Chapter 10: Investment Company Products 17-20 questions

Question 1

What is an investment Company?

Answer 1

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

Question 2

Investment Companies act of 1940

Answer 2

Provides for SEC regulation

Classifies investment companies into 3 broad types:

1. Face amount certificate companies (FACs)
2. Unit investment trusts UITs
3. Management investment companies

Question 3

Face Amount Certificate Company

Answer 3

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

Question 4

Unit investment Trust

Answer 4

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

Question 5

Management Investment Companies

Answer 5

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

Question 6

Closed end Investment company

Answer 6

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

Question 7

Open end investment company (Mutual Fund)

Answer 7

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

Question 8

Diversified investment company

Answer 8

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

Question 9

Nondiversified Investment Co.

Answer 9

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

Question 10

Exchange Traded Funds

Answer 10

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

Question 11

Mutual Fund vs ETF

Answer 11

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.

2. Margin- ETFs can be bought and sold on margin. Mutual funds cannot.
3. Operating costs-Lower than mutual funds usually
4. 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)

Question 12

An investment company must register with the SEC if:

Answer 12

1. If it is in the business of investing in, reinvesting in, owning, trading or holding securities
2. Has 40% or more invested in securities (government and majority owned subsidiaries not included)

Question 13

Registration Requirements for investment companies

Answer 13

May not issue securities unless it has:

1. Private capitalization (seed money) of 100k
2. 100 investors and
3. 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%

Question 14

Require material for an investment company to register with SEC

Answer 14

Registration Statement and follow public offering procedure

Must identify:

1. Type of investment company
2. Plans to raise money by borrowing
3. Intention to concentrate Investments in a single industry (if it will do that)
4. Plans for investing in real estate or commodities
5. Conditions where an investment strategy change would take place
6. Name and address of affiliated people
7. Business experience of each officer and director in past 5 years

Question 15

Investment Company registration Statement

Answer 15

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:

1. Investment objectives
2. Costs of investing
3. Principal invest strategies, risk and performance
4. Investment advisers and portfolio managers
5. Brief purchase sales and tax info
6. Financial intermediary compensation

Question 16

Open End investment company share offerings

Answer 16

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

Question 17

Mutual fund must disclose the following investment strategies and meet specific financial requirements

Answer 17

Purchasing securities on margin
Selling securities short
Participating in joint investment accounts

Question 18

The following issues must be voted on by shareholders:

Answer 18

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

Question 19

Investment company Board of Directors

Answer 19

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

Question 20

Investment company: Investment Adviser

Answer 20

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

Question 21

Investment Company: Custodian

Answer 21

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:

1. Keep the investment company’s assets physically segregated
2. Restrict Access to certain officers and employees of invest company

