Series 6: Investment Companies (Investment Company Overview)

At the market opening, a customer purchases 200 shares of an S&P 500 Inverse ETF (-1x) at $50 per share. At the end of that day, the S&P 500 Index declines by 10%. The next day, the index partially recovers and closes up 5%. What is the market value of the 200 shares position?

$10,450 Since this ETF is "-1x", it is an inverse ETF that moves at the same rate (1x), but in the opposite direction (-), to the market. The customer starts with 200 shares at $50, or a $10,000 position. At the end of the first day, because the index falls by 10%, this position will rise by 10% to $11,000 value ($10,000 x 1.1). At the end of the second day, because the index goes up by 5%, the ETF value will decline by 5%. $11,000 x .95 = $10,450.

Which of the following investment companies must be closed-end?

$9.00 NAV / $8.50 purchase price Only a closed-end fund can trade at a discount to net asset value. A discount occurs when investors are bearish on the fund. The minimum price for an open-end fund is net asset value. If an open-end fund has a purchase price equal to the NAV, as in Choice (B), this fund is most likely a "no-load" fund. If the open-end fund imposes a sales charge, then the fund is a "load" fund.

All of the following are Exchange Traded Funds EXCEPT:

ADSs SPDRs (Standard and Poor's 500 Index - symbol = SPY), DIAmonds (Dow Jones Industrial Average Index - symbol = DIA), and QUBES (NASDAQ 100 Index - symbol = QQQ) all are exchange traded index funds. An ADS is an American Depositary Share - the means by which a foreign issuer offers its securities in the United States.

"SPIDERS" trade on the:

American Stock Exchange SPIDERS is the trade name for the "SPDR" - Standard and Poor's 500 Index Exchange Traded Fund. SPDRs trade on the AMEX, as do - DIAmonds (Dow Jones Industrial Average Index - symbol = DIA).

The primary difference between an open-end and a closed-end management company is:

Capital structure The main difference between an open-end management company and a closed-end company is capital structure. Open-end management companies continuously issue and redeem common shares. They cannot issue preferred stocks or bonds. Closed-end funds have a one-time issuance of common stock, and at that point the fund's books are closed to new investment. Then the shares are listed and trade like any other stock. The only way for a closed-end fund to raise additional capital is to sell preferred stock or bonds. Thus, closed-end funds are capitalized like any other publicly traded corporation. Both closed-end and open-end companies are management companies with investment advisers to manage the investment portfolio. When comparing an open-end fund to a closed-end fund that have the same objective, the managers will likely have similar portfolio compositions to achieve that objective. Both open-end and closed-end management companies are corporations that have a Board of Directors. The rules for the composition of the Board are the same for both types of companies under the Investment Company Act of 1940.

Which of the following statements describes a way that exchange traded funds (ETFs) differ from mutual funds?

Exchange traded funds trade throughout the day; mutual funds trade at the next calculated net asset value Exchange Traded Funds (ETFs) are passively managed fund shares that are listed and trade like any other stock. They are index fund shares that are continuously traded. In contrast, mutual fund shares do not trade. They are bought at that day's closing NAV, plus a sales charge if the fund is a load fund.

Which of the following investment companies offer redeemable securities? I Open-end investment companies II Closed-end investment companies III Unit investment trusts IV Face amount certificate companies

I & III only The investment companies issuing redeemable shares are open-end management companies and unit investment trusts. Closed-end company shares trade in the secondary market and the fund does not redeem them. Face amount certificates are not redeemable, although investors may surrender them early for a reduced surrender value. Also remember that face amount certificates are an obsolete investment type.

