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For this section, we take a look at the various products on offer that a registered representative can suggest to their customers that help meet suitability standards.

Much of this you will know about but you must understand them fully.

The aim is to be able to understand the unique characteristics when it comes to various securities that you can suggest.

STOCK, BONDS, OPTIONS – THE BASIC SECURITIES

With equity securities, the corporation that issues them is not obligated to ensure a return for investors.

It’s the investors that take on the risk and the corporation that collects their money for buying the issues.

When we speak specifically about equity securities, we are generally referring to two specific types: common stock and preferred stock.

That which a corporation will issue is known as common stock.

When an investor buys stock in a company, they are buying themselves a small piece of ownership of that company.

These shares are referred to as equity

Ultimately, however well (or badly) a company performs will determine what it is that investors get back.

Let’s break these stock options down a little further:

Common stock

There is no fixed value to this type of security which is often just known as stock.

As investor demand for a common stock changes and it’s traded through buying and selling thereof, its value will fluctuate.

The greatest risk with common stock volatility, or sudden changes in market prices for which see the value of the stock drop significantly over a quick period of time.

Generally, however, stock prices will move up and down.

When market shares increase in market price and show growth, it’s known as capital appreciation.

A realized capital gain is when an investor sells common stock shares for more than they purchased them for.

If they make a gain when selling common stock shares, it is known as a realized capital gain.

Show the prices go up and the investor doesn’t sell their stock, they are sitting on an unreleased capital gain.

Should the opposite be true, it’s an unrealized capital loss.

For investors that are growth-orientated, their investment time horizon is usually longer and they are willing to accept substantially more risk.

What about the income potential of common stock?

Based on company earnings, companies that issue common stock often pay out cash dividends to their investors when the company has performed well.

These usually happen each quarter.

As the profitability of the company increases, so do the dividend payouts.

These dividends are often the reason why customers look to stock as a form of investment.

If an investor is looking for something that will provide both growth and income, then common stock is most certainly an option too.

And we’ve already seen that thanks to the fact that it can be the perfect vehicle for not only capital appreciation but dividend income as well.

When it comes to this type of investment, where both growth and income are the objectives of the investor, then, for the most part, the moderate risk is acceptable.

Preferred stock

As a result of the fact that it constitutes ownership in a corporation, preferred stock is also an equity security.

When compared to common stock, however, it certainly doesn’t have the same potential when it comes to appreciation.

It’s also important to note that preferred stock is not something that all corporations issue.

It’s similar to a bond.

And that’s because it will provide a state of return that’s fixed.

This is also sometimes known as a stated rate of return.

With a preferred stock, a dividend, instead of an interest payment, is what investors receive as payouts.

For that reason, if an investor is wanting a security that will provide them with a form of income, preferred stock is a good option.

When it comes to dividends, for most preferred stocks, they will be fixed.

However, there are adjustable rate preferred stocks where the payouts from dividends do change.

These are like bonds and other assets that offer fixed income in the way that stock prices are linked to interest rates but move inversely to them.

If you are asked on the Series 6 exam about the voting rights that come with preferred stock, you can assume that they aren’t any.

That’s because, for exam purposes, they are always seen as nonvoting.

While the growth potential of preferred stock isn’t as high as common stock, it does offer other advantages.

  • When dividends on the stock are declared by the board of directors of the company, preferred stock owners will always get paid first before the owners of common stock
  • Preferred stocks also have a higher priority in receiving claims on assets should a corporation go under. Once the creditors have been paid, preferred stock owners’ claims will be paid before those holding common stock.

Both of these advantages can come up on the Series 6 exam.

From an income and overall safety perspective, it’s for these reasons that many investors prefer preferred stock over common stock.

Let’s talk a little more about the fixed rate of return that’s associated with most types of preferred stock.

For investors that a registered representative would see as income-orientated, it can be a huge plus point for them.

The annual dividend payment on a preferred stock helps to identify it.

This is shown as a percentage of its par value.

For Series 6 exam purposes, this par value is always $100 unless you are told otherwise.

Contrary to common stock, investors find the par value of a preferred stock as meaningful information.

For example, a preferred stock that pays a $4 annual dividend and has a par value of $100 will be called a 4% preferred or in some cases a $4 preferred.

The price of a preferred stock acts as a bond price in a way.

That’s because the dividend payment is a stated price.

And remember, interest rates and the price will have an inverse relationship to each other, so when interest rates go up, the price of the preferred stock will go down.

Should interest rates go down, the price of the preferred stock will go up.

The difference between a preferred stock and a bond is the fact that there is no maturity date for preferred stock.

It can be bought and sold as an investor sees fit without having to worry about maturity values or redemption dates.

For the Series 6 exam, always remember that while preferred stock is similar to common stock in the fact that it allows ownership in a company to those who invest in it, it remains sensitive to the rise and fall of an interest rate in the same way the price of a bond would be.

Preferred stock features

Let’s look at some of the features of preferred stock.

Let’s start with straight (noncumulative).

With this type of preferred stock, other than a stated dividend payment, there are no other extra features, and the investor holding stock will not be paid any skipped dividends.

Whenever a dividend is paid out to common shareholders, the stated dividend must also then be paid on straight preferred.

Then there is cumulative preferred.

One reason why investors opt for preferred stock is the reason that it offers fixed-dividend payments.

Note, however, that dividend payments can be reduced and in some cases, suspended on not only common stock but preferred stock too should a company be struggling financially.

Those that are cumulative preferred shareholders, however, will receive their payments when a company can afford it as all dividends will accumulate should this be the case.

The total accumulated dividends, including any that are in arrears, will be paid to cumulative preferred stockholders when the financial health of the company improves.

This will take place before the preferred dividends of the current year are paid out.

Common stockholders, however, will have to wait.

They will only receive their dividends once all preferred dividends have been paid out.

It’s for this reason that investors see preferred stock as a more dependable stream of income when compared to common stock.

It’s important to note that a cumulative feature that’s offered to preferred stock isn’t for free.

In fact, that kind of benefit means that income from dividends will be lower when compared to straight preferred stock, or less reward for less risk.

Then we also need to mention convertible preferred.

When preferred shares can be exchanged for common stock shares by the owner, a preferred stock is said to be convertible.

The stock certificate will show the price at which that conversion can take place and this is always a preset amount.

The price of the convertible preferred stock will alter in line with that of the common stock.

This is a result of the fact that the value of the two stock types is linked.

Because they can enjoy capital gains should the investor choose to convert their preferred stock into common stock, when issued, the convertible preferred stock will have a lower stated dividend rate than preferred stock that cannot be converted.

The overall number of outstanding common shares will increase when preferred stock is converted into common stock.

This has an impact on the earnings per common share and it will normally get lower.

In turn, that can affect the market value of the common stock and it may decrease too.

The number of shares of the underlying common stock that an investor will get from the conversation will be at its parity price when it reaches the same market value as that of the convertible preferred stock.

When stock offers a share of profits, it’s known as participating preferred.

That share, however, will only be paid once all the dividends and interest are paid on other securities the company has issued.

As for how much an investor will receive, well that percentage will appear on the stock certificate.

A common dividend has to be declared, however, before investors receive the participating preferred stock dividend.

An example of how this would appear is “ABC 5% preferred participating to 10%”.

In that case, when the company is profitable and the board allows it, holders of participating preferred stock would receive extra dividends of up to 5%.

There’s another stock type to note here and that’s callable preferred.

Also known as redeemable preferred stock, this stock type allows corporations to buy the stock back from investors.

This can occur on either the call date or once that has passed and the buy back will be at a stated price.

A company can use this option when interest rates fall.

In that way, they can supersede a high fixed-dividend obligation with one that is lower.

When a stock is called, on the call date, conversion rights to that stock will cease.

No dividend payments will be made after this point either.

For the right of the call privilege, a premium that’s higher than the par value of the stock when the call took place may be paid by the company.

Because this type of stock might be recalled by a company, when compared to noncallable preferred stock, callable preferred stocks will have a higher stated rate of dividend payment.

Always remember, a callable stock is likely to be called when there is a drop in interest rates.

The last type we need to look at is adjustable-rate preferred.

In some cases, adjustable (variable) dividend rates can be a component of preferred stock issued by a company.

These rates can be adjusted by the company, usually every quarter, semiannually, or annually.

As for the dividends for adjustable-rate preferred stocks, they are generally linked to Treasury bills, money market rates, or other interest rate benchmarks.

TYPES OF DEBT SECURITIES AND THEIR CHARACTERISTICS

Let’s quickly recap what debt securities are.

It’s a way for a company to effectively lend money from investors because that’s what’s happening when they opt to purchase bonds or other types of debt securities from them.

The investor effectively becomes a creditor of the company that they buy the bonds from.

That means that they will need to be paid back and the company issuing the bonds or other types of debt securities is obligated to do so.

As for risk, well, when a corporation issues debt, for investors, that risk is fairly conservative.

It is far higher for the issuing corporation, however.

With a bond, you can expect it to have a fixed principal value which is usually set at $1,000.

Investors who hold the bond until the point that it matures get the fixed principal value back.

They will get extra money, however, and that comes in the form of the interest that bonds pay twice a year from the point the investor buys one, right until it matures.

In some cases, the bond issuer may default and fail to pay.

So that’s a risk that investors have to face.

But there is another as before they reach maturity, the bonds could be sold.

An investor can incur a loss when this happens but only if the secondary market price of the bonds is lower than par and the bonds are then sold.

Also, should interest rates go up over the period between the issuing of the bonds and the date on which they mature, there might be a decrease in the bonds’ market value as well.

When this happens, bonds that are older with lower payment rates aren’t in demand and investors can take a loss should they be sold at that time.

Independent rating agencies play a part in bonds too because they provide ratings for them.

Should they downgrade the rating on a bond, the market prices could drop below par.

Usually, these downgrades happen when the company that has issued the bond is having financial difficulties, raising the possibility that they might default on them.

Now let’s get into the different types of bonds and other debt securities.

Corporate bonds 

When we talk about corporate bonds, there are two types, secured and unsecured.

With secured bonds, interest and principal payments are covered by some form of collateral.

This is usually in the form of assets that the issuer has put aside to cover the bond, with a trustee controlling the title of these assets.

Bondholders are able to place a claim on these assets should the issuer default on the bonds.

In the event of a liquidation, it’s important to note that none of the other assets owned by the company can be used to pay the bondholders, only the asset that forms part of the collateral.

In cases where that asset doesn’t cover all the claims, the unpaid balance can be paid to the bondholder but now they become a general creditor.

That moves us onto unsecured bonds.

As you probably can guess, these have no form of collateral backing them.

This sees them classified as debentures or subordinated debentures.

The issuing corporation’s general credit is what backs a debenture and if someone owns one of these, they are seen as a general creditor to that company.

When a claim is made on corporate assets should a company liquidate, debentures have seniority over subordinated debentures but not over preferred or common stock.

In fact, a subordinated debenture is the lowest of all the creditor claims.

Because they are therefore a riskier option, investors will receive higher incomes from this debenture type.

Many subordinated debentures will also include the option to convert.

Other types of unsecured corporate debt include guaranteed bonds, income bonds, and corporate zero-coupon bonds.

Another option when it comes to debt securities is treasury securities.

As a way to meet federal budget needs, the U.S. Treasury Department will decide on both the types and number of government securities that it needs to issue.

The interest rate that these securities will pay to investors will be determined by the market, however.

While subject to federal taxation, the interest investors receive from government securities is not taxed at the state or municipal level.

U.S. government securities receive full faith backing for both interest and principal and are considered a low credit risk because of this.

That’s not to say that there is no risk at all.

Because they trade on the secondary market, like all debt securities, their value can be affected by interest-rate risk.

For the Series 6 exam, you should know the following types of Treasury securities:

  • Treasury bills or T-bills: Offer a liquid cash position to investors because they will mature in a year or less
  • Treasury notes or T-notes: These have a longer maturity span, around 2 to 10 years.
  • Treasury Inflation-Protected Securities or TIPS: Offering investors protection against purchasing power, twice a year, the principal amount of TIPS is adjusted although it does have a fixed interest rate. The adjustment in the principal will be the same at the Consumer Price Index change. Because they are adjustable, when compared to other conventional Treasury securities, TIPS are available at a lower interest rate.
  • Separate Trading of Registered Interest and Principal Securities or STRIPS: This is very similar to a zero-coupon bond. Issues are highlighted by the Treasury and these are then broken into a principal and an interest component. This is carried out by broker-dealers as well as banks. They will trade in STRIPS too.

Always remember, bonds with a longer maturity will always be the most affected by interest-rate changes.

When these changes occur, it’s Treasury bonds that are most affected.

Next, we have government agency securities.

These are issued by various agencies of the federal government as authorized by Congress, hence their name of agency securities.

  • Farm Credit System (FCS)

These lending institutions are found throughout the United States and provide credit and financing in agriculture.

While it’s government-sponsored, the FCS system is owned privately.

Through the sale of Farm Credit Debt securities to investors, loanable funds are raised.

Farmers can then gain access to these funds through these lending institutions and banks while the whole system is overseen by a government agency, the Farm Credit Administration (FCA).

  • Government National Mortgage Association (GNMA or Ginnie Mae).

This corporation is owned by the government and provides support for the Department of Housing and Urban Development.

Because they are backed by mortgages, the life expectancy of a Ginny Mae is average, although they do have a state 30-year life, so can be held for that long if an investor so chooses.

Ginnie Mae investors are paid back the full principal that’s outstanding on that loan at par when a mortgage is paid off before the stated maturity date.

When an early payout occurs, it’s termed a prepayment risk.

  • Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac).

This corporation provides mortgage capital and is publicly held with the general credit of the FHLMC backing up the securities it creates.

Organizations like the Federal Housing Administration (FHA) and the Veterans Administration (VA) are some of the agencies from where the FNMA buys conventional and insured mortgages.

