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Unformatted text preview: Generic Knowledge: The Finance Industry (910) DISCLAIMER
These materials are issued by Kaplan Education on the understanding that: 1. Kaplan Education and individual contributors are not responsible for the results of any action taken on the basis of information in these materials, nor for any errors or omissions; and 2. Kaplan Education and individual contributors expressly disclaim all and any liability to any person in respect of anything and of the consequences of anything done or omitted to be done by such a person in reliance, whether whole or partial, upon the whole or any part of the contents of these materials; and 3. Kaplan Education and individual contributors do not purport to provide legal or other expert advice in these materials and if legal or other expert advice is required, the services of a competent professional person should be sought. The views expressed by presenters delivering course material by lecture or workshop may not necessarily be those of Kaplan. COPYRIGHT
© Kaplan Education, 2008. All rights strictly reserved. No part of these materials covered by copyright may be reproduced or copied in any form or by any means (graphic, electronic or mechanical, including photocopying, recording, taping or information retrieval systems) without the written permission of Kaplan Education. Kaplan Education makes every effort to contact copyright owners and request permission for all copyright material reproduced. However, despite our best efforts, there may be instances where we have been unable to trace or contact copyright holders. If notified, Kaplan Education will ensure full acknowledgement of the use of copyright material. ACKNOWLEDGEMENTS
All ASX material is © ASX Limited. All rights reserved. All ASX material is reproduced by the publisher with the permission of ASX Limited. No part of this material may be photocopied, reproduced, stored in a retrieval system, or transmitted in any form or by any means, whether electronic, mechanical or otherwise, without the prior written permission of ASX Limited. Kaplan Education acknowledges the support of Aspect Huntley Pty Ltd Morningstar, Dow Jones, EBSCO Australia and ProQuest in the development of its course material. Contents Introduction Unit 1 Unit 2 Unit 3 Unit 4 Unit 5 Unit 6 Unit 7 Providing financial advice Obligations and liabilities of advisers Operation of the financial services industry The economic environment Financial products Investment concepts Taxation concepts Introduction About this Generic Knowledge module
This module provides the Generic Knowledge component of the Tier 1 (Diploma level) training and assessment required for individuals who provide personal financial advice to retail clients. It addresses the generic knowledge requirements of the ASIC competencies set out in RG 146 in relation to the following units of competence: • Provide advice in Managed Investments • Provide advice in Superannuation • Provide advice in Derivatives • Provide advice in Securities • Provide advice in Life Insurance • Provide advice in Financial Planning • Provide advice in Foreign Exchange FNSASIC503TB FNSASIC503UB FNSASIC503VB FNSASIC503WB FNSASIC503XB FNSASIC503ZB FNSASIC503SB. You are referred to the ASIC website at <www.asic.gov.au> for further information on compliance obligations. Overall program structure
The Tier 1 Compliance Program has three components: Generic Knowledge, Specialist Knowledge and Adviser Skills. This module must be completed in conjunction with the Specialist Knowledge and Adviser Skills components to achieve a Statement of Attainment for the relevant ASIC unit(s) of competency. Note: The Generic Knowledge and Adviser Skills components only need to be completed once. If you are undertaking more than one advice area you only need to undertake the Specialist Knowledge assessment for each additional advice area.
Generic Knowledge Assessment 40 multiple-choice questions Specialist Knowledge area Assessment Case study assignment Statement of Attainment Adviser Skills © Kaplan Education 2 Generic Knowledge: The Finance Industry (910) Role of experience and prior learning
If you have significant industry experience (five years in the past eight years) relevant to the area in which you advise or you have undertaken recognised programs of study relevant to the advice area, you may request assessment only options in both ‘Knowledge’ and ‘Skills’ areas to demonstrate competency. How knowledge will be assessed
Assessment for Generic Knowledge is an online examination of 60 minutes duration and comprises 40 multiple-choice questions. The examination is delivered via Kaplan’s Online Learning Centre. A pass mark of 70% is required for the exam which is open book. The examination for this module will assess the generic knowledge applicable to the entire industry as outlined in the ASIC Competency evidence guide and supported by these learning resources. The generic knowledge requirements to be assessed are set out below.
Generic Knowledge requirements • Generic knowledge about the economic environment; the characteristics and impact of economic and business cycles, including interest rates, exchange rates, inflation, and government monetary and fiscal policies Generic knowledge about the operation of financial markets; the roles played by intermediaries and issuers, structure and inter-relationships within the financial markets, and inter-relationship between industry sectors Generic knowledge about financial products; including the concept of a financial product, general definition, specific inclusions and exclusions, types of financial investment projects, types of financial risk products General knowledge about the taxation issues in relation to the products and markets in which they operate General knowledge about advisory functions; the role of the representative/adviser, participants in the advisory services market, range of services provided, profile and financial information of the client, appropriateness of a risk assessment Generic knowledge about the legal environment and disclosure and compliance; the role of the representative/adviser, relevant legal principles (e.g. Corporations Act, ASIC Act, Privacy Amendment (Private Sector) Act) and Trade Practices Act etc.) the relationship between ethics and regulatory requirements (e.g. good faith, utmost good faith, full disclosure of remuneration/fees and any other conflicts of interest which may influence the adviser’s recommendation) Knowledge of relevant industry Codes of Practice and conduct Knowledge of complaints resolution procedures (internal and external) Knowledge of regulators guidelines including the requirements of ASIC’s Regulatory Guide 146 • • • • • • • • 910.SM1.5 Introduction 3 Pre-requisites for this module
This module also addresses the underpinning knowledge requirements for the following industry competencies: FNSFPLN501B FNSFPLN502B FNSFPLN503B FNSFPLN504B FNSFPLN505B Comply with financial planning practice ethical and operational guidelines and regulations Conduct financial planning analysis and research Develop and prepare financial plan Implement financial plan Review financial plan and provide ongoing service. Recognition of competence
Once you have successfully met the assessment requirements for this Generic Knowledge module, you will also need to satisfy the Specialist Knowledge and Adviser Skills assessment requirements to receive a Statement of Attainment for each of the ASIC competencies set out in RG 146. Pathway to qualifications
The Tier 1 competencies identified on your Statement of Attainment will be recognised for advanced standing to FNS50804 Diploma of Financial Services (Financial Planning). Getting the most from the learning materials
This module has been designed for as a self-study resource to prepare candidates for the Generic Knowledge examination. It also provides a reference for the practical application of concepts and principles in the workplace. Tier 1 Compliance Program competencies
• Provide Advice in Managed Investments • Provide Advice in Securities • Provide Advice in Superannuation • Provide Advice in Life Insurance • Provide Advice in Derivatives • Provide Advice in Foreign Exchange • Provide Advice in Financial Planning. © Kaplan Education 4 Generic Knowledge: The Finance Industry (910) Administrative queries
For information about logins, exams, results or program information contact: Student Advice Centre
Australia Tel: 1300 135 798 (free call) Tel: 02 8248 6799 email@example.com International Tel: +61 2 8248 6799 firstname.lastname@example.org 910.SM1.5 1
Providing financial advice
Overview 1.1 Unit learning outcomes ....................................................................1.1 1 1.1 1.2 1.3 1.4 2 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 3 3.1 3.2 3.3 3.4 3.5 The licensing regime 1.2 Background to the licensing regime..........................................1.2 Purpose of licensing ...............................................................1.2 Obligations of licensees ..........................................................1.3 Representatives of licensees...................................................1.3 Providing a financial service 1.4 What is a financial service? .....................................................1.4 What is a ‘financial product’? ..................................................1.4 When are you providing financial product advice? ......................1.5 What is ‘financial product advice’? ...........................................1.5 What professional advice is excluded from the definition?..........1.6 Who is included in the definition of ‘providers of advice’?...........1.6 Who isn’t included in the definition of ‘providers of advice’?.......1.7 Financial advisers and financial planners ..................................1.7 Types of financial product advice 1.8 Investment advice ..................................................................1.8 Insurance advice ....................................................................1.8 Retirement advice...................................................................1.9 Estate planning ......................................................................1.9 Business financial advice ........................................................1.9 4 4.1 4.2 4.3 4.4 4.5 4.6 5 5.1 5.2 6 6.1 6.2 6.3 6.4 6.5 7 7.1 Scope of financial advice 1.10 What advice are you accredited to provide? ............................1.10 Full advice ...........................................................................1.11 Limited advice......................................................................1.11 No advice ............................................................................1.12 Requirement to have a reasonable basis for advice .................1.12 Warnings and disclaimers to clients .......................................1.12 Financial advising process 1.13 Financial plans to meet clients’ goals.....................................1.13 Referral between advisers .....................................................1.14 Disclosure requirements 1.15 Ethics of disclosure ..............................................................1.15 Disclosure documents ..........................................................1.15 Product disclosure statements (PDS) .....................................1.17 Statement of advice (SOA).....................................................1.18 Adviser remuneration ............................................................1.20 In summary 1.25 Checklist .............................................................................1.25 1.27 Suggested answers Appendix Unit 1: Providing financial advice 1.1 Overview
This unit examines the regulatory regime relating to financial advisers and financial products and services. The Corporations Act regulates who is allowed to give financial product advice to retail clients and sets out and imposes numerous obligations on such advisers. It is important that advisers understand the scope of their role and recognise when their statements to clients will legally be regarded as the provision of advice. In this unit, we look at what constitutes ‘financial product advice’, what information must be disclosed to retail clients and how financial advisers are paid. We also outline the possible ramifications of giving poor advice. Advisers are liable under the Corporations Act for recommendations made and advice provided to a client, and must have a reasonable basis for any such recommendation and advice. We also look at the types of formal information that must be provided to retail clients such as a financial services guide (FSG), a product disclosure statement (PDS) and a statement of advice (SOA). Staying up to date
Ensure you stay up to date with the latest changes and information regarding compliance and disclosure within the financial services industry by regularly checking ASICs financial services homepage <http://www.asic.gov.au>. Unit learning outcomes
On completing this unit, you should be able to: • describe the types of financial advice available • determine whether advice or factual product information is being given • decide whether advice is full or limited • outline the different methods of receiving payment for financial advice. © Kaplan Education 1.2 Generic Knowledge: The Finance Industry (910) 1
1.1 The licensing regime
Background to the licensing regime
The primary legislation governing the regulation of the finance industry is the Corporations Act. The Corporations Act contains a single licensing and disclosure regime for those providing financial services in Australia. ASIC (the Australian Securities and Investments Commission) supervises the licensing requirements. Under the Corporations Act a person who carries on a financial services business must generally hold an Australian financial services (AFS) licence, unless the person is a representative of a licensee. One of the primary aims of financial services reform was to introduce a harmonised licensing regime that cut across the previous institutional regulatory regimes, including those applicable to securities dealers and advisers, futures brokers and dealers and insurance agents. Unit 3 on the ‘Operation of the financial services industry’ will cover the key regulatory authorities. 1.2 Purpose of licensing
The ASIC licensing regime serves an important function in ensuring the efficient operation of the financial services industry. Clients often rely heavily on the actions of financial service providers and consequently there is a need to ensure: • services are provided competently and honestly • advice is not subject to any bias • clients’ property held in the custody of the professional is secure • there is no fraud by the relevant professional. It is difficult for a client, especially a retail client, to determine whether the relevant professional will be able to ensure the above standards are met. Consequently, the licensing regime is heavily focused on organisational soundness and investor protection principles. A licensing regime has the effect of excluding from the industry those that cannot meet the relevant standards, and ensuring that those who are licensed continue to meet the relevant standards. 910.SM1.5 Unit 1: Providing financial advice 1.3 1.3 Obligations of licensees
Under s 912A of the Corporations Act, an AFSL holder has the following obligations: • to do all things necessary to ensure that the financial services covered by the licence are provided honestly, efficiently and fairly • have in place processes that manage the possibility of conflicts of interest • to comply with financial services laws and licence conditions • to take reasonable steps to ensure its representatives comply with financial services law • unless the licensee is regulated by APRA (in which case APRA provisions apply), to have adequate: – resources (financial, technological and human resources) to provide the financial services and carry out supervisory arrangements – risk management systems • to maintain competence to provide financial services • to ensure that its representatives are adequately trained and competent to provide financial services • if the financial services are provided to retail clients, to have a complying dispute resolution system. ASIC also has powers under s 914A to impose specific conditions on licences issued by it. 1.4 Representatives of licensees
In general, if a person provides financial services as a representative of an AFS licensee, that person needs to hold a written authorisation from the licensee. However, a representative does not need to hold an authorisation if they are an employee or director of the licensee or a related body corporate. Only the licensee can appoint authorised representatives. Licensees cannot authorise other licensees. The licensee must notify ASIC, in writing, within 15 business days of the appointment of an authorised representative. Where an individual provides financial services on behalf of a number of licensees, that individual must be an authorised representative of each licensee. © Kaplan Education 1.4 Generic Knowledge: The Finance Industry (910) 2
2.1 Providing a financial service
What is a financial service?
A person will provide a financial service if they provide financial product advice or deal in a financial product (among other things). Financial services include: • dealing in financial products • providing financial product advice • making a market in financial products (other than as a financial market) • operating a registered managed investment scheme • providing a custodial or depository service. While an AFS Licence is applicable for all types of services and products, in practice licences will be issued for the particular products and services relevant to the licence applicant and for which they have the necessary expertise. The primary requirement is that a licensee must do all things necessary to ensure that the financial services covered by the licence are provided efficiently, honestly and fairly. Licensees will be responsible for the conduct, training and competence of their representatives. 2.2 What is a ‘financial product’?
A ‘financial product’ means generally a facility through which a person: • makes a financial investment • manages financial risk • makes non-cash payments. A financial product can be any instrument (usually of a contractual nature) employed in the transfer or accumulation of monetary wealth or financial risk management. Financial products include: • a superannuation interest • a security • an interest in a registered managed investment scheme • a derivative • a general insurance product, life risk insurance product or investment life insurance product (with a number of specified exceptions) • first home saver accounts. 910.SM1.5 Unit 1: Providing financial advice 1.5 2.3 When are you providing financial product advice?
The legal definition of ‘financial product advice’ is important to anyone working in the financial services industry. If any of your statements or recommendations fall within this definition, there are important legal consequences. It is therefore important that, when you are dealing with another person, both you and your client are quite clear about whether or not financial product advice is being given. 2.4 What is ‘financial product advice’?
The Corporations Act provides that a recommendation or a statement of opinion (or a report of either of those things) is ‘financial product advice’ if it is intended to influence a person in making a decision concerning a particular financial product, class of products or an interest in such products. This includes any decision to buy, sell or hold a particular financial product or class of financial products. For example: • a decision to exercise a right or option to acquire or dispose of a financial product • a decision to acquire an equitable interest in a financial product • a decision to accept or reject a takeover offer. However, in determining whether or not financial product advice has been given, the intention of the person making a recommendation or statement of opinion is not the only consideration. A recommendation or statement of opinion is also financial product advice if it could reasonably be regarded as being intended to influence a person making a decision concerning a particular financial product or class of financial products or an interest in such products. This means that you need to take into account the overall impression created by a communication and all the surrounding circumstances to determine whether or not it amounts to financial product advice. Overall impression and circumstances
When taking into account the overall impression created by a communication and the surrounding circumstances ASIC has stated that the factors to consider include the following (Licensing: The scope of the licensing regime: Financial product advice and dealing — an ASIC Guide, para 1.2.3): • the means by which the provider(s) of the communication (and their associates) are remunerated • any representation made to the person to whom the communication is provided (who might be a retail or wholesale client). A communication is more likely to be financial product advice if its provider is remunerated by the client or stands to benefit depending on the decision of the client. Example: Financial product advice
Bill enquires about life insurance while he completes the paperwork for his mortgage. Margaret, who is his loan officer, gives him a quotation for death and TPD cover as well as personal accident insurance and suggests he might be better off taking the personal accident insurance. Margaret receives commission for selling this type of insurance. © Kaplan Education 1.6 Generic Knowledge: The Finance Industry (910) Factual information
Communications that consist only of factual information will generally not amount to financial product advice. Factual information is reasonably ascertainable information whose truth or accuracy cannot be reasonably questioned. However, in some circumstances, a communication consisting of factual information may amount to financial product advice. ASIC gives the example of factual information which is presented in a manner which may reasonably be regarded as suggesting or implying a recommendation to buy, sell or hold a particular financial product or class of financial products. Quote concerning cost
A quote concerning the cost of a financial product or the rate of return of a financial product is specifically excluded from the definition of ‘financial product advice’ (as set out in s 766B(6) or (7) of the Corporations Act 2001). 2.5 What professional advice is excluded from the definition?
The Corporations Act 2001 specifically states that the following professional advice does not come within the definition of financial product advice (s 766B): • advice given by a lawyer in their professional capacity about matters of law, legal interpretation or the application of the law to any facts • advice given by a registered tax agent given in the ordinary course of activities as such an agent. 2.6 Who is included in the definition of ‘providers of advice’?
The requirements of the Corporations Act 2001 apply to persons who ‘provide’ financial product advice. The person who provides the advice will generally include: • the author(s) of the advice as well as the licensee for whom they act • any other person who endorses the advice (Licensing: The scope of the licensing regime: Financial product advice and dealing — an ASIC Guide, para 1.4.1). 910.SM1.5 Unit 1: Providing financial advice 1.7 2.7 Who isn’t included in the definition of ‘providers of advice’?
The corporations legislation provides that a person does not provide financial product advice in the following specific situations: • the person provides an exempt document or statement, e.g. a financial services guide that does not include personal advice or a product disclosure statement that does not include personal advice or general advice about another product • the person has only passed on, published, distributed or otherwise disseminated a document containing financial product advice in specified circumstances (this might include a publisher or internet portal operator) • the person’s conduct occurs in the course of work of a kind ordinarily done by clerks and cashiers • the person advises another person about the manner in which voting rights attaching to securities or interests in managed investment schemes may or should be exercised (with certain provisos) • the person gives advice on the structuring of remuneration packages for another person’s employees • the person provides a recommendation or statement of opinion as part of handling or settling claims concerning an insurance product • the person provides a recommendation or statement of opinion about the allocation of funds among certain types of product (including shares, managed investment products, superannuation products, deposit products and other types of asset) as long as the statement doesn’t relate to specific financial products or classes of products • a product issuer prepares general advice about its own product(s) but only where a third party licensee gives the advice to its recipients — in such a case the licensee will be taken to be the provider of the financial product advice. 2.8 Financial advisers and financial planners
In RG 146 (which sets out the minimum training standards for those advising retail clients) ASIC uses the term ‘adviser’ broadly to cover anyone giving financial product advice. Financial planning is identified as one of a number of specialist advice areas, along with securities, derivatives, superannuation, insurance and managed funds. A financial planner is therefore one type of adviser who offers a range of services including the development and implementation of a full financial plan and a monitoring/review service. © Kaplan Education 1.8 Generic Knowledge: The Finance Industry (910) 3 Types of financial product advice
This section briefly outlines the following different types of financial advice: • investment advice • insurance advice • retirement advice • estate planning • business financial advice. 3.1 Investment advice
Investment advice is the advice provided on financial assets, such as cash deposits, term deposits, debentures, government bonds, shares, derivatives, managed unit trusts, managed investment schemes and insurance investment products such as investment bonds, superannuation bonds and annuities. Investment advice takes into account a customer’s goals and investment preferences in order to develop a portfolio that places their funds in a range of investments that provide different degrees of income and growth. Investment advice would also seek to maximise the returns after tax and allowing for inflation. Investment advice could also include advice on savings and whether it would be appropriate for the client to borrow to invest. 3.2 Insurance advice
Advice on death or disability
Insurance advice includes life and general insurance. Life insurance advice involves an assessment of the impact that a client’s death or disability would have on their dependants. Once an assessment is complete, the adviser can recommend different products that provide a lump sum or regular income in the event of the insured event. General insurance advice includes advice on policies which cover, for example, building, household contents, public risk, motor car and private health benefits. 910.SM1.5 Unit 1: Providing financial advice 1.9 3.3 Retirement advice
Retirement funding advice is investment advice for the purpose of creating a lump sum large enough to provide income for the client and dependants after the client retires. When most people think of retirement income funding, they think of superannuation, but retirement funding is not limited to this investment vehicle and advisers should also consider a client’s other assets. Retirement income
Retirement income advice is about maximising the income from the client’s assets. This income would be obtained from the investment portfolio. It also could include structuring the client’s assets and income to try to obtain government benefits when they are available. 3.4 Estate planning
Comprehensive financial advice should include estate planning advice. Estate planning is the appropriate transfer of ownership of personal assets at the time of death to the beneficiaries that the client has selected. Estate planning issues include: • the preparation of a will • the use of powers of attorney • the establishment of testamentary trusts • the selection of beneficiaries for superannuation savings. Estate planning advice would include tax effective distribution of estate assets. For example, superannuation lump sums are paid tax free to dependants, but if paid to a non-dependant, taxes will apply. Therefore, advice should be provided to transfer superannuation assets to dependants and non-super assets to non-dependants if still equitable. While recommendations can be made by advisers, the actual drafting and execution of the relevant paperwork should be done by a qualified legal practitioner. 3.5 Business financial advice
Financial advisers can provide advice for business, as businesses also need to maximise benefits from their financial assets. Business owners need to consider the loss of profits in the event of the death or disability of one or more key individuals, and how they will fund any succession plans for the business in the event of the death of one of the owners. © Kaplan Education 1.10 Generic Knowledge: The Finance Industry (910) 4
4.1 Scope of financial advice
What advice are you accredited to provide?
The type and scope of advice that a particular adviser can give will be defined in the relevant Australian financial services licence issued by ASIC. The licence may be unrestricted or limited to a specific range of financial products. For example, a financial adviser who is RG146 accredited to provide advice in managed investments, futures and securities markets, cannot advise on insurance products. Clients might also seek further advice from other professional advisers, such as accountants or solicitors, or real estate agents who specialise in property investments in their advice and funding arrangements for the purchase of property. The scope of financial advice that is provided to a client can vary from a single communication with a client concerning a specific query or event, to a full financial planning service offering comprehensive, ongoing advice. Example: Limited advice
A client who says to an adviser ‘I’ve left my job and have to roll over $45,000 of superannuation, can you help me?’ is seeking limited advice. In such a case, the advice given can be limited to superannuation products for the sum of $45,000 without addressing needs, financial objectives and wants outside this area, such as savings, insurance, estate planning or wills. Refer to Figure 1 below which summarises scope of financial advice.
Figure 1 Scope of financial advice
Full advice Limited advice No advice or ‘execution only’ • client provides all relevant information • adviser helps client towards personal and financial goals by developing and implementing a full financial plan • adviser offers ongoing monitoring and review • adviser restriced to giving advice on specific types of product(s) • different from situation where client has not been disclosed all relevane information • adviser accepts client decision and only processes documentation • adviser takes no responsibility for appropriateness of decision Clients should receive warning 910.SM1.5 Unit 1: Providing financial advice 1.11 4.2 Full advice
Full financial advice generally refers to the process where an adviser helps an individual move towards meeting personal and financial goals through the development and implementation of a full financial plan. A full financial plan includes more than just investment advice and may also cover retirement planning, risk management (insurance), estate planning and taxation and social security planning. Full advice relies on the client providing all relevant financial information and being prepared to carefully review their goals. Advisers offering full financial advice are generally known as financial planners. The role of financial planners and the scope of the services they provide are discussed later in this subject. 4.3 Limited advice
The term ‘limited advice’ refers to situations where the adviser is restricted to giving advice on a specific type or types of financial products. This might be because: • the client is only seeking advice on specific products, or • the relevant licence limits the advice that may be given, e.g. a licence may be restricted to advice on managed funds, insurance products, term deposits etc. When giving limited advice, an adviser should give the client a clear warning that this is the case and may refer the client on to another adviser if appropriate. Another example of limited advice would be where a client says: ‘I don’t want advice on foreign investments or government bonds.’ ‘Limited advice’ needs to be distinguished from advice given to clients who have only provided ‘limited information’. Limited client information does not necessarily mean that the adviser can only give ‘limited advice’. Example: Limited information
A client says to an adviser ‘I have $2m that I want to put away in managed funds with a 10-year time frame to generate funds for gifts for my grandchildren. I am worth $25m net but this is no business of yours’. The client has withheld the fact that he has a heart disease and will die in a year and that his children cannot be trusted to provide for his grandchildren. The adviser can give advice on a full range of securities and managed funds. However, as the client has refused to discuss a large part of his personal situation, the adviser must warn him that the advice may not be appropriate. In this case he needs estate planning advice because his children will probably spend the money after his death, leaving nothing for the grandchildren. An adviser must indicate to the client at an interview the type and limitations of any advice they are going to be given. This is to ensure that a client can seek additional advice if the financial adviser is not reviewing a specific issue. © Kaplan Education 1.12 Generic Knowledge: The Finance Industry (910) 4.4 No advice
No advice or ‘execution only’ refers to a situation where the financial adviser is merely accepting the decision of the client and processing documentation. When the financial adviser gives no advice, then no responsibility is taken for the appropriateness of the product decision of the client. Examples of a ‘no advice’ transaction would be where a client drops off a unit trust application for processing at their local bank, or has already made an investment decision before seeing the financial adviser. 4.5 Requirement to have a reasonable basis for advice
An Australian financial services licensee or an authorised representative must only provide advice to a retail client where the licensee has a reasonable basis for that advice. The advice must be personal advice and the provider of the advice must: • ascertain the client’s objectives and their financial situation and needs • investigate and consider options available to the client • base the advice on that consideration and investigation. 4.6 Warnings and disclaimers to clients
Financial advisers are responsible for the advice they provide to clients but, if the client does not allow them access to all the facts, it can be difficult to provide suitable advice. In such cases the financial adviser has two choices: • advise the client that, unless they provide all the information needed, the financial adviser will be unable to provide a recommendation • proceed, but warn the client that the financial adviser cannot be held responsible if any information withheld affects the quality of advice given. Where a financial adviser communicates information about financial products but does not actually give financial product advice, ASIC has recommended that the adviser should consider giving clients a disclaimer stating that: • they are not providing financial product advice • the client should consider obtaining independent advice before making any financial decisions. In this way, the adviser will avoid misleading or confusing clients about the purpose of the communication (Licensing: The scope of the licensing regime: Financial product advice and dealing — an ASIC Guide, para 1.2.10). In these cases, the financial adviser must take particular care to record the warnings to protect against future client action. Any complaint is likely to be based on the argument that the advice given was inappropriate to the client’s needs. The client should sign this disclaimer and a copy should be kept on file by the financial adviser. 910.SM1.5 Unit 1: Providing financial advice 1.13 5 Financial advising process
Whether or not an adviser is giving full or limited financial advice, they should follow a process which ensures that the advice given truly meets the client’s needs. Indeed it is a legal requirement that advisers giving personal advice to a retail client make reasonable inquiries into the personal circumstances of the client and have a reasonable basis for their advice. ASIC’s list of the skills required by an adviser provides a useful summary of the advice process: • establish a relationship with the client • identify the client’s objectives, needs and financial situation • analyse the client’s objectives, needs, financial situation and risk profile • develop appropriate strategies and solutions • present appropriate strategies and solutions to the client • negotiate the financial plan/policy/transaction with the client • coordinate implementation of the agreed plan/policy/transaction • complete and maintain necessary documentation • provide an ongoing service (optional at discretion of client). Note that this list does not reflect the services offered by all financial advisers. ASIC specifically states that all elements need not be met if demonstrably irrelevant to the adviser’s activities. See Appendix 1.1 for a list of the skills required by advisers. 5.1 Financial plans to meet clients’ goals
Financial planners providing full financial advice use specialist knowledge and skills to construct a financial plan, made up of strategies and actions designed to help clients meet their stated goals. These goals may include: • earning a certain level of income • maintaining or increasing the value of assets • saving and investing within a level of risk acceptable to the client • having reasonable levels of liquidity and flexibility • maintaining an adequate level of security through insurance on assets and income-earning capacity • reaching financial independence in the future • maximising the after-tax return within appropriate risk levels • having an appropriate timetable for the purchase of investments, the holding period and subsequent sale. Within these goals, emotional and lifestyle requirements will also affect financial decisions. Financial planners need to understand how these requirements will influence individuals and couples. © Kaplan Education 1.14 Generic Knowledge: The Finance Industry (910) Types of advice covered
To provide a recommendation to a client, a financial plan might incorporate: • cash flow (budgeting) and financing • investment planning • taxation and social security planning • retirement planning (superannuation and retirement income streams) • risk management (insurance) • estate planning (including the use of family trusts) • business planning. As each year passes, changes to the markets, regulations, products and the client’s situation will necessitate review and possible modification of the plan. Financial planners act as pathfinders and will need to understand the economic environment in order to provide clients with a clear path for their financial goals; removing obstacles and barriers as they move forward. 5.2 Referral between advisers
As clients’ expectations of advice increase, advisers may find that they do not have the specialist knowledge needed to satisfy all of their clients’ needs. Many organisations and individuals have a policy of referring the client to another adviser to ensure that all their financial needs can be met. They might have formal arrangements, spotters’ fees and other incentives to encourage referrals. When commissions or other benefits are involved, the client must be told of these payments (disclosure). Apply your knowledge 1: Providing financial advice
1. If a client comes to you seeking superannuation advice, should you limit your recommendations only to superannuation products or should you consider other products that would provide a retirement income? _______________________________________________________________ _______________________________________________________________ _______________________________________________________________ _______________________________________________________________
2. What action would you take to ensure that your client understands that you are providing ‘limited advice’? _______________________________________________________________ _______________________________________________________________ _______________________________________________________________ _______________________________________________________________ 910.SM1.5 Unit 1: Providing financial advice 1.15 6
6.1 Disclosure requirements
Ethics of disclosure
At common law, an agent has a duty to inform his/her principal of any circumstance which may interfere with the provision of disinterested advice. In the financial services industry, this obligation is reinforced by the Corporations Act for the purpose of providing a level playing field for all investors. Clearly, the duty of disclosure by financial services providers is based on the longstanding professional ethical standard that one should not profit from information to the disadvantage of one’s client. This standard of behaviour is encapsulated in the Australian Securities Exchange’s core values which state ‘integrity is the core value of ASX and ensuring market integrity is our point of difference’. From this background of seeking to establish a system of integrity, fairness and equity to all market participants, the Corporations Act regulates the conduct of financial services providers to achieve this objective. The aim is to increase investor confidence and promote the integrity and efficiency of the market by facilitating the flow of investor funds to promote economic growth. 6.2 Disclosure documents
Disclosure requirements enforced under the Corporations Act 2001 aim to ensure that retail clients receive sufficient information to make informed decisions about whether or not to take up a financial service and whether to act on the advice they receive. These requirements involve three separate documents, each of which has its own purpose and relates to a different stage of the investment process: • financial services guide (FSG) — what service am I getting? • statement of advice (SOA) — what advice am I getting? • product disclosure statements (PDS) — what product am I getting? There are criminal and civil liability consequences for both the licensee and the representative for: • failing to provide a disclosure document where required, or • providing a defective disclosure document. A financial services licensee is only required to provide the above disclosure documents to retail clients. © Kaplan Education 1.16 Generic Knowledge: The Finance Industry (910) Financial services guide (FSG)
An FSG is a disclosure document that sets out key information about the services offered by a financial services licensee. The obligation to provide an FSG is an obligation on both the licensee and the representative. The key content requirements of an FSG are: • the identity of the licensee and a description of the kinds of services provided • the remuneration (including commission) and other benefits of the licensee and related entities • other relationships that could be capable of influencing the services provided • dispute resolution procedures • whether the licensee is a market participant • if the licensee provides advice, whether an SOA is provided. An FSG must be given to a client ‘as soon as practicable’ after it becomes apparent that a financial service is likely to be provided, and in any event before the service is provided. The Corporations Regulations 2001 provide that if the amount of remuneration or benefits to the licensee cannot be ascertained at the time the FSG is given, a description of the means by which the remuneration and other benefits are to be calculated must be provided. An FSG is not required where: • the client has already received the information • the providing entity is a product issuer dealing in its own products • the providing entity is a responsible entity of a registered scheme and the financial service consists only of the operation of the registered scheme • financial advice is general advice provided in a public forum • the dealing is in a ‘basic deposit product’ of an authorised deposit-taking institution (ADI). Changes to an FSG’s content must be communicated to clients by way of an FSG update. 910.SM1.5 Unit 1: Providing financial advice 1.17 6.3 Product disclosure statements (PDS)
A PDS sets out the essential details of products being provided or recommended. Under the Corporations Act, a product disclosure statement (PDS) must be given to a client where: • a retail client is provided with a personal recommendation to acquire the product (by issue or transfer), or • a regulated person offers to issue or sell a financial product to a retail client. This disclosure obligation applies to all financial products other than securities including managed investments, derivatives, insurance, superannuation and bank products, with only limited exceptions. The statement must be prepared by the issuer and dated. It must be kept up-to-date but need not be lodged with ASIC unless it is to be traded on a licensed market. A PDS is not required in the following circumstances: • where the client has already received the PDS • where the client already holds the product and the advice relates only to switching or dividend reinvestment • a managed investment product for which there is no consideration • an option for which there is no consideration for the option of the exercise • takeover offer • interim insurance contract • a managed investment product where the client is associated with the responsible entity of the registered scheme. A PDS is not required for small-scale offerings of managed investment products to less than 20 people in 12 months and where the amount raised is less than $2 million. A PDS must contain certain prescribed information, including: • the issuer or seller (name and contact details) • significant benefits of the product and the circumstances and manner in which those benefits accrue • significant risks • the cost of the product, including ongoing charges and deductions after the product is purchased • the return generated and any expenses deducted from earnings • other significant characteristics or features • dispute resolution arrangements • significant tax implications • cooling off regime • how to access additional information • for investment products, the role of social, environmental or ethical considerations • any amounts debited from the original investment amount • and any other information that might reasonably be expected to have a material influence on the decision of a reasonable person to invest. © Kaplan Education 1.18 Generic Knowledge: The Finance Industry (910) The disclosure standard is limited by the extent to which information is ‘actually known’ by certain persons including, amongst others, the responsible person, the issuer/seller or a person consenting as being named in the PDS. This is different from the prospectus disclosure rules for securities, which impose an absolute standard (i.e. disclosure of information known or which could be obtained by certain persons making reasonable enquiries). There are also on-going disclosure obligations to investors about material changes and significant events (other than for financial products already subject to enhanced disclosure) and an obligation to provide investors with any additional information requested. 6.4 Statement of advice (SOA)
The third element of the Corporations Act disclosure requirements is for a written SOA to be provided where ‘personal advice’ is given to a ‘retail client’. The SOA provides information about the basis on which advice is provided. ‘Personal advice’ is advice given or directed to a person in circumstances where the person providing the advice has considered the objectives, financial situation and needs of the person, or a reasonable person might expect the provider to have considered those matters. If the SOA does not form part of the advice, it must be given to the client at the same time, or as soon as practicable after the advice is given or in any event before any other service (such as issuing a product) is provided to the client. The SOA must contain the following information: • the advice • the basis of the advice and the information on which the advice is based • the providing entity • any remuneration or benefits capable of influencing the advice, or any other interests of the providing entity • a warning if it is based on incomplete information (e.g. client has not completed a profile) and the client should consider the appropriateness of the advice before acting on it. The level of detail required in the SOA is such that a person would have the information they reasonably require for the purpose of deciding whether or not to act on the advice. An exemption exists from the SOA requirement for ‘execution related telephone advice’ relating to financial products that are able to be traded on a financial market where all of the following are satisfied: • the client agrees not to receive an SOA • the FSG indicates that an SOA will not be provided • the licensee makes any commission or benefits disclosure when the advice is given • the licensee must keep a record of the advice and provide it to the client on request. 910.SM1.5 Unit 1: Providing financial advice 1.19 In the case of general advice given to a retail client, the providing entity must provide a warning (at the same time and by the same means) that: • the advice does not take into account the client’s personal objectives and financial circumstances • the client should consider the appropriateness of the advice on that basis • in the case of a product issue, the client should obtain a copy of the PDS. Warning requirement where general advice is provided to a retail client
Where general advice is provided to a retail client, the client must be warned that the advice has been prepared without taking into account the client’s objectives, situations and needs. And, before acting on the advice, the client should consider the appropriateness of the advice to their situation. An SOA does not have to be given to a retail client where general advice is provided. Statement of additional advice
Where an adviser has an existing relationship with a client and has already issued them with an SOA, the adviser may not need to issue an entire new SOA when providing some additional advice. Instead, the adviser can issue a statement of additional advice (SOAA) and ‘incorporate by reference’ certain information from the previous SOA. Certain conditions must be met to prevent consumer confusion and ensure that the adviser’s potential liability for the disclosure document is not diminished. Those conditions are that the SOAA must: • be dated • inform the client that it must be read with the original SOA • contain the new advice (and supporting information) provided since the original SOA • highlight any changes since the original SOA • repeat any required warnings and the additional information required if recommending a replacement of one product with another. A statement of additional advice must be clearly titled as such. It must clearly indicate that it is to be read in conjunction with the original SOA and specify which (if any) information in the original SOA is no longer relevant or accurate and is not being included in the SOAA. All relevant information in the original SOA is deemed to be included in the SOAA unless otherwise specified. The information which cannot be incorporated by reference, and therefore must be included explicitly in the SOAA is: • the warning where advice is based on incomplete or inaccurate information about the client’s relevant personal circumstances • information about the costs and benefits of replacing one product with another • that the client can obtain a copy of the original SOA free of charge • the date of the SOAA. © Kaplan Education 1.20 Generic Knowledge: The Finance Industry (910) An SOAA can only apply to one original SOA. It cannot incorporate multiple SOAs. Furthermore, it cannot incorporate by reference information in an earlier SOAA. Therefore, each time an SOAA is given to a client, it will need to expressly include in full any information that was set out in any previous SOAAs. This is to ensure that the client will never need to refer to more than two documents at any one time. Use of the SOAA will promote clear, concise and effective disclosure and make it easier for clients to read and understand the information presented to them. It will help minimise the unnecessary duplication of information and keep documents slimmer. Record of advice
In situations where advice is not urgent, there is scope to allow the provider to produce a record of advice, instead of a SOA. The record of advice need only be provided at the client’s request, however, the provider would be required to keep the record of advice for seven years (as is the case for SOAs). This record of advice would contain information subsequent to that set out in the initial SOA, including the basis on which any recommendations to the client were made. This would be available to providers of personal advice. 6.5 Adviser remuneration
Dollar disclosure policy
In 2005, ASIC issued what is now Regulatory Guide (RG 182) on dollar disclosure. The dollar disclosure regime will mean that those who provide personal advice and product issuers will be required to disclose a range of fees, costs, charges, expenses, benefits and interests as amounts in dollars. These dollar amounts must be included in: • statements of advice (SOAs) • product disclosure statements (PDSs) • periodic statements. You can download Regulatory Guide 182 from ASIC’s website for further detail regarding this regime. Payment for advice
In the financial services industry advisers are paid by their principal employer or licensee in various ways. Employees are usually paid a salary and often this will be linked to a bonus or performance payment. Other employees may be engaged on a basis of a percentage sharing of all commissions and fees, which they develop for the practice. Advisers who are not employees but who are authorised representatives of a licensee will be contracted on a basis of a percentage sharing of revenue which they generate under their authority. The financial services guide provided to a prospective client should show details of the range of services provided by the firm, the capacity of the adviser who will be attending to the client and the structure of the fees charged or applying for these services. Further, a statement of advice given by an adviser to a client must disclose full details of any remuneration (including commissions) or other benefits that might reasonably be expected to be or have been capable of influencing the adviser in giving the advice.
