UNIT 4

What are investment companies?

Pool investors’ money

Invest in securities on investors’ behalf

What’s the purpose of investor companies?

Diversify

Professional management

Purchasing power for small investors

Whats the Governing Law?

Defines and regulate investment companies in the U.S.

Investment Company Act of 1940

What are the main types of investment companies?

Face-Amount Certifications (FACs): guaranteed future payment

Unit Investment Trust (UITs): Fixed potrfolio

Management Companies: actively managed portfolios

Why do investors use investment companies?

Diversify

Professional Management

Liquidity

Purchasing Power

What is Face-Amount Certificates (FACs)

Contract promising investors a fixed future payment.

Investors’ Pay:

Lump sum or Installments

Issuers’ Promise: Specific future amount

FAC Facts

Fully paid: Investor pay full amount up front

Modern Relevance: Uncommon today

What is a Unit Investment Trusts (UITs)?

Investment company organized as a trust with a fixed portfolio.

UIT Features

Fixed Portfolio:

No active management

Securities generally do not change

Trustees instead of BOD

Redeemable Shares: Investors redeem units with issuer.

Fixed Term: have a maturity/end date

Debt UIT: end when bonds mature

Equity UIT: Liquidates on stated date

What is a management investment companies?

Actively managed investment companies

What are the two types of management investment companies?

Closed-end funds

Open-end funds (mutual funds)

What are close-end funds?

Fixed Capitalization: limited # of shares issued in IPO

After IPO

Shares trade:

On exchanges

OTC market

Who determines the pricing of a close-end fund?

Supply and demand

Above NAV (premium)

Below NAV (discount)

Close-end fund features

Shares issued: Fixed

2nd market trading: Yes

Redeemable with fund: NO

Can issue bonds/preferred stock: Yes

What are open-end funds (Mutual funds)?

Continuous offering = continuously issues new shares

Redeemable shares: Investors sell shares back to fund

2nd Market trading: No, directly with issuer

Open-end Fund Features

Shares issued: Unlimited

2nd market trading: No

Redeemable: Yes

Pricing: NAV

Can issue preferred stock: NO

Can issue bonds: No

Mutual Fund Facts

Issue only common stock

May issue fractional shares

Calculate NAV daily

ARE HIGHLY LIQUID

What is a Net Asset Value (NAV)?

Per-share value of investment companey

NAV = value per share of the fund

Formula: (Asset - Liabilities) / Shares Outstanding

What are shareholder rights for a Mutual fund?

Voting rights:

BOD

Approval of investment adviser

Changes to investment objective

Changes to sales charges

Fund liquidation

Dividends

What is a mutual fund?

Professional investment company manages to:

Pools investors money

Invest according to stated objective

EX:

Growth

Income

Balanced

Bond funds

How does mutual funds work?

Buy shares from fund

Redeem shares with fund

NOT TRADED IN 2ND MARKET

Mutual fund characteristics

Redeemable securities: redeem shares at NAV

Liquidity: High guarantees redemption

Undivided Interest: Own proportional interest in portfolio

Fractional Shares: investor own partial shares, allowing exact $ investment

Professional Management: professional managers make decisions

Diversification

How are mutual funds distributed?

Dividends: Income from stocks and bonds held by the fund.

Capital Gains: Profits from selling securities at a gain

Investors Choices: Take Cash OR Reinvest at NAV

What is a sales Charge (Loads)?

A load is a sales commission paid when buying or selling mutual fund shares.

Max. Sales Charge = 8.5% of the Public Offering Price (POP)

What are Class A Shares?

Front-end load

Commission deducted before money is invested.

Formula: Investment x sales charge % = Load

Investment - Load = Amount invested

What is a Class B Share?

Back-en Load (CDSC)

No sales charge when purchasing.

Entire investment goes to work when redeemed

Sales charge APPLIES when REDEEMED

Charge declined over time

Often converts to Class A after 5-7 years.

