Investment Company Products
Five parties work together to operate an investment company:
BOD, IA, custodian, transfer agent, and underwriter
When must an investment company's prospectus be distributed to an investor and what does it contain?
Before or during any solicitation by the company. The prospectus contains information on the fund's objective, investment policies, sales charges, management expenses, and services offered.
Closed-end fund sales charges
Closed-end funds do not have sales charges. An investor pays a brokerage commission in an agency transaction or pays a markup or markdown in a principal transaction.
Registration Statement of Investment Company
Contains 2 parts. Part 1 (N1-A prospectus or a summary prospectus) is the prospectus and must be furnished to every person offered securities by the company. Must contain any SEC disclosures including that the SEC does not disapprove/approve the securities. Part 2 (statement of additional information or SAI) contains information that doesn't need to be furnished to every investor.
Nondiversified Investment Company
Fails to meet the 75-5-10 test.
Where do shares of closed-end companies trade?
Like corporate shares, in the secondary market.
(Stock Funds) Specialized (Sector) Funds
Many funds attempt to specialize in particular economic sectors or industries. Examples include gold funds (gold mining stock), technology funds, and low-grade (noninvestment grade) bond funds, among others. Sector funds offer high appreciation potential but may also pose higher risks to the investor.
What happens to redeemed mutual funds?
Mutual fund shares that have been redeemed are canceled. They are never reissued.
Assume an NAV of $10 and a sales charge of 5%. What is the POP?
NAV / (100% - sales charge %) = POP $10/(100%-5%) = $10/95% = $10/.95 = $10.53
(Stock Funds) Combination Funds
also called a growth and income fund, may attempt to combine the objectives of growth and current yield by diversifying its portfolio among companies showing long-term growth potential and companies paying high dividends.
A fund can charge an 8.5% sales load only if it offers what?
breakpoints, rights of accumulation, and reinvestment at NAV. (Remember, all newly formed funds offer reinvestment at NAV.)
Types of Investment Companies
face-amount certificate companies (FACs) unit investment trusts (UITs) management investment companies
Who is not permitted to receive breakpoint price reductions?
investment clubs or a parent and child above the age of majority. They are allowed for corporations, husband and wife, and a parent and child below the age of majority.
No Load
means investors pay no sales or liquidation fees.
Who can buy below the POP?
member firms. The public and nonmembers can only buy at POP.
Can mutual fund shares be used as collateral in a margin account?
mutual fund shares may be used as collateral in a margin account if they have been held fully paid for more than 30 days.
An investor buys and redeems shares at the price ______
next calculated (forward pricing)
Does the NAV per share change when new shares are issued or shares are redeemed?
no
Classes of Shares
■ Class A—front-end load that can be reduced or eliminated by breakpoints ■ Class B—back-end load that declines over time combined with 12b-1 fees ■ Class C—12b-1 fees charged quarterly with small back-end load in first year ■ Class D—level load plus a redemption fee Class B, C, and D shares cannot take advantage of breakpoint reductions. A long term investor should therefore consider the value of class A shares before making a decision. Class B-D shares are more appropriate for smaller investments.
What's the maximum POP sales charge?
8.5%
(Stock Funds) Income Funds
An income fund stresses current income over growth. The fund's objective may be accomplished by investing in the stocks of companies with long histories of dividend payments, such as utility company stocks, blue-chip stocks, and preferred stocks.
Sales at the POP
Any sale of fund shares to a customer (nonmember) must be made at the public offering price (POP). Only a member acting as a dealer or an underwriter can purchase at a discount. POP = NAV/share + sales charge
Back-End Loads
also called a contingent deferred load, is charged at the time an investor redeems mutual fund shares. The sales load, a declining percentage charge reduced annually (e.g., 8% year 1, 7% year 2, 6% year 3, etc.), 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 an extended holding period. The sales load schedule is specified in a fund's prospectus.