910.SM1.5 Unit 1: Providing financial advice 1.21 Upfront transaction commissions
A commission is the payment to the adviser of a percentage of funds invested or the insurance premiums paid by the client. An adviser is paid when the client accepts their recommendation and proceeds with the transaction. The chief characteristics of upfront commission payments are: • Commissions encourage the adviser to recommend transactions, as the adviser is paid only if there is a transaction, e.g. investment in a product. • Commissions encourage the adviser to ensure the transaction is completed properly. Upfront commissions are generally only paid if transactions are completed. Upfront commissions encourage advisers to complete the documentation properly, because they won’t be paid if the documentation is not complete. • Commissions are not paid if the client leaves their money with the same institution or in the same stock portfolio. This can encourage a practice known a twisting or churning where a client is encouraged by their adviser to change the company with which their insurance policies are held once the agent is no longer subject to their commission being withdrawn by the life company. (Churning can also apply when funds are moved from one managed fund to another without adequate reason or where managed portfolios are regularly turned over.) Note: While some would argue that this ensures the client gets the best policy and increases pressure on life companies to innovate, widespread churning also increases insurance costs overall because the life company must recover their upfront costs. A major proportion of initial insurance premiums is in the adviser commissions and underwriting costs. Life companies try to recover these costs over the first few years of the life of the policy. Almost all fund management companies pay for the sale of their products by way of commissions. The adviser may be paid differently. The licensee may choose to pay the adviser a proportion of the commissions paid to the dealer group, or may use the commissions to fund different remuneration processes. Trailing commissions
A trailing commission, also known as a regular commission, is paid to a licensed security dealer on a regular basis over the life of the investment. Their introduction was an incentive for financial advisers to leave investors’ money in place, as it gave the adviser recurrent revenue. They are normally calculated as a percentage of the value of client investment funds, which the fund manager holds at the date of payment. Once the client funds are redeemed or moved the trailing commissions are terminated. Trailing commissions are generally paid by all retail fund managers and the rate of payment varies between 0.25–0.55% per annum. In some cases the rate can be varied up or down if this is agreed with the client. Dealership firms treat trailing commissions as generic income and, in most cases, the payment is not directly identified with an individual client. It has been suggested that some statement of the commission part should be made on any receipt/statement of payment given to the client. © Kaplan Education 1.22 Generic Knowledge: The Finance Industry (910) Soft dollar incentives
Soft dollar incentives are incentives offered or paid by fund managers, life insurance companies or institutional employers to encourage advisers to use their products in preference to others. They include competitions, trips, computers and other incentives and are often aimed at the adviser’s spouse. In some cases, soft dollar incentives will only be paid once a certain volume of business has been reached. The influence of a soft dollar incentive will depend upon its level of materiality. For example, a fund manger might invite a group of advisers to attend a conference in Hong Kong or subsidise the annual principal’s adviser conference in Hawaii. Both of these payments are quite material and would require the advisers of the firm to disclose this payment in their recommendations provided to clients. An example of an immaterial contribution to an adviser would be an invitation to attend an economic briefing luncheon. This type of event is provided by most fund managers and could not be seen to unduly influence an adviser to give preference to the products of one specific firm. Some advisers argue that soft dollar arrangements are difficult to disclose, because it is impossible to measure the degree of influence that the arrangement has over the adviser. The opposite argument is that the companies know what influence these arrangements have, or they wouldn’t spend the large sums involved in establishing and maintaining them. Fee for service
More advisers are now moving to a fee-for-service arrangement. Under fee-for-service, advisers can: • charge for work done according to a cost schedule, e.g. a written plan for $500 • charge for work on an hourly rate • charge a rate based on total assets under advice, usually as a percentage of assets, providing an agreed level of service. There is an industry trend towards charging on a fee-for-service basis and rebating all commissions to clients. 910.SM1.5 Unit 1: Providing financial advice 1.23 Apply your knowledge 2: Disclosure
1. Why is it important to inform a client fully about all benefits which an adviser might receive if the client accepts the advice? _______________________________________________________________ _______________________________________________________________ _______________________________________________________________ _______________________________________________________________ _______________________________________________________________ _______________________________________________________________ _______________________________________________________________ _______________________________________________________________ _______________________________________________________________
2. Some financial advisers believe that they should not have to disclose their commissions and argue that when you buy other products such as a car or a suit, you do not know what commission has been paid. What are the arguments against this view? _______________________________________________________________ _______________________________________________________________ _______________________________________________________________ _______________________________________________________________ _______________________________________________________________ _______________________________________________________________ _______________________________________________________________ _______________________________________________________________ _______________________________________________________________ © Kaplan Education 1.24 Generic Knowledge: The Finance Industry (910) Review your progress 1
1. Which of the following statements would not be considered financial advice? (a) (b) ‘I think you should invest in the Woolly Furry Unit Trust.’ ‘The rate of return is 6%, however, you can expect the interest rates to improve over the next few months as I understand the Reserve Bank will be reducing interest rates.’ ‘You can withdraw your funds after two days’ notice.’ ‘I would advise you not to proceed with that investment’. Client: You: (b) Client: You: What is the interest rate on my savings account? You are earning 1% per annum. That is a very low rate. A term deposit would return 4.5%. I have $30,000 in a savings account. Do you think I would be better putting it into a term deposit? You have a substantial sum sitting in your savings account. Did you know the interest rate on this in only 1%? You need $5000 minimum to open a term deposit account. Currently the interest rate is 4.5%, paid 6 monthly, which is very competitive. If you did need to access the funds early, you would be liable for an early termination fee of $40. The interest rate is higher than inflation and would help you maintain the real value of your savings. (c) Client: You: I want to start a savings account for my five-year old daughter. What is the best account for me to open? The old passbook accounts we often used to open for our children are no longer available. A big bank builder account would seem to be the answer, the fees are low, in fact they are waived if you have a monthly minimum balance of $500. For this to really build up you would need to put away at least $10 a month. Who could I talk to about investing in some shares? Shares are really much more volatile than some other forms of investment. My phone company shares are actually worth less than when I bought them. However, we do have advisers and I’d suggest we arrange a meeting with Howard Ho, our branch adviser. 3. Kate is a planner whose practice largely caters for potential and actual retirees. She always backs up her advice with written advice sent out to the client. Her obligation to disclose her commission and other matters is taken care of in her letterhead — there is a printed footer that is quite detailed and makes full disclosure. The footer is printed in 8-point type. Has Kate made full and proper disclosure? (c) (d) (a) 2. At what point (if any) in these conversations is advice being given? (d) Client: You: 910.SM1.5 Unit 1: Providing financial advice 1.25 7 In summary
This unit has outlined the legal and licensing requirements for those giving financial advice. Financial advice was defined and distinctions between providing financial advice and not providing financial advice were made. The different types of financial advice were discussed. We also look at the disclosure requirements for advisers. 7.1 Checklist
Below are the main points covered by this unit. Use this to check your learning. • The legal definition of ‘financial product advice’ is of significant practical importance for everyone working in the financial services industry. There are important legal consequences if statements or recommendations fall within this definition. • A ‘financial product’ is a facility through which a person: makes a financial investment; manages financial risk; or makes non-cash payments. • A recommendation or statement of opinion is ‘financial product advice’ if it is intended to influence a person in making a decision concerning a particular financial products, class of products or an interest in such products or if it could reasonably be regarded as being intended to have such an influence. • You need to take into account the overall impression created by a communication and all surrounding circumstances to determine whether or not it amounts to financial product advice. • Communications that consist only of factual information will generally not amount to financial product advice. • Certain professional advice is excluded from the definition of financial product advice, e.g. advice given by a lawyer in their professional capacity about matters of law and advice given by a registered tax agent in the ordinary course of their activities. • Persons providing advice will generally include the author(s) of the advice as well as any other person who endorses the advice. • The Corporations Act specifically lists situations where a person does not provide financial product advice. This includes work ordinarily done by clerks or cashiers. • Financial advice can include investment advice, insurance advice, retirement advice, estate planning advice and business financial advice. • Advisers give ‘limited advice’ where they are restricted to giving advice on a specific type or types of financial products, e.g. where the client is only seeking advice on specific products. • ‘Limited advice’ should be distinguished from the situation where the client only provides limited information. Limited client information does not necessarily mean that the adviser can only give ‘limited advice’ but the adviser should warn the client that the adviser cannot be held responsible if any information withheld affects the quality of the advice given. • Providers of financial advice include financial planners, advisers working for organisations (e.g. banks, life companies, building societies, dealer groups), stockbrokers and superannuation advisers. © Kaplan Education 1.26 Generic Knowledge: The Finance Industry (910) • The terms ‘financial adviser’ and ‘financial planner’ have been used interchangeably in the past. Under the amended Corporations Act, the term ‘financial product adviser’ or ‘financial adviser’ refers to anyone providing financial product advice. The term ‘financial planner’ refers to advisers who offer a range of services, including the development and implementation of a full financial plan and a monitoring/review service. • The financial advising process includes the following steps which are listed by ASIC as the skills required of an adviser: – establish a relationship with the client – identify the client’s objectives, needs and financial situation – analyse the client’s objectives, needs, financial situation and risk profile – develop appropriate strategies and solutions and present them to the client – negotiate the financial plan/ policy/ transaction with the client – complete and maintain necessary documentation – provide an ongoing service (optional at discretion of client). • Advisers are paid by their employer or licensee in a number of ways, e.g. salary, upfront commissions and trailing commissions. Soft dollar incentives are also offered by fund managers, life insurance companies or institution employers to encourage advisers to use their products in preference to others. • There is an industry trend towards charging clients on a fee-for-service basis and rebating all commissions to the clients. • Advisers must disclose full details of any remuneration (including commissions) or other benefits that might reasonably be expected to be capable of influencing the adviser in giving the advice. • Financial advisers are legally liable to their clients for the advice that they give and need to have procedures in place to minimise the risk of legal action. • The Corporations Act contains a single licensing and disclosure regime for those providing financial services in Australia. • Under this licensing regime a person who carries on a financial services business must generally hold an Australian financial services licence (AFS licence), unless the person is a representative of a licensee. • Financial advisers must comply with other obligations contained in the Corporations Act concerning conduct and disclosure. • Disclosure requirements under the Corporations Act aim to ensure that retail clients receive sufficient information to make informed decisions about whether or not to take up a financial service and whether to act on the advice they receive. • A financial services guide (FSG) is a disclosure document that sets out key information about the services offered by a financial services licensee. • An FSG must be given to a retail client by a licensee (or authorised representative) ‘as soon as practicable’ after it becomes apparent that a financial service is likely to be provided and, in any event, before the service is provided. • A statement of advice (SOA) must be provided where ‘personal advice’ is given to a ‘retail client’. 910.SM1.5 Unit 1: Providing financial advice 1.27 Suggested answers
Apply your knowledge 1: Providing financial advice
1. All products should be considered, unless your license is of a limited nature. 2. Explain to the client at the meeting as well as on the statement of advice that they are receiving only limited advice and include the appropriate disclaimers. For example: ‘I confirm that I have provided only limited details to the adviser and I do not require the adviser to make any investigation or recommendation in relation to any other financial products. I understand that any strategy or recommendation made by the adviser will be based on the limited details provided by me.’ Apply your knowledge 2: Disclosure
1. This is a legislative requirement. Full disclosure enables the client to make an informed decision. The client cannot later sue the adviser on the grounds of having provided inappropriate advice for the sake of commission/fees. 2. Other industries are not yet regulated. Financial services is a long-term investment, investing in a person’s long-term goals. Larger amounts of money are involved. Review your progress 1
1. (a) (b) (c) (d) 2. (a) (b) (c) (d) Advice Advice Fact Advice Fact Largely fact but in the final phase you are moving very close to providing advice. Largely fact but again the final phase you are moving close to advice. Fact 3. Full and proper disclosure is really only made if you know that the person you are making it to can either read or hear it (as applicable) AND reasonably be expected to understand it. Many of Kate’s clients would have poor eyesight and might easily overlook such small print. © Kaplan Education 1.28 Generic Knowledge: The Finance Industry (910) Notes 910.SM1.5 1
RG 146 Financial Product Advisers Competencies 9 Provide ongoing service (where agreed) . Have I ...
8 Complete and maintain necessary documentation. Have I ... – provided written supporting documentation? – explained the possible risks? – explained the nature of the underlying financial products? – drafted a plan/policy/ transaction for presentation to client? – determined the ability to underwrite and accept the transfer of risk? – assessed if specialist advice is required? – assessed the client's risk profile in light of needs and objectives? – analysed all relevant information? – explained in plain language the proposed transaction(s)? – discussed any client concerns? – confirmed with client the preferred plan/policy/transaction? – identified to them who is the responsible license holder? – explained fees? – explained complaints handling procedures? – identified relevant tax obligations? – determined cash flows (required and projected)? – collected information on client risk profile? – collected information on client objectives and goals? – collected personal financial and business details? 3 Analyse client objectives, needs, financial situation and risk profile. Have I ... 2 Identify client objectives, needs and financial situation. Have I ... – explained the services offered? – conducted relevant research analysis/modelling? – identified and assessed available options? – explained my role as adviser? – established what my client's knowledge level is? 5 Present appropriate strategies and solutions 4 Develop appropriate strategies and solutions. Have I ... 1 Establish relationship with client. Have I ... – explained ongoing fees for clearly defined ongoing services? – signed a formal agreement? – provided the ongoing service as agreed? – exchanged a signed agreement? – provided client with reports regarding performance? – conducted a review with client if/when parameters change? – explained time frames for execution? – explained associated fee and cost structures? – gained final agreement? Unit 1: Appendix 1 RG 146 Financial Product Adviser Competencies 7 Co-ordinate implementation of agreed plan/policy/ transaction. Have I ... 6 Negotiate financial plan/ policy/transaction with client. Have I ... 1 Notes 2
Obligations and liabilities of advisers Overview 2.1 Unit learning outcomes ....................................................................2.1 1 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 2 2.1 2.2 2.3 2.4 3 3.1 3.2 The law of contract and agency 2.2 What is the law of contract? ....................................................2.2 Essential elements of a contract..............................................2.2 The general law of principal and agent......................................2.5 Fiduciary relationships ............................................................2.7 Fiduciary obligations ...............................................................2.7 Duty to maintain separate client accounts ................................2.8 Duty to avoid/disclose conflict of interests ...............................2.9 Duty of confidentiality ...........................................................2.10 Minimising risks of legal action..............................................2.10 Misrepresentations 2.11 Pre-contractual misrepresentation ..........................................2.11 Misrepresentations — tort ....................................................2.12 The tort of negligence ...........................................................2.13 Disclaimers and exclusions ...................................................2.13 Other unlawful conduct 2.14 Misleading or deceptive conduct ............................................2.14 Hawking...............................................................................2.14 4 4.1 4.2 4.3 4.4 4.5 4.6
4.7 4.8 Ethical perspective 2.15 Defining ethics .....................................................................2.15 Ethical standards .................................................................2.15 Principles for ethical behaviour ..............................................2.16 Relationship between law and ethics......................................2.17 Ethical standards and expectations versus compliance ............2.18 Strategies for promoting ethical best practice in the workplace ............................................................................2.18 Minimising the risk of legal action ..........................................2.19 Case studies........................................................................2.20 Privacy and personal information 2.21 Handling of personal information by private sector organisations .......................................................................2.21 Requirements of the National Privacy Principles ......................2.21 In summary 2.23 Checklist .............................................................................2.24 5 5.1
5.2 6 6.1 Appendix Unit 2: Obligations and liabilities of advisers 2.1 Overview
This unit discusses the important relationships between financial advisers and their clients and the duties and obligations flowing from those relationships. The unit addresses the fiduciary relationship and the principal and agent relationship between the financial adviser and their client. We will look at some basic legal concepts under contract law. Contract law is important because the law governing the relationship of the financial adviser and client is really a subset of contract law. The unit then discusses the various forms of misleading and deceptive statements and conduct which are prohibited in the regulation of the business relationships, both under the common law and by various pieces of legislation. We will also explore the ethical nature of the confidence and trust relationship arising from the fiduciary relationship. The role of ethics and compliance in the financial markets and the various industry codes of conduct promote ethical behaviour and ensure that business is conducted within a framework that facilitates an efficient and competitive environment. Unit learning outcomes
On completing this unit, you should be able to: • describe the requirements for an enforceable contract and the terms that bind the parties • list the remedies that are available to an aggrieved party • identify the nature of the legal relationship between financial advisers and their clients and how that relationship arises • describe the fiduciary obligations of financial advisers to their clients • discuss elements of statements which may be considered misrepresentation under common law • discuss ethical and compliance issues relating to the provision of financial advice • discuss the key responsibilities of licensees in relation to organisational expertise, risk management and dispute resolution • discuss the application of the National Privacy Principles to financial advisers. © Kaplan Education 2.2 Generic Knowledge: The Finance Industry (910) 1 The law of contract and agency
Financial advisers are legally responsible to their clients for the advice that they give and failure to provide appropriate advice may lead to litigation both under the common law and/or various statutory provisions. The basic legal relationship that exists between financial advisers and their clients is that of principal and agent. The law of principal and agent is part of contract law. 1.1 What is the law of contract?
The law of contract is that area of law which tells us when a promise, or set of promises, is legally binding. Contract is a common law concept, that is, its rules are derived from case law. The law of principal and agent is part of contract law, which will be discussed in the following pages. Key concept: Definition of contract
A contract may be defined as an agreement that the law will enforce. Where a contract exists, the parties to it have rights and obligations. Generally, these rights are confined to the parties to the contract and do not apply to third parties. The basis of a contract is an agreement which, in most cases, may be broken down into an offer made by one party and the acceptance of that offer by the other party. The agreement may be expressed orally or in writing. Where the terms of a contract are not written, in certain circumstances they may be deduced from the conduct of the parties. However, some contracts must be in writing to be enforceable, for example, contracts for the sale of land. Legislation requires cheques, insurance policies and transfers of shares in a company to be in writing. In the following sections, we examine the elements of a contract as well as considering variation and discharge of a contract and remedies for breach of a contract. 1.2 Essential elements of a contract
If an agreement between two parties is to amount to an enforceable contract, it must contain all of the following elements: • offer and acceptance • consideration • intention to create legal relations • capacity to contract • genuine consent • lawfulness of object. 910.SM1.5 Unit 2: Obligations and liabilities of advisers 2.3 1. Offer and acceptance
Every contract is said to be formed by acceptance of an offer. This process of offer and acceptance is achieved by: • express words, such as a proposal by one party to which the other party responds by words like, ‘okay, it’s a deal’ • actions only, such as when purchasing a newspaper at a newsstand, the offer being made by showing the cashier a newspaper and tendering payment, which is accepted by the cashier taking the money • a combination of express words and actions. 2. Consideration
Every contract contains at least one promise. Consideration is something given, done or suffered in return for a promise. In effect, it is the price the other party pays for the promise. Thus, consideration encompasses the notion of a bargain. In general, a promise without consideration is unenforceable. For example, Paul writes ‘I solemnly swear to pay Diana $100’. Even if Diana writes underneath ‘I agree’, there is still no legally enforceable agreement by Diana because she has not done or agreed to do anything. Paul’s promise remains a gratuitous promise unsupported by consideration from Diana. On the other hand, if Diana agreed to clean Paul’s house for the $100, there is consideration flowing from both parties. 3. Intention to create legal relations
If an agreement is to be treated as a contract, it is essential for the parties to have intended to enter into a legally binding relationship. If the agreement is expressed to be ‘subject to contract’, in other words, the parties state that they will not be bound until a formal agreement has been prepared and signed, then it is clear the parties had no intention of entering into contractual relations. The position would be different if the parties intended to be bound by a preliminary agreement which contemplated the preparation of more formal documentation later. A common example of the latter situation would be the offer and acceptance of finance facilities, which are almost always subject to security documents. Sometimes an agreement may be expressed to be subject to a condition precedent. A condition precedent is one that delays the vesting of a right until the happening of an event. For example, a sale of shares may be subject to shareholder approval. In that case, the obligations of the parties to complete the sale of the shares will not come into effect until the condition precedent (of shareholder approval) has been satisfied. However, an agreement to agree on something in the future is generally not a binding agreement. © Kaplan Education 2.4 Generic Knowledge: The Finance Industry (910) 4. Capacity to contract
The general rule is that any natural person can enter any contract, but some natural persons’ rights to contract may be qualified or denied (for example, persons under the age of 18 years, or mentally disabled persons). A natural person is a person in the ordinary sense of the word as opposed to artificial persons or corporations. Under the Corporations Act, a company has the legal capacity of a natural person; that is, by virtue of statute, a company is empowered to do anything a natural person is legally able to do. Persons contracting with companies are entitled to rely on certain statutory assumptions — that the dealings with the company comply with the company’s constitution, that the persons acting on behalf of the company have authority to do so and that the company’s seal (if it has one) has been properly affixed. However, these assumptions do not apply where the person dealing with the company has, or should have, knowledge to the contrary. 5. Genuine consent
Without consent there can be no agreement and no contract. Consent may be given under pressure (undue influence) or by mistake, or may have been induced by a false statement (fraud or misrepresentation). Duress and undue influence A court will relieve a party from performing its obligations under a contract entered into as a result of certain types of unfair influence or conduct on the part of the party to the contract, such as actual or threatened violence or taking advantage of a person who is drunk or mentally incompetent. Unconscionable terms of the contract The unconscionable terms of the contract may have resulted from inequality of bargaining power, the incomprehensibility of written documents or the presence of undue influence or other unfair tactics. Unconscionable contracts can be re-opened and rewritten by the courts. Mistake The concept of ‘mistake’ in contract law has a very restricted and technical meaning. A party will not be relieved from performing a contract simply because it made a mistake when entering the contract. For example, a person who bought a painting believing it was more valuable is not, by reason of that fact alone, entitled to avoid the contract. An error of judgment gives no right of release from a contract. 910.SM1.5 Unit 2: Obligations and liabilities of advisers 2.5 Misrepresentation A misrepresentation is a false or misleading statement made by one party to the other to induce that party to enter into a contract. Actionable misrepresentations can be divided into three classes: • innocent • negligent • fraudulent. Depending on the circumstances, the injured party, after discovery of the misrepresentation, has the option of either affirming the contract (i.e. continuing with the contract) or rescinding it (i.e. having the contract set aside). The choice to rescind the contract is made at the time the misrepresentation is discovered. 6. Lawfulness of object
A contract that has as its object, some matter which is prohibited by statute or common law, may be wholly or partly void or unenforceable. For example, it has been held that a broker cannot recover a fee for advising a company in a takeover situation where the services provided by the broker include market manipulation prohibited by s 1041 of the Corporations Act. Some forms of share and commodity trading involving the ‘adjustment of differences’ have been held to be void because they are gambling contracts prohibited by the gaming and betting legislation. These principles also have the potential to apply to some forms of swap contracts (i.e. derivative contracts). 1.3 The general law of principal and agent
As stated above, the basic legal relationship that exists between financial service providers and their clients is that of principal and agent. The law of principal and agent is part of contract law. The agent/principal relationship is one based on trust and the agent must always deal with the principal in good faith. Contract of agency
A contract of agency is formed when one person, the agent, has authority to act on behalf of another person, the principal. Hence, where Anne, acting as agent for Carl, enters a contract with Bill, two contracts are involved: • the contract of agency between Anne and Carl which permitted Anne to bring Carl into contractual relations with Bill • the contract between Bill and Carl. The contract of agency is formed by the agreement of the principal and the agent. The agreement can be express (stated orally or in writing) or implied (unsaid or unwritten but taken for granted). No formality is necessary. All that is needed is words or conduct which show that the two parties consent to be principal and agent. © Kaplan Education 2.6 Generic Knowledge: The Finance Industry (910) Instructions
A fiduciary (see section 1.4 below) has a clear obligation to comply with the instructions received from its principal during the course of their relationship. The terms of the instructions given by a client to a financial adviser, and therefore the terms of the contract, may be express (i.e. stated orally or in writing) or implied (i.e. unsaid or unwritten but taken for granted by both parties). • Express instructions In most cases, the instructions by the client to the financial services provider will be given orally. The financial services provider is required by the Corporations Act to keep records of its dealings with clients, particularly monies received or paid. • Implied instructions In contracts of agency, many terms are implied rather than being expressly mentioned when the agreement is formed, because their inclusion is so obvious that it goes without saying. It is an important rule of the law of principal and agent that the usages and customs of the market upon which the agent is instructed to deal are implied into the contract between the agent and principal, unless they have been expressly excluded. For customs and usages to be implied into a contract of agency, they must be: • notorious: be very well known by the persons dealing in the market generally • certain: the nature of the custom or usage must be precise and clear • reasonable: their application must give a fair result to the parties bound by them. Nature of the financial services provider’s duties
In all cases, the financial services provider owes a duty to its client to act ethically over and above the specific duties described below. It is only if financial services providers act in accordance with ethical principles that investor confidence in Australia’s financial markets can be attained and maintained. The law will imply into every contract between financial services providers and their clients a term that the providers will use all reasonable care and skill commensurate with their professional standing and experience. If a financial services provider fails to fulfil its general common law duties to its client, it may lose the right to receive a commission and the right of indemnity which it would normally have under the contract of agency with its client. In addition, it could be liable to pay damages to its client for any loss suffered by the client as a result of the breach of duty. 910.SM1.5 Unit 2: Obligations and liabilities of advisers 2.7 1.4 Fiduciary relationships
A fiduciary relationship in law describes a relationship of special trust and confidence between two parties. Here the fiduciary is held to owe particular duties to their principal in the fulfilment of certain obligations specified through their legal relationship. The notion of fiduciary duties is familiar in futures and security advising between an adviser and client. Conventionally, that interest and concern has focused upon the situations and relationships the law has characterised as fiduciary and the legal consequences which derive from this fact. What is equally important is the primary ethical ideas that underpin the law’s identification and application of the fiduciary relationship, namely trust and confidence. These values are of special importance within the framework of the financial markets. In fact, it is these values which underlie all business and professional relationships. The relationship between an adviser and their client is based upon these values. The importance of trust and confidence derives from what it says about the quality and nature of the relationships that are part of everyday decisions and conduct of financial market participants. In this context it is worth remembering that the motto of the London Stock Exchange continues to be, ‘My word is my bond’. 1.5 Fiduciary obligations
When giving advice, a financial services provider will be in a fiduciary relationship with their client. This means that the financial services provider owes a duty of utmost good faith to their client. At common law, a fiduciary cannot enter a transaction where there is likely to be conflict between its duty to (in this context) the client and its own interests, unless it has made full disclosure to the client of its exact interest and the client has consented to the fiduciary continuing to act. If a financial services provider in the position of a fiduciary does not disclose every material fact relating to a conflict of interest that would be likely to affect its judgment, the transaction could be liable to be set aside at the client’s option. The client could also sue for damages for any loss sustained. The fairness of the transaction is immaterial. A potential conflict may be enough to set aside a transaction, without needing to show that the financial services provider’s judgment was actually affected by it. © Kaplan Education 2.8 Generic Knowledge: The Finance Industry (910) A number of provisions of the Corporations Act and ASX Market Rules reflect the fiduciary obligations of a financial services provider by requiring the financial services provider to: • disclose any interests in a transaction with a client in a financial services guide or any statement of advice • give priority to client orders (again this applies if the provider is buying or selling products that can be traded on a licensed market) • disclose to the client when dealing on the other side of a transaction on their own behalf, i.e. the financial services provider is effectively acting as either the buyer or seller of their client’s transaction. This applies if the provider is doing a transaction with a non-licensee involving a product that can be traded on a licensed market such as the ASX or SFE. A financial services provider who receives money from a client for a special purpose (say, to buy securities) holds that money in a fiduciary capacity. The practical importance of this is that the courts acknowledge that the money belongs to the client, not the financial services provider. Any money which can be identified as held by the financial services provider in this capacity cannot be used to satisfy the financial service provider’s creditors in the event of its insolvency. 1.6 Duty to maintain separate client accounts
A financial services provider must keep the client’s property separate from its own property and keep proper accounting records which enable identification of the client’s property. This basic common law rule is reinforced by the more precise provisions of the Corporations Act and the rules of ASX relating to trust accounts and scrip. Money received by a financial services provider on behalf of its clients must be paid into a designated trust account. The reason for this is to segregate clients’ funds from the financial services provider’s own funds so that if the financial services provider were to become bankrupt, the client’s funds could not be used to pay the financial services provider’s general debts. The financial services provider must accurately account to the client for all the client’s money that comes into the financial services provider’s possession. Profit and loss accounts and balance sheets must be prepared and audited. Financial services providers’ accounts must be audited by a registered company auditor and lodged with ASIC. 910.SM1.5 Unit 2: Obligations and liabilities of advisers 2.9 1.7 Duty to avoid/disclose conflict of interests
Financial services providers in the securities industry must not place themselves in a position in which their personal interests conflict with their duty to the client. The potential for conflict most clearly arises where a broker or financial services provider contracts directly with a client but, of course, there are other possible conflicts of interest. Utmost good faith
Financial services providers owe a duty of good faith to their clients to avoid a potential or actual conflict of duty and interest. Where a financial services provider contracts with a client, it must act with utmost good faith and make full disclosure of any personal interest that is likely to influence the client. The financial services provider cannot adopt the view that it is up to the client to look after his/her own interests and make his/her own decision as to whether or not the proposed contract is in his/her interests — the financial services provider must first make detailed disclosure of its interest in the transaction and then the ultimate decision is up to the client. When a financial services provider provides personal financial product advice, they must disclose particulars including: • information about any remuneration (including commission) or other benefits that the financial services provider (including its related bodies and employees) is to receive that might reasonably be expected to be or have been capable of influencing the financial services provider in providing the advice • information about: − any interests, whether pecuniary or not and whether direct or indirect of the financial services provider (or any of its associates) − any association or relationships between the financial services provider (and any associate of the financial services provider) and any issuers of any financial products that might reasonably be expected to be or have been capable of influencing the financial services provider in providing the advice. Example: Conflicts of interest
An example of conflicts of interest and the corresponding duty in the financial services provider/client relationship is set out below. Situation: Financial services provider failing to disclose commission paid on a recommended product. Conflict: The financial services provider is receiving a fee for a product that he/she is recommending that the client is not aware of. Duty: The financial services provider must tell the client about all fees they are paid that may influence the advice they are giving. © Kaplan Education 2.10 Generic Knowledge: The Finance Industry (910) 1.8 Duty of confidentiality
The existence of a duty of a financial services provider to keep the affairs of its clients in confidence is a consequence of the fiduciary relationship. For example, it would be improper for a financial services provider to disclose that a client had placed a particular order. This duty is overridden where the financial services provider is bound by law to disclose information concerning its clients’ affairs, for example to ASIC or the ASX. 1.9 Minimising risks of legal action
There are a number of tangible and positive steps that advisers can take to minimise the danger of being sued by their clients for their advice. These steps include: • ensuring that systems are in place to develop an intimate understanding of clients and their needs, objectives, preferences and risk tolerance — many complaints arise where advisers misread their clients and therefore do not provide appropriate advice for their particular personal circumstances • rather than making decisions for clients, ensuring that clients take responsibility for their own decisions — this means that clients must fully understand any risks involved and assume responsibility for those risks • putting in place appropriate measures, processes and procedures to ensure compliance with financial services laws • putting in place risk management systems to identify business risks and having measures in place to keep those risks at a minimum • maintain professionalism by staying up to date with industry trends and practices and backing up advice with appropriate research. Not only are these steps good business and risk management practice, they are also legal requirements. For example, the Corporations Act requires advisers to investigate their clients’ personal circumstances in order to give appropriate personal advice. The Act also requires holders of AFS licenses to take reasonable steps to ensure that their representatives comply with financial services laws and have adequate risk management systems in place. Appendix 2.1 describes a case where a stockbroker was found liable for negligence. 910.SM1.5 Unit 2: Obligations and liabilities of advisers 2.11 2 Misrepresentations
This discussion deals with liability for ‘misrepresentation’ and ‘negligent misstatement’ and the legal remedies available to a person who receives wrong advice from an adviser. If there is a contractual relationship between the parties, the common law may give the representee a right to sue for breach of contract. If there is no contract, the representee may be able to sue in tort for negligence or deceit if the misstatement was deliberate or made recklessly. The representor may have also contravened the misleading or deceptive conduct provisions of the Corporations Act. Each of the above causes of action has different elements that need to be proved by the representee in an action against the representor. These will be explored throughout this unit. 2.1 Pre-contractual misrepresentation
Where a person makes a statement that is wrong, misleading or otherwise capable of deceiving the person to whom it is made, the law may give the representee the right to sue the representor. A statement which is false or misleading is called a ‘misrepresentation’. However, not all misrepresentations give rise to an automatic right to sue. Misrepresentations can be broken down into three groups: • Innocent misrepresentation It is a misrepresentation which is made in circumstances where there is no duty of care owed by the representor and no deceit on its part. • Negligent misrepresentation or misstatement This is a misrepresentation made by a person who owes a duty of care to the representee, upon which the representee relies and thereby suffers loss. • Fraudulent misrepresentation or deceit This is a misrepresentation of fact, made by the representor in the knowledge that it is false or with reckless disregard as to whether or not it is false, that induced the representee to enter into the contract, and as a result, suffer financial loss. The law of civil wrongs (or torts) does not give any relief in respect of an innocent misrepresentation. The law of tort gives the representee the right to sue for damages only if the misrepresentation is either a negligent misrepresentation or a fraudulent misrepresentation. Frequently, within professional relationships, conduct may constitute both a breach of contract and a tort. For example, a securities adviser who gives careless advice to a client who has paid a retainer may be liable for breach of the implied contractual obligations to exercise care in advising the client and may also be liable in the tort of negligence. Although the remedies in contract and tort may co-exist, for the sake of simplicity we consider first the position of a person to whom a misrepresentation has been made in a contractual relationship, and then the position where there is no contract. © Kaplan Education 2.12 Generic Knowledge: The Finance Industry (910) Contractual remedies
A representee who has been induced to enter a contract on the basis of a misrepresentation has the following options available: • rescind the contract (i.e. bring it to an end), or • where the misrepresentation has become a term of the contract: – let the contract continue and claim damages for losses suffered by having to perform it, or – treat the contract as terminated (if the breach is serious enough). The representee may also have other non-contractual remedies, e.g. damages for misleading or deceptive conduct under the Trade Practices Act or the Fair Trading Acts. 2.2 Misrepresentations — tort
What is a tort?
