Example
Determine yield, given the following information: $ 0.50: Dividend distribution
$ 1.50: Capital gain distribution $17.40: Offering price
$0.50 divided by $17.40 = 2.87% yield
An open-end investment company has a dividend of $1.20 per year and a capital gains distribution of $0.50. The offer price at the time of purchase is $22.40 and the net asset value is $21.05 based on a minimum investment. Assuming a minimum investment, what is the yield of the investment company? (A) 2.23% (B) 2.37% (C) 5.36% (D) 0.70% Answer
(C) 5.36%. The yield of a mutual fund is the dividend divided by the offer price. In this case, the dividend is $1.20 and the offer is $22.40, so 1.20 divided by 22.40 = .0536 = 5.36%.
9.2 EX-DIVIDEND DATES
The mutual fund will select the RECORD DATE for distributions of dividends and/or capital gains. Anyone owning shares of the mutual fund on this date is entitled to receive the dividend.
The EX-DIVIDEND DATE (or EX-DATE) is set by the board of directors and is usually the next business day after the record date. The ex-dividend date is the day on or after which the buyer of the mutual fund shares is not entitled to receive the dividend.
On the ex-dividend date, the net asset value will be reduced by the dividend and/or capital gains distribution, since this money is no longer an asset of
Capital gains are not used to
determine yield.
would not change, although the investor would have to pay taxes on the distribution (whether or not it was taken in cash or automatically reinvested).
Example
An investor buys $30,000 of a no-load mutual fund on Monday, June 3 at $30 per share. The fund goes ex-dividend on Tuesday, June 4. The fund is making a $0.50 dividend distribution. On the ex-date, the NAV drops to $29.50 (assuming no other changes in the net asset value). What are the tax liabilities for the investor?
Answer
There is no change in the value of the investment. The investor still owns 1,000 shares of the mutual fund now worth $29,500, and has $500 in dividends, which may be reinvested. The investor also has a tax liability on the $500 distribution, and will have to pay ordinary income tax on the dividend whether or not it is reinvested.
The investor would have saved money and not had to pay taxes if he had waited to purchase the shares until the next day — assuming the market value of the securities owned by the mutual fund had not changed. It is a violation of the NASD Conduct Rules for a registered representative to entice an investor to buy shares of a mutual fund just before the ex- dividend date by describing the investment in the mutual fund as one that will “pay a dividend.” The representative must alert the prospective investor about the potential tax consequences of the purchase of a mutual fund prior to the distribution of dividends. This prohibited practice is known as SELLING DIVIDENDS.
10.0 CLASSIFICATIONS OF INVESTMENT COMPANIES
The additional investment company descriptions listed in this section are for both open-end and closed-end investment companies.
10.1 DIVERSIFIED INVESTMENT COMPANIES
In classifying investment companies, an investment company is either a diversified investment company or a nondiversified investment company. The word diversification defines whether the investments that are purchased by the investment company are spread among different companies and different types of securities or focused on one company or a select few types of investments.
According to the Investment Company Act of 1940, a DIVERSIFIED INVESTMENT COMPANY is a company that invests a least 75% of its total assets in such a way that no more than 5% of total assets are invested in any one company at a given time. Also, a diversified investment company cannot own more than 10% of the outstanding voting stock of any one company.
Selling dividends is a violation of the NASD
Exam tip: Know 75%, 5%, and 10%, in that order.
The other 25% of the diversified investment company’s assets can be invested in one company, in one industry, or the assets can be invested in other securities the investment company selects that match the investment objectives of the mutual fund. If a company is a diversified investment company, it must state this fact in its prospectus.
A nondiversified investment company is defined as any investment company that does not meet the criteria for a diversified investment management company. Investment companies must register with the SEC as either diversified or nondiversified. The distinction between diversified and nondiversified is applied whether the investment management company is an open-end company or a closed-end company.
Which of the following best describes a “diversified investment management company”?
(A) 75% of the investment company’s assets must be invested such that no more than 5% may be invested in any one company, and the fund cannot own more than 10% of the outstanding voting shares of another company.
(B) 10% of the investment company’s assets must be invested such that no more than 75% may be invested in one industry, and the fund cannot own more than 5% of the outstanding shares of another company.
(C) 75% of the investment company’s assets must be invested such that no more than 10% may be invested in any one issuer, and the fund cannot own more than 5% of the outstanding shares of another company.
(D) 5% of the investment company’s assets must be invested such that no more than 10% may be invested in one industry, and the fund cannot own more than 75% of the outstanding shares of another company.
Answer
(A) 75% of the investment company’s assets must be invested such that no more than 5% may be invested in any one company, and the fund cannot own more than 10% of the outstanding shares of another company. (Know this!)
