Unit 5 Alternative Investments
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) $150,000. C) $400,000. D) $250,000.
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.
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) $0. B) $50,000 ordinary income. C) $50,000 short-term capital gain. D) $50,000 long-term capital gain.
A) $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.
Which of the following is NOT registered with the SEC under the Investment Company Act of 1940? A) Exchange-traded notes B) Exchange-traded funds C) Unit investment trusts D) Open-end investment companies
A) Exchange-traded notes Exchange-traded notes (ETNs) register as debt securities under the Securities Act of 1933.
Market conditions are deteriorating and your client, who owns a plumbing business, is looking for a safe haven that will also provide some income. Which of the following would most likely be your recommendation? A) Rental real estate B) High-yield bonds C) Commodity futures D) Precious metals
A) Rental real estate In general, rental real estate will provide returns, even in a down market. Of note, the client is in the plumbing business which means that maintaining the property will be easier than someone in a white collar profession. Precious metals and commodity futures will generate zero income and high yield (junk) bond are definitely not the place to be in a sour market.
All of the following would flow through as a loss to limited partners except A) principal repayment on partnership debt. B) depletion. C) interest payments on partnership debt. D) accelerated depreciation.
A) principal repayment on partnership debt. Principal repayments are not an expense for tax purposes. The interest on the debt is an expense and, along with depletion and depreciation expenses, does flow through to the limited partners as passive loss.
Your client has heard about investment opportunities in life settlements. Among the risks involved with this investment is A) the insured may live well past the expected mortality date B) the insurance company may not have the funds to pay the death benefit C) the insured may change the beneficiary without notifying the investor D) the insured may cease paying premiums, leading to a policy lapse
A) 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).
Which of the following would not be considered an agricultural commodity? A) Oats B) Aluminum C) Coffee D) Soybeans
B) Aluminum Aluminum is traded as an industrial commodity; all of the others are agricultural.
An investment adviser representative (IAR) 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) Copper B) Platinum C) Nickel D) Aluminum
B) Platinum
Many investment advisers follow a program of asset allocation. Which of the following categories of assets is most likely classified as an alternative asset? A) Preferred stocks B) Real assets C) Cash D) Callable bonds
B) Real assets Traditional assets in an allocation program include cash, bonds, and stocks, regardless of the adjective used. Alternative assets include four major categories: real assets, hedge funds, private equity, and structured products.
Which of the following is not a feature in owning a limited partnership? A) Legislative risk B) Tax-free income C) Flow-through of income and expenses of a business to the individual limited partner D) An investment managed by others
B) 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.
Flow-through is one of the features of A) variable annuities. B) direct participation plans. C) open-end investment companies. D) REITs.
B) 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. LO 5.a
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) 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. C) ETNs are issued by financial institutions; therefore, I should be concerned about the credit worthiness of the issuer. D) ETNs are equity securities because they trade on exchanges.
C) 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.
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 A) I and II B) II, III, and IV C) I, II, III, and IV D) II and III
C) I, II, III, and IV DPPs are appropriate for investors who can benefit from substantial tax deductions or credits, are not bothered by illiquidity, understand the business risks and benefits involved, and can stay in the program until completion.
Active real estate investment would include all of the following except A) buy, renovate, and sell. B) buy, hold, and rent. C) buy a RELP. D) build new and sell.
C) buy a RELP. 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 general, an investor wishing to gain economic exposure to commodities would find it easiest to do so by A) investing in forwards contracts B) buying the commodity directly C) investing in futures contracts D) growing the commodity
C) 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.
Someone who wishes to invest in precious metals would consider any of the following except A) gold. B) platinum. C) lead. D) silver.
C) lead.
One type of alternative investment considered to be a pooled investment vehicle is the inverse exchange-traded fund (ETF). Inverse ETFs, also known as bear or short funds, are managed to A) be used only by professional traders and market makers. B) be profitable only when interest rates are rising. C) perform contrary to a benchmark market index such as the S&P 500. D) outperform a benchmark market index such as the S&P 500.
C) perform contrary to a benchmark market index such as the S&P 500. Inverse funds, also known as short or bear 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.
Regarding the use of the term direct participation programs, when referring to tax-sheltered investments, which of the following is not a DPP? A) Equipment leasing limited partnership B) Real estate limited partnership C) Oil and gas limited partnership D) Real estate investment trust
D) Real estate investment trust DPPs include any form of business that allows for the direct pass-through of tax consequences to participants. REITs do not allow for the pass-through of losses.
Investing in commodities could involve investing in any of these except A) animals B) industrial metals C) agricultural items D) consumer durables
D) 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.
A client wishing to invest in precious metals could consider each of the following except A) gold B) silver C) platinum D) lead
D) 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.
It would be correct to state that an inverse ETF A) is suitable for sophisticated investors with a long time horizon. B) moves in tandem with the index being tracked. C) is a form of private equity fund. D) utilizes derivatives to achieve its objectives.
D) 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.
Your client has turned bearish on the market, but does not have a margin account. Which of the following securities would probably best meet your client's needs? A) An interest rate swap B) An inverse fund C) A long call option D) A balanced mutual fund
B) An inverse fund Those who are bearish wish to profit in a market downturn. Inverse funds are sometimes called short funds because they deliver positive returns when the underlying benchmark declines in value. This client can't sell short because you need a margin account for that.
