Unit 3 - Pooled Investments (Study Guide) Flashcards
1
Q
There are three borad types of investment companies. What are they?
A
The Investment Company Act of 1940 classied the three types: Face-Amount Certificate Companies (FACC); Management Investment Companies, & Unit Investment Trusts (UITs)
2
Q
What is a management investment company?
A
A management investment company, which actively manages a securities portfolio to achieve a stated investment objective.
3
Q
what are the two types of Management Investiment Companies?
A
They cosed-end or open-end
4
Q
Are Mutual Funds closed-end or open-end nvestment companies?
A
They are Open-End Investment companies
5
Q
What is NAV and how is it determined?
A
NAV is Net Asset Value per share. It is determined by subtracting liabilities and dividing that by the number of shares outstanding.
6
Q
Does the definition of investment company include holding companies?
A
No
7
Q
What is the composition of Management Investiment companies board of directors?
A
No more than 60% who meet the definition of interested persons. Or, at least 40% of the board must be non-interested or outside directors. That is to say, are just normal investors.
8
Q
Open-Ended Investiment companies are prohibited from engaging in several activities. Mutual Funds may not do what?
A
Purchase any security on margin
Participate on a joint basis in any trading account in securities (i.e., an investment -company cannot have a joint account with someone else)
Sell any security short; or
Acquire more than 3% of the outstanding voting securities of another investment company.
9
Q
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.
A
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.
10
Q
In order for an investment company’s board to make fundamental investment policy changes, a majority vote of the outstanding voting stock is required. Examples of fundamental changes would include:
A
A change in subclassification, such as from an open-end to a closed-end company or from a diversified to a nondiversified company;
Deviation from any fundamental policy in its registration statement, including a change in investment objective; and
Changing the nature of its business so as to cease to be an investment company.
11
Q
What must an investment company be worth prior to the public offering of securities?
A
No registered investment company is permitted to make a public offering of securities unless it has a net worth of at least $100,000.
12
Q
A majority vote of the shareholders is required to approve the contract between the investment company and its investment adviser and the contract with its principal underwriter. These contracts must be in writing and provide what in that the contract?
A
Precisely describes all compensation to be paid;
Will be approved at least annually by the board of directors or by majority vote of the shareholders if it is to be renewed after the first two years; and
May be terminated at any time, without penalty, by the board of directors or by majority vote of the shareholders on not more than 60 days’ written notice to the investment adviser.
13
Q
Individuals who are affiliated with the investment company or its underwriter have certain restrictions when it comes to dealing with the fund. These individuals cannot do what?
A
Sell any personally owned security to the fund except redeeming personally owned shares of the fund (like any other investor);
Borrow money from the fund; or
Purchase from that investment company any security other than the fund’s shares.
14
Q
What is the definition of an affiliated person?
A
An affiliated person is defined as any person directly or indirectly owning, controlling, or holding, with power to vote, 5% or more of the outstanding shares of the investment company.
An affiliated person also includes any person directly or indirectly controlling, controlled by, or under common control with the investment company or any officer, director, partner, or employee of the investment company.
However, while technically considered an affiliated person, no person is deemed to be an “interested person” for purposes of the maximum percentage of interested persons on the board solely by reason of being a member of the fund’s board of directors or
an owner of its securities. A person is deemed to be a control person when owning or controlling more than 25% of the outstanding shares.
15
Q
What is a control person?
A
A person is deemed to be a control person when owning or controlling more than 25% of the outstanding shares.
16
Q
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.
A
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.
17
Q
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
A
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.
18
Q
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
A
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.
19
Q
What type of stock is open-ended, or Mutual Funds, allowed to issue?
A
Common Stock
20
Q
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.
A
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.
21
Q
What must be given to a prospective investor before or during an soliciation for sale?
A
Because mutual funds are a continuous new offering, the prospectus must be distributed to a prospective investor before or during any solicitation for sale
22
Q
How does a Closed-end investment company raise capital and subsequently trade?
A
It does so by offering common stock. It registers a fixed number of shares with the SEC and offers them for a limited time. They can also issue bonds or preferred stock.
23
Q
Closed-end investment companies are known as?
A
Publicy Traded Funds
24
Q
Closed-end investment companies trade based on what for their shares?
A
Supply and Demand whose market price is independent of the fund’s NAV.
25
What are country funds?
