Chapter 7: Investment Companies

Question 1

Transfer Agent - Mutual Fund

Answer 1

The transfer agent is contracted by the fund to perform the following basic clerical functions:

-Issuance of physical shares or book entry;

-Cancellation of redeemed shares; and

-Disbursement of dividend and capital gains distributions to shareholders.

Question 2

Class A shares sales load

Answer 2

Class A shares purchased at the POP have no deferred sales charge. They are front-end loaded. When an investor purchases Class A shares, the initial investment is less than the amount paid because the sales charge is taken out up front. With A shares, because the POP includes the sales charge, we would say that it is a net transaction. Class A shares are redeemed at NAV at the time of redemption.

Question 3

Class B shares sales load

Answer 3

Class B shares purchased at NAV have a potential back-end load called a contingent deferred sales charge, or CDSC. The CDSC is based on the lower of the share’s cost basis or current NAV at the time of redemption. The sales charge declines each year the investment is held, eventually reaching 0%. At that time, Class B shares convert into Class A shares.

Question 4

Class C shares sales load

Answer 4

Class C, or level load, shares are also purchased at NAV, but have a back-end sales charge that runs for only 1 year. Unlike Class B, however, Class C shares do not become Class A shares. Even though Class C shares have a lower expense ratio than Class B shares, they may be costly over a longer term since they can never be converted to Class A shares.

Question 5

Unit Investment Trust

Answer 5

• Fixed portfolio, thus not actively managed
• Stocks and/or bonds
• Redeemable, meaning can sell back to the trust
• Has an expiration date, then when UIT terminates, investors get their share of the net assets. Usually between 12 and 14 months.

If the UIT features a fixed portfolio, no substitution of securities may be made without written notice to the SEC. All unit holders must be notified of a substitution within 5 days. Furthermore, the SEC can order the liquidation of a UIT if it determines that the trust is ineffective or that such liquidation would be in the best interest of the unit holders. At maturity, the proceeds are distributed to the investors on a per unit basis.

• Available on secondary market at market value

Question 6

Managed Companies

Answer 6

-Have a fund manager
-Are open-end (=mutual funds) or closed-end

Question 7

Open- end Mutual funds

Answer 7

• do not trade in the secondary market.
• are sold at net asset value (NAV)
• Sold using forward pricing
• actively managed

Question 8

Closed-end mutual funds

Answer 8

• issues a fixed number of shares through a single initial public offering (IPO). No new shares are issued.
• can sell on secondary market at market price
• actively managed
  -typically focus on a single sector

Question 9

Face amount certificates

Answer 9

• almost never used nowadays
• raises money by issuing investors debt securities of a specified value.
• usually have actual collateral backing, similar to mortgage bond debt financing.
• pay a fixed amount of annual interest and then refund the principal of the securities at a specified termination date (at least 24 months)
• Companies used FACs to obtain financing at relatively low-interest rates.

Face amount certificates issue debt certificates that offer predetermined interest rates. The certificates can be purchased with either periodic installments or a lump-sum payment. Face amount certificates have a maturity of at least 24 months.

Holders of these certificates are entitled to redeem them for a fixed amount on a specified date. The certificates can be redeemed prior to maturity for their stated surrender value. Face amount certificates are rarely issued today due to changes in tax laws that make them less attractive.

Question 10

Underwriter/Sponsor of mutual fund

Question 11

Balanced fund vs. blended fund

Answer 11

Blended - mix of growth and value stocks

Balanced - mix of debt (bonds) and equity (stocks)

Question 12

Investment company

Answer 12

An investment company is an issuer in the business of investing, reinvesting, owning, holding or trading in securities. Investment companies fall into the following classifications: management companies, unit investment trusts, and face-amount certificates.

Investment companies are structured as either corporations or trusts in which investors are able to pool their funds for increased diversification and professional management. Average investors usually lack sufficient resources to adequately diversify their portfolios, but gain the advantage of wide diversification by pooling their funds with those of similar investors with like objectives.

Investment companies provide a way for investors to pool their money in a single fund. The assets in the fund are used to purchase securities that will enable the fund to reach its stated objectives, such as growth or income. Each investor owns an undivided interest in the portfolio of securities. In other words, no single shareholder has any right or claim that exceeds the rights or claims of other shareholders. The investment company concept offers an investor access to professional portfolio management and a level of diversification that average investors could not afford or achieve on their own. This section will discuss the many other features and benefits that investment companies offer the average investor.

Question 13

Management companies

Answer 13

The management company employs an investment adviser (a.k.a. “fund manager”) to manage a portfolio of securities in such a way as to achieve a specified investment objective over time. To reach this objective, each fund has its own specific investment objective or guideline. This investment objective outlines the types of securities and investment strategies, which the fund employs in pursuing its stated objective.

Management companies are organized as either open-end or closed-end. The most widely known and utilized type of management company is the open-end, or “mutual fund.” Indeed, this is the broadly accepted definition of the “mutual fund” concept among the general public. The main difference between open-end and closed-end management companies is in the shares they issue, or how they are capitalized. In the summary below, notice that shares of closed-end management companies are issued and traded just like shares of any other corporation.

Regarding pricing, note that closed-end funds also maintain a calculated net asset value (NAV) per share. However, due to market supply and demand, shares may be trading at a premium or a discount (values above or below the current NAV). Investors buy the shares at the market price plus a sales commission.

A management company, whether open-end or closed-end, can be either diversified or nondiversified. In order for a fund company to market itself as diversified, its portfolio must be invested in a manner specified in the Investment Company Act of 1940 and often referred to as the “75-5-10 rule.” According to the rule, at least 75% of the total assets must be invested in securities of other issuers, with no more than 5% of total assets invested in any one company. Additionally, the fund cannot own more than 10% of any company’s voting stock. There are no investment restrictions on the remaining 25% of the fund’s assets.

For example, if a fund has $1,000,000 in total assets under management,
-$250,000 is unrestricted and can be invested in any way;
-$750,000 must be invested with the following limits:
-No more than $50,000 (5% of total assets) in any one company; and
-No more than 10% of any company’s voting stock.

Many funds choose to market themselves as nondiversified. These management companies find it more expedient to pursue their stated goals by concentrating their investments in a manner inconsistent with the 75/5/10 guidelines.

Question 14

Closed-End Management Companies

Answer 14

Closed-end management companies have the following characteristics:
-Usually capitalized through a one-time public offering of a fixed number of shares;
-After the initial public offering, the shares trade in the secondary market;
-The share price in the secondary market is determined by investor demand;
-Trading in shares may take place on an exchange or in the OTC market; and
-Do not redeem shares held by investors.

Because closed-end company shares are priced by market demand, they may trade at a premium above or at a discount below their net asset value. When investors want to liquidate their shares, they must liquidate them at the then-current market price. Closed-end shares are purchased at market price plus a sales commission.

Question 15

Open-end management companies

Answer 15

Mutual Funds are the most common type of investment company security today.