As Freddie Mac and Fannie Mae are corporations that are publicly owned, they are also sometimes called GSEs or government-sponsored entities.

Municipal bonds

Let’s quickly recap on what a municipal bond is.

Well, it’s never issued by the federal government or an agency thereof but instead by states, counties, cities, transportation authorities, school districts, and towns.

In terms of overall risk, municipal bonds are one of the safest investment options for a customer.

The only safer options in terms of default risk are securities that are issued by the U.S. government or agencies thereof.

In terms of income, an investor will receive from buying municipal bonds, this comes from interest.

This will be paid out semiannually, with the interest schedule put in place when at the issuing of the bonds.

  • Tax benefits of municipal bonds

One of the advantages of municipal bonds is the fact that they provide tax benefits.

For the most part, the debt obligations of municipalities will not be taxed by the federal government.

Capital gains, however, will be subject to taxation.

Municipalities can pay lower interest rates on bond issues because of municipal bonds’ tax-advantaged status.

Because they provide more tax savings to those investors from higher tax brackets, municipal bonds are a far more appropriate investment option for higher earners.

With these types of securities, bond ratings are important.

We’ve talked about collateral and it’s an important addition for many investors as if the borrower does struggle financially, there are backups in place to pay investors should they be needed.

Investors also turn to rating services to help them determine the risk of various securities.

The three main services in this regard are:

  • Fitch Ratings, Inc
  • Moody’s Investors Service, Inc
  • Standard and Poor’s Rating Service (S&P)

Of the three, S&P and Moody’s are the most important rating organizations.

They provide a letter rating for the overall quality of the debt and ultimately, how safe it is for an investor to buy into.

They do this by looking at each debt issue and analyzing them in great detail.

Let’s move on.

We know that bond prices and interest rates are linked and move inversely to each other.

Volatility is the phrase used to describe how sensitive a bond is to these movements.

A less volatile bond will move less when the interest rate does change, while the opposite is true for a more volatile bond.

Here, interest changes can cause big fluctuations in the bond price.

Consider the fact that a bond’s price will be more volatile and influenced by interest rate changes the longer it has left till it matures.

There’s a second factor that needs to be considered and that’s the coupon rate of a bond.

A bond will be more volatile the lower its coupon rate is.

For example, when you compare two bonds with four years remaining to maturity, the 4% bond is going to be more volatile than the 7% bond.

When you use maturity and coupon price as a way to measure the overall maturity of a bond, this is known as duration.

A more volatile price will see a higher duration and the less volatile a bond price the lower the duration.

Duration doesn’t necessarily need to only apply to a single bond either.

It can be used as a measurement yardstick for a bond portfolio too.

For the Series 6 exam, you won’t need to calculate duration at any point but you will need to understand what it is.

Now let’s discuss bond features.

These are various added extras that can be attached to a bond.

They could have a call feature, a put feature, or a convertible feature.

Let’s look a little closer at each of these:

  • Call feature

We’ve talked a little about this already.

When a bond has a call feature, the issuer can at any point before the bond reaches maturity decide to call it in and this happens when interest rates drop.

In other words, if they are paying 7% interest to investors but the interest has fallen to 5%, they will call in the bond because they are paying extra money.

It’s a feature that’s not to the benefit of the investor but the issuer.

When called, the bondholder now has to search for something that has a similar rate of return.

And that’s not always easy in a low-interest-rate environment.

  • Put feature

With a put feature, the roles are reversed when compared to a call feature.

Before the bond matures, the bondholder can opt to put the bond back.

In other words, they give it back to the bond issuer.

This scenario plays out when interest rates are on the rise.

For example, their current bond is only paying 7% interest but other options are paying 10% interest.

They will then invest in that higher interest-paying bond using the principal returned by exercising the put feature.

As opposed to a call feature that benefits the issuer, a put feature is something that will benefit the bondholder.

  • Convertible feature

We’ve discussed convertible preferred stock already and a convertible feature on a bond is pretty similar.

If an investor that holds a bond with this feature wants to, they can opt to change the bond into common stock shares.

Ultimately, they are moving into owning rights in the company through the conversion from a debt instrument (the bond) to common stock.

If bonds carry a convertible feature, it is considered to be an investor benefit.

Those bonds that are seen as having a feature that benefits issuers will see a higher coupon rate of interest as a way to make them more attractive to investors.

The opposite is true for those bonds that have features that benefit investors.

The lower rate of return is made up for through these added features.

Money market instruments

When investors are looking for debt securities with a short-term maturity, they can turn to money market instruments.

These usually will mature in one year and often less.

The issuers of these types of securities usually have high-credit ratings and that means this type of debt security isn’t that risky.

That and the fact that they are also extremely liquid, mean that money market instruments are used by investors to utilize investment situations and they are also perfect for emergencies (as money is easily taken out if needed).

U.S. Government money market instruments and those issued by its agencies include:

  • Treasury bills trading on the secondary market
  • Treasury bills and agency securities that have one year or less till they reach maturity
  • Smaller agency issued short-term discount notes

When it comes to these money market securities, the primary risk is related to inflation and if the securities lose ground to it.

In the industry, this is known as inflation risk.

It might also be referred to as a purchasing power risk or constant dollar risk.

No investment is ever risk-free and while these funds don’t often lead to any losses for investors, it’s important to note that money market funds are not insured in any way.

Let’s look at some examples of money market instruments that you should know about.

  • Bankers’ acceptance (BA)

These have a specified payment date drawn on a bank and are used in the import and export business as a short-term time draft.

They work much like a line of credit or a post-dated check with the payment date anything from 1 to 270 days.

They are mostly used as a way to finance international trade by American corporations, BAs are issued at discount to face value.

  • Commercial paper (prime paper)

Also called promissory notes, these are issued for the short term by corporations.

They use these commercial papers as a way to raise money for either seasonal inventory excesses or accounts receivable.

When compared to bank loan rates, the interest on a commercial paper is lower.

As for their maturities, well they are similar to BAs in the fact that they are anything from 1 to 270 days.

Most, however, will mature within 90 days.

They are also issued at discount from face value like BAs are. 

  • Negotiable CDs (Jumbo CDs)

Banks will issue these which act as time deposits.

While most are issued for over $1 million, they must have a face value of $100,000 or more.

If a negotiable CD is issued above $250,000, it’s considered to be an unsecured bank promissory note.

That’s because it’s above the FDIC insurance limit.

As for maturity, that’s often as the buyer decrees so as to suit their particular needs but it is usually a year or less.

That’s not always the case, however.

These money market instruments can also be traded on the secondary market, thanks to the fact that they are negotiable.

The difference to other money market instruments that we’ve covered is that negotiable CDs not only pay interest, but when issued they are at face value.

That interest is paid at maturity for those that mature within a year and semiannually for those that have maturity set at over a year.

OPTIONS 

Because the value of the contract is based on the underlying security value, an option is seen as a type of derivative.

There’s risk involved with buying and selling options contracts, and it can be unlimited.

That’s why it’s critical that an investor is deemed suitable to trade in options before a broker-dealer opens an options account for them.

This includes the completion of an options disclosure document.

An account won’t be allowed to trade in options until the broker-dealer receives this.

This document will provide an investor with all the information they need regarding options trading and also highlights the risks thereof.

Where are options traded?

Well, you find them on exchanges such as the Chicago Board Options Exchange (CBOE) and they will always be issued by The Options Clearing Corporation (OCC) in standardized formats.

Options are fairly easy to trade because the OCC will support them should the firm issuing them fail as well as the fact that the exchanges on which they are traded provide the forums by which to do so.

By nature, options are speculative, hence the need for the risks to be explained to potential options investors through the options disclosure document.

Again, we cannot emphasize enough that suitability requirements need to be carried out on investors that want to trade in options too.

When it comes to options, there are two contract types: calls and puts with each representing 100 shares of the underlying security.

Regardless of the market price of the security, the options contract will have a strike price (also called an exercise price) at which it can be bought and sold.

Options contracts last for nine months usually.

  • Call option: Here, the buyer of the contract has a bullish position as they can pay the strike price to buy the security. When selling, however, they have a bearish position due to the fact that if the put option is exercised, they must buy the stock at the strike price.
  • Put option: Here, the buyer of the contract has a bearish position as they can sell the security at the strike price. When a seller sells a put contract, their position is bullish due to the fact that if the put option is exercised, they must buy the stock at the strike price.

Leverage and income

Purchasers of options contracts have leverage.

That’s because they can control an investment that would usually require a large sum of money to purchase only through a small cash outlay instead.

Here’s an example of what we mean.

Should the stock be worth $30 per share, if they wanted to buy 100 shares, they would need $3,000.

If they opt for a call on those 100 shares, however, the price is approximately $300 and above, significantly less than if they had bought the shares, I am sure you will agree.

Income is the objective for someone who sells an options contract.

Ultimately, the writer of the contract will sell and collect the premium from that sale.

They then hope to keep the premium which they can should the contract expire.

That’s their aim.

With a call option, the right to buy is that of the buyer of the call while the obligation to sell falls on the seller of the call.

With a put option, the right to sell is that of the buyer of the put, while the obligation to buy is that of the seller of the put.

For the exam, it’s important to understand this thoroughly as well as the bullish and bearish positions of the buyer and seller of both calls and puts.

Nonequity options

When compared to equity options, these almost function in the same way.

They do have different contract sizes, as well as delivery and exercise standards and that’s because the underlying instruments of nonequity options are not stock shares.

When we speak of nonequity options, there are two types: index options and currency options.

Let’s look at index options in a little more detail.

The profit to be made by investors using index options banks on either market or market segment movements.

To make those profits, they would hedge against those swings in the market.

These can either be narrow or broad-based.

Sometimes they can look specifically at other indexes as well, those that have a certain focus.

With broad-based indexes, the entire market’s movement is reflected.

This will include the Major Market Index (XMI), the S&P 500 index as well as the S&P 100 Index (OEX).

For narrow-based indexes, a certain country will be looked at and the market segments there are tracked.

An example of a sector in this regard would be technology.

Indexes like the volatility market index (VIX) have a distinct focus.

This looks specifically at S&P 500 index options found on CBOE and traded there and measures their implied volatility.

Also traded on the CBOE are VIX index options, and their purpose is to show over a period of the next 3 days, what investor expectations are with regard to market volatility.

This index is sometimes known as a fear gauge.

When high readings occur, they are an indication of the fear of investors that volatility will hit the market and aren’t ever an indication of whether it’s bullish or bearish.

Should that fear be high with regards to the volatility of the market, then option contract premiums generally will get higher.

What about the features that index options offer?

When we talk of a multiplier that’s used for index options, it’s usually $100.

To work out the cost of an option, this $100 will be multiplied by the premium amount.

As for the index’s total dollar value, to work that out, multiple $100 by the strike price.

Just like the equity option, it’s the next business day on which the buying and selling of index options are settled.

For broad-based options, trading is till 4:15 pm (ET) while narrow-based options top fifteen minutes earlier, at 4:00 pm (ET).

When an index option is exercised, cash, and not the security must be delivered by the following business day.

The cash amount delivered by the writer when the option is exercised is equal to the value of the option to the buyer.

The closing value of the index on the day it is exercised is what the settlement price of the index option will be.

Similar to equity options, it’s on the third Friday of the expiration month that index options expire.

When it comes to settlement, index options and equity options are quite different.

If an index option is exercised, it’s settled the next business day but for equity options, it’s two business days.

Now that we have a clearer idea about their features, let’s look into index options strategy.

Sometimes, when it comes to the movement of markets, index options can be used as a way to speculate on this.

So investors will either write index puts or buy index calls if they think there will be a rise in the market.

On the other hand, they will write index calls or buy index puts if they think that there will be a fall in the market.

One of the popular uses of index options, therefore, is to hedge a portfolio.

The manager of a diverse portfolio might buy a put on an index so that if the market value of stocks falls, the loss is offset.

When this is carried out, it’s called portfolio insurance.

The systematic risk of a decline in the overall market is something that index options can protect against.

Next, let’s briefly look at interest rate options.

Because they have a relationship that’s directly related to interest rate movement, these options are yield-based, specifically when it comes to T-bills, T-notes, and T-bonds.

As an example, an interest rate option will reflect a yield of 3%, for example, when the strike price of the option is 30.

Let’s look at a scenario.

T-notes currently sit with a rate of 4%, something an investor believes in the near future, will rise.

If they buy a call option at the money or in other words, a strike price of 40, they can then receive cash equal to the intrinsic value of the option if they exercise when the rates rise to 5%, for example.

In this scenario, the investor would receive $1,000.

That’s each point the rate goes up is worth $100 and it has risen by 10 points.

So overall profit is $1,000 minus the paid premium.

There is another option for an investor in this situation, however.

They could have closed their position.

This would have seen a profit as a result of selling the option and receiving the difference of the premium paid and the premium received between the closing position.

So the strategy here isn’t difficult to work out.

Puts are bought and calls written when there is a belief that a fall in rates is imminent.

Calls are bought and puts are written when there is a belief that a rise in rates is imminent.

It’s worthwhile noting yield-based options and when they are exercised.

This can only happen on the day of their expiration.

Now that we have looked into index options, let’s move on to currency options.

These are used by investors in two ways.

First, they can be used as a way to speculate on foreign currencies.

Second, they can help protect currency exchange rates that are moving up and down against the U.S. dollar.

Used in the importing and exporting business as a way to hedge currency risk, current options are available on the following foreign currencies:

  • Japanese yen
  • Swiss franc
  • Euro
  • Canadian dollar
  • British pound
  • Australian dollar

Here are a few more facts about currency options worth knowing:

  • Just like equity options, on the third Friday of their expiration month, currency options will expire
  • The next business day is when currency options need to be settled.
  • Settlement must occur on the next business day should a foreign currency option be exercised
  • A European-style exercise option applies to foreign currency options that are exchange listed

In the import and export business, it’s critical to know which currency options are best to use at what time.

