Chapter 7 - Investment Vehicle Characteristics

Funds which pay out at least ____________% of net investment income annually qualify as "Regulated Investment Companies" under Sub Chapter M of the IRS code, which means they are exempt from paying tax on dividends which are distributed.

90%

Classes of Shares

Funds offer three different classes of shares to give investors a choice as to how to pay for sales charges and annual expenses: 1) Class A Shares - Charge investors an upfront sales charge which cannot exceed 8.25% under FINRA rules. They offer the *lowest annual expense charges* a. Class A Shares are the only mutual fund shares that provide sales charge breakpoints. 2) Class B Shares - Are back-end loaded funds that have a Contingent Deferred Sales Load. Expense charges are higher for Class B shares than for Class A shares. The sales load is charged on a declining scale. Therefore, the longer the investor owns the shares, the lower the sales load will be (ex. redeem shares within one year, the sales load is 5% - Redeem shares in the second year, the sales load would be 4%). 3) Class C Shares - No upfront sales load and no back-end load, but have the *highest annual expense charges*

Hedge Funds - Formation

Hedge funds are normally established in the form of a *limited partnership.* These private investment partnerships take on long and short positions, use leverage and derivatives, as well as private equities and currencies, but in allowing these forms of investment, hedge funds subject investors to a *larger degree of risk*

Bonds trading at a DISCOUNT will always have a basis (YTM) which is __________ than the coupon rate.

Higher

REITs do not provide investors with depreciation write-offs and *losses are not passed through to investors*

*Earnings* come from the *difference* between rental income and interest paid on borrowed money.

Hedge Funds - Liquidity

*Hedge funds are not normally as liquid as other securities.* Most hedge funds allow for the sale or redemption of hedge fund shares *monthly, quarterly, or annually.* a. Daily trading/pricing is generally not offered.

Indirect investments in Real Estate include:

*Real Estate Investment Trusts (REITS)* - Publicly traded companies that manage a portfolio of real estate assets in an attempt to earn profits for shareholders. Here, a trust or a corporation uses investor's money to buy and operate income properties (ex. malls, office buildings, etc.). Though the value of a REIT is based on underlying properties, shares of a REIT are not considered "derivatives" because REITs directly invest in real estate.

ETF Characteristics:

1) *ETFs trade like a stock* and can be bought and sold anytime during normal market hours a. Mutual funds are only priced at the close of the market (once per day) 2) ETFs *can be purchased on margin and can be sold short* 3) Annual expenses of ETFs are generally low. 4) *Commissions* are charged on transactions just like with common stock and *ETFs have NO sales load,* which generally lowers costs to investors. 5) Dividend payments are possible, but not usual. 6) Settlement is T+2 business days (previously T+3) 7) *Options are available on most ETFs* 8) An industry sector ETF would be less affected by overall changes in the market and offers less diversification when compared to a broad-based ETF but would provide diversification within a particular sector.

Types of REITs include:

1) *Equity REITs* - Take equity positions in real estate. Shareholders receive income (from rents received) and capital gains when the property is sold at a profit. 2) *Mortgage REITs* - Lend money to building developers and pass the interest income on to shareholders. Mortgage REITs are generally *highly leveraged* (ex. their capital structure has a high amount of debt in relation to equity) 3) *Hybrid REITs* - Are a mix of equity and debt investments

Non-Traditional ETF's:

1) *Leveraged ETFs* - Track an index fund or a benchmark. In addition to the money already received by investors, *these funds barrow capital* with the *goal of generating a greater percentage return.* The expectation is that the returns of the fund will be higher than the borrowing costs. These funds *also use derivatives such as futures and options* a. *Because of the leverage, percentage gains or losses in the fund would be magnified* 2) *Inverse ETFs* - Seek to *deliver the opposite of the performance of the index or benchmark that they track.* These funds profit if an index declines and lose money if the index rises. *Inverse funds can also be leveraged and are sometimes called "Short ETFs."* Many investors use inverse funds for *hedging purposes.* Like leveraged funds, inverse funds maintain derivatives in their portfolios but they rely more on derivatives to achieve their investment objectives than leveraged only funds.

Annuity Pay Out Options:

1) *Single Life or Life Annuity* - Annuitants receive regular income payments until the die regardless of how long they live. This payment option usually provided the highest amount of payment to the annuitant. There are no beneficiaries and when the annuitant dies, the insurance company keeps any remaining balance. 2) *Joint and Last Survivor Annuity* - Income payments are made while both annuitants are alive, and then the survivor continues to receive payments after the death of the other annuitant. The payment may be 50% to 100% of the original amount paid depending on the plan. 3) *Joint Life* - Payments last as long as both annuitants are alive and stop upon the death of either annuitant. This option is *rarely* used. 4) *Life Annuity-Period Certain* - the annuitant will receive regular payments until death, but if the annuitant dies before a chosen period has expired, the beneficiary will receive payments until the period certain ends (ex. 10 years measured from the date of the contract). 5) *Refund Annuity* - If the income payments of the annuitant do not equal the premium paid, the balance of the account is paid to a beneficiary of the annuity either in payments or a lump sum. 6) *Immediate Annuity* - Annuity contract bought with a *single payment* and a specified payout plan begins right away. 7) *Deferred Annuity* - Annuity whose contract provides that payments be postponed until a number of periods or years have elapsed. For Example: Payments to an annuitant will only begin when the annuitant reaches the age of 70.

There are two basic types of life insurance:

1) *Term Insurance* - A term insurance policy is *"temporary"* insurance which is only good for a set period of time (for example 1 year, 5 years, 10 years). a. It provides a *death benefit only* b. There are *no cash values.* Policyholders may NOT take out loans against the policy. c. It can be for a *level or decreasing death benefit* - *Level benefit* means that the death benefit stays the same, but the amount of premium paid for the policy may stay the same for a specific period or may increase over time. - *Decreasing benefit* means that the amount of premium paid each year remains the same but the amount of death benefit will decrease each year. d. Term policies provide *the highest amount of death benefit for every dollar of premium paid* e. This type of policy is particularly suitable for *young people on a tight budget* 2) *Permanent Life Insurance* - is *lifetime* insurance assuming premiums are paid in full as they come due. a. Examples of permanent life insurance are: - Whole life - Universal life - Variable life - Variable Universal insurance b. Permanent life insurance provides a *Death Benefit and a Cash Surrender Value,* also called a living benefit. Some policies provide for flexible premium payments. - The *cash surrender value (CSV)* is the amount available in "cash" upon the voluntary termination of a policy if the policyholder surrenders or cancels the policy before it becomes payable by death. Policyholders may take out loans against the CSV. *The amount paid is the cash value of the policy less any surrender charge or outstanding loan balance* - Flexible premiums payments means that the policyholder can pay the premiums out of pocket or have the premiums deducted fro the cash surrender value. NOTE: *If the cash surrender value is paid to the policyholder, the policy is terminated and the death benefit lost.

A Permanent Life Insurance policy can be participating or non-participating:

1) A *participating* policy is one that *pays dividends* to the policyholder. The dividends can be used to reduce the premium. 2) a *non-participating* policy does NOT pay dividends.

