FNCE20003 Lecture 5: Passive Management Styles

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Questions and Answers

What is a key characteristic of actively managing an equities portfolio?

Buy and hold strategy for equities

Investing in cash deposits

Continually buying and selling shares (correct)

Selecting bonds for long-term holding

What determines how the equities team will specifically invest the allocated funds?

The geographic location of the equity investments

The past performance of previous investments only

The company's market capitalization

The risk profile of the fund and regulatory restrictions (correct)

Which of the following best describes a bond?

A short-term cash deposit earning interest

A contract evidencing the issuer's obligation to make future cash payments (correct)

An investment that is always backed by physical assets

An equity security with variable returns

Which statement about coupon-paying bonds is correct?

They provide regular fixed payments of interest Signup and view all the answers

What is the defining feature of zero-coupon bonds?

They pay only the principal upon maturity with no interest Signup and view all the answers

What percentage of portfolio return is attributed to asset allocation according to empirical studies?

90% Signup and view all the answers

What is the primary objective of strategic asset allocation (SAA)?

To set target allocations among asset classes Signup and view all the answers

Tactical asset allocation (TAA) is best characterized by which of the following?

An approach based on mispriced asset classes Signup and view all the answers

How do most managers typically respond to their strategic asset allocation targets over time?

They periodically rebalance their portfolio back to those targets Signup and view all the answers

Which strategy involves attempting to outperform a passive benchmark through market timing?

Tactical asset allocation (TAA) Signup and view all the answers

Dynamic asset allocation (DAA) can refer to which of the following practices?

Periodic rebalancing of portfolio weights under SAA and TAA Signup and view all the answers

What is a significant challenge faced by managers implementing tactical asset allocation?

Poor performance in market timing Signup and view all the answers

Which of the following best defines the term ‘dynamic asset allocation’ as used by some investors?

An approach to replicate return distributions and manage risks Signup and view all the answers

What are characteristics of government bonds in the Australian bond market?

Low default risk Signup and view all the answers

Which type of bond is primarily associated with a higher default risk?

Corporate bonds Signup and view all the answers

What is the approximate value of non-government bonds outstanding in the Australian market?

$1.4 trillion Signup and view all the answers

Why do many corporate bond issues obtain a credit rating?

To enhance creditworthiness Signup and view all the answers

What is a significant challenge for small investors in bond investments?

Need for a large sum to invest Signup and view all the answers

What are zero-coupon bonds primarily characterized by?

Payments made only at maturity without periodic interest Signup and view all the answers

Which factor is NOT critical for the valuation of coupon-paying bonds?

Bond color Signup and view all the answers

How is the effective interest of a zero-coupon bond determined?

By taking the difference between face value and purchase price Signup and view all the answers

What does a basis point represent?

0.01 of 1% Signup and view all the answers

If a bond has a quoted coupon rate of 7.75% payable half-yearly, what is the amount of each coupon payment for a par value of $100,000?

$3,850 Signup and view all the answers

What is an advantage of investing in international equities?

Increased potential for diversification Signup and view all the answers

Why might the coupon rate not equal the market interest rate?

Both B and C are correct Signup and view all the answers

Which method of stock selection is aligned with portfolio theory?

Random selection Signup and view all the answers

What determines the timing of coupon payments on bonds?

Frequency can vary but is often semi-annual Signup and view all the answers

What are commercial bills, as related to zero-coupon bonds?

Short-term securities backed by bank guarantees Signup and view all the answers

What potential reward is offered for participating in the Share Price Forecasting game?

Up to 2% bonus marks Signup and view all the answers

When is the submission period for the Share Price Forecasting game?

August 21 to August 23 Signup and view all the answers

What are the two main recognized methods for selecting specific stocks from available equities?

Fundamental and technical analysis Signup and view all the answers

How is an individual’s taxable income determined in relation to their gross salary?

It is the gross salary decreased by mandatory superannuation contributions. Signup and view all the answers

What is the maximum tax reduction an individual can receive under the Low Income Tax Offset (LITO) for income up to $37,500?

$700 Signup and view all the answers

What threshold must an individual exceed to start paying income tax?

$18,200 Signup and view all the answers

What is the effect of a franked dividend on an individual’s income tax calculation?

It compensates for tax already paid at the corporate level. Signup and view all the answers

Which of the following financial considerations relates to home ownership?

Rent v buy decision Signup and view all the answers

In the context of taxable income, what does the term 'retained' refer to?

