CHAPTER 16

POOLED INVESTMENT VEHICLES

FOR FIXED-INCOME INVESTORS

CHAPTER SUMMARY
In prior chapters, we have focused on individual debt instruments. In this chapter, we describe
investment vehicles that represent pooled investments and are referred to as pooled investment
vehicles or collective investment vehicles. They include investment company shares, exchange-
traded fund shares, hedge funds, and real estate investment trusts.

INVESTING IN POOLED INVESTMENT VEHICLES

Bond investors including retail investors and institutional investors have an opportunity to invest
in a pooled investment vehicle in lieu of constructing their own portfolio. For retail investors, the
benefits of investing in pooled investment vehicles rather than the direct purchase of individual
bonds to create a portfolio are better diversification in obtaining the desired exposure, better
liquidity, and professional management.

Institutional bond investors use pooled investment vehicles to obtain exposure to different bond
sectors. A pooled investment vehicle can be used by an institutional bond portfolio manager for
several reasons. For example, it can be the best way to obtain a sufficient number of bond issues
in a sector whose exposure is sought. Additionally, certain pooled investment vehicles allow the
creation of leverage and the shorting of the bond market.

An investor in a pooled investment vehicle owns a proportional interest in the portfolios value.
The portfolio value is equal to the market value of the assets in the funds portfolio reduced by the
funds liabilities. When this difference is divided by the number of equity shares that have a claim
on the funds assets, the net asset value (NAV). In equation form, we have:

Market value of portfolio assets Liabilities

NAV
Number of shares outstanding

Certain vehicles will sell at their NAV. Other vehicles may trade at a premium (above the NAV)
or at a discount (below the NAV).

A pooled investment vehicle whose investment objective is to replicate some bond index is
referred to as a passive (or indexed) fund and is said to be a beta product. A pooled investment
vehicle where the investment objective is to outperform some bond index is referred to as an active
fund and is said to be an alpha product. Bond portfolio managers who manage pooled investment
vehicles receive compensation in the form of fees. A management fee (or investment advisory
fee) is based on the amount of assets managed and may depend on the performance relative to the
benchmark. The second type of fee is an incentive fee based strictly on performance.

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INVESTMENT COMPANY SHARES

Investment companies sell shares to the public and invest the proceeds in a diversified portfolio of
financial assets. In this chapter, we focus on investment companies that invest in debt instruments
such as bonds, bank loans, and securitized products.

An investment company is defined by the Securities and Exchange Act of 1940 as an issuer which
is or holds itself out as being engaged primarily in the business of investing, reinvesting or trading
in securities. If a pooled investment vehicle satisfies this definition, then it is an investment
company and must register with the Securities and Exchange Commission (SEC). For this reason,
investment companies are more appropriately referred to as registered investment companies
(RICs). Investment companies are classified as management companies and unit investment trusts.

Types of Management Companies

Management companies are classified as either an open-end company (or open-end funds) or a
closed-end company (or closed-end fund). Management companies are typically structured as a
corporation or a trust.

Open-end bond funds are portfolios of bonds whose NAV or price is determined only once each
day, at the close of the day. The number of shares is not fixed but increases or decreases as the
fund sells new shares or redeems outstanding shares. Fund shares are sold and redeemed at the
closing NAV.

New shares of a closed-end bond fund are initially issued by an underwriter and after their
issuance, the number of shares remains constant. Unlike open-end bond funds but like common
stock, the NAV of a closed-end bond fund is determined by supply and demand in the market
where the fund shares are traded. Because the funds price is determined by the market, the price
can differ from the NAV.

Numerous studies have sought to explain why there can be a significant divergence between a
closed-end funds market price and its NAV. Explanatory factors include: current yield on stock
price/NAV; current discount/premium; dividend cuts/increases; fund performance; performance
of the closed-end funds sector; investor sentiment; market outlook; sector outlook; and,
availability of comparable products.

Another type of pooled investment vehicle, exchange-traded funds (ETFs), poses a threat to the
growth of both open-end and closed-end management companies. Technically, under federal
securities law, ETFs are a form of regulated investment company. Fundamentally an ETF is a
hybrid closed-end fund that trades on exchanges but typically trades very close to the NAV.

Fund Fees

Investors in the shares of management companies bear two types of costs. the first is the
shareholder fee (or sales charge). This cost is a one-time charge debited to the investor for a

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specific transaction, such as a purchase, redemption, or exchange of shares. When there is a sales
charge for a mutual fund, there can be an option to pay that charge at the time of purchase (front
load) or when the shares are sold (back load). A fund that imposes no sales charge is referred to as
a no-load fund. No-load funds can still charge other fees.

The second cost is the annual operating expense. The operating expense is debited annually from
the investors fund balance by the fund sponsor. There are three main categories of annual operating
expenses: management fee, distribution fee, and other expenses. Also referred to as the investment
advisory fee, the management fee is charged by the investment advisor for managing a funds
portfolio. For many mutual funds there is also a fixed annual fee to cover annual distribution and
marketing costs. This fee, referred to as a 12b-1 fee, is typically used as an alternative to a sales load.
The maximum 12b-1 fee is 1%. Other expenses include primarily the costs of custody, the transfer
agent, independent certified public accountant fees, and directors fees.

The funds total annual fund operating expenses, referred to as the expense ratio, is the sum of
the annual management fee, the 12b-1 fee (if any), and other annual expenses. The funds
prospectus shows all the cost information. A multi-class structure gives the investor an option to
select a fee and expense structure that the investor prefers.

Types of Bond Funds by Investment Objective

Management companies that invest in fixed income products cover a wide spectrum of investment
objectives. There are various ways to classify funds. The broadest categorization is in terms of
taxable and tax-exempt funds (also called municipal bond funds).