Country funds are funds that concentrate their investments in the securities of companies domiciled in foreign countries. Well-known examples are the Korea Fund, the New Germany Fund, and the Mexico Fund.
26
What is Public Offering Price (POP)?
any person who wants to invest in the company buys shares directly from the company or its underwriters (or a broker-dealer with a selling agreement) at the public offering price (POP).
27
What is the value of POP?
NAV plus any applicable sales charges.
28
How are Net Assets calculated?
Calculated daily by subtracting assts from liabilities.
29
How is NAV per share calculated?
Dividing the funds assets by the number of outstanding shares.
30
What are redeemable securities?
When an investor sells shares, the company redeems that at their NAV.
31
What is the difference between open-end and closed-end as it relates to capitalization?
Open-end is Unlimited, continuous offering of stocks; Closed-end offers fixed, single offering of shares'
32
What is the difference between open-end and closed-end as it relates to Issues?
Open-end issues common stock only, no debt securities; Closed-End issues common stock, preferred stock, & debt securities
33
What is the difference between open-end and closed-end as it relates to shares?
Open-End offers full or fractional shares whereas Closed-end officers only full shares.
34
What is the difference between open-end and closed-end as it relates to offering and trading?
Open-end seld and redeemed by fund only, continuous primary offering, must redeem shares, and NAV + Sales charge. Closed-end initial primary offering, secondary trading via exchange or OTC, does not redeem shares, at current market value plus commission
35
What is the difference between open-end and closed-end as it relates to pricing?
Open-End selling price determined by formula in the prospectctus and the price can never fall be the NAV; Closed-end price is determined by supply and demand so it can be above, below, or the same as NAV.
36
When is the NAV computed for both types of investment companies?
Open-end companies commpute it daily whereas Closed-end compute it once per week is determined by supply and demand.
37
What is Forward Pricing?
Price is detemined on went the order is requested. If before 4 PM than the price will be what the NAV is calculated that day. If an order is received after 4 PM, the price will be the computed NAV of the next day.
38
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
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.
39
All mutual funds, load and no-load, have expense ratios. The expense ratio is calculated how?
The expense ratio is calculated by dividing annual operating expenses by the average dollar value of
the fund’s assets under management. The sales charge is not considered an expense when calculating a fund’s expense ratio.
40
Mutual funds distributors use three different methods to collect the fees for the sale of shares. What are they?
Front-end loads (difference between POP and net NAV)
Back-end loads (contingent deferred sales loads)
12b-1 fees (asset-based fees—technically not a sales charge, but may be referred to as an asset-based sales charge on the exam)
41
What are Class A shares?
Front-End Loads. Front-end sales loads are reflected in a fund’s public offering price. The charges are added to the NAV at the time an investor buys shares. They are frequently referred to as Class A shares and have lower operating expense ratios than other classes.
42
What is another name for Back-end sales loads?
Contingent Deferred Sales Charge or load (CDSC), is charged at the time an investor redeems mutual fund shares. The sales load, a declining percentage charge that is reduced annually (for instance, 8% the first year, 7% the second, 6% the third, and so forth), is applied to the proceeds of any shares sold in that year. The back-end load is usually structured so that it drops to zero after six to eight years, at which time the shares are converted to Class A with their lower operating expense ratios. They are frequently referred to as Class B shares.
43
What are Class B shares?
Back-End sales load, aka a contingent deferred sales charge or load (CDSC).
44
What are 12b-1 Asset-Based Fees?
Mutual funds cannot act as distributors for their own fund shares except under Section 12b-1 of the Investment Company Act of 1940. This provision permits a mutual fund to collect a fee for promotion or sales-related activities in connection with the distribution of its shares. The fee is determined as a percentage of the fund’s average net assets during the year.
45
Is there a limit to 12b-1 Asset-Based Fees
typically they are 0.5% of net assets but cannot exceed 0.75% of net assets.
46
At what fee level is a fund restricted from using the term No-Load (no front-end or back-end load)?
If the fee exceeds 0.25%, the fund cannot use the term no-load (no front-end or back-end load).
47
What is required to charge a 12b-1 fee?
The plan has been approved initially by a vote of at least a majority of the outstanding voting securities of the investment company.
The plan, together with any related agreements, has been approved initially and reapproved at least annually by a vote of the board of directors of the company, and of the directors who are not interested persons of the company (the outside directors).
The plan may be terminated at any time by a vote of the majority of the members of the board of directors of the company who are not interested persons of the company, or by a vote of the majority of the shareholders of the company.
