Chapter 2 Insights

An investor has unexpectedly received $30,000 from an old debt he had written off. This money will come in handy for a business venture planned for three years from now. Meanwhile, he would like to generate some income on the money with as little risk and as little expense as possible. Which of the following recommendations is likely to be the most suitable for this customer?

Class C shares of the ABC Investment-Grade Bond Fund. The customer wants income with as little risk as possible, so our answer must be one of the choices that offer an investment-grade bond fund. Of those offered, Class C shares would be best because the customer would pay no front-end sales charge and no CDSC after a short time, probably one year. He will pay somewhat higher 12b-1 fees than with Class A shares, but this will amount to only a fraction of 1% per year, and only for the three years of his investment. Reference: 2.4.3.2.3 in the License Exam Manual

To register new securities, an investment company mustI. supply detailed information about itself to the SEC. II. supply detailed information about the new securities to the SEC.

I and II The registration statement and prospectus filed with the SEC must disclose all material facts of the issuer and the security being issued. The SEC does not approve new issues, nor does any SRO. Reference: 2.2.2 in the License Exam Manual

Which of the following statements regarding a fixed-time withdrawal plan offered by a mutual fund are TRUE?I. The amount received each month by the client may vary. II. The amount received each month by the client will be the same. III. No funds offer this type of withdrawal. IV. This plan is self-exhausting.

I and IV A fixed-time withdrawal plan of a mutual fund calls for an unpredictable amount to be paid out each month over a fixed period of time. By contrast, a fixed-dollar plan calls for a fixed amount to be paid out each month over an unpredictable period of time. Reference: 2.5.1.3.3 in the License Exam Manual

If a registered representative uses a prospectus as a sales aid, what must accompany the prospectus in the presentation?

No other information is required unless requested Although the prospectus is required before or during any solicitation for sale, no other literature or documentation is needed unless requested. Reference: 2.3.6.1 in the License Exam Manual

A contractual plan company is what type of investment company?

Unit investment trust.

Your client wishes to purchase units in a municipal bond UIT that was issued two years ago. These units would be purchased

from the UIT UITs are redeemable securities that are not traded by retail investors in the secondary market; they are purchased and sold directly through the issuer. Reference: 2.1.2.2 in the License Exam Manual

A mutual fund's expense ratio is its average net assets for the year divided into:

its expenses for the year By dividing a mutual fund's expenses by its average net assets, you can calculate the fund's expense ratio. The expense ratio measures the efficiency of fund management.

As written in the Investment Company Act of 1940, investment companies must do all of the following EXCEPT:

maintain adequate debt/equity diversification in the fund's investments. According to the Investment Company Act of 1940, at least 40% of a company's directors must be noninterested persons (a simple majority if the fund charges a 12b-1 fee), the company must state and follow a clearly defined investment objective, and a company must have a minimum of $100,000 in net assets before it may operate. Reference: 2.2 in the License Exam Manual

Under SEC Rule 498, a summary prospectus may be used in a mutual fund sales presentation resulting in a sale

only when the investor is able to access a statutory prospectus online SEC Rule 498 permits sales to be made using a summary form of the prospectus. An investor who purchases fund shares on the basis of the summary prospectus must be able to access a statutory prospectus online. Reference: 2.3.6.2 in the License Exam Manual

Which of the following is a major advantage of a nonqualified variable annuity compared to a mutual fund?

tax deferral A nonqualified variable annuity has the advantage of tax deferral over investing in a mutual fund; the other choices are common to both investments. Reference: 2.7.1.3 in the License Exam Manual

In registering with the SEC, an investment company must provide all of the following information EXCEPT:

the current professional and trade society memberships of each officer and director. Officer and director memberships in professional societies are not required on the investment company registration documents. Reference: 2.2.1 in the License Exam Manual

An investment company may lend money to one of its officers:

under no circumstances An investment company is not permitted to make loans to affiliated or interested persons under any circumstances; an officer is an affiliated person of an investment company. Reference: 2.3.1 in the License Exam Manual

Provided that it has shareholder approval, an open-end investment company may

underwrite the securities of another issuer. Borrowing and lending money and securities and underwriting the securities of another issuer may be done with a majority vote of the outstanding shares. Mutual funds may not sell securities short. Reference: 2.2.3.2 in the License Exam Manual

Your customer, in his 30s, is extremely optimistic about business, not just in the United States, but worldwide. He has received a $50,000 legacy and would like to invest it for long-term growth. Which of the following funds would make the most suitable recommendation?

