Series 7 Investment Companies Notes

Investment Companies – Series 7 Notes

Investment Company Act of 1940

Defines 3 types of investment companies: invest in securities

  1. Face amount certificate company
    1. Defined type of investment company
  2. Unit investment trust
    1. Characteristics
      1. Sold with a prospectus
      2. No management fees
      3. Way to get a diversified bond portfolio for $1,000
      4. Not negotiable
      5. Efficient
      6. Investments don’t change once they are initially made
    2. Fixed UIT
    3. Participating UIT (Variable Annuity)
  3. Management company: Means that there is an investment manager/advisor who is in control of the funds – manager/adviser must be registered
    1. Open-End Fund: Mutual Fund
      1. Continuously issue and redeem their own shares, owner can redeem at any time
      2. Shares are redeemable, NOT negotiable!
      3. Buy at the public offering price (POP) in the prospectus
        1. Every share is a new issue sold with a prospectus
      4. POP is the next computed Net Asset Value (NAV) plus a sales charge
        1. Based off ending day’s closing asset value
      5. Actively managed fund
      6. Can’t buy on margin because it’s a new issue!
    2. Closed End Fund: Publicly traded funds (not ETF)
      1. 1-time stock issuance, then the books are closed to new investment
      2. Listed on an exchange and trade
      3. Negotiable, NOT redeemable
      4. Buy at the market price, and pay a commission
      5. Can trade below NAV (discount)
      6. Actively managed fund
      7. Can margin and short
    3. ETF – hybrid between closed and open funds
      1. Passively managed funds benchmarked to an index
      2. Can buy on margin, and short
      3. Closed end funds can sell at discount to NAV, ETFs do not trade at discounts
      4. Has a built-in arbitrage mechanism – trades right around NAV

Mutual Funds

  1. Structure / Characteristics
    1. Has a fund sponsor (Fidelity, American Funds, etc.)
    2. Sets up a fund (“Phoenix Fund”)
      1. Hire a Custodian Bank
        1. Safekeeps the assets of the fund
        2. Acts as transfer agent, issuing and redeeming shares
        3. Acts as paying agent for distributions
        4. Not the manager of the fund!
      2. Hire an Investment Advisor
        1. Must be registered under the act of 1940
        2. Supposed to manage to fund within its stated objectives
          1. Usually a subsidiary of the fund sponsor
          2. Gets a % of AUM fee (0.5%+)
        3. For fund objective to be changed, the shareholders have to vote and approve the change
      3. Hire a Fund Distributor / Underwriter
        1. Markets the fund to the public to raise AUM
        2. Sign-up a selling group of FINRA member broker-dealers
        3. Only sold with a prospectus, at the POP (no discounts)
        4. POP = next computed NAV plus the appropriate sales charge
          1. Set at a maximum of 8.5% of POP (FINRA)
    3. Class A Fund Share
      1. Up-front sales charge reduced by break-points (load)
        1. Can do better, but not worse than the stated break-points
      2. Has to offer with rights of accumulation
        1. Cumulative position counts towards break-point
        2. Must complete the breakpoint contract first!!
      3. A break-point sale is a bad thing!!
        1. Must make the customer aware that they are close to the break point prior to investing
        2. Letter of Intent – offer customer ability to put more money (13 months) to complete the break-point
          1. Back-dated up to 90 days
    4. Rule 12b-1
      1. Allowed mutual funds to sell without up-front sales prices
      2. Created Class B Fund Shares
        1. No upfront sales charge
        2. Instead, “contingent deferred sales charge” (CDSC)
          1. If you redeem year 1, we will charge you 7% to go out. If year 2, 6%. 5% for year 3. Etc. etc. down to 0%
        3. Hidden cost of an annual 12b-1 fee
          1. “trail commission” of 0.50% annually
      3. Class C Share
        1. No upfront sales charge, so CDSC, but charges the highest possible 12b-1 distribution fee at 0.75% annually
          1. Good for clients with a lot of money and only a few-year time horizon
      4. Pure no load is no upfront sales charge, no CDSC, and no 12b-1 fee
    5. Money Market Mutual Funds
      1. Show value as $1 consistently, the number of shares you own increases with appreciation, rather than more value per share
      2. No load, but does have mgmt. fees
  2. Tax Treatment of Mutual Fund Investments
    1. Fund income statements are sent bi-annually
      1. Side note: mutual funds can’t send electronic prospectuses
    2. Net Investment Income: is the income that can be distributed to shareholders
      1. If >90% of NII is distributed, it is termed a regulated fund under Reg M
        1. Fund pays no tax on the distributed income, taxes flow through to the shareholders only
        2. Funds cannot distribute losses to shareholders!
      2. Fund expense ratio: used to analyze mutual funds. Take all expenses as a percentage of Total Net Assets
        1. Measures: operating efficiency

Exchange Traded Funds (ETFs)

  1. Characteristics
    1. Buying and selling at the current market price
    2. Can buy/sell on margin
      1. 25% x leverage if levered
    3. SPDR – S&P 500
    4. DIA – Dow Jones
    5. QQQ – NASDAQ 100