Hedging with Options:

1) A Hedge is a market strategy used to offset investment risk. Options can be used to *hedge or protect* an existing portfolio of securities or an individual stock position that an investor already has. a. Hedging - *Protecting* a position you already have. b. When hedging, you always establish a position that is on the *opposite side* of the market you are already on. c. Hedging limits your risk by putting you on *both sides of the market* d. The best *downside* protection with options would be a *LONG PUT*, needed when the investor is *long the stock.* Being long the stock and long a put is also called a *"Protective Put"* For example: A *bullish* investor is *long ABC common stock* but is concerned that the stock may decline in value. To hedge or protect this investment against a loss, the investor could *buy a put* option to protect against a decline in market value. e. the best *upside* protection with options would be a *LONG CALL*, needed when the investor is *short the stock* For example: A *bearish* investor is *short ABC common stock* and is concerned that the stock may rise in value. To hedge or protect this position, the investor could *buy a call* option to protect against a rise in the market value of the stock. *Important points about Hedging with options:* 1) *Long puts* protect or hedge *long stock* positions. 2) *Long calls* protect or hedge *short stock* positions. 3) Investors generally buy options to hedge but *do not sell options to hedge* f. Basic Breakeven on Equity Options: 1) *Buy a Call = exercise price plus the premium paid* 2) *Sell a Call = exercise price plus the premium received* 3) *Buy a Put = exercise price minus the premium paid* 4) *Sell a Put = exercise price minus the premium received* CALL UP PUT DOWN

ETNs and ETFs:

1) A primary differentiation between ETFs and ETNs is that because of the debt instrument structure of an ETN and the liability to the issuing bank, *ETNs do not have the tracking errors that are common with ETFs* 2) ETNs will have *counterparty risk,* because the liability of the ETN rests with the issuing bank and there are no actual products backing the ETN (unsecured). For this reason, if the bank goes bankrupt or defaults, the holder of an ETN will become a creditor of the bank, similar to the manner that a bondholder becomes a creditor of a company that goes bankrupt. 3) Both ETNs and ETFs have market risk associated with the performance of the market which the ETN or ETF is attempting to mirror.

Common and Preferred Stock Characteristics:

1) All cash dividends which are paid are FULLY TAXABLE to the investor, whether common or preferred, and are generally taxed at 15% 2) Both common and preferred stock will generally be registered, either at the federal level (SEC) or at the state level (under the USA). Without additional information, neither type of security would qualify for exemptions from registration. 3) If a common or preferred stock is traded on a stock exchange or on NASDAQ, these securities will be HIGHLY LIQUID 4) When equity securities such as common and preferred stock are issued, the issuing company has no obligation to re-pay those who buy the securities. Instead, if the shareholders of stock no longer wish to own the stock, they can sell their securities at the current market price. This will result in a capital gain or capital loss, depending on the purchase and sale price. a. Long-term Capital Gains - Capital gains where the security was held for 1 year plus 1 day or longer. b. Short-term Capital Gains - Capital gains where the security was held for 1 year or less.

Letter of Intent (LOI)

1) Allows investor a 13 MONTH period to reach the breakpoint amount 2) Investors must be advised about breakpoint discounts or the broker is in violation of FINRA rules. 3) Investment clubs are not eligible for quantity discounts.

Investments in Real Estate

1) An IA and/or IAR may recommend Real Estate as a suitable investment in certain investment portfolios. Real estate is a separate asset class and, therefore, *provides diversification* in the asset allocation of a portfolio. 2) *Real estate prices frequently move in the opposite direction from the prices of financial assets such as stocks and bonds, and therefore can reduce the risk in an investment portfolio* 3) Real estate investors make money from *price appreciation and rental income.* Also, real estate can provide "leverage" to the investor because most conventional mortgages only require 25% down. That means that the investor controls the whole property and the equity that it holds by only "paying" a fraction of the total value up front. 4) Investors can invest in real estate either directly or indirectly through a fund.

Capital Gains Distributions:

1) Are derived from *realized long-term gains* on the portfolio. Appreciation in the value of the portfolio is not taxable. 2) Are *always long-term to the investor,* regardless of how long fund shares have been held by the investor 3) May be taken in the form of cash or shares. 4) *Are taxable each year* to the investor regardless of how they are taken (cash or reinvested in additional shares) and may be used to offset other capital losses. 5) Must be paid out 100% to investor, at least once a year. 6) When paid, *reduce the NAV of the fund* 7) Are reinvested at the net asset value of the fund (if they are reinvested). NO Sales Load is charged.

Investment Income or Dividends:

1) Are derived from dividends, interest, and short-term gains in the portfolio. 2) *Are always taxed as ordinary income* to the investor, whether taken as cash or reinvested in additional shares. 3) *Fund deducts its operating expenses* prior to paying customers. 4) Funds which pay out at least *90% of the net investment income* qualify as "Regulated Investment Companies", under Sub Chapter M of the IRS code, which means that the investment company is exempt from paying tax on the dividends distributed but is taxed on the dividends not distributed and this is referred to as the Conduit or Pipeline Theory. 5) Reinvestment of dividends will increase the investor's cost basis. 6) Dividend distributions which are reinvested may be reinvested at the Public Offering Price or less depending on the fund. 7) Dividend distributions reduce the NAV on the ex-date. 8) The *Ex-Dividend* date for a mutual fund is set by the fund.

When computing TOTAL RETURN on a mutual fund that provides for reinvestment of dividends and capital gains distributions, the calculation would consider:

1) Beginning price 2) Beginning number of shares 3) Ending price 4) Ending number of shares

Collateralized Mortgage Obligations (CMOs)

1) CMOs are a type of mortgage-backed security that passes through interest and principal payments from a pool of mortgages to investors *monthly* 2) CMOs are multiclass bonds backed by a pool of mortgage loans. CMO pools may be collateralized by Ginnie Maes (GNMA), Fannie Maes (FNMA), Freddie Macs (FHML), FHA Mortgage Loans, and Conventional Mortgages. 3) In structuring a CMO, the issuer distributes the cash flow coming in from the mortgages to a series of different classes of short, medium, or long-term maturities of the CMO which are called "Tranches". Because CMOs are backed by mortgages which can be (and frequently are) prepaid prior to maturity, each CMO tranch will have an average life expectancy anywhere from 2 to 20 years. Thus, CMOs can have: a. *Implied Call Risk* - Which is the risk that principal will be *returned sooner* than expected. OR b. *Extension Risk* - Which is the risk that the life of the security may be *longer* than anticipated. 4) CMOs are traded OTC in the secondary market with markups and markdowns. Interest payments to investors are subject to both Federal and State income tax. 5) Although investors must consider the credit rating of the underlying mortgage loans, most CMOs have carried a *AAA rating.* The primary risks or concerns to investors include liquidity, average-life sensitivity, and price sensitivity. 6) Oftentimes, debts can be combined into a pool and used to collateralize the issuance of new securities that are sold to the investing public, including pension plans, investment company portfolios, etc. When mortgages, student loans, auto loans, or credit card debts are collateralized to create these securities, the debts are said to be *"securitized"* 7) Private CMOs: a. Are securities issued by private institutions such as banks, investment banks, and home builders. b. Some of these private CMOs will include agency mortgages in their portfolios. They are also made up of other types of mortgage loans, pools of mortgage loans, and letters of credit. c. Private CMOs are backed only by the issuer of the product and are not backed by any government guarantee. These CMOs can also be referred to as "Private-Label CMOs" d. Independent credit agencies provide ratings on these products based on their collateral and the issuer.

Closed-End Investment Companies

1) Closed-end investment companies have a fixed amount of shares. 2) Once shares of a closed-end investment company are issued, no additional shares will be issued. 3) Shares of a closed-end investment company trade in the secondary market, similar to common stock. 4) The market price of a closed-end investment company's shares in the secondary market often is unrelated to the investment company's Net Asset Value (NAV). 5) If a quote for investment company shares is lower than NAV, the fund has to be a closed-end fund, because open-end investment company shares are priced at NAV plus a sales load.

