The property income is ring-fenced in the PAIF, but other taxable income is subject to
income is ring- corporation tax at 20%.
fenced in the PAIF
Distributions made to investors are split into three types of income:
• Property income
income. This is usually paid net of 20% income tax (non-taxpayers can reclaim
Chapter 6.2

the tax or they can be paid gross, if the fund is held within an ISA or a pension wrapper,
the income is also paid gross).
• Interest income
income. Distributions of interest are paid gross.
• Dividends
Dividends. Also paid without the deduction of any tax, i.e. they are paid gross.
Only OEICs can qualify as PAIFs, so an authorised unit trust would have to convert to an
OEIC.

Be aware
Main conditions for PAIFs
The main conditions that PAIFs have to meet include:
• at least 60% of the PAIF’s net income in an accounting period must be from the exempt
property investment business;
• at the end of each accounting period, the value of the assets involved in the property
investment business must be at least 60% of the total assets held by the PAIF; and
• its shares must be widely held, with no corporate investor holding 10% or more of the
fund’s NAV.

J2B Insurance company property funds

Life assurance
Life assurance companies generally have funds that specialise in direct holdings of
companies commercial property. These are usually available as both regular and single premium unit-
generally have
funds that
linked life assurance contracts.
specialise in direct
holdings of The main features are:
commercial
property • the value of units is directly linked to the value of the property in the portfolio, and is
established by regular professional valuations;
• the funds cannot borrow money;
• liquidity is significantly higher than with direct property investment, although encashment
can sometimes be suspended for a specific period in difficult market conditions; and
• any income and capital gains are subject to up to 20% tax within the fund.
Chapter 6 6.2: Other indirect investments including life assurance based-products 6/95

J3 Offshore property companies

A number of investment groups have set up unauthorised investment trusts as offshore
companies. This structure avoids the restrictions placed on authorised investment trusts and
allows them to invest 100% of their assets directly in property rather than property
companies. The companies usually obtain a UK stock market listing, so that their shares are
eligible for inclusion in ISAs.
An offshore structure generally results in the fund paying less corporation tax than an
onshore company, although the exact amount depends on where the company is based. The
company is not liable to UK corporation tax, but is liable to UK income tax at the basic rate
on rental income from UK property (net of debt financing and allowable expenses). The
company would not be liable to tax on capital gains.

Be aware
Taxation
UK-resident investors receive dividends gross. Where the company is a UK-listed, closed-
ended investment company, any gains on disposal of shares are taxed under capital gains
rules. The first £2,000 of dividend income received in this tax year is tax free. Sums above
that will be taxed at 7.5% for non-taxpayers and basic-rate taxpayers, 32.5% for higher-
rate taxpayers and 38.1% for additional-rate taxpayers.

J4 Real estate investment trusts (REITs)

REITs became available in 2007 and have a similar structure to the REITs that have been REITs became
available for many years in a number of countries, including the USA, Australia and France. available in 2007

The aim of a REIT is to provide a savings and investment vehicle that:

Chapter 6.2
• provides a liquid market in property investment;
• is widely accessible by the private investor; and
• has a tax treatment that is closely aligned to the tax arrangements in place for direct
investment in property.

J4A Basic structure

REITs must be closed-ended companies (so cannot be an OEIC), resident in the UK for tax REITs must be
purposes and can only issue one class of ordinary share. They must be listed on a recognised closed-ended
companies, listed
stock exchange, which includes AIM. on a recognised
stock exchange
A REIT usually has two separate elements for tax purposes:
• a ring-fenced property letting business, which is exempt from corporation tax (except on
sales of certain property developments); and
• the remaining non-ring-fenced business, which contains any other activities, e.g. the
provision of property management services:
– profits and gains from this business are subject to corporation tax.
Certain conditions must be met to qualify as a REIT:
• at least 75% of the company’s total gross profits must be from the property rental
business (the tax-exempt part of the business);
• at the beginning of each accounting period, the value of the assets in the tax-exempt part
of the business must be at least 75% of the total value of the assets (ignoring secured
loans) held by the company; and
• REITs cannot have an excessive amount of debt financing: REITs cannot have
– interest on borrowings has to be at least 125%, covered by rental profits (before an excessive
amount of debt
deducting interest costs), because below this level the company will be taxed on the financing
excess interest.
 6/96 R02/July 2018 Investment principles and risk

Table 6.9: Tax treatment

Internal tax • At least 90% of the profits of the tax-exempt part of the business
(income, not capital gains) arising in an accounting period must be
distributed as a dividend within twelve months of the end of the
accounting period. Stock dividends can be issued in lieu of cash
dividends for the purpose of the distribution requirements.
• Property can be developed within the ring-fenced, tax-exempt part of
the business, providing it is for the purpose of generating future rental
income, i.e. it is added to the property portfolio.
• If a property is developed to be sold for a profit, then the disposal would
be treated as non-tax exempt and corporation tax would be payable.
However, where a property is developed for investment purposes but
later sold, providing a period of three years has elapsed, the sale will be
treated as tax-exempt.
Investor tax • Distributions from REITs can comprise of two elements:
– A payment from the ring-fenced part of the business that is exempt
from corporation tax. For individual investors, this is treated as UK
property income, and will be paid net of basic-rate tax (20%). Non-
taxpayers can reclaim the tax deducted. ISA and SIPP investors
receive payments gross. Higher- and additional-rate taxpayers will
pay extra, as shown in the example below.
– A dividend payment from the non-ring-fenced part of the business
that is not exempt from corporation tax. This is treated in the same
way as any other UK dividend. Whether the investor owes income tax
depends on their tax position, as shown in the example below.
• Gains on REIT shares are subject to CGT in the usual way.

Example 6.14
Chapter 6.2

Ring-fenced (tax exempt) element of the business

If a shareholder holds 100 shares and the REIT declares a distribution of £1 per share, the
company pays £80 to the shareholder and £20 to HMRC. Non-taxpayers can reclaim the
tax that has been deducted at source. Income from UK property is chargeable to tax at
20% for basic-rate taxpayers (so they will have nothing further to pay), at 40% for higher-
rate taxpayers and at 45% for additional-rate taxpayers (who will need to pay an
additional 20% and 25% of the gross distribution respectively).
Non-ring-fenced (non-exempt) element of the business
UK-resident investors receive dividends gross. The first £2,000 of dividend income
received in this tax year is tax free. Sums above that will be taxed at 7.5% for basic-rate
taxpayers, 32.5% for higher-rate taxpayers and 38.1% for additional-rate taxpayers.
Chapter 6 6.2: Other indirect investments including life assurance based-products 6/97

K Private equity
Private equity is regarded by some as an asset class in its own right and involves providing
medium- to long-term finance in return for an equity stake in potentially high-growth,
unquoted companies. Investment in small new businesses is riskier than investing in listed
companies, mainly because some new businesses will fail, but also because the investment
may be difficult to realise. Some private equity funds specialise in a particular sector or type
of company, while others are more general.
Some of the main ways in which investment in this asset class can be achieved are through:
• an enterprise investment scheme (EIS);
• a seed enterprise investment scheme (SEIS); and
• a venture capital trust (VCT).
These products may involve higher charges than other funds. This is because a significant
amount of time will be spent researching and spending time with the management team of
small fledgling companies.

K1 The enterprise investment scheme (EIS)

The enterprise investment scheme (EIS) was introduced to encourage private investment in
small, higher-risk, unquoted UK companies by providing tax incentives, provided that the
company meets certain criteria.

K1A Tax relief

Income tax relief at 30% is given for qualifying investments.
Relief can be claimed up to a maximum of £2 million invested in EIS shares, providing any

Chapter 6.2
amount in excess of £1 million is invested in knowledge-intensive companies and the investor
has an income tax liability of at least the amount being claimed.
The relief is given as a reduction to the investor’s tax liability.
The current tax regime has the following characteristics:
• relief is withdrawn if the shares are disposed of within three years, except to a spouse and
not on the death of the investor; and
• an investor may carry back income tax relief to the previous tax year by claiming that the
qualifying shares are treated as having been issued in the previous year, and as long as the
annual limit for the purposes of calculating income tax relief in any particular tax year is
not exceeded.
Payment of tax on a capital gain can be deferred by reinvesting the gain into an EIS Payment of tax on
company. Where only this relief is claimed (CGT deferral relief), there is no upper limit. This a capital gain can
be deferred by
works as follows: reinvesting the
gain into an EIS
• reinvestment must take place in the period beginning one year before and ending three company
years after the disposal giving rise to the gain;
• the deferred gain is brought into charge when the EIS shares are disposed of, unless a
further qualifying reinvestment is made;
• the CGT rate applied to a deferred gain will be the rate at the time the deferral ends and
the gain becomes liable to tax;
• gains arising on the disposal of EIS investments that qualified for income tax relief are
exempt from CGT, as long as the shares have been held for three years; and
• losses on EIS investments are allowable where either income tax relief or CGT deferral
relief has been obtained, although a deduction is made for the initial income tax relief that
has been given. A loss can be set against either chargeable gains or income.

Be aware
Shares held for at least two years
If the shares are held for at least two years, they qualify for 100% business relief for IHT
purposes as unquoted companies.
 6/98 R02/July 2018 Investment principles and risk

K1B Main conditions for enterprise investment scheme relief

The main conditions for EIS relief are as follows:
• tax relief is given to qualifying individuals who subscribe for eligible shares in a qualifying
company carrying on a qualifying business activity;
• a qualifying individual is someone who is not connected with the company when
subscribing, although they can subsequently become a paid director of the company;
• a non-UK resident is eligible, but can only claim tax relief against any liability to UK income
tax;
• no income tax relief is given if more than 30% of the capital is acquired, although CGT
deferral relief would still be available;
• eligible shares are new ordinary shares that are not redeemable for at least three years;
• a qualifying company must be unlisted when the shares are issued, and there must be no
arrangements at that time for it to become listed;
• a company raising money under an EIS must have fewer than 250 full-time employees
(knowledge-intensive companies can employ up to 500 people) at the date on which the
shares are issued;
• the gross assets of the company must not exceed £15 million immediately before the issue
of shares, nor £16 million immediately afterwards;
• to qualify for relief, the company must have raised no more than £5 million under all
venture capital schemes in the twelve months ending on the date of investment (£10
million for knowledge-intensive companies) and no more than £12 million in the
company’s lifetime (or £20 million for knowledge-intensive companies):
– if the limit is exceeded, none of the shares will qualify for relief under the EIS;
• the company must carry on a qualifying trade and have a permanent establishment in the
UK, which can include companies whose shares are traded on the AIM;
Chapter 6.2

• there must not be any pre-arranged exit provisions designed to minimise investment risks;
and
• investment must be made within seven years of the company’s first commercial sale (or
ten years for knowledge-intensive companies), although this rule does not apply where
the investment represents more than 50% of turnover averaged over the previous five
years.
Since 6 April 2015, companies benefiting substantially from subsidies for the generation of
renewable energy have been excluded from also benefiting from EIS.

K1C Enterprise investment scheme – risks

Investing in
Investing in unlisted trading companies is a high-risk activity as there is a possibility of the
unlisted trading companies failing. An EIS must be held for three years to retain the income tax and CGT
companies is a
high-risk activity
relief. Even after that period, it may be difficult to dispose of the shares, as the market is
likely to be very illiquid or even non-existent.

K1D Seed enterprise investment schemes (SEISs)

The SEIS is designed to help small start-up companies raise equity, offering tax reliefs to
individual investors who buy new shares in those companies. It runs alongside the EIS but, in
recognition of the problems which young companies face in attracting investment, it offers
tax relief at a higher rate. The rules are designed to reflect the EIS, because it is thought that
companies may want to go on to use an EIS after an initial investment in an SEIS.
Reinvestment relief allows an individual to treat 50% of a gain as exempt from CGT, if SEIS
shares are acquired. You cannot get reinvestment relief unless you also get income tax relief.
Income tax relief is available at 50% of the cost of the shares, on a maximum annual
investment of £100,000. The relief is given by way of a reduction of tax liability, providing
there is sufficient tax liability against which to set it. The shares must be held for a period of
three years from the date of issue for relief to be retained. If they are disposed of within the
three-year period, relief will be withdrawn or reduced.
Chapter 6 6.2: Other indirect investments including life assurance based-products 6/99

It is also possible to ‘carry back’, which means an investor can treat the cost of shares bought
in a tax year as if they had been bought in the previous year. The tax relief for the previous
year is also given, up to the allowed limit for each year. (The ‘carry back’ facility equally
applies for capital gains re-investment relief as it does for income tax relief).
If income tax relief was given on the cost of the shares (and not later withdrawn) and the
shares are disposed of after three years, any gain is free from CGT.
Business relief of 100% for inheritance tax is also available after two years.
The main conditions are that the company must:
• be unquoted at the time of issue of the shares;
• employ 25 people or less;
• be no more than two years old;
• have less than £200,000 in gross assets; and
• meet the qualifying trade rules.
– Most trades qualify but some do not, e.g. dealing in land, commodities, financial
activities like banking and insurance, and property development.
Since 6 April 2015, companies benefiting substantially from subsidies for the generation of
renewable energy have been excluded from also benefiting from SEISs.

Useful website
This list is not exhaustive; see www.gov.uk/guidance/venture-capital-schemes-apply-to-
use-the-seed-enterprise-investment-scheme for more information.

K2 Venture capital trusts (VCTs)

Chapter 6.2
The VCT scheme was designed to encourage individuals to invest in certain types of small,
higher-risk trading companies not listed on the official list of any stock exchange.
VCTs are very similar to investment trusts since both are listed companies, run by fund
managers who are generally members of larger investment groups. Investments in both can
be made by subscribing for new shares when a trust is launched, or by purchasing shares
from other investors after the trust is established.

Be aware
Shares and securities in a VCT
A VCT must predominantly hold the shares and securities of unlisted companies.

By investing in a VCT, investors are able to spread the investment risk over a number of
companies.

K2A Tax relief

Income tax relief is at 30% up to a maximum investment of £200,000 in new issues of
ordinary shares in VCTs.
Dividends received from VCT investments of up to £200,000 per tax year are exempt from
income tax (whether acquired by subscription or by purchase from another shareholder).
Gains arising on the disposal of VCT shares that were acquired by subscription or purchase
are exempt from CGT and there is no minimum period for which the shares must be held.
Any losses on VCT shares are not allowable losses for CGT purposes. Neither are they Any losses on VCT
available to offset against other capital gains. shares are not
allowable losses
Income tax relief is taken back if the shares are not held for at least five years. for CGT purposes
 6/100 R02/July 2018 Investment principles and risk

K3 Conditions to qualify as a venture capital trust

VCTs have to be approved by HMRC and must satisfy a number of conditions. The main ones
are:
• must be listed on the London Stock Exchange;
• all money raised must be used within two years;
• income must be wholly or mainly derived from shares or securities, and they must not
retain more than 15% of the income;
• at least 70% of their investments by value must be in qualifying holdings
holdings, which are newly
issued shares in qualifying, unlisted trading companies, including companies traded on
AIM;
• not more than 15% of total investment must be invested in any single company or group;
• at least 70% of their qualifying holdings by value must be in new ordinary shares that have
no preferential rights;

At least 10% of the

• at least 10% of the total investment in any one company must be in ordinary, non-
total investment in preference shares;
any one company
must be in • a company raising money under a VCT must have fewer than 250 full-time employees at
ordinary, non- the date on which the shares are issued (knowledge-intensive companies can employ up
preference shares
to 500 people); and
• to be a qualifying holding of a VCT, a company must have raised no more than £5 million
(£10 million for knowledge-intensive companies) under all venture capital schemes in the
twelve months ending on the date of the investment.
– If the limit is exceeded, none of the shares will rank as a qualifying holding for a VCT. In
addition, no more than £12 million can be raised during the company’s lifetime (or £20
million for knowledge-intensive companies).
Chapter 6.2

Other features include:

• Companies benefiting substantially from subsidies for the generation of renewable energy
are excluded from also benefiting from VCTs.
• Investments in VCTs that are conditionally linked in any way to a share buyback, or that
have been made within six months of a disposal of shares in the same VCT, are excluded
from qualifying for new tax relief.
• Investors can subscribe for VCT shares through nominees.
• For shares issued on or after 6 April 2014, VCTs will be prevented from returning capital
that does not relate to profits on investments within three years of the end of the
accounting period in which shares were issued to investors.
• The company must also satisfy a number of other conditions broadly similar to EIS
companies, e.g. investment must be made within seven years of the company’s first
commercial sale (or ten years for knowledge-intensive companies), although this rule
does not apply where the investment represents more than 50% of turnover averaged
over the previous five years.

Be aware
Taxation
A VCT is exempt from corporation tax on gains arising on the disposal of its investments,
and these realised gains can be distributed to investors as dividends with no additional
tax liability for the investor.

HMRC will give provisional approval to a VCT if it is satisfied that the conditions will be
fulfilled within specific time periods. However, a VCT must at all times have 70% of the value
of its investments in qualifying holdings to gain and retain approval.
Where a VCT makes a cash realisation on the disposal of an investment that had been part of
its qualifying holdings for at least six months, the disposal will be ignored for the next six
months for the purpose of the 70% test. This will give the VCT up to six months to reinvest or
distribute the disposal proceeds.

Question 6.8
In what ways are VCTs similar to investment trusts?
Chapter 6 6.2: Other indirect investments including life assurance based-products 6/101

K4 Venture capital trusts – risks

A VCT has a five-year holding period for the retention of income tax relief, although it may A VCT has a five-
be difficult for an investor to sell their shares after that time, even though the shares are year holding
period for the
listed. The demand for existing shares is likely to be low, since the tax relief is only available retention of
on subscriptions of new shares, not those bought in the market. income tax relief

Consider this
this…
…
A VCT is a pooled investment, although the underlying investments are relatively high
risk, while an EIS, although it can be purchased as a fund, can also be an investment in just
one company.

L Individual savings accounts (ISAs)

L1 Introduction
An ISA is not itself an investment; it is a wrapper within which a wide range of savings and
investment products can be held free of UK income tax and CGT.
ISAs allow individuals to hold cash deposits, certain life assurance policies and investments
in UK and overseas shares, corporate and government bonds. These can be held directly or
through collective investment schemes. They can only be operated by HMRC-approved
account managers.

Be aware
Taxation
Investors do not pay income tax on any interest or dividends they receive from the

Chapter 6.2
investments held in an ISA, nor CGT on any gains made on disposal of the ISA.

L2 Eligibility
An ISA investor must be an individual who is:
• resident in the UK for tax purposes;
• a Crown employee, such as a diplomat or member of the armed forces who is working
overseas and paid by the UK Government:
– spouses and civil partners of such individuals are also eligible to subscribe;
• aged 18 or over to invest in a stocks and shares ISA or innovative finance ISA;
• aged over 18 but under 40 to open a Lifetime ISA; and
• aged 16 or over to invest in a cash ISA (including the Help to buy ISA).
– However, if the capital is derived from a parent, and the interest, together with any
other income from all capital provided by the parent, is more than £100 a year, the
income will be treated as the income of the parent until the child reaches age 18; and
– the income must be reported on the tax return of the parent, and may not be tax free.

Consider this
this…
…
If an ISA holder ceases to be resident in the UK, they can keep the ISA and retain the tax
benefits, but cannot pay in any further money.

ISAs may only be arranged on an individual basis and cannot be assigned/placed in trust.

L3 Structure of ISAs
Investors can subscribe to the following types of ISA:
• cash ISA;
• stocks and shares ISA;
• innovative finance ISA (IFISA); and
• Lifetime ISA.
 6/102 R02/July 2018 Investment principles and risk

L4 Subscription limits
There is a maximum that can be saved, which can either be in one of the ISA types or it can
be split across some or all of the ISA types. In 2018/19, the maximum subscription is
£20,000, although the maximum that can be saved in a Lifetime ISA is £4,000 in a tax year.
If the ISA is ‘flexible’, cash can be taken out and put back in again during the same tax year
without it affecting the current year’s subscription.

L5 How to invest
Applications may be made in writing, by phone or online. Applications can allow for
subscriptions to be made in the year of application, and in each successive year in which the
applicant subscribes. This allows, for example, a continuous subscription by direct debit,
provided at least one payment is made in each tax year.
Applications cease to be valid at the end of a tax year in which the investor fails to make a
subscription. When this happens, the investor must make a fresh application before
subscriptions can recommence.
Investment may be made by way of cash, including direct debit, credit and debit card, and
electronic transfer. Gifts of cash from third parties are acceptable.
Investment in a stocks and shares ISA can be in the form of a CGT-free direct transfer of
shares from an approved share-incentive plan or a savings-related share option scheme
(SAYE). The shares must be transferred within 90 days from the date they emerge from the
scheme. The value of shares at the date of transfer counts towards the annual subscription
limit.

How it works
Chapter 6.2

Investing in an ISA
It is not possible to transfer newly issued or windfall shares into a stocks and shares ISA.
All share transfers, other than employee share schemes as described above, are by way of
sale and reinvestment.

L6 Tax advantages
ISA investments
ISAs have the following tax advantages:
are free of UK
income tax and • Withdrawals can generally be made at any time without loss of tax relief (subject to the
CGT ISA manager’s terms and conditions); although there are different rules for withdrawing
money from a Lifetime ISA.
• Interest, dividends and property income distributions from ISA investments are exempt
from any income tax and do not have to be reported to HMRC.
• The manager receives interest distributions from corporate bond funds and mixed funds
that hold both equities and bonds (where at least 60% of the fund is invested in bonds)
without the deduction of any income tax.
• Property income distributions from REITs are paid gross to ISA managers.
• Capital gains on ISA investments are exempt from CGT, which also means that losses
cannot be used against gains made elsewhere.
In respect of life assurance policies held in an ISA
ISA:
• the insurer does not have to pay tax on income and capital gains on investments used to
back ISA policies; and
• the investor has no tax to pay on withdrawals, or when the policy is cashed.

Consider this
this…
…
Tax-free returns from ISAs can benefit an investor who is entitled to the MCA. It also
reduces the risk of an investor becoming liable to pay higher-rate tax.

L7 Invalid ISAs
If an investor exceeds the overall subscription limit, the excess subscriptions are invalid.
Chapter 6 6.2: Other indirect investments including life assurance based-products 6/103

After the end of a tax year, when the ISA managers make their returns, the Savings Scheme
Office (SSO) identifies if there has been an invalid subscription. The SSO will notify the ISA
manager and the investor of the error and the action that needs to be taken to correct it:
• Where necessary, they will arrange with HMRC to repay any tax relief that has been given
in error.
– The investor will be given details of any income or gains from the investments, which
must be reported to their tax office if they are due to pay tax.
• Where an ISA holds life assurance, the policy must end if the subscription is invalid.
– The policy may give rise to a taxable gain if the proceeds are greater than the
premiums paid.
• The ISA manager will repay any tax due to HMRC at the basic rate, but the investor must
report the gain to their tax office and may have to pay more tax if they are a higher-rate
taxpayer.

L8 Investment rules
There are strict rules regarding the investments that can be held within an ISA.

L8A Eligible investments

Eligible investments in an ISA include:
• Shares that are officially listed on a recognised stock exchange anywhere in the world,
including those on AIM. Shares in unquoted companies do not qualify.
• Small- and medium-sized enterprise securities (not just equities) admitted to trading on a
recognised stock exchange.

Chapter 6.2
• Corporate bonds that are officially listed on a recognised stock exchange.
• Listed bonds issued by a cooperative and community benefit society.
• Gilts and similar securities issued by governments of countries in the European Economic
Area (EEA) and ‘strips’ of all these securities.
• UK-authorised unit trusts and OEICs.
• Units or shares in a non-undertakings for collective investment of transferable securities
(UCITS) retail scheme, provided they do not restrict the ability of savers to access their
funds by more than two weeks (limited redemption funds are not eligible).
• UK-listed investment trusts (including REITs).
• Units or shares in an FCA-recognised UCITS scheme.
• Shares acquired within the previous 90 days from a SAYE or a share incentive plan. This
applies even where the shares would not otherwise be qualifying investments (e.g.
because they are not listed on a recognised stock exchange).
• Units in a stakeholder, medium-term investment product, which can consist of unitised
investments and unitised insurance investments.
• Life assurance policies criteria include:
– must be on the own life of the ISA investor, i.e. joint life, multiple life and ‘life of another’
policies are not allowed;
– must be a life assurance contract and can include supplementary health benefits (e.g.
sickness, critical illness, accident) and waiver of premium benefit – it must not be an
annuity, a personal portfolio bond or a pension; and
– must not incorporate a requirement to pay any further premiums after the first
(although policy terms may favour the payment of additional amounts) and may not be
used as collateral for a loan or placed in trust.
• Certain Core Capital Deferred Shares (CCDS) issued by a building society.
• Certain securities, such as retail bonds, which have less than five years to run to maturity
at the time they are first held in the account.
 6/104 R02/July 2018 Investment principles and risk

L9 Stakeholder standards
Stakeholder standards apply to a wider range of products than just ISAs. Products (other
than smoothed investment return products) that meet the stakeholder standards can be
sold through ‘basic advice’.
To earn the name ‘stakeholder’, the products have to meet conditions designed to ensure
that they are straightforward and good value.

Be aware
Stakeholder products
There are three stakeholder products that can be held in an ISA:
• stakeholder deposit account;
• stakeholder medium-term investment product (MTIP), which is a type of unit trust or
similar investment; and
• smoothed MTIP, similar to a with-profit life assurance policy.

L9A Stakeholder conditions

The minimum conditions for stakeholder products are as follows:
Cash ISAs – stakeholder deposit account:
• There are no charges to pay on stakeholder cash ISAs.
• The minimum deposit cannot be higher than £10.
• Deposits can be made to the account in any of the following ways: cash, cheque, direct
debit, standing order and direct credit (BACS or automated transfer).
• Unlimited withdrawals can be made, and these should be paid within seven days or less.
• The interest rate that is paid must be no less than 1% below the Bank of England base rate.
Chapter 6.2

Interest rate paid

must be no less • If the base rate increases, the minimum interest rate must also increase within one month.
than 1% below the
Bank of England
base rate
Stocks and shares ISAs – stakeholder medium-term investment products:
• The annual charge is limited to 1.5% of the fund during the first ten years and 1% thereafter,
with no other charges.
• The minimum investment cannot be higher than £20.
• No more than 60% of the fund can be invested in riskier assets (e.g. shares and property).
• Investments can be made to the account in any of the following ways: cash, cheque, direct
debit, standing order and direct credit (BACS or automated transfer).
• The prices at which units or shares in the fund are bought and sold must be the same, and
the price should be published daily.
Extra terms apply to the smoothed MTIP:
Managers must
• Some of the return in good years is paid into a ‘smoothing account’ to be used to top up
make available the return in bad years.
information about
their smoothing • If the smoothing account needs extra capital, policyholders can be charged extra.
and charging
policies • Managers must make available information about their smoothing and charging policies.
• The whole of the with-profit fund and the whole of the smoothing account, apart from
specific deductions allowed by law, are for the benefit of the policyholders.

L10 Types of ISA

The main types of ISA now available are:
• Unit trust and OEIC ISAs
ISAs may also be
These are very popular as they provide a broad spread of holdings for relatively small
invested in any investments. ISAs may be linked to one or more funds and many managers offer an
UCITS scheme
recognised by the
extensive choice of funds.
FCA Corporate bond ISAs, based on unit trusts and OEICs, have also proved to be popular; in
particular, high-yield bond funds, investing in sub-investment grade bonds, have
attracted many income seekers.
ISAs may also be invested in any UCITS scheme recognised by the FCA.
Chapter 6 6.2: Other indirect investments including life assurance based-products 6/105

• Investment trust ISAs

Investment trust ISAs are similar to their unit trust and OEIC counterparts, but usually
carry explicit additional charges to those levied within the investment trust. The choice of
investment trusts is smaller than for unit trusts and OEICs.
• Managed ISAs
Some stockbrokers use ISAs as a component of large equity portfolios. The CGT freedom
of ISAs means that they can be used to shelter the actively traded part of a portfolio.
• Self-select ISAs
These allow the more sophisticated investor to select their own ISA equity and bond
holdings, including collective funds. Some account managers restrict their choice to FTSE
100 constituents, but others will allow investors to choose any eligible investment.
The combination of charges and the relatively small income tax benefits mean that self-
select ISAs appeal to higher- and additional-rate taxpayers who regularly use their CGT
annual exempt amount.
• Corporate ISAs
Some listed companies use external account managers to offer ISAs that may only invest
in that one company’s shares. Charges are generally low because the sponsoring
company subsidises costs from the savings it makes on individual share registration.
Nevertheless, the small income tax benefit of ISAs means many investors will be better off
holding their shares directly.
• Derivative-based ISAs
A small number of ISA managers have used Dublin-based, listed companies holding
derivatives and cash deposits to offer ‘guaranteed’ ISAs. This tortuous structure allowed
the creation of plans that could not be offered through UK-based funds.
Derivative-based ISAs typically offer a stock market index-linked capital return at the end

Chapter 6.2
of three to five years and either a fixed income or a minimum maturity guarantee.
• Cash ISAs
The cash ISA is basically a tax-free deposit account. A full range of instant access and The cash ISA is
fixed-term and/or fixed-rate accounts is available. A handful of providers offer terms basically a tax-free
deposit account
linked to stock market index performance rather than to interest rates.
• Help to buy ISAs
The Help to buy ISA is a type of cash ISA for first-time buyers, which offers a Government
bonus when investors use their savings to buy their first home. For every £200 saved, a
£50 bonus payment is made, up to a maximum of £3,000. If £12,000 is saved, then the
Government will boost this to £15,000. The bonus is available for home purchase of up to
£450,000 in London and up to £250,000 elsewhere.
The bonus only applies for home purchase. However, savers can have access to funds if
they need them for any other purpose. The maximum initial deposit is £1,200 and the
maximum monthly saving is £200.
The Help to buy ISA will be open for new savers until 30 November 2019 and open to new
contributions until 2029.
Savers can save into a Help to buy ISA and a Lifetime ISA, but will only be able to use the
Government bonus from one of their accounts to buy their first home. Alternatively,
transfers can be made from a Help to buy ISA to a Lifetime ISA.
• Innovative finance ISAs (IFISAs)
These enable savers who use peer-to-peer lending platforms to receive tax-free interest
and capital gains up to the annual ISA allowance. Peer-to-peer lending allows savers to
lend directly to borrowers, therefore cutting out the need for a bank. This is seen by the
Government as a way of encouraging competition in the banking industry. It is possible to
switch existing ISA funds into an innovative finance ISA, thereby retaining the tax-free
status of such an investment.
• Lifetime ISAs
The Lifetime ISA was launched in April 2017 as a longer term savings account for those
aged 18 and over (although they have to be under 40 at outset). A government bonus is
paid of 25% of the invested amount up to a maximum of £1,000 per year. The maximum
contribution is £4,000 a year and this can be paid until the age of 50. Qualifying
investments in a Lifetime ISA are the same as for cash or stocks and shares ISAs.
 6/106 R02/July 2018 Investment principles and risk

If the eligibility criteria is met, it is possible to have a cash ISA, a stocks and shares ISA, an
innovative finance ISA, as well as a Lifetime ISA – all within the overall ISA limit of £20,000.

Question 6.9
Name four eligible investments for a stocks and shares ISA.

L11 Charges and expenses

The structure of ISA charges is not regulated in the same way as that for unit trusts and
OEICs, although there is a voluntary maximum charging structure with stakeholder products.
The greater freedom has resulted in a variety of charging structures for stocks and shares
ISAs, including initial and annual charges
charges.

L11A Initial charge

For a stocks and shares ISA that holds unit trusts or OEICs, the initial charge will generally be
the standard initial charge (typically 5%), but a growing number of groups discount this
down to 2–3%. The advent of fund platforms has seen actual buying costs fall to less than 1%
in some instances.
Other things to bear in mind include:
• some groups make no initial charge, either because they are selling direct or because
early encashment penalties are applicable – usually for five years;

For unit trusts and

• for unit trusts and OEICs, the initial management charges must be taken from the ISA
OEICs, the initial subscription, i.e. they cannot be in addition to the usual subscription limit; and
management
charges must be • charges and fees on direct investments in an ISA may be levied over and above the
taken from the ISA subscription limit.
Chapter 6.2

subscription

L11B Annual charges

Unit trust and OEIC annual charges are usually between 1% and 1.5%, and virtually all ISAs
levy only this charge. On most funds, annual charges can be increased by first giving
investors notice. Additional fees, e.g. for custody, may add 0.1% to 0.5%.
Investment trusts carry their own internal annual charge, which may be as low as 0.3% for
large general trusts. However, most investment trust ISAs incorporate an additional AMC of
around 0.5% (plus VAT) or between £25 and £30 (plus VAT).

Be aware
Non-collective investment ISAs
Many non-collective investment ISAs operate on an annual charge of 0.5% to 1% (plus
VAT). This may be subject to a minimum charge of £15 (plus VAT) to discourage small
investments. Some self-select ISAs charge no annual fee, but collect their expenses in
other ways.

L11C Other charges

Alongside these two main charges, ISA managers also generate income from other levies:
• Early encashment penalties
Some unit trust and OEIC ISAs have low or zero initial charges, but then impose an early
encashment penalty over the first three to five years. This may be expressed as a
percentage of the original investment or current value.
Some ISA providers, particularly on self-select ISAs, also levy a termination fee when the
plan is cashed or transferred.
• Commission

Purchase or sale of
The purchase or sale of investment trusts or shares will usually involve stockbroking
investment trusts commission. This may be a flat rate charge, at the full private client rate or, in the case of
or shares will
usually involve
some investment trusts and ISAs, at a specially discounted bulk rate of 0.2% to 0.5%.
stockbroking • Dividend collection fee
commission
Self-select ISA managers may levy a fee on each dividend, in place of an annual charge.
This is VAT free and is usually between £4 and £7.50, which favours larger shareholdings.
Chapter 6 6.2: Other indirect investments including life assurance based-products 6/107

• Report charges
Share-based ISAs will often levy a substantial fee, e.g. £50 (plus VAT), for investors who
wish to receive annual reports or attend shareholder meetings. The size of the fee is
designed to be a deterrent – in practice, annual reports are usually easily obtainable from
other sources.

L12 Transfers between ISA managers

The regulations stipulate that ISA managers have to allow transfers, although there is no
corresponding requirement for managers to accept transfers. It is possible to transfer ISA
savings to a different type of ISA or to the same type of ISA.
• Transferred savings relating to any current year’s payments must be transferred as a
whole and money invested in previous years can be transferred in full or in part.
• If cash and assets are transferred from a Lifetime ISA to a different ISA before the age of
60, a withdrawal fee of 25% is levied.
• It is possible to transfer cash from an innovative finance ISA to another provider, but it
may not be possible to transfer other investments from it. The provider’s terms and
conditions would need to be checked for any transfer restrictions. It is also possible to
switch existing ISA funds into an innovative finance ISA.
• ISA transfers should take no longer than 15 working days for a cash ISA and a cash
Lifetime ISA and no more than 30 working days for a stocks and shares ISA, investments
held in an innovative finance ISA and stocks and shares in a Lifetime ISA.
Subject to the terms and conditions of both managers, ISAs may be transferred in a variety Subject to the
of ways: terms and
conditions of both
• investments may be re-registered in the new ISA manager’s name; managers, ISAs
may be transferred

Chapter 6.2
• transfers may be made in cash; or in a variety of ways

• transfers can be made in a combination of investments and cash.

ISA managers must transfer investments and/or cash direct to the new ISA managers
because, if the transfer is made to the investor, it will be treated as a withdrawal.

