Unit #17: Alternative Investments and Other Assets

A client wishing to invest in precious metals could consider each of the following EXCEPT A) lead B) platinum C) silver D) gold

A *Although it has always been the alchemist's dream to convert lead to gold, until that becomes a reality, lead is not considered a precious metal.

In order to achieve its goals, an inverse ETF uses A) derivatives and debt. B) arbitrage. C) preemptive rights. D) short selling.

A *An inverse ETF will almost always use derivatives, such as options and, in the case of a leveraged ETF, will use debt, primarily in the form of margin. Inverse ETFs do not engage in short selling; they are an alternative to selling short a specific index without the unlimited risk potential of the short sale. Arbitrage is used, typically by institutional investors, to take advantage of temporary imbalances between the ETF's net asset value and market price.

A high net worth client of yours invested $250,000 into an oil and gas limited partnership drilling program for which she received a 10% interest in the project. Unfortunately, after 2 years of drilling without success, the project was foreclosed with outstanding debt of $4 million. Your client is liable for A) $0 B) $150,000 C) $400,000 D) $250,000

A *An investor's liability in a limited partnership is generally limited to the original investment. If there are any funds that the investor has committed for, but not yet contributed to, there is a liability for that amount as well.

Commodity futures contracts are available on all of the following except A) single family homes. B) industrial metals. C) eggs. D) soybeans.

A *Commodity futures contracts are available on metals, both precious and industrial, animal products, such as eggs, and agricultural crops, such as soybeans. Single family homes are not a tradeable commodity.

An agent must obtain written verification of an investor's net worth for which of the following investments? A) Direct participation programs B) Variable contracts C) Unit investment trusts D) Real estate investment trusts

A *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.

Active real estate investment would include all of the following except A) buy, renovate, and sell. B) build new and sell. C) buy a RELP. D) buy, hold, and rent.

C *A RELP is a real estate limited partnership (DPP) and, as a limited partner, legally, the investor can only take a passive role. Each of the other choices has the investor taking an active role.

In discussing a direct participation program with your customer, rank the following items in order of importance from most to least. 1. Tax write-offs 2. Liquidity and marketability 3. Potential for economic gain A) II, III, I B) I, II, III C) III, I, II D) III, II, I

C *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.

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) broad market ETFs B) conservative growth mutual funds C) leveraged ETFs D) target date mutual funds

C *Because most leveraged funds reset daily, they are best utilized by investors with a very short time horizon

Investing in commodities could involve investing in any of these EXCEPT A) animals B) industrial items C) agricultural items D) consumer durables

D *Commodity contracts are not available on consumer durables such as refrigerators and washing machines. They are available on agricultural items, such as corn, wheat, and soybeans. Likewise, investing in animal items such as cattle and pork bellies is possible. Finally, industrial items, primarily metals such as lead, zinc, and aluminum, are popular investments.

Real estate investing can be passive or active. An example of a passive real estate investment would be A) renting out single family homes B) flipping homes C) managing an apartment building D) a real estate limited partnership

D *DPPs such as a real estate limited partnership offerings, are passive investments because the investor takes no part in the management or running of the enterprise. In each of the other choices, the investor must do some work.

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 products are created as a tool to meet the issuer's debt financing needs when they will result in a lower cost than a standardized financial instrument available in the market place.

One type of alternative investment considered to be a pooled investment vehicle is the exchange-traded note. Exchange-traded notes (ETNs) are 1. unsecured debt securities 2. unsecured equity securities 3. issued by financial institutions, such as banks 4. insured by the FDIC A) I and III B) I and IV C) II and III D) II and IV

A *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.

The price of which of the following commodities is most likely to be impacted by weather? A) Orange juice B) Gold C) Lead D) Livestock

A *If you ever saw the movie, Trading Places, with Eddie Murphy and Dan Aykroyd, you would certainly know that weather can have a major impact on the orange crop. Metals are not affected by heat or cold, or rain and snow. Years ago, before heated/air conditioned barns and other protective devices, livestock would freeze in a bad winter, but that is no longer much of an issue.

