Investment Companies Flashcards
Face-Amount Company / Face-Amount Certificates
An investor may enter into a contract with an issuer of a face-amount certificate to contract to receive a stated or fixed amount of money (the face amount) at a stated date in the future. In exchange for this future sum, the investor must deposit an agreed lump sum or make scheduled installment payments. Face-amount certificates are rarely issued today as most of the tax advantages that the investment once offered have been lost through changes in the tax laws.
Unit Investment Trust (UIT)
A unit investment trust will invest either in a fixed portfolio of securities or in a nonfixed portfolio of securities. A fixed UIT traditionally will invest in a large block of government bonds or municipal debt. The bonds will be held until maturity and the proceeds will be distributed to investors in the UIT. Once the proceeds have been distributed to the investors, the UIT will have achieved its objective and will cease to exist. A nonfixed UIT will purchase mutual fund shares in order to reach a stated objective. A nonfixed UIT is also known as a contractual plan. Both types of UITs are organized as a trust and operate as a holding company for the portfolio. UITs are not actively managed and they do not have a board of directors or investment advisors. Both types of UITs issue units or shares of beneficial interest to investors which represent as undivided interest in the underlying portfolio of securities. UITs must maintain a secondary market in the units or shares to offer some liquidity to investors.
Management Investment Companies (Mutual Funds)
A management investment company employs an investment advisor to manage a diversified portfolio of securities designed to obtain its stated investment objective. The management company may be organized as either an open-end company or a closed-end company. The main difference between an open-end company and a closed-end company is how the shares are purchased and sold. An open-end company offers new shares to any investor who wants to invest. This is known as a continuous primary offering. Because the offering of new shares is continuous, the capitalization of the open-end fund is unlimited. Stated another way, an open-end mutual fund may raise as much money as investors are willing to put in. An open-end fund must repurchase its own shares from investors who want to redeem them. There is no secondary market for open-end mutual fund shares. The shares must be purchased from the fund company and redeemed to the fund company. A closed-end fund offers common shares to investors through an initial public offering, just like a stock. Its capitalization is limited to the number of authorized shares that have been approved for sale. Shares of the closed-end fund will trade in the secondary market in investor-to-investor transaction on an exchange or in the OTC market, just like common shares.
75-5-10 Test
To be called a diversified mutual fund: 75% of the fund’s assets must be invested in securities of other issuers. Cash and cash equivalents are counted as part of the 75%. A cash equivalent may be a T-bill or a money market instrument. The investment company may not invest more than 5% of its assets in any one company. The investment company may not own more than 10% of any company’s outstanding voting stock.
Investment Company Registration
Investment companies are regulated by both the Securities Act of 1933 and by the Investment Company Act of 1940. An investment company must register with the SEC if the company operates to own, invest, reinvest, or trade in securities. A company also must register with the SEC as an investment company if the company has 40% or more of its assets invested in securities other than those issued by the U.S. government or one of the company’s subsidiaries.
Three Requirements to Register with the SEC
Minimum net worth of $100,000, at least 100 shareholders, clearly defined investment objectives.
Investment Company Components
Investment companies have several different groups that serve specialized functions. Each of these groups plays a key role in the investment company’s operation. They are: the board of directors, the investment advisor, custodian bank, transfer agent.
Bonding of Key Employees
The investment company is required to obtain a bond to cover itself and each officer, director, and employee with access to the investment company’s assets. The company may obtain a bond for each employee or may obtain a blanket bond for all employees that are required to be bonded. In the case of a blanket bond, the company must list the names of the employees to be covered. The bond only covers the employees for negligence. Any criminal acts or acts of bad faith are not covered.
Investment Adviser
The investment company’s board of directors hires the investment adviser to manage the fund’s portfolio. The investment adviser is a company, not a person, which must also determine the tax consequences of distributions to shareholders and ensure that the investment strategies are in line with the fund’s stated investment objectives. The investment adviser’s compensation is a percentage of the net assets of the fund, not a percentage of the profits, although performance bonuses are allowed. The investment adviser’s fee is typically the largest expense of the fund and the more aggressive the objective, the higher the fee. The investment adviser may not borrow from the fund and may not have any security-related convictions.
Custodian Bank
The custodian bank or the exchange member broker dealer that has been hired by the investment company physically holds all of the fund’s cash and securities. The custodian holds all of the fund’s assets for safekeeping and provides other bookkeeping and clerical functions for the investment company, such as maintaining books and records for accumulation plans for investors. All fund assets must be keep segregated from other assets. The custodian must ensure that only approved persons have access to the account and that all distributions are done in line with SEC guidelines.
