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Chapter1
TheInvestmentIndustry:ATopDown
View
byIanRossaOReilly,CFA

Copyright2014CFAInstitute

LEARNINGOUTCOMES

Aftercompletingthischapter,youshouldbeabletodothefollowing:

A. Describethefinancialservicesindustry

B. Identifytypesoffinancialinstitutions,includingbanksandinsurancecompanies

C. Definetheinvestmentindustry

D. Explainhoweconomiesbenefitfromtheexistenceoftheinvestmentindustry

E. Explainhowinvestorsbenefitfromtheexistenceoftheinvestmentindustry

F. Describetypesandfunctionsofparticipantsoftheinvestmentindustry

G. Describeforcesthataffecttheevolutionoftheinvestmentindustry.

1.INTRODUCTION

Likeitornot,thevastmajorityofushavetowork.Weworktosustainourselvesandourdependents.

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Often,weearnmoneyforourlabourandusethatmoneytopurchasegoodsandservices.Butmoney
canbeusedformorethaneverydayneeds.Ifwespendlessthanweearn,wehavesavings.Ifweseek
toearnareturnonoursavings,weareinvesting.

Toexplainhowsaversbecomeinvestors,considertheexampleofaCanadianentrepreneurwhoneeds
moneytosetupanewbusiness.Sheneedstofindsaverswhoarewillingtoinvestinherbusiness,so
shespendsweeksaskingherfriendsandneighboursuntilsheeventuallyfindsafriendwhoiswilling
toinvest.Thisfriendbelieveshewillgetbackmoremoneythanhelends,soheispreparedtoinvest
someofhissavings.

Theentrepreneurishappybecauseshecannowstartherbusiness.Butthesearchformoneyhastaken
alongtimeitcouldhavebeensomuchquickerandeasierforhertofindthemoneyiftherewasa
systemthatconnectedthosewhoneedmoneywiththosewhohavesavingsandarewillingtoinvest
thesesaving.Well,thereissuchasystem!Itiscalledthefinancialsystem.

2.THEFINANCIALSERVICESINDUSTRY

Thefinancialsystemhelpslinksaverswhohavemoneytoinvestandspenderswhoneedmoney.
Withinthefinancialsystem,thefinancialservicesindustryoffersarangeofproductsandservicesto
saversandspendersandhelpschannelfundsbetweenthem.Notethatinthischapterandintherestof
thecurriculum,thetermsmoney,cash,funds,andfinancialcapital(orcapital)areused
interchangeably.1

Saversincludeindividuals(households),companies,andgovernmentsthathavemoneytoinvest.
Spendersalsoincludeindividuals,companies,andgovernments.Forexample,individualsborrowto
payforhouses,education,andotherexpenses.Companiesborrowtoinvestinland,buildings,and
machinery.Governmentsborrowwhentheircurrenttaxreceiptsareinsufficienttomeettheircurrent
spendingplans.

TERMINOLOGY

Typically,thetermsavercharacterisesthosewhohaveaccumulatedsavings.Asillustratedinthe
exampleearlier,thesesavingsareofteninvested.Whensavershavemadeinvestments,theyare
typicallycalledinvestorsandbecomeprovidersofcapital.Iftheinvestmentisaloanthatis,
moneythatisexpectedtoberepaidwithinterestinvestorsareoftenreferredtoaslenders.
Similarly,thetermspendercharacterisesthosewhoneedmoney.Whenspendershavereceived
themoneytheyneedandstartusingit,theybecomeusersofcapital.Iftheyarerecipientsofa
loan,theyaretypicallycalledborrowers.Notethattherearetimeswhentheterms
savers/investors/lenders/providersofcapitalorspenders/borrowers/usersofcapitalareused
interchangeably.

Savingscanbeinvestedinawiderangeofassets.Assetsareitemsthathavevalueandincludereal
assetsandfinancialassets.Realassetsarephysicalassets,suchasland,buildings,machinery,cattle,
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andgold.Theyoftenrepresentacompanysmeans(orfactors)ofproductionandaresometimes
referredtoasphysicalcapital.Incontrast,financialassetsareclaimsonreal,orpossiblyother
financial,assets.Forexample,ashareofstockrepresentsownershipinacompany.Thissharegivesits
owner,whoiscalledashareholder,aclaimtosomeofthecompanysassetsandearnings.An
investorstotalholdingsoffinancialassetsisusuallycalledaportfolioorinvestmentportfolio.

Financialassetsthatcanbetradedarecalledsecurities.Thetwolargestcategoriesofsecuritiesare
debtandequitysecurities.

Debtsecuritiesareloansthatlendersmaketoborrowers.Lendersexpecttheborrowerstorepay
theseloansandtomakeinterestpaymentsuntiltheloansarerepaid.Becauseinterestpayments
onmanyloansarefixed,debtsecuritiesarealsocalledfixedincomesecurities.Theyarealso
knownasbonds,andinvestorsinbondsarereferredtoasbondholders.Moreinformationabout
debtsecuritiesisprovidedintheDebtSecuritieschapter.

Equitysecuritiesarealsocalledstocks,sharesofstock,orshares.Asmentionedearlier,
shareholders(alsoknownasstockholders)haveownershipinacompany.Thecompanyhasno
obligationtoeitherrepaythemoneytheshareholderspaidfortheirsharesortomakeregular
payments,calleddividends.However,investorswhobuysharesexpecttoearnareturnbybeing
abletoselltheirsharesatahigherpricethantheyboughtthemand,possibly,byreceiving
dividends.EquitysecuritiesarediscussedfurtherintheEquitySecuritieschapter.

Marketsareplaceswherebuyersmeetsellerstotrade.Placeswherebuyersandsellerstradesecurities
areknownassecuritiesmarkets,orfinancialmarkets.Howsecuritiesareissued,bought,andsoldis
explainedinTheFunctioningofFinancialMarketschapter.

Exhibit1showshowthefinancialservicesindustryhelpschannelfundsbetweenthosethathave
moneytoinvest(thesaversthatbecomeprovidersofcapital)andthosethatneedmoney(thespenders
thatbecomeusersofcapital).Keyindustryparticipantsandprocessesaredescribedinmoredetaillater
inthischapter.

