Chapter 11: Other investment classes Flashcards
Collective investment schemes (CIS)
Provide structures for the management of investments on a grouped basis. Provide an opportunity for investors to achieve a wide spread of investments and therefore to lower portfolio risk.
2 types of CIS
Close-ended
Open-ended
Close-ended CIS
Once the initial tranche of money has been invested, the fund is closed to new money.
Open-ended CIS
New money can enter the fund, money can leave the fund as well.
E.g. Managers can create/cancel units in the fund as new money is invested/divested.
4 Regulation aspects of CISs
- Categories of assets held
- Whether unquoted assets can be held
- Maximum level of gearing
- Any tax reliefs available
6 Features of Investment trust companies (ITCs)
- Stated investment objectives
- Funds are closed-ended
- investors buy shares in an ITC, priced by supply and
demand - Public companies, governed by company law
- Gearing is allowed
- Share price often stands at a discount to net asset
value (NAV) although it can stand at a premium- Stated investment objectives - Funds are closed-ended
- investors buy shares in an ITC, priced by supply and
demand - Public companies, governed by company law
- Gearing is allowed
- Share price often stands at a discount to net asset
value (NAV) although it can stand at a premium
Key parties involved in ITCs
- board of directors,
- investment managers
- shareholders
6 Key features of Unit Trusts
- Stated investment objective
- investors buy units in a UT, priced at a net asset value
(NAV). - Funds are open-ended
- They are trusts, governed by law
- Limited power to use gearing (ie to borrow)
- Guaranteed marketability
Key parties in unit trusts
- Trustees (eg insurance company or bank)
- Investment managers (eg merchant bank)
- unitholders
Differences between ITCs and UTs
- Shares in ITCs are often less marketable than the underlying assets, whereas the marketability of units in UTs are guaranteed by the managers
- Some UTs (eg property) need to hold cash to maintain liquidity, which implies lower expected returns but greater price stability
- ITCs can gear, leading to extra volatility. UTs have limited power to gear.
- Increase volatility of ITCs implies higher expected return
- May be possible to buy assets at less than NAV in an ITC
- ITC shares are more volatile than underlying assets because of the size of any discount to NAV can change. Volatility of units in a UT should be similar to that of underlying assets.
- May be uncertainty as to the true level of NAV per share of an ITC, especially if the investments are unquoted.
- ITCs can invest in a wider range of assets than UTs
- May be subject to different tax treatment
Advantages of indirect investment vs direct investment
- Access to larger / more unusual investment
- Economies of scale in the case of larger collective schemes
- Discount to NAV - assets may be bought cheaply (ITCs only)
- Diversification
- Divisibility
- Expected return higher due to the extra volatility associated with gearing
- Expected return higher due to extra volatility associated with the discount to NAV
- Expenses associated with direct investment avoided
- Expertise of investment managers
- Index-tracking of a quoted investment index is possible
- Marketability may be better than that of underlying securities (although they may also be less marketable than the underlying assets)
- Quoted prices, which make valuation easier
- Tax advantages possible
Disadvantages of collective investment schemes vs direct investment
- Loss of control
- Management charges incurred
- Extra volatility caused by gearing/discount to NAV (ITCs only)
- Tax disadvantages are possible
Net asset value per share (NAV)
Company’s underlying assets divided by the number of shares.
Reasons for discounted NAV in ITC’s
- Management charges
- Concerns over marketability
- Concerns over the quality of management
- Market sentiment/fashion (out of fashion by investors)
Derivative
A financial instrument whose value is dependent on the value of another underlying asset.
Forward contract
-A contract to buy (or sell) an asset on an agreed basis
in the future.
-Non-standardised.
-Over-the-counter
-Credit risk dependent on the creditworthiness of the counterparty.
Futures contract
-A STANDARDISED contract, TRADED ON A
RECOGNISED EXCHANGE, to buy (or sell) an asset on
an agreed basis in the future.
-Liquid market due to a high amount of identical futures
Functions of the exchange
- Set the details of standardised contracts
- Authorise who can trade on the exchange
- Bring buyers and sellers together
- Operate sub-institution called the clearing house.
Options
Gives an investor the right - but not the obligation - to buy/sell a specified asset on a specified future date.
Warrant
-Option issued by a company.
-The holder has the right to purchase shares at a
specified price at specified times in the future.
-Similar to a call option.
-Bond warrants do exist as well
The long position in an asset
Means having a positive economic exposure to that asset.
Short position in an asset
Having a negative economic exposure to that asset.