ETNs are issued on 4 basic sectors:

1) Commodities 2) Currencies 3) Emerging Markets 4) Strategy/Index (like the S&P 500 Index)

Convertible Bonds

1) Convertible bonds are debt securities that have one key feature: They give convertible bond holders the option to convert their bonds to shares of common stock of the issuer. 2) Bonds are converted at a specified rate called the Conversion Price. The conversion price tells you how many shares of common stock that the investor would receive upon conversion. The formula to calculate the number of shares upon conversion is: Par Value / Conversion Px = Common Shares Received Example: A convertible bond has a conversion price of $50. how many shares of common stock are produced if the bond is converted? $1000 (par) / $50 = 20 shares of Common Stock

Variable policies with Separate Accounts generally have deductions from the separate account or the premiums.

1) Deductions from the Separate Account generally include: a. Investment Advisory or Management Fees b. Mortality and expenses charges c. Death benefit guarantee charges 2) Deductions from the Premiums generally include: a. Sales Charges b. Premium tax charges c. Administration fees such as billing, recordkeeping, and communication with policyholders

ETN Characteristics:

1) ETNs are unsecured debt instruments that are *not principal protected* but do *participate in the performance of a specific index* or investment strategy for which the ETN was issued. 2) If the index or strategy appreciates in value, the unit holders would *participate in the the appreciation less the investor fees,* which normally accumulate annually. 3) If the index or strategy depreciates in value, *the unit holders can see losses associated with their ETN holdings and would still be subject to the investor fees, so the return of all principal is not guaranteed.* 4) ETN units *trade like stock* and ETNs can be sold short. However, the ETN units *do have a final maturity and can be callable* 5) A primary benefit of an ETN for individual investors is that the *ETNs allow the investor to participate and access markets and sectors which were previously unavailable to them* or may have been unsuitable. EXAMPLE: If Mr. Smith is a conservative investor but wants to participate in an anticipated upward movement in the crude oil market, Mr. Smith would normally have to speculate in futures on commodities directly in order to do so. An ETN that mirrors an oil index or an investing strategy similar to Mr. Smith's would allow Mr. Smith to participate in the underlying commodity without opening and speculating in the commodities or futures markets.

Lump sum payments are *generally tax exempt* to the beneficiary, but may be taxable under the transfer for value rule if the policy had been sold to a third party prior to death.

1) Installment payments will usually have a *taxable interest* element. 2) Death benefits may be subject to the *federal estate tax* if the estate exceeds the excludable amount and the decedent owned the life insurance policy.

*Death Benefits* are usually paid as a *lump sum,* but can be paid using the following *Settlement options:*

1) Interest only 2) Fixed annual installments until the funds are exhausted 3) Fixed period installments until the period ends or 4) A life annuity

REITs may:

1) Invest in long-term mortgages 2) Own real property 3) Make short-term real estate construction and development loans 4) Invest in other REITs 5) Issue debt

Investment Companies - General Information

1) Investment Companies can either be open-end or closed-end. 2) With any fund, diversification is achieved whether within a certain sector, or across global markets with foreign securities. 3) Investment companies allow investors to diversify without going to the trouble of buying the securities of many individual companies. 4) Though investment companies create diversification, they: a. Do NOT eliminate risk b. Will NOT reduce risk associated with currency fluctuation. c. Do NOT eliminate tax liabilities.

REITS are:

1) NOT Redeemable 2) NOT investment companies 3) NOT regulated under the Investment Company Act of 1940 4) NOT direct participation programs

Open-End Investment Companies

1) Open-end investment companies (mutual funds) stand ready to issue and redeem shares on a daily basis. 2) Shares are issued and may only be redeemed with the issuing investment company. 3) The price of open-end investment company shares is directly tied to the Net Asset Value (NAV) of the fund and a sales load is added to this price. 4) A Breakpoint is a volume discount offered to investors in investment companies, where the investor can receive a lower sales load due to the amount of money invested. a. If an investor is near a breakpoint, it is considered an unethical practice for the agent to fail to mention the breakpoint to the investor prior to the sale. b. Buying mutual fund shares just below a breakpoint amount forces the investor to pay a higher sales load.

Bonds trade in the secondary market at either:

1) Premium 2) Par 3) Discount

Common Stock Issued by a Corporation:

1) Represents equity ownership of a corporation 2) Can pay voluntary dividends which are declared by the Board of Directors of the corporation. *Dividends are not mandatory* 3) Generally has voting rights, allowing all shareholders to vote for members of the Board of Directors and on important matters such as stock splits, regardless of when or how the common stock was acquired. 4) Is considered to carry a high level of risk since the shareholders would be the last to be paid in a corporate liquidation. 5) Is highly susceptible to market risk.

Preferred Stock issued by a corporation:

1) Represents equity ownership of a corporation 2) Is a fixed income security, since it pays a fixed or set dividend rate. Dividends are not mandatory on any equity security, but dividends are EXPECTED on preferred stocks. 3) Does NOT normally have voting privileges. 4) Offers less potential for appreciation than common stock since it is a fixed income security.

Examples of ETFs:

1) SPDR (Standard and Poor's Depository Receipts) - Represents the S&P 500 Composite Index 2) DIAMONDS - Represents the Dow Jones Industrial Average 3) QQQ - Represents the NASDAQ 100 Index 4) HOLDERS (Holding Company Depository Receipts) - Represents 16 trusts related to the largest European companies' common stocks traded on the NYSE, Amex, and NASDAQ.

Replacing a policy with a new policy is permitted, but is highly regulated.

1) State replacement requirements include a *written comparison* of the new and old policies covering policy provisions such as the suicide clause, the incontestability clause, and the conversion period. 2) Replacements can avoid current taxation on any gain in the old policy by making a Sec. 1035 exchange. Such tax-free exchanges can only be done once every 3 years.

Cash surrender values accumulate on either a fixed basis on whole life policies, or variable basis on variable policies. The policy holder can access the cash by:

1) Taking a policy loan against the cash values, or 2) Surrendering the policy for its cash surrender value. The cash surrender value will be taxable as ordinary income if it exceeds the total premiums paid.

ETN Taxation:

1) The IRS has not yet made a final ruling on the treatment of ETNs. 2) At this time, *ETNs do not usually pay dividends or have coupon rates,* so there is not normally any annual income to the investor. For this reason, *holders of ETNs will pay capital gains or losses associated with their units, but these holders can reap the benefits of long-term capital gains rates.*

Exchange Fee

A fee charged to investors if they exchange or transfer shares of one fund for shares of another fund within the same fund family.

Redemption Fee

A fee charged to investors when they redeem their shares. The SEC limits redemption fees to 2%.

Purchase Fee

A fee that some funds charge investors when they purchase fund shares and is separate from the front-end sales load because it is paid to the fund, not to the broker.

Derivative

A Derivative is a contract that *is valued based upon the value of an underlying asset, index, or security* (ex. equity options are tied to the value of common stock of a corporation). *Derivatives are leverage investments* because a small investment can control a large position resulting in a greater rate of return (or less). The following are examples of derivatives: 1) Futures Contracts 2) Forward Contracts 3) Equity Options 4) LEAPs Options 5) Index Options 6) Foreign Currency Options 7) Swaps - including interest rate swaps 8) Warrants 9) Rights NOTE: The following *ARE NOT* derivatives because the underlying asset is owned: 1) Real Estate Investment Trusts (REITs) 2) Investment Companies, including: a. Open-End Investment Companies (mutual funds) b. Closed-End Investment Companies c. Unit Investment Trusts (UITs)

Viatical Settlement Agreement

A Viatical Settlement Agreement is one in which an investor buys a life insurance policy from a policyholder with a terminal disease with a life expectancy of less than two years at a substantial discount from the death benefit. At the time of the transaction, the purchase price of the policy will be more than the cash value but less than the death benefit, therefore both the policyholder and the investor benefit. The investor continues to pay the premiums and becomes the beneficiary and collects the death benefit.

