Chapter 4 - Investment Company Securities

Question 1

When is a mutual fund allowed to buy securities on margin?
A) Only with special permission from the SEC
B) Only after opening a margin account
C) Only in the first 10 trading days of each month
D) Never

Answer 1

Correct Answer:
D) Never

Answer Explanation
Mutual funds are prohibited from selling securities short and also from buying securities on margin or with borrowed funds.

Textbook Reference
Please see textbook section 4.2.3

Question 2

Open-end and closed-end company investments share all of the following characteristics EXCEPT
A) Professionally managed by an investment manager subject to registration under the Investment Company Act of 1940
B) The NAV per share is calculated by subtracting the fund liabilities from the fund’s assets and dividing by the number of shares outstanding
C) Shareholders own an undivided interest in all securities with the portfolio
D) They issue a single class of shares

Answer 2

Correct Answer:
D) They issue a single class of shares

Answer Explanation
Open-end companies commonly issue A, B and C shares which reflect different types of sales charges. Closed-end funds issue one type of share class only.

Textbook Reference
Please see textbook section 4.6

Question 3

Intra-day trading is available for both
A) Closed-end funds and UITs
B) Closed-end funds and hedge funds
C) Closed-end funds and ETFs
D) Open-end funds and ETFs

Answer 3

Correct Answer:
C) Closed-end funds and ETFs

Answer Explanation
Intra-day trading is available for both closed-end funds and ETFs.

Textbook Reference
Please see textbook section 4.6

Question 4

Which two statements correctly compare ETFs and closed-end funds?

I. Both are investment company products
II. Closed-end funds are investment company products; ETFs are not
III. Both have a stable pool of capital
IV. Closed-end funds have a stable pool of capital; ETFs offer shares continuously
A) I and III
B) II and IV
C) II and III
D) I and IV

Answer 4

Correct Answer:
A) I and III

Answer Explanation
Closed-end funds are actually considered a type of ETF by some. These are both classified as closed-end investment companies because they have a stable pool of capital that is raised through their initial public offering.

Textbook Reference
Please see textbook section 4.6

Question 5

Which two of the following are characteristics of closed-end companies and their shares?

I. May be purchased on margin
II. Issue multiple share classes
III. May be purchased with stop or limit orders
IV. Are redeemed by the fund
A) II and IV
B) I and IV
C) II and III
D) I and III

Answer 5

Correct Answer:
D) I and III

Answer Explanation
Closed-end funds are traded on exchanges and may be purchased or sold with specified pricing terms through stop and limit orders. They may be purchased on margin, unlike open end company shares. They issue a single class of shares only, and they are not redeemed by the fund. Shareholders must sell their shares on exchanges to liquidate their positions.

Textbook Reference
Please see textbook section 4.3.2.6

Question 6

The NAV of a mutual fund share will decrease by the amount of the dividend
A) at the start of trading on the morning the dividend is announced.
B) on the ex-dividend date.
C) when announced by the board of directors of the fund.
D) on the payable date.

Answer 6

Correct Answer:
B) on the ex-dividend date

Answer Explanation
The NAV of the fund will decrease on the ex-dividend date.

Textbook Reference
Please see textbook section 4.2.5

Question 7

Money market funds are most appropriate for investors who
A) Are willing to take high degrees of risk.
B) Have no alternative investment choices available to them.
C) Are seeking safety and stability in their investment portfolio.
D) Are looking for tax deferred investments owing to their high tax bracket.

Answer 7

Correct Answer:
C) Are seeking safety and stability in their investment portfolio

Answer Explanation
Money market funds are suitable for investors who are seeking safety and stability in their investment portfolio. These products will often provide a high degree of liquidity.

Textbook Reference
Please see textbook section 4.2.4.2

Question 8

In addition to management companies and face-amount certificates, what is the third basic investment company type regulated under the Investment Company Act of 1940?
A) Private Equity funds
B) REITs
C) Direct participation programs
D) Unit Investment Trusts

Answer 8

Correct Answer:
D) Unit Investment Trusts

Answer Explanation
The three basic types of investment companies that are regulated under the Investment Company Act of 1940 are management companies, face-amount certificates and unit investment trusts.