Be aware
Preservation of tax benefits
Where an ISA is transferred all the tax benefits are preserved. Investments and/or cash
transferred are not treated as new subscriptions.

L13 Termination
There is no tax charge on the termination of an ISA; however, as the ISA is exempt from CGT, There is no tax
any capital losses are not allowable against other gains. The charges on termination will charge on the
termination of an
usually be the same as those on transfer. ISA

An investor may withdraw either cash or investments from the plan. If investments are
withdrawn, their base cost for capital gains purposes is the market value at the date of their
withdrawal.
On death, an ISA becomes a ‘continuing account of a deceased investor’ (a continuing ISA).
While no further funds can be added, income and gains remain tax-free up until the earlier of
the estate being administered, the ISA being closed or three years from the date of death.
If an ISA saver in a marriage or civil partnership dies, their spouse or civil partner inherits a
one-off additional ISA allowance (an additional permitted subscription) set at the higher of
the value of the deceased’s continuing ISA on the date of death or on the date when the
investments wrapped in the ISA are passed on. Once probate has been granted, the
surviving spouse/civil partner can either encash the investment they have inherited (that
was formerly in the deceased’s ISA wrapper) and re-invest the proceeds using the inherited
ISA allowance or they can invest monies from another source to use the inherited ISA
allowance.
 6/108 R02/July 2018 Investment principles and risk

L14 Junior ISAs and Child Trust Funds (CTFs)

L14A Junior ISA
The key features of the Junior ISA (JISA) are set out below:
Eligibility:
• All UK-resident children (aged under 18) who do not have a Child Trust Fund (CTF) are
eligible.
Types of account:
• Both cash and stocks and shares JISAs are available.
• The qualifying investments for each of these are the same as for existing ISAs.
• Children are able to hold up to one cash and one stocks and shares JISA at a time.
• All returns are tax free, both for the child and their parents.
Annual subscription limit:
• Each eligible child can receive contributions of up to £4,260 in the 2018/19 tax year.
• Any person or organisation is able to contribute to a child’s JISA.
Account opening
• Anyone with parental responsibility for an eligible child is able to open a JISA on their
behalf.
• Eligible children at the age of 16 are also able to open JISAs for themselves.
Account operation
• Until the child reaches 16, accounts will be managed on their behalf by a person who has
parental responsibility for that child.
• This will initially be the person who applied for the account for the child, but this
responsibility can be transferred to another person with parental responsibility.
Chapter 6.2

• At age 16, the child assumes management responsibility for their account.
• Withdrawals are not permitted until the child reaches 18, except in cases of terminal illness
or death.
Transfers
• It is possible to transfer accounts between providers, but it is not possible to hold more
than one cash and one stocks and shares JISA at any time.
• It is possible to transfer a CTF to a JISA.
Maturity
• At age 18, the JISA will, by default, become an adult ISA and funds will be accessible to the
child.
• Having a JISA does not affect an individual’s entitlement to an adult cash ISA. It is possible
for JISA account holders to open adult cash ISAs from age 16, and JISA contributions do
not impact upon adult ISA subscription limits.

L14B Child Trust Funds (CTFs)

CTFs offer the
CTFs were the predecessor to JISAs and, when they were launched in 2005, the
same tax Government made contributions at specific ages (these have now stopped). They offer the
advantages as a
JISA, including the
same tax advantages as a JISA, including the exemption from tax for income derived from
exemption from parental gifts.
tax for income
derived from Every child born on or after 1 September 2002 was eligible for a CTF, provided:
parental gifts
• Child Benefit had been awarded for them by HMRC;
• the child was living in the UK (the children of Crown servants posted abroad qualified
because they are treated as being in the UK); and
• the child was not subject to immigration controls.
There are three basic types of CTF account: savings, share accounts and stakeholder CTFs.
It is still possible to make contributions to existing CTFs. Contributions can be made by
parents, relations and friends. In 2018/19, the maximum amount that can be subscribed is
£4,260.
Chapter 6 6.2: Other indirect investments including life assurance based-products 6/109

Before the child reaches age 16, accounts are managed by a person who has parental
responsibility for the child. At age 16, the child assumes management responsibility for their
account. Withdrawals are not allowed until the child reaches 18, except in cases of terminal
illness or death.
The CTF matures at age 18, at which point the underlying investments are re-registered in
the (adult) child’s name outside of the ISA wrapper, although it is possible to roll over a CTF
into an ISA to maintain the tax benefits.

M National Savings and Investments (NS

(NS&
&I)
products
National Savings and Investments (NS&I) products are Government investments that can be See chapter 1.1,
section A4 for
bought online, by phone or by post directly from NS&I. They are all secure investments as more on NS
NS&&I
they are guaranteed by the Government. There are several types of product, with different products

tax treatments.

Useful website
To remain up-to-date with NS&I products and the rates of interest being paid, you are
advised to regularly check the Quick Guide for Financial Advisers from NS&I:
www.nsandi.com.

N Purchased life annuities

An annuity is a contract to pay a given amount (the annuity) each year to an annuitant (the
person on whose life the contract depends) whilst they are alive.

Chapter 6.2
Purchased life annuities (PLAs) are bought from life assurance companies and are split into
two elements:
• The capital element, which is tax free as it is deemed to be a part return of the original
capital. The capital element is fixed at the outset and is calculated by dividing the
purchase price by the number of years the annuitant is expected to live from outset, using
HMRC mortality tables. If the annuitant survives for the expected time, the purchase price
is received tax free.
• The income element, which is taxed as savings income.
The taxation of a PLA is more favourable than a pension annuity, which is taxed in full as
income. Therefore, many individuals in retirement use the tax-free pension commencement
lump sum (PCLS) to buy a PLA.
Various features can be added, such as capital protection in the form of a guarantee period,
as well as a level or escalating annuity.

O Derivatives
A derivative is a financial contract that derives its value from the value of an underlying A derivative is a
investment. Originally, the underlying investments were basic commodities, such as cocoa, financial contract
that derives its
coffee, sugar and wheat. In recent years, the underlying investments have increasingly value from the
consisted of bonds, currencies, short-term interest rates, individual shares or stock market value of an
underlying
indices, such as the FTSE 100. investment

In the last 20 years, the international markets in derivatives have grown into a major part of
the world financial structure. In some markets, the turnover has become much larger than
the turnover of the underlying securities themselves.
Derivatives can be used for many purposes. They are usually used to reduce risk, although
they can be used for speculation, which may increase risk. They have been blamed for
adding to the volatility of the markets, but they may also give stability in many situations.
 6/110 R02/July 2018 Investment principles and risk

Few private investors participate directly in the derivatives markets. They tend to be the
province of institutions and high net worth individuals who are looking for ways to manage
financial risk. However, many financial products purchased by private investors now use
derivatives as a matter of course.
Derivatives can be either exchange traded
traded, when they are bought or sold on a recognised
exchange, or they can be over-the-counter (OTC)
(OTC), when they are created and sold directly
to customers by banks and other financial institutions. An OTC instrument is tailored to suit
the requirements of the client, whereas an exchange traded contract has standardised terms
and conditions. This makes them cheaper to enter into and easier to trade on an exchange.
Derivatives are generally traded on specialist exchanges such as the NYSE London
International Financial Futures and Options Exchange (NYSE Liffe).

Broadly two types

Using derivatives allows investors to take an exposure in relation to the underlying asset
of derivative are without actually requiring ownership of the asset. They allow investors to make profits on
traded on
exchanges: futures
upward or downward movements in the underlying asset.
and options
There are broadly two types of derivative that are traded on exchanges, futures and options.

O1 Futures
A future is an exchange-traded forward contract. It is a legally binding agreement to buy or
sell an asset at a specified future date, at a price that is agreed when the contract is made.
The contract imposes an open-ended obligation on both parties until expiry or closing out.

Be aware
Contract specifications
The exchange standardises the contract specifications in terms of the quality, quantity,
delivery date and delivery price for each commodity and financial asset.
Chapter 6.2

O1A Operation of a futures contract

For each futures contract, there must be a buyer and a seller:
• Buyers of futures are said to have a long position. They have an obligation to purchase the
underlying asset sometime in the future for the price agreed when the contract was made.
They hope prices will rise.
• Sellers of futures are described as having a short position. They have an obligation to
deliver the underlying asset at some date in the future for the price agreed when the
contract was made. They hope prices will fall.
Both parties to the contract, the counterparties, have to honour their obligations.

O1B Trading financial futures

An initial trade
An initial trade opens a client’s position in the derivatives market. This may be either a
opens a client’s purchase or a sale trade. Open positions are those in which rights or obligations to the
position in the
derivatives market
market are ongoing.
The price agreed when the futures contract is opened is not paid or received in full, nor does
the underlying asset change hands at that time. Instead, both the buyer and seller of the
contract deposit an initial margin with an independent third party, as follows:
• NYSE Liffe uses the services of the London Clearing House (LCH), which stands between
each counterparty of a futures contract to ensure that every contract is honoured.
• The initial margin acts as collateral which can be used, if needed, to fulfil either side of the
contract, i.e. pay or deliver what has been promised.
As open positions could be maintained for long periods of time, they are re-valued on a daily
basis through a process known as marking to market
market. This takes into account any
movement in the price of the contract and closely mirrors changes in the price of the
underlying asset. The profits and losses resulting from the daily price changes are known as
variation margin, and these margins are paid and received on a daily basis.
Chapter 6 6.2: Other indirect investments including life assurance based-products 6/111

The clearing house pays profits to one side of the contract and receives losses from the The clearing house
other. pays profits to one
side of the
At expiry of the contract, the client will already have been credited with the profit, or have contract and
receives losses
paid the loss if the contract went against them. from the other

If a client fails to pay their variation margin, the exchange will close all of the client’s open
positions immediately by buying equal but opposite contracts, charged to the client.

Be aware
Positions
A position in a futures contract undergoes a daily revaluation until either:
• the contract reaches its expiry date, when it is either settled by physical delivery of the
underlying asset or for cash, depending on the nature of the futures contract; or
• the investor decides to close out an open position by executing an equal and opposite
trade.
At this point, the initial margin is returned.

O1C Delivery
Where futures contracts are physically settled, e.g. bond or commodity futures, the short
side (the seller) has to deliver to the long side (the buyer) the appropriate quantity of the
underlying asset at the expiry of the contract. In return, the long side will pay the short side
the Exchange Delivery Settlement Price (EDSP) (EDSP). This is the closing price of the futures
contract at the time of delivery, which matches the cash market price of the underlying
asset. After netting off the daily profits and losses that have been credited or paid through
the system of variation margin, this will leave the long investor in profit if the market rose or
in loss if it fell, and vice versa for the short investor.

Chapter 6.2
Where a futures contract is settled in cash, the open positions are ‘closed out’ on the last day
of trading at the EDSP.
Not all futures contracts can be settled by physical delivery of the underlying asset. Some, Not all futures
such as interest rate contracts or index contracts, are always settled in cash. contracts can be
settled by physical
delivery of the
underlying asset
O2 Options
An option gives the buyer the right, but not the obligation, to buy or sell a specified asset at
a fixed price before or on a certain date in the future. The fixed price is called the strike price
or exercise price.

Be aware
Call options and put options
The option can either be a call option or a put option:
• a call option gives the buyer of the option the right to buy the underlying asset; and
• a put option gives the buyer of the option the right to sell the underlying asset.
The seller of the option is obliged to meet the obligation placed upon them by the buyer:
• the seller of a call option must sell the underlying asset to the option holder; and
• the seller of a put option must purchase the underlying asset from the option holder.

O2A Paying for options

The buyer (or holder) of an option pays the premium, which is the cost of the option, plus an
additional commission, but does not have to make any margin payments.
The seller (or writer) of the option receives the premium, but pays commission and also has
to make margin payments. An initial margin is deposited with the LCH upon writing the
option, and variation margin calls will be made on a daily basis.
 6/112 R02/July 2018 Investment principles and risk

O2B Choices open to option holders

Choices open to
The choices open to the holder of an option are to:
option holders are
to exercise the • exercise the option;
option, sell it
before expiry or let
• sell the option before expiry; or
the option expire • let the option expire worthless.
worthless
Exercise the option
This is the process by which the option holder uses the right given by the option. The time by
which exercise has to have taken place is called expiry:
• An option that can only be exercised at expiry is known as a European-style option.
• One that can be exercised at any time during its life is known as an American-style option.
The majority of UK options are American-style, although Liffe offers European-style options
on the FTSE 100 and a number of European indices.
Sell the option before expiry
With a traded option, the right to exercise the option can be bought and sold. Its value will
rise and fall according to the movement in the underlying asset and the length of time the
option has to run to expiry.
The value of an option has two components: intrinsic value and time value
value.
Intrinsic value
value:
• a call option will have intrinsic value if the current price of the underlying asset is above
the option’s strike price; and
• a put option will have intrinsic value if the current price of the underlying asset is below
the option’s strike price.
Chapter 6.2

Be aware
Intrinsic value
Options with intrinsic value are referred to as in-the-money; those without any intrinsic
value are out-of-the-money. When the strike price equals the current price of the
underlying asset, the intrinsic value is zero, and the option is referred to as at-the-money.
The premium that has been paid is ignored when determining whether an option is in-,
out-, or at-the-money. The calculation compares just the current price against the
exercise price.

Time value
value:
Before it expires, the market value of an option will generally exceed its intrinsic value by an
amount called the option’s time value. This is:
• the amount an investor is prepared to pay for an option, above its intrinsic value, in the
hope that its value will increase before it expires because of a favourable change in the
price of the underlying asset; and
• directly related to how much time an option has until expiry. It erodes throughout the
option’s life.
At-the-money and out-of-the-money options do not have any intrinsic value, because they
do not have any real value. Their price reflects time value, which gradually decreases to zero
as the option approaches expiry:

The more time an

• The more time an option has until expiry, the greater the chance that it will end up in-the-
option has until money.
expiry, the greater
the chance that it • At expiry, all an option is worth is its intrinsic value, it is either in the money or it is not.
will end up in-the-
money Let the option expire worthless
If, at expiry, the market price of the underlying asset is below the strike price, i.e. the option
is out-of-the money, there is nothing to be gained by exercising the option. The holder can
simply let it expire valueless, and will incur a loss equal to the premium paid to the option
writer.
Chapter 6 6.2: Other indirect investments including life assurance based-products 6/113

O3 Using futures and options

Futures and options can be used for a variety of purposes; the two major uses are hedging Futures and
and speculation: options are mainly
used for hedging
• the object of hedging is to protect an existing exposure against future adverse price and speculation

movements; and
• the purpose of speculation is to try to profit by correctly forecasting future price
movements, at the risk of making losses if the forecasts are wrong.

O3A Hedging a future purchase

A fund manager may expect to receive a large amount of cash in the next few months, which
is to be invested across the FTSE 100 market. If the fund manager is concerned that the
market is going to rise before the money is received, they have three choices:
• wait until the money is received and buy the securities at their higher prices;
• borrow sufficient funds to invest immediately, repaying this with interest when the cash is
received; or
• use derivatives.
Using futures
The fund manager can buy FTSE 100 futures:
• if the market rises, the profit on the futures contracts can be used to offset the increased
cost of buying shares at their higher prices; and
• the risk for the fund manager is that if the market falls, there will be a loss on the futures
contracts, although this will be offset by the reduced cost of purchasing the shares at
their lower price.

Chapter 6.2
Either way, the fund manager will have locked into the FTSE 100 at the price prevailing when
the futures contracts were purchased.
Using options
The fund manager can buy a FTSE 100 call option:
• if the market rises above the exercise price of the option, it can be exercised profitably,
and the gain on the option will compensate for the increased cost of buying the shares;
and
• if the market falls, since the holder has a right rather than an obligation, the fund manager
could let the option expire.

Be aware
Risk for the fund manager
The risk for the fund manager if the market falls is limited to the premium paid for the
option, plus transaction costs.

O3B Hedging a portfolio

If a UK equity fund manager believes that there is going to be a sharp downturn in the
market in the short-term and wants to protect the value of the fund, they have two choices:
• They could sell part of the portfolio
portfolio. However, many fund managers’ mandates restrict
them to a small cash position, so that this strategy is not always possible. If the manager
sells stocks now and the market fails to fall, they will have incurred significant dealing
costs unnecessarily. It may also prove impractical to liquidate a large portfolio.
• They could use derivatives
derivatives.
Using futures
The fund manager can sell FTSE 100 futures:
• if the market falls, the profit on the futures contracts can be used to offset the capital loss
on the equity portfolio; and
• the risk for the fund manager is that if the market rises, there will be a loss on the futures
contracts, which will offset the capital gain of the portfolio.
Either way, the fund will remain static, i.e. it is hedged.
 6/114 R02/July 2018 Investment principles and risk

Using options
The fund manager can buy a FTSE 100 put option:
• if the market falls below the exercise price of the option, the gain on the option will
compensate for the fall in the capital value of the portfolio; and
• if the market rises, the fund manager could let the option expire.
The risk for the fund manager is limited to the premium paid for the option, plus transaction
costs.

O3C Asset allocation

Consider a fund manager who currently has a diversified UK portfolio divided between
equities and fixed-interest securities in a ratio of 65:35, and who expects a short-term
underperformance of equities in relation to fixed-interest securities. They may wish to
change the asset allocation of the portfolio to 55:45. They have two choices:
• They could trade the underlying physical assets. This might take time and would incur
costs. It would also need individual share analysis to decide which stocks should be sold,
which the manager might not wish to undertake, particularly in a rush.
• They could sell FTSE 100 futures on 10% of the portfolio value and buy Long Gilt futures
on an equivalent cash amount.

Be aware
Benefits of using futures
Using futures offers significant benefits in terms of:
• lower dealing cost;
• speed of dealing; and
• liquidity, i.e. the ease of trading any volume at any time without drastically affecting
Chapter 6.2

market prices.

O3D Speculation
Consider a speculator who expects that soon to be released UK data will indicate the
likelihood of changing interest rates, which would lead to changes in bond yields and so to
the prices at which they are bought and sold. They may trade Long Gilt futures in the
expectation of making a profit, as follows:
• if the expectation was that interest rates would rise, so that bond prices would fall, they
would sell Long Gilt futures; and
• if the expectation was that interest rates would fall, so that bond prices would rise, they
would buy Long Gilt futures.

Consider this
this…
…
Speculators find futures an ideal tool if they want to take an aggressive position in an
underlying index. It is both expensive and time consuming to buy the underlying
securities; futures allow them to gain an exposure quickly and for considerably less cash
investment.

O3E Writing options

The risk for buyers
The risk for buyers of options, both calls and puts, is limited to the premium paid:
of options, both
calls and puts, is • the reward for buyers of a call is unlimited – the more the price rises above the exercise
limited to the price, the greater the reward; and
premium paid
• the reward for buyers of a put is greatest if the price of the underlying asset falls to zero.
Sellers of options, called writers, face almost unlimited risks in return for the premium they
receive; yet, for every buyer of an option, there has to be a willing seller. Most writers are
major investment banks or specialised traders, but there are some circumstances when fund
managers can make use of option writing, despite the apparent risks.
Chapter 6 6.2: Other indirect investments including life assurance based-products 6/115

Writing a call
A fund manager may increase income to the fund by writing call options and receiving the
option premium. In return, the manager has to accept the possibility that the option will be
exercised if the share price rises sufficiently and the shares are handed over at the agreed
strike price.
Provided the fund owns the underlying stock, when the options are referred to as being Provided the fund
‘covered’, the risk is minimal. It may be that the fund manager has identified the exercise owns the
underlying stock,
price as the level at which the shares would have been sold. Consequently, they have when the options
benefited from the premium income in addition to the potential selling price, but at the cost are referred to as
being ‘covered’,
of foregoing any profits on selling at above that price. the risk is minimal

The writer of a call option believes that the share price is likely to either stay the same or fall.
If that happens, the writer simply pockets the premium received and will not have to deliver
the shares.

Be aware
Largest risks
The largest risks come from writing options over shares (or other assets) that the writer
does not own. In these instances, the writer may have to buy the shares in the market if
the option is exercised, possibly at a price well above the exercise price. This would lead
to a real loss by the writer. This strategy is called writing uncovered calls.

Writing a put
A fund manager who writes a put option receives premium income, but in return enters into
an obligation to purchase an asset at a fixed price.
The expectation is that the underlying asset price will not fall significantly. If it does, the
writer of the put option will be exercised against, and will have to buy the asset at a price

Chapter 6.2
above the current market price. The worst case would arise if the price of the asset falls to
zero. If this happens, the loss will be the exercise price less the premium received.

Consider this
this…
…
What the put writer hopes for is that the put option will not be exercised. This will occur if
the asset has a price above the exercise price at expiry.

O4 Taxation of derivatives
Profits from both futures and options are usually chargeable to CGT, although, if someone is
classed as a trader, their profits will be taxed as income.
For individual investors, there is no CGT where the underlying asset is a gilt or qualifying
corporate bond.
Buying options:
• if a call option is exercised, the cost of the option is treated as part of the total cost of
purchase;
• if a put option is exercised, the cost of the option is treated as an allowable deduction
from the sale proceeds (the exercise price); and
• if the option is allowed to expire worthless, this is treated as a disposal for CGT purposes,
giving a capital loss on the date of expiry.
Futures:
• when a futures position is closed, any money received is treated as consideration for the
disposal of the futures contract, and any money paid is treated as an incidental cost of
disposal; and
• if the futures contract is not closed out, each party is treated as having made a disposal of
an asset:
– any payment made or received is treated as consideration for, or an incidental cost of,
the disposal.

Question 6.10
What are the two main uses of futures and options?
 6/116 R02/July 2018 Investment principles and risk

P Hedge funds
Hedge funds refer
Hedge funds refer to funds that adopt non-traditional investment methods. They are pooled
to funds that adopt investments, where a number of investors entrust their money to a fund manager, who
non-traditional
investment
invests in various traded securities. Hedge fund managers will actively manage the
methods investments as they seek to provide positive absolute returns, regardless of overall market
movements.
They will use one or more alternative investment strategies, which can include:
• hedging against market downturns;
• investing in asset classes, such as currencies or securities, that are trading below their true
value; and
• using return-enhancing tools such as gearing, derivatives and arbitrage.
The Hedge Fund Association recognises at least 14 distinct investment strategies adopted
by its members, each offering different degrees of risk and return. It reports that there are
currently 10,000 active hedge funds.

Consider this
this…
…
Within the hedge fund industry, there are many interpretations of strategy, with new
themes emerging as the financial markets develop. Funds vary considerably in terms of
the risks involved, their level of borrowing (gearing) and the investments purchased.
Many, but by no means all, use derivatives in their investment approach.

P1 Common features
For all of the variety, there are some common hedge fund features and these are discussed
in the following sections.
Chapter 6.2

P1A Investment objectives

Absolute return
Most hedge funds
Hedge funds generally do not adopt a ‘long only’ strategy, i.e. holding a portfolio of equities
aim to limit and/or bonds. The funds aim for an absolute return with limited volatility, rather than
downside
volatility, e.g. via
performance relative to an index benchmark. They seek higher risk-adjusted rates of return.
the use of options Most hedge funds aim to limit downside volatility, e.g. via the use of options.
Limited correlation with equity and bond markets
The various investment methods of hedge funds mean that they frequently have limited or
even negative correlation to the markets in which they operate. As a consequence, even
when markets are falling, hedge funds can and do achieve positive returns, although the
opposite can also be true.

P1B Investment instruments used

The development of the derivatives markets over the past 20 years has encouraged new
hedge fund strategies. It made it easier for funds to adopt significant positions in various
securities without the need to purchase the underlying asset.
Use of gearing to enhance portfolio returns
Some hedge funds
Some, but not all, hedge funds use gearing to provide a potential boost to investment
use gearing to returns, so this should be a key factor when assessing a fund.
provide a potential
boost to
investment returns P1C Structure of the investment vehicle
Offshore status or a US limited partnership structure
Hedge funds are usually structured as a collective investment scheme or a US limited
partnership, and most have traditionally been established offshore to minimise set up,
regulatory and administration costs. The majority of offshore funds operate from Bermuda
and the Cayman Islands.
Chapter 6 6.2: Other indirect investments including life assurance based-products 6/117

P1D Investment strategy

While there are no universally agreed definitions, there are four broad categories of hedge
fund strategy. For example:
• Long/short funds
funds: these funds invest in equity and/or bond instruments, and combine
long investments with short sales of individual securities and derivatives to reduce market
exposure. Long/short funds can operate with a bias towards either the long or short side
or a balance between the two in a ‘market neutral’ approach. This is the most popular
strategy of hedge funds.
• Relative value funds
funds: these funds are often referred to as adopting ‘market neutral’
strategies because there is no market-related element in their returns. Instead, the
managers rely on arbitrage to produce returns, i.e. by identifying and exploiting pricing
anomalies between similar investments or combinations of investments. Although these
strategies usually have limited volatility, they can still suffer when market liquidity dries
up.
• Event-driven funds
funds: these hedge funds use the price movements arising from anticipated
corporate events to achieve their returns. The approach tends to be uncorrelated with
investment markets, but usually performs best in strong market conditions when there is
greater corporate activity. As with relative value funds, event-driven funds generally fall
into the lower volatility range of hedge funds.
• Tactical trading funds
funds: these are hedge funds that most closely match the public
perception of a hedge fund. In reality, they now represent a relatively small part of the
hedge fund universe. They trade in currencies, bonds, equities and/or commodities. In
each asset class, they may use the same long/short approach as equity hedge funds.

P1E Funds of hedge funds

Funds of funds work on the basis that they spread risk. To this end, many companies have

Chapter 6.2
created funds of hedge funds that allow investors to access a range of hedge fund
investments, relying on the company to employ specialist research teams to perform the
due diligence. In one respect, this is similar to investing in UK equities by choosing a
collective investment scheme; the manager’s skills in assessing in which hedge funds to
invest are paid for by the investor − in return for (hopefully) better performance than the
investor could achieve doing it themselves.

P2 Risks in hedge funds

It is important to be aware of the differences that can exist between the various hedge
funds, as their investment returns, volatility, and levels of risk can vary enormously,
depending on the particular strategies that are used. Since the managers can use a variety of
techniques to try to achieve their objectives, it may be difficult to establish the risks that are
likely to be involved.
If the fund is highly geared, the risks can be magnified if things go wrong. If a hedge fund is
highly geared, the
Hedge funds were traditionally limited to institutional and very wealthy individuals, but the risks can be
availability of funds of hedge funds has opened the market to retail investors. magnified if things
go wrong
The disadvantage of a fund of funds is that they are expensive. The underlying fund may
have an annual charge as high as 2% per year, with a typical performance bonus of 20%. On
top of this, there may be a fee of up to 2% to the manager selecting the range of hedge
funds.

Be aware
Appropriateness and performance of hedge funds
Hedge funds may be appropriate for high net worth individuals with adventurous risk
profiles (although a lot of investors are now pension funds and insurance companies) and
could help to diversify their portfolio. However, they generally lack transparency and the
risks involved in how they operate are difficult to assess.
 6/118 R02/July 2018 Investment principles and risk

Q Absolute return funds

Absolute return
Absolute return funds aim to achieve a positive absolute return for investors in all market
funds aim to conditions. They focus on the value created purely by the fund manager and measure their
achieve a positive
absolute return for
return against an absolute return objective such as cash, rather than relative to a market
investors in all benchmark.
market conditions
They achieve their results by adopting widely differing investment strategies. These can
include investing in a wide range of assets, including not only shares, bonds and cash, but
also commodities and private equity. They can also use derivatives, which allow the fund to
make money when an asset is falling as well as when the price is rising. However, not all
absolute return funds carry the same risk – some managers may be prepared to take more
risk to produce a greater absolute return.

Be aware
Performance of absolute return funds
Given their different strategies, it is to be expected that the performance of absolute
return funds will vary over time and this emphasises the importance of taking a long-term
approach.

Q1 Multi-asset funds
Multi-asset funds have grown in popularity since the financial crisis. They invest across all the
asset classes and include cash, fixed-interest securities and equities, providing
diversification to help enhance performance but also offering protection from the volatility
that can come from investing in a single asset class.
Product providers offer a range of multi-asset funds, tailored to specific risk profiles
depending on the allocation between equities and fixed-interest securities. These types of
Chapter 6.2

fund tend to sit within the ABI Mixed Investment sector definitions:
• Mixed Investment 0-35% Shares (up to 35% in equities).
• Mixed Investment 20-60% Shares (between 20% and 60% in equities).
• Mixed Investment 40-85% Shares (between 40% and 85% in equities).
• Flexible Investment Sector (no minimum or maximum requirement for investment in
equities).
Sector statistics from the Investment Association (IA) show that, between 2008 and 2017,
the 20-60% Shares sector, where many multi-asset funds in the market sit, has been the
best-selling sector four times.

R Structured products
Structured
Structured products are investment vehicles designed to offer tailored combinations of risk
products are and return. Many structured products offer some form of capital protection to appeal to
designed to offer
tailored
retail investors, whilst some offer absolute return profiles or geared growth with similar
combinations of downside risks as an active fund.
risk and return

Be aware
Market for structured products
The market for structured products has developed substantially from the simple FTSE 100
growth products of the early 1990s, supported by an increase in the availability of
derivatives both on exchanges and in the OTC market. However, the market growth of
structured products was hit by the financial crisis, which brought home to investors and
advisers risks that had previously received little attention.
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R1 Characteristics of structured products

‘Structured products’ is a generic term used for a range of investment products marketed
under a variety of names, such as ‘capital protected growth bonds’, ‘structured funds’ and
‘investment notes’.
The development of the derivative markets and, in particular, OTC derivatives allowed more
sophisticated products to be created with a wide range of underlying assets and a
considerable variety of capital protection gearing and other features on offer.

Be aware
Nature of a structured product
A structured product is actually not a product type in itself, but rather a wrapper designed
to achieve a specific set of investment objectives with a specific risk/reward profile. It
achieves this by offering a degree of participation in the return from a higher-performing,
but riskier, underlying asset, often combined with an element of capital protection. For
example, the same structured product may be offered as an ISA investment, a self-
invested personal pension (SIPP) investment, a deposit or a direct investment.

The ‘structuring’ of the product could include offering participation in the return from
virtually any underlying index or fund, such as the FTSE 100, S&P 500, Nikkei or Eurostoxx
50. In recent years, the range of underlying assets has extended to include commodities and
even indices, which have been developed specifically for structured products. Alongside
capital protection, there can be a variety of other features, the number of which continues to
grow.
As a result, there is a wide variety of structured products currently available and sold in
recent years. To understand how they are structured, however, we will look at a simplified
example.

Chapter 6.2
Example 6.15
A simple structured product might offer a five-year term, 100% protection and
participation in the growth of the FTSE 100 index up to a specified limit.
The way this works is to combine two instruments within the wrapper of the structured
product:
• a zero coupon bond; and
• a call option.
A zero coupon bond is a fixed-interest security that pays no coupon (income), but is
instead sold at a discount to its par value and so can provide a known amount at its
maturity. For example, for every £1,000 invested in the structured product, only £825
might be invested in a zero coupon bond that will repay £1,000 at maturity in five years’
time. In this way, the zero coupon bond provides the capital guarantee element of the
structured product.
The remaining money invested in the structured product – £175 – will be used partly to
meet distribution and production costs, with the remainder used to buy an OTC five-year
call option on the FTSE 100, capped at the specified limit. The call option will provide the
return on the FTSE 100, but will exclude any dividends paid by the constituent companies.
If the index rises over the term of the structured product, the investor will receive the
return on the call option plus the maturity proceeds of the zero coupon bond. If the index
falls, however, the call option will be worthless, but the investor will receive the maturity
proceeds on the zero coupon bond.
The structure of the product allows the investor to gain some exposure to the potential
growth in the FTSE 100 and, in return for surrendering any dividends from the underlying
companies, the investor is able to benefit from protection of the capital invested.
 6/120 R02/July 2018 Investment principles and risk

There are many variations on the simple example above, but some of the common
characteristics of structured products are:

Structured
• There is usually a stated fixed term, although this may be a maximum term. Five or six
products are years are the most common terms, as these are acceptable for ISA investment. Often,
usually fixed-term
investments
plans will have terms of marginally over a round number of years, e.g. 5.09 years, with
five-year exposure to the chosen asset and the balance accounted for by the offer period.
• In many cases, early withdrawals are not permitted.
• There is either a return of capital or income (rarely both), but not necessarily a 100%
return of capital in all cases.
• The FCA view is that structured products can offer guarantees (as opposed to capital
protection) if they are deposits or life policies. In theory, other structured products can
use independent third parties to provide guarantees but, in practice, this does not
happen.
• The low fixed-interest yields currently available mean that providers are using a variety of
mechanisms to make products both marketable and financially viable. These tweaks
include caps on growth, kick-out clauses (see below) and capital protection, which is lost
if a barrier (typically a 40−50% fall) is crossed.
• Minimum or maximum returns are pre-specified.
• Increasingly, there are ‘kick-out’ (also called ‘auto-call’) features, which result in a product
maturing early if a performance threshold is reached. For example, a plan may
automatically mature on any anniversary with a fixed payment if the underlying index is
not below the starting level.
• Returns for retail products are usually based on the performance of an index such as the
FTSE 100. In practice, the FTSE is the dominant index, usually accounting for the majority
of retail products on offer.
• The lack of an established secondary market means that investors are unable to trade the
Chapter 6.2

products in the interim unless they are the kind of structured product that is listed on the
stock exchange or are a UCITS fund.

R2 Types and methods of investing

The range of structured products available is wide and growing, as product providers design
new structures to meet changing market conditions.
Whilst the type of structured product will change from provider to provider and from time to
time, they will generally fall into one of three main structures:

Structure type Features

100% capital The investor receives the return on the underlying index or a
protection specified fixed return provided the index has risen and, if it has not
risen, they receive 100% return of the capital invested.
Partial capital A set return or income level is offered, but capital protection is only
protection provided so long as the underlying index does not decline below a
set amount. For example, the capital protection might apply
provided that the FTSE 100 does not fall below 40% of its value at
the start of the period. This is known as ‘soft protection’ or
‘contingent capital protection’. The FCA classes such products as
structured capital-at-risk products (SCARPs).
No protection A few structured products provide no capital protection at all and
instead offer exposure to 100% of the movement in the underlying
asset or index or a greater leveraged return. These also count as
SCARPs.

Structured products are available from a range of providers including banks, fund
management groups and specialist companies.
Chapter 6 6.2: Other indirect investments including life assurance based-products 6/121

There is also a range of structured products available that, once issued, are listed on the Investment notes,
London Stock Exchange. These are referred to as investment notes and offer the investor once issued, are
listed on the
the opportunity to sell their note and take profits early if the markets rise before the maturity London Stock
of the note. These are typically provided by investment banks and are usually more complex Exchange
than retail packaged products. The underlying investment choice is also much wider – some
products relate to shares in single companies.

R3 Returns
The returns from structured products will vary depending upon their terms and on the
performance of the underlying index or asset.

Consider this
this…
…
One of the attractions of structured products is that the client should know at the outset
how much they can gain or lose, which is quite different to making direct investments in
equities or other assets. That being said, there are products which offer contingent capital
protection, or barriers, which do introduce further uncertainty into the structured product
market.

Some of the benefits of structured products include the following:

• A wide range of underlying asset combinations is available, from single indices or funds to
mixes of assets for more complex investment strategies.
• There is no exposure to a particular manager’s style or ability, unless the product is linked
to a fund or portfolio of funds.
• The degree of upside participation will be explicitly stated.
• A level of capital protection is generally included.