Forward Contract

A cash contract in which the seller agrees to deliver a specific cash commodity to the buyer at some point in the future. Forward contracts are personal agreements between two parties and are *not traded.* Since Forward contracts are not traded, they would be used primarily by users or producers of commodities to hedge spot or cash price movements. SPOT = CASH

Credit Spread

A credit spread on bonds is the difference between two bonds of similar maturity, generally a corporate bond and a treasury bond. The credit spread or simply "the spread" cited most often is the difference of a corporate issue compared with a US Treasury security. So, if a GM 30-year bond has a yield of 5% and the 30-year Treasury bond has a yield of 3.5%, the spread would be 1.5%. Note, however, that spreads are quoted in BASIS POINTS. A basis point on a bond is equal to 1/100th of a point, or 0.01% of the $1000 par value. A change of 1% in the yield of a bond (ex. 7% to 8%) is equal to 100 basis points. So in our example above the spread is 150 basis points. If you note a varying credit spread between Treasuries and a range of other corporate bonds, the ones with the higher spreads would be considered riskier.

Certificate of Deposit (CD):

A debt instrument issued by a bank which has a *fixed rate of interest and a maturity date.* It is a "time deposit" where the investor agrees to leave their "savings" in the bank for a set period of time. If funds are withdrawn early, the investor will have to pay a *penalty.* CDs are *not considered to be a "liquid" investment* since funds are not readily available to the investor.

Account Fee

A fee charged to investors for the maintenance of their accounts.

Hedge Funds

A hedge fund is a form of investment vehicle established for affluent and semi-affluent investors. Hedge funds are *not considered investment companies* and are *not as heavily regulated* as other investment products such as investment companies.

Futures Contract

A legal binding contract made on the trading floor of a futures exchange to buy or sell a specific commodity or financial instrument at some point in the future. Financial futures include futures on individual stocks or stock indices. So for example, if you thought the market was about to rise, you would buy or go long a stock index futures. These contracts are standardized for quality, quantity, and delivery time as well as location of the commodity. The variable part of the contract is the price, which is based on the cash market value of the commodity. 1) Futures are used by: a. Speculators such as: - hedge funds - portfolio managers - high net worth investors b. Hedgers such as: - producers of commodities - consumers of commodities 2) To hedge or protect portfolio values. a. A *Long Hedge* would be used by *buyers* of commodities to protect against *rising prices* b. A *Short Hedge* would be used by *sellers* of commodities to protect against *falling prices* **SEE COMPARISON CHART ON PAGE 128** 3) Calculation Example: An investor buys 1 soybean futures contract at $0.45. Later, the investor sells the futures contract at $0.43. A soybean future has a contract size of 5,000 bushels. What is the result of the transaction? B- 0.45 S+ 0.43 = -0.02 x 5,000 bushels = $100 loss *Gain or loss* x *Contract size* = *Total gain or loss*

Health Savings Account (HSA)

A tax-advantaged medical savings account set up with a qualified HSA trustee, such as a bank or insurance company. Individual taxpayers can *contribute to and withdraw* money from the account for certain medical, dental, and vision expenses on a tax-free basis. These accounts may only be established if the individual enrolls in a high-deductible health plan (HDHP) and has no other health coverage or Medicare 1) HSAs have triple tax benefits: a. *Deductible contribution limits* of $3,550 for individuals and $7,100 for families plus an additional $1,000 catch-up contribution for persons 55 and older. b. *Tax-deferred earnings* c. Within limits, *money can be used at any time* for qualified medical expenses and is tax free when used for such purposes. 2) Other features of HSAs are: a. They are individual accounts. Don't confuse HSAs with FSAs (Flexible Spending Accounts) which must be established through an employer. b. They can be established as savings or investment accounts. c. *Withdrawals before age 65 for non-health purposes will result in ordinary income taxes plus a 20% penalty tax. Withdrawals after age 65 for non-health purposes will be taxed as ordinary income, but will not be subject to the penalty tax.

Premium payments for life insurance are generally paid with __________________.

After Tax Dollars. If a policyholder discontinues premium payments on a cash value policy, the policyholder can elect to receive a reduced, paid up policy, or extended term insurance.

Fixed Income (Bond) ETFs

Although ETFs have historically been equity funds, they have recently become popular as bond funds too. The Characteristics of a Bond ETF are: 1) They give an *investor the opportunity to invest in "bonds" without investing directly in one particular bond. 2) Many *Bond ETFs are more liquid than the bonds themselves* (some bonds do not actively trade on a daily basis) 3) *Bond ETFs are a low cost way to invest in bonds* 4) *The market price of shares in a Bond ETF is based on supply and demand and can be different than the NAV per share of the fund.* The market value may be higher (a premium) or lower (a discount) from the NAV. During slow markets, there is a close relationship between the market price and the NAV, but in fast markets, the difference can be sizeable.

Annuity

An Annuity is simply a series of periodic payments, such as $100 per month, paid to an annuitant for life usually for retirement income or can be paid to an annuitant and their beneficiary for a minimum "period certain", like a 10-year period. It is therefore a suitable investment for an individual with an investment objective of long-term capital appreciation. 1) Annuity contracts are issued by life insurance companies 2) the annuity contract holder buys the contract by paying a lump sum to the life insurance company called a *"single premium"* or by paying a series of installment payments called *"periodic payments"* or Flexible Premiums. 3) *Immediate Annuity* - After the annuitant has deposited their single premium payment, the income payments to the annuitant begin immediately (after the start date) and are paid for a specific period of time or for the life of the annuitant. 4) *Deferred Annuity* - Income payments do not start until a later date in the future, usually when the annuitant retires. 5) There are two basic types of annuities, fixed or variable: a. A *Fixed Annuity* pays the same predetermined dollar amount each period, for example $100 per month. The insurance company bears the investment risk. b. A *Variable Annuity* pays a fluctuating dollar amount each period, for example $100 in January, $103 in February, $99 in March. The amount paid varies based on the value of the securities in the Separate Account of the insurance company issuing the variable annuity contracts. The annuitant (or policy holder) bears the investment risk. This annuity may act as a hedge against inflation. 6) On both a Fixed and Variable Annuity, *the earnings are tax deferred* until annuitization, unless the holder makes early withdrawals.

After-Tax Yield (equation)

Annual Interest x (100% - Investor's tax rate) For Example: An investor buys a taxable bond with a coupon of 4% at par. The bond is exempt from state tax and the investor has a 28% marginal tax-rate. 0.04 x 0.72 (100% - 28%) = 0.0288 = 2.88% After-Tax Yield

12b-1 Fees

Annual fees charged by a fund (NOT BY AN IA) against the fund's assets to cover sales and marketing expenses. *Charged by the fund, not the IA*

Hedge Funds - Comparisons

Because hedge funds are not heavily regulated, their performance figures are not always standardized from hedge fund to hedge fund. For this reason, comparisons to other types of investments or other hedge funds can be difficult/misleading and should not be performed.

