Chapter 10: Investment Company Products 17-20 questions Flashcards
What is an investment Company?
An Invest company pools investors money and invests in securities on their behalf
Tries to invest more efficiently than the single individual
Sell shares for capital and must abide by same registration and prospectus requirements imposed by Securities act of 1933
Investment Companies act of 1940
Provides for SEC regulation
Classifies investment companies into 3 broad types:
- Face amount certificate companies (FACs)
- Unit investment trusts UITs
- Management investment companies
Face Amount Certificate Company
Contract in which the issuer guarantees a future payment in return for a lump sum or series of payments
Very few operate today due to tax law changes
Unit investment Trust
Does not have a board of directors, employ investment advisors or actively manage a portfolio
Functions as a holding company for investors
Purchase other invesmtent company shares or gov and municipal bonds
Then issue shares of beneficial interest in the underlying portfolio
Any security liquidated is distributed
Can be fixed (purchase portfolio of bonds that will liquidate) or nonfixed (shares of a mutual fund)
Customers can ask to liquidate a position
Not actively managed, not traded in secondary, must be redeemed by trust
Not traded in response to market conditions
Management Investment Companies
Actively managed to achieve a specified investment objective
Either closed end or open end
Both sell securities at beginning, difference lies in type of securities and where investors buy and sell shares
Closed end Investment company
Conducts a common stock offering to issue shares
Funds capitalization is fixed unless public offering is made later
Can also issue bonds and preferred stock
Shares are not redeemed by issuer rather a customer liquidates a position by selling their securities in the OTC or on exchange
Prospectus only needed during IPO
Open end investment company (Mutual Fund)
Registers an open offering with the SEC and does not specify how many shares it will sell
Fund sells underlying holding when an investor wants to sell
Mutual fund shares are sold at the Net Asset Value plus a sales charge which is the POP
Has a board of directors and management
Ex date is set by BOD instead of an exchange
Diversified investment company
Under the Investment Company Act of 1940, an investment company qualifies as diversified if it passes the 75-5-10 test
75% of total assets- invested in securities outside of mutual fund or affiliates. Cash on hand and money market is counted
Within 75% no more than 5% invested in one issuer
With 75%, fund does not own more than 10% of outstanding voting securities of any one issuer
Other 25% okay to do, so a company could own 30% of one issuer if other part is diverse
Nondiversified Investment Co.
Fails to meet 75-5-10 rule
Not necessarily a fund that invests only in a certain industry
Specialized or Sector funds are often diverse in a specific industry or geographic area
Both open and closed can be diversified or non diversified
Exchange Traded Funds
Legally classified as a UIT or Open end fund but differ from tradition
Issue shares in large blocks (50,000 shares) known as creation units, usually purchased by large institutional traders and then broken apart
Positions can be sold in secondary market or in creation units back to issuer. Usually will be given underlying securities instead of cash if sold in creation unit
Cannot be called mutual fund shares, though they will be compared to
Trade throughout day
Mutual Fund vs ETF
Advantages of an ETF over a mutual fund:
1. ETFs are priced throughout the day and can be traded during the day. Mutual funds are usually priced at end of day.
- Margin- ETFs can be bought and sold on margin. Mutual funds cannot.
- Operating costs-Lower than mutual funds usually
- Do not usually distribute capital gains, so they are more tax efficient
Disadvantages-
1. Commisionable transaction to buy an ETF unlike a mutual fund (cannot charge commission on Prospectus sold shares)
An investment company must register with the SEC if:
- If it is in the business of investing in, reinvesting in, owning, trading or holding securities
- Has 40% or more invested in securities (government and majority owned subsidiaries not included)
Registration Requirements for investment companies
May not issue securities unless it has:
- Private capitalization (seed money) of 100k
- 100 investors and
- Clearly defined investment objective
May still register if it can meet these requirements in 90 days
Investment objective may only be changed by majority vote later
Open Ended companies also are required to only have one share class and a minimum asset to debt ratio of 300%
Require material for an investment company to register with SEC
Registration Statement and follow public offering procedure
Must identify:
- Type of investment company
- Plans to raise money by borrowing
- Intention to concentrate Investments in a single industry (if it will do that)
- Plans for investing in real estate or commodities
- Conditions where an investment strategy change would take place
- Name and address of affiliated people
- Business experience of each officer and director in past 5 years
Investment Company registration Statement
2 parts
Part 1- Prospectus of the company, also known as N1-A Prospectus or summary Prospectus
Part 2- Information not required to be distributed but must be made publicly available. Also called: statement of additional information (SAI). Will usually contain consolidated financial statements. Available upon request to Investor.