REITs (Real Estate Investment Trusts)

  1. Characteristics
    1. Similar to closed end funds!!
    2. Are registered under the act of 1933
    3. Invest in commercial, residential real estate properties and distribute the lease income to the investors
    4. Do not do single family homes, or invest in limited partnerships
    5. Listed on exchanges and trade
    6. Not considered investment companies under the 1940 act because they do not deal in securities!
    7. Can’t invest in DPPs but can invest in government securities
  2. Equity REITs
    1. Invest in commercial real estate, no single family homes
    2. Negatively correlated to the markets
    3. Dividends paid are taxed at regular income rates
  3. Mortgage REITs
    1. Highly leveraged, issue bonds and debt and use proceeds to buy mortgages, mortgage backed securities, and CMO tranches
  4. Tax Treatments
    1. Subject to tax flow-through
    2. Regulated under subchapter M (IRC)
    3. Must distribute at least 90% of NII, and must earn 75% of their income from real estate related activities

Business Development Company (BDC)

  • Takes the venture capital model and makes it more accessible for lower-tier investors
  • Invests in private start-ups
  • Listed on exchanges and trade (no liquidity risk)
  • Open to all investors
  • High level of investment risk due to high failure rate
  • BDC vs. VC Fund
    • VC fund is essentially a hedge fund, aka only open to wealthy investors
    • Private partnerships (VC) whereas (BD) are registered securities sold with a prospectus
    • Huge liquidity risk for VC funds (long-term investments)

Keogh Plans (HR10)

  • Retirement plans for self-employed individuals
  • 20% of income is the actual contribution capped at $54k (2017)
  • Contributions are tax-deductible!
  • If employer sets up plan for himself, must include employees at employer own expense
    • Must be age 21, 1 year of service, full-time
  • If the employer contributes the max, then the employer must put in 25% for the employee

Variable Annuities

  1. Characteristics:
    1. Sold by insurance companies as a hybrid product, essentially buying a mutual fund
    2. Takes the insurance payments/premiums and invests them in a separate investment account, where the performance of the account determines the annuity amount or benefit received
    3. Non-exempt securities, because the investment risk is borne by the customer
      1. Registered and sold with a prospectus, must be licensed to sell (series 6 or 7 plus state licensing) – must have state insurance commission registration
    4. Investment risk is borne by the purchased
    5. Distributions are tax-deferred but must be reinvested, compared to mutual funds where there is no required to be reinvested, but are taxable
  2. Fixed Annuities: Differences
    1. Fixed annuities invest the premiums into the company’s general investment account, rather than a separate account
    2. Fixed has no investment risk, and you get fixed periodic payments for life
  3. Insurance Company provides 2 Guarantees
    1. Mortality Guarantee: if the purchaser lives longer than expected, the insurance company will continue to pay the annuity for that person’s life
    2. Expense Guarantee: promises that expenses will not increase above a stated level
    3. Rate of return is not guaranteed!
  4. Accumulation Phase
    1. Money put into a VA are used to buy accumulation units in the separate accounts
      1. Units are purchased instead of shares, since this is a UIT
    2. Each separate account buys shares of a designated mutual fund – the performance of this account determines the annuity
    3. Accumulation phase is when payments are being made into the account to buy units
      1. During accum phase, money can be put into the plan, but withdrawals can’t be taken without a penalty until 59.5
      2. Any earnings on the account must be reinvested during the accumulation phase!
    4. Build-up tax deferral
      1. All reinvested dividends and capital gains are tax-deferred (not the case with the direct purchase of mutual fund shares)
      2. Contributions are not tax deductible, since this is not a “qualified” retirement plan. Tax-deferred buildup is the biggest benefit
  5. Annuity Phase
    1. Once the contract has “annuitized”, the number of accumulation units are converted into a fixed number of annuity units
      1. Units received depends on:
        1. Dollar amount of the separate account
        2. Annuity option chosen
        3. Customers expected life span
    2. Annuity Payment Options (can’t be changed once chosen)
      1. Life annuity: pay only for that person’s life
        1. Largest monthly payments!!
      2. Life Annuity – Period Certain: pays for that person’s life, but if that person dies before the stated time period, the annuity will be paid to a beneficiary for the balance of the stated period
      3. Joint and Last Survivor Annuity: pays a married couple until the second party dies
      4. Until Refund Annuity: if the contract holder dies earlier than expected, the balance left in the separate account is refunded to a beneficiary
    3. The number of annuity units’ times the unit value determines the monthly payment. Fixed # of annuity units with a varying unit value
  6. Guaranteed Minimum Income Benefit (GMIB)
    1. An optional offer made in variable annuity contracts
    2. Guarantees a minimum growth rate
      1. The account will be valued based off the GMIB even if the account grows at a lower rate over the given year
      2. Only applies during the annuity phase, not the accumulation phase!!
  7. Assumed Interest Rate (AIR)
    1. In the prospectus, a VA contract comes with an assumed interest rate illustration
    2. AIR is a conservative interest rate assumption that shows how the annuity would be received if the separate account grew at a certain rate
      1. It is no way a guarantee on interest rates
    3. If during the annuity phase, the separate account grows at the AIR, then the annuity payment is unchanged. It is increased if account grows above the AIR, and decreased if the growth is slower than AIR
  8. Death Benefit
    1. If the contract holder dies prior to annuitization, the insurance company pays the greater of current NAV or the amount invested to a beneficiary
      1. No death benefit if dies after the annuitization
  9. Tax Treatment
    1. When the annuities are coming in, the build-up amount (tax-deferred earnings) is taxable as ordinary income, but no tax to the original capital contributed