Taxable-Bond Funds

Government bond funds have an allocation of at least 90% to government bond issues.
Investment-grade bond funds invest in corporate bonds and other investment-grade issues such
as tranches of nonagency mortgage-backed securities and asset-backed securities that have an
investment-grade credit rating. A bond fund with at least 65% of its assets invested in bonds that
have a non-investment-grade rating is called a high-yield bond fund. Bond funds classified as
inflation-protected bond funds invest primarily in debt securities that adjust their principal
values to the rate of inflation.

Bank loan bond funds invest primarily in bank loans. Multi-sector bond funds invest in a wide
spectrum of bond classes: U.S. government obligations, foreign bonds, and high-yield debt
securities issued by U.S. entities. Convertible bond funds invest in both convertible bonds and
convertible preferred stock.

There are specialized bond funds known as inverse and leveraged funds. The manager of an
inverse bond fund pursues a strategy that will generate a return that is opposite to that of the
benchmark index. Effectively, this type of fund is shorting the benchmark index and hence is also
referred to as a short bond fund. The manager of a leveraged bond fund uses leverage to generate
a multiple of the return of the benchmark index.

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Bond funds are classified as long term, intermediate term, and short term based on the portfolio
duration or portfolio average effective maturity. A fund that has a portfolio duration of less than
one or an average effective maturity that must be less than one year is referred to as an ultrashort
bond fund. A limited duration bond fund is a fund that has a portfolio duration that typically
does not exceed three. There are bond funds that are target term trusts, which are structured as
closed-end funds. With a target term trust, there is a termination or maturity date for the funds.
The manager seeks to return the original issuance price plus a competitive return over the life of
the trust. If a fund invests at least 40% of its assets in foreign bonds traded in foreign markets, it
is called a global bond fund or a world bond fund. These funds can either have foreign currency
exposure or hedge foreign currency risk. An emerging-markets bond fund invests at least 65%
of assets in bonds issued by entities in emerging markets.

Tax-Exempt Bond (Municipal Bond) Funds

Tax-exempt or municipal bond funds invest in municipal securities whose interest income is
exempt from federal income taxes. The state tax treatment varies. Bond funds in this category are
classified as municipal national funds and state-specific funds.

Municipal national funds do not focus their portfolio holdings on any particular state. These bond
funds are further classified based on the creditworthiness of the securities permitted in the
portfolio. More specifically, a high-yield municipal bond fund invests at least 50% of its assets
in municipal securities that are either not rated or that are rated BBB/Baa or below. State-specific
municipal bond funds invest in one specific state and must have at least 80% of their portfolio
holdings in the municipal securities issued by that state.

Taxation of RICs

To qualify as a RIC so as to not pay taxes at the fund level but only at the shareholder level, several
criteria must be satisfied by a bond fund. One criteria is that a bond fund must distribute to the
funds shareholders at least 90% of its net investment income, excluding any realized capital gains
or losses to shareholders, and are not required to pay taxes at the fund level prior to distributions
to shareholders.

Capital gains are either long-term or short-term capital gains (depending on whether the fund held
the security for a year or more) and must be distributed annually. Redemption of shares may
produce a realized capital gain and thereby a tax liability to accrue to the remaining fund investors.

EXCHANGE-TRADED FUNDS

An exchange-traded fund (ETF) is a pooled investment vehicle that under federal securities law
is a type of investment company. ETF shares trade on an exchange continuously throughout the
trading day just like the stock of any public corporation. Moreover, ETF shares can be purchased
on margin and sold short, and orders are executed using the types of transactions available for
taking a position in any stock. There are even futures and options where an ETF is the underlying.

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The management of an ETF is based on a benchmark index. The first generation of ETFs requires that
the ETFs portfolio manager achieves the same total return as the benchmark index. Second-generation
ETFs are those that are actively managed in attempting to outperform the benchmark index.

Although it has features similar to open-end and closed-end funds, an ETF has features that make
it more attractive as a pooled investment vehicle. In fact, the dramatic growth of ETFs since their
first introduction in 1993 was due to what is viewed as faulty design features of open-end and
closed-end funds.

The price of the share of an open-end fund is the days closing price. That is, transactions cannot
be made at intraday prices, but only at closing prices. A closed-end fund, in contrast, is traded on
an exchange and transactions can be executed at intraday prices. In this respect, ETFs are like
closed-end funds. However, unlike a closed-end fund wherein its market price can trade at a
significant discount from the NAV, the creation and redemption process for an ETF provides a
mechanism for an ETFs market price to trade very close to its NAV.

Two other features make ETFs more attractive than open-end and closed-end funds. First, ETF
shareholders are subject to capital gains taxes only when they sell their ETF shares (at a price above
the original purchase price). ETFs do distribute cash dividends and may distribute a limited amount
of realized capital gains, and these distributions are taxable. The actions of ETF managers do not
cause potentially large capital gains tax liabilities that accrue to those who held their positions in
order to meet shareholder redemptions due to the unique way in which they are redeemed. Second,
relative to open-end or closed-end funds, ETFs typically have a lower expense ratio.

Types of Bond ETFs and Sponsors

There are classifications for bond ETFs. Based on data in the ETF Database, there are different
types of bond ETFs within each classification. The types of funds are the same as those for open-
end and closed-end bond funds. A bond ETF can be passively or actively managed.

Creation and Redemption of Passively Managed ETF Shares

For an actively managed ETF, the managers objective is to create a bond portfolio that matches
the performance of the benchmark index as closely as possible. To avoid the drawback of a closed-
end bond fund where the funds market price is below the funds NAV, an investor wants the
ETFs market price not to deviate significantly from the ETFs NAV. To accomplish this requires
the intervention of a third party that is charged with the responsibility of arbitraging any
discrepancy between the ETFs NAV and the ETFs share price.

