Recall that the three types of investment companies are unit investment trusts (UITs), face amount certificate companies, and management investment companies. All three types have the following characteristics in common:

• undivided interest in the fund proportional to the number of shares held
• diversification in many securities
• professional management
•specific investment objectives

The most common type of investment company is the management investment company. A management investment company actively manages a portfolio of securities to achieve its investment objectives. There are two types of management investment companies-- open-end and closed-end. There are two primary differences between a open-end and closed-end management company:

1. Where investors buy and sell their shares (primary vs. secondary market)
2. The types of securities they sell

Open-end companies are also known as mutual funds, and closed-end companies are also known as closed-end funds (CEFs). People who are planning to obtain the Series 6 license will deal mainly with mutual funds in their investment business.

REGISTRATION, REGULATIONS, AND RULES FOR INVESTMENT COMPANIES

Recall that the following rules were already discussed in the "Securities Industries Regulations" section:

The Investment Company Act of 1940 -- This legislation was passed by Congress to protect the interests of investors regarding investment companies. If a company is in the business of owning, holding, and trading securities, or if 40% or more of the company's assets are invested in securities, the company must register with the SEC as an investment company. Note from the other section that there are exceptions regarding who must register. Registration must occur within 90 days and must meet the following minimum requirements:

•the company must have at least $100,000 in investment capital
•it must have 100 or more investors in the company
•it must have explicitly defined investment objectives
•it can have no more than one class of security

The Securities Act of 1933 -- A company must register any new securities it intends to sell with the SEC. The registration consists of two parts-- the prospectus, and the statement of additional information.

Remember that the Securities Act of 1933 deals primarily with the issuance of new securities. The Securities Exchange Act of 1934 pertains to securities that have already been issued and are now trading on the secondary market.

STRUCTURE, MANAGEMENT, AND OPERATION OF MUTUAL FUNDS

Board of Directors

A management investment company has a CEO, a team of officers, and a board of directors. Although they are responsible for serving the interests of their shareholders, their primary responsibility is to handle the administrative matters of the investment company.

The shareholders of an investment company elect the board of directors. The board determines the types of funds that will be offered to the public. They also list the objectives of these funds. For example, to meet the investment needs of many individuals, the board might suggest offering a selection of funds such as growth funds, international funds, income funds, etc. The board approves and hires the investment adviser, transfer agent, and custodian for each fund.

Sponsor

The principal underwriter of a mutual fund is called a "distributor" or "sponsor." The sponsor has a written contract with the investment company that allows it to purchase fund shares at the current net asset value, and resell the shares to the public at the full public offering price. This is done through outside dealers or through its own sales force. The contract is subject to annual renewal to ensure that the sponsor is distributing and marketing the shares in a satisfactory manner.

Custodian

The custodian handles the investment company's clerical functions and is responsible for the possession of the securities purchased by the investment company for its own portfolio. Once securities are transferred to the custodian for safekeeping, he keeps the assets physically separated, restricts account access to only authorized personnel of the company, and allows withdrawals only per the SEC's rules.

Investment Adviser (IA)

An investment adviser is hired to invest the cash and securities that are held in the fund's portfolio. He also implements any objectives defined by the board, manages the day-to-day trading of the portfolio, and handles other tasks that involve the tax implications of the share. Since he is acting as a "fund manager" or "fund adviser," he is paid with management fees that come from the fund's net assets. Usually, he earns an annual percentage of the fund's value and an incentive bonus if the fund exceeds certain performance goals.

Transfer Agent

The transfer agent issues, redeems, and cancels fund shares. He also distributes funds to clients. In certain cases, the custodian will act as the transfer agent. The fund company usually pays the transfer agent a fee for the services rendered.

Dealers

The sponsor usually distributes shares of the mutual fund through dealers. A dealer purchases shares from a sponsor at a discounted POP and also fill orders for clients. Dealers may not buy shares for their own account to sell at a later date. They are allowed to purchase shares if they redeem them right away (at the time they purchase the shares). They cannot be sold to another investor.

