07 Investment Companies

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Module 7

INVESTMENT COMPANIES

Learning Objectives After completing this module, you should be able to apply the following key concepts:

! Types of investment companies

! Differences between open-end and closed-end management investment companies

! How to determine the net asset value (NAV) of an investment company, as well as the offer price

! Purchasing mutual funds: Sales breakpoints, breakpoint sales, and letters of intent

! Mutual fund share redemptions

! Taxation on dividends, capital gains distributions, sales of mutual funds, and mutual fund family exchanges

! Dollar cost averaging and current yield for mutual funds

NASD Series 7 Module 7: Investment Companies

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INVESTMENT COMPANIES CONTENTS

EXECUTIVE SUMMARY: TEST INFORMATION YOU MUST KNOW................................................. 7 – iii

1.0 INVESTMENT COMPANIES.............................................................................................................7 – 1 1.1 Types of Investment Companies ......................................................................................................7 – 1

2.0 NONMANAGED INVESTMENT COMPANIES...............................................................................7 – 2 2.1 Two Types of Nonmanaged Investment Companies ........................................................................7 – 2 2.2 Face-Amount Certificate Companies................................................................................................7 – 2 2.3 Unit Investment Trusts (UITs)..........................................................................................................7 – 2

3.0 MANAGEMENT INVESTMENT COMPANIES...............................................................................7 – 3 3.1 Two Types of Management Investment Companies ........................................................................7 – 3 3.2 Open-End Management Investment Companies (Mutual Funds).....................................................7 – 3 3.3 Purchasing Shares of a Mutual Fund ................................................................................................7 – 4 3.4 Closed-End Management Investment Companies ............................................................................7 – 5 3.5 Purchasing Shares of a Closed-End Management Investment Company .........................................7 – 5

4.0 COMPARISON OF OPEN-END AND CLOSED-END COMPANIES..............................................7 – 7 4.1 Method of Raising Capital................................................................................................................7 – 7 4.2 Comparison Chart of Open-End and Closed-End Investment Companies .......................................7 – 8

5.0 PURCHASING MUTUAL FUNDS.....................................................................................................7 – 9 5.1 Methods of Purchasing .....................................................................................................................7 – 9 5.2 Determining the Public Offering Price ...........................................................................................7 – 11 5.3 Quantity Discounts .........................................................................................................................7 – 12 5.4 Sales Breakpoints ...........................................................................................................................7 – 12 5.5 Breakpoint Sales .............................................................................................................................7 – 13 5.6 Rights of Accumulation..................................................................................................................7 – 14 5.7 Letter of Intent ................................................................................................................................7 – 15 5.8 Conversion Privileges (Exchange Privileges).................................................................................7 – 15 5.9 Dollar Cost Averaging....................................................................................................................7 – 16

6.0 REDEMPTION OF MUTUAL FUND SHARES ..............................................................................7 – 17 6.1 Redemption Fees ............................................................................................................................7 – 17 6.2 Taxation on Redemptions ...............................................................................................................7 – 18 6.3 Withdrawal Features of Mutual Funds ...........................................................................................7 – 18

7.0 INVESTMENT COMPANY ACT OF 1940......................................................................................7 – 19 7.1 Boards of Directors.........................................................................................................................7 – 19 7.2 Investment Advisers .......................................................................................................................7 – 19 7.3 Custodian Bank ..............................................................................................................................7 – 20 7.4 Transfer Agent................................................................................................................................7 – 21 7.5 Operating Expenses ........................................................................................................................7 – 21 7.6 Advertising of Investment Companies and Prospectus Delivery....................................................7 – 22 7.7 Prohibited Purchases.......................................................................................................................7 – 22

Module 7: Investment Companies NASD Series 7

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8.0 MUTUAL FUND PROSPECTUS AND REPORTS..........................................................................7 – 23 8.1 Mutual Fund Prospectus Requirements ..........................................................................................7 – 23 8.2 Other Reports to Shareholders ........................................................................................................7 – 23 8.3 Regulated Investment Companies...................................................................................................7 – 24

9.0 MUTUAL FUND DISTRIBUTIONS ................................................................................................7 – 25 9.1 Computing Yield ............................................................................................................................7 – 26 9.2 Ex-Dividend Dates..........................................................................................................................7 – 26

10.0 CLASSIFICATIONS OF INVESTMENT COMPANIES .................................................................7 – 27 10.1 Diversified Investment Companies.............................................................................................7 – 27 10.2 Specialized Investment Companies ............................................................................................7 – 28 10.3 Stock Funds ................................................................................................................................7 – 29 10.4 Bond Funds.................................................................................................................................7 – 29 10.5 Hybrid Funds ..............................................................................................................................7 – 30 10.6 Money Market Funds..................................................................................................................7 – 30 10.7 Other Types of Funds .................................................................................................................7 – 31

11.0 EXCHANGE-TRADED FUNDS.......................................................................................................7 – 31

12.0 NEWSPAPER FOOTNOTES ............................................................................................................7 – 33

INVESTMENT COMPANIES EXAM......................................................................................................... E7 – 1

INVESTMENT COMPANIES EXAM ANSWERS ................................................................................... E7 – 12


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INVESTMENT COMPANIES EXECUTIVE SUMMARY:

TEST INFORMATION YOU MUST KNOW

To help you streamline your studying efforts, the following sections will be tested on the exam. Reading the full section will give you a thorough understanding of these must know points and their impact as well as other important information.

Section 1.0 As required by the Investment Company Act of 1940, a registered investment company must have a minimum of $100,000 in capital and 100 shareholders before its securities can be offered and sold to the public. This $100,000 is called the capitalization of the investment company.

Section 1.1 There are two major types of investment companies that are required to register with the Securities and Exchange Commission (SEC) under the Investment Company Act of 1940:

• Nonmanaged • Managed

Section 2.1 There are two major types of nonmanaged investment companies: • Face-amount certificate companies • Unit investment trusts (UITs)

Section 2.3 A unit investment trust (UIT) issues redeemable trust certificates that represent an undivided interest in a portfolio of securities. This fixed portfolio usually consists of municipal bonds, or corporate bonds, but can contain other investments, including stocks.

Section 3.1 There are two major types of management investment companies: • Open-end management investment companies, more commonly called

“mutual funds” • Closed-end management investment companies, also known as “publicly

traded funds”

Section 3.2 Open-end management investment companies are best known as mutual funds.

Section 3.2 NAV is calculated daily for each fund upon the close of the New York Stock Exchange.

Section 3.2 Because mutual fund shares are continuously offered as a new issue security, a prospectus must accompany each new sale of mutual fund shares.

Section 3.3 Mutual funds are not listed on exchanges because shares can only be purchased as new issues at a public offering price.

Section 4.0 The primary difference between open-end companies and closed-end companies is the capitalization of the company.

Section 4.1 The most that open-end companies may borrow from a bank is one-third of their net asset value (i.e., their net asset value must be at least three times greater than the amount of money they borrow).

Section 4.1 Closed-end companies can issue common stock, preferred stock, and bonds.


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Section 4.2

Section 5.1 The public offering price (POP) of a given purchase is based on the next computation of the net asset value (NAV) per share following the receipt of the order. This is known as forward pricing.

Section 5.1 The maximum aggregate front-end and contingent deferred sales charges on a mutual fund are 8.5% of the offering price, according to NASD Conduct Rules. This maximum sales charge can only be charged if:

• Quantity discounts are available for large purchases. • Rights of accumulation (cumulative quantity discounts) are available. • No service fees are charged for personal service or maintenance of shareholders’

accounts. • No 12b-1 fees (asset-based sales charges) are charged by the mutual fund.

Section 5.1 The Securities Act of 1933 forbids the purchasing of any new issues (including mutual fund shares) on margin (paying only a portion of the purchase price).

Section 5.2 To determine the offer price or public offering price (POP) of a mutual fund, set up the following formula (including the lines underneath):

Section 5.3 Quantity discounts are not given to investment clubs, partnerships, or others who are banding together for the purpose of taking advantage of a sales breakpoint.

Section 5.3 Husbands, wives, and minor children investing together are allowed to take advantage of sales breakpoints.

Section 5.3 The salesperson must inform customers of the availability of a discount and of their right to take advantage of the quantity discount.

Comparison of Open-End and Closed-End Companies

Open-End Company Closed-End Company

Stock Common stock only Common stock and preferred stock

Borrow Up to 1/3 of net asset value

Cannot borrow money from a bank but can issue bonds up to 1/3 of NAV

Method of Purchase Continually issues new shares of stock; shares are not traded on exchanges, but redeemed by the investment company

Shares issued and sold first through a public offering, then traded on an exchange or over the counter

Capitalization Continuously changing Fixed

POP = NAV + SALES CHARGE

$ = +

100% = +


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Section 5.4 A sales breakpoint is the term for a dollar amount at which a reduced sales charge is given to the investor.

Section 5.5 A breakpoint sale takes place when a customer buys a large dollar amount that is near, but below, the sales breakpoint, and the customer is not informed of the sales breakpoint.

Section 5.5 Test-taking tip: It is important to distinguish between a sales breakpoint and a breakpoint sale.

• A sales breakpoint is the term used to describe the point at which sales charges are reduced. A sales breakpoint is good for the buyer.

• A breakpoint sale is when the registered representative allows the customer to invest without informing him of the possibility of reduced sales charges.

Section 5.6 Rights of accumulation are cumulative quantity discounts that allow an investor to take advantage of reduced sales charges based on the investor’s accumulated ownership in a mutual fund.

Section 5.7 The letter of intent states that the investor intends to take advantage of reduced sales charges by purchasing enough funds over a 13-month period to qualify for the discounted sales charge.

Section 5.7 A letter of intent can be backdated up to three months (90 days) to include previous purchases in taking advantage of the reduced sales charge.

Section 5.8 When an investor exchanges one mutual fund for another within a mutual fund family, the investor may have a tax consequence for any capital gains or capital losses associated with the liquidation of the mutual fund(s) that is being replaced by the purchase of another fund in the family of funds. If the investment is in a retirement account, the investor does not have a tax liability.

Section 5.9 Dollar cost averaging is a method of investing over a period of time.

Section 5.9 The theory behind dollar cost averaging is that over time, the average cost per share of the mutual fund will be less than if the mutual fund investment was purchased at one time.

Section 6.0 If an investor decides that he no longer wishes to own shares of a mutual fund and desires to sell the shares, the person simply redeems them to the company.

Section 6.0 The redemption price is the next computation of the NAV less any redemption fee.

Section 6.0 When a mutual fund receives a redemption request from an investor, the fund must send the net asset value of the shares being redeemed, less a redemption cost, if any, to the investor within seven calendar days of receiving the redemption request.

Section 6.3 Each mutual fund company may offer their specific withdrawal plans that are marketed as income plans for retirees or individuals who need the income from these investments.

Section 7.0 The Investment Company Act of 1940 requires the registration of all investment companies, which includes face-amount certificate companies, unit investment trusts, and management investment companies (either open-end or closed-end).

Section 7.0 The Investment Company Act of 1940 requires that the investment company have a minimum of $100,000 of capital and 100 shareholders before it can offer shares of its fund to the public.

Section 7.0 The investment company must also establish its investment objectives and keep to these objectives in all investments within the portfolio. With management investment companies the investment objectives may be changed only by a majority vote of the shares as voted by the shareholders.


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Section 7.1 The Investment Company Act of 1940 requires that no more than 60% of the individuals on the board of directors can be associated with other aspects of the investment company’s operations, and at least 40% of the individuals on the board cannot be affiliated with the operations of the investment company.

Section 7.2 Investment advisers, or management companies, are responsible for deciding what securities to buy and sell and when to buy and sell them, as well as when they need to hold assets in cash.

Section 7.2 The management fee is usually the largest expense of the fund and is typically 1/2% of the average annual net assets of the investment company.

Section 7.2 Under the Investment Advisers Act of 1940, any person who provides investment advice and charges a fee for that advice is considered an investment adviser and must be registered.

Section 7.5 A mutual fund’s expense ratio is: ANNUAL OPERATING EXPENSES

TOTAL NET ASSET VALUE

Section 7.6 The following types of mutual fund advertising do not require that a prospectus be delivered: • Tombstone announcement • Omitting prospectus • Generic advertising

Section 8.1 The requirements for producing a mutual fund prospectus are as follows: • A new prospectus is required to be issued once every 13 months, and must not

contain financial information more than 16 months old. • A statement of additional information, with further details about the mutual fund,

must be provided upon request.

Section 8.1 Each prospectus must also contain the SEC approval clause, stating that the SEC does not approve or disapprove of the security and any representation to the contrary is a criminal offense.

Section 8.2 All investment companies, open-end and closed-end, must send reports to shareholders at least quarterly, detailing the number of shares owned, their value as of a certain date, and the total value of the account. If there is activity in the account, the investment companies must send a monthly statement.

Section 8.2 When an investor purchases mutual fund shares, the investor must receive a confirmation of the transaction, unless the transaction is part of a periodic payment plan. The broker/dealer must send the confirmation of the mutual fund transaction at or before the completion of the transaction.

Section 8.3 IRS regulations that pertain to these investment companies allow the IRS to give them special tax treatment if they pass at least 90% of their net investment income to their shareholders.

Section 8.3 This special tax treatment is based on the “conduit theory” or “pipeline theory” under Subchapter M of the Internal Revenue Code.

Section 9.0 Mutual funds make two basic types of distribution of money to shareholders: • Capital gains from the profits of buying and selling investments • Net investment income from interest and dividends

Section 9.0 Dividends are distributions made from income on stock and bonds owned by the mutual fund.

Section 9.0 Dividend and interest distributions are considered part of the shareholder’s ordinary income whether reinvested or accepted in cash, and are taxed in the year received.


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Section 9.0 Capital gains distributions are considered return of capital and are taxed to shareholders as long-term capital gains, regardless of whether received as cash or reinvested, and no matter how long the shares in the investment company were held.

Section 9.1 A mutual fund’s yield is calculated by dividing the annual dividend distribution by the ask (or offering) price. The capital gains are never used to determine yield, because capital gains are considered a return on capital, and yield is based only on income.

YIELD = ANNUAL DIVIDEND CURRENT OFFER PRICE

Section 9.2 The ex-dividend date (or ex-date) is set by the board of directors and is usually the next business day after the record date. The ex-dividend date is the day on or after which the buyer of the mutual fund shares is not entitled to receive the dividend.

Section 9.2 An investor would be buying the dividend if he or she purchased the fund just before the ex-dividend date. The total value of the investment would not change, although the investor would have to pay taxes on the distribution (whether or not it was taken in cash or automatically reinvested).

Section 10.1 According to the Investment Company Act of 1940, a diversified investment company is a company that invests a least 75% of its total assets in such a way that no more than 5% of total assets are invested in any one company at a given time. Also, a diversified investment company cannot own more than 10% of the outstanding voting stock of any one company.

