SIE Study Guide 2.1 – Securities products in capital markets

SIE Study Guide Navigation

• SIE Study Guide Home
• 1.1 Regulatory organizations, establishments and participants in the capital market
• 1.2 Structure of capital markets
• 1.3 Understanding economic factors
• 1.4 Types of security offerings
• 2.1 Securities products in capital markets
• 2.2 Various types of investment risk
• 3.1 Settlement, trading, and corporate actions
• 3.2 Compliance considerations and customer accounts
• 3.3 Prohibited activities
• 4.1 Associated persons SRO regulatory requirements
• 4.2 Reportable events and employee conduct

When it comes to securities products, there are a few that the SIE exam covers including:

• Equity securities
• Debt instruments
• Options
• Packaged products
• Municipal fund securities
• Direct participation programs
• Real estate investment trusts (REITs)
• Hedge Funds
• Exchange-traded products (ETPs)

The following are not considered to be securities:

• Whole and term life insurance
• Fixed annuities
• Currency/Cash
• Future contracts
• Commodities
• Personal residence

2.1.1 Product: Equity securities

On the securities market, there is a range of equities available.

Common stock

Those who hold common stock in a company can vote on the election of the board of directors as well as corporate policies.

As the name suggests, the most common way to buy into a company is by purchasing common stock.

Investors, therefore, have a say in the management of the company they invest in.

Shareholders can be rewarded too.

This happens when companies distribute their net earnings either in the form of stock dividends or even cash.

Should a company be liquidated, common stock shareholders can recoup their investment through company assets.

This only takes place, however, once creditors, preferred shareholders, and bondholders have been paid out.

Limited liability stock, however, means that they cannot go below what they paid for the stock.

Common stock can be classified in four ways:

• Authorized: Defined by the company charter and covers the shares issued by the company when raising capital
• Issued: Authorized stock that has already been sold to investors and the company has received the proceeds of those sales.
• Outstanding: This is stock issued by the company and now belongs to investors. If a company gets that stock returned, by donation, for example, it is not considered to be outstanding stock anymore.
• Treasury: Should stock that was issued be reacquired by a company, it becomes treasury stock. This stock type doesn’t have rights like common shares would. For example, you cannot receive dividends for treasury stock.

Common Stock Equivalents

Various securities can be turned into common stock

This involves the market price and the exercise price and happens when the market trades higher than the exercise price.

Common stock equivalents include:

• Options
• Warrants
• Convertible bonds
• Convertible stock options

Employment stock option plans (ESOPs) can offer common stock equivalents too.

This is achieved by offering discounted options/warrants and once vested, they can be converted to common stock.

Preferred stock

Preferred stock is different from common stock in that it offers investors certain advantages.

These included priority repayments in the event a company goes into liquidation as well as fixed cumulative dividends, for example.

Preferred stock also offers a fixed rate of return which attracts investors that are income-orientated.

Note, however, that those investors who purchase preferred stock do not have any voting rights or any preemptive rights.

Pre-emptive rights

Should a company want to raise more capital through the issue of another round of common stock, its shareholders get pre-emptive rights to buy that stock before the general public.

Pre-emptive rights allow them to preserve their share ratio against the total number of shareholders.

Warrants

This is a certificate that allows investors certain rights when it comes to buying common shares from the corporation issuing them.

For example, the holder can buy the shares at a fixed exercise price for the duration of the warrant, which can span several years.

Shares issued for stock warrants are done so directly by the corporation with the proceeds becoming capital.

Stock options

A stock option is similar to a warrant in that it lets you buy common shares at a set price within the time stated by the option.

It differs from a warrant in that the set prices are usually lower and the time period to buy the stocks is far shorter.

Often, stock options are used as compensation for employees and usually accompany an investing schedule.

Repo/Repurchase agreement

With a repurchase agreement, two parties agreed that one will purchase securities from the other, but for a specific time period.

Once that agreed-upon time period ends, the original seller will buy the securities back at a slightly higher amount.

Often, for tax and accounting purposes, a repo will take the form of a short-term loan and includes high-quality trades, for example, a U.S. Treasury Bond.

American Depository Receipts (ADRs)

These represent shares in the stock of a foreign country and take the form of certification.

ADRs can be traded on the stock exchanges within the United States, not in the foreign currency of the country they represent but in U.S. dollars.

The rights of shareholders

Those who buy shares in a company are afforded certain rights, some of which we’ve covered above.

Here are more that are extremely important as well.

Voting rights

All common shareholders have voting rights.

This allows them to vote for the board of directors of a company and they have one vote for each share that they own.

Note, that there are two types of voting systems that can be used.

With statutory voting, votes relate to each open board position.

So if there are three board positions open and you have 50 shares, you have 50 votes for each of the three positions.

With cumulative voting, votes can be disproportionately allocated to positions, for example.

Here, if you have 50 shares and there are three positions open, you have 150 votes to allocate where you like.

Restricted and controlled stock compared to freely-tradable stock

Restricted securities are those that are unregistered and bought through a private sale.

They cannot be sold again until they have been held for a total of six months.

To sell them, the restriction on them must be released by the issuer.

The phrase “the sale effectively registers the stock” is linked to this action.

That means if someone buys this stock, the restrictions that were on it no longer apply to them.

Control securities are placed with an issuer affiliate and they often own 10% or more of the voting stock of the issuer as well as directors or officers of a company.

They are considered to be restricted as they have limitations on their resale as imposed by SEC regulations as per Rule 144.

This will help find out how many shares the control person aims to sell in a 90-day period.

Most stock, however, is freely tradeable.

This allows shareholders who own it to sell their stock when they’d like to and without restrictions or limitations like those placed on controlled and restricted stock.

Order of payment should liquidation occur

Should a company be liquidated there is an order in which claims are paid.