RESTRICTIONS ON MUTUAL FUND OPERATIONS

Unless it meets strict financial and disclosure requirements, a mutual fund is restricted from engaging in certain activities. A mutual fund is restricted from selling securities short, buying securities on the margin, and participating in joint investments or joint trading accounts. If the fund meets an exception requirement and is allowed to participate in those activities, it must disclose them in the prospectus. It must also describe the extent to which it plans to participate in the activities.

Recall that the Investment Company Act of 1940 defines "affiliated person" and "interested" parties. Remember that these people must be regulated by the SEC, and are not allowed to borrow money from the investment company. They are also prohibited from selling a security or property to the investment company or to any companies that the investment company controls.

Lastly, the board of directors must have 40% outside representation. In other words, at least 40% of the board must be made up of individuals who do not have a position with or affiliation to the fund. This restriction includes anyone associated with the underwriter, investment adviser, custodian or transfer agent.

BENEFITS OF MUTUAL FUND OWNERSHIP

The three main advantages of investment companies are liquidity, diversification, and professional management.

Liquidity

Liquidity refers to the quality of an investment's asset-to-cash transfer. Mutual funds can be sold on any given business day. Investors are able to convert these shares into cash within a short period of time (a week or less) and at a reasonable price. They can sell the shares in-person, online, or by phone within seconds. Since it is so easy to convert non-cash assets to cash, mutual funds are described as highly liquid investments.

Diversification

Diversification reduces the risk of owning too much of the same thing ("putting all your eggs in one basket"). A mutual fund is a convenient way for investors to spread out their risk among different investments. The mutual fund pools money from many sources to purchase interests in hundreds of companies. This allows investors who would otherwise be unable to adequately diversify their holdings to do so with a limited amount of assets.

Professional Management

Although this is a major advantage for anyone investing in a mutual fund, it is especially helpful to investors who are inexperienced or who are strapped for time and need to fund their retirement or a college tuition. Basically, these "average" investors are paying a small amount of money to receive money management services from experienced financial consultants.

Other Services

In addition to liquidity, diversification, and professional management, mutual fund companies also offer several types of services that make investment management a lot easier for a client. Examples are as follows:

•Investors receive regular statements, summaries, and reports showing cost basis, gains or losses, contribution amounts, and year-end tax information.

•Investors can arrange to have regular contributions systematically invested, dividends and capital gains reinvested, or funds automatically withdrawn.

•Investors have voting rights similar to common stockholders. They can vote on sales charge modifications, change the board of directors, approve or reject an investment adviser, and decide on (or against) changes to a fund's investment objectives.


TYPES OF MUTUAL FUNDS

There are a multitude of mutual funds available to investors. Investors typically prefer to invest in mutual funds because they offer liquidity and diversification, are affordable, and are professionally managed. There is almost always a mutual fund that is suitable for an investor’s needs, no matter what his goals might be. Mutual funds can be categorized numerous ways which can prove confusing to investors. They often fall into multiple categories or sub-categories of other funds.

They might also be classified according to investment goals, the type of investment, or based on the mutual fund’s structure. Sometimes they are just grouped into broad categories (i.e. equity funds) or by specific sectors (i.e. real estate funds). When deciding which mutual fund to invest in, it is important to look at the mutual fund’s holdings, objectives, risks that could cause loss, and potential for capital gains. Again, there are many different types of mutual funds.

Money Market Funds-- A money market fund is an open-ended mutual fund that can only invest in short-term investments issued by the federal, state, and local governments (i.e. T-bills, commercial paper). These short-term investments of one year or less are also high-quality. The objective of a money market fund is to earn interest for shareholders while maintaining a net asset value (NAV) of $1 per share. They are very safe, extremely liquid, and have low-volatility. Investors can withdraw money at any time with no risk of principal loss.

Equity Funds-- An equity fund is an investment fund that buys ownership in a business. When investors buy stock in a business, they are purchasing equity (ownership) in that company. Since there are many different types of equities, there are many different types of equity funds. An equity fund invests in stocks, and its goal is growth and profit for the investor.

