AF4 Investment Planning

Question 0

Absolute return funds a.k.a hedge funds

1. They are able to use derivatives
2. They can short a holding so if its price falls the fund makes a profit
3. This should provide steady growth rather than high peaks and deep troughs (see/saw effect)/neutralise volatility/non correlation
4. They are not limited to any specific sector/strategy
5. Can hold any asset class to any proportion of the value
6. Aim to provide a positive return
7. Cash plus

Answer 0

Disadvantages

1. High charges
2. Opaque investment structure/strategy
3. High risk/geared investment
4. High minimum investment levels/available investment amount gives little opportunity to diversify amongst hedge funds
5. Offshore administration/company domiciled offshore/lower regulatory standards than onshore.
6. Lack of potential liquidity
7. Lack of information on performance/investment updates
8. Reliance on a quality fund manager

Question 1

Shares - discretionary management vs OEICS (income)
Advantages
1. Diversification: Investing in a single stock or bond is very risky; owning a mutual fund that holds numerous securities reduces risk significantly. Mutual funds provide diversification, which is crucial to a well-balanced portfolio
2. Professional management: It is difficult and time consuming to pick the best stocks and bonds for your portfolio and to try to beat the benchmarks.
3. Minimal transaction costs: Buying individual stocks and bonds is expensive in terms of transactions costs. Mutual funds offer the advantage of economies of scale in purchases and sales because mutual fund transactions are typically large.
4. Liquidity: Money invested in mutual funds is generally liquid. You can usually sell your shares and collect money from open-ended funds within two business days. If the open-end funds are no-load funds, not required to pay transactions costs when you buy/redeem shares. Closed-end funds are funds that trade on stock exchanges or OTC that may trade above/below its NAV.
5. Flexibility: Owning individual stocks and bonds does not allow for much flexibility in terms of liquidity, or the ability to access your money.
6. Low up-front costs: Certain types of mutual funds have financial benefits that make them less expensive than individual stocks and bonds. For example, no-load mutual funds can be sold and redeemed without incurring any sales charges, and open-ended mutual funds can be purchased at the fund’s net asset value (NAV). A fund’s NAV is calculated daily by subtracting the fund’s liabilities from its assets and dividing the resulting amount by the number of outstanding shares.
7. Service: Mutual fund companies generally have good customer service representatives who can answer your questions and help you open accounts, purchase funds, and transfer funds. Mutual fund companies may also offer other services, including automatic investment and withdrawal plans; automatic reinvestment of interest, dividends, and capital gains; wiring funds to and from your accounts; account access via phone; optional retirement plans; bookkeeping services; and help with taxes.

Answer 1

Disadvantages

1. Lower-than-market performance: Generally, most actively managed mutual funds have not beaten their benchmarks over the long-term.
2. High costs: Unless you analyze funds carefully before you buy them, you may inadvertently choose a mutual fund that charges significant management fees, custodial fees, transfer fees, and many mutual funds charge initial charge/dilution levy.
3. Risks: Mutual funds are subject to both market-related risks and asset-related risks, particularly in very concentrated portfolios, which are not as well diversified.
4. Premiums or discounts: Closed-end mutual funds may be traded at a premium (discount) to the fund’s underlying net asset value. These premiums are based on investor demand more than they are based on actual share value; therefore, premiums are not constant over time.
5. New investor bias: Shares purchased by new investors dilute the value of the shares owned by current investors. When new money enters the mutual fund at net asset value, the money must be invested, which costs roughly 0.5 percent in an average U.S. stock fund. Thus, the funds of current investors are used to subsidize the purchase of the new investors’ shares.
6. Cash drag - funds need to keep cash aside for investors who want to sell their investments.

Question 2

Exchange traded commodities

Structured as debt security

Answer 2

Advantages

1. Will only risk initial investment
2. Liquid
3. No expiry date/no physical delivery
4. Diversification

Disadvantages

1. Volatile
2. Usually tracks an index rather than a specific grade or quality commodity
3. Possible counter party risk

Question 3

REITs real estate investment trusts

1. Market sentiment affects investor demand for REITs shares
2. This will impact positively or negatively on the REITs share price
3. Which in turn will mean the REIT can trade at a discount or premium to net asset value

Property income distributions are taxed as income, non PID is taxed as dividend income

Can be ISA and pension wrapped

Answer 3

1. At least 75% of gross profit arises from property lettings.
2. Interest on borrowings must be at least 125% covered by rental profits.
3. They must pay out 90% of rental profits as dividends.
4. They must be UK resident.
5. They must be listed on a recognised stock exchange
6. They must be close ended

Question 4

Alternative investment

1. An alternatives investment is an investment product other than traditional investments such as stocks, bond or cash
2. The aim is to have minimal or no correlation with traditional investments to increase diversification to investor portfolios

Answer 4

1. Real estate/Property
2. Private equity/EIS/VCT
3. Commodities
4. Hedge funds
5. Derivatives
6. Structured Products
7. Events & Insurance related risk - e.g. Films/Shows Life Policies
8. Collectables - Art, Wine, Antiques, etc
9. Resources - Water, trees, renewable fuels etc

Question 5

Exchange traded funds a.k.a ETF’s

1. ETF’s are very efficient index trackers
2. Empirical evidence shows that the majority of actively managed funds fail to outperform leading index tracking funds over the medium to long term
3. The costs of buying and management of index tracking funds are lower than most actively managed funds or portfolios and ETF’s have particularly low expense ratios
4. ETF’s trades throughout market opening hours similar to share and therefore more liquid than managed funds
5. Dividends received by an ETF are usually reinvested immediately so there is no cash drag
6. ETF’s are free of UK stamp duty
7. ETF’s can be shorted
8. Can offer physical/synthetic tracking and swap based performance.

