Investment Vehicle Characteristics
Domain 2: Investment Vehicle Characteristics
This domain tests the features, risks, valuation, and tax treatment of equities, fixed income, derivatives, pooled vehicles, and alternatives. Questions often compare two vehicles on a specific risk or cost dimension.
Core rules and concepts
- Equity: Common stock carries a residual claim and voting rights; preferred stock ranks ahead for dividends and liquidation but is rate-sensitive. Dividends are not tax-deductible to the issuer; qualified dividends receive favorable individual tax rates.
- Fixed income: Price is inverse to yield. Duration approximates percentage price change for a 1% yield change; convexity refines it. Credit risk, call risk, and reinvestment risk vary by issuer and structure.
- Derivatives: Options give rights; futures create obligations. Long calls and long puts have limited loss (premium); short options can lose more. Futures are marked to market daily.
- Pooled vehicles: Open-end mutual funds issue redeemable shares at NAV; ETFs trade intraday and may trade at premiums or discounts; closed-end funds trade at market price and can use leverage.
- Alternatives: REITs, hedge funds, private equity, and commodities offer diversification but carry liquidity, valuation, and leverage risks. REIT distributions are generally taxed as ordinary income.
Worked example
A bond has duration 5 and yield 4%. If yields rise to 5%, estimated price change is about minus 5 times 1%, or minus 5%. A $100,000 position loses about $5,000. If the bond is callable at par and rates fall, the issuer may call it, capping upside. The adviser compares a non-callable bond with similar duration and a Treasury with no credit risk.
Traps
Using maturity instead of duration; ignoring call features; assuming ETFs always trade at NAV; confusing options rights with obligations.