A Guide to Investments. Meet your financial goals and objectives.

Transcription

1 A Guide to Investments Meet your financial goals and objectives

2 02 A Guide to Investments For clients today the scope of opportunities available for their investments is fantastic. In the last twenty years we have seen a real drive from the Investment industry to offer clients access to products and investment funds that allow better tax planning but more importantly better risk management. This document explains the key areas that are available to clients and how they will assist in supporting a client s financial goals & objectives. At Financial Advice Centre Ltd both our Advisers and Investment Team will have access to many areas through the different platforms and products available. So as a client (or potential client), you should be confident that we regularly review what opportunities are available to ensure that you can meet your financial goals and objectives. Areas covered in the document: OEICS & Unit Trusts Structured Products Passive vs Active Investments Exchange Traded Funds (ETF) Investment Trusts Venture Capital Trusts (VCT) Enterprise Investment Schemes (EIS) Seed Enterprise Investment Schemes (SEIS) Cash / Money Markets Property Investments

3 03 Unit Trusts and OEICs Within the UK market a retail investor has five main options of investment; buying direct stocks and shares, corporate bonds and gilts, investing in Investment trusts, investing in Unit Trusts and finally investing in OEICs. The two most popular are Unit Trusts and OEICs as these are the most widely available to a retail investor. Also commonly known as mutual funds in other parts of the world, Unit Trusts and OEICs purchase directly; equities, bonds, property and private equity on the investors behalf, which allows access to investment areas which could be either to costly or difficult to invest in directly. Both Unit Trusts and OEICs are widely used by Investors, Wealth Managers and Financial Advisers to utilise investment into many areas. Unit Trusts have been around for a number of years and were the first option available to investors to invest directly into a market. Since the 1990 s OEICs have become the most popular type of direct investment. Setup Both Unit Trusts and OEICS are set up in the same way as an equity, in regard to the fact that all funds available will have a unit (Unit Trust) or share (OEIC) available to purchase which will all be equal in value. This unit or share will then entitle the holder to any income and/or growth of the underlying investments proportionate to the amount of units held. Unit Trust A Unit Trust will have a bid and offer value which will be slightly marginally different and will be affected on many factors including the underlying fund and market performance, inflows and outflows of the fund and general consensus of using the fund in the future. The difference between the bid and offer price is called the bid offer spread. This difference has to be taken into account when buying a Unit Trust as this can affect the underlying growth going forward. goals OEIC An OEIC only has one buying and selling price, also known as the share price, which reflects the same information as the Unit Trust. Due to the fact that an OEIC only has one price has meant they have become far more popular way of investment as the tracking of performance and monitoring against its peers and benchmarks is far easier and more consistent. All new share issuance in this area is done through an OEIC. Open Ended Investment Open ended investment is a phrase that is used when describing both Unit Trusts and OEICS as it describes the nature of the ongoing management of the investment. Having an open-ended structure allows the manager to increase or decrease the number of units/shares in issue depending on the popularity of the fund. Increase in unit shares: This will usually occur when the popularity is increasing and more buyers are available to purchase the fund. This will usually slightly detract in performance as more holders are available than previous. Investors should be wary of big inflows of investment as the manager may have to wait to produce more units if the investments are not available to be utilised. Decrease in number of shares: This will generally occur when there has been a selloff in the fund and there are extra units/ shares available compared to demand. This could provide a good buying opportunity for an investor if the price drops significantly but could highlight issues with the fund which would highlight not to invest or sell more units/shares if applicable. Share Classes All Unit Trusts and OEICS will have a share class attached to them. This just highlights what availability is attached to each fund. Retail investors will only usually be able to access retail share classes, while institutional investors can access the retail share class as well as the institutional share class. Some funds may also be classed as offshore or SICAV investments. These will only really be accessed by institutional investors. However, some retail investors will use these but caution should be applied as not all offshore funds have the same parameters set up in regard to closure and liquidation which could mean that losses could be greater utilizing this share class over a UK registered retail or institutional share class.