In the financial markets, people often make investment decisions or take action on the basis of advice given by participants such as brokers, trustee companies, fund managers and bank managers — regardless of whether the person giving advice is a licensed adviser under the Corporations Act. Often there is no contract between the representor and the representee, so if a misrepresentation is relied upon, to its loss, the representee is unable to take action in contract. However, even where there is no contract between the representor and the representee, the representee may still be able to bring an action in tort. Tort is a technical term for any group of actionable legal wrongs. The tort of deceit
The law relating to deceit gives an innocent party a right to damages against the maker of a fraudulent misrepresentation. A fraudulent misrepresentation is: • a misrepresentation of fact • made with knowledge on the part of the representor that it is false or, alternatively, made with reckless disregard as to whether or not it is false • as a result of which the representee is induced to enter into a transaction whereby it suffers financial loss. It is important to note that proof of fraud is often very difficult to establish because it requires proof that the representor was deliberately dishonest in making a representation or that the representation was made recklessly. The court will consider whether the representor believed the statement to be true according to its meaning as understood by the representor. If the representor held such a belief, there is no deceit. If a case of deceit is made out, the fraudulent misrepresentor is required to pay damages to the representee to restore it, as far as possible, to the position that it would have been in if the deceit had not been committed. 910.SM1.5 Unit 2: Obligations and liabilities of advisers 2.13 2.3 The tort of negligence
The law relating to negligence gives an innocent party a right to damages against the maker of a negligent misstatement. Negligent conduct is conduct which falls below the standard regarded as normal or acceptable in society. It covers many areas of activity including road accidents, factory accidents, injuries caused by defective products and financial damage or loss. Tort of negligent misstatement
To make out a case of negligent misstatement successfully, the representee needs to prove that: • the representor owed it a legal duty of care • the representor, in making certain statements, failed to meet the standard expected under that duty of care • as a result, the person suffered loss. The onus of proving negligence rests with the person who asserts it, that is, the representee. If there is no loss, then there has been no tort of negligence. 2.4 Disclaimers and exclusions
If the circumstances justified the person relying on the advice, despite the disclaimer given, it is possible that the disclaimer might not be effective. Alternatively, liability may depend upon whether the adviser knew, or should have known, that the advice would be relied upon, in which case a disclaimer would be a factor to be considered. A disclaimer may try to limit the class of persons who could claim, by stating that the advice is directed only at a certain person or class of persons. For public policy reasons, while a disclaimer may be effective in regard to misstatements made negligently, it may not preclude liability in respect of statements made dishonestly. In any event, courts always try to read down disclaimers. Where a contractual relationship exists between parties, it is possible for an agreement to be reached that, in specified circumstances, one party will not be liable to the other in tort. There seems to be no reason, in principle, why liability in tort for negligent misstatement cannot be excluded by contract. © Kaplan Education 2.14 Generic Knowledge: The Finance Industry (910) 3
3.1 Other unlawful conduct
Misleading or deceptive conduct
Under the Corporations Act, a person must not engage in conduct in relation to a financial product or a financial service that is dishonest, misleading or deceptive, or likely to mislead or deceive. 3.2 Hawking
Historically, the prohibition of hawking of securities was designed to prevent canvassers moving from house to house and offering securities to investors who lacked a detailed understanding of company securities and the volatility of the share market. Usually, these canvassers were paid on commission and fraud could often be present. Section 736 prohibits certain persons to offer securities for issue or sale in the course of, or because of, an unsolicited telephone call or meeting with another person. This includes offers made by way of invitations and also distributing application forms. Exempt from the prohibition on securities hawking are offers made in the following circumstances: • where an offer does not require a disclosure document because it is made to a sophisticated investor • where an offer does not require a disclosure document because it is made to a professional investor • the offer is of ASX listed securities made by telephone by a licensed securities dealer (i.e. a stockbroker) • the offer is made by a licensed securities dealer to a client of the dealer who has dealt with the dealer in the last 12 months. 910.SM1.5 Unit 2: Obligations and liabilities of advisers 2.15 4
4.1 Ethical perspective
In the context of the financial services industry, ethical considerations affect the way a deal is transacted and the manner in which an individual or an organisation conducts themselves when dealing with clients and in the marketplace. Ethics places importance on considerations other than the profit motive when conducting a transaction. The considerations include: • non-discriminatory behaviour towards clients, employees, colleagues and other financial organisations • fiduciary obligations towards clients (i.e. making relevant disclosures in respect of the transaction proposed). Ethics and ethical conduct are important to the reputation and integrity of an organisation and to investor confidence. Ethical considerations have resulted in the development of the following codes of conduct: • Banking Code of Conduct • Australian Financial Markets Association (AFMA) Code of Conduct • Australian Securities Exchange (ASX) Code of Conduct or rules • other financial institutions’ and organisations own codes of conduct, for example Financial Planning Association (FPA). 4.2 Ethical standards
Ethical standards should reflect the values and standards of a particular organisation and the environment in which it operates. An important role of compliance is ensuring that relevant participants in the market understand the regulatory requirements. However, it is just as important to ensure that participants act within the ‘spirit of the law’. This is extremely important where the formal regulatory environment is not well defined. © Kaplan Education 2.16 Generic Knowledge: The Finance Industry (910) 4.3 Principles for ethical behaviour
The following principles could provide a basis for defining ethical behaviour: • Honesty: this includes being honest not only to your colleagues, but also to counterparties, clients and shareholders — even when the information is unpalatable. • Integrity: having the ability to determine what is appropriate behaviour and standards, and always acting in accordance with those standards. This includes reporting inappropriate behaviour to the relevant person or organisation or being wary of situations that may result in a conflict of interest (e.g. the accepting of inappropriate gifts). • Acting in the best interests of clients and the markets: this includes ensuring that clients are not misled, either intentionally or otherwise (e.g. ensuring that clients understand the product being offered). • Fairness and remaining objective: at times it is difficult to remain objective, for example, when trying to deal with a complaint from a counterparty or a client. However, ensuring that situations are settled in an objective and fair manner in the first instance may reduce the risk of future legal action. • Not disadvantaging a client: either through negligence, carelessness, or intentional behaviour. Much of the regulation that governs the financial markets is based on these principles. For instance, the Corporations Act prohibits conduct which is misleading, deceptive or likely to mislead or deceive; and the purpose of the Financial Transaction Reports Act 1988 is to maintain the integrity of the financial system by identifying behaviour or transactions that may be the result of tax evasion or money laundering. Limits and boundaries When determining limits for ethical behaviour you need to consider: • the motivations and aims of business • personal and corporate values in business • the principles which form the touchstones of the relational nature of all business transactions and dealings. You need to balance your own interests, and the interests of your friends, with broader concerns. That is, you should consider: • the course of action or conduct that is for the common good • the course of action or conduct which conforms with our shared and accepted notions of honesty, loyalty and trustworthiness. 910.SM1.5 Unit 2: Obligations and liabilities of advisers 2.17 You also need to make judgments, based on positive values such as: • compassion • competence • courtesy • self-discipline • honesty • integrity • loyalty • sensitivity • tolerance. You would also avoid acting on negative or destructive values such as: • greed • corruption • malice • disloyalty • selfishness • intolerance. In making ethical decisions, you will be guided not only by your personal conscience but by industry factors that include: • increased expectations of clients and consumers of financial services • clearer identification of financial advice as a distinct area of professional expertise • past failure by those involved in financial services work to meet the high ethical expectations assumed to apply in the provision of that advice and those services. 4.4 Relationship between law and ethics
While you need to act within the ethical confines laid out in the law, the law will set only minimum standards and benchmarks from an ethical perspective. Ethics will also require you to make individual judgments about your specific business circumstances. The ‘fiduciary’ nature of the obligations and responsibilities owed by the adviser to their client emphasise the significance of the nature and character of that business and professional relationship as involving special trust and personal commitment on the part of the adviser. These ideas are premised upon the appreciation that an adviser provides a service for their client that involves the application of expertise, professional guidance, information and advice. © Kaplan Education 2.18 Generic Knowledge: The Finance Industry (910) 4.5 Ethical standards and expectations versus compliance
It remains important to distinguish between promoting ethical standards and creating a framework for encouraging the expectation of living out those standards and values, from entrenching a culture of mere compliance in ethical conduct and practice. A culture of compliance is not just about an enforcement process for dealing with transgressions in practice and conduct in financial markets. It can also be part of adopting a legalistic structure of responding to and enforcing standards and competencies in self-regulatory codes and business rules. It is important not to allow failure to meet certain standards in practice and conduct to lead to a desire for compliance with narrow and prescriptive rules. The culture of regulatory compliance is evident by the fact that usually any large organisation, such as a broking house or funds manager, allocates matters concerning codes to sections or departments called ‘Regulation/Compliance/Audit’. This can also be true with industry regulators such as ASX The emphasis needs to be upon the development and nurturing of an ethical character and personal commitment to ethical standards by advisers and all people in the financial markets. 4.6 Strategies for promoting ethical best practice in the workplace
The focus of much of the discussion in this unit in terms of the relevant business relationships for the financial markets has been upon the adviser–client relationship. However, the stakeholder theory argues that the financial organisation has many stakeholders. The ethical context of wider social and community obligations and responsibilities has been referred to. Yet, the business of work should be understood to embrace ethics at two levels of involvement: • the framework of decision making within the areas of substantive business • the human relationships which form part of the environment of the financial markets. The second dimension, which exists in all advising contexts, is important in terms of how a person responds to and manages particular workplace relations ethically. Appreciating the two levels of ethical response in business is part of understanding how best to build a strategic framework to enable ethics and ethical awareness to be integrated into all decisions and conduct in the finance and securities industry. A useful and practical process for developing such a strategy requires you to respond to the following questions: • What are the facts? • What assumptions am I relying on? • Who are the people who are affected by my decision or conduct? • Which of my values are significant? • Are there alternative ethical perspectives for resolving the issue? • What alternative options are available to me? • How do I justify my decision? • Have I integrated ethical awareness into my decisions and conduct? 910.SM1.5 Unit 2: Obligations and liabilities of advisers 2.19 4.7 Minimising the risk of legal action
Advisers should observe the following practices to minimise their legal risk and reduce the risk of adversely affecting clients: • research the product and any advice given to hold, sell or buy a financial product • research their clients to understand their needs, objectives, risk tolerance etc. • provide written reports to clients • keep comprehensive files, including: – a copy of the client’s profile questionnaire – a copy of the client’s letter of engagement – a copy of all correspondence to and from the client – a copy of any statement of advice – copies of letters to fund managers, life companies and other people concerning the client’s affairs – copies of investment and insurance application forms • restate the client’s instructions and the criteria on which the recommendations were based and have the client sign-off on them • keep up to date with industry practice • receive an adequate level of training on products, procedures and strategies to maintain their professional competency and integrity • develop procedures to continually improve their client’s knowledge and understanding of how recommendations are matched to their financial needs and goals • include appropriate disclaimers when giving advice • have adequate professional indemnity insurance and understand the policy’s limitations. Reflection
An important part of minimising risk of litigation is to act with true professionalism and to maintain a code of ethics. The adviser should consider the following: • client’s interests should be placed before the adviser’s • maintenance and improvement of knowledge and competence • diligence in the performance of duties • establishment and maintenance of honourable relationships with other professionals • work to improve public understanding and awareness. Many of these sound like ‘motherhood statements’ but failure to follow these can be disastrous. Can you think of recent examples? © Kaplan Education 2.20 Generic Knowledge: The Finance Industry (910) 4.8 Case studies
The following case studies illustrate a number of ethical issues that you might encounter in practice concerning disclosure of benefits. 1. Jane is a young financial adviser who has just started out in a new job. She is in a position to make recommendations to clients and can choose from many funds. She must, however, disclose any remuneration she gets from the funds. A more experienced and successful colleague tells Jane that he always recommends a product that gives him the highest commission, as long as that product performs as well as possible alternative products. While he always discloses his commission to his clients (as required by law), he doesn’t disclose the fact that there is a difference between the commissions of alternative products. Q. Should Jane follow his example? If Jane adopts the suggested practice of recommending products that give the highest commission, she should disclose this to her clients up front. Her clients should then be given the opportunity to look at equivalent products so that they can make their own informed choices. A good test for Jane to apply is: ‘How would it look if her practices were exposed on the 6 o’clock news?’ 2. Sam advises a wide range of people about various products, but especially about a certain listed property trust. The trust performs quite well — in fact, Sam has himself bought units in it and he also encourages the vast majority of his clients to invest in that trust as well. As more and more people invest in the trust and the trust performs well, Sam’s investment increases in value. He always discloses the commission he makes but doesn’t disclose his own investment (unless it happens to come up in conversation or unless he’s asked). After all, it’s personal! Q. Is Sam justified in thinking that his investment in the property trust is a personal matter that does not need to be disclosed? In this case it is obligatory for Sam to disclose his interest. Whatever Sam’s initial (and perhaps even continuing) motives, he gets deeper and deeper into a conflict of interest. 3. James has a practice that largely caters for potential and actual retirees. He always discharges his obligation to disclose his commission and other matters by explaining such matters to them in a very formal fashion, often ‘firing off’ the ‘magic words’ in almost machine gun fashion. Sometimes clients’ eyes glaze over; sometimes they just smile. Q. Has James made full and proper disclosure? Full and proper disclosure is really only made if you know that the person you are making it to can either read or hear it (as applicable) AND reasonably be expected to understand it. 910.SM1.5 Unit 2: Obligations and liabilities of advisers 2.21 5
5.1 Privacy and personal information
Handling of personal information by private sector organisations
The National Privacy Principles (NPPs) contained in the Privacy Act 1988 (Cth) regulate the handling of personal information by private sector organisations. Personal information is information or an opinion, whether true or not, and whether recorded in a material form or not, which identifies an individual or from which that individual’s identity can reasonably be ascertained. Examples of personal information include a person’s name, address and financial details, racial origins, political opinions, religious beliefs, membership of professional organisations, sexual preferences, criminal records or health information. When collecting, using, disclosing and otherwise handling personal information about individuals an adviser must comply with the requirements of the NPPs. Generally the collection of sensitive information always requires consent. 5.2 Requirements of the National Privacy Principles
If the business of a broker or financial services licensee has an annual turnover of less than $3 million, then the NPPs do not apply to that business. This exemption is, however, subject to the following provisions, and if any of the following apply to that business it will be subject to the NPPs as of 21 December 2002: • the business discloses ‘personal information’ about an individual to anyone for a benefit, service or advantage • the business provides someone else a benefit, service or advantage to collect personal information • the business is related to an organisation with an annual turnover of greater than $3 million • the business elects to be covered by the NPPs by opting into the federal privacy regime. The Privacy Act 1988 (Cth) also regulates the handling of tax file number information and credit information. 6 Anti-money laundering/counter-terrorism financing regime
A new anti-money laundering/counter-terrorism financing regime was introduced with the commencement of the AML/CTF Act in December 2006 and December 2007. The regime is being introduced in two tranches (stages). The first tranche is being implemented over a two-year period from December 2006 to December 2008 and is discussed below. Any business is required to comply with the AML/CTF Act where that business provides ‘designated services’, such as: • opening an account • accepting money on deposit • making a loan • issuing a debit card • issuing traveller’s cheques • leasing goods or services • issuing or selling a security or derivative. The new regime does not generally cover the provision of financial advice in itself. However, it will affect the holder of an Australian financial services licence where the holder moves to the next stage of acting on the recommendations (e.g. providing a financial product). 910.SM1.5 Unit 2: Obligations and liabilities of advisers 2.23 Some of the principal obligations under the new regime include: • customer identification and verification of identity • expanded record keeping • establishing and maintaining an AML/CTF program • ongoing customer due diligence • reporting of ‘suspicious matters’, threshold transactions ($10,000) and international funds transfer instructions. 7 In summary
Financial advisers are legally responsible to their clients for the advice that they give, and failure to provide appropriate advice may lead to litigation both under common law and/or various statutory provisions. Common law is the law made by judges in the cases heard by them. This includes the law of contract and negligence. Here are some examples of common law actions which clients might bring against advisers for poor advice: • breach of contract ⎯ the law of contract regulates the relationship between advisers and their clients. The law of contract will imply into every contract between an adviser and client a term that the adviser will use all reasonable care and skill commensurate with the adviser’s professional standing and experience • breach of fiduciary duty ⎯ the basic legal relationship between financial services providers and their clients is that of principal and agency (part of contract law). The agent/principal relationship is one based on trust and is one of the relationships described as a ‘fiduciary’ relationship. An agent (adviser) must always deal with a principal (client) in the utmost good faith • negligence ⎯ advisers have a special relationship with their clients which is based on the fact that the clients rely on their advice. This means that advisers have a ‘duty of care’ towards their clients and can be sued for negligent advice. Advisers can be sued in negligence even if there is a contractual relationship with the person to whom they are giving advice, e.g. one-off advice at a barbeque. This unit also looked at a number of other common law and statutory requirements prohibiting: • misleading or deceptive conduct • false and misleading representations • dishonest conduct. The last section of this unit identified the impact of the Privacy Act on participants in the financial services industry, highlighting additional obligations of organisations under the federal Act. © Kaplan Education 2.24 Generic Knowledge: The Finance Industry (910) 7.1 Checklist
Below are the main points covered by this unit. Use this to check your learning. • The law of contract is that branch of law which states when a promise, or set of promises, is legally binding. • A contract is enforceable if it contains all of the following elements: – offer and acceptance – consideration – intention to create legal relations – capacity to contract – genuine consent – lawfulness of object. • Every contract is formed by offer and acceptance. This is achieved by: express words only, actions only, or a combination of express words and action. • Consideration is something given, done or suffered in return for a promise, i.e. the price the other party pays for the promise. To be valid, consideration must be current and sufficient. • Terms of a contract may be either express or implied. • When a contract comes to an end, it is discharged. A contract can be discharged through performance, agreement, frustration, breach. • The remedies for breach of contract include: damages, injunction, specific performance. • A contract may be voidable if it has been entered into where there is an abuse of power. • Misrepresentations can be: – innocent – negligent – fraudulent or deceitful. • Any misrepresentations resulting in damages or loss can result in rescission of the contract or the right to sue for damages. • Conduct may constitute both a breach of contract and a tort. • There is a right to rescind a contract if: – the other party made a misrepresentation of fact – the misrepresentation of fact was material to the contract – the person was induced to enter into the contract by the misrepresentation – the rights of innocent third parties are not affected – the contract has not been affirmed by the party seeking to rescind it – the parties can be restored to their former position. • Exclusion clauses and disclaimers may limit liability, but this depends on the particular circumstances. 910.SM1.5 Unit 2: Obligations and liabilities of advisers 2.25 • Liability in tort for negligent misstatement can arise if: – the person making the statement owes a duty of care to the recipient – the duty of care has been breached – the representor intended the recipient to rely on the statement or it was reasonable for the recipient to rely on the statement – the recipient has suffered loss and damage as a result. • Ethics can be explained as the process of thinking which involves the values and principles concerned with the making of choices and commitments in our decisions, actions and conduct. • Ethical standards reflect the values and standards of a particular organisation in the environment that it operates in. • The struggle to be ethical is more about trying to act on the basis of what is good or right. • Ethical principles include: – honesty – integrity – acting in the best interests of clients and the markets – fairness and objectivity – acting within the spirit and letter of the law – not disadvantaging a client. • What determines, influences and encourages choices based upon the positive ethical qualities is concerned with our character and what in the end we regard as fundamentally important. • Ethics requires a person to think about their decisions and actions and what underpins those particular courses of action. It also requires thinking practically in terms of what a person should do. • The law will only set minimum standards and benchmarks from an ethical perspective — ethics will require more of an individual. • Codes of conduct provide a benchmark to which organisations can measure their own internal policies and procedures against market standards. • In general, if a person provides financial services as a representative of an AFS licensee, that person needs to hold a written authorisation from the licensee. • When handling, using and storing personal information about individuals a securities dealer or adviser, futures broker or adviser, or financial services licensee who falls within the application of the Privacy Act 1988 (Cth) must comply with the requirements of the 10 National Privacy Principles. © Kaplan Education 2.26 Generic Knowledge: The Finance Industry (910) Notes 910.SM1.5 2
Case study ⎯ stockbroker liable for negligence 1 Unit 2: Appendix 1 Case study ⎯ stockbroker liable for negligence
The decision in Ali v Hartley Poynton  VSC 113 illustrates the consequences of an adviser failing to include the client in the decision-making process. In that case the client (Ali) successfully sued a stockbroker with Hartley Poynton (Martin) on several grounds, including for negligent misrepresentations and negligent trading. The issues and facts in that case were complex and will not be dealt with here in detail. Basically, Martin successfully gained Ali’s business after making a number of representations including representations about the potential returns he could achieve for Ali. Ali then provided two sums for investment: one amount to be traded on the stockmarket and the second amount for the purchase of Telstra shares. Despite Ali’s instructions, the Telstra shares were sold by Martin and the funds traded. As to the general trading funds, it was held that the representations made by Martin concerning the rate of return that could be achieved were misleading and that Martin had breached his duty of care to Ali. The following comments by the Supreme Court of Victoria outline the pattern of interaction between Martin and Ali which made Hartley Poynton vulnerable to legal action: • Martin played down the risks involved, assuring Ali that to invest through Hartley Poynton would be as safe as in the bank but would generate greater returns. During the preliminary discussions, he played down any suggestion of risk. • Martin insisted that he have control and the ultimate responsibility for the investment outcome and Ali accepted that position. • Martin was reckless in his approach to risk and dismissive of it. He represented that trading in shares on his advice was ‘not risky’. • Ali would, from time to time, give instructions to Martin which Martin would refuse the carry out. He would then ask Martin to confirm his refusal in writing giving reasons. In this way he sought to protect himself and hold Martin responsible for the outcome. • Hartley Poynton, through Martin, had discretionary control. The pattern was for Ali to criticise, give instructions and record concerns but to allow the arrangement to continue. Termination was raised more than once but not carried out. Ali’s requests were ‘recommendations’ instead of ‘instructions’. They were requests which Martin was not obliged to follow so long as he was attempting to achieve the agreed target and had responsibility for the trading outcome. 2 The mere fact that Hartley Poynton had a compliance system in place did not protect the company from being successfully sued – a system of checking that the policies were being implemented was also required. The Court made the following comments: A stockbroker employing brokers cannot supervise each dealing they make as they make it. It can, however, set down policies. This [Hartley Poynton] did through its Compliance Committee in Perth. Policies, however, are worthless without systems and people in place to enforce those policies by checking from time to time that they are being applied. There was, more particularly, no supervision and control of the way Martin carried out his trading activities, except for debt aspects and possibly, at one point his short selling activity. … There is a singular lack of evidence from [Hartley Poynton], or submissions, on the monitoring, if any, of brokers by the Compliance Committee. 3
Operation of the financial services industry Overview 3.1 Unit learning outcomes ....................................................................3.1 1 1.1 1.2 1.3 2 2.1 2.2 2.3 2.4 2.5 2.6 2.7 3 3.1 3.2 Functions of the financial system 3.2 The economy and the financial system .....................................3.2 The flow of funds....................................................................3.3 Intermediation........................................................................3.3 Types of financial markets 3.4 Overview ................................................................................3.4 What is a security? .................................................................3.4 The equity market...................................................................3.5 The debt market .....................................................................3.5 The foreign exchange market ...................................................3.6 The derivatives market ............................................................3.6 Globalisation of financial markets ............................................3.6 Features of financial markets 3.7 Primary and secondary markets ...............................................3.7 Liquidity.................................................................................3.9 4 4.1 4.2 4.3 4.4 4.5 4.6 4.7 4.8 4.9 4.10 4.11 4.12 4.13 4.14 5 5.1 5.2 6 6.1 6.2 6.3 6.4 6.5 7 Intermediaries in the financial services industry 3.10 Participants and the flow of funds ..........................................3.10 The government as an intermediary........................................3.11 The Reserve Bank of Australia ...............................................3.12 Retail banks.........................................................................3.12 Investment banks .................................................................3.12 Finance companies...............................................................3.13 Building societies .................................................................3.13 Credit unions .......................................................................3.13 Friendly societies..................................................................3.14 Home mortgage lenders ........................................................3.14 Fund managers ....................................................................3.14 Stockbrokers........................................................................3.15 Superannuation funds...........................................................3.15 Life insurance companies......................................................3.15 Types of financial services 3.16 Retail financial services ........................................................3.16 Wholesale financial services..................................................3.19 Regulation of the financial services industry 3.19 Financial services reform.......................................................3.19 Regulatory authorities ...........................................................3.20 Consumer protection legislation.............................................3.23 Insurance legislation.............................................................3.24 Codes of conduct .................................................................3.26 In summary 3.27 Unit 3: Operation of the financial services industry 3.1 Overview
This unit provides an overview of the operation of the financial services industry. It focuses on: • the financial system • the flow of funds throughout the financial system • types of financial instruments and markets • the features of finance and securities markets • the various intermediaries that operate in the financial services industry • the regulation of the financial services industry. Unit learning outcomes
On completing this unit, you should be able to: • describe the functions of the financial system in the modern economy • list and briefly describe the major markets that make up the Australian financial system • differentiate between primary and secondary markets • distinguish clearly between debt and equity • list the characteristics of securities considered by investors • distinguish between retail financial services and wholesale financial services • list the major types of financial intermediaries operating within the Australian financial system • list and briefly describe the role of the major regulatory authorities in the Australian financial system. © Kaplan Education 3.2 Generic Knowledge: The Finance Industry (910) 1
1.1 Functions of the financial system
The economy and the financial system
The financial system provides for: • Mobilisation of funds. It aids in the mobilisation of the community’s savings and the transfer of these savings to sectors that make productive use of them. The financial system makes efficient use of resources when: – funds are allocated to the most efficient users of the funds (allocative efficiency) – transfers are carried out at least cost (operational efficiency). • Flexibility in investment. Financial markets also allow people to alter their existing investments (by selling shares and buying government bonds). • Implementation of monetary policy. Through the financial system, government authorities can affect holdings in financial assets, exert an influence on interest rates and ultimately the level of activity in the economy (i.e. spending on goods and services). The Federal Government relies on monetary and fiscal policy to influence the level of economic activity, the rate of inflation and the level of the Australian dollar. The Reserve Bank of Australia has been empowered by the Federal Government to manage inflation within a target level and to do this its primary tool is to operate in the money market (independent of the Federal Government) to influence the price of short-term securities. This, in turn, influences interest rates in the financial markets generally, which impacts on the level of activity in the economy. • An efficient savings process. By providing savers with a safe repository for their surplus funds, the financial system encourages saving and so increases the volume of resources available for investment in productive assets, such as plant and machinery. The following is a comprehensive diagram showing all the sectors of the economy and the financial flows between them.
Labour input Income $ Household sector Business sector Sales receipts $ Goods and services Savings Finance sector Investment Taxation Government sector Government expenditure Imports Overseas sector Exports 910.SM1.5 Unit 3: Operation of the financial services industry 3.3 1.2 The flow of funds
Within the financial system there are two main types of financial flow: • Direct funds flow. Direct financing refers to the flow of funds direct from savers to borrowers. This method of transferring funds is only efficient where the sums involved are large for both borrowers and lenders, or where the needs of borrowers and lenders are exactly matched as to term, interest rate, amount and repayment arrangements.
Figure 1 Direct funds flow $ Saver Borrower • Indirect funds flow. Indirect financing refers to the flow of funds through financial intermediaries. Savers’ funds are pooled and packaged and are then on-lent to borrowers for a fee. This is the process most often used by savers and borrowers in today’s financial system, and is called ‘intermediation’.
Figure 2 Indirect funds flow
Borrower $ $ Saver $ Saver Intermediary
$ Saver $ $ Borrower $ Saver Borrower 1.3 Intermediation
Intermediation refers to the activities of financial intermediaries in assisting the indirect flow of funds through the financial system. Financial intermediaries act as middlemen, pooling the funds of lenders (savers) and passing that money on to end users (borrowers). Financial intermediaries also trade financial assets such as shares and bonds through specific markets established for this purpose. These markets include share markets, short-term debt markets, long-term debt markets, foreign exchange markets and derivative markets. These concepts are discussed further in this unit. Examples of intermediaries include banks, life insurance offices, superannuation and pension funds, finance companies, investment banks, building societies, credit unions and unit trusts. © Kaplan Education 3.4 Generic Knowledge: The Finance Industry (910) 2
2.1 Types of financial markets
A market is the coming together of buyers and sellers of goods and services, whether physically or electronically. Financial markets exist to facilitate the trading (buying and selling) of financial instruments within the financial system between participants. There are four major markets in the Australian financial system: • equity market • debt market • foreign exchange market • derivatives market. Before we look at what each market does, let’s first check what we mean by the term ‘securities’. 2.2 What is a security?
