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Sep

2023

7 Factors That Cause Inflation

By Colin Dodds | invest, Investing, Preparing for Retirement | Comments Off

There are a number of factors that can cause inflation, including an increase in the cost of raw materials, an increase in the currency supply, and more. When the cost of goods and services rise over time, and consumers have to spend more to buy basic items, that’s considered inflation.

Inflation is an economic reality, but the government tries to regulate inflation so that it remains at a low but steady pace. The target is 2.0%, but historically it’s closer to 3.3%. A period of higher inflation began in early 2021, thanks in part to supply chain bottlenecks resulting from the pandemic.

Inflation isn’t necessarily a bad thing — it can also result from an economic upturn. But when the prices of goods and services rise in relation to the dollar, or the currency in use, the result is that each unit of currency will buy less of just about everything than it previously did.

Here’s a closer look at how to track inflation, and seven factors that cause prices to increase.

How to Track Inflation

The most commonly used measure to track inflation is the Consumer Price Index (CPI), which is produced by the U.S. Bureau of Labor Statistics (BLS) each month. The CPI tracks the average of prices of a set of goods and services. While the CPI leaves out important aspects of consumer spending, such as real estate and education, it is considered a valuable gauge of the ever-changing cost of living.

What Is Core Inflation?

Core inflation also measures the rising cost of goods and services, but it excludes food and energy costs. The reason being that both food and energy prices are partly driven by the price of commodities — which tend to be volatile, owing to speculation in the commodities markets. So the short-term price changes in food and energy make it difficult to include them in a long-term reading of inflationary trends: hence the core inflation metric.

The Consumer Price Index and the core personal consumption expenditures index (PCE) are the two main ways to measure underlying inflation that’s long term.

Inflation also shows up in the wholesale price index (WPI), which measures and tracks the changes in the price of commodities and other goods that are traded between businesses.

💡 Quick Tip: All investments come with some degree of risk — and some are riskier than others. Before investing online, decide on your investment goals and how much risk you want to take.

Types of Economic Inflation

There are a range of different types of inflation, although they are fundamentally interrelated.

Cost-Push Inflation

Cost-push inflation occurs when the price of commodities rises, pushing up the price of goods or services that rely on those commodities. For example, owing to high demand for certain types of minerals used in technology equipment, the prices for those goods are likely to rise.

Demand-Pull Inflation

Rising demand for goods and services can trigger inflation when there’s an imbalance in supply vs. demand. This is known as demand-pull inflation. For example, if there’s a high demand for pork (or if there’s a slump on the supply side owing to pork shortages), that could drive up the price of bacon, ham, and other pork products.

Built-In Inflation

Built-in inflation is the result of an upward spiral in wages, as workers seek raises to keep up with the cost of living. This in turn can lead businesses to raise their prices, adding to the higher prices.

As you can see, these three types of inflation are connected through the loop of supply and demand.

Recommended: 5 Tips to Hedge Against Inflation

What Causes Inflation?

While inflation has become a persistent factor in most of the world’s economies, it can result from a range of different causes. Understanding the different causes can help investors manage inflation risk — i.e. the possibility that the money you invest won’t earn enough to keep up with inflation.

1. The Economy Is Going Strong

When the economy is growing, more people have jobs, wages increase in order to hire and keep those workers, and more people have money to spend. As a result, they buy more necessities and some even splurge on luxury items.

In this environment, businesses can increase their prices, and consequently, wholesalers can increase prices. The net result of this cycle of expansion is higher prices across the board: aka inflation.

This scenario is why inflation isn’t always bad news. In fact, the Federal Reserve aims for a target annual inflation rate of around 2%, because it indicates a growing economy. As noted above, this kind of inflation is a type of “demand-pull inflation,” because it is driven by consumer demand.

In fact, deflation — when the prices of goods fall for a period of time — can also be considered unhealthy because it can mean demand among consumers is weak.

2. There Is More Currency Available

Inflation can also occur when the Fed, or another central bank, adds fiat currency into circulation at a rate that exceeds that of the economy’s growth rate. That creates a situation in which there are more dollars bidding on fewer goods and services. The result is that goods and services cost more.

One reason that inflation has been a constant in the U.S. since 1933 is that the Fed has continually increased the money supply. In response to the 2008 financial crisis, the Fed dropped its lending rate close to zero as a way to inject more liquidity into the economy, which led to increased inflation but not hyperinflation. While those increases have usually moved in step with growth, that hasn’t always been the case.

