Chapter 7

administrative charges

Administrative charges are deducted from the net assets of an investment company and used to pay various costs including the payments that are made to custodian banks and/or transfer agents.

advantages of mutual funds

*diversification, professional management, liquidity, convenience and cost, trades at net value (NAV)*

Three distributions methods for a mutual fund

1.) fund→ principal underwriter→ dealers → investors 2.) fund→ principal underwriter→ investors 3.) fund→ investors

availability of breakpoints and rights of accumulation and LIOs

Breakpoints, letters of intent, and rights of accumulation may be made available to any of the following: An individual purchaser A purchaser's immediate family members (i.e., spouse and dependent children) A fiduciary for a single fiduciary account A trustee for a single trust account Pension and profit-sharing plans that qualify under the Internal Revenue Code guidelines Other groups, such as investment clubs, provided they were not formed solely for the purpose of paying reduced sales charges Before mutual fund shares are purchased by a client, an RR must inquire as to whether the client owns other mutual funds within the same fund family in a related account—even if the account is held by another broker-dealer. For a fund to assess the maximum allowable sales charge of 8.5%, it must offer investors both breakpoints and rights of accumulation. If the fund omits either of these features, the maximum sales charge it's permitted to assess is lowered according to a set schedule.

class A shares

Class A shares usually have *front-end loads, but have small or nonexistent 12b-1 fees.* In addition, investors who purchase large amounts of shares within the same fund family may be able to take advantage of reduced sales charges through the use of breakpoints or rights of accumulation (both of which are described below). The disadvantage of Class A shares is that not all of the investor's money is directed into the portfolio. For example, if an investor purchases $1,000 worth of Class A shares of a common stock fund that has a 5% sales charge, only $950 is invested in the fund. The $50 is deducted as a sales charge and benefits the selling brokers.

class C Shares

Class C shares assess an *up-front sales charge, which is usually 1%, plus many assess an annual 12b-1 fee or level load that's usually equal to 1% of the fund's assets*. In some cases, an investor may also pay a contingent deferred sales charge if the shares are sold within 12-to-18 months after being purchased.

closed-end investment companies

Closed-end investment companies are the other type of management company. Unlike open-end management companies (mutual funds), closed-end funds typically conduct a *one-time issuance of common shares* to the public. Although they may issue additional shares later, they don't continuously issue new shares or stand ready to redeem their shares for cash. Beyond issuing common shares, closed- end funds may also issue senior securities (i.e., preferred stock or bonds). After a closed-end investment company issues its shares, these shares trade in the *secondary market.* Therefore, an investor who wants to purchase shares in a closed-end investment company will buy them on a traditional exchange (e.g., the NYSE or Nasdaq). As these securities trade in the secondary market, there's no prospectus delivery requirement. *Additionally, the shares are able to be purchased on credit (i.e., they're marginable).* The price that an investor pays for shares is determined by supply and demand. Unlike mutual funds, closed-end funds may trade at prices that are at a discount or a premium to NAV. When closed-end funds are purchased or sold in the secondary market, the investors pay commissions rather than sales charges.

dollar cost averaging (DCA)

Dollar cost averaging is a popular method of investing in mutual funds in which a person *invests a fixed- dollar amount at regular intervals, regardless of the market price of the shares.* An investor who uses dollar cost averaging is ultimately buying *more shares when the price is low and fewer shares when the price is high.* Dollar cost averaging lessens the risk of investing a significant amount of money at the wrong time and is especially appropriate for *long-term investors*, such as those investing for retirement.

equity income funds

Equity income funds invest in companies that pay *high dividends* in relation to their market prices. These funds usually hold positions in mature companies that have less potential for capital appreciation, but are also less likely to decline in value than growth companies.

diversification

Essentially, the diversification in a mutual fund is exemplified by the adage, "don't put all your eggs in one basket." Diversification allows investors to reduce their risk by spreading their money among many different investments.

prohibited sales practice

FINRA has established rules that address different violations relating to the sale of investment company securities. Some of FINRA's concerns involve RR s who ignore the best interest of their clients and attempt to maximize their sales commissions by ignoring discounts that may be available to clients. violations are on the following few cards

confirmation disclosure

If customers purchase investment company shares that assess a deferred sales charge at redemption, FINRA rules require that they be provided with a written disclosure which includes the following statement: "On selling shares, an investor may pay a sales charge. For details on the charge and other fees, see the prospectus." Although no sales charge is assessed at the time that Class B shares are purchased, RRs may not attempt to sell them as the equivalent of a *no-load.*

12b-1 charges (distribution fees)