Exhibit1.OverviewoftheFinancialServicesIndustry

Providersandusersofcapitalmayinteractthroughfinancialmarketsorthroughfinancial
intermediaries.Themovementoffundsthroughfinancialmarketsiscalleddirectfinancebecausethe
providersofcapitalhaveadirectclaimontheusersofcapital.Forexample,ifyouownsharesof
Nestl,youhaveaclaimontheassetsandearningsofNestl.

Providersandusersofcapitaloftenrelyonfinancialintermediariestofindeachotherandtochannel
fundsbetweeneachother.Thisprocessisindirectfinancebecausefinancialintermediariesactas
middlemenbetweensaversandspenderstheformerdonothavedirectclaimsonthelatter.Financial
intermediariesmayalsocreatenewproductsandsecuritiesthatdependonotherassets.

Financialintermediariesplayanimportantroleinthefinancialservicesindustry.Manysaversdonot
havethetimeortheexpertisetoidentifyandselectindividuals,companies,andgovernmentstolendto
orinvestin.Oncesavershavelentmoney,theyhavetomonitortheborrowersbehaviourand
financialhealthtoensurethattheywillgettheirmoneybackataskthatistimeconsumingand
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costly.Matchingsaversandborrowersandmonitoringborrowersbehaviourandfinancialhealthare
functionsthatfinancialintermediariescanperformbetterandmorecheaplythanmostinvestorscando
ontheirown.

3.FINANCIALINSTITUTIONS

Financialinstitutionsaretypesoffinancialintermediaries.Theirroleistocollectmoneyfromsavers
andtoinvestitinfinancialassets.Thetwomajortypesoffinancialinstitutionsarebanksand
insurancecompanies.

3.1.Banks
Bankscollectdepositsfromsaversandtransformthemintoloanstoborrowers.Indoingso,they
indirectlyconnectsaverswithborrowers.Thesaverdoesnothaveadirectclaimontheborrowerbut
ratherhasaclaimonthebankthroughitsdeposit,andthebankhasaclaimontheborrowerthrough
theloan.Banksarealsocalleddeposittakinginstitutions(ordepositoryinstitutions)becausethey
takedeposits.Inexchangeforusingthedepositorsmoney,banksoffertransactionservices,suchas
checkwritingandcheckcashing,andmaypayinterestonthedeposit.Banksmayalsoraisemoneyto
makeloansbyissuingandsellingbondsorstocksonfinancialmarkets.

Banksvaryinwhomtheyserveandhowtheyareorganised.Theymayhavedifferentnamesin
differentcountries.Buildingsocieties(alsocalledsavingsandloanassociationsinsomecountries)
specialiseinfinancinglongtermresidentialmortgages.Retailbanksprovidebankingproductsand
servicestoindividualsandsmallbusinesses.Theseproductsandservicesincludecheckingandsavings
accounts,debitandcreditcards,andmortgageandpersonalloans.Anincreasingnumberofretail
bankingtransactionsarenowperformedeitherelectronicallyviaautomatedtellermachines(ATMs)or
overtheinternet.Commercialbanksprovideawiderangeofproductsandservicestocompaniesand
otherfinancialinstitutions.

Cooperativeandmutualbanksarefinancialinstitutionsthattheirmembersownandsometimesrun.
Theymayspecialiseinprovidingmortgagesandloanstotheirmembers.Somecooperativeand
mutualbanksmayofferawiderrangeofproductsandservices,similartothoseofferedbycommercial
banks.Depositorsbenefitbecausetheyearnareturn(ininterest,transactionservices,dividends,or
capitalappreciation)ontheircapitalwithouthavingtolocatetheborrowers,checktheircredit,
contractwiththem,andmanagetheirloans.

Ifborrowersdefault,banksstillmustpaytheirdepositorsandotherlenders.Ifthebankscannotcollect
sufficientmoneyfromtheirborrowers,thebankswillhavetousetheirownerscapitaltopaytheir
debts.2Theriskoflosingcapitalshouldfocusthebanksattentionsothattheydonotoffercredit
foolishly.However,notablelapsesoccasionallyoccur,suchasintherunuptothefinancialcrisisof
2008.Investorstoooftenwerenotawareof,ignored,orcouldnotcontroltherisksthatbankswere
taking.

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3.2.InsuranceCompanies
Insurancecompanieshelpindividualsandcompaniesoffsettheriskstheyface.Toprotect
themselvesagainstapotentialloss,individualsandcompaniesbuyinsurancecontracts(alsoknownas
policies)thatprovidepaymentsintheeventthatlossesoccur.Theytypicallypayinsurancecompanies
upfront,nonrefundablepremiumswhentheypurchaseinsurancecontracts.Iftheinsuredrisks
materialise,theinsuredindividualorcompanymakesaclaimtotheinsurancecompanyandcollects
theinsurancesettlement.

Therearetwomaintypesofinsurancecompanies:propertyandcasualtyinsurersthatcoverassetssuch
ashomes,cars,andbusinesses,andlegalliabilityandlifeinsurersthatpayoutasumofmoneyupon
deathorseriousinjuryofthepersoninsured.

Insurersarefinancialintermediariesbecausetheyconnectbuyersoftheirinsurancecontractswith
providersofcapitalthatarewillingtobeartheinsuredrisks.Thebuyersofinsurancecontractsbenefit
becausetheycantransferriskwithoutsearchingforsomebodywhowouldbewillingtoassumethose
risks.Theprovidersofcapitalbenefitbecausetheinsurancecompanyallowsthemtoearnareturnfor
takingontheseriskswithouthavingtomanagetheinsurancecontracts.Theinsurancecompany
managestherelationshipswiththeinsuredindividualandcompaniesprimarily,thecollectionofthe
premiumsandthesettlementofclaims.Inaddition,theinsurancecompanyhopefullycontrolsvarious
issuesininsurancemarketsforexample,fraud,moralhazard,andadverseselection.Fraudoccurs
whenpeopledeliberatelycauseorfalselyreportlossestocollectinsurancesettlements.Moralhazard
occurswhenpeoplearelesscarefulaboutavoidinglossesoncetheyhavepurchasedinsurance.Moral
hazardpotentiallyleadstolossesoccurringmoreoftenwithinsurancethanwithout.Adverse
selectionoccurswhenonlythosewhoaremostatriskbuyinsurance,causinginsuredlossestobe
greaterthanaveragelosses.

