Mutual funds revolutionized investing, but they weren't the end of the story. Since the 1990s, a wave of innovation has created new packaged products—each designed to solve specific problems or access particular markets. ETFs trade like stocks. REITs own real estate. Hedge funds use aggressive strategies. DPPs pass through tax benefits. Understanding these alternatives is essential for the modern securities professional.
Exchange Traded Funds (ETFs)
ETFs emerged in 1993 with the launch of the SPDR S&P 500 ETF (ticker: SPY). They've since become one of the most successful financial innovations in history, holding trillions in assets.
ETFs are packaged products that operate like closed-end funds but with a crucial mechanism that keeps prices close to NAV.
How ETFs Work
- Bought and sold via broker-dealer on exchanges
- Trade continuously throughout the day
- Not redeemable by retail investors — you sell to another investor
- Large institutions can use creation units to redeem shares for underlying assets — this arbitrage mechanism keeps prices near NAV
ETFs vs. Mutual Funds
| Feature | ETF | Mutual Fund |
|---|---|---|
| Trading | Continuous, like stocks | Once daily at 4 PM NAV |
| Minimum Investment | Price of one share | Often $1,000+ |
| Margin/Short Selling | Yes | No |
| Expense Ratios | Generally lower | Generally higher |
| Tax Efficiency | Generally more efficient | Less efficient |
Leveraged ETFs
Leveraged ETFs deliver multiples of index performance:
- 2X ETF: If the index goes up 10%, the ETF goes up 20%
- Also works in reverse: index down 10% = ETF down 20%
Inverse ETFs
Inverse ETFs move opposite to the index:
- S&P 500 up 5% = Inverse ETF down 5%
- Used for hedging or bearish speculation
Leveraged and inverse ETFs are designed for short-term trading only. Due to daily rebalancing, they can diverge significantly from their target over longer periods. They are NOT "buy and hold" investments.
Exchange Traded Notes (ETNs)
ETNs look like ETFs but have a fundamentally different structure:
- Debt securities — you're lending money to the issuer
- No periodic interest payments — returns based on index performance
- Backed only by the issuer's credit — if the issuer defaults, you're an unsecured creditor
| Feature | ETFs | ETNs |
|---|---|---|
| Structure | Open-end fund | Bond |
| Maturity | No set maturity | Maturity date set by issuer |
| Trading | Like stock | Like stock |
| Ownership | Own piece of underlying portfolio | Unsecured loan to issuer |
| Credit Risk | Minimal | Issuer default risk |
| Tax Efficient? | Yes | Yes |
In 2008, when Lehman Brothers collapsed, holders of Lehman-issued ETNs discovered that "backed by the issuer" meant exactly that. No underlying assets to claim—just an unsecured creditor position in bankruptcy.
Real Estate Investment Trusts (REITs)
Congress created REITs in 1960 to give regular investors access to commercial real estate. Before REITs, you needed serious capital to own shopping centers, office buildings, or apartment complexes.
REITs are similar to closed-end funds but invest in real estate rather than securities:
- Own properties, construction loans, and mortgages
- Provide diversification and liquidity
- Issue shares of beneficial interest (not common stock)
- Trade on exchanges or OTC — can be bought on margin or sold short
Subchapter M Requirements for REITs
To avoid corporate taxation, REITs must meet four tests:
| Requirement | Standard |
|---|---|
| 75% Income Test | At least 75% of income from real estate (rentals, mortgage interest, property sales) |
| 75% Asset Test | At least 75% of assets in real estate, government securities, or cash |
| Structure | Unincorporated entity managed by Trustee(s) |
| 90% Distribution | At least 90% of net investment income distributed |
Tax Note: REIT dividends are taxed as ordinary income, not at the lower qualified dividend rate. The tax advantage is at the corporate level, not the shareholder level.
Types of REITs
| Type | SEC Registered | Exchange Traded | Liquidity |
|---|---|---|---|
| Private REITs | No | No | Low — accredited investors only |
| Non-Listed REITs | Yes | No | Low — no secondary market |
| Listed REITs | Yes | Yes | High — most common for retail |
Hedge Funds
The name dates to 1949, when Alfred Winslow Jones created a fund that "hedged" by holding both long and short positions. Today's hedge funds use a wide variety of strategies, not all of which involve hedging.