Hedge Funds - Suitability and Regulation

Because of the higher levels of risk, hedge funds are not suitable for your average investor. Though hedge funds are largely unregulated, there are regulations that have been established for investing in hedge funds to protect the general public. 1) Hedge fund investment is limited to Accredited Investors, Qualified Investors, and Semi-Affluent Investors: a. Accredited investors are defined as having: - A net worth over $1 Million; or - Earned income that exceeded $200,000 in each of the last two years with the expectation of income exceeding $200,000 in the current year ($300,000 for married couples) b. Qualified Investors are defined as having: - A net worth of $2.1 Million or more; or - $1 Million in assets invested under the specific investment manager c. Semi-Affluent Investors do not meet the criteria of being accredited or qualified, but do meet minimum investment requirements. - Investors may be required to deposit a minimum investment of $25,000, for example. - Semi-Affluent Investors are able to invest in certain types of hedge funds that are established as Funds of funds or Open-end funds 2) Because of these requirements, hedge fund investors are typically more sophisticated than the general investing public. For this reason, suitability is often less of a concern than it would be for other investors, such as a normal investor setting up a retirement plan.

Bonds

Bonds are a debt security that pay interest to investors semi-annually at a stated rate. This is why bonds are considered "fixed-income" securities. The par or face value of a bond is $1000.

Bonds trading at PAR have a market value EQUAL to par of $1000.

Bonds trading at par typically are paying interest rates equal to those in the prevailing market. This means that the bond may pay interest of 5% and the prevailing market rates are 5% as well.

Sales Practices Consideration of Non-Traditional ETFs

Both leveraged and inverse ETFs can be more volatile and risky than traditional ETFs. *They are reset or rebalanced daily.* Most of these funds are designed for short-term (daily) trading objectives and are designed for sophisticated investors. Consequently, FINRA has issued guidance regarding the sale of these products. 1) FINRA believes that *leveraged and inverse ETFs that reset daily are unsuitable for retail investors who plan to hold them for longer than one day*

Yield to Maturity or Basis:

Both preferred stock and bonds are fixed-income securities. Therefore, their market prices are sensitive to interest rate movements. Their market prices move in the opposite direction to interest rates. Inverse Reaction means that as interest rates go up, the prices of outstanding bonds will fall and that as interest rates go down, the prices of outstanding bonds will rise.

If a bond has a Coupon Rate of 8% and a basis of 7%, it is trading at a _____________

Premium

Capital Needs Analysis

Capital Needs Analysis is used to determine if an individual has enough life insurance to fund their future financial goals. When doing this analysis, you would consider the client's expected income, general life expectancy, number of dependents, savings, and the current rate of inflation. You would NOT need to consider stock market fluctuations.

Commodities and Precious Metals:

Commodities are raw materials we use to live, trade, and store. Energy, metals, and agricultural products are the three classes of commodities, and they are the essential building blocks of the global economy. From an investing perspective, they are also an asset class. Most commodities trade on an exchange such as the Chicago Board of Trade (CBOT). Examples of energy commodities are crude oil, natural gas, coal, and electricity. Examples of agricultural commodities are coffee, soybeans, cattle, oranges, and corn. 1) Precious metals are generally rare, naturally-occurring metals from the earth such as Gold, Silver, Platinum, and Palladium. These metals are held by central banks as some backing to world currencies, can be made into coins and jewelry, and are used for industrial applications. Prices are determined by supply and demand. 2) Precious Metals include (but are not limited to): a. Gold - has always been a symbol of wealth and used to be used as currency or a standard for currency. It is also used in the electronics industry. Gold is generally considered to be a separate asset class by itself. b. Silver - is considered to be a more affordable precious metal and is used in the electronics industry because of its conductivity and thermal value. c. Platinum - is used for computers, automotive parts, and medical equipment. d. Palladium - has the ability to withstand extreme temperatures. It is used for water purification and refining oil and gas. 3) Investing in precious metals provides a way for investors to be shielded from long-term inflation. As a general concept, *precious metal values tend to move in the opposite direction of the equities markers.* Also, when there is a devaluation of cash assets, precious metal prices rise. 4) The risks or disadvantages of investing in precious metals include: a. Price Volatility b. the discovery of new metal reserves, which will increase the supply of the metal. c. If investors actually purchase "bars" or "coins", that investment must be kept in a safe place, such as a bank vault. 5) Investors can invest directly or indirectly in precious metals, particularly Gold. a. Directly investing means buying and holding physical gold bars (bullion), coins, and jewelry at current "spot" or cash prices plus a mark-up which is paid to the seller. Direct investment has no income potential, but does have capital gain or loss potential. Directi investment also involves storage and insurance costs. Certain US Government or State issued gold, silver, platinum, and palladium coins and bullion may be purchased by an investor in a brokerage account or in a Retirement Account, if the broker-dealer offers that service. b. Indirect investing would include investing in: - Mining company stocks - Gold futures and options contracts - Gold mutual funds and ETFs and ETNs - Gold commodity pools and indices 6) Investing or speculating in Gold is very risky because of its price volatility.

If a bond has a Coupon Rate of 8.5% and a basis of 9.3%, it is trading at a ________________

Discount

Exchange Traded Notes (ETNs):

ETNs are debt instruments issued by *banks*. The bank promises to repay the principal amount less investor fees at final maturity and the *performance of the ETN is linked to a specific index* or a particular strategy of investing.

If a bond trading at a premium (103) has a call price which is lower (102), the final yield to call (should the bond be called away), would be less than the coupon rate of the bond. Flip for example

Lets say you are looking at a bond which will mature in 10 years. It has a coupon rate of 5.25% and is trading at 103. If the bond is called away from the customer at 102 in 3 years, the investor would end up with a yield to call of less than coupon (5.25%) because the customer would suffer a loss in yield income and a loss in principal value. Market Price 103 Call price - 102 = 1 point loss Bond being called 7 years early would mean interest income loss of: Annual interest $52.50 x 7 years = $367.50 LOSS

REITs have ________________________ to other financial assets owned by investors because real estate investments react differently than stocks and bonds.

Low Correlation

Bonds trading at a PREMIUM will always have a basis (YTM) which is __________ than the coupon rate.

Lower

Long-term bonds carry __________ risk than short-term bonds. Short-term bonds are considered to be __________ when ranking the safety of investments.

MORE SAFER

Some REITs are traded OTC and some are traded on exchanges. If they are _____________ sold, REITS must be ______________________. They are not exempt from registration (ex. They are not exempt securities)

Publicly sold Registered with SEC

No specific tax bracket or net worth is needed to invest in a REIT. There are ________ minimum investment or net worth requirements needed to invest.

NO

Policy loans are _________________.

NOT taxable. Policy loans must be repaid with interest. Unpaid policy loans are subtracted from death benefits.

Yield to Call

On callable bonds, the yield to call refers to the expected yield that the investor will receive, assuming that the bond is called on the first or next available call date. Callable bonds are normally issued with a call price that is above the par value of the bond (Call Premium) 1) Yield to call is affected by: a. Call Premiums b. Time to Call date c. Price paid for the callable bond 2) Call premiums: a. A call premium over the face or par value of the bond will cause the yield to call on the bonds trading at a discount or par value to be higher than the yield to maturity. 3) Assuming a call price that is equal to the face or par value of the bond, the yield to call will be: a. Higher than the Yield to Maturity on bonds trading at a discount. b. Lower than the Yield to Maturity on bonds trading at a premium

Mutual Fund Fees and Expenses

Operating a mutual fund involves the normal costs of running a business. Fees and expenses vary from fund to fund and should be a major consideration when buying fund shares because small differences in fees translate into large differences in returns for investors. All fund fees and charges are identified in a fee table in the front of the fund's prospectus under the heading "Shareholder Fees". The fees and expenses include: Annual Fund Operating Expenses Sales loads (Front and Back End) No-Load Fund Redemption Fee Exchange Fee Account Fee Purchase Fee

Dividends paid by REITs are generally taxed at the individuals _______________________.

Ordinary income tax rate.