In a limited partnership program, which partners manage the partnership's day-to-day operations and incur unlimited personal liability for the partnership's debts? A) The general partners. B) Both the general partners and the limited partners. C) Neither the general partners nor the limited partners. D) The limited partners.

A *In a limited partnership, the general partners manage the day-to-day operations and incur unlimited personal liability. Limited partners invest money in the partnership and are liable for the partnership's debts only up to the amount invested. They are denied a voice in the management of the partnership.

Which of the following most accurately identifies a private equity investment in income-producing real estate? A) Direct ownership of real estate properties B) Investment in a real estate investment trust (REIT) C) Private market mortgage lending by an insurance company D) Investment in a real estate mutual fund

A *Real estate investments take four 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 would be considered a precious metal? A) Lead B) Platinum C) Copper D) Tin

B *The easiest way to answer this question is to add a word to each choice—copper wire, lead pipe, platinum ring, and tin can. Along with silver and gold, platinum is a commonly traded precious metal in the commodities markets.

Which of the following is NOT a feature in owning a limited partnership? A) Tax-free income B) Legislative risk C) An investment managed by others D) Flow-through of income and expenses of a business to the individual limited partner

A *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 impact ownership of such investments.

An investment adviser representative has several clients who are interested in adding precious metals to their portfolios. Which of the following is the IAR most likely to recommend? A) Platinum B) Copper C) Nickel D) Aluminum

A *The only one of these considered a precious metal is platinum. For the exam, there are likely only going to be 3 precious metals: gold, silver, and platinum.

A client was reading an offering document for an oil and gas drilling limited partnership program and noticed that one of the features was flow-through benefits. How would you explain this? A) Rather than being a separate taxable entity, the program's income or losses pass through directly to the investors. B) Once the program has paid taxes on its income, the entire remaining balance passes through to the investors. C) Investors in the program are assured of a steady flow of income if the drilling is successful. D) Losses generated by the program pass through to the investor and may be deducted in full against ordinary income.

A *The philosophy behind flow-through is that any income or losses generated by a program of this type (DPP) flow directly to the investors—there is no tax at the entity level. If there are losses, they may only be deducted against passive income (e.g., income from other partnerships). No assurances can ever be given.

Your client has heard about investment opportunities in life settlements. Among the risks involved with this investment is A) the insured may change the beneficiary without notifying the investor B) the insured may live well past the expected mortality date C) the insured may cease paying premiums, leading to a policy lapse D) the insurance company may not have the funds to pay the death benefit

B *Although it is always possible that the insurance company could default, that is so rare, it is not usually a consideration. Life settlements are priced based on providing a stated return assuming normal mortality. If the insured lives far past that, the rate of return to the investor goes way down. The insured does not pay the premiums (the investor does) and the insured no longer has the rights to change the beneficiary (the investor does).

Which of the following would NOT be considered an agricultural commodity? A) Oats B) Aluminum C) Coffee D) Soybeans

B *Aluminum is traded as an industrial commodity; all of the others are agricultural.

Which of the following investments is not registered under the Investment Company Act of 1940? A) UITs B) ETNs C) FACCs D) ETFs

B *Exchange-traded notes, sometimes called equity-linked notes, are registered under the Securities Act of 1933 as debt instruments. All of the other choices are registered as investment companies under the Investment Company Act of 1940.

For a customer interested in buying an inverse exchange-traded fund (ETF) tracking the performance of the Standard & Poor's 500 Index, which of the following market views would make that purchase most inappropriate? A) Bearish B) Bullish C) Bullish or bearish D) Neutral

B *Inverse (reverse) ETFs are designed to deliver returns that are opposite of the benchmark index they are tracking. Therefore, buying an inverse ETF that tracks the S&P 500 Index at a time when the market outlook is bullish would be most inappropriate. If the index rises with the anticipated bullish market, the fund that delivers returns that are the opposite of the index would fall in value.

In general, an investor wishing to gain economic exposure to commodities would find it easiest to do so by A) buying the commodity directly B) investing in futures contracts C) investing in forwards contracts D) growing the commodity

B *It is generally agreed that using commodity futures is the easiest and most common way to gain economic exposure to commodities. Forwards are more commonly used by producers or users because, unlike futures, most forward contracts result in the delivery of the actual commodity. Only about 1% of all futures contract positions involve the delivery of the underlying commodity.

