Unit 3 | Pooled Investments

Question 1

The Investment Company Act of 1940 prohibits registered open-end investment companies from engaging in any of the following practices except
A. issuing common stock.
B. selling short or purchasing securities for the company’s portfolio on margin.
C. owning more than 3% of the outstanding voting securities of another investment company.
D. opening a joint account with another investment company.

Answer 1

A. The one thing that all open-end investment companies must do is issue common stock. That is the form of ownership. All of the other activities are prohibited.

Question 2

ABC is an FINRA member broker-dealer. Among other functions, it serves as the principal underwriter of the XYZ Mutual Fund. Which of the following transactions of ABC would be prohibited?
A. ABC tenders, from its investment account, 500 shares of the XYZ Mutual Fund for redemption.
B. ABC purchases, for its investment account, 500 shares of XYZ Mutual Fund.
C. ABC purchases some securities directly from XYZ’s portfolio.
D. All of these.

Answer 2

C. It would be a violation of the Investment Company Act of 1940 for any affiliated person, such as the principal underwriter, to purchase any security from an investment company other than shares of the fund itself. Investing in the fund’s shares would be permitted, not prohibited.

Question 3

Which of the following statements correctly expresses requirements under the Investment Company Act of 1940?
I. A registered open-end investment company using a bank as custodian must choose one that has FDIC coverage.
II. If an affiliated person of a registered investment company wishes to borrow money from the fund, there must be at least 300% asset coverage.
III. No investment advisory contract may be entered into that does not provide for termination with no more than 60 days’ notice in writing.
IV. No registered investment company may acquire more than 3% of the shares of another investment company.
A. I and II
B. I and IV
C. II and III
D. III and IV

Answer 3

D | The Investment Company Act of 1940 requires that all advisory contracts contain a provision that the contract may be terminated upon no more than 60 days notice in writing, choice III. The act prohibits any registered investment company from owning more than 3% of the shares of another investment company, choice IV, making choice D the correct answer. There are no circumstances under which an affiliated person can borrow from the fund, and it is not a requirement that the custodian bank have FDIC insurance.
LO 3.a

Question 4

As described in the Investment Company Act of 1940, the term management investment company would include
A. face-amount certificate companies, unit investment trusts, and open-end and closed-end investment companies.
B. unit investment trusts and open-end and closed-end investment companies.
C. open-end and closed-end investment companies.
D. growth funds and income funds.

Answer 4

C | The act describes three kinds of investment companies: FACCs, UITs, and management companies. Management companies are divided into two types: open end and closed end. The definition in the act does not list different objectives, such as growth and income.
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Question 5

An investor is always purchasing newly issued shares of common stock when investing in
A. a closed-end investment company.
B. an open-end investment company (mutual fund).
C. a unit investment trust (UIT).
D. a holding company.

Answer 5

B. A unique characteristic of mutual funds is that they are capitalized by a continuous offering of new shares. Whenever an investor adds to her portfolio, she is buying new shares of common stock issued by that fund. In a UIT, the investor is purchasing units, not shares.

Question 6

Daniella has a number of investment company products within her retirement portfolio. One of these investments trades on an exchange and may trade at a premium or discount to its net asset value. These features are most likely found in what type of investment?
A. Closed-end investment company
B. Unit investment trust
C. Open-end investment company
D. Face-amount certificate company

Answer 6

A. A closed-end investment company (closed-end fund, or CEF) is a type of investment company whose shares trade in the secondary market. It is critical to remember for the exam that the price of the shares of a closed-end company is based on supply and demand and, therefore, can sell at, above, or below the fund’s net asset value.

Question 7

When discussing investment companies, the term sales load most commonly refers to
A. the fund’s sales charge, expressed as a percentage of the NAV.
B. the fund’s sales charge, expressed as a percentage of the public offering price.
C. the commission earned by the broker-dealer making the sale.
D. the 12b-1 fee.

Answer 7

B. Class A shares of an open-end investment company (mutual fund) have a “front-end” sales charge, or sales load, which is computed as a percentage of the public offering price. That is, if the fund’s POP is $10 and the NAV is $9.50, the 50-cent sales charge is 5% of the $10 offering price. In general, the majority of the sales load is paid to the broker-dealer making the sale as compensation. The 12b-1 fee is never referred to as a sales load because it is not related to the sale of shares. However, you will see the phrase asset-based sales charge.

