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Certified Financial Planner Core Curriculum > Chapter 11: Advanced Investing > Flashcards

Chapter 11: Advanced Investing Flashcards

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1
Q

What is the biggest perceived advantage of real estate investing?

A

The presence of a tangible asset

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2
Q

What are the (4) reasons that make real estate investing attractive?

A
  1. Tangible asset
  2. Often acquired for income
  3. Opportunity for capital appreciation
  4. There can be tax advantages
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3
Q

Which costs associated with owning and maintaining a rental property are tax deductible?

A

Mortgage interest, insurance, property taxes, maintenance, general upkeep.

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4
Q

When would an expense related to a rental property be considered a capital cost rather than a deduction?

A

General maintenance/upkeep as well as costs associated with improving a rental property to make it more accessible for disabled tenants are all considered deductions. Other capital improvements are normally considered capital costs.

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5
Q

What are (4) limitations to real estate investing?

A
  1. Hefty capital requirements
  2. Liquidity is restricted
  3. Maintenance and upkeep costs
  4. Liability and property risk
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6
Q

What is correlation?

A

The extent to which the value of any two investments will fluctuate in relation to one another.

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7
Q

How does asset allocation differ from portfolio construction?

A

Asset allocation refers to the balance between cash, income, and growth assets while portfolio construction refers to the specific investments held in a portfolio.

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8
Q

What are the 3 primary asset classes?

A
  1. Cash
  2. Income
  3. Growth
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9
Q

What are the (4) most common reasons for holding cash in a portfolio?

A
  1. Liquidity
  2. Portfolio “insurance”
  3. Buying opportunities
  4. Uncertainty
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10
Q

How much cash should a typical portfolio hold?

A

5% to 20% of its value in cash

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11
Q

What defines income assets?

A

Assets that generate regular income, but also feature an element of capital preservation.

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12
Q

Which assets fall into the “income” category?

A

GICs, bonds, debentures, preferred shares, mortgages, most annuities, certain real estate investments.

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13
Q

What is the general rule of thumb to determine the equity mix (correct mix of growth investments in a portfolio)?

A

100 - age
Example: someone who is 50 would hold 50% of their portfolio in growth. Someone who is 20 would hold 80% of their portfolio in growth.

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14
Q

What was Harry Markowitz known for?

A

Influential in the development of Modern Portfolio Theory and the application of mathematical models to construct portfolios.

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15
Q

Who is Benjamin Graham and what is he known for?

A

Considered the “father of value investing”. Most famous for his influence on Warren Buffett. Graham’s thesis revolved around the idea that a patient investor who did careful research and was not influenced by short-term fluctuations in market prices could expect to profit in the long term.

Most influential refutation of the efficient market hypothesis.

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16
Q

Who is William Sharpe and what is he known for?

A

Sharpe was an early student of Markowitz’, introduced the CAPM and the Sharpe ratio. He introduced the idea that risk could be quantitatively measured. Advocates for passive investing as active management “cannot, mathematically, be better for the investor than low-cost index investing”.

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17
Q

Who is Eugene Fama and what is he known for?

A

Considered to be the father of Modern Portfolio Theory. He determined that MPT did not work in its pure form, and additional factors had to be considered to measure risk and return. His models create a sort of hybrid of active and passive investing, sometimes referred to as factor-based investing.

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18
Q

Who is Nassim Talib and what is he known for?

A

Recent entrant to the field of investing, called into question the use of common statistical models such as standard deviation. His work indicates that we tend to grossly underestimate the severity and likelihood of big events, leading us to act as if those big events are not actually so significant. His models rely on using safe and reliable investments for the most part, with a few long-shot bets that will pay off in the event of a significant move in the markets.

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19
Q

What are the risks associated with leveraged investing?

A
  • Debt servicing requirements. Must continue to make payments, even if something happens. A regular investor can simply put their savings on hold.
  • Subject to interest rate risk, would need to increase payments if interest rates rise
  • Psychological risk of panic if markets drop
  • Opportunity risk. Leveraged investor may have difficulties borrowing the future due to the outstanding loan.
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20
Q

What are PPNs?