What is a Class C Share?

Level Load

no front-end load, but ongoing annual fees

Typical Fees:

.25% shareholder service fee

12b-1 fees

Small-short-term CDSC

Best for: Investors with shorter time horizons

What is a No-Load fund?

No sales charges

Purchased at NAV

May still charge:

Redemption fees

Exchange fees

Account fees

THESE ARE NOT CONSIDERED LOADS

What does it mean to reinvest and compound?

When distributions are reinvested:

More shares are purchased at NAV

Future distributions are earned on the larger number of shares

Compounding: Your money earn money, you own more shares.

If you reinvest those extra shares can generate their own future dividends and capital gain.

Who gets taxed?

Dividend Distribution

Capital Gain distribution

Reinvested Distribution

Memory Trick for classes

A = at the beginning

B = Back-end

C- Continuous fees

No-load = no commission

What are breakpoints?

Discounts on Class A sales charges based on investment size.

Easy rule: The more you invest, the lower the % you pay

What is front-end load?

A sales charge paid when you buy Class A shares

EX: You invest $10,000 with a 5% load

$10,000 × 5% = 500 sales charge

$10,000 - 500 = $9,500 amount you invest

Breakpoint schedule

$1-$9,999 = 8.5% sales charge

$10,000-$24,999 = 6.5% sales charge

$25,000-$49,999 = 4% sales charge

$50,000+ = 2% sales charge

What’s the breakpoint violation?

Representative must tell clients when they qualify for a reduced sales charge.

FAILURE TO DISCLOSE

If a representative does not inform the customer, it is a breakpoint sale violation.

How do you reach a breakpoint?

By combining certain related accounts.

Can Combine:

Individual accounts

Spouse accounts

Minor children’s accounts

CANNOT Combine: Investment club accounts

What is a letter of intent (LOI)?

An investor promises to invest enough money within 13 months to qualify for a breakpoint now.

“I promise”

What are the rules for LOI?

Time limit = 13 months

Backdating allowed = 90 days

Escrow shares held = Yes

Appreciation counts = NO

Reinvested dividends count = No

If investors FAIL to complete LOI

They must either:

Pay the higher sales charge, or

Forfeit escrow shares

What are rights of accumulation (ROA)?

Exisiting holdings in the fund family count toward future breakpoint discounts.

Easy Explanation: What you already own helps you get lower loads on future purchases

What are the key features of Rights of Accumulation (ROA)?

No time limit

Existing holding count

Market appreciation DOES NOT for exam purposes

What is a combination privilege?

Investment in different funds within the same mutual fund family can be combined to qualify for breakpoints.

What is an exchange priviliege?

Move money from one fund to another within the same fund family without paying a new sales charge.

The exchange can still be TAXABLE if shares are sold at a GAIN

What’s the true definition of Net Asset Value (NAV)?

Per-share value of mutual fund

What is an expense ratio?

Annual operating expenses divided by average net assets

Includes:

Management fees

Administrative costs

12b-1 fees

Does NOT include: Sales Loads

What is Forward Pricing?

Mutual fund orders are executed at the next calculated NAV

Easy Rule: You never know the exact price when you place the 1st order, but you get the NAV calculated after your oder is received.

What is a Public Offering Price (POP)?

The price investors pay to purchase mutual fund shares.

Load fund: POP > NAV

No-Load fund: POP = NAV

What is the POP formula?

NAV + Sales Charge

What is Mutual Fund Dividend Dates?

1. Declaration Date

2. Record Date

3. Ex-dividend date (the day after the record date)

Special Rule: For mutual funds, the ex-dividend date is one business day after the record date.

Mutual Fund Disclosure Documents

Full Prospectus = Complete disclosure

Summary Prospectus = Short version

Statement of Additional Information (SAI) = Extra details

Omitting Prospectus = Advertisment only

What is full prospectus?

