Chapter 14: Investment Vehicles

Dow Jones Utilities includes only 15 large US company stocks from the utility sector.

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Index funds may have to sell securities if withdrawal requests from investors exceed additional investment from investors.

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What are the 2 important elements that affect the value of an index?

1. The securities included in the index 2. The weight assigned to each security in the index

What are 3 distinctions of hedge funds?

1. their availability to only a limited number of investors 2. Agreements that lock up the investors' capital for fixed periods 3. Their managers' performance-based compensation

Definition of Prospectus

All pooled investment vehicles disclose their investment policies, deposit and redemp- tion procedures, fees and expenses, and past performance statistics in an official offering document called a prospectus.

Definition of Back-End Sales Loads

Back-end sales loads are fees that investors may have to pay when they sell shares in a fund that they have not held for more than some pre-specified period, typically a year or more.

Definition of Broad Market Indices?

Broad market indices cover an entire asset class—for example, stocks or bonds—generally within a single country or region.

What is riskier, a closed-end or open-end fund?

Closed-end funds generally are riskier than similar open-end mutual funds because the discounts and occasional premiums at which closed-end funds trade relative to their NAVs vary over time.

Definition of Money Market Securities

Generally very short-term, low-risk debt securities issued by entities with very high-quality credit.

Definition of Hedge Fund

Hedge funds are private investment pools that investment managers organise and manage. As a group, they pursue diverse strategies. The term "hedge" once referred to the practice of buying one asset and selling a correlated asset to take advantage of the difference in their values without taking much market risk—thus the use of the term hedge because it refers to a reduction or elimination of market risk.

Definition of Index Funds

Index funds, which are passively managed, are among the most common types of pooled investment vehicles and are used widely in most parts of the world. They are popular because they provide broad exposure to an asset class and are cheap relative to many other products.

What happens when a manager restarts a hedge fund?

Restarting gives managers a new high-water mark.

Definition of Style Indices?

Style indices provide benchmarks for common styles of investment manage- ment. Examples of equity-style indices include indices of value and growth stocks; of small-, mid-, and large-capitalisation stocks; and of combinations of these classifications, such as small-cap growth.

Definition of Net Asset Value (NAV)

The net asset value (NAV) of a fund is calculated by dividing the total net value of the fund (the value of all assets minus the value of all liabilities) by the fund's current total number of shares outstanding.

What is the organizer of a pooled investment called?

The organizer is often called the sponsor.

Definition of Close-End Funds

Unlike open-end funds, closed-end funds have a fixed number of shares; they do not issue or redeem shares on demand. They may issue additional shares in secondary offerings or through rights offerings or they may repurchase shares, but these events are uncommon. Accordingly, the total number of shares outstanding for most closed- end funds rarely changes.

Separate accounts can be managed for the exclusive benefit of a single investor, but they can be expensive to manage. In contrast, commingled accounts provide investors the benefit of economies of scale in asset management.

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Investors in taxable accounts can often minimise their tax liabilities through careful investment management decisions. In particular, most jurisdictions do not tax capital gains until they are realised.

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Some funds also charge purchase or redemption fees. Investors pay these fees to the fund as opposed to paying them to the distributor as in a front-end or back-end sales load.

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Tax-advantaged accounts allow investors to avoid or defer paying taxes on investment income and capital gains. Investors in taxable accounts can also often minimise their tax liabilities through timing of investment decisions and choice of investments.

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What are 2 important distinctions between pooled investment vehicles?

1. Almost all closed-end funds use active management strategies. Open-end mutual funds may use active or passive investment strategies, depending on the fund. Most exchange-traded funds use passive indexing strategies, but some are actively managed. 2. Many closed- end funds and exchange-traded funds trade in organised secondary markets just like common stocks. In contrast, open-end mutual funds are not exchange traded.

What are the 3 types of sales loads?

1. Front-End 2. Back-End 3. Safe

What are 4 advantages of indirect investment?

1. Indirect investments are professionally managed. 2. Indirect investments allow small investors to use the services of professional managers, whom they otherwise could not afford to hire. 3. Indirect investments allow investors to share in the purchase and ownership of large assets, such as skyscrapers. 4. Indirect investments allow investors to own diversified pools of risks and thereby obtain more stable, although not necessarily better, investment returns. 5. Indirect investments are often substantially less expensive to trade than the underlying assets.

What are 4 advantages of direct investment?

