Unit 4 - Investment Companies

Investment Company Act of 1940

• defines investment companies

  • mutual funds, face-amount certificates (FACs), unit investment trusts, and management companies

• investment company: a corporation or trust that pools investors’ money and then invests that money in securities on their behalf

  • each fund has a clearly defined objective (ex. growth or income)

• pooling funds in this way gives a small investor the purchasing power of a large investor

• raise capital by selling shares to the public

  • must abide by the same registration and prospectus requirements imposed on other issuers by the Securities Act of 1933

  • subject to regulations regarding how their shares are sold to the public

Face-Amount Certificates (FACs)

• a contract between an investor and an issuer in which the issuer guarantees payment of a stated (face) amount to the investor at some set date in the future

• in return, the investor agrees to pay the issuer a set amount of money

  • either as a lump sum (fully paid FAC) or in periodic installments

• not managed

• once the portfolios are composed, they don’t change

**investment companies under the Investment Company Act of 1940

Unit Investment Trusts (UITs)

• an investment company organized under a trust

• have trustees

• create a portfolio of securities designed to meet the UIT’s objectives

• sell redeemable units or shares in the portfolio

  • each share is an undivided interest in the entire portfolio

  • portfolio is fixed

• have a fixed end or maturity date

• debt-based → will end when the last bond in the portfolio matures

• equity-based → end date when the portfolio is liquidated and the funds are distributed to investors

• b/c it’s fixed, there’s no need for active management and no portfolio turnover

• don’t assess management fees

• shares are redeemable with the issuer at intervals specified in the prospectus

Management companies

• actively manages a securities portfolio to achieve a stated investment objective

• closed end or open end

• both sell shares to the public in an IPO

  • closed end → initial offering of shares is limited (closes after a certain # of shares are sold)

  • open end → perpetually offering new shares to the public

Open End vs Closed End Investment Companies

Mutual Funds

• a pool of investors’ money invested in various securities as determined by the fund’s stated investment objective

• issues common stock

• don’t trade in the secondary market

• investors purchase shares from the fund

• redeem shares with the issuer who sends out money and cancels the investor’s shares

  • shares are redeemable securities (guaranteed) → the shares are marketable and liquid

• owners have an undivided interest → no owner has higher status than another

• generate dividends and capital gains for investors

  • they choose to either reinvest those or receive them in cash

  • reinvestments are done at the fund’s current NAV

  • distributions are taxable

  • may be sold in full or fractions

    • allows investors to specify a $ amount rather than # of shares

• managed by investment managers

• provides an investor w/ ownership in a diversified portfolio even w/ a small investment

• maximum sales charge is 8.5% of the POP

• shareholders have voting rights

• Divided into Class A, B, C, or no load

Class A (Front-End Load) Shares

• front-end sales charge

• sales charges are paid at the time an investor buys shares

• charge is taken from the total amount invested

Class A shares are best for investors with large investments and longer time frames. This allows the investor to lower the load cost overall and spread the one-time cost over several years.

Class B (Back-End Load) Shares

• back-end sales load

  • contingent deferred sales charge (CDSC)

• charge is paid at the time an investor redeems shares

• the full investment amount is available to purchase shares

• reduced by a % each year after purchase (declining sales charge)

• charge is applied to the proceeds of any shares redeemed that year

• usually drops to 0 after awhile

  • becomes Class A shares at that point

Class B shares are best for investors with smaller investments and longer time frames to get past the back-end loads.

Class C (Level-Load) Shares

• have a 0.25% annual shareholder services fee, charged quarterly

  • fees never go away → level load

• typically have a one-year, 1% CDSC to discourage short-term trading of the fund

• have 12b-1 fees

• appropriate for investors who have short time horizons b/c the annual charges make them expensive

Class C shares are best for investors with short time frames of at least a year but not more than five years. The size of the investment is less relevant for Class C shares; for Class C, it is the time frame that matters.

