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AF4
2 Day
Revision Workshop
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Aims of the revision workshop
Agenda
Your role
The exam itself / resources on the day
Techniques to pass
Resources you will have available
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Aims of the Revision Workshop
• Review knowledge elements of the study guide• To build on your own exam study, develop your knowledge, and
enable you to apply this to answer AF4 style questions.• Opportunity to receive feedback on your exam technique• Identify your main learning areas post-workshop• Formulate a study plan aimed at passing AF4
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Your Role……
Get involved Ask Questions
Respect your fellow delegates
Please!
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Agenda & Objectives
• Understand appropriate exam technique;• Apply ratios when evaluating direct
investments;• Understand the impact of microeconomics on
future investment returns;• Explain the features, risks and taxation of
direct investments;• Explain the features, risks and taxation of
indirect investments;• Apply this knowledge to successfully answer a
range of AF4 style questions and scenarios
• As a result of this workshop, you will be able to:
• Explain different investment strategies inc.EMH, top-down, passive v active;
• Calculate, mean, median, weighted probability and CAPM;
• Explain standard deviation, alpha and beta, and correlation;
• Explain how to measure performance using different measures;
• Apply this knowledge to successfully answer a range of AF4 style questions and scenarios.
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The Exam Itself / Resources• 160 marks available (Only!)
• Published pass mark is 55%
• All written answers
• 3 case studies (80/40/40)
• Number of marks indicated per question
• Tax tables provided.
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Advanced Diploma - Exam Technique (1)
In the exam:• Read the question at least twice – be clear what is being asked!• Relate your answer to specifics in the case study; just generic
knowledge will not score highly• Spot the verb: explain, describe, calculate, list/state• Spend your time where the marks are• Typically, 1 mark = 1 substantive point or step in a calculation• Look through all the questions first before studying the case study
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Advanced Diploma - Exam Technique (2)
• Positive marking – you can’t have marks taken away!
• Marks not lost for untidy handwriting
• Don’t use block capitals
• Use bullet points
• Leave space between parts of questions
• If in doubt, put it down
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Exam 2018 2017 2016 2015 2014 2013 2012 2011
AF1 55.58% 49.10% 45.02% 57.55% 53.36% 55.50% 57.28% 60.97%
AF2 51.66% 48.28% 53.52% 52.27% 50.54% 42.25% 49.32% 48.25%
AF3 31.34% 51.26% 37.25% 31.47% 40.92% 45.94% 51.93% 44.83%
AF4 47.86% 48.96% 63.37% 63.88% 62.58% 65.65% 62.93% 60.65%
AF5 58% 64.60% 66.88% 61.75% 65.71% 61.05% 66.55% 55.82%
AF6 44.23% N/A 78.95% 72.29% 44.71% 47.52% 58.82% N/A
AF4 – historical pass rates
Source: CII published data
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AF4 Key Content – Past Performance
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AF4
Portfolio returns
Equity ratios
Investment Theories
Other areas
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Equity Ratiosand
AnalysingCompanyAccounts
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Investment ratios• EPS• Dividend yield• Dividend cover• P/E ratio (known as ‘historic P/E ratio’)• NAV• PEG• Payout Ratio
Equities
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Earnings Per ShareProfit attributable to ordinary shareholders
_________________________________
Number of ordinary shares in issue
The profit after corporation tax and preference dividends is used in the calculation of this ratio because it represents the profit available for distribution as dividends to ordinary shareholders.
It represents the amount in pence the company has earned during the year for each ordinary share.
The trend in EPS over time indicates growth or otherwise in the profit attributable to each ordinary share.
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Dividend YieldNet dividend per share ____________________ x 100
Current share price
This measures the relationship between the net income from a share and its price.
The dividend yield measures the ordinary shareholders' annual return on investment, and may be compared with what could be obtained by investing in some other company.