Here’s a brief breakdown:

  • If an exporter is worried that foreign currency value will drop, they should buy puts
  • If an importer is worried that foreign currency value will rise, they should buy calls

Option administration and compliance

The OCC is the regulation body when it comes to options but the Chicago Board of Options Exchange is involved with regulating their trade.

An options disclosure document (ODD) will be provided by the OCC to any new customers who want to open an options account.

They must receive the ODD either before their account is approved or at the time it is approved as this document contains all the information they need to know about options.

This includes the risks associated with options trading, options strategies, and rewards.

The main aim of this document is to ensure that before a client embarks on any options trading, they are provided with full and fair disclosure.

Once a customer has received the OOD, the broker-dealer’s registered options principal (ROP) will have to approve the options account before it can be used in trades.

When setting up an options account to trade, the following steps are to be followed:

  • Based on the client’s investment objectives and their circumstances, a registered representative must be of the opinion that options are an appropriate investment for them
  • A copy of the ODD is received by the client before the client trades using the options account
  • The ROP approves each client’s options account for trading
  • Trading can start once this approval has been given
  • A signed options agreement must be returned to the broker-dealer by each client within 15 days after their options account has been approved

There are several critical things that the options agreement covers:

  • It confirms that the client has received and read through the ODD
  • That when it comes to options trading, they understand the risks thereof
  • They confirm that all the regulations of options trading will be honored by them

Any changes to their financial situation or their overall investment agreements must be reported to the broker-dealer when it happens.

By signing the options agreement, they undertake to alert the broker-dealer to these changes as soon as possible.

Should the options agreement not be returned using the conditions we’ve gone through above, only closing transactions can be carried out on that customer’s account.

INVESTMENT TAXATION

Understanding the various taxation needs of a customer is another crucial aspect of what a registered representative will need to consider when analyzing the right kind of investment recommendations.

Part of that is differentiating short and long-term capital gains and income taxation as well as understanding how taxation affects reinvestments.

Long-term capital gains

When we talk of long-term capital gains, a position must have been held for a year or more to be eligible for this kind of tax treatment.

Should a position not be held that long, it is treated as a short-term gain.

The way short-term and long-term gains are taxed is different too, that’s why it’s critical to know if it has been held long enough.

If it has, then it can receive long-term capital gains.

That rate will change regularly and it’s not something that will appear on the Series 6 exam.

For exam purposes, however, know that when compared to the ordinary income tax rate of an investor, the long-term rate will always be lower.

For those that have invested in mutual funds, for example, gains will be paid out once per year once those funds realize capital.

Short-term capital gains

So if long-term capital gains can only be made on assets held for more than a year, it’s obvious that those that are held for less than a year would be considered short-term.

But did you know that these are then taxed as ordinary income?

If asked on the exam, when compared to the long-term capital gains tax rate, the ordinary income tax rate will always exceed it.

Long and short-term capital losses

Now we are on the other side of the coin and instead of looking at gains, we are instead discussing losses.

The Series 6 exam won’t test anything that deals with how long and short-term capital gains and losses are handled with taxation in mind.

It can, however, include questions about capital losses and the use thereof.

On a dollar-for-dollar principle, capital losses could be used as a way to counterbalance capital gains.

In any given year, investors can use up to $3,000 of their losses to reduce ordinary income.

This is if their losses are higher than their gains in that year.

The losses can also be carried forward to the next year if the investor’s losses are in excess of her gains and the $3,000 amount allowed.

When this happens, the losses are known as carry forward losses.

There actually is no timeline on them either, and they can be carried forward until the point they are used.

So here’s a quick example:

  • Capital gains of an investor: $14,000
  • Capital losses of an investor: $22,000
  • Net loss of the investor: $8,000

If they reduce their ordinary income by the $3,000 allowed, the remaining $5,000 loss can be carried into the next tax year.

On open positions, you will find that there can be unrealized gains and losses and these have no tax impact at all.

If you bought a stock for $5 and it rose to $12, as an investor, there are no tax implications if you continue to hold that stock because the gain is unrealized.

As soon as you sell it, however, which then closes the position, the $7 that you made is now a realized capital gain and on that, taxes are due.

Also, when a portion of a position is sold, the principle of FIFO is applied, or first-in, first-out.

This is an IRS default and sees that the oldest position is the first that is sold.

Wash sale

We’ve spoken about how an investor can offset capital gains through the use of capital losses.

When they try to generate a loss for tax reasons and intend on still owning the securities, this is known as a wash sale.

It’s triggered within 30 days of the loss by buying up the same securities again (repurchasing them) or other securities that are substantially equal.

When this happens, the loss generated through the sale at that time isn’t allowed for tax purposes.

This is not illegal at all.

It is illegal, however, to use wash sales losses as a way to reduce tax.

There are some other factors regarding wash sales that you need to note:

  • It applies to both recreating short and long positions
  • Wash sale rules cover when trying to recreate the same position either using the same security type or others that are almost identical.

Cost basis on gifts and inheritance

The donor’s cost basis and the holding period are retained if a living person gives someone securities as a gift.

For those that are inherited, it’s different.

Here, the date of the decedent’s death plays a role.

The cost basis of the securities will now be based on their overall value on the day that the descendant passed away.

If the estate prefers, however, it can decide on another date.

This has to be six months after the descendant died.

For tax purposes, shares that are inherited are seen as a long-term holding.

Interest

When debt securities or other investments provide interest income, this will be considered portfolio income.

For tax purposes, any income generated in this way must always be added to the ordinary income of a customer.

Dividends

Dividends, which can either be qualified or nonqualified are payments received by an investor who has bought shares in a company.

They are paid out when that company declares a profit and the board decides that dividends should be paid.

Qualified dividends

When it comes to qualified dividends taxation, this is always at a capital gains tax rate for investors which when compared to their ordinary tax rate will be lower.

A dividend is considered to be qualified if it meets these benchmarks:

  • It can only be from the stock of a U.S company or American depositary receipt. If eligible under a tax treaty, foreign corporation stock is also allowed.
  • Beginning 60 days before the ex-dividend date, over a 121-day period from that point on, the stock must have been held for 60 days or more.

Preferred stock dividends are usually qualified.

The Series 6 exam, however, won’t test the holding period.

Nonqualified dividends

A dividend is considered to be nonqualified if it does not meet the criteria set out above.

As for taxation, well, it’s at the ordinary income tax rate of the investor.

Investment companies and pipeline theory taxation

It’s possible to avoid triple taxation of the income from investments.

That’s subject to the Internal Revenue Code’s subchapter M and whether a mutual fund qualifies under that or not.

It may do so, by qualifying as a regulated investment company in a specific situation.

And this deals with the distribution of net investment income (NII) which sees the mutual fund acting as a pipeline or conduit in carrying out this task.

If this happens, only the investment income the fund keeps following the distribution is subject to tax.

As for the income that shareholders will receive?

Well, at the mutual fund level, this will not be taxed.

There are things to note that Subchapter M, however:

  • 90% (or above) of NII must be passed on to shareholders. This will not be taxed
  • The remaining 10% will be taxed

Should only 85% be paid to shareholders, for example, then a full 100% of the NII will be taxed.

For the Series 6 exam, remember that Form 1099-DIV is used to report dividends to shareholders.

Whether dividends are received by the investor or they choose to reinvest them, tax is paid in both scenarios.

Remember that it is not the public offering price but the NAV that the reinvestment of dividends or capital gains is based on for mutual fund customers.

INVESTMENT COMPANIES

Money is pooled and used by investment companies to buy securities on behalf of investors.

Usually, these companies take the form of corporations or trusts.

The idea is that instead of individuals investing for themselves, these specialist companies do it for a group and in a more efficient manner.

In other words, investment companies should always outperform regular investors and that’s why people turn to them.

That said, it’s important that an investment company provides those looking to invest with an investment objective that is clearly laid out and achievable.

An investment manager for the fund must direct the fund to that objective.

With a clear objective in place, investors can find the best fund to meet their particular investment needs.

Investment companies are similar to corporations that issue securities in the way that shares are sold to the public as a means to raise capital.

In doing so, they are bound by the 1933 Securities Act in complying with the prospectus and registration conditions as set out in the act.

There are other regulations that they need to take note of under the 1940 Investment Company Act and these pertain specifically to how shares are sold to public investors.

This act allows for three types of investment companies.

Only two are actively tested in the Series 6 exam: unit investment trusts (UITs) and management companies.

The third is face amount certificates (FACs) but that’s just for your overall knowledge and don’t get spooked if you see it on the exam.

Just don’t choose it as an answer because it’s probably a red herring.

The SEC registration requirements for an investment company are:

  • $100,000 in net assets. The SEC does allow for companies with less net assets to register a public offering but there is a condition – they will have 90 days from the day of registration to meet the $100,000 net asset requirement.
  • Investment objectives that are clearly laid out. Can this investment objective change in the future? Yes, but only a majority vote of outstanding shares of the company.

Let’s take a look at each type of investment company as outlined above.

Unit Investment Trusts (UITs)

UITs are just like any other investment company in the fact that they have a defined investment goal and that they use pooled money from those that buy into them to make their investments.

There is a major difference, however.

Barring any major events, for example, bankruptcy or perhaps a merger, UITS will have the same portfolio for the life of the trust once it has been set.

Investors in UITs will buy shares which are commonly called units.

This is how the UIT will raise money and it’s usually done through a one-time public offering.

By buying a unit, an investor is effectively getting a section of ownership of the trust.

In turn, that section of ownership gives them rights to any generated capital gains and income from the fund.

This is a proportional amount that is based on the number of units they own.

The investments themselves are stocks or bonds usually.

As for the investment return, well that’s determined by the underlying investment and their overall performance.

Fund fees will be subtracted from this, however.

The investments themselves are usually set and for the life of the fund, the UIT will hold the securities it first invested in.

The trust or issuer of the units will establish redemption rules for the UIT and it can be redeemed by them.

Most UITs allow for daily redemption, but it depends on whether you can find UITs that have rules that cover weekly or monthly redemptions, for example.

Also remember that UITs are never referred to as a fund, only as a trust.

For the Series 6 exam remember:

  • UITs are designated as investment companies under the 1940s Investment Company Act.
  • Their shares are called units
  • The trust must redeem these units and they are traded on the secondary market
  • No board of directors or investment adviser will actively manage a UIT

Management companies

Next, we have management companies, perhaps the most recognized of all of them.

Here too, there is a stated investment objective by the company, and the security portfolio held by the management company is always managed so that the objective can be reached.

Note, that there are two types of management investment companies: those that are closed-end and those that are open-end.

In one area these two are similar and that’s the fact that they will have an initial public offering where shares are sold to the public.

So what’s the difference between them then?

Well, a closed-end company will make limited shares available in their initial offering.

So after a certain amount of authorized shares have been sold, the initial offering will close.

An open-end management company can offer new shares to the public over and over again.

This means that it always has shares for new investors to buy into.

There is obviously more to it than that for both types, so let’s start by looking into closed-end management companies a little more in-depth.

It’s via a common stock offering that a closed-end management company will raise portfolio capital.

With regards to raising capital, it’s similar to any publicly-traded company.

That also means that the initial offering (the number of shares they hope to sell) has to be registered with the SEC.

This offering would require a prospectus and are available for investors to purchase through the chosen underwriters.

New investors cannot participate in the fund once all the shares made available during the initial offering have been sold.

When the sector in which the fund wishes to invest has a meager amount of securities available, it often will choose the closed-end option.

If they choose to, bonds and preferred stock can be issued by closed-end investment companies as well.

From time to time, they are also known as publicly traded funds, and following the initial offering, the shares are then traded between private investors on the secondary market, either over-the-counter or on various exchanges.

As for the price when they are traded in these markets, well that will be determined solely by supply and demand for both the bid price and the ask price.

As for the NAV of closed-end fund shares, they can trade at both above or below (or at a premium or discount to the NAV).

Normally, a commission has to be paid to execute the trade of these shares on the secondary market.

Note that registered representatives that have a Series 6 qualification are only allowed to sell shares from a closed-end company on the primary market or in other words, the initial public offering.

They may not sell them on the secondary market.

Now we move on to open-end management companies.

By far the biggest section of the open-end management company segment is mutual funds.

While there are other types, the Series 6 exam when talking about an open-end company will often use the term mutual fund.

As for the shares that a mutual fund will issue, well there is only one class and that’s the common share.

When it intends to make these available, the open-end management company must register an open offering with the SEC.

There is no need to specifically mention how many shares the company will make available either.

This allows the primary offering of common stock to be continuously offered by the company.

Note that investors can only purchase this common stock from the mutual fund but in turn, the mutual fund can add many types of securities to their investment portfolios.

This includes bonds, preferred stock, common stock, and a range of other options.

As for investment capital, well the mutual fund can continue to raise it whenever necessary because they are continually issuing new shares.

As mentioned earlier, new investors can participate in buying these shares because of this.

These shares will never trade on the secondary market and that’s important to note.

So what happens if an investor wants to sell their shares?

Well, when they do this, the shares are redeemed by the fund itself.

Based on the number of shares an individual investor owns, they have a proportional right to ownership in the fund.

This means they are able to receive an income and capital gains the fund might generate from the various investments it carries out.

It’s the stated objective of this type of fund that will determine the particular investments it will make.

These are known as underlying investments.

Where the fund is actively managed, this is also guided by the fund managers that control it.

When it comes to the fund’s investment returns, these are generated by the overall performance of the various investments carried out by the fund with the fund fees that investors need to pay subtracted from them.

On the Series 6 exam, a comparison between open and closed-end management companies often comes up.

So let’s break them down into seven distinct aspects to see where they are similar and where they differ.

These aspects are capitalizations, issues, shares, offerings and trading, pricing, shareholders’ rights, and ex-date.