Question 8

Barbara wishes to invest in the KAPCO Growth Fund, an open-end investment company. She expects to hold the shares for at least 10 years. If she purchases KAPCO’s Class A shares, each of these would be a way for her to receive a reduction on the sales charge except
A. a single investment that reaches a breakpoint.
B. joining together with her sister to make a purchase at a breakpoint level.
C. signing a letter of intent.
D. benefiting from the right of accumulation.

Answer 8

B. Reaching a breakpoint is the way in which investors can receive a “break” on the sales load charged when purchasing Class A shares. Purchases may be combined with spouses and dependent children, but not other family members, such as siblings, making the exception here. The three ways to reach a breakpoint are:
• a lump-sum purchase;
• using a letter of intent granting 13 months to reach the breakpoint; or
• taking advantage of rights of accumulation (no time limit).

Question 9

Which of the following types of investment company is permitted to capitalize with common stock and preferred stock?
A. A balance fund
B. A unit investment trust
C. An open-end investment company
D. A closed-end investment company

Answer 9

D | One of the unique characteristics of closed-end companies (CEFs) is that they can issue common stock, preferred stock, and debt securities. Note that this question is not asking about the portfolio contents; it is asking about the kinds of securities the company can issue to raise capital.
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Question 10

The GEMCO Growth Fund, an open-end investment company, calculates its net asset value per share to be $9.15. Orders that were received prior to the cut-off time are executed at a public offering price of $10 per share. From this information, you know that the sales charge is
А. 8.5%.
В. 9.3%.
C. in excess of the permitted maximum.
D. based on the net asset value per share.

Answer 10

2. А
   The sales charge of a mutual fund is based on the public offering price (POP), not the NAV.
   In this case it is the $0.85 difference between the POP and the NAV ($10 - $9.15) divided by the POP of $10. That means the sales charge is 8.5%, the maximum allowable.
   LO 3.0

Question 11

One of your friends is an entrepreneur who is looking for a way to raise capital for her fledgling business. Because the enterprise has no operating history, it is most likely that her best bet would be to approach
A. a hedge fund.
B. a mutual fund.
C. a private equity fund.
D. a venture capital fund.

Answer 11

D. When a business is in the pre-operating stage, it is of most interest to venture capitalists. Private equity funds, including hedge funds, invariably invest in going concerns, and mutual funds are almost always limited to purchasing securities that are marketable.

Question 12

Which type of investment company is most often organized as a limited partnership?
A. Face-amount certificate company
B. Exchange-traded fund
C. Hedge fund
D. Unit investment trust

Answer 12

C. For various legal reasons, mostly related to the need to avoid registration with the SEC, hedge funds are generally structured as limited partnership entities, with the organizers invariably sinking their own funds into a few units.

Question 13

You may be required to know what hedge funds and mutual funds have in common.
Which of the following would you choose?
A. A high degree of transparency
B. Relatively low management costs
C. A pooled investment with other investors
D. High liquidity

Answer 13

C. From what we’ve covered, you should have seen that hedge funds do not offer the transparency of mutual funds. The key to getting that point is that they are not registered with the SEC, so the disclosures it must make are limited.
The management fees for hedge funds are much higher than mutual funds, and due to the lock-up period, their liquidity is questionable. However, the common characteristic is that they are pooled investments.

Question 14

Which of the following would be most likely to invest in a company based on an idea rather than actual operating results?
A. An aggressive mutual fund
B. A hedge fund
C. A private equity fund
D. A venture capital fund

Answer 14

D | It is the venture capital fund that tends to invest in start-ups before operations have begun. That is what venture funding is all about. Private equity tends to come later when it can offer additional funding and management expertise. With rare exceptions, mutual funds do not invest in companies that are not publicly traded. A hedge fund might take a chance on a company like this, but it would be out of the ordinary.
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Question 15

The most common structure of a hedge fund is
A. a closed-end investment management company.
B. a corporation.
C. an open-end investment management company.
D. a partnership.

Answer 15

D | Hedge funds are a popular investment vehicle for those looking to diversify their portfolio or generate high returns. One of the primary reasons why hedge funds are structured as partnerships is due to the legal considerations involved. The partnership structure provides a level of flexibility that is not available with other investment vehicles, allowing for a range of investment strategies to be implemented. Additionally, profits can be distributed in a way that is beneficial to both the fund managers and investors.