The arbitrage process that the third party must undertake is as follows. First, if the ETFs share
price exceeds the ETFs NAV, the ETFs share price is expensive on a relative basis. The action
taken by the third party would be to buy the underlying ETF portfolio and sell the ETFs share.
Second, if the ETFs share price is below that of the ETFs NAV, the ETFs share price is cheap
on a relative basis. The action taken by the third party would be to sell the underlying ETF portfolio
and buy the ETFs share.

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The third party in the arbitrage process is a group of large institutional investors selected by the
ETFs sponsor to perform the function described. Because they are retained by the ETF sponsor to
take the action just described to bring about the equality of the ETF share price and the ETFs NAV
by creating and redeeming ETF shares, they are referred to as authorized participants (APs).

An authorized AP provides the ETF sponsor with a specified basket of securities in exchange for
which the AP receives ETF shares (called Creation Units). These units can only be done in large,
specified quantities of ETF shares. When the AP delivers a specified number of ETF shares to the
ETF sponsor in exchange for a specific basket of securities, the ETF shares exchanged are referred
to as Redemption Units.

Tracking Performance of Bond ETFs

Using daily returns, studies look at metrics to determine how closely the ETFs track their
respective benchmark index: daily tracking error and absolute daily tracking error. The daily
tracking error is defined as the return on the ETF minus the return on the benchmark index. The
daily tracking error can be positive or negative. The average daily tracking error can therefore
cancel out large positive and negative values. In contrast, the absolute daily tracking error does not
allow for the offsetting of large positive and negative tracking errors when averaging takes place.

HEDGE FUNDS

Another pooled investment vehicle where the portfolio may consist of bonds is a hedge fund. The
Dodd-Frank Wall Street Reform Act of 2010 changed the registration of hedge funds that were
previously granted exemption because they were classified as private adviser, replacing the
exemption with several narrower exemptions for advisers.

A fair description of the attributes of a hedge fund is as follows. First, the word hedge in the
term hedge funds is misleading. Second, hedge funds use a wide range of trading strategies and
techniques in an attempt to earn superior returns. The strategies can include one or more of the
following: leverage, short selling, arbitrage, and risk control. Third, the management fee structure
is a combination of a management fee and an Incentive fee.

In evaluating hedge funds, investors focus on the absolute return realized, not the relative return.
A hedge funds absolute return is simply the return realized; a hedge funds relative return is the
difference between the absolute return and the return on some benchmark or index.

Types of Hedge Bond Funds

A wide range of hedge funds invest in different asset classes. Those that invest in bonds (called
hedge bond funds) fall into the following two types: convergence trading and distressed investing.

Convergence Trading Hedge Bond Funds

If an observed relationship between the yields on the two bonds is out of line but is expected to
realign to the historical relationship, then there is an opportunity to capitalize on this expectation.

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For the strategy to succeed, the perceived misalignments of yields must move back to or
converge to the expected relationship. Hence, these hedge bond funds are referred to as
convergence trading strategies. The groups of bond hedge funds that fall into the category of
convergence trading hedge funds are fixed-income arbitrage hedge funds, convertible bond
arbitrage hedge funds, and relative value hedge funds.

Distressed Investing Hedge Bond Funds

The bonds of entities that are in bankruptcy as well as those where the issuer has defaulted are said
to be distressed securities. The objective of the hedge fund manager is to identify distressed
securities that are undervalued relative to what the hedge fund manager believes will result from
the outcome of the bankruptcy proceedings.

REAL ESTATE INVESTMENT MORTGAGE TRUSTS

A real estate investment trust (REIT) is an entity that issues stocks that represent an equity interest
in either a pool of real estate properties (called an equity REIT), a pool of real estate mortgage
debt (called a mortgage REIT), or a pool consisting of both real estate properties and real estate
mortgage debt (called a hybrid REIT). About 90% of the REITs traded are equity REITs.

General Characteristics of a REIT

A REIT is similar to a closed-end fund because the stock is publicly traded and the market price
can differ from that of the REITs NAV. As with the other pooled investment vehicles, the
principal advantages of investing in a mortgage REIT are that that they allow investors access to
an illiquid asset class; provide for better diversification than can be achieved by individual
investors; and provide for management with better skills in evaluating and selecting the borrowers
who are included in the portfolio.

Tax advantages are available to a company that qualifies as a REIT. For a company that qualifies
as a REIT, they avoid the double taxation of income found in corporations. They do this by
following a dividend distribution policy wherein all their taxable income is distributed to their
shareholders and therefore no corporate taxes are paid.

Types of Mortgage REITS

The portfolio of a mortgage REIT includes debt instruments that represent financing to owners,
developers, and purchasers of real estate. The returns to investors are generated from the interest
earned on the financing they provide. Mortgage REITs are classified based on the type of real
estate property for which financing is provided: residential property and commercial property.

KEY POINTS

Pooled investment vehicles, also referred to as collective investment vehicles, represent an

equity interest in a portfolio of assets.

