2.4.3. RISK
2.4.3.1. RISK REQUIREMENT
It has been mentioned that the portfolio must have an overall risk of 60% of the Financial Times All Share Index equating to a beta value of 0.6.
2.4.3.2. RISK THEORY
The price of securities is determined by two major kinds of risk:
1. Systematic Risk, which influences the market as a whole.
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2. Specific Risk, which influences specific securities.
(see appendix …..)
Risk is caused by factors that affect the prices of virtually all securities, although in different proportions. Examples include changes in interest rates and consumer prices.
Although it is not possible to eliminate systematic risk through diversification, it is possible to reduce it by acquiring securities (for example, those of utilities and many blue chips) that have histories of relatively slowly changing prices.
The following factors determine these types of risk:
Systematic Risk Specific Risk
Economic growth. Development of a company
Economic situation
Political events. Particular events in a given sector
Price levels
Employment situation. Strikes
Foreign trade Change of management
3.0 INVESTMENT DECISIONS AND SUGGESTIONS
3.1. PROPERTY
3.1.1. MORTGAGE
Conservative Consulting Ltd advises against taking out a new mortgage despite this being one of the cheapest forms of borrowing. It is often found to be unwise and self-defeating to have a mortgage alongside other investments on a low-risk financial strategy. The returns from other investments are rarely much larger than the interest being paid out on the mortgage. Also the government has abolished mortgage tax relief (MIRAS) and homeowners have to pay a mortgage out of their taxed income, this involves a considerable loss for people in the highest tax brackets.
3.1.1.1. Paying of the existing mortgage.
Paying of the existing mortgage eradicates one of the largest debts providing comfort and security for the future along with a boost in income after the payment. We strongly advise that your first investment is to pay off the existing mortgage.
3.1.2. BUYING A PROPERTY
Investing in the property market is one of the best tangible assets. House prices generally rise giving capital growth upon future sale. A buy-to-let option provides regular income up to the point of sale. The buying of a property is virtually risk free as the investment is in bricks and mortar.
The present situation in the housing sector means it is an ideal time to become a landlord. Second mortgages (if required) are cheap along with the current high demand for property from young professional and students make the buy-to-let option very attractive.
As advised, the first investment you should undertake is to pay off the existing mortgage on your current property.
Current Mortgage = £10,000
3.1.3. FINANCING THE PROPERTY
Figure 1 : Initial Property Costing Table
The refurbishment and furnishing cost is based on replacing old/damaged furniture and the conversion of a reception room into a fourth bedroom. This will increase the yearly income by having more tenants in the house. Despite the large initial cash flow to convert this room it is seen to be a good long-term investment, the cost of conversion will be paid off within the first year from the rent that the extra tenant will be paying.
3.1.4. PAYBACK
Figure 2: Property Payback Table
3.1.5. PROPERTY INCOME LESS COSTS AND TAX
The cost breakdown and yearly profits are highlighted in the following table,
Figure 3: Overall Property income and cost table with tax
Beta value = 0.5 can be assumed for property
Additional Notes:
- It is taken that the house will be financed without the use of a mortgage as advised by us. The cost of the house can be paid in full using the £300,000 inheritance
- The rent is based on a monthly charge on £50 per person per week; the house selected accommodates four people (after the conversion) hence a yearly income from the rent of £10 400 can be expected.
- The agency fee is included to ease the stress associated with letting out property, for example the contractual side. This can be waved if Mr. Roberts feels able to rent out the property himself.
- Depreciation is included to provide a general source of finance for maintenance costs that will obviously be incurred due to occupation of the property. Again this can be waved if Mr. Roberts decides to introduce a damage deposit from his tenants.
- The house is under Mr. Robert’s spouse’s name and tax is at 22% due to her income being under £29,900.
3.1.6. DESCRIPTION OF THE PROPERTY
The house chosen is in Lenton. This is situated in close proximity the University of Nottingham and hence there will be a constant demand for the property from students, this helps to eliminate the risk involved in the buy-to-let option. The house includes two reception rooms; it could be possible to convert one of these into a fourth bedroom to increase the annual income from rent.
Information sheet on the exact details (Appendix….)
