Series 66 Study Guide Navigation

There are many investment vehicles available to those who work in the securities industry and in this module we look at them and the characteristics that make them unique. 

A. Fixed income securities: Valuation factors

Let’s start with fixed-income or debt securities as they are also known. 

When we talk about these types of securities, think of a bond which ultimately is a contract with two parties involved. 

First, we have the issuer, who is the borrower and then we have the investor, who is the lender. 

Debt financing over the long-term, usually a period of 20-30 years. 

The pricing of bonds

Let’s look at how the prices for government and corporate bonds are worked out.

When we talk about par value for these bonds, remember that it is always $1,000.

Municipal and corporate bonds

When these bonds are quoted, it’s always a percentage of 100 (which is par) or $1,000.

A bond point will equal $10 and they are often quoted in fractions which are in eighths or $1.25.

So a bond at 901/4 is equal to $902.50 in monetary terms.

Government bonds

It’s at a percentage of par that these bonds are also quoted at. 

In this case, however, while a bond point is also $10, 0.1 is equivalent to $0.3125 or 1/32.

So if a government bond is quoted at 90.8, that is worth $902.50. 

Rating bonds

Ratings can play a major role in determining which bonds investors choose to invest in.

In order to determine the relative safety of a debt security they might wish to purchase, one should look at the overall strength of the borrower.

Collateral can further increase the loan’s strength.

Many investors turn to rating services to determine how safe a debt security is for their clients.

For the exam, Moody’s and S&P ratings are often tested.

Let’s look at their rating systems


  • Aaa – Highest quality bonds
  • Aa – High quality bonds
  • A – While their security of principal and interest is adequate currently, Moody’s think that in the future, they may be impaired
  • Baa – These bonds are considered to be neither poorly secured nor very well protected. They are medium grade bonds.
  • Ba – The future of these bonds is not considered to be well assured by Moody’s. As far as quality goes, they are seen as speculative.
  • B – These bonds are seen as having any characteristics that would make them a suitable investment target
  • Caa – These bonds may be defaulted and are considered by Moody’s to be in poor standing
  • Ca – These bonds are often in default and considered by Moody’s to be speculative
  • C – These are the lowest rating bonds in the Moody’s system. They are not considered to offer any investment value at all.

Standard and Poor’s

  • AAA – Highest quality bonds
  • AA – Debt obligations of high quality
  • A – While they may be affected by other influences, these bonds are considered to be more than capable of paying both principal and high interest.
  • BBB – The capacity to pay interest and principal on these bonds is considered by S&P to be adequate. Changing circumstances as well as unfavorable economic conditions can make them more vulnerable.
  • BB – With limited positive investment characteristics, these bonds are of lower medium grade
  • B – When exposed to unfavorable conditions, these speculative bonds are filled with major risk and uncertainty
  • CCC – These bonds may be defaulted and are in poor standing
  • C – No interest is being paid on these income bonds
  • D – Bonds with this S&P rating are in default.

Investment-grade debt

The top four categories in bond ratings (BBB or Baa and higher) are also called investment grade

These are often sought after when purchased by institutions such as insurance companies or banks, for example. 

They are far more liquid than lower-grade bonds. 

High-yield bonds

Lower-grade bonds are often called junk bonds.

While they are riskier than their higher-rated counterparts, they can offer high yields.

Because of that, they are often called high-yield bonds.

As mentioned, because they are lower rated than BB or Ba, there are other risks that are associated with them.

The main risk here is that they may default while price erosion is also a concern during an economic downturn. 

In terms of overall creditworthiness, well that could be a problem too. 

Calculations for bond yields

In this section, we look at how various bond yield calculations are carried out and what information they can portray.

Nominal yield

The nominal yield, sometimes called the coupon rate, is shown on the bond certificate as the interest rate of the bond as a percentage of its par value. 

From it, you can work out the bond’s annual interest payment in dollars by taking the nominal yield and then multiplying it by the face amount of the bond, which is always $1,000 unless told otherwise. 

For example, a bond will pay out $70 per year if it has an interest rate of 7%.

This is a fixed amount each year and because of this, bonds are called fixed-income investments.

Current yield

Return on investment is something that all investors want to know. 

You can work it out in an easy manner by taking the return and dividing it by the investment. 

The annual interest in dollars is always going to give you the return value (for a stock, this will be the dividend in dollars). 

As for the investment, well that is the current market price, or in other words, the investment that would need to be made for an investor to own the security.

This provides us with the current yield/return. 

The price of bonds will fluctuate on the market although, when issued, it is always with a face/par value of $1,000.

Always remember that there is a movement in opposite directions of a bond price and yields. 

Bond prices will drop when interest rates increase. 

Premium and discount

When bonds trade at a premium will see their current yield go down while those trading at a discount see their current yield go up. 

So remember this:

  • An investor is getting less if they pay more 
  • And they are getting more if they pay less

In other words, an investor will receive a rate of return lower than the coupon yield (or nominal yield) stated on the face of a bond if buying at a premium.

The opposite is true if they buy a bond at discount. 

As for par value, well we know that the annual interest rate is based on this dollar amount but it’s also what the investor receives once the bond matures. 

So an investor will receive an amount more than what they paid for the bond if they hold it to maturity and if they bought it at a discount originally. 

The opposite is true if they bought the bond at a premium and hold it to maturity. 

Yield to maturity

This gain or loss that an investor will receive at maturity is reflected in what is known as the yield to maturity, also known as true yield. 

So if an investor bought a bond at $800 (discount), at maturity, they will receive $1,000 for it. 

They will receive the interest that the bond generates every year. 

If they bought it at $1,200 (premium), they will lose $200 at maturity on the bond’s value but they will still gain the interest it generates along the way to reaching maturity. 

Here’s some key ideas to understand about this:

  • A bond is issued at par of $1,000 and this is what the issuer is borrowing.
  • A fixed percentage of the par or face value of the bond is what is paid out as interest on the bond to the investor. 
  • This interest amount will never change, no matter how the market value of the bond goes up and down. 
  • Supply and demand determines the current market price for a bond
  • The market price of the bond can be above, below, or at par
  • When a bond matures, it is always at par
  • When a bond is purchased at par, at maturity, the amount paid for the bond originally is what the investor will receive back
  • If they bought the bond below par (at a discount) they will receive more at maturity than they originally paid.
  • If they bought the bond above par (at a premium) they will receive less at maturity than they originally paid.

Yield to maturity (YTM) is higher on a discounted bond than the current yield of that bond and if the bond is bought at a premium, the reverse is true. 

Yield to call (YTC)

Some bonds have call features.

This means that before the bond reaches maturity, the issuer thereof can make the decision to call the bond. 

The call price when this occurs can never be at a discount, only at par or at a premium. 

When it comes to calculations relating to YTC, the calculations will show that the bond was called early as well as the premiums accelerated loss from the purchase price of the bond. 

The bond’s rate of return from the date it was purchased until the date it was called and priced is the YTC value.  

When compared to YTM, this will be a lower return.

Summary of the relationship between price/yield

Interest rates rise and fall and there are several reasons why they do. 

For the exam, the main area of concern is that price fluctuations when it comes to bonds are as a result of changes in interest rates. 

Just remember that they always move in counter to one another. 

So when compared to bonds that have been in the marketplace for an extended period of time, newly issued bonds that pay a higher interest rate are more attractive. 


This measures a debt security and its overall sensitivity to changes in interest rates. 

So a longer duration means that the market price movement is greater and a shorter duration means that it is less. 

Overall, the computation to measure duration is pretty complex, but let’s simplify it a little. 

The main element here is the investment principal and what duration measures is the time that it takes for the cash flow, for example, interest payments, to repay it. 

For the most part, the duration will be shorter if interest rates are higher than when they are lower. 

Two elements are important in these calculations.

They are the maturity date and the interest rate. 

So when we compare two bonds with similar maturity dates, the one with the shorter duration will be paying the higher interest rate. 

What if the coupon rates are the same?

Well, the bond that matures first is then the one that will have the shortest duration.  

While the computation of duration isn’t something that’s tested, you should understand how it will work. 

You will need to look at the interest and repayment of principal (or the present value of the future cash flows of the bond) which is weighted by the length of time till their receipt and divide this by the current market value of the bond.

Note that a shorter duration and less market volatility is attached to a higher present value rate. 


When we talk about duration, we also need to touch on the subject of convexity.

When plotting a bond’s price movements as interest rates change, this is the resulting curve and the measurement thereof.

When the changes in interest rates are significant, convexity provides us with a far more accurate analysis of what’s happening to the price of a bond than duration can. 

Here are three points that you should know about convexity for the exam:

  • Convexity measurements are a curve, while duration provides us with a linear measurement
  • A bond with a higher convexity in comparison with another means that yield falls with a greater price increase. With a small decrease, yields will rise, which is what you are looking for.
  • If two bonds have the same duration, the one that’s the better option would have the higher convexity. This is because compared with the other, it has better protection against interest rate fluctuations. 

Discounted cash flow (DCF)

By looking at the free cash flow that a fixed-income security will generate in the future and discounting it to arrive at the present value,  you have a tool that can help you assess its value. 

Free cash flow includes two elements in the form of the principal that’s returned eventually as well as the interest payments received. 

Simply put, you look at the given future period for the investment and take all the money that it will generate.