In response to the Covid-19 pandemic and subsequent lockdowns, the Fed released the equivalent of $3.8 trillion in new liquidity in 2020. That amount was equal to roughly 20% of the dollars previously in circulation. And it is one reason why many investors were watching the CPI closely in 2021 — and were not surprised when inflation began to climb through 2022.

3. Basic Materials Increase in Price

In the 1970s in the U.S., inflation was rampant. There were many reasons for this, but one major one was the OPEC oil embargoes. The embargoes led to a gas shortage, higher prices for home-heating oil, higher prices at the pump, and increases in the prices of manufacturing and shipping for nearly every single consumer good.

Between 1973 and 1974, inflation-adjusted oil prices jumped from $25.97 per barrel to $46.35. And as a result, inflation topped 11% that year.

Another one of the most dramatic periods of inflation was the period of 1979-1981, when inflation topped 10% for three straight years. Again, oil was a major contributing factor, as the Iranian Revolution set off further increases in the price of oil.

Recommended: Guide to Investing in Oil

4. The Housing Market Takes Off

The housing market is a major part of the U.S. economy, and it has an outsized impact on the broader economy. When the housing market is strong and home prices are rising, then homeowners have more equity to call upon to make major purchases, which can goose inflation.

At the same time, a strong housing market means that homeowners, contractors, and builders are spending more on home improvements and buying the raw materials that make those new and improved homes possible. That, in turn, drives up the prices of those raw materials, such as steel, lumber, and oil, which can lead to more inflation.

💡 Quick Tip: Newbie investors may be tempted to buy into the market based on recent news headlines or other types of hype. That’s rarely a good idea. Making good choices shouldn’t stem from strong emotions, but a solid investment strategy.

5. The Government Implements Expansionary Fiscal Policies

The federal government will occasionally try to jumpstart economic growth with new policies. These expansionary fiscal policies often seek to increase the amount of discretionary income that businesses and consumers have to spend.

Often, these policies take the form of reduced taxes with the belief that businesses will spend it on employee compensation and new hiring. That will allow more consumers to spend on goods and services.

Other times, those policies consist of massive infrastructure projects, which can increase the demand for goods and services. The increasing of overall liquidity due to central bank monetary policy is also considered an expansionary policy.

6. New Regulations Increase Costs

While a shortage of an essential commodity, like oil, can cause inflation, so can an increase in costs related to a commodity suddenly becoming more expensive because of government regulations.

Sometimes new tariffs can increase the costs of imported goods, which can lead to inflation. At the same time, new regulations that make a particular commodity or service more expensive or time-consuming to obtain can also increase the costs to consumers, leading to inflation.

7. The Exchange Rate Changes

The value of the U.S. dollar in relation to all other foreign currencies is constantly in flux. If the dollar goes down, then imported commodities and consumer goods get more expensive. But it also makes goods exported from the U.S. cheaper abroad, which can actually be a boost for the economy.

The Takeaway

Inflation in the U.S. has been a constant since 1933. Most years inflation is a slow drip of almost imperceptible price increases, but there have been times when it has risen sharply, as it did during the late 70s and early 80s. This was a painful period for many consumers and inflation became a major political issue.

Inflation was fairly gradual in the decades since then, but after stimulus packages during the Covid-19 pandemic and a reopening of the economy boosted prices and growth, inflation took off. It reached a peak of about 9.02% in June of 2022, and has eased down closer to the historical average of about 3.28% throughout 2023.

The forces that can stir or mitigate inflation are important for investors to understand. Managing your investment strategy in light of the inevitable impact of inflation can help offset inflation risk — the risk that your money won’t retain its purchasing power in the future.

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FAQ

How does raising interest rates help inflation?

Higher interest rates may help slow spending, because the cost of borrowing increases as rates rise. People may also be inclined to take advantage of higher rates by saving more, which can also slow demand and cool the economy.

How quickly does inflation decrease to normal levels?

Cycles of inflation historically have lasted many years, or a couple of months. How quickly inflation subsides depends on economic conditions overall, as well as the origins of a particular bout of inflation. If employment numbers change, if interest rates rise or fall, if demand overshoots supply — these are among the factors that can influence inflation.

Who benefits from inflation?

