Types of Investment Products Available to Individuals and Companies - Essay Example

Supervisor There are many types of investment products available both to individuals (employees and the self-employed) and to the incorporated businesses.' The various types of investment products which may be both for short-term or long term have different tax implications to people and organisations. Some may eliminate, reduce or minimize while others may have no effect on tax liabilities. This is important both to people and organisations for investment decisions and for tax planning purposes. Required Examine the main types of investment products available to individuals and companies.' - Advantage and disadvantage of different form of investment.' - The tax implications of different types of investment products. By. October, 2008 TABLE OF CONTENTS 1.0 Introduction 2.0 Types of Investment Products with advantages and Disadvantages 2.1 Equities (Stocks and Shares) 2.2 Bonds and Gilts 2.3 Unit Trust 2.4 Superannuation 2.5 Funds/Managed Funds 2.6 Cash Equivalent Investment types 3.0 Tax Implication of the Different Investment Types 3.1 Tax Implications of Equities (Stocks and Shares) 3.2 Tax Implications of Bonds and Gilts 3.3 Tax Implications of Unit Trust 3.4 Tax Implication of Superannuation 3.5 Funds/Managed Funds 3.6 Cash equivalent Investment Types 4.0 Conclusion and Recommendations 1.0 Introduction It has often been said that some investment types such as unit trusts are more profitable as compared others such as open ended investment companies (Atrill & Elliot 2005). In this paper we critically review this assertion by looking at literature on the subject of different investment types. The paper begins by providing an overview on the various investment types and afterwards concentrates on evaluating which one is a better investment vehicle by weighing their advantages and disadvantages with respect to their various tax implications. The rest of the paper is organised as follows: section 2 presents an overview of the various investment types focusing on their advantages and disadvantages as an investment vehicle; section 3 provides an overview of these same investment types but this time paying attention on their various tax implication, section 4 presents a brief summary of both investment vehicles as well as some empirical evidence on the performance of some of these investments; while the last section presents some concluding remarks. In finance, Investors typically faced two challenging questions. How much to invest' And where to invest (Berlin & Lexa 2005, Brealey & Myers 2005). These are some of the pertinent issues this paper seeks to address. By examining the various investment options available to potential investors. By the end of this paper, we intend to make important conclusion and recommendation as to the best investment option. 2.0 Types of investment products with advantages and disadvantages Globalisation, the new information technology, and deregulation of financial markets have eased not only the provision and search of finance but investment opportunities open to investors. Millions of shares are traded every day on the world's stock markets. (Penman, 2003). Investors who trade on these stocks are often forced to ask themselves whether they are buying or selling at the right price. (Penman, 2003). They often attempt to provide answers to these questions by turning to various media including internet chat rooms, printed press, "talking heads" on television and financial networks, who often voice opinions on what they feel the stock prices should be. (Penman, 2003). In addition, investors consult investment analysts who provide an almost endless stream of information and recommendations investment options opened to them to sort out. There are often claims that some shares are undervalued and vice versa. (Penman, 2003, Shapiro 2003, Ross et al. 1999). This information pertaining to the various investment options at times becomes confusing leaving the investor with no clear indication of what the true prices these investment options should be. (Penman, 2003, Brealey & Myers 2005, Damodaran 2002). Under such circumstances, the investor is forced to make the investment decision following his/her instinct or based on the information provided by the market. (Penman, 2003). Investors who make the decision based on instinct are referred to as intuitive investors while those who make investment decisions based on capital market efficiency are referred to as passive investors. (Mclaney & Atrill 2005). Passive investors carry out their investment decisions based on the assumption that the market price is a fair price for the risk taken, that is, that market forces have driven the price to the appropriate point. (Penman, 2003). The next section looks at the various types of investment options. 