Unit 7
Which of the following trade actively in the secondary market? I. Open-end funds II. Closed-end funds III. Unit investment trusts IV. Real estate investment trusts (REITs). A) II and IV B) I and III C) I and II D) III and IV
a Closed-end funds and REITs trade actively in the secondary market. Open-end funds and unit investment trusts do not trade in the secondary market; instead, shares are redeemed by the issuer.
A customer asks for sales literature for a money market mutual fund. Upon receiving the literature, she notices A) the fund's current yield is insured by the Federal Deposit Insurance Corporation. B) the fund is an appropriate addition for investors seeking capital appreciation. C) the fund stipulates that future results will be substantially the same as the past performance listed in the 1-, 5-, and 10-year returns. D) the fund seeks to maintain a stable price but the fund can lose money.
d Sales literature for money market mutual funds must include the fact that it is possible to lose money when investing in the fund.
A customer who seeks to supplement his retirement income and has a high risk tolerance would find which of the following securities most suitable? A) High-yield bond funds B) Treasury STRIPS C) Investment-grade bond funds D) Municipal GOs
a High-yield bonds yield more than investment-grade bonds. Because the client has a high risk tolerance, these bonds are more appropriate than investment-grade bonds, which yield less. Not only do the Treasury STRIPS provide zero income, but they certainly are not suitable for those with a high risk tolerance. Similarly, the municipal GO bonds are generally quite safe and, at least for exam purposes, municipal bonds are never a suitable investment unless the investor is in a high tax bracket.
Closed-end investment company shares can be purchased and sold A) over the counter only. B) in the secondary market. C) from the closed-end company. D) from the sponsor.
b A closed-end company share is bought and sold in the secondary market.
The performance of the XYZ Growth Fund has been in the top 1% of all funds in its category for the past 1-, 5-, and 10-year periods. Which of the following would be the biggest risk factor to an investor investing in this fund? A) The manager's tenure is six months B) Lack of diversification in the portfolio C) A dividend yield of less than 2% D) Past performance is no assurance of future results
a Although one cannot predict the future based on the past, when a portfolio manager has consistently been ranked at the top, it is not considered a major risk to bet on a winner. The problem here is that almost all of that performance was achieved under the direction of previous management. With only six months on the job, the new manager is untested and there is no way to know how the future performance will rank. You might see this referred to as tenure risk. Diversification is one of the benefits, not risks, of a mutual fund. In a growth fund, one does not expect a high dividend yield.
A municipal securities dealer informed XYZ municipal bond fund that it was the leading retailer of XYZ shares and that, in return, XYZ should employ the dealer in effecting more transactions for the fund's portfolio. Which of the following statements regarding the request is true? A) It is not permissible because it violates the MSRB anti-reciprocal rule. B) It is permissible because MSRB rules do not cover municipal bond issuers or funds. C) It is not permissible because municipal securities dealers are not allowed to execute trades for the portfolios they underwrite. D) It is permissible because it suggests a more reciprocal arrangement between the two parties.
a An investment company must select a dealer to execute its portfolio transactions based on services provided. It is a violation of the anti-reciprocal rule (Municipal Securities Rulemaking Board Rule G-31) for an investment company to choose a firm to trade its portfolio based solely on sales of units or shares of the fund.
Under the conduit theory of taxation, which of the following statements are true? I. A fund is not taxed on earnings it distributes if it distributes at least 90% of its net investment income. II. Investors are not taxed on earnings they reinvest. III. A fund is only taxed on interest income. IV. Investors are taxed on earnings they receive in cash. A) I and IV B) III and IV C) I and II D) II and III
a By qualifying as a regulated investment company (the conduit, or pipeline, tax theory), the fund is liable only for taxes on retained income if it distributes at least 90% of its net investment income to shareholders. Investors will pay taxes on distributed income, whether it is received in cash or reinvested.
A sophisticated client has expressed an interest in becoming more aggressive with her investment strategy. Her current portfolio consists of the following: $50,000 cash $200,000 in retirement accounts $100,000 in various individual stocks in different industries $100,000 in a balance fund She is willing to invest $25,000 for a minimum of 7 to 10 years and accepts that the investment can and will fluctuate in value over time. Which of the following investments would be the most appropriate? A) ABC Capital Appreciation Small-Cap Fund B) DEF Asset Allocation Fund C) XYZ Value Equity Fund D) MNO High-Yield Bond Fund
a For someone who is willing to take the risk and invest for the long haul, a small- or mid-cap growth fund would be appropriate.
Nonstatistical factors used in comparing one mutual fund to another would include all of the following except A) management fees. B) reinvestment privileges. C) conversion or exchange privileges. D) withdrawal plan options.
a Nonstatistical factors are those that cannot be quantified. That is, you cannot put an exact number on them. Management fees are a measurable statistic. The other factors listed are features, but do not have numbers, as such, attached to them.