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 The manager of a pooled investment vehicle charges a management fee that is based on the
amount of the assets managed and possibly an incentive fee based on performance.
The net asset value of a pooled investment vehicle is found by determining the net asset value
(market value of assets minus liabilities) and dividing by the number of shares.
A funds NAV need not be the same as the price of the funds stock in the market.
From an investors perspective, in general there are three advantages of a pooled investment
vehicles compared to a direct investment in the same assets that are in the funds portfolio:
better portfolio diversification, better liquidity, and professional management.
Depending on the type of investment vehicle, there may be favorable tax treatment.
Pooled investment vehicles that invest in bonds include investment companies, exchange-
traded funds, hedge funds, and real estate investment trusts.
Investment companies must be registered with the SEC and are therefore referred to as
registered investment companies, with one type of investment company classified under federal
securities law as a management company.
Management companies, created as either corporations or trusts, are classified as open-end
funds (also called mutual funds) and closed-end funds.
The investment objectives of an investment company are described in the funds prospectus.
Management companies that invest in fixed-income products cover a wide spectrum of
investment objectives, with the broadest categorization being taxable funds and tax-exempt
funds (also called municipal bond funds).
A fund can be actively managed (alpha product) or passively managed (beta product).
Investors in the shares of management companies bear two types of costs: shareholder fee
(usually called the sales charge) and annual operating expense (which includes the management
fee, the distribution fee, and other expenses).
Management companies are classified as either an open-end company (open-end funds or
mutual funds) or a closed-end company (closed-end fund).
Open-end bond funds are portfolios of bonds whose NAV or price is determined at the close of
the day with the number of shares not fixed because the fund sells new shares or redeems
outstanding shares.
In contrast to open-end funds, the shares of a closed-end fund are fixed at the time of the
launching of the fund and are traded on a secondary market.
Unlike open-end funds, a closed-end funds market price is determined by supply and can trade
at a premium or discount to its NAV. Several reasons have been suggested as to why the share
price in the market might differ from its NAV.
Exchange-traded funds are pooled investment vehicles that overcome the two design features
of open-end funds: that they can only be transacted at prices at the end of the trading day and
tax inefficiencies.
ETFs are similar to open-end funds in that they trade based on net asset value, but unlike open-
end funds they trade like stocks.
The dominate type of ETF is one that is a passively managed so as to replicate the performance
of a designated benchmark as closely as possible.

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 A key player in an ETF is the authorized participant, whose role is to arbitrage any difference
between the ETFs NAV and market price so that the ETF shares market price will be close to
that of the NAV.
A study that has investigated whether the market price follows the NAV closely finds that the
difference is greater the less liquid the bonds in the benchmark index.
Common attributes of pooled investment vehicles referred to as hedge funds are that they
employ significant leverage, short selling, arbitrage, and risk control in seeking to generate
superior returns that are typically measured on an absolute return basis.
Despite the term hedge in their title, hedge funds do not completely hedge their positions.
Hedge bond funds follow one of two strategies: convergence trading or distressed investing.
Real estate investment trusts are publicly traded stocks that represent an interest in an
underlying pool of real estaterelated investments.
The NAV of an REIT is determined just like that for a closed-end fund: supply and demand.
Hence, the market price can differ from the REITs NAV.
One type of REIT is the mortgage REIT, which provides financing for properties either by the
origination or acquisition of loans and investing in mortgage-related securities.
Mortgage REITs are classified based on the type of mortgage debt: residential mortgage debt
or commercial mortgage debt.
There are tax advantages for a company that qualifies as a REIT, such as elimination of double
taxation of the income generated.

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 ANSWERS TO QUESTIONS FOR CHAPTER 16
(Questions are in bold print followed by answers.)

1. What are the advantages of pooled investment vehicles relative to the direct purchase of
fixed-income assets?

Investment vehicles that represent pooled investments are referred to as pooled investment
vehicles or collective investment vehicles. They include investment company shares, exchange-
traded fund shares, hedge funds, and real estate investment trusts. Thus, one advantage of pooled
investment vehicles is the variety of vehicles that are available. As such, bond investors including
retail investors and institutional investors have an opportunity to invest in a pooled investment
vehicle in lieu of constructing their own portfolio to obtain exposure to the broad bond market
and/or specific sectors of the bond market. For retail investors, the benefits of investing in pooled
investment vehicles rather than the direct purchase of individual bonds to create a portfolio have
the advantages of better diversification in obtaining the desired exposure, superior liquidity, and
professional management.

Another advantage of pooled investment vehicles can be seen from the point of view of
institutional bond investors who can utilize pooled investment vehicles to obtain exposure to
different bond sectors where they might not have the necessary expertise. To elaborate, a bond
portfolio manager might have a benchmark that is a broad-based market index but would not have
expertise in sectors included in that index. For example, a bond portfolio manager may have
expertise in corporate bonds but not mortgage-backed securities (MBS). Rather than develop a
team that has expertise to invest in MBS, there are pooled investment vehicles managed by a team
of MBS experts. Such vehicles can be used to obtain exposure to the MBS sector. Another reason
why a pooled investment vehicle might be used by an institutional bond portfolio manager may be
that the funds size may not be large enough to obtain a sufficient number of bond issues to track
the sector whose exposure is sought. Finally, certain pooled investment vehicles have the
advantage of creating leverage and the shorting of the bond market.

2. An open-end investment company has $510 million of assets, $10 million of liabilities, and
50 million shares outstanding.

Answer the below questions.

(a) What is its NAV?

An investor in a pooled investment vehicle owns a proportional interest in the portfolios value.
The portfolio value is equal to the market value of the assets in the funds portfolio reduced by the
funds liabilities. When this difference is divided by the number of equity shares that have a claim
on the funds assets, the net asset value (NAV) is obtained. For an open-end bond fund, its NAV
or price is determined at the close of each day with the market value of fund shares being sold
and redeemed based on this price. Thus, for our problem the $510 million of assets would be
valued at its NAV, which practically speaking is its market value. Thus, in equation form, we have:

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 Market value of portfolio assets Liabilities
NAV
Number of shares outstanding

Inserting our given values into our NAV equation, we have:

$510,000,000 $10,000,000 $500,000,000

NAV $10
50,000,000 50,000,000

Thus, the net asset value or NAV is $10.00 per share.

(b) Suppose the fund pays off its liabilities while at the same time the value of its assets
doubles. How many shares will an investor who invests $50,000 receive?

The proportion of ownership for our investor is given by $50,000 (investors initial investment)
divided by the value of the assets at that ($510 million) minus the liabilities at that time ($10
million). Thus, the investors proportion of ownership is $50,000 / ($510,000,000 $10,000,000)
= 0.0001 or 1.00%. One percent of 50 million shares is 5,000 shares. This assumes that the investor
does not sell or redeem shares over time as can be the case for an open-end investment company.
It is shown below that this is the same number of shares owned when the liabilities are paid off if
the number of shares do not change.

