3. Investment Planning. 3. Pooled Investments Flashcards
Module Introduction
Imagine you received a small inheritance from a relative. You know that you want to invest the money and you begin to consider your options.
You understand that money market instruments pay a fair amount of interest and keep your money safe. However, once you look into money market instruments a little further, you realize the denominations of these short-term fixed income securities are more than you can afford.
Next, you consider purchasing multiple bonds, which can diminish the credit risks associated with owning bonds; however, you find you don’t have enough money to buy multiple bonds.
Then, you ponder investing in stocks. The gain realized through the capital appreciation of stocks is potentially greater than other assets over the long run; however, you realize you don’t have the time or expertise to evaluate stocks, nor are you sure when to buy, hold or sell once you own them.
What do you do?
One solution many Americans have sought is to invest in professionally managed pooled investments. Today, the majority of workers in the United States have invested in pooled investments either through employer-sponsored retirement plans, insurance investments or personal savings in mutual funds. Pooled investments can make it easier for small investors to invest in securities they might otherwise be unable to afford. Pooled investments can also lower risk through diversification and leave the hassle of choosing the right securities to professional money managers.
The Introduction to Pooled Investments module, which should take approximately one hour and 20 minutes to complete, will explain the various types of pooled investments that are available to investors.
Upon completion of this module you should be able to:
* Define investment companies
* Describe closed-end funds
* Describe open-end funds
* List measures of mutual funds performance evaluation, and
* Compare and contrast other types of pooled investments.
Module Overview
Once collected, the combined assets are given to a professional money manager to be invested, administered, and managed accordingly. By combining their money, investors are able to significantly amplify their investment power. Pooled investments enable small investors to experience the same benefits of investing in the securities market that were once exclusive to large investors.
To ensure that you have an understanding of pooled investments, the following lessons will be covered in this module:
* Investment Companies
* Closed-End Funds
* Open-End Funds
* Evaluating Mutual Funds
* Other Pooled Investments
Section 1 – Investment Companies
Investment companies manage pooled investments for a fee, in order to achieve set investment objectives. Mutual funds and unit investment trusts are both examples of investment companies. Variable annuity companies could also be seen as an investment company.
Each pooled investment is its own company with a board of trustees or directors (depending on how it is registered with the government). One of the board’s responsibilities is to hire a professional money manager to run the daily administration and management of the pooled assets.
The advantages of investing in investment companies include economies of scale and professional management.
To ensure that you have an understanding of investment companies, the following topics will be covered in this lesson:
* Net Asset Value
* Unit Investment Trust
* Mutual Funds
Upon completion of this lesson, you should be able to:
* Explain net asset value,
* Describe unit investment trust, and
* Enumerate the advantages and disadvantages of investing in mutual funds.
Example (NAV Calculation)
An investment company holds two common stocks (Company A and Company B). At the end of the day, Company A’s stock traded at $10/share and Company B’s stock traded at $20/share. The investment company holds 10 shares of each stock.
* So the total assets of the investment company at the end of the day was __ ____??____ __.
* If the investment’s total liabilities for the day was $50, then the net asset value would be __ ____??____ __.
* The per share NAV is __ ____??____ __ at the close of the day.
NAV Per Share
(Assets – Liabilities) ÷ Shares Outstanding = NAV
- So the total assets of the investment company at the end of the day was $300 = ($10 x 10 shares) + ($20 x 10 shares).
- If the investment’s total liabilities for the day was $50, then the net asset value would be $250 = $300 - $50.
- The per share NAV is $12.50 ($250 / 20 shares) at the close of the day.
Describe a Unit Investment Trust
Some of the earliest pooled investments were unit investment trusts. A unit investment trust (UIT) is an investment company that owns a fixed set of securities for the life of the company. That is, the investment company rarely alters the composition of its portfolio during the life of the company.
Most unit investment trusts hold fixed-income securities that expire after the last security has matured. Life span for these companies can be as short as six months, for unit investment trusts of money market instruments, or as long as 20 years or more, for trusts of bond market instruments. Although UITs are less popular in the United States, they still draw European investors seeking to invest in fixed-income securities with a set maturity date.
Formation of a Unit Investment Trust
Purchase securities. A sponsor purchases a specific set of securities and deposits then with a trustee (such as a bank)
Sell shares to public. A number of shares known as redeemable trust certificates are sold to the public. These certificates provide their owners with proportional interests in the securities that were previously deposited with the trustee.
Pay out income & principal repayment. All income received by the trustee on these securities is subsequently paid out to the certificate holders, as are any repayments of principal.
Exam Tip: Unit Investment Trusts are passively managed. The professional management happens in the beginning for the asset selection. After that, no changes will be made to the portfolio except payment of interest and principal. Passive management results in lower management costs due to less turnover costs.
