Series 7 Unit 8

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According to investment company rules, open-end investment companies may not distribute long-term capital gains to their shareholders more frequently than A) quarterly. B) annually. C) monthly. D) semiannually.

B) annually. Under the Investment Company Act of 1940, investment companies may not distribute long-term capital gains more frequently than once per year. LO 8.f

One of your clients purchased shares of the Ajax Mutual Fund several months ago. At that time, the net asset value (NAV) of the fund was $17.20. Today, the NAV is $17.56, and your client wants to know what accounts for the difference. You should advise her that the difference likely represents A) realized appreciation. B) unrealized appreciation. C) capital gains. D) capital losses.

B) unrealized appreciation. The NAV of mutual funds is marked to the market daily; the increase reflects higher market prices for the securities in the fund's portfolio. LO 8.c

Municipal Securities Rulemaking Board rules prohibit dealers from entering into which of the following transactions with a mutual fund? A) Acting as a broker's broker for a large block of bonds the fund wishes to sell B) Purchasing the fund's shares to fill customers' orders C) Accepting portfolio trades from the fund as compensation for sales of the fund's shares D) Accepting orders from a fund to buy a new municipal issue

C) Accepting portfolio trades from the fund as compensation for sales of the fund's shares This prohibited practice is known as reciprocal dealing between a broker-dealer and an investment company. The other examples are routine practices. LO 8.j

Your customer owns a leveraged ETF, having a performance goal of 200% of the underlying index. When purchased two weeks ago, the ETF was priced at 50. If the index was up 10% the first week and down 20% the second week, what is the value of the ETF today if it performed as it was intended to? A) 36 B) 45 C) 44 D) 40

A) 36 Priced at 50 when purchased, after the first week's 10% increase in the index, the 2× leveraged ETF would be up 20% (20% × 50 = 10 point increase) to 60. After the second week's 20% decline in the index, the 2× leveraged ETF would be down 40% (40% × 60 = 24 point decrease) to 36. LO 8.h

An investor wants to allocate 15% of an existing portfolio to mirror the overall market's performance. This investor understands and is comfortable with mutual funds as an investment and market risk. The client notes her dislike for funds that are so actively managed that it adds to high portfolio turnover and high transaction and management fees. Which of the following would be a suitable recommendation, given the client's investment criteria? A) Equity index fund B) Asset allocation fund C) Money market fund D) U.S. government bond fund

A) Equity index fund An equity index fund mirrors a market index and should perform in line with the overall market's performance. Because its portfolio mirrors an index, it is not actively managed, and therefore, has lower expenses than managed funds. Asset allocation funds are actively managed with higher portfolio turnover and expenses, and neither money market funds nor government bond funds would be used to mirror the overall market's performance. LO 8.h

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 2x ETF. B) a high-yield bond mutual fund. C) an equity UIT. D) an broad market index fund.

A) a 2x ETF. 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. LO 8.i

When a customer transfers the proceeds of a sale from one fund to another within the same family of funds, what are the tax consequences? A) No gains or losses are recognized until the final redemption. B) All gains and losses are recognized on the transfer date. C) Gains are taxed at the time of the transfer, but losses are deferred until the final redemption. D) Losses are deducted at the time of the transfer, but gains are deferred until the final redemption.

B) All gains and losses are recognized on the transfer date. Although a transfer within a family of funds is generally not subject to a sales charge, the customer is liable for any taxes due. The IRS considers this transaction a sale and a purchase. Any losses or gains must be declared on that year's tax form. LO 8.e

Mutual fund shares represent an undivided interest in the fund, which means that A) the fund can only hold securities of certain companies. B) each investor owns a proportional part of every security in the portfolio. C) the number of shares outstanding is limited to a predetermined maximum. D) investors can only purchase full shares.