48
What are 12b-1 bees used for?
The 12b-1 fee is used for marketing and distribution purposes only. None of that money is used to pay the for the fund’s portfolio management.
49
What are the classes of funds shares?
There are three classes: Class A, Class B, Class C, Class I, & Class R
50
What differentiates the classes of fund shares?
Class A shares (front-end load): investors pay the charge at the time of purchase.
Class B shares (back-end load): declines over time so investors pay the charge at redemption.
Class C shares (level load): no sales charge to purchase; generally a 1% CDSC for one year, with a continuous 12b-1 charge.
Class I shares, which would be sold only to institutional investors (hence the letter I), and usually have lower fees and expenses.
Class R shares, which would be sold only to participants in retirement plans, such as a 401(k), and have no front-end or back-end load, but may have a 12b-1 fee that is lower than Class B and Class C shares, but higher than Class A shares.
51
What are two ways that an investor can take advantage of reduced sales charges available on Class A shares for larger purchases?
Breakpoints—a scale of declining sales charges based on the amount invested
Rights of accumulation—permits an investor to aggregate shares owned in related accounts in some or all funds in the fund family to reach a breakpoint discount with no time limit.
52
What is a breakpoint?
The schedule of discounts a mutual fund offers is called the fund’s breakpoints. Breakpoints are available to any person. For a breakpoint qualification, the term any person includes married couples, parents and their minor children, and corporations. Investment clubs or associations formed for the purpose of investing do not qualify for breakpoints
53
What is breakpoint sales?
Selling investment company shares in a dollar amount just below the point at which the sales charge is reduced. This is known as a breakpoint sale, and this practice is considered contrary to just and equitable principles of trade.
54
What is a Letter of Intent (LOI)?
A person who plans to invest more money with the same mutual fund company may decrease overall sales charges by signing a letter of intent (LOI). The LIO states the breakpoint will be reachd within 13 months.
55
What is Rights of Accumulation?
Rights of accumulation allow an investor to combine previous investments in the fund with today’s investment to determine today’s sales charge.
56
What is Rights of Accumulation?
Rights of accumulation allow an investor to combine previous investments in the fund with today’s investment to determine today’s sales charge.
57
What are the ways Rights of Accumulation differ from a Letter of Intent (LOI)?
Are available for subsequent investments (the reduced sales charges will not apply to initial transactions)
Do not require making a specific commitment for future investment
Allow the investor to use prior share appreciation to qualify for breakpoints, and
Do not impose time limits.
58
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.
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.
59
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.
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.
60
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
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.
61
2. 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
A. 8.5%.
B. 9.3%.
C. in excess of the permitted maximum.
D. based on the net asset value per share
A) 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.
62
What is a private fund?
Private funds, generally referred to as private equity funds, limit their ownership so as not to be considered investment companies. As long as there are no more than 100 investors, the law does not consider these investment companies requiring registration—that is the 3(c)(1) fund exemption.
63
As it relates to the characteristics if private funds, what is a qualified purchaser?
Qualified purchasers are individuals with at least $5 million in investments, or business entities with at least $25 million in investments.
64
Private funds are separeted into two different categories, what are they? What is the difference between them?
Direct & Portfolio investments. The difference is Direct investments, the funds have a 10% or greater voting interest in an operating company with the goal of influencing management and operations. In the latter case, the fund does not acquire a control position and builds a portfolio that may be stocks, bonds, derivatives, or any combination of these.
65
What is a private liquidity fund?
any private fund that seeks to generate income by investing in a portfolio of short-term obligations in order to maintain a stable net asset value (NAV) per unit or minimize principal volatility for investors
66
What are venture capital funds?
are generally organized as limited partnerships where the investment decisions are made by the general partner with the capital coming from the limited partners. Those LPs can be wealthy individuals, pension and endowment funds, and even hedge funds. VC funds look for young, up-and-coming companies with an expectation of high returns in exchange for the high risk. Unlike private equity funds, it is more typical that venture capital fund investments are made in businesses that are not yet fully operational.
67
What is a common characteristic of private equity and venture capital funds?
Compensation to the fund manager. Typically, the annual management fee is 2% of committed capital plus 20% of the profits when the business is sold. This is usually referred to as the carried interest.
68
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.
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.
69
What is a hedge fund?