The longer the maturity of a bond, the more its price will decline when interest rates go up. - Short-term bonds react the ______________ to interest rate changes. - Long-term bonds react the _______________ to interest rate changes.

Quickest Greatest

Riders

Riders are special optional features that can be added at the request of the customer for an *additional cost.* There are numerous types of riders and they can vary significantly from one financial institution to another, but some common riders are guaranteed minimum income benefit, bonus credits, and long-term care protection. The key takeaway is riders add to the cost of the purchase of the variable contract (annuities or life insurance) and, consequently, *must be disclosed* to the customer before a decision to purchase is made.

Standard and Poor's and Moody's evaluate the credit quality of corporate, government, and municipal bonds and emphasize the default risk (interest and principal risk) associated with the bonds.

STANDARD AND POOR'S BOND RATINGS: AAA AA A BBB _______________________________________________INVESTMENT GRADE SPECULATIVE GRADE BB B CCC CC C DDD DD MOODY'S BOND RATINGS: Aaa Aa A Baa _______________________________________________INVESTMENT GRADE SPECULATIVE GRADE Ba B Caa Ca C

Sales Loads

Sales Loads are generally fees imposed on investors who buy their fund shares from a Broker-Dealer. Although there are funds that do not use outside B/D's to distribute fund shares, some will still charge a sales load. FINRA limits sales loads to 8.5%. There are two basic types of sales loads: a. Front-end load - Investors pay the load when they purchase the shares. b. Back-end or Deferred Sales Load - Investors pay the load when they redeem the shares

Rights of Accumulation

Some funds give the investor "Rights of Accumulation" (ROA), permitting a reduced sales charge on new purchases when the TOTAL VALUE of already-held shares plus the additional amount to be invested exceeds the sales charge breakpoint.

Annual Fund Operating Expenses

The cost of regular and recurring fund operating expenses. These expenses are paid out of the fund's assets (portfolio) rather than a separate fee charged to investors. Although investors do not pay these expenses directly to the fund, the cost is still a fee to investors, since the expenses are taken out of the assets of the fund. Included in these expenses are: a. Management Fees b. Distribution and/or Service Fees (12b-1 fees) c. Custodial Fees d. Legal Expenses e. Accounting expenses f. Administration expenses and Transfer Agent expenses

No-Load Fund

The fund does not charge a front-end or back-end load but may instead charge purchase fees, exchange fees, account fees, and redemption fees.

Types of Life Insurance:

The primary purpose of life insurance is *income replacement* for the beneficiary or beneficiaries of a life insurance policy related to the life of the insured person. When an individual buys a life insurance policy, the individual will be required to pay premiums to the insurance company for the policy. An insurance premium is the amount a policyholder (buyer of the policy) pays for a life insurance policy. For example, a policyholder might pay $300 per month for a $1,000,000 life insurance policy. *For life insurance products, the premiums are generally paid with after-tax dollars and are not tax-deductible*

Bonds trading at PAR will always have a basis which is __________ as the coupon rate.

The same

Types of Structured Products:

There are many structured products out there. We focus on two types: 1) Equity-Linked Notes (ELNs) - An equity-linked note is a debt security but differs from the traditional fixed-income security in that the final payout is based on the return of the underlying *equity* (which could be a single stock, index, or basket of stocks). Note that many issuers of ELNs include a cap on the return. 2) Market Linked Notes (MLNs) - Another common structured product is a Market-Linked Note (MLN). They share many characteristics with the ELNs. In simplest terms, they are debt securities that have a return that is linked to the performance of another asset or assets. They are not limited to equities like ELNs as MLNs can be structured to include commodities, foreign currencies, equities, and international market indices. *Basic Characteristics of ELNs and MLNs (we will refer to them as structured products below): 1) *Principal Protection* - Many structured products are issued with a guarantee of either full or partial return of the original investment *if held to maturity*; some are issued without this protection. 2) *Performance/Return* - Although structured products pay interest payments as ordinary notes do, the performance or return of these products *at maturity* is tied to (or derived from) the selected underlying security, such as a single stock or stock index. Some, particularly MLNs, may not pay a fixed interest payment or coupon because the value of the payment would be based on the performance of the underlying market. 3) *Listing* - Some structured products are exchange-listed and others are *unlisted* 4) *Issuance* - Investors can buy structured products as new offerings or in the secondary market (for those that are listed). 5) *Risks* associated with structured products - These are some primary risk considerations and those that you should be familiar with for the exam: a. *Principal Risk* - Principal is guaranteed by the *issuer only* and only if the note is held to maturity. The amount of principal protection varies by note, and is disclosed in the relevant offering documents. b. *Performance Risk* - Structured products pay a return based upon the performance of the underlying asset(s). However, the performance of the structured product may not match the underlying asset if the structured product contains a cap on performance. This would be disclosed in the offering documents. c. *Liquidity Risk* - Issuers make no guarantee of a secondary market. Structured products are generally NOT designed to be short-term trading instruments and investors should be willing to hold the note to maturity. 6) Also, investors assume more risk if they purchase unlisted structured products because selling them may be more difficult than selling listed ones as there are may not be a market readily available for unlisted products. In fact, even some listed structured products can be difficult to sell as they may have a thinly-traded market. a. *Credit Risk* - Structured products are subject to the credit risk of the issuer. There is no government-backed guarantee on structured products. If the issuer is unable to meet its financial obligations, the investor may lose the entire investment. b. *Call/Reinvestment Risk* - Some structured products are callable by the issuer. The issuer will likely call the note if it is advantageous for them to do so. If the note is called, it is possible, if not likely, that the investor may be unable to reinvest the proceeds at the same or a greater yield.

Equity Options

There are two basic types of options classes: *Puts and Calls.* The trading of puts and calls can be used for stocks and futures contracts. These options trade on an exchange. 1) Call Option: a. Gives the *buyer* the *right* to *purchase* the underlying security or future at a set *exercise* price for a limited period of time. b. *Obligates* the *seller* to *sell* the underlying security or future at the *exercise* price for a limited period of time. 2) Put Option: a. Gives the *buyer* the *right* to *sell* the underlying security or future at a set *exercise* price for a limited period of time. b. *Obligates* the *seller* to *buy* the underlying security or future at the *exercise* price for a limited period of time. 3) Traditional vs. Long-Term Equity Options: a. A *Standard or Traditional* option contract has a maximum expiration of *9 months* from the time it is created. b. *LEAPS* - Long-Term Equity Anticipation Securities are long-term options on stocks and on stock indexes and have maximum expirations of *39 months* from the time they are created. 4) An investor would: a. *Buy Calls* if they expect the values of stocks or futures to rise and also lock in the price of buying more shares in the future. b. *Sell Calls* if they expect values of stocks or futures to remain stable or decline modestly and are looking for *income* c. *Buy Puts* if they expect the values of stocks or futures to decline. d. *Sell Puts* if they expect the values of stocks or futures to remain stable or appreciate modestly and are looking for *income* 5) Option Exercise Styles: a. *American* - These options can be exercised *at any time* at the discretion of the buyer. b. *European* - These options can only be exercised *at expiration* 6) Options may *NOT* be bought *on margin,* although they may be bought *in a margin account* (always have to pay 100% of the premium) 7) Leverage, in this case using options instead of buying the stock to invest, provides the opportunity to improve the investor's rate of return without increasing the amount of capital invested. 8) Using Put and Call options provides investors with "leverage" since the investor has the same profit potential they would have had by trading the stock but with a much smaller capital commitment since they are only required to pay the premium on the option when buying puts or calls. EXAMPLE: An investor is bullish on ABC when ABC is trading at 50. The investor could spend $5,000 and buy 100 shares of ABC or the investor could use leverage and buy call options instead of buying the stock. Let's say that ABC 50 Calls are trading at a premium of 5. A premium of 5 equals a cost of $500 for 1 option ($5 per share x 100 shares). With the same $5,000, the investor would have used to buy the stock, the investor could have purchased 10 Call options ($5,000/$500 = 10 Calls) which would have *magnified or leveraged their profit (or loss) potential 10 times! **SEE BASIC OPTIONS SUMMARY CHART ON PAGE 131**

Exchange Traded Funds (ETFs)

These are funds that are similar to normal index mutual funds with a portfolio that mirrors a *specific index or industry sector basket of securities.* The primary difference between an ETF and an index fund is that ETF's have shares that trade like common stock shares.