• Administrative claims
• Debts
• Equity (first to preferred shareholders and lastly, common shareholders)

Order of payment should liquidation occur

There is always risk when investing in securities, some more than others.

Two types are risks are prominent.

• Market risk: Markets decline and as we know, can crash. Even stocks that are stocks bought from corporations with long histories of effective market returns can drop in value if this happens.
• Business and sector risk: Stocks can suffer if a business sees demands for their stock decline for any number of reasons. It could be bad management, a falling interest in their products, or more. The sector they operate in plays a role. Think of the travel industry during the Covid-19 pandemic.

2.1.2 Debt Instruments issued by governments, agencies, and corporations

Let’s look at the debt instruments issued by the government, agencies, and corporations.

Debit issuers

To start, let’s look at what a debt issuer is defined as.

Well, they loan money from investors.

By the end of the loan or the maturity date, debt issuers will pay back the original amount borrowed but also interest accrued during the duration of the loan.

Treasury securities

The United States government has many different ways in which it borrows money.

• Treasury bonds: Interest on a treasury bond is paid every six months but it’s free from state taxes. These bonds are long-term loans (up to 30 years).
• Treasury notes: Interest on a treasury note is paid every six months but it’s free from state taxes. These bonds are intermediate-term loans (between two and six years).
• Treasury bills: Interest on a treasury bill is paid at maturity. It’s calculated as the surplus of the face amount over the purchase price, which is discounted by interest. These bonds are short-term loans (one year or less). Treasury bills are often referred to as T-Bills.

When it comes to T-Bills, the U.S. Treasury auction them off weekly.

Investors can either place a non-competitive tender on the offering or a competitive bid.

Once all the bids have been received, the price of the offering is determined.

Those investors who bid at the lowest discount rate (winning yield) or above will get the T-Bills.

Municipal securitiesld liquidation occur

Municipalities or the legislators in a city or town operate at the local government level and have corporate status.

Projects carried out by these municipalities, cash flow deficits, and day-to-day obligations are funded in various ways.

Let’s take a look at how this is done.

General obligation bond

This is the financing method that’s used to raise capital for infrastructure funding.

They are supported by the total tax and operating revenue of a municipality.

That means they are not backed by collateral at all.

Revenue bonds

These bonds can also be issued to raise capital for public projects.

Those who purchase the bonds, however, receive their repayments from the income accrued by the project itself and never from the total revenue of the issuer.

Special tax bonds

Special tax bonds are considered a blend of a general obligation and revenue bond.

While they also fund public projects, they differ from the other two in the way bondholders receive repayments.

To do this, local government will raise a specific tax, usually a special assessment tax or an excise tax.

A municipality might impose a special excise tax on gas, for example.

Special tax bonds

If a local government wanted to fund a facility that will produce income, it will probably use these bonds to do so.

An example of this is toll roads.

The revenue generated by the operation of the facility not only pays the interest but the principal when maturity is reached.

Taxable bonds

These are fixed-income municipal securities.

They tend to fund projects that don’t provide a significant benefit to the public in general, for example, funding for public pensions or debt refunding.

They are not tax-exempt or subsidized in any way.

Municipal notes

These are short-term debt securities exempt from federal income tax that mature in less than a year typically.

When they do mature, the principal and income are paid at the same time in one payment.

Corporate bonds

We’ve seen how corporations can raise capital through stock offerings.

Another method to do this is to issue bonds to investors.

Here, interest on the bonds will be paid every six months typically.

At maturity, the repayment of the principal is made to bondholders.

Let’s look at two other bonds that are also considered corporate bonds.

• Convertible: This bond gives a company the option to use cash instead of common stock to repay the loan.
• Zero-coupon: This bond has no interest payments. Below face value is what the investor pays at first. When the bond matures, they receive full value for it.

Money market instruments

These are short-term fixed-income debt instruments that are considered safe and liquid.

Normally, they take up to 270 days to mature.

Let’s look at a few examples.

CD or Certificate of deposit

Issued by a credit union or bank, a CD is similar to a savings account.

Over a fixed period – usually six months, one or five years – it will generate a set interest on a fixed amount of money.

Should an investor draw funds early, they run the risk of penalization.

Traditional CDs are held by banks while brokered CDs can be purchased from brokerage firms.

These are considered more of a risk as bank-held CDs include federal insurance.

Banker’s acceptance

These trade on the secondary money market before they mature.

Mostly used in international transactions, they are guaranteed future payments that mature between 30 and 180 days.

Depending on their length to maturity, they are sold at discount to face value.

Order of payment should liquidation occur

These interest-paying, unsecured securities are also called promissory notes.

They cover the short-term obligations of large corporations that traditionally issue them.

These papers act as a promise to pay back an agreed-upon amount of money over a certain period.

They are normally sold at face value but also at a discount from time to time.

Par value

Par value is also referred to as nominal value, face value, or principal.

It describes the value of the bond once it matures.

Interest rates

Interest rates too can be referred to by other names

These include the coupon rate or nominal yield.

The interest rate on a bond is always paid to investors by the bond issuer and is expressed as a percentage.

These payments generally happen twice a year.

To determine the interest rate, take the sum of the yearly coupon payments and divide them by the bond’s face value.

Accrued interest

When interest is earned that has not yet been paid, that’s known as accrued interest.

To calculate it, take the time between the last coupon payment as well as the number of business settlement days.

Then dived that by the number of days in the year and finally multiply by the coupon interest rate.

Now you have the accrued interest figure.

It’s critical to note, however, that the number of business settlement days is always three (3) and days in the year is 360 for municipal and corporate bonds.

Yields

This describes investment and the rate of return expected from them.

In bonds, the rate of return is measured by interest while in stocks, it’s dividends.

