Series 65 Unit 5 Alternative investments and other assets

direct participation programs (DPPs)

one class of alternative investments

many of which are limited partnerships

limited partnerships

allow the economic consequences of a business to flow-through to investors

any income or loss to the investor is considered passive because the investor does not take an active role in the management of the business

an investor should choose to invest in a specific limited partnership because:

economically viable

potential tax benefits for investors

experienced management team

aligned objectives and timeline with investor needs

comparable start-up costs and projected revenues

the GPs are the active investors in a limited partnership and assume responsibility for all aspects of the partnership's operations

a general partner:

makes decisions that bind the partnership

buys and sells property for the partnership

manages the partnership property and money

supervises all aspects of the partnership's business

maintains a minimum 1% financial interest in the partnership

limited partner

passive investors with no management or day-to-day decision-making responsibilities

they usually are not held personally responsible for the partnership's indebtedness

Practice Question

In a direct participation program, liability for the debts of the business falls upon the

A. general partner(s)

B. limited partner(s)

C. shareholder(s)

D. agent(s) selling the program

Answer: A. DPPs consist of at least one GP and one LP. The liability of the limited partners is limited to their investment, including commitments made but not yet fulfilled. On the other hand, the general partners bear the liability for the debts of the entity.

exchange-traded notes (ETNs)

unlike ETFs, they do not buy or hold the assets replicating the performance of the underlying index

some of the indexes and investment strategies used by ETNs can be sophisticated and very complex, carrying many different risks

they should be offered only to people who are knowledgeable and comfortable with the risks

the risks associated with investing in ETNs include:

credit risk (ETNs are unsecured debt obligations);

market risk

liquidity risk (although exchange traded, a trading market may not develop)

call, early redemption, and acceleration risk (ETNs may be called at the issuer's discretion)

conflicts of interest - the issuer may engage in trading activities that are at odds with note holders shorting, for instance

leveraged ETFs

leveraged funds aim to deliver multiples of benchmark index returns (e.g., 2× or 3×)

no regulatory limits on leverage amount

numerous 2× and 3× leveraged funds available

leverage magnifies both gains and losses

if the benchmark index falls, losses are magnified by the leverage factor

inverse (short or bear) funds

inverse funds, sometimes referred to as bear or short funds, attempt to deliver returns that are the opposite of the benchmark index they are tracking

for example, if the benchmark is down 2%, the fund's goal is to be up 2%

in addition, inverse funds can also be leveraged funds or, said another way, 2 or 3 times the opposite of the indices' return

you won't find investors looking for a bull inverse fund

that would be one where if the index goes up, the value of your investment goes down; not an attractive strategy

identify the different types of commodities and precious metals that are popular investments

invest indirectly through ETPs or mutual funds in commodity-related businesses

example: oil and gas funds invest in energy sector stocks.

historically, agricultural products (corn, wheat, etc) were primary commodities.

animal-based commodities include beef, pork, and eggs.

crude oil is the most traded commodity, coffee is often second

industrial metals (aluminum, nickel, etc) are actively traded but not precious metals

gold and silver are popular for wealth storage, historically and today

the DPP investor enjoys several advantages, including:

an investment managed by others

flow-through of income and certain expenses

limited liability—the most the investors can lose is the amount of their investment plus any funds committed for, but not yet remitted

the exam will probably give more attention to the following DPP disadvantages:

liquidity risk

legislative risk

risk of audit

depreciation recapture

Practice Question

Benefits of investing in a DPP would include

I. high liquidity

II. flow-through of operating losses

III. limited liability

IV. immunization against tax audit

A. I and II

B. I and IV

C. II and III

D. III and IV

Answer: C. DPPs are structured as flow-through entities, giving their investors to opportunity to receive income without the partnership being taxed first. In addition, if there are losses, they get the opportunity to write off those losses against passive income from other DPPs. As limited partnership vehicles, they offer their investors liability limited to their investment. They generally have very low liquidity, and, instead of reducing the tax audit risk, they actually increase it.

benefits of investing in commodities:

potential hedge against inflation

diversification because commodities are generally not correlated with stock market returns

potential returns -as with any other investment, those who buy low and sell high will make money - commodity prices are subject to supply and demand on a global basis and can provide handsome returns to those who predict future shortages

risks of investing in commodities:

principal risk - commodity prices can be extremely volatile

because commodities represent a global investment, in addition to the risks of the commodities themselves, there is also the vast array or risks that one faces when investing in foreign markets

high leverage can work against the investor in a down market

lack of income - no matter how long you hold gold or silver, you will never receive a dividend or an interest check - in fact, with any commodity, there is no income, only the chance for capital gains

Practice Question

An investor is reading a report that industrial demand for copper is expected to double in the next 5 years. This might lead the investor to

A. buy corn futures

B. sell copper futures

C. invest in several copper mining companies

D. modify the investor's portfolio to take a larger cash position

Answer: C. If the demand for copper increases, those companies producing the commodity should find their stock prices increase nicely. Selling copper futures would be when one expects the demand (and, therefore, prices) to fall.

Practice Question

Investors interested in adding precious metals to their portfolios would likely consider

A. coal

B. diamonds

C. gold

D. tin

Answer: C. Of these choices, only gold is considered a precious metal. Diamonds are certainly precious, but they are not a metal. Tin, is a metal, but is not considered precious.