Insurersarenotonlyfinancialintermediariesbutalsoamongthelargestinvestors.Theyusuallyinvest
asignificantportionofthepremiumstheyreceivefromthebuyersofinsurancecontractsinfinancial
marketsinordertomeetthecostoffutureclaims.

4.HOWECONOMIESBENEFITFROMTHE
EXISTENCEOFTHEINVESTMENTINDUSTRY

Theinvestmentindustryisasubsetofthefinancialservicesindustry.Itcomprisesalltheparticipants
thatareinstrumentalinhelpingsaversinvesttheirmoneyandhelpingspendersraisecapitalin
financialmarkets.Majorinvestmentindustryparticipants,suchastypesofinvestorsandservice
providers,arepresentedinSection6ofthischapter.Theactivitiesperformedbyserviceprovidersare
discussedfurtherintheStructureoftheInvestmentIndustrychapter.

4.1.EconomicSystems
Theinvestmentindustryanditsparticipantsdonotexistinisolationtheyoperatewithineconomic
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systemsthatvaryfromcountrytocountry.Economicsystemscantakemanyforms,frompure
capitalismwithfreemarketstoplannedeconomieswithcentralisedauthorities.Agoalofmost
economicsystemsistheefficientallocationofscarceresourcestotheirmostproductiveuses.

Resources,suchaslabour,realassets,andfinancialcapital,arenecessarytoproducegoodsand
services.Desireforgoodsandservicesisunlimited,butresourcesarelimited.Toillustratethis
conceptofscarcity,assumethatanindividualhasalimitedbudgetinotherwords,hisfinancialcapital
isscarce.Shouldhespendhismoneybuyingfood,payinghismortgage,purchasinganewcar,or
goingonholiday?Similarly,shouldacompanyfocusitsresourcesonanexistingproductoronanew
onethatmightproduceahigherprofit?Andshouldgovernmentsspendmoneyonhealthcare,
education,defence,orinfrastructure?

Becauseresourcesarescarce,decisionsmustbemaderegardingtheallocationoftheseresources.
Participantsineconomicsystemsmustaddressthreequestions:(1)Whichgoodsandservicesshould
beproduced?(2)Howshouldthegoodsandservicesbeproduced?(3)Whoshouldreceivethegoods
andservicesthatareproduced?Theallocationofscarceresourcesisefficientifthescarceresources
areusedtoproducegoodsandservicesthatbestsatisfytheneedsofconsumers.

Capitalism isaneconomicsystemthatpromotesprivateownershipasthemeansofproductionand
marketsasthemeansofallocatingscarceresources.Inapure,freemarket,capitalisticeconomy,there
isnocentralauthority,suchasagovernment,directingeconomicactivity.Instead,individualsand
companiesmaketheirowndecisionsaboutwhatgoodsandservicestomanufactureandprovide,and
theygettokeeptheprofitsfromtheiractivities.Whenscarceresourcesareusedinanefficientmanner
throughthemarkets,economiescangrowandsocietybenefits.

However,pure,freemarketcapitalismexistsonlyintheory.Intherealworld,governmentsplayarole
inalleconomicsystems.Insomecapitalisticeconomies,suchasinWesterneconomies,the
governmentsroleinbusinessmayberelativelyminimal.Ineconomieslargelydependentonthe
extractionofnaturalresources,suchassomeformerSovietRepublicsandsomeMiddleEastern,
African,andSouthAmericancountries,thegovernmentmaymaintainsignificantcontroloverkey
nationalindustries.Intransitioneconomies,whicharemovingfromplannedeconomiestomarket
economies,thegovernmentmayplayasignificantroleinbusiness.Chinaseconomyisoften
describedasstatecapitalismbecausetheChinesecentralandlocalgovernmentshavesignificant
ownershipofmanybusinesses.PeoplecanalsocreateandinvestinbusinessesinChina,andmarket
competitionisincreasing.

4.2.HowtheInvestmentIndustryFostersEconomicGrowth
So,whatroledoestheinvestmentindustryplayinsupportingthecreationofgoodsandservicesand,
ultimately,enhancingthelivesofconsumers?Asmentionedpreviously,theinvestmentindustryis
instrumentalinchannellingfundsbetweensaverswhohavemoneytoinvestandthosewhoneed
moneytofinancebusinessesandprojects.

Theinvestmentindustrycontributestotheefficientallocationofresourcesintheeconomy.Without
theinvestmentindustry,saverswouldhavetospendsignificantresourcesfindingindividuals,
companies,andgovernmentsofferingsuitableinvestmentopportunities.Resourceswouldalsobe
spentonthesearchforcapitalratherthanonconsideringhowtobestuseit,whichwouldresultinless
efficiency.

Theinvestmentindustryplaysanimportantroleinprovidingandprocessinginformationabout
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investmentopportunities.Ithelpsinvestorscollectandanalysedataabouteconomiesandinformation
aboutindividuals,companies,andgovernments.Italsoassistsinvestorsindeterminingthevalueof
realandfinancialassets.Thetypesofinputsandtoolsusedbyinvestmentindustryparticipantsare
describedinthechaptersintheInputsandToolsmodule.

Investmentindustryparticipantspackageinvestmentopportunitiessothattheysatisfytheneedsof
investors.Inparticular,theinvestmentindustryoffersawiderangeofservicesandproductsthat
makesiteasierforsaverstoinvest.Theseinvestmentservicesandproductsarediscussedinthe
chaptersintheIndustryStructuremodule.