Structured Products

This is a broad term applied to an array of diverse investment products. FINRA describes structured products as "securities derived from or based on a single security, a basket of securities, an index, a commodity, a debt issuance, and/or a foreign currency." These products were created to provide investors (retail and institutional) with investment options that go beyond your typical stock and bond investing by exposing them to different asset classes. They are issued by financial institutions such as banks or broker-dealers. Structured products may not be suitable for all retail investors. 1) Structured products typically have two components - a note and a derivative (often an option). The fixed income component of the product pays interest to the investor at a specified rate and interval. The derivative component establishes the payment at maturity based on the performance of the underlying asset. Despite the derivative component of a structured product, they are often marketed to investors as debt securities.

Type of Permanent Life Insurance: Variable Life Insurance

This type of policy has an investment component which allows the policyholder to allocate a portion of the premium paid into an investment fund of stocks, bonds, mutual funds, and other types of investments. a. *The policy offers a Fixed Level of Premium* - The payments go into a *Separate Account.* The Separate Account, in turn, has sub-accounts with various investment objectives. The investment returns are not guaranteed. The Separate Account has greater investment potential than a General Account. b. The policy offers a *Variable Death Benefit* - The death benefit will vary depending on the performance of the investment option chosen by the policyholder. *There is usually a guaranteed minimum death benefit* c. The policy offers a *Cash Surrender Value that will vary* depending on the performance of the investments chosen by the policyholder. d. *The Cash Surrender Value must be calculated at least monthly.* Policyholders may borrow against the cash value up to certain limits. Interest is charged on the policy loan. e. This type of policy is a security and must register with the SEC. A prospectus must be delivered before or with the offer to sell. - The SEC permits the delivery (hard copy or electronic) of an *initial summary prospectus* to new investors of variable contracts (annuities and life insurance) provided the full prospectus is available online. The initial summary prospectus contains a table of key information on the contract's fees, risks, and other important considerations. - Regarding investors who already own a variable contract, the SEC permits the delivery (hard copy or electronic) of an *updating summary prospectus,* which would include a brief description of certain changes to the contract that occurred during the previous year as well as other key information. f. Variable life is convertible to whole life during the first two policy years. g. A prospectus for variable life should be a person with some investment sophistication and a tolerance for possible wide fluctuations in "Cash Surrender Value" h. Lapsed policies may be reinstated with evidence of insurability and payment of unpaid premiums. i. These policies have surrender charges and management fee expenses. j. A Variable life insurance policy is a possible hedge against inflation.

Brady Bonds

US Dollar-denominated bonds issued by Latin American countries that are collateralized by US Treasury zero-coupon bonds. They were issued to convert defaulted loans into bonds and thereby reschedule the issuer's debt repayments. They are named after former Treasury Secretary Nicholas Brady who was instrumental in developing them. The key characteristics of a Brady Bond are: a. They are coupon-bearing bonds with fixed or variable interest rates that mature in 10 to 30 years. b. They are secured by the US Treasury zero-coupon bonds.

Yankee Bonds

US Dollar-denominated bonds issued in the USA by foreign companies or governments. They are used when interest rates in the USA are low. They must be registered with the SEC.

Type of Permanent Life Insurance: Universal Life Insurance

Universal Life Insurance also called *Adjustable Life Insurance* - this type of policy allows the holder, at certain times stated in the policy, to "adjust" the amount of premium and the amount of the death benefit. a. *The policy offers Flexible Premium Payment* - The premium payments go into a *General Account* b. The policy offers an *Adjustable Death Benefit* c. The policy offers a *Cash Surrender Value* that is based on fluctuating interest rates but there is a *minimum guaranteed rate.* Investors can borrow from the policy up to the CSV amount. Interest is charged on the policy loan. d. *Policyholders do not choose the investments* and therefore do not bear the investment risk. e. Lapsed policies may be reinstated with evidence of insurability and payment of unpaid premiums.

Variable Annuities

Variable Annuities are basically made up of an investment portfolio of mutual funds or other professionally managed securities held in a special, *tax-deferred account* of the insurance company called the *Separate Account.* They are considered to be *long-term investments* that may provide a possible hedge against inflation and would be suitable for an investor with an investment objective of long-term capital appreciation. 1) there are two basic types of *"units"* in a variable annuity contract depending on whether you are paying into the plan (*accumulation units*) or receiving payments from the plan (*annuity units*). -When you annuitize the number of units is "fixed," but the value fluctuates based on the value of the securities in the sub account. 2) Returns in a variable annuity are directly tied to the investments chosen by the contract holder. *The contract holder chooses investments and bears the investment risk of the portfolio.* Measuring returns in a variable annuity is as simple as measuring yields of the various investments and separate account (or sub-accounts) that the holder of the contract chooses. 3) Variable annuities generally have high levels of expenses and fees compared to investment company shares with similar features to the annuity. **Often variable annuities will include an investment in investment company shares. In these situations, the investor ends up paying fees associated with both the investment company and the annuity, resulting in higher fees than if the investor would have simply invested in the mutual fund directly. 4) Benefits of investing in a variable annuity include: a. Tax-deferred earnings b. Participation in upward fluctuations in the market which allow investors to receive higher levels of return than with standard fixed annuities. c. The ability to change investments within the annuity with changes in investment objective or investment strategy. d. Investors have added control over how annuity funds are invested in the market. e. Professional management of funds. f. Guaranteed minimum death benefit. NOTE: Variable Annuities do not have guaranteed cash values. 5) *Qualified Annuities* are bought with *before tax* dollars. all of the distributions are taxable. - *Non-qualified annuities* are bought with *after tax* dollars. On distribution, only the earnings are taxable. - In both cases, the *earnings accumulate on a tax-deferred basis* 6) The taxation of an early withdrawal is LIFO (Last In, First Out), meaning that earnings are taxed first, plus a *10% penalty* if the annuitant is under 59.5 years of age. 7) Predictions and projections are not allowed on Variable Annuities. 8) Variable Annuities are structured like an investment company and are registered with the SEC pursuant to the Investment Company Act of 1940.

Type of Permanent Life Insurance: Variable-Universal Life Insurance

Variable-Universal Life Insurance is a type of permanent life insurance that has an investment component which allows the policyholder to allocate a portion of the premium paid into an investment fund of stocks, bonds, mutual funds, and other types of investments. a. The policy offers a variable death benefit and cash values and has flexibility in premium payments. b. The policy has Premiums and death benefits that fluctuate based on the performance of the *Separate Account.* It is a security. c. the policy has surrender charges and management fee expenses. d. The policyholder bears the investment risk. e. The policyholder can take out policy loans. f. There is no guaranteed Cash Value. g. The only guarantee is the Rate of Mortality and the right to keep the policy in force. h. this is a good choice for a high risk tolerance client.

