Investment Principles and risk. Learning Outcome 8

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1 Investment Principles and risk Learning Outcome 8 By the end of this learning material you will be able to demonstrate an understanding of the principles of investment planning.

2 8.1 The Main Approaches to Asset Allocation Asset allocation is about reducing risk to preserve capital. The correct asset allocation for an individual client will depend on their: Investment objectives Attitude to risk Investment preferences Need for access Timescales There are two principle approaches to asset allocation: Theoretical Pragmatic Theoretical approach Modern Portfolio Theory (MPT) is an example of a theoretical approach to asset allocation. It promotes the idea that portfolios should be built to maximize returns and manage risks through diversification. The key concept of MPT is the efficient frontier, which describes the relationship between the return that can be expected from a portfolio and the risk of the portfolio as measured by the standard deviation Pragmatic approach Pragmatists, the pre-runners to Modern Portfolio Theorists, use forward looking judgments of likely returns and volatility to determine portfolio weightings. These judgments tend to assume that returns and volatility will come close to their historical averages over longer timescales. Short term predictions are high risk as investments tend to be more volatile over shorter timeframes Limitations of approaches MPT is under question especially in the light of the credit crunch optimised portfolios did not deliver the expected benefits from diversified assets as all asset classes with the exception of gilts and cash delivered negative returns. Purely pragmatic approaches have the downside that they may tend to over or under invest Aviva Financial Adviser Academy v2017

3 in a particular asset class based on subjective estimations of prospective returns. 8.2 Portfolio Optimisation Asset allocation based on MPT derives portfolios from a process of optimisation Starting with a matrix of asset classes that may be included in a portfolio, it then looks at their historic returns, volatility and correlation before creating a large sample of potential portfolios and the returns that could be expected. The returns are then plotted on a graph to identify which will provide the highest level of return for the lowest risk exposure. MPT states that a rational investor will only ever hold an investment or portfolio of investments that lies somewhere on the efficient frontier. A client s attitude to risk will determine how far along the frontier they are prepared to go. Investments A, C and E lie on the efficient frontier. This means they are expected to provide the maximum return for the level of risk taken. A rational investor would not take out investment B as investment A is expected to give the same return for less risk and investment C is expected to give a greater return for the same risk. Aviva Financial Adviser Academy v2017

4 Likewise a rational investor would not take out investment D as investment C is expected to give the same return for less risk and investment E a greater return for the same risk Correlation Portfolio optimisation can be enhanced by choosing negatively correlated investments. That is investments where as one rises in value, the other falls and vice versa. An example of negatively correlated assets might be the shares of producers of snow shoes and the shares of producers of sun hats. Positive correlation is where both rise or fall at the same time. An example of positively correlated assets might be the shares of the producers of sun hats and the shares of the producers of sun tan lotion. No correlation means there is no relationship between the assets. An example of assets with no correlation might be the shares of a life assurance company and the shares of a company that produces cattle feed. Limitations of Optimisation It assumes that standard deviation is the correct measure of risk It assumes investors are rational and consider only their attitude to risk when selecting investment It uses historical data Forecasts may be inaccurate Transaction costs are ignored and in reality an investor may not want to change portfolios as the model recommends The portfolio may use specific assets whose behaviour differs from those used in the modeling portfolio Stochastic Portfolio Modeling Stochastic means having a chance or random element. It uses a mathematical technique to generate a probabilistic assessment of returns and volatility. By changing one of the variables, e.g. interest rates, it then generates forecasts for a range of possible returns from different portfolios. It can help clients choose the appropriate portfolio of investments by showing the range of possible outcomes from each portfolio and the probability of achieving them. Care needs to be taken as a small change to one assumption can result in a large change in the outputs. Understanding the assumptions on which the model is based is therefore essential. Aviva Financial Adviser Academy v2017

5 8.3 Alignment with Client Objectives To create an appropriate portfolio, the adviser needs to have a clear understanding of the client s risk tolerance and target return i.e. their risk profile. If formal risk profiles are not used then an adviser could create a portfolio based on historic data. Whichever method is used the customer should be fully aware of the method and understand how it has been created. 8.4 Strategic and Tactical Asset Allocation There are three main approaches to asset allocation: 8.5 Portfolio Construction The purpose of active portfolio constriction is to achieve diversification to reduce risk. There are two main methods of portfolio construction: Top down Bottom up Aviva Financial Adviser Academy v2017

