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RPA 2 > Lesson 8 > Flashcards

Lesson 8 Flashcards

1
Q

8.1.1 Differentiate between investment companies and other investment organizations in the context of managed funds. Give 5 examples of other investment organizations

A

Investment companies and other investment organizations are the two main intermediaries that offer managed funds. Investment companies are financial intermediaries that collect funds from individual investors, pool those assets and invest them in a range of securities or other assets.

Other investment organizations are intermediaries that are not formally organized or regulated as investment companies and include”

  1. comingled funds,
  2. real estate investment trusts,
  3. segregated funds,
  4. private equity and
  5. hedge funds.
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2
Q

8.1.2 Identify four functions provided by investment companies and other investment organizations offering managed funds for their investors.

A

Investment companies provide a mechanism for small investors to team up to obtain the benefits of large scale investing.

1) Recordkeeping and administration
2) Enable diversification and divisibility
3) Provide access to professional management at a lower cost
4) Provide lower transaction costs - savings on brokerage fees and commission due to trading large blacks

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3
Q

8.1.3 Explain NAV

A

The NAV expresses the value of each share held in a managed fund. Investment companies pool assets among those investors. Investors buy shares in investment companies with ownership proportional to the number of shares purchased. The formula for calculating NAV is

(MV assets - Liab)/Shares or units outstanding

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4
Q 
8.1.4 Composition of the portfolio is:
Stock A: 200K shares, market price $35
Stock B: 300K shares, market price $40
Stock C: 400K shares, market price $20
Stock D: 600K shares, market price $25
No loan debt or accounts payable but it's accrued mgmt fee totals 30K, 4M shares outstanding. Calculate the NAV of the fund
A

The value of each share in the fund is $10.49

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5
Q

8.1.5 Assume the fund is a closed end fund with a portfolio currently worth $150M an outstanding loan of $1.75M, 250K in dividends declared but not yet paid and 4M shares outstanding. Calculate the NAV

A

The value of each share in the fund is $37

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6
Q

8.2.1 Describe open end mutual funds

A

Open end mutual funds don’t trade on exchanges, they do redeem and issue shares which are purchased through investment companies at NAV, and prices cannot fall below NAV.

Purchases and redemptions may also have a load, a sales charge paid to the seller.

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7
Q

Define NAV

A

Net Asset Value

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8
Q

8.2.1.b Describe Closed End mutual funds and list three figures provided in association with them

A

Closed end funds don’t redeem or issue shares. Shares of closed end funds are purchased through brokers like common stock and may have prices that differ from NAV.

Exchange listings of closed end funds usually provide three key figures:

1) The fund’s most recent NAV
2) The closing share price
3) The % difference between those two: (Price-NAV)/NAV

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9
Q

8.2.1.c list two kinds of managed funds

A

closed end and open end

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10
Q

8.2.2.a Outline the key characteristics of money market mutual funds

A

These funds invest in money market securities including government and corporate issues.

The NAV of the share is fixed so there are no tax implication such as capital gains or losses associated with the redemption of shares

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11
Q

8.2.2.b Outline the key characteristics of fixed income mutual funds

A

These funds specialize in the fixed income sector which has considerable room for specialization.

Various funds may concentrate on corporate bonds, Canada bonds or MBS. Others specialize in a maturity of security, from short to long term, or in the credit risk of the issuer, from safe to high yield

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12
Q

8.2.2.c Outline the key characteristics of balanced and income mutual funds

A

These funds hold both equities and fixed income securities in relatively stable proportions. Asset allocation funds are similar to balanced and income funds except their managers engage in market timing.

In the context of Canadian retirement plans these would be tactical asset allocation funds and would fall into the category of balanced funds.

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13
Q

8.2.2.d Outline the key characteristics of equity mutual funds

A

These invest primarily in stock but may hold fixed income or other types of securities and at least some money market securities to provide liquidity.

It is a practice to classify stock funds according to their emphasis in capital appreciation or current income.

Income funds tend to hold shares of firms with high dividend yields which provide high current income. Growth funds forgo current income and focus on prospects for capital gains.

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14
Q

8.2.2.e Outline the key characteristics of index mutual funds

A

These funds try to match the performance of the broad market index. The fund buy securities included in a particular index in proportion to the securities representation in that index.

