1. Certificate for Introduction to Securities & Investment (Cert.ISI) Unit 1 Lesson 42:  The UK Investment market  Investment funds  Investment styles  The benefits of collective investment 42cis

2. The UK Investment market The UK asset management industry forms a major part of the UK’s financial services industry. It is responsible for managing the investment of institutional and retail fund totalling more than £3trn. The Investment Management Association (IMA) is the trade body for the UK-based asset management industry, and promotes high standards. It represents the interests of the industry when dealing with the government and regulators, as well as the press and public. Its members manage:  Authorised investment funds, such as unit trusts and OEICS  Pension funds  Stocks and Shares ISAs 7 th Asset Management Survey (Source: IMA)  Assets managed in the UK as of end Dec. 2008 totalled an estimated £3trn  76% of assets managed in the UK are invested on behalf of institutional investors and 24% on behalf of the retail market  Over 25,000 people are directly employed in the asset management industry  IMA member firms hold approximately 43% of the UK stock market  The revenue earned by UK-based asset management firms was £9.4bn

3. Corporates (Equity-Debt) Exchanges Investment Banks Securities Houses “Sell side” Broadly speaking, the financial services sector can be divided into two main functions The UK Investment market  The “sell side”  Selling investment ideas, strategies, advice and services to the owners or managers of money  The “buy side”  Owners or managers of money who pay for these services with fees or commission Investment managers are positioned at the very heart of this process Corporates (Equity-Debt) Exchanges Investment Banks Securities Houses Investment Managers Consultants Pension Funds, Local Authorities, Charities Banks / Insurance sales Advisers Insurance funds Private Investors / Individuals “Sell side” “Buy side”

4. Before making any investment, individuals ask themselves the following sorts of questions Where to invest? How to invest?  What am I investing for?  Retirement  Tuition fees  I just want to make money  What amount of money will I need?  When will I need it?  70% of my average pre-retirement income  £9,000 x 3 inflation- adjusted for two kids  At least one million  Age 65  First child turns 19 yrs old in 15 years time  By the age of 40  What risks am I prepared to take?  Very low: I will need this to live  Medium risk is acceptable  High risks  What types of asset are right for me?  How can I avoid risk?  Steady, reliable income yield: bonds, annuities  Income yield and some capital gains: equities  Capital gains: speculative stocks, commodities  Pass up the chance of making capital gains  Choose blue-chips with dividend track record  Have a diversified portfolio

5. Different types of financial assets carry with them different levels of risk Where to invest? How to invest? The greater the required return, the greater the risk that must be taken. Investors seeking a high return must be prepared to see a fall in the value of their financial assets without panicking.  In an investor is not prepared to take on any risk whatsoever, then investing in the stock market is not a suitable course of action  The investor should definitely not consider investing in derivatives or commodities Investors also need to consider whether they need to draw down an income from their investments immediately or whether they can let that income accumulate in their investment fund An investment fund where dividends or interest is re-invested will produce much more powerful growth over time This investor has drawn down £2,500 of income over the 10 years but has sacrificed £3,144 of potential returns

6. The benefits of collective investment Collective investment schemes (i.e. funds) pool the resources of a large number of investors with the aim of pursuing a common investment objective This pooling of funds brings a number of benefits, including  Economies of scale  Large investments orders attract much more competitive dealing fees and commissions  Managers of large funds get much more attention from brokers and investment bankers o Investment information can be more timely and comprehensive  Diversification  But an investor needs a substantial amount of money before he/she can build up a diversified portfolio of investments directly o Most UK on-line brokerages charge a minimum commission of £12.50 per trade, irrespective of the size of the deal. £5,000 invested across 30 stocks would incur charges of £375 – 7.5% of the entire investment fund! o £5,000 invested in a fund might give access to 80 investments in the fund for an initial fee of, say, 5%  A diversified portfolio is less risky than a portfolio with just one or two investments in it

7. Diversification Diversification can be achieved in a number of ways  Sector diversification within the same asset class  Geographical diversification within same asset class  Investments in many different countries, e.g. bond issued by governments in UK, US, Japan and Germany  Bond portfolio o Bonds spread across several types and maturities, such as Gilts, Index-linked Gilts, Corporate Straights, Zero Coupon, Commercial Papers etc  Equity portfolio o Shares spread across several sectors, such as Utilities, Pharmaceuticals, Industrials, Transport, Retail, etc A typical portfolio of US stocks  Diversification across different asset classes  A mixed portfolio of bonds, equities, property and cash deposits EquitiesPropertyCashBonds