Theinvestmentindustryalsoprovidesliquidity.Liquidityreferstotheeaseofbuyingorsellingan
assetwithoutaffectingitsprice.Someassets,suchasrealestate(landandbuildings),areinherently
illiquid.Forexample,ifyouwanttosellyourhouse,itwilllikelytakesometimetosell,evenifitis
pricedfairlycomparedwithotherhousesinyourneighbourhood.Ifyouwanttosellyourhouse
quickly,youmayhavetosellitatalowerpricethanyouthinkisfair.Otherassetsaremoreliquid,
suchassharesthattradeactively.Butaninvestormayholdalargenumberofsharesandsellingallthe
sharesquicklycouldhaveanegativeeffectontheshareprice.Forexample,ifaninvestorowns100
sharesinacompanywithactivelytradedshares,shewilllikelybeabletosellhersharesquicklyand
notaffecttheshareprice.Butifsheowns100,000shares,shemaynotbeabletosellhershares
quicklywithoutaffectingtheshareprice.Asaresult,shemayhavetoacceptalowerpriceforsomeor
allofthesharesshewantstosell.Liquidityisaveryimportantaspectofwellfunctioningfinancial
markets.Highlyliquidmarketsallowinvestorstocompleteatransactionquickly(andtoreverseit
quicklyiftheychangetheirminds)andtohaveconfidencethattheyaregettingafairpriceatthat
particularmoment.

Allofthesebenefitsincreasethewillingnessofsaverstosupplyfundstothosewhoneedthem.Capital
thatisputtomoreproductiveusefosterseconomicgrowth,whichultimatelybenefitssociety.

5.HOWINVESTORSBENEFITFROMTHE
EXISTENCEOFTHEINVESTMENTINDUSTRY

Inawellfunctioninginvestmentindustry,investorsaretreatedfairlyandhonestly.Asaresult,they
haveconfidencetocommittheirsavingstoinvestments.Ideally,investmentindustryparticipants
competefairlyforinvestorsbusiness,andtheyarecompetentandtrustworthyinadvisingon
investmentmattersandmanaginginvestmentproductsandportfolios.

5.1.HowtheInvestmentIndustryServesInvestors
Belowaresomeofthemostimportantfeaturesthatdefineawellfunctioninginvestmentindustryand,
inturn,benefitinvestors.

Animportantfeaturethatcharacterisesawellfunctioninginvestmentindustryistheavailabilityofa
broadrangeofinvestmentopportunitiesthatmeetsinvestorsneeds.Investorscaninvestindebtand

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equitysecuritiesandtheycanalsoinvestinderivativesandalternativeinvestments.Theseinvestments
aredescribedinmoredetailintheInvestmentInstrumentsmodule.Investorsmayalsochoosetosave
throughinvestmentvehiclesthatexistsolelytoholdinvestmentsonbehalfoftheirshareholders,
partners,orunitholders(unitsrefertosharesandbondsforequityanddebtsecurities,respectively).
Theownershipinterestsofthesecompaniesarecalledpooledinvestmentvehiclesbecauseinvestorsin
thesevehiclespooltheirmoneyforcommonmanagement.Typesandcharacteristicsofinvestment
vehiclesarediscussedintheInvestmentVehicleschapter.

Investmentindustryparticipantsmayalsobuyandsellvariousrealandfinancialassetsandthen
packagethemtocreatenewassetsthatsuittheneedsofinvestorsbetterthantheoriginalassets.
Mortgagebackedsecuritiesareanexampletheyrepresentaclaimonthemoneygeneratedbyalarge
numberofmortgagesthathavebeengroupedtogetherinaprocesscalledsecuritisation,whichis
furtherdiscussedintheDebtSecuritieschapter.

Inadditiontobeingabletochoosefrommanyinvestmentopportunities,investorsbenefitfromhaving
accesstoabroadrangeofinvestmentservicesthathelpthemmakebetterdecisionsandimplement
thosedecisions.Theinvestmentindustryoffersservicesofvaluetoinvestorsincludingplanning,
management,information,andtradingservices.TheseservicesarediscussedintheStructureofthe
InvestmentIndustrychapter.Howinvestmentindustryparticipantsassessandservetheneedsof
investorsisdiscussedfurtherinthechaptersintheServingClientNeedsmodule.

Investorsbenefitwhenfinancialmarketsarecompetitive.Competitivemarketsleadtofairprices,
whichensurethatbuyerspayandsellersreceiveareasonableandsatisfactoryprice.Marketsin
generalandfinancialmarketsinparticulararecompetitiveifalargenumberofparticipantscompete
withoneanotherwithoutanyoneofthemhavinganundueinfluenceonsupplyordemand.Supply
referstothequantityofagoodorservicesellersarewillingandabletosell,whereasdemandrefersto
thequantityofagoodorservicebuyersdesiretobuy.Moreinformationaboutsupplyanddemandand
howtheinteractionofsupplyanddemandaffectspricesofgoodsandservicesispresentedinthe
Microeconomicschapter.Competitivemarketspromotehigherproductionefficiencyandhelpkeepthe
pricesofgoodsandservices,includinginvestmentproductsandservices,down.

Investorsalsobenefitwhenfinancialmarketsareliquidandtransactioncostsarelow.Asmentioned
earlier,liquidityensuresthatinvestorscanquicklybuyorsellanassetwithoutaffectingitsprice.
Transactioncostsarethecostsassociatedwithtrading.Becausetransactioncostsreducethereturn
saversmakeontheirinvestments,thelowerthetransactioncosts,thebetter.

Tomakereasonablejudgmentsaboutwhattoinvestin,saversneedrelevantandreliableinformation
aboutthecompaniesandgovernmentstowhichtheyprovideormayprovidecapital.Byhelping
collectandprocessfinancialinformation,investmentindustryparticipantsprovidebenefitsto
investors.Thetimelinessofthisinformationisalsocriticalbecausesecuritiespricesmaychange
quicklyinresponsetonew,relevantinformation.Forexample,thesharepriceofanoilcompanythat
announcesithasdiscoveredalargenewoilfieldwilllikelyincreaseasinvestorsanticipatethatthe
companywillmakehigherprofit.

