Series 65 Flashcards
Investment Act of 1940
The Investment Advisers Act of 1940 was enacted to protect the public by requiring those who provide investment advice for compensation to register as advisers with the Securities and Exchange Commission (SEC).
The 3 criteria that must be present to require registration as an investment adviser
- Giving advice about securities
- Being in the business of giving that advice
- Being compensated for that advice
Exemptions from registration as an IA under the Investment Act of 1940
Banks, or bank holding companies
Professionals, such as lawyers, accountants, teachers, etc., whose advice is incidental to their profession and who receive no special compensation for making recommendations
Publishers of bona fide newspapers, magazines or financial publications of a general and regular circulation
Government securities advisers
Broker-dealers and their registered representatives whose advisery services are incidental to the securities business and who receive no special compensation for making recommendations
IAs whose clients are all residents of the state of the IA’s principal office and who do not provide advice on securities traded on any national exchange
IAs whose only clients are insurance companies
IAs who qualify for the private-adviser exemption (i.e., less than 15 clients, do not hold themselves out to the public as investment advisers and do not advise registered investment companies)
You can expect at least one question on the “out of state” clients
preferred stock
also represents equity ownership in a corporation, but usually does not have the same voting rights or appreciation potential
Normally pays a fixed quarterly dividend
Has priority claims over common stock
Capital appreciation
Increase in the market price of securities
dividend yield
Annual dividend/stock price
Rights of stockholders
Common stockholders have the right to vote for corporate directors
Stock is freely transferable to anyone who wants to buy it or receive it as a gift
A right to limited access to the corporation’s books
The right to receive an audited set of financial statements of the company’s performance each year (annual statement)
Usually have preemptive right to maintain their proportionate share of ownership in the corporation
Limited liability of equity ownership
One is personally at risk only for the amount invested
Risks of equity ownership
Market risk
Decreased or no income
Low priority at dissolution
Benefits of equity ownership
Potential capital appreciation
Income from dividends
Hedge against inflation
Preferred stock
Is an equity security because it represents a class of ownership in the issuing corporation Shares characteristics with a debt security
Rate of return on a preferred stock
Is fixed rather than subject to variation as with common stock. As a result, its price tends to fluctuate with changes in interest rates rather with the issuing company’s business prospects unless, dramatic changes occur in the company’s ability to pay dividends (called interest rate or money rate risk)
Voting rights of preferred stock
Unlike common stock, most preferred stock is nonvoting.
Benefits of preferred stock
Less growth potential than common stocks, but preferred stockholders must be paid prior to common stockholders
Fixed dividend is a key feature for income-oriented investors
Prior claim over common stockholders, but after debt holders in event of bankruptcy
Has no preset maturity date so it functions like a perpetual security
Straight (noncumulative) preferred stock
Has no special features beyond the stated dividend payment. Missed dividends are not paid to the holder
Cumulative preferred stock
Accrues payments due its shareholders in the event dividends are reduced or suspended
Dividends in arrears must be paid to preferred stockholders before any dividends are paid to common stockholders
Because of this unique feature found only with cumulative preferred stock, an investor seeking steady income would find this to be most suitable type of preferred stock
Callable (or redeemable) preferred stock
Company can buy back stock from investors at a stated price after a specified date. The right to call the stock allows the company to replace a relatively high fixed dividend obligation with a lower one when the cost of money has gone down.
Convertible preferred stock
Allows the owner to exchange the shares for a fixed number of common stock shares. Because the value of a convertible preferred stock is linked to the value of the common stock, the convertible preferred’ s price tends to fluctuate in line with the common. Generally issued with a lower stated dividend.
Adjustable (variable) rate preferred stock
Usually tied to the rates of other interest rate benchmarks (e.g. T-bills and money market rates). Because the payment adjusts to current interest rates, the price of the stock remains relatively stable. For investors looking for income through preferred stocks, this would be their least appropriate choice.
Risks of owning preferred stock
As a fixed income security, there is no inflation protection
As a fixed income security, when interest rates rise, the value of preferred shares decline
As an equity security, there is the risk that dividends may be skipped
As an equity security, all creditors except for common stockholders have prior claim
Benefits of preferred stock
Fixed income from dividends
Prior claim ahead of common stock
Convertible preferred sacrifices income in exchange for potential appreciation
Preferred stock risks
Market risks
Possible loss of purchasing power
Interest rate risk
Business difficulties risk- e.g. bankruptcy
American Depositary Receipts (ADRs)
Are negotiable securities that represent a receipt for shares of stock in non-US corporation usually from 1-10 shares. Everything is done in English and in US dollars. Most common stockholder rights apply to ADR owners.
Currency risk for ADR owners
In addition to normal stock ownership risks, ADR investors are subject to currency risk. ADRs are issued by domestic branches of American banks and even though they are traded in US dollars, they still bear currency risk
Custodian bank
Domestic branch of large US commercial banks issue ADRs. A custodian, typically in the issuer’s country, holds the shares of foreign stock that the ADRs represent. The stock must remain on deposit as long as the ADRs are outstanding because the ADRs are the depositary bank’s guarantee that it holds the stock
Custodian bank
Domestic branch of large US commercial banks issue ADRs. A custodian, typically in the issuer’s country, holds the shares of foreign stock that the ADRs represent. The stock must remain on deposit as long as the ADRs are outstanding because the ADRs are the depositary bank’s guarantee that it holds the stock
Registered owner
ADRs are registered on the books of the US banks responsible for them. The individual investors in the ADRs are not the stock’s registered owners.
Taxes and ADRS
Although portions of ADRs may be withheld to pay local taxes, owners of ADRs can claim a US tax credit for these withholdings.
Emerging Markets
Markets in lesser developed countries associated with:
· Low levels of income, as measured by the country’s GDP
· Low levels of equity capitalization
· Questionable market liquidity
· Potential restrictions on currency conversion
· High volatility
· Prospects for economic growth and development
· Stabilizing political and social institutions
· High taxes and commission costs for foreign investor
· Restrictions on foreign ownership and on foreign currency conversion
· Lower regulatory standards resulting in a lack of transparency
Developed markets
Highly developed markets with stable political and social institutions that are characterized by:
· Large levels of equity capitalization
· Low commission rates
· Few, if any, currency conversion restrictions
· Highly liquid markets with many brokerage institutions and market makers
· Many large capitalization securities
· Well-defined regulatory schemes leading to transparency similar to that enjoyed by those investing in US securities
Reasons for investing in foreign securities
· Expanded potential investment universe
· Foreign securities sometimes outperform domestic ones
· Low correlation with domestic securities which results in a reduction of overall portfolio risk
Unique foreign securities risks
Country risk
· Exchange controls
· Withholding, fees, and taxes
Country Risk
A composite of all the risks of investing in a particular country. These may include political risks, such as revolutions or military coups, and structural risks such as confiscatory policies toward profits, capital gains, and dividends. Economic policies, interest rates, and inflation are also elements of risk of investing in emerging countries.
Exchange controls
Foreign investors can also be subject to restrictions on currency conversion or movement
Withholding, Fees and Taxes
Some foreign countries may withhold a portion of dividends and capital gains for taxes. Some also impose heavy fees and taxes on securities that the investor must bear in addition to generally higher brokerage commissions.
Real Estate Investment Trusts (REITs)
· Normally own commercial property (equity REITs)
· Own mortgages on commercial property (mortgage REITs)
· Do both (hybrid REITs)
REITs are organized as trusts in which investors buy shares of certificates of beneficial interest either on stock exchanges or over the counter.
Subchapter M
Under the guidelines of Subchapter M of the Internal Revenue Code, a REIT can avoid being taxed as a corporation by receiving 75% or more of its income from real estate and distributing 90% or more of its taxable income to the shareholders.
Four Important points to remember about REITs
An owner of REITs holds an undivided interest in a pool of real estate investments
· REITs trade on exchanges and over the counter
· REITS are not investment companies (mutual funds)
· REITs offer dividends and gains to investors but do not pass through losses like limited partnerships are therefore are not considered to be direct participation programs (DPPs)
Advantages of REITs
· Opportunity to invest in real estate without the degree of liquidity risk found in direct ownership
· A negative correlation to the general stock market
· Reasonable income and/or capital appreciation
Risks of REITs
Because the investor has no control, much of the risk in investing in REITs has to do with the quality of the management
· Problem loans in the portfolio could cause income and/or capital to decrease
· Dividends are not considered qualified for purposes of 15% maximum tax rate and are taxed at full ordinary income rates
Rights and Warrants
Rights and warrants allow investors to buy additional shares of stock under defined circumstances. Preferred stockholders do not have the right to subscribe to rights offerings.
Preemptive rights
Entitle existing common stockholders to maintain the proportionate ownership shares in a company by buying newly issues shares before the company offers them to the general public. Preferred stockholders do not have the right to subscribe to rights offerings.
Rights offering
Allows stockholders to purchase common stock below the current market price. The rights are valued separately from the stock and trade in the secondary market during the subscription period.
Stockholders who receive rights may:
· Exercise the rights to buy stock by sending the rights certificates and a check for the required amount to the rights agent
· Sell the rights and profit from their market value (rights certificates are negotiable securities)
· Let the rights expire and lose their value
Warrants
Certificates granting its owner the right to purchase securities from the issuer at a specified price, normally higher than the current market price. Unlike a right, a warrant is usually a long-term instrument that gives the investor the option of buying shares at a later date at the exercise price.
Origination of warrants
Warrants are usually offered to the public as sweeteners in connection with other securities, such as debentures or preferred stock, to make those securities more attractive. Such offerings are often bundled as units.
Because the value of rights and warrants is dependent upon the value of the underlying stock into which the right or warrant may be exchanged, these are considered derivatives.
Employee stock options
Give an employee the right to purchase a specified number of shares of the employer’s common stock at a stated price over a stated time period. For publicly traded stock, the “strike” price is usually the market price of the stock at the time the option is granted. There is usually a vesting period. 2 types of plans: nonqualified stock options & incentive stock options
Nonqualified stock options (NSOs)
Most common type of employee stock options. NSOs are treated as compensation. When NSOs are exercise, the difference between the current market price at the time of the exercise and the strike price is reported as wages on the tax returns of the ER and the EE. Therefore, instead of capital gains treatment, the EE is taxed as ordinary income while the ER receives a tax deduction as a salary expense for the difference between the current market price and the strike price.. Because the spread between the market price and the strike price is considered salary, it is subject to payroll taxes as well as income tax.