Chapter 6.2
• The risk and return characteristics are fixed and transparent – although a clear
understanding of this can require detailed consideration.
The potential drawbacks of structured products include:
• Caps on participation rates will limit the returns investors could have made in a strongly
rising market.
• Kick-out features can mean a product matures early and the investor misses out on future
growth.
• Averaging of index measurements may dilute returns in rising markets.
• If the product cannot be sold in the secondary market, maturity could take place during a
market fall, meaning that any profits that might have been made will either be reduced or
disappear.
• Most retail products are for fixed terms and early encashment (other than as a result of a
kick out) may be impossible or costly. This means that they are not suitable to hold funds
that might be needed at short notice.
• Falls in equity and other markets could be significant enough for the product to lose its
capital protection. Once lost, it cannot be regained.
Selection of a suitable structured product needs to be based on the investor’s aims, attitude
towards risk and ability to accept loss to identify a product that provides an appropriate mix
of capital protection, with the possibility of higher returns from more volatile investment
vehicles. The underlying asset of the structured product should also be considered in terms
of portfolio balance.
 6/122 R02/July 2018 Investment principles and risk

R4 Risks
It is important that
It is important that investors and their financial advisers considering structured products
investors and their thoroughly understand the risks and characteristics of any structured product before
financial advisers
considering
investment. The failure of Lehman Brothers in 2008, and the subsequent effect this had on
structured products where Lehman was a counterparty, has underlined the importance of considering
products
thoroughly
all risks. Upon examining structured products, investors and their financial advisers should
understand the ascertain the following:
risks and
characteristics of
any structured Return • Precise details of how the return will be calculated – many products
product before
investment
apply smoothing to index numbers or use intra-day values;
• what factors might change the initial estimates;
• the extent to which the investor will capture any upward
movement in the markets;
• the value of giving up the dividend flow so that the cost of the
protection can be judged.
Risk profile • Assets forming the structure of the product;
• risks to the original capital invested;
• the extent of any capital protection;
• provisions relating to limited protection;
• the extent of protection under the Financial Services
Compensation Scheme (FSCS) or other EU schemes – UK deposit-
based structured products will be covered up to £85,000 per
investor.
Costs • Costs and fees associated with buying, holding and selling the
structured product;
• tax implications for the investor.
Encashment • Any early encashment penalties;
Chapter 6.2

• the transparency of pricing if the product can be sold on the stock

market or otherwise encashed;
• liquidity in the secondary market;
• costs associated with any stock market sale.
Credit risk • Creditworthiness of the issuer;
• creditworthiness of any counterparties involved in the underlying
derivatives;
• credit rating of any zero coupon bond or other instrument;
• extent to which counterparty risk is protected by collateral – some
counterparties over-collateralise with gilts, but the added
protection reduces potential returns.

Consider this
this…
…
The Lehman Brothers Minibond scandal refers to events related to the company’s
bankruptcy in 2008, and the unravelling of structured products known as Minibonds.
Minibonds paid interest until they matured, at which point the investor was entitled to a
redemption payment. The interest on offer was much higher than the deposit rates on
offer at the time, so, consequently, they were very popular with investors, who had little
interest in, or comprehension of, the risk factors contained in the small print. Lehman
Brothers had arranged nine series of Minibonds and was also the swap counterparty,
which meant that when it went bankrupt, it defaulted on the interest payments. This then
led to some early redemptions and liquidation of the underlying assets which, because of
the global credit crisis, had fallen dramatically.
The products were sold as low risk to investors who were unlikely to understand the many
risks they were in fact exposed to.

It is vital that a realistic assessment is made of the risks associated with any structured
product. Advisers must have a full understanding of these so they can communicate them
clearly and ensure the client has a firm understanding of the potential risks and rewards.
Chapter 6 6.2: Other indirect investments including life assurance based-products 6/123

R5 Summary
Structured products can have a valuable role to play in financial planning. Investors whose
priority is capital protection can find solutions from amongst the wide range of products on
offer. For instance:
• Investors who are cautious about stock market investments, but who want to share in the
potential upside that exposure to markets can offer, can consider products that offer
combinations of market participation and capital protection.
• For the more adventurous, there are products that offer exposure to commodities, hedge
funds and foreign exchange markets as their underlying assets and others that offer a mix
of different asset classes, indices or baskets of individual equities. Structured products
can offer access to asset classes that would not usually be available through traditional
investment funds and offer the potential for diversification within an overall investment
strategy.

Question 6.11
When investors consider using structured products, what areas in particular should they
find out about?

Question 6.12
What are investment notes?

S Sharia-compliant investments

Chapter 6.2
The demand for Islamic banking and investment products is growing and increasingly being
provided by financial institutions.
Under Sharia law, Muslims are restricted from investing in certain investments. The two most
important effects of Sharia law on Islamic finance are the restrictions on paying interest
(Riba) and making unlawful investments in areas such as gambling, alcohol, pork products,
tobacco and others that are against Muslim values.
To be Sharia compliant, a fund’s strategy for investment must be compatible with the
principles and all Sharia-compliant investments must be certified by Sharia experts, usually
through a panel or board.

S1 Sharia-compliant funds
There are three common types of Sharia-compliant funds: equity funds, commodity funds There are three
and Ijarah funds. common types of
Sharia-compliant
funds: equity
S1A Equity funds funds, commodity
funds and Ijarah
Returns are generated mostly through capital gains, although dividends are permissible if funds.

these are from companies that have been approved by a Sharia board.

S1B Commodity funds

These buy Halal commodities at a fixed price to re-sell for profit. Compliant funds cannot be
involved in commodity futures, as this is deemed gambling.

S1C Ijarah funds

Ijarah funds hold tangible assets such as property, so the main source of income for
investors is from rent. A ‘sukuk’ is issued to the subscriber, which is a Sharia-compliant bond
with similar characteristics to a conventional bond, except it is asset-backed. A sukuk
represents proportionate beneficial ownership in the asset.
 6/124 R02/July 2018 Investment principles and risk

S2 Sharia-compliant bank accounts

These accounts provide the same banking services as other current accounts. However, they
do not provide a return on the deposit or offer overdrafts because the principle of paying or
charging interest is against the law of Islam. Any money invested is kept separate from other
accounts and it will not be used to generate interest or be invested in businesses that are
prohibited.
With a Sharia-compliant savings account, the bank uses the money in a way that is
consistent with Islamic beliefs, instead of lending it and charging interest which is then
passed to the client. The bank will follow the advice of a panel to ensure that the profit-
generating activities are Sharia-compliant. Some of the profit earned is then returned to the
client, allowing them to grow their money without earning interest.
Cash put into UK banks or building societies authorised by the Prudential Regulation
Authority (PRA) is protected by the FSCS – the savings protection limit is £85,000 or
£170,000 for joint accounts per authorised firm.

T Direct investment compared to indirect

investment
Finally, we will consider the advantages and disadvantages of direct investment in securities
and assets compared to indirect investment through collectives and other products.

T1 Features of direct investment

The main features of directly holding equities and fixed-interest securities
securities, rather than
through a collective investment like a unit trust or life assurance policy, are as follows:
Chapter 6.2

• Many clients are interested in having direct holdings in specific companies, whose
fortunes they enjoy following.
• Optimal portfolio diversification is only achieved after adding about the 20th stock. In
Edwin J. Elton and Martin J. Gruber’s book Modern Portfolio Theory and Investment
Analysis, they conclude that the average standard deviation (risk) of a portfolio of one
stock was 49.2%, while increasing the number of stocks in the average well-balanced
portfolio could reduce the portfolio’s standard deviation to a maximum of 19.2% (this
number represents market risk). However, they also found that with a portfolio of 20
stocks, the risk was reduced to about 20%. Therefore, the additional stocks from 20 to
1,000 only reduced the portfolio’s risk by about 0.8%, while the first 20 stocks reduced the
portfolio’s risk by 29.2% (49.2% to 20%).
• They are likely to interest investors who have a reasonable attitude to risk because, unless
the portfolio is large, it is likely to have greater volatility of performance.
• There are low costs on switching investment managers because a transfer of stocks can
be arranged without having to sell and repurchase the investments.
• The portfolio can be tailored to the investor’s particular requirements and the manager
can also add value via asset allocation in multi-asset class portfolios.
• It is easier to exclude holdings in specific stocks for ethical or any other reasons.

With direct
• There is greater transparency of all costs.
investment, there • Gains are subject to CGT, but this may be limited or avoided by the annual exempt
is greater
transparency of all amount.
costs
• Larger portfolios can enjoy an economy of scale and lower ongoing charges figures (OCF)
than can be achieved through collective investments, where each unit carries an identical
cost.
• There may be higher volatility of performance, because fewer investments will be held
than within a collective investment.
• For smaller portfolios, the costs may be higher.
• It generally requires greater involvement by an investment manager, particularly for an
advisory client.
Chapter 6 6.2: Other indirect investments including life assurance based-products 6/125

• The results may be more variable, because they depend largely on individual managers,
and the performance of one or two stocks could have a disproportionate effect on the
overall portfolio.
• In larger portfolios, CGT may be payable on gains realised within the directly-invested In larger portfolios,
portfolio. It may be necessary to switch individual investments more frequently than CGT may be
payable on gains
collective investments, thereby possibly incurring a CGT charge. realised within the
• There may be more administration than with collective investments, although this will directly-invested
portfolio
usually be minimised by the use of nominee and other services such as dividend
collection.
• Value added tax (VAT) will be charged on management fees, which are not tax relieved in
any way.

T2 Collective investments
The alternative to direct investment is to use a collective
collective. In this subsection, we will look at
the advantages and disadvantages of the most popular collective investments: unit trusts,
OEICs and investment trusts. These all allow the individual investor to participate in a large
portfolio of shares with many other investors.

T2A Advantages of unit trust/OEIC investment management

services
Holding a portfolio of unit trusts and/or OEICs that are actively managed by an investment
manager is advantageous in several ways:
• A wide variety of unit trusts and OEICs is available. This includes institutional and overseas
funds, which should meet the particular needs and risk profiles of most investors.
• A spread of risk (including overseas investment) can be achieved, even for smaller

Chapter 6.2
portfolios.
• Further diversification can be obtained through a managed portfolio of unit trusts and
OEICs with different fund managers who have a variety of investment styles and
objectives, e.g. stock picking, top down, recovery, blue chip.
• Specialised unit trusts and OEICs can give exposure to particular markets or sectors that
might prove difficult or expensive for a directly invested portfolio.
• CGT is not payable on gains realised within the trust or OEIC.
• VAT is not payable on the annual charges levied within the funds.
• There is no stamp duty reserve tax (SDRT).

T2B Disadvantages of unit trust/OEIC investment management

services
There are several drawbacks to investing through portfolios of unit trusts and OEICs:
• Further management fees are payable in addition to the initial and AMC levied by the fund
management groups. However:
– most brokers buy units at creation price or creation plus 0.25%; and
– there are some low-charging unit trusts and OEICs, e.g. some index tracker funds.
• Changes to the portfolio of funds may be relatively expensive. This is because of the
selling-to-buying price spread that most unit trusts operate and the initial charge levied
on most OEICs.
• There is generally little direct involvement by investors.
• Changing investment managers may involve higher costs.
 6/126 R02/July 2018 Investment principles and risk

T2C Investment trusts vs. unit trusts and OEICs

Unit trusts, OEICs and investment trusts have much in common, but there are certain
differences that give each of them advantages and drawbacks. These are outlined below:
• The costs of purchasing shares in investment trusts are often lower than investing in unit
trusts. For example:
– There may be a charge for disposing of investment trust shares, which is not usually the
case with a unit trust or OEIC. Stamp duty is paid on investment trust share purchases
at the rate of 0.5%.
– The AMCs of older investment trusts are generally considerably lower than those of
most unit trusts and OEICs; but with some modern investment trusts, the total annual
charges can be similar.
– On balance, it is cheaper to invest in most investment trusts rather than most unit trusts
and OEICs, although each investment trust should be looked at individually.

Risk (and reward)

• The risk (and reward) of investing in investment trusts is often said to be greater than the
of investing in risk (and reward) of investing in unit trusts. There are several reasons for this:
investment trusts
is often said to be – Investment trusts usually trade at a discount to NAV. The risk is that the discount might
greater than the get wider. However, if the discount narrows, the shares may outperform the trust’s
risk (and reward)
of investing in unit assets. In the case of unit trusts and OEICs, however, the price of units cannot rise or fall
trusts any further than the rise or fall in value of the underlying investments.
– Discounts can widen if the market does not like the way an investment trust is being
managed and there are more investors trying to sell than buy. However, shareholder
pressures may produce an improvement in performance or even a change of manager.
Investors in unit trusts and OEICs have no power to bring such changes about.
– Investment trusts can borrow to invest. Unit trusts and OEICs have much tighter
restrictions on their borrowing powers, unless they are UCITS funds, which have
Chapter 6.2

considerably more flexibility. In certain cases, borrowing can increase the volatility and
risk profile of an investment trust. At other times, it can reduce the risk if the managers
use borrowings to finance the hedging of their positions, either in the market generally,
in particular securities or in currencies.
• Investment trusts can provide higher levels of income than the equivalent unit trust or
OEIC if there is a discount to NAV. The same amount of money buys exposure to more
securities within an investment trust with a discount to NAV, and, as a consequence, a
greater annual income.
• There are several different types of investment trust securities that have specialist uses,
such as shares in split capital trusts and warrants. For instance:
– Split capital shares divide out the investment returns from the trust to different classes
of shareholders. The shares also involve different degrees of risk, from lower risk zeros
to higher risk capital shares.
– All investors in a unit trust or OEIC, on the other hand, have an equal entitlement to any
income and capital gains, and bear the same amount of risk.
– There are some types of unit trusts and OEICs that do not exist in investment trust
form.
• Investment trusts are closed-ended public limited companies and unit trusts and OEICs
are open-ended funds.

Question 6.13
If a fund is a UCITS fund, what is the implication in terms of investment of the fund’s
assets?
Chapter 6 6.2: Other indirect investments including life assurance based-products 6/127

Key points
The main ideas covered by this chapter can be summarised as follows:

Life assurance-based investments

• There are many forms of life assurance and packaged investments on the market. Some
offer growth potential, others can provide an income, while others can provide a
combination of the two to suit an individual’s situation.
• The tax benefits of many life products apply to relatively few individuals. For many
investors who are willing to accept equity-based investments, there are often more
appropriate investment vehicles, such as ISAs.
• However, the variety of products available means that investors can enjoy additional
benefits, such as guaranteed income vehicles, relative security in with-profit funds and
children’s saving products in tailor-made plans.
• For higher-rate taxpayers, HMRC taxation rules for qualifying policies can benefit their
tax situation by giving tax-free benefits after ten years. However, this benefit has been
reduced, with the cap on contributions now at £3,600 per year. There are also other
investments that can provide investors with a tax-efficient form of income.

Exchange traded products

• ETFs can be bought and sold like other shares listed on a stock exchange and provide
instant exposure to an entire index through a single security.
• They combine the flexibility of a share with the diversification of a fund.
• ETCs work on the same principle, tracking the performance of the underlying
commodity or basket of commodities either directly or by tracking an index designed to
measure the value of that commodity.

Property-based investments
• An alternative to direct property investment is to invest directly through shares in listed

Chapter 6.2
property companies; property unit trusts and investment trusts; insurance company
property funds and REITs.
• Pooled investment funds, such as REITs, are a convenient way of investing in property
for an investor with limited funds.

Private equity
• EISs, SEISs and VCTs encourage investment in small unquoted companies by providing a
range of tax reliefs if certain criteria are met. However, tax relief should not be the main
motivation in choosing investments.

Individual savings accounts (ISAs)

• ISAs
– ISAs allow investors to hold equities and bonds in a more tax-efficient way than
owning them directly.
– Investors can invest in: cash ISAs, stocks and shares ISAs, innovative finance ISAs and
Lifetime ISAs.
– Maximum contribution for 2018/19 is £20,000, of which up to £4,000 can be invested
in a Lifetime ISA by those eligible to contribute to one.
– ISA investments are free of UK income tax and CGT.
– Transfers can only take place between ISA managers.
– Junior ISAs (JISAs)
ƒ For UK-resident children (aged under 18) who do not have a CTF.
ƒ The maximum annual subscription is £4,260.
• Child Trust Funds (CTFs)
– Children born on or after 1 September 2002 may have a CTF.
– The Government provided an initial voucher for £250 (doubled for low income
families).
– Contributions can be made by family and friends until the child’s 18th birthday.
– The Government stopped issuing new CTF vouchers from 1 January 2011, introducing
the JISA in November 2011.
– CTFs can be transferred to JISAs.
 6/128 R02/July 2018 Investment principles and risk

National Savings and Investments (NS

(NS&&I) products
• NS&I offer a wide range of products with both variable and fixed rates of interest, some
of which are tax free.
• Keep up-to-date with the range of products available at www.nsandi.com.
Purchased life annuities (PLAs)
• An annuity is a contract to pay a given amount each year to an annuitant whilst they are
alive.
• PLAs are split into two elements: the capital element and the income element.
• The capital element is tax free, as this is deemed to be a part return of the original
capital. The income element is taxed as savings income.

Derivatives
• Derivatives can be used to manage risk by hedging, or to increase risk through
speculation.
• The purchase of an option results in rights over an underlying asset; the purchase of a
future results in an obligation.
• They can be either exchanged traded or OTC.

Hedge funds
• Hedge funds are pooled investments whereby a number of investors entrust their money
to a fund manager who invests in various traded securities.
• The fund managers will actively manage the investments seeking to provide positive
absolute returns, regardless of overall market movements.
• Funds of hedge funds have opened the market to retail investors and are intended to
spread the risk over several funds.

Absolute return funds

Chapter 6.2

• These aim to achieve a positive absolute return for investors in all market conditions by
adopting widely different investment strategies.
• Success of the strategy is heavily dependent on the skill of the fund manager.

Structured products
• These are investment vehicles designed to offer tailored combinations of risk and return.
• Many offer some form of capital protection to appeal to retail investors.
• Structured products is a generic name for a range of investments marketed under names
such as ‘capital protected growth bond’ or ‘structured funds’.

Sharia-compliant investments
• Under Sharia law, Muslims are restricted from investing in certain investments, in
particular restrictions on paying interest (Riba) and making investments that are against
Muslim values, such as gambling, alcohol, pork products and tobacco.
• To be Sharia compliant, a fund’s strategy for investment must be compatible with the
principles and all Sharia-compliant investments must be certified by Sharia experts,
usually through a panel or board.
• There are three types of Sharia-compliant funds: equity funds, commodity funds and
Ijarah funds – the latter being funds that hold tangible assets such as property, so the
main income for investors is rent.

Direct investment compared to indirect investment

• The alternative to direct investment is to use a collective. This is where investors
participate in a large portfolio of securities or other assets with many other investors.
Chapter 6 6.2: Other indirect investments including life assurance based-products 6/129

Question answers
6.7 Four from:
• They are investments that provide investors who are relatively risk averse with
some exposure to equity markets.
• Bonuses are not directly linked to investment performance as it is possible for life
offices to use their reserves to produce a cushioning effect. This smooths out
sharp rises and falls.
• Over the past ten years, with-profit policies have outstripped inflation.
• They allow investors to participate in the profits of the insurance company’s
trading activities.
• Ownership of a mutual life office’s with-profit policies represents ownership rights
in the life office itself, generating additional profits or shares if the company is
demutualised.
6.8 Both are listed companies run by fund managers who are generally members of
larger investment groups.
Investments in both can be made by subscribing for new shares when a trust is
launched or by purchasing shares from other investors once the trust is established.
6.9 Four from:
• Shares that are officially listed on a recognised stock exchange or AIM. Shares in
unquoted companies do not qualify.
• Small- and medium-sized enterprise securities (not just equities) admitted to
trading on a recognised stock exchange.
• Corporate bonds that are officially listed on a recognised stock exchange.

Chapter 6.2
Qualifying securities include any loan stock or similar security of a company,
whether secured or unsecured.
• Listed bonds issued by a cooperative and community benefit society.
• Gilts and similar securities issued by governments of EEA countries and ‘strips’ of
all these securities, which have at least five years to maturity when purchased by
the ISA manager.
• UK-authorised unit trusts and OEICs, which invest in shares and securities or
warrants, or are structured as fund of funds schemes which invest in them.
• Money market funds, futures and options funds, geared futures and options funds,
and feeder funds are specifically excluded.
• Units or shares in a non-UCITS retail scheme, provided they do not restrict the
savers’ ability to access their funds by more than two weeks (limited redemption
funds).
• UK-listed investment trusts.
• Units or shares in an FCA-recognised UCITS scheme.
• Shares acquired within the previous 90 days from an all employee savings-related
share option scheme, an approved profit-sharing scheme or a share incentive plan.
This applies even where the shares would not otherwise be qualifying investments
(e.g. because they are not listed on a recognised stock exchange).
• REITs.
• Medium-term stakeholder products and life assurance products.
6.10 Hedging and speculation.
6.11 Return; risk profile; costs; encashment; credit risk.
6.12 Investment notes are structured products that, once issued, are listed on the London
Stock Exchange. These offer the investor the opportunity to sell their note and take
profits early if the markets rise before maturity.
6.13 If a fund is a UCITS fund, this means that the fund manager has a lot more flexibility
on how the funds are managed. This includes the ability to leverage, sell short and
use derivatives.
 6/130 R02/July 2018 Investment principles and risk

Self-test questions
13. Explain briefly what you understand by the term market value reduction (MVR).
14. Which bonds separate income and capital so that the income paid reflects the
income generated by the fund, leaving the capital intact? For which type of
investor are they are a suitable investment?
15. State the various with-profit savings plans which are currently in force.
16. What are the main types of life assurance policies for the investment of lump sums?
17. What are the chargeable events for non-qualifying policies?
18. What is the aim of a REIT?
19. Describe the tax position of an investor receiving income from a REIT.
20. Explain how CGT re-investment relief operates for an EIS.
21. Who is eligible for a Junior ISA?
22. What happens to a Junior ISA when the child reaches age 18?
23. If a UK equity fund manager believes that there is going to be a sharp downturn in
the market in the short-term and wants to protect the value of their fund, apart
from selling part of the portfolio, what else can they do?
24. What are the four broad categories of hedge fund strategy?
25. Give three drawbacks of investing directly in securities.

You will find the answers at the back of the book

Chapter 6.2
Chapter 6 6.2: Other indirect investments including life assurance based-products 6/131

Appendix 6.3: Treatment of a single £10,000

bond vs. a cluster of twenty
£500 segments

Unit growth rate of 5% assumed

1. In year three, the investor wishes to withdraw £2,200.
The investment has now grown to £11,000 (20 segments @ £550).

One policy £
Partial withdrawal 2,200
Cumulative allowance
(5% × £10,000 × 3) – includes the current year 1,500

Chargeable gain (excess over the 5% allowance) 700

Top-slicing – includes the current year ÷3
Top-sliced gain 233

Twenty segments £
Amount encashed (4 segments) 2,200

Chapter 6.2
Original investment (4 × £500) 2,000

Chargeable gain 200

Top-slicing – complete years since start of policy ÷2
Top-sliced gain 100
The maximum tax liability for a higher-rate taxpayer is therefore reduced from
£140.00 (£700 × 20%) to £40.00 (£200 × 20%).
2. In year six, the investor wishes to draw a further £2,548. The investment is now
worth £10,192 (16 segments @ £637).

One policy £
Partial withdrawal 2,548
Cumulative allowance
(5% × 10,000 × 3) – since last chargeable event 1,500

Chargeable gain (excess over the 5% allowance) 1,048

Top-slicing – includes the current year ÷3
Top-sliced gain 349

Twenty segments (16 left) £

Encashment (4 segments) 2,548
Original investment (4 × 500) 2,000

Chargeable gain 548

Top-slicing – complete years since start of policy ÷5
Top-sliced gain 109
The maximum tax liability for a higher-rate taxpayer has been reduced from
£209.60 (£1,048 × 20%) to £109.60 (£548 × 20%). In addition, the possibility of
the higher rate being attained has been reduced by the greater top-slicing
relief.
 6/132 R02/July 2018 Investment principles and risk

Appendix 6.3: Treatment of a single £10,000

bond vs. a cluster of twenty
£500 segments

3. Final encashment in year nine. The investment is now worth £8,844 (12
segments @ £737)
One policy £
Final encashment 8,844
Plus all previous withdrawals 4,748

13,592
Less original investment 10,000

3,592
Less previous chargeable gains (excess over the 5% allowance) 1,748
Chargeable gain at maturity 1,844
Top-slicing – complete years since start of policy ÷8
Top-sliced gain 230

Twenty segments (12 left) £

Chapter 6.2

Encashment 8,844
Original investment (12 × 500) 6,000

Chargeable gain 2,844

Top-slicing – complete years since start of policy ÷8
Top-sliced gain 355
 The investment
7
advice process
Contents Syllabus learning
outcomes
Learning objectives
Introduction
Key terms
A Providing investment advice 7.1
B Risk and return objectives 7.1
C Applying asset allocation 7.2
Key points
Question answers
Self-test questions

Learning objectives
After studying this chapter, you should be able to:

Chapter 7
• explain the investment advice process;
• understand the ‘know your client’ requirements;
• outline the importance of the client and adviser relationship;
• determine the aims and objectives of clients;
• describe risk and return objectives;
• explain the influence of time horizon and liquidity on risk tolerance;
• discuss the factors that can influence an investor’s tolerance of risk;
• explain the main constraints that can impact on the choice of investments; and
• state how asset allocation is applied to generate portfolios.
 7/2 R02/July 2018 Investment principles and risk

Introduction
In this chapter, we will examine the investment advice process, the ‘know your client’
requirements, consider the relationship between the client and adviser, and examine the
aims and objectives of clients. This involves considering the factors that influence investors’
tolerance of risk, and identifying the main constraints that impact on the choice of
investments. Finally, we will look at the way in which asset allocation is applied to generate
portfolios.

Key terms
This chapter features explanations of the following:
Asset allocation Attitude to risk Capacity for loss Client objectives
Diversification Ethical issues Fact-finding Investment strategy
Platforms Rebalancing Risk and time horizon Socially responsible
investing (SRI)
Strategic asset Tactical asset Tax wrappers Time horizon
allocation allocation

A Providing investment advice

Providing investment advice is an art rather than a science, despite much of the data being
numerical. It involves balancing the emotional and financial needs of the client against the
expected, but rarely certain, performance of the available investments. Uncertainties
relating to clients’ circumstances (job, marital status, health, etc.) and uncertainties in the
financial world means that giving investment advice can never be a purely mechanical or
mathematical process.

A1 The investment advice process

Providing professional investment advice to consistent standards requires the adviser to
adopt and adhere to a clearly defined and structured process.
Chapter 7

Be aware
Important advantages of using a structured process
The important advantages of using a structured process are that it provides a discipline
for advisers, an administrative template for a sequence of actions and that it can be
documented so there is a clear compliance trail.

Engaging the
Whilst an adviser needs to have a thorough knowledge of the various investment products
client fully in the available in the marketplace, and of the tax issues affecting investment, this technical
process helps to
deliver optimal
knowledge is only beneficial to the client if it is applied in the right context to the relevant
results information, and communicated effectively. It is through engaging the client in the process
and ensuring the client fully understands the implications of major decisions that optimal
results will be achieved.
The high level investment advice process is shown in Figure 7.1.
Chapter 7 The investment advice process 7/3

Figure 7.1: The investment advice process

Determine client’s
requirements

Revisit investments, Analyse client’s

objectives and financial position
strategy

Produce
Formulate a
recommendations
strategy to meet
and implement
objectives

The process can be broken down further to include:

• establishing and defining the relationship between the client and the adviser;
• gathering client data, determining goals, expectations and any ethical issues;
• analysing and evaluating the client’s financial status;
• creating a risk profile in agreement with the client;
• formulating the investment strategy for asset allocation;
• selecting investments, funds and products;
• selecting wrappers for tax efficiency;
• presenting and implementing the recommendations; and
• monitoring the portfolio and making any necessary adjustments, rebalancing the portfolio
and switching out of underperforming funds.
The Conduct of Business Sourcebook (COBS) from the Financial Conduct Authority (FCA)
states that firms must take reasonable steps to make sure any recommendations provided

Chapter 7
to clients are suitable.
When assessing the suitability of investments for clients under MiFID II, firms are not only
required to take account of the client’s investment objectives, but also to obtain information
about:
• the client’s knowledge and experience in the investment field concerned;
• the client’s risk tolerance; and
• their ability to bear losses.
The overall objective is to identify – and obtain the client’s agreement to – a portfolio
designed to meet their key requirements as closely as possible. It is also important to explain
and obtain their agreement to any critical trade-offs made in the portfolio’s construction. In
many respects, it is an educational process: helping clients to understand such concepts as
risk, real returns (i.e. post-inflation) and nominal returns (which take no account of inflation)
and the effects of business cycles on the markets.

A1A Establishing the client relationship

At the start of a client relationship, an adviser should inform the client about the scope of the
services on offer and any costs for the adviser’s work. This will typically be provided in the
agreement, which, among other things, sets out:
client agreement
• remuneration;
• the service that will be provided and the timescale in which it will be provided, e.g.
quarterly valuations;
• duration of the agreement; and
• frequency of contact, e.g. not less than annual meetings.
 7/4 R02/July 2018 Investment principles and risk

Be aware
The main purpose of a client agreement is to ensure that the client has a clear
understanding about issues, such as:
• the amount of reporting on investments;
• the frequency of reviewing the client’s circumstances and plans; and
• whether or not the adviser will alert the client to any changes to their planning that
might be needed in the future.

A1B Gathering client data

Any options need
The circumstances of every individual are unique and it is essential that an adviser considers
to be fully which investment strategy is appropriate to meet a client’s varying needs before making any
described with
advantages and
recommendations.
disadvantages

How it works
An adviser must be able to fully explain to the client, in a way that the client will
understand, how each recommendation meets the identified financial goals and
objectives. If a recommendation requires the use of a particular product, then any options
need to be fully described and the relative advantages and disadvantages of any
alternatives pointed out.
It is important that an adviser understands the true needs of the client and obtains enough
information to ensure that any recommendations made are suitable and relate to the
client’s aims, objectives and circumstances.

See section A1G Fact-finding extends beyond ‘hard’ information such as age and income to include ‘soft’
for more
information on facts such as ethical and family values and attitudes to risk. It can be a long and delicate
ethical issues process, which involves not only listening to what clients want, but also includes helping
them to identify:
• their true investment aims and what they want to achieve;
• the level of risk that they are comfortable with;
• how much they wish to save regularly or invest and for how long the money is to be
Chapter 7

invested; and
• other issues – such as ethical or socially responsible investing or restricting investments
on the basis of religious beliefs.
An adviser will need to gain a client’s trust so that the client will feel confident about
expressing their personal needs and concerns, and provide true facts about their financial
position, including their current income, expenditure, assets and liabilities. This will provide
the adviser with a full and clear understanding of a client’s financial and personal situation.
Several meetings, as well as telephone conversations and correspondence, may be needed
to gather all the information the adviser needs. Once this process has been completed, the
adviser should have a sufficient understanding of the client’s financial position and
investment objectives to undertake analysis and cash flow projections.
The key areas in which information is required are:
• needs and objectives;
• assets and liabilities;
• income and expenditure;
• priorities; and
• attitude to risk.

Often, the initial

Often, the initial ‘fact-find’ will be through the client’s completion of an online questionnaire.
‘fact-find’ will be The adviser will need to review the answers given in the questionnaire, and then ask
through an online
questionnaire
supplementary questions to fully appreciate the client’s needs, which most people are
unable to articulate with total clarity through a form.
Chapter 7 The investment advice process 7/5

Be aware
Most important outcome of the fact-finding process
The most important outcome of the fact-finding process is a clear understanding of the
client’s goals and their expectations. It is therefore advisable to secure their agreement to
a formulation of these before moving onto the analysis stage.

Example 7.1
Goals and needs
Alex, aged 41, is married with two young children, and has expressed his goals as buying a
bigger house, building up a fund of at least £10,000 for each child when they reach 21 and
for him to retire when he is 60. The adviser lists his needs in priority order as:
• increasing contributions to retirement plans;
• increasing contributions to a cash deposit account for house purchase; and
• contributing to stock market-linked savings plans for each of his children.

A1C Analysing the situation

Clients may have desires or ‘wants’ that may be unrealistic both in terms of timescale and Clients may have
cumulative cost. The adviser’s role is to identify the client’s main needs, prioritise them and ‘wants’ that are
unrealistic in
establish if these are achievable with the resources available. In the investment process, timescale or
needs can be matched to sums of cash (income or capital) required at certain dates in the cumulative cost
future. Explaining this to the client and demonstrating the investment returns required to
meet these needs will often enable clients to engage with setting these priorities. If the
adviser’s view is that the goals are not achievable, then further negotiation with the client
over the timescale and outcomes will be required.
Judging the achievability of the client’s objectives will require cash flow projections and
assessment of future requirements for income and capital, usually in more precise terms
than the client has previously undertaken. The conversion of the client’s goals, especially for
retirement income, into capital sums will often show that they cannot afford to contribute
enough to generate those sums unless very high rates of return are achieved. This can
provide the opportunity to discuss some key concepts with clients, in particular the effect of
compounding and the importance of considering real returns rather than nominal returns.

Chapter 7
In other words, it is necessary to start with a client’s ‘hoped for’ target return and then
temper this by applying their attitude to risk to obtain a more balanced view of their
objectives.
Where clients have unrealistic goals, the adviser needs to make them aware and negotiate Where clients have
more realistic ones. See Table 7.1 for two examples. unrealistic goals,
the adviser needs
to make them
aware and
Table 7.1: Renegotiating objectives negotiate more
realistic ones
Scenario Issue Renegotiation
Retirement On the basis of current and The adviser concludes that the
projected savings, the adviser client will need to contribute to
concludes that the client will not their retirement savings plans for
be able to retire at their between three and five more
proposed age of 63. years to achieve their target
retirement income. The client
may agree to this delay in their
retirement age, or decide to
lower their income target to
ensure they can retire at 63.
Mortgage repayment A client with an interest-only The client will have to choose
mortgage with a savings plan between increasing their
has achieved a much lower rate contributions, using other capital
of growth in the plan over a 15- towards repayment of the loan,
year term than will be required or reallocating some, or all, of the
to repay the loan at redemption plan to higher-risk investments.
in 10 years’ time.
 7/6 R02/July 2018 Investment principles and risk

Question 7.1
If the adviser considers the client’s expressed goals to be unrealistic, what should they
do?

A1D Creating a risk profile

Many advisers use questionnaires to establish a client’s attitude to risk.

A risk profile is a
A risk profile sets limits on the extent of the maximum loss likely within different timescales,
key factor in and can be directly linked to asset allocation and, if required, model portfolios. It is a key
creating
appropriate
factor in creating appropriate portfolios.
portfolios

Consider this
this…
…
Do you think that the pain and grief suffered by people when they lose money is greater
greater,
as, or less than the pleasure they experience when they make money?
the same as

Behavioural Interestingly, research into behavioural finance has established that, in general, people suffer
finance was
examined in pain and grief approximately twice as intensely when they lose money as they experience
chapter 3, pleasure when they make money. It appears that a significant degree of ‘risk aversion’ is part
section E
of most people’s psychological make-up. Generalising from the accounts given by successful
investors, we can also say that with experience, people can learn to override their immediate
reactions of pain or regret, and most clients will do so, at least to some extent, provided they
feel that they understand what is happening. It follows that a typical client’s understanding
of, and attitude to, risk will change as they gain investment experience.

Be aware
Risk
The most important conclusion is that risk is inescapably a psychological and subjective
issue. The discussion of risk within a finance theory framework takes no account of
subjective factors and is, therefore, of limited use in enabling clients to come to terms with
the actuality of the risk–return trade-off and its possible consequences for them.

