Invesetments - Bryant

Question 1

Investment Company Act of 1940: who must register?

When must the required parties disclose their information to investors?

What doesn’t the SEC supervise or weigh in on?

Answer 1

This Act regulates the organization of companies, including mutual funds, that engage primarily in investing, reinvesting, and trading in securities, and whose own securities are offered to the investing public.

The regulation is designed to minimize conflicts of interest that arise in these complex operations.

The Act requires these companies to disclose their financial condition and investment policies to investors when:

1. stock is initially sold and,
2. subsequently, on a regular basis.

The focus of this Act is on disclosure to the investing public of information about the fund and its investment objectives, as well as on investment company structure and operations.

It is important to remember that the Act does not permit the SEC to directly supervise the investment decisions or activities of these companies or judge the merits of their investments.

Question 2

Securities Act of 1933

Answer 2

Often referred to as the “truth in securities” law, the Securities Act of 1933 has two basic objectives:

1. Public Info for Public Sale Securities:
   
   1. require that investors receive financial and other significant information concerning securities being offered for public sale; and
2. Prevent Fraud:
   
   1. prohibit deceit, misrepresentations, and other fraud in the sale of securities.

Purpose of Registration:

• A primary means of accomplishing these goals is the disclosure of important financial information through the registration of securities. This information enables investors, not the government, to make informed judgments about whether to purchase a company’s securities.
• While the SEC requires that the information provided be accurate, it does not guarantee it.
• Investors who purchase securities and suffer losses have important recovery rights if they can prove that there was incomplete or inaccurate disclosure of important information.

Question 3

What was the purpose of the Securities Exchange Act of 1934?

Answer 3

1. SEC
2. Fraud prevention and disciplinary powers
3. Authorized to require periodic reporting of information by companies with publicly traded securities

Question 4

Registration Process under Securities Act of 1933

What are the requirements?

What are the Exemptions?

Answer 4

In general, securities sold in the U.S. must be registered

Requirements: the registration forms companies file provide essential facts while minimizing the burden and expense of complying with the law:

1. a description of the company’s properties and business;
2. a description of the security to be offered for sale;
3. information about the management of the company; and
4. financial statements certified by independent accountants.

Exemptions:

1. private offerings to a limited number of persons or institutions;
2. offerings of limited size;
3. intrastate offerings; and
4. securities of municipal, state, and federal governments

Why Exempt?

• By exempting many small offerings from the registration process, the SEC seeks to foster capital formation by lowering the cost of offering securities to the public.

Question 5

What are the powers of the SEC?

What are the Periodic Reporting requirements?

When must proxy materials be filed with the SEC?

What is the threshold for Tender Offer that forces information to be filed with SEC?

Insider Trading?

Who is required to register with the SEC under the 1934 Act?

Answer 5

1934 Act - Empowers the SEC with road authority over all aspects of the securities industry, including the power to register, regulate, and oversee brokerage firms, transfer agents, and clearing agencies as well as the nation’s securities self regulatory organizations (SROs). The various securities exchanges, such as the New York Stock Exchange, the NASDAQ Stock Market, and the Chicago Board of Options are SROs. The Financial Industry Regulatory Authority (FINRA) is also an SRO.

Periodic Reporting

1. Annual & Periodic Reports:
   
   1. $10 Million in assets
   2. 500 owners
   3. These reports are available to the public through the SEC’s EDGAR database
2. Proxy Solicitation
   
   1. The Securities Exchange Act also governs the disclosure in materials used to solicit shareholders’ votes in annual or special meetings held for the election of directors and the approval of other corporate action. This information, contained in proxy materials, must be filed with the Commission in advance of any solicitation to ensure compliance with the disclosure rules. Solicitations, whether by management or shareholder groups, must disclose all important facts concerning the issues on which holders are asked to vote.
3. Tender Offers
   
   1. the Securities Exchange Act requires disclosure of important information by anyone seeking to acquire more than 5 percent of a company’s securities by direct purchase or tender offer. Such an offer often is extended in an effort to gain control of the company. As with the proxy rules, this allows shareholders to make informed decisions on these critical corporate events
4. Insider Trading
   
   1. The securities laws broadly prohibit fraudulent activities of any kind in connection with the offer, purchase, or sale of securities. These provisions are the basis for many types of disciplinary actions, including actions against fraudulent insider trading. Insider trading is illegal when a person trades a security while in possession of material nonpublic information in violation of a duty to withhold the information or refrain from trading.
5. SEC Registration under 1934 Act
   
   1. The Act requires a variety of market participants to register with the Commission, including exchanges, brokers and dealers, transfer agents, and clearing agencies. Registration for these organizations involves filing disclosure documents that are updated on a regular basis.
   2. The exchanges and the Financial Industry Regulatory Authority (FINRA) are identified as self-regulatory organizations (SRO). SROs must create rules that allow for disciplining members for improper conduct and for establishing measures to ensure market integrity and investor protection. SRO proposed rules are subject to SEC review and published to solicit public comment. While many SRO proposed rules are effective upon filing, some are subject to SEC approval before they can go into effect.

Question 6

What type of Securities does the 1939 Trust Indenture Act apply to?

What is the interplay between the Trust Indenture Act of 1939 and Securities Act of 1933

Answer 6

Securities - Offered for PUBLIC SALE:

1. Bonds
2. Debentures
3. and notes

Interplay:

• Even though such securities may be registered under the Securities Act, they may not be offered for sale to the public unless a formal agreement between the issuer of bonds and the bondholder, known as the trust indenture, conforms to the standards of this Act.

