Module 3: Equity Investments and Managed Assets Flashcards
Bondholder vs Stockholder
Shareholders have proportionate shares of the assets and earnings of the corporation.
Bondholder is entitled to a fixed rate of payment and a return of principal but does not have an ownership.
Bondholders do have a right, above that of stockholders, to the corporation’s assets in the event of default or liquidation.
Equity disadvantage
not tax deductible for income tax purposes but bond interest is.
Common stock
units of ownership in a publicly traded corporation
stock’s par value
dollar per share and has no economic meaning in terms of actual value.
Blue-chip stocks
highly regarded, well capitalized companies. Historically paid dividends regardless of the economy.
Growth stocks
Companies that have sales and earnings growth rates exceeding those of the average company in their industry.
Do not pay dividends; they invest their earnings back into the company.
Emerging growth
smaller and younger growth companies, that survived the early years and are just beginning to grow and expand. Emerging growth stocks great potential for investment, but subject to tremendous risk.
Income stocks
stocks issued that pay regular, consistent dividends and provide current income for investors. Ex: Stock issued by a utility company. Often in the maturity phase of the industry life cycle.
Value Stocks
Trade at low prices, given the historical earnings and asset values. Value investment managers attempt to find these high-quality companies that are temporarily undervalued by the market in hopes that the market will recognize their true value and their price will increase.
Growth stocks can become value stocks.
Cyclical stocks
stocks that prosper in a growing economy and tend to do poorly during declining economic conditions (e.g., automobile manufacturers, consumer discretionary companies, and restaurants).
If economy is growing, demand strengthens and companies make large profits. If economy is in a downturn, companies hurt by decline in demand and are less profitable.
Defensive stocks
Stocks unaffected by the business cycle (e.g., grocery chains). Have steady (although slow) growth, popular during economic recessions, and lose popularity in economic booms. Provide products that are necessary for everyday life. The demand for these products are not adversely affected by changing economic cycles.
Technology Stocks
Part of broader technology sector. Relates to research, development, and distribution of products. Include companies involved in electronics, data storage, computer software, robotics, and life science.
Market Risk
Changes in the market to influence the prices of equities. When the market rises, stocks increase in value. Stocks fall with a declines in the market. A move in the market is by change in economic environment.
Interest Rate Risk
Interest rates rise, there is negative pressure on the value of common stocks; when interest rates fall, stocks tend to increase in value.
Business Risk
Speculative nature of the business, the management of the business, and the philosophy of the business
Financial Risk
Firms method to acquire assets is directly related to financial risk or financial leverage. With regard to capital structure, companies may use debt through the issuance of bonds, or they may issue equity securities. When companies choose debt to finance the purchase of additional assets, it increases the level of financial risk.
capital gain or loss
Gain/Loss = net sales price - shareholder’s basis in the shares
Rights
Rights are a purchase option for stock that allows a shareholder the opportunity to buy shares of the new stock issue, thereby maintaining the overall percentage ownership in the corporation.
- Short Term
- On issuance, exercise price below market price
- issued by a corporation to raise funds by issuing new stock to public.
- Current shareholder is given one right for each share of stock
- Stockholders offered rights, purchase company’s common stock below current market price.
Warrants
Long-term, customized call options
On issuance, exercise price higher than market price
For a small premium, guarantees the opportunity to buy stock at a fixed price during a period. (higher than current market price)
sweetener or equity kicker, making the issue more attractive
Warrants vs Call Options
Warrant is issued by a corporation
Call is written by an individual.
Warrant is customized
Call is standardized terms
Warrant has maturity date (five years or more)
Call expires within nine months
Warrant Profit Formula
Profit = (gain on stock - cost of warrant) x number of shares
Dividend
Declared on common (or preferred) stock by board of directors before any realized income.
A bonds is a guaranteed payment.
Not all shareholders receive dividends; only shareholders of record.
shareholder of record
owner listed on the record date.
Record Date
The first business day after the ex-dividend date.
On record date, trades are settled and reflected on the corporation’s books.
To be listed as a shareholder of record, the investor must purchase stock before the ex-dividend date.
