Section 3 - Client Investment Recommendations and Strategies
If a corporation has 100,000,000 shares outstanding with a current market value of $20.50 a share, their market capitalization is:
$2,050,000,000 The market capitalization value of a corporation is determined by multiplying the number of issued and outstanding shares of common stock by the current market price of one share. This would be a mid-cap company. Companies with between $2 Billion to $10 Billion are mid-cap companies.
During the calendar year, a client had $2,000 in short-term capital gains and $6,000 in long-term capital losses. What is the tax implication for the year?
$3,000 deductible as capital losses with a $1,000 carry over IRS rules permit investors to net their capital gains against their capital losses dollar for dollar. The $2,000 in short-term capital gains may be netted against the $6,000 in capital losses to arrive at a final position of $4,000 in capital losses. However, tax rules only allow investors to write off a maximum of $3,000 in capital losses in any given year, so $1,000 of the net capital loss would carry over to next year.
Your client has invested $10,000 each in three different stocks. Stock A pays a $200 dividend. Stock B pays a $600 dividend. Stock C pays no dividend. After one year, stock A's value is down 20%, stock B's value is up 5%, and stock C's value is up 7%. What is the total return?
0 % Total return is yield plus growth (or minus depreciation in this case). First, let's look at the dividends paid. Stock A paid $200. Stock B paid $600. In total, these two stocks paid $800 in dividend income. Now let's figure out the growth (or depreciation as the case may be). Stock A went down 20%, which is -$2,000. Stock B went up 5%, which is +$500. Stock C went up 7%, which is +$700. Now you need to add those together, -2000 +$1200 = -$800 in depreciation. Take the dividends of +$800 minus the depreciation of $800 and you are at a 0% total return.
An investor buys a stock at $500 per share, receives a dividend of $5, and sells the stock for $550 one year later. What is his or her total return?
11% This investor has a $50 capital gain plus $5 in dividends for a total return of $55. To find the total return as a percentage, divide $55 by the $500 paid for the stock. The answer is 11%.
An investor purchased 100 shares of common stock for $50 a share on July 1, 2010. On July 1, 2011, the investor sold the shares for $55 a share. During the holding period, he or she received $2 per share in dividends but, according to the Consumer Price Index, inflation increased by 3%. What was this investor's total return?
14 % Total return calculations on stock include both dividends and gains. In this case, the investor had a $5 capital gain plus $2 in dividends ($7) during the year. Divide $7 by the price paid for the stock ($50) to find the total return of 14%. Do not confuse total return with yield, which is based only on earnings. The investor's yield was only 4%, which can be found by disregarding the capital gain and dividing the dividends earned ($2) by $50. The Consumer Price Index (CPI) is considered when calculating inflation-adjusted (or real) return
In 2011 under Federal Gift Tax rules, which of the following gifts is taxable?
15,000 gift to a child Under the Federal Gift Tax rules in 2011, an individual may give up to $13,000 per year to any number of individuals without generating the Federal Gift Tax. Since the $15,000 gift to one child exceeds this amount, $2,000 would be taxable to the donor. However, gifts to charities or to spouses are exempt from the gift tax. Please know the current year's gift tax exclusion for your exam.
A client bought 100 shares of XYZ common stock at $50 and sold it one year later for $60. During the holding period, the client received dividends of $2 per share. The client is in a 35% combined tax bracket. The after-tax total return was?
16 % First, determine the client's before-tax total return by dividing $12 by the $50 invested, which is 24%. The $12 is the total of the $10 long-term capital gain and the $2 received in dividends. The only tax rate you are given is 35% so you must use that. Next, determine how much of the $12 the investor will be able to keep after paying 35% of it in taxes, which is $7.80. Now, divide the $7.80 by the $50 invested to find the after-tax total return of about 16%.
An investor bought a stock for $95 and sold it one year later for $100. During the year, the investor received $3 in dividends. If the investor is in a 28% combined tax rate, what was the after-tax yield?
2.3 % Again, since this question is asking about yield rather than total return, disregard the capital gain - it is just there to trick you! If the investor received $3 in dividends taxable at the rate of 28%, then he would only have $2.16 left after paying taxes. To calculate the after-tax yield, divide the $2.16 by the $95 purchase price, which is about 2.3%.