Which of the following investments is least appropriate for a client primarily concerned with liquidity? A) Bank savings account B) Preferred stock C) Direct participation program D) Municipal bond mutual fund
C) Direct participation program There is little secondary market liquidity for direct participation programs (DPPs); of those securities listed, they are the least appropriate for a client seeking liquidity.
Which of the following categories of assets is most likely classified as an alternative asset? A) Real assets B) Preferred stocks C) Convertible bonds D) Cash
A) Real assets Traditional investments include cash, bonds, and stocks, regardless of the adjective used. Alternative investments include four major categories: real assets, hedge funds, private equity, and structured products.
A feature common to all passive real estate investing is A) someone other than the investor is doing the management. B) flow-through of operating losses. C) high liquidity. D) low initial investment requirements.
A) someone other than the investor is doing the management. The concept of passive investing is that, in all cases, someone else is running the show. Although some passive real estate investments, such as the exchange-traded REIT, are very liquid, others, such as DPPs, are generally not. In the same vein, while one can purchase a REIT for as little as the price of one share, a unit in a RELP (real estate limited partnership) can be $25,000 or more. Finally, although DPPs are flow-through vehicles, REITs and ownership of stock in real estate companies are not. LO 5.e
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) there are no unusual risks associated with these funds other than those one would incur with any index tracking fund B) some leveraged funds are exchange-traded products C) the funds attempt to return a multiple of the return of a benchmark index they are tracking, perhaps 2 or 3 times D) these funds sometimes use derivatives products to achieve their stated goals
A) there are no unusual risks associated with these funds other than those one would incur with any index tracking fund Because the fund's 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.
The price of which of the following commodities is most likely to be impacted by weather? A) Orange juice B) Gold C) Livestock D) Lead
A) 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.
Which of the following commodities is least likely to be affected by the weather? A) Silver B) Orange juice C) Wheat D) Pork bellies
A) 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.
Real estate investing can be passive or active. An example of a passive real estate investment would be A) a real estate limited partnership B) managing an apartment building C) renting out single family homes D) flipping homes
A) 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. LO 5.e
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) Bullish Inverse (short) 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 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 A) a leveraged ETF. B) an inverse ETF. C) selling a call option on the S&P 500 Index. D) an inverse leveraged ETF.
D) an 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.
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) Both the general partners and the limited partners B) The general partners C) Neither the general partners nor the limited partners D) The limited partners
B) 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. LO 5.b
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) A money market mutual fund B) U.S. Treasury notes C) A limited partnership in rental real estate D) NYSE-listed preferred stock
C) 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.
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) an inverse fund. B) a z-tranche CMO. C) an arbitrage. D) a structured product.
D) a structured product. 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.
A client invests $100,000 in a commercial real estate venture taking a 10% interest as a limited partner. Unfortunately, the demand for new office space deteriorates and the partnership is unable to meet the mortgage payments. The end result is foreclosure with a net loss of $2 million. This would have the effect of: A) a potential claim against the agent who sold the client this program. B) requiring the client to pay his share of the loss to the creditors. C) giving the client a passive loss of $100,000. D) giving the client a passive loss of $200,000.
C) giving the client a passive loss of $100,000. The most the client can lose is the amount of the investment, in this example, $100,000. Because DPPs are considered passive investments, the loss may only be deducted against passive income. As a limited partner, the loss is "limited" to the original investment. Sure, the client could always make a claim against the agent, but nothing in this question indicates that the agent did anything wrong so that would not be the "best" answer.
When discussing direct ownership of investment real estate with a client, an agent should point out that A) the use of leverage usually has the effect of reducing potential returns B) real estate tends to be a hedge against deflation C) investment real estate is generally illiquid when compared to listed stocks D) real estate prices tend to mirror those of the overall stock market
C) investment real estate is generally illiquid when compared to listed stocks Direct ownership of real estate invariably presents the client with limited liquidity; certainly when compared to listed stock. Leverage is used to increase potential returns and real estate prices generally have a low correlation to the stock market. Real estate is a hedge against inflation, not deflation.
An alternative investment vehicle that is managed to perform contrary to a benchmark market index such as the S&P 500 is A) a long put on the index. B) an equity-linked note. C) a leveraged exchange-traded fund. D) an inverse exchange-traded fund.
D) an inverse exchange-traded fund. Inverse exchange-traded funds (ETFs) 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.
Which of the following terms best describes ETNs and leveraged ETFs? A) Alternative investments B) Registered investment companies C) Speculative investments D) Forms of hedge funds
A) Alternative investments These are two popular alternative investments. Are they speculative? Yes, but there are many other speculative investments that are not considered alternative investments. The question asks for the best description and, although it might seem like a close call, these are "alts." The leveraged ETF is a registered investment company, but the ETN is not.
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 active real estate investing can be deducted against ordinary income D) 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 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) Variable annuity accumulation unit/money market mutual fund shares C) 10-year corporate bonds/U.S. T-bills D) Annuity units of a variable annuity/unit in a direct participation program (DPP)
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.
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) Losses generated by the program pass through to the investor and may be deducted in full against ordinary income. D) Investors in the program are assured of a steady flow of income if the drilling is successful.
A. 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.
Although the terms are frequently used synonymously, historically, viatical settlements differed from life settlements in that A) the buyer of the viatical policy did not know the identity of the seller B) the seller of the viatical policy was someone who was terminally ill C) the seller of the viatical policy was someone with a life expectancy of up to 15 years D) the buyer of the viatical policy was someone who was terminally ill
B) 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 somewhat healthy but had reached an age (generally at least 65), and the need for life insurance was not as important as having the cash for personal use.