2.1 Equities (Stocks and Shares There are basically two types of stocks, common and preferred stocks. Bodie, Kane & Marcus (2005) stipulated that, ownership of stocks in a company entitles you to a shareholder. According to the researchers, when you invest in stocks, you're buying a share of ownership in a corporation and become a shareholder. To companies, stocks provide a way to raise money for start-up or growth (Bodie, Kane & Marcus 2005). Kolb (2002) refers to Common stock as stocks in a company offering the holders a percentage of ownership in the firm. Kolb went further and give an example to show that a person who owns one share in a company made up of one hundred shares owns one percent of the company. This investment option has been applauded because beneficiaries have the right to vote on issues affecting the companies. Preference share type of investment option according to Brealey & Myers (2005) usually does not entitle their bearers to voting rights but shareholders are generally entitled to dividends (the company's profits distributed in cash). Holders of this investment option typically receive dividends at specified times and in predetermined amounts; where as their counterpart common stockholders may or may not receive dividends based on company profits. Hand et al (1992) however caution that, common and preferred stocks investment returns and risks depend on factors such as political, the economy, and the company performance. On the contrary studies of the redistribution hypothesis show that downgrades lead to an increase in shareholder value whereas upgrades lead to a decrease in value. Goh and Enderington (1993) for example show that not all rating downgrades represent bad news to shareholders. Basically, downgrades that come as a result of changes in capital structure simply reflect a transfer of wealth from bondholders to shareholders. They conclude that only downgrades that occur as a result of poor financial outlooks such as increases in default probabilities lead to negative abnormal returns to shareholders and thus a decrease in shareholder value. (Goh and Enderington, 1993). 2.2 Bonds and Gilts Bonds are loans and debts offered by individuals or third parties to an organization. Bond holders are creditors to the company of the beneficiary organization. Holthausen & Leftwith (1986) argue that, bonds are financial instruments issued for a set period of time during which interest payments are made to the bondholders. However, Brealey & Myers (2005) caution that, the amount of these payments depends on the interest rate established by the issuer of the bond (the government or company) when the bond is issued. Unlike stocks, bond issuers are requested to pay the par value of the bond plus accumulated interest at maturity. Hand et al. (1992) find that bonds are more stable investment compared to stocks because they provide a steady flow of income. Hand et al. (1992) caution that because they're more stable, their long-term return probably will be less than that of stocks. 2.3 Unit Trust A unit trust represents a collective investment vehicle created under trust. A portfolio of financial securities (the fund) is created through the trust by pooling money from numerous individual investors (Luther & Matatko 1994). Unit trusts first came into existence in the United Kingdom in 1931. They were offered by the M&G group under a deed that allowed little variation in investment policy. A unit trust is a large fund of monies and or investments pooled together and controlled by trustees with the intention of attaining capital appreciation, income, or both (Luther & Matatko 1994). Later on by 1936, flexible unit trusts were offered to individuals for the first time in the UK (unit (Fowler, Grieves & Singleton 2007). Investments in unit trusts is open ended, indicating that units can be created at any time that an investor puts money into the fund and liquidated when an investor withdraws money. The fund is therefore capable of reacting to demand, as well as capable of growing continuously through prosperous periods, and giving investors more exposure to the advantages of larger investments, such as discounts. On the contrary, during periods of poorer performance, the fund may need to sell assets to allow investors to withdraw their monies, thus making the fund smaller. Unit trusts are constituted of "units". A unit has a bid price and an ask price and the bid-ask spread represents the fund management charges. A current value of an investor's holding in the trust is computed by multiplying the number of units held by the current price per unit (Fowler, Grieves & Singleton 2007). 2.4 Superannuation Superannuation refers to an investment vehicle set up specifically to hold retirement savings. Depending on the super fund, you can invest in a wide range of underlying assets, including shares, property, bonds, fixed interest and managed funds (Fletcher 1999). The investment option has been applauded because investors can access almost all the same assets with a range of attractive tax advantage. This option is good for savings made solely for funding personal retirement. In addition the method can be successfully used to reduce taxes. 2.5 Funds and Managed Cash Abel & Fletcher (2004) state that, an investment fund pools money from unrelated investors having similar investment objectives. This fund is handed over to a portfolio manager who invests the money in a portfolio of securities and other instruments according to the specified investment objectives (Abel & Fletcher 2004). Advantages of this kind of investment options to investors include The fund provides a unique opportunity for single investors to carry out diversification. The fund provides various types of securities and other instruments to investors to build a diversified portfolio. Ross et al. (1999) stated that the is more guarantee in the fund as it is managed by experienced professionals who with access to information on the economy. In addition, Brealey & Myers (2005) postulated that, you can invest in a diversified portfolio, enjoying the same earnings potential from the securities that would have been accessible exclusively to institutional investors. 