Given that the market value of the portfolio assets has doubled, the liabilities are now zero, and
assuming the number of shares outstanding have remained at 50 million, we use our NAV equation
to get:

($510,000,000) 2 $0 $1,020,000,000 $0
NAV $20.40
50,000,000 50,000,000

First, let us note that the NAV has increased by ($20.40 $10) / $10 = 1.0400 or 104.00%. The
increase of $20.40 $10.00 = $10.40 means that investor has more than doubled their initial
investment of $10 per share and now has an investment valued at $50,000(20.4/10) =
$50,000(2.04) = $102,000. Given the total value is now $1,020,000,000, this means the investors
proportion of ownership is $102,000 / $1,020,000,000 or 1.00%. Thus, the investor still owns
1.00% of the company and 1.00% of shares outstanding. Assuming 50 million shares are still
outstanding, this means that the investor still owns 0.0001(50 million shares) = 5,000 shares.

3. An open-end funds NAV is determined continuously throughout the trading day.

Explain why you agree or disagree with this statement.

While they may trade continuously throughout the day, open-end funds are portfolios whose NAV
or price is determined only once each day, at the close of the day. Thus, while you would agree
that they are bought and sold continuous throughout the day, the price does not continuously
change during the day as is the case for closed-ends fund and ETFs that can experience intraday
pricing or change in NAV or price throughout the day. Unlike a closed-end fund wherein its market

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price can trade at a significant discount from the NAV, the creation and redemption process for an
ETF provides a mechanism for an ETFs market price to trade very close to its NAV.

4. Why might the price of a share of a closed-end fund diverge from its NAV?

Unlike open-end bond funds, the NAV for a closed-end bond fund is determined by supply and
demand in the market where the fund shares are traded and the transaction requires the payment
of a brokerage commission. Because the funds price is determined by the market, the price can
differ from the NAV. If a funds price is above the NAV, it is said to trade at a premium, whereas
a share trading below the NAV is said to trade at a discount.

Numerous studies have sought to explain why there can be a significant divergence between a
closed-end funds market price and its NAV. Research provides several factors that cause this
discrepancy between market price and NAV. The factors are those that impact supply and demand
and include: current yield on stock price/NAV (relative to other closed-end funds/investment
products); current discount/premium; dividend cuts/increases; fund performance (relative to other
closed-end funds/investment products); performance of the closed-end funds sector (relative to
other closed-end funds/investment products); investor sentiment; market outlook; sector outlook;
and, availability of comparable products.

5. Why do mutual funds have different classes of shares?

One reason for mutual funds having different classes of shares involves offering investors a
preference between when expenses are preferred to be paid (such as paying less now versus paying
more at later). To achieve this outcome of offering investors choices, a mutual fund may have a
multi-class structure that gives investors an option to select a fee and expense structure that they
prefer. For example, a multi-class structure could have Class A shares, Class B shares, and Class
C shares. Longer term investors will prefer Class A as this will be a less expensive alternative for
them. Whereas the costs with Class A may be greater upfront, over time their other fees are lower
and will more than make up for any greater initial costs. Each investor has to examine the fee
choices along with an investment horizon to determine which class would have cheaper expenses
given a particular time frame.

6. What costs are incurred by an investor when purchasing a mutual fund?

As noted in the previous problem, a mutual fund may have a multi-class structure that gives the
investor an option to select a fee and expense structure that the investor prefers. For example, a
multi-class structure could have Class A shares, Class B shares, and Class C shares. Relative to
other mutual fund classes in the structure, Class A shares have a front-end sales load but a lower
12B-1 fee and lower annual expenses. No front-end sales load is typically charged for Class B
shares, but there is a contingent deferred sales load as well as a 12b-1 fee and other annual
expenses. Class C shares have a 12b-1 fee and other annual expenses. The sales load is either a
front-end or back-end sales load but it is lower than the Class A and Class B shares. As explained
in the previous problem, each investor has to examine the fee choices along with their investment
horizon to determine which class would have cheaper expenses given their time frame.

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7. What are the design flaws of a mutual fund?

One design flaw is that trades for mutual funds cannot always be made at intraday prices, but only
at closing prices. Another flaw is that there can be unfavorable tax consequences arising from the
redemption of shares. There is also the flaw that redemption of shares can force managers to sell
securities if the cash position is not sufficient to fund the redemptions. An additional flaw is that
historically mutual fund have high expenses ratios. An exception to the latter high expense
involves wealthy investors who can circumvent the high overall fees by not paying upfront costs.

8. What are the advantages of an exchange-traded fund relative to open-end and closed-end
investment companies?

Although it has features similar to open-end and closed-end funds, an ETF has features that make
it more attractive as a pooled investment vehicle. In fact, the dramatic growth of ETFs since their
first introduction in 1993 was due to what is viewed as faulty design features of open-end and
closed-end funds. Thus, ETFs have the advantage of overcoming certain design flaws. To
illustrate, the price of the share of an open-end fund is the days closing price causing transactions
(purchases and sales) to be performed only at closing day prices and not at intraday prices. A
closed-end fund, in contrast, is traded on an exchange and transactions can be executed at intraday
prices. Because they are shares of a stock, ETFs, like closed-end funds, have the advantage of
being traded at intraday prices. In this respect, ETFs are like closed-end funds. However, unlike a
closed-end fund wherein its market price can trade at a significant discount from the NAV, the
creation and redemption process for an ETF has the advantage of overcoming the divergence
between the market price and the NAV.