Open-end funds:

  • Capitalization: These are unlimited and the fund offers shares continuously
  • Issues: Only common stock
  • Shares: Can be fractional or full
  • Offerings and trading: The fund sells and redeems shares
  • Pricing: The prospectus will include a formula by which the selling price of the shares is calculated
  • Shareholders’ right: Shareholders can vote and when will receive dividends if they are declared by the fund
  • Ex-date: The board of directors will set the ex-date

Closed-end funds:

  • Capitalization: Only a fixed, single offering of shares
  • Issues: Debt securities, preferred and commons stock allowed
  • Shares: Only full shares allowed
  • Offerings and trading: A primary offering initially after which shares can be traded on the secondary market (either over-the-counter or on exchanges). Shares are never redeemed by the fund.
  • Shareholders’ rights: Shareholders can vote and have preemptive rights. They will receive dividends if the fund declares them
  • Ex-date: SRO will set the ex-date

Exchange-traded funds

ETFs as they are known, are a style of open-end management company and bring together both conventional stocks as well as mutual fund features.

A pooled investment fund, ETFs are similar to mutual funds in that regard and also are professionally managed while their portfolios are diverse.

The similarity to conventional stocks (and difference from mutual funds) is in the fact that they can be traded on stock exchanges, their prices fluctuate and they can be bought and sold throughout the trading day.

Their similarity to open-end companies comes in the fact that the buying and selling of stocks at the NAV price take place daily and are available directly to investors on the primary market.

ETFs, unlike mutual funds, will only accept assets-in-kind and not money.

Shares or creation units are made available and these have both purchase and redemption minimums (usually into the millions of dollars).

When investors redeem their creation units, they won’t receive cash for them but instead securities of equal value.

Due to the nature of ETFs, when it comes to suitability, they are for institutional investors only.

Note, however, that institutional investors who own ETF shares are allowed to sell them on secondary markets.

It’s there, however, that retail investors are allowed to buy and sell ETF shares.

Mutual fund disclosure documents

Investors interested in mutual funds will receive disclosure documents with all the information they need.

When it comes to these documents, there are four types.

First, we have the full prospectus. 

Sometimes called a statutory prospectus, this has all the information an investor will need to be able to make an investment decision with as much information provided as they could possibly need.

Investors must receive this prospectus either before or during the solicitation of a sale carried out by a registered representative.

All full prospectus’ for mutual funds must include information that is in a standard order and appears on the front of the document.

This must include the objective of the fund, policies regarding investing, what the sales charges for the fund are, the management expenses that will be charged, and what services are offered.

Performance histories can be found here as well and will include whichever is short of a one, five, and 10-year period or over the overall life of the fund.

For mutual funds, the prospectus is considered to be ongoing and not a once-off.

That’s due to the fact that new investors are always being attracted to mutual funds due to their nature of selling new shares on the primary market continually.

Each year, the prospectus of a mutual fund should be updated.

In the case of its use for the solicitation of sales, a prospectus can only be valid for a period of 16 months.

That four-month overlap – remember, we said that it has to be updated each year – is to allow for the out-of-date prospectus to be discarded and replaced with the new one.

For the Series 6 exam, always remember that a prospectus cannot be changed in any way.

This even means that nothing may be highlighted in it so as to bring a certain aspect of the prospectus to the attention of a potential investor.

Second, we have a summary prospectus.

A summary prospectus is available to potential investors in a mutual fund if they so wish.

An application to purchase shares can be found in this summary prospectus as well.

But how does a summary prospectus differ from the full version?

Well, the clue is in its name.

Yes, it’s a summary and it includes the key information that any investor needs to know about the mutual fund.

When an investor receives a summary prospectus, they can either immediately choose to purchase funds using the application that will come with it, or they can look for further information about the fund by requesting a full prospectus.

It’s important to note that should they choose the first route and buy shares in the mutual fund, by the confirmation of the sale, they should have access to the full prospectus as well.

This can be delivered to them online which is how most investors will receive it anyway.

On the cover page of the summary prospectus, the following information must appear.

If it’s not on the cover, it can appear at the beginning of the document.

  • The name of the fund
  • The share class or classes available
  • A legend explaining that the document is only a summary prospectus and that statutory prospectus’ is available to all investors either by contacting a toll-free number (provided) or a website where they can be downloaded (with the link provided).
  • Other information including investment, the risks associated with the fund, overall fund performance, table of fees, the investment objectives of the fund, the strategies that will be used by the fund, portfolio holdings, financial highlights, shareholder information, and management details.

Thirdly, there is the statement of additional information.

Also known as the SAI, this must be available for all closed-end funds and mutual funds at the request of investors.

If they do request it, the fund has three working days to make it available to them.

Alternatively, it can be obtained from the SEC as well as broker-dealers that are selling shares on behalf of the fund.

While the additional information isn’t mandatory, it’s useful to have it available for those investors that want it.

It also is the perfect vehicle for the fund to provide extra information that cannot be part of the prospectus.

This could include a history of the fund for example or even fund policies.

Other information in this statement includes:

  • A fund balance sheet
  • Operations statement
  • Income statement
  • The current portfolio list of the fund

It’s important to note that balance sheets must be made available to investors who request them.

Our fourth document is a Rule 482 prospectus or omitting prospectus.

This is basically the fund’s advertisement and for new funds, is usually a tombstone ad.

Note that in terms of soliciting a sale, just handing a potential investor an omitting prospectus isn’t enough.

There just isn’t enough information in it for them to aid them in making an informed investment decision about the fund.

Mutual fund categories

When compared to the hundreds of different individual mutual funds available to investors, major fund categories aren’t that many.

Here’s a list:

  • Those that invest in stocks are known as stock funds
  • Those that invest in bonds are known as bond funds
  • Those that invest in bonds and stocks are known as balanced funds
  • Those that invest in short-term investments are known as money market funds (but also described as cash equivalents).

For retail investors, money market funds have a stable NAV.

This is usually $1 per share.

While it’s rare, it’s not impossible for retail investors to lose money with these funds and no investment is 100% safe and they are not guaranteed or protected by FDIC insurance.

Following the economic crisis of 2007/08, amendments were put in place by the SEC with regards to money market mutual funds.

This was to lower both the liquidity and credit risks of these funds.

To stop a run on these types of securities they are allowed to float their NAV.

Also, money market mutual funds can include redemption and liquidity gates as well.

Note that only one other fund type has a stable NAV and that’s government money market funds.

The portfolio of these funds should almost exclusively be made up of investments that are very liquid.

This can include government securities or cash, for example.

Those investors that buy into a mutual fund effectively become part-owners of it thanks to the shares they hold.

That makes mutual funds an equity investment.

In fact, stock and bond funds are equity investments as well.

But it’s critical to understand the difference between an investor that owns an individual bond fund and buying shares in a fund that instead owns the bond.

Bond funds do not promise a return on the investor’s principal or a specific rate of interest that individual bonds would.

That’s because bond funds own many different types of bonds.

Each of these will have its own specific rate of interest and certainly won’t all mature at the same time.

Those that invest in these funds will receive a share of the capital gains and interest the funds receive from the various bonds that they invest in.

So it is not a piece of the portfolio’s securities that are held by investors in bond funds but instead they own a piece of its overall value.

Stock funds

Also, known as equity funds, the stated objective of this mutual fund type is met through the use of stocks as the investment vehicle.

When growth is a primary or secondary objective of a stock fund, the portfolio will most likely include common stock.

Over most 10-year time horizons, equity funds usually perform above inflation.

Growth funds

With growth funds, purchased stocks will include companies that are growing at a fast pace.

Often, however, dividends are not paid on growth funds.

Instead, they look to research and development as a way to reinvest any profits that they generate.

So instead of focussing on income, growth funds aim to generate capital gains.

They do have higher levels of risk, however.

This is primarily because managers of growth funds look to overvalued stocks as they can still have upside potential.

Some growth funds do offer less risk, however.

These are usually blue-chip funds that look to more established companies to invest in and those that have large market capitalization.

Also known as market cap, this worked out with a simple formula.

To work it out, take the current market value of the share and multiply it by the number of shares of common stock that are still outstanding.

For example, a listed company is considered to have a large cap stock if it has 300 million shares that are still outstanding and the price per share is $100.

That would make their market cap $30 billion.

Often, those funds that look to invest in companies with large cap stock (and market capitalization of over $10 billion) are known as large-cap funds.

In turbulent markets, they provide more stability to investors but are never without risk.

When it comes to suitability, they are an option for investors who are open to investing for five to seven years at moderate risk.

Aggressive growth funds

Also known as performance funds, as a way to ensure the best possible capital appreciation, these funds will often take more risk than others.

Those risks see them invest in newer companies that don’t have high capitalization, certainly not like the blue-chip companies that we spoke of above.

In fact, the companies targeted by these funds have a capitalization of below $2 billion.

These are known as small cap funds.

With shares in companies that have a capitalization of between $2 and $10 billion, mid cap funds are less aggressive while with large cap funds, capitalization is anything over $10 billion.

Just remember that overall volatility increases the lower the market cap is.

Should an investor not mind the risk and are prepared to invest for a period of 10 to 15 years, a small or mid market cap fund might be the perfect suggestion for them.

Value funds

When stocks are undervalued they are usually snapped up to form part of a value fund’s portfolio.

What do we mean by undervalued?

Well, the price of the stock doesn’t show their true earning potential.

The idea is that the performance of the companies issuing the stock will improve and that will lead to a profit for those that have bought into the stock.

When compared to growth stocks, valued stocks will have higher dividends than usual.

Also when compared to growth funds, they are seen as more conservative.

As for suitability, if an investor is prepared to wait seven to 10 years for maturity at moderate risk, value funds are an excellent option.

Equity income funds

Unlike funds that focus on growth, an equity income fund is only concerned with one thing – income.

That’s why the types of companies that you will find in the portfolio of an equity income fund are those that have an excellent record of paying out dividends to shareholders.

This includes blue-chip stocks, for example, and these funds are always managed with that income generation in mind.

Equity income funds present investors with low to moderate risk and are the perfect option when an investor is looking for his investments to generate regular income payouts.

Option income funds

An option income fund will buy into securities that provide the option of covered calls, or in other words, allow for call options that can be sold on them.

Income is generated by then selling the option, or writing it as it’s known in the world of securities.

This income generated is based on the value of the premium.

When options are traded at a profit, capital gains can be earned as well.

Growth and income funds

Also known as a combination fund, here the fund will diversify its portfolio of stock so that it combines securities to meet its objective of growth as well as current yield.

In other words, the fund invests in companies that regularly pay out excellent dividends as well as those that show potential for long-term growth.

The fund is managed using both value and growth management methods.

When investors are only looking towards securities with moderate risks but want capital appreciation, as well as dividends as their objective, growth and income funds would be an excellent option for them.

Specialized funds

Specialized funds are also called sector funds.

The sectors that they invest in can be anything from a geographical region (for example, investing in companies from Silicon Valley) or certain parts of the economy.

For a fund to be realized as a sector fund, the specialist section that they invest in must make up 25% of all of their assets.

Because of this concentration of investments, there are higher risks associated with sector funds as they are speculative.

Having said that, however, they also have high appreciation potential, so it’s certainly a case of risk and reward when it comes to these funds.

Examples of what these funds can invest in include precious metals such as gold, biotechnology, pharmaceutical, technology, and more.

Note that the Names Rule applies to these funds too.

This states that when the name of the geographical area, sector, or specific industry is used by the mutual fund, 80% of the assets of that fund must be invested in the name used.

Special situation funds

When a company might have an advantage for changes in the economy, for example, their securities are often bought up by special situation funds.

An example of this is companies that are candidates for takeover or turnaround circumstances.

Of course, due to their nature, these funds are considered to be extremely speculative and offer high risks to investors.

Blend/Core funds

When a portfolio includes every different stock, they are said to be a blend/core fund.

Here you can find anything from growth stocks offering high potential returns at high risk to blue-chip stocks and fund managers will employ both value and growth management styles for a fund like this.

The idea behind this is to provide a single fund in which investors can diversify their investments easily.

Blended/core funds are not as conservative as value funds.

Index funds

Here, the fund takes a market index such as the S&P 500 and then invests in securities that mirror that by buying and selling the same funds.

Index funds can choose to mirror broad or narrow indexes.

When it comes to overall performance, it should be similar to that of the index that it is tracking.

Because only trades that take place on the index are mirrored, an index fund’s portfolio won’t have a high turnover of securities.

Change only happens when a change takes place in the index and this is usually only one company taking the place of another.

This has an impact on the overall expenses an investor incurs when they choose an index fund as management fees, commissions, and even taxation are reduced.

Suggest an index fund to an investor who doesn’t want to pay for a managed funds professional selection of stock and that believes that on the whole (or in part), it’s difficult to perform better than the market, so why not mirror it.

 Foreign and international funds

From their name, it’s easy to deduce that these funds only invest in foreign stocks.

The companies that these stocks are bought from will always be based outside of the United States when it comes to their principal business activities.

While some of these funds do look to make current income, for most, the primary objective is capital appreciation.

Global funds

Sometimes called worldwide funds, these don’t just invest in foreign stock but also securities from the United States as well.

Note that when compared to just a domestic fund, the risks are different for funds that include foreign stocks too.

For example, foreign stocks can be significantly influenced by political and currency risks, and obviously, these risks will apply to global funds then.

Often, they look to pre-emerging foreign economies as their investment targets and it’s important to note that when compared to the United States, regulatory and accounting laws are less strict.

Investors that are looking to diversify their portfolio might consider buying into foreign funds.

It’s always important that investors are told about the greater risks associated with foreign funds when compared to domestic funds, however.

A registered representative might suggest a global fund to an investor that has a well-diversified portfolio that includes stocks and bonds of a domestic nature.

This can help them diversify even further.