2.6 Cash Equivalent-Open Ended Investment Companies OEICs OEICs came into being in the UK in 1997 (Fletcher 1999). OEICs work in a similar way to unit trusts except for the fact that open ended investment companies are limited companies (Fletcher 1999). They are not trusts and thus have no trustees (Fletcher 1999). OEICs rather have a depository, which pools all the securities and performs similar functions/duties to a trustee. The depositary can be an independent person or financial institution like a clearing bank whose role is to protect the interests of shareholders and to act as the custodian of the fund assets. The depositary is authorised by the Financial Services Authority (FSA). Investors hold shares in the OEIC, which gives them rights like holding shares in direct equities. The vast majority of OEICs have only one price, which is linked directly to the underlying assets. In other words, the share price of an OEIC is the value of all the assets held, divided by the number of shares in issue. All the shares in an OEIC are bought and sold at this price. The price is normally based on the net asset value (NAV) of the OEIC and it is different from the bid and ask price of a Unit trust (Fletcher 1999). Other types of funds include Money market Passbook savings Certificate of Deposits Mutual funds However, these investment options can be classified under unit trust or open ended investment companies. Investors can therefore make better investment decisions with OEICs than with Unit Trusts given that prices of Unit Trusts are not quoted on the Financial Press. Even if they are quoted, they will be quoted as bid and ask prices which will make things more difficult for investors. In addition shares can be quoted in foreign currency, thereby giving room for investors abroad or UK investors to use them as a means of hedging against currency fluctuations (Financial Mail 1996). OEICs also give room for managers to create sub-funds with different objectives and geographical spreads, which in turn makes switching between funds easier and cheaper than under the unit trust system (Financial Mail 1996). In addition to the above shortcomings for Unit Trusts, empirical evidence suggests that Unit Trusts do not provide investors with superior returns on their investors. For example, in New Zealand, Unit trusts represent important savings and investment vehicles to investors. This is evidenced by the fact that many fiduciaries recommend unit trusts to their clients owing to the fact that Unit trusts offer professional management, liquidity and diversification. However, Fowler et al suggest that New Zealand investors may be ill-served by the lack of disclosure of actual unit trust holdings. Basically, the study suggests that most of trusts although equity-oriented hold as much as one-third of their assets in fixed interest, which indicates that investors will be disappointed in their trust's performance, especially if they had developed their own asset allocation using multiple vehicles and were expecting from equity-like returns from these trusts (Fowler et al. 2007). Unit trusts have also been found to bias their portfolios towards smaller companies. For example, Luther and Matatko after direct examination of trusts' portfolios find that the selection of investments that comply with ethical criteria appears to constrain the managed portfolios to being biased towards smaller companies. Consequently, Luther and Matatko recommend that it is inappropriate to compare the performance of unit trusts with the market as a whole 3.0 Tax Implication of the Different Investment Types Brealey & Myers (2005), use tax advantage to refer to the economic bonus which applies to certain accounts or investments. That is, by statute, tax-reduced, tax-deferred, or tax-free as defined within the laws. The most obvious examples common to most countries are Retirement plans (Bodie, Kane & Marcus 2005). In addition, investments in many state or municipal bonds can also be exempt or benefit from certain tax advantage. According to Damodaran, (2002) Governments establish the tax advantaged status of these form of investment options to encourage private individuals to contribute money when it is considered to be in the public interest (Brealey & Myers 2005). Thus, to encourage contribution to certain investment schemes and vehicles, some investment options are given a tax advantaged status in order to encourage more people to contribute to such arrangements. 3.1 Tax Implications of Equities (Stocks and Shares) Brealey & Myers echoed that, investing in stocks involves higher risks than investing in debt or money market instruments however; it offers investors the advantage of higher earning potential. This can be gained from stocks through capital appreciation and dividends. In the past,'stock investments have in general outperformed bond and money market instruments over time (Bodie, Kane & Marcus 2005). Holders suffer from double taxation because of the taxes on company's profit and subsequent taxes on dividends. How ever, in the case of stock appreciation holders benefit from capital gain tax. 3.2 Tax Implications of Bonds and Gilts Damodaran (2002) asserts that bonds are financial instruments used as a 'core' investment to build the foundation of a balanced portfolio. Bonds offer a wide range of maturities, interest payment terms and credit quality ratings selected to fit most portfolio needs. However, holders of debt instruments such as bonds and treasury bills pay the normal taxation. Taxes are charged on the interest payment received by the instruments holder. Their holders have a senior claim over