Retirement Plans

ERISA – Employee Retirement Income Security Act of 1974

  • Passed to protect employee pension funds from employer mismanagement
  • Only applies to corporate pension plans (private sector only!!)
  • Qualified plans: contribution is deductible, grows tax deferred, distributions at retirement age are fully taxable. 2 types under ERISA:
  1. Defined Benefit
    1. Requires an Actuary – defines the benefit (usually based off last year’s salary) and determines the annual minimum funding to go into the plan to meet the pension liability
    2. Can have an unfunded pension liability
    3. Benefits older people retiring sooner
  2. Defined Contribution
    1. 401(k)
      1. Separate account for each participant/employee
      2. Contribution is made by the employee and is deductible
      3. Typically have a corporate match
      4. Don’t need an actuary!
      5. No unfunded pension liability!
      6. (Benefits younger employees with more time to retirement)
  • IRA’s are not subject to ERISA!!

403(b) Plan

  • Same as a 401k, but for the non-profit sector
    • School systems, universities, hospital (if NFP), police, firemen, public employees
  • Can make the same contribution amount as 401k
  • Big administrator is TIAA (Cref)
  • All are permitted investments in a 403(b) plan except: common stock!!
    • Not giving the people who have these retirement accts the ability to pick stocks…but they can pick between mutual funds, variable/fixed annuities

457 Plan

  • Add-on plan on top of 403(b) not-for-profit
  • For upper level employees, allowing them to add additional retirement monies, and for older employees
  • NO penalty tax for distributions prior to age 59.5!!

IRA Traditional

  • Individual can open and contribute 100% of income, capped at 5,500 (2017)
    • 6,500 if you are older than 50
    • Double numbers if married couple, even if only 1 works
  • Must have earned income (can’t be trust income)
  • Deductibility: if you are not covered by a qualified plan (401k), regardless of income, it is deductible
    • If you are covered by another qualified plan, and you earn too much, you can still contribute but it is not deductible
  • 59.5 is when you can start taking without penalty, at 70.5 you a are required to start taking a required minimum amount (April 1st of the year after reaching 70.5)
    • 50% penalty tax for not taking your RMD
  • Rollover IRA within 60 days of termination – 1 rollover per year, can rollover without a limit

Roth IRA

  • Same contribution amount as a traditional IRA
  • Contribution is not deductible
  • Builds tax deferred. When you take distributions, they are not taxable!
    • Have to take distributions after 59.5 for them to be tax free
  • Can keep contributing after age 70.5, if you are still working (different than traditional)
    • No required RMD’s
  • Not available to high earners! Phase out around 200k


  • Retirement plan for small companies (employers)
  • Simplified Employee Pension (SEP)
  • Company can change contribution % on a yearly basis, depending on how profitable or unprofitable they are
    • If unprofitable, they do not have to make a contribution (not true for ERISA)
  • Gives employer flexibility!!

Simple IRA (Savings Incentive Match)

  • Retirement plan for small companies (employers)
  • Think of this as 2/3 of a 401k, with a match
  • Employee makes deductible contribution (salary reduction), and then the employer must match it
    • Employer has no choice, they are forced to match, either 2% of all employee compensation whether they participate or not OR 3% of participating employees

Education Savings Plans

  1. Coverdell ESA
    1. Not available to high earners!
    2. Annual contribution of $2,000 per child
    3. Not deductible
    4. When used to pay for “qualified education expenses”, it is tax free
    5. Can be used for all levels and types of education
    6. Must start using it at age 18!!
      1. Account must be depleted by age 30
        1. Unexpended funds are subject to regular tax + 10% penalty
          1. Avoid by transferring to a relative for their education
  2. 529 Plans
    1. State-sponsored college savings plans
      1. MSRB is the regulator
    2. Essentially buying a mutual fund in a state “wrapper”
    3. No deduction for the contribution
    4. Contribution amount is set by the specific state
    5. Builds tax deferred, and tax free when used to pay for college or grad school
    6. Regular tax + 10% penalty if not used for college
    7. If student gets a scholarship, and funds are not needed, then subject to tax BUT no penalty tax
    8. Any relative can give a one-time contribution to a 529 plan of 5x the federal gift tax exclusion without being subject to gift tax
    9. Age-weighted 529 plan: mutual fund as investment vehicle for 529 plan where the portfolio is rebalanced throughout the life of the kid

Health Savings Accounts – HSA

  • If a corp has a “high deductible health plan”
    • Employer sponsored!
    • Set up an HAS availability
    • Employee is allowed to put in funds for medical expenses
    • Is tax deductible, grows tax deferred, no taxes when used for medical