Balanced funds

Sometimes called hybrid funds, these look to invest in both stocks and bonds.

Investing in stocks is for appreciation purposes, while the bonds will help to generate income in the investor’s portfolio.

A formula is used by the fund manager to purchase securities.

Depending on market conditions, this formula can be adjusted too.

As an example, the portfolio of a balanced fund might have 65% stocks and 35% bonds

As we’ve already mentioned, this ratio can change as the fund manager sees fit.

This is the perfect type of investment for those who want both stocks and bonds and a conservative balance between them.

Asset allocation funds

This offers split investments as well.

Generally, there are three different types of securities that form part of these funds.

Just like a balanced fund, there are stocks to provide growth while income generation is covered by bonds.

The added security is either cash or money market instruments.

Their primary aim is to bring stability to the fund.

According to the performance (or expected performance) of the group of funds, fund managers will switch around percentages in each category of assets.

From time to time, real estate, precious metals (gold for example), and other hard assets can be held in this type of fund as well.

As an example of the breakdown of this kind of fund, it might have 55% in stock, 25% in bonds, and the final 20% invested in cash.

Should the fund manager expect stock market performance to improve, they can then adjust the breakdown to include more stocks switching from the bond and cash portion and placing it into stocks.

For the most part, these are target funds with a specific goal in mind.

This goal could be retirement, for example, and they usually have a certain period in mind when it comes to maturity like 5, 10, 15, or even 20 years.

When the fund is closer to reaching that target time frame, fund managers will look to make adjustments so that the investment mix is more conservative as a way to protect the money the fund has generated for the investor.

When it comes to suitability, this is the perfect kind of investment to suggest to someone who is looking at retirement in 20 years, for example.

Target-date funds

Also called a life-cycle fund, these have become popular and make up around 90% of employer-sponsored defined contribution plans.

The main idea behind this type of fund is that they look at investment risk specifically and the ways in which it can be managed.

Of course, there is a target date in mind for the investor, for example, they aim to retire in a certain year.

As that approaches, the target date fund managers will look to change the investment approach.

They do this by opting for investments that are less risky.

This doesn’t mean that target-date funds are not risk-free.

As we know, there is no true risk-free investment.

FINRA has some concerns about these types of funds.

And that’s the fact that investors don’t seem to understand that there isn’t a 100% guarantee that these types of funds will provide investors with income when they reach maturity.

Also, while funds like this may all seem similar, FINRA feels that investors don’t seem to understand that they all have unique risk profiles and used different investments.

Should the stocks and bonds that the fund has invested in suddenly drop, target-date funds can lose money.

While certain target date funds might look similar, they are all unique when it comes to how assets are allocated as well as the various investment strategies that they will employ.

This does have an impact on their overall risk, so it’s important that registered representatives explain this to interested investors.

These factors too can have an impact on the worth of the fund at certain points in time, most importantly, after retirement.

Bond funds

The main investment objective of a bond fund is income

They invest in a range of securities to achieve this from investment-grade corporate bonds to government issues, which while not offering the same levels of income as the former, are less risky.

By investing in lower-rated bonds that provide higher yields, some bond funds are all about generating capital appreciation.

We are going to go a little more into detail about these different bond funds that we’ve briefly mentioned but it’s important to alert you to some information that often appears in the Series 6 exam.

You should always remember that:

  • Bond funds are different from bonds. That’s because they will pay dividends and not interest like bonds do. Those dividends will only be paid should the fund’s board of directors give the go ahead. In other words, it’s not a given.
  • While equity and debt oriented funds pay monthly dividends, for bond funds, dividends are either quarterly or semiannual if given the green light.
  • Bond prices will fall when interest rates rise. This will affect bond funds and their prices will drop too. Of course, the opposite is true when interest rates drop.
  • The traits of the source of the dividend of a conduit will be passed on to the dividend as per conduit (pipeline) theory. Take a municipal bond fund and the dividends it generates. These are a result of municipal bond interest and for tax purposes, that’s how the dividends will be treated.

Ok, so let’s get into the types of bond funds in a little more detail.

We are going to start with corporate bond funds.

While they are seen as investment grade or non-investment grade portfolios, when compared to various government issues, corporate bond funds have a higher credit risk.

However, the yield is always greater as the risk increases.

So the highest yields, because of increased credit risk, are provided by high-yield bond funds.

Because of this, they are seen as speculative investments.

The second bond fund we are going to look at is tax-free (or tax-exempt) bond funds.

These will look to invest in municipal bonds or notes that will produce income for investors through dividends.

This income is not subjected to federal income tax, hence the name of this type of bond fund.

So who are these bonds for?

Well, the perfect target market is those investors who want to generate income from their investments but are already in high marginal tax brackets.

Then we have principal protected funds.

When an investment in these funds is held for a specific period, principal protected funds will guarantee that the initial investment made will be returned.

If they choose to liquidate before that period elapses, the guarantee falls away.

When an investor wants to ensure that their principal is preserved and isn’t worried too much about capital appreciation, this is an excellent option as an investment for them.

U.S. Government funds are the next bond fund to cover.

These funds target securities that are issued by agencies of the U.S. government or the U.S. Treasury

A Ginny Mae is an example of the kind of securities that are bought up by this kind of fund but there are numerous other examples.

For an investor who is looking for a fund that offers excellent safety overall but will still provide income, then this is the type of fund that a registered representative can suggest.

In terms of safety, U.S. government funds offer more safety than when government agency funds in terms of default risk.

In terms of yield, however, agency funds because they are slightly riskier, will provide higher yields than U.S government funds.

Agency funds

When you see the word agencies, it’s generally discussing two bond types:

  • U.S. federal government agency issued bonds or those guaranteed by these agencies
  • Government-sponsored enterprises (GSEs) issued bonds. Congress creates these corporations for a specific public purpose, for example, to create affordable housing

Just like treasuries, many of the bonds issued in this manner have full faith and credit in the form of U.S. government backing.

Through this, investors are assured should they wait for the fund to mature, they are guaranteed to receive their principal investment in full.

Also, it is a commitment that interest payments will be made to investors.

Not all bonds issued by GSEs have this backing, however.

An example of those that don’t is Federal National Mortgage Association bonds or Federal Home Loan Mortgage Corporation bonds (also known as Fannie Mae and Freddie Mac).

The federal government considers agency securities to be moral obligations and it’s assumed that should there be a default on them, the issues will be backed by the government.

It’s for that reason that in terms of risk when compared to corporate debt, they are considered to be a safer option.

For investors that want their investments to generate income but at the same time are risk-averse, agency security funds might be a great suggestion over something like a U.S. government bond fund.

That’s because, in terms of yield, it will perform better.

THE PURCHASE AND LIQUIDATION PROCESS FOR VARIOUS INVESTMENT COMPANIES

Close-ended funds: Buying and selling

The shares of a closed-end management company can be sold by a licensed representative holding a Series 6 as part of a primary offering.

The licensed representative with a Series 6 cannot sell these shares when they move to the secondary market, however.

This is something about closed-end funds that’s often an exam question, so it’s worth remembering.

With an agency transaction, an investor has to pay a brokerage commission while with a principal transaction, they have to either pay a markup or markdown.

Also relative to their NAV, closed-ended funds can trade above (or at a premium) or blow (at a discount).

For the exam, remember that it’s on the secondary market where close-ended funds will trade.

As for their price (both the bid and ask), that’s determined by their overall supply and demand.

While there is a similarity between the public offering price and NAV when it comes to bid price, they are not the same.

UITs

It’s the issuer that will directly sell UITs through a prospectus.

That allows those representatives that have passed the Series 6 exam to sell them.

Note that the sales charges are built into the price of the UIT and a set number of units are issued.

An investor can redeem the shares with the UIT issuer when the shares are sold.

The redemption process isn’t always the same.

That’s because issuers sometimes have different rules from one another as to how it is carried out.

The redemption process isn’t something that’s covered on the exam because of the fact that there is no standardized way in which it is carried out.

What is important to know is that securities from UITs do have an end date.

When this is reached, any proceeds they make are passed on to the investor after the UITs have been liquidated.

Mutual funds

We already know that there is no secondary market trading for mutual funds.

It is from the mutual fund itself that shares are bought by investors.

There can be an intermediary in this transaction in the form of a broker or fund sponsor.

But what happens when an investor wants to generate cash to perhaps fund another sale?

Again, they can go directly to the fund to redeem their shares.

The next calculation of NAV is what any investor orders are derived from.

In the securities world, this is known as forward pricing.

NAV 

The net asset value is a critical part of all mutual funds.

At least once during a business day, it will need to be calculated although if the fund wants to calculate it more often, they can.

This doesn’t happen often though.

How is the NAV of a mutual fund calculated?

Well, we first start with determining the mutual fund net assets.

For that, the following equation is used: Mutual fund net assets = total assets – liabilities.

When we talk about liabilities, these could be an expense relevant at the time, for example, it could be securities that may have been purchased, but to that point, have not been paid for.

Once you have the net assets of the mutual fund, working out the NAV isn’t difficult at all.

Of course, there is another equation involved.

That equation is: NAV= net assets divided by shares outstanding.

For example, the XYZ mutual fund has $50 million in assets and $2.5 million in liabilities with 5 million shares outstanding, the NAV per share would be $9.50 per share.

Here’s a quick breakdown just to show you how we arrived at NAV by plugging the relevant figures into the equation:

Net assets are $50 minus – liabilities of $2.5 million – $47.5 million.

So NAV = Net assets ($47.5 million) divided by shares outstanding (5 million) = $9.50 per share.

As we know, NAV is important because, upon redemption of their shares, this is what the investor will receive per share.

It’s certainly a critical piece of information that they would want to be made available to them too and hence the fact that at least once every business day, NAV will need to be calculated.

For most funds, they will base their NAV calculations on when the NYSE closes and that’s at 4:00 pm ET.

Note, the NAV that is worked out after a redemption request has been received from the customer is the price they will receive per share should they opt to sell.

Can the NAV be calculated more than once per day?

The answer to that is yes.

If a fund chose to do that, however, then one of the calculations made is gleaned from the close of the trading day’s portfolio value.

Also note that when investors opt to redeem their shares in a mutual fund, within seven days of having to do so, they must receive their proceeds.

INVESTMENT COMPANIES: DIFFERENTIATING BETWEEN FEES, SALES CHARGES, AND EXPENSES

It can get a little bit confusing when we talk about sales charges, fees, or expenses when dealing with various investment companies and products.

This section looks into all of that in a little more detail.

Fees

Broker-dealer’s charge fees and commissions when trades take place on the secondary market.

This can be for both the buying and selling of various securities.

These securities include closed-ended funds or ETFs, for example.

The thing with the term fees is that it covers a broad range of charges.

For example, it could refer to:

  • Sales charges
  • Commissions
  • Other non-trading related charges

Sales Charges

These are also called loads or distribution fees in the industry and are charged when shares of mutual funds are either bought or redeemed.

Loads are applied by the fund sponsor when this happens.

With open-end funds, fees like commissions or expenses usually form part of the POP.

These expenses are varied and include commissions (for underwriters, dealers, brokers, and registered representatives), advertising, and sales literature.

Mutual funds work differently and used trailer commissions as a way to ensure that registered representatives receive the necessary commissions continually from the sales of shares, for example:

  • Front-end loads (differentiation between NAV and POP)
  • Back-end loads (contingent deferred sales loads)
  • Level loads (asset-based fees. The Register representative handling the account will receive trail commissions)
  • No-load funds (Sponsor adds no sales charge. Broker-dealer might add commission charge, however)

Front-end loads

Class A shares are the way that those sold with a front-end load are described.

The fund’s POP will already have these sales charges included.

When the investor purchases shares, the NAV will have the charges added to it.

When underwriters or broker-dealers provide a service to investors, this is often the most common method used to pay them for those services.

As for Class A shares, well, they are the domain of investors that are prepared to invest lots of money at a time, for breakpoint purposes, over longer periods.

These are commonly called large dollar investors.

Note that unless the sale is from one broker-dealer to another, the sales prices cannot be discounted.

Under FINRA rules, the sales load can never be higher than 8.5%.

Here’s a quick example of how sales loads work.

Let’s take an investor who is going to invest $5,000 in a mutual fund.

The front-end load on that fund is 5% which equates to $250.

That’s taken off their initial $5,000 amount, so then $4,750 will be placed in the fund’s portfolio (at NAV) and invested on the client’s behalf.

How to reduce front-end sales loads

Earlier, we briefly mentioned breakpoints.

Let’s see how they work in reducing front-end loads.

Ultimately, a breakpoint is a quantity discount.

They are given on mutual funds, which you may see called open-end management company shares from time to time, so don’t get filled by that if you do.

A breakpoint works as follows.

Sales charges get lower as the dollar amount of the shares purchased rises.

Note, that there isn’t a schedule for this that can be followed, as breakpoints are standardized.

They are applied in different ways from fund to fund.

Here’s a simple example of how a mutual fund breakpoint might work.

Say an investor is buying an investment between $1 and $9,999.

The sales charge could be 8.5%.

But if they are prepared to invest $50,000 and above, using breakpoints that could drop to 2%.

These amounts are not fixed, they are just an example to give you an idea.

As a registered representative, it’s important to tell investors about the various breakpoints.

Perhaps they are investing an amount that’s just a few thousand dollars off reaching the next breakpoint.

If they have that extra money they can make significant savings on sales charges.

In some situations, different orders from customers can be combined so better breakpoints can be reached.

Also, an investor could combine an order with that of a spouse, for example, to reach a better breakpoint.

Note that one specific type of client in the form of investor clubs does not get breakpoints.

Another way to reduce front-end loads is via letters of intent.

This can be signed by an investor that is going to invest again in a mutual fund company that they have done so in the past.

Should they sign a letter of intent, the overall sales charge can be decreased by the mutual fund company.