‘Herding’ applies to
The starting point for an assessment of the client’s risk profile is usually a questionnaire. The
Chapter 7

financial as well as typical questionnaire will gather information about the client
client’’s attitude to risk based on
social decisions
hypothetical questions such as: ‘How would you feel if the value of your investments fell by
20%?’ While this may reveal something about the client’s personal attitude to risk, it is
important to note that perception and tolerance of risk are also socially influenced.

How it works
Herding
‘Herding’, the tendency of people to imitate others, is a widespread social phenomenon,
and behavioural finance research has established that it applies to financial as well as
social decisions.
For example, many people simply ignored the risks involved in the high-flying tech stocks
of the 1999−2000 dotcom bubble, or in buying holiday properties in Spain in 2007, mainly
because so many other people were doing it.

The adviser needs to find out what experience the client has had of risk, either with
investments or in their business life, in order to see if this is consistent with their expressed
attitude. Recent experience may influence their perceptions and attitudes. Someone who
has lost money in the stock market will probably perceive that there is more risk involved in
investing in the market than someone who has previously made a profit.

Attitudes and
Attitudes and perception of risk can change throughout an individual’s life. They will be
perception of risk affected as they experience the positive and negative outcomes of their previous
can change
throughout an
investment decisions, get older or wealthier, or their work situation changes.
individual’s life
The final component of the risk profile is the client loss. Unlike the other two
client’’s capacity for loss
factors, this is objective.
Chapter 7 The investment advice process 7/7

Example 7.2
If an individual loses 20% of their capital, their income from this will shrink by 20% and
their lifestyle may be uncomfortably constrained. The adviser must take this into account
in creating a risk profile, even if the person defines themselves as a bold investor. The
capacity for loss is determined by the resources available, the consequences of a loss of
capital or income and the ability to replace any losses.

It is important that an adviser establishes in detail the returns that a client feels are required,
and the level of risk they can tolerate, as it is the client’s risk tolerance that will establish
realistic return objectives. If an investor expresses their expectations only in terms of returns,
there is a danger that a high-target return will lead to an adviser selecting higher-risk assets
and the resulting risk may not be acceptable to the client.
The range of possible returns from a selected asset allocation over any time period can be The range of
estimated using historical data. It is important to note that future returns will not necessarily possible returns
from a selected
conform to those of the past, so this can be no more than an estimate. Stochastic modelling asset allocation
uses probabilistic methods to estimate the ranges within which returns may fall over future over any period of
time can be
periods, but care must be taken not to allow clients to ‘anchor’ on these returns. In extreme estimated using
conditions, such as 2008-09, returns can fall below the ranges derived from probabilistic historical data
extrapolations of historic data.

Be aware
Three components of the client
client’’s risk profile
The client’s risk profile should be based on the client’s attitude to risk, tolerance of risk
and capacity for loss. The client should confirm their acceptance of their risk profile in
writing.

The objective and subjective factors that may influence the client’s risk profile are covered
later in this chapter.
When a portfolio is being arranged to meet more than one investment objective, a client
may have a different attitude to risk in respect of each objective. This may reflect a
phenomenon identified by behavioural finance known as ‘mental accounting’, whereby
objectives and the plans to meet them are kept entirely separate, largely, it seems, because
it is easier for most people to keep track of them in this way.

Chapter 7
In extreme cases, couples may wish to have separate portfolios, each with different risk
profiles, or separate portfolios for different objectives (e.g. retirement income, capital
growth). According to finance theory, this is less efficient and could result in lower returns
but, in practice, there is no reason why an adviser cannot accommodate this type of request.

A1E Formulating the investment strategy for asset allocation

The investment strategy is applied using an asset allocation based on the client’s risk profile. The investment
Asset allocation generally has a much larger impact on portfolio performance than the strategy is applied
using an asset
selection of successful or less successful fund managers. Usually, advisers will construct allocation based
between three and ten risk profiles, each of which has an asset allocation based on expected on the client’s risk
profile
risks and returns. For example, cautious and adventurous risk profiles might have the
following allocations:

Asset class Cautious Adventurous

Percentage of total capital allocated to asset
class
Cash deposits/money market 10% 5%
instruments
Fixed-interest securities 25% 10%
Property 15% 10%
Equities 50% 75%
Total 100% 100%
 7/8 R02/July 2018 Investment principles and risk

A1F Selecting investment funds

The selection of
It is important to note that allocation of capital to asset classes is only one means of
investments within controlling the risk–reward ratio. The selection of investments within an asset class can also
an asset class can
also play a
play a significant role.
significant role in
controlling the For example, within fixed-interest securities, allocation of capital to higher-yielding bond
risk–reward ratio funds might be appropriate for adventurous investors, while, for cautious investors, funds
holding portfolios limited to government bonds and investment grade corporate bonds
would be more appropriate.
Likewise, smaller company funds or ‘alpha’ funds would be suitable for adventurous
investors, while equity income funds would better suit cautious investors, and funds
investing in real property are more suitable for cautious investors than funds investing in
listed property securities or REITs.

Table 7.2: Differential risk profiles of funds within asset classes

Fixed-interest securities Equities
Lower risk Gilt funds Equity income funds
Global government bond funds Income and growth funds
Investment grade corporate
bond funds
Higher risk Emerging market bond funds Alpha funds
High-yield bond funds Smaller company funds
Tactical bond funds Specialist funds (e.g.
technology, resources)

While some funds will be common to several portfolios, a large number of individual funds
will be required to create a complete set of model portfolios. This requires the adviser to
research a significant number of funds, and those unwilling to do this may instead choose to
use multi-manager funds where the manager undertakes the research and allocates capital
to selected fund managers.
Most advisers create model portfolios for each risk profile, using either their own methods or
Chapter 7

Model portfolios
show the third-party portfolio modelling tools. These model portfolios will show the percentage of
percentage of
capital to be
capital to be invested in each set of funds. If the adviser creates their own model portfolios,
invested in each these should be reviewed and, if necessary, revised at regular intervals.
set of funds
Portfolios generated by modelling tools will vary depending on the assumptions and
selection criteria used as inputs. advisers using multi-manager funds will need to review
these regularly against their peer groups.

Be aware
If advisers generate their own model portfolios
portfolios… …
If advisers generate their own model portfolios, they need to establish a process for fund
research, selection and monitoring.

Question 7.2
How does choice of individual funds within a portfolio affect the risk-reward ratio?

A1G Ethical issues

Client objectives for investments do not always include purely economic goals. Many people
have strong ethical reasons for choosing or excluding certain types of investments.
Broadly, socially responsible investing (SRI) reflects the ethical, moral, religious or socially
responsible beliefs which can heavily influence the choice of investments.
Chapter 7 The investment advice process 7/9

Be aware
Ethical and socially responsible investment
In the investment world, the expressions ‘ethical investment’, ‘environmental investment’,
‘green investment’, ‘responsible investment’ and ‘socially responsible investment’ are
often used interchangeably. More recently, the term ‘impact investing’ has been used to
refer to investments which are made where the intention is to generate a beneficial social
or environmental impact as well as financial gain. It can be thought of as falling
somewhere between charitable giving and socially responsible investment. Also included
in this group are the growing numbers of Sharia investments, which meet the strict rules
of Islamic finance.

The latest estimate by Vigeo Eiris of the size of ethical and green funds across Europe
indicates that UK retail investors invested more than £15bn in these funds in 2016.
There are several different approaches to ethical investment, including the following:
• Positive screening involves investing in companies that have a responsible approach to
business practices, products or services. For example, some funds focus on investment in
those companies that have the best practice in their industries, while others focus on
particular themes, such as social or ethical issues or environmental technologies. In the
latter case, issues such as biodiversity, alternative energy sources, water management
and genetic engineering may be of particular interest to investors.
• Negative screening or avoidance means not investing in companies that do not meet the
ethical criteria that the fund sets. This usually focuses around ethical issues such as
alcohol, tobacco, pornography and animal rights in both testing and the fur trade. This is
the oldest and best-known approach to responsible investment.
In many areas, there are both negative and positive aspects to a given ethical issue. For
example, oil and gas companies may be the leading source of emissions of carbon dioxide, a
major greenhouse gas – but they may also hold the key to more environmentally friendly
future energy solutions.
There is no single, correct, black-and-white approach to any issue. Approaches may vary
from being strictly against something to having no concern about a given issue. However,
where there is a wide public consensus about an issue, the approach adopted by different
funds may be very similar.

Chapter 7
Activity 7.1
Ethical investing does not have to mean accepting sub-standard investment returns. Look
up the past performance of ethical funds, e.g. at www.hl.co.uk/funds/research-and-news/
fund-sectors/ethical, and consider how these compare to mainstream funds.

Ethical banking
Some smaller banks have specialised and differentiated themselves as ‘ethical banks’ by
using social, environmental and/or ethical criteria for their lending and other activities. As
with green and ethical funds, they may focus on investing positively in certain areas or
emphasise instead the activities or operations not permitted for their business customers;
they may also offer a combination of these.
Major banks are increasingly aware of the social and environmental impact of their lending Major banks are
activities, particularly in the developing world, as some have come under criticism for their increasingly aware
of the social and
involvement in controversial projects (for example, the construction of dams for environmental
hydroelectric power). impact of their
lending activities

A1H Choice of tax wrappers

Investments should be selected on the basis of expected risk/return characteristics, which
are independent of their tax treatment. The selection of vehicles within which to hold
investments should follow and not precede risk profiling and asset allocation decisions.
 7/10 R02/July 2018 Investment principles and risk

The adviser will

The adviser will often need to recommend allocation of capital to a combination of accounts
often need to with different tax treatments. The most important tax features of these accounts are set out
recommend
allocation of
in table 7.3. Where the client is to hold investments in several accounts, the key requirement
capital to a is to hold individual investments within the account giving the most favourable tax
combination of
accounts with
treatment, which is relatively easy when all a client’s investments are held on a platform.
different tax
treatments
Table 7.3: Tax features of accounts (tax year 2018/19)
Account Tax on income derived from Tax on
capital gains
Cash deposits Fixed interest Property Equities
Direct 0%, 20%, 0%, 20%, 20%, 40%, 7.5%, 32.5%, 10% or 20%(2)
40%, 45%(1) 40%, 45%(1) 45%(1) 38.1%(1)
Individual Nil Nil Nil Nil Nil
savings
account (ISA)
Pension Nil Nil Nil Nil Nil
Onshore 20% 20% 20% Nil 20%(3)
bond fund
Offshore Nil Nil Nil Nil Nil
bond fund
(1) Dependent upon personal tax rate. Note: basic-rate taxpayers have a £1,000 personal savings
allowance, higher-rate taxpayers have a £500 personal savings allowance and dividends from
equities received over £2,000 are taxed at 7.5% for basic-rate taxpayers, 32.5% for higher-rate
taxpayers, and at 38.1% for additional-rate taxpayers.
(2) Gains in excess of the annual personal capital gains exempt amount on shares, property and
fixed-interest securities (other than gilts and qualifying corporate bonds) are added to the
individual’s taxable income in the relevant tax year. If the aggregate exceeds the higher-rate
income tax threshold, a rate of 20% applies to the amount of gains above the threshold, while a
rate of 10% applies to the amount of gains below the threshold. Different rates apply to
residential property.
(3) After allowance for retail prices index (RPI) indexation. You should note that, since 1 January
2018, any indexation allowance is only calculated up to 31 December 2017.
Chapter 7

Example 7.3
Ben is a higher-rate taxpayer. His £200,000 portfolio is divided equally between an ISA
and direct holdings. The recommended portfolio includes a £30,000 holding in bonds.
Optimum tax efficiency will be achieved if these are all held within the ISA, where the
income will bear no tax.

Whilst tax should not be a driver of the asset allocation decision, it can come into play in the
selection of investments within asset classes. In particular, for those investors with a higher
risk profile, investments in venture capital trusts (VCTs), enterprise investment schemes
(EISs) and the seed enterprise investment schemes (SEISs) may be attractive for the tax
advantages they offer.

A1I Platforms
A platform enables
Whichever tax wrappers are selected, they will often be held on a platform. A platform
a single set of enables a single set of investments to be managed across several wrappers. For example,
investments to be
managed across
the client may hold some assets in their own name, some in ISAs and some in a pension
several wrappers account, all on a single platform. This has major advantages in terms of simplicity and
convenience for both client and adviser.
See chapter 6 for In selecting a suitable platform, the adviser must consider the range of tax wrappers
more on
platforms available, the range of investments available and the cost to the client of the platform itself.
Advisers will generally use more than one platform since their features and charges vary; the
one chosen should be the one best suited to the client’s resources and requirements.
Chapter 7 The investment advice process 7/11

A1J Presenting recommendations

Most advisers present their recommendations in the form of a report. To make it easier for Most advisers
clients to grasp, best practice is to present an outline of the client’s circumstances and needs present their
recommendations
with a summary of the recommendations, followed by more detailed sections on risk profile, in the form of a
asset allocation and investment and wrapper selection. report

Wherever possible, graphs and charts should be used, since most people find it easier to
assimilate information in this way. Many advisers provide their clients with an investment
strategy statement to explain briefly and clearly why and how a portfolio is constructed.

Example 7.4
A typical statement could be:
Over the ten years to Mr Brown’s retirement, the strategy will be to seek growth in
capital, assuming no requirement for any income or capital withdrawals. Any
income generated will be reinvested within the portfolio. The portfolio will use an
asset allocation based on Mr Brown’s risk profile, which is defined as adventurous.
Capital will be invested in UK-authorised open-ended funds investing in money
market instruments, bonds, property, commodities and equities. No fund will
account for more than 10% of the capital value. Funds using aggressive growth
strategies may account for up to 25% of the capital value. The portfolio will be
reviewed at six-monthly intervals.

Where income is required, it is best specified as an actual annual or monthly amount, with
targets for any rate of increase (for example, ‘increasing in line with the consumer prices
index (CPI)’). Where income is not required, it should be specified that it is available for
reinvestment within the portfolio.

A1K Monitoring the portfolio

The basis and frequency of reviews should be covered in the client report and the client The basis and
agreement. This may specify that reviews are undertaken six-monthly or annually, and that frequency of
reviews should be
recommendations for changes will be made only at these times; or that the adviser will make covered in the
recommendations as and when they consider it appropriate. client report and
the client
Firms providing investment advice must agree with a client whether a periodic assessment agreement

Chapter 7
of suitability will be performed and if so, it must be at least annually and the continued
suitability confirmed in writing.
The adviser needs to structure a process for reviewing portfolios and generating valuations
and reports. An important feature of these is performance of the portfolio, which should be
compared with a suitable benchmark, such as one of the MSCI Wealth Management
Association (WMA) Private Investor indices. The report should explain any divergence of
portfolio performance from the benchmark.
Under the previous FCA rules, periodic portfolio reporting to investors (including valuations)
was a minimum of every 6 months. Under MiFID II, the minimum frequency is every three
months. There is also a new requirement to communicate to clients if their portfolio’s value
falls by 10% over a single reporting period.
The adviser will need to set up systems for monitoring and reviewing each of the funds
contained in client portfolios.
Where appropriate, recommendations should be made for disposal of funds with
unsatisfactory performance and their replacement with others.
 7/12 R02/July 2018 Investment principles and risk

B Risk and return objectives

The investment process as described is an ideal template. In practice, investment decisions
are often subject to constraints that may require the adviser to adjust their
recommendations. These constraints fall into two categories: derived respectively from
objective and subjective factors. We will consider each in turn.

B1 Client objectives
Main client
The main client objectives are concerned with:
objectives concern
return • return requirements; and
requirements and
risk tolerance
• risk tolerance.
If an investor expresses their expectations only in terms of returns, there is a danger that a
high-target return will lead to an investment manager investing in higher risk assets and the
resulting risk may not be acceptable to the client.

Risk tolerance
The primary factor to consider is the risk tolerance of the client, including their ability and
determines willingness to take on risk. That tolerance will determine realistic return objectives.
realistic return
objectives

Reinforce
It is necessary to start with a client’s ‘hoped for’ target return and then temper this by
applying their attitude to risk to end up with a more balanced view of their objectives.

Looking at investment solutions that may address these objectives, there are two main
categories:
• Investments that maximise returns for a given level of risk
risk. Examples of such funds are
collective investment schemes, e.g. unit trusts, open-ended investment companies
(OEICs), investment trusts and discretionary managed accounts.
• Investments designed to match future liabilities
liabilities. Examples of such funds are defined
benefit (DB) pension funds (final salary schemes), life assurance products, general
insurance products and investment funds that meet specific income requirements.
In many cases, an investment solution will require a mixture of maximising returns and
Chapter 7

liability matching (e.g. a mix of investment funds, pension provision and protection
products).

B1A Investor risk tolerance

Broadly speaking, investors can be classified into one of five risk classes:

Risk class Description

No risk Not prepared to accept any fall in the value of their investments – will
invest in cash-based products and perhaps short-dated bonds.
Low risk Cautious – prepared to accept some value fluctuation in return for long-
term growth but will invest mainly in secure investments.
Medium risk Will have some cash or bond investment but will have a fair proportion
in asset-based investments using diversified collective investment
schemes or a well-diversified share portfolio if their fund is large
enough. May have a small amount in higher risk funds.
Medium
Medium––high risk Cash allocation is kept to the minimum. Will be prepared to invest
outside the UK and in high risk funds. Will take a long-term view and
may choose to sacrifice some diversification for a more focused and
volatile portfolio.
High risk Cash is kept to the minimum. Prepared to have direct holdings in listed
and unlisted shares, high risk funds and highly geared unprotected
structured products.
Chapter 7 The investment advice process 7/13

Risk tolerance is partly subjective, whereas capacity for loss is largely a matter of fact. Capacity for loss is
Capacity for loss is the client’s ability to absorb any negative financial outcome that may the client’s ability
to absorb any
arise from making an investment. Most clients will have some idea of their attitude to risk but negative financial
they are unlikely to have thought precisely about capacity for loss. For example, a client who outcome that may
arise from making
is retired and drawing an income from their portfolio is likely to have a reduced capacity for an investment
loss. In comparison, someone in their mid-30s will have a greater capacity for loss, as they
will have the opportunity to replace any portfolio losses through future earnings.
In a lot of cases, capacity for loss will play the most important role in determining the client’s
overall risk profile.

B1B Investors
Investors’’ return objectives
For private investors, return objectives may be specified in terms such as capital
preservation, capital appreciation, current income and total return.

Table 7.4: Investment objectives

Examples of • Capital preservation
preservation. This is generally for risk-averse investors who
these include: want to minimise the risk of loss, usually in real terms. This means they
want to achieve a return that is equal to or above the inflation rate.
• Capital appreciation
appreciation. This is usually for longer-term investors where
growth in the value of the assets in real terms is the priority, perhaps
to build a retirement fund. Under this strategy, growth usually comes
from capital gains.
• Current income
income. This is often for investors who are focusing on
income rather than capital gains. Perhaps income from the portfolio is
needed to pay for living expenses.
• Total return
return. This is usually for long-term investors who are looking
for growth in the value of a portfolio to come from both capital gains
and reinvestment of income.

Investment objectives might also be expressed in general terms, e.g. capital growth, income
or a balance of income and capital growth. They may also be expressed more specifically,
e.g. an annual income of £5,000 after tax to provide for school fees of £20,000 a year
starting in seven years’ time, or to provide the capital to repay a loan in ten years’ time.

Chapter 7
Be aware
Both short-term and long-term objectives
For most clients, it is unlikely that they will be able to express their objectives easily. Most
clients have both short-term and long-term aims and the combination of the two
objectives need to be considered. The adviser’s role is to establish these and guide the
client as to how these objectives can be achieved.

B2 Constraints
In addition to establishing the investor’s objectives, the investment adviser also needs to In addition to the
consider constraints that impact on the investments made in the portfolio. These include: investor’s
objectives, the
• time horizon; adviser also needs
to consider
• liquidity; constraints that
impact on the
• tax; investments made

• legal and regulatory factors; and

• unique needs and preferences.
We will look at time horizon and liquidity in more detail since they directly impact on the
ability of a client to take on risk.
 7/14 R02/July 2018 Investment principles and risk

B2A Time horizon

Whenever an investment is considered, the time horizon of the client must be taken into
account:
• As a general rule, the shorter the time horizon, the more important it is to preserve the
capital value.
– If a tax bill has to be paid in six months’ time, the investment must be made with the
minimum of risk, e.g. in very short-dated gilts or a six-month, fixed-term deposit, rather
than in shares or other investments which could go up or down in value. These
investments might produce higher returns but, over such a short period, the risk is too
great that short-term market volatility could lead to the tax bill not being covered.
• The longer the time horizon, the less important are short-term fluctuations in capital
value. Instead, it becomes more important to maintain value and to produce returns
higher than inflation.
• When the time horizon is longer, short-term volatility becomes more acceptable as long
as the clients are warned of the likelihood of such short-term movements in value.

Be aware
‘Rainy day
day’’ fund
In addition to definite requirements for cash, it is generally advisable for clients to hold a
float equivalent to between six and nine months’ expenditure in the form of easily-
accessible cash deposits. This emergency or ‘rainy day’ fund should be sufficient to cover
most contingencies.

B2B Risk and time horizon

Risk is closely related to time horizon, at least with investments like equities, where the
overall expectation is growth of income and capital. Economic cycles and disasters such as
wars may cause setbacks that can last for several years but, in the long-term, a well-
diversified portfolio of investments in businesses or property is likely to recover. However,
the investor must be prepared to remain invested in these asset-based holdings for very
long periods. The longer an investor can hold on to such investments, the more chance there
is of riding out cyclical and other major downturns. This can be seen using the Barclays
Equity Gilt Study 2016:
Chapter 7

• It can be demonstrated that, over the period since 1899, equities have generally
outperformed cash deposits. Over that period, equities have produced real annualised
returns of 5.1% per annum compared to just 0.8% for cash.
• The returns over such a long period, however, disguise periods when cash was the better
performer. Equities have outperformed cash in 77 out of the last 114 years, but that still
leaves a large minority of periods in which cash was the better performer.
• When the holding period is extended out to ten or more years, equities more consistently
produce better returns.
• Table 7.5 illustrates the performance of equities against cash for different holding periods.
The first column shows that over a holding period of two years, equities outperformed
cash in 77 out of 114 years; thus, the sample-based probability of equity outperformance is
68%. Extending the holding period out to 10 years, the probability of equity
outperformance rises to 91%.

Table 7.5: Equity performance

Number of consecutive years
2 3 4 5 10 18
Outperform cash 77 79 81 83 96 97
Underperform cash 37 34 31 28 10 1
Total number of years 114 113 112 111 106 98
Probability of equity outperformance 68% 70% 72% 75% 91% 99%
Source: Barclays Equity Gilt Study 2016.
Chapter 7 The investment advice process 7/15

B2C Liquidity
All personal portfolios should include some level of cash liquidity, but there are degrees of
liquidity. Some key factors are:
• If investors need to draw money to meet an emergency, they should not be forced to
realise an investment at an inappropriate time.
• An element of liquidity also allows the investor to take advantage of short-term
investment opportunities, such as a new share offering or rights issue.
• Most people need some money that is instantly available. However, they can perhaps hold
the bulk of their cash in a form that can be retrieved without penalty after two weeks or
even two or three months, so long as they know it is available without loss or penalty at
the end of a specific period.
• As longer terms may provide higher returns, it is worth estimating the degree of liquidity
likely to be needed.
There is no fixed percentage of assets or cash that is automatically right for every portfolio.
An investor with a secure, well-paid job and low outgoings may be less concerned with
liquidity than individuals who depend solely on their portfolio for income. Each situation
should be examined on an individual basis.
It should be remembered that excess cash is ultimately a relatively inefficient investment,
particularly for higher-rate taxpayers, and that the liquidity of individual investments varies
considerably.

B2D Risk and liquidity

A need for liquidity will generally reduce the risk that can be taken in the portfolio, or at least
the portion of the portfolio that will need to be held in cash or short-term investments. An
investor who has cash requirements may not have the flexibility to ride out the short-term
volatility in markets.

Question 7.3
Identify two constraints that will have an impact on an investor’s ability to tolerate risk.

Chapter 7
B2E Resources
People with substantial income and assets have a greater risk capacity; the loss of some People with
capital will not necessarily put their lifestyle at risk. Those with modest capital are often substantial income
and assets have a
more dependent on it, and therefore have a lower capacity for loss, even though they may greater risk
express a willingness for more adventurous investment. For example, younger investors with capacity
many years left until retirement have the potential to recover any capital losses through
future earnings and investment growth, and so have greater risk capacity than those
investors who are near to retirement.
A common issue affecting resources is whether a client should pay off a mortgage from an
available sum of capital or invest the capital in the hope of securing a higher return. Many
people wish to be free of debt and, in most cases, where the interest rate payable on the loan
is higher than can be secured on bond funds, paying off such capital will make sense. Usually,
this will result in an increase in disposable income, part of which could be allocated to long-
term savings plans. However, some borrowers may have mortgages with low interest rates,
and may be better off investing the capital. Also, it should be noted that many borrowers
have loans on terms they may not be able to secure from lenders today.
It is important for clients to realise that short-term debt is likely to carry much higher interest
rates and, in almost all cases, paying it off as fast as possible should be a high priority.

Example 7.5
An adviser is working with a client to put together an investment portfolio. The client has
£5,500 of outstanding balances with credit cards, with an average interest rate of 14.9%,
which she has been paying off at the rate of £150 per month. The adviser recommends
diversion of £5,500 from the proposed investment portfolio to clear these balances
immediately.
 7/16 R02/July 2018 Investment principles and risk

C Applying asset allocation

Asset allocation enables advisers to generate portfolios that meet the needs of clients.
Those needs are for specific sums of money at specific future dates. Portfolios based on
asset allocation linked to risk profile are most likely to generate these sums with the least risk
of returns diverging from the average annual return.

C1 Risk profiles
To apply the
To apply the principles of asset allocation to client portfolios, the adviser must understand
principles of asset the level of risk the client is willing to take.
allocation to client
portfolios, the In the past, some of the risk measures have been quite broad. Investors have been placed
adviser must
understand the into ‘cautious’ or ‘low risk’, ‘balanced’ or ‘medium risk’, or ‘aggressive’ or ‘high risk’ categories
level of risk the after a range of different types of investment attitudes have been used to find out which is
client is willing to
take closest to the client’s view.
However, this is a somewhat simplistic approach and too broad − clients can mean different
things by ‘low risk’ or ‘medium risk’. Advisers are now able to use quite sophisticated tools to
more precisely measure their clients’ attitudes to risk.
There are a number of approaches that can be taken to establish the client’s attitude,
perception and capacity to take risk, including:
• printed questionnaires;
• computer-based assessments;
• psychometric profiling;
• numerical scales (1–10);
• open discussions; and
• graphical representations.
The most effective approach may be one that incorporates some or all of these elements.
Computer-based assessments and psychometric profiling tools are widely available from a
number of different sources, both as stand-alone software packages and online. These offer
a more scientific approach to establishing risk and often incorporate some or all of the
elements listed above, as well as direct statements and closed questions.
Chapter 7

Increasingly, many advisers use computer-based risk profiling tools, while others rely on
more or less formal interviews. Whatever approach is taken – and often it is a mix – the most
important part of the process is usually the discussion between the adviser and the client,
rather than a formal questionnaire.

Example 7.6
Having completed a risk tolerance questionnaire with your client, you have identified that
they are a cautious investor and have a requirement to generate income from their
portfolio. Considering this, you recommend they allocate 15% to cash, 40% to bonds, 15%
to property and 30% to equities.

The range of investor risk profile classifications and asset allocation models in use within the
financial services industry is quite significant. Some firms create their own bespoke risk
classifications and model portfolios, while others use software developed by third parties to
essentially do the same job. Irrespective of the method being used, the purpose is to
determine an appropriate mix of assets that will, based on historical analysis, deliver the
required return for a known amount of risk.
The MSCI WMA Private Investor Indices are a set of calculations which indicate the returns
that investors might expect from their portfolios. They can be used as a benchmark for
assessing and comparing the performance of discretionary fund managers and as a measure
to compare the performance of similar funds.
Example 7.7 is based on the MSCI WMA Private Investor Indices as at 1 December 2017.
These provide investors with an objective benchmark against which to measure their
investment portfolios.
Chapter 7 The investment advice process 7/17

The indices represent the performance for growth-orientated, income, balanced and
conservative funds. Each of the portfolios contains different proportions of UK shares,
international shares, bonds, cash and alternative investments to reflect the investment aims.

Example 7.7
Targeting specific client needs

Conservative Income Growth Balanced Underlying asset

index index index index index
UK equities 17.5% 30% 35% 30% MSCI United
Kingdom IMI
International 15% 22.5% 42.5% 32.5% MSCI All Country
equities World Index
(ACWI) Ex-UK
Bonds: UK gilts 10% 5% 2.5% 5.0% Markit iBoxx GBP
Gilts
Bonds: 25% 17.5% 5% 10.0% Markit iBoxx GBP
£ corporates Corporates
Bonds: 5% 2.5% 0% 2.5% Markit iBoxx UK
£ inflation-linked Gilt Inflation-
Linked
Cash 5% 5% 2.5% 5% Cash Equivalent
(GBP 1W LIBOR –
1%)
Real estate 5% 5% 5% 5% MSCI UK IMI
Liquid Real Estate
Alternatives 17.5% 12.5% 7.5% 10% MSCI World DMF
50% + 1W LIBOR
(GBP) 50%
Total 100% 100% 100% 100%

Global growth index Underlying asset index

Chapter 7
Cash 2.5% Cash Equivalent (GBP 1W LIBOR – 1%)
Alternatives 2.5% MSCI World DMF 50% + 1W LIBOR (GBP)
50%
Developed world 90% MSCI World
equities
Emerging world 5.0% MSCI Emerging Markets
equities
Total 100%

Table 7.6: Asset allocations between different risk profiles

Proportion of capital allocated to:
Risk profile Cash deposits Bonds Property Equities
Cautious income 15% 40% 15% 30%
Cautious growth 15% 35% 10% 40%
Balanced income 10% 30% 15% 45%
Balanced growth 10% 30% 10% 50%
Income and growth 5% 25% 15% 55%
Growth 5% 15% 15% 65%
Adventurous 5% 10% 10% 75%
 7/18 R02/July 2018 Investment principles and risk

Be aware
Use of absolute return funds or hedge funds
These allocations are based only on the traditional major asset classes. Today, many
advisers will use absolute return funds or hedge funds in their portfolios. These can be
considered as a separate asset class, with their potential limitation for loss and relatively
stable returns making them an attractive contributor to portfolio stability.

C2 Diversification
Advisers can achieve diversification not just through asset allocation but through choice of
fund managers using different styles and methods. Each style is likely to go through periods
of above- and below-average returns, though predicting these in advance is difficult. For
example, value-based strategies often produce superior performance in relatively stable
economic conditions, while momentum styles tend to work best during periods of rapid
growth. An adviser can tilt a portfolio towards styles that appear best suited to current
conditions, but include some funds of different types as a balance.
Likewise, large-cap and small-cap equities undergo periods of superior performance, as do
investment grade and high-yield bonds. In each asset class, there is a variety of asset sub-
classes and investment strategies, which can be accessed either through active funds or
through a growing range of passive (index tracker) funds, including exchange traded funds
(ETFs).

C3 Strategic and tactical asset allocation

If an investor’s aim
Asset allocation methodology is based on the benefits of diversification and is therefore
is capital growth essentially defensive, placing capital protection before capital growth. If an investor’s aim is
only, the right
technique is to
out-and-out capital growth, then, as Warren Buffett has remarked, the right technique is not
concentrate to diversify but to concentrate capital.
capital

Be aware
Tools of asset allocation
The prime tool of asset allocation methodology is the use of a risk profile to determine a
suitable strategic asset allocation for the client. Some advisers use only strategic asset
Chapter 7

allocation, with regular rebalancing.

Some advisers seek to counterbalance the defensive tendencies of asset allocation

methodology by applying tactical asset allocation. This can have two different meanings.
In the first meaning, the proportions of capital to be invested in any one asset class are set as
a band, say, 10–20%.
At any time, more capital can be allocated to one class to take it to the top of its range, while
another is reduced to the bottom of its range. These tactical moves away from the mid-
points of the permitted range for each asset class may be implemented on a short-term
basis. See Table 7.7 for a simplified example.

Table 7.7: Strategic and tactical allocation

Asset class Strategic range % Tactical allocation % Variation from mid-
point %
Cash 10–20 10 –5
Fixed-interest 10–40 20 –5
securities
Equities 45–75 70 +10
Total 100 100 _

The second meaning is for allocations within asset classes, where you could say that a
decision to hold half of a holding of US equities in the form of small-cap funds based on
considerations of growth and valuation was tactical, and independent of the strategic
decision as to the proportion of capital to be held in US equities.
Chapter 7 The investment advice process 7/19

Significant variations to asset allocations

In practice, significant variations to asset allocations tend only to be applied to growth
portfolios, since large-scale changes tend to cause interruptions in the flow of income
from a portfolio that would be unwelcome to an income-oriented investor.

C4 Rebalancing
If the asset allocation and portfolio are selected on the basis of a correct understanding of See chapter 8,
section L6 for
the client’s needs and risk tolerance, then the adviser should recommend a rebalancing of more on
the portfolio if variations in returns cause significant changes. rebalancing
portfolios

How it works
For example, if the initial allocation to equities was 50%, but a powerful bull market meant
that after two years the actual allocation at that time was 70%, then the correct approach
would be to sell enough equities to bring them back to 50% of the capital. The cash can be
allocated to top up the other asset classes, which would have declined to smaller
proportions of the capital.

Portfolio theory and ‘efficient frontier’ portfolios are based on frequent rebalancing, though
research suggests that rebalancing more frequently than every six months yields little
additional benefit. Rebalancing effectively assumes that reversion to the mean will prevail,
and the evidence for this is strong enough (though timescales of reversion are
unpredictable) to make this a profitable strategy.