Link to site with picky on
3.2. BOND INVESTMENT
3.2.1. OVERVIEW
A bond is a debt security. It involves the investor lending money to the issuer, who promises to pay you a specific rate of interest during the life of the bond and to repay the bond when it matures.
In the last two years many bonds, unlike equity shares, have had returns well over 15%. In a diversified investment portfolio bonds are an essential inclusion. Bonds can boast the following:
- Bonds are a form of debt to a firm. In an investment situation this means that debtors’ claims are met before shareholders, and should the firm have to be liquidated, debtors are given preference over ordinary shareholders in the queue for the remainder of the company’s cash.
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Economic environment. A strong market for bonds is one in which interest rates are declining. Recently, the federal reserve in the U.S.A., cut interest rates by ½%, and the bank of England announced (on 7th November) that they would keep interest rates the same, although predictions suggest that they will fall soon too, in line with America. This will affect the changing value of money, and hence will alter the value of the selling price.
3.2.1.1. METHODS OF BOND INVESTMENT
There are several ways of including bonds in a portfolio, they are:
- Individual bonds
- Bond funds
- Money market funds
- Bond unit investment trusts
3.2.2. REASONS FOR BOND INVESTMENT
Due to our customer’s attitude to risk and annual income desires, the best way to take advantage of the benefits of bond investment would be a mixture of individual bonds and bond funds. We have discarded money market funds as they are for short-term investors, and bond unit investment trusts also because, while similar to bond funds, they have the disadvantage of no direct management. We feel that Mr. Roberts should invest for consistent income and secured return on principal, rather than for short-term profits by quick re-sales and gambles on interest rates.
Bonds allow for more control over ones choices and although less secure than a fund, they will generally give a fixed income that does not eat into your principal. Bond funds, however, will generate a more variable income due to the constant additions and elimination’s from the portfolio in response to market conditions/investor demand. It is also for this reason they do not have a specific maturity date due. Bond funds also have the extra advantages of:
- Extra diversification. A wide range of investments across different countries, industries and companies would lower unsystematic risk of a portfolio.
- Economies of scale. Investors have buying strength in bulk; they can negotiate better deals.
- Professional management. Being managed by a professional body can capitalise on the expertise and contacts of the managers in charge, contacts that would have otherwise been unavailable to an individual investor.
- Issue / administrative costs are not a problem. The worry and hassle of paperwork and trading of shares, at the correct times, in the correct quantities is avoided for those who do not want the full time job of managing these bonds.
- Access to international markets. Investors have the chance to dabble in foreign markets, whilst keeping a low overall level of risk. This helps give an insight as to which are profitable.
- Personally managed funds can beat the market. Assuming that the efficient market hypothesis is a weak assumption, it is thought that a talent investment manager can possibly beat the market and make above average returns.
Unfortunately, as with everything, there is a price to pay for these low risk investment opportunities. These include
- Annual charges. The managing firm will require a percentage charge of initial investment, annual income and, in some cases, withdrawal of capital. Although, income costs are based on profits, i.e. A variable cost that will only occur if the returns are favourable.
- Dependant on manager taking decisions. A degree of trust in the investment manager must be present, as a substantial amount of money is being placed in his/her care. This trust is not always rewarded by prudent, wise decision making. Careful selection is a key portfolio component!
3.2.3. THE INVESTMENT TYPES AND ACTUAL INVESTMENTS.
3.2.3.1. TYPES OF BOND
Corporate bonds – General Electric, Canadian Government
Treasury bonds – U.S. Government
Bond funds – Fremont, state farm
3.2.3.2. CORPORATE BONDS
General Electric CAP CORP MTN BE
Coupon: 7.000
Maturity: 02-03-2003
Ratings: aaa/aaa
Industry: financial
Pay frequency: semi-annual
Quantity available: 88
Minimum: 20
Price: 101.239
Yld to mat: 0.329
Current yld: 6.914
Amount invested £5000
Since this is rated aaa/aaa by standard and poor it can be assumed that the relevant beta value is zero.