Investment in an index fund is a low cost way for small investors to pursue a passive investment strategy, that is to invest without engaging in security analysis

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15
Q

Define MBS

A

Mortgage backed securities

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16
Q

8.2.3 Describe the direct and salesforce distributed methods for selling mutual funds

A

Direct marketed funds are sold through mail and offices of the fund, over phone and internet. Investors can contact the fund directly to purchase shares. These direct marketed funds have historically been sold on a no load basis.

Salesforce distributed funds are sold by brokers or financial advisors who receive a commission for selling shares to investors. The commission is ultimately paid for by the investor.

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17
Q

8.2.4 Explain how the rate of return on investment in a mutual fund is determined

A

The rate of return is the increase or decrease in NAV over the period that the asset is held plus income distributions such as dividends or distributions f capital gains.

The formula is R= (NAV1-NAV0+Income+Cap gains)/NAV0

NAV1=end of period
NAV0= Beginning of period

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18
Q

8.2.5 Assume the fund began with NAV of 13 and ended the period with NAV=13.50. The fund paid distributions of $2.25. Calculate the investors rate of return on the fund

A

The rate of return was 21.15%

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19
Q

8.2.6 Explain how returns on investment made by mutual funds are taxes

A

Mutual funds issue statements with capital gains and dividend/interest income that has been recognized. Returns are taxable in the hands of investors, not the management company or fund, provided proceeds are paid out annually to investors.

Paying taxes annually prevents the accumulation of tax liability contingent on disposal of shares. Even though taxes are paid annually on recognized returns, the fund tracks accumulated annual declarations of investment returns because recognized returns are typically not distributed to investors, they are reinvested.

All RPPs and CAPs covered in this course are tax deferred plans so the issue of taxation is not applicable during the period a particular plan holds investments in mutual or comingled funds.

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20
Q

8.2.7.a List three kinds of fees associated with investing in mutual funds

A

1) front/back end load fees
2) Operating expenses
3) other charges

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21
Q

8.2.7.b What is the combination of operating expenses and other charges in mutual funds referred to?

A

Management expanse ratio. These expenses are periodically deducted from the assets of the fund and are paid for through the reduced value of the portfolio

22
Q

8.2.7.c In respect to mutual funds define Front end and Back end load fees

A

Fees paid to cover commissions paid to selling agents and to deter investors from rapidly switching in and out of funds, which is detrimental to keeling assets fully invested in long term assets. A front end load reduces the initial investment and a back end load leaved the investment intact until it is redeemed.

Back end loads are usually higher the first year and reduced the longer the money is left in the fund. The load fees may also decrease with the size of the investment.

23
Q

8.2.7.d In the context of mutual funds define operating expenses

A

These are costs incurred by the mutual fund in operating the portfolio, admin expenses and advisory fees paid to the investment manager. Operating expenses usually range from 0.2% to 2.5%

24
Q

8.2.7.e In the context of mutual funds define other charges

A

These include expenses related to advertising, promotional literature (Prospectuses, annual reports) and commissions paid to brokers.

25
Q

8.3.1 Outline key characteristics of comingled funds

A

comingled funds fall into the category of other investment organizations. They are intermediaries that aren’t formally organized or regulated as investment companies but serve similar functions.

Comingled funds are partnerships or investors that pool funds. The management firms that organizes the partnership, for example, a bank or insurance company, manages the fund for a fee. Typical partners in a comingled fund might be trust or retirement accounts that have portfolios larger than individual investors but too small to warrant managing on an individual basis.

26
Q

8.3.2 Explain how comingled funds differ from open ended mutual funds

A

Comingled funds are similar to open end funds however instead of shares comingled funds offer units which are bought and sold at NAV.

27
Q

8.3.3.a List two types of comingled funds commonly used as investments for Canadian pension and other retirement plans

A

1) Pooled funds

2) Pooled segregated funds

28
Q

8.3.3.b Define pooled funds

A

pooled funds are operated by institutional pension fund managers that offer services to pension plan sponsors that aren’t of sufficient size to manage their plan investments themselves.

These manages normally make funds available in different asset classes. Sometimes, if the pension fund is large enough they may establish a “Separate fund” for that client and structure it in accordance with that fund’s requirements.