Ex-dividend date
The first day a stock is traded without the buyer being eligible to receive a previously announced dividend.
EX: If 10/2/2023 is record date, when would investor purchased stock to received declared dividend? Sept. 30th.
Who receives dividends first, preferred stockholders or common stockholders?
Preferred Stockholders.
Common shareholders claim on residual earnings after bondholders and preferred stockholders are paid. Hopefully their dividends increase as the company’s earnings increase, a major attraction to owning common stock.
Some dividend-paying companies aim to pay a common stock dividend that is a set percentage of earnings.
Dividend Payout Ratio
Company’s earnings/share = $2.00
The company pays 30% of its earnings as a dividend.
Payout Ratio = 30% of $2.00, or $0.60, per share to common stockholders.
Dividend Reinvestment Plans (DRIPs)
purchase add’l stock using cash dividends, paying little or no commission and at a discount to market price.
Buy and hold progra, benefits of dollar cost averaging
DRIP income tax purposes
Unlike cash dividends, the amount of reinvested dividends adds to the investor’s tax basis.
Taxation of Cash Dividends
Qualified and qualified corporate dividends are permitted preferential tax treatment.
Corporations whose stock of American depositary receipts is readily tradable on an established U.S. securities market also qualify.
Nonqualified dividends are taxed at the ordinary income tax rate.
Qualified dividend income may be treated at favorable long-term capital gain rates (0%, 15%, or 20%) if it meets the following criteria
Dividend received is a domestic corp or qualified foreign corp.
Stock held for greater than 60 days during 121-day period beginning 60 days before the ex-dividend date.
*Dividends declared by a corporate board of directors of a domestic corporation are qualifying dividends
Stock Dividends
Additional shares of company stock rather than in cash.
When stock dividend declared and paid, value of common stockholders share is reduced (price of stock decreases on a basis relative to stock dividend).
When does Dilution occur
when a company issues a stock dividend in place of a cash dividend.
Stock Splits
Par value/share is reduced and number of shares is increased proportionately.
Companies split stock to reduce stock’s market price/share, making it more attractive to smaller investors. Resulting in an increase of total shares outstanding.
Still own same percentage
Never income taxable, basis per share is adjusted downward
Reverse stock split
Company reduces total shares outstanding to increase the price of the outstanding shares, making the company less likely to be delisted by an exchange and more attractive to potential investors.
Open-End Investment Company
(mutual fund)
Type of investment company.
Popular for small/individual investors.
Pool capital from investors and invest in stocks, bonds, money market instruments.
Categorized as open end because unlimited # of shares sold to investors.
prospectus
Contains important information about investment company fees and expenses, investment objectives, strategies, risks, performance, pricing, and more.
net asset value (NAV)
Calculated everyday because purchase (buys) and redemption (sell) prices are based on the NAV
Formula for Funds Total Net Asset Value (NAV)
Funds total NAV = assets (cash + current value of securities) − liabilities
Formula for Total Net Asset Value (NAV) Per Share
Nav/share = funds nav / # shares outstanding
mutual funds charge a sales commission referred to as
sales load
Front-end load (Class A shares)
Shares have commission added to cost of shares.
Have a lower total cost structure than other classes, making it suitable for long-term investment horizons.
Back-end load (Class B shares)
(aka contingent deferred sales charge (CDSC))
Assesses shares if investor sells within a certain time of purchase. The contingent deferred sales charge may be waived after holding the shares five years or longer.
Level-load fund (Class C shares)
Asset based
Uses the annual 12b-1 fee as a sales charge.
Management Fee
(Mutual fund operating expense)
Paid by a mutual fund to investment advisor for services relating to managing the fund (salaries of the portfolio manager(s), analysts, and other related research expenses.
12b-1 fees
(Mutual fund operating expense)
Named for an SEC rule
Originally for marketing and advertising promoting the funds. Today, used to compensate investment advisors on an ongoing basis for selling the funds.
Other expenses
(Mutual fund operating expense)
Administrative or outside services (shareholder recordkeeping and reports, auditing, custodial services, legal services, proxy solicitations, annual meeting costs, directors’ fees, and state and local taxes).