The letter of intent contains information that confirms that the investor is going to place additional funds in the fund that will reach a specific breakpoint and that they will do this within a 13-month period of having signed it.

This is a bonded, one-sided contract but is only completed when the customer invests the amount they need to reach the specific breakpoint and qualify for reduced sales charges.

As for the extra shares, they are held in an escrow account and the investor’s account will receive them when they deposit the money as set out in the letter of intent.

Any reinvested dividends or appreciation on the shares over the time it takes for the investor to deposit the money will not count.

If 13 months pass and the customer has not paid the money as stated in the letter of intent, they have two options:

  • They can either send a check that covers the sale charge difference
  • Use escrowed shares as a way to make up the difference

Then we have rights of accumulation, another method that can help investors with reduced sales charges.

There is a difference between them and breakpoints, however.

  • Rights of accumulation do not apply to the initial transactions but are available for investments that follow
  • Prior share appreciation can be used through rights of accumulation as a way to reach breakpoints
  • There are no time limits that apply to rights of accumulation

So how do they work?

Well, when the shares the investor is purchasing together with shares previously bought reach a total value that is more than a certain dollar amount, reduced charges might become a possibility.

So how do investors qualify?

Well, that’s either thanks to their total purchases made in that mutual fund or the number of securities they have to their name on the higher current NAV.

As mentioned earlier, should an investor combine the investment they want to make at that moment with those they have made previously to determine the sales charge, that will be applied.

Next, we have combination privilege.

A family of funds is more than one fund that’s offered by a mutual fund sponsor.

That means to reach a breakpoint that will see them get a reduced sales charge, investors might be allowed to amalgamate two separate investments in different funds in the same family.

There’s exchange privilege too that can lead to reduced sales charges.

Within families of mutual funds, sponsors also can make exchange or conversion privileges available to investors.

This sees no additional sales charges added for a second purchase in the situation where an investor converts an investment in one fund for one that’s equal in another fund from the same family.

Tax consequences, however, might occur as this is considered to be a process that is taxable.

Lastly, we look at a breakpoint sale.

This specifically refers to a sale that takes place just under the breakpoint.

If this happens, it could be construed that the registered representative is looking for higher sales charges so they can share in them.

Of course, this is considered unethical but FINRA doesn’t provide exact provisions as to how close to a breakpoint a violation would be triggered.

As a way to ensure that they don’t violate this, even if it is through an oversight, registered representatives should always inform their clients of the respective breakpoint schedules of the mutual funds the client is interested in.

In this way, they cannot, either by doing it on purpose or by accident, earn higher concession dollars on a sale that just doesn’t make the next breakpoint.

What is important to note here is the violation is caused by not giving the client all the information they need to make an informed decision regarding their investment and the various breakpoints and not the order that’s below the breakpoint itself.

Back-end loads

When a share has a back-end load or contingent deferred sales charge (CDSC), it’s known as a Class B share.

So how does this fee work?

Well, as soon as an investor redeems shares in a mutual fund, the redemption fee is charged.

The earnings of shares sold in that year will see the sales load applied to them.

Note that the sales load will decline each year.

For example, it might be 5% the first year and then decline a further percentage each year after that.

After an extended holding period, usually around seven years, for example, the back-end load is designed to drop to zero.

Should an investor hold the shares for that long, once they reach the point where the sales load falls away, the B shares will change to an A share.

This conversion will cost the investors nothing.

When it comes to the CDSC, it’s on the cost basis that it will often be based.

Should it be less than the purchase prices, some mutual funds will apply the charge related to the current NAV.

Small dollar investors that are prepared to hold mutual fund securities for a long period of time are an excellent option for Class B shares.

Note that when an investor deposits an amount in a mutual fund, only when they withdraw money will the sale load be deducted.

And that has to happen before the CDSC expires.

The main idea behind this sales charge is to ensure that mutual fund accounts don’t trade too frequently.

Level loads

Level load is something that applies to Class C shares.

Normally, the CDSC is for 1-year and is at 1. 

It’s perfect for those clients that have time investment time horizons that are very short.

There is also a 0.75% 12b-1 fee.

Also known as an asset-based distribution fee, this is allowed via an SEC regulation.

In fact, it’s named after that rule.

These fees specifically cover the distribution of the fund to members as well as marketing costs.

This fee also helps pay trailer commissions for those registered representatives that work with an investor’s account.

Note, however, that this fee is not a sales charge.

That’s a separate fee.

12b-1 fees are a percentage of the average total NAV of the fund and are deducted every three months.

Note that:

  • 0.75% is the maximum 12b-1 fee for promotion and distribution
  • The level of the distribution services must be reflected in the fee

To charge a 12b-1 fee, noninterested persons must make up the majority of the board of the fund and the fee is reviewed each quarter.

To remove it, a vote must be placed by noninterested board members.

These are people that while having a role on the board, don’t hold any position with either the fund’s sponsor or the fund itself.

Their primary role is to ensure that the board has representation from the public.

When a fund has a 12b-1 fee higher than 0.25% it is not allowed to be called a no-load fund or it is violating the conduct rules of the SEC.

Here’s a quick recap of information regarding 12b-1 fees that you might come across on the Series 6 exam:

  • While it’s reviewed every quarter, 12b-1 fees are shown as an annual amount
  • Advertising, sales material, and the delivery of prospectuses are part of the charges covered by 12b-1 fees. Fund management expenses are never covered by this fee
  • Funds are not allowed to charge higher than 0.25% of their average net assets for 12b-1 fees should they want to be seen and marketed as a no-load fund
  • 12b-1 fees may never be higher than 0.75% as per FINRA regulations
  • Shareholder services allow for an extra 0.25% to be added to charges, but this is not added to 12b-1 fees

Working out how to compute sales charge percentages is critical knowledge as well.

Let’s look specifically at a mutual fund where the NAV is $5.00 and a POP of $5.25.

The sale charge percentage can be determined easily when you know the NAV and POP.

To do so, take the sales charge dollar amount ($0.25) and divide it by the POP ($5.25) which is 4.8%.

Should you know the sales charge and the NAV, there is a formula to work out the POP as well.

Take the NAV and divide it by 100% – sales charge percentage to give you the POP.

Also, remember that NAV pulse sales charge dollar amount equals POP dollar amount.

The way a mutual fund works out the NAV as well as how the sales charge is added must always appear in the prospectus (including the formulas used).

Also, it’s not the NAV that the sales charge is based on but always the POP.

Long-term investing is an option for loaded funds because of the sales charge.

So let’s do a little test then.

Let’s say we have a POP of $20 and a NAV of $19.

Can you work out what the sales charge would be?

First, you need to calculate the sales charge percentage and this is done by finding the sales charge amount.

That’s just taking the NAV off the POP, so it’s $1.

So then, the sales charge percentage is then $1 divided by the POP and equals 5%.

Can you work out the POP if you have the sales charge percentage and the NAV?

Remember, to do so you have to take the NAV and divide it by the answer of 100% minutes the sales charge percentage.

So that’s $19 divided by 0.25 = $21.05.

A good tip here is that when the NAV is provided, the answer for the POP is always going to be higher than the NAV.

So if you have only one option in the answers that is higher than the NAV, that’s going to be your answer even without you having to work it out.

No-load funds

There is no sales load charged by these types of funds.

That doesn’t mean that they cannot charge fees, however.

The following are fees that no-load funds can charge their clients:

  • Redemption fees
  • Exchange fees
  • Account fees
  • Purchase fees

These are not linked to sales loads at all, so therefore they can be charged.

Just a note about redemptions fees.

While they are similar to a deferred sales load in the fact that they are taken from redemption proceeds, they are not seen as a sales load.

FINRA also allows funds to still be called a no-load fund when paying annual operating fees but there is a proviso.

And that’s the fact that separate shareholder fees or the 12b-1 fees charged when combined may not go above 0.25% of the average annual net assets.

When it comes to the shares of no-load funds, direct sales from the fund to investors are often how they are sold.

Mutual fund expense ratio

When management feeds and operating expenses are compared with the fund’s net assets, we can see the expense ratio of a fund.

No matter the type of mutual fund, even no-load funds, this is something that they all have.

To work it out, there is a simple formula that you will need to follow.

That formula is taking all the expenses of the fund and dividing them by the average net assets of the fund.

If we look at stock funds, generally, their expense ratio is 1% to 1.5% but usually, the more aggressive a fund, the higher the expense ratio will be.

Bond funds have lower expense ratios than stock funds and they are usually around 0.5% to 1%.

An expense ratio will incorporate the following:

  • The fee charged by managers
  • Any administrative fees including for attorneys, accountants, transfer agents, and trading feeds
  • The costs associated with the board of directors
  • 12b-1 fees

Note that anything that would impact the overall return of a fund and have a direct impact on its assets is considered to be fund expenses.

So, expect lower returns from funds that have higher expenses.

Also, sales charges or loads are never part of the expense ratio.

Let’s look at an example of how an expense ratio of 1.10% will impact a fund.

Well, what it means is that each year, for every $100 of the fund’s assets, $1.10 is deducted due to the expense ratio.

From time to time, you might see the phrase turnover ratio for a mutual fund.

This isn’t the same as an expense ratio but will have an impact on it.

Turnover ratio is how the portfolio of the fund “turns over” which is another way of saying how much trading the fund carries out.

Because trading means money is being paid out, the higher the turnover ratio, the more a fund’s expense ratio is going to be.

Mutual funds board of directors

Strategic decisions that guide a mutual fund are made by a board of directors.

All mutual funds have them and a board will comprise both noninterested (at least 40%) and interested members.

Earlier, we mentioned that noninterested board members are those that are not associated with the fund or a fund sponsor.

They are part of the board of directors as a way in which the general public can be represented on the fund’s board.

While the board of directors has numerous tasks, these are the three things that you should remember:

  • They oversee the policy with regards to 12b-1 fees
  • They oversee the investment manager of the fund (this includes contract negotiations)
  • They oversee the contracts and relationships between the fund and its sponsor as well as attorneys, accountants, transfer agents, and other support services

A board of directors must act with fiduciary responsibility at all times.

Accumulation plans

When executing investment programs, mutual funds have several options at their disposal.

For example, if a customer deposits periodic investments at regular intervals voluntarily, then the fund uses a voluntary accumulation plan.

Of course, there are rules in place for this, for example, the lowest amount that’s allowed to be deposited and this will be found in the fund’s prospectus.

The main aim of a plan like this is to instill good investment habits in customers but at the same time, give them leeway regarding their investment deposits.

Other rules for this type of plan govern what the customer’s minimum first purchase must be as well as the minimum allowed on further purchases following that.

To further simplify things, funds can also offer automatic withdrawals from customer banking accounts.

Note that because the plan is voluntary, should the customer miss a payment for whatever reason, there are no penalties in place.

Should a customer sign up for one of these plans and wish to withdraw at any point, they may do so.

Dollar cost averaging

This is just another option open to investors who want to purchase shares in a mutual fund.

Here at regular intervals, a client will invest the same amount.

Using this method means that when share prices are low, the amount stipulated for the investment will purchase more shares than when prices rise.

Over an extended period in fluctuating markets, the average price of the shares will be higher than the average cost per share paid.

In a declining market and because prices could continue to drop over a long period of time, this approach doesn’t mean that a profit will always be made.

While the investor will be buying more shares for their fixed dollar amount, it’s in a sinking market.

Let’s take a look at how dollar cost averaging works.

  • January: $800 invested | Price per share – $20 | Number of shares bought – 40
  • February: $800 invested | Price per share – $10 | Number of shares bought – 80
  • March: $800 invested | Price per share – $30 | Number of shares bought – 27
  • April: $800 invested | Price per share – $40 | Number of shares bought – 50

To find the average price per share, you add up the prices paid ($100) and divide it by the number of investments made (4), giving an answer of $25.

To find the average cost per share, you add up the total amount spent ($3200) and divide that by the total share number that was purchased (197), giving an answer of $16.24.

So now the average cost per share is $8.76 lower than the average price per share.

For the Series 6 exam, dollar cost averaging is critical, so make sure you go through this section again to clearly understand the advantage it offers.

That advantage is simply that for the most part, dollar cost averaging leads to a lower average cost per share when compared to average price per share.

But as we mentioned, there is no promise that it will always lead to a profit.

Neither will it guarantee protection from potential losses.

Mutual fund withdrawal plans

This free service is available to those who invest in some mutual funds.

We are not talking about lump-sum withdrawals here.

That’s when a customer sells all of their shares.

Instead, mutual funds also provide other withdrawal plans that take a systematic approach.

There are some requirements, however.

For one, the account must be worth a certain amount of money before the mutual fund will allow the investor to initiate a withdrawal plan.

In many instances, when withdrawals begin, many funds will deter clients from further investments.

Withdrawal plans are not something that is offered by all mutual funds.

Let’s look at a few examples of plans that could be offered.

We start with fixed-dollar plans where clients are allowed to request withdrawals at certain periods.

When they do, shares are liquidated to meet the sum that the client wants to withdraw.

It’s interesting to note that the account earnings for that period could be higher or lower than the amount that the client wants to liquidate.

While the amount of the check is always clear, how long it lasts is not.

That’s because that fact is only established by how the fund performs.

The second one to look at is fixed-percentage plans.

These are also known as fixed-share plans and here, each period, either a fixed percentage of the client’s account or a fixed number of shares are liquidated.

Here, in theory, there is no end date in sight and the plan has a variable check.

For example, this could be a distribution every month that amounts to 1% of the fund.

Next, we have fixed-time plans.

With this withdrawal plan, there is a fixed period over which a client will liquidate their earnings.

This could be 10 years, as an example but it’s unknown as to how long the checks will last as well as how much they will be.

That’s because the checks are reliant on how the fund performs and that’s simply never a known factor at all.

It’s important to remember that when it comes to any of the withdrawal plans that we’ve briefly mentioned, they are not guaranteed at all.