Which of the followng are advantages of investing in a pooled investment over buying individual securities? Click all that apply.
* The ability to control capital gains tax
* The ability to save money on transaction costs and get a better price of securities
* The ability to sell shares back to an issuer who stands ready to buy them back
* The ability to pick and choose which securities to buy and sell
* The ability to take advantage of more risk
* The ability to lower risk by investing in a greater variety of securities at once
The ability to save money on transaction costs and get a better price of securities
The ability to sell shares back to an issuer who stands ready to buy them back
The ability to lower risk by investing in a greater variety of securities at once
* Investing in mutual funds provides investors with many benefits. For instance, by investing in more than one company, the fund increases its diversification, creating less risk for investors. Investing in mutual funds is also more cost efficient, and provides individual investors with both volume discounts and exposure to a wider variety of stocks. Another benefit to investors is that open-end funds stand ready to buy back sahres, making it easy fo investors to sell their shares.
Section 1 – Investment Companies Summary
Economies of scale make it possible for an investment company to provide diversification at a lower cost (per dollar of investment) than would be incurred by a small, individual investor.
By purchasing shares of an investment company, an individual turns over all details of investing, including making buying and selling decisions, as well as keeping records of all transactions for tax purposes, to a professional money manager.
In this lesson, we have covered the following:
- Net Asset Value (NAV) is the market value of all assets owned by the investment company, minus its total liabilities, then divided by the number of outstanding shares issued.
- A Unit Investment Trust (UIT) is a type of investment company that owns a fixed set of securities for the life of the company.
- A Mutual Fund is a type of investment company that manages a pool of investments from small investors with common objectives. For a fee, the fund’s manager invests in various securities based on set investment objectives.
Which of the following are the advantages of mutual funds? (Select all that apply)
* Minimal transaction costs
* Marketability
* Flexibility
* Service
* Taxation
Minimal transaction costs
Marketability
Flexibility
Service
* The advantages of mutual funds are diversification, professional management, minimal transaction costs, marketability, flexibility, and service.
* Distributed capital gains from mutual funds could lead to unplanned tax payments.
The Net Asset Value (NAV) is the market value of all securities owned by a mutual fund, minus its total liabilities, then divided by the number of shares issued.
* False
* True
True
* When calculating the net asset value of securities, the total liabilities of a mutual fund are deducted from the market value of all securities owned. The difference is then divided by the number of shares issued. NAV is an important measure of how investment companies perform.
Section 2 - Closed-End Funds
The Investment Company Act of 1940 provides two classifications for investment companies: unit investment trusts and managed investment companies. Both closed-end and open-end funds fall under the classification of managed investment companies.
Unlike open-end investment companies, closed-end funds do not stand ready to purchase their own shares. Instead, the shares of these funds are traded in either an organized exchange or an over-the-counter market. Thus, an investor who wants to buy or sell shares of a closed-end fund must place an order with a broker.
To ensure that you have an understanding of closed-end funds, the following topics will be covered in this lesson:
* Closed-End Fund Quotations
* Pricing of Shares
* Investing in Fund Shares
* Exchange Traded Funds
After completing this lesson, you will be able to:
* Explain closed-end fund quotations,
* Discuss how shares are priced,
* Explain the benefits and risks involved in investing in fund shares, and
* Describe exchange traded funds.
Which of the following is true about a Fund that has a NAV of $9 and a market price of $10? (Click all that apply)
* It is a premium
* It is a discount
* Its demand is greater than its supply
* Its supply is greater than its demand
It is a premium
Its demand is greater than its supply
* The Fund is at premium because its market price is greater than its NAV. Therefore, its demand is greater than its supply.
Section 2 – Closed-End Funds Summary
Closed-end funds do not stand ready to purchase their own shares. Instead, shares of closed-end investments are traded either on an organized exchange or in the over-the-counter market.
In this lesson, we have covered the following:
* Closed-end Fund Quotations are the market prices of the shares of closed-end funds that are published daily in the financial press, provided that the funds are listed on an exchange or traded actively in the over-the-counter market.
- Prices of Shares that are above their net asset values are said to sell at a premium. Share prices that sell below their net asset value are said to sell at a discount.
- Investing in Fund Shares enables an investor to earn more than just the change in the company’s NAV by purchasing closed-end fund shares at discount. Even if the company’s discount remains constant, the effective dividend yield will be greater than that of an otherwise similar no-load, open-end investment company.
- Exchange Traded Funds are traded throughout the day on an exchange. ETFs are a type of closed-end investment company which offers the same trading flexibility of a stock and with lower expense ratios.
If closed-end fund shareholders want to sell their shares, they would go to the __ ____??____ __.