C5 Accumulation and decumulation

Whether a client is accumulating capital or drawing upon it is a key issue in portfolio Whether a client is
construction. A body of research suggests that for many people in their 60s, an average accumulating
capital or drawing
decumulation rate of over 4% risks running capital down to almost nothing before death – upon it is a key
which is now not likely to occur until after the age of 90 for someone in good health. issue in portfolio
construction
There are many important factors that advisers need to take into account in projecting
portfolio cash flows in decumulation. These include:
• initial yield on investments;

Chapter 7
• overall rate of income generated;
• likely level of inflation and interest rates; and
• probable rate of growth in company dividends.
In many cases, clients will want to draw more income than can reasonably be assumed to be
sustainable, and whilst it is legitimate to adopt a higher-risk investment strategy in an
attempt to compensate, the client must be made aware of the risks involved, preferably not
just at the outset but on the occasion of every portfolio review.
In contrast, clients who are accumulating assets can take advantage of cost averaging
through regular purchases. Also, if returns do fall short of those expected, the client usually
has plenty of time for any shortfall to be made good. In contrast, older clients who suffer
capital losses have no such opportunity.
Thus, with decumulation portfolios, there are strong grounds for ‘taking money off the table’
after any period of high returns, and using the increased quantity of cash to fund immediate
income requirements.
 7/20 R02/July 2018 Investment principles and risk

Key points
The main ideas covered by this chapter can be summarised as follows:

Providing investment advice

• Giving investment advice can never be a purely mechanical or mathematical process.
• Providing professional investment advice to consistent standards requires the adviser to
adopt and adhere to a clearly defined process.
• The process of providing investment advice includes:
– establishing and defining the relationship between the client and the adviser;
– gathering client data, determining goals, expectations and any ethical issues;
– analysing and evaluating the client’s financial status;
– creating a risk profile;
– formulating the investment strategy for asset allocation;
– selecting investments, funds and products;
– selecting a choice of wrappers for tax efficiency;
– presenting and implementing the recommendations;
– monitoring the portfolio and making any necessary adjustments; and
– rebalancing the portfolio, switching out of underperforming funds.
• At the start of a client relationship, an adviser should provide the client with information
about the scope of the services that are being offered and the cost of any work that the
adviser will carry out.
• Clients are likely to have desires or ‘wants’ that may be unrealistic in terms of their
timescale or their cumulative cost. The adviser’s role is to identify the client’s main
needs, prioritise them and establish if these are achievable with the resources available.
• The client’s risk profile should be based on the client’s attitude to risk, tolerance of risk
and capacity for loss. The client should confirm their acceptance of their risk profile in
writing.
• The investment strategy is applied using an asset allocation based on the client’s risk
profile. Asset allocation generally has a much larger impact on portfolio performance
than the selection of successful or less successful fund managers.
• Client objectives for investments do not always include purely economic goals. Many
people have strong ethical reasons for choosing or excluding certain types of
investments.
Chapter 7

• The selection of vehicles within which to hold investments should follow and not
precede risk profiling and asset allocation decisions.
• In selecting a suitable platform, an adviser must consider the range of tax wrappers
available, the range of investments available and the cost to the client of the platform
itself.
• Best practice is to present an outline of the client’s circumstances and needs with a
summary of the recommendations, followed by more detailed sections on risk profile,
asset allocation and investment and wrapper selection.
• The adviser will need to set up systems for monitoring and reviewing each of the funds
contained in client portfolios.

Risk and return objectives

• A client’s risk tolerance, in terms of their ability and willingness to take risk, will help
determine realistic return objectives.
• Return objectives are often specified in terms of capital preservation, capital
appreciation, current income and total return.
• Constraints will affect how a portfolio is invested. These include time horizon, liquidity,
tax, legal and regulatory factors, and unique needs and preferences.
• An investor with a long time horizon is in a better position to take on risk, as they can
usually ride out volatility in markets and so will tend to invest more in asset classes such
as equities.
• The higher the need for liquidity, the less risk the client is likely to take and a portion of
the portfolio will need to be held in cash.
Chapter 7 The investment advice process 7/21

Applying asset allocation

• Asset allocation enables advisers to generate portfolios that meet the needs of clients.
• To apply the principles of asset allocation to client portfolios, the adviser must first
define a set of risk profiles corresponding to the preferences, risk tolerance and risk
capacity of clients.
• advisers can achieve diversification not just through asset allocation, but through choice
of fund managers using different styles and methods.
• Asset allocation methodology is based on the benefits of diversification and is
essentially defensive, placing capital protection before capital growth.
• The adviser should recommend a rebalancing of the portfolio if variations in returns
cause significant changes.
• Whether a client is accumulating capital or drawing upon it is a key issue in portfolio
construction.

Chapter 7
 7/22 R02/July 2018 Investment principles and risk

Question answers
7.1 The adviser should explain to the client why the goal(s) is/are unrealistic – and assist
them to frame more realistic ones.
7.2 By selecting funds with a risk–reward ratio lower or higher than the market average,
an adviser can reduce or increase the prospective returns and volatility of the
portfolio.
7.3 The time horizon of the investor and their liquidity requirements will affect their
ability to take on risk.
Chapter 7
Chapter 7 The investment advice process 7/23

Self-test questions
1. Why is three-monthly volatility a relatively unimportant measure of risk for
investment strategies with a 20-year time horizon?
2. Why is it a good idea for investors to keep some of their investment portfolio in a
liquid, easily accessible form?
3. If a client is saving for retirement in 15 years’ time, explain why they are more likely
to have a higher proportion of their portfolio in equities than in short-dated gilts.

You will find the answers at the back of the book

Chapter 7
Chapter 7
 The principles of
8
investment planning
Contents Syllabus learning
outcomes
Learning objectives
Introduction
Key terms
A The main approaches to asset allocation 8.1
B Portfolio optimisation 8.1
C Strategic and tactical asset allocation 8.1
D Alignment with client objectives 8.1
E Portfolio construction 8.2
F Fund selection 8.2
G Selection of tax wrappers 8.3
H Platforms 8.3
I Discretionary management services 8.3
J Provider selection issues 8.3
K Recommendations and suitability 8.3
L Portfolio reviews 9.2
Key points

Chapter 8
Question answer
Self-test questions

Learning objectives
After studying this chapter, you should be able to:
• explain the principles and advantages of asset allocation methods;
• discuss the weaknesses and limits of probabilistic methods of creating portfolios;
• allocate risk profiles to clients based on capacity for and tolerance of risk;
• use portfolio modelling tools to generate portfolios;
• distinguish between strategic and tactical asset allocation;
• apply filters to fund selection to generate shortlists for detailed evaluation;
• use ratio analysis as part of the fund selection process;
• discuss the advantages for client and adviser in the use of platforms;
• explain the importance of the portfolio review process; and
• discuss which factors should be considered in a portfolio review.
 8/2 R02/July 2018 Investment principles and risk

Introduction
In this chapter, we will start by considering the main asset allocation methods (examining
stochastic modelling and strategic and tactical asset allocation). The rest of the chapter
considers the practicalities of portfolio construction. This chapter builds on the theory
studied in earlier chapters.

Key terms
This chapter features explanations of the following:
Bottom-up method Discretionary Fund management Fund selection
management styles
services
Platform accounts Portfolio Portfolio Stochastic modelling
construction optimisation
Efficient frontier Top-down method Use of derivatives Use of structured
and hedging products

A The main approaches to asset allocation

There are two principal approaches to asset allocation: the theoretical and the pragmatic
pragmatic. In
practice, most advisers use elements of both.
Asset allocation is, in essence, a defensive strategy, the main focus of which is on the
preservation of capital and the reduction of risk.

Consider this
this…
…
As every entrepreneur knows, concentration of capital is the strategy for building wealth,
while diversification is primarily a wealth-preservation strategy.

A1 Theoretical approach to asset allocation – modern

portfolio theory (MPT)
The theoretical
The theoretical approach to asset allocation is based on the work of Harry Markowitz. It uses
approach to asset mathematical analysis and techniques with the aim of obtaining the desired risk–return
allocation is based
on the work of
trade-off, representing the maximum return consistent with a given level of volatility, or the
Harry Markowitz lowest volatility consistent with a desired rate of return. These ‘optimal’ portfolios can be
created from sets of asset classes using historic data for returns and volatility.
For more on MPT,
Chapter 8

In particular, the returns and volatility of a portfolio will depend not just on volatility and
see chapter 3,
section A return rates of the various investments it contains, but on the correlation between assets.
The addition of an asset to a portfolio with higher-than-average returns and volatility can
result in a reduction in the volatility of that portfolio. For instance, this can happen if the new
asset’s returns have a low or negative correlation with most of the assets in the portfolio.

A2 Pragmatic approach to asset allocation

The division of
The division of capital between different asset classes was practiced long before the
capital between creation of MPT. Practitioners recognised the reduction in risk that resulted from owning
different asset
classes was
different asset classes. Instead of using probabilistic analysis to derive optimal portfolios,
practiced long pragmatists simply use long-run average rates of return from the relevant asset classes,
before the creation
of MPT
together with historic data on the maximum range of returns over different time periods.
Rather than weighting capital allocations purely on the basis of this data, pragmatists use
forward-looking judgments of likely returns and volatility to determine portfolio
weightings. Often, these judgments will reflect the expectation that both returns and
weightings
volatility will revert to their historic means over some selected timeframe.
Chapter 8 The principles of investment planning 8/3

A3 Combining approaches
Investment decisions are inevitably about the future, not the past, and theorists often adjust
the inputs to their models so that expectations rather than historic data are used.
In particular, they are aware that using relatively short runs of recent data (three years is Adjustment of
typical in the case of volatility) can result in allocating too much or too little capital to an both volatility and
returns using
asset class. Adjustment of both volatility and returns using mean-reversion is also common. mean-reversion is
also common

Consider this
this…
…
Pragmatists today tend to pay closer attention to recent volatility in assessing the overall
level of risk in a portfolio than they did before the creation of MPT.

A4 Strengths and weaknesses of the approaches

The theoretical apparatus of MPT is not particularly robust. Many of its elements have been The theoretical
questioned in recent years, and finance theory, on which MPT is based, has itself been under apparatus of MPT
is not particularly
heavy criticism in the wake of the financial crisis. The tendency of asset returns and volatility robust
to correlate closely during crises was already known but reached extreme proportions in
2008/09, when virtually all asset classes (with the exception of government bonds and
cash) delivered negative returns. The result was that optimised portfolios did not deliver the
expected benefits of diversification.
A common response to this is that probabilistic techniques of portfolio creation work well
during ‘normal’ conditions but not in crises, and that, provided clients understand this, the
methodology is acceptable. However, without any method of predicting how frequent or
how severe crises will be, the usefulness of this approach is limited because the biggest
potential causes of loss derive from uncertainty.

Be aware
A purely pragmatic approach?
A purely pragmatic approach, however, is subject to the risk of bias for or against asset
classes based on subjective estimations of prospective returns. This can result in portfolio
risk turning out much higher than expected.

B Portfolio optimisation
Asset allocation based on MPT derives portfolios from a process of optimisation. It starts Asset allocation
with a matrix of potential assets that may be included in the portfolio (or more often, with based on MPT
derives portfolios
asset classes). This shows their historic annualised returns, volatility (standard deviation)

Chapter 8
from a process of
and correlation. A large number of sample portfolios containing these assets in different optimisation
proportions can be generated, and their historic returns and volatility plotted.

Be aware
Efficient frontier
Those with the highest returns for a given level of volatility (or least volatility for a given
return) will form a series: the ‘efficient frontier’. Each portfolio represents the best choice
for an investor whose risk tolerance is represented by the portfolio’s volatility rating.

The efficient frontier represents the set of portfolios that have the maximum rate of returns The efficient
frontier was
for every given level of risk with each portfolio lying on the efficient frontier offering the discussed in
highest expected return relative to all other portfolios of comparable risk. A rational investor chapter 3

will only ever hold a portfolio that lies somewhere on the efficient frontier. However, it is not
possible to say which portfolio an individual investor would prefer, as this is determined by
the maximum level of risk that the investor is prepared to take.

Be aware
Efficient or optimised portfolios
Efficient or optimised portfolios are those that are expected to deliver the highest return
for a given level of risk, or the least risk for a given level of return.
 8/4 R02/July 2018 Investment principles and risk

B1 Correlation
The extent to
The extent to which an asset contributes to the overall risk–return characteristics of a
which an asset portfolio is determined by its correlation with other assets in the portfolio. Table 8.1 shows a
contributes to the
overall risk–return
correlation matrix for five assets. From this, we can read higher and lower degrees of
characteristics of a correlation; the assets with lowest correlation (such as A and D) will contribute most to a
portfolio is
determined by its
reduction in portfolio volatility.
correlation with
other assets in the
portfolio Table 8.1: A typical asset correlation matrix
Asset A Asset B Asset C Asset D Asset E
Asset A 1.00 0.69 0.84 0.25 0.37
Asset B 0.69 1.00 0.77 0.26 0.41
Asset C 0.84 0.77 1.00 0.41 0.38
Asset D 0.25 0.26 0.41 1.00 0.76
Asset E 0.37 0.41 0.38 0.76 1.00

B2 Assumptions in optimisation
Optimisation models depend on assumptions. The nature of these and their possible
weaknesses need to be understood.

Table 8.2: Optimisation assumptions and weaknesses

Risk Models assume returns fall into a normal distribution measured by
standard deviation, yet returns do not always follow a normal
distribution.
Historic data Data for risk, returns or correlation may be a poor guide to the future.
Forecasts Forecasts for return, risk or correlation may be inaccurate.
Costs Optimisation models may assume rebalancing at a frequency that
imposes unrealistically high transaction costs, which often are not taken
into account.
Implementation A portfolio manager may use specific assets which differ from those
used in the modelling process.

B3 Stochastic portfolio modelling

Pragmatic users of asset allocation tend to use the historic range of returns to estimate the
Chapter 8

maximum and minimum returns that could be earned in future.

In contrast, stochastic modelling applies a mathematical technique to generate a
probabilistic assessment of returns and volatility. It does this by specifying a number of
factors, each of which may vary within a determined range.

Be aware
Stochastic modelling assumptions
For example, interest rates may vary between 1% and 5%, or inflation may vary between
1% and 4%, over a specified time period.
The model takes an initial set of assets, assumes that their behaviour is affected in a
specific way by a change in one variable, and generates thousands of scenarios using
randomised combinations of variables.
The outcomes are plotted and the most common outcome is taken as the central or most
likely path of the portfolio in respect of returns and volatility.
Usually, results are plotted with a narrow central band representing the most likely
outcome and progressively wider bands around it representing less likely ones.

See Figure 8.1 for an example – in which there is a target income of £60,000.
Chapter 8 The principles of investment planning 8/5

Figure 8.1: Stochastic model output: portfolio forecast – 20 years

Source: e-Value

Be aware
Use of stochastic modelling
Stochastic techniques are even more dependent on assumptions than optimisation
models. Such models need to be used with caution. Often, a very small change in one
assumption will result in a large change in the output. A good understanding of the effects
of variations in assumptions is essential.

Question 8.1

Chapter 8
What is stochastic modelling?

C Strategic and tactical asset allocation

Strategic asset allocation is for the long-term and will only be adjusted in extreme conditions
or if the client’s requirements or circumstances change.
Most practitioners of asset allocation methods focus on strategic asset allocation for two
main reasons:
• If the adviser is confident in having specified the client’s requirements and risk tolerance
then, in theory, there is an ideal asset allocation to which their portfolio should conform.
• MPT says it is not possible to ‘time the market’, which means that switches between asset
classes are as likely to incur loss as to generate profit.
However, some advisers employ tactical asset allocation by having asset allocation models
that give a range for the percentage of capital in each asset class. If the range given for
equities is 60% to 70%, then any deviation from the central 65% can be regarded as a tactical
move, to be adjusted as the adviser’s assessment of the outlook changes. This places more
onus on the adviser to monitor portfolios and recommend variations in tactical positions.
 8/6 R02/July 2018 Investment principles and risk

It is also possible to use models where a proportion of capital (say, 80%) is allocated to asset
classes in the conventional way, and the balance (20%) is used ‘tactically’ to over-weight
certain assets. If this is done opportunistically and without re-evaluation of the portfolio, the
result can be that the volatility becomes much higher than originally intended.
Tactical asset allocation does to some extent override mathematical models of portfolio
construction with judgment calls on asset classes. This may be obscured by the use of other
mathematical techniques to select the asset classes which are over- or under-weighted.

Be aware
Use of tactical allocation methods
Tactical allocation methods are more often applied by discretionary fund managers than
by those operating on an advisory basis.

C1 Implementing asset allocation

Most academics
Asset allocation methods derive from MPT, which also implies that the market is efficient, at
have concluded least in the sense that the current market price represents investors’ collective best guess
that selecting
actively managed
about the future and that it is difficult to beat this ‘wisdom of crowds’ by active selection.
funds is not This is the theoretical argument for using index tracker funds. The pragmatic argument is the
worthwhile for the
individual investor
scores of academic papers studying actively-managed, collective-investment fund
performance over the past three decades, none of which have found more than very minor
tendencies for superior performance to be maintained from one period to the next. Most
academics have concluded that selecting actively managed funds is not worthwhile for the
individual investor, who is more likely to lose than gain from the exercise:
• One school of practitioners applies this by implementing asset allocation exclusively
through the use of ‘passive
passive’ index-tracking funds. By definition, the volatility of the
portfolio cannot exceed that of the indices used, whereas as soon as active funds are
used, both risk and return may diverge from the market averages.
• Other practitioners believe they can identify superior active funds and implement asset
allocation exclusively through such funds.
• A third group combine active and passive funds within portfolios on a pragmatic basis.

Consider this
this…
…
A practitioner may observe, for example, that there are very few actively managed North
American equity funds that have beaten their benchmark (usually the S&P 500 Index)
with any consistency, and therefore use passive funds to invest in the US, while using
active funds for the Japanese market, where many funds have beaten their benchmark
index with reasonable consistency.
Chapter 8

• Some practitioners use passive funds as ‘core’ portfolio holdings, and satellite active
funds to complement the core and give potential for higher returns. See Figure 8.2.
However, the distinction between active and passive is not necessarily as clear-cut as this
suggests. Every index can itself be considered to be an active portfolio (constituents are
chosen by rules and altered in accordance with rules). The capitalisation-weighted indices
(such as the S&P 500 and the FTSE 100), which have been historically used as benchmarks
by institutional investors, are only one means of representing the listed-equity asset class.
Equal-weighted and fundamental-weighted indices are equally valid. The choice of index to
represent an asset class is itself a significant investment decision.
Chapter 8 The principles of investment planning 8/7

Figure 8.2: Core

Core–
–satellite management
Smaller cap
Property funds
funds

Commodity Passive funds –

funds • Global bond tracker
• Global equity tracker

Country
funds Specialist
funds

Be aware
Passive funds
Cost and efficiency are the reasons some advisers use passive funds as part of a portfolio.

D Alignment with client objectives

To create an appropriate portfolio, the adviser needs to understand the client’s risk See chapter 7 for
more on the
tolerance, their capacity for risk and their target for returns. Together, these will determine investment
the investments that are suitable. Usually, risk tolerance, risk capacity and a return target are advice process

combined into a ‘risk profile’ that specifies the target rate of return over an appropriate
period.

Consider this
this…
…
A risk profile could, for example, include an annualised return target of 9% over a five-year
period, with a maximum probable loss of 15%.

Risk tolerance can be regarded as a composite of risk perception (often superficial and
influenced by recent events) and attitude to risk, formed through family background,
education and lifetime experience. It can be measured though calibrated questionnaires,
though academics continue to debate the stability and reliability of the scores. At best, such
assessments deliver a snapshot at one point in time and, crucially, it is known that risk
tolerance usually changes over time. Therefore, regular re-assessment of tolerance is
desirable, especially if there have been major changes in the client’s circumstances.
Risk capacity is a more objective measure of the client’s ability to withstand losses or

Chapter 8
shortfalls in returns.

Table 8.3: Assessment of risk capacity

Assessment of risk capacity is regarded as an essential step in determining suitability by
regulators. It requires consideration of circumstances and consequences, for example:
• Would the client suffer an unacceptable reduction in their standard of living if pension
income was £5,000 a year lower than expected because of a shortfall in pension fund
growth?
• Would encashment of investments at a capital loss threaten the client’s standard of
living now or in the future?
• What percentage of the client’s overall wealth (or what multiple of their annual income)
is being placed at risk, and how great is that risk?
Vulnerability to loss reduces risk capacity, while a longer timescale and large expectations
(say, of inheritance) may increase it.

Investigation of risk capacity will tend to lead the adviser to consideration of investment
drawdown – the maximum historic loss incurred on the proposed asset mix over the relevant
timeframe.
Allocation of a risk profile should be based on consideration of risk capacity as well as of risk
tolerance.
 8/8 R02/July 2018 Investment principles and risk

If formal risk profiles are not used, the adviser still requires the timeframe, the annualised
target return and the maximum permitted loss as inputs to generate a suitable asset
allocation. The adviser can then create a portfolio in the following ways, in ascending order
of complexity:
• Historic
Historic: using historic data for return, risk and correlation for the relevant asset classes,
the adviser can create a portfolio that would, in the past, have generated the required
returns with the given risk.
• Adjusted historic
historic: taking into account the historic ranges of returns and volatility over
relevant time periods, the adviser can adjust return and volatility expectations, which will
alter the allocation of capital to the various asset classes.
• Stochastic
Stochastic: using a portfolio modelling tool, the adviser can simply input the required
returns, expected volatility and time period and rely on the tool to generate an optimal
portfolio.
Whichever method is used, the adviser will need to explain why the chosen portfolio
matches the client’s requirements. Care should be taken to specify the circumstances in
which the portfolio might fail to meet its objectives.

E Portfolio construction
Within an asset allocation framework, portfolios are created applying the same techniques
to the selection of individual investments as are applied to asset classes.

The essential data

The essential data for any potential investment is return, volatility and correlation. In theory,
for any potential a share portfolio could be constructed simply by using this data for a large number of
investment is
return, volatility
securities. However, this would require a large amount of data processing and might expose
and correlation the portfolio to unanticipated risks.

E1 Top-down method of portfolio construction

The aim of portfolio construction has been to achieve diversification on the basis that this
should reduce risk. In practice, it has usually followed a top-down process, broadly in this
order:
1. Determine asset allocation, e.g. invest 50% of the fund in equities.
2. Allocate the geographical distribution, e.g. UK 30%, North America 20% etc.
3. Choose the sector weightings, e.g. mining 5%, pharmaceuticals 2% etc.
4. Stock or fund selection, possibly taking into account income and socially responsible
investing (SRI) considerations as well as reflecting investment performance issues.
However, economic globalisation and the closer correlation of equities on a global basis
Chapter 8

during crises mean such benefits cannot be assumed to apply at all times. Some theorists
argue that steadily increasing globalisation will result in greater correlation of equities in
different areas of the world. Many investment managers now assess large companies, such
as the large oil producers, car manufacturers, and pharmaceuticals, in a global context, and
theme funds, such as natural resources, agriculture, technology and equity income, are
increasingly run on a global basis.

Often, portfolios
Often, portfolios constructed on the basis of geography will be ‘benchmark aware’. If a
constructed on the portfolio is compared with a specific index, the manager will take account of stock
basis of geography
will be ‘benchmark
weightings within the index. Any divergence from these weightings represents a risk to the
aware’ manager, in that it can create underperformance as well as outperformance. The extent to
which a manager will diverge from index benchmarks is therefore a significant factor in
assessing a fund. Portfolios that diverge significantly from index benchmarks will typically
display greater short-term volatility. The question for advisers is whether this is a price worth
paying for longer-term performance that exceeds the benchmark.
Chapter 8 The principles of investment planning 8/9

Be aware
Active funds
Active funds levy fees much higher than those of passive index-trackers and need to
demonstrate that they are seeking to add value and are not simply ‘closet index trackers’.
The top-down method is usually applied in a consistent way within a group of funds by
managers following a set of house rules.

E2 Bottom-up method of portfolio construction

Managers applying the bottom-up method of portfolio construction pay no attention to Managers applying
index benchmarks. They select stocks purely on the basis of their own criteria (value, the bottom-up
method of
momentum, Growth At A Reasonable Price (GAARP), etc.) and may end up with significant portfolio
allocations to countries or sectors. construction pay
no attention to
In practice, management group house rules restrict the extent to which capital may be index benchmarks

concentrated in this way, but such portfolios can be much more volatile than those
constructed using the top-down method.
The bottom-up method is usually dependent on the style or approach of the individual fund
manager or team of managers (see Table 8.4).

E3 Combined approaches
Many management groups claim to apply elements of both top-down and bottom-up Many management
approaches. The key question in fund assessment is which element is dominant. This may groups claim to
apply elements of
vary within a group of funds, especially with ‘star’ managers who have developed their own both top-down
personal style over a period of years. and bottom-up
approaches. The
It is also important to identify any change in the approach used by a fund manager or key question in
fund assessment is
management group, since it is likely to affect the volatility of their funds. which element is
dominant

E4 Fund management styles

A fund management style is an approach to stock selection and management based on a
limited set of principles and methods. The most widely recognised pure styles are shown
below:

Table 8.4: Fund management styles

Value • This is the oldest style, dating back to Warren Buffett’s 1930s
mentor Ben Graham.

Chapter 8
• Its core statement comes from Graham: ‘In the short run, the
stock market is a voting machine; in the long run, it is a
weighing machine.’ Votes are investors’ purchases and sales;
what the machine weighs is profits, dividends and asset
values.
• The value investor believes that, using deep and rigorous
analysis, they can identify businesses whose value is greater
than the price placed on them by the market.
• By buying and holding such shares, often holding for long
periods, they can earn a higher return than the market
average. Managers of ‘equity income’ or ‘income and growth’
funds often adopt this style, since ‘out of fashion’ stocks often
have high dividend yields.
GAARP • GAARP is based on finding companies with long-term
sustainable advantage in terms of their business franchise,
quality of management, technology or other specific factors.
• Proponents argue that it is worth paying a premium price for
a business with premium quality characteristics. Many of its
proponents use screens to identify potential stocks.
• The style is used mainly by active growth managers.
 8/10 R02/July 2018 Investment principles and risk

Table 8.4: Fund management styles

Momentum • Studies have shown that in equity markets, there is a small
tendency for both good and bad performance to persist,
although these studies do not conclusively show that it can
generate a sufficiently large extra return to compensate for
trading costs.
• Momentum is the strategy most widely adopted by middle-
of-the-road fund managers.
• Successful momentum investors have to use this type of
analysis to be ahead of the latest swing in opinions. ‘Sector
rotation’, where sectors are expected to perform well at
particular points in the economic cycle, is one example of
momentum investing.
Contrarianism • The thesis of contrarian investors is that the average opinion
is usually wrong, and that high returns can be achieved by
going against the trend.
• Correctly judging the point where a trend has reached an
extreme of optimism or pessimism is difficult and risky.
• This style is found most often in hedge fund managers.

Example 8.1
Contrarians would have sold out of tech stocks well before their peak in 2000. However,
they might also have bought bank stocks after their first big declines in 2008 and suffered
further losses as their share prices kept falling.

In practice, successful managers usually develop their own personal style over a period of
years, usually based on one or other of the major styles. Extremely successful managers
have written books explaining their style.

Some fund
Some fund management groups claim to adopt a multi-style approach, where they alter
management their style in tune with prevailing market conditions. In this case, careful analysis of
groups claim to
adopt a multi-style
performance will be required to identify whether these changes actually occur and, if so,
approach whether they add value.

E5 Use of derivatives and hedging

The latest trends in portfolio construction use derivatives to separate the market-related
return (beta) from the specific return (alpha). Alternatively, a fund may aim to ‘lock in’
positive returns by purchasing index put options, thus limiting the potential subsequent loss.
Such techniques, formerly the province of hedge fund managers, are now commonly
adopted within UK-authorised funds governed by undertakings for the collective investment
Chapter 8

of transferable securities (UCITS) rules.

Example 8.2
A portfolio manager may buy Japanese shares and, at the same time, sell short a Japanese
stock market index future. Then, they will make a profit so long as the chosen securities
perform better than the index. This return, independent of the direction of the market, is
‘alpha’.

Managers often apply such strategies as ‘overlays’, where a core portfolio is held and
derivatives are used to alter currency and market exposures.
Where such strategies are employed, they should be clearly disclosed in fund prospectuses.
Advisers need to understand the range and limits of the strategies, and their likely effects on
returns and volatility.

E6 Use of structured products

An alternative to
An alternative to the use of funds is structured products, which typically limit the capital risk
the use of funds is of equity investment in return for a lock-in period of up to six years. Managers use
structured
products
derivatives to secure the returns, so all structured products involve counterparty risk, the
returns being dependent on the institution from which the derivatives are bought. Specialist
services analyse structured products and rate them using probabilistic methods:
Chapter 8 The principles of investment planning 8/11

• Some structured products give ‘hard protection’, in which case a given return (say, a Structured
products are
return of 120% of the FTSE 100 Index or full return of capital, if the index is lower at examined in
redemption) is guaranteed. chapter 6.2.
section R
• Some structured products only give ‘soft protection’, in which case the investor’s capital is
at risk if a threshold is breached. For example, an income of 7% annually may be payable
with full return of capital unless the index falls by 50% or more, in which case capital loss is
on a pro rata basis.
Structured products are difficult to accommodate within a conventional asset allocation Structured
framework. Many advisers will regard capital placed in structured products as in the ‘low risk’ products are
difficult to
category and agree a higher risk profile for the client’s remaining capital than would apply if accommodate
they had not invested in the structured product. In this case, care must be taken to review within a
conventional asset
the situation when a structured product is redeemed, since the residual portfolio may then allocation
represent a higher risk profile than is appropriate. framework

Structured products may often seem to provide exposure to relatively risky asset classes,
but with valuable limitations to the downside risks. On that basis, they can seem attractive.
They can, however, have some limitations, and advisers should be aware of these when
considering their role in a client’s portfolio:
• Many structured products are not very liquid in terms of early access, and early
encashment can lead to significantly reduced returns. Some exchange traded funds
(ETFs) have similar characteristics to certain structured products and may provide
greater liquidity.
• The timescale over which a structured product provides its planned returns may not in
practice correspond to an appropriate timescale for the investor.
• When downside protection is especially desirable, it may turn out to be rather expensive.
• The proposition may be too confusing, with too many balancing features and conditions.
Assessment of counterparty risk is problematic, since, in the past, highly-rated financial
institutions acting as structured product counterparties have failed (e.g. Lehman Brothers).
Unlike most market risks, counterparty risk is binary (failure can mean an instant 100% loss)
and probabilistic assessment may not deal adequately with risk capacity issues for clients.
Many providers now offer full collateralisation to mitigate the risk, though at the cost of
lower potential returns.

F Fund selection
There are thousands of actively managed funds available in the UK and offshore. There are
thousands of
Fund selection requires methods of filtering to generate much smaller lists of potential actively managed
investments. The main criteria used in fund selection are: funds available in

Chapter 8
the UK and
• fund objective; offshore

• costs and charges;

• strength and reputation of management group;
• skill and reputation of individual fund manager, including past performance; and
• type and structure of fund.
We will consider these in turn.

F1 Fund objective
The Investment Association (IA) divides funds into sectors containing up to several hundred For more on the
IA and fund
funds. These funds do not necessarily share a common investment objective, though they sectors, see
may invest in the same area. For example, of funds investing in Europe, some aim for capital chapter 6.1,
section B1
growth from unconstrained concentrated stock selection, others for growth from diversified
mid-cap and large-cap stocks, and others to generate a rising dividend income from a large-
cap portfolio. Managers’ pursuit of each of these objectives should generate different
risk–return characteristics.
 8/12 R02/July 2018 Investment principles and risk

F2 Costs and charges

The main charges applied by UK-authorised funds are:
• AMC
AMC. The annual management charge (AMC) applied as a percentage of assets under
management (AUM). For passive funds, the usual range is 0.2% to 0.75% and for actively
managed funds, from 0.75% to 1.75%.
• OCF
OCF. The ongoing charges figure (OCFs) adds the AMC and all the other costs and
charges of the fund but does not take into account initial charges, exit costs or certain
fund expenses, such as dealing costs. The OCF is expressed as a percentage of the AUM
and is typically between 1% and 2%. Many costs are fixed monetary amounts, so OCFs are
often lower for larger funds. The OCF is the most commonly used method of comparing
ongoing charges incurred by investors.
• Performance fees
fees. An increasing minority of funds levy performance fees. Usually, they
apply to the incremental performance above a set threshold, which may be the
benchmark index (e.g. the FTSE 100 Index) or, in the case of absolute return funds, a
margin above London Interbank Offered Rate (LIBOR), e.g. ‘LIBOR plus 5%’.
• Total cost of ownership (TCO)
(TCO). The true cost of an investment to the client including the
cost of the service, the product, any third party charge and any transaction that may
affect the total return.
Each of these charges may be used as a filter in fund selection.
Other costs that investors incur in funds are:
• Initial charge
charge. Formerly, initial charges ranged up to 5%, but most managers today offer
funds at no initial charge through platforms.
• Bid
Bid– spread. Dual-priced funds (such as most unit trusts) quote two prices, and the
–offer spread
spread between the two represents a cost to the investor. Even when no initial charge is
levied, the creation price of units or shares is usually above the redemption price.
• Stamp duty
duty. UK-authorised funds incur stamp duty on UK share purchases at a rate of
0.5%. Fund managers do not have to pay stamp duty reserve tax (SDRT) when investors
surrender their units in UK unit trust schemes or shares in a UK open-ended investment
company (OEIC).
• Turnover
Turnover. Each purchase and sale of securities incurs transaction costs. The higher the
portfolio turnover rate (PTR), the greater the costs incurred by investors. A few funds
have low PTRs of 20% or less, but the majority fall in the 50% to 100% range, with highly
active funds incurring higher rates. The actual costs are highest for equity funds, since
transaction costs in bonds and derivatives are generally lower, although bid–offer spreads
in corporate bonds may be higher than for blue chip equities.
MiFID II requires firms to provide investors with a full breakdown of all the costs and charges
impacting their investments, separating the costs into four main components:
Chapter 8

1. ongoing charges for the fund;

2. one-off fees (such as entry and exit fees);
3. incidental fees; and
4. transaction fees.

F3 Strength and reputation of management group

The regulation of UK-authorised funds means that investors incur no risk of monetary loss if
a management group fails, since independent custodians hold the assets.

A weakly
However, the financial strength of a management group does have implications for
capitalised or over- investors. A weakly capitalised or over-indebted management group may have difficulty
indebted
management
retaining investment managers. Star fund managers in small management firms often
group may have receive a significant part of their remuneration in the form of equity in the business.
difficulty retaining
investment A large group with upwards of £50 billion in assets will probably have sufficient cash flow
managers
from its AMC to survive a severe market downturn, whereas fixed costs are likely to
represent a higher proportion of a smaller group’s revenues.
Chapter 8 The principles of investment planning 8/13

Consider this
this…
…
Reputation is based not just on performance but also on consistency in strategy. Groups
that opportunistically launch fashionable funds to attract AUM are likely to suffer
reputational damage.

F4 Skill and reputation of individual fund manager

In the case of actively managed funds, the skills of one or more key managers are a key In the case of
consideration. Often, managers will have specialised in a particular area for many years, and actively managed
funds, the skills of
most analysts believe that such skills are not easily transferable, especially in areas such as one or more key
natural resources, technology, absolute return strategies and high-yield credit markets. managers are a key
consideration
From an investor’s perspective, the longer a successful manager remains in place, the better.
Advisers may take the view that the manager is all-important and that if they leave, the
adviser will recommend a sale of the fund, or may seek funds where the management group
has other managers who can take over the management using ‘team’ processes.
The aim is to identify managers who can provide the best performance consistent with the The aim is to
defined investment objective and tolerance to risk. However, it is important to realise the identify managers
who can provide
following points: the best
performance
• past performance is not necessarily a reliable guide to the future, but the use of past consistent with the
performance statistics can be an indication of possible future performance, provided it is defined investment
objective and
clear how that past performance was achieved; tolerance to risk
• past performance should be considered over a variety of periods with the aim of
identifying consistency;
• volatility of performance will provide an indication of the level of risk employed; and
• investors should identify whether the individuals and methods responsible for past good
performance are still present in the particular investment management group.
A number of criteria need to be considered in addition to past performance when choosing
an investment manager.
The following is suggested as a list of additional criteria that most practitioners would use:
• Relevant experience – the investment manager’s experience should match the form of
investment and the particular investment objectives. For example:
– a large segregated pension fund looking for discretionary management would review
investment houses operating in that particular area; and
– a portfolio manager creating a unit trust or OEIC investing in a new emerging market,
where no such funds have previously existed, would look for managers with general
emerging market experience and preferably some in the specific market or a similar

Chapter 8
market.
• Structure and style of investment – there can be wide variations in management style and
therefore performance:
– most investment managers now have a strong central or house policy, with strong
internal controls on individual managers. This controlled approach has been
encouraged by a court case in which a pension fund trustee sued an investment
manager who had produced widely differing results for their clients from portfolios
with identical remits; and
– a few houses promote a relatively individualistic style where performance can depend
much more on the individual manager assigned to the portfolio than any house style or
view.