Clearing house
-Self-contained institution whose only function is to
clear FUTURES trades and settle margin payments.
-The clearing house checks that the buy and sell orders
match
-Acts as a party to every trade.
-Guarantees each side of the original bargain, remove
credit risk. Uses initial and variation margins.
Clearing house as a party to every trade
It simultaneously acts as if it had sold to the buyer and bought from the seller.
Following registration, each party has a contractual obligation to the clearing house.
In return, the clearing house guarantees each side of the original bargain, removing the credit risk to each of the individual parties
Closing out position
By taking out an equal but opposite contract.
E.g. buy a 3-month future (the price of X will be paid) and 3 months later, just before delivery, sells identical future at price Y. Therefore the profit or loss is Y-X.
3 Main reasons to hold foreign assets
- Match liabilities in the foreign currency
- To increase expected returns
- Reduce risk by increasing the level of diversification
How would foreign assets increase expected returns
- strengthening currencies
- higher risk or fast-growing economies
- undervalued markets
FUNDAMENTAL Drawbacks of Overseas Markets
- Mismatch of domestic liabilities
- Tax (withholding tax and possible double taxation)
- The volatility of the currency (currency risk)
PRACTICAL drawbacks of overseas investment
- need an overseas CUSTODIAN
- poorly REGULATED markets
- additional ADMINISTRATION
- possible lack of MARKETABILITY and liquidity
- LANGUAGE problems
- lack of good quality INFORMATION
- restrictions on ownership of certain shares by FOREIGN investors
- cost of obtaining EXPERTISE
- possible TIME delays
- problems REPATRIATING funds
- different ACCOUNTING methods/standards
- POLITICAL instability & risks (asset confiscation)
CRAM LIFE TRAP
Indirect overseas investments include investments in:
- MULTINATIONAL companies based in the home market
- domestic companies with a substantial EXPORT trade
- DERIVATIVES based on overseas assets.
- Companies with INTERNATIONAL SUBSIDIARIES
- (ITCs) COLLECTIVE INVESTMENT SCHEMES specialising in overseas investment
Special characteristics of emerging markets
Can be very volatile (gives the investor chance of making very big gains/losses).
- Can be affected by enormous flows of money generated by changes in investor sentiment.
- Economies and markets of many smaller markets are less interdependent than those of major economic powers, resulting in good diversification.
Factors to consider before investing in emerging markets
- Current market VALUATION
- range of companies available.
- extent of additional DIVERSITY generated.
- Possibility of high ECONOMIC GROWTH rate
- degree of POLITICAL stability
- RESTRICTIONS on foreign investment.
- market REGULATION
- STABILITY AND STRENGTH of the currency
- EXPERTISE in the markets
- availability and quality of INFORMATION.
- COMMUNICATION problems
- level of marketability
- extra EXPENSES
Matching liabilities in the foreign currency
For funds with domestic liabilities, the reasons for overseas investment depend on the effect that such investments have on the expected risk/return of the whole portfolio.
Why may returns on overseas investments be higher than returns on domestic investments?
- fair compensation for the higher risk involved
- inefficiencies in the global market, allowing fund managers to find individual countries whose markets are undervalued.
Diversification w.r.t. overseas investment
- Investing in a number of different countries or economies with a low degree of correlation helps to reduce risk.
- achieved by investing in industries that are not available for investment in the home market
- gives a larger number of companies from which to construct a diversified portfolio.
Withholding tax
tax deducted at source from dividends or other income paid to non-residents of a country.
Double taxation agreement
Done between the domestic tax authorities and the particular overseas country, allowing for the domestic tax to be reduced/eliminated because of the overseas tax already paid.
Advantages of investing in multinational companies based in the home market
- EASY to deal in the familiar home market
- better/increased ACCESS
- companies will have EXPERTISE and tend to conduct their business in the most profitable areas overseas, including areas where direct investment may be difficult.
- more MARKETABLE
Disadvantages of investing in multinational companies based in the home market
- such a company’s earnings might be DILUTED by domestic earnings
- investor will have no CHOICES in where the company transacts its business.
Emerging market
Stock markets in countries with developing economies.
- can offer high growth rates and possible market inefficiencies
Attractions of investments in emerging markets
- Current market valuation
- inefficient markets
- perceived to be risky
- Rapid economic growth
- Better diversification
Drawbacks of investment in emerging markets
- Volatility
- Marketability
- Political stability
- Regulation of the stock market
- insider trading by local investors
- fraud
- Restrictions on foreign investment
- Communication problems and availability and quality of information