3.2.3.3 TREASURY BONDS
Canadian Government
Coupon: 6.750
Maturity: 08-28-2006
Ratings: aaa/aaa
Industry: foreign government
Pay frequency: semi-annual
Quantity available: 3000
Minimum price: 113.320
Yld to mat: 2.971
Current yld: 5.957
Amount invested £3000
U.S Government T-note
Coupon: 4.250
Maturity: 01-15-2010
Settlement date: 11-22-2002
Pay frequency: semi-annual
Quantity available: 200
Price: 112.15
Yld to mat: 2.390
Current yld: 3.789
Amount invested £2000
3.2.3.4. BOND FUNDS
FREMONT BOND FUND (FBDFX)
We have decided to invest £8000 in this fund.
We feel that this large, stable fund worth over $1,159.1 million, is a good fund in which to invest for a number of reasons:
- The firm’s objectives focus on long term goals by having balanced portfolios through diversified portfolios. To ensure consistent performance, management normally keeps duration within a moderate range and utilizes all major sectors of the fixed-income market.
- It is also important to pick not only the investing firm, but also the portfolio manager. This is the job of bill gross, one of the best known and most respected fixed-income managers in America today.
- This portfolio is suited to Mr. Roberts’ situation as the average maturity of the fund is between five and ten years, which makes it an excellent choice for investors looking for income and lower risk of principal.
- The portfolio invests in a wide range of bond securities including mortgage-backed securities, u.s. treasury bonds, international bonds, and corporate bonds.
- The bond has also outperformed the Lehman brothers aggregate bond index for investment periods of 5 years or more, backing up claims of the company objective of long term vision
The weighted average coupon for the fund = 3.73% (after annual operating expenses)
Maturity, portfolio average = 8.37years
Credit quality, portfolio average = aaa
The top five holdings for this fund are as follows:
STATE FARM BOND FUND (SFBAX, CLASS A)
We have decided to invest £6000 in this fund.
This fund (worth $41.5m), unlike the Fremont fund, has a larger element of risk attached. It suits an investor seeking higher potential returns than money market funds and willing to accept the price volatility of bonds with longer maturities. However, the firm has retirement plans set-up so it’s not exclusively a high-risk investor. Even though this is not the in the criteria set down by Mr. Roberts, we feel that a small investment in this fund will add to the diversified portfolio.
The investment objectives are based around attempts to realize, over a period of years, the highest yield consistent with investing in investment grade bonds. State farm deem a bond to investment grade if Moody's investors service, inc. ("Moody's") or S&P have rated the bond in one of their respective four highest rating categories. (Non-investment grade bonds are commonly referred to as "junk bonds.")
- Asset type: stocks & bonds
- Net assets (as of 9/30/2002): $41,477,864.42
- Maturity, portfolio average 5.51years
- 65% of the funds invested are in bonds rated: aaa.
- The weighted average coupon for the fund 4.3% (after annual operating expenses)
The bond fund may invest in the following instruments:
- corporate debt securities
- U.s. government debt securities
- Foreign government debt securities
- Asset backed and mortgage backed securities
- Other issuer debt securities
The managing firm is state farm investment management corporation, which has over 30 years managing investment company assets and is currently responsible for over $5.2 billion in assets
3.3. EQUITY INVESTMENTS
3.3.1 FUND INVESTMENTS
3.3.1.1 FUNDS INTRODUCTION
Funds are investment vehicles that pool the money of many small investors and invest it in a range of shares or other assets.
3.3.1.2 ADVANTAGES OF FUNDS
- Investing in managed funds involves much less work for the individual investor than investing individually in the stock market, and serves as a useful way of diversifying a portfolio such as yours.
- When investing in funds, the risk of a single investment in a company is spread through diversification. Funds invest in at least ten companies across different industries and often in different countries, so the poor performance of a single company won’t affect your returns. This reduces the risk of investment.
- Investing in riskier world and emerging markets brings higher returns than home markets. Buying individual shares in these markets is very difficult, so only through funds these benefits can be found.
- Funds are managed by qualified and experienced professionals. They are therefore likely to make the correct investment decisions as they specialize in the selection and maintenance of investments. They also have industry contacts to call on detailed information. Skilled fund managers are an important factor in the choice of a fund. Fund managers can also negotiate better deals with the increased buying power of the pooled assets that trusts bring.
3.3.1.3. DISADVANTAGES
The only drawbacks of investing in trusts are the charges made to invest in them. These are typically an initial charge and then an annual management charge, both taken as a percentage of the investment. This is also an important factor in selecting a fund.
