Investment Funds

Question 1

Direct Investment

Answer 1

Direct investment is when an individual personally buys shares in a company, such as buying shares in Apple, the technology giant.

Question 2

Indirect Investment

Answer 2

Indirect investment is when an individual buys a stake in an investment fund, such as a mutual fund that invests in the shares of a range of different types of companies, perhaps including Apple.

Question 3

What is an Open-ended fund?

Answer 3

An open-ended fund is one that can create new shares in response to investor demand or cancel them when sold so that their capital can expand or contract – an example is a mutual fund.

Question 4

What is a close- ended fund ?

Answer 4

A closed-ended fund, by contrast, has a fixed capital base so if an investor wants to buy shares, they will do so on the stock exchange and buy them from another investor who wants to sell. They have a fixed capital base as is seen with US closed-ended funds.

Question 5

What are the benefits of pooling of funds?

Answer 5

1. Economies of scale
2. Diversification
3. Access to professional investment management
4. Access to geographical markets, asset classes or investment strategies which might otherwise be inaccessible to the individual investor
   In some cases, the benefit of regulatory over­sight, and
   In some cases, tax deferral.

Question 6

What is passive management?

Answer 6

Passive management is seen in those types of investment funds that are often described as index-tracker funds. Index-tracking, or indexation, involves constructing a portfolio in such a way that it will track, or mimic, the performance of a recognised index. Index funds have been one of the fastest growing areas of investment.
Indexation is undertaken on the assumption that securities markets are efficiently priced and cannot therefore be consistently outperformed. Consequently, no attempt is made to forecast future events or outperform the broader market.

Question 7

What are the advantages of employing indexation?

Answer 7

1. Relatively few active portfolio managers consistently outperform benchmark indices.
2. Once set up, passive portfolios are generally less expensive to run than active portfolios, given a lower ratio of staff to funds managed and lower portfolio turnover.

Question 8

What are the disadvantages of adopting indexation?

Answer 8

1. Performance is affected by the need to manage cash flows, rebalance the portfolio to replicate changes in index constituent weightings and adjust the portfolio for stocks coming into, and falling out of, the index. This can lead to tracking error if the performance does not match that of the underlying index.
2. Most indices assume that dividends from constituent equities are reinvested on the ex-dividend (xd) date, whereas a passive fund can only invest dividends when they are received, up to six weeks after the share has been declared ex-dividend.
3. Indexed portfolios may not meet all of an investor’s objectives.
4. Indexed portfolios follow the index down in bear markets.

Question 9

What is active management?

Answer 9

Active management seeks to outperform a predetermined benchmark over a specified period. It does so by employing fundamental and technical analysis to assist in the forecasting of future events, which may be economic or specific to a company, so as to determine the portfolio’s holdings and the timing of purchases and sales of securities. Actively managed funds usually have higher charges than those that are passively managed.

Question 10

Top-down

Answer 10

Top-down means that the manager focuses on economic and industry trends rather than the prospects of particular companies.

Question 11

Bottom-up

Answer 11

Bottom-up means that the analysis of a company’s net assets, future profitability and cash flow and other company-specific indicators is a priority.

Question 12

Bottom-up rage of investment styles:

Answer 12

1. Growth investing – which is picking the shares of companies with present opportunities to grow significantly in the long term
2. Value investing – which is picking the shares of companies that are undervalued relative to their present and future profits or cash flows
3. Momentum investing – which is picking the shares whose share price is rising on the basis that this rise will continue, and
4. Contrarian investing – the flip side of momentum investing, which involves picking shares that are out of favour and may have hidden value.

Question 13

Open-Ended Funds

Answer 13

An open-ended fund is an investment fund that can issue and redeem shares at any time. Each investor has a pro rata share of the underlying portfolio and so will share in any growth of the fund. The value of each share is in proportion to the total value of the underlying investment portfolio.

Question 14

What are some key characteristics of US Open ended funds?

Answer 14

1. The mutual fund can create and sell new shares to accommodate new investors.
2. Investors buy mutual fund shares directly from the fund itself, rather than from other investors on a secondary market such as the New York Stock Exchange (NYSE) or National Association of Securities Dealers Automated Quotations (NASDAQ).
3. The price that investors pay for mutual fund shares is based on the fund’s net asset value (the NAV, which is the value of the underlying investment portfolio) plus any charges made by the fund.
4. The investment portfolios of mutual funds are typically managed by separate entities known as investment advisers, who are registered with the Securities Exchange Commission (SEC), the US regulator.

Question 14

US Open-Ended Funds

Answer 14

The most well-known type of US investment fund is a mutual fund, as defined by the Investment Company Act of 1940 (the ‘40 Act’). Legally, it is known as an ‘open-end company’ under federal securities laws. A mutual fund is one of three “main types of investment fund in the US; the others are considered later in this chapter in the section on closed-ended funds.

