Sách dạy Nấu ăn #1

Economic for Me # 4

401(k) and Qualified Plans: Introduction (Retirement plan details change frequently. TeachMeFinance.com is intended for educational purposes only. TeachMeFinance.com is an informational website, and should not be used as a substitute for professional financial, legal or medical advice. Please contact your attorney or accountant before making actual investment or retirement decisions. Also please read our disclaimer.) Retirees normally receive their income from one of the following three main sources: Benefits from the social security system Their regular savings account A retirement plan (for example, IRAs or employer-sponsored plans) In some cases, employers will establish a “qualified plan” which is the mechanism that handles the retirement benefits for their employees and their families. Whereas SEP and SIMPLE IRSs are linked to the IRA, a qualified plan has no connection to the IRA and therefore it does not need to abide by the same regulations regarding contributions and distributions. Businesses can choose to set up a qualified plan or an IRA-based plan. This decision will generally be made based upon how much the business is prepared to contribute and if they want and have the capacity to administer the plan. Qualified plans are more difficult to administer than SIMPLE IRAs or SEP. Qualified plans can be defined either by their benefits or contributions. Employers receive tax deductions in return for the contributions that they make to the plan. Employees are generally not required to pay taxes on the assets in the plan until after distribution. Another advantage is that earnings are tax deferred with qualified plans. For a plan to have “qualified” status, it is required to comply with the requirements set out in the Internal Revenue Code (IRC), the Employee Retirement Income Security Act 1974 (also known as ERISA) and the Department of Labor (DOL).

Defined-Benefit Plans

A defined-benefit plan is a qualified plan in which the retirement benefits that an employee receives are based on their personal characteristics, such as their compensation, age and years of service. An example of this is a plan that says that when an employee retires, his or her benefits will be 1% of the average salary that they received in the last five years with the company for the same period of time as their length of service. Another option is that the plan may state the exact amount (for example, $200 a month) of the benefit.

EXAMPLE: John spent 10 years working for ABC Company. He earned $65,000 in 2004, $70,000 in 2005, $80,000 in 2006, $90,000 in 2007 and 100,000 in 2008. This means that his average salary for his last five years was $81,000. In turn, that means that 1% of his last five years average salary is $810. According to the plan, John is entitled to receive $810 for the same number of years that he worked for the company, that is, for 10 years.

This is the predetermined retirement benefit and the employer is required to make contributions to equal this amount. In making these contributions they will use actuarial assumptions that take into account the expected investment growth. When the investments made by the plan fail to perform and do not reach the required amount, the employer must contribute more to make up the balance. Contribution limits are much higher for defined-benefit plans than defined-contribution plans. Operating a defined-benefit plan will usually require actuarial assistance as it is based on formulas and actuarial assumptions.

Defined-Contribution Plans

With a defined-contribution plan, the specific amount that the employee will receive when they retire is not promised. Employees, employers or (in some cases) both make contributions to these plans. The contribution is usually a percentage of the employee’s compensation package. The employer contributions may be compulsory or discretionary, depending on the type of plan used. The plan will invest the contributions on behalf of the employee. The benefit that they will receive upon retirement is based on the contributions that were made and the investment results (earnings or loss). In these types of plans, employers don’t have to compensate for the possible loss on the investments. These plans may take the form of a profit-sharing plan, a 401(k) plan, an ESOP (employee stock ownership plan) or a money-purchase pension plan.

Plan Definitions

Profit-Sharing or Stock-Bonus Plans

As the name suggests, a profit sharing plan is used by businesses to share profits with their employees. Employers are able to make these types of contributions whether or not the business actually profited during the year. These contributions will usually be discretionary, meaning that the employer decides whether or not they want to contribute to the plan in a particular year. Although this may seem a very flexible system, the employer cannot let too many years pass without making a contribution. The IRS doesn’t exactly specify the number of years that are allowed, but there are requirements that the contributions must be recurring and substantial.

With a stock-bonus plan the employer will use stock in the company to make contributions or distributions. These types of plans cannot be used by sole proprietorships or partnerships.

Profit-sharing plans and stock-bonus plans can have a 401(k) feature. These plans are well suited for newly established employers who are unable to accurately predict their future profit levels or who would like their contributions requirements to be flexible.

Money-Purchase Pension Plan

Generally speaking, money-purchase and defined-benefit plans have less flexible contribution requirements than profit-sharing plans. Money-purchase plans have fixed contribution levels that are not related to the profits of the business. For example, if the plan says that members will receive 10% of their compensation, then the employer must contribute that amount regardless of the company’s profits. These types of plans suit employers that have a clear picture of their profit trends and who don’t mind making compulsory annual contributions.

401(k) Profit-Sharing Plan

In a 401(k) plan employees can defer receiving a portion of their compensation and elect to have that amount put into their plan. This is also commonly known as CODA, which stands for “cash or deferred arrangement”. The deferred contributions (also known as “elective deferrals”) are usually made to the plan before tax. Employers will choose the type of plan that they use and it could either be a stand-alone 401 (k) plan or a plan that combines profit-sharing with 401(k). The employer will also choose whether they want to make additional contributions to the plan. 401(k) plans are designed for employers that want their employees to help with the plan funding.

Age-Weighted Plans

An age-weighted feature can also be added to retirement plan. This basically means that an increased proportion of the plan contributions will be allocated to older employees. This is based on the assumption that these older employees are going to retire sooner and have less time to build their savings. These plans suit situations where the business owners are much older than the employees and they have not yet accumulated sufficient retirement savings.

Employee Stock Ownership Plans (ESOPs)

ESOPs are a type of defined-contribution plan which involves investments primarily in stock of the company. These plans were authorized by Congress in order to encourage increased employee involvement in corporate ownership.

Why Establish a Qualified Plan?

Choosing the most suitable retirement plan is a business decision with huge financial implications. The plan needs to suit the immediate needs of the employer and to be consistent with their business and financial profile. Qualified plans benefit both employers and employees.

Benefits for Employers

• Some plans offer employers tax deductions when they make contributions
• It may enable the employer to attract and retain the best employees. A qualified plan may be the factor that makes a sought after employee select one company over another.
• In some situations the employer can claim a tax credit to cover part of the costs of establishing the plan. This is only possible if the expenses were incurred after December 31, 2001. The maximum credit available is $500 for the initial three years of the plans operation. This covers 50% of the establishment, administration and employee education expenses.

Benefits for Employees

• Employees have peace of mind from some guarantee of their financial security in retirement.
• Where the plan involves a salary-deferral feature, the employee can defer paying tax on the amount of compensation that they contribute to the plan until it is distributed. At this time their tax bracket will probably be lower so overall they will pay less tax.
• In some plans employees are permitted to take out loans from the plan. Interest on the loan is credited to the employee’s account. This makes it a better option that loans from a financial institution where the interest goes to that institution.

401(k) and Qualified Plans: Eligibility Requirements

Any type of business can set up an establishment plan. It doesn’t matter if the business is a sole proprietorship, a partnership, or corporation of a government entity. Employees cannot set up a qualified plan. The plan must be established by the employer.

Establishing a Qualified Plan

A qualified plan normally is made up of two documents: 1) the adoption agreement and 2) the plan document. The plan document sets out the provisions of the plans operation. The plan is formally adopted when the employer passes a resolution which says that they are adopting the plan. They will then complete the adoption agreement and issue a summary plan description (SPD) to employees. The SPD is required to be written in plain language so that all employees are able to understand it clearly. The SPD must include the following information:

• the plans location and identification number
• how the plan will operate and what it will provide for employees
• when it will commence
• how the benefits and length of employee service will be calculated under the plan
• when the employee will be entitled to their benefits
• when and how employees will receive their benefits
• how benefits should be requested
• possible situations where employees could be denied or lose their benefits
• rights of the employee under ERISA

It is important that employees read the SPD so that they are aware of the provisions of the plan that apply to them. When the plan’s provisions change, the employer must issue a revised SPD or a new document known as a summary of material modifications (SMM).

Choosing a Plan Provider

Employers have the option of establishing their own plan that is specifically designed for their business or choosing a plan designed by a sponsoring organization that has been approved by the IRS.

Individually Designed Plans

The point of an individually designed plan is to meet the specific needs of a particular employer. No other employers are permitted to use this document. These types of plans are typically used by large companies that have certain specifications in mind for their plan that they can’t get from a prototype. Individually designed plans are not required to be approved in advance by the IRS ,, however, the employer can apply for IRS approval if they want to be assured that the plan satisfies the regulations. They will need to pay a fee and ask for a determination letter. Lawyers and tax professionals are normally involved in drafting new plans and their fees will vary.

Master or Prototype Plans

Small businesses are often attracted to master or prototype plans that have already been approved by the IRS so there is no need to apply and pay for a determination letter. These types of plans can be used by more than one employer. In master plans, the operator will set up one trust or custodial account that will be used by all employers that adopt the plan. In prototype plans, separate trusts or accounts are set up for each employer. Several different types of organizations can sponsor master or prototype plans including:

• banks (this includes certain approved federally insured credit unions and savings and loan associations)
• trade unions or professional organizations
• mutual fund or insurance companies
• attorneys, financial planners or accountants

Establishment Deadline

Qualified plans are required to be established before the final day of the employer’s tax year. The employer is required to make contributions for that year and all subsequent years according to the provisions in the plan.

Eligibility Requirements for Employees (Plan Participants)

There are specific requirements that employees must meet in order to participate in the plan. It is important that business owners don’t implement requirements that would mean that they cannot participate in the plan. For example, if a business owner is 19 years old then a requirement that plan participants be over 21 would mean that he or she is excluded. Qualified plans will generally have the following eligibility requirements for employees:

The employee is over age 21. The minimum age of a plan cannot be more than 21 and employees under this age can be excluded. Maximum age limits are not permitted, meaning employees cannot be excluded for reaching an upper age limit.

The employee has been working for the company for at least one year. For plans other than 401(k) plans, this requirement is increased to two years of service. These plans also provide that after service of less than two years the contributions will be vested and the employee will have a non-forfeitable right to the total of his or her benefit. According to a qualified plan, one year of service is usually equivalent to 1,000 hours of service per plan year. Employees who don’t work 1,000 hours in a year are not considered to have worked for one year even if they worked over a 12 month period.