In a 12b-1 arrangement, mutual funds may pay for distribution expenses through deductions from the portfolio's assets. These 12b-1 charges are used to pay the costs of distributing the fund's shares to the public and will cover expenses such as sales concessions and the costs associated with advertising and the printing of the prospectus. A *12b-1 fee is an ongoing asset-based charge that's deducted from the customer's account on a quarterly basis.* Typically, 12b-1 fees *range between .25% and 1%,* but the maximum 12b-1 fee is an *annualized 1%* of the fund's assets. 12b-1 commissions is the sales charge paid to the brokers. It's not the regular general commission- that's a sales tax

liquidity

Liquidity is defined as the ability to sell an asset at a reasonable price within a short period. Mutual funds are extremely liquid investments; however, unlike standard stocks, mutual fund shares are not traded throughout the day. Instead, mutual fund shares are issued by, and subsequently redeemed back to, the fund itself.

No-load funds

Not all mutual funds assess sales charges. When a mutual fund sells its shares to the public at their net asset value (i.e., with no sales charge), it's referred to as a no-load fund. In other words, this fund's net asset value and public offering price are equal. Most no-load funds are purchased directly from the fund's distributor without any compensation being paid to the salespersons. To be marketed as a no load fund, this type of fund may not assess a front-end load, a deferred sales load, or a 12b-1 fee (described next) that exceeds .25% (or 25 basis points) of the fund's average annual net assets.

Fees and charges

Prior to purchasing mutual fund shares, investors must review the total cost of fund ownership since, in addition to sales loads, funds assess annual fees that are based on the NAV of their holdings including *12b-1 fees, service fees, and administrative fees.*

no discounts on Class B Shares

RRs should not recommend buying Class B shares to a client who intends to place a large order. The client should be directed toward Class A shares since only this share class qualifies for breakpoints.

asset allocation funds

Similar to balanced funds, these funds *also invest in stocks, bonds, and money-market instruments.* Fund managers determine the percentage of the fund's assets to invest in each category *based on market conditions.*

Board of directors

The board of directors of a mutual fund is elected by its shareholders. The Investment Company Act of 1940 dictates that a *majority of these directors must be independent* (disinterested--they cant work for fidelity, maybe they're deans of unis, politicians, CEOs of other companies, there has to be outside representation). The board's main functions are to protect the shareholders' interests and to be responsible for: Establishing the fund's investment policy (any fundamental changes in the policy must be approved by shareholders) Determining when the fund will pay dividends and capital gains distributions Appointing the fund's principal officers that run the fund on a day-to-day basis (e.g., the investment adviser that manages the fund's portfolio) Selecting the fund's custodian, transfer agent, and principal underwriter Hires outside companies for services *Sets the fund's objective*, but *does NOT manage the portfolio* They're not a board for each fund, they're a board for the company

expense ratio

The expense ratio is defined as the percentage of a fund's assets that are used to pay operating costs and is calculated by dividing the fund's total expenses by the average net assets in the portfolio. The expense ratio includes the management fee, administrative fees, and 12b-1 fees, but doesn't include sales charges. *expense ratio = total expenses / average net assets* Expense ratios typically range between .20% and 2% of a fund's average net assets and must be disclosed in the fund's prospectus. The expense ratio varies based on the type of fund and the share class that's selected by the investor. No-load funds typically have lower expense ratios, since their 12b-1 fees are limited to 25 basis points per year. Passively managed will be lower, bond funds would have lower expense ratios than equity funds, international might have higher expense ratio, etc.

Sales Charges (Front-end Loads)

This is what pays the broker When investors purchase mutual fund shares with an associated front-end load (Class A shares), they pay the *public offering price (POP),* which consists of the NAV plus a sales charge. Under FINRA rules, the maximum sales charge permitted is 8.5%; however, breakpoints (reduced sales charges) are often available to investors who purchase a significant amount of Class A shares. A mutual fund's sales charge is expressed as a percentage of the POP and is calculated using the following formula: *sales charge % = (POP-NAV)/ POP For example, if the XYZ fund has an NAV of $17.25 and a POP of $18.40, the sales charge percentage is 6.25% (the difference in values of $1.15 ÷ $18.40).

switching shares

When an RR recommends that a client sell the existing mutual fund shares that she owns of one fund family and invest the proceeds into another fund family, the RR's recommendation is referred to as switching. The concern is that the movement between different fund families will result in a new sales charge being assessed. the better alternative is *Exchanging shares*

redemption fees

When mutual fund shares are redeemed, some funds deduct a small redemption fee from the amount that's paid to the investor. *Redemption fees have a range of .5% to approximately 2% and are returned to the fund's portfolio.* Ultimately, the fee, which is separate from any deferred charge that may apply, is designed to discourage investors from redeeming shares too quickly. Some funds waive redemption fees after the shares have been held for a specific period.

categories of mutual funds

aggressive growth funds growth funds specialized or sector funds international and global funds equity income funds growth and income funds bond funds index funds value funds balanced funds asset allocation funds money-market funds

structure of a mutual fund

check notebook for diagram

Share class summary

check notes for diagram

tables to summarize investment companies

in notebook

the following are test Qs

next

Calculating POP

when given the NAV and the sales charge percentage, use the following procedure to calculate the offering price: *POP = NAV / (100 - Sales charge %)*

In what way are mutual funds and REITs similar? A. Their securities are traded on an exchange. B. They are actively managed. C. Their securities are redeemable by the issuer. D. They offer flow through of losses.