Clements Global Equity Fund. Long-term growth requires an equity rather than a debt investment. This customer expects both foreign and U.S. business to do well in the coming years. An international, or foreign, stock fund would have only foreign stocks in it, no U.S. stocks. A global or worldwide equity fund would include both American and foreign stocks. Reference: 2.4.4.1.8 in the License Exam Manual

One of your clients is interested in purchasing an index annuity. When discussing this product, you should mention I.the rate cap II.the participation rate III.the surrender period is shorter than most other annuities IV.taxation of dividends received

I and II Index annuities are designed to give their owners participation in the performance of a specific index. The degree to which they participate is known as the participation rate and can range from 70% to 100%. In most cases, there is also a rate cap, a ceiling on the amount that will be credited. The surrender period is longer than most other annuities. Reference: 2.7.1.1.1 in the License Exam Manual

Which of the following may a registered representative use to solicit an order for open-end investment company shares?

II and III The prospectus, sometimes referred to as the statutory or final prospectus, is the most complete one and may always be used. A summary prospectus, sometimes called a Rule 498 summary, may also be used as long as the client can access one online. A preliminary prospectus (red herring) may NEVER be used to solicit anything more than an indication of interest—not an order. Reference: 2.3.6.2 in the License Exam Manual

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

II and IV Both exchange-traded funds and closed-end investment companies are traded on exchanges; therefore, investors pay a commission when purchasing and liquidating shares. Both may be sold short (and purchased on margin). Neither is redeemable with the issuer as they are traded in the secondary market. Reference: 2.1.3.2 in the License Exam Manual

Which of the following occurrences will result in the issuance of a Form 1099? I.A stock dividend II.A stock split III.Dividends distributed by a mutual fund and received in cash IV.Capital gains reinvested into a mutual fund

III and IV Distributions from mutual funds are taxable events (whether reinvested or not) and are reported on IRS Form 1099. Reference: 2.5.1 in the License Exam Manual

If an investment company has a fixed portfolio of municipal bonds with high duration, how will substantial changes in general interest rates affect the company's portfolio?

The market value will fluctuate significantly, but the investment income will remain stable. For an investment company with a fixed portfolio of high duration municipal bonds (a UIT), the market value of the portfolio will fluctuate with changing interest rates, but the income will remain stable because the same bonds remain in the portfolio and there has been no change to their coupon rates. Reference: 2.1.2.2 in the License Exam Manual

If your client wishes to invest $50,000 in a portfolio of mutual funds, payment may be made via each of the following EXCEPT

a loan from the broker-dealer complying with the limits of Regulation T Credit may not be extended on the purchase of mutual fund shares. Reference: 2.2.1.2 in the License Exam Manual (because then you are purchasing shares on margin)

When shares of a closed-end investment company are purchased by an investor, the price paid is the

ask plus a commission Closed-end investment company shares are priced based on supply and demand. The ask is the price that investors will pay for purchasing shares. Investors will also pay a commission as this is what the broker charges for executing the transaction. Reference: 2.1.2.3.1 in the License Exam Manual

A couple wishes to start a withdrawal plan from a mutual fund they have owned for 12 years. As a registered representative, you must

never use charts or tables unless the SEC specifically clears their use Required disclosures include only using charts or tables the SEC specifically clears, never promising a guaranteed minimum rate of return, and stressing to the investor that it is possible to exhaust the account earlier than expected. A fixed-dollar plan will provide the most consistent check Reference: 2.5.1.4 in the License Exam Manual

One risk of a withdrawal plan is that the:

principal value fluctuates. Withdrawal plans have no guarantee of payment; the investor's account value is subject to market fluctuations. Thus, there is uncertainty as to the amount available or the time required to withdraw it. Reference: 2.5.1.4 in the License Exam Manual

