Mutual Funds and Individual Securities

Transcription

1 Mutual Funds and Individual Securities This Document Will Help You Prepare To Take The Online Examination Prepared by Peggy Erland, 2017 for A Center for Continuing Education 707 Whitlock Ave, SW, Suite C-27 Marietta, GA Fax:

2 Written by Peggy Erland. Published by Erland Education Services (Formerly Erland Financial Education Services). About the Author Erland Education Services is a provider of financial continuing education curriculum for financial professionals, which began operations in The company s curriculum is written and researched using a variety of current, reliable sources. The proprietor and curriculum author, Peggy Erland, has a background including thirty-two years as a licensed agent, seven years as a licensed securities representative, four years as a dean of training for a nationwide firm, and six years managing insurance and securities sales support units. Her experience includes curriculum development, individualized and group training, training evaluation, technical manual creation, and research and documentation of thousands of technical sales issues. No part of these courses may be reproduced, transmitted in any form or by any means, electronic or mechanical, for any purpose, without the express permission of Erland Education Services (Formerly Erland Financial Education Services). Although great effort has been made to ensure this publication contains accurate, timely information, it is provided with the understanding that the author is not engaged in rendering legal, accounting, tax, or other professional service. If professional advice is required, the services of a competent legal advisor should be sought. Copyright Erland Education Services 1996, 2001, 2003, 2006, 2010, 2011, 2013, 2014, 2015, 2016, 2017 Mutual Funds and Individual Securities ii

3 Table of Contents INTRODUCTION... 1 CHAPTER ONE: ADVANTAGES OF MUTUAL FUNDS... 2 OBJECTIVES... 2 PROFESSIONAL MANAGEMENT... 2 DIVERSIFICATION... 2 VARIETY OF OBJECTIVES... 2 LIQUIDITY... 2 VARIETY OF INCOME OPTIONS... 2 EASE OF EXCHANGE... 3 SERVICE... 3 CHAPTER TWO: TYPES OF MUTUAL FUNDS... 4 OBJECTIVES... 4 MUTUAL FUND COMPANIES... 4 Open-End Funds... 4 Closed-End Funds... 4 FUND OBJECTIVES AND INVESTMENT POLICIES... 4 Objectives, Investment Policy and Risk... 5 Objectives, Investment Policy and Suitability... 5 Common Fund Objectives - An Overview... 5 Investment Risks... 6 Financial or Default Risk... 6 Bond Rating Agencies... 6 Market Risk... 7 Interest Rate Risk... 7 Purchasing Power Risk... 8 Types of Mutual Funds... 8 Municipal Bond Funds... 8 UITs Government Funds Corporate Bond Funds Equity Funds CHAPTER TWO STUDY QUESTIONS CHAPTER THREE: MUTUAL FUND FEATURES OBJECTIVES MUTUAL FUND FEATURES Dollar Cost Averaging Regular Investment Programs Asset Allocation Systematic Withdrawal Distribution Options Mutual Funds and Individual Securities iii

4 Reinvesting Distributions Receiving Distributions Distribution Dates Exchange Privileges Minimum Investment MUTUAL FUND VALUES MUTUAL FUND RETURNS Yield Total Return CHAPTER THREE STUDY QUESTIONS CHAPTER FOUR: THE MUTUAL FUND PROSPECTUS OBJECTIVES THE DATE OF THE PROSPECTUS THE FUND S INVESTMENT OBJECTIVE AND INVESTMENT POLICIES INVESTMENT RISKS EXPENSES Shareholder Transaction Expenses Sales Charges or Loads Annual Operating Expenses Management Fees b-1 Fees Other Expenses Financial Highlights and Performance Investment Advisor Information The Portfolio Manager The Transfer Agent Shares How to Purchase Shares How to Sell Shares Distributions Tax Information Dividends Capital Gains Shareholder Taxation of Gains and Losses Required Disclosures and Cover Statements SUMMARY PROSPECTUS CHAPTER FOUR STUDY QUESTIONS CHAPTER FIVE: STOCKS OBJECTIVES PREFERRED STOCK Preferred Stock Dividends Convertible Preferred Stock COMMON STOCK Mutual Funds and Individual Securities iv

5 Growth Stocks Blue-Chip Stocks Income Stocks Cyclical Stocks Defensive Stocks Risks of Common Stocks Fluctuation of Price Financial Risk Market Risk International Stocks American Depository Receipts Risks of International Equities CHAPTER FIVE STUDY QUESTIONS CHAPTER SIX: STOCK FUNDAMENTALS OBJECTIVES STOCK PRICES STOCK MARKETS New York Stock Exchange The NYSE MKT LLC (Formerly the American Stock Exchange) The Over-The Counter Market Regional Exchanges Regional Exchanges STOCK INFORMATION The Corporation s Annual Report Security Prospectus SEC Reports K Report K Report Research Services Newspapers BUYING AND SELLING STOCK Market Order Market Maker Limit Order Stop-Loss Order Stop-Buy Order MARGIN TRANSACTIONS CHAPTER SIX STUDY QUESTIONS CHAPTER SEVEN: BONDS OBJECTIVES BOND FUNDAMENTALS Face Value Coupon Mutual Funds and Individual Securities v

6 Notes vs. Bonds Callable Bonds Refunding Convertible Bonds Bond Yields Current Yield Yield to Maturity Yield to Call CORPORATE BONDS Unsecured Bonds Secured Bonds Mortgage Bonds Collateral Trust Bonds Equipment Trust Certificates How to Purchase Corporate Bonds MUNICIPAL BONDS Municipal Bond Pricing How Municipal Bonds are Sold US GOVERNMENT DEBT INSTRUMENTS Risks of US Government Securities Treasury Bills Yield of Treasury Bills How T-Bills are Sold Treasury Notes Treasury Note Yields How Treasury Notes are Sold Treasury Bonds FEDERAL AGENCY SECURITIES Government National Mortgage Association Securities GNMA Pass-Through Securities Taxation of GNMA Securities Federal National Mortgage Association Securities FNMA Discount Notes FNMA Foreign Discount Notes Benchmark Bills Investment Notes Taxation of FNMA Securities CHAPTER SEVEN STUDY QUESTIONS CHAPTER EIGHT: OPTIONS OBJECTIVES TYPES OF OPTIONS Put Options Call Options Mutual Funds and Individual Securities vi

7 OPTION PREMIUMS Covered Option Writing Options as a Protection Against Loss USE OF OPTIONS BY MUTUAL FUNDS Increasing Yields Protection Against Loss Adding Diversification HOW OPTIONS ARE SOLD RISKS OF OPTIONS CHAPTER EIGHT STUDY QUESTIONS CHAPTER NINE: EXCHANGE-TRADED FUNDS (ETFS) OBJECTIVES ETF STRUCTURE TYPES OF ETFS Passively Managed ETFs Actively Managed ETFs HOW ETFS ARE TRADED Active Participant Trades Other Investor Trades ETF NAV AP Arbitrage TAXATION OF ETFS ETF EXPENSES MINIMUM INVESTMENT REQUIREMENTS CHAPTER NINE STUDY QUESTIONS CHAPTER TEN - MEETING CLIENT NEEDS WITH MUTUAL FUNDS AND INDIVIDUAL SECURITIES OBJECTIVES INCOME REDUCTION OF CURRENT INCOME TAXATION LONG-TERM SAVINGS OTHER GOALS CHAPTER TEN STUDY QUESTIONS ANSWERS TO STUDY QUESTIONS Mutual Funds and Individual Securities vii

8 INTRODUCTION The mutual fund industry is a very important part of the financial markets. Its importance provides both opportunity and challenge for the registered representative. The registered representative must diligently ascertain suitability and ensure that clients understand the risks involved in mutual fund investing. Particularly when the older customer is investing in mutual funds, the registered representative must walk carefully, taking the investment experience and investment knowledge of each prospect carefully into consideration before suggesting a plan or product. Individual securities may also have a significant place in an investment portfolio. Depending on the size of the customer s portfolio, his savings objectives and risk tolerance, a customer s most suitable product may be an individual security. An understanding of individual securities also equips the registered representative offering mutual funds to better understand the characteristics and risks of the mutual funds he or she sells. This manual provides a fundamental overview of mutual fund products and their associated features and risks. The types, characteristics and risks of individual stocks, bonds and options are also explored. This course will equip the registered rep with an understanding of the key aspects of mutual funds and individual securities to enable him or her to ably assist each client in the development of an investment plan. Mutual Funds and Individual Securities 1

9 Objectives CHAPTER ONE: ADVANTAGES OF MUTUAL FUNDS Upon completion of this chapter, the student will be able to: Identify the advantageous characteristics of mutual funds Define diversification Mutual funds have several advantages, particularly when compared to owning individual securities or placing savings in instruments outside the securities market. when it is weak. Professional Management Mutual funds are managed by professionals. Fund managers have a thorough understanding of the markets in which they buy and sell securities. They are schooled in investment theories, financial and accounting issues. They have an understanding of the ways in which securities act in market upswings and downturns, when interest rates change and when the economy is strong or Diversification Diversification is the buying of more than one security in order to spread risk over several securities. The idea behind diversification is that if different securities are owned, when one security goes down, another security will go up, or at least may not go down as much as the first security. The entire portfolio will have less volatile returns than if one security were held. Mutual funds include many securities in a fund, providing diversification that the average individual would not be able to afford alone. Variety of Objectives Mutual funds include a wide variety of objectives, as is discussed in the following chapter. An individual can find a mutual fund with the objective desired, for example income, at a risk level that the individual feels comfortable with - from low risk to aggressive. Liquidity Open-end mutual funds are easily redeemed by the mutual fund company. Variety of Income Options If income is desired from a mutual fund, the shareholder can receive dividend distributions, regular systematic withdrawals, or can liquidate shares whenever Mutual Funds and Individual Securities 2

10 desired. Income may be sent to the customer as a check, or in some cases may be wired directly to a bank account. Ease of Exchange Mutual funds offer several funds within a family. Shares are easily exchanged from one fund to another within the family. Often, only a phone call or a visit to a website is needed. Service Mutual fund companies provide quick, efficient service. Whether a request is made to purchase, liquidate, exchange, change ownership, make withdrawals, or change an address, mutual funds on the whole complete the request correctly and in a timely manner. Mutual Funds and Individual Securities 3

11 CHAPTER TWO: TYPES OF MUTUAL FUNDS Objectives Upon completion of this chapter, the student will be able to: Define the term mutual fund Differentiate the risk levels and characteristics among various mutual fund types Describe the objectives of common mutual fund types Define convertible bond Explain the basic tax treatment of various mutual funds Know the purpose of investing in particular types of securities within mutual funds Mutual funds exist for virtually every investment objective, and for the conservative to the aggressive investor. The registered representative has an overwhelming number of fund choices to suggest to a client. This chapter will provide an overview of the various mutual fund types, as well as the objectives and relative risks associated with each fund type. Mutual Fund Companies A mutual fund is an investment company which offers shares of pooled securities to the public. Mutual fund companies may offer shares from two types of funds, open-end and closed-end. Open-End Funds Open-end funds offer new shares continuously to the public, and buy shares back on demand. Closed-End Funds Closed-end funds have a fixed number of shares to offer. Once issued, closed end shares are traded on the market rather than redeemed by the mutual fund company. This manual focuses on open-end mutual funds, although a form of closed-end fund, the UIT, is discussed later in this chapter. Fund Objectives and Investment Policies Each mutual fund must adhere to the fund objective as stated in the fund s prospectus. Generally, the objectives found in a prospectus include capital appreciation or growth, current income, total return, and stability of principal or preservation of capital. Along with the fund objective, the prospectus details the investment policies of the fund. The investment policy includes the type of securities which will be invested in, and whether options, futures or derivatives will be used. In some cases a specific minimum or Mutual Funds and Individual Securities 4

12 maximum investment percentage allowable for particular types of securities is identified. Objectives, Investment Policy and Risk Two funds with the same objective can have markedly different risk levels because of the investment policy and portfolio composition. For example, assume Fund A and Fund B both have the stated objective of current income. However Fund B s investment policy indicates it can invest up to 15% of the fund s assets in hedging instruments such as options, futures, and derivatives and its portfolio composition shows that 15% of its assets are in such instruments. Fund A on the other hand allows up to 5% of the fund s assets to be invested in covered calls and puts and its portfolio shows 2% of its assets so invested. Obviously, Fund B is subject to significantly more risk than Fund A. Objectives, Investment Policy and Suitability A fund objective is as the name implies: an objective. The fund prospectus will typically state the risks inherent to the investment objective and investment policy and will not guarantee the fund will meet its stated objective. The fund objective, investment policy, and associated risk are key considerations in determining the suitability of a mutual fund for a client. Common Fund Objectives - An Overview Capital Appreciation Capital appreciation is growth in the share value of the portfolio. A fund with capital appreciation as its objective will be comprised largely of equities. If the fund fulfills its objective, as the individual equity securities in the fund increase in value, the fund s portfolio value will rise, and each share will increase in price. This objective may be expressed as long term capital appreciation. Typically, the inclusion of long-term implies investment in common stocks of established corporations in contrast to the objective of growth or capital appreciation which can imply investment in companies with potential for significant short or intermediate term growth, such as small company stocks. Total Return Total return refers to the percentage of growth in a fund from both capital appreciation and reinvested income. A fund with the objective of total return will typically invest in dividend paying securities which also have capital appreciation potential, or will seek a balance of investments to generate both income and capital appreciation. Income Income can come from dividends from common stocks, government or corporate bonds. An objective of high current income would indicate that the fund is more aggressive than a fund seeking simply current income. Income funds may also include the objective of capital preservation, e.g. seeks current income consistent with the preservation of capital. This means that the fund does not intend to pay income at the Mutual Funds and Individual Securities 5

