Series 66 Module 3 – Investment strategies and recommendations for clients and customers

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In this module, we not only look at various investment strategies and recommendations but who they are best for, how securities are traded, and how performances can be measured.

A. Client types

Accounts can be opened for anyone that is of a majority age, meets the legal definition of a person, and who isn’t declared legally incompetent. 

This doesn’t only cover individuals but business and government entities as well. 

Categories of account ownership

Let’s begin by looking at the various types of accounts that can be opened. 

Individual accounts

The first place to start are those accounts that can be opened for a single person who is described as a natural person. 

That’s not the only category, however, that falls under an individual account. 

It also includes trusts as well as estates of the deceased.

The main point about these accounts is that there can only be one beneficial owner.

In the case of investment advisers, when we talk of an individual account, it’s for an individual client.

The adviser will then manage their various investments.

Businesses that are set up as sole proprietorships are also seen as an individual account, however.

Together with their client, the adviser will draw up an Investment Policy Statement (IPS) which states not only the investment objectives but the investment strategy to be used to reach them.

Based on this, they can then make the necessary recommendations to each client. 

From time to time, advisers will need to review each of their clients to ensure that there have been no changes in their overall investment objectives or in their circumstances. 

State and federal regulations govern the suitability of recommendations made to clients.

When investment products and strategies are suggested, this must always be done with the following in mind:

  • The client’s needs
  • Their investment objectives
  • Their financial situation

Joint accounts

There are two (or more) owners when it comes to a joint account. 

Those who form part of the account, have control over it. 

This means suitability information is required from all the owners of the account.

There are three ways in which joint accounts can be set up:

  • Tenants in common  
  • Joint tenants with rights of survivorship  
  • Tenants by the entirety

No matter how they are set up,  all the owners will need to sign for anything related to a joint account.

Any one of the parties in the joint account can also initiate trading requests for both buying and selling. 

Any securities purchased will reflect all the names of the account owners on the certificate 

Any securities sold will need the signature of all owners who participate in the joint account.

Let’s look at the different types of joint accounts a little closer starting with tenants in common (TIC)

Here, the fractional interest of any deceased tenant is kept by the estate.

In other words, it won’t ever be passed on to any of the other tenants. 

This account type will permit unequally divided ownership.

In the event of a tenant’s death, their cash and securities will be distributed according to their will.

Let’s move on to joint tenants with rights of survivorship (JTWROS)

If a tenant in this account configuration dies, their remaining tenants will have the account interests of the deceased transferred to them. 

It’s interesting to note that, no matter how much each tenant contributes to a JTWROS account, all those participating in it will have an equal interest in any cash or securities in said account. 

The next account type is tenancy by entirety (TBE).

This is also an account where there are multiple owners with each having an undivided interest.

Note, however, that these accounts are only for married persons and they are the only clients that can have them created. 

If a tenant wishes to give or sell their portion of the account, the other tenant must give their permission. 

The other spouse will receive their portion of the account if one spouse dies.

It’s generally for ownership of real estate that these accounts are used. 

We’ve spoken a bit above about undivided interest, so let’s just define exactly what that is.  

Whenever there is a joint account, all those participating in it are said to have undivided interest, especially in a TIC where unequal shares are possible.

Well, an undivided interest means that no single tenant that participates in the account, when it comes to a specific asset has a designated interest therein. 

In other words, a tenant cannot lay claim to one type of stock in the account over another even when shares are unequal. 

Joint account suitability

There’s no difference when it comes to suitability from an individual account to a joint account other than the fact that there is more than one person to consider.

All recommendations must be made on a reasonable basis after gathering the required information as expected by regulations. 

For example, while one individual in a joint account meets the requirements for an accredited investor and the other doesn’t, you will only be able to make investment suggestions that would fall in with the latter.

Opening accounts and the legal requirements thereof

We begin with an individual account and for one to be opened, the client will fill in a new account agreement. 

This document provides them with information about their rights and obligations as well as what is expected from the adviser, and what they will charge. 

Other information required from clients includes:

  • Their legal capacity: Are they full legal age in the state the account is opened in?
  • Their current employment capacity
  • Other Customer Identification Program (CIP) information. We won’t go into all the details here but include name, date of birth, address, social security number, and more. 

All parties involved in a joint account must provide the above information.

One person will act as the primary contact.

They will receive all the necessary information/communication related to the account. 

When it comes to opening options accounts for clients, NASAA does not have guidelines, but there are FINRA requirements to consider.

This means that a supervisory person will have to approve the opening of these accounts.

In order to open an account like this, the client receives an Options Disclosure Document (ODD) detailing risks related to options accounts and how they work.

When an account is approved, this will indicate:

  • The date they received the ODD
  • What transactions have been approved for the account
  • An agent assigned to the account
  • The supervisor who approved the account and when they did so
  • When information related to the account was verified

Customers will have to provide a written agreement within 15 days of the account having been approved that they understand the FINRA rules binding them when trading options.

Following the approval of an options account, the broker-dealer has a 15 day period to obtain a written agreement from the customer that they are aware of and are bound by FINRA regulations.

Business accounts 

Let’s look at the various business accounts that are available. 

Sole proprietorships

The easiest way to set up a business account is as a sole proprietorship.

These are very much like individual accounts and are handled in much the same way. 

Note that the individual in this account scenario is linked to the account, in other words, should they incur losses, their assets can be liable for any business debt.

General partnership

In a general partnership, at least two people are involved and in an unincorporated association. 

Partners in this situation will run the business as well as be liable for any debt that it incurs.

While they are pretty easy to start up, a general partnership isn’t the best format when looking to raise large capital sums.

For the purposes of tax, profits and losses made by the partnership flow through to investors.

This means that profits are not double taxed at both the business and individual levels.

Limited partnership

With a limited partnership, the limited partners are protected and have limited liability on the investments they make.

They can only play a passive role in the partnership, however.

An example of this is a direct participation program (DPP).

Limited liability company (LLC)

With a LLC, the benefits of incorporation in the form of limited liability are evident as well as providing the tax advantages as a partnership would in the form of flow-through of taxable earnings/losses. 

In other words, LLC owners are not seen as shareholders, but instead as members.

This means that if the LLC incurs debt, they won’t be held personally responsible.

The suitability of LLC members must be assessed on an individual basis.

S Corporation

Treated in the same way when it comes to tax as a partnership would be, an S corporation has a benefit for investors in the form of limited liability. 

Profit and losses will also be passed through to investors, but this is based on their proportion of ownership in the S corporation.  

C Corporation

It’s as independent entities that the company and its owners are viewed when it comes to a C corporation. 

C corporations are one of the best choices when a large capital sum is needed.

Any debt incurred by the C corporation cannot be held against any officers thereof, so in other words, there is no personal liability on their part. 

As for shareholders, no corporate income tax will be passed onto them as the corporation is the sole entity that’s covered here. 

Fiduciary accounts 

We know that when it comes to fiduciary accounts, the adviser has control over the account.  

This also means that full account management is in their hands as well but as always, decisions must be made in the interests of the account owner. 

 These are examples of fiduciaries:

  • Trustees
  • Executors
  • Administrators
  • Guardians
  • Custodians
  • Receivers

Anyone who is authorized or appointed legally to act for another party is a fiduciary. 

Trust/Estate accounts

Trusts and estates are two types of fiduciary accounts that can appear on the exam.

Trust accounts

These accounts are seen as legal entities and are useful to those looking to transfer property.

This property transfer could be for personal reasons but in many cases, there are charitable motives behind them as well. 

Why trust accounts are chosen to do this is for the flexibility they provide.

They are also seen as legal entities. 