Two other features give ETFs an advantage and make them more attractive than open-end and
closed-end funds. The first advantage is that EFTs avoid the unfavorable tax consequences arising
from the redemption of shares in a pooled investment vehicle that are found for open-end funds.
Redemptions may force managers of open-end funds to sell securities (if the cash position is not
sufficient to fund the redemptions), thus causing a capital gain or loss for those who held their
shares. (Because there are no share redemptions for closed-end funds, this issue does not apply to
them). For a different reason, this issue does not arise for ETFs. Specifically, an ETFs manager
has the advantage of not having to sell portfolio securities because redemptions are affected by
an in-kind exchange of the ETF shares for a basket of the underlying portfolio securitiesnot a
taxable event to the investors under the U.S. federal income tax code. ETF shareholders as a result
are subject to capital gains taxes only when they sell their ETF shares at a price above the original
purchase price. ETFs do distribute cash dividends and may distribute a limited amount of realized
capital gains, and these distributions are taxable. Just as with open-end funds that follow an index
strategy, a passively managed ETF avoids realized capital gains and its taxation due to low
portfolio turnover. However, in contrast to a closed-end fund that is passively managed, the actions
of ETF managers do not cause potentially large capital gains tax liabilities that accrue to those who
held their positions in order to meet shareholder redemptions due to the unique way in which they
are redeemed.

A final advantage of an ETF (relative to a comparable open-end or closed-end fund) is that ETFs
typically have a lower expense ratio.

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9. What is the role played by an ETFs authorized participants?

The role play by as an authorized participant (AP) is to arbitrage any discrepancy between the
ETFs NAV and the ETFs share price. Below we explain in detail this role.

For an actively managed ETF, the managers objective is to create a bond portfolio that matches
the performance of the benchmark index as closely as possible. To avoid the drawback of a closed-
end bond fund where the funds market price differs from the NAV, an ETF employs a third party,
called an authorized participant (AP), who is charged with the responsibility of arbitraging any
discrepancy between the ETFs NAV and the ETFs share price.

The arbitrage process that the AP must undertake is as follows. Consider the following two
scenarios:

Scenario 1: The ETFs share price exceeds the ETFs NAV.

Scenario 2: The ETFs share price is below that of the ETFs NAV.

In Scenario 1, the ETFs share price is expensive on a relative basis. The action taken by an as AP
would be to buy the underlying ETF portfolio and sell the ETFs share. The result of the action of
the AP would be the generation of a profitable arbitrage and the result would be to reduce the
ETFs share price until it comes close enough to the ETFs NAV so that a profitable arbitrage is
no longer possible.

In Scenario 2, the ETFs share price is cheap on a relative basis. The action taken by the AP would
be to sell the underlying ETF portfolio and buy the ETFs share. As in Scenario 1, this action taken
by the AP would be the generation of a profitable arbitrage. The result of this action in Scenario 2
would be to increase the ETFs share price until it comes close enough to the ETFs NAV so that
a profitable arbitrage is no longer possible.

As can be seen, a third party (e.g., AP) plays a critical role in the process of keeping the ETFs
price close to the ETFs NAV. The third party in this process is a group of large institutional
investors selected by the ETFs sponsor to perform the function described. Because these
institutional investors perform the arbitrage, they are referred to as arbitrageurs. Because they are
retained by the ETF sponsor to take the action just described to bring about the equality of the ETF
share price and the ETFs NAV by creating and redeeming ETF shares, they can be deemed as
authorized.

One an AP can create ETF shares by providing the ETF sponsor with a specified basket of
securities in exchange for which the AP receives ETF shares, called Creation Units. These units
can only be done in large, specified quantities of ETF shares. The action taken by the AP in
Scenario 1 results in Creation Units. When the AP delivers a specified number of ETF shares to
the ETF sponsor in exchange for a specific basket of securities, the ETF shares exchanged are
referred to as Redemption Units. In Scenario 2, the action by the AP results in Redemption Units.

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The arbitrage process just described becomes more difficult for an actively managed ETF. The
reason is that the AP does not know what the underlying portfolio is because the portfolio is
permitted to deviate from the benchmark index. Hence, there is greater risk that the ETFs share
price will diverge from the ETFs NAV.

The difficulty and riskiness in the role played by APs can be seen in the financial crisis of 2008
where credit markets became highly illiquid. As a result, the ETF share creation/redemption
mechanism for keeping the ETFs market price close to the ETFs NAV required APs to transact
in the ETFs portfolio of bonds. When credit spreads were extremely high in the high-yield bond
market during this crisis, the creation/redemption trades were increasingly costly and risky for
APs because they faced both high spreads and uncertainty about whether they could transact in
the underlying portfolio of bonds. The end result was large tracking errors.

10. The stock price of a passively managed ETF will also sell in the marketplace within 1%
of its NAV. Explain why you agree or disagree with this statement.

One would disagree with the statement in that it is possible (even if not the norm) for passively
managed ETF to sell in the marketplace beyond 1% of its NAV. While the calculation for NAV
involves assets and liabilities, market prices are determined by supply and demand. Thus,
deviations beyond 1% between the prices and NAV are possible. Below we supply more details.

Managers of pooled investment vehicles can pursue either active or passive strategies. A pooled
investment vehicle whose investment objective is to replicate some bond index is referred to as a
passive (or indexed) fund and is said to be a beta product. Open-end bond funds are portfolios of
bonds whose NAV or price is determined only once each day, at the close of the day. Fund shares
are sold and redeemed at the closing NAV. Thus, there is no deviation as the price and the NAV
are the same. For close-end funds and ETFs, the NAV can deviate and at times deviate significantly
beyond 1% of their NAVs.

Numerous studies have sought to explain why there can be a significant divergence between the
funds market price and the funds NAV. Research provides several factors that cause a
discrepancy between market price and NAV. The factors are those that impact supply and demand
and include: current yield on stock price/NAV (relative to other closed-end funds/investment
products); current discount/premium; dividend cuts/increases; fund performance (relative to other
closed-end funds/investment products); performance of the closed-end funds sector (relative to
other closed-end funds/investment products); investor sentiment; market outlook; sector outlook;
and, availability of comparable products. Thus, there are a lot of factors that can potentially cause
more than a 1% or more deviation from a funds NAV.