There are a couple of scenarios where inflation can be beneficial. For example, those with bigger debts can benefit from inflation because the money they’re using to pay off their car or home loan, say, is now less valuable than the money they borrowed. Those working in jobs made more secure by rising demand can also benefit. In some cases, holding foreign currency may be more beneficial in relation to the inflationary currency. Inflation is fluid, and it’s important to gauge which factors are at play before deciding what is beneficial or not.

Who is hurt most by inflation?

Lower-income households are disproportionately affected by inflation, because the cost of goods and services is rising faster than wages. Another group hit hard by inflation is retirees and those living on fixed incomes, because their money is buying less over time.

Photo credit: iStock/Delmaine Donson

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INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

Sep

2023

How Dark Pools Operate – and Why They Exist

What Is a Dark Pool in Trading?

By Colin Dodds | Growing Wealth, invest, Investing, Terminology | Comments Off

Dark pools, sometimes referred to as “dark pools of liquidity,” are a type of alternative trading system used by large institutional investors to which the investing public does not have access.

Living up to their “dark” name, these pools have no public transparency by design. Institutional investors, such as mutual fund managers, pension funds, and hedge funds, use dark pool trading to buy and sell large blocks of securities without moving the larger markets until the trade is executed.

Understanding the History of Dark Pools

The history of dark pools in the trading world starts in the 1980s, following changes at the Securities and Exchange Commission (SEC) which effectively allowed brokers to make trades in large share blocks. Later, in the mid-2000s, further SEC changes that were meant to cut trading costs and increase market competition led to an increase in dark pool trading.

Dark Pool Examples

There are many dark pools out there, and they can be operated by independent companies, brokers or broker groups, or stock exchanges themselves. An internet search would bring up names of specific dark pools.

But to get a sense of how a dark pool can be used to investors’ benefit, say there’s a mutual fund looking to sell 2 million shares of Stock X. Given that selling that amount of shares would create ripples in the market, the mutual fund may not want to sell them all at once. As such, they sell them in blocks of 10,000, 1,500, or 5,000 shares — and find buyers for the smaller blocks accordingly.

This method makes it less obvious that a huge number of shares are being sold, which could avoid Stock X’s shares losing value quickly.

Who Runs Dark Pools?

Investment banks typically run dark pools, but some other institutions run them as well, including large broker-dealers, agency brokers, and even some public exchanges. Some trading platforms, where individual investors buy and sell stocks, also use dark pools to execute trades using a payment for order flow.

Recommended: What Is a Market Maker?

The role of dark pools in the market varies over time. At times, dark pool trades comprise as much as half of all trading in a single day, while at other times, they make up significantly less of U.S. equity volume.

Because trades in a dark pool aren’t reflected in the prices on a public exchange, participants in a dark pool trade based on the prices offered on a public exchange, using the midpoint of the National Best Bid and Offer (NBBO) to set prices.

💡 Quick Tip: Look for an online brokerage with low trading commissions as well as no account minimum. Higher fees can cut into investment returns over time.

Why Institutions Use Dark Pools

Large, institutional investors such as hedge funds, may turn to dark pools to get a better price when buying or selling large blocks of a single stock. That’s because of the way that large trades impact the public markets.

As discussed, if a mutual fund manager, for example, wants to sell a million shares of a given stock because it’s underperforming or no longer fits their strategy, they’d need to use a floor trader to unload the position on a public exchange. Selling all those shares could impact the price they get, driving down the VWAP (volume weighted average price) of the total sale.

To avoid driving down the price, the manager might spread out the trade over several days. But if other traders identify the institution or the fund that’s selling they could also sell, potentially driving down the price even further.

The same risk exists when buying large blocks of a given security on a public market, as the purchase itself can attract attention and drive up the price.

New Risks

The risks of attracting attention from other traders have intensified with the rise of algorithmic trading and high-frequency trading (HFT). These strategies employ sophisticated computer programs to make big trades just ahead of other investors. HFT programs flood public exchanges with buy or sell orders to front-run giant block trades, and force the fund manager in the above example to get a worse price on their trade.

Dark Pool Benefits

Utilizing a dark pool and conducting a dark trade, institutional investors can sell a million shares of a stock without the public finding out because dark pool participants don’t disclose their trades to participants on the exchange. The details of trades within a dark pool only show up after a delay on the consolidated tape — the electronic system that collates price and volume data from major securities exchanges.

There are other advantages for an institutional trader. Because the buyers and sellers in a dark pool are other institutional traders, a fund manager looking to sell a million shares of a given stock is more likely to find buyers who are in the market for a million shares or more. On a public exchange, that million-share sale will likely need to be broken up into dozens, if not hundreds of trades.

