Investing - PDF

Document Sample
Investing - PDF Powered By Docstoc
					Introduction to
    If you are new to investing, this guide is for you. Seasoned investors may learn few
    particular insights from it. But a 2002 study for HM Treasury found that even experienced
    financial advisers were often lacking in a grasp of investment fundamentals...

    Investing is a form of saving in which an individual’s   In this guide, we’re going to cover all those key
    money can potentially generate a return. This            points and explain these simple rules.
    return can be in the form of income (like interest       •   Direct versus Indirect investments - and
    or dividends) or appreciation of the value of the            the benefits of the latter.
    lump sum invested.
                                                             •   The types of investment vehicles out
    Investing involves two key variables: ‘risk’ and             there.
    ‘return’. The object of successful investing is to       •   Managing risk through ‘diversification’.
    maximise the returns you can get for the level           •   ‘Asset Allocation’ - a key concept that has
    of risk you’re prepared to take. Or looked at                been with the investment industry for 60
    another way, to manage the risks you face from               years but has only recently made it into
    the level of return you want.                                the retail market.
    Sadly there is no crystal ball to help you achieve       •   The tax-advantaged ‘wrappers’ for investing
    this or to see clearly into the financial future. But         - like ISAs and Pensions.
    if you’re new to investing and want a little more        •   Investing through ‘Fund Supermarkets’.
    than putting you’re money in the Post Office,              •   The points to consider about your
    understanding the key points and following a few             objectives and circumstances before
    simple rules can go a long way.                              making a decision.

2                                                                                                              Last Updated:
                                                                                                                 June 2008
Essentially there are 2 main types of investment: direct and indirect investments.
Intethic is in the business of promoting indirect investment - Unit Trusts and Oeics. But
understanding direct investment first is key to understanding risk and return.

Direct investment is as the name suggests -                tax. Shares can usually be sold, potentially
where you invest directly into something which             for a profit depending on how buyers view
can change in value.                                       the prospects for the company, with any
                                                           gain potentially subject to Capital Gain
Most people are familiar with direct Cash                  Tax.
investments: -
• Current Accounts. Offered by Banks and                •   Bonds are a form of long-term loan which
    Building Societies, these are accounts                 an individual can make to companies or the
    where the investor can invest as little as £1.         Government, as a way for them to generate
    This in turn can generate interest, though                                                [
                                                           capital. UK Government Bonds are nowns4(• )Tjl1 Tso
    often not very much, with the interest
    rate varying between institutions. You can
    access your money instantly as cash.
• Deposit Accounts. Similar to current
    accounts, but usually paying a little more
    interest in return for requiring some form
    of notice period for withdrawals.
• Cash ISA (Individual Savings Account). A
    type of account where an individual can
    save up to £3,600 each tax year (6th-5th
    April). This generates interest that is not
    subject to tax.
These cash investments have two important
qualities. Firstly, their value never falls in cash
terms. In periods of high inflation, their real value
may fall. But if you put a £1,000 in the Bank, you
will get at least £1,000 back - assuming there are
no Bank charges, of course.
Secondly, even where you need to give a notice
period, withdrawing or spending the money is
straightforward. These investments are said to
be very liquid.
Non-Cash direct investments include: -
• Stocks & Shares (equities). A share in a
   company can be bought and sold by private
   investors. These shares bring certain rights
   over the company and can provide income
   in the form of dividends. UK equities are
   received with a 10% tax credit with higher-
   rate tax-payers being liable for additional
    Indirect investments give individual investors an exposure to much the same investment
    opportunities as direct investments. But they work on the basis of pooling the monies
    of many individuals into a fund and leaving it to a professional fund manager to buy
    direct investments on the fund’s behalf.

    The size of these pooled funds gives them a          - like dealing costs and the annual management
    significant advantage over most private investors.    charge.
    Their fund managers can buy a wide range of
    direct investments.                                  Very few financial firms promote direct
                                                         investment beyond the cash-holding activities of
    The manager of an equity fund for example            Banks. This is because most direct investments
    can buy shares in many different companies -          are simply not diversified.
    something private individuals would need large
    amounts of cash for to make transaction charges      Single company shares, for example, are subject
    and research costs worthwhile.                       to such vagaries as an individual company’s
                                                         own performance. A key executive leaving
    This illustrates an important investment concept     or a profits warning can cause the value of a
    - diversification - which we will come back to        company’s shares to plunge while the shares of
    later.                                               other companies are doing fine.
    Crucially, the returns on indirect investments       Pooled (or Collective) investments avoid many
    depend on the direct investments that the fund       of these problems.
    makes, less the costs of actually running the fund

4                                                                                                       Last Updated:
                                                                                                          June 2008
            If the concept of pooled investment funds makes sense, you will probably not be
            surprised to read that the world of financial services is naturally inclined to complicate
            matters. Thankfully, Unit Trusts and Oeics are fairly easy to understand in practice.