Closed-end management companies may: I issue preferred stock II issue bonds III borrow against fund assets

I and II only Closed-end management companies have a one-time issuance of common stock and then "close" their books to new common shareholders. The common shares are then listed and trade like any other stock. To raise additional capital, this type of fund can issue preferred stock or bonds. To issue bonds, the company must have an asset coverage ratio of at least 300% - that is for every $3 of net assets, the fund may sell bonds equal to $1. To issue preferred stock, the company must have an asset coverage ratio of at least 200% - that is, for every $2 of net assets, the fund may sell preferred stock equal to $1. Closed-end companies may not borrow from banks to raise capital. Note, in contrast, that open-end (mutual) funds cannot sell bonds or preferred stock, but they may borrow from banks, as long as asset coverage is 300% (for every $3 of net assets, the fund may borrow $1).

Which of the following statements about open-end and closed-end management companies are correct? I Open-end companies offer their shares for sale continually II Closed-end companies offer their shares for sale continually III Open-end companies redeem their shares continually IV Closed-end companies redeem their shares continually

I and III Open-end companies offer their shares for sale continually and redeem shares continually. Closed-end companies make a 1-time public offering of shares; close their books to new investment; and then the shares are listed and trade. Closed-end fund shares are not redeemable; rather they are negotiable.

Open-end management companies: I are structured as corporations II are structured as trusts III issue common shares IV issue shares of beneficial interest

I and III Open-end management companies are mutual funds. They are corporate entities that only issue common stock that is redeemable with the fund. Management companies have an investment manager that changes the fund's portfolio holdings to meet an investment objective. For this service, management fees are charged. In contrast, unit investment trusts are another type of investment company structure. They are fixed trusts that issue "shares of beneficial interest." They have no manager and do not charge management fees.

Which of the following are types of unit investment trusts? I Fixed II Variable III Participating IV Convertible

I and III only UITs are either Fixed or Participating. The sponsor of a Fixed UIT assembles a fixed portfolio, typically of bonds. Once the portfolio is created, the securities are transferred into trust and investors can buy minimum $1,000 units of the trust. For that $1,000 investment, a customer buys a "piece" of a diversified portfolio. A Participating UIT invests in an underlying mutual fund - so it invests in a security that is being managed; however, the UIT itself is not managed. This is the structure for a variable annuity.

Which of the following securities can be issued by open-end management companies? I Common stock II Preferred stock III Bonds

I only Open-end management companies can only issue common shares that are redeemable with the sponsor. They cannot issue senior securities such as preferred stock and bonds. Note, in contrast, that closed-end funds issue common stock in a 1-time offering; and can raise additional capital later on by selling preferred stock and bonds, like any other publicly traded corporation.

Which statements are true regarding ETFs (Exchange Traded Funds)? I ETFs are available on broad-based stock indexes II ETFs are available on narrow-based stock indexes III ETFs are available on international stock indexes IV ETFs are available on bond indexes

I, II, III, IV ETFs have been increasing in popularity as compared to traditional mutual funds because of their low cost (low expense ratios); ease of buying and selling like any other stock; and tax efficiency (no mandatory annual long term capital gain distributions). ETFs are now available based on sector indexes; narrow-based stock indexes; broad based stock indexes; bond indexes and international stock indexes.

Which of the following are defined as investment companies under the Investment Company Act of 1940? I Face amount certificate company II Unit investment trust III Real estate investment trust IV Management company

