Investments - Generic

Question 1

An investment policy statement should sum up the investment strategy by setting out:

Answer 1

• the purpose of the investments
• the income or growth objectives
• the timescale
• a statement about risk profile
• a statement about asset allocation
• other issues such as SRI

Question 2

Describe active fund management

Answer 2

• Active fund management introduces human factor
• manager aims to use their skill to outperform the market
• main approaches are:
• top down - where the fund manager considers asset allocation first before considering sector and stock selection
• bottom up - where they select single stocks based on their own merits - stock picking
• many investment managers now use a mix of underlying active and passively managed funds
• the term “core satellite” portfolio is often used for a portfolio that is mainly indexed (its core) with actively managed, often specialist, funds around it (its satellite)

Question 3

The main passive fund management techniques are:

Answer 3

• Buy and hold - buy stocks and hold them regardless of market conditions
• Indexation - this aims to replicate an index with no attempt to outperform it

Question 4

The main types of indexation are:

Answer 4

• full replication - buying every stock in the index. Advantage is it will be accurate but disadvantage is expensive
• stratified sampling - buying a representative sample of the stocks in the index. Less expensive but potentially encourages biases to those stocks with the best perceived prospects
• optimisation - using a statistical model of the market to make buy and sell decisions. Costs less than replicating the index but can be more complex

Question 5

What are the benefits of tracker funds

Answer 5

• low/cost effective
• run by computer system/no human judgement
• potential for growth
• perform in line with the index
• exposure to different asset classes
• geographical diversification/global
• can track any index/wide range of indices to track
• simple to understand/easy access to markets

Question 6

What are the drawbacks of tracker funds

Answer 6

• will underperform the market due to charges
• tracking error/will never match the market exactly
• perform poorly in falling market
• no active management/alpha
• currency risk due to global index trackers
• lack of control over underling assets

Question 7

Advisory versus Discretionary

Explain Advisory service

Answer 7

Advisory

• manager ascertains ATR and a suitable asset allocation
• manager makes recommendations about which shares to buy and sell
• client makes the decision whether to accept the advice
• the manager charges based on the value of assets in their portfolio
• the manager should produce an end of year statement for tax return completion

Question 8

Advisory versus Discretionary

Explain Discretionary service

Answer 8

Discretionary

• manager ascertains ATR and a suitable asset allocation
• the manager buys and sells shares on their behalf
• they may specify areas in which they do not wish to invest
• trading limit may be imposed that cannot be exceeded without referring to client
• the manager will charge based on the value of assets in their portfolio
• the charge will be higher than for the adviser service
• the manager should produce an end of year statement for tax return completion

Question 9

Benefits and drawbacks of using a DFM

Answer 9

Benefits
- professional active management giving the potential for higher returns
- regular reviews
- will give a bespoke service specifically targeting objectives
- no requirement for ongoing involvement
- consolidated tax statements provided/information (useful for tax returns)
- wider investment options
- can utilise tax efficient allowances
Drawbacks
- higher charges
- no guarantee of performance
- may not provide regular service
- lack of control
- may invest in unacceptable sectors
- may not provide tax advice/tax efficiency is not always considered

Question 10

What are the benefits of holding investments on a platform?

Answer 10

• Quick transfer process with minimal effort for Jim and Sandra
• Easy access online at all times
• total wealth can be seen at the press of a button
• wide range of providers/asset classes/funds/investments/tax wrappers
• performance is easy to obtain
• full details of investments - online switching
• consolidated tax statements are automatic
• time and effort efficient for tax returns
• can promote good relationship with adviser
• unbundled charging/transparent
• funds can usually be bought without an initial charge
• large portfolios can attract volume discounts
• calculation tools
• reduced paperwork/admin
• reports and valuations can be stored online
• automatic rebalancing

Question 11

Why is diversification important?

Answer 11

• can reduce risk in a portfolio
• by holding a different range of assets
• each different investment can perform well in certain markets
• downside risk of an investment can be offset by the upside potential of another one
• can reduce stock specific risk but not market risk

Question 12

Main benefits of investing in a diversified investment portfolio

Answer 12

• reduces volatility/risk
• non correlated assets
• can match ATR
• can be rebalanced
• potential for higher returns

Question 13

Explain how diversification can be used to manage and reduce risk

Answer 13

• reduces risk by reducing concentration/increasing number of asset classes
• some asset classes are not strongly correlated - a loss of one might not mean a loss of another
• geographical diversification spreads the risk across several different economies/currencies/national markets
• sector diversification reduces the risk associated with specific areas of the economy or firms

Question 14

State the limitations of using an asset allocation model

Answer 14

• doesn’t recommend an appropriate tax wrapper/take account of tax position
• charges are not considered
• questions asked aren’t always relevant
• different models produce different results
• underlying assumptions subject to change/based on historic model
• needs to be reviewed

Question 15

Explain why a multi-asset fund may be suitable for Jim’s ATR

Answer 15

• diversification across all asset classes/geographical spread
• potential for growth
• correlation of assets controlled/non correlation
• reduces volatility/risk
• actively managed/professional management
• rebalances regularly
• risk rated to match ATR
• access to specialist investments - eg ETFs, derivatives

Question 16

Describe the features of a VCT

Answer 16

• minimum investment of 80% in unquoted companies including AIM
• max 15% in one company with a minimum of 10% in ordinary shares
• dividends are exempt from income tax from VCT investments up to £200,000 per tax year
• 30% income tax relief on the first £200,000
• 5 year holding period
• no CGT (no holding period)
• no reinvestment relief
• forms part of estate for IHT

Question 17

Describe the features of an EIS

Answer 17

• investment in unquoted trading companies including AIM companies
• dividends are liable to income tax
• 30% income tax relief up to £2m - any amount over £1m must be invested in knowledge intensive companies
• 3 year holding period
• CGT free after 3 years
• reinvestment relief available
• 100% business relief after 2 years for IHT

Question 18

Descibe the features of an SEIS

Answer 18

• designed to help small start up unquoted companies raise finance
• dividends are liable to income tax
• 50% income tax relief on first £100,000
• 3 year holding period
• CGT free after 3 years
• reinvestment relief available - 50% exempt of the reinvested amount
• 100% business relief after 2 years for IHT