SIE Exam Series Part 12 Alternate Investments

Chapter 9: Alternative Investments

Types of Investment Companies

  • Investment Company Act of 1940: Governs various types of investment vehicles.

Exchange-Traded Funds (ETFs)

  • Definition: ETFs are investment funds traded on stock exchanges, much like stocks.

  • Structure: Comprised of a basket of securities representing an index (e.g., S&P 500).

    • Example: The ETF holds the same stocks in the same percentage as the underlying index.

    • Weighting: Stocks within the ETF are weighted according to their presence in the index.

  • Types of ETFs:

    • Regular ETFs: Passively managed and track market indices.

    • Inverse ETFs: Designed to profit from a decline in the market; moves opposite to market changes.

    • Leveraged ETFs: Multiply market moves by a specified factor (2x, 3x, etc.).

    • Example: If a 2x leveraged ETF experiences a market gain of 10%, the ETF would gain 20%.

    • Risks: High risk for down markets; potential for significant losses if market declines.

    • Recommendation: Not suitable for long-term investing due to volatility, better for day trading.

  • Advantages of ETFs:

    • Lower management fees due to passive management.

    • Lack of sales charges as seen with mutual funds.

    • Investors buy and sell ETFs like stocks on exchanges (market price, not NAV).

Investment Notes and Considerations

Exchange-Traded Notes (ETNs)

  • Definition: Similar to ETFs, ETNs are debt instruments issued by banks that track an index or asset.

  • Characteristics:

    • Subject to credit risk since they are essentially bonds.

    • No periodic payouts; returns are dependent on market performance and only received at maturity.

  • Questionable Risk: Credit risk is predominant due to the nature of being a debt instrument rather than equity.

Hedge Funds

  • Overview:

    • Definition: Similar to unregulated mutual funds; invest in securities to outperform the market.

    • Target Audience: Primarily for accredited investors due to high-risk strategies and illiquid nature.

  • Diverse Strategies: Employ various hedging techniques to mitigate risk, sometimes including illiquid securities.

  • Investor Restrictions: Investors may only withdraw quarterly and often face restrictions on liquidity.

  • Fees: Common structure involves a 2% management fee and 20% of profits, although trends show fee reductions.

  • Types of Hedge Funds:

    • Private Equity Funds (PE): Focus on raising capital for small businesses, often promoting growth and public offerings.

Real Estate Investment Trusts (REITs)

  • Definition: Investment vehicles that allow individuals to invest in real estate portfolios.

  • Regulatory Framework: Governed by various acts (Act of '33 for issuance; '34 for trading), distinct from the Investment Company Act of 1940.

  • Investment Characteristics:

    • Liquidity: REITs are generally liquid and can be traded on exchanges (especially exchange-traded REITs).

    • Diversification: Provide exposure to multiple properties, reducing individual asset risk.

    • Tax Structure: Qualify for a conduit status, passing through 90% of net income to avoid double taxation, but dividends taxed as ordinary income.

Direct Participation Programs (DPPs)

  • Concept: Similar to limited partnerships, where investors become limited partners for specific projects.

  • Structure: Must include at least one limited partner and one general partner (GP).

    • Limited Partner: Passive investor with limited liability, only liable for investment amount.

    • General Partner: Manages the day-to-day activities of the partnership.

  • Financial Structure: DPPs do not pay taxes at the partnership level; all profits/losses passed through to partners.

  • Capital Calls: May require additional capital contributions from partners during operational needs.

  • Risks and Limitations:

    • Illiquidity and lack of control over partnership decisions.

    • Complexity in tax returns and potential capital calls from general partners.

Consideration before Recommending

  • Investment Analysis:

    • Ensure investors understand the illiquid nature and risks associated with limited partnerships.

    • Confirmation of investors’ ability to handle potential losses and capital calls is essential.

  • Regulation of Sales:

    • Investment recommendations must be documented in writing; any discretionary investment decisions regarding limited partnerships require prior written consent from investors.

Conclusion of Chapter 9

  • Recap of Investment Vehicles:

    • ETFs: Tradeable, passively managed, marginable.

    • ETNs: Debt instruments, non-equity, not subject to 1940 Act, marginable.

    • Hedge Funds and PE Funds: Non-tradeable, unregistered, not marginable.

    • REITs: Tradeable, not under the Act of '40, often marginable.

    • DPPs: Limited market trading ability, not subject to Act of '40, generally non-marginable.

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