Anotherimportantfeatureofawellfunctioninginvestmentindustryistheabilitytodealwithrisk.
Riskreferstotheeffectofuncertainfutureeventsonanorganisationorontheoutcomesthe
organisationachievesandisdiscussedingreaterdetailintheRiskManagementchapter.Riskisan
inherentelementofinvesting,andinvestorsshouldalwaysconsiderbothreturnandriskwhenthey
makeinvestmentdecisions.Forexample,themanwholenthissavingstohelpstarthisfriends
businessfacestheriskthatthefriendsbusinessfailsandhenevergetshismoneyback.Althoughthe
friendsbusinesscouldturnouttobethenextApple,Google,orMicrosoft,theinvestormaydecide
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nottolendmoneytohisfriendiflosinghisentireinvestmentwouldhaveadevastatingeffectonhis
lifestyle.Theinvestmentindustrycanhelphimassesshowriskytheinvestmentis.

Theinvestmentindustryalsoprovideswaysofreducingrisk.Forexample,contractsandproductsthat
representsomeformofinsurancemaybeavailableforpurchase.Orindustryprofessionalsmay
provideadviceonhowbesttomitigatetheriskofinvestments.Thosewhoarewillingandabletotake
onriskmaysellinsuranceorofferinvestmentsthatallowotherstoreducetheirrisks.

5.2.NeedforTrust,Laws,andRegulations
Themanybenefitsthattheinvestmentindustryprovidestotheeconomyandinvestorsarenot
sustainablewithouttrust,laws,andregulations.

Trustisessentialtotheproperfunctioningofthefinancialsystemingeneralandtheinvestment
industryinparticular.Saversshouldbeconfidentthattheywillbetreatedfairlybythosetheylendto
orinvestinaswellasbythosewhoadvisethem,selltheminvestmentproductsorservices,and
managetheirinvestments.Iftrustislacking,saverswillbereluctanttoinvest,andtheeconomyand
societywillsuffer.

Lawsandregulationsarenecessarytoensurethatinvestorsaretreatedfairlyandhonestly.Usually,
lawsarepassedbyalegislativebody,suchasCongressintheUnitedStates,ParliamentintheUnited
Kingdom,andtheDietinJapan.Regulationsarecreatedbyagencies,suchastheCanadianSecurities
AdministratorsinCanada,theAutoritdesMarchsFinanciersinFrance,andtheSecurities&Futures
CommissioninHongKong.Lawsandregulationsmustbeenforceabletobeeffective.

Theformandextentoflawsandregulationsvarybetweencountriesandchangeovertime,buta
numberofgeneralprinciplesarewidelyapplied.Lawsandregulationsaredesignedto

preventfraud,

protectinvestmentindustryparticipants,inparticularinvestors,and

promoteandmaintaintheintegrity,transparency,andfairnessoffinancialmarkets.

Forexample,tradingbasedonnonpublicinformationthatcouldaffectasecurityspriceknownas
insidertradingisforbiddeninmostjurisdictions.Forexample,ananalystwholearnsduringaprivate
meetingwithacompanysmanagementthatthecompanyisabouttoacquireacompetitorisnot
allowedtobuyorsellsharesinthecompanyoritscompetitoruntilthecompanyhasofficially
announcedtheacquisition.Iftheanalysttradesbeforethisinformationisavailabletoallmarket
participants,hecouldgainfromthisinsideinformationandtheintegrityandfairnessofthefinancial
marketwouldbecompromised.Inmanyjurisdictions,theanalystcouldalsofacepunitivelegalor
regulatorymeasures.

Althoughtheinvestmentindustryissubjecttolawsandregulations,theselawsandregulationscannot
covereverysituationandcannotpreventfraudormarketabusefromhappening.Thisriskiswhyitis
importantthat

individualswhoworkintheinvestmentindustrybehaveethically,inaccordancewithasetof
moralprinciples,andactprofessionally,and

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organisationspromoteculturesofintegrity.

Ethicalbehaviouronthepartofinvestmentindustryparticipantsisparamounttoprotectthereputation
ofandmaintaintrustintheindustry.Withouttrust,saversarelesslikelytomakeinvestments,which
wouldbedetrimentaltotheeconomyandsociety.

WereturntothediscussionofethicsandregulationinthechaptersintheEthicsandRegulation
module.TheRiskManagementchapteraddressestheissueofcompliancewithlawsandregulations.

6.INVESTMENTINDUSTRYPARTICIPANTS

Therearemanyinvestmentindustryparticipantswhohelpspendersraisecapitalandsaversinvesttheir
money.Anybodyworkingintheinvestmentindustryorpurchasingproductsandservicesprovidedby
theinvestmentindustryislikelytocomeincontactwithanumberoftheseparticipants.Key
participantsareintroducedinSections6.1and6.2.Therestofthecurriculumprovidesmore
informationabouthowinvestmentindustryparticipantsoperateandhowtheyinteractwithinvestors
andwithoneanother.

Asawayofintroducingsomeofthemaininvestmentindustryparticipants,letustakealookatthe
Canadianentrepreneurscompanyfiveyearslater.Overthattime,thecompanyhasbeensuccessful,
anditnowneedsnewcapitaltocontinuegrowing.Themoneythecompanygeneratedfromits
operationsisnotenoughtosupportitsgrowthplans,andthecompanyhastoturntoinvestorsto
provideadditionalcapital.ThefinancialservicesindustrycanhelptheCanadiancompanyraisethe
moneyitneedsandallowinvestorstoparticipateinthecompanysgrowth.Wefirstintroducethose
participantsthatcanhelpthecompanytoraisecapital.Then,wediscussinvestorsandfocusonthe
maininvestmentindustryparticipantsthatcanhelpthemtoinvesttheirmoney.

