1
Q
What benefits do common shareholders enjoy?
A
voting rights, the opportunity for capital appreciation, and current income as well as limited liability.
2
Q
Why include common stock in a client’s portfolio?
A
■ Potential capital appreciation
■ Income from dividends
■ Hedge against inflation
3
Q
What are the risks of owning common stock?
A
- Market risk—The chance that a stock will decline in price is one risk of owning com- mon stock. A stock’s price fluctuates daily as perceptions of the company’s business prospects change and influence the actions of buyers and sellers. Investors have no assurance whatsoever that they will be able to recoup the investment in a stock at any time. The price of a stock when an investor wishes to sell shares may be higher or lower than when the shares were ini- tially purchased.
- Decreased or no dividend income—A risk of stock ownership is the possibility of divi- dend income decreasing or ceasing entirely if the company loses money. The common stock- holders have the last claim on earnings, and there is no guarantee that dividends will be paid out. The decision to pay a dividend rests with the BOD, and it is not guaranteed.
- Low priority at dissolution—If a company enters bankruptcy, the holders of its bonds and preferred stock have priority over common stockholders. A company’s debt and preferred shares are considered senior securities. Common stockholders have residual rights to corporate assets upon dissolution. Once all debtholders and preferred shareholders are paid, residual funds would be paid out to the common stockholders. Common stockholders are the most junior class of investors in a company.
4
Q
In the event a company liquidates, what is the priority of claims on the company’s assets that will be sold?
A
- IRS (taxes) and employees (unpaid wages)
- Secured debt (bonds and mortgages)
- Unsecured liabilities and general creditors (suppliers and utilities)
- Subordinated debt (debtholders who agreed to be paid back last of all debtholders in the event a liquidation ever needed to occur)
- Preferred stockholders
- Common stockholders
5
Q
What are the benefits of owning preferred stock?
A
- Dividend preference—When the BOD declares dividends, owners of preferred shares must be paid before any payment to common shareholders.
- Priority at dissolution over common stock—If a corporation goes bankrupt, preferred stockholders have a priority claim over common stockholders on the assets remaining after creditors have been paid.
6
Q
What are the risks of owning preferred stock?
A
- Purchasing power risk—This is the potential that, because of inflation, the fixed income produced will not purchase as much in the future as it does today.
- Interest rate sensitivity—Like a fixed-income security, when interest rates rise, the value of preferred shares declines. (This will be discussed in greater detail later in this unit.)
- Decreased or no dividend income—Like common stock ownership, there is the possibility of dividend income decreasing or ceasing entirely if the company loses money. The decision to pay a dividend rests with the BOD, and it is not guaranteed.
- Priority at dissolution—While preferred shareholders are paid before common shareholders if a company enters bankruptcy, they are paid behind all creditors.
7
Q
What are the six types of preferred stock?
A
- Straight (noncumulative)—Straight preferred stock has no special features beyond the stated dividend payment. Missed dividends are not paid to the holder.
- Cumulative—Cumulative preferred stock accrues payments due its shareholders in the event dividends are reduced or suspended. Dividends due cumulative preferred stock accumulate on the company’s books until the corporation’s BOD decides to pay them. When the company resumes dividend payments, cumulative preferred stockholders receive current dividends plus the total accumulated dividends— dividends in arrears—before any dividends may be distributed to common stockholders.
- Callable preferred—Corporations often issue callable (or redeemable) preferred stock, which a company can buy back from investors at a stated price after a specified date. The right to call the stock allows the company to replace a relatively high fixed dividend obligation with a lower one when the cost of money has gone down. This is similar to refinancing a mortgage. When a corporation calls a preferred stock, dividend payments cease on the call date. In return for the call privilege, the corporation may pay a premium exceeding the stock’s par value at the call, such as $103 for a $100 par value stock.
- Convertible preferred—A preferred stock is convertible if the owner can exchange the shares for a fixed number of shares of the issuing corporation’s common stock.
Convertible preferred is generally issued with a lower stated dividend rate than nonconvertible preferred of the same quality because the investor may have the opportunity to convert to common shares and enjoy greater capital gain potential. - Adjustable-rate preferred—Some preferred stocks are issued with adjustable (or variable) dividend rates. Such dividends are usually tied to the rates of other interest rate benchmarks, such as Treasury bills and money market rates, and can be adjusted as often as quarterly. Because the payment adjusts to current interest rates, the price of the stock remains relatively stable.
- Participating preferred—In addition to fixed dividends, participating preferred stock offers its owners a share of corporate profits that remain after all dividends and interest due other securities are paid. The percentage to which participating preferred stock participates is noted on the stock certificate.
8
Q
What does SEC Rule 144 regulate?
A
the sale of control and restricted securities, stipulating the holding period, quantity limitations, manner of sale, and filing procedures. Selling shares under Rule 144 effectively registers the shares. In other words, buyers of stock being sold subject to Rule 144 are not subject to any restrictions if they choose to resell.
9
Q
What are control securities?
A
Those owned by directors, officers, or persons who own or control 10% or more of the issuer’s voting stock.
10
Q
What are restricted securities?
A
those acquired through some means other than a registered public offering. A security purchased in a private placement is a restricted security. Restricted securities may not be sold until they have been held fully paid for six months. According to Rule 144, after holding restricted stock fully paid for six months, an affiliate may begin selling shares but is subject to the volume restriction rules as enumerated in the following. In any 90-day period, an investor may sell the greater of: ■ 1% of the total outstanding shares of the same class at the time of sale; or ■ the average weekly trading volume in the stock over the past four weeks on all exchanges or as reported through Nasdaq. After the six-month holding period, affiliated persons are subject to the volume restrictions for as long as they are affiliates. For unaffiliated investors, the stock may be sold completely unrestricted after the six-month holding period has been satisfied.
11
Q
What are Rule 144A Transactions Under the Act ‘33
A
exemption under the Securities Act of 1933 that is only available to certain large institutions, referred to as qualified institutional buyers (QIBs). A QIB owns and invests a minimum of $100 million in securities on a discretionary basis. If a QIB purchases securities under a 144A exemption, it is permitted to resell the securities with no volume restriction or holding period as long as the buyer is also a QIB.
12
Q
What is an ADR?
A
American Depository Receipt. a type of equity security designed to simplify foreign investing for Americans. created when common shares are purchased in the foreign company’s home market. These shares are then deposited in a foreign branch of a U.S. bank, and a receipt (the ADR) is created. Each ADR may represent one or more shares of the foreign company’s shares held on deposit. The ADR provides U.S. investors with a convenient way to diversify their holdings beyond domestic companies.
13
Q
What is a Penny Stock?
A
an unlisted (not listed on a U.S. stock exchange) security trading at less than $5 per share. Equity securities defined as penny stocks are considered highly speculative. In this light, SEC rules require that customers, before their initial transaction in a penny stock, be given a copy of a risk disclosure document. The member must receive a signed and dated acknowledgment from the customer that the document has been received. Not surprisingly, the penny stock disclosure document fully describes the risks associated with penny stock investments. Regardless of activity in the account, if the account holds penny stocks, broker-dealers (BDs) must provide a monthly account statement to the customer. This must indicate the market value and number of shares for each penny stock held in the account as well as the issuer’s name.
14
Q
What are the SEC’s rules regarding cold-calling potential penny stock customers?
A
when a BD’s representative contacts a potential customer to purchase penny stocks (this is a solicitation to buy like those occurring during a cold call), the representative must first determine suitability on the basis of information about the buyer’s financial situation and objectives. The customer must sign and date this suitability statement before any initial penny stock trades may be placed. In addition, the BD must disclose:
■ the name of the penny stock;
■ the number of shares to be purchased;
■ a current quotation; and
■ the amount of commission that the firm and the representative received.
Established customers are exempt from the suitability statement requirement, but not from the disclosure requirements. An established customer is someone who:
■ has held an account with the BD for at least one year (and has made a deposit of funds or securities); or
■ has made at least three penny stock purchases of different issuers on different days.
15
Q
What is a term bond?
A
structured so that the principal of the whole issue matures at once. Because the entire principal is repaid at one time, issuers may establish a sinking fund account to accumulate money to retire the bonds at maturity.
16
Q
What is a serial bond?
A
schedules portions of the principal to mature at intervals over a period of years until the entire balance has been repaid.
17
Q
What is a balloon bond?
A
When an issuer schedules its bond’s maturity using elements of both serial and term maturities. The issuer repays part of the bond’s principal before the final maturity date, as with a serial maturity, but pays off the major portion of the bond at maturity. This bond has a balloon, or serial and balloon, maturity.
18
Q
What does the coupon of a bond represent?