Answer 5

Tracker fund comparison

Advantages
1. Diversification - one ETF can give exposure to a group of equities, market segments or styles - Tracker fund will track one index.
2. Swap based ETF can benefit from backwardation - where new future contract for same exposure cost less than the expiring one, generating positive roll return
Disadvantages
1. ETF’s track a broader market so yields maybe lower
2. Low volume ETF’s may have an excessively high bid/offer spread
3. Leveraged ETF’s could magnify losses
4. Index funds don’t generally charge an initial charge and there is no broker commission to pay
5. Can be too much choice/complexity for investor in comparison to easy to understand tracker
6. Swap based ETF’s can suffer from contango - where new future contract for same exposure cost more than the expiring one, creating negative roll return

Question 6

Current Ratio

Used to measure a company’s ability to pay short term obligations

Also know as liquidity ratio, cash asset ratio and cash ratio

Answer 6

Current ratio = current assets / current liabilities

The higher the ratio the more capable the company is of paying its obligations, a ratio under 1 suggests a company would be unable to pay off its obligations if they came due at that point.

Question 7

Net asset value (N.A.V)

Return of Equity

Answer 7

Value of assets/number of shares in issue

Net profit/value of shareholder funds (total assets - total liability)

1. Return of equity measures the rate of return on an investment made by shareholders and the firms efficiency at generating profits.
2. It is also a measure of earnings growth.

Question 8

Ways to reduce risk in equity holdings

Answer 8

1. Buy put options
2. Sell call options
3. Buy negatively correlated assets
4. Spread bet
5. Financial futures
6. Sell Holdings

BSBSFS

Question 9

PIBS a.k.a Permanent interest bearing shares

De-mutualised building society PIBS become perpetual subordinated bonds

Answer 9

Lowest ranking in the event of a wind up/liquidation
More affected by inflation
No end date presents greater/higher risk/volatility
Coupon can be missed/non cumulative/default risk
Capital value can reduce
Not covered under the FSCS
PIBS may be less liquid
Losses may not be carried forward
Gains exempt from CGT

Question 10

Risk profiling software

Answer 10

Drawbacks include
Assumptions used by the software are not known
Can pigeon hole the client and limits outcomes
Often based on historic data
May not ask suitable questions e.g. soft facts
May not be suitable to use for all clients
Clients often do not understand
Does not take into account client objectives i.e. growth, income, ethical considerations
Can provide a range of returns therefore often not a definitive answer is given

Question 11

Sovereign debt default

Vs

Corporate debt default

For creditors

In both cases the monetary value of the debt held will fall and the debt will become illiquid as no one will want to take on the debt of a defaulting state or company.

Answer 11

Sovereign
Default can mean devaluation of their monetary worth for creditors
Nations can default with no legal recourse for creditors
Nations are also ore willing to cancel debt held by foreign creditors
Or they may opt to restructure their debt and extend the term/reduce interest payments

Corporate
Creditors are able to issue proceedings to foreclose on any collateral used to secure the debt
Even if there is no collateral, creditors can sue for bankruptcy to ensure that the company’s assets are used to repay debts.

Question 12

Inflation

Answer 12

Main causes
Rising demand
Fueled by expanding money supply
War or shortages/decreasing supply
Currency devaluation
High wage demands and general increasing higher costs
Investment sentiment leading to investment ‘bubbles’

Question 13

AIM listing requirements

Accounts
The company must normally have published or filed audited accounts for a period ending no more than six months before the planned flotation. However, there is no requirement for a minimum trading record, as is the case for a listing on the Main Market.

Working capital
The company must be able to show it has enough working capital for its current needs and for at least the 12 months following flotation. The company’s reporting accountants will prepare a report assessing whether this is the case.

Answer 13

1. Must be public company (or equivalent)
2. Shareholders must be able to transfer their shares without any restriction and the shares must be eligible for electronic settlement
3. It must appoint a nomad (nominated adviser) and a broker (which are required for as long as the company is listed on AIM)
4. Published accounts must conform with International Accounting Standards, or, for certain countries of incorporation, their Generally Accepted Accounting Principles
5. Under the AIM Rules all companies must produce an admission document (or prospectus, if applicable), which contains the information necessary to enable an investor to assess the company’s prospects and the rights attaching to the shares to be admitted.
6. The admission document includes factual information about the company and its trading history as well as details of the directors’ backgrounds, the shareholders and financial information. Any investors investing in the company at the time of the flotation will base their investment decisions on the information contained in the admission document.
7. A prospectus is required unless one of the following exceptions apply - if the issue amounts to less than 2.5 million euros or to fewer than 100 people
8. To be suitable for listing, it must satisfy its nomad that it is suitable.
9. Nomad will look at prospects for growth, either based on sustainable revenue or future revenue.