Your client Jim bought a house in 2000 for $150,000. He is single. He just recently sold his house for $350,000. How much of the gain is taxable?
200,000 When a person sells a home that has been his or her primary residence for two out of the last five years, he or she is allowed to exclude some of the gain from taxable income. If your client is single, then he or she may exclude up to $250,000 of the gain from taxable income. If your client is married filing jointly, he or she may exclude up to $500,000 of the gain from taxable income. This is a significant tax break! So if the answer choice of zero had been available to you, under current tax law, that would be the right answer. But, it just so happens sometimes, that the right answer isn't there. So this question must not be aware of the current tax law, and the 200K gain is taxable.
An investor bought a stock for $95 and sold it one year and one day later for $100. During the year, the investor received $3 in dividends. What was the yield?
3.2 Do not confuse yield with total return. Yield formulas are based upon earnings, not appreciation or capital gains. In this case, simply divide the annual dividends of $3 by the purchase price paid of $95 to find that the yield is about 3.2%.
An investor bought shares of an open-end mutual fund for $10 a share on July 1, which appreciated in value to $12 a share by June 30 of the following year, when he redeemed them. If, during the year, the mutual fund also paid a dividend of $1 per share, what was the investor's total return?
30 % Total return is the rate of return that incorporates the return on investment from all sources including appreciation, dividends, and interest. Total return on a mutual fund includes the change in price of the shares plus any dividend or capital gain distributions expressed as a percentage of the original investment. This investor had a $2 capital gain upon redemption plus $1 in dividends, so $3 divided by $10 equals a 30% total return.
You bought a bond at par with a 4% nominal yield. After two semi-annual interest payments, the bond is called at a 3% premium. What is the bond's total return?
7 % Total return is yield plus growth. The dividends paid over one year are $40 (4% nominal yield). The bond was called at $1,030, which is $30 of growth. The total of $70 divided by what was paid for the bond (par) = 7%
Which of the following is a true statement? BA Traditional IRA must begin distributions by 70 1/2
A Traditional IRA must begin distributions no later than April 1st of the year after the client turns 70 1/2. Roth IRAs do not follow the RMD rule. Variable annuities have early withdrawal penalties on withdrawal taken under age 59 1/2. The rate of return on a variable annuity depends upon the performance of the various sub-account selected by the investor. The rate of return is not guaranteed on a variable annuity.
A contrarian investor
A contrarian investor is one who does the opposite of what most investors are doing at any particular time. According to contrarian opinion, if everyone is certain that something is going to happen, it probably is not going to happen.
Under ERISA, an adviser managing a pension plan is considered to be a fiduciary. His or her main responsibility is to manage the plan's assets for the benefit of the employee participants.
A large corporation appoints you to manage their pension plan. Under ERISA, your main fiduciary duty is to: The employees covered by the plan
All of the following are true about indexing EXCEPT: AA portfolio manager choosing indexing must invest in mutual funds BIndexing is considered to be a passive strategy CIndexing is one way to maintain a diversified portfolio DCosts are generally lower for indexed portfolios
A portfolio manager choosing indexing must invest in mutual funds While many mutual fund portfolio managers use the passive strategy of indexing because it helps with diversification and lowers expenses, they do not have to.
The Dow Jones Industrial Average tracks the performance of 30: ALarge-cap companies
Although there are separate Dow averages for 20 transportation companies and 15 utility companies, the DJIA tracks the performance of 30 companies whose stocks are considered to be blue chips or large-cap stocks. The DJIA average is the oldest and most quoted market indicator.
Which of the following would be considered to be passive investment strategies?
An asset allocation with a periodic rebalancing strategy (also known as a strategic asset allocation), a buy and hold strategy, and a portfolio indexing strategy are all considered to be methods of passive portfolio management rather than active. Passive strategies tend to generate less in the way of expenses since portfolios are relatively fixed. However, tactical asset allocation, which uses market timing to shift portfolio assets in order to take advantage of temporary opportunities, is considered to be an active strategy.
Who is most suitable for investing in a portfolio of municipal bonds? AAn investor in a 10% tax bracket BA large pension plan CAn investor in a 33% tax bracket DA retired school teacher
An investor in a 33% tax bracket Due to the fact that interest on a municipal bond is federal income tax free, municipal bonds are most suitable for investors in high tax brackets. Qualified retirement plans generally do not invest in municipal bonds because the earnings are tax-deferred anyway. You do not know the tax bracket of the retired school teacher. Municipal bonds generally have lower yields than corporate bonds and as such, are of little value to investors in low tax brackets who already pay little in taxes.
