Investment Companies & Mutual Funds

Question 1

Under the conduit theory, taxes payable on dividends and interest distributed by a regulated investment company are paid:

a. By the investment company only
b. By the shareholder only
c. By both the investment company and the shareholder
d. Only if distributions are made in cash

Answer 1

b. By the shareholder only

According to the conduit or pipeline theory of taxation, dividends and interest distributed by a regulated investment company flow through the fund and are paid only by the shareholders.

Question 2

Which of the following would NOT be contained in a letter of intent?

a. A clause stating that the maximum time limit for the letter of intent is 13 months
b. A clause stating that the letter of intent may be backdated 90 days to include a past purchase of shares
c. A clause stating that the fund may stop a redemption during the duration of the letter of intent
d. A clause stating that the fund may withhold some of the initially purchased shares in an escrow account to insure fulfillment of the letter of intent

Answer 2

c. A clause stating that the fund may stop a redemption during the duration of the letter of intent

A letter of intent has a duration of 13 months. The letter may be backdated 90 days to include previous purchases. Also, a certain amount of the initially purchased shares may be placed in an escrow account to insure that the letter of intent is fulfilled. If the terms of the letter are not met, these shares in the escrow account will be used to cover any additional sales charges that are due. The letter of intent will not contain a clause stopping a redemption during the 13-month period.

Question 3

An investor who is studying various funds’ holdings is interested in an income fund. The investor would most likely choose a fund holding:

a. Securities of companies that consistently earn above-average income
b. Securities of companies with liberal payout ratios
c. Securities of growth companies
d. Securities with A+ ratings

Answer 3

b. Securities of companies with liberal payout ratios

An investor primarily interested in income would most likely choose a fund holding securities of companies with liberal payout ratios. Companies that earn above-average income may not necessarily pay the income out as dividends. This is typical of a growth company, whose earnings are growing at a rapid rate but who retains the earnings to finance future growth.

Question 4

In order to qualify as diversified, an investment company must:

a. Have at least 75% of its assets invested in a prescribed way
b. Own investments in at least 10 different industries
c. Own stock in at least 25 different companies
d. Both (b) and (c)

Answer 4

a. Have at least 75% of its assets invested in a prescribed way

To call itself diversified under the Investment Company Act of 1940, an investment company must accept two specific restrictions on 75% of its portfolio. (1) It cannot own securities of any one company in an amount that would be greater than 5% of its total portfolio. (2) Within the restricted part of the portfolio, it may not own more than 10% of the voting stock of any one company. The remaining 25% of the portfolio can be invested in any manner.

Question 5

The custodian bank of a mutual fund:

a. Manages the fund
b. Acts as the distributor of the fund
c. Holds the fund’s cash and securities and performs essential clerical functions
d. Guarantees investors against any loss that may be incurred if the fund should decline in value

Answer 5

c. Holds the fund’s cash and securities and performs essential clerical functions

The custodian bank of a mutual fund only holds the fund’s cash and securities and performs essential clerical functions. It does not manage the fund, distribute the fund, or guarantee investors against any loss that may be incurred if the fund should decline in value.

Question 6

An investor’s objective is long-term growth that keeps pace with inflation without excessive volatility. Which of the following types of mutual funds would best meet this objective?

a. Industry sector fund
b. Aggressive growth fund
c. Conservative growth fund
d. Long-term government bond fund

Answer 6

c. Conservative growth fund

Mutual funds that invest in equities are more likely to keep pace with inflation than bond funds. Conservative growth funds invest in “blue chip” stocks, which are less volatile than the stocks owned by aggressive growth or sector funds.

Question 7

Which of the following does NOT issue redeemable securities?

a. Open-end investment company
b. Closed-end investment company
c. Face-amount certificate company
d. Unit investment trust

Answer 7

b. Closed-end investment company

All investment companies issue redeemable securities except closed-end investment companies. Once issued, shares of closed-end funds trade between market participants in the secondary market.

Question 8

At the end of the year, an investor receives a 1099-DIV from a mutual fund containing the following information:
Total Ordinary Dividends – $70 (of which $40 are qualified dividends)
Long-term capital gains – $225
How are these distributions reported for tax purposes on the investor’s return if the distributions were reinvested in additional shares of the fund?

a. $30 is reported as ordinary income; $265 is taxable at a maximum rate of 20%.
b. $70 is reported as ordinary income; $225 is taxable at a maximum rate of 20%.
c. $295 is taxable at a maximum rate of 20%.
d. None of the distributions are reported since taxes on them are deferred because they were reinvested.

Answer 8

a. $30 is reported as ordinary income; $265 is taxable at a maximum rate of 20%.

Mutual fund dividends are taxed based upon the type of distribution made to the shareholder. The mutual fund reports to the taxpayer the dividends paid during the year on Form 1099 DIV. This information must be included on the investor’s tax return. Qualified dividends and long-term capital gains are taxed at the same maximum rate of 20%. Nonqualified dividends are taxable as ordinary income.