Question 14

Investment trust vs unit trusts

Advantages

1. Lower initial charges
2. Lower annual management charges
3. Can gear to leverage returns
4. Investment manager does not have to sell holdings when investor sells their shares
5. Less cash drag as no need to sit to keep cash in case investors want to sell.
6. Can keep up to 15% dividends in reserve to keep income payments stable in volatile markets.
7. Can offer access to markets that open ended funds can’t/won’t such as hedge funds and other illiquid markets.

Answer 14

Disadvantages

1. Fixed number of shares mean that assets can trade at discount/premium to asset value - margins can widen/narrow depending on perception/circumstances.
2. Gearing can magnify losses.
3. In falling markets NAV of investment will fall alongside widening discount increasing losses.
4. More volatile as traded directly on the stock exchange
5. Can invest in more volatile markets, making them riskier than open ended funds.

Question 15

130/30 funds

1. 100% of the fund is invested in long only stocks that are favoured by the fund manager
2. 30% of the fund goes short/sells stocks that the manager believes will fall in value
3. The proceeds from the 30% short selling of unfavoured stocks allows the fund manager to buy an additional 30% of favoured stocks and therefore the final position is 130% long and 30% short

Answer 15

Advantages

1. 130/30 funds are authorised and regulated in the UK thus, providing some investor protection
2. The extent of any short selling, which can be highly risky, is limited by the proportion of short to long holdings

Disadvantages

1. 130/30 funds are limited in terms of the type of underlying investment, they cannot go totally short even if that might prove profitable
2. They could be at a disadvantage to hedge funds in a falling market as they can’t go 100% short

Question 16

Corporate Bonds

Answer 16

1. Issued by companies
2. At least one year duration at issue
3. Listed on exchanges/tradable
4. Pay a regular coupon/income
5. Coupon is taxed as income
6. Repayment/par value at maturity
7. Will have a risk/credit rating
8. Taxable to income

Question 17

Structured products

Market participation
Purchase of a call option.
If the underlying index rises the call option will give a positive participation in the relevant index.
But the remainder of the portfolio will be invested to give a return of the original investment at maturity.

Answer 17

Advantages

1. The income is usually higher than that available from cash deposits
2. The income is fixed so there is a known quantity for budgeting
3. The income is fixed for the term
4. They can be used in a pension/ISA

Disadvantages

1. They are illiquid
2. They have a fixed rate of return, so might prove uncompetitive with open market over the term
3. They may suffer from counter party insolvency risk
4. They may suffer from provider insolvency
5. The relevant index might fall below the protection level resulting in capital loss
6. Their income could cease if index fails to perform accordingly

Question 18

Information Ratio

Is a measure of risk adjusted return in relation to the benchmark, the higher the information ratio the better. Positive IR is indication of above average management.

Active return/Tracking Error = Information Ratio

Alternative method is alpha/tracking error

Answer 18

Rp-Ri/Tracking error

Rp = return of the portfolio
Ri = return of the index
Tracking error represents how closely the portfolio or fund tracks the relevant index to which it is benchmarked

Active return is portfolio return minus index return.

Tracking error = standard deviation.

Question 19

Investor policy statement

Answer 19

It is a written statement on how portfolio is to be managed
Establish investor objectives
And their attitude to risk
Impose investment parameters/discipline/limitations/exclusions
It is a regulatory requirement
Provides reciprocal/mutual point of reference
And will reduce disputes/litigation

Question 20

Volatility a.k.a Standard Deviation

1 standard deviation will occur 68% of the time
2 standard deviation will occur 95% of the time
Most other occurrences/99% will fall within 3 standard deviations

Standard deviation measures dispersion/fluctuations/volatility/variation of returns around the mean/average/expected return.

Answer 20

Root of variance over the time period = volatility = standard deviation
Total return - expected return =
(Tr - Er)squared =
Result x probability = variance

Limitations of standard deviation
Because it uses historical data, the outcome can be manipulated by altering the time frame measured to include or exclude periods of excess volatility.
It is not intuitive, the standard deviation doesn’t mean much without some context around the results.

Question 21

Hedge fund strategy

Global macro
Fund takes sizable positions in share, bond or currency markets in anticipation of global macroeconomic events in order to generate a risk-adjusted return. Fund managers use macroeconomic (“big picture”) analysis based on global market events and trends to identify opportunities for investment that would profit from anticipated price movements. They have a large amount of flexibility due to ability to use leverage to take large positions in diverse investments in multiple markets, timing of the implementation of the strategies is important in order to generate attractive, risk-adjusted returns.

Directional
Utilize market movements, trends, or inconsistencies when picking stocks across a variety of markets. Computer models can be used, or fund managers will identify and select investments. Greater exposure to the fluctuations of the overall market than market neutral strategies. Directional hedge fund strategies include US and international long/short equity hedge funds, where long equity positions are hedged with short sales of equities or equity index options.

Answer 21

Event driven
An event-driven investment strategy finds investment opportunities in corporate transactional events such as consolidations, acquisitions, recapitalizations, bankruptcies, and liquidations. Capitalize on valuation inconsistencies in the market before or after such events, and take a position based on the predicted movement of the security or securities in question. Large institutional investors such as hedge funds are more likely to pursue event-driven investing strategies than traditional equity investors because they have the expertise and resources to analyze corporate transactional events for investment opportunities.