4 04 A Guide to Investments Accumulation or Income Units Most funds will either be income paying or capital accumulating depending on the managers or investors preference. Income paying funds will distribute income a set amount depending on what is set up in the fund documents. Capital accumulating funds will not pay out any income. All income will be retained by the manager to purchase additional units of the preferred stock they are holding or to keep the cash reserve at a set level. How to Buy Both retail Unit Trusts and OEICS are available directly from the provider of the fund or through tax wrapper investments with life companies and wrap propositions. Buying direct may provide greater costs as some funds have an initial fee and exit fee attached. These are normally paid for by the life company or wrap proposition if the investor is buying through one of these means. All investors should be wary of buying any investment direct due to the fees that can be involved. Some funds also have minimum investment amounts attached to stop investors coming into and out of funds quickly thus affecting the units or shares available. Also when buying directly tax may become an issue depending on the type of fund bought and whether it was an income paying or capital accumulating fund. Some Wrap propositions do allow investors to access institutional share classes as well as funds with minimum investments as they will cover the minimum investment and initial fee internally. Trading Unit Trusts and OEICS are not intra-day traded. Depending on the platform of trading most mutual funds will be bought on a bulk basis at one point in the day. This can provide investors with risks mainly due to the fact that any buying or selling price is not known. The investment would not be able to be bought or sold at an exact price for this reason. It also means that monies may not be available straight away once a trading action has been put through as the platform would have to sell the units then make the cash available for the investor. Costs All Unit Trusts and OEICS will have an ongoing fee attached. This is known as a TER (total expense ratio) or OCF (ongoing fund charges figure). Since the implementation of RDR back in 2012 the FCA called for greater transparency with ongoing fund charges and so new clean classes of shares have been introduced. This has basically reduced all costs and made the costing more transparent. Some fund groups have taken this further by introducing an OCF which is has even greater transparency. All costs ongoing are published so the investor knows exactly what is being paid and when. This makes it far easier to compare funds and see what effect charges will have on returns going forward. The FCA is continuing to crack down on charges and so more transparency should be seen going forward within the fund management space. All charges should be taken into account when looking to utilise any mutual fund. Tax The tax payable will depend on how the mutual fund is purchased. If purchased within a tax wrapper with other investments the tax liability will be what is specified for this. If purchased directly any income paid out from the fund will be liable for income tax for the tax year where it was paid. Any capital gain made on the fund will be classed for Income tax purposes for that tax year. Where do Mutual Funds Invest? Due to the ever increasing globalization of the worldwide economy, accessibility of investment and growing number of investors in the worldwide marketplace, the number of mutual funds available to utilize is ever growing. There are currently 32 fund sectors which the Investment Management Associate (IMA) currently oversee. Within this oversight role the IMA sectionalises all funds into one of these sectors dependent on whether they fulfill the criteria for that section. Below is a list of the current IMA sectors and a definition of investment into each. IMA Sector Definitions Targeted Absolute Return Funds managed with the aim of delivering positive returns in any market conditions, but returns are not guaranteed. Funds in this sector may aim to achieve a return that is more demanding than a greater than zero after fees objective. Funds in this sector must clearly state the timeframe over which they aim to meet their stated objective to allow the IMA and investors to make a distinction between funds on this basis. The timeframe must not be longer than three years. Asia Pacific excluding Japan funds which invest at least 80% of their assets in Asia Pacific equities and exclude Japanese equities.

5 05 Asia Pacific including Japan funds which invest at least 80% of their assets in Asia Pacific equities including a Japanese content. The Japanese content must make up less than 80% of total assets. China/Greater China funds which invest at least 80% of their assets directly or indirectly in equities of the People s Republic of China, Hong Kong or Taiwan. All countries may be used. Europe excluding UK funds which invest at least 80% of their assets in European equities and exclude UK equities. Europe including UK funds which invest at least 80% of their assets in European equities. They may include UK equities, but these must not exceed 80% of the fund s assets. European Smaller Companies funds which invest at least 80% of their assets in European equities of the MSCI/FTSE pan European indices of companies which form the bottom 20% by market capitalisation in the European market. They may include UK equities, but these must not exceed 80% of the fund s assets. Flexible Managed these funds have a range of different investment and the fund manager has significant flexibility over what to invest in. There is no minimum or maximum requirement for investment in equities Global funds which invest at least 80% of their assets in global equities. Funds must be diversified by a geographic region. Global Bonds funds which invest at least 80% of their assets in fixed interest securities. All funds which contain more than 80% fixed interest investments are to be classified under this heading regardless of the fact that they may have more than 80% in a particular geographic sector, unless it s the UK, when the fund should be classified under the relevant UK heading. Global Emerging Markets funds which invest 80% or more of their assets in