A
the interest rate the issuer has agreed to pay the investor. At one time, bonds were issued with interest coupons attached that the investor would detach and turn in to receive the interest payments. While bonds are no longer issued with physical coupons attached, the interest rate the bond pays is still called the coupon rate. It is also referred to as the stated yield or nominal yield. It is calculated from the bond’s par value, usually stated as a percentage of par. Par value, also known as face value for a bond, is normally $1,000 per bond, meaning that each bond will be redeemed for $1,000 when it matures. Therefore, a bond with a 6% coupon is paying $60 in interest per year (6% × $1,000 par value = $60).
19
Q
What is a nominal yield of a bond?
A
Also called Coupon or stated yield is set at the time of issue. Remember that the coupon is a fixed percentage of the bond’s par value.
20
Q
What is a bond’s current yield?
A
CY measures a bond’s annual coupon payment (interest) relative to its market price, as shown in the following equation:
annual coupon payment ÷ market price = CY
21
Q
What is a bond’s yield to maturity
A
A bond’s YTM reflects the annualized return of the bond if held to maturity. In calculating YTM, the bondholder takes into account the difference between the price that was paid for a bond and par value received when the bond matures. If the bond is purchased at a discount, the investor makes money at maturity (i.e., the discount amount increases the return). If the bond is purchased at a premium, the investor loses money at maturity (i.e., the premium amount decreases the return).
22
Q
What is a bond’s yield to call?
A
Some bonds are issued with what is known as a call feature. A bond with a call feature may be redeemed before maturity at the issuer’s option. Essentially, when a callable bond is called in by the issuer, the investor receives the principal back sooner than anticipated (before maturity). YTC calculations reflect the early redemption date and consequent acceleration of the discount gain if the bond was originally purchased at a discount, or the accelerated premium loss if the bond was originally purchased at a premium.
23
Q
What is a bond with a call feature?
A
allows an issuer to call in a bond before maturity. Issuers will generally do this when interest rates are falling. From the issuer’s perspective, why pay 6% interest to investors on an existing bond if current interest rates have fallen to 4%? It is better to call in the 6% bond and simply issue a new bond paying the lower current interest rate. This feature benefits the issuer.
24
Q
What is a put feature of a bond?
A
the opposite of a call feature. Instead of the issuer calling in a bond before it matures, with a put feature the investor can put the bond back to the issuer before it matures. Investors will generally do this when interest rates are rising. From the investor’s perspective, why accept 6% interest on a bond one owns if current interest rates have risen to 8%? It is better to put the 6% bond back to the issuer, take the principal returned, and invest it in a new bond paying the current interest rate of 8%. This feature benefits the bondholder. If called, the (former) bondholder now has the dilemma of finding a similar rate of return in a low interest rate environment.
25
What is a convertible bond?
issued by corporate issuers, allowing the investor to convert the bond into shares of common stock. Giving the investor the opportunity to exchange a debt instrument for one that gives the investor ownership rights (shares of common stock) is generally considered a benefit for the investor.
26
What are treasury bills?
T-bills are direct short-term debt obligations of the U.S. government. They are issued weekly with maturities of 4 weeks, 13 weeks, 26 weeks, and at times, 52 weeks. Though the maximum maturity for T-bills is subject to change, they are always short-term instruments— that is, one year or less.
T-bills pay no interest in the way other bonds do; rather, they are issued at a discount from par value and redeemed at par. For example, an investor might purchase a $10,000, 26-week T-bill at a price of $9,800. She would receive no regular interest check, but, at maturity, the Treasury would send her a check for $10,000. The difference between the $9,800 she paid and the $10,000 she received would be considered her interest income, though she never received a separate interest check.
27
What are four key points to remember regarding T-bills?
■ T-bills are the only Treasury security issued at a discount;
■ T-bills are the only Treasury security issued without a stated interest rate;
■ T-bills are highly liquid; and
■ the 13-week (a.k.a. 90-day) T-bills are used in market analysis as the stereotypical risk-free investment.
28
What are Treasury notes?
Direct debt obligations of the U.S. government. They pay semiannual interest as a percentage of the stated par value, and they mature at par value. T-notes have intermediate maturities (2–10 years).
29
What are treasury bonds?
direct debt obligations of the U.S. government. They pay semiannual interest as a percentage of the stated par value and mature at par value. These government obligations have long-term maturities, greater than 10 years and up to 30 years.
30
What are treasury receipts?
Created by brokerage firms from U.S. Treasury notes and bonds. BDs buy Treasury securities, place them in trust at a bank, and sell separate receipts against the principal and coupon payments. This separating of the coupon interest payments from the principal creates new securities and provides investors with several maturities to choose from. This stripping process also yields more profit for the BD versus selling the original Treasury securities outright.
Although the Treasury securities held in trust collateralize the Treasury receipts, the receipts (unlike Treasury securities) are not backed by the full faith and credit of the U.S. government.
31
What are Treasury STRIPS?
The Treasury Department’s version of receipts known as Treasury STRIPS (Separate Trading of Registered Interest and Principal of Securities). The Treasury Department designates certain issues as suitable for stripping into interest and principal components. Banks and BDs perform the actual separation of interest coupon and principal and trading of the STRIPS.
32
What federal government agencies are authorized by U.S. congress to issue debt securities?
■ Farm Credit Administration
■ Government National Mortgage Association (GNMA, or Ginnie Mae)
Other agency-like organizations operated by private corporations include the following:
■ Federal Home Loan Mortgage Corporation (FHLMC, or Freddie Mac)
■ Federal National Mortgage Association (FNMA, or Fannie Mae)
■ Student Loan Marketing Association (SLMA, or Sallie Mae)
33
What is the Farm Credit System (FCS)?
a national network of lending institutions that provides agricultural financing and credit. The system is a privately owned, government-sponsored enterprise that raises loanable funds through the sale of Farm Credit Debt Securities to investors. These funds are made available to farmers through a nationwide network of banks and Farm Credit lending institutions. The Farm Credit Administration (FCA), a government agency, oversees the system.
34
What is the government national mortgage association (GNMA) or ginnie Mae?
a government-owned corporation that supports the Department of Housing and Urban Development. The only agency securities backed by the full faith and credit of the federal government. Although many of these securities have a stated 30-year life, GNMA’s are typically sold based on an average life expectancy since the issues are backed by mortgages, which are often retired early. When a mortgage is paid off before its stated maturity, the GNMA investor will receive back all outstanding principal of that loan at par. This early payout is referred to as prepayment risk.
Occasionally, GNMA securities are purchased by BDs that use the underlying assets to create hybrid securities called collateralized mortgage obligations (CMOs). These hybrid securities separate principal and interest payments into various investment choices called tranches. CMO customers typically receive payments monthly. CMOs are considered to be corporate securities and must be registered under the Securities Act of 1933.
35
What is the Federal Home Loan Mortgage Corporation (FHLMC) or Freddie Mac?
a public corporation. It was created to promote the development of a nationwide secondary market in mortgages by buying residential mortgages from financial institutions and packaging them into mortgage-backed securities for sale to investors.
36
What is the Federal National Mortgage Assocation (FNMA) or Fannie Mae?
a publicly held corporation that provides mortgage capital. FNMA purchases conventional and insured mortgages from agencies such as the FHA and the VA. The securities it creates are backed by FNMA’s general credit.
37
What is a mortgage bond?
Just as the owner of a home pledges a real asset (the home and land) as collateral for a loan (the mortgage), a corporation will borrow money backed by real estate and physical assets of the corporation. Just as a home ordinarily would have a market value greater than the principal amount of its mortgage, the value of the real assets pledged by the corporation will be in excess of the amount borrowed under that bond issue. If the corporation develops financial problems and is unable to pay the interest on the bonds, those real assets pledged as collateral are generally sold to pay off the mortgage bondholders. Having the real assets as collateral for the loan puts the purchaser of a mortgage bond in a position of safety. This is a secured loan.
38
What are equipment trust certificates?
Corporations, particularly railroads and other transportation companies, finance the acquisition of capital equipment used in the course of their business. For example, railroads will issue equipment trust certificates to purchase their rolling stock and locomotives. Title to the newly acquired equipment is held in trust, usually by a bank acting as a trustee, until the certificates have been paid in full. When the railroad has finished paying off the loan, it receives clear title to its equipment from the trustee. If the railroad does not make the payments, the lender repossesses the collateral and sells it for his benefit. Again, this is in an example of secured loan; the obligation to pay the investor is secured by the equipment.
39
What are collateral trust bonds?