Incentive stock options (ISOs)
Generally no tax consequences for ER. As long as stock purchased through exercise of an ISO is held at least 2 years after the date of grant and one year after the date of exercise, any profits are reported as long-term capital gains. If these time limits are broached, the ISO is taxed like an NSO. There is one other time stipulation- a maximum 1o-year limit for exercise. When and ISO is exercised, the difference between the market value at time of purchase and the strike price is a preference item used in calculating the Alternative Minimum Tax (AMT).
Things to remember about ISOs
No income recognized when option is granted
· NO tax due when option is exercised
· Tax is due when stock is sold
o Gain is capital if held at least one year and sold at least two years after grant
o Otherwise-ordinary income
· Difference between option price and the FMV on date of exercise is an add back for AMT purposes
Debt capital
Debt capital refers to long term financing. Long term debt (also called funded debt) is money borrowed for a minimum of 5 years.
Municipal bonds
Largest issuer of debt securities is the US government. Government bonds usually mean federal government. Municipal bonds usually means state or other municipality.
4 key questions for lender
How much am I lending
- How safe is my loan and how sure am I that I will get my money back?
- How much interest will I be paid for the use of my money?
- How and when will I get my money back?
Par value
For common stock, par value is of no importance to the investor. With preferred stock, par value is the number on which the dividend is based. Par value is even more important with bonds because not only does it represent what the interest payment is based on, but it also represents the amount of principal to be repaid at maturity.
Mortgage Bonds
If the corporation develops financial problems and is unable to pay the interest on the bonds, those real assets pledged as collateral are generally sold to pay off the mortgage bondholders.
Equipment Trust Certificate
Similar to car loan. When the corporation has finished paying off the loan it receives clear title to its equipment from the trustee. If the company does not make the payments, the lender repossesses the collateral and sells it for his benefit.
Debenture
Is a debt obligation of the corporation backed only by its word and general creditworthiness. Debentures are not secured by any pledge of property. They are sold on the general credit of the company.
Guaranteed bonds
Is a bond that is guaranteed as to payment of interest or both principal and interest, by a corporate entity other than the issuer. The value of the guarantee is only as good as the strength of the company making that guarantee.
Senior
Means the relative priority of claim of a security. Every preferred stock has a senior claim to common stock. Every debt security has a senior claim to preferred stock. Secured bonds have a senior claim to unsecured bonds. The term senior securities means bonds and preferred stock, because they have a claim senior to common stock. Mortgage and equipment trust certificates have prior claim ahead of unsecured creditors.
Subordinated
A subordinated debenture has a claim that is behind (junior to) that of any other creditor. However, no matter how subordinated the debenture, it is still senior to any stockholder.
Liquidation priority
Wages earned up to 180 days prior to employer’s declaration of bankruptcy
· Taxes
· Secured creditors (e.g. mortgage bonds, equipment trust certificates, collateral trust bonds)
· Unsecured creditors (e.g. general creditors including debenture holders)
· Subordinated debt holders
· Preferred stockholders
· Common stockholders
Taxation of payment to recipient
· Common stock- taxable as dividend in most cases
· Preferred stock- taxable as dividend in most cases
· Bonds- taxable as ordinary income in most cases
General obligation bonds (GOs)
Backed by pledge of the issuer’s full faith and credit for prompt payment of principal and interest
Revenue bond
Payable from the earnings of a revenue –producing enterprise, such as a water, sewer, electric or gas system, toll bridge, airport, college dormitory, etc.
US Treasury Bills (T-bills)
Are the direct debt obligations of the US Treasury with the following characteristics:
· They pay semiannual interest as a percentage of the state par value
· They have intermediate maturities (2,3,4,7,and 10 years)
· They mature at par value
US Treasury Bonds
· Pay semiannual interest as a percentage of the state par value
· Have long-term maturities, generally 10-30 years
· Older 30-year bonds are usually callable at par beginning 25 years after issue. However, the last callable 30-yuear bond was issued in November 1984
· They mature at par value
Treasury Inflation Protection Securities (TIPs)
Help protect investors against purchasing power risk. These notes are issued with a fixed interest rate, but the principal amount is adjusted semiannually by an amount equal to the Consumer Price Index (CPI). They are issued in maturities of 5, 10, and 30 years.. The investor receives interest payments every six months with the newly adjusted principal reflecting inflation and deflation. Like other Treasury notes, they are subject to federal taxes, but exempt from state and local taxes.
TIPS adjust the principal every 6 months to account for the inflation rate. Therefore, the real rate of return will always be the coupon.
Taxation on federal securities
· Subject to federal taxes
· Exempt from state and local taxes
US Federal Securities
Are issued by US government agencies that have been authorized by Congress to issue debt securities
Do not have direct Treasury backing
Considered moral obligations of the US government
Most agency bonds are described by their titles
2 principal US government agencies that issue debt securities are the Federal Farm Credit Banks & the Federal Home Loan Bank (FHLB)
Federal Land Banks
Are supervised by the Farm Credit Administration. FLBs through Federal Land Bank associations, make loans secured by mortgages to farmers and ranchers
Federal Intermediate Credit Bank
The FICB consists of 12 banks authorized to make loans to farmers for expenses, machinery, and livestock. The loans are intermediate term, running no longer than 10 years
Banks for Cooperatives
Are operated under the Farn Credir Administration. These banks make loans to farm cooperatives.
Federal Home Loan Banks
Operating under the supervision of the Federal Home Loan Bank board, FHLB is the agency that stands behind the nation’s savings & loans. The FHLB lends to members S&Ls to augment the money these S&Ls receive from their regular depositors.
FHLB borrows money in the open market by issuing various debt securities, then relents it to S&Ls who relend it to home buyers
Federal Home Loan Association (FNMA) Fannie Mae
Was a government owned corporation that was converted to a private corporation in 1968. Is commons trades on NYSE. FNMA purchases & sells mortgages- primarily those insured by Federal Housing Authority (FHA) or guaranteed by the Veterans Administration.
FNMA issues mortgage-backed bonds that can be purchased by individual investors. Considered to be quite safe.
Issued at par and pay semiannual interest
Like other federal issues, they come out in book entry forms
FNMA interest is subject to state and local taxation
Government National Mortgage Association (GNMA) Ginnie Mae
In late 1960s when the FNMA was split into 2 corporations (FNMA- privately owned & GNMA- publicly owned)
GNMAs are known as modified pass-through certificates
They represent an interest in pools of FHA insured mortgages and VA or Farmer Home Administration guaranteed mortgages
Carry a minimum denomination of $25,000
Unlike other agencies, they are backed by full faith and credit of US government
GNMA interest is subject to state and local taxation
Pass-through securities (GNMA)
Means that as homeowners make their monthly mortgage payments , these payments are collected in the pool and the shares pass through to the investor.
Payment differs from most other securities in 2 respects
1. Payments are received monthly because mortgages are paid monthly
2. Each payment the investment receives consists partly of principal and partly of interest
Unrated bonds
The issuer does not want to pay for the cost of receiving the rating
The issuer does not have a sufficient credit history to enable the rather to make a fair judgment
High-yield bonds
Volatility is usually substantially higher
Prime rate
The rate charged by major banks to their most creditworthy customers
In order for the bank to enjoy a real rate of return, nominal interest rates must be above the rate of inflation
Yield spread
Difference between yields on bonds with the same maturity,, but different quality (rating) to get a sense of the market sentiment.
It tends to widen when economic conditions sour and narrow when conditions improve
Nominal yield (coupon rate)
Rate stated on the face of the bond
Also referred to as coupon rate
Current yield (current return)
Return (annual interest in dollars)/investment
Also called current return
Bond discount and premium
When a bond is selling at a price above par, it is selling at a premium
When a bond is selling at a price below par, it is selling at a discount
If you pay more, you get less
If you pay less, you get more
Yield to maturity or basis
Current market price of bond Is determined by supply and demand
Taxability of Municipal bonds
Interest is free from federal income taxes, and if the investor resides in the issuer’s state, it is free from state tax as well.
Tax equivalent yield (TEY)
Yield/100-tax rate= tax equivalent yield (TEY) for municipal bonds
Coupon/ 100-tax rate
The tax equivalent yield for a municipal bond issued by an entity within a state with a state income tax will have a other equivalent yield to a resident of that state due to the “double” tax exemption
Corporate and municipal bond pricing
Corporate & municipal bonds are quoted as a percentage of par
Each bond point represents $10, and the fractions are in eighths
90 1/4 = $902.50
101 3/4 = $1,017.50
Government bond pricing
Government bonds are quoted as a percentage of par
Each bond point is $10, and each 0.1 represents 1/32
- 8 = $902.50
- 24 = $1,017.50
Zero coupon bonds
Nominal (coupon) rate is 0
Always issued at a discount
No reinvestment risk because there are no interest payments to reinvest
More volatile than other bonds of similar quality
Even though no periodic interest payments are received, the IRS requires the issuer to send a Form 1099-OID indicating the taxable interest to be reported each year
Useful in college education funds and qualified retirement plans because of tax treatment. Low tax bracket for child & tax deferral in retirement plan
Zero coupon exists in both corporate and municipal
Bond listings
DEF 5s35 @106
DEF is the issuer 5 is the nominal or coupon rate 35 is the maturity date of 2035 106 is the price of $1,060 "s" is nothing but the separation between the coupon and the maturity date
Callable bonds
Callability is a feature that permits the issuer to redeem the bids (pay off the principal) before maturity if it so desired
Refunding
Issuer takes advantage of lower cost of borrowing by issuing new bonds at lower rates prevailing in the market and using those proceeds to Csll in the only bonds with higher coupons
Similar to refinancing a mortgage
Call protection
The number of years into the issue before the issuer may exercise the call provision. The best call protection a bond may have is if a bond is noncallable
Convertible bonds
Issued by corporations only, it is the option to exchange the bond for shares of the company’s common stock.