6 8.5.1 Top Down Method of Portfolio Construction Fundamental analysis Looks at the detail of the company s management and performance aligned to its market, along with analysis of cash flow and business ratios. Technical analysis Considers past performance by way of share price valuations to predict the future Bottom Up Methods of Portfolio Construction Here the fund manager exercises their skill and judgment to select stocks on their own merit. They pay no attention to index benchmarks Combined Approaches Many funds combine both top down and bottom up methodology. Aviva Financial Adviser Academy v2017

7 When comparing combined funds, it is important to identify which is the dominant style and note when any change to this is made as this would impact on the funds potential volatility. Generally funds which are predominated by the top down approach are less volatile than funds predominated by a bottom up approach Fund Management Styles Four widely recognised fund management styles Value The value fund manager believes that by undertaking analysis they can identify businesses whose value is greater than is reflected in their current share price. By buying and holding these shares for the long term, they aim to achieve a higher return than the market average. Growth At A Reasonable Price (GAARP) Based on finding companies with long term sustainable advantages in terms of their business franchise, quality of management, technology or other specific factors. A reasonable price is paid for an asset seen to be of quality and therefore have quality long term growth potential. Active Growth managed funds favour this style. Momentum Analyse the market and aim to be ahead of the latest swings in opinion Sector rotation is one example of momentum investing, identifying which part of the business cycle the markets are in and looking to capitalise on the direction it will be taking. Contrarianism Go against the trend, based on the assumption that average opinion is usually wrong By correctly identifying the exact point at which a market has reached a peak of optimism or pessimism they can change their purchasing / sales strategy This is seen a risky strategy and is often found being used by Hedge Fund Managers N.B. Some fund management groups claim to adopt a multi style approach to their management approach and will adapt to meet the market conditions Use of Derivatives and Hedging A manager who lacks cash at present and thinks share prices will rise, may wish to buy futures or call options to peg the price he will have to pay for those shares in the future when he does have the cash required. A manager who thinks share prices will fall, may wish to sell futures or buy put options to protect the fund from potential losses. Aviva Financial Adviser Academy v2017

8 A fund s prospectus should detail any of the hedging strategies in use and an adviser needs to understand the impact these may have on underlying investments and in particular the returns and volatility of a fund Use of Structured Products Structured products offer an alternative to pooled funds. They may limit the capital risk with a return provided after a set lock in period. Managers use derivatives in order to provide the returns and therefore structured products may be exposed to counterparty risk. Liquidity risk is a concern as early encashment of structured products can lead to penalties being applied and significantly reduced returns with no capital guarantee. Investing to protect against the downturn of a market in this way could also restrict the benefits from any unseen upturn in the market. 8.6 Fund Selection The main criteria used in fund selection are: Fund Objectives The Investment Association (IA) divides funds into sectors for more easy identification. Common themes are identified such as areas of investment but they do not necessarily share a common objective some may aim for growth, others for income with differing asset allocation. Aviva Financial Adviser Academy v2017

9 8.6.2 Costs and Charges Costs eat into returns and are therefore an important factor in fund selection. The main charges a client will come across are: Main client charges Initial charge Annual Management Charge Ongoing Charges Performance Fees Bid-Offer Spread Stamp Duty Adviser Remuneration Usually a % of the initial amount invested. Applied as a % of the funds under management. Lower charges for passive funds than active funds. Excludes initial charges but includes all ongoing charges including the AMC and is expressed as a % of the funds under management. TERs are often lower for larger funds than smaller funds as some of the ongoing costs are the same irrespective of the size of the fund. Usually applied if a fund manager s fund performance exceeds a set threshold or a benchmark index. The difference between the buying and selling price. Stamp Duty for paper transactions. Stamp Duty Reserve Tax for electronic transactions. Either an hourly fee or set amount for advice Trading costs, generally not quoted, can be estimated from the Portfolio Turnover Ratio Strength and Reputation of the Management group and the Fund Managers The regulation of UK authorised funds means that investors incur no monetary loss if the management group fails as the funds are held by an independent custodian i.e. the trustees in the case of a unit trust. However, the financial strength of a management group does impact on their ability to recruit and retain good investment managers so it is still an important factor. For actively managed funds, the skill of the fund managers is key. Advisers will need to guide clients in decisions as to whether to move funds following a change in fund manager or whether to stay put. Aviva Financial Adviser Academy v2017

10 8.6.4 Type and Structure of Funds The risk profile of a fund impacts on its suitability for selection: Aviva Financial Adviser Academy v2017