Sometimes, a corporation wants to borrow money and has neither real estate (to back a mortgage bond) nor equipment (to back an equipment trust) to use as collateral. Instead, it deposits securities it owns into a trust to serve as collateral for the lenders. The securities the corporation deposits as collateral for a trust bond can be securities issued by the corporation itself or by stocks and/or bonds of other issuers. Regardless of the issuer, all deposited collateral securities must be marketable (readily able to be liquidated). Collateral trust certificates are secured by the securities deposited—and obviously, the better the quality of the securities, the better the quality of the certificate.
40
What is a debenture?
a debt obligation of the corporation backed only by its word and general creditworthiness. Written promises of the corporation to pay the principal at its due date and interest on a regular basis. Although this promise is as binding as a promise for a secured bond such as a mortgage bond, debentures are not secured by any pledge of property. They are sold on the general good faith and credit of the company, unsecured.
41
What is a guaranteed bond?
backed by a company other than the issuing corporation, such as a parent company. The value of the guarantee is only as good as the strength of the company making that guarantee. This is an unsecured debt security.
42
What are income bonds?
also known as adjustment bonds, are used when a company is reorganizing and coming out of bankruptcy. Pay interest only if the corporation has enough income to meet interest on debt obligations and if the BOD declares that the interest payment be made. Obviously, income or adjustment bonds fall under the heading of unsecured debt securities.
43
What are municipal bonds?
Securities issued either by state or local governments or by U.S. territories, authorities, and special districts. Investors who buy such bonds are lending money to the issuers for the purpose of public works and construction projects (e.g., roads, hospitals, civic centers, sewer systems, and airports). Municipal securities are considered second in safety of principal only to U.S. government and U.S. government agency securities, but the safety of any particular issue is based on the issuing municipality’s financial stability.
Interest on most municipal bonds is tax free on a federal level and tax free on a state level if the investor lives in the state of issuance. (Please note that capital gains or trading profits on these securities would still be taxable.) Municipal securities settle T+2 and pay accrued interest based on a 30-day month/360-day year.
Two categories of municipal securities exist: general obligation bonds and revenue bonds.
44
What are general obligation bonds?
municipal bonds issued for capital improvements that benefit the entire community. Typically, these projects do not produce revenues, so principal and interest must be paid by taxes collected by the municipal issuer. Because of this backing, GO bonds are known as full faith and credit issues and are backed by the municipality’s taxing power. Bonds issued by states are backed by income taxes, license fees, and sales taxes. Bonds issued by towns, cities, and counties are backed by property (ad valorem) taxes, license fees, fines, and all other sources of direct income to the municipality. School, road, and park districts may also issue municipal bonds backed by property taxes.
Finally, the amount of debt that a municipal government may incur can be limited by state or local statutes to protect taxpayers from excessive taxes. Debt limits can also make a bond safer for investors. The lower the debt limit, the less risk of excessive borrowing and default by the municipality. If an issuer wishes to issue GO bonds that would put it above its statutory debt limit, a public referendum is required. In this light, GO bonds are often associated with requiring voter approval.
45
What are revenue bonds?
type of municipal bond that can be used to finance any municipal facility that generates sufficient income. These municipal bonds are considered to be self-supporting debt because principal and interest payments are made exclusively from revenues generated by the project or facility for which the debt was issued, such as:
■ utilities (water, sewer, and electric);
■ housing (public housing projects);
■ transportation (airports, bridges, tunnels, and toll roads);
■ education (college dorms and student loans);
■ health (hospitals and retirement centers);
■ industrial (industrial development and pollution control); and
■ sports (stadium facilities).
Sometimes issued by authorities, which are quasi-governmental entities often tasked with building roads, tunnels, bridges, and other infrastructure. In many cases, a transit authority might own several bridges or tunnels. Bondholders must be aware that each bond may only be backed by a specific portion (not all) of the authority’s overall revenues that is earmarked for that bond issue.
Keeping in mind that these bonds are not supported by the issuers’ authority to tax, they are not subject to statutory debt limits and therefore do not require voter approval.
46
What are short term municipal obligations (anticipation notes)?
short-term securities that generate funds for a municipality that expects other revenues soon. Usually, municipal notes have less than 12-month maturities, although maturities may range from 3 months to 3 years. They are repaid when the municipality receives the anticipated funds. Municipal notes fall into several categories.
■ Municipalities issue tax anticipation notes (TANs) to finance current operations in anticipation of future tax receipts. This helps municipalities to even out cash flow between tax collection periods.
■ Revenue anticipation notes (RANs) are offered periodically to finance current operations in anticipation of future revenues from revenue producing projects or facilities.
■ Tax and revenue anticipation notes (TRANs) are a combination of the characteristics of both TANs and RANs.
■ Bond anticipation notes (BANs) are sold as interim financing that will eventually be converted to long-term funding through a sale of bonds.
■ Tax-exempt commercial paper is often used in place of BANs and TANs for up to 270 days, though maturities are most often 30, 60, and 90 days.
■ Construction loan notes (CLNs) are issued to provide interim financing for the construction of housing projects.
■ Variable rate demand notes have a fluctuating interest rate and are usually issued with a put option. This means the investor could periodically (e.g., weekly, monthly) return the security to the issuer for its stated value.
■ Grant anticipation notes (GANs) are issued with the expectation of receiving grant money from the federal government.
47
What are Build America Bonds (BABs)?
created under the Economic Recovery and Reinvestment Act of 2009 to assist in reducing costs to issuing municipalities and stimulating the economy. While bonds to fund municipal projects have traditionally been sold in the tax-exempt arena, BABs are taxable obligations. Bondholders pay tax on interest received from BABs, but tax credits are provided in lieu of the tax-exempt status usually afforded the interest on municipal securities. These bonds attracted investors who would normally not buy tax-exempt municipal bonds, and expanded the pool of investors to include those in lower-income tax brackets, investors funding retirement accounts where tax-free securities would normally not be suitable, public pension funds, and foreign investors. Two types of BABs are issued: tax credit BABs and direct payment BABs.
■ Tax credit BABs provide the bondholder with a federal income tax credit equal to 35% of the interest paid on the bond in each tax year. If the bondholder lacks sufficient tax liability to fully use that year’s credit, the excess credit may be carried forward.
■ Direct payment BABs provide no credit to the bondholder, but instead provide the municipal issuer with payments from the U.S. Treasury equal to 35% of the interest paid by the issuer.
48
What is a Section 529 Plan?
a specific type of education savings account available to investors. The plans allow money saved to be used for qualified expenses for K-12 and post-secondary education. Qualified expenses include tuition at an elementary or secondary public, private, or religious school for up to $10,000 per year. Because they are state sponsored, they are defined as a municipal fund security. As such, the sale of these plans must be accompanied or preceded by an official statement or offering circular (similar to a prospectus) in the same way other municipal securities sales would be.
There are two basic types of 529 plans: prepaid tuition plans for state residents and savings plans for residents and nonresidents. Prepaid plans allow resident donors to lock in current tuition rates by paying now for future education costs. The more popular option is the savings plan, which allows donors to save money to be used later for education expenses.
Any adult can open a 529 plan for a future college student. The donor does not have to be related to the student. (An adult student may also contribute to her own 529 plan.) With a 529 plan, the donor can invest a lump sum or make periodic payments. When the student is ready for college, the donor withdraws the amount needed to pay for qualified education expenses (e.g., tuition, room and board, and books).
Contributions, which are considered gifts under federal tax law, are made with after-tax dollars, and earnings accumulate on a tax-deferred basis. Withdrawals are tax free at the federal level if they are used for qualified education expenses. Most states permit tax-free withdrawals as long as the donor has opened an in-state plan. In addition, many states allow contributions into in-state plans to be tax deductible. Therefore, if one of your customers wishes to open an out-of-state plan, you must advise the customer that certain tax advantages, such as the one just noted, may not be available to out-of-state donors.
If a beneficiary does not need the funds for school, there are no tax consequences if the donor changes the designated beneficiary to another member of the family. For example, if one child gets a full scholarship, a parental donor can roll funds from that child’s 529 plan into a sibling’s plan without penalty.
Other relevant points regarding Section 529 plans are as follows.
■ Overall contribution levels can vary from state to state.
■ Assets in the account remain under the donor’s control, even after the student becomes of legal age.
■ There are no income limitations on making contributions to a 529 plan.
■ Plans allow for monthly payments if desired by the account owner.
■ Account balances left unused may be transferred to a related beneficiary.
■ Rollovers are permitted from one state’s plan to another state’s plan, but no more than once every 12 months.
49
What is a local government investment pool (LGIP)?
Established by states to provide other government entities, such as cities, counties, school districts, or other state agencies, with a short-term investment vehicle to invest funds.
Generally formed as a trust in which municipalities can purchase shares or units in the LGIP’s investment portfolio.
While not a money market fund, most LGIPs operate similar to one. For instance, an LGIP may be permitted to maintain a fixed $1 net asset value (NAV). Maintaining a stable NAV, similar to a money market mutual fund, facilitates liquidity and minimum price volatility.