The best measurement of performance for comparison purposes is: AReal return BHolding period return CAnnualized return DTotal return
Annualized Return Rates of return are more comparable if they are converted into annual figures. If the holding period is less than a year, the simple annualized return is the holding period return multiplied by the number of holding periods in a year. For example, if an investor has a six month holding period return of 5%, the simple annualized return would be 10% since there are two six month holding periods in a year. If the holding period is more than a year, compound annualized returns are calculated assuming that the investment also pays on accumulated returns as well as returns on the initial investment.
nano-cap companies have a market cap of less than $50 million; micro-cap companies have a market cap of $50 million to $300 million; small-cap companies have a market cap of $300 million to $2 billion; mid-cap companies have a market capitalization of $2 billion to $10 billion; large-cap companies have a market cap of $10 billion to $200 billion; and mega-cap companies have a market capitalization of $200 billion plus.
Caps
In the OTC market, the difference between a market maker's bid and ask prices is known as the: The Spread
Commissions are charged by brokers when executing agency transactions on behalf of their customers. Although OTC market makers (or dealers) do charge mark-ups when selling out of their inventory to customers and mark-downs when buying for their inventory from customers, the difference between their quoted bid and ask price is known as the spread. Generally, the more active the market on a stock, the narrower (closer) the spread will be.
IRA Contributions
Contributions to a Roth IRA are never tax deductible but qualified distributions are tax free. The 70 1/2 rule does not apply to Roth IRAs but it does apply to Traditional IRAs. Contributions to a Traditional IRA are deductible only if the participant is not covered by any other qualified plan or if their annual income is below a specified level.
Dollar Cost Averaging
Dollar Cost Averaging is a portfolio funding technique that requires an investor to invest the same amount of money in the same stock or mutual fund over a period of time regardless of price. Of course, investing the same amount of money in the same stock will not always buy the same number of shares. In a fluctuating market, the investor's average price will always be lower than his average cost, although the investor could still lose money in a down market.
A 50 year old client hires you to manage his or her retirement portfolio. The time horizon for the portfolio should be:
His lifetime The time horizon for a portfolio is the length of time the money will remain invested even if the investor takes some income out from time to time. For example, an investor saving to send a child to college in 10 years has a relatively short time horizon. However, an investor planning for retirement has a time horizon of their expected lifetime.
Which of the following would be considered to be passive investment strategies? I. Asset allocation with periodic rebalancing II. Buy and hold III. Indexing IV. Tactical asset allocation
I. Asset allocation with periodic rebalancing II. Buy and hold III. Indexing
A client in a 30% tax bracket has a 6% CD maturing shortly. If he or she elects to reinvest the money in a municipal bond instead, the bond should have an equivalent yield of: 4.2 %
If the customer is in a 30% tax bracket, he or she would only have 70% of the 6% earned left after paying taxes, which would be 4.2%. For example, 6% of a $10,000 CD is $600 but since interest earned on CDs is taxable as ordinary income, the investor would have to pay 30% (or $180) of the $600 in taxes; therefore, he or she would only have $420 left. If he or she instead invested the $10,000 in municipal bonds, which are federal tax free, a 4.2% rate of return would be equivalent.
Which of the following is true about a portfolio manager who engages in market timing in an attempt to beat the market? AHe or she is engaged in a tactical asset allocation strategy
It is tactical asset allocation that engages in market timing in an attempt to beat the performance of the market. To accomplish this, deviations from the normal asset mix are intentionally made in response to perceived changing market opportunities. Often, portfolio managers rely on business cycle analysis involving economic forecasting to determine when to deviate from the normal asset mix.
A 35 year old female makes $85,000 a year, which supports both her and her 7 year old daughter comfortably. If she inherits $250,000 of GM stock, her most immediate concern should be:
Lack of Diversification Although this question is subjective, the most immediate concern would be the unsystematic risk related to owning just one stock, which could be reduced by diversification.