The desire for a separate fund may be to implement a desired environmental or other specific belief into a portfolio managed by a specific fund manager.

29
Q

8.3.3.c Define pooled segregated funds

A

Segregated funds are similar to pooled funds but are segregated from the insurers’ general funds and owned by the investors in the pool.

Pooled segregated funds are used by both DB and CAP funds. The significant financial commitments made by some Canadian insurers to their CAP mbr admin systems has resulted in insurers becoming major providers or investment funds for CAPs.

In addition to maximize their access to the CAP market insurers may offer segregated funds that invest in mutual funds and pooled funds by institutional pension fund managers. In these latter cases investors in the pooled segregated funds buy units of the segregated funds which invests in the underlying mutual or institutional manager’s fund.

30
Q

8.3.4 describe how pooled funds operated by institutional pension fund managers and pooled segregated funds operated by insurers differ from mutual funds. (5)

A

1) investors buy units of both and the price of units is determined in a manner that is similar to that used in determining the NAV of a mutual fund.
2) Both are open end funds
3) Pooled segregated funds operators by insurers are not under IFIC jurisdiction and as such a prospectus isn’t issued. They are subject to insurance industry legislation. And issue information about funds under CAPSA including information summaries and investment policy statements.
4) They are no load funds
5) Cost of investing isn’t shown as a % but as a separate investment management fee. Tee HST/GST is applicable to those fees and fees are typically set based on specific circumstances.

31
Q

What is the IFIC

A

Investment Funds Institute of Canada

32
Q

8.4.1 Describe the basic characteristics of hedge funds

A

Investors buy shares in hedge funds like with investment pooling, the NAV of each share represents the value of the investor’s stake.

Hedge funds are commonly structured as private partnerships and subject to minimal regulation. Many are only open to wealthy or institutional investors.
They may have initial locked in periods, as long as several year. This allows hedge funds to invest in illiquid assets.

The lack of regulation allows them strategies with heavy used of derivatives, short sales and leverage.

They can invest in a wide range of investments such as derivatives, distressed funds, currency speculation, convertible bonds, emerging markets, merger arbitrage etc.

Other funds might move from one asset class to another as perceived opportunities shift.

33
Q

8.4.2 Outline implications of the regulatory environment for hedge funds for transparency of information provided to the public.

A

Hedge funds are commonly structured as limited liability partnerships and provide minimal information about portfolio composition and strategies, and only to their investors.

In contrast mutual funds are subject to regulation that requires the fund to periodically provide information on portfolio composition to the public.

34
Q

8.4.3 Contrast hedge funds and mutual funds in terms of investment strategy

A

Hedge funds effectively choose any strategy and can act opportunistically. They don’t commit to a specific asset class and can have a range of investments.

Mutual funds set out a general investment approach in their prospectus. They face pressure to avoid style drift. Most mutual funds limit their use of short selling and leverage. Their leverage use is highly restricted.

35
Q

8.4.4.a What is a directional strategy as employed by hedge funds

A

A directional fund maintains some exposure to the market without placing much emphasis on hedging risk. It assumes one sector will outperform other sectors of the market.

Fund manages focus on making higher than expected returns for a given amount of risk. Returns may experience wide fluctuations from year to year but returns tend to be higher over the long run than nondirectional. They appeal to aggressive investors who look for investments that outperform the market

36
Q

8.4.4.b What is a nondirectional strategy as employed by hedge funds

A

Nondirectional strategies are designed to exploit temporary misalignments in security valuation. The fund isn’t betting on broad movements in the market but on specific securities.

This kind of fund addresses the needs of conservative investors who are concerned with risk reduction even at the price of returns. Nondirectional funds generate fixed income.

37
Q

8.4.4.c List two general strategies used by hedge funds

A

directional and nondirectional

38
Q

8.4.5 Explain statistical arbitrage

A

Statistical Arbitrage often involves trading in hundreds of securities a day with holding periods that can be measured in minutes or less.

This requires extensive use of quantitative tools such as automated trading and mathematical algorithms to identify profit form the smallest of perceived mispricing opportunities. Statistical arbitrage assumes that it can identify reliable small market inefficiencies . By taking small positions in many of these opportunities the probability of profiting becomes high.

39
Q

8.4.6 Outline the fee structure associated with hedge funds

A

The typical hedge fund fee structures includes an annual management fee (1-2% of assets) plus an annual incentive fee based on performance.