Question 15

UCITS

Answer 15

UCITS refers to a series of EU regulations that were originally designed to facilitate the promotion of funds to retail investors across Europe. A UCITS fund, therefore, complies with the requirements of these directives, regardless of which EU country it is established in.

Question 16

What are SICAVs- Société d’Investissement à Capital Variable- main characteristics?

Answer 16

1. They are open-ended, so new shares can be created or shares can be cancelled to meet investor demand.
2. Dealings are undertaken directly with the fund management group or through their network of agents.
3. They are typically valued each day and the price at which shares are bought or sold is directly linked to the NAV of the underlying portfolio.
4. They are single-priced, which means that the same price is used when buying or selling and any charges for purchases are added on afterwards.
5. They are usually structured as an umbrella fund, which means that each fund will have multiple other funds sitting under one legal entity. This often means that switches from one fund to another can be made at a reduced charge or without any charge at all.
6. Their legal structure is a company which may be domiciled in Luxembourg and, although some of the key aspects of the administration of the fund must also be conducted there, the investment management is often undertaken in London or another European capital.

Question 17

FCPs

Answer 17

FCPs do not have a legal personality; instead, their structure is based on a contract between the scheme manager and the investors. The contract provides for the funds to be managed on a pooled basis.
As FCPs have no legal personality, they have to be administered by a management company, but otherwise the administration is very similar to that described above for SICAVs.

Question 18

Unit Trusts

Answer 18

A unit trust is an investment fund that is established as a trust, in which the trustee is the legal owner of the underlying assets and the unitholders are the beneficial owners.
As with other types of open-ended funds, the trust can grow as more investors buy into the fund, or shrink as investors sell units back to the fund and they are cancelled. As with SICAVs, investors deal directly with the fund when they wish to buy and sell.

Question 19

What is the role of the unit trust manager ?

Answer 19

To decide, within the rules of the trust and the various regulations, which investments are included within the unit trust. This will include deciding what to buy and when to buy it, as well as what to sell and when to sell it. The unit trust manager may outsource this decision-making to a separate investment manager. The manager also provides a market for the units by dealing with investors who want to buy or sell units. It also carries out the daily pricing of units, based on the NAV of the underlying constituents.

Question 20

Who is the trustee?

Answer 20

The trustee is the legal owner of the assets in the trust, holding the assets for the benefit of the underlying unitholders. The trustee also protects the interests of the investors by, among other things, monitoring the actions of the unit trust manager. Whenever new units are created for the trust, they are created by the trustee. The trustees are organisations that the unitholders can trust with their assets, normally large banks or insurance companies.

Question 21

Trust pricing

Answer 21

The pricing of units in a unit trust is done on a dual-priced basis rather than the single-priced basis adopted by SICAVs:

1. The underlying portfolio of a unit trust is valued daily at both the bid and offer prices for the investments contained within the portfolio.
2. This produces two NAVs, one representing the value at which the portfolio’s investments can be sold for and another for how much it will cost to buy.
   These values are then used to calculate two separate prices, one at which investors can sell their units and one which the investor pays to buy units.

Question 22

Open-Ended Investment Companies (OEICs)

Answer 22

An OEIC is another form of investment fund found in Europe. They are a form of ICVC that is structured as a company with the investors holding shares.
The term ‘OEIC’ is used mostly in the UK, while in Ireland they are known as a variable capital company (VCC). They have similar structures to SICAVs and, as with SICAVs and unit trusts, investors deal directly with the fund when they wish to buy and sell.

Question 22

What are the key characteristics of OEICs?

Answer 22

The key characteristics of OEICs are the parties that are involved and how they are priced.

1. When an OEIC is set up, it is a requirement that an authorised corporate director (ACD) and a depository are appointed. The ACD is responsible for the day-to-day management of the fund, including managing the investments, valuing and pricing the fund and dealing with investors. It may undertake these activities itself or delegate them to specialist third parties.
2. The fund’s investments are held by an independent depositary, responsible for looking after the investments on behalf of the fund’s shareholders and overseeing the activities of the ACD. The depository plays a similar role to that of the trustee of a unit trust. The depository is the legal owner of the fund investments and the OEIC itself is the beneficial owner, not the shareholders.

Question 23

How are OEICs priced?

Answer 23

An OEIC has the option to be either single-priced or dual-priced. In fact, most OEICs operate single pricing. Single pricing refers to the use of the mid-market prices of the underlying assets to produce a single price at which investors buy and sell. In other words, when a fund is single-priced, its underlying investments will be valued based on their mid-market value. This method of pricing does not provide the ability to recoup dealing expenses and commissions within the price. Such charges are instead separately identified for each transaction. It is important to note that the initial charge will be charged separately when comparing single-pricing to dual-pricing.