Then take the time value of money and adjust it with that in mind. 

To calculate DCF, you must have knowledge of the following three variables:

  • Principal amount
  • Coupon rate
  • How many interest payments will be received

B. Equity securities: Valuation factors

When it comes to capital markets, equity securities are extremely important. 

In this section, we are going to look at the various valuation factors and the ways in which they are analyzed.

Let’s start with a bit of background first, however. 

When buying equity securities, investors are buying equity (or ownership) of the company that’s issuing the stock. 

That ownership allows them to take part in the prosperity of the company as earnings are shared with stockholders in the form of dividends.

They benefit too when the company does well and the price of their shares increase.

We are not going to go into too much detail here, but buying into a company by purchasing stock can happen in a few ways.

Investors can purchase:

  • Common stock
  • Preferred stock

Equity securities: Basic features

Here’s some of the basic features of equity securities that you should remember. 

Capital gains

Capital appreciation is the increase in the market price of securities owned.

Over the years, those investors who purchase common stock will see that investment providing returns, when compared to inflation, are higher. 

In fact, common stock is often used as a hedge against inflation by investors. 


Equity securities provide investors with a form of income and this comes as a result of the dividends that they pay out. 

As profitability increases, over time, these dividends may well increase too and this is one of the major reasons why investors buy company stocks.

That being said, a corporation doesn’t have to pay dividends to its stockholders which is unlike the interest payments that debt securities generate for investors.

Stockholders rights

Those that hold stock in a company have certain rights.

For example, they can participate in the voting process when it comes to selecting a board of directors. 

The stock they hold can also be freely transferred to someone else.

They could be buying it, for example, or it can even be passed on as a gift. 

Limited liability

Both common stock and preferred stock offer limited liability.

This means that should the corporation the investor holds stock in go bankrupt, the personal assets of the investors are not at risk.

They might lose their investment made in the corporation, however. 

Determining the value of equity securities

Now that we have a background regarding equity securities, let’s look at the ways in which analysts can determine their value.

There are two approaches that are used: technical analysis and fundamental analysis.

The fundamental analysis approach will evaluate:

  • Economic trends that are broad-based
  • Current business conditions in the particular industry they are studying
  • The finances and management of the particular corporation

The technical analysis approach will evaluate:

  • Based on price and trading volume patterns, the direction the price of the security is moving
  • This doesn’t take into account the profitability of the issuer

Let’s look at this in more detail.

Fundamental analysis

So we know that this looks at an individual company and within the context of the industry it operates as well as how the overall economy is doing, looks at the overall business prospects thereof.

This is carried out by looking at the company in minute detail, which includes not only the financial aspects of it, but also those running it. 

The value of the common stock of the company is determined using dividend models, for example, but another tool used here is the P/E ratio, especially as a way to determine stock market pricing.

Let’s talk a little more about the dividend discount model

There are two elements critical to this model: the current market value of the company stock and the present value of all future dividends.

The model says that these should be equal. 

So, the expected future returns of the investors (in the form of dividends) is discounted to give us the present value. 

Don’t worry about knowing the formula for the exam, but this can be worked out by taking the annual dividend and dividing it by the expected turn (also called the required rate of return). 

Here’s an example:

Let’s say a stock is paying investors a dividend of $1.20, while 6% is the required rate of return in the marketplace. 

This means that (1.20/0.06) gives us a stock that should be worth $20. 

Anything priced below that is undervalued while anything priced above it is overvalued. 

There’s another model used when it comes to dividends and that’s the dividend growth model

With this model, the assumption is made by analysts that it’s at a constant rate that the amount of the annual dividend will grow. 

Overall, it’s with other forecasting tools that this model works best. 

When dividends are expected to grow, the computed value will be higher. 

Technical analysis

The focus of technical analysis is not the company, but instead the market itself.

So it looks at particular security and then will attempt to measure the market risk linked to it.

This isn’t long-term, but more of a short-term analysis.

For example, it’s over a period of four to six weeks that this method looks to try to predict trends in stock prices. 

Technical analysis makes predictions based on trends in the current stock price and its relationship to trends that occurred in the past. 

The movement of these trends are plotted on charts over time, so all the information is easily available, including previous price trends. 

Using these charts, technical analysts will then try to determine movements in price in the future.

They do this as a way to try and minimize timing risk so investors don’t purchase stock at the wrong time. 

In an attempt to validate trends, the volume of stock that traded in the past also comes into play. 

With technical analysis, there are some key terms that you should note.

First, it’s trendlines

By charting where the stock has been in the past from a price perspective, analysts can try to predict where it is going. 

By drawing a trendline, they can use their chart to determine what a particular trend has been. 

Next, we look at support and resistance

By studying the chart relating to a specific stock, technical analysts can tell much about it. 

In particular, there are two conclusions that they will look at in particular and these relate to support and resistance levels.

Where the price of the stock bottoms out is the support level.

At this point, an imbalance exists between the number of investors buying the stock as opposed to selling it.

In other words, there are more investors wanting to buy than those currently selling.

When this happens, the price of the stock will start to rise. 

The opposite of this is the resistance level. 

This is when the price of the stock reaches a high point and there are far more sellers than buyers. 

At this point, the price of the stock will no longer rise. 

When either the support or resistance level is penetrated by the movement of the stock price, this is commonly termed a breakout. 

When this occurs, analysts will predict a price movement that rapidly goes in the breakout’s current direction. 

This will continue until either a new support or resistance level has been established. 

A good buying opportunity exists when a breakout through resistance can be spotted early enough. 

The opposite is true for a breakout through a support level and here, if spotted early enough, an opportunity for short sellers to make a profit is available. 

Lastly, there are moving averages

This is used by analysts to look at stock price trends and the volatility that’s frequently present in them and does so by trying to modify fluctuations in the price into a smoothed trend.  

Here’s an example of determining the average closing price of a stock over a 13-week period.

All the analyst would do is look at what the stock closed at on a Friday for the last 13 weeks, add those prices all together and divide by 13 to get an average.

They would then plot this on a graph and from that point on, in the next week, they would delete the first closing price and add the new one.

The same calculation would be carried out to work out the new average for the rolling 13-week period. 

When the price of the security crosses over the moving average, a change in the trend of the stock price plotted can be identified.

So if the price drops under that of the moving average, the market is usually changing from a rising one to a declining one and vice versa.

Technical market theories

When it comes to market trends, there are a number of theories that technical analysts follow.

Let’s look at some of them. 

Short interest theory

Here, the analyst is particularly interested in the number of shares that have been sold short. 

The reason for this is that eventually, short positions will have to be repurchased at some point in the future. 

This, analysts believe, sees a support level for stock prices that is created by mandatory demand and short interest will reflect that. 

It’s important to note that a bearish indicator is low short interest while high short interest is a bullish indicator. 

Odd-lot theory

When it comes to odd-lot trading, it’s usually small investors that will be involved.

With this form of trading, transactions are usually lower than 100 shares. 

The theory with this, however, is that small investors often get it wrong in terms of the right time to buy and sell. 

So odd-lot analysts are typically bearish when odd-lot traders are buying shares and bullish when they are selling shares. 

Advance/decline theory

Market breadth is reflected by the number of issues that close up or down on a specific day. 

The relative strength of the market can be indicated through the number of declines or advances technical analysts believe. 

Even if the market is closed higher, it is believed to be bearish should the number of declines outnumber advances by a significant amount.

When advances outnumber declines by a significant amount, then the market is bullish. 

Using a graph, technical analysts will plot the daily advances and declines.

This will establish an advance/decline line and helps show an indication of trends in market breadth. 

C. Pooled investments: Evaluation

Pooled investments include a vast range, from mutual funds to ETFs, REITs, and others. 

They are called pooled investments for the simple fact that a number of investors contribute to these fund pools. 

The first type of pooled investment vehicles we are going to look at are investment companies.

Investment company types

There are three main types of investment companies:

  • Face-amount certificate companies (FACC)
  • Management investment companies
  • Unit investment trusts

Let’s expand on that a little.


With these, the investor and the issuer have a contract between them. 

This guarantees the investor that at some specified point in the future, they will receive a payment of a fixed sum. 

The investor has to, however, pay a fixed sum to the issuer (or periodic installments) to receive this fixed sum.

Management investment companies

Of all the investment company types, this is the most familiar. 

Here, a stated investment objective is the goal and a portfolio that’s actively managed is the way in which it is achieved. 

These types of investment companies can either be open-end (like a mutual fund) or closed-end. 

While both types will sell shares to the public initially, they are different in several ways. For example, they raise capital differently and how investors are able to purchase and sell shares is different too (either the primary or secondary market).


We will cover UITs in greater detail later in this guide, but they include a portfolio that is fixed and usually comprises both bonds and stocks. 

In other words, they can provide either dividend income to investors or capital appreciation. 

Investment Company Act regulations

There are various regulations as set out in the Investment Company Act that investment companies, like mutual funds, have to abide by. 

Here are some that you should remember for the exam.

Board of directors

To start, only up to 60% of persons who can be defined as interested persons in the investment company can serve on the board of directors. 

In other words, at least 40% of the board must be made up of directors that are considered as outside directors which are usually respected community members and academics.  