For the exam, make sure you understand the following:

  • Trustee responsibilities
  • Taxation of trusts and how it is carried out
  • Advisers and their roles in working with trusts

What about the parties involved in a trust? 

They are:

  • Settlor (provides the property for the trust)
  • Trustee (acts in the fiduciary role, and holds the legal title of the property. The trustee can be an individual or an entity)
  • Beneficiary (the property is held in the trust for the beneficiary. At a later date, they will receive it)

All three of these roles must be taken up by someone in the trust document but they can be carried out by a single person. 

For a valid trust, the settlor and trustee must be competent parties,

The beneficiary, however, is often a minor and in some cases, a legally incompetent adult. 

Let’s compare simple trusts vs complex trusts

Income earned from assets that are received during a year by a simple trust must be distributed that year as well. 

If this doesn’t happen, the trust is then considered a complex one. 

Trusts like this are allowed to build income.

They also allow the principle or net income to be taken out for distribution. 

Should the capital gains not be reinvested for a complex trust, they are considered as part of the distributable net income. 

The way income is distributed is the main difference between a simple and complex trust. 

Next are living vs testamentary trusts

For a living trust formation, this happens during the maker’s lifetime. 

Revocable living trusts are controlled by the person who established them. 

Whenever necessary, assets can be added or removed, as well as other changes made.

A testamentary trust is controlled by the settlor until death.

When the testator dies, the property is placed in trust for their beneficiaries as stipulated in his or her will.

Charities and foundations

Let’s first look at philanthropic funds

Funds of this kind allow for certain flexibility and tax advantages for those who donate to them. 

They are usually established by wealthy individuals.

Banks and mutual fund sponsors give persons the opportunity to donate a large sum of money to these funds.

The benefit of this is that they will not only receive a current tax deduction but are investing assets that will generate earnings over a certain period. 

Donors then choose a favored charity and specify the distributions to be made to them.

We must also discuss impact investments

What are these exactly?

With these, capital is intentionally allocated to have a positive impact either socially and environmentally.

Crucially, however, this impact must be able to be measured. 

In other words, it involves finding a charity or company aligned with the goals of the donor, and then providing funds in order to help them reach those goals.

Lastly, we have management obligations

In this case, an entity’s board of directors must select and preside over the investment manager’s activities. 

Part of this is devising an investment policy statement (IPS) which will state the necessary goals and objectives for the manager to adhere to.    

Ultimately, what is outlined in the IPS will be used to judge the manager’s overall performance. 

B. Profiles of Clients

Because clients are all unique individuals, advisers will have to ensure they find out as much as they can about them so their specific investment goals become clearer. 

Without finding out this suitability information about each client, an account for them shouldn’t be opened.  

So what’s the best way to go about this?

Working out the financial status of a client

To start out, having a client complete a questionnaire is often the best way of getting the ball rolling in terms of finding out necessary financial information about them. 

Furthermore, to find out more about their investment attitude and the way they view risk, conducting a personal interview is a must. 

Clients: Financial profile

By assessing a client, you can determine the following about them

  • Their current  tax status
  • Their current expenditure levels
  • What their current debt obligations are
  • Their various sources of income
  • What assets they hold

By determining this information, an adviser can draw up a family balance sheet for each client which lists their assets and liabilities. 

Income, for example, isn’t part of this, and you might find a question on the exam trying to trick you regarding this. 

What this also does is give an overview of:

  • Each client’s net worth
  • Each client’s cash flow
  • Each client’s overall liquidity 

A balance sheet can also show how investors can make investments, for example, do they have the resources to use a lump sum, or would they only be able to invest money periodically?

Non Financial aspects to consider

These include information that hasn’t got anything to do with the financial side of things:

  • Age
  • Marital status
  • Overall investment experience
  • Dependents
  • How stable their employment is
  • Their educational and healthcare needs

Tolerance for risk

Each individual will have a unique tolerance when it comes to risks taken while investing.  

This is a critical factor in molding their investment profile, more so than their financial status. 

There are numerous variables to be considered here:

  • Their unique investment objectives
  • The amount of disposable money they bring to the investment table
  • Their overall risk aversion

Clients are placed in one of three categories in terms of their overall tolerance to risk:

  • Conservative: These clients don’t want too much risk, especially in terms of principal loss. They generally want their investments to bring in a guaranteed income 
  • Aggressive: Those with this type of investment mindset won’t worry too much about accepting losses (even up to as much as 50%). With the chance of substantial returns, they will be prepared to sit through market volatility
  • Moderate investors: These types of investors find themselves somewhat having a conservative and aggressive investment approach 

Based on the investment approach of a client, you can narrow down the types of investments that you could suggest to them.   

Investment objectives and constraints

Once you’ve determined the critical information that we’ve covered above about each client, you can start with setting their financial goals.  

With most clients, goals are generally one of these below:

  • Capital preservation
  • Generate current income
  • Capital growth
  • Speculation

In the way of these goals, however, are the investment constraints unique to each client.  

These can include

  • Time horizon. This is the period of time they want the goals to be met in
  • Liquidity
  • Taxes
  • Laws and regulations
  • Unique preferences or circumstances

Let’s look at the specific investment goals named above in more detail.

Capital preservation

For those investors that don’t want to see their investments decline, ensuring capital preservation is key.  

There are numerous investments that can provide the safety they are looking for, including bank-insured CDs, savings accounts or money market funds. 

With capital preservation, however, returns on investments are low, so this is something that a client will need to understand. 

Of course, risk won’t go away, for example inflation, especially as fixed-term investments, which suit capital preservation, can still be subjected to it.  

Generate current income

To generate current income, investments like mutual funds or specific individual securities are a good choice. 

These can include:

  • Agency and government bonds
  • Government notes
  • Preferred stock
  • Utility company common stock 

Obviously, generating income is linked to risk, so it’s important to determine just how much risk an investor is willing to take on.  

Capital growth

Growing invested money can be achieved through common stock investments.

To generate returns over time, however, when compared to short-term investments, while they are more volatile, equity markets should be considered. 

While there are many investments that can facilitate capital growth, much will depend on the investor’s risk tolerance. 

For example, should that be high, and they are prepared to be in it for the long haul, aggressive growth stocks make an attractive option. 

For those with less risk tolerance but still looking for capital growth, large capitalization stock funds are the way to go. 

Speculation

Speculation does promise high returns but there is some serious risk attached to that as well. 

Investments perfect for investors that don’t mind speculation include:

  • Volatile stocks  
  • High yield (junk) bonds
  • Options on stock
  • Options on stock indexes
  • Commodity futures

We now know the four major investment objectives that most people will have, but why do they look to invest?

Well, it could be:

  • To generate funds to pay college tuition for their children
  • To generate funds for their retirement 
  • To provide death benefits for their family when they die
  • To ensure there is money available should they become disabled

College tuition

For those looking to generate funds for their children’s education, an investment like a zero-coupon bond makes perfect sense. 

These have a maturity date which can be linked to the time when their children need the funds to pay for their college. 

Some investment options provide tax advantages for investors who want to invest in their children’s education.

A Section 529 plan is an excellent example of this.

Retirement

Having enough money for retirement is a concern for many people. 

To work out their retirement needs, you have to consider their company pension, their savings, their insurance as well as their social security. 

Investment time horizon also plays a role here, and, the earlier they begin, the better for them. 

For those that start earlier, investment risk can be raised which will then lower as retirement age approaches. 

Investments that lower longevity risk, such as fixed, index and variable annuities are an excellent option to ensure accumulated money lasts for their retirement. 

That’s because these investments have lower longevity risks when compared to others. 

Death benefits

As part of their investment portfolio, many clients look to something that will provide a death benefit for their loved ones should they die. 