Exceptions to these eligibility requirements may be implemented by employers (for example, they may reduce the minimum age or change the required hours of service). There are some eligibility criteria though that must conform to the regulations governing qualified plans. Employers must consult with a lawyer regarding eligibility requirements that haven’t been approved by the IRS before implementing the plan.

Excludable Employees

Employers are permitted to exclude certain employees from the plan, for example those who are unionized or nonresident aliens.

Vesting - Employees Non-Forfeitable Rights to Employer Contributions

The term “vesting” refers to the process whereby the employee becomes entitled to a non-forfeitable right to access the benefits that their employer has contributed. Vesting schedules have been set up to meet regulatory requirements and qualified plans need to abide by these requirements. Employees will always have vesting rights in relation to the contributions that they make to the plan. There are two different type of vesting schedules that an employer can choose from. They are:

Cliff Vesting. With a cliff-vesting schedule the employee is required to stay with the company for three years of service before the employer contributions will be considered vested. Following three years, these contributions will be 100% vested.

GradedVesting. With graded-vesting schedules, the employer contributions will become 20% vested after the employee has completed two years of service. The vesting then increases by 20% in each subsequent year until it gets to 100%. This will occur following six years of employee service.

Exchange-Traded Funds (ETFs)

Exchange-Traded Funds (ETFs) (Examples of funds are listed, but this listing in no way implies a recommend to invest in particular funds. TeachMeFinance.com is intended for educational purposes only. TeachMeFinance.com is an informational website, and should not be used as a substitute for professional financial, legal or medical advice. Please contact your attorney or accountant before making actual investment decisions. Also please read our disclaimer.) ETFs are generally considered to be a good investment option for all levels of investors, from very experienced money managers to people who are getting started cresting their portfolio. ETFs can be used as the sole component of an investment portfolio. It is possible to create a diverse portfolio that consists only of a few ETFs. Alternatively, ETFs can also be used in conjunction with other investment strategies. Like any other investment option, it is essential that investors understand how ETFs work and how they should be used. ETFs are quite straightforward investment vehicles. They trade similarly to stocks and appear to be similar to mutual funds. The performance of an ETF is based on an underlying index. There are some structural differences between an ETF and a mutual fund. There are also differences in the way that these two types of funds are managed. ETFs are more passively managed due to the fact that they track an index. Investors with mutual funds will normally use a more active management style. An index mutual fund (for example, the S&P 500) and an ETF based on tracking the same index (for example, the SPDR S&P 500 ETF) would be considered equivalent from an investment point of view. These two funds would perform very similarly. The main difference is availability. Mutual funds are generally only available for major indexes, while ETFs are available for a larger range of indexes giving more investment

ETFs are a lot more recent than mutual funds. The first ETFs in the United States were the S&P 500 depository receipts. These were launched by State Street Global Advisors and are commonly referred to as SPDRs or “spiders”. Originally, ETFs were available to track broad market indexes, however the application of ETFs has now spread into different sectors, commodities, currencies and global investments. Morgan Stanley has released information claiming that, at the end of 2007 there were 1,171 ETFs in existence throughout the world and the combined value of these ETFs was $800 billion. An ETF basically means that you have a share in owning a unit investment trust (UIT). A UIT holds diversified portfolios consisting of a range of stock, bonds, commodities and currency.

Comparisons are often made between ETFs and mutual funds. These include:

• Both ETFs and mutual funds involve the pooling of the assets held by investors. Professional managers are then used to invest the money in ways that are designed to meet clear objectives (for example, capital appreciation). Both types of funds will also have a prospectus. Purchasers of an ETF will receive a prospectus and investors are provided with a product description which outlines the important ETF information.
• When an investor purchases or redeems from a mutual fund, they do so according to the NAV (net asset value) of the fund. The NAV is calculated on a daily basis. When an investor buys an ETF the shares are purchased on the stock exchange in the same way as any other listed stock. There are a large number of index mutual funds that are available and they are usually actively managed. ETFs are usually passively managed because they track according to specific indexes, but there are a few actively managed ETFs.
• ETFs and mutual funds have opposite creation and redemption processes. With mutual funds, interested investors send cash to the company that is managing the fund and it is used to purchase shares and securities which are issued to the fund. When it comes time to redeem, the investor is paid cash for the return of the shares to the mutual fund. The ETF creation process does not involve cash at all.

Creation
When an ETF is created, the investor is issued a security certificate that says that they have the legal right of ownership in relation to part of a collection of stock certificates. Before an ETF can be created in the United States, a fund manager is required to send a detailed plan outlining the procedures and composition of the fund to the Securities and Exchange Commission (SEC). Generally speaking, this can only be done by the biggest of the money management firms because they have the best contacts (in terms of major investors, international money managers and pension funds) that are required to create ETFs. These firms are also able to facilitate the demand for new ETFs (either with institutional or retail customers). The next step in the creation process involves a middleman (known as an authorized participant, market maker, or specialist) assembling the collection of stocks. They will usually assemble enough to purchase between 10,000 and 50,000 ETF shares. These shares (known as the creation unit) are delivered to a custodial bank who then forwards them to the market maker.

Redemption

When an authorized participant wants to redeem shares they will buy a large amount of ETFs and send them to the designated custodial bank in return for an equal amount of individual stocks. These shares are generally returned to the institution from which they came, but they can also be sold on the stock exchange. There are two ways for an investor to redeem an ETF:

• They can submit the shares to the fund that is managing the ETF in return for the underlying shares.
• They can simply sell the ETF to another investor on the secondary market.

In most cases investors will choose the second option. This difference in redemption methods is one of the biggest differences between ETFs and mutual funds. ETFs cannot be called mutual funds because of the limited options to redeem them.
Arbitrage
The opportunity for arbitrage is one of the most distinctive and important characteristics of an ETF. In a situation where the price of the ETF begins to split from the NAV of the stocks that it is comprised of, participants are able to take actions to profit from the differences. If the shares in an ETF are trading for a price that is lower than the NAV, then the shares are bought by arbitrageurs on the open market. The arbitrageurs use the shares to make new creation units which are then redeemed with the custodial bank in return for the underlying securities. When ETF shares are trading for a higher price than the NAV, the arbitrageurs purchase the underlying securities. These are then redeemed for creation units and the ETF shares are sold to make a profit. Arbitrageur actions mean that ETF prices and the underlying NAV remain very similar.
Popular Types of ETFs
SPDRs SPDRs stands for Standard & Poor’s Depositary Receipts. These are managed by a firm called State Street Global Advisors (or SSgA). SPDR S&P 500 EDF is the most popular in the range of SPDRs available. There are also ETFs that track each of the main S&P 500 sectors. These are known as Select Sector SPDRs.
iShares iShares is a type of ETF that is managed by Barclays Global Investors. This money management firm is the largest global provider of ETFs (according to research conducted by Morgan Stanley). They provide ETFs in a broad range of sectors both in the US and internationally, including various industry sectors, commodities and fixed income.
Vipers VIPERS stands for Vanguard Index Participation Receipts and these ETFs cover a broad range of different industry sectors, international ETFs and bond ETFs. These types of ETFs are issued by Vanguard, a firm that is well known for offering a wide choice of index mutual funds.

PowerShares This is a new player in the ETF market. Powershares most popular ETFs are the QQQQ or Nasdaq 100 ETF. They also offer ETFs that are quantitatively based, meaning that they use “dynamic indexing” to constantly find the stocks that are performing the best in each index. Powershares offer ETFs in industry sectors, the broad market, fixed income, international indexes, commodities and currency.
Features
Most ETFs will track a particular index. This means that their performance will always be very similar to the index fund, but not exactly the same. Sometimes there will be a difference between the returns of index and the fund. This is known as a tracking error which will occur as a result of inconsistent composition, management, expenses, and dealing with dividends. These factors are considered in further detail below:
Small investors can benefit from trading in ETFs
Buying and Selling ETFs Can Be Good for the Small Investor
ETFs have continuous pricing, meaning that they can be traded on the stock exchange at any time during the trading day. With ETFs you can place an order such as a limit order or a stop loss order in the same way that you would with individual stocks. You can also sell ETFs short. There is a difference in the pricing of mutual funds and ETFs. The prices of mutual funds are determined by the net asset value (NAV) that they have at the end of a trading day. ETFs, on the other hand, are priced according to the market prices that are listed on the exchange. These are similar to, but independent of, the NAV. The actions of arbitrageurs mean that the values of ETFs and the NAV will remain very similar. It’s possible for investors to purchase just one share of anETF, however most will buy a board lot. Purchases of less than a board lot are much less cost-efficient for investors. Investors are able to buy ETFs from anywhere in the world. This is another advantage when compared to mutual funds, as mutual funds can usually only be bought where they are registered.

Treatment of Dividends
Dividends from the underlying stocks of an ETF are typically paid out each quarter. The underlying stocks may pay dividends several times during the quarter, meaning that the fund is holding cash. This occurs regardless of the fact that the underlying benchmark is not made up of cash. When an ETF pays a dividend, the cash is sent to the investors brokerage account just like it would be with regular stock. To reinvest that amount, the investor is required to make another purchase.
Tax Efficiency
ETFs will usually offer investors bigger tax benefits than a mutual fund because they are passively managed. The low turnover of securities means that the generated capital gains are much smaller and less frequently realized than with an actively managed fund. Securities in an index ETF are only sold when there is a change in the underlying index. A mutual fund’s e unrealized capital gains accumulate when the stock rises in value. The capital gains are then distributed proportionately to investors when the fund decides to sell the stocks. This means that these investors have to pay higher taxes.