Prohibited activities

Below are various prohibited activities that investment companies may not partake in: 

  • Securities cannot be purchased on margin
  • No joint accounts that trade in securities
  • No selling securities short
  • When it comes to other investment companies, no buying of more than 3% of their outstanding voting securities

Investment policy changes

A majority vote of outstanding stock would be required if any major investment policy changes are to be made.

These changes include the following:

  • Subclassification changes. This includes changing from a diversified to a non-diversified company but could also be a change from open-end to closed-end, for example. 
  • Veering from any fundamental policies as outlined in the registration statement. An example of this would be changing the stated investment objective. 
  • Ceasing to be an investment company by changing the overall nature of the business

Investment company size

Only registered investment companies with a net worth of $100,000 are allowed to make a public offering of securities. 

Underwriting and investment advisory contracts

When a contract between the company and either an investment advisor or principal underwriter is entered into, this can only be done through a majority shareholder vote. 

These contracts must be in writing and they must 

  • Indicate how compensation will be paid
  • Be approved each year. This will be either from a majority vote of shareholders if renewal takes place after two years or by the board of directors
  • Include provisions that it can be terminated at any point without incurring a penalty, either by a shareholder majority vote or by the board of directors, and with a written notice of 60 days

Underwriter and affiliated person transactions

Individuals that are affiliated with the underwriter or the investment company cannot:

  • Sell any securities to the fund that they own personally (they may redeem shares of the fund they own, however) 
  • Borrow fund money
  • Buy other securities of the investment company, only the shares of the fund


Assets of all registered investment companies must be kept with a custodian which usually is a bank but can be a broke-dealer as long as they are a member firm of a securities exchange that operates nationally. 

Mutual funds – Redemption of shares 

Within seven days of having made the request, investors in mutual funds should receive their proceeds as per law.


Annual financial reports must be filed with the SEC by all investment companies and will include both a balance sheet and income statement that has been audited. 

Financial information must also be sent to shareholders twice a year. 

Management investment company capitalization

When it comes to capitalization, there are differences between open-end and closed-end investment companies. 

Initial capitalization: Open-end investment companies

When we talk about this kind of investment company, we are referring to a mutual fund. 

They will never give an actual number and when registering with the SEC, it will be for an open offering. 

By continuously issuing new shares, they are able to raise an unlimited amount of capital. 

This does mean, however, that it’s new issues that mutual fund investors are purchasing in the form of these primary offerings. 

Also, this is only common stock because that’s all that an open-end company can issue. 

With the money raised, those managing the portfolio will look to the fund objectives and only invest in securities that meet them. 

Initial capitalization: Closed-end investment companies

A common stock offering is how a closed-end investment company will raise capital. 

To start, a fixed number of shares will be registered with the SEC for the initial offering.

These are offered through an underwriter (or group) to the public, but it is for a limited time only. 

Unless an additional public offering is made at some point down the line, the fund’s capitalization will be fixed. 

Because they also issue preferred stock and bonds, a closed-end investment company’s capital structure is similar to that of other corporations. 

Management investment company pricing

Let’s move on to the differences in the way that open and closed-end investment companies are priced. 

You would have seen that closed-end investment companies are also known by the term publicly traded funds. 

This is because, once the stock is distributed, it can then be traded on the secondary market (both OTC and on exchanges). 

The bid and ask price for this stock is solely determined by supply and demand and shares will trade at either a discount or premium to the NAV. 

With open-end investment companies, investors buy shares directly or from underwriters. 

These will be purchased at the public offering price (POP). 

To determine that, the NAV (which is calculated daily)  is taken per share and then relevant sales charges are added. 

As for the NAV per share calculation, that’s done by taking the fund’s NAV and then dividing the number of shares outstanding into it. 

Securities sold by open-end investment companies are known as redeemable securities.

This means that the company will redeem the shares at their current NAV when an investor opts to sell them.

When investors do redeem shares, the capital in a mutual fund will shrink.

Unlike stock, investors can purchase shares in a mutual fund in both full as well as fractional units. 

Here’s a handy table comparing open and closed-end investment companies.


  • Capitalization: Shares can be offered continuously, so this is unlimited
  • Issues: Common stock
  • Shares: Both full and fractional are available to investors
  • Offering/trading: Sold by the fund and redeemed by the fund only. The primary offering is continuous and shares must be redeemed
  • Pricing: NAV (with sales charge). The price will never be below the NAV and is worked out using a formula that is found in the prospectus


  • Capitalization: Single offering of shares, so this is fixed
  • Issues: Includes common stock, preferred stock, and debt securities
  • Shares: Only full shares are offered
  • Offering/trading: Starts with a primary offering after which shares can be traded on exchanges or OTC. Shares are not redeemed
  • Pricing: Shares are priced at what the current market value for them is as well as added commission. Supply and demand will determine the price which could be below, at, or above NAV. NAV calculations are carried out for closed-ended funds once a week

We also need to mention forward pricing

We know that the NAV is computed once per day for open-end investment companies and this occurs at the close of markets. 

The forward pricing principle is used as a way to base the price determination of purchases and sales. 

This means that when an order to purchase or redeem shares comes in, it’s carried out at the price per share which will be taken from the next NAV computation. 

Share classes and loads: Mutual funds

Let’s look at the various share classes for mutual funds and the different loads that investors will be charged for them. 

Note that SEC regulations stipulate that when members underwrite open-end investment company shares, sale charges can not be higher than 8.5% of the POP. 

If an investor wants to know the exact schedule relating to sale charges, they can find this in the prospectus. 

An investor’s returns will be lowered by charges such as sales loads and management fees as well as operating expenses. 

For the most part, mutual funds are normally associated with front-end fees up to 8.5% but funds make use of back-end fees too.

These are only then charged when an investor withdraws money out of the fund. 

Under section 12b-1 of the Investment Company Act, funds can also charge ongoing fees as a way to pay for marketing and distribution costs. 

All funds will have an expense ratio and this shows both operating expenses and management fees expressed as a percentage of the net assets of the fund.

To work the expense ratio of a fund out, two elements are needed. 

First, the annual operating expenses of the fund and then the fund’s assets under management and the net dollar cost thereof. 

When making this calculation, you won’t have to include the sales charge as this is not considered to be an expense. 

Fund share classes

There are various class shares that are offered by mutual funds and through these, an investor can make a choice as to how they will pay their sales charges. 

  • Class A shares: Because these have a front-end load attached to them, it’s at the time of purchase that the investor will pay the charge
  • Class B shares: These are back-end loaded funds so the investor will pay charges once they redeem shares 
  • Class C shares: These shares have a level load. At purchase, there is no sales charge but they will have continuous 12b-1 charges as well as, for a period of a year, a 1% CDSC charge. 

Usually, Class C shares will have the lowest charge. 

Sales charge reductions

It’s possible for investors to receive reductions in sales charges in several ways. 

Two of the most important are:

  • Breakpoints: This is based on the amount invested. The more an investor puts in, the more the sales charges will decline when they reach certain breakpoints. 
  • Rights of accumulation: Here, breakpoints can be reached when investors are allowed to aggregate their shares in related accounts, This would be in a fund family, for example. 


A breakpoint schedule would look something like this:

  • Purchase amount: $25,000 to $49,999 | Sales charge: 5.5%
  • Purchase amount: $50,000 to $99,999 | Sales charge: 5%
  • Purchase amount: $100,000 to $249,999 | Sales charge: 3%
  • Purchase amount: $250,000 to $449,999 | Sales charge: 2%
  • Purchase amount: $500,000 to $999,999 | Sales charge: 1%
  • Purchase amount: Over $1 million | No sales charge

There are various ways in which investors can qualify for these breakpoints, for example, for those that can, a large sum of money can be invested straight up. 

For example, $500,000 to reach the 1% breakpoint on their transaction.

Or, they can use a letter of intent, which we will look at a little later. 

There are stringent regulations in place when it comes to breakpoints and investors must be made aware of when they are approaching them.

In other words, as a way to earn a higher commission, the next breakpoint cannot be kept from an investor. 

We spoke earlier about a letter of intent (LOI).

This is another method in which investors can reach certain new breakpoints. 

When an investor signs a LOI, they are committing to reaching new breakpoints by adding more funds to their investment down the line.

In terms of the regulations regarding a LOI, the investor has up to 13 months to add these funds. 

This allows them to purchase extra shares but until the LOI is completed and the funds they have committed to paying are paid, the extra shares bought will be held in escrow. 

Regulations also allow for the LOI to be backdated.

This means that after the initial purchase has been made, the investor can opt for a LOI up to 90 days afterwards and so, prior purchases can be included. 

The 13-month period is still in effect, however, and prior purchases cannot extend beyond this time frame. 

Private funds

Let’s move on to the various characteristics associated with both venture capital and private funds. 

These are not the same as investment companies.

The reason for this is that they have limited ownership. 

Also known as  3(c)(1) funds, there as some key regulations you should remember about them:

  • The fund can only allow 100 investors or less
  • These investors must be considered as qualified

On occasions, a 3(c)(7) provision allows exemptions in terms of the number of investors allowed in these funds.

If they have this provision, the fund can allow up to 1,999 investors. 

In terms of their overall organization, most private funds are in the form of partnerships. 

There’s a special type of private fund that we should mention called a hedge fund, but we will look into these in a bit more detail later on. 