Section 10.1 Exam tip: Know 75%, 5%, and 10%, in that order.

Section 10.2 A specialized investment company, sometimes referred to as a sector fund, is an investment company that invests in stocks whose issuers are primarily in one specific industry, type of business, size of company, or geographical area.

Section 10.3 Stock funds invest in a wide variety of issuers, but the investment company must focus a majority of the investment money in equities, or stocks.

Section 10.3 Growth funds invest primarily in companies that are growing and pay very little in dividends.

Section 10.3 Aggressive growth funds invest primarily in the common stock of relatively new companies with the potential for rapid and high capital appreciation.

Section 10.3 Conservative growth funds primarily invest in the common stock of well-established companies with the potential for capital appreciation.

Section 10.4 Bond funds invest mainly in fixed-income securities of publicly traded companies and municipal issuers.

Section 10.4 The value of bond funds is based on the underlying value of the bonds held in the fund. If interest rates increase, the net asset value of the bond fund would decrease in value.

Section 10.4 Among the types of bond funds, corporate bond income funds focus on investing in debt securities of publicly traded companies.

Section 10.5 A balanced fund invests in a specific mix of fixed income and equity securities. The investment objective is a hybrid to preserve principal, produce dividends and interest, and obtain long-term growth.

Section 10.6 A money market fund is a mutual fund that invests in short-term debt securities, such as commercial paper, banker’s acceptance, repurchase agreements, T-bills, negotiable CDs, and the like.

Section 10.6 One of the most popular features available in money market mutual funds is the check-writing feature.


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Section 11.0 The shares of an ETF are initially “created” by an institution or other large investor. The institution deposits a specified number of shares of a portfolio of stocks with a trustee that correlate to the index that the ETF is following.

Section 11.0 Other important aspects regarding ETFs are that the shares can be purchased on margin and the ETF shares can be sold short.

Section 12.0 The following are footnotes used by the NASD in the mutual fund price information released for newspapers and periodicals to publish:

• “p” indicates that there are 12b-1 fees charged by the company • “r” indicates that there are redemption fees or contingent deferred sales charges • “t” indicates that both 12b-1 fees and redemption fees or contingent deferred sales

charges apply • “NL” indicates a no-load mutual fund


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INVESTMENT COMPANIES 1.0 INVESTMENT COMPANIES

Investment companies are formed for the purpose of pooling small investors and their money to purchase securities, with the aim of profiting from increases in those securities’ prices and from income generated through dividends and interest. Such companies invest in stocks and bonds of other companies, as well as in short-term money market instruments. One of the biggest benefits for an investor in investment companies is the ability to diversify their investment in different securities.

Investment companies are financial companies whose purpose is to produce income. As required by the Investment Company Act of 1940, a registered investment company must have a minimum of $100,000 in capital and 100 shareholders before its securities can be offered and sold to the public. This $100,000 is called the CAPITALIZATION of the investment company.

1.1 TYPES OF INVESTMENT COMPANIES There are two major types of investment companies that are required to register with the Securities and Exchange Commission (SEC) under the Investment Company Act of 1940:

• Nonmanaged • Managed

A NONMANAGED INVESTMENT COMPANY pools the investments from different investors for the purchase of different investments, and is not actively managed. Conversely, a MANAGED INVESTMENT COMPANY, or MANAGEMENT INVESTMENT COMPANY is actively managed by an investment adviser.

Note: Holding companies, investment clubs, broker/dealers, banks, insurance companies’ pension plans, and the like are not considered to be investment companies and are not subject to the Investment Company Act.


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2.0 NONMANAGED INVESTMENT COMPANIES

2.1 TWO TYPES OF NONMANAGED INVESTMENT COMPANIES

There are two major types of nonmanaged investment companies: • Face-amount certificate companies • Unit investment trusts (UITs)

Neither a face-amount certificate company nor a unit investment trust uses an investment adviser to actively manage the assets in the investment company. Therefore, neither is classified as a management investment company.

2.2 FACE-AMOUNT CERTIFICATE COMPANIES A FACE-AMOUNT CERTIFICATE COMPANY is a type of investment company that offers units similar to certificates of deposit, but the certificates can be paid for either at once in a lump sum or over time in installments. The certificate is issued at a discount, and the investor redeems it at the full face amount, which includes earnings, upon maturity. The investor can also redeem the investment early at a surrender value. The funds in the face-amount certificate are typically invested in mortgage-backed bonds, corporate securities, and collateralized mortgage obligations (CMOs).

The certificates are not insured by any governmental agency, and the performance of the face-amount certificate will depend upon the risks associated with the underlying investments. Interest rate risk is a primary concern for an investor, since the certificate pays a fixed rate of interest.

2.3 UNIT INVESTMENT TRUSTS (UITS) A UNIT INVESTMENT TRUST (UIT) issues redeemable trust certificates that represent an undivided interest in a portfolio of securities. This fixed portfolio usually consists of municipal bonds, or corporate bonds, but can contain other investments, including stocks.

The unit investment trust may be traded like a closed-end bond fund that sells on an exchange or in the over-the-counter market. The UIT issues a TRUST INDENTURE, which outlines the obligations of the trustee (manager of the trust).

A unit investment trust is the only type of investment company that has a board of trustees instead of a board of directors. All other investment companies have boards of directors.

One unit investment trust is the Standard & Poor’s Depositary Receipt (SPDR) Trust, which is an EXCHANGE-TRADED FUND (ETF). As an exchange-traded fund, the investment represents a pool of stocks that represent the S&P 500. The ETF tracks the performance of the S&P 500, but is not actively managed. These unique investments can be traded on an exchange, similarly to the way stocks are traded.



3.0 MANAGEMENT INVESTMENT COMPANIES

MANAGEMENT INVESTMENT COMPANIES are commonly called OPEN-END FUNDS (MUTUAL FUNDS) and CLOSED-END FUNDS (INVESTMENT TRUSTS). These funds are managed by professional managers or investment advisers.

3.1 TWO TYPES OF MANAGEMENT INVESTMENT COMPANIES

There are two major types of management investment companies: • Open-end management investment companies, more

commonly called “mutual funds” • Closed-end management investment companies, also known as

“publicly traded funds”

3.2 OPEN-END MANAGEMENT INVESTMENT COMPANIES (MUTUAL FUNDS)

OPEN-END MANAGEMENT INVESTMENT COMPANIES are best known as mutual funds. Remember, these terms can and will be used interchangeably from this point forward. Mutual funds are management investment companies because professional investment advisers who are hired by the board of directors of the mutual fund do the purchasing and selling of securities. These investment advisers are paid a management fee by the fund, typically one-half of 1% of the average net assets of the fund.

NET ASSETS are the value of the assets of the investment company, including both cash held and the securities in which the company has invested. The combined value of these assets less the mutual fund’s liabilities is called the net assets of the fund. When a mutual fund’s net asset value is divided by the number of shares the fund has outstanding, the result is called the NET ASSET VALUE per share, or NAV.

Review the calculation below for a better understanding of a mutual fund’s share price: NAV = MARKET VALUE OF FUND’S SECURITIES - MUTUAL FUND’S LIABILITIES

NUMBER OF SHARES OUTSTANDING

NAV is calculated daily for each fund upon the close of the New York Stock Exchange. The total value of the shares is calculated by adding the closing values of the stocks and other investments in the mutual fund for that day. The prices that are quoted in the newspaper will generally include the NAV and the price that customers pay or the PUBLIC OFFERING PRICE (POP). NAV plus a sales charge (if applicable) equals the price at which an investor will purchase shares (the POP).

When a customer sells shares, the customer will sell at the NAV price, less any redemption charges that may apply.

Mutual funds continuously offer their shares to the public as new issues. Because mutual fund shares are continuously offered as a new issue security, a PROSPECTUS must accompany each new sale of mutual fund shares. The prospectus must be delivered at the time of the



solicitation or before the transaction is completed. The prospectus discloses how the mutual fund shares can be purchased or redeemed. Because the capitalization of a mutual fund is continuously changing (due to the purchase of new shares and the redemption of older shares) the capitalization is described as being “open” because shares can be regularly created or redeemed. Thus mutual funds are also described as open-end investment companies.

Advertising costs and printing costs for prospectuses used in sales of fund shares are paid out of the sales charges that investors pay upon purchasing shares of the mutual fund. These charges are not included within the mutual fund operating expenses. Therefore, mutual funds that do not impose a sales charge will generally have an expense described as 12b-1 CHARGES or fees. 12b-1 charges are used to pay for advertising, marketing and prospectus costs and are often described as ASSET-BASED SALES CHARGES. The 12b-1 charge is also used to compensate broker/dealers for the sales of mutual funds.

The primary advantages for investors in purchasing shares of a mutual fund versus investing in other investments include diversification, liquidity, and professional management services that are not available with other investments. In addition, mutual funds offer various methods for an investor to invest, access their investment, and redeem their investment over time.

3.3 PURCHASING SHARES OF A MUTUAL FUND When an investor wishes to purchase shares of a fund, the investor pays the price that is set by the fund. This price, called the ASK PRICE, also know as the OFFER PRICE or PUBLIC OFFERING PRICE (POP), is computed by adding any applicable sales charges to the net asset value.

The net asset value of a mutual fund is typically determined at the close of the New York Stock Exchange, and any sales of shares will be sold at this net asset value.

The price an investor pays for full and fractional shares will be based upon the next computation of the net asset value. The mutual fund company receives the order and fills the order based on the next computation of the net asset value. This method of purchasing is called FORWARD PRICING, since the purchaser does not know the exact amount per share of the mutual fund until after the order is placed to purchase the shares.

Once the net asset value is determined, the company will add a sales charge to determine the price per share the investor will have to pay. This sales charge, or portion thereof, is used to compensate other dealers and their registered representatives assisting in selling shares of the fund. The price the investor must pay (the public offering price, ask price, or offer price) already includes the sales charge, and no additional commission can be charged.

How to determine the public offering price is discussed in further detail in Section 5.2, Determining the Public Offering Price.

Mutual funds are not listed on exchanges because shares can only be purchased as new issues at a public offering price. The exchanges are auction markets where stock prices are bartered. New issues are sold at a specified price, which cannot be changed.



EXCHANGE-TRADED FUNDS (ETFs) are a type of nonmanaged investment company fund that typically follow an index. These funds, unlike mutual funds, trade like closed-end funds — over an exchange.

Mutual fund shares can only be purchased as a new issue from the mutual fund company or through a broker/dealer. The fund shares are purchased through the fund company using an application that must be completed by the investor. If the broker/dealer is able to offer shares via wire order, the mutual fund shares can be purchased directly in a brokerage account, similarly to stocks. Either the mutual fund company or the broker/dealer will be responsible for forwarding a prospectus before the completion of the sale.

3.4 CLOSED-END MANAGEMENT INVESTMENT COMPANIES Like mutual funds, CLOSED-END MANAGEMENT INVESTMENT COMPANIES have managers who manage their assets. Also, like mutual funds, closed-end management investment companies invest mainly in stocks and bonds. Unlike mutual funds, closed-end management investment companies typically offer their new securities to the public only during an initial offering and do not redeem their shares. The closed-end management investment company’s capitalization is relatively stable, or “closed.” After their initial offering at an initial offering price, shares of closed-end management investment companies are traded either on exchanges or over the counter (OTC), just like stocks. The price of a closed-end fund is partially determined by supply and demand. The major component of the price of the closed-end fund is determined by the investments underlying the fund. The net asset value of the fund is computed like open-end, mutual-fund share NAV, but the price at which shares are sold depends upon the sell price in the market, not on the net asset value. Closed-end management investment companies are also known as PUBLICLY TRADED FUNDS or INVESTMENT TRUST SHARES.

3.5 PURCHASING SHARES OF A CLOSED-END MANAGEMENT INVESTMENT COMPANY

When purchasing shares of a closed-end management investment company after the initial offering, the price is partially determined by supply and demand, and shares may sell above or below net asset value.

The net asset value is important for the valuation of the fund, but the supply of and demand for the closed-end fund shares is what will influence the closing price of the shares. The fund shares typically trade at a premium to the NAV or at a discount to the NAV.

If the stock is selling above net asset value, it is selling at a premium. If the stock is selling below the net asset value, it is selling at a discount.

The trading of closed-end management investment company shares is performed similarly to the buying and selling of stocks. Commissions can be charged by the broker/dealer acting on behalf of the customer to execute an order over the counter or on an exchange. Closed-end fund shares can be bought on margin 30 days after the initial sale of the shares. The initial sale of the shares is called an INITIAL PUBLIC OFFERING, or IPO. During the IPO, the trading of these securities must follow the Securities Act of 1933. After the IPO, the trading of these shares on the secondary market



must follow the rules of the Securities Exchange Act of 1934, just like stocks.

Which of the following are not considered to be registered investment companies under the Investment Company Act of 1940?

I Face-amount certificates II Investment clubs III Unit investment trusts IV Holding companies V Closed-end management companies (A) I only (B) II and IV only (C) III and V only (D) III, IV, and IV only

Answer (B) II and IV only. Investment clubs and holding companies are not considered to be investment companies due to the nature of their business. They do not have to register with the SEC under the Investment Company Act of 1940. All of the others must register and are, therefore, “registered companies” under this security law. Mutual funds are not registered investment companies, even though “mutual fund” is the common name for an open-end management investment company, and open-end management investment companies are required to register. However, the term “mutual fund” is not used in the Investment Company Act of 1940. So, if you encounter questions on your exam on this point, remember that “mutual funds” are not required to register with the SEC, but “open-end management investment companies” are required to register.

Which of the following are not considered to be management companies under the Investment Company Act of 1940?

I. Unit investment trusts II. Face-amount certificates III. Open-end management investment companies IV. Closed-end management investment companies (A) II only (B) IV only (C) I and II only (D) III and IV only

Answer (C) I and II only. Unit investment trusts and face-amount certificates invest in a specific portfolio of securities that are not actively managed. Open-end and closed-end management investment companies hire an investment adviser to manage their portfolios and must register as management investment companies (either open-end or closed-end) with the SEC under the Investment Company Act of 1940.

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4.0 COMPARISON OF OPEN-END AND CLOSED-END COMPANIES

The primary difference between open-end companies and closed-end companies is the capitalization of the company. The capitalization equals the number of shares multiplied by value per share. Since an open-end company continuously issues new shares, its capitalization fluctuates more than the capitalization of a closed-end company. Let’s look at this and other differences in greater detail.

4.1 METHOD OF RAISING CAPITAL Open-end companies (mutual funds) can issue common stock only. For that reason, most mutual funds now offer multiple classes of common stock shares. (Think of a mutual fund share representing a share of common stock.)

• CLASS A SHARES — Also known as FRONT-END LOAD SHARES. The investor’s net investment will equal the public offering price less the sales charge.