A

Principal Protected Notes. These are bank sponsored investments often sold by independent investment advisors. Similar to GICs in that they normally have a fixed maturity date and guarantee the return of invested principal. Any returns generated are taxed as ordinary income. Typically have a min investment of $5,000 or more. PPNs provide the investor to participate in positive market performance (like an equity-linked GIC)

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21
Q

Why are PPNs generally not ideal for non-registered accounts?

A

They provide returns in the form of ordinary income.

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22
Q

Who are PPNs useful for?

A

Investors looking for a combination of market performance and guaranteed principal (like equity-linked GICs)

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23
Q

What is margin?

A

The requirement to maintain a certain balance in an account when leverage is being used.

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24
Q

What is a margin call?

A

If a leveraged investor’s account falls below a certain level, the broker may impose a margin call which compels the investor to bring their account back into a position where the risk is limited to an appropriate degree.

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25
Q

What are the 2 general ways to resolve a market call?

A
  1. Add additional funds from another account

2. Sell some of the underlying investments and repay any debt to a broker

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26
Q

How does short selling work?

A

An investor borrows shares from a broker and immediately sells those shares. They wait for the price to fall, then buys the shares back at the lower price. They then use those shares to repay the broker.

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27
Q

What is the greatest concern associated with short selling?

A

The investor’s loss is theoretically infinite as a share’s price could increase to any price.

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28
Q

How are earnings measured for publicly traded companies?

A

On the basis of earnings per share (EPS)

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29
Q

How do you calculate the P/E ratio?

A

Price to Earnings ratio is calculated as the stock price divided by the EPS.

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30
Q

What can be said about a stock with a high P/E ratio?

A

It would be classified as a growth stock as investors are most likely counting on substantial increases in the company’s earnings.

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31
Q

What are 4 factors that stock valuation methods can be based on?

A
  1. Dividend payout
  2. Dividend growth
  3. Corporate assets
  4. Corporate earnings
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32
Q

What is a prospectus?

A

Detailed disclosure document that explains the underlying investment.

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33
Q

Which types of investments are exempt from prospectus requirements?

A
  • GICs
  • Segregated funds
  • Private placements
  • Land banking
  • PPNs
  • Mortgage investment corporations
  • Flow-through shares
  • Hedge funds
34
Q

What are private placements?

A

Solicitations for the sale of securities that have not been publicly offered.

35
Q

Where is land banking gaining popularity?

A

Western Canada

36
Q

What are Mortgage Investment Corporations (MICs)?

A

A way for investors to enjoy returns from backing a mortgage, commonly hold high-risk mortgages.

37
Q

Who typically uses flow-through shares?

A

High-net worth clients looking to reduce their tax burden.

38
Q

What are prospectus exemptions and how many are there?

A

Exemptions for prospectus requirements for certain investments that do not require them. There are about 130 available in Canada.

39
Q

What are the (4) most common prospectus exemptions?

A
  1. Accredited investor
  2. Offering memorandum
  3. Large investments
  4. Friends and family
40
Q

What is the accredited investor prospectus exemption?

A

In certain cases, only accredited investors can purchase exempt market securities. These investors must meet minimum requirements for annual income or net assets.

41
Q

What is the theory behind the accredited investor prospectus exemption?

A

The theory is that an investor with this level of individual worth can do more research on their own, and the lack of a prospectus will not harm them. They are also better able to absorb a loss if their investment fails.

42
Q

What are the minimum requirements to qualify as an accredited investor in Ontario?

A
  • $200K of individual annual income
  • $300K of family annual income
  • $1M of net investable assets
  • $5M of total assets
43
Q

What is the offering memorandum prospectus exemption?

A

Provides smaller companies with a means to raise capital. An OM is a sort of “prospectus-lite”. Provides the same details as a prospectus without the same level of 3rd party oversight required in a prospectus.

44
Q

What is the purpose of the large investment prospectus exemption?

A

If an investor can write a cheque for $150K or more at one time for the purchase of a security, they can qualify for many exempt market purchases. The theory is that the investor has a significant net worth and can absorb a loss if their investment fails, and that they can do research on their own.