6.1.HowCompaniesandGovernmentsRaiseCapital
TheCanadiancompanywantstoissuesharestoraisecapital.Untilnow,ithasbeenaprivate
companyithasnotraisedmoneybyissuingsharespublicly.Itwantstotaketheopportunityto
becomeapubliccompanyandhaveitsshareslistedontheTorontoStockExchange.Stockexchanges
areorganisedandregulatedfinancialmarketsthatallowbuyersandsellerstotradesecuritieswitheach
other.

Thecompanycontactsaninvestmentbanktohelpit.Investmentbanks,alsoknownasmerchant
banks,arefinancialintermediariesthathaveexpertiseinassistingcompaniesandgovernmentsraise
capital.Investmentbankshelpcompaniesorganiseequityanddebtissuancesthatis,thesaleof
sharesandbondstothepublic.InthecaseoftheCanadiancompany,theequityissuanceiscalledan
initialpublicoffering(IPO)becauseitisthefirsttimethecompanysellssharestothepublic.The
EquitySecuritiesandTheFunctioningofFinancialMarketschaptersprovidemoredetailsaboutIPOs
andotherequityissuances.

Investmentbanksarespecialistsinmatchinginvestorswithcompaniesandgovernmentsseeking

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capital.Theinvestmentbankspaycloseattentiontothetypesofinvestmentsthatinvestorsmostwant
sothattheycanhelpcompaniesandgovernmentsdesignsecuritiesthatwillsuittheneedsofthe
companyorgovernmentandappealtoinvestors.Byofferingsecuritiesthatinvestorswanttopurchase,
companiesandgovernmentsareabletoobtaincapitalatalowercost.

TheinvestmentbankwillhelptheCanadiancompanydeterminethepriceatwhichthenewshareswill
beissued.Todoso,theinvestmentbankhastogaugeinvestorinterestinpurchasingthecompanys
shares.Theinvestmentbanksanalystsoftencalledsellsideanalystsbecausetheyworkforthe
organisationsellingthesecuritieswillcollectandanalyseinformationaboutthecompanyandits
competitorsandprepareadetailedreportthatcanbesharedwithpotentialinvestors.

WhentheCanadiancompanybecomesapubliccompany,itwillhavetocomplywiththerulesofthe
TorontoStockExchangeandwithrelevantCanadianlawsandregulations.Itwill,forinstance,haveto
filequarterlyfinancialstatementsandauditedannualfinancialstatements.Auditorswillevaluatethe
companysinternalcontrolsandfinancialreportingandensurethatinvestorsreceiverelevantand
reliablefinancialinformation,akeyfeatureofwellfunctioningfinancialmarkets.Moreinformation
aboutfinancialstatementsandtheroleofauditorsisprovidedintheFinancialStatementschapter.

6.2.HowtheInvestmentIndustryHelpsSaversInvestTheirMoney
TheCanadiancompanymaysellitssharestomanyinvestorswhoseneedsvary.Abasicdistinctionis
oftenmadebetweenindividualandinstitutionalinvestors.Thedesignationindividualinvestoris
selfexplanatoryanindividualinvestorissimplyapersonwhohasinvestments.Incontrast,
institutionalinvestorsaretypicallyorganisationsthatinvesteitherforthemselvestoadvancetheir
missionsoronbehalfofothers.

Withineachofthesetwocategoriesofinvestorsindividualandinstitutionalthereisfurther
variation.Forexample,investmentindustrypractitionerstypicallydistinguishbetweenindividual
investorsaccordingtotheirtotalamountofinvestableassets.Thereisnouniversalstandardtoclassify
individualinvestorsthedistinctionbetweencategoriesofindividualinvestorsvariesacrosscountries,
currencies,andinvestmentfirms.Butasageneralrule,retailinvestorshavethelowestamountof
investableassets,whereashighnetworthinvestorshavehigheramountsofinvestableassets.

Theservicesthattheinvestmentindustryprovidestoindividualinvestorsdifferdependingonthe
investorswealthandlevelofinvestmentknowledgeandexpertise,aswellasontheregulatory
environment.Retailinvestorstendtoreceivestandardisedservices,whereaswealthierinvestorsoften
receiveservicesspeciallytailoredtotheirneeds.

Institutionalinvestorsthatinvesttoadvancetheirmissionsincludethefollowing:

Pensionplans,whichholdandmanageinvestmentassetsforthebenefitoffutureandalready
retiredpeople,calledbeneficiaries.

Endowmentfunds,whicharelongtermfundsofnotforprofitinstitutions,suchasuniversities,
colleges,schools,museums,theatres,operacompanies,hospitals,andclinics.

Foundations,whicharegrantmakinginstitutionsfundedbyfinancialgiftsandbytheinvestment
incomethattheyproduce.

Sovereignwealthfunds,whichtypicallyinvestagovernmentssurpluses.Governmentsmay
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accumulatesurplusesbycollectingtaxesinexcessofcurrentspendingneeds,bysellingnatural
resources,orbyfinancingthetradeofgoodsandservices.Thesesurplusesareusuallyinvested.
Somegovernmentswithsignificantsurpluseshavecreatedsovereignwealthfundstoinvesttheir
surplusesforthebenefitofcurrentandfuturegenerationsoftheircitizens.

Institutionalinvestorsthatinvestonbehalfofothersincludeinvestmentfirmsandfinancial
institutions,suchasbanksandinsurancecompanies.Differentcategoriesofinvestorsandtheirneeds
arediscussedfurtherintheInvestorsandTheirNeedschapter.

Despitethedifferencesbetweeninvestorsandtheirneeds,manyoftheservicestheyrequireare
commontoallofthem.SomeoftheseservicesareshowninExhibit2.

Exhibit2.InvestorServices

Wheninvestorswanttobuyorsellshares,theyneedtofindanotherinvestorwhoiswillingtosellor
buyshares.Brokersanddealersaretradingserviceprovidersthatfacilitatethistrading.Brokersactas
agentsthatis,theydonottradedirectlywithinvestorsbuthelpbuyersandsellersfindandtradewith
eachother.Incontrast,dealersactasprincipalsthatis,theyusetheirownaccountsandtheirown
capitaltotradewithbuyersandsellersinwhatisknownasproprietarytrading.Theymakemarkets
insecuritiesbyactingasbuyerswheninvestorswanttosellandassellerswheninvestorswanttobuy.
Theyoftenhavethousandsofclientssoifoneclientwantstosellsharesatacertainprice,thedealer
canusuallyidentifyanotherclientwhoiswillingtobuythesharesatasimilarprice.Brokersand
dealersbothprovideliquidityandhelpreducetransactioncostsasmentionedearlier,liquidityandlow
transactioncostsarebeneficialtoinvestors.