Transparency
Because ETFs closely replicate the actions of the index or commodity to which they are linked, investors are always aware of the value of what they are buying and what the ETF is comprised of. The fees are also a lot more obvious with ETFs. Mutual funds are only required to report what stock they hold twice annually which means that there is not as much transparency for investors.
Fees and Commissions
One of the principle advantages of an ETF, when compared to a traditional mutual fund, is the low annual fees that they charge. The passive management structure, reduced expenses of marketing, distribution and accounting, are all factors that mean that ETFs have lower fees. One possible problem is the fact that investors will have to pay a brokerage fee each time that they buy or sell shares in an ETF. When an investor is doing this often it will dramatically increase the cost involved in their ETF investment. However, new budget brokerage fees are now becoming more common, meaning that ETF trading is more cost efficient for small or frequent purchases.
Options
Several ETFs now come with tradable options. These can be used together with the underlying ETF to formulate new investment strategies. Using these strategies investors can create additional leverage in their portfolios.
SPDR S&P 500 ETF
The SPDR S&P 500 ETF is the original ETF in the United States and it is now the most popular. This ETF is managed by State Street Global Advisors and it tracks the S&P 500 Index which is one of the most popular indexes throughout the world. State Street Global Advisors are one of the largest ETF management firms in the world.
SPDR S&P 500 ETF Objective
The purpose of the SPDR S&P is to mirror the S&P 500 Index as closely as possible in terms of the value of the return before expenses. In 2008 there were 525 million outstanding shares on the S&P 500 Index and it had a total net asset value of just over $73 billion. The S&P 500 Index is available to be traded on the American Stock Exchange (the AMEX) where it is represented by the letters SPY. SPY is one of the most popular stocks on the AMEX. It trades over 100 million shares each day. On particularly busy days it can trade more than 400 million shares.
Characteristics of the S&P 500 Index
The S&P 500 is an index that is made up of the market capitalization trading of 500 companies that are the largest in the United States. This index represents approximately 75% of the total equity market capitalization in the United States, according to Standard and Poor’s, and is referred to as a large cap index. There are 10 industrial sectors represented in the index according to the Global Industrial Classification Standard (GICS).

Performance of SPDR S&P 500 ETF
The annual returns of both the S&P 500 Index and the SPY ETF are provided. These returns refer to the returns for the designated periods as of April 30, 2008.

• 1 year S&P 500 Index -4.68% , SPY ETF 4.67%.
• 3 year, S&P 500 Index 8.23% , SPY ETF 8.16%.
• 5 year, S&P 500 Index 10.62% , SPY ETF 10.56%.
• 10 year, S&P 500 Index 3.89%, SPY ETF 3.78% .

As illustrated in the above table, there is a very close relationship between the SPY ETF and the S&P 500 index. The slight difference results from the higher expenses that are incurred by the SPY. Many investors consider SPY to be a good equity holding to have partially due to the fact that its expense ratio is quite low.

EXAMPLE: Assume that on May 21, 2008 an investor buys 300 shares for a closing price of $129.75 each. This would cost $38,925.00 with the commission not included. The expense ratio of this transaction is .0945%. This adds about $37 to the annual cost for the investor.

Investors may purchase the SPY in order to give exposure to the US stock market in his or her portfolio. In other cases, an investor may want to combine the spy with other ETFs to create a customized exposure in relation to US stocks. The ETF can also be actively traded. Its popularity means that it is very easy to liquidate and it can be bought and sold regularly without incurring large extra costs.

Active Vs Passive Investing

Indexing has been very popular with institutional investors for some time , but it has only recently been used by individual investors. The first issue for investors to consider is whether they want to adopt a passive or active investment strategy. Indexing and trading in ETFs are predominantly considered to be passive strategies.

Rationale for Active Investing

Most investors these days use active investment strategies in an attempt to profit from outperforming the market. Active management techniques are based on beating a specific market benchmark. Most mutual funds adopt an active management strategy. Active managers devote a lot of time to gathering information and insights (based on market trends, economic factors and company-specific data) on which to base their investment decisions. The ultimate goal of these investors is to outperform the market and many of them will use complicated systems to guide their security selection and trading. These active managers use a wide variety of different active management methods which are generally based on a combination of fundamental, technical, quantitative or macroeconomic analysis. Active managers try to use their insight to exploit any inefficiencies, anomalies or irregularities that may exist in the capital markets. Prices on the capital market are generally quite slow to react to new information and this allows fast and skillful investors to profit.

Rationale for Passive Investing

A passive management strategy is based on making exactly the same investment (the same securities and proportions) as an established index like the S&P 500 or the Dow Jones Industrial Average. This is also referred to as indexing. In these cases the managers of the portfolios are not required to make any decisions at all about which securities they will buy and sell. They are simply applying identical investment methodology as the indexes, and is called passive investing. The passive manager is attempting to match the performance of the index. These types of investors will invest in a wide variety of the market using different indexes or asset classes. They are prepared to accept the average return produced by a particular asset class. This investment strategy is based on the efficient market hypothesis (commonly referred to as the EMH). This theory is based on a rationale that the market is quick to reflect available information and therefore prices will always be fair. Investors who believe in EMH think that it is very difficult for any type of investor (large or small) to consistently outperform the market. Their goal is not to outperform the market, just to match it.

Which is better? - Passive or Active Management

This has been a topic of debate since the 1970s. Academic researchers at universities and other private research institutions argue in favor of passive management strategies. Banks, insurance companies and Wall Street firms support active management strategies because they have a vested interest in profiting from this type of investment. Logical arguments can be made by both sides. The difference generally comes down to different philosophies, similar to the difference between political parties. The advantages and disadvantages of both sides are briefly outlined below:

Active Management – Advantages and Disadvantages

ADVANTAGES:

• Active managers can use their superior skills to outperform the index. Making informed decisions resulting from research, knowledge and experience means that their investment decisions will frequently lead to good performance.
• Active managers are able to execute defensive strategies to guard against a market downturn. If they foresee a market downturn, they can hedge or increase their cash positions so that their portfolios are not affected too badly.

DISADVANTAGES

• There are higher costs (fees and operating costs) involved in active investing. This factor can impede the consistent long term performance of an active manager.
• Active managers will generally have portfolios that concentrate on a smaller base of securities. This means that if their investment decisions are wrong they could under-perform significantly. Their investment decisions may not reflect market reality for an extended period of time, meaning that their portfolio fails to perform.

Passive Management – Advantages and Disadvantages

ADVANTAGES

• Passive investing will always closely match the index performance level. The strategy is based on tracking the chosen index as efficiently as possible.
• The manager is not required to make very many decisions in relation to the investments.
• This strategy has much lower operating costs and the investor benefits from this by having to pay much lower fees.

DISADVANTAGES

• The performance of a passively managed investment will never exceed the underlying index that it is tracking. The investor must be happy to be limited by the performance of this index.
• There is nothing that passive investment managers can do if they foresee a general market decline or if they want to sell individual securities.

Index Funds Vs. ETFs

In many ways, it can be very difficult to compare mutual funds (actively managed) and ETFs (passively managed) because they have completely different characteristics. If an investor wants to utilize a passive investment strategy, then he or she should consider the best way for it to be implemented. This will involve using either index funds or ETFs.

Index Funds and ETFs

Index funds have been available in the United States for a lot longer than ETFs – Index funds were first traded in the 1970s and ETFs in 1993. The number of ETFs and index funds now in existence is very similar, but ETFs have a much broader spread (they cover around 5 times more indexes than index funds). There are some indexes where it is more appropriate that they are covered by an ETF than an index fund and these are usually dealt with by newer ETF structures. This means that some indexes can only be tracked using an ETF because there is no available index fund for that particular index.

Costs

Index funds and ETFs have distinct advantages and disadvantages in terms of the costs involved and this can often be the factor that makes one preferable to the other. No-load index funds can be purchased free of any transaction costs. ETFs, on the other hand, require the payment of brokerage commissions.

Tax Efficiency

In most cases, an ETF will have greater tax benefits than the equivalent index fund. This is due to the creation and redemption processes for ETFs and the fact that these processes eliminate the selling of securities. Index funds involve the buying and selling of securities which results in the distribution of capital gains to unit holders. Even though index funds have lower turnover than other type of active managed funds, they still result in higher taxes than an ETF.

Dividends

ETFs accumulate and distribute dividends and interest from the securities to shareholders on a quarterly basis. Index funds do not accumulate dividends or interest but immediately invest them.

Rebalancing

People who invest in ETFs and index funds will sometimes want to rebalance their portfolio. This involves selling some positions that they hold and purchasing new ones. When investors want to rebalance their ETFs they will have to pay commissions for each sale and purchase. It will also be very difficult for this investor to get the exact proportion of ETFs that they want because ETFs are generally traded in board lots. It is even more difficult for small portfolios. This is not a problem with index funds because the investor is able to buy fractional units. This means that they can get the exact weightings that they want. There isno transaction costs involved in no-load funds.

Dollar-Cost Averaging

Attempting to use dollar-cost averaging (that is, trying to spend a designated amount on your portfolio at regular intervals) is generally considered to be impractical for ETF trading. It becomes very expensive to implement this technique, due to the commissions and the additional costs of buying odd-lots. Dollar-cost averaging, as an investment strategy, is better suited to mutual funds.

Liquidity

The costs of ETF trading are also increased by their lack of liquidity. This lack of liquidity has the effect of increasing the bid-ask spread. Smaller and less popular ETFs are also unlikely to attract the same level of interest from arbitrageurs which means that there may be a large difference between the net asset value of the stocks and the prices on the market. With index funds, this difference doesn’t exist and investors will always get the end of day NAV.

Equity ETFs

ETFs were originally developed so that portfolios could be diversified and linked to equity indexes. Equities make up a core asset class for investors so it is very important that investors are aware of the different ETF options that are available before they invest.