3.3.1.4 TYPES OF FUND
There are several different types of fund available. The main ones are:
Unit trusts – These are run by investment managers, banks, building societies, insurance companies and direct sell financial operations. When you invest, you buy units, whose price fluctuates with the value of the trust’s investments. There are two prices for units; a buying price and a lower selling price. These change daily and can be sold at any time. There are initial and annual charges.
Open ended investment companies (OEICs) - These are the same as unit trusts, except that the investment vehicles are limited companies, so shares, rather than units are traded. There is a single share price, unlike unit trusts.
A specialist type of investment trust is the venture capital trust (VCT), which invests in small, unquoted companies. This was introduced by the government in 1995 to aid small businesses. High interest rates can often be found due to the frequent explosions in growth of small businesses. However, small businesses frequently go bust, so VCTs are of a relatively high risk. They have several differences to normal investment trusts, notably tax benefits in the form of a 20% income tax rebate on the sum invested – i.e. invest £100 and it only costs the tax payer £80, provided the investment is held for three years.
3.3.1.5 FUNDS INVESTED IN
Funds Selected:
JUPITER HIGH INCOME FUND
This is a unit trust offered by Jupiter Unit Trust Managers Ltd. with the objective of achieving a high and rising income with capital growth. The Fund's investment policy is to attain this objective by investing principally in equities and high yielding convertible securities, with some exposure to fixed interest securities, primarily in the UK. It has 110 holdings.
The Jupiter High Income Fund is managed by Anthony Nutt, who is a director of Jupiter Unit Trust Managers. He has been managing institutional investment funds since 1983 and therefore has a large amount of expertise and experience in this field, and has managed the since its launch in January 1996.
The consistent performance of the fund is partly explained in the fund manager’s commentary: “The fund retains 26% of its assets in fixed interest stocks, in addition to cash deposits of 7.04%. This has proved predictably defensive against the background of a market that fell 12% in September.”
Fund Facts:
Fund Charges: Initial charge: 5.25%, Annual charge: 1.5%
Total number of Holdings: 110
Launch Date: 24.01.96
Fund Value: £249 million
THE BARING EMERGING EUROPE TRUST PLC (BEET)
The Baring Emerging Europe Trust PLC (BEET) is an investment trust with the objective of achieving long-term capital growth. This is principally through investment either in securities of companies listed or traded on an emerging European (mainly eastern European) securities market, or in securities of companies listed or traded elsewhere, the majority of whose revenues and/or profits are, or are expected to be, derived from activities in emerging Europe. High returns have been experienced from this fund in recent years, and can be expected to continue.
The fund is managed by Klaus Bockstaller and Stuart Richards. Both have extensive experience in a market that requires specialist knowledge.
Fund charges: management fee of 1.25% p.a., secretarial fee of 0.25% p.a.
CLOSE BROTHERS DEVELOPMENT VCT PLC
The Close Brothers Development venture capital trust invests in a diversified portfolio of established unquoted companies. Close Brothers started dealing in VCTs in 1996 and this trust has been trading since 1999. A ‘C’ share issue offer is currently underway to increase the fund size, closing in April 2003. The trust is the best performing VCT over five years, and its high performance is expected to continue. The high tax efficiency of this investment, as mentioned earlier is an added bonus. The VCT is managed by Roderick Davidson, Francis Malcolm, David Pinckney and Jonathon Thornton. This team again has wealth of experience spread through its ranks.
Management charge per year: 2.25%
My references:
www.baring-asset.com
3.3.2. STOCKS AND SHARES
Shares have often been considered a risky investment because of their short-term volatility. However, over the longer term, shares have outperformed most other asset classes. Investing in shares, with a long-term view (approximately a decade), maximizes your potential for wealth creation. Yet, there is also the chance to earn a growing stream of dividend income. There are also no fees or annual charges to be paid on the ownership of shares.
While in the UK share ownership is increasing, this is largely as a result of employer-led share schemes and from the flotation of public companies. Many people still believe buying and selling shares is elitist and not for them. However, the recent growth in online financial information and publications aimed at helping people understand how the stock-market works could help newcomers to take advantage of it.