*B. They are actively managed.* Mutual funds and REITs both have portfolios that are managed, with investments that are purchased and sold on a regular basis. REIT securities trade on exchanges, but mutual fund shares do *not*. Instead, mutual fund shares are redeemable by the issuer. Neither mutual funds nor REITs offer flow through of losses

convenience

A person who wants to invest monthly may arrange to have the funds automatically deducted from their checking accounts. Investors are also able to have income dividends and capital gains reinvested automatically.

exchanges at net asset value

Another benefit of investing in mutual funds is that shareholders may exchange the shares they own in one fund for shares of another fund at the net asset value (the fundamental value of the shares) as long as both funds are in the same family (brand name). If the exchange is made within the same fund family, an additional sales charge will not be assessed. (what exactly is a fund family?)

fee disclosure

In the front of its prospectus, a mutual fund is required to disclose all of its fees using a standardized table.

settlement of transaction

Mutual fund transactions typically settle on the same day as the purchase/redemption. Unlike stocks, the ex-dividend date for a mutual fund is actually determined by the fund or its principal underwriter. Typically, a mutual fund's ex-dividend date is the business day following the record date.

aggressive growth funds

These funds invest in *small companies* and often participate in the initial public offerings of these companies' shares. the stocks of these companies can be very volatile, but historically they have also produced high returns for long-term investors

face-amount certificate companies

These types of investment companies are very rare today. A face-amount certificate company *issues debt certificates that pay a predetermined rate of interest.* Investors purchase these certificates in either periodic installments or by depositing a lump sum and then receive a fixed amount if they hold the certificates until maturity. However, investors who cash in their certificates early will receive a lesser amount—referred to as a *surrender value.*

Growth funds

*Capital appreciation* is the main objective of a growth fund. The advisers of these funds invest in stock that they believe will show above-average growth in share price

letter of intent (LOI)

A letter of intent qualifies an investor for a discount made available through breakpoints without initially depositing the entire amount required. The letter indicates the investor's intention to deposit the required funds over the next 13 months. The LOI may be backdated for 90 days to include prior purchases. Since letters of intent are non-binding, an investor will not be penalized for failing to make the additional purchases. However, this failure will result in a price adjustment that equals the higher sales charge that would have applied to the original purchase. Basically, if a person fails to invest the amount stated in the LOI, the fund will retroactively collect the higher fee.

diversified vs non-diversified

A management company may be either diversified or non- diversified. In order to qualify as a diversified company, the portfolio must be invested in the following specific manner: At least 75% of the assets must be invested in a diversified manner with: No more than 5% of the invested assets may be invested in any one company no more than 10% of the voting stock of any one company may be owned The other 25% can be invested however they decide A diversified company must meet these standards at the time of initial investment; however, subsequent market fluctuations or consolidations will not nullify the company's status as diversified. A *non-diversified investment company* usually invests in one specific asset category or industry, and in a few securities within each category/industry. The risk with non-diversification is that bad news from just one or two companies in a particular industry can hurt the prices of all stocks in that industry. It could really invest in any manner, it doesn't have these 75% regulations and shit

the investment adviser

Aka a *portfolio manager/fund manager* Must be registered with SEC as an investment advisor under the Investment Advisor Act of 1940 They manage the fund based on the objectives set out by the board of directors- could be growth, income, capital appreciation, preservation of capital, international, global, could be mixed, etc. IAs research and analyze financial and economic trends and decide which securities the fund should buy or sell in order to maximize performance. They implement appropriate diversification. For these services, the investment adviser is *paid a management fee* which is *based on the assets under management (AUM)*, but not based on performance. This is generally the largest expense of a mutual fund: the advisory/management fee. It is common that a company's advisor is its own company- but like Vanguard's advisor is wellington. They might want an advisor with different perspectives Generally only one advisor for each fund