Broad-Based U.S. ETFs

Broad-based ETFs (also known as total market ETFs in the United States) cover the entire US equity market. Popular indexes, such as the S&P 500 and the Dow Jones Industrial Average, cover only a section of the whole market. The S&P 500, for example, represents around three-quarters of the US market capitalization. A total market ETF has a broader reach and enables investors to cover all US equities using a single ETF. These types of ETFs are usually inexpensive as well as having low expenses and narrow bid-ask spreads. They are also a lot less volatile that ETFs that are more focused. Three of the most popular broad-based indexes include:

• SPDR DJ Wilshire Total Market ETF
• iShares Russell 3000 Index Fund
• iShares Dow Jones U.S. Total Market Index Fund

All World ETFs and All World Excluding U.S. ETFs

It is also now possible for investors to diversify their portfolio to cover global equities by investing in an all world ETF. These ETFs cover most stock exchanges throughout the world. There are different types of global ETFs available depending on whether you want to include the US market (all world ETFs) or exclude the US market (all world ex-US). The all world excluding US option is generally preferred by investors who already own US stocks. Examples of these types of ETFs include:

• iShares MSCI All Country World Index Fund ETF
• SPDR S&P World ex-US ETF

Developed Versus Emerging Markets

There is a considerable difference in the characteristics of stocks that are available in the developed world compared to those in emerging markets. These are similar to the differences between large and small cap stocks. When thinking about the best way to construct a portfolio, it makes good sense to consider the three following entities separately:

• US equities
• Developed countries excluding the US (Europe, Australia, Far East )
• Emerging markets

Sector ETFs

With sector ETFs an investor is able to invest in stocks in several different industrial sectors. These can be used either to build a diverse portfolio, or to invest in a specific industry (for example, energy or technology). Using sector ETFs to build a portfolio means that you have a greater ability to fine-tune the portfolio creation than you would with a broad-based ETF. The portfolio can also be easily rebalanced regularly. The performance of the portfolio can also be improved by selling sectors that have performed well and buying sectors that have underperformed. With sector ETFs you are able to avoid trading in industrial sectors that are overvalued. These types of ETFs are usually more expensive, and have higher operating costs, than broad-based ETFs. It is advisable not to blend different industrial sectors when you are trading in ETFs. Two examples of sectors ETFs are:

• Barclays iShares Dow Jones Sector ETFs
• State Street Global Advisors S&P Sector ETFs

Market Capitalization ETFs

Stocks can also be divided into three separate categories according to their market capitalizations. These categories are small, mid and large cap stocks. Investors are able to fine tune their portfolio by investing in ETFs that cover each of these three categories. This gives a wider opportunity for customization. The family of ETFs should not be mixed when adopting this approach. Three examples of these different market cap ETFs are:

• SPDR DJ Wilshire Small Cap ETF
• SPDR DJ Wilshire Mid Cap ETF
• SPDR DJ Wilshire Large Cap ETF

Growth and Value ETFs

Investors can also choose to purchase ETFs that are either value or growth stocks. Value stocks generally seem to be a relatively inexpensive option. They have a low P/E ratio, high-dividend yield and the price to book value is much lower than other ETFs. When looking at the current fundamentals growth stocks seem more expensive, however it is assumed that they will produce higher earnings, dividends and value in the future. An entire market ETF provider categorizes stock as being value or growth stocks so they will appear in only one ETF. Examples of these types of ETFs include:

• iShares Russell 3000 Growth Index Fund
• iShares Russell 3000 Value Index Fund

Leveraged ETFs

Leveraged ETFs are one way to invest in broad market indexes in the US with a higher level of volatility. One example of a leveraged ETF is the ProShares Ultra S&P 500 ETF, which is the leveraged version of the S&P 500. Investing in this leveraged ETF means that if the value of the S&P 500 increases by 1%, the value of the Proshares ETF will increase by 2%. This also applies to decreases in value. A leveraged ETF is different to a regular ETF in that it uses options and futures rather than index stocks. Futures provide a higher level of leverage and the extra cash that this generates is used to buy bonds. The bond investment covers the running costs of the ETF and increases the dividends that are paid to the investors.

Active traders often use leveraged ETFs to trade in short-term movements on the market. Leveraged ETFs are also used to gain access to increased index exposure without getting into debt. Retirement accounts will also often use leveraged ETFs as these accounts are usually prohibited from engaging in margin lending. The expense ratios for leveraged ETFs tend to be higher than standard ETFs. Three popular leveraged ETFs are:

• ProShares Ultra S&P500 ETF
• ProShares Ultra QQQ ETF
• ProShares Ultra MidCap400 ETF

Quantitative ETFs

Quantitative ETFs give investors the capacity to outperform an index. They do this by using enhanced indexing. A set of predefined rules are used to rank stocks within an index based on a variety of characteristics. This ranking process uses both technical and fundamental factors to indentify a group of stocks in an index that are more likely to perform well. The best stocks are then selected and used to form a new index. The new index is made up of a small group of stocks and these can be rebalanced each quarter in order to reflect rankings changes. Another type of quantitative indexing is the fundamentally-weighted index. This is not based on market capitalization, but instead uses cash flow and earnings to value stocks. A disadvantage of investing in a quantitative ETF is that the stocks that it includes are not visible. This makes creating a diversified portfolio a difficult process. The quarterly rebalancing also means that there may be more trading of stock which will result in higher expenses as well as reducing the tax efficiency. Quantitative ETF examples include:

• First Trust Large Cap Core AlphaDEX Fund
• PowerShares Dynamic Market Portfolio

Fixed-Income and Asset-Allocation ETFs

Since their creation (as an alternative way of trading equities), ETFs providers have broadened their scope to now include bond and asset allocation ETFs. Asset allocation refers to those ETFs that encompass a range of different classes of assets.

Fixed Income ETFs

One disadvantage of bonds is that they lack the liquidity and transparency of equities. Also, bonds are not traded on an exchange in the way that stocks are. Bond ETFs eliminate these disadvantages. They are traded on an exchange and they have similar liquidity and transparency as stock ETFs. Whereas stock ETFs will usually be made up of all the stock in a particular index, with bond ETFs the fund will hold a proportion of the bonds in the underlying index. The calculation of bond prices involves a relationship between the coupon, the rate, the bond quality and the time before it matures. The fund managers use these factors and a sampling technique which enables them to replicate the performance of the underlying index. With bond ETFs, interest is paid out each month, and capital gains are paid annually. These dividend payments are classed as interest or capital gains for tax purposes.

Broad-Based Bond ETFs

There are also broad-based bond ETFs that are similar to the broad-based stock ETFs outlined above. These ETFs contain a mixture of government and corporate bonds at various stages of maturity. Broad-based bond ETFs are usually considered a fundamental part of a bond portfolio. The iShares Lehman Aggregate Bond is an example of a broad-based bond ETF.

Yield Curve Bond ETFs

Another option for investors is to purchase Treasury bonds at different maturity stages of the yield curve. Investors will generally use short-term bond ETFs as a place to secure their money to earn a good return, while the long-term bond ETFs are typically used to speculate on fluctuations in interest rates. Examples of different yield curve bond ETFs are:

• iShares Lehman 1-3 Year Treasury Bond Fund
• iShares Lehman 3-7 Year Treasury Bond Fund
• iShares Lehman 7-10 Year Treasury Bond Fund
• iShares Lehman 10-20 Year Treasury Bond Fund
• iShares Lehman 20+ Year Treasury Bond Fund

Inflation Protected Bond ETFs

Treasury Inflation Protected Securities (or TIPS for short) are linked to inflation in that the interest that they pay is equal to the Consumer Price Index (CPI) plus a predetermined amount. These funds are designed to guard against inflation and will generally perform better than regular bonds when a rise in inflation is expected. The iShares Lehman TIPS Bond Fund is an example of this type of ETF.

Asset Allocation ETFs

Asset allocation ETFs are relatively new offerings for a lot of mutual fund companies. These ETFs involve investing in a range of different asset classes so that investors can get a fully diversified portfolio after buying only one ETF. Popular asset allocation ETFs include:

• PowerShares Autonomic Balanced NFA Global Asset Portfolio
• PowerShares Autonomic Balanced Growth NFA Global Asset Portfolio

Target Date ETFs

Target date funds (also known as life-cycle funds) have experienced a surge in popularity in recent years, particularly within the pension plan market. ETFs with the same features of these funds have also recently been created. These funds are identical to balanced asset allocation funds except for one important difference – as they get nearer to the target date the fund will reduce risks and adopt a more conservative approach. They do this by selling risky stocks and purchasing more secure bonds. These funds are primarily used where the investor has a savings goal that they want to reach at a designated end date. They are commonly used for retirement savings. Investors who invest in target date ETFs do not need to manage the investment at all, they don’t need to make any further decisions after purchasing the ETF. Three popular target date ETFs currently available are:

• TDAX Independence 2010 ETF
• TDAX Independence 2030 ETF
• TDAX Independence 2040 ETF

ETF Alternative Investments

Investing in alternative asset classes is a good way to further diversify a portfolio and add to the core components which are usually equity investments and fixed income. Alternative investments are suitable for both trading and hedging. Several different ETFs enable investments in foreign currencies or commodities. Another option is using inverse ETFs to profit from a decline in the market.

Currency ETFs

As the name suggests, currency ETFS were introduced to track currency fluctuations in the exchange market. These ETFs are based on underlying currency investments which come from futures contracts or foreign cash deposits. Where the ETF is based on futures the excess cash is usually invested in US Treasure bonds (or other bonds). Any fees and operating expenses are deducted from the interest earned.

There are currently several different types of currency ETFs available. You can purchase an ETF to track an individual currency or a group of currencies. A currency ETF is not suitable as a long-term investment option. It is usually better to purchase foreign stock or bond ETFs if you want to diversify away from US dollar investments. Currency ETFs can be useful for hedging against exposure to foreign currencies. Some popular currency ETFs include:

• PowerShares DB U.S. Dollar Bullish Fund (AMEX:UUP)
• PowerShares DB U.S. Dollar Bearish Fund (AMEX:UDN)

Commodity ETFs

Investing in a commodity ETF is another way to diversify a portfolio because commodities are a distinct class of assets compared to stocks and bonds. Commodity investment can also be a way to protect against inflation as it involves hard assets. There are three types of commodity ETFs:

• ETFs tracking an individual commodity (for example, gold or oil)
• ETFs tracking a group of different commodities
• ETFs tracking a selection of companies that all produce the same commodity

Commodity ETFs will hold either a future contract to purchase the commodity, or they will hold the actual commodity. If they purchase a futures contract then there will be uninvested cash and this is used to buy government bonds. Interest earned on the bonds is used to pay any expenses incurred by the ETF and to pay dividends. Examples include:

• iShares GSCI Commodity-Indexed Trust ETF (PSE:GSG)
• · PowerShares DB Commodity Index Tracking Fund ETF (PSE:DBC)

Inverse ETFs and Leveraged Inverse ETFs

Inverse ETFs allow investors to put their money against the market. They are designed to react in the opposition way to the benchmarks that they are tracking. For instance, when the S&P 500 increases by 1%, the inverse ETF linked to that index would decrease by 1%. If the S&P 500 decreases by 1%, then the inverse ETF will increase by 1%. Leverage Inverse ETFs operate in the same way, but with double the difference. For example, if the S&P 500 decreases by 1%, the leveraged inverse ETF will increase by 2%.

