SEMINAR IN A BOX

Chapter 14 (Part 1)

Dr. Jingyi Mao

CHAPTER 14
INVESTMENT VEHICLES

2
AFTER COMPLETING THIS CHAPTER, YOU
SHOULD BE ABLE TO DO THE FOLLOWING:
a) Compare direct and indirect investing in securities and assets;
b) Distinguish between pooled investments, including open-end
mutual funds, closed-end funds, and exchange-traded funds;
c) Describe security market indices, including their construction and
valuation, and identify types of indices;
d) Describe index funds, including their purposes and construction;
e) Describe hedge funds;
f) Describe funds of funds;
g) Describe managed accounts;
h) Describe tax-advantaged accounts and describe the use of
taxable accounts to manage tax liabilities.

3
DIRECT VS. INDIRECT INVESTING

Payment for
the Use of
Borrowed
Money

4
INDIRECT INVESTMENT VEHICLES
PROVIDE MANY ADVANTAGES

They are professionally managed.

They allow small investors to use the services of professional
managers.
They allow investors to share in the purchase and ownership of
large assets, such as skyscrapers.
They allow investors to own diversified pools of risks and thereby
obtain more predictable, although not necessarily better, returns.
They often are substantially less expensive to trade than the
underlying assets.

5
ADVANTAGES OF DIRECT INVESTING

Investors can exercise more control over their investments than

investors who hold indirect investments.
Investors can choose when to buy or sell their investments to
minimise their tax liabilities.
Investors can choose not to invest in certain securities, such as
companies that sell tobacco or alcohol.
Investors who are wealthy can often obtain high-quality
investment advice at a lower cost when investing directly rather
than indirectly.

6
POOLED INVESTMENTS

Most retail investors choose to save through pooled investment

vehicles managed by investment firms. Liabilities
Assets
• The sole purpose of these investment vehicles is to own securities
and other assets.
• The investment vehicles, in turn, are owned by their investors, who
share in the profits and losses in proportion to their ownership
It is important to note that investors in an investment vehicle do
not share ownership of the investment securities and assets
held by the investment vehicle.
• Instead, they share in the ownership of the investment vehicle itself.
• That is, they are the beneficial owners of the investment vehicle’s
securities and assets, but not their legal owners

7
INVESTMENT COMPANIES

Pooled Investments
Banks, insurance companies, and investment management firms
organise most investment companies; they are often called the
sponsor.
• A board of directors, a board of trustees, a general partner, or
a single trustee oversees every investment company.
• The directors appoint a professional investment manager, who is
almost always an affiliate of the sponsor.
• All pooled investment vehicles disclose their investment policies,
deposit and redemption procedures, fees and expenses, and past
performance statistics in an official offering document called a
prospectus.

8
OPEN-END FUNDS

Open-End Funds
Shares issued and redeemed as necessary
May be no-load or investors may pay sales-loads
• No load: no deposit or redemption fees
• Sales load: may have to pay sales load at the time of
purchase, at the time of redemption, or over time,
usually 3% to 9%
Price equals net asset value (NAV) at close of trading
• NAV = Total net value of fund ÷ Number of shares outstanding

9
MONEY MARKET FUNDS

Money Market Funds

A special class of open-end mutual funds that investors
view as uninsured interest-paying bank accounts
• Regulators permit money market funds to accept deposits
and satisfy redemptions at a constant price per share
• They may only hold money market securities
• Generally, very short-term, low-risk debt securities issued
by entities with very high-quality credit
• Vulnerable to a run on assets

10
CLOSED-END FUNDS

Closed-End Funds
Unlike open-end funds, closed-end funds do not issue or redeem
shares on demand.

They sell shares to the public in initial public offerings (IPOs) and then
use the proceeds to purchase investment securities or other assets.
• After the IPO, investors who want to buy or sell a closed-end fund
do so through exchanges and dealers.
• Closed-end funds are actively managed and generally trade at
values different from their NAV.
• Discounts are more common than premiums.

11
EXCHANGE-TRADED FUNDS

Exchange-Traded Funds
Exchange-traded funds (ETFs) are pooled investment vehicles that are
typically passively managed to track a particular index or sector,
although an increasing number of ETFs are actively managed.
• ETFs are generally managed by investment professionals who
provide investment, managerial, and administrative services.
• The fees for these services and trading costs are low, particularly
for ETFs that are passively managed.

12
COMPARISON OF OPEN-END FUNDS, CLOSED-END
FUNDS, AND EXCHANGE-TRADED FUNDS

Open-End Exchange-
Closed-End Funds
Mutual Funds1 Traded Funds
Yes, actively or Yes, primarily Yes, primarily
Managed
passively actively passively

Yes, but not traded Yes, traded

Exchange-traded No
continuously continuously

If exchange-traded, Can be large,

Small, usually
size of the gap usually trade at a
N/A trade at close to
between the price discount to
the NAV
and the NAV the NAV
Redeemable Yes No Yes

1Including Money Market Funds

13
COMPARISON OF OPEN-END FUNDS, CLOSED-END
FUNDS, AND EXCHANGE-TRADED FUNDS

Open-End Exchange-
Closed-End Funds
Mutual Funds1 Traded Funds
Risky Yes Yes Yes

Few issues, Management not Few issues,

particularly particularly particularly if
Management
if funds are responsive to funds are
accountability
passively shareholders’ passively
managed concerns managed
High if actively
managed, High because Low if passively
Management fees
low if passively actively managed managed
managed

1Including Money Market Funds

14
SEMINAR IN A BOX

Chapter 14 (Part 2)

Dr. Jingyi Mao

SECURITY MARKET INDICES

A security market index is a group of securities representing a

given security market, market segment, or asset class.

