DPPs, REITs, Hedge Funds, and ETPs

Mutual funds set the default in most students' heads. You'll meet four products that break it in different ways. For each, know where it trades, who may buy it, and who pays the tax.

DPPs: the business passes its taxes to you

A direct participation program (DPP) is a business venture that passes its income, gains, losses, deductions, and credits through to its investors. The program pays no federal income tax; each investor reports a share of the results on a personal return. That is pass-through taxation. The partnership files Form 1065 and sends each investor a Schedule K-1.

The outline gives two forms:

• A limited partnership has at least one general partner and any number of limited partners. The general partner runs the business and carries unlimited liability. A limited partner stays passive and can lose no more than the amount invested.
• Tenants in common (TIC) gives each investor a fractional deeded interest in the property itself, rather than a partnership interest.

A limited partner who helps manage the business can lose limited liability and be treated as a general partner. Passive means passive.

Each kind of program sells a different tax benefit. Real estate sells depreciation. Oil and gas sells intangible drilling costs and depletion. Equipment leasing sells depreciation against rental income.

Every DPP is unlisted and generally illiquid. No exchange lists the interests, and no active secondary market exists. If you want out of a DPP early, expect a steep discount, if you can sell at all. Each program also has a limited life.

REITs: real estate income taxed once

A real estate investment trust (REIT) owns or finances income-producing real estate. It escapes corporate income tax by paying its earnings out, so the income is taxed once. A REIT keeps that treatment by meeting three tests:

• At least 75% of its assets must be real estate, cash, or government securities.
• At least 75% of its gross income must come from real estate sources such as rent and mortgage interest.
• It must distribute at least 90% of its taxable income each year.

Sort REITs by what they hold. An equity REIT owns and operates buildings and earns rent. A mortgage REIT holds mortgages and mortgage-backed securities and earns interest, which makes it the most rate-sensitive type. A hybrid REIT does both.

Then sort by how they trade, which gives the outline's three types:

• A listed REIT trades on a stock exchange, so you can sell on any trading day.
• A registered non-listed REIT registers with the SEC and files reports, but no exchange lists it. Upfront fees often total 9% to 10%, and no per-share value may appear for 18 months after the offering closes.
• A private REIT does not register with the SEC. It sells through private placements to accredited investors and discloses the least.

Hedge funds and private equity: private, costly, slow to exit

A hedge fund is a private pooled fund that does not register with the SEC as an investment company. It usually takes the form of a limited partnership, with the manager as general partner and investors as limited partners. Taxes pass through, as in a DPP.

Hedge funds are not marketed to retail investors. A buyer must be an accredited investor or a qualified purchaser (someone with at least $5 million in investments, a higher bar than accredited investor). Minimums commonly start around $250,000. A hedge fund manager can use your money for leverage, short selling, and derivatives, so losses can run deep.

Fees run high. Investors pay a management fee of 1% to 2% of NAV plus a performance fee of 15% to 20% of profits. The industry calls that "2 and 20". A high-water mark stops the manager from charging that fee twice on the same gains.

A lock-up period of a year or more blocks withdrawals at the start. After that, redemptions usually open four times a year or fewer, and the fund may suspend them in stressed markets.

A private equity fund shares that structure and differs in what it buys: controlling stakes in operating companies, held for ten years or more.

ETPs: fund exposure that trades like a stock

An exchange-traded product (ETP) tracks an index or a basket of assets and trades on an exchange all day. The outline gives two: ETFs and ETNs.

An exchange-traded fund (ETF) registers with the SEC as an open-end fund or a unit investment trust and holds the actual securities. Its shares trade all day at prices that can sit above or below NAV. You can buy an ETF on margin, sell it short, and trade options on it. A mutual fund allows none of that.

An authorized participant, usually a large bank, creates and redeems ETF shares by swapping them for baskets of the underlying securities. That in-kind swap holds the price near NAV and produces few capital gains distributions, so ETFs are more tax-efficient than mutual funds.

Fees follow the active and passive split. A passive ETF tracks an index and can charge under 0.10% a year; an actively managed ETF charges more. An ETF buyer also pays a brokerage commission, which a no-load mutual fund does not charge.

An exchange-traded note (ETN) is an unsecured debt obligation of a bank that promises the return of a stated index. No basket of assets sits behind it. If the bank defaults, you are an unsecured creditor and can lose the investment even when the index rose. The payoff is contractual, so an ETN has no tracking error, the gap between a fund's return and the index it follows.

How this gets tested

Most items hand you a product and ask for one attribute: liquidity, tax treatment, or who may buy it. One split answers most of them. Private and unlisted products (DPPs, registered non-listed REITs, private REITs, hedge funds, private equity funds) are illiquid, and the private ones need an accredited investor. Listed products (listed REITs, ETFs, ETNs) trade daily and are open to any brokerage customer.

Watch the name "tenants in common". Here it is a DPP type. In the customer accounts section it is a joint account registration.