Mutual fund operating expense)
Totals management fees, 12b-1 fees and other expenses and is the total annual operating expenses for the fund, paid from the fund’s income.
Expense Ratio
annual operating expenses / fund’s average annual assets.
Taxable Bond Funds
Objective to provide maximum current income or tax-free income income to shareholders.
Bond funds pass through to shareholders the interest income from debt securities (dividends), on a monthly basis.
Primarily purchased for income stream, bond funds provide capital gains or capital losses.
Bond Funds vs. Individual Bonds
4 differences (interest, maturity, yield and time)
Bond funds interest income changes
Individual bonds have fixed-interest
Bond fund has no fixed maturity. No future date when original principal will be repaid.
Individual bonds quoted in current yield, yield-to-maturity and yield-to-call. Bond fund has no maturity or call date, yield is based on current income relative to its net asset value.
Bond funds make interest distributions monthly,
Individual bonds pay interest semiannually.
Investment-Grade Funds
(type of fund)
Corporate bonds in the top four bond rating categories
(Standard & Poor’s AAA, AA, A, and BBB)
(Moody’s ratings Aaa, Aa, A, and Baa).
Have less default risk
Own U.S. Treasury and mortgage-backed securities, low risk of default.
For investors who want higher income than from a straight bond, and high degree of assurance that interest and principal will be paid.
Bond maturities range 10-30 years.
High-Yield Funds
(Junk Bonds)
Bonds rated lower than BBB (Standard & Poor’s), Baa (Moody’s) and nonrated.
High Yield vs Investment Grade
1. Have higher coupon rates, which give advantages of issue diversification and lower interest rate risk providing high current income with low to moderate safety of principal.
Government Bond Funds
Investors seeking current income and max safety of principal.
Funds are interest-rate sensitive
Not credit-quality sensitive.
Advantage is absence of call risk (except for GNMAs).
No call provisions, lock in high coupon securities until maturity.
Closest to a risk-free investment.
Treasury funds
Funds having no debt except that which is fully guaranteed by the U.S. government
GNMA Funds
80% of portfolio in mortgage-backed securities guaranteed by Ginnie Mae.
Interest and principal payments are obligations of the U.S. government
NAV fluctuates with interest rates
GNMA funds have higher current income than government securities to compensate for principal repayment uncertainty (repayment depends on when underlying mortgages are paid off).
Multisector Bond Funds
(aka strategic income bond funds)
3 types of bonds:
U.S. government (Gov’t)
high-yield corporate (HY)
foreign bonds (up to 25% of portfolio) (FB)
Have a low correlation with each other, affected by different factors.
- Gov’t- interest rate changes.
- HY- changes in the economy
(e.g., Economy improves, occuring after interest rates fall, HY do well as possibility of default lessens). - FB affected by their countries’ interest rate change
Foreign World Bond Funds
Seeking current income from debt securities of foreign companies and governments.
Foreign bond funds pay monthly (or quarterly)
Interest income by purchasing bonds issued in foreign currencies.
AA or AAA ratings
Take advantage of higher interest rates in foreign countries.
Global bond.
invests in securities that are traded worldwide, including U.S. issues.
International bond.
invests in securities of companies that are located outside the United States.
Municipal bond funds (munis)
For higher income tax brackets
Interest is free from Federal income tax
State Municipal Bond Funds
These funds contain issues within specific state.
Purchased by residents of state to obtain income free from federal and state income tax (called double tax exempt).
Sometimes, they are free from local income tax (called triple tax exempt).
Residents of other states avoid bc they cant use the state-tax-free feature.
Compare their yields to general municipal bond fund yields on an after-state-tax basis to determine which type of fund provides the better yield.
National Municipal Bond Funds
Most of interest income is subject to state income tax.
If exempt from state tax, will be reported to investor
Example, if 10% of a national fund’s interest income came from issuers in California. California residents could exempt 10% of that interest from their state income tax.
These funds tend to invest primarily in intermediate-or long-term bonds.
