B2.09: INVESTMENT MANAGEMENT

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1 B2.09: INVESTMENT MANAGEMENT SYLLABUS Types of risk Uses and risks of different asset classes Meeting investor needs Role of tracker funds Management styles Types of investment management service Nominee accounts Portfolio distribution Taking over a portfolio Types of risk Almost all investments carry a degree of risk, though the risk can take different forms The higher the degree of risk, the greater the potential return an investor would require in order to justify investing Capital risk is the risk of a loss of all or part of the original capital invested Shortfall risk is the risk that an investment does not perform as well as hoped and so does not produce the expected return Interest rate risk reflects the fact that interest rates can change Income risk is the potential for the level of income produced by the investment to change Inflation risk is the risk of inflation eroding the value of the investment and/or the level of income produced Liquidity risk is the risk that it may not be possible to dispose of the investment when desired, or that a buyers market will result in a poor price being achieved So an illiquid investment (ie one that may be hard to dispose of) carries a higher risk than a liquid investment (which can readily be disposed of) Currency risk is the risk of changes in exchange rates affecting the value of investments which are denominated in a foreign currency Uses and risks of different asset classes Deposit accounts and similar investments such as cash ISAs are generally classified as low risk, because there is little or no capital risk, but inflation risk is generally present There is also an element of capital risk because the deposit taking institution could fail, although this is reduced by the compensation arrangements (and eliminated for investors holding no more than the maximum amount covered) Interest rate risk and shortfall risk might be present, depending on the account concerned However, deposits are always useful for emergency funds and short term holdings, for example prior to investment elsewhere, because of the desirability of low risk exposure in this situation With fixed interest securities, there is capital and shortfall risk unless held to redemption, because the value of holdings fluctuates on the market

2 Capital risk is greater where the term to redemption is relatively long, but least with shortdated securities ie those close to their redemption date It is greatest with non-redeemable securities (ie those with no fixed redemption date) such as undated gilts and building society PIBS (Permanent Interest Bearing Shares) Inflation risk is also present with fixed interest investments Fixed interest securities are exposed to interest rate risk in the sense that a change in interest rates is likely to affect the capital value of the investment even though the income produced is unchanged Fixed interest securities such as gilts, corporate bonds and building society PIBS are particularly useful where the investor needs income at a known level The risk of the failure of the issuer is present, but gilts virtually eliminate this because of their UK government backing However, gilt yields are lower than can be achieved with corporate bonds as a consequence of the lower level of risk Although the income is secure, it is generally fixed, which means that its real value will be eroded by inflation, particularly over the longer term Fixed interest securities also provide some insulation from changes in interest rates for those intending to buy an annuity in the future This reflects the fact that generally, the value of fixed interest securities rises if interest rates fall (and as a result annuity rates become more expensive) and vice versa Equities are subject to most of the risk types mentioned, other than liquidity risk (assuming the equities are quoted) and currency risk (assuming they are quoted in the UK Unquoted shares may be difficult or impossible to dispose of and so can carry considerable liquidity risk Direct property investment is subject to most of the risk types mentioned above, including liquidity risk, but excluding currency risk if the property is in the UK Equities and property give the best chance of outperforming inflation in the long term, but are unsuitable for short term investment (for which low risk investments are better suited) Income should increase over the years as company profits or rental income increases, and this tends to support an increase in capital value too In general, equities will produce a mix of income and capital growth, though some holdings emphasise one rather than the other For example, preference shares and cumulative preference shares offer income, but (depending on the terms) may have limited capital growth prospects Investment trust zero dividend preference shares ( zeros ) give no income, but provide only the potential for capital growth In general, the more and the greater the risk factors are, the greater the potential return The existence of the various risk types tends to support a recommendation for diversification of a portfolio across asset classes Warrants and derivatives provide the potential for still higher returns than equities and property, but at the price of an increased degree of risk For example, warrants, which are often issued alongside new investment trust shares, give the opportunity to buy further shares, usually at par, on one or more fixed future dates