Textbook Reference
Please see textbook section 4.4

Question 9

An investor purchased shares of a mutual fund two years ago for $3,500 and has since reinvested dividend distributions of $375 and $325. The investor’s total cost basis in this fund is now
A) $700.00
B) $2,800.00
C) $3,500.00
D) $4,200.00

Answer 9

Correct Answer:
D) $4,200.00

Answer Explanation
The investor’s cost basis in this mutual fund is their original purchase price ($3,500) plus the reinvested dividends ($700), for a total of $4,200. This topic is not explicitly covered in the textbook, but as long as you review this rational for this question you will be covered for exam purposes.

Textbook Reference
Please see textbook section 4.2.5.7

Question 10

A customer that purchases closed-end fund shares may pay all of the following EXCEPT
A) Fund expenses
B) Commissions to a sales representative
C) Management Fees
D) 12b-1 fees

Answer 10

Correct Answer:
D) 12b-1 fees

Answer Explanation
Closed-end company shares do not have 12b-1 fees. These are marketing fees incurred by the investor.

Textbook Reference
Please see textbook section 4.3.2.3

Question 11

A risk of investing in an international bond UIT that is not commonly associated with other bond UITs is
A) Reinvestment risk
B) Interest rate volatility
C) Currency risk
D) Liquidity risk

Answer 11

Correct Answer:
C) Currency risk

Answer Explanation
International bond UITs hold debt in foreign companies and governments that is denominated in foreign currencies and then converted into U.S. dollars. The dollar does not always hold strong value against other foreign currencies.

Textbook Reference
Please see textbook section 4.4.3.1

Question 12

A UIT sells units to investors
A) Through representatives of broker dealers with which selling agreements have been established
B) In private placements only
C) Through the trustee that administers the trust
D) Directly through the sponsor

Answer 12

Correct Answer:
A) Through representatives of broker dealers with which selling agreements have been established

Answer Explanation
The units of UITs are typically distributed by the representatives of broker dealers. A broker dealer must have a selling agreement with the UIT to distribute the UIT’s shares through its representatives.

Textbook Reference
Please see textbook section 4.4.2

Question 13

In a unit investment trust the party that is responsible for the trust’s organization is the
A) Trustee
B) Administrator
C) Investment manager
D) Sponsor

Answer 13

Correct Answer:
D) Sponsor

Answer Explanation
A sponsor initiates the formation of a unit investment trust, and is also responsible for the selection of securities that are held in the portfolio.

Textbook Reference
Please see textbook section 4.4.1

Question 14

Which of the following features is associated with mutual fund shares but NOT ETFs?
A) Professionally managed pool of securities
B) Securities held by investors represent an equity interest
C) Exchange traded
D) Continuous primary offering

Answer 14

Correct Answer:
D) Continuous primary offering

Answer Explanation
Mutual fund shares are issued through a continuous primary offering, which means shares are available when investors want to purchase them. Closed-end company shares are limited because there is a fixed pool of capital. ETFs are traded on exchanges, mutual fund are not.

Textbook Reference
Please see textbook section 4.6

Question 15

An individual that invests in a unit investment trust holds
A) An interest in a variable portfolio of securities that is held for a specified period of time
B) An interest in a variable portfolio of securities that will terminate at the discretion of the sponsor
C) A fixed interest in a portfolio that is held for a specified period of time
D) A fixed interest in a portfolio that will terminate at the discretion of the sponsor

Answer 15

Correct Answer:
C) A fixed interest in a portfolio that is held for a specified period of time

Answer Explanation
Investors in UITs purchase a share of a portfolio of securities that will be held until its date of termination which is defined at the inception of the trust.

Textbook Reference
Please see textbook section 4.4.1.2

Question 16

When one of an investor’s goals when purchasing mutual funds is to minimize fees, consideration should be given to
A) Actively managed funds
B) Hedge funds
C) Target date funds
D) Index funds

Answer 16

Correct Answer:
D) Index funds

Answer Explanation
Index funds are appropriate for investors seeking to minimize fees. The other choices will generate more significant fees due to their active management.

Textbook Reference
Please see textbook section 4.2.4.6

Question 17

Which of the following are true about Exchange Traded Funds?
A) They are marginable
B) They are actively managed
C) They can only be purchased as new issues
D) They cannot be sold short

Answer 17

Correct Answer:
A) They are marginable

Answer Explanation
Exchange Traded Funds are a type of exchange traded products mirrors a stock index. They are not actively managed, they are supervised. ETF’s can be sold short; they can be purchased as new issues or on exchanges in the secondary market, and are marginable.