emerging market equities as defined by the relevant FTSE or MSCI Global Emerging Markets index. Global Equity Income funds which invest at least 80% of their assets in global equities. Funds must be diversified by geographical region and intend to achieve a historic yield on the distributable income in excess of 110% of the MSCI World Index yield. Japan funds which invest at least 80% of their assets in Japanese equities. Japanese Smaller Companies funds which invest at least 80% of their assets in Japanese equities of companies which form the bottom 30% by market capitalisation. Mixed Investment 0-35% Shares funds in this sector are required to have a range of different investments. Up to 35% of the fund can be invested in company shares (equities). At least 45% of the fund must be in fixed income investments (for example, corporate and Government bonds) and/or cash investments. Cash can include investments such as current account cash, short-term fixed income investments and certificates of deposit. Mixed Investment 20-60% Shares funds in this sector are required to have a range of different investments. The fund must have between 20% and 60% invested in company shares (equities). At least 30% of the fund must be in fixed income investments (for example, corporate and Government bonds) and/or cash investments. Cash can include investments such as current account cash, short-term fixed income investments and certificates of deposit. Mixed Investment 40-85% Shares funds in this sector are required to have a range of different investments. However, there is scope for funds to have a high proportion in company shares (equities). The fund must have between 40% and 85% invested in company shares. Money Market funds which invest their assets in money market instruments and comply with the definition of a Money Market fund set by the FCA. North America funds which invest at least 80% of their assets in North American equities. North American Smaller Companies funds which invest at least 80% of their assets in North American equities of companies which form the bottom 20% by market capitalisation. Pensions funds, other than money market funds, which principally aim to provide a return of a set amount of capital back to the investor (either explicitly protected or via an investment strategy highly likely to achieve this objective) plus the potential for some investment return. Property funds which predominantly invest in property. In order to invest predominantly in property, funds should either: Invest at least 60% of their assets directly in property; or Invest at least 80% of their assets in property securities; or When their direct property holdings fall below the 60% threshold for a period of more than six months, invest sufficient of the balance of their assets in property securities to ensure that at least 80% of the fund is invested in property, whereupon it becomes a hybrid fund. Protected funds, other than money market funds, which principally aim to provide a return of a set amount of capital back to the investor plus the potential for some investment return.

6 06 A Guide to Investments Short-Term Money Market funds which invest their assets in money market instruments and comply with the definition of a Short-Term Money Market fund set out by the FCA. Specialist funds that have an investment universe that is not accommodated by the mainstream sectors. Performance ranking of funds within the sector as a whole is inappropriate, given the diverse nature of its constituents. Sterling Corporate Bond funds which invest at least 80% of their assets in sterling denominated (or hedged back to sterling), Triple BBB minus or above corporate bond securities (as measured by external rating agency). This excludes convertibles, preference shares and permanent interest bearing shares (PIBs). Sterling High Yield funds which invest at least 80% of their assets in sterling denominated (or hedged back to sterling) fixed interest securities and at least 50% of their assets in below BBB minus fixed interest securities (as measured by external rating agency), including convertibles, preference shares and permanent interest bearing shares (PIBs). Sterling Strategic Bond funds which invest at least 80% of their assets in sterling denominated (or hedged back to sterling) fixed interest securities. This includes convertibles, preference shares and permanent interest bearing shares (PIBs). 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 Manager s stated intention to retain the right to invest across the sterling fixed interest credit risk spectrum. Technology & Telecoms funds which invest at least 80% of their assets in technology and telecommunications sectors as defined by major index providers. UK All Companies funds which invest at least 80% of their assets in UK equities which have a primary objective of achieving capital growth. UK Equity & Bond Income funds which invest at least 80% of their assets in the UK, between 20% and 80% in UK fixed interest securities and between 20% and 80% in UK equities. These funds aim to have a yield in excess of 120% of the FTSE All Share Index. UK Equity Income funds which invest at least 80% in UK equities and which intend to achieve a historic yield on the distributable income in excess of 110% of the FTSE All Share yield at the fund s year end. UK Gilt funds which invest at least 95% of their assets in sterling denominated (or hedged back to sterling) government backed securities, with a rating the same or higher than that of the UK, with at least 80% invested in UK government securities (Gilts). UK Index Linked Gilt funds which invest at least 95% of their assets in sterling denominated (or hedged back to sterling) government backed index linked securities, with a rating the same or higher than that of the UK, with at least 80% invested in UK Index Linked Gilts. UK Smaller Companies funds which invest at least 80% of their assets in UK equities which form the bottom 10% by market capitalisation. Unclassified any fund which does not want to be classified into any other IMA sector. e.g. private equity funds or funds which have been removed from other IMA sectors. Within these different sectors the IMA currently manages over 2500 individual funds. Alongside this there are 10,000 plus investments that are classed as offshore, closed