Here are a few examples of different yield types:

• Current yield: This refers to bonds and their expected annual rate of return. Divide annual interest by the bond’s current market price to calculate it.
• Yield to maturity: Also called a YTM, redemption or book yield, this describes the expected yield overall for a bond should it be held right up to the maturity date.
• Yield to call: Also called a YTC, this relates to callable bonds. If the issuer calls the bond prior to the maturity date, the YTC is the overall expected yield at the time it is called.

Length/Term to maturity

This is the time between the date the bonds are issued and the date on which they will mature for both corporate and treasury bonds.

When dealing with mortgage-backed and asset-backed maturities, they are traded on something known as average life, also called weighted average life.

This describes the outstanding length of time expected for each dollar of principal.

And the average life is shorter than the length to maturity based on the fact that included in periodic payments are interest and partial repayments of principal.

As a reminder, an asset-backed security is linked to a pool of underlying assets.

It’s from this that their value and income payments are obtained.

A mortgage-backed security provides investors with payments periodically, much like bond coupon payments.

They are secured by mortgages, like home loans and other real-estate lendings.

Further bond characteristics

From time to time, certain provisions will be added to bond offerings by issuers.

This is to make them more attractive to potential investors.

• Callable: This allows the issuer the ability to pay off the bond earlier than the maturity date. Because they offer a higher risk, callable bonds have higher interest rates most of the time.
• Convertible: Instead of paying the loan with cash, a convertible bond give the issuers the ability to use common stock instead.
• Zero-coupon: There is no interest paid on these bonds. An investor will still receive full value at maturity but pays below the face value of the bond when securing them.
• Puttable: Lower risk bonds with lower interest rates, a puttable bond allows those holding it the ability to recoup the principal amount before the maturity date. This still takes place on or after a specific date that is made known beforehand.
• Insured: This applies to municipal bonds only. When municipalities have poor credit ratings, they have the option to buy bond insurance. This ensures that interest and principal are paid in a timely manner which will boost the confidence of prospective investors. Bonds like these are guaranteed by the Municipal Bond Insurance Corporation.

Rating agencies

Around 95% of all international bond ratings are carried by three rating agencies.

They are:

• Moody’s
• Standard and Poor (S&P)
• Fitch Group

Agencies look at debt securities and evaluate the credit risk they pose.

Then the securities are assigned a rate that ranges from AAA for those with the highest quality and lowest risk down to Bs and Cs for higher risk, lower quality options.

Liquidation priority

Priority of payment is often used to rank different types of bonds as sometimes an issuer might have more than one bond issue outstanding.

The top priority is given to senior secured debt.

Senior debt – which typically is secured debt – follows and then subordinated debt, which is unsecured.

No matter what the debt type it always has priority over equity.

Price, interest rate, and the relationship between them

An inverse relationship exists between bond market prices and interest rates.

So when bond market prices rise, then interest rates will fall.

And when interest rates rise, bond markets fall.

A few factors can have an impact on both of these as well.

Debt securities and their risk

There’s always a risk involved in investing.

Let’s take a look at a few more prominent risks.

• Political risk: Political changes in a country can play a role in capital markets and have an impact on issuers. Perhaps, these changes lead to a debt downgrade or a risk of default.
• Credit risk: This is a default on loan payments by the issuer.
• Liquidity risk: Too few buyers are available for securities that the issuer needs to sell quickly.
• Interest rate risk: Unexpected fluctuations in the interest rate cause bonds to decrease in value.
• Inflation risk: A decline in the expected return on a bond due to purchasing power diminishing due to inflation.

Negotiated vs Competitive municipal bond offerings

Underwriters have two ways to buy municipal bonds for resale.

There are through either negotiated or competitive sales.

Negotiated sales

The terms of the bond as well as the terms of the sale are directly negotiated in a two-party process.

The parties are the issuer and the underwriters, who the issuer is allowed to select.

Also, indications of interest (IOIs) can be submitted in negotiated sales by investors.

These IOIs aid the underwriter determine the final offering price as well as selling the bonds.

Competitive sales

A notice of sale is released to the public by the issuer.

This advertises their bonds for sale and includes the terms of the bond issue and the terms of sale.

Broker-dealers, banks, and other underwriters then bid on those bonds at a date and time specified by the issuer.

The underwriter that offers the lowest interest rate wins.

2.1.3 Options

As you know, an option is a type of derivative contract drawn up between two investors, one the buyer and the other, the seller.

Options – of which there are two types, put and call – are traded on trade exchanges that purposely deal with them, for example, the Chicago Board Options Exchange.

• Call options: This contract allows a buyer the opportunity to buy options within a specific time period at a specific price. The option they buy, be it a stock, bond or commodity is known as the underlying asset. Buyers are never obligated to buy the options.
• Put options: With this contract, the owner of the option has the right to sell the security or underlying asset on the expiration date or even before it.

The writer or seller of the option gives the buyer the right, not an obligation, to buy or sell the underlying asset at a specific price and date (or before it).

For this, they receive a fee or premium.

If the option is exercised, the writer is legally bound to deliver or purchase the underlying asset.

Terminology related to options

Here are a few terms related to options that are important.

Covered and uncovered

With covered options, they are already owned by those who want to sell them.

With uncovered options, the seller of the option doesn’t own it yet and has to buy it first before they can sell it to an interested investor.

Underlying assets

Because an option is a derivative product, the value thereof depends on the value of its underlying asset of which the most common are stock.

And that value can fluctuate.

As an example, when you purchase a stock option for a certain company that authorizes you to buy shares, the underlying asset would be the stock of that company.

Other examples of underlying assets are foreign currency, debt securities, and market indices.

Expiration date

They can range from a short period, a week for example, or last for years.

The contract on options has an expiration date.

The longer the option lasts and the further into the future the expiration date, the more expensive the option will tend to be.

Strike price

Also known as an exercise price, this is the price at which a put or call option can be exercised and is agreed upon and enforced contractually.