13 expense of net asset value (NAV). A fund with such an objective will tend to be managed more conservatively than a fund with a sole objective of high current income. Preservation of Capital Preservation of capital is never the sole objective of a fund. It always accompanies an objective of income or growth. It is an indication that the fund intends to follow its objective of growth or income only to the extent that it will not cause loss of capital. Investment Risks Securities are subject to certain risks. These risks include Financial or Default Risk, Market Risk, Interest Rate Risk, and Purchasing Power Risk. Some fund types have risks associated only with the securities invested in by that fund. For example, Exchange Rate Risk is found in funds investing in securities issued outside of the US. These fund specific risks are discussed in conjunction with the description of the respective fund type later in this chapter. The more universal risks are described below: Financial or Default Risk Financial risk is the risk that the underlying corporation or issuing entity will be financially unable to meet the obligations of the security. In the case of stocks, financial risks include the risk that the corporation will be unable to pay dividends and/or will reduce or eliminate dividend payments. Financial difficulties within the corporation can also cause the value of the stock to fall, just as financial strength can drive share values up. The financial or default risk of a bond is the risk that the issuing entity, whether a corporation, a state or local government, or the federal government, will be unable to meet the obligations of the bond issue. The relative risk of default of a bond is based on the creditworthiness of the issuer. Therefore, the risk of default of a bond issued by the US government is considered to be virtually nonexistent whereas the risk of default of a small, undercapitalized corporation, or a large corporation newly reorganized to avoid bankruptcy will be considered to be quite high. Bond Rating Agencies Bond rating agencies perform credit analysis and assign ratings to bond issues. The best known agencies are Moody s Investor Services, Standard & Poor s Corporation and Fitch Investors Service. The focus of the evaluation of rating agencies is the relative ability of the issuer to meet the specific obligations of the bond. Moody s and S&P assign letter ratings to the different risk levels, or grades. The higher the rating, the lower the risk of default. The different rating agencies use different descriptions for the letter grades assigned, but the industry has general terms applied to the different bond grades, as shown in the table following: Mutual Funds and Individual Securities 6

14 General Industry Description Investment Grade Moody s S&P Prime Aaa AAA High Quality Aa AA Upper Medium Grade A A Medium Grade Baa BBB Below Investment Grade Moderately Speculative Ba BB Speculative B B Highly Speculative Caa CCC Lowest Quality C C,D Market Risk Market risk refers to the risk of price fluctuation of a particular security, securities of a particular industry group, e.g. all airlines or all pharmaceutical companies, or for the entire securities market. Financial difficulties within an industry can impact price, as can competition, regulations, public perception, political upheaval, etc. Some professionals refer to components of market risk as event risk rather than market risk to emphasize the inability to predict the occurrence or impact of a massive oil spill, a series of airplane accidents, the discovery of (another) cancer causing element found in a popular food item, etc. Interest Rate Risk When interest rates change, equities may be affected due to the relative attractiveness of competing securities. For example, if rates in long-term, prime bonds have been relatively low, a certain portion of risk averse investors who had been invested in bonds may accept additional risk for the expected additional return and move to high quality stock funds. Once bond rates rise, these investors may return to the long-term bonds they feel more comfortable with. Interest Rate Changes and Bond Prices Bond prices are impacted by changes in interest rates. When interest rates move up or down, generally the bond price moves in the opposite direction. For example, if a bond with a fixed rate of 7% were purchased, and rates fell to 5%, the price of the bond will rise, because investors will be willing to pay more for the 7% rate. If rates rise, the bond s price will fall because investors will pay less for the 5% rate. Mutual Funds and Individual Securities 7

15 Interest Rate Changes and Bond Term and Quality The longer the term of the bond, or the greater the number of years to the bond s maturity, the more sensitive the bond price to interest rate changes. Since there are a greater number of years for the bond to be impacted by the rate change, the relative impact on price is greater. In addition, the higher the bond quality, the greater the relative impact of interest rates on the bond s price. Since high quality bonds have low default risk, the high quality bond s price is based primarily on its interest rate. Low quality, or junk bond s prices are impacted by the acceptance of default risk by the investor. Therefore, if interest rates change, the impact on a high quality bond will be relatively greater than the impact on a low quality, or junk bond. Sensitivity to rate changes is also impacted by the options of a bond, such as whether the bond is callable, and whether the rate paid, or the coupon, is a fixed rate or floating rate based on an index. Purchasing Power Risk Purchasing power risk is the risk that a security will not increase in value to keep pace with inflation. Inflation results in the reduced purchasing power of currency. If a stock or bond returns 5% and the inflation rate is 6% during the same period, the security will be generating returns which will not offset the effects of inflation on purchasing power. Fixed coupon bonds have a greater susceptibility to purchasing power risk than a bond with a floating coupon. Equities are generally considered as a hedge against inflation, since generally common stock prices have moved upward as inflation indices, such as the Consumer Price Index, have risen. Types of Mutual Funds Municipal Bond Funds Municipal bond funds are comprised of bonds issued by municipalities and states for projects such as roads, schools and buildings. A primary advantage of municipal bond funds is that the interest generated from the bonds is generally exempt from federal income tax. This advantage increases in value relative to the municipal bond fund holder s tax bracket, as shown in the table following: Mutual Funds and Individual Securities 8

16 Holder s Tax Bracket 7% Municipal Bond Fund s After Tax Return After Tax Return of A Taxable Investment Paying 7%. 15% 7% 5.95% 28% 7% 5.04% 33% 7% 4.69% It is important to note that although interest income from municipal bonds are federally tax exempt, capital gains earned by municipal bond transactions are not exempt. After - tax return is calculated by this formula : Before tax return x (1-marginal tax bracket). Types of Municipal Bond Issues There are several general types of municipal bond issues. To understand the risks related to a municipal bond or municipal bond fund, it is important to know the differences in the terms of an issue. Of particular significance is the method of revenue backing the issue s obligations. General Obligation Bonds General obligation bonds are backed by the full faith, credit and taxing authority of the issuing municipality. Therefore, revenue from any taxable source of the municipality can be used to pay any obligations of the bonds. General obligation bonds are generally considered to have the lowest default risk of municipal bonds backed by the tax authority of a municipality. Special Tax Bonds Special tax bonds are secured by a specific tax or taxes of a municipality. The default risk of a special tax bond is based on the ability of the tax to generate the revenue needed to support the bond issue. Revenue Bonds Revenue bonds are backed by the revenue produced by the project being funded. For example, a highway may be built by the issue of a revenue bond and secured by tolls to be collected once the highway is complete. The risk of default in a revenue bond varies depending upon the specific terms and revenue generating methods of the issues. Housing Authority Bonds Housing authority bonds are backed by the full faith and credit of the US government. They are issued to build low-rent housing projects. A federal agency, the Housing Assistance Administration, pledges an annual contribution to these projects. Because Mutual Funds and Individual Securities 9

17 housing authority bonds are backed by the US government, they are considered high quality bonds with no default risk. Industrial Revenue Bonds Industrial revenue bonds are issued by a municipality on behalf of a corporation or business. The business will lease the facility built and the income from the lease is used to meet the issue s payment obligations. The default risk of these bonds is dependent on the viability of the business use of the property and the ability of the business to generate sufficient payments to meet the issue s obligations. Insured Municipal Bonds Insurance can be purchased on municipal bonds by the issuer to protect bond purchasers from the risk of default. Since the risk of default is reduced, bond rating agencies will assign a higher credit rating to an insured municipal bond issue than for the same issue had it been uninsured. Since the insurance costs the issuer money, the interest rate of the bond issue will generally be lower than if the issue were uninsured. However, yields on insured issues are generally competitive with other high quality municipal bond issues. Some professionals question the necessity of insurance for municipal bonds, since only the highest quality bonds are able to obtain insurance. Types of Municipal Bond Funds Single State Municipal Bond Funds A primary advantage of a single state municipal bond fund for a purchaser who pays taxes in the state of issue is that most states exempt the interest from municipal bond funds from that state s income taxation. Therefore, the purchaser receives the benefit of both federal and state income tax exemption from the fund s interest income. The yield on municipal bonds issued in states with high income tax tend to be lower than those of states where state income tax is not a consideration. Single state funds may hold a small percentage of municipal bonds from outside the state. The mutual fund company will normally generate a statement at the end of each year for the holders which indicates the percentage of the income generated from the fund from the various state holdings in the fund to enable the proper reporting of taxable income. National Municipal Bond Funds National municipal bond funds invest in municipal bonds issued across the US. A national fund can provide more diversification than a single state issue, since there is a larger pool of securities from which to choose. Insured Municipal Bond Funds Both single state and national municipal bond funds are available with portfolios comprised of insured municipal funds. These funds tend to be competitive in yield with other high quality municipal bond funds, but provide the purchaser with a hedge against default risk. Of course, interest rate risk is still a concern, as with all bond funds. Mutual Funds and Individual Securities 10

18 UITs Closed-end mutual funds include Unit Investment Trusts or UITs. Unit Investment Trusts are pools of investments, often municipal bonds. Rather than shares, the purchaser receives units of ownership. The portfolio of a UIT does not change over time. It is fixed upon the formation of the trust. The purchaser knows the portfolio composition, including the quality and maturity of the issues from the outset. The income from a UIT is passed to the unit holder, like all mutual funds. If a bond in the portfolio is sold, the unit holder receives the principal. Income is paid on a monthly, quarterly, semi-annual or annual basis. Unit Investment Trusts come in short-term (five years or less), intermediate-term (six to fifteen years) and long-term (fifteen years and over) issues. At the end of the period, the UIT is no longer because all principal will have been paid to the unit holders. Government Funds Government bond funds invest primarily in bonds and other securities issued by the US government or government agencies. Issuing departments or agencies of the US government include the US Treasury, the Federal Home Loan Bank, the Government National Mortgage Association (Ginnie Mae), the World Bank or International Bank for Reconstruction and Development, the Federal Intermediate Credit Banks, the District Banks for Cooperatives, the Federal Land Banks and the Inter-American Development Bank. The risk of default on government issued securities backed by the full faith and credit of the federal government is considered to be extremely low. Government securities are considered the safest investment in terms of default risk. Some securities found in government funds are from government agencies, not directly from the US Treasury. These securities may or may not be backed by the full faith and credit of the federal government. As bonds and bond-like securities, government issued securities are still subject to interest rate, market and purchasing power risks. Depending upon the structure of the security, these risks may be minimal, as in a Treasury Bond held to maturity, to very high as in an inverse floater CMO tranche. The objective of government funds is generally current income with relatively low fluctuation in NAV. However, the objective and share volatility vary from fund to fund. Some funds are 100% invested in treasury securities; others use options, futures, CMOs and CMO derivatives. The relative risks and volatility in these different funds will obviously be quite different. Mutual Funds and Individual Securities 11

19 US Government Funds US Government funds typically have the objective of current income, and many include the objective of capital preservation as well. Typically, US Government funds which seek current income only will allow investment in options and futures to a greater degree than those funds including the objective of capital preservation. Government funds may be comprised largely of short-term, intermediate or long-term bonds, or may have portfolios of securities with a variety of maturities. Typically, if a fund is invested for a specific maturity, the fund name will indicate so, e.g. the ABC Short-Term US Government Fund ( short-term indicates maturities of five years or so). The average maturity of the portfolio impacts the return and volatility of the fund. A short-term government fund s volatility is generally lower than the return and volatility of a long-term government fund. However, a fund s entire portfolio composition and the impact of the interest rate environment on all portfolio assets mean that name alone cannot be used to anticipate volatility related to interest rate risk. Ginnie Mae, or GNMA Funds GNMA funds are funds largely comprised of pass-through securities. Ginnie-Mae passthrough, or participation, securities are pools of mortgages wherein the investor (in this case the mutual fund) owns an interest. The principal and interest payments made on the mortgages are passed through to those with a share in the pool. Mortgage securities can provide a higher rate of return than many other government issued securities, but carry the risk that the mortgagees may pay off their mortgages early, e.g. in a decreasing rate environment. This risk is known as pre-payment risk. When mortgages are paid off early, which can mean either before the terms of the mortgage agreement or before the expected pay off date, principal is returned to the investors and the interest payments cease. New mortgages purchased in a lower rate environment will pay lower interest to the pool participants. CMOs A method used by some GNMA portfolio managers, and managers of other mortgage security funds, to reduce prepayment risk is investment in CMO s, or collateralized mortgage obligations. A CMO is a security backed by a pool of pass-throughs, actual loans, or stripped mortgage backed securities. Basically, a CMO is structured so that the underlying mortgages are placed into several classes, or tranches, of bonds with varying stated maturities. The prepayment risk of the pool is spread among the bond tranches, with some tranches having less prepayment risk than the overall pool and other tranches having more. The yield on the higher risk tranches is higher than those of the lower risk tranches. A fund manager may purchase CMOs with the intent of reducing prepayment risk on the overall fund portfolio. Other mortgage securities may be found in a GNMA portfolio to increase yields as well as hedge against interest rate risks. Derivatives such as IOs and POs, PACs and Inverse Floaters range from moderate to high risk methods of yield enhancement. The Mutual Funds and Individual Securities 12

20 prospectus of a fund should be read thoroughly to ascertain the amount of risk a fund is assuming by its use of derivatives. Adjustable Rate Mortgage Funds Adjustable rate mortgage funds (ARM funds) invest in adjustable rate mortgage securities. These funds may or may not limit these mortgages to those issued by the US government: by prospectus the funds may invest in private mortgage-related securities. ARM funds were often positioned as a low-risk alternative to money-market funds when first introduced in the mid-1980 s and early 90 s. Many funds intended stable NAVs along with higher yields than money market funds. However, the decrease in interest rates in the early 1990 s made apparent the relative volatility possible in an ARM fund, along with the subsequent downturn in return. Some fund managers purchased higher yielding CMOs and other mortgage security derivatives to increase yields. As rates continued to fall, these strategies resulted in further decreased returns in funds so managed. When the real estate market began crumbling in 2006 and collapsed in the fall of 2008, hedge funds using CMOs and other mortgage security derivatives declined in value dramatically. Their steep losses impacted the entire financial marketplace. ARM funds have been shown to have the potential to be much more volatile than money market funds, especially ARM funds with a significant portion of assets in derivatives. ARM fund stability is dependent upon the ability of borrowers to meet their mortgage obligations, and in the past, ARMs have been offered to and utilized by many borrowers who did not have the means to repay them. However, ARM funds with small exposure to riskier CMO securities can provide an investor willing to accept moderate risk levels the potential of higher returns than a fixed mortgage fund. ARM fund investors must be willing to accept prepayment risk along with greater interest rate risk than found in a traditional money market fund or conservative government securities. ARMs are structured to respond to changing market rates. In a rising rate environment, ARM funds with securitized mortgages backed by borrowers who have the capacity to repay can provide a higher return than a fund with securitized fixed rate mortgages. US Government Treasury Funds US Treasury funds hold assets comprised solely or primarily of debt issued by the US Treasury. These funds too may be short-term, intermediate or long-term. The longterm funds have the greatest volatility, and show the greatest return when interest rates fall. Because treasury funds either limit or do without mortgage-backed securities, the risks related to prepayment as found in a Ginnie Mae fund are not normally found in a treasury fund. And since government backed securities are considered to have no risk of default, the major risk found in a treasury fund is interest rate risk. Mutual Funds and Individual Securities 13

