Chapter 17:
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 2 volatile days?
$40.50 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 one (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 2 volatile days, the fund should be priced at approximately $40.50.
Which of the following most accurately identifies a private equity investment in income-producing real estate? A) Investment in a real estate investment trust (REIT) B) Private market mortgage lending by an insurance company C) Direct ownership of real estate properties D) Investment in a real estate mutual fund
C) Direct ownership of real estate properties
debnetures
security of some type?
Structured Products
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.
Which of the following statements is NOT true? A) Limited partners are not liable for funds in excess of the amounts they have invested or otherwise committed for. B) Limited partners have the option of actively managing the business operations. C) It is the general partners rather than the limited partners who bear the liability for partnership debt. D) Management of the enterprise is solely within the jurisdiction of the general partner(s). Explanation
B) Limited partners are passive investors in a partnership whose liability is limited to the amount of funds they have invested and committed to, but have not yet contributed. They do not manage the funds in the partnership; the general partner has that responsibility.
An agent must obtain written verification of an investor's net worth for which of the following investments? A) Variable contracts B) Direct participation programs C) Real estate investment trusts D) Unit investment trusts
B) Direct participation programs. DPPs require complete financial disclosure because of minimum suitability standards set by the states in which they are sold. REITs, unit investment trusts, and variable contracts do not have specific net worth suitability requirements for investors.
The alternative asset investments class is least associated with which of the following characteristics? A) Diversification B) Non-normal returns C) Efficient pricing D) Illiquidity
C) Efficient Pricing Alternative assets are most often characterized by inefficient pricing, providing potential abnormal returns or alpha returns.
Many sophisticated investors have added alternative investments to their portfolios. Benefits in doing so would include A) lower expenses than traditional stock and bond investments B) returns that generally exceed those of traditional stock and bond investments C) portfolio diversification D) greater regulation than traditional investments such as stocks and bonds
C) Portfolio diversification Alternative investments, such as limited partnership vehicles and hedge funds, have a tendency to add diversification to a traditional stock and bond portfolio. Many alternative investments have little or no regulation and their expenses are typically high.
clients need to be aware that Structured products have
Credit or default risk because they are unsecured obligations of the issuing institution Limited or no liquidity As unsecured obligations, their safety 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 these 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.
Viatical Settlement
involves selling an existing life insurance policy for an amount in excess of the cash value, but less than the death benefit. Exact numbers are hard to compute without knowing all the details of the type of policy and health of the insured, but it would certainly be well above the $150,000 cash value. An IRS Section 1035 transfer to an annuity will not put any additional cash in the client's hands.
One type of alternative investment considered to be a pooled investment vehicle is the exchange-traded note. Exchange-traded notes (ETNs) are
unsecured debt securities issued by financial institutions, such as banks 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.
Which of the following categories of assets is most likely classified as an alternative asset? A) Convertible bonds B) Real assets C) Cash D) Preferred stocks
B) real assets Traditional investments include cash, bonds, and stocks, regardless of the adjective used. Alternative investments include 4 major categories: real assets, hedge funds, private equity, and structured products.
One type of alternative investment considered to be a pooled investment vehicle is the reverse ETF. Inverse exchange-traded funds (ETFs), also known as reverse or short funds, are managed to
perform contrary to a benchmark market index such as the S&P 500
An investor owns a reverse ETF. If the underlying index should decrease in value,
the fund shares will increase in value A reverse, or inverse, 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.
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 A) leveraged ETFs B) broad market ETFs C) conservative growth mutual funds D) target date mutual funds
A) Leveraged ETF Because most leveraged funds reset daily, they are best utilized by investors with a very short time horizon.
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
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.
You have a 70-year-old client with a $500,000 whole life insurance policy purchased 25 years ago. The policy currently has a cash value of approximately $150,000. With all of the children on their own and successful, the client no longer feels the need for the insurance, and asks you if there is any option that might result in netting more than surrendering the policy for its cash value. You might recommend A) engaging in a viatical settlement B) keeping the policy because the cash value will continue to grow C) canceling the policy, but leaving the cash value with the insurance company with interest D) using IRS Section 1035 to transfer the cash value into a deferred annuity
A) Engage in viatical settlement
Which of the following must be considered in evaluating the suitability of a DPP investment for a customer?
Risk tolerance Other holdings financial situation Age The key here is to recognize that with DPPs, the customer's age is a relevant consideration in determining suitability. DPPs are long-term, illiquid, and high-risk investments. It is unlikely that DPPs would be suitable for a customer near retirement age, regardless of the customer's financial situation.