Intrinsic value

Options have the possibility of being “in the money”, “out of the money”, or “at the money” and that’s because of the fluctuation in the prices of options contracts.

Let’s look at what those terms mean using stock as an example.

• In the money: This is when the underlying stock trades higher than the strike price on a call option. On a put option, the scenario flips around with the underlying stock trading lower than the strike price. In both of these, the stock and put options are said to have intrinsic value.
• Out of the money: This is when underlying stock trades lower than the strike price on call options. On a put option, the underlying stock trades higher than the strike price. Now, both the stock and put options have no intrinsic value and those holding either option would probably not exercise their rights to sell or buy.
• At the money: If the current price of the underlying stock is the same as the strike price, it is said to be at the money and has no intrinsic value.

Long vs Short option contracts

In the securities trade, a long call is when an investor has purchased a call option.

A short call is when an investor decides to sell a call option.

The same adheres to the buying and selling of put options.

Strategies for options

There are several reasons why option contracts are bought and sold.

The most common, however, is that they are used to reduce exposure to investment losses.

The term to describe that is hedging.

Investors use hedging by taking a position in another investment to lower the risk of current investments.

Here are some hedging strategies that are often used.

Covered call writing

Consider this scenario.

Let’s say an investor holds 10 shares of stock.

He decided to write a call option for them.

By this, he offers them for sale at a strike (or fixed) price over a certain time in return for a premium.

Should the stock’s value decline, the dollar amount of the premium received gives downside protection.

But should the stock’s value improve, that gain will be capped.

That capped figure is determined by the amount the strike price exceeds the current market price of the stock.

Covered call writing is the process of writing a call on stock already owned by the investor.

Protective put buying

Let’s go back to that investor with 10 shares of stock.

Now he decides to purchase a put option on them which contractually locks in a strike price at which stock can be sold should it decline in value.

A premium, however, has to be paid to contractually fix the price at which they are allowed to sell their shares.

It’s worth it, however, should the value of the stock decline.

Protection like this is known as protective put buying.

Capital gains

Capital gains refer to substantial upside profit (or capital gains) when someone buys a call when you think the stock price will rise in value or buying a put when you think it will fall in value.

Buy to cover

Buy to cover sees an investor borrowing shares from a broker as they believe stock prices will decline and then selling them at the current market price.

When the market does drop, they buy the shares back on the open market and then return them to the broker.

Other options knowledge

Options Clearing Corporation (OCC)

The OCC works under the supervision of the Commodities Futures Trading Commission (CFTC) and the SEC and clears put and call option transactions.

Options Disclosure Document (ODD)

When an investor opens an options account with a brokerage firm, before account approval, they must provide a full disclosure document to that investor.

This is called an ODD.

The main aim of the document is to educate investors as to how options work and the potential risks involved in trading.

The ODD will also include the rules of the COE and the OCC.

American style v European style

In certain cases, options contracts can only be exercised on the expiration date.

This is known as the European style.

For American style options, the contract can be exercised at any time, not just on the expiration date.

2.1.4 Understanding Packaged Products

In this section, we cover a range of package products.

These include exchange-traded funds, variable life insurance, and mutual funds.

Generally, when you see the term packaged, this means a collection of stocks or bonds.

Often, this is also called a portfolio of securities.

Investment companies make packaged portfolios of varying stocks or bonds available for the investing public to buy in the form of shares.

Let’s look at some examples of packaged products.

For the most part, mutual funds are open-ended.

This means investors are allowed to invest as much as they want in shares that form part of that fund or portfolio.

The net value asset (NAV) or price of the fund fluctuates every day.

That’s because it is calculated by taking the fund’s total securities value divided by the number of outstanding shares.

Investors in mutual funds own shares of the fund, not underlying securities.

One and more portfolio managers (often investment firms) are tasked with actively managing the fund.

They make the critical decisions of buying and selling securities but they aren’t doing it alone.

Most have teams of research analysts who look at market trends to help with decision-making.

Mutual funds can offer various share classes.

There are four main types: Class A, Class B, Class C, and Class D.

With Class A shares, a front-end fee is required when purchased.

With Class B shares, a back-end fee is required when sold.

Critically, mutual funds often have a purchase minimum for those who want to buy into them.

For retail funds, for example, this can range from $500 to $5,000.

Note, however, that this fee is often waived if mutual funds are purchased through IRAs or 401(k) retirement accounts.

Mutual funds have other expenses too which are listed in their prospectus.

These can include account fees, management fees, sale load, and redemption fees, for example.

The prospectus, which is delivered to all potential investors showing an interest in the fund also includes details of the managers of the fund, the securities held, fees, minimum investment amounts, and the overall fund objectives.

Orders for traditional mutual funds are executed when the market closes each day (4:00 PM EST) and at a purchase price that’s based on net asset value.

All orders for both bought and sold mutual funds must be placed before the market closes.

It is prudent to take note of the disclosure requirements for mutual funds.

This requires that every quarter, a report must be filed with full lists of their holdings and not later than 60 days after the end of the fiscal quarter.

SEC Forms N-Q and N-CSR are used to file these reports

As for mutual fund advertising, all must be approved by a principal of a FINRA member firm.

Should a firm only have been a FINRA member for a year or less, advertising must be submitted to FINRA at least 10 days before it is scheduled to be used.

In summing up, almost all mutual funds will fall under the following categories:

Money market funds, bond funds, stock funds, and target-date funds.

All have their risks, strategies, and objectives.

• Money market funds: These funds may only invest in specific government, bank, or corporation short-term, high quality debt investments as required by law. Because of this, they are considered to be one of the safest investments that can be made.
• Bond funds: While riskier than money market funds, a bond fund is still a safer investment than a stock fund. Here, the goal is to invest in corporate or government debt securities. Investors receive a monthly return through interest payments.
• Stock (equity) funds: Stock funds have a far greater potential to grow but this makes them riskier too. There are a few different types as well, each of which has distinct goals. A growth fund invests in stocks with high returns while industry funds buy corporate stocks from the energy industry, for example.
• Target date funds: These are for investors that have retirement in mind. As the target date of retirement approaches, investments change and become more conservative. Funds like this are a mix of equity, debt, and other investments.

