CEMAP 1 Topic 8- Collective Investments

Question 1

Why do collective investments appeal to investors?

Answer 1

MAIN FORM OF COLLECTIVE INVESTMENTS VEHICLES:
- unit trusts;
- investment trusts;
- investment bonds; and
- OEICs

COLLECTIVE INVESTMENTS Advantages:
- Investment manager expertise
- Diversification
- reduced dealing costs
- Wide choice of funds

Question 2

What are Unit Trusts?

Answer 2

A unit trust is a pooled investment created under trust deed.

A unit trust is categorised as an equity trust where the underlying assets are mainly shares, or as a fixed‑income trust where investment is mainly in interest‑yielding assets. An equity trust pays a dividend, while a fixed‑income trust pays interest.

A unit trust is divided into units, with each unit representing a fraction of the trust’s total assets. It is ‘open‑ended’, so if lots of investors want to buy units in it, the trust manager can create more units.

Unit trusts may offer the following units:
- Accumulation units automatically reinvest any
income generated by the underlying assets. This would suit someone looking for capital growth.
- Distribution or income units split off any
income received and distribute it to unit
holders. The units may also increase in value in
line with the value of the underlying assets.

Question 3

How are units priced?

Answer 3

To price the fund, the manager will calculate the total value of trust assets, allowing for an appropriate level of costs, and then divide this by the number of units that have been issued. On a daily basis, managers calculate the prices at which units may be bought and sold, using a method specified in the trust deed. Unit prices are directly related to the value of the underlying securities that make up the fund.

There are four important prices in relation to unit trust transactions:
- The creation price is the price at which the trustee/depositary creates units on behalf of the unit trust manager.
- The offer price is the price at which investors buy units from the managers.
- The bid price is the price at which the managers will buy back units from investors who wish to cash in all, or part, of their unit holding.
- The cancellation price is the minimum permitted bid price, taking into account the full costs of buying and selling. At times when there are both buyers and sellers of units, the bid price is generally above this minimum
level, since costs are reduced because underlying assets do not need to be
traded

Question 4

How are units bought and sold?

Answer 4

Unit trust managers are obliged to buy back units when investors wish to sell them. No need for a secondary market in units and not traded on the Stock Exchange.
Units can be bought direct from the managers or through intermediaries. They can be purchased in writing, by telephone or online.

Purchasers may receive two important documents from the managers:
- The contract note – specifies the fund, the number of units, the unit price and the amount paid. It is important because it gives the purchase price, which will be needed for CGT purposes when the units are sold.
- The unit certificate – this specifies the fund and the number of units held, and is the proof of ownership of the units.

In order to sell units, the holder signs the form of renunciation on the reverse of the unit certificate and returns it to the managers. If only part of the holding is to be sold, a new certificate for the remaining units is issued.

Question 5

How are unit trusts regulated and managed?

Answer 5

In the UK, unit trusts are primarily regulated under the terms of the Financial Services and Markets Act 2000, and must be authorised by the FCA if marketed to retail investors.

The FCA specifies rules aimed at reducing the risks associated with unit trusts. The rules require that a unit trust fund is suitably diversified and specify that the fund cannot borrow an amount of more than 10 per cent of the fund’s net asset value and only for a temporary period.
The trust deed places obligations on both the manager and the trustees. The manager aims to generate profit for the unit trust provider from the annual management charge and dealing in units. The trustees’ overall role is to ensure
investors are protected and that the manager is complying with the terms of the trust deed. The role of trustee is usually carried out by an institution such as a clearing bank or life company.

Question 6

Unit Trust responsibilities

Answer 6

Manager’s responsibilities
— Managing the trust fund in line with the trust deed
— Valuing the assets of the fund
— Fixing the price of units
— Offering units for sale
— Buying back units from unit holders

Trustees’ responsibilities
— Setting out the trust’s investment directives
— Holding and controlling the trust’s assets
— Ensuring that adequate investor protection procedures are in place
— Approving proposed advertisements and marketing material
— Collecting and distributing income from the trust’s assets
— Issuing unit certificates (if used) to investors
— Supervising the maintenance of the register of unit holders
The trustee usually also acts as the depositary, in which case they would also be subject to regulatory obligations applicable to depositaries

Question 7

How are unit trusts taxed?

Answer 7

Authorised unit trusts fall into two main categories:
- If more than 60% of the underlying investments within a unit trust are cash or fixed‑interest securities, such as UK gilts or corporate bonds, the fund will be classed as a fixed‑income or non‑equity fund and any income distributions will be treated as interest payments.
- If less than 60% of the underlying investments are cash or fixed‑interest securities, the fund will be classed as an equity fund and all income
distributions will be treated as dividends.