Owners of all of the following types of companies have limited liability EXCEPT:
Limited Partnership LPP Limited partners in a limited partnership have liability that is generally limited to the amount they invested. However, due to their active role in management, the general partners in a limited partnership have unlimited liability. Remember, to form a limited partnership, there must be at least one general partner and one limited partner. Note that stockholders in both C and S corporations and owners of LLCs also have limited liability.
Market capitalization is
Market capitalization is determined by multiplying the company's current stock market price by the number of shares outstanding. Although there are more than just large-cap, mid-cap and small-cap, these are the three we talk about most commonly within the industry.
When an adviser uses randomly generated behaviors of various asset classes to determine the possible outcomes for an investor's portfolio, he or she is utilizing which of the following?
Monte Carlo simulations The question describes a Monte Carlo simulation. The Random Walk theory, also known as the Efficient Market theory, states that it is impossible to beat the market over a period of time so it is best to simply build a diversified portfolio that moves with market averages. Modern Portfolio theory states that diversification only works when funds are invested in assets whose prices move inversely to each other. A contrarian investor does the opposite of what most investors are doing at any particular time.
Which of the following investments is least suitable for an IRA? AMunicipal bonds BStocks CU.S. Government bonds DCorporate bonds
Municipal Bonds Earnings in an IRA are tax-deferred so it is usually best to fund your IRA with higher yielding investments. Since the interest paid on municipal bonds is exempt from federal income tax, they generally have lower yields than other types of bonds. Although neither growth nor dividends are guaranteed on stocks, they have kept up inflation as measured over a period of time so they are suitable for most IRA investors.
Selling a Stock Short MUST be done in a Margin Account
Options may be purchased either in a cash account or in a margin account. Since they have no loan value, they must be fully paid for in cash on the settlement date. However, all short sales of stock must be done in a margin account. Open-end mutual funds must be purchased in a cash account since new issues sold in the primary market are not marginable.
Which form of business ownership is the easiest to set up? APartnership BS Corporation CC Corporation DLimited Liability Company (LLC)
Partnership Generally, a sole proprietorship is the easiest type of business to set up but it was not one of these four choices. Of these choices, the Partnership would be the easiest to set up. The LLC requires that Articles of Organization are filed with the State. To establish an S Corporation or a C Corporation, Articles of Incorporation must be filed with the Secretary of State. The business organization with the least amount of paperwork is a Partnership, therefore, it is the easiest to set up.
Which of the following rollovers is not permitted? ATraditional IRA to a Roth IRA BRoth IRA to another Roth IRA CRoth IRA to a 401(k) DSimple IRA to a Roth IRA
Roth IRA to a 401(k) You cannot rollover from a Roth IRA into a 401(k). You can rollover from a 401(k) into a Roth IRA. A Roth IRA rollover into another Roth IRA is allowed as is a Traditional IRA to a Roth IRA rollover. You may rollover from a Simple IRA into a Roth IRA as well.
C corporations do pay taxes
S corporations and limited partnerships are both flow through tax entities with the business itself owing nothing in taxes. Taxes for both of these types of businesses are owed by the owners of the business. A C corporation is subject to double taxation. First, the corporation owes taxes before it pays out the dividend to its shareholders. Second, the dividend received by the shareholders is also taxable.
Which ERISA provision protects employers from employee lawsuits related to investment decisions made by the employee in their retirement account?
Safe Harbor Provision in Section 404(c)
The basis for measuring risk-adjusted return is the rate of return currently being paid on which of the following?
Short Term T- bills To calculate risk-adjusted return on a stock or a portfolio, you would need to know the current interest rate on short-term T-bills (which are considered to be risk free), the Beta of the stock or portfolio, and its actual rate of return. For example, suppose a portfolio earns 10%, has a Beta of 2, and that the current interest rate on short-term T-bills is 4%. The risk-adjusted rate would be 4% + (6% / 2), or 7%.
Which of the following business structures would pay tax as an entity? ALLC BPartnership CS corporation DSole proprietorship
Sole Proprietorship This is quite a bizarre question. Just like the real test, it must be trying to get at something. They all seem to be flow through entities but you have to pick one. When you own a sole proprietorship, you pay your taxes owed on your personal 1040, schedule C. If you had more than one business, you would have more than one schedule C with the two businesses income and expenses listed separately. This is the only possible correct answer. As a member of an LLC, you get a K-1. S corps are also flow through tax entities as well. A partnership does not pay taxes as an entity either. So it must be sole proprietorship; it is the least evil answer!