ended, bank denominated or structured products that a retail client can currently invest in. This is why it is massively important for investors to use every available option when looking to invest in the retail space as a person cannot physically look through all the funds. Also trying to determine the difference between two very similar funds can be very tricky and so using someone with the appropriate knowledge can go a long way to help eradicate picking the wrong investment. The best way to highlight this is by looking at the average all the IMA sectors in general and then two specific sectors. IMA sectors 2014: In 2014 alone the difference between the top and bottom performing sectors is staggering. The top performing sector was IMA UK Index Linked Gilts with an average across all the funds of 18.3% for the year. The bottom performing sector IMA UK Smaller Companies averaging a return of -1.7% across all the funds in the sector. This is a difference of 20% which is huge difference if you were investing in one of the sectors or not. This highlights that asset allocation is key for investments going forward. Diversification too can provide less volatility and reduce major losses in portfolios. This discrepancy in returns can be shown in even greater detail even you look at an individual sector for IMA Sector Best Worst Difference Performing Performing Fund Return Fund Return UK Index Linked Gilts 21% 3.7% 17.3% UK Smaller Companies 24% -14.8% 38.8% This highlights even greater emphasis that picking the wrong fund could have a massive impact on returns and utilising experts in these areas is required going forward. Along with asset allocation and diversification fund selection is important too as the can be a huge difference in between fund returns also.

7 07 Structured Products A structured product is an investment option placed with a bank or insurance institution who agrees to pay out some form of derivative of growth or income dependent on the type of product used. It is an exchange of cash flow between one counterparty and one investor. All structured products have a derivative attached which will be based on some form of underlying investment. This will then provide an extra payment above the initial investment amount if the derivative contract completed. The counterparty will then purchase another bond to invest the capital amount so this can then be returned at the end of the investment return. If the derivative does not complete the investment will be returned on the basis of the counterparty and type of structured product used. All products have a counterparty bank attached to them and so as long as the terms are met (investment based) or the bank does not default (deposit based), a client should receive their capital invested at the end of the contract. This is why structured products should be utilized in many circumstances for many clients as the risks and rewards are known. Whether it is income, growth, participation or a combination of these options a structured product can provide a known return for the risk that is participated in within the product. There are two types of product; Investment and Deposit based. Each has its own risk vs rewards structure and these are explained below. Investment Based Products Also known as a SCARP or investment account, investment based structured products are the most prevalent in the market with more options available in this structure. An investment based product is classed as capital at risk as the initial capital investment is placed at risk and will only be returned if certain criteria are met. This is usually based on 1 of two options; a European Barrier or American Barrier of Investment. European Barrier: This is a barrier that is placed on the underlying asset and if this is breached at the end of the term only then the investment capital placed in the product is at risk. The capital will reduce normally on a basis of 2:1 of the investment percentage that it is opposite. Example: A European Barrier is set at 50%. The product at the end of the term is 60% below its start price. This means that the product is technically 10% lower than the barrier. On a 2:1 basis in total the investor will lose 20% of its starting capital. American Barrier: This is a capital at risk barrier which comes into effect at day one of the plan. The capital is affected if the barrier is breached on any day of trading with the term of the plan. Once breached if the product then finishes below its starting price the investor will lose the capital on a 1:1 percentage point basis. Example: An American Barrier is set at 50%. In the third year of trading out of 5 the barrier is breached. The plan then continues and at the end of the term the end value is 30% lower than the starting value the client will then lose 30% of its starting capital value. It does not matter if the end value is above the barrier if this barrier has previously been breached. Setup Investment based structured products can be quite complex in set up depending on the firm and the type of product. However for most products that track an index or basket of indexes/funds the setup is relatively straight forward. All products will have some form of counterparty attached that will be a high ranking investment or insurance institution that is allowed to hold client money i.e. RBS/Lloyds. This counterparty will take the money off the investor and do two things: 1) They will firstly set up some form of zero preference bond/ share that will pay back the capital that the client has initially invested and will have the barrier breach levels written in. 2) They will then purchase a call option on a market/index/basket of shares that will pay a premium if the derivative does what it should. This then gives the counterparty the monies to pay the growth/income/participation for the investor. If the derivative fails then the investor would not receive payment anyway and is not expecting this and so the derivative closes. Once the plan reaches its payment date and end of term depending on the type of product some form of capital will be repaid. FSCS Coverage Investment based products are not covered through the FSCS. This is due to how it is setup. In the event of insolvency of the counterparty, investors capital will, at that point be placed at risk.