The incentive fee is typically 20% of returns above benchmark.

40
Q

8.4.7 Assume a hedge fund with a NAV of $52 has a high water mark of $56. Explain whether the value of the performance fee is more or less than it would be if the high water mark was $57.

A

Managers tend to only charge a fee if the high water mark is surpassed.

The highest peak over a period is called the high water mark and if the fund falls from that high generally a performance fee isn’t incurred.

41
Q

8.5.1.a Define ETF and explain how it is traded and owner entitlements

A

Exchange traded funds. A fund that tracks an index, commodity bod or basket of assets and divides ownership of those assets into shares

Shareholders don’t directly have a claim to assets. ETF shareholders are entitled to a proportion of profits such as interest or dividends and may get a residual value if the fund is liquidated. The ownership can be bought or sold like stocks on public exchanges.

42
Q

8.5.2 Outline the advantages of ETFs compared to mutual funds

A

ETFs trade continuously while mutual funds NAV is quoted daily.

ETFs can be sold short or purchased on the margin.

When mutual fund investors redeem their shares the fund must sell securities to meet the redemptions. This may trigger capital gains tax which must be paid by shareholders. In ETFs investors simply sell their interest in the fund.

Larger investors can exchange their ETF shares for shares in the underlying portfolio avoiding tax liability. This ensures the price of an ETF cannot depart significantly from the NAV.

43
Q

What does it mean to purchase on the margin?

A

Buying on margin is borrowing money from a broker to purchase stock. You can think of it as a loan from your brokerage. Margin trading allows you to buy more stock than you’d be able to normally. To trade on margin, you need a margin account.

44
Q

8.5.3 Outline the disadvantages of ETFs compared to mutual funds

A

Because ETFs trade securities there is a possibility their prices can deviate from NAV. Even small discrepancies can negate the cost advantage of ETFs over mutual funds.

Also while mutual funds can be no-load ETFs must be purchased from a broker for a fee.

45
Q

8.6.1 Assume a fund had a return last year which placed it in the top 10% of all funds with the same investment policy. Provide a rationale for whether it will be a top performer next year.

A

Past performance isn’t an indicator of future performance, especially with higher performing funds. For it to have been in the to 10% the manager must have taken a risk which might turn unfavourable next year.

46
Q

8.6.2 Explain why the liquidity of assets is an important factor in assessing hedge fund performance

A

The CAPM allows for the possibility of a return premium for investors willing to hold less liquid assets.

Hedge funds tend towards the illiquid. They can do this by imposing withdrawal restrictions. Performance might then reflect compensation for illiquidity rather than unusual returns.

47
Q

What does CAPM stand for?

A

Capital Asset Pricing Model

48
Q

8.6.3 Explain how survivorship bias and backfill bias affects the measured performance of hedge funds

A

Survivorship bias occurs when unsuccessful funds that stop operation stop reporting returns and leave a database, leaving only the successful funds. Attrition rated for hedge funds are more than double those of mutual funds.

Backfill bias occurs because hedge funds report returns to database publishers only if they choose to and may only do so when performance is good. Funds started with seed capital will open to the public only if past performance is sufficient to attract clients. Therefore, the prior performance of funds eventually included in a sample may not be representative of typical performance.

49
Q

8.6.4 Identify the types of information that can inform an analysis of fund performance

A

1) Information relevant to the type of fund in question. As a means of providing meaningful comparisons funds must be grouped by type, such as balances, dividend, CAD equity, US equity, international equity, money market bond. mortgage and real estate. There must be a measure of volatility and a list of returns for periods from 3 months to 10 years, net of fees and including reinvestment of dividends.

The compound annual rate of return over different periods can be included as well as sales commission or loads.

2) management expense ratio

50
Q

8.6.5 Provide an example of software used in Canada to analyze mutual fund performance and outline the types of information such software provides

A

PAL Trak, provided by Morningstar Canada, provides data on performance, management expense ratios, load structures, asset allocation, NAV and dividend payouts.

It also provides a comparative historical summary of the fund’s returns, a breakdown of asset class composition, a description of the return an risk of the fund, and a classification of risk such as P/E ratio and price/book value

RPA 2 (12 decks)

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