Be aware
Assessing house style
One way to assess the house style is to look for a spread of investment returns achieved
from similar portfolios or collective investment vehicles. A wide spread of results may
suggest that the investment manager does not impose a strong house view and that
individual managers are given more than usual discretion.
 8/14 R02/July 2018 Investment principles and risk

• Size, access to relevant resources – the choice of an investment manager may depend to
some extent on the size of their funds under management. There is a view that an
investment manager needs a certain critical mass to ensure access to relevant resources
and research:
– many of the necessary resources can be outsourced and research can be supplied by
external providers; and
– smaller investment managers may be vulnerable if markets turn down significantly and
their income falls sharply, because it is usually related to funds under management.
Having said that, smaller houses may be able to provide specialist services or products
that are not available from some larger companies.
• Quality of staff and their stability – staff stability generally has been a vital part of past
good performance for many investment managers. A stable team is likely to have a better
chance of outperforming than an unsettled one.
• Administration – increasingly, clients expect a first-class administration service. The
quality and clarity of investment reports, portfolio valuation and easy access to
information are important aspects of the overall service offered by investment managers.
• Costs – cost differences between managers are often considered to be minor issues in
relation to differences of investment performance, as long as the charges are perceived as
reasonable. However, in a low return environment, costs become a much greater issue.
For some types of investment, cost is more significant in the decision-making process. For
instance, if an investment manager provides an index-tracking service, the differences in
initial (if any) and AMC may be significant.
• Past performance – there is little evidence that the average active manager outperforms
benchmarks. This has contributed to the growing popularity of index funds to gain
exposure to markets.
A drawback of index trackers is that many investors do not realise or wish to accept the
full market risk (you will recall that the beta of the market is 1) in return for the market
return.
There is also mixed evidence on the consistency of performance. If performance is not
consistent, it means that a fund that performs well in one period is no more likely to
perform well in the next period than any other fund.
Much marketing of investment funds chooses to ignore the fact that ‘past performance is
not a guide to the future’, which is an important health warning. The examination and
interpretation of performance statistics is fraught with difficulties and traps for the
unwary. For example:
– If performance is good over the previous twelve months, this can hide previous poor
performance in cumulative statistics. Discrete year-by-year performance is a more
valuable guide, and is an actual requirement of the Financial Conduct Authority (FCA)
when performance is mentioned in an advertisement.
Chapter 8

– Classification issues
issues. Funds may not always be classified in the relevant sector, so a
fund can boast top quartile performance without necessarily being compared with its
true peers.
– Funds and sectors change
change, with the result that long-term performance may reflect a
different set of fund investment aims to those current.
– The measurement of returns alone ignores risk
risk. A manager could achieve sector-
topping performance by adopting a much higher-risk profile than their peers. It is
important to consider risk-adjusted performance measures.
– Some specialist funds end up in ‘rag bag
bag’’ sectors, because there are not enough
funds. Heading such a sector can be more to do with what the markets
comparable funds
favour than the investment expertise (e.g. Korean stocks).
Chapter 8 The principles of investment planning 8/15

F5 Type and structure of fund

Certain types of fund may be more or less suitable for portfolios, depending on the risk
profile. Among the relevant factors are:
• Open-ended or closed-ended
closed-ended. Open-ended funds that always trade at net asset value
(NAV) are less volatile than closed-ended funds, where the premium or discount to NAV
can change. Closed-ended funds are generally more appropriate for illiquid asset classes,
since it may not be possible either to price illiquid assets with any degree of precision or
to sell them in the volumes that might be necessary to meet redemptions in an open-
ended fund.
• Gearing or leverage
leverage. Many closed-ended funds have borrowings, which potentially add to
returns but also increase volatility.
• Multi-manager and fund of funds
funds. These funds assemble portfolios of funds, reducing the
adviser’s work in fund selection. Fund of fund portfolios may be narrow (e.g. UK equity
income, European equity), global or risk-rated (e.g. cautious, growth).

Consider this
this…
…
Advisers recommending fund of fund or multi-manager funds need to research similar
funds to justify their recommendations. If a fund of fund is given a risk rating, the adviser
needs to check how this relates to their own risk profiles allocated to clients.

F6 Passively managed funds

An alternative to the use of actively managed funds to implement an asset allocation
strategy is to use passive funds that simply replicate the performance of an index
representing the chosen asset class. For almost all major asset classes and sub-classes, there
are now index tracker funds, often in the form of ETFs as well as OEICs.
While some passive funds have low charges, cost is not the principal issue. Rather, the key
advantage of such funds is that they eliminate the possibility of returns diverging from those
of the chosen index. Their prime advantage is to limit the volatility of a portfolio as
compared with a portfolio of actively managed funds.
The two key aspects of passive fund selection are index selection and structure:
• Index selection
selection. For most asset classes, several indices are available. In some cases, the
differences are slight but, in others, they are large and have had major effects on returns.
Especially for specialised asset classes, such as high-yield bonds or private equity, the
choice of index is critical and the adviser needs to understand the index methodology.
• Structure
Structure. Passive funds may take the form of investment trusts, OEICs or ETFs. ETFs may
be ‘physical’, in which case they hold stocks to replicate an index, or ‘synthetic’, in which

Chapter 8
case they use derivatives to match an index. Advisers need to understand the advantages
and drawbacks of these structures.

See chapter 7 for

F7 Socially responsible investing (SRI) and ethical fund more on the
selection investment
advice process

For some clients it is important that the funds are selected for their ethical or SRI criteria.
 8/16 R02/July 2018 Investment principles and risk

G Selection of tax wrappers

The decision about
The decision about which tax wrappers to use should be made in the light of the asset
which tax allocation and fund selection. Choosing the right tax wrapper should be based on two main
wrappers to use
should be made in
factors: first, the client’s individual tax and financial circumstances and, second, the
the light of the underlying assets to be held in the tax wrapper.
asset allocation
and fund selection The main wrappers under consideration are:
• collective investments, such as open-ended investment companies (OEICs) and unit
trusts;
• individual savings accounts (ISAs);
• personal pensions/self-invested personal pensions (SIPPs);
• UK life assurance bonds; and
• offshore life assurance bonds.

Other options available

In addition, some clients may wish to consider enterprise investment schemes (EISs),
venture capital trusts (VCTs) and seed enterprise investment schemes (SEISs).

G1 Client
Client’’s circumstances
The client’s current (and likely future) tax position is a critical factor in decisions about the
suitability of different tax wrappers:
• Investors who pay 40% or 45% tax on their investment income will gain relatively more
from tax relief on pension contributions and from the tax-free roll-up of income within
pension funds and ISAs than basic-rate taxpayers. Likewise, the few investors who pay
capital gains tax (CGT) on a regular basis because of the size of their portfolios will gain
relatively more from wrappers that provide tax-free roll-up of gains.

An investment
• It is also necessary to consider the client’s probable future circumstances in relation to
wrapper may offer their current position. An investment wrapper may offer the opportunity to shelter income
the opportunity to
shelter income
while an investor is subject to the higher rates of tax, and then to tax the proceeds at a
while an investor is time when the client may be subject to the basic rate. For example, those with taxable
subject to the
higher rates of tax,
incomes of £150,000 or more, who are subject to 45% income tax, could find some
and then to tax the wrappers provide them with a helpful tax shelter.
proceeds at a time
when the client • Any extra costs should be taken into account. Some tax wrappers, such as ISAs, often
may be subject to involve little or no additional costs, but life assurance bonds and pensions usually require
the basic rate
the payment of additional fees and there can be substantial differences between different
providers.
Chapter 8

• Additional complexity and inflexibility are other factors to be taken into account in
deciding on particular tax wrappers. ISAs are cheap, simple and flexible, but they cannot
be held in a trust. Despite the changes to flexibility, pensions are complex; access to them
is restricted until a certain age, they are subject to rules that constantly change and costs
are typically higher than for other wrappers.

The tax savings on G2 Asset allocation across tax wrappers

non-dividend
income are greater Many tax wrappers have a greater impact on the returns from rolled-up income than from
than the tax
savings on
capital gains, especially for 40% and 45% taxpayers. For example, in an ISA, the tax saving
dividends from on capital gains is a maximum of 20% of the gain, whereas, for income, the tax saving is
equities
worth up to 40% or 45%. The tax savings on non-dividend income are greater than the tax
savings on dividends from equities.
Chapter 8 The principles of investment planning 8/17

G3 Gains
Where an investment generates gains, it is generally more advantageous to hold it so that Where an
the gains are subject to CGT rather than income tax. The annual exempt amount is relatively investment
generates gains, it
high (£11,700 in 2018/19), losses are often easier to offset against gains and the rates are is generally more
lower, especially for higher-rate and additional-rate taxpayers. advantageous to
hold it so that the
gains are subject
to CGT rather than
G4 Planning with tax wrappers income tax

The main issues in deciding which tax wrappers are appropriate are as follows.

Table 8.5: Planning with tax wrappers

Collectives • Most clients are likely to find that collectives are the most tax efficient
and simple way to hold equity-based investments. Dividends are taxed in
the usual way and gains are subject to CGT when the units or shares are
disposed of, rather than when individual securities within the fund are
sold. This freedom from tax on gains within funds makes collectives a
convenient CGT tax shelter. Collectives can be held by other tax
wrappers.
• Fund of funds allow portfolios of different mutual funds to be actively
managed without incurring a CGT charge. This is theoretically attractive,
but small investors generally find that the annual exempt amount covers
their gains, while larger investors often look for a more bespoke service.
There is also a degree of double charging.
ISAs • ISAs can hold collectives or direct investments in shares, fixed-interest
securities or cash.
• The income is tax free. Capital gains are also tax free, although the
potential tax saving is somewhat less than for income, especially for
higher- and additional-rate taxpayers. For a basic-rate taxpayer who is
unlikely to pay CGT, an ISA provides relatively little benefit in comparison
with a direct holding of collective funds.
• The main advantages are that it is not necessary to make a return of the
income or gains to HMRC and that the investor’s circumstances may
change, and they could become liable to higher-rate tax or CGT.
• One limitation is that there is an annual limit on ISA investment, which
means it can take a number of years to transfer some investors’ wealth
across. It makes sense to ensure that investors’ ISAs can be transferred
from one provider to another without loss of the tax benefits, so ensuring
relatively little risk in adviser selection.
• A few providers do not allow ‘in-specie’ transfers – in which case,
investments have to be sold before transfer and then repurchased
afterwards, possibly leading to delay and being un-invested for several
weeks.

Chapter 8
Personal • The main issue with investing in a pension has been whether the tax
pensions/ advantages compensate for the additional costs, inflexibility and
SIPPs complexity of investing within a registered pension.
• The greatest benefits arise where the investor is a higher-rate or
additional-rate taxpayer in the years of contribution and build-up of the
funds, but a basic-rate taxpayer in the years of drawing benefits. There is
also the advantage of the tax-free pension commencement lump sum.
Since April 2015, investors aged 55 and over have been able to draw
down freely from remaining defined contribution funds, subject to their
marginal rate of income tax.
• The differences between personal pensions and SIPPs have blurred in
recent years.
• Many personal pensions offer access to third party managers and this
may be adequate if the client does not require the wider range of options
available from a SIPP. Equally, the costs of having a SIPP have fallen
considerably with some providers and may be less than some insured
personal pensions.
• An important consideration when choosing a personal pension provider
and (even more) a SIPP provider is the efficiency of the administration
systems.
 8/18 R02/July 2018 Investment principles and risk

Table 8.5: Planning with tax wrappers

UK life • The underlying fund within a UK life assurance bond is subject to UK tax
assurance at rates that are very similar to those paid by basic-rate tax payers.
bonds However, unlike most basic-rate taxpaying investors, the funds suffer a
deduction for tax on capital gains.
• UK life policies are relatively more attractive to higher- or additional-rate
taxpaying investors where the underlying investments generate income
rather than capital growth. The 5% withdrawal facility can be particularly
attractive for higher- and additional-rate taxpayers who need income.
• The tax shelter characteristics of the life assurance bond can be
maximised if it can be arranged for the investor to be a basic-rate
taxpayer in the year of encashment. Top slicing relief may help to ensure
this can be achieved where the investor has held the bond for a number
of years. Top slicing relief is available to basic-rate taxpayers who are
pushed into the higher rates of tax by a gain.
• Where the investor is a higher-rate taxpayer, the fact that the gain on the
bond is not grossed up for the basic-rate tax credit reduces the total
effective rate of tax on the gain below 40% or 45%.
• It is possible to gift bonds to trustees or other individuals without
triggering a tax charge; in contrast, the gift of an asset that is subject to
CGT does trigger a tax charge. Bonds are generally advantageous for
trustees to hold.
• Qualifying life policies (maximum investment plans) can be used to
accumulate funds that are free of higher-rate tax after ten years of regular
contributions. The drawbacks are the inflexibility of the investment in the
build-up period, although tax-free access is possible after three-quarters
of the premium paying term has elapsed – in practice, after seven and a
half years from inception. The maximum contribution into these schemes
is capped at £3,600 per year.
Offshore • An offshore bond has many of the characteristics of a UK bond. The main
bonds differences are that the fund is not subject to UK tax and so the fund
should grow more than the equivalent UK life fund, although this may be
more than offset by the tax at encashment (when there is no tax credit for
the insurance company’s rate of tax on income and gains).
• As a result, the net returns from offshore bonds for taxpayers tend to be
lower than for onshore bonds, whereas offshore bonds tend to be
worthwhile for those who could reasonably expect to be non-taxpayers,
e.g. by becoming non-resident.
• Offshore bonds can involve higher charges than UK bonds, although this
is not always the case.
VCTs, EISs • The tax benefits that arise from investing in VCTs, EISs and SEISs need to
and SEISs be weighed up against the requirement for the underlying investments to
be in small and relatively risky, illiquid assets.
Chapter 8
Chapter 8 The principles of investment planning 8/19

H Platforms
Since the introduction of platforms in the UK, the value of funds held and the number of
providers offering these accounts has continued to grow.
In simple terms, an administrative platform is one that allows clients to consolidate their
investment arrangements and manage these in one place. It is a service rather than a
product, and includes the following features:
• A single fee across all accounts and transparency on costs.
• Reduced paperwork and simplified administration.
• A wide choice of investment funds, often including investment trusts, ETFs and listed
structured products.
• Access to tax wrappers with no or low charges, including ISAs, SIPPs, offshore and
onshore investment bonds.
• Asset allocation across tax wrappers.
• Consolidated valuations, income and gains statements.
• Access to online valuations.
• Adviser fees deductible from cash accounts.
• Automatic re-balancing of portfolios.
Other features of platforms are included in Table 8.6:

Table 8.6: Features of platforms

Reduced paperwork • Consolidating investments into a single account or platform
and administration means reduced administration for advisers and less paperwork
for clients.
• Transferring assets on to or off a platform is usually quite
straightforward and, in some cases, may be done ‘in-specie’.
• Consolidated transaction summaries can also be produced
quickly, avoiding the need to collate statements from various
providers who may all use different formats to present the same
information.
Choice of funds • Most platforms offer access to the vast majority of UK-authorised
funds, and may also provide a share-dealing account for
purchasing investment trusts and ETFs.
• Some advisers use their own back-office administration system
as an alternative to a platform. Here, the adviser collates
information on all of the client’s plans and investments onto a
database, combines it with a live price feed and then uploads the
information on to a secure website for the client to access.

Chapter 8
Consolidated valuations and transactional information can then
be provided on demand.
• Some of the larger independent financial adviser (IFA) firms have
already adapted their in-house administration systems to support
such a service. Although there are fewer back-office systems
capable of delivering ‘platform style’ services for smaller IFAs,
these may prove to be suitable for firms who offer restricted
advice.
Tax wrappers • The majority of platforms provide access to ISAs, pensions,
onshore bonds and offshore bonds. These are in addition to the
general investment and cash accounts, which do not have any
associated tax benefits.
• In most cases, there is no charge for the ISA wrapper; however,
additional charges may apply to the others.
• The onshore/offshore bonds and pension wrappers may also lack
some of the features of standalone products, e.g. capital or
income protection mechanisms.
• The same range of funds and investments is usually accessible
throughout all of the tax wrappers and existing tax wrappers may
be transferred onto the platform, e.g. ISAs, SIPPs as cash
transfers or ‘in-specie’.
 8/20 R02/July 2018 Investment principles and risk

Table 8.6: Features of platforms

Allocation across tax • A platform enables advisers to implement asset allocation
wrappers strategies across several tax wrappers and to present the results
as one consolidated portfolio.
• Where, for reasons of tax efficiency, the adviser recommends the
allocation of all capital in an ISA to fixed-interest investments,
and all capital in an onshore bond to equities, the client can have
difficulty in seeing the overall picture if they receive separate
statements and valuations.
• On a platform, their consolidated valuation will show their total
capital and its allocation to the asset classes, with the allocation
of capital in the wrappers shown separately. This helps the client
to distinguish between the vehicles through which capital is held
and the investments within them.
Consolidated • There will be a cash account, providing transparency on all cash
statements flows.
• Separate consolidated statements for income and gains help to
distinguish between those from tax-exempt sources and those
that are potentially liable to tax.
• Statements and valuations can also be generated by the adviser
or the client at any time.
Portfolio • Some platforms provide a service where portfolios are
rebalancing automatically rebalanced against a target asset allocation and at
an agreed frequency.
• This helps to minimise risk and ensure that the portfolio remains
closely aligned to the asset mix that was discussed and agreed at
the outset.

Holding all investments on a platform creates benefits for both clients and advisers. Advisers
gain an improved perspective on the client’s portfolio, making holistic financial planning
easier, while clients are able to access valuations and consolidated tax statements on
demand. The administrative overhead associated with managing a diverse portfolio of
investments across many different providers and tax wrappers is significantly reduced,
enabling advisers to offer a more streamlined, cost efficient and transparent service to their
clients. Some providers have also developed tools on their website that enable clients to
model their portfolio, carry out goal planning and project the future value of the portfolio
based on various assumptions.

H1 Administration fees and transparency

The platform charges a fee for their services and, up until April 2014, this was usually part of
Chapter 8

the ongoing product provider charge which was then passed onto, or rebated to, the
platform provider.
The charge for investments since 2014 must be paid separately, direct to the platform. This
FCA rule was introduced to improve remuneration transparency and to help consumers
compare platform services; there is an exception, in that a provider can pay a cash rebate to
a platform provider if it is passed to the client in full in the form of additional units.

I Discretionary management services

The adviser may, as part of their investment proposition, recommend the placement of all or
part of a client’s capital with a third-party, discretionary-management service.
Such services may be general portfolio management, or specialised services in venture
capital or ‘alternative’ assets such as forestry. In some cases, the audited historic returns that
are available for collective funds may not exist. Often, managers provide samples of client
portfolios to illustrate historic returns. Care must be taken in evaluating this data and
establishing exactly what is being reported and how well this matches what clients are
currently being offered.
Chapter 8 The principles of investment planning 8/21

Advisers also need to ensure that the discretionary manager’s risk profiles correspond to
their own, or are matched in such a way as to ensure clients do not end up incurring more
risk than the adviser has assessed as acceptable.

Be aware
Tax management
Tax management is a key issue in discretionary services. If assets are held in the client’s
name (i.e. not within a tax wrapper), then the manager’s actions can trigger CGT liabilities.
Good communication between the adviser, discretionary manager and client is essential.

J Provider selection issues

Where advisers are selecting UK providers of regulated investment products, the regulatory
and supervisory framework should ensure that their capital is not at risk from fraud or theft.
However, while this is generally true, there have been instances of products that incurred
losses despite apparently having strong institutional backing.
Since most of these occurred ‘out of the blue’, conventional assessments of credit risk
ratings and balance sheet strength of providers may be insufficient.
A key question is: ‘What would happen to the client’s money if the provider went bust?’ The A key question is:
issue is often the way the assets are held. In the case of authorised funds, an independent ‘What would
happen to the
custodian holds the underlying assets, so there is no risk if the fund manager fails. However, client’s money if
if the client holds funds through a third party (e.g. a platform), then a relevant question is: the provider went
bust?’
‘What would happen if this third party went bust?’ An important aspect of due diligence in
product selection is ensuring that, as far as possible, the provider has insulated clients from
any adverse consequences of its own financial problems.

K Recommendations and suitability

Advisers using asset allocation methods will start their recommendations by explaining the
client’s risk profile based on assessments of risk tolerance and risk capacity, and how it has
been used to generate the asset allocation and the recommended portfolio. This top-level
introduction focuses on timescale (including access to capital), returns (income, where this
is a factor) and risk. It should indicate the range of expected returns and volatility over the
given timeframe, with appropriate caveats about circumstances in which these expectations
may not be met.
The following topics should then be covered:
• The method of selection of funds within the various asset classes – why the adviser has

Chapter 8
selected active/passive funds, open/closed funds or fund of funds in each category.
• Summaries of the most important features of the funds recommended, with fund fact
sheets provided as appendices.
• Explanation of the choice of tax wrappers and/or platform.
• The frequency of review and the basis of ongoing advice and recommendations.
• The costs of the service – initial and ongoing.

L Portfolio reviews
The investment policy statement is a critical element in the portfolio review process. It is The investment
formulated when a new client is taken on and must be updated on a regular basis. policy statement is
a critical element
of the portfolio
review process
L1 Investment policy statement
The FCA requires authorised organisations to agree investment objectives with their clients.
These objectives and principal factors or constraints on how the portfolio will be managed
(for example, legal constraints and the tax position of the client) will be set out in the
investment policy statement.
 8/22 R02/July 2018 Investment principles and risk

The investment manager may have a general house style regarding the acceptable level of
risk that the fund would generally incur. For instance, some managers may have a general
policy not to deal in derivatives, or not to encourage clients to gear their portfolios by
borrowing.
The investment manager must establish clients’ overall investment objectives and attitude
to investment risk. These should be agreed in writing and would apply until they are
amended by discussion and again confirmed in writing.
In very general terms, the overall investment objective may be classified as follows:

Overall investment Explanation

objective
Capital growth priority Income requirements are not a prime concern and emphasis
should be placed on investments considered to have longer-
term growth potential.
Income priority Income considerations will be given priority over the long-term
prospects for capital growth. This could result in the erosion of
purchasing power of the capital.
Balance between capital A combination of capital growth and income investments,
growth and income designed to produce growth in both capital and income.

Examples of classification of risk are shown below:

Risk classification Explanation

Lower or secure Investments would mainly comprise cash and fixed-interest
securities with a credit rating of at least A.
Medium or balanced In addition to those included in lower or secure risk, investments
might include larger UK companies, as well as larger overseas
listed companies and unit trusts, OEICs and investment trusts.
The portfolio could also hold a proportion of the assets in
medium-sized or smaller UK companies, and have exposure to
international markets.
Higher or adventurous In addition to medium or balanced risk, investments might
include a greater exposure to more volatile markets, smaller
companies and more speculative investments, such as securities
without an official listing, with the objective of achieving higher
than normal capital and/or income returns. Alternative
investments might also be included. This policy would inevitably
involve higher risks.
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L2 Principal factors affecting investment strategy

A number of important factors can affect investment strategy and these should be reflected
in the overall investment objectives and level of risk agreed with the investment manager.

L2A Legal constraints

Legal constraints
Any legal constraints should be clearly explained and identified. Limitations are most likely
are most likely to to arise where the investment portfolio is being managed for trustees. For instance:
arise where the
investment • Most modern trust deeds contain wide powers of investment. The nature of the trust and
portfolio is being
managed for its liabilities will be the principal factors affecting investment strategy.
trustees
• Where a trust deed has no specific investment powers, the Trustee Act 2000 allows
trustees of trusts established in England and Wales to invest monies as if they were their
own, provided they have regard to the standard investment criteria of suitability and
diversification. Similar provisions also apply to trusts created in Northern Ireland and
Scotland.
Chapter 8 The principles of investment planning 8/23

L2B Nature of liabilities

This consideration is particularly relevant to defined benefit (DB) pension funds, where
liabilities are very long-term. A typical new member may join at the age of 30, may retire at
60, draw a pension until age 85 and then die, leaving a surviving spouse who draws a further
pension for perhaps another five years – a grand total of 60 years.
During these long periods, there are likely to be many important developments affecting
members:
• There could be significant price inflation.
• Salary rates have usually risen faster than prices
prices. For DB pension schemes, which have
benefits linked to final salaries, the liabilities may increase dramatically. For a pension fund
to remain viable during any long period of inflation, its assets must be of a suitable type. In
particular, the assets must stand a good chance of increasing in value at a rate at least as
fast as the rate of increase in salaries. For this reason, it has long been held that pension
funds should have a high exposure to real assets, such as equities and property, although
inflation risk can be more accurately hedged by using index-linked bonds or inflation
swaps.

L2C Cash flow

A further influence on investment strategy is whether the portfolio will enjoy positive cash
flows. With a strong positive cash flow, the manager can:
flows
• take a long-term view of certain types of investment; and
• accept short-term uncertainty, or even short-term capital losses, in the expectation of
better long-term profits.

L2D Taxation
Pension funds are exempt from income tax and CGT. Provided the fund has a strong cash Pension funds are
flow, the investment manager can therefore invest for growth as well as income. The aim will exempt from
income tax and
be to choose investments that will produce the overall best return and best meet future capital gains tax
liabilities without having to concern themselves with the effects of taxation. (CGT)

L3 Reviewing the investment policy statement

The importance of reviewing the investment policy statement on a regular basis cannot be
over-emphasised.

Be aware
Investment policy statement
The policy statement may need to be revised as a result of changes in client

Chapter 8
circumstances, regulations, taxation and the market environment.

L3A Client circumstances

There are a number of circumstances that can lead to major changes in a client’s investment
objectives. These include:
• receiving an inheritance;
• illness;
• marriage;
• divorce; and
• a change in employment, redundancy or retirement.
More generally, as a client gets older and approaches retirement, there will usually be a need
to take less risk and focus on income rather than capital gains. Typically, this involves
moving a portfolio away from equity investments and increasing the weighting in fixed-
income investments.
 8/24 R02/July 2018 Investment principles and risk

L3B Regulation and taxation

Regulations
Regulations affecting the investments of different client types are subject to change. More
affecting the frequently, there will be tax changes that may significantly alter the preference for capital
investment of
different client
gains versus income, or impact on the tax status of different trust structures, products and
types are subject asset classes.
to change

L3C Market environment

New asset classes
Although investor objectives and long-term strategies should not change in response to
may become short-term market changes, there will inevitably need to be a reassessment of strategies in
accessible to some
investors
light of longer-term changes. The risks of individual asset classes and the relationship
between those assets will alter over time, and new asset classes may become accessible to
some investors.

L4 New products and services

In response to regulatory and tax changes, new products and services become available.
Many of these will be complex and require analysis. This puts heavy demand on investment
advisers who may not have the time or necessary skills to analyse them. In this case, rather
than simply ignoring new products that may be beneficial to their clients, the adviser should
look at using third party advice or external services to assist them in deciding whether they
are appropriate investments.

L5 Client reporting
Providing regular
Providing regular reports to clients allows the client to engage in the review process.
reports to clients
allows the client to The means and frequency of client reporting will usually be contained in the terms of
engage in the business letter given to clients; otherwise, it should be agreed in writing between the
review process
investment manager and the client.
The principal items reported by investment managers are typically as follows:
• purchases and sales;
• summary portfolio valuation and cash statements showing income, interest received,
dividends collected and cash outflows;
• general market commentary and calculated investment return earned by the portfolio,
compared with the appropriate and agreed market indices or other benchmarks; and
• recommended changes in investment strategy.
Timing and frequency of reports
Under the previous FCA rules, periodic portfolio reporting to investors (including valuations)
Chapter 8

was a minimum of every six months. Under MiFID II, the minimum frequency is every three
months. There is also a new requirement to communicate to clients if their portfolio’s value
falls by 10% over a single reporting period. MiFID II requires firms to provide investors with a
full breakdown of all the costs and charges impacting their investments, separating the costs
into four main components:
• ongoing charges for the fund;
• one-off fees (such as entry and exit fees);
• incidental fees; and
• transaction fees.
Chapter 8 The principles of investment planning 8/25

Contract notes
With all forms of investment management, contract notes should be prepared and
dispatched immediately after each purchase and sale. The contract note usually gives the
following information:
• bargain date;
• person for whom the purchase was made;
• number of shares bought/sold, and the price;
• full name of the share or stock;
• amount of charges, including stamp duty; and
• settlement date.
Summary portfolio valuation
A summary portfolio valuation will be issued at agreed intervals, usually quarterly or half- Summary portfolio
yearly. Typically, the summary valuation shows: valuations are
usually issued
• portfolio value at the date of the last report; quarterly or half-
yearly
• addition of cash or stock;
• reduction by each withdrawal;
• appreciation or depreciation; and
• new portfolio value and date of the report.
Details of holdings
Individual holdings will be itemised and the following will usually be provided:
• holding and description;
• market price and value;
• book or acquisition cost; and
• gross income and dividend yield.
Other reports vary, depending on the nature of the investment service and the reporting
basis agreed with individual clients.

L6 Rebalancing portfolios
Rebalancing portfolios will often result from the portfolio review process. Transactions may Rebalancing
result from a change in asset allocation or a change in securities held within an asset class. A portfolios will
often result from
switch of investments arises when a new investment is effected as a result of a full or partial the portfolio
encashment of an existing investment: review process

• A churn is a switch of investments where the primary aim is to generate income for the
benefit of the adviser firm, rather than to act in the best interests of the client. This clearly

Chapter 8
breaks the FCA Conduct of Business rules.
• An investment that is genuinely underperforming should be replaced if a switch can be
demonstrated to be in the best interests of the client, after taking into account the
transaction and any tax costs of the switch.

L6A Reasons for switching

A justifiable switch generally arises in one or more of the following circumstances, i.e. where:
• there has been a clear change in the client’s objectives or circumstances that necessitates
a move to investments with less or more risk exposure or a change in yield;
• market conditions adversely affect the original investment or weigh in favour of an
alternative investment;
• the client gives clear instructions to effect a switch;
• there has been consistent underperformance of an investment over a medium to long
period; or
• the value of an investment is returned as part of a takeover or capital restructuring.
 8/26 R02/July 2018 Investment principles and risk

L6B Tax issues on switches

Disposing of an
As we have seen, cashing in an investment bond may have income tax implications if the
investment can investor is a higher rate or additional rate taxpayer.
have tax
implications Disposing of an investment can also have capital gains tax implications in the case of a
property, a collective investment or shares.
• It may be possible to reduce (or eliminate) a potential charge by transferring some (or all)
of the asset before making a disposal to the investor’s spouse/civil partner. This can
ensure that both CGT annual exempt amounts are used and/or the asset is held by the
partner that pays a lower rate of tax.
• The gain may also be offset against other realised losses.
• If CGT cannot be avoided, it may not be worth incurring the tax charge to make the
switch. A low charge in relation to the sale proceeds will make the decision easier. Much
will also depend on the quality of the investments to be replaced:
– If the investment is a single shareholding in a company and constitutes a high
proportion of the client’s wealth, the high level of risk inherent in this lack of
diversification could make the switch essential, despite the tax cost. Switching would
be especially appropriate for a cautious investor.
– The decision is much more finely balanced if the investment is a collective investment,
such as a unit trust or investment trust, which has not performed adequately.
Chapter 8
Chapter 8 The principles of investment planning 8/27

Key points
The main ideas covered in this chapter can be summarised as follows:

The main approaches to asset allocation

• Asset allocation is primarily a defensive methodology concerned with capital
preservation, which is achieved through diversification of capital across asset classes:
– This type of diversification can be applied in a pragmatic way, where the practitioner
uses historic data only as a reference point and bases allocation mainly on judgements
about the future or a theoretical way using mathematical analysis and techniques to
create optimised portfolios, which in theory will deliver the greatest return for a given
level of risk or the least risk for a given rate of return.
– The high volatility experienced in 2008/09 – far higher than predicted by MPT
models – has resulted in practitioners making more adjustments to optimisation
processes. In particular, mean reversion is often used to adjust expected returns and
volatility.
– Within each asset class, the practitioner can select investments that embody greater
or lesser risk and return than the average for the asset class. Portfolios with the same
percentages of capital allocated to each asset class, but which contain different sub-
classes of assets, can have very different characteristics.

Portfolio optimisation
• Optimisation uses stochastic modelling to generate a large number of portfolios with
different allocations of capital to the same assets or asset classes. It is assumed that
returns and volatility of assets are affected in specific ways by changes in a number of
variables, such as interest rates and inflation. Portfolios that generate the best returns
within a volatility range corresponding to the investor’s risk profile are optimal.
– Stochastic models are highly sensitive to changes in inputs. Small changes in variables
may generate large changes in the range of returns and volatility in the outputs.
Practitioners using such models therefore need to fully understand the model’s rule
base and the effects of such variations.

Strategic and tactical asset allocation

• Strategic asset allocation matches the client’s risk profile with a set of assets, which are
appropriate in relation to their risk profile and are intended to be maintained for the
long-term.
• Tactical asset allocation applies judgement to the allocation of capital to asset classes
and the investments within them. Tactical allocations are usually reviewed more
regularly than strategic allocations, often monthly:
– In one form of tactical allocation, the strategic allocation to an asset class is a band
rather than a precise figure. For example, the allocation to equities may be 60% to
70%. The tactical decision is what figure within that range to hold at any point in time.
– Another form of tactical allocation is to allocate only, say, 80% of the portfolio on a
strategic basis and to use the remaining 20% opportunistically to add to selected
asset classes.

Chapter 8
– Since MPT claims that it is not possible to make consistent profits from market timing,
an active tactical allocation approach is not consistent with the methodology of MPT.

Alignment with client objectives

• The first step in creating a portfolio that is aligned with the client’s objectives, risk
tolerance, risk capacity and timescale is to generate an appropriate risk profile. This will
usually specify the targeted range of returns and likely volatility over the relevant
timescale.
 8/28 R02/July 2018 Investment principles and risk

Portfolio construction
• The two principal methods used in portfolio construction are the ‘top-down method’,
driven by economic analysis, and the ‘bottom-up method’, driven by stock selection.
• In top-down methodology, the initial decision is the allocation of capital to asset classes
and sub-asset classes. This is followed by a geographic allocation. Then, within the
selected countries or regions, capital is allocated to business sectors. Selection of stocks
within those sectors is the final stage of the process:
– Funds managed by the top-down method usually pay close attention to their
benchmark index and often limit deviations from the index allocation more narrowly
than funds managed by the bottom-up method. Bottom-up managers may explicitly
state that a wide divergence between the fund and its most relevant index is to be
expected.
• In bottom-up methodology, the fund manager simply searches for stocks meeting the
fund’s criteria as defined by its objectives and constraints. Such constraints may limit the
percentage of the fund’s capital that may be allocated to countries, regions or sectors.
– Funds using the bottom-up method can be expected to be more volatile than those
using the top-down method.
• In practice, many fund managers combine both methods and it may not be clear from
fund managers’ promotional material which discipline predominates. The extent to
which fund managers actively select sectors and stocks and therefore diverge from
index benchmarks can be assessed by analysis of their performance.

