Types of Investment Companies

• Face Amount Certificate Companies
• Unit Investment Trusts (UITs)
• Management Companies
  • Open End (Mutual Funds) → Closed End [Fixed # of shares]
  • Hedge funds, REITs, and PE funds are not investment companies

Investment Companies

• A corporation (sometimes a trust) that invests in pooled funds of investors; typically into a diversified portfolio of securities
  • Allows investors to acquire an interest in a large number of securities
  • Mutual funds benefits include:
    • Professional management 
    • Diversification
    • Liquidity
    • Convenience and cost
    • Exchanges at net asset value (NAV)

Diversified v. Non-Diversified

• Diversified qualifications
  • 75% of total assets must be specifically structured so that:
    • No more than 5% is invested in any one company, and
    • No more than 10% of a company’s voting stock is owned
  • The other 25% may be invested in any manner
• If the value of a position grows to above 5%, the mutual fund may still represent itself as diversified

• Non-diversified
  • Assets may be invested in any manner

Diversifying a $100 Million Fund

Prospectus Contents:

• A prospectus must precede or accompany any solicitation and include the following details:
  • Investment objectives
  • Risk disclosure
  • Performance information
  • Sales charge disclosure
  • Operating expenses disclosure
  • Share class comparison table
  • Breakpoint table
  • Exchange privileges

Where would investors find the most detailed information on what they’re purchasing?

• The prospectus 

Questions

• An individual’s interest in a specific mutual fund is represented by common stock
• Diversification provides an investor with the ability to invest a small amount and obtain an interest in a large number of securities
• A diversified fund is not permitted more than 5% in any one company and cannot control more than 10% of any one company’s voting securities
• For a diversified fund, no less than 75% of a fund’s assets must be diversified, while the remaining 25% can be invested in any manner
• A prospectus must precede or accompany any solicitation of mutual fund shares

Mutual Fund Structure:

Board of Directors

• Investment Company Act of 1940 requires that a majority of the board be independent (Disinterested)
• Elected by, and responsible to, shareholders
• Deals with policy and administrative matters
• Hires outside companies for services
• Sets the fund’s objective, but does not manage the portfolio

Investment Advisor

• Also referred to as the fund manager
• Registered with the SEC under IA Act of 1940
• Manages based on the objectives as stated by the Board of Directors
  • Invests the assets of the fund’s portfolio
  • Provides analysis and research
  • Implements appropriate diversification
• Earns a management fee
  • Expressed as a percentage of assets
  • Generally the largest fund expense

Transfer Agent and Custodian Bank

• Transfer Agent
  • Computes the net asset value
  • Keeps track of share ownership; issues, redeems, and cancels the fund’s shares
  • Sends customer confirmations and fund distributions
  • Receives a fee for its services
• Custodian Bank
  • Maintains custody of the fund’s total assets (i.e., provides safekeeping)
  • Responsible for both payable and receivable functions
  • Receives a custodial fee for its services
  • Does not manage the portfolio

Principal Underwriter:

• Underwriter (often referred to as sponsor/wholesaler/distributor)
  • Appointed by the board
  • Receives a portion of the sales charge for marketing and selling the fund shares to the public; may also receive a distribution fee
  • Able to buy shares at the NAV and sell directly to investors or market the shares through independent dealers with whom its shares the sales charge (wholesaling)

• Dealer won’t buy the shares till they get a request from the public

Matching:

• Transfer agent
  • Issues, redeems, and cancel the fund’s shares
• Board of directors
  • Sets the fund’s objectives and deals with administrative matters
• Custodian bank
  • Responsible for the safekeeping of the fund’s assets
• Underwriter
  • Receives a portion of the sales charge for selling shares to the public
• Investment Adviser
  • Determines investments to meet the fund’s objectives

Buying individual bonds v bonds fund

• Interest rate risk
• The fund will always have the same maturity and won’t come closer like an individual bond

Net Asset Value (NAV)