Most convertibles are debentures
The conversion is exercisable at the discretion of the investor
The indenture tells you the number of shares into which the bond is convertible
If a $1000 bond converts into 50 shares and the stock is selling at $40, the investor is getting them at $20 ($1000/50)
Bond prices follows the stock’s price
Most convertible bonds are callable
If the bond prices become too high, issuer can force the investors to convert by exercising the Csll provision. It’s I’d called. Forced conversion
Forced conversion
For convertible bonds
If the bond prices become too high, issuer can force the investors to convert by exercising the Csll provision. The reason the bond price went up is because the underlying stock went up. If a bond is called at a price significantly lower than its current market, it will be to the bondholder’s advantage to convert the bond into stock. Once that occurs, the issuer owes nothing
Parity
Wen two things are equal. If the convertible bond and the common stock we would get upon conversion are worth the same, we osay they are at parity
Advantages of convertible bonds
Downside protection- as long as the company’s solvent, investors will be paid
There is a market level to which the bond price will drop and go no further on the basis of its coupon
Convertibles carry a lower interest rate because of the convertibility factor
Upside potential- if the business does well, investor can convert
Disadvantages of convertible bonds
Lower interest rate than nonconvertible debt
Possibility that convertible bond may be called away before investor is ready to convert
Anti-dilution protection
One concern of any convertible security holder is protection against the potential dilution resulting from a stock split or a stock dividend
Money market
Market for buying and selling short-term loanable funds
It is called money market because that is what is traded there, money not cash
The buyer of a money market instrument is the lender of the money; the seller is the borrower
Maturity dates are 1 year or less; most less than 6 months
Safe
Commercial paper less safe than t-bill
Treasury securities
T-bills are the bellwether of the money market
T-bills, t-notes, and t-bonds are the treasury securities
Low risk, extremely high liquidity
Exempt from state tax, but not federal
Yields are the lowest in the money market
Negotiable certificates of deposit (CDs)
Created in the mid 1960s
Unsecured time deposits
Negotiable CDs can be sold in the open market prior to maturity date
CDs are the only money market instrument that pays interest semiannually
To be a negotiable CD, it must have a value of $100,000, with $1 million being the most common
Commercial paper
Short-term paper issued by corporations, primarily I raise working capital. Used for current rather than long-term needs
Commercial paper is exempt from registration as long as the maximum maturity is less than 270 days
Mortgage-backed securities
Debt obligations backed by a pool of mortgages and usually have a pass-through feature.
GNMA is an example
Investors have a undivided interest, do not own a specific mortgage, and have a proportionate share in the cash flow
GNMAs have denominations of $25,000
GNMA investors receive monthly payments
GNMAs, FHA- insured, and VA- guaranteed mortgages back by full faith and credit of US government
Freddie Mac participation certificate (PC)
Federal Home Loan Mortgage Corporation (FHLMC) is another type of pass-through
It is sometimes called a participation agreement (PC)
Freddie Mac PCs comprise qualifying FHLMC, conventional, residential mortgages on single-family homes.
Fannie Maes and lFreddie Mac PCs are not backed by full faith and credit of the US government.
Freddies and Fannies have higher rates than GNMAs
Collateralized mortgage obligations (CMO)
Introduced in June 1983
Bonds that are collateralized by mortgages and mortgage-backed securities
Most of the mortgages are private, not qualified under VA or FHA
CMOs have a stated maturity with loans of varying maturity dates
Complicated and difficult to understand
Prepayment risk leads to mortgages being refinanced when rates drop
Default risk; particularly if the mortgages are subprime
Reinvestment risk
Liquidity risk
Cash flow analysis
Difficult to predict a cash flow on a portfolio of mortgage backed securities
Although they do have default risk (other than GNMA), the specific risk is due to prepayment, complicates the computation
When doing cash flow analysis on a mortgage-backed pass-through security, you would want to know the average maturities
Eurodollars
Eurodollars are US dollars deposited in banks outside the US; that is, the deposits remain denominated in US dollars rather than the local currency
European are Japanese yen deposited in banks outside Japan.
When a currency is preceded by the prefix euro, it refers to a bank deposit outside of the country’s currency
Time deposits tend to be short-term, ranging from overnight to 180 days
European banks lend Eurodollars to other banks much in the same way US banks lend federal funds.
Interest rate is usually based on LIBOR
Eurobond
Any long-term debt instrument issued and sold outside the country of the currency in which it is denominated.
e.g. A US dollar-denominated Eurobond is called eurodollar bond.
Contrasting eurobonds and eurodollar bonds
Eurodollar bonds pay in US dollars
Eurobonds pay in foreign currency
These instruments must be issued outside of the US
Eurodollar bonds are issued in bearer form
Interest is paid once per year
Holders are not subject to withholding test
Yankee bond
A Yankee bond is a US dollar- denominated bond issued by a non-US entity in the US market
A Eurobond is a US dollar- denominated bond issued by a non-US entity outside of the US
E.g. maple bond- Canada, Matilda bond- Australia
Brady bond
Named after former US Treasury Secretary Nicholas Brady were created in 1989 to exchange defaulted bank loans issued in less developed countries with a security that can be carried on the bank’s books as a performing asset
Partners include the IMF and the World Bank
Most are denominated in US$
Maturities range from 10 to 30 years
Can be interest bearing or zero coupon
Safety of Brady bond depends on the pledged collateral
Liquidity of Brady bonds is far superior to that of other debt issues from emerging markets
T-bill issuance
T-bills are always issued at a discount, they pay no interest.
The investor receives par value and makes the difference between the discounted purchase price and the par received at maturity.
All government bonds are now book entry
There has not been a T-note or bond issued since July 1986 with interest coupons attached.
Preferred stock
Preferred stock carries a fixed dividend that must be paid before any distribution to common stockholders
There is no obligation to pay the dividend
The yield is invariably higher than that on debt issues
Fixed return may not keep up with inflation, regardless of corporate earnings
The dividend will not change so there is no hope of increased income
Pooled investments
Because of the way many investors combine their investment capital, investment companies are frequently referred to as “pooled investments
Investment companies = pooled investments
Investment company
A corporation or trust path rough which individuals invest in large diversified portfolios of securities by pooling their funds with other investors’ funds
Advantages of investment companies
Diversification of investments
Lower transaction costs
Professional management
Securities Act of 1933
Investment companies must abide by similar registration and prospectus requirements imposed by Securities Act of 1933
Investment Company Act of 1940
The Investment Company Act of 1940 classifies investment companies into three broad types:
Face-amount certificate companies
Unit investment trusts
Management investment companies
Face amount Certificate (FAC) Companies
A contract between an investor and an issuer in which the issuer guarantees payment of a stated (or fixed) sum to the investor at some set date in the future. IN return for this future payment, the investor agrees to pay the issuer a set amount of money either as a lump sum or in periodic installments.
Fully paid FAC
If the investor pays for the face-amount certificate (FAC) in a lump sum, the investment is known as a fully paid FAC. Issuers of these investments are called FAC companies. Few FAC companies operate today because tax law changes have eliminated their tax advantages
Things to know about face-amount certificates (FACs)
· FAC companies pay a fixed rate of return
· FAC companies do not trade in the secondary market; they are redeemed by the issuer
· FAC companies are classified as investment companies
Unit Investment Trusts (UITs)
· Is an unmanaged investment company organized under a trust indenture
· Do not have boards of directors
· Do not employ an investment adviser; and
· Do not actively manage their own portfolios (trade securities)
· Trustees typically buy other investment company shares (nonfixed (UIT) or stocks or bonds (fixed UIT) to create the desired portfolio
· Because UITs are not managed, when securities in the portfolio are liquidated or called, the proceeds must be distributed.
Fixed UITs
· Typically purchase a portfolio of bonds and terminates when the bonds in the portfolio mature
· When UITs consist of bonds, the UIT terminates when the bonds in the portfolio mature
· When fixed UITs consist of equities, a liquidation date is set in the offering documents
Nonfixed UITs
Purchase share of underlying mutual funds
Under Investment Company Act of 1940, the trustees of both fixed and nonfixed UITs must maintain secondary markets in the units thus allowing unit holders the ability to redeem their units.
Exchange traded funds (ETFs
Most ETFs are organized as UITs and trade, as the name implies on exchanges or NASDAQ
UITs
· Are not actively managed; there is no board of directors (BOD) or investment adviser
· UIT shares (units) must be redeemed by the trust
· UITs are investment companies as defined under the Investment Company Act of 1940
Management Investment Companies
· The most familiar type of investment company
· Actively manages a securities portfolio to achieve a stated investment objective
· Is either closed-end or open-end
· Initially both closed- and open-end companies sell shares to the public; the difference between them lies in the type of securities they sell and how investors buy and sell their shares- in the primary of secondary market.
Closed-end companies
· Trade upon supply and demand for their shares
· To raise capital, a closed-end investment company conducts a common stock offering.
· For the initial offering, the company registered a fixed number of shares with the SEC and offers them to the public for a limited time through an underwriting group
· The fund’s capitalization is fixed unless an additional public offering is made
· Closed-end companies can also issue bonds and preferred stock
· Closed-end companies are also called publicly traded funds
Closed-end companies
· After the stock is distributed, anyone can buy or sell shares in the secondary market either on an exchange or OTC
· As a result, their buying and selling price does not have a direct relationship to the NAV of the shares
Bid price
Price at which an investor can sell
Ask price
Price at which an investor can buy
Open-end Investment Companies
· Does not specify the exact number of shares it intends to issue
· It registers an open offering with the SEC
· Can raise an unlimited amount of investment capital by continuously issuing new shares
· Any person who wants to invest in the company buys shares directly from the company or its underwriters at the public offering price (POP)
Public Offering Price
NAV + any applicable sales charges
Net Asset Value (NAV)
Fund’s liabilities – total assets
Net Asset Value (NAV) per Share
NAV/# of outstanding shares
Country funds (generally closed-end)
· Country funds are funds that concentrate their investments in the securities of companies domiciled in foreign countries. Well-known examples are the Korea Fund, the New Germany Fund, and the Mexico Fund.
· Country funds are generally organized as closed-end (rather than open-end) companies because it is often difficult to liquidate the foreign securities to get their value into the United States
Investment Company Capitalization
· open-end: unlimited; continuous offering of shares
· closed-end: fixed; single offering of shares
Investment companies can issue
· open-end: common stock only; no debt securities; permitted to borrow
· closed-end: may issue common stock, preferred stock, debt securities
Offering and trading of investment company shares
open-end:
o sold and redeemed by fund only
o continuous primary offering
o must redeem shares
· closed-end
o initial public offering
o secondary trading OTC or on an exchange
o does not redeem shares
Pricing of investment company shares
· Open-end
o NAV + Sales charge
o Selling price determined by formula in the prospectus
· Closed-end
o Current market value + commission
o Price determined by supply and demand
Shareholder rights in investment companies
· Open-end: dividends (when declared), voting
· Closed-end: dividends (when declared, voting, preemptive
Computing NAC on closed-end investment companies
Because the trading price of closed-end investment company shares is determined by supply and demand, these funds computer their NAV only once per week, rather than daily with open-end companies
Diversified and nondiversified companies
· Under the Investment Act of 1940 an investment company qualified as diversified if it meets the 75-5-10 test
· 75% of total assets must be invested in securities issued by companies other than the investment company or its affiliates.