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Dividend CoverEarnings Per Share ________________
Dividend Per Share
• The profit after corporation tax and preference dividends is used in the calculation of this ratio as it represents the profit available for distribution as dividends to ordinary shareholders
• It represents the number of times a dividend is covered by earnings and indicates how likely it is that the company will be able to maintain future dividends on ordinary shares at their current level if profits were to fall in future years
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Payout Ratio= Inverse of Dividend Cover
Dividend Per Share ________________
Earnings Per Share
• It represents the % of profit that has actually been distributed as a dividend to the ordinary share holders
• A high ratio may not be sustainable if profits go down, whereas a low payout ratio indicates that a company is primarily focused on retaining its earnings rather than paying out dividends
• Low ratio indicates growth companies i.e. reinvesting
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Price Earnings (P/E) RatioCurrent Market price of share_______________________
Earnings Per Share
• Market view of the earnings growth potential of the company. They should only be used to compare companies in the same sector
• A company’s P/E ratio higher than the average for an industry sector suggests high demand for the shares. The shares are relatively expensive, but investors would expect to be compensated by higher than average earnings in the future.
• A lower ratio than average suggests that a company is not greatly favoured by investors / have poor growth prospects.
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Price Earnings Growth (PEG)PE Ratio
_______________Earnings Growth %
• Helps to determine a stock’s value while taking the company’s earnings growth into account
• It provides a more complete picture than the P/E ratio on its own
• The lower the PEG ratio, the more the stock may be undervalued, given its earnings performance.
• So under 1 means shares may be undervalued, so attractive
• Over 1 usually a sign that the share is overvalued
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Net Asset value (NAV)Total net assets attributable to ordinary shareholders
NAV = ___________________________________
Number of ordinary shares in issue
Net Assets = Total assets – Total liabilities – Value of Preference Shares
A share would normally be expected to sell at a premium to its net asset value, as investors would be willing to pay something for
goodwill i.e. the company’s management, expertise and reputation.
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Long Term Loans + Preference Shares Gearing Ratio = _______________________
Total Equity – Preference Shares
Gearing Ratio
• This helps determine what proportion of the company’s share capital is being “leveraged” by borrowing.
• A number over 1 indicates the company is borrowing above its equity value, so is highly geared, perhaps being aggressive with its financing.
• This can impact on earnings because of the extra interest expense payable
• Financial leverage is the ratio of long term debt to equity referred to as gearing
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Current RatioCurrent Assets
Current Ratio = _______________________
Current Liabilities
• A typical current ratio should be between 1.5 and 2, but depends on the type of business and the prevailing economic conditions.
• A low ratio for a particular business may indicate a potential future insolvency.
• A high ratio may mean a business may have too much working capital, which usually means that assets are not being used as profitably as they might be.
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Liquidity RatioCurrent Assets - Stock
_______________________
Current Liabilities
• A more cautious ratio is the liquidity ratio (also called the ‘quick’ or ‘acid’ test), because it measures only those assets that can be quickly and definitely turned into cash.
• As a generalisation, the liquidity ratio should be at least 1
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Return on Equity (ROE)
Net Profit After Taxation & Preference Dividends ______________________
Capital And Reserves (Shareholders’ Funds)
• ROE measures the % rate of return the company is achieving on the investment funds provided by shareholders, which come from share purchase as well as retained earnings
• Retained earnings are earnings accumulated over the years from profits not paid out as dividends these will be shown in the profit and loss section of the balance sheet as reserves
• It indicates how efficiently a company’s management has utilised the shareholder’s funds.
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Return on Capital Employed (ROCE) Profit Before Interest And Taxation
______________________Capital Employed*
*(Ordinary shareholder funds + long term debt)
• Measures the return being achieved on capital employed in the business, so helps show how well the company assets are being used to make money AND how well costs are being managed.
• Capital employed includes ordinary shareholder funds (including reserves) PLUS long-term debt (as the loans and any preference shareholder share value are being used to finance productivity)
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Analysing Company AccountsPlus lots of Operational management measures,
• Sales per employee• Statistics per employee• Wage costs as a % of sales• Admin costs as a % of sales• Asset turnover• Assets per employee• R&D as a % of sales
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Analysing Company Accounts
Limitations to ratio analysis:
Often based on historic data
Changes in organisational accounting policies
Only as good as the source material
Shouldn’t be considered in isolation – should look for
trends over time
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The Macroeconomic
Environment
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Microeconomics: Quiz
1. What are the four stages of the economic cycle?2. What is the difference between fiscal and monetary policy?3. Quantitative easing: what is it, how is it supposed to work?4. Explain why deflation might damage the economy.