10.2 SPECIALIZED INVESTMENT COMPANIES
A SPECIALIZED INVESTMENT COMPANY, sometimes referred to as a SECTOR FUND, is an investment company that invests in stocks whose issuers are primarily in one specific industry, type of business, size of company, or geographical area.
To qualify as a specialized investment company, the fund must invest more than 25% of its assets in one the specific type of issuer.
The types of investments it manages will also classify a specialized investment company. The following investment types are used to classify
FIRE Drill
A specialized investment company cannot own more
than 10% of any one company.
• Hybrid funds
• Money market mutual funds
Mutual funds are also categorized by RISK and INVESTMENT
OBJECTIVES. Risk is a term indicating the potential for an investment to lose value. High risk indicates a higher chance of losing value, yet high risk may also lead to higher potential rewards. Risk and investment objectives must be matched between the investor’s risk tolerance and investment objectives with the mutual fund’s risk profile and overall investment objective.
10.3 STOCK FUNDS
Stock funds invest in a wide variety of issuers, but the investment company must focus a majority of the investment money in equities, or stocks. Among stock funds, the following types of stock funds are selected based on their unique investment objectives and the underlying investments within the mutual fund:
• Growth funds
• Growth and income funds • Global equity funds • Income equity funds • International funds • Regional equity funds • Sector equity funds
GROWTH FUNDS invest primarily in companies that are growing and pay very little in dividends. The earnings generated by growth investment companies are usually reinvested in the company and not paid out as dividends.
Growth funds distribute very few dividends. However, it is hoped that the net asset value of their investments will be worth more when they are later redeemed.
There are two types of growth funds: • Aggressive growth funds • Conservative growth funds
Aggressive growth funds invest primarily in the common stock of relatively new companies with the potential for rapid and high capital appreciation. There are rarely any dividends paid, but there is the high potential for growth due to the industry the target companies are in.
Conservative growth funds primarily invest in the common stock of well-established companies with the potential for capital appreciation.
The primary aim is to increase the value of the investment rather than generate a flow of dividends.
10.4 BOND FUNDS
BOND FUNDS invest mainly in fixed-income securities of publicly traded companies and municipal issuers. The investment objective for fixed income includes wealth or asset preservation. Bonds, especially highly rated bonds, are generally secure investments that may not lose principal value. Of course, as interest rates decline, the value of bonds increases, and as interest rates increase, the value of bonds declines. The
Earnings are reinvested in
value of bond funds is based on the underlying value of the bonds held in the fund. If interest rates increase, the net asset value of the bond fund would decrease in value.
Bond funds can vary with their investment objectives and types of bonds that are purchased as an investment. The range of investment objectives for these bond funds include corporate bond funds, global bond funds,
government bond funds, mortgage backed bond funds, and several others.
Among the types of bond funds, corporate bond income funds focus on investing in debt securities of publicly traded companies. The bonds that are purchased can be categorized by the length of time it takes the investment to mature or the bonds that are purchased may be categorized by industry or sector. General, short-term, and intermediate-term describe the lengths of time over which the bonds mature. Global bond funds invest in companies throughout the world.
10.5 HYBRID FUNDS
Hybrid mutual funds are categorized by the overall investment objective that these funds follow. A balanced fund is one type of hybrid fund.
A balanced fund invests in a specific mix of fixed income and equity securities. The investment objective is a hybrid to preserve principal, produce dividends and interest, and obtain long-term growth.
10.6 MONEY MARKET FUNDS
A MONEY MARKET FUND is a mutual fund that invests in short- term debt securities, such as commercial paper, banker’s acceptance, repurchase agreements, T-bills, negotiable CDs, and the like. Money market funds will usually not invest in non-negotiable CDs. These funds usually purchase only securities that mature in less than 30 days, although if a good rate is available and interest rates are decreasing, they will invest in securities that mature in up to six months.
Shares in money market funds are purchased and redeemed at the same price, which is usually $1. There are no sales charges, but management fees are charged to the shareholder. Sometimes 12b-1 fees of up to one-quarter of 1% are charged. Of course, as is the case with all other mutual funds, a prospectus must be delivered to the customer with the first purchase of money market shares.
The money market funds do not make daily, monthly, or semiannual distributions, but instead credit interest to the customer’s fund on a daily basis. This interest is taxable, and will be reported on the IRS Form1099 sent to the investor after the end of the year.
Since most money market funds are no-load funds, they need to have only one board member from outside the fund, rather than the usual 40%.
One of the most popular features available in money market mutual funds is the check-writing feature. Since the securities underlying a money market mutual fund are highly liquid securities, many investment
which in most cases pay less interest on customer balances than do money market mutual fund accounts.
10.7
OTHER TYPES OF FUNDS
Other lesser-known mutual funds to mention include: • Index funds
• Option funds
Index funds invest in securities that mimic a particular index and will usually perform very close to the way that index performs. Since these funds mimic an index, the role of the investment manager is minimal. Option funds, a relatively new fund, has as its main objective to buy and sell put and call options, looking to profit from the purchase and sale of these put and call option contracts.
