Chapter 7: Investment Funds

Question 1

Two ways to invest into an asset class:

Answer 1

1. Direct investment - individual personally buys shares in a company
2. Indirect investment - individual buys a stake in an investment fund, and invests in the shares of a range of different types of companies.

Question 2

What are collective investment schemes and what are the benefits?

Answer 2

Pool the resources of a large number of investors. The pooling has benefits:

1. Economies of scale
2. Diversification
3. Access to professional investment management
4. Access to geographic markets
5. Regulatory oversight
6. Tax deferral

Question 3

How is the UK Investment market split?

Answer 3

Sell side:
- Corportates through to exchanges, securities houses and investment banks

Buy side:
- Investment managers, consultants, pensions funds through to banks, advisers and insurance funds which ends with private investors

Question 4

Active management is?

Answer 4

Seeks to outperform a predetermined benchmark over a specified time period.

Employs technical analysis to assist in the forecasting of future events which are specific to a company.

Actively managed funds have higher charges than passive funds.

1. Top down:
   Manager focuses on economic and industry trends
2. Bottom up:
   Analysis of a company’s net assets, future profitability and cash flow

Question 5

Features of bottom up approach in active management are?

Answer 5

1. Growth investing - picking shares of companies that present opportunities to grow
2. Value investing - which is picking the shares of companies that are undervalued relative to their present and future profits/cash flows
3. Momentum investing - picking shares whose share price is rising on the basis that this rise will continue
4. Contrarian investing - picking shares that are out of favour and have ‘hidden’ value

Question 6

What is passive management?

Answer 6

Constructing a portfolio that tracks or mimics the performance of a recognised index.

Question 7

Advantages of indexation:

Answer 7

1. Less expensive to run than active portfolios
2. Funds charges will be lower than active mgmt funds

Question 8

Disadvantages of indexation:

Answer 8

1. Doesn’t meet all of an investors objectives
2. Indexed portfolios follow the index down in bear markets

Question 9

Combining active and passive mgmt…

Answer 9

Known as core-satellite management.

70-80% of portfolio gets indexed to minimise risk of underperforming. Rest of portfolio gets fine tuned by investing into individual securities or specialist funds - satellite part.

Question 10

What are UCITS?

Answer 10

Series of EU regulations that were designed to facilitate the promotion of funds to retail investors across EU.

The aim was to create a framework for cross-border sales of investment funds throughout the EU, which would allow an investment fund to be sold throughout the EU.

The rationale was that allowing funds to be sold across borders would reduce costs involved and improve customer choice, while ensuring a level playing field through common standards of investor protection.

Must provide an ongoing charges figure (OCF) and quote this in key investor information document (KIID).

Question 11

What is NURS?

Answer 11

Funds can also be set up under NURS regulations. NURS stands for ‘non-UCIT retail schemes’ and these are funds that are deemed by the UK regulator to be suitable for retail investors, but do not meet the more prescriptive rules of the European UCITS directive.

Question 12

What is a unit trust?

Answer 12

Is a CIS in the form of a trust in which the trustee is the legal owner of the underlying assets and the unit holders are the beneficial owners. Can be authorised or unauthorised.

Question 13

What do investors do with a unit trust?

Answer 13

Investors pay money into the trust in exchange for units. Money is invested in a diversified portfolio of assets. If portfolio increases in value, value of units will increase. Opposite works too.

Question 14

Role of unit trust manager

Answer 14

Decide, within the rules of the trust and the various regulations, which investments are included within the unit trust to meet its investment objectives.

Manager also provides a market for the units, by dealing with investors who want to buy or sell units.

Question 15

Legal structure of unit trusts

Answer 15

Every unit trust must appoint a trustee. This person is the legal owner of the assets in the trust.

Trustee also protects the interests of the investors by monitoring actions of unit trust manager.

Question 16

What is an ‘open ended investment company’ (OEIC)?

Answer 16

Another form of authorised CIS. They are referred to as ‘investment companies with variable capital’ (ICVCs) by the FCA.

An ICVC commonly found in Europe is the ‘Societe d’investissement a capital variable’ (SICAV). They are set up in Luxembourg by AM firms.

OEIC is a CIS structured as a company, with investors holding shares.

Question 17

How does OEIC work?

Answer 17

Invests shareholders money in a diversified pool of investments.

OEICs are companies but they are established under special legislation and not the companies act. They are not subject to share repurchase restrictions, create new shares and redeem existing ones.

Question 18

What happens when an OEIC is set up?

Answer 18

It’s a requirement that an ‘authorised corporate director’ (ACD) and a depository are appointed.

ACD = manages investments

Question 19

How are prices of OEICs sorted?

Answer 19

Single priced - use of mid market prices of the underlying assets to produce a single price. Does not involve the ability to recoup dealing expenses and commissions. Such costs are recouped either by applying a separate charge known as a DILUTION LEVY. Initial charge will be charged separately.