Because mutual funds offer a variety of different investment objectives, investors can select funds to meet their specific investment objectives. Owning shares of a mutual fund gives the investor an undivided interest in the fund’s entire portfolio. The significant degree of diversification that is instantly available by investing in mutual funds would require a substantial investment beyond the means of the average investor if that investor were to purchase individual securities meeting the same objectives.

As previously mentioned, open-end mutual funds provide a continual offering and redemption of shares.

Investors purchase fund shares at the public offering price, or POP, which is composed of the NAV per share plus any applicable sales charge. If the dollar amount of the purchase does not compute into an even number of shares, the mutual fund issues fractional shares, computed to 1/1,000 of a share.

For example, an investor wants to purchase $1,000 of Fund ABC. At the time of the order, the fund is priced at $32.05 per share. The investor is issued 31.201 shares, computed by dividing $1,000 by $32.05 per share.

Prices of mutual fund shares are reduced, in the same manner as common stocks, to reflect dividends paid on the stock. Mutual funds sell ex-dividend on the date determined by the board of directors (usually the next business day after the record date). As with stock, “selling dividends” is a prohibited practice, and occurs when investors are encouraged to purchase shares just prior to a dividend distribution for the sole purpose of receiving the dividend. This is prohibited because the current value of the fund share drops by the dividend distribution on the ex-dividend day. If the investor were to purchase the share just prior to the ex-dividend day (to receive the distribution), taxes would be owed on the dividend and there would be no economic benefit since the market value of the share drops by the amount of the dividend when it is paid. Consequently, the investor also suffers a capital loss.

The prohibition against selling dividends applies equally to stocks and mutual fund shares.

On the day that a security is quoted ex-dividend, members are required to adjust the price and or quantity of shares prior to executing an order from another broker/dealer or customer. This also applies to securities that are quoted ex-rights, ex-distribution or ex-interest, unless the cash dividend or distribution is less than one cent. (FINRA Rule 5330)

Question 16

Mutual fund purchase pricing

Answer 16

Investors purchase fund shares at the public offering price, or POP, which is composed of the NAV per share plus any applicable sales charge. If the dollar amount of the purchase does not compute into an even number of shares, the mutual fund issues fractional shares, computed to 1/1,000 of a share.

For example, an investor wants to purchase $1,000 of Fund ABC. At the time of the order, the fund is priced at $32.05 per share. The investor is issued 31.201 shares, computed by dividing $1,000 by $32.05 per share.

Question 17

Mutual funds and dividends

Answer 17

• Mutual funds sell ex-dividend on the date determined by the board of directors (usually the next business day after the record date).
• the current value of the fund share drops by the dividend distribution on the ex-dividend day.
• If the investor were to purchase the share just prior to the ex-dividend day (to receive the distribution), taxes would be owed on the dividend and there would be no economic benefit since the market value of the share drops by the amount of the dividend when it is paid.
• Consequently, the investor also suffers a capital loss

Question 18

Diversification- Industries

Answer 18

Specialized funds may concentrate a large percentage of their portfolio in a specific industry such as chemicals, pharmaceuticals, or business machinery. Funds with holdings in a wide range of industries tend to reduce the effect of periodic downturns in a particular area of industry on their portfolios.

Question 19

Diversification - types of investment instruments

Answer 19

A portfolio containing different types of securities can offer some stability in volatile markets. This is called asset allocation.

For example, a well-diversified income-oriented fund might hold common stocks with a history of high dividends as well as preferred stock, corporate and treasury bonds and money market instruments.

Question 20

Diversification - variety of securities issuers

Answer 20

A growth-oriented equity fund may find that positions in a large number of companies, including large-, medium- and small-cap issuers, would prove to be a successful long-term strategy.

Question 21

Diversification - geographic area

Answer 21

Specialized funds may also be diversified by geographic region, concentrating their assets in a particular region, state, or foreign country.

If a fund’s strategy includes international holdings, diversification may be achieved by including investments in Europe, Latin American and Far Eastern countries

Question 22

Equity funds

Answer 22

equity funds are those that invest in common and/or preferred stocks as opposed to debt securities.

Though common stocks are generally considered to be a growth-oriented investment, funds that hold equities may pursue a variety of objectives.

Question 23

Blue chip funds

Answer 23

large, mature companies with high consumer recognition and brand loyalty. They have established products and distribution channels, proven earnings and consistent dividend payment histories.

Blue chip stock values tend to be stable, and are more durable if declining markets. A blue chip fund would suit an investor who wants stock market exposure, but prefers less volatility than other equity alternatives.

Blue chips carry systematic risk, but less credit and volatility than other equity funds.

Question 24

Income funds

Answer 24

Income funds have an objective of current income. For that reason, these funds will hold securities with dividend yield potential.

Depending upon its investment policies, an income fund may seek to achieve its objective by holding a combination of preferred stock or common stock with a history of high dividends in relation to its market value. These common stocks include common stocks of blue-chip companies with solid earnings histories.

They also include stocks of utility companies, which pay regular dividends to their investors. Income funds typically have below-average growth potential and are exposed to credit risk and interest rate risk.

Question 25

Growth funds

Answer 25

Growth funds typically include common stocks of blue-chip companies with solid earnings histories; however, they may include younger, smaller companies that the fund manager judges to have significant growth potential for long-term appreciation.

Dividend income is a lower priority in most growth funds, because these companies will often retain their earnings to fund further expansion.
Market risk is the most prevalent risk factor for growth funds.

Question 26

Growth and Income Funds

Answer 26

Growth/income funds are a combination of the two previously mentioned fund types: income and growth. These funds tend to hold well-established companies that pay some dividends, but still retain earnings for expansion.

Growth and income funds tend to be less volatile than pure growth funds, but usually under-perform growth funds during market advances.

Growth and income funds are subject to market risks and possibly to purchasing power risks if dividend payments and capital appreciation fail to keep up with cost-of-living increases.

Question 27

Aggressive growth funds

Answer 27

Aggressive growth funds are potentially volatile funds because these portfolios may be heavily invested in companies of cutting-edge industries or start-up companies whose earnings are unproven.

Companies in aggressive growth funds have strong research and development divisions and retain their earnings for expansion. In addition, aggressive growth funds often exhibit high portfolio turnover as the fund manager is more likely to take profits and seek new opportunities.

The pay-off for the increased volatility is the potential for substantial gains in advancing markets.

These funds are strongly susceptible to market risk and timing risk if investors are not able to hold them through declining periods.

Question 28

Value funds

Answer 28

Value funds primarily hold stocks that are deemed to be undervalued in price for any number of reasons and thus have significant upside potential.

The mutual fund manager of such funds generally utilizes a “buy and hold” strategy for the underlying securities in an attempt to give the securities enough time for any market inefficiencies in the true value of the security to be corrected.

These funds tend to underperform during a general market advance and outperform in a decline.

Question 29

Blended funds

Answer 29

Blended funds hold no fixed income securities, but contain a mix of growth and value stocks.