• CLASS B SHARES — Typically charge no front-end sales charge, but the investor will incur a sales charge if the shares are redeemed within the surrender period. The charge is referred to as a CONTINGENT DEFERRED SALES CHARGE (CDSC).

• CLASS C SHARES — Sometimes considered no-load shares. If the mutual fund has incorporated a 12b-1 fee greater than .25%, the shares cannot be called no-load.

• CLASS X or M (or other letter) SHARES — Used for investment programs or in the case of an F share mutual fund, the shares are available for purchase at no-load by existing shareholders of another fund managed by the same investment company.

Although open-end companies can issue only common stock, they may also borrow money from a bank in order to leverage their investing or meet shareholder liquidations for a short period of time. The most that open-end companies may borrow from a bank is one-third of their net asset value (i.e., their net asset value must be at least three times greater than the amount of money they borrow).

Closed-end companies can issue common stock, preferred stock, and bonds. Most issue only common and preferred stock, and they can issue only one class of common stock.

Method of Purchase Comparison Open-end companies have a continuous offering of new shares of stock to new investors and to existing shareholders. Open-end company shares do not trade on exchanges; rather, people wishing to sell the shares they own redeem the shares to the investment company. These companies are referred to as open-end because they are continuously issuing new shares and repurchasing issued shares.

Closed-end companies issue their securities first through a public offering. Once issued, the securities are traded either on an exchange or over the



counter, and the transactions are subject to the NASD markup policy for charges associated with their purchase and sale.

The chart in the following section compares the differences between open-end and closed-end companies.

4.2 COMPARISON CHART OF OPEN-END AND CLOSED-END INVESTMENT COMPANIES

An open-end company’s net assets must equal at least how much more than its bank borrowing?

(A) Two times (B) Three times (C) Five times (D) Ten times

Answer (B) Three times. The net assets must be at least three times, or 300%, of the bank borrowing. In other words, the investment company can borrow up to one-third of the net assets.

Comparison of Open-End and Closed-End Companies

Open-End Company Closed-End Company

Stock Common stock only Common stock and preferred stock

Borrow Up to 1/3 of net asset value

Cannot borrow money from a bank but can issue bonds up to 1/3 of NAV

Method of Purchase Continually issues new shares of stock; shares are not traded on exchanges, but redeemed by the investment company

Shares issued and sold first through a public offering, then traded on an exchange or over the counter

Capitalization Continuously changing Fixed

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5.0 PURCHASING MUTUAL FUNDS

This section reviews and expands on the concepts presented in Section 3.3, Purchasing Shares of a Mutual Fund, which provides an introduction to pricing and purchases of mutual fund shares.

5.1 METHODS OF PURCHASING Investors can purchase mutual fund shares in one of the following ways:

• The fund sells its shares to the underwriter, who sells the shares to a broker/dealer, who sells the shares to the investor.

• The fund sells its shares to the underwriter, who sells the shares to the investor.

• The fund sells its shares directly to the investor. This is typically how no-load mutual funds are sold, since a sales charge is not part of the fees paid by the investor.

• The fund sells its shares to a contractual plan company (usually a unit investment trust), which sells the trust certificates as part of a contractual installment purchase agreement to the investor. (This will be discussed in greater detail in Section 6.0, Contractual Plans.)

In each case, the investor will pay the public offering price as disclosed in the prospectus. Remember, the prospectus must be delivered to the investor with the initial offer or sale of the fund.

The investor can make an initial investment in a mutual fund by filling out an account application and sending a check to the broker/dealer, the underwriter, or the fund. The investor must pay in cash for mutual funds and cannot purchase on credit (margin). Most funds have a minimum initial investment of between $1,000 and $5,000. However, the investor may establish a retirement account, and/or a contractual plan, with a smaller minimum investment.

The investor may make subsequent investments by mail, telephone, or Internet via the brokerage firm’s or fund’s Web site. These purchases can be paid for with cash (usually a check), electronic transfer from a bank, or the sale of mutual funds already owned. When an investor sells one mutual fund and uses the proceeds to purchase a new mutual fund, it is called an EXCHANGE. Subsequent purchases usually have minimum investment requirements that are disclosed in the prospectus, along with the minimum initial investment requirements.

The public offering price (POP) of a given purchase is based on the next computation of the net asset value (NAV) per share following the receipt of the order. This is known as FORWARD PRICING.

• If the fund has a front-end sales charge, the POP = NAV + Sales Charge.

• If the fund is a no-load mutual fund or has a deferred sales charge, there is no sales charge added to the purchase price and the POP = NAV.



• If the fund has a deferred sales charge or a redemption fee, the deferred sales charge or redemption fee will be deducted from the NAV when the investor sells the shares.

The maximum aggregate front-end and contingent deferred sales charges on a mutual fund are 8.5% of the offering price, according to NASD Conduct Rules. This maximum sales charge can only be charged if:

• Quantity discounts are available for large purchases. • Rights of accumulation (cumulative quantity discounts) are

available. • No service fees are charged for personal service or

maintenance of shareholders’ accounts. • No 12b-1 fees (asset-based sales charges) are charged by the

mutual fund.

A SPONSOR or UNDERWRITER of the fund acts as the distributor for the mutual fund shares. Underwriters buy the shares at the NAV and distribute the shares through broker/dealers. The broker/dealer that sells mutual funds to the customer must enter into a SELLING AGREEMENT in order to receive any compensation for selling the mutual fund shares. The shares are sold to customers at the public offering price, but the selling agreement will specify how the broker/dealer is compensated. Depending on the class of share, the broker/dealer can receive the sales charges or 12b-1 fees as compensation for the sale of the shares.

The Securities Act of 1933 forbids the purchasing of any new issues (including mutual fund shares) on MARGIN (paying only a portion of the purchase price). After the shares have been purchased and owned for 30 days, they can be used as collateral in a margin account to purchase other securities.

As noted above, the maximum sales fee a mutual fund can charge is 8.50% of the public offering price. Remember, the public offering price of a mutual fund is also referred to as the ask price.

Note: The old provision in the NASD Conduct Rules provided that in order to charge the maximum sales charge, the fund had to reinvest dividends at net asset value. This provision is no longer in the rule. However, most mutual funds allow dividend and capital gains distributions to be automatically reinvested at net asset value with no sales charge.

What is the maximum sales charge that can be assessed on a purchase of open-end investment company shares?

(A) 0.25% (B) 6.25% (C) 7.25% (D) 8.50%

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Answer (D) 8.50%. The maximum sales charge is allowable only if the investor has the following privileges with the purchase of open-end investment company shares:

• Quantity discounts • Rights of accumulation • Reinvestment privileges at the net asset value

5.2 DETERMINING THE PUBLIC OFFERING PRICE To determine the offer price or public offering price (POP) of a mutual fund, set up the following formula (including the lines underneath):

POP Since the offering price is 100% of the price being paid by the customer, the combined total of the net asset value (NAV) and the sales charge must equal this percentage. Given the NAV and sales charge, you can determine the offer price and/or the amount of the sales charge. Likewise, if you know the POP and the sales charge, you can calculate the NAV.

Example

Find the public offering price of a mutual fund with an NAV of $18.40 and a sales charge of 8%.

POP = NAV + Sales charge $ ___ = 18.40 + _________ 100% = _____ + 8% Since 100% = 92% + 8%, the blank under the $18.40 is 92%; and now that we have $18.40 over 92%, we can divide $18.40 by 92%. This will give an offer (or ask) price of $20. From there, we can figure out that the amount of the sales charge is $1.60.

Try one yourself:

If the NAV is $9.30 and the sales charge is 7%, what is the offering price and how much is the sales charge?

Answer $10 and $0.70)

A mutual fund has a NAV of $18.60 and a sales charge of 6%. What is the offering price of the fund?

(A) $17.48 (B) $19.71 (C) $19.79 (D) $20.89


$ = +

100% = +

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Answer (C) $19.79. The offer price includes the NAV plus the sales charge. Set it up like this: POP = NAV + SC $ ?? = 18.60 + ___ % 100 = .94 + .06 (because 100% is the total and 6% is the sales charge) That leaves 18.60 divided by .94, which equals 19.79.

5.3 QUANTITY DISCOUNTS QUANTITY DISCOUNTS allow a customer to purchase mutual fund shares with a reduced sales charge. The sales charge discount is allowed if an investor is purchasing a large dollar value of a mutual fund. Quantity discounts must be outlined in the prospectus. Individuals, corporations, and pension funds may all take advantage of quantity discounts on mutual fund share purchases.

Special exceptions to the quantity discounts available to customers: • Quantity discounts are not given to investment clubs,

partnerships, or others who are banding together for the purpose of taking advantage of a sales breakpoint.

• Husbands, wives, and minor children investing together are allowed to take advantage of sales breakpoints.

The salesperson must inform customers of the availability of a discount and of their right to take advantage of the quantity discount. The salesperson violates NASD Conduct Rules by not informing customers of breakpoints, especially if the amount invested is close to an existing breakpoint.

5.4 SALES BREAKPOINTS A SALES BREAKPOINT is the term for a dollar amount at which a reduced sales charge is given to the investor. Breakpoints usually start at about $10,000 to $15,000 and go as high as $1 million. The point at which breakpoints start will vary from one mutual fund to another.

Example

Sales Breakpoint

A mutual fund has sales charges as follows:

$0 to $24,999 : 7 % sales charge $25,000 to $49,999: 6 % sales charge $50,000 and above: 5 % sales charge An investor purchases $35,000 worth of a mutual fund using the above breakpoints. The investor will pay 6% sales charge on the entire amount invested.

Customers must be informed of quantity discounts, which must also be in the prospectus.



5.5 BREAKPOINT SALES Breakpoint sales are violations of the NASD Conduct Rules. A BREAKPOINT SALE takes place when a customer buys a large dollar amount that is near, but below, the sales breakpoint, and the customer is not informed of the sales breakpoint. The result of breakpoint sales is that the customer pays a higher sales charge for purchasing the mutual fund than if the customer committed a slightly larger amount to qualify for the breakpoint discount. A breakpoint sale, then, would occur if a representative induced a customer to purchase a dollar amount immediately below a breakpoint. The breakpoint sale can be avoided by informing the customer of the breakpoint and having either of the following signed by the customer:

• A letter of intent (to be discussed in Section 5.7, Letter of Intent) • A customer statement that the customer was informed but declined

to take advantage of the breakpoint discount

Example

Breakpoint Sale

A mutual fund has sales charges as follows:

$0 to $24,999: 7% sales charge $25,000 to $49,999: 6% sales charge $50,000 and above: 5% sales charge

If a customer invests $24,000 and is not told of the sales breakpoint at $25,000, the representative has violated the NASD Conduct Rule, which prohibits breakpoint sales.

A breakpoint sale can occur also if a representative recommends an investment be split between two or more separate mutual funds (not in the same family of funds) and fails to disclose the impact on sales charges by making separate investments. With the above schedule of breakpoint discounts, if a customer invests $15,000 in one mutual fund and invests $15,000 in another mutual fund without being informed about the possible discount, the representative has recommended a breakpoint sale.

Test-taking tip: It is important to distinguish between a sales breakpoint and a breakpoint sale.

• A sales breakpoint is the term used to describe the point at which sales charges are reduced. A sales breakpoint is good for the buyer.

• A breakpoint sale is when the registered representative allows the customer to invest without informing him of the possibility of reduced sales charges.

All of the following types of customers can take advantage of reduced sales charges, such as a breakpoint in Class A shares, except:

(A) A husband and wife with separate money (B) A woman and her minor daughter (C) Two business partners purchasing for their company (D) A father and his adult son

When the customer is not told of a sales breakpoint, this is a breakpoint sale.

Don’t confuse a sales breakpoint (good) with a breakpoint sale (bad).

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Answer (D) Correct answer (false statement): A father and his adult son. Since the adult son and father are separate adults and are not considered to be a legal entity like a husband and wife, they cannot invest to take advantage of sales breakpoints. All of the others can take advantage of sales breakpoints. Note: Partnerships formed for the purpose of investing in mutual funds are not eligible for the reduced sales charge.

5.6 RIGHTS OF ACCUMULATION RIGHTS OF ACCUMULATION are cumulative quantity discounts that allow an investor to take advantage of reduced sales charges based on the investor’s accumulated ownership in a mutual fund. The sales charge an investor would pay on each subsequent purchase is based on the total value of shares previously purchased (and still owned) plus the securities currently being purchased. The total value of the shares currently owned may be based on:

• The current value (net asset value, or maximum public offering price)

• The original purchase price • The higher of the current value or original purchase price (most

funds use this method)

All the details concerning rights of accumulation, including the valuation of previously purchased shares, must be disclosed in the prospectus.

Example

An investor purchased $5,000 in a mutual fund three years ago that offers rights of accumulation. The current value of his account is $6,000. The mutual fund offers the following breakpoints for quantity purchases: 0 to $9,999 8.5% $10,000 to $24,999 7.75% $25,000 or more 6.25%

The mutual fund values rights of accumulation on current value or original purchase price, whichever is higher. (Note: Use this valuation option if no option is given.) If the investor wants to make an additional $4,500 investment, what sales charge will he have to pay?

Answer 7.75% on $4,500, or $348.75, if he requests the right of accumulation at the time of the subsequent purchase.

Points to remember: • The reduced sales charge is on the new purchase only. • The investor will not get any sales charge refund on previous

purchases. • Rights of accumulation are typically unrestricted by time. • The investor must request rights of accumulation at the time of the

new purchase.



• Rights of accumulation must be available if the fund charges an 8.5% sales charge.

• Rights of accumulation are only available if offered by the mutual fund and disclosed in the prospectus.

5.7 LETTER OF INTENT A LETTER OF INTENT is a form letter that is issued by a mutual fund and signed by an investor. The letter of intent states that the investor intends to take advantage of reduced sales charges by purchasing enough funds over a 13-month period to qualify for the discounted sales charge.

By signing a letter of intent, an investor may originally invest less than the dollar amount needed to reach a breakpoint, but will be credited as if the investor had invested enough to qualify for a reduced sales charge. The investor is not required to purchase the minimum amount for the discount initially, but is obligated through the letter of intent to purchase the minimum before 13 months have expired. The letter of intent is binding on the mutual fund, but it is not binding on the investor.

To make up the difference in the reduced sales charge and the sales charge owed if the investor does not fulfill the letter of intent, the mutual fund will hold in escrow some of the shares purchased.

If the investor reaches the breakpoint, the extra shares generated by the reduced sales charges are credited to his account. If the investor does not reach the breakpoint, the extra shares are kept by the mutual fund to compensate for the higher sales charge the investor originally avoided.

A letter of intent can be backdated up to three months (90 days) to include previous purchases in taking advantage of the reduced sales charge.

A letter of intent can be backdated up to how long?

(A) One month (B) Three months (C) Six months (D) Cannot be backdated

Answer (B) Three months. A letter of intent is good for 13 months, but it can be backdated up to three months.