Unit Investment Trusts (UITs)
an investment company organized under a trust indenture and identified by several characteristics. No BOD, IAs, or active management of their own portfolios. Functions as a holding company for investors. Typically purchase other investment company shares or government and municipal bonds. They then issue redeemable shares, also known as units or shares of beneficial interest, in its portfolio of securities. Each share is an undivided interest in the entire underlying portfolio. Because UITs are not managed, when any securities in the portfolio are liquidated, the proceeds must be distributed prorata to the unit holders.. Can be fixed or nonfixed. A fixed UIT typically purchases a portfolio of bonds and terminates when the bonds in the portfolio mature. A nonfixed UIT purchases shares of an underlying mutual fund. Under the Act of 1940, the trustees of both fixed and nonfixed UITs must stand ready to redeem the units, thus providing liquidity to shareholders. Like other investment company products, UITs can be structured to meet different investment objectives, such as growth, income, balanced, or international diversification. UIT shares (units) are not traded in the secondary market; they must be redeemed by the trust.
When are 12b-1 fees charged and when are they approved?
charged quarterly, approved annually
With NAV of $10 and POP of $10.50, what is the sales charge percentage?
sales charge ($ amount)/POP = sales charge % ($10.5-$10)/$10.5 = Sales charge % .5/10.5 = 4.8%
When comparing funds with similar objectives, the investor should review information regarding their:
■ performance; ■ costs; ■ portfolio turnover; and ■ services offered.
Securities law requires that each fund disclose the average annual total returns for _ _ _ years.
1, 5, and 10 years, or since inception. Performance must reflect full sales loads with no discounts. The manager's track record in keeping with the fund's objectives as stated in the prospectus is important as well.
Backdating the Letter
A fund often permits a customer to sign a letter of intent as late as the 90th day after an initial purchase. The LOI may be backdated by up to 90 days to include prior purchases but may not cover more than 13 months in total.
Expense Ratio
A fund's expense ratio compares the management fees and operating expenses, including any 12b-1 fees, with the fund's net assets. All mutual funds, both load and no load, have expense ratios. The expense ratio is calculated by dividing a fund's expenses by its average net assets. e.g. An expense ratio of 1.72% means that the fund charges $1.72 per year for every $100 invested. Stock funds generally have expense ratios between 1 and 1.5% of a fund's average net assets. Typically, more aggressive funds have higher expense ratios. For bond funds, the ratio is typically between .5 and 1%.
Redemption of Fund Shares
A mutual fund must redeem shares at NAV within 7 calendar days of receiving a written request to do so or, if the customer holds the fund certificates, within 7 days of when the certificates and instructions for redemption are received by the custodian bank with a guaranteed customer signature. The redemption requirement may be suspended only when: ■ the NYSE is closed other than for a customary weekend or holiday closing; ■ trading on the NYSE has been restricted; or ■ the SEC has ordered the suspension of redemptions for the protection of the company's securities holders.
Letter of Intent (LOI) discounts
A person who plans to invest more money with the same mutual fund company may immediately decrease the overall sales charges by signing a LOIthat states the investor's intention to invest additional funds for the breakpoint qualification within 13 months. If the customer does not complete the additional investment within the 13 months they will be given the choice to of writing a check for the difference in the sales charges or cashing in the escrowed shares to pay the difference. The LOI is only binding on the fund but the customer must complete the investment to qualify for the reduced sales charge. Until executed, the fund holds the extra shares in escrow. Appreciation/reinvested dividends do not count toward an LOI.
Balanced Funds
Balanced funds invest in stocks (equities) for appreciation and bonds (debt) for income. The debt securities offer some downside protection when equity markets are faltering or underperforming. In a balanced fund, the different types of securities are purchased according to a formula that the manager may adjust to reflect market conditions, adding more equities or more debt when appropriate. e.g. A balanced fund's portfolio may contain 60% stocks and 40% bonds.
Investment Company Custodian
Due to Act of 1940, the investment company must place its portfolio securities in the custody of a bank or stock exchange member BD. The bank or BD acts as the custodian of the company's securities and cash. The custodian usually handles the clerical functions. The custodian must: ■ keep the investment company's assets physically segregated at all times; and ■ restrict access to the account to certain officers and employees of the investment company.
Performance (comparing mutual funds)
Fund must disclose 1, 5, and 10 year avg annual total returns. Performance must also reflect sales load w/ no discounts.
Bond Funds
Income is main objective. Some funds invest solely in investment-grade corporate bonds. Others, seeking enhanced safety, invest in government issues only. Still others pursue capital appreciation by investing in lower-rated bonds for higher yields.
When must a prospectus be used for a close-end investment company?
Like corporations only in the IPO. No prospectus is given when shares are purchased in the secondary market.
Can fractional shares of a closed-end investment company be purchased?
No, like corporate shares only full shares can be purchased.
