Lesson 3.5: Benefits and Risks of Pooled Investments

Question 1

The most liquid investment.

Answer 1

Money market funds are the most liquid investment. In virtually all cases, they come with check-writing privileges.

Question 2

Which of the following statements regarding REITs are not true?

I. Investors receive flow-through benefits of income as well as loss.
II. Hybrid REITs own properties, as well as make loans on others.
III. Equity REITs are prohibited from using leverage to acquire properties.
IV. REITs are easily traded in the secondary market.

Answer 2

I & III

It is not true that REITs offer flow-through of losses; they are not DPPs. As with most real estate purchasers, leverage, usually in the form of a mortgage, is used to acquire property. A hybrid REIT contains the features of both an equity REIT and a mortgage (debt) REIT, and most REITs trade on the exchanges or Nasdaq. Note: Even though there has been an increase in the number of non-traded REITS, unless something in the question indicates that, the question will be dealing with publicly traded REITS.

Question 3

You have a client who invested in the PQR Growth Fund 10 years ago and now, as retirement age approaches, asks you about using the exchange privilege to move into the PQR Balanced Fund. The client should know that:

Answer 3

this exchange is considered a taxable event as of the date of the exchange.

The exchange privilege allows for an exchange at net asset value (NAV) between funds that are members of the same family. The exchange is considered a taxable event. Because the exchange is made at NAV, the concept of breakpoint is irrelevant.

Question 4

When advising an investor on the purchase of mutual funds, the agent should instruct the client to compare open-end mutual funds with the same objective for all of the following except

Answer 4

Liquidity.

Shares in an open-end investment company (mutual fund) are liquid. By federal law, all mutual funds are required to redeem shares at their net asset value within seven days; therefore, that should not be a consideration when comparing mutual funds with the same objective. Sales loads, management fees, and operating expenses reduce an investor’s return. Most of these fees continue throughout the holding period and have a significant impact on performance. Portfolio turnover is significant, as gains in the portfolio will likely all be short-term gains, which are usually taxable to the investor at a higher rate than long-term capital gains. Services that mutual funds offer include retirement accounts, investment plans, check-writing privileges, telephone transfers, conversion privileges, withdrawal plans, and others.

Question 5

Characteristics of a money market mutual fund?

Answer 5

A) Shares are offered without a sales charge.
B) All purchasers must receive a copy of the prospectus.

Money market funds are offered without sales loads or redemption fees. As with all mutual funds, a prospectus is required.

Question 6

An investor has been comparing several different mutual funds with the same objectives. When making the decision as to which fund to purchase, which of the following factors would be the most important?

Answer 6

The fund manager’s tenure (the number of years that manager has been managing that fund’s portfolio) is important because, although past performance is no guarantee of the future, in general, investors prefer someone who has performed well over the years instead of a manager with only a year or two at the helm. Because investors in mutual funds invariably purchase in a dollar amount rather than by the number of shares, the NAV per share is not a factor. That is, if you invest $10,000, what difference does it really make if the NAV per share is $10 or $100? No mutual funds are traded on the listed exchanges, and why would someone buy a fund based on the date of the annual meeting?

Question 7

Which type of investments would have the lowest liquidity risk?

Answer 7

Money market funds offer check-writing privileges permitting their investors to cash out virtually immediately.

Question 8

Why would you suggest a client invest in international mutual funds or ETFs?

I. Diversification
II. Tax benefits
III. Avoids having to pick individual stocks
IV. Greater regulatory controls

Answer 8

I and III

An international mutual fund (or ETF) invests in the securities of companies that are not domiciled in the United States. Therefore, we have the benefit of added diversification. These pooled investment vehicles offer investors the specific benefit (whether foreign or domestic) of not having to worry about individual stock selection—the professional managers do that. There are no specific tax benefits to investing through the fund rather than directly, and in most cases, the regulatory controls in other countries do not offer the same degree of investor protection as those of the United States.

Question 9

One of your advisory clients meets the financial requirements for investing in a hedge fund. Having read so much about their outstanding performance, he asks you to describe any negatives to adding one to his portfolio. You could respond that

Answer 9

expenses tend to run very high, diminishing the funds’ performance.