5.8 CONVERSION PRIVILEGES (EXCHANGE PRIVILEGES) If a mutual fund company offers mutual funds in a family of funds arrangement, the company will have several mutual funds with differing investment objectives that can be used to qualify for quantity discounts or allow a customer to diversify investments within the same mutual fund company. If the investor wishes to transfer assets from an income-oriented mutual fund to a growth mutual fund, the investor can transfer or exchange these funds at little if any cost, simply by contacting the mutual fund company. These arrangements encourage an investor to keep investments within the same mutual fund company.

A letter of intent states that the investor intends to purchase enough of the mutual fund to receive reduced sales charges.

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When an investor exchanges one mutual fund for another within a mutual fund family, the investor may have a tax consequence for any capital gains or capital losses associated with the liquidation of the mutual fund(s) that is being replaced by the purchase of another fund in the family of funds. If the investment is in a retirement account, the investor does not have a tax liability.

5.9 DOLLAR COST AVERAGING DOLLAR COST AVERAGING is a method of investing over a period of time. The investment strategy allows an investor to purchase shares on a monthly basis, investing the same amount of money each month. The investor’s continual purchase of new shares can take advantage of declines in the public offering price of the mutual fund and make it possible to purchase more shares when the price drops. Conversely, if the public offering price rises, the investor purchases fewer shares and so may lose value in the investment when the price declines. The theory behind dollar cost averaging is that over time, the average cost per share of the mutual fund will be less than if the mutual fund investment was purchased at one time. Using dollar cost averaging, the investor will track the average cost per share rather than the average price per share.

Investment payments must be made on a periodic basis in order to make this method effective, regardless of whether the market is rising or falling. Investors interested in dollar cost averaging should consider their ability to make periodic payments even in times of serious market declines. You do not need to memorize the following chart, it is used to only to explain the dollar cost averaging concept.

Example

If an investor makes four consecutive monthly payments of $100, where the cost per share at each payment is, respectively, $5, $10, $15, and $10, the numbers work out this way:

Month 1st 2nd 3rd 4th Total Dollars invested $100 $100 $100 $100 $400 Cost per share $5 $10 $15 $10 — Shares bought 20 10 6.7 10 46.7

To find the dollar cost average, divide the total amount invested by the total shares purchased ($400 divided by 46.7 = $8.57).

The average market price ($5 + $10 + $15 + $10 = $40 divided by 4 = $10) is always greater than the dollar cost average, which is sometimes called the average cost per share. Note in this example that the dollar cost average ($8.57) is less than the average market price ($10) for the shares over the same period of time. The average cost per share will be less than the average periodic price, provided the price is fluctuating and the same dollar investment is made at each time period.



Which of the following is true of dollar cost averaging in a mutual fund investment plan?

(A) The dollar average is always lower than the average cost. (B) The average cost is always lower than the market price average. (C) Only in a rising market will the dollar average be greater than the

average cost. (D) There is no difference between the dollar average and the average

cost in a mutual fund investment plan.

Answer (B) The average cost is always lower than the market price average. This is the idea behind a mutual fund investment plan, that the average cost per share is less than the average dollar paid per share. This is to the investor’s benefit.

6.0 REDEMPTION OF MUTUAL FUND SHARES

If an investor decides that he no longer wishes to own shares of a mutual fund and desires to sell the shares, the person simply redeems them to the company. The mutual fund shares in a brokerage account must also be sold back to the mutual fund company. To redeem the shares, the investor sends a letter, calls the fund company, or requests that the brokerage liquidate the shares. In some cases, the mutual fund may charge a redemption fee. Remember that because of forward pricing, the REDEMPTION PRICE is the next computation of the NAV less any redemption fee.

When a mutual fund receives a redemption request from an investor, the fund must send the net asset value of the shares being redeemed, less a redemption cost, if any, to the investor within seven calendar days of receiving the redemption request.

Mutual funds are not traded in the secondary market. They can only be purchased from the mutual fund company and sold back to the mutual fund company. They are purchased from the mutual fund at the public offering price, and redeemed by the fund at the redemption price (bid price or NAV). Any redemption fees are deducted from the net asset value.

6.1 REDEMPTION FEES When mutual fund shares are redeemed, they are redeemed at the net asset value, less a REDEMPTION FEE (if any is charged). If there is a redemption fee, it can be up to 1% of the bid price.

Example

An investor will redeem 1,000 shares of RPL mutual fund when the offer price is $18.60; the sales charge is 7% with a redemption fee of 1% on all redemptions. How much will he receive?

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Up to 1% of the bid price can be charged as a redemption fee.



Answer First, find the net asset value by subtracting the sales charge:

$18.60 × 7% = $1.30 and subtract = $17.30

Second, find the redemption price by subtracting the redemption fee:

$17.30 × 1% = $0.17 and subtract = $17.13

Finally, multiply by the number of shares redeeming:

$17.13 × 1,000 shares = $17,130

6.2 TAXATION ON REDEMPTIONS In order to declare a gain from the sale of shares of a fund as a long-term gain as opposed to a short-term gain, a shareholder must have owned the fund for more than one year and one day. The trade dates of the respective transactions are used to determine the amount of time securities were held by the investor. Therefore, the HOLDING PERIOD of a security for an investor begins on the day the securities were acquired, or the acquisition date (trade date), and ends on the trade date of the sale.

Note that this is when an investor sells his shares; it does not pertain to mutual fund distributions.

For distributions of capital gains, the shares only have to be held one day, but for long-term capital gains status, the shares have to be held for more than one year.

6.3 WITHDRAWAL FEATURES OF MUTUAL FUNDS Mutual funds offer investors the privilege of withdrawing funds. This allows mutual fund investments to be a type of retirement plan. Investors may withdraw either a percentage of the net asset value, or a fixed dollar amount. Such withdrawals may be made either monthly or quarterly.

Following are some of the mutual fund withdrawal plans available to investors:

• Fixed dollar plan — A fixed dollar amount on a periodic basis. • Fixed time plan — A plan that pays out the entire amount over a

specified period. • Fixed shares plan — A plan that pays out the same number of

shares for each payment. • Fixed percentage plan — A plan that pays a fixed percentage of the

invested dollars each payment to the investor.

Each mutual fund company may offer their specific withdrawal plans that are marketed as income plans for retirees or individuals who need the income from these investments.

An investor must own a fund for more than one year and one day to declare long-term gains when it is sold.



7.0 INVESTMENT COMPANY ACT OF 1940

The Investment Company Act of 1940 requires the registration of all investment companies, which includes face-amount certificate companies, unit investment trusts, and management investment companies (either open-end or closed-end). This act places further requirements on management companies, with the aim of protecting shareholders. The investors in management companies must trust and rely on the judgment and discretion of investment advisers that manage the pooled assets with the intention of producing investment profits. The investment advisers manage customer assets, and the act assures that the advisers follow specific laws and procedures in the management of investors’ money.

The Investment Company Act of 1940 requires that the investment company have a minimum of $100,000 of capital and 100 shareholders before it can offer shares of its fund to the public.

The investment company must also establish its investment objectives and keep to these objectives in all investments within the portfolio. With management investment companies the investment objectives may be changed only by a majority vote of the shares as voted by the shareholders. Note that it is a majority of the shares, not a majority of the shareholders.

7.1 BOARDS OF DIRECTORS The board of directors of a management investment company is elected by the shareholders to oversee the operation of the investment company and to protect the rights of the shareholders.

The Investment Company Act of 1940 requires that no more than 60% of the individuals on the board of directors can be associated with other aspects of the investment company’s operations, and at least 40% of the individuals on the board cannot be affiliated with the operations of the investment company. An affiliated person is any officer, director, employee, or owner of 5% or more of the outstanding shares of voting stock, which also includes control persons, such as the fund’s underwriter and investment adviser.

As discussed earlier, the board of directors must approve establishing 12b-1 plans (asset-based sales charges) and review the expenses periodically.

The board of directors is also responsible for establishing the policy for distributing dividends and capital gains to shareholders. Shareholders do not vote on distributions.

7.2 INVESTMENT ADVISERS The investment adviser of an investment company is hired by the board of directors of the investment company to manage the assets of the company (stocks, bonds, and cash) according to the investment objectives. In essence, an investment adviser is hired to manage the fund’s portfolio. An initial contract with an investment adviser must be for two years and is



renewable annually after this initial period with the approval of shareholders and the board of directors.

Investment advisers, or management companies, are responsible for deciding what securities to buy and sell and when to buy and sell them, as well as when they need to hold assets in cash. They research and analyze financial and economic trends and specific securities, and make daily decisions about the investments in the mutual fund. The investment adviser is also responsible for making sure that advice given conforms to federal securities and tax laws and to the funds objectives as outlined in the prospectus, with regard to the following:

• Growth of capital • Current income • Other specific objectives in the prospectus

Professional management of the investment company’s portfolio is one of the major advantages of investing in mutual funds. Investment advisers, or portfolio managers, are paid a management fee for their services. They do not receive any compensation from the sales charges. The management fee is usually the largest expense of the fund and is typically 1/2% of the average annual net assets of the investment company.

The investment adviser is required to register as an investment adviser with the SEC under the Investment Advisers Act of 1940. Any person who provides investment advice and charges a fee for that advice is considered an investment adviser and must be registered.

The investment adviser for an investment company is compensated with which of the following?

(A) Service fee (B) Sales charge (C) Management fee (D) Asset-based sales charge

Answer (C) Management fee. The investor will pay the investment adviser a management fee for providing professional investment advice. This management fee is usually the investment company’s largest operating expense. The service fee is charged for maintenance of shareholder accounts and is usually paid to the transfer agent. The sales charge is paid to underwriters and broker/dealers for selling expenses and commissions earned from selling shares of the fund.

7.3 CUSTODIAN BANK The CUSTODIAN BANK is usually a commercial bank that provides safekeeping and protection of the investment company’s portfolio of securities and cash. The custodian bank can also be a trust company or exchange member firm.

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7.4 TRANSFER AGENT The TRANSFER AGENT, which can also perform as the custodian, functions as a bookkeeper in that it handles clerical duties related to the shareholders list, such as the following:

• It issues physical shares or certificates representing ownership in the investment company (if provided by the company and requested by the share owner), or it maintains a record of shares of the investment company in book-entry form.

• It maintains shareholder accounts, including the tracking of transactions, any charges, reports to the IRS, and so on.

• It sends out cash disbursements on dividends and capital gains distributions to shareholders, unless the shareholder elects to have them automatically reinvested. In the case of automatic reinvestment, the transfer agent tracks shares purchased for the shareholder via the automatic reinvestment of dividend and capital gains distributions.

• It cancels redeemed shares and sends redemption checks to shareholders.

7.5 OPERATING EXPENSES Operating expenses are the day-to-day costs of operating an investment company. These operating expenses include:

• Board of directors’ salaries and expenses • Management fees (the largest expense) • Custodian fees • Service fees • Brokerage fees to execute portfolio transactions • Audit and legal fees • Printing and distribution costs to existing shareholders

These operating expenses are reported in the mutual fund’s financial statements and are used to calculate the expense ratio. For an open-end management investment company, a mutual fund’s EXPENSE RATIO is:

ANNUAL OPERATING EXPENSES TOTAL NET ASSET VALUE

Which of the following expenses are considered part of the costs of operation of a mutual fund?

I. Service fees II. Brokerage fees III. Management fees IV. Audit and legal fees V. Printing costs for prospectuses sent to potential investors (A) III only (B) I, II, and III only (C) I, II, III, and IV only (D) I, II, III, IV, and V

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Answer (C) I, II, III, and IV only. Service fees are paid to the transfer agent to maintain customer accounts. Brokerage fees are paid to broker/dealers to execute portfolio transactions. Management fees are paid to the investment adviser to manage the mutual fund’s portfolio. Fees are paid for the annual audit of the fund’s financial statements. Legal fees are paid to attorneys to make sure the fund is in compliance with federal and state security laws and tax laws. However, printing costs for prospectuses sent to potential investors are costs of distribution, normally paid from the sales charge. Do not assume the mutual fund has a 12b-1 plan unless it is stated in the question.

7.6 ADVERTISING OF INVESTMENT COMPANIES AND PROSPECTUS DELIVERY

Mutual funds are covered under the Securities Act of 1933 and NASD rules regarding advertising. By definition, advertising consists of any oral, written, or visual means of inducing a purchase, which is considered to be any offer to sell securities. In the case of mutual fund shares, the offer must be preceded or accompanied by a prospectus. Advertisements cannot include a mutual fund application or solicit customers to send money to purchase shares. The advertisement can only offer the prospectus. The following types of mutual fund advertising do not require that a prospectus be delivered:

• Tombstone announcement • Omitting prospectus • Generic advertising

A tombstone consists of the name of the mutual fund company, the investment objectives of the mutual fund, the investment adviser to the fund, and straightforward information about the mutual fund company.

The omitting prospectus resembles a prospectus; however, the omitting prospectus does not contain all of the information that is required in the prospectus.

Generic advertising consists of typical information about a mutual fund company and may mention the value of investing in mutual funds; however, this type of advertising cannot mention a specific mutual fund.

NASD rules require that all advertising materials regarding mutual funds be filed with the NASD within 10 days of use for the NASD’s review.

Remember, the prospectus must be presented to the customer at the time of solicitation, or at least before the sale is completed.

7.7 PROHIBITED PURCHASES Under the Investment Company Act of 1940, mutual funds cannot purchase any of the following for their investment portfolios:

• Real estate • Commodities • Other mutual funds unless they are specifically permitted under the

investment objectives of the mutual fund • Securities purchased on margin



• Specific securities if a person associated with the investment company owns one-half of 1% or more of the issuer’s stock

Mutual funds are allowed to invest in option contracts, and to borrow or lend money, provided these activities are part of the investment objective or policy as disclosed in the prospectus or STATEMENT OF ADDITIONAL INFORMATION (SAI).

8.0 MUTUAL FUND PROSPECTUS AND REPORTS

The Investment Company Act of 1940 mandates that a prospectus is required anytime a representative presents a specific mutual fund to a customer. Since mutual fund shares are always new issues, a prospectus must accompany all mutual fund solicitations. A representative is not required to provide a client with a prospectus when talking to customers about mutual funds in general and not referring to specific mutual funds. The purpose of the prospectus is to provide the potential investor with all important details concerning the new issue. This is called “providing full and fair disclosure.”

8.1 MUTUAL FUND PROSPECTUS REQUIREMENTS The requirements for producing a mutual fund prospectus are as follows:

• A new prospectus is required to be issued once every 13 months, and must not contain financial information more than 16 months old.

• A statement of additional information, with further details about the mutual fund, must be provided upon request.

• A report to stockholders must be sent semiannually and must list current portfolio holdings, including the number of shares and/or bonds in the mutual fund’s portfolio as well as their current market values.