8 08 A Guide to Investments Deposit Based Products A lesser available vehicle for investors. Deposit-based structured products have a similar set up as investment based products. However, due to the deposit nature of these types of investments the risks are far less. All deposit based products are non capital at risk as they are protected under the FSCS coverage of bank deposits. This makes these vehicles far more accessible for lower risk investors as they have the same arrangements of insolvency as any other bank deposit. Due to the product having no capital at risk there are no barriers attached to the product. This means the setup is less complex due to compensation arrangements and due to the risk involved being lower the returns available will be far less. Depending on the type of product setup they can be more expensive as coverage under FSCS has be to place within the product. Some banks will not provide counterparty holdings for deposit based structured products for this reason. Setup Deposit-based structured products can be quite complex depending on the firm and the type of product. However for most products that track an index or basket of indexes/funds the setup is relatively straight forward. All products will have some form of counterparty attached that will be a high ranking investment or insurance institution that is allowed to hold client money i.e. RBS/Lloyds. This counterparty will take the money off the investor and do two things: 1) They will set up some form of zero preference bond/share that will pay back the capital that the client has initially invested and will have the barrier breach levels written in. 2) They will then purchase a call option on a market/index/ basket of shares that will pay a premium if the derivative does as it should. This then gives the counterparty the monies to pay the growth/income/participation for the investor. If the derivative fails then the investor would not receive payment and is not expecting this and so the derivative closes. Once the plan reaches its payment date and end of term depending on the type of product, all capital will be repaid. FSCS Coverage All deposit based structured products are covered under the FSCS. This means that if the counterparty bank becomes insolvent at any time during the plan or fails to pay the capital back at the end of the term then the FSCS should cover this if the investor is within the statutory limits. For deposit based products this is 85,000 per person per institution. If an institution owns another institution then it is only 85,000 in total for both holdings. Pros, Cons & Risks As with any investment there are risks with investing in structured products and depending on the type of product and whether these are investment or deposit based the risks can be far greater. Structured products will have the following risks: 1) Counterparty risk: Risk that the bank/insurance based counterparty becomes insolvent. 2) Capital risk: Risk that full capital will not be repaid at the end of plan.* 3) Market risk: Risks that the barriers will be breached due to market factors. 4) Market risk: Risk that the plan will not provide any income or growth as the plan does not do what it says on the tin. *Only relevant for investment products* Pros Even though there are risks attached to using structured products they can be an excellent opportunity for investors to diversify risk and fully understand the risk vs return relationship of the investment they are using. The higher risk investment based products which utilise markets or investments that would be classed as high/very high risk assets as the risks are known with the product research can be used if suitable. Extensive research can be carried out on the products to make sure the product fits with an investors attitude to risk and goals. They are highly transparent which allows easier understanding. All products have a counterparty attached which will have a credit rating. This means different counterparties can be researched to find the best one for a type of product. Extensive research is provided by the companies to make sure all counterparties are viable.

9 09 All the risks are known to the client. The returns are also defined so as long as the product does as it says then that return will be provided to the investor. This makes these types of investments far less volatile. There is a secondary market available which allows investors to cash in products if required or repurchase products already in force. All deposit based products are bank deposit based and so are covered through FSCS. Cons There are some disadvantages of using structured products. As described above depending on the type of product there are risks attached to all products and investment based products may not suit a lower risk investor. There are also risks with barrier breaches, counterparty insolvency and market risk that the product does not achieved its desired aim. There are also two other drawbacks attached to this investment which are tax on growth and income and also what happens the product on death. Tax As with all investments there are tax implications of holding these types of Investment. These will have to be taken into consideration when looking at using on these types of product. Income Tax- This is payable on all deposit based structured products. Any profits made on the investment will be classed under income tax rules at the investor s marginal tax rate. Any income paid direct to the investor from an investment based structured product will also be subject to income tax at the investors marginal rate of tax. Capital Gains Tax CGT will be payable on any gain made from an Investment based structured product where income hasn t been paid directly out of the plan. What happens to the product on death? Unlike some other investments structured products cannot be transferred on death. This can cause problems for investors as on death these will need to be sold and the proceeds will then be placed into the investors Estate. This will increase the investor s Estate and may push any gain made over inheritance tax thresholds. It may also have to be sold under par value and may create a loss on the original investment amount. Where to use structured products It does not matter what your attitude to risk is when deciding your investments what is more important is your capacity for loss and need for capital in the future. Taking this into account structured products should be used only where the capital is not readily required. These products can be bought and sold on the secondary market, however, they should be viewed to be held for the longer term. Taking this into account investors should only use monies with these investments with a longer term outlook. Due to the amount of products available all clients should utilize the products where available and can use them in the following circumstances: 1) To utilise holdings in cash for the foreseeable future. The returns on bank deposits are extremely low and will stay low for the foreseeable future. 2) Diversification through the use of products in markets/stocks that may not be accessible. 3) To utilize known returns in fairly to overpriced valued markets US, UK & Developed Europe. 4) To utilize investments in volatile markets without the on-going volatility Japan & Europe. Within any asset allocation structured products can be used instead of or in conjunction with investment funds/stocks or Bonds. Many products are currently being used to access certain basket of shares without having to buy the shares directly. This reduces the risk and volatility but allows investors to participate in the returns. It also means depending on the setup if the barrier is not broken capital should be repaid. If the stocks were bought directly then losses would be made to the investor. These should not be purchased with all an investors capital. They should be used as a satellite vehicle for investors that understand the risks and setup of these products. The general consensus from the industry is that no more than 20% of a clients total wealth should be invested in products and no more than 10% in one product. These are not guidelines from the FCA. These indicators should be used to fit the clients investment goals. If this means 100% of an investment should be placed into a structured product then this is allowable as long as the investor understands the risk of this.