Criticism of Dark Pools

As dark pools have grown in prominence, they’ve attracted criticism from many directions, and scrutiny from regulators. For instance, the lack of transparency in dark pools and the exclusivity of their clientele makes some investors uneasy. Some even believe that the pools give large investors an unfair advantage over smaller investors, who buy and sell almost exclusively on public exchanges.

The Takeaway

As discussed, dark pools are sometimes referred to as “dark pools of liquidity,” and are a type of alternative trading system used by large institutional investors to which the investing public does not have access. They’re typically run and utilized by large investment banks.

Given the nature of dark pools, they attracted criticism from some due to the lack of transparency, and the exclusivity of their clientele. While the typical investor may not interact with a dark pool, knowing the ins and outs may be helpful background knowledge.

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FAQ

How can you see dark pool trades?

Investors can access dark pool trading data through various securities information processors, and can be accessed through FINRA’s website as well.

Who regulates dark pools?

The Securities and Exchange Commission, or SEC, is the government body that regulates dark pools and dark pool trading.

What are dark pools in cryptocurrency?

A dark pool in cryptocurrency is more or less the same as a dark pool in other equities markets, and is a place that matches buyers and sellers for large orders outside of a public exchange or view.

How do dark pools differ from lit pools?

As many might surmise, lit pools are effectively the opposite of dark pools, in that they show trading data such as number of shares traded and bid/ask prices.

Photo credit: iStock/DNY59

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INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

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Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

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Sep

2023

What Is Tax Lien Investing?

By Colin Dodds | Financial Independence, Growing Wealth, invest, Investing | Comments Off

Tax lien investing involves an investor buys the claim that a local government makes on a property when an owner fails to pay their property taxes. Each year, states and municipalities sell billions of dollars in tax liens to the public.

The lien itself is a legal claim of ownership that a city or county makes against any property whose owner hasn’t paid taxes. The government then sells those claims, usually at auction, to investors. It is considered an alternative investment and a way to get real estate exposure in a portfolio.

How Tax Lien Investing Works

Tax lien investing involves an investor purchasing a property at auction that currently has a tax lien against it. They pay off the lien, and then the property is theirs, typically purchased as an investment.

If an investor wins a tax lien certificate at auction, they must immediately pay the state or local government the full amount of the lien. Then entitled to collect the property’s tax debt, plus interest and penalty fees. The interest that the property owner must repay the investor varies from state to state, but is usually in the 10%-12% range, using a simple interest formula. Some states charge as much as 2% per month on tax liens.

Property Tax Liens Explained

Between 2009 and 2022, historically low interest rates led many income-oriented investors have started to look more closely into buying tax lien certificates as a way to generate more returns from their portfolios. With relatively high interest rates, tax liens offer one way to generate investment income. Unlike many other interest rates, the rates on property taxes aren’t affected by market fluctuations, or decisions by the Federal Reserve. Instead, state statutes set the interest rates on overdue taxes.

That makes tax liens a potentially attractive alternative investment in a period of rock-bottom interest rates. But they come with their own unique risks. For starters, the investor only realizes the high interest rates if the property owner agrees to pay them.

The fact that the property owner is delinquent on their taxes may indicate, however, that they’re in a bad state financially, and unable to pay back the new owner of the lien. In that case, the only way for an investor to recoup the initial cost of buying the lien, plus interest and penalty fees, is to foreclose on the property and sell it. In that situation, the investor gets the money from the proceeds from the sale.

The good news for tax lien investors is that the lien certificate they receive from the local government usually supersedes other liens on the property, including any mortgages on it. That entitles the tax-lien investors to full proceeds from a foreclosure sale in most cases. The only creditor on a property who may have priority over tax-lien investors is the federal government for liens imposed by the Internal Revenue Service.

The bad news is that the lien certificates don’t, in any circumstances, give the investor ownership of the property. In cases where the property owner doesn’t pay the investor the money owed, a tax-deed foreclosure is the only way an investor can get paid.Those proceedings, along with eviction, repairs and other costs, can cut into returns made by the investor.

💡 Quick Tip: Did you know that opening a brokerage account typically doesn’t come with any setup costs? Often, the only requirement to open a brokerage account — aside from providing personal details — is making an initial deposit.