Each prospectus must also contain the SEC approval clause, stating that the SEC does not approve or disapprove of the security and any representation to the contrary is a criminal offense.

One would think that because the SEC reviews the prospectus, the prospectus is approved, but this is not the case. The SEC only reviews the prospectus for completeness and compliance with prospectus requirements.

8.2 OTHER REPORTS TO SHAREHOLDERS All investment companies, open-end and closed-end, must send reports to shareholders at least quarterly, detailing the number of shares owned, their value as of a certain date, and the total value of the account. If there is activity in the account, the investment companies must send a monthly statement.

When an investor purchases mutual fund shares, the investor must receive a confirmation of the transaction, unless the transaction is part

The prospectus must be issued at least every 13 months.

All investment companies must provide shareholders with quarterly reports.



of a periodic payment plan. The broker/dealer must send the confirmation of the mutual fund transaction at or before the completion of the transaction.

In addition to these reports, the investment companies must send a report disclosing total dividend distributions and capital gains distributions to the shareholders for tax purposes.

The reports are sent on IRS Form 1099 DIV, showing both dividends and capital gains distributions from the mutual fund, and if some dividends are tax-free, these must be separated and reported as such.

All tax reports of a current year must be sent to shareholders by January 31 of the following year.

The objectives of a mutual fund can be changed if a majority of which of the following vote for the change.

(A) Shareholders (B) Board of directors (C) SEC board of directors (D) Shares

Answer (D) Shares. Yes, the shares do the voting. The shareholders vote, but they only get as many votes as they have shares.

8.3 REGULATED INVESTMENT COMPANIES All investment companies are regulated by the IRS. Consequently, all investment companies (both open- and closed-end) are REGULATED INVESTMENT COMPANIES.

IRS regulations that pertain to these investment companies allow the IRS to give them special tax treatment if they pass at least 90% of their net investment income to their shareholders. Such tax treatment allows investment companies to avoid “triple taxation,” first on corporate revenues, then on the income to the investment companies, and finally on the dividends to the investor.

This special tax treatment is based on the “conduit theory” or “pipeline theory” under Subchapter M of the Internal Revenue Code, and allows interest and dividends (net investment income) to flow through to the investment company shareholder without being taxed while it is in the possession of the investment company.

Shareholders in the investment company pay taxes on the money distributed. The investment company pays taxes only on income and dividend distributions that are not distributed to its shareholders.

FIRE Drill

Passing through 90% of net investment income qualifies an investment company for special tax treatment.



An investment company that distributes at least 90% of its net investment income is called a:

(A) Registered investment company (B) Regulated investment company (C) Diversified investment company (D) Specialized investment company

Answer (B) Regulated investment company. The investment company is “regulated” by the IRS in that the investment company must pass at least 90% of its net investment income to the shareholders, or else all its income will be taxed like that of a regular corporation.

9.0 MUTUAL FUND DISTRIBUTIONS

Mutual funds make two basic types of distribution of money to shareholders:

• Capital gains from the profits of buying and selling investments

• Net investment income from interest and dividends

When a mutual fund distributes profits from the investments in the securities in the mutual fund, these profits are called CAPITAL GAINS and represent realized gains on the stocks and bonds in the fund’s portfolio. Distributions of net investment income are distributions from the fund to the shareholders, paid out of dividends received on stock and interest received on bonds.

Distributions of net investment income are usually called DIVIDENDS, because these are distributions made from income on stock and bonds owned by the mutual fund. In some instances these types of distributions are deemed “interest” for tax purposes. However, because they are distributions from a corporation (the investment company), they are technically dividends. These distributions are never called capital gains.

Dividend and interest distributions are considered part of the shareholder’s ordinary income whether reinvested or accepted in cash, and are taxed in the year received. These distributions are generally paid every month.

Capital gains distributions are considered return of capital and are taxed to shareholders as long-term capital gains, regardless of whether received as cash or reinvested, and no matter how long the shares in the investment company were held.

Even if a person purchases the investment company shares and receives a capital gain distribution one month later, the distribution is considered a long-term capital gain.

FIRE Drill

Distributive shares of the profits is called capital gains, while distributive shares of net investment income are not.

Dividend and interest distributions are taxed in the year received.



9.1 COMPUTING YIELD A mutual fund’s YIELD is calculated by dividing the annual dividend distribution by the ask (or offering) price. The capital gains are never used to determine yield, because capital gains are considered a return on capital, and yield is based only on income. See the example below to learn how to determine yield. Remember, the yield is calculated at a point in time and it will change as the value of the shares change and as distributions change. Yield for all securities is determined by the same formula:

YIELD = ANNUAL DIVIDEND CURRENT OFFER PRICE

Example

Determine yield, given the following information:

$ 0.50: Dividend distribution $ 1.50: Capital gain distribution $17.40: Offering price

$0.50 divided by $17.40 = 2.87% yield

An open-end investment company has a dividend of $1.20 per year and a capital gains distribution of $0.50. The offer price at the time of purchase is $22.40 and the net asset value is $21.05 based on a minimum investment. Assuming a minimum investment, what is the yield of the investment company?

(A) 2.23% (B) 2.37% (C) 5.36% (D) 0.70%

Answer (C) 5.36%. The yield of a mutual fund is the dividend divided by the offer price. In this case, the dividend is $1.20 and the offer is $22.40, so 1.20 divided by 22.40 = .0536 = 5.36%.

9.2 EX-DIVIDEND DATES The mutual fund will select the RECORD DATE for distributions of dividends and/or capital gains. Anyone owning shares of the mutual fund on this date is entitled to receive the dividend.

The EX-DIVIDEND DATE (or EX-DATE) is set by the board of directors and is usually the next business day after the record date. The ex-dividend date is the day on or after which the buyer of the mutual fund shares is not entitled to receive the dividend.

On the ex-dividend date, the net asset value will be reduced by the dividend and/or capital gains distribution, since this money is no longer an asset of the fund but money owed to shareholders as of the record date.

An investor would be buying the dividend if he or she purchased the fund just before the ex-dividend date. The total value of the investment

Capital gains are not used to determine yield.

FIRE Drill



would not change, although the investor would have to pay taxes on the distribution (whether or not it was taken in cash or automatically reinvested).

Example

An investor buys $30,000 of a no-load mutual fund on Monday, June 3 at $30 per share. The fund goes ex-dividend on Tuesday, June 4. The fund is making a $0.50 dividend distribution. On the ex-date, the NAV drops to $29.50 (assuming no other changes in the net asset value). What are the tax liabilities for the investor?

Answer There is no change in the value of the investment. The investor still owns 1,000 shares of the mutual fund now worth $29,500, and has $500 in dividends, which may be reinvested. The investor also has a tax liability on the $500 distribution, and will have to pay ordinary income tax on the dividend whether or not it is reinvested.

The investor would have saved money and not had to pay taxes if he had waited to purchase the shares until the next day — assuming the market value of the securities owned by the mutual fund had not changed.

It is a violation of the NASD Conduct Rules for a registered representative to entice an investor to buy shares of a mutual fund just before the ex-dividend date by describing the investment in the mutual fund as one that will “pay a dividend.” The representative must alert the prospective investor about the potential tax consequences of the purchase of a mutual fund prior to the distribution of dividends. This prohibited practice is known as SELLING DIVIDENDS.

10.0 CLASSIFICATIONS OF INVESTMENT COMPANIES

The additional investment company descriptions listed in this section are for both open-end and closed-end investment companies.

10.1 DIVERSIFIED INVESTMENT COMPANIES In classifying investment companies, an investment company is either a diversified investment company or a nondiversified investment company. The word diversification defines whether the investments that are purchased by the investment company are spread among different companies and different types of securities or focused on one company or a select few types of investments.

According to the Investment Company Act of 1940, a DIVERSIFIED INVESTMENT COMPANY is a company that invests a least 75% of its total assets in such a way that no more than 5% of total assets are invested in any one company at a given time. Also, a diversified investment company cannot own more than 10% of the outstanding voting stock of any one company.

Selling dividends is a violation of the NASD Conduct Rules.



Exam tip: Know 75%, 5%, and 10%, in that order.

The other 25% of the diversified investment company’s assets can be invested in one company, in one industry, or the assets can be invested in other securities the investment company selects that match the investment objectives of the mutual fund. If a company is a diversified investment company, it must state this fact in its prospectus.

A nondiversified investment company is defined as any investment company that does not meet the criteria for a diversified investment management company. Investment companies must register with the SEC as either diversified or nondiversified. The distinction between diversified and nondiversified is applied whether the investment management company is an open-end company or a closed-end company.

Which of the following best describes a “diversified investment management company”?

(A) 75% of the investment company’s assets must be invested such that no more than 5% may be invested in any one company, and the fund cannot own more than 10% of the outstanding voting shares of another company.

(B) 10% of the investment company’s assets must be invested such that no more than 75% may be invested in one industry, and the fund cannot own more than 5% of the outstanding shares of another company.

(C) 75% of the investment company’s assets must be invested such that no more than 10% may be invested in any one issuer, and the fund cannot own more than 5% of the outstanding shares of another company.

(D) 5% of the investment company’s assets must be invested such that no more than 10% may be invested in one industry, and the fund cannot own more than 75% of the outstanding shares of another company.

Answer (A) 75% of the investment company’s assets must be invested such that no more than 5% may be invested in any one company, and the fund cannot own more than 10% of the outstanding shares of another company. (Know this!)

10.2 SPECIALIZED INVESTMENT COMPANIES A SPECIALIZED INVESTMENT COMPANY, sometimes referred to as a SECTOR FUND, is an investment company that invests in stocks whose issuers are primarily in one specific industry, type of business, size of company, or geographical area.

To qualify as a specialized investment company, the fund must invest more than 25% of its assets in one the specific type of issuer.

The types of investments it manages will also classify a specialized investment company. The following investment types are used to classify most mutual funds:

• Stock funds • Bond funds

FIRE Drill

A specialized investment company cannot own more than 10% of any one company.



• Hybrid funds • Money market mutual funds

Mutual funds are also categorized by RISK and INVESTMENT OBJECTIVES. Risk is a term indicating the potential for an investment to lose value. High risk indicates a higher chance of losing value, yet high risk may also lead to higher potential rewards. Risk and investment objectives must be matched between the investor’s risk tolerance and investment objectives with the mutual fund’s risk profile and overall investment objective.

10.3 STOCK FUNDS Stock funds invest in a wide variety of issuers, but the investment company must focus a majority of the investment money in equities, or stocks. Among stock funds, the following types of stock funds are selected based on their unique investment objectives and the underlying investments within the mutual fund:

• Growth funds • Growth and income funds • Global equity funds • Income equity funds • International funds • Regional equity funds • Sector equity funds

GROWTH FUNDS invest primarily in companies that are growing and pay very little in dividends. The earnings generated by growth investment companies are usually reinvested in the company and not paid out as dividends.

Growth funds distribute very few dividends. However, it is hoped that the net asset value of their investments will be worth more when they are later redeemed.

There are two types of growth funds: • Aggressive growth funds • Conservative growth funds

Aggressive growth funds invest primarily in the common stock of relatively new companies with the potential for rapid and high capital appreciation. There are rarely any dividends paid, but there is the high potential for growth due to the industry the target companies are in.

Conservative growth funds primarily invest in the common stock of well-established companies with the potential for capital appreciation. The primary aim is to increase the value of the investment rather than generate a flow of dividends.

10.4 BOND FUNDS BOND FUNDS invest mainly in fixed-income securities of publicly traded companies and municipal issuers. The investment objective for fixed income includes wealth or asset preservation. Bonds, especially highly rated bonds, are generally secure investments that may not lose principal value. Of course, as interest rates decline, the value of bonds increases, and as interest rates increase, the value of bonds declines. The

Earnings are reinvested in growth investment companies.



value of bond funds is based on the underlying value of the bonds held in the fund. If interest rates increase, the net asset value of the bond fund would decrease in value.

Bond funds can vary with their investment objectives and types of bonds that are purchased as an investment. The range of investment objectives for these bond funds include corporate bond funds, global bond funds, government bond funds, mortgage backed bond funds, and several others.

Among the types of bond funds, corporate bond income funds focus on investing in debt securities of publicly traded companies. The bonds that are purchased can be categorized by the length of time it takes the investment to mature or the bonds that are purchased may be categorized by industry or sector. General, short-term, and intermediate-term describe the lengths of time over which the bonds mature. Global bond funds invest in companies throughout the world.

10.5 HYBRID FUNDS Hybrid mutual funds are categorized by the overall investment objective that these funds follow. A balanced fund is one type of hybrid fund.

A balanced fund invests in a specific mix of fixed income and equity securities. The investment objective is a hybrid to preserve principal, produce dividends and interest, and obtain long-term growth.

10.6 MONEY MARKET FUNDS A MONEY MARKET FUND is a mutual fund that invests in short-term debt securities, such as commercial paper, banker’s acceptance, repurchase agreements, T-bills, negotiable CDs, and the like. Money market funds will usually not invest in non-negotiable CDs. These funds usually purchase only securities that mature in less than 30 days, although if a good rate is available and interest rates are decreasing, they will invest in securities that mature in up to six months.

Shares in money market funds are purchased and redeemed at the same price, which is usually $1. There are no sales charges, but management fees are charged to the shareholder. Sometimes 12b-1 fees of up to one-quarter of 1% are charged. Of course, as is the case with all other mutual funds, a prospectus must be delivered to the customer with the first purchase of money market shares.

The money market funds do not make daily, monthly, or semiannual distributions, but instead credit interest to the customer’s fund on a daily basis. This interest is taxable, and will be reported on the IRS Form1099 sent to the investor after the end of the year.

Since most money market funds are no-load funds, they need to have only one board member from outside the fund, rather than the usual 40%.

One of the most popular features available in money market mutual funds is the check-writing feature. Since the securities underlying a money market mutual fund are highly liquid securities, many investment companies have made it possible for customers to write checks directly from their money market mutual fund accounts. This feature has made these accounts highly competitive with ordinary bank savings accounts,



which in most cases pay less interest on customer balances than do money market mutual fund accounts.

10.7 OTHER TYPES OF FUNDS Other lesser-known mutual funds to mention include:

• Index funds • Option funds

Index funds invest in securities that mimic a particular index and will usually perform very close to the way that index performs. Since these funds mimic an index, the role of the investment manager is minimal.

Option funds, a relatively new fund, has as its main objective to buy and sell put and call options, looking to profit from the purchase and sale of these put and call option contracts.

All of the following are true of money market funds, except:

(A) Their appreciation will be taxed as a capital gain in the year withdrawn.

(B) They are purchased at the NAV and redeemed at the NAV. (C) The NAV is maintained at one dollar. (D) Most money market funds invest in commercial paper, T-bills, and

banker’s acceptances.

Answer (A) Correct answer (false statement): Their appreciation will be taxed as a capital gain in the year withdrawn. Appreciation or earnings on a money market mutual fund will result from interest and dividends that are paid regularly by the money market fund. As a result, the appreciation in a money market account will be taxed as income in the year it is received, not as a capital gain.