Legal document that gives investors complete details about an investment company or security.

Investment objectives

Policies

Risks

Fees

Expense ratio

Performance history

Delivery Rule: Must be provided before or at the time of solicitation

What is a summary prospectus?

A condensed version of the full prospectus that can be used for sales.

What is a statement of additional information (SAI)?

Financial statements

Portfolio holdings

Additional disclosure

Delivery Rule: Must be sent within 3 business days if requested

What is an omitting prospectus?

An advertisement (tombstone ad)

CANNOT be used by itself to sell the fund

What are the rules for prospectus?

Cannot be altered

Cannot be highlighted

Cannot contain handwritten notes

What is conduit theory (pipeline theory)?

Prevents mutual fund income from being taxed at the fund level when certain requirements are met.

What happens when you are without Conduit Theory?

Without Conduit Theory:

1. Corporation pays tax

2. Mutual fund pays tax

3. Investor pays tax

What happens when you are with Conduit Theory?

The fund passes income through to investors, avoiding an extra layer of tax.

What are the requirements to qualify?

The investment company must:

Qualify under Subchapter M.

Calculate net investment income (NII)

Distribute at least 90% of NII

What’s the NII formula?

Dividends + Interest - Expense = NII

What is an annuity?

A contract with an insurance company designed to provide retirement income.

What are phases of an annuity?

Accumulation Phase = Contributions and growth

Annuitization = Convert account value into income

Annuity Phase = Receive payments

What are the characteristics fixed annuities?

Fixed return

Insurance company bears investment risk

Investor bears inflation risk

Not securities; require only an insurance license

What are the charcateristics of variable annuities (VAs)?

Investors selects investment options

Returns fluctuate

Investor bears investment risk

What are seprate accounts?

Premiums are invested in a separate account divided into subaccounts

What are subaccounts?

Operate similarly to mutual funds but are not mutual funds.

What are the type of fees that exist?

Administrative fees

Advisory fees

Custodial fees

Surrender charges

What are some licensing requirements?

Selling a variable annuity requires:

Securities license

Insurance license

What are annuitization?

An irreversible election that converts the account value into stream of income payments.

What are some SAAPI factors?

Initial payment amounts are based on:

Sex

Age

Amount invested

Payout option

IR (Assumed Interest Rate)

Fixed vs. Variable Annuities

Fixed Variable

Return Fixed Market-based

Investment risk Insurance Company Investor

Inflation protection Limited Better potential

Security No Yes

Who is suitable?

Retirement income

Long-term investors

Investors comfortable with market risk W

Who’s not suitable?

Short-term goals

Capital preservation

Investors who have not fully used employer retirement plans

Maximize qualified retirement plans before buying a variable annuity

What is a Tax-Deferred Growth?

No taxes until money is withdrawn

What are the withdrawal rules?

Annuitization = Part taxable, part return of principal

• A stream of periodic payments

  • Monthly, Qaurterly, Lifetime income

• Return of principal (not taxed)

• Earnings/growth (taxable)

Why? investor already paid taxes on the original contributions (principal)

Lump sum = Earnings taxable

• Taking all the money out at once (og. investments + accumulated earnings)

• Return of principal (not taxed)

• Earnings/growth (taxable as ordinary income NOT capital gains)

Partial withdrawal = LIFO taxation

We take partial of the earning number

• Return of principal (not taxed)

• Earnings/growth (taxable)

What is an exclusion ratio?

Determines the tax-free portion of annuity payments

What’s the Exclusion Ratio formula?

Principal / Total Value

The exclusion ratio is tax-free return of the principal

What is Partial Withdrawals - LIFO?

Last In, Last Out

Earnings are withdrawn first and taxed first

What’s the early withdrawal penalty?

Withdrawals before age 591/2

10% penalty on the taxable portion

What’s a 1035 exchange?

A direct transfer from one annuity to another.

Tax Result:

No current tax

Surrender charges may still apply