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Fiscal and Monetary policyFiscal - Use of government spending and taxation
• During recession, govt spending may increase or taxes cut to stimulate the economy
• In a boom, spending may be reduced or taxation increased to dampen demand
• Approach by govt will impact upon individual investments respectively raising or reducing profit making capability
Monetary policy – Control of interest rates and money supply• Attempts to provide economic control through manipulation of interest rates
and money supply.• Bank of England responsible for interest rate policy in UK. Forward looking -
a change in rates now only likely to have full impact in 18-24 months’ time.
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Impact of Monetary PolicyEasing• Rates reduced• Asset prices rise
– Bonds?– Property?– Equities?
• Savers suffer• Businesses can borrow and invest more
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Inflation
Effect on investments
•Cash•Fixed interest securities
•Equities.
Terminology
•Disinflation•Deflation
•Stagflation
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Exchange ratesEffect on UK shares
Indicator Rise in the pound Fall in the pound
Profitability of exports
Share price of major exportersValue of profits earned overseas by UK companies when translated into sterling
Firms benefiting
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Exchange ratesEffect on UK shares
Indicator Rise in the pound Fall in the pound
Profitability of exports Reduces Increases
Share price of major exporters
Reduces Increases
Value of profits earned overseas by UK companies when translated into sterling
Reduces Increases
Firms benefiting Firms that import heavily e.g. raw
materials
Exporters
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Direct Investments
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Cash Investments General characteristics• Interest rate variations• No capital growth
Risks• Default• Inflation• Interest rate fluctuations• Exchange rate movements (FX accounts).
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Fixed Interest SecuritiesGeneral ‘Fixed’ characteristics:
– Interest – The ‘coupon’– Redemption Value – Par Value– Redemption Date
Pricing- Clean price – Ignores value of any accrued interest- Dirty price
Yield- Interest/Running/Income/Flat Yield – All the same!- Redemption Yield – Takes account of price paid vs redemption value
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Bond yields Interest yield
Annual Coupon (Gross) x 100Market Price (Clean)
Calculate the interest yield:Coupon of 5%, clean price of 107.50
Interest yield is: 5/107.50 x 100 = 4.65%
Bond yields Gross redemption yield
Profit (or Loss) to redemption / No of years to redemption
Market Price (Clean)
Interest yield
+ or -
x 100
Calculate the Gross Redemption Yield, assuming 5 years to redemption:
Interest yield is: 5/107.50 x 100 = 4.65%
Capital Loss at redemption = - £7.50
-£7.50/5 years = £1.50/107.50 x 100 = -1.40%
4.65% - 1.40% = 3.25%
Annual Coupon (Gross) Market Price (Clean) x 100
CP < £100 CP > £100
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Fixed interest securities - Risks
Specific or commercial
risks
Market risks –interest rates,
inflation
Volatility (Most volatile = longer
dated, lower coupon)
Duration / Modified Duration
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Fixed interest securities - Risks• Duration (Macaulay)
– Period of time it will take to repay initial outlay (in terms of interest and capital)
– Used to measure sensitivity of fixed interest investment to changes in interest rates
– Modified Duration estimates the change in a bond’s value if there is a change in interest rate (and thus yields)
• Modified Duration Formula– Duration (Macaulay)
(1 + GRY)
• 1% change to interest rates– Modified Duration x 0.01 x Clean Price = Change in bond value– In £
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Yield curves
Time to Maturity(Years)
Gross RedemptionYield
Normal – Upward Yield Curve
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Yield curves
Time to Maturity(Years)
Gross RedemptionYield
Reverse / Inverse Yield Curve
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Yield curves
Time to Maturity(Years)
Gross RedemptionYield
Flat –Yield Curve
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Equities: Quiz
1. Name six factors that will affect the price of a share.
2. What is a rights issue? What is the impact on the investor?
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EquitiesRights issues• Reasons
– Fund specific expansion plans– Strengthen the balance sheet– Refinance the company after a crisis
• Options for investors– Take up the offer (pay full amount due)– Sell the rights in the market– Sell sufficient to take up the balance– Lapse (company sells rights and distributes proceeds)
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Types of Equity
• Two main classes– Ordinary and preference
• Differ in three main areas:– Dividends– Company control– Return of capital if company goes into liquidation
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Preference Shares• Fixed dividend half yearly• Priority over dividends on ordinary shares• No voting rights• Rank ahead of ordinary shares on company liquidation• Different types –
– Cumulative– Non cumulative– Participating– Redeemable– Convertible
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Ordinary Shares• Bulk of company share capital
• Rights to profits after preference shareholders
• Attend/vote at AGM
• Last in line for assets in the event of liquidation
– After all other debts discharged
– And other shareholders have received their entitlements
• Non voting
– Known as “A” Shares
• Deferred
– No dividend until……
– ordinary shareholder dividends reach a set level or
– end of a specific period after issue
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Property Investment - Agenda
• Residential - Investment considerations
• Commercial property - Considerations and associated problems.
