Lesson 3.4: Other Pooled Investments

Question 1

Regarding exchange-traded funds (ETFs) :

Answer 1

A) ETFs may be passively managed.
B) ETFs can be bought on margin.
C) ETFs trade based on supply and demand for the shares rather than their NAV.

Exchange-traded funds (ETFs) can be sold short and can be bought on margin just like other listed securities. Because most ETFs are based on an underlying index, they are passively managed, and like other listed securities, their price is based on supply and demand rather than the NAV (although the price will generally be close).

Question 2

REITs (real estate investment trusts):

Answer 2

Even though REITs (real estate investment trusts) share many of the same characteristics of investment companies, they are NOT included in the definition as found in the Investment Company Act of 1940 of investment companies.

Question 3

Investments that is required by law to have at least 75% of its assets represented by real estate assets such as real property or loans secured by real property, cash, and U.S. government securities?

Answer 3

In order to qualify as a REITs, it must have a requirement that at least 75% of their assets include real property or loans secured by real property as well as cash and U.S. government securities. Specialized (or sector) funds are generally required to have at least 25% of their assets in the area of specialization. This should not be confused with the “names” rule (35d-1) of the Investment Company Act of 1940. The rule requires a registered investment company with a name suggesting that the company focuses on a particular type of investment (e.g., an investment company that calls itself the ABC Stock Fund, the XYZ Bond Fund, or the QRS U.S. Government Fund) to invest at least 80% of its assets in the type of investment suggested by its name. Please note: The names rule is not in your material—it is not tested on the exam. This question is an example of how the exam will sometimes include in the answer choices an incorrect reference to a topic you haven’t seen. You need to focus on the correct information.

Question 4

With regard to taxation of distributions from a REIT:

Answer 4

I. In the majority of cases, dividends are taxed as ordinary income.
II. Capital gains distributions are treated as long-term capital gains.

Although there are some rare exceptions, you should consider any dividend paid to an investor in a REIT subject to taxation at ordinary income rates. Just as with mutual funds, capital gains distributions are treated as long-term capital gain.

Question 5

An investor is looking for a pooled investment product that can provide rental income as well as potential capital gains. You would most likely recommend:

Answer 5

an equity REIT.

When you see “rental,” you immediately think of renting real estate. Of the two basic types of REITs, an equity REIT is the one that owns property. Rental income is received from the users of those properties. As an owner of real estate, there is always potential to sell the property for a gain. Think of the difference between an equity REIT and a mortgage REIT as the difference between a stock and a bond. A stock offers the possibility of income through dividends and a bond through interest. But, it is only the stock (equity) where there is a real potential for capital gain.

Question 6

A customer is interested in an exchange-traded fund (ETF). With regard to the trading of ETFs, the customer should be aware of what

Answer 6

I. ETFs can be purchased throughout the trading day.
II. Real-time quotes are available for ETFs.

ETFs can be traded throughout the trading day. Changing price quotes are available in real time as investors buy and sell. Although ETFs have a NAV that is calculated on the basis of the portfolio holdings, the trading price is determined by supply and demand in the open market, with customers paying commissions.

Question 7

A registered investment company whose portfolio consists of equity securities and does not change in response to market conditions is probably:

Answer 7

Unit investment trusts (UITs) are registered investment companies with a fixed portfolio. That is, at the time of organization, the portfolio is purchased and, because there is no ongoing management company, there are basically no changes made.

Question 8

A REIT is able to pass-through what?

Answer 8

Taxable income from operations

REITs are required to distribute a minimum of 90% of their taxable income from operations. Unlike the traditional flow-through vehicle, they do not pass through losses. When a gain is unrealized, there is nothing to distribute.

Question 9

If an investment company invests in a fixed portfolio of municipal or corporate bonds, it is classified as:

Answer 9

A unit investment trust issues shares that represent units of a particular portfolio; management has no authority, or only limited authority, to change the portfolio. The portfolio is fixed; it is not traded.

Question 10

In which type of real estate investment does an investor have a reasonable expectation of receiving periodic distributions in the form of dividends?

Answer 10

A REIT is an indirect form of ownership of real estate. For tax purposes, at least 90% of the REIT’s taxable income is distributed to investors in the form of a taxable dividend. Unlike DPPs, there is no flow-through of losses.

Question 11

What investment vehicle provides for redemption by the issuer?

Answer 11

Unit investment trust (UIT).

A UIT typically issues redeemable securities (or units), like a mutual fund, which means that the UIT will buy back an investor’s units, at the investor’s request, at their approximate net asset value. ETFs and CEFs are traded in the secondary markets, and investors sell their shares in the marketplace rather than redeeming them through the issuer. Face-amount certificates are not redeemable—the investor’s funds are returned when the debt is paid off.

Question 12

Features of exchange-traded funds (ETFs) are also features of mutual funds?

Answer 12

They compute their NAV daily.

Both ETFs and mutual funds compute their NAV on a daily basis. Because ETFs are traded on exchanges and the prices are based on supply and demand, the price of an ETF will generally vary somewhat from its NAV. Only ETFs can be purchased on margin and be sold short.

Question 13

Among the characteristics of exchange-traded funds (ETFs), what distinguishes them from mutual funds is that:

Answer 13

they are traded on listed exchanges.

