Chapter 10-Other investment classes Flashcards
- Describe the purpose of collective investment schemes.
Collective investment schemes (usually called mutual funds in the US) provide structures for the management of investments on a grouped basis. They provide the opportunity for investors to achieve a wide spread of investments and therefore to lower portfolio risk.
Managers of such schemes are likely to have management expertise, particularly in specialist areas such as overseas investment, which is otherwise available only to the largest institutional investors.
- Distinguish between closed-ended and open-ended collective investment schemes.
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. After launch, the only way of investing in an investment trust is to buy units from a willing seller.
In contrast, 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.
- Outline the regulations covering collective investment schemes.
The regulations covering collective investment schemes vary from country to country and different types of scheme will be subject to different rules.
Regulations typically cover aspects such as:
* the categories of assets that can be held
* whether unquoted assets can be held
* the maximum level of gearing
* any tax relief available
Some schemes may only be available to certain classes of institutional investors such as pension funds.
- State the eight main differences between investment trusts and unit trusts.
- The marketability of the shares of closed-ended funds is often less than the marketability of their underlying assets. The marketability of units in an open-ended fund is guaranteed by the managers.
- Gearing of closed-ended funds can make their share price more volatile than that of the underlying equity. Most open-ended funds cannot be geared and those that can may only be geared to a limited extent.
- Share prices in closed-ended funds are also more volatile than the prices of the underlying equities because the size of the discount can change. The volatility of unit prices in an open-ended fund should be similar to that of the prices of the underlying assets.
- This increased volatility of closed-ended funds means that they should provide a higher expected return.
- At any point in time there may be uncertainty as to the true level of net asset value per share of closed-ended funds, especially if the investments are unquoted.
- Closed-ended funds may be able to invest in a wider range of assets than unit trusts.
- It may be possible to buy assets at less than net asset value in a closed-ended fund.
They may be subject to tax at different rates.
- List the main advantages of collective investment schemes compared to direct investment.
For individual investor:
* ability to achieve diversification even with small amounts of investment
* access to specialist expertise of the investment manager
* access to larger investments than could be secured directly
* benefit from lower dealing costs than would be available if undertaking direct investments
* holding likely to be more marketable than underlying assets
* holdings are divisible
* can be used to track an investment index
* possible tax advantages
For institutional investors:
* access to specialist expertise in new sectors
* convenient and quick way to get exposure to new sectors
* to enhance expected return
- exposure to gearing
- narrowing of the discount to NAV (ITCs only)
* diversification from direct investments
* possible tax advantages
- List the main disadvantages of collective investment schemes compared to direct investment.
- Loss of control - the investor has no control over the individual investments chosen by the managers.
- Management charges are incurred.
- There may be tax disadvantages such as withholding tax, which cannot be reclaimed.
- Explain the differences between a futures contract and a forward contract.
A forward contract is a non-standardised, over-the-counter-traded contract between two parties to trade a specified asset on a set date in the future at a specified price.
Like a forward contract, a futures contract is a standardised, exchange-traded contracts between two parties to trade a specified asset on a set date in the future at a specified price.
- Contrast the features of a forward, futures and an exchange-traded option.
Futures
* obligation to trade
* exchange-tradable
* standardised
* no premium paid by buyer or seller
* margin paid to clearing house by both parties
* price quoted in the marketplace
Forward
* obligation to trade
* OTC-traded
* non-standardised
* no premium paid by buyer or seller
* price negotiated
Option
* right to trade
* exchange-tradable or OTC-tradable
* standardised or non-standardised
* premium paid from holder to writer
* margin paid to clearing house by writer only
* price quoted in the marketplace
- Explain the difference between a long position and a short position in futures and forward dealing.
Having a long position in an asset means having an economic exposure to the asset. In futures and forward dealing the long party is the one who has contracted to take delivery of the asset in the future.
Having a short position in an asset means having a negative economic exposure to the asset. In futures and forward dealing the short party is the one who has contracted to deliver the asset in the future.
- Describe the main features of put and call options.
An option is the right but not the obligation to buy or sell an asset. An option writer sells options. The price paid to the writer for an option is called the option premium.
A put option is the right, but not the obligation, to sell a specified asset at a specified price on a set date or dates in the future.
A call option is the right, but not the obligation, to buy a specified asset for a specified price on a set date or dates in the future.
The exercise price is the price at which an underlying security can be sold to (for a put) or purchased from (for a call) the writer or issuer of an option (or option feature on a security). This is also known as the strike price.
- What is a traded option?
Traded options are option contracts with standardised features actively traded on organised exchanges.
- What is a 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.
- Explain the difference between an American option and a European option.
An American option is an option that can be exercised on any date before its expiry.
A European option is an option that can only be exercised at expiry.
- When calculating the price of derivatives, what needs to be included?
Derivative transactions are not cheap and the cost of the derivative and any collateral the counterparty may require need to be included in the calculations.
- Explain the main reasons why an investor may wish to hold foreign assets.
There are three main reasons why an investor may wish to hold foreign assets:
* to match liabilities in the foreign currency
* to increase the expected returns
* to reduce risk by increasing the level of diversification.
Investors with only domestic liabilities need to consider the effect that overseas investments have on the expected risk / return performance of the whole portfolio.
Returns on overseas investment can be higher than domestic either because they are fair compensation for the higher risk involved, or if inefficiencies in the global market allow fund managers to find markets undervalued.
A major benefit of overseas investment is diversification. Investing in different countries or economies with a low degree of correlation helps to reduce risk. Diversification is also achieved by investing in industries that are not available for investment in the home market.