Securities are documentary evidence of ownership of financial assets, or alternatively, they are an acknowledgment of indebtedness and the requirement for repayment at some future time. The distinguishing feature of securities is that they are exchangeable or saleable in the marketplace. They may be such things as a BHP Billiton share certificate or a government bond evidencing lending to the government. The development of the ASX Clearing House Electronic Subregister System (CHESS) has led to the introduction of paperless transfer of securities, but the principles remain in place. The terms ‘securities’, ‘investments’, ‘finance’ and ‘capital’ are often used interchangeably in the markets and also in this subject. A useful way of distinguishing the term ‘security’ is by its legal connotation. A ‘security’ is specifically included under the Corporations Act as a type of financial product. Section 761A of the Act defines a security as: (a) (b) (c) (d) a share in a body (corporate) a debenture of a body a legal or equitable right or interest in relation to (a) or (b) an option to acquire by way of issue (a), (b) or (c) but does not include an excluded security. For the purposes of this module, however, securities are defined as the paper right to a generally tradeable financial asset. 910.SM1.5 Unit 3: Operation of the financial services industry 3.5 Securities can also be classified as either debt or equity. The concepts of debt and equity are central to the finance industry. • Debt. The obligation on the part of a person or company to pay a specific amount of money to another party. Such an obligation will involve specific provisions regarding the term of the debt, the interest rate payable, the repayment arrangements and security (or collateral). • Equity. In the context of financial markets, the term ‘equity’ is used interchangeably with shares. When shares (equities) are purchased, you acquire part ownership in the issuer of the shares (such as a company). This means you share in its profits (through the receipt of dividends) and the rise (or fall) in value of its shares. 2.3 The equity market
The equity market, also known as the share market or stockmarket, is a major part of the financial system. It enables companies to raise funds through the issue of shares and enables investors to receive a capital gain or loss through investing in companies via shares. 2.4 The debt market
In Australia, there are two distinct segments of the debt market: 1. The short-term debt market, also referred to as the money market. A security or loan with a maturity of one year or less is referred to as a short-term security. Short-term debt securities include: • bank accepted/endorsed bills • negotiable certificates of deposit • Treasury notes. 2. The long-term debt market, also referred to as the fixed interest market. The long-term debt market represents the trading of securities with a term to maturity of more than one year. Long-term debt securities include: • Treasury bonds. These are the major borrowing instrument used by the Commonwealth Government when it wishes to raise funds. • Semi-government bonds. State governments also issue long-term debt securities. • Corporate bonds, unsecured notes, debentures and asset-backed securities. Companies can also raise medium- and long-term funds in this market through corporate bonds, debentures, unsecured notes and asset-backed securities. Corporate bonds are fixed interest securities (i.e. bonds) issued by companies to fund their operations. As lending money to a company is riskier than lending to a government, corporate bonds offer a higher yield than government bonds. © Kaplan Education 3.6 Generic Knowledge: The Finance Industry (910) 2.5 The foreign exchange market
Foreign exchange trading involves the buying and selling of different currencies, exchanging one for the other or for one’s own currency. Foreign exchange dealing is not confined to the financial institutions. Corporations enter the foreign exchange market to cater for their transactional needs as an end user. Some are in the business of speculation on exchange rate movements in a similar fashion to banks. Typically, companies will be involved in the importing and exporting of commodities or machinery. 2.6 The derivatives market
Derivatives are financial instruments whose value is derived from underlying financial assets. They include instruments such as futures, options, forwards and swaps. 2.7 Globalisation of financial markets
Globalisation refers to the integration of world markets as a result of technological innovations that facilitate the trading of securities across all markets. Globalisation means that no market is isolated from developments in other markets. Whenever a major event affecting overseas markets occurs, the impact of that event will be felt simultaneously in Australia. The extent to which globalisation affects Australia’s financial markets cannot be overstated. As in the case of the share market, a number of factors are likely to affect the daily prices for shares — pushing them up or down. If the Dow Jones (an index of the US stock market) or the NASDAQ has a sharp rise or fall, the Australian stockmarket will be affected. For example, a fall in the international gold price might result in a lowering in the value of specific mining stocks in Australia. A change in the value of the US dollar affects trading on the foreign exchange market. These are just a few examples of how Australia is affected by global factors. Australian shares are traded on overseas markets (e.g. ANZ and BHP are traded on the London share market). These securities are affected by domestic factors, as well as trends in the overseas market on which they are traded. 910.SM1.5 Unit 3: Operation of the financial services industry 3.7 3 Features of financial markets
Now that we are familiar with the four types of markets operating within the financial system, we can examine some of the features of these markets. 3.1 Primary and secondary markets
The primary market
The term primary market is used to describe new lending and borrowing arrangements and new equity issues. An example of primary market activity is the issue of Treasury bonds on the long-term debt market by the Commonwealth Government. This transaction takes place directly between the borrower and lender. This is illustrated in Figure 3.
Figure 3 A debt security on the primary market Government Borrower $ Investor IOU (interest) Lender Another example of primary market activity is the new issue of shares on the share market. Investors provide a company with funds that are used to develop and grow the business. In return, they expect to receive a portion of the profits, which are paid in the form of dividends. This is illustrated in Figure 4.
Figure 4 Primary market for equities Company Equity issuer $ Investor Share (dividends) Equity holder Companies are increasingly using the equity markets for new capital rather than raising debt. Company restructuring is also a key influence on the level of new equity raising, as companies float a portion or a particular business unit. The secondary market
The term secondary market is used to describe the subsequent buying and selling of existing securities. Using the Treasury bond example, the original buyers of the Treasury bonds might decide to sell them before they mature (i.e. before they are due to be paid out by the Commonwealth Government). In order to sell their Treasury bonds, original holders might approach stockbrokers to offer the Treasury bonds for sale on the stock exchange or offer them for sale to a bank. The buyers of the Treasury bonds might in turn sell them, and the bonds might be bought and sold many times before they mature. Figure 5 illustrates this concept. © Kaplan Education 3.8 Generic Knowledge: The Finance Industry (910) Similarly, investors in shares might not want to hold their shares indefinitely. They too can liquidate their investment by selling their shares on the secondary market.
Figure 5A Trading a debt security on the secondary market Government Borrower IOU $ Secondary market sell bond Investor 1 Lender payment for bond ($) Investor 2 Lender The sale of the bond creates a new relationship between the Government and Investor 2.
FIGURE 5B A new relationship created by the secondary market Government Borrower IOU Investor 1 Lender Investor 2 Lender 910.SM1.5 Unit 3: Operation of the financial services industry 3.9 Link between primary and secondary market
The success of a float or a security issue on the primary market is closely linked to expectations of activity in the secondary market. Many investors do not wish to hold debt securities until maturity, nor equities for a significant length of time or until the company is wound up. Therefore, they will participate in the primary market only if they have a reasonable expectation of being able to sell their securities in the secondary market. For instance, when a new share issue is over-subscribed, many investors expect the price of the shares to rise sharply soon after the float, which is considered a very attractive investment. Hence, there will be a great deal of interest in acquiring the shares in the primary market in order to sell quickly on the secondary market at a profit. 3.2 Liquidity
Where there is a significant number of active buyers and sellers in a market, that market situation is regarded as a deep market. The opposite of this is a shallow or ‘thin’ market where there is very little activity, few sellers and few buyers. A deep market offers the benefits of liquidity (i.e. the ability to buy and sell a reasonable number of securities readily), without undue disturbance to the market price. Securities traded in liquid markets are generally more attractive to investors than those available in markets lacking depth. Lenders (investors) are able to liquidate (i.e. sell) their securities without undue delays, and borrowers have access to a wider range of lenders. Investors in illiquid markets hope to be compensated by higher returns. The liquidity of markets is improved by some traders and dealers in that market being prepared to ‘make a market’ (i.e. to quote buying and selling prices or to be both a buyer and a seller at a price). © Kaplan Education 3.10 Generic Knowledge: The Finance Industry (910) 4
4.1 Intermediaries in the financial services industry
Participants and the flow of funds
Within the financial system, there are numerous market participants who facilitate the flow of funds between the various sectors of the economy. These participants can broadly be classified into borrowers and lenders, capital raisers and investors. These participants interact through the financial markets. To assist them, they generally engage the services of an intermediary or service provider. They facilitate the flow of funds between those with money and those needing money. They pool and package funds from those with surplus capital and pass those funds to those requiring capital for a fee. In the process, they assume a number of risks. Intermediaries do not however match one lender with one borrower, as direct financing does. Intermediaries pool the funds of capital providers (i.e. those with surplus funds) and provide those funds to a number of users of capital in return for a fee. This fee or margin is designed to compensate for risk and to earn a profit. One of the main reasons for the predominance of intermediation in our economy is that the mix of securities offered by other users of capital (corporates and governments), while attractive to the capital user, is often unattractive in terms and conditions to the providers of capital (savers). Financial intermediaries offer packaged securities to investors that are more attractive than original ‘lumpy’ securities. Financial intermediaries might be specialists in one financial market, operate across a number of markets or be active in all markets. Markets and examples of the intermediaries active in those markets are shown in Table 1.
Market Share market Long-term debt market Short-term debt market Derivatives market Foreign exchange market Financial markets and intermediaries
Examples of intermediaries Stockbrokers, fund managers Banks, life companies, superannuation funds, fund managers Banks, fund managers Futures brokers, fund managers Banks, foreign exchange dealers, fund managers Bearing of risk
The pooling of funds involves the intermediary taking a number of risks. It is the ability of the intermediary to take these risks and the willingness of the borrower to pay a fee for the intermediary’s bearing of risk that distinguishes indirect flows of funds (intermediation) from direct flows. The following are some of these risks: • Liquidity risk. The risk that the lender will want all their money back when it has been on-lent to the borrower. • Credit risk. The risk that the borrower will not be able to repay the loan. • Interest rate risk. The risk that interest rates will move in such a way as to make the transaction unprofitable. 910.SM1.5 Unit 3: Operation of the financial services industry 3.11 Seldom do borrowers’ and lenders’ needs match exactly in terms of credit risk, maturity dates, interest rate, liquidity, or currency risk. By pooling the funds of lenders, and sometimes pooling the needs of borrowers (e.g. mortgage originators), intermediaries are able to cover this mismatch. Intermediaries are specialists at managing these risks and therefore play a valuable role in the financial system.
Figure 6 Flow of funds in the financial markets Debt market Investors Intermediation Speculators Equity market Foreign exchange market Derivatives market Intermediation Capital Users Speculators Direct financing Capital & income 4.2 The government as an intermediary
The major body acting as a source, user and intermediary for funds is the government. Government expenditure is about a quarter of Australia’s gross domestic product (GDP). The government raises funds in a number of ways including taxation, issues of bonds and treasury notes, government loans and borrowings from overseas. The government exercises economic policy through two arms: fiscal policy and monetary policy. Fiscal policy involves government budgeting, expenditure, revenue, taxation, etc. One of the major ways the government implements fiscal policy is through the Federal Budget brought down in May each year. Monetary policy involves government controls over the amount of money in circulation. The government does this through the Reserve Bank’s open market operations in bonds and treasury notes. Changing the supply of liquidity (cash) in the market moves the level of interest rates up or down. In addition, the government’s wages policy has played an increasingly important role in its economic strategy in the fight against domestic inflation and the effort to improve Australia’s international competitiveness. Unit 4 will cover these economic concepts in more detail. © Kaplan Education 3.12 Generic Knowledge: The Finance Industry (910) 4.3 The Reserve Bank of Australia
The Reserve Bank of Australia (RBA) is Australia’s central bank. The RBA acts as banker and financial agent for the Commonwealth Government and provides banking services to some State and Territory governments. For example, as agent for the Commonwealth, the RBA handles the new issue of government debt securities. The Reserve Bank is responsible for the implementation of monetary policy, the maintenance of systematic stability within the financial system and the establishment and management of the Payments System Board to oversee the opening up of the payments system to new operators. 4.4 Retail banks
Banks are Australia’s largest and oldest financial institutions. Australian banks are regulated by the Banking Act 1959 (Cth), which only allows bodies corporate authorised by the Treasurer to carry on the business of banking. Under the Banking Act 1959 (Cth), only those institutions licensed under the Act may call themselves a bank. Banks provide a broad range of financial services including: • cheque and savings accounts • overdraft facilities • cash management services • stockbroking • foreign exchange • bank bill facilities • superannuation accounts • housing loans • leasing • insurance • wholesale lending • managed funds • personal loans • money market operations. 4.5 Investment banks
Investment banks provide mainly wholesale services. However, they also provide some services to retail investors such as cash management trusts and managed funds. They are involved in activities such as syndicated loans. In a syndicated loan, a group of banks, investment banks and other financiers form a syndicate, with each member providing only part of the funds required by the borrower. Investment banks have considerable expertise in this field and might be the lead bank which manages the syndicate. 910.SM1.5 Unit 3: Operation of the financial services industry 3.13 4.6 Finance companies
Finance companies developed in the 1950s as providers of consumer credit in the form of hire purchase and instalment credit but now are predominantly lenders to business; a large proportion of all finance company lending is now in this area. They provide services such as: • property finance • leasing • motor vehicle dealer finance • factoring • personal motor vehicle finance • consumer durables finance. The major finance companies are wholly owned by major banks. This association is advantageous in terms of raising funds because of the perception of reduced risk for the lender through having a bank as the parent company. Finance companies raise funds in the marketplace by issuing debentures. They borrow funds directly from the retail sector through the public issue of various classes of debentures, notes and deposit instruments. Finance companies associated with banks usually pay less for these funds than those without this link. 4.7 Building societies
Building societies are non-bank financial institutions serving the retail market. In their earliest form, building societies were created by a small group of workers who, because of their common frustration at being unable to afford a home directly, decided to pool both their money and labour to build their homes one by one. Members would contribute their weekly ‘dues’ and draw lots for the order of preference. When the building program was completed, the funds were wound down and the society terminated (terminating building society). As the concept of a building society gained acceptance, a more sophisticated system evolved and the permanent building societies were established. Building societies offer a range of services including home loans, credit cards, bill paying services, variable interest rate accounts, investment loans, cash management trusts and travel services. 4.8 Credit unions
Credit unions (also known as credit co-operatives) are a comparatively small part of the Australian financial scene. Credit unions are retail service providers that provide loans to their customers (members). A bond is the key characteristic that distinguishes credit unions from other non-bank financial intermediaries. The bond is the definition of the common attributes that apply to members (e.g. a Teachers’ Credit Union bond is such that members are usually teachers or work within the education system). Membership is normally approved only where an individual fits the bond characteristics, which might be based on workplace, geography, religious or other community or ethnic-related identifiers. Credit unions hold money on deposit, provide chequeing, ATM (automatic teller machine) and bill-paying facilities (usually via the medium of one of the major trading banks) and lend money to members, usually in the form of personal loans and, increasingly, housing loans. © Kaplan Education 3.14 Generic Knowledge: The Finance Industry (910) 4.9 Friendly societies
Friendly societies invest the savings of their members on a fiduciary basis. They are often also referred to as mutual associations. A friendly society takes the money of its members (as would a fund manager) and invests it on their behalf, so as to maximise the returns to members and ensure the security of the funds. Having grown from fraternal beginnings, friendly societies flourished in the 1980s owing largely to a tax regime that favoured friendly societies’ insurance bonds, which has since been changed to remove this advantage. However, in the 1990s, the larger, dominant friendly societies took a commercial focus with a view to providing safe, sound, tax-efficient investments in a low-cost environment. Many of these mutual associations are now demutualising and listing their securities on the stock exchange trading as normal companies offering products and services such as funds management and health insurance. 4.10 Home mortgage lenders
Over the last two decades many specialist mortgage managers have emerged (e.g. Aussie Home Loans and RAMS). These mortgage originators offer housing loans at rates lower than many of their competitors and are able to raise finance independently of banks through the issue of securities secured against a pool of mortgages, sometimes using intermediaries such as investment banks. Aggressive marketing, low cost distribution (often home visits rather than an expensive branch network) and a customer service focus have also contributed to the success of mortgage originators in gaining market share from banks. 4.11 Fund managers
Fund managers invest, manage and monitor the assets of their clients. Portfolio management entails the selection and monitoring of an appropriate mix of investments in a portfolio. The portfolio manager’s task is to select the appropriate mix of investments in the asset classes (cash, shares, fixed interest, property, international securites and alternative investments) to ensure that the portfolio achieves the maximum return within an acceptable level of risk. Fund managers are expanding their capabilities by offering alternative areas of investment. These include infrastructure projects (roads, airports, power stations and railways); venture capital (investment in new and expanding businesses such as internet companies, biotechnology companies, specialty manufacturers and retailers); ethical funds (socially responsible investments) and emerging markets (e.g. Brazil), which can provide different risk/return profiles to traditional asset classes. 910.SM1.5 Unit 3: Operation of the financial services industry 3.15 4.12 Stockbrokers
Stockbrokers act on behalf of investors and issuers of securities by buying and selling those financial assets that are traded on share markets, particularly equity securities. They also provide a range of financial services in capital raising and investment and corporate and personal financial advice. Stockbrokers fulfil a pivotal role in the financial system through the management of equity raisings, giving companies access to risk capital. The stock exchange acts as a financial intermediary in raising money for companies by providing a marketplace where the shares of companies are bought and sold. Government and semi-government securities are also traded on the exchange. 4.13 Superannuation funds
Superannuation is money saved during your working life, used to fund income needs upon retirement. More than 90% of all workers in Australia are covered by superannuation. The vast majority of all funds operating in Australia are small funds with fewer than five members, commonly referred to as self-managed superannuation funds and now regulated by the Australian Taxation Office (ATO). Some small funds are still regulated by APRA and these are known as small APRA funds. Superannuation funds are usually managed: • personally by individuals and small businesses as a ‘self-managed’ fund (a form of management that is increasing, owing to a desire to have personal control over the assets under management) • internally by companies (some large superannuation funds employ professional investment managers who invest the assets of the superannuation fund) • externally by professional fund managers (such as life offices and fund managers). 4.14 Life insurance companies
Life insurance companies are among the largest financial institutions in Australia. They are required to be registered under the Life Insurance Act 1995 (Cth) when operating in Australia. Sections of the Life Act relating to life insurance institutions are administered by APRA, while provisions relating to life products and consumer protection are regulated by ASIC. Life insurance companies are required to maintain policy holder assets in statutory funds. Statutory funds are similar to trust funds, with separate and distinct assets held to provide policy holders with benefits. In addition to providing life insurance, life insurance companies offer many of the services offered by fund managers. © Kaplan Education 3.16 Generic Knowledge: The Finance Industry (910) Insurance brokers and agents
While the insurer provides the policy to the insured, it is an intermediary, authorised representative or broker who effects the sale. Developments in the industry have elevated the role of the broker from a conduit to one adding value to the process through determining the suitability of the policy for the insured. Brokers are not tied to an individual insurer (or insurers) but run an independent business. The issue of independence is critical to the broker, and is one that is a contributing factor in moving away from a multi-agent arrangement to becoming a registered broker or a licensed broker. A broker is a representative of the insured (client) and acts on their behalf to arrange insurance (either life or general) for the insured. The level of accountability lies with the broker to act on behalf of the insured, therefore the insurance company is not responsible for the broker’s conduct in the same manner as with an agent or authorised representative. Brokers and agents are normally paid by commissions on the sale of products, paid by the life company. 5 Types of financial services
Financial intermediaries are providers of financial services, which fall into two main groupings: • Retail financial services. Services to individuals and small/medium corporations. • Wholesale financial services. Services to large corporations and governments. Some financial intermediaries are engaged mainly in retail services (e.g. building societies and credit unions), while others concentrate on wholesale services (e.g. investment banks). Some intermediaries offer both retail and wholesale services (e.g. banks that, in addition to retail banking services, offer a range of wholesale financial services, including funds management, share brokerage, equity and debt underwriting, and life and general insurance). Increasingly, however, the distinction between retail and wholesale financial services is becoming less clear, with the emergence of products that offer retail investors and borrowers access to wholesale services (such as through mortgage lenders and master trusts). 5.1 Retail financial services
Retail financial services fall into three main categories: • deposit taking • lending • investment. 910.SM1.5 Unit 3: Operation of the financial services industry 3.17 Deposit taking
A wide range of investment options is available to the retail investor, from passbook savings accounts to cash management trusts. Competition between financial intermediaries for the retail investor’s dollar is strong. Credit unions, building societies, finance companies, banks, life offices and fund managers all offer products designed to attract retail funds. Returns (e.g. interest rates) paid on these investments are influenced by: • interest rates on the wholesale market; however, the retail market tends to lag behind changes in the wholesale market, while wholesale rates are in turn influenced by economic conditions. • the demand for borrowings from financial intermediaries (i.e. when demand for retail borrowings is high, financial intermediaries need to attract deposits to fund those loans and therefore must offer higher interest rates). Interest rates are also influenced by the ease of access to those funds required by the lender. Funds at call in general pay a lower rate than funds committed for a specific term. This is the case in both the wholesale and retail markets, and relates to the intermediary’s role in matching imbalances between borrowers and lenders. From the intermediary’s viewpoint, a premium must be paid to the lender in return for obtaining funds for a definite period. A premium in this context is a higher rate to the depositor. The period does not necessarily have to be long term; the important factor is that funds are available for a definite period. The choices available to the retail investor have improved markedly in recent times for a number of reasons: • Increased competition in the retail mortgage market. The entry of new players into the retail mortgage market has significantly increased competition and choice for borrowers. • Development of cash management trusts (CMTs). This has given the retail investor access to wholesale interest rates. CMTs pool deposits and invest in the short-term money market, primarily bank accepted bills of exchange. • Technology. Intermediaries are able to service a greater number of clients with fewer staff. The retail investor’s options are not restricted to placing surplus funds into deposits. Other options available to the retail investor are: • debt securities (e.g. bonds) • hybrid securities (e.g. convertible notes) • equity investments (e.g. shares, options). These are discussed further in this module in the unit on Financial Products. © Kaplan Education 3.18 Generic Knowledge: The Finance Industry (910) Lending
Retail lending (i.e. lending to individuals and small business) takes a number of forms, including: • housing loans • personal loans • credit cards • overdrafts • term loans • hire purchase • leasing • retail credit. Services such as overdrafts, leasing and term loans are utilised by both the wholesale and retail markets. The difference between the two markets is the amount borrowed/lent. Financial intermediaries providing these services include banks, credit unions, building societies and finance companies. The majority of retail sector lending by financial intermediaries is for housing. Once dominated by the banks, this sector has been opened up by the entry of other types of lenders. Specialised home mortgage lenders such as Aussie Home Loans and RAMS have rapidly gained market share at the expense of banks and building societies. These changes have resulted in a much more competitive market for the provision of housing finance in Australia. The other major area of retail lending is consumer finance: personal finance commitments, which encompass credit cards, hire purchase, personal loans and retail credit. Since the introduction of credit cards, personal credit has grown considerably in Australia. This market is expected to become more competitive, with new players (including the specialist mortgage lenders) entering the credit card finance market. Investment advice and financial planning
One of the major growth areas is in the financial planning/investment advising industry. Investment advice is available from a range of specialists, which includes independent advisers, stockbrokers, accountants, solicitors, fund managers, finance companies, life companies, building societies, credit unions, investment banks and trustee companies. More recently, the Federal Government’s emphasis on individuals providing for their own retirement through the introduction of compulsory superannuation gave a further boost to the industry. There has been substantial growth in superannuation funds and in individuals seeking advice on how to arrange their superannuation. 910.SM1.5 Unit 3: Operation of the financial services industry 3.19 5.2 Wholesale financial services
Wholesale financial services refer to the services provided to large companies and governments, including semi-government authorities. The distinction between the wholesale and retail market is linked to the size of the transaction/business, as well as to the nature of the transaction or service. The range of services provided overlaps to some degree with those provided to the retail market, with both sectors using services such as: • overdrafts • term loans • leasing • investment. Services that are generally restricted to the wholesale market include: • raising capital (both debt and equity) • corporate borrowing • advice on acquisitions • foreign exchange dealing. Please note that ASIC RG 146 Tier 1 adviser accreditation is required for advisers providing financial advice to retail clients only. 6
6.1 Regulation of the financial services industry
Financial services reform
The primary legislation governing the regulation of the finance industry is the Corporations Act which contains a single licensing and disclosure regime for those providing financial services in Australia. Under the Corporations Act a person who carries on a financial services business must generally hold an Australian Financial Services (AFS) licence, unless the person is a representative of a licensee. One of the primary aims of financial services reform was to introduce a licensing regime that cut across the previous institutional regulatory regimes, including those applicable to securities dealers and advisers, futures brokers and dealers, and insurance agents. ASIC communicates compliance requirements, interpretations and clarifications by means of Regulatory Guides (RG). Further resources
You can learn more about financial services reform on the ASIC website, <www.asic.gov.au>. © Kaplan Education 3.20 Generic Knowledge: The Finance Industry (910) 6.2 Regulatory authorities
Australia has one regulatory authority for each of the main areas of financial system regulation. • Reserve Bank of Australia (RBA). The RBA is Australia’s central bank and was established in 1959. It is responsible for the payments system, the stability of the financial system as a whole and for implementing monetary policy. • Australian Securities and Investments Commission (ASIC). ASIC enforces the Corporations Act, which covers all aspects of corporate behaviour. Formerly the Australian Securities Commission, ASIC is now responsible for consumer protection in financial products covering superannuation, life insurance, general insurance and deposit taking (but not credit products). It does this by setting standards in relation to disclosure, licensing of intermediaries, prohibited conduct offences and complaints resolution. • Australian Prudential Regulation Authority (APRA). APRA is responsible for the prudential supervision of banks, insurance companies, superannuation funds, building societies, credit unions and friendly societies. Prudential regulation is aimed at reducing the likelihood of insolvency and the consequential losses to investors, policy holders and depositors. APRA’s responsibilities therefore cover over 85% of assets in Australia’s financial system. • Australian Competition and Consumer Commission (ACCC). The ACCC’s role is to oversee competition and consumer protection within the financial system. The Commission administers the Trade Practices Act 1997 and the Prices Surveillance Act 1983. These Acts cover anti-competitive and unfair market practices. • Australian Transactions Report and Analysis Centre (AUSTRAC). The Centre oversees compliance with the Financial Transactions Report Act (FTRA) in relation to reporting large ‘cash’ transactions, suspicious transactions, monitoring money laundering and tax evasion activities. • Federal Privacy Commission. The Privacy Act was enacted in December 2001 to promote privacy in relation to collection, retention, use and disclosure of personal and sensitive information held by organisations.
Figure 7 Summary of the regulatory framework in Australia
Australian Prudential Regulation Authority Australian Competitor and Consumer Commission ACCC Australian Transaction Reports and Analysis Centre AUSTRAC Reserve Bank of Australia Australian Securities and Investments Commission ASIC APRA RBA Corporations Act APRA Act Trade Practices Act Financial Transaction Reports Act Reserve Bank Act • Disclosure • Licensing • Prohibited dealer conduct • Complaint resolution Prudential supervision of financial institutions • capital adequacy • liquidity • statistics • Anti-competitive conduct • Unfair market practices • Tax evasion • Suspicious transactions (money laundering) • Monetary and banking policy • Payments system Source: Commonwealth Bank of Australia, 2002. 910.SM1.5 Unit 3: Operation of the financial services industry 3.21 Self-regulatory bodies
The Corporations Act governs the operation of markets and the establishment of exchanges for listed securities and futures. The two principal exchanges and markets that have been established under this legislation are: • ASX — the market for listed entities and other quoted securities, such as unit trusts and debentures • SFE — the market for futures. In July 2006, under a scheme of arrangement, the SFE holding company (SFE Corporation) became a wholly owned subsidiary of the ASX holding company (ASX Limited which now operates under the brand Australian Securities Exchange.) As at May 2007, ASX Limited had not announced any short or medium term plans to integrate the SFE derivatives and the ASX equities and derivatives markets, according to the annual assessment report for ASX Limited produced by ASIC (May 2007). Although the main function of ASX and SFE is to provide a market in listed securities and futures, these organisations are also known as ‘self-regulatory’ bodies. They are both required to include certain provisions in their Market Rules (ASX) and Operating Rules (SFE), and have a duty to assist ASIC in the exercise of its powers. Australian Securities Exchange (ASX Limited)
The objectives of ASX are to facilitate an internationally competitive, fair and well-informed market for listed securities and to regulate the market for listed securities. In addition to the relevant provisions of the Corporations Act, those authorised to trade on ASX (ie. stockbrokers) must comply with the ASX Market Rules which govern matters such as accounts, audits, client relations, trading and delivery, and settlements. ASX and/or ASIC undertake inspection visits of members to ensure compliance with the Market Rules and the Corporations Act. The rules governing all companies and other securities listed on ASX are known as the Listing Rules. The Listing Rules cover the minimum requirements for a company to gain listing and include, among other things, minimum shareholder requirements, profit performance and capital requirements. The Listing Rules also outline requirements to maintain listing and govern a broad range of matters, including disclosure of price-sensitive information, dividends and announcements. The Listing Rules have the legislative backing of the Corporations Act, which give ASIC and ASX power to apply to the court for orders when the Listing Rules or Market Rules have been contravened. © Kaplan Education 3.22 Generic Knowledge: The Finance Industry (910) ASX also plays an integral role within the ASX Corporate Governance Council (CGC). In an endeavour to restore investor confidence following a string of high profile listed corporate collapses, the CGC was formed for the purpose of developing, in consultation with the business community and investor groups, a set of best practice corporate governance principles for the guidance of Australian listed companies. The ‘Principles of Good Corporate Governance and Best Practice Recommendations’ were released in March 2003 and articulate 10 essential principles that the CGC believes underlie good corporate governance. These principles encourage companies to: • lay solid foundations for management and oversight • structure the board to add value • promote ethical and responsible decision making • safeguard the integrity of financial reporting • make timely and balanced disclosure • respect the rights of shareholders • recognise and manage risk • encourage enhanced performance • remunerate fairly and responsibly • recognise the legal rights of stakeholders. Listed companies have to explain in their annual reports whether they have complied with the guidelines and associated best practice recommendations, and ‘if not, why not’. Co-regulation with ASIC
ASX and ASIC co-regulate the market with respect to listed securities. ASX undertakes extensive monitoring of the market and, depending on the nature of any abnormalities detected, either takes action directly and/or refers the matter to ASIC. ASX has a statutory obligation to notify ASIC of any suspected contraventions of the Corporations Act it detects. ASIC assesses these matters and other possible contraventions of the Act that come to its attention and considers whether a formal investigation is appropriate. Memorandum of understanding
On 1 July 2004, ASIC and ASX entered into a new memorandum of understanding (MOU) to improve the efficiency of market supervision by promoting ‘cooperation, effective communication and mutual assistance’ between the two organisations. The MOU is intended to be a statement of guiding principles covering aspects of the relationship between ASX and ASIC. Further resources
The MOU is available on the ASX website at <www.asx.com.au>. The ASIC/ASX MOU sets out how ASIC will supervise ASX as a listed entity as part of the arrangements under the Corporations Act which govern a demutualised ASX. It does not affect the other MOUs. The ASX Settlement and Transfer Corporation Pty Limited (ASTC), and Australian Clearing House Pty Limited (ACH) are also covered by this MOU as subsidiaries of ASX. 910.SM1.5 Unit 3: Operation of the financial services industry 3.23 Sydney Futures Exchange Limited (SFE)
The Sydney Futures Exchange (SFE) is currently the leading exchange in Australia on which futures contracts are actively traded. As noted above, in July 2006 SFE became a wholly owned subsidiary of ASX Limited. The futures market is co-regulated by ASIC and SFE and the requirements are set out in Chapter 7 of the Corporations Act. ASIC aims to ensure that futures markets in Australia are efficient, well informed and serviced by honest, competent and financially sound brokers. The Corporations Act also provides for the protection of clients of futures brokers in a number of ways. These include segregation of client and broker funds, the provision of information to clients, rules about the conduct of trading and requiring exchanges to have a fidelity fund to protect clients against fraud by a futures broker. Pursuant to the Corporations Act, SFE is responsible for ensuring that: • its participants are of good character and high business integrity • its participants conduct their dealings efficiently, honestly and fairly • there is an orderly and fair market for dealings in futures contracts. Futures exchanges are required to incorporate certain regulations into their Operating Rules. These include rules relating to the admission of members and their training, conduct and accounting practices. Exchanges are required to liaise with ASIC regarding changes to these rules. 6.3 Consumer protection legislation
Trade Practices Act
The consumer protection provisions in the ASIC Act apply to financial services from 1 July 1998. Any activities that might constitute unconscionable conduct or misleading or deceptive conduct before that date may still be captured by the Trade Practices Act 1974 (TPA). The TPA is therefore still an important legislative tool for both the regulator and consumer to remedy alleged misconduct. The ACCC is responsible for the Trade Practices Act. The key provisions of the Act are: • Part IVA - preventing unconscionable conduct • Part V - preventing making representations about future matters • Part V - prohibiting misleading and deceptive conduct (silence may also constitute misleading and deceptive conduct) • Part V - prohibiting false and deceptive statements. Fair Trading Acts
State Fair Trading Acts may also provide for claims based upon deceit or misrepresentation in the course of dealing or advising in relation to securities. The provisions of these Acts mirror the consumer protection provisions of the Trade Practices Act, which is a federal Act. © Kaplan Education 3.24 Generic Knowledge: The Finance Industry (910) Privacy requirements
Under the Privacy Act, all public sector organisations are required to adhere to a set of 10 national privacy principles. These principles deal with the collection, use and storage of personal information about clients and allow clients access to information held about them. Importantly, clients will be able to gain access to their own information and to have information changed if it is inaccurate, incomplete or out of date. In December 2001, the Privacy Amendment (Private Sector) Act 2000 extended the scope of the original Act to include all private sector organisations with income in excess of $3 million, as well as all health service providers, all organisations trading in personal information and all Commonwealth contractors. As an alternative to the national privacy principles, organisations may conform to their own privacy code, which must be approved by the Office of the Federal Privacy Commissioner. 6.4 Insurance legislation
Insurance Contracts Act 1984
As with other insurance Acts, the Insurance Contracts Act 1984 is administered by ASIC. The major development of this Act was to provide improved standards for consumer protection. The Act includes provisions covering: • duty of utmost good faith, requiring both the insurer and the insured to act honestly with one another in their dealings with the contract • insurable interests • disclosure and misrepresentations, requiring the insured to disclose what they know to be a relevant matter and what a reasonable person could be expected to know to be relevant, in the same circumstances. The Financial Services Reform Act supersedes the consumer protection provisions of this Act. Insurance Act 1973
The Insurance Act 1973 regulates companies involved in general insurance. General insurance, for the purposes of this discussion, concerns any non-legislated compulsory insurance and specifically precludes life insurance. Common examples of general insurance are home and contents insurance and motor vehicle insurance. The critical difference between life and general insurers is the need for the statutory fund. General insurers need not distinguish between policy holders’ funds and shareholders’ funds, unlike life insurers who must establish and maintain a statutory fund. 910.SM1.5 Unit 3: Operation of the financial services industry 3.25 To ensure that policy holders are adequately protected, the Insurance Act has set minimum solvency requirements that must be met by general insurance companies. From 1 July 2002 amendments to the Act gave APRA its power to issue prudential standards. APRA released draft prudential standards for capital adequacy, liability valuation, risk management and reinsurance as well as two new standards relating to assets inside Australia and transfer of business. Insurers had until July 2004 to meet the new capital adequacy standard. You can review the APRA web site for updates and amendments to these standards at <www.apra.gov.au>. Life Insurance Act 1995
The Life Insurance Act is concerned with the overall structure of the life insurance industry. Significant sections of the Act cover: • registration of life insurance companies • statutory funds • financial management of life companies • monitoring and investigating life companies. Insurance (Agents and Brokers) Act 1984
The Insurance (Agents and Brokers) Act 1984 established the intermediary regime for the sale of insurance products and the registration of brokers. The Act is solely regulated by ASIC and it applies equally to life and general insurance. The Act provides for ASIC to register brokers on an annual basis according to Part III of the Act. Part IV of the Act gives ASIC the ability to conduct investigations, commence criminal prosecutions, seek production of documents and cancel or suspend a broker’s registration. The Act defines an insurance broker as a person who carries on the business of arranging contracts of insurance, whether in Australia or elsewhere, as agent for the intending insured. An insurance intermediary means a person who, for reward and as an agent for one or more insurers or as an agent for the intending insured, arranges contracts of insurance in Australia or elsewhere, and includes an insurance broker. © Kaplan Education 3.26 Generic Knowledge: The Finance Industry (910) 6.5 Codes of conduct
AFMA code of conduct
The Australian Financial Markets Association (AFMA) is a self-regulatory body for the financial markets industry and as such has established a code of conduct (in consultation with regulators and other industry bodies) that represents minimum behaviour standards expected of market participants, for both organisations and individuals. Financial services industry codes of practice
There are a number of financial services industry related codes of practice. These include: • Code of Banking Practice • Building Society Code of Practice • Credit Union Code of Practice • Electronic Funds Transfer Code of Practice • General Insurance Code of Practice • General Insurance Brokers’ Code of Practice • Financial Planners Code of Ethics and Rules of Professional Conduct • Internet Code of Conduct • Consumer Credit Code. Many of these codes of practice can be accessed from ASIC’s website. 910.SM1.5 Unit 3: Operation of the financial services industry 3.27 7 In summary
This unit has provided a broad introduction to the financial services industry. We began by examining the functions of the financial system and the flow of funds throughout the system. We also considered the types and features of financial instruments and markets. We then discussed the various intermediaries that operate within the Australian financial system, i.e. the players that provide financial services, and the roles that they play. We then examined their services to both retail and wholesale clients. Finally, we reviewed the regulatory environment of the financial services industry, introducing the main regulators and also providing an overview of the financial services reform legislation. Figure 8 provides an overview of some the key players in the financial system.