These funds are designed to appreciate in value by means of capital gains.

Question 30

Balance funds

Answer 30

Balanced funds provide a combination of fixed income instruments and equities, and their goal is to achieve growth in value and income, as well as preservation of capital.

Question 31

Fixed income funds

Answer 31

Fixed income securities are those with a consistent yield like debt securities and preferred stocks.

They provide a return of fixed periodic payments known in advance (e.g., fixed-rate government bonds).

While the income is guaranteed, the return on investment is usually lower than in other forms of securities. In addition to supplementing income, fixed income securities help investors reduce volatility in their overall portfolio.

A fixed income fund may be sub-classified according to its holdings.

Question 32

Government fixed income funds

Answer 32

Government fixed income funds typically hold treasury and government agency debt and offer safety and generally less volatility.

In return for this limited credit risk, government bond funds offer low yields.

Question 33

Tax-exempt funds (a type of income fund)

Answer 33

Important: Tax-exempt funds hold only municipal bonds and offer advantages for those in high tax brackets.

State or municipal government fixed income investments generate federally tax-exempt interest income and may be exempt from state tax if the holder is a resident of the issuing state.

These funds are only suitable for investors in high tax brackets because other investors are better served by the higher (taxable) yields of corporate bond funds.

Question 34

High-yield fixed income funds

Answer 34

High-yield fixed income funds
generally hold corporate debt with low credit ratings, referred to as speculative or sometimes “junk” bonds. These carry high default risk and are generally more volatile.

High-yield fixed income funds could supplement a well-diversified portfolio, but are mostly suitable for aggressive long-term investors who are primarily interested in yield rather than safety.

These securities include above average share price fluctuation in return for the potentially higher yield.

Question 35

Money market funds

Answer 35

Money market funds invest in safe, liquid, short-term debt instruments.

They have the distinctive feature of attempting to maintain a stable $1 per share value (NAV) although it is not guaranteed.

The type of securities they hold differentiates these funds. A money market fund invests in short-term (1-year maximum maturity), high-quality debt such as corporate commercial paper, bankers’ acceptances, negotiable (jumbo or brokered) CDs, and repurchase and reverse repurchase agreements. They also invest in Treasury bills (T-bills).

These funds provide capital preservation. Thus, a risk of money market funds is that over the long term, they may not produce returns sufficient to keep up with inflation.

Question 36

Money market funds - taxes

Answer 36

• Taxable money market funds are suitable for most investors (in lower tax brackets).
• Tax-exempt funds invest in federally tax-exempt money market instruments which offer lower yields than other money market instruments. Because tax-free funds offer lower yields, they are suitable only for investors in higher tax brackets who can benefit from the tax-free income which these funds provide.

Question 37

Money market funds - retail vs. institutional investors

Answer 37

Some money market funds are intended for retail investors, while others are more suitable for institutional investors.

The initial investment for retail investors is generally lower, but fees are higher.

Large institutional investors, like pension funds, insurance companies, hedge funds and investment advisers, have higher initial investment requiremen

Question 38

Sector (or Specialized) funds

Answer 38

Specialized funds, also known as sector or industry funds, concentrate a major portion of their assets in a specific industry, market sector, or geographic region.

Specialized funds are usually not suitable for the average investor with a lower risk tolerance, or an investor who needs greater diversification.

Specialized funds have the potential for substantial gains in advancing markets but are vulnerable to changes in industry specific or sector-specific economic trends.

Additionally, funds specializing in international sectors are vulnerable to currency exchange risk and foreign legislative risk.

Question 39

Geographic concentration funds

Answer 39

A fund with a geographic concentration purchases securities of companies from a common geographic region, such as the Midwest, the Southwest, or the Northeast.

Because the fund is dependent on this one region, it carries more risk.

It would be most suitable for sophisticated investors who are already diversified and wish to concentrate a small portion of their portfolios

Question 40

Asset allocation fund

Answer 40

• I know what that is
• occasionally rebalances

Question 41

International fund

Answer 41

A mutual fund that invests a concentration of its assets in overseas companies and markets (e.g., Asia, Australia, or South America) is an international fund.

These funds are considered to have a higher degree of risk because of different regulatory, political and economic factors. They carry more legislative risk and also carry currency exchange risk.

Question 42

Mortgage-backed security fund

Answer 42

These mutual funds invest primarily in mortgage-backed securities issued by agencies such as Ginnie Mae, Freddie Mac, Fannie Mae, or possibly private corporations.

These entities issue collateralized mortgage obligations (CMOs) and real estate mortgage investment conduits (REMICs).

Because the mortgage bonds provide monthly principal and interest, this mutual fund pays a monthly dividend to its shareholders. Therefore, this fund is most suitable for the investor who seeks regular income.

These funds generally carry a higher degree of default risk than government bond funds but also a higher yield.

Question 43

Funds I know

Answer 43

• Index funds
• Fund of funds
• Precious metals fund - hedges against inflation
• Lifecycle/Target retirement funds

Question 44

Interval funds

Answer 44

Interval funds invest in illiquid assets, such as commercial property and private equity, and do not offer shareholders the ability to redeem shares on a daily basis.

Instead, they periodically offer to repurchase shares from their shareholders at a price based on net asset value.

However, shareholders are not required to accept these offers and sell their shares back to the fund.

Investors benefit from the opportunity to invest in large properties and other investments that would not ordinarily be available to individuals.

Question 45

Functions of board of directors

Answer 45

The board of directors is responsible for the establishment and implementation of a mutual fund’s investment policies. The board members are elected by the fund’s shareholders. In accordance with the Investment Company Act of 1940, a minimum of 40% of the board members must be unaffiliated with the fund (outside directors). The remaining 60% can include the fund’s employees, underwriters, or its investment adviser. However, if the fund has a 12b-1 fee or if any conflicts of interest exist, the majority of the board of directors must be outside board members (51%).

The board selects officers to carry out the operations of the investment company, and oversees their performance. The selection of investment company officers does not require a shareholder vote. Board members are not involved in the management of the investment portfolio; that responsibility falls to the investment adviser.

Other functions of the board of directors are as follows:
- Appoint and oversee investment advisers, transfer agents, custodians;
- Establish investment policy; and
- Establish dividend and capital gains policy for the fund.

The mutual fund’s board of directors has limited authority when engaging in certain activities. Many of the board’s activities are dependent on shareholder approval. The rights of shareholders include the following:
- Voting rights/proxies;
- Approving changes in investment objectives and policies;
- Approving investment advisory agreements;
- Approving changes in fees;
- Electing directors; and
- Ratifying selection of independent auditors.

Registered investment companies are prohibited from changing the investment policy of a mutual fund without authorization gained by the vote of a majority of its outstanding voting shares. This prohibition also applies to any divergence from its policy with respect to concentration of investments in a particular industry or group of industries.

