Section II.A. Investment Vehicles Flashcards
What are Exchange Traded Products (ETPs)?
• a derivative security that trades on a national securities exchange on an intra-day basis
• the underlying asset is often a commodity, currency, equity share price, or interest rate
• ETPs may be indexed or actively managed
• examples include exchange traded funds and notes
What are Exchange Traded Funds (ETFs)?
Description
• a security that trades on an exchange
• shares may be bought and sold throughout the day
• commonly, passive strategies that track an index
• allows smaller investors access to professional money managers
Application
• usually lower annual fees and expenses (vs. mutual funds)
• Examples: “spiders”, “diamonds” and “cubes”
• Potential advantages:
– Trade continuously like stocks
– Can be sold short or purchased on margin
– Lower costs
– Tax efficient
• Potential disadvantages:
– Prices can depart by small amounts from NAV
– Must be purchased from a broker
Taxation – tax coverage is being seen less and less in this exam
Investing in ETFs is typically more tax-efficient than investing in comparable mutual funds. Of course, it all depends on the specific ETF and mutual fund.
ETF managers reduce or eliminate internal taxation by buying and selling “units of
investment exposure”, thus not creating a taxable gain within the fund that would
otherwise have to be passed through to shareholders (like is the case for mutual funds).
Thus, in most cases the ETF itself does not create significant taxable gains/losses that
are passed through to the shareholders. The shareholders however are taxed when they sell their shares if a capital gain is captured (just like with mutual funds).
The taxation of dividends received from holding ETF shares is comparable to the
treatment of dividends received from holding mutual fund shares. Taxable dividends are treated based on holding period and subject to either ordinary income rates or long-term capital gains (i.e., holding period largely determines whether the dividend is “qualified” for cap gains treatment or is treated as ordinary income for tax purposes).
What are Exchange Traded Notes (ETNs)?
• ETNs are traded on a major exchange
• unsecured debt securities
• can be sold short or purchased on margin
• no coupon payments
• ETNs have a maturity date
• Taxation
– Typically, more efficient than mutual funds and ETFs
– Typically, no internal taxation generated for shareholders
– Shareholders typically only pay taxes if/when recognizing a gain upon sale of their shares
Most ETNs do not pay interest; rather they pay a cash payment at maturity that is linked to the performance of the underlying benchmark or index.
How do you calculate Net Asset Value?
Calculation:
(Market Value of Assets - Liabilities) /
Shares Outstanding
*While tested in the past, this seems to be low probability of showing up on your exam now.
Types of Investment Companies
Managed Investment Companies
– Open-End
• Fund issues new shares when
investors buy in and redeems
shares when investors cash out
• Priced at Net Asset Value (NAV)
– Closed-End
• no change in shares outstanding; old
investors cash out by selling to new
investors
• Priced at premium or discount to NAV
Closed-End funds shares are sold on organized exchanges through a broker.
What are Closed End Funds (CEFs)?
Description
• publicly traded investment company
• raises capital through an IPO
• trades like a stock on a stock exchange
Application
• strategies usually include sector, industry or geographic focus or specialization
• may be sold at a premium or discount to NAV
• a closed-end fund is an investment pool managed by an advisor that is actively priced and traded on a stock exchange
• capital is raised through an initial public offering (IPO)
• CEFs differ from exchange traded funds (ETFs) and open-ended mutual funds in that CEFs may not raise new funds (contributions)
How to calculate Fees and Mutual Fund Returns?
Initial NAV = $20
Income distributions of $.15
Capital gain distributions of $.05
Ending NAV = $20.10:
Rate of return =
(NAV1-NAV0 + Income and capital gain distributions) / NAV0
($20.10 - $20.00 + $.15 + $.05) / 20
Rate of Return = 1.5%
How are mutual funds taxed?
Mutual funds generate “internal” capital gains and dividend income that are
taxable to the shareholders of its fund.
These realized gains, within the fund, become recognized for tax purposes to
the shareholder – even when the mutual funds are not sold by the investor.
Thus, the mutual fund shareholder can experience tax liability while simply
“holding” the shares, and also when selling his/her shares if a gain is experienced. This is not double taxation, but rather additional taxation. As a consequence, many mutual funds should not be considered tax-efficient.
