Investment Fundamentals

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The value of pensions and the income they produce can fall as well as rise. You may get back less than you invested.


Investment fundamentals

There are two key aspects:

  1. The products (the wrappers or ‘pots’ that you hold your investments in)
  2. The assets (the underlying investment holdings)
The two should not be confused! For example, Unit Trusts are not in themselves ‘risky’ investment products. Unit Trusts can be cautiously invested, and if so, they are suitable for cautious investors. They can equally be invested in highly speculative asset classes, in which case they are only suitable for speculative investors, comfortable with potentially very high volatility.

For advice that takes account of your circumstances from experts who can clearly explain the most suitable investment products and assets, please contact us. For some summary information on investment products, read on…

Unit Trusts

Unit trusts are collective funds that allow private investors to pool their money in a single fund:

  • spreading their risk across a range of investments
  • getting the benefit of professional fund management
  • reducing their dealing costs.
Unit trusts are open-ended (unlike Investment Trusts) and different trusts have different objectives:

  • income or growth
  • small companies or large
  • geographical regions
The first Unit Trust was launched in 1931 by M&G. The Unit Trust Industry now manages £3 trillion in over 2,000 funds across over 30 different sectors

  • Tax
    • Income is taxed at 32.5 per cent.
    • Capital gains on any gain in excess of your annual capital gains tax allowance are liable to a flat rate of CGT at 18 per cent. Exempt for ISA and pensions.

Investment Trusts

The price of the investment trust shares depends on two main factors:

  • the value of the underlying investments (which works in the same way as open-ended investment funds); and
  • the popularity of the investment trust shares in the market.
This second point applies to investment trusts but not to open-ended investment funds or life assurance investments. The reason is because they are closed-ended funds. The laws of economics say that if there is a high demand for something, but limited supply, then the price goes up. So, if you own some investment-trust shares and there are lots of people queuing up to buy them then you can sell them for more money. On the other hand, if nobody seems to want them, then you will have to drop the price until someone is prepared to buy.

The result is that investment trust shares do not simply reflect the value of the underlying investments, they also reflect their popularity in the market. The value of the investment trust’s underlying investments is called the net asset value (NAV). If the share price is exactly in line with the underlying investments then it is called trading at par. If the price is higher because the shares are popular then it is called trading at a premium and if lower, trading at a discount. This feature may make them more volatile than other pooled investments (assuming the same underlying investments).

Gearing

There is another difference that applies to investment trusts – they can borrow money to invest. This is called gearing. Gearing improves an investment trust’s performance when its investments are doing well. On the other hand, if its investments do not do as well as expected, gearing lowers performance. Example:

If the investment trust is made up of £50m of investors’ money and £50m of borrowing then the total fund available for investment is £100m.

Say the value of the fund goes down by 10% as a result of losses in the stock market – the value of the overall fund falls from £100m to £90m.

However, bear in mind that the borrowing is still £50m, therefore the remaining £40m belongs to the investors.

So, although the overall fund went down by 10%, the investors’ money part has actually gone down by 20% (ie from £50m to £40m). Gearing boosts gains, but it also magnifies losses.

Not all investment trusts are geared and deciding whether to borrow and when to borrow, is a judgement the investment manager makes. A gearing figure of 100 means that an investment trust is not geared. Any figure over 100 shows the proportion of its total investments that is borrowed. For example, a gearing figure of 120 means that borrowed money amounts to one-sixth of a trust’s total investments.

An investment trust that is geared is a higher-risk investment than one which is not geared (assuming the same underlying investments).

Tax is like OEICs

Open Ended Investment Companies (OEICs)

OEICs are hybrid investment funds, like a cross between Investment and Unit Trusts. They are companies that issue shares on the London Stock Exchange.

They use money raised from shareholders to invest in other companies. Unlike investment trusts, they are open-ended which means that when demand for the shares rises the manager just issues more shares. With an investment trust, if demand exceeds supply, the response may be a rise in the share price. The price of OEIC shares is determined rather differently, with the key factor being the value of the underlying assets of the fund.

In contrast to unit trusts, there is no bid/offer spread, so the price of the shares should be the same whether you are buying or selling. OEICs have been popular on the continent but were only launched in the UK in 1997.

The direct tax treatment of OEICs is established by the Authorised Investment Funds (Tax) Regulations 2006 (SI2006/964) which came into force on 1 April 2006. OEICs are one class of authorised investment fund (AIF) as defined by the regulations and authorised unit trusts (AUTs) constitute the second major class of AIF.