• Yields – Calculation
• Stamp duty land tax
• Letting part of main residence - rent a room relief
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Stamp Duty Tax Key Points• SDLT Rates are NOW given in the tax tables, so don’t need to learn – just
how to use!• Difference between residential and commercial• Sales & re-mortgages are ignored
• Stamp Duty Reserve Tax –.5% on purchase only• Gilts/ETF/Unit Trust/OEIC/AIM shares/Divorce /Probate EXEMPT• PTM Levy- £10,000
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Property Investment – Rental YieldsRental yields are a good way of assessing the percentile return on aproperty investment. For Rental Yields to be accurate we need to factorin costs associated with purchasing or buying the property.
If a property is advertised at £150,000 with an estimated rental income of £600 the Rental Yield would be :
£600 x 12------------- (x100)= 4.8%
£150,000
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Property investment – Rental YieldsHowever the above does not take into account any costs associated with purchasing the property. Let us estimate £4,500 for associated fees.
£600 x 12-------------- (x100) = 4.66%£154,500
Any costs associated with renting the property will further reduce the yield. Now let us estimate annual service charges by the letting agent of £1000.
£600 x 12 (-£1,000)------------------------- (x100) = 4.01%
£154,500
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Property – Rent a Room (RAR)• The individual must occupy the property as their main residence. One exempt amount per residence of £7,500 • No tax is payable if the gross rent for a tax year, before deducting expenses, is less than £7,500• The rent taken into account is the payment for the accommodation plus any payment for related goods and services e.g. cleaning & meals• It can be let to anyone• If the rent exceeds £7,500, taxpayers have a choice:1. choose to pay tax on the excess over £7,500, with no deduction for expenses;
or2. they can be taxed on the gross rent received, less expenses, with no rent-a-
room relief.
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Indirect Investments
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Exercise:
• What are investment trusts?
• How do they differ to unit trusts/OEICs?
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Investment Trusts v UTs/OEICs
Investment trusts••••••
UTs/OEICs••••••
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Offshore Funds• Reporting funds
– Income declared to HMRC, Investor taxed as income arises
– Taxed like UK dividends or interest for UK investor
• Non-reporting funds– Mainly ‘Roll-Up’ funds – no income distributed
– Gain calculated using CGT principles
– However, gain taxed as income, @ 20, 40 or 45%
– PSA available at £1,000 or £500 on savings income.
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Real Estate Investment Trusts ‘REITS’ (1)
• Closed ended
• Investment trust with public listing (incl. AIM)
• Investor owns shares in a product that invests in property
• Provides a liquid market in property investment with taxation broadly linked to that of direct property
• Can add diversification into property sector without the need to purchase property directly.
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Real Estate Investment Trusts ‘REITS’ (2)
• Has two internal sub-sections providing two different income streams
• A tax-exempt (ring-fenced) section which contains the property
• A non-tax exempt (non ring-fenced) section often providing property management services
• These are explored on the next slides.
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Real Estate Investment Trusts ‘REITS’ (3)
• Ring fenced property letting business must represent at least 75% of overall gross profits & 75% of fund in property
• 90% of the rental profits from this part of the business must be distributed within 12 months of end of accounting period
• Rental profits must cover costs of gearing by 125%
Internal taxation of REIT (ring fenced
business):
Exempt from Corporation Tax on rental profits and
capital gains
Taxation for investor:
• Treated as property income and paid net of
basic rate (20% tax)
• can be reclaimed by non taxpayers incl. ISAs and
pension funds
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Real Estate Investment Trusts ‘REITS’ (4)
• Non ring fenced business (other property related activities)
• Dividend paid gross
Internal taxation of REIT (non ring
fenced business):
Corporation tax payable as usual
Taxation of investor:
Usual dividend treatment i.e.
Dividend allowances and dividend rates
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Property Authorised Investment Funds ‘PAIFs’ (1)
• Open ended• Must be structured as an OEIC• Investor owns shares in a product that invests in property
• Structure is similar to a REIT but open-ended• Also contains cash element to aid liquidity.