Class B Shares

Although Class B shares generally have *no up-front sales charges, higher 12b-1 fees are usually assessed.* Investors are subject to contingent deferred sales charges (CDSC) if the shares are redeemed before a certain period. Once the specified number of years has passed and the back-end charge is reduced to zero, most Class B shares will convert to Class A shares. Unlike Class A shares, Class B shares *don't* qualify for breakpoint (sales charge) discounts

the organization of a mutual fund

Although most mutual funds are organized as corporations, some are established as trusts. In many ways, the structure of a mutual fund resembles a regular corporation. A fund has a *board of directors* that's responsible for administering the fund for the benefit of the *shareholders.* The fund's shareholders are the persons who invest their money in the fund. there is a board of directors, investment advisor, transfer agent, custodian bank. check the notebook for diagram

other types of investment companies

Although mutual funds are by far the most common type of investment company, let's examine some of the other varieties, including: *face-amount certificate companies, unit investment trusts, and closed-end investment companies*

classes of shares

Although the specifics of the different classes that each fund sells may vary widely, most funds offer the following classes of shares: *class A shares, class B shares, class C shares, other share classes* The difference between classes are the ways in which the sales charges and distribution charges are assessed. Investors may choose between shares with front-end loads and varying 12b-1 fees (marketing fees), back-end loads with higher 12b-1 fees, or some other combination

prospectus delivery requirement

Any offer to sell a fund's shares must either be preceded by or accompanied by the current prospectus since mutual fund purchases are primary issuances. The delivery may be made in physical or electronic form. Dealers must have systems in place to ensure that clients receive this document before any purchase orders are processed. *Also, registered representatives are not permitted to alter, mark, or highlight a prospectus in any way.*

dividend reinvestment

Most mutual funds make dividends and capital gains distributions to their shareholders on an annual basis. Once a distribution is made, the investor must then choose to either receive the money or reinvest it. However, mutual funds make the choice easy by allowing investors to reinvest their dividends and other distributions, usually at the NAV, without paying a sales charge.

breakpoint sales

RRs who induce clients to purchase shares at a level just below the dollar value at which a breakpoint is available are engaging in a prohibited practice that's referred to as a breakpoint sale. Instead, clients should be reminded that LOIs may be used if all of the funds are not currently available. Also, RRs should avoid allocating a client's investments into several different fund families. This practice may result in the client not receiving a breakpoint that would have been available if all the funds were allocated to a single family.

index funds

Index funds have become increasingly popular in recent years. An index fund creates a *portfolio that mirrors the composition of a particular benchmark stock or bond index, such as the S&P 500 Index.* The fund attempts to produce the same return as the index; therefore, investors cannot expect the fund's returns to outperform the relevant benchmark. Since index mutual funds are passively, rather than actively managed, they typically have lower management fees.

exchanging shares

Most mutual funds offer investors the ability to sell shares of one fund and buy shares of another fund *within the same fund family* without sales charge implications. Unlike switching shares, exchanging shares doesn't create a sales practice issue. However, regardless of whether the investor is involved in switching or exchanging shares, the IRS considers them both the sale of one fund's shares and the purchase of another fund's shares. Any resulting gain or loss will represent a taxable event for the investor.

breakpoints

Mutual fund shares must be quoted at the maximum sales charge percentage that the fund charges. However, *most mutual funds offer sales breakpoints on shares that are purchased with a front-end load.* Breakpoints are dollar levels at which the sales charge is reduced (the mutual fund industry's version of a volume discount). A fund's breakpoints must be clearly stated in its prospectus. It usually will be structured like in increments of how much you deposit, so less than $25,000 might have a 5% sales charge as a percentage of the offering price, whereas the $500,000-$1 mil amount might have 2% sales charge as a percent of the offering price

rights of accumulation (ROAs)

Rights of accumulation give investors the ability to receive cumulative quantity discounts when purchasing mutual fund shares. The reduced sales charge is based on the total investment made within a family of funds (fund complex) provided the shares are purchased in the same class. Rather than using the original purchase price, the current market value of the investment *plus* any additional investments is used to determine the applicable sales charge.

SEC registration

The Investment Company Act of 1940 requires every investment company that has *more than 100 shareholders* to register with the Securities and Exchange Commissions (SEC). Also, a fund must have a *minimum net worth of $100,000* in order to offer its shares to the public.

value funds

These funds *invest in "out-of-favor" companies* that are considered undervalued and are often in the process of restructuring. Due to the nature of their investments, value funds are most suitable for investors with *long time* horizons.

An investment company that is purchased in installments and that matures at a fixed-dollar amount is called a: A. Face-amount certificate company B. Unit investment trust C. Variable annuity contract D. Management company

*A. Face-amount certificate company* Face-amount certificate companies issue certificates of the installment type. The investor makes periodic payments and receives a fixed sum at the end of the period. Lump-sum payment certificates are also available.