Long term - large principal fluctuations
Domestic Equity Funds
Capital appreciation with dividend income not being a primary concern for investors.
Growth Funds
- Growth of capital through common stocks.
- current income (through appreciation and income)
High volatility > low safety of principal
Market Capitalization
Size of company
of shares outstanding x price/share
Small-cap stocks
companies with capitalizations of up to $2 billion
Mid-cap stocks
companies with capitalizations ranging from $2 billion to $10 billion
Large-cap stocks
companies with capitalizations over $10 billion
Aggressive Growth Funds
Focus on maximizing capital appreciation, no current income
Investors willing to take above-average risk.
Risks = purchasing stocks of small companies, emerging growth, and special situations (unique opportunity).
Warrants, with legal restrictions regarding their sale, stock index futures, and options sometimes are purchased.
Small Company Funds
Invest for capital appreciation no regard for current income.
Primarily invest in small-and medium-sized companies, a portion of assets in larger companies.
A subcategory is called micro-cap fund, Some define as investing in companies under $500 million and others as investing in companies under $100 million in market capitalization.
Invest in emerging growth companies and small, special situation companies with an important niche or a new or better product or service.
Sector Funds
Funds investing in stocks of one industry or theme, such as energy, financial services, utilities, technology, real estate, or health care.
Specializing in one geographical area.
A specific type of security, a specific industry, or a specific investment theme, such as leisure.
Minimum of 25% of assets invested in their specialties.
They are broadly based and narrowly based sector funds.
Reading prospectus and looking at current investments show if broad or narrow
Index Funds
Cap-weighted, those with the largest capitalization have the most impact on the indexes’ movements.
Investors do as well as the overall market (less fees)—not trying to beat or do worse than market.
Participate in bull and bear markets.
Low portfolio turnover
Tend to be tax-efficient.
Low current income or stock index
High Current Income for bond index.
Global funds
- Invests in U.S. stocks and in international stocks.
- Foreign securities have currency and political risk
- Purchased to diversify portfolio
International stock
Stocks of foreign companies.
Diversified by economies of various nations vs just United States.
Large-cap stocks are correlated with large-cap international stocks, providing less diversification than previous years.
Developing countries offer a greater possibility of capital appreciation from securities with higher risk.
International small stocks, have indicated they offer more diversification than international large stock funds.
Asset Combination Hybrid Funds
Combination of equity and debt securities.
Asset Allocation Funds
Diversified portfolio by investing in equities, bonds, money markets and precious metals (gold, real estate, etc).
A fund may have 50% in stock, 30% in bonds, and 20% in cash. If stock market goes up, switch cash and bonds to stock. Result of of 80% stock, 10% bonds, and 10% cash. If stock market goes down, invest in cash and sell stock.
Known as target funds that target a specific goal (e.g., retirement) in a 5-, 10-, 15-, or 20-year period.
Balanced Funds
Three-part investment objective:
(1) Conserve investors’ initial principal,
(2) Pay current income, and
(3) Promote long-term growth of principal and income.
Portfolio mix of bonds, preferred stocks, and common stocks.
60% of their assets in stocks
40% in bonds.
Good overall investments
Considered “total return” funds, because they provide both current income and appreciation.
Flexible portfolio
100% invested in stocks, bonds, or money market instruments.
Flexibility for advisor, permitted to invest in stocks of any size to achieve the fund’s objective, capital growth.
Lifestyle Fund
Funds of funds (one fund investing in several funds)
Lifecycle Fund
Target-retirement fund or target-date fund.
Aims for a specific target date investor retired.
Adjusts portfolio to become more conservative over time.
Growth and Income Funds
Produce capital appreciation and current income, priority to appreciation potential in portfolio’s stocks.
Low to moderate yields, from 1% to 3%.
High-grade stocks with steady growth.
These funds use one of two strategies:
(1) owning dividend-paying stocks, or
(2) owning growth stocks and income stocks or bonds.
Precious metals
A hedge against inflation.
When real (after inflation) interest rates are low, and inflation rates increase, gold does well in periods of political and economic uncertainty.