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Property Authorised Investment Funds ‘PAIFs’ (2)
• Has three internal sub-sections providing three different income streams
• A tax-exempt (ring-fenced) section which contains the property
• A non-tax exempt (non ring-fenced) section often providing property management services
• A cash section to aid liquidity
• These are explored on the next slides.
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Property Authorised Investment Funds ‘PAIFs’(3)
• Ring fenced property letting business must represent at least 60% of overall gross profits & 60% of fund in property
• No corporate investor can hold more than 10% of the funds Net Asset Value (NAV).
Internal taxation of PAIF (ring fenced
business):
Exempt Corporation Tax on rental profits
and capital gains
Taxation of investor:
• Treated as property income and paid net of
basic rate (20% tax)
• can be reclaimed by non taxpayers incl. ISAs and
pension funds
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Property Authorised Investment Funds ‘PAIFs’(4)
• Non ring fenced business (other property related activities)
• Dividend paid gross.
Internal taxation of PAIF (non ring
fenced business):
Corporation tax payable as usual
Taxation of investor:
Usual dividend treatment i.e.
Dividend allowances and dividend rates
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Property Authorised Investment Funds ‘PAIFs’(5)
• Cash element mainly held to ensure liquidity within the PAIF as fund is open-ended
• Interest paid gross.
Internal taxation of PAIF (Cash element):
Corporation tax payable as usual
Taxation of investor:
Usual interest treatment i.e.
Personal Savings Allowances and
savings rates
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REITs v PAIFs
• Exercise: 5 Minutes
• In Pairs/Groups.
• A REIT and a PAIF share many common characteristics. • List the key differences between them.
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REITs v PAIFs
REIT• Closed ended• Investment trust• 75% minimum in property• 2 income streams
– Property (Ring fenced)– Dividends (Non ring fenced)
• Can be in ISA
PAIF• Open ended• OEIC• 60% minimum in property• 3 income streams
– Property (Ring fenced)– Dividends (Non ring fenced)– Cash element
• Can be in ISA
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Exchange Traded Funds ‘ETF’s’ (1)
•Open ended fund index tracking funds •Trade like shares on exchanges with continuous “real time” pricing•More transparent than funds •Give exposure to specific markets •Dividends are payable if the underlying securities pay them.
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Exchange Traded Funds ‘ETF’s’ (2)
•Cheaper than other collectives•Bought and sold like shares so brokerage commissions•No stamp duty is now payable•OCF’s – Ranging from 0.3 – 0.75%•Spreads•Rebalancing costs.•Physical or Synthetic
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Taxation: VCT v EIS v SEISVCT EIS SEIS
Annual investment limit £200,000 £1M £100,000
Carry back to last tax year
Income tax relief 30% 50%
Tax relief clawed back if held for less than:
Reinvestment relief:•Before gain made•After gain made
Tax free dividends (ignoring dividend allowance)
Tax free capital gains
IHT BR?
71*50% of reinvested gain is exempt; remaining 50% are chargeable
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Alternative investments
Collectables- No income, capital growth only. - Specialist markets. - Extra cost of ownership.- Viability- Hard and soft commodities
Commodities• Risks• Direct investments rare• Usually through:
– Funds– Exchange traded commodities
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Derivatives (1)
• A financial contract that ‘derives’ its value from the value of an underlying asset
• Originally used in commodity trading but more recently used for stocks & shares as well
• Can be used to speculate and more commonly to hedge risk• Need a general understanding of these for AF4 as questions are
relatively common.
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Derivatives (2)
• Different types to consider –– Futures– Options– Swaps– Contract for difference (CFDs)
• Each allows traders and hedgers to make a profit on both the upward and downward movement in the value of the underlying asset without actually needing to hold the asset.
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Derivatives (3)
Futures• An obligation to purchase / sell an asset at a specified price
(strike price) on a specified future date• Legally binding• Can be subsequently traded on a derivatives exchange• Buyer has a long position (committed to buy), seller has a short
position (committed to sell).
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Derivatives (4)
Options• An option not obligation to purchase / sell an asset at a specified
price (strike price) on / before a specified future date• Buyer of an option has the right to exercise their option, can trade it
on a derivative exchange or allow it to expire worthless• Either arranged directly (over the counter) or on a derivative
exchange (exchange traded)• A call option is the right to buy• A put option is the right to sell.
