05 Investment Companies Flashcards
Sector funds concentrate on particular industries. In which of the following sector funds would an investor be especially interested if she anticipated an economic downturn/recession?
A. Restaurants
B. Automotive
C. Communications
D. Pharmaceuticals
D. Pharmaceuticals
Rationale:
In a downturn, buy “defensive stocks” in companies that produce products and deliver services that consumers consume even during a downturn. Pharmaceuticals,
food, clothing, etc.
Open- and closed-end funds share all of the following characteristics except:
A. Charge management fees
B. Maybenon-diversified
C. Traded among investors
D. Dearly stated investment objectives
C. Traded among investors
Rationale:
Open-end funds are redeemed; only the closed-end fund is traded among investors on the secondary market.
Preventing an investor from achieving a discount on quantity purchases is:
A. A violation called “rescission”
B. A violation called “breakpoint selling”
C. A violation called “selling away”
D. A violation called “backing away”
B. A violation called “breakpoint selling”
Rationale:
Never prevent an investor from getting a lower sales charge, aviolation called “breakpoint selling.” Selling away is a violation in which the sales representative is selling securities not sponsored by the employing firm. Backing away has to do with refusing to honor a firm quote.
The main advantage of reinvesting dividend distributions in a mutual fund is:
A. Purchasing new shares without a front-end load
B. Diversification
C. Tax deferral
D. Anticipating market movements
A. Purchasing new shares without a front-end load
Rationale:
Even if the fund charges a front-end load (A shares), that load is avoided on reinvestments. Also, the test wants you to know that reinvesting dividends and/or capital gains distributions has NO EFFECT whatsoever on a person’s tax situation.
All of the following statements are true of open-end mutual funds except:
A. Covered by FDIC insurance
B. Must redeem shares within 7 days
C. Do not trade on the secondary market
D. Do not have to maintain diversified portfolios
A. Covered by FDIC insurance
Rationale:
Bank deposits are FDIC insured, but securities are not bank deposits. There is no requirement that all funds must be diversified—the requirement is that if the fund advertises as being diversified, it has to meet the 75/5/10 rule’s criteria for making such a claim. Fund shares are redeemed/sold back to the issuer, not traded among investors.
Which of the following are non- redeemable investment company products?
A. Closed-end funds
B. Face-amount certificates
C. Unit investment trusts
D. Open-end funds
A. Closed-end funds
Rationale:
The closed end fund is the only investment company product that has to be traded either on an exchange or OTC. The other three types are redeemable, which is the opposite of tradable. You either trade your closed end-fund shares, or you redeem the UlT’s, mutual funds, and face-amount certificates.
The NAV (net asset value) of an open-end corporate bond fund has increased dramatically. The most likely reason is that:
A. Interest rates have risen
B. Investors have bought substantially more shares
C. Yields have dropped
D. Bond prices have fallen
C. Yields have dropped
Rationale:
Remember that buying and selling shares has no effect on NAV, ever. Also remember that the NAV is the price/value of the bonds in the portfolio. So, for the NAV to increase bond prices need to increase, which happens when rates go down, not up. Rates/yields go one way; price always goes the other. The NAV of a bond fund IS the price of the bonds.
The Net Asset Value of an open- end bond fund would not be affected if:
A. The fund pays a dividend distribution
B. Redemptions increase dramatically
C. Securities held in the portfolio decrease in value
D. Interest rates rise sharply
B. Redemptions increase dramatically
Rationale:
Remember that redemptions and share purchases have no effect on NAV. Remember that If the fund pays OUT money, not all of it will be reinvested by shareholders. NAV is just the assets of the fund (cash, securities) versus the liabilities. Cash goes out and doesn’t come back… that definitely drives down the NAV. Less cash. Cash is an asset, and suddenly there isn’t as much of that asset.
Which of the following investments would be expected to have the lowest volatility?
A. Long-term government bond fund
B. Mid cap fund
C. Money market fund
D. Small cap fund
C. Money market fund
Rationale: Small cap funds or aggressive growth funds have bigger price fluctuations than other funds, and stock funds are more volatile than bond funds. Anyway, you really didn't even have to determine whether stock or bond funds have higher betas (volatility) for this one, because money market shares maintain a stable value of $1.