Type of Permanent Life Insurance: Whole Life Insurance

Whole Life Insurance which is also called *ordinary and straight life insurance* characteristics include: a. The policy offers a *Fixed Level of Premium* - The premium payments remain the same and go into a *General Account* b. The policy offers a *Fixed Death Benefit* c. The policy offers a *Cash Surrender Value* - This value is increased based on a fixed cash value table or schedule. Policyholders can borrow from the policy up to the Cash Surrender Value amount. Interest is charge on the loan if the policyholder barrows from the policy. d. *Policyholders do not choose the investments* and therefore do not bear the investment risk. e. Lapsed policies may be reinstated with evidence of insurability and payment of unpaid premiums.

Duration is a measure of the sensitivity of a bond's market price to changes in interest rates (ex. a bond with a duration of 5 will have a price movement of 5% for every 1% movement in the interest rate)

a) A zero-coupon bond always has a duration equal to its maturity and coupon bonds always have a lower duration because the coupon bonds pay interest whereas the zero-coupon has no interest payment. b) For large yield changes greater than 1%, the bond price volatility is measured by convexity.

Bonds trading at a DISCOUNT have a market value BELOW the par value of $1000.

a. Bonds often trade at a discount due to the fact that the bond is paying an interest rate that is lower than the current prevailing rate in the market. b. This means that the current rates might be 5% and the bond in question is paying 2% which drives the market price of the bond down.

Bonds trading at a PREMIUM have a market value ABOVE par of $1000.

a. Bonds often trade at a premium due to the fact that the bond is paying an interest rate that is higher than the current prevailing rate in the market. b. This means that current rates might be 5% and a bond that pays 10% will be trading above its par of $1000 because of this fact.

Advantages of investing in REITs include:

a. Appreciation in property values b. Dividend income to investors c. Liquidity - an investor could sell their shares d. An increased demand for real estate (expected over time) NOTE: A decrease or weakening in demand for real estate would not be advantageous to REITs.

Equity Indexed Annuities: 3) Valuation/Computation on Modern Indexed Annuities

a. Indexed Annuities can measure the movement of the index in three different ways: 1) *Annual Reset* - Beginning of year to end of year. The annuitant locks in gains every year that the index is positive. 2) *High Water Mark* - Takes high point of index and compares it to index value at the beginning of the period. 3) *Point-to-Point* - Compares the change of the index at one point in time to another point in time. For example, the beginning of one year to the end of the second year. the interest is credited at the end of the period based on the participation rate or cap rate. *NOTE:* The principal and credited interest are protected from loss. This is called the "no loss" protection. b. There are three basic means of determining how the interest will be calculated and credited to the client's account. These include via: 1) *Participation Rates* a. Any gains seen in the index will be credited to the annuity at a given participation rate, while years of losses remain flat. For Example: - If the index goes up by 10%, and an investor's participation rate is 80%, the investor's equity indexed annuity is credited with 80% of a 10% increase, or is increased by 8% - If the index goes down by 5%, regardless of the participation rate, the investor's equity indexed annuity does not see a decrease in principal. 2) *Spread/Margin/Asset Fees* a. A set fee is taken from any gains instead of a participation-rate-base equation. For Example: - The fee is 4% of any gains to the index. - If the index goes up by 10%, then the equity indexed annuity is credited with 6%, while the remaining 4% goes towards fees. - If the index goes down, again, no fee is charged. 3) *Interest Rate Caps* a. A set cap is placed on the amount of appreciation of the index. For Example: - The cap on increases is 5% - If the index goes up by 10%, then the equity indexed annuity is credited with 5% (the cap) - If the index goes down, no fee is taken.

Bond Yields: (equations)

a. Nominal Yield = Coupon or interest rate on face of the bond b. Current Yield on Bonds = Annual Interest / Market Price *Interest is paid semi-annually* For Example: An investor purchases a 9% bond @ 90, the current yield is: __________% - Trading at a Discount - Current yield will be higher b/c investor is getting $100 additional at maturity 0.09 x 1000 (par) = 90 90/900 = 10% (current yield)

REITs offer investors:

a. Professional asset management b. Diversification of real estate assets c. Regular income from profits - high yields d. Possible share appreciation e. Liquidity (shares traded on an exchange like stocks) f. Limited liability.

Direct Real Estate Investment would include:

a. Raw Land - Investing in undeveloped land is generally regarded as *risky* because: - There is no income - The owner must make the mortgage payments. - The owner must pay taxes and maintain the property. - The market price may decline and it is an illiquid investment. - Since depreciation does not apply to raw land, the depreciation tax deduction is not available. NOTE: *The only upside is the potential long-term capital gain if the property value increases* b. *Primary Residence* - A home is frequently the largest asset an investor owns. In addition to being a home for the investor, this long-term investment can provide annual income tax deductions (ex. the interest on mortgage payments) and exclusions from taxes on realized long-term capital gains on the sale of the home ($250,000 for single filers and $500,000 for joint filers) if the owner has lived in the house for 2 of the last 5 years. But home prices can also decline and a home requires maintenance and is generally regarded as an illiquid asset. c. *Basic rental properties* - An investor can buy a property and rent it out to a tenant. The property can, therefore, provide a monthly rental income and possible long-term price appreciation. The investor, as landlord, is responsible for the mortgage payments, taxes, and the costs of maintaining the property, not to mention the problems of a bad tenant or no tenant (The investor can hire a property manager to handle these responsibilities).

Equity Indexed Annuities: 2) Modern Approach

a. Recent developments in the equity indexed annuity markets have created new products which are structured like fixed annuities with a fixed-interest rate, but also have a fluctuating interest rate which is lined to an index. b. For exam purposes, these products fall somewhere between a fixed annuity and a variable annuity. 1) Remember that *fixed annuities are not considered securities* and are relatively safe (as safe as the issuing insurance company). a. *Insurance company takes the investment risk* 2) Remember that *variable annuities are considered securities* and are considered to carry more risk. a. *Investor takes the investment risk* c. In today's market, most equity indexed annuities are not considered securities but must be registered with each state's insurance commission. d. *Point-to-Point Indexing* - While annuities are most commonly calculated annually, some employ the point-to-point indexing valuation method. Point-to-point is a term that refers to a fixed indexed annuity crediting method. Indexed annuities credit a level of interest to the contract owner. This level of credited interest can be based on or linked to the performance of equity markets. Point-to-point means that the level of credited interest is based on the difference (or a percentage of the difference) in an index value over some period of time. For Example: Say that the S&P 500 index is 2500 at the beginning of a given year, and it is currently at 2750. The difference between these two points in time is 250 points or 10 percent of the starting index value.

REITs avoid double taxation on profits applicable to other corporations if they satisfy 4 considerations:

a. The REIT must distribute *at least 90% of its profits* in the form of dividends to shareholders annually. b. The REIT must have *at least 75% of its assets* invested in real estate, mortgage loans, shares of other REITs, cash, or government securities. c. The REIT must derive at least 75% of its gross income from rents, mortgage interest, or gains from the sale of property. d. The REIT must have at least 100 shareholders and less than 50% of the outstanding shares can be concentrated in the hands of 5 or fewer shareholders.

Equity Indexed Annuities: 1) Traditional Approach

a. Traditionally, an equity indexed annuity provided payments linked to a specific stock index, like the S&P 500. If the index increased in value, the contract holder would be credited with at least part of the gain (with a cap to how much they would receive). If the index declined in value, the contract holder would be debited at least part of the decrease in value. All contract holders are guaranteed a minimum value on their annuity. b. Due to the ability to increase/decrease in value, *these products were treated as "securities" and had to be supervised like any other securities transaction"

When assessing the safety of a bond issue, an analyst would use cash flows, revenue to assets, and leverage ratios but would not use...

profitability ratios