21 Corporate Bond Funds Corporate Bond Funds, as the name suggests, invest mainly in corporate bonds. A number of different types of corporate bond funds are available. High Yield Corporate Bond Funds High yield corporate bond funds are the most aggressive of the corporate bond fund types. They are generally invested in corporate bonds issued by financially troubled companies. The bonds have a higher coupon rate than those of more financially stable corporations. The risk of default in high yield funds is reflected in the potential for higher returns. Whether the return is ample enough for the default risk is up to the fund managers to determine. The funds often allow, by prospectus, a percentage of the fund assets to be in common or preferred stock as well. Some funds also invest in futures and options. Again the overall portfolio composition affects the overall risk of the fund. Corporate Bond Funds - High Quality High quality corporate bond funds generally invest in investment grade corporate debt along with treasuries and government agency securities. The risk of default in high quality corporate bond funds is low, but the funds retain the interest rate risk of all bond funds. Like government funds, corporate bond funds can be found with portfolios comprised of short term, intermediate term or long-term bonds. The average maturity of the portfolio will impact the relative interest rate risk of a fund since short term bonds are generally less sensitive to interest rate risk than long-term bonds. Corporate Bond Funds - General Corporate bond funds which are not comprised of high-yield or high-quality bonds have a wide variety of objectives. Generally, corporate bond funds invest primarily in investment-grade domestic corporate debt. Other investments can include US government securities, stock, foreign securities and small percentages of less than investment grade bonds. Generally, the risk levels and return of a corporate bond fund should fall somewhere between high quality and high yield corporate bond funds. However, the return, interest rate and default risks are dependent on the specific portfolio of the corporate bond fund. World Bond Funds World bond funds include funds which invest solely in bonds from outside the US (also known as International bond funds) and those which also include US corporate bonds in their portfolios (also known as Global bond funds). The risks of the political and economic environment vary from country to country or region to region in the world markets. Issues such as trade agreements and embargoes, multi-nation treaties, such as NAFTA and GATT, and wars or uprisings can all have an impact on the default risk or a world bond fund. Some countries are very stable, such as many western European nations, Mutual Funds and Individual Securities 14

22 and others have highly volatile economies and political environments, such as some eastern European nations. World bond fund portfolios may also be short-term, intermediate and long-term. Since the world market can be much more volatile than US investments, however, a shortterm world bond fund will generally consist of bonds with greater risk than a shortterm domestic (US government or US corporate) bond fund. Exchange rate risk is a risk found only in bond funds holding bonds from outside the US. Exchange rate risk is the risk that the currency in a foreign country will decrease in value relative to other currencies, such as the dollar. If so, the bonds issued from that country will be worth less to investors from countries with stronger currency, or currency which is relatively higher in value. Not only will the bond price be worth less if the currency decreases, but the relative value of the coupon payments, reinvested income and capital gains will decrease as well, to the foreign investor. For example, assume that today a bond issued in Japan is worth $8000 US dollars and pays a coupon rate equivalent to 10%. If the yen falls in value compared to the dollar, that same bond price will decrease in value to an American investor, as will the coupon rate. On the other hand, if the dollar dropped compared to the yen, the bond will be worth more to an American investor. Exchange rate risk can be hedged against by foreign exchange futures and options. Or a fund manager may choose to diversify among many countries to reduce exchange rate risk, along with default and interest rate risks. World bond funds are generally considered aggressive funds. However, some funds also invest in a great deal of US bonds, only venturing into foreign markets when the risk and return trade-off is ascertained to be a prudent risk by the fund manager. These funds may be considered low risk within the world bond fund arena. Others are highly speculative, entering newly emerging foreign markets with highly volatile political and economic environments. Convertible Bond Funds Convertible bonds may be converted to common stock for a specified price. Generally, funds comprised of these securities are intended to offer levels of return and risk which fall between corporate stock funds and corporate bond funds. When compared to purchasing common stock from the same issuer, a convertible bond will typically provide less potential for growth, but generally will not have as much downside risk as the common stock. The reason the bond will not provide the same opportunity for growth as the common stock is that the convertible bond will be more expensive than the purchase of common stock outright. The purchaser is paying for the reduced risk of a bond. The relative risk of a corporate bond is lower than that of the corporation s common stock because of the guarantees of the issue: that a certain coupon rate is paid and at maturity, the bond will have a certain value. Mutual Funds and Individual Securities 15

23 Convertible bonds have specific features which make them different from a typical corporate bond fund. Convertible bonds are typically callable under certain circumstances, such as when the price of the corporation s common stock is greater than the established call price of the bond. Convertible bond funds may have the objective of current income, total return, capital preservation, or all three. Convertible funds often invest in both convertible bonds and convertible preferred stock. The composition from fund to fund varies from extremely high quality securities to low quality, and the ratio of bonds to equities and other securities held, so relative risk and return, of course, varies by fund. Equity Funds Equity funds are funds largely comprised of common stocks. The universe of equity funds is even more diverse in objective and portfolio composition than bond funds. Aggressive Growth Funds The primary objective of an aggressive growth fund is capital appreciation. Portfolios normally hold large amounts of stocks from small and midsize companies, with good, as defined by the fund managers, potential for growth. Options and futures may also be heavily utilized in aggressive growth funds. As the name implies, aggressive growth funds generally provide excellent opportunity for growth, but can also be highly volatile. This fund type is for the long-term investor able to ride out potentially extreme fluctuations in return. Historically, these fund types are more volatile than other growth funds in the short term Growth Funds The objective of a growth fund is growth of capital, or capital appreciation. The portfolio mix in growth funds ranges from stocks from a wide variety of large corporations to funds which invest in stocks from established corporations in certain sectors of the marketplace, such as technology or health care. Growth funds are less volatile, generally, than aggressive growth funds due to their more conservative, higher quality stock portfolios. Those with portfolios with a high concentration in a particular sector are subject to more market risk than those with a more diversified portfolio. Investment in foreign stocks can also increase risk and volatility in a growth fund. Small Cap or Small Company Funds Small Cap stock funds invest in stocks of small to midsize companies. Generally, the objective of these funds is capital appreciation. Small company funds may seek appreciation through a values approach - the fund managers seek out securities which they determine are undervalued in price given their potential for growth - or by focusing on growth potential by picking stocks from companies which show strong earnings and revenue growth. Mutual Funds and Individual Securities 16

24 The amount of diversification in a small cap fund impacts its subjectivity to market risk -- some small cap funds are heavily invested in certain sectors. Recently, technology firms have been one such sector. Sector swings will impact these funds more greatly than more diversified small cap funds. Small cap funds vary in overall risk and portfolio quality, and may be appropriate for the moderate to aggressive investor, with a long term investment horizon to ride out the market s potential volatility. Growth and Income Funds The objective of growth and income funds is current income and capital appreciation. Generally, portfolios are comprised of high dividend stocks and convertibles. Portfolios may also include some small-cap stocks and bonds. Growth and income funds are generally considered less risky than growth funds, because of their emphasis on stocks from large, established corporations with histories of healthy returns and dividend payments. Since these funds are equity funds, their short-term volatility makes them suitable for the long-term investor. Equity Income Funds Equity income funds are generally considered the most conservative of the equity funds. Generally, an equity income fund s objective is current income and capital appreciation. Portfolios generally consist of high quality, high-dividend stock and convertibles, as well as bonds. Equity income funds generally return lower yields than a corporate bond fund, but over the long-term have the potential for greater total return than a corporate bond fund due to the capital appreciation of the stocks within the portfolio. Short-term volatility is an issue, as with all equity funds. World Stock Funds World stock funds include both funds which invest solely in stocks issued by companies outside the US (also known as International stock funds) and those which invest in stocks from companies both inside and outside the US (also known as Global stock funds). The risks are similar to those of world bond funds; exchange rate risk, political and economic risks are all applicable. Sector Funds Sector funds are funds which invest in stocks within certain sectors, such as financial, retail, services, utilities, etc. Depending on the sector invested in, the fund may have the objective of capital appreciation or current income. For example, utility funds have the objective of current income, while precious metals funds have the objective of capital appreciation. Sector funds are generally used as hedging instruments in a portfolio, hedges against purchasing power risk, against interest rate risks, or against general market risks. Sector funds tend to be volatile, since their exposure to sector swings is high. But, when Mutual Funds and Individual Securities 17

25 used in a diversified portfolio, can actually reduce overall risk in an individual s portfolio return. Sector funds are meant to be part of a diversified investment portfolio, for the long-term investor. Balanced Funds Balanced funds are both bond and equity funds. A balanced fund s portfolio includes a mixture of preferred stocks, common stocks, and bonds. The objective of a balanced fund is generally to achieve long term growth or capital appreciation and earn current income while conserving principal. Balanced funds generally have less opportunity for growth than an equity fund, but have the advantage of less volatility due to the bonds and preferred stocks in the portfolio. Through the diversification of their portfolios, default risk, market risk, interest rate risk and purchasing power risk can all potentially be reduced through a balanced fund. However, as with all general fund categories, each individual fund considered a balanced fund is different. Some balanced funds emphasize capital appreciation through the investment in a high percentage of growth stocks. Others seek current income and invest in conservative, high quality bonds and income-oriented stock. The investment emphasis in the portfolio will impact the types and degree of risks in the fund. Money Market Mutual Funds Money market funds are generally considered as cash equivalents: very liquid with stable NAV. However, as mutual funds, there is no guarantee that NAVs will remain stable in a money market. If a fund were to make bad investments, it is possible that share values could drop below the $1 par value normally set for money market funds. Money market funds typically invest in short term liquid vehicles, such as short-term commercial instruments such as CDs, bankers acceptances and commercial paper, short-term government securities, and short-term municipal securities. Some money market funds include short term securities issued around the world, to enhance yield. Although as mentioned, there is some risk of principal in money market funds, they are generally the most conservative, least risky mutual fund available. Mutual Funds and Individual Securities 18

26 Chapter Two Study Questions 1. List four common objectives of mutual funds. 2. The fund prospectus ( will / will not ) guarantee the fund will meet its stated objectives. 3. Match the objective with its definition by listing the number of the definition next to the objective. a. Capital Appreciation 1. Percentage of growth in a fund from both capital appreciation and reinvested income. b. Current Income 2. Growth in the share value of a portfolio. c. Total Return 3. Dividends from common stocks, government or corporate bonds. 4. Match the risk with its definition by listing the number next to the risk. a. Financial or Default Risk 1. Price fluctuations due to changes in interest rates. b. Market Risk 2. The risk that expected income from mortgages will not be paid due to pre-payment of mortgages. c. Interest Rate Risk 3. The risk that the underlying corporation or issuing entity will be unable to meet the obligations of the security. d. Purchasing Power Risk 4. The risk that the currency in a foreign country will decrease in value relative to other currencies. e. Exchange Rate Risk 5. The risk that a security will not increase in value to keep pace with inflation. f. Political Risk 6. The risk of price fluctuation of a particular security. g. Pre-Payment Risk 7. The risk that political events will result in price fluctuations in a security. Mutual Funds and Individual Securities 19

27 5. US Government securities (are riskless / are subject to interest rate, market and purchasing power risks). 6. World bond funds (are always aggressive / may be aggressive). 7. It is (possible/impossible) for a money market fund s NAV to drop below $1. Mutual Funds and Individual Securities 20

28 CHAPTER THREE: MUTUAL FUND FEATURES Objectives Upon completion of this chapter, the student will be able to: Define mutual fund features Explain the uses of mutual funds based on their features Mutual Fund Features Mutual funds features provide the purchaser with valuable tools for diversification and reallocation of assets. They also provide flexibility for both purchasing and liquidating shares. A fund s features can be used to enhance the fund s utility in a client s investment portfolio. For example, a young client may be best suited for a growth fund, but may have little money for an initial investment. The registered representative can direct the client to a suitable fund which has a low initial investment requirement. A customer seeking income is not limited to income funds, but may also take advantage of an equity fund s systematic withdrawal program if his or her risk tolerance and portfolio size so suggests. The features offered by a mutual fund can include dollar cost averaging, systematic withdrawal programs, asset allocation, various distribution options, exchange privileges, and monthly automatic bank check programs. Each mutual fund company may have slightly different elements which make up specific features, but the general structure of these features is similar among those funds which offer them. Dollar Cost Averaging Dollar cost averaging is a strategy used to reduce the impact of market fluctuations on the value of a portfolio. It involves investing a fixed amount of money on a regular basis, e.g., monthly or quarterly, into a mutual fund (or mutual funds). When prices are high, the investment purchases fewer shares, and when prices are low, the investment purchases more shares. This method often results in the average price per share being lower than if all shares were purchased at once, or randomly over the same period that dollar cost averaging is used. It is not a fail-safe method of reducing share price. If the stock goes into a long period of declining share value, for example, dollar cost averaging will not provide a hedge against loss. However, if a stock follows the historical up and downs of the market, over a four to six year period, dollar cost averaging can provide a method of purchasing shares at a lower price per share than the average price per share during the same period. Mutual Funds and Individual Securities 21

29 Dollar cost averaging is not for the client who does not intend to hold shares. It is a strategy for a buy and hold customer who will ride the markets ups and downs to take advantage of the benefits of dollar cost averaging. Most mutual funds which have a dollar cost averaging feature require that a certain amount of money is held in a money market fund, or other relatively stable NAV, conservative fund in the fund family s portfolio. On a regular basis, monthly or quarterly, a certain amount of money will be shifted from the money market fund to the fund or funds selected by the client. Regular Investment Programs Another method of dollar-cost averaging is to make regular contributions through bank drafts to a mutual fund. The owner authorizes his or her bank to make automatic monthly drafts to the fund. The owner designates on the contract application or special form in which funds the draft amount will be invested. Besides the benefit of dollarcost averaging, these programs often offer the smaller savings customer an opportunity to participate in a fund. Bank draft programs often require minimum monthly contributions of only $25 to $50. Asset Allocation Some funds offer an asset allocation program. Normally, a bond fund, equity fund and money market fund are used as the asset allocation vehicles. Periodically, say, once a quarter, the fund s asset allocation committee will meet and determine the best percentage allocation for a portfolio to diversify against market and interest rate risks. For example, the asset allocation mix could be 60% in the equity fund, 35% in the fixed income or bond fund, and 5% in the money market fund. If a client had signed up for the asset allocation program with the fund, the fund would automatically allocate the investments in the appropriate funds to meet the proscribed asset allocation mix. The asset allocation need not be changed every time the committee meets. Or the asset allocation committee may meet as needed and may make a change when market conditions indicate, rather than on a calendar quarter. It is important to note that moving shares from fund to fund does involve liquidating shares, and therefore causes potential capital gains, and subsequent taxation. If this is a concern, some funds have a history of relatively few asset allocation movements, e.g. annually or semi-annually. Another alternative for a client interested in asset allocation is the purchase of a single fund, similar to a balanced fund, which is managed as an asset allocation fund: Similar to the strategy described above, an asset allocation fund is typically managed by a committee who meet and determine the appropriate asset allocation. The methods of determining the asset allocation mix vary from fund to fund or fund company to fund company. Some funds use sophisticated computer programs; others rely on the analytical skills of the managers. Mutual Funds and Individual Securities 22