All of the following are features of limited partnership direct participation programs except A) the limited partners have limited liability. B) the limited partners may participate in the management of the partnership. C) the general partner determines when distributions are made to the limited partners. D) the general partner controls the business activities of the partnership.

B *Should a limited partner assume a management role, there is the danger that the limited liability protection would be lost and that partner would now have the same unlimited liability of a general partner. It is the general partner who manages the program; the limited partner is a passive investor.

Your customer is asking if either exchange-traded funds (ETFs) or exchange-traded notes (ETNs) might be suitable investments for his portfolio. The customer makes several statements regarding his understanding of the products, but only one of them is accurate. Which is it? A) ETFs have a fixed coupon rate that I should expect to realize when they mature. B) ETNs are issued by financial institutions; therefore, I should be concerned about the credit worthiness of the issuer. C) If I want to sell my shares of an ETF, I have to wait until the next price is calculated to value the portfolio of securities. D) ETNs are equity securities because they trade on exchanges.

B *The only accurate statement is the one expressing that ETNs are issued by financial institutions and, therefore, the credit worthiness of the issuer should be a concerning factor. ETNs are debt instruments, not equity instruments. ETNs have a final payment at maturity based on the return of a single stock, a basket of stocks, or an equity index. While ETF prices fluctuate based on the value of the securities within the fund portfolio throughout the trading day, they are priced by supply and demand, like all exchange-traded products. They are not forward priced like open-end mutual fund shares are.

One of your clients is considering allocating about 10% of her portfolio to commodities. Her current portfolio is a mix of stocks, bonds, and broad market index ETFs. Relative to her existing portfolio, you would explain to her that the primary benefit of the commodity investment is most likely A) lower trading costs. B) commodity returns have a low or negative correlation to the other assets in her portfolio. C) an increase in the reliability of income generated in the portfolio. D) increased short-term performance.

B *The returns on commodities exhibit low or even negative correlation with stock and bond returns. This is generally cited as a major advantage to investing in commodities. Commodities do not generate income; there are no dividends or interest paid on them - the investor recognizes a gain or a loss, but no income. In general, allocating a small percentage of the portfolio to commodities should be viewed as a long-term strategy, not short-term. There is no evidence that trading costs on commodities are lower than on traditional investments. In fact, it seems likely the opposite is true.

Which of the following categories of assets is most likely classified as an alternative asset? A) Cash B) Real assets C) Preferred stocks D) Convertible bonds

B *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.

Your customer is interested in a leveraged fund and makes the following statements about leveraged funds to you. All of the statements regarding leveraged funds are true EXCEPT A) some leveraged funds are exchange-traded products B) these funds sometimes use derivatives products to achieve their stated goals C) there are no unusual risks associated with these funds other than those one would incur with any index tracking fund D) the funds attempt to return a multiple of the return of a benchmark index they are tracking, perhaps 2 or 3 times

C *Because the fund objective is to achieve returns that are a multiple of the returns of the benchmark index, the result could be a multiple of any loss incurred by the benchmark index as well. In addition, because these funds utilize derivatives products to achieve their stated objectives, they may not be suitable for anyone that derivatives products are not suitable for, given the additional risks associated with those products.

A client who is interested in investing in commodities might look at any of the following EXCEPT A) gold B) heating oil C) debentures D) corn

C *Debentures are a security; each of the others is a commodity.

Flow-through is one of the features of A) variable annuities B) REITs C) direct participation plans D) open-end investment companies

C *Flow-through is the term commonly used to describe that any income or loss generated by a direct participation program flows through to the owner(s). In the case of a REIT, the only thing that passes through is income or gains, never losses.

If you overheard an analyst referring to an investment's indicative value, the discussion would most likely be about A) REITs. B) ETFs. C) ETNs. D) TIPSs.

C *The calculated value, called the indicative value or closing indicative value for ETNs, is calculated and published at the end of each day by the ETN issuer

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 A) the investment horizon is longer than that of stocks and bonds, balancing the duration of the portfolio. B) gold values are tied to cyclical industries. C) low correlation between traditional asset returns and gold. D) gold is a renewable resource, so Brownard can profit from the investment for many years.

