Unit 6 - Other Investment Types

Municipal Fund Securities

• sponsored by an individual state

• subject to rules of the Municipal Securities Rulemaking Board (MSRB)

• funds consisting of a portfolio of other securities

Section 529 Plan

• allow saved money to be used for qualified expenses K-12 and post-secondary (college) education

• state-sponsored

• sale of these plans require an official statement or offering circular

• two types

  • prepaid tuition plans for state residents

    • allow residents to lock in current tuition rates by paying now for future education costs

    • hedge against tuition inflation

  • savings plans for residents and nonresidents

    • allows donors to save money in a separate account to be used later for education expenses

    • more popular

Common traits of both

• Overall maximum (aggregate) contribution levels can vary from state to state. Note that there is no annual maximum contribution.

• Gift transfer taxes apply to donations, but the law allows a donor to forward gift up to five years.

• Assets in the account remain under the donor's control, even after the student becomes of legal age.

• Funds may be used for qualified education expenses for both K–12 and post-secondary (college) costs.

• Withdrawals are tax free if used for qualified purposes.

• Grow tax deferred and the funds may be withdrawn tax free if used for qualified education expenses.

• There are no income limitations on making contributions to a 529 plan.

• Account balances left unused may be transferred to a new beneficiary that is related to the original beneficiary.

• Rollovers are permitted from one state's plan to another state's plan, but not more often than once every 12 months.

Differences

	Prepaid Tuition Plan	College Savings Plan
Contributions	Placed in an account managed by the educational institution	Placed in a selection of investments selected by donor
Provides inflation protection	Yes, institution guarantees a portion of tuition payment	Possible, depending on investment returns
Exceeds inflation	No	Possible, depending on investment returns
Loses value	No	Possible, depending on investment returns
Institution specific	Yes	No

Local Government Investment Pool (LGIP)

• states establish these to provide other government entities w/ a short-term investment vehicle

• formed as a trust in which municipalities can purchase shares in the LGIP’s investment portfolio

• maintain a stable NAV (like a money market fund) which allows for liquidity and minimum price volatility

• not required to register w/ the SEC b/c its sponsored by a state

  • means no prospectus

Achieving a Better Life Experience (ABLE) Accounts

• tax-advantaged savings accounts for individuals w/ disabilities and their families

• created by the ABLE Act of 2014

• beneficiary → account owner

• income earned by the account is not taxed

• available to individuals w/ significant disabilities

  • onset of disability must have occurred before age 26

  • if they are already getting benefits from another insurance group, they are automatically eligible to make an ABLE account

  • one per person

• contributions to the account can be made by any person

  • made using after-tax dollars

  • not tax deductible for federal income taxes

• have an annual maximum contribution

  • changes w/ inflation

• growth is tax deferred

• withdrawals are tax-free

Partnerships

• partners manage the business and pay taxes on the business’ profits in relation to the size of a partner’s ownership

• tax-reporting entities but not tax-paying entities

• reports profits and how much went to which partner to the IRS

• the partners reflect the income on their tax returns and pay income taxes on the amount they receive

• partnership agreements

General Partnerships

• all the partners are general partners (GPs)

• all the partners have some level of management authority

  • specific duties are in the agreement

• ownership may be unequal

  • ownership interests in the agreement

  • the business results (P/L) are distributed in proportion to the partner’s ownership interest

• GPs have no liability protection

  • partners may be sued for actions taken by the partnership

Limited Partnerships (LP)

• has one or more GPs and one or more LPs

• GPs manage the business and have no liability protection

• LPs have no management responsibilities and are protected from the liabilities of the partnership

• if a LP participates in the management of the business, they may lose their liability protection

• passive income → income received from the LP by limited partners

• LP = direct participation program (DPP)

• formed to invest in a specified type of business

  • most common are real estate, energy, and equipment leasing

  • programs often experience losses in the early part of the program

    • losses pass through to the investors and may be used to offset sources of passive income from other programs

  • DPPs use depreciation and depletion to reduce taxable income

    • not actual costs

    • they reduce taxable income w/o affecting cash flow

Selling and Liquidating Limited Partnerships

• LPs may be sold through private placements or public offerings

• if sold privately, investors receive a private placement memorandum for disclosure

  • involve a small group of LPs, each contributing a large sum of money

• in a public offering, LPs are sold by a prospectus

  • a larger number of limited partners each make a relatively small capital contribution

• LPs are liquidated on a predetermined date specified in the agreement

  • early shutdown may occur if the partnership sells or disposes of its assets or a decision is made to dissolve the partnership by the limited partners holding a majority interest