The most obvious way to cover this is through life insurance. 

Running an individual capital needs analysis can provide all the figures you need to determine how much that insurance should cover in an effort to:

  • Pay any outstanding debt
  • Pay any outstanding mortgages
  • Secure income for the family for a specific time period
  • Pay dependants’ education fees 

Disability

There are three different types of replacement income for those looking to cover a potential disability. 

These are:

  • Social security
  • Worker’s compensation (should they have been injured while on work duty)
  • Disability insurance

Time horizon

The age of an investor plays a massive role in the types of investments you should suggest to them. 

 For a 30 year old client short-term volatility in their investments is acceptable (if they are risk tolerant).

A client who is retiring in the next five years, however, won’t want that volatility but instead, safe investments that also offer liquidity. 

That’s how the investment time horizon works.  

C.  Theory: Capital markets

Modern portfolio theory holds that it’s in a rational manner that investors will mostly behave.

When looking at capital market portfolio theory, there are two prime examples:

Capital Asset Pricing Model (CAPM)

Here, it’s the investors that will be allowed to work out the expected rate of return of an investment. 

The amount of risk needed to be taken to reach the investor’s wanted return is what this theory looks at.  

This means that it’s ultimately going to be a risk-adjusted return and to achieve this, the systematic risk of the asset is the focus. 

With CAPM, two risks are said to be part of any investment.

These are systematic (which cannot be diversified away)  and unsystematic risks.

Modern portfolio theory (MPT)

MPT pertains to ways in which portfolio risk can be controlled and quantified.  

The focus is on the total portfolio here, not just specific securities with a particular interest in its overall risk and reward. 

This theorizes that by making use of portfolio diversification, the risk of some type of securities can be set aside, specifically by using investments with uncorrelated returns. 

MPT assumes portfolios will reach the returns expected of them. 

For this to occur, diversification is the only way in which risk can be reduced, but the portfolio must have assets that move either at different periods or opposite to each other. 

Efficient market hypothesis (EMH)

This holds that the prices of securities will change quickly to any new information that comes to the market.

Prices quickly adjust to what that information reflects and fairly so. 

There are three types of EMH that correspond to the type of information available.

Firstly, weak-form market efficiency.  

Here, the price of a current stock will include all historical data related to market and price trends and therefore, there is no value in trying to predict changes in the price down the line. 

Second, semi-strong-form market theory

Here, current stock prices reflect several factors including analyzing financial statements as well as the industry of the company and the economic outlook at present. 

Third, strong-form market theory

The prices of securities incorporate not only public sources of information, but private ones too. 

The information gleaned from past markets is also included in this theory and in a nutshell, no one group of investors has exclusive access to this information.

D. Strategies, Styles, and Techniques of Portfolio Management

Let’s start with the various strategies that can be employed.

Strategic asset allocation

Here, consideration is given to an investment portfolio with long-term goals.

The main focus is the proportion of the various investment types in that portfolio. 

Taking a passive approach, portfolio managers believe that no management style is capable of consistently outperforming market indices.

For this reason, the portfolio constructed by them will look to mirror a chosen market index or they could tell their clients to invest in specific index funds or ETFs. 

The main idea behind this approach is returns over a long term with turnover that’s minimal. 

Tactical asset allocation

Here, a more active role is taken which includes making short-term portfolio adjustments to mix up classes of assets.

These adjustments will take into account current market conditions and the sentiment of the investor. 

With this, individual securities are bought and sold to ensure they’ve selected the right stock and to outperform market indexes.

Active selection and market timing are critical here as well as judging the market overall. 

Other portfolio management techniques

There are other techniques in which portfolios are managed including:

Contrarian

Here, the portfolio is going opposite to current market trends.  

Capital appreciation vs income

Capital appreciation, depending on an investor’s needs, can come in many forms, for example, moderate to aggressive.

While other securities can provide this appreciation, it’s mostly linked to growth stock. 

Income is all about what a portfolio can generate. 

For example, as a way to generate income, managers could look to foreign securities or high-yield bonds, but with those, risk goes up too. 

Other income generating options include debt securities. 

Portfolio management: Techniques

Numerous techniques can be applied to portfolio management as well. 

Dollar cost averaging

By using this technique, the average cost per share can be brought down, specifically with stocks and mutual funds. 

Investors need to make regular investments in them, however, for example, each month.  

Because of this, timing risk is reduced as a result of buying more shares when they are lower and fewer shares when prices are higher.

This then causes the averaging out effect. 

So when markets are fluctuating, the average cost per share will be lower than the average price per share.

Equity options hedging

Hedging a market position can limit risk, especially for those holding a long position (owning the stock).  

Long stock and long puts

Investors may worry that they will lose money when the stock price drops when they own certain stocks.

This can be protected against in the form of put buying.  

Should the price go down, by exercising the put before its expiration date, the investor can sell the stock.

By doing this, a decline in the price of the stock is offset.

This is known as portfolio insurance. 

Covered call writing (Long stock and short calls)

A covered call is written (sold) on stock already in the portfolio of an investor.

There can be two reasons for this:

  • The risk on the long position they hold will be lowered
  • They will receive income (from premiums) when the call is sold

Should the call not be exercised, the call writer then keeps the premium. 

If it is exercised, then the writer of the call must deliver the stock.  

Therefore, a covered call writer reduces any potential gain they might make in exchange for some protection against a loss.

What about partial protection?

The premium amount will reduce the stock cost when a covered call is written with the premium then received too. 

In the event that the stock price drops below the purchase price minus the premium received, a loss will be incurred.

Most of the time, a stock will be called if its price rises substantially. 

Short stock and long calls

In order to sell short stock, an investor sells borrowed stock because they think the price will drop.

The stock loan will then have to be repaid.

The investor will hope that’s at a lower price by buying stock to do so. 

A short seller can buy calls to protect against stock price increases.

E. Tax considerations

There are different ways to tax investments based on their type. 

An investor’s investment preferences can be heavily influenced by various tax implications.

Tax has different filing statuses too and these are:  

  • Single filing (for individuals)
  • Joint filing for married couples
  • Separate filing for married couples
  • Head of household filing
  • Qualifying widow or widower with dependant filing

Other factors will play a role in tax considerations as well:

  • Age
  • The state they reside in
  • Citizenship

Tax treatment: Capital gains and capital losses  

Capital gains

The sale of an asset results in a capital gain when it is sold for more than it was originally bought for.

Capital losses

If an asset is sold for less than what it was originally purchased for, it is called a capital loss.

With both, the cost basis is critical. 

This is the investment’s total cost.

It helps investors see if they made a capital gain or loss. 

For IRS tax consideration, this basis must reflect stock splits and dividends. 

Net capital gains and losses

A taxpayer can figure out their tax liability by adding their short-term (less than a year) capital gains and losses.

Then, any long-term capital (more than a year) gains or losses are added.

The taxpayer offsets the total gain or loss per year to work out the net capital gain or loss.

A net long-term capital gain sees taxation at 15% (the rate for any capital gains made).

Taxes on capital losses are deducted from any income earned, up to a maximum of $3,000.

This can be carried forward to offset any capital gains in the future. 

AMT: Alternative minimum tax  

AMT ensures that high-income earners pay the necessary federal income taxes.

Working out  alternative minimum taxable income (AMTI) sees all taxable income having certain items added back in for favorable tax treatment 

These include::

  • Property accelerated depreciation (only from 1986 onwards)
  • Costs associated with certain limited partnership programs
  • Taxes on non-incoming generating investments as well as interest
  • Private purpose municipal bonds issued after August 7, 1986 with tax-exempt interest 
  • Certain examples of incentive stock options (ISO). These must have a stock price lower than the employer’s stock’s fair market value.