Index Funds

Index funds are similar to mutual funds in several ways.

They too invest in securities portfolios and then investors can buy into those portfolios by purchasing shares.

The difference comes in the way they are managed.

While mutual funds are actively managed, index funds are managed passively.

For that reason, when it comes to expenses, those for index funds are far lower than mutual funds.

Because of the lower expenses, index funds prove to be quite popular, especially with investors who are looking to diversify the stocks they buy into.

So how do index funds work?

The aim is to reproduce the performance of a chosen stock market index which is used as a benchmark, for example, the Dow Jones.

It does this by seeing what securities the particular index tracks and then purchasing the same ones.

Index funds offer several advantages.

We already mentioned that they are cheaper than mutual funds, but they also don’t need a very hands-on approach to manage.

They are taxed lower too and all of these have seen their popularity grow significantly in recent years.

There are risks, however, such as index tracking not being accurate, market volatility, and low flexibility.

Closed-end funds (CEFs)

Available fund shares for CEFs are limited and focus on just one sector/industry.

An actively managed fund, CEFs use IPOs to raise capital and can be bond or equity funds

That is then traded on stock exchanges.

A CEFs never will buy back shares from investors and doesn’t issue new shares following the IPO.

In terms of trading, CEFs shares are found on the secondary market.

Because prices are set by the market, they will vary.

That means at times they will exceed or be lower than the net asset value.

If someone sells their CEFs at a higher NAV, they’ve done so at a premium, and lower than the NAV is said to be a discount.

CEFs differ from mutual funds in that they may leverage their net assets by issuing debt or preferred shares.

While this is likely to raise distributions to investors, the NAV of the fund can become more volatile too.

When it comes to distributions, generally they are paid each month, but some funds pay quarterly.

Distributions are paid out as interest income, repayment of principal, capital gains, or dividends.

Unit Investment Trusts (UITs)

UITs have to be registered with and regulated through the SEC and have a certain investment objective.

To reach that, they maintain portfolios of securities over a long-term period.

Capital is raised from investors using an on-off public offering by the trust sponsor.

This is similar to a closed-end fund.

But UITs have characteristics of mutual funds too in that the trust sponsor can purchase units back from investors.

These transactions are carried out at the estimated NAV at the time.

Some UITs also allow for trade on the secondary market between investors.

There isn’t any need for active management when it comes to UITs.

Stock is bought and then held for a long period according to the life of the UITs.

Should an investor be interested in seeing what securities form part of the UITs, they can review its prospectus.

This also includes information about dividends, the UITs date of termination, fees schedules, and more.

As for the termination date of UITs, this is created when the trusts originate.

All remaining securities at termination are sold.

The proceeds raised from this are paid out to investors.

Other investments

Other than what we have covered above, there are other investment options too.

Variable life insurance

Life insurance companies make these permanent policies available to the general public.

Upon the death of the person covered, the beneficiary will receive the benefits afforded by the specific policy.

To fund these payouts, the policy’s cash value is invested into securities, for example, a mutual fund.

When compared to a traditional life policy, this investment sees variable life insurance offering greater upside potential.

With a permanent life policy, a person is covered as long as the premiums are paid on time.

Variable life policies provide a minimum benefit that is guaranteed.

Because of this, compared to a traditional life policy, this minimum is lower and it has higher premiums too.

So in theory, should the variable investments perform below predictions, a variable life policy can cost more than a traditional one.

529 College saving Plans – Municipal fund securities

This is popular for parents who want to prepare for their children’s education, particularly after they leave secondary school.

They can fund anything from tuition to study materials.

Because they are not only created but sponsored in each state separately, the SEC refers to them as municipal fund securities.

Separate accounts of variable annuities

Maintained by insurance companies, these portfolios are invested by variable annuity investors.

They do this for the most part for long-term tax deferral reasons.

Important terminology relating to packaged products

Let’s look at some terminology that’s important when it comes to packaged products.

Loan funds

When mutual funds charge a commission fee, they are known as loan funds.

The fee, also known as a load or sales charge is capped at 8.5% of the purchase-sale by FINRA.

If the fee is charged when the investor makes the purchase it is known as a front-end fund.

If it is charged at the time that the investor sells their securities, it is known as a back-end fund.

Some funds don’t charge at the purchase or during the sale.

These are called no-load funds and have other ways of collecting their fees.

As designated FINRA regulation 12-1b, a fund can be a no-load fund if its fees are lower than a maximum of 0.75% of the net asset of the fund.

Investment objective

All funds will have an investment objective and this is something that will be stated about the fund.

For example, they may want to:

• Generate income from bonds and stocks
• Focus on capital preservation
• Grow invested capital

Those are just a few examples of what the investment objective for a fund could be.

Surrender charge

There are penalties fees charged to investors should they withdraw funds during the surrender period.

This applies to mutual funds, annuities, and insurance policies, for example.

The surrender period is generally a certain length of time, from when they first set up their insurance policy.

Breakpoint

Breakpoint describes a mutual fund discount on sales charges.

Investors will reach it at a certain dollar level.

To see breakpoints for mutual funds, look at its prospectus as they have to be outlined there.

There might be both eligibility requirements associated with the breakpoint as well, although not all mutual funds have these.

For example, a lumpsum proviso covers single purchases.

In other words, an investor makes a large enough single purchase that immediately qualifies them for breakpoint sales charge discounts.

Due to the size of these large investment sales that could qualify for a lumpsum charge discount, you will find that they are usually made by institutional investors.