Money Market Funds
No-load, open-end mutual funds that serve as temporary holding tanks for investors who are most concerned with liquidity. Interest rates on money market funds are not fixed or guaranteed and change often. The interest these funds earn is computed daily and credited to customers' accounts monthly. The NAV of money market funds is set at $1 per share. Although this price is not guaranteed, a fund is managed in order not to "break the buck" regardless of market changes. Thus, the price of money market shares does not fluctuate in response to changing market conditions. Money market funds and other no-load funds are both purchased and redeemed at their NAV.
Open-end (mutual fund) are required to provide enhanced disclosure in their prospectuses in a "summary section" that specifies:
1. Investment objectives 2. Costs of investing 3. Principal investment strategies, risks, and performance 4. Investment advisers and portfolio managers 5. Brief purchase, sale, and tax information 6. Financial intermediary compensation
12b-1 Asset-Based Fees
12b-1 allows a mutual fund to act as its own distributor and collect fees for promoting, selling, or undertaking activity to do with the distribution of it's shares. The fees for these activities are calculated annually at a flat-dollar amount or percentage of the avg total annual NAV and then charged quarterly. This fee is disclosed in the prospectus. Requirements: ■ 12b-1 fees can have different norms depending on share class. The maximum allowed under any share class condition is 1% of a fund's net assets. ■ The fee must reflect the anticipated level of distribution services. The payments represent fees that would have been paid to an underwriter if sales charges had been negotiated for sales, promotion, and related activities. The following 12b-1 restrictions also exist. ■ Approval: The 12b-1 plan must be approved initially and reapproved at least annually by a majority of the outstanding shares, the BOD, and those directors who are noninterested persons. ■ Termination: The 12b-1 plan may be terminated at any time by a majority vote of the noninterested directors or by a majority vote of outstanding shares. ■ Misuse of no-load terminology: A fund with a deferred sales charge or an asset-based 12b-1 fee of more than .25% of average net assets may not be described as a no-load fund.
Investment Company financial reports
Act of 1940 requires that shareholders receive financial reports at least semiannually. One of these must be an audited annual report. The reports must contain: ■ the investment company's balance sheet; ■ a valuation of all securities in the investment company's portfolio as of the date of the balance sheet (a portfolio list); ■ the investment company's income statement; ■ a complete statement of all compensation paid to the BOD and to the advisory board; and ■ a statement of the total dollar amount of securities purchased and sold during the period. In addition, the company must send a copy of its balance sheet to any shareholder who requests one in writing between semiannual reports.
Management Investment Companies
Actively manages a securities portfolio to achieve a stated investment objective. A management investment company is either closed end or open end. Initially, both closed-end and open-end companies sell shares to the public; the difference between them lies in the type of securities they market and where investors buy and sell shares.
Open-end fund sales charges
All sales commissions and expenses are paid from the sales charges collected. Sales expenses include commissions for the managing underwriter, dealers, brokers, and registered representatives, as well as all advertising and sales literature expenses. Mutual fund distributors use three different methods to collect the fees for the sale of shares: ■ Front-end loads (difference between POP and net NAV) ■ Back-end loads (contingent deferred sales loads) ■ 12b-1 sales charges (asset-based fees)
Combination Privilege
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.
Investment Company IA
BOD contracts with an outside investment adviser or portfolio manager to: ■ invest the cash and securities in the fund's portfolio; ■ implement investment strategy; ■ identify the tax status of distributions made to shareholders; and ■ manage the portfolio's day-to-day trading. The IA cannot transfer the portfolio management responsibility to anyone else and the investment company cannot lend money to its IA. Their contract is for a maximum of 2 years, but subject to annual shareholder approval. Earns a management fee, usually a set annual percentage of the portfolio's value paid from the net assets of the fund and can earn a bonus if he outperforms a market performance benchmark. This tends to be the fund's single greatest expense.
Shareholders' Right to Vote
Before any change can be made to a fund's published bylaws or objectives, shareholder approval is mandatory. In voting matters, it is the majority of shares voted for or against a proposition that counts, not the majority of people voting. Thus, one shareholder holding 51% of all the shares outstanding can determine a vote's outcome. Among the changes requiring a majority vote of the shares outstanding are: ■ changes in borrowing by open-end companies; ■ issuing or underwriting other securities; ■ purchasing or underwriting real estate; ■ making loans; ■ changing subclassification (e.g., from open-end to closed-end or from diversified to nondiversified); ■ changing sales load policy (e.g., from a no-load fund to a load fund); ■ changing the nature of the business (e.g., ceasing business as an investment company); and ■ changing investment policy (e.g., from income to growth or from bonds to small capitalization stocks).