Relative value
Take advantage of relative discrepancies in price between securities. The price discrepancy can occur due to mispricing of securities compared to related securities, the underlying security or the market overall. Hedge fund managers can use various types of analysis to identify price discrepancies in securities, including mathematical, technical or fundamental techniques. Relative value is often used as a synonym for market neutral, as strategies in this category typically have very little or no directional market exposure to the market as a whole.

Question 22

Debt Equity Ratio

Earnings per share - indicator of a company’s profitability.

Dividends per share

Answer 22

Debt/Equity x 100

Net profits/number of shares in issue

Dividends paid/number of shares in issue x 100

Question 23

Rights issue

1. The pre rights share price is likely to fall towards the rights price
2. The post rights price is likely to rise towards the pre rights share price
3. Both prices are likely to become the weighted average price, excluding market forces

Answer 23

1. The reasons behind the rights issue
2. Is the discount on the current share price attractive?
3. How will the market react to the rights issue?
4. Would he prefer a premium for his rights issue?
5. Does the client want to own more shares in the company/sector

Question 24

Gearing

Answer 24

Gearing = Long-term debt / Shareholders funds

Question 25

Price elasticity of demand

Measures the extent to which demands responds to a given change in price

Answer 25

When a good has elastic demand, a small price decrease would lead to a large increase in demand, assuming adequate supply for the product and a reasonable profit margin. Then profitability should increase substantially with a small price decrease or decrease substantially with a small price increase.

Goods with elastic demand are usually frequently bought goods with many substitutes in competitive markets where consumers are price sensitive.

Price/quantity = axis on chart.

Question 26

Key investment ratios

Ratios that can be used to when selecting a share to meet a clients objectivise

Answer 26

Payout Ratio - indicative if a firm is a growth firm or stock is good for income generation. Lower payout ratio indicates focus is on growth
Return on equity - return of shareholder funds
Earnings per share - revenue per ordinary share
Price earnings ratio - earnings as a percentage of share price
Return on Capital Employed - return on shares and loans utilised within business
Gearing - borrowing as a percentage of shareholder funds

Question 27

Wrap platform

Typical charges
1. Initial charges. 2. Annual charges. 3. Transaction charges. 4. Product charges

Main features

1. It is an administrative platform that consolidates the valuation of the clients investments
2. It can hold the details of any asset that a client may hold
3. It permits investors to view the total value of their investments in one place
4. It allows quick detailed analysis of the clients holdings
5. Tax consolidation

Answer 27

Considerations when selecting platform(s):
• The platform provider (for example, their reputation and financial standing);
• Terms and conditions of using the platform;
• Charges – including actual cost, charging structure and transparency of charges;
• Range of funds, tax wrappers and other products available • Range of asset classes
• Functionality (for example the ability to switch or re-register off platform or record legacy assets);
• Accessibility;
• Additional tools (for example, risk profiling and asset allocation tools); and
• Support services (for example, help facilities and training).

Question 28

M0: Cash outside Bank of England + banks’ operational deposits with Bank of England. (No longer published.)

M4: Cash outside banks (i.e. in circulation with the public and non-bank firms) + private-sector retail bank and building society deposits + private-sector wholesale bank and building society deposits and certificates of deposit.

Answer 28

Ways to increase/reduce money supply

Increase
Monetary easing - BoE buying back gilts/bonds to inject money into the economy.
Lowering interest rates, reducing the benefit of saving and the cost of borrowing in an attempt to stimulate spending.

Reduce
Increasing interest rates to encourage saving and discourage borrowing

Question 29

Enterprise investment schemes

30% Income Tax relief (on investments up to £500,000 in the2011/12 tax year and up to £1m in 2012/13) if EIS held for at least 3 years
Capital Tax-free gains on any profits from the investment (after 3 years) provided income tax relief was claimed
Capital Gains Tax deferral relief
100% Inheritance Tax exemption on all investments (after 2 years)
Loss relief - can use losses (menus any income tax relief already claimed) to offset current year income tax liabilities
Can elect to offset against previous year income tax liability instead of year of purchase

Answer 29

Venture capital trusts

There were changes to the qualifying company limits from April 2012. An increase in the size of company a VCT can invest in to £15 million from £7 million, and an increase in the maximum number of employees from 50 to 250. Finally, there was an increase in the annual investment limit per qualifying company to £5 million.

Up-front income tax relief of 30% (on up to £200,000 invested per tax year if the shares are retained for five years)
tax-free dividends
tax-free capital gains (when you sell your shares)

Question 30

Nominal/par value shares - the issue value of the share

Market value of share - the market value is the amount a share is being sold at

Answer 30

A share can never trade below its par value

Question 31

Alpha - Measure of a managers stock picking skill, in terms of outperformance of the expected market returns

A.k.a CAPM model

Beta is a measure of volatility against the market as a whole

Answer 31

Alpha = E(Ri) - [Rf + Bi (E(Rm) - Rf)]
E(Ri) = expected Portfolio return
Rf = risk free return
Bi = beta
E(Rm) = expected market return

Question 32

Role of a benchmark within portfolio management

Answer 32

1. A benchmark is a mix of assets which the consensus agrees is the most likely to reflect the clients long term objectives.
2. The purpose of the benchmark is to establish the neutral/independent long term position for the portfolio.
3. The manager can chose to take a different view on any asset class from the consensus, going overweight or underweight with their exposure to the benchmark with the expectation to improve performance above that of the benchmark.
4. The benchmark thereby provides a sound basis for comparison against which to evaluate the investment performance of a manager.