Fund selection
• Many factors may be used in the process of fund selection. Commonly used factors are:
– Objective
Objective. Often, the number of funds sharing a similar objective is quite small (e.g.
funds investing in small-cap European equities for capital growth).
– Style
Style. Fund managers may use one or a combination of styles, the main ones being
value, GAARP, momentum and contrarian. Each can be expected to influence the
pattern of returns and volatility.
– Costs
Costs. The most important costs for the investors are the annual management charge,
the ongoing charges figure, the portfolio turnover rate and any performance fee.
– Strength and reputation
reputation. Large well-resourced fund management groups do not
always produce the best fund performance, but smaller groups involve risks deriving
from their business model.
– Manager skill
skill. The contribution of the individual manager to returns will vary
according to the methodology of the management group. In some cases, a team
approach predominates, while, at the other extreme, star managers have considerable
autonomy.
– Type
Type. Closed-ended funds may be more appropriate for investing in less liquid asset
classes, but open-ended funds are less volatile. Closed-ended funds also may use
gearing, adding to volatility. Funds may use UCITS powers to invest in derivatives,
which can increase or reduce volatility. Fund of funds may limit the task of fund
selection.
– Performance
Performance. Advisers can use sophisticated tools and ratio analysis to identify funds
Chapter 8

that have generated above-average risk-adjusted returns.

– Index and structure
structure. For passively managed funds, selection of an appropriate index
for the asset class or sub-class is critical, and both OEIC and ETF structures may have
advantages.
Chapter 8 The principles of investment planning 8/29

Selection of tax wrappers

• The selection of tax wrappers is based on the client’s financial and tax position and on
the assets to be held within the wrappers.
• Higher-rate and additional-rate taxpayers benefit to a large extent from the tax-free roll-
up of income within pension and ISA wrappers.
• Clients (whether higher-rate or basic-rate taxpayers) who may face capital gains tax
liabilities at 20% or 10% respectively will also benefit to a greater extent from the tax
exemption of gains within ISAs and pension funds.
• Those paying higher income tax rates now, who are confident they will pay lower tax
rates in retirement, may benefit from the tax deferment possible with investment bonds.
• Limitations on access to cash may restrict the extent to which certain wrappers may be
used, especially pension funds, but also investment bonds where withdrawals in excess
of the 5% cumulative allowance could have adverse tax consequences.
• While the ISA wrapper often comes free of charge, any additional costs for other
wrappers need to be taken into account.
• Pension and ISA tax wrappers deliver larger tax savings for higher-rate and additional-
rate taxpayers in respect of income than of capital gains. This means that where a range
of assets is to be held in several tax wrappers, the greatest tax savings will be achieved
by holding income-generating investments in pensions and ISAs.
• Few investors regularly make gains in excess of their annual CGT exempt amount. For
most people, holding assets whose main return is capital gain (e.g. most types of
equities) directly in collectives and using wrappers to shelter income-generating
investments is the most advantageous strategy.

Platforms
• The principal benefits of platforms are convenience and simplicity, both for the adviser
and the client.
• The selection of a platform should take into account the administration features, fund
availability, tax wrappers and cost.

Discretionary management services

• Advisers may recommend clients to a discretionary management service from a third
party rather than offer advisory portfolio services.
• Selection of a discretionary management service requires the same due diligence as
fund selection, with particular care in analysing past performance data.
• Good communication between adviser, client and discretionary manager is essential,
especially in respect of transactions that may trigger CGT liabilities.

Provider selection issues

• Many investment clients will be placing sums in excess of the £50,000 covered by the
Financial Services Compensation Scheme (FSCS) − note that this is £85,000 for

Chapter 8
deposits. An important aspect of provider selection is therefore capital security in the
event of the failure of a product provider.
• The capital strength of the provider can be an important factor. However, this is not an
issue with the managers of UK-authorised funds, since independent custodians hold the
assets.
• A key question is: ‘What would happen to the client’s assets if a provider failed?’

Recommendations and suitability

• Investment recommendations should start with an explanation of how the client’s risk
profile has been generated, followed by an indication of the range of likely returns and
volatility over selected timescales.
• The method of fund selection should be explained and specific reasons given for the
selection of each fund in the portfolio.
• Recommendations for the use of tax wrappers should explain their benefits and the
reasons for holding specific assets within them.
• Recommendations for platforms should clearly explain the costs as well as the benefits.
• The basis and frequency of portfolio reviews should be covered.
 8/30 R02/July 2018 Investment principles and risk

Portfolio reviews
• The investment policy statement (IPS) is agreed between the fund manager and the
client and sets out the client objectives in terms of risk and return, as well as other issues
including legal constraints, liabilities, and cash flow requirements from the portfolio.
• The IPS needs to be reviewed on a regular basis as client circumstances, regulation, tax
and the market environment may change. New products and services may also become
available.
• Client reporting will include contract notes, valuations and summaries of holdings.
Chapter 8
Chapter 8 The principles of investment planning 8/31

Question answer
8.1 Stochastic modelling applies a mathematical technique to generate a probabilistic
assessment of returns and volatility.

Chapter 8
 8/32 R02/July 2018 Investment principles and risk

Self-test questions
1. How can advisers apply asset allocation without the use of probabilistic statistical
techniques?
2. Why might a portfolio lying on the ‘efficient frontier’ deliver less than optimal
performance over the next five years?
3. Between which pair of asset classes would you expect the highest degree of
correlation over any three-year period:
A. cash and equities;
B. gilts and equities; or
C. cash and gilts.
4. Which investment style is most commonly adopted by managers of UK equity
income funds?
5. For what reasons might an adviser decide not to use closed-ended funds in a
portfolio with a cautious risk profile?

You will find the answers at the back of the book

Chapter 8
 The performance
9
of investments
Contents Syllabus learning
outcomes
Learning objectives
Introduction
Key terms
A Introduction to investment performance 9.1
B Performance measurement 9.1, 3.2
C Performance attribution 9.1
Key points
Question answers
Self-test questions

Learning objectives
After studying this chapter, you should be able to:
• discuss whether past performance is a guide to future performance;
• calculate time-weighted and money-weighted returns over multiple periods;
• discuss the methods of evaluating the risk-adjusted returns of an investment; and
• use performance attribution to analyse where managers have added value.

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 9/2 R02/July 2018 Investment principles and risk

Introduction
In this chapter, we will examine the performance of investments. We start by discussing the
issue of whether past performance is a guide to future performance before moving on to
look at performance measurement and attribution.

Key terms
This chapter features explanations of the following:
Asset allocation Benchmark return Market timing Money-weighted rate
of return (MWR)
Performance Performance Risk-adjusted returns Time-weighted rate
attribution measurement of return (TWR)

A Introduction to investment performance

It is important to
It is important to know how individual investments, portfolios, sectors and markets have
know how performed in the past. This information is essential for:
individual
investments, • understanding investment markets generally;
portfolios, sectors
and markets have • assessing the competence of fund managers and investment portfolio managers;
performed in the
past • in many cases, rewarding investment managers; and
• charging performance-related fees, where applicable.

A1 Predictions
Future
The extent to which past performance is a guide to future performance is more difficult to
performance is assess. In a sense, past performance is all we have to go on but, when it is used for predictive
more difficult to
assess
purposes, it is important to understand the limitations. For example:
• UK equities have tended to outperform UK deposits and fixed-interest securities over
longer periods. However, there have been significant periods when equities have
underperformed.
• When predictions or inferences become more specific, the value of past performance
seems to diminish, e.g. in comparisons of fund managers’ track records.
• Most systems of identifying attractive investments depend on the analysis of past
performance and then extrapolating it into the future. For example, beta factors are a
measure of the relative volatility and correlation of individual securities to the market as a
whole. This helpful analytical tool depends on the future volatility and correlation
remaining much the same as in the past – which may not turn out to be the case.

A2 Investment management services

Good performance
Good performance can be due to luck as well as skill; therefore, it is advisable to evaluate the
can be due to luck investment process that has delivered the performance. It is also important to assess the
Chapter 9

as well as skill
overall service provided to the client and the charges that have been paid.

A3 Financial calculations
Investment is becoming increasingly mathematical and rigorous in its analysis. An
understanding of compound interest is fundamental to performance assessment and related
financial calculations that need to be performed to help fully advise clients. In chapter 3, we
have covered the calculation of risk. Here, we consider using return to measure performance
over multiple periods, incorporating cash flows and the importance of benchmarks.
Chapter 9 The performance of investments 9/3

B Performance measurement
In looking at the performance of an investment manager, it is necessary to differentiate Differentiate
between performance measurement and performance evaluation: between
performance
• Performance measurement involves the calculation of the investment return over a measurement and
performance
stated period. evaluation
• Performance evaluation is concerned with determining two issues:
– whether the investment manager added value by meeting or outperforming a suitable
benchmark; and
– how the investment manager achieved the calculated return (e.g. by taking high or low
risks or having a particular stock or asset strategy).

B1 Calculating returns
The calculation of the return from a portfolio can be measured in a number of ways; the two
most common are the money-weighted rate of return (MWR) and time-weighted rate of
return (TWR)
(TWR).
MWR measures the overall return on capital invested over a specific period, whereas TWR MWR measures the
allows comparisons to be made of the performance of different fund managers. overall return on
capital invested
(You should note that MWR is often used in the investment industry to refer to internal rate over a specific
period. TWR
of return (IRR). However, knowledge of IRR is not required for your R02 assessment.) allows
comparisons to be
made between the
B1A Money-weighted rate of return (MWR) performance of
different fund
The return on a portfolio may be expressed as being equal to the sum of: managers

• the difference in the value of the portfolio at the end of the period and the value of the
portfolio at the start of the period; and
• any income or capital distributions made from the portfolio during that period.
The holding period return expresses the return in terms of the value of the portfolio at the
beginning of the period. In equation form:

D + V1 − V0
R=
V0

where R is the holding period return, V0 is the value of the portfolio at the start of the period,
V1 is the value of the portfolio at the end of the period and D is the income received during
the period.

Example 9.1
The calculation of a holding period return for a portfolio worth £25,000 at the start of the
period (V0), £28,000 at the end of the period (V1) and which had £1,000 income paid out
(D) is as follows:
= (1,000 + 28,000 – 25,000) ÷ 25,000
= 0.16
Chapter 9

or 16%.

When new funds are invested or withdrawn during the year, the calculation can be modified
to allow for differences in the timing of capital additions or withdrawals, weighting each by
the number of months of the year remaining at the time they are affected.

Be aware
Income withdrawn (D)
Please note that income withdrawn (D) is not being treated as a cash flow (C).
 9/4 R02/July 2018 Investment principles and risk

The MWR is essentially a modified form of the holding period return formula and is used to
calculate the return over the year, adjusting for cash inflows into the portfolio:

D + V1 − V0 − C
MWR =
(
V0 + C × n / 12 )
where
n is the number of months remaining in the year
and
C is the new money introduced during the year. If it is added to the portfolio, it is a positive
figure and will be subtracted from the returns in the numerator; if it is a withdrawal, it is a
negative figure and has to be added back in to get the return. On the bottom line of the
equation, this logic is reversed – as we had the use of any capital injected for the balance of
the year and lost the use of withdrawals for the balance of the year.
If income is received throughout the year and immediately reinvested, it can be ignored in
calculating the total return on the portfolio.

Example 9.2
If a portfolio was worth £20,000 at the start of the year (V0), £24,000 at the end of the
year (V1), with the following transactions taking place during the year:
£3,000 invested at the end of March,
£2,000 withdrawn at the end of September,
then the MWR would be calculated using:

D + V1 − V0 − C
MWR =
( ) (
V0 + C1 × n/ 12 + C2 × n/ 12 )
But D = 0, so can be ignored.

24,000 − 20,000 − 1,000

=
( ) (
⎡20,000 + 3,000 × 9÷12 + −2,000 × 3÷ 12 ⎤
⎣ ⎦ )
In the numerator, £3,000 has been added and £2,000 withdrawn, creating a net cash
inflow of £1,000 (£3,000 – £2,000 = £1,000), which we deduct.
In the denominator, we have reversed this logic to add the £3,000 capital we had for 9/
12ths of the year and subtract the £2,000 capital lost for the last 3/12ths of the year.

3,000
=
20,000 + 2,250 − 500

= 0.1379

Remember to multiply by 100 to express as a percentage.

MWR = 13.79%.
Chapter 9

If you need to calculate the MWR for a fund with no cash flows, then D = 0 and C = 0.
Consequently, you will be back to a basic holding period return:

V1 − V0
MWR =
V0

The rate of return produced by this method can be considered the rate of interest that the
initial portfolio, plus net new money, must earn in a deposit account to equal the
portfolio’s actual value at year end.
Chapter 9 The performance of investments 9/5

Drawbacks of MWR
The MWR method of measuring returns is not considered appropriate when trying to
evaluate and compare different portfolios. This is because it is strongly influenced by the
timing of cash flows − this timing could be outside of the fund manager’s control and is often
decided by the client. It does not identify whether the overall return for the investor is due to
the ability of the fund manager or as a result of when additional funds were invested.

B1B Time-weighted rate of return (TWR)

The TWR attempts to eliminate the distortions caused by the timing of new money by
breaking down the return for a particular period into sub-periods between each addition or
withdrawal of capital. The TWR for the overall period is established by compounding the
returns of each sub-period. It is the change in the value of money invested on day one that
stays invested for the whole period.
For each sub-period, we need to calculate the holding period return.
We can then link all these discrete returns together to calculate the TWR for the overall
period. The general formula is:
1 + R = (1 + r1)(1 + r2)(1 + r3)(1 + r4)…(1 + rn)
where R = TWR and ri is the holding period return in each sub-period, when there are n sub-
periods.
In the case of two periods, it would be:

V1 V2
TWR = R = × −1
V0 (V + C)
1

An exact calculation of a TWR would require a full valuation of the portfolio whenever a cash
flow occurs. In practice, approximations are made so that the TWR can be calculated using
either monthly or quarterly portfolio valuations.

Example 9.3
Assume that all investments are directed into one stock that rises sharply over the course
of one year. At the start of the year, the stock has a value of 100p; after six months, its
value is 110p; and, by the end of twelve months, it has risen to 130p.
Manager A receives £200 at the start of the period, while manager B receives £100 at the
start of the period and then a further £100 after six months.
Manager A
Value of initial fund: £200 (200 shares at 100p)
Value of final fund: £260 (200 shares at 130p)

V1 − V0
Holding period return =
V0
(There are no dividends so D = 0)
Rate of return =
(260 − 200)
200
= 0.30 or 30% (which is also the TWR since we are only considering one period)
Chapter 9

Manager B
Initial investment of 100 shares grows to be worth £110.

V1 − V0
Holding period return =
V0
(There are no dividends so D = 0)
110 − 100
=
100
= 0.1 or 10%
Second investment:
With the second £100, we can buy 90 shares (100 ÷ 1.10 rounded down to the nearest
number of whole shares). This means we start with 190 shares worth £209, plus £1 cash,
which is £210 (190 × £1.10 + £1), and end the period with £248 (190 × £1.30 + £1).
 9/6 R02/July 2018 Investment principles and risk

V1 − V0
Holding period return =
V0
(There are no dividends so D = 0)
248 − 210
=
210
= 0.1810 or 18.10%
We can now link these returns as they relate to the same period:
1 + R = (1 + r1)(1 + r2)
where R = TWR.
1 + R = (1.1)(1.1810)
1 + R = 1.2991
R = 1.2991 – 1
R = 0.30 or 30%.
The TWR is the same for both funds (there is a small difference due to the £1 in cash not
generating a return, but this is lost in rounding) since both invested in the same stock. The
TWR has not been distorted by the cash flow to manager B at the end of six months.
However, calculating the MWR reveals that manager B achieves a higher return.

MWR =
(248 − 100 − 100)
100 + ( × 100)
1
2

= 48÷150 = 0.32 or 32%

Both managers were instructed to invest in only one share, but their respective measured
performance (MWR) might suggest that manager B achieved a better result. To overcome
this problem, TWR is usually used to allow direct comparisons between managers. The
investment performances between cash flows is used to determine the overall
performance. This method takes into account investment income and new money, as well
as both realised and unrealised capital profits or losses.

In summary, MWR can be used to calculate a valid rate of return for an individual portfolio,
but it gives misleading results if it is used for comparative purposes. TWR is universally used
for comparative purposes, because it is not affected by the timing of cash flows and
different new money flows.

Question 9.1
A fund manager is given £1 million to invest at the beginning of the year. After three
months, the portfolio has risen in value to £1.15 million and the client gives the manager
another £0.2 million to invest. At the end of the year, the portfolio is worth £1.25 million.
Calculate the MWR and TWR for the portfolio over the year.

B2 Risk-adjusted returns
Chapter 9

Performance measurement has become much more sophisticated in recent years, with the
availability of a range of tools and services employing statistical analysis.
Simple performance analysis consists of looking at actual total returns and volatility over
cumulative and discrete periods, comparing a fund with its benchmark index, sector index
and possibly a small peer group of funds sharing common strategies and aims.
Cumulative returns shown in tabular form are a poor guide because they can conceal
alternating periods of good and bad relative performance, and a period of good
performance near the end of the period can mask earlier underperformance. Study of
discrete periods (often successive calendar years) can reveal greater or lesser consistency in
returns and volatility.
Chapter 9 The performance of investments 9/7

Sophisticated performance analysis takes monthly returns and volatility, and subjects them
to analysis using a number of ratios. This helps to reveal whether the manager’s decisions are
adding value. Analysis could show that a manager’s positive returns result from having a
portfolio with a higher than average beta. In upwards trending markets, this will result in
above average returns, but it will also result in lower than average returns in falling markets.
When assessing portfolio performance, it is critical to consider the returns against the risk When assessing
that has been taken. If a portfolio manager has taken a high level of risk, it is reasonable for portfolio
performance, it is
an investor to expect a higher return to compensate for the risk taken and, similarly, a client critical to consider
who requests a low-risk strategy should expect relatively low returns. the returns against
the risk that has
Earlier we considered two ways that risk can be measured: been taken

• volatility of returns, measured by standard deviation of returns; and

• systematic or market risk, measured by beta (ß).
We will now consider three ways to measure risk-adjusted returns: the Sharpe ratio, alpha
and the information ratio
ratio.

B2A Sharpe ratio

The Sharpe ratio is a measure of the risk-adjusted return of an investment. It measures the The Sharpe ratio is
excess return for every unit of risk that is taken to achieve the return and is frequently used a measure of the
risk-adjusted
for comparing investments to see which offers the most return for a given amount of risk. return of an
For instance: investment

return on the investment − risk-free return

The ratio is:
standard deviation of the return on the investment

• The difference between the return achieved by the investment and the risk-free rate is the
excess return received for taking some risk.
• Risk is measured by the standard deviation of returns.
It is usually desirable to measure risks and returns using fairly short periods, e.g. monthly.
However, it is common practice to annualise the data (multiplying the average monthly
returns by twelve, and a monthly standard deviation by the square root of twelve) for the
purposes of standardisation and to be able to make comparisons between investments.

Example 9.4
The Sharpe ratio
An investment portfolio has an annualised return of 10% compared to a 4% annual return
from a risk-free investment. The standard deviation of the portfolio is 8%.

10.0 − 4.0
The Sharpe ratio is = 0.75
8.0

This indicates that the portfolio earned a 0.75% return above the risk-free rate for each
unit of risk taken.

The Sharpe ratio is a method for comparing different risk/reward options. Generally, the A negative Sharpe
higher the Sharpe ratio, the better the return on an investment compensates an investor for ratio indicates that
a risk-free asset
the risk taken. A negative Sharpe ratio indicates that a risk-free asset would have performed
Chapter 9

would have
better than the investment being analysed. performed better
than the
It can be a useful measure to identify whether the returns on a portfolio or fund are due to investment being
analysed
the skilful investment decisions of the manager or the result of taking excessive risk.
Although one portfolio or fund may achieve higher returns than its peers, it is only a good
investment if the higher returns do not come with too much additional risk.

Be aware
Interpreting the Sharpe ratio
The greater a portfolio’s Sharpe ratio, the better its risk-adjusted performance has been.
 9/8 R02/July 2018 Investment principles and risk

Example 9.5
Comparing portfolio performance with the Sharpe ratio
If manager A generates a return of 14%, while manager B generates a return of 11%, it
would appear that manager A has a better performance. However, if manager A, who
produced the 14% return, took greater risk than manager B, it may not actually be the case
that manager A has a better risk-adjusted return.
If the risk-free rate is 4% and manager A’s portfolio has a standard deviation of 8%, while
manager B’s has a standard deviation of 5%, then:

14.0 − 4.0
The Sharpe ratio for manager A is = 1.25
8.0
11.0 − 4.0
The Sharpe ratio for manager B is = 1.40
5.0

Based on these calculations, manager B was able to generate a higher return on a risk-
adjusted basis.

Question 9.2
Calculate the Sharpe ratio for a portfolio that has an annualised return of 9.5%, if the
standard deviation of the portfolio is 8% and the return from a risk-free investment is 3.5%.

B2B Alpha
Alpha, α, or, more accurately, Jensen’s alpha, is the difference between the return you would
expect from a security, given its beta, and the return that it has actually produced. It is the
part of the return which cannot be explained by movements in the overall market.
In some cases, alpha is used by managers to simply mean the under or outperformance of an
investment in relation to its benchmark.

Be aware
Positive and negative alpha
An alpha can be positive or negative:
• a positive alpha indicates that the security has performed better than would be
predicted given its beta; and
• a negative alpha indicates that it has performed worse than would be predicted by its
beta.

For an investment fund or portfolio, alpha allows us to quantify the value added or taken
away by a manager through active management, since it is independent of the underlying
market or benchmark performance and is a measure of a manager’s stock-picking skill. It is
the return that is not explained by the capital asset pricing model (CAPM).
The CAPM is The formula is:
covered in
chapter 3,
section B
α = actual portfolio return – [Rf + ßi (Rm – Rf)]
where:
Chapter 9

Rf is the risk-free rate of return;

Rm is the market return; and
ßi is the beta of the fund or portfolio.
Note that we are now using actual returns rather than expected returns, since we are
applying the CAPM to historic data. Often, the calculation uses monthly returns over the last
three years, although the reported alpha is usually an annualised number. The alpha for an
individual security is calculated in the same way as a portfolio or fund.
Chapter 9 The performance of investments 9/9

Example 9.6
Calculating alpha
Fund A Fund B
Fund return 12% 10%
Risk-free rate 4% 4%
Market return 10% 10%
Beta 1.2 0.8
Alpha 12 – [4 + 1.2(10 – 4)] 10 – [4 + 0.8(10 – 4)]
= 0.8% = 1.2%

Note that when working out the alpha of the above funds, we calculate the inner brackets
first. For example, in fund A, 10 – 4 is 6. Next is the multiplication, so 1.2 × 6 is 7.2. Then we do
the addition, 4 + 7.2 is 11.2, and, finally, we subtract 11.2 from 12, which gives us the alpha for
fund A of 0.8%.

Question 9.3
Calculate the alpha of a fund that has provided an average return of 12% per year, if the
fund has a beta of 1.5, the return on the market was 8% and the risk-free rate was 2%.

Alpha is widely used to evaluate funds and a portfolio manager’s stock-picking ability. As we
just saw, positive alpha means that the manager has outperformed the market after
adjusting for beta, while a negative alpha would indicate that the manager has
underperformed the market after adjusting for beta. In some cases, however, a negative
alpha can result from the fund management expenses that are present in the fund
performance figures, but not in the figures of the comparative benchmark index.

B2C Information ratio

The information ratio is used to assess the risk-adjusted performance of active portfolio The information
managers. It is often used to gauge the skill of fund managers and shows the consistency ratio is used to
assess the risk-
with which a manager beats a benchmark index. adjusted
performance of
The information ratio measures the relative return achieved by an investment manager active portfolio
divided by the amount of risk the manager has taken relative to a benchmark. The relative managers

return is the difference between the return on the actively managed portfolio and the return
on the benchmark. This relative return can be positive or negative. The risk taken relative to
the benchmark is the tracking error, which is the standard deviation of the relative returns.
The formula is:

Rp − Rb
Information ratio =
tracking error

where:
Rp is the portfolio return and Rb is the benchmark return.
Chapter 9

Example 9.7
Information ratio
Fund A Fund B
Fund return 12% 11%
Benchmark return 10% 10%
Tracking error 8% 3%
Information ratio (12 – 10) ÷ 8 = 0.25 (11 – 10) ÷ 3 = 0.33

Although fund A has a higher return than fund B, when we adjust for the risk taken against
the benchmark to achieve these returns, the information ratios show that B has generated a
higher risk-adjusted return.
 9/10 R02/July 2018 Investment principles and risk

Question 9.4
Calculate the information ratio for a fund that has provided an average return of 13% per
year compared with a benchmark return of 10%, if the fund has a tracking error of 6%.

The higher the positive information ratio, the higher the value added by the manager
through active management, based on the amount of risk taken relative to the benchmark.

Be aware
Negative information ratio
A negative information ratio means that an investor would probably have achieved a
better return by matching the index using a tracker or index fund.

C Performance attribution
Portfolio managers
It is also important to evaluate how portfolio managers achieve their returns. Portfolio
achieve good or managers achieve good or bad results by the exercise of the following:
bad results by the
exercise of asset • Asset allocation
allocation: the division of the investments into the different types of assets, such as
allocation, stock
selection, market different markets or different types of securities. If the US market outperforms other
timing and risk markets during a period and the manager has a high proportion of the portfolio in that
market, it will make a considerable difference to the returns achieved. Most portfolio
managers tend to describe themselves as top-down strategists, where performance
comes first from asset allocation.
• Stock selection
selection: the choice of shares that have individually outperformed.
• Market timing
timing: deciding on when to introduce or withdraw funds from the market.
• Risk
Risk: managers may decide to take more or less risk than the benchmark, depending on
their views about the market.
In performance evaluation, it is necessary to show the separate contribution of these
approaches. Some investment managers aim to achieve above average returns from their
skill in stock selection, while others may choose to run a riskier portfolio.

Be aware
Success or failure?
It is important to be able to distinguish the basis of success or failure by performance
evaluation. This is usually achieved by comparing the composition of the portfolio with a
suitable benchmark portfolio and then looking at the effects of asset allocation and stock
selection separately.

Step 1: The benchmark

Choose an appropriate benchmark to compare the portfolio. In the case of a charity that
needs to provide a high level of income, an average charity’s portfolio might be appropriate.
There are a variety of portfolios that have now been benchmarked for different purposes,
depending on the attitude to risk and the income needs of the clients. In the case of a
pension fund, the appropriate benchmark would depend on the size and maturity of the
Chapter 9

pension scheme. Where there are many pensions in payment, the proportion of the fund in
UK fixed-interest is likely to be higher than a fund where most of the members are relatively
young.
Step 2: The benchmark asset allocation
Find out the asset allocation for the benchmark fund over the period to be evaluated. For
example, it might be as follows:

UK equities 55%
Overseas equities 25%
Fixed interest 15%
Cash 5%
Chapter 9 The performance of investments 9/11

Step 3: Benchmark returns

Calculate the return that each asset class in the benchmark portfolio would have achieved if
it had performed in line with the appropriate index for its sector. For example, the index for
UK equities would probably be the FTSE All-Share Index.
During the period, the various indices for the component parts of the portfolio performed as
follows:

UK equities 20%
Overseas equities 15%
Fixed interest 10%
Cash 5%

So the return on UK equities in this benchmark portfolio would be 55% × 20% = 11%.
The actual index performance of each class of asset is then applied to the asset allocation of
the benchmark portfolio to provide the model rate of return; this is then compared with the
actual portfolio.

Asset class Benchmark asset Index Contribution to

allocation performance for return
% each class %
%
UK equities 55 20 11.00
Overseas equities 25 15 3.75
Fixed interest 15 10 1.50
Cash 5 5 0.25

Overall contribution to return 16.50

This table shows that the manager could have achieved a return of 16.5% over the period if
they had:
• copied the distribution of the asset classes in the model portfolio, in this case, the average
asset allocation for the market; and
• tracked the appropriate index for each class of asset.
Step 4: Comparison of asset allocation
Compare this benchmark or model performance with the actual portfolio’s performance in
terms of the asset allocation. This comparison is made by assuming that the:
• asset allocation is the same as the manager’s portfolio; and
• performance of each class of asset is the index performance (rather than the actual
performance achieved by the manager).
This should show how the manager’s allocation between different classes of asset
Chapter 9

contributed towards the portfolio in isolation from other factors, such as stock selection.

Asset class Manager asset Index Contribution to

allocation performance for return
% each class %
%
UK equities 45 20 9.00
Overseas equities 25 15 3.75
Fixed interest 20 10 2.00
Cash 10 5 0.50

Overall contribution to return 15.25

 9/12 R02/July 2018 Investment principles and risk

The contribution to return for each asset class is calculated by multiplying the asset
allocation of each asset class by the index performance:
• In this particular case, the manager had a portfolio of UK equities that was 10%
underweight compared to the model; i.e. the model had 55% in UK equities and the
manager’s portfolio had 45% in this class of asset. UK equities in general, as measured by
the benchmark index performance, did well over the period (equities returned 20% versus
the average benchmark return of 16.5%), so being underweight has a negative effect on
the portfolio.
• Fixed-interest securities were overweight and performed poorly in the benchmark index
(returned 10% versus the average benchmark return of 16.5%), so this asset allocation
decision also has a negative effect on the portfolio.
• Similarly, cash was overweight (10% versus 5% benchmark weighting) and performed
poorly in the benchmark index, which had a further negative effect.
• Overall, the benchmark portfolio performed better than the manager’s asset allocation.
The benchmark portfolio rose by 16.5% over the period and the estimated performance
applying to the asset allocation of the manager’s portfolio was 15.25%, so 1.25% was lost
due to the manager’s asset allocation decisions.
Step 5: Stock selection and/or sector choice
Calculate the effect of stock selection or sector choice. This involves comparing the index
performance for each class of asset with the manager’s actual performance within these
categories, thereby removing the effects of asset allocation. The aim is to see how the
manager’s selection of investments within each asset class performed relative to the
appropriate index. Outperformance or underperformance could be the result of either:
• Sector choice, i.e. being overweight or underweight in particular sectors.
For example, property and bank shares underperformed most of the rest of the UK market
during the financial crisis and so a portfolio that was overweight in these areas would
probably have underperformed. In large markets like the UK, there are individual indices
for each component part of the overall index.
• Stock selection
selection, i.e. being overweight or underweight in a particular share in a sector. For
example, within the construction and building materials sector, one particular share may
have outperformed the rest of the constituent companies.
The contribution of stock or sector selection can be isolated from asset allocation by
multiplying the difference in actual and index performance by the benchmark asset
allocation.

Asset class Benchmark Index Actual Contribution to

asset performance performance return
allocation % % %
%
UK equities 55 20 25 +2.75
Overseas equities 25 15 5 –2.50
Fixed interest 15 10 10 0
Cash 5 5 10 +0.25
Chapter 9

Overall contribution to +0.50

return

The manager outperformed the UK equity index over the period by 5% and this constituted
55% of the benchmark portfolio. So (25 – 20) × 55% = 2.75%.
The outperformance of UK equities and cash in this portfolio was largely offset by the
underperformance of stock or sector selection in overseas equities, and the overall stock
selection contribution was very low at only 0.5%.

Consider this
this…
…
This explanation is an oversimplification. In practice, the analysis of overseas equities
would look at the weighting of different markets and the performance of each group of
overseas shares in relation to its local market index.
Chapter 9 The performance of investments 9/13

Activity 9.1
Let us say that you have client portfolios which contain more than one asset class. Use
performance attribution to analyse whether value has been added from asset allocation,
and/or stock selection over the benchmark over the past year. Does the result tie in with
what you intuitively thought would be the case before you did the calculation?

Chapter 9
 9/14 R02/July 2018 Investment principles and risk

Key points
The main ideas covered by this chapter can be summarised as follows:

Introduction to investment performance

• It is important to know how individual investments, portfolios, sectors and markets have
performed in the past.
• When past performance is used for predictive purposes, it is important to understand
the limitations.
• It is advisable to evaluate the investment process, as well as the performance numbers,
when judging the performance of an investment manager.

Performance measurement
• The two most common ways of measuring return are the money-weighted return
(MWR) and time-weighted return (TWR).
• The formula for MWR is:
D + V1 − V0 − C
MWR =
(
V0 + C × n/ 12 )
where:
V0 is the value of the portfolio at the start of the period, V1 is the value of the portfolio at
the end of the period, D is the income paid out during the period, n is the number of
months remaining in the year and C is the new money introduced during the year. The
MWR is affected by the timing of the cash flows and is not suitable for comparing fund
managers’ performances.
• The formula for TWR is:
TWR = (1 + r1)(1 + r2)(1 + r3)(1 + r4)…(1 + rn) – 1
where ri is the holding period return in each sub-period (usually calculated between cash
flows) and there are n sub-periods. TWRs are unaffected by the timing of cash flows, so
this method is more appropriate for comparing fund managers.

Risk-adjusted returns
• The Sharpe ratio is a measure of how well the return on an asset compensates the
investor for the risk taken.
• Alpha (α) is the difference between the return you would expect from a security, given
its beta, and the return that it has actually produced.
• The information ratio is used to assess the risk-adjusted performance of active portfolio
managers. It shows the consistency with which a manager beats a benchmark.

Performance attribution
• Performance attribution can be used to differentiate between returns that are a result of
asset allocation decisions versus sector or stock selection decisions.
• The first steps in performance attribution are to identify the benchmark, determine the
asset allocation of the benchmark, and determine the performance of each asset class
and the benchmark return. After identifying the portfolio asset allocation, calculate the
return of the portfolio with the same asset allocation and compare this to the benchmark
return to work out the effect of the manager’s asset allocation decision. The difference
between the portfolio return and benchmark return is explained by sector and stock
selection.
Chapter 9
Chapter 9 The performance of investments 9/15

Question answers
9.1 The MWR and TWR for the portfolio over the year would be:

V1 − V0 − C
MWR =
(
V0 + C × n÷12 )
1.25 − 1.0 − 0.2
=
(
⎡1.0 + 0.2 × 9÷12 ⎤
⎣ ⎦ )
Note it is 9/12 in the denominator since the money was added three months into the
year.

0.05
=
1.15
= 0.0435
MWR = 4.35%

In the case of two periods TWR is given by:

V1 V2
TWR = R = × −1
V0 (
V1 + C )
1.15 1.25
= × −1
1 (
1.15 + 0.2 )
(
= 1.15 × 0.9259 − 1 )
= 1.0648 − 1
TWR = 6.48%

Note the MWR is lower since the performance deteriorated after the cash inflow.
Please note that you should use the full values as shown on your calculator when
doing this calculation. The figures shown here have been rounded to four decimal
places for presentation purposes.
9.2 The Sharpe ratio for a portfolio would be:

9.5 − 3.5
Sharpe ratio = = 0.75
8

9.3 The alpha of the fund would be:

Alpha = 12 – [2 + 1.5 (8 – 2)] = 1%
9.4 The information ratio of the fund would be:

13 − 10
Information ratio = = 0.5
Chapter 9

6
 9/16 R02/July 2018 Investment principles and risk

Self-test questions
1. What is the MWR for a portfolio initially worth £384,000, now valued at £426,500,
and which had £16,000 withdrawn out?
2. What are the purposes of MWR and TWR?
3. What does the Sharpe ratio measure?
4. What does Jensen’s alpha measure?
5. a. What does the information ratio measure?
b. What does a positive information ratio indicate?