Inverse ETFs use either futures contracts or short positions. Where they use futures contracts, the excess cash is invested in bonds and the interest this generates is used to cover the costs of the ETF and pay dividends. There are several factors that support the use of inverse ETFs. For example, if an investor has a particular position that they don’t want to sell (due to illiquidity or unrealized profits) then it may be difficult for them to make a bearish bet. Buying an inverse ETF is one way that these investors are able to hedge. For many investors this option is preferable to short selling an index. Tax-deferred accounts can be used to purchase inverse ETFs, whereas selling stocks short is not permitted due to the possibility that the investor will be exposed to unlimited losses. With an inverse ETF an investor can only lose the ETFs value. Inverse ETF examples include:

• ProShares Short QQQ ETF
• ProShares Short S&P500 ETF

Leveraged inverse ETF examples include:

• ProShares UltraShort QQQ ETF
• ProShares UltraShort S&P500 ETF

Investment Strategies using ETFs

Using ETFs adds a significant amount of flexibility to the portfolio creation process and other investment strategies. The investment strategies vary from the simple (portfolio diversification) to the very sophisticated (such as complicated hedging techniques).

Core Holding

Investors might want to consider having ETFs to make up the core holdings of their portfolio. This is an easy way to create a diversified portfolio that covers most asset classes with minimal expense. This is a good starting point from which an investor can customize their portfolio by adding other securities or funds.

Asset Allocation

ETFs make asset allocation easy; you could even purchase an ETF that is designed with asset class diversification in mind. Depending on the investor, an active or passive approach can be adopted. They can actively rebalance the portfolio to give additional weight to the individual assets that are expected to perform the best. Alternatively, they can adopt a passive approach to rebalancing and simply ensure that there is a strategic mix that will provide good long term returns.

Diversification

Another advantage of ETFs is the broad range of portfolio diversification that they open up for the investor. With ETFs, an investor can create a portfolio that includes all major classes of assets, including equity (both US and foreign), and fixed income. They can also purchase investments that are unrelated to these major assets, such as commodities, emerging markets, real estate and many more.

Hedging

An investor can also use ETFs for hedging strategies. If an investor expects the market to decline, then they are able to buy inverse (or leveraged inverse) ETFs to hedge against this. These ETFs increase in value when the market is in decline. Similarly, when the investor expects there to be a period of inflation, they can invest in commodities or ETF bonds that are protected against inflation. Investors can also hedge any foreign currency risks that they hold with a currency ETF. Investors can also buy a short ETF as a hedging strategy for a specific stock. There are many different options for using ETFs for hedging. They may be used independently or with the underlying ETF.

Cash Management

Some investors will also use an ETF to “equitize” cash. This means that they are using the simplicity of the ETF structure to invest in the market on a short term basis until they decide what they want to do in the long term. This provides a way of parking money temporarily that will still generate an income.

Tax-Loss Harvesting

Tax-loss harvesting refers to the process of realizing a capital loss in an investment, and then using the funds from the sale of the investment to purchase similar stocks. This strategy means that the portfolio remains mostly the same. There is a rule that prevents investors from repurchasing a security that they have just sold for a loss within 30 days (this is known as the wash-sale rule). ETFs get around this rule by allowing the investor to buy an ETF that is substantially the same as the security or fund that they sold. The portfolio remains very similar and the wash-sale rule is not invoked.

Completion Strategies

ETFs enable an investor to create a well rounded portfolio without necessarily becoming an expert in each investment area. For example, an investor can purchase an emerging market index ETF without having to research the emerging market area. This increases the exposure that investors have to a broader range of sectors and asset classes.

Portfolio Transitions

ETFs also allow investors to ensure that their money is always working for them and that it is not dormant in-between investments. If an investor wants to move his or her assets to a different advisor or fund, then there will usually be a transition period before this occurs. Investing the funds in an ETF during this period means that they will continue to generate income.

Futures  
Profit And Loss - Cash Settlement

When it comes to calculating profits and losses of a futures contract, it will depend on the way that the market for that particular contract fluctuates on a daily basis. Take the above example of the price of the wheat futures contract. Say that the day after the farmer and baker enter into the above futures contract (for $5 a bushel) the futures contracts dealing with wheat increase to $6 per bushel. This means that the holder of the short position (the farmer) will have made a loss of $1 per bushel because he is obliged to sell his wheat at $5 instead of $6 per bushel. The holder of the long position (the baker) has made a profit of $1 per bushel as he now has to pay less than the market value in the future for the wheat. This profit and loss is reflected in the accounts of the farmer and the baker on the day that the value changes. The farmer has $6000 deducted from his account ($1 for each of the 6,000 bushels) and the baker has $6,000 added to his account. These changes are made each time the market moves and the value of the commodity changes. Futures positions are updated with profits and losses being added or subtracted from the trader’s account on a daily basis. This makes the futures market different from the stock market. The stock market doesn’t realize the gains or losses that have occurred as a result of changing prices until the investor sells the stock. The daily adjustment of prices in the futures market means that most of the transactions that are taking place in this market are settled in cash. The actual commodity that is being traded will be purchased in the cash market. Prices of commodities tend to maintain similar values in the case and futures markets. When the futures contract for a commodity expires, the prices in each market merge into one. The futures contract is settled whenever either party decides to close their futures position.
Take the above example of the wheat farmer and the baker; if the contract was settled at the time that the price was $6 per bushel, the farmer loses $5000 and the baker profits by $5, 000. After this settlement the baker then needs to buy the wheat in the cash market for the current cash market value which will be $6 per bushel. This means that he has to spend a total of $30,000 (5,000 bushels at $6 each). But, the profits that he has made on the futures contract will be put towards the wheat purchase, meaning that he ends up paying the price that was agreed on in the futures contract. The purchase price of the wheat on the cash market ($30000) less the futures profit ($) equals $25, 000 which is the value of the original futures contract (5,000 bushels at $5 each). After closing the contract, the farmer can then sell his wheat for the cash market value of $6 per bushel. However, because of the loss that he has made on the futures contract, the real value will actually be $5 per bushel. His losses are offset by charging a higher price when selling in the cash market. This process is known as hedging.
From the above scenario it is easy to see how futures contracts are actually financial positions that can be traded by speculators. In the above example, the two parties may not necessarily have been a farmer and a baker, they could have been speculators. Speculators trade in the futures contracts without trading the commodities on the cash market when the contract expires. The speculator with the short position in the above example would have lost $5,000 and the speculator with the long position would have profited by the same amount.
The Futures Market is Important for the Economy
The futures market is a very active market and is central to global trade and commerce. This makes it a good place to gather information about the market and economic sentiment.
Price Discovery
Because the futures market is highly competitive, it can be used as a tool to determine prices. This is done by looking at the current and estimated future levels of supply and demand. There is a high degree of transparency in the futures market because it relies on the continuous availability of information from all over the world. A lot of different political, social and economic factors (such as war, weather, default on debts, deforestation, migration and land reclamation) can influence levels of supply and demand, which in turn affects current and future commodities prices. The way that this information is viewed by people means that commodities prices are constantly changing. This is referred to as price discovery.
Risk Reduction
People also use the futures market to reduce their risks involved in purchasing commodities. The fact that the price is fixed means that participants are able to determine the quantity that they need to trade. Because there is less risk, there is a reduced chance that traders will increase their prices to cover any losses made in the cash market. This reduces the final cost to the consumer.

The Players
There are two categories of players in futures. They are known as hedgers and speculators.
Hedgers
A hedger is someone who trades in the futures market in order to guarantee the price of a particular commodity that will be sold in the cash market at some point in the future. Hedgers can include importers, exporters, farmers, and manufacturers. They use the futures market to protect themselves against the risk of fluctuating prices. The long position holder (the party who will buy the commodity) is attempting to lock in the lowest price that they can. The short position holder (the party who will sell the commodity) is trying to secure the highest possible price. The advantage for both parties is that the futures contract gives them both certainty relating to the price. Hedging with futures contracts is also a good way of securing a sufficient margin between the production costs and the retail value of a particular product.
EXAMPLE – A jeweler needs to purchase enough silver six months in the future to make products that have already been advertised at set prices. The jeweler would be in a very difficult position if the price of silver were to rise in the next six months as the prices of the products have already been set. The additional cost cannot be added to the retail cost so it would have to be absorbed by the jeweler. To prevent this from occurring, the jeweler needs to hedge his risk against a silver price increase. To do this he would need to purchase a futures contract that would be settled in six months time at a set price. Say that he got a price of $6 per ounce. If the cash market price of silver increased to $7 after six months then the jeweler would have avoided the price rise. However, if the cash market price of silver declined during that period, then he would have been in a better position if he didn’t enter into the futures contract. Because silver is a very volatile market, the futures contract is a good way for the jeweler to protect himself from risk.
Basically, hedging refers to the attempt to reduce risks by securing the prices of future transactions. Someone buying a futures contract in securities can hedge against futures increased in equity. If the equity price has increased when the contract expires, the contract can be closed at the increased value. Hedgers can also go short in a futures contract to hedge against a future decrease in stock prices. For example, a potato farmer can hedge against a future decrease in the prices of French fries. A restaurant can hedge against a future rise in the price of potatoes. A company that anticipates that it will need a loan in the future can hedge against higher interest rates, and a coffee shop can hedge against futures increases in the prices of coffee beans.
Speculators
Speculators are not using the futures market to reduce risk but are aiming to derive a benefit from the risky nature of the market itself. Whereas hedgers are aiming to protect themselves from price changes, speculators are aiming to profit from these changes. They increase the risks that they take on the futures market in order to maximize their profits. A speculator in the futures market will usually buy a contract at a low price with hopes of selling it at a higher price at some point in the future. They will usually be buying this type of futures contract from a hedger that is selling a low priced contract because lower prices are anticipated in the future. The speculator is not actually interested in purchasing the commodity involved in the contract. They are only interested in using the market to profit from the rising and declining prices of futures contracts.
Hedgers and speculators can be differentiated as follows:
The Hedger:

• In the short position the hedger is looking to secure a price to guard against the risk of lower prices in the future.
• In the long position the hedger is looking to secure a price to guard against the risk of higher prices in the future.