The net income remaining after deductions and tax payments. Signup and view all the answers

What is the taxable income of the individual who earned a gross salary of $125,000 and had $1,800 in deductions?

$112,075 Signup and view all the answers

What is the first step in calculating the tax payable on the taxable income of $112,075?

Apply the standard tax rates to determine the base tax liability. Signup and view all the answers

What primarily drives the movement in individual company share prices?

General market 'drag' and new information Signup and view all the answers

Which stock selection method is consistent with portfolio theory and promotes diversification?

Random selection Signup and view all the answers

What interpretation can investors take from new information released in the market?

Investors can interpret it as good news, bad news, or no news Signup and view all the answers

Which method in stock selection is commonly used by professional investment advisers?

Fundamental analysis Signup and view all the answers

In what form has the efficient market hypothesis (EMH) been demonstrated to hold well in practice?

Semi-strong form Signup and view all the answers

What is typically examined in fundamental analysis?

Available company data such as financial statements Signup and view all the answers

What can be a consequence of herd mentality in stock investing?

Exaggerates stock price movements Signup and view all the answers

What is a primary reason for the formation of an extensive stock selection services industry?

The complexity of fundamental and technical analysis Signup and view all the answers

What is the typical role of brokers in equity transactions?

Providing research and executing trades Signup and view all the answers

What is the most common form of documentation to evidence the purchase of shares?

Contract Note Signup and view all the answers

Which factor is least likely to influence an investor's decision on investment strategy?

Seasonal market trends Signup and view all the answers

What is the main purpose of conducting company and sector research in the context of investing?

To inform buy/sell/hold decisions Signup and view all the answers

Which of the following is typically the most expensive form of transaction related to shareholding?

Company and sector advice Signup and view all the answers

What document is used to specify a shareholder's identification and shares held in a company?

Holding Statement Signup and view all the answers

Which investment technique focuses on financial analysis and company fundamentals?

Fundamentals Signup and view all the answers

Which of the following choices is NOT a common method used to start investing in shares?

Selecting random stocks without research Signup and view all the answers

What is the impact of holding an asset for more than one year in relation to capital gains tax?

A 50% discount on the taxable gain is applied. Signup and view all the answers

How is the taxable income calculated from capital gains when shares are sold at a profit?

Selling price minus purchase price minus any capital losses. Signup and view all the answers

What does the dividend imputation system primarily ensure for the recipient shareholder?

Taxable income from dividends is grossed up by prior corporate tax paid. Signup and view all the answers

What tax implication arises when a shareholder receives franking credits?

They reduce the individual's tax on the grossed-up dividend amount. Signup and view all the answers

What would be the assessable income if 600 WBC shares were sold for a profit when the asset had been held for less than one year?

$2,630 taxed at MTR without discounts. Signup and view all the answers

What is the relationship between a property's sale price and the amount of stamp duty payable?

The stamp duty increases proportionally with the price. Signup and view all the answers

Which of the following fees is NOT typically associated with purchasing a property?

Interest rate fee Signup and view all the answers

What is a potential benefit of purchasing land and then building a property?

You will pay less stamp duty. Signup and view all the answers

How much would the mortgage registration fee amount to for an $850,000 property?

$119.70 Signup and view all the answers

Which type of loan is characterized by payments consisting only of interest over a certain period?

Interest only mortgage Signup and view all the answers

Which of the following is a type of loan where the interest rates can vary over time?

Variable rate mortgages Signup and view all the answers

What is the typical range for an establishment fee when borrowing?

$400 - $600 Signup and view all the answers

What is a major consideration when deciding between renting and buying a home?

The flexibility of moving without financial penalties. Signup and view all the answers

What is the forecasted number of working-age people for every person over 65 by 2031?

Less than three Signup and view all the answers

Which risk is not commonly associated with retirement due to aging populations?

Market volatility risk Signup and view all the answers

What percentage of men is projected to reach age 60 according to the forecasts?

Nine out of ten Signup and view all the answers

What is the anticipated impact on tax burden from funding retirement pensions through taxation?

It will require an ever-increasing tax burden Signup and view all the answers

How many years will about 50% of the population spend in retirement according to projections?

25 years Signup and view all the answers

What characterizes Defined Contribution (DC) plans in relation to an individual's retirement income?

Contributions directly influence the amount available for retirement income. Signup and view all the answers

Which feature of superannuation funds is true regarding employee contributions?