1. Investors exercise more control over direct investments than over indirect investments. 2. Investors choose when to buy or sell their direct investments to minimise their tax liabilities. 3. Investors can choose not to invest directly in certain securities. 4. Investors who are wealthy can often obtain high-quality investment advice at a lower cost when investing directly rather than indirectly.

What are two examples of a type of structure for a hedge fund?

1. Most hedge funds serving US investors are organized as domestic limited partnerships in which the manager is the general partner and the investors are the limited partners. 2. Some hedge funds are domiciled in offshore financial centres where tax rates may be lower. The Cayman Islands are a popular domicile for hedge funds because of favourable laws and regulations for investors and investment managers and the tax advantages this location offers.

What are the 3 main types of pooled investment vehicles?

1. Open-end mutual funds 2. Closed-end funds 4. Exchange-traded funds

Although the majority of investment managers work faithfully to serve their clients, what are 4 problems that can lead to investment losses?

1. Poor research 2. Missed opportunities 3. Self-serving advice 4. Fraud

What are the 3 different approaches used to assign weights to the securities included in an index?

1. Price-weighted 2. Capitalization-weighted 3. Equal-weighted

What are 5 difference between pooled investment vehicles?

1. Risks 2. Management accountability 3. Costs 4. Taxes 5. Passive or Active Management

What are 4 examples of indirect investment vehicles?

1. Shares in mutual funds and exchange-traded funds 2. Limited partnership interests in hedge funds 3. Asset-backed securities, such as mortgage-backed securities 4. Interests in pension funds

Definition of Price-weighted Index

A price-weighted index is an index in which the weight assigned to each security is determined by dividing the price of the security by the sum of all the prices of the securities. As a consequence, high-priced securities have a greater weighting and more of an effect on the value of the index than low-priced stocks.

Definition of Security Market Index

A security market index is a group of securities representing a given security market, market segment, or asset class. The security market indices just mentioned are widely published equity market indices. Practitioners have also created many other indices.

Definition of After-Tax Funds

After-tax funds are the amounts that remain after taxable income and gifts are received and taxed. When placed in tax-advantaged accounts, the funds grow tax free. When withdrawn, taxes, if any, are collected only on the accumulated investment income and capital gains earned during the period of the investment. The original investment (principal), which was taxed once, is not taxed again.

Are open-end and close-end funds passively or actively managed?

Almost all closed-end funds use active management strategies whereas open- end mutual funds can use active or passive investment strategies. Most ETFs are passively managed.

What are some costs associated with trade?

Another type of cost is associated with trading. Investors can trade most listed closed- end funds or ETFs at any time they can find a counterparty willing to take the other side of their trade. In contrast, investors in open-end mutual funds can trade only at the end of the day.

Definition of Equal-weighted Index

Equal-weighted indices show what returns would be made if an equal value were invested in each security included in the index. The prices of these securities change continuously.

Definition of Exchange-Traded Funds

Exchange-traded funds (ETFs) are pooled investment vehicles that are typically pas- sively managed to track a particular index or sector, although an increasing number of ETFs are actively managed. ETFs are generally managed by investment professionals who provide investment, managerial, and administrative services. The fees for these services and trading costs are low, particularly for ETFs that are passively managed.

Definition of Fixed-income Indices

Fixed-income indices cover debt securities and vary by characteristics of the underlying securities and by characteristics of the issuers. For example, sepa- rate indices are available for securities issued by governments (sovereign) and companies (corporate); short-, mid- (intermediate-), and long-term bonds; investment-grade and high-yield bonds; inflation-protected and convertible bonds; and asset-backed securities.

Example of a Hurdle Rate

For example, a manager who receives "2 and 20" compensation will receive 2% of the fund assets in management fees every year plus a performance fee of 20% of the return on the fund assets that exceeds the hurdle rate.

Definition of Front-End Sales Loads

Front-end sales loads are fees that investors may have to pay when they buy shares in a fund.

Definition of Funds of Funds

Funds of funds are investment vehicles that invest in other funds. Fund-of- funds managers seek to add value by selecting managers who will outperform their peers rather than by selecting securities that will outperform other securi- ties. Fees can be high because investors implicitly pay two levels of fees.

What is the compensation of a hedge fund manager?

Hedge fund managers generally receive an annual management fee plus a performance fee that is often specified as a percentage of the returns that they produce in excess of a hurdle rate.

Definition of High-Water Mark

Hedge fund managers usually earn the performance fee only if the fund is above its high-water mark. The high-water mark reflects the highest value, net of fees, that the fund has reached at any time in the past.

