Chapter 11: Other investment classes Flashcards
What is a collective investment scheme?
Collective investment schemes provide structure for the management of investments on a grouped basis.
Outline the purpose of collective investment schemes from the perspective of both the investor and the management of the CIS
From in investor’s perspective:
* Diversification and lower portfolio risk
* Access to expertise
* Access to larger / unusual investments
* Economies of scale (reducing investment expenses
* Possible tax advantages
From the management of the CISs perspective:
* To follow the stated investment objective
* To create return for investors commensurate with the level of risk taken.
Define closed-ended in the context of CISs
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.
Define open-ended in the context of CISs
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.
Define net asset value (NAV) per share for an ITC
NAV per share is equal to the value of the underlying assets of the company divided by the number of ordinary shares.
If gearing is allowed, the underlying assets would be net of the debt liabilities.
Outline the differences between closed-ended and open-ended CISs
- 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.
- It may be possible to buy assets at less than net asset value in a closed-ended fund.
- The increased volatility of closed-ended funds means that they should provide a higher expected return
- 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 open-ended fund should be similar to that of the prices of the underlying assets.
- At any point in time there may be uncertainty as to the true level of net asset value per share of a closed-ended fund, especially if the investments are unquoted.
- Closed-ended funds may be able to invest in a wider range of assets than unti trusts.
- They may be subject to tax at different rates.
Define open-ended investment company (OEIC)
OEIC is an investment vehicle similar in corporate governance features to an investment trust but with the open-ended characteristics of a unit trust.
Outline 10 investment and risk characteristics of an investment trust company
- Stated investment objectives written into prospective / offer for sale document
- Closed-ended
- Public company, governed by company law
- Often quoted on an exchange
- Can raise both debt and equity capital
- Operated by company directors and investment managers
- Directors and investment managers receive fees
- Investors buy “shares” in the ITC
- Share price is determined by supply and demand
- Share price often stands at a discount to the company’s NAV per share
Outline 9 investment and risk characteristics of a unit trust
- Stated investment objective
- Open-ended
- Trust, governed by trust law
- Limited ability to gear
- Operated by trustees and management company / investment managers
- Trustees ensure UT is managed legally in accordance with the trust deed, hold assets and oversee the calculation of the bid and offer prices and the administration of the UT
- Trustees and UT managers receive fees
- Investors buy “units” in the UT
- Unit price is based on NAV per share
Outline the advantages of investment in CISs compared with direct investment
- Access to larger / more unusual investments
- Discount to NAV - assets may be bought cheaply
- Diversification
- Divisibility
- Economies of scale in the case of larger collective schemes
- Expected return higher due to the extra volatility associated with gearing and changes to the discount to NAV
- Expertise of investment managers
- Index-tracking of a quoted investment index is possible
- Marketability (possibly)
- Quoted prices make valuation easier
- Suitable for small investors
- Tax advantages (possibly)
Outline the disadvantages of investment in CISs compared to direect investment
- Loss of control
- Additional layer of charges: Management fees for investment managers
- Need to hold som cash for liquidity which reduced expected exposure / return (UT only)
- Extra volatility caused by gearing / discount to NAV changing (ITC only)
- Tax advantages (possibly)
Define a derivative
A derivative is a financial instrument whose value is dependent on - or derived from - the value of another underlying asset.
The asset may be a financial asset such as an equity or a commodity such as grain.
A derivative can be thought of as a contract between two parties to trade an underlying asset at a date in the future.
Derivatives can be used to either reduce risk (hedging) or increase risk (speculation)
Define a forward contract
A forward contract is a contract to buy (or sell) an asset on an agreed basis in the future.
Forwards are non-standardised contracts.
Define a futures contract
A futures contract is a contract to buy (or sell) an asset on an agreed basis in the future.
Futures are standardised contracts.
Features of a forward contract
- Tailor made, non-standardised
- OTC traded
- Default risk depends on counterparty
- No margin paid as traded OTC
- Less liquid than future
- No quoted price as traded OTC
- Often results in delivery
Features of a futures contract
- Standardised
- Exchange traded
- Clearing house removes defualt risk
- Margin paid to clearing house
- More liquid than forward
- Quoted price
- Often closed out before delivery
Define a long and short position in relation to futures and forwards contracts
Having a long position in an asset means having a positive 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 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.
Define an option
An option is the right, but not the obligation, to buy or sell an asset.
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.