Exchanges Within a Family of Funds
Exchange privileges (conversion privileges) allow an investor to convert an investment in one fund for an equal investment in another fund in the same family, often without incurring an additional sales charge. This exchange is considered a taxable event, and there may be tax consequences.
(Stock Funds) Foreign Stock Funds
Foreign stock funds invest mostly in the securities of companies that have their principal business activities outside the United States. Long-term capital appreciation is their primary objective, although some funds also seek current income.
(Stock Funds) Growth Funds
Growth funds invest in stocks of companies whose businesses are growing rapidly. Growth companies tend to reinvest all or most of their profits for research and development rather than pay dividends; therefore, growth funds are focused on generating capital gains rather than income.
Sales Loads
Historically, mutual funds have charged front-end loads of up to 8.5% of the money invested. This percentage compensates the sales force. Many low-load funds charge between 2 and 5%. Other funds may charge a back-end load when funds are withdrawn. Some funds charge ongoing fees under Section 12b-1 of the Investment Company Act of 1940. These funds deduct annual fees to pay for marketing and distribution costs. Rules prohibit members from assessing sales charges in excess of 8.5% of the POP on customer mutual fund purchases.
(Stock Funds) Index Funds
Index funds invest in securities to mirror a market index, such as the S&P 500. An index fund buys and sells securities in a manner that mirrors the composition of the selected index. The fund's performance tracks the underlying index's performance. Turnover of securities in an index fund's portfolio is minimal. As a result, an index fund generally has lower management costs than other types of funds.
Fund to Underwriter to Dealer to Investor (mutual fund share marketing)
Investor gives an order for fund shares to a dealer who then places the order with the underwriter. The fund then sells shares to the underwriter at the current NAV. The underwriter then sells the shares to the dealer at the NAV + concession (public offering price or POP less the dealer's reallowance/discount). Finally the dealer sells the shares to the investor at POP.
Face-Amount Certificate Companies
Issuers of face-amount certificates.
Exchange-Traded Funds (ETFs)
Legally classified as open-end investment companies or UITs but differ in some aspects. ETFs issue shares in blocks (eg 50,000 shares) called Creation Units purchased by institutional traders or investors that are then sold individually in the secondary markets. ETF investors can either sell individual shares in the secondary markets or sell Creation Units back to the ETF. ETFs generally redeem Creation Units with securities that comprise the portfolio instead of cash. Due to ETF shares' limited redeemability ETFs are not considered mutual funds.
Rights of Accumulation
Like breakpoints, these allow a customer to qualify for reduced sales charges based on total purchases. The major differences are that rights of accumulation: ■ are available for subsequent investments and do not apply to initial transactions; ■ allow the investor to use prior share appreciation to qualify for breakpoints; and ■ do not impose time limits. Customer may qualify for reduced charges when the total value of shares purchased and shares being purchased exceed a specific dollar amount. For qualification purposes, the fund bases the quantity of securities owned on the higher of either current NAV or total purchases made to date. After the total accumulation has hit a certain amount, the investor would be entitled to a lower percentage sales charge regardless of the size of future investments.
Statement of Additional Information (SAI)
Mutual Funds and closed-end funds are required to have SAIs available to investors upon request without charge. The SAI affords the fund an opportunity to have expanded discussions on such matters as the fund's history and policies. It will also typically contain the fund's consolidated financial statements. The SAI typically contains the fund's consolidated financial statements, including: ■ balance sheet; ■ statement of operations; ■ income statement; and ■ portfolio list at the time the statement was compiled.
NAV and Forward Pricing
Mutual funds must calculate the NAV at least once per day since the purchase/redemption prices are based on NAV. This is usually done after the NYSE closes at 4pm ET. The price of purchase or redemption for mutual fund shares is determined at the next NAV calculation after an order is entered. This is known as forward pricing. A Fund's NAV = Assets[i.e. cash + current value of securities] - liabilities NAV per share = ((cash + current value of securities) - liabilities)/# of outstanding shares
Continuous Public Offering Securities
Open-end investment company shares. all sales must be accompanied by a prospectus. The financial information (statements) in the prospectus must be dated not more than 16 months before the sale. With closed-end funds, only the initial public offering of stock is sold with a prospectus.