B) each investor owns a proportional part of every security in the portfolio. Each mutual fund shareholder owns an undivided interest in the investment company's portfolio. Because each share represents one class of voting stock, the investor's interest in the fund is reflected by the number of shares owned. LO 8.e

The primary objective of a particular mutual fund is the payment of dividends, regardless of the market's current state. Capital growth is a secondary objective. Which of the following industry groups would be appropriate for the fund's portfolio? A) Aerospace B) Consumer appliances C) Public utilities D) Computer technology

C) Public utilities Utilities are defensive industries; they tend to pay dividends consistently. LO 8.g

The exchange privilege offered by open-end investment companies allows investors to A) delay the payment of taxes on shares. B) purchase new fund shares from dividends. C) exchange shares of one open-end fund for another in the same fund family at a net asset value basis. D) exchange personally owned securities for shares of the investment company.

C) exchange shares of one open-end fund for another in the same fund family at a net asset value basis. Exchange privileges allow an investor to convert the value of shares held in one fund for those of an equal value in the same family. Remember that conversion is a taxable event—if the shares converted have increased in value, capital gains taxes will be due. LO 8.e

Leveraged index funds I. can be exchange-traded funds (ETFs). II. can never be exchange-traded funds. III. can be inverse or reverse funds. IV. can never be inverse or reverse funds.

D) I and III Leveraged funds—those attempting to deliver a multiple (e.g., 2X or 3X) of the returns delivered by the index they track—can be ETFs, as well as inverse (reverse) funds. Inverse funds attempt to deliver returns the opposite of those realized by the index they track. LO 8.h

A customer buys AC Growth Fund and enjoys a substantial paper capital gain. When he believes the market has reached its peak, he switches into AC Income Fund within the AC family of funds. He incurs a small service fee but is not charged an additional sales charge. What is the tax effect? A) Any gain in AC Growth Fund is taxable because the exchange is treated as a sale and a purchase. B) The tax basis of AC Income Fund is adjusted to reflect the gain in AC Growth Fund. C) It is a tax-free exchange. D) Any gain or loss is deferred until he liquidates the AC Income Fund.

A) Any gain in AC Growth Fund is taxable because the exchange is treated as a sale and a purchase. The exchange is treated as a sale of the growth fund shares followed by a purchase of the income fund shares. The gain or loss is determined by comparing the cost basis of the growth fund shares with the net asset value at the time of exchange. Any difference is a capital gain or loss, even though the proceeds were immediately used to purchase the income fund. LO 8.e

A mutual fund, frequently used as the default option in employer-sponsored retirement plans, that adjusts its portfolio growth orientation to principal conservation as a specified date approaches is A) a target date fund. B) a Section 529 fund. C) a balanced fund. D) a hedge fund.

A) a target date fund. This is exactly what target date funds are designed for. As the investor gets closer to the target retirement age, the portfolio managers shift the concentration from equities to fixed income. That is why a high percentage of corporate retirement plans use those as the investment option when the employee does not make a selection. A balanced fund does adjust between equity and fixed income, but does so based on market conditions, not a specified future date. Investments in Section 529 plans do follow a similar strategy as college nears, but these are never available in retirement plans. LO 8.g

An unmanaged portfolio is a characteristic of A) a unit investment trust. B) an open-end investment company. C) a closed-end investment company. D) a single state municipal bond fund.

A) a unit investment trust. The most significant distinguishing characteristic of a UIT compared with other investment companies is the lack of ongoing portfolio management. Once the initial portfolio is assembled, it remains fixed until the termination date. Closed-end and open-end companies are classified as management companies because of the ongoing portfolio management responsibilities. Unless something indicates to the contrary, when the exam refers to a fund, it is a mutual fund (open-end investment company). LO 8.a

Investors looking for preservation of capital will find money market mutual funds and bank-insured CDs to be appropriate vehicles. When comparing the two, it is important for a registered representative to point out that A) the bank CDs are insured by the FDIC while there is no assurance that the value of the money market fund will not lose money. B) broker-dealers sell money market mutual funds, but not CDs. C) the redemption fees charged by money market mutual funds are comparable to the early withdrawal penalties on a CD. D) money market funds are eligible IRA investments while bank-insured CDs are not.