Question 33

FTSE futures

Answer 33

£10 x index = 1 contract

E.g.

£10 x 5000 = £50,000 for one contract

To work out profits made

Number of contracts x number of points moved x £10 = result

Question 34

Share split

Capital reserves does not change/does not expand equity base of company.

Typically 2-1/3-1/4-1

Answer 34

Scrip issue of shares

Impact on company
Share capital is increased
Reduces retained profits/reserves of a company
Reduces the company’s ability to pay dividends
Share price reduces which makes it more marketable

Impact on shareholder
Has more shares/number of share increases
No cost to shareholder
Market value of shareholders holdings remains unchanged
Can have the effect of reducing income tax liability as selling the issue generates capital gain instead.

Question 35

Strategic asset allocation specifies the proportion of various asset classes in a portfolio designed to provide an investor with an appropriate risk/return profile over a longer period of time. A strategic asset allocation framework will specify a range of allocations appropriate for various levels of risk tolerance. For example, those with lower risk tolerance will tend to have lower exposure to more volatile, higher-risk assets such as stocks and commodities, and higher allocations to less volatile, lower-risk assets, including bonds and cash.

Answer 35

Tactical asset allocation focuses on such drivers as valuation, momentum, sentiment, the business cycle, and fiscal and monetary factors, among others, to identify asset classes that are expected to outperform in the near term or under perform their longer-term expectations.

Question 36

Futures

Similar to forwards but have a range of settlements as the position can be closed early, while forwards have a predetermined expiry date.

Answer 36

Advantages

1. High leverage/potentially high return for low outlay/margin
2. Returns locked in daily by margin calls
3. Futures specify a specific grade or quality

Drawbacks

1. Very high risk - rises and falls in underlying assets are fully reflected
2. Risk of losing more than initial investment
3. Must honour on expiry
4. Risk of physical delivery

Question 37

Full Replication
Fund will hold every stock in the same percentage as the index tracked, meaning that every time the index is rebalanced, so will the tracker. This results in very low tracking error and ensures accuracy but can also limit flexibility. Can be expensive due to high transaction costs of illiquid stocks, therefore need to be big sized fund to benefit from economies of scale.

Stratified sampling
Shares are selected by dividing the index into sub groups with representatives taken from each. The objective is to create a portfolio that mirrors the characteristics of each sub group and collectively represent the market. This approach results in greater tracking error in comparison to full replication but comes with a reduced cost.

Answer 37

Synthetic tracking
Instead of buying the underlying shares, or bonds, in the index, the ETF will enter into an agreement with a third party investment bank (a counterparty) to swap the performance of a basket of investments (collateral) in exchange for the exact return of the stock market or commodity it’s tracking. This is a type of derivative contract and subject to count party risk.

Optimisation
Cheapest of the tracking methods to operate, uses computer/statistical models to make buying/selling decisions. Sampling/mathematical models use historical data aim to build a portfolio to track the index. Often plays catch up with the market and not easily adaptable to a changing investment environment.

Question 38

Passively managed funds

A.k.a

Tracker funds

Answer 38

Advantages

1. Low costs/cheap to run
2. Focuses/defines exposure
3. Easy to understand/simple
4. No additional risk taken over and above market risk/low tracking error/tracks an index
5. Not reliant on ‘star’ manager/concerns about manager leaving.

Disadvantages

1. Tracking error means that the tracker can never fully replicate the performance of the target index.
2. Cannot outperform the target index as its aim is to replicate the index, therefore can never add alpha.
3. Rebalancing fund to match changes in index can result in costly trades when dealing with illiquid stock.
4. Cannot avoid poor performing sectors/following market downturns due to tracking, whereas actively managed funds can take measures I.e. avoiding banking sector during the credit crunch

Question 39

Evaluating performance

Answer 39

Performance evaluation is achieved by comparing the composition of the portfolio with a suitable benchmark or agreed target/portfolio and then looking at the effects of asset allocation and stock selection separately

Question 40

Top-down and bottom-up

Investors can use either a top-down or bottom-up approach.

The top-down investor starts his analysis with global economics, including both international and national economic indicators, such as GDP growth rates, inflation, interest rates, exchange rates, productivity, and energy prices. He narrows his search down to regional/industry analysis of total sales, price levels, the effects of competing products, foreign competition, and entry or exit from the industry. Only then does he narrow his search to the best business in that area.

The bottom-up investor starts with specific businesses, regardless of their industry/region.

Answer 40

Fundamental analysis maintains that markets may misprice a security in the short run but that the “correct” price will eventually be reached. Profits can be made by purchasing the mispriced security and then waiting for the market to recognize its “mistake” and reprice the security.