A percentage of salary is deducted and contributed to a fund. Signup and view all the answers

What is a requirement for a superannuation fund to qualify as a Complying Superannuation Fund (CSF)?

It must be regulated and comply with the Superannuation Industry (Supervision) Act. Signup and view all the answers

What is the primary requirement imposed on employers regarding Superannuation Guarantee (SG) contributions?

Employers must deduct 11.5% from an employee’s gross salary and deposit it into a super fund. Signup and view all the answers

What is a consequence of the shift from Defined Benefit (DB) schemes to Defined Contribution (DC) schemes in Australia?

Retirement income security becomes uncertain for many individuals. Signup and view all the answers

What happens if a new employee has an existing super account?

The new employer will direct contributions into the employee’s stapled fund. Signup and view all the answers

At what point can an employee access their accumulated superannuation balance?

At preservation age, with limited exceptions. Signup and view all the answers

What role do superannuation funds play in the economy?

They function as a source of investment funds within the economy. Signup and view all the answers

What is a primary advantage of the Superannuation Guarantee (SG)?

It enhances overall national savings. Signup and view all the answers

What is the impact of inadequate participation in retirement schemes for recent retirees?

They are likely to experience insufficient retirement income. Signup and view all the answers

In what way can members contribute to their super fund?

By rolling over funds from other super accounts. Signup and view all the answers

What constitutes a contribution to a super fund?

Funds received from an employer's salary deduction. Signup and view all the answers

Why might some governments seek to phase out social security retirement benefits?

To encourage individual saving and investment for retirement. Signup and view all the answers

What is a characteristic of 'stapled' super funds?

Members retain the same super fund as they change employment. Signup and view all the answers

Which of the following best describes a 'rollover' concerning super funds?

The transfer of funds from one super account to another. Signup and view all the answers

What is the general requirement for contributions to a super fund?

Individuals must meet eligibility criteria to contribute. Signup and view all the answers

What is the maximum limit for concessional contributions per year as of 2024?

$30,000 Signup and view all the answers

What type of contributions are salary sacrifice contributions considered?

Pre-tax contributions Signup and view all the answers

Which of the following types of contributions can be made on behalf of a spouse under age 65?

Both concessional and non-concessional contributions Signup and view all the answers

How is the taxable income affected when utilizing a salary sacrifice arrangement for concessional contributions?

It decreases the taxable income by the amount of salary sacrificed. Signup and view all the answers

When can a person aged between 70 and 75 make concessional contributions?

Provided they are gainfully employed at least on a part-time basis Signup and view all the answers

What happens to the tax saving derived from salary sacrifice contributions?

It is retained in the super fund. Signup and view all the answers

What are non-concessional contributions primarily sourced from?

After-tax income Signup and view all the answers

Which of the following is NOT a type of acceptable concessional contribution?

After-tax personal contributions Signup and view all the answers

What contribution type applies to mandated employer contributions regardless of employee age?

Concessional contributions Signup and view all the answers

Which rule applies to making concessional contributions for a spouse aged over 69?

Prohibited regardless of employment status Signup and view all the answers

What will be the purchasing power of $1,995,706 in today’s money if the expected accumulation is for 35 years?

$709,241 Signup and view all the answers

Which factor does NOT increase an accumulation according to the accumulation formula?

Increased taxes on contributions Signup and view all the answers

If the contribution period is extended from 35 years to 40 years, by how much would the expected accumulated value increase?

$3,224,614 Signup and view all the answers

What impact would a poor investment portfolio choice have on an accumulation?

Potential reduction in accumulation Signup and view all the answers

What factor contributes to the reduction of accumulation during the contribution period?

Periods of unemployment Signup and view all the answers

How does inflation impact the purchasing power of future accumulated values?

It diminishes purchasing power over time Signup and view all the answers

Which of the following is NOT considered a method to enhance an accumulation in retirement savings?

Reducing employer contributions Signup and view all the answers

If inflation is targeted at 3% per annum, what is the factor by which purchasing power is deflated after 35 years?

0.3554 Signup and view all the answers

Study Notes

Passive Management Styles

Approximately 90% of portfolio return results from asset allocation decisions.
Minimal value is added through the selection of specific assets within asset classes.

Strategic Asset Allocation (SAA)

SAA involves setting target allocations among different asset classes.
Focuses on efficient allocation and the "buy and hold" strategy.
Assumes aggregate asset classes are priced efficiently, with no abnormal profits from switching.
Managers periodically rebalance portfolios to align with target allocations.