The dollar amount that the client will receive each period is fixed when it comes to fixed-dollar plans.

Everything else is variable for the three plans we have covered above.

This includes the length of the specific plan and the share number that’s liquidated.

The period, however, for a fixed-time plan is fixed with the money received variable.

Withdrawal plans, due to their nature of not being guaranteed require that a registered representative:

  • Can never tell investors that their rate of return is guaranteed
  • Must tell investors that their account can be exhausted at an earlier point than they expect if the fund doesn’t perform well
  • Can only use principal cleared charts or tables related to the fund. If they haven’t been cleared by the principal, they may not be used

VARIABLE INSURANCE PRODUCTS

For those with a Series 6 license, a large section of their sales will be made up of life insurance products and annuities.

Life insurance and fixed annuities are not considered as securities.

Variable versions (separate accounts) of them, however, are seen as securities.

So all of the funds (or a portion of them) will be invested in a separate account when an investor places money in a variable insurance product.

But this separate account isn’t always a single entity.

At times, it can contain several subaccounts.

And the investments into these separate accounts, what happens with them?

Well, they are put into a version of an open-end management company, which is a type of security and the reason why variable insurance products are seen as such.

Note that if these products are to be sold by a registered representative, they require both an insurance and securities license.

Characteristics of variable annuities

In a nutshell, the goal of an annuity is to provide retirement income for a client and it takes the form of an insurance contract.

The client, or annuitant, will receive payments as provided by the annuity investment.

These can be for the lifespan, till a certain age, or for a set number of years and it depends on the type of annuity they’ve picked as to which it will be.

While the payment stream will be guaranteed, the actual amount to be paid is not.

Annuities have mortality guarantees as well.

That’s as a result of the fact that they provide income to a client for life.

As we’ve seen, when it comes to annuities, there are two kinds: fixed and variable.

With both, money invested in the annuities will grow and is always tax-deferred.

When the client retires, the funds can be accessed in two ways.

Either the client can take it all as a lump sum or they can choose to be paid periodically (for example, each month).

The second option is for the rest of their lives.

IF they so choose, an early withdrawal can be made from the annuity but a 10% penalty, as well as full income tax, will be applied on withdrawals over cost basis and if the client is younger than 59.5.

There are exceptions to this age rule, however.

These are:

  • The death of the client
  • Annuitization as per Rule 72 (t) which is something we will look at in more detail later on

Usually, because no front-end loads are charged, the investor will see 100% of their money go into the annuity.

When contracts are canceled within a certain time frame, usually between seven to 10 years, the investor will have to pay surrender charges.

All the annuities that we will discuss are considered nonqualified annuities.

This means that the money in them will have tax-deferred growth and that they are funded via after-tax dollars.

Taxation on nonqualified annuities only takes place at distribution when the earnings are taxed.

Fixed annuities

With this type of annuity, an insurance company’s general account is where money is invested that clients pay through premiums to the company.

Depending on how much is paid in each month, the company must pay a guaranteed payout amount.

Usually, these payouts take place monthly.

The investment risk is taken on by the insurer.

That’s because they guarantee a certain rate of return.

That, however, means that fixed annuities are not seen as securities.

There is a risk, however, for the annuitant.

This comes in the form of inflation or purchasing power risk.

Due to inflation, the fixed payment each month, for example, will lose buying power over time.

An example of this is if someone took out a fixed annuity in 1990.

The monthly payment then of $500 would be enough to live on but 20 years later it might not be the case.

Anyone wanting to see this type of insurance product won’t need a securities license but will need an insurance license.

Their popularity stems from the fact that they allow participation in the market for investors and provide a guarantee against loss.

Index annuity

These products came about as a way to master inflation risk (fixed annuities) as well as the variable annuities market risk.

For those clients that want a guarantee against loss while participating in the market, index annuities have become very popular.

So how does it work?

Well, an investor will receive interest payments to their account from the annuity, which is the major difference when compared to a fixed annuity.

The amount of interest is determined via a formula.

In turn, this formula looks at a particular stock index, like the S&P 500, and is established from its performance.

Should the index perform, then a pre-specified percentage of the growth index is received by the annuitant.

In general, this is known as the participation rate and is between 80% to 90% of the index growth.

Some index annuities will stipulate a minimum interest rate of up to 2%.

The annuitant will receive this even if the stock index related to the index annuity has not performed well.

Here’s an example of how it all works.

Let’s look at an index annuity with a participation rate of 80%.

Annuitants are also guaranteed a minimum of 1%.

During the period measured, the index expands by 9% in total growth.

If we take, 9% of the 80% participation rate, that means that overall, 7.2% is the amount of growth that will be credited to the annuitant as a result of that growth.

If the index performed poorly and dropped, the annuitant still will receive 1% thanks to the guaranteed minimum.

Before we end this section on index annuities, we must also mention the cap rate, which is often 12%.

This provides a form of protection for the index annuity itself so that if the index that it follows performs incredibly well, the highest payout to annuitants can never go above the cap rate.

Lastly, only an insurance license is needed to sell index annuities.

This is because they are considered similar to a fixed annuity.

Variable annuities

We talked briefly about variable annuities in the introduction to this section but let’s go a little more in-depth now.

As a way to keep up with inflation, variable annuities were introduced as a potential insurance product.

Note that these are considered securities for one main reason.

And that’s the fact that none of the investment risk taken on is for the insurance company but for the investor instead.

For that reason, those who sell this type of product must have both a securities and insurance license.

The annuity itself must also include a prospectus when sold.

Separate accounts are used by the insurer to invest the premium payments made for any variable annuity.

In turn, these accounts are made up of various subaccounts.

These operate in a very similar manner to the way in which a mutual fund would and each has its own specific objective when it comes to investments.

For example, one subaccount could be all about growth, another about generating income, or another might combine growth and income.

Note that the principal invested can be lost as these separate accounts do not guarantee returns.

Because variable annuities have had issues in the past with suitability for investors as well as unethical behavior, FINRA instituted Rule 2330 to regulate them.

It specifically deals with 1035 exchanges of deferred variable annuities as well as recommended purchases.

It also covers initial subaccount allocations.

What is a 1035 exchange?

Well, it allows a tax-free exchange that gets the green light from the IRS.

This means that without incurring a tax liability, clients who have life insurance policies can exchange them.

This allows them to exchange their current policy with another one from a different insurance company without worrying about tax implications.

All the cash in one policy can then be easily moved from the old policy to the new policy.

While the 1035 exchange won’t cover transfers into a life insurance policy from an annuity it does cover the following cash values:

  • Annuity to annuity
  • Life to life
  • Life to annuity

For the Series 6 exam, it’s also important to know the various disadvantages of a 1035 exchange.

It’s critical that registered representatives point these out to their clients.

They are:

  • The old policy might include various surrender charges
  • The new policy might include various surrender charges too (which will come into effect if they perform another 1035 exchange at some point down the line)
  • The older policy might have a higher death benefit than the new policy that they are transferring to

The features of variable annuities must also be carried over including:

  • Any surrender charges as well as a surrender period (if necessary)
  • Tax penalties related to the redemption or selling of the variable annuities before the age of 59.5
  • Expense fees
  • Mortality fees
  • Investment advisory fees
  • Market risk
  • Deferred variable annuities investment and insurance components

Finally, if the customer has a variable annuity that they are exchanging, they must be asked if within the last 36 months it had been exchanged.

Now let’s look at the various key features of fixed and variable annuities as an easy way to see the major differences between them.

Fixed annuity:

  • Payments: After tax-dollars are used for payments and are invested in a single general account
  • Portfolio: Real estate and fixed income securities
  • Risk taken by: Insurer
  • Is it considered to be a security: No
  • Rate of return: This is guaranteed
  • Administrative expenses: These are fixed
  • Guaranteed lifetime income option: Yes
  • Monthly payments: Constant payments
  • Risk protection against purchasing power: No
  • Regulation: Insurance regulations must be followed

Variable annuity

  • Payments: After tax dollars are used for payments and are invested in a separate account
  • Portfolio: Mutual, equity, and debt funds
  • Risk taken by: Annuitant
  • Is it considered to be a security: Yes
  • Rate of return: Reliant on the separate account and its performance
  • Administrative expenses: These are fixed
  • Guaranteed lifetime income option: Yes
  • Monthly payments: Will move up and down
  • Risk protection against purchasing power: Generally, there is some form of protection against purchasing power
  • Regulation: Insurance regulations, as well as securities regulations, must be followed

Variable annuities allow for monthly income for life, but it’s never going to be a fixed amount thanks to the fact that it depends on how the separate account performs.

So that means it will go up and down each month.

For investors who want the benefits of both a fixed and variable annuity, a combination annuity might be the answer.

For the Series 6 exam, always remember that the term “variable” means two licenses are required to sell products like this, both a securities and insurance license.

You might be tested too as to whether suitability must be determined and whether a prospectus is necessary.

The answer to both of those is yes.

Purchasing annuities

With annuities, there are several purchasing options that insurance companies will offer.

That’s what we are going to look at in this section.

We must first mention aggregate fees.

Also known as conditional deferred sales loads (CDSLs), they include both front-end sales charges as well as those that become due on the surrender of the annuity.

More often than not, on purchase, no load will be asked.

If the annuity is surrendered and that’s not because of annuitization, then charges will be levied and they can be significant, especially in the first few years of the contract.

When purchasing an annuity, investors have several options.

For example, as far as payment goes, it can be made as a period payment with the option of either monthly or quarterly each year or it could even be paid as a lump sum.

When an annuity is purchased with a lump sum, it’s known as a single premium deferred annuity.

When it comes to the benefits payout for this type of annuity, the date is set by the annuitant.

When investments are made over time, that’s known as a periodic payment deferred annuity.

Here, benefit payments will be deferred.

The annuitant can determine the date on which these benefits are paid out and it’s at some point in the future.

With an immediate annuity, benefits start to be paid out within 60 days of the annuitant having bought the annuity.

Note, however, that to purchase it, they will require a lump sum.

This might be a question on the Series 6 exam, so remember that no periodic payments are available on immediate annuities.

Bonus annuities

Sometimes annuities will have financial benefits attached to them.

These are known as bonus annuities and the benefits they include could see the insurance company look to enhance the buyer’s premium.

As an example, this could be 3% to 5% which is added to their premium payment by the insurance company.

Of course, this isn’t really a freebie.

For the most part, if there are bonuses added to annuities, when compared to others that don’t have them, you will find that fees are higher.

When compared to standard contracts that have surrender periods of between seven and 10 years, on those with bonuses, the surrender period is usually longer.

If a customer is interested in this type of annuity, it goes without saying that not only must the bonuses be thoroughly explained (probably the reason they are wanting to buy one) as well as the additional costs that they can expect.

As for the bonus amount, well if they go ahead and purchase an annuity that includes this option, upon that initial investment, the bonus is added to their account.

Annuity sales charges

Sales charges on variable annuities must be fair and reasonable as set out by the SEC and regulated by FINRA.

Having said that, the maximum sales charges that can be set are not specified.

No sales charges or a fairly low fee is often what you will find on both fixed and variable annuities.

The fact that they often don’t have sales charges is compensated for in the surrender charges that are imposed on annuitants that opt for early termination of their annuities.

For bonus annuities, the surrender period is even longer than with fixed and variable annuities.

Index annuities have the longest surrender period.

Accumulation phase

There are two phases through which a variable annuity goes.

First up, we have the growth phase.

This is commonly called the accumulation phase.

When the payout phase happens, we call that the annuity phase.

Depending on the contract phase, the interest in a separate account that makes up the owner’s interest is either called annuity or accumulation units.

Depending on how the separate account performs, accumulation units will differ in value.

Payout phase

The annuitant will choose the kind of settlement option they will prefer when they opt to annuitize the contract to receive payments.

When annuitized, a contractual obligation between the insurance company and the owner of the annuity is entered into.

This deals with how the asset is to be distributed.

Distribution takes place in the method chosen by the annuitant which we will discuss later in this guide.

As a result of the annuitization, accumulation units convert into annuity units.

This will be a fixed number.

Monthly payouts during retirement are based on this and other factors.

Note that it’s on the performance of the separate account that the value of annuity units will be based.

For test purposes, remember that it’s the actual performances versus the assumed interest rate that annuity unit values are worked out.

This happens monthly.

Annuity distributions

There are numerous factors in play that help to determine the monthly check an investor will receive once they have chosen annuitization.

Let’s look at what they are:

  • Gender of the investor. Typically the check for an investor who is female will be less for those that are male. This is down to the fact that for the most part, females live longer than males do and that’s got to be catered for
  • The value of the contract (from a dollar perspective). Obviously, the more money the contract has in it, the bigger the check will be
  • Age. Older investors will receive a bigger check than those that are younger than them
  • Payout option (this is something we look into later in the guide)
  • The return on investment compared against assumed interest rate (AIR) for variable annuities. This is something we look at in more detail a bit later as well

Payout option

When an annuitant selects a payout option, they will receive scheduled payments for the rest of their life.

There are several types of payout options to choose from including:

  • Life annuity. This is also called life only or straight life.
  • Life annuity with period certain
  • Joint life with last survivor annuity
  • Unit refund option

Let’s take a look at these in more detail.

We start with life annuity/straight life.

A payment for life is the outcome should an annuitant select this option.

That means that while they are alive they will receive payouts but that stops at their death.

In other words, if there is money remaining in the account after the annuitant has died, it goes to the insurer and there are no beneficiaries to this option when chosen.

One of the overall advantages of this option not having beneficiaries is the fact that of all the options the annuitant can choose, this will provide them with the biggest check every month.

Again, this is all because of the fact that, at their death, all obligations for payments by the insurance company come to an end.

Of course, advising the client on the best option is critical.

Is a life annuity a good option for a male client who is over 80 years old and in poor health?