Technical analysis maintains that all information is reflected already in the stock price. Trends ‘are your friend’ and sentiment changes predate and predict trend changes. Investors’ emotional responses to price movements lead to recognizable price chart patterns. Technical analysis does not care what the ‘value’ of a stock is. Their price predictions are only extrapolations from historical price patterns.

Question 41

Nomad and broker

Regulatory information service
The information which is required by these rules must be notified by the AIM company no later than it is published elsewhere. An AIM company must retain a Regulatory Information Service provider to ensure that information can be notified as and when required.

Answer 41

1) The Nomad

The role of the Nomad is essential to the listing of a company on AIM. The company must appoint a Nomad (an organisation approved by the London Stock Exchange) to guide it through the AIM application procedure and to act as Nomad at all times to advise it on the AIM Rules on a continuing basis after flotation. If an AIM company ceases to have a Nomad for any reason, the London Stock Exchange will suspend trading in the company’s shares.

A Nomad is responsible for ensuring and confirming to the London Stock Exchange that an applicant to the market meets the requirements set out in the AIM Rules. The Nomad will usually be responsible for maintaining the admission document (or prospectus) and will arrange for the scheduling of the date of admission of the company to the market. Nomads must comply with a specific set of rules published by the London Stock Exchange.

2) The Broker

An AIM quoted company must also retain a broker at all times. The broker acts as the company’s main interface with the market and potential investors. This may be the same firm as the Nomad and must be a member of the London Stock Exchange.

As well as advising on market conditions and the likely level of demand from investors for the company’s shares, the broker also actively markets the shares to potential investors and can advise on the best method of flotation, size of offer, timing and price. It will continue to work with the company after flotation to look to maintain liquidity and profile in the after-market.

Question 42

Foreign investing

Can hedge currency risk via hedging

Purchase forward contract - sets a predetermined price in the future
Purchases foreign currency options - gives the opportunity to buy/sell at a pre determined price at a pre determined date
Buy spot contracts - buy/sell at current rates and executed within two days
Buy gold - can use gold and other precious metals to hedge
Arrange for foreign currency swaps
Financial futures

Answer 42

Main risks
Political risk - Changing political environment can have a direct impact on the performance of assets in the country of investment.
Taxation risk - Changes in taxation and the tax treatment of foreign investments can effect the value of the investment.
Exchange rate risk - Changes in the value of the currency can affect the value of the investment.
Inflation risk
Different rate of inflation affecting the real return of the investment
Default risk - Risk of provider defaulting
Regulatory risk - Different/less stringent regulatory regime

Question 43

Credit crunch

Origins of financial crisis

Macroeconomic indicators such as GDP, employment, investment spending, capacity utilization, household income, business profits, and inflation fall, while bankruptcies and the unemployment rate rise.

Answer 43

1. Relaxation of financial regulation in the US lead to US and UK banks engaging in imprudent lending to borrowers who had poor credit records/could not afford repayments/lenders failed to make due checks on credit worthiness.
2. Such lending is sometimes referred to as sub-prime
3. Easing of credit led to increase in supply and demand within the housing sector
4. Residential property values formed a bubble
5. The loans had been securitized and sold on to create investment products
6. Defaults on the loans led to the securitized loans/investment products having less value than had been supposed
7. Defaulting borrowers led to billions being written off due to falling property prices/negative equity.

Question 44

Exchange traded notes E.T.N’s

Pays an investor the performance of index tracked minus the issuing bank’s fees when held to maturity
The bank also agrees to pay large shareholders the exact value of the note on a weekly basis through redemption, which helps the ETNs track very closely to the underlying index return.
Different to other by and hold structured products, liquid as they can be bought and sold during normal trading hours.
Given the relative newness of ETNs not all enjoy high liquidity. The effectiveness of ETNs at tracking indices is contingent on their ability to garner enough support in the market.
As senior unsecured and unsubordinated debt their risk is not rated by any credit agency

Answer 44

Created by Barclays

1. Structure product created as a senior debt note by the issuing bank. Subject to credit risk as well as market risk as it is backed by the issuing bank.
2. Therefore credit rating downgrade of the issuing bank will also affect the ETN.
3. ETN makes no income distributions therefore tax is only payable on disposal, whereas ETF’s have to make yearly capital gains or income distributions.
4. ETN tracks the index perfectly which an ETF is unable to do so, due to maximum allocation limits on ETFs, minus the management fee.
5. May be bought and sold on the exchange during normal trading hours. For institutional size redemption, investors can offer their ETN for repurchase to the issuer once a week.
6. Some ETN’s also offer leverage rather than tracking an index, magnifying gains/losses of the index tracked.
7. ETN’s do not own the assets tracked.
8. Offer access to hard to reach exposure/asset classes/strategies normally out of reach to individual investors.

Question 45

Correlation Coefficients

Positive correlation = returns of different assets tend to move up and down together.
Negative correlation = returns of different assets tend to move in opposite direction to each other.
No correlation = returns of assets are not related to each other in any way.