No-Load Shares

• companies marketing their shares directly to the public, eliminating the need for underwriters and the sales charges used to compensate them

• shares purchased at NAV

• permitted to charge fees that aren’t considered sales charges

Reducing Front-end Loads

• Class A shares have lower expense ratios, making them a more efficient way for most people to invest

• b/c the sales charge is paid up front, the investor has no surprise sales charges when they redeem their shares

• downside → investor loses a portion of their invested capital up front (impacting their return)

• there are ways to reduce the charge (breakpoints)

Breakpoints

• quantity discounts on Class A mutual fund sales charges

• the greater the $ amount of a purchase, the lower the sales charge

• follows a breakpoint schedule

• most mutual funds allow investors to combine orders among related accounts in order to achieve a better breakpoint

Letters of Intent (LOI)

• a person who plans to invest more money w/ the same mutual fund may decrease the sales charges by signing a LOI

• investors tells the fund company their intention to add the additional funds needed to reach a specified breakpoint within 13 months

  • the fund applies the better breakpoint to all purchases during that period

• lower sales charge = customer buying more shares for the amount they invest

  • extra shares from the reduced sales charges are held in escrow

  • a customer who completes the LOI received the escrowed shares

  • if someone doesn’t complete the LOI can either pay the difference in sales charges or surrender the escrowed shares

• can be backdated up to 90 days

  • LOI begins the date of the letter

Breakpoint Sales

• a sale just below a breakpoint

• allowing a sale at an amount just below a breakpoint can be viewed as an effort by representatives to make higher sales charges

• inconsistent w/ just and equitable principals of trade

• the representative’s failure to disclose the breakpoint that triggers a violation

Rights of Accumulation

• allow an investor to qualify for reduced sales charges

• are available only for later investments

• allow for reduced sales charges that will not apply to the first transaction

• allow the investor to use any growth in the share price to qualify for breakpoints

• don’t impose time limits

• the customer may qualify for reduced sales charges when the total value of shares purchases meets a breakpoint

• looks at the higher of these two:

  • current value of the position

  • the total of the investments made to date

Combination Privilege

• a mutual fund sponsor (fund family) may offer more than one fund

• an investor may receive a reduced sales charge by combining investments of two or more funds within the same family to reach a breakpoint

Exchange Privilege

• allow an investor to redeem an investment in one fund for an equal investment in other fund in the same family w/o paying an additional sales charge

• avoids any new sales load

• taxable event

NAV

(total assets - total liabilities) / outstanding shares = NAV per share

• calculated at least once per day

Liabilities and Expense Ratio

• manager’s fee: cost of the investment advisor that makes the investment decisions for the portfolio

• admin costs: trading, legal and accounting, transfer agent, etc

• board of director’s costs: board members paid for their time plus other things related to them

• 12b-1 fees: used to pay for certain costs of distribution, usually for advertising and trailing commissions to BDs

• expense ratio → actual cost of the expenses

  • fund’s expenses for a year / its average net assets for that year

Forward Pricing

the transaction price is based on the next time NAV is calculated going forward

Public Offering Price (POP)

NAV + SC = POP

• sales charge (SC) is a percentage of POP

• load fund → POP will always exceed the NAV

• no-load fund → NAV = POP

• SC can’t exceed 8.5% of POP

• NAV > POP → closed-end fund

**order for MF → declaration day, record and pay date, ex-dividend date

Disclosure Documents

Conduit Theory to Mutual Fund Taxation

• to avoid the potential for taxation at three levels on the same dollar (triple taxation)

• allows investment companies to avoid taxes on the dividends it pays shareholders if they meet certain criteria

  • companies qualify under subchapter M of the Internal Revenue Code

  • company calculates their Net Investment Income (NII) by doing Dividends + Interest - Expenses

  • investment company distributes at least 90% of the funds NII in dividends

Annuity

• contract made with a life insurance company and is designed to provide retirement income

• stream of payments guaranteed for some period of time

• non-qualified

• the investor puts money into an annuity where it grows tax deferred

  • accumulation phase → investor doesn’t pay taxes until money is withdrawn

• annuitization → at retirement, the investor begins to receive an income

• annuity phase → period during which the investor receives payments

Fixed Annuities

• The contract has a set interest rate during the growth phase (also called the accumulation phase).