Private funds come in two main categories:

  • The first type are those where direct investments are made with the objective of management of the operating company as well as impacting the operation thereof
  • The second type are those that don’t have a controlling position and instead have a portfolio that consists of a range of securities

Venture capital funds

When a venture capital fund is structured, it’s generally as a limited partnership. 

The capital for these funds is provided by the limited partners (LPs) while the general partner will make the investment choices.  

While individuals are included amongst those who make up the LPs, they can be other funds too, like pension, endowment, or hedge funds. 

Generating high returns is the aim of most of these types of funds.

To do so, they won’t invest in companies that have already established themselves, but in those that are relatively new and have the potential for massive growth.

This is usually done with an exit plan in place as well as a time frame of around a decade. 

Venture capital and private equity funds have one feature in common: the compensation paid to the fund manager.

This is referred to as carried interest and is usually paid annually as a management fee which is calculated based on capital committed to the fund. 

The usual amount is 2% of that capital but the fund manager also receives part of the profits generated, normally around 20%. 

Hedge funds

Hedge funds, which allow for 100 investors or less,  are not SEC-registered but those portfolio managers that govern them need to be.  

When it comes to the way that they are organized, hedge funds are limited partnerships but are a little less transparent than mutual funds and don’t need a prospectus either. 

They also won’t need to register with the SEC. 

In terms of investment strategies, when compared to open or closed-ended funds, hedge funds take a riskier stance which includes using arbitrage strategies, using leverage as well as derivatives. 

Their overall goal, however, is the reduction of volatility and risk while preserving capital, no matter what the conditions of the market, ensuring that investors are delivered positive returns. 

In terms of compensation, hedge funds make use of a 2&20 system. 

This means that a management fee of 2% is charged but any profits generated sees 20% taken by the fund as well. 

From time to time, hedge funds might include a hurdle rate that comes into effect when a certain threshold is reached, for example, 6%.

If this is indeed the case, extra incentive fees are then paid to the fund managers for reaching that point.  

When it comes to hedge funds investments, there are rules in place in terms of how long investors will have their funds tied up in one. 

Termed a lock-up provision, because of this, when compared to other investment types, hedge funds don’t offer much liquidity. 

Why investors’ money is kept with a certain time frame in mind is to ensure that the hedge fund has enough capital available for fund managers to make use of. 

While institution clients and individuals can invest in hedge funds, they must be accredited investors.

There’s an indirect manager for regular investors to take part but this only occurs with a mutual fund of a hedge fund. 

These are an excellent way to add portfolio diversification while they are more liquid as well. 

Unit investment trusts (UITs)

Organized under a trust indenture, UITs are not management investment companies.

This means they don’t have a specific investment advisor that runs them and neither do they have a board of directors. 

Because they don’t have an investment advisor that runs them, they are therefore not actively managed and do not trade in securities. 

So how do they work?

Well, UITs issue redeemable securities.

These are also called shares of beneficial interest or units.  

The investor is buying an undivided interest in specific securities in a portfolio when they buy a unit.

The capital the investor puts into a UIT purchases the securities that will help meet the trust’s stated objective. 

As for the portfolio, well once it is set up, it won’t change at any point as it is considered to be fixed. 

Exchange-traded funds  (ETFs)

When we talk about ETFs there are two types: Unit investment trusts or UIT EFT and open-end ETFs with both types requiring SEC registration. 

ETFs will invest in a specific index and calculate their NAV daily like other open-end companies. 

As for what they invest in, well there’s quite a range.

For example, it will include stocks and bonds but ETFs can also invest in real estate and commodities, for example.  

There are many similarities between EFTs and index mutual funds but differences do exist.

ETFs, like stocks traded on an exchange, are traded in the same way, and in that sense, are similar to closed-end investment companies.

The investor gains from market-induced price changes rather than just the stock’s intrinsic value.

Recently, actively traded ETFs have become extremely popular. 

Unlike normal ETFs, they are not passive with managers selecting an index that they will try to mirror the assets of. 

EFTs are like other listed stocks in the fact that they can be bought on margin and sold short according to regulations. 

In terms of benefits for investors, well they have tax advantages.

For smaller investors, they are a better option than a no-load index fund, especially if they are wanting to invest regularly. 

That’s due to the fact that all trades made will be charged a commission by the ETF. 

While an EFT is never thought of as a mutual fund because it doesn’t have redeemable shares, by law they are classified as UITs while some are also considered as open-ended companies. 

When it comes to their difference from closed-end funds, well the latter will see a price that differs from the NAV which is as a result of supply and demand.  

In late market activity, a premium or discount between the trading price of an ETF and its NAV will be seen with the difference narrowing the next day when trading begins. 

Real estate investment trusts (REITs)

Publicly traded REITs produce income for investors from real estate investments and offer an excellent option for portfolio diversification thanks to the fact that they are managed professionally. 

There are three types of REITs:

  • Equity REITs. These own commercial property
  • Mortgage REITs. The own commercial property mortgages
  • Hybrid REIT. These own a combination of the two

Organized as trusts, investors have the opportunity to buy and sell shares of REITs which can be found on stock exchanges as well as OTC markets.

They cannot be redeemed however, unlike UITs and mutual funds can be. 

As for federal tax rates, REITs have a hybrid status and that’s due to the fact that they are eligible for a dividend paid deduction.

For tax purposes, you should note that REITs are considered a corporation and are taxed in two ways. 

First, when dividends are paid out, they are taxed. 

Second, on the disposition of shares, gains will be taxed

Corporate taxes are never applied to them should most of their taxable income be paid out to shareholders.

In terms of this taxable income, this amounts to 90% of what they’ve received of which 75% must have been generated from real estate. 

Pooled investment: Benefits and risks  

Here are the benefits and risks associated with all the pooled investment types that we have looked at so far. 

Mutual funds

Let’s start with the benefits

First up, we look at diversification

Most investors will want a diverse portfolio of assets, and mutual funds allow that.

Second, fund managers mean they are professionally managed. 

These fund managers are SEC-registered and have to abide by the regulations set out by the governing body. 

Investors can also see the mutual fund objectives as set out in the prospectus and this is something the fund has to adhere to.

This means that various market parameters will be taken into account when the fund buys and sells securities. 

Third, funds have chosen objectives.

So no matter what the investors are looking for, there probably is a mutual fund to fit in with their investment needs.

Fourth, mutual funds are convenient for investors.

Because they are easy to invest in, mutual funds are an excellent option for those new to the investment game. 

Mutual fund investment can be controlled online and shares can be bought or sold with ease.

Fifth, mutual funds are very liquid

There are rules that investors will need to follow, however, should they want to redeem their mutual fund shares.

When they are redeemed, the price per share paid to them will be at the next computed NAV and within seven days, they will receive their payment. 

Sixth, mutual funds have a low initial investment.

You don’t need a massive lump sum to invest in a mutual fund and this again suites investors who are just starting out. 

Subsequent investments following the initial one don’t have to be massive either.

In fact, mutual funds allow investors to put in $100 if they choose. 

Seventh, they give helpful tax information.

Those investing in mutual funds will receive 1099 forms each year, provided by the fund itself.

This means that sorting out tax on a mutual fund isn’t complicated at all. 

From these documents, they will be able to determine whether distributions made by the funds are taxable.

The final benefit of a mutual fund is combination privilege.

Investors have access to more than one mutual fund offering when mutual funds are packaged as a family.

In other words, various breakpoints can be reached by buying into more than one fund of the same family.  

What about mutual fund risks?

It doesn’t matter how much management or diversification there is, changing market prices cannot be controlled.

Also, different types of mutual funds have different risks associated with them. 

For example, interest rate risk is something that you would associate with bond funds, while stock funds have to worry about market risk. 

Also, there is no maturity date when it comes to bond funds. 

While money market funds don’t move too much in terms of price, their disadvantage comes in the fact that they do not provide massive income for investors. 

Expenses and fees are also something to consider for mutual funds and there can be quite a few which may surprise investors.

They are:

  • Sales charges
  • Tax fees 
  • Management fees
  • 12b-1 fees
  • Redemption fees  

When looking at mutual funds with objectives that are similar, the following should be considered: 

  • Services offered
  • Experience of the fund manager
  • Costs
  • Taxation levels
  • How the fund has performed compared to the  benchmark  

Finally, let’s talk about net redemptions.

When there are more shareholder redemptions than the purchase of new shares, it results in a net redemption.

This will happen when markets are declining and because prices are falling, the manager of the portfolio will have to decide which assets to liquidate. 

Fund’s suffering from a net redemption don’t perform too well either. 

Private funds

We move on to the benefits offered by private funds.

Firstly, they provide an opportunity for large profits for those that invest in them. 

Timing is everything here, however, for example, investing in a company before it has matured and while it is still growing.  

When the first public offering is made, for those that have already invested in the company, the possibility of large profits lies ahead. 

Secondly, because of the way they are structured, investors can have a say in private funds.

This includes influencing the overall development of the company as well as the management thereof. 

Thirdly, private funds, when compared to the overall market, have a low correlation and this means they add diversification to a portfolio as well. 

What are the risks that come with private funds?

Well, to start, there’s business risk.

Startups can fail, so that’s a real concern for investors. 

An investor who invests in a start-up that fails may lose some or all of their money.

It is possible that this will happen since many start-ups fail.

The second risk is that of liquidity risk.

The secondary market for investors’ shares is rarely available, so their shares can be restricted.