There’s also a letter of intent (LOI) where investors in mutual funds will commit to purchasing shares in a fund over a certain time period.

This is usually 13 months.

By making smaller payments and not one lump sum, those with fewer assets can get immediate breakpoint discounts.

It’s often retail investors that make use of LOIs.

Rights of accumulation (ROA)

This sees investors in mutual funds qualify for charge discounts on bulk sales.

This only happens, however, when their accumulated investments meet or exceed some breakpoint thresholds and of course, this doesn’t happen overnight.

In fact, it’s likely to take a number of years.

$25,000, $50,000, and $100,000 are common breakpoint thresholds when it comes to rights of accumulation.

2.1.5 Securities – Municipal Funds

While we’ve briefly touched on municipal fund securities, in this section of our guide, we go a little deeper.

In that regard, we are specifically going to look at ABLE accounts, investment pools used by local government, and 529 college savings plans.

That’s where we will start.

College savings plans

529 college savings plans are used by many parents to help give their children a monetary boost when it comes to postsecondary education.

It’s not only tuition that’s expensive, either.

What about textbooks, accommodation, and extra-curricular activities?

They cost a pretty penny too, that’s for sure.

When it comes to 529 college savings plans, the SEC refers to them as mutual funds and as such, that’s how they are treated by investors.

They are designated as such because each state in the United States creates and sponsors its own specific 529 college savings plans.

When it comes to these plans, account owners are allowed to adjust their investments twice per annum.

These plans are either direct-sold or advisor-sold, which is important to note.

• Direct-sold plans: These are state-sponsored 529 college plans and are not offered by a broker-dealer. These fixed portfolios are not as flexible as an advisor-sold plan but their fees are lower.
• Advisor-sold plans: An advisor-sold 529 college saving plan is bought from a registered broker-dealer. They do carry higher fees but offer more flexibility than direct-sold options. The extra fees are in the form of commissions charged by brokers on the sales of investment products.

The earnings on 529 college saving plans are not seen to be taxable income, which makes these plans popular due to the tax benefits they offers.

Some other tax benefits include:

• No taxes are charged on capital gains or investment income
• Tax-free withdrawals

Of course, this only relates to when the funds are used to cover educational expenses and only those that cover qualified postsecondary education.

But that’s not the only benefit that can be gained from a 529 plan.

More than 30 states across America provide either partial or full tax deductions when it comes to contributions towards 529 plans.

ABLE accounts

Achieving a Better Life Experience or ABLE accounts are aimed specifically at Americans with disabilities.

These municipal fund securities allow those who qualify the ability to save for disability-related expenses – up to $15,000 per annum.

Like direct-sold 529 college savings plans, ABLE accounts are created by the states themselves.

There are tax-free withdrawal options on these plans too, but only when it comes to disability-related expenses.

These, for example, would include expenses related to healthcare or specialized transportation.

Who is eligible to hold an ABLE account?

First, those individuals who receive a Supplemental Security Income (SSI) or a Social Security Disability Insurance (SSDI) qualify.

Secondly, individuals who have had a liability, or had a diagnosis of blindness before the age of 26 are also eligible.

Individuals that have the power of attorney, parents, or guardians acting on behalf of a beneficiary can open ABLE accounts.

While contributions aren’t tax-deductible, they can be made post-tax by anyone.

ABLE accounts have a monthly maintenance fee which is charged by the state.

Some may also include a minimum contribution limit.

Again, like the monthly maintenance fee, this varies from state to state.

Local Government Investment Pools (LGIPs)

LGIPs are state government investment vehicles that don’t require registration with the SEC.

This sees local government resources pooled and invested in short-term securities.

The goals of these LGIPs could be to secure a return on investment or for liquidity reasons while the resources used include counties, cities, and even school districts.

LGIPs are generally sponsored by either the state, local government, or by cities or counties operating under a joint power agreement.

The last example, however, depends on whether state laws allow such a collaboration.

2.1.6 DDPs – Direct Particpation Programs

Direct Participation Programs (DDPs) are another option as an investment vehicle.

This is considered an alternative form of investment that sees investors buy directly into a business that offers these DDP investment options.

For their investment into a particular business, an investor can take part in the business’s cash flow and tax benefits, for example.

DDPs are often organized legally as limited partnerships, real estate investment trusts (REITs), or limited liability corporations (LLCs).

When participating in DDPs, an investor buys into the program as a limited partner.

The general partner then uses the pooled money from investors to invest in various businesses.

All investors receive income and tax benefits from DDPs over the course of the limited partnership, which runs from between five to 10 years in most cases.

The biggest advantage that DDPs offer is the fact that, at the investor level, their profits are only taxed once in what is called a pass-through model.

Here, instead of the DPP entity doing so, individual investors report profits as income.

Compare that to regular corporations that are double-taxed and you can immediately see this is a major advantage.

In terms of liquidity and marketability, ownership units in DDP investments are similar to shares but typically won’t be traded or listed on stock exchanges.

This makes it difficult for limited partners who sell their units to withdraw from the DDP to do so.

In other words, as in investment, DDPs are more aimed at those investors looking more long term and who don’t require their sellable investments that are readily available.

But there’s more to the suitability of DDPs that we need to cover.

In most states, DDPs are only sold to accredited investors, those that can handle their non-liquidity.

Those who want to participate in DPPs must also meet various income and net worth conditions.

Note that these often vary, not only depending on the state the investor is in, but the DDP they are looking to invest in as well.

Lastly, DDPs offer limited liability.

This means that it is similar to other passive investments in the fact that the maximum loss an investor can incur as a result of financial or legal problems for the DDP will be capped at their investment amount.

Tenants in Common (TIC)

The last DDP to cover in this section is known as Tenants in Common or TIC.

This revolves around real estate and investors buying into TICs to purchase fractional ownership.

This is also commonly referred to as co-ownership interest.