30 An asset allocation program or fund should not be confused with an overall asset allocation strategy for a particular client. These programs should be used in conjunction with the overall optimum asset allocation plan for a client, and may be found to be a suitable component of a portfolio through the customer profiling process. Systematic Withdrawal Systematic withdrawal programs, as the name implies, allow the withdrawal of a specific amount of money on a regular basis, e.g. monthly, from a fund. For example, if $500 of income is desired monthly, the fund will liquidate the number of shares equal to $500 each month and issue a check to the owner, or designated payee. A common use of systematic withdrawal programs is the distribution of qualified money to meet required minimum distributions. Many mutual fund companies will calculate required minimum distributions for the qualified plan fund owner and make the distributions via the systematic withdrawal feature if the owner desires regular income. An important benefit of systematic withdrawal programs is that they allow regular income through an avenue other than dividend distribution. This means that a client desiring income is not limited to income funds, whether bond or equity income. Rather, if the client is satisfied with a growth fund he has held for years, and now desires income, he can remain in the fund he feels meets his risk tolerance and objectives and request systematic withdrawal payments. Systematic withdrawal programs provide consistent income, rather than the fluctuating income dividends can provide, which can be very important to the client in retirement. Most funds which offer systematic withdrawal programs are able to generate hypotheticals which illustrate historical returns assuming the desired withdrawal amount. The historical results shown on a hypothetical are not a guarantee of future performance; however, a hypothetical illustration can help the client understand the way in which a systematic withdrawal program works. It is important that the client completely understand that systematic withdrawals can exceed or fall within current returns, and that the fund value does not remain constant during the withdrawal period. Receiving systematic withdrawal income is not the same as receiving coupon payments from an individual bond, nor like receiving interest from a fixed rate CD: the value within the fund will fluctuate. Distribution Options Besides systematic withdrawal programs, a mutual fund will offer the fund owner the option of: a) receiving dividend and capital gain income; b) reinvesting income; or c) receiving dividend income and reinvesting capital gain income. Mutual Funds and Individual Securities 23

31 Reinvesting Distributions Even though distributions are reinvested, unless the mutual fund is qualified, e.g., an IRA or pension plan, or is a municipal bond fund, the distributions are subject to taxation. Remember that municipal bond interest income is federally tax-exempt, but capital gains are not. However, reinvested distributions allow for greater growth, since the reinvested distributions will begin generating capital gains and income within the fund account. Some funds charge a sales charge on reinvested distributions, which is an important fact the client should know. Receiving Distributions The fund may distribute income on a monthly or quarterly basis. Some funds distribute capital gains less frequently, e.g. annually. Income distributions may vary in amount, based on the yield since the last payout. Some clients have the mistaken impression that if they receive interest income from a bond fund, the remaining value in the mutual fund remains stable. Certainly, some funds have stability of principal as an objective, but individual share values will fluctuate in any mutual fund. As stated when discussing systematic withdrawals, it is important for the client to understand that receiving income from a mutual fund is not the same as receiving interest from an individual bond or from a fixed rate CD because account values will fluctuate. Distribution Dates Mutual funds may pay dividends monthly, quarterly, semi-annually or annually. Capital gains are generally distributed annually. Record Date The record date is the date a purchaser is considered a shareholder of record. Shareholders of record as of the record date receive income and capital gains distributions from the fund. Ex-Dividend Date The ex-dividend date is the date a distribution is subtracted from a share s NAV. It generally follows the record date by one or two days, or may be the same date as the record date. Exchange Privileges An exchange privilege is the ability to transfer shares within a fund, typically without additional sales charges. It is important to note that some fund families include funds which will charge a full or partial sales charge even if shares are purchased through the liquidation of shares within the same fund family. The types of funds which are typically excluded from the normal exchange privilege rules are funds which have higher sales charges than the other funds in the family due to special management requirements, such as a high risk foreign stock fund. It is important to check the prospectus carefully concerning the requirements for exchanges. Sometimes, even if a fund has a higher initial load than other funds in the family, if shares have been held Mutual Funds and Individual Securities 24

32 within the fund family for a certain length of time, even shares from the higher loaded funds can sometimes be purchased through fund exchange privilege terms. The advantage of exchange privileges is the ability to reallocate portfolio assets easily and inexpensively. Some funds allow for the ability to exchange shares over the phone if appropriate authorizing paperwork has been completed. Minimum Investment The minimum investment requirement of a fund is most important, of course, to the client with small amounts of cash to invest. Certain funds have minimums of as little as $25 - $100 if monthly automatic investment payments are established. Others require an initial investment of $1000, and subsequent monthly investments of, for example, $50. Overall, fund minimum investment requirements are generally $ $5000, but can be much higher. Mutual Fund Values Mutual fund shares are valued based on the market price of the underlying assets and liabilities of the fund. The value of each share is known as the Net Asset Value (NAV) and represents fund assets, including receivables, less liabilities. The NAV is the price received if shares are liquidated. The Public Offering Price (POP) is the purchase price of shares, and includes any sales charges or loads which are charged at purchase. Shares are valued at the close of each day the market is open. Mutual Fund Returns The return of a mutual fund is expressed through calculations of yield and total return. Yield The yield of a fund is basically the amount of annual income received per share, expressed as a percentage of the current or average share price. As a simple example, if the current share price of a fund is $10.00, and $1.00 of income was earned per share over the past twelve months, the yield would be 10% ($1.00 / $10.00). The actual yield calculation required for mutual funds (the SEC Yield ) is much more complex than this example. It includes incorporating risk premiums, special accounting for foreign security distributions, and other complicated computations. Total Return The total return of a fund is a calculation which incorporates the change in share price over a period of time and assumes distributions are reinvested as they are received. It is expressed as a percentage of the share price excluding loads or including loads. Sometimes yield is emphasized and total return is overlooked when a fund is purchased for income purposes. However, yield alone does not give an adequate Mutual Funds and Individual Securities 25

33 picture of a fund s performance. For example, a yield may be a positive number and the total return for the same fund a negative number, meaning that the share value decreased enough to offset the positive distribution income from the fund. When total returns and yields are quoted by a fund in the prospectus or other literature, they will be accompanied by a statement similar to Total returns and yields are based on past results and are not an indication of future performance, as the SEC requires. Mutual Funds and Individual Securities 26

34 Chapter Three Study Questions 1. Dollar cost averaging ( always results / may result ) in a lower average price per share than if all shares were purchased at once, or randomly over the same period that dollar cost averaging is used. 2. Asset allocation is used to against risk. 3. List a benefit of systematic withdrawal programs. 4. List three distribution options: a. b. c. 5. Exchanges ( never / may ) include a sales charge. 6. NAV is the price received if shares are. POP is the price paid for shares. 7. Total return includes both change in share price and reinvested. Mutual Funds and Individual Securities 27

35 CHAPTER FOUR: THE MUTUAL FUND PROSPECTUS Objectives Upon completion of this chapter, the student will be able to: List the required disclosures within a mutual fund prospectus Differentiate between accurate and inaccurate disclosure in a prospectus The prospectus is a condensed version of the registration statement filed by the mutual fund company with the SEC in order to issue shares of a mutual fund. The prospectus contains information about the issue and issuer in order that an investor can make an informed investment decision. The statutory prospectus contains the following information: The name of the fund The date of the prospectus The fund s investment objective and investment policies Investment risks Expenses Financial highlights and performance Investment Advisor information Portfolio Manager information Transfer Agent information Share valuation, purchases, redemptions and special purchase or redemption programs Distributions Required disclosures and cover statements The Date of the Prospectus The prospectus must be updated at least annually. The Fund s Investment Objective And Investment Policies The statutory prospectus describes the objective of the fund and the investment strategies or policies which can be used toward meeting the objective. Included are details such as what percentage of the fund s assets can be invested in any particular type of securities and/or derivatives, what type of company s stocks and bonds will be considered for purchase, and under what circumstances a security might be sold. Mutual Funds and Individual Securities 28

36 Depending on the prospectus, the policies may be explained in great detail, or in comparatively general terms. The fund s Statement of Additional Information (SAI) can be referred to for more detail than a prospectus provides. The SAI is available from a fund to anyone who asks for it. The SAI includes, among other things, the compensation of the directors and officers of the fund, all securities within the fund s portfolio as of the end of the fund s fiscal year, the audited financial statements of the fund, and all investors who own five percent or more of the fund. Investment Risks The risks associated with each of the investment policies described are included in the statutory prospectus. Expenses Expenses in a mutual fund include shareholder transaction expenses which are sales charges or loads, redemption fees and exchange fees, and annual operating expenses, which are management fees and 12b-1 fees. Shareholder Transaction Expenses Sales Charges or Loads Front-End Loads A fund may charge a fee each time a purchase is made. This is known as a front-end sales charge or load. Front-end loads commonly range from 3-4% of purchase price. Typically, funds with a front-end load higher than the average are funds which, based on the fund objective, have a limited pool of securities to buy from or require special management, such as a fund with securities from a single country. Back-End Loads A fee may be charged at liquidation or redemption of shares rather than at purchase. This type of load is known as a back-end load or a contingent deferred sales charge. Back-end loads are charged if shares are liquidated within a certain period of time from purchase, for example, within five years. Often, the charge decreases each year subsequent to purchase. For example, a five year contingent deferred sales charge schedule may charge a 5% charge for shares liquidated within one year of purchase, a 4% charge for shares liquidated within two years of purchase, a 3% charge for shares liquidated within three years of purchase, and so on. The percentage charged may either be of the purchase price paid for the shares or of the share price at redemption. Spread Load Charges Another type of fee arrangement is the spread load charge, wherein a level charge is levied each year. Typically, the charge is 1% and is charged against the shareholder s Mutual Funds and Individual Securities 29

37 assets whether shares are liquidated or not. This arrangement can be advantageous if the shareholder plans to switch to different fund families regularly, but if the fund is held long-term, this arrangement can be the most expensive. Other Sales Charge Arrangements A fund may have other sales charge arrangements, such as a load spread over a specific period of time, or a combination of front and back-end loads. If a fund offers more than one type of sales charge schedule, the shares purchased under each respective arrangement are considered as being in different classes. Typically, Class A shares are shares purchased with a front-end load, Class B shares are shares purchased with a back-end load, and Class C shares are shares purchased with a spread load. The fund defines the fee arrangements for each class, and may have several classes. Sales Charges for Reinvested Dividends Some mutual funds charge a sales load on shares purchased with reinvested dividends. Redemption Fees A fund may charge an administrative fee at redemption, or may charge a fee for wiring funds. Exchange Fees Some funds charge a fee for exchanging shares of a fund to another fund in the same family. This fee is separate from any sales loads which may be applicable. For example, a fund may charge $15 for an exchange. Often, funds do not charge additional sales loads for exchanging shares from one fund to another, although in certain cases there may be sales loads charged for exchanges to certain funds within a family. Annual Operating Expenses Annual operating expenses are paid by the fund, not by the individual investor. They pay for items such as fund management, record-keeping, issuing statements and financial reports, 12b-1 fees, fees to any outside distributors or marketers, fees to transfer agents, and legal, accounting and custodian fees. These fees are reflected in the overall return of the fund. Management Fees Management fees pay for the management of the fund. The amount of the fee is related to the expense of managing the fund. The percentage charged depends on the investment strategies and types of securities in the fund. Funds with higher risk objectives, such as a foreign stock fund normally have higher expense charges than a lower risk fund such as a US Government securities fund. The management of these higher risk funds is considered more demanding than most lower risk funds. Index funds often have the lowest expense levels of all, since they are managed to mirror the portfolio composition of a stock index. Mutual Funds and Individual Securities 30

38 12 b-1 Fees 12 b-1 fees are subtracted from the fund s assets to pay for the marketing and distribution costs of the fund. They go to the distributor of the fund, and/or to the brokers selling the fund. A 12 b-1 fee cannot be greater than.75 percent of a fund s average net assets per year. Other Expenses Other expenses may include legal and accounting fees and custodian fees. A custodian may be an entity which administers qualified plans, or handles all statements and reporting for a fund. Financial Highlights and Performance The financial highlights listed in the statutory prospectus include financial figures such as asset size, net asset value, income distributions, total return, expenses and portfolio turnover ratio. These figures are shown on an annual basis for ten years, or since the fund s inception if less than ten years. Performance information provides return information and defines the calculation for total return, yield and any other calculations the fund may use to describe return. Investment Advisor Information An Investment Advisor is a company which provides the fund with investment research, investment recommendations and possibly administrative accounting or other services. The Investment Advisor and fund company may be the same entity. The Portfolio Manager A short resume of each manager of a fund is included in the prospectus. The manager s experience, tenure with the fund and education are normally included. Prospectuses for money market funds and index funds do not have to include information regarding portfolio managers. The Transfer Agent The transfer agent maintains account holder records, generates account statements, tax records and reports. The transfer agent may be the mutual fund company, a subsidiary or an outside entity. The transfer agent handles the correspondence and reporting of most transactions on a mutual fund account. Shares How to Purchase Shares The procedure for purchasing shares is explained in the prospectus. Minimum purchase requirements, the process the fund uses in establishing the share price, when payment Mutual Funds and Individual Securities 31