You overhear the phone conversation of another registered representative discussing the purchase of exchange-traded fund (ETF) shares as opposed to mutual fund shares with a customer. The registered representative makes several statements, but one of them is incorrect. Which of the following is false? A) "Just like mutual funds, ETFs use forward pricing, so when you place an order, it will be executed at the next calculated NAV for the fund." B) "Remember that you can't buy mutual fund shares on margin, but you can for ETF shares." C) "Unless an ETF makes a capital gains distribution, you don't have to be concerned with tax consequences until you sell your shares." D) "I know that you like to sell short sometimes, which you can do with ETF shares."
a One of the advantages of ETF shares is that they can be purchased throughout the trading day, like all exchange-traded products. Mutual funds, on the other hand, use forward pricing, which must be done at least once per business day. ETF shares can be purchased on margin and sold short, and there are no tax consequences until the shares are sold unless the ETF makes a capital gain distribution (rare, but allowable).
Under the Conduct Rules, the maximum sales charge on any transaction involving an open-end investment company share is A) 8.5% of the offering price. B) 9% of the offering price. C) 8.5% of the net asset value. D) 9% of the net asset value.
a Open-end investment companies (mutual funds) are limited to a maximum sales charge of 8.5% of the offering price.
Five years ago, the ABCD mutual fund bought 200,000 shares of Comet Industries at an average price of $42.25. After a series of accounting scandals, the shares are now trading at $6. If the fund decides to sell its shares, what will be the impact of the sale of Comet shares on the net asset value (NAV) of the ABCD fund? A) The NAV will not change. B) The NAV will rise. C) The NAV will fall. D) This depends on whether the fund can claim a tax loss on the sale.
a Portfolio holdings in a mutual fund are marked to the market each day. Therefore, the NAV of the fund already reflects the current value of each security in its portfolio, including Comet Industries. When the fund sells the position, the value of the stock is replaced by an equivalent amount of cash, so NAV does not change.
One of your customers has recently celebrated a 58th birthday. The investor began a regular investment program into shares of the KAPCO Growth Fund over 20 years ago. The account is showing a substantial gain. Because retirement is getting closer, you suggest using the exchange privilege offered by the KAPCO fund group. Your recommendation is to place half of the holdings into the KAPCO Balanced Fund. Following this recommendation would result in A) a taxable transaction for those shares exchanged. B) a taxable transaction for those shares exchanged plus a 10% tax penalty for early withdrawal. C) tax deferral of any gains because the money is still in the KAPCO fund group. D) tax deferral of any gains because the investor has not received any proceeds.
a The exchange or conversion privilege allows the investor to exchange shares of one fund in a family of funds for another at net asset value. The benefit is the saving of sales charge. The IRS treats this exchange as the sale of one security and the purchase of another. Therefore, any gains will be subject to tax. There is no 10% tax penalty. That applies only when there has been deferral of earnings, such as in an IRA.
An investor wants to invest $200,000 in the banking industry sector. The investor would like to use leverage and make this purchase in a margin account. Additionally, she stresses wanting to avoid year-end tax statements showing capital gains liabilities. You would suggest which of the following as suitable, given the investor's criteria? A) A bank sector exchange-traded fund (ETF) B) A money market fund holding short-term bank notes C) Stocks in the three largest U.S. banks D) A bank sector mutual fund
a The investor's criteria eliminates mutual funds as suitable. Mutual funds make annual capital gains distributions for which the owner incurs a tax liability, and mutual funds cannot be purchased on margin. Conversely, an ETF will rarely make a capital gains distribution, and because they trade like all exchange-traded products, they can be purchased on margin, making them more suitable for this investor. Buying only a few select bank stocks is not a good representation of the entire sector.
Which of the following statements regarding a unit investment trust is not true? A) It charges no management fee. B) Overall responsibility for the fund rests with the board of directors. C) It invests according to stated objectives. D) It is considered an investment company.
b A unit investment trust (UIT) has no board of directors; rather, it has a board of trustees. A UIT must follow a stated investment objective (as must any investment company) and does not charge a management fee because it is not a managed portfolio.
SEC regulations for securities issued by investment companies prohibit which of the following? I. Closed-end funds from issuing preferred stock II. Open-end funds from issuing preferred stock III. Closed-end funds from issuing bonds IV. Open-end funds from issuing bonds A) I and IV B) II and IV C) II and III D) I and III
b Closed-end funds may issue more than one class of security, including debt issues and preferred stock. Open-end funds may issue only one class of security: redeemable, voting common stock. They may not issue senior securities.