• Account value of a fund’s positions; marked-to-the-market at closing prices as of 4:00 pm ET
  • NAV is synonymous with the bid price or redemption (liquidation) price for mutual fund shares
    • Investors who redeem their shares receive the next computer NAV (forward pricing)
  • Public Offering Price (POP) is the NAV + any applicable sales charge
    • Investors who purchase fund shares pay the next computed POP

Calculating NAV per Share: (Total Assets – Total Liabilities) / # of Shares Outstanding

Calculating the Sales Charge

• Difference between the NAV (Bid) and POP (Ask) is the sales charge
• NAV (Bid) = 9.20
  • Price at which a client redeems
• POP (Ask) = 10.00
  • Price at which a client buys
• Sales charge is expressed as a percentage of the POP
• Calculating Sales Charge % = (POP – NAV) / POP (memorize)
• (10 – 9.2) / 10 = 8%

Calculating Public Offering Price

• When given the NAV and sales charge percentage, use the following procedure to calculate the offering price 
• NAV / (100 – Sales Charge %)

Question

• A mutual fund has a NAV of $24 and a POP of $26.09
• What is the fund’s sales charge percentage?
  • 8.0% ($26.09 – $24) / $26.09
• If the fund’s shares could be purchased with a 5% sales charge,what would be the public offer price (POP)?
  • $25.26 ($24 / 95%)

Sales Charges

• Amount deducted from an investor’s purchase
  • Benefits the selling brokers
  • Used to cover the costs of promotion and sales literature
    • Industry rules prohibit assessing charges in excess of 8.5% of the POP
• Front-End Loads
  • Total investment, less the sales charge, is directed to the portfolio when they initially invest
• Back-End Loads (Contingent Deferred Sales Charges)
  • Assessed at the time an investor redeems (sells)
  • Percentage decreases as the holding period lengthens 
  • 
  • Longer you hold the share, the lower the back-end loads
• 12b-1 Fees
  • Established under Section 12b-1 of the Investment Company Act of 1940

12b-1 Fees

• An annual fee levied against the fund’s assets
  • Allows distribution costs to be borne by the fund, rather than front-end charges
• Used to finance promotion, advertising commissions
  • Includes continuing commissions or “trailers”
  • If a written contract exists, it may be paid to RRs who are still employed with a firm or to retiring RRs based on existing assets 

Transactional portfolio commission is not under 12b-1 fees (when they buy/sells shares)

No-Load Funds

• For a fund to be described as a no-load, it must have (no sales charge)
  • 1. No front-end sales charge (load)
  • 2. No deferred sales charge (back-end load)
  • 3. No 12b-1 fee that exceeds .25% of the fund’s average net assets per year 
• A no-load fund may have a redemption fee (since the fee is not considered a sales charge)

Fees and Charges

• Ongoing fees are NOT sales charges
  • These fees may be based on a percentage of assets under management or on amounts redeemed early from a fund
  • Management (Advisory) Fee
    • Paid to the investment advisor
    • Asset-based; not tied to profits or losses
    • Typically the largest of the fees
  • AdministrativeFee
    • Custodian bank payments
    • Transfer agent costs
  • • Does not go to underwriter or dealer
    • Remains behind in the fund, benefiting other owners 

Mutual Fund Expense Ratio

• Defined as the percentage of a fund’s assets paid for operating expenses and management fees, including 12b-1 and administrative fees, and all other asset-based costs incurred by the fund
  • Calculated by dividing a fund’s expenses by its average net assets (sales charges are not expenses)
  • Will decline if:
    • Assets under management increase
    • Any fee or expense is reduced
• The largest expense for a fund is typically the management fee

Classes of Shares

• SIE type question: What defines A, B, or C type shares?
• Be able to compare A, B, and C

What is the best class for a client to invest a large amount of money?

