Chapter 11 Flashcards
Other Investment Classes (19 cards)
Name all the investment classes: (8)
- Cash deposits
- Money market instruments
- Equities
- Property
- Collective investment schemes (CIS)
a)Investment trusts
b)Unit trusts
c)Open-ended investment companies - Futures and options
- Overseas markets
- Emerging markets
Collective investment schemes (CISs)
o CISs provide the opportunity for investors to achieve a wide spread of
investments, while benefiting from specialist management expertise.
o There are two fundamental types of CISs - closed-ended and open-ended.
▪ In a closed-ended scheme, such as an investment trust, once the initial
tranche of money has been invested the fund is closed to new money.
▪ In an open-ended scheme, such as a unit trust, managers can create or
cancel units in the fund as new money is invested or disinvested.
Regulation of CISs typically covers aspects such as: (4)
- categories of assets that can be held
- Can unquoted shares be held
- any tax relief available
- the maximum level of gearing
Key features of Investment trusts (closed-ended CIS): (7)
- Have a stated investment objective
- Key parties: BoD, investment managers, shareholders
- investors buy shares which are priced by supply and demand
- share price often stands at a discount to net asset value per share (NAV)
- closed-ended
- public companies governed by company law
- gearing is allowed
why is the actual share price of many investment trust companies lower than the NAV? (4)
- Management charges
-dividends distributed after deducting management charges - Concerns over marketability
-discount on share value to account for this - Concerns over the quality of management
-to increase demand, lower share values - Market sentiment
-In a market where low-cost passive funds are trending, demand for actively managed ITCs may drop, widening the discount.
Key features of Unit trusts (open-ended CIS): (6)
- Have a stated investment objective
- Key parties: Trustees, investment managers, unitholders
- investors buy units in a UT, which are priced at net asset value per unit.
- open-ended
- They are trusts governed by trust law
- limited power to use gearing
Feature of Open-ended investment companies:
o They are similar to investment trusts in terms of corporate governance but have open-ended characteristics like unit trusts.
Differences between closed-ended and open-ended funds: (9)
- Marketability - closed-ended funds are often less marketable than the underlying assets (There is no guarantee that an investor can sell quickly or at fair value), open-ended funds is guaranteed by the managers. (they are always ready to buy back your units at the fund’s NAV)
- Gearing - closed ended can gear leading to extra volatility while open-ended have limited power to gear
- It may be possible to buy assets at less than the NAV in a closed-ended fund.
- The increased volatility of closed-ended funds implies a higher expected return.
- Shares in closed-ended funds are also more volatile than the underlying assets because the size of any discount to the NAV can change.
- The volatility of units in an open-ended fund should be similar to that of the underlying assets.
- There may be uncertainty as to the true level of the NAV per share of a closed-ended fund, especially if the investments are unquoted.
- Closed-ended funds can invest in a wider range of assets.
- They may be subject to different tax treatment.
CISs vs direct investment: 7:3
o Advantages of CISs compared with direct investment are:
▪ Access to expertise.
▪ Diversification.
▪ Some of the direct costs of investment are avoided.
▪ Holdings are divisible.
▪ Possible tax advantages
▪ marketability may be better than that of the underlying.
▪ They can be used to track the return on a specific index.
o Disadvantages of CISs compared with direct investment are:
▪ loss of control.
▪ management charges incurred.
▪ may be tax disadvantages, e.g., withholding tax.
Derivative? Definition:
A derivative is a financial instrument with a value dependent on the value of some other, underlying asset.
The main uses of derivatives
- Hedging
-reduce risk of price fluctuations on the underlying asset - Speculation
-buy and sell derivatives in the hope of profiting from changes in the value of the underlying asset - Arbitrage
-buying and selling two or more assets simultaneously to take advantage of price discrepancies - Asset allocation
-diversify and manage risks (future used to gain exposure to a specific asset class without having to buy the underlying asset)\ - Risk management
-a company might use a swap contract to exchange fixed-rate debt for floating-rate debt, to reduce their exposure to interest rate fluctuations.
Forward and future contracts, definitions:
A forward contract is a non-standardised, over-the-counter-traded contract between two parties to trade a specified asset on a set date in the future at a specified price.
A futures contract is a standardised, exchange-tradable contract between two parties to trade a specified asset on a set date in the future at a specified price. (Futures contracts can be used to set a price in advance.)
Main functions of a clearing house: (5)
-clear futures trades and settle margin payments
▪ The clearing house checks that the buy and sell orders match each other.
▪ It then acts as a party to every trade.
* In other words, it simultaneously acts as if it had sold to the buyer and bought from the seller.
▪ Following registration, each party has a contractual obligation to the clearing house.
▪ In turn, the clearing house guarantees each side of the original bargain, removing the credit risk to each of the individual parties.
Information dump about Options: (7)
o An option gives an investor the right, but not the obligation, to buy or sell a specified asset on a specified future date at the specified exercise (or strike) price.
o Call options give the right to buy.
o Put options give the right to sell.
o An American option is an option that can be exercised on any date before its expiry.
o A European option is an option that can only be exercised at expiry.
o A warrant is an option issued by a company over its own shares.
▪ The holder has the right to purchase shares from the company at a specified price at specified times in the future.
o Options enable financial institutions to alter the structure of their portfolios without the need to trade in the underlying assets.
Reasons for investing overseas: (3)
- match liabilities in the foreign currency
- increase expected returns
-higher risk, inefficiencies in the market - Diversification reducing risk
-overseas markets have lower correlation with domestic markets
Drawbacks of investing overseas: (13)
- Different market performance to home market (mismatching risk)
- Currency fluctuating risk
- Cost of obtaining expertise
- Additional administration functions (custodian)
- possible tax disadvantages (withholding tax)
- different accounting practices
- lack of good quality information
- Language problems
- possible time delays
- poorly regulated markets
- political risks
- possible lack of liquidity
- restrictions on ownership of certain shares by foreign investors
Indirect overseas investment may involve investment in: (3)
- multinational companies based in the home market.
- collective investment schemes specialising in overseas investment.
- derivatives based on overseas assets.
Factors to consider before investment in emerging markets include: (12)
- Current market valuations
- Possibility of high economic growth rate
- currency stability and strength
- level of marketability
- degree of political stability.
- market regulation.
- restrictions on foreign investment.
- range of companies available.
- communication problems.
- availability and quality of information.
- Also consider the general drawbacks of investing overseas.
- possible market inefficiencies, giving investors the chance of making very big gains (or very big losses).