3 They are traded separately on the stock market However, if the warrants are not exercised, usually because the market price of new shares is less than the exercise price, they will become worthless Meeting investor needs Any investment manager will need to spend time identifying the needs of the investor, so he can manage the portfolio accordingly Even if the manager is responsible for only a part of the investor s overall portfolio, he will want to be aware of the overall context This might include checking that the investor has sufficient emergency funds in cash or nearcash form to cope with any unexpected events Identifying the client s ability to accept risk is a major aspect of the manager s Know Your Customer/Client obligation Role of tracker funds Tracker funds provide a cheap and effective way of achieving performance broadly in line with the market as a whole Tracker funds are available based on various UK and overseas indices, and for some specialist market sectors They reduce non-systematic risk (ie the risk which flows from choosing to invest in particular companies) but not systematic risk (which affects the market as a whole) This is true of diversification of a portfolio of equities in general, so a tracker fund is a particular approach to building in diversification Tracker funds are passively managed (merely aiming to match the market as measured by an index) rather than actively managed (aimed at outperformance by effective selection of investments) As a result, management charges for a tracker fund can be kept lower than would apply to an actively managed fund Performance is not guaranteed to keep pace with the selected index however The difference (known as tracking error) will usually be least with a fund adopting a full replication approach This approach aims to keep the fund holdings in line with the make-up of the index as closely as possible Precise matching however is not feasible in practice, particularly bearing in mind dealing costs and other charges Other approaches, including stratified sampling, based on a computer model, tend to have greater tracking error levels Tracker funds are treated for tax purposes in the same way as actively managed funds Management styles There are many possible management styles for actively managed funds, and this section covers only a few of the major styles Top-down management focuses on choosing attractive market sectors and then choosing shares within those sectors Bottom-up management seeks to identify attractive individual shares irrespective of sector

4 Value investment looks for shares which the manager believes to be undervalued by the market Growth investment is based on identifying shares in companies with significant growth potential The barbell approach addresses the need for income and growth through different holdings, which may therefore be at different ends of the investment spectrum Types of investment management service Various levels of service are available from managers, at a range of costs A discretionary management service involves the manager taking all the investment decisions on behalf of the client, and reporting periodically Broad criteria will have been agreed with the client in advance however, for example to determine whether the requirement is capital growth, production of income, or a mixture of the two An acceptable approach to risk will also have been agreed An advisory management service is one where the manager makes personal recommendations to the client, but the client makes each decision The manager would not therefore take action to buy or sell any investments without the client s specific agreement An execution only service means that the manager is reactive rather than proactive He will neither make personal recommendations to the client, nor initiate any dealing activity Instead, he will simply carry out instructions from the investor He might however comment on investment conditions generally, or highlight certain funds as being well-managed, while stressing that decisions are the responsibility of the client The execution only service is the cheapest service as a result Nominee accounts Managers often require or recommend that the investor s assets are placed in a nominee account operated by the manager This allows dealing to take place without the need for the investor to complete paperwork in relation to each transaction For example, it would not be necessary to obtain the client s signature for a share transfer where the shares are held in the client s own name Regular reports will however be made to the investor and the approach to dealing will be in line with the type of service provided (as discussed above) The taxation position is not altered by the existence of the nominee account the income and any gains remain taxable on the investor Portfolio distribution The portfolio distribution must reflect the needs of the investor and the proportion of his total portfolio which is being managed For example, if the manager is dealing with the entire portfolio, there are likely to be a mix of assets of various classes, including cash, fixed interest securities and equities

5 On the other hand, the manager may only be looking after the client s equity portfolio (or part of it), in which case the portfolio may be close to 100% invested in equities (though some cash will always be held to meet charges etc) Taking over a portfolio A manager taking over a portfolio may find that the existing holdings are not in line with his recommendations taking account of the client s circumstances However, although he might ideally like to adjust the portfolio, this may not be appropriate, at least immediately One issue is cost each transaction will involve cost, so changing the portfolio would not be justified if the cost of change was likely to outweigh the expected benefit This is likely to be the case if the portfolio is close to, but not exactly in line with the normal recommendation of the manager Another issue is the client s tax position For example, suppose a client is overweight in equities in the manager s view (ie he has a greater proportion of equities than the manager would recommend) Disposing of some of the equities could trigger an immediate capital gains tax (CGT) liability which could be avoided if the disposals were made over a number of years, in order to fully utilise the client s annual exemptions Once again, the potential advantages of any proposed change would need to be considered in the light of the tax implications and weighed against them A similar situation arises when a portfolio is reviewed, because different levels of growth will have been experienced with different investments, and this will have changed the portfolio distribution For example, suppose a portfolio of 100,000 is originally invested 70,000 (70%) in equities and 30,000 (30%) in cash If the return experienced over a period is + 12% for the equities and + 4% for the cash, the holdings will have become 78,400 in equities and 31,200 in cash In percentage terms, the portfolio is now valued at 109,600 in total, of which the holding in equities is 71.53% and the cash is 28.47% The manager will need to decide if the change in relative weighting is acceptable, or whether an adjustment should be made