How to Buy Tax Liens

Not every state allows the public auction of overdue property taxes, but thousands of municipalities and counties across the country currently sell tax debt to the public.

For a new investor, one place to start looking into buying tax liens is by getting in touch with your local tax revenue official. They can point you to the publication of overdue taxes. Most states advertise property tax lien sales for before the actual sale. Most of the time, these advertisements let you know the property owner, the legal description of the property, and the amount of delinquent taxes.

How Do Tax Lien Sales Work?

Tax lien sales often, or mostly, happen at auction. The auctions themselves vary by municipality and state. Some are online, and others are in person. Some operate by having the investors bid on the interest rate. In this auction format, the municipality sets a maximum interest rate, and the investors then offer lower interest rates, with the lowest bidder winning the auction.

In another popular auction format, investors bid up a premium they’re willing to pay on the lien. In this format, the bidder who’s willing to pay the most — above and beyond the value of the lien — wins. But the investor can also collect interest on that premium in many cases.

If that sounds like too much work and research, investors can access this unique asset class by purchasing shares in a tax lien fund run by an institutional investor. Institutional investors may have the research, focus, and experience new investors may not have, or want to develop. Professional investors also have experience with some of the litigation and other expensive pitfalls that can come with a property foreclosure.

Tax Lien Investing Risks

As a financial asset, tax liens offer a unique opportunity for income, but they also have their own set of risks. The first is the property itself. The neighborhood and condition of the property make a difference in the value of the property and the ease with which an investor can sell it.

Another investment risk to keep in mind is that some owners may never pay back the property taxes they owe, and if the value of the property, after foreclosure, may not pay back the money invested in the lien. Investors also may have to deal with a property embroiled in litigation, or on which other creditors have a claim. This is one area where research can make a big difference.

Also, liens don’t last forever. They come with expiration dates, after which the owner can no longer foreclose on the property or collect overdue taxes and interest from the property owner. In some cases, investors will pay taxes on the property to which they own the lien for years, just to keep a claim on the underlying property. This can be a smart strategy if it gets the investor the property at a lower price, but it can also create opportunity costs.

Finally, the overall returns on tax liens are going down in many cases, as more large institutional investors start bidding on tax lien auctions. More bidders drive down the interest rates or drive up the premiums, depending on the auction format.

Benefits to Investing in Tax Liens

Investing in tax liens also has its potential benefits, including the chance of generating outsized returns (but keep the risks in mind, too). Sometimes, properties can be purchased for a relative bargain — such as a few hundred or a few thousand dollars, which can obviously be attractive to investors, though it may not be typical. Tax lien investing is another way to diversify a portfolio as well.

The Takeaway

Tax lien investing involves buying the claim that a local government makes on a property when an owner fails to pay their property taxes. Once an investor buys that claim, they then pay off the back taxes, and take ownership of the property. Each year, states and municipalities sell billions of dollars in tax liens to the public, making for ample opportunity.

Tax lien investment can offer an alternative investment that balances out a diversified portfolio, but it has many risks that individual investors should understand. Of course, there are plenty of other ways that investors can put their money to work for them.

For a limited time, opening and funding an Active Invest account gives you the opportunity to get up to $1,000 in the stock of your choice.

FAQ

How can you get started in tax lien investing?

Prospective tax lien investors can get in touch with local tax officials to learn more about tax liens in their area, or do some internet searches to find when and where auctions are taking place. They can then bid and potentially win a claim on a property.

What’s the difference between tax liens and mortgage liens?

Tax liens are placed on a property by the government for unpaid property taxes, whereas a mortgage lien is placed on a property by a lender in order to secure it for a borrower failing to pay their home loan.

Are IRS tax liens public record?

IRS tax liens are federal tax liens, and are public record. The IRS will file a public document to alert others in the even that a federal lien is being placed on your property.

Photo credit: iStock/nortonrsx

SoFi Invest®

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

Sep

2023

What Is a Collective Investment Trust (CIT)?

What Is a Collective Income Trust (CIT)?

By Brian O'Connell | Growing Wealth, invest, Investing | Comments Off

A collective investment trust (CIT), also commonly called a commingled trust or collective trust fund, is a pooled investment fund that’s similar to a traditional mutual fund — but a CIT falls under a different regulatory path and may offer lower fees and tax advantages.

Similar to a mutual fund, a collective investment trust generally consists of assets pooled from investors — but in the case of a CIT the funds come only from qualified, employer-sponsored retirement plans, such as 401(k)s, pension plans, and government plans. They are typically not available to retail investors directly.