C *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.

In a life settlement, the seller receives more than the premiums paid into the policy but less than A) the cash value. B) the future premiums payable. C) the face amount. D) the accumulated dividends.

C *The sale price of a life settlement is always more than the cash value and less than the face value

One way in which active and passive real estate investing differ is that A) losses from active real estate investing can only be deducted against income from other active investing projects B) there are circumstances under which losses from passive real estate investing can be deducted against ordinary income C) there are circumstances under which losses from active real estate investing can be deducted against ordinary income D) only real estate professionals can deduct losses from active real estate investing.

C *There are certain conditions under which active real estate investors can deduct as much as $25,000 in losses from ordinary income. Those conditions are likely to be far more complex than the exam will delve, but it can be important to know that this is possible. Passive real estate losses can only be deducted against passive income.

Although the terms are frequently used synonymously, historically, viatical settlements differed from life settlements in that A) the buyer of the viatical policy was someone who was terminally ill B) the buyer of the viatical policy did not know the identity of the seller C) the seller of the viatical policy was someone who was terminally ill D) the seller of the viatical policy was someone with a life expectancy of up to 15 years

C *Viatical settlements came of age during the AIDs crisis of the 1980s. They provide cash in exchange for the sale of a life insurance policy to those who were racking up substantial medical bills and had a short (generally less than 2 years) life expectancy. As medical advances changed the "death sentence" for an AIDS diagnosis (and many cancers as well), the life settlement became the more popular option when the policy owner was healthy but had reached an age (generally at least 70), and the need for life insurance was not as important as having the cash for personal use.

It would be correct to state that an inverse ETF A) is suitable for sophisticated investors with a long time horizon. B) is a form of private equity fund. C) moves in tandem with the index being tracked. D) utilizes derivatives to achieve its objectives.

D *Inverse, or short, ETFs move in the opposite direction of the index being tracked. To achieve their goals, various types of derivatives are used. This type of ETF is used only for short-term investments, rarely as long as a single month. These are registered investment companies, not private.

Your client who owns a DPP that generated a $10,000 passive loss for the year could A) deduct $10,000 against capital gains B) deduct $10,000 against ordinary income C) deduct $3,000 against ordinary income and carry over the rest D) only deduct the passive loss against passive income

D *Passive losses, such as those generated by limited partnership investments (DPPs), are only deductible against passive income.

One of your clients approaches you looking for an investment that will provide ready marketability and income. Which of the following would be the least appropriate recommendation? A) U.S. Treasury notes B) A money market mutual fund C) NYSE-listed preferred stock D) A limited partnership in rental real estate

D *The key is meeting both needs—marketability and income—and each of them supply both except the limited partnership. The client could expect income from a DPP investing in rental real estate, but the liquidity is missing.

Passive real estate investment would include all of the following except A) buying shares of a company that manages commercial property. B) investing in raw land through a DPP. C) buying shares of a REIT. D) renting out single family homes.

D *The only one of these choices where the investor is doing any work is renting out property. In each of the other cases, someone else is doing the work; a key component of passive real estate investment.

An investment adviser representative has several clients who are interested in adding precious metals to their portfolios. Which of the following is the IAR most likely to recommend? A) Aluminum B) Nickel C) Copper D) Platinum

D *The only one of these considered a precious metal is platinum. For the exam, there are likely only going to be 3 precious metals: gold, silver, and platinum.

A benefit of active investment in real estate that is not available to purchasers of REITs is A) dividends from active investments are generally qualified. B) the Section 1035 exchange privilege. C) greater liquidity. D) the Section 1031 exchange privilege.

D *Under Internal Revenue Code Section 1031, no gain or loss is recognized on the exchange of real estate held for investment if such property is exchanged solely for real estate of like-kind which is to be held for investment. This does not apply to REITs where an exchange is considered a sale with a realized gain or loss for tax purposes. Section 1035 is similar in concept, but deals with insurance products, usually annuities. Dividends are paid by corporations, not those who flip houses and, because most REITs are publicly traded, they are the ones with greater liquidity.