11 - Other investment classes Flashcards
Outline the purpose of collective investment schemes from the perspective of both the investor and the management of the CIS
From the investor’s perspective:
- Diversification and lower portfolio risk
- Access to expertise
- Access to larger / unusual investments
- Economies of scale (reducing investment expenses)
- Possible tax advantages
From the management of the CISs perspective:
- To follow the stated investment objective
- To create return for investors commensurate with the level of risk taken
Define closed-ended in the context of CISs
In a closed-ended scheme, such as an investment trust company (ITC), once the initial tranche of money has been invested the fund is closed to new money. After launch, the only way of investing in the ITC is to buy shares from a willing seller.
Define open-ended in the context of CISs
In an open-ended scheme, such as a unit trust or open-ended investment company, managers can create or cancel units in the fund as new money is invested or disinvested.
Define net asset value (NAV) per share for an ITC
Net asset value per share is equal to the value of the underlying assets of the company divided by the number of ordinary shares.
If gearing is allowed, the underlying assets would be net of the debt liabilities
Outline ten investment and risk characteristics of an investment trust company
- Stated investment objectives written into prospective / offer for sale document
- Closed-ended
- Public company, governed by company law
- Often quoted on an exchange
- Can raise both debt and equity capital
- Operated by company directors and investment managers
- Directors and investment managers receive fees
- Investors buy “shares” in the ITC
- Share price is determined by supply and demand
- Share price often stands at a discount to the company’s NAV per share
Outline nine investment and risk characteristics of a unit trust
- Stated investment objective
- Open-ended
- Trust, governed by trust law
- Limited ability to gear
- Operated by trustees and management company / investment managers
- Trustees ensure UT is managed legally in accordance with the trust deed, hold assets and oversee the calculation of the bid and offer prices and the administration of the UT
- Trustees and UT managers receive fees
- Investors buy “units” in the UT
- Unit price is based on NAV per share
Outline the advantages of investment in CISs compared with direct investment
- Access to larger / more unusual investments
- Discount to NAV – assets may be bought cheaply
- Diversification
- Divisibility
- Economies of scale in the case of larger collective schemes
- Expected return higher due to the extra volatility associated with gearing and changes to the discount to NAV
- Expertise of investment managers
- Index-tracking of a quoted investment index is possible
- Marketability (possibly)
- Quoted prices make valuation easier
- Suitable for small investors
- Tax advantages (possibly)
Outline the disadvantages of investment in CISs compared with direct investment
- Loss of control
- Additional layer of charges: Management fees for investment managers
- Need to hold some cash for liquidity which reduced expected exposure / return (UT ONLY)
- Extra volatility caused by gearing / discount to NAV changing (ITC ONLY)
- Tax advantages (possibly)
List nine differences between CE and OE collective investment schemes
- Shares in CE CISs are often less marketable than the underlying assets. Marketability of units in OE CISs is usually guaranteed by the managers.
- Some OE CISs need to hold cash to maintain liquidity => lower expected returns but greater price stability
- CE CISs can gear, leading to extra volatility. OE CISs cannot be geared or have limited gearing.
- Shares in CE CISs are also more volatile than the prices of the underlying shares because the size of the discount to NAV per share can change. The price volatility of units in an OE fund should be similar to that of the underlying assets.
- Increased volatility of CE CISs => higher expected return
- There may be uncertainty as to the true level of NAV per share of a CE CIS, especially if the investments are unquoted.
- CE CISs can invest in a wider range of assets
- May be possible to buy assets at less than NAV in a CE CIS
- They may be subject to different tax treatment
Define a futures contract
A standardized, exchange-traded contract to buy (or sell) a specified asset at a specified price on a specified date in the future
Define a forward contract
A non-standardized, OTC traded contract to buy (or sell) a specified asset at a specified price on a specified date in the future
Features of a futures contract
Standardized Exchange traded Clearing house removes default risk Margin paid to clearing house More liquid than forward Quoted price Often closed out before delivery
Features of a forward contract
Tailor made, non-standardized OTC traded Default risk depends on counterparty No margin paid as traded OTC Less liquid than future No quoted price as traded OTC Often results in delivery
Define a long and short position in relation to futures and forwards contracts
Having a long position in an asset means having positive economic exposure to the asset. In futures and forward dealing the long party is the one who has contracted to take delivery (to buy) of the asset in the future
Having a short position in an asset means having negative economic exposure to the asset. In futures and forward dealing the long party is the one who has contracted to deliver (to sell) the asset in the future
Define the term ‘warrant’
A warrant is an option issued by a company over its own shares. The holder has the right to purchase shares at a specified price at specified times in the future from the company.
Outline the main uses of derivatives
- Providing protection against the risk of adverse market movements:
- using futures contacts to set the price of input goods in advance
- E.g. using a put option to protect asset portfolios against significant market value falls - Aiming to achieve higher returns / profits through speculation
- Allowing financial institutions to alter the structures of their portfolios without needing to trade in the underlying assets
Outline three main reasons for investing overseas
- Matching liabilities dominated in a foreign currency
- Diversification by:
- Country
- Economy
- Stock market
- Currency
- Industry
- Company - Higher expected return:
- As fair compensation for higher risks involved
- As a result of exploiting inefficiencies
What are the fundamental problems with overseas investment?