How a Collective Income Trust Works

CITs have grown in popularity over the years, likely due to their lower cost structures and the potential tax advantages they offer.

The goal for a collective income trust is to pool fund assets together into a single account (called a “master trust account”) and manage the investment funds in a highly diversified, low-cost manner. Although the trust is typically managed by a bank or trust company, the trustee can opt to hire an investment management firm in a sub-advisory capacity to manage the income portfolios.

The CIT investment process is fairly standard. Structurally, the bank or trust company will collect funds from various retirement-oriented investment accounts and commingle them into a single fund (i.e., the CIT), and thus become the trust’s “owner.” CIT investor participants don’t own any direct assets in the trust — instead they hold a participatory interest in the CIT fund assets (similar to the way investors hold mutual fund shares).

The trust, meanwhile, is free to invest in a wide variety of investment vehicles, including stocks, bonds, mutual funds, currencies, derivatives, or possibly alternative investments like commodities or precious metals. Strategically, the trust manager’s mandate is two-fold:

1. Collect investment assets from participating investment plans and commingle them into a single fund.

2. Manage the single fund like any mutual fund manager does — with a specific investment strategy, and goals and track the fund’s performance to ensure the fund is meeting its investment goals.

💡 Quick Tip: Did you know that opening a brokerage account typically doesn’t come with any setup costs? Often, the only requirement to open a brokerage account — aside from providing personal details — is making an initial deposit.

Collective Income Trusts vs Mutual Funds

CITs are often compared to mutual funds because in both cases, investors’ assets are pooled and invested in a diversified portfolio of securities. Other than that, these two investment vehicles have some stark differences.

• Individuals can invest in a mutual fund through an online brokerage or a personal retirement account like an IRA, but investors can only access CITs through an employer-sponsored retirement plan, pension plan, or insurance plan.

• A collective investment trust is not regulated by the SEC but overseen by the Office of the Comptroller of the Currency (OCC) for national banks, or state banking authorities for state banks and the Department of Labor (DOL). As a result, a CIT is typically less transparent about its holdings than a mutual fund.

• Unlike a mutual fund, a collective income trust is not required to register under bylaws created in the Investment Company Act of 1940. Thus, because a collective investment trust isn’t subject to the same operational, disclosure, and reporting rules of federal and state securities laws, the cost to invest in a CIT is generally lower than a mutual fund.

• Whereas mutual fund fees are set by the investment firm as an expense ratio and are non-negotiable, some CIT costs can be negotiated.

• CIT earnings are considered a tax exempt investment, not merely tax deferred as mutual fund earnings within an employer-sponsored plan might be.

• A collective investment trust is set up as a trust and offered by a bank, trust company or other financial institution, whereas a mutual fund is offered by an asset management company.

A History of Collective Investment Trusts

Collective income trusts have been around for nearly a century. The first fund rolled out in 1927 on a limited basis. When the stock market crashed in 1929, CITs fell under additional scrutiny owing to the pooled nature of these funds, their lack of transparency, and the timing of the crash. Subsequently, CITs were significantly restricted by the government, which mandated that CITs could only be offered to trust company clients and through employee-sponsored retirement plans.

About 20 years ago, though, CITs began providing daily valuation and standardized transaction processing — in other words they began to operate more like mutual funds — which greatly increased adoption by defined contribution plans.

The real turning point came in 2006, when the Pension Protection Act provided for the use of Qualified Default Investment Alternatives (QDIA) for certain 401(k) plan investors. Target date funds, many of which include CITs, were designated as QDIAs, thus giving more investors access to CITs (although banks and trusts still couldn’t, and can’t, offer CITs directly to retail investors).

Since then, the cost efficiency of collective investment trusts has drawn the attention of many fund managers, and the use of CITs over traditional mutual funds in target-date fund series has grown.

Collective Income Trusts: Things to Know

By design, collective income trusts offer several unique features — and potential drawbacks — for qualified retirement plan providers and their investors:

CITs as fiduciaries

CITs must abide by the rules and regulations laid out in the Employee Retirement Income Security Act of 1974 (ERISA). That means CITs must meet minimum standards of conduct, like requiring CIT providers to give investors critical information such as plan features and funding. As such, a CIT trustee is held to ERISA fiduciary standards for the ERISA plan assets invested in CITs.