39 must be received by the transfer agent, and how to purchase additional shares are described. Any special purchasing arrangements will also be described in the prospectus. For example, if shares may be purchased by pre-authorized bank drafts, or if dollar-cost averaging or asset allocation programs are available, the procedures and requirements for these programs will be described. How to Sell Shares The statutory prospectus includes the procedure for redemption of shares. Typically, shares may be redeemed by a written request or may be liquidated based on phone authorization if this service is signed up for prior to the redemption request. Some redemptions may require a written request with a signature guarantee. If a redemption is of a certain amount or more, the fund may require a signature guarantee. The prospectus will identify which entities can guarantee a signature, e.g. a bank, broker-dealer, credit union, securities exchange or association, or a savings association. The amount requiring a signature guarantee varies greatly from fund to fund, ranging from as little as $10,000 to amounts of $100,000 or more. Distributions Typically, a fund will have several options regarding distributions: reinvestment in the same fund; reinvestment in another fund within the same family; mailing out or delivering all distributions; or mailing out or delivering dividend income and reinvesting capital gains. Tax Information The statutory prospectus includes general information regarding taxation. The tax consequences of fund transactions are passed on to the shareholders of the fund. When the fund buys and sells securities within the fund, it experiences capital gains. When dividends are paid on the securities to the fund or bond interest payments are made to the fund, the fund experiences dividend income and interest income. These gains and income are required to be passed onto the shareholders of the fund, who bear the tax consequences of the funds capital gains, dividend income and interest income. Dividends Dividends from fund assets which are distributed to shareholders are taxed as ordinary income to shareholders, or if qualified dividends, are generally subject to a maximum tax rate of 15%. When a shareholder opts to reinvest dividends, they are still treated as distributions for tax purposes, and are generally taxable. Mutual Funds and Individual Securities 32

40 Municipal Bonds and Taxation An exception to the rule that dividend distributions are taxable occur with municipal bond income. Interest from municipal bonds is generally exempt from federal income tax. Income from municipal bonds is also often exempt from state taxation in the state in which they are issued. Private Activity Bonds There are certain types of municipal bonds which are not exempt from federal income tax. Interest on private activity or private purpose bonds may not be exempt. Bonds which fall into this category are used to fund industrial development or other private activity and are issued after August 7, Determination of whether a bond is or is not exempt from federal income tax depends on a number of complex factors. Special law firms render opinions regarding the taxability of a municipal bond issue. If a bond purchased by a fund is considered to be a private activity bond, the fund will provide shareholders the tax information necessary for the shareholders to properly report income from such bonds. Private activity bond interest is generally considered a tax-preferred item in the calculation of alternative minimum tax for individuals and corporations. Social Security Tax Tax-exempt interest is included when calculating the taxability of social security payments. Capital Gains from Municipal Bonds Capital gain distributions from municipal bond funds are not federally tax-exempt. Capital Gains Capital gains can result from a shareholder selling shares or from a fund selling assets within the fund. Capital losses may be used to offset capital gains. Capital gains and losses may be either long-term or short-term. A short-term gain or loss is one which occurs when property held for one year or less is sold. A long-term gain or loss arises from property held over a year. The Jobs and Growth Tax Relief Reconciliation Act of 2003 reduced the capital gains tax rates. Long-term capital gains that occurred prior to May 6, 2003, were taxed at a maximum rate of 20%. Under the provisions of the 2003 Act, such capital gains were taxed at a maximum of 15%. For those in a 10% or 15% tax bracket, these capital gains were taxed at a maximum rate of 5% through The Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA) extended the 15% capital gains rate for those in a tax bracket of 25% or above through 2010, and applied a capital gains rate of 0% for those in the tax brackets of 10% and 15% from 2008 through The maximum tax rate was increased to 20% in 2013, due to provisions in the American Taxpayer Relief Act of 2012, but not many taxpayers are impacted by the highest rate. Mutual Funds and Individual Securities 33

41 Effective in 2013, a net investment tax applies to capital gains included in income. This tax is a Medicare surtax on investment income. The IRS issued a final guidance on the application of this tax on November 26, The net investment tax applies at a rate of 3.8% for taxpayers with income above threshold amounts. These threshold amounts are set by statutory law and not subject to adjustment for inflation: Filing Status Threshold Amount Married filing jointly $250,000 Married filing separately $125,000 Single $200,000 Head of household with $200,000 qualifying person Qualifying widow(er) with $250,000 dependent child Short-term capital gains from a fund s assets are treated as dividends for income tax purposes. Therefore, they are generally taxed as ordinary income. However, under the provisions of the 2003 Act, some of the ordinary income may include dividends (called qualified dividends ) that qualify for preferential tax treatment, with a maximum tax rate of 15% and a minimum tax rate of 0%. The Tax Reform, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (TRA 2010) extended the 0% to 15% tax treatment of qualified dividends through The American Taxpayer Relief Act of 2012 (ATRA 2012) made this 0% to 15% tax rates permanent for qualified dividends paid to: individual taxpayers with taxable income below $400,000; and joint taxpayers with taxable income below $450,000. Mutual Funds and Individual Securities 34

42 The 15% capital gain thresholds for taxable income adjusts with tax rates, and for the years from 2013 are: Year Maximum Individual Taxable Income Maximum Joint Taxable Income 2013 $400,000 $450, $406,750 $457, $413,200 $464, $415,050 $466, $418,500 $470,700 These dividends, other than those subject to the permanent 0% to 15% rate, are now subject to a maximum tax rate of 20%. Each mutual fund company will report to its shareholders the type of distributions that it has made and the corresponding tax information on a 1099-DIV. Mutual Funds and Individual Securities 35

43 Qualified Dividends Qualified Dividends IRS Publication 17 Explanation Qualified dividends are ordinary dividends subject to the same 0%, 15% or 20% maximum tax rate that applies to net capital gain. They should be shown in box 1b of the Form 1099-DIV you receive. The maximum rate of tax on qualified dividends is: 0% on any amount that otherwise would be taxed at a 10% or 15% rate. 15% on any amount that otherwise would be taxed at rates greater than 15% but less than 39.6% 20% on any amount that otherwise would be taxed at a 39.6% rate. To qualify for the maximum rate, all of the following requirements must be met. The dividends must have been paid by a U.S. corporation or a qualified foreign corporation. The dividends are not of the type listed later under Dividends that are not qualified dividends. You meet the holding period. Holding period. You must have held the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date. The ex-dividend date is the first date following the declaration of a dividend on which the buyer of a stock is not entitled to receive the next dividend payment. Instead, the seller will get the dividend. When counting the number of days you held the stock, include the day you disposed of the stock, but not the day you acquired it. See the examples later. Exception for preferred stock. In the case of preferred stock, you must have held the stock more than 90 days during the 181-day period that begins 90 days before the ex-dividend date if the dividends are due to periods totaling more than 366 days. If the preferred dividends are due to periods totaling less than 367 days, the holding period in the previous paragraph applies. Examples You bought 5,000 shares of XYZ Corp. common stock on July 9, XYZ Corp. paid a cash dividend of 10 cents per share. The ex-dividend date was July 16, Your Form 1099-DIV from XYZ Corp. shows $500 in box 1a (ordinary dividends) and in box 1b (qualified dividends). However, you sold the 5,000 shares on August 12, You held your shares of XYZ Corp. for only 34 days of the 121-day period (from July 10, 2013, through August 12, 2013). The 121-day period began on May 17, 2013 (60 days before the ex-dividend date), and ended on September 14, You have no qualified dividends from XYZ Corp. because you held the XYZ stock for less than 61 days. Assume the same facts as in Example 1 except that you bought the stock on July 15, 2013 (the day before the ex-dividend date), and you sold the stock on September 16, You held the stock for 63 days (from July 16, 2013, through September 16, 2013). The $500 of qualified dividends shown in box 1b of your Form 1099-DIV are all qualified dividends because you held the stock for 61 days of the 121-day period (from July 16, 2013, through September 14, 2013). You bought 10,000 shares of ABC Mutual Fund common stock on July 9, ABC Mutual Fund paid a cash dividend of 10 cents a share. The ex-dividend date was July 16, The ABC Mutual Fund advises you that the portion of the dividend eligible to be treated as qualified dividends equals 2 cents per share. Your Form 1099-DIV from ABC Mutual Fund shows total ordinary dividends of $1,000 and qualified dividends of $200. However, you sold the 10,000 shares on August 12, You have no qualified Mutual Funds and Individual Securities 36

44 dividends from ABC Mutual Fund because you held the ABC Mutual Fund stock for less than 61 days. Maximum Long-Term Capital Gains and Qualified Dividends Rates 0% If taxable income falls in the 10% or 15% marginal tax brackets 15% If taxable income falls in the 25%, 28%, 33%, or 35% marginal tax brackets 20% If taxable income falls in the 39.6% marginal tax bracket 28% On collectibles 28% On qualified small business stock after exclusions Note that the 20% maximum tax rate for higher income individuals effectively becomes 23.8% due to the net investment tax. (See IRS Publication 550 for more information on qualified dividends, qualified small business stocks and other capital gains issues.) Shareholder Taxation of Gains and Losses Shareholders have more than one option to determine gain and loss of shares from the sale of shares. Share Identification The shareholder can specify which shares the fund is to sell by identifying the shares by purchase date. The shareholder will often want to sell the shares with the highest price, minimizing capital gain consequences. The IRS requires that there is a written record of the share price and date of purchase and redemption in order to use this method, so it is important that the shareholder keep such a record. The fund should return written confirmation that the specified shares were sold to the shareholder for such a request. Averaging Methods If a shareholder bought shares at different prices, generally the shareholder can select an averaging method to determine any gain or loss when selling shares. The shareholder must elect an averaging method on his or her tax return, and then must use this same method for all other shares within the fund family for which the method was elected. Double Category Averaging Method Under this averaging method, shares owned are separated into short and long-term categories. The shares purchased within the last year or less are placed into the shortterm category, and all shares purchased over a year prior are in the long-term category. An average price is determined for all the shares in each category by taking the aggregate price divided by the number of shares. This becomes each share s cost basis. When shares are sold, the shareholder can select shares from either category. Shares sold from the short-term category result in a short-term gain or loss. Shares sold from the long-term category result in a long-term gain or loss. Mutual Funds and Individual Securities 37

45 Single Category Averaging Method Under the single category method, basis is determined by calculating an average share price of all shares, regardless of length of time held. Shares are considered to be sold according to the FIFO method - the first shares purchased (in) are the first shares sold (out). FIFO Method If a shareholder cannot identify shares by purchase and redemption date and price, the shares will be taxed as though the first shares purchased were the first shares sold (the FIFO method). Exchanges An exchange of shares within a fund family is considered a sale and purchase of shares for tax purposes. Required Disclosures and Cover Statements The statutory prospectus must include certain disclosure statements. One such statement basically states that the SEC does not approve or disapprove the mutual fund, nor does it vouch for the accuracy of the prospectus. Another required cover statement is that the mutual fund shares are not guaranteed by a financial institution nor by the FDIC. This statement also states that the shares are subject to investment risk, including the possible loss of principal. Summary Prospectus The statutory prospectus includes a summary statement at the beginning, with the key elements of the prospectus summarized to help the reader better understand the securities product being described. The summary includes: 1. investment objectives 2. costs (including the fee table and example) 3. principle investment strategies, risks, and performance 4. investment advisors and portfolio managers 5. brief purchase and sale and tax information 6. financial intermediary compensation A mutual fund may provide a summary prospectus by giving it or mailing it by first class US mail to a purchaser, and may provide the statutory prospectus online. Mutual Funds and Individual Securities 38

46 Chapter Four Study Questions 1. Place an S next to each expense which is a shareholder transaction expense, and an A next to each expense which is an annual operating expense. a. Exchange Fees b. 12b-1 Fees c. Sales charges d. Management fees e. Redemption fees 2. Class A shares typically have a - end load. 3. Financial figures are shown in the prospectus on an annual basis for years. 4. A fund may require that certain withdrawals are guaranteed. 5. Dividends, excluding municipal bond dividends, are generally taxed as income. 6. A short-term gain or loss is one which occurs when property held for or less is sold. 7. If a shareholder cannot identify shares by purchase and redemption date and price, the shares will be taxed as though the shares purchased were the shares sold. Mutual Funds and Individual Securities 39

47 CHAPTER FIVE: STOCKS Objectives Upon completion of this chapter, the student will be able to: 1. Differentiate between preferred and common stock 2. Identify risks of common stock Stocks represent shares of ownership in a corporation. Stocks may be issued as preferred or common. Preferred Stock Preferred stock is preferred in comparison to common stock because owners of preferred stock are paid before owners of common stock in the event a corporation is dissolved or goes into bankruptcy. Preferred stock, although considered an equity security, in many ways acts like a debt instrument. Preferred Stock Dividends Preferred stock pays a dividend annually. The dividend is either a fixed amount, a fixed percentage of the stock s face value, or a floating rate tied to an index. Because preferred stock pays a dividend, it is like a bond. However, a preferred stock dividend is unlike a bond dividend in that it must be earned and declared annually by the corporation s board of directors. If a bond does not pay its stated interest income, it is considered in default. If a preferred stock does not pay a dividend, the issue is not in default, but the market may view the non-payment as evidence of a corporation s financial difficulty. Preferred stock may have cumulative or non-cumulative dividends. A cumulative dividend provision in a preferred stock issue means that any preferred stock dividends not paid will accumulate for payment at a later date. Dividends of cumulative preferred stock must be paid before any common stock dividends are paid. A preferred stock with a dividend based on a fixed rate is more sensitive to interest rate changes than a dividend subject to a floating rate. Convertible Preferred Stock Convertible preferred stock can be converted to common stock at a certain price and/or as a certain number of common stock shares. The price where the value of the preferred Mutual Funds and Individual Securities 40

48 stock is equal to the price of the common stock is known as the parity price. Once the convertible preferred stock reaches or goes beyond the parity price of the common stock, the preferred stock will in some ways begin to behave like common stock: its price will increase as the common stock s price does. But because it has a stated dividend, when the common stock s price falls, the preferred stock will generally not fall below a certain level. The preferred stock has an inherent value because of the stated dividend. Common Stock Common stockholders share in the performance of the issuing corporation. If a company is doing well, its common stock will reflect its healthy performance. If it is doing poorly, the common stock will also reflect this condition in lower prices. Common stocks are issued by many types of corporations and have different characteristics and risks based on the issue terms and the underlying corporation s lines of business. Growth Stocks Growth stocks are stocks issued by companies who are considered to have a propensity for substantial expansion. Growth companies retain earnings in order to expand their business and generally are younger companies, or companies in an industry with strong demand. In the realm of growth stocks, there are companies which are considered to issue aggressive growth stock because of the possibility for rapid high growth along with high risk of financial setbacks or out and out failure. Companies on the leading edge of various technologies without other diversified businesses fit into the aggressive category. Blue-Chip Stocks Blue-Chip stocks, like the high-valued chips in the game of poker, are common stocks from companies who have proven themselves over time to be of high value. These companies are dominant market players with consistent above-average growth. A Blue-Chip company typically has a long record of dividend payments. Income Stocks Income stocks pay a relatively high dividend on a consistent basis. Companies with income stock are typically strong financially and do not need to re-invest income to finance growth. Cyclical Stocks Some companies are in an industry or a line of business which is cyclical in nature. Cyclical industries include consumer goods such as appliances, houses and automobiles. These industries depend on consumers having disposable income. In Mutual Funds and Individual Securities 41

