Investments An Introduction, 11thE, Mayo, Ch 7, Questions

How do exchange-traded funds (ETFs) differ from mutual funds? Why may they be considered alternative to index mutual funds?

As the name implies, shares in exchange-traded funds (ETFs) are bought and sold in the secondary markets while shares in mutual funds are bought and sold (redeemed) for their net asset value as of the end of the trading day. The initial exchange-traded funds constructed portfolios that tracked an index of the aggregate stock market. These ETFs are, in effect, an alternative to the index mutual fund. Over time, ETFs have become more specialized; currently ETFs track a wide-spectrum of indexes and subsections of indexes.

Why does arbitrage virtually assure that an ETF will sell for its net asset value?

ETFs may be bought and sold (including selling short). If the net value were to deviate from the fund's net asset value, large financial institutions would arbitrage away the difference. If the net asset value of the fund exceeded the value of the underlying assets, the institutions would buy the assets and short the fund. They would then deliver the purchased shares to cover the short positions.

Why are hedge funds and privet equity funds of little interest to most investors?

Hedge funds are private (not public) partnerships. Participants have to have sufficient income and assets to participate. In addition, the number of participants is limited. The net result is that most individuals are excluded from investing in a hedge fund.

How may mutual funds, close-end investment companies and ETFs be used to take positions in foreign securities?

Researching foreign securities and keeping abreast with foreign markets and foreign economies is difficult (if not impossible) for U. S. investors. Purchasing shares in investment companies such as a mutual fund with foreign portfolios may be a means to achieve a diversified portfolio of foreign securities. The managements of these funds should be better able than the individual investor to keep abreast with events that may affect the specific securities included in the portfolio. The same ideas apply to closed-end investment companies and ETFs based on indexes of foreign securities. For example, iShares track a specific foreign index.

Why may investing in an ETF such as the various iShares be preferable to acquiring shares in a mutual fund that makes foreign investments?

Since the ETFs are a passive investment, their lower operating expenses should be lower than the operating costs of mutual funds, which invest in specific foreign firms. The ETFs may also have lower portfolio turnover. Lower costs may increase returns and lower turnover may generate more long-term instead of short-term capital gains. Either of these reasons may result in the ETFs being preferred to the traditional mutual funds.

What are the difference between a closed-end investment company and a mutual fund (opened-end investment company)? What are the sources of return form an investment in a closed-end investment company?

The difference between closed‑end and open‑end investment companies (mutual funds) is their capital structures. A closed‑end investment company has a fixed number of shares, while a mutual fund's number of shares continuously changes. Mutual funds issue new shares when investors buy shares and redeem the shares when investors sell their positions back to the investment company.

Using the information on the taxation of REIT distributions what was the tax status of recent annual distributions made by Plum Creek Timber (PCU), UDR Inc. (UDR), and Washington Real Estate Investment Trust (WRE)?

The taxation of REIT distributions is more complicated than cash dividends from corporation. REIT distributions may be earnings, capital gains, and return of capital, each of which is subject to different tax rates. Plum Creek holds timber and its distributions are generally taxed as long-term capital gains. UDR and WRE hold real properties and their distributions may be income, capital gains, and/or return of capital.

What differentiates a real estate investment trust (REIT) from a firm involved in building, developing, and owning properties? What differentiates a mortgage trust from and equity trust? What advantages do REITs offer investors over direct investments in real estate properties?

-A real estate investment trust (REIT) is an investment company that specializes in real estate investments. These investments may be mortgage loans or improvement loans, or the trust may own property and lease it to firms needing the space. -Firms that construct, build, and develop properties actively participate in the construction process. REITs may buy existing buildings. Since they are a type of closed‑end investment company, their earnings are not taxed at the corporate level but are passed through to stockholders. There is an active secondary market in the shares of REITs, and like the shares of a closed-end investment company, the stock of a REIT may sell for a discount or premium over its net asset value (i.e., the value of the properties). -An equity REIT invests in real property and leases the space to whoever has use for it. A mortgage REIT invests in loans to finance real estate. During periods of inflation, equity trusts may fare better as the value of their holdings appreciates. Mortgage trusts may not do as well if their loans are for fixed rates. If management of a mortgage REIT anticipates inflation, it may make loans with variable rates, which will rise during a period of inflation. -An equity REIT has several advantages over the direct investment in real estate properties. The trusts have professional management and can construct a diversified portfolio of properties. For the individual investor they are passive investments that involve none of the work associated with the individual's managing a property.

Why can a closed-end investment company sell for a discount from net asset value but a mutual fund cannot sell for a discount?

-Investors acquire shares of mutual funds(opened-end) for their net asset value plus any applicable load charges. The shares are redeemed by the fund at the shares' net asset value minus any applicable exit fees. -Closed-end investment companies are bought and sold in the secondary markets. The prices of the shares are established by supply and demand and may sell for a discount from net asset value. (They may also sell for a premium above their net asset value.)