An investor seeking to track the performance of medium sized companies should refer to which of the following indexes?
Standard and Poor's 400 Indexes and averages are used to measure and report value changes in representative stock groupings. The DJIA tracks 30 industrial large blue chip companies. S&P maintains several indexes including the 400 for mid-cap companies, the 500 for large exchange listing companies, and the 600 for small-cap companies
Which of the following is not an asset class used in determining the allocation of a portfolio? ACommon stock BStock options CReal estate DDebentures
Stock options Since they are intangible and may expire worthless, stock options (puts and calls) are not considered to be an asset class. Asset classes include cash equivalents, stocks, bonds, real estate, precious metals, collectibles, and industry groupings of common stocks, such as large-, mid- and small-cap stocks.
An investor's real rate of return on an investment may be found by:
Subtracting out inflation
A client has $200,000 to invest for two years. During that time, he or she would like to maximize returns while taking minimal risk. What would you recommend? AIndexed mutual funds BLarge 'cap' stocks CMunicipal bonds DT-bills
T-Bills Questions regarding the suitability of recommendations should be answered after carefully considering the client's investment objectives. While common stocks and mutual funds may do well over a period of time, this investor only has money to invest for two years and wants minimal risk. While municipal bonds are safe, they also have low yields and since we do not know the client's tax bracket, we cannot assume that they would maximize his or her returns. Only go with municipal bonds if the question gives you a high tax bracket for the client. So, it appears that T-bills would be most suitable since they are safe and short-term.
The 10% penalty for premature IRA distributions
The 10% penalty for premature IRA distributions is waived (up to $10,000) for first time home buyers for the purpose of buying a principal residence, not a second home. Penalties are also waived for early annuitization, medical expenses, college expenses, death, or disability. Although the 10% penalty may be waived, distributions may still be taxable.
A 5.2% municipal bond issued by the state of Florida is purchased by an Arizona investor who is in a 27% marginal federal income tax bracket and a 3% marginal state income tax bracket. The investor's after-tax yield is approximately: 5.04 %
The 5.2% ($52) of nominal interest is exempt from federal income tax but since the investor does not live in the same state that issued the bond, the interest is subject to state income tax at the rate of 3%. So, 97% of the interest is tax free and 3% is not. Multiply .052 by .97 to find the after-tax yield of about 5.04%.
'Expected return' may be measured by which of the following? Capital Asset Pricing Model
The Capital Asset Pricing Model says that the expected return of a security or a portfolio is equal to the rate of return on a risk-free security (T-bill) plus a risk premium. Beta and the Sharpe Ratio are used to measure risk adjusted return. Black Scholes is an options pricing model.
What is the best definition of a benchmark portfolio? A pre-determined set of securities used to compare the performance of an actual portfolio
The best definition is that a benchmark portfolio is a pre-determined set of securities (such as the S&P 500) used to compare the performance of an actual portfolio.
A client bought a 5% corporate bond in the secondary market for 97. One year later, he or she sold the bond for 101. What is the total return in dollars? 90.00
The nominal interest rate of 5% on this bond is based upon its par value of $1,000, not its present market value. So, 5% of $1,000 is $50. This is the interest that the investor earned during the year. He also sold the bond for 101 ($1,010), which is $40 more than the 97 ($970) he paid for it; therefore, his total return is $90 ($50 interest + $40 capital gain). To find his total return as a percentage, divide the $90 by the $970 purchase price, which is almost 9.3%.
An investor buys a stock for $100, receives dividends of $3 and sells the stock for $115 after holding for only three months. His or her return of 18% is which of the following? I. Total return II. Holding period return
The return is both the total return (which describes that both dividends and capital gains are included) and a holding period return (which describes that the return is calculated over the three month investment period rather than annualized).
All of the following are true about indexed portfolios EXCEPT:
They are designed to outperform the underlying index Managers of indexed portfolios seek to match the performance of the index, not to outperform it. Indexing is a passive strategy that is usually based upon a benchmark portfolio such as the S&P 500. Indexing often results in lower expenses. However, indexed portfolios may be subject to a tracking error, which is defined as any deviation between the index and the portfolio designed to replicate it.