* primary market
* secondary market
* fund company
* issuer
secondary market
* Closed-end funds are traded in the secondary market after the initial public offering.
* When the company is initially offered, it is sold in the primary market.
* From then on, the shares are traded through brokers in the open market. The fund company/issuer can only engage in the trading of its shares through the secondary market.
When an investor decides to purchase or sell shares of a closed-end fund, the price is based on which of the following?
* Supply and demand
* Fund assets minus liabilities
* NAV
* Public offering price
Supply and demand
* In the case of a closed-end fund, the fund’s price is determined by its supply and demand in the open (secondary) market.
* The net asset value becomes a benchmark to tell whether or not the shares are trading at a discount or premium.
* The public offering price is the price that the shares are originally offered to the market from the fund.
A share of a closed-end fund that has an NAV of $10, is selling in the market at a discount of 10% or $9, with an equivalent open-end fund selling at an NAV of $10. Both the closed-end and the open-end fund paid a $1 dividend.
Which statement(s) is(are) true regarding this close-end fund? (Select all that apply)
* The effective dividend yield would be lower than the equivalent open-end fund.
* The effective dividend yield will be greater than the equivalent open-end fund.
* The investor’s overall return may be less than the equivalent open-end fund.
* The investor’s overall return may be more than the equivalent open-end fund.
The effective dividend yield will be greater than the equivalent open-end fund.
The investor’s overall return may be more than the equivalent open-end fund.
* Since the fund is selling at a discount, $1/$9 (closed-end fund) is a greater dividend yield than $1/$10 (open-end fund).
* Holding all other factors the same, as the price of the shares increases, the return will be greater for the lower cost basis of the discounted closed-end shares.
Section 3 – Open-End Funds
Today, when people talk about mutual funds, they are typically referring to the open-end mutual funds. Open-end funds have become by far, the most popular pooled investment vehicle in the United States. Unlike closed-end investment companies, open-end investment companies (or open-end funds) stand ready at all times to purchase their own shares at par or their net asset value. These professionally managed pooled investments are easily accessible. You can buy them directly, or through brokers or advisers, retirement plans, or insurance vehicles.
To ensure that you have an understanding of open-end funds, the following topics will be covered in this lesson:
* No Load vs. Load Funds
* Loads and Fees
* Open-End Fund Quotations
* Types of Investment Objectives
Upon completion of this lesson, you should be able to:
* Differentiate between no load and load funds,
* Describe loads and fees,
* Discuss open-end fund quotations, and
* Explain the types of investment objectives.
Describe No-Load vs. Load Funds
Open-end funds are sold either directly from the company or through a sales force involving brokers, financial planners, and employees of insurance companies and banks. The method used to sell open-end funds is based on whether there is an additional sales commission charged to the investor. A sales commission, called a load, is used to pay for the sales of a fund. Open-end funds that are sold without these commissions (at NAV) are called no-load funds. Those that are sold with a commission are called load funds.
There are no noticeable differences in performance between no-load versus load funds. The difference is in the services provided. No-load funds, which charge lower transaction costs and generally provide fewer services, are beneficial for investors who have some investment knowledge and an understanding of how mutual funds work. Load funds are beneficial for investors who are seeking advice or guidance from a broker or adviser and do not mind paying a sales charge.
Practitioner Advice: The decision to buy a load or no-load fund is really a decision of whether to pay for advice. The quality of the fund cannot be determined solely by cost.
Which of the following specialized funds has more risks:
* International Fund
* Japan Fund
Japan Fund
* The Japan Fund is more aggressive because the risks associated with Japan specifically cannot be diversified away by investing in companies of other countries.
* An International Fund can spread country specific risks among several countries.
Practitioner Advice: Which class is suitable for the investor
Practitioner Advice: Which class is suitable for the investor?
* It all depends on the holding period.
* Anyone with large investment amounts should take advantage of breakpoints available for Class A (front load) shares. The longer you plan on holding the shares, the more beneficial it is to hold Class A shares. You are better off paying your entire load as a percentage of the initial investment amount than over time as a percent of your account each year.
* If your account grows each year, the percentage becomes a larger actual amount paid.
* For Class B (CDSC) shares, although the load disappears over time, there is a higher 12b-1 fee that is paid annually as a percentage of the account.
* Class C (level load) shares have an annual fee, again based on the size of the account.
Share Class Fees and Loads
* Class A shares. Typically, Class A shares of a fund charge a front load which can be reduced through breakpoints for larger investments. Typically charge a lower 12b-1 fee.
* Class B shares. Typically, Class B shares of a fund are shares with CDSC charge plus a 12b-1 fee. After the CDSC’s term is up, the Class B share may convert to Class A shares.
* Class C shares. Typically, Class C shares charge an annual 12b-1 fee.
