Chapter 11 - Other investment classes Flashcards
What is a collective investment scheme?
CIS provides structures for the management of investments on a grouped basis. Offer the opportunity for indirect investment in underlying asset classes.
Typically have a stated investment objective
What are some advantages of investing in a CIS
Lower portfolio risk through indirect diversification
Gain exposure to management expertise
Attractive to individuals with smaller sums or with less experience since gain exposure to asset classes they normally wouldn’t when investing directly.
What regulations could be applied to CISs?
Categories of assets which may be held
Restrictions on investment in unquoted assets
Maximum of gearing which may be applied
Tax relief available (ie to avoid double taxation)
What is a close ended investment scheme?
Once initial tranche of money has been invested the scheme is closed to new money.
Only way to invest is to buy existing units/shares from a willing seller.
Investment trust is one example.
What is an open ended investment scheme?
Manager can create or cancel units as money is invested or disinvested.
Example is a united trust.
What is an investment trust?
Closed-ended
Public company
Manage shares and other investments
Legal structure is a company (not a trust) and has the ability to raise loan capital
Normally shares are quoted on a stock exchange.
NAV is reasonable expectation for share price.
Main stakeholders are:
Board of directors
Investment managers
Shareholders
What is a unit trust?
Open-ended
Investors can buy units in an underlying pool of assets.
Managers can create and buy back units.
Legal structure is a trust - limited borrowing power
Unit price is calculated regularly as market value of underlying assets/number of units, with some practical complications
Main stakeholders are:
Management company
Trustees
Investors
What are some practical complications when valuing units?
Whether to use bid or offer price of underlying assets
Allowing for expenses incurred in trading units
Allowing for charges incurred to investors
Rounding
What is an open-ended investment company?
Open ended
Similar corporate governance to investment trust.
Managers can create and redeem shares.
Main difference with a unit trust is there is a single price for the shares as opposed to the bid/offer price spread of units.
Similar to mutual funds in the US
Discuss the main differences in characteristics between open and closed ended schemes.
Marketability:
- Marketability of closed ended shares can be very different to that of the underlying assets, depending on the company and the underlying assets
- Marketability of open-ended fund is guaranteed by the managers
Gearing:
- Gearing activities of closed-ended funds can increase the volatility of share values (as well as expected return)
- Open-ended CISs can normally not be geared/are very restricted in gearing
Price of shares/units relative to NAV:
- May be possible to buy closed ended shares at a discount to NAV
- Extra source of volatility in return
- Opportunity to increase returns if buying at a high discount and selling at a low discount
- Concept does not apply to unit trusts since value is determined by the management and is directly related to the value of the underlying assets.
Expected returns and volatility:
- Extra volatility due to gearing and NAV discount margin should lead to higher expected returns for closed ended compared to open ended
- Volatility of units in open ended should be similar to underlying assets
Price uncertainty:
- May be uncertainty in NAV if underlying assets are difficult to value/unquoted
- Pricing difficulties involved with calculating unit prices
Diversification:
- Closed-ended funds may be able to invest in a wider range of assets than unit trusts
Tax:
- May be subject to different tax rates
Discuss possible reasons that prices of closed ended investment schemes, such as investment trusts, are often at a discount to NAV.
Allow for management charges
Concerns over marketability of shares
Concerns over quality of management
Market sentiment/fashion
Discuss the main advantages (7) of indirect investment through CISs compared to direct investment (3).
Advantages are great for smaller investors:
- Access to specialist expertise
- Easy way of obtaining diversification
- Avoid costs involved with direct investment management
- Holdings are divisible
- Possible tax advantages
- Possible marketability advantages
- Can track return on a specific index
Main disadvantages:
- Loss of control over investment
- Management charges
- May be tax disadvantages
What is an index tracker fund?
CIS who’s stated objective is to track the return of a specific index.
What is a derivative? What are their main uses?
Financial instrument whose value is dependent on the value of an underlying asset. Financial contract to trade an underlying asset at a specific price on/before a certain date. They allow investors to gain exposure to underlying assets without necessarily trading in the underlying assets.
Hedging
Speculation
What is a forward contract?
Agree to buy/sell asset on agreed basis in the future.
Non-standardised contract negotiated between the two parties
Traded over the counter (OTC)
What is a futures contract?
Agree to buy/sell asset on agreed basis in the future.
Standardised contracts
Traded on an exchange
Very liquid due to ease of valuation, standardisation and ease of administration
What are the functions of an exchange with regards to futures contracts?
Setting details of the standardised contracts
Authorising trades
Intermediary for buyers and sellers
Operating the clearing house
What is the clearing house and how does it operate?
Self-contained institution whose only function is to clear futures trades and settle margin payments.
Checks buy and sell orders match each other.
Acts as a party to every trade (acts as buyer and seller in-between actual buyer and seller)
Removes credit risk to individual parties, while parties have contractual obligation to clearing house.
Receives initial margin and then adjusts regularly with variation margin.
What is a long and short position?
Long - positive economic exposure to the asset
Short - Negative economic exposure to the asset
What is a warrant?
Option issued by a company over its own shares.
Holder has right to purchase shares at a specified price at specified times in the future.
Could be bond or equity warrants
Often issued as an add-on to other benefits
Why would a company want to issue warrants?
Makes bond more appealing to investors
Efficient way to obtain finance.
Discuss the main reasons to invest in overseas markets
Match liabilities in a foreign currency
Increase in expected returns
- Could be higher expected returns in overseas markets due to compensation for higher risk or if inefficiencies in the global market lead to undervalued overseas markets.
- More likely to be a factor in emerging markets than developed markets
Diversification
- Investing in countries with economies that have low degree of correlation helps to diversify risk
What are the main issues with overseas investment? (13)
Mismatching risk
Currency fluctuation risk
May require increased expertise to assess the market
Additional admin such as custodianship, dividend tracking and collection
May be different tax treatment and lead to double taxation
Different accounting practices
Less information may be available
Communication and language problems
Time delays (not such a huge issue in modern times)
Poor market regulation
Political risk
Liquidity may be a problem
Restrictions on ownership of shares
Discuss the main ways to achieve indirect investment in overseas markets.
Investment in multinational companies based in the home market:
Advantages
- Easy to deal with
- Companies have expertise and conduct business in most profitable areas overseas
Disadvantages
- Overseas earnings diluted by local earnings
- No choice in where company conducts business
