Chapter11-Other investments classes

Question 1

Framework

Answer 1

1 Purpose of collective investment schemes
2 Close-ended and open ended collective investment schemes
3 Net asset value per share for an ITC
4 Investment and risk characteristics of an investment trust company
5 Investment and risk characteristics of a unit trust
6 Advantages of collective investment schemes over direct investment
7 Disadvantages of collective investment schemes over direct investment schemes
8 Differences between open-ended and close-ended CISs
9 Futures and forwards
10 Long and short positions
11 Options
12 Warrant
13 Main uses of derivatives
14 Main reasons for investing overseas
15 Fundamental problems of investing overseas
16 Practical problem with investing overseas
17 Methods of indirect overseas investment
18 Advantages and disadvantages of investment in multinational companies
19 Factors to consider when investing in emerging markets

Question 2

Investment and risk characteristics of an investment trust company (10)

Answer 2

1. Stated investment objective written into prospectus / offer for sale document
2. Closed-ended
3. Public company, governed by company law
4. Often quoted on stock exchange
5. Can raise both debt and equity capital
6. Operated by company directors and investment managers (eg merchant banks or specialist ITC managers)
7. Directors and investment managers receive fees
8. Investor buys ‘shares’ in the ITC
9. Share price is determined by supply and demand
10. Share price often stands at a discount to (i.e is less than) the company’s NAV per share

Question 3

Investment and risk characteristics of a unit trust (9)

Answer 3

1. Stated investment objective
2. Open-ended
3. Trust, governed by trust law
4. Limited ability to gear
5. Operated by trustees (eg insurance companies or large banks) and management company / investment managers (eg life insurance company)
6. Trustees ensure UT is managed legally in accordance with the trust deed, hold the assets and oversee the calculation of the bid and offer prices and the administration of the UT
7. Trustees and UT managers receive fees
8. Investor buys ‘units’ in the UT
9. Unit price is based on NAV per uni

Question 4

Advantages of collective investment schemes over direct investment (12)

Answer 4

Access to larger / more unusual investments

Discount to NAV – assets may be bought cheaply (ITC only)

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 (ITC only)

Expertise of investment managers

Index-tracking of a quoted investment index is possible

Marketability (possibly)

Quoted prices making valuation easier

Suitable for small investors

Tax advantages (possibly)

Question 5

Disadvantages of collective investment schemes over direct investment schemes (5)

Answer 5

Loss of control

Additional layer of charges: management fees for investment managers

Need to hold some cash for liquidity which reduces expected exposure / return (UT only)

Extra volatility caused by gearing / discount to NAV changing (ITC only)

Tax disadvantages (possibly)

Question 6

Differences between open-ended and close-ended CISs (9)

Answer 6

1. Shares in closed-ended CISs are often less marketable than the underlying assets. Marketability of units in open-ended CISs is usually guaranteed by the managers.
2. Some open-ended CISs (eg property UTs) need to hold cash to maintain liquidity → lower expected returns but greater price stability.
3. Closed-ended CISs can gear, leading to extra volatility. Open-ended CISs cannot be geared or have limited gearing.
4. Share prices in closed-ended CISs are also more volatile than the prices of the underlying assets because the size of the discount to NAV per share can change. The price volatility of units in an open-ended fund should be similar to that of the underlying assets.
5. Increased volatility of closed-ended CISs → higher expected return.
6. There may be uncertainty as to the true level of NAV per share of a closed-ended CIS, especially if the investments are unquoted.
7. Closed-ended CISs can invest in a wider range of assets.
8. May be possible to buy assets at less than NAV in a closed-ended CIS.
9. They may be subject to different tax treatment.

Question 7

Futures and forwards

Answer 7

Futures contract – a standardised, exchange-traded contract to buy (or sell) a specified asset at a specified price on a specified date in the future.

Forward contract – a non-standardised, OTC traded contract to buy (or sell) a specified asset at a specified price on a specified date in the future.

Future Forward

Standardised Tailor-made, non-standardised

Exchange-traded OTC traded

Clearing house removes Default risk depends on
default risk counterparty

Margin paid to clearing No margin paid as traded
house OTC

More liquid Less liquid

Quoted price No quoted price as traded
OTC

Often closed out before Often results in deliver
delivery

Question 8

Practical problem with investing overseas (11)

Answer 8

Custodian needed

Additional admin required

Time delays

Expenses incurred / expertise needed

Regulation poor

Political instability

Information harder to obtain (and less of it)

Language difficulties

Liquidity problems

Accounting differences

Restrictions on foreign ownership / repatriation problems

Question 9

Methods of indirect overseas investment

Answer 9

1. Investment in multinational companies based in the home market
2. Investment in collective investment schemes specialising in overseas investment
3. Investment in derivatives based on overseas assets