I, II, and IV only The Investment Company Act of 1940 defines 3 types of investment companies: Face Amount Certificate Companies; Unit Investment Trusts; and Management Companies. Face Amount Certificate Companies are basically an obsolete form of investment company. An investor could buy a certificate that would pay, say $10,000, 10 years from now. The investor might be required to pay, monthly payments of $50 per month over the next 10 years to get this guaranteed amount at the end of 10 years. Thus, for total payments of $600 per year x 10 years = $6,000, the investor will get back $10,000 at the end of year 10. The difference between the $6,000 paid in over 10 years and the $10,000 paid at maturity is the "interest" earned on the certificate. Unit Investment Trusts hold a portfolio of securities that does not change - there is no management of the portfolio. For example, if a bond trust is established, the portfolio is assembled by the sponsor, transferred into trust, and then the investor can buy $1,000 "units" of the trust. For the $1,000 investment, the customer owns a piece of a diversified bond portfolio. Management Companies hold a portfolio of securities that is "managed" - that is, changed by a manager to meet the fund's investment objective. Because there is a manager, these funds impose management fees. The Act then subcategorizes management companies into "open-end" and "closed-end." Open-end management companies are "open-ended" to new investment - these are mutual funds. Closed-end management companies are "closed" to new investment - they have a 1-time stock issuance; the books are "closed" to new investment and the shares are listed and trade like any other stock. REITs - Real Estate Investment Trusts - are structured in a similar manner to closed-end investment companies. They have a 1-time stock issuance; the books are closed to new investment and the shares are listed and trade. However, instead of investing in securities, the trust invests in real estate. These are not defined as an Investment Company under the 1940 Act because they are not making investments in securities.

The exchange traded fund(s) based on indexes by industry sector or country are known as:

I-Shares Exchange traded funds based on indexes by industry sector, country, or market capitalization, are known as "I-Shares", as in "Index Shares". Other Exchange traded funds are SPDRs (Standard and Poor's 500 Index - symbol = SPY), DIAmonds (Dow Jones Industrial Average Index - symbol = DIA), and QUBES (NASDAQ 100 Index - symbol = QQQ).

Exchange Traded Funds (ETFs) are: I registered under the Investment Company Act of 1940 as closed-end management companies II registered under the Investment Company Act of 1940 as open-end management companies III regulated by the SEC and FINRA IV regulated by FDIC and the Department of Treasury

II and III ETFs are almost a "hybrid" type of investment company structure because they allow for the creation of additional shares, like an "open-end" fund; but they are listed and trade like a "closed-end" fund. Technically, most ETFs are structured as open-end investment companies, since they allow for the creation of additional shares in minimum "creation units" of $50,000 - $100,000. If the shares are trading in the market at a discount to NAV, institutional investors can buy new creation units and short the equivalent shares that compose the units, in an arbitrage trade. This mechanism insures that the fund shares will not trade at a discount to NAV. Because new shares can be created, these are registered as open-end funds under the Investment Company Act of 1940. Since ETFs are securities, they are regulated by the SEC and FINRA.

"QUBES" are: I a mutual fund II an exchange traded fund III based on the NASDAQ 100 Index IV based on the NASDAQ Composite Index

II and III QQQ is the symbol for the "Qube" - the NASDAQ 100 Index Depository Receipt. This is an Exchange Traded Fund traded on NASDAQ.

Which statements are TRUE when comparing an index mutual fund to an index exchange traded fund? I Mutual funds can be purchased on margin; exchange traded funds cannot be purchased on margin II Mutual funds cannot be purchased on margin; exchange traded funds can be purchased on margin III Mutual funds can be sold short; exchange traded funds cannot be sold short IV Mutual funds cannot be sold short; exchange traded funds can be sold short

II and IV only Mutual funds cannot be purchased on margin because they are a new issue prospectus offering - and new issues are not marginable until they have "seasoned" for 30 days. Mutual funds cannot be sold short. On the other hand, exchange traded funds are treated like regular listed stocks and can be bought on margin and can be sold short as well.

Open-end investment companies may: I issue preferred stock II issue bonds III borrow against fund assets

III only Open-end management companies (mutual funds) can issue only one class of stock - common stock. They may not issue senior securities such as preferred stock or bonds. They may borrow from banks as long as their ratio of fund holdings pledged to bank borrowings is at least 300% (this means that for every $3 of fund assets pledged to a bank for a loan, $1 may be borrowed).

The MINIMUM price at which an open-end fund share can be purchased is:

NAV No-Load mutual funds do not have a sales charge. In this case, the NAV (Net Asset Value) and the POP (Public Offering Price) are the same. Any shares are purchased at NAV, with no additional commissions charged because each share is newly issued.