Diversified Investment Company
Qualifies if it meets the 75-5-10 test. 75% of total assets must be invested in securities issued by companies other than the investment company or its affiliates. Cash on hand and cash equivalent investments count. Within the 75%, no more than 5% of total assets are invested in securities of a single issuer. The fund does not own more than 10% of outstanding voting securities of a single issuer. Because the remaining 25% of the fund's assets does not have to be diversified in this manner, a fund could have as much as 30% of its assets invested in one company (25 + 5) and own more than 10% of a company and still call itself diversified.
Can mutual fund shares be purchased on margin?
Regulation T of the Federal Reserve Board prohibits the purchase of mutual fund shares on margin.
Restrictions on Money Market Funds
Restrictions include the following. ■ The front cover of every prospectus must prominently disclose that an investment in a money market fund is neither insured nor guaranteed by the U.S. government and that an investor has no assurance the fund will be able to maintain a stable NAV. This statement must also appear in all literature used to market the fund. ■ Investments are limited to securities with remaining maturities of not more than 13 months, with the average portfolio maturity not exceeding 90 days. ■ Investments include T-bills, commercial paper, repurchase agreements, and banker's acceptances.
Breakpoints
Schedule of quantity based purchase discounts a mutual fund offers. Available to anyone meeting the price point (breakpoint) except investment clubs or associations formed for the purpose of investing.
Breakpoint Sales
Solicited sales at dollar amounts just below the point where a breakpoint (reduced sales charges) would occur. A breakpoint sale is a violation of industry rules.
Specialized or Sector Funds
Some investment companies choose to concentrate their assets in an industry or a geographical area, such as health care, technology stocks, or northeast coast company stocks. These companies can be either diversified or non diversified depending on the 75-5-10 test.
(Stock Funds) Special Situation Funds
Special situation funds buy securities of companies that may benefit from a change within the companies or in the economy. Takeover candidates, companies with patents pending, and turnaround situations are common investments for these funds.
Asset Allocation Funds
Split investments between stocks for growth, bonds for income, and money market instruments or cash for stability. Fund advisers switch the percentage of holdings in each asset category according to the performance, or expected performance, of that group.
Tax-Free (Tax-Exempt) Bond Funds
Tax-exempt funds invest in municipal bonds or notes that produce income exempt from federal income tax. Tax-free funds can invest in municipal bonds and tax-exempt money market instruments.
Investment Companies Additional Disclosures
The SEC also requires the fund to include in its prospectus or annual reports the following: ■ A discussion of those factors and strategies that materially affected its performance during its most recently completed fiscal year ■ A line graph comparing its performance to that of an appropriate broad-based securities market index ■ The name(s) and title(s) of the person(s) primarily responsible for the fund portfolio's day-to-day management
portfolio turnover ratio
The costs of buying and selling securities, including commissions or markups and markdowns, are reflected in the portfolio turnover ratio. The portfolio turnover rate reflects a fund's holding period. Agressive growth funds usually have a turnover rate of 100% or more meaning the fund replaces its portfolio annually. e.g. turnover rate of 100% means it holds its securities, on average, for less than one year. Therefore, all gains are likely to be short term and subject to the maximum tax rate. Turnover rate of 25% has an avg holding period of 4 years and gains are likely taxed at the long-term rate.
What must mutual funds disclose even if it meets stringent disclosure and financial requirements of the SEC in its prospectus?
The following activities and the extent to which the mutual fund plans to engage in these activities: ■ Purchasing securities on margin ■ Selling securities short ■ Participating in joint investment or trading accounts or acting as distributor of its own securities, except through an underwriter
Closed-End Investment Companies
To raise capital for its portfolio it conducts a common stock offering. For the IPO, the company registers a fixed number of shares with the SEC and offers them to the public for a limited time through underwriters. The fund's capitalization is fixed unless an APO is made in the future. Closed-end shares are not redeemable by issuer and must be liquidated in the secondary market, on an exchange, or OTC. Supply/demand determine bid/ask and shares may trade at discount or premium compared to underlying value.
U.S. Government and Agency Security Funds
U.S. government funds purchase securities issued by the U.S. Treasury or an agency of the U.S. government, such as Ginnie Mae. Investors in these funds seek current income and maximum safety.