· Cash on hand or cash equivalents count as part of the 75% required investment in outside companies
· Of this 75%, no more than 5% can be invested in any one corporation’s securities
· Of this 75%, this investment company can own no more than 10% of an outside corporation’s voting class securities
Nondiversified investment company
· Does not meet the 75-5-10 test
· A company that specializes in one industry is not necessarily nondiversified
Specialized or sector funds
Can still be considered diversified if they meet the 75-5-10 test
Open –end investment companies
· Investors may purchase fractional shares
· Usually called mutual funds
· Selling price usually includes a sales charge
Open-end investment companies (mutual funds)
· Must redeem shares at NAV
· Offer guaranteed marketability
· Investor owns an undivided interest in the entire underlying portfolio
· No investor has preferred status
· Fund issues only one class of common stock
· Investor shares mutually in gains and distributions with other investors
· Investors share in fund’s performance based on number of shares owned
Net redemptions
· An excess of shareholder redemptions over new share purchases
· Manager must then decide which assets to liquidate
Mutual fund sales charges
· When buying shares of mutual funds, FINRA sets a maximum sales charge of 8.5% of the POP
· The actual schedule of sales charges is specified in the prospectus
Closed-end funds
Do not carry sales charges. An investor pays a brokerage commission
Open-end funds
· All sales commissions are paid from the sales charges collected
· Sales charges include commissions for whole food chain plus advertising, sales lit, etc.
Types of Mutual Fund sales charges
· Front-end loads (difference between POP and net NAV)
· Back-end load (contingent sales charge)
· 12b-1 fees (asset-based fees, technically not a sales charge)
Front-end loads (Class A shares)
· Are reflected in a fund’s public offering price (POP)
· The charges are added to the NAV at the time the investor buys shares
· Class A shares have lower operating expense ratios than the other classes
Back-end loads (Class B shares)
· Also called a contingent deferred sales charge (CDSC) is charged at the time an investor redeems mutual fund shares
· The sales load is a declining percentage charge that is reduced annually
· Is usually structured so that it drops to 0 after 6 or 8 years at which time they are converted to Class A shares with their lower operating expense ratios
12b-1 asset-based fees
· Mutual funds cannot act as distributors for their own fun shares except under Section 12b-1 of the Investment Company Act of 1940.
· Investment Company Act of 1940 Section 12b-1 allows a mutual fund to collect a fee for promotion or sales-related activities in connection with distributing its shares
· Fee is flat dollar amount of % of assets of average total NAV during the year
· Fee is disclosed in the firm’s prospectus
· Fee must reflect the anticipated level of distribution services
· Annual fee cannot exceed 0.75% of net assets
· If fee exceeds 0.25%, fund cannot use the term no-load
· 0.25% is viewed as the fees that would have been paid to an underwriter had sales charges been negotiated
Fund share classes
· Class A shares (front-end load): investors pay at the time of purchase; lowest operating costs
· Class B shares (back-end load): declines over time so investors pay the charge at redemption
· Class C shares (level load): no sales charge to purchase, generally a 1% CDSC for one year, with a continuous 12b-1 charge
Reductions in Sales Charges
· Breakpoints- a scale of declining sales charges based on the amount invested
· Rights of accumulation
Breakpoints
· Available to any person
· In this case, person means married couples, parents and their minor children, and corporations
· Investment clubs or associations formed for the purpose of investing do not qualify for breakpoints
Breakpoint sales
· Registered reps making higher commissions by selling shares in dollar amounts just below breakpoint levels
· FINRA prohibits reps from doing this
Letter of Intent (LOI)
· Person who plans to invest more money with the same mutual fund company may decrease overall sales charges by singing a letter of intent (LOI)
· LOI informs the investment company that he intends to invest the additional funds necessary to reach the breakpoint within 13 months
· Each deposit is charged the reduced sales charge at the time of purchase
Letter of Intent (LOI)
· Is a one-sided contract binding on the fund only.
· The customer must complete the intended investment to qualify for the reduced sales charge.
· Fund holds the extra shares purchased as a result of the reduced sales charge in escrow
· When investor deposits sufficient money to complete the LOI, he receives the escrowed shares
· Appreciation and reinvested dividends do not count toward the LOI
· If the customer has not completed the investment within 13 months, he will be given the choice of sending a check for the difference in sales charges or cashing in escrowed shares to pay the difference
Backdating LOIs
· Funds often permit customer to sign an LOI as late as 90 days after an initial purchase
· The LOI still cannot exceed 13 months to complete the transaction
Rights of Accumulation
· Allow an investor to qualify for reduce sales charges
· Unlike LOIs, they are available only for subsequent investment and do not apply to initial transactions
· Allow the investor to use prior share appreciation to qualify for breakpoints
o Customer may qualify for reduced charges when the total value of shares previously purchased and shares currently being purchased exceeds a breakpoint amount
· Do not impose time limits
Rights of Accumulation
· For the purpose of qualifying customers for breakpoints, the mutual fund bases the quantity of securities owned on:
o The current level of the securities at either NAV or POP
o Total purchases of the securities at the actual offering price; or
o The higher of current NAV or the total of purchases made to date
Combination privilege
Mutual fund company offers more than one fun and refers to these multiple offerings as its family of funds. Investors can get a reduced sales charge by combined separate investments within the same family to reach a breakpoint
Exchange within a family of funds
· Exchange privileges allow an investor to convert an investment in one fun for an equal investment in another fun in the same family at net asset value without incurring an additional sales charge.
· Any exchange of funds is considered a sale for tax purposes. Any gains or losses are fully reportable at the time of the exchange
Mutual fund characteristics
· A professional investment adviser manages the portfolio for investors
· Mutual funds provide diversification by investing in many different companies
· A custodian holds a mutual fund’s shares to ensure safekeeping
· Most funds allow a low minimum investment, often 4500 or less, to open an account and allow an additional investment for as little as $25
Mutual fund characteristics
· An investment company may allow investments at the reduced sales charges by offering breakpoints, for instance, through a letter of intent and/or rights of accumulation
· An investor retains voting rights, such as the right to vote for changes in the board of directors of the investment company, approval of the investment adviser, changes in the fund’s investment objective, changes in sales charges, and liquidation of the fund
· By FINRA rules, all funds created after 4/1/2000 offer automatic reinvestment of capital gains and dividend distributions without a sales charge. To remain competitive, almost all of the old funds do so as well. This has the effect of compounding the investment
Mutual fund characteristics
· An investor can liquidate of apportion of his holding without having to select a specific security- the fund generally has enough cash on hand to process redemption requests.
· Tax liabilities for an investor are simplified because each year the fund distributes a 1099 form explaining taxability of distributions
· A mutual fund may offer various withdrawal plans that allow different payment methods at redemption
Investment Objective
The objective must be clearly stated in the prospectus and can be changed only by a majority vote of the fund’s outstanding shares
Growth funds
· Companies tend to reinvest all or most of their profits for research and development rather than pay dividends
· A growth fund with a high dividend has not followed its investment objective
Income funds
Stresses current income over growth
Combination funds (growth and income)
· Combines objectives of growth and income
· Specialized (sector) funds
· Specialize in particular economic sectors or industries. Some specialize in geographic areas. These funds have 25% - 100% invested in their specialties and are more likely than other funds to stick to a relatively fixed allocation
· Offer higher appreciation potential, but also pose higher risks
Special Situation Funds
Buy securities of companies that may benefit from a change within the corporations or in the economy. Takeover candidates and turnaround situations are common investments
Index Funds
· Invest in securities to mirror a market index. Performance tracks the underlying index’s performance
· This approach reflects the pass style of portfolio management
· Lower management costs
· Minimal turnover (for investors seeking minimal capital gains)
Foreign Stock funds
· Invest in the securities of companies that have their principal business activities outside of the US
· Long term capital appreciation is their primary objective although some funds seek current income
· Involve foreign currency risks as well as usual equity risks
Two types of foreign funds
· International funds- have their entire portfolio invested in securities issued outside of the US
· Global funds have portfolio invested around the globe which includes US
Tax-free (Tax-exempt) Bond Funds
Invest in municipal bonds or notes that produce income exempt from federal income tax. Note that any capital gains distributions from the fund are taxable just as with any other fund
US Government and Agency Security Funds
Buys US treasuries, GNMAs, etc. Investors in these funds seek current income and maximum safety
Asset Allocation Funds
Balanced Funds
Invest in stocks for appreciation and bonds for income, and different types of securities are purchased according to a formula
e.g. – a balanced fund’s portfolio might contact 60% stocks and 40% bonds
Asset allocation funds
· Split investments between stocks for growth, bonds for income, and money market instruments (cash) for stability.
· The fund adviser switches the percentages of holdings in each asset category to the expected performance of that group.
Money market funds
· No-load, peon-end mutual fund that serves as temporary holding accounts for investors’ money
· The term no-load means that investors pay no sales or liquidation fees
· Most suitable for investors who financial goals require liquidity above all
· Dividend rates are neither fixed nor guaranteed
· Interest the fund distributes as dividends is computed daily and credited to accounts monthly
· NAV is fixed at $1
· $1 Price is not guaranteed, but the fund is managed not to “break the buck”
· Price does not fluctuate much in response to interest rate changes
· Generally offer check-writing privileges
Investors should select review fund information regarding
· Performance
· Costs
· Taxation
· Portfolio turnover
· Services offered
· Suitability
Performance
· Securities law requires that each fund disclose the average annual total returns for 1,5, and 10 years or since inception
· A manager’s track record in keeping with the fund’s objectives, as stated in the prospectus, is important as well
· Returns must be expressed assuming maximum sales loads applied
Expense ratio
· Expresses the management fees and operating expenses as a percentage of the fund’s net assets.
· All mutual funds, load or no-load, have expense ratios.
· Calculated by dividing a fund’s expenses by its average net assets
· The sales charge is not generally considered an expense when calculating a fund’s expense ratio
· Typically more aggressive funds have higher expense ratios- more trading in the fund’s portfolio
· Stocks funds generally have expense ratios between 1% and !.5% of a fund’s average net assets
· Bond funds typically have expense ratios between 0.5% and 1.0%
Mutual Fund Taxation
· Mutual fund investors pay taxes on income and capital gains distributed by the fund.