Question 46

Functions of investment adviser

Answer 46

The investment adviser is employed to manage the fund’s portfolio. The investment adviser is paid a fee for advisory services that is typically based on a percentage of the net asset value under management (also called assets under management, or AUM) over a specified period of time. This fee is classified as an operating expense of the fund. The majority of shareholders, members of the board, or both must approve investment advisory contracts.

The investment adviser’s duties include the following:
- Supervising the fund’s portfolio by obtaining the appropriate diversification of securities held by the fund and making decisions regarding the appropriate timing of investments;
- Providing investment advice in conformity with federal securities regulations and tax laws;
- Researching and analyzing financial and economic trends; and
- Conforming to investment objectives and policy decisions established by the board of directors. (Most funds’ policies forbid such practices as short selling or margin buying.)

Question 47

Functions of custodian

Answer 47

A custodian is a financial institution that holds customers’ securities for safekeeping, providing administrative and operational support. The custodian must safeguard the physical assets of the mutual fund, perform payable and receivable functions of securities transactions, and register the receipt of interest and dividends for the fund. A mutual fund is required to have a national bank, trust company, or other qualified institution to perform as its custodian.

The custodian does not perform any management, supervisory, or investment functions; nor does it have any involvement in the sale of shares. The custodian may, however, perform as the fund’s transfer agent.

Question 48

Functions of transfer agent

Answer 48

The transfer agent is contracted by the fund to perform the following basic clerical functions:

• Issuance of physical shares or book entry;
• Cancellation of redeemed shares; and
• Disbursement of dividend and capital gains distributions to shareholders.

Note: Book entry means that shares are owned, recorded and transferred electronically without issuing a physical stock or bond certificate. The security is registered in the investor’s name on the issuer’s books, and either the broker/dealer or its transfer agent holds the security in book-entry form. The Direct Registration System (DRS) facilitates the transfer of securities electronically.

Question 49

Fund expenses

Answer 49

The shareholders and the board of directors must approve all of the expenses for the operation of the mutual fund. Detailed information concerning fund expenses is covered in the prospectus.

Fund expenses also include the management fee paid to the investment adviser. Management fees are usually the largest expenses of operating a fund, and are expressed as a percentage of the fund’s net asset value.

Expenses also include the cost of services such as custodian, transfer agent, board of directors, etc. Other administrative and distribution expenses may be charged by the fund.

Question 50

No-load funds

Answer 50

No-load funds sell direct to the investor at NAV. Since they do not outsource their sales effort, their sales-related costs are charged against the fund as an expense.

No-load funds do not charge front- or back-end sales loads, but may include a small 12b-1 fee. Note that if a fund has a sales charge or a 12b-1 fee in excess of 0.25%, it may not describe itself as a no-load fund. This is considered a misuse of the “no-load” terminology and is a violation of the FINRA Conduct Rules.

Know This! No-load funds cannot charge a 12b-1 fee greater than 25 basis points so they may have lower expense ratios than those with a load.

Question 51

Expense ratio

Answer 51

The expenses of a mutual fund are expressed as the fund’s expense ratio. The expense ratio is determined by dividing the total expenses by average net assets (assets minus expenses) of the portfolio. Total expenses include the investment adviser’s management fee and the fees to the custodian, transfer agent, and board of directors. If we were given the net assets for January 1 and December 31, we could add these two numbers and divide by two to calculate average net assets.

Expense Ratio = Total expenses / average net assets Jan1 and Dec 31

Know This! The sales charge or load is not included in the expense ratio. The load is not a direct operating expense of a mutual fund.

Question 52

Functions of underwriter

Answer 52

A mutual fund’s sponsor, or distributor, is known as the fund’s principal underwriter. Sometimes the underwriter is called the wholesaler, since it “wholesales” the shares to dealers. The underwriter has an exclusive agreement with the fund that allows it to purchase fund shares at the current net asset value (NAV). The shares are then sold to the public, through either outside dealers or the underwriter’s sales force, at the full offering price, or POP (public offering price).

The following chart outlines the flow of a mutual fund sale:

The fund’s underwriter markets the fund’s shares to dealers that sell the shares to the public. Only dealers that have a selling agreement with the fund may sell shares. The underwriters “wholesale” or market to these dealers to help them make sales. They create and pay for retail communication material to better market the shares to dealers, and compensate the dealers for shares that are sold.

Question 53

Direct sales to the public

Answer 53

In some cases, dealers make direct sales to the public by purchasing shares from the underwriter at a discount from the POP and then reselling them to investors. Dealers can never buy mutual fund shares for their inventory; shares must be purchased to fill customer orders only.

Question 54

POP and NAV

Answer 54

• Know This! Mutual fund investors buy at the POP and redeem at NAV.
• POP = NAV + Sales Charge
• The NAV must be calculated at least once a day and is usually computed as of the close of the New York Stock Exchange. Buy and sell orders are based on the next price to be computed, referred to as forward pricing.
• Know This! The redemption value of an open-end investment company, or mutual fund, is based on NAV after the order is received.

Note: Mutual fund companies are prohibited from allowing certain investors to engage in late trading, which means buying or selling after the close of the exchange. By buying or selling after pricing is done for the day, the standard forward pricing methodology is not applied, and this is a violation.

Question 55

Mutual fund sales charge

Answer 55

The sales charge of a mutual fund is expressed as a percentage of the public offering price. FINRA’s Conduct Rules limit the sales charge to a maximum of 8.5% of the POP. If the fund does not offer three privileges, then the sales charge is limited to a maximum of 6.25%. These three privileges are as follows, and will be discussed later in the course:

1. Dividend reinvestment at NAV;
2. Breakpoints; and
3. Rights of accumulation.

All sales charges on mutual fund shares repurchased or redeemed within 7 business days of the transaction date must be refunded.

Note that 8.5% is the maximum sales load under FINRA rules. Under the Investment Company Act of 1940, the maximum sales load is 9%.

Sales charges are not included in the expense ratio calculation because they are added to the net asset value per share to form the sales price (NAV + SC = POP).

Question 56

Exemptions from selling mutual funds at POP

Answer 56

The Investment Company Act of 1940 requires that redeemable mutual fund shares be sold to retail customers at the Public Offering Price (POP).

However, the Act allows for exemptions from the rule for scheduled sales load variations (such as breakpoints) or the elimination of the sales load altogether. The investment company, its dealers, and underwriters are exempted from the rule, and may offer discounts from the POP only when:

• Discounts are applied uniformly to all investors in a particular class;
• Existing shareholders and new investors are provided with adequate information about the sales price variations;
• The investment company prospectus is revised to show new sales load variations before making them available to new investors; and
• The investment company informs existing shareholders of the new sales price variations within 1 year of the date when they are available to new investors.

Question 57

Class A, B and C shares - practical application

Answer 57

A) A shares are most appropriate for large investments with a long-term time horizon;

B) B shares are appropriate for small investments with a long-term time horizon; and

C) C shares are investment neutral and short-term time horizons.