A put option is the right, but not the obligation, to sell a specified asset for a specified price on a set date or dates in the future.
A European option is an option that can only be exercised at expiry.
An American option is an option that can be exercised on any date before its expiry.
Define 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.
Outline the main uses of derivatives
- Futures contracts can be used to set prices in advance
- Allows a financial institution to trade in assets they otherwise won’t be able to.
- While a financial institution can trade in futures, it needs to be sure of being able to sell long positions before delivery.
- Gives financial institutions the opportunity to alter the structure of their portfolios without needing to trade in the underlying assets.
Outline 3 main reasons for investing overseas
- To match liabilities in the foreign country
- To increase the expected returns
- To reduce risk by increasing the level of diversification
What are the fundamental problems with investing overseas?
- A different market performance to the home market and the associated mismatching risk
- Currency fluctuation risk. Significant losses can be made very quickly if the currencies purchased fall in value.
- Increased expertise needed to assess the market
- Additional administration functions: custodian, dividend tracking and collection
- Different tax treatment
- Different accounting practices
- Less information may be available than in the home market
- Language problems - although many of the larger overseas companies publish accounts in English
- Time delays - timing differences have presented difficulties in the past, but advances in communications have made this much less of a problem
- Poorer market regulation in some countries - although some large companies are listed in more than one major financial centre
- risk of adverse political developments
- liquidity - many less developed markets are not very liquid
- restrictions on the ownership of certain shares
Outline 3 ways of indirectly investing in overseas assets
- Investment in multinational companies based in the home market.
- Investment in collective investment vehicles specialising in overseas investemnt
- Investment in derivatives based on overseas assets.
Discuss the advantages and disadvantages of investing indirectly overseas by investment in mutlinational companies based in the home market
Advantages:
* It is easy to deal in the familiar home market
* the companies will have expertise and tend to conduct their business in the most profitable areas overseas, including areas where direct investment may be difficult
Disadvantages:
* Such a company’s earnings will be diluted by domestic earnings
* The investor will have no choice in where the company transacts its business
List the factors to consider before investing in emerging markets
- Current market valuation
- Possibility of high economic growth rate
- currency stability and strength
- level of marketability
- degree of political stability
- market regulation
- restrictions on foreign investments
- range of companies available
- communication problems
- availability and quality of information
Discuss the attractions of investment in emerging markets
With the prospects of high growth rates, and possible market inefficiencies, opportunities exist for profitable investment, but with a correspondingly higher level of risk.
Current market valuation:
* Inefficient markets: The pricing of the currencies and the stock markets of developing economies is less efficient than that of the world’s largest markets. This means there may be significant anomalies from time to time, giving investors the opportunity to buy cheaply.
* Perceived to be risky: Investment in emerging markets is often perceived to be risky. This should lead to lower demand, and lower prices.
Rapid economic growth:
* Some of the developing economies will grow at rates that are just not attainable by the large developed economies.
* Equity investors in fast-growing economies share in this incrase in wealth.
Better diversification:
* The economies and markets of many smaller countries are less interdependent than those of the major economic powers.
* Therefore investment in emerging markets may provide a good method of diversification
Drawbacks of investment in emerging markets
Volatility:
* The markets of small economies can be significantly affected by large flows of money, leading to stock markets and currencies of developing economies being potentially very volatile.
* The best performing and the worst performing of the world’s stock markets in a given period will often by from the emerging markets.
* This will give investors an unwanted extra level of uncertainty.
Marketability:
* Stocks issued in emerging markets may be less marketable and this will be of concern to many investors
Political stability:
* The governments of some emerging markets lack stability, and this can increase the volatility of investment returns.
Regulation of the stock market:
* Because the emerging markets are newer and generally smaller, there are more question marks against the efficiency of the processes for regulating the markets.
* Where markets are poorly regulated, foreign investors may lose out through insider trading by local investors and fraud.
Restrictions on foreign investment:
* Some of the emerging markets have tight controls on ownership by foreigners.
* On a related issue, there is a greater chance of direct action against foreign investors, e.g. following a change in political leadership.
* Developing nations tend to be less stable politically.
Communication problems and availability and quality of information:
* The inefficiency of the markets can also make it much more difficult for the investor to get enough good quality information to substantiate a view that investment is worthwhile.
* Specialist local expertise is therefore especially important.
* There may be greater communication issues, for example, language barriers, time zones and how information is presented.