Even when the company has made a public offering, that holds true for public funds.

The final risk is lack of transparency.

Securities for these funds are unregistered.

A regulatory body has not received or reviewed any offering documents with regard to them at all. 

Hedge funds

Here are the benefits for an investor when it comes to hedge funds. 

Firstly, hedge funds can generate positive returns, even in failing markets.

This is how they are designed to work.

Secondly, they provide investors with different choices.

No matter what their investment goals are, investors can look towards hedge funds to meet them thanks to the variety of investment options that they offer. 

Thirdly, they are an excellent means of reducing portfolio risk.

When they are part of an asset collection class, hedge funds offer ways that can lead to excellent returns while reducing volatility.

The final benefit of hedge funds is that they provide a level of diversification.

It’s possible to secure uncorrelated returns when an investor makes a careful choice in the hedge funds they choose. 

What about risks associated with hedge funds? 

To start, they are expensive.

That’s because hedge fund managers will not only charge an overall fund, but share in any profits generated too. 

Hedge funds are also linked to liquidity risk.

Investors aren’t able to access their money during the lock-up period of the fund but even after that, liquidity risk remains as the securities connected to them aren’t traded on exchanges.

There simply is no active secondary market when it comes to hedge fund securities. 

Our next risk is that investing in hedge funds could end up in a loss of capital.

This is simply because risky strategies when it comes to the investment choices made are how some hedge funds operate. 

The final risk is the necessity of partnership approval

Hedge funds are structured as limited partnerships.

This means that approval is needed when partnership interests in a fund are sold.


Here are the REITs benefits that investors can expect. 

REITs provide a real estate investment opportunity.

Also, unlike direct ownership, they don’t have that level of liquidity risk.  

Second, properties that form part of REITS are selected by professionals.

When it comes to their negotiating power, it’s far stronger than what an individual investor would have. 

Next, REITs when it comes to the stock market, REITs are negatively correlated to it.

REITs also provide both reasonable capital appreciation and income.

What about their risks?

Well, to start, when an investor opts to buy into REITs, they have little control over them.  

Only those that manage them will have a say in REITs. 

Also,  greater price volatility is a concern with REITs when in comparison to other investments, including owning the real estate instead. 

The problem here lies in the fact that stock market conditions can have a significant impact on REITs.

REITs are also highly taxed as ordinary income tax rates apply.

This is because they don’t qualify for 15% maximum tax rate purposes. 

Limited liquidity is another risk associated with REITs.

This is especially true of those that are not traded publicly. 

Due to certain limitations, only a certain amount of shares outstanding can be redeemed each annum. 

The redemption, however, when compared to the current price or the price the investor paid originally for the shares, could be significantly lower. 

Also, in some circumstances, other added taxes can apply to REITs. 

The last risk is that both income and capital can fall due to problem loans

D. Futures

Futures are a form of non-security derivatives, let’s look into them in a little more detail.

What are futures contracts?

Futures and forwarding contracts are often mentioned together.

The former, however, is an exchange-traded obligation, while the latter isn’t. 

With a futures contract, when it comes to the full value thereof, it’s the buyers and sellers who are responsible. 

This is how it works. 

Because they have taken up a long position, the obligation lies with the buyer. 

This means that delivery of the commodity to the buyer will be on a future specified date as per the terms laid out by the contract. 

While the buyer is in a long position, the seller then holds the short position. 

So if they do not own the commodity and need to buy it to deliver to the buyer, they can suffer a potentially unlimited loss. 

That’s because they will have to acquire it for that delivery and will have to pay what the current market rates are. 

Futures positions that are open are calculated each day for gains and losses based on the settlement price.

Then, both long and short open positions will have these gains and losses credited and debited to them. 

Then, when trading opens the next day, the firm as well as the trader accounts, must be settled. 

With these contracts, both buyers and sellers can benefit from working with clearinghouses that will make it easier to offset futures positions before delivery. 

An investor’s position will have to either be closed, offset, or liquidated using the opposite transaction that they began it with. 

Three things are critical when this is carried out: 

  • The same commodity must be used
  • The same delivery month is a necessity
  • This must happen on the same exchange as the opening transaction

Is an offset common before delivery?


Around 98% of highly leveraged futures positions make use of an offset. 

If at expiration, the settlement price is higher than the delivery price, those investors holding a long position will gain a profit while those with a short position will suffer a loss. 

The opposite is true should the settlement price be lower than the delivery price. 

Five components usually make up an exchange-traded futures contract:

  • The quantity of the commodity   
  • The quality of the commodity 
  • The price the buyer will pay 
  • Delivery time
  • Where it will be delivered 

When it comes to futures contracts, these are often used by speculators. 

Advantages of investing in futures

Like other derivatives, futures provide a range of advantages for investors.

Let’s just touch on what they are briefly.

Futures provide the following advantages:

  • They can provide leverage
  • They are less risky 
  • They are an alternative to selling short
  • Hedging
  • Time decay
  • Taxation

E. Alternative investments: Application, risks and characteristics

It was around the 1990s that investors started taking an interest in alternative investments, commonly called alts in the industry. 

Back then, alts consisted of a few options, including exchange-traded notes (ETNs), leveraged ETFs as well as financial derivatives. 

One thing that characterizes alts, no matter which ones an investor chooses, is their complexity. 

Because of this, suitability standards must be applied for those investors who are looking to invest in alts. 

Let’s look at various options that they have should they qualify:

Direct participation programs (DPPs)

When it comes to their overall structure, most DPPs will be set up as a limited partnership. 

Investors in these DPPs will get the flow-through of the economic consequences of the business itself. 

This is in a passive manner, both for income gained or losses made. 

That’s because, as a limited partner in the business, an investor will never be allowed to take an active role.

DPPs will never pay investors dividends either, because of their limited partnership structure. 

Investors will therefore have incomes, gains, losses, deductions, and credits passed on to them. 

They also have limited liability because of their distinct role. 

Only general partners are in the firing line should debt be defaulted on, not limited partners.

They can suffer the loss of their investment should the business go under, but they cannot lose any assets that they personally own to make up the debt outstanding. 

Limited partnerships and those that invest in them

While some investors want to buy the stock of a company, others choose an alternative way of investing in one, and that’s through a DPP. 

There’s a tax advantage to be gained here, and that’s thanks to the flow-through of income and losses because of the way a DPP is structured. 

That structure also relates to how capital provided by investors is used as well as how management runs the business.

Two main roles are found in all DPPs in the form of the general partner (who runs the business) and the limited partner (who invests in it).

When looking to become an LP in a DPP, investors should check out the following:

  • Is the DPP currently economically viable?
  • Does it have tax benefits on offer?
  • Do the GPs have experience, or have they run similar businesses before?
  • Does the investment time frame correspond to both the investment objectives of the client and the program?
  • Do cost and revenue projections compare with similar ventures?

Investors should always ensure that the stated objectives of the program meet not only their current but also their future goals.


Those taking the role of general partner are seen as the active investor in a limited partnership.

This means they:

  • Make decisions  
  • Buy and sell property (where necessary)
  • Manage finances and property
  • Supervises the partnership
  • Keeps a financial interest of at least 1% in the partnership

Because of unlimited liability, they will be liable for business losses and debt personally and this means that creditors can go after their personal assets if need be. 

Because of their fiduciary relationship with any LPs, GPs must always run the business with the best interests of the investors in mind. 


LPs make no management decisions due to their passive role.

Those that do get involved can see their limited liability protection stripped from them should the business go bankrupt. 

In terms of what LPs will receive for their investment, this comes in the form of not only distributions but capital gains as well. 

Partnership investments and their issuing 

There are several ways in which DPPs are offered as investments for example, as a private placement or even publicly registered. 

Here are some pooled investments that are a category of alts that could appear on the exam.

Exchange-traded notes (ETNs)

ETNs and ETFs shouldn’t be confused, even if they are from the same family. 

There are many differences between the two, but perhaps the biggest is how they are structured with ETFs as investment companies and ETNs as debt instruments. 

Also, as ETNs are issued and redeemed, their price remains consistent with their calculated value which is then published when the trading day comes to an end. 

More notes will be issued to bring the price down when it is at a premium, while the opposite will be true when trading at discount. 

There can be a conflict of interest, however, because the issuer and redemption of these notes lie in the hands of the issuer. 

Risks associated with ETNs include::

  • Conflicts of interest. There is a possibility that the trading activities carried out by the issuers of the ETN may not meet the needs of those holding notes. 
  • Early redemption: They may be called early. 
  • Liquidity risk. This is because there may not be a suitable trading market for specific ETNs.
  • Because they are an unsecured debt obligation, they are open to credit risk
  • Market risk

Leveraged ETFs

With these funds, a benchmark index is tracked with the aim of securing as high a percentage of that index’s return. 

For example, an attempted return of three times higher than the tracked index is the aim of a 3x leveraged fund. 

Portfolios and leverage applied to them are not regulated, which results in many 2x and 3x funds. 

Without a doubt, these funds can provide stunning returns, but when compared to other types of investments, they are very volatile. 

For example, there are triple the losses in a 3x leveraged fund should the benchmark it is tracking drop.

As a way to reach their stated investment objectives, these leveraged ETFs look to derivative products such as options, swaps, and futures.

In terms of suitability, these aren’t the type of investment products you would suggest to your average investor. 