MTV
- Mismatching domestic liabilities
- Taxation (may not be able to recover withholding taxes paid)
- Volatility of currency
What are the practical problems with overseas investment?
CATERPILLAR
Custodian needed Additional admin required Time delays Expenses incurred / expertise needed Regulation poor Political instability Information harder to obtain (and less of it) Language difficulties Liquidity problems Accounting differences Restrictions on foreign ownership / repatriation problems
Outline three different ways of indirectly investing in overseas assets
- Investment in multinational companies based in the home market
- Investment in collective investment schemes specializing in overseas investment
- Investment in derivatives based on overseas assets
Discuss the advantages and disadvantages of investing indirectly overseas by investment in multinational companies based in the home market
Advantages:
- Easier to deal in familiar home market
- Multinational companies will have expertise and tend to conduct their business in the most profitable areas overseas
- Gives access to areas where direct investment may be difficult
Disadvantages:
- Overseas earnings are diluted by domestic earnings
- Investor has no choice in where the company transacts its business
List thirteen factors to consider when investing in emerging markets
- Higher expected return due to higher risk (and possible market inefficiencies)
- Extra diversification (less correlated than larger developed economies)
- Possibility of high economic growth
- Current market valuation of assets
- Inefficient markets: Buy cheaply
- Perceived to be risky: Buy cheaply - Currency stability and strength
- Level of marketability (may be less)
- Degree of political stability
- Market regulation
- Restrictions on foreign investment
- Range of companies available
- Communication problems
- Availability and quality of information
- Markets in small countries are highly influenced by swings in international investor sentiment and a sudden big flow of cash.
4 Regulation aspects of CISs
- Categories of assets held
- Whether unquoted assets can be held
- Maximum level of gearing
- Any tax reliefs available
Key parties involved in ITCs
- board of directors,
- investment managers
- shareholders
Key parties in unit trusts
- Trustees (eg insurance company or bank)
- Investment managers (eg merchant bank)
- unitholders
Net asset value per share (NAV)
Company’s underlying assets divided by the number of shares.
Reasons for discounted NAV in ITC’s
- Management charges
- Concerns over marketability
- Concerns over the quality of management
- Market sentiment/fashion (out of fashion by investors)
Functions of the exchange
- Set the details of standardised contracts
- Authorise who can trade on the exchange
- Bring buyers and sellers together
- Operate sub-institution called the clearing house.
Clearing house
-Self-contained institution whose only function is to
clear FUTURES trades and settle margin payments.
-The clearing house checks that the buy and sell orders
match
-Acts as a party to every trade.
-Guarantees each side of the original bargain, remove
credit risk. Uses initial and variation margins.
How would foreign assets increase expected returns
- strengthening currencies
- higher risk or fast-growing economies
- undervalued markets
Special characteristics of emerging markets
Can be very volatile (gives the investor chance of making very big gains/losses).
- Can be affected by enormous flows of money generated by changes in investor sentiment.
- Economies and markets of many smaller markets are less interdependent than those of major economic powers, resulting in good diversification.
Factors to consider before investing in emerging markets
- Current market VALUATION
- range of companies available.
- extent of additional DIVERSITY generated.
- Possibility of high ECONOMIC GROWTH rate
- degree of POLITICAL stability
- RESTRICTIONS on foreign investment.
- market REGULATION
- STABILITY AND STRENGTH of the currency
- EXPERTISE in the markets
- availability and quality of INFORMATION.
- COMMUNICATION problems
- level of marketability
- extra EXPENSES
Diversification w.r.t. overseas investment
- Investing in a number of different countries or economies with a low degree of correlation helps to reduce risk.
- achieved by investing in industries that are not available for investment in the home market
- gives a larger number of companies from which to construct a diversified portfolio.
Withholding tax
tax deducted at source from dividends or other income paid to non-residents of a country.
Double taxation agreement
Done between the domestic tax authorities and the particular overseas country, allowing for the domestic tax to be reduced/eliminated because of the overseas tax already paid.
Advantages of investing in multinational companies based in the home market
- EASY to deal in the familiar home market
- better/increased ACCESS
- companies will have EXPERTISE and tend to conduct their business in the most profitable areas overseas, including areas where direct investment may be difficult.
- more MARKETABLE
Disadvantages of investing in multinational companies based in the home market
- such a company’s earnings might be DILUTED by domestic earnings
- investor will have no CHOICES in where the company transacts its business.
Attractions of investments in emerging markets
- Current market valuation
- inefficient markets
- perceived to be risky
- Rapid economic growth
- Better diversification
Drawbacks of investment in emerging markets
- Volatility
- Marketability
- Political stability
- Regulation of the stock market
- insider trading by local investors
- fraud
- Restrictions on foreign investment
- Communication problems and availability and quality of information
