Lesson 5.2: Alternative Pooled Investments

Question 1

Inverse ETFs are suitable primarily for investors:

Answer 1

with a very short time horizon.

Inverse and leveraged ETFs are structured in such a manner that makes holding them for more than a few days or a week become unattractive. They are for bearish investors, which is why they are often referred to as short funds. They are purchased for short-term capital gains; there is no income. The passive strategy is for the long term, not the short term.

Question 2

An investor owns an inverse ETF. If the underlying index should decrease in value,

Answer 2

the fund shares will increase in value.

An inverse, or short, fund will move in the opposite direction of the underlying index. If it were leveraged, then it could move at a rate of 2x or 3x, but nothing in the question mentioned leverage.

Question 3

One type of alternative investment considered to be a pooled investment vehicle is the exchange-traded note. Exchange-traded notes (ETNs) are which of these?

I. Unsecured debt securities
II. Unsecured equity securities
III. Issued by financial institutions, such as banks
IV. Insured by the FDIC

Answer 3

I and III

Exchange-traded notes are unsecured debt securities issued by financial institutions, such as banks. Their prices can be impacted by changes in the credit rating of the issuer, and they are not insured by the FDIC.

Question 4

One type of alternative investment considered to be a pooled investment vehicle is the inverse exchange-traded fund (ETF). Inverse ETFs, also known as bear or short funds, are managed to:

Answer 4

perform contrary to a benchmark market index such as the S&P 500.

Inverse funds, also known as short or bear funds, try to deliver returns that are the opposite of the benchmark index they are tracking. When they are exchange traded, they can be bought on margin and are priced throughout the trading day like other exchange-traded funds.

Question 5

One of your clients is 10 years away from retirement and is trying to decide what would be a suitable investment for this year’s IRA contribution. You would probably not recommend:

Answer 5

leveraged ETFs.

Because most leveraged funds reset daily, they are best utilized by investors with a very short time horizon.

Question 6

If you overheard an analyst referring to an investment’s indicative value, the discussion would most likely be about

Answer 6

ETNs

The calculated value, called the indicative value or closing indicative value for ETNs, is calculated and published at the end of each day by the ETN issuer.

Question 7

An exchange-traded fund whose strategy is to generate performance opposite that of the designated index is called:

Answer 7

an inverse fund.

Inverse ETFs (also called short funds) seek to deliver the opposite of the performance of the index or benchmark they track. There are some who call these reverse funds, but the SEC, FINRA, and NASAA do not use that term. Leveraged ETFs seek to deliver multiples of the performance of the index or benchmark they track. There are leveraged inverse funds, but the term inverse would have to be in the description. Hedge funds are not exchange traded.

Question 8

An alternative investment vehicle that is managed to perform contrary to a benchmark market index such as the S&P 500 is:

Answer 8

an inverse exchange-traded fund.

Inverse exchange-traded funds (ETFs), frequently referred to as bear or short funds, are designed to move in the opposite direction of the index they are tracking. They can be leveraged, but the term leveraged can also apply to an ETF that goes in the same direction as the index. A put option is not a managed alternative investment.

Question 9

Among the characteristics of leveraged exchange-traded funds is that:

Answer 9

leveraged ETFs may be purchased on margin.

Because an exchange-traded fund is purchased and sold on an exchange, the rules generally applying to all exchange products, such as purchasing them on margin, would apply. Leveraged funds use derivative products to generate the leverage, not bank borrowing. When it comes to suitability, they are for aggressive investors, but there is no requirement that they meet the accredited investor standard. However, the very nature of the product is that it is designed for short-term trading, not long-term trading.

Question 10

It would be correct to state that an inverse ETF:

Answer 10

utilizes derivatives to achieve its objectives.

Inverse, or short, ETFs move in the opposite direction of the index being tracked. To achieve their goals, various types of derivatives are used. This type of ETF is used only for short-term investments, rarely as long as a single month. These are registered investment companies, not private.

Question 11

What investment is not registered under the Investment Company Act of 1940?

Answer 11

ETNs

Exchange-traded notes, sometimes called equity-linked notes, are registered under the Securities Act of 1933 as debt instruments. All of the other choices are registered as investment companies under the Investment Company Act of 1940.

Question 12

An investor owns a 2x leveraged inverse ETF. If the underlying index should decrease in value,

Answer 12

the ETF shares will increase in value by a factor of 2.

An inverse, or short, ETF will move in the opposite direction of the underlying index. It is known as a short fund because as the underlying index goes down, the value of the shares increases. Because this is a 2x (2 times) leveraged fund, it will move at a rate that is twice that of the index. Although the choice, “the fund shares will increase in value” is a true statement, it is not the most accurate answer to the question because it ignores the 2x leverage.

Question 13

A number of different pooled investment vehicles are included in the term alternative investment. One of them, a synthetic investment instrument that has been created to meet a specific need that cannot be met by a standardized financial instrument, is known as:

Answer 13

a structured product.

Structured products are created as a tool to meet the issuer’s debt financing needs when they will result in a lower cost than a standardized financial instrument available in the market place.

Question 14

Which term best describes ETNs and leveraged ETFs?

Answer 14

Alternative investments

These are two popular alternative investments. Are they speculative? Yes, but there are many other speculative investments that are not considered alternative investments. The question asks for the best description and, although it might seem like a close call, these are “alts.” The leveraged ETF is a registered investment company, but the ETN is not.