Not required to register with the SEC and are not subject to the SEC’s regulatory requirements, given that LGIPs fall within the governmental exemption, just as municipal securities do. Therefore, investment guidelines and oversight for LGIPs can vary from state to state.
With no SEC registration required, there is no prospectus. However, LGIP programs do have disclosure documents, which generally include information statements, investment policy, and operating procedures. The information statement typically details the management fees associated with participation in the LGIP.
50
What are Achieving a Better Life Experience (ABLE) accounts?
tax-advantaged savings accounts for individuals with disabilities and their families. They were created as a result of the passage of the ABLE Act of 2014. The beneficiary of the account is the account owner, and income earned by the accounts is not taxed.
The ABLE Act limits eligibility to individuals with significant disabilities where the age of onset of the disability occurred before turning age 26. In this light, remember that one need not be under the age of 26 to be eligible to establish an ABLE account. One could be over the age of 26, but as long as the onset of the disability occurred before age 26, one is eligible to establish an ABLE account.
If an individual meets the age/onset criteria and is also receiving benefits either through Social Security insurance (SSI) and/or Social Security disability insurance (SSDI), he is automatically eligible to establish an ABLE account. Only one ABLE account per person is allowed.
Contributions to these accounts, which can be made by any person including the account beneficiary themselves, as well as family and friends, must be made using after-tax dollars and is not tax deductible for purposes of federal income taxes. Some states, however, do allow income tax deductions for contributions made to an ABLE account. Contributions by all participating individuals are limited to a specified dollar amount per year, which may be adjusted periodically to account for inflation.
51
What is the difference between the capital market and the money market?
The capital market serves as a source of intermediate-term to long-term financing, usually in the form of equity or debt securities with maturities of more than one year.
The money market, on the other hand, provides very short-term funds to corporations, banks, BDs, government municipalities, and the U.S. federal government.
Money market instruments are fixed-income (debt) securities with short-term maturities, typically one year or less. Because of their short-term maturities, they are considered to be highly liquid. These securities also provide a relatively high degree of safety. Consider that because they are short term, they have little time to default. In return for the safety, investors forgo a higher return for the lower returns generally associated with money market securities.
Finally, investors who purchase money market securities generally do not receive interest payments; instead, these securities are typically issued at a discount and mature at face value. The return is the difference between the discounted purchase price and the face value received at maturity.
52
What is a certificate of deposit (CD)?
Banks issue and guarantee these with fixed interest rates and minimum face values of $100,000 (jumbo CDs), although face values of $1 million or more are common. Most mature in one year or less. Some that can be traded in the secondary market are known as negotiable CDs. Only these negotiable CDs are considered to be money market instruments.
A negotiable CD is a bank’s version of an unsecured promissory note in the same way commercial paper is for corporations. In other words, it is a bank’s promise to pay principal and interest—secured by no physical asset and backed only by the bank’s good faith and credit.
53
What is a banker’s acceptance (BA)?
a short-term time draft with a specified payment date drawn on a bank. Essentially, it is a postdated check or line of credit. The payment date of is normally between 1 and 270 days (nine months). Corporations use these extensively to finance international trade; that is, a BA typically pays for goods and services in a foreign country.
54
What is a commercial paper?
Also known as a prime paper or promissory note. Corporations issue short-term, unsecured promissory notes, to raise cash to finance accounts receivable and seasonal inventory gluts. Maturities range from 1 to 270 days, although most mature within 90 days. Typically, companies with excellent credit ratings issue commercial paper.
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What is a repurchase agreement (repo)?
financial institution, such as a bank or BD, raises cash by temporarily selling some of the securities it holds with an agreement to buy back the securities at a later date at a slightly higher price. Thus, a repo is an agreement between a buyer and a seller to conduct a transaction (sale), and then to reverse that transaction (repurchase) in the future. The contract would include the repurchase price and a maturity date.
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What is a reverse repurchase agreement or reverse repo?
A dealer agrees to buy securities from an investor and sell them back later at a higher price.
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What are federal funds?
Any deposits in excess of the amount that the FRBs member banks are required to keep on reserve at the FRB. These excess reserves (federal funds) can be loaned from one member bank to another for the purpose of meeting the reserve requirement. These loans are very short term, and in most cases, can literally occur overnight.
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Why would you place money market securities in a client’s account?
■ Highly liquid
■ Very safe
■ A good place to invest money that will be needed soon (short term)
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What are the risks of using money market securities?
■ Because of their many advantages, the rate of return is quite low, so these are not suitable for long-term investors.
■ Due to short-term maturities, principal is potentially being reinvested at a different rate each time the instrument matures (short intervals). In this light, not only is income minimal, but also it will fluctuate with each new instrument purchased.
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What is an option contract?
derivative securities. This means that they derive their value from that of an underlying instrument, such as a stock, stock index, interest rate, or foreign currency. They offer investors a means to hedge, or protect, an investment’s value or speculate on the price movement of individual securities, markets, foreign currencies, and other instruments.
Two parties are involved in the contract—one party has the right to exercise the contract to buy or sell the underlying security, and the other is obligated to fulfill the terms of the contract. The amount paid for the contract when purchased, or received for the contract when it is sold, is called the contract premium.
Can be created on any item with a fluctuating market value. The most familiar are those issued on common stocks; they are called equity options.
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Who is the buyer Or owner of an options contract?
The person who pays the premium for the contract. Also referred to as the holder, or party who is long the contract. This person has the right to exercise the contract but risk losing the premium paid for the contract if the option expires worthless.
Begins the process with an opening purchase of the contract. If they decide to sell the contract later, the second transaction is referred to as a closing sale.
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Who is the seller or writer of the options contract?
The person who receives the premium for the contract. Also referred to as the party who is short the contract. Will be obligated to perform if the buyer chooses to exercise the contract. Can potentially profit by the amount of premium received for the contract if the option expires worthless. Begin the process with an opening sale of the contract. If they decide to buy back the contract later, the second transaction is referred to as a closing purchase.
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What is a long call (Purchase)?
A call buyer owns the right to buy 100 shares of a specific stock at the strike price before the expiration if he chooses to exercise the contract. Therefore, a call buyer is a bullish investor (one who anticipates the price of the underlying security will rise).
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What is a short call (sale)?
A call writer (seller) has the obligation to sell 100 shares of a specific stock at the strike price if the buyer exercises the contract. Therefore, a call writer is a bearish investor (one who anticipates the price of the underlying security will fall).
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What is a long put (purchase)?
A put buyer owns the right to sell 100 shares of a specific stock at the strike price before the expiration if he chooses to exercise the contract. Therefore a put buyer is a bearish investor because he wants the price of the underlying security to fall.
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What is a short put (sale)?
A put writer (seller) has the obligation to buy 100 shares of a specific stock at the strike price if the buyer exercises the contract. Therefore, a put writer is a bullish investor because he wants the price of the underlying security to rise or remain unchanged.
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What is an index option?
tracks the performance of a particular group of stocks such as the S&P 500 Index or Dow Jones Industrial Average (DJIA). If an index option is exercised, no delivery of the underlying shares is made. Instead, the writer pays the options owner the differential in cash.
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What are VIX options?
An Index designed to measure expected volatility of the U.S. stock market and is based on pricing from the S&P 500 Index. Investors use these options to speculate on volatility of the equity markets. Often referred to as the fear index, and tends to spike upward when the stock market experiences a severe downdraft. These options settle in cash with European exercise provisions.
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When is a call in the money?
when the price of the stock exceeds the strike price of the call. A buyer will exercise calls that are in the money at expiration. Buyers want options to be in the money; sellers do not.
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When is a call at the money?
when the price of the stock equals the strike price of the call. A buyer will not exercise contracts that are at the money at expiration. Sellers want at-the-money contracts at expiration; buyers do not. Sellers then keep the premium without obligations to perform.
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When is a call out of the money?
When the price of the stock is lower than the strike price of the call. A buyer will not exercise calls that are out of the money at expiration. Sellers want contracts to be out of the money; buyers do not. Sellers then keep the premium without obligations to perform.
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What is the intrinsic value of a call?
the same as the amount a contract is in the money. A call has intrinsic value when the market price of the stock is above the strike price of the call. Options never have negative intrinsic value; intrinsic value is always a positive amount or zero. Options that are at the money or out of the money have an intrinsic value of zero. Buyers like calls to have intrinsic value; sellers (writers) do not. A call that has intrinsic value at expiration will be exercised by the buyer. A call that has no intrinsic value will simply be allowed to expire.
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When is a call or put value at parity?
when the premium equals intrinsic value.