Still includes disclaimer from SEC saying SEC does not in anyway approve the securities
Open End Must also include an additional disclosure (summary section) of:
- Investment objectives
- Costs of investing
- Principal invest strategies, risk and performance
- Investment advisers and portfolio managers
- Brief purchase sales and tax info
- Financial intermediary compensation
Open End investment company share offerings
Considered to be one continuous public offering
Prospectus must be delivered each time and all info must be updated within 16 months
Reason why regulation t bans buying on margin
Mutual fund shares however can be used as collateral as long as they are fully paid for 30 days
Mutual fund must disclose the following investment strategies and meet specific financial requirements
Purchasing securities on margin
Selling securities short
Participating in joint investment accounts
The following issues must be voted on by shareholders:
Change in company bylaws Change in borrowing by open End company's Issuing or underwriting securities Purchasing or underwriting real estate Making loans Changing sub classification Changing load policy Changing nature of business Changing investment policy
Investment company Board of Directors
Consists of a CEO, officers and a board
The board:
- Defines the type of funds to offer
- Defines the funds objective
- Approves and hires the transfer agent, custodian and investment adviser
Majority of Directors must be non interested or independent
Must serve terms no shorter than a year and no longer than 5
Investment company: Investment Adviser
Investment company’s BOD contracts with an outside IA or Portfolio Manager to:
- invest cash and securities in the portfolio
- Implement an investment strategy
- Identify tax status of distributions
- Manage the portfolios day to day trading
Company may not contract with the IA if they have committed a securities related felony
Investment Company may not borrow funds or transfer responsibility to anyone else
IA must be registered under the Investment Advisers Act of 1940
IA contract is for a maximum 2 years but subject to annual approval and receives the managers fee
Investment Company: Custodian
Act of 1940 requires that securities must be put in custody of a bank or stock exchange member broker dealer
Handles clerical function
Can put Securities in a system for easy bookkeeping
Custodian must:
- Keep the investment company’s assets physically segregated
- Restrict Access to certain officers and employees of invest company
Receives a fee for service
Investment Company: Transfer Agent
- Issues, redeems and cancels fund shares
- Handles name changes for funds
- Sends customer confirmations and fund distributions
- Records outstanding shares so distributions are made properly
Can be the custodian, fee is paid
Investment Company: Underwriter
Sometimes called the sponsor or distributor
Receives fee for selling and marketing the fund shares to public
Sells only to help issuer fill custom orders
May not keep an inventory
Adds sales charge to the NAV
Fund can act as it’s own underwriter if a noload or by charging 12b-1 fees
12b1 funds very common
Investment company Prospectus
Must be distributed before or during solicitation for sale
Contains info on fund objective, invest policy, sales charges, MNG expenses and services offered
Also discloses 1-,5-,10- year performance
Invest company’s SAI
Includes: BS Statement of ops IS And portfolio list
Act of 1940 in regards to financial reporting for invest companies
Must be sent semiannually and must include an annual report once a year
Must contain:
The company BS
Valuation of all securities in portfolio as of date in Bs
Income Statement
Compensation paid to BOD and advisory board
Total dollar amount of securities sold
BS must be made available to any shareholder who requests one in writing between semiannual reports
SEC requires:
Factors affecting performance
Line graph comparison to a market index
Name and titles of funds managers
Characteristics of a mutual fund
Must redeem shares at NAV and guaranteed marketability
All investors are mutual participants, one common stock share class
May be purchased in full or fractional units
An investor may liquidate without upsetting portfolio balance
Fund distributes a 1099 form explaining tax
Allow small investments ($500 up) and additional investments of $25 and up
Most offer auto reinvestment of cap gains and dividends
May offer break point in fees
May offer reinstatement option where an investor can withdraw and put back in funds without incurring a sales charge
Types of stock funds
Most funds have at root common stock that generates growth
Growth fund- Companies that grow rapidly and usually don’t distribute capital gains
Income funds- stresses current income over growth, invest in companies with long history of dividend payment such as utilities
Combination fund- Mix between growth and income
Specialized (sector) fund- example gold funds
Special situation fund- Invest in companies that may be bought, have a patent pending
Index funds- try to mirror an index, low turnover/management costs
Foreign stock fund- principal business activity out of us, long term capital appreciation is main goal
Balanced Fund
Invest in stocks for appreciation and bonds for income
Asset Allocation Funds
Split between stocks for growth, bonds for income, and money market instruments or cash for stability
Bond funds
Main objective is income
Tax exempt funds invest in Municipal bonds or notes and tax exempt money market instruments
US government and agency funds also fall in category
Dual purpose funds