45
Q

What is the purpose of the friends and family prospectus exemption?

A

An exemption is allowed when friends and family go into business with one another in order to allow family businesses to operate and friends to go into business together.

46
Q

What are common advantages and disadvantages of exempt market instruments?

A

Advantages:
- Uncorrelated to the rest of the market
- May provide tax-efficient flow of income to the investor
- Unconventional, may be able to provide higher returns
Disadvantages:
- Less formal disclosure
- Lack of regulation/protection
- Risk
- Liquidity (lack of an active secondary market)

47
Q

What does the Income Tax Act provide deductions for to encourage investment in natural resources? How does this work?

A

Deductions for expenditures in oil and gas exploration and mining exploration. Rather than a capital cost, these expenditures are immediately deductible.

48
Q

Why is a partnership called a “flow-through” structure?

A

It allows both deductions and income to flow through to partners.

49
Q

What will those in the resource exploration business often do to attract investors?

A

Set up limited partnerships. Units of the limited partnership are known as flow-through shares and can be sold to high-net-worth investors who can benefit from a tax deduction. These units are generally sold at a premium (a $100,000 investment might turn into a partnership interest worth $85,000). The limited partner is able to deduct the full amount invested, then the investor will realize gains (usually capital) once the investment matures.

50
Q

What is the typical time horizon for LPs as investments?

A

Limited partnerships as investments typically have a time horizon between 1 to 3 years, although there is no regulatory requirement dictating this.

51
Q

Why are limited partnerships (as investments) popular with high-net-worth investors? What are their limitations?

A

Their ability to generate virtually unlimited tax deductions.

The At-Risk rules limit the investor’s tax benefit to the amount of after-tax dollars invested. Example: an investor who invests $100K and receives an $85K tax deduction would only be able to get a further $15K in tax benefits (deductions or credits). If the investor generated a further $10K in taxable income, then that would open up the possibility of a further $10K in tax benefits (or $25K beyond the original $85K).

52
Q

What is generally considered the greatest advantage of investment funds?

A

Professional management - by pooling resources, investors can hire a professional manager who will make investment decisions on their behalf.

53
Q

What are the general rules for diversification within mutual funds?

A

Funds generally cannot hold more than 10% of its value in one security (or 10% of one class of shares issued by a particular company).

54
Q

What does the term “Continuous Primary Distribution” refer to?

A

The feature of mutual funds where they continuously issue new units (or units cease o exist when redeemed). This is in contrast to individual shares where an interested buyer will need to find a willing seller.

55
Q

What is the NAV of a fund?

A

The sum total of all the investments held by the fund is its net asset value.

56
Q

How often are most mutual funds required to calculate their NAV?

A

At least once per week by the close of the business day.

57
Q

How is the NAVPU/NAVPS affected when a fund produces a distribution to all unitholders?

A

The distribution may reduce the NAVPU and increase the number of units held by each investor through the cash being reinvested.

58
Q

What is a Flow Through mutual fund structure?

A

Some investment funds have some flow-through characteristics. This means that the income generated by the fund retains its tax characteristics as it flows through the fund and into the investors hands. (Example: A mutual fund in a trust structure that generates eligible dividend income will then create eligible dividend income for the investor).

59
Q

What is the custodian’s role with an investment fund? Who is the custodian normally?

A

The custodian actually holds the securities comprising the fund’s value. This is normally a 3rd party, separate from the fund company.

60
Q

What is the role of the registrar to an investment fund?

A

A third party organization that provides record keeping services to the fund.

61
Q

What are the two basic mutual fund structures?

A
  1. Trust - investments in the fund are held in trust for investors. Income earned by the trust flows through to the investors, retaining its original tax characteristics. Switches/redemptions will trigger any capital gains liability.
  2. Corporate class - investments in the fund are owned within a corporation and investors become shareholders in the corporation. The corp receives any income and investors receive relatively small regular taxable distributions, but can defer most gains until disposition.
62
Q

Which two self-regulatory organizations handle most mutual fund regulation?