Settle accounts in this order

1. secured lenders

2. other creditors

3. limited partners (first for their claims to shares of profits and then for their claims to a return of contributed capital

4. GPs

Benefits of Limited Partnerships

• an investment managed by others (GPs)

• Limited liability (can only lose the amount invested)

• Flow through of income and certain expenses

Risks of Limited Partnerships

• business risk

• liquidity risk

  • any transfer of interest in an LP requires permission of the GP

  • an investor in an LP should assume she will own the program until it ends

  • highly illiquid

• Audit/Recapture of Tax benefit

  • If the IRS disallows a prior tax benefit, the consequences flow through to the limited partners

  • IRS would likely impose taxes and penalties for the underreporting of income plus interest on the unpaid taxes

  • recapture of tax benefit occurs when the IRS determines the deductions weren’t valid

    • loss of tax benefit flows through to the investor

Real Estate Investment Trusts (REITs)

• manage a portfolio of real estate or mortgages, or both which is a hybrid of the two, to earn profits for shareholders

• pool capital like investment companies but aren’t investment companies b/c they don’t hold other securities

• shareholders receive dividends from investment income or capital gains distributions

• REITs normally

  • own commercial property (equity REITs), own mortgages on commercial property (mortgage REITs), or do both (hybrid REITs);

  • are organized as trusts in which investors buy shares or certificates, either on stock exchanges or in the over-the-counter (OTC) market;

  • fall under the conduit tax theory (subchapter M), meaning that they are taxed the same way as a mutual fund and can avoid triple taxation.

• public REITs → registered w/ the SEC and are subject to all disclosure requirements

• private REITs → not registered which aren’t subject to the same disclosure requirements as public ones and are subject to greater risk

  • difficult to price and have less liquidity than a listed REIT

Exchange-traded Funds (ETFs)

• considered an equity security and it invests in a specific group of stocks and generally does so to mimic an index

  • makes it similar to a mutual fund that tracks an index

  • Difference → trades like a stock on the floor of an exchange like a closed-end investment company

  • registered as either an open-end fund or as a UIT but very different from them

• Because they trade in the secondary market, an investor can take advantage of intraday (within one day) price changes.

• ETFs can be purchased on margin (with borrowed money) and sold short.

• Expenses tend to be lower than those of mutual funds, and the management fee is also low.

• Like an index fund, most ETFs do not actively trade within the fund. This generally results in greater tax efficiency for the investor, since the index fund realizes less taxable capital gains.

• Every time a person purchases or sells shares, there is a commission, and those charges can add up over time.

Advantages and Disadvantages of ETFs

ADVANTAGES

• Pricing and ease of trading. Because individual ETF shares are traded on exchanges, they can be bought or sold anytime during the trading day at the price they are currently trading at, as opposed to mutual funds, which use forward pricing and are generally priced once at the end of the trading day.

• Margin. ETFs can be bought and sold short on margin like other exchange-traded products (ETPs). Mutual funds cannot be bought on margin, nor can they be sold short.

• Operating costs. ETFs traditionally have operating costs and expenses that are lower than most mutual funds.

• Tax efficiency. ETFs can and sometimes do distribute capital gains to shareholders like mutual funds do, but this is rare. Because these capital gains distributions are not likely, there are usually no further tax consequences with ETF shares until investors sell their shares. This may be the single greatest advantage associated with ETFs.

DISADVANTAGES

• Commissions. The purchase or sale of ETF shares is a commissionable transaction. The commissions paid can erode the low-expense advantage of ETFs. This would have the greatest impact when trading in and out of ETF shares frequently or when investing smaller sums of money.

• Market influences on price. Because ETFs trade on exchanges, share prices can be influenced by market forces such as supply and demand, like any other investment that trades in the secondary market. Investors need to recognize that they might receive less than NAV per share when selling ETF shares.

Exchange-Traded Notes

• ETNs are unsecured debt securities issued by banks or financial institutions

  • backed only by the issuer’s creditworthiness, not by underlying assets.

• They track the performance of a market index, but do not represent ownership of a pool of securities like ETFs or mutual funds.

• ETNs are bond-like with a stated maturity, but pay no interest and offer no principal protection; payout at maturity is based on index performance minus fees.

  • in an example question → at maturity, a girl got her principal back plus an interest payment based on the returns of 5 well-known tech companies

• Investors face market risk and significant credit (default) risk if the issuing bank’s financial condition deteriorates.

• ETNs often have limited issuance and poor liquidity; despite the name, many do not actively trade on exchanges.