Although many people are disappointed with their shares - and this includes many of those held in big name companies, such as Marks & Spencer and British Airways - there are plenty of experts who believe now is an excellent time to buy.
3.3.2.1. DIVERSIFICATION
In order to diversify your investment portfolio, you will probably have part of your money in the share market. You may buy shares directly or through managed funds or your superannuation scheme.
Investing in shares has many benefits including a high level of liquidity, which unlike property, gives you ready access to your money. There are more than 1200 companies on the stock-market in which you can buy shares so there are plenty to choose from to match your investment needs. However, equity has generally a higher degree of risk and therefore ideally you should spread your investments among a variety of industries and companies although you might choose to have two companies in the same industry if their business is sufficiently different to give you diversification.
Compared to other investments like property, shares are very portable. They can be bought and sold quickly, and the brokerage on the transactions is lower than for a property transaction. Unlike selling a property, you can sell any number of shares.
Conversely, investing in too many shares can make it impossible to monitor them effectively. The process of increasing diversification tends to reduce the power of each investment hence a sufficient ‘boom’ in one industry will have marginal increases in income generated from the portfolio.
3.3.2.2. SELECTION OF EQUITIES
It is generally accepted for first time investors into the stock market that for adequate diversification an investor should invest in typically 7 – 15 companies. Due to the reasons already mentioned Conservative Consulting advises an investment in the following seven companies shown below and also an overall investment of …..% of the total inheritance fund. Where possible we have advised in investing in well-established companies on the FTSE –100 index with betas generally around or lower than the market risk of one, except for the ‘wild card’ investment in Homestyle. All the companies chosen have a relatively high % dividend yield.
3.3.2.3. SOCIAL RESPONSIBILITY
Investing in individual companies on the stock exchange allows for easy compliance with the social responsibility factor. As shown below we advise investment into environmentally friendly companies such as ‘body shop’, who refuse to test any of their products on animals. Major corporations such as Sainsbury’s and Abbey National are very aware of the issues of corporate responsibility and Sainsburys in particular produce the highest proportion of organic foods. Severn Trent is a water company that is concerned with providing fresh, clean water.
3.3.2.4. SHARE INVESTMENT PROPOSALS
3.3.2.5. ASSUMPTIONS WITH INVESTING IN THE STOCK MARKET
3.4. SAVINGS
3.4.1. CONTINGENCY FUNDS
It would be a wise move for the family to put a proportion of the money into an instant access account to be accessed in case of emergencies. There is quite a range of accounts available to the family including high street current accounts, Internet accounts, offshore accounts, notice accounts and post office accounts. The money will simply be left in this account and hopefully never used and should be expected to have a lower interest rate to compensate for the requirement of instant access and flexibility. We suggest the family put £10,000 in this account.
We suggest the family open the Flex account from Nationwide. As £10,000 will be placed in the account the higher rate of interest will be earned which is currently set at 2%. The family will however be able to draw on this money instantly if it is needed and with the Nationwide being a national bank it will always be possible to find a branch. They do however offer Internet banking and telephone banking also and offer the option to have a link card to withdraw cash from over 32,00 cash machines Nationwide.
We suggest that they account be opened in Mrs. Roberts name to be more tax efficient as she is in a lower tax band for salary.
3.4.2. SAVINGS ACCOUNT
We suggest that the family put some of the money into savings accounts. For this purpose ISO's are the best option as they offer returns free from both income tax and capital gains tax on an investment of up to £7,000. There are two types of ISA available for the family to invest in; these are a mini ISA and a maxi ISA although it is only permitted to have 1 ISA per person.
When looking for an ISA you may notice a CAT mark. A CAT marked ISA is one, which satisfies certain government criteria relating to charges and terms. A CAT mark does not ensure good performance, low risk or the stability of the ISA. Most funds are not CAT marked thus ISA’s without this mark should not be neglected solely on these grounds.
Funds put into an ISA’s should not be treated as current access accounts although access to the money is generally quick (Often within a month).
A mini ISA is an account that allows an individual to invest up to £3,000 in stocks and shares, up to £3,000 in cash and up to £1,000 in life assurance. These can be from the same or from different providers. Although you may own the three individual parts to the ISA you cannot own the same part twice. For example you cannot invest in stocks and shares twice.