B and C shares are offered with a back-end sales load or charge, which is also called a contingent deferred sales charge (CDSC). Funds with a CDSC are offered at the NAV, but there is a charge if the shares are redeemed within a certain period of time after their purchase. The CDSC is based on the lower of the share’s cost basis or current NAV at the time of redemption.

Note that shares in Classes B or C status have higher expenses than A shares. Because of this, they represent an alternate method of recovering the marketing costs that would have been paid up front had A shares been purchased. Again, all of these differences are detailed in the prospectus.

Determining which sales charge is appropriate for an investor’s purchase varies with such factors as the investment horizon, the amount of the initial investment, the frequency of investments, and the probability of withdrawal of funds before intended

Question 58

Letter of intent

Answer 58

allows an investor to qualify for the sales discounts without initially investing the entire amount required. The letter states the investor’s intent to invest the required amount over the next 13 months.

Letters of Intent can be backdated 90 days. If the LOI is backdated, note that there will be less than 13 months remaining to complete the investment, because the 13-month window begins at the date of original purchase.

Letters of intent are not binding on the investor. If the investor fails to deposit the required amount by the time the letter expires, the fund will charge the investor an amount that equals the higher sales charge that applied to the amount invested so far. The fund ensures that it will be able to recover these charges by holding a sufficient number of shares in escrow to cover the expenses.

Only investor contributions are considered part of additional deposits. Appreciation of shares owned is not credited toward completion of the letter.

Question 59

Rights of accumulation

Answer 59

Mutual fund companies typically permit rights of accumulation for members of the immediate family and children younger than 21 living at the same residence. Immediate family could also be considered relatives if they are financially dependent on the family.

Fund companies also typically permit rights of accumulation for large groups such as schools, hospitals, corporations, etc. These groups usually invest through some type of retirement program.

Question 60

Redemption fee

Answer 60

• Certain funds may also charge a redemption fee when an investor liquidates his or her shares.
• Normally, this occurs when shares are held for less than 90 days or perhaps up to 1 year.
• Most often this is to discourage short-term trading of shares by the investor.
• Note that this is not a sales charge and is computed based on the value of the shares that are redeemed.

Question 61

Methods to redeem mutual fund shares

Answer 61

Written Request — Mutual Funds may be redeemed through a written request if the fund has this privilege.

Telephonic — Mutual Funds may be redeemed through telephone redemption if the fund has this privilege, and the investor chooses it when the account is opened.

Check Writing — Mutual Funds may be redeemed through check writing if the fund has this privilege. This is usually limited to money market funds and some bond funds.

Through a Dealer — An investor wishing to redeem mutual fund shares can do so through the dealer who sold the funds or directly with the transfer agent. No-load funds are redeemed by direct contact with the issuing transfer agent or custodian bank, because there is no dealer involved.

Under certain conditions, funds may require a signature guarantee before redeeming shares to ensure that the request is valid. A signature guarantee is usually required for wire transfers, redemptions to addresses different than the address of record on the account, or for dollar amounts above certain limits.

If a physical certificate was issued for the shares, it must be presented for cancellation in order to redeem the shares. This is rare since most sales are recorded on a book-entry basis

Question 62

Required content in mutual fund prospectus

Answer 62

must contain all material information necessary for the investor to make an informed investment decision. This required information includes

• Investment objectives, policies, and restrictions;
• Sales loads and fees including:
  - Front end;
  - Contingent deferred; and
  - 12b-1 fee;
• Redemption fee;
• Management fee;
• Other expenses.
• Expense table;
• Breakpoint, rights of accumulation, combination of accounts and letter of intent;
• Exchange privileges within a family of funds;
• Per-share income and capital changes;
• Methods of sale (including determining pricing);
• Methods of redemption;
• Investment and withdrawal plans; and
• Financial statements.

Question 63

Statement of additional information

Answer 63

If the investor would like additional disclosure, a statement of additional information can be requested. This statement must be made available to all current and potential investors within 3 days of the request.

Question 64

Automatic Reinvestment of Dividend Income and Capital Gains Distribution

Answer 64

Mutual funds typically offer reinvestment of capital gains and dividends at net asset value (meaning without a sales charge). If a customer chooses to reinvest distributions, these monies are automatically used to purchase additional mutual fund shares in the customer’s account. Investors benefit from the accumulation of new shares over time, which makes a significant difference in portfolio accumulation value due to the compounding effect.

Investors may choose to reinvest distributions back into the fund, or they may take the distributions in cash. Because investors have this choice, the IRS taxes mutual fund distributions in the year distributed. The IRS calls this choice “constructive receipt.” Since the mutual fund investor has constructive receipt of the dividends and capital gains distributions, the distributions are taxed, whether the investor receives them OR reinvests them back into the fund.

Although capital gains are generated when a mutual fund’s manager sells an asset at a profit and are based upon the fund’s holding period, they are distributed once a year, typically at the end of the year. Dividends are distributed quarterly.

Question 65

Exchange Privileges within Families of Funds

Answer 65

Most funds allow investors to redeem shares in one fund and reinvest the proceeds in another fund within their fund family at net asset value (NAV). These exchanges do not incur additional sales charges, but some funds charge a small exchange fee. Because redemption of shares normally results in a realized capital gain or loss, the IRS defines these exchanges as a sale for capital gain and taxation purposes. Investors must be informed of the tax consequence of a switch before they execute the switch, because the tax consequence is a consideration in the switch decision.

Although a mutual fund that charges the maximum sales charge of 8½% is required to offer dividend reinvestment, breakpoints, and rights of accumulation, exchange rights are a convenience privilege and are not required by the Investment Company Act of 1940.

Question 66

Dollar cost averaging

Answer 66

• I know the concept
• DCA always produces the same result: The investor’s average cost per share is less than the average price per share over the investment period
• When discussing DCA plans, the agent must alert investors of the following:
  1) They still can sustain a loss if the current market value of the shares is below the average share cost; and
  2) The plan does not protect them from a loss in a steadily declining market.

Question 67

Systematic withdrawal plans

Answer 67

Many investment companies provide investors with an option for systematic monthly, quarterly, or annual withdrawals. Payments can be received at specified intervals in either fixed or flexible amounts. Much like systematic investment plans help an investor accumulate monies in an account, systematic withdrawal plan helps an investor liquidate an account in a more predictable manner.

There is usually a requirement for a minimum net asset value for the account from which the distribution is being made. Payments are made first from dividends and then from capital gains. If these are not sufficient, fund shares are liquidated. If the account value falls below the minimum required for distributions, the mutual fund will generally ask that the account either be liquidated or that future distributions are discontinued.

Investors need to be aware that systematic withdrawal plans have a potential to exhaust their principal. These are not guaranteed to last for a certain length of time (as compared to annuities, which will be discussed in the next chapter). In some cases, this is the ultimate goal of the systematic withdrawal plan itself. By setting up the plan in such a way, an investor can know with greater certainty the timeframe of the liquidation. A fixed share plan, which is discussed in the next section, is an example of this type of liquidation. It should be noted, however, that since the share value fluctuates with the market, the dollar value of distributions will increase and decrease as well.