49 times of economic health, companies offering these products do well, and in slow economic times, these companies often experience slow growth or even financial difficulties. Such companies stock is known as cyclical stock and may be used to add diversification to a portfolio. Defensive Stocks Other companies provide products or services which do not fluctuate greatly with the economy. Items such as groceries and utilities fall into this category. In an economic downturn, these stocks do not generally lose as much in value as the general market. Conversely, in an economic upswing, these stocks do not enjoy the growth of stocks more dependent upon a healthy economy. These stocks are known as defensive stocks because they help keep returns level over time in a diversified portfolio. Risks of Common Stocks Fluctuation of Price As a security, common stocks offer no guarantee of principal. The shares may go up and down in price. Financial Risk The financial strength or weakness of the underlying company affects share price and dividend payment. Market Risk New competition, technological change, changes in demographics, and business cycles can all impact a company s business. International Stocks Corporations outside the US issue stock which is traded on foreign stock exchanges. Foreign or international securities can offer diversification opportunities not found in the US. Industries which are mature in the US may be at the beginning of the growth curve in other countries. Fast food, entertainment, and supermarkets offered growth decades ago in North America, but are industries in their infancy in many overseas countries. American Depository Receipts There are a few foreign securities traded directly on US exchanges. However, foreign equities are commonly traded as American Depository Receipts (ADRs) in the US. ADRs are negotiable receipts representing a share or shares of stock in a foreign security. The shares are commonly deposited in a bank (the depository) within the country in which they were issued. A US correspondent bank creates the ADRs. Although ADRs are traded like stock on the New York Stock Exchange, the American Stock Exchange and the over-the-counter market, they are different from domestic Mutual Funds and Individual Securities 42

50 stock. For example, some ADRs do not include voting rights. ADR dividends are converted to US dollars for which the depository charges a fee to the ADR holder. Risks of International Equities Risks in international investing include political, economic and exchange rate risk along with the risks associated with common stocks. Foreign securities may also be less liquid than domestic securities. Political Risks Foreign governments vary from being very stable to being close to anarchy. The biggest risk in a foreign country is that business assets will be seized by the government, or that assets will be frozen. This is considered a political risk. Economic Risks Economic climate in a country has an impact on its securities just as the domestic economy has an impact on many of the securities issued in the US. Exchange Rate Risk The value of the currency of the country in which the international stock is issued relative to the dollar affects the value of the stock. The stock s performance for a US investor may be enhanced or reduced by the difference in the value of the dollar. Mutual Funds and Individual Securities 43

51 Chapter Five Study Questions 1. For the following stock characteristics, place a P next to characteristics of preferred stock, a C next to characteristics of common stock and a B next to characteristics of both common and preferred stock: a. convertibility b. dividends c. cumulative dividends 2. List three types of risk associated with common stocks. 3. List three types of risk associated with international stocks. Mutual Funds and Individual Securities 44

52 Objectives CHAPTER SIX: STOCK FUNDAMENTALS Upon completion of this chapter, the student will be able to: Distinguish among the types and activities of stock exchanges Define market order, limit order, stop-loss order and stop-buy order Stock Prices When stock is originally issued, it is assigned a value called the par value or the stated value. Once it is traded through an exchange or over-the-counter, it has a market value. The market value is the price at which the stock actually is being bought and sold on the market. Each share of stock has a bid and ask price. The bid price is the price paid to the seller of stock. The ask price is paid to purchase a share of stock. The ask price is always higher than the bid price. The difference between the bid and ask price is usually 12.5 (1/8) or 6.25 (1/16). For a stock which is not frequently traded, the difference between the bid and ask may be twenty-five to fifty cents (¼ to ½). The greater the spread, the less frequently the stock is traded, meaning the stock may be a risky issue. Stock Markets Stocks are traded on exchanges and on the over-the-counter market (OTC). To be listed on a particular exchange, a stock issue must meet the requirements of that exchange. New York Stock Exchange The New York Stock Exchange (NYSE) is the largest stock exchange. Most of the largest US corporations trade on the NYSE. The NYSE was established in A seat on the NYSE is quite expensive. Only the largest companies are typically listed on it. The NYSE MKT LLC (Formerly the American Stock Exchange) The NYSE MKT LLC has roots going back before 1910 when it was called the New York Curb Market Association. Originally, no stock listed on the NYSE was listed on the NYSE MKT LLC. However, this rule was abolished in Besides the stocks from the NYSE which are dually listed on the NYSE MKT LLC, the NYSE MKT LLC typically lists stocks of smaller and younger companies than those on the NYSE. It also has a history of trading securities such as warrants which the NYSE was hesitant to do. Mutual Funds and Individual Securities 45

53 The Over-The Counter Market The over-the-counter (OTC) market is not an exchange at a fixed location. Rather it is a method of trading stocks not listed on an exchange. There are no minimum requirements which must be met to be traded through the OTC. Basically, the only requirement is that there is a market for the stock-- that someone or some entity is willing to buy or sell the stock. The OTC is a negotiated market, wherein the purchasers and sellers use no intermediary. OTC trades are quoted on the National Association of Securities Dealers Automatic Quotations (NASDAQ) computer system. The NASDAQ shows all the different dealers bid and ask prices for a stock. The broker can then choose the best price and contact that appropriate dealer and make the trade. Regional Exchanges Several regional exchanges exist which list local companies which do not qualify for the larger NYSE or NYSE MKT LLC. These regional exchanges also list many of the stocks listed on the NYSE or NYSE MKT LLC, so that broker-dealers not members of the NYSE or NYSE MKT LLC are able to buy and sell these securities. If such a broker-dealer has to go through the NYSE or NYSE MKT LLC, these exchanges would take a portion of the trade s commission. Regional Exchanges Boston Stock Exchange CBOE Stock Exchange Chicago Stock Exchange National Stock Exchange Philadelphia Stock Exchange Pacific Stock Exchange Stock Information Information about a stock s price history and performance, as well as financial information about the issuing corporation is available from many sources. The Corporation s Annual Report All publicly traded companies are required to publish an annual report which discloses the company s financial position, business activities during the year and general outlook for the near future. Security Prospectus In order to initially offer stock, a corporation must file a registration statement with the SEC. The prospectus is a condensed version of this registration statement and includes more detailed financial information than the annual report. Mutual Funds and Individual Securities 46

54 SEC Reports The SEC requires several reports from publicly held companies, including the 8-k report and the 10-k report. 8-K Report This is a monthly report which discloses any business activity which may have an impact on debt, equity, capital assets, or any other item that may affect the company s stock. 10-K Report This annual report is available to shareholders free of charge from the company. It provides detailed financial information. Research Services Several companies publish information on corporations and stock issues. Standard & Poor s, Moody s, and Value Line all have several publications available which provide a stock s price and dividend payment history, company financial information and business activity of interest to a shareholder or market watcher. Morningstar has recently entered this arena as well, providing reports on US Equities. Newspapers Financial newspapers and most metropolitan and statewide newspapers include stock price information. These prices are based on the close of business on the exchange where the stock is listed. NASDAQ closing quotes on most actively traded OTC stocks are reported also. The report will also give the change in price from the previous market business day. Buying and Selling Stock Market Order A market order is the most common type of order when buying or selling stock. It is an order to buy or sell at the best price in the market at the time the order is placed with the market maker. Market Maker A market maker is a firm that stands ready and able to buy and sell a security on a regular and continuous basis at a publicly offered price. A market maker must generally be able to buy and sell at least 100 shares of the security for which it makes a market. Several market makers may be part of large security transactions. Limit Order A limit order includes a price at which the stock will be either bought or sold and how long the order is in effect. For example, if a stock currently has a $20 bid and $20 1/8 Mutual Funds and Individual Securities 47

55 ask, a limit order to purchase may be 100 shares at $18, good until canceled. Then, if the shares bid price drops to $18, the limit order will be filled. Stop-Loss Order A stop-loss order is used to sell stock if the price hits a certain price. The stockholder may place the stop-loss order at any price, higher or lower than his purchase price. For example, the purchase may have been at $60 a share. To limit a potential loss on the stock, a stop-loss order may be placed at $50. If the stock falls to this price, it will be sold. Or, the stockholder may place a stop-loss order at $90, higher than the purchase price. Basically, this stockholder wants to take his profits and run if the stock price rises to this level. Stop-Buy Order A stop-buy order is like a stop-loss order, but is an order to buy at a certain price. This order is used if a stock was sold short. Selling a stock short means that an individual borrows stock from another stockholder (through his broker), then sells it. The borrower believes the stock price is going to fall. He buys stock, ideally at a lower price than when the stock was borrowed, and replaces the stock he borrowed. The lender receives the money paid for the stock when the borrower sold it as collateral until the borrower replaces the stock. A stop-buy order is placed at a price higher than the price the shares were originally borrowed for. Then, if the stock price goes up, rather than down as the borrower expected, the stock will be sold, limiting the borrower s potential loss. Margin Transactions Stocks may be bought or sold on margin. Buying a stock on margin means that a portion of the stock s purchase price (50%) is paid for with cash, and the other portion is borrowed through the brokerage firm. Many brokerage firms allow a stock portfolio to be used as collateral for the loan. If the stocks in the margin account go up in price, the equity in the margin account goes up. If the stock price goes down, the equity decreases. Currently, if the borrower s equity goes below 25%, the borrower must provide more cash, or the stock will be sold to pay off the loan. Obviously, buying stock on margin can be risky. When the stock market crashed in October, 1987, many people who had margin accounts were badly hurt. As late as 1993, brokerage firms had liens against people s homes due to unpaid margin account loans from In 2000, when tech stocks took a beating, many people who had highly leveraged portfolios due to the use of margin accounts were financially devastated. In the steep market descent of 2008, investors found their margin accounts uncovered because their portfolios had decreased significantly. The brokerage may have the right to sell the investor s shares in order to cover the margin debt, or the investor may be required to make an immediate deposit to cover the loss. Mutual Funds and Individual Securities 48

56 There is typically a loan fee of from % on margin accounts. Some brokerage firms offer margin account loans which are used like a credit card or equity line. The stock portfolio is put up as collateral, and the borrower draws cash from his brokerage firm credit line. Mutual Funds and Individual Securities 49

57 Chapter Six Study Questions 1. Define bid price. 2. Define ask price. 3. List two purposes of regional stock exchanges. a. b. 4. The OTC is a market. 5. List five sources of stock information: a. b. c. d. e. 6. Match the type of stock order with its definition by listing the number next to the order. a. market order b. limit order c. stop-loss order 1. An order to sell or buy a stock at a specific price for a specified period of time. 2. An order to sell stock if the price hits a certain price. 3. An order to buy or sell at the best price in the market. Mutual Funds and Individual Securities 50

58 7. Selling short means that stock is sold which is from a stockholder. 8. If a borrower s equity in a margin account goes below %, the borrower must provide more cash for the account. Mutual Funds and Individual Securities 51

59 CHAPTER SEVEN: BONDS Objectives Upon completion of this chapter, the student will be able to: Explain the characteristics of a bond Differentiate among bond types by their features Bond Fundamentals A bond is a debt instrument. The purchaser is the lender, and the bond issuer is the borrower or debtor. A bond includes a promise to pay interest and principal to the borrower. The principal will be paid by a specified date - the maturity date. Bonds are issued by corporations, local and state municipalities and the federal government and its agencies. Bonds are contractual agreements. A bond contract is called an indenture. The indenture includes all the provisions of the bond issue. Bond prices fluctuate with interest rates. Bonds have an inverse relationship with interest rates because when interest rates go up, bond prices go down, and when interest rates go down, bond prices go up. Face Value The face value of the bond is the amount for which the bond was originally issued. Bonds are typically issued in multiples of $1000. A bond which is issued for less than $1000 is called a baby bond. Coupon The coupon is synonymous with interest rate in the bond market. Coupons equal to the number of interest payments are attached to bearer bonds, or bonds which can be redeemed by whoever possesses or bears them. The coupons are clipped as interest payments come due for redemption. Although actual coupons are found only on bearer bonds, the term coupon or coupon rate is used to mean the interest rate for bonds in general. Some bonds have a fixed coupon rate. Others have a floating rate, tied to an index. Mutual Funds and Individual Securities 52

60 Notes vs. Bonds A note is a short-term bond. A note typically has a maturity of ten years or less. In the case of corporate bonds, notes are sometimes issued prior to the release of a longterm bond issue. Most features found in bonds can be found in notes. Callable Bonds If a bond is callable, the issuer can redeem the bond prior to the bond s stated maturity date. A call feature may allow the issuer to redeem the bond at any time, or only under certain conditions. Typically, a bond is not callable in the first 5-10 years of issue, and is redeemable by the issuer at a certain premium above its face amount. Refunding If a bond issue is redeemed by the issuer in order to fund a new bond issued, the redeemed issue is said to be refunded. Very often, the indenture of callable bonds includes a provision that the bonds cannot be called for the purpose of refunding. Convertible Bonds Corporate bonds may be convertible to common stock. Bond Yields A bond pays interest over the term of the bond and also pays principal equal to the face amount at the bond s maturity date. The yield on a bond may be quoted as the current yield or may be quoted as the yield to maturity or yield to call. Current Yield The current yield calculation for a bond is the annual interest / current bond price. For example, if $75 of interest is received and the bond s current price is $1000, the current yield would be 7.5%: $75/$1000. Yield to Maturity The yield to maturity reflects the impact of receiving interest payments over the life of the bond, followed by the receipt of the face value of the bond at maturity. The yield to maturity on a bond is different from the current yield if a bond is selling at a discount or premium. Assume five years after issue, a ten year $1000 bond with a 7.5% rate is now selling for $960. The yield to maturity for this now five-year bond is 8.5%. This figure comes from a bond yield table. Bond yield tables (or more often today, computerized yield to maturity calculations) take into account the time value of money, the number of years to maturity, and the redemption of face value at maturity. Note that in this example that because rates in the market had risen since the bond was purchased, the bond is selling at a discount to yield the market rate of 8.5%. The longer the period to maturity, the greater the bond s price will fluctuate with changes in interest rate. At a certain point, however, the price fluctuation will Mutual Funds and Individual Securities 53