Hedge funds are a form of fund generally organized as a limited partnership with no more than 100 investors that does not have to register with the SEC, although the portfolio managers generally are required to register as investment advisers.
70
What are some of the differences between a Mutual Fund and a Hedge Fund?
the hedge fund’s lack of transparency; a mutual fund is offered via a prospectus filed with the SEC, while a hedge fund’s prospectus is generally referred to as a private placement memorandum, containing significantly less information.
71
Hedge funds have a very high initial investiment minimum. Why is that important to know?
Because these funds are suitable for only a small pecentage of investors.
72
As it relates to Hedge Funds, what is meant by having "skin in the game'?
The portfolio managers invest along with the investors. "They have “skin in the game,” so they have a greater motivation to succeed. The partnership is the issuer of the ownership units.
73
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
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.
74
What is the Fund of Hedge Funds?
Hedge funds are indirectly available to ordinary investors through funds of hedge funds. This offers the investor diversification because the fund of funds (FOF) will contain several different hedge funds.
75
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
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 that must be made 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.
76
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
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 in a bit later, when it can offer additional funding and management expertise. With rare exceptions, mutual funds do not investment in companies that are not publicly traded. It is possible a hedge fund might take a chance on a company like this, but it would be out of the ordinary.
77
2. 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.
D) For a number of reasons, mostly legal, hedge funds are most commonly structured as partnerships.
78
What is a Unit Investment Trust (UIT)?
A unit investment trust (UIT) is an unmanaged investment company organized under a trust indenture.
79
What do UITs not have?
Do not have boards of directors
Do not employ an investment adviser
Do not actively manage their own portfolios (trade securities).
80
What do Unit Investment Trust (UITs) only issue?
unit investment trust issues only redeemable securities, known as units or shares of beneficial interest, each of which represents an undivided interest in a portfolio of specified securities.
81
What is an example of a UIT?
A UIT solely invested in municipal bonds where the trust liquidates after the final bond in the portfolio matures.
82
What is an equity trust?
Where, because stock doesn’t mature, the portfolio is liquidated at a predetermined date and the proceeds distributed to unit holders or reinvested into a new trust at the investor’s option
83
What are features of UITs?
UITs are not actively managed; there is no board of directors (BOD) or investment adviser.
UIT shares (units) must be redeemed by the trust.
UITs are investment companies as defined under the Investment Company Act of 1940.
84
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
D. A unit investment trust (UIT) is a type of investment company which is generally unmanaged as the money manager initially selects the securities to be included in the portfolio and then holds those securities until they mature or the UIT terminates.
85
What are Exchange-Traded Funds?
Registers with the SEC under the Investment Company Act of 1940 either as a unit investment trust (a UIT ETF) or as an open-end management company (an open-end ETF).
Invests in a specific index, such as the S&P 500.
Any asset class with a published index and liquidity can be transformed into an (ETF), including real estate and commodities, alongside stocks and bonds.
ETFs function similarly to index mutual funds, but with a key distinction: they trade like stocks on exchanges such as Nasdaq, akin to closed-end investment companies.
Allows investors to capitalize on market-driven price fluctuations rather than solely on the underlying value of the portfolio's stocks.
86
Is there anything as it relates to ETF commissions?
There are now some U.S.-listed ETFs available for commission-free trading on certain select platforms (these are typically proprietary funds). There are no trading costs, the objection to using them in dollar cost averaging programs is eliminated. For exam purposes, these are the exceptions rather than the rule.
87
How are ETFs classified?
Most ETFs are legally classified as open-end companies (although those cannot be referred to as mutual funds because shares are not redeemable), with the rest as unit investment trusts.
88
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
C. One thing that neither of these products can claim is performance better than the underlying index. Think about it: the index has no management fees. Even though the management fees on index funds are very low and those on ETFs generally lower than that, there are still expenses making it unlikely that their performance can beat that of the index. The fact that an investor can trade the ETF during the day instead of accepting whatever the next computed price is can be a benefit for those who are trying to time the market. And for those who wish to add
the leverage of margin trading (explained more fully in Unit 23), that can only be done with ETFs, not index mutual funds.
89
What is a Real Estate Investment Trust (REIT)?
Pronounced “reet”), is a company that manages a portfolio of real estate investments to earn profits and/or income for its shareholders.
90
What are characteristics of REITs?
Professionally management and diversified
Normally publicly traded and serves as a source of long-term financing for real estate projects.