Question 15

In order to achieve its goals, an inverse ETF uses:

Answer 15

derivatives and debt.

An inverse ETF will almost always use derivatives, such as options, and—in the case of a leveraged ETF—will use debt, primarily in the form of margin. Inverse ETFs do not engage in short selling; they are an alternative to selling short a specific index without the unlimited risk potential of the short sale. Arbitrage is used, typically by institutional investors, to take advantage of temporary imbalances between the ETF’s net asset value and market price.

Question 16

What ETF would have a negative correlation with the underlying index?

Answer 16

Inverse ETF

The purpose of an inverse fund is to move in an opposite direction of the index. That means the returns are negatively correlated. Some inverse funds achieve a –1.0 correlation. All of the others would have a high correlation to the specific index. If the question asked about correlation to the overall market, the answer would be the same—the inverse fund. As far as the other three choices, the highest correlation would generally be the large cap. No definitive statement can be made about the correlation to the overall market of the other two.

Question 17

If an investor was of the opinion that the market was going to have a bad day, to maximize that investor’s gains, you might recommend:

Answer 17

an inverse leveraged ETF.

An inverse ETF should go up if the market goes down. Adding leverage to it means moving by a factor of 2x or 3x, so to maximize the potential gain, we combine leverage to the inverse and suggest the inverse leveraged ETF.

Question 18

A client with limited assets seeking additional income in retirement would probably find which of the following investment choices to be the least suitable?

Answer 18

ETNs

The question describes an individual with a low risk tolerance, so the Treasury bonds and CDs would certainly be considered appropriate. Because ETNs are a debt security backed solely by a single issuer while an ETF based on a specific index of debt securities represents a large group of issuers, ETNs are only suitable for those who can understand and take the risks involved.

Question 19

What is true regarding ETNs?

Answer 19

Their value can be impacted by changes in the issuer’s credit rating.

ETNs are unsecured debt obligations carrying credit risk based on the issuer’s credit rating. Fixed-income investments have the market risk more commonly referred to as interest rate risk, and they are usually callable. These are sophisticated instruments that are not suitable for conservative investors.

Question 20

In search of higher returns, many investors have turned to alternative investments, such as structured products. Non-exchange-traded structured securities products (SSPs) typically have:

Answer 20

some form of embedded derivatives.

It is commonplace for SSPs to use derivatives, such as options. There is no insurance coverage and, unless listed for trading such as an ETN, low or no liquidity. These are highly complex products and would not be suitable for the average conservative investor.

Question 21

The alternative asset investments class is least associated with which of the following characteristics?

Answer 21

Efficient pricing

Alternative assets are most often characterized by inefficient pricing, providing potential abnormal returns or alpha returns. That is the prime reason for their popularity, especially with institutional investors.

Question 22

A 3x leveraged fund priced at $42 tracks an index that is up 2% one day and then down 3% on the next day. What should this fund be approximately priced at following these two volatile days?

Answer 22

Starting with the $42 purchase price, a 2% increase to the index on Day 1 equals $0.84 up (0.02 × $42 = $0.84). Given the 3x leverage, this would equate to a $2.52 increase on Day 1 (3 × $0.84 = $2.52). At the start of Day 2, the fund would be priced at $44.52 ($42 + $2.52 = $44.52). On Day 2, the index falls by 3%. A 3% decrease in the fund equals $1.34 [0.03 × $44.52 ($1.3356 rounds up to 1.34)]. Again due to the 3x leverage structure of the fund, the $1.34 decrease equates to a $4.02 drop in the fund price (3 × $1.34 = $4.02). Therefore, after the two volatile days, the fund should be priced at approximately $40.50.

Question 23

Equity-Linked Notes (ELNs)

Answer 23

Even though the term “equity” appears in the name, equity-linked notes (ELNs) or exchange-traded notes (ETNs) are technically debt securities.

Question 24

In search of higher returns, many investors have turned to structured products such as structured notes. Your clients need to be aware that these are complex instruments that have which of the following characteristics?

I. Credit or default risk because they are unsecured obligations of the issuing institution
II. High price transparency
III. Limited or no liquidity
IV. High initial returns that diminish over time

Answer 24

I&III

As unsecured obligations, their safety of these notes is only as good as the financial strength of the issuer, and because these tend to be one-of-a-kind products, they do not have liquidity. A particular hazard of investing in structured notes is that there is a low level of pricing transparency; another concern is that the returns are generally not fully realized until the maturity date.

Question 25

Your client has turned bearish on the market, but does not have a margin account. Which of the following securities would probably best meet your client’s needs?

Answer 25

An inverse fund

Those who are bearish wish to profit in a market downturn. Inverse funds are sometimes called short funds because they deliver positive returns when the underlying benchmark declines in value. This client can’t sell short because you need a margin account for that.

Question 26

What is a motivation for creating structured products?

Answer 26

Structured products improve market completeness.

The primary motivation for financial structuring is to increase market completeness. What does that mean? As stated in the LEM, structured products are created to meet a specific need for which there is nothing available in the current market. Creating this structured product is said to be “completing the market.” Creating structured products is a cost to issuers. Investors pay fees to access structured products in addition to transaction costs. They may, in fact, improve the structuring broker-dealer’s profits, but that is not what NASAA will be looking for as an answer.

Question 27

What is NOT registered with the SEC under the Investment Company Act of 1940?

Answer 27

Exchange-traded notes (ETNs) register as debt securities under the Securities Act of 1933.