Otherparticipantsthatprovidetradingservicesincludeclearinghousesandsettlementagents,which
confirmandsettletradesaftertheyhavebeenagreedon.Custodiansanddepositoriesholdmoneyand
securitiesonbehalfoftheirclients.

Institutionalinvestorsmayemployanalyststoreviewpotentialinvestments.Theseanalystsarecalled
buysideanalystsbecausetheyworkfortheorganisationbuyingthesecurities.Togatherdataabouta
companyandthemarketsinwhichitoperates,analystsoftenrelyoninvestmentinformation
providers,suchasdatavendorsthatprovideinformationresourcesandinvestmentresearchproviders
thatproduceinformationreports.

Individualinvestorsoftendonothavethetime,theinclination,ortheexpertisetomanagetheentire
investmentprocessontheirown,somanyofthemseekthehelpofinvestmentprofessionals.Financial
planningserviceproviders,suchasfinancialplanners,helptheirclientsunderstandtheirfuture
financialneedsanddefinetheirinvestmentgoals.Investmentmanagementserviceproviders,suchas
assetmanagers,makeandhelptheirclientsmakeinvestmentdecisionsinordertoachievetheclients
investmentgoals.

Manyinvestors,particularlyretailinvestors,arewillingtoinvestbutlacksufficientfinancialresources
tocontractwithaninvestmentmanagertolookaftertheirinvestments.Theseinvestorsoftenbuy
investmentproductscreatedandmanagedbyinvestmentfirms,banks,andinsurancecompanies.For
example,anindividualwhowantstoplanforherretirementmayneedaconvenientandinexpensive

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waytoinvestmoneyregularly.Shemaybuysharesinamutualfund,aprofessionallymanaged
vehiclethatinvestsinarangeofsecurities.

MEETSOMEOFTHEINVESTMENTINDUSTRYPARTICIPANTS

ZhangLiisaretailinvestor.Sheearns5,000Singaporedollarsamonthandwantstosave
foradepositonanapartmentinthesuburbsofSingapore.Shealsowantstosavetopayfor
hersonsuniversityeducation.Shegoestoherbankforinvestmentadvice.
MikeSmithisahighnetworthinvestorwholivesinCalifornia.Hehasrecentlysoldhis
technologycompanyandhas$10milliontoinvest.Hehiresafinancialplannertohelphim
definehisinvestmentobjectivesintermsofreturnandrisk.
AnnaHuberisaninstitutionalinvestorforEuroPensionFund,whichislocatedinFrankfurt,
Germany.ThefundreceivesmoneytofinancetheretirementoftheEuroPensionPlan
members,investsthemoneyreceived,andpaysoutmoneytotheretiredmembers.Ithasan
assetmanagementteamthatdevisesitsstrategyandimplementsit,managinga50billion
portfolioinvestedinawiderangeofassets.Huberisamemberofthatteam.
PeterRobinsonisanassetmanagerforAusLtd.,whichisbasedinSydney.AusLtd.invests
moneyonbehalfofitsclientsinshares,bonds,andalternativeinvestments.Ithiresadata
vendorandtwoinvestmentresearchproviderstokeepitupdatedwiththelatestmarket
developments.AusLtd.hasabrokerthatcarriesouttradesonitsbehalfandacustodianthat
safeguardsclientsmoneyandassets.
AminaAlSubariisabrokeratMiddleEastCorp.,whichisbasedinDubai.Investors,such
asAusLtd.andEuroPensionFund,askhertofindandtradeassetsinthemarket.Middle
EastCorp.canfindandtradetheseassetsonanexchangeandalsodealdirectlywithother
investorswhowanttoselltheirassets.
JamesArmisteadiswithBigBankFinancialServices,acustodianwithofficesalloverthe
world.Whenaninvestor,suchasEuroPensionFundorAusLtd.,buyssecurities,thetrade
isconfirmedbyaclearinghouseandsettlementagent.Thecustodianthenholdsthesecurity
onbehalfoftheinvestorandmakessureaproperrecordiskeptofthesecurityanditsprice.

7.KEYFORCESDRIVINGTHEINVESTMENT
INDUSTRY

Likemostindustries,theinvestmentindustryisnotstatic.Itisconstantlychangingtomeetnewneeds
andtoreacttoeventsandevolutioninfinancialmarkets.Someofthesechangesaredriveninternally
thatis,byindustryparticipants.Theseinternalforcesare

Competition.Competitionintheinvestmentindustryisfierceandmanifestsitselfthrough
innovativeinvestmentproductandserviceofferings,pricing,andperformance.

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Technology.Technology,andcomputerisationinparticular,hasdramaticallydecreasedtrade
processingcostsandincreasedtradeprocessingcapacity.Ithasalsospurredthedevelopment
andanalysisofinnovativetypesofinvestmentproductsandvehicles.

Otherchangesaredrivenbyexternalforces.Theseexternalforcesare

Globalisation.Investorslookoutsidetheirdomesticmarketstodiversifytheirinvestmentsand
generatehigherreturns.Theseforeigninvestmentscontributetoeconomicdevelopmentandto
theoverallprofitsoftheinvestmentindustry.

Regulation.Globally,thereisatrendtowardgreaterregulationofthefinancialservicesindustry,
includingtheinvestmentindustry.Internationalcooperationamongfinancialregulatorshas
playedandshouldcontinuetoplayanimportantroleinraisingglobalstandardsofsecurities
regulation.