ETFs trade on all of the following markets EXCEPT:

OTC Exchange Traded Funds, as the name says, trade on stock exchanges. Most are AMEX listed, but there are ETFs on the NYSE and NASDAQ as well. The OTC market for equities is the OTCBB and the Pink OTC Market. These are markets for thinly traded illiquid securities.

Which of the following MUST be closed-end management company shares?

Shares purchased where a commission is charged Closed-end fund shares trade in the market and are purchased like any other stock. They are purchased at the market price, plus a commission must be paid to execute the trade. These shares trade in the secondary market. The shares are NOT redeemable with the sponsor. The only way for an owner of closed-end fund shares to "cash out" is to sell them in the market like any other stock. In contrast, all mutual fund shares are "new issues" (primary market) that are purchased at the Public Offering Price (which includes any sales charge). The shares do not trade in the secondary market. The only way for an owner of mutual fund shares to "cash out" is to redeem them with the sponsor at the current NAV per share. Note that the Initial Public Offering of a closed-end fund occurs in the primary market; but the question asks which choice MUST be a closed-end purchase. Choice A can only be a mutual fund, because only mutual fund shares are redeemable. Choice B can only be a secondary market purchase of a closed-end fund, because they are the only investment company type that, once issued, trades in the market like any other stock. Choice C can only be a mutual fund, because only mutual fund shares are sold with sales charges. Choice D could either be the purchase of a mutual fund or it could be the IPO of a closed-end fund.

SPDRs are based on the:

Standard and Poor's 500 Index SPDR is the acronym for the Standard and Poor's 500 Index Depository Receipt. This is an Exchange Traded Fund traded - an ETF.

Which of the following terms best describes an ETF?

Stock ETF stands for Exchange Traded Funds. These are fund shares that trade like any other stock. They are not mutual fund shares because they cannot be redeemed at any time with the sponsor. Rather, they are negotiable securities.

Which term best describes an ETF?

Stock ETF stands for Exchange Traded Funds. These are fund shares that trade like any other stock. They are not mutual fund shares because they cannot be redeemed at any time with the sponsor. Rather, they are negotiable securities.

Which statement is TRUE regarding ETFs (Exchange Traded Funds)?

The purchaser of an ETF is required to receive either a prospectus or a Product Description summarizing key information about the ETF Regarding Exchange Traded Funds (ETFs), the shares trade in the secondary market like any other stock. However, any purchaser is required to be delivered either a prospectus (similar to that for a mutual fund) or a Product Document summarizing key information about the ETF and the details of where a prospectus can be obtained. The basic idea here is that the customer is buying the equivalent of an exchange traded index-mutual fund; and even though technically each purchase is not a "new issue" like the purchase of a mutual fund, the customer must still receive a disclosure document. An Offering Memorandum is the disclosure document used for a Regulation D private placement. An Official Statement is the disclosure document used for a new municipal bond issue.

Which of the following statements concerning closed-end investment companies is correct?

They can issue preferred stock and bonds Closed-end funds do not redeem their shares, and capitalization for these funds is fixed. Remember, closed-end funds have a 1-time stock issuance; the books of the fund are closed to new investment; and the shares are listed and trade like any other stock. Closed-end funds cannot pledge portfolio assets for loans, but they can issue preferred stock and bonds to raise additional capital.

All of the following statements about unit investment trusts (UITs) are true EXCEPT:

UIT investments are actively managed by an investment adviser. UITs are redeemable and have fixed portfolios. Once the portfolio is created, the securities are transferred into trust and investors can buy minimum $1,000 units of the trust. For that $1,000 investment, a customer buys a "piece" of a diversified portfolio. There is no management of the portfolio - the trust composition does not change. Thus, there are no management fees. There is no trading of trust units. The sponsor of the trust makes a market in trust units and will redeem them at current market value for any purchaser that wishes to sell.