61 minimize. For example, the difference between a sixty-year bond and a one hundred year bond s change in price due to an interest rate change is very minimal. Yield to Call A bond may be called before maturity, so another calculation used to measure yield is the yield to call calculation. It is similar to the yield to maturity calculation, except that the call date is used rather than the maturity date. Other sophisticated yield calculations include calculating the probability a bond will be called at a certain time based on varying interest rate assumptions. Corporate Bonds Several types of corporate bonds are available, some secured by collateral, others not. Bonds are issued by all types of corporations - there are more corporate bonds listed on the exchanges than are equities. Corporate bonds often pay interest semiannually, but some pay quarterly or annually. Unsecured Bonds Unsecured bonds are bonds which are not backed by collateral, but are backed by the corporation issuing the bond. Unsecured bonds are known as debentures. Debenture bondholders are general creditors should the corporation fail financially. Subordinated debentures are another type of unsecured bond. Subordinated debenture bondholders, as the name indicates, are behind debenture holders and other creditors claims on the issuing corporation. Subordinate debentures as a class pay higher interest rates than debentures and secured bonds pay. They also may be convertible to common stock to make them a more attractive buy. Debentures and subordinated debentures which may be converted to common stock are called convertible debentures. Debentures may be bonds or notes and, although unsecured, may include provisions which can reduce the level of risk the purchaser carries. For example, the indenture can include a provision that the debenture be of a specific size, and no further debenture series may be issued until the first issue is paid. Or, a specific amount of working capital may be required to be maintained equal to the amount of outstanding debentures. Secured Bonds There are a number of ways bond issues can be secured with collateral. The most common secured bond types are mortgage bonds, collateral trust bonds and equipment trust certificates. Mutual Funds and Individual Securities 54

62 Mortgage Bonds A corporation may place a mortgage lien on property it holds as security for a bond issue. The mortgage may be a first mortgage or a combination of a first mortgage on a portion of the secured corporate property and second or even third mortgages on other corporate property. Collateral Trust Bonds Collateral trust bonds are backed by specific corporate assets, such as securities. Through the bond indenture, if the issue goes into default, the corporate trustee of the issue is given the authority to sell the collateral to pay off the bond debt. Equipment Trust Certificates Equipment Trust Certificates are issued primarily by corporations in the transportation industry -users of railroad cars, trucks, air transport planes or oil tankers. Basically, the corporation orders equipment, such as railroad cars, from a manufacturer. The manufacturer gives legal title to a trustee. The trustee leases the equipment to the corporation and sells the equipment trust certificates, or guaranteed loan certificates, as they are called in the airline industry. Proceeds from the sale of the equipment trust certificates are used to pay the manufacturer. The rental payments from the corporation are used to pay off the equipment trust certificates debt. If the corporation is unable to make the lease payments, the trustee leases the equipment to a different corporation. Equipment trust certificates are considered relatively low-risk, because the equipment is usable by many different corporations in the same industry. How to Purchase Corporate Bonds An underwriting group or syndicate brokers the initial offering of a bond issue. The underwriters are securities brokerage firms and investment banking firms. Subsequent to the initial sale, bonds are traded on the exchanges and the OTC. Each time a bond is purchased or sold, a commission is paid, and the yield on the bond is effectively reduced to the purchaser or seller. Municipal Bonds Municipal bonds are bonds issued by government entities at the state, city, county and other local government levels. Interest payments from municipal bonds are generally exempt from federal income tax. Municipal bonds are generally issued in $5000 denominations. They may be bearer bonds or fully registered, meaning an owner is assigned. Interest payments are generally paid semi-annually. Types of municipal bonds available are discussed in Chapter Two, and the taxation of municipal bonds is discussed in Chapter Four. Mutual Funds and Individual Securities 55

63 Municipal Bond Pricing Municipal bond prices are quoted by the yield to maturity percentage. A $1000 corporate bond may have a quote of 99 bid ($990) and 99 1/2 offer ($995). A $1000 municipal bond may have a quote of 5.40% bid, 5.30% offered. To determine the price, a bond basis book may be referred to. The face amount of the bond, the years to maturity and the coupon rate must all be known to use the basis book. Financial calculators are also used to calculate the bond price. How Municipal Bonds are Sold Initial offerings of municipal bonds are brokered by municipal bond dealer firms, securities brokerage firms, investment banking firms and commercial banks. Secondary trading is done through municipal bond dealers, securities brokers and commercial banks. Municipal bonds are not traded using a quote system like the NASDAQ. Rather municipal bond inventories held by the various dealers are listed daily on the Blue List. Trades are negotiated primarily by telephone. Brokers may contact several different bond dealers to get a municipal bond bid. The broker will then accept the bid that is best for the purchaser or seller. US Government Debt Instruments The US Government issues several different types of debt securities -- bills, notes, bonds and derivatives. This chapter discusses bills, notes and bonds. The following chapter discusses derivative securities. Risks of US Government Securities US Government securities are considered the safest security in terms of risk of default. Since they are backed by the full faith and credit of the federal government, the risk of default is considered by the securities marketplace to be nonexistent. As debt instruments, these securities are subject to interest rate risk. Face value is paid upon maturity, providing stability of principal if the bill, note or bond is held to maturity. However, if the security is sold prior to maturity, it is subject to market pricing, which may be higher or lower than the original purchase price. Treasury Bills Treasury bills have a maturity of one year or less. Typically they are issued with 4-, 13-, 26- or 52-week maturities. Treasury bills, or T-Bills, do not pay interest. Rather, they are issued at a discount, then at maturity pay face value. The gain on T-Bills is short term, and is taxed accordingly. The minimum purchase amount for a T-Bill is $100. They are purchased in multiples of $100. Traditionally, they have been purchased in $1000, $10,000, $15,000, $100,000, $500,000 and $1 million amounts. The maximum bill amount that may be purchased in a single auction is $5,000,000 in a noncompetitive bid, or up to 35% of the offering on a competitive bid. Institutional investors offer Mutual Funds and Individual Securities 56

64 competitive bids. The primary source for purchasing all treasury securities is through the government website TreasuryDirect, or Yield of Treasury Bills The formula for calculating the yield on T-Bills which mature in 52 weeks is The Face Value of the Bond - The Price of the Bond / The Price of the Bond. For example, if the price of a $10,000 T-Bill is $9500, the calculation is 10, / 9500, or 500/ 9500 = 5.26%. If a T-Bill matures in less than 52 weeks, the calculation is: The Face Value of the Bond -The Price of the Bond / The Price of the Bond divided by The Days To Maturity / 365 (the number of days in a year) If a $10,000 T-Bill matures in 26 weeks and has a price of $9800, the calculation is: 200 / 9800 divided by 182 / 365 =.0204 / 499 =4.09% How T-Bills are Sold The Treasury auctions 13 and 26 week T-Bills weekly, normally on Mondays. 52-week T-Bills are auctioned monthly. The term auction is used because purchasers submit bids for the bills. The Treasury accepts the best (highest) bids submitted by a specific time on the auction date. Since each week a set dollar amount of bills are auctioned, if a bid is too low it may not be accepted. Individual purchasers often submit a non-competitive bid for the bills. This is done through The price for a bill when a non-competitive bid is submitted is the average of the competitive bids accepted for a particular auction. New issues of T-Bills may be purchased from treasurydirect.gov, brokerage houses, from the federal reserve, and from some large banks who act as dealers. After issue, T-Bills are traded on the OTC. Commission on the trade is in the form of a mark-up which is reflected in the yield quoted on the bill. Treasury Notes Treasury notes are issued in multiples of $100. They have maturity dates ranging from two to ten years. The maximum non-competitive auction purchase for a T-Note is Mutual Funds and Individual Securities 57

65 $5,000,000. A competitive bidder may offer to purchase up to 35% of the auction offering. Unlike T-Bills which do not pay interest, Treasury notes pay a fixed amount of interest semi-annually. Treasury Note Yields Yields for Treasury notes are calculated as discussed in the first section of this chapter where current yield and yield to maturity calculations were discussed. How Treasury Notes are Sold Auctions are held for Treasury notes. Notes are bid for like bills, and can be purchased directly from the federal reserve, or through a commercial bank or brokerage house. Purchasers not making competitive bids can purchase the notes directly from the US Treasury at treasurydirect.gov. They can be issued as bearer securities, in book entry, or as registered securities. A registered security is one where the owner is recorded as owning the security. The secondary market for Treasury notes (and bonds) is on the NYSE MKT LLC and the OTC. Treasury Bonds Treasury bonds are similar to Treasury notes except that they have maturities of over ten years. The difference between Treasury bonds and notes is that some issues of Treasury bonds are callable. The call date on these bonds is usually five years prior to maturity. Federal Agency Securities Several federal agencies and federally sponsored agencies issue securities. They borrow money in order to provide credit for certain activities or certain segments of society. The most active agencies in issuing credit are involved in the housing and agricultural industries. Some agency securities are backed by the full faith and credit of the federal government. Others are not, but may have the ability to borrow from the US Treasury if the need arose. There are a multitude of agency securities available. A few are described below: Government National Mortgage Association Securities Government National Mortgage Association (GNMA) securities are backed by the full faith and credit of the federal government. The GNMA is an agency of the Department of Housing and Urban Development. It issues securities in order to provide financing for various housing projects. Mutual Funds and Individual Securities 58

66 GNMA Pass-Through Securities As discussed in Chapter One, pools of mortgages underlay pass-through certificates. The mortgages backing these certificates are FHA and VA. GNMA guarantees the certificates. The minimum denomination of most of these certificates is $25,000. The GNMA passes on the principal and interest collected on the mortgages to the certificate holders. Interest payments are paid monthly to the certificate-holder fortyfive days after the mortgage holder is paid. Mortgage pass-throughs are subject to prepayment risk. If mortgagees prepay their mortgage, the expected interest will not be paid on the certificates, because the principal will be paid. Taxation of GNMA Securities GNMA securities are subject to federal, state, and local income taxes. Federal National Mortgage Association Securities The Federal National Mortgage Association (FNMA) issues securities in order to buy mortgages such as FHA and VA mortgages from lenders. It is not an agency of the federal government, but rather is a private corporation. FNMA securities are not guaranteed by the federal government, but FNMA has the authority to borrow from the Treasury Department if necessary. FNMA Discount Notes FNMA Discount Notes are sold at a discount from the principal face amount. They have maturities ranging from overnight to 360 days, although three- and six-month maturities are not issued. They are issued in denominations of a minimum of $1000 and in $1000 increments above this amount. There are no interest payments made from Discount Notes. These notes are sold through U.S. Federal Reserve Banks. FNMA Foreign Discount Notes FNMA issues short-term debt obligations that are denominated in foreign currencies, known as FX Discount Notes. These Discount Notes are available in maturities from five days to 360 days and may be issued in all tradable currencies. They are sold in the Euro money market. Benchmark Bills Benchmark Bills are issued in minimum denominations of $1000 and increments of $1000 above the minimum amount. They are typically issued as three- and six-month maturities and occasionally in one year denominations. These are sold through a Dutch auction conducted through the Internet and offerings are typically announced on Mondays. Mutual Funds and Individual Securities 59

67 Investment Notes Investment Notes are issued weekly to retail investors. Most Investment Notes are callable and have maturities ranging from four to thirty years. These notes are offered at their par value and have varying interest payment dates. They are offered in minimum denominations of $1000 and $1000 increments above this amount. Taxation of FNMA Securities FNMA securities are subject to federal, state, and local income taxes. Mutual Funds and Individual Securities 60

68 Chapter Seven Study Questions 1. Notes typically have a maturity of years. 2. A bond s yield to maturity is different from its current yield when the bond is selling at a or. 3. The current yield for a bond selling at $1050 and earning $60 of interest annual is: 4. Match the type of unsecured bond to its definition by listing the number of the definition next to the bond type. a. debenture b. subordinated debenture c. convertible debenture 1. debentures which can be converted to common stock. 2. an unsecured bond. 3. an unsecured bond which is behind debentures and other creditor claims on the issuing corporation. 5. Match the type of secured bond to its definition by listing the number of the definition next to the bond type. a. Mortgage bonds b. Collateral Trust Bonds c. Equipment Trust Certificates 1. A bond with a mortgage lien as security. 2. A bond with specific corporate assets as security. 3. A certificate backed by corporate equipment placed in a trust. 6. Municipal bonds generally pay interest - and are issued in denominations of $. Mutual Funds and Individual Securities 61

69 7. Next to the following US Government security characteristics write Bill if the characteristic applies to T-Bills, Note if it applies to T-Notes, and Bond if it applies to T-Bonds. a. maturities of two to ten years. b. maturities of over ten years c. maturities of one year or less d. issued at a discount, no interest payments e. can be callable 8. GNMA pass-through certificates (are / are not) backed by the full faith and credit of the US Government. FNMA pass- through certificates (are /are not) backed by the full faith and credit of the US Government. Mutual Funds and Individual Securities 62

70 Objectives CHAPTER EIGHT: OPTIONS Upon completion of this chapter, the student twill be able to: Define option, put option and call option Explain the purpose of options in portfolio management Identify risks found in the use of options Options are securities which give the purchaser the right to buy or sell a security at a specified price within a specified period of time. They are used by individual investors and investment professionals, such as mutual fund managers to earn income and protect or hedge a portfolio against loss. Types of Options Put Options An option to sell a security at a specific price is called a put option. The put gives the option buyer the right to sell 100 shares of a security at a specified price. The specified price in the option contract is called the exercise price or contract price. An option contract is always for 100 shares, so each 100 shares is known as one contract. A put option is profitable to the buyer if the stock to which the put applies drops in price. For example, assume XYZ stock is selling for $40 a share. Three put contracts (300 shares) are purchased for $4 a share, with an exercise price of $40. The option contracts, not including commission, costs $1200. The option contract expires in six months. The stock goes down in price to $30 during the contract period and the put option is exercised. The option holder purchases 300 shares of stock at the current price of $30 ($9000) and then puts them to the option seller who must pay $40 a share ($12,000) according to the contract. The option buyer makes a profit of $1800, not counting commission charges: $12,000 less $1200 paid for the option contracts and $9000 paid for the 300 shares of stock. If the stock had gone up in price rather than down, the put would have been worthless and the buyer would have been out $1200 plus commission. The put seller would have earned the premium of $1200, less commission. Call Options A call option is the option to buy a security at a specified price within a specified time frame. The purchaser of a call option makes a profit if the stock price rises. Mutual Funds and Individual Securities 63