Which of the following investments would be expected to have the highest volatility?
A. Small cap growth fund
B. Tax-exempt money market fund
C. Large cap value fund
D. Mid cap growth fund
A. Small cap growth fund
Rationale:
For “high beta” or “volatile” look for small cap stocks over mid- and large- cap. Then, if it comes down to a tie between growth and value, tell the exam that the growth fund would be more volatile. So, a large cap value fund would be considered less volatile than a large cap growth fund, should the exam really want to see you sweat. Growth is considered more volatile than value. It’s more expensive and propped up by more speculation.
Which of the following statements is true concerning 12 b-1 fees?
A. May not be charged by any “no load” company
B. May be used to cover management fees
C. Annual fees charged quarterly
D. Associated with A-shares only
C. Annual fees charged quarterly
Rationale:
12 b-1 fees cover the same distribution costs (selling, printing, mailing, advertising) that sales loads/charges cover, but they are not called “sales loads” or “sales charges.” No load funds usually DO charge 12 b-1 fees; they just have to keep the fee no greater than .25% (25 basis points) of average net assets. Otherwise, they have to drop the “no load” from their marketing/advertising/selling literature.
Advantages of closed-end funds over open-end funds would not include the fact that:
Rationale:
Closed-end funds trade exactly like shares of common stock, because, that’s what they are—common stock. They trade on exchanges and OTC, so they can be shorted, and
their price is purely up to supply and demand.
Open-end funds typically do not engage in which of the following?
A. Selling an unlimited number of shares to investors
B. Selling portfolio securities short
C. Selling shares to an unlimited number of investors
D. Closing off purchases to new investors
B. Selling portfolio securities short
Rationale:
Margin and short selling go together, because one can not sell short unless one is in a margin account. Mutual funds cant trade on margin or short securities. That’s for “hedge funds,” which are not on the test. Yet. Note that a fund can close itself off to new investors if it has more money than it
knows what to do with, but that doesn make it a “closed-end fund.” Closed end funds are designed to be “closed end” from the get-go.
XYZ Aggressive Growth Fund reports net income of $1,000,000 and distributes $980,000 directly to investors. Therefore, the fund will be taxed on what amount?
A. $20,000
B. $1,000,000
C. As stipulated in the prospectus
D. $1,200,000
A. $20,000
Rationale:
The fund has to send out at LEAST 90% ($900K in this example) to qualify as a “Regulated Investment Company” under “Internal Revenue Code Subchapter M.” If the fund sends out at least 90% to the investors, the fund only pays tax on the remaining 10%. If they send out more than 90%, they have less left to pay taxes on. But if the fund fails to distribute 90%, they would pay tax on ALL of it.
All of the following are potential advantages of investing in
open-end funds compared to investing in stocks and bonds directly except:
A. Professional management
B. Simplified tax reporting
C. Leverage
D. Diversification
C. Leverage
Rationale:
Open-end funds don’t use leverage, and mutual fund
shares are not purchased on margin.
Mutual funds must report to shareholders:
A. Monthly
B. Semi-annually
C. Daily
D. Quarterly
B. Semi-annually
Rationale:
Twice a year, semi-annually, and the annual report must be audited. Download a semi-annual report to increase your understanding of open-end funds and many other testable points, too.
Mutual funds must redeem shares:
A. Within 5 business days
B. As stipulated in the prospectus
C. Within 7 days
D. Immediately, on demand
C. Within 7 days
Rationale:
And it’s 7 calendar days, not 7 business days.
A mutual fund that always invests in both stocks and
bonds is called:
A. A balanced fund
B. A blend fund
C. A mixed fund
D. A diversified fund
A. A balanced fund
Rationale:
Memorize it—the “balance” is between stocks and bonds.
Which of the following investors may be combined for the purpose of receiving a quantity discount?
A. Investment clubs
B. Mother and 33-year-old daughter
C Three college friends investing in separate accounts
D. Father and 7-year-old son
D. Father and 7-year-old son
Rationale:
The other three are not eligible for breakpoints. Minor children in a custodial arrangement (UGMA), yes, but not a parent and adult child, and never an investment club. If the three friends were in a joint account, that would be different.