11 8.6.5 Performance The ratios most used in assessing fund performance are: Information ratio Sharpe ratio Alpha We will cover each of these measures in detail in Learning Outcome Selection of Tax Wrappers The client s current and future tax positions need to be considered when selecting an appropriate tax wrapper. Higher rate and additional rate tax payers may benefit more from tax efficient growth within a pension fund or an ISA than basic rate tax payers. The maximum saving from an ISA in respect of capital gains is 20% but for income purposes in an interest distributing fund it is 45% for additional rate tax payers. Clients who regularly realise capital gains may benefit from investing in areas that provide tax free roll up of gains such as offshore bonds. Future tax considerations are important as a tax shelter from additional tax now may not be required at a later stage in their life. For example, life assurance bonds allow higher and additional rate tax payers tax deferred income and, if they become basic rate tax payers later in life, they may find they have no additional tax to pay. EISs and VCT also offer tax savings but are at the higher end of the risk spectrum. Any additional costs or complexity involved in tax efficient products needs to be balanced with the potential for tax savings. Aviva Financial Adviser Academy v2017

12 8.8 Discretionary Management Services Discretionary services can be available for general portfolios or those with specialist investments. Where investments are held in the clients name and the manager has the discretion to deal with these no consideration will be given to capital gains made and realised and therefore communication between manager and adviser is essential. 8.9 Provider Selection Issues UK providers of regulated investment products have the regulated framework and supervisory regime to adhere with and therefore should ensure that investors capital is not at risk from fraud or theft. Consideration to how the assets are held must be given are they held by an independent custodian such as within an OEIC or by a third party on a wrap platform Recommendations and Suitability Recommendations should commence with an explanation of the clients risk profile and how this has been used to generate an asset allocation and recommended portfolio. Timescales, access to capital, income and risk should be detailed within any recommendations. The range of returns expected and the volatility over a given timeframe should be evident along with caveats about circumstances in which these expectations may not be met. The following should be covered: Aviva Financial Adviser Academy v2017

13 8.11 Wrap (Platform) Accounts Wraps are administrative platforms with the following features: A single administration fee across all accounts A wide choice of funds from various providers A wide choice of tax wrappers Asset allocation tools Consolidated valuation forms i.e. income and gains statements Access to online valuations Adviser fees deductible from cash accounts Reduced paperwork/simplified administration Automatic rebalancing of portfolios Aviva Financial Adviser Academy v2017

14 Investment Principles and Risk Learning Outcome 8 (LO8) End of Module Test Multiple Choice Questions Question 1 - Which of the following statements is CORRECT in relation to the pragmatic approach to asset allocation? Answer A. It measures the financial strength of a firm. B. It is based on modern portfolio theory. C. It uses forward-looking judgments of likely returns. D. It uses correlations to predict the risk and return of each asset class. 2 - A client may incur a performance fee if 3 - Which of the following funds is likely to have the highest Total Expenses Ratio? 4 - Which of the following is a benefit of using a tracker fund in a client's portfolio? A. The fund they are invested in performs in excess of a given threshold. B. The fund manager incurs higher costs in achieving higher performance. C. Any fund they are invested in outperforms the benchmark it is set against. D. Any fund manager outperforms his peers by 10%. A. A UK equities fund, with funds under management of 100m. B. A European tracker fund, with funds under management of 150m. C. An Emerging markets fund, with funds under management of 60m. D. A US fixed interest fund, with funds under management of 125m. A. To achieve superior fund performance via tactical stock picking. B. To limit the risk of underperformance of a portfolio as compared with a portfolio of actively managed funds. C. To give the portfolio the means to outperform the tracker index. D. To provide a short term haven for realised gains. Aviva Financial Adviser Academy v2017

15 5 - Which of the following statements is INCORRECT? A. For most clients collectives are the most tax efficient and simple way to hold equity based investments. B. The differences between personal pensions and SIPPs have blurred over recent years. C. Assets held within a discretionary management service are exempt from CGT when sold by the manager. D. An investment wrapper may offer the opportunity to shelter income from tax. - End of Questions - Aviva Financial Adviser Academy v2017

16 Answers Question 1 - Which of the following statements is CORRECT in relation to the pragmatic approach to asset allocation? 2 - A client may incur a performance fee if 3 - Which of the following funds is likely to have the highest Total Expenses Ratio? 4 - Which of the following is a benefit of using a tracker fund in a client's portfolio? 5 - Which of the following statements is INCORRECT? Answer C. It uses forward-looking judgments of likely returns. A. The fund they are invested in performs in excess of a given threshold. C. An Emerging markets fund, with funds under management of 60m. B. To limit the risk of underperformance of a portfolio as compared with a portfolio of actively managed funds. C. Assets held within a discretionary management service are exempt from CGT when sold by the manager. Aviva Financial Adviser Academy v2017