Answer 45

1 = perfectly positively correlated 
-1 = perfectly negatively correlated 
0 = uncorrelated

Negatively correlation optimizes diversification due to ice cream and umbrellas theory

Question 46

Screening and engagement - ethical investing

Answer 46

Screening

1. List of companies is created
2. Companies are identified based on positive criteria or negative criteria
3. Ethical investment research service/external research provides data
4. Only invest in companies on list

Engagement

1. No companies are excluded
2. Areas are identified where companies can improve their environmental/social/ethical performance
3. Fund managers engage to make improvements
4. By setting targets for improvement

Question 47

Investment trusts
Split capital investment trusts are more complicated and offer at least two different class of shares

Zero Dividend Preference shares: no dividends, only capital growth at a pre-established redemption price (assuming sufficient assets)
Income shares: entitled to most (or all) of the income generated from the assets of a trust until the wind-up date, with some capital protection
Annuity Income shares: very high and rising yield, but virtually no capital protection
Ordinary Income shares (AKA Income & Residual Capital shares): a high income and a share of the remaining assets of the trust after prior ranking shares
Capital shares: entitled most (or all) of the remaining assets after prior ranking share classes have been paid; very high risk

Answer 47

IT’s

1. Public limited companies that are closed ended and listed on stock exchange
2. Can trade at a discount or premium to net asset value
3. Fund manager can borrow to leverage returns
4. Must be resident in UK
5. Must distribute at least 85% of its income as dividend
6. Must hold no more than 15% of its assets in a single company

Question 48

Modern Portfolio Theory (MPT)

Linked to CAPM

Criticisms of CAPM
Not all the assumptions that it is based on is realistic.

Answer 48

Assumes that all investors:

1. Are rational
2. Want to maximize returns
3. Are risk averse
4. Are aware of the exact of risk they wish to take
5. There are no taxes
6. There are no transaction costs
7. They have access to the same information
8. They can lend and borrow an unlimited amount
9. They are price takers (cant influence prices)
10. Deal with securities that are all highly divisible into small parcels.

Question 49

Relevant benchmarks

Answer 49

FTSE All-Share (UK Equities)
FTSE World Ex-UK index calculated in sterling (World Equities)
FTSE Gilts All Stocks index (Bonds)
7 Day Libor - 1% (London Interbank Offer Rate) (Cash)
FTSE Hedge Fund Index (Hedge Funds)
FTSE UK Commercial Property Index Series (Commercial Property)

Question 50

Investment annual valuation statement

Main reporting items

Answer 50

Account type
Account name
Account number
Gross interest paid
Less tax deducted
For the period ending
Balance as at
Interest/dividends credited
New balance

Question 51

Efficient frontier model

Drawbacks
It is based on historical data, therefore it looks backwards, rather than forwards.
Past performance does not guarantee the same future performance

Answer 51

Three types of data used
Asset class returns
Standard deviations
Details of the correlation between each pair of asset class

Reason for using efficient frontier in portfolio construction
Measure the risk of assets
How to mix them into a portfolio
Together the maximum result

Question 52

Sharpe Ratio

Identifies whether a portfolios returns are due to good management or excess risk taken. Based on modern portfolio theory investors will always want best return for lowest risk possible. Higher Sharpe = more return per unit of risk

Standard deviation is a measure of the volatility of an investment.

Answer 52

X = (Rp - Rf)/Standard Deviation

p = rate of return
f = risk free return (Treasury bills)

A.k.a PF

Question 53

Total return funds

A Total Return Fund is typically a long only funds that aims to generate long term positive returns and minimise capital losses

Answer 53

They are benchmarked against cash for cautious positive returns and operate an unrestrained investment strategy across a broad mix of assets, using derivatives and safer assets to mitigate losses, however due to their defensive nature they may not participate fully in market rallies

Question 54

Four stages of business cycle

1. Boom - increase in inflation/rise in interest rates/demand may not be satisfied/high employment
2. Slowdown - reduction/decrease in the levels of sales/reduced production
3. Recession - levels of buying/selling/production diminish/falling interest rates/unemployment rises - two consecutive quarters of negative GDP growth.
4. Upswing/recovery - increased consumer spending/investment increases/production rises/employment increases/interest rates remain low

Answer 54

1. Prices of equities start to falter/fall/reach their peak as interest rates rise
2. Prices fall as corporate earnings fall/decrease
3. Prices reach their trough/start to rise as people seek bargains at the bottom of the cycle.
4. Prices are strong or increase as interest rates stay low and corporate earnings recover/company profits increase.

Question 55

Main functions of a central bank

Answer 55

1. Monetary policy
2. Lender of last resort
3. Debt management/manages government debt
4. Banking supervision/regulate the banks
5. Stability of the financial system

Question 56

Clean price

How to work out what a client can pay to achieve desired yield

Answer 56

Current yield / required yield x 100 = clean price

E.g. 5.5% stock 5.25% required = clean price of £104.7

Question 57

Redemption yield aka yield to maturity or YTM

Answer 57

Loss or gain at redemption
Par value - Purchase price = loss/gain

Percentage loss/gain
Loss or gain / purchase price x 100 = %

Divide by years to redemption
% / years = loss or gain

Deduct from running yield
Running yield -/+ redemption loss/gain = redemption yield

Question 58

Dividend Payout Ratio

Companies with lower payout ratio indicate

1. They are reinvesting more into the business than they are paying out in dividends
2. This would indicate that they are growth companies