It should be noted that exchange-traded funds (ETFs) are hybrid closed-end funds that trade on
exchanges typically (but not always) very close to the NAV. Unlike a closed-end fund wherein its
market price can trade at a significant discount from the NAV, the creation and redemption process
for an ETF provides a mechanism for an ETFs market price to trade very close to its NAV and
thus within 1% of its NAV. To avoid the drawback of a closed-end bond fund where the funds
market price is below the funds NAV, an investor wants the ETFs market price not to deviate
significantly from the ETFs NAV. To accomplish this requires the intervention of a third party

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that is charged with the responsibility of arbitraging any discrepancy between the ETFs NAV and
the ETFs share price. As described in the previous problem, an authorized participant (AP) is
needed to prevent this deviation.

11. Why is it difficult for the stock price to follow the NAV of an active ETF?

As noted in previous problems, the arbitrage process conducted by authorized participants (APs)
becomes more difficult for an actively managed ETF. The reason is that the AP does not know
what the underlying portfolio is because the portfolio is permitted to deviate from the benchmark
index. Hence, there is greater risk that the ETFs share price will diverge from the ETFs NAV.
The end results is that it can be quite difficult at time for the stock price to follow the NAV of an
active ETF. While this can be the case, there are forces at work that enable the stock price to
approximate the NAV. More details on this subject are supplied below.

The price of an ETF share on a stock exchange is swayed by the forces of supply and demand.
While imbalances in supply and demand can trigger the price of an ETF share to stray from its
NAV, large deviations tend to be short-term for many ETFs. Two chief features of an ETFs
structure support trading of an ETFs shares at a price that approaches the ETFs NAV. They are
portfolio transparency and the ability for APs to create or redeem ETF shares at NAV at the end
of each trading day.

Transparency of an ETFs holdings through full disclosure of the portfolio or established

relationships of the components of the ETFs portfolio with published indexes or other indicators
enables investors to try to profit from incongruities between the ETFs share price and its
underlying value during the trading day. When there are incongruities between an ETFs share
price and the value of its underlying securities, trading can more closely bring into line the ETFs
price and its underlying value. For example, if an ETF is trading at a discount to its underlying
value, investors may buy shares and/or sell the underlying securities. This modification in demand
for the ETF shares and the underlying securities should change their respective prices and shrink
the gap between the ETF share price and its underlying value.

The ability of APs to create or redeem ETF shares at the end of the trading day also helps an ETF
trade at market prices that approach the underlying market value of its portfolio. When a deviation
between an ETFs market price and its NAV occurs, APs may buy or sell creation units to capture
a profit. For example, when an ETF is trading at a premium, APs may find it profitable to sell short
the ETF during the day while concurrently buying the underlying securities. APs then swap the
creation basket of securities for ETF shares that they use to cover their short sales. These arbitrage
actions by APs help maintain the market price of an ETFs shares close to its underlying value.

12. What are the two major types of strategies followed by hedge bond funds?

Hedge funds use a wide range of trading strategies and techniques in an attempt to earn superior
returns. In general, the strategies can include one or more of the following: leverage, short selling,
arbitrage (i.e., simultaneous buying and selling of related financial instruments to realize a profit
from the temporary misalignment of their prices), and risk control (which is more general than
hedging and often involves the use of financial instruments such as derivatives to reduce the risk

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of loss). In regards to two specific major types of strategies followed by hedge bond funds, they
can be classified as: convergence trading and distressed investing. More details on these two
strategies are given below.

To understand hedge bond funds that pursue convergence trading strategies, it is necessary to
understand that there are certain yield relationships observed in the bond market that are viewed
as stylized facts. For example, supposed that the difference in the yield spread between yields
offered on two types of bonds have historically fallen within a certain range an extremely high
percentage of times. If an observed relationship between the yields on the two bonds is out of line
but is expected to realign to the historical relationship, then there is an opportunity to capitalize on
this expectation. For the strategy to succeed, the perceived misalignments of yields must move
back to or converge to the expected relationship. Hence, these hedge bond funds are referred to
as convergence trading strategies. Hedge fund managers believe the misalignment will generate a
profit with little risk and too often refer to such a strategy as a risk arbitrage strategy. This is a
regrettable mislabeling of a convergence trading strategy because an arbitrage strategy indicates
that there is no risk. The groups of bond hedge funds that fall into the category of convergence
trading hedge funds are fixed-income arbitrage hedge funds, convertible bond arbitrage hedge
funds, and relative value hedge funds.

Hedge bond funds that pursue distressed investing take positions to capitalize on the anticipated
impact of a bankruptcy on the value of a bond. It could be investing in a corporation that is in a
Chapter 11 bankruptcy proceeding or anticipated by the hedge fund manager to be forced into
filing a Chapter 11 bankruptcy. However, the strategy is not limited to corporate bankruptcies.
Hedge bond funds also are key participants in the bond market for the debt of bankrupt
municipalities or those likely to have a bankruptcy filing. Bankruptcy is not the only condition that
may provide for an opportunity to generate attractive returns. A company that has defaulted on its
obligations may provide opportunities as the price of the bond issue declines. Sovereigns provide
a good example. The bonds of entities that are in bankruptcy as well as those where the issuer has
defaulted are said to be distressed securities. The objective of the hedge fund manager is to identify
distressed securities that are undervalued relative to what the hedge fund manager believes will
result from the outcome of the bankruptcy proceedings. To see the participation of hedge bond
funds in distressed securities, look at a recent municipal bond bankruptcy. The city of Detroit is
the largest municipal bankruptcy as of mid-June 2014. Hedge bond funds have purchased the
pension bonds and general obligation bonds of Detroit backed by monoline insurance firms that
hedge fund managers believe to be underpriced. The pension bonds, for example, could be
purchased at a price of 41 cents on the dollar. Just two weeks after Detroits bankruptcy filing, the
supply of such bonds dried up in the marketplace. Bonds do not necessarily have to sell at very
deep discount prices for hedge bond fund managers to identify an opportunity.