A REIT pools capital in a manner similar to an investment company.
Shareholders receive dividends from investment income or capital gains distributions. In most cases, those dividends are taxed at ordinary income rates rather than as qualified dividends.
Capital gains distributions are generally taxed at the favorable long-term capital gains rate.
91
What are REITs normally invested in?
Own commercial property (equity REITs);
Own mortgages on commercial property (mortgage REITs); or
Do both (hybrid REITs).
92
How are REITs organized?
Organized as trusts where investors buy and sell shares on sotck exchanges or in the OTC market.
93
What are three numbers relating to REITs. REITs must:
Invest at least 75% of its total assets in real estate assets and cash;
Derive at least 75% of its gross income from real estate related sources, including rents from real property and interest on mortgages financing real property; and
Distribute at least 90% of its taxable income to shareholders annually in the form of dividends.
94
What are four important points to remeberabout REITs?
An owner of REITs holds an undivided interest in a pool of real estate investments.
REITs are liquid because they trade on exchanges and over the counter.
REITs are not investment companies (mutual funds).
REITs offer dividends and gains to investors but do not flow through losses like limited partnerships, and therefore are not considered direct participation programs.
95
1. 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.
A) A unit investment trust has no board of directors; rather, it has a board of trustees. A UIT must follow a stated investment objective (as must any investment company) and does not charge a management fee because it is not a managed portfolio.
96
2. 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
A) The investor’s criteria eliminate mutual funds as being suitable. Mutual funds typically make annual capital gains distributions, for which the owner incurs a tax liability, and mutual funds cannot be purchased on margin. Conversely, an ETF will rarely make a capital gains distribution, and because they trade like all exchange-traded products, they can be purchased on margin, making them more suitable for this investor. Buying only a few select bank stocks is not a good representation of the entire sector.
97
3. 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.
A) Most real estate investments are not readily marketable. Therefore, an investor in real estate can generally expect some difficulty in converting a property to cash if cash is needed quickly. However, a REIT securitizes real estate properties, thereby allowing REIT investors to easily sell REIT shares in the open market. For purposes of 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.
98
What do the different types of pooled investments vehicles share?
Diversification: By pooling assets with many others, investors have the opportunity to own an interest in a far greater number and range of securities than available to almost any individual investor.
Professional management: In almost all cases, someone with expertise is “minding the store.” Even in the case of a UIT, where there is no ongoing management, the initial portfolio is constructed by experts.
99
What are the benefits of Mutual Funds?
Diversification: The old saying “don’t put all of your eggs in one basket”.
Professional management: Those individuals in charge of managing a mutual fund’s portfolio must be registered as investment advisers with the SEC. The Investment Company Act of 1940 requires that they follow the stated objectives set forth in the prospectus.
Choice of objectives: Whatever an investor’s investment objectives are, there are mutual funds available to match. There are many shades of growth funds, from highly aggressive to very conservative, but all with the goal of growing the investment. The same is true with income funds where the goal is to generate current income with varying degrees of risk from government bonds to high-yield bonds. If the objective is capital preservation, money market funds fit the bill, and then there are funds that combine objectives, such as growth and income funds. There are even specialized funds (sector funds) that concentrate at least 25% of their portfolio into specific industries or geographic areas, such as a biotech fund or a Southeast Asia fund.
Convenience: Buying and liquidating shares, changing reinvestment options, and getting information can be accomplished conveniently by going online at the fund’s website
Liquidity: The Investment Company Act of 1940 requires that an open-end investment company stand ready to redeem shares at the next computed NAV per share. Payment must be made within seven days of the redemption request.
Minimum initial investment: It doesn’t take a great deal of wealth to get started investing in funds and, generally, once you are a shareholder, most funds permit additional investments of $100 or even less.
Convenient tax information: Tax liabilities for an investor are simplified because each year the fund distributes a 1099 form explaining taxability of distributions.
Combination privilege: A mutual fund company frequently offers more than one fund and refers to these multiple offerings as its family of funds. An investor seeking a reduced sales charge may be allowed to combine separate investments in two or more funds within the same family to reach a breakpoint.
Exchanges within a family of funds: Many investment companies offer an exchange or conversion privilege within their families of funds. This feature allows an investor to convert an investment in one fund for an equal investment in another fund in the same family at net asset value without incurring an additional sales charge. For example, someone who started investing when in their 30s or 40s by placing their money into an aggressive growth fund might consider moving into something more conservative when they reached their 50s. Once they hit their 60s and 70s, they would want to have a greater percentage of their money in income funds.