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Derivatives (5)
• Swaps: An agreement between two parties to exchange a series of cash flows over a period of time.
• Contract for Difference (CFDs): An agreement to exchange the difference in the value of an asset for a period of time.
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Hedge Funds (1)
• A term given to investment funds that adopt non-traditional investment methods
• Can adopt a number of ‘house styles’Long / short – combining long and short investments
Relative value – Identifying price anomaliesEvent-driven – Using world events as triggers to trade
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Hedge funds (2)
Benefits• Diversification
• Expertise
• Variety
• Volatility
Drawbacks• High cost
• High entry level
• Complexity
• Volatility
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Investment Advice Process
& Planning Principles
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Investment Advice Process
• Establish & define the relationship• Gather client goals• Ethical considerations• Analyse & evaluate the client’s financial situation• Create a risk profile• Formulate the investment strategy for asset allocation• Select investment funds using appropriate tax wrappers• Present and implement recommendations• Monitor portfolio and adjust where necessary
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Passive Management Strategies• A strategy not attempting to outperform the market
• Should not require active intervention but will be self-maintaining.
• 2 main techniques:
• Buy & Hold• Indexation
• Full replication• Stratified sampling• Optimisation
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Active Management Strategies
• Analysis used in attempt to achieve above average or superior risk-adjusted returns
• 2 main approaches
• Top-down• Bottom-up
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Top-down Active Management Strategy
1. Asset allocation– Strategic asset allocation– Tactical asset allocation
2. Geographical distribution3. Sector selection4. Stock Selection
– Fundamental analysis– Technical analysis
– Chartists– Mechanical trading rules
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Bottom-up Active Management Strategy
• Securities selected on own merits• Often applies when objectives of the
fund make asset allocation irrelevant• ‘Stock-picking’
– Value– GAARP
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Measurement & Management of
Risk
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Median & Mean Examples
Median• The return that other returns have a 50%
chance of being above and a 50% chance of being below.– Put the returns in order– If it is an odd number of returns it is the
middle figure– If it is an even number of returns it is
the mean of the middle two returns
Mean• The average of returns, each return
weighted by the probability of it happening.– Multiply each return by their probability,
then total the resulting ‘weighted probability’.
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Median & Mean Examples
Returns:• Share price over last 5 days has been:
– 130p, 136p, 132p, 138p, 136p.
• Median:– 130p, 132p, 136p, 136p, 138p.
• Mean– (130 + 132 + 136 + 136 + 138) = 672 = 134.4p
5 5
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Weighted Probability ExampleThe number of times a specific mean % return has been achieved for an investment over the last 10 years:
One year returnr (%)
Probabilityp
r x p(%)
-5%
0%
5%
10%
-5% 0% 5% 10%2 2 4 2
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Risk
• Risk = Volatility
• Two main measures of volatility – Standard deviation (MPT)– BETA (CAPM)
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Standard Deviation (1)
• Standard Deviation measures how widely the actual return on an investment varies around the mean– If returns stay close to the mean, it will have a low SD
and be regarded as being low risk– Returns fluctuating widely around the mean would have
a high SD and be regarded as being high risk.• It is calculated by taking the square root of the
variance– i.e. a variance of 30.60 = √30.6 = 5.53 SD
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Standard deviation (2)
Expected returns: Assume that the portfolio has a Standard deviation of 7% and mean average returns are 15%.
There will be :• Around a 68% chance that the actual return will lie
somewhere between 8% and 22% (15% ± 7)and
• Around a 95% chance that the actual return will lie somewhere between 1% and 29% (15% ± 2 x7).
and• Around a 99% chance that the actual return will lie
somewhere between -6% and 36% (15% ± 3x7).
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Correlation
• Correlation is a number between +1 and -1. • The most effective diversification comes from combining investments that are
negatively correlated.Return
Time
Investment A
Investment B
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Correlation Question
Asset X Y Z
X 1.0 0.8 -0.2
Y 0.8 1.0 0.3
Z -0.2 0.3 1.0
In respect of these correlation values, which is correct:
A. if asset X rises by 7% asset Z willrise by 2%.
B. if asset X rises by 9% asset Y will rise by 7.2%.
C. if asset Z falls by 4% asset X will fall by 0.8%.
D. if asset Z falls by 3% asset Y will fall by 3%.
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Diversification – Other Aspects
To reduce risk further, diversification across:• Asset classes• Equities within asset classes, large / small, industries, sectors, blue chip / aim• Geographical – UK / overseas.