· Dividends that qualify are taxed at 15%; for test purposes, all capital gains distributions are from the fund’s long term gains, so they are taxed at 15% to the investor
· Dividends and capital gains distributions are currently taxable to investors whether they are taken in cash or reinvested to purchase additional shares
· Dividends must be reported as dividend income and will be taxed either as ordinary income or as a qualifying dividend with a maximum rate of 15%
· Capital gains distributions must be report as a long-term capital gain
Portfolio turnover rate
· Reflects the fund’s holding period. If a fund has a turnover rate of 100%, it holds its securities, on average, for less than one year & therefore, all gains are likely to be short term and subject to the maximum tax rate
· A fund with portfolio turnover rate of 25% has an average holding period of 4 years & most gains are taxes at the long-term rate
Services offered by mutual fund companies include:
· Retirement accounts
· Investment plans
· Check-writing privileges
· Phone transfers
· Conversion privileges
· Combination investment plans,
· withdrawal plans, etc.
Advantages of mutual funds
· The #1 advantage is the diversification offered
· Professional management, convenience, liquidity, and minimum initial investment are also important
Disadvantages of mutual funds
· Market risks
· Fees and expenses
Exchange Traded Funds (ETFs)
· This type of fund invests in a specific index
· Any class of asset that has a specific index around it and is liquid can be made into an ETF
· Differs from an index fund in that it is closed-in and trades like a stock
· Price changes are due to the market, rather than the underlying value of the portfolio
Exchange Traded Funds (ETFs)
· ETFs can be purchased on margin
· ETFs can be sold short
· Expenses are lower than mutual funds
· Because there are brokerage fees, ETFs are generally not competitive with no-load index funds for the small investor
· ETFs are included in the term “pooled investments”
Hedge Funds
· Does not currently have to register with SEC, although portfolio managers are generally required to register as investment advisers
· Pending legislation that would require all hedge funds to register
· Free to adopt far riskier investment strategies than those open to ordinary mutual funds
o Arbitrage strategies
o Massive short positions during bearish markets
· Use leverage and derivatives such as options and futures
· Considered to be in the asset class of alternative investments
Hedge funds
· Primary aim of most hedge funds is to reduce volatility and risk while attempting to preserve capital and deliver positive returns under all market conditions
· Management fees tend to be much, much higher than with other investments
· Almost all hedge funds charge performance-based fees. The typical fee structure is known by the vernacular “2&20- most funds take a 2% management fee and 20% of the profits
· Because of the risk, investments are limited to institutional clients and wealthy individuals, known as accredited investors
· Most hedge funds are organized as limited partnerships with the portfolio managers investing along with the investors. So they have a greater motivation to succeed. The partnership is the issuer of the ownership units
· Hedge funds are indirectly available to ordinary investors through mutual funds called funds of hedge funds
Why to include hedge funds in a portfolio
· Designed strategy of many hedge funds is to generate positive returns in both rising and falling markets
· With a large variety of available investment styles, investors have a plethora of choices to assist them in meeting their objectives
· A part of an asset allocation class, hedge funds may reduce overall portfolio risk and volatility and increase returns
A proper selection of hedge funds can create
Uncorrelated returns, adding a level of diversification. In doing so, the client would be incurring the following risks:
· Expenses can be quite high
· The risky strategies can backfire leading to significant loss of capital
· There is limited liquidity because there is no active secondary market (they’re not listed on exchanges)
firm quote
Market maker’s current bid and offer on a security
Current bid
Highest price at which the dealer will buy
Current offer
Lowest price at which the dealer will sell
Spread
Difference the bid and the as,
Inside quote
The best and the best offer selected among all the market makers of a security
Market order
Order executed immediately at the market price with no restrictions
Limit order
Limits the amount paid or received for securities
Not guaranteed to execute.
Can only be filled if the stock’s market price reaches the limit price
Ensures that an investor does not pay more than a predetermined amount for a stock
Stop order
Becomes a market order if the stock reaches or goes through the stop price
Stop limit order
Entered as a stop order and changed to a limit order if the rock hits or goes through the trigger price
Day order
Expires if not filled by the end of the day
Good till cancelled
Does not expire until filled cancelled
Good till canceled order
Does not expire until filled or canceled
Fill or kill order
Must be executed immediately in full or be canceled
Immediate or cancel order
Must be executed immediately in full or in part; any part of the order that remains unfilled is canceled
UPIA (Uniform Prudent Investor Act)
All though the UPIA permits the delegation of portfolio management decisions, trustees cannot delegate certain fiduciary duties, such as determining the amount and timing of distributions.
Prudent Expert Rule
Fiduciary must act with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent professional would use.
Fiduciaries
Under ERISA provisions, the fiduciary must be as prudent as the average expert, not the average person. To act with care, skill, prudence, and caution, the fiduciary must:
Diversify plan assets
Make investment decisions under the prudent expert standard
Monitor investment performance
Control investment expenses; and not engage in prohibited transactions
Fiduciary- transaction costs
Transaction cost is not a determining factor in security selection. That I, when the fiduciary is deciding what security will fit the needs of the portfolio, the amount of commission involved in the purchase is not consider when determining if that security is an appropriate selection.
Investment Policy Statement
Not specifically mandated under ERISA
Each plan should have one, preferably in writing
Guideline for plan’s fiduciary
Investment Policy Statement (IPS)
A typical IPS includes:
Investment objectives for the plan
Determination of cash flow needs
Investment philosophy including asset allocation style
Investment selection criteria
Methods for monitoring procedures and performance
Prohibited Transactions by the plan fiduciary
Fiduciary is strictly prohibited from any conflicts of interest
Self dealing with plan assets in his own interests
Acting in transactions on behalf of a party with interests averse to the plan
Receiving compensation for his personal account ini connection to the plan
ERISA Section 407
A plan may not acquire any security or real property of the ER, if immediately after such acquisition the aggregate fair market value of ER securities and ER real property held by the plan is > 10% of the fair market value of the assets of the plan
Party in interest
Anyone who has an impact on an EB plan including those who render advice to the plan. All transactions involving parties in interest to an ERISA- covered plan are prohibited, unless there is an exemption for them
Loans from the plan
Trustees may not use plan assets to make loan to the ER, even if failure to do so could lead to the ER suffering a financial failure.
ERISA Section 404(c)- Safe Harbor Provisions
Diversification provision
Deals with 401(k) plans
Trustee is safe from liability as long as certain conditions are met
A participant must have for his own account:
Investment selection
Investment control
Have required communication of information
Investment selection- 404(c)
A plan participant must be able to:
materially affect portfolio return potential and risk level
Choose between at least 3 investment alternatives; and
Diversify his investment to minimize the risk of large losses
Trustee reducing liability
The trustee of a 401(k) would be able to reduce his ERISA fiduciary exposure and meet the safe harbor provisions of 404(c) if the plan offered a broad index fund, a medium term bond fund, and a cash equivalent fund.
404(c)- investment control
Allowing EEs to exercise independent control over the assets by letting them make their own investment selections (at least 3 options)
Informing EEs they can change allocations at least quarterly
Fiduciaries must still monitor performance
404(c) - Communicating required information
Making info available upon request (prospectuses, financial statements, reports, annual operating expenses
Statement that the plan is intended to constitute an ERISA 404(c) & that plan fiduciaries may be relieved of liability for investment losses
Explanation of how to give investment instructions
Real time access to accounts via telephone or Internet
Summary Plan Description
Plan administrator provided to participants free of charge
Important description of how plan works
Defined benefit plan
Contributions to a DB plan are not affected by the participant’s gender
ER Contributions
ER contributions to DB & DC pension plans are mandatory. Although profit sharing & 401(k) plans are DC plans, they are not pension plans & ER plans are not mandatory
Exchange market
Is composed of the NYSE and other exchanges on which listed securities as traded
Location
Listed markets, such as NYSE and AMEX, maintain central marketplaces and trading floors
Pricing system
Listed markets operate as double-auction markets. Floor brokers compete to execute trades at favorable prices
Plus tick
When a floor broker representing a buyer executes a trade by purchasing stock at a current offer price higher than the last sale, a plus tick occurs (market up)
Minus tick
When a selling broker accepts a current bid price below the last sale price, a minus ticket occurs (market down).
Specialist (also known as DMM- designated market maker)
Maintains an orderly market and provides price continuity. He fills limit and market orders for the public and trades for his own account to either stabilize or facilitate trading when imbalances in supply and demand occur
Specialist (also known as DMM- designated market maker)
Chief function is to maintain a fair and orderly market in the stocks for which he is responsible.
Specialist
Minimizes price disparities that may occur at the opening of daily trading by buying and selling, as a dealer, stock from his own inventory only when a need for such intervention exists.
Over-the counter (OTC) Market
· Interdealer market
· Unlisted securities
· No central marketplace
OTC pricing system
Interdealer network. Registered market makers compete to post the best bid and ask price. The OTC market is a negotiated market.
Market makers
Broker/dealer who stand ready to buy and sell the minimum trading unit, usually 100 shares (or any larger amount that they have indicated), in each stock in which they have published bid and ask quotes.
Market makers acting in a principal capacity
Sell from their inventory at their asking price and buy for their inventory at the bid price
Price dynamics
When a market maker raises its bid price to attract sellers, the stock price rises; when a market maker lowers its ask price to attract buyers, the stock price declines
OTC market
· Securities prices determined through negotiation
· Regulated by FINRA
· Broker/dealers must register with both SEC and FINRA
· Trade at many locations across the country
NYSE market
· Securities prices determined through auction bidding
· Regulated by the NYSE
· Broker/dealers must be registered with the SEC and Exchange members
· Traded only on the NYSE floor
Exchange
Listed securities + prices determined by auction
OTC
Unlisted securities = prices determined by negotiation
Government and municipal and unlisted corporate stocks and bonds trade in the OTC market
Broker/dealers
Most securities firms act as both brokers and dealers, but NEVER in the same transaction
Brokers
Agents that arrange trades for clients and charge commissions. Brokers do not buy share for inventory, but facilitate trades between buyers and sellers
Dealers (or principals)
Buy and sell securities for their own accounts. This practice is called position trading.
Dealers (or principals)
When selling from their inventories, dealers charge the buying customers a markup rather than a commission. A markup is the difference between the current interdealer offering and the actual price charged the client. When a price to a client includes a dealer’s markup, it is called a net price.