            There are several types of vehicles following the    Legally funds can be constituted in several ways
            pooled investment concept. Each of these can         - as Companies and as Trusts.
            be clasified in 3 different ways: in terms of its
            capital structure, its legal status and of course,   There are essentially two different tax regimes
            the tax regime applying.                             for pooled investment funds. Some holdings are
                                                                 taxed in a similar way to company shares. Others
            In terms of capital structure, a fund can be         are taxed, slightly oddly, as if they were a form of
            either open-ended or closed-ended. An open-          life assurance. This is really an anacranism left
            ended fund means that an investor can buy or         over from the 19th century and is broadly the less
            encash their holdings directly with the fund, and    favourable approach for individual investors.
            unless these transactions balance out, the fund
            manager will end up buying or selling the fund’s     To summarise the main types of indirect
            direct investments accordingly.                      investments in practice: -

            With a closed-ended fund, once a block of holdings   •   Unit Trusts and Open Ended Investment
            have been subscribed and paid for, they cannot           Companies (‘Oeics’) are both forms of
            normally be added to or encashed with the fund.          Mutual Funds (or ‘Funds’). Both are
            Some closed-ended funds are established with a           ‘open ended’ investments though, as the
            set wind-up date - when investors get back their         names suggest, they differ slightly in their
            share of the fund’s assets. Other than this, the         legal status.
            only opportunity for an investor to realise the          In fact both are taxed in a similar manner
            value of his investments is to sell his holding to       to companies. Units can provide capital
            other investors.                                         growth or income in the form of dividends.
                                                                     Capital growth is subject to capital gain tax
                                                                     (‘CGT’) when sold if an investor’s total gains
                                                                     in that tax year are greater than the annual
                                                                     allowance (currently £9,200). Dividends
                                                                     are received with a 10% tax credit meaning
                                                                     that only higher-rate taxpayers have any
                                                                     further liability (currently 20% of the gross
                                                                     For this reason, some of these funds offer
                                                                     2 types of ‘unit’: income units which
                                                                     pay the fund’s income as dividends, and
                                                                     acmmulation units that reinvest the
                                                                     income for capital gain.

Last Updated:                                                                                                           5
  June 2008
•   Investment Trusts. Despite their name,                and proved popular in conjunction with
    these are formed as Companies and                     ‘interest only’ mortgages for a number of
    returns from investments in them are                  years, until the Life Assurance Industry got
    again taxed in a similar maner to Company             found out.
    shares. Unlike Mutual Funds, these are
    closed-ended vehicles i.e. they have a set        •   Pension products and Individual Savings
    number of shares available.                           Accounts (‘ISAs’) complicate the landscape
                                                          still further. Though often regarded as
    The individual investor will purchase                 investments in themselves, they are more
    shares in an Investment Trust and in order            properly understood as tax-wrappers for
    to realise the value of these (before any             the investment types we’ve described
    pre-set wind-up date) the shares have                 above.
    to be sold. To faciliate this, Investment
    Trusts are usually listed on a recognised             In truth, many traditional offerrT*0 T19.7(nder)
    stock-exchange e.g. the London Stock                                                 ffo
                                                          this label have tenSalesman’s er limited
    Exchange. Returns on these investments
    can again be made in the form of ‘capital
    gains’ when sold and on dividends paid in
    the meantime.
•   Life Assurance Based Investments. These
    days most of these appear to work in a
    similar way to open-ended mutual funds.
    A key difference is that the actual holdings
    are wrapped in a Life Assurance product .
    The client holds a policy, such as a Bond
    (not to be confused with the Government
    and Coprporate Bonds described earlier).
    This is then said to be ‘unit-linked’ i.e. the
    investment element is invested in the Life
    Company’s funds.
    These funds are themselves taxed in line
    with the basic rate of income tax on all
    income and gains they make. Additionally,
    any gains in the hands of the individual
    investor over what they paid in can be
    subject to additional taxation where the
    the investor is or would be a higher-rate
    taxpayer once the gains are taken into
•   Endowments and Whole-of-Life plans
    water down the investment element by
    providing for a built-in element of life cover.
    In truth these are pretty expensive plans
    with the charges usually loaded to pay the
    Insurance Salesman’s commissions. Not
    withstanding these high and often hidden
    charges, these plans were widely sold
Sensible use of pooled investment funds like Unit Trusts and Oeics can reduce the
reduce some of the risks of investing while preserving the opportunity for worthwhile
returns. It’s all down to diversification...