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Efficient FrontierReturn
Risk
Efficient frontier curve
A B
CED
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Capital Asset Pricing Model (CAPM)• Calculates expected return which investor should receive for given
level of risk
• Assumes investors are well diversified
– no specific / unsystematic risk
• Introduces new concepts:
– Risk free rate of return
– Market return.
• An individual security’s sensitivity to systematic risk is referred to as
it’s Beta (β)
– The market, by definition, has a Beta of 1.
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Beta• Beta is used to measure the volatility of an investment compared to the
market average
• If an investment moves exactly in line with the market, then it will have a Beta of 1
• Beta of 0.8 means that in investment rises and falls at a slower rate than the market, hence is less volatile and hence is less volatile – less risky.
• If an investment has a beta of 1.2 then it is higher risk and you would expect a higher reward in return.
• The higher the Beta, the higher the risk.
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CAPM Assumptions• Investors are rational and risk averse
• Investors make decisions on risk and return alone • All investors have the same holding period• Market has many buyers and sellers• No one individual can affect the market price• There are no taxes, costs or restrictions on shorting
• Information is free and simultaneously available to all• Unlimited funds can be borrowed or lent by all investors at the risk free rate.
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CAPM Formula
ERi = Rf + [ßi(Rm - Rf )]ERi = Expected return to the
investment/portfolio
Rf = Risk free rate of return
ßi = Beta of the investment/portfolio
Rm = Return of the market
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CAPM – Exercisea) Calculate the expected return based on the following information:
• Risk free rate is 3%• Beta is 1.5• Expected market return is 8%
b) What would be the alpha produced if the fund manager achieved an 14% return?
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CAPM FormulaERi = Rf + [ßi(Rm - Rf )]
In the AF4 exam, you might be given the expected return of the share / fund
and be expected to calculate the market return instead……
This involves a bit of ‘formula re-arranging’:
ERi - Rf = ßi x (Rm – Rf)
ERi – Rf = Rm – Rf
ßi
{ERi – Rf } + Rf = Rmßi
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CAPM – Exercise 2
a) Calculate the expected market return based on the following information:
• Risk free rate is 2.4%• Beta is 0.9• Expected portfolio return is 6%
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Measurement of return - Alpha
Alpha (denoted α ) – measures the return over or below that suggested as a minimum by CAPM
α = Actual return minus CAPM predicted return
Positive alpha – return in excess of CAPMNegative alpha – return below CAPM prediction
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CAPM
Main limitations: • Studies have shown that not all non-systematic risk can be
eliminated through diversification• Betas are historic and can be unreliable • Two academics, Eugene Fama and Kenneth French studied the
historic return on US stocks to that expected under CAPM and found no relation.
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Arbitrage Pricing Theory
• CAPM is a single factor model – price is solely dependent on the security’s relationship to the market measured by beta
• APT states risk premium is based on a number of independent factors i.e. multi factor
• Can be market or industry related• Can include macroeconomic variables e.g. Interest rates, inflation,
industrial production • Each factor taken into account and extent risk will affect that
security.
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• Main assumption – efficient and perfect market competition.– share prices already reflect all available information
• Mature stock market, as found in the UK– a large number of securities, buyers and sellers, – a large number of market makers
• Assumes all the information about all shares is readily available• The hypothesis supports the development and use of index
tracking funds / ETFs
Efficient Market Hypothesis (1)
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• In reality:– information distribution is not equally disseminated through the market.
There may be occasions when individuals have advance knowledge which can lead to an advantage.
• In respect of individual portfolios it encourages a wide selection of shares to diversify the risk as much as possible.
• Weak, Semi-strong, and Strong-form efficiency definitions expand the hypothesis
Efficient Market Hypothesis (2)
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Impact of emotion and psychology on investing/biases• Prospect theory
– Investors not always rational – gains/losses viewed differently• Regret
– Reluctance to realise losses, loss more distressing than equivalent gain is rewarding- sell winners/hold losers
• Overconfidence and over/under reaction– Overestimate own skills in predicting success, underestimate inability to influence
negative outcomes– Assume short term trends will be the norm, without reference to historical data or
statistics.
