Packaged Securities - Introduction

Packaged securities is the collective term for investment companies, variable annuities and REITS, each of which will be defined and discussed in turn. These, combined with the array of retirement and estate planning accounts recognized by the Internal Revenue Service, comprise the major vehicles available to investors.

Because the general public tends to not to be as Wall Street-savvy as many experienced analysts who tend to trade exotic instruments, the federal government takes great pains to regulate these popular funds so that unscrupulous traders and advisors do not take advantage of the general public.

  1. Real Estate Investment Trusts (REITS): these are trusts that hold real estate and must satisfy certain criteria. The REIT must have at least 75% of its assets invested in real estate, cash,government bonds, other REITS or mortgages. It must pay out at least 90% of its annual taxable income, exclusive of capital gains, as dividends to shareholders, must have at least 100 shareholders with concentration of less than 50% of the outstanding shares with five or fewer shareholders and at least 75% of the REIT's gross income must derive from rents, gains from the sale of real property or mortgage interest. Finally, REITS are generally liquid and trade on exchanges, though some are not.
  2. Direct Participation Programs (DPPs): these programs allow for the investor to participate directly in the flow-through of tax advantages. Examples are real estate, oil and gas, and cattle programs. Many of these programs are organized as limited partnerships, with the general partner bearing unlimited liability and the limited partners being liable only to the extent of their partnership investment. Some are organized as limited liability corporations (LLC) with similar flow-through benefits. Some large limited partnerships that trade publicly on exchanges are referred to Master Limited Partnerships (MLP).
  3. Investment Companies: Where assets are pooled and managed professionally.
      1. Open End Companies (Mutual Funds): shares are purchased directly from the fund either by the investor him- or herself or with the assistance of a representative. When the client sells the shares, they are redeemed through the company. These companies sell shares on a continuous basis, rather than a fixed number of shares. Therefore, a prospectus is always issued to the purchaser. For reasons of strategy, the fund's trustees may decide to close a fund if it is getting too large and presenting the portfolio manager or management team with difficulty in putting new money to work. Mutual funds invest in fixed income, equity, real estate and cash, as well as combinations of the foregoing, in pursuit of a particular strategy or objective. Funds can pursue a particular investment style, such as small cap core or large cap value. Some funds are characterized as stock picker or ‘go anywhere' funds that seek opportunities across a broad spectrum of investment types.
      2. Closed-End Companies (closed-end funds): a type of investment company that issues a fixed number of shares at an initial public offering and trades in the secondary market like a stock. The fund may trade at a premium or discount to its net asset value (fund assets minus liabilities). These funds do not continuously sell new shares. As a result, the prospectus is only delivered to investors at the fund's initial public offering (IPO). Like their open-ended brethren, closed-end funds invest in various asset classes in pursuit of a particular objective.
      3. Exchange-Traded Funds (ETFs): operate much like a closed-end fund, but are typically passive, in that the strategies track various indices of specific market and may be purchased on margin and sold short. Their structure effectively minimizes arbitrage opportunities, which means that the premium and discounts to the fund's net asset value are considerably less. Though most are passive, some funds use derivatives to pursue excess return (alpha), rather than the market return only (beta). Arbitrage opportunities are reduced as they create and redeem shares with the expedient of an authorized participant (AP), a large institutional investor (hedge fund, market maker or broker/dealer).

        i. The AP puts together a securities portfolio matching that of the ETF.
        ii. The AP delivers the securities or creation basket to the ETF and receives a creation unit or large batch of ETF shares based upon its net asset value.
        iii. The AP breaks down the basket into smaller shares, selling them to the public or retaining them.
        iv. Redemption of shares reverses the aforementioned process.