The Speculator:

• In the short position the speculator is looking to secure a price in anticipation of lower prices in the future.
• In the long position the speculator is looking to secure a price in anticipation of higher prices in the future.

Because the futures market is rapid in its response to the constant flow of information, speculators and hedgers are able to work together and benefit from the market. When the expiration of a contract gets close, the information about the commodity involved will become more solid. This creates an accurate picture of the true supply and demand and the price of that particular commodity.
Regulatory Bodies
The Commodity Futures Trading Commission (also known as the CFTC) is responsible for regulating the futures market in the United States. The CFTC is not a government agency. The National Futures Association (NFA) also regulates the market. The NFA is a self-regulatory agency that is authorized by Congress. It is subject to supervision by the CFTC. A broker or firm that wants to trade in futures contracts must be registered with the CFTC and the NFA. If there is any illegal activity on the futures market, the CFTC is able to initiate criminal proceedings against the person involved via the Department of Justice. A violation of the NFA’s code of conduct can lead to a person or company being permanently banned from participating in the futures market. Investors that want to trade in futures must become familiar with these regulations. It is also very important that the brokers or firms used by investors are appropriately licensed.
It is imperative that investors know their rights. If there is any conflict with brokers or brokering firms, an investor may seek arbitration with the NFA and compensation from the CFTC.
Characteristics
The calculation of gains and losses made on the futures market occurs a little differently to the stock exchange. Here is a brief explanation of the concepts used:
Margins
The definition of “margin” is different in the futures market and the stock market. In the stock market, margin refers to the money that is borrowed for the purpose of buying securities. In futures, the margin is an initial “good faith” deposit that a market participant is required to make into their account before they will be permitted to enter into a contract. This amount is used to cover any daily losses that may occur. The futures exchange specifies the minimum sum of money that is required as the initial deposit for each futures contract. This is known as the initial margin. This amount is refunded (with the gains or losses of the contract) at the time that the contract is closed. The amount of money that is held in the margin account will vary each day according to market fluctuations. The minimum initial margin set by the exchange will usually be between 5-10% of the value of the contract. This amount is reviewed frequently. If the market is particularly volatile, then the exchange will usually increase the required initial margin.
There is also a “maintenance margin”. This refers to the lowest amount that is permitted in an account before it is required to be topped up. If a margin account loses money consistently and it reaches the maintenance level, then the responsible broker will make a margin call. This involves the owner of the account making a deposit so as to replenish it to the initial amount.
EXAMPLE: Assume that you have entered into a futures contract with a $2000 initial margin, and a $800 maintenance margin. A series of declining prices in the market has meant that your account has reduced to $500. Your broker would then make a margin call and ask you to deposit a minimum of $1500 in the account. This would restore the value of the account to the $2000 initial margin.
An important point to note is that funds normally need to be delivered immediately after a margin call. If this is not done, the broker may be able to liquidate your entire position to cover the losses that they have incurred.
Leverage
When dealing with the futures market, leverage refers to controlling commodities with very large cash values while paying relatively small amounts of capital. Put simply, it refers to situations where you can pay a small initial margin to enter into a futures contract that is valued at much more than you have paid. People say that price changes in the futures market are leveraged to a much greater extent than other types of investments. This means that a small variation in the price of a futures contract can result in large profits or losses for the people involved. The high leverage exists because the initial margins are only a small percentage of the cash market value of the futures contracts. This makes the futures market a double-edged sword because it is very useful for traders, but can also be extremely risky. Where a futures contract has a small the initial margin (as a percentage of the value of the contract), it will have high leverage.
EXAMPLE: Assume that you purchase the long position of a futures contract where the commodity involved is 30,000 pounds of coffee, and that the initial margin for this contract is $5,000. The actual value of the coffee however, is $50,000. This will be viewed as an investment with very high leverage. The inherent risks of the futures market become more obvious when you understand the ways that leverage works. A highly leveraged investment will produce either huge profits or huge losses. Leverage means that even a small variation of the value of a futures contract will translate into very large gains or losses when compared with the initial margin that has been invested.
EXAMPLE: Assume that there is an anticipated rise of stock prices and, in order to capitalize on this, you purchase a futures contract. The index currently stands at 1300 and your initial margin is $10,000. The contract price is the index multiplied by $250, so upon entering into the contract it is valued at $325,000 ($250 x 1300). This means that whenever the index gains or loses a point, the account will be credited or debited by $250. Say that after 2 months the index was now standing at 1365. This would mean that you have earned $16,250 ($250 x 65). This is a profit of 162% on the initial margin! However, if the index lost 65 points then you would lose $16,250 and you would need to pay an additional $6,250 in order to cover your losses. These huge changes (either positive or negative) are brought about by only a 5% change in the index. In some cases the change to profit or loss can be more than the initial margin. This illustrates the riskiness of leverage. Even if a commodity does not seem to be very volatile in terms of its value, small changes can translate into huge profits and losses for the investor. This is due to the high leverage and small initial margins that exist in futures contracts.

Pricing and Limits
Competitive price discovery plays a large role in influencing futures contracts. Prices used in futures contracts are expressed in the same way as they are in the cash market. For example, they are quoted in dollar/cent value or per the relevant unit depending on the commodity (ounce, barrel, index point and so on). One important characteristic of futures contract prices is that there is a set minimum that restricts their movement. The futures exchange sets these minimums and they are referred to as “ticks”. An example may be a minimum that restricts the movement of the price of a bushel of grain (in either direction) to a quarter of a cent in one day. Investors need to understand the way that minimum prices will influence futures contracts.
EXAMPLE: Assume that a particular grain contract uses the minimum set above (one quarter of a cent). A futures contract for 2,000 bushels of grain would have a minimum of $500 ( 2,000 bushels x 0.25 cents). This means that the contract could earn or lose $500 each day.
There is also a limit set on the upper and lower prices that the contract can trade at. These boundaries are set on a daily basis. The upper and lower values are calculated by adding and subtracting the price change limit with the value of the contract at close on the previous day.
EXAMPLE: Assume that the price change limit for silver is $0.25 per ounce. If silver closed yesterday with a value of $6 then the upper price limit of silver today is $6.25 and the lower price limit is $5.75. If any futures contract dealing with silver reaches either of these boundaries during a day then the futures exchange will shut down all silver trading. New boundaries are calculated each day based on the value of silver at close on the previous day. The daily price is able to rise or fall by no more than $0.25 until it finds an equilibrium.
The fact that trading is closed when a commodity reaches the daily limit means that there may be some situations in which liquidation of a futures contract is not possible at a particular time. The futures exchange has the power to change price limits when necessary. They will frequently abolish price limits during the month of a contract’s expiration (this period is also known as delivery or the “spot” month). They do this because this is the most volatile trading period as each party is trying to get the best price before close.
The futures exchange and the CTFC also sets a limit on the amount of contracts or units in a particular commodity that one person is permitted to invest in. This is to reduce the possibility of unfair advantages when one person is able to control the market price. These are commonly referred to as position limits.
Strategies
Futures contracts are essentially based on attempting to predict the future value of a particular commodity or index. Speculators use a variety of strategies to benefit from rising and falling prices in the futures market. The most popular strategies used are going long or short, and spreads.
Going Long
Going long refers to entering into a futures contract to purchase and receive the particular commodity at a fixed price. Investors engaging in this strategy are attempting to profit due to price increases in the commodity in the future.
EXAMPLE: An investor buys a futures contract in June for 2000 ounces of gold at $250 an ounce. Delivery is due in September. The total price of the contract is $500,000 and the initial margin is $2,000. This investor is going long as they are anticipating that the value of gold will increase between June and September. Let’s say that the price of gold in August has risen to $252 per ounce. The investor can then sell the contract to realize the profit. The price of the contract is now $504,000 meaning that the investor can make a profit of $4,000. Given that this contract was highly leveraged (with an initial margin of only $2,000) the investor has made a profit of 200%. This is an example of successfully going long. However, remember that the investor would have had a 200% loss if they price of gold had dropped by $2 per ounce. Also bear in mind that if the margin fell below the maintenance margin at any time while the investor held the contract, he or she would have had to pay margin calls and this would also have affected the profit or loss.
Going Short
Going short refers to entering a futures contract to sell and deliver a commodity for a fixed price. An investor who uses this strategy is hoping to profit from decreasing prices. If a speculator sells high at a certain time, they can then repurchase the contract at a future date for a lower price and make a profit.
EXAMPLE: An investor researched the market and concluded that the price of oil would decline during the following six months. To make a profit she could sell an oil contract now at a high price and then re-purchase the same contract in six months time at the lower price. Speculators use going short to benefit from a declining market. Assume that this investor held an oil contract of 2000 barrels valued at $30 per barrel (so the total value is $60,000) with an initial margin of $3,000. She sold this contract in May for $60,000. In March the price of oil had fallen to $25 per barrel. She could then repurchase the contract for $50,000 and make a $10,000 profit. The going short strategy could still have ended in a large loss if the investor had made different decisions.
Spreads
The two strategies outlined above (going long and going short) both involve investing in contracts with the hope of profiting from changing prices in the future. “Spreads” is a different strategy. Spreads refers to the situation where an investor purchases two contracts dealing with the same commodity and attempts to benefit from a difference in price between them. This is a much more conservative approach to futures trading because it is less risky than going long or going short. Some of the different forms of spreads include:
Calendar Spread – An investor is simultaneously buying and selling futures contracts in the same commodity with identical prices but different expirations.
Inter-market Spread –An investor has two contracts that expire in the same month but they deal with two different products. In one market they go long and in another they go short.
Inter-Exchange Spread –An investor creates positions in two or more futures exchanges. For example, they enter into futures contracts in futures exchanges in both London and Chicago.