Bond Funds-- As the name suggests, bond funds are professionally managed portfolios that invest solely in bonds. Since there are various bonds to choose from, each fund states an investment objective and usually just focuses on that particular sector (i.e. corporate, treasury, investment grade, high-yield, etc). An investor who purchases a bond fund is seeking current income and capital preservation. Recall that a bond fund is comprised of specific types of bonds (same or mixed). As a result, the bond fund subject to the risks associated with each bond in its portfolio (credit risk, call risk, interest rate risk, and reinvestment risk).

While the broad categories for mutual funds are equity funds, bond funds, and money market funds, recall that there are a plethora of funds that fall under each category into smaller categories. Also remember that many of these funds might have overlapping characteristics and fit into more than one category. The main objectives for equity, bond, and money market funds are capital, income, and growth.

Although many portfolios contain multiple investment vehicles, some mutual funds intentionally divide the portfolio's assets into specific percentages of stocks, bonds, or money market securities. Two examples of funds that do this are as follows:

Balanced Funds-- These funds invest in stocks and bonds. In other words, an investor's portfolio will contain both stocks and bonds. The goal of this type of fund is to balance debt and equity. In other words, the high risk and returns of the portfolio's equity funds are balanced out by the safety of the portfolio's debt instruments. Aggressive funds will hold more equities and conservative funds will hold more bonds.

Asset Allocation Funds-- With this type of fund, an investor's portfolio contains a mixture of the three main asset classes (stocks, bonds, and money market securities). The fund manager will allocate the amount of each asset class to the portfolio according to investment style. For example, a conservative asset allocation fund might be composed of 60% bonds, 30% stocks, and 10% money market instruments, while a moderate growth asset allocation fund might contain 60% stocks, 35% bonds, and 5% money market instruments.

Funds can also be categorized as "specialized" investments. When a fund focuses on a particular industry or sector of the economy, it is often referred to as a sector fund. The market contains several types of sectors and sub-sectors. For example, Bank of America an Allstate are both in the financial sector. However, Bank of America is also in the banking sector, while Allstate is also in the insurance sector. This is why funds cannot be grouped into just one specific category. Some main sectors that a fund might invest in are technology, finances, consumer, utilities, healthcare, real estate, natural resources, and precious metals. Since specialized/sector funds are not very diversified, they have a higher degree of risk.

Foreign funds can also fall under "specialized" investments. They can be equity funds or bond funds. Per their name, these funds invest in the various economic or industrial areas of one or more countries. International and global funds are the two generic categories of foreign funds.

International Funds-- These funds invest in companies located outside the U.S. They might invest in the securities issued by companies located in just one single country (i.e. Japan), or in several countries in a specific region(i.e. Asia).

Global Funds-- These funds invest in securities all around the world including those in the United States. Although an investor's portfolio will contain U.S. and foreign securities, at least 80% of them will be foreign.

There is one category of funds that is not actively managed. They are sometimes referred to as a type of "sector fund," because each fund only focuses on the components of a market index.

Index Funds-- As previously stated, these funds invest in all the stocks and bonds of one market index (i.e. Standard & Poor's 500 Index). Since investors are purchasing the shares of an index fund, they own all of them, and will not try to trade them. In other words, when an investor purchases (shares of) an index fund, he is basically buying a huge chunk of stocks and bonds with just one purchase. Since he bought the index as a whole and did not individually pick the stocks, he owns the entire index and cannot trade out any of those stocks. Additionally, he is not just betting on a few stocks to succeed, but has a large amount that could earn him a profit. Due to this diversification, index funds have low risk. They are also considered to be a passive investment approach since no active trading occurs. In other words, since the index fund is just mimicking the performance of a chosen index (and no one is researching companies to choose good individual stocks), the fund does not need much management.


MUTUAL FUND MARKETING

Mutual fund shares are marketed in accordance with the the rules of the Investment Company Act of 1940. Any mutual fund advertisement containing performance data must include a legend that discloses the following important facts:

•The data represents past performance and does not indicate future results.
•An investor's principal value will fluctuate and might end up being worth less than the original amount invested.