CIT’s long-term focus

Unlike a mutual fund, a CIT doesn’t need to distribute 90% of its taxable income every year (mutual funds are regulated investment companies and are required to provide annual taxable income distributions to investors.) That allows collective income trusts to hold investment funds in the trust, allowing those investments to grow in value over time.

No FDIC coverage

Unlike bank deposits, investor deposits in a collective income trust are not insured by the Federal Deposit Insurance Corporation (FDIC). While investments in a 401(k) are not FDIC-insured either, if deposits (e.g. savings, money markets, CDs) are covered by an FDIC-insured institution, then the deposits are as well.

CITs and rollovers

Collective income trusts don’t offer the same investment portability of mutual funds. Trust customers have to liquidate their positions in the CIT into a cash account before they can roll over funds adding an extra step to the account rollover process. Thus, CIT investors should work closely with their plan sponsors when rolling plan funds over to another retirement plan.

The Takeaway

Although a collective investment trust is often compared to a mutual fund, the only two similarities of these vehicles is that they are both pooled investment portfolios, with funds from many investors commingled — and both are used in retirement plans. For now, though, a CIT is only available to investors through certain qualified plans.

Collective income trusts are becoming more common in the employment retirement plan universe, as more target date funds opt to include CITs. CITs are also quite different from mutual funds. They follow a different regulatory flow and are not overseen by the SEC. With more room to operate in a regulatory sense than traditional mutual funds, CITs can offer clients a unique long-term investment option tailored to their investment management needs, and in a cost-effective manner — all managed in a single investment account.

For a limited time, opening and funding an Active Invest account gives you the opportunity to get up to $1,000 in the stock of your choice.

FAQ

How is a collective investment trust valued?

A collective investment trust (CIT) is usually valued daily, and its valuation is a summation of the assets that it holds, like many other investment vehicles.

How do you start a CIT?

Starting a CIT is an intricate process, and is by no means simple. It would involve putting together several governing documents, assuring that the CIT is operating within the confines of state and federal laws, working with regulators, and then pooling investments — no easy feat.

Are CITs recommended to diversify a portfolio?

CITs may be recommended by a financial professional as a way to diversify an investment portfolio, as they comprise many different individual investments under one fund or trust.

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INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

Sep

2023

Exchange-Traded Notes: What Are ETNs? ETN Risks, Explained

What Is an Exchange-Traded Note (ETN)?

By Ashley Kilroy | Growing Wealth, invest, Investing | Comments Off

Exchange-traded notes, or ETNs, are debt securities that offer built-in diversity, and offer alternatives to other investment vehicles that may have certain problems for investors, like tracking errors and short-term capital gains taxes.

ETNs are similar to ETFs (exchange-traded funds), in that they may be a popular pathway to diversification because they expose investors to a wide range of financial assets, and come with lower expense ratios compared to mutual funds. As such, it can be beneficial for investors to understand ETNs and how they work.

What Is an Exchange-Traded Note (ETN)?

An ETN, or an exchange-traded note, is a debt security that acts much like a loan or a bond. Issuers like banks or other financial institutions sell the “note,” which tracks the performance of an underlying commodity or stock market index benchmark.

ETNs do not yield dividends or interest in the way that ETFs do. Before investors can earn a profit from an ETN, they must hold the security long enough for it to mature — typically ten to thirty years. Upon maturity, the ETN pays out one lump sum according to their underlying commodity’s return.

Exchange-Traded Notes Meaning

The term “exchange-traded note” may sound a bit off to some investors, but its meaning is fairly straightforward. For one, ETNs are “exchange-traded” because they’re literally traded on exchanges, like many other securities. And they’re called “notes” because they are debt securities, not pools of investments like a fund (as in ETF).

Examples of ETNs

To further illustrate how an ETN works and is constructed, suppose you purchase an ETN that tracks the price of gold. As an investor, you don’t own physical gold, but the note’s value tracks gold’s performance. When you sell the ETN, during or at the end of the holding period, your return will be the difference between gold’s sale price at that time and its original purchase price, deducting any associated fees.

Similarly, you could, hypothetically, create an ETN that tracks the price of a commodity like oil. Again, investors don’t actually own barrels of crude, but the ETN would track oil prices until it matures, and then pay out applicable returns.

💡 Quick Tip: Did you know that opening a brokerage account typically doesn’t come with any setup costs? Often, the only requirement to open a brokerage account — aside from providing personal details — is making an initial deposit.