Which one of the following statements concerning money-market funds is TRUE? A. These funds will maintain a stable NAV of one dollar. B. These funds are typically invested in Treasury bonds. C. These funds are FDIC insured. D. These investments are liquid.

*D. These investments are liquid.* Money-market funds are investments in which investors park cash holdings to wait out dips in the market or to maintain a source of liquid funds. These *mutual funds* are *not* FDIC insured, and will not necessarily maintain a stable NAV. Rather than investing in long-term debt like T-bonds, money-market funds typically hold short-term investments (e.g., T-bills).

What are investment companies?

An investment company pools funds from numerous investors and purchases securities that are held in a portfolio for the benefit of those investors. The method by which investment companies are organized and operated is governed by the *Investment Company Act of 1940.* Investment companies are known as *passive* investors- they invest in other companies but not to hold or manage the other companies (like berkshire hathaway who holds and manages other companies to influence them)

redeeming shares

An investor may redeem (sell) shares back to the fund on any business day. Since shares are redeemed at the NAV, a fund must calculate its NAV at least daily; however, some funds may do the pricing more frequently. The Investment Company Act of 1940 requires mutual funds to pay the redemption proceeds to their investors within seven calendar days. this will incur *Redemption fees*

balanced funds

Balanced funds maintain some percentage of their *assets in stocks, bonds, and money- market instruments* (cash equivalents). Although the percentages will vary from time to time as market conditions change, a portion of the portfolio will always be invested in each type of security.

Net Asset Value (NAV)

It is an accounting term that describes a fund's positions; marked-to-the-market at closing prices as of 4pm. ET NAV is synonymous with the bid price or redemption (liquidation) price for mutual fund shares The NAV of a mutual fund (or any other investment company) is determined by dividing its total net assets (securities valued at their current market price, plus cash, minus total liabilities) by the total number of shares outstanding. *net asset value (NAV per share) = total net assets / number of outstanding shares* The net asset value of a fund must be computed at least once per day. A fund's prospectus discloses the cutoff time that's used for share purchases and redemptions and explains how its NAV is calculated. The NAV is normally computed daily as of the close of trading on the New York Stock Exchange (4:00 p.m. Eastern Time). This is called *End of day pricing*

Other share classes

Many fund families also offer additional classes of shares for employees of broker-dealers, institutional investors, retirement plans, or other special categories of investors. In its prospectus, a fund provider must fully disclose each of the share classes that it offers as well as the different sales charges and applicable 12b-1 fees.

money-market funds

Money-market funds invest in *short-term debt (money-market) instruments* that typically have maturities of less than one year. The two principal benefits for investors in money-market funds are liquidity and safety.

professional management

Most retail investors don't have the time or expertise to manage their own investments adequately and cannot afford to hire their own professional manager. By investing in mutual funds, the investors receive the services of professional managers for much less than they would need to pay individually. These money managers must be registered as investment advisers under the Investment Advisers Act of 1940. Note, an investment adviser (IA) is the management company, while investment adviser representatives (IARs) are the individuals who work for the IA.

international and global funds

Mutual funds that focus on foreign securities are often the easiest way for *U.S. investors to invest abroad.* *International funds* invest primarily in the securities of countries other than the United States. They include funds that invest in a single country and regional funds that invest in a particular geographic region (e.g., Europe or the Pacific Basin). On the other hand, *global funds* invest all around the world, both in the U.S. and abroad.

Mutual Fund Terminology

Since mutual fund disclosure documents use specialized language, a list of substitute terms is provided below: The sales charge is also referred to as the *sales load* The net asset value (NAV) is also referred to as the *bid* or *redemption price* The public offering price (POP) is also referred to as the *net asset value plus the sales charge (if any)*

bond funds

The main objectives of bond funds are *current income and preservation of capital*. Since the portfolio consists of bonds only, many of these funds are susceptible to the same risks as direct investments in bonds, including credit risk, call risk, reinvestment risk, and interest-rate risk. *Difference between buying individual bonds vs bond funds? If you invest money in individual bonds today, and their maturities are in 10 years, then 10 years later you will get all your principal back if you keep them there for ten years. If you buy the bonds today and they mature in 10 years, they have the same level of interest rate risk as ten year bonds, but 8 years from today those bonds will mature in 2 years, so now their interest rate risk has declined because they were ten year bonds and now they mature in 2 years, so now their maturity is lower (lower maturity, lower risk). A bond fund will always have the ten year maturity, so there is greater degree of interest rate risk than individual bonds because those decrease in risk as years left get lower.