Describe the availability of hedge funds.

Hedge funds are usually available only to some investors who meet various wealth, income, and investment knowledge criteria that regulators set. The criteria are designed to ensure that these investment vehicles are suitable for their investors.

Definition of Tax Advantages

In general, tax-advantaged accounts allow investors to avoid paying taxes on invest- ment income and capital gains as they earn them. In addition, contributions made to these accounts may have tax advantages. In exchange for these privileges, investors must accept stringent restrictions on when the money can be withdrawn from the account and sometimes on how the money can be used.

What are advantages of index funds?

Index funds are generally broadly diversified and highly transparent, with relatively low management and trading costs. They are tax-efficient because they do not do a lot of trading that can generate taxable capital gains. The low level of trading also reduces trading costs.

Index Funds are popular among who?

Index funds are popular among individual and institutional investors because they produce returns that closely track market returns.

Definition of Industry Indices?

Industry indices cover single industries.

Definition of Commingled Account

Investment managers can hold their institutional clients' investments in separate accounts or in commingled accounts. In a commingled account, the capital of two or more investors is pooled together and jointly managed. In contrast, funds and securities in a separate account are always kept separate from those of other investors, even if the investment manager uses identical investment strategies for several such accounts.

Definition of "Churning"

Investment managers who receive commissions on trades that they recom- mend may execute too many trades. Some managers have been known to sell and replace their entire portfolios once or more over the course of a year.

Definition of Investment Vehicles

Investment vehicles are assets offered by the investment industry to help investors move money from the present to the future, with the hope of increasing the value of their money.

When are investors worried about management accountability? For open-end or back-end funds?

Investors are more concerned about the accountability of managers of actively managed open-end mutual funds and ETFs.

Definition of Indirect Investment

Investors give their money to investment firms, which then invest the money in a variety of securities and assets on their behalf. Thus, investors make indirect investments when they buy the securities of companies, trusts, and partnerships that make direct investments.

Definition of Direct Investment

Investors make direct investments when they buy securities issued by companies and governments and when they buy real assets, such as precious metals, art, or timber.

Definition of Sales Loads

Investors may have to pay sales loads to the fund distributor, who markets the fund, at the time of purchase, at the time of redemption, or over time. Typically, the fund distributor receives the fee and pays part of it to the investment manager and part of it to anybody who helped arrange the sale, except where legally restricted from doing so.

How is an IPO associated with a close-end fund?

Listed closed-end funds sell shares to the public in initial public offerings (IPOs). They then use the proceeds from the IPO to purchase securities and other assets. After the IPO, investors who want to buy or sell a listed closed-end fund do so through exchanges and dealers. The closed-end fund does not participate in these transactions aside from registering the resulting ownership changes. Investors buy and sell the shares at whatever prices they can obtain in the market.

Summary of Open-End Mutual Funds (Including Money Market Funds)

Managed: Yes, actively or passively Exchange traded: No If exchange traded, size of the gap between the price and the net asset value: N/A Redeemable: Yes Risky: Yes Management accountability: Few issues, particularly if funds are passively managed Management fees: High if actively managed, low if passively managed

Summary of Closed-End Funds

Managed: Yes, primarily actively Exchange traded: Yes, but not traded continuously If exchange traded, size of the gap between the price and the net asset value: Can be large, usually trade at a discount to the NAV Redeemable: No Risky: Yes Management accountability: Management not particularly responsive to share- holders' concerns Management fees: High because actively managed

Summary of Exchange-Traded Funds

Managed: Yes, primarily passively Exchange traded: Yes, traded continuously If exchange traded, size of the gap between the price and the net asset value: Small, usually trade at close to the NAV Redeemable: No Risky: Yes Management accountability: Few issues, particularly if funds are passively managed Management fees: Low if passively managed

Definition of Tax Deductible

Many countries allow contributions to certain tax-advantaged accounts to be tax deductible, which means that they reduce the income on which taxes are paid. Tax- deductible contributions are common for retirement accounts.

Definition of Capitlization-weighted Index

Many indices are capitalisation-weighted indices (also known as cap-weighted indices, market-weighted indices, or value-weighted indices). The weight assigned to each security depends on the security's market capitalisation. Market capitalisa- tion is equal to the market price of the security multiplied by the number of shares outstanding of the security.

Definition of Money Market Funds

Money market funds are a special class of open-end mutual funds that investors view as uninsured interest-paying bank accounts. Unlike other open-end mutual funds, regulators permit money market funds to accept deposits and satisfy redemptions at a constant price per share (typically one unit of the local currency—for example, a euro per share in the eurozone) if they meet certain conditions.