10 10 A Guide to Investments This is where we can help At Financial Advice Centre Ltd we research all available structured products through spwrap.com and structured product review. We then compile a best buy list of deposit and investment based products available at that time. With the help of the structured product provider we then compile a suitability report detailing the investment and reasons for investment. These are done on an individual basis. Investor brochures will also be provided. A database is run on a monthly basis which details all products used by the firm, pricings and general details of each product. Using this service means that clients are not missing out on other areas that could be majorly beneficial. These are products are being utilised because they are right for certain clients in certain circumstances. Passive vs Active Investment Many investment management firms now offer both active and passive investments due to the growing requirement by investors to have a lower cost passive option for investment in some markets whether they believe that they cannot outperform the performance of the market. Active Based Investment: Most mutual funds will be actively based in the UK. When a manager utilises an active investment approach they are only utilizing aspects of the market they are investing in to provide an action than the investment that is different to the market. Examples include producing alpha and trying to outperform a benchmark, having a lower beta which will reduce risk and volatility compared to the market or only investing in one section of a given market. Active managers will interpret market situations and manage the investment accordingly. There may be frequent changes dependent on the current circumstances and the due to this costs may be considerably higher. Passive Based Investment: Over the past two decades passive investment has been growing with the demand for lower cost and manager s underperformance of markets. Passive investment can be made electronically or by human management. The fund will replicate the holdings of the market it is tracking and will either synthetically hold the assets or physically hold the assets and will not deviate from these holdings. A synthetic version will replicate through the use of derivatives to match the index. A physical version will directly hold the underlying investments to match. The investment will only change when the underlying index changes. The fund will automatically rebalance on a quarterly, half yearly or yearly basis to make sure the fund does not deviate from the underlying holdings. As the fund will not have to make wholesale changes on a regular basis and the manager does not have much management on-going, the costs on passive funds can be extremely lower over the long term. This then provides clients with a conundrum as whether to use Active or Passive based funds. Which is better? Active based funds do tend to underperform passive funds over the longer period of time. However this is mainly due to the fact that active fund managers will have years of greater growth and then with changing market circumstances. It is difficult to choose one active manager over another as it is mainly due to factors outside academic research. Passive Investment takes this away. Passive Investments are run on market capitilisation and so the biggest investments will have the biggest share. This can distort returns going forward. In the FTSE 100 alone 37% of the index is held by the top 10 investments. Active managers can choose to not buy a particular investment at any time. During 2008 and onwards a passive fund would have to have invest in banks, whereas an active manager does not. It is difficult for a Passive Investment to have any view or standpoint. E.g. ethical or suitability view. Active managers do not tend to stay in the roles for long. The average turnover rate for an active manager is 3.5 years. Charges are generally higher for active managers rather than passive. Also on-going charges are far easier understood with passives as some active funds do have hidden costs which do not have to be disclosed to an investor. All holdings in a passive fund are known whereas the holdings in an active fund may be harder to understand. Passive Investments are only an option if there is a market/ index to track. If there is not there cannot be an investment. There are many positives and negatives of using both active and passive and what is being delivered now through most investment houses and fund investments is an approach to utilising both active and passive investments. Utilising the two together can provide better growth for an investment going forward, keeping the costs lower but also reducing the volatility. There is no right or wrong answer to using a passive or active set investment. As shown below both have their positives and negatives from an investment return perspective.

