Unit 14

Structure of Investment Companies

Board of directors -No felonies or securities related misdemeanors -Minimum 40% non-interested -no more than 60% of the directors may be interested persons

Who safeguards the securities held in a mutual fund's portfolio? A) The corporation B) The manager C) The custodian D) The trustee

C. The Investment Company Act of 1940 requires that investment companies employ the services of a commercial bank as custodian to hold and safeguard the physical assets (cash and investment portfolio) of the fund. U14LO1

Shareholders' right to vote

Changing nature of business -From open end to closed end Changing investment objective or policies Changing investment adviser

Asset-based sales charges will generally be lowest when holding A) Class A shares B) Class C shares C) Class T shares D) Class B shares

Class A shares have a front-end load, but a low- or no asset-based sales charge. Class B and C shares don't have a front-end load, but do have a higher asset-based sales charge. Class T shares always have a 12b-1 charge. U14LO4

Pricing of Closed end and Open end companies

Closed end priced via supply and demand -Can be at a discount to or premium over NAV -Not based on NAV Open end priced via a formula - Forward pricing (assets - liabilities) / number of shares

Difference between affiliated and control person

Control = 25% holding Affiliated = 5% holding

One way in which closed-end management investment companies differ from open-end investment management companies is that A) they are federal covered securities B) they were in existence prior to 1940 C) their portfolio may contain common stock, preferred stock and debt securities D) they trade at a price independent of their net asset value

D. Unlike open-end companies (mutual funds) where the price is based on the net asset value (NAV), closed-end companies trade at a market price based on supply and demand which could be above, below or the same as the NAV. Both are federal covered, both can have equity and debt in their portfolios (although only closed-end companies can issue senior securities) and both were in existence prior to passage of the Investment Company Act of 1940. U14LO3

Benefits of Investment Company Securities

Diversification Professional management Liquidity Low minimum initial investment

The exchange privilege offered by open-end investment companies allows investors to

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. U14LO10

Mutual fund Class A shares

Front end load Investors pay sales charge on each purchase No back end load (CDSC) No front end load on no load funds

Regarding open-end investment companies, which of the following sales charges is based on the NAV per share?

If the fund has a redemption charge (CDSC), it is based on the NAV per share, not the public offering price (POP). That is, if the client liquidated shares when the NAV was $10 per share and the POP was $10.50, the CDSC would be charged based on the $10 rather than the $10.50. Commission is not a term used with mutual funds. The 12b-1 fee is a charge against overall assets of the fund; it is not considered to be a charge related to the buying or selling of fund shares. U14LO4

Class I shares

Institutional only including employer plans No front end load; no CDSC

Risks of investment company securities

Market risk for equity funds Interest rate risk for bond funds Fees and expenses No control over manager's timing of purchases or sales

REITS are NOT flow through vehicles like DPP's

Must distribute at least 90% of net income -Dividends are generally not qualified -Capital gains are generally long term Losses do not flow through -Only income flows through

Investment Company Act of 1940

Three categories: 1. Face amount certificate company -Kind of investment company 2. Unit investment Trust 3. Management companies -Open or Closed end DOES NOT include Holding Companies

Requirements of contract for IA to manage portfolio for a fee

Two year initial contract, renewable annually Maximum 60 day termination - Must be in writing

hurdle rate

Used by hedge funds where the incentive fee will only be paid if the fund return exceeds a set threshold return (e.g., 4%).

Affiliated persons (5% holding or more) and Underwriters CANNOT

sell any personally owned security to the fund except redeeming personally owned shares of the fund (like any other investor) borrow money from the fund purchase from that investment company any security other than the fund's shares

One reason that a private equity fund may operate under the Section 3(c)(7) exemption of the Investment Company Act of 1940 is that A) greater liquidity would be assured B) investors would only need to be accredited rather than qualified C) registration would not be required of the investment adviser D) it would be able to have more than 100 investors

A. Private equity funds operate under two exemptions found in the Investment Company Act of 1940. The 3(c)(1) exemption limits the number of investors to 100 while no such limit applies to the 3(c)(7) exemption. Under the 3(c)(7) exemption, all investors must be qualified, a significantly higher standard than accredited. Investment advisers to private funds generally have to register and the selection of which exemption to use doesn't impact that. As private investments, liquidity is very limited. U14LO5

Class B shares

Back end load (CDSC) Investors pay declining charge at redemption -Based on NAV (not POP) at redemption Higher 12b-1 fee than class A & C shares

Class C shares

Level load Purchase at NAV with 1% CDSC for 1 year Higher 12b-1 fee than Class A but lower than B May be less expensive for investors with short investment horizons

REIT's

Not an investment company undivided interest in a pool of real estate investments. Tradable units in portfolio of real estate or mortgages -Equity trusts - invest in portfolio of operating real estate -Mortgage (debt) trusts - loan money for mortgages to owners of real estate in (purchase) existing mortgages -Revenues generated primarily by the interest that they earn on the mortgage loan

Private Funds

Not registered with SEC or states -Fund manager registered if not exempt -High risk - low liquidity -High compensation to managers PF's look for going concerns No more than 100 investors - All must be qualified clients

A registered investment company whose capitalization may include preferred stock and/or bonds is

Only the closed-end company is legally permitted to issue senior securities (preferred stock and bonds). U14LO2

ETF's

Open end investment companies Can be bought on margin or shorted Can be registered under a UIT or open end company Price to purchase an ETF is determined by supply and demand

Requirements for investment company Registration with SEC

Private capitalization of $100K Clearly defined investment objective Annual financial reports to SEC -Semiannual to shareholders Shareholders have to have the right to vote

It is unlawful for any registered investment company to

Purchase any security on margin Effect a short sale of any security Participate in any joint trading account in securities Acquire greater than 3% of the voting shares of another investment company

A mutual fund must redeem its tendered shares within how many days after receiving a request for their redemption?