Each of the following factors may determine the amount of payout from a variable annuity EXCEPT

the annuitant's insurability Mortality expense, age, sex, and rate of return all have a bearing on the size of payout; the annuitant's insurability does not. Reference: 2.7.4 in the License Exam Manual

A type of life insurance where the death benefit varies based upon the investments selected by the policyowner is known as

variable life Although variable life offers a guaranteed minimum death benefit, because the policyowner can select the separate accounts into which a portion of the premium will be invested, that death benefit will vary with account performance. Reference: 2.8.2 in the License Exam Manual

Over the first four years, the average sales charge on a spread-load contractual plan can be no more than:

16% per year. The Investment Company Amendments Act of 1970 state that a spread-load plan cannot take more than 20% of any plan payment as a sales charge and that the charges may not exceed an average of more than 16% during the first 4 years of the plan's investment. Contractual plans are no longer sold, but there are still plans in effect. Reference: 2.5.1.2 in the License Exam Manual

Which of the following individuals would be considered a noninterested person in a mutual fund?

A member of the board of directors who does not hold another position within the investment company NOT A person who holds a position with the fund's underwriter An interested person is defined as someone in a control relationship with the fund or someone who owns 5% or more of the outstanding shares. Merely sitting on the board does not make someone an interested person. Thus, a director with no other relationship with the fund qualifies as a noninterested person. Reference: 2.3.1 in the License Exam Manual

Financial information may not be used in a mutual fund prospectus if the information is older than

16 months A mutual fund prospectus may not contain financial information that is more than 16 months old. Reference: 2.2.1.1 in the License Exam Manual

Annuities

Both can choose a guaranteed monthly income, though amount determined by performance of separate accounts for variable annuities Paid MONTHLY

All of the following statements regarding variable annuities are true EXCEPT:

although investors bear the investment risk, the insurance company provides a minimum return guarantee.

The death benefit of a variable life policy must be calculated at least:

annually

From which of the following might you be able to purchase shares of a closed-end investment company after its initial offering?

II.From other stockholders in the OTC market. III.From other stockholders on the NYSE.

The capital structure of an open-end investment company might include:

issuing one class of security with limited bank borrowing. Open-end investment companies may only issue redeemable common stock. Preferred stock, bonds, and other forms of senior securities are not allowed. Bank borrowing is allowed subject to certain limitations. Reference: 2.2.1.3 in the License Exam Manual

variable vs fixed annuities

Fixed: invest in fixed income securities, investors receive a guaranteed fixed income as a result variable, invests in variable income securities, investors NOT guaranteed a fixed income as a result ALL ANNUITIES have a MORTALITY GUARANTEE

A majority vote of the outstanding shares of an open-end investment company is needed in order to approve a change I.from a diversified company to a nondiversified company. II.from an open-end company to a closed-end company. III.in the fund's breakpoints. IV.in the portfolio of the fund.

I and II Some of the changes that require a majority vote of the shares outstanding include issuing or underwriting other securities, changing subclassification (e.g., from open-end to closed-end or from diversified to nondiversified), and changing investment policy (e.g., from income to growth or from bonds to preferred stock). Breakpoint schedules are set by the board, and changes to the portfolio, within the scope of the funds' investment policy, are decisions of the portfolio manager. Reference: 2.2.3.2 in the License Exam Manual

Which of the following must be registered as investment companies under the Investment Company Act of 1940?I. Closed-end investment companies. II. Separate accounts of insurance companies offering variable products. III. Variable annuity contracts. IV. Variable life insurance policies.

I and II Under the Investment Company Act of 1940, face-amount certificate companies, unit investment trusts, open- and closed-end management companies, AND separate accounts of insurance companies used to fund variable annuity and variable life contracts must register with the SEC as investment companies. Note that the separate account is registered as an investment company, not the variable contract. Reference: 2.1.2 in the License Exam Manual

The number of accumulation units increases as investment continues (so the number of accumulation units varies)

Once annuitized though, the number of annuity units STAYS THE SAME

What is the greatest risk to an investor in an asset allocation portfolio?