Furthermore, partnerships offer limited liability protection to the fund managers, which can be crucial in mitigating potential risks. This means that in the event of any legal claims or losses, the personal assets of the managers are not at risk. This protection provides a significant advantage over other types of investment vehicles, such as corporations.

Another significant benefit of hedge funds being structured as partnerships is that they are not subject to identical regulatory requirements as other types of investment vehicles. This can be a significant advantage in terms of avoiding regulatory compliance costs and restrictions. The partnership structure allows for more flexibility in terms of regulatory compliance, which can be particularly beneficial for newer or smaller funds.

Overall, the partnership structure is the most common choice for hedge funds due to its numerous benefits and ability to meet the specific needs of the investment managers and investors involved. Whether it’s flexibility, limited liability protection, or regulatory advantages, the partnership structure provides a range of benefits that make it an ideal choice for those looking to invest in hedge funds.
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Question 16

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?
A. Closed-end investment company
B. Face-amount certificate company
C. Open-end investment company
D. Unit investment trust

Answer 16

A Unit Investment Trust (UIT) can be described as a type of investment company that operates passively. The UIT investment approach involves selecting a group of securities for inclusion in its portfolio by a professional money manager. The securities can include a variety of assets, such as stocks, bonds, and other types of securities. After the securities have been chosen, the UIT unit is created, and the manager holds them until they mature or the UIT terminates. During this time, the UIT investors own a proportional share of the underlying securities in the portfolio.

UITs are generally a fixed portfolio and are not actively managed. In other words, the investment strategy is predetermined, and it remains unchanged over time. Therefore, UIT investors can easily predict the performance of their investment and have a clear understanding of the securities that they own. This predictable nature of UITs makes them an attractive investment option for many investors who prefer a more passive investment approach. Additionally, UITs provide diversification benefits to investors as they can invest in various securities across different asset classes.

Question 17

Louis owns an unmanaged portfolio investment 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?
A. Closed-end investment company
B. Face-amount certificate company
C. Open-end investment company
D. Unit investment trust

Answer 17

D. A Unit Investment Trust (UIT) is an investment company that provides investors with a low-risk option for long-term investment. UITs are generally unmanaged and operate by the selection of securities by a money manager. The money manager initially selects the securities to be included in the portfolio and then holds them until they mature or the UIT terminates. UITs are primarily fixed-income securities that aim to offer a stable source of income to investors. Additionally, UITs offer diversification benefits by holding a wide range of securities in a single portfolio, which helps to reduce overall risk exposure. However, it is essential to note that UITs are not actively managed, so the portfolio’s performance is dependent solely on the performance of the underlying securities. Therefore, investors should consider their investment objectives, risk tolerance, and financial situation before investing in a UIT.

Question 18

Which of the following is not touted as an advantage to purchasing ETFs instead of index mutual funds?
A. Intra-day trading
B. Typically, lower expense ratios
C. Better general performance than the underlying index
D. Can be purchased on margin

Answer 18

C. It is essential to remember that index funds and exchange-traded funds (ETFs) offer a cost-effective way for investors to track the performance of a market index. However, neither of these investment options can claim to surpass the benchmark index’s performance. This situation is because the index itself does not incur any management fees, whereas even the most affordable index funds and ETFs still come with some level of expense ratio. Therefore, it can be quite a challenge for investors to outperform the benchmark index with either of these investments consistently.

Despite this, ETFs have some advantages over index funds. Firstly, they can be traded throughout the day on an exchange, while index funds are typically priced only at the end of the trading day. This opportunity can benefit investors who want to time their trades or take advantage of intraday price movements. Additionally, ETFs are the only option for investors who wish to use leverage through margin trading, as index mutual funds do not support this feature.

In conclusion, both index funds and ETFs offer investors a cost-effective way to access the returns of a particular market index. However, it is crucial to consider the differences between these two investment options and determine which features are most important for your investment strategy.

Question 19

Which of the following statements regarding a unit investment trust is not true?
A. Overall responsibility for the fund rests with the board of directors.
B. It invests according to stated objectives.
C. It charges no management fee.
D. It is considered an investment company.

Answer 19

A | A Unit Investment Trust (UIT) is a type of investment company that pools funds from investors to purchase a fixed portfolio of securities, which may include bonds, stocks, or a combination of both. Unlike mutual funds, UITs have no board of directors; instead, they are governed by a board of trustees that oversees their operations.