Inflation

Inflation A good example of inflation can be seen by looking at the prices of certain goods during World War II. At this time, a loaf of bread cost $0.15; a new car was around $1,000; and you could buy an average house for $5,000. The current prices of these products are obviously a lot more than they were 60 years ago. This is because there has been a high level of inflation during this time period. The late 1970’s was a time of a dramatic surge in inflation rates and this was accompanied by high levels of public anxiety. Since then, inflation rates have decreased somewhat; however inflation still remains a major concern for the general public. The main reason for this concern is the fact that most people simply don’t understand why inflation occurs and how it will affect their quality of life. In this section we will consider these and other characteristics of inflation.

 What Is Inflation?
Inflation is the rate of sustained increase in the prices of goods and services, measured as a percentage increase over an annual period. When there is an increase in inflation rates it means that for each dollar that you spend you will be able to buy a smaller amount of a particular product or service. Inflation means that the value of a dollar (in terms of what it can buy) is not constant. This is referred to as the “purchasing power” of the dollar. When rates of inflation rise there is a corresponding reduction in purchasing power as the money is able to buy less tangible goods.
EXAMPLE: Assume that the inflation rate of a particular economy is 2% per year. This means that a product that currently costs $2 will cost $2.04 at the same time next year. Inflation increases the price and you can’t buy the same goods with a dollar as you previously could.
Other variations of inflation are:

• Deflation – this is inflation in reverse in that it refers to the decrease in prices of goods and services over time.
• Hyperinflation – this term refers to inflation that occurs at an unusually rapid pace. For example, the extreme case of Germany in 1923 where there was a 2,300% rate of inflation in a single month! This can sometimes result in the collapse of a national economy.
• Stagflation – this refers to situations where there is the co-existence of high unemployment, stagnation of the economy and high rates of inflation. An example of this occurred in industrialized countries in the 1970’s when the increase in oil prices by OPEC was combined with unhealthy national economies.

Most developed countries are currently attempting to maintain inflation rates of between 2 and 3%.
Causes of Inflation
Economists generally relish the opportunity to discuss the reasons for inflation. While there is no universally accepted cause of inflation, there are two widely approved theories:
Demand-Pull Inflation. This theory is based on situations where the demand for goods and services is increasing faster than their supply. In other words, there is a lot of money and not enough goods to satisfy the demand.. This pushes the prices up and generally occurs in economies that are experiencing growth.
Cost-Push Inflation. When the costs to produce goods and services increase, companies will need to increase their prices to maintain a margin of- profit. Some factors that may lead to increased costs for companies include taxes, increased import costs, and wages.

Costs of Inflation
Inflation isn’t necessarily always a bad thing. The impact of inflation will be different for different people, depending on whether or not it was anticipated. Where the inflation rate is anticipated (meaning that it corresponds with the rate that most people expected) then it will not have a large impact. In these situations people and institutions can take certain steps to compensate for the expected increase, for example, a consideration of the rates can be incorporated into wage increases or the interest rates that are charged by banks.
The big problems occur when inflation is unanticipated. Possible problems in these situations include:

• Unfair advantages for debtors. An unanticipated rise in inflation can mean that a product bought with a loan agreement will be worth more at the time that the loan is paid than at the time of initial purchase.
• Damage to the economy based on uncertainty which results in less spending by corporations and consumers.
• A reduction in the standard of living for people who have a fixed income (retirees for example) as they have less purchasing power.
• The huge costs of re-pricing items. Updating labels, menus and other price lists is a huge expense for the economy to absorb.
• A reduction in the competitiveness of domestic products for the export market where prices would be lower in other countries.

While many people complain about the rising prices that are associated with inflation, they often don’t take into consideration the fact that they are also receiving higher wages. The main issue to consider when dealing with inflation is whether there is a balance between the inflation rate and rising wages. Another point is the reality that inflation is generally an indication of economic growth. Low inflation rates and deflation can often be a sign of a weakening or unstable economy. Labeling inflation as good or bad is a difficult exercise that may be highly dependent upon the strength of the overall economy and an individual’s personal situation.
How Is Inflation Measured?
Government statisticians are faced with the difficult task of measuring the rate of inflation. This is done by creating a sample of goods that collectively will represent the entire economy. This is known as the “market basket”. The costs involved in purchasing the goods in the market basket are compared at different points in time. The difference in the price of the market basket over a yearly period, as a percentage, is known as the “price index”.
North America measures inflation using the following two price indexes:

• Consumer Price Index. Commonly known as the CPI, this index measures the change in the price of consumer purchases such as gasoline, food, and cars. In the United States, this data is compiled by the Bureau of Labor Statistics.
• Produced Price Indexes. Also known as PPI, these are a collection of indexes dealing with the changing prices that domestic producers charge for goods and services. This data is also compiled by the Bureau of Labor Statistics in the United States.

An easy way to think of the CPI and PPI is that they are like large-scale surveys. The Bureau of Labor Statistics regularly contacts a large list of companies (such as stores, restaurants, property renters and many others) to find out what prices they are charging for specific items. They collect this pricing data for about 80,000 different goods and services every month and they use this information to measure price changes and calculate the CPI. When a long period of time is considered, the PPIs and the CPI will be a similar rate. In the short term the PPI rates will sometimes rise prior to a rise in the CPI. Investors generally rely more upon the CPI.

Inflation and Interest Rates
Inflation rate updates are usually linked with updates regarding interest rates. Interest rates in the United States are set by the Federal Reserve (also known as the “Fed”). They meet eight times each year to decide what the short-term interest rate targets should be. These decisions are largely based upon the CPI and PPIs at the time of the meetings.
The interest rates that the Fed sets are very important because they have a direct impact on the credit market. When interest rates are high, obtaining a loan costs more and borrowing is less appealing. When interest rates are lower people tend to borrow more, spend more and this results in higher levels of economic growth. Therefore it is clear that the way that the Fed changes interest rates can have dramatic implications for employment levels and overall economic stability. However, it is important to remember that extreme economic growth can be dangerous. When an economy grows rapidly it has an increased likelihood of suffering from hyperinflation. On the other hand, when there is no inflation the economy will generally stagnate. The optimal level of economic growth and inflation is between these two scenarios and the Fed is attempting to keep the economy at this level. In simplified terms, increasing interest rates (also known as tightening)an attempt to prevent excessive inflation. Decreasing interest rates (also known as easing) designed to encourage economic growth.
Inflation is only one of the factors that influence the Fed when they are setting interest rates. Another factor (and one that is particularly important during a financial crisis) is liquidity. This refers to the capability to get out of investments. Lowering interest rates gives borrowers increased flexibility which prevents the market from breaking down.
Inflation and Investment
One of the most important questions for investors is “How will inflation impact my investments?” This issue can be particularly concerning for people (such as retirees) who have a fixed income. The way that your portfolio is affected by inflation will depend upon the securities that you hold. If your portfolio is comprised solely of stocks then you needn’t worry about inflation as the revenue of a company should increase in line with inflation rates. This will generally occur except for cases of stagflation where a bad economy combined with rising costs will have a negative impact on the value of stocks.
It is often useful to think of a company as being similar to a regular consumer. If it has a lot of cash reserves, then its purchasing power will decrease to a greater extent if the inflation rate increases. A problematic element of dealing with stocks is that companies tend to overstate their returns. This means that high inflation rates may create the perception that a company is prospering much more than it actually is. It is very important that you remember that the technique used by the company to value their inventory can have a major impact on the information presented in their financial statements.
As previously mentioned, increased inflation rates have the greatest impact on fixed-income earners.
EXAMPLE: Assume that you invested $2000 in a Treasury bill with an interest rate of 10%. A year later you would be able to collect $2200 that is owed to you. The 10% ($200) return that you made cannot be considered real due to the affect that inflation has on your purchasing power. Rising inflation means a reduction in purchasing power which, in turn, means a reduction in the actual value of your return. If the inflation rate for that year was 4% then the interest rate on the investment needs to be reduced by this amount, making it an actual interest rate of 6%. This situation illustrates the difference between a nominal and real interest rate. Nominal interest rate refers to the rate that your money grows (10% in the above example), whereas the real interest rate refers to the nominal rate minus the inflation rate (6% in the above example). It is important that investors look at the true value of the interest rates of their investments. Many investors make the mistake of only considering the nominal interest rate and forgetting about what this means in terms of purchasing power.
Inflation-Indexed Bonds
Some types of securities guarantee to investors that the return will not be reduced by inflation. One example is Treasury inflation-protected securities, commonly referred to as TIPS. TIPS are similar to other Treasury bonds except that they are linked to the CPI and will increase to compensate for rising inflation rates. While this may appear to be a good deal in theory; in reality, it is very rare that investors will look for an inflation protected investment. Inflation rates have been consistently low recently so it hasn’t been considered to be a big issue. Also, because these are such a safe investment option, the interest rates that they offer are so low that most investors are simply not interested.

IPO Initial Public Offerings

IPO Initial Public Offerings (TeachMeFinance.com is intended for educational purposes only. TeachMeFinance.com is an informational website, and should not be used as a substitute for professional financial, legal or medical advice. Please contact your attorney or accountant before making actual investment decisions.  During the technology market booms of the 1990’s, the phrase “initial public offering” (IPO) became very common. Each day there seemed to be a new announcement of a Silicon Valley millionaire cashing in an IPO. This period in time also created the term “siliconaire” to refer to the young entrepreneurs who were becoming very rich as a result of their dotcom company IPOs. In this lesson we will discuss the meaning of an IPO; how they have been used to create personal profits; and how individuals go about getting an IPO.

