CH10 - Other investment classes

Question 1

Collective investment schemes (CSIs)

Answer 1

CISs provide the opportunity for investors to achieve a wide spread of investments, whilst benefiting from specialist management expertise

Question 2

Two types of collective investment schemes

Answer 2

1. Closed-ended
   In a closed-ended scheme, such as an investment trust, once the initial tranche of money has been invested the fund is closed to new money.
2. Open-ended
   In an open-ended scheme, such as a unit trust, managers can create or cancel units in the fund as new money is invested or disinvested.

Question 3

Regulation of collective investment schemes typically covers (4)

Answer 3

It covers aspects such as:

1. the categories of assets that can be held
2. whether unquoted assets can be held
3. the maximum level of gearing
4. any tax relied available

Question 4

Key features of investment trusts (7)

Answer 4

The key features of investment trusts include:

1. a stated investment objective
2. the key parties involved are the board of directors, investment managers and shareholders
3. investors buy shares in an investment trust company, which are priced by supply and demand
4. share price often stands at a discount to net asset value per share (NAV)
5. the funds are closed-ended
6. they are public companies (and so are governed by company law)
7. gearing is allowed

Question 5

Key features of unit trusts (6)

Answer 5

The key features of unit trusts include:

1. a stated investment objective
2. the key parties involved are trustees (e.g. an insurance company or bank), the management company (including investment managers) and unitholders
3. investors buy units in a UT, which are priced at net asset value per unit
4. the funds are open-ended
5. they are trusts (and so are governed by trust law)
6. limited power to use gearing (i.e. to borrow)

Question 6

Open-ended investment companies

Answer 6

Similar to investment trusts in terms of corporate governance, but open-ended characteristics like unit trusts.

Question 7

Differences between closed-ended and open-ended funds (8)

Answer 7

1. Investments in closed-ended funds are often less marketable than the underlying assets, whereas the marketability of investments in open-ended funds is guaranteed by the managers.
2. Closed-ended funds can gear, leading to extra volatility. Open-ended funds have limited power to gear.
3. It may be possible to buy assets at less than NAV in a closed-ended fund.
4. The increased volatility of closed-ended funds implies a higher expected return.
5. Shares in closed-ended funds are also more volatile than the underlying assets because the size of any discount to NAV can change. The volatility of units in an open-ended fund should be similar to that of the underlying assets.
6. There may be uncertainty as to the true level of NAV per share of a closed-ended fund, especially if the investments are unquoted.
7. Closed-ended funds can invest in a wider range of assets
8. They may be subject to different tax treatment.

Question 8

Advantages of CISs compared with direct investment (6)

Answer 8

Advantages of CISs compared with direct investment are:

1. access to expertise
2. diversification
3. some of the direct costs of investment are avoided
4. holdings are divisible
5. possible tax advantages
6. marketability may be better than that of the underlying

Question 9

Disadvantages of CISs compared with direct investment (3)

Answer 9

Disadvantages of CISs compared with direct investment:

1. loss of control
2. management charges incurred
3. may be tax disadvantages

Question 10

Derivatives

Answer 10

A derivative is a financial instrument with a value dependent on the value of some other, underlying asset.

Question 11

Forward contract

Answer 11

A forward contract is a non-standardised, exchange-tradable contract between two parties to trade a specified asset on a set date in the future at a specified price.

Question 12

Futures contract

Answer 12

A futures contract is a standardised, exchange-tradable contract between two parties to trade a specified asset on a set date in the future at a specified price.

Question 13

Long position

Answer 13

A long position in an asset means having a positive economic exposure to that asset. In futures and forwards dealing, the long party is the one who has contracted to take delivery of the asset in the future.

Question 14

Short position

Answer 14

A short position in an asset means having a negative economic exposure to that asset. In futures and forwards dealing, the short party is the one who has contracted to deliver the asset in the future.

Question 15

Option

Answer 15

An option gives an investor the right, but not the obligation, to buy or sell a specified asset on a specified future date at the specified exercise (or strike) price.
Call options give the right to buy.
Put options give the right to sell.

Question 16

Americal option

Answer 16

An American option is an option that can be exercised on any date before its expiry.

Question 17

European option

Answer 17

A European option is an option that can only be exercised at expiry.

Question 18

Warrant

Answer 18

A warrant is an option issued by a company over its own shares. The holder has the right to purchase shares from the company at a specified price at specified times in the future.

Question 19

Use of futures and options

Answer 19

Future contracts can be used to set a price in advance.
Options enable financial institutions to alter the structure of their portfolios without need to trade in the underlying assets.

Derivative transactions are not cheap, and need to allow for any collateral the counterparty may require.

Question 20

Reasons for investing overseas (3)

Answer 20

There are three main reasons why an investor may wish to hold foreign assets:

1. to match liabilities in the foreign currency
2. to increase the expected returns
3. to reduce the risk by increasing the level of diversification

Question 21

Drawbacks of investing overseas (13) CATERPILLAR MTV

Answer 21

Overseas investment has some potential drawbacks:

1. different market performance to the home market and therefore mismatching risk
2. currency fluctuation risk
3. cost of obtaining expertise
4. additional administration functions: custodian, dividend tracking and collection
5. possible tax disadvantages, e.g. withholding tax
6. different accounting practises
7. lack of good quality information
8. language problems
9. possible time delays
10. poorly regulated markets
11. political risks (e.g. confiscation of assets)
12. possible lack of liquidity
13. restrictions on ownership of certain shares by foreign investors.

Question 22

Indirect overseas investment (3)

Answer 22

Indirect overseas investment may involve investment in:

1. multinational companies based in the home market
2. collective investment schemes specialising in overseas investment
3. derivatives based on overseas assets.

Question 23

Emerging markets

Answer 23

Emerging markets (stock markets in countries with developing economies) can offer high growth rates and possible market inefficiencies, giving investors the chance of making very big gains (or very big losses)

The economies and markets of many smaller countries are less interdependent than those of the major economic powers, resulting in good diversification.

Question 24

Factors to consider before investing in emerging markets (10)

Answer 24

Factors to consider before investment in emerging markets include:

1. current market valuation
2. possibility of high economic growth rate
3. currency stability and strength
4. level of marketability
5. market regulation
6. restrictions on foreign investment
7. range of companies available
8. communication problems
9. availability and quality of information.