A

Mutual Fund Dealers Association (MFDA) and Independent Investment Regulatory Organization of Canada (IIROC)

63
Q

Describe ETFs

A

Investment funds that sell on a stock exchange with value based on an underlying basket of investments. Most ETFs are designed to track an index.

64
Q

How do institutional investors keep the price of ETF units representative of the value of the underlying securities?

A

May purchase and redeem units in bulk directly through the issuer, and will do so when there is an inefficiency in the ETFs price.

65
Q

What is a factor based ETF?

A

Hybrid between active and passive management. Takes a purely passive strategy and applies some weight (tilt) to certain stocks. An example of this tilt could include being underweight in securities with a PE over a certain threshold.

66
Q

What is the name of the insurance contract that a segregated fund investor enters into?

A

An Individual Variable Insurance Contract (IVIC)

67
Q

How is ownership in a segregated fund represented?

A

In notional units since the investor does not actually own the investments in a seg fund.

68
Q

How do the tax consequences of seg funds differ from mutual funds?

A

No deferral is generally available, tax consequences of the underlying investments flow through to the investors in the year in which they arise. The upside is that the investor can realize losses without having to dispose of units in the fund (during down years)

69
Q

When does a seg fund qualify for creditor protection?

A

When the contract owner has named a parent, spouse, child, grandchild, or any irrevocable beneficiary.

70
Q

How are hedge funds usually strcutured?

A

Either as limited partnerships or under a mutual fund structure.

71
Q

How does hedge fund manager compensation work?

A

Hedge fund managers typically have to obtain a high-water mark in order to start receiving compensation.

72
Q

What are wrap accounts and pooled funds?

A

Essentially custom-built mutual funds for those who have large investments. Allow investors with very specific needs to have a professional money manager help obtain their investment goals. Often, the manager will operate the funds on a discretionary trading basis, and then simply charge a percentage against the total value of assets held. Regulation of these accounts is handled more like that of individual stocks and bonds.

73
Q

What are Labour Sponsored Funds?

A

Also called Labour-Sponsored Venture Capital Corporations. Investment fund usually on a mutual fund platform with particular tax advantages for the investor (Federal LSVCC tax credit). Provide access to smaller companies, usually with some sort of innovative focus.

74
Q

Where do Labour-Sponsored Funds get their name?

A

The funds normally have representation from labour unions on their boards.

75
Q

What tax advantages are associated with labour-sponsored funds?

A

Government has permitted a set of tax credits as these funds help facilitate the flow of capital to small businesses. Federal LSVCC tax credit provides a 15% credit on an investment of up to $5000 per year. Tax credit is lost if the funds are withdrawn in the next 7 years after the investment is made. (Uncertainty around the future of this credit).

These funds are also RRSP eligible, so you can receive a credit and deduction simultaneously.

76
Q

What is the purpose of private equity funds/pools?

A

Generally seek to purchase entire companies and turn them from publicly traded companies to privately held companies.

77
Q

Which types of funds could be considered closed ends funds? What is meant by a fund being closed-ended?

A

Can include ETFs, pooled funds, wrap accounts. Means that they do not necessarily allow new investment dollars to flow in. Instead, investors would have to buy and sell units with other investors.

78
Q

What is the purpose of investment trusts? What is the only investment that is able to be structured as an investment trust?

A

Means to create investments that pass their underlying characteristics on to investors. Only available to Real Estate Investment Trusts.

79
Q

What are the 3 characteristics of REITs that distinguish them from other sorts of investment funds?

A
  • Uncorrelated to the rest of the market
  • Tax efficient (due to the ability to claim CCA and pass on income as taxable distributions). Investor receives a distribution about half of which is fully taxable as income, and half is tax-free. The tax-free portion reduces the investor’s ACB.
  • Stable income
80
Q

What is land banking?

A

Exempt market investment that gives investors the opportunity to pool their resources, usually to take part in residential or commercial land development.

81
Q

How does land banking work?

A

Basic structure typically involves investors pooling their dollars using an experienced land developer as manager. Developer acquires a swath of land, develops it, and sells it to appropriate customers. Returns flow to the investors in the form of taxable distributions.

Certified Financial Planner Core Curriculum (16 decks)

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