Advertisements for investment products often         Ultimately, the shares of a single company could
carry fairly standard text about how the value       be worthless if that company fails. In two high
of investments can fall as well as rise, how         profile cases, investors in Northern Rock and
investment returns are not guaranteed and so         Railtrack shares lost considerable investments
forth. And this is fundamentally true.               when these firms were nationalised.

Diversification can help reduce these risks and       Unit Trusts and Oeics effectively diversify away
works in two ways. The first element is inherent      this unsystematic risk by investing in many
in the pooled investment concept.                    different companies, leaving the performance of
                                                     the funds being linked more to the fortunes of
By investing in the shares of many different          the market generally - or the specific sector of
companies, the fund signficantly reduces its          the market on which the fund focuses.
exposure to the types of events that could cause
a single company’s shares to crash in value - like   A diversified fund is said to be exposed largely to
CEO changes or a profits warning.                     systematic or markt risk .

        Most investors can benefit from a second element of diversification. The idea is that
        investments should be diversified by investing in several different investment types or
        asset classes - as the example in the diagram below shows.

        People in the investment industry refer to this     An increase in inflation on the other hand is likely
        spread of investments as asset-allocation. This     to reduce the real value of cash and potentially
        is an important linking concept with the direct     the value of Bonds, whereas companies
        investment types we discussed earlier.              increasing the prices of their goods and services
                                                            with inflation means that equities will tend to
        An asset class is basically a specific area of       retain their real value in inflationary times.
        investment whose values react slightly differently
        to any specific economic or political factors when   The main asset classes, sometimes referred to
        compared to other investment areas.                 as ‘primary asset classes’ are defined in terms
                                                            of the direct investments outlined earlier: cash,
        This can be best understood by looking at some      equities, bonds and property.
        examples using the types of direct investment.
        An increase in interest rates, for example, will    As can be seen from the diagram below, ‘sub
        tend to have a downward impact on equities and      classes’ of these usually need to be considered
        a lesser impact on property.                        when it comes to portfolio construction.

     Cash                                                                                               UK Equities
      5%                                                                                                   25%


                                                                                                         US Equities

High-Yield Bonds

                                                                                                      European Equities

 Quality Bonds                                                                                       Far Eastern Equities
     15%                                                                                                     4%

    8                                                                                                         Last Updated:
                                                                                                                June 2008
Asset Sub-Classes
Diversifying your investments by investing across
the main asset classes usually needs to consider
the ‘sub classes’ to work efficiently.
Equities as an asset-class are usually subdivided
by geographical location. Fundamentally, if
your circumstances and objectives warrant a
fair degree of exposure to equities, this should
include an element of overseas equities. Often,
this split is more specific e.g. UK, European, North
American, Far Eastern et cetera.
This rationale for diversifying to this degree is
because markets are influenced in the short term
by different economic and local political factors.
Market sentiment in the UK is less likely to have
a significant impact on Japanese markets for
In the longer term, the growth prospects of the
underlying economies may differ significantly
depending on such factors as the economic
regime in place.
Another way of looking at exposure to equities is
to look at the size of the companies in question
- the market capitalisation (‘market cap’). For
     Whereas many clients find the theoretical background to investing interesting, for a
     great number of these it still does not answer the fundamental question: how should I
     actually invest my monies to achieve my investment objectives? Here are some practical