• Class A shares

Methods to Decrease Sales Charge

• Breakpoints
  • When investing an amount at or above the breakpoint, the investor qualifies for the lower sales charge on the entire purchase
  • Purchases of multiple funds within the same family or complex of funds are consolidated to determine the sales charge

• If an investor has a large sum of money to invest all at once, the best method is A Shares

Breakpoints – Example

• A customer invests $60,000 in a mutual fund. The fund’s next calculated NAV is $19.61 and the maximum offering price is $21.32. The fund charges a 1% redemption fee. Using the previous breakpoint schedule, how many shares is the investor able to purchase?
• $60,000 / $20.53 = 2,922.552 shares (you can buy fractional w/ mutual funds)

Letter of Intent (LOI)

• Optional provision that allows investors to qualify for a breakpoint without initially depositing the entire amount required
  • 13-month time period
  • May be backdated 90 days
    • If backdated, the fund will re-compute the sales charge on previous purchases
  • Non-binding on customer; a portion of shares held in escrow in case of non-performance
    • Ex: Investor puts up $80k, firm will give 3.5% instead of 4.5% for investor to put up $20k 

Rights of Accumulation (ROA)

• Rights to add up all purchases made from same family of funds
  • When a breakpoint is crossed, current and future purchases will have a lower sales charge
• Rights of accumulation may be made available to any of the following
  • An individual purchaser
  • A purchaser’s immediate family members (spouse, dependent children)
  • A fiduciary for a single fiduciary account
  • A trustee for a single trust account
  • Pension and profit-sharing plans that qualify under the Internal Revenue Code guidelines
  • Other groups (investment clubs) provided they were not formed solely for the purpose of paying reduced sales charges

Investor puts up 40,000, the sales charge is 5.75%. Years later, the client’s value of the fund is now $70,000 from $40,000. Investor gets bonus check of $40,000, they’ll be over $100,000, so they pay a sales charge of only 3.5%, this is rights of accumulation 

• Regardless of which firm you hold the shares at

Dollar Cost Averaging (DCA)

• A method of investing which involves making the same periodic investment regardless of share price over a fixed price
  • Does not guarantee attainment of any specific investment goals
  • Necessary disclosures:
    • No assurances of long-term growth
    • Prices are subject to change
    • Contributions must continue even when prices decline, otherwise losses could occur

Redeeming/Selling Mutual Fund Shares

• The Redemption Process
  • A mutual fund investor may redeem (sell) shares and receive the share’s next calculated net asset value (minus any applicable contingent deferred sales charges or redemption fees)
  • Funds are required to send investors the payment for their shares within seven calendar days of receiving the redemption notice)
• Redemption Fees
  • Assessed against investors who redeem their shares after holding them for a short period (one year or less)
  • NOT a sales charge; it is returned to the fund’s portfolio

Withdrawal Plans

• Allows investors to receive regular, periodic payments from their accounts
  • A minimum account value is required
  • A variety of withdrawal methods are available, such as:
    • Fixed dollar amount
    • Fixed percentage
    • Fixed time
    • Fixed number of shares
  • Payments are not guaranteed for the life of the investor 
• Clients should not be advised to engage in a systematic purchase and withdrawal plan simultaneously 

Sales Practice Violations

• Breakpoint sales
• Soliciting sales of shares at amounts just below a breakpoint
• Recommending purchases from different fund families due to the potential for higher sales charges
• Switching between different fund families due to the impact of new sales charges or holding periods
  • For switch recommendations, RRs may be responsible for justification of:
    • Tax ramifications (both exchanges and switches are taxable)
    • Potential sales charges on new purchase
  • Excessive purchases of Class B shares
    • Salespersons should not recommend purchasing large quantities of B shares (since they do not qualify for breakpoints)

Other Types of Investment Companies

• Face amount Certificate Company (FAC)
  • Issues debt certificates
  • Issuer promises face value at maturity or surrender value if presented prior to maturity 
• Unit Investment Trust Company
  • Supervised, not managed (no management fee)
  • Portfolio generally remains fixed for the life of the trust
  • Ownership usually referred to as shares of beneficial interest (SBI)

Closed-End Compared to Open-End

• If client purchased an investment company and paid a commission, this would be a closed-end fund
  • Open-end is sales charge

Matching

• Portfolio is supervised, not managed
  • Unit investment trust
• Shares may trade at a price less than the NAV
  • Closed-end fund
• A fixed amount is paid at a specific date
  • Face amount certificate
• Shares always remain in the primary market
  • Open-end fund