8. The benefits of collective investment (cont.) Collective investment schemes also give investors access to professional investment management and geographical areas or asset classes with which they may be unfamiliar The great majority of private investors have very little knowledge of stock-markets outside their own country o Professional fund management firms usually maintain teams of fund managers who specialise in investing in specific areas of the world  But some of the best performance can be found in some of the least accessible markets around the world Professional fund managers follow their chosen markets closely and will consider carefully what to buy or sell and more importantly:  When to buy or sell o Timing is key to successful investment Dow Jones Industrial Average, July 1987 – Jan 1988 Professional fund managers charge fees for their services.  Entry fees or initial charges for collective investment schemes  Exit fees to leave collective investment schemes  Annual management fees

9. Investment styles Collective investment schemes (funds) are available with a wide range of investment objectives and investment styles Investment objectives  To invest in UK companies with above- average potential for capital growth  Example of an investment objectives: Each fund will make it clear what types of assets the fund manager will invest in (e.g. bonds, equities, etc), and whether derivatives will be used to hedge currency of other market risks Investment styles  To outperform the FTSE 100 index  Example of investment styles:  Active management of the portfolio to outperform an index  Top-down or bottom-up investing An extract from a typical fund prospectus

10. Active investment style Active management seeks to out-perform a predetermined benchmark over a specific time period  These future events might relate to the economy as a whole (important for forecasting overall profits growth of the corporate sector, or movement of interest rates)  The fund manager would use fundamental and technical analysis to assist in forecasting future events If the FTSE 100 rose by 15% in one year and the value of a fund’s UK large-cap share portfolio rose by 20%, it can be said to have outperformed its benchmark. The active management has paid off for the fund’s investors.  These future events might relate to specific companies, such as dividend announcements, or earnings announcements In December 2004, fund manager Anthony Bolton celebrated his 25th anniversary in charge of the Fidelity Special Situations fund. At that point, Bolton’s fund had returned an average compound rate of return of 19.9% per annum, against 13.5% for his benchmark index, the FTSE All-Share index. One thousand pounds invested at launch was worth circa £90,000. That was more than 3.5 times what the index had returned over the same period, and more than double the cash return recorded by the second best performing fund in Bolton’s peer group, UK equity unit trusts.

11. Active investment styles Two commonly used terms in the context of active management are “top-down” and bottom-up”  This means the manager focuses on economic and industry trends rather than the prospects of particular companies  Top-down investing  These future events might relate to specific companies, such as dividend announcements, or earnings announcements  Bottom-up investing Top-down investors believe that stock selections are not so important if you can predict the bigger economic picture. Bottom-up investors believe that some companies can buck the overall economic trend Bottom-up investing also includes the following investment styles:  Growth investing: picking the shares of companies with opportunities to grow in the long term  Value investing: picking the shares of companies that are under-valued relative to their present profits or cash-flows  Momentum investing: picking the shares whose value is rising (on the assumption this will continue)  Contrarian investing: picking the shares that are out of favour and may have value the rest of the market may not have spotted

12. Passive investment style Although all active fund managers charge fees for their expertise, relatively few active fund managers outperform their benchmarks  The performance of the portfolio is designed to “track” the up-and-down” movements of the index. No attempt is made to forecast future events  Passive fund management recognises phenomenon by constructing a portfolio which simply replicates the index itself. It buys the index constituent stocks In such cases, investors would have been better off simply investing in the market itself, because the index actually performed better than the active fund manager’s stock selections  Once set up, passive portfolios are generally less expensive to run than active portfolios  This is known as index-tracking, or indexation. It assumes that shares are efficiently priced by the market and cannot, therefore, be consistently outperformed  The ratio of staff to funds managed is lower than for actively managed portfolios  Turnover of the portfolio is lower, leading to lower dealing costs Source: Financial Express Analytics, November 2010

13. Passive investment styles (cont.) Active and passive management are not mutually exclusives. Some funds employ both styles – this is known as core-satellite management  Performance is affected by the need to manage cash-flows, rebalance the portfolio to replicate changes in the index constituent weightings and to adjust for stocks being promoted into – and being relegated from – the index.  Disadvantages of pure passive management include Core-satellite management seeks to index the core of the fund – say 70-80% – to minimise the risk of under-performance. It will then actively invest the remainder to try to achieve outperformance  Most indices assume that dividends from constituent equities are re-invested on the ex-dividend (xd) date but a passive fund can only re-invest dividends when actually received (usually six weeks after the share has been declared ex-dividend.  Indexed portfolios may not meet all an investor’s objectives  Indexed portfolios must necessarily follow the index down in bear markets Total return indices of the unmanaged Global Market Index (GMI) versus its year-end unmanaged twin (GMI-R). Monthly data to January 2010. Source: The Beta Investment Report