A) the bank CDs are insured by the FDIC while there is no assurance that the value of the money market fund will not lose money. One of the key points that must be made when comparing a money market mutual fund investment to an insured bank CD is the FDIC insurance that applies only to the CD. Other than in very unusual (and not tested) circumstances would there be a redemption charge for a money market mutual fund; there generally is a penalty for early withdrawal from a CD. Many broker-dealers sell brokered CDs. These may or may not be FDIC insured and have other differences from those purchased directly from banks. They are issued by banks, with the broker-dealer serving as an intermediary. Both of these are eligible IRA investments. LO 8.g

An individual owns Class A shares of the KAPCO Growth Fund with a total value at the current offering price of $20,000. KAPCO has a sales charge of 8% that reduces to 5% at $25,000. If the fund offers a right of accumulation, the sales charge on an additional investment of $10,000 will be A) $800. B) $500. C) $250. D) $400.

B) $500. The question tells us that there is a breakpoint at $25,000. Once that dollar amount is reached, the sales charge on all new purchases is reduced from 8% to 5%. Rights of accumulation means that we add a new purchase to the existing account value. If that total reaches or exceeds the breakpoint, the entire purchase is made with the lower sales charge. In this question, adding the $10,000 purchase to the existing $20,000 takes the customer's account past the $25,000 breakpoint. Therefore, the entire new purchase is charged 5%. So, $10,000 times 5% equals $500. LO 8.d

The KAPCO Growth mutual fund's annual report shows receipt of $10,000,000 of interest income from corporate bonds, $15,000,000 in cash dividends, and $5,000,000 of operating expenses. According to the conduit theory, how much must the fund distribute to investors if it wishes to avoid paying any taxes? A) $10,000,000 B) $18,000,000 C) $20,000,000 D) $16,000,000

C) $20,000,000 According to Subchapter M of the Internal Revenue Code, the conduit theory requires that an investment company pay out a minimum of 90% of its net investment income (NII) to investors. In that case, the fund pays taxes on the remaining 10%. However, distributing 100% of the NII leaves no taxable income remaining. A fund's net investment income is the gross investment income minus the expenses. The NII for this fund is the interest ($10 million) plus the dividends ($15 million) minus the expenses ($5 million). That is $10 million + $15 million = $25 million minus $5 million = $20 million. LO 8.f

An investor with $5,000 to spend could purchase approximately how many shares of a mutual fund with a net asset value per share of $13.00, a sales charge of $1.00 and an underwriter's concession of $0.20? A) 362 shares B) 352 shares C) 357 shares D) 378 shares

C) 357 shares Mutual funds sell at NAV plus sales charge. In this case, $13.00 plus $1.00 = $14.00 public offering price (POP). Dividing $5,000 by $14 equals 357 shares. What about the underwriter's concession of $0.20? That is part of the $1.00 sales charge. On each sale, the principal underwriter of the fund earns $0.20 and the selling broker-dealer keeps the other $0.80. LO 8.c

Last year, ABC Mutual Fund paid dividends of $1.50 per share and distributed $0.80 per share in capital gains. The fund has a bid price of $13.50 and an asked price of $14.20. An investor who purchased shares in this fund nine months before the distributions receives $100 in nonqualifed dividends and $53 in capital gains. All distributions were reinvested in additional shares. If this is the individual's only investment, she will I. not be required to pay federal taxes on the dividend income. II. be required to pay federal taxes at the ordinary income rate on the dividend income. III. be required to pay capital gains tax on $53. IV. not be required to pay capital gains tax on $53.

C) II and III Investors are required to pay taxes on all distributions from mutual funds; it makes no difference if they are taken in cash or reinvested in additional shares. Nonqualified dividends are taxed at ordinary income rates. Capital gains distributions are always considered long term and taxed at the capital gains rate, unless something in the question states otherwise. LO 8.f

The main purpose of dividend reinvestment in a mutual fund accumulation plan is to A) avoid commissions or sales charges. B) avoid taxes. C) compound the growth of a mutual fund investment. D) protect against capital loss.