Closed end funds can meet two objectives
Income shares that receive all dividends and interest
Capital gain shares that receive all income from portfolio holdings
Two different share classes listed differently
Money Market funds
Usually no load (no sales or liquidation fee) open End
Investors concerned with liquidity
Interest computed monthly
NAV is set at $1, try not to deviate
SEC requires that it must be disclosed that these funds are not insure by US gov in front cover of prospectus and marketing material
Limited to securities with less than 13 months till maturity with average not exceeding 90 days
Investments include Tbills, commercial Paper, repurchase agreements, and bankers acceptance
Lifecycle fund
Tailored to meet investment objective of a time horizon
Adjusted quarterly or on some other schedule
Sometimes role into an income fund at end of target
Funds of hedge funds
Invest primarily in unregistered hedge funds
Hedge funds are usually reserved for accredited investors
Funds of hedge funds give investors exposure
Expense ratio
All mutual funds have an expense ratio
Divide fund expenses by average net assets
Percentage is based off of units of $100
Stock funds typically are between 1-1.5%
Bond Funds .5-1
Turnover rate
100% means that the fund cycled all assets on average during the year
Aggressive growth funds typically have a turnover rate over 100%
Marketing of Mutual Fund Shares
- Fund to Underwriter (underwriter takes a concession) to the dealer who then sells for full public offering price
- Fund to Underwriter to Investor- cuts out dealer and sales charge is split between dealers
- Fund to investor- No load fund that pays all expenses (may also be referred to as no load is under .25% in 12b-1 fees
Member vs non member
All sales to non members must be made at POP
Members may receive a discount
Forward pricing
All mutual funds must calculate NAV at least once a day (usually after market close)
The price the customer pays is that next recalculation
NAV is Assets-liabilities (all assets are included regardless of their use)
NAV per share is decreased by distributions of gains
Does not change when shares are redeemed or when securities are bought and sold
NAV per share increases when fund receives investment income
Closed end fund sales charges
No sales charges on mutual fund side
Investor will pay commission with an agency transaction or a markup/ markdown in a principal transaction as normal
Open End funds expenses
All sales commisions and expenses are paid from sales charges collected
Three methods to collect:
Front end load (difference in POP and NAV)
Back load (contingent deferred sales load)
12b-1 fees (asset based fees)
Front end loads
Most common way to pay for services of an underwriter
Taken from the amount invested
Example 10000 invested in front end load of 5% means the customer has an investment of $9500
Back end loads (contingent deferred load)
Declining sales load charged on the proceeds
Usually structured to drop to zero at the end of an extended holding period
Specified in Prospectus
12b-1 Asset Based Fees
Mutual fund cannot act as distributor unless it charges a 12b-1 fee
Used for promoting, selling and undertaking activity in distributing shares
Determined annually as flat dollar amount or percentage of average total NAV and charged quarterly
Max 12b-1 is 1% of a Funds net assets (different from normal 8.5% max)
Must be approved at least annually be majority shareholders, BOD and noninterested parties
Can be terminated any time by majority of shares
May not be described as no load of over .25%
Sales charge percentage
Is a percentage of the POP not the NAV
NAV/ 1-% = POP
Maximum of 8.5% or 6.25% Max of 8.5% if it: -Has breakpoints (scale of declining sales charges) -Rights of accumulation and -automatic reinvestments of NAV
Breakpoints
Investment clubs or associations formed for purpose of investing do not qualify for breakpoints
Child and parent only qualify while child is under age
No industry standard, must be disclosed in Prospectus
Purchases may be aggregated to reach breakpoints
May sign a letter of Intent to decrease the overall sales charge
Letter of intent specifies when additional investment will occur within next 13 months
Investor must complete to qualify for reduced sales charge, not binding for customer
Mutual fund holds extra shares in escrow
Letter of Intent can be backdated 90 days but still hold to the 13 months
Breakpoint sale in which a registered rep specifically buys just under a breakpoint is a violation
Right of accumulation
Allow investor to get to a lower sales charge
Available for subsequent investments
Allow investor to use prior share appreciation to qualify
Do not impose a time limit
Done on amount invested or current NAV
Automatic reinvestment of Distributions
Shareholder may elect to reinvest distributions instead of receive cash generated
Similar to compounding interest
May only do so if:
Shareholders not participating may participate
Plan described in Prospectus
Security issuer bears no additional cost beyond normal
Shareholders are notified of plan once a year
Conversion principles in family of funds
May allow the combination of funds to reach a breakpoint
Sponsors allow investors to move from fund to fund
Considered a taxable event
Different classes of shares
Class A- Front end load, reduced by breakpoints
Class B- back end that declines over time combined with 12b-1
Class C- 12b-1 charged quarterly with small back end load charge at end of first year
Class D- Level load plus a redemption fee
B, C, and D cannot take advantage of breakpoint reductions like A shares