      1. Unit Investment Trusts (UIT): these have characteristics of both open-end and closed-end companies. The UIT makes an initial offer of a fixed number of shares which, in turn, are used to purchase a portfolio of securities that are not managed, but, rather, held to maturity. The UIT may redeem shares and terminates at some future date. A trustee oversees the portfolio and how it is to be sold. There is no investment management company. There is a secondary market for UITs

  4. Hedge Funds: these are privately organized investment vehicles (often designed as limited partnerships) that manage publicly and privately held securities and, depending upon the strategy, derivatives. The hedge fund may invest long and short and utilize leverage. Though the regulatory trend has been toward greater disclosure, it is less than that required for more garden variety types of investments, as these funds are offered to accredited investors who must satisfy income and net worth requirements (minimum net worth exceeding $1,000,000 or income in each of the previous two years of $200,000 for an individual or $300,000 for a married couple) and the expectation that earnings will equal or exceed these amounts in the year of investment.
  • Market Directional – This type of strategy takes positions in securities based upon a belief as to the direction of their price.
    1. Equity Long/Short: this type of fund both buys securities and sells them short (e.g. borrows money, sells them in the expectation that they decline in price and repurchases them at the lower price). The objective is to capture potential upside in the long position and downside in the short one. One position may offset the other, minimizing losses or preserving some gains.
    2. Equity Market Timing: this strategy attempts to time the purchase of securities
    3. Short Selling
  • Corporate Restructuring – These funds utilize strategies that attempt to be on the right side of trades that involve securities of companies, in events such as mergers acquisitions and bankruptcy.
    1. Distressed Securities: funds purchase severely undervalued securities in the expectation that a re-organization will benefit their value.
    2. Merger Arbitrage: when two companies combine, often the shares of the acquired company experience an increase in value, with the expectation that the acquiring company would achieve better results. By contrast, the acquiring company may assume a significant debt burden to acquire the company, which would negatively impact its share price.
    3. Event Driven: these funds take advantage of any number of situations involving corporate restructuring, including spin-offs, with a view to selecting the security expected to benefit from the restructuring.
  • Convergence Trading
    1. Fixed Income Arbitrage
    2. Convertible Bond Arbitrage
    3. Statistical Arbitrage
    4. Relative Value Arbitrage
  • Opportunistic – These funds, by design, look to take advantage to earn alpha (the excess return over what the market yields) or beta from whatever opportunities present themselves.
    1. Global Macro: one of the better know and more highly publicized strategies, global macro funds invest in equities, fixed income and currencies across the globe, looking to take advantage of favorable conditions in different markets.
    2. Fund of Funds (FOF): this is a fund that contains several hedge funds with varying strategies. The FOF utilizes tactical asset allocation among the funds to select the ones whose strategies are apt to outperform and exit those expected to deliver a mediocre performance.
  1. Private Equity: refers to securities that are privately purchased and not publicly traded. The four common strategies subsumed under this rubric are the financing of start-up companies known as venture capital, public companies repurchasing all of their stock to become private with the assistance of leverage known as leveraged buy outs (LBOs), a mix of private debt and equity financing known as mezzanine financing (a type of bond with an equity sweetener such as a warrant), and investment in troubled private companies known as distressed debt investing.
  2. Principal Protected Securities (PPS): a structured product, PPS offer returns from a basket of equities and have a fixed term of five to seven years, after which they return principal and gains. In this sense, they resemble a bond. The PPS caps returns in exchange for protection of principal. The caps vary by PPS and employ options, stock futures and zero-coupon bonds that mature simultaneously with the PPS to secure return of principal.
  3. Structured Products: given their complexity, it is not surprising that scholars and practitioners may offer differing definitions of what constitutes a structured project. In general, they are designed to utilize techniques to create a bespoke process to meet funding, liquidity, risk transfer or other needs of the asset's owner, when an off-the-rack product cannot. Such transactions typically involve some combination of interest rate and credit derivatives in a separate entity that a financial institution uses to satisfy tax, accounting or risk transfer objectives. A wide ranging treatment of these instruments is beyond the scope of the Series 7 exam. What follows is a list of some of the more common structured products.
  • Interest rate derivatives: options, caps, floors, swaps, futures and forwards.
  • Credit derivatives: credit default swaps, asset swaps, total return swaps.
  • Securitization: collateralized debt obligations (cash flow and synthetic),
  • Credit-linked notes and structured notes.
  • Project financing
Investment Companies


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