What is the best way to determine whether AMT is owed by an investor?

Simply by working out not only the value of AMT but also their normal taxation amount. 

The highest of the two is what needs to be paid as tax. 

Loss and income: Sources  

Other than a salary, bonuses, or earnings from a business or trade, there are other sources to consider when it comes to tax.  

Alimony

The ex-spouse can be paid alimony directly or through a third party on their behalf.

Generally, however, the spouse making the payment is entitled to a tax deduction on alimony paid. 

For tax purposes,  the spouse receiving alimony must treat it as income.

Child support

Alimony should not be confused with child support, it’s a legal obligation to provide a child with financial support. 

There is no deduction for this, nor does the recipient have to report it as income.

Passive income and losses

Income derived from property rentals, limited partnerships, and other enterprises in which an individual does not play an active role is still seen as active income.

It is an earned income for a general partner in a limited partnership, but passive income for a limited partner.

It is calculated by netting passive income against passive losses in order to determine the net taxable income.

This is taxed at regular rates, with passive income offset by any passive losses suffered.

Portfolio income

Portfolio income comes in many forms including dividends, interest, or capital gains through the sale of securities. 

No matter the source, tax will have to be paid by the investor.  

Here’s some examples:

  • Dividend income has a tax rate of up to 15%
  • Interest income is taxed at normal income rates

Reinvested distribution taxation needs to be mentioned as well. 

By reinvesting distributions, an investor creates a compounding effect.

The issuer must disclose the source of each distribution, in particular, whether it comes from capital gains or income.

Each year, shareholders will receive a Form 1099 with distribution-related tax information and on that, dividends received can be added.

Then, it’s either as ordinary income or a qualifying dividend that they will be taxed. 

Also, any mutual fund distributions will be taxed as capital gains.

Let’s also quickly discuss how reinvestments affect cost basis.

The investor’s cost basis increases when an asset is sold, so tax won’t be owed again following the sale. 

So the required taxes were paid when the income was reinvested.

Distributions related to retirement plans

Generally, any funds taken from a retirement plan are taxed at the investor’s ordinary income rate.

Taking out money before the age of 59.5 will result in penalties that will need to be paid, usually a 10% early withdrawal fee.  

Margin expenses

Any interest gained on margins is tax deductible too. 

There is an exemption, however. 

As municipal interest income is federal tax-exempt, margin interest expenses for municipal securities cannot be deducted.

If an investor purchases securities with borrowed money, interest expenses can be deducted

There is a proviso, however, that interest expenses cannot exceed net investment income.

Any capital gains, dividends, and interest income are included here.

Effective tax rate

Effective tax rate is not the same as marginal tax rate.

In contrast to marginal tax rate, which is paid on income received, effective tax rate refers to the overall rate paid on an investor’s total taxable income.

Taxation: Estates

An estate of a decedent is taxed based on its value at death. 

When an individual transfers an amount (which can be unlimited) to their spouse, there is no federal tax due. 

This is known as a marital deduction. 

A person may transfer an unlimited amount or even property to an eligible charity without incurring tax consequences.

Let’s focus on taxable estate vs gross estate

Federal estate tax is calculated using a formula, with the first component thereof being gross estate (all the property owned by the individual when they died).

A gross estate includes all property transferred to a charity or spouse, even though these are not normally taxed at federal level. 

To find out the adjusted gross estate (AGE), certain expenses need to be deducted. 

A decedent’s debt and charitable contributions, for example, are included in the AGE. 

By deducting unlimited charitable and marital deductions from the AGE amount, you arrive at the final figure for the taxable estate.

Consider alternative valuation dates as well. 

The executor of an estate can value estate assets at the time of death or six months later if they wish.

It is particularly beneficial if there are assets in the estate that have lost value following the death of the deceased.

In the event that an asset was appraised at the time of death and then sold at a higher/lower price, the executor will use the sale price as long as it represents fair market value. 

Is there a payment date for estate taxes?

Regardless of whether an alternative valuation date or the death date is used, estate taxes are due nine months after the death.

Should an extension be needed, one can be applied for, however. 

Income taxation on estates

It is possible for estates to still earn interest and even capital gains during the liquidation process.

While the income must always be reported, it is taxed like a trust income.

Gift tax: Obligations

Donors will be subject to gift tax if they transfer property during their lifetime. 

The amount of a gift over $11.4 million during a lifetime will no longer be subject to gift tax as of 2019. 

It is also tax-free to gift $15,000 per year to any number of individuals without having to pay federal gift taxes. 

This can be $30,000 per person per gift for a married couple. 

There is, however, a difference between gifts between spouses. 

These gifts are exempt from tax for U.S. citizens.

Gifts of up to $155,000 can be made to a spouse who is not a US citizen. 

F. Retirement plans

There are many options to choose from for investors when it comes to these plans. 

Traditional IRAs

Contributions to an IRA are tax-deductible up to the following amount:

  • Individuals: $6,000 per individual
  • Per couple: $12,000

A person’s capital gains or income are not taxed until they withdraw them.

IRAs regard  the following as compensation: wages, salaries, tips, commissions, bonuses, self-employment income, alimony from divorce decrees (pre-2019), and nontaxable combat pay.  

IRAs do not consider these as compensation: Capital gains, dividends received, interest received, pension, annuity income, child support, passive income from DPPs, or alimony from divorces. 

Catch-up IRA contributions

People over 50 can make catch-up contributions to their traditional or Roth IRAs.

This goes beyond the allowed maximum annual contribution limit and this allows more savings towards retirement with $1,000 the permissible amount. 

Taxpayers under the age of 70.5 who report income during a given tax year may contribute to a traditional IRA.

If one spouse earns no income (or very little) and files a joint tax return with their partner, a spousal IRA can also be opened.

Contribution limits are just like other IRAs.

Excess contributions

During a year, excess contributions will be penalized with a 6% penalty tax.

It is possible for the owner of the IRA to withdraw these contributions, but it must be done either by the time they file their tax return or no later than mid-April.

Roth IRAs

In this section, we’ll focus more on the differences between Roths and traditional IRAs, although they are similar in numerous ways. 

When it comes to differences, contributions, withdrawals, and how they are taxed are what you should know about. 

A Roth IRA is not tax-deductible, unlike traditional IRAs which means tax-free and not tax-deferred earnings. 

Earnings can be withdrawn tax-free after five years if they meet the following conditions:

  • Account holder is older than 59.5
  • The withdrawn money will be used towards the first-time purchase of a principal residence
  • Account holder has suffered a disability or died

Roth IRA: Contribution limits

Traditional and Roth IRA contribution limits are the more-or-less the same with one significant difference. 

Roth IRAs allow taxpayers to contribute after the age of 70.5 as long as they have earned income.

Is it possible to contribute to both of these IRAs?

Yes, as long as the contributions combined aren’t more than $6,000 (investors under 50)  and $7,000 (investors over 70). 

Roth IRAs: Requirements for eligibility  

In general, eligibility is determined by income earned.

Roth IRAs can be opened by individuals whose adjusted gross income (AGI) is below a specified income level.

These figures will guide you:

  • AGI of less than $122,000 for a single person allows for a full amount contribution
  • AGI of between $122,000 and $137,00 will see a phasing out of the individual’s ability to contribute
  • AGI of $193,000 for married couples posting joint tax returns
  • AGI of between $193,000 and $203,000 will see a phasing out of the couple’s ability to contribute

How traditional IRAs are converted into Roth IRAs

It is possible to convert a traditional IRA into a Roth IRA, but there are tax implications when doing so. 