A maxi ISA is an account that allows an individual to invest up to £7,000 in the stock market or up to £3,000 in cash with the remainder invested in the stocks and shares from the same provider.
We recommend that Mr. Roberts invest £7,000 in a Maxi ISA with the full £7,000 invested in stocks and shares.
We suggest that Mr. Roberts invest his maxi ISA allowance in the Aberdeen Fixed Interest Fund. Paul Reed, who has over 30 years of investment experience, manages this fund and has done since May 1991. It has been statistically estimated that the probability that Paul Reed adds value to this fund rather than being lucky is 99%.
The fund is built up of preference and other fixed interest securities and Gilt-edged stocks with all stocks in sterling. It is fairly risk free as its volatility compared to the FTSE All share Index is only 0.3.
The fund gives a net yield value of 6.9% with an annual management charge of 1.25% and has an initial set up charge of 4.25%.
We therefore recommend that Mr. Roberts Place £7297.5 in this bond to cover the initial set up charge and invest the maximum in this ISA.
We recommend that Mrs. Roberts also invests £7,000 in a Maxi ISA. We recommend that the full amount be invested in a corporate bond component. This fund gives a stable regular income as the fund manager invests predominantly in corporate bonds making the fund low risk. HSBC allows switching between funds if your needs should change with the first two changes being free of charge.
The fund gives a net yield of 5% with an initial set up charge of 4%.
We therefore suggest that Mrs. Place £7280 into this ISA to get the full amount invest and thus get maximum tax efficiency from the ISA.
3.4.3. SAVINGS ACCOUNT
We suggest that Mr. Roberts invest a small proportion of the money in a savings account for his son. This account could either take the form of a high interest, non-tax account available to people of his son's age or a cash ISA.
Many high street banks offer a young person's bank account with a higher rate of interest due to the account being tax-free. The other option is to take out cash ISA. Unlike mini and maxi ISA’s where you need to be over 18 a cash ISA can be opened by a person over the age of 16. Cash ISA’s enjoy all the tax benefits that mini and maxi ISA’s receive although there is an investment limit set at £3,000 per year.
We recommend Master Roberts opens the First Saver account from the Britannia Building Society and Mr. Roberts places £2,000 in it.
This account gives 4.7% interest on the savings and allows for instant access.
If these funds are not used for University we suggest the money be transferred into a cash mini ISA at the age of 18.
4.0. PENSIONS
Mr Roberts has been a member of the Universities Superannuation Scheme (USS) for over thirty years, when he first started working for the University. The normal annual contribution to the scheme is 6.35% of salary and the University also pay into the scheme. The scheme operates on a pensionable salary basis and Mr Roberts pensionable salary will be at least £50 000 (see appendix).
Assuming Mr Roberts retires at the normal age (65) he will receive pension for life at the annual rate of 1/80th of pensionable salary for each year of pensionable service. He will also receive a lump-sum payment of 3/80ths pensionable salary for each year of pensionable service. Hence based on a salary of £50 000 and 40 years service, he will receive a lump sum of £75 000 and an annual payment of £25 000.
Mr Roberts must purchase an annuity using his pension fund by the time he is 75, and the return from this annuity will be at least equal to the minimum guaranteed pension provided by the scheme.
Mrs Roberts could invest in a separate pension scheme such as a stakeholder scheme offered by banks like HSBC. However personal pensions are not performing at all well at the moment and a higher return could be earned for the Roberts’ by investing elsewhere. Also in the event of Mr Roberts’ death there is a provision in the USS scheme for Mrs Roberts to receive around £12 500.
Mr Roberts could increase the final value of his pension fund by increasing his contributions into the fund to the maximum amount allowed by the Inland Revenue of 15% salary. To do this he would have to purchase Additional Voluntary Contributions (AVCs) from an insurance company such as Legal & General or Scottish Life. It has been decided that because of the complexities of the AVC plans and the fact that no contribution is made towards AVCs by the University Mr Roberts’ money would be better invested somewhere else.
APPENDIX
Pensionable salary is the highest of either:
- Highest salary maintained for 12 months earned during the three years before retirement.
- Highest yearly average for any three consecutive years not earlier than 10 years before retirement.