Fund Family

The term fund families or *fund complexes* is used when defining a single investment company or mutual fund company that has many different types of mutual funds from which a customer may choose to purchase. A fund family is essentially a brand name that applies to several related individual mutual funds. A customer may be able to invest a large sum of money with one fund family, receive a sales *breakpoint* (reduced sales charge), diversify his assets, and be allowed to switch between mutual funds.

growth and income funds

These funds have both *capital appreciation and current income* as their investment objectives. Growth and income funds invest in companies that are expected to show more growth than a typical equity income stock and higher dividends than most growth stocks. However, the trade-off is that they usually offer *less capital appreciation than pure growth funds, and lower dividends than income funds.*

The fund that would probably have the most price volatility is a(n): A. International equity fund B. Growth fund C. Income fund D. Municipal bond fund

*A. International equity fund* In general, bond funds are less volatile than equity funds. Within the equity category, the NAVs of growth and income bond funds are considerably less volatile than international equity funds whether corporate or municipal. International equity funds are not only vulnerable to market risk, but exchange and political risk as well.

Jamie has inherited 500 shares of an investment company. She calls her broker to redeem the shares and is informed that the kind of investment company she owns makes no provision for future purchases or redemptions. What kind of investment company does she own? A. An open-end fund B. A closed-end fund C. A unit investment trust AD. face-amount certificate company

*B. A closed-end fund* A closed-end fund makes no provision for future purchases or redemptions from the issuing fund. Shares are bought and sold in the open market in the same manner as the common stock of corporations. *All of the other* types of funds listed do provide for future purchases to and redemptions from the fund.

XYZ Mutual Fund, an open-end investment company, has an NAV of $20 and a public offering price of $21.40. The prospectus states that the sales charge for purchases of fund shares of $25,000 through $49,999 is 4%. Approximately how many shares can the customer buy for $35,000? A. 1,600 shares B. 1,635 shares C. 1,680 shares D. 1,750 shares

*C. 1,680 shares* To compute the number of shares that can be purchased, first determine how much of the investment will go to the sales charge. This amount is $1,400 ($35,000 investment x 4% sales charge). This leaves $33,600 for purchasing shares. The investor will purchase 1,680 shares ($33,600 divided by $20 NAV per share). You do not divide by the public offering price since it includes a sales charge and you have already deducted $1,400 in sales charges.

All of the following statements are TRUE about closed-end investment companies, EXCEPT that the: A. Number of outstanding shares is constant B. Shares are sold at the current market price C. Shares may not sell below the current net asset value D. Shares may be listed on the NYSE

*C. Shares may not sell below the current net asset value* Closed-end investment companies are bought and sold in the same manner as common stocks. If a customer wants to sell a closed-end fund at the market, he would receive the current bid price (the market quote, not the net asset value). If a customer wants to buy a closed-end investment company at the market, he would buy it at the current offering (asked) price. The market price of the shares can be at, above, or below the net asset value. Closed-end investment companies have only one issue of shares. Once sold, no new shares are issued. The amount of outstanding shares remains constant. The shares may be listed on an exchange or may trade in the OTC market.

Which of the following stipulations is *NOT* included in a letter of intent? A. The maximum time limit for the letter of intent is 13 months. B. The letter of intent may be backdated for up to 90 days. C. The fund may stop redemptions during the duration of the letter of intent. D. The fund may place some of the initially purchased shares in an escrow account to protect against the failure to fulfill the letter of intent.

*C. The fund may stop redemptions during the duration of the letter of intent.* A letter of intent (LOI) has a maximum duration of 13 months and may be backdated for up to 90 days to include previous purchases. Also, to protect against the client's failure to fulfill the letter of intent, a certain amount of the initially purchased shares *may be placed in an escrow account by the customer's broker-dealer*. If the terms of the letter are not met, the shares in the escrow account will be liquidated and used to cover any additional sales charges that are due. The letter of intent will not contain a clause which stipulates that redemptions are prohibited during the 13-month period.

The purchase price of a no-load fund is determined by: A. The net asset value plus a sales charge B. The net asset value plus a commission C. The net asset value as computed at the end of the business day D. The supply and demand for the fund

*C. The net asset value as computed at the end of the business day* A no-load fund has no sales charge. The purchase price is determined by the net asset value as computed at the end of each business day.

An individual who is considering the purchase of closed-end fund shares would pay: A. The closing NAV plus any applicable sales charge B. The next computed NAV plus any applicable sales charge C. The next computed NAV plus any applicable commission D. A market price as determined by the supply and demand for the shares

*D. A market price as determined by the supply and demand for the shares* Closed-end fund shares trade in the secondary market and their prices are determined by supply and demand for the shares. Although the shares have an NAV, it's only for comparative purposes.