Tax-efficient funds can however take advantage of tax loss harvesting and
other techniques to reduce the negative impact of taxes “within” the fund –
and this benefit is passed through to the investor. But not all mutual fund
managers actively employ such strategies.
What are Separately Managed Accounts (SMAs)?
Description
• SMAs are individually segregated accounts that are actively managed by professional money managers
• an investment advisor usually oversees the account
• SMAs offer the benefit of individual cost basis
Application
• Usually recommended/sold through traditional brokerage houses
• SMAs can invest in REITs
• Less popular now given new products available and the rise of the independent advisor
Separately managed accounts offer some level of customization or individualization to investors. The funds may be as liquid as mutual fund shares. Fee and expenses are typically higher than those of mutual funds, but is not always the case. The risk inherent in the two structure can be nearly the same; it is the underlying investments that dictate the overall risk.
What are Unit Investment Trusts (UITs)?
• a UIT is an investment vehicle that offers a fixed, unmanaged portfolio of stocks and/or bonds
• usually issued in increments of $1,000
• UITs can be traded on a secondary OTC market and every trust has an expiration date
• a UIT may be a registered investment corporation (RIC) where investors are joint owners, or a grantor trust offering proportional ownership
Description
• offer fixed, unmanaged portfolio of stocks and/or bonds
• redeemable units offered for a specific period of time
• usually offered in $1,000 units through brokers
• registered investment corporation (RIC) – investors are joint owners
• grantor trusts – investors receive proportional ownership
Application
• more popular with retirees seeking income
• more susceptible to inflation as interest is fixed for the life of the security
• allows concentrated positions
• bond UITs more popular than stock UITs
3 chief characteristics of UITs:
1) the sponsor pools securities and then sells public shares in the trust
2) the portfolio is fixed for the life of the fund
3) most are invested in fixed-income portfolios
What are Real Estate Investment Trusts (REITs)?
Description
• may be public (trades on exchange) or private
• considered a form of UIT
• invests in real estate directly
• must distribute 90%+ of income to shareholders
• receives special tax treatment
• offers diversification, professional management, higher yields, tax advantages, liquidity
Application
• equity REITs
• mortgage REITs
• hybrid REITs
REITs invest in real estate or real estate secured loans. They may raise capital from banks and by issuing mortgages. They are similar to closed-end funds and shares are typically exchange traded.
REITs must generally follow the same rules as Unit Investment Trusts (UITs) but must follow the same method of self-assessment as corporations.
How does REIT Taxation for entities?
• Rental income is treated as business income to REITs (applies to expenses)
• Income distributions to shareholders is not taxed to the REIT (tax liability is passed thru)
• Exempt from tax at the trust level if they meet requirements including 90% distribution rule
• REITs still face corporate tax on retained
earnings and income
How does REIT Taxation work to Unitholders?
• Dividends paid are taxed as ordinary
income unless considered “qualified
dividends” which are taxed as capital
gains
• Dividends may be considered “return of
capital” in which case they reduce cost
basis and are not considered taxable
income
What are Master Limited Partnerships (MLPs)?
Description
• publicly traded limited partnership
• limited partners provide capital, general partners manage activities
• approximately 90% of cash flow must come from investments in real estate, commodities, or natural resources
Application
• taxation to unitholders upon distributions
• offers liquidity
What are Mutual Funds?
• investment vehicles that allow pooled funds to be managed professionally
• investments within these structures are often made in stocks, bonds, and money market securities
• mutual funds give smaller investors an opportunity to access professional money managers
• purchases and redemptions done at end of day
• mutual fund units are offered for purchase based on a fund’s net asset value (NAV) - a.k.a. “open-end fund”
Most mutual funds are actively managed, despite a growing number of passively managed index funds coming to market. Most mutual funds have an annual expense ratios under 2% (typically ranging from 0.50%-1.50%). Passively managed (e.g. index funds) mutual funds often have expense ratios under 50 basis points. Most mutual funds do not however have mandates limited expense ratios to under 2.00%.
Mutual funds may be considered pass-through entities for tax purposes. Income plus capital gains distributions plus appreciation divided by the fund’s initial net asset value (NAV) equals the rate of return on a mutual fund. Closed-end funds are priced at a premium or discount to NAV. Open ended funds issue new shares when investors buy in and redeem shares when investors cash out.