Figure 8 Overview of the financial system
Federal Government The Reserve Bank The financial system Sydney Futures Exchange ASIC Australian Stock Exchange APRA AFMA • • • • Intermediaries Banks Specialist banks Non-banks ACCC AUSTRAC Lenders and savers • Governments • Businesses • Households • Offshore Debt market Intermediation Derivatives market Foreign exchange market Intermediation Lenders and savers • Governments • Businesses • Households • Offshore Equities market Source: Commonwealth Bank of Australia, 2002. © Kaplan Education 3.28 Generic Knowledge: The Finance Industry (910) Notes 910.SM1.5 4
The economic environment
Overview 4.1 Unit learning outcomes ....................................................................4.1 1 1.1 2 2.1 2.2 2.3 2.4 2.5 2.6 3 3.1 3.2 3.3 3.4 4 4.1 4.2 5 Introduction to economics 4.2 The relevance of economics to financial advisers ......................4.2 Economic indicators 4.3 National accounts...................................................................4.3 Gross domestic product (GDP) .................................................4.3 Partial indicators of demand ....................................................4.3 Inflation .................................................................................4.4 Australia’s balance of payments ..............................................4.5 The business cycle .................................................................4.6 The role of interest rates in the economy 4.7 Overview ................................................................................4.7 The wholesale interest rate market ..........................................4.7 The yield curve .......................................................................4.8 Interest rate components ........................................................4.9 Monetary and fiscal policies 4.9 Monetary policy ......................................................................4.9 Fiscal policy .........................................................................4.10 In summary 4.10 Unit 4: The economic environment 4.1 Overview
An understanding of basic economic principles and how the economy works will be important for you in giving advice and making recommendations to clients. In this unit we explore the following concepts: • economics and the economy • interest rates • economic indicators • monetary and fiscal policies. Unit learning outcomes
On completing this unit, you should be able to: • explain the relevance of the economy and economic analysis to investment decisions • explain the role of interest rates in the financial system • describe the key economic indicators • explain the influences of monetary and fiscal policy on interest rates. © Kaplan Education 4.2 Generic Knowledge: The Finance Industry (910) 1
1.1 Introduction to economics
The relevance of economics to financial advisers
The study of economics is about how people interact as consumers and workers, as managers of businesses and as government policy makers in trying to use the resources available to them to meet their varied and changing objectives. A basic understanding of economics can help a financial adviser better understand how and why the financial markets and their prices can be affected by underlying economic changes and the government policies — monetary, budgetary and regulatory — used to influence the structure and performance of the economy. For financial advisers, the markets of most interest are those that deal in capital — the money, share, foreign exchange and property markets. The focus is movement of prices — the interest rates, share prices, exchange rates, rents and capital values — of what is traded in these markets. An understanding of economics helps explain how changes in the economy and government policies might impact on the performance of investment portfolios and how and why they should be structured and reviewed. To help this understanding, economic analysts use a variety of economic and financial data and tools, including trying to find ‘leading indicators’. These are statistics or events that usually signal a change in the economy or government policies. They are part of the external or environmental considerations that you will analyse when making recommendations to your clients. When your clients ask ‘Where is the share market going?’ or ‘Are interest rates going up or down?’, it will be helpful for you to have at least a basic understanding of how recent and prospective developments in the economy might be affecting financial markets and the investment outlook. Let’s now look briefly at the major economic indicators. 910.SM1.5 Unit 4: The economic environment 4.3 2
2.1 Economic indicators
Economists have developed a particular structure or way to view the economy to help their understanding of how it operates and what might be the impacts on the economy and financial markets of particular events, changes or economic shocks. This structure is called the national accounts. The national accounts represent a certain statistical picture of the economy, based on a certain theory of how the economy operates and how it can be described. When an economist, financial journalist or a government spokesperson, such as the Federal Treasurer, says ‘economic growth was 1% in the June quarter’, they are invariably referring to the national accounts statistics produced by the Australian Bureau of Statistics (ABS) and particularly the overall measure of the size of the economy known as gross domestic product. Gross national expenditure
Another important national accounts term is gross national expenditure, which is consumption + investment + government. It is an estimate of the total spending in the Australian economy. 2.2 Gross domestic product (GDP)
Gross domestic product (GDP) is the measure of the flow of goods and services produced in an economy. Changes in the level of GDP (i.e. a measure of an economy’s growth) will affect the demand for money, the rate of inflation and the balance of payments, thereby influencing the level of interest rates. In calculating GDP, an attempt is made to put a value on final goods and services and so provide a national total. GDP is a gross measure as it does not allow for depreciation on capital goods etc., and it is a domestic measure as it excludes income earned outside the country. 2.3 Partial indicators of demand
Because the national accounts are released quarterly, typically two months after the quarter they are supposed to measure, the markets and the Reserve Bank focus on partial indicators of demand in order to obtain information about how the economy is doing now. Consumption indicators
Retail trade, released monthly by the ABS, is the primary indicator of consumption (accounts for around 80%) and provides a good guide to the direction of consumption in the national accounts. Consumer sentiment indices are also published monthly in an attempt to provide markets and policy makers with an early predictor of where a big part of the economy is going. © Kaplan Education 4.4 Generic Knowledge: The Finance Industry (910) Dwelling indicators
Dwelling investment is another of the components of the national accounts and the monthly indicators that markets and policy makers watch, as are building approvals and housing finance statistics. Labour force data
If we choose to focus on the income side of the national accounts, then compensation of employees is the biggest component, accounting for around 50% of GDP. Growth in employee compensation at a national accounts level reflects a combination of growth in employment plus growth in wages. The ABS publishes a labour force survey on a monthly basis. This contains a measure of changes in employment levels, as well as the unemployment rate. The ANZ Banking Group publishes a ‘job ads’ series as a leading indicator of employment trends. Information on wage rates, however, is less timely and can be found in the quarterly ABS ‘Average Weekly Earnings’ statistics. 2.4 Inflation
Inflation is the rate of change of the general price level in the economy. It is important in understanding what is happening to real spending power or investments and Australia’s international trade competitiveness. In Australia, inflation is generally measured by reference to the consumer price index (CPI), which is compiled and released every three months by the ABS. The CPI represents a weighted average of the prices of a ‘basket’ of goods and services, which is considered to reflect the spending patterns of Australian households. The rate of inflation is important to investors because a rising price level erodes the real value of money over time, and it reduces the real value of assets that have fixed nominal values. Example: Rate of inflation
For example, if 100 baskets of goods and services cost $10,000 in June 2007, by June 2008 they would cost $10,600. If $10,000 had been saved in June 2007 to spend in June 2008, it would now only buy 943 baskets. So the saver has suffered a loss of 57 baskets in their real purchasing power. They would have needed to earn 6% on their savings to be able to buy the same number of baskets. If tax had to be paid on those earnings, they would have needed to earn even more to ensure they could still buy the 100 baskets. The value of assets such as bonds, debentures and bank and building society accounts falls in real purchasing power, or value, during inflationary periods. While such investments earn interest, which provides some protection against the effects of inflation, many investors in an inflationary environment find it hard to protect the real value of their capital, particularly when taxation of the interest is taken into account. In contrast, the value of other investments, such as shares and property, broadly track or do better than inflation over the medium to longer term. In addition, only 50% of the realised capital gain on the sale of such investments is taxed if they are held for more than 12 months. These two features can provide more protection against inflation.
910.SM1.5 Unit 4: The economic environment 4.5 Consumer price index
The CPI measures the prices of a basket of goods and services that account for a high proportion of the expenditure of private households. It is an indicator of the average change in prices over time. There are two inflation numbers that markets focus on — the headline rate of inflation and the underlying rate of inflation. The headline rate of inflation refers to the percentage change in the total CPI over the quarter or year in question. However, some items in the CPI basket are affected by seasonal, erratic or policy influences. For example, the Treasury underlying rate of inflation (which refers to the percentage change in various sub-baskets of the CPI over the quarter or year in question) excludes fuel costs, mortgage interest and consumer credit charges, fresh fruit and vegetables and government-related taxes and charges. The resulting index covers 69% of the headline CPI basket. The reason these items are excluded is to provide a clearer reading of inflationary trends and the direction of monetary policy. For example, seasonally bad weather that forces up vegetable prices and the headline CPI in a quarter is not a sign, on its own, that monetary policy will have to be tightened. Likewise, a jump in the headline inflation rate because of a rise in mortgage rates does not mean higher inflation ahead. The converse might actually apply, because the tightening in monetary policy that produced the rise in mortgage rates in the first place was implemented to slow the economy and inflation further down the track. In the past, market participants closely watched the underlying inflation rate, as opposed to the headline rate of inflation, because it irons out the above anomalies or seasonality impacts. 2.5 Australia’s balance of payments
A final key indicator is the balance of payments. The balance of payments is a systematic record of Australia’s economic transactions with the rest of the world, and is divided into two accounts — the current account and the capital account. Current account
This is the sum of three main segments: • the balance on merchandise trade (exports less imports of goods) • net services (the difference between service credits and debits) • net income and unrequited transfers (this is essentially the cost of servicing Australia’s stock of foreign debt). A widening current account deficit tends to be associated with a depreciating currency. Therefore, overseas investors demand higher interest rate returns to compensate for currency losses when they convert their investment back into their home currency. On the credit risk side, overseas investors might demand a premium in the event of Australia’s country credit rating being downgraded. © Kaplan Education 4.6 Generic Knowledge: The Finance Industry (910) Capital account
The other component of the balance of payments records transactions in Australia’s financial assets and liabilities. The balance of payments data is only produced on a quarterly basis. However, markets can still monitor monthly movements in exports of goods and services in international trade in goods and services. 2.6 The business cycle
The fluctuation in economic activity between boom times and bad times is known as the business cycle (also called the economic cycle or trade cycle because it is a cycle of economic activity). Economic fluctuations refer to increases or decreases in the magnitude of economic variables such as national income, national output, employment, national consumption, investment, saving, and general levels of prices and wages. As all the economic variables are interdependent, a change in one affects the others. Thus, economic fluctuations involve a series of changes in the economy that affect the total level of aggregate demand. While we use the term cycle in the context of economic fluctuations, it should be understood that these fluctuations do not follow an exact regular or repetitive pattern. Economic growth does not proceed in a regular or steady pattern. One difficulty in the study of cycles is that there are cycles within cycles. Some shorter cycles are more commonly referred to as technical corrections when a market is over-bought or over-sold. The cycle that most economists talk about is usually thought of as occurring over four years from peak to peak or two years from peak to trough. The amplitude of cycles is usually consistent around what economists call a trend line, with declines from peak to trough by around 25–35%. 910.SM1.5 Unit 4: The economic environment 4.7 3
3.1 The role of interest rates in the economy
Interest rates are determined by a large number of unpredictable and volatile factors. Nevertheless, financial service participants such as investment managers or traders are required to have a view on the level and direction of interest rates. The time horizon for this view could be hourly in the case of a trader or yearly for an investment or fund manager. An interest rate is the price of money. From the borrower’s perspective, the interest rate (often expressed as a percentage) is the charge for borrowing money. From the lender’s perspective, the interest rate is the return obtained from lending money. There are often different interest rates quoted for different periods of time. The role of interest rates in Australia, as in other industrialised Western economies, is to use market forces of supply and demand to allocate money among borrowers, such as governments, companies and homebuyers. In financial markets, interest rates on securities (bank bills, bonds, etc.) are often referred to as yields. Yield specifically refers to the annual rate of return calculated as a percentage of the market price of the security that will be earned on the initial outlay if the security is held to maturity. Yield is usually expressed in percentage per annum. Financial markets make one important differentiation between wholesale and retail interest rates. Wholesale rates apply to organisations that borrow and lend large amounts of money, for example big corporations, banks, fund managers or superannuation funds. Retail rates are those that apply to individuals, e.g. on bank deposits, credit cards or mortgages. 3.2 The wholesale interest rate market
The wholesale interest rate market is broken up into the short-term money market and the long-term bond (or fixed interest) market. The short-term money market refers to securities with a maturity of less than one year. The two most watched interest rates in this grouping are the official cash rate (which is determined by the stance of official monetary policy) and the 90-day bank bill rate. The bond or fixed interest market refers to securities where interest payments are fixed at the time of issue and the maturity of the security is in excess of one year. The most watched rates in this market tend to be 3-year and 10-year bonds. Interest rates, or the yield on a 10-year bond, are often referred to as the long bond rate. Both short- and long-term interest rates are reported and commented on daily in the financial press. You should make a habit of following these commentaries for the duration of the course and trying to identify the tools that are being used to exploit trends in short and long rates. The main issuers of bonds are the Commonwealth Government, State governments, local government bodies, and companies — both financial and industrial. © Kaplan Education 4.8 Generic Knowledge: The Finance Industry (910) The Commonwealth Government issues paper in both the short-term money market (e.g. Treasury notes) and long-term fixed interest market (e.g. government bonds). Interest rates or yields on government securities are typically the lowest available in the marketplace. This is because there is a negligible chance of the Commonwealth Government defaulting on its obligations — if it is in trouble it can go to the taxpayer and raise more revenue or alternatively direct the RBA to print more money (though it is highly unlikely the Government will seek this option as a result of the inflation it causes. Typically, the next least risky class of issuer is State governments (all borrow on behalf of their local governments and utilities, e.g. Treasury Corporation of Victoria and Queensland). The most risky class of issuer is the corporate sector. 3.3 The yield curve
What is the yield curve?
This term structure of interest rates is summarised by the yield curve. The yield curve is a graph that shows the relationship between the yield to maturity and term to maturity for a similar group of securities. The benchmark yield curve captures all terms to maturity of Commonwealth Government debt. Generally, short-term interest rates are lower than long-term rates (see Figure 1) because the longer a person has funds invested at a certain rate in a market, the more chance there is that conditions in that market will change and that this change will be adverse for the lender. Therefore, the investor will want a higher return in the long term to compensate for this type of risk. Alternatively, investors usually expect a higher real return for deferring consumption for a longer period. This results in what is termed a normal or positive yield curve (Figure 1).
Figure 1 Positive (normal) yield curve Yield 0 Time However, there are exceptions to the general rule that the longer investors are without their money the higher the rate of return demanded. The main exception occurs when interest rates for short-term securities are higher than those for the long term. This can happen, for example, when the RBA increases interest rates, but the market expectation is for interest rates to fall in the future. This means, short-term rates are high relative to long-term interest rates and results in an inverse (or negative) yield curve. 910.SM1.5 Unit 4: The economic environment 4.9 3.4 Interest rate components
Prior to predicting or forecasting interest rates it is important to know why interest rates are at their current level. Fundamentally, interest rates are financial compensation for deferring current consumption: if money is lent to a borrower, the lender cannot use it for their own purposes. Lenders obviously expect to be repaid — they also seek some recompense for temporarily transferring some of their purchasing power to the borrower. It follows logically then that if prices are rising rapidly, lenders will want greater compensation for loss of purchasing power than if prices are stable. Viewed in this way, interest rates can be regarded as having three major components. They are: • a real component • an inflation compensation component • a risk premium. 4
4.1 Monetary and fiscal policies
If the economy is growing too quickly, monetary policy is usually tightened which means the Reserve Bank will then increase the sale of government securities (mainly Treasury notes) via its open market operations. This action reduces the funds available in the marketplace and increases the cash rate. A higher cost of funds in the wholesale market will eventually flow through into retail rates. If the economy is weak or needs stimulus, monetary policy is eased. An easing of monetary policy in the short term will lower interest rates. The Reserve Bank buys government securities and, in so doing, increases the supply of funds in the financial system, resulting in a lower official cash rate. This in turn lowers the cost of wholesale funds and eventually translates into lower retail lending rates. If the economy is growing at a rate that is not causing inflation to rise, or unemployment to fall, monetary policy will be left on hold. The mechanism used by the Reserve Bank to influence the cash rate is that of open market operations. The Reserve Bank board meets monthly to discuss the direction of monetary policy. At its meetings, a host of economic indicators (leading, lagging and coincident) are reviewed and these provide feedback on whether the current stance of monetary policy is appropriate to meet the Reserve Bank’s objectives. Financial markets have a similar stock of information available to them about trends in economic growth, the labour market, inflation and currency. Much effort is put into trying to second-guess the Reserve Bank with every piece of economic information to filter into the market. © Kaplan Education 4.10 Generic Knowledge: The Finance Industry (910) 4.2 Fiscal policy
If the government decides to change taxation (government revenue) or government spending in order to achieve its economic objectives, then it is said to be using fiscal policy. Fiscal policy can be used to increase or reduce the level of spending in the economy. In a recession, fiscal policy is eased and in a period of strong growth, fiscal policy is tightened. A Commonwealth Government budget deficit represents a positive financing requirement. Typically, the Commonwealth Government will issue a mixture of short and long-term debt instruments (Treasury notes and bonds) to finance the shortfall. In a budget surplus year, the Commonwealth Government has a negative financing requirement, that is, it buys back debt from the market. An easing in fiscal policy occurs when the financing requirement is greater than that for the previous year. Unlike changes in monetary policy, which have an immediate and visible impact on interest rates, changes in fiscal policy have a more subtle and longer term impact on interest rates. 5 In summary
Before analysing investments or giving investment advice, it is essential to understand the environment within which these investments operate. We therefore began this subject by considering the relevance of economics to financial advisers, emphasising the importance of understanding key economic concepts. We considered the various sectors in the economy and saw how the financial system facilitates the interaction of these sectors. We also looked at the economic factors affecting the trends in Australian interest rates and outlined the key economic indicators. Finally we looked at the role of government and how it influences the economy through its fiscal policies and the role of the Reserve Bank through its monetary policies. 910.SM1.5 5
Overview 5.1 Unit learning outcomes ....................................................................5.1 1 1.1 1.2 1.3 1.4 2 2.1 2.2 2.3 2.4 3 3.1 3.2 4 Financial products concepts 5.2 Income v growth .....................................................................5.2 The asset classes ..................................................................5.3 Risk ......................................................................................5.8 Diversification ......................................................................5.10 Types of financial services products 5.12 Direct investment .................................................................5.12 Pooled (or managed) funds....................................................5.14 Equity investments ...............................................................5.26 Debt securities.....................................................................5.27 Financial risk products 5.27 Insurance products to meet risk.............................................5.27 Derivatives...........................................................................5.30 In summary 5.33 Unit 5: Financial products 5.1 Overview
In this unit we first look at some basic characteristics of investment products: • income or growth • classification of assets • risk • diversification. We then look at direct investment, pooled investment, equity investments and debt securities. The unit also discusses insurance products that can be used to minimise risks. Unit learning outcomes
On completing this unit, you should be able to: • outline the characteristics of different types of financial products • describe the main features of the various asset classes • discuss the use of financial products to reduce financial risk. © Kaplan Education 5.2 Generic Knowledge: The Finance Industry (910) 1
1.1 Financial products concepts
Income v growth
People invest for two basic reasons: • to provide capital and income at some future time, either to meet a future obligation or need, or to transfer to the next generation • to provide a hedge against inflation (to maintain the purchasing power of their money). The specific reason for investments can be as short term as the desire to fund a vacation, though increasingly investors are considering the longer term goal of achieving financial independence in retirement through investment in superannuation (and non-superannuation) products. The financial adviser needs to explain two investment outcomes, both of which might have tax and social security implications: income and growth. Income is defined as the total money accruing to a person. It includes most payments, such as salary and wages, net business income, rental income, interest and dividends. Payments that are not regarded as income include gifts, gambling and lottery winnings, and some items of a capital nature. Growth is defined as an increase in capital value over time. Some investments produce only income, others produce a mix of income and growth, while a third category produces only growth. Some examples of each of the three categories are set out below. Income only
• debentures (held to maturity) • cash management trusts (CMTs) • mortgage trusts • annuities and pensions (including allocated pensions) • government and semi-government loans (held to maturity) • bank accounts (including building society and credit union accounts). Income and growth
• rental property • equities (shares) • equity trusts (share trusts) • certain fixed interest securities (where traded) • property trusts. 910.SM1.5 Unit 5: Financial products 5.3 Growth only
• land (undeveloped) • collectables (including gold and other precious metals, stamps, coins, etc.) • most resource shares • residential property. A major part of the financial adviser’s task will be to get the balance right between income and growth for their clients’ portfolios. In striking this balance, taxation will also have to be considered. It used to be thought that retirees, in need of a regular income stream, would not want to invest in growth assets, as they would regularly have to sell assets to meet their income needs. However, people are now living longer, so they still need to own growth assets to provide income for the longer term. Products have been developed to hold growth assets and regularly pay out an income stream — allocated pensions are an example. Longer term growth can also be achieved through direct investment or through pooled investment, e.g. in a master trust, or through the development of a personal portfolio. At the very heart of your investment recommendations will be your understanding of the differences between income and growth assets, and how they are taxed and treated by the Department of Families, Housing, Community Services and Indigenous Affairs (FaHCSIA). It is not enough to understand the end results of investment decisions. You will need to understand how, and how often, distributions of income are made. For someone who needs income to meet general living expenses, it is not appropriate for payments to be made every six months. Retired people (or the unemployed) need regular, stable amounts to be generated by investments. Employed investors usually depend on their salary or earned income to support their current lifestyle, so their concerns about distribution are likely to be different. 1.2 The asset classes
The main asset classes are: • cash • domestic fixed interest securities • domestic equities (shares) • domestic property • international shares. Although there are many other specialist assets, such as international fixed interest investments and international property, commodities and precious metals, derivatives (futures and options) and emerging market shares, most of your clients will be investing in the five main asset classes, whether through direct investments, pooled unit trusts or insurance bonds. © Kaplan Education 5.4 Generic Knowledge: The Finance Industry (910) Most clients already hold certain investments. Most would have some cash, some investments, some insurance policies and some income, often from different sources. An essential first step in the financial planning process is to assess each client’s existing assets, both to find sources of additional investment money and as a starting point to building their portfolio. The portfolio an adviser will recommend will contain the main asset classes, represented by selected products, and a recommendation as to how much money should be invested in each asset class. An optimal financial plan is diversified. It matches the clients’ time horizon with the level of risk they are prepared to accept. The following section will look at each asset class in turn. Each type of asset has distinctive characteristics with regard to capital growth, income, security, volatility, marketability, liquidity and risk. Cash
Cash in a portfolio is not just notes and coins: it includes assets that can be readily converted to cash with little risk of any capital loss. It can include such short-term investments as government bonds, bank bills and debentures issued by corporations that have a maturity date of less than 90 days. Cash produces income rather than capital growth. It is a low-risk investment — it is unlikely to decline in value. The main risk with cash is that it is likely to produce lower returns than other asset classes. The money market deals specifically in funds that are available for investment for short periods only, often as briefly as overnight — hence the name short-term money market. Banks, finance companies, merchant banks, large corporations, savings banks, building societies, credit unions, life offices and superannuation funds trade short-term money, and borrow and lend cash for short periods of time (generally less than 12 months). Transactions by these institutions are usually in millions of dollars. Domestic fixed interest securities
Fixed interest securities earn a set rate of interest over a fixed term or time period. These securities are available for different terms, and interest rates differ with the term — the longer the term, the greater the risk. The investor lends money to a company, bank or government authority, and interest (coupon) is paid at a stated rate (fixed interest), at a set time (maturity date). The capital is usually repayable on a stated date. Fixed interest products provide investors with income. They might also provide capital gains (or losses) when they are traded rather than held until maturity (institutions actively trade fixed interest securities). Income from fixed interest investments is usually taxed in full at the owner’s marginal tax rate. Domestic fixed interest securities are those issued by Australian financial institutions. 910.SM1.5 Unit 5: Financial products 5.5 The interest-bearing securities traded in Australia are: • Treasury notes and Treasury bonds. Also called Commonwealth Government loans (CGLs). • Semi-government bonds. Issued by state-based organisations, they have a state Government guarantee of payment of principal and interest. • Indexed bonds. Offered by a number of lenders. The interest rate is fixed at a certain percentage above an inflation index, such as the Consumer Price Index (CPI), so they provide a guaranteed hedge against inflation. However, their capital value can fluctuate as interest rates and perceptions about inflation change. • Company debentures. Issued by any limited liability company to borrow money. The repayment of the principal and interest is not guaranteed, but investors rank as creditors of the company if the company is wound up, and so have some security. • Company unsecured notes. Unsecured notes are similar to debentures, but, unlike debentures, they are not secured against the company assets. Investors rank as unsecured creditors in the event of the company being wound up. • Corporate bonds. Bonds issued by a company, which state that a specified sum is owed, which will be repaid at a specified date. • Fixed term deposits. Offered by banks, building societies and credit unions. Rather than buying bonds or debentures directly, retail clients often invest in this asset class through managed investments. Domestic equities (shares)
Domestic equity represents equity raising by Australian companies. A share is a basic unit of ownership (equity) in a company. The equity capital of a company is divided into shares. For example, the equity capital of a company might be $100,000, and it might be divided into 100,000 shares at $1 each. Shares are one of the primary investments that provide both capital growth and income and, in some cases, tax rebates in the form of franking credits. The ownership of a share entitles the holder to a proportionate share of the profit distributed by the company in the form of dividends. The returns from company shares are directly related to the performance of the company, as interpreted by the sharemarket and general economics. Income from ordinary shares is paid as dividends, which are expressed as an amount per share, e.g. 20 cents per share (cps). The amount of the dividend can fluctuate from year to year at the discretion of the directors of the company. When comparing the return from different companies, investors look at the dividend yield (i.e. the income yield), which is calculated as a dividend per share divided by the share price, multiplied by 100. This is listed in tables of prices such as in each day’s Australian Financial Review. Note that dividend yields average about 4% p.a. Investors usually buy shares because shares are viewed as an asset that will produce a growing income stream and will increase in value over time. © Kaplan Education 5.6 Generic Knowledge: The Finance Industry (910) Many managed funds hold some shares in their portfolios. Superannuation funds, for example, are probably the biggest investors in the sharemarket. Over time, the total returns from shares, including income (dividends) and growth (capital appreciation), have been higher than for other asset classes. The volatility of the returns from year to year can also be higher than for other asset classes. Shares generally meet most of the criteria of investment managers who assess investments according to their returns for risk, liquidity, diversification and tax effectiveness. In summary: • Shares provide income in the form of dividends, which can be reinvested to purchase more shares to maximise the compounding effects. • Capital growth over the longer term is usually in excess of inflation. • Shares are tax effective because many dividends are franked, i.e. the company has paid tax on profits before distributing the dividends. The resulting franking credits may be used by investors to offset other tax commitments. This is called dividend imputation. • Shares are highly liquid in that they can easily be converted to cash if necessary. • Diversity can be obtained across a whole range of shares in different market sectors such as mining, industrial, banks and media. Further diversification can be achieved by investing in overseas shares. Domestic property
Like share investments, an investment in property or real estate is an equity investment involving ownership, variable income and capital growth. It also has characteristics similar to those of fixed interest, where the rental stream is the coupon rate and the term is the length of ownership. However, unlike fixed interest, there is no contractual obligation to repay capital plus interest (except to the bank if you borrowed funds to buy the property). Over the longer term (10 years or more), property is generally expected to produce higher returns than fixed interest investments, but lower returns than share investment. The rate of return per annum on an income-producing property can vary, typically between 2% and 15% of the value. Property is also expected to be more volatile than fixed interest and less volatile than shares. The risk–return characteristics of property are different from those of the other asset classes. Return on all types of property includes capital growth as well as income (or yield). Property has traditionally been regarded as a hedge against inflation, and in the long run has shown investors real returns in most forms. Short-term fluctuations and cycles do occur, and the timing decisions of the investor could well depend upon whether the goal is short-term speculation or long-term capital growth. The level of growth, or capital appreciation, varies between property types and locations. In a balanced portfolio, property provides diversification, with the potential to reduce the overall riskiness/volatility of the portfolio without significantly reducing returns. This is because the phases of the property cycle are different from those of the sharemarket (i.e. the cyclical peaks and troughs during the business cycle will usually not coincide). The most common types of property available for investment are residential (homes and apartments), central business district (CBD), commercial, industrial and retail. An investment in property can be obtained directly through the purchase of land or buildings or through single property syndicates. Investment can be indirect, through an investment in a property trust, or as part of a balanced, managed or capital secure trust.
910.SM1.5 Unit 5: Financial products 5.7 International shares
The Australian sharemarket is around 2% of world sharemarkets by capitalisation, leaving international investments to cover the remaining 98% of the total world share market. Yet most private investors have little or no investment in international markets and what they do have would usually be through unit trusts. Institutional investors are likely to have around 15% of their general portfolio in international investments. There is little scope for retail investors to invest directly in overseas shares, although the Internet has enabled easier access. Even so, with the lack of coverage and marketing, it would be hard to foresee much change. While there are a few international sharebrokers, they tend to serve institutional buyers. The purchasing of international shares listed on the Australian Securities Exchange (ASX) is limited because of the lack of such shares. Investing in Australian companies with overseas exposure is also of limited use for diversifying the portfolio, as investors have to take the Australian exposure of these companies along with the international exposure. The main additional issue with investing in international equities is the management of currency risk. Currency risk can be summarised as the risk an investor takes of the domestic currency moving in such a way against international currencies that the end investment result is lowered or even brought into a negative position despite good performance by the underlying assets. The cost of currency risk management controls can be high, and might actually protect against positive currency performance. However, this needs to be weighed up against the significant costs of being unhedged. Asset allocation
Asset allocation is the process of determining, from time to time, the mix of investments in a portfolio among the different asset classes (cash, bonds, domestic equities, property and international shares). The process must consider both the investment outlook and the risk–return objectives of the investor, investment manager or product. The objective is to achieve an asset allocation that aims to be the most efficient with regard to the risk–return trade-off, and can be called portfolio optimisation. Diversification (discussed further in this unit) calls for investment across asset sectors. A fully balanced portfolio worth, say, $150,000 would require an asset allocation similar to the one shown in Table 1.
Table 1 Example of a balanced portfolio
Type of asset 10 shares at $6,750 per holding Would have to be a term deposit Too small an amount to get direct exposure to the property market Minimal amount Not a suitable amount to conveniently buy international equities Value $67,500 $30,000 $22,500 $7,500 $22,500 $150,000 Percentage of portfolio 45% 20% 15% 5% 15% 100% Asset class Australian equities Australian fixed interest Property* Cash International equities* Total portfolio * Exposure would have to be gained through pooled assets. © Kaplan Education 5.8 Generic Knowledge: The Finance Industry (910) Asset allocation means deciding which assets are appropriate for a portfolio given the client’s attitude to risk and their requirements for income, growth and tax or social security management. The dollar value is placed on the amount (or weighting) of each asset. The portfolios below represent possible constructions for conservative and balanced portfolios. The difference between the two portfolios in Table 2 is the amount of money allocated to each asset class. The conservative portfolio does not invest in the two more ‘risky’ asset classes — domestic and international shares. But the trade-off is that the conservative portfolio earns a lower return.
Table 2 Comparison of a conservative and a balanced portfolio
‘A’ Conservative Portfolio Cash @ 3% Domestic fixed income @ 5% Domestic shares @ 11% Domestic property @ 8% International shares @ 12% Investment Percentage return 90,000 4,750 4.75% 15,000 1,200 Investment ($) 10,000 65,000 Income ($) 300 3,250 ‘B’ Balanced Investment ($) 5,000 10,000 45,000 10,000 30,000 100,000 Income ($) 150 500 4,950 800 3,600 10,000 10% 1.3 Risk
The basic principle of investment risk is simple: the higher the possible reward the higher the risk of not getting any reward at all or, conversely, the safer the investment, the lower the expected return. Basically, to attract investors to a product with a high uncertainty as to levels of returns (including total loss of funds), a higher potential return needs to be offered. Investors face different types of risk when they purchase an asset. The first risk is that the maximum return will not eventuate, and they make a low return or receive only the purchase price back or lose some or even all of the purchase price. Some people are risk-averse. They will only play the game if they have a high level of assurance that they will get their money back. When preparing financial advice, the ‘know your client’ rule includes knowing the level of risk that the investor is willing to accept. In general, investors seek the best return from their investments with the lowest level of risk. Most would choose an investment that offered a 4% return with minimal chance of loss (e.g. bank deposits with a 4% return) rather than one that had a 25% chance of loss. This is rational. The decision gets tricky when a product advertisement offers 15% returns with a 35% risk of total loss. Would this offer be acceptable to your client? With a high-risk product, the product provider has a scheme, method or special asset they believe will make a very high return — if it works. They know that they will make a considerable profit. But they need money to get the product running. As the product is risky, they need to calculate how much of their potential profit they need to give away to attract investors.
910.SM1.5 Unit 5: Financial products 5.9 The potential investor assesses the risk of the product failing and the level of likely return if it makes it. Each individual will have their own way of making that assessment, but where the risks seem equal or lower than the potential for return, some investors will commit their money. Investment products and risk
Figure 1 illustrates how you can rank investment and risk management products for your client.