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When is a put in the money?
when the price of the stock is lower than the strike price of the put. A buyer will exercise puts that are in the money at expiration. Buyers want in- the-money contracts; sellers do not.
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When is a put at the money?
when the price of the stock equals the strike price of the put. A buyer will not exercise contracts that are at the money at expiration. Sellers want at-the-money contracts; buyers do not.
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When is a put out of the money?
when the price of the stock is higher than the strike price of the put. A buyer will not exercise puts that are out of the money at expiration. Sellers want out-of-the-money contracts; buyers do not.
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When is a put at the money?
when the price of the stock equals the strike price of the put. A buyer will not exercise contracts that are at the money at expiration. Sellers want at-the-money contracts; buyers do not.
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What is the intrinsic value of a put?
the same as the amount a contract is in the money. A put has intrinsic value when the market price of the stock is below the strike price of the put. Remember that options never have negative intrinsic value; it is always a positive number or zero. Buyers like options to have intrinsic value; sellers do not. A put that has intrinsic value at expiration will be exercised. A put that has no intrinsic value at expiration will simply be allowed to expire.
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What is the options clearing corporation?
The clearing agent for listed options contracts—that is, those listed for trading on U.S. options exchanges. Its primary functions are to standardize, guarantee the performance of, and issue option contracts. It determines when new option contracts should be offered to the market on an underlying security. It designates the contract specifications such as strike prices and expiration months for new contracts utilizing standards to maintain uniformity and liquidity. The following are some standards and characteristics of listed option contracts.
■ Trading times—Listed options trade from 9:30 am—4:00 pm ET.
■ Settlement—Listed options settle on the next business day after trade date (T + 1).
■ Expiration—Listed options expire on the third Friday of the expiration month at 11:59 pm.
■ Exercise—Listed options can be exercised by the owner from the time of purchase until they expire. The exercise process is guaranteed by the OCC. If a holder of an option wishes to exercise his contract, his BD notifies the OCC.
■ Automatic exercise—Any contract that is in the money by at least .01 will be exercised automatically at expiration for the holder unless the holder gives “do not exercise” instructions.
■ Assignment—When the OCC receives an exercise notice, it assigns the exercise notice to a short BD; that is, one who has a customer who is short the contract. The short BD assigns a short customer who is now obligated to perform (buy or sell the stock at the strike price).
The OCC assigns exercise notices to short BDs on a random basis. BDs may then assign exercise notices to their short customers on a random basis, on a first-in, first-out (FIFO) basis, or any other method that is fair and reasonable.
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What documents are required by the OCC to open options accounts?
The OCC Options Disclosure Document (ODD) must be provided at or before the time the account approval. This document explains options strategies, risks, and rewards, and is designed to provide full and fair disclosure to customers before they begin options trading.
Before any trading can take place, an options account must be approved. Initially, it can be approved by a branch office manager (BOM), but then promptly thereafter, it must be approved by a Registered Options Principal (ROP) of the firm.
Then, not later than 15 days after the account approval, the customer must return the signed options agreement. This document states that the customer has read the ODD, understands the risks of options trading, and will honor all rules regulations regarding options trading. By signing, the customer also agrees to advise the firm if any changes occur in his financial situation, investment objectives, and so forth that would impact whether or not the account should still be approved for options trading.
If the signed options agreement is not returned within 15 days of account approval, the investor cannot open new options positions. Only closing transactions are allowed if the options agreement is not returned as required.
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What is a covered option?
the writer already owns the underlying security. This ensures the writer’s ability to perform (deliver), should the owner exercise the contract.
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What is an uncovered (naked) option?
the writer does not own the underlying security. If the contract is exercised by the owner, the writer will need to purchase the underlying security at the current market price to deliver it.
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What is an investment company?
corporation or trust that pools investors’ money and then invests that money in securities on their behalf. Investors are able to pool their money and have the investment company invest it based on a clearly defined objective such as growth or income. By investing these pooled funds as a single large account, jointly owned by every investor in the company, the investment company is able to invest in many different securities and therefore reduce the overall risk associated with investing in only one or a few. These pooled investments can total hundreds of millions or even billions of dollars. They are very popular investment vehicles, as it is common for them to allow minimum investments of perhaps only $100 or even less.
Like corporate issuers, investment companies raise capital by selling shares to the public. Investment companies must abide by the same registration and prospectus requirements imposed by the Securities Act of 1933 on other issuers. Investment companies are subject to regulations regarding how their shares are sold to the public, and they are regulated by the Investment Company Act of 1940.
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What are the three types of investment companies classified in the investment company act of 1940?
face-amount certificate (FAC) companies, unit investment trusts (UITs), and management investment companies.
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What types of investments do Face Account Certificate (FAC) companies issue?
A contract between an investor and an issuer in which the issuer guarantees payment of a stated (face amount) sum to the investor at some set date in the future. In return for this future payment, the investor agrees to pay the issuer a set amount of money either as a lump sum or in periodic installments. If the investor pays for the certificate in a lump sum, the investment is known as a fully paid FAC.
Does not trade in the secondary market. Redeemable only through an issuer. Not managed—once portfolio is composed it does not change.
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What is a unit investment trust (UIT) company?
an investment company organized under a trust indenture. UITs do not have boards of directors (they have trustees).
UITs create a portfolio of debt or equity securities designed to meet the company’s objectives. They then sell redeemable interests, also known as units or shares of beneficial interest, in their portfolio of securities. Each share is an undivided interest in the entire underlying portfolio.
A UIT may be fixed or nonfixed. A debt-fixed UIT typically purchases a portfolio of bonds and terminates when the bonds in the portfolio mature. An equity-fixed UIT purchases a portfolio of stocks and, because stocks don’t have a maturity date, terminates at a pre- determined date. Since a fixed UIT’s portfolio is static, there is no need for active management and little or no portfolio turnover. UITs do not generally assess management fees since there is no need to hire an investment adviser to monitor and trade positions within the portfolio. A nonfixed UIT purchases shares of an underlying mutual fund.
Does not trade in the secondary market. Redeemable only through an issuer. Not managed—once portfolio is composed it does not change.
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What is a managed investment company?
actively manages a securities portfolio to achieve a stated investment objective.
Can be either closed end or open end. Both closed- and open-end companies sell shares to the public in an initial public offering (IPO); the primary difference between them is that a closed-end company’s initial offering of shares is limited (it closes after a specific authorized number of shares have been sold) and an open-end company is perpetually offering new shares to the public (it is continually open to new investors).
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What is a closed end investment company?
A company that will raise capital for its portfolio by conducting a common stock offering, much like any other publicly traded company that raises capital to invest in its business. In the initial offering, the company registers a fixed number of shares with the SEC and offers them to the public with a prospectus for a limited time through underwriters. Once all the shares have been sold, the fund is closed to new investors. Many times, a fund elects to be a closed-end company because the sector in which it intends to invest has a limited amount of securities available. Closed-end investment companies may also issue bonds and preferred stock.
often called publicly traded funds. After the stock is sold in the initial offering, anyone can buy or sell shares in the secondary market (i.e., on an exchange or OTC) in transactions between private investors. Supply and demand determine the bid price (price at which an investor can sell) and the ask price (price at which an investor can buy). Closed-end fund shares may trade above (at a premium to) or below (at a discount to) the shares’ NAV. Simply put, the fund’s NAV is its assets minus its liabilities. The NAV per share is the fund’s NAV divided by the number of outstanding shares.
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What are open end investment companies?
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Also called mutual funds. Only issues one class of security, which is common stock (no preferred shares or bonds). It does not specify the exact number of shares it intends to issue but registers an open offering with the SEC. In other words, mutual funds conduct a continuous primary offering of common stock. With this registration type, they can raise an unlimited amount of investment capital by continuously issuing new shares.
When investors want to sell their holdings in a mutual fund, the fund itself redeems those shares at the fund’s current NAV. In this respect, mutual fund shares are like FACs and UITs in that they do not trade in the secondary market. When an investor sells shares back to the fund (the fund is redeeming the shares), the fund sends the investor money for the investor’s proportionate share of the fund’s net assets. Therefore, a mutual fund’s capital shrinks when investors redeem shares but so does the number of outstanding shares; the value of each share does not fall as a result of the redemption. When a client acquires mutual fund shares, she pays the current public offering price (POP).
Mutual funds are priced at the end of each business day, with sellers receiving the next calculated NAV and buyers paying the next calculated POP. All transition requests must be entered by 4:00 pm. Any requests to buy or sell that are entered after 4:00 pm will receive the next business day’s NAV or POP. For example, a seller who places an order after the close (4:00 pm ET on Friday) will receive Monday’s NAV when liquidating her shares.