13. Some hedge funds refer to their strategies as risk arbitrage strategies. What does that
mean?

A risk arbitrage strategy involves transaction-specific investigation that desires to profit by

obtaining securities which are discounted from the value to be paid for them such as in a planned
merger or acquisition due to the uncertainty of the timing and completion of the transaction. The
snag is in analyzing the risk of postponement or non-completion and deciding when it is best to

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take a position in order to achieve profits. The position can be taken anywhere from the start of a
planned transaction to its conclusion. Risk/merger arbitrage portfolio managers typically seek
speculative profits from the purchase of shares in forecasted acquisition targets, while maintaining
defensive positions through hedges in acquiring companies and disciplined risk management.

Hedge fund managers believe the misalignment will generate a profit with little risk and too often
refer to such a strategy as a risk arbitrage strategy. This is an unfortunate mislabeling of a
convergence trading strategy because an arbitrage strategy indicates that there is no risk.

14. How does the management fee structure of a hedge fund differ from that of an asset
manager of a mutual fund?

The management fee structure for a hedge fund is a combination of a management fee and an
incentive fee. For a hedge fund the main difference in the management fee is that it is typically
two to four times greater compared to a mutual fund. More details are supplied below.

Hedge funds differ significantly from mutual funds in terms of fees. Not only are the fees paid by
investors higher than they are for mutual funds, they include some additional fees that mutual
funds don't charge. The management fee for a hedge fund is for the same service that the
management fee covers in mutual funds. The difference is that hedge funds typically charge a
management fee of 2% of assets managed and can be even higher if the manager had an excellent
track record. This compares to an average management fee between 0.5% and 1% for mutual funds.

This higher fee for hedge funds makes managing a hedge fund attractive, but it is the incentive fee
that makes it a profitable endeavor for good fund managers as this fee can range between 10% to
20% of fund profits. Some hedge funds have even gone as high as 50%. The idea of the incentive
fee is to reward the hedge fund manager for good performance, and if the fund's performance is
attractive enough, investors are willing to pay this fee. For example, if a hedge fund manager
generates a 20% return per year, after management fee, the hedge fund manager will collect 4% of
those profits, leaving the investor with a 16% net return. In many cases, this is an attractive return
despite the high incentive fee, but with more mediocre managers entering the industry in search of
fortune, investors have more often than not been disappointed with net returns on many funds.

There is one caveat to the incentive fee, however. A manager only collects an incentive fee for
profits exceeding the fund's previous high, called a high-water mark. This means that if a fund
loses 5% from its previous high, the manager will not collect an incentive fee until he or she has
first made up the 5% loss. In addition, some managers must clear a hurdle rate, such as the return
on U.S. Treasuries, before they collect any incentive fees.

Hedge funds often follow the so-called "two and twenty" structure where managers receive 2%
of net asset value managed and 20% of profits, though as mentioned, these fees can vary among
hedge funds.

15. What is the tax advantage for a company that qualifies as a REIT?

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A REIT is similar to a closed-end fund because the stock is publicly traded and the market price
can differ from that of the REITs NAV. Tax advantages are available to a company that qualifies
as a REIT. Specifically, under the U.S. federal tax code, dividends paid by a corporation cannot
be taken as a tax deduction in determining taxable income, resulting in the double taxation of
corporate income (i.e., taxes are paid at the corporate level and then taxed again when distributed
to shareholders). This disadvantage is avoided by a company that qualifies as a REIT because the
company is permitted to deduct the dividends paid to its shareholders in determining its corporate
taxable income. Shareholders are only taxed when the dividends are paid to them. The same federal
income tax treatment applied to REITs is followed by most states. Consequently, to avoid double
taxation of income, most REITs follow a dividend distribution policy wherein all their taxable
income is distributed to their shareholders and therefore no corporate taxes are paid.

16. Two investors are arguing about the types of investment made by real estate investment
trusts. One investor believes that REITs are investors in real estate properties. The other
investor believes that REITs provide financing for the purchase of real estate properties. The
two investors ask you: Who is right? How would you respond to these investors?

A REIT, or Real Estate Investment Trust, is a company that owns or finances income-producing real
estate. Thus, both investors together have captured the definition of REITS. More details are given below.

A real estate investment trust (REIT) is an entity that issues stocks that represent an equity interest
in one of the following: (1) a pool of real estate properties (called an equity REIT), (2) a pool of
real estate mortgage debt (called a mortgage REIT), or (3) pool consisting of both real estate
properties and real estate mortgage debt (called a hybrid REIT). About 90% of the REITs traded
are equity REITs. The mortgage REIT (which is the focus of our chapter) is a smaller sector within
the REIT market. A company must satisfy certain requirements in order to qualify as a REIT under
the federal income tax law. The bulk of its invested assets must be in real estate-related investments.
As for the income generated, the source must come from primarily real estate investments, and at
least 90% of its taxable income must be distributed to shareholders annually in the form of dividends.

17. What are the two types of mortgage REITs?

Let us first point out that a mortgage REIT does not own real estate. Instead, a mortgage REIT
originates and then retains in its portfolio various types of debt that are used to purchase real estate
or purchase various types of mortgage-related debt such as mortgage-backed securities (where the
latter is a type of asset-backed security that is secured by a mortgage, or more commonly a pool
of up to hundreds of mortgages). As such, the portfolio of a mortgage REIT includes debt
instruments that represent financing to owners, developers, and purchasers of real estate. The
returns to investors are generated from the interest earned on the financing they provide.

In regards to the two types of mortgage REITS, they are classified based on the type of real estate
property for which financing is provided: residential property and commercial property.
Residential property includes single-family homes. Commercial property includes the other types
of real estate properties described as commercial MBS.

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