In the event of conversion, the investor’s ordinary income will be boosted by the entire converted amount.

If investors are 59.5 or younger, to avoid a 10% early distribution tax penalty, the funds must either be transferred from trustee to trustee or, if distributed to the owner,  rolled over within 60 days. 

Withdrawals from traditional IRAs 

Investors who don‘t want to pay an early withdrawal penalty should wait until they are older than 59.5. 

Penalties won’t be paid if the withdrawal is because of death, disability, towards paying for a primary residence, paying for qualified higher education for immediate family, or in some cases, covering specific medical expenses. 

The maximum age they can wait to is 80.5 and in the April of the following year, withdrawals have to start. 

As they come from tax-deductible contributions it’s as ordinary income that withdrawals are taxed. 

A formula will be used when there are both deductible and non deductible contributions, however. 

Using the substantially equal periodic payment exception (SEPP), penalties won’t have to be paid on withdrawals before the age of 59.5 

This decrees that a penalty won’t be applied if individuals receive IRA payments annually based on their life expectancy. 

Nondeductible capital withdraws

When after-tax dollars are contributed to an IRA and later withdrawn, they are not taxed.

When withdrawn, funds that result in investment gains or income will be taxed at ordinary rates.

IRA characteristics

The most common way for securities firms to set up IRAs is as self-directed plans.

Their funds are then used to buy a range of investments.

IRA investments are usually conservative.

Here, long-term growth is the idea while taking the age and risk tolerance of the investor into account too.   

Ineligible investments for IRAs include collectibles, while purchasing insurance contracts isn’t allowed either. 

Although tax-free municipal bonds, municipal bond funds, and municipal bonds aren’t popular due to their low yields, they are eligible options. 

 Ineligible investment practices for IRAs include:

  • Speculative option strategies
  • Short selling stock
  • Margin account trading

Covered call writing is allowed.

How about real estate investments in an IRA?

While allowed as a 401 (k) plan participant and for IRAs, it’s not something often seen, just because of the extra precautions that need to be considered with real estate investments. 

That’s because if not done correctly, there could be significant tax implications. 

When it comes to moving IRAs, there are three ways to do so.

  • Direct rollover
  • 60-day rollover
  • Transfer from trustee-to-trustee 

IRAs inherited by investors

The inheritance rules will vary depending on whether the IRA is inherited by a spouse or some other relative.

Let’s examine a spousal beneficiary.

Two decisions need to be made in this regard:

  • The spouse’s IRA can include the amount of the IRA inheritance in what is known as a spousal rollover. 
  • You can leave the IRA but take ownership as a beneficiary 

And a nonspouse beneficiary?

These have fewer options:

  • Take the cash straight away
  • In five years, cash the IRA
  • Over the course of their own lives, they can take out RMDs

IRA disclaiming

Beneficiaries of a deceased person’s IRA sometimes don’t want it.

When proceeds are disclaimed, you should understand the process that takes place. 

In most cases, the assets are then passed onto a contingency beneficiary instead.  

Qualified/ unqualified retirement plans

Keogh plans

Self-employed individuals or unincorporated businesses with owner-employees are who these plans are primarily for.

From a contribution point of view, an individual will pay more for a Keogh plan than an IRA.

Contributions levels (2019) are up to $56,000 for those participating in these plans. 

Employers and owners must contribute the same percentage.

This is to ensure that Keogh plans are nondiscriminatory.

Individuals can hold both an IRC and a Keogh plan.

When they do, and if earning limits are exceeded, the IRA contribution will not be deductible.

Keogh plans are available for the following employees

  • Full-time employees  
  • Tenured employees  
  • Adult employees (between 21 and 70.5)

The similarities between Keogh plans and IRAs are:

  • Both have tax-deferred contributions
  • Until they are withdrawn, they are tax-sheltered
  • Both have cash contributions only. Cash and securities deposits are allowed with rollovers
  • Penalties do not apply to distributions from 59.5
  • Penalties (10%) apply to early withdrawals
  • Payouts are either lump sums or in periodic installments
  • Payments will be made to a beneficiary if the plan holder passes away

403 (B) Plans

Public school employees, churches, charities, and other nonprofits can take advantage of these tax-deferred retirement plans.

Contributions are tax-deductible for employees if limits aren’t exceeded.

Tax penalties will apply to withdrawals before 59.5 because these are designed to promote retirement savings.

Tax advantages:

  • In the calculation of gross income, contributions are not included
  • Tax-free growth of earnings until distributions

In order to qualify for a 403 (b) plan, employers must be either:

  • A religious organization
  • A 501 (c)3 tax-exempt organization
  • A 403 (b) public institution

Employees of these organizations are all eligible for these plans and contributions to them are in the form of a salary reduction before taxation. 

Employer contributions are either $56,000 per annum or 100% of the employee’s compensation, whichever is the lowest. 

Retirement plans: Corporate sponsored

Companies sponsor many types of retirement plans, including 401(k)s, profit-sharing plans, and pensions.

Defined benefit and defined contribution plans

For a retirement plan to be recognized as a qualified one, it will come from either of these types:

  • Defined contribution plans: These involve tax-deductible contributions that don’t have a specific outcome
  • Defined benefit plans: These plans don’t specify a current contribution level, but they have defined retirement benefits

Let’s look at defined contribution plans.

They consist of 401 (k) plans, money-purchase pension plans, and profit-sharing plans. 

Employers are permitted to contribute up to $56,000.

In addition to funds generated by plan investments resulting in interest and capital gains, the value of these plans at retirement depends on how much was contributed.

The deductions for these plans cannot exceed 25% of the employee’s annual salary for eligible employees who have joined the plan.

In addition, there are defined benefit plans

There are certain benefits associated with these, including monthly payments following retirement, or a straight up lump sum. 

As stated in the contract terms, regardless of how well the investment performed, the benefits will always be paid.

Profit-sharing plans

In this type of plan, employees of a business share in the profits generated by the company, and they are extremely popular. 

Benefits are either:

  • Paid to employees
  • Put into an account for future payment
  • Combination of both

For this type of plan to qualify, substantial and recurring contributions are required.

401 (k) plans

In these plans, an employer deducts a percentage of employees’ salaries.

The employer matches the contribution with pretax dollars with both then paid into a retirement account.

Roth 401 (k) plans

Employers can add Roth features to 401(k) plans, requiring after-tax contributions but tax-free withdrawals (if the account is 5 years old and the participant is 59.5 or older).

Employer contributions must be made to a regular 401(k) plan.

Withdrawals are fully taxable which means employees have the option of contributing to both their regular 401(k) and Roth 401(k) accounts.

Contributions are not allowed to be transferred between the two, however.  

Participants in these plans are not restricted by income.

Contrary to a Roth IRA, withdrawals must be made by 70.5.

Section 457 plans 

In the tax code, these are known as deferred compensation plans. 

Hospitals, unions, and charities, among others, can use them, as do states, their political subdivisions, and agencies.

Compensation can be deferred by employees if they wish and they will receive a deduction each year based on that.

SIMPLE plans

A Savings Incentive Match Plan for Employees (SIMPLE) can be opted for by businesses with fewer than 100 employees earning $5,000 or more in the previous calendar year.

SIMPLE is an easy-to-run program that allows employees to contribute up to $13,000 to the plan while it also includes a catch-up provision of $3,000.

This can be matched by employers in either of the ways below:

  • Via a 2% contribution (non-elective). This is 2% of an employee’s compensation up to $280,000, whether they opt in to contribute or not
  • Employees must contribute themselves to receive dollar-for-dollar matching contributions up to 3% of their compensation.

What about nonqualified plans?