Fund to Underwriter to Investor (mutual fund share marketing)
Underwriter acts as dealer and uses its own sales force to sell the shares to the public. An investor give an order for the shares to the underwriter and the order is then filled by the fund selling the shares to the underwriter at NAV who then adds a sales charge (which is split amongst the salespeople) and sells the shares to the investor at the POP.
Cancelation of Fund Shares
When a share is redeemed by an open-end fund, the share is destroyed because the fund makes continuous public offerings and cannot be sold to other shareholders. An investor purchasing mutual fund shares recieves new shares.
Fund to Investor (mutual fund share marketing)
When an open-end investment company distributes shares directly to the public with no sales charge. i.e. a no-load fund Funds that offer shares with a 12b-1 fee of less than .25% may also be referred to as no-load funds.
Computing the Sales Charge Percentage
When the NAV and the POP are known, the sales charge percentage can be determined as shown: POP - NAV = sales charge ($ amount) sales charge ($ amount)/POP = sales charge % If NAV and sales charges are known, the the formula for POP is: NAV + sales charge ($) = POP ($) Prospectus must include formula for determining NAV and the added sales charge. the sales charge is always based on the POP and the POP can be determined as follows: NAV/(100% - sales charge %) = POP
Which investment company type offers guaranteed marketability?
a mutual fund must redeem shares at the net asset value. Unlike other securities, mutual funds offer guaranteed marketability: there is always a willing buyer for the shares—the fund itself.
Dual-Purpose Funds
closed-end funds that meet two objectives: investors seeking income purchase income shares and receive all the interest and dividends the fund's portfolio earns, and investors interested in capital gains purchase the gains shares and receive all gains on portfolio holdings. The two types of shares in a dual fund are listed separately in the financial pages of major newspapers.
What types of securities can closed-ends issue?
common, preferred, and bonds like corporations.
face-amount certificate
contract between an investor and an issuer in which the issuer guarantees payment of a stated (or fixed) sum to the investor at some set date in the future. In return for this future payment, the investor agrees to pay the issuer a set amount of money either as a lump sum or in periodic installments. If the investor pays for the certificate in a lump sum, the investment is known as a fully paid face-amount certificate. Very few face-amount certificate companies operate today because tax law changes have eliminated their tax advantages.
Lifecycle Funds
initially invest in more risk-oriented securities and become increasingly conservative and income-oriented as a specified retirement date approaches. structured as "funds of funds" so that investing in one generally means that you are invested in a number of funds offered by the same fund family. Companies offering lifecycle funds add new ones for distant target dates as they are needed and some are set up to have the lifecycle fund automatically roll into one of the fund families' more conservative funds, such as an income fund, when the target date is reached.
Investment Company Underwriter
often called the sponsor or distributor is appointed by the BOD and receives a fee for selling and marketing the fund shares to the public. Open-end investment company sells shares to the underwriter at NAV but only as the underwriter needs in order to fill customer orders. Underwriter is prohibited from maintaining an inventory of open-end company shares and is compensated by adding a sales charge to the shares' NAV when sold to public. A mutual may not act as its own distributor or underwriter except for no-load and 12b-1 funds.
Funds of Hedge Funds
registered mutual funds available to all investors that invest primarily in unregistered hedge funds known as funds of hedge funds. They can target and diversify among several hedge funds and, in this way, give non-accredited investors access to hedge funds. These funds share some of the benefits and risks associated with hedge funds. One benefit could be that lower initial investments might be required than when investing directly in a hedge fund. In contrast, one risk to note is that like all mutual funds, the shares are not traded and that divesting of them can only occur if the mutual fund company redeems them. Recommendations of funds of hedge funds would need to include the specific risks associated with hedge funds and the transfer of those risks that occurs when mutual funds invest in hedge funds.
Funds of Hedge Funds
registered mutual funds available to all investors that invest primarily in unregistered hedge funds. They can target and diversify among several hedge funds and, in this way, give non-accredited investors access to hedge funds. These funds share some of the benefits and risks associated with hedge funds. Usually have a lower initial investment required than a hedge fund. In contrast, one risk to note is that like all mutual funds, the shares are not traded and that divesting of them can only occur if the mutual fund company redeems them. Recommendations of funds of hedge funds would need to include the specific risks associated with hedge funds and the transfer of those risks that occurs when mutual funds invest in hedge funds.