No, it wouldn’t be as they may pass away a few months after receiving their monthly payouts, and then there is no beneficiary to receive any of the remaining money, which then goes to the insurer.

The second option to look at is life annuity with period certain.

If someone would prefer that a beneficiary can be named should they pass away, then this is an excellent choice and certainly less risky too.

Even after the annuitant has passed away, this option ensures that a certain number of minimum payments will still be made and obviously, those will go to a beneficiary.

As for the period chosen, that could be 10 or 20 years even.

Note that when compared to a life annuity/straight life, the monthly check is smaller as a result of the fact that there is a beneficiary attached to the annuity.

Here’s basically how it all works.

If a 70-year-old client chooses a life annuity with period certain of 10 years, if they live to 90, they will receive payments every month.

If they live to 75, however, and then pass away, there are still five years of the period certain in which their nominated beneficiary will receive the designated payments.

The third option is joint life with last survivor annuity.

When an investor has a spouse and wants to provide an option for them to receive money, then choosing a joint life with last survivor annuity is a good idea.

That’s because it will provide payments over two lives.

Obviously, this will have an impact on the monthly check payments and they are lower than both the options we have already looked at.

With this annuity, if one spouse passes away, the other will continue to receive payments.

It’s important to note, however, that these payments will be less.

The fourth example is a unit refund option which is also called a rider.

With this, following annuitization, a minimum number of payments will be made.

A beneficiary will also receive a lump sum if the annuitant should die but only if there is value still remaining in their account.

As far as guaranteeing that the contact’s money is distributed, only a unit refund option provides that as well as a monthly check for life.

So should an investor opt for a contract of $75,000, all of that will be paid and in some cases, maybe even more if the investor lives for a long period of time.

It is never less, however.

Assumed interest rate

Earlier, we briefly spoke about the assumed interest rate (AIR).

With a variable annuity, the opening value of the annuity units as well as the payment the investor receives in their first month will be determined by the actuarial department of the insurance provider.

Also, it’s at this point that the AIR is set.

But what is it?

Well, AIR looks at the separate account and makes a projection of how it might perform during the contract’s estimated life span.

This projection tends to be on the conservative side.

When compared to the AIR, annuity value, as well as the monthly income that’s paid to the annuitant, will always differ based on the performance of the separate account.

The following rules will apply to help to ascertain if payments will stay the same as the previous month, increase or decrease:

  • When compared to the AIR, if the separate account’s performance is better, the payment next month will be more than the current month
  • When compared to the AIR, if the separate account’s performance is the same, the payment next month will be the same as the current month.
  • When compared to the AIR, if the separate account’s performance is worse, the payment next month will be less than the current month

Surrendering an annuity

If they so wish, an annuitant may surrender their annuity.

This means that they cash it in.

When this happens, the total amount that has been invested will form the investor’s cost base.

Should they be under the age of 59.5, they will be liable for not only the income tax on any growth but also a penalty.

And that’s 10% of the overall growth.

Annuitant’s death

If an annuitant dies, any benefits their annuity has, depending on the option they have taken, will now come into effect.

Remember, if there is a beneficiary, they will either receive the greater of the annuities total value or the invested amounts total value/.

Any growth will be liable to income tax but should the beneficiary be younger than 59.5, they won’t have to pay a 10% penalty.

Suitability

When used in an effective manner, a variable annuity can be a critical part of an investor’s financial health.

As always, however, suitability factors must always be considered when suggesting these annuities to potential clients.

The main idea behind a variable annuity is to provide another form of income to the investor in a period of their life when it will be necessary.

It’s nothing to do with the preservation of capital and if that’s what an investor is looking to do, then this isn’t the right kind of product.

It is all about supplemental retirement income, however.

Let’s look at some basic suitability rules with regard to variable annuities.

First, if someone can fund the contract using cash, a variable annuity is extremely suitable for them.

They should never be withdrawing equity or refunding their home to be able to finance a variable annuity for example, as that isn’t suitable at all.

It’s not suitable either to cash in on an existing annuity or cash out a life insurance policy to fund a variable annuity either.

But using cash to fund it, as mentioned above, is most desirable.

Second, if someone has invested money in a variable annuity but later might want a lump sum of that money for another investment, then the variable annuity is not suitable for them.

This could include lump sums that might be needed for a child’s education, buying a house, or any other large cash outlay.

Money for that should never come from a lump sum withdrawal from a variable annuity.

Third, a variable annuity is never an option over an IRA or other tax-favored accounts.

That’s because only until withdrawal is the growth on a variable annuity tax-deferred but not thereafter.

Fourth, for investors who are not confident in stock market investments or have a low-risk tolerance, a variable annuity is not suitable.

That is because using their separate account, variable annuities invest in a portfolio of various securities and this is at some risk.

Fifth, a variable annuity is only a suitable recommendation when an individual has made maximum contributions to other retirement savings options at their disposal.

These include 401(k), IRAs, and pensions, for example.

In other words, they are the perfect supplementary retirement product but should never be used as a primary product first and foremost when the above-mentioned are at the disposal of a client.

Taxation

Let’s just reiterate two things that we learned in the section above.

  • Variable annuities are a supplementary addition to a client’s retirement savings plan
  • They are only taxed on withdrawal. Any growth in the seperate account during the life of the variable annuities is not taxed

When the investor opts to withdraw from their variable annuity, it’s treated as ordinary income.

And that’s for the year in which the withdrawal takes place.

For the Series 6 exam, always consider a variable annuity to be nonqualified unless the question states otherwise.

Should the owner choose to opt for annuitizing and securing a life income by converting the lump sum, part is seen as a return of principal (which is known as the exclusion ratio) while a section of the regular payment is seen as income.

There is no taxation applied to the return of principal.

For the Series 6 exam, it’s considered unsuitable if using a variable annuity inside an IRA or other account that is tax-advantaged.

Interestingly, this is not forbidden by regulators such as FINRA and the SEC.

Separate accounts within an annuity require registration with the SEC.

This is because they are a kind of management company.

Note that the annuity is not where the registration is required, just the separate account.

Voting rights

A separate account in a variable annuity is broken into various units, as we already know.

With these units come voting rights for the unitholders.

This is similar to the voting rights that mutual fund shareholders have.

For example, if there is to be a change in the overall account objectives or the investment manager is set to change, an owner of a variable annuity can vote on it.

Characteristics of life insurance

In the event of the insured person’s premature death, a life insurance policy will pay out a death benefit to the beneficiary named in the policy and chosen by the policyholder.

Many who choose life insurance have various needs from a policy and that means several variations of both term insurance and life insurance are available to clients.

In this section, we will look at the various options available but specifically at the one option that’s seen as a security.

Whichever occurs first out of an insured person reaching 100 or their death is what permanent life insurance is designed to cover.

If a person needs to borrow for the policy, they can take from the accrued cash value.

For those who want to sell a life insurance product, an insurance license is necessary.

It’s also therefore never sold as an investment.

As for the premium for life insurance, there are several factors that are used to calculate this including:

  • The age of the policyholder
  • Their gender
  • Their overall health
  • The face amount of the policy when it is issued

Note that with whole life insurance, the premiums are divided.

This sees a section of the premium moved to the insurance company’s general assets which in turn ensure that minimum death benefits are paid out.

The cash value of the policy is then in a separate account.

It will consist of the balance of the premium.

This cash value is never guaranteed due to the reason that the money in the separate account’s value will change.

If the client continues to ensure that they pay their premiums, the death benefit defined in the policy will always be paid and never be below the minimum amount stipulated.

It can, however, be more than this thanks to investment results.

Variable life insurance is seen as a security because of the fact that there is investment risk for the section of the premium that is kept in a seperate account as we have described above.

Even if the separate account goes down in value, the policy will remain in effect for as long as the client is paying their monthly premiums.

In terms of the separate account, it has various subaccounts that can be chosen.

It’s in one of these that the net premium will be deposited.

The net premium total is worked out once all expenses have been taken off.

The subaccounts include:

  • Growth
  • Income
  • Balanced (a mixture between income and growth)
  • Index or indices
  • Money market

Lastly, for most life insurance policies, no income taxes are applied to death benefits when activated.

Variable life prospectus delivery

It’s an insurance product as well as a security and it’s for that reason that a prospectus must be delivered to any new client that takes out a variable life policy as would have to be done with any new issue.

The prospectus cannot be changed in any way, for example, highlighting certain aspects for the client to see.

As for delivery, well at the time of solicitation, a prospectus must be made available to a client.

Variable death benefits and assumed interest rates

Annually, a variable life policy’s payable death benefit will be adjusted.

This means that it can go up or down and this depends on the comparison between the AIR and the separate account’s overall performance.

There’s an advantage for the policyholder here too.

That’s due to the fact that as a way to keep up with inflation, there might be an upwards adjustment in the death benefits from time to time.

When compared to the AIR, should greater returns occur in the separate account, any extra earnings will see the cash value of the policy as well as the death benefits increase.

If the AIR and returns on the separate account are equal, the death benefit won’t change.

This is because the estimated expenses meet the actual earnings.

Finally, should the separate account perform poorly and the returns be below the AIR, then death benefits will drop.

Again, it’s important to note, however, that it can never go lower than the minimum guarantee as set out in the policy.

Illustrating hypothetical returns

We’ve established that the separate account’s investments are linked to the cash value of the policy and this must be calculated at least once every month.

It’s similar to the death benefit too in the fact that it’s impacted by the performance of the separate account.

This means it fluctuates, moving up and down in relation to that performance.

It can even drop right to zero should the performance on the separate account be poor over an extended period of time.

For the cash value for variable life insurance products, hypothetical returns can be illustrated with a maximum of 12% for the gross return as long as a client is also shown what a 0% return looks like.

Either by taking a loan or surrendering the scheduled premium policy, a client may access the cash value of that policy.

There are a few things to note about variable life policies and the AIR.

First, the cash value accumulation is not affected by it, only the death benefit.

So as long as their seperate account performs well, the cash value accumulation goes up.

As for the relationship between the death benefit and the air, well we’ve covered that above, but here’s a quick recap, because it is important:

  • In the year in which it’s measured, the death benefit will go up should the separate account performance be higher than the AIR.
  • There is no change in the death benefit should the AIR and the separate account performance be equal.
  • The death benefit will go down should the separate account performance be lower than the AIR.

Loans

If money has accumulated in the contract, a variable life policy is similar to a traditional whole life policy in the fact that the holder can choose to borrow money against the cash value.

These loans are free of any income tax payments.

That’s due to the fact that they are not seen as a constructive receipt of income but there are still some restrictions in place.

For example, for most variable life policies, when the insured person looks to borrow from the cash value, it will never be the full amount that has accrued.

It’s only a certain percentage.

If the policy has been ongoing for three or more years, the amount that is made available is 75% of the cash value.

If a loan is taken like this, there is no structured repayment schedule at all.

However, should the policyholder die and there is still money outstanding, that total will be taken off the death benefit amount before it is paid out to any beneficiaries.

This type of loan will have its associated interest rate laid out in the prospectus.

Should the cash value drop to a negative amount while a loan is outstanding, then the policyholder must ensure they deposit money into the account to rectify this.

This doesn’t have to happen straight away, however, as they have 31 days to do so.

Termination of the contract is carried out by the insurance company should they not deposit the required amount.

The loan will not then need to be repaid.

Contract exchange

A client can choose to swap their variable life policy for a fixed-benefit whole life policy but this can only happen early on in the life of their policy.

While the time frame in which this can be done will vary depending on who they have taken their policy out with, it may not be less than 24 months.

Should an exchange take place, certain guarantees are in place for the policyholder.

For example, the contract length, as well as the date, will stay the same.

The variable life contract’s minimum death benefits are carried over as well.

No evidence of insurability is required for this exchange to take place either.

As for the premiums, well they are treated as per the original contract.

Often, the Series 6 exam will include questions on contract exchanges.

The most important points to know regarding these are:

  • A policyholder must be allowed to exchange their contract should they wish to for a minimum period of 24 months after having taken it out
  • Insurability evidence, for example, medical underwriting, is not necessary should the policyholder wish to make the exchange

Sales charges

These are linked to the payments made during the fixed-premium variable life contract’s overall lifespan which is usually a maximum of 20 years.

They may never exceed 9% of those payments.

As far as renewal commissions go, it’s right up to the 20th anniversary of the policy issue that they can be earned.

Refund provisions

For new policyholders, a free look period is mandatory and must be provided by an insurer.

The length of time for this, however, is whichever is longer of a 10-day period when the holder received the policy or 45 days of the execution of the policy application having taken place.

Should the policyholder choose, they are free to terminate the policy during this period.

Any payments they might have made must be refunded to them as well.

There’s a two-year period from when the policy was issued that certain refund provisions must extend as well,

Should a policyholder decide to end the contract they will receive the cash value of the contract.

This is determined after the point at which the redemption notice goes to the insurer.

Note that a certain percentage of sales charges will be taken off this cash value.

Should the two-year period pass, all sales charges are kept by the insurer with just a refund of the cash value taking place.

Refunds and sales charge questions often appear in the Series 6 exam.

Here are the critical facts to remember:

  • Over the duration of a contract, sales charges can never be more than 9%
  • If within 45 days the policyholder requests a refund, they must have all money paid returned to them
  • The cash value of the variable life policy is the surrender value should it have been in operation for two years

Variable life insurance suitability

We’ve covered suitability for various securities and other products and it’s no different for variable life cover.

It’s up to the registered representative to ensure that in terms of suitability, this type of cover is exactly what a client needs.

To start, the most important thing in terms of suitability is whether life insurance is needed.

Once you’ve determined that, the client needs to be informed about the fact that there is no guarantee to the cash value of the policy while they will also need to understand how the separate account works and be happy with that.

The variable death benefit feature is also critical and that must be clearly understood as well.

Lastly, the client must receive a prospectus.

This can be during solicitation or before.

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