     Use Your ISA Allowance                                The disadvantage is that a single fund like this
     One thing that can be said with a degree of           concentrates in one area - so you may be taking
     certainty when thinking of investing via Unit         more risk than you should be or need to.
     Trusts and Oeics is to use your ISA allowance         Investing in a particular equity fund concentrating
     first. Investing the first £7,200 via an ISA will       on a particular geographical sector can be pretty
     mean that any gains will be free of Capital Gains     risky - especially when you add in the risk of
     Tax. Again, this is just a ‘tax wrapper’ - you can    adverse exchange rate movements. This usually
     still invest in the same range of Unit Trusts and     only makes sense if you can afford to suffer large
     Oeics with your ISA monies.                           losses if things go wrong or if it’s intended as an
                                                           add-on to a more balanced portfolio.
     3 Ways To Select Your Investment Funds
     There are several ways to select your actual          2. Select a Mix of Funds Representing a Mix
     investment funds, whether inside or outside of        of Assets - geared to your Risk Profile and
     your ISA - and the same principles can apply to       Investment Objectives.
     Pensions like SIPPs as well.                          The main advantage of this approach is that it
                                                           gives you a diversified portfolio - so you do not
     1. Select a Particular Fund in a Particular Sector.
                                                           end up taking more risk than you’re comfortable
     This could be a specific fund you’ve had your
                                                           with and you increase the prospects for
     eyes on or seen in the press.
                                                           investment returns for the level of risk you’re
     Or it could be a fund investing in a particular       prepared to take.
     sector you think has good prospects - like the Far
                                                           It is also a fairly flexible approach to investing:
     East or North America (depending on your view).
                                                           do this via our platform and you can switch from
     If you do this, we suggest you select one of the
                                                           fund-to-fund as your investment objectives
     funds we rate.
                                                           or risk tolerance change or the prospects for
     The advantage of this approach is simple: if your     particular funds and fund managers change.
     particular fund manager or your choice of Sector
     does well, so will your investment.                   The disadvantage of this approach is that getting
                                                           both the underlying ‘asset allocation’ right for
                                                           your own objectives and risk-profile and selecting
                                                           the funds with the right managers is easier said
                                                           than done.
                                                           Our example portfolios are here to help. You can
                                                           find these on our website, updated from time
                                                           to time. Read them carefully to ensure that you
                                                           select the right one for you.
                                                           These portfolios are drawn from our ‘Star Funds’
                                                           list which can help you select a good fund for
                                                           any sector whilst our ‘Dog Funds’ list can tell you
                                                           which funds to avoid.

10                                                                                                           Last Updated:
                                                                                                               June 2008
           3. Invest via a single ‘Fund of Funds’ - one         The advantage to using a good ‘Fund of Funds’ is
           matching your Risk Profile and Investment             that it can achieve a high level of diversification
           Objectives.                                          for a relatively small investment - often from as
           Again, it’s important to use a genuine ‘multi-       little as £500. The ‘Fund of Funds’ manager will
           asset’ fund that in turn invests in funds that in    also monitor the performance of the underlying
           turn invest in all the major asset classes.          funds and make switches where needed without
                                                                you having to keep an eye on things.
           Also, we believe it’s important to use a major       The main disadvantage with a ‘Fund of Funds’ is
           international Investment House with a breadth        usually cost - total expenses can exceed 2% per
           of expertise. And to look for a ‘close fit’ between   annum. With any Unit Trust or Oeic, you usually
           the fund and your risk profile and objectives -       pay the fund managers costs and underlying
           don’t pick a particular fund just because it’s the   dealing costs. With a ‘Fund of Funds’, you also pay
           nearest one the firm appears to offer from a           for an additional layer of fund management.
           limited range.
                                                                This underlines the importance of selecting a
           Avoid the new generation of ‘Broker Funds’           good value ‘fund of funds’ and using a Broker who
           being pushed by some IFAs - that is, funds where     can effectively secure reduced annual charges
           an IFA firm advises the Fund Manager or indeed        for you by rebating part of the trail commission
           manages the funds themselves.                        ordinarily payable to an IFA or Broker.
           Such firms really lack the experience and             Our ‘Star Funds’ list includes a small number
           research resource of larger International Houses,    of Investment Houses able to offer good value
           regardless of what they claim. Arguably, these       good quality ‘Funds of Funds’. We can lower
           funds are geared to squeezing additional margin      the cost further by rebating part of the trail
           at the expense of the client.                        commission payable.

Last Updated:                                                                                                         11
  June 2008
     ‘Fund Supermarkets’ or ‘Platforms’ are web-based administration systems that
     dramatically simplify the buying, switching and ongoing management of investments
     compared to how things were only a few years ago.

     Until recently, you could get Unit Trusts and Oeics
     through financial advisers if they were to handle
     the copious amounts of paperwork involved (and
     charge you accordingly).
     Alternatively - especially around ISA season - you