Redemption of Mutual Fund Shares
Must redeem in seven calendar days of written request
Signature of customer must be guaranteed
Redemption requirement may be suspended if:
NYSE closes outside of normal
Trading on NYSE is restricted or
SEC has ordered suspension of redemptions
All fees and sales loads may not exceed 8.5%
Shares sold in 7 business days since purchased
Any fees or concessions are given to underwriter
Net investment income
Dividend and interest income minus operating expenses
Advertising and sales expenses are not included in operating expenses
Conduit Theory
Under subchapter M of the Internal Revenue Code, if mutual funds serve as a flow through entity, they are only taxed on their retained investment income
Funds that comply are known as regulated investment companies
Requires distribution of 90% of net investment income
If fund distributed only 89%, then it would pay 100% of net invest income
Long term capital gain distributions may be made only once per year
Fund yield
Annual dividend paid from Net invest income
Divided by
Current offering price (POP)
Yield quotations must disclose
General direction of stock market
Fund NAV at begin and end of period
Percent Change in fund price
Current yield is preceding 12 months
Most distribute quarterly dividend, and all identify where the income is from
IMPORTANT Ex dividend date for mutual funds is set by BOD, usually day after record date
Selling dividends
A registered rep may not encourage investors to purchase fund shares before a distribution, as it is a violation of FINRA rules
Form 1099
Details tax information related to distributions for a year
Investor cost basis
Derived by taking purchase price for shares plus sales charge, reinvested dividends and cap gain distributions
Accounting methods for selling shares
First in First out- IRS assumed, cost of shares held longest is used to calculate gain
Share identification- investor keeps track of shares purchased, uses info when deciding to liquidate
Average basis- Total cost of all shares/ total
Other tax considerations with mutual funds
Withholding tax- If investor fails to supply a Social Security or tax Id number, then fund withholds percent of distributions
Customers who receive dividends
Reduces his proportionate interest in the fund each time a dividend is made
May make additional investment but may have to meet a Funds minimum requirement
Voluntary accumulation plan
Deposit regular periodic investments on a voluntary basis
Many funds offer automatic withdrawals
May require a minimum initial purchase or additional purchase amounts
A missed payment is not penalized because it is voluntary
Dollar cost averaging
Person invests identical amounts at regular intervals
Allows investors to purchase more shares at lower amount and less at higher
Results vary depending on the market
Fixed dollar withdrawals
Withdrawls plans are usually offered for free if offered at all
Fund liquidates enough shares to send the same sum, liquidates same percentage or number of shares or at a same time
Shares usually have to meet a minimum amount
Most funds discourage reinvesting after plan starts
Registered reps using a withdrawal plan must
Not promise a guarenteed return
Possible to overwithdraw
Never use charts or tables unless cleared by SEC
Quoting a Mutual Fund
Bid Price is the NAV
Offering price is the NAV plus the maximum sales charge applicable to a fund
Sales charge%
Sales charge / POP
Index tracking funds
Are not investment company products but have similar characteristics
Can create additional shares and are publically traded
Used to:
Follow industry trends, balance a portfolio, speculative trade and hedge
Have intraday trading, can be purchased on margin and be short sold unlike mutual funds
Spiders track the S&P
Many are ETFs and one of the most popular is the Qs which tracks the Nasdaq 100
Leveraged Funds
Attempt to deliver a multiple return
Most use derivatives (options, futures and swaps to enable them to achieve the stated goal
Inverse funds
Try to deliver returns opposite of the benchmark
Hedge funds
Unregulated by US securities law
Usually suitable for sophisticated investors
Very nature of the investment is usually considered speculative
May have lock up provisions that are dependent on the strategy of the hedge fund
May hold blind pool Securities that are like blank check Companies only an industry is indicated
Holding company Depository receipts
Broker dealer issued products traded on exchange
Represent ownership in underlying stock
No capital gain distributions
Underlying company getting sold would mean the customer owning the holder would receive the security
Rebalancing occurs manually in a HOLDR
Can only be purchased in round lots
Owners have a right to vote and receive all disclosure material unlike in a mutual fund or etf
Flat fee charged quarterly per round lot of HOLDRs; fluctuates with value and is decreased by dividends
Letter of Intent for 15000
Initial Invest of 9000
Dividends of 720 during 13 month period
Still need to invest the 6000 though the value of the shares is now 9720
Major difference between closed end and open end mutual funds
Open End companies continuously offer their shares
Closed end have a limited number of shares
A fund must notify its shareholders of their ability to reinvest dividends
Annually
Client must receive the prospectuses
Before or during the sales solicitation
A management company receives a fee based on
Average annual net assets of the fund
A member receiving a discount must
Have the discount in writing and provide for a refund of the concession if the shares are redeemed in 7 business days