The practice of dollar cost averaging requires the investor to A) buy a security in a falling market and sell it in a rising market. B) buy a security in a falling market and buy it in a rising market. C) sell a security in a falling market and sell it in a rising market. D) sell a security in a falling market and buy it in a rising market.
b Dollar cost averaging requires the investor to invest a fixed amount of money on a regular basis, regardless of whether the stock market is rising or falling. When this is done, more shares are purchased when the price per share is low and fewer when the price per share is high. In following this scheme, the investor's average cost per share is lower than the average price paid per transaction.
When discussing mutual funds with a customer, which of the following statements is not prohibited? A) Buy the shares on record date to receive the dividend. B) Buy shares of different funds in the same fund family, and you may qualify for a breakpoint on the total purchase. C) Get a few friends to join with you to form an investment club, and you may qualify for a breakpoint. D) The income yield of the fund consists of both dividends and capital gains.
b Most funds provide a combination privilege, allowing investors to aggregate purchases made in different funds in the same family to qualify for a breakpoint. The income yield of a mutual fund includes dividends only. A group of friends is not eligible for a breakpoint. (Investment clubs are not eligible.) Selling dividends is a prohibited practice because of the immediate tax liability incurred with the dividend and the share price adjustment that results after the dividend distribution. LO 7.d
One way in which open-end investment companies differ from closed-end investment companies is that an open-end investment company's shares A) may be priced at a premium or discount relative to its net asset value. B) outstanding will vary in number at any point in time. C) are purchased and redeemed based solely on supply and demand. D) are traded on an exchange.
b Open-end investment companies are capitalized with a continuous offering of new shares. As a result, the number of shares outstanding is constantly changing. It is the closed-end company, traded in the secondary markets, whose share prices are based on supply and demand, which causes them to be bought or sold at a premium or discount to the NAV.
An investor has unexpectedly received $30,000 from an old debt he had written off. This money will come in handy for a business venture planned for three years from now. Meanwhile, he would like to generate some income on the money with as little risk and as little expense as possible. Which of the following recommendations is likely to be the most suitable for this customer? A) Class B shares of the ABC Investment-Grade Bond Fund B) Class C shares of the ABC Investment-Grade Bond Fund C) Class B shares of the XYZ Growth Fund D) Class A shares of the MNO High-Yield Bond Fund
b The customer wants income with as little risk as possible, so our answer must be one of the choices that offer an investment-grade bond fund. Of those offered, Class C shares would be best, because the customer would pay no front-end sales charge and no CDSC after a short time, probably one year. He will pay somewhat higher 12b-1 fees than with Class A shares, but this will amount to only a fraction of 1% per year, and only for the three years of his investment.
You have a client who invested in the PQR Growth Fund 10 years ago and now, as retirement age approaches, asks you about using the exchange privilege to move into the PQR Balanced Fund. The client should know that A) any tax consequences are deferred until the Balanced Fund shares are liquidated. B) this exchange is considered a taxable event as of the date of the exchange. C) the old shares are liquidated at NAV and the new shares are purchased at the POP. D) the exchange qualifies for any breakpoint reduction.
b The exchange privilege allows for an exchange at net asset value (NAV) between funds that are members of the same "family." The exchange is considered a taxable event. Because the exchange is made at NAV, the concept of breakpoint is irrelevant.
The diversification and professional management offered by many investment companies tends to lower the investor's risk. That does not mean elimination of risk. Of the following, it is likely the greatest risk would be investing in A) a high-yield bond mutual fund. B) an equity UIT. C) a 2x ETF. D) an broad market index fund.
c Leveraged funds (2x or 3x) are considered the investment companies carrying the highest risk. Although high-yield bonds, at least on an individual basis, are considered high risk, the diversification and professional management of the mutual fund reduce (do not eliminate) the risk.
Which of the following statements regarding mutual fund dividend distributions are true? I. The fund pays dividends from net investment income. II. A single taxpayer may exclude $100 worth of dividend income from taxes annually. III. An investor is liable for taxes on distributions, whether taken in cash or reinvested in the fund. IV. An investor is not liable for taxes if he automatically reinvests distributions. A) I and II B) III and IV C) I and III D) II and IV
c Mutual funds pay dividends from net investment income, and shareholders are liable for taxes on all distributions, whether reinvested or taken in cash.