Principal
A broker/dealer acts as a principal in a dealer transaction.
A firm CANNOT act as both a broker and a dealer in the same transaction
Principal
A principal of a firm is a person who acts in a supervisory capacity
Principal
Face value of a bond or asset in a trust
Making a hidden profit
When a firm makes a market in a stock, marks up that stock, and then adds an agency commission. If the firm acts as a broker, it may charge a commission. If it acts as a dealer, it may charge a markup or markdown.
Broker
Acts as an agent, transacting orders on the client’s behalf
Broker
Charges a commission
Broker
Is not a market maker
Broker
Must disclose its role and the amount of its commission to the client
Dealer
Acts as a principal, dealing in securities for its own account and at its own risk
Dealer
Charges a markup or markdown
Makes markets and/or takes positions (long or short) in securities
Must disclose its role to the client, but not necessarily the amount or source of the markup or markdown
Markup
The difference between the lowest current offering price among dealers and the higher price a dealer charges a customer
BACC/DPP
Brokers act as agents for commissions/ dealer act as principals for profits
Market order
An order sent immediately to the floor for execution without restrictions or limits. It is executed immediately at the current market price and has priority over all other types of orders
Market order
A market order to buy is executed at the lowest offering price available
A market order to sell is executed at the highest bid price available
Limit order
A customer limits the acceptable purchase or selling price. A limit order can be executed only at the specified price or better (lower in a buy order, higher in a sell order)
Limit order
If the limit order cannot be executed at the market, the commission house broker leaves the order with the specialist who records the trade in the order book and executes the order if and when the market price meets the limit order price
Limit order
A customer who enters a limit order risks missing the chance to buy or sell if the market moves away from the limit price.
The market may never go as low as the buy limit price or as high as the sell limit price
Limit order
Sometimes limit orders are not executed, even if a limit price is met. The most common explanation for this is stock ahead
Stock ahead
Limit orders on the specialist’s book for the same price are arranged according to when they were received. If a limit order at a specific price was not filled, chances are that another order at the same price took precedence, that is, there was stock ahead.
Limit order
If any part of an order can be filled at the limit price, it is done. All that can be is executed before the market closes, that sale is confirmed and the order for the balance is cancelled.
Selling short (short sales)
The short seller borrows stock from a broker/dealer to sell at the market.
The investor expects the stock to decline enough to allow him to buy shares at a lower price and replace the borrowed stock at a later date.
Selling short (short sales)
Unless the stock declines to zero, the short seller is obligated to buy the stock and replace the borrowed shares to close the short position
Selling short (short sales)
Is risky because if stock price rises instead of falls, an investor still must buy the shares to replace the borrowed stock- and the stock price can rise without limit- therefore, unlimited risk
Stop orders (stop loss order)
May be entered to protect a profit or prevent a loss if the stock begins to move in the wrong direction
Stop orders (stop loss order)
Becomes a market order once the stock trades at or moves through a certain price, known as the stop price.
There is no assurance of any specific price
Stop orders (stop loss order)
Stop orders for listed stocks are usually left with and executed by the specialist.
Stop orders (stop loss order)
A stop order takes two trades to execute
- Trigger- the trigger transaction at or through the stop price activates the trade
- Execution- the stop order becomes a market order and is executed at the market price completing the trade
Stop limit order
Is a top order that, once triggered, becomes a limit order instead of a market order
Buy stop orders
· Protect against loss in a short stock position
· Protect a gain from a short stock position
· Establish a long position when a breakout occurs above the line of resistance
Sell stop orders
· Protect against loss in a long stock position
· Protect a gain from a long stock position
· Establish a short position when a breakout occurs below the line of support
Mechanics of a stop order
· 2 steps- trigger- when security moves through the stop price & the execution
· Buy- moves through at a higher price; sell moves through at a lower price
Difference between a stop order different from a stop limit order
Once the order has been triggered, enter a limit order do not pay any more than $X for the stock, while the stop order will buy the stock at the next lowest price . With limit you can’t pay more than $X
Stop orders (stop loss orders)
Danger in using stop orders is that once they are triggered, the marketplace receives an increase of sell orders in a falling market and buy orders in a rising market. This can have the tendency to accelerate the direction of the market; sell stops in a bearish market, buy stops in a bullish one
Block trade
10,000 or more shares of a stock
Dividend Disbursing Process (4 dates)
- Declaration (announcement) date- date the announcement of a forthcoming dividend is made known
- Record date- date that a list will be made of owners and only those owners will receive the dividend
- Payable date- date payment is made
- Ex-dividend date- the SRO decides- the date that purchasers will not receive the dividend
Ex-dividend date
The last day an investor can purchase a stock and still receive a previously declared cash dividend
Traditional IRA limits
$5000 for individual
$10,000 for couple
Traditional IRA limits
For those covered by qualified employer plans, the tax deductibility of contributions to traditional IRAs is phased out as income increases over a specified level.
Traditional IRAs
Not eligible after age 70 ½
Compensation for IRA purposes
· Wages, tips, and salaries
· Commissions and bonuses
· Self-employment income
· Alimony
· Nontaxable combat pay
Not compensation for IRA purposes
· Capital gains
· Interest and dividend income
· Pension or annuity income
· Child support
· Passive income from DPPs
IRA contribution limits
The contribution limits for IRAs is subject to increase based on the inflation rate. These limits will also apply to the total combined contribution that might be made to a traditional IRA and a Roth IRA
Catch up contributions for older IRA owners
The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) was the source of the legislation permitting certain individuals to make additional contributions to their IRAs. Individuals aged 50 and older are allowed to make catch-up contributions to the IRAs above the scheduled maximum annual contribution limit. These catch-up payments can go either to a traditional IRA or a Roth IRA
Roth IRA
The Taxpayer Relief Act of 1997 created the Roth IRA.
Contributions to Roth IRAs are not tax deductible
Regular contributions can be withdrawn tax free because they are made with nondeductible contributions
Roth IRA withdrawals
- Earnings accumulated may be withdrawn tax free following the initial deposit provided the:
- Account holder is 59 ½ or older
- Money withdrawn is used for the first-time purchase of a principal residence (up to $10,000)
- Account holder has died or become disabled
- Money is used to pay for authorized higher education expenses; or
- Money is used to pay for certain medical expenses or medical insurance premiums
Roth IRA Contribution limits
Same as those for traditional IRAs
Lesser of $5000 or 100% of earned income
Contributions can be made past age 70 ½ as long as individual has earned income
Roth IRA Eligibility Requirements
Single person with an AGI of $110,000 or less may contribute the full amount to Roth IRA
Phased out after $125,000
Married person who file jointly _ $173,000; phased out after $183,000
Deductible to determine AGI
Traditional IRA payments
Alimony paid
Self-employment tax and
Penalties paid on early withdrawal from savings account
Key points to remember about the Roth IRA
Maximum (current) contribution is $5000/year/individual
Contributions are not tax deductible
Distributions tax free if taken > 59 ½ & if account open for at least 5 yrs.
Distributions not required to begin at 70 ½
No 10% early distribution penalty for death, disability and first time home purchase
Minor can be named as beneficiary
SEPs
· Offer self-employed persons and small businesses easy-to0 administer pension plans.
· A qualified plan that allows an employee to contribute money directly to an IRA set up for each EE
SEP eligibility
· EE must be at least 21 years of age
· EE must have performed services for the ER during at least 3 of the past 5 yrs.
· EE must receive at least $550 (indexed for inflation) in compensation from ER
SEP participation
ER must allow all eligible EEs to participate
SEP funding
SEP allows ER to contribute up to 24% of an EE’s salary each year up to a maximum of $50,000 per EE per year
ER must contribute the same % for each EE & ER
SEP IRA vesting
Immediate full vesting
SEP IRA taxation
ER contributions deductible
$ Not taxable until withdrawn
$ accumulate tax deferred
Traditional IRA & SEP withdrawals
Without penalty at age 59 ½
Must begin by 4/1 of the year following attainment of age 70 ½
(If you reach 70 ½ on 1/1/2010, you must begin receiving distributions by 4/1/2011)
Subsequent payments by 12/31
Required minimum distribution (RMD)
Must begin by 4/1 of the year following attainment of age 70 ½
(If you reach 70 ½ on 1/1/2010, you must begin receiving distributions by 4/1/2011)
Penalty is 50% of amount not withdrawn
Roth IRAs have no RMD
Substantially equal periodic payment exception
Under IRS rule 72t, you can receive IRA payments at least annually based on your life expectancy (or joint life expectancies of you & beneficiary) with withdrawals NOT subject to 10% penalty
You can postpone beginning distributions until the later of:
4/1 of the calendar year after you turn 70 ½ or
4/1 of the calendar following your retirement (only for qualified plans, not an IRA)
IRA penalty waivers
Early withdrawal penalties for all IRAs are waived in the event of death or disability
Spousal IRA
If one spouse has little or no earned income and a joint tax return is filed, a spousal IRA may be opened for that person
Contributions limits are the same as for any other IRA
IRA custodians
Can be securities firms, banks, S&Ls, insurance companies, credit unions, mutual funds,
IRA deductibility
Deductibility is reduced or eliminated if individual participates in an ER-sponsored retirement plan and earns more than a specified amount
IRA contribution deadline
4/15 of the filing year- not even if you get an extension
Contributions exceeding the maximum are subject to a 6% penalty until the $ is withdrawn
IRA Ineligible Investments & Practices
· Collectibles
· Whole life insurance
· Term life insurance
· Short sales of stock
· Speculative option strategies
· Margin account trading
Real estate in a qualified plan
Permissible, but problematic
Needs to be a hands-off investment
Prohibited person cannot use the property or benefit from it
Prohibited persons
People who can’t benefit from real estate held in an IRA or qualified plan
Includes spouses, descendants, ancestors, but not siblings
IRA rollovers
Account owner can take temporary possession of funds to move to another custodian
Can do this only once per 12 month period
100% of $ must be rolled over or unrolled balance subject to taxes & penalties
Rollover must be completed in 60 calendar days
Rollovers have 20% withholding
Rollovers by non-spouse beneficiaries of certain retirement plan distributions
Effective 1/1/2007, Pension Protection Act of 2006 amended the IRC 1986 to allow non-spouse beneficiaries to roll over qualified retirement plan distributions to an inherited traditional IRA
Transfer must be trustee to trustee
Checks made out to beneficiary not eligible for rollover
IRA must be set up as an inherited IRA
RMD rules apply to beneficiaries
Direct rollovers from retirement plans to Roth IRAs
Effective 1/1/2008, the Pension Protection Act of 2006 amended the IRC 1986 to allow rollover from qualified plans directly to Roth IRAs, providing the clients meets the requirements for converting
Main requirement is that the client must report the entire amount converted into the Roth as ordinary income in the year of the conversion (or rollover)
IRA transfer
· Direct custodian to custodian, unlike IRA rollover
· Owner never takes possession
· Number of IRA transfers owner may make per year is unlimited
· Rollovers have 20% withholding
· No 60 day requirement
Earnings Limitations for Tax Benefits for IRAs
AGI limits increase every year
Individuals who are ineligible to participate in qualified plans may deduct IRA contributions regardless of income level
Inheriting an IRA
Rules differ between spouses and non-spouses
Beneficiaries do not have to be relatives
Spouse Beneficiaries of Inherited IRAs
Can be rolled over into spouse’s own IRA
Can continue to own IRA as beneficiary
If spouses roll over to own IRA, their age and rules apply
If left in inherited (or beneficiary IRA), decedent’s age applies (no 59 ½, but sooner RMD
Non-spouse IRA
· 10% penalty at age 59 ½ does not apply
· RMD must begin the year after the death of the account owner, but the payment is based on the life expectancy of the beneficiary, not the decedent
· Non-spouse beneficiaries can distribute the entire amount over 5 years
Disclaiming IRAs
When an individual disclaims an IRA proceeds pass to the contingent beneficiary
Person disclaiming cannot decide were the $ goes
If no contingent beneficiary, proceeds follow the provisions of the will
Roth IRAs
Do NOT have RMDs
Keogh (HR-10) Plans
ERISA- qualified plans intended for self-employed individuals and owner-employees of unincorporated business concerns or professional practices.