71 Assume ABC stock is selling for $30 a share. Four call contracts are purchased for $4 a share ($1600 plus commission). The contracts have an exercise price of $30 and expires in nine months. The stock moves up to $40 a share. The option buyer exercises the call, buys 400 shares of ABC at $30 from the call seller ($12,000) and sells them at $40 a share ($16,000). The profit, again not including commissions, is $2400. However, if the stock did not rise during the next nine months, or did not rise enough to cover the cost of the option contracts, the option is worthless. Option Premiums Besides exercising options, income can be made by trading options. The seller or writer of an option earns the premium, less commission, paid for the option. As stock prices move up and down, the related option prices will move up and down as well. Option prices can be quite volatile, depending on the movement of the related stock, the length of time in the options contract, and the exercise price. Covered Option Writing If the seller of a call owns the security on which the option is written, the seller is said to be writing a covered call. If the securities are not owned by the writer, he or she is writing a naked call. Covered calls are not subject to the large losses of a naked call. If the call option is exercised and the writer must sell securities at the strike price, the writer delivers the shares owned. He or she is not forced to go into the market and purchase securities in order to meet the call as the writer of a naked call must. Options as a Protection Against Loss When put options are purchased at the same price as stock purchased, the stockholder/option buyer is basically buying insurance on the stock for the period of the option contract. Should the stock fall in value, the stockholder can exercise the call option and sell at the price for which the stock was originally purchased. An analogy can be drawn to property insurance, or term life insurance: if a claim is never made, the insurance purchaser is out the insurance premium. Similarly, if the price on the stock does not fall, and the option is not used, the purchaser is out the option premium. Use of Options by Mutual Funds Mutual funds use options to increase yields, to protect against loss, and to add diversification to a portfolio without the expense of buying more securities. Increasing Yields Selling options provides income to the seller. Some funds enhance yields by earning premium income by selling options. Depending on the amount of option writing, the fund may minimally or significantly impact its risk level by this activity. Mutual Funds and Individual Securities 64

72 Protection Against Loss Like individual investors, mutual fund managers may buy puts as a type of insurance on a portfolio. Or, they may use much more sophisticated option methods. Spread options are one such method. A spread option is the purchase of one option and the sale of another option on the same security, index or even market. A spread option can be used to hedge against risks which exist in a portfolio. Spread options include yield curve spreads, money market spreads, and spreads on various markets, such as the mortgage market. Adding Diversification Buying options can have the effect of leveling returns, which is one of the outcomes of diversification. Diversification levels out returns since different securities have different levels of return at any given time. Buying options can provide this same benefit without the outlay involved in actually buying the securities. Diversification through options can be more risky than the purchase of the actual security, however. How Options Are Sold Options are traded on the NYSE MKT LLC, some regional exchanges and the OTC. Risks of Options Market risk is the predominant risk in options. The rise and fall in price of the related securities can make an option worthless, or of high value. The short-term nature of the contracts adds to their volatility. Options are for those individuals willing to accept a high degree of risk, or for managers of mutual funds who use options to meet the objectives of the fund. If options are used in a fund, the prospectus will describe the activity and the applicable risks involved. Mutual Funds and Individual Securities 65

73 Chapter Eight Study Questions 1. Define put option. 2. Define call option 3. The writer of an option earns the, less commission, paid for the option. 4. Define covered call. 5. Three reasons a mutual fund may use options are: a. b. c. Mutual Funds and Individual Securities 66

74 Objectives CHAPTER NINE: EXCHANGE-TRADED FUNDS (ETFS) Upon completion of this chapter, the student will be able to: Describe the basic elements of ETFs Recognize the roles of the various parties in an ETF transaction Differentiate between an actively managed and passively managed ETF Know the advantages and limitations of ETFs for the average investor Exchange-traded funds (ETFs) combine features of mutual funds and individual stocks. As the name suggests, they are traded on the exchanges. They are also pools of investments managed by professionals, like mutual funds. ETF prices fluctuate during the trading day as they are bought and sold, like individual securities. Most ETFs are structured as open-ended funds, and are registered under the Investment Company Act of 1940, like mutual funds. Some ETFs that hold commodities or currencies are not registered. This course discusses the open-ended, registered funds. ETF Structure ETFs enter into contracts with large financial institutions, normally broker-dealers. The financial institution agrees to act as an Authorized Participant (AP). The AP purchases from, and redeems shares in, the ETF in large blocks, called Creation Units (CUs). The AP sells some of its shares on the exchanges, which allows individual purchasers access to them. ETFs hold shares of hundreds to thousands of companies or municipalities in order to track or match the security benchmark or style. Types of ETFs Passively Managed ETFs The first ETFs were created to track the performance of specific U.S. equity indexes such as the NASDAQ-100 Index, S&P 500, or Dow Jones. This type of ETF that matches the performance of a U.S. index is the most popularly traded type of ETF. These types of ETFs seeking to match or track performance of an index are passively managed ETFs, where there is not a lot of active trading of securities by the managers of the portfolio. Besides matching or tracking an index, passively managed ETFs may track: an industry or industry sector types of corporate or government bonds and fixed instruments types of securities, such as large-cap, small-cap, micro-cap foreign indexes or fixed income instruments Mutual Funds and Individual Securities 67

75 Actively Managed ETFs There are also actively managed ETFs. These ETFs are managed with a particular objective, and are likely to have more frequent trading of the securities within them by the ETF managers. In comparison with passively managed ETFs, actively managed ETFs hold very few assets. Passively managed ETFs are more popular with investors by far. Inverse ETFs are one form of actively managed fund. An Inverse ETF is managed to profit from a decline in the value of the benchmark. The benchmark, for example, would be an index, or a tracked industry sector. The Inverse ETF is comprised of derivatives and utilizes complex trading methods to achieve its objectives. The Inverse ETF is an example of a high risk ETF. Actively managed ETFs also take the form of money market funds. These ETFs have the objective of outperforming money market portfolios. They are considered relatively low risk and can provide an investor with the opportunity of greater returns than a traditional money market fund. They tend to have some short-term securities in their portfolios that are relatively high risk in order to generate the higher return, but keep the level of investment in such securities to a minimum. There are various other actively managed ETFs. Commonly, they are managed to avoid a downside risk characteristic of the security group that comprises the ETF. For example, an actively managed high income bond ETF may have an objective to avoid junk bonds that are the result or subject of a highly leveraged buyout. Removing this risk is intended to remove some volatility in the ETF. There are actively managed ETFs that seek to match the performance of large, popular mutual funds. These ETFs seek to emulate their return, while having the structure of an ETF. Why not just invest in the mutual fund itself? Generally, because of the tax characteristics, availability or the expense levels that the ETFs possess and the mutual funds in question do not. How ETFs are Traded Active Participant Trades When an AP purchases shares of an ETF it pays for them by assembling and depositing a basket of securities and cash with the ETF. The basket of securities represents the holdings of the ETF. The AP then has the right to hold the ETF shares, or to trade them through the secondary market to individual investors, institutions or market makers. When an AP seeks to redeem shares (or creation units) it holds with the ETF, it delivers the shares to the ETF and receives a basket of individual securities or equivalent cash. Mutual Funds and Individual Securities 68

76 Other Investor Trades When investors other than APs purchase shares on an exchange they purchase them at market prices. This price is likely to be higher or lower than the NAV of the ETF. This is one of the differences between an ETF purchase and a mutual fund purchase. All purchasers of mutual fund shares buy the shares at NAV (plus any front-end loads). ETFs are traded at market prices on an exchange. The NAV of a fund is set daily; ETF market prices may change throughout the trading day. Generally speaking, however, an ETF s market price will be close to the ETF s NAV. ETF NAV An ETF s NAV is calculated at the end of the trading day, like a mutual fund s NAV is. During the trading day, an ETF s NAV is estimated every 15 seconds and communicated through the exchange. The estimated value is known as the intraday indicative value (IIV), or the intraday operative value (IOPV), depending on the exchange on which it is listed. The IIV or IOPV is based on the estimated value of the fund s holdings throughout the trading day. AP Arbitrage An ETF s NAV is normally different than the IIV or IOPV throughout the trading day. This gives APs the opportunity to use a trading strategy known as arbitrage to make a profit. An AP can purchase shares directly from the ETF, and can sell the shares through the exchanges. Quite obviously, if the shares are selling for more than the NAV, an AP can make a profit by selling shares purchased at the NAV from the ETF on the exchange for the higher amount. An arbitrage trade can occur in a matter of moments, and a fluctuation in price can be taken advantage of by an AP quickly through an exchange trade. An AP will execute an arbitrage trade when the ETF s exchange price varies from its estimated NAV. Such variance is generally because of market forces. For example, perhaps a lack of investor confidence causes many ETF shares to be sold, and the market price falls below the NAV. An AP could purchase the ETF shares through the market, and then redeem them at NAV with the ETF. The AP makes a profit by doing so. Or, there may be high demand for the ETF, and the market price increases due to this high demand. The ETF share price is higher than the NAV. The AP can purchase shares from the ETF and sell them through the market for a profit. Individual investors (non-aps) can buy and sell short though an exchange to participate in ETF arbitrage opportunities, but normally do not have the investment power that an AP does to engage in such activity. Taxation of ETFs Recall that when an AP purchases shares of an ETF it delivers a basket of securities to the ETF that represents the holdings of the ETF. This is an in-kind exchange between the AP and the ETF. Because it is an in-kind exchange, no capital gains are realized. This means that the ETF does not have capital gains to pass through to investors on the exchange of securities with the AP. If in-kind exchanges occur regularly with an ETF, it Mutual Funds and Individual Securities 69

77 is likely to have fewer capital gains to pass onto investors than a mutual fund. This is not always the case, but is a feature that makes ETFs attractive to investors. Otherwise, taxation of mutual funds and ETFs are subject to the same rules. If the ETF sells securities in its portfolio at a gain, the gain must be passed onto ETF shareholders. When the ETF earns dividend income or is paid bond income, it must pass on the income to the shareholders. Even if the income is reinvested, it is subject to taxation on the part of the shareholders. Gain from ETF transactions is reported to investors through IRS Form 1099-B. The investor is responsible to properly report and pay taxes on the gain, whether long-term or short-term. ETF Expenses ETFs do not have sales charges or loads like mutual funds do. Because they are sold through an exchange, the ETF trade comes with a broker fee, as a stock transaction through a broker does. This fee varies by broker. Obviously, the more often an investor makes an ETF trade, the more broker fees the investor will have to pay. The services of the broker, such as generating statements and tax forms, also impact the amount of fees charged to an investor. The expense ratios of a passively managed ETF are often significantly lower than expenses in a mutual fund. This means that the return to an investor could be higher than a mutual fund with a similar objective, but there is no guarantee that the lower expenses will result in a higher return. An actively managed ETF will have higher expenses than a passively managed ETF, generally speaking. Historically, actively managed ETFs experience lower expenses than a mutual fund. The structure of the ETF with the involvement of large institutional APs causes expenses to be lower than a mutual fund that is often dealing with many individual investor cash purchases and redemptions and individual investor services. In addition, ETFs do not have 12b-1 fees, as mutual funds do (recall that 12 b-1 fees go to the distributor of the fund, and/or to the brokers selling the fund). Minimum Investment Requirements ETF shares trade on the exchanges. A broker will buy and sell one share of an ETF if that is the order placed by the customer. So, the minimum investment for an ETF is the cost of one share, plus the broker s fee, unless the broker has a minimum investment requirement for its customers. This is not to suggest that buying one share of an ETF is the appropriate course for a small investor because the investor may be able to afford it. The cost of the broker and the investment holding period and other factors should be considered, as they would be for any securities investment. Some large brokers may allow an investor to that places money with them regularly to be charged a reduced fee, similar to regular investing with a mutual fund. For example, Mutual Funds and Individual Securities 70

78 if the investor signs up for an automatic contribution to the broker of $100 per month, the broker may not charge the investor as much per trade as a person who randomly invests $100 periodically through the broker. It pays for an investor to shop around, and determine which broker offers ETF investing on terms that are best for the investor. Mutual Funds and Individual Securities 71

79 Chapter Nine Study Questions 1. Exchange Traded Funds combine features of and. 2. The most popular type of ETF is: a. passively managed b. actively managed 3. The large institutional investors that purchase shares directly from ETFs are known as: a. active participants b. creation units 4. During the trading day, an ETF s NAV is estimated every and communicated through the exchange. 5. In-kind exchanges of securities do not result in Mutual Funds and Individual Securities 72

80 Objectives CHAPTER TEN - MEETING CLIENT NEEDS WITH MUTUAL FUNDS AND INDIVIDUAL SECURITIES Upon completion of this chapter, the student will be able to: List the ways in which mutual funds meet the need for income, reduction of current taxation, long-term savings and other investment goals Describe the ways in which a mutual fund meets each of these objectives The primary responsibility of the registered representative is assisting the client in finding suitable vehicles to meet the client s financial needs. The wide universe of mutual funds and securities allows the registered representative a great deal of choices for a client. The client s overall profile must be considered when determining the best fund or security for his or her needs. This chapter will focus on specific customer needs and the choices within the securities universe in meeting those needs. Income Many clients, especially older clients, have a need for income. If they have reached retirement age, they need income to supplement social security and pension plan income and to support their retirement lifestyle, which may include travel and recreation. If a client desiring income has a profile indicating he or she is willing to accept some fluctuation in principal in exchange for a yield or return potential higher than that available in a more conservative instrument, such as a CD or fixed annuity, a mutual fund may be a suitable income producing vehicle. The key elements of importance for the client to understand regarding a mutual fund purchased for income are: Account values will fluctuate; they may lose all or a portion of what was invested. The yield and return on the fund is not guaranteed. Generally, the return on the investment is a reflection of the risks the client is assuming If income is taken via distribution of dividends, the amount of the check will vary based on the yield of the account and the number of days in the period for which the check is payable. Many clients, especially older ones, are used to using the bank certificate of deposit as an income vehicle. As opposed to the information just listed, CDs have the following attributes: Mutual Funds and Individual Securities 73