All of the following are true of money market funds, except:
(A) Their appreciation will be taxed as a capital gain in the year withdrawn.
(B) They are purchased at the NAV and redeemed at the NAV. (C) The NAV is maintained at one dollar.
(D) Most money market funds invest in commercial paper, T-bills, and banker’s acceptances.
Answer
(A) Correct answer (false statement): Their appreciation will be taxed as a capital gain in the year withdrawn. Appreciation or earnings on a money market mutual fund will result from interest and dividends that are paid regularly by the money market fund. As a result, the appreciation in a money market account will be taxed as income in the year it is received, not as a capital gain.
11.0 EXCHANGE-TRADED FUNDS
An exchange-traded fund (ETF) is a newer method for a small investor to own shares of a diversified portfolio of stocks that will track a specific index. The investor purchases shares of a mutual fund, unit investment trust, or a depositary receipt that represent the shares of common stock within the ETF. The ETF shares closely track the performance of the specific index.
The shares of an ETF are initially “created” by an institution or other large investor. The institution deposits a specified number of shares of a portfolio of stocks with a trustee that correlate to the index that the ETF is following. A minimum of 50,000 shares is required to create a unit (creation unit) for the larger funds, while the funds on mid-cap stocks only require 25,000 shares per unit. A retail investor cannot purchase shares of an ETF until the shares are listed on an exchange.
• When purchasing the shares of an ETF, a prospectus can be obtained from the issuer.
• A prospectus is not required on secondary purchases through a broker/dealer.
• A representative must be qualified with the Series 7 license to sell ETFs.
Some Exchange-traded funds follow the broad-based indexes such as the Dow Jones Industrial Average Index, the Nasdaq-100 Index, or the S&P 500 Index. These ETFs purchase shares of the same stocks that are represented in the index. ETFs can also follow an index that has been established specifically for the ETF. These specialty indexes may follow specific industries, regions, or size of company criteria (e.g., mid-cap) Some of the more well known ETFs are traded as QQQ for the Nasdaq-100 Index and are commonly called the “Qubes;” SPY for the S&P 5OO Index (SPDR Trust Series 1) and are commonly called “Spiders;” and DIA for the DJIA Index and commonly called “Diamonds.” “HOLDRs” or an
abbreviation for Holding Company Depositary Receipts represent a series of different ETFs issued by Merrill Lynch which follow different indexes. The stocks that make up an ETF are based on they index they mimic, and are held by a trustee. ETFs offer diversification for the investor, since the investment represents a diversified portfolio of stocks that mimics an index or investment strategy.
• Additionally, ETFs have relatively low expense ratios since the stocks are purchased and held.
• Few changes occur within the index; therefore unlike actively managed funds, buying and selling shares doesn’t occur as frequently.
ETF shares are bought and sold similar to shares stock throughout the day and from any brokerage firm, so are more like a closed-end management company rather than an open-end management company (mutual fund). Unlike a closed-end management company, ETF shares can also be redeemed to the institution, which sponsors the ETF. The redemption occurs through a redemption unit in the same number of shares that composed the creation unit.
Other important aspects regarding ETFs are that the shares can be purchased on margin and the ETF shares can be sold short. The investor can buy as few as one share or in round-lot amounts of 100 shares. No sales charges are charged by the ETF; however, commission charges will be added to the purchase and sale of ETF shares by the broker/dealer handling transactions in ETF shares.
The turnover associated with managed mutual funds is reduced, because the ETF must remain closely aligned with the index of securities it follows. The tax liabilities associated with potential capital gains from an actively managed mutual fund are reduced, because the stocks within the ETF are not as frequently traded as in an actively managed mutual fund. An owner of an ETF share can receive dividends, if the stocks in the portfolio pay dividends and after the fees and expenses by the management
Trading generally stops at 4:00 pm, but some will continue until 4:15 pm. The closing prices are then shown in the major newspapers on the next day.
12.0 NEWSPAPER FOOTNOTES
Mutual fund prices are displayed in the newspaper finance sections after the fund calculates its NAV. These prices include some additional information about the mutual funds, including the symbol for the fund, the type of share, and possibly the year-to-date performance.
The following are footnotes used by the NASD in the mutual fund price information released for newspapers and periodicals to publish:
• “p” indicates that there are 12b-1 fees charged by the company • “r” indicates that there are redemption fees or contingent
deferred sales charges
• “t” indicates that both 12b-1 fees and redemption fees or
contingent deferred sales charges apply
• “NL” indicates a no-load mutual fund
This allows investors to track their investments on a day-to-day basis, but investors should realize that most mutual funds are designed for long-term investing.
* * * * * * * * *
Newspapers and financial periodicals use certain footnotes to provide