Those who enter into a TIC investment see their money pooled with other investors.

This is then used to acquire a property asset that no single investor could realistically acquire on their own.

Typically secured as DDPs, TIC investments are tax-deferrable but also not very liquid at all.

There are suitability requirements when it comes to TICs, just as there are with DDPs.

These broker requirements cover reasonable-basis and include customer-specific suitability.

2.1.7 REITs – Real Estate Investment Trusts

Real Estate Investment Trusts or REITs are another popular type of investment.

Obviously, REITs all revolve around real estate.

Generally, REITs see a group of companies investing in real estate that produces income or other real estate assets.

This could be anything from office buildings, to apartments or even resorts.

The money invested in these real estates by the REITs comes from various investors which are pooled together to make the specific investment.

While they are similar to packaged portfolio products, REITs aren’t made up of securities, only real estate and investments in that field.

They are similar to DDPs, however, in the fact that they too must submit to a pass-through taxation model.

Let’s look at the types of REITs available to investors.

• Private REITs: For the most part, these REITs don’t need to register with the SEC. They are not traded on stock exchanges either but instead are bought through private placement offerings. That means, private REITs have fewer disclosure requirements than most others. This, however, does make it difficult to valuate them. They also do carry added risks when analyzed against others.
• TFs and stocks, they are traded on the national securities exchange. Public traded REITs are bought through brokerage accounts and offer far more liquidity than other REITs.
• Public non-listed REITs: Registered through the SEC these REITs can be bought by all investors from a brokerage that offers them.
   They don’t offer much liquidity and are not traded on a stock exchange.

Equity and Mortgage REITs

There are two other forms of REITs that we must cover – equity and mortgage (or debt) REITs which usually invest in mortgage loans or property.

Sometimes, they will invest in both.

Equity REITs

A large portion of the REITs market is made up of this type.

Equity REITs first acquire and then manage commercial real estate.

This includes the likes of apartments or hotels, for example.

But how do they generate revenue?

Well, by leasing out the properties and then collecting rent from those tenants or businesses that live in or use them as a commercial space.

When operating costs are met, an equity REIT will start to pay out income to shareholders in the form of dividends.

This must amount to 90% of the income generated.

These dividends are paid in various ways but usually either monthly or once a quarter.

Equity REITs can also make further income due to real estate price appreciation.

Mortgage REITs

Around 10% of this market is made up of Mortgage REITs, also known as Debt REITs.

Revenue with Mortgage REITs is generated when they lend money to real estate buyers and then collect interest on the mortgage loans and other debt instruments, for example.

Just like Equity REITs, they must also pay shareholders at least 90% of the annual taxable income earned.

As they do not own physical real estate like Equity REITs, Mortgage REITs won’t benefit from property price appreciation.

Suitability

So who can buy into REITs?

Well, FINRA says that they should only be sold to those investors who have a grip on just how volatile the real estate market is.

That’s because these investors need to understand that their invested principal could be exposed to losses.

That means accredited investors are favored, especially for private REITs.

2.1.8 – Hedge Funds

Hedge funds are just another form of investment that’s available.

It targets sophisticated investors, however, especially those that are either institutional investors or accredited.

The capital generated through these investments is used to produce large returns, and quickly.

For that reason, hedge funds have a particular set of suitability as well as entry requirements.

They provide far less liquidity than mutual funds and are considered to be high-risk profiles, hence the stringent requirements regarding who can invest in them.

How are hedge funds structured?

In the United States, most hedge funds are structured as limited partnerships.

Those that manage the fund, however, act in the capacity of general partners with investors as the limited partners.

Why is this important?

Well, as a limited partner, an investor can only be liable according to the amount they have invested in the hedge fund.

The general partner, the fund managers are saddled with unlimited liability, however.

That unlimited liability means that the general partners in a hedge fund are often LLC entities.

The individual fund manager then operates as a member or owner of the LLC.

In this way, the personal assets of the fund manager are protected through limited personal liability.

Hedge funds provide pass-through tax treatment, just like DDPs and mutual funds do.

Profits, therefore, are only taxed once for investors.

Hedge fund leverage

Investment returns for hedge funds are often increased through the use of leverage, or borrowed money.

That’s because they can purchase securities on margin.

This sees the purchase of a massive amount of securities by borrowing funds from a broker to be able to do so.

There is another option, to purchase securities other than borrowing funds from a broker.

And that’s by using third-party lenders for credit lines.

In both of these, however, it’s all about using some form of borrowing to help increase the overall gains made.

Of course, there’s a massive risk too.

For example, should investments lose their value, this can increase losses significantly.

Hedge fund suitability

Because money is invested for a period of time – at least one year – hedge funds are seen to be illiquid.

It’s only after that period has passed that investors are allowed to make withdrawals.

The time period in which they cannot touch their investment is known as the lock-up period.

As mentioned earlier, investors must be seen to be accredited before they are allowed to invest in a hedge fund.

Remember that an accredited investor is someone who:

• Either alone or with a spouse has a $1,000,000 or higher net value or
• Over the last two years as well as expecting the same in the current year, has earned at least $200,00 per annum ($300,00 if including a spouse)

Hedge fund fees

When investing in a hedge fund, the minimum investment that can be made is $100,000,

For those who want to invest more, the maximum allowed is $2 million.

When compared to mutual funds, ETFs, or other packaged portfolios, the fees associated with hedge funds are far higher.

Most use a fund compensation structure called two and twenty.

This means an annual asset management fee of around 2% is charged on the amounts invested.

That’s not all though.

A performance fee is charged as well.

This is for fund profits above the hurdle rate and amounts to around 20%.

As far as the hurdle rate is concerned, this is defined as a threshold of return the fund must reach for the performance fee to be paid out.

It’s predetermined too.

While fees generally do change across different hedge funds, two and twenty are the standard for most.

