12. Perennial Favourites

Question 1

4 basic types of investment companies

Answer 1

• CEF (closed end funds, known as LIC in NZ and AUS)
• Mutual Funds (open end funds)
• Unit investment trust (UIT)
• ETF (exchange traded fund)

Question 2

CEF (4)

Answer 2

Closed end fund - type of investment company whose shares are traded on the open market
Bid-ask spread
Active fund
Closed to new shareholders

Question 3

CEF Process

Answer 3

proceeds raised through IPO, no more capital raising after that, will invest capital in other companies (typically stocks unless speciality commodity CEF)

Question 4

Is a CEF active or passive?

Answer 4

Active - investment management team, regularly buying and selling with market (sell overpriced, buy underpriced)

Question 5

Ways that capital can increase in CEF

Answer 5

Capital gain from stocks (selling for profit), borrowing money, offering secondary share issue, rights offering.

Question 6

CEF’s can be…

Answer 6

liquidated –> resulting in capital outflow

Question 7

Open-end/Mutual fund (4)

Answer 7

Not traded on stock exchange
No bid-ask spread
Open for new investors
Much larger than CEF

Question 8

Process of entering closed-end/mutual fund

Answer 8

Approach the company and they will issue new shares (buying more securities from companies –> increasing AUM), they are unable to issue new units without purchasing additional securities

Question 9

Process of exiting open-end/mutual fund

Answer 9

return shares to the fund manager –> no need to sell on stock market

Question 10

Similarities between CEF and Mutual Fund (4)

Answer 10

1. Professional Managers
2. Expense Ratio - they will charge fees for services
3. Both have portfolios of underlying assets
4. Offer income/capital gains distribution (if securities within fund pay dividends)

Question 11

ETF (3)

Answer 11

Exchange Traded Fund
Hybrid of Mutual and CEF
Traded on stock exchange - but you can create and redeem additional shares as an authorised participant (AP)

Question 12

Process of creating additional units in an ETF

Answer 12

AP will approach company to purchase, AP will purchase all underlying assets of the ETF and exchange them with ETF issue for units.

Question 13

Inverse ETF (3)

Answer 13

designed to produce returns opposite to underlying index (e.g. index increase 2.5%, inverse ETF will fall 2.5%)
utilises derivatives
similar to a short position (expect the index to fall)

Question 14

Leveraged ETF

Answer 14

Over-investing in underlying index by borrowing money

Question 15

ETF price fluctuates like…

Answer 15

a stock

Question 16

ETFs are generally what type of fund?

Answer 16

passive

Question 17

Most ETFs are open end funds but some are…

Answer 17

UIT

Question 18

Characteristics of a UIT

Answer 18

Unit Investment Trust
* fixed termination date
* holdings are fixed unless there is corporate action (rights offering, etc.)
* do not lend out shares, cannot borrow, no board of directors and accumulate cash dividends to pay out quarterly (no reinvestment)
* fixed number of units –> redeemable
* not listed
* bond UITs more common than stock UITs

Question 19

ETFs may be converted back into

Answer 19

units of underlying assets

Question 20

Convertibility of ETF mens that

Answer 20

prices do not stray far from the NAV of the fund for an extended period of time

Question 21

NAV =

Answer 21

net assets/number of units

Question 22

For CEF’s the unit price may be

Answer 22

different from NAV

Question 23

Purpose of ETFs

Answer 23

passively track a market index

Question 24

Are ETFs liquid?

Answer 24

Yes - most are liquid and heavily traded due to low T-costs (low bid-ask spreads and price impact)

Question 25

Why is the demand for ETFs so high?

Answer 25

expense ratio generally too low

Question 26

Pitfalls of ETF (3)

Answer 26

• enable poor market timing
• trading ETF cheaper, but if done too frequently is costly
• proportion of a firm’s shares held by ETF’s tends to reduce the information efficiency of that stock

Question 27

How do ETF’s tend to reduce the information efficiency of that stock?

Answer 27

Stocks held by ETF are unavailable for public trading, hence less market research able to be done if only (e.g. 50% of a whole companies shares is available for trading) leading to low information and decreased information efficiency.

Question 28

Defined Benefit (DB)

Answer 28

guarantees a specific payout upon retirement

Question 29

Providers of especially defined benefits struggle to…

Answer 29

meet the benefit promises they have made to current and former workers

Question 30

DB are a huge cost for

Answer 30

companies and it affects their market valuations

Question 31

Defined contributions are becoming more popular than DB’s since ____ as…

Answer 31

2000, as it shifts the investment risk of their obligations to the employee/worker

Question 32

Differences between DB and DC plans?

Answer 32

DB defines the benefits payable to the employee in retirement while a DC plan defines the contribution made by the employee
With DB plans, benefits known in advance
With DC plans, total amount at retirement date is unknown – financial crisis may reduce the amount in the account

Question 33

DRIPs or DRPs

Answer 33

Dividend Reinvestment Plans

Question 34

What do DRIPS provide?

Answer 34

The opportunity for an investor to reinvest their dividend in the company by purchasing additional shares –> no requirement for cash dividend to be paid, company completes this on your behalf

Question 35

DRIPS are generally…

Answer 35

commission free

Question 36

How many shares do you need to hold to participate in a DRIP?

Answer 36

1 –> in US can purchase directly from company, in NZ must purchase directly from broker

Question 37

Do ETFs participate in DRIPs?

Answer 37

Yes, all dividends reinvested into ETF

Question 38

Restrictions with DRIPs

Answer 38

if shares are purchased sometimes restriction on how soon you can sell that share

Question 39

Benefits of DRIPs

Answer 39

will provide share on same day dividend is paid, cash dividend payment sometimes delayed

Question 40

If you own a stock that pays cash dividends, you signed up for the DRIP long ago. You then sell the stock after the ex-dividend date but prior to the payment date, will you receive dividend?

Answer 40

Yes –> sold after the last day trading with dividend rights, entitled to a cash dividend