Advertisements are also required to state where a potential investor can obtain a prospectus. The ad is required to recommend that an investor should carefully read the prospectus before investing any money. An application to invest in the investment company's fund may not accompany any type of mutual fund advertisement. Detailed information regarding the various marketing rules for mutual fund companies can be found in the "Marketing and Sales" and "Customer Accounts" sections of this course.

MUTUAL FUND PRICING

Investors must pay the full price when buying mutual fund shares. This "full price" is called the public offering price (POP). It is the net asset value (NAV) plus any sales charges. The net asset value (NAV) is determined by dividing the net assets of the fund by the total number of outstanding shares. The NAV is calculated at the end of trading on the New York Stock Exchange. Any orders to buy and sell the fund are based on the price to be computed at that time. Therefore, if an investor buys shares of the fund at 10:30AM, he will not know the actual price he paid until after the close of trading for that day. The formula used to calculate the NAV of a mutual fund is as follows:

                                               NAV = (Assets - Liabilities ) / Number of Outstanding Shares

SALES CHARGES AND EXPENSES

In order to pay for management costs, distribution costs, and other administrative liabilities, open-end management companies charge fees to any investors buying mutual fund shares. There are different types of sales charges. The charges and fees that are assessed will depend on which fund shares are being purchased. A no-load mutual fund is one that can be bought or sold at any time without having to pay any sales charges or commissions.

A front-end load is a fee paid to purchase shares of a mutual fund. The drawback to a front-end charge is that it is deducted from the amount of the investment, so it lowers the size of the investment. The charge is stated as a percentage of the public offering price (POP). This percentage is computed by subtracting the NAV from the POP, then dividing the total by the POP.   Sales Charge= ( POP - NAV ) / POP

A back-end load or contingent deferred sales charge (CDSC) is a fee paid when an investor sells a specific investment (when it is redeemed). It is expressed as a percentage and must be disclosed to potential investors in the security's prospectus. The amount of back-end load that an investor will pay will depend on how long the investor has held the shares. The amount will gradually decrease over time. If the investor holds on to the shares long enough (usually 5-7 years), the charge might not even be applied. In other words, the shares would be redeemed at the NAV and no sales charge would be assessed.

12b-1 fees are charges that are used to pay for marketing and distribution expenses, and for the commissions that are paid to financial advisers. These fees are taken out of a mutual fund's assets, and are usually between 0.25 and 1% of the fund's net assets. One percent is the maximum fee that is allowed.

These fees differ in amount according to share class. Clients who buy shares of mutual funds with high 12b-1 fees usually wind up paying more in sales charges than if they would have just initially purchased shares with a front-end load. However, investors who are looking for short-term returns will benefit from buying one of the nonfront-end loaded funds.

The expense ratio is the percentage of the total fund assets used for the operation and management expenses of a mutual fund. The amount will be stated in the fund's prospectus and will vary, depending on how active the portfolio manager is in regards to trading. The amount will be taken from the fund's assets, lowering the return to the investor. Operating expenses include brokerage fees, taxes, investor services, and interest expenses. The management fee is charged by the portfolio manager and is often a fixed percentage. The expense ratio is also known as the management expense ratio (MER).


SHARE CLASSES

Most open-end investment companies offer several classes of mutual fund shares, but the most common are A, B, and C. Share classes are characterized by two major things--the type of investor and the size of his initial purchase (investment). For these reasons, each share class assesses sales charges or fees differently (there might be a load/charge, there are different types of loads, there might be 12b-1 fees, the amount of 12b-1 fees will differ, etc).

Besides A, B, and C shares, there are other share classes (i.e. R, F). These are for special types of investors (i.e. employees of broker-dealers, 529 college savings plan investors, institutional investors, or investors with fee-based accounts).