SUMMARY

Withoutthefinancialservicesindustry,moneywouldhavedifficultyfindingitswayfromsaversto
individuals,companies,andgovernmentsthathavebusinessesandprojectstofinancebutinsufficient
capitaltodosothemselves.Atitsbest,theindustryefficientlymatchesthosewhoneedmoneywith
thosewhohavesavingstoinvest,minimisingthecoststoeachandallowingmoneytosupportthe
mostproductivebusinessesandprojects.Theinvestmentindustryactsonbehalfofsavers,helping
themtonavigatethefinancialmarkets.Whentheinvestmentindustryisefficientandtrustworthy,
economiesandindividualsbenefit.

Thepointsbelowsummarisewhatyouhavelearnedinthischapteraboutthefinancialservicesand
investmentindustries.

Thefinancialservicesindustryexiststoprovidealinkbetweensavers/lenders/providersof
capitalwhohavemoneytoinvestandspenders/borrowers/usersofcapitalwhoneedmoney.

Financialintermediariesactasmiddlemenbetweensaversandspenders.

Themainfinancialinstitutionsarebanksandinsurancecompanies.Bankscollectdepositsfrom
saversandtransformthemintoloanstoborrowers.Insurancecompaniesarenotonlyfinancial
intermediariesthatconnectbuyersofinsurancecontractswithprovidersofcapitalwhoare
willingtobeartheinsuredrisks,butalsoamongthelargestinvestors.

Theinvestmentindustry,asubsetofthefinancialservicesindustry,includesallparticipantsthat
helpsaversinvesttheirmoneyandspendersraisecapitalinfinancialmarkets.

Agoalofeconomicsystemsistheefficientallocationofscarceresourcestotheirmost
productiveuses.Financialmarketsandtheinvestmentindustryhelpallocatecapital,ascarce
resource,tothemostproductiveuses,whichfosterseconomicgrowthandbenefitssociety.

Theinvestmentindustryprovidesnumerousbenefitstotheeconomy,includingtheefficient
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allocationofscarceresources,betterinformationaboutinvestmentopportunities,productsand
servicesthatareappropriateforprovidersandusersofcapital,andliquidity.

Thebenefitsforinvestorsofawellfunctioninginvestmentindustryincludeabroadrangeof
investmentproductsandservicesthatmeettheirneeds,competitivemarketsthatprovide
liquidityandkeeptransactioncostslow,timelyandefficientdisclosureofinformation,andthe
abilitytomodifytheirriskexposures.

Trustisessentialtothefunctioningoftheinvestmentindustryaswellastothebroaderfinancial
servicesindustry.Lawsandregulationsarenecessarytoprotectinvestorsandensurethe
integrity,transparency,andfairnessoffinancialmarkets.

Companiesandgovernmentsuseinvestment(merchant)bankstohelpthemraisecapital.

Keyinvestmentindustryparticipantsontheinvestingsideincludethefollowing:

Categories Participants KeyCharacteristics

Investors Retailinvestors Individualinvestorswiththeleastamountof
investableassets
Highnetworth Individualinvestorswithahigheramountof
investors investableassets
Institutional Organisationsthatinvesttoadvancetheirmissionor
investors onbehalfoftheirclients
Financial Financial Professionalswhohelptheirclientsunderstandtheir
advisoryservice planners futurefinancialneedsanddefinetheirinvestment
providers goals
Investment Assetmanagers Professionalswhohelptheirclientscarryout
management investmentstoachievetheirinvestmentgoals
serviceproviders
Investment Buyside Professionalswhoreviewpotentialinvestments
information analysts
serviceproviders Datavendors Organisationsthatprovideinformationresources
Investment Organisationsthatproduceinformationreports
research
providers
Tradingservice Exchanges Organisedandregulatedfinancialmarketsthatallow
providers investorstotrade
Brokers Professionalsandtheirfirmsthatfacilitatetrading
betweeninvestors,actingasagents(theydonottrade
withtheirclients)
Dealers Professionalsandtheirfirmsthatfacilitatetrading
betweeninvestors,actingasprincipals(theytradewith
theirclients)
Clearinghouses Organisationsthatconfirmandsettletrades
andsettlement
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agents
Custodialservice Custodiansand Organisationsthatholdmoneyandsecuritiesonbehalf
providers depositories oftheirclients

Fourkeyforcesthatdrivetheinvestmentindustryarecompetition,technology,globalisation,
andregulation.

CHAPTERREVIEWQUESTIONS
Copyright2014CFAInstitute

Testyourknowledgeofthischapteratcfainstitute.org/claritasstudy.

1. Thefinancialservicesindustrybenefitstheeconomybyprovidingalinkbetweenprovidersof
capitaland:

A. savers.

B. lenders.

C. borrowers.

2. Theinvestmentindustrybenefitstheeconomyby:

A. increasingrisk.

B. decreasingliquidity.

C. increasingefficiency.

3. Amajorbenefitofcompetitioninfinancialmarketsfortheindividualinvestoris:

A. risktransfer.

B. lowerprices.

C. greaterintegrity.

4. Whichofthefollowingwouldmostlikelyassistindividualsindefiningtheirinvestmentgoals?

A. Dealers

B. Financialplanners

C. Investmentbankers

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5. Whichofthefollowingismostlikelytofacilitatetradingandhelpreducetransactioncosts?

A. Brokers

B. Analysts

C. Assetmanagers

6. Aninstitutionalinvestorthatinvestsagovernmentssurplusesisa(n):

A. foundation.

B. endowmentfund.

C. sovereignwealthfund.

7. Abrokerwillactasa(n):

A. agent.

B. principal.

C. proprietarytrader.

8. Asellsideanalysttypicallyworksfora(n):

A. pensionplan.

B. investmentbank.

C. endowmentfund.

9. Whichofthefollowingforcesthatdrivetheinvestmentindustrypromotestransparencyof
financialmarkets?

A. Regulation

B. Competition

C. Computerisation

10. Aforcedrivingtheinvestmentindustrythathasledtodecreasedtradeprocessingcostsis:

A. regulation.

B. technology.

C. globalisation.

11. Globally,regulationoftheinvestmentindustryhas:

A. increased.

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B. decreased.

C. remainedstable.

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