You will find the answers at the back of the book

Chapter 9
Self-test answers i

Chapter 1.1
self-test answers
1. • Inflation risk.
• Interest rate risk.
• Default risk.
2. Up to 100% of the first £85,000.
3. • Notice accounts.
• Term deposit accounts.
4. The secondary market.
5. • The price at which the gilt will be redeemed at the redemption date.
• The amount on which the interest that will be received is calculated using the gilt’s
coupon.
6. The interest or running yield measures the income return an investor receives on the
amount paid for a bond. The formula is:
coupon
× 100
clean price

7. The most volatile bonds are those with a long period to maturity and low coupons.
8. A reverse yield curve indicates that yields are lower for longer-dated bonds than for
short-dated ones – that is, the yield curve falls from left to right. This is the opposite to a
normal yield curve, which rises from left to right to reflect the higher yield usually
required for investors to hold longer-dated bonds. A reverse yield curve occurs
temporarily (although, in some circumstances, for many months at a time) when long-
term interest rates are substantially below current short-term levels and short-term
interest rates are expected to decline.
9. A corporate bond often yields more than the equivalent gilt. There is a higher credit risk
involved in lending to commercial concerns: they can become insolvent, unlike a
government. The corporate bond market is also generally less liquid, leading to wider
bid–offer spreads and an increased risk that a bond cannot be traded when desired, for
which investors require a compensating higher return.
ii R02/July 2018 Investment principles and risk

Chapter 1.2
self-test answers
10. • Future expectations.
• Historic and current knowledge of a company’s performance.
11. A rise in interest rates is likely to depress builders’ share prices as higher mortgage
costs could deter house buyers.
12. Preference shares are similar to bonds in that they pay a fixed income in the form of a
dividend that has preference over normal dividends. Preference share dividends are
taxed as dividend income and not at the savings rates payable on the receipt of
interest. Also, preference shares are often issued with redemption dates.
13. Ordinary shareholders are only entitled to share the residual value of a company’s
assets after all debts are discharged and other shareholders have received their
entitlements. They therefore rank as the lowest type of share.
14. Whilst private equity can deliver high returns, there is a high risk of losses, as some of
the companies in which a fund invests will fail and others will not grow quickly. They
can also carry high leverage and are vulnerable to a domestic downturn or recession.
Listed private equity stocks are less liquid than listed securities. This can make realising
an investment difficult and it also makes the share prices more volatile, as trading
volumes can be very low.
15. The P/E ratio compares the company’s share price with its earnings per share. A high
P/E ratio usually indicates that investors are optimistic about the future earnings
growth of the company. However, a P/E ratio does not indicate whether a share price
will rise or fall.
16. A key reason would be to obtain additional diversification, especially from equity
investments. Property values tend to follow business profitability, in very general terms,
and are therefore less volatile than stock markets. Where property is let on attractive
terms to good quality tenants, it has some of the characteristics of fixed-interest
securities. Yet, because property is asset backed, it can also provide long-term
protection against inflation.
17. • They usually do not generate any form of income.
• They often cost money to keep, and may incur charges in the form of insurance
premiums, specialist storage charges, security costs or maintenance.
• Demand is driven by the tastes of collectors, which can change.
• Authenticity can be difficult to prove.
• There are high costs associated with buying and selling.
• It can be difficult to diversify.
• Specialist knowledge is needed to buy successfully.
18. • Hard commodities, which are the products of mining and other extractive
processes – they include metals, crude oil and natural gas.
• Soft commodities, which are typically grown – they include coffee, cocoa, sugar,
corn, wheat and livestock.
Self-test answers iii

Chapter 2
self-test answers
1. A government’s policy changes can have an important impact on economic and
financial conditions. Political developments can change the investment climate, both
for the economy and for individual sectors.
2. National economies have become increasingly integrated and financial markets move
more and more in step, so investors need an international perspective when allocating
assets.
3. • Recovery followed by expansion or acceleration of economic growth;
• boom;
• slowdown or contraction; and
• recession.
4. Share prices generally begin to recover while the economy is in recession, falter when
interest rates are raised to curb inflation in a boom and fall back as the economy slows
down.
5. • The different tax treatment of different types of asset will influence investment
decisions.
• The tax treatment of a company’s earnings will affect its dividend policy and whether
it raises capital through debt or equities.
6. The most commonly quoted measures of money supply in the UK are M0 (narrow
money) and M4 (broad money):
• M0 comprises notes and coins in circulation, plus banks’ operational deposits with
the Bank of England.
• M4 comprises notes and coins in circulation, plus all instant access and deposit
accounts of UK residents with UK banks and building societies.
7. • It eases monetary policy.
• If the market agrees with the Bank’s view of the prospects for inflation, longer-term
interest rates will reduce.
• This will lead to rising asset prices, wealth will increase, making people more willing
to borrow and spend, stimulating demand.
• Low interest rates will encourage more borrowing.
• Those dependent on income from cash deposits will be worse off.
8. • If there is a surplus, it means that the country exports more goods than it imports.
Buyers have to acquire the currency to pay for the goods, increasing the country’s
foreign reserves and strengthening the currency.
• If there is a deficit, it implies the need to sell the local currency to acquire foreign
goods.
9. The value of any profit earned from either investments in overseas markets or from
selling products overseas is affected by the exchange rate. The profit may be increased
or reduced depending on the exchange rate when it is converted into the domestic
currency.
The profitability of their export business affects the value of the shares of exporting
companies.
iv R02/July 2018 Investment principles and risk

Chapter 3
self-test answers
1. The standard deviation measures how widely the actual return on an investment varies
around the mean or expected return. The greater the standard deviation, the greater
the volatility and the associated risk.
2. Beta measures the sensitivity of a security to a market.
3. Non-systematic or investment-specific risk.
4. The efficient frontier represents the set of portfolios that have the best risk–reward
trade-offs, so for any level of risk the portfolio on the frontier with that level of risk will
give the best return for an investor.
5. Ninety-one-day Treasury bills, as there is virtually no default risk and, because of their
short life, interest and inflation risks are minimal. Another risk-free rate that is less
commonly used is the long-gilt yield.
6. APT is based on the belief that there is more than one type of risk that influences
security returns, with different securities having different sensitivities to each risk.
CAPM argues that returns are based on the systematic risk to which a security is
exposed, rather than total risk.
7. Weak form efficiency. This states that current security prices fully reflect all past price
and trading volume information and future prices cannot be predicted by analysing this
type of historical data.
Semi-strong form efficiency. This states that security prices adjust to all publicly
available information very rapidly and in an unbiased way, so that no excess returns can
be earned by trading on that information.
Strong form efficiency. This states that security prices reflect all information that any
investor can acquire.
8. Behavioural finance highlights inefficiencies caused by the irrational way in which
investors react to new information, which causes market trends and speculative
bubbles.
Self-test answers v

Chapter 4
self-test answers
1. FV = £20,000 × (1 + r)n
= £20,000 × (1.03)5
= £20,000 × 1.16
= £23,185.48.
Please note that you should use the full values as shown on your calculator when
doing this calculation. The figures shown in this example have been rounded to two
decimal places, where appropriate, for presentation purposes.
2. r = 0.06
n = 12
so
EAR/APR/AER = (1 + r/n)n – 1
= (1 + 0.06 ÷ 12)12 – 1
= (1.005)12 – 1
= 1.0617 – 1
= 0.0617.
And multiply by 100 to express as a % to two decimal places
AER = 6.17%.
Please note that you should use the full values as shown on your calculator when
doing this calculation. The figures shown in this example have been rounded to four
decimal places, where appropriate, for presentation purposes.
3. Building Society A:
AER = (1 + r/n)n – 1
= (1 + 0.057 ÷ 2)2 – 1
= (1.0285)2 – 1
= 1.0578 – 1
= 0.0578 or 5.78%.
Building Society B:
AER = (1 + r/n)n – 1
= (1 + 0.0565 ÷ 12)12 – 1
= (1.0047)12 – 1
= 1.0580 – 1
= 0.0580 or 5.80%.
Building Society B offers a marginally better rate.
Please note that you should use the full values as shown on your calculator when
doing this calculation. The figures shown in this example have been rounded to four
decimal places, where appropriate, for presentation purposes.
4. FV = PV (1 + r)n
£10,000 = PV (1.02)3
£10,000 = PV (1.0612)
£10,000 ÷ 1.0612 = PV
PV = £9,423.22
Please note that you should use the full values as shown on your calculator when
doing this calculation. The figures shown in this example have been rounded to two
decimal places, where appropriate, for presentation purposes.
vi R02/July 2018 Investment principles and risk

5. RREAL = RNOM – RINF

RREAL = 6% – 3%
= 3%
The approximate real rate of return is 3%.
Self-test answers vii

Chapter 5
self-test answers
1. No, maximising nominal returns with investment safety is usually more important,
although inflation could be a major issue in periods of high inflation. In periods of low
inflation, it is more of an issue for longer-term investments.
2. Interest rate risk, credit risk and inflation risk are the main risks, but event risk and
liquidity risk should also be considered.
3. The five different types of credit risk are:
• Default risk – the risk the issuer defaults on an interest payment or repayment of
capital.
• Downgrade risk – the risk the bonds are downgraded by a rating agency or a
downgrade is anticipated.
• Credit spread risk – the risk that credit spreads change. A widening of credit spreads
will lead to corporate bonds underperforming gilts.
• Counterparty risk – the risk that a counterparty will not pay what it is obliged to pay
on a security or other transaction.
• Bail-in risk – the risk that financial assistance comes from the existing capital base,
i.e. the institution’s shareholders, bondholders and depositors, not a government or
central bank.
4. If the investment costs £100,000, say, and they borrow 25%, which is £25,000, then
their outlay is £75,000. If the investment falls by 10% or £10,000, then this is 13.33% of
£75,000. They have lost 13.33% of their original investment.
viii R02/July 2018 Investment principles and risk

Chapter 6.1
self-test answers
1. The authorised corporate director (ACD).
2. 90%.
3. The register must contain:
• the name and address of the unitholders;
• number of units of each type held by each unitholder; and
• the date on which the holder was registered.
4. Market the trust in any of the EU Member States, subject to that state’s marketing rules.
5. An equalisation payment will usually be included in the first distribution to a unitholder
and represents a partial refund of the original capital invested (as the price paid per
unit included accrued income). It is not subject to income tax and is instead treated as a
deduction from book cost for CGT purposes.
6. A collective investment (in the form of a public limited company) that pools the money
of many investors, spreading it across a diversified portfolio of stocks and shares that
are selected and managed by professional investment managers. Investment trusts
issue a fixed number of shares and are regulated by company law, and their shares are
traded on the London Stock Exchange.
7. • The investment managers must have adequate experience.
• There must be an adequate spread of investment risk.
• The company must not control, or seek to control, or be actively involved in the
management of the companies in which it invests.
• The trust must not, to a significant extent, be a dealer in investments.
• The trust must have a board that can act independently of its management.
8. Conventional and split capital investment trusts.
9. The redemption yield measures the capital and income return on a particular share until
wind-up, expressed as an annual percentage.
10. • Zeros have fixed redemption dates, typically no more than ten years. They pay no
income and have preferential rights over the distribution of capital.
• They are issued at an initial value, which rises at a pre-determined compound annual
growth rate until it reaches the final redemption value.
11. Financial gearing is when investment trust managers borrow money to take advantage
of a good investment opportunity which they would not otherwise be able to take due
to a lack of free capital.
12. • Investment trusts approved by HMRC are not subject to any tax on gains made from
the sale of shares or other holdings in their portfolios.
• They are not subject to any tax on franked income.
• They have to pay corporation tax on unfranked income. Trusts may reduce their tax
liability by offsetting their own expenses against the unfranked income.
• Investors are liable to CGT on their profits, if they are selling investment trust shares
for more than the initial cost.
Self-test answers ix

Chapter 6.2
self-test answers
13. The MVR is applied to unitised with-profit funds and was previously known as the
market value adjustment factor.
Life offices usually reserve the right to reduce the amount paid on surrender of a policy
during times of adverse market conditions and do this by applying the MVR.
It does not usually apply on death or maturity. Its aim is to prevent the value of assets
leaving the fund exceeding the value of the underlying assets.
14. Distribution bonds – suitable for cautious investors requiring income.
15. • Conventional with-profit endowment.
• Low-cost endowment savings plans.
• A unitised with-profit fund of a unit-linked contract.
16. • Guaranteed income bonds.
• High income bonds.
• Guaranteed growth bonds.
• Unit-linked bonds.
• Distribution bonds.
• Guaranteed/protected equity funds.
• With-profit bonds.
17. • Death of the life assured.
• Maturity.
• Surrender or final encashment of a policy.
• Certain part surrenders.
• Assignment for money or money’s worth.
18. To provide the private investor with a liquid market in property investment through a
widely accessible savings and investment vehicle, which has a tax treatment that is
closely aligned to the tax arrangements in place for direct investment in property.
19. Distributions from REITs can comprise of two elements:
• A payment from the ring-fenced (tax-exempt) property letting element. For
individual investors, this is treated as UK property income, and will be paid net of
basic-rate tax (20%). Non-taxpayers can reclaim the tax deducted. ISA investors
receive payments gross. Higher- and additional-rate taxpayers will pay extra.
• A dividend payment from the non-ring-fenced (non-exempt) element. This will be
treated in the same way as any other UK dividend. Whether they owe any tax
depends on the investor’s individual tax position.
20. Re-investment must take place in the period beginning one year before and ending
three years after the disposal giving rise to the gain:
• deferred gain is brought into charge when the EIS shares are disposed of, unless a
further qualifying reinvestment is made;
• CGT rate applied to a deferred gain will be the rate at the time the deferral ends and
the gain becomes liable to tax;
• gains arising on the disposal of EIS investments that qualified for income tax relief
are exempt from CGT as long as the shares have been held for three years; and
• losses on EIS investments are allowable where either income tax relief or CGT
deferral relief has been obtained, although a deduction is made for the initial income
tax relief that has been given. A loss can be set against either chargeable gains or
income.
21. UK resident children aged under 18 who do not have a CTF.
x R02/July 2018 Investment principles and risk

22. At age 18 the Junior ISA will by default become an adult ISA. The funds are then
accessible to the child.
23. Sell FTSE 100 futures or buy a FTSE 100 put option.
24. • Long/short funds;
• relative value funds;
• event driven funds; and
• tactical trading funds.
25. Three from:
• There may be higher volatility of performance, because fewer investments will be
held than within a collective investment.
• For smaller portfolios, the costs may be higher.
• Direct investment generally requires greater involvement by an investment manager,
particularly for an advisory client.
• The results may be more variable, because they depend largely on individual
managers, and the performance of one or two stocks could have a disproportionate
effect on the overall portfolio.
• In larger portfolios, CGT may be payable on gains realised within the directly-
invested portfolio. It may be necessary to switch individual investments more
frequently than collective investments, thereby possibly incurring a CGT charge.
• There may be more administration than with collective investments, although this
will usually be minimised by the use of nominee and other services such as dividend
collection.
• Value added tax (VAT) will be charged on management fees, which are not tax
relieved in any way.
Self-test answers xi

Chapter 7
self-test answers
1. The longer an investor can hold onto volatile investments, such as shares or property,
the greater is the likelihood that they can ride out cyclical or other short-term
downturns.
2. There are two reasons why liquidity within a portfolio can be advantageous: a) the
client may have unexpected needs for cash, which could result in serious capital loss if
market prices are low; b) it enables clients to take opportunities for adding to holdings
at times of distress or panic selling.
3. This is a relatively long time horizon and there is no mention of liquidity requirements,
so it is likely that the client is willing to tolerate a medium or high level of risk in the
portfolio. In this case, equities are a more appropriate investment than short-term gilts.
xii R02/July 2018 Investment principles and risk

Chapter 8 self-test
answers
1. By using long-run, historic average returns and volatility data for the major asset
classes as the basis of constructing portfolios.
2. Actual (or ‘realised’) return and volatility over the investment period do not correspond
to those assumed in the portfolio modelling process.
3. Cash and gilts.
4. Value investing.
5. Closed-ended funds are more volatile because of their gearing and the variations in the
discount/premium to NAV.
Self-test answers xiii

Chapter 9
self-test answers
1. The MWR for a portfolio would be:
MWR = (426,500 – 384,000 + 16,000) ÷ 384,000
= 0.1523
= 15.23%.

2. MWR is used to calculate a valid rate of return for a portfolio, while TWR is used to
compare performances of portfolios as the calculation is not distorted by new
investment influxes and cash flows.
3. The Sharpe ratio measures the return above the risk-free rate for every unit of risk
taken (as measured by the standard deviation). It identifies whether the return on a
portfolio is due to the skilful decisions of the manager or the result of taking excessive
risk.
4. Jensen’s alpha measures the difference between the return you would expect from a
security, given its beta, and the return it has actually produced. For a portfolio, it is the
return that is independent of the market and is a measure of a manager’s stock picking
skills.
5. a. The information ratio measures the relative return achieved by an investment
manager divided by the risk taken relative to a benchmark (tracking error).
b. A positive information ratio indicates that the manager has added value through
active management.
xiv R02/July 2018 Investment principles and risk
 xv

Legislation
E
European Savings Directive, 6F7A

F
Finance Act 1998, 6H19, 6H23
Financial Services and Markets Act 2000,
6G4
Financial Services and Markets Act 2000
(FSMA), 6C5

I
Income and Corporation Taxes Act 1998,
6G4

M
Markets in Financial Instruments Directive II
(MiFID II), 7A1, 7A1K, 8F2, 8L5

T
Trustee Act 2000, 8L2A

U
UCITS III, 6B6, 6F4
xvi R02/July 2018 Investment principles and risk
 xvii

Index
A basis, 6C22
offer spread, 6C22
absolute return funds, 6Q
price, 6C22, 6G2A
accumulation
bond
and decumulation, 7C5
compared with offshore funds, 6H22
of regular savings, 4A4A
compared with onshore bonds, 6H21
accumulation and decumulation
distribution, 6H17
investment strategy for, 7A1E
factors affecting prices, 1B5
risk profiles, 7C1
life assurance, 8G4
ACD, 6D
markets, 1B3
advice, providing investment, 7A
offshore, 6H20, 8G4
AER, 4A3A
titles, 1B1A
alternative investments, 1E
yields, 1B4
commodities, 1E2
bottom-up method of portfolio
works of art and collectables, 1E1
construction, 8E2
annual
box, 6C22
equivalent rate (AER), 4A3A
business cycles and investments, 2C1
management charge, 6G12A
business relief (BR)
percentage rate (APR), 4A3A
AIM shares, 1C2
APR, 4A3A
arbitrage pricing theory (APT), 3C1
asset allocation, 7C, 8A
across tax wrappers, 8G2, 8H1 C
diversification, 7C2 capital asset pricing model (CAPM), 3B
implementing, 8C1 assumptions for, 3B3
pragmatic approach, 8A2, 8A3, 8A4 formula for, 3B2
rebalancing, 7C4 limitations of, 3B4
strategic and tactical, 7C3, 8C cash
theoretical approach, 8A1, 8A3, 8A4 effects of inflation on, 2E4A
authorisation of funds, 6B8 general characteristics, 1A1
authorised corporate director (ACD), 6D interest rates and, 2E6A
investments, 1A
ISAs, 1A3E

B risks of, 1A2

charges, 6G12, 6G12C, 8F2
balance of payments, 2F
annual management, 6G12A, 8F2
capital account, 2F2
bid-ask spread, 8F2
current account, 2F1
initial, 8F2
bank and building society accounts, 1A3
ongoing charges figure (OCF), 6G12B, 8F2
foreign currency deposits, 1A3C
performance-related, 8F2
instant access accounts, 1A3A
stamp duty, 8F2
offshore sterling deposit accounts, 1A3D
turnover, 8F2
restricted access accounts, 1A3B
churns, 8L6
behavioural finance, 3E
client
criticisms of, 3E1D
data, 7A1B
over and under reaction, 3E1C
objectives, 7B1, 8C
overconfidence, 3E1C
relationship, 7A1A
prospect theory/loss aversion, 3E1A
reporting, 8L5
psychological factors, 3E1
closed-ended funds/investment trust
regret, 3E1B
companies
beta, 3B1
capital structure, 6G5
bid
charges, 6G12, 6G12A, 6G12B, 6G12C
ask spread, 8F2
xviii R02/July 2018 Investment principles and risk

conventional trusts, 6G5A

dealing in, 6G14
E
economic and financial cycles, 2C
disclosure requirements, 6G13
efficient frontier, 3A3, 8B
discounts and premiums, 6G2C
limitations of, 3A3A
dividends and taxation, 6G17
Efficient market hypothesis (EMH), 3D, 3D2
gearing, 6G11, 6G11A
semi-strong efficiency, 3D1
investment performance, 6G3
strong form efficiency, 3D1
ISAs, 6G16
weak form efficiency, 3D1
main categories of, 6G1
EISs, 8G4
offshore, 6G18
EMH, 3D
ongoing charges figure (OCF), 6G12B, 8F2
Enterprise Investment Schemes (EISs), 8G4
operation of, 6G2
risks, 6K1C
property authorised (PAIFs), 6J2A
tax relief, 6K1A, 6K1B
regulation and approval, 6G4
equalisation, 6C8
savings and investment schemes, 6G15
equities, 1C, 2C1B
share
dealing in, 1C2
buy-backs, 6G10
effects of inflation on, 2E5A
classes, 6G7
factors affecting prices, 1C1
split capital, 6G6
indices, 1C6
suitability for investors, 6G9
interest rates and, 2E6C
vs. unit trusts and OEICs, 6G19
ordinary, 1C3B
warrants, 6G8
preference, 1C3A
collective investment schemes, 6A
private, 1C4
combined method of portfolio construction,
types of, 1C3
8E3
underlying investments in offshore funds,
commodities, investment in, 1E2
6F8A
‘contrarianism’ style of fund management,
ETFs
8E4
ethical fund selection, 8F7
convertible bonds, 1B9
issues, 7A1G
corporate fixed-interest securities, 1B8
event risk, 5A7
correlation, 3A2C, 8B1
exchange
Cryptocurrencies, 1E3
rate, 2E7
currency
effect of, on domestic shares, 2E7B
accounts, 1A3C
effect of, on foreign investments, 2E7A
risk, 5A5
exchange traded commodities (ETCs), 6I2
underlying investments in offshore funds,
exchange traded funds (ETFs), 6I1
6F8C, 6F8D
exchange traded notes (ETNs), 6I3
exchange traded products, 6I

D
defined contribution (DC) pension
arrangements
F
Fama and French model, 3C
derivatives, 6O, 8E5
finance, Islamic, 6S
futures, 6O1
Financial Services Compensation Scheme
options, 6O2
(FSCS), 1A2A
taxation of, 6O4
fiscal and monetary policy, 2D
using futures and options, 6O3
fixed interest securities
deflation, 2E3
bond markets, 1B3
direct investment compared to indirect
bond titles, 1B1A
investment, 6T
bond yields, 1B4
discounting of regular savings, 4A4A
convertible bonds, 1B9
discretionary management services, 8I
factors affecting bond prices, 1B5
tax management as part of, 8H
floating rate notes, 1B10
disinflation, 2E2
general characteristics, 1B1
distribution bonds, 6H17
gilts, 1B7
diversification, 3A2B, 5B, 7C2
yield curves, 1B6
Index xix

fixed-interest securities, 1B, 2C1A eligibility, 6L2

corporate, 1B8 innovative finance ISA, 6L10, 6L12
effects of inflation on, 2E5 invalid, 6L7
interest rates and, 2E6B investing in, 6L5, 6L8
underlying investments in offshore funds, junior, 6L14
6F8B Lifetime ISA, 6L10
floating rate notes, 1B10 NS&I direct, 1A4A
foreign currency accounts, 1A3C stakeholder standards, 6L9
forward pricing, 6C23 stocks and shares
friendly society policies, 6H24 investment trusts, 6G16
FRNs, 1B10 OEICs, 6D3
FSCS, 1A2A unit trusts, 6C16, 6C17
fund structure of, 6L3
active, 8E1 subscription limits, 6L4
management tax advantages, 6L6
and administration, 6D2 termination, 6L13
styles, 8E4 transfer between managers, 6L12
objective, 8F1 types of, 6L10
of funds, 6E1A inflation
of hedge funds, 6P causes of, 5A2D
passive, 8F6 deflation, 2E3
index-tracking, 8E1 disinflation, 2E2
selection, 8F effect of, on investments, 2E4, 5A2B, 5A2C
future value (FV) end of?, 5A2E
definition of, 4A1 risk, 1A2B, 5A2A
linking with present value, 4A2 initial charge, 6L11A
futures, 6O1 instant access accounts, 1A3A
insurance company property funds, 6J2B
interest rate(s), 2E6
G (r) definition of, 4A1
gearing, 5C, 6G11 risk, 1A2C, 5A3
financial, 6G11 investment
risk of, in investment trusts, 6G11A advice, 7A
structural, 6G11 analysis, 7A1C
‘Growth At A Reasonable Price’ fund choice of tax wrappers, 7A1H
management (GAARP), 8E4 client relationship, 7A1A
Guaranteed Growth Bonds, 1A4H ethical issues, 7A1G
Guaranteed Income Bonds, 1A4G gathering client data, 7A1B
management services, 9A2
ongoing charges figure (OCF), 6G12B
H platforms, 7A1I
presenting recommendations, 7A1J
hedge funds, 6P
process, 7A1A
common features, 6P1
ratios, 1C5
funds of, 6P1E
dividend cover, 1C5C
risks in, 6P2
dividend yield, 1C5B
hedging, 3A2A
earnings per share (EPS), 1C5A
a future purchase, 6O3A
limitations of, 1C5F
a portfolio, 6O3B, 8E5
net asset value (NAV), 1C5E
historic pricing, 6C23
price earnings (PE) ratio, 1C5D
risk profile, creating, 7A1D
selecting funds, 7A1F
I specific risk, 3A3A
individual savings accounts (ISAs), 1A3E,
strategy for asset allocation, 7A1E
6L, 8G4
strategy, factors affecting, 8L2
cash, 1A3A
charges and expenses, 6L11
xx R02/July 2018 Investment principles and risk

trust companies/closed-ended funds, 6G segmentation, 6H26

capital structure, 6G5 taxation of, 6H25
charges, 6G12, 6G12A, 6G12B, 6G12C unit-linked
conventional trusts, 6G5 bonds, 6H16
dealing in, 6G14 funds, 6H8
disclosure requirements, 6G13 returns, 6H10
discounts and premiums, 6G2C savings plans, 6H13
dividends and taxation, 6G17 with-profit policies, 6H2, 6H3, 6H4, 6H5,
gearing, 6G11, 6G11A 6H6, 6H7
investment performance, 6G3 liquidity risk, 5A6
ISAs, 6G16
main categories of, 6G1
offshore, 6G18 M
ongoing charges figure (OCF), 6G12B, management
8F2 investment, 9A2
operation of, 6G2 services, discretionary, 8H
property authorised (PAIFs), 6J2A manager
regulation and approval, 6G4 fund, selecting a, 8F3, 8F4, 8F5
savings and investment schemes, 6G15 of managers funds, 6E1B
share buy-backs, 6G10 unit trust, 6C1, 6C1B
share classes, 6G7 market
split capital, 6G6 makers’ spread or turn, 6G2A
suitability for investors, 6G9 risk, 3A4
vs. unit trusts and OEICs, 6G19 value reduction, 6H2A, 6H2B
warrants, 6G8 maximum
investment policy statement, 8L1, 8L3 investment plans, 8G4
investments, Sharia-compliant, 6S spread, 6C22
modern portfolio theory, 3A, 8A1
‘momentum’ fund management style, 8E4
K monetary policy, 2D2
Key Investor Information Document (KIID) money
platforms, 6G13 market investments, 1A5
characteristics of, 1A5A
investment vehicles, 1A5C
L types of, 1A5B
Land and Buildings Transaction Tax (LBTT), multi-asset funds, 6Q1
1D4 multi-factor models, 3C
Land transaction tax (LTT), 1D5 multi-manager products, 6E1
life assurance based investments, 6H MVR, 6H2A, 6H2B
appeal of, 6H11
as an investment, 6H28
bonds, 8G4 N
as trust investments, 6H19 National Savings and Investments (NS&I)
bonuses, 6H2A products, 1A4, 6M
distribution bonds, 6H17 bank accounts, 1A4F
early encashment, 6H14 children’s bonds, 1A4C
friendly society policies, 6H24 direct ISA, 1A4A
insurance vs. investment, 6H1 income bonds, 1A4D
investment-linked funds, 6H9 investment bonds, 1A4E
lump sum investments, 6H15 savings certificates, 1A4B
MVR, 6H2A, 6H2B net asset value (NAV), 6G2B
offshore bonds, 6H20
compared with offshore funds, 6H22
compared with onshore bonds, 6H21 O
personal portfolio bonds, 6H23 OEICs, 6D
second-hand policies, 6H27 advantages to, 6D5
Index xxi

and unit trusts, 6E personal

approved securities and eligible markets pensions/SIPPs, 8G4
for, 6B5 portfolio bonds, 6H23
borrowing by, 6B7 platforms, 6E2, 7A1I
diversification rules for, 6B6 policy statements, investment, 8L1
fund management and administration of, political
6D2 effect of factors on world economies and
general characteristics of, 6B globalisation, 2B1
investment powers and restrictions of, 6B4 political risk, 5A8
investment risks of, 6B3 portfolio
investment strategy for, 6B2 client reporting, 8L5
ISAs, 6D3 construction, 8E
management services for, 6E bottom-up methods, 8E2
product structure, 6D1 Combined approaches, 8E3
sectors and categories of, 6B1 top-down methods, 8E1
single pricing, 6D4 investment policy statement, 8L1
taxation of, 6D6 reviewing, 8L3
vs. investment trusts, 6G19 investment strategy, 8L2
offer modelling, stochastic, 8B3
basis, 6C22 monitoring, 7A1K
price, 6C22, 6G2A new products and services, 8L4
offshore optimisation, 8B
accounts, 1A2D rebalancing, 8L6
bonds, 6H20, 8G4 reviews, 8L
compared with offshore funds, 6H22 predictions, 8A3, 9A1
compared with onshore bonds, 6H21 present value, 4A4
funds, 6F, 6F6, 6F7 definition of, 4A1
classes of recognised schemes, 6F2 linking with future value, 4A2
investment companies, 6G18 primary market, 1B3A, 2G1
OEICs, 6F3A private equity, 6K
property companies, 6J3 property, 1D
specialist, 6F3B authorised investment funds (PAIFs), 6J2A
UCITS, 6F4 based investments, 6J
UK marketing status, 6F5 choosing, 1D1B
umbrella, 6F3A commercial, 1D7
underlying investments, 6F8 drawbacks to investing in, 1D1A
sterling deposit accounts, 1A3D expected yield in, 1D2
ongoing charges figure (OCF), 6C24, insurance company property funds, 6J2B
6G12B, 8F2 investment in residential, 1D1
ongoing management charge (OCF), 6G12B letting part of main residence, 1D6
operational risk, 5A9 offshore property companies, 6J3
options, 6O2 real estate investment trusts (REITs), 6J4
shares in listed property companies, 6J1
tenure, 1D1C
P unit trusts and investment trusts, 6J2
past performance, 9A1 provider selection issues, 8J
pensions, 8G4
defined contribution (DC) arrangements,
6N Q
performance Quick guide for financial advisers, 1A4
investment, 9A
measurement, 9B
past, 9A1 R
ratios, 9B2 ratios
performance attribution, 9C alpha, 9B2B
information ratio, 9B2C
xxii R02/July 2018 Investment principles and risk

Sharpe ratio, 9B2A systematic risk, 3A4

real estate investment trusts (REITs), 6J4 vs. unsystematic risk, 5A1
real returns, 4B
vs nominal returns, 4B
rebalancing portfolios, 8L6 T
recommendations and suitability, 8K tactical asset allocation, 7C3, 8C
reporting, client, 8L5 tax
restricted wrappers, 7A1H
access accounts, 1A3B tax wrappers, 8H1
wraps and platforms, 8H choice of, 7A1H
reviews, portfolio, 8L gains, 8G3
risk planning with, 8G3
adjusted returns, 9B2 selection of, 8G, 8G3
alpha, 9B2 taxation
information ratio, 9B2 of funds, 6F7
Sharpe ratio, 9B2 of investors, 6F6
and return objectives, 7B Technological change, 2A5
client objectives, 7B1 time
constraints, 7B2 period (n)
profile, 7A1D, 7C1 definition of, 4A1
of funds, 7A1F value of money, 4, 4A
types of, 5A weighted rate of return (TWR), 9B1B
currency, 5A5 Top-down methods of portfolio
event, 5A7 construction, 8E1
inflation, 5A2 total expense ratio (TER), 6G12B
interest rate, 5A3 Trends in investment markets, 2A
liquidity, 5A6 effect of elections and inflation on, 2A1B
operational, 5A9 effect of speculative fashions on, 2A3
political, 5A8 impact of international relations on, 2A2
systematic vs. unsystematic, 5A1

U
S UCIS, 6B8
SDLT, 1D3 UCITs, 6F4
second-hand life policies, 6H27 Directives, 6F4A
secondary market, 1B3B, 2G1 Undertakings for Collective Investments in
Seed Enterprise Investment Schemes Transferable Securities (UCITS), 6F4
(SEISs), 6K1D Directives, 6F4A
segmentation, 6H26 unit trusts, 6B, 6C
share exchange facilities, 6C20 and OEICs
share indices, 1C6 approved securities and eligible markets
Sharia law, 6S for, 6B5
socially responsible investing (SRI), 7A1G, authorisation of funds, 6B8
8F7 borrowing by, 6B7
socio-economic issues, 2A4 diversification rules for, 6B6
stakeholder standards, 6L9 general characteristics of, 6B
Stamp duty land tax (SDLT), 1D3 investment powers and restrictions of,
standard deviation, 3A1 6B4
stochastic portfolio modelling, 8B3 investment risks of, 6B3
strategic asset allocation, 7C3, 8C investment strategy for, 6B2
structured products, 6R, 8E6 management services for, 6E
characteristics of, 6R1 sectors and categories of, 6B1
returns, 6R3 vs. investment trusts, 6G19
risks, 6R4 bid
types and methods of investing, 6R2 basis, 6C22
switching, 8L6A, 8L6B offer spread, 6C22
Index xxiii

price, 6C22 conventional, 6H3B

buying and selling, 6C18, 6C19, 6C22 endowment savings plans, 6H12A
certificates, 6C3 disadvantages of, 6H6
charges, 6C24 low-cost endowment savings plan, 6H12B
distributions, 6C9, 6C13 MVR, 6H2B
equalisation, 6C8 performance, 6H4
forward pricing, 6C23 unitised, 6H3A
general rules, 6C6 works of art and collectables, investment in,
historic pricing, 6C23 1E1
impact of allocations on unit prices, 6C15 world economies and globalisation, 2B
income political factors of, 2B1
allocations, 6C9 wraps and platforms, 6E2, 8H
and accumulation units, 6C14 administration fees and transparency, 8H1
link to ISAs, 6C16, 6C17
managers, 6C1, 6C1B
maximum spread, 6C22 Y
offer yield curves (bonds), 1B6
basis, 6C22
price, 6C22
pricing and valuation, 6C21
registration, 6C2
reporting, 6C4
share exchange facilities, 6C20
tax elected funds, 6C12
taxation
fund, 6C7
management, 8H
of investor, 6C10, 6C11
trustees, 6C1, 6C1A
unitholder rights, 6C5
unit-linked
bonds, 6H16
funds, 6H8
returns, 6H10
savings plans, 6H13
unsystematic risk, 3A4
vs. systematic risk, 5A1

V
‘value’ fund management, 8E4
VCTs, 8G4
Venture Capital Trusts (VCTs), 6K2, 8G4
qualifying as a, 6K3
risks, 6K4
tax relief, 6K2A
volatility of returns, 3A1

W
warrants, 6G8
with-profit policies, 6H2
advantages of, 6H5
bonuses, 6H2A
closed, 6H7
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