A weak dollar encourages investors to buy gold to preserve purchasing power.
Silver has more industrial uses is more tied to economic activity.
Market for silver is smaller, so price of silver is more volatile than gold.
Commodity Funds
Inflation hedges
Contain combination of stocks in commodity-producing companies, commodity-linked derivative instruments, and commodity futures. Some own TIPS if emphasis is on real returns.
Volatile, with standard deviations typically in the high 20s or low 30s (about 50% higher than the total U.S. stock market).
Tax Characteristics of Mutual Funds
Annual income in one of three forms: (1) ordinary taxable dividends,
(2) exempt interest dividends (e.g., from a municipal bond fund), and
(3) capital gain distributions- report distributions as ordinary income dividends but—typically—as long-term capital gains.
Shareholders receive distribution that is a tax-free return of capital from sale of shares; these are nontaxable distributions.
Have an automatic reinvestment option
No actual cash is received but still pay tax on these payments.
Tax Measured Mutual funds
If an investor sells shares of a mutual fund, there is a tax owed on any gain.
Gain is measured by the net sales price received for the shares (after deducting any expenses of sale) less the investor’s basis (or adjusted cost) in the shares.
Three methods the investor may use to calculate basis:
(1) the specific identification method (Most favorable)
(2) the average cost method (most frequent)
(3) first in, first out (FIFO) (least favorable)
Closed-End Investment Companies
Company whose shares trade the same as publicly traded stocks trade in the secondary market on a stock exchange or over the counter.
Forces of supply and demand, sell at a discount or premium relative to NAV. Investors can profit from changes in the discount to NAV
Shares can be bought on margin and/or sold short.
After IPO, will not issue additional shares.
Capitalization is considered fixed,
not have available additional sources. Permit the manager to invest in less-liquid securities.
Open-end funds
Shares can be purchased and redeemed at their NAVs
Offer to sell new shares, and these shares sell at a base price equal to the NAV (plus any applicable loads).
Purchase shares of open-end funds directly from investment companies
Closed-End Funds
- Share price can differ from their NAVs
- Issue a fixed number of shares.
- Trade on exchanges
- Trade like common stocks.
- Can be bought on margin or sold short.
- Sell at a discount, premium, or at the shares NAV.
- No provision for redemption of outstanding shares
Unit Investment Trusts (UITs)
Fixed portfolios of securities, most frequently in fixed income that an investor pays a load upfront to own, but have no turnover because it is a fixed portfolio of self-liquidating securities that have no management fee.
- Sold in secondary market
- Passively managed
- Have lower management fees
- Maturity date securities are liquidated, and proceeds go to investors or trust beneficiaries.
TAX
Taxed with capital gains, interest, and dividends earned by the trust passed through and taxed to the unit holders.
Separately Managed Accounts
Diversified portfolio of individual securities
Money manager purchases securities on behalf of the individual investor
Minimum investment of $50,000 or more.
Investor owns 100% of the securities
one advantage is the ability to maintain an individual cost basis in the securities held in the account.
Long- Term Bond Fund
Have large principal fluctuations
Exchange-Traded Funds (ETF’s)
ETFs trade like stock, can be bought on margin and can be sold short. They are tax-efficient, generally low cost, and large investors conduct trades by making in-kind exchanges, whereby they give or receive shares of stock that are in the fund. ETFs trade near net asset value (NAV), if not at NAV
ETF’s sample the index
Indexing
investing in index mutual funds or ETFs, is passive portfolio management. Purpose is not to beat the targeted index (e.g., S&P 500 Index) but match its long-term performance, less any management fees and administrative costs.
Index funds tend to be distinguished by their low administrative costs and low turnover of existing assets.
Hedge Funds
- Required to be accredited investors. A hedge fund is an unregistered, privately offered, managed pool of capital for wealthy investors.
- In addition to short selling, a hedge fund will implement a wide array of risky trading strategies in order to exploit market inefficiencies.