Private equity funds

While many people confuse the two, hedge funds and private equity funds are not the same thing although there are certain similarities between them.

Those are:

• They draw the same type of investors
• How compensation is structured
• Their overall legal structure (both are seen as limited partnerships)

When it comes to differences, however, hedge and private equity funds have completely different goals and investment strategies.

You will find that hedge funds can be invested in pretty much anything, as long as they can generate profits over the short term.

This includes derivatives, currencies, debt securities, and equity securities.

Looking at private equity funds, however, you will find them aiming for long-term returns.

That sees them investing in companies.

They do this by either buying the company or when it comes to publicly traded companies, purchasing controlling stock.

Private equity funds have far longer lock-up periods too but are less risky when compared to hedge funds.

2.1.9 – ETPs – Exchange-Traded Projects

Exchange-traded products or ETPs are investment products that provide a low-cost option for those who don’t want to invest in actively managed funds, or mutual funds, for example.

Bought and sold like an individual stock, ETPs track underlying securities, indices as well as other financial instruments.

The prices of ETPs are then obtained from these underlying instruments.

For the most part, ETPs are structured as:

• UITs (recap on Packaged Products to refresh your memory)
• ETFs

They can be both passively or actively managed.

With passively managed ETPs, the objective is to try to reproduce the performance of the financial instruments that are tracked.

With actively managed ETPs, replicating the performance benchmark isn’t the aim.

Instead, the fund manager of the ETP will pick certain instruments to attempt to outperform the benchmark.

ETFs – Exchange-traded funds

What are ETFs?

Well, they offer either a limited number of shares or packaged portfolios for investors to buy into.

Found on an exchange where investors can trade in them, it’s about buying shares of a particular fund, not the underlying assets or securities.

While they operate in an almost identical way to closed-ended funds, there is a small technical difference.

Just like mutual funds, portfolio diversification is allowed.

The difference comes because of real-time pricing (also called intraday pricing) and the fact that lower investment minimums and brokerage commissions (even zero) are the order of the day with these funds.

ETFs also track an index and can be traded at the bid or ask prices on stock exchanges, just like regular corporate stocks are.

Let’s talk a little about intraday or real-time pricing.

Like other individual stock, this just means that the ETFs price is not static and changes throughout the day.

This differs significantly from mutual funds, for example.

They are priced at the end of trading and this allows buyers and sellers to receive the same price.

As for the cost of an ETF, it comprises four primary direct costs but also varying indirect costs.

When it comes to the direct costs, however, they include taxes, premiums, expense ratio as well as brokerage commissions.

Not only are ETFs more liquid than mutual funds, but they carry fewer fees too.

Let’s quickly cover the types of ETF stocks available, as there are a few different types, each with its own specific investment strategy too.

• Stock ETF: This describes equities portfolios that are found in a particular index sector. Those that have dividend-paying equities mostly do so each annum, but some pay more frequently.
• Bond ETF: This pays out dividends each month and sees investment in fixed-income securities and bonds.
• Real-estate ETF: This sees investment in REITs and real estate operating companies for the most part. Some, however, might even own physical real estate.

ETFs and tax

Let’s see how tax relates to the various ETF options covered above.

When compared to mutual funds, stock ETFs are more tax-efficient.

That’s because generally, they do not sell off holdings, and therefore don’t make frequent capital gain distributions as they are passively managed.

Also different from mutual funds is the fact that the fund manager doesn’t have to sell holdings in order to pay an investor who has sold off shares of an ETF.

The reason for this is the direct trade of the shares on the exchange between investors.

So when does an investor get taxed when it comes to stock ETFs?

Well, if they are paid a dividend or sell their shares for profit, they will be taxed.

For example, if selling their shares for profit, an investor is charged capital gains tax.

This is based on how long they held the ETF.

If they are paid a dividend, tax payments depend on whether that was unqualified or qualified.

Unqualified dividends are seen as ordinary income and therefore, investors are taxed in that manner.

Because a qualified dividend is held over a period of time – or the holding period – they get taxed at lower capital gains tax rates.

That’s it for taxation and stock ETFs but let’s not forget about bond ETFs.

While they are mostly treated like stock ETFs when it comes to taxation, there are some differences with some examples.

To start, if an investor sells bond ETF shares and receives a profit, they will have to pay capital gains tax.

This is based on the length of time they held the shares.

That’s the same as with stock ETFs, right?

But the difference comes in the fact that bond ETFs will mature at a faster rate and for that reason, capital gains distributions happen at a faster rate than with stock ETFs.

So it’s important to bear that in mind.

Note too that corporate bond ETF interest payments are not seen by the IRS as qualified dividends.

This means they are taxed as ordinary income.

There are exemptions as well.

This depends on the various bond options held within a portfolio.

Interest payments made for certain bond ETFs, for example, those including U.S. government bonds, are often exempt from state and local taxes.

Exchange-traded notes (ETNs)

Much less common than and distinct from ETFs are exchange-traded notes.

Issued straight from a financial institution, a bank, for example, these are senior, unsecured debt obligations.

They do not hold a portfolio of securities or assets but track a benchmark index.

When the ETN matures, the issuer will pay the holder based on the underlying benchmark index’s performance.

Of course, there are applicable fees taken off as well.

As for the date of maturity, well that’s usually anything from 15 to 30 years from the date of issue for most ETNs.

There are several risks associated with ETNs and for that reason, they aren’t for all investors.

For example, ETNs make no promise to repay the principal amount someone may have invested.

And unlike other debt instruments, there are no periodic interest repayments.

When it comes to payments from ETNs, it all depends on underlying assets and is only made once the ETN matures.

There’s the possibility too that these can be either lower or higher than the principal amount invested and from time to time, the variance can be huge.

Other negatives with ETNs include:

• Liquidity risk
• Market risks
• Credit risk for the issuer