C) compound the growth of a mutual fund investment. Reinvesting dividends compounds the growth of the fund with periodic purchases of new shares. Taxes are due on dividends whether or not they are reinvested. Capital gains or losses will occur whether or not dividends are reinvested. The purchase of additional shares with reinvested dividends may increase the capital gain or loss in proportion to the dividends reinvested. Avoiding commissions or sales charges is not the main rationale for reinvesting dividends, even though sales charges are not applied to reinvested dividends. LO 8.f

An investor's portfolio contains a number of different securities. Included are equity and debt positions in several business development companies (BDCs). It would be correct to state that A) distributions from both BDC positions are treated as dividends. B) distributions from both BDC positions are treated as interest. C) distributions from the equity BDC positions are treated as dividends while those from the debt positions are interest. D) distributions from the equity BDC positions are treated as a return of capital while those from the debt positions are interest.

C) distributions from the equity BDC positions are treated as dividends while those from the debt positions are interest. A BDC (business development company) is a specialized type of closed-end investment company. As such, it can issue debt securities as well as equity. Most operate as regulated investment companies (RICs) under the Internal Revenue Code. Being a RIC requires distributing at least 90% of the company's net investment income. This, just as with other investment company distributions, is treated as a dividend. When the BDC issues a debt security, just as with other debt securities, interest is paid to the lenders. ** This question deals with material not covered in your LEM, but it relates to recent rule changes and/or student feedback. LO 8.b

Recent years have shown an enormous growth in the sales of exchange-traded funds (ETFs). Some of the benefits of using ETFs in your clients' portfolio would include A) lower risk than most comparable mutual funds. B) greater management flexibility than most comparable mutual funds. C) greater tax efficiency than most comparable mutual funds. D) greater diversification than most comparable mutual funds.

C) greater tax efficiency than most comparable mutual funds. In general, largely because of the lack of need to rebalance the portfolio to meet investor redemption requests or market changes, ETFs have fewer taxable events. That translates into fewer taxes to their shareholders. Because an ETF is generally restricted to those securities in the index it tracks, there will be the same diversification as a mutual fund tracking that same index. Because the mutual fund is not necessarily tied to an index, the greater management flexibility can offer greater diversification. The risk is based on the portfolio, not the structure of the company. LO 8.i

An open-end investment company that does not distribute at least 90% of its net income A) does not require a restricted type of management. B) is unable to retain all or part of its realized capital gains. C) is liable for federal taxes on its net income. D) continues to qualify as a registered investment company based on interpretations of the IRS.

C) is liable for federal taxes on its net income. Investment companies that do not distribute at least 90% of their net investment income become liable for federal income taxes on all the net investment income. Shareholders would also be responsible for taxes on any distributions received. By distributing 90% of investment income, open-end companies can avoid double taxation. LO 8.f

A breakpoint sale is defined as the sale of mutual fund shares in an amount A) at or above the dollar amount at which the sales charge is reduced. B) just below the public offering price of the fund. C) just below the dollar amount at which the sales charge is reduced. D) required as the minimum investment in a fund, as specified by the SEC.

C) just below the dollar amount at which the sales charge is reduced. The term breakpoint sale refers to the violation that occurs when a sale is made just below the point at which the investor would receive the reduced sales charge. The practice earns a higher commission for the salesperson but is not in the interest of the customer. LO 8.d

The Profligate Perpetual Growth Fund's prospectus states that the fund meets the Investment Company Act of 1940's qualifications of a diversified management company. If the fund has net assets of $1 billion, A) no more than $250 million can be invested in the voting shares of any single issuer. B) no more than $50 million can be invested in the voting shares of any single issuer. C) no more than $300 million can be invested in the voting shares of any single issuer. D) no more than $100 million can be invested in the voting shares of any single issuer.