100
For tax purposes, what is the exchange of funds considered?
They are considered a sale. Any gains or losses are full yreportable at the time of exchange.
101
What is the number one advangtage to investing in mutual funds?
Diversification
102
What are the risks to mutual funds?
Markets fluctuate
Fees and Expenses – Sales charges, qw2b-1 fees, & possible redemption fees. Management fees, investor has no control over the manger’s timing of purchases/sales possibly causing tax issues.
Other factors – Services offered, costs, taxation, tenure (management proven), performance compared to benchmark
Net Redemptions – in a down market, there are more sellers than buyers.
103
What are benefits to Private Funds?
By investing before the company matures enough for a public offering, there is an opportunity for very large profits.
Many private funds are structured so as to give the investors a say in the management and development of the company.
Added diversification, because these usually have a low correlation to the overall market.
104
What are risks for Private Funds?
Business risk—A high percentage of start-ups do not succeed
Liquidity risk—There is rarely an opportunity to find a secondary market, and even when the company has a public offering, these investors’ shares are likely to be restricted
Lack of transparency—Being unregistered securities, no regulatory body has reviewed the offering documents
105
What are the benefits of a hedge fund?
Hedge funds are to generate positive returns in both rising and falling markets.
Investors have a plethora of choices to assist them in meeting their objectives.
As part of an asset allocation class, hedge funds may reduce overall portfolio risk and volatility and increase returns.
A proper selection of hedge funds can create uncorrelated returns, adding a level of diversification.
106
What are the risks of Hedge Funds?
High Expenses
Risky strategies could backfire.
Liquidity risk: Locked in to the investment & no active secondary market for these unregistered securities; they are not listed on any exchanges.
The sale of partnership interests may require approval of the general partner.
107
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
D. A lock-up period refers to a set period of time, such as 6 months, that an investor’s funds must remain invested in the hedge fund. During that time period, withdrawal requests are not permitted.
108
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.
D. Hedge funds typically use risky strategies to generate profit regardless of market direction, but there is no assurance that the objective will be realized.
Redemption may be difficult with these funds, and higher management fees make for higher expenses than traditional mutual funds.
109
What are the benfits of REITs?
The opportunity to invest in real estate without the degree of liquidity risk found in direct ownership
Properties selected by professionals with greater negotiating power than an individual
A negative correlation to the general stock market because real estate prices and the stock market frequently move in opposite directions
Reasonable income and/or potential capital appreciation
110
What are the risks to REITs?
Lower control, because much of the risk in investing in REITs lies with the quality of the management.
REITs generally have greater price volatility than direct ownership of real estate because they are influenced by stock market conditions.
Dividends are not considered qualified for purposes of the 15% maximum tax rate and are taxed at full ordinary income rates.
If a REIT is not publicly traded, liquidity is very limited. There is the need for more stringent suitability standards, and the regulators give greater scrutiny to trades in unlisted REITs.
Failure to meet the distribution rules could cause a REIT to be taxed.
Problem loans in the portfolio could cause income and/or capital to decrease.
111
In order 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.
B. In order to qualify under IRS regulations, REITs must distribute at least 90% of their taxable income in the form of dividends to shareholders. At least 75% of a REIT’s income must come from real estate investments.
112
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.
C) The two primary advantages of mutual funds are diversification and professional management. If the investor in individual
stocks happens to pick a few real winners, the performance will likely exceed that of a mutual fund. There is no general yes or no on that. Some would say that individual investments offer more tax advantages because the investor selects when and what to sell. Although the mutual fund will typically pay less in trading costs than an individual investor, the other expenses, especially the management fee, can make investing in mutual funds more expensive than selecting securities on your own.
113
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.
A) Under the guidelines set by the Internal Revenue Code, a REIT can avoid being taxed as a corporation by receiving 75% or more of its income from real estate and distributing 90% or more of its net investment income to its investors.
114
Identify two trading strategies that 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
II. Trading on margin to purchase portfolio securities
III. Purchasing speculative or low-rated securities
IV. Short selling of stock
A. I and III
B. I and IV
C. II and III
D. II and IV
D) While there can be limited and rare exceptions, mutual funds are prohibited from purchasing securities on margin and selling securities short. Both strategies, however, are commonly employed by hedge funds.