Martha is 58 years old and nearing retirement. She is more interested in safe investing and income. Which of the following would be the most suitable investment for her? Treasury Bonds
To answer a question such as this, I suggest that you make a mini "risk spectrum." Listing these four choices from safest to riskiest, you have: T-bills, T-bonds, muni bonds, and mutual funds. Now, review the client's investment objective - safe investing and income and look at your choices again. Are there any that you can get rid of right off the bat? Who is the only type of client that you should sell muni bonds too? Rich people! So that one is out! Your riskiest choice left is mutual funds. Does that seem suitable for Martha who is looking for safety and income? No way! So mutual funds are also out! This leaves you with two last choices: treasury bills and treasury bonds. They are both safe. That is agreed. But which one will normally pay more in interest? The Treasury bond would! That is your answer! The yield on the T-bill would normally be lower than that of the T-bond and there was nothing in this question that said she wanted the most conservative choice, or had to have the money in a year or two. Try that method with all of your suitability questions - it usually works really well!
You buy a bond at par with a 4% nominal yield. The current market price of the bond is 101. What is the bond's current yield? 3.9 %
To figure current yield, take the annual interest of $40 divided by the current market price of $1,010 = 3.96%. You know that the current yield has to be less than the nominal yield because the current market price is more than par (at a premium).
A measurement of performance that takes into consideration yield plus growth is used to determine an investor's:
Total Return Total return is defined as yield plus growth. Yield comes from earnings such as interest or dividends and growth comes from unrealized appreciation. For example, an investor paid $10 for a stock. During the year, the stock paid $1.00 in dividends and increased in value to $11. The total return would be 20%, which could be found by dividing $2 by $10.
A self employed married client with four young children has annual adjusted gross income of $250,000. In order to increase retirement income, he or she should invest in which of the following:
Traditional IRA The only choice that would work in this situation would be the Traditional IRA. Married persons filing jointly with adjusted gross income (AGI) of $179,000 or more may not contribute to Roth IRAs. Anyone with earned income, regardless of amount, may contribute to Traditional IRAs. Further, married persons filing jointly with AGI of $220,000 or more may not contribute to ESAs. 403b plans are only for employees of non-profit public educational institutions, religious affiliates, or charities (501c-3s). These are the limits in effect in 2011. Please know the current year's applicable limits.
Under ERISA rules regulating pension plans, fiduciaries are prohibited from doing which of the following? I. Investing more than 10% of the plans' assets in securities issued by the employer II. Allowing the employer to loan money to the plan III. Allowing the plan to loan money to the employer IV. Allowing the employer to sell property to the plan
Under ERISA (Employee Retirement Income Security Act), fiduciaries are obligated to protect pension plan participants so all of these are prohibited.
A 70 year old retiree who wants current income but ready access to his funds should invest in which of the following?
VA, LPP, CD, MMF Money Market is Answer Money market funds provide relative safety, liquidity, and current income. Both CDs and variable annuities are subject to surrender charges so they are not viable. There is no secondary market for limited partnership units.
Which type of portfolio would be considered to be most volatile? A90% stocks, 10% bonds
Volatility is the tendency for a security or market to rise and fall sharply within a short period of time. The term is used to describe the size and frequency of fluctuations in price. Generally speaking, stocks are more volatile than bonds, so the more stocks in a portfolio, the more volatile it is. Volatility of particular stocks is measured by assigning an alpha factor, while market-related volatility, also known as systematic risk, is measured by Beta.
Subtracting Out Inflation
When prices are changing rapidly due to inflation, the stated or nominal rate of return on an investment may not be a very good indicator of the actual return. It may be better to measure the investor's real return (or inflation-adjusted return) by adjusting for the rate of inflation. For example, if an investor invests $100 today and receives $106 a year from now, his nominal rate of return was 6%. However, if inflation during this time was 2%, his real rate of return was only about 4%.
Yield to maturity (YTM)
Yield to maturity (YTM) is used to measure yields on bonds, not stock. It is the return on investment an investor would receive if he or she purchased the bond today at its market price, held it to maturity, and received all of the bond's interest and principal payments. However, to find the total return on stock, you would need to determine the amount of appreciation (or gain) plus dividends and divide them by the investor's purchase price.