Answer 58

Dividend per share / earnings per share x 100 = payout ratio

Question 59

Running yield aka flat yield or interest yield

Answer 59

Par/purchase price * coupon = running yield

E.g. £100 par/£95 clean price * 5% coupon = 5.26%

Question 60

Return Of Capital Employed (ROCE)

Capital employed = average debt liabilities + average shareholder equity

Answer 60

Trading profit before interest and tax / Capital Employed x 100 = ROCE %

Or

Stock turnover x Net profit margin = ROCE %

Question 61

Future value of money

Present value of money

Same formula to work out compound interest

Answer 61

Amount x (1+rate of return)power

Power represents time frame of investment

To work out original investment multiply by negative power formula does not need to change

Question 62

Modified duration

Answer 62

Macauley duration / (1+I) = Modified duration

I = interest rate

In order to use this to calculate effect of increase in interest rate:
-modified duration x .interest rate x clean price = change

Question 63

Property rental yield

Answer 63

Rental income - mortgage interest / value - borrowings

E.g. 10,000 income - 5,000 interest / 100,000 value - 50,000 mortgage = 5,000 / 50,000
= 10% yield net of interest based on equity

Question 64

Money Weighted Return

Does not take into account the timing of cash flows
It does not identify whether the return is due to the skill of investment manager

Answer 64

((Current value - initial value +/- cash inflow/outflows)/initial value)

Question 65

Longer term gilt/bond yields

Answer 65

There is greater risk taken so greater reward is expected.
There is a longer wait before capital is returned.
There is a greater chance that inflation will erode capital/income.
There is an increased likelihood that interest rates will rise in the long term meaning that gilt prices will fall.

Question 66

Macaulay duration

Answer 66

The period of time required to repay the purchase price in terms of income and capital receipts
It is used to measure the sensitivity of the gilts price to changes in interest rates
The lower the Macaulay duration the better

Question 67

Return on Equity ROE

Vs

Return of capital employed ROCE

Answer 67

ROE tells you how easy it is for a company to profitably expand its business.

ROCE is an important measure of a company’s profitability, is used to gauge managements ability to generate earnings from a company’s total pool of capital.

ROCE is used to measure the leverage effect on creating value

Question 68

Real rate of return

Answer 68

1 + money rate / 1 + inflation rate = 1 + real rate

E.g.
If money rate was 10% and inflation rate was 3%
1 + 0.1 / 1 + 0.03 = 1.0679 or 6.79%

Question 69

Relative strength index

Answer 69

Range from 0-100

An asset is deemed overbought once the RSI approaches the 70 level which indicates that it might be getting overvalued and is a good candidate for a pullback.

An asset is deemed oversold once the RSI approaches the 30 level and therefore likely to be undervalued.

Question 70

Annual Equivalent Rate (A.E.R)

Answer 70

AER (1+r/n)n - 1
R = gross rate of interest
N = number of times interest paid

Question 71

Time weighted return

Or

Holding period return

Answer 71

Current value / initial value = A1
New current value / previous value (+/- inflow/outflow)= A2

A1 x A2 - 1 = percentage return

Question 72

Dividend Cover

Simplified formula net profit/dividends paid

Answer 72

The opposite to payout ratio
EPS/DPS

Generally speaking a ratio of 2 or higher is considered safe, in the sense that the company an well afford the dividend.
Anything below 1.5 is deemed to be risky
If the ratio is below 1, the company is using retained profits to pay this years dividends

Question 73

Price Earnings Growth (PEG)

Price earnings growth (PEG) historic price earnings ratio/earnings growth %

1. Lower PEG indicates greater growth potential
2. A PEG ratio of less than 1 indicates that shares may be undervalued and potentially attractive

Answer 73

Advantages

1. It is easy to calculate
2. It is a widely used indicator of value
3. It uses forward rather than historic projections

Disadvantages

1. The earnings growth figure is often based on estimates of future profits which may not prove to accurate
2. The system can only cater for shares who’s earnings have risen/are expected to rise consistently
3. There are several different ways of arriving at a PEG figure

Question 74

Weighted probability of returns

Answer 74

%R. No. of occasions. Probability P. Weighted Probability R x P

Question 75

Historic Price Earnings Ratio

In the absence of share price alternative method is

Share capital/net profit

Answer 75

Share Price/EPS

Higher than average price earnings ratio can be interpreted as

1. The share is overpriced
2. The market expects earnings to rise

Question 76

Treasury bill yield

91 days therefore power to 4 and regarded as risk free due to government being least likely to default and short time to redemption

Answer 76

100 - stock price = return %
(1.00x)4 = A.E.R

E.g.
100 - £99.40 = 0.60% quarterly return
(1.006)4 = 2.42% A.E.R

Question 77

Macaulay duration formula components

Answer 77

1. Interest yield
2. Bonds price
3. Maturity value
4. Present value
5. Coupon payable
6. Number of compounding periods

IBMPCN

Question 78

Gross profit margins

The gross profit margin is used to analyse how efficiently a company is using its raw materials, labour and manufacturing related assets in generating profits. A higher margin percentage is a favourable profit indicator.

Answer 78

Net sales - cost of goods sold = gross profit

Gross profit/net sales x 100