The following are some well known indices, by country:

• United States: S&P 500 Index

• United Kingdom: FTSE 100

(practitioners commonly pronounce FTSE as “footsie”)

• France: CAC 40

• South Korea: Korea Stock Price Index (KOSPI)

16
THE INDEX UNIVERSE
Broad Market indices cover an entire asset class

Multi-Market indices cover an asset class across many countries or

regions

Industry indices cover single industries

Sector indices cover broad economic sectors

Style indices provide benchmarks for common styles of investment

management

Fixed-Income indices cover debt securities

Other indices track the performance of alternative investments

17
INDEX WEIGHTINGS

Two important elements affect the value of an index:

• the securities included in the index and
• the weight assigned to each security in the index.
Weighting Factor Largest Impact Examples

Price-weighted High-price stocks DJIA, Nikkei 225

Capitalisation- Stocks with high total

Hang Seng, FTSE
weighted market values
100, S&P 500
(value-weighted or (price × shares
Market Weight
market-weighted) outstanding)
All stocks have the S&P 500 Equal
Equal-weighted
same impact Weight

18
VARIATIONS IN INDICES

As of August 2018, Apple was the largest company by market

capitalisation.
• Apple stock is included in both the S&P 500 Equal Weighted and
Market Weighted Indices.
• Because the S&P 500 Equal Weighted Index assigns the same
weights to all the stocks it includes, Apple represents only 0.2%
(1/500th) of the S&P 500 Equal Weighted Index.
• Because the S&P 500 Market Weighted Index assigns to each stock
a weight that reflects the company’s market capitalisation, Apple
represents about 4.5% of the S&P 500 Market Weighted Index.
• A change in the price of Apple’s stock will have a small effect on the
S&P 500 Equal Weighted Index, but will have a much larger effect
on the S&P 500 Market Weighted Index.

19
INDEX FUNDS

Security Indices
Products created by the
investment industry
Index Funds
• Popular because they generally are broadly diversified and
highly transparent, with very low management and trading
costs.
• Funds may invest in every security in the index, a strategy
known as full replication.
• Or they may invest in only a representative sample of the index
securities, a strategy called sampling replication.

20
CHARACTERISTICS OF HEDGE FUNDS

Private Investment Pool: Distinguished by availability to only a

limited number of select investors, lock-up agreements, and
managers’ performance-based compensation

Non-Traditional Investment Strategies

Available only to some investors who usually meet various wealth,

income, and investment knowledge criteria that regulators set

21
CHARACTERISTICS OF HEDGE FUNDS

Most are open-end investment vehicles subject to lock-up

provisions.

Management and performance fees:

Hedge fund managers generally receive an annual
management fee plus a performance fee that is a
specified percentage of the returns that they produce in
excess of a hurdle rate.

Fund has to be above its high-water mark; also called

loss-carryback provisions.

22
CHARACTERISTICS OF HEDGE FUNDS

Risks: Although many are not particularly risky,

the asymmetry in management compensation
encourages some managers to take
substantial risk.

The legal structure and legal domicile of hedge

funds generally depend on their managers’ and
investors’ tax situations.

23
FUNDS OF FUNDS

Investors pay fees twice:

• To each fund
• To the fund-of-funds manager

24
MANAGED ACCOUNTS
Many investors contract with investment professionals to
help manage their investments for an advisory fee or for
commissions on the trades that they recommend.

Institutional investors that do not manage investments in-

house use fee-based investment professionals.

Retail investors often use wrap accounts in which the charges for
investment services, such as brokerage, investment advice,
financial planning, and investment accounting, are all wrapped into
a single flat fee.

Investment managers can hold their institutional clients’

investments in separate accounts or in commingled
accounts.

25
TAX-ADVANTAGED ACCOUNTS

Deferral of
Gains or
Losses
Tax-
Tax-Free
Deductible
Distributions
Contributions

Possible
Tax
Benefits

26
MANAGING TAX LIABILITIES
Capital Gains:
• Usually deferred until realised and often at a lower rate
• Often can be offset by capital losses
Whether investors should defer taxable income depends on
• the tax regime,
• their expectations of future tax rates (including estate tax rates,
which are imposed on the transfer of properties from the deceased
to his or her heirs), and
• the probability that they will need money that they cannot access if
placed in a tax-advantaged account.

27
SUMMARY

Investment vehicles reduce the cost of investing, control

risk, and can improve returns

Direct and indirect investing

Closed-end funds, open-end funds, and exchange-

traded funds

28
SUMMARY

Indices and index funds

Hedge funds and funds of funds

Separate and commingled accounts

Taxable and tax-advantaged accounts

29