ETN
Exchange Traded Note / Equity Linked Note -Index linked note -Debt security -Maturity payment based on underlying security / group of securities -No coupon or interest payments to investor during ownership -Purchased / sold any time during trading day -Purchased on margin and sold short -Risk: unsecured and credit risk of issuing bank or broker dealer -PPN is principal protected note - held to maturity, carry principal guarantee = issuer's credit rating - not 100% guaranteed
One of the benefits of adding precious metals to an investor's portfolio is
Inflation hedge Precious metals are traditionally viewed as a hedge against inflation. One of their benefits is that they have a low correlation with the stock market. Transaction costs for precious metals tend to be higher than securities—the dealer spreads can be relatively high. One significant negative is that these investments generate no income.
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
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.
Which of the following is a motivation for creating structured products? Structured products
improve market completeness. 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.
Your client who owns a DPP that generated a $10,000 passive loss for the year could A) only deduct the passive loss against passive income B) deduct $10,000 against ordinary income C) deduct $3,000 against ordinary income and carry over the rest D) deduct $10,000 against capital gains
only deduct the passive loss against passive income Passive losses, such as those generated by limited partnership investments (DPPs), are only deductible against passive income.
Lisa Brownard is considering investing in gold. She owns a portfolio of stocks, bonds, and money market securities. Relative to her existing portfolio, the primary benefit of the gold investment is most likely
low correlation between traditional asset returns and gold. The returns on gold and other precious metals exhibit low correlation with stock and bond returns. This is generally cited as the key advantage to investing in hard assets. Cyclicality and a long investment horizon are disadvantages of gold investments. Gold is not a renewable resource.
Among the characteristics of leveraged exchange-traded funds is that
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.
Which of the following is NOT a characteristic of owning a limited partnership? A) Flow-through of income and expenses of a business to the individual limited partner B) An investment managed by others C) Legislative risk D) Tax-free income
D) Tax free income The income from limited partnerships is not tax exempt. An investor, however, may use a tax loss from a partnership to offset the income from another passive investment. In limited partnerships, the investor enjoys the advantages and disadvantages of owning a business without having to actually manage one. Limited partnerships are vulnerable to legislative changes that adversely affect ownership of such investments.
An investment adviser who is discussing forward contracts with a client would most likely be referring to an investment in
A) puts and calls B) a diversified portfolio C) an equity index annuity D) an agricultural commodity
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 A) a structured product B) a z-tranche CMO C) an inverse fund D) an arbitrage
A) Structured Product
Forward contracts
Forward contracts are available on commodities, such as agricultural products (e.g., corn, wheat, and soybeans). Puts and calls are options, not forward contracts; although this could be a way to diversify the portfolio, that does not directly answer the question.
An investor in a high tax bracket who invested in a DPP should have which of the following characteristics?
Need for tax benefits Substantial liquid assets Ability to identify both risks and merits of the program Ability to commit money for a long time
In discussing a direct participation program with your customer, rank the following items in order of importance from most to least.
Potential for economic gain Tax write-offs Liquidity and marketability A program's economic viability is the first priority in the assessment of DPPs. The IRS considers programs designed solely to generate tax benefits abusive. Because there is a very limited secondary market for DPPs, liquidity and marketability should be a low priority.
Real estate investment
Real estate investments take 4 major forms: private equity, publicly traded equity, private debt, and publicly traded debt. Private equity investment in real estate refers to direct ownership of real estate properties. Mortgage lending by banks or insurance companies is best described as private debt. Indirect ownership of real estate through equity securities such as REITs is an example of publicly traded equity.
Which of the following is true regarding ETNs? A) They are non-callable prior to maturity. B) As fixed-income investments, they do not have market risk. C) Their value can be impacted by changes in the issuer's credit rating. D) They are suitable for conservative investors seeking income.
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.
The sale of a life insurance policy in the secondary market by a terminally ill individual is known as
Viatical settlement
A REIT and a direct participation program are similar because they both
are operated by a centralized management Both a REIT and a DPP are run by centralized management. A REIT may not pass through losses to its investors, and it is not a limited partnership. A DPP cannot be easily traded in the secondary market.
Which of the following statements regarding the general partner in a direct participation program (DPP) is NOT true? A) The general partner (GP) is the active investor in a limited partnership and assumes responsibility for all aspects of the partnership's operations. B) The GP cannot borrow from the partnership, compete with the partnership, or commingle personal funds with partnership funds. C) A GP has a fiduciary relationship to the limited partners (LPs). D) The GP, as the active manager of the partnership, does not maintain a financial interest in the partnership and only receives income distributions from profits on the business prior to the limited partners.
D) The GP, as the active manager of the partnership, does not maintain a financial interest in the partnership and only receives income distributions from profits on the business prior to the limited partners. General partners (GPs) must maintain a financial interest in the partnership and generally do not receive distributions from profits before those paid to the limited partners. The GP is the active investor in a limited partnership and assumes responsibility for all aspects of the partnership's operations and has a fiduciary relationship to the LPs. The GP, as a fiduciary, cannot borrow from the partnership, compete with the partnership, or commingle personal funds with partnership funds.
