Unit 5: Alternative investments and other assets

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

A) utilizes derivatives to achieve its objectives. 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.

An investor bought a parcel of raw land for $50,000 several years ago. A developer has offered to exchange another property, currently valued at $100,000, with this investor. Under Section 1031 of the Internal Revenue Code, the investor's tax consequences would be A) $50,000 short-term capital gain. B) $50,000 ordinary income. C) $50,000 long-term capital gain. D) $0.

D) $0. Section 1031 permits a tax-free exchange of one property for another. This has the effect of deferring any gain until final disposition of the property. This is a parallel to Section 1035 for annuity products.

The alternative asset investments class is least associated with which of the following characteristics? A) Efficient pricing B) Diversification C) Illiquidity D) Nonnormal returns

A) Efficient pricing Alternative assets are most often characterized by inefficient pricing, providing potential abnormal returns or alpha returns. That is the prime reason for their popularity, especially with institutional investors.

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

A) III, I, II 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) leveraged ETFs. B) conservative growth mutual funds. C) target date mutual funds. D) broad market ETFs.

A) leveraged ETFs. Because most leveraged funds reset daily, they are best utilized by investors with a very short time horizon.

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) ETNs are issued by financial institutions; therefore, I should be concerned about the credit worthiness of the issuer. B) ETFs have a fixed coupon rate that I should expect to realize when they mature. C) ETNs are equity securities because they trade on exchanges. D) 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.

A)ETNs are issued by financial institutions; therefore, I should be concerned about the credit worthiness of the issuer. 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.

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

B) Orange juice 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.

Many sophisticated investors have added alternative investments to their portfolios. Benefits in doing so include A) returns that generally exceed those of traditional stock and bond investments. B) portfolio diversification. C) greater regulation than traditional investments such as stocks and bonds. D) lower expenses than traditional stock and bond investments.

B) 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.

Which of the following is a motivation for creating structured products? A) Structured products reduce costs to issuers. B) Structured products improve profits for broker-dealers. C) Structured products are less expensive for investors to buy and trade. D) Structured products improve market completeness.

D) Structured products improve market completeness. The 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.

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

D) derivatives and debt. 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.

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

D) direct participation plans. 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.

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) investing in futures contracts 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.

Which of the following is true regarding ETNs? A) They are noncallable 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.

C) 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.

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 two years of drilling without success, the project was foreclosed with outstanding debt of $4 million. Your client is liable to the partnership's creditors for A) $0. B) $400,000. C) $250,000. D) $150,000.

A) $0. One of the benefits of being a limited partner is that the most you can lose is your investment. Just as it would for a stockholder in a corporation, the concept of limited liability applies. You can lose your entire investment, but you have no liability for debts of the business. This question describes a DPP that has gone bankrupt (liabilities exceed the assets) and wants to know the share of the $4 million in outstanding debt that is the responsibility of this investor. Even though she owns 10% of the partnership, as a limited partner, she has no liability for any of that debt.

A REIT and a direct participation program are similar because they both A) pass through losses to investors. B) are operated by a centralized management. C) are traded actively in the secondary market. D) can be described as a limited partnership.

B) 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.

One type of alternative investment considered to be a pooled investment vehicle is the exchange-traded note. Exchange-traded notes (ETNs) are which of these? Unsecured debt securities Unsecured equity securities Issued by financial institutions, such as banks Insured by the FDIC A) II and IV B) I and III C) II and III D) I and IV

B) I and III 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 securities is eligible for a Section 1031 exchange? A) Listed stocks B) Direct participation programs C) Annuities D) Real estate limited partnership (RELP) programs

D) Real estate limited partnership (RELP) programs Section 1031 of the Internal Revenue Code deals with like-kind exchanges of real property that is held for use in a trade or business or for investment. Real property, also called real estate, includes land and generally anything built on or attached to it. A RELP is a real estate-based security qualifying for the Section 1031 exchange. The benefit is that no taxes are paid on gains until the last sale of the property. In simple terms, it permits tax deferral of gains when real estate is exchanged for other real estate.

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) only real estate professionals can deduct losses from active real estate investing. C) there are circumstances under which losses from passive real estate investing can be deducted against ordinary income D) there are circumstances under which losses from active real estate investing can be deducted against ordinary income

D) there are circumstances under which losses from active real estate investing can be deducted against ordinary income 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.

If near-term liquidity is the only objective for a client, which of the following pairs of investments represents the most/least liquid? A) Common stock listed on the New York Stock Exchange/unit in a direct participation program (DPP) B) 10-year corporate bonds/U.S. T-bills C) Annuity units of a variable annuity/unit in a direct participation program (DPP) D) Variable annuity accumulation unit/money market mutual fund shares

A) Common stock listed on the New York Stock Exchange/unit in a direct participation program (DPP) Stock listed on the NYSE is considered highly liquid, while ownership units in a DPP are generally illiquid. Once a variable annuity's accumulation units have been exchanged for annuity units (payout time), there is no liquidity. The corporate bonds and T-bills have the order reversed; it is the T-bills with high liquidity and corporate bonds have the lower liquidity. Variable annuity accumulation units are liquid and so are money market mutual fund shares. However, because the fund shares have check-writing privileges, they are the more liquid of the choices, so the order is reversed from what the question seeks.

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

B) Direct ownership of real estate properties 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.

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 two volatile days? A) $45.86 B) $41.55 C) $43.18 D) $40.50

D) $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 1 (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 two volatile days, the fund should be priced at approximately $40.50.

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) Once the program has paid taxes on its income, the entire remaining balance passes through to the investors. B) Losses generated by the program pass through to the investor and may be deducted in full against ordinary income. C) Investors in the program are assured of a steady flow of income if the drilling is successful. D) Rather than being a separate taxable entity, the program's income or losses pass through directly to the investors.

D) Rather than being a separate taxable entity, the program's income or losses pass through directly to the investors. 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.

A client with limited assets seeking additional income in retirement would probably find which of the following investment choices to be the least suitable? A) Treasury bonds B) ETNs C) Insured bank CDs D) ETFs

B) ETNs The question describes an individual with a low risk tolerance, so the Treasury bonds and CDs would certainly be considered appropriate. Because ETNs are a debt security backed solely by a single issuer while an ETF based on a specific index of debt securities represents a large group of issuers, ETNs are only suitable for those who can understand and take the risks involved.

Which of the following statements regarding the general partner (GP) in a direct participation program (DPP) is not true? A) The 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) 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) A GP has a fiduciary relationship to the limited partners (LPs).

C) 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 (LPs). 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.

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 insurance company may not have the funds to pay the death benefit C) the insured may live well past the expected mortality date D) the insured may cease paying premiums, leading to a policy lapse

C) the insured may live well past the expected mortality date 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).