UITs are required to adhere to a specific investment objective, which is typically outlined in the trust’s prospectus. This objective must be followed throughout the life of the trust, and any changes to the investment strategy require a vote from the trust’s unit holders.

One of the key benefits of investing in a UIT is that it does not charge a management fee since the securities in the portfolio are fixed and do not require active management. As a result, UITs can be a cost-effective way to gain exposure to a diverse range of securities.
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Question 20

An investor wants to invest $200,000 in the banking industry sector. The investor would like to utilize leverage and do this purchase in a margin account. Additionally, she stresses wanting to avoid year-end tax statements showing capital gains liabilities.
You would suggest which of the following as suitable given the investor’s criteria?
A. A bank sector exchange-traded fund (ETF)
B. A money market fund holding short-term bank notes
C. Stocks in the three largest U.S. banks
D. A bank sector mutual fund

Answer 20

A | The investor’s criteria suggest that mutual funds may not be an ideal investment option. This is the case because mutual funds tend to distribute annual capital gains, which can lead to a tax liability for the owner. Besides, mutual funds cannot be purchased on margin, limiting investors’ ability to leverage their investments for higher returns.

However, the investor can consider investing in ETFs, a more suitable option. ETFs do not make capital gains distributions frequently, and they can be purchased on margin, allowing the investor to increase their investment potential. Since ETFs are traded like any other exchange-traded product, they offer greater flexibility and liquidity than mutual funds.

It is worth noting that investing only in a few bank stocks would not provide a diversified representation of the entire financial sector. Therefore, the investor should consider other options, such as ETFs that offer exposure to the broader financial sector.
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Question 21

One of the characteristics of real estate investment trusts (REITs) Is that they generally
A. have a high degree of marketability,
B. reinvest most of their income.
C. offer new shares continually to investors.
D. pay federal income tax on their earnings.

Answer 21

A | Real estate investments are typically considered illiquid, meaning they can’t be easily converted to cash. This lack of liquidity can present a challenge for investors looking to sell their property quickly or in a short amount of time. Unlike stocks and bonds, which can be easily traded on an exchange, real estate transactions typically require a more involved and time-consuming process that may involve working with real estate agents, lawyers, and other professionals. Additionally, real estate investments tend to be more capital-intensive than different types of investments, which means that investors may need to commit a significant amount of their money upfront to acquire a property. These factors can make it difficult to sell real estate investments quickly, and investors should be prepared to hold onto their properties for an extended period to realize a return on their investment in converting a property to cash if cash is needed quickly. However, a REIT securitizes real estate properties, allowing REIT investors to sell REIT shares in the open market quickly. For the exam, all REITs are publicly traded unless something in the question indicates otherwise. REITs must flow through at least 90% of their income to investors. Therefore, the investors and not the REITs pay tax on these distributions.
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Question 22

Julia, an analyst for a large investment advisory firm, is analyzing various policies utilized by hedge funds recommended by her firm. Julia has summarized the policies as follows:
Policy 1: During the fundraising period, each new investor must contribute a minimum of $500,000 to the fund.
Policy 2: The hedge fund manager will return incentive fees to investors in the event that the minimum required return is not met.
Policy 3: Investors must provide redemption requests to the hedge fund manager at least 60 days before the funds are to be withdrawn.
Policy 4: New investors may not withdraw funds during the first 6 months that the funds are invested with the hedge fund manager.
Which of the policies identified by Julia specifies a lock-up period?
A. Policy 1
B. Policy 2
C. Policy 3
D. Policy 4

Answer 22

D. In the world of hedge funds, a lock-up period is a common practice that involves an agreement between the investor and the fund manager regarding the duration for which the investor’s funds must remain invested in the fund. This period is typically set to a fixed time frame, such as six months, and is designed to ensure stability and continuity for the fund’s portfolio. During the lock-up period, the investor cannot withdraw their funds from the hedge fund, regardless of any changes in market conditions or the fund’s performance. This scenario means that the investor must commit their capital to the fund for the entire lock-up period, which can vary depending on the specific terms of the agreement. It is crucial for investors to carefully consider the lock-up period before investing in a hedge fund, as it impacts significantly on their liquidity and ability to manage their investments effectively.

Question 23

One of your clients wishes to invest in a hedge fund. You should explain which of the following points?
A. Shares of these funds are easy to redeem.
B. The fund can be expected to generate a profit whether the markets trend up or trend down.
C. These funds purchase a large amount of preferred stock.
D. Expenses for these funds tend to be higher than those for traditional mutual funds.