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What is an annuity?
an insurance contract designed to provide retirement income. The term refers to a stream of payments guaranteed for some period of time. That might be for the life of the annuitant, until the annuitant reaches a certain age, or for a specific number of years. The actual amount to be paid out may or may not be guaranteed, but the stream of payments itself is. Because an annuity can provide an income for the rest of someone’s life, the contract has a mortality guarantee. When you think about a retiree’s greatest fear, it is typically outliving his income. This product can take away that fear.
Insurance companies introduced the variable annuity as an opportunity to keep pace with inflation. For this potential advantage, the investor assumes the investment risk rather than the insurance company. Because the investor takes on this risk, the product is considered a security. Individuals who are both insurance licensed and securities licensed are eligible to sell variable insurance products. These contracts also include the death benefit. Beneficiaries will receive greater of contribution amount or current value if the owner dies during the accumulation period.
The premium payments for variable annuities are invested in what is called the separate account. The separate account comprises various subaccounts that behave like the diversified portfolios of mutual funds (we just can’t call them mutual funds). These accounts will have various objectives to choose from such as growth, income, and growth and income. The returns in the separate account are not guaranteed, and therefore, a loss of principal is possible.
If the investment manager of an insurance company is responsible for selecting the securities to be held in the separate account, the separate account is directly managed and must be registered under the Investment Company Act of 1940 as an open-end management investment company. However, if the investment manager of the insurance company passes the portfolio management responsibility to another party, the separate account is indirectly managed and must be registered as a UIT under the Investment Company Act of 1940.
All fees directly related to the product must be disclosed to a variable annuity buyer. These product-specific charges include administrative fees, investment advisory fees, and custodial fees. Buyers must also be made aware of any surrender charges associated with the product.
There is no limit to the annual contribution amounts on commercial (nonqualified) contracts. Qualified variable contracts used in some employer-sponsored retirement plans are funded with pretax contributions, but these are limited to annual maximums similar to those found in 401(k) plans.
A fixed annuity simply promises a stated rate of return. Therefore, it is the insurance company who is at risk to provide the rate of return it promised. The investor assumes no investment risk with a fixed annuity. With no investment risk for the investor to shoulder, the product is not considered to be a security.
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What is a mutual (open end) fund?
a pool of investors’ money invested in various securities as determined by the fund’s stated investment objective.
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What are redeemable securities?
Securities that do not trade in any secondary market, such as mutual funds. Contains terms allowing the holder, upon its presentation to the issuer or to a person designated by the issuer, is entitled (whether absolutely or only out of surplus) to receive approximately his proportionate share of the issuer's current net assets, or the cash equivalent thereof.
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What are 11 characteristics of mutual funds?
1. A professional investment adviser manages the portfolio for investors.
2. Mutual funds provide diversification by investing in different companies or securities.
3. Most funds allow a minimum investment, often $500 or less to open an account, and they allow additional investment for as little as $25.
4. An investment company may allow investments at reduced sales charges based on the amount of the investment.
5. An investor retains voting rights similar to those extended to common stockholders, such as the right to vote for changes in the board of directors (BOD), approval of the investment adviser, changes in the fund’s investment objective, changes in sales charges, and liquidation of the fund.
6. Mutual funds must offer reinvestment of dividends and capital gains at NAV (without a sales charge), but these reinvestments are taxable.
7. An investor may liquidate a portion of his holdings without disturbing the portfolio’s balance or diversification.
8. Tax liabilities for an investor are simplified because each year, the fund distributes a Form 1099 explaining taxability of distributions.
9. A fund may offer various withdrawal plans that allow different payment methods at redemption.
10. Funds may offer reinstatement provisions that allow investors who withdraw funds to reinvest up to the amount withdrawn within 30 days with no new sales charge. This provision must be in the prospectus, and is available one time only.
11. Many mutual funds are part of a related (branded) family of funds or mutual fund complex. Switches between funds in the same family are taxable events.
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What are Class A shares?
Share of a mutual fund with front-end sales charges (loads). The sales charges are paid at the time an investor buys shares and the sales charge is taken from the total amount invested. Front-end loads are the most common way of paying for mutual fund shares.
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What are Class B shares?
Mutual fund shares that have a back-end sales load, also called a contingent deferred sales charge (CDSC). A back-end sales charge is paid at the time an investor sells shares previously purchased (has them redeemed). The sales load, a declining percentage charge reduced annually (e.g., 8% the first year, 7% the second, 6% the third), is applied to the proceeds of any shares sold in that year. The back-end load is usually structured so that it drops to zero after an extended holding period—usually no longer than five years. At that time, the shares are converted to Class A shares, and no sales charge would be applied at the time of redemption.
While it might seem appealing to pay sales charges later—at the time of redemption instead of at the time of purchase as with A shares—it must be considered that if the shares grow in value as one hopes they will, the sales charges will be paid on amounts that are greater than the amount initially invested. This means that if the shares aren’t held long enough to have the sales charge dissipate to zero, the sales charges can be costly as redemptions take place over time.
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What are Class C (level-load) shares?
Mutual fund shares that typically have a one-year, 1% contingent deferred sales charge (CDSC), a .75% 12b-1 fee (fees used to promote the fund discussed later), and a .25% shareholder services fee. Because these fees never go away, C shares are commonly referred to as having a level load. Class C shares are appropriate for investors who have short time horizons because the annual charges make them expensive to own if investing for more than four to five years.
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What are no load shares?
Mutual fund shares marketed directly to the public, eliminating the need for underwriters and thus the sales charges used to compensate them. As the name no load implies, the fund does not charge any type of sales charge and are purchased at NAV. However, not every type of fee passed on to shareholders is considered to be a sales charge. No-load funds are permitted to charge fees that are not considered sales charges, such as purchase fees, account fees, exchange fees, and redemption fees. Although a redemption fee is deducted from redemption proceeds just like a deferred sales load, it is not considered to be a sales load as it is generally much smaller and often a fixed dollar amount instead of a percentage of the redemption.
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What is market timing?
short-term buying and selling of mutual fund shares to take advantage of inefficiencies in pricing. Market timing can harm long-term mutual fund shareholders because it can dilute the value of their shares. While not illegal per se, market timing is prohibited by the vast majority of mutual funds. Consider that mutual fund investments are intended to be best suited for investors with longer-term investment time horizons, and in fact, have sales charges structured this way. They are not intended to be investments where day- trading (trading in and out of a security many times over a short time period) or market timing should be the investment strategy of the investor purchasing mutual fund shares.
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How is the value of a mutual fund share determined?
To calculate the net asset value (NAV) of a fund share, the fund starts with its total assets and subtracts out its total liabilities: total assets – total liabilities = total NAV of the fund.
The fund then divides the total net assets by the number of shares outstanding. This gives the NAV per share: NAV of the fund / shares outstanding = NAV per share.
The NAV of a fund share is the amount the investor receives upon redemption. It must be calculated at least once per business day. A typical fund calculates its NAV at the end of each business day. The price the customer receives is the next NAV calculated after receipt of his redemption request. This practice is known as forward pricing; we always have to wait until the next available calculation to determine the value of shares redeemed or, for that matter, the number of shares purchased.
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What is forward pricing?
Waiting until the next available calculation to determine the value of shares redeemed or, for that matter, the number of shares purchased. This is used in mutual fund redemptions. The price the customer receives is the next NAV calculated after receipt of his redemption request and a fund typically calculates its NAV at the end of each business day.
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What is the public offering (POP) of a fund (purchase price of a fund share)?
For the class of fund shares known as front-end loaded shares, it is simply the NAV plus the sales charge: NAV + SC = POP.
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What is a mutual fund prospectus?
This is the full and fair disclosure document that provides a prospective investor with the material information needed to make a fully informed investment decision. If using a prospectus to solicit a sale, it must be distributed to an investor before or during the solicitation. The front of a mutual fund prospectus must contain key information to appear in plain English in a standardized order. Information in this clear and concise format includes the fund’s objective, investment policies, sales charges, management expenses, and services offered. It also discloses 1-, 5-, and 10-year performance histories, or performance over the life of the fund, whichever is shorter.
The delivery of any type of sales literature is considered a solicitation of sale and therefore must be accompanied or preceded by the delivery of a prospectus. A prospectus may never be altered in any way (no highlighting, underlining, writing comments, trying to attract attention to a particular section, etc.)
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What is a summary prospectus?
standardized summary of key information on the fund’s full or final prospectus, sometimes referred to as the fund’s statutory prospectus. Investors who receive the summary have the option of either purchasing fund shares using the application found therein or requesting a full (statutory) prospectus. An investor who purchases fund shares on the basis of the summary prospectus must be able to access a full prospectus no later than the confirmation of the sale. Delivery may be made online.
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What are requirements of a summary prospectus?