Question 68

Types of systematic withdrawal plans

Answer 68

The types of withdrawal plan payouts include

• Fixed-dollar periodic payments — an investor requests that a specified dollar amount be received in each payment.
• Fixed-percentage periodic payments — an investor requests that a fixed percentage of shares be liquidated at fixed intervals.
• Fixed-shares periodic payments — an investor requests that a fixed number of shares be liquidated at specified intervals.

Question 69

Safekeeping of portfolio securities

Answer 69

All securities issued by the Treasury Department are issued in book-entry form, meaning they exist only as electronic records in computers without physical certificates of ownership. Members must use a securities depository for book-entry settlement, an electronic system of custody, transfer, delivery and settlement. Book-entry settlement allows shares to move electronically through the Depository Trust Corporation system, transferring securities with simultaneous cash settlement.

Members cannot effect a delivery-versus-payment or receipt-versus-payment transaction in a depository eligible security with a customer unless the transaction is settled by book-entry using the facilities of a securities depository.

The custodian is charged with the safekeeping of the fund’s securities, and also maintains a record of share ownership. Shareholders own fund shares through book-entry form and do not have to maintain a physical certificate. Should a shareholder possess share ownership certificates, however, they would have to be surrendered in order to redeem shares.

Question 70

Ease of account inquiry

Answer 70

Shareholders can inquire about the current status of their funds at any time during the hours the fund is open. Most funds also have 24-hour automated account information and Internet access for shareholders.

Question 71

Mutual fund simplified tax information

Answer 71

Investment companies provide shareholders with 1099 forms and explanations of the type of distributions made. The 1099 provides documentation to the IRS and to the investors of all potentially taxable events, such as dividends, realized short-term and long-term capital gains and capital losses.

Mutual funds pay dividends quarterly and capital gains annually, usually in January for the prior year. The quarterly dividend is paid out of net investment income from portfolio holdings. Net investment income is calculated by adding all dividend and interest generated by the portfolio and subtracting fund expenses. Fund expenses are the fees to the board of directors, transfer agent, custodian, and investment adviser.

Net Investment Income = Portfolio interest + dividends - fund expenses

The mutual fund must pay out at least 90% of its net investment income to the shares to avoid taxation on the distributed portion. If the fund does so, it is only taxed on the small portion of net investment income which it retains. This special taxation is available through IRS Subchapter M, and is also known as the Conduit or Pipeline Theory.

For example, if a fund pays out 93% of net investment income, it is taxed only on the 7% the fund retains. However, if the fund pays out 89% of net investment income, it is taxed on 100%.

Question 72

Important Factors in Comparison of Funds

Answer 72

• Investment Objective—For example, it would not be appropriate to compare the performance results of a fund with a growth objective with a fund having an income objective, for example.
• Investment Policies—Even funds with the same overall objective can utilize very different investment policies to pursue those objectives. For example, one growth fund may invest exclusively in domestic stocks, while another may invest primarily in stocks of far eastern countries.
• Quality of Management—Quality of management can be compared by duration of current management and consistency of performance relative to like funds.
  Risk Factors—Risk factors can be compared by the fund’s calculated risk coefficient, beta, Sharpe ratio, and risk/return factors.
• Portfolio Turnover—The frequency with which a fund buys and sells securities in its portfolio (turnover rate or turnover ratio) can affect its cost to the investor. For example, a turnover rate of 100% would indicate that a fund completely replaces its portfolio every year, while a rate of 50% means it typically changes half of its portfolio each year. One could expect a fund with a high turnover rate to have higher expenses (trading costs) and probably higher short-term capital gains distributions.

Question 73

Statistical comparisons of mutual funds

Answer 73

Some of the most helpful statistical analysis is based on the following characteristics:

• Total Return for a given holding period (1 year, 5 years and 10 years, or life of fund) includes the effect of reinvested distributions and share price appreciation, net of sales charges and expenses for the period.
• SEC yield or current yield — The current yield is calculated by dividing the annual dividend by the current POP. For example, suppose a fund’s most recent quarterly dividend was $.25. The current POP is $20. To calculate current yield, first multiply the quarterly dividend by 4 to get an annual dividend of $1. Then divide the dividend by $20.
  $.25 × 4 = $1
  $1 ÷ $20 = 5%
  Current yield is a snapshot of the benefit of owning the fund at this moment.
• Expense Ratio — Higher expenses have the effect of reducing current yields and total returns. Be careful to note that newer funds, especially those with fewer total assets under management than their peers, usually experience higher expense ratios in their earlier years.

Question 74

ETFs

Answer 74

• ETFs do not sell individual shares directly to investors and only issue their shares in large blocks (50,000 shares, for example) that are known as “Creation Units.” It is important to know that the number of creations varies depending on the fund. After purchasing a Creation Unit, a broker/dealer may split it up and sell the individual shares in a secondary market or sell the Creation Unit back to the ETF.
• Unlike in mutual funds, investors do not purchase or redeem shares from the exchange traded fund, but instead buy and sell shares on an exchange. Like stocks, ETF prices fluctuate continuously throughout the day according to changes in the underlying portfolio of securities. ETFs also offer the same intraday liquidity as other securities traded on exchanges, such as closed-end funds. However, as opposed to closed-end funds which can trade at a premium or discount to their NAV, ETFs usually trade near their NAV.
• ETFs can also be purchased on margin 30 days after the initial public offering or IPO.

Question 75

Passive vs. active ETFs

Answer 75

• Passive ETFs are designed to passively track a particular market index. They invest in all or a representative sample of the stocks in an index.
• Active ETFs are managed by a portfolio manager who buys and sells stocks based on a defined investment strategy, rather than tracking an index.

Question 76

Leveraged ETFs

Answer 76

• Leveraged ETFs differ from more traditional ETFs because they use a multiplier. For example, a 200% or 300% multiplier may be used with a leveraged ETF which would make the leveraged ETF more volatile than a more traditional ETF. The underlying instruments are not only the securities found in the index but also derivatives such as options, futures and swaps.
• Leveraged ETFs also have a higher margin maintenance requirement than more traditional ETFs, which mirror the underlying stocks maintenance of 25%. The maintenance requirement for 200% leverage ETF would be 50% of the market value for a long position or two times the normal maintenance requirement of 25%.

Question 77

Inverse ETFs

Answer 77

Inverse ETFs are created from various derivatives to profit when an underlying benchmark or market sector declines. Most investors use inverse ETFs to hedge their portfolios against market declines. Inverse ETFs can also be used instead of short positions without establishing a margin account.