Open-End Investment Companies (Mutual Funds)
registers an open offering with the SEC. With this registration type, the open-end investment company can raise an unlimited amount of investment capital by continuously issuing new shares. Conversely, when investors liquidate holdings in a mutual fund, the fund's capital shrinks because the fund redeems shares. The offering never closes because the number of shares the company can offer is unlimited. Any person who wants to invest in the company buys shares directly from the company or its underwriters at the public offering price (POP). A mutual fund's POP is the net asset value (NAV) per share plus a sales charge. Cannot have more than one class of security (common stock) issued, because they are allowed to borrow from banks, and must maintain a minimum asset-debt ratio of 300% (3:1).
Front-End Loads
the charges included in a fund's public offering price. The charges are added to the NAV at the time an investor buys shares. Front-end loads are the most common way of paying for the distribution services a fund's underwriter provides. e.g. An investor deposits $10,000 with a mutual fund that has a 5% front-end load. The 5% load amounts to $500, which is deducted from the invested amount. A total of $9,500 would be invested in the fund's portfolio on the investor's behalf.
Changes in NAV
■ NAV per share increases when portfolio securities increase in value or when the portfolio receives investment income. ■ NAV per share decreases when portfolio securities decrease in value or when portfolio income and gains are paid to shareholders. ■ NAV per share does not change when shares are sold or redeemed or when portfolio securities are bought or sold. In these circumstances, the fund exchanges securities for cash so that the NAV per share remains unchanged.
ETF advantages compared to open-end companies (mutual funds)
■ Pricing/ease of trading: ETF shares are traded on exchanges and can be bought/sold anytime at market price whereas mutual funds use forward pricing and are usually priced once at the end of the trading day. ■ ETFs can be bought and sold short on margin whereas mutual funds cannot. ■ ETFs generally have lower operating costs/expenses than mutual funds. ■ ETFs sometimes distribute capital gains to shareholders like mutual funds but this is rare. Since this is rare, there are no other tax implications until investors sell their shares.
ETF disadvantages compared to open-end companies (mutual funds)
■ Purchase/sale of ETF shares is a commissionable transaction which can counter the low-expense advantage making them less suitable for frequent trading or investing with smaller sums of money. ■ Excessive trading can result due to the easy of trading ETFs and can erode the advantages of a diversified portfolio and other advantages through the commissions due for each trade.
Sales Charge Reductions Max permitted sales charge of 8.5% will be reduced to 6.5% if an investment company does not offer certain features. To qualify for the 8.5% charge, the company must offer:
■ breakpoints—a scale of declining sales charges based on the amount invested; ■ rights of accumulation; and ■ automatic reinvestment of distributions at NAV. All newly formed mutual funds offer automatic reinvestment of distributions at NAV.
Investment Company BOD
■ defines the type of fund(s) to offer (e.g., growth, income, or sector); ■ defines the fund's objective; and ■ approves and hires the transfer agent, custodian, and investment adviser. Investment company board members must serve terms that are no less than one year but not longer than five years.
A company must register with the SEC as an investment company if it:
■ is in the business of investing in, reinvesting in, owning, holding, or trading securities; or ■ has 40% or more of its assets invested in securities (government securities and securities of majority-owned subsidiaries are not used in calculating the 40% limitation).
Investment Company Transfer Agent functions
■ issuing, redeeming, and canceling fund shares; ■ handling name changes for the fund; ■ sending customer confirmations and fund distributions; and ■ recording outstanding shares so distributions are properly made. The transfer agent may be the fund custodian or a separate service company. The fund pays the transfer agent a fee for its services.
An investment company may not register with the SEC or issue securities to the public unless it has:
■ private capitalization (seed money) of at least $100,000 of net assets; ■ 100 investors; and ■ clearly defined investment objectives which may only be changed by a majority vote of outstanding shareholders
In filing for registration, an investment company must identify:
■ the type of investment company it intends to be (i.e., open-end or closed-end); ■ plans the company has to raise money by borrowing; ■ the company's intention, if any, to concentrate its investments in a single industry; ■ plans for investing in real estate or commodities; ■ conditions under which investment policies may be changed by a vote of the shares; ■ the full name and address of each affiliated person; and ■ a description of the business experience of each officer and director during the preceding five years.