The following must be included on the cover page or at the beginning:
1. The fund’s name and the class or classes of shares
2. The exchange ticker symbol for the fund’s shares; and if the fund is an exchange-traded fund (ETF), identification of the principal U.S. market or markets on which the fund shares are traded
3. A legend which must appear on the cover page that refers to the summary nature of the prospectus and the availability of the fund’s full (statutory) prospectus; the legend must provide a toll-free number to request paper delivery of prospectus or a website where one may be downloaded.
***must also provide specific information in a particular sequence such as investments, risks, and performance; fee tables; investment objectives, investment strategies, and any related risks; the portfolio holdings and details regarding management; shareholder information; and any financial highlights.***
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What is a statement of additional information (SAI)?
Mutual funds (open end) as well as closed- end funds are required to have this available for delivery within three business days of an investor’s request without charge. Investors can obtain a copy of the SAI by calling or writing to the investment company or by contacting a BD that sells the investment company shares, or by contacting the Securities and Exchange Commission (SEC).
While a prospectus is always sufficient for the purpose of selling shares, some investors may seek additional information not found in the prospectus. This additional information is not considered mandatory to make an informed investment decision, but may be useful to the investor.
The SAI affords the fund an opportunity to have expanded discussions on matters such as the fund’s history and policies. It will also typically contain the fund’s consolidated financial statements, including:
■ the balance sheet;
■ statement of operations;
■ an income statement; and
■ a portfolio list at the time the SAI was compiled.
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What additional disclosures are required by the SEC in a funds prospectus or annual reports?
1. a discussion of factors and strategies that materially affected its performance during its most recently completed fiscal year;
2. a line graph comparing its performance to that of an appropriate broad-based securities market index; and
3. the name(s) and title(s) of the person(s) primarily responsible for the fund portfolio’s day- to-day management.
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What must the semiannual financial reports distributed to shareholders contain (as required by the Investment Company Act of 1940)?
1. the investment company’s balance sheet;
2. a valuation of all securities in the investment company’s portfolio as of the date of the bal-
ance sheet (a portfolio list);
3. the investment company’s income statement;
4. a complete statement of all compensation paid to the BOD and to the advisory board; and
5. a statement of the total dollar amount of securities purchased and sold during the period.
**Note, an investment company must also send a copy of its balance sheet to any shareholder who requests one in writing.***
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What services do mutual funds provide that incur costs and fees?
retirement account custodianship, investment plans, check-writing privileges, transfers by telephone or online, withdrawal plans, and numerous other services and privileges.
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What is any funds greatest expense?
The fund portfolio management fee. Paid to those hired to manage the investments in the fund portfolio, it is calculated as a percentage of assets under management. Charged as a percentage of funds assets.
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What is a 12b-1 asset based fee From Section 12b-1 of the Investment Company Act of 1940?
permits a mutual fund to collect a fee for promoting, selling, or undertaking activity in connection with the distribution of its shares. The fee is determined annually as a flat dollar amount or as a percentage of the fund’s average total NAV during the year, and is charged quarterly. The fee must be disclosed in the fund’s prospectus.
Typically, these 12b-1 fees are associated with no-load fund companies; however, if the fee is more than .25% of the average net assets, the fund may not use the term no-load to describe itself.
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What is a fund’s expense ratio?
It compares the management fees and operating expenses, including any 12b-1 fees, with the fund’s net assets. All mutual funds, both load and no load, have expense ratios. The expense ratio is calculated by dividing a fund’s expenses by its average net assets. This is a way for investors to compare one fund’s expense charges to another.
Average is between 1% and 1.5% of a fund’s average net assets. Typically, more aggressive funds—perhaps those employing more sophisticated or risky investment strategies—have higher expense ratios. For bond (debt) funds, the ratio is typically between .5% and 1%, a bit lower than stock funds.
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What are the advantages/disadvantages of non-U.S. market securities?
most are structured for long-term capital appreciation. Generally, the advantage for an investor is the ability to add worldwide diversification to one’s investment portfolio.
While the funds themselves are U.S. securities and would be considered to be liquid and so on, the securities in the fund portfolio wouldn’t be U.S. securities. Those securities within the portfolio could be subject to political forces, currency risk, and liquidity risk.
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What are direct participation programs (DPPs)?
unique forms of business that raise money to invest in real estate, oil and gas, equipment leasing, and other similar business ventures. DPPs are not taxed directly as a corporation would be; instead, the income or losses are passed directly through to the owners of the partnership—the investors. The investors are then individually responsible for satisfying any tax consequences.
There is virtually no secondary market for an investor to divest interest in a DPP, and in this regard, DPPs are considered highly illiquid. Therefore, on the point of liquidity alone, they are not suitable for many investors.
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What are real estate DPPs?
can invest in raw land, new construction, or existing properties. Depending on the properties held by the program, they can provide investors with the following benefit opportunities:
■ Capital growth potential—achieved through appreciation of property
■ Cash flow (income)—collected from rents
■ Tax deductions—from mortgage interest expense and depreciation allowances for “wearing out the building” and capital improvements
■ Tax credits—for government-assisted housing and historic rehabilitation (tax credits are very strong incentives as they reduce tax liability dollar for dollar)
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What are oil and gas DPPs?
include speculative or exploratory (wildcatting) programs to locate new oil deposits (generally considered the riskiest developmental programs that drill near existing producing wells in hopes of locating new deposits) and income programs that invest in producing wells (generally considered the least risky). Unique tax advantages associated with these programs include the following.
■ Intangible drilling costs (IDCs)—These are costs associated with drilling, such as wages, supplies, fuel, and insurance that have no salvage value when the program ends. These IDCs can be written off (deducted) in full in the first year of operation. In contrast, tangible drilling costs are associated with items that have some salvage value at the end of the program, such as drilling equipment. These types of tangible costs, instead of being immediately deductible, are deductible over several years. The deduction is taken as depreciation. In other words, each year, the asset is worth a little less, and that depreciated amount can now be deducted.
■ Depletion allowances—These are tax deductions that compensate the program for the decreasing supply of oil or gas (or any other resource or mineral) after it is taken out of the ground and sold.
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What is an equipment leasing program DPP?
created when DPPs purchase equipment leased to other businesses. This type of equipment can be as far ranging as jetliners or railcars leased to airlines and railroads, trucks leased to shipping companies, or computers leased to any business in need of them. Investors receive income from lease payments as well as a proportional share of write-offs from operating expenses, interest expense, and depreciation of the actual equipment owned by the program. The primary investment objective of these programs is tax-sheltered income (the income being sheltered by the write-offs).
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What is a limited partnership DPP?
investment opportunities that permit the economic consequences of a business to flow or pass through to investors. The businesses themselves are not tax-paying entities. These programs pass through to investors a share in the income, gains, losses, deductions, and tax credits of the business entity. The investors (partners) would then have the responsibility to report individually to the IRS.
The greatest disadvantage to limited partners is the lack of liquidity in the partnership interest. The secondary market for LP interests is extremely limited; investors who wish to sell their interests frequently cannot locate buyers (i.e., interest in the business is not freely transferable).
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What types of partners are involved in an LP DPP?
the general partner and the limited partner. An LP must have at least one of each. Property in these partnerships is usually held in the form of a tenants in common (TIC), which provides limited liability and no management responsibilities to the limited partners.
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What is a real estate investment trust?
a company that manages a portfolio of real estate, mortgages, or both to earn profits for shareholders. REITs pool capital in a manner similar to an investment company but are not investment companies, neither open nor closed end. Shareholders receive dividends from investment income or capital gains distributions. REITs normally:
■ own commercial property (equity REITs);
■ own mortgages on commercial property (mortgage REITs); or
■ do both (hybrid REITs).
REITs are organized as trusts in which investors buy shares or certificates of beneficial interest, either on stock exchanges or in the OTC market.
Under the guidelines of Subchapter M of the Internal Revenue Code, a REIT can avoid being taxed as a corporation by receiving 75% or more of its income from real estate and distributing 90% or more of its net investment income to its shareholders.
* *Important points:
1. An owner of REITs holds an undivided interest in a pool of real estate investments.
2. REITs may or may not be registered (public or private) with the SEC.
3. REITs may or may not be listed (trade) on exchanges.
4. REITs are not investment companies (open end or closed end).
5. REITs offer dividends and gains to investors but do not pass through losses like LPs, and therefore are not considered to be DPPs.
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What are exceptions to the definition of being an investment company under the investment company act of 1940?
As long as they are not classified as FAC companies, UITs, or management companies (open end or closed end). These companies are commonly known as private investment companies. Some private investment companies can be what are known as hedge funds. These companies are considered to be unregulated since they do not have to be registered with the SEC.
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What are common strategies employed by hedge funds?