Receives a fee for service

Question 22

Investment Company: Transfer Agent

Answer 22

• 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

Question 23

Investment Company: Underwriter

Answer 23

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

Question 24

Investment company Prospectus

Answer 24

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

Question 25

Invest company's SAI

Answer 25

``` Includes: BS Statement of ops IS And portfolio list ```

Question 26

Act of 1940 in regards to financial reporting for invest companies

Answer 26

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

Question 27

Characteristics of a mutual fund

Answer 27

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

Question 28

Types of stock funds

Answer 28

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

Question 29

Balanced Fund

Answer 29

Invest in stocks for appreciation and bonds for income

Question 30

Asset Allocation Funds

Answer 30

Split between stocks for growth, bonds for income, and money market instruments or cash for stability

Question 31

Bond funds

Answer 31

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

Question 32

Dual purpose funds

Answer 32

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

Question 33

Money Market funds

Answer 33

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

Question 34

Lifecycle fund

Answer 34

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

Question 35

Funds of hedge funds

Answer 35

Invest primarily in unregistered hedge funds Hedge funds are usually reserved for accredited investors Funds of hedge funds give investors exposure

Question 36

Expense ratio

Answer 36

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

Question 37

Turnover rate

Answer 37

100% means that the fund cycled all assets on average during the year Aggressive growth funds typically have a turnover rate over 100%

Question 38

Marketing of Mutual Fund Shares

Answer 38

1. Fund to Underwriter (underwriter takes a concession) to the dealer who then sells for full public offering price 2. Fund to Underwriter to Investor- cuts out dealer and sales charge is split between dealers 3. 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

Question 39

Member vs non member

Answer 39

All sales to non members must be made at POP Members may receive a discount

Question 40

Forward pricing

Answer 40

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

Question 41

Closed end fund sales charges

Answer 41

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

Question 42

Open End funds expenses

Answer 42

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)

Question 43

Front end loads

Answer 43

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

Question 44

Back end loads (contingent deferred load)

Answer 44

Declining sales load charged on the proceeds Usually structured to drop to zero at the end of an extended holding period Specified in Prospectus

Question 45

12b-1 Asset Based Fees

Answer 45

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%

Question 46

Sales charge percentage

Answer 46

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 ```

Question 47

Breakpoints

Answer 47

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

Question 48

Right of accumulation

Answer 48

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

Question 49

Automatic reinvestment of Distributions

Answer 49

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

Question 50

Conversion principles in family of funds

Answer 50

May allow the combination of funds to reach a breakpoint Sponsors allow investors to move from fund to fund Considered a taxable event

Question 51

Different classes of shares

Answer 51

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

Question 52

Redemption of Mutual Fund Shares

Answer 52

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%

Question 53

Shares sold in 7 business days since purchased

Answer 53

Any fees or concessions are given to underwriter

Question 54

Net investment income

Answer 54

Dividend and interest income minus operating expenses Advertising and sales expenses are not included in operating expenses

Question 55

Conduit Theory

Answer 55

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

Question 56

Fund yield

Answer 56

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

Question 57

Selling dividends

Answer 57

A registered rep may not encourage investors to purchase fund shares before a distribution, as it is a violation of FINRA rules

Question 58

Form 1099

Answer 58

Details tax information related to distributions for a year

Question 59

Investor cost basis

Answer 59

Derived by taking purchase price for shares plus sales charge, reinvested dividends and cap gain distributions

Question 60

Accounting methods for selling shares

Answer 60

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

Question 61

Other tax considerations with mutual funds

Answer 61

Withholding tax- If investor fails to supply a Social Security or tax Id number, then fund withholds percent of distributions

Question 62

Customers who receive dividends

Answer 62

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

Question 63

Voluntary accumulation plan

Answer 63

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

Question 64

Dollar cost averaging

Answer 64

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

Question 65

Fixed dollar withdrawals

Answer 65

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

Question 66

Registered reps using a withdrawal plan must

Answer 66

Not promise a guarenteed return Possible to overwithdraw Never use charts or tables unless cleared by SEC

Question 67

Quoting a Mutual Fund

Answer 67

Bid Price is the NAV | Offering price is the NAV plus the maximum sales charge applicable to a fund

Question 68

Sales charge%

Answer 68

Sales charge / POP

Question 69

Index tracking funds

Answer 69

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

Question 70

Leveraged Funds

Answer 70

Attempt to deliver a multiple return Most use derivatives (options, futures and swaps to enable them to achieve the stated goal

Question 71

Inverse funds

Answer 71

Try to deliver returns opposite of the benchmark

Question 72

Hedge funds

Answer 72

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

Question 73

Holding company Depository receipts

Answer 73

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

Question 74

Letter of Intent for 15000

Answer 74

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

Question 75

Major difference between closed end and open end mutual funds

Answer 75

Open End companies continuously offer their shares Closed end have a limited number of shares

Question 76

A fund must notify its shareholders of their ability to reinvest dividends

Answer 76

Annually

Question 77

Client must receive the prospectuses

Answer 77

Before or during the sales solicitation

Question 78

A management company receives a fee based on

Answer 78

Average annual net assets of the fund

Question 79

A member receiving a discount must

Answer 79

Have the discount in writing and provide for a refund of the concession if the shares are redeemed in 7 business days