Inverse/reverse funds

Also known as a reverse or short fund, this too tracks a benchmark with the aim of delivering the opposite of what that benchmark delivers.  

So if the tracked index fell by 2%, the tracked fund would gain 2% and it would do this by using derivatives, for example, options. 

Like leveraged ETFs, funds can try to return 2x or 3x the opposite of a tracked fund. 

Once the trading day ends and after they’ve attempted to reach their stated objectives, leveraged ETFs are effectively reset.  

For investors who look to buy and hold, these funds aren’t a good option simply due to the fact that over a longer period of time, the benchmark’s performance could differ significantly from these funds. 

Note that both inverse and leveraged funds are called EFTs when exchange traded. 

This means that supply and demand will determine their price, they can be traded on margin and they can be bought and sold at any point during the trading day. 

Note, however, that inverse mutual funds are not exchange-traded investments and instead, just like investment company shares, will be priced, purchased, and redeemed. 

Lastly, while all of these funds will have a stated objective, there is no guarantee that they will meet them. 

Structured products

Structured products, most of which are debt issues,  provide an investment option that’s aimed at meeting specific investment needs.  

Their overall structure sees issuers paying lower borrowing costs while lenders have an increase in the potential return they can gain. 

While investors will enjoy several benefits, for that, they will have to accept lower interest rates.

These are extremely complex products, and because of that, rule out many types of investors and more specifically, are aimed at sophisticated ones that understand the risk involved.   

In terms of benefits, perhaps the greatest that structured products offer is that they can significantly help with portfolio diversification. 

Structured notes with added principal protection

It consists of a bond with a derivative component and falls under structured products. 

The principal protection aspect of these structured notes means that a partial or full return on principal is on offer once they reach maturity. 

For the most part, there’s an underlying asset combined here. 

For example, that could be a zero-coupon bond with an option. 

Until the zero-coupon bond matures, there is no interest paid out to the investor.

When it does mature, however, they will also receive payoffs from the underlying assets. 

As for the principal return at maturity, while this is promised to be either a full or partial return, it’s never guaranteed. 

The overall financial strength of the issuer will determine if this is paid out or not. 

Structured product risks

Let’s look at the risks associated with structured products.

Perhaps the biggest is the fact that they aren’t liquid at all.

This is due to the fact that they are custom-made.

They aren’t short-term investments either and are only for investors that are willing to wait on returns that are fully realized at maturity. 

Credit risk is a factor as well, based on the financial institution that issued them and their overall financial strength. 

The final risk is efficient pricing. 

This can affect the overall value of a structured product which might not show when it comes to its prices on the market. 

Life and viatical settlements  

When it comes to life and viatical settlement products, there are numerous things that are similar between them, but they are very different too. 

For now, we will focus on those differences as that’s what’s likely to feature in the exam. 

It’s prudent to note those differences as these can appear on the exam. 

Viaticals are for clients that have a terminal illness and have less than two years to live.

There is no age restriction on this type of product as the basic premise of a viatical is that when they are settled, the medical expenses of the client get paid. 

With life settlements, age, and health, do play a role.

Most clients taking out this type of product are over the age of 65 but in relatively good health. 

Life settlements are paid out when the insured person dies and these take the form of defined death benefits. 

A transaction involving either of these products occurs when a life insurance policy or right to receive a death benefit is sold to a person other than the insurer.

No matter the health of the insured or their age, the NASAA sees these products as securities, and therefore, those selling them will be governed by state security laws.  

Licensing is a little different and is applied differently across states.

Certain states might require that someone selling these products hold only a life insurance license.

However, others will require the seller to have a life settlement license as well.

There are some states that require a securities agent license as well.

Regulators are most concerned with stability and disclosure.

Whenever such a policy is sold to investors, they gain a financial interest in the death of the insured person.

That means the investor agrees to maintain policy costs and pay premiums for the time period that the insured person is alive as well as a lump sum. 

When the insured person passes away, the investor that was paying then will get the death benefits of the specific policy that was taken out. 

This comes with some risks:

  • Because no secondary market exists for these policies, working out a fair evaluation for them is not easy which means investors can simply pay too much for them
  • Lower returns will be received by investors if a situation arises where the person insured is alive for a longer period than originally thought 
  • The investment company through which the policy was taken might not pay out because they are struggling financially. That said, this is pretty rare, but a risk nonetheless. 

F. Products that are insurance based

Let’s move on to products that are insurance-based.

We are going to look particularly at variable annuities and variable life insurance both of which are pooled investment vehicles.

We will also look at other insurance based products that, while not securities, are important for the exam.

Annuity types

Let’s start with the different types of annuities, something security professionals should be aware of even if they are classified as securities on non-securities

With annuities, we have a contract between the life insurance company that offers it and the individual that it covers.

Here, the annuitant is the investor who pays the premium on the contract. 

They have an option in terms of how that policy pays out.

For example, at a future date, they can choose to either get a lump sum payout or receive income distributions on a regular basis

The first option is only available to them if they surrender the policy.

Annuities are a valuable tool to those looking to gain extra funds for their retirement and this is because they are tax-deferred. 

There are two main types of annuities: fixed and variable. 

Fixed annuities

The term “fixed” gives you an idea of how this will operate as it’s the rate of return that is fixed

At the point that the annuitant elects to start the process of receiving income from the annuity, there are calculations that determine the payout. 

The elements involved here are the value of the account as well as the expectancy of the annuitant’s life. 

No time is a fixed annuity considered to be a security.

This is because the return is guaranteed and there is no risk involved in losing the interest or principal. 

That doesn’t mean that no risks are associated with a fixed annuity because annuities can suffer a loss in purchasing power due to inflation. 

Variable annuities

Annuities are different from fixed annuities because their purchase payments are directed differently.

With a fixed annuity, payments from annuitants are deposited in the general account of the insurance company.

With variable annuities, it will go into sub accounts linked to the main account. 

Here they can be invested in money market securities, bonds as well as stock portfolios, which are a popular option. 

Because variable annuities present the chance of greater gains they naturally are more risky than their fixed counterparts. 

This is also true because, instead of accepting the guarantees from the insurance company, it opts to invest in the securities mentioned above. 

Because the value of the various subaccounts the investor’s money is put into will fluctuate, so will the unit worth of the annuity. 

Here’s a breakdown to remember the key differences between the two.

Let’s start with characteristics of fixed annuities

  • Fixed monthly payout
  • Interest rate is guaranteed
  • The insurance company takes on the investment risk
  • Fixed-income securities and mortgages make up the portfolio
  • Investor payments go into a general account
  • Inflation can affect it 
  • Falls under insurance regulations

Now the characteristics of variable annuities

  • Variable monthly payout
  • Rate of return is variable 
  • The annuitant takes on the investment risk
  • Equities, money-market instruments and debt make up the portfolio
  • Investor payments go into separate accounts
  • Inflation resistant
  • Falls under both securities and insurance regulations

We’ve mentioned these separate accounts above, but let’s look at them in greater detail.

These accounts are set apart from the general fund of the insurance company.

It’s for investors to decide into which sub accounts their money will go.

Some might opt for more conservative investments while others would want to be more aggressive.

No matter what their strategy is there is a sub account that will suit their needs

With a variable annuity, the investor is taking on the risk and that’s why they are considered to be a security.

Those selling these products have to have both a securities and insurance license to do so.

Variable annuity/Mutual fund comparison

For many new investors, there doesn’t seem to be much difference between a mutual fund and a variable annuity.

Yes, there are similarities but they have many differences too. 

This breakdown will help us.

Features of a mutual fund: 

  • They are an investment company
  • They involve shares
  • They have varied investment objectives
  • They offer no guarantees
  • They are redeemed by the issuer
  • A formula is used to determine their price
  • They provide voting rights

Features of a variable annuity 

  • They are an insurance company product
  • They involve units
  • They have varied investment objectives
  • They offer only some guarantees
  • They are redeemed by the issuer
  • A formula is used to determine their price
  • They provide voting rights

Pretty similar, right?

That’s true, but let’s investigate a little more.

We start with the advantages that variable annuities present when compared to mutual funds

  • They offer tax-deferred growth
  • They offer a guaranteed death benefit
  • They provide lifetime income
  • They allow IRS Section 1035 exchanges
  • They have no 70.5 age requirements
  • There are no contribution limits
  • If transfers are made between subaccounts, these can be carried out tax-free
  • There is no probate

What about the disadvantages that variable annuities present when compared to mutual funds?

  • It is as ordinary income that earnings are taxed
  • Fees related to insurance and administrative expenses are generally higher than those associated with a mutual fund
  • There is a penalty when it comes to early withdrawals (before the age of 59.5), around 10%. 
  • There is a conditional deferred sales charge that is associated with most variable annuities. If they are surrendered early on, added costs will have to be paid. 

Index annuities

Next up we look at index annuities (IA), sometimes called a fixed index annuity or even an equity index annuity. 

These were developed with two things in mind.

First, they don’t have the purchasing power risk that’s associated with fixed annuities. 

Second, they don’t have the market risk associated with index annuities.

For those investors who want to take part in the market but need to have a guarantee against potential losses, index annuities are proving popular. 

Looking at a particular stock index, and using a formula that’s based on its performance, those owning an IA will get interest credited to their accounts, which is unlike a more traditional fixed annuity. 