In both cases there is no tax on gains within the fund, meaning that the investor may be liable to capital gains tax if they make a gain when encashing the investment.

Equity‑based funds taxation

For equity‑based unit trust funds, the tax treatment is the same as for shares.
Income is paid without deduction of tax. Where an investor’s total dividend in a tax year is less than the dividend allowance (DA), there is no income tax on the dividend.
Where dividend income is in excess of the DA, then the income is taxed at different rates based on which tax band it falls into.

Fixed‑income (or non‑equity) funds taxation

Interest from a fixed‑income fund is classed as savings income. The income is paid gross, without deduction of tax. Where the interest is received by a non‑taxpayer, falls within the starting‑rate band for savings, or falls within the
PSA of a basic‑ or higher‑rate taxpayer, then no tax is payable. Taxpayers who have used their PSA are taxed on the excess income and are required to declare the income to HMRC through self‑assessment.

Question 8

What are the risks of investing in a unit trust?

Answer 8

The legal constitution of a unit trust helps to mitigate risk of fraud because the trustees have a responsibility to ensure there is proper management.

The risks involved in investing in a unit trust are lower than those for an individual investing directly into equities on their own behalf because a unit trust is a pooled investment. Unit‑trust funds will typically invest in a spread
of between 30 and 150 different shares.

The actual risk will depend on the type of unit trust selected. The wide range of choice means that there are unit trusts to match most investors’ risk profiles.
A cash fund will carry similar risks to a deposit account, while specialist funds that invest in emerging markets, for instance, are high risk by their very nature.
Overseas funds carry the added risk of currency fluctuations.
Unit trusts provide no guarantee that the initial capital investment will be returned in full or that a particular level of income will be paid.

Question 9

What are investment trusts and how to invest?

Answer 9

Investment trusts are public limited companies whose business is investing in the stocks and shares of other companies. As a company, an investment trust is established under company law and operates as a listed plc; its shares are
listed on the stock exchange. A unit trust and an OEIC must be FCA authorised. An investment trust, by contrast, must meet FCA requirements
to gain a stock market listing, and it is governed by rules in its memorandum and articles of association.
As with all companies, shares are sold to investors. The number of shares available remains constant – the company does not create more just because investors want them – so an investment trust is said to be ‘closed‑ended’ (in contrast to the open‑ended nature of unit trusts and OEICs).

Investing in an investment trust can be done through:
- a stockbroker;
- a financial adviser; or
- direct from the investment trust manager.
To cash in the investment, it is necessary to sell these shares, via a stockbroker or back to the investment trust manager directly

The shares trade at a single price but dealing fees are added to any purchase and deducted from any sale. An annual management charge is also payable.
The share price of an investment trust depends on the value of the underlying investments, but not so directly as in the case of a unit trust: the price can also depend on factors that affect supply and demand.
The share price of an investment trust may be more or less than the net asset value (NAV) per share. Where the share price is less than the NAV the trust is said to be trading at a discount, meaning that an investor should achieve
greater income and growth levels than would be obtained by investing directly in the same underlying shares. Where the share price is higher than the NAV, the trust is said to trade at a premium.

NET ASSET VALUE PER SHARE
Total value of the investment fund divided by the number of shares issued

Question 10

Gearing

Answer 10

Because investment trusts are constituted as companies, they can borrow money to take advantage of investment opportunities – this is known as gearing or leverage.

This facility is not open to unit trusts or OEICs, which are only permitted to borrow money over the short term and against known future cash inflows.
Gearing enables investment trusts to enhance the growth potential of a rising market, but investors should be aware that it can accentuate losses in a falling market.
The ability to ‘gear up’ is one of the reasons why investment trusts are viewed as being riskier than a similar unit trust or OEIC. Some investment trusts are described as being ‘highly geared’ or ‘highly leveraged’, which means they have a high level of borrowing relative to the assets they hold; the investment trust will be pursuing high returns but there is the risk of being unable to service interest and/or repayments on borrowings.

Question 11

How are investment trusts taxed?

Answer 11

At least 85 per cent of the income received by the fund managers of investment trusts must be distributed as dividends to shareholders. As it is constituted as a company, an investment trust pays income in the form of dividends.

The taxation situation is broadly the same as that described for equity unit trusts. As with unit trusts, fund managers are exempt from tax on capital gains.
Investors are potentially liable to CGT on the sale of their investment trust shares, in the event that their gain, when added to the value of their other gains realised in a tax year, exceeds the CGT annual exempt amount.