Tactical Asset Allocation (TAA)

TAA is approached when managers believe certain asset classes are mispriced.
Mispricing typically references short-term discrepancies between asset classes.
Active strategy aiming to outperform passive benchmarks through market timing.
Empirical evidence suggests difficulty among managers in successfully timing the market.

Dynamic Asset Allocation (DAA)

DAA refers to periodic rebalancing of portfolio weights under SAA and TAA strategies.
Some equate DAA with market timing within TAA, while others see it as a strategy to replicate return distributions.
Involves tactics like portfolio insurance and stop-loss strategies.

Investment Asset: Cash and Bonds

A bond is a contract between issuer and investor, with obligations for specified cash payments.
Payments include principal plus interest; classified into coupon-paying bonds and zero-coupon bonds.

Coupon-Paying Bonds

Regular interest (coupon) payments and principal repayment at maturity.
Coupon rate may differ from market rates but is generally close at issue date.
Cash flows are structured as: initial investment followed by regular coupons and final principal repayment.

Zero-Coupon Bonds (ZCB)

ZCBs provide no interest payments, only a single principal payment at maturity.
Issued at discount to par value; effective interest is the difference between face value and purchase price.
Includes commercial bills and treasury notes known as pure discount securities.

Bond Valuation

Valuation based on present value principles considering cash flows, time to maturity, and yield.
Yield changes are discussed in basis points, where 100 basis points equal 1%.

Other Bond Types

Types include convertible, callable, annuity, asset-backed, indexed, and junk/speculative bonds.
The classification of bonds into “investment grade” reflects their creditworthiness.

Australian Bond Market

Comprises government and corporate bonds; government bonds are low risk and corporations higher risk.
Non-government bonds outstanding around $1.4 trillion, roughly 50% of ASX company value.
Total ASX market capitalization reported at $2.6 trillion as of May 2024.

Cash Management Trusts and Bond ETFs

Smaller investors face challenges with large investments in bonds.
Broader investment options include international equities for further diversification.

Stock Selection Methods

Common stock selection methods include fundamental analysis, technical analysis, and random selection.
Random selection aligns with portfolio theory and diversification principles.
A wide array of services exists in the industry focusing on the first two analysis methods.

A forecast game for the closing share price of Bapcor (BAP) and Karoon Energy (KAR) will take place.
Participation is voluntary; potential for bonus marks up to 2%.
Forecast submissions are due by a specified deadline, with winners announced later.

Shareholder’s Marginal Tax Rate

Individual shareholders are taxed on company net income before tax, subjecting them to their marginal tax rate.

Income Tax Calculation Example

Gross salary of 125,000withafrankeddividendof125,000 with a franked dividend of 125,000withafrankeddividendof1,400 and unfranked dividend of $750.
Work-related deductions amount to $1,800; the Low Income Tax Offset (LITO) does not apply due to high income.
Taxable income (TI) calculated as gross salary minus superannuation contributions (11.5%).
Final taxable income is 112,075,resultinginataxliabilityof112,075, resulting in a tax liability of 112,075,resultinginataxliabilityof26,052 after applying the relevant tax rates.

Tax Rules and Offsets

Tax-free threshold is 18,200,withalowerthresholdof18,200, with a lower threshold of 18,200,withalowerthresholdof416 for unearned income of minors.
LITO aids taxpayers earning up to 66,667,reducingtaxuptoamaximumof66,667, reducing tax up to a maximum of 66,667,reducingtaxuptoamaximumof700 for income up to $37,500.
Individuals can earn up to $21,884 before any income tax is imposed.

Home Ownership Considerations

Major financial decision involving the choice between renting and buying a home.
Factors influencing this decision include savings discipline, capital appreciation, and tax implications of owner-occupied housing.

Share prices react to new information, economic cycles, and herd mentality.
Efficient Market Hypothesis (EMH) suggests that stock prices reflect available information, leading to consensus-driven movements.

Methods of Stock Selection

Different stock selection methods include fundamental analysis, technical analysis, and random selection.
Random selection aligns with diversification principles and portfolio theory.

Fundamental Analysis

Professional advisers use company data and market resources to guide investments.
Stock exchanges and brokers provide essential research and financial reports.

Transaction Costs and Documentation

Transaction prices vary by service; online transactions are typically the least expensive.
Documentation for shareholding includes contract notes, holding statements, and dividend distribution statements.