In order to determine which share class is best for a client, the representative should find out the following three things:

1. How much money the client plans to invest over the next 13 months
2. How long the client plans to own the mutual fund shares
3. If the client owns any other mutual funds

Class A Shares -- These usually have front-end loads. An investor who purchases a large number of shares can take advantage of reduced sales charges known as breakpoints. Class A shares also have lower 12b-1 fees.

Class B Shares -- These have back-end loads. Aside from those charges, the only other sales charges are 12b-1 fees. B shares have the highest 12b-1 fees of all the class shares. If the back-end loads decrease until they reach zero percent, these funds are converted from B shares to A shares.

Class C Shares -- These have an even load charge that is equal to a stated percentage of the fund's assets. This sales charge will be assessed by the fund for either a stated period of time such (i.e. 3-5 years) or for the entire holding period.

Without incurring a sales charge, an investor has the privilege to convert the holdings in one fund for an equal investment amount in another fund, as long as the funds are in the same share class. Some share classes do not allow this at all. Others might limit exchanges to a certain amount allowed per year, or to the total amount (value) of what the investor currently holds. Exchanges have the same tax consequences as ordinary sales and purchases (any gains will be taxable, and any losses may be used against other gains).

SALES DISCOUNTS

When an investor purchases a fund's shares, he might qualify for a reduced sales charge if he reaches a certain dollar amount. This is called a breakpoint. For example, a company might charge a front-end load of 5% on all investments that are less than $50,000. However, if the client chooses to invest between $50,000 and $99,999, the company might reduce the front-end load from 5% to 4%. Each dollar amount (i.e. $25K, $50K, $100K, etc) that allows for a discount is called a breakpoint. As breakpoints increase, discounts increase. In other words (and per the example, as the dollar amounts increase (the more a client invests), the charges (%) decreases.

If multiple (associated) people are investing and trying to reach a breakpoint, they are considered to be just one investor. For example, a married couple would count as a single investor. The same rule applies to corporations, and to parents and their minor children. Aside from that condition, there are various ways for an individual investor to qualify for a breakpoint. An investor might add a larger lump sum to his purchase in order to reach a breakpoint. Mutual fund companies offer the following investing incentives that will also help clients reach breakpoints:

•Letters of Intent (LOI): Although a client might not have enough money right now to qualify for a breakpoint, he might gain more in the future. If he wants to invest in a fund's shares now but wants a discounted sales charge for this current purchase, he can sign a letter of intent. The LOI states that he agrees to invest any additional funds that are necessary to reach the breakpoint. However, all those additional funds must be invested within 13 months. Otherwise, he must make up the difference by either writing a check or redeeming escrowed shares.

•Rights of Accumulation (ROA): This is a right that a shareholder has in regards to reaching a breakpoint. For example, if a client wants to make a new purchase, the amount he already holds in his account is also counted towards the breakpoint. In other words, if the amount he already holds in his account plus the new amount he wants to purchase equal the breakpoint amount, he qualifies! There is also no time limit on how long the fund need to be held to meet this qualification.


REDEEMING MUTUAL FUND SHARES

An investor can partially or fully redeem shares of his mutual fund by selling them at the NAV. Remember, the redemption price is determined when the fund company computes the daily NAV (usually at the close of business of the NYSE). When shares are redeemed, the company must pay the investor within seven calendar days.


FUND PERFORMANCE

Just because a fund charges lower fees does not mean that it will be low-performing (and vice versa). In other words, a fund with low fees might be high-performing, or a fund with high fees might perform very poorly. When analyzing a fund, it is important to consider the after-tax return and the total return, not just the dividend yield. The total return is the actual rate of return of an investment over a given period of evaluation.

Since a variety of securities can be in a fund, the fund's performance is affected by all the different types of risk to which each security is exposed. Quantitative risk management is the process of using financial information to evaluate the performance of a fund.

Tracking the performance of an investment company's securities can be done in various ways. Mutual fund quotations are available in daily publications (i.e. the Wall Street Journal or in the business section of the local newspaper). There are also several websites that provide free mutual fund quotes. Typically, the investment company will have its own website that allows clients and representatives to download fact sheets, prospectuses, and detailed information on fund holdings and investment objectives.