Question 24

Closed-Ended Investment Companies

Answer 24

A closed-ended investment company is another form of investment fund. When they are first established, a set number of shares is issued to the investing public, and these are then subsequently traded on a stock market. Investors wanting to subsequently buy shares do so on the stock market from investors who are willing to sell.

The capital of the fund is, therefore, fixed and does not expand or contract in the way that an open-ended fund’s capital does. For this reason, they are referred to as closed-ended funds in order to differentiate them from mutual funds, SICAVs, unit trusts and OEICs.

Question 25

Characteristics of Closed-ended Investment companies in the US

Answer 25

In the US, closed-end funds come in many varieties and can have different investment objectives, strategies and investment portfolios. They also can be subject to different risks, volatility and charges. They are permitted to invest in a greater amount of illiquid securities than are mutual funds. (An illiquid security generally is considered to be a security that cannot be sold within seven days at the approximate price used by the fund in determining NAV.) Due to this feature, funds that seek to invest in markets where the securities tend to be more illiquid are typically organised as closed-end funds.

The other main type of US investment company is a unit investment trust (UIT). A UIT does not actively trade its investment portfolio; instead, it buys a relatively fixed portfolio of securities – for example, five, ten or 20 specific stocks or bonds – and holds them with little or no change for the life of the fund.

Question 26

Characteristics of Closed-ended Investment companies in Europe

Answer 26

In Europe, closed-ended funds are usually known as investment trusts and, more recently, as investment companies.

Despite its name, an investment trust is actually a company, not a trust. As a company, it has directors and shareholders. However, like a unit trust, an investment trust will invest in a range of investments, allowing its shareholders to diversify and lessen their risk.
Some investment trust companies have more than one type of share. For example, an investment trust might issue both ordinary shares and preference shares. Such investment trusts are commonly referred to as split capital investment trusts.
In contrast with OEICs and unit trusts, investment trust companies are allowed to borrow money on a long-term basis by taking out bank loans and/or issuing bonds. This can enable them to invest the borrowed money in more stocks and shares – a process known as gearing or leverage. Also, some investment trusts have a fixed date for their winding-up.

Question 27

Investment trusts

Answer 27

A company-not a trust-which invests in a diversified range of investments.

Question 28

Share Classes

Answer 28

Some investment trust companies might issue both ordinary and preference shares. A split-capital investment trust, which has a limited life, will issue other classes of shares. For example, preference shares. For example, an investment trust might issue both ordinary shares and preference shares.
Preference shares can be issued on different terms, such as convertible preference shares that are convertible into ordinary shares or as zero dividend preference (ZDP) shares. As the name suggests, ZDPs receive no dividends and the investor instead receives their return via the difference in the price they paid and the amount they receive when the ZDP is repaid at a fixed future date.

Question 29

Real Estate Investment Trusts (REITs)

Answer 29

They are normal investment companies that pool investors’ funds to invest in commercial and possibly residential property.
One of the main features of REITs is that they provide access to property returns without the previous disadvantage of double taxation.
REITs give investors access to professional property investment and might provide them with new opportunities, such as the ability to invest in commercial property. This allows them to diversify the risk of holding direct property investments.
This type of investment trust also removes a further risk from holding direct property, namely liquidity risk or the risk that the investment will not be able to be readily realised. REITs are closed-ended funds and are quoted on stock exchanges and shares in REITs are bought and sold in the same way as other investment trusts.

Question 30

Exchange-Traded Funds (ETFs)

Answer 30

An exchange-traded fund (ETF) is an investment fund, usually designed to track a particular index. This is typically a stock market index, such as the S&P (Standard & Poor’s) 500. Unlike investment trusts, ETFs are open-ended funds. This means that, like OEICs, the fund gets bigger as more people invest and gets smaller as people withdraw their money.

Question 31

What investment method is used to manage ETFs?

Answer 31

ETFs use passive investment management, which is a method of managing an investment portfolio that seeks to match the performance of a broad-based market index. Its investment style is described as passive because portfolio managers do not make decisions about which securities to buy and sell; instead, they invest in the same securities that make up an index. It, therefore, seeks to hold a portfolio that mirrors the index it is tracking and undertakes trading only to ensure that the portfolio’s performance is in line with the index.

Question 32

What is physical replication and what are its tracking methods?