stockholders on a company's assets, should they be liquidated.Damodaran (2002) argues that, the tax benefits of debt or tax advantage of debt refers to the fact that from a tax perspective it is cheaper for firms and investors to finance with debt than with equity. Under 3.3 Tax Implications of Unit Trust Empirical evidence on Unit Trusts, suggests that, Unit Trusts do not provide investors with superior returns on their investors. For example, in New Zealand, Unit trusts represent important savings and investment vehicles to investors (Fowler et al. 2007). This is evidenced by the fact that many fiduciaries recommend unit trusts to their clients owing to the fact that Unit trusts offer professional management, liquidity and diversification. However, Fowler et al suggest that New Zealand investors may be ill-served by the lack of disclosure of actual unit trust holdings. Basically, the study suggests that most of trusts although equity-oriented hold as much as one-third of their assets in fixed interest, which indicates that investors will be disappointed in their trust's performance, especially if they had developed their own asset allocation using multiple vehicles and were expecting from equity-like returns from these trusts. Unit trusts have also been found to bias their portfolios towards smaller companies (Fowler et al. 2007). Thus investors within this investment option also suffer from double taxation. 3.4 Tax Implication of Superannuation Superannuation owners can typically choose from a variety of options how to receive income payments from their annuities. So far, this is the best investment options with little tax implication. Income payments accruing to superannuation holders can be guaranteed for life, no matter how long, or for a specified period of time. Income payment to investment holders can be fixed and guaranteed or they can be varying from one payment to the next as a reflection of the performance of the sub-accounts selected to support the payments. Taxes to superannuation are minimal and in most countries (e.g., Australia, UK) it is zero. However, in some other countries only the earnings portion of each income payment is taxable and where funds are in tax-qualified plans, they will be taxed according to the rules applicable to such plans (Fowler et al. 2007).. 3.5 Funds/Managed Funds Managed funds are also quite tax-efficient. Because of the way they are created and redeemed, they allow an investor to pay most of his capital gains upon final sale of the underlying assets, delaying it until the very end (Damodaran 2002). There is however, no way to avoid capital gains, but delaying it is valuable because the amount that would have been paid to taxes can continue to accumulate wealth (Damodaran 2002). In some situations, Damodaran (2002) argues that mutual funds accumulate unrealszed capital gains liabilities for stocks that have risen in value. "Upon sale of these stocks the fund calculates and periodically distributes the capital gains to its investors in proportion to their ownership". 3.6 Cash equivalent Investment Types Cash equivalent such as savings accounts deposit and other forms of deposits in the banks and depository institutions attract huge amount of taxes. Beneficiaries' interest is taxed at upfront. However, it is a safe investment options for risk adverse investors. 4 Conclusion This paper set out to determine whether some investment options are more flexible investment vehicles for investors in terms of their advantages and tax component than the others. Based on the evidence at hand, one can conclude that stocks investment options provides a more flexible investment vehicle than the other investment options. This is because of the possibilities of capital gain exposure to this investment. Firstly, unit trusts such as bonds suffer from the bid-ask spread which increases transaction costs to investors when trying to buy or liquidate an interest in the trust. Secondly, stocks investment option gives the holder an opportunity to invest in a wide range of securities and operated as financial companies with shares quoted in the financial press giving investors room to compare prices and make investment decisions with greater ease and flexibility than is the case with the other options. Empirical evidence suggests that Unit Trusts tend to invest in fixed income securities, which are less risky as well as less rewarding. According to Abad-Romero and Robles-Fernandez (2006) the information content hypothesis of rating changes has been a subject of debate in recent years. Citing Wakeman (1990) Abad-Romero and Robles-Fernandez (2006) assert that on the one hand, bond rating agencies only summarise public information and therefore rating changes should have no impact on stock markets if these markets are assumed to be perfect. Our findings proof that each investment option has advantages and disadvantages. For example, in countries like the United States, stock holders benefit from capital gain tax, while in Australia the issue of double taxation is a point of contention. References Abad-Romero P., Robles-Fernandez M. D. (2006). 'Risk and Return Around Bond Rating Changes: New Evidence from the Spanish Stock Market', Journal of Business Finance & Accounting, vol. 33 No.5 & 6, pp. 885-908. Abel E, Fletcher J. (2004). An empirical examination of UK emerging Market Unit trust performance. Emerging Markets Review 5 (2004) 389- 408 Atrill P and Elliot J., (2005). Financial Accounting for non specialists. 3th Edition. 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