Behavioural Finance
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Performance Measurement
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Performance measurement
Performance attribution
Fund manager selection Portfolio reviews
Investment performance
Investment Performance
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Performance Measurement
Risk-adjusted returns
• Sharpe ratio
• Information ratio
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Sharpe RatioMeasures risk adjusted return of investment -based on the excess
return for every unit of risk that is taken to achieve the return
Return on investment - risk free return (TB) standard deviation
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e.g. Fred’s OEIC returned annualised 10% compared to 4% from a risk free investment
The standard deviation of the fund is 8% so:
10% - 4% = 0.758%
Meaning the OEIC returned just 0.75% return above the risk free rate –hardly worth it!
The greater the Sharpe Ratio the better its risk adjusted return has been
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Information RatioMeasures risk adjusted return of the performance of active portfolio
managers against their market/benchmark
Portfolio return – Benchmark returnTracking error
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e.g. Fred’s OEIC returned annualised 10% compared to 9.5% from his benchmark. If the tracking error is 0.9:
10% - 9.5% = 0.560.9
Meaning the OEIC beat its benchmark and active management has in effect been justified.
The greater the Information Ratio the better its risk adjusted return has been.
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Select an appropriate benchmark
Establish the asset allocation for the benchmark fund
Calculate the return for each asset class in the benchmark fund
Compare the benchmark to actual portfolio performance in terms of asset allocation
Calculate the effect of stock selection or sector choice
Performance Attribution5-step approach:
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Performance AttributionStep 1: Select an appropriate benchmark• A mix of assets which reflects the client’s long-term objectives
• It establishes a neutral / independent long-term position for the portfolio to compare
with
• The portfolio manager can take a different view on asset allocation (i.e. overweight /
underweight)
• The benchmark provides a sound basis for comparison against which to evaluate the
investment performance of a manager
• Wealth Management Association benchmarks frequently used
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Performance Attribution
Step 2: Benchmark asset allocationFor example, the Wealth Management Association (WMA) balanced portfolio:
Asset class % Representative Index
UK shares 32.5 MSCI UK IMI
International shares 30.0 MSCI All Country World Index ex UK
Bonds 17.5 Market iBoxx Gilt/Corporate/UK Inflation Linked
Cash 5.0 GBP LIBOR -1% w/ floor 0%
Commercial property 5.0 MSCI UK IMI Liquid Real Estate
Alternatives 10.0 MSCI World DMF 50% + 1 W LIBOR (GBP) 50%
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Performance Attribution
Step 3: Benchmark returnsAsset class % Index performance
for each class (%)Contribution to
return (%)UK shares 32.5 8.0 2.6International shares 30.0 5.0 1.5Bonds 17.5 4.0 0.7Cash 5.0 1.0 0.05Commercial property 5.0 -3.0 -0.15Alternatives 10 -1.0 -0.1Overall contribution to return 4.6
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Performance Attribution
Step 4: Comparison of asset allocationAsset class Manager
asset allocation
%
Index performance for each class (%)
Contribution to return (%)
UK shares 45.0 8.0 3.6International shares 30.0 5.0 1.5Bonds 17.5 4.0 0.7Cash 5.0 1.0 0.05Commercial property 0.0 -3.0 0Alternatives 2.5 -1.0 -0.025Overall contribution to return 5.825
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Performance Attribution
Step 5: Stock selection and/or sector choiceAsset class Benchmark
asset allocation
(%)
Index performance
(%)
Actualperformance
(%)
Contribution to return (%)
UK shares 32.5 8.0 7.8 -0.065Int. shares 30.0 5.0 5.1 0.03Bonds 17.5 4.0 3.6 -0.07Cash 5.0 1.0 1.2 0.01Comm. prop 5.0 -3.0 0 0.15Alternatives 10.0 -1.0 1.0 0.2Overall contribution to return 0.255
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Fund Manager Selection
1. What key factors would you take into account when selecting a fund manager?
2. What would you consider as part of a investment portfolio review?
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Summing Up….
By the end of this session you will be able to:• Apply your knowledge of
investments to answer AF4 exam style questions.
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Aims of the revision workshop
• Review knowledge elements of the study guide• To build on your own exam study, develop your knowledge,
and enable you to apply this to answer AF4 style questions.• Opportunity to receive feedback on your exam technique• Identify your main learning areas post-workshop• Formulate a study plan aimed at passing AF4
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CII Past Papers Webinars x 2
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125
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