Employers are not allowed to deduct contributions from their current taxes with these plans.

The tax deduction will be passed on to the employer when the money is paid out to the employee.

There are no nondiscrimination rules in place here either, as there are for qualified plans. 

Let’s look at other elements you should know about these plans.

Taxation of nonqualified plans

In relation to these plans, we have already discussed an aspect of taxation. 

Employee contributions can be designed so that, until the benefit is received, they aren’t taxable.

In these plans, investors’ cost base consists of already-taxed contributions.

Investors will not be taxed on the cost base when they withdraw money from the plan, but they will be taxed on the earnings.

Nonqualified plans types

There are three:

  • Payroll deduction plan
  • Deferred compensation plan
  • Retention (or supplemental executive retirement) plan

Remember the following when comparing qualified and nonqualified plans:

Qualified plans

  • Tax-deductible contributions
  • Approved by the IRS
  • Anyone can join
  • Is subject to ERISA regulations
  • Amounts accumulated are tax-deferred
  • The withdrawal of funds is taxed
  • The plan is set up as a trust

Nonqualified plans

  • Non-tax deductible contributions
  • IRS approval is not necessary
  • There is discrimination against those who can join 
  • Not subject to ERISA regulations
  • Tax-deferred on accumulation
  • Taxation on excess over cost base
  • The plan is not set up as a trust

G. Erisa concerns

Retirement plans are regulated by the Employee Retirement Income Security Act (Erisa) based on:

  • Eligibility
  • Funding
  • Vesting
  • Communication
  • Nondiscrimination

Public sector plans are not subject to ERISA regulations, only corporate plans are.

ERISA fiduciary responsibility 

Since most retirement plans are set up as trusts, Erisa had a long line of trust laws to help it govern them. 

Fiduciaries’ investment practices changed significantly as stock markets grew in the 1960s.

Consequently, the Uniform Prudent Investors Act (UPIA) was enacted to modernize trust investment laws. 

Following are some changes made by the UPIA in terms of prudent investing:

  • Prudence applies to the entire portfolio
  • A fiduciary’s primary concern is risk-return trade-offs
  • All categorical restrictions on investment types were removed
  • Investing prudently requires diversification
  • Investment function delegation is possible, as long as certain safeguards are in place

ERISA’s Section 404 must be mentioned here.

Fiduciaries of retirement plans are specifically regulated in this document. 

All responsibilities must be performed in accordance with the document specifications of the employee benefit plan if acting in this capacity.

Delegation of fiduciary duties to trustees is not allowed.  

The trustees can hire a qualified investment manager to manage investment responsibilities, if necessary. 

Investment policy statement (IPS)

An IPS should be part of every employee benefit plan, although it is not a regulated requirement. 

Funding decisions and investment management decisions will be governed by this fiduciary standard.

In most cases, an IPS will include the following:

  • Investment objectives
  • Future cash flow needs
  • Investment philosophy and asset allocation style
  • Criteria for investment selection
  • How performance and procedures are monitored

In addition, Erisa defines prohibited investments

Art, gems, collectibles, coins, and other valuable items fall into this category. 

It is important to distinguish this from prohibited transactions that a fiduciary cannot engage in.

Those that lead to a conflict of interest are not allowed including:

  • Plans assets used for their own benefit, assets from their own account, or self-dealing
  • Conducting a transaction contrary to the plan on behalf of a party
  • Receiving compensation for any transactions related to the plan on their own account

Safe harbor provisions

Section 404 (c) provides that a fiduciary who acted correctly is not liable for any losses suffered by the plan.

The regulation does, however, require three conditions:

  • Selection of the investments
  • Control of the investments
  • Communication of relevant and required information

Summary plan description (SPD)

Anyone who joins an ERISA-covered retirement plan receives an SPD. 

In addition to explaining what the plan will provide to participants, it shows how it works too.

Benefit calculations, vested dates, payment schedules, and more are covered by an SPD.

H. Special account types

In this section, we cover special account types that could feature in the exam. 

Coverdell education savings accounts

In Coverdell ESAs, students are the beneficiaries and the maximum contribution with these is $2,000.

All contributions made for these accounts are done so after-tax. 

Coverdell ESAs allow contributions (cash only) until the beneficiary is 18, although this age limit is not in place for those seen as special needs beneficiaries).

All contributions are nondeductible. 

When qualified education expenses are paid, the earning portion will not be included in the income.

If the recipient does not use the withdrawn earnings to pay for their education, they will have to pay a 10% tax penalty.

Section 529 plans

These state-operated plans allow you to save toward the education of a dependent.

Prepaid tuition plans

This works in conjunction with participating educational facilities and lets those saving for college prepay for their tuition.

Because state governments sponsor them, many will include requirements pertaining to residency.

College savings plans

In these plans, the account holder establishes an account for a beneficiary and makes contributions towards it.

Here, there are investment options that can be chosen for the plan to invest in including mutual funds, bond mutual funds, and money market funds. 

There are no residency requirements for college savings plans. 

529 plans and tax

The tax benefits provided by 529 plans are outstanding.

While contributions are made with after-tax earnings, they are not subject to federal tax and most won’t be subject to state tax either.

These tax rules apply only to withdrawals for college expenses.

Any withdrawal for other reasons will be subjected to a 10% federal tax penalty.

Restrictions for withdrawals

Withdrawals that are not related to education are subject to a tax penalty, we know that. 

Rolling over funds to a beneficiary’s family member does not incur tax liability, however, only within certain rules. 

Within 60 days after distribution, the rollover must occur, for example.  

529 plan contributions

Beneficiaries don’t necessarily have to be family members.

Contributions can be made in periodic payments or as a single lump sum. 

Withdrawals that are taxed are the responsibility of the beneficiary, not the donor. 

The maximum contribution to a 529 plan is $75,000 ($150,000 for married donors).

Donors retain control over the assets in the plan, which can be reclaimed at any time, should they wish to.

If they do, this could incur a penalty of 10%.

UTMA/UGMA accounts

In the past, custodial accounts under the Uniform Gift to Minors Act were a popular way for parents to fund their kids’ education. 

An account of this type sees the custodian who manages it entering all trades.

An adult must serve as a trustee for both UTMA and UGMA accounts.

Cash or security can be gifted to these accounts without restriction.

Custodian

Custodians who manage the account can:

  • Buy/sell securities
  • Exercise rights or warrants
  • Hold, trade, or liquidate securities

These accounts are subject to certain limitations and the custodian has a fiduciary responsibility.

Those limitations include:

  • These are cash only accounts
  • No securities can be purchased on margin
  • It is not possible to use securities as collateral for a loan
  • Reinvestments of  cash proceeds, interest, and dividends generated is a necessity
  • Investing decisions should always take the minor’s age and custody relationship into account
  • A right or warrant must be sold or exercised

As a result of performing their management duties on these accounts, custodians may be reimbursed for reasonable expenses incurred. 

In accordance with the laws governing these accounts, securities can be donated to minors.

It is then no longer possible for the donor to take back the securities after they have been transferred.

Custodian/minor death

If the person who established the account dies, a court will appoint a new one.

In the event of a minor’s death, the account securities will be included in their estate and are not transferred to their guardians/parents. 

UTMA unique features

You should note the differences between UTMA/UGMA accounts for the exam despite the fact that they are similar. 

While UGMA accounts cannot hold real property, such as partnership interests and certain intangibles, UTMA accounts can.

This means that UTMA accounts provide more investment options than their UGMA counterparts. 

Transferring UTMA accounts to minors can also be delayed and doesn’t have to happen when they reach majority age. 

Health savings accounts

Medical expenses are paid through these accounts. 