• The rate may fluctuate from year to year but is never less than zero.

• When the annuitant chooses to begin payments (called annuitization), the amount is fixed based on a formula and the payment does not change.

• This is called the annuity phase.

• The investment (called a premium) is invested in a general account and managed by the insurance company.

• The insurance company must pay the guaranteed return even if the investment return does not cover the cost.

  • This is called investment risk. The insurance company takes on the investment risk with a fixed annuity.

• The rate of return and fixed payment may not keep pace with inflation.

  • This is called inflation or purchasing power risk. The investor takes on inflation risk in a fixed annuity.

• There is no market risk in a fixed annuity, so a fixed annuity is not a security.

• A fixed annuity requires a life insurance license to sell, not a securities license.

Variable Annuities

• investor takes on the investment risk

• Premiums are placed into a separate account to be invested as the customer directs.

• Funds in the separate account are directed into one or more subaccounts.

  • Subaccounts are a type of investment company and are classified as UITs or open-end management companies.

  • A classification as an open-end management company is more common.

  • Subaccounts operate much like mutual funds, but they are not mutual funds. They are separate accounts; do not call them mutual funds.

  • The subaccounts will have investment objectives similar to mutual funds.

  • Subaccounts are investment companies under the Investment Company Act of 1940, so they are considered securities.

  • The presence of securities within the VA makes the VA a security and subject to securities regulations.

• The value of a separate account fluctuates with the investment returns of the subaccounts.

• The returns may exceed the rate of inflation but are not guaranteed to do so.

• Subaccounts may lose value due to market fluctuations.

• All fees must be disclosed, and they include

  • administrative fees,

  • investment advisor fees,

  • custodial fees, and

  • surrender charges.

• If the annuitant dies during the accumulation period, the beneficiary receives the greater of the account value or the premiums paid.

• Sales of VAs require both a securities license and a life insurance license.

• supplement an investor’s retirement

  • should maximize use of qualified retirement accounts before using a VA

Fixed vs Variable Annuities

Annuitization

• when an investor reaches retirement, they may choose to annuitize their contract

• a one-time, irreversible election to give up ownership of the assets of the annuity in return for a lifetime income guaranteed by the insurance company

• initial payment based on a formula that has SAAPI

  • S of the annuitant

  • Age of the annuitant

  • Amount in the annuity

  • Payout option selected

  • assumed Interest rate (AIR) from investments in the separate account

Suitability of VAs for customers

• A VA is for retirement income, not for a more immediate purpose like education funding or a home purchase.

• A VA is a supplement to retirement income and is not a suitable investment for other investment needs.

• A VA is not for preservation of capital.

• A VA should be funded with available cash. VA funding should not come from

  • existing retirement or other tax advantaged savings,

  • cashing out a life insurance policy,

  • selling other investment assets,

  • borrowing against an asset, like a home equity loan.

• A VA should not be used inside another tax-advantaged account like an individual retirement account or 401(k).

• All other available contributions to qualified retirement plans should be maximized before a VA is used.

• The customer should have the risk tolerance to handle market risk.

Tax Rules for VAs

• they’re tax deferred, not tax-free

• no tax consequences until they are withdrawn

• when growth is withdrawn from a VA, it is taxable as ordinary income (not capital gain) for the year of the withdrawal

• taxing annuitization

  • when the investor annuitizes, they surrender the value of the account to the insurance company in return for a life income

  • each payment will be part return of principal (the exclusion ratio) and part taxable income

• taxing lump sum

  • the investor takes everything out and closes the annuity

  • the growth becomes taxable income and the rest is return of principle

• taxing partial withdrawal

  • happens when the investor takes out a portion of the investment in a VA

  • withdrawal is from the growth first

    • (LIFO)

**any taxable amount taken out before the annuitant is 59.5 years old will be subject to a penalty of 10%

1035 Exchange

Funds in an annuity may be transferred directly to another annuity

• these funds aren’t considered a withdrawal and aren’t subject to taxes

• there still may be surrender fees