Hedge funds are:
- Private funds — not registered as investment companies
- Limited partnerships — sold only to accredited investors
- Illiquid — typically require lock-up periods
- Pass-through taxation — gains and losses flow to partners
- Aggressively managed — use leverage, short selling, derivatives
- Expensive — the famous "2 and 20" fee structure
Accredited Investor Requirements
| Requirement | Threshold |
|---|---|
| Net Worth | >$1 million (excluding primary residence) |
| OR Annual Income | >$200K individual / >$300K joint |
Fund of Hedge Funds
For investors wanting hedge fund exposure without picking individual managers:
- Invests in a portfolio of hedge funds
- May or may not be registered
- Two layers of fees — both underlying hedge funds AND the fund-of-funds charge fees
- Still illiquid and risky
Direct Participation Programs (DPPs)
DPPs are limited partnerships that pass income, gains, losses, and deductions directly to investors.
Key Characteristics
- General partner manages the business
- Limited partners are passive investors — no day-to-day involvement
- Pass-through taxation — the partnership itself pays no tax
- Income is passive income — losses can only offset other passive gains
- Illiquid — generally don't trade on exchanges
Oil and Gas Programs
The most common DPP type, with three risk profiles:
| Program Type | Also Called | What It Is | Risk/Return |
|---|---|---|---|
| Exploratory | "Wildcat well" | Drilling where no one has drilled before | High risk, high potential return |
| Developmental | "Step out well" | Drilling near existing oil fields | Medium risk, moderate return |
| Income | "Stripper well" | Buying producing wells with proven reserves | Low risk, lower return |
Test Tip: Remember the nicknames: wildcat (exploratory), step-out (developmental), and stripper (income). The exam may use either term.
Private Equity Funds
Private equity funds pool investor capital to buy controlling interests in companies, improve them, and sell them for profit.
The Typical Pattern
- Raise capital from accredited investors
- Acquire companies (often using leverage)
- Improve operations, cut costs, grow revenue
- Sell or take public in 3-7 years
- Distribute proceeds to investors
Characteristics
- Illiquid — capital locked up for years
- Accredited investors only
- High minimum investments — often $250,000+
- Performance fees — similar to hedge funds
Know Your Products
| Product | Structure | Liquidity | Investor Type |
|---|---|---|---|
| ETF | Investment company | High (exchange traded) | Any investor |
| ETN | Debt security | High (exchange traded) | Any investor |
| Listed REIT | Trust | High (exchange traded) | Any investor |
| Hedge Fund | Limited partnership | Low (lock-ups) | Accredited only |
| DPP | Limited partnership | Low (no trading) | Varies by offering |
| Private Equity | Limited partnership | Very low | Accredited only |
Test Tip: Know the key distinctions: ETFs trade on exchanges (mutual funds don't), ETNs are debt (ETFs are equity), REITs must distribute 90% of income, hedge funds are for accredited investors only.
Key Points to Remember
- ETFs: Trade like stocks, use creation units, generally lower costs
- ETNs: Debt securities, issuer credit risk, no underlying assets
- REITs: 75%/90% tests, dividends taxed as ordinary income
- Hedge funds: Accredited investors, 2-and-20 fees, illiquid
- DPPs: Pass-through taxation, passive income, illiquid
Chapter 6 Summary
Packaged products democratized investing. They also created complexity. Understanding the differences between mutual funds, ETFs, CEFs, REITs, and alternative investments isn't just exam material—it's essential knowledge for anyone advising investors.
The key questions for any packaged product:
- Structure: Open-end? Closed-end? Trust? Partnership?
- Pricing: NAV? Market price? Premium/discount?
- Liquidity: Daily redemption? Exchange traded? Lock-up period?
- Costs: Front-end load? 12b-1 fees? Expense ratio? Performance fees?
- Taxes: Pass-through? Corporate level? Ordinary income? Capital gains?
- Suitability: Long-term? Short-term? Accredited only?
Master these distinctions, and you'll master this section of the exam.
"An investment in knowledge pays the best interest." — Benjamin Franklin