Question 12

What is a split‑capital investment trust?

Answer 12

Split‑capital investment trusts are fixed‑term investment trusts offering two or more different types of share.
The most common forms of share offered are:
- income shares – these receive the whole of the income generated by the portfolio but no capital growth;
- capital shares – these receive no income but, when the trust is wound up at the end of the fixed term, share all the capital growth remaining after fixed capital requirements have been met.

Most companies will also offer shares with differing balances of income and
growth, so as to meet different investor objectives.

Question 13

What is a real estate investment trust?

Answer 13

REITS are tax‑efficient property investment
vehicles that allow private investors to invest in property while avoiding many of the disadvantages of direct property investment.

One particular advantage is that stamp duty reserve tax is charged at 0.5 per cent
on purchase.

REITs became available in the UK from January 2007.
In the UK, REITs pay no corporation tax on income or growth for the property rental portion of their income, provided they meet the requirements listed below:

Qualifying Features of REITS:
* At least 75% of their gross income must be
derived from property rent.
* The remainder can come from development or
other services but corporation tax is charged
on income and gains made here.
* At least 90% of their profits must be distributed to their shareholders net of basic-rate tax. Higher- and additional-rate shareholders will have to pay additional income tax.
* Dividends can be paid in cash or as stock dividends (the allocation of further shares)
and are taxable at dividend rates.
*No individual shareholder can hold more than 10 per cent of the shares.
*Single-property REITs are only allowed in special cases –for example, a shopping centre with a large number of tenants.
*They can be held in ISAs, Junior ISAs, Child Trust Funds and self-invested personal pensions

Question 14

What is an OEIC?

Answer 14

An OEIC is an ‘open‑ended investment company’ – a limited liability company that pools the funds of its investors to buy and sell the shares of other companies and deal in other investments.

To invest in an OEIC, the investor buys shares in the company; no limit to the number of shares that can be issued, ‘open‑ended’. The open‑ended nature means that the fund can expand or contract, depending on if shares being issued in response to demand, or being redeemed if investors wish to sell. The value of the shares varies according to market value of company’s underlying investments.
An OEIC may be structured as an ‘umbrella’ company that is made up of several sub‑funds. Different types of share can be made available within each sub‑fund.
OEICs have been popular in other parts of Europe for many years and have been
available in the UK since 1997. They share a number of characteristics with unit trusts and investment trusts. For instance, as with unit trust and investment trusts,
investments can be made by lump sum, regular contribution or a combination of
both. One difference to note, however, is that while both investment trusts and OEICs operate as companies, an investment trust can borrow money to finance its activities but an OEIC can only borrow for short‑term purposes.

Question 15

How are OEICs regulated and managed?

Answer 15

An OEIC is established as a limited liability company under a structural framework set by HM Treasury under the Open‑Ended Investment Companies Regulation 2001 (as amended) and associated FCA rules.
Unlike an investment trust (unless it is
self‑managed), OEICs must be authorised by the FCA.
The role of overseeing the operation and ensuring that it complies with the requirements is carried out by a depositary, who is authorised by the FCA. The role of the depositary is similar
to that of the trustee of a unit trust.

An authorised corporate director, whose role is much the same as the manager of a unit trust, manages the OEIC. The role of the corporate director is to:
- manage the investments;
- buy and sell OEIC shares as required by investors;
- ensure that the share price reflects the underlying net asset value of the OEIC’s investments.

OEICS valued by divided total value of its assets by the number of shares currently in issue.

CHARGES
In addition to the cost of buying the shares, the OEIC will levy:
- an initial or buying charge – which is added to the unit price and is normally in the region of 3-5% to 5 of the value of the individual’s investment;
- annual management charges based on the value of the fund
- a dilution levy – this may be added to the unit price on purchase of shares or deducted from the price on sale of shares in situations where there are large flows of funds into or out of the OEIC.
Other administration costs may also be deducted from the income that is generated

Question 16

How are OEICs taxed?

Answer 16

The tax treatment of UK‑based OEICs is exactly the same as that for unit trusts. In terms of income, an OEIC will be classified as either fixed‑income or equity‑based. If it is fixed‑income, the interest is paid without deduction of tax but is subject to income tax as savings. If an OEIC is equity‑based, a dividend
is paid, again without deduction of tax. There will be a further liability for income tax for basic‑, higher‑ and additional‑rate taxpayers if total dividend income exceeds the investor’s dividend allowance.

Question 17

What are the risks of investing in OEICs?