Keogh (HR-10) Plans
Included self-employed individuals include” independent contractors, consultants, freelancers, and anyone else who files and pays self-employment Social security taxes
Owner-employee
The term owner-employee means sole proprietor
Keogh contributions
Only earnings for from self-employment count towards determining the maximum that can be contributed.
Keogh contributions
A Keogh plan participant may also make non non-deductible contributions.
If voluntary contribution results in a total contribution that exceeds the annual maximum, the excess may be subject to a penalty tax
Keogh eligibility
Full time EEs who work 1000 hours
Tenured EEs who have complete 1 or more years of continuous service
Adult EEs who are 21 or over
Cannot be over 70 ½
Keoghs & IRAs Contrasted
IRAs do not involve ER contributions, Keoghs do
IRA not qualified by ERISA, Keoghs are
Keogh & IRA Comparisons
Taxes deferred on contributions until distributed
Investment income and capital gains deferred until distribution, then ordinary income taxes
Only cash may be contributed
Distributions can begin without penalty at age 59 ½; same penalties & exemptions apply
Same payout options
Same beneficiary options
403(b) tax advantages
Contributions (which come from salary reduction) are excluded from participant’s gross income
Participant’s earnings accumulate tax free until withdrawn
Income exclusion
If an EE contributes to a 403(b), the contributions are excluded from RR’s gross income for that year. The contribution is not counted as income, resulting in lower current income taxes
403(b) investments
Usual investments
GICs (guaranteed insurance contracts)
NOT life insurance
403(b) eligibility
EEs of qualified institutions must be 21 and have completed 1 year of service
403(b) plan requirements
Plan must be in writing and made through a plan instrument, a trust agreement , or both
ER must remit plan contributions to an annuity contract, mutual fund, or another approved investment
403(b) limit
For 2012, limit is $17,500 with a $5,500 catch-up provision
For ER contributions, maximum is the lesser of 100% of EE’s compensation or $50,000 per year
Same distribution rules as other qualified plans
ERISA guidelines for the regulation of all retirement plans
Eligibility- if a company offers a plan, all EEs must be covered if:
- They work 1000 hrs./yr.
- they are 21 or older
- have 1 yr. of service
ERISA guidelines for the regulation of all retirement plans
· Funds contributed to the plan must be segregated from other corporate assets
· Trustees have a fiduciary responsibility to invest prudently
ERISA vesting
EEs must be entitled to their entire retirement benefit amounts within a certain time, even if they no longer work for the ER
ERISA communication
Plan must be in writing
EEs must be kept informed of plan benefits, availability, account status, & vesting annually
ERISA nondiscrimination
A uniformly applied formula determines EE benefits and contributions
ERISA
Also known as Pension Reform Act
ERISA
ERISA regulations apply to private sector plans only. Plans for federal or state government works are not subject to ERISA
Uniform Prudent Investor Act (UPIA) of 1994
Was an attempt to update trust investment laws
Growing acceptance of modern portfolio theory
Standard of prudence is applied to any investment as part of the total portfolio, rather than just to individual investments
UPIA
Risk-return trade-off in all investments is considered
All categorical restrictions on types of investments have been removed
Diversification has been integrated into the definition of prudent investing
Investment functions can be delegated
UPIA
· Trustee must invest & manage trust assets as a prudent investor considering everything
· Decisions must be evaluated in the context of the total portfolio & overall strategy
· Examines economic conditions, inflation or deflation, tax consequences, role that each asset plays, expected total return, other resources of beneficiaries
UPIA
Trustee who has special skills or expertise and is named trustee is held to the stringent prudent expert standard for one acting as a professional money manager
Trustees may delegate investment and management functions, but must do so with care selecting adviser, establishing scope of delegation, monitoring performance, etc.
ERISA Section 404
For each person who acts as a fiduciary has to perform duties as specified in plan document
Trustees cannot delegate fiduciary duties, but can delegate investment management to a qualified manager
ERISA 404
Fiduciaries must:
- Act solely in the interest of plan participants and beneficiaries
- Other standard items
Noncontributory plan
Only the ER contributed
Annual review
it is highly recommended that advisors perform annual reviews with their clients to ensure that all recommendations remain suitable
investment policy statements: objectives – return requirements
· minimum annual income requirements;
· accumulation amount needed to meet financial goals, and so forth
Investment policy statements: objectives – risk tolerance
investors risk tolerance based on self-evaluation, objective questionnaire, and past experience
Investment policy statements: constraints – time horizon
timeframe in which goals must be obtained
Investment policy statements: constraints – liquidity
what is cash need?
For defined benefit plans, this may be high;
for individual retirement plans, this may be low
Investment policy statements: constraints – taxes
tax characteristics event investor and desired level of tax management
Investment policy statements: constraints – laws and regulations
any legal prohibitions on types of investments or transactions
Investment policy statements: constraints – unique circumstances and/or preferences
investor preferences or desires to avoid particular types of assets
Trust accounts
a trust is a legal entity that offers flexibility to an individual who wishes to transfer property
trust may be established for a variety of personal and charitable property transfers
trusts are also establish as the legal entity for corporate retirement plan
the prudent investor rule is an outgrowth of defining trustee responsibilities
Trust parties
for trust to be valid, three parties must be specified in the trust document
these parties are a settlor, a trustee, and a beneficiary
under certain circumstances the settlor, trustee, and beneficiary may be the same individual
for trust to be valid and the trustee must be competent parties
however, the beneficiary may be a minor or a legally incompetent adult
The settlor
· the settlor is the person who supplies the property for the trust
· trust property is also referred to as its principal or corpus
· settlor is also known as the maker, grantor, trustor, or donor
trustee
· the trustee is an individual or other party holding legal title to property held for the benefit of another person
· the trustee must administer the trust by following directions in a trust document or in a will
· the trustee must perform certain duties relative to the trust property
trustee
· the trustee is a fiduciary and is obliged to perform in the interests of the beneficiaries
· the trustee may be one or more adult individuals or entity in the business of trusteeship that is responsible for investing administering and distributing trust assets for the benefit of the beneficiary
trustee
· in many ways a trustee’s duties are like those of an executor for an estate
· however I trustee’s duties generally continue for more time than a typical estate settlement, and the trustee is charged with greater duty of investing trust assets
beneficiary
a person for whose benefit property is held in trust
a beneficiary is one who receives or is designated to receive benefits from property transferred by trustor
there is no requirement that the beneficiary hold legal capacity
beneficiary
thus the beneficiary of a trust may be one or more minors or an adult individual declared legally incompetent
although it does not happen often, the grantor of the trust can also be the trustee and/or the beneficiary
contingent beneficiary
an individual whose benefit depends on the occurrence of an event usually someone’s death
remainderman
what a trust is run its course and all expenses and distributions have been made, the person who receives the remaining balance is call the remainderman
the most common case involves real estate
Simple trusts
all income earned on assets placed into a simple trust must be distributed during the year it is receive
if the trust does not distribute all of its net income at least annually, the trust is a complex trust the trustee is not empowered to distribute the trust principal from a simple trust
Complex trust
a complex trust may accumulate income
at complex trust is permitted deductions for distributions of net income or principal
capital gains are deemed part of the distributable net income of a complex trust unless reinvested
furthermore the trustee may distribute trust principal according to trust terms
Complex trust versus simple trust
the key difference between a simple and a complex trust is that the simple trust must distribute all of its annual income, whereas a complex trust is not obligated to do so
Living trust
a living trust, also known as an inter-vivos trust, is established during the maker’s lifetime
a testamentary trust is established according to the instructions of a will – that is, not with the death of the maker
testamentary trust
· the settlor retains control over the assets until he dies
· the individuals will specifies that, at death, the testator’s property is to be placed in trust for the benefit of one or more beneficiaries
· the testamentary trust does not reduce the grantor’s income or estate tax exposure
· furthermore assets that passed to a testamentary trust to not avoid probate because the validity of the wills instructions to pass property to the trust must be substantiated probate court
Revocable trusts
· a revocable trust must be a living trust because only the living grantor has the power to change or revoke the trust
· at the grantor’s death, the trust becomes irrevocable because the individual with the power to change or revoke the trust no longer lives
· no estate tax benefit is available for revocable living trust
· the value of any trust assets in which the grantor retains power to revoke the trust and again own the trust property out right is includable in the grantor’s gross estate
Irrevocable trust
for trust to be considered irrevocable the settlor must give up all ownership and property transferred into the trust
property placed in in a revocable trust is usually not includable in the trustor’s estate for federal estate tax purposes
certain exceptions to the general rule can jeopardize the effectiveness of an irrevocable trust to reduce estate taxes
Exceptions to the general rules of irrevocable trusts
the grantor retains a life interest, or life income
the grantor retained a reversionary interest in the trust that is considered more than incidental. Reversionary interest means, without getting overly complicated that the grantor may receive property back from the trust. Under tax law the grantor is treated as the owner of any portion of a trust in which he has a reversionary interest in either the corpus or the income if the value of the interest exceeds 5% of the value of that portion.