Usually, they will receive whatever the participation rate is when the index does well.

This is around 80% to 90% of the growth it achieves.

Should it do poorly, the investor will still receive whatever the guaranteed rate of the IA is, and this is normally 1% to 3%. 

Note, some IAs can also have what is known as a capped rate.

This will see the investor receive a percentage amount that’s capped, say 10% even if the index increases above that amount. 

One huge negative when it comes to IAs is the fact that, when it comes to surrender charges, these can have a very long time frame. 

This is especially true of those that include a front-end bonus. 

Buying annuities 

In this section, we look into different annuities and the purchase and settlement options associated with them. 

Deferred annuity

A single-premium deferred annuity is one that has been bought with the investment of a single lump sum.

Only when the annuitant chooses to receive them will the benefits payout.

Periodic payment deferred annuity

Here, instead of a lump sum, periodic payments are made by the annuitant. 

This can be invested each month, each quarter, or even each year, depending on what they choose. 

Again, only when the annuitant chooses to receive them will the benefits payout.

Immediate annuity

A single lump sum is needed to purchase an immediate annuity,

Here the payouts are different however and the benefits can be in the account of the Investor within a period of 60  days.

Accumulation stage

The accumulation stage is the pay-in period for a deferred annuity.

During this period there are flexible contract terms also investors who miss payments won’t forfeit any contributions that they have made already. 

During the accumulation stage, the investor can choose to terminate the contract if they wish.

This will result in surrender charges on their minds that they take out should they do so within the first 5 to 10 years after the contract has been issued.


Accumulation units

The investor’s share of the ownership in a separate account is measured by what is termed an accumulation unit.

The same way in which the value of a mutual fund’s shares are determined is the same method used to work out the value of an accumulation unit. 

As the value of the securities held in the seperate account change, so will accumulation unit value change. 

Annuities distributions

The annuity stage is the term used to describe an annuity’s payout period.

Payout options

When opting to receive their payout, the contract holder will have to make a decision regarding the settlement option of which there are several to choose from when it comes to an annuity. 

These include:

  • Leaving the money to accumulate
  • Withdrawing the funds in a lump sum
  • Annuitizing the contract and withdrawing funds from it periodically

When the investor converts stages, moving from the accumulation to the distribution phase, the contract is said to have been annuitized. 

When they do this, the payout option that they’ve chosen is then locked in and once this happens, it cannot be changed to another. 

Let’s look at some annuity payout options starting with the largest monthly payout to the smallest.

We begin with life annuity/straight life/pure life

With this option, the annuity will receive periodic payments up until they die with these payments usually being monthly.

This is the option that will provide annuitants with the largest periodic payment.

There are no other benefits to this option, so payments will cease upon their death.

Next is life annuity with period certain

With this option, the annuitant will receive payments for life.

There is a certain minimum period guaranteed and this means that if the annuitant dies before that expires their name beneficiaries will receive the payments.

This carries on until the certain minimum period guaranteed comes to an end. 

What happens if the annuitant lives longer than the period certain?

In that case, they will receive payments until the point of their death.

Then there is the joint life with last survivor annuity.

Here two or more people are covered by the annuity and it’s on all lives that the payout is conditioned. 

This is typically an option for married couples. 

The benefits of the contract will continue to be paid, as long as one of those covered by the annuity remains alive. 

Depending on the contract, however, payments may be reduced when one party dies, but this isn’t always the case. 

There’s a refund annuity as well. 

With this type of annuity, also sometimes called a unit refund annuity, the payments continue after the insured has passed away.

They will do so until the initial principal’s full value has been paid to the beneficiary as set out in the contract.

This payment could be a one-off lump sum or monthly installments. 

Our last payout option is mortality guarantee

As long as the annuitant is living, the company with which they hold the annuity contract guarantees payments.

A mortality guarantee means that should the annuitant live longer than the company originally thought they would, it will take on the increased mortality costs. 

Annuity units

While speaking about these various annuities, we need to discuss annuity units as well. 

These come into being at the annuitization of a variable annuity and as a result of the exchange of accumulation units for them. 

But what are they?

Well,  these are only used during the payout period of an annuitized contract and are simply a measure of value calculated as soon as the owner of the contract annuitizes it. 

Annuity units are therefore used during the payout period to work out each payment that the annuitant is going to receive.

Because these are variable annuities, there is a fluctuation in the amount of each unit’s value each month. 

The basis for working out variable annuity distributions is the assumed interest rate (AIR)

This looks at the separate account and then provides an earnings target for it and generally is calculated in a conservative manner.

Annuity payments will increase when AIR is exceeded by actual earnings and decrease when they are lower.

Annuities taxation 

Let’s look at how taxation of annuities works particularly with only withdrawal in mind.

When annuities are not part of an employer-sponsored retirement plan the contributions to them are made with after-tax dollars.

This means that at the point the investors opt to annuitize, the contributions have already been taxed.

Taxes won’t be imposed on the portion of each payment that represents a return on the original principal.

So the money the investor spends here constitutes the investor’s cost basis, much like other investments.  

One of the main advantages of an annuity is when tax on interest, dividends, and capital gains is paid.

These are all deferred until such a time that the investor decides that they are ready to withdraw money from the annuity. 

At this point, ordinary income tax is applied to the amount that surpasses the investor’s cost basis. 

Random withdrawals

Here, the principle of last in, first out (LIFO) is used. 

This means that the IRS sees that the last money to come into the account is through earnings and these are then considered to be the first to be withdrawn. 

This means that when they are taxed, it is ordinary income. 

Following that, no tax is applied when contributions, which correspond to cost basis, are withdrawn. 

Lump-sum withdrawals

LIFO is used with lump-sum withdrawals as well. 

So here, earnings are removed and this is done before contributions. 

Should the investor take out a lump-sum withdrawal before they are 59.5 years of age, the portion of the withdrawal considered as earnings is taxed as ordinary income.

A penalty tax of 10% will also be applied to it.

This penalty doesn’t apply if withdrawal is as a result of a disability or death benefit or when it forms part of fixed payouts from a life-income option plan. 

When it comes to annuitized payouts, an exclusion ratio is applied to the way they are taxed.

It’s monthly that these payouts usually happen. 

Life insurance

We now move on to the different types of life insurance products available.

Life insurance allows beneficiaries to be paid out in the event of the death of the insured. 

This compensation comes from the insurance company through which the insured has entered a contract. 

Obviously, premiums need to be paid each month as part of this contract to ensure that the beneficiaries are paid the death benefit.he name, you can already tell that there is no contract term here of 20 years for example

When it comes to the types of contracts available, there are numerous options, each serving different needs.

Let’s look at a few options you will need to know for the exams.

Term insurance

This takes a specific period and provides protection for that.

When it comes to overall cost, this is the cheapest type of life insurance available. 

Here are a few critical factors that you should know about term insurance:

  • Each contract has a policy term for which temporary insurance protection is provided. This can be a number of years, or up to a specific age
  • If the insured dies during this policy term, the death benefit is paid out. 
  • Cash value is not accumulated by these policies. In other words, a policy for $100,000 will pay out that amount should the insured die during the benefit term. The face value of the policy will remain the same should it be renewed at the end of the term. Premiums, however, will go up as the person insured is now older

There is a range of applications that term insurance is used for. 

For the most part, it’s used to provide substantial cost-effective coverage. 

It also allows an individual to opt for more coverage than they might otherwise be able to afford because it provides pure protection. 

This is useful for those young individuals who are married and have children and have a need for added protection, for example.

Whole life insurance (WLI)

From the name, you can already tell that there is no contract term here.

Those taking out WLI are covered for the rest of their lives, so when they do pass away, the death benefit will be paid out, as long as premiums are kept up.

Those premiums are set at the start of the policy and won’t change during its duration.

Premiums can be paid in a number of ways, with options including monthly, quarterly semiannually and annually.  

Let’s look at the cash values that are provided by this type of insurance. 

We know that there is a death benefit, just like with term insurance, but there’s a saving element as well. 

Every year the policy is kept in force, this will go up and it’s commonly called the cash surrender value.

With traditional WLI policies, the insurer will look to conservative investments like bonds and real estate to invest reserves and by doing so, can guarantee the cash value of the policy

This cash value is used to determine the nonforfeiture options of the policy. 

The insurer’s general account is where traditional life insurance reserves are held. 

WLI can allow policy loans as well. 

This is borrowed as a portion of the cash value but in order to restore the overall policy value, it will have to be paid back.

This includes the payment of some interest as well. 

The face value of the policy is reduced by the loan amount still outstanding (with interest) should the policyholder die. 

In other words, the money outstanding is removed from the death benefit that is paid out. 

The advantage of WLI policies is that it provides permanent insurance for the length of an individual’s life while the cost of premiums won’t ever change. 

The disadvantage of WLI policies is that premiums will need to be paid past the point that an individual is earning an income through regular employment. 

Also, when compared to term insurance, the protection per dollar of premium provided isn’t as high. 

Policy owners can decide to surrender the policy, which means they stop paying premiums. 

Should this be the case, they can:

  • Receive the cash value of the policy
  • Opt for a reduced paid-up policy. This means premiums don’t need to be paid from that point, but because of that, the overall death benefit will be reduced
  • Opt for extended term insurance. Now, if they die within a time period as specified, the full face amount of the policy will be paid as a death benefit to their beneficiaries

Universal life  

In the 1970s, because of the low interest rates that were being earned by whole life insurance cash values, universal life insurance was developed. 