Transfer Agent
The transfer agent for the investment company handles the issuance, cancelation, and redemption of fund shares. The transfer agent also handles name changes and may be part of the fund’s custodian or a separate company. The transfer agent receives an agreed fee for its services.
Mutual Fund Distribution
Most mutual funds do not sell their own shares directly to investors. The distribution of the shares is the responsibility of the underwriter. The underwriter for a mutual fund is also known as the sponsor or distributor. The underwriter is selected by the fund’s board of directors and receives a fee in the form of a sales charge for the shares it distributes. As the underwriter receives orders for the mutual fund shares, it purchases the shares directly from the fund at the net asset value (NAV). The sales charge then is added to the NAV as the underwriter’s compensation. This process of adding the sales charge to the NAV is responsible for the mutual fund pricing formula, which is NAV + SC = POP. The underwriter may purchase shares from the mutual fund only to fill customer orders. They may not hold mutual fund shares in inventory in anticipation of receiving future customer orders.
Selling Group Member
Most brokerage firms maintain selling agreements with mutual fund distributors, which allow them to purchase mutual fund shares at a discount from the public offering price (POP). Selling group members may then sell the mutual fund shares to investors at the POP and earn part of the sales charge. In order to purchase mutual fund shares at a discount from the POP, the selling group member must be a member of FINRA. All non-FINRA members and suspended members must be treated as members of the general public and pay the public offering price.
Distribution of No-Load Mutual Fund Shares
No-load mutual funds do not charge a sales charge to the investors who invest in the mutual fund. Because there is no sales charge, the mutual fund may sell the shares directly to investors at the NAV.
Characteristics of Open-End Mutual Funds
All open-end mutual fund shares are sold through a continuous primary offering and each new investor receives new shares from the fund company. The new shares are created for investors as their orders are received by the fund. Investors purchase shares from the fund company at the public offering price (POP) and redeem them to the fund company at the NAV. The mutual fund has seven calendar days to forward the proceeds to an investor after receiving a redemption request. If the investor has possession of the mutual fund certificates, the fund then has seven calendar days from the receipt of the certificate by the custodian to forward the proceeds. Suspension of the seven-day rule may be allowed only if: the NYSE is closed for an extraordinary reason, the NYSE’s trading is restricted or limited, the liquidation of the securities would not be practical, an SEC order has been issued.
Additional Characteristics of Open-End Mutual Funds
Diversification, professional management, low minimum investment, easy tax reporting, reduction of sales charges through breakpoint schedule, letter of intent, and rights of accumulation, automatic reinvestment of dividends and capital gains distributions, structured withdrawal plans.
Equity Funds
The only investment that will meet a growth objective is common stock. Growth funds seeking capital appreciation will invest in the common stock of corporations whose business is growing more rapidly than other companies and more rapidly than the economy as a whole. Growth funds seek capital gains and do not produce significant dividend income.
Equity income Fund
An equity income fund will purchase both common and preferred shares that have a long track record of paying consistent dividends. Preferred shares are purchased by the fund for their stated dividend. Utility stocks are purchased because utilities traditionally pay out the highest percentage of their earnings to shareholders in the form of dividends. Other common shares of blue-chip companies also may be purchased.
Sector Funds
Mutual funds that concentrate 25% or more of their assets in one business are or region are known as sector funds. Technology, biotech, and gold funds would all be examples of sector funds. A northeast growth fund would be an example of a sector fund that concentrates its assets geographically. Sector funds traditionally carry higher higher risk reward ratios. If the sector does well, the investor may enjoy a higher rate of return. If, however, the sector performs poorly, the investor may suffer larger losses. The high risk-reward ratio is due to the fund’s concentration in one area.
Index Funds
An index fund is designed to mirror the performance of a large market index such as the S&P 500 or the Dow Jones Industrial Average. An index fund’s portfolio is comprised of the stocks that are included in the index that the fund is designed to track. The fund manager does not actively seek out which stocks to buy or sell, making an index fund an example of a fund that is passively managed. If the stock is in the index, it will usually be in the portfolio. Portfolio turnover for an index fund is generally low, which helps keep the fund’s expenses down.
Growth and Income (Combination Fund)
A growth and income fund, as the name suggests, invests to achieve both capital appreciation and current income. The fund will invest a portion of its assets in shares of common stock that offer the greatest appreciation potential and will invest a portion of its assets in preferred and common shares that pay high dividends, in order to produce income for investors.