How are money market funds vulnerable?

Money market funds are vulnerable to a run on assets. In particular, if investors expect that the value of their money market funds will decline in the near future, they may rush to redeem their shares before the NAV falls.

Definition of Lock-Up Agreements

Most hedge funds lock up their investors' capital for various periods, the length of which depends on how much time the hedge fund managers expect that they will need to successfully implement their strategies. Funds that engage in high-frequency strategies generally have shorter lock-up periods than funds that engage in strategies that may take much more time to realise the expected returns, such as strategies that involve reforming corporate governance.

Definition of Pooled Investments

Most indirect investment vehicles are pooled investments (also known as collective investment schemes) in which investors pool their money together to gain the advantages of being part of a large group.

Definition of Multi-market Indices?

Multi-market indices cover an asset class across many countries or regions.

Definition of Open-End Mutual Funds

Open-end mutual funds are pooled investment vehicles used by many individual and institutional investors. These pooled investment vehicles are called open-end because they have the ability to issue or redeem (repurchase) shares on demand.

What are other examples of indexes?

Other indices track the performance of alternative investments, such as hedge funds, real estate investment trusts (REITs), and commodities. As discussed in the Alternative Investments chapter, real estate investment trusts are public companies that mainly own, and in most cases operate, income-producing real estate.

Who oversees a pooled investment vehicle?

Pooled investment vehicles are overseen by a board of directors, a board of trust- ees, a general partner, or a single trustee; the governance structure depends on the form of legal organisation.

How do pooled investment vehicles distribute their income?

Pooled investment vehicles generally distribute the income (typically interest and div- idends) that they receive from holding securities as cash dividends to their investors.

Definition of Wrap Account

Retail investors often obtain the services of fee-based investment professionals through wrap accounts. In a wrap account, the charges for investment services, such as brokerage, investment advice, financial planning, and investment accounting, are all wrapped into a single flat fee. The fee typically ranges between 1% and 3% of total assets per year and is usually paid quarterly or annually.

What is the U.S index?

S&P 500 Index

Definition of Safe Sales Loads

Sales loads are calculated as a percentage of the sales price. The percentage is usually around 3%, but can be as high as 9%.

Definition of Sector Indices?

Sector indices cover broad economic sectors—sets of industries related by common products or common customers, such as healthcare, energy, or transportation.

What are the biggest costs with pooled investment vehicles?

The biggest costs are those associated with management, distribution, and account maintenance.

What does the high-water mark incenvtivise?

The high-water mark provision ensures that investors pay the managers only for net returns calculated from the ini- tial investment and not for returns that recoup previous losses. This provision is also called the loss-carryback provision.

Definition of Index Fund

The investment industry creates many investment products based on security market indices, such as index funds. An index fund is a portfolio of securities structured to track the returns of a specific index called the benchmark index. An index fund is a passive investment strategy because the index fund manager aims to replicate the benchmark index.

What is and who determines the net value of a fund?

The manager of an open-end mutual fund determines the prices at which deposits and redemptions occur. No-load funds, which do not charge deposit or redemption fees, set the same price for deposits and redemptions on any given day. This price is the net asset value of the fund.

Definition of Index Reconstitution

The process of adding and removing securities included in the index is called index reconstitution.

What are examples of investment vehicles?

These assets include securities, such as shares, bonds, and warrants; real assets, such as gold; and real estate.

What are disadvantages of hedge funds?

They are less widely used by investors than index funds because they tend to be more complex, less transparent, and less liquid, with higher costs and a high minimum investment level.

Definition of Index Rebalancing

To maintain the equal weights between securities, regular index rebalancing is necessary. That is, the weights given to securities whose prices have risen must be decreased, and the weights given to securities whose prices have fallen must be increased.

Why do countries give tax advantages?

To promote savings for retirement income, educational expenses, and health expenses, many countries give tax advantages to certain investment accounts.

What happens when one wants to put money or withdraw money from an open-end mutual fund?

When investors want to invest in a mutual fund, the fund issues new shares in exchange for cash that the investors deposit. When existing investors want to withdraw money, the fund redeems the investors' shares and pays them cash. So from the fund's point of view, investor purchases and sales are deposits and redemptions, respectively.

When are funds traded at discounts?

A fund is said to trade at a discount if the trading price is lower than the fund's NAV or at a premium if the trading price is greater than its NAV.