One of the risks of investing in hedge funds is the very high overhead, largely in the form of management fees. The other choices here are all advantages of hedge funds.

Question 10

Your married customers, ages 48 and 50, have a combined annual income of more than $200,000. They are concerned about the effects of rising inflation, and because they are heavily invested in bonds, they seek to invest a portion of their portfolio in a fund that will provide additional diversification. Which of the following mutual funds is the most suitable for these customers?

Answer 10

Investment in an overseas equity fund will provide diversification not necessarily subject to U.S. inflation. The tax-free fund will not provide additional diversification nor the best hedge against inflation. A high-grade bond fund will not add diversification.

Question 11

A client of yours comes to the office and shows you some sales literature from a mutual fund that has him very excited. According to the material, the fund’s average annual return over the past 10 years has been in excess of 15% and it has achieved the highest rating from the major fund rating services. Before recommending this fund to your clients, the first thing you would probably check for in the fund’s prospectus is

Answer 11

the portfolio manager’s tenure.

Because this client has been “sold” on past performance, you need to verify if the manager achieving those results is still on the job. That is the prime reason why the regulations require disclosure of the fund manager’s tenure; it is important for investors to know if the current manager was the one who had the winning streak or if that manager just came on board. The other choices are something to look at, but in this instance, they take a back seat to checking on the manager’s tenure. Sure, the expense ratio is important, but the past performance is after expenses, so that has already been taken into consideration.

Question 12

A client of yours recommends your services to his mother, who is 80 years old. She lives on Social Security ($2,215 per month) and has a home with a net value of $186,000. She has lost a large amount of money that she had placed into a high-risk technology fund about 10 years ago. The fund is part of a family that has a wide range of funds with varying objectives. With only $27,000 left in that account, what would you suggest as the best option for her?

Answer 12

Move her to a lower-risk fund that is in the fund family.

Obviously, this client invested in a fund that is not suitable for someone in her situation. Because families of funds offer the exchange privilege (exchanging shares from one fund to another at NAV), it is generally considered an unfair business practice to move to another fund and potentially incur a new sales charge.

Question 13

A sector fund is one where the assets are

Answer 13

concentrated in a particular industry or geographical area.

Sector funds (specialized funds) target at least 25% of their investments toward a specific industry or geographical location.

Question 14

If a couple has a long-term growth objective and is willing to accept a reasonable amount of risk, which of the following mutual funds is most suitable for them?

Answer 14

A common stock fund will help the couple meet their long-term growth objective.

Question 15

What is not an advantage of investing in a mutual fund?

Answer 15

Absence of market and business risk

Mutual funds offer investors the benefits of portfolio diversification, identifiable investment objectives, and professional portfolio management. They do not completely do away with market and business risk, however. Even if a mutual fund invests in a diversified portfolio of stocks, a poorly performing market can reduce the fund’s returns. In addition, portfolio managers for mutual funds can sometimes perform poorly and fail to generate acceptable returns.

Question 16

Investment adviser representatives are often called upon to help clients select an appropriate mutual fund. When making a recommendation, what would not be a consideration?

Answer 16

The fund’s net asset value per share

The price per share (NAV per share) of a fund is not a relevant factor when considering recommending a mutual fund. The fund’s investment objective must align with that of the client, and it is important to know if the fund’s portfolio manager has just come aboard or has been managing the fund for a number of years. All other things equal, the IAR will generally look for the funds with lower expense ratios.

Question 16

If an investor is looking for an open-end investment company with an objective of providing current income to its shareholders, she would most likely choose

Answer 16

Income funds provide the highest current income of the choices offered. The other choices would generally not hold many income-producing securities in their portfolios.

Question 17

The tax consequence of transferring proceeds from one fund to another within the same family of funds is

Answer 17

on the date of the transaction, any gain or loss is recognized for tax purposes.

An exchange is the sale and then a purchase of a new security and is therefore a taxable event.

Question 18

A mutual fund would have net redemptions when

Answer 18

the number of shares being liquidated by investors exceeds those being purchased.

One of the characteristics of an open-end investment company (mutual fund) is the ease of redeeming holdings. When the dollar amount of shares being redeemed exceeds that of those being purchased, the result is net redemptions. Although poor performance could lead to net redemptions, that is not always the case, so it is not always a true statement.

