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Course 402
Alternative Investments

Introduction

For investors familiar only with stocks, bonds, and conventional mutual funds, the variety of alternative investment vehicles on the market might seem overwhelming. There are many investment types that are similar in nature to mutual funds in that they hold or track baskets of securities, but each of these has its own unique characteristics.

For those seeking clarity on what some of these lesser-known investment types are and how they work, here's a primer.

Exchange-Traded Funds (ETFs)

ETFs are becoming increasingly popular and are very similar to conventional open-end mutual funds in that they invest assets in a portfolio of securities, often--but not always--tracking an index. Among key differences are the fact that while conventional mutual funds are priced once a day after the market closes, ETFs are repriced and traded throughout the day. There also are structural benefits regarding how an ETF operates that often lead to lower fees compared with mutual funds investing in similar portfolios, as well as some tax efficiencies. (For more on ETFs, see Portfolio 403: ETFs or Mutual Funds: Which to Choose?)

Exchange-Traded Notes (ETNs)

It sounds similar to an ETF but is actually quite different. An ETN essentially is a promissory note from a financial institution to match the return of an index, minus fees. Like a bond, it has a maturity date, and like an ETF it can be traded throughout the day. The danger here is that an ETN is an unsecured obligation, meaning that if the financial institution issuing it can't meet its obligations, assets invested in the ETN may be lost. For that reason investing in an ETN entails a degree of credit risk along with the risk inherent in the performance of the index it tracks.

Unit Investment Trusts (UITs)

In the broadest sense, this refers to a type of investment company that holds a fixed portfolio of securities for a specified period of time. More specifically, it is also a structure used by some older ETFs that prevents them from making distributions until the end of each quarter, from holding securities not in the indexes they track, and from lending out securities. The inability to reinvest dividends daily, as newer ETFs and conventional mutual funds may do, can lead to tracking error, in which the ETF's performance diverges from its index. No new ETF has used this structure since 2002.

Quiz 402
There is only one correct answer to each question.

1 What is the difference between an exchange-traded fund and a mutual fund?
a. Mutual funds are priced once a day after the market closes; ETFs are repriced and traded throughout the day.
b. Due to structural benefits, ETFs often carry lower fees compared with mutual funds investing in similar portfolios
c. Both A and B.
2 Which alternative investment below is a promissory note from a financial institution to match the return of an index, minus fees?
a. An exchange-traded fund
b. An exchange-traded note
c. Holding company depository receipts
3 Which type of fund does not have capital flowing into and out of it based on shareholders buying or redeeming shares?
a. Closed-end funds
b. Exchange-traded funds
c. Mutual funds
4 Which statement below is true?
a. Because of the stability of the capital they hold, many mutual funds leverage their assets up to a given percentage.
b. Because of the stability of the capital they hold, many exchange-traded funds leverage their assets up to a given percentage.
c. Because of the stability of the capital they hold, many closed-end funds leverage their assets up to a given percentage.
5 Investing in an exchange-traded note entails:
a. Credit risk
b. The risk inherent in the performance of the index it tracks
c. Both A and B
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