Answer 23

D. Hedge funds are investment funds that use aggressive strategies to generate returns, regardless of the market direction. These strategies often involve high-risk investments, such as short selling, leverage, and derivatives, which can produce significant profits but also come with higher levels of risk. However, there is no guarantee that these objectives will be realized, and investors may lose money if the market turns against them.

Furthermore, hedge funds can be challenging to redeem, as they often have long lock-up periods and limited liquidity. This aspect means that investors may not be able to access their funds when they need them most. Additionally, hedge funds generally charge higher management fees than traditional mutual funds, leading to higher investor expenses.

Overall, while hedge funds can offer the potential for higher returns, they come with significant risks and limitations that investors should carefully consider before investing.

Question 24

For a REIT to avoid being taxed like a corporation, it must distribute at least
A. 75% of its taxable income.
B. 90% of its taxable income.
C. 95% of its taxable income.
D. 100% of its taxable income.

Answer 24

B. To meet the requirements set by the Internal Revenue Service (IRS), Real Estate Investment Trusts (REITs) must distribute a minimum of 90% of their taxable income as dividends to their shareholders. Additionally, at least 75% of a REIT’s total income must be generated from real estate investments, such as rental income from properties, sales, or mortgage interest. This regulation ensures that REITs are transparent in their financial operations and that investors receive a significant portion of the trust’s profits.

Question 25

When discussing the advantages of mutual funds, it is permissible to point out that they offer
A. better performance than investing in individual securities.
B. tax advantages not available to the individual investor.
C. diversification and professional management.
D. lower expenses than “do-it-yourself” investing.

Answer 25

C | Mutual funds are an attractive investment option for many individuals due to their two primary advantages - diversification and professional management. By pooling money from multiple investors, mutual funds invest in a diversified portfolio of securities that reduces the risk of losses. Additionally, professional management ensures that the portfolio is managed by experienced financial experts who deeply understand the market trends and developments.

However, some investors prefer individual stocks as they believe they can pick winning stocks that outperform mutual funds. The performance of individual stocks is more volatile compared to mutual funds, which can lead to higher returns but also higher risks. Therefore, there is no clear yes or no answer to whether individual investments or mutual funds are better.

One argument favoring individual investments is that investors can choose when and what to sell, allowing them to optimize their tax liabilities. On the other hand, mutual funds typically pay lower trading costs due to economies of scale. Still, the management fee and other expenses can make investing in mutual funds more expensive than selecting individual securities. Therefore, investors should consider their investment objectives, risk tolerance, and overall financial goals before deciding between mutual funds and individual investments.
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Question 26

A REIT can avoid being taxed as a corporation by
A. receiving 75% or more of its income from real estate and distributing 90% or more of its net investment income to its investors.
B. receiving 100% of its income from real estate and distributing 90% or more of its net investment income to its investors.
C. receiving less than 75% of its income from real estate and distributing 100% of its net investment income to its investors.
D. receiving less than 50% of its income from real estate and distributing 50% or more of its net investment income to its investors.

Answer 26

A | As per the specifications laid out by the Internal Revenue Code, a real estate investment trust (REIT) can steer clear of being taxed as a corporation if it meets the following criteria - it must generate at least 75% of its revenue from real estate activities, such as rental income from real property or interest on mortgages that finance tangible property assets. Additionally, the REIT must distribute 90% or more of its net investment income to shareholders as dividends. These requirements ensure that the REIT primarily engages in real estate investment and management activities and that the profits generated from these activities are passed on to its investors.
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Question 27

Identify two trading strategies a hedge fund can employ in its portfolio but a mutual fund cannot.
I. Limiting investments to a narrow group of securities within one industry Il. Trading on margin to purchase portfolio securities
Ill. Purchasing speculative or low-rated securities
IV. Short selling of stock
A. I and III
B. I and IV
C. Il and III
D. Il and IV

Answer 27

D | Mutual funds are generally not allowed to purchase securities on margin, which means borrowing money from a broker to buy additional shares. Additionally, mutual funds are not permitted to sell securities short - the practice of selling borrowed shares in hopes the price will drop so they can be repurchased at a lower price and returned to the lender, pocketing the difference. On the other hand, hedge funds often use these strategies to generate profits and manage risk. However, in rare cases, mutual funds may be granted permission to use these techniques under certain circumstances.
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