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Flashcards in Chapter 12.5 Deck (24):

Hedge Funds

A form of investment vehicle established for affluent and semi-affluent investors. Hedge funds are not considered investment companies and are not as heavily regulated as other investment products such as investment companies.


Formation of Hedge Funds

Normally established in the form of a limited partnership. These private investment partnerships take on long and short positions, use leverage and derivatives as well as private equities and currencies, but in allowing these forms of investment, hedge funds subject investors to a larger degree of risk


Liquidity in hedge funds

Not normally as liquid as other securities. Most hedge funds allow for the sale or redemption of hedge fund shares monthly, quarterly, or annually.

**Daily trading/pricing is generally not offered.


Suitability and regulation of hedge funds

Hedge funds are not suitable for the average investor. Hedge fund investment is limited to Accredited Investors, qualified investors, and semi-affluence investors. Suitability is often less of a concern than it would be for other investors.


Accredited Investors

-Net worth of $1,000,000 or
-Income of $200,000 or more in each of the last 2 years with the expectation of income exceeding $200,000 in the current year


Qualified Investors

-Net worth of $1,500,000 or
-$750,000 in assets invested under the specific investment manager


Semi-affluent Investors

Do not meet the criteria of being accredited or qualified, but do meet minimum investment requirements.
-Investors may be required to deposit a minimum investment of $25,000, for example
-Semi-Affluent investors are able to invest in certain types of hedge funds that are established as fund of funds or open-end funds.


Hedge fund Comparisons

Performance figures are not always standardized from hedge fund to hedge fund. Comparisons to other types of investments or hedge funds can be difficult/misleading and should not be permitted.


Exchange Traded Funds(ETFs)

These are funds that are similar to normal index mutual funds with a portfolio that mirrors a specific index or industry sector basket of securities. The primary difference between an ETF and an index fund is that ETFs have shares that trade like common stock shares.


ETF Characteristics

-ETFs trade like a stock and can be bought and sold anytime during normal market hours.
-ETFs can be purchased on margin and can be sold short
-Annual expenses on ETFs are generally low
-Commissions are charged on transactions just like common stock and ETFs have no sales load which generally lowers costs to investors.
-Dividend payments are possible, but not usual
-Settlement is T+2 business days
-Options are available on most ETFs
-An industry sector ETF would be less affected by overall changes in the market and offers less diversification when compared to a broad-based ETF, but would provide diversification within a particular sector.
-ETFs are required to deliver a prospectus with the "new issue" but are not required to deliver a prospectus with secondary market trades. All ETFs must deliver a prospectus upon request


Examples of ETFs



ETF's are marginable

ETF's are margined just like common stock, 50% Reg T and are subject to the same minimum maintenance as common stock, 25% on a long ETF and 30% on a short ETF.


Fixed income(Bond) ETFs Characteristics:

-They give an investor the opportunity to invest in "bonds" without investing directly in one particular bond
-Many bond ETFs are more liquid than the bonds themselves
-Bond ETFs are a low cost way to invest in bonds
-The market price of shares in a Bond ETF is based on supply and demand and can be different than the NAV per share of the fund.


Leveraged ETFs

Track an index fund or a benchmark. In addition to the money already received by investors, these funds borrow capital with the goal of generating a greater percentage return. These funds also use derivatives such as futures and options
-Because of leverage, percentage gains and losses in the fund would be magnified


Maintenance requirement for Leveraged ETF's

Long ETF: 25% of the market value
Short ETF: 30% of the market value

If the ETF is more highly leveraged, the maintenance margin levels would:
-Double for an ETF offering 200% leverage
-Triple for an ETF offering 300% leverage


Maintenance Example #1: Long 100 shares ABC ETF @ 28.00(200% leverage)

Market value: $2,800
Maintenance requirement: 2*.25 = .50
$2,800 * .50 = $1,400 required maintenance


Maintenance Example #2: Short 100 shares DEF ETF @ 26.00(300% leverage)

Market value: $2,600
Maintenance requirement: 3*.30 = .90
$2,600 * .90 = $2,340 required maintenance


Inverse ETFs

Seek to deliver the opposite of the performance of the index or benchmark they track. Many investors use inverse funds for hedging purposes.


Sales Practices consideration of Non-Traditional ETFs

Both leveraged and inverse ETFs can be more volatile and risky than traditional ETFs. They are reset or rebalanced daily. They are designed for short-term trading objectives and are designed for sophisticated investors.

**FINRA believes that leveraged and inverse ETFs that reset daily are unsuitable for retail investors who plan to hold them for longer than one day.


Exchange Traded Notes

Debt instruments issued by banks. The bank promises to repay the principal amount less investor fees at final maturity and the performance of the ETN is linked to a specific index or a particular strategy of investing.


Exchange Traded Notes Characteristics:

-Unsecured debt securities that are not principal protected but do participate in the performance of a specific index or investment strategy for which the ETN was issued.
-If the index or strategy appreciates in value, the unit holders would participate in the appreciation less the investor fees, which normally accumulate annually
-If the index or strategy depreciates in value, the unit holders can see losses associated with their ETN holdings and would still be subject to the investor fees, so the return of all principal is not guaranteed.
-ETN units trade like a stock and ETNs can be sold short. However the ETN units have a final maturity and can be callable.
-A primary benefit of an ETN for individual investors is that the ETNs allow the investor to participate and access markets and sectors which were previously unavailable to them or may be been unsuitable.


Differences between ETNs and ETFs

-ETNs do not have the tracking errors that are common with ETFs
-ETNs will have counterparty risk, because the liability of the ETN rests with the issuing bank and there are no actual products backing the ETN. If the bank goes bankrupt or defaults, the holder of the ETN will become a creditor of the bank.
-Both ETNs and ETFs have market risk associated with the performance of the market which the ETN or ETF is attempting to mirror.


ETNs are issued on 4 basic sectors:

-Emerging Markets
-Strategy/Index(S&P 500 Index)


ETN Taxation

-The IRS has not yet made a final ruling on the treatment of ETNs
-ETNs do not usually pay dividends or have coupon rates, so there is not normally any annual income to the investor. Holders of ETNs will pay capital gains or losses associated with their units, but these holders can reap the benefits of long-term capital gains rates.