11.0 EXCHANGE-TRADED FUNDS

An exchange-traded fund (ETF) is a newer method for a small investor to own shares of a diversified portfolio of stocks that will track a specific index. The investor purchases shares of a mutual fund, unit investment trust, or a depositary receipt that represent the shares of common stock within the ETF. The ETF shares closely track the performance of the specific index.

The shares of an ETF are initially “created” by an institution or other large investor. The institution deposits a specified number of shares of a portfolio of stocks with a trustee that correlate to the index that the ETF is following. A minimum of 50,000 shares is required to create a unit (creation unit) for the larger funds, while the funds on mid-cap stocks only require 25,000 shares per unit. A retail investor cannot purchase shares of an ETF until the shares are listed on an exchange.

FIRE Drill



• When purchasing the shares of an ETF, a prospectus can be obtained from the issuer.

• A prospectus is not required on secondary purchases through a broker/dealer.

• A representative must be qualified with the Series 7 license to sell ETFs.

Some Exchange-traded funds follow the broad-based indexes such as the Dow Jones Industrial Average Index, the Nasdaq-100 Index, or the S&P 500 Index. These ETFs purchase shares of the same stocks that are represented in the index. ETFs can also follow an index that has been established specifically for the ETF. These specialty indexes may follow specific industries, regions, or size of company criteria (e.g., mid-cap)

Some of the more well known ETFs are traded as QQQ for the Nasdaq-100 Index and are commonly called the “Qubes;” SPY for the S&P 5OO Index (SPDR Trust Series 1) and are commonly called “Spiders;” and DIA for the DJIA Index and commonly called “Diamonds.” “HOLDRs” or an abbreviation for Holding Company Depositary Receipts represent a series of different ETFs issued by Merrill Lynch which follow different indexes.

The stocks that make up an ETF are based on they index they mimic, and are held by a trustee. ETFs offer diversification for the investor, since the investment represents a diversified portfolio of stocks that mimics an index or investment strategy.

• Additionally, ETFs have relatively low expense ratios since the stocks are purchased and held.

• Few changes occur within the index; therefore unlike actively managed funds, buying and selling shares doesn’t occur as frequently.

ETF shares are bought and sold similar to shares stock throughout the day and from any brokerage firm, so are more like a closed-end management company rather than an open-end management company (mutual fund). Unlike a closed-end management company, ETF shares can also be redeemed to the institution, which sponsors the ETF. The redemption occurs through a redemption unit in the same number of shares that composed the creation unit.

Other important aspects regarding ETFs are that the shares can be purchased on margin and the ETF shares can be sold short. The investor can buy as few as one share or in round-lot amounts of 100 shares.

No sales charges are charged by the ETF; however, commission charges will be added to the purchase and sale of ETF shares by the broker/dealer handling transactions in ETF shares.

The turnover associated with managed mutual funds is reduced, because the ETF must remain closely aligned with the index of securities it follows. The tax liabilities associated with potential capital gains from an actively managed mutual fund are reduced, because the stocks within the ETF are not as frequently traded as in an actively managed mutual fund.

An owner of an ETF share can receive dividends, if the stocks in the portfolio pay dividends and after the fees and expenses by the management are taken out. Generally, dividends from the index will be negligible. The gain from the performance of the index of securities represents the investment gains for the investor.



Trading generally stops at 4:00 pm, but some will continue until 4:15 pm. The closing prices are then shown in the major newspapers on the next day.

12.0 NEWSPAPER FOOTNOTES

Mutual fund prices are displayed in the newspaper finance sections after the fund calculates its NAV. These prices include some additional information about the mutual funds, including the symbol for the fund, the type of share, and possibly the year-to-date performance.

The following are footnotes used by the NASD in the mutual fund price information released for newspapers and periodicals to publish:

• “p” indicates that there are 12b-1 fees charged by the company • “r” indicates that there are redemption fees or contingent

deferred sales charges • “t” indicates that both 12b-1 fees and redemption fees or

contingent deferred sales charges apply • “NL” indicates a no-load mutual fund

This allows investors to track their investments on a day-to-day basis, but investors should realize that most mutual funds are designed for long-term investing.

* * * * * * * * *

Newspapers and financial periodicals use certain footnotes to provide information to the reader.

NASD Series 7 Module 7: Investment Companies Exam

COPYRIGHT © FIRE SOLUTIONS, INC. ALL RIGHTS RESERVED. NO REPRODUCTION WITHOUT AUTHORIZATION. E7 – 1

INVESTMENT COMPANIES INVESTMENT COMPANIES EXAM

This exam tests the information found in the Investment Companies Module. If you would like more information on a question than is given in the rationale in the Exam Answers, please refer to the section of text referenced in each answer.

1. A mutual fund has a net asset value (NAV) of $14.20, a sales charge of 8%, and a 1% redemption fee. If an investor wanted to redeem 500 shares of this fund, how much money would he receive?

(A) $6,461 (B) $6,466 (C) $7,029 (D) $7,100

2. Income distribution from a mutual fund can qualify for long-term capital gains tax status:

(A) If the shares were held more than six months (B) If the investment company is a “regulated” investment company (C) If the investment company is an income fund (D) Under none of the above circumstances

3. A mutual fund paid $0.30 in dividends and $0.75 in capital gains during the year. The offer (ask) price at the end of the year is $6.50. What is the current yield on this fund?

(A) 4.1% (B) 4.6% (C) 5.9% (D) 7.5%

4. Which of the following is not redeemable by the issuer?

(A) Closed-end investment company shares (B) Series HH bonds (C) Open-end investment company shares (D) Debenture bonds

5. A mutual fund has increased in value because of a rise in the market. That would be:

(A) A capital gain (B) Appreciation (C) A profit (D) None of the above

6. Listed below are a group of mutual funds. If an investor sells his shares in IDS mutual fund, he will receive:

Net Asset Value Offer Price Net Change Founders Group 11.55 12.67 - .05 FPA Fund 12.70 13.85 + .07 Franklin Group 5.14 NL + .09 IDS 13.42 14.63 - .08

(A) $13.34

Module 7: Investment Companies Exam NASD Series 7

E7 – 2 COPYRIGHT © FIRE SOLUTIONS, INC. ALL RIGHTS RESERVED. NO REPRODUCTION WITHOUT AUTHORIZATION.

(B) $13.42 (C) $14.55 (D) $14.63

7. Listed below are a group of mutual funds. Franklin Group fund is a:

Net Asset Value Offer Price Net Change Founders Group 11.55 12.67 - .05 FPA Fund 12.70 13.85 + .07 Franklin Group 5.14 NL + .09 IDS 13.42 14.63 - .08

(A) No-load fund (B) Balanced fund (C) Closed-end fund (D) Growth fund

8. A money market mutual fund will invest in all of the following, except:

(A) A non-negotiable certificate of deposit (B) A banker’s acceptance (C) Commercial paper (D) A repurchase agreements

9. The primary difference between an open-end and closed-end investment company is:

(A) The capitalization (B) The stocks they purchase (C) How they figure the net asset value (D) The bonds they purchase

10. An investor has $72,000 to invest in mutual funds. He decides to invest equal amounts in three mutual funds. The customer is not told by the broker that the three funds offer reduced sales charges on investments in excess of $25,000. Based upon the above information, which of the following is true?

I. The investor has achieved diversification by buying three mutual funds and will probably make a profit.

II. The broker has violated the “breakpoint sale” provision of the NASD as to a quantity discount on a large purchase.

III. The broker has not violated the NASD Rules of Fair Practice because he followed the customer’s instructions and purchased the three different mutual funds.

(A) II only (B) III only (C) I and II only (D) I and III only

11. What kind of investment company makes no provision for future purchases or redemptions?

(A) An open-end management company (B) A unit investment trust (C) A closed-end management company (D) A face-amount certificate company

12. The redemption price of a mutual fund is synonymous with:

(A) The offering price minus the redemption fee, if any (B) The offering price (C) The net asset value minus a redemption fee, if any (D) None of the above



13. An investor who bought 200 shares of Pioneer Fund would pay:

Bid price Offer price Change Pioneer Fund 4.60 5.03 + .05 Putnam Fund 7.85 8.56 + .08

(A) $920 (B) $1,006 (C) $920 + commissions (D) $1,006 + commissions

14. The board of directors of a mutual fund would like to change the investment objectives of the fund. This could be done provided that:

(A) The management could switch at their discretion without a vote of the shareholders. (B) More than 10% of the stockholders voted for the change and the board of directors

approved. (C) More than 50% of the voting shares held by stockholders voted for the change. (D) Holders of the fund were given the choice of switching into a similar fund with the same

objectives.

15. A “sales breakpoint” of a mutual fund is:

(A) A dollar amount for a purchase of a mutual fund where a volume sales charge discount is given

(B) A share amount for a purchase of a mutual fund where a volume sales charge discount is given

(C) The point at which a letter of intent can be obtained (D) The point at which a letter of intent can be backdated

16. Which of the following is responsible for the safekeeping of the securities owned by a mutual fund?

(A) The registrar (B) The custodian bank (C) The sponsor (D) The transfer agent

17. A mutual fund investor most interested in current yield would probably purchase:

(A) A growth fund (B) A specialized fund (C) A no-load fund (D) An income fund

18. The custodian bank of a mutual fund:

(A) Manages the fund (B) Acts as the distributor of the fund (C) Holds the fund’s cash and securities and performs essential clerical functions but does not

manage the fund (D) Guarantees investors against any loss that may be incurred if the fund should decline in

value

19. A mutual fund NAV is calculated to be $16 at the end of the day. The offer price for a minimal purchase is $17.39. The fund has sales breakpoints every $25,000 and a purchase of $50,000 to $75,000 would have a 5% sales charge. If a customer purchases $70,000 worth of the fund that day, the customer would receive approximately:

(A) 4025 shares (B) 4,157 shares



(C) 4,166shares (D) 4,375 shares

20. A mutual fund has a bid price of $15 and an ask price of $15.65. The fund has distributed a capital gain of $2.05 and a dividend of $0.38 during the past year. The yield for the fund was:

(A) 2.15% (B) 2.43% (C) 2.53% (D) 15.5%

21. An investor has purchased 2,000 shares of DFM Mutual Fund in September. Two months later, the fund distributes a $0.05 dividend and a $1.10 capital gain distribution. How will the investor treat these for tax purposes in that tax year?

I. The dividend will be treated as ordinary income. II. The dividend will be treated as a short-term capital gain. III. The capital gain distribution is treated as a short-term gain. IV. The capital gain distribution is treated as a long-term gain. (A) I and III (B) II and III (C) I and IV (D) II and IV

22. Which of the following are synonymous?

(A) Bid price and management fee (B) Selling price and bid price (C) Net asset value and redemption price (D) Net asset value and offering price

23. Which of the following are true about mutual funds?

I. The maximum sales charge is 7%. II. Investors can receive a reduced sales charge if they sign a 10-month letter of intention to

purchase a certain dollar amount of mutual fund shares. III. Under the “rights of accumulation” option, investors can receive a reduced sales charge

on new purchases when a “breakpoint” is reached. IV. No-load funds may charge a liquidation fee when an investor sells the fund.

(A) I only (B) III only (C) III and IV only (D) I, II, and IV only

24. Someone interested primarily in income would be least likely to purchase:

(A) An aggressive growth fund (B) A government bond fund (C) A high-yielding bond fund (D) An income fund

25. An investor owns 1,000 shares of a mutual fund. The offering price is $12 per share and the fund charges an 8% sales charge and has a 1% redemption fee. If the investor redeemed his shares he would receive:

(A) $10,930 (B) $11,040 (C) $11,880



(D) $12,000

26. Which of the following statements about investment companies are true?

I. All dividend distributions are exempt from taxes under current federal income tax laws. II. An investment company qualifies as a “regulated” investment company if it distributes

90% of its capital gains to its shareholders. III. Dividend and capital gains distribution can never be added together when computing the

yield of a mutual fund. IV. A “regulated” investment company will be taxed at corporate income tax rates on all

income and dividend distributions that are not distributed to its shareholders.

(A) I and II only (B) II and III only (C) I and IV only (D) III and IV only

27. As a custodian bank for a mutual fund, a bank can act in all of the following capacities, except:

(A) Transfer agent and registrar (B) The holder of the fund’s securities for safekeeping (C) Dividend and capital gains disbursing agent (D) Distributor of mutual fund shares (the sponsor)

28. A type of investment company that distributes 90% of its net investment income to its shareholders is called:

(A) Balanced (B) Diversified (C) Dual-purpose (D) Regulated

29. A mutual fund has a net asset value of $17.40 and a sales charge of 6% on a quantity discount. What is the ask price at that quantity of purchase?

(A) $10.44 (B) $18.44 (C) $18.51 (D) $29.00

30. The purchase price of a no-load fund is determined by:

(A) The net asset value plus a sales charge (B) The net asset value plus a commission (C) The net asset value as computed at the end of the business day (D) The supply and demand for the fund

31. An investor’s pledge to purchase a specified amount of a mutual fund within a specified period of time is called:

(A) A promissory note (B) An investment letter (C) A letter of intent (D) A stock power

32. Which of the following statements regarding mutual funds is true?

(A) The custodian bank cannot act as the transfer agent of the fund. (B) The underwriter (sponsor) receives a management fee that is based upon the total assets

of the fund.



(C) The investment adviser is responsible for all purchases and sales of securities held in the fund’s portfolio and receives a management fee based upon the total assets of the fund.

(D) The investment adviser receives a sales charge as compensation for managing the securities in the fund’s portfolio.

33. A mutual fund investor who redeems his shares will receive:

(A) The bid price of the previous day’s close (B) The current offering price (C) The next computed bid price on the day the shares are sold (D) The next computed ask price on the day the shares are sold

34. Your customer wishes to invest $50,000 in three different mutual funds with income as his main objective. You should notify your customer that if he invested the entire $50,000 in one fund he could save money because of the quantity discount on large purchases available through:

(A) Automatic reinvestment of dividends and capital gains (B) The availability of a withdrawal plan (C) The possibility of exchanging one fund for another without paying a sales charge (D) Purchases at “sales charge breakpoints”

35. What is the offering price of a mutual fund that has a net asset value of $14.35 and an 8% sales charge?

(A) $11.50 (B) $13.20 (C) $15.50 (D) $15.60

36. Mutual funds are also known as:

(A) Open-end investment companies (B) Closed-end funds (C) Front-end loads (D) No-load funds

37. Which of the following statements is true about closed-end investment companies?

(A) The amount of outstanding shares is constantly increasing. (B) The shares are sold at the current market price. (C) The shares are sold at the current net asset value. (D) They are continually offering new shares for sale.