Question 9

Listed below are the net asset value and offer prices of two investment companies:

	        Net 	        Offer 
	        Asset 	Price
	        Value
Fund A	$ 9.20	$10.00
Fund B	$12.50	$12.00

Based upon the information shown above, you can determine that:

a. Both funds are open-end
b. Both funds are closed-end
c. A is closed-end and B is open-end
d. B is definitely closed-end and A is probably open-end

Answer 9

d. B is definitely closed-end

When the net asset value is higher than the offering price, the fund definitely is closed-end. Closed-end funds have a price determined by supply and demand, and their prices may be more or less than the net asset value per share, while open-end funds are prohibited from ever selling their shares for less than the net asset value. Thus Fund B, which has an offering price less than its net asset value, must be a closed-end fund, while Fund A could be either.

Question 10

The right of accumulation includes the:

a. Right to add up the total of all past and present purchases when determining sales charges
b. Right to accumulate commissions until retirement
c. Amount of deferred income to which a retiring executive is entitled
d. Right to switch from one fund to another without incurring additional sales charges

Answer 10

a. Right to add up the total of all past and present purchases when determining sales charges

The right of accumulation is the right to add together the total of all past and present purchases when determining eligibility for breakpoints on sales charges.

Question 11

Which of the following are true of a redemption fee charged by a mutual fund?

I. It is used to defray distribution expenses.
II. It is returned to the fund’s portfolio.
III. It is usually 2% or less.
IV. No-load funds may not charge redemption fees.

a. I and III only
b. II and III only
c. II and IV only
d. I, II, III, and IV

Answer 11

b. II and III only

Redemption fees are charged by some mutual funds when investors sell shares back to the fund. The fees are added to the fund’s portfolio. They are not used to pay for distribution costs as 12b-1 fees are. Most redemption fees are 2% or less. Some no-load mutual funds charge redemption fees to discourage shareholders from frequently switching out of the fund. Excessive switching results in extra expenses for the fund, which is a burden on the remaining shareholders.

Question 12

If the NAV of an equity fund dropped while the general level of stock prices was rising, one might conclude that:

I. The portfolio was not participating in the overall market rally
II. The fund value was being diluted through greater share issuance
III. The fund had just paid a large dividend or capital gains distribution
IV. Fund expenses were rising

a. I and II only
b. I and III only
c. II, III, and IV only
d. I, II, III, and IV

Answer 12

b. I and III only

The NAV of a fund falls if the underlying securities depreciate or the fund makes a distribution of dividends or capital gains. The NAV does not drop when new shares are issued because cash, an asset, is received. Fund expenses do not vary enough over a short period of time to have a significant effect on the NAV.

Question 13

The management fee a mutual fund pays to its investment adviser is considered:

a. An operating cost of the fund
b. Part of the acquisition cost (sales charge) the purchaser must pay
c. A cost to the sponsor (distributor) of the fund
d. A nonrecurring expense of the sponsor

Answer 13

a. An operating cost of the fund

The management fee paid to a fund’s investment adviser is considered part of the operating costs of the fund.

Question 14

Al Jackson has $20,000 to invest and would like to hold a diversified portfolio of stock, bonds, and money-market instruments. He would like to adjust the percentage invested in each of these categories as the financial markets change. However, he does not believe he will have ample time to monitor the markets. Which of the following types of mutual funds would be MOST suitable for Mr. Jackson?

a. Asset allocation fund
b. Stock index fund
c. Bond index fund
d. Option income fund

Answer 14

a. Asset allocation fund

Asset allocation funds hold diversified portfolios of stocks, bonds, and money market instruments. The percentage of the portfolio invested in each of these categories is shifted by the fund manager from time to time, often according to computer models.

Question 15

Which of the following is/are TRUE about mutual funds?

I. The maximum sales charge according to the Investment Company Act of 1940 is 5%.
II. Investors can receive a reduced sales charge if they sign an 18-month letter of intent to purchase a certain dollar amount of mutual fund shares.
III. Under the rights of accumulation option, investors can receive a reduced sales charge on new purchases when a breakpoint is reached.
IV. No-load funds may charge a liquidation fee when an investor sells the fund.

a. I only
b. III only
c. III and IV only
d. I, II, and IV only

Answer 15

c. III and IV only

The only true statements regarding mutual funds are that, under the rights of accumulation option, mutual fund investors can receive a reduced sales charge on new purchases when a breakpoint is reached, and no-load funds may charge a liquidation fee when an investor sells the fund. The maximum sales charge, for contractual plans, under the Investment Company Act of 1940 is 9%. A letter of intent for a reduced sales charge covers 13 months, not 18 months

Question 16

Midcap Growth is a diversified common stock fund that is sold by many broker-dealers in the United States. Midcap’s distributor is the wholesaler of the fund. Its primary role is to:

a. Solicit investors to buy shares at the net asset value (NAV)
b. Buy shares at the NAV and market the shares to broker-dealers
c. Buy shares at the NAV and hold them for investment purposes
d. Consult with the board of directors regarding investment strategy

Answer 16

b. Buy shares at the NAV and market the shares to broker-dealers

The distributor of a fund has a contractual right to buy shares at the NAV and sell them to other broker-dealers pursuant to a written agreement. The distributor and retailing broker-dealer divide the total sales charge.