11 11 Market/Fund 5 Year Return FTSE % FTSE UK TRACKER 25% UK All Companies Sector * 56% *All companies funds can utilize other FTSE indices in UK other than FTSE 100. (Only used for illustrative purposes only). This shows that over a 5 year period, investing in an active investment would provide on average a better return than tracking the market. It also shows that a passive fund will always underperform the market that it is tracking due to costs and tracking error of a fund. This is why even when choosing a tracker fund it is best to utilise investment professionals as they will help to choose the best option for an investor. Even though active management has outperformed over the long run, as shown by the smaller companies sector which was the worst performing sector over 12 months last year it s not as easy as just picking a fund. Sector/Fund 1 year 2 Year 3 Year 5 Year Return Return Return Return IMA Smaller Companies This highlights that even active management should be a lot more hands on. You would have produced a very good return if invested in the smaller companies sector for 5 years. However, if you invested for the last year the return would of actually been negative. When producing an active managed portfolio of investments diversification is key. Active management is also key to make sure the best markets and indexes are covered. Any portfolio should be diversified to reduce volatility and smooth returns going forward. This is also the case with passive investment as diversification is required to minimize the volatility and smooth out returns going forward. There are two options when investing into passive funds: 1. Passive Unit Trusts/OEICs discussed earlier 2. Exchange traded funds Exchange Traded Funds Exchange traded funds are the new breed of passive investment options that are extremely popular in America over the last decade and have since started to enter European investment markets. Setup ETFs are set up in the same was other collectives and are opened companies that are traded on an exchange. These exchanges are daily traded and allow investors access for investment at any time during the trading day. As with OEICs ETFs have one buying and selling price. This price will be the price that any investor will buy or sell at. The price will fluctuate with regards to many factors including the underlying market, how the market is tracked and how popular the particular ETF is. They have an open ended structure and so the number of units in issue will rise or fall depending on the above factors. Trading ETFs are traded intraday. This allows investors to buy and sell at any point with real-time dealing available. A market dealer will match a buy and sell bid in real time allowing the seller and buyer to understand fully the price of the deal. This is why ETFs have become a popular investment vehicle as investors can invest in and out of the investment extremely quickly and understand where any gain or loss has been made. Due to how they are traded ETFs will have a very tight spread to the underlying indices price that it is tracking. This makes it a more popular vehicle for investment over a conventional tracker fund. Costs Due to the set up and the amount under management many ETFs will invest at very low costs. They are traded on an exchange, however no stamp duty is payable on transactions. Some platforms and investment options will charge for the use of ETFs due to access in the UK and Europe is still limited.

12 12 A Guide to Investments Tracking Options: The two main options for tracking within an ETF is synthetic and physical replication. Synthetic Replication: Uses a total return swap to mimic the performance of the index while not investing in its actual constituents. This type of replication is good for an investor as it has good tax optimisation. It also limits cash drag in the ETFs and finally means that optimisation can be carried out easily and quarterly or half yearly changes can be made limiting the cost for the investor. There are risks when using swap derived ETFs mainly due to the risk of the counterparty who has enacted the swap. If this counterparty fails then this could put pressure on the ETF holder due to the fact that the holdings will not have any replication going forward. Optimisation: This is one the more popular ETF replication methods. It utilises the match the basic characteristics of an index using part investment directly and partly multi factor risk model. This is useful in overseas markets where full replication cannot be achieved due to cost or access. It is also important in markets where full replication would not be possible due to number of holdings in the index. The advantages of using optimization are that there is no counterparty risk, the tracking of large indices or less indices can be done and there is also lower on-going costs for the fund. The disadvantages of using optimisation are that due to the holdings of some of the assets and the set up and running of the multi factor model costs can mean underperformance to the index it is tracking. There are re-optimisation costs within this replication. Full Replication: The most popular option in the smallest and most liquid markets. The ETF will proportionally invest in all constituents of the index and physically hold each security. The advantages of using full replication are that there is full transparency, there is no counterparty risk and the security lending revenue can offset some the costs within the ETF. The disadvantages are that there are transaction and custody costs when first purchasing and the on-going management of the holdings. Withholding holding tax is payable and there can be cash drag when purchasing and selling the assets. All three options are a viable option and work well in different markets and when tracking different indices. As well as how the ETF is set up in regard to replication there are other factors that need to be taken into account when choosing which ETF to choose. These include: Overall cost What index is being tracked Tracking error Independent rating of the fund Risk management Brand Track