38. Which of the following statements about a closed-end investment company is correct?

(A) It is continually issuing shares. (B) Its shares can be redeemed by the issuing investment company. (C) Its shares are sold in the open market at their current offering price. (D) It can issue only common stock.

39. As far as open-end companies are concerned, which of the following is true regarding dividend and capital gains distributions:

(A) They can be combined to determine the total yield. (B) The taxes can be deferred if they are invested in additional mutual fund shares. (C) Dividends are taxed as long-term capital gains. (D) They can automatically be reinvested in additional shares if the fundholder chooses to do

so.



40. Ace Investment Company has an offering price of $19.45 and a net asset value of $17.90. If they have had a $0.75 dividend and a $1.35 capital gain distribution for the year, what is the yield of the mutual fund?

(A) 3.6% (B) 3.9% (C) 10.8% (D) 11.7%

41. A customer buys 100 shares of an investment company and pays the market price plus a commission. The investor has bought shares issued by a(n):

(A) Closed-end investment company (B) No-load fund (C) Open-end investment company (D) None of the above

42. The following closed-end investment companies are listed in The Wall Street Journal:

Net Asset Value Market Price Circle Investment Co. 23.75 24.25 CNA Investment Co. 21.85 21.50

A customer purchasing shares of the CNA Investment Company at the current market price would pay:

(A) $21.50 + a sales charge (B) $21.85 + a sales charge (C) $21.50 + a commission (D) $21.85 + a commission

43. A specialized or specialty fund invests in stocks that are primarily:

(A) Special situations (B) Traded in the OTC market (C) In a particular industry or geographical area (D) In many industries

44. If the net asset value is $13.45 and the ask price is $14.40 for Shady Green Investment Co., the sales charge is what percent of the offering price?

(A) 6.6% (B) 7.1% (C) 7.2% (D) 9.3%

45. An investor is purchasing a large amount of Mary Jane Mutual Fund. Normally the fund has an 8% sales charge, but when purchasing a certain minimum amount, the fund charges only 6%. If the net asset value is $22.40 at the time of the purchase of an amount allowing the 6% sales charge, what is the offering price the customer has to pay per share?

(A) $23.74 (B) $23.83 (C) $24.34 (D) $24.19

46. On a particular day Pigeon Hole Investment Co. had an NAV of $12.65 and an offer price of $13.75. The fund has sales breakpoints every $20,000 so that there is a 6% sales charge on a quantity purchase of $50,000. If an investor purchases $50,000 that day, approximately how many shares would the investor receive?



(A) 3,636 shares (B) 3,715 shares (C) 3,728 shares (D) 3,952 shares

47. Investment companies with no management fee and low sales charges that invest in a fixed portfolio of municipal or corporate bonds are categorized as:

(A) Open-end investment companies (B) Unit investment trusts (C) Closed-end investment companies (D) Face-amount certificate companies

48. All of the following statements regarding a letter of intent are true, except:

(A) A letter of intent is good for 13 months. (B) A shareholder’s privilege to redeem shares is suspended during the time the letter of

intent is in effect. (C) A letter of intent may be backdated for up to 90 days. (D) When shares are purchased under a letter of intent, it is customary for the fund to hold

some shares in escrow in the event the additional payment is not made, and an additional sales charge will be required.

49. Which of the following must be registered as an investment adviser under the Investment Adviser’s Act of 1940?

(A) A broker giving advice on which investments are best for his clients (B) A broker/dealer firm that sends out suggestions on the best buys of the week (C) A broker who gives advice to some of his clients and charges a fee (D) A broker who sends out market tips from the firm

50. An investor buys ABC mutual fund. The fund sends a capital gains distribution three months later. Eleven months after purchasing the shares, the investor has to sell the mutual fund due to personal reasons for a capital gain. Which of the following are true?

I. The capital gains distribution is a short-term gain. II. The capital gains distribution is a long-term gain. III. The sale for a capital gain is a short-term gain. IV. The sale for a capital gain is a long-term gain.

(A) I and III (B) I and IV (C) II and III (D) II and IV

51. Which of the following is the best description of a breakpoint sale?

(A) The point at which an investor will receive a reduced sales charge (B) The point below which an investor makes a purchase and the broker does not inform the

investor of the possible sales breakpoint (C) The point at which a sale will be broken because the investor did not pay in time (D) The point at which the mutual fund will refuse the order

52. What is the expense ratio of a mutual fund?

(A) Net operating expenses Net asset value

(B) Management fees Net operating revenues



(C) Gross operating revenues Management fees

(D) Management fees Gross operating revenues

53. The managers of a mutual fund are paid in which of the following ways?

(A) They are paid a percentage of the amount they earn in interest and dividends. (B) They are paid a percentage of the profits they make on the securities they hold. (C) They are paid a percentage of the net assets they manage. (D) They are paid a percentage of all net gains and income they derive for the fund.

54. A mutual fund has listed that it charges each account holder 12b-1 fees. These fees can be used for which of the following?

I. Advertising II. Front-load broker’s commissions III. Management fees IV. Sales charges V. Expenses of the fund

(A) I and IV only (B) I and III only (C) II and V only (D) III and V only

55. Under which of the following circumstances can a fund sell shares at less than the public offering price?

(A) At no time (B) To a broker to fill a customer’s order or to a broker/dealer for the firm’s own account (C) To a non-NASD member to sell to a customer (D) To a non-NASD member to sell to an NASD member who is buying for a customer

56. A mutual fund receives a letter from an investor informing the fund that he would like to redeem all of his shares of the fund for personal reasons. How long does the fund have to mail the proceeds to the client?

(A) Three business days (B) Five business days (C) Seven calendar days (D) 10 calendar days

57. An open-end investment company can borrow money at certain times to help it through a cash shortage during redemptions. What is true regarding the amount the fund can borrow?

(A) The fund can borrow up to 25% of the fund’s assets. (B) The fund can borrow up to 33% of the fund’s assets. (C) The fund can borrow up to 50% of the fund’s assets. (D) The fund can borrow up to 100% of the fund’s assets.

58. Which of the following is true regarding the borrowing practices of an open-end investment company?

(A) The net asset value must be four times the bank borrowing. (B) The net asset value must be three times the bank borrowing. (C) The net asset value must be five times the bank borrowing. (D) The net asset value must be 10 times the bank borrowing.



59. What percent of the board of directors of an open-end investment company can be made up of people directly associated with the fund itself?

(A) 20% (B) 33% (C) 40% (D) 60%

60. Which of the following is true of all investment companies?

I. Minimum capitalization is $100,000. II. Margin purchases for stocks and bonds are not allowed. III. At least 40% of the investment company’s board of directors must be from outside the

fund. IV. A majority vote of the shareholders must approve a change in the objectives of the

investment company. V. A majority vote of the shares must approve a change in the objectives of the investment

company. VI. A prospectus must be given to any purchaser of new shares of the investment company.

(A) I, II, III, IV, and VI only (B) I, II, III, V, and VI only (C) II, V, and VI only (D) I, II, and IV only

61. Mr. Lockhart is interested in purchasing shares of the HLY Global Equity Fund. He is new to mutual funds, but a friend of his recommended this particular loaded fund as a good investment. Mr. Lockhart is reading the prospectus on this fund but is still confused about how much he will pay for each share of this fund. Which of the following best describes what Mr. Lockhart will pay per share?

(A) The bid (B) The net asset value (C) The net asset value plus a sales charge (D) The net asset value minus a sales charge

62. All mutual funds are obligated to send shareholders statements on their accounts at least:

(A) Weekly (B) Monthly (C) Quarterly (D) Annually

63. Which of the following statements is not true regarding sales breakpoints?

(A) Registered representatives are not required to inform customers about breakpoints, provided a prospectus disclosing these is given to the client.

(B) Spouses investing together can qualify for breakpoints. (C) Partnerships and investment clubs are not allowed to qualify for breakpoints. (D) Registered representatives are required to inform customers of breakpoints even if a

prospectus disclosing these is provided to the client.

64. Mrs. Blaylock is interested in purchasing shares of the JNK Emerging Markets Income Fund. She is new to mutual funds investing outside of U.S. markets, but a friend of hers from her investment club recommended this particular fund as a good investment for a small portion of her account. Mrs. Blaylock has read the prospectus on this fund but is still confused about how much she will pay per share. Mrs. Blaylock can expect to pay for each share:

(A) The bid (B) The net asset value



(C) The net asset value minus a sales charge, if any (D) The net asset value plus a sales charge, if any

* * * * * * * * * *



INVESTMENT COMPANIES INVESTMENT COMPANIES EXAM ANSWERS

Each correct answer includes the rationale for the correct choice. The section of text that addresses each answer is referenced at the end of the paragraph.

1. (C) $7,029. Don’t forget the redemption fee. 500 shares times the net asset value (or bid price) of $14.20 = $7,100 less the 1% redemption fee ($71) = $7,029. The sales charge has nothing to do with this problem because you are already given the net asset value. [Investment Companies Module, Section 6.1]

2. (D) Under none of the above circumstances. Income is either dividends or interest, and thus is classified as ordinary income, not as a long-term gain. If a capital gains distribution is made, then it is always long-term. [Investment Companies Module, Section 9.0]

3. (B) 4.6%. You must remember that yield is calculated at a point in time, and it changes as the value of the shares change and as distributions change. In this case what you get is the dividend and what you pay is the ask price. Do not consider the capital gain. We always use the dividend and the ask price. Then just do the division, and $0.30 divided by $6.50 = 4.6%. [Investment Companies Module, Section 9.1]

4. (A) Closed-end investment company shares. Closed-end investment companies are sold in the open market and are not redeemed by the issuer. Open-end companies, such as mutual funds, are bought from and sold to the issuer; Series H bonds are bought from and sold to the government (the issuer); and all bonds are redeemed by the issuer at maturity. [Investment Companies Module, Section 3.4]

5. (B) Appreciation. Appreciation is any gain in market price. A capital gain is not considered a gain until it is realized, which occurs upon sale of the shares. Profit is determined by subtracting the original price (base price) from the sale price to determine the realized gain. [Investment Companies Module, Section 9.0]

6. (B) $13.42. Always look to the net asset value (NAV) for an investor’s sales proceeds. $13.34 was the NAV the day before, but remember the price is determined at the end of the day the money is received. $13.55 and $14.63 are based on the ask price, not the bid price, which is the NAV or redemption price. [Investment Companies Module, Section 6.0]

7. (A) No-load fund. This is because the NAV and the ask prices are the same. Additionally, the “NL” in the offer price column also identifies the fund as a no-load fund. [Investment Companies Module, Section 4.1, 5.1 & 12.0]

8. (A) A non-negotiable certificates of deposit. A mutual fund will not invest in non-negotiable CDs. Money market funds will invest in negotiable CDs, which are very short-term (14 to 30 days), but not non-negotiable CDs. Non-negotiable CDs are long-term investments that may charge surrender fees for early withdrawal. Investment companies will invest in commercial paper, banker’s acceptances, and repurchase agreements, especially if the fund is a money market fund. [Investment Companies Module, Section 10.6]

9. (A) The capitalization. Open-end companies issue common stock only, while closed-end companies issue common and preferred stocks and bonds. They both determine net asset value by dividing assets by shares, and they invest in the same types of stocks and bonds. [Investment Companies Module, Section 4.0]

10. (A) II only. By not telling the customer of the reduced sales charges, the broker has violated the breakpoint sale provision of the NASD. If he had told the customer, or the customer had signed a letter of intent and then proceeded to buy the three mutual funds, no violation would have occurred. The broker didn’t tell of the breakpoint, so he violated the rules, even though he did follow the customer’s instructions. We



cannot tell whether he has achieved diversification or not, and there is no sure profit. [Investment Companies Module, Section 5.5]

11. (C) A closed-end management company. Closed-end investment companies issue stock only once. All the others issue shares and then redeem them from the investor. Open-end companies have a continuous offering, while face-amount certificate companies and unit investment trusts issue shares of stock that mature at a future date. Closed-end management company stock trades in the secondary market after being issued by the company. [Investment Companies Module, Section 3.4]

12. (C) The net asset value minus a redemption fee, if any. The redemption fee is subtracted from this price. The NAV is the same as the bid price, not the offering price. [Investment Companies Module, Section 6.0]

13. (B) $1,006. Whenever you buy shares, you always pay the ask (offer) price, unless taking advantage of a breakpoint and lower sales charge. Since the sales charge is built into the price, no commission can be taken, or it would be a violation. So, to find how much this investor would pay, multiply the ask price ($5.03) by 200 to get $1,006. [Investment Companies Module, Section 3.3]

14. (C) More than 50% of the voting shares held by stockholders voted for the change. (Remember, if given a choice between shares and stockholders, the shares vote, not the people.) Changes in policy must always be voted upon, no matter what choices the holders are given; and more than 50% must agree to the change in order for it take effect. Management can’t make changes without shareholder approval. [Investment Companies Module, Section 7.0]

15. (A) A dollar amount for a purchase of a mutual fund where a volume sales charge discount is given. This level is represented in dollars, not the number of shares. A letter of intent can be obtained at any level, and can be backdated three months. [Investment Companies Module, Section 5.4]

16. (B) The custodian bank. Shares are not given to the holders of the fund, but held in a bank. The sponsor is the fund itself, and must issue the stock; the registrar and transfer agent are used in changing a name on shares of stock from one owner to another owner. [Investment Companies Module, Section 7.3]

17. (D) An income fund. Any customer interested in current yield would invest in an income fund because the fund’s objectives include the generation of income from dividends, interest, and capital gains. Growth funds attempt to produce long-term capital gains by investing in companies whose earnings are growing. The growth fund will invest and sell according to the stock performance of the underlying securities, and the income from the fund would not be predictable. A specialized fund deals only in one industry and may not produce income. A no-load fund just has no sales charge, and may or may not produce income. [Investment Companies Module, Section 10.3]

18. (C) Holds the fund’s cash and securities and performs essential clerical functions but does not manage the fund. The custodian bank does not manage the fund nor act as a distributor (sell shares) for the fund, and never guarantees the fund. [Investment Companies Module, Section 7.3]

19. (B) 4,157 shares. Since this is a quantity purchase, the investor will receive the breakpoint discount. The breakpoint discount is represented by the sales charge of 5%, not the sales charge that would be calculated by determining the difference between the POP and the NAV. In this case, the $70,000 qualifies for a 5% sales charge. You can find the new offer price using the following formula and divide that offer price into the $70,000.