Question 78

ETNs

Answer 78

• Exchange-Traded Notes (ETNs) are senior unsecured debt instruments issued by an underwriting bank or other large institution. Normally, ETNs do not pay periodic interest and have no principal protection. Instead, they are backed by the credit of the issuing bank.
• Most ETNs are based on and track the performance of an underlying index or benchmark. ETNs are not equities or index funds; rather, they are debt securities and do not own the underlying index/benchmark.
• Like other debt instruments, ETNs have a maturity date. At maturity, the underwriting bank pays the investor the value of the ETN, based on the underlying market index, minus fees. ETNs can be traded on an exchange, held until maturity, or large blocks may be redeemed directly with the issuer prior to maturity. During the trading day, it is possible for an ETN to trade at a premium or discount to its “indicative value.” The indicative value is the value of the ETN based on the underlying benchmark.
• There are many types of ETNs, including leveraged ETNs, sector, commodity and currency ETNs, and ETNs that track investment strategies, such as covered call writing. ETNs can provide investors with exposure to strategies or investments that would otherwise be costly or difficult for them to implement on their own. ETNs are generally considered complex investments only suitable for experienced investors.

Know This! Exchange-traded notes (ETNs) are subject to credit risk since they are backed by the credit of the issuing bank.

Question 79

ETFs vs. ETNs

Answer 79

A major difference between ETNs and ETFs is that ETFs carry market risk and ETNs carry both market risk and credit risk because they rely on the issuer’s ability to pay at maturity. Therefore, ETNs are adversely affected if the issuer’s credit rating is downgraded.

Question 80

Holding Company Depository Receipts (HOLDRs)

Answer 80

• Holding Company Depository Receipts (HOLDRs) are traded on the NYSE AMEX (American Stock Exchange).
• HOLDRs allow investors to trade one security comprised of a bucket of stocks in a specific market sector or industry.
• HOLDRs fluctuate in value based on the performance of those stocks.

Question 81

Equity-linked Securities (ELKS)

Answer 81

• An equity-linked security (ELKS) is a hybrid debt instrument linked to the equity markets.
• The performance of an equity-linked security is linked to a single stock, a group of stocks or a stock index.

-ELKS typically guarantee principal and offer small returns based on the underlying security or index.

• ELKS are structured as annuities, mutual funds or CDs.

Question 82

REITs - Basics

Answer 82

• REITs invest at least 75% of their investment portfolios in real estate or products related to real estate.
• The assets are selected by the portfolio manager, placed in a trust and monitored. The portfolio is static; there is no active trading. There is a finite number of shares. Also, REITs have a finite life. On a date designated in the prospectus, the REIT will liquidate the portfolio holdings and pay each investor a share.
• When distributing REIT shares in an initial public offering (IPO), it is important to note that in the second half of the tax year no more than 50% of the shares may be owned by 5 or fewer people in order to qualify as a REIT. REITs are traded in the secondary market at either a premium or discount to NAV. Unless stated otherwise, for the purpose of the exam, assume it is a publicly-traded REIT

Question 83

REITs - Tax status

Answer 83

• REITs enjoy tax-advantaged income without double taxation. Unlike corporations that pay tax on income before making distributions to investors who are then taxed on the distributions they receive, REITs pay tax only on the income they keep.
• IMPORTANT: However, in order to enjoy a pass-through of the taxation and for the trust to avoid paying taxes, the REIT must distribute at least 90% of its income in the form of dividends to the investors.

Question 84

REITs - Regulation

Answer 84

• Also, REITs are not investment companies and are not regulated by the Investment Company Act of 1940. The portfolio holdings are not securities; they are real estate, real estate mortgages, or a combination of the two. REITs sell shares to investors. Each share represents a proportionate ownership interest in all of the investments in the trust.

Question 85

REITs vs. DPPs

Answer 85

• REITs are not direct participation programs (DPPs).
• Unlike DPPs, REITs do not distribute losses to the investors; the REIT takes the losses at the trust level. Only the REIT’s income passes through to the investors.
• Pursuant to Subchapter M of the IRS Tax Code, the REIT must distribute at least 90% of its portfolio income to the investors to avoid taxation itself. If the REIT distributes at least 90%, only the investors are taxed.
• Both REITs and DPPs, however, have centralized bookkeeping and professional management.

Question 86

Publicly-traded REITs (a.k.a. Exchange-traded REITs)

Answer 86

Publicly-traded REITs, also called Exchange-Traded REITs or listed REITs, are registered with the SEC and are required to file reports with the SEC. They trade on the NYSE or over the counter (OTC) on Nasdaq and traded in the secondary market. This is typically a liquid investment that an investor can readily buy and sell.

Question 87

Nontraded REITs ( a.k.a. Nonlisted REITS)

Answer 87

Nontraded REITs, or nonlisted REITs, are also registered with the SEC, but they are not listed on an exchange and are not publicly traded. Therefore, they are characterized by greater risks than listed REITs, including lack of liquidity and high fees.

• cannot easily convert investment to cash, but instead must wait until the REIT is listed on an exchange or liquidates its assets.
• However, real estate is a long-term investment and investors may have to wait a number of years to see a return on their investment.
• Though nontraded REITs often have share redemption programs, they may have significant limitations and may be discontinued at the discretion of the REIT without prior notification. Such programs also may require that shares be redeemed at a discount.

Nontraded REITs typically have high upfront fees, which can be up to 15% of the offering price. Also, transactions costs, such as, property acquisition fees and asset management fees, add to the cost of owning a REIT.

Nontraded REITs often offer high distributions, or dividend yields, but they may not be generated by operations. These distributions are often declared prior to the acquisition of significant assets. In fact, nontraded REITs may use the proceeds from the offering and borrowings to pay distributions. This reduces the value of the shares and limits the cash that the REIT can use to purchase real estate assets.

With no public market to determine the value of the shares of a nontraded REIT, it is difficult for an investor to gauge current performance. Share valuation is based on periodic appraisals of the real estate properties.

Finally, nontraded REITs are typically externally managed. They do not have their own employees. Rather than being aligned with the interests of the shareholders, the external manager may, in fact, collect large transaction fees from the REIT and may work for other REITS in a similar fashion.

Question 88

Three types of REITs

Answer 88

1. Equity
2. Mortgage
3. Hybrid

Question 89

Equity REIT

Answer 89

Equity REITs invest in real estate, either for income or capital appreciation. A REIT that provides an income for investors invests in income-producing properties, such as apartments, shopping centers or office buildings. The property income generates dividends to the investors. These are often established properties that are already producing income, so the investor receives dividends immediately. Capital appreciation REITs invest in vacant land. The REIT then develops the property and sells it. Typically, these are commercial developments, such as office or retail space, or perhaps apartments. The objective is to profit through appreciation.

Question 90

Mortgage REITs

Answer 90

Mortgage REITs invest in real estate mortgages. These mortgages are typically held on commercial properties, and provide immediate income to investors.

Question 91

Hybrid REIT

Answer 91

A hybrid REIT is a combination of an equity and a mortgage REIT. Because it engages in both real property and in mortgages, the hybrid REIT is more diversified in its activities. A hybrid REIT can provide both income and potential capital appreciation.