Figure 1 Investment products ranked by risk Most risk y seed capital options, futures, high gearing specially taxed agricultural gearing commodities and resources venture capital, collectibles direct equity and property managed equity and property superannuation and rollovers fixed interest investments personal finance, mortgage personal loans home, car, furniture, property insurance personal insurance bank and bank-backed savings Least risk y © Kaplan Education 5.10 Generic Knowledge: The Finance Industry (910) Efficient frontier
Evidence shows that achieving consistent long-term investment performance is due more to correct asset allocation than to exact investment selection. Studies have shown that, with appropriate diversification through various asset classes, a portfolio’s investment risk can be reduced. Other studies have shown that more consistent longterm returns can be achieved by the alternative of exact investment selection, with a lesser degree of portfolio diversification. A financial planner must endeavour to quantify both likely returns and risks of asset classes and investments, ensuring that, wherever possible, a constructed portfolio is positioned on what is known as the efficient frontier of a risk–return matrix. That means that for each unit of collective portfolio risk carried by a client, the client must be rewarded with at least a commensurate unit of return. A detailed examination of the concept of the efficient frontier is beyond the scope of this unit. To get the best results from portfolio optimisation, sophisticated software and a knowledgeable operator are required. Generally, the efficient frontier is the line that depicts the trade-offs between risk and return that an individual investor or a portfolio will accept. The line is formed by investors making rational choices about investment portfolios. When given different risk–return characteristics, a rational investor will choose the portfolio that gives the best return. In the lowest risk part of the matrix, investors often do not make rational choices because of some associated concern. For example, a retiree might be more familiar with property than fixed interest because they own a house. Therefore, they might be inclined to invest in a property trust over other asset classes. 1.4 Diversification
Diversification is a basic rule of investment, and represents another way of saying spreading risk. It is often associated with the saying ‘Don’t put all your eggs in one basket’. Behind diversification are the concepts of business cycles and counter-cyclical businesses, and an understanding of lag and leading investments, countries and divergence of behaviour. Example: Diversification
Equity and bond markets provide a good illustration of the benefits of diversification. Equity and bond markets generally fluctuate against each other, i.e. when the equity market is up, bond markets are down and vice versa. In a portfolio in which funds are invested in both the equity and bond markets, this effect evens out investment returns. The aim of a fund manager is to have consistently good returns, not necessarily the highest in the industry at any one time. 910.SM1.5 Unit 5: Financial products 5.11 Diversification can add elements to a portfolio that will compensate for poor performance in other areas. Diversification can be at a macro level — splitting up investment money between countries — or it can be at an asset class level, on the principle that if one asset class is providing poor returns, then another will be doing well. For example, if a manager is expecting interest rates to drop, this will mean cash earnings will drop. Low interest rates are seen as good for companies that borrow, such as manufacturers, so they should provide good performance. The manager would move money out of the cash asset class and into the sharemarket, specifically in borrower companies, because their costs of doing business will drop and profits will rise. In Figure 2 the main business cycle is shown as a solid line. Some products might have a cycle that is at its peak when others are at their trough, as shown by the broken line. These products or businesses are called counter-cycle, or defensive. Products that do better in a recession are called recession-proof.
Figure 2 Counter-cyclical products Counter- cyclical products Business cycle Some products, sectors or countries come out of a recession faster than others; other products, sectors or countries might go into recession later than others. As a fund manager, you would make an initial investment in a company that is just coming out of its trough, so its price is low: you could buy a lot of shares for little money. You continue to own the company while it rides the business cycle upwards. Then you sell the shares when the company is at its peak, and you reinvest the original money, plus the profits from the sale, into another company that is coming out of its trough. This is a good example of how diversification would raise the performance of the portfolio. If all fund managers could do this, their investors would be rich. Why doesn’t it happen? While fund managers might come to the conclusion that certain countries, asset classes, sectors or companies might have good investment opportunities, the market is fickle and unpredictable so they can never be sure that their strategies will eventuate as planned. Therefore, fund managers are generally risk-averse with their own business management — they do not want to risk losing clients with low performance, and will diversify specific asset selection, sectors or asset classes, locally or internationally, to protect themselves from looking ‘bad’ in the market. A by-product of this risk aversion is that investors are not exposed to fund managers’ outright gambling. Financial advisers use the principle of diversification. It is important for advisers to balance risk and return, and use the principle of diversification to lower the overall risk in their clients’ portfolios. This balancing process will take into consideration the factors discussed above: • time periods • markets, sectors within markets and investments within sectors • fund managers. © Kaplan Education 5.12 Generic Knowledge: The Finance Industry (910) 2
2.1 Types of financial services products
Investments in each of the asset classes are available to individual investors, though some have limitations for all but the largest investors. For many investors, their biggest problem is their inability to decide whether a particular investment is right for them. This section examines the key characteristics of investments that should be evaluated so that a rational and prudent investment decision can be made. The characteristics are as follows. • Cost. Some direct investments cost virtually nothing to establish, e.g. a savings account, while others might cost a great deal in fees and charges, e.g. purchase of a mortgaged property. The cost in itself is not as important as the nature of the underlying asset and the conditions under which it is purchased. • Leverage. Leverage is the use of a minimum amount of cash or capital to obtain ownership of an investment, with the balance being borrowed. The less cash or capital required as a proportion of the whole, the greater the leverage and the greater the potential for capital appreciation (or loss). • Income flow. The rate of return is the actual or anticipated income to be received from an investment. For example, if you own gold bars, you do not receive interest or any other form of income from them, so the rate of return is zero. If you own 100 shares, which you bought at $10 per share, and you are paid a $1 dividend per share per year, then your rate of return is 10%. The shares should also give you capital appreciation (or loss), which is a different investment characteristic. Fixed interest investments might be purchased for their income-producing characteristics and capital stability. • Capital appreciation. A savings account pays interest, but it does not appreciate in value, whereas a commodity contract, with its low margin requirement, could appreciate considerably. • Inflation protection. This is closely linked to capital appreciation. To calculate a satisfactory inflation protection figure, subtract the annual inflation rate from the potential capital appreciation factor. • Risk. Safety or risk refers to the security of the investment. Interest-bearing deposits, such as Commonwealth bonds, have a very low risk factor ⎯ they are loans to the Federal Government and they are guaranteed. In contrast, futures contracts on commodities have a very high risk. • Volatility. Volatility refers to the fluctuation in the price of an investment. Interest-bearing deposits remain static and have no volatility, unless they are traded before maturity. Highly speculative investments, such as commodities and gold, fluctuate enormously in value and are therefore very volatile. • Tax factors. For many investors, tax considerations are crucial when choosing investments. Some types of investments provide the opportunity to reduce investor tax in certain situations (tax implications are discussed throughout this subject). • Timing. Timing is critical in many investments. Entry time (purchase), exit time (sale) and holding period, or duration, are all important. • Expertise required. Some investments require little or no investment skill. The choice of shares to purchase requires a high level of professional skill. The investor needs to assess the past performance of the shares and predict the future outlook for the industry.
910.SM1.5 Unit 5: Financial products 5.13 Limitations on direct investment by the retail sector
Achieving cost-effective and convenient diversification by direct investment in the retail sector is very limited for several reasons. The price of equity assets, or shares, is within the range of retail investors, but they need to be held in a diversified portfolio to provide for risk management. Putting together a diversified equity portfolio means buying at least 10 different equities, carefully selected over different sectors, to complement each other. And at least $6000 to $10,000 should be invested in each equity holding to make the holding worthwhile. This indicates a total Australian equity component in a portfolio of between $60,000 and $100,000. Such a portfolio would be beyond the capacity of most investors, given that they might also require investment in other asset classes. It is estimated that, at present, average individual shareholdings total less than $10,000. Direct investment into cash instruments such as bank bills is also restricted by dollar value and the need to diversify over issuers. For most investors, cash management trusts are the only means of accessing the money market. Direct investment in fixed interest investments (other than short-term bank term deposits and small government savings instruments) is also limited by the high face value of the instruments. Residential and smaller commercial property is available and might be affordable for individual investors, but investing directly means that there is little possibility of diversification. The higher costs of borrowing, the lack of liquidity and the management requirements also make direct ownership inefficient for many investors. The direct commercial property market is dominated by institutional ownership. Companies own their own premises or own other properties as investments. Fund managers (or rather the trustees) hold title for large portfolios of direct property market investments. Generally, individual property ownership does not extend beyond ownership of a residence, a vacation or a retirement property, or perhaps a small commercial holding. Investment market drivers
With direct investments, the actual investments — whether they are shares, property or bonds — are bought and owned by the investor. All decisions about changing those investments are made by the owner, with the help of their financial adviser. Some important distinctions separate direct investments into categories: • loans versus ownership (or equity) • listed equities versus unlisted equities • local equities versus overseas equities. An important difference exists between investments that pay a fixed return and those that represent a part ownership of a company, and a claim to dividends and capital growth. Therefore, we distinguish between a loan-type investment, such as debentures (where the interest is specified), and an ownership-type investment, such as shares (where the dividends paid depend on the profitability of the company and the determination of the company’s board as to how much of the profit will be paid to shareholders and how much will be re-invested in the company). © Kaplan Education 5.14 Generic Knowledge: The Finance Industry (910) Direct investment, while nominally open to retail investors, is really run by the large domestic and international institutions. Many asset classes or sectors are all but closed to individuals because of the amount of money needed to make investments into that asset class or sector. Large institutional investors usually set the pace and direction of the market. When the institutions are active, the market volumes soar and price movements can be magnified, either upward or downward. When the institutions are inactive, the volumes can drop to next to nothing, and pricing can be very volatile as one small trade can make the market (that is, set the price on the market at that time). 2.2 Pooled (or managed) funds
Managed funds are investments in which individual investors pool their funds with those of other investors. Managed funds are sometimes called collective or pooled investments, managed investments, investment funds, or just ‘funds’. Unit trusts, mutual funds, investment and insurance bonds or investment companies are examples of managed funds. For the purpose of this course we will use ‘managed funds’ to include all of these terms. Managed funds are also called indirect investments because investors do not make investment decisions. Example: Managed funds
A cash management trust consists of a pool of money contributed by a number of individual investors. A professional investment manager invests this pool of money in a range of short-term interest-bearing investments. The interest earned, after the deduction of management and other fees and costs, provides the return to the individual investors. A share or equity trust consists of a pool of money contributed by individual investors which a professional investment manager invests in a range of shares. Dividends paid on those shares provide a return to the investors in the share trust. When the value of the shares increases or decreases, the total value of the pool of share investments also increases or decreases. From an investor’s perspective, managed funds can be divided into five main types: • general managed funds (e.g. retail unit trusts and wholesale funds) • superannuation funds • property trusts • life insurance company investment funds • friendly society bonds. 910.SM1.5 Unit 5: Financial products 5.15 Advantages of managed funds
Individuals, institutions and companies invest in managed funds because the funds’ professional investment managers can access a broader range of investments than an individual can. This is particularly so in the derivatives markets, which are used increasingly. The investment managers’ expertise should provide a greater level of return for a given level of risk than most investors could achieve through direct investments. The significant advantages of managed funds include: • access to experienced professional investment managers • the ability to diversify even a small portfolio in order to spread risk (see the discussion on diversification earlier in this unit) • greater speed and flexibility in switching between different investment products with the growth of information technology • access to a wider range of investment opportunities, many of which require specialist knowledge or are normally available only to investors with large amounts to invest • economies of scale, such as volume discounts on brokerage and other fees, and relief from many of the administrative details involved in direct investment • ease of access on the part of investors to their money • a wide range of customer services provided by the promoters of managed funds • taxation advantages (depending on the type of managed fund and the investor’s tax situation) • the fact that, through margin lending, financial institutions will lend equal to and in some cases more against managed funds than direct equities. Disadvantages of managed funds
While managed funds have many benefits for investors, those benefits come at a cost. This cost has two aspects: one is monetary and relates to loss of control. These disadvantages may be summarised as follows: • Investors give up the selection of investment assets, and the fund manager takes this role. • The benefit of being able to make decisions about investment timing might be lost. Asset sale and purchase decisions become the role of the fund manager. • Investors might lose control in determining their exposure to particular investment sectors (e.g. commercial versus residential property) and asset allocation. This is particularly important for investors who might have significant investment in broadly based funds where the asset allocation fluctuates significantly over the shorter term. • Ongoing charges for asset management and the possibility of entry or exit fees are a significant disadvantage. Investors must be satisfied that the benefits of professional management and asset diversification offered by managed funds adequately offset the costs. © Kaplan Education 5.16 Generic Knowledge: The Finance Industry (910) Retail and wholesale managed funds
Managed funds may be divided into two broad categories: retail and wholesale. Retail funds Retail managed funds are marketed to the general public through a prospectus or customer information brochure and must contain information about the managed funds to help the investor make an informed decision. Many managed funds offer savings plans, which allow regular contributions from as little as $50 per month. There are five main types of investments in managed funds. Some funds have all of these (multi-sector funds) and others specialise in one category. The five main categories (both domestic and international) are: • Cash. Large pools of ‘at call’ funds that offer a high rate of return (compared with bank deposits) from the first dollar invested. • Fixed interest. Made up of assets such as government bonds, corporate bonds and mortgage-backed securities. • Property. Many options are available, ranging from rural property trusts, which invest in different types of farms and forests, to investments in commercial properties of various kinds in a number of locations. • Shares/equities. Shares in companies, both local and offshore. Direct investment in shares would require buying shares in many companies to reduce investment risk. Managed funds that invest in shares have sufficient volume to achieve diversification, as well as offering professional management. Investing in share trusts is an excellent way to own a diversified portfolio. • Alternative assets. Assets that offer a potentially high return, but which form part of a generally higher risk asset class. Examples include infrastructure (e.g. roads and tunnels) and private equity (i.e. where a fund has an equity stake in private companies). Also included in this class of assets are hedge or long/short funds which can benefit from rising or falling markets depending on fund manager positions. Retail managed funds can be used for: • retirement planning • education funding • any savings goal. The time frame for the use of the money, the client’s attitude to investment risk, their tax position and the need for income/growth are all crucial factors in the selection of investments. The tax treatment of different funds often dictates whether it is best to use unit trusts or tax-paid superannuation trusts. Wholesale funds Wholesale managed funds usually involve large amounts of money (over $500,000 per investment) and are marketed to professional investors, including trustees of superannuation funds, promoters of retail managed funds, corporate treasurers or administrators and investor directed portfolio services (IDPS) (e.g. wrap accounts or master trusts). 910.SM1.5 Unit 5: Financial products 5.17 Unitised and account-based managed funds
In a unitised managed fund, the pooled fund is divided into units of equal value. The price of units is a reflection of the value of the fund’s underlying assets. Units are priced daily. When someone makes an investment, they receive a number of units based on the current unit price and the amount of money they invest. Account-based managed funds are those in which the assets of the pooled fund are invested and an earnings rate (sometimes called an interest rate) is applied to the amount contributed to the pool by each investor. The earnings rate reflects both the investment returns and the time each $1 of investor’s savings has been invested. General managed funds
General managed funds are funds that pool the money of a number of investors and give those investors rights to the benefits produced by the fund, but no day-to-day control over the operation of the fund. General managed funds include listed property trusts, listed investment companies, wholesale and retail unit trusts and trustee company common funds. Most general managed funds are structured on a unitised basis, with the pooled fund being divided into units of equal value. Any income or dividends earned by general managed funds (other than limited investment companies) are passed on to the investors and can be used to provide a regular income stream. Alternatively, this money can, at the direction of the investors, be automatically reinvested (used to purchase additional units). Most general managed funds allow the investor to redeem the investment at any time on request. General managed funds are currently regulated under the Corporations Act and supervised by the Australian Securities and Investment Commission (ASIC). Taxation issues
Most general managed funds that are structured as unit trusts do not pay tax as long as they distribute to unit holders all income earned in any year. The tax liability falls on the individual investor and is paid at the investor’s marginal rate of tax. Such investments are tax transparent — channelling investment income through the trust does not alter or affect the tax liability. Capital gains are passed on to the investor, who may be subject to capital gains tax liabilities; franked dividends are passed on as franked dividends and taxed accordingly, and so on. The exception is capital gains tax losses, which are kept within the trust and offset against future capital gains before the investors receive those net capital gains and are subjected to tax. The amount and type of taxable income is calculated for each investor at the end of the tax year and detailed clearly on the trust’s distribution statement. Income received is calculated according to the investor’s entitlements by the end of the tax year, whether or not they physically receive the income. Proposed tax changes have introduced the concept of ‘collective investment vehicles’, which, as widely held Australian-based unit trusts, will retain their current ‘flow-through’ tax treatment as well as benefit from the concessional capital gains tax (CGT) rate. © Kaplan Education 5.18 Generic Knowledge: The Finance Industry (910) General managed fund products
Cash management trusts Cash management trusts (CMTs) offer short-term money management within a unit trust structure. CMTs are useful for investors who want to manage their cash flows. They are also an ideal way of saving and are useful places to hold funds while investment decisions are being made. They are generally used as the centre of investment portfolios, a good place for proceeds and funding for investments, plus a collection point for investment income. CMTs are considered a low-risk investment, as they invest in secure, short-term money market securities, and investor’s funds are available on short notice. Their rates of return move with market interest rates. Many CMTs are rated AAA by the ratings agencies. CMTs are prospectus-based, and usually entered into directly and managed like a bank account, with instant redemption (possible with ATM or some credit card access), a cheque book facility and direct deposit facilities linked to phone redemptions and possibly Internet access. They have no entry or exit fees, and the financial adviser generally receives an ongoing commission (e.g. 0.3%) on the funds under management (FUM). Australian equity products There are many types of equity products. Some seek high levels of dividend imputation as their main goal, while others equity growth. Some invest in the top 50 or 100 shares, and others have a wider spread. Some equity trusts are considered balanced in that they make asset allocation decisions between industrials and resource shares. Some managers classify listed property trusts, and listed property securities trusts, as property and an exposure to the sector. Some provide portfolio insurance protection through derivatives programs. Others never use derivatives. Equity investments, which can be designed for growth, income, a combination of both, or for a specialist purpose, provide the investor with opportunities to receive: • income from dividends paid by the underlying shares • tax-effective benefits from the franking credits accompanying the dividends • possibly a return of capital. The underlying features of the assets, such as volatility and higher levels of short-term risk, also pass through to investors. Equity investments earn income, so they can be used in a negative gearing program. 910.SM1.5 Unit 5: Financial products 5.19 Bond trusts Authorised investments in bond trusts include Federal and State public securities, public authority investments, corporate bonds and often a proportion of liquid assets (short-term money market securities and bank bills). They might be invested for the longer term, or the mid-term or be actively traded across various maturity dates to pick up extra returns. Additional returns might be achieved through the security selection of the fixed term assets. All income is assessed as being interest income. There are no tax-effective measures within fixed interest assets. (Even in zero coupon bonds, price accumulation is deemed to be income within the year.) Units in bond trusts are valued daily. Debentures Debentures are a bank-style product promoted by a non-bank financial institution, such as a building society or finance company. Debentures are quoted similarly to term deposits, in that they offer a rate of return for a given period. Debentures, usually offered for three years (two- to five-year options), carry re-investment risk. Most investors ignore this risk, do not understand it or manage it with serial debenture purchases by purchasing debentures on a staggered basis and then rolling them (i.e. reinvesting in later debenture offerings) as they mature. Master trusts and WRAP products Master trusts and WRAP products are primarily administration vehicles for selecting and holding a range of underlying investments. They are structures that enable an investor to channel money to one or more underlying wholesale managed funds or direct investments. There are two major categories of master trust: • discretionary funds • fund of funds. Some master trusts allow an investor (member) to select the underlying unit trusts rather than leave the investment decision to the manager of the master trust. These are referred to as member discretionary funds. Through a master trust structured as a member discretionary fund, a unit holder in the master trust can indirectly invest in a range of unit trusts (by directing the acquisition of units in specified unit trusts to be held by the master trust’s trustee). Unit holders keep control of their portfolios (which are distinct from other portfolios) and the manager of the master trust provides administrative and other services, in addition to access to wholesale funds that are not generally available to retail investors. Such wholesale funds are generally provided by the underlying fund managers at a lower cost (than equivalent retail funds). Disclosure to investors in member discretionary funds is a significant issue, and a variation to the general product disclosure statement requirements applies. © Kaplan Education 5.20 Generic Knowledge: The Finance Industry (910) Master trusts may operate as superannuation or non-superannuation trusts. The advantages (to advisers) of master trusts over retail managed funds include: • Once clients have been brought into the master trust, the whole of their financial affairs can be contained within the one structure, and it is less likely that they will leave the financial advising network. • Clients normally receive a consolidated investment report on a half-yearly or quarterly basis. If a financial advising network moves to fee for service, collected as a percentage of funds under management, the master trust can automatically debit the client’s account (usually a cash account used to collect distributions and proceeds before re-investment). • There is also the potential for financial advisers to run their own discretionary accounts for clients, in which they determine investment strategies and enact them on behalf of their clients. In a fund of funds, a predetermined blend of fund managers is structured into a single product that provides the investor with a diversified exposure to investment markets. The fund managers of the underlying managed funds are independent of the manager of the retail trust. Funds of funds have a longer history than feeder funds, but it is only in recent years that significant investment has been made through funds of funds. Most of that investment has been in superannuation. Fund of funds’ managers typically promote their ability to select underlying funds of above average performance and to take advantage of market opportunities and the benefits of diversification. WRAP products are a simple administration service that financial planners and their clients can use to hold investments. The product allows investors access to wholesale products at wholesale rates and provides consolidated reporting and tax information similar to master trusts. They are particularly useful to self managed superannuation funds that need the choice of investments funds but not the superannuation features of a master trust. Superannuation fund products
Superannuation funds are funds set up specifically to help people to save for their retirement. Any income or dividends remain within the funds and in most instances money paid into superannuation funds cannot be withdrawn until the investor reaches preservation age and has ceased work, or reaches 65 years of age. Superannuation is discussed in greater detail in the Kaplan Professional subject Superannuation and Retirement Planning (FIN213). Except for self-managed superannuation funds, superannuation funds behave as a specialist form of managed fund, bound by an additional set of rules. Current government legislation requires employers to contribute 9% of wages or salary into complying superannuation funds on behalf of their employees. This is known as the superannuation guarantee (SG). Superannuation funds are taxed at concessional rates, which makes them more attractive than other types of investment. 910.SM1.5 Unit 5: Financial products 5.21 The main types of superannuation funds include: • company funds, established for the benefit of employees of a particular company or group of companies • self-managed and small superannuation funds • industry funds, which cover a specific industry or range of industries • public sector funds, which cover government employees • public offer funds, which are operated by promoters who market the funds to investors, and which are mostly unitised. Superannuation funds are regulated under the Superannuation Industry (Supervision) or SIS Act, and supervised by the Australian Prudential Regulation Authority (APRA). First home saver accounts
A first home saver account allows a person to attract a government contribution in order to buy or build their first home. First home saver accounts have been available from 1 October 2008. Unlike an ordinary savings account or investment, a person can only use the funds in this type of account to buy or build a home that they live in, and only after they have saved for at least 4 financial years. Main features of first home saver accounts • savings are matched by a 17% government contribution on amounts up to $5000 in a financial year. For example, if you contribute $5000 this financial year, the government will top up your savings with $850 • low (15%) tax on interest or earnings • interest or earnings on your savings from your financial institution. Unlike ordinary savings accounts, the money in a first home saver account cannot be taken out of the account whenever a person wants. If the money in the first home savers account is not used to buy or build a home that will be lived in, the money must be transferred into a superannuation fund. Only in limited circumstances can a person access their superannuation before they retire so a person needs to consider the possibility of their circumstances changing before they commit to the First home savers accounts. Who is eligible? A person can only open an account if they: • are at least 18 years and under 65 years • have never owned a home in Australia in which you have lived. If you have owned an investment property that you have not lived in, you may be eligible • have never opened a first home saver account. You can only have one first home saver account (except in some limited circumstances) but you may move your account between financial institutions • can supply a tax file number and other proof of identity. © Kaplan Education 5.22 Generic Knowledge: The Finance Industry (910) Property trusts
A property trust is another specialist form of pooled investment. It is a legal vehicle that invests mainly in direct property. Property trusts can be public or private, listed or unlisted, taxable or non-taxable. The main advantages of property trusts are as follows: • There is no need to be directly involved in the day-to-day management of the property. • Unit holders can buy or sell some or all of their investment on the stock exchange. Unlisted property trusts can usually buy or sell through the manager of the trust, although there might be restrictions, such as a minimum period of notice before the transaction can be effected. • In a legal sense, the liability of unit holders is generally limited to their investment. Potential disadvantages of property trusts include the following: • Management costs must be paid — the manager typically takes a significant fee for managing the trust. • Investors do not have direct control over the assets in the trust. • The trusts usually contain a selection of properties, not all of which might be suitable for the investor. Listed property trusts The larger listed property trusts generally seek a return on their investments commensurate with a prudent degree of risk. They generally seek to spread risk by achieving a ‘balanced portfolio’ of commercial, retail and industrial property, usually diversified by state. There are exceptions to this rule. Westfield Trust, for example, invests almost exclusively in retail property, although the retail property portfolio is well spread geographically by state, mainly in major regional shopping centres. While the investment objectives of the larger listed property trusts remain reasonably constant, their investment strategies change over time, according to changes in the property market. They sometimes reduce their portfolios in some areas and add to them in others. Because of the poor liquidity of direct property investment in recent times and the large hangover of unsaleable properties with many institutions, most new property exposure for these institutions is expected to be through listed property trusts. This is one of the reasons why many previously unlisted property trusts, which have since listed on ASX, have been so well received. Sector-specific listed property trusts have also become popular, permitting investors to undertake their own asset allocation between office, retail and industrial trusts. Unlisted property trusts Unlisted property trusts are mainly corporate investment vehicles that have extended redemption periods (e.g. 12–18 months). These vehicles are attractive to larger funds that are seeking direct property exposure but do not have the in-house expertise to invest directly in property. 910.SM1.5 Unit 5: Financial products 5.23 Mortgage trusts Mortgage trusts are a sub-set of property investments. Instead of investing in real property assets, mortgage trusts purchase the income stream from interest payments on mortgages over properties. Mortgage trusts lend funds for the purchase of property, often commercial property backed by the mortgagee’s personal assets (their home, for instance). Some invest in residential properties, such as new housing estates. Mortgages within trusts are usually arranged on an interest only basis and are usually for fixed periods of between three and five years. Mortgage trusts should be very liquid, with both incoming funds and payments from borrowers. The rate of return from a mortgage trust depends on: • the management of the trust • the types of properties held within the trust • the fees and charges. A well-managed mortgage trust should return results above the bond rate. Diversification across a number of mortgaged properties provides greater risk management. Investors do not need to make ongoing management decisions, as there is no end term with mortgage trusts. The outcomes of mortgage trusts are similar to those of fixed interest trusts: they provide a stream of income with little or no capital growth. Life insurance company managed funds
Life insurance company managed funds are also known as investment bonds, insurance bonds or life bonds. These funds are 10-year life insurance policies backed by investments within a life insurance company statutory fund. The contributions (minus establishment fees, commissions, etc.) are usually directed towards investment, rather than life insurance. Investment moneys are directed into the life offices’ statutory funds, which are part of the overall life office structure. When the life insurance company investment fund matures or is redeemed, the investor receives a payment based on the value of the contributions plus any earnings on those contributions. Life insurance company investment funds retain any income and profits from the fund’s investments and the value of the investor’s managed funds appreciates over time. While it is possible to redeem a life insurance company investment fund at any time, because of initial commission costs and tax advantages after 10 years, it is usually far more practical for investors to hold these investments for at least 10 years. Insurance products are tax-paid investments — the tax is paid by the insurance company — so the investor does not have any tax liability from their investment, provided the investment has been held for at least 10 years. Changes are likely in the future as part of the tax reform process. © Kaplan Education 5.24 Generic Knowledge: The Finance Industry (910) Friendly society bonds
Friendly societies are non-profit organisations that offer a range of services, including sickness, funeral, health and insurance benefits, as well as managed funds, which are very similar to life insurance company investment funds. The major differences between life insurance company investment funds and friendly society bonds are in the taxation treatment of earnings on the investments and restrictions imposed on friendly society bonds regarding authorised investments. The standard friendly society bond is an account-based fund with an underlying cash or fixed interest portfolio. Each year the accounts are drawn up; the friendly society pays tax on the earnings of the fund; and the society declares a crediting rate, which is applied to all investment accounts. Profits are returned by means of the crediting rate on the funds. Most friendly society bonds are similar to capital guaranteed, capital stable or cash insurance company investment funds with investments concentrated on low-risk, low-return investments. Because friendly societies are non-profit organisations their fees and charges are competitive. Friendly society bonds are tax-paid investments — the tax is paid by the friendly society, and investors do not generally have any tax liability from their investment, as long as the bond is held for at least 10 years. The taxation treatment of friendly society bonds is very similar to that of life insurance company investment funds, except that friendly societies pay a different tax rate. Changes are likely in the future as part of the tax reform process. Choosing pooled fund structures
The product approach In the product or style approach, investors select a managed fund to satisfy their specific investment objectives. These managed funds are investment portfolios created by promoters, and they follow different investment approaches or styles. The different managed funds offer investors a range of different return and risk characteristics. The performance achieved will conform to the investment style of that investment. Investment managers package investments into different managed funds to offer investors a range of risk–return characteristics (see Figure 3). These managed funds can be divided into investment opportunities that are: • capital guaranteed • capital stable • capital secure and capital protected • fully discretionary, balanced or growth oriented • growth. Under the product approach, the investment manager assesses expected asset performance and then creates the best portfolios for each particular type of managed fund. 910.SM1.5 Unit 5: Financial products 5.25 Figure 3 A schematic explanation of managed fund opportunities over the long term l l Balanced Growth Return l Capital secure l Capital stable l Capital guaranteed Risk The asset approach Under the asset approach, investment managers select an appropriate mix of asset classes to satisfy a fund’s objectives. This mix of asset classes is also selected with the aim of achieving a particular set of return and risk characteristics. To arrive at an appropriate asset allocation, the investment manager would consider: • the nature of the underlying liabilities (i.e. repayment to investors) • the timeframe over which to achieve investment returns • expected return targets • the acceptable level of risk, which may be expressed as limits on the likelihood of certain adverse outcomes for the managed fund (e.g. no negative crediting rates) • the range of allowable investments • the desired level of diversification • any liquidity requirements that the managed fund might have • the taxation implications. Under the asset approach, the investment manager assesses expected asset performance and then creates a number of portfolios, covering a range of investment styles. © Kaplan Education 5.26 Generic Knowledge: The Finance Industry (910) 2.3 Equity investments
Equity involves ownership. If you have an equity investment, you own part of an asset (e.g. a house or a company). When you buy ordinary shares in a company, you become an owner of the business and share in the profits or losses of that company. A share is the basic unit of ownership in a company (e.g. the equity capital of a company might be $1,000,000 and it might be divided into 1,000,000 shares issued at $1 each). Shares are marketable securities, that is written undertakings acknowledging ownership, which are tradeable in the marketplace. They are evidenced by pieces of paper known as share certificates or stock certificates. The equity capital of a business is the owners’ interest in it, comprising capital permanently invested by the owners (which excludes all loans), together with any undistributed profits. Equity capital is often described as risk capital, because investors have no guarantee of any return on their investment or its repayment. The future returns of an equity holder are much less certain than those of a lender. Equity has the potential for much larger returns, but also for much greater risk of loss. Shares
Types of shares Ordinary shares normally represent the bulk of a company’s basic ownership money (or equity capital). Ordinary shares typically represent a company’s permanent capital. Shares are issued at a price determined by the directors of the company to reflect the company’s equity value. As a result of recent legislation, shares no longer have a par value (i.e. face or nominal value). There are transitional provisions to preserve the effect of existing contractual arrangements that refer to par value. Amounts of money can no longer be credited to share premium accounts. Voting rights are attached to ordinary shares. As a contributor of risk capital, the ordinary shareholder is one of the owners of the business. This entitles the shareholder to exercise control over its management. An ordinary shareholder’s control is exercised through voting rights, which may be exercised at annual general meetings or any extraordinary general meetings that might be called. An example of a company raising equity through the issue of ordinary shares would be Wesfarmers Ltd, which sold $2.6 billion in new shares to help refinance its $18 billion acquisition of supermarket operator Coles. Wesfarmers offered shareholders the new shares at $29 each on a one for eight basis for each share they now own. 910.SM1.5 Unit 5: Financial products 5.27 2.4 Debt securities
Debt securities are written undertakings acknowledging a debt and the requirement to repay money. They are saleable in the marketplace. The debt securities market is no different from any other market where a buyer meets a seller and together they negotiate a price and exchange goods and money. In the debt securities market, participants are dealing with money. The buyer of money (borrower) negotiates with a seller of money (the investor) about the price (interest rate) at which the investor will lend money to the borrower. In Australia there are two distinct segments of the debt market: • short-term debt market — the money market • long-term debt market — the capital market, or fixed interest market. The short-term money market deals in discount securities, while the long-term fixed interest market deals in coupon securities. Discount securities are securities with a fixed maturity date, where the interest is paid in a lump sum at the end of the term of the loan. Long-term fixed interest market deals in coupon securities. A coupon security is any security with a fixed maturity date, which pays periodic interest (or coupon) payments throughout the term. 3
3.1 Financial risk products
Insurance products to meet risk
We have considered investment risk and ways it can be minimised. But there is another aspect of risk that financial advisers need to communicate to their clients, which has more to do with wealth protection than wealth creation. The financial adviser must remain aware of both sides of their role. Some suggestions of risks that your client should be reminded of are: • loss of life leading to loss of income to business or family • loss of ability to earn a living • loss of use of or damage to the body or mind through illness or an untoward event • loss of, or damage to, property • loss of income through damage or impairment of income-generating property • loss owing to claims for damages made by other parties. The need to consider risks leading to potential financial loss facing a client, as well as wealth creation and management, should be part of any financial advising process — even if the concept of risk and the means to protect against it are simply highlighted and the client advised to seek advice from a specialist. © Kaplan Education 5.28 Generic Knowledge: The Finance Industry (910) What is a risk product?