The grantor retained general power to direct to home trust property will pass.
The grantor transfers one or more life insurance policies into an irrevocable trust while retaining certain incidents of ownership including the ability to make loans from policy cash values and or beneficiaries
Grantor
the grantor retains a life interest, or life income
the grantor retained a reversionary interest in the trust that is considered more than incidental. Reversionary interest means, without getting overly complicated that the grantor may receive property back from the trust. Under tax law the grantor is treated as the owner of any portion of a trust in which he has a reversionary interest in either the corpus or the income if the value of the interest exceeds 5% of the value of that portion.
The grantor retained general power to direct to home trust property will pass.
Grantor
The grantor transfers one or more life insurance policies into an irrevocable trust while retaining certain incidents of ownership including the ability to make loans from policy cash values and or beneficiaries
designed to pass assets to beneficiaries – usually children in a way to minimize gift and/or estate taxes
the grantor transfers property into a trust (a GRAT) that provides that the grantor will receive each year a fixed annuity usually for term of years
at the end of the term the remainder beneficiaries will get whatever’s left the gift involves equals the theoretical value of the remainder determined by using the discount rate specified in IRS tables
Grantor
if the assets of the trust earn more than the IRS rate, any earnings in excess of that rate could go to the beneficiary free of estate and gift taxes
however the grantor dies during the term of the trust the remaining assets are considered part of the deceased estate
even though this is technically in a revocable trust because the guarantor has a retained interest the tax liability of the trust income falls on the grantor
Distributable net income (DNI)
because of the onerous tax implications, most trusts and estates distribute their income
taxable income is known as distributable net income
DNI determines the amount of income that may be taxable to beneficiaries or the grantor in the case of a living trust, whereas the balance may be taxed to the trust as indicated above
Bypass Trust
Is an estate planning tool used to take advantage of the lifetime estate tax exclusion
It is commonly used between two spouses
Unified credit
The first 3.5 million of estate does not incur an estate tax
Generation Skipping Trust (GST)
$ goes to grandchildren or great-grandchildren without estate tax
Direct skip
When the assets, either directly, through an estate, or through a trust, are left to a beneficiary at least two generations below the transferor
Direct skip
with the direct skip, the donor or the donor’s estate, the executor pays a generation skipping transfer tax (GSTT)
taxable termination
applies when a trust is terminated and pays out the remainder of its funds
under a taxable termination, the trustee is responsible for paying the GSTT
a termination is just reviewed the principal and, if applicable accumulate income to a trust beneficiary who is a skip person, the most common case of this is when a skip person is the contingent beneficiary of someone in the generation above who is now passed away typically that persons parent
taxable distribution
means any distribution from the trust to person (other than a taxable termination or direct skip).
With a taxable distribution, the recipient is required to pay the GSTT
GRAT
One of the risks in setting up a GRAT is that if the grantor dies during the term of the trust (usually 3-10 years), the assets put in the GRAT, plus any appreciation are included in her estate
Estate account
a custodial account that, like a trust account, is directed by an executive or on behalf of the beneficiary or beneficiaries of an estate
if intestate, these functions are performed by a court appointed administrator
the executor or administrator makes the investment, management, and distribution decisions for the account
the taxation on undistributed income of an estate is the same as that of trusts and the tax is computed on form 1041
per stirpes
Latin for per branch
trust suitability issues
the trust document will usually spell out the trust objectives, and these must be followed
in the case of an estate, the will must be followed
tax considerations conflicts between the grantor and the beneficiary may exist
Partnerships
is a business formed under a partnership agreement that identifies the goals and purpose of the partnership
partnerships are easy to form an easy to dissolve, but are generally not suited for raising large sums of capital
partnerships allow the business’s profits and losses to flow directly through to the investors for tax purposes, thus avoiding double taxation of profits at the business and individual levels
Limited partnership
the management (a liability) is assigned to the general partner while the limited partners are passive and have liability limited to their investment
limited liability company (LLC)
is a business structure that combines the benefits of incorporation (limited liability) with the tax advantages of a partnership (flow-through of taxable earnings)
the LLC owners are members (not shareholders) and are not personally liable for the debts of the LLC
the objectives and financial constraints of the individual members must be considered from a suitability standpoint
S corporations
although taxed like a partnership, S corporations offer investors the limited liabilities associated with corporations in general
profits and losses are passed through directly to shareholders in proportion to their ownership in the S Corporation
unlike in LLC which can have unlimited number of members, an S corporation may not have more than 100 shareholders, none of whom may be a nonresident alien, or more than one class of stock (presumably common)
losses on S corporation stock may be claimed only to the extent of investor’s basis shares
S corporations
loss is limited to the amount of the investor’s basis
C corporations
a business structure that distinguishes the company as a separate entity from its owners
officers and directors are shielded from personal liability for the corporation’s debts and losses in most circumstances
creditors cannot reach the shareholders assets to satisfy the corporation’s debts
income tax applies to the corporation as an entity rather than being passed through to the shareholder
C corporations
earnings are subject to double taxation
before distribution, earnings are taxable to the corporation and then are taxed again to the shareholder when they are paid out as dividends
distributions from LLCs and S corporations are taxed only once because there is no taxation at the business entity level
Sole proprietorship
the easiest business to set up, especially if you don’t expect much liability
because the business and the owner are inseparable, there is unlimited liability
no limits to the amount of loss that may be claimed on the proprietor’s tax return
Business structures
Partnerships and LLC’s are generally easier to form and dissolve than a C Corporation
Partnerships, LLCs, and S corporations
Benefits of structuring a business as a general partnership, and LLC, or an S corporation would include no double taxation as is the case with the C Corporation
C corporations
A company that expects to be very profitable should be a C corporation instead of a partnership, and LLC, or an S corporation because in those three all earnings passed through to owners – nothing can be retained
C corporations
the only logical choice were a large amount of capital is to be raised is a C corporation
Business structures
only the sulfur partnership in the C Corporation are taxed on their income
the sole proprietorship on his personal income tax and the Corporation on a Form 1120
Business structures
it is a limited liability owners as well as low income or loss are the limited partnership, LLC, an S corporation.
The C Corporation has limited liability but no flow-through
the sole proprietorship and general partnership have flow-through but unlimited liability
Corporations (including LLCs) survive the death of their owners (even if there’s only one shareholder in an S Corporation or C Corporation, or one member of the LLC)
when it comes to transferability of ownership, the corporate form, especially the C Corporation, is the preferred choice (selling shares is usually pretty straightforward).
Sole proprietors
file their tax returns and business information on a Schedule C
LLCs and shareholders of S corporations
receive a Form K – 1 to report their income
C corporations
report their income on a Form 1120
Negotiable jumbo CDs
trade in the money market
Capital appreciation
Large cap stocks
Growth
Balance/moderate growth- large cap stocks, defensive stocks
Aggressive growth
Technology stocks, sector funds, or cyclical stocks
Bank Insured CDs
Eliminate interest rate risk (their value remains constant, even when interest rates change)
They are not savings accounts with a maturity date
They would be included as an asset on a family balance sheet
The preferred answer when a client wants capital preservation with no risk of loss
FDIC- insured
1st choice for preservation of capital
Bank insured CDs
They are not marketable and therefore have no interest rate risk
Their value is fixed and you can always redeem them at face value, regardless of direction of interest rates
For current income, investors typically want:
Government bonds- greatest safety
Corporate bonds and notes and funds- high yield income
Municipal bonds and funds- tax free income
Preferred stock and utility stocks- from a stock portfolio
Speculation
Highly volatile stocks;
High-yield (junk bonds);
Stock or index options;
Commodity futures
College tuition
Zero coupon bonds in 529s or Coverdell ESAs
Term insurance
Younger people are better off purchasing term insurance because the lower premiums offer them significantly more protection
For those 60 and older, the rates are generally prohibitive
Life insurance tax implications
Premiums are non-deductible
Municipal bonds
Income is tax-free
Capital gains are fully taxable
Liquidity
Money market funds
Asset allocation
Spreading of portfolio funds among different asset classes
Proponents feel that the mix of assets within a portfolio is the primary factor underlying the variability of returns in portfolio performance
Asset allocation
Three major asset classes:
Stocks (with subclasses based on market capitalization, value vs. growth, and foreign equity)
Bonds (with subclasses based on maturity (intermediate vs. long term) and issuer
Cash (focusing mainly on the standard risk-free investment- the 90-day T-bill, & other short term investments)
Strategic asset allocation
proportion of various types of investments composing a long-term portfolio
Standard asset allocation model
standard asset allocation model suggests subtracting a person’s age from 100 to determine the percentage of the portfolio to be invested in stacks. According to this map, a 30 year-old would be 70% invested in stocks and 30% in bonds and cash; a 70 year old would be invested 30% in stock’s with the remainder in bonds and cash.
Constant ratio plan (strategic asset allocation)
investment plan that attempts to maintain the type of relationship between debt and equity (or other asset classes)
periodically, the account is rebalanced to bring it back to the desired ratio
Constant dollar plan (strategic asset allocation)
under this investment plan, the goal is to maintain a constant dollar amount in stacks moving money in and out of the money market fund when necessary
tactical asset allocation
tactical asset allocation refers to short-term portfolio adjustments that adjust the portfolio mix between asset classes in consideration of current market conditions
Tactical asset case
tactical asset allocation refers to short term portfolio adjustments that adjust the portfolio mix between asset classes in consideration of current market conditions
Active management style
active management relies on the manager’s stock picking and market timing ability to outperform market indexes
Passive management style
a passive portfolio manager believes that no particular management style consistently outperform market averages and therefore constructs a portfolio that mirrors a market index
passive portfolio management seeks low-cost means of generating consistent, long-term returns with minimal turnover
Passive management style
passive portfolio management is very similar to strategic asset allocation
the same could be said about the relationship between active management and tactical asset allocation
growth
Growth portfolio manager is using the gross style of management focus on stocks of companies whose earnings are growing faster than most other stocks and are expected to continue to do so
because rapid growth in earnings is often priced into the stock’s, growth investment managers are likely to buy stocks that are at the high end of their 52-week price range