Their benefits include:

  • Contributions to them are eligible for tax deductions
  • Employer HSA contributions can be excluded from gross income
  • Contributions stay in an individual’s account until they are used
  • Earnings from interest are tax-free
  • Distributions are tax-free when used to pay for medical expenses
  • HSA’s can be carried across to a new employer when changing jobs

HSA eligibility

Requirements include:

  • It is necessary for individuals to be covered by highly deductible health insurance  
  • Individuals cannot have any other health coverage unless permitted by HSA rules
  • Individuals cannot have Medicare cover
  • An individual cannot be listed as a dependent on another’s tax return
  • The use of joint HSAs is not permitted

HSA contributions

In the case of a HSA provided by an employer, both parties can contribute to it. 

Contributions to HSAs can only be made in cash as per regulations. 

I. Estate planning techniques

TOD accounts

When a client dies, as a way to keep brokerage account assets from becoming subject to probate, the easiest approach is to use a transfer-on-death account. 

In addition, the account owner’s wishes can be followed in how funds are distributed. 

TOD accounts are subjected to state taxes, however.

In terms of paper assets, most of these will include TOD account options. 

These include savings and checking accounts, stocks, bonds, CDs as well as other securities.

In terms of the rights to the property, while they are alive, that’s only for the owner, with the named beneficiaries having the property transferred to them straight away when the owner dies. 

While alive, owners can change beneficiaries whenever they so choose. 

Assets can also be distributed unequally, as decided by the account owner.  

TOD accounts are popular because they do not require legal documents.

A TOD designation can be applied to the following accounts:

  • Individual accounts
  • JTWROS accounts
  • Tenants by the entirety accounts

J. Trading securities

Margin and cash accounts

Margin or cash are the two options customers have when opening an account.

It ultimately comes down to how they will pay for the securities as to the type of account opened for them. 

Securities bought in a cash account are settled with the full purchase price.

A margin account allows customers to borrow part of the purchase price.

Let’s examine cash accounts in more detail.

Anyone eligible to buy securities can open these accounts.

There are some accounts that may only be this type of account including:

  • IRAs and other personal retirement accounts
  • Corporate retirement accounts
  • UTMAs and other custodial accounts
  • Coverdell ESAs

There are a few more details when it comes to margin accounts.

Customers can control their investments here with less money than they can with a cash account.

Borrowing is the reason for this.

It is the amount of cash that a customer must deposit to buy securities that is called margin. 

However, there’s another aspect to consider.

This is due to the fact that a margin account can be used as a cash source by a customer.

When they have securities in their accounts that are fully paid up, this is allowed by regulations.

Their broker-dealer will lend them cash based on the value of their securities and up to the FRB’s margin limit.

There are certain suitability requirements for opening a margin account.

Also, when buying on margin, it’s through the use of financial leverage.

In other words, borrowing funds increases the possibility of potential gain (and loss).

What about marginable securities?

Regulation T highlights securities that can be used as loan collateral and those that can be purchased on margin.

These include:

  • Exchange listed bonds
  • Exchange listed stocks  
  • Nasdaq traded stocks
  • Exchange traded warrants 

If an investor has owned certain types of securities for at least 30 days, you can use them as margin collateral and include:

  • New issues
  • Mutual funds

Margin accounts require a few important documents.

The main document is the margin agreement.

Two supplementary documents are also necessary:

  • Credit agreement: Establishes the debtor/creditor terms between the firm and the client
  • Hypothecation agreement: The client authorizes the firm to use their securities as collateral by signing this document

It is optional to include a third document in the form of a loan consent. 

Clients who sign this form give the firm permission to use and lend their securities. 

Quotes, bids and offers

During the trading of securities, specific terminology is used. 

A market maker’s current bid and offer is known as a firm quote

A dealer’s highest purchase price is called the current bid, while their lowest offered price for a security is called the current offer. 

The difference between the bid price and the ask price is termed the spread, with a narrow spread linked to active stock.

When a stock isn’t bought and sold often, the spread between its bid and ask price will be wider. 

Market makers include the number of shares on offer in their quotes and the term used to describe this is size.  

If not included, a single round lot of 100 shares is what the quote is for. 

Order types

The order ticket shows you what the order is.

Regulations deem that the order ticket is prepared before a trade with the following disclosures:

  • Account number
  • Type of order discretionary, solicited, or unsolicited
  • If it’s a long or short sale (when the order is for a sale)
  • Whether the order is a stop, limit, or market order
  • If a stock, the shares, or if it’s a bond, the aggregate par value
  • Order entry time
  • Name of broker-dealer 
  • Name of the registered person who accepted the specific order

Price

A transaction’s price can be restricted by certain orders:

  • Market order: This is executed immediately at the market price  
  • Limit order: This order limits the amount paid for securities
  • Stop order: This order becomes a market order if the stock reaches or passes the stop price’s designated level. 
  • Stop limit: This is first entered as a stop order but if the stock gets to the trigger price, or moves above it, it then becomes a limit order,

Time

Transaction prices are restricted in some orders, including:

  • Day order: When a day order isn’t filled by the end of the trading day it is for, it then expires.  
  • Good till canceled (GTC) order: This order will remain valid until it is either filled or canceled. There is no time frame in play here. 

Market orders

These have no restrictions so when received, market orders will be executed.

It has priority over other orders and will always be processed before them.

Execution of a market order takes place at the lowest market price (buying) or highest market price (selling).

Limit orders

A customer can limit the purchase or selling price with this order type. 

An order will only be executed if the specified price (or higher) is in play. 

For example, a better price is one that is lower than that set by the customer on a buy order, and higher on a sell order.

If this can’t happen immediately, the order remains in the order book until such a time that the order price is met. 

Risks and disadvantages associated with limit orders are useful to know. 

For example, if this order type is used, the customer risks bypassing the chance to either sell or buy the specific security.

A market moving away from the price set by the limit order can lead to this outcome.

Stop orders

Clients can use stop orders to protect profits or avoid losses when stock prices move in the opposite direction.

It’s executed once the stock price reaches the client’s set level with this known as the stop price. 

As soon as this occurs, the stop order changes into a market order. 

In order for a stop order to be executed, there are the following trades need to take place:

  • Trigger: Activates trade when the trigger transaction is at or through the stop price
  • Execution: This sees the stop order become a market order, completing the trade at the market price.  

Stop orders fall into several categories.

When triggered, the stop limit order becomes a limit order instead of a market order.

There are also buy stop orders for those holding short stock positions which can protect a profit or limit a loss.

These are entered above what the current market is sitting at and when the market price reaches that, execution occurs. 

Sell stop orders are similar, but instead it’s a long stock position that they are protecting.  

High frequency trading and dark pools

In the stock market, high frequency trading (HFT) has become increasingly popular, with around 50% of all trades on equity markets in the U.S. using this method. 

This is trading carried out by computers with high speed internet connections that are connected to various exchanges. 

Profits are made by making use of the slight differences in pricing across different exchanges.

This is done by trading huge quantities, which result in a profit from said trade.  

Markets are more efficient thanks to this, but regulators have concerns about HFT.

That’s because, without a doubt, it leads to a more fragile financial/market system.  

HFT benefits

  • A rise in market liquidity. Actively traded stocks are particularly affected by this
  • As the market becomes more efficient, spreads narrow
  • Lower costs, particularly for mutual funds.  

HFT negatives

  • Market manipulation: As a result of massive HFT trading volumes. For example, trades can be entered and canceled which results in market activity that’s not genuine
  • Small investors don’t have access to the systems or information available to HFT traders  
  • As a result of their high volumes, HFTs can have a massive impact on the market and pricing

Dark pools

Investing public doesn’t have access to dark pools’ trading volume.