Dual priced - using markets bid and offer prices of the underlying assets to produce separate prices for buying and selling of shares/units in the fund

Question 20

Charges in funds:

Answer 20

• Initial charge
• Annual management charge (AMC)
• Audit costs
• Commission
• Legal fees
• Fees for advice

Question 21

What charges does UCIT face?

Answer 21

Ongoing charges figure (OCF) - costs of UCIT management company, depositary, custodian, investment advisor, reg fees, audit fees, payments.

Question 22

What’s a fund supermarket/platform?

Answer 22

Specialises in offering investors easy access to a range of unit trusts and OEICs from different providers. They offer online dealing, valuations, portfolio planning tools and access to key features documents and illustrations.

Question 23

How does settlement take place ?

Answer 23

With each fund group. Once investment has been made and the amount invested has been received, the fund group will record ownership of the relevant number of units or shares in the funds share register.

When investor decides to sell, they need to instruct fund manager who then has four days from receipt of the instruction and settle the sale and remit the proceeds to the investor.

One widely used system is EMX.

Question 24

What’s an investment trust?

Answer 24

A company. Has directors and shareholders. Uses a diversified portfolio.

Question 25

What happens when a new investment company is established?

Answer 25

It issues shares to new investors. They are closed ended. Cash will be invested in a number of other investments.

Question 26

Share classes of investment trusts

Answer 26

If a company has more than one type of share then they are known as a split capital investment trust.

Can issue preference or ordinary shares.

Question 27

Features of REITs

Answer 27

Provide access to property returns without the previous disadvantage of double taxation.

REITs can be held in ISAs and SIPPs.

Provides new opportunities.

Pay no tax on property income or capital gains.

Question 28

What is gearing?

Answer 28

Companies are allowed to borrow more money on a long term basis by taking out loans or issuing bonds. This can enable them to invest the borrowed money in more stocks and shares.

Question 29

Premium or discount:

Answer 29

If investment trust share price is above NAV (net asset value) it is said to be trading at a premium. Opposite = discount.

Question 30

What is an ETF?

Answer 30

Exchange traded fund - designed to track a particular index. Investor buys shares in the ETF which are quoted on stock exchange. Open ended funds.

Question 31

What mgmt do ETFs use?

Answer 31

Passive management

Question 32

Physical or synthetic replication:

Answer 32

Index tracker funds are based on market capitalisation indices. Fund will use either physical or synthetic replication.

Physical replication is the traditional form of index replication. Employs one of three established tracking methods:

1. Full replication - accurate but most expensive
2. Stratified sampling - less expensive but lack of statistical analysis renders it subjective and potentially encourages biases towards those stocks with the best perceived prospects
3. Optimisation - costs less but is more complex. Uses sophisticated computer modelling.

Question 33

Synthetic replication:

Answer 33

Involves fund manager entering into a swap with a market counterparty to exchange the returns on the index for a payment. Advantage is that responsibility for tracking the index performance is passed on to the swap provider and costs are substantially lower. Downside is that investor is exposed to counterparty risk.

Question 34

What are hedge funds?

Answer 34

Reputed to be high risk. Market risk is the risk that is faced by an investor in shares.

1. Structure - most hedge funds are established and unauthorised meaning they cannot be generally marketed to private individuals/retail investors because they are considered too risky.
2. High investment entry levels - require minimum investments in excess of £500k
3. Investment flexibility - lack of regulation, means can invest in so much
4. Gearing - borrow funds
5. Prime broker
6. Liquidity
7. Cost - can be pricey

Question 35

What is private equity?

Answer 35

Medium to long term finance. Private equity is invested in exchange for a stake in a company. The private equity firm is rewarded by companies success.

Raise capital mainly from large investing institutions.

Question 36

Ranges of funds available

Answer 36

2500 UK domiciled authorised funds available.

IA is trade body for UK authorised open ended funds industry. AIC is for investment trusts (close ended)

1. UK gilts - invest at least 95% of assets in Sterling denominated government backed securities, with a rating the same as or higher than that of the UK, with at least 80% invested in UK gov securities
2. UK index linked gilts - invest at least 95% of their assets in sterling denominated government backed index linked securities, with a rating the same as or higher than that of the UK, with at least 80% invested in UK index linked gilts
3. Corporate bonds - invest at least 80% of assets in Sterling denominated triple BBB-minus or above corporate bond securities. This excludes convertibles, preference shares and permanent interest bearing shares (PIBS)
4. Strategic bonds - funds which invest at least 80% of assets in Sterling denominated fixed interest securities. Excludes convertibles, preference shares and permanent interest bearing shares. At any point in time, the asset allocation of these funds could theoretically place the fund in one of the other fixed interest sectors. The funds will remain in this sector on these occasions since it is the mangers stated intention to retain the right invest across the sterling fixed interest credit risk spectrum.
5. High yield - funds which invest at least 80% of their assets in Sterling denominated fixed interest securities and at least 50% of their assets in below BBB-minus fixed interest securities, excluding convertibles, preference shares and PIBS