Open-end management companies (Mutual funds)

Any investment company is a corporation (sometimes a trust) that invests the pooled funds of investors; typically into a diversified portfolio of securities Open-end management companies are by far the most popular type of investment company. The basic idea is that, for a cost, a mutual fund provides a means for investors with similar goals (e.g., long-term growth) to pool their money and invest in a portfolio of securities (stocks, bonds, money market instruments). Then, the portfolio/fund distributes common stock back to its investors representing an interest in the specific portfolio. (owning mutual funds is considered owning shares of common stock even though its a mixture of securities like stocks, bands, and other money market instruments) Allows investors to acquire an interest in a large number of securities Vanguard, fidelity, blackrock, these are mutual funds. Think of them like a collection of funds. As with other companies, this investment pool elects a board of directors (BOD). A mutual fund's BOD will hire an expert *(i.e., an investment adviser)* to perform the security selection and trading functions. (Important: there are hedge funds, real estate investment trusts, private equity funds-- *these are NOT types of investment companies)* Open end funds (mutual funds) and closed end funds are investment companies, these above^ are not

systematic withdrawal plans

Many mutual funds offer investors the opportunity to withdraw funds systematically. If investors elect to begin a systematic withdrawal plan, they will receive regular payments, typically on a monthly or quarterly basis. Payments are first made from dividends and then capital gains; however, if these amounts are insufficient, the fund will redeem the investor's shares until the principal in the account is exhausted. Investors who choose systematic withdrawal plans have three payout options—*fixed-dollar, fixed- percentage, or fixed-time.* With *fixed-dollar payout plans,* investors will receive the same amount of money with each payment. For example, a person who has $25,000 worth of shares could request that the fund send her $200 per month until all of the funds are exhausted. Investors may also request that their fund liquidate a *fixed-percentage* of their shares at regular intervals —for example, 1% each month or 3% each quarter (using a fixed-percentage payout plan). With this payout option, the exact dollar amount to be received by the client will vary based on the NAV of the shares at the time they're sold. The third choice for investors is to have their holdings liquidated over a *fixed-time* (using a fixed-time payout plan). A client who chooses this method must provide the fund with an exact ending date. Once the date is set, the fund will liquidate the client's shares in amounts that will exhaust the account by the date specified by the client.

Principal underwriter

Most funds use a principal underwriter (also referred to as the *sponsor, wholesaler, or distributor*) to sell their shares to the public. *An underwriter may sell shares directly to the public or it may employ intermediaries (dealers) such as a discount or full-service brokerage firm.* Many funds use a network of dealers to market their funds to investors. The dealers are essentially brokerage firms that have a written contract with the underwriter and are compensated for selling the fund's shares to investors. All FINRA member firms must use the same pricing and may not sell fund shares at a discount to non-member firms. there are three distribution methods

Transfer agent

Most of back office and paperwork is done by the transfer agent and the custodian bank *(which are often the same entity)* The transfer agent computes the net asset value (NAV), they keep track of ownership, send confirmations, issue new shares and cancel the shares that investors redeem, distributes capital gains and dividends to the fund's shareholders and forwards the required documents to shareholders, including statements and annual reports. Receive a fee for their services, you can see this stuff in the prospectus Today, most of these securities functions are done electronically without physical certificates changing hands.

buying and selling mutual fund shares

Mutual fund shares are purchased at their *public offering price (POP)* and redeemed (sold) at their intrinsic *net asset value (NAV)*. The difference between these two values is the *sales charge or load*. *Net Asset Value + Sales Charge = Public Offering Price* The equation above represents the process that's used to determine the purchase price of the shares of a traditional *front-end load fund (Class A shares*). In this case, the investor pays an up-front sales charge that's added to the NAV at the time of purchase. Fractional shares may be purchased if the amount being deposited is not sufficient to purchase an even number of whole shares. If a client intends to sell (redeem) shares, he receives the next calculated NAV.

the prospectus

Mutual funds are considered new issues. Even if a fund has been in business for decades, every time you buy a new share they're creating a new share which means you must receive a prospectus, like a disclosure agreement A fund's prospectus is the primary disclosure document for potential investors and includes the following information: Investment objectives Investment policies and restrictions Principal risks of investing in the fund Performance information (whether the fund made money) The fund's managers Operating expenses (the costs that are deducted from the fund's assets on an ongoing basis) Sales charges (what investors pay a salesperson when buying shares) Classes of shares the fund offers How the fund's NAV is calculated How investors redeem or purchase shares Exchange privileges (whether the investor can exchange shares in one fund for shares of another fund) Basically fully discloses what you are purchasing, there is a main overview page, but then there is detailed info about the mutual fund you are purchasing in the body

recordkeeping

Mutual funds provide a number of services that make investing easy. The fund takes care of most of the recordkeeping and ensures that shareholders receive regular reports that show their purchases, redemptions, and end-of-the-year tax summaries (Form 1099-DIV). Mutual funds also must send detailed financial reports to their shareholders at least twice per year. These *semiannual and annual reports* provide the shareholders with the most current information about the fund's finances and holdings as of a particular date.