Buying Shares

To invest in shares, establish an account with a broker, considering investment strategy based on available savings.
Strategy could involve regular savings or one-off transactions utilizing different stock selection techniques.

Taxation of Capital Gains

Capital gains taxed at an individual's marginal tax rate; long-term gains (held >1 year) are typically subject to a 50% discount.
Example: Selling shares results in taxable income adjusted for costs.

Taxation of Dividends

Dividend imputation system aligns dividend tax rate with the shareholder's marginal tax rate.
Corporate tax paid on earnings adds to net dividends, which are grossed up for tax calculations.

Land (Stamp) Duty

State governments impose stamp duty based on property sale price; higher prices incur higher duties.
Example: Victorian stamp duty on an 850,000propertycantotal850,000 property can total 850,000propertycantotal46,070.
First home-buyers enjoy special reductions, and purchasing land to build can lower duty costs.

Additional Costs in Property Purchase

Extra government fees include mortgage registration and transfer fees; an example costs approach $2,088 for transfer.
Borrowing costs may include establishment fees (400−400-400−600) and valuation fees (~250),alongsidesolicitors’fees( 250), alongside solicitors’ fees (~250),alongsidesolicitors’fees( 500).

Alternative Home Loans

Various mortgage types include fixed-rate, interest-only, low-start, and hybrid "cocktail loans."
Mortgage offset accounts can provide tax savings.

Rent vs. Buy Decision

Young individuals often face the challenge of deciding between purchasing a home or renting.
Buying leads to eventual ownership after mortgage payments, whereas renting offers flexibility without long-term property obligations.

Longevity and Aging Population

Life expectancy for 65-year-old males is approximately 20.2 years.
Over 35% of women and 21% of men are predicted to live to 90 or older.
The working-age population (20-65 years) is at its lowest, financing pensions for those over 65 becoming more challenging.
By 2031, the ratio of working-age individuals to those over 65 will decline to less than 3:1.

Retirement Risks

Longevity risk: The possibility of outliving retirement savings.
Inflation risk: The potential for inflation to diminish purchasing power over time.
An increasing tax burden on workers is expected to fund pensions as each generation supports the retirees.

Superannuation and Retirement Schemes

Australia primarily uses Defined Contribution (DC) plans which depend on individual contributions.
Defined Benefit (DB) schemes are phasing out, making retirement lump sums less predictable for employees.
Workers are often unable to fully fund adequate retirement income due to insufficient participation in retirement schemes.

Superannuation Guarantee System (SGS)

Employers must contribute 11.5% from employees’ salaries into an approved superannuation fund.
Employees can choose investment options but will default to a MySuper account if no choice is made.
Access to funds is restricted until the employee reaches 'preservation age'.

Complying Superannuation Funds (CSFs)

CSFs must be resident funds controlled in Australia and comply with the Superannuation Industry (Supervision) Act 1993.
Significant national savings have been observed since the introduction of the SGS.
The SGS positively impacts the Australian Stock Exchange, debt markets, and infrastructure investment.

Contributions to Superannuation

Contributions can be made by employers, personally, on behalf of a spouse, and under certain employment awards.
Concessional contributions include compulsory employer contributions and voluntary salary sacrifice.
Non-concessional contributions consist of after-tax income sources.

Taxation and Contribution Limits

A super fund may accept mandated employer contributions up to $30,000 per year (increased from $25,000).
Salary sacrifice contributions are pre-tax and subject to a 15% contributions tax.
Specific criteria apply to contributions based on age and employment status.

Implications on Retirement Funding

The future value of accumulated funds heavily depends on factors like the earning rate, salary growth, contribution rate, and duration in the scheme.
Inflation could reduce the purchasing power of accumulated retirement savings significantly over time.
Factors adversely affecting accumulation include employment gaps, poor investment choices, and legislative risks.

Divorce Impact on Superannuation

About 40% of marriages in Australia end in divorce, which can lead to superannuation asset splitting.

Overall Financial Planning Considerations

Proper planning must account for longevity, inflation, potential changes in contributions, and personal circumstances.
Maximizing contributions and understanding the superannuation framework are essential for building a sustainable retirement fund.

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Description

This quiz explores passive management styles in investment, focusing on empirical studies that highlight the dominance of asset allocation in portfolio returns. It examines the implications of these findings regarding the selection of specific assets and their alignment with diversification principles as stated in investment theory.