C) no more than $300 million can be invested in the voting shares of any single issuer. Diversified management companies must follow the 75-5-10 rule. That means, of 75% of the fund's net assets, no more than 5% of the fund's total assets can be in the voting shares of a single issuer. There are no restrictions on the other 25%; it can be invested as desired. Five percent of the $1 billion total is $50 million. The other 25% of the total assets ($250 million) can be invested in this stock without limitation. That makes the total possible investment into the voting shares of one issuer 30% of the total net assets or $300 million. LO 8.a

A customer with no other mutual fund investments wishes to invest $47,000 in the XYZ Technology Fund. If the Class A shares are eligible for a breakpoint sales charge discount at the $50,000 investment level, the least appropriate action for an agent is to A) inform the customer that she can reduce her sales charge through a letter of intent. B) inform the customer that she can reduce her sales charge by investing an additional $3,000. C) place the order as instructed. D) inform the customer that she can reduce her sales charge by combining purchases in other funds offered by XYZ group.

C) place the order as instructed. If a customer intends to invest an amount just below a breakpoint threshold, she should be informed of the breakpoint discount, as well as the various methods by which she can receive it. LO 8.d

All of the following events will affect the net asset value (NAV) per share of a mutual fund except A) changes in the market value of the fund's portfolio of securities. B) the fund pays dividends to its shareholders. C) wholesale redemption of fund shares. D) the fund receives cash dividends on the securities in its portfolio.

C) wholesale redemption of fund shares. Dividends paid and received by the fund directly affect NAV. Changes in the portfolio value affect NAV because the securities are marked to market daily. While share redemption will reduce total NAV, the number of shares outstanding decreases in proportion, so the NAV per share stays the same. LO 8.a

A letter of intent for a mutual fund does not contain which of the following provisions? A) The letter can be backdated 90 days to include a previous deposit. B) The fund will keep some of the initially issued shares in an escrow account to ensure payment of the full sales load. C) The time limit is 13 months. D) The fund can halt redemption during the time the letter of intent is in effect.

D) The fund can halt redemption during the time the letter of intent is in effect. A letter of intent is not binding on the client in any way. Should the client decide to liquidate the account before completing the letter, the company will reduce the redemption by the amount of shares held in escrow. LO 8.d

When speaking to a customer about exchange-traded funds (ETFs), a registered representative could accurately state that these funds A) cannot be bought on margin. B) can be purchased only by paying a sales charge added to the net asset value. C) cannot be purchased using traditional limit or stop orders. D) do not have the same potential tax consequences as mutual funds, such as making capital gains distributions annually.

D) do not have the same potential tax consequences as mutual funds, such as making capital gains distributions annually. With ETFs, portfolio turnover rate is minimized because they do not have to buy and sell shares within their portfolio to accommodate shareholder purchases and redemptions. This can affect the potential tax consequences. While an ETF can make a capital gains distribution, they generally do not—unlike a mutual fund, which generally would make such distributions on an annual basis. ETFs can be traded like other exchange products using traditional stock trading techniques and are priced by supply and demand. Customers pay commissions, not sales charges. LO 8.h

An individual participates in the 401(k) plan offered by the employer. Every two weeks, 4% of the employee's salary is deferred into the plan. The contributions are made into several different mutual funds. This practice is using A) dollar-weighted returns. B) time-weighted returns. C) constant dollar investing. D) dollar cost averaging.

D) dollar cost averaging. Investing the same amount on a regular basis is the definition of the formula-based system of dollar cost averaging. In a fluctuating market, this will always provide the lowest average cost per share. Time-weighted and dollar-weighted are ways to measure the return on the investment. A constant dollar plan is one where the amount invested remains constant, but the allocation among equity, fixed income, and cash is adjusted to reflect a specified percentage. Although dollar cost averaging is covered in your material, the other terms are not. If any of them appear as a correct answer, we will note that in the content updates on your dashboard. LO 8.e


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