One of the main distinctions between ETFs and mutual funds is in their name—exchange-traded. No mutual funds trade on exchanges. Both ETFs and mutual funds compute NAV daily, and there are index mutual funds that are managed to mimic an index in the same way most ETFs are. Both ETFs and mutual funds are registered with the SEC.

Question 14

If general interest rates increase, the interest income of a bond unit investment trust (UIT) will probably:

Answer 14

remain the same

Because the portfolio of a UIT is fixed, the income generated by that portfolio will not change. Remember, a UIT does not have a portfolio manager.

Question 15

Louis owns an investment that is an unmanaged portfolio in which the money manager initially selects the securities to be included in the portfolio and then holds those securities until they mature or the investment portfolio terminates. This statement best describes which type of investment?

Answer 15

Unit investment trust (UIT).

A unit investment trust (UIT) is a type of investment company whose units are sold in the secondary market and is generally unmanaged or passively managed. The trust manager initially selects the securities to be included in the portfolio and then holds those securities until they mature or the UIT terminates.

Question 16

The most common characteristics of a REIT?

Answer 16

I. It is traded on an exchange or over the counter.
II. It is professionally managed.

A REIT shares some features with a limited partnership, but it is a different type of business entity. REITs are traded on exchanges and OTC and are professionally managed. Both REITs and limited partnerships provide pass-through of gains to investors, but REITs do not provide pass-through of losses. Please note: NASAA has recognized that, over the past few years, there has been an enormous growth in non-traded REITs. Non-traded REITs don’t trade, so there is little or no liquidity. Unless something in the question refers to a non-traded REIT, assume that all REITs are publicly traded either on the stock exchanges or OTC.

Question 17

Which of the following are true of a REIT?

I. It can qualify for special tax treatment under Subchapter M of the Internal Revenue Code if it distributes at least 90% of its taxable income.

II. It may loan money for commercial construction projects.

III. It generates income by the spread between rental income, the combined mortgage interest, and operating expenses of the property.

IV. It is only suitable for an investor who has annual earnings of at $120,000, or who has a net worth in excess of $500,000, or who is able to benefit from the flow-through of losses.

Answer 17

I, II, & III

A real estate investment trust (REIT) is an investment that makes direct investments in real estate, generating its income from renting the property (e.g., apartments, shopping malls) to lessees. Alternatively, it can make mortgage loans and generate income from them. Depending on its distribution of income, it may qualify for the same type of special tax treatment as a regulated investment company. REITS are not flow-through vehicles like DPPs.

Question 18

Which of the following statements correctly describe similarities between exchange-traded funds and closed-end investment companies?

I. There are a limited number of outstanding shares.
II. They are traded on registered stock exchanges.
III. They trade at prices that are not dependent upon but are close to their net asset value.
IV. Investors pay commissions to purchase and liquidate their positions.

Answer 18

II & IV

Both exchange-traded funds (ETFs) and closed-end investment companies are traded on exchanges; therefore, investors pay a commission when purchasing and liquidating shares. Only closed-end investment companies have a limited number of shares. Closed-end funds may trade at significant premiums or discounts from their NAV, while ETFs rarely stray far from the NAV.

Question 19

To qualify as a REIT, a company must have the bulk of its assets and income connected to real estate investments and must distribute at least what percentage of its taxable income to shareholders annually in the form of dividends?

Answer 19

90%

Under SEC rules, to qualify as a REIT, a company must have the bulk of its assets and income connected to real estate investments and must distribute at least 90% of its taxable income to shareholders annually in the form of dividends. Don’t confuse this with the requirement to have at least 75% of its income from real estate or 75% of its assets invested in real estate–related assets.

Question 20

Reasons for investors to purchase an ETF:

Answer 20

I. they have lower taxable distributions than most mutual funds.
II. shares may be purchased and sold throughout the day.
III. they have lower annual expenses than those of mutual funds.

Equity ETFs are often organized as regulated open-end investment companies and rarely as limited partnerships (never on the exam). Therefore, they must distribute at least 90% of their net investment income and capital gains. However, the method by which those capital gains are realized by the ETF is different from that of a mutual fund and, in almost all cases, results in lower taxable capital gains distributions. Unlike limited partnerships, there is no flow-through of losses. Expenses are generally lower as well, and ETFs trade during the day just like any stock.

Question 21

Characteristic of a real estate investment trust (REIT)?

Answer 21

A) Pooling of capital to purchase properties or mortgage loans
B) Shares are traded on exchanges much like the stocks of other companies
C) Potential dividends from investment income or capital gains distributions

A real estate investment trust (REIT) is a company that pools its capital to purchase properties and/or mortgage loans. Investors buy REIT shares and, in turn, receive dividends from investment income or capital gains distributions. REIT shares are traded on exchanges much like the stocks of other companies. This provides relatively high marketability, especially compared with most other types of real estate investments.

Please note: We recognize that, over the past few years, there has been an enormous growth in non-traded REITs (exactly what that says—they don’t trade; there is limited or no liquidity). Unless something in the question refers to a non-traded REIT, assume that all REITs are publicly traded either on the stock exchanges or OTC.