Question 92

Hedge funds

Answer 92

Hedge funds are pooled investment vehicles that are typically structured as either limited partnerships or limited liability companies. Their investment objective is to preserve capital and provide positive or absolute returns under all market conditions. However, it should be understood that these are very risky investments and have no guarantee that they will provide any investment return at all. In fact, the investor could lose all, or part, of their original capital investment.

Hedge funds use aggressive and, sometimes, complex strategies that involve investing in derivatives (options and futures contracts), distressed or bankrupt companies, volatile international markets, tangible assets such as real estate, and private equities. They employ the following techniques:

• Leverage — borrowing money;
• Arbitrage — simultaneous buying and selling a security in different markets to take advantage of the difference in prices;
• Short selling — selling a security that is not owned;
• Hedging — buying a security to offset a potential loss; and
• Concentrating positions — investing in a single issuer or market index.

Question 93

Hedge fund strategies

Answer 93

• Equity market directional funds — take long and/or short positions in individual stocks or ETFs that partially offset each other, limiting overall equity exposure;
• Relative value (or arbitrage) funds — trade various spreads taking advantage of relative price differentials;
• Corporate restructuring funds — trade stocks and bonds issued by companies that are in distress, bankrupt or involved in a merger; and
• Macro trading funds — take directional positions in stock indices, currency exchange rates, interest rates and commodities.

While hedge funds offer greater investment flexibility relative to traditional investments, they are illiquid investments that employ risky investment strategies. There is often a lock-up provision that precludes investors from making withdrawals during a specified initial period. The available information about the funds is generally limited. If they are unregistered, they are not subject to the SEC’s registration and disclosure requirements.

Remember! Hedge funds are appropriate only for the experienced, sophisticated, wealthy investor.

Question 94

Hedge funds and the SEC

Answer 94

Hedge funds were offered initially as unregistered securities that were only available to a limited number of wealthy, financially sophisticated investors. Depending on the assets under management, some hedge fund advisers may not be required to register with the SEC. If the adviser of the hedge fund manages $150 million or more, they would be required to register but the fund itself would not be required to register with the SEC.

Traditional unregistered hedge funds are regulated by the Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC). As such, they can only accept investment capital from accredited investors or qualified purchasers, including:

• Public employee retirement plans;
• Corporate employee retirement plans;
• University endowments;
• Foundations and nonprofit organizations;
• Family offices; and
• High-net-worth individuals:
  - An individual whose net worth, or joint net worth with the person’s spouse or spousal equivalent, exceeds $1 million at the time of the purchase, excluding the value of their primary residence; or
  - Individuals with a yearly income of $200,000 or higher in each of the two most recent years or joint income with a spouse or spousal equivalent exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year.

Question 95

Hedge fund fees

Answer 95

Hedge funds typically charge an annual asset management fee of 1% to 2% of assets as well as a performance fee of 10% to 20% of a hedge fund’s profit. Fund managers only receive the performance fee if the fund makes money. These fees are typically higher than the fees charged by a mutual fund.

Question 96

Blind pools and blank checks

Answer 96

• A blind pool means that less than 75% of the investments are known in advance.
• A blank check company is one that has no specific business plan.

Question 97

Hedge funds are not subject to…

Answer 97

• Hedge funds are not required to provide the same level of disclosure as mutual funds and, therefore, do not provide many of the same investor protections. In addition, investors may not be aware of exactly how the fund is being managed. Unlike mutual funds, hedge funds are not subject to rules that govern:
• Liquidity in the fund;
• Limits on how much can be invested in one security;
• Redemption of fund shares;
• Conflicts of interest;
• Fairness in pricing of fund shares;
• Disclosure requirements related to holdings, fees and expenses, performance, and information about the fund’s management; and
• Leverage limits.

Question 98

Hedge funds taxes

Answer 98

Investors share in the partnership’s income, expenses, gains and losses. Partners are taxed on their respective share of the partnership.

Question 99

Hedge funds - Funds of funds

Answer 99

In addition to unregistered hedge funds, there are also funds of funds, which are registered with the SEC. Funds of funds (also called, funds of hedge funds) are pooled investments in unregistered, private hedge funds. They offer an investor the opportunity to invest in a number of funds through a single investment. This provides greater diversification among investment styles, strategies and hedge fund managers.

Funds of funds may register with the SEC under the Investment Company Act of 1940. Additionally, the fund of fund’s securities can be registered for sale to the public under the Securities Act of 1933.

Registered funds of hedge funds may have lower minimum investment requirements than traditional unregistered hedge funds and can be offered to an unlimited number of investors.

Funds of funds have several disadvantages. Shares may be redeemed directly with the fund only if and when offered. Shares are not usually listed on an exchange and there is no secondary market available to facilitate a sale of securities. In addition, registered funds of funds may have adverse tax consequences due to the complex nature of their tax structure. Lastly, tax reporting information may be delayed.

Question 100

Investment analysis tools

Answer 100

In recent years, technology and the Internet have made it possible for member firms to offer a multitude of interactive investment analysis tools to investors. FINRA considers these tools retail communications and regulates their use by members.

FINRA defines an investment analysis tool as an interactive technology that creates simulations that allow investors to see the possible outcomes of various investments, investment styles, and investment strategies, and provides an analysis of potential risks and rewards.

A member that offers an investment analysis tool to retail customers must make the tool and any templates for reports produced by the tool available to FINRA’s Advertising Regulation Department within 10 business days of its first use. In addition, any retail communications regarding the investment tool must also be submitted within 10 business days of their first use.

Question 101

Investment annals is tools - Required FINRA disclosures

Answer 101

According to FINRA rules, members are allowed to provide an investment analysis tool, reports generated by the tool, and retail communications related to the tool only if it contains the following disclosures written in a narrative form that are displayed in a clear and prominent manner:

• A description of the criteria and methodology including its limitations and underlying assumptions;
• A statement that results can vary with each use and over time;
• When applicable, a description of the universe of investments that the tool analyzes and how the tool selects an investment. In addition, if the tool favors certain types of investments, there must be an explanation as to why, and a statement that other investments outside the universe may have similar or superior investment characteristics; and
• A disclosure stating the following: “IMPORTANT: The projections or other information generated by (name of investment analysis tool) regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.”

Question 102

Mutual fund suitability exercise

Answer 102

As a registered representative you may make recommendations to a customer after gathering certain information about the customer’s needs, goals, and financial status. For example:

• What is your income?
• How stable is your income?
• Do you have employee stock options?
• What is your net worth, including home ownership, securities, assets and liabilities?
• How old are you?
• Are you married and do you have dependents? What are their ages?
• What plans do you have for the money you invest?
• What kinds of risks are you comfortable taking?
• How liquid must your investment be?
• How important are tax considerations?
• What is your time horizon?
• What is your investment experience?

After determining the customer’s financial status and investment objectives, the registered representative can begin to search for the most appropriate mutual fund.