Which of the following would be considered improper by FINRA? A) A mutual fund distributor offering a member firm a free training seminar held at the distributor's home office for up to two representatives selected by the member firm. B) A registered representative giving a $500 wedding gift to her brother who is one of her clients. C) A member firm awarding a $1,000 cash bonus to any employee who, during the next month, sells at least $100,000 of the company's proprietary mutual fund D) A member firm awarding a $1,000 cash bonus to any employee who, during the next month, sells at least $100,000 of any mutual funds the firm has sales agreements with
c No compensation, especially in the form of a bonus, may be conditioned on the sale of a specific product. This is particularly egregious behavior when the product is proprietary. Paying a $1,000 bonus for reaching a sales goal is fine, as long as no specific product is targeted. Training seminars, even with all expenses paid by a fund distributor, are fine as long as the firm selects the attendees based on other considerations than sales of that distributor's funds and the location is appropriate. It would be hard for FINRA to fault this wedding gift to a brother in spite of the client relationship.
A unit investment trust has 90% of its portfolio invested in high-grade bonds with an average maturity of almost 25 years. If the industry consensus was that long-term interest rates were about to increase sharply, which of the following actions would most likely be taken? A) Liquidate the long-term bonds and begin to move into cash or cash equivalents B) Ladder the maturities C) No action would be taken D) Shorten the average maturity by moving into short-term bonds
c One of the key distinctions of a UIT is its lack of management. Once the portfolio has been created, it is fixed until maturity, in the case of debt securities, or until some predetermined liquidation point, in the case of an equity trust.
An investment company that holds which of the following does not meet the definition of a diversified investment company under the Investment Company Act of 1940? A) Four percent of its assets invested in the stock of a major publicly held corporation B) Eighty percent of its assets in securities of 50 health care companies C) Eight percent of a given corporation's voting stock in its portfolio D) Thirty-three percent of its assets in securities issued by a small-cap new issue
d An investment company that has invested 33% of its assets in any issue, small-cap or not, exceeds the limits set in the 75-5-10 test. This test requires that 75% of the assets be invested in securities issued by companies other than the investment company (regardless of the type of companies) so that no more than 5% of total assets are invested in any one company and no more than 10% of an outside corporation's voting securities are owned by the investment company.
An exchange-traded fund whose strategy is to generate performance opposite that of the designated index is called A) a hedge fund. B) a leveraged fund. C) an obverse fund. D) an inverse fund.
d Inverse ETFs (also called short funds) seek to deliver the opposite of the performance of the index or benchmark they track. They may also be referred to as reverse or short funds because, at least on the exam, they are always going to be bearish. Leveraged ETFs seek to deliver multiples of the performance of the index or benchmark they track. There are leveraged inverse funds, but the term inverse would have to be in the description. Hedge funds are not exchange traded. There is no such term as an obverse fund.
Your client wishes to invest $50,000 into shares of the ACE Mutual Fund. This morning's financial news indicated that the POP for ACE was $10.86, while the NAV was $10 per share. The client's order is placed at 2:00 pm Eastern time. Based on this information, you could confirm to the client a purchase of A) more than 4,604.052 shares, but fewer than 5,000 shares. B) 4,604.052 shares. C) 5,000 shares. D) nothing yet, as you must wait for the POP to be computed based on the day's close.
d Mutual funds use forward pricing, so we never know what we'll be paying per share (if purchasing) or receiving per share (if redeeming) until the next calculated price.
Under the Investment Company Act of 1940, which of the following statements regarding the renewal provisions of an investment adviser's contract is not true? A) The renewal must be approved by either majority vote of the board or majority vote of the outstanding shares, as well as majority vote of the noninterested members of the board. B) The renewal must state the adviser's compensation. C) The contract must be terminable upon no more than 60 days' notice. D) The renewal may be executed orally, provided it is done within two years of the initial contract.
d When an investment company employs an outside investment advisory firm to manage its portfolio, the act requires a written contract setting forth the adviser's compensation. The contract is for two years initially and must be renewed annually thereafter. The contract must be initially approved by a majority vote of the outstanding shares and the noninterested members of the board of directors and annually renewed by either a majority vote of the board of directors or of the outstanding shares, as well as a majority vote of the noninterested members of the board. The contract must be terminable at any time, with a maximum of 60 days' notice and with no penalty, upon a majority vote of the board of directors or of the outstanding shares, and it must terminate automatically if assigned. LO 7.j
In July, a customer invested $10,000 in the ABC Mutual Fund. In December of the same year, ABC announced a long-term capital gains distribution. In May of the next year, the customer decided to redeem his shares for a capital gain. How are both of the capital gains treated for tax purposes? I. The capital gain distribution is treated as long term. II. The capital gain from redemption is treated as long term. III. The capital gain from redemption is treated as short term. IV. The capital gain distribution is treated as short term. A) II and IV B) I and II C) III and IV D) I and III
d When long-term capital gains are distributed, the length of time an investor has owned the fund is not relevant; it's still a long-term distribution. However, redemption of shares follows the normal holding period rules. Therefore, when this customer sold shares 10 months (July to May) after the purchase, the gain, like any other gain from a holding period that does not exceed 12 months, is short term.