Textbook Reference
Please see textbook section 4.5.1.2

Question 18

With regard to the price of closed-end fund shares held by investors which of the following statements is TRUE?
A) Shares are sold at the price calculated at the close of business on that day
B) Shares may be sold at a discount or premium to their NAV
C) Shares are sold at a discount when the securities in the fund have increased in value relative to their NAV
D) The price is set by formula each business day

Answer 18

Correct Answer:
B) Shares may be sold at a discount or premium to their NAV

Answer Explanation
Closed-end company shares trade in the secondary market on exchanges. Their prices are determined by supply and demand and may be priced at a premium or discount to their NAV.

Textbook Reference
Please see textbook section 4.3.2.2

Question 19

A privilege that applies to mutual fund shareholders and allows them to receive sales charge discounts based on a prior purchase is
A) Conversion privilege
B) A Breakpoint schedule
C) Rights of accumulation
D) Dollar cost averaging

Answer 19

Correct Answer:
C) Rights of accumulation

Answer Explanation
The rights of accumulation privilege allows mutual fund investors to receive breakpoint discounts based on purchases made at a prior time, in different accounts, by other close family members, and for purchase of other funds within the same family. For example, if a mutual fund offers a breakpoint for purchases of $25,000 or more, an investor with shares worth $20,000 could get a reduced sales charge on a $5,000 investment.

Textbook Reference
Please see textbook section 4.2.5.6

Question 20

A mutual fund sponsor receives a request for redemption just after market close and redeems the shares at the NAV just calculated at the close. Which of the following statement is TRUE?
A) Since the order was received after market close, the redemption should have taken place at market opening on the next business day
B) This is standard practice for the redemption of fund shares since redemption must be made on the day of request
C) This is a prohibited practice known as late trading
D) This is a permitted practice known as late trading

Answer 20

Correct Answer:
C) This is a prohibited practice known as late trading

Answer Explanation
This is an example of the prohibited practice of late trading. Mutual fund redemptions are to be made following the forward pricing convention, which means they are to receive the next calculated price. An information advantage may be available if forward pricing is not followed, and a number of large fines have been assessed on firms that engaged in this practice.

Textbook Reference
Please see textbook section 4.2.6

Question 21

Closed-end funds are subject to regulation by which of the following?
I. The Securities Act of 1934
II. The Investment Company Act of 1940
III. The Investment Advisors Act of 1940
A) I and II only
B) II and III only
C) I, II, and III
D) I and III only

Answer 21

Correct Answer:
C) I, II, and III

Answer Explanation
Closed-end companies are subject to regulation under all major securities Acts, including the Securities Exchange Act of 1934, the Investment Company Act of 1940 and the Investment Advisors Act of 1940. The Securities Act of 1933 also applies when the closed-end fund is first issued.

Textbook Reference
Please see textbook section 4.1

Question 22

An investor that wishes to liquidate ETF shares will receive cash
A) Equal to the market value of the shares at the end of the trading day
B) Equal to the NAV
C) In the amount of the market value of the shares at the time the order is executed
D) Equal to the POP

Answer 22

C)

Answer Explanation
ETF shares trade on exchanges, typically the NYSE or NASDAQ. Investors receive the market price of their shares, less any transaction charges, when shares are liquidated. The price of the shares could be a discount or premium to the NAV of the fund’s shares.

Textbook Reference
Please see textbook section 4.5.1.2

Question 23

Which type of investment company product issues a single class of shares only and trades on the market at a discount or premium to its NAV?
A) Open end company
B) Both closed-end companies and UITs
C) Closed-end company
D) Unit investment trust

Answer 23

C) Closed-end company

Answer Explanation
Closed-end companies issue a single share class of securities only; mutual funds commonly issue Class A, B and C shares. Closed-end shares trade on exchanges at a discount or premium to NAV; UITs are redeemed by the trust.

Textbook Reference
Please see textbook section 4.3.2.2

Question 24

An investor holding a face-amount certificate owns an instrument most similar to a(n)
A) bond
B) ETF
C) Share of common stock
D) ADR

Answer 24

A) Bond

Answer Explanation
A face-amount certificate is a type of investment company that issues debt securities, obligating the issuer to pay a fixed amount at a specified date.

