In
a previous article, we introduced the CFA Institute Investment Foundation
Program (Read
more here). It is a free program
designed for anyone who wants to enter or advance within the investment
management industry, including IT, operations, accounting, administration, and
marketing. Candidates who successfully
pass the online exam earn the CFA Institute Investment Foundations Certificate.
There
are total of 20 Chapters in 7 modules, covering all the essential topics in
finance, economics, ethics and regulations.
This series of articles will highlight the core knowledge of each
chapter.
Chapter
14 provides an overview of Investment Vehicles. The learning outcome of chapter
14 is as follows:
·
Compare
direct and indirect investing in securities and assets;
·
Distinguish
between pooled investments, including open-end mutual funds, closed-end funds,
and exchange-traded funds;
·
Describe
security market indices including their construction and valuation, and
identify types of indices;
·
Describe
index funds, including their purposes and construction;
·
Describe
hedge funds;
·
Describe
funds of funds;
·
Describe
managed accounts;
·
Describe
tax-advantaged accounts and describe the use of taxable accounts to manage tax
liabilities.
Index
funds, which are passively managed, are among the most common types of pooled
investment vehicles and are used widely in most parts of the world. They are
popular because they provide broad exposure to an asset class and are cheap
relative to many other products.
A
security market index is a group of securities representing a given security
market, market segment, or asset class. The security market indices just
mentioned are widely published equity market indices. Practitioners have also
created many other indices. They are popular because they provide broad
exposure to an asset class and are cheap relative to many other products.
A
price-weighted index is an index in which the weight assigned to each security
is determined by dividing the price of the security by the sum of all the prices
of the securities. As a consequence, high-priced securities have a greater
weighting and more of an effect on the value of the index than low-priced
stocks. The DJIA in the United States and the Nikkei 225 in Japan are examples
of price-weighted indices.
Many
indices are capitalisation-weighted indices (also known as cap-weighted
indices, market-weighted indices, or value-weighted indices). The weight
assigned to each security depends on the security’s market capitalisation.
Market capitalisation is equal to the market price of the security multiplied
by the number of shares outstanding of the security. The Hang Seng in Hong Kong SAR, the FTSE 100
in the United Kingdom, and the S&P 500 Market Weight Index are examples of capitalisation-weighted
indices.
Equal-weighted
indices show what returns would be made if an equal value were invested in each
security included in the index. The prices of these securities change
continuously. Thus, to maintain the equal weights between securities, regular
index rebalancing is necessary. That is, the weights given to securities whose
prices have risen must be decreased, and the weights given to securities whose
prices have fallen must be increased. The S&P 500 Equal Weight Index is an
example of an equal-weighted index.
An
index fund is a portfolio of securities structured to track the returns of a
specific index called the benchmark index. An index fund is a passive
investment strategy because the index fund manager aims to replicate the
benchmark index.
Hedge
funds are private investment pools that investment managers organise and
manage. As a group, they pursue diverse strategies. The term “hedge” once
referred to the practice of buying one asset and selling a correlated asset to
take advantage of the difference in their values without taking much market
risk—thus the use of the term hedge because it refers to a reduction or
elimination of market risk. Although many hedge funds do engage in some
hedging, it is not the distinguishing characteristic of most hedge funds today.
Funds
of funds are investment vehicles that invest in other funds. They can be
actively managed or passively managed.
Two main investment strategies characterise most actively managed funds
of funds. Some managers try to identify funds with managers they believe will
outperform the market. They then invest in funds managed by those managers.
Others use various proprietary models to predict which investment strategies
are most likely to be successful in the future and then invest in funds that
implement those strategies. Both types of managers try to hold well-diversified
portfolios of funds to reduce the overall risk of their funds.
The
costs of investing in an actively managed fund of funds can be high because
investors pay two levels of fees. They pay management and performance fees
directly to the fund of funds manager and they also indirectly pay fees to the
managers of the funds in which the fund of funds invests.
To
promote savings for retirement income, educational expenses, and health
expenses, many countries give tax advantages to certain investment accounts.
In
general, tax-advantaged accounts allow investors to avoid paying taxes on
investment income and capital gains as they earn them. In addition,
contributions made to these accounts may have tax advantages. In exchange for
these privileges, investors must accept stringent restrictions on when the
money can be withdrawn from the account and sometimes on how the money can be
used.
Investors
in taxable accounts can often minimise their tax liabilities through careful
investment management decisions. In particular, most jurisdictions do not tax
capital gains until they are realised.
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