Custodian Bank

Often the same entity as the transfer agent In order to prevent the theft or loss of a fund's assets, the Investment Company Act requires the fund to appoint a qualified bank as its custodian that will maintain its assets. Main point is that the custodian holds the securities. So if you have money in vanguard and want to write a check coming from that account, your check will have the custodian bank's name on it, like Wells Fargo for instance. Means that a mutual fund company buys security from a brokerage firm, and those securities are held separately from an investment company and instead with a custodian bank. The custodian bank maintains the assets, receives a fee, but they DON'T manage The *custodian is responsible for safeguarding the fund's cash and securities and collecting dividend and interest payments from these securities.* However, the custodian neither guarantees the fund's shareholders against investment losses, nor does it sell shares to the public. A fund's custodian may also serve as its transfer agent.

end of day pricing

Orders to buy and sell fund shares are based on the next computed price. This is referred to as *forward pricing* since purchases and redemptions are based on the next calculated price. For example, if an individual places an order to purchase shares at 11:00 a.m., the purchase price will not be known until the net asset value is computed after the close of business on that day. If a client places an order at 4:10 p.m. on Wednesday (after the close); it will not be executed until the close of business on Thursday. This is an* important distinction between mutual funds and other types of funds, such as closed-end funds or ETFs*. (ETFs will be discussed in the next chapter.) Shares of closed- end funds and ETFs trade throughout the day like individual stocks and bonds.

back-end loads -- also known as contingent deferred sales charges (CDSC)

Rather than assessing a sales charge at the time of purchase, some funds allow investors to buy shares at the NAV and will then assess a sales charge when the investors redeem their shares. Usually, the longer the investor owns the shares, the greater the decrease will be in the back-end load. Due to the decreasing charge, this form of load is referred to as a contingent deferred sales charge (CDSC). In fact, if the investor holds the shares long enough, there may be no sales charge imposed at the time of redemption. This requires a *confirmation disclosure*

Service fees

Service fees are charges that are deducted under a 12b-1 plan and used to pay for personal services or the maintenance of shareholder accounts. Trailing commissions (trailers) are an example of a service fee. These ongoing trailer fees are paid to RRs as compensation for continuing to service their clients' accounts.

determining the offering price for a reduced load

Since breakpoints affect the purchase price of mutual fund shares, SIE candidates should be able to determine a fund's offering price based on the reduced sales charge percentage. This adjusted POP is calculated by using the following formula: *POP = NAV / (100 - Sales Charge %)* For example, if the XYZ Fund has an NAV of $10 and a person invests $100,000 into the fund, it will entitle him to a 3.25% breakpoint. What's the adjusted offering price for the investor? POP= ($10)/(100%-3.25%) = 10/96.75 = $10.34 At this price, the investor is able to purchase 9,671.18 shares ($100,000 ÷ $10.34).

specialized or sector funds

Some funds concentrate their investments to stocks in a *particular industry* (e.g., high tech stocks or pharmaceuticals) or in a *particular geographic location.* Although specialized funds are riskier than more diversified funds, they allow fund managers the opportunity to take advantage of unusual situations.

What are the three different types of investment companies

The Act of 1940 identifies three different types of investment companies—*face-amount certificate companies, unit investment trusts (UITs), and management companies.* The Act further divides *management companies* into *open-end and closed-end companies.* Open-end management companies are more commonly referred to as *mutual funds.*

Additional disclosure: the Statement of Additional Information (SAI)

The Statement of Additional Information provides more detailed information than the prospectus about a fund and its investment policies and risks. Unlike the prospectus, the SAI is not required to be given to any person who simply expresses an interest in purchasing the fund's shares. However, the fund is required to provide a copy of the SAI to any person who requests it.

unit investment trusts

Unit investment trusts (UITs) are formed under a legal document that's referred to as an *indenture* and have trustees rather than boards of directors. *UITs invest in a fixed portfolio of income-producing securities, such as bonds or preferred stocks.* UITs issue only redeemable securities that are referred to as units or *shares of beneficial interest (SBIs)* that are generally sold in minimum denominations of $1,000. Investors are able to buy or sell SBIs in the secondary market. Each unit entitles the holder to an *undivided interest* in the UIT's portfolio that's proportionate to the amount of money invested. UITs are supervised, but not managed, investment companies. In other words, UITs don't utilize the services of investment advisers to determine what securities to buy and sell. Since these trusts are not managed, they don't have associated management fees.