Pros of ETNs

ETNs are a relatively newer type of financial security compared to some others available on the market. Their design comes with perks that some investors may find appealing.

Access to New Markets

Some individual investors may struggle to access niche markets like currencies, international markets, and commodity futures, since they require high minimum investments and significant commission prices. ETNs don’t have these limitations, making them more available to a larger pool of investors.

Accurate Performance Tracking

Unlike ETFs, ETNs don’t require rebalancing. That’s because ETNs do not own an underlying asset, rather they duplicate the index or asset class value it tracks. This means investors won’t miss any profits due to tracking errors, which means a difference between the market’s return and the ETF’s actual return.

Tax Treatment Advantages

Investors of ETNs don’t receive interest, monthly dividends, or annual capital gains distributions — which in turn means they don’t pay taxes on them. In fact, they only face long-term capital gains taxes when they sell or wait for an ETN to mature.

Liqudity

Investors have two options when selling ETNs: They can buy or sell them during regular day trading hours or redeem them from the issuing bank once a week.

Cons of ETN

Every investor must be wary of their investments’ drawbacks. Here are some potential cons of trading ETNs.

Limited Investment Options

Currently, there are fewer ETN options available to investors than other investment products. Additionally, though issuers try to keep valuations at a constant rate, pricing can vary widely depending on when you buy.

Liquidity Shortage

ETFs and stocks can be exchanged throughout the trading day according to price fluctuations. With ETNs, however, investors can only redeem large blocks of the security for their current underlying value once a week. This has the potential to leave them vulnerable to holding-period risks while waiting.

Credit, Default, and Redemption Risk

There are a range of risks associated with ETNs.

1. Risk of default. An ETN is tied to a financial institution such as a bank. It’s possible for that bank to issue an ETN but fail to pay back the principal after the holding period. If so, they’ll go into default, leaving you with a loss. There’s no absolute protection for owners in this case since ETNs are unsecured. External and social factors can lead to a default, too, not just economic influences.

2. Redemption risk. Investors can also take a loss if the institution calls its issued ETNs before maturity. This is called call or redemption risk. In this case, the early redemption may result in a lower sale price than the purchase price, leading to a loss.

3. Credit risk. The institution that issues the ETN impacts the credit rating of the security, which has to do with credit risk. If a bank experiences a drop in its credit rating, so will the ETN. That leads to a loss of value, regardless of the market index it tracks.

ETN vs. ETF: What’s the Difference?

Comparing ETNs and ETFs may help investors to see the pros and cons of either asset more clearly. Both ETNs and ETFs are exchange-traded products (ETPs) that track the metrics of an underlying commodity they represent. Other than that, though, they operate differently from each other.

Asset Ownership

ETFs are similar to a mutual fund, in that investors have some ownership over multiple assets that the ETF bundles together. You invest in a fund that holds assets. They issue periodic dividends in returns as well.

In comparison, ETNs are debt instruments and represent one index or commodity. They are an unsecured debt note that tracks the performance of an asset but doesn’t actually hold the asset itself. As a result, they only issue one payout when you sell or redeem them.

Taxation

These differences impact taxation. An ETF’s distributions are taxable on a yearly basis. Every time a long-term holder of a conventional ETF receives a dividend, they face a short-term capital gains tax.

Comparatively, ETN’s one lump-sum incurs a single tax, making it beneficial for investors who want to minimize their annual taxes.

Recommended: ETF Trading & Investing Guide

The Takeaway

ETNs are unsecured debt notes that track an index or commodity, and are sold by banks and other financial institutions. Like any investment, ETNs have both benefits and drawbacks — and while they may sound like ETFs, there are differences between these two products, notably that with ETNs you do not own any underlying assets.

ETNs may have a place in an investment portfolio, but it’s important that investors fully understand what they are, how they work, and how they can be incorporated into an investment strategy. It may be helpful to speak with a financial professional for guidance.

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FAQ

Who developed ETNs?

Barclays, a large international bank, first developed exchange-traded notes (ETNs) in 2006 as a way to give retail investors an easier path to investing in asset classes like commodities and currencies.

How is an ETN related to ETPs?

ETPs, or exchange-traded products, is a term that refers to a range of financial securities that trade on exchanges. ETNs, or exchange-traded notes, fall under the ETP umbrella, since they are investments that trade on exchanges.

Where are ETNs listed?

ETNs are listed on different exchanges, and can often be found by searching for their respective ticker or symbol.

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INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

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