While life insurance for business protection has legal and tax implications that might occasionally be beyond the scope of the financial adviser, the concepts are straightforward and easy to explain. House, contents, motor vehicle and legal liability insurance would be familiar to all financial advisers and clients. The adviser should check that the client is aware of the need for insurance and has adequate arrangements in place, emphasising the effects of underinsurance. Business and commercial property insurance for businesses with turnovers up to about $500,000 can be handled by insurance company packages, but for anything but the simplest business an insurance broker may be recommended. A risk product is an insurance policy to pay the insured party the agreed amount or sum insured if the specified event occurs following the acceptance of an application, evidence of the insured’s condition or situation, and payment of a premium. As an example, ABC Insurance agrees to pay Mrs X $100,000 on the death of Mr X, having accepted that Mr X is in good health and Mrs X having paid the first year’s premium of $450. Types of risk products
Death cover There is no argument over the certainty of eventual death, and none over the definition of the event. Clients need to be made aware of the likelihood of untimely death and its financial consequences to their dependants, creditors, partners and businesses. Most discussion will centre on the type of insurance needed and the quantity, price and ownership. Common usage is that a risk policy is a term policy, i.e. one that has no cash value except as a result of death (total and permanent disablement (TPD) and trauma or crisis cover may be added). There is no savings element in a term policy. However, the definition should be extended to cover risk policies, such as whole of life and endowment, which do have cash values on surrender or maturity. After all, if Mrs X has her whole of life policy on Mr X accepted for a sum insured of $100,000, pays the first year’s premium of $2500 and Mr X is killed in a car accident the day after the policy is issued, the insurer will pay the $100,000. The potential cash, surrender or maturity values are then irrelevant. The risk was taken by the insurer, and the loss has been made good. While whole of life and endowment policies have higher premiums than level or yearly renewable term policies, many advisers consider that the long-term cash values make the policies attractive to clients of a particular profile. However, these policies have lost popularity over the years. A long-term care component might be added in the near future. 910.SM1.5 Unit 5: Financial products 5.29 Disablement and illness insurance Total and permanent disablement cover provides payment of the sum insured should the person insured become totally incapacitated through injury or illness to the extent that they cannot ever perform the duties of their own occupation, or any other occupation for which they are suited by education, training or experience. Trauma, critical illness or crisis cover insurance cover provides financial protection in the event of death or specified medical catastrophes. Other optional benefits, such as total and permanent disability, may be added for the payment of an additional premium. It is usually guaranteed renewable and non-cancellable, and premiums are stepped. It is often added to conventional term policies. Disability income insurance provides for the payment of a benefit in the form of a monthly income in the event that the person insured suffers total disability. Benefits start to accrue from the end of the waiting period selected, and benefit entitlements are payable monthly in arrears. Since income paid to a person while they are disabled is included in assessable income, disability income protection premiums are generally tax deductible. Business risk products Business expenses plans can help to keep your client’s business going if they are unable to work because of illness or injury. The eligible business overheads are reimbursed for up to one year. It makes it more likely that your client’s business will survive until they get better. Business insurance using life policies — death cover is usually provided by term insurance policies, because the cost of permanent policies, such as whole of life, might be considered prohibitive. For older lives or where the risk to be covered could last a long time, the level premiums and offsetting cash build-up of permanent policies might be attractive. The main business uses of life policies are: • partnership protection and share purchase or succession plans • key person insurance to protect a business from the loss of expertise of an important person in the business. General insurance This is usually related to property protection and liability to third parties. Domestic — all advisers and most clients will be aware of the need to protect themselves against loss of home, contents and motor vehicles. In addition to these risks, most domestic policies include public liability. Extensions are readily available to cover personal possessions, such as jewellery and cameras when they are taken outside the home. Domestic workers, such as cleaners or gardeners, can also be covered. © Kaplan Education 5.30 Generic Knowledge: The Finance Industry (910) Travel cover is available to insure against loss of deposits owing to cancellation, loss or theft of possessions, and medical expenses incurred as a result of illness or accident while travelling. Small business — The Australian Bureau of Statistics reported that in the 2002 to 2003 financial year over 2.9 million people were employed in over 1.1 million small businesses. Furthermore, the Insurance Council of Australia has reported in recent years that less than half of Australian small businesses were either underinsured or not insured at all (although this is improving), so a large market for small business insurance packages exists. Risks for small business are more extensive because there is more property involved and more contact with third parties, staff, suppliers, purchasers and contractors. Professional indemnity insurance A basic policy provides indemnity for the insured’s legal liability following a negligent act, error or omission, or a breach of professional duty arising out of the normal course of business. The standard professional indemnity policy excludes several areas, but cover can be purchased by standard extensions for items such as: • libel and slander • fraud and dishonesty (of employee) • loss of documents. 3.2 Derivatives
In its simplest form, a derivative is a date specific contract to buy or sell an underlying physical asset (such as wheat or wool) or, more typically, a financial instrument (such as an index or stock). The contract (whether it’s a forward, futures or options contract) is derived from the underlying asset and therefore would not exist without it. (There are some exceptions to this where there is no underlying asset or financial instrument such as weather derivatives.) One does not need to have an ownership interest in the underlying asset in order to buy or sell derivative contracts, although one might acquire an interest upon exercise or close out of a contract, whether to crystallize a profitable contract or to cover losses on an unprofitable contract. The basic pricing structure of a derivative remains related to the core underlying asset. For example, bank bill futures are based on the price of bank bills traded in the money market; 10-year bond futures are based on the price of 10-year bonds traded in the fixed interest market; a BHP Billiton call option or warrant is based on the price of BHP Billiton shares trading on the stock exchange A derivative, in theory, responds to changes in the same economic fundamentals as would the underlying asset. For example options would fluctuate in value with changes in actual interest rates. 910.SM1.5 Unit 5: Financial products 5.31 Derivatives are used as instruments for managing price risk. By varying maturity, altering repayment methods or locking in interest rates for a period, the use of derivatives can alter the associated risk of trading or holding the underlying instrument. Uses of derivatives
Corporations, government entities, financial institutions and fund managers alike are concerned with managing interest rate risk. Ideally, they want to earn the maximum amount of interest on funds invested and pay the minimum amount of interest on borrowed funds. However, as the maturity dates of their investments and loans do not always match, and because of the volatility of interest rates, they may wish to minimise their exposure to unfavourable interest rate changes by using interest rate hedging tools. These tools act as a form of insurance. For example, a company that had borrowed $100,000 for three months at 6.00% would be exposed to a movement in interest rates if the company was required to extend the borrowing for a further term at a newly negotiated rate. Similarly, an investor lending for three months is exposed to the same movements. If interest rates were to rise then the investor would benefit. If interest rates fell then the borrower would benefit. Derivatives enable companies to lock in interest rates now for future borrowings or investments. By using derivatives, companies can: • Protect against future adverse interest rate movements: Achieve the desired ‘worst case’ borrowing or lending rate. This is a process called hedging. When borrowers or investors hedge their exposure to interest rate risk they are endeavouring to protect against the extra cost/opportunity cost of adverse interest rate movements. The hedge should make money for the borrower/investor when the underlying market moves against their position i.e. interest rates move up for a future borrower; interest rates move down for a future investor. Derivatives offer borrowers and investors the tools by which to implement a hedge. • Reduce borrowing costs/increase investment returns: Derivatives can provide opportunities for companies to reduce their interest rate costs/increase investment returns. Through interest rate swaps in particular, a company might swap floating rate borrowing obligations on a loan for fixed rate obligations to achieve a lower overall borrowing cost. Alternatively, an investor holding a fixed interest security may swap the fixed coupon of the bond to a floating rate enabling the investor to benefit from increasing interest rates. • Increase flexibility: Derivatives can be traded and in some cases (e.g. futures contracts) liquidity is very deep, and in turn transaction costs are lower than in the underlying or physical market. • Match borrowing structure to company needs: Through the use of derivatives, companies can transfer the nature of their debt obligations to a structure that best suits their needs, e.g. from floating rate to fixed rate or vice versa. © Kaplan Education 5.32 Generic Knowledge: The Finance Industry (910) Types of derivative products
Derivative products are either traded in a centralised marketplace (such as exchange-traded derivatives) where the contract specifications are standardised and operations monitored by the Exchange, or they are traded between banks and financial institutions as over-the-counter (OTC) derivatives where the contracts are specifically tailored to meet the needs of the customer. The main types of derivatives are outlined below. Futures Futures are contracts (legally binding agreements) to buy or sell something in the future. That ‘something’ could be gold, copper, wheat, corn, a foreign currency, shares or interest rates. Each contract specifies the commodity, the quantity, quality and time of delivery or cash settlement. The buyer and seller of a futures contract agree on a price today for a product to be delivered and paid for in the future — that is why they are called futures contracts. Trading in futures contracts is conducted by a futures exchange (e.g. the Sydney Futures Exchange). The exchange provides the meeting place where the buying and selling of futures contracts occurs. Forward rate agreement A forward rate agreement (FRA) is an agreement between two parties which sets a fixed interest rate for a period beginning on a future date (the start date) and ending on an agreed date (the maturity date). A FRA is an OTC contract. For example, a borrower who needs to borrow funds for three months in two months time and fears that interest rates may increase in the meantime, could hedge using a two month against five month FRA. This is quoted in the market as 2–5. Options An option is a contract between two parties in which one party (the buyer) has the right, but not the obligation, to buy or sell a specified asset at a specified price at or before a specified date from or to the other party (the seller). Options are generally exchange-traded. Warrants A warrant is a tradeable security that gives the holder the right to purchase the underlying security at a fixed price (the exercise price) for a fixed period of time (the exercise period). Essentially, warrants are long-term options. Like options, there are both call (buy) and put (sell) warrants. These are listed on the Australian Stock Exchange trading system (SEATS) and are traded in a very similar way to shares. Swaps A swap is an agreement between two parties to exchange (or swap) a predetermined series of payments over time. Like forward agreements, the terms of the contract tend not to be standardised. The key difference is that a swap involves a series of payments through time, rather than a single payment at maturity. Swaps are OTC contracts. 910.SM1.5 Unit 5: Financial products 5.33 4 In summary
This unit considered the structures, features and benefits of various financial investment and risk products. The proliferation of investment products in the market place offers enormous benefits to the investor. It is essential that both advisers and investors understand the details of investment products available. The potential benefits of these investments to the investor are immense, and careful selection is vital. It is also essential that advisers be able to recommend the right type of risk product for their clients in order to protect their clients’ wealth. © Kaplan Education 5.34 Generic Knowledge: The Finance Industry (910) Notes 910.SM1.5 6
Overview 6.1 Unit learning outcomes ....................................................................6.1 1 1.1 1.2 1.3 2 2.1 2.2 2.3 2.4 3 4 4.1 4.2 4.3 4.4 5 The time value of money 6.2 Overview ................................................................................6.2 What is the time value of money? ............................................6.2 Simple interest.......................................................................6.3 The principle of compounding 6.5 Overview ................................................................................6.5 Interest paid on interest..........................................................6.6 Compounding frequency ..........................................................6.7 What is the effective rate of interest?.......................................6.8 Risk–reward trade-off 6.12 General investment concepts applied to managed funds 6.13 Investment return .................................................................6.13 Investment risk ....................................................................6.14 Diversification ......................................................................6.16 Modern portfolio theory .........................................................6.18 In summary 6.20 Unit 6: Investment concepts 6.1 Overview
In this unit we will look at investment concepts. The concepts we will examine are: • the time value of money • the principle of compounding • risk–reward trade-off • rational choices • diversification. Unit learning outcomes
On completing this unit, you should be able to: • illustrate the concept of the time value of money • resolve problems using both the simple interest and compound interest formulae • distinguish between nominal and effective rates of interest • describe the effect of frequency of payments on the overall return of fixed interest investments • describe the relationship between term to maturity and yield for a given class of securities • demonstrate an understanding of general investment concepts applied to managed investments • explain the relationship between risk and return • describe some factors affecting investment return • illustrate the principle of diversification • explain the basic principles of modern portfolio theory. © Kaplan Education 6.2 Generic Knowledge: The Finance Industry (910) 1
1.1 The time value of money
This concept underlies many of the debt market valuations (including bank accounts, cash management trusts and other types of borrowing or savings). As with the adage of a bird in the hand, a dollar in an investor’s hand today is worth more than the pledge of a dollar to be paid some time in the future. We often show our regard for friends by lending them money to be paid back without interest. We are forgoing the interest we would have obtained if we had invested the money and gained a return. When a borrowed or invested sum is considered in terms of its value at some time in the future, there are two concerns: • What if I don’t get my money back? (This is the ‘default risk’.) • Will my money lose value due to inflation? What return would I have earned if I was receiving interest? (This is called ‘opportunity cost’.) 1.2 What is the time value of money?
When a sum of money is considered in terms of its value at some time in the future, its value is larger because it accumulates interest. Conversely, when a sum of money due at some time in the future is considered in terms of its current value, it is discounted and becomes smaller. Figure 1 illustrates how the dollar value of money increases with time.
Figure 1 The time value of money Money Time A dollar invested today will return, at a specific future date, both the original dollar invested and some interest. For example, if you invested $100 for one year at 11%, then the value of your investment at the end of the year would be: $100 + (11% × $100) = $111 In this example the time value of money is 11% p.a., i.e. the return. Conversely, when considering the value today of $111 in one years time, the value today would be $100. 910.SM1.5 Unit 6: Investment concepts 6.3 1.3 Simple interest
Calculating the time value of $100 in the above example involved a simple interest calculation. Formula
Simple interest assumes there will be a once-only interest payment at maturity. The formula for simple interest is: I= P×r ×t 100  where: I = interest earned over t periods P = amount invested over t periods r = rate of interest paid per period expressed as a percentage (e.g. 8.25%) (note the effect of the % is seen in the 100 as the denominator) t = number of periods. Example 1: Simple interest
$1000 is invested for three years at 9% p.a. simple interest. How much interest will be paid at the end of the period? Using formula : I= = P×r×t 100
1000 × 9 × 3 100 = $270. It is usual to express the interest rate as a decimal and omit the 100 in the denominator, i.e. divide the quoted rate by 100. Then 9% is entered in the formula as 0.09. The calculation then becomes: I = $1000 × 0.09 × 3
= $270. Future value
In this example, the future value S of $1000 equals $1270, i.e. S=P+I  and substituting formula  into formula , S = P + [P × (r × t)]
Thus  S = P (1 + rt)
where r is now expressed as a decimal.  © Kaplan Education 6.4 Generic Knowledge: The Finance Industry (910) These and other formulae may be rearranged to suit the particular problem. You should develop the ability to break down a problem into its parts and apply the relevant formula to derive a solution. Consider the following examples: Example 2: Future value
What will $3000 amount to over four years at 9.5% p.a. simple interest? What interest will be earned? Using formula : S = P (1 + rt)
= $3000 (1 + 0.095 × 4) = $3000 (1 + 0.38) = $3000 × 1.38 = $4140. Interest earned is determined by rearranging formula : I = S–P
= $4140 – $3000 = $1140. Rearranging formula  allows for the calculation of present values. Example 3: Future value
We want to receive $4140 in four years’ time. How much must we invest now at 9.5% simple interest to amount to $4140? Use formula  and rearrange: P=
= = = S 1 + rt $4140 1 + 0.095 × 4 $4140 1.38 $3000 as given in example 2. For calculations where the period considered is in days: t= days to maturity of investment 365 910.SM1.5 Unit 6: Investment concepts 6.5 Example 4: Future value
What will be the future value of $5000 if it is invested at 7% p.a. simple interest for 90 days? Again, using formula : S= = P (1 + rt) 90 ⎞ ⎛ $5000 ⎜ 1 + 0.07 × ⎟ 365 ⎠ ⎝ $5000 (1 + 0.07 × 0.246575) $5000 (1 + 0.017260) $5000 × 1.017260 $5086.30 = = = = You have now developed some important skills based on the concept: Future value S = Present value + =P + Interest payments I which is formula  and can be rearranged to suit a particular purpose. This equation is the basic model used in finance and in the next section we shall see how it is used in the pricing of discount securities on the money market. 2
2.1 The principle of compounding
The principle of compounding is central to the finance and investment industry. So far in our discussion we have assumed that interest is paid only once — at maturity. What if interest is paid more frequently, for example six-monthly? Treasury bonds, unlike bills, are interest-bearing or coupon securities, which pay the holder interest equal to the face value times the interest (i.e. coupon) rate at which they are issued. Thus, an investor who bought $1 million of Treasury bonds with a 10% coupon would receive $100,000 interest during each year the securities were outstanding. The interest is usually paid in semi-annual instalments (i.e. every six months), giving the investor the opportunity to reinvest the interest and so earn interest on interest. This is known as compounding. © Kaplan Education 6.6 Generic Knowledge: The Finance Industry (910) 2.2 Interest paid on interest
As we saw in the case of simple interest, the return was paid only on the purchase price or the principal invested. However, many investments are based on the compounding principle where, in addition, interest is paid on interest. Example 5: Compounding interest
Assume $100 is invested for two years in a fund that pays interest at the rate of 8% p.a. compounding. What will the balance of the fund be at maturity? Using formula , we know: Year 1
Interest at the end of Year 1 is: I = P×r×t = 100 × 0.08 × 1 = $8. Year 2
We know the interest earned is added to the original investment of $100, so the opening balance is $108. As before: I = 108 × 0.08 × 1 = $8.64 At the end of Year 2, the balance is made up as follows: Original investment Year 1 interest Year 2 interest $100.00 8.00 8.64 $116.64 What if the fund extended for three years? The interest earned during Year 3 would be $9.33 (which you should verify), so the balance at the end of Year 3 would be $125.97. Summarising the results identifies a pattern:
Year 1 2 3 P (1 + i)
n Balance at end
1 100 (1 + 0.08) 100 (1 + 0.08) 100 (1 + 0.08) $108.00 $116.64 $125.97 2 3 910.SM1.5 Unit 6: Investment concepts 6.7 Check the results: P (1.08) = 1.080 × 100
1 2 3 = 108.00 P (1.08) = 1.1164 × 100 = 116.64 P (1.08) = 1.2597 × 100 = 125.97 from which an important relationship emerges: S = P (1 + i) where: S = future value P = present value i = interest rate per period expressed as a decimal
n n  n = number of periods for which the amount will compound. The quantity (1 + i) is the amount that one unit will grow to if invested at i% compound interest per period for n periods. Note that it is % per period.
Note: Always think in terms of % per period rather than % per year and much confusion will be avoided — as we shall now see. 2.3 Compounding frequency
Example 6: Compounding frequency
Choose between two investments. One pays 9% p.a. with annual payment (compounding) periods and another pays 8.5% p.a. with quarterly payment (compounding) periods. Assume a two-year term. Using formula : Case 1: Annual periods
S = (1 + 0.09) = $1.19.
2 = $1.188100 Case 2: Quarterly periods
Here there are eight periods and interest is paid at the end of each period. The appropriate rate to use per period is 8.5% ÷ 4 = 2.125%. Hence: S = (1 + 0.02125) = $1.183196 = $1.18. Thus the future value in Case 1 is higher than that in Case 2, and therefore, the better investment. Problems of the kind illustrated by Example 6 are easily solved provided you think in terms of interest per period. A common error is to use an interest rate that does not correspond to the relevant compounding period. The compounding period is the elapsed time between interest payments.
8 © Kaplan Education 6.8 Generic Knowledge: The Finance Industry (910) Unless specified to the contrary, an interest rate is quoted as an annual rate. If it is paid more frequently than annually, the convention is to divide the annual nominal rate by the number of payment periods. If, for example, the quoted rate is 11% p.a. with interest payable semi-annually, then the appropriate rate per period is 5.5% (i.e. 11% ÷ 2 = 5.5%). Example 7: Monthly compounding interest
Compute the amount in an account with $1 at the end of five years if interest is paid at the rate of 9% p.a. compounded monthly. Using formula : S = P (1 + i)
n 60 = 1 (1 + 0.0075) = $1.565681 = $1.57 where: P=1 n = 5 × 12 = 60 i = 9% ÷ 12 = 0.75%. So, $1.00 invested at 9% p.a. with interest payable monthly over five years would amount to $1.57. 2.4 What is the effective rate of interest?
This leads us into distinguishing between nominal and effective rates of interest (return). Example 8: Compounding periods
If we wish to invest $100 for one year and can earn: • 7.50% paid monthly • 7.75% paid quarterly • 8.00% paid semi-annually • 8.25% paid annually which is the best return? As the rates have different compounding periods, it is important to calculate the future values to obtain a consistent measure. We will adapt formula  to accommodate interest paid more frequently than annually. Remember the convention is to divide the annual nominal rate by the number of periods. 910.SM1.5 Unit 6: Investment concepts 6.9 This gives us the formula:
⎛ S = P ⎜1 + ⎝
i⎞ ⎟ j⎠
n where: S = future value P = present value i j = nominal interest rate = number of interest rate periods per year. n = number of interest rate periods over the term of the investment Thus the future value is calculated as follows: 7.50% paid monthly
0.075 ⎞ ⎛ S = 100 ⎜ 1 + ⎟ 12 ⎠ ⎝ 7.75% paid quarterly 0.0775 ⎞ ⎛ S = 100 ⎜ 1 + ⎟ 4⎠ ⎝
4 12 = $107.76 = $107.97 8.00% paid semi-annually 0.08 ⎞ ⎛ S = 100 ⎜ 1 + ⎟ 2⎠ ⎝ 8.25% paid annually 0.0825 ⎞ ⎛ S = 100 ⎜ 1 + ⎟= 1⎠ ⎝
1 2 = $108.16 $108.25 In this example, 8.25% paid annually gives the best return. © Kaplan Education 6.10 Generic Knowledge: The Finance Industry (910) Example 9: Frequency of payment
Calculate the return for $100 invested for one year at the following annual rates rather than the compounding periods used in the previous example: • 8% p.a. paid monthly • 8% p.a. paid quarterly • 8% p.a. paid semi-annually • 8% p.a. paid annually. We can compute the future values as follows: • 8% paid monthly
0.08 ⎞ ⎛ S = 100 ⎜ 1 + ⎟ 12 ⎠ ⎝
12 = $108.30 • 8% paid quarterly
0.08 ⎞ ⎛ S = 100 ⎜ 1 + ⎟ 4⎠ ⎝
4 = $108.24 • 8% paid semi-annually
0.08 ⎞ ⎛ S = 100 ⎜ 1 + ⎟ 2⎠ ⎝
2 = $108.16 • 8% paid annually
0.08 ⎞ ⎛ S = 100 ⎜ 1 + ⎟ 1⎠ ⎝
1 = $108.00 The yield (the annual return expressed as a percentage) would be as follows: 8% paid monthly produces a return of $8.30 on $100 or 8.30% Similarly, the others: • 8% paid quarterly • 8% paid semi-annually • 8% paid annually = 8.24% = 8.16% = 8.00% From Example 9, you can see that the higher the frequency of payments the higher the return, for the same annual rate of interest. In this example, 8% was the nominal rate and 8.30%, 8.24%, 8.16% and 8.00% were the equivalent effective rates. Example 10: Return on investment
Which will produce the higher return: Investment A, which pays 8% p.a. paid semi-annually, or Investment B, which pays 7.75% p.a. paid monthly? Using the same method as in Example 9, you will see that: • Investment A (8% p.a. paid semi-annually) yields 8.16% annually • Investment B (7.75% p.a. paid monthly) yields 8.03% annually. 910.SM1.5 Unit 6: Investment concepts 6.11 In general terms, the effective interest rate p.a. can be calculated using the following formula:
i⎞ ⎛ E = ⎜1 + ⎟ − 1 n⎠ ⎝
n  where: E = effective rate of interest i = nominal rate of interest n = number of compound periods per year. Summary
• Simple interest is the interest paid on the initial investment (the principal) only. It does not take into account interest earned on interest. • Compound interest takes into account that interest earned is reinvested, with interest being earned on that interest, as well as on the principal. • The return on investment should be expressed as an annualised compound return if held for more than 12 months. The difference between simple return and compound return is very important in practice. Investors might be disappointed that their investment in ‘growth’ assets such as shares did not live up to their expectations over a reasonable period, say 10 years. If they have been stripping out dividends (i.e. not reinvesting the dividends) and not participating in rights issues, they will not have had the benefits of compounding. It is important to realise that if the benchmark for performance evaluation purposes is, for example, the S&P/ASX 200 Accumulation Index (a measure of the performance of the Australian sharemarket), dividends must be reinvested, not spent, to reach a fair assessment of an equity portfolio’s performance. © Kaplan Education 6.12 Generic Knowledge: The Finance Industry (910) 3 Risk–reward trade-off
The concept of a guaranteed return of investment money and a guaranteed income return shields the investor from taking any risk, but the risk simply shifts to the guarantor. The guarantor has assessed the underlying risks, chosen the investment with the lowest level of risk and charged a ‘fee’ to provide the guarantee. The fee compensates the guarantor for the potential risk. The fee is taken out of the return of the assets. Thus, if the underlying assets are paying 5% interest, the guarantor might take 1.5% of the return as a fee for providing the guarantee (taking the risk). The investors get their money back and will get a guaranteed return of income. The hitch is that the investor only gets 3.5%. Low risk is accompanied by low returns. Another risk an investor faces is that while the asset performs well on average, there is no consistency in its performance. That means that when the investor contemplates selling the asset, they face a high level of uncertainty about the price they will achieve. This is called ‘volatility’. Simple performance reporting does not address the volatility risk. Table 1 below shows volatility within a simple performance outcome (fees, taxes, etc. not included).
Day Price Simple performance outcome to show volatility
60 1.00 90 1.25 120 0.80 150 1.00 180 1.15 210 1.20 240 1.10 270 0.70 300 1.10 365 1.20 The investor who entered the fund on day 60 and sold on day 365 made a 20% return — an excellent achievement. The investor who entered on day 210 and sold on day 365 broke even. The investor who entered on day 120 and sold on day 365 made a 50% return — spectacular. However, the investor who entered the market on day 90 and sold on day 270 took a substantial loss — they invested $1.25 and only got back 70 cents, making a 44% loss. This rate of price volatility might be unacceptable to some investors. The volatility of an asset and the expected holding period of an investor are closely related. The shorter the holding period of the investor, the lower the desired volatility of any investment asset. For example, shares are very volatile compared with bonds. So an investor with a long investment horizon might be able to withstand the higher volatility of shares in the expectation of achieving higher returns. Whereas an investor with a short timeframe might prefer bonds as they are less volatile, even though they offer lower returns than shares. 910.SM1.5 Unit 6: Investment concepts 6.13 4 General investment concepts applied to managed funds
Growth versus income
Managed funds are generally divided into growth or income investments depending on the returns that they generate for the investor. Growth investments have a more aggressive style of management. They concentrate on generating a return in the form of capital gain rather than seeking regular income. In contrast, income investments concentrate on generating a regular income stream for the investor. Equities and property are known as growth assets owing to their capacity to generate capital gains (or losses!) as well as an income stream from dividends or rents. Fixed interest and cash generate mainly an income stream and are known as ‘defensive’ asset classes. There is a high degree of certainty regarding the future cash flows of these assets, especially if they are held to maturity. 4.1 Long-term versus short-term
Time horizon is an important element when considering risk. Growth assets usually exhibit more volatility and might go through periods of negative returns. The long-term investor can bear short-term fluctuations in the market, knowing that in all probability the market will trend upwards over the long term. On the other hand, a person who requires their funds within the next few years for other purposes, such as to retire or buy a house, is considered to have a short-term investment horizon. Such an investor wants a high degree of certainty as to the amount of money that will be available in the near future and would therefore take a more risk-averse approach. They would choose assets where the likelihood of a negative return is minimal. Comparison of returns
Absolute return Absolute return is simply the raw return number, usually presented as an annualised compound return. Often investors will compare this return with returns offered by alternative investments, such as their risk-free bank account. When doing this it is important to bear in mind the long term expectation. For example, an equity fund might provide a very low return (could be negative) over a one-year period; however, over a long period it could be expected to outperform a bank account.
Relative returns In determining whether a return is reasonable it is common practice to compare it to a suitable benchmark. For example, if an investor in an Australian equities trust receives a gross return of 1% for a period, could that be considered a reasonable return? If the S&P/ASX 200 Accumulation Index produced a –10% movement for the same period, certainly the fund manager would argue that they had clearly outperformed the market, and therefore return is reasonable. © Kaplan Education 6.14 Generic Knowledge: The Finance Industry (910) In this example, the ability of the investor to accept the return as reasonable is largely dependent on the individual understanding the volatile nature of that market and on realising that although it is only 1%, it is well above the benchmark. Fund managers use a range of ‘benchmarks’ against which to measure performance.
Industry comparisons A common practice has been the comparison of the fund’s performance with that of other funds in the market, or sometimes an average investment return of other managers. However, there are problems with this approach: • The use of other fund managers might not provide relevant points of comparison for the investor’s fund if the investment objectives are different. • Given that the risk levels of any two funds are rarely ever the same, performance evaluation is not valid without some form of risk adjustment. In simple terms, because you would expect higher levels of risk to equate to higher levels of return, an adjustment should be made for risk in measuring performance. 4.2 Investment risk
What is risk?
Risk of investments relates to the variability of income returns, capital returns and the combined result from income and capital movements. In this context, risk is the extent to which investment results might vary from expected returns. Most investors focus on downside risk, i.e. the risk that the income earnings or the capital movements will be lower than expected. Investments that at times produce good returns can at other times produce extremely poor results. Responsible financial advisers spend much time evaluating the risk element associated with a particular investment. It is important that the risks associated with a particular investment are clearly understood. Measures of risk
The most widely used measure of risk in the investment business is the ‘variance’, or its square root, ‘the standard deviation’. This is a measure of the probability distribution that the actual return will equal the expected return. If an investor is asked what return they might expect from a new investment, they might reply either with a point estimate, say 10%, or qualify their response by giving a range, say as low as –10% and as high as +20%. The point is the larger the range of possible returns, the more uncertain the investor is regarding the actual return, and therefore the greater the risk. It is possible to determine how certain an investor is regarding the expected rate of return on an investment by analysing the probability distribution of expected returns. A probability distribution is a term in statistics means simply that the range of ‘possible’ returns and assigns a probability to each of them (from zero (no chance) to one (complete certainty)). The tricky part is that the probabilities are subjective estimates that are made by the investor (i.e. forecasts) or are based on past history. 910.SM1.5 Unit 6: Investment concepts 6.15 But dispersion measures of risk such as variance and standard deviation have not been completely satisfactory. If volatility resulted from happy surprises (i.e. outcomes turning out better than expected), would investors really call that risk? Downside risk is the risk that returns will fall below a certain level, e.g. the expected inflation rate or benchmark. From a portfolio viewpoint, one can minimise downside risk by investing only in cash, which is a risk-free security. Through the use of derivatives, downside risk can also be minimised, especially through the use of options. However, this is not free of risk and is achieved by sacrificing some of the upside. Another common measure of risk used in portfolio management is ‘tracking error.’ Tracking error provides a measure of the active risk a manager takes, where active risk is defined as deviating from the benchmark. Types of investment risk
Basically there are three types of investment risk: • General market risk: relates to the overall risk to a broad range of investments, i.e. equity market. • Market sector risk: relates to a particular sector of a market, for example that industrial stocks will perform better than resource stocks, or that retail property will perform better than central business district office space. • Stock specific risk: relates to the performance of a particular security in an investment portfolio. Total asset risk can be subdivided into diversifiable and non-diversifiable risk. We often call non-diversifiable risk ‘systematic risk’ or ‘general risk’.
Can we control investment risk? General market risk cannot be controlled, short of reducing exposure to the market or opting out of the market totally. However, by investing in a diversified portfolio with a long-term horizon, risk can be minimised. Market sector risk can be managed by diversifying across multiple sectors. The specific risk that one investment will not perform over another can be minimised by diversifying the securities in the portfolio by careful investigation of securities prior to purchase. This process requires expertise and is time-consuming. The contribution of portfolio risk from the asset — specific risks might be reduced as the number of assets in the portfolio is increased. © Kaplan Education 6.16 Generic Knowledge: The Finance Industry (910) Risk premium
A risk-free investment is defined as one for which the investor is certain of the amount and timing of the income stream. In the real world, investors can often be unsure of how much income they will receive or when they will receive it. Because most investors do not like such uncertainty (i.e. they are risk-averse to some degree) they will require an additional return from an investment to compensate for uncertainty. This additional required return is known as a risk premium. While the risk premium is a composite of all uncertainty, it is possible to consider several main sources of risk premium: • business risk or specific risk • financial risk • liquidity risk. Business risk (or specific risk) is the uncertainty of income flows caused by the nature of a firm’s business. A government bond has no uncertainty of income, but a small gold exploration company has a large range of possible returns from going broke to having a very large income. Financial risk is the uncertainty introduced by the method of financing an investment. If a firm uses debt to help finance an investment, it introduces financing charges (i.e. interest) that must be paid prior to paying the shareholders. Thus the uncertainty of returns increases and causes investors to increase their risk premium. Liquidity risk is the uncertainty introduced by the secondary market for an investment. If an investor wishes to liquidate an investment, two uncertainties arise. First, how long will it take to liquidate and, second, what price will be received? The ability to buy or sell an investment quickly without a substantial price concession is known as liquidity. The less liquid an investment, the greater the risk premium required to compensate. For example, cash is highly liquid (although it depends on the currency involved) and carries no risk premium. Property, however, carries a higher risk premium since it can take a long time to liquidate, during which time markets might move. 4.3 Diversification
Diversification of assets is the main way managed funds reduce risk. In other words, promoters of managed funds do not put their investors’ nest eggs all in one basket! Managed funds are able to diversify their investments by: • choosing a range of asset classes, e.g. Australian and international shares, Australian and international fixed interest, property and cash • choosing a wide range of sub-classes within asset classes, such as small and large company shares, resource and industrial shares, property investments across office, retail and industrial in different geographic locations • selecting a range of investment managers with different investment styles, e.g. value or growth managers in Australian equities. Diversification reduces risk because it is unlikely that all the asset classes will perform badly at the same time, so returns are likely to be more stable (less volatile) from year to year. In this section we discuss the issues related to achieving diversification at the asset allocation level. 910.SM1.5 Unit 6: Investment concepts 6.17 Correlation between asset classes
Diversification as a means of reducing overall portfolio risk is a basic tenet of financial theory. Correlation identifies the extent to which two asset sectors are related (see Table 2). If two asset classes are positively correlated, they will react in a similar way to particular events or information. The best diversifiers are assets that are negatively correlated (so that if one asset class declines the negatively correlated assets increase in value). The higher the degree of negative correlation, the better the diversification for the portfolio.
Table 2 Correlations — ten years to July 2005
Aus bonds Aus property trusts Aus direct property Aus equity Int equity Aus cash Aus cash Aus bonds Int bonds Aus property trusts Aus direct property Aus equity Int equity 1.00 0.205 0.352 0.006 0.199 0.069 0.142 Int bonds 1.00 0.434 0.387 –0.026 0.360 0.024 1.00 0.023 –0.080 –0.073 0.172 1.00 0.065 0.612 0.245 1.00 0.084 –0.025 1.00 0.325 1.00 Source: Dimensional Fund Advisors Inc. The causation links between equities, bonds and property mean that holding a mixture of these assets reduces the risk of specific economic scenarios negatively affecting asset values. For example, a rise in inflation, while reducing the attractiveness of bonds, might increase the attractiveness of equity or property, or at least reduce their attractiveness by less. Moreover, the degree of price movement in different asset classes will differ, even though all asset classes respond to the same external event and in the same direction. Responses both in different directions, and in the same direction but to differing extents mean that a portfolio with diversified asset classes will have reduced risk. © Kaplan Education 6.18 Generic Knowledge: The Finance Industry (910) 4.4 Modern portfolio theory
Investment theory plays two roles in the life of a portfolio manager. First, it can provide a self-consistent framework for decision making and, second, it can provide a language for communicating expectations to interested parties, such as clients, consultants and internal management. In this section we will very briefly cover the fundamentals of modern portfolio theory (MPT). Since the 1950s, three related theories of portfolio management have been developed, which tend all to go under the generic title of modern portfolio theory. These are known as modern portfolio theory, capital asset pricing model (CAPM) and arbitrage pricing theory. The first of these, and the theory we will briefly explore, was established by Harry Markowitz in a doctoral thesis in 1952. Essentially Markowitz’ contribution to investment theory was to reformulate the question being asked by portfolio managers in a way that allowed them to view risk in a portfolio context. Until Markowitz, analysts would penalise the attractiveness of an investment by applying a heavier discount to risky securities, but they could take no explicit account of the effects of diversification on overall portfolio risk. Along the way, Markowitz also gave portfolio managers a tool to help them compute how much to invest in different securities. Formalising notions of risk
Markowitz framed the portfolio manager’s problem in terms of expected portfolio return and expected portfolio risk. In Markowitz’ model, portfolio managers and their clients can be characterised by preferring: • higher expected portfolio returns to lower returns • lower expected portfolio risk to higher risk. The concept of expected portfolio return is a simple one; it is simply the weighted average of the expected return for each security in the portfolio, where the weights are the weights in the portfolio. Note that Markowitz had nothing to say about how analysts would go about forecasting expected returns. His framework just gave analysts something to do with the expected returns when they had formulated them. The concept of risk is more complicated. Markowitz saw risk in investment in terms of uncertainty. If the outcome of an investment was certain, the portfolio manager would identify the stock with the highest expected return and place the entire portfolio in that stock. He argued that what made investment more interesting was that the actual return from any investment was uncertain ex ante (i.e. before the event). Therefore, while the expected return was the best estimate of that return, any analysis of the strategy must consider the likelihood that the estimate was wrong. 910.SM1.5 Unit 6: Investment concepts 6.19 Applications of modern portfolio theory
Modern portfolio theory has proved to be a useful way for investors to think about investment. However, its shortcomings have limited its application. There are two areas where modern portfolio theory and its offshoots continue to be seen frequently: in asset allocation decisions and in thinking about the active risk of a portfolio.