What is an Initial Public Offering?
Selling Stock
When a company first sells its stock to the public it is known as an IPO. The two primary ways that a company can raise money is by issuing equity or debt. When they issue equity to the public for the first time, it is called an IPO.
Companies can be classified as being either private or public. A private company typically has less shareholders and the owners of the company are not required to disclose as much company information. It is possible for anyone to incorporate a company. All that is required is contributing the initial capital, filing the correct documents and following the relevant reporting rules. The majority of small businesses are private companies, but some very large companies including Hallmark Cards and IKEA are privately held.
Typically, it’s not possible for investors to purchase shares in a privately held company. If they want to invest in a company, an investor can ask the owners of the company, but there is no obligation to sell. Public companies differ from private companies primarily because public companies have already sold shares to the public and these shares are being traded on a stock exchange. For this reason, it is commonly said that when a company issues an IPO they are “going public”.
A public company will generally have a large number of shareholders (into the thousands), and must comply with strict regulations. Each public company must report particular financial data on a quarterly basis and are required to have a board of directors. Their financial information is reported to the Securities and Exchange Commission (SEC) in the United States, and to similar governing bodies in other countries. Stock in a public company is traded on the open market, making it very exciting for investors. As long as an investor has the cash, they are able to invest in the company. There is nothing that anyone involved in the company can do to prevent an investor from purchasing company stock.

Why do Companies go Public?
The main reason for companies to issue an IPO is to raise a lot of money. There are a lot of other financial advantages associated with going public. These include:
It is possible to get better rates when the company issues debt. A public company has higher levels of scrutiny and is a better credit risk.
The ability to issue more stock when there is a sufficient level of demand makes it easier for a public company to engage in mergers and acquisitions because the deal can include issuing stock.
Open market trading increases liquidity. It makes it easier to attract employee talent by using incentives such as an employee stock ownership plan.
Being traded on one of the major exchanges provides a lot of prestige for a company. Previously, it was quite difficult for private companies to qualify for an IPO. They needed strong fundamentals in order to be listed. The dotcom era changed this situation and it became much easier for companies without a strong history or financial records to issue an IPO. At this time, IPOs began to be issued by small startup companies that were trying to expand. One of the problems was the fact that a lot of these companies had not yet profited from their business and t weren’t planning on producing a profit in the near future. Many of these companies were based on funding from venture capital. They created excitement in the market for their company, only to spend all the cash, and have the company collapse. In some cases, there is a suspicion that the public offering was for the sole purpose of making money for the owners. This is commonly referred to as an “exit strategy”, which suggests that the founders have no intention of making the company profitable for investors. In these cases, the IPO signals the end, not the beginning, of the company.
It may seem wrong that this can be permitted to happen, but remember that going public is really all about the sale of stock. If a company is able to convince investors to purchase their stock, it will be able to raise a considerable amount of cash from an IPO.
Becoming Part of an IPO
Underwriting
Becoming part of a popular, new IPO can be an extremely difficult task. The first step in understanding how this happens is to understand the way that an IPO takes place. This is referred to as “underwriting”.
The initial thing that a company needs to do to become public is to engage an investment bank. In theory, it is possible for a company to sell its own shares but, in reality, an investment bank is always used. The term “underwriting” refers to the way that a company can raise money by issuing debt or equity (with an IPO we are talking about the issue of equity). The underwriters are the investment banks that act as middlemen between the company and the investors. The largest investment banks involved in underwriting include: Merrill Lynch, Goldman Sachs, Credit Suisse, Morgan Stanley and Lehman Brothers.
The investment bank meets with the company to work out the terms of the deal. The issues to be resolved at this point generally include the amount of money to be raised; the security type that the company wants to issue; and the other details of the agreement. There are many ways that the deal can be arranged. One way is known as a “firm commitment” which involves the underwriter guaranteeing their purchase of the complete offer. They will then sell it to the public ensuring that the company raises a specific amount. Another type is a “best efforts agreement” in which the underwriter sells the stock on behalf of the company without making any guarantees of the amount that will be raised. It is also common for investment banks to work together to create a syndicate of underwriters to avoid taking on all of the risk involved in an IPO. A syndicate will typically involve one leading underwriter and several others that work to sell a portion of the offer.
When the company and the underwriter(s) agree on the terms of the deal, the underwriter completes the registration statement that is required to be filed at the SEC. The registration statement includes the details of the offer and relevant company information, including financial statements, the planned use of the new funds, background on the management, details of any legal problems and insider holdings.
There is a mandatory “cooling off period”, during which time the SEC will investigate the company and ensure that they have disclosed all required information. If everything is in order, the SEC will approve the offering and set the date (known as the “effective date”) that the stock will go on offer to the public.
The underwriter works during the SEC’s cooling off period to create an initial prospectus that is commonly referred to as the “red herring”. This contains all the relevant information about the offer and the company, except the effective date and the offer price as this information is not yet known. The company and the underwriter use the red herring to start to build hype about the offer. They take the red herring on tour (often referred to as a “dog and pony show”), to generate interest from large institutional investors. After the effective date has been set, the company and underwriter will discuss and set the offer price. This can be a very difficult task and will be based on the current level of interest in the offer and the condition of the market at that time. It is obviously beneficial for both the company and the underwriter to set the price as high as possible.
The final step in this process is the sale of securities on the stock market and the collection of money from new investors.

How can people get involved?
As discussed above, underwriting an IPO is a complex process and individual investors do not get involved until the final step. Underwriters do not target an IPO to individual investors who have relatively small amounts of money to invest. The underwriters will generally focus their attention on institutional clients and offer them securities at the initial offer price.
The only way that an individual investor can be part of the IPO allocation is to have an account with an underwriting investment bank. However, even if this is the case, the account will need to be large with frequent trading in order to be considered a valuable enough client to be offered a part of a hot IPO. This means that individual investors have a very slim possibility of being part of the IPO, unless they are on the inside. When an individual investor does get shares in the IPO, it is typically an indication that no one else wanted them.
There are some exceptions to this general rule, but in the majority of cases, it is extremely unlikely that an individual investor will be able to get involved in an IPO.
Things to think about
If an investor is offered an IPO, it is important that they don’t just jump in. There are a few things that an investor should consider before purchasing shares including:
Company history can be difficult to understand even if the history is of established companies, and a company issuing an IPO will usually be even more difficult due to the lack of historical data. The main source for company information is the red herring prospectus. They will focus on the information about the company managers and the planned use of the IPO funds.
The Underwriters are the bigger brokerage firms and will usually focus on promoting successful IPOs. If an IPO is being underwritten by a small investment bank, it may be indication of a less successful company and offering.
The Lock-Up Period
Financial charts often reflect a steep downturn in the value of stocks in the few months following an IPO. This generally occurs as a result of the lock-up period. As part of the IPO, company employees and officials are required by the underwriter to enter into a lock-up agreement. This is a contract between company insiders and the underwriter that specifies the company insiders are not permitted to sell company stock for a set period. The minimum lock-up period, according to the SEC law known as Rule 144, is ninety days, however it can be much longer and is often up to 2 years. The main problem occurs when the lock-up period expires and suddenly all the company insiders are allowed to sell their securities. These people rush the market to sell to realize a profit and this excess in sales can push the stock price down.
Flipping
Flipping refers to the practice of reselling popular IPO securities immediately after purchasing them in order to make a fast profit. Flipping is not easy and brokerages strongly discourage this behavior because companies are interested in having investors who will hold the stock for the long-term period, rather than traders.
Flipping is not prohibited by law; but it may mean that a broker will blacklist an investor from being involved in future offerings. There are some double standards involving flipping because institutional investors regularly engage in this practice in order to make huge profits. Unfortunately, there is nothing to be done about this because these investors have such great purchasing power. Flipping means that it is generally regarded as unwise to purchase IPO shares that are not part of the initial offering. The IPOs may gain in the first day or two and return to a realistic level after the institutional investors have profited.
Avoiding the Hype
An important point to remember is underwriters are performing a sales role in intentionally creating hype about the offer. The fact that each company will only have one IPO means that underwriters will often advertise them as “once in a lifetime” chances for investors. It is true that some IPOs are very successful and the company shares continue to rise in value after the IPO, but many others will drop to values well below the initial offer price in their first year of trading. Investors need to think about the overall value of the investment, without being distracted by the IPO hype.
Tracking Stocks
When one company creates a new separate entity from one of its departments (a process known as a spin-off) then tracking stocks are created. The company will do this based on the principle that separating the division will create more value than keeping it as part of the larger company.
There are many advantages for the company in issuing tracking stock. They still have control over the operations of the subsidiary company, but the financial information (including all expenses and revenues) are now separate and not included on the financial statements of the parent company. A company will often do this so that a division experiencing high-growth can have its own financial data and will not be associated with large losses in the parent company’s financial statements. If there is a sudden rise in the value of the tracking stock, the parent company can use this stock rather than cash to make acquisitions.
A spin off of tracking stock may occur as an IPO, but this is different from the IPO that occurs when a company goes public for the first time. Tracking stocks investors will generally not have voting rights, and in some cases, there is not a separate board of directors responsible for the tracking stock. Although this means that the shareholders have fewer rights, it doesn’t necessarily make tracking stocks a bad investment. They are just different from a regular IPO.

Economic vocabularies:

-Compound: phuchop, hopchat à compound amount: tong vonlai à compound interest: Laikep, lai gop à compound rate: lai suatkep à compound growth: tang truong kep à compound discount: chietkhau laikep à compound annual return: tien laikep hangnam.

-Liability: trachnhiem phaply, taisan no, khoan no à liability account: TS no à liability certificate: giay chung nhanno

-Equity: von codong, von cophan, tien von à equity earnings: loi nhuan cophan

-Hedge fund: Hoi dautu, quy dautu hoptac.

-Speculator: nguoi dautu, ke dauco, nguoi hay suydoan.

-Liquid: chatlong,de chuyen thanh Cashà Liquid assets: taisan long, TS luudong àliquid balance sodu TS luu dong, sodu tienmat àliquid capital: von de chuyen thanh Cash.

-short-selling contract: hopdong ban khong.

-turnover: doanhthu, 

From internet source