Poor portfolio management. In an asset allocation portfolio, the investor is dependent on the fund manager's ability to allocate assets based on market performance. The manager has the authority to choose the percentage of assets that should be directed into stock, bonds, and/or cash, for the purpose of avoiding the other risks listed. Reference: 2.4.4.3 in the License Exam Manual

A high price-to-earnings ratio denotes a GROWTH FUND as growth funds have a lot of investor confidence which is expressed in the high stock price often indicates that the company, and its stock, will increase in value with time.

Price to earnings refers to the actual earnings of the company, (which as a growing company is reinvesting its earnings in R & D rather than distributing dividends and that sort of thing).

Where would an investor find a complete list of holdings for a particular mutual fund?

Semi-annual or annual report (NOT the prospectus) A statutory prospectus will list investment objectives but not holdings. The SAI contains additional information about the fund and includes further disclosure regarding operations but not a list of holdings. A complete list of holdings will be found as of the date of publication of semi-annual and annual reports. Reference: 2.3.6.4 in the License Exam Manual

A customer in his 40s, with ample income to meet his needs, has unexpectedly received $250,000 and would like to invest it in mutual funds. He emphasizes that he is interested in long-term growth and is willing to accept moderate risk. He proposes to his registered representative that the investment be split among three funds: the XYZ Balanced Fund, whose portfolio includes stocks and bonds of many old and successful companies; the KPL Growth and Income Fund, which has shown excellent performance over the last several years; and the NYF International SmallCap Stock Fund, which he feels will provide diversification by investing in foreign companies. In discussing the customer's proposal, the registered representative might make which of the following points?

The proposal does not address the customer's objective: long-term, moderate-risk growth. Also, by splitting the investment among different fund families, he will probably pay higher sales charges. The customer's proposal involves investing in comparatively high-risk, not moderate-risk, small-cap foreign stocks; in debt instruments, which do not provide growth; and in a balanced fund, whose objective is quite different from the customer's objective: long-term, moderate-risk growth. Reference: 2.4.4.7 in the License Exam Manual

At age 65, your customer purchased an immediate variable annuity contract. He made a lump-sum $100,000 initial payment and selected a life income with ten-year period certain payment option. The customer lived until age 88. The insurance company made payments to him

for 23 years. An annuity with life and a ten-year certain will pay for the greater of ten years or the life of the annuitant. The customer lived for 23 more years, which is more than the ten certain. Reference: 2.7.4 in the License Exam Manual

A FINRA member broker/dealer buying shares of an open-end investment company may NOT buy shares of the fund

for the purpose of resale at a later date A broker/dealer may buy shares only to fulfill existing orders or for its own investment account, not for inventory. Reference: 2.3.5 in the License Exam Manual

A variable annuity contract holder commences the payout period, receiving an initial benefit of $400 based on an assumed interest rate of 4%. In the second month, the contract holder receives $425 on the basis of an annualized rate of return of 10% earned by the separate account. If the separate account experiences an annualized net investment rate of 8% during the third month, the payout to the contract holder will be:

more than $425 The assumed interest rate (in this case, 4%) serves as a base of projection for calculating periodic payments. If the actual return is greater than the AIR, the next month's benefit check will increase in value. Because the account actually earned 8%, which is higher than the AIR, the value of the check would increase again (greater than $425). Always compare the actual return to the AIR, not to the previous month's performance. Reference: 2.7.4 in the License Exam Manual

All of the following actions would constitute rules violations EXCEPT

sending a potential customer a prospectus and sales literature at the same time (is the correct answer) You are NOT allowed to show a mutual fund's performance over the past ten years in an advertisement that is not an omitting prospectus Any solicitation for sale must be preceded or accompanied by a prospectus. Any sales literature that contains mutual fund performance data must include data from the past one, five, and ten years. If the fund has not been in operation for ten years, then it must show performance for the life of the fund. The only advertisements that are permitted to reflect performance (also for one, five and ten years) are those that comply with Rule 482 as an omitting prospectus. Reference: 2.3.6.1 in the License Exam Manual

Question ID: 613524 Dollar cost averaging results in a lower average cost per share than the average price per share paid, only if the share price during the investment period:

shows any fluctuation. Under dollar cost averaging, any fluctuation in the share price, up, down or both, will result in a lower average cost per share than the average price per share paid. Reference: 2.5.1.1 in the License Exam Manual

