Unit 17
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 to the partnership's creditors for
$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.
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
$0.00. 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.
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.
Being a limited partner in a direct participation program is analogous to being
a holder of common stock in a corporation. Limited partners in DPPs are owners of the business in much the same way as common stockholders of a corporation. They assume no management responsibilities simply by virtue of their ownership interest. Similarly, limited partners share the same type of limited liability as corporate shareholders.
Real estate investing can be passive or active. An example of a passive real estate investment would be
a real estate limited partnership 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.
Which of the following commodities is least likely to be affected by the weather?
Silver Silver is a precious metal and its price is not influenced by the weather. Crops, such as wheat and oranges, certainly are and livestock is affected as well.
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 limited partnership in rental real estate 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.
Which of the following would NOT be considered an agricultural commodity?
Aluminum Aluminum is traded as an industrial commodity; all of the others are agricultural.
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?
Bullish 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.
If near-term liquidity is the only objective for a client, which of the following pairs of investments represents the most/least liquid?
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 2 choices and so the order is reversed from what the question seeks.
A client with limited assets seeking additional income in retirement would probably find which of the following investment choices to be the least suitable?
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, they are only suitable for those who can understand and take the risks involved.
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?
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 alternative asset investments class is least associated with which of the following characteristics?
Efficient pricing Alternative assets are most often characterized by inefficient pricing, providing potential abnormal returns or alpha returns.
Which of the following would not generally be considered a passive form of real estate investing?
Flipping houses Flipping houses generally requires work on behalf of the investor. That makes it active rather than passive. Investing REITs or RELPs involves no effort on the part of the investor. Buying a condominium as a personal residence is not considered to be investing in real estate. Moreover, even if so, it is passive.
In discussing a direct participation program with your customer, rank the following items in order of importance from most Tax write-offs Liquidity and marketability Potential for economic gain
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.
Which of the following statements is NOT true?
Limited partners have the option of actively managing the business operations. 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.
The price of which of the following commodities is most likely to be impacted by weather?
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.
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?
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.
Which of the following is NOT a feature in owning a limited partnership?
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 impact ownership of such investments.
Which of the following statements regarding the general partner in a direct participation program (DPP) is NOT true?
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.
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?
The general partners. 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.
A viatical sale would generally involve
an individual with a terminal illness. The term "viatical" comes from a Latin word with a religious connotation involving prayers for those near death. Viatical settlements stem from that definition and are generally used by those with a terminal illness and a life expectancy of 2 years or less. It is the sale of a life insurance policy, almost always whole life or another form of permanent insurance - rarely a term insurance policy.
An alternative investment vehicle that is managed to perform contrary to a benchmark market index such as the S&P 500 is
an inverse exchange-traded fund. Inverse exchange-traded funds are designed to move in the opposite direction of the index they are tracking. They can be leveraged, but the term leveraged can also apply to an ETF that goes in the same direction as the index. A put option on an index will go up in value when the index falls, but it will not rise when the index increases.
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
commodity returns have a low or negative correlation to the other assets in her portfolio. 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.
Investing in commodities could involve investing in any of these EXCEPT
consumer durables 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.
When comparing active to passive real estate investing, the primary benefit to active is
control. The main benefit of active investing is control. The investor determines what type of projects (e.g., single family home, apartment building, or commercial property) and then selects the specific property or properties. In addition, the management of the property is under the investor's control, even when the decision is to employ third-party management. In some, but not all, passive investments, there is high liquidity. The best example of that is an exchange-traded REIT. A house or apartment building is not usually very liquid. Many passive real estate investments can be made with a small sum; that is usually not the case with active. Finally, because the results of active investing rely greatly on the individual investor rather than with professional management, active real estate investing generally carries higher risk than is the case with passive investing.
In order to achieve its goals, an inverse ETF uses
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
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.
It would not be considered passive real estate investing when buying
homes and flipping them. Real estate investing where the investor works with the property is active rather than passive. In a passive real estate investment, as with any other passive investment, the work is done by others, not the investor. Examples are REITs and stock in real estate companies, such as those who build homes.
In general, an investor wishing to gain economic exposure to commodities would find it easiest to do so by
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.
A client wishing to invest in precious metals could consider each of the following EXCEPT
lead 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.
Someone who wishes to invest in precious metals would consider any of the following EXCEPT
lead Lead is not considered a precious metal.
With respect to liquidity and potential for diversification, in comparing alternative investments to exchange-traded stocks, the markets for alternative investments are generally:
less liquid and provide more opportunity for diversification. Alternative investments can provide exposure to unique risks and trading strategies and thus provide good diversification to a stock and bond portfolio. The markets for alternative investments are generally less liquid than most listed stocks.
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.
Among the differences between an investment in a limited partnership offering and in a corporation is that
limited partnership offerings do not pay dividends; corporations do. One of the key features of a limited partnership investment is the concept of flow-through of operating results. If the business operates at a loss, the limited partner's share of that loss is treated as a passive loss on the investor's tax return. If the business is profitable, the limited partner's share of the profit is treated as passive income. Corporations issue securities, primarily stocks and bonds, while limited partnerships issue units representing the limited partner's interest in the venture. Those units are investment contracts and, as taught in Unit 4, LO4, securities. Limited partners who take an active role in the partnership lose their limited status.
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.
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 Inverse funds, also known as short funds, try to deliver returns that are the opposite of the benchmark index they are tracking. When they are exchange traded, they can be bought on margin and are priced throughout the trading day like other exchange-traded funds.
Commodities contracts are available on
platinum. You might like diamonds, pearls, emeralds, and rings with those stones mounted in a platinum setting. Only platinum is a precious metal with commodity contracts available.
You have a client who wishes to allocate a portion of his funds to investment real estate in an attempt to generate additional income. That goal could be reached by investing in any of the following EXCEPT
raw land Raw land does not generate income; it is most often held for future capital appreciation.
An investor owns a 2x leveraged inverse ETF. If the underlying index should decrease in value,
the ETF shares will increase in value by a factor of 2 An inverse, or short ETF, will move in the opposite direction of the underlying index. It is known as a short fund because as the underlying index goes down, the value of the shares increases. Because this is a 2x (2 times) leveraged fund, it will move at a rate that is twice that of the index. Although the choice, "the fund shares will increase in value" is a true statement, it is not the most accurate answer to the question because it ignores the 2x leverage.
In a life settlement, the seller receives more than the premiums paid into the policy but less than
the face amount. The sale price of a life settlement is always more than the cash value and less than the face value.
Your client has heard about investment opportunities in life settlements. Among the risks involved with this investment is
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).
Although the terms are frequently used synonymously, historically, viatical settlements differed from life settlements in that
the seller of the viatical policy was someone who was terminally ill 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.
One way in which active and passive real estate investing differ is that
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.
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
there are no unusual risks associated with these funds other than those one would incur with any index tracking fund 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.