Answer 17

The risks associated with investing in an OEIC are similar to those of investing in a unit trust:
- An OEIC is subject to the same FCA rules on diversification and fund borrowing as apply to unit trusts, and these rules help to reduce risk.
- As an OEIC is a pooled investment employing the services of professional investment managers, the degree of risk is lower than it would be for an individual investing directly in equities.
- Risk is also mitigated by the spread that can be achieved for a relatively small investment.

Question 18

Endowments

Answer 18

Endowments are a type of investment based on life assurance. They combine life assurance and regular savings. A lump sum is either paid if the life assured dies during the term or, if they survive to the end of the term, it is paid at
maturity.
In the 1970s and 1980s endowments were very popular, being used both as repayment vehicles alongside interest‑only mortgages or as savings schemes in their own right. The introduction of schemes such as ISAs reduced their popularity but many plans remain in existence.
Endowments vary according to the nature of the underlying investment structure, and common types are with‑profits and unit‑linked. As long as
premium payments are maintained, with‑profits endowments are comparatively low risk as they offer the guarantee of at least a minimum value at maturity.
Unit‑linked plans do not carry such a guarantee and the value at maturity depends on how the underlying investments perform.

Friendly society plans
Friendly societies date from the eighteenth century when they were established as mutual self‑help organisations. Over time they have evolved, with many now offering a range of financial services.
A friendly society is able to market a tax‑exempt savings plan, effectively an endowment with tax benefits, because the friendly society pays no tax on its investment returns. This can be compared with a conventional endowment on
which the life assurance company would pay tax on some income and gains within the fund.
As there is preferential tax treatment, the amount that can be saved is limited to £270 per year (as a lump sum),£25 per month or £75 per quarter. The plan is set up over an initial ten‑year term and there is no tax upon encashment.
Friendly society plans are often marketed as savings plans that enable parents
and grandparents to save on behalf of their children and grandchildren

Question 19

Investment bonds

Answer 19

Investment bonds are collective investment vehicles based on unitised funds

Investment bonds are available from life
assurance companies and are set up as single‑premium, whole‑of‑life assurance policies. An individual who wants to invest does so by paying a single (lump sum) premium to the life company.
If an investment bond is unit‑linked, the investor then receives a policy document showing that the premium has purchased a number of units in a chosen fund, and that those units have been allocated to the policy. In order to cash in the investment, the policyholder accepts the surrender value of the policy, which is equal to the value of all the units allocated, based on the bid price on the day when it is surrendered.

Investment bonds are attractive to investors because of the:
- relative ease of investment and surrender;
- simplicity of the documentation; and
- ease of switching from one fund to another – companies generally permit switches between their own funds without charging the difference between bid and offer prices.

The range of available funds is similar to those offered by unit trusts and investment trusts.

As an alternative to a unit‑linked structure, some companies offer with‑profits investment bonds, in which premiums are invested in a with‑profits fund. If a with‑profits bond is cashed in within a specified period after commencement (typically five years), the amount received is likely to be less than the value of the units. In the event of the death of the life assured, the policy ceases and a slightly enhanced value (often 101 per cent of the bid value on the date of death) is paid out.

Question 20

How are investment bonds taxed?

Answer 20

The funds in which the premiums are invested are an insurance company’s life funds and their tax treatment is different from that of unit trusts. In particular, they attract internal tax at 20%on capital gains (whereas unit trust funds are exempt) and this tax is not recoverable by investors even if they themselves would not pay capital gains tax.
The taxation system for policy proceeds in the hands of the policyholder is complex. Policies may be qualifying or non‑qualifying with tax consequences, particularly for higher‑ and additional‑rate taxpayers as 20 per cent tax is
deemed to have already been paid within the fund. Investment bonds are non‑qualifying policies.

QUALIFYING AND NON‑QUALIFYING LIFE POLICIES
Life assurance policies are designated as ‘qualifying’ or ‘non‑qualifying’ policies for tax purposes. The benefit of a qualifying policy is that there is no tax liability on the proceeds of the plan on death or maturity; a non‑qualifying
plan may result in a tax liability for higher‑ and additional‑rate taxpayers.

Qualifying Criteria for Tax Purposes:

Premiums- Must be payable annually, half-yearly, quarterly or monthly and set up for at least ten years

Discontinuing payment of premiums-
If premiums cease within ten years, or three-quarters of the original term if this is less than ten years, the policy becomes non-qualifying

Sum payable on death
Must be at least equal to 75 per cent of the total premiums payable

Balance of premiums
Premiums in any one year must not exceed twice the premiums in any other year, or
one-eighth of the total premiums payable

Any tax liability at the end of the bond’s life is determined by ‘top slicing’. Top slicing is the way of determining what tax is due for UK residents by calculating the average return over the term of the bond, so that the whole gain is not taken into consideration in one single year.