An investor purchased a variable annuity some years ago and has been making regular payments into it. He has encountered financial difficulties and asks his registered representative if he can arrange to delay his next few payments. The registered representative explains that:

the customer may pay in as much or as little, as frequently or as infrequently, as he pleases, with no penalty. A variable annuity does not require scheduled premium payments. The customer may miss as many payments as he wishes with no fear of forfeiting earlier payments. Reference: 2.7.2 in the License Exam Manual

Your customer wishes to enter into a withdrawal plan with his mutual fund. In view of his financial needs, you recommend a fixed-dollar plan. Your explanation of how the plan works could include all of the following statements EXCEPT:

the customer will know in advance precisely when his account will be exhausted. Because fund shares change in value from day to day, a fixed-dollar plan requires that a different number of shares be liquidated each month to yield the same dollar amount to be sent to the customer. Thus, with a fixed-dollar plan, though the investor knows how much he will receive each month, he cannot know in advance precisely when his account will be exhausted. Reference: 2.5.1.3.1 in the License Exam Manual

A variable annuity characteristic that contractually guarantees payments for life is:

the mortality guarantee. The company assumes the mortality risk by guaranteeing payments for life, though the payments are not guaranteed as to amount. Reference: 2.7 in the License Exam Manual

All of the following charges are included in the computation of a mutual fund's expense ratio EXCEPT

the sales load paid to the underwriters The expense ratio of a mutual fund is calculated by dividing the expenses of the fund by the fund's average net assets. Fund expenses include the fee paid to board members, the investment adviser's fee, the custodian's fee, the transfer agent's fee, the 12b-1 fee, and other expenses such as legal and accounting. The sales load paid to the underwriters is not an expense to the fund; it is a cost to the investor. Reference: 2.4.5.2.2 in the License Exam Manual

A nonqualified variable annuity valued at $400,000 is annuitized and the annuitant received $220,000 in payments until his death. At his death, if his wife received a lump sum payment of $180,000, this example illustrates a:

unit refund annuity. When the unit refund option is chosen, the insurer guarantees, at minimum, to distribute the amount of money that funded the annuity. At the annuitant's death, if the guaranteed amount has not been fully distributed, the survivor receives the balance of the account; typically, in a lump sum payment. Reference: 2.7.4 in the License Exam Manual

An investor must be provided with a statement of additional information (SAI) about a mutual fund:

upon REQUEST An investor must be given the statement of additional information (SAI) within THREE business days of receipt of a request for one. The SAI typically contains the fund's consolidated financial statements, including the balance sheet, statement of operations, income statement, and portfolio list at the time the statement was compiled. Reference: 2.3.6.3 in the License Exam Manual

How much of an investment company's assets must be invested in securities before it must register with the SEC as an investment company?

At least 40% If a company is in the business of investing in securities and, among other things, has at least 40% of its assets so invested (excluding government securities and the securities of majority-owned subsidiaries), it must register with the SEC as an investment company. Reference: 2.2 in the License Exam Manual

An investment company must report to shareholders:

SEMIANNUALLY Shareholders receive two reports a year, one of which must be an audited annual report.

A hedge fund and a traditional mutual fund are similar in that:

both can have noticeable effects on day-to-day trading. Both hedge funds and traditional mutual funds may have billions of dollars to invest and thus can both have a noticeable effect on trading. Reference: 2.1.3.1 in the License Exam Manual

Which of the following withdrawal plans would an investor select if she wanted to receive a fixed monthly payment from the investment company?

fixed dollar A fixed-dollar plan is the only type of plan that fixes a definite dollar payment. Reference: 2.5.1.3.1 in the License Exam Manual

An open-end investment company may do all of the following EXCEPT:

issue senior securities Open-end companies (mutual funds) only issue one class of security: common stock. They do not issue senior securities such as bonds or preferred stock. They may borrow and lend money and purchase call contracts. Reference: 2.2.3 in the License Exam Manual

The result of dollar cost averaging is to:

obtain a lower average cost per share than average price per share.