In broad terms, the gains of an OEIC are not subject to Corporation Tax and shares in an OEIC, like units in a unit trust, are treated in the same way as other shares. It also means that provisions in the Tax Acts and TCGA 1992 which are generally applicable to companies but which do not apply in relation to authorised unit trusts – for example, the group relief rules – do not apply in relation to OEICs.

Investment Bonds
Investment bonds are designed to produce medium-to-long-term capital growth, but can also be used to give you an income. You pay a lump sum to a life assurance company and this is invested for you until you cash it in or die. There will usually be a charge if you cash in the bond during the first few years.

The bond includes a small amount of life assurance and, on death, will pay out slightly more than the value of the fund.

For most investment bonds, you take the risk of losing some money for the chance of making more than you could get from putting money in a savings account. Some investment bonds offer a guarantee but this will cost you more in charges.

Tax
  • Any growth in investment bonds is subject to income tax. The investment will pay tax automatically while it is running so, if you are a:
  • non-taxpayer – you will not have to pay any further income tax but you cannot reclaim any tax;
  • basic-rate taxpayer – you will not normally have to pay any further income tax; and
  • higher-rate taxpayer (or close to being one) – if you withdraw more than 5% of the original investment amount in a year or you have made a profit when you cash in the investment, you may be liable for more income tax.
Depending on your circumstances, the overall amount of tax you pay on investment bonds may be higher than on other investments (like a unit trust, for instance).

But there may be other reasons to prefer an investment bond. For example:

  • it may be that the policy can provide a tax-deferred income
  • Or you may want to set up the investment within a trust as part of your inheritance tax planning
If there is not a good reason to take out an investment bond, you may be better off using a different investment with a lower tax liability

Offshore Investment Bonds

Offshore bonds benefit from ‘gross roll up’ which means that the investments within the bond grow virtually free of income tax and capital gains tax. But, there may be tax to pay when you take benefits from the bond

Venture Capital Trusts
VCTs have been available since 6th April 1995. They exist to encourage investment in small companies, not listed on a recognised stock exchange. VCTs are themselves companies listed on LSE. HMRC approval is needed, and if approved, VCT offer:

  • 30% income tax relief (set against actual income tax, irrespective of rate paid)
  • Free from capital gains tax
  • Free from Corporation tax
VCTs are only available to private UK investors, aged 18+. Only new ordinary shares, with no preferential rights and no redemption within 5 years. The maximum investment in each tax year is £200,000.

Exchange Traded Funds
ETFs are Investment vehicle traded on stock exchanges which hold assets such as stocks or bonds and trade at approximately the same price as the net asset value of its underlying assets over the course of the trading day.

Most ETFs track an index, such as the S&P 500, and can be attractive as investments because of their low costs, tax efficiency, and stock-like features.

Only so-called authorized participants (typically, large institutional investors) actually buy or sell shares of an ETF directly from/to the fund manager, and then only in creation units, large blocks of tens of thousands of ETF shares, which are usually exchanged in-kind with baskets of the underlying securities. Authorized participants may wish to invest in the ETF shares long-term, but usually act as market makers on the open market, using their ability to exchange creation units with their underlying securities to provide liquidity of the ETF shares and help ensure that their intraday market price approximates the net asset value of the underlying assets. Other investors, such as individuals using a retail brokerage, trade ETF shares on this secondary market.

Contracts for difference
A CFD is a contract between two parties, typically described as “buyer” and “seller”, stipulating that the seller will pay to the buyer the difference between the current value of an asset and its value at contract time.

If the difference is negative, then the buyer pays instead to the seller, e.g. when applied to equities, such a contract is an equity derivative that allows investors to speculate on share price movements, without the need for ownership of the underlying shares.

Contracts for difference allow investors to take long or short positions, and unlike futures contracts have no fixed expiry date, standardised contract or contract size. Trades are conducted on a leveraged basis with margins typically ranging from 1% to 30% of the notional value for CFDs on leading equities.

UCITs

Undertakings for Collective Investment in Transferable Securities’ (or UCITS, pronounced yoo-sits) are a set of European Union directives that aim to allow collective investment schemes to operate freely throughout the EU on the basis of a single authorisation from one member state. In practice many EU member nations have imposed additional regulatory requirements that have impeded free operation with the effect of protecting local asset managers.