Asset allocation There are probably two reasons for mean/variance analysis (i.e. modern portfolio theory) continuing to be used in asset allocation decision making: • By definition it is a decision where the number of inputs is lower than is the case where each security is individually considered. This reduces the size of the calculation and reduces the problem of estimation error. • Asset allocation decisions are often (though not always) longer term decisions than those pertaining to individual securities. As such, it is sometimes argued that the actual outcome is more likely to approximate the estimates of expected return (i.e. the risk). This, in fact, confuses the nature of the inputs; the ‘risk’ estimate is supposed to measure uncertainty (an estimate made, by definition, ex ante or before the event) not volatility (which can only be observed ex post, i.e. after the event).
Tracking error Investors often impose constraints on the level of active risk that a portfolio manager can take in managing the portfolio of securities. In many cases active risk is characterised as tracking error. This is particularly common for portfolios invested in Australian equities and international equities but is sometimes used for portfolios invested in other asset classes as well. Tracking error is defined as the standard deviation of excess returns, where excess return is defined as the return of the portfolio less the return on the benchmark over the same period. As with calculations of risks in total return space, risks in relative return space have to consider not just individual risk (tracking error in this case) but the correlation of the excess returns. Actual tracking errors can be calculated based on the actual historical excess returns (this is often referred to as ex-post tracking error). In addition, risk models exist that can provide a forecast for the tracking error of a given portfolio relative to its benchmark (this is called ex-ante tracking error). In both cases the tracking error provides a measure of the dispersion of results around the excess return (actual dispersion in the case of ex-post and forecast dispersion in the case of ex-ante tracking error).
Information ratio In relation to the investment process, the information ratio is the ratio of the excess return arising from an investment activity with the standard deviation resulting from that investment activity. It is a measure of the reward (excess return) per unit of risk taken. As with tracking error, it can be calculated based on historical information or forecast data. This risk-adjusted performance measure helps an investor compare and evaluate the performance of managers with different levels of risk in their portfolios. All else being equal, a more positive information ratio is preferred. © Kaplan Education 6.20 Generic Knowledge: The Finance Industry (910) 5 In summary
The aim of this unit was to introduce some basic investment concepts in order to aid your understanding of the managed funds industry. First, a few basic investment concepts were discussed, e.g. the idea of investment return. It is important to understand such notions as compound interest and pre- and post-tax returns. Understanding how such factors can affect the returns available to investors is an important step in making investment decisions. This unit also explored the notion of investment risk. Defined as variability of returns, risk is the extent to which returns vary from expectations. Downside risk (i.e. returns lower than expected) is of most concern to investors. The types of risk were defined and ways to control each type were discussed. The concept of diversification was explored. Diversification is essential to portfolio management and is a fundamental part of this subject. Finally, a review of modern portfolio theory was provided. Modern portfolio theory has proved to be a useful way for investors to think about investment. It provides the theoretical constructs that enable investment managers to classify, estimate and control the sources of risk and return, and to select optimal portfolios. 910.SM1.5 7
Overview 7.1 Unit learning outcomes ....................................................................7.1 1 1.1 1.2 2 2.1 2.2 2.3 2.4 2.5 2.6 3 3.1 3.2 4 4.1 4.2 5 5.1 5.2 5.3 5.4 5.5 5.6 6 Principles of taxation 7.2 Who pays tax?........................................................................7.2 When is income tax paid? .......................................................7.2 Components of tax liability 7.3 General tax formula ................................................................7.3 Assessable income ................................................................7.5 Taxable income ......................................................................7.6 Calculation of personal tax liability ...........................................7.6 Tax offsets.............................................................................7.8 The Medicare levy...................................................................7.9 Some other principles of taxation 7.10 Marginal versus average rates ...............................................7.10 Fringe benefits tax ................................................................7.11 Taxation of investments 7.12 Taxation of direct investments ...............................................7.12 Taxation of pooled (managed) investments .............................7.13 Capital gains tax 7.13 What is capital gains tax (CGT)?.............................................7.13 Assets subject to CGT...........................................................7.14 When does CGT apply? .........................................................7.14 How is CGT calculated?.........................................................7.16 How does CGT affect the investor?.........................................7.17 Impact of taxation and inflation..............................................7.17 In summary 7.21 Unit 7: Taxation concepts 7.1 Overview
Taxation plays a critical role in all investment planning and decision making. The high rates of personal income tax in this country have dramatically affected investment strategy in the past and continue to do so. One of the aims of investment advising is to protect an appropriate level of income from tax erosion. This unit focuses on the important factors that affect personal investment. In particular, we look at individual income tax, capital gains tax and the Medicare levy. Unit learning outcomes
On completing this unit, you should be able to: • outline how personal income tax is collected • describe the steps in determining tax payable • calculate taxable income in simple examples • compare marginal tax rates (MTR) with average tax rates • distinguish between tax deductions and tax offsets • calculate the basic Medicare levy • outline how CGT applies to investments • calculate CGT for individual’s investments after October 1999. © Kaplan Education 7.2 Generic Knowledge: The Finance Industry (910) 1
1.1 Principles of taxation
Who pays tax?
Taxpayers include: • resident individuals • non-resident individuals • trusts/trustees • private companies • public companies (listed and unlisted) • superannuation funds • pooled development funds. Different types of taxpayers are often used as investment structures by investors. For example, an investor with a high marginal tax rate (refer section 3.1) might decide to incorporate a company to hold investments. Although the company is owned and controlled by the investor, the company is the taxpayer and accordingly corporate tax rates will apply to the investment’s earnings. Other structures commonly used to hold investments are: • family trusts • superannuation funds (remember that superannuation funds are entities through which investments are held, not investments in themselves.) This unit focuses on the individual taxpayer. 1.2 When is income tax paid?
Income tax is payable on earnings in each tax year, i.e. from 1 July to 30 June. The final amount payable is assessed after an income tax return is lodged. How the income is being received determines when and how the tax payments are actually made. Pay as you go
Most individuals receive net income from their employer after tax has been deducted from their gross salary. However, large investors will often have to pay tax quarterly whereas smaller ones might only choose to do so to manage their cash flow more effectively. Quarterly instalments are based on the previous year’s income less net capital gains; the rate will be notified by the ATO. 910.SM1.5 Unit 7: Taxation concepts 7.3 2
2.1 Components of tax liability
General tax formula
Your income tax is based on your income. This means adding all components of your income. The Australian tax legislation refers to three separate and distinct types of income: exempt income, assessable income and taxable income. The basic idea is that all income — let us call that gross income — should be considered taxable income until proven otherwise. This is true for both business and personal income. However, you might have to spend money to make money (e.g. resources, equipment), so you don’t have to pay tax on the income needed for that. You subtract ‘allowable deductions’ to get your taxable income and any tax payable is calculated on this amount. To work out the tax payable, there are two more steps. You subtract any tax offsets and any tax that has already been paid. This gives the tax payable (or the refund owing) for the taxpayer. For taxpayers (personal and business) the general tax liability formula is calculated using the following terms (see Figure 1): • assessable income • taxable income • tax liability • final tax liability • tax payable = = = = = gross income less exempt income assessable income less allowable deductions taxable income times tax rates tax liability less tax offsets/imputation credits final tax liability less tax already paid (PAYG). © Kaplan Education 7.4 Generic Knowledge: The Finance Industry (910) Figure 1 Calculation of tax payable Gross income Less exempt income Asessable income Less allowable deductions Taxable income Tax liability (Taxable income @ personal (or corporate) tax rates) Less tax offsets/imputation credits Final tax liability Less tax paid (eg. PAYG) Tax payable 910.SM1.5 Unit 7: Taxation concepts 7.5 2.2 Assessable income
Gross income includes: • wages, salaries, fees, commissions and any other earnings for services rendered (even if illegal) • business income • dividends (including imputation credits) • interest • rental income • royalties • capital gains. We will look at capital gains and dividends later. Note: Ignore cents for gross income; do not round up. Foreign income and non-residents
Special rules apply to income earned overseas by Australians and to Australian income earned by non-residents. These areas are outside the scope of this unit. Exempt income
Exempt income refers to those classes of income that, although received as income and otherwise taxable, are listed in the legislation as exempt from income tax. Some examples are: • some government pensions and payments • tax-free/tax-deferred income from trusts (especially property trusts) • many education payments. Exempt income is beyond the scope of this unit. Assessable income
Assessable income = Gross income – Exempt income © Kaplan Education 7.6 Generic Knowledge: The Finance Industry (910) 2.3 Taxable income
The tax legislation defines taxable income as assessable income (as we have just discussed) minus general and specific deductions. Taxable income = Assessable income – Allowable deductions Allowable deductions
In general, costs of earning income are deductible expenses unless the income is exempt. If expenses are considered by the ATO as being for private or domestic use, they are not deductible. Allowable deductions include: • expenses relating to employment, e.g. specialist equipment • expenses in conducting business activities, e.g. rent, purchase of goods • interest relating to income-producing activities, e.g. interest on a loan to buy shares. In addition to the general provisions, the Tax Act contains specific provisions allowing tax deductions for specific costs and outgoings. These include: • tax-related expenses, e.g. accountant’s fees for preparing a tax return • contributions to certain superannuation schemes for employees • gifts to approved public institutions and charities • prior year losses subject to certain restrictions • depreciation on plant or articles used or held for the purpose of producing income. 2.4 Calculation of personal tax liability
Personal income tax is calculated using a progressive scale (for individuals) where higher income is taxed at a higher rate than lower income, or a specified single tax rate (for companies and certain other taxpayers such as trustees of a superannuation fund). Resident taxpayers are charged no tax on the first $6000. This is called the ‘tax-free threshold’. A taxpayer earning $10,000 is only charged tax at the applicable rate on the amount over the first $6000, i.e. 15% of $4000 = $600. As an average rate, this is 6.0% compared with the marginal tax rate of 15%. Different rates may apply for resident individuals, non-resident individuals, minors and trustees. The 2008/09 personal income tax rates for residents is shown below in Table 1.
Table 1 Personal income tax rates ⎯ scale from 1 July 2008
Taxable income $0 – $6000 $6001 – $34,000 $34,001 – $80,000 $80,001 – $180,000 $180,001 and over Nil Nil plus 15 cents for each $1 over $6000 $4200 plus 30 cents for each $1 over $34,000 $18,000 plus 40 cents for each $1 over $80,000 $58,000 plus 45 cents for each $1 over $180,000 Tax rate Note: This scale does not allow for current Medicare levy of 1.5% or low income offset. 910.SM1.5 Unit 7: Taxation concepts 7.7 To calculate the tax liability, find which scale applies, e.g. $37,000 is in the third scale with a marginal tax rate of 30 cents. You are given the tax on the first $34,000 ($4200), and only need to calculate the tax on the balance over $34,000. The following examples do not take into account either the Medicare levy or lowincome tax offset. Example: Taxable income of $37,000
Tax on $34,000 Tax on ($37,000 – $34,000) = = = Total gross tax Tax on $37,000 = = $4200 $3000 × 30% $900 $4200 + $900 $5100 Example: Taxable income of $83,000
Tax on $80,000 Tax ($83,000 – $80,000) = = = Total gross tax Tax on $83,000 = = $18,000 $3000 × 40% $1200 $18,000 + $1200 $19,200 Example: Taxable income of $34,000
A taxpayer earns a salary of $39,500 p.a. She also receives $500 in interest, and is entitled to claim $204 for a seminar, as well as making a deductible donation of $300 to the Smith Family. What is her tax liability? Gross income Assessable income = = = Tax on $34,000 Tax ($39,496 – $34,000) = = = Total gross tax = = $39,500 + $500 = $40,000 $40,000 – $300 – $204 $39,496 $4200 $5496 × 30% $1648.80 $4200 + $1,648.80 $5848.80 Calculations of tax payable do include cents. © Kaplan Education 7.8 Generic Knowledge: The Finance Industry (910) 2.5 Tax offsets
The ATO allows a tax offset rather than a deduction for certain expenditures. Tax offset is the new term for tax rebate. A tax offset is an amount that is subtracted from the tax that would otherwise be payable. Tax offsets can reduce only the income tax payable by a person. They do not reduce the Medicare levy. Tax offsets are available for a variety of situations; the following discussion is limited to dependent tax offsets but also mentions some of the other offsets available. Dependent tax offsets
The underlying concept is that an individual, with no dependants, has full use of their earnings. An individual who has dependants must share that income to cover the dependants. There are four types of dependent tax offsets. The types of offsets available, the maximum offset levels and entitlement thresholds change frequently. You should ensure that you have access to current information. The ATO web site is very useful: <http://www.ato.gov.au>. Types of dependent tax offsets include: • spouse • child–housekeeper • invalid relative • parent. Other tax offsets
Additional personal tax offsets are available including those for: • housekeeper • sole parent • low-income earner • residents in defined remote areas of Australia (‘zone tax offsets’). Of significance for the financial adviser are: • Provisions relating to superannuation contributions. • Dividend imputation tax offset relating to dividends paid by most companies. An investor receives a dividend statement that details the amount of the dividend paid plus the imputation credit, i.e. the company tax that has already been paid. Both are included in the total income but the imputation credit is treated as a tax offset. (Calculation of imputation credits is beyond the scope of this unit but the Australian Taxation Office website has useful further information.) Unused tax offsets are usually lost and cannot be used against the Medicare levy. Unused imputation credits can be refunded. 910.SM1.5 Unit 7: Taxation concepts 7.9 Low-income tax offset
Resident taxpayers with a taxable income below $30,000 p.a. may receive a tax offset of $1200. For taxpayers with annual income above $30,000, the offset begins to phase out, cutting out completely at $60,000. Table 2 outlines the low income tax offset for 2008/09.
Taxable income $0 – $30,000 $30,001 – $60,000 $60,000 + Offset 2008/09 $1200 $1200 – [(taxable income – $30,000) × 4%] Nil Example: Example 1
A taxpayer has a tax liability of $4300 and a spouse tax offset of $280. The tax payable would be $4020. Example: Example 2
A taxpayer receives $40,000 in salary, $990 in dividends and $510 in imputation credits in the2008/2009 tax year. What is the tax payable assuming no other income was received or any allowable deductions apply? (Ignore the Medicare levy.) Assessable income = = Tax liability = = Final tax liability = = $40,000 + $990 + $510 $41,500 $4200 + 30% of ($41,500 – $34,000) $4450 $4450 – $510 $3940 2.6 The Medicare levy
Residents of Australia are liable to pay a Medicare levy. The levy is based on taxable income and is collected with the tax payable. The Medicare levy is 1.5% of taxable income. Example: Medicare levy
A resident individual taxpayer has a taxable income of $37,000 p.a. that includes a taxable capital gain of $8000. If the taxpayer had not made a capital gain, the taxable income would have been only the salary of $29,000. What amount of Medicare levy would the taxpayer pay? Medicare levy = = = Taxable income × Rate of Medicare levy $37,000 × 1.5% $555.00 © Kaplan Education 7.10 Generic Knowledge: The Finance Industry (910) Note: The Medicare levy is calculated on total taxable income (i.e. taxable income including any net capital gain and before any tax offsets). Low-income relief
Income thresholds for application of the levy have been set to give relief to low-income earners. Medicare levy surcharge
In addition to the Medicare levy, there is a 1% surcharge on higher income individuals and families who do not have private patient hospital insurance or where private insurance excess is beyond set limits. The ATO calculates this levy when the individual’s tax return is lodged. In the 2007/08 financial year, this means $50,000 for a single taxpayer and $100,000 or greater for a family (the level rises if there are two or more dependent children). 3
3.1 Some other principles of taxation
Marginal v average rates
You must distinguish between the two names used for tax rates: • the marginal rate is the rate applying to each additional $1.00 of income • the average rate is the percentage of tax paid as a proportion of total taxable income. Investors often try to reduce income assessable at the marginal rate by converting assets so they do not generate as much income. It is important not to become overly obsessed with a high marginal rate (which might only apply to a small proportion of overall income), but to concentrate on the overall tax liability. Example: Marginal v average rates
What will be the tax payable on an annual income of $41,000? What is the average rate of tax? What is the marginal rate? The marginal rate of tax is the easiest to calculate — just look at the tax scale. The marginal rate is 30%. The total tax is $4200 + 30% of $(41,000–34,000) = The average rate is
$6300 × 100 $41,000 $6300. 15% = 910.SM1.5 Unit 7: Taxation concepts 7.11 Effect of tax-free threshold
The tax-free threshold (currently $6000) for lower income earners means that they pay an average tax rate lower than their marginal tax rate. Example: Effect of tax-free threshold
Consider a taxpayer earning $18,000 p.a. Tax-free threshold Assessable income Income taxed at first tax bracket rate of 15% Tax liability Average tax rate (i.e. Marginal rate
$1800 × 100) $18,000 $6000 $18,000 $12,000 $1800 10% 15% 3.2 Fringe benefits tax
Employers, not individuals, pay fringe benefits tax. It is important from a financial planning perspective as it has implications for salary packaging. The Fringe Benefits Tax Assessment Act (Cth) (FBT) became effective on 1 July 1986 and created tax provisions separate from the Income Tax Assessment Act. Since 1 April 1999, the grossed up value of fringe benefits provided to employees must be disclosed on their group certificates. The effect has been to increase employee liability to items such as income-tested surcharge and reduce income-tested concessions. Some of the benefits that attract FBT are: • motor vehicles • low interest loans • entertainment • club fees • car parking. © Kaplan Education 7.12 Generic Knowledge: The Finance Industry (910) 4 Taxation of investments
When you are selecting investment products for your clients, you must be aware of the tax implications. Advisers must exercise caution in advising clients in the area of tax planning as the taxation legislation is vast, complex and continually changing. Advisers should direct clients to an accountant for detailed advice. 4.1 Taxation of direct investments
Financial advisers need to be aware of the basics of taxation of investment products. Direct investments pay income to individual (or corporate) owners. The owners are then required to include this income in their tax assessment. Products that pay out income-only distributions include: • savings, or other bank accounts • fixed interest investments, such as debentures • shares • rental properties. Savings and fixed interest
Interest received from savings accounts and fixed interest investments is assessable income. Where fixed interest holdings are traded, there is also the possibility of gains (or losses). Such gains are usually treated as income for taxation purposes. The interest accruing on discounted and deferred interest securities (like the DINGO bonds) is taxable to the investor each year. Shares
Shares usually pay an income distribution (called a dividend). Depending on the type of company, and the company’s own taxation, these distributions might come with ‘franking credits’. A franked dividend is not exempt from tax. It has an imputation credit equivalent to the company tax paid. This credit might be enough to avoid any tax due by the recipient. When shares are traded, the individual might incur a liability for a capital gain, or use/carry forward a capital loss to offset other capital gains. Property
Property investments usually pay rental income. Upon sale, the owner might incur a capital gain or a loss, which will be treated under the capital gains tax provisions. 910.SM1.5 Unit 7: Taxation concepts 7.13 4.2 Taxation of pooled (managed) investments
Unit trusts do not attract income tax, provided the income of the trust is distributed in full to unit holders every year. Unit trusts are ‘pass through’ structures. Dividends, distributions, interest and capital gains are passed through to the unit holders in periodic distributions. (The manager takes out certain fees and costs prior to making the distribution.) There are some circumstances where a unit trust will pay out a return of capital. Franking credits and other tax benefits that are attached to the underlying asset returns are also passed on to the unit holder. While the distributions might be paid quarterly or every six months, the manager is required to send unit holders an annual statement of their holdings and the composition of the distributions. Insurance bonds
Insurance bonds, unlike unit trusts, pay tax within their structure. There might be tax efficiencies for clients in investing in insurance bonds. Insurance bonds, redeemed after 10 years, are tax-paid in the hands of the investor, although a proposal to abolish their tax-paid status is still to be implemented through legislation. 5
5.1 Capital gains tax
What is capital gains tax (CGT)?
The taxation of capital gains means that a taxpayer’s assessable income includes gains from selling assets. The taxation of capital gains applies to all assets, with limited exceptions, that have been acquired after 19 September 1985 by an Australian resident or a non-resident who holds taxable Australian assets. Any capital gain on assets bought and sold within 12 months must be included in the taxpayer’s assessable income. The legislation also recognises capital losses, which, as a general rule, may be carried forward indefinitely against current or future capital gains. A capital loss is non-deductible against trading or other income. A capital gain may be offset against trading losses and against losses from negatively geared real property investments. A revised method of calculating the tax applies for assets acquired after 21 September 1999 (see below). © Kaplan Education 7.14 Generic Knowledge: The Finance Industry (910) 5.2 Assets subject to CGT
A CGT asset is defined as ‘any kind of property, or a legal or equitable right that is not property’. Examples include: • land and buildings • shares in companies and units in unit trusts • options • debts owed to a taxpayer • a right to enforce a contractual obligation • foreign currency. Other assets specifically included are: • goodwill • an interest in the asset of a partnership • capital expenditure on acquisition, including purchasing cost and improvements, is included in the asset cost base, as well as costs incurred on disposal. Assets purchased before 20 September 1985 are exempt from CGT. A person’s main residence is also an important exemption. For CGT purposes, assets are divided into: • collectables • personal-use assets • other assets. For the purpose of this unit, we will focus on capital gains made on investments. Tax advice should be sought for details of taxation of other capital gains. 5.3 When does CGT apply?
The legislation takes you through a series of steps to determine your CGT liability. • Step 1: Have you made a capital gain or a capital loss? • Step 2: Work out the amount of the capital gain or loss. • Step 3: Work out your net capital gain or loss for the income year. Under the old CGT provisions, a capital gains tax liability normally arose if there was disposal or change of ownership in an asset. Revised provisions in s 100–20(1) state that you can make a capital gain or loss only if a CGT event happens. A CGT event is defined in s 104–5. Most CGT events involve a CGT asset, which is defined in Division 108. Once a CGT event has been identified, you need to know if there is an exception or exemption that would reduce the capital gain or loss. 910.SM1.5 Unit 7: Taxation concepts 7.15 The exceptions are contained in Division 104 and the exemptions are in Division 118. A further exemption is the rollover provisions, which are contained in ss 112–115 and 112–150. Division 104 sets out all the CGT events for which you can make a capital gain or loss. It tells you how to work out if you have made a gain or loss from each event and the time of each event. It also contains exceptions for gains and losses for many events (such as the exception for CGT assets acquired before 20 September 1985) and some cost base adjustment rules. You should be aware of where to find the listed events and exemptions in case you need to decide whether to get further professional advice. Disposal
You dispose of a CGT asset if a change of ownership occurs from you to another entity. The most common disposal is by selling the asset. A change of ownership does not occur if you stop being the legal owner but continue to be its beneficial owner (i.e. the person who enjoys or is entitled to the benefit of the assets). It also does not occur because of a change of trustee. A disposal will occur for CGT purposes where there has been an entire loss or destruction of an asset. However, neither the death of an asset holder nor the transfer of property from the deceased’s personal representative to a beneficiary will give rise to a CGT event. The compulsory acquisition of an asset is deemed to be a disposal although, as is the case with assets lost or destroyed, there are provisions to defer the CGT. Contract date
The timing of the event is when you enter into the contract for the disposal or, if there is no contract, when the change of ownership occurs. Example: Contract date
In June 2008 you entered into a contract to sell land. The contract is to be settled in October 2008. You have made a capital gain of $50,000. In which tax year did you make the capital gain? The correct answer is that the gain was made in the 2007/08 tax year, i.e. when you entered into the contract and not when you settled the contract. If the contract falls through because of failure by the other party to complete it, there is no disposal as no change of ownership took place. What about capital losses?
Capital losses realised on assets (other than personal-use and specifically exempted assets) will be available to be offset against current year capital gains on other assets. Alternatively, the losses may be carried forward indefinitely and be offset against capital gains realised in subsequent years. Other important points are: • losses on personal-use assets are ignored in working out a net capital gain or loss • losses on collectable assets are only deductible against gains realised on other collectable assets • ordinary income tax deductible losses may be offset against realised capital gains.
© Kaplan Education 7.16 Generic Knowledge: The Finance Industry (910) Can CGT be deferred?
CGT can be deferred in certain situations involving changes in the ownership of business assets. A deferral of CGT is called a rollover and applies in the following situations: • business reorganisation where beneficial ownership is maintained • the transfer of assets between spouses pursuant to a Family Court order • involuntary disposals such as compulsory acquisition, theft or destruction • death. 5.4 How is CGT calculated?
There are two methods for calculating capital gains. The indexation method can apply for assets purchased before 21 September 1999 and makes allowance for the effects of inflation. Effectively, the real gain was taxed at full marginal tax rates. Calculation using this method is beyond the scope of this unit. Under the current rules there is a 50% discount for capital gains on assets acquired after 21 September 1999 and held for more than a year. This means that there will be an effective top rate of 23.25% (half of 45% plus Medicare levy 1.5%). For superannuation funds, two-thirds of the realised capital gain will be treated as assessable income, equating to a 10% rate on the total actual gain. Example: CGT
Shares are purchased for $4000 on 2 October 2007 and sold on 1 April 2008 for $4500. The assessable gain will be $500, as they were not held for a year. If the same shares are held until 2 November 2008 and sold for $4800, the assessable gain of $800 is discounted to $400. Assets purchased before 21 September 1999
When assets purchased before 21 September 1999 are sold after 1 October 1999 the taxable gain will be the difference between the sale price and the cost, adjusted for inflation between the time of purchase and 30 September 1999. Indexation is frozen at the September quarter 1999. Individuals may then choose either to include this entire amount in the assessable income or to include half the nominal gain, i.e. making no adjustment for inflation. 910.SM1.5 Unit 7: Taxation concepts 7.17 5.5 How does CGT affect the investor?
The investor should remember that CGT applies to investments that counter the effects of inflation. CGT should not be viewed as a deterrent to earning capital gains, just as income tax is not a deterrent to earning income. Capital gains are taxed favourably compared with income, as CGT is levied on only half the gain (or only on the portion of gain that is not caused by inflation under the old rules). The effect of CGT can be minimised by timing the realisation of investments, so that the gains are taken when income is low. The dividend imputation system allows for excess imputation credits to be offset against tax payable on non-dividend income. Therefore, taxpayers should be able to utilise excess credits against tax payable on assessable capital gains. Investors should also note: • ordinary income tax deductible losses may be offset against realised capital gains although the converse is not the case, i.e. capital losses are not deductible from trading or other income • losses incurred from the negative gearing of real property investments may be offset against capital gains realised from their disposal. The implementation of CGT introduces some complications for the investor and advice should be sought in relation to trusts in general and property trusts in particular. 5.6 Impact of taxation and inflation
Consider an individual earning 6.5% p.a. interest who pays the maximum marginal tax rate of 45%. Assume inflation is running at 3.5% p.a. % Gross return less inflation less tax at 45% on 6.2% p.a. Equals effective return Note: This excludes the Medicare levy. In this climate the investor would have to earn a return of over 6.3% p.a. just to break even (i.e. make back the costs including taxation). Consider an example of interest paid on $5000 with the rates shown above. Interest = 6.2% of $5000 3.5% of $5000 = $310 = $175 $135 less tax at 45% on $325 Equals effective return $140 –$5 i.e. a real loss. less cost of inflation = 6.2 3.5 2.7 2.8 –0.1 © Kaplan Education 7.18 Generic Knowledge: The Finance Industry (910) Clearly, a combination of inflation and tax can eat up the gain. Taxation can have a dramatic effect on the real (after inflation) net (after tax) return on an investment. One of the major traps for investors considering their options is to ignore the impact of tax. Who pays the tax?
Broadly speaking, investments can be divided into two categories: • those on which tax is paid before the interest or income is credited to the investor and which are assessed again when redeemed by the individual investor • those that pay a gross return to the investor, who is then required to pay tax on the assessable portion of the return. In the case of the former, tax is paid by the fund at a fixed rate that might be reduced by certain tax credits such as franking credits. In the latter case, taxes on the assessable part of income and gains received from the second category are paid by the investor at the investor’s marginal tax rate. Who benefits most?
These differences can introduce arbitrages or inefficiencies into the after-tax return received by the investor. For example, an investor on the top marginal tax rate might pay less tax, and therefore receive a higher net return from an investment in a ‘tax-paid’ vehicle than would have been the case if the same investment had been made in a ‘distributing’, (i.e. category 2) option. Alternatively, an investor on a low marginal rate could be disadvantaged by investing in a tax-paid vehicle because more tax could be paid than would otherwise be payable, thus reducing the after-tax return. When comparing returns from various investments, it is necessary first to determine whether it is a tax-paid or pre-tax return. 910.SM1.5 Unit 7: Taxation concepts 7.19 Example: Marginal tax rate (MTR)
For example, take the case of an investor who has the choice of investing in fixed interest securities through: • an insurance bond offering a return of 6% (tax-paid by fund), or • a unit trust offering a return of 10% (tax-paid by investor). Which is the more attractive investment return assuming the investment is held for at least 10 years? (Note: This application assumes issuer risk and fees are identical and ignores Medicare.) The first point to note is that these returns are not comparable at the moment because one is pre-tax and the other is after-tax. To make a comparison, the unit trust rate must be adjusted for tax in the hands of the investor, so that it is converted from pre-tax to an after-tax rate of return, i.e. the net return. The formula for this adjustment is: Adjusted unit trust rate = Pre-tax rate of return × (1 – tax rate) In this case, the tax rate is the marginal tax rate (MTR) of the investor.
MTR Adjusted unit trust rate = = = = 45% 10% × (1 – 45%) 10% × 55% 5.5% (after tax) MTR Adjusted unit trust rate = = = = 15% 10% × (1 – 15%) 10% × 85% 8.5% So, in this case the insurance bond (tax-paid) option offers the more attractive return for a top marginal rate taxpayer (45%), as 6% after-tax is greater than 5.5%. For an investor whose marginal tax rate is 15%, the unit trust offers the more attractive return, as 8.5% (after-tax rate of return) is greater than the 6% return from the insurance bond. So far in this discussion we have limited the investment to ‘non-growth’ assets, such as interest-bearing securities and cash (liquids). The reason for this is that the investment earnings on these assets are fully taxable, making illustration of these concepts easier. However, the point must be made that most growth assets receive some form of favourable tax treatment, which results in less tax being paid on ‘income’. These ‘tax breaks’ might include imputation credits, short- and long-term capital gains tax, building allowances and plant and equipment depreciation. The result is that the net return will often be greater for growth assets when compared with interest-bearing securities, assuming the same gross return. To summarise, it is essential when comparing investment returns to adjust for the effects of taxation to ensure you have an equitable basis for comparison. It is also essential that investment returns be assessed in the context of the effect of inflation. Failure to do so might lead to the creation of a ‘financial mirage’ implying greater wealth than is actually the case. To illustrate, the combined effect of inflation over time reduced the value of the equivalent of $1 in 1960 to 11 cents in 2000. Put another way, the value of $1 invested in 1960 needed to increase to almost $9.00 by 2001 just to maintain its spending power in current dollars. © Kaplan Education 7.20 Generic Knowledge: The Finance Industry (910) For example, given an inflation rate of 4% p.a., an investor on the 30% marginal tax scale would need to achieve a gross return of 5.7% just to maintain the real spending value of the capital. As we noted earlier, recognition of the need to provide a hedge against inflation is one of the primary reasons people choose to invest. However, failure to adjust expected returns for the effect of inflation can lead to us deluding ourselves about the ‘real’ future value of our savings. The challenge of a low inflation environment
Low levels of inflation provide an interesting challenge for investors, that of, how to maintain overall returns in the absence of the main driving force behind higher investment returns. The use of monetary policy to fight inflationary trends creates high interest rates, which provide high levels of income to investors who have ‘lent’ their capital back to the financial system. The keys to adjusting to investment in a low inflation environment are: • not to be tempted into higher risk investments to ‘make up’ the income shortfall • to understand the difference between nominal and real rates of return. Investors in need of income are concerned with the lost purchasing power caused by inflation. If inflation is halved there is no corresponding drop in the cost of their groceries, electricity, etc. They still have the same current costs of living and, in the short term, their purchasing power has been dramatically reduced. For example, if rates of return reduce from 14% p.a. to 7% p.a., investors receive only 50% of the income that they had been living on previously. This concept is illustrated in Table 3.
Table 3 Amount of income after tax from a capital investment of $10,000
Tax rate Nil $1,400 $700 Tax rate 15% $1,190 $595 Tax rate 30% $980 $490 Tax rate 45% $770 $385 Nominal interest rate % p.a. 14.00 7.00 Source: The Paul Resnik Consulting Group. For investors concerned with capital growth now for future income, a reduction in inflation is beneficial. As can be seen in Table 4, the actual real rate of return to the investor is higher when nominal interest rates are 7% and inflation is 2% than when they are 14% and 9% respectively. The reason for this is that less tax is payable. Remember that tax is calculated on the gross return despite the level of inflation, i.e. on an investment of $10,000 with a 14% return ($1400), tax would be $630 (tax rate of 45%). Inflation would then apply. This compares with a return of 7% ($700), which would have a tax liability of $315 (tax rate 45%).
Table 4 Real rate of return after tax and inflation
Tax rate Nil % p.a. 5.00 5.00 Tax rate 15% p.a. 2.90 3.95 Tax rate 30% p.a. 0.80 2.90 Tax rate 45% p.a. –1.3 1.85 Nominal interest rate % p.a. 14% with 9% inflation 7% with 2% inflation Source: The Paul Resnik Consulting Group. 910.SM1.5 Unit 7: Taxation concepts 7.21 6 In summary
In this unit we have looked at the principles of taxation and seen that because of the ‘social contract’ the government at all levels can ask the people for money in a regimented way. In looking at how the assessment and calculation operates we have seen difficulties in language (‘marginal’ or ‘average’ rate of tax) and calculation. Considerations for advisers include the tax effects of income, of disposal and even of tax packaging. This unit also looked at how inflation affects long-term investment returns, as well as some of the challenges and opportunities that a high inflation environment presents. These are an important part of the investment decision process. © Kaplan Education 7.22 Generic Knowledge: The Finance Industry (910) Notes 910.SM1.5 ...
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This note was uploaded on 10/10/2010 for the course ECON 7300 at University of Sydney.