Textbook Reference
Please see textbook section 4.1

Question 25

The NAV of mutual fund shares will increase in which of the following circumstances?
A) Outstanding shares are redeemed
B) The fund receives interest from bonds that are held within the portfolio
C) Capital gains of the fund are distributed
D) Shareholders reinvest dividend and capital gains distributions

Answer 25

B) The fund receives interest from bonds that are held within the portfolio

Answer Explanation
The NAV of mutual fund shares increases when the value of securities held in the portfolio increases, when the portfolio receives distributions of dividends or interest from securities it owns, or when it sells portfolio securities at a profit. There is no change to NAV when new shares are issued or when shares are redeemed. The NAV of shares falls when the fund makes dividend or capital gains distributions.

Textbook Reference
Please see textbook section 4.2.4

Question 26

An investor is interested in an investment opportunity in which he can have an ownership interest in a specific portfolio of bonds for the next 20 years, and does not have to pay high management fees. Which of the following investments is most suitable?
A) A structured note
B) Units in a bond UIT
C) A closed end bond fund
D) A fixed income mutual fund

Answer 26

B) Units in a bond UIT

Answer Explanation
Unit investment trusts hold a specified portfolio of investments for a defined period that is established at the creation of the trust. Because their portfolios are fixed, investors are not subject to high management fees.

Textbook Reference
Please see textbook section 4.4.3

Question 27

With respect to raising capital, closed-end funds may issue
A) bonds only
B) Common stock, bonds and preferred stock
C) common stock only
D) common and preferred stock only

Answer 27

B) Common stock, bonds and preferred stock

Answer Explanation
Closed-end funds may issue ‘senior securities’, such as preferred stock and bonds, as opposed to open-end funds which may only issue common stock to raise capital.

Textbook Reference
Please see textbook section 4.3.2.5

Question 28

All of the following statements regarding the organization of a unit investment trust are true EXCEPT
A) An investment manager is hired to actively manage the trust assets
B) The securities to be held in the portfolio are selected to meet a specified investment objective
C) The Trust Indenture is the document that initiates the formation of the trust
D) The trust must register under the Securities Act of 1933

Answer 28

A)

Answer Explanation
A unit investment trust is not actively managed. The trust securities are selected by the trust sponsor and held with few exceptions until the trust is terminated.

Textbook Reference
Please see textbook section 4.6

Question 29

An investment company where the purchase and redemption price are the same is a
A) No-load fund
B) Index fund
C) Diversified fund
D) Value fund

Answer 29

A) No-load fund

Answer Explanation
A “no-load” fund is one which is sold to the public at the NAV, without any sales charge being added. Consequently, the NAV & POP would be the same in this instance.

Textbook Reference
Please see textbook section 4.2.5.2

Question 30

Which two of the following statements describe closed-end funds?

I. They are a continuous primary offering
II. There is a fixed number of shares
III. Shares are liquidated through exchange trading
IV. Shares are redeemed by the fund
A) I and III
B) I and IV
C) II and III
D) II and IV

Answer 30

C) II and III

Answer Explanation
Closed-end fund shares issue a limited number of shares through IPOs. To receive cash for their shares, investors sell closed-end company shares in secondary market transactions on exchanges. They are not redeemed by their issuer, like mutual fund shares.

Textbook Reference
Please see textbook section 4.3

Question 31

A mutual funds are typically prohibited from engaging in which two of the following activities?

I. Short selling of securities
II. Investing in senior equity and debt securities
III. Distributing its own securities
IV. Borrowing funds to purchase securities
A) II and IV
B) II and III
C) I and IV
D) I and III

Answer 31

C) I and IV

Answer Explanation
Typically, mutual funds are prohibited from purchasing securities on margin and short selling. Additionally, mutual funds cannot issue preferred stock or debt securities, but they are permitted to invest in them within their portfolios.