Answer 32

Physical replication is the traditional form of index replication and is the one favoured by the largest and long-established ETF providers. It employs one of three established tracking methods:

1. Full replication – this method requires each constituent of the index being tracked to be held in accordance with its index weighting. Although full replication is accurate, it is also the most expensive of the three methods and so is only really suitable for large portfolios.
2. Stratified sampling – this method requires a representative sample of securities from each sector of the index to be held. Although this method is less expensive, the lack of statistical analysis renders it subjective and potentially encourages biases towards those stocks with the best perceived prospects.
3. Optimisation – this method costs less than fully replicating the index tracked, but is statistically more complex. Optimisation uses a sophisticated computer modelling technique to find a representative sample of those securities which mimic the broad characteristics of the index tracked.

Question 33

What is synthetic replication?

Answer 33

Synthetic replication involves the fund manager entering into a swap (an OTC derivative) with a market counterparty to exchange the returns on the index for a payment. The advantage of this approach is that responsibility for tracking the index performance is passed on to the swap provider and costs are lower. The downside is that the investor is exposed to counterparty risk, namely that the swap provider fails to meet their obligations.

Question 34

Hedge Funds

Answer 34

Hedge funds are private investment partnerships that use a variety of non-traditional strategies, many of them considered too risky by more conventional fund managers, with the objective of delivering exceptional returns. The risks are reduced by using an approach called hedging.

Question 35

What are the common aspects of a hedge fund?

Answer 35

1. Structure – most hedge funds are established as unauthorised and therefore unregulated CISs, meaning that they cannot be generally marketed to private individuals because they are considered too risky for the less financially sophisticated investor.
2. High investment entry levels – most hedge funds require minimum investments in excess of US$500,000 some exceed US$1 million.
3. Investment flexibility – because of the lack of regulation, hedge funds are able to invest in whatever assets they wish (subject to compliance with the restrictions in their constitutional documents and prospectus). In addition to being able to take long and short positions in securities like shares and bonds, some take positions in commodities and currencies. Their investment style is generally aimed at producing absolute returns – positive returns regardless of the general direction of market movements.
4. Gearing – many hedge funds can borrow funds and use derivatives to potentially enhance returns.
5. Liquidity – to maximise the hedge fund manager’s investment freedom, hedge funds usually impose an initial ‘lock-in’ period of between one and three months before investors can sell their investments on. This increases the notional exposure to market volatility and adds many multiples to the cash (nominal) value of the investment (also known as leverage).
6. Cost – hedge funds typically levy performance-related fees which the investor pays if certain performance levels are achieved, otherwise paying a fee comparable to that charged by other growth funds. Performance fees can be substantial, with 20% or more of the net new highs (also called the ‘high water mark’) being common.

Question 36

Private Equity

Answer 36

Private equity is medium- to long-term finance, provided in return for an equity stake in potentially high-growth companies. It can take many forms, from providing venture capital to complete buy-outs.

Private equity firms raise their capital from a variety of sources, but mainly from large investing institutions. These may be happy to entrust their money to the private equity firm because of its expertise in finding businesses with good potential.

Question 37

How can the pooling of funds via a collective investment scheme (CIS) benefit a retail investor?

Answer 37

Polling might provide a number of benefits but the key one is the pooling of funds with other investors to gain access to professional investment management.

Question 38

What is an investment management approach that seeks to produce returns in line with an index known as?

Answer 38

An investment approach that seeks to produce returns in line with an index is known as passive investing or index tracking.

Question 39

For which type of collective investments vehicle would the fund manager most likely quote bid and offer prices?

Answer 39

A unit trust will typically quote bid and offer prices; the bid price is the price an investor receives when they are selling and the offer price is they pay when buying.

Question 40

How does the trading and settlement of a unit trust differ from an exchanged-traded fund (ETF)?

Answer 40

An investor wanting to buy or sell units in a unit trust would deal directly with the fund manager, whereas if they wanted to buy or sell shares in an ETF, they would place an order with a stockbroker who would execute the trade on a stock exchange.

Question 41

Who is the legal owner of the investments held in an open-ended investment company (OEIC)?

Answer 41

The depository will hold the investments held in an OEIC.

Question 42

What are some of the principal ways in which a closed-ended fund differs from a unit trust and OEICs?

Answer 42

A closed-ended fund has a fixed share capital unlike open-ended funds such as a unit trust or OEIC whose capital can expand and contract in response to investor demand. The other major difference is that the shares of a closed-ended fund are bough and sold on a stock exchange compared to dealing directly with a fund manager for an open-ended fund.

Question 43

Which is an open-ended type of investment vehicle that is trades on a stock exchange?

Answer 43

An exchange-traded fund ETF is an open-ended fund that is bought and sold on a stock exchange in the same way as other shares.

Question 44

What type of investment vehicle makes extensive use of short positions?

Answer 44

Hedge funds typically make extensive use of short positions.

Question 45

Premium and Discount

Answer 45

When the share price is above the NAV, it is said to be trading at a premium.
When the share price is below the NAV, it is said to be trading at a discount.