record Liquidity Efficiency All are majorly important when deciding what ETF to choose. However tracking error is especially important due to what it shows for an ETF. Tracking Error: Tracking Error is the standard deviation of the daily differences in return between the NAV and its index When looking at any passive option the tracking information can be the most important piece of information. The higher the tracking error the less returns will be made on the investment compared to the index. A lower tracking error is better. However, due to regulation there is not set way of calculation tracking error and some companies will complete it differently. Caution should always be taken when looking into tracking error. Due to the complexities with ETFs, their structure and what an investor should look out for, investment personnel with experience and knowledge should be consulted when looking into these as a viable investment option, mainly due to the fact that choosing the wrong ETF could produce unfavorable outcomes in the future. Smart Beta Smart Beta is a new type of investment in the ETF area which emphasis more of an active management approach on the conventional index tracking model. The set up can be the same as a conventional ETF, however what they are invested into can be different. Some will use physical replication but many will use optimization to access the areas required. Most smart beta investments will try and beat the market they are tracking by applying investment parameters to allow greater return. This could be from the following areas: Selecting a select number of stocks Reduce beta of the market and decrease volatility Increase Alpha on market and gain greater return Use target ratios to select stocks

13 13 Smart beta strategies are a new type of ETF which will continue to grow. As they are extremely affordable many investors will look to utilise this type of investment due to the fact that the strategy will be to beat the tracking market or limit the volatility of the investment. Investment Trusts An investment trust is a closed-ended investment company set up in the same manner as Unit Trusts and OEICs. There are some differences in the on-going running of an investment trust. Investment trusts were the first investments that UK investors could access. The longest running investment trust available is the F&C investment trust and has been live since March Many of the investment companies that are around now started with an investment trust operation and moved across to other investment opportunities. Due to the nature and set up many investment trusts are more than 50 years old, have steady management and good inflows of capital over the long run. New issuances of investment trusts are rare due to costs and funding but they do occur occasionally. Many of the well-known Unit Trusts and OEIC investments used today have an Investment Trust option which have been around for as long if not longer. Basics of Investment Trusts An investment trust is a limited company which is listed on a stock exchange. Due to the age and size of many of the investment trusts they are actually listed on the FTSE250 with F&C and Baillie Gifford trusts also appearing on the FTSE100 on occasion. The investment allocation of a trust is set out in the rules of investment and most trusts will access any listed investment they want to use. There are not any limits usually on what can be accessed. All trusts are closed-ended and so a known number of shares is in force at any one time. Shares will be reissued and bought back when there is a need for less or more shares in the market. Tax treatment Investment trusts are HMRC authorized and so they are free from CGT on internal dealings and are also covered on the basic rate dividend tax for tax payers. As with Unit Trusts, depending on the tax wrapper that investment trusts are held under, tax maybe payable on income or growth when selling the investment. If held directly all dividend payments are covered for basic rate tax payers. However due to the set up any dividend payment made to a higher or additional rate tax payer will be taxed at 25% and 30.56% respectively. Capital Gains Tax will be payable on any gain made on the sale of the investment above any exemption that an investor has for that tax year if the investment is held directly. Gearing As an investment trust is set up in the same instance as company on a stock exchange, it has the same right to borrow monies from difference sources for capital expenditure. In this instance it is known as gearing. Many trusts will be geared which means they have borrowed money over and above the capital sold to investors. Gearing usually takes place in the form of loans from the bank, preference share issues, debentures or bank loans. They all do exactly the same job but one may be preferable over another dependent on, market circumstances, interest rates costs at that period in time. When illustrated gearing will show as a percentage on invested capital. A company that is geared will have a percentage greater than 100%. Gearing is a risk to the trust and thus the investor, however it can benefit investors as it can allow managers to have a steady flow of cash to purchase assets when required. If bought at a good rate know it could provide even greater returns in the future. However if a trust is geared an investor should be cautious. Mainly due to the fact this is a liability on the trust which will have to be paid back at redemption. If the manager has got the gearing wrong or the trust is too highly geared this could put pressure on the price and stability of the investment in the future. Discounts Premiums and NAV All prices of investment trusts are determined by supply and demand on the stock market it is listed on. Due to the setup and the forces behind the price a trust may stand above or below its NAV price. NAV (Net Asset Value) is the actual value of the trusts shares at any one point. If supply and demand is good or bad this will affect the price of the investment trust and the buying and selling price could be higher or lower than the current NAV.