1.6 ETFs, REITs & Fund Analysis
This chapter covers the pooled products built on top of the basic fund structures: ETFs and ETNs, the common fund categories, REITs, and the numbers used to judge a fund, such as alpha and beta. It also explains how fund income and gains are taxed and why dollar cost averaging lowers average cost. Suitability questions on the exam, and recommendations to real clients, depend on knowing what a fund holds, what it costs and how it is taxed.
What each topic covers
ETFs, ETNs & Leveraged Funds explains that an ETF is organized as an open-end company but trades on exchanges as a negotiable security. It names the three ETFs to know: Spyders for the S&P 500, DIAmonds for the Dow Jones Industrial Average and Qubes for the Nasdaq 100. It compares ETFs with mutual funds, shows how inverse and 200% or 300% leveraged funds move against an index, and sets ETFs, which carry no default risk, against ETNs, which are debt with credit risk.
Fund Objectives & Categories sorts funds by objective and holdings. Growth funds seek capital appreciation, aggressive growth funds take more risk, and income funds hold only income-producing securities. Balanced funds hold bonds and stock, while growth and income funds hold stock only. It also covers Ginnie Mae, which guarantees mortgage-backed securities, against Fannie Mae and Freddie Mac, which purchase mortgages. Life cycle funds, money market funds at $1.00 per share, specialized funds and index funds round out the list.
Equity, Mortgage & Hybrid REITs describes REITs as trusts that pool investor money into real estate. Equity REITs own properties and earn lease income plus possible appreciation, mortgage REITs hold commercial mortgages and mainly seek income, and hybrids combine both. It also separates public listed, public non-listed and private REITs by liquidity risk, and notes that unlisted and private REITs suit only sophisticated investors.
Alpha, Beta & Management Style defines alpha as actual return minus expected return, and beta as volatility compared with the market. A beta of 1.5 means a 10% market gain should produce 15%, and a negative beta moves opposite the market. It works through the full alpha formula using the risk-free rate, warns to pick the benchmark that matches the fund, and notes that passive funds should show alpha near zero and beta near 1.
Subchapter M & Fund Distributions covers how fund payouts are taxed. Qualified dividends are taxed at 0%, 15% or 20%, non-qualified dividends at the marginal bracket, and long-term gains need a holding period longer than one year. It explains cost basis, the $3,000 annual loss deduction, FIFO, LIFO, specific share identification and average cost, single category. It closes with the conduit rule, which requires a fund to distribute at least 90% of net investment income, and the extra 75% tests for REITs.
Dollar Cost Averaging & Fund Suitability says a fund’s suitability follows the securities it holds, so the real differences are diversification and fees. Dollar cost averaging invests a fixed amount at regular intervals to reduce market timing risk. A worked example buys $4,000 of shares across four falling prices, giving an average cost of $11.85 against an average price of $13.50.