These paid higher interest rates during times of inflation while offering more flexibility over traditional insurance policies. 

This is because, based on their current needs, those holding this type of policy can adjust not only their death benefits but their premium payments as well. 

Because it has the same elements in the form of death protection and a cash value as a WLI policy, they are pretty similar.

The difference comes in the fact that there are no fixed and guaranteed amounts.

Instead, the death protection provided is much like a one-year renewable term insurance.

Also, it’s at the current interest rates that the cash value will grow.

Let’s look at some of the characteristics of a universal life policy

  • Premium payments are paid towards the insurance protection and separated first. The cash value of the policy, including interest, is then built from the remaining balance 
  • The death benefit can be upped or lowered by the policy owner
  • As long as the premium is paid so the policy is maintained, it can be changed. If there is enough cash value in the policy to keep it in force, premiums can even be skipped from time to time
  • Subject to a guaranteed minimum, the interest the cash amount earns will vary

We also need to look into interest rates and how they affect a universal life policy.

There are two different interest rates that these policies are subjected to.

These are:

  • The current annual rate: According to market conditions, this will vary
  • The contract rate: This is the minimum guaranteed interest rate. That means that a policy cannot pay lower than what this amount is. 

 Let’s move on to the death benefits of universal life policies

There are normally two options to choose from.

The first option, which is normally called Option A, looks at the face amount of the policy and then will provide a death benefit that is equal to that. 

Over time, the cash value of the policy will increase and that sees a decrease in the net death protection over the life of the policy.

In this way, it is somewhat comparable to a whole life contract. 

Option A’s major advantage is that for the same face amount of death coverage, premiums are lower but there is a tradeoff.

And that’s the fact that in terms of inflation, the level of death benefit won’t be able to keep up.

The second option, also called Option B, sees an increasing death benefit.

This will be equal to both the face amount of the policy as well as the cash amount. 

Here the advantage is the growth of the cash value, which is at a quicker time frame, thanks to the initial higher premiums and lower death benefit starting out. 

This means that the cash value is boosted due to the greater part of the premiums being added to it as well as the fact that it can grow interest-free.

As for universal life policy loans, they operate in the same way as a whole life policy would. 

Loans are subject to interest. 

Should they not be repaid, the loan and any interest it generates is taken off the policy’s face amount. 

Finally, let’s look at the uses of universal life insurance

For those looking for permanent life insurance that has the ability to build cash values faster than traditional whole life, this is certainly an option.

Most policies will have a guaranteed minimum interest rate attached to them, which is normally about 2%.

So if the investment performs below that, this will always be the lowest return on investment that the insured party can receive. 

For those who want to be able to adjust the death benefit of the policy as well as the premiums, then a universal life insurance policy is a must.

That’s one of its unique features.

Clients should be warned, however, that the policy could lapse if payments are reduced so much that the policy is no longer supported by them. 

For those who can pay more than what the premiums are, the policy can be “overfunded”. 

This means that the cash value thereof will greatly increase as the excess money paid goes into the savings portion.

Variable life insurance

This differs from regular life insurance in the fact that it is not in the general account of the insurance company where premiums are invested.

Instead, they will go into separate accounts where they can be invested in stock, bonds, money market instruments, and others with the insured person providing some insight into what they would prefer.

The idea behind this is that some of the investment risk is taken on by the insured and not just the insurance company. 

The performance of the sub accounts that are chosen will see the cash value in the policy vary. 

This doesn’t affect the minimum guaranteed death benefit that this type of policy has, however. 

So while the benefit amount can certainly go over the minimum value as outlined in the policy because the subaccounts perform well, should they not do so, it cannot drop below it.

The other key thing about variable life insurance policies is that they are considered to be securities.

This means those selling them will need not only an insurance license to do so but also a securities one. 

Let’s look at the different types of variable life insurance policies that are available. 

Scheduled premium variable life (VLI)

Also known as a fixed premium VLI contract includes a minimum guaranteed death benefit which will be determined at the point of issue. 

This will take the following into account when calculated:

  • The age of the insured
  • Their sex
  • The face amount of the policy at issue

After that, the premium is worked out and the necessary expenses are taken off before the remaining net premium is then invested in sub accounts chosen by the policyholder. 

Flexible premium variable life

Also known as a universal variable life insurance (UVL), this has both flexible premiums and death benefits. 

Note that a seperate account is where the premiums will be invested, and these can be raised, lowered and even skipped. 

At all times, however, the minimum cash value of the policy must be preserved. 

Premium deductions

When deductions are taken off the premium, the result is that the money invested in the separate account will get less.

The gross premium will have the following charges taken from it:

  • Admin fees (usually a one-time charge)
  • Sales load
  • Any state premium taxes that need to be applied

Seperate account deductions

The investment return that’s payable to the policy owner will be reduced when deductions are made from the separate account. 

The following charges will be taken off the separate account:

  • Mortality risk fee 
  • Expense risk fee
  • Investment management fee

Death benefits of variable life insurance

There are two parts to this:

  • The guaranteed minimum. The funds in the general account provide for this
  • The variable death benefit. The funds in the seperate account provide for this  

There will never be a change in the guaranteed minimum.

What must be recalculated, and at least once per year, is the total benefit, which includes the variable portion of the death benefit. 

When we look at the change in earnings and the effect it can have on the variable death benefit of the contract, then a comparison has to take place. 

This comparison looks at the insurance company’s assumed performance thereof and the way in which it has actually performed. 

The insured will have extra funds available to them should the returns in the separate account be more than AIR.

This will see the overall death benefit increase. 

If returns in the seperate account are equal to AIR, there is no change but if they are less, then the death benefit can drop but never below the guaranteed amount as stipulated by the contract. 

Cash value of variable life insurance

The investments held in the separate account are linked to the cash value of the policy. 

This value will have to be calculated each month. 

Depending on how the separate account performs overall, this amount may fluctuate. 

Unlike the death benefit, this is not related to AIR and the cash value will grow as a result of positive performances and decrease in the case of negative performances. 


  • Death benefits must be calculated at least annually
  • Cash values must be calculated at least monthly
  • Finally, each day, the separate account unit values must be calculated

Here’s a hand breakdown comparing whole life, variable life, and universal variable life policies.

We start with whole life:

  • Premiums: These are scheduled
  • Death benefit: This is fixed
  • Premiums: Are paid to the general account
  • Cash value: Guaranteed

Next, let’s look at variable life:

  • Premiums: These are scheduled
  • Death benefit: Variable, but the minimum benefit in the contract is guaranteed
  • Premiums: Are paid into the general and separate accounts
  • Cash value: Not guaranteed

Lastly, let’s look at universal variable life:

  • Premiums: Flexible
  • Death benefit: Variable
  • Premiums: Are paid into the separate account
  • Cash value: Not guaranteed

Special features of variable life policies

Here are some of the special features that variable life policies offer.


There is a way for those holding the policy to borrow against the cash value thereof. 

Obviously, this is only possible after a period of time when money has accumulated and there is a noteworthy cash value. 

They can’t borrow it all, however, only a certain percentage. 

The general rule is that once the policy has been in effect for a period of three years, the minimum percentage available to loan is 75% of its value. 

Should the death benefit need to be paid with a loan still outstanding on the policy, this will be deducted from it. 

Interest will also have to be charged on the loan and this will differ from policy to policy. 

Contract exchange

With these policies, should the insured have a change of heart, they can be accommodated, but only during the beginning stages of their contract.

Here, should they wish, they can change from the VLI policy to a type of permanent insurance offered by the same company.

It must have comparable benefits as the original contract, however, and more often than not, the best option to change to is a whole life policy. 

While the time frame in which this is allowed will change from provider to provider, regulations state that the period that the original contract must have been held for is nothing less than two years. 

Should the exchange go ahead, the new policy assumes the same contract date as the old one and the death benefit is that of the minimum guaranteed by the original contract. 

The premiums will stay the same as well. 

Voting rights

Those who hold variable life insurance will have voting rights.

This includes voting on investment objective changes, amongst others. 

This isn’t a single vote either, and is based on how much cash value is found in the separate account.

G. Other types of assets 

In this section, we are briefly going to cover two other asset types in the form of investment real estate and commodities. 

Investment real estate

Earlier, we covered a number of ways in which real estate can provide a passive investment opportunity, for example, REITs.

Here, the investor provides the monetary value they want invested, and then all the other work is carried out for them. 

But there are options for active investment too, and with these, the investor carries out more of the work.

One example of this which has become extremely popular over the last decade is flipping.

No doubt that you’ve heard of this before and it sees property investors buying houses, fixing them up and then selling (or flipping) them at a profit. 

Another active approach to real estate investment has been around for ages – property rental. 


There are numerous commodities and special metals that form attractive investments. 

We’ve already discussed futures in an earlier section of this guide while certain products or commodities can be invested in indirectly through exchange-traded products (ETPs) as well as ETFs that look to follow a commodity index. 

Even some mutual funds will look for commodity-related businesses to invest in. 

Commodities trading historically has been based around agricultural products, and these remain popular. 

The most popular modern commodities traded are crude oil, precious metals, and coffee, for example.

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