- Hedge fund managers are paid based on fund performance
Hedge Fund Strategies
(1) arbitrage, exploit price discrepancies for same securities in different markets
(2) purchase distressed securities (stocks and/or bonds) low prices due to bankruptcy or reorganization;
(3) long-short strategy, being long on some securities and short on other;
(4) follow a global macro investing strategy, profit from changes in global economies—tied to government policies impact interest rates which impact currency, stock, and bond markets;
(5) participate in venture capital offerings, private offerings, and IPO’s
(6) sell short a variety of securities beyond the standard stocks and bonds
(7) employ leverage, process of borrowing to enlarge a position in a security;
(8) use derivatives.
hedge fund manager
paid on the basis of fund performance and owns a significant percentage of the fund’s shares.
Leverage
Risk associated with hedge fund
Hedge funds will typically borrow money, with certain funds borrowing amounts exponentially greater than the initial investment
Short selling.
Risk associated with hedge fund
Due to the nature of short selling, the losses that can be incurred are potentially unlimited.
Higher risk investments.
Risk associated with hedge fund
Hedge funds are more likely to take on underlying investments that carry high degrees of risk, such as debt obligations based on subprime mortgages.
Lack of Transparency
Hedge funds have few public disclosure requirements.
fund of funds (FOF)
point is to achieve diversification bc highly correlated with equity markets
10 to 30 hedge funds
good entry-level investment.
Can target and diversify among several hedge funds and give nonaccredited investors access to hedge funds.
Strategic allocation.
FOF
Refers to the FOF’s long-term percentage allocation of capital to each category of hedge fund style or strategy (e.g., equity and macro).
Tactical allocation.
FOF
Refers to deviating from the FOF’s strategic allocations to take advantage of perceived short-term opportunities.
Manager Selection
FOF
Involves choosing which specific hedge funds to invest in. Liquidity is a consideration here because more liquid funds may give the FOF more opportunity for active allocation among managers.
Guaranteed Investment Contracts (GICs)
Similar to (CDs) but issued by insurance companies, not commercial banks.
Rate of return guaranteed by insurance company for a fixed period (e.g., five years).
Not federally (FDIC) insured;
Carry more investment risk than CDs. Proceeds invested in commercial mortgages and investment-grade corporate and government bonds.
Major purchasers are institutions, (employers), for 401(k) or pension plan for vested employees.
Participating GIC = variable rate of return based on interest rate changes. (rates expected to increase)
Nonparticipating = fixed rate of return. (Rates expected to decline)
Dollar Cost Averaging
Systematic - purchasing securities over time at regular intervals accomplished through automatic withdrawal plan
Advantage = risk of making a bad timing decision with a lump-sum investment is minimized.
Goal= reduce effects of market $ fluctuations.
utilizes a fixed dollar amount at regular intervals regardless of price
Averaging Down
process of buying low and selling high
buying when the price is below the price previously paid
Value Averaging
Periodic investments to ease investor into market.
not a viable strategy; the idea is to buy low and sell high.
Share Averaging
equal number of shares of a stock or fund are purchased each period.
appealing for financially able, to increase their periodic dollar amount of purchases.
purchases the same number of shares and requires different dollar amount
DCA vs value averaging vs share averaging
DCA
simple to implement
already utilized with 401(k) contributions.
Value averaging
Monitoring to determine amount invested at each interval. Psychological hurdle, as it forces them to invest more $ in a declining market.
DCA Example
Year 1 2 3 4 5
Investment 800 800 800 800 800
Stock Price $75 $78 $80 $70 $68
A. $70.50
B. $73.80
C. $75.00
D. $78.50
$800 ÷ 75 = 10.7
$800 ÷ 78 = 10.3
$800 ÷ 80 = 10.0
$800 ÷ 70 = 11.4
$800 ÷ 68 = 11.8
$4,000 ÷ 54.2 = $73.80 average cost per share
What happens when a dividend is paid?
Retained earnings are debited for the amount of the stock dividend and common stock and paid in capital are credited.
The firm’s equity and par value are unchanged.
The stock price will drop by the amount of the dividend.
Money Market Fund
Hold money market instruments like negotiable CDs, Treasury bills, banker’s acceptances, commercial paper, and repurchase agreements.