If, in the year when the plan is surrendered, the planholder is a higher‑rate or additional‑rate taxpayer, the gain may be subject to tax.

The gain will be the surrender value plus any withdrawals previously made that have not already been taxed, less the original investment.

Unlike investment trusts and unit trusts, investment bonds do not normally provide
income in the form of dividends or distributions, but it is possible to derive a form of ‘income’ from them by making small regular withdrawals of capital.

Investors can withdraw up to 5% of the original investment each year without incurring an immediate tax liability, regardless of their tax rate. This 5 per cent allowance can, if not used, be carried forward and accumulated, up to an amount of 100 per cent of the original investment.

These withdrawals are tax‑deferred, not tax‑exempt: when the investment
ends, on maturity, death or encashment, a tax liability may ari

Question 21

Non‑mainstream pooled investments

Answer 21

Collective investment schemes may only be sold to the general public in the UK if they adhere to regulations relating to investment and promotion set out in the FCA Handbook.

Schemes that do not fulfil the criteria for regulated collective investment schemes are classified as non‑mainstream pooled investments (NMPIs).
The FCA Handbook defines an NMPI as:
- a unit in an unregulated collective investment scheme (UCIS);
- a unit in a qualified investor scheme;
- a security issued by a special vehicle, unless an excluded security;
- a traded life policy;
- rights or interest in any of the investments listed above.
NMPIs may invest in non‑traditional assets, carrying a higher risk. If the provider is based abroad, an investor may have limited recourse to the Financial Ombudsman Scheme and the Financial Services Compensation Scheme. For these reasons, NMPIs are only considered suitable for a very small group of high‑net‑worth individuals. The FCA does not generally permit the marketing of NMPIs to retail customers.

Question 22

Structured products

Answer 22

The defining characteristic of structured products is that they offer some protection of the capital invested (up to 100 per cent in some cases), while enabling investment in underlying assets that have the potential for higher returns but are also higher risk (such as ordinary shares). They appeal to investors who are cautious about direct exposure to the possible downside of stock markets but who would like to share in the growth possibilities.
The FCA classifies structured products as either deposits or investments in its Handbook in a number of ways.

Structured capital‑at‑risk products (SCARPs)
A SCARP is defined as a product other than a derivative that provides an agreed level of income or growth over a specified investment period and displays the following characteristics:
a) The customer is exposed to a range of outcomes in respect of the return of initial capital invested.
b) The return of initial capital invested at the end of the investment period is linked by a pre‑set formula to the performance of an index, a combination of indices, a ‘basket’ of selected stocks (typically from an index or indices),
or other factor or combination of factors.
c) If the performance in b) is within specified limits, repayment of initial capital invested occurs. If it is not, the customer could lose some or all of the initial capital invested.

Non‑SCARP structured investment product
A non‑SCARP investment is one that promises to provide a minimum return of 100 per cent of the initial capital invested as long as the issuer(s) of the financial instrument(s) underlying the product remain(s) solvent. This repayment of
initial capital is not affected by the market risk factors in b) above.

The risks associated with structured products
There are a number of risks associated with structured products including:
- counterparty risk;
- market risk;
- inflation risk.
The products are also complex, with terms varying widely between providers.

Question 23

Wraps and platforms

Answer 23

Wrap accounts are a long‑established feature in the US and Australia, and were introduced into the UK in the early 2000s. The basic premise of a ‘wrap’ account is that one provider sets up an internet‑based platform to hold all of the investor’s investments within one framework, enabling the investor to see all relevant information in one place. The wrap account allows the investors to analyse and quantify the holdings according to value, tax treatment and
product type. Wraps are generally offered by independent financial advisers, who levy
charges in addition to any individual fund management charges that apply to
the investments held in the framework. Most wraps are able to hold any class of asset or fund on behalf of the investor.

A fund supermarket is designed to provide access to a wide range of funds, such as OEICS, unit trusts and ISAs, but not investment trusts. The investor has a ‘general investment account’, which is exposed to the UK tax regime (apart from any ISAs that are included, as they are tax‑free). The investors pay a charge for the service: either a flat fee or a percentage of funds held – this is how the fund supermarket makes its money.
Both wraps and fund supermarkets are often referred to as ‘platforms’, but they are different

A wrap offers all the same investments as a fund
supermarket, plus a range of other investments, such as investment trusts, offshore investments and direct equities (shares)