POP = NAV + SALES CHARGE (DOLLARS) $ = $16 + (PERCENT) 100% = 95% + 5%

Divide 16 by .95 to arrive at 16.84 per share. Dividing $70,000 by 16.84 results in about 4,156.7 or 4,157 shares. An easier way to calculate the number of shares is to deduct the sales charge from the total purchase. 5% of $70,000 = $3,500. Deduct $3,500 from 70,000 to arrive at $66,500. Divide $66,500 by the NAV of 16 per share to arrive at 4,157 shares. [Investment Companies Module, Section 5.2]



20. (B) 2.43%. In computing yield on a current basis, never combine dividends and capital gains. You just divide the yearly dividend by the ask price. Remember, yield is calculated at a point in time, and it changes as the value of the shares change and as distributions change. In this case, you just divide the $0.38 by $15.65 to get 2.43%. [Investment Companies Module, Section 9.1]

21. (C) I and IV. Dividends come from interest and dividend income from the stocks and bonds held by the mutual fund — so are treated as ordinary income. Dividends can never be taxed as capital gains. Dividend income is always taxed as ordinary income. Capital gains distributions are always treated as long-term capital gains, regardless of the length of time the shares were held by the investor. This is because the distribution is from long-term holding of the securities by the investment company. Do not mix distributions with sales of the fund shares. If this had been the sale of fund shares, then the gain would have been a short-term gain since the shares were only held for two months. [Investment Companies Module, Section 9.0]

22. (C) Net asset value and redemption price. Net asset value and redemption price are the same in an open-end investment company (mutual fund). In a closed-end company, the NAV may or may not be equal to the bid price, which is what you get when you sell your shares. In mutual funds, when turning in your shares, you receive the NAV, and at times pay a redemption fee (of 1%). In any event, NAV and redemption price (before fee) are the same. [Investment Companies Module, Section 6.0]

23. (C) III and IV only. Mutual funds allow reduced sales charges on quantity purchases, and no-load funds may have a redemption fee. The maximum sales charge is 8.50%, not 7%, and the letter of intent is for 13 months, not 10 months. [Investment Companies Module, Sections 5.2, 5.3, 5.6 & 5.7]

24. (A) An aggressive growth fund. An aggressive growth fund will have the investment objective of investing in companies that are projected to grow. These companies are not expected to produce dividends, and thus would not be expected to produce income. An investor interested in income would want a high-yielding bond fund or some kind of income fund. [Investment Companies Module, Section 10.3]

25. (A) $10,930. To determine this, first find the net asset value (NAV). The sales charge is 8%, the ask price is $12, so the bid price, or NAV, is 92% (100% - 8% sales charge) multiplied by $12 to get $11.04 (the bid + sales charge = ask price). 1,000 shares times $11.04 is $11,040, but a 1% redemption fee ($110.40) is assessed, so $11,040 - $110 = $10,930. [Investment Companies Module, Sections 5.2, 6.0 & 6.1]

26. (D) III and IV only. Regulated investment companies have special tax treatment, in that they pay no tax on dividends and interest passed on to shareholders. They pay tax only on money they keep. Also, dividends and capital gains distribution can never be added together to compute yield. No dividends are exempt from federal taxes, and it is not true that regulated investment companies must pass 90% of their capital gains to the shareholders, but only income from dividends and interest. [Investment Companies Module, Sections 8.3 & 9.1]

27. (D) Correct answer (false statement): Distributor of mutual fund shares (the sponsor). Banks cannot sell (or distribute as the sponsor) mutual fund shares. They can act as a transfer agent in changing or adding names to the company’s list of shareholders; the bank can hold the fund’s securities; and the bank has the primary responsibility of distributing money to shareholders. [Investment Companies Module, Section 7.3]

28. (D) Regulated. “Regulated” investment companies must distribute 90% of their net investment income (passive income) to shareholders, or the company gets taxed on all of it at corporate rates. Investment income is dividends and interest. Regulated investment companies can be any of the other three choices balanced, diversified, or dual-purpose as long as they distribute 90% of the investment income. [Investment Companies Module, Section 8.3]

29. (C) $18.51. We find the ask price by dividing the NAV by 100% minus the sales charge. In this case, $17.40 divided by 94% (100% - 6%) equals $18.51. Remember the formula:


$ 17.40 = +

100% = 94% + 6%



[Investment Companies Module, Section 5.2]

30. (C) The net asset value as computed at the end of the business day. All investment companies must compute the NAV daily (some do it twice), so they usually do it at the end of the day. Since it is no-load, no sales charge or commission is added, and since it is a fund, or open-end investment company, there are no supply and demand restrictions on the price. Remember, a no-load fund has to be offered by an open-end investment company because such companies are the only ones that deal in loads (or lack thereof). Closed-end investment companies have commissions. [Investment Companies Module, Section 3.3]

31. (C) A letter of intent. This is a pledge to purchase a specified amount of a mutual fund within a period of time. A promissory note is a financing instrument used to raise money for companies. An investment letter deals with a private placement of stock, and a stock power is a signature on a separate piece of paper to allow the sale and transfer of sold shares of stock. [Investment Companies Module, Section 5.7]

32. (C) The investment adviser is responsible for all purchases and sales of securities held in the fund’s portfolio and receives a management fee based upon the total assets of the fund. The management company does buy all the securities and receives a fee (a percentage of the net asset value). They do not get a sales charge for managing the fund’s portfolio, only a fee. The bank is the transfer agent for the fund. The underwriter gets a sales charge (sometimes called an underwriter’s fee), not a management fee. [Investment Companies Module, Sections 7.2–7.5]

33. (C) The next computed bid price on the day the shares are sold. Any redeeming or purchasing of shares is done at “the next computed price of the day.” It is not based on the previous day’s closing bid price, nor is the redeeming of shares ever done on the ask, or offering, price. [Investment Companies Module, Section 6.0]

34. (D) Purchases at “sales charge breakpoints.” Discounts to clients or other members of the public can only be given when sales breakpoints are reached. This is not due to the automatic reinvestment privilege, which is available in most funds; nor to the availability of withdrawal plans, which all funds have; nor because of exchange privileges. [Investment Companies Module, Section 5.4]

35. (D) $15.60. Again, we use the formula ASK = NAV + SALES CHARGE. It is best to set the formula up as follows:


$ = $14.35 +

100% = 92% + 8%

Since the sales charge is 8% of the ask price, the NAV must be 92% of the ask price, and $14.35 divided by 92% equals $15.598, or $15.60, as the offering, or ask, price. [Investment Companies Module, Section 5.2]

36. (A) Open-end investment companies. (Know this!) Front-end loads are contractual investment companies that are open-end; no-load funds are mutual funds with no sales charge; and a closed-end fund is an investment company that trades on exchanges. [Investment Companies Module, Section 3.1]

37. (B) The shares are sold at the current market price. Shares of closed-end investment companies are sold to investors at the offering price (or market ask price). They are bought from an investor at the bid price, by a market maker or an exchange specialist. Customers always buy (pay) at the ask price and receive the bid price from a market maker when selling, which will usually be different from the net asset value. Closed-end companies issue stocks only one time, after which they are sold in the open market; they do not continually offer new shares as open-end companies do. For this reason, the number of outstanding shares is constant. [Investment Companies Module, Section 3.4 & 3.5]

38. (C) Its shares are sold in the open market at their current offering price. Open-end companies can only offer one type of stock — common; they continually offer new shares; and they redeem their own shares. A closed-end company does none of these three things. [Investment Companies Module, Sections 3.4, 3.5 & 4.2]

39. (D) They can automatically be reinvested in additional shares if the fundholder chooses to do so. Dividends and capital gains can be reinvested in open-end investment companies because new shares are given



by open-end companies. You can’t combine dividends and capital gains to determine yield. Only insurance companies can defer taxes with variables. Dividends are always taxed as ordinary income. [Investment Companies Module, Sections 5.1 & 9.1]

40. (B) 3.9% (3.85% rounded off). Here again is a yield question, and yield is what you currently get for what you currently pay. In this case, you get $0.75 and you pay $19.45. Remember, do not use the capital gains in any way. In this problem we divide .75 by 19.45 to obtain a current yield of 3.85%, rounded to 3.9%. [Investment Companies Module, Section 9.1]

41. (A) Closed-end investment company. A closed-end company is the only type of investment company among the choices available in which commissions are paid for buying and selling shares. Open-end investment companies have a sales charge built into the price, and no-load companies have neither commissions nor sales charges. [Investment Companies Module, Section 3.5]

42. (C) $21.50 plus a commission. This is a secondary market transaction, so there is no sales charge. The commission is always added to the ask price on a purchase, and subtracted from the sale price on a sale. In this case, we are dealing with a purchase; thus, $21.50 plus a commission. [Investment Companies Module, Section 3.5]

43. (C) In a particular industry or geographical area. Specialized funds have more than 25% invested in one area. Diversified funds deal in many industries. All funds trade stock in the OTC market. Special situations have nothing to do with specialized funds. [Investment Companies Module, Section 10.3]

44. (A) 6.6%. We are looking for the sales charge percent, which is a percentage of the offering price. The ask (or offering) price is $14.40 and the sales charge is $0.95 ($14.40 - $13.45), and when .95 is divided by 14.40 we find the sales charge is 6.6%. [Investment Companies Module, Section 5.2]

45. (B) $23.83. Normally a person purchasing this fund pays the 8% sales charge, but in this instance the investor has decided to make a quantity purchase, so is entitled to the lowered sales charge rate. Since the quantity rate is given as 6%, we then find the offering price the same way as with any other value of sales charge. We set it up as follows:

POP = NAV + SALES CHARGE $ ____ = 22.40 + ____ 100% = 94% + 6%

Divide the 22.40 by 94% to find the offering price of $23.83. [Investment Companies Module, Section 5.2]

46. (B) 3,715 shares. This is a quantity purchase, so the public offering price is not used. Instead, a new offering price, based on the amount of the purchase must be used. In this case, the $50,000 qualifies for a 6% sales charge. You can find the new offer price using the following formula and dividing that offer into $50,000.

POP = NAV + SALES CHARGE (DOLLARS) $ = $12.65 + (PERCENT) 100% = 94% + 6%

We can determine that the ask price will be 13.457, or 13.46. We then divide the $50,000 by 13.46 and get about 3,715 shares. An easier way, however, is that since the sales charge is part of the offer, just take out the sales charge of 6%, or $3,000, leaving $47,000. Then divide $47,000 by the NAV of 12.65 to get about 3,715 shares. [Investment Companies Module, Section 5.2]

47. (B) Unit investment trusts. Unit investment trusts mainly invest in bonds, and can be remembered by the last word of their name trust. All corporate bonds sell under a trust indenture. Open-end and closed-end investment companies have high management fees. Face-amount certificates are certificates that are backed by real estate. [Investment Companies Module, Section 2.3]

48. (B) Correct answer (false statement): A shareholder’s privilege to redeem shares is suspended during the time the letter of intent is in effect. The shareholder can redeem anytime! A letter of intent may be backdated for up to 90 days. Know this: When shares are purchased under a letter of intent, it is customary for the fund



to hold some shares in escrow in the event the additional payment is not made, and an additional sales charge will be required. [Investment Companies Module, Section 5.7]

49. (C) A broker who gives advice to some of his clients and charges a fee. Any person who charges a fee has to be registered under the Investment Advisers Act of 1940, as well as with each state in which he gives advice and charges a fee. [Investment Companies Module, Section 7.2]

50. (C) II and III. The capital gains distribution is a long-term gain and the sale for a capital gain is a short-term gain. All distributions by the mutual fund company to investors represent long-term gains, yet if an investor holds a mutual fund investment for one year or less, the gains are deemed short-term gains for income tax purposes. [Investment Companies Module, Section 9.0]

51. (B) The point below which an investor makes a purchase and the broker does not inform the investor of the possible sales breakpoint. This is a breakpoint sale: Remember, Breakpoint Sale = BS = failure to inform. [Investment Companies Module, Section 5.5]

52. (A) Net operating expenses Net asset value

This is the formula. Since the question asked for the expense ratio, you would look for an answer with “expenses” in it. [Investment Companies Module, Section 7.4]

53. (C) They are paid a percentage of the net assets they manage. The managers of a mutual fund are paid based only on what they manage. [Investment Companies Module, Section 7.2]

54. (A) I and IV only. Advertising and sales charges. 12b-1 fees are sales charges that carry on throughout the time the person has an account. These are usually levied by no-load funds, and are used for advertising. Some can be used for sales charges, but most goes to advertising prospectuses for new purchasers. [Investment Companies Module, Sections 3.2 & 7.7]

55. (B) To a broker to fill a customer’s order or to a broker/dealer for the firm’s own account. No sale at less than the offering price can be given unless a sales agreement is in force and the sale is to a broker/dealer to fill a customer’s order or for their own account. [Investment Companies Module, Sections 5.1 & 7.5]

56. (C) Seven calendar days. The fund has one week from the day it receives the letter to mail the check. [Investment Companies Module, Section 6.0]

57. (B) The fund can borrow up to 33% of the fund’s assets. At no time can the fund borrow more than this. Borrowing usually occurs around tax time and during the summer months. [Investment Companies Module, Sections 4.1 & 4.3]

58. (B) The net asset value must be three times the bank borrowing. At no time can the fund borrow more than this. Borrowing usually occurs around tax time and during the summer months. [Investment Companies Module, Sections 4.1 & 4.3]

59. (D) 60%. 60% of the board of directors of an open-end investment company can be made up of people directly associated with the fund itself. The fund must have at least 40% of its directors from outside the fund. [Investment Companies Module, Section 7.1]

60. (B) I, II, III, V, and VI only. Minimum capitalization is $100,000, and margin purchases are not allowed. 40% of the board of directors must be from outside, and the vote is by the shares, not the shareholders. Always know that a prospectus must be given for new shares, open-end or closed-end. The secondary market does not need the prospectus. [Investment Companies Module, Section 1.0, 3.2 & 7.1]

61. (C) The net asset value plus a sales charge. To buy shares of a mutual fund, an investor must pay a price equivalent to the net asset value (NAV) plus the appropriate sales charge as determined in the prospectus. Depending on the size of Mr. Lockhart’s investment, it may also be appropriate to mention that this sales charge can vary based on the amount invested. [Investment Companies Module, Section 5.2]



62. (C) Quarterly. All mutual funds are obligated to send shareholders statements on their accounts at least quarterly. If there is any activity in the account, then a statement must be sent to the individual shareholder monthly. [Investment Companies Module, Section 8.2]

63. (A) Correct answer (false statement): Registered representatives are not required to inform customers about breakpoints, provided a prospectus disclosing these is given to the client. Registered representatives are required to inform customers of breakpoints even if a prospectus disclosing these is provided to the client. Spouses investing together can qualify for breakpoints. Partnerships and investment clubs are not allowed to qualify for breakpoints. [Investment Companies Module, Section 5.5]

64. (D) The net asset value plus a sales charge, if any. To buy shares of a mutual fund, an investor must pay a price equivalent to the net asset value (NAV) plus the appropriate sales charge as determined in the prospectus. If this JNK Emerging Markets Income Fund is a loaded fund, and depending on the size of Mrs. Blaylock’s investment, it may also be appropriate to mention that the sales charge can vary based on the amount invested. [Investment Companies Module, Section 5.2]

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Documents

07 Investment Companies