Question 17

Which of the following allocations would be the LEAST suitable for an investor with a thirty-year time horizon, moderate risk tolerance, and the goal of long-term growth?

a. 50% money-market funds, 50% long-term government bond funds
b. 50% large-cap stock index funds, 25% small-cap funds, 25% emerging markets funds
c. 75% large-cap stock funds, 25% international stock funds
d. 50% equity income funds, 30% small-cap funds, 10% global funds, 10% balanced funds

Answer 17

a. 50% money-market funds, 50% long-term government bond funds

An investor with a long time horizon and a goal of growth should have some part of her portfolio in equity securities. Choice (a) is unlikely to meet this investor’s goal.

Question 18

An aggressive growth portfolio would be suitable for an investor:

a. With low-risk tolerance
b. With a large amount of capital that must be kept fairly liquid
c. Whose only investment experience lies with fixed annuities
d. Who is financially secure, has a high income level, and has a high tolerance for risk

Answer 18

d. Who is financially secure, has a high income level, and has a high tolerance for risk

An aggressive growth portfolio is invested in growth companies that pay little income but have a great potential for capital appreciation. However, due to the emphasis on capital gains, aggressive growth funds carry a great deal of risk. Financially secure investors are most appropriate for these investments and are best able to absorb the risk of this type of portfolio.

Question 19

The Blue Fund has a net asset value of $9.00. The underwriter’s concession is 20 cents per share. The sales charge for the fund is 90 cents and the administrative fee is 40 cents. How much would an investor pay for a share of the Blue Fund?

a. $9.00
b. $9.20
c. $9.90
d. $10.30

Answer 19

c. $9.90

An investor pays the public offering price for mutual fund shares. The public offering price consists of the net asset value plus the sales charge. In this question, the net asset value is $9.00 and the sales charge is 90 cents. This makes the public offering price $9.90. Administrative fees are subtracted from the total assets in the portfolio.

Question 20

Which of the following would be considered the most volatile mutual fund?

a. A U.S. government securities fund
b. A balanced fund
c. A municipal bond fund
d. An emerging markets fund

Answer 20

d. An emerging markets fund

Emerging markets funds invest in securities issued by countries with unsure economic, political, and social climates. This leads to significant volatility in share prices.

Question 21

The net asset value per share of an open-end investment company is $22.20. The sales charge is 8%. What would be the asked price?

a. $20.42 
b. $22.20 
c. $23.98 
d. $24.13

Answer 21

d. $24.13

To find the asked price, divide the net asset value per share by the complement of the sales charge, as follows:

NAV / (100% - Sales Charge = Ask Price

$22.20 / 100% - 8% (0.92) = $24.13

Question 22

Which of the following are advantages of investing through an open-end investment company rather than investing individually?

a. Individuals generally pay higher commissions than mutual funds.
b. An investor can own an interest in a larger number of securities.
c. It is easier to have an interest in higher-priced shares.
d. All of the above

Answer 22

d. All of the above

All of these are advantages to investing in mutual funds (open-end investment companies). Institutional investors such as mutual funds can negotiate lower commission rates than individuals. The investor can also have an ownership interest in a far greater number of securities, and in securities with higher prices.

Question 23

An investor is seeking a high current return that is relatively secure. The most appropriate investment would be a(n):

a. Aggressive growth fund
b. High-yield corporate bond fund
c. U.S. government bond fund
d. Zero-coupon Treasury bond

Answer 23

c. U.S. government bond fund

The U.S. government bond fund would be relatively secure in that it is highly unlikely that the U.S. government would default on its obligations. The value of the securities would move in relation to interest-rate changes. The corporate bond fund would offer a higher yield but the individual fund holdings would carry a relatively high default risk. The zero-coupon Treasury would not provide current income, nor would an aggressive growth fund.

Question 24

A customer has purchased an investment in which up to 50% of the first year’s payments may be deducted as a sales charge. The customer has purchased:

a. An exempt unit investment trust
b. A back-end load mutual fund
c. A front-end load contractual plan
d. A spread load contractual plan

Answer 24

c. A front-end load contractual plan

A front-end load contractual plan may deduct up to 50% of the first year’s payments as a sales charge. Over the life of the plan, the sales charge may not exceed 9%.

Question 25

Which of the following is an advantage of a unit investment trust when compared to a mutual fund?

a. It usually has lower operating costs.
b. Its securities are redeemable.
c. The manager can adjust the portfolio when market conditions change.
d. It is not registered with the SEC.

Answer 25

a. It usually has lower operating costs.

Since unit investment trusts (UITs) are fixed portfolios with no manager, they have no management fee and, therefore, lower operating costs than most mutual funds. Both UITs and mutual funds issue redeemable securities and are registered with the SEC under the Securities Act of 1933 and the Investment Company Act of 1940.