■ highly leveraged portfolios (borrowing to purchase securities);
■ the use of short positions (selling securities the portfolio does not own);
■ the utilization of derivative products such as options and futures;
■ currency speculation;
■ commodity speculation; and
■ the investment in politically unstable international markets.
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What are exchange traded products?
securities that trade intraday on a national securities exchange, and are priced so the value of the product is derived from other investment instruments, such as a commodity, a currency, a share price, or an interest rate. Generally, these types of products are benchmarked to stocks, commodities, or indices. They can be actively or passively managed portfolios.
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What are exchange traded funds?
an equity security, invests in a specific group of stocks and generally does so to mimic a particular index, such as the S&P 500. In this way, an ETF is similar to a mutual fund that tracks an index. The difference is that the ETF trades like a stock on the floor of an exchange and, in regard to how it trades, is similar to a closed- end investment company rather than an open-end mutual fund. They are registered however, as either an open-end fund or as a UIT, but are obviously different in many ways.
Because of the way they trade, an investor can take advantage of intraday price changes due to normal market forces, rather than just the underlying value of the stocks in the portfolio. And, unlike mutual funds, ETFs can be purchased on margin and sold short.
Expenses tend to be lower than those of mutual funds, and the management fee is low as well. Consider that the portfolio is designed to track an index, and just as the securities contained in the index are unlikely to change, so are the securities in the fund portfolio. In other words, there is little trading activity required to keep the fund securities aligned with those in the index it is intended to track. This generally results in greater tax efficiency for the investor.
On the other hand, every time a person purchases or sells shares, there is a commission, and those charges can add up over time.
Understanding that ETF shares are not mutual fund shares, but are registered as open-end funds, it should be expected and is common that they are often compared to mutual fund shares. In that light, ETFs have some advantages and disadvantages to be considered when compared to open-end mutual funds.
The following are some advantages of ETFs when compared to open-end mutual funds.
■ Pricing and ease of trading—Since individual ETF shares are traded on exchanges, they can be bought or sold anytime during the trading day at the price they are currently trading at as opposed to mutual funds, which use forward pricing and are generally priced once at the end of the trading day.
■ Margin—ETFs can be bought and sold short on margin like other ETPs. Mutual funds cannot be bought on margin, nor can they be sold short.
■ Operating costs—ETFs traditionally have operating costs and expenses that are lower than most mutual funds.
■ Tax efficiency—ETFs can and sometimes do distribute capital gains to shareholders like mutual funds do, but this is rare. Understanding that these capital gains distributions are not likely, there are no further tax consequences with ETF shares until investors sell their shares. This may be the single greatest advantage associated with ETFs.
The following are some disadvantages of ETFs when compared to open-end mutual funds.
■ Commissions—The purchase or sale of ETF shares is a commissionable transaction. The commissions paid can erode the low expense advantage of ETFs. This would have the greatest impact when trading in and out of ETF shares frequently or when investing smaller sums of money.
■ Overtrading—Given the ability to trade in and out of ETFs easily, the temptation to do so is possible. Excessive trading can eliminate the advantages associated with investing in a diversified portfolio and add to overall commissions being paid by the investor, further eroding any of the other expense and operating cost advantages associated with ETFs.
■ Market influences on price—Because ETFs trade on exchanges, share prices can be influenced by market forces such as supply and demand, like any other ETP. In this light, investors need to recognize that just as they might receive less than book value per share when selling corporate shares of stock, they might also receive less than NAV per share when selling ETF shares.
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What are exchange traded notes?
senior, unsecured debt securities issued by a bank or financial institution. Therefore, they are backed only by the good faith and credit of the issuer. The notes track the performance of a particular market index, but do not represent ownership in a pool of securities the way share ownership of a fund does.
ETNs are bond-like instruments with a stated maturity date, but they do not pay interest
and offer no principal protection. Instead, ETN investors receive a cash payment linked to the performance of the underlying index minus management fees when the note matures. Since the returns of ETNs are linked to the performance of a market index or basket of securities, investors are also exposed to market risk.
While the market price of an ETN, in theory, depends on the performance of the underlying index or benchmark, the ETN has an additional risk compared to an ETF; if the credit of the underwriting bank should falter, the note might lose value in the same way any other senior debt of the issuer would. Additionally, there are limits to the size of ETN issues. This means, with limited availability, there are times when an ETN might trade at a premium to its inherent valuation. Investors purchasing at a premium could be subject to losses later depending on the value of the note at maturity.
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What is systematic risk?
changes in the overall economy will have an adverse effect on individual securities regardless of the company’s circumstances. It is generally caused by factors that affect all businesses, such as war, global security threats, or inflation. Regardless of the portfolio diversification, systematic risk will still exist. The most common types of this type of risk are market risk (overall market may decline), interest rate risk (potential change of bond prices cause by change in market interest rates), reinvestment risk (difficult to reinvest proceeds when interest rates decline and make same level of income), and inflation/purchasing power risk (potential for investment yield to be lower than inflation).
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What are nonsystematic risks?
risks that are unique to a specific industry, business enterprise, or investment type. Diversification can help limit these types of risks.
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What is beta?
measures the volatility of an asset. The market (using the S&P 500 Index as proxy) has a beta of 1.00. If a security has a beta that is greater than 1.00, it is more volatile than the market. If an asset has a beta of less than 1.00, it is more stable than the market as a whole. The bottom line is that a high beta security is considered riskier.
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What is capital risk?
the potential for an investor to lose some or all of her money—her invested capital—under circumstances unrelated to an issuer’s financial strength. A nonsystematic risk.
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What is business risk?
an operating risk, generally caused by poor management decisions. At best, earnings are lowered; at worst, the company goes out of business and common stockholders could lose their entire investment. A type of nonsystematic risk.
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What is financial risk?
relates primarily to those companies that use debt financing (leverage). An inability to meet the interest and principal payments on those debt obligations could lead to bankruptcy and, once again, total loss for the stockholders. For that reason, this is sometimes called credit risk or default risk. A type of nonsystematic risk.
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What is call risk?
the risk that a bond might be called before maturity and an investor will be unable to reinvest the principal at a comparable rate of return. In this light, the occurrence of call risk can lead to reinvestment risk, as discussed earlier. When interest rates are falling, bonds with higher coupon rates are most likely to be called. Investors concerned about call risk should look for call protection—a period during which a bond cannot be called. Most corporate and municipal issuers generally provide some years of call protection.
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What is prepayment risk?
the risk that a borrower will repay the principal on a loan or debt instrument (bond) before its maturity and thus deprive the lender of future interest payments. This risk is often associated with call risk, as discussed earlier. Securities such as GNMAs are subject to prepayment risk since the underlying mortgages may be refinanced when interest rates fall. The refinancing will result in a partial pay down of principal to the GNMA holder, who now needs to find a suitable reinvestment in a lower interest rate environment. A nonsystematic risk.
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What is currency risk?
the possibility that an investment denominated in one currency could decline if the value of that currency declines in its exchange rate with the U.S. dollar. Fluctuating currency exchange rates become an important consideration whenever investing in a foreign security or any security denominated in a foreign currency. Currency is quoted at the spot rate, meaning a given currency’s current market value. Currency is always quoted in relative terms between two currencies. For example, the euro could be getting stronger or weaker versus the U.S. dollar. A nonsystematic risk.
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What is liquidity risk?
The risk that an investor might not be able to sell an investment quickly at a fair market price is known as liquidity risk or marketability risk. The marketability of the securities a registered representative (RR) recommends must be consistent with the client’s liquidity needs. A nonsystematic risk.
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What is regulatory risk?
A sudden change in the regulatory climate can have a dramatic effect on the performance of a business and entire business sectors. Changes in the rules that a business must comply with can devastate individual companies and industries almost overnight.
Common examples of this risk are rulings made by the Environmental Protection Agency (EPA) or the Food and Drug Administration (FDA). Rule changes for affected businesses to follow can sometimes upset their business models and their ability to be profitable. A nonsystematic risk.
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What is a legislative risk?
It is common to lump together regulatory and legislative risk, but there is a difference. Whereas regulatory risk comes from a change to regulations, legislative risk results from a change in the law. A government agency, state or federal, may pass certain regulations, but only a legislature can pass a law. Changes to the tax code are the most obvious legislative risks. A nonsystematic risk.
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What is political risk?
While political risk can be interrelated with legislative risk, most attribute this risk specifi- cally to the potential instability in the political underpinnings of the country. While this is particularly true in emerging economies, it can occur even in highly developed societies. A nonsystematic risk. For example, Sovereign risk ratings capture the risk of a country defaulting on its commercial debt obligations. When a country is at risk of defaulting on its debt, the impact is felt on financial markets worldwide.
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