The 7-day redemption rule is required by the Investment Company Act of 1940. U14LO1

in handy for a business venture planned for 3 years from now. Meanwhile, he would like to generate some income on the money with as little risk and expense as possible. Which of the following recommendations is likely to be the most suitable for this customer? A) Class B shares of the XYZ Growth Fund B) Class B shares of the ABC Investment-Grade Bond Fund C) Class C shares of the ABC Investment-Grade Bond Fund D) Class A shares of the MNO High-Yield Bond Fund

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 1 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 3 years of his investment. U14LO4

A customer has been following several investment company quotes in the newspaper. She notices that the GEM Fund has an net asset value (NAV) of $12 and an ask price of $12.50, and that the ABC Fund has an NAV of $11.50 and an ask price of $10.98. The customer should conclude that A) ABC and GEM are both unit investment trusts B) GEM may be an open- or closed-end fund and ABC is a closed-end fund C) ABC is an open-end fund and GEM is a closed-end fund D) both are open-end funds

The price for open-end funds is determined by adding the sales charge to the NAV. An open-end fund can never have an ask (or offering) price less than its NAV, therefore ABC cannot be an open-end fund. U14LO3

Breakpoint Sale

Violation under FINRA and NASAA Selling beneath the breakpoint

Hybrid REIT

both equity and debt

Expense ratio

calculated by dividing annual operating expenses by the average dollar value of the fund's assets under management Does not consider sales charge

Direct investments

funds have a 10% or greater voting interest in an operating company with the goal of influencing management and operations

Differences between open and closed end companies

when the exam uses an adjective to describe a fund (balanced, common stock, etc.), it is always an open-end company (mutual fund).

Class R shares

sold only to participants in retirement plans, such as a 401(k) no front-end or back-end load, but may have a 12b-1 fee.

Venture Capital Funds

look for young, promising companies with an expectation of high returns in exchange for the high risk

Rights of accumulation

permits an investor to aggregate shares owned in related accounts in some or all funds in the fund family to reach a breakpoint discount with no time limit. Only available in Class A shares

Key numbers of REITs

(1) at least 75% of a REIT's assets must be represented by real estate assets such as real property or loans secured by real property, cash, and U.S. government securities; (2) at least 75% of the REIT's annual gross income must be from real estate-related income, such as rents from real property and interest on obligations secured by mortgages on real property; and (3) in order to qualify as a REIT, the REIT must distribute at least 90% of its taxable income.

12-b1 fee

Used by open end companies for marketing and promotion Annual expense charged against fund's NAV -Paid on a quarterly basis -Not a CDSC The maximum 12b-1 fee for marketing and promotion is .75% -No load funds are limited to .25%

Portfolio investments

the fund does not acquire a control position and builds a portfolio that may be stock, bonds, derivatives, or any combination of these

Letter of Intent

the investor informs the investment company that he intends to invest the additional funds necessary to reach the breakpoint within 13 months. Receives breakpoint sale discount Can be done up to 90 days after initial sale Appreciation and reinvested dividends do not count toward the LOI. If the customer has not completed the investment within 13 months, he will be given the choice of sending a check for the difference in sales charges or cashing in escrowed shares to pay the difference.

Hedge fund

form of PF Pooled investment vehicle that uses sophisticated strategies -Leveraging through margin and derivatives -Short selling -Arbitrage - legal activity Not required to register with the SEC -Advisers to the fund are registered -Limited transparency compared to mutual funds Limited liquidity -Usually issued as limited partnership interests -Lock up period - not able to sell freely High Expenses -Management generally receives a fee (2%+20%) -Management generally has a partnership interest (skin in the game) Accredited (or qualified) investors only

A management investment company owns portfolio securities with a current market value of $100 million. The company owes $10 million for securities purchased but not yet paid for and accrued management fees of $5 million. If there are 2,611,437 shares outstanding and the current asking price of the shares is $36.38 per share, it would be correct to state that this investment company is A) selling at a premium.

When a closed-end investment company is selling at a price in excess of its net asset value, it is said to be selling at a premium. The net asset value per share of a management investment company (either open-end or closed-end) is computed by dividing the net assets (assets minus liabilities) by the number of outstanding shares. In this example, the net assets are the $100 million portfolio value minus the liabilities of $10 million for the unpaid securities plus the $5 million in accrued management fees. That leaves $85 million divided by the 2,611,437 shares outstanding, which is approximately $32.55. Once we know the NAV, it is clear that the price of $36.38 is a premium over the NAV. And, we know that this can't be an open-end investment company because if it was, the $3.83 sales charge represents 10.5% of the asking price, well in excess of the maximum 8.5% permitted. U14LO3

UNIT INVESTMENT TRUSTS (UITs)

unmanaged investment company organized under a trust indenture do not have boards of directors do not employ an investment adviser do not actively manage their own portfolios (trade securities) shares (units) must be redeemed by the trust.