Which of the following investment companies issues "Shares of Beneficial Interest"?

Unit investment trust Shares of Beneficial Interest are issued by unit investment trusts. In contrast, open-end management companies issue common shares only; while closed-end management companies can issue both common and preferred shares.

Participating UITs invest in:

mutual fund shares A Participating UIT invests in an underlying mutual fund - so it invests in a security that is being managed; however, the UIT itself is not managed. This is the structure for a variable annuity. In contrast, fixed UITs invest in a fixed portfolio of either bonds or stocks.

An investment in an inverse ETF would be profitable in a:

bear market An inverse ETF uses short selling to move in the opposite direction as compared to the overall market. Whereas a regular ETF is profitable in a bull market, an inverse ETF is profitable in a bear market.

Active asset managers select investments based primarily upon:

inefficient market pricing of the investment Active asset managers believe that by performing fundamental analysis, they can find undervalued companies - that is, companies that are not "efficiently priced." Passive asset managers believe that the market is basically efficient, and that one cannot consistently find "undervalued securities" - so why bother? Instead, just invest in an asset that mimics the index - that is, an index fund. This will do as well as the "market" with much lower expenses than those associated with "active" asset management.

Exchange traded funds are NOT:

redeemable ETFs (Exchange Traded Funds) such as SPDRs are negotiable - they trade as would any regular stock. They are marginable; and they are diversifiable, since ETFs are available for many different indexes and sectors. ETFs are not redeemable - it is mutual fund shares that are redeemable.

A customer asks the following; "One of my neighbors was talking about his investment in an ETF (Exchange Traded Fund) and said that it is "low cost." Is this true?" The registered representative should respond that:

the expense ratios of most ETFs are lower than those for comparable index mutual funds ETFs have been increasing in popularity as compared to traditional mutual funds because of their low cost (low expense ratios). However, when buying or selling an exchange traded fund, there is a commission cost; whereas when buying or redeeming a mutual fund there is no charge if the fund is "no-load" or there can be a sales charge.

All of the following statements concerning open-end management companies are correct EXCEPT their shares:

trade over-the-counter or on the stock exchanges Shares of open-end management companies do not trade OTC or on exchanges. They are non-negotiable, meaning they can't be traded. Rather, they are redeemable with the issuing company.

Which statement concerning closed-end investment companies is TRUE? Shares are:

traded over-the-counter or on the stock exchanges Closed-end management companies have a 1-time stock issuance; the books of the company are closed to new investment; and then the shares are listed and trade like any other stock. In contrast, shares of open-end companies are issued continually by the fund and are redeemable with the fund. They do not trade on the secondary market.

A customer just made an investment in a security that represents an interest in a fixed portfolio. The customer will receive income quarterly and eventually the issuer will repay the principal. This investment is most likely:

units in a unit investment trust A face amount certificate guarantees an investor a certain face amount at maturity, but it does NOT pay income periodically during the life of the investment. Both closed-end and open-end funds offer shares in a portfolio that changes as the manager determines in order to meet the fund's objectives. The manager continually buys and sells securities in both of these companies to meet these objectives. The investment is, therefore, most likely a unit trust, which has a fixed portfolio. Most of these are bond portfolios. As interest payments are received from the bonds in the portfolio, the sponsor will send the pro-rata portion to each unit holder. The unit holder can choose to receive these payments semi-annually, quarterly, monthly, etc. As bonds in the portfolio mature, the sponsor sends each unit holder the pro-rata portion of the principal repayment(s). Thus, fixed UITs are self-liquidating.

Passive asset management is:

using index funds as the investments for each asset class Passive asset management does not mean that there is no management. Passive asset management is the use of index funds (which are managed to mirror a chosen index benchmark) as the security selections within an asset class. Thus, the actual specific security selection and management is embedded within the index fund chosen for investment.