Question 19

One way for an accredited investor with an aggressive stance to reduce the overall risk in his portfolio is by

Answer 19

purchasing a hedge fund.

Although the T-bills and the CDs will reduce the overall risk, they are not the best answer because the question is dealing with an aggressive investor. One of the reasons HNW clients buy these funds is for the diversification offered by adding an asset subclass to their portfolios.

Question 20

One of the potential effects of a mutual fund’s portfolio manager having poor investment results might be

Answer 20

net redemptions.

Poor results will frequently lead to investors liquidating their holdings in a greater amount than new investors coming in. This leads to net redemptions; more money going out than coming in. No mutual fund can ever sell below NAV and the management contract is renewed on an annual, not bi-annual basis.

Question 21

If a client prefers mutual fund investments in companies that primarily generate capital appreciation to companies that pay a steady dividend, what type of mutual fund and associated investment objective would you recommend?

Answer 21

A growth mutual fund invests in stocks that are growing rapidly and stresses capital appreciation rather than income. The key is that the growth and appreciation are synonymous.

Question 22

A client of yours has been investigating a particular mutual fund. She mentions that she saw a blurb on the internet that the fund has had net redemptions over the past six months and asks you to explain how that might affect the fund’s performance. You should explain which of these?

I. This is a good thing because now, with less money to invest, the fund’s adviser is able to be more selective.
II. Performance will probably suffer because the fund’s adviser will have to sell positions prematurely in order to meet redemption requests.
III. This would be a good time to buy because the supply of shares exceeds the demand.
IV. Many of the fund’s expenses are relatively fixed, so with less assets in the fund, the expense ratio will probably increase.

Answer 22

II & IV

When a fund has net redemptions, it means that less money is coming in than is going out. In order to meet those redemptions, the fund’s manager will either have to sell securities that they planned to hold onto or maintain more assets in cash (which generally will return less than other investments). Because the expense ratio is the annual expenses divided by the average annual assets, with less assets to cover the fixed expenses, the ratio will probably increase.

Question 23

The Alpha-Gamma Mutual Fund reports a large number of their investors liquidating shares of the fund, so much so that the dollar amount of liquidations exceeds the incoming cash for new purchases. This would lead to a condition known as:

Answer 23

** Net Redemptions**

One of the main features of open-end investment management companies (mutual funds) is that there is a continuous offer of new shares and ready redemption of old ones. When redemptions exceed new purchases, the fund suffers from net redemptions.

Question 24

Under adverse market conditions, it is not unusual for mutual fund investors who had been investing on a regular basis to cease or reduce their level of financial commitment. This can have the effect of:

Answer 24

Net redemptions

In adverse market conditions, not only do some investors stop putting money in, they also liquidate their holdings. If new sales fall while liquidations rise, the effect could be net redemptions. The NAV is not affected by supply and demand, and if anything, the expense ratio would rise because some of the expenses would remain the same but would be shared by fewer assets. Mutual funds do not receive the sales charges—they go to the underwriter.

Question 25

Last year, the bond market was profitable and ABC Fund had 70% of its assets in bonds. Next year, the fund’s managers expect the equity market to outperform and will adjust the fund’s portfolio so that 60% of its assets will be invested in stock. ABC is most likely:

Answer 25

an asset allocation fund.

A mutual fund whose portfolio managers have the flexibility to allocate between different investment classes is known as an asset allocation fund.

Question 26

The exchange privilege offered by open-end investment companies allows investors to:

Answer 26

exchange shares of one open-end fund for another in the same fund family at a net asset value basis.

Exchange privileges allow an investor to convert the value of shares held in one fund for those of an equal value in the same family. Remember that conversion is a taxable event; if the shares converted have increased in value, capital gains taxes will be due.

Question 27

If a customer’s portfolio is heavily invested in common stock mutual funds, what is the customer’s greatest risk?

Answer 27

Loss of principal

A mutual fund with a portfolio of common stock is subject to market risk. If the market falls, the value of the fund’s shares also falls, subjecting the owner to loss of principal.

Question 28

By their very nature, pooled investment vehicles offer investors:

Answer 28

diversification

Most pooled investment vehicles invest in a broad range of investments, giving their investors diversification.