Textbook Reference
Please see textbook section 4.2.3

Question 32

All of the following practices are prohibited in the sales of mutual fund shares EXCEPT
A) An investor is encouraged to engage in a trading strategy that involves regularly purchasing and redeeming shares within a short time frame to take advantage of share pricing inconsistencies
B) A redemption request that is received today is processed at the NAV calculated at the previous day’s close
C) A registered representative recommends that an investor make a slightly larger investment to qualify for a breakpoint
D) An investor is encouraged to purchase shares in a fund just before the ex-dividend date to receive the dividend distribution

Answer 32

C)

Answer Explanation
Breakpoints allow investors to receive a discount on the sales charge based on the dollar amount invested. Registered representatives are required to disclose the existence of breakpoints to clients. Late trading is the prohibited practice of redeeming or purchasing shares at a price previously calculated instead of following the forward pricing rule. Market timing, or executing short term purchase and sales of mutual fund shares is also a prohibited practice. Because of their fee structures, mutual funds should be recommended as a long-term investment. Encouraging the purchase of shares just prior to a dividend distribution is called “selling dividends” and subjects the investor to a taxable event and a reduction in share value, since the NAV of fund shares falls when a dividend is distributed.

Textbook Reference
Please see textbook section 4.2.6

Question 33

An investor plans to purchase a home in the next 6 – 12 months and would like to invest funds for a down payment in a mutual fund. Which of the following choices is most suitable?
A) A money market fund
B) A balanced fund
C) A real estate fund
D) A U.S. government bond fund

Answer 33

A) A money market fund

Answer Explanation
Money market funds are appropriate for investments that need to be liquidated for their full value in a short time frame. Although not guaranteed, the value of each share has been held constant at $1, so investors in money market funds do not lose principal and can liquidate their shares for their full value plus interest that was earned.

Textbook Reference
Please see textbook section 7.4

Question 34

When comparing ETFs and closed-end funds, which two of the following statements are TRUE?

I. ETFs typically trade at a deeper discount or higher premium from NAV
II. Closed-end fund shares typically trade at a deeper discount or higher premium
III. Closed-end funds typically experience more volatility then ETFs
IV. ETFs typically experience more volatility than closed-end funds
A) I and III
B) II and III
C) I and IV
D) II and IV

Answer 34

B) II and III

Answer Explanation
Closed-end funds can commonly trade at a discount or premium of 10%– 20% of their NAV, while ETFs are normally trading within 1% of their NAV. There is much greater market volatility in the price of closed-end shares than in ETFs.

Textbook Reference
Please see textbook section 4.5.1.2

Question 35

When a UIT reaches the termination date specified at its creation, the trust
A) Has a new offering of units
B) Is sold and proceeds are distributed to unit holders
C) Can refile with the SEC for a subsequent primary offering
D) Is dissolved and no longer active

Answer 35

D)

Answer Explanation
A UIT is created for a specified period of time. Its termination date is established at the time the trust is created, and the trust is dissolved when that date is reached.

Textbook Reference
Please see textbook section 4.4.1.2

Question 36

The responsibility of the sponsor of a unit investment trust includes which of the following?

I. Selection of the securities for the trust
II. Organizing the formation of the trust
III. Tax reporting for the trust
IV. Recordkeeping for the trust
A) II and III
B) II and IV
C) I and II
D) I and IV

Answer 36

C) I and II

Answer Explanation
The sponsor of a UIT organizes the trust and is responsible for the selection of the portfolio securities. The trustee handles administrative functions, including the recording keeping, accounting and tax reporting duties.

Textbook Reference
Please see textbook section 4.4.1

Question 37

Closed-end funds are subject to regulation by which of the following?
I. The Securities Act of 1934
II. The Investment Company Act of 1940
III. The Investment Advisors Act of 1940
A) I and II only
B) I, II, and III
C) I and III only
D) II and III only

Answer 37

B) I, II, and III

Answer Explanation
Closed-end companies are subject to regulation under all major securities Acts, including the Securities Exchange Act of 1934, the Investment Company Act of 1940 and the Investment Advisors Act of 1940. The Securities Act of 1933 also applies when the closed-end fund is first issued.

Textbook Reference
Please see textbook section 4.1

Question 38

An individual enters an online order for the purchase of mutual fund shares directly from the fund’s sponsor. He will purchase shares at the
A) POP price calculated on that morning’s market opening
B) POP price next calculated
C) NAV price calculated on that morning’s market opening
D) NAV price next calculated

Answer 38

B) POP price next calculated

Answer Explanation
Mutual fund shares are purchased and redeemed at the next calculated price – the concept of forward pricing. The customer will purchase shares at the public offering price next calculated (POP). Shares are redeemed at the next calculated NAV.

Textbook Reference
Please see textbook section 4.2.5.1