TRY Fund has a NAV of $10.00 and a POP of $9.50. XLZ Fund has a NAV of $9.00 and a POP of $9.50. Which of the following are true statements?
I. TRY is an open end fund
II. TRY is a closed end fund
III. XLZ could be an open end fund
IV. XLZ could be a closed end fund
A. I, IV
B. II, IV
C. I, III, IV
D. II, III, IV
D. II, III, IV
Rationale:
If you ever see a fund, like TRY, trading below the NAV,
that has to be a closed-end fund. Open end/mutual funds are never bought below their NAV. XLZ could be an open- end fund ,or a closed-end fund that’s trading at a premium.
One of your investing clients has $100,000 to invest in the ABC Equity Income Fund. The fund offers A, B, and C shares. Which share class would be most suitable for the investor, if her expected holding period is 10 years?
A. The C shares, because of the low 12b-1 fees
B. The A shares, because of the breakpoints and lower operating expenses
C. The B shares, because of the usual 12b-1 fee waiver offered
D. The A shares, because of the high 12b-1 fees associated
B. The A shares, because of the breakpoints and lower operating expenses
Rationale:
A-shares offer breakpoints starting usually at $50,000. They also charge lower annual operating expenses, often 75 basis points lower than the expenses charged on B- and C-shares. B- and C-shares have high 12b-1 fees, which is what takes their operating expenses up much higher than those charged to the owners of A-shares. B- shares are suitable for investors with a small amount to invest. C-shares are suitable for shorter-term investors. If the investor has a decent amount to invest and a long anticipated holding period, put him into the A-shares and save yourself a lot of aggravation.
What is the maximum sales charge allowed over the life of a contractual plan operating under the Act of 1940?
A. 50%
B. 20%
C. 8.50%
D. 9%
D. 9%
Rationale:
Under 1940, they take 50% the first year. Under 1970, they take 20% the first year. But over the life of the plan (often 20 years), the maximum has to drop down to 9%. 8.5% for mutual funds; 9% for contractual plans.
Your client’s objective is maximum current income but she is not comfortable with excessive risk. Therefore, you
would most likely recommend:
A. Investment-grade corporate bond funds
B. Open end funds
C. High-yield bond funds
D. Money market funds
A. Investment-grade corporate bond funds
Rationale:
Corporate bonds are good for “maximum current income.” If she were comfortable with risk, you might recommend “high-yield” or “junk” bonds. But she isn’t, so now we’re down to money market and investment-grade bond funds. Maximum current income from a money market fund? More like MINIMUM current income, right?
Your client’s goal is to accumulate money for retirement. She has a good job and no debt beyond a modest mortgage payment. She is not risk-averse. Which of the following funds would you least likely recommend?
A. Aggressive Growth Fund
B. Money Market Fund
C. Science and Technology Fund
D. Overseas Opportunities Fund
B. Money Market Fund
Rationale:
You don’t get growth in a money market fund. If you’re real lucky you’ll match the rate of inflation, less management fees. So, you would LEAST likely recommend a money market fund to THIS client, right? Dont make the mistake of thinking that since “money market” sounds safe, that’s what the test wants you to recommend to all clients. You have to make suitable recommendations based on each individual’s needs. Some need safety, others growth, some a little of both, etc.
Jill originally invested $9,000 into the VanWhitman Value
Fund. She has since reinvested dividend distributions of $1,000 and capital gains distributions of $500. If Jill currently holds 1,000 shares of the fund, her cost basis is:
A. Indeterminable
B. $11.50 per share plus commissions
C. $10.00 per share plus sales charges
D. $10.50 per share
D. $10.50 per share
Rationale:
All the $ going into her investment has been taxed, so it’s all part of her cost basis of $10,500.
An omitting prospectus for a mutual fund containing performance data must include a legend disclosing which of the following?
I. The performance data quoted represents past performance
II. Past performance does not guarantee future results
lll. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost
IV. The fund has less than a .03% chance of finishing in the top 3.0% of its peer group.
A. I, II, III, IV
B. I, II, III only
C. I only
D. I, II only
B. I, II, III only
Rationale:
Eliminate the answer choice that predicts future results –never, ever, ever. The other warnings/caveats need to be included in a mutual fund advertisement.