Institutional traders and trading desks conduct the trading here away from exchange desks.

A large volume of transactions is seen in alternate trading systems or crossing trading networks. 

In these systems, buy and sell orders will be matched electronically and then executed without first being first routed through an exchange or market. 

The way this happens has regulators worried, however. 

For example, there is a distinct disadvantage for those market participants who aren’t making use of these dark pools. 

That disadvantage is the fact that information on the trades taking place in these dark pools isn’t available to them. 

So the price the stock was bought or sold at, isn’t something that’s possible for them to find out leading to a less transparent market overall. 

Market participants and the costs of trading securities

Market participants include the following and you should be aware of how they operate:

  • Broker-dealers and their role
  • The role of custodians
  • The role of market makers

Trading securities requires you to understand how exchanges work as well. 

The following factors are important when it comes to the cost of trading securities:

  • Commissions
  • Markups
  • How best execution operates

K. Measuring portfolio performance

Bond yield reviewing

As a way to measure performance, yield is one of the most critical metrics available. 

And there’s more than one way to assess it. 

Current yield

A debt or equity investment’s current yield can be calculated by dividing the current market price by the annual income stream (interest or dividends).

In the case of a debt security, the annual interest rate does not change when the market price changes.

That’s because it is always fixed as a percentage of the par value.

So the interest on a 5% bond is paid every six months as two $25 payments.

Yield to maturity 

Yield to maturity is only related to debt securities and no others. 

This is because they have a maturity date and when reached, there is a payback of the loan principal. 

Among yields to maturity, yields to call are a subset thereof. 

In calculating the return here, the call date is the variable used as opposed to the maturity date, and this aids in working out the securities return. 

Bonds selling at a premium see YTC lower than YTM, CY, and NY. 

Bonds selling at a discount see YTC higher than YTM, CY, and NY.

How to measure investment returns

Total returns

These will include:

  • Dividend income
  • Interest earned
  • Capital appreciation 

These are earned over a certain period of time, but usually, this is measured per annum. 

As a measuring tool, total returns are important as they are the simplest way to work out just how a security owned by a client has performed. 

In addition, we should mention mutual fund returns

In this case, the total return may include real capital gains in addition to dividend income.

As well as any unrealized appreciation or depreciation, the total return must include them all but always should be kept apart from current return. 

Only income distributions over the past 12 months are used in current return calculations and as per SEC regulations, is divided by the current per share price. 

So current yield = annual dividend / current price.

Holding period return

Holding periods refer to the length of time a client keeps an investment. 

During that period, an investment will earn a return known as the holding period return (HPR).

HPR is similar to total return, but total return is calculated on an annual basis while HPR can be calculated for any period of time.

Annualized return

An investor’s annualized return is the amount they will earn if they hold onto an investment for a 12-month period. 

This can be calculated by the annualization factor which is then multiplied by the actual return the investment made. 

Taking 12 (for the number of months in a year) and dividing it by the investment’s holding period (in months) will give you its annualization factor. 

Inflation-adjusted return

Inflation is taken into account in this calculation which is also known as real return. 

Because inflation can reduce the buying power of a currency, investment performance can be adjusted to measure the buying power of an investment. 

Real rates of returns are returns adjusted in this manner.   

In order to calculate a debt security’s inflation-adjusted rate of return, you will need to lower its nominal return by the CPI-based inflation rate.

The inflation-adjusted return on equity securities is calculated by lowering the total return by the CPI reflected inflation rate.

After-tax return/yield

Taxes are generally applied to capital gains and income reducing any return that an investment makes. 

That return is known as after-tax or adjusted return. 

Calculate the return of the investment by reducing it by the tax rate of the client.

The client will retain 75% of the 10% yield on a return if the return makes a 10% yield for them in the 25% tax bracket.

Probable return

This is an estimate of what a return will be on an investment.

You can work it out by looking at each investment and calculating its probable return based on earnings.

Multiply that by the probability that all of this will occur. 

The sum of those probably returns is what gives us the expected return.  

Here’s the formula for this, which should make everything clear. 

Expected return = (return A x probability A) + (return B x probability B).

Risk-adjusted return

The Sharpe index, as it is also known, evaluates a portfolio and quantifies the risk associated with it.

What are the steps involved in this? 

It starts with two specific pieces of information:  First, the risk-free rate (the 91-day T bill rate)  and second, the overall return of a portfolio.  

Then take the risk free rate from the overall return which gives you the portfolio’s premium risk which you divide by its standard deviation.  

The return per unit of risk will be shown by this. 

A higher ratio means a higher return on risk, and a lower ratio means a lower return on risk.

Let’s quickly look into risk premium while we are mentioning the Sharpe ratio.

An investment’s actual return must exceed the risk-free return for this to be positive with the return commonly referred to as the risk premium.  

Risk-free return plus a risk premium combined gives us the required rate of return.

Internal rate of return (IRR)

When it comes to IRR, you should keep three things in mind:

  • It’s the best way to determine return on a DPP
  • IRR considers the time value of money
  • IRR can be used to calculate a bond’s yield to maturity

We must look at time-weighted returns too. 

An investment’s rate of return is calculated by time-weighted returns and dollar-rated returns.

However, their goals are very different.

Time-weighted returns ignore the investor’s cash flow. 

Therefore, it evaluates the investment’s performance over a period of time.

Performance measurement would focus on the investor for a dollar-weighted approach. 

Most mutual funds report time-weighted returns because investment managers don’t control future cash flows. 

Dollar-weighted returns have been mentioned above, but let’s explore them further. 

Investments and withdrawals are what’s focussed on here, for example, the sale of stocks.

Also as we’ve seen, over a certain period, the focus is on the investor’s return rather than the investment itself.

The rate of return is different when compared to the time-weighted method. 

Portfolio benchmarks

In both the overall market and its sectors, various indexes serve as benchmarks to measure performance.

The stock price of a large company will have a greater impact on indexes.

This is because they are weighted for capitalization. 

When portfolios are compared to them, they can also be used as benchmarks.

Mirroring is a factor too. 

Index funds and ETFs buy securities that mimic the performance of benchmark indexes.

Here are some of the indexes that may appear on the exam:

Dow Jones Industrial index (DJIA)

This includes 30 industrial stocks from many famous corporations and provides a true average due to the fact that it is price weighted.

By adding all 30 corporations’ share prices and then dividing by 30, the index was originally calculated.

However, stock splits over the years have changed the original divisor of 30 to include more. 

Standard and Poor’s 500

A cap-weighted index, the S&P 500 is broken down as follows:

  • 400 industrials
  • 20 transportations companies
  • 40 financial companies
  • 40 public utility companies

Most stocks are found on the NYSE but some are traded on Nasdaq. 

New York Stock Exchange Index

There are 3,000 common stocks from various companies listed on this index published by the NYSE and this index is cap-weighted. 

This index is the most comprehensive measure of market activity on the NYSE.

Nasdaq Composite Index

This cap-weighted index is for over-the-counter stocks.

Over 3,000 OTC companies are listed here.

Russell 2000 Index

It measures the performance of U.S. small-cap equities with over 2,000 securities featured.

The minimum market cap for this index is $300 million. 

EAFE

This foreign stock index is also known as the MSCI EAFE and is capitalization-weighted with stocks from 21 developed countries included. 

This is probably the most common benchmark for foreign stock funds in the securities world. 

The Wilshire 5000

This uses readily available price data to measure the performance of equity securities in the U.S. 

It was first created in 1974 with 5,000 issues, but has since declined to under 3,500. 

The Wilshire 5000 represents the broadest coverage of U.S. stock markets.

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