Question 7

What are the requirements for an adviser to register under the Act?

Who do they register with?

Answer 7

This law regulates investment advisers. With certain exceptions, this Act requires that firms or sole practitioners compensated for advising others about securities investments must register with the SEC and conform to regulations designed to protect investors.

Since the Act was amended in 1996 and 2010, generally only advisers who

1. have at least $100 million of assets under management or
2. advise a registered investment company must register with the Commission.

Question 8

What was the purpose of the Sarbanes-Oxley Act of 2002

Answer 8

On July 30, 2002, President Bush signed into law the Sarbanes-Oxley Act of 2002, which he characterized as “the most far reaching reforms of American business practices since the time of Franklin Delano Roosevelt.”

The Act mandated a number of reforms to

1. enhance corporate responsibility,
2. enhance financial disclosures and
3. combat corporate and accounting fraud, and created the “Public Company Accounting Oversight Board,” also known as the PCAOB, to oversee the activities of the auditing profession.

Question 9

Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010

Answer 9

The Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into law on July 21, 2010 by President Barack Obama. The legislation set out to reshape the U.S. regulatory system in a number of areas including but not limited to consumer protection, trading restrictions, credit ratings, regulation of financial products, corporate governance and disclosure, and transparency.

Question 10

The Jumpstart Our Business Startups Act (the “JOBS Act”) was enacted on April 5, 2012

Answer 10

The Jumpstart Our Business Startups Act (the “JOBS Act”) was enacted on April 5, 2012. The JOBS Act aims to help businesses raise funds in public capital markets by minimizing regulatory requirements.

Question 11

What is an investment company under the 1940 Act?

What are the 3 basic types?

What are some types of exclusions?

Answer 11

Any issuer which:

1. is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting, or trading in securities
2. is engaged or proposes to engage in the business of issuing face-amount certificates of the installment type, or has been engaged in such business and has any such certificate outstanding
3. is engaged or proposes to engage in the business of investing, reinvesting, owning, holding, or trading in se­curities, and owns or proposes to acquire investment securities having a value exceeding 40 per centum of the value of such issuer’s total assets (exclusive of Government securities and cash items) on an unconsolidated basis.

3 Basic Types:

1. Mutual Funds - legally known as open-end companies
2. Closed-end funds - legally known as closed-end companies
3. UITs - legally known as unit investment trusts

Exclusions - (e.g. most Hedge Funds)

1. Private Investment Funds with no more than 100 investors, and
2. Private investment Funds whose investors each have a substantial amount of investment assets
   3.

Question 12

What are the share features of Mutual Funds, Close-end funds, and UITS?

Answer 12

Redeem Shares?

1. Mutual Funds = Yes
2. Close-End Funds = No
   
   1. Instead, when closed-end fund investors want to sell their shares, they generally sell them to other investors on the secondary market, at a price determined by the market
3. UITs = Yes

Question 13

What are some variations within each type of investment company?

Answer 13

1. Stock Funds
2. Bond Funds
3. Money Market Funds
4. Index Funds
5. Interval Funds
6. Exchange Traded Funds (ETFs)

Question 14

NAV = ($ of Stock A x # of shares of Stock A) + ($ of Stock B x # of shares of Stock B) - Liabilities

NAV per share = NAV / Outstanding shares

Example 1

Assume that a mutual fund has $100 million worth of total investments in different securities, which is calculated based on the day’s closing prices for each individual asset. It also has $7 million of cash and cash equivalents on hand, as well $4 million in total receivables. Accrued income for the day is $75,000. The fund has $13 million in short-term liabilities and $2 million in long-term liabilities. Accrued expenses for the day are $10,000. The fund has 5 million shares outstanding. The NAV is calculated as:

How often is NAV updated?

Answer 14

Example 1

NAV = [($100,000,000 + $7,000,000 + $4,000,000 + $75,000) - ($13,000,000 + $2,000,000 + $10,000)] / 5,000,000 = ($111,075,000 - $15,010,000) / 5,000,000 = $19.21

How often is NAV updated?

It is important to note that while NAV is computed and reported as of a particular business date, all of the buy and sell orders for mutual funds are processed based on the cutoff time at the NAV of the trade date. For instance, if the regulators mandate a cutoff time of 1:30 p.m., then buy and sell orders received before 1:30 p.m. will be executed at the NAV of that particular date. Any orders received after the cutoff time will be processed based on the NAV of the next business day.

Question 15

What are the life spans of a UIT

Answer 15

1. Life span
   
   1. As short as 6 months (unit trusts of money market instruments)
   2. As long as 20 years or more
   3. Life span
      
      1. As short as 6 months (unit trusts of money market instruments)
      2. As long as 20 years or more

Question 16

What are the advantages of a Mutual Fund?

What are the disadvantages of Mutual Fund?

Answer 16

Advantages

1. Diversification
   
   1. you purchase a small fraction of the mutual fund’s diversified holdings
2. Professional Management
   
   1. Lets you gain access to professional management
3. Minimal transaction costs
   
   1. Economies of Scale
4. Liquidity
   
   1. open-end fund shares are easy to convert to cash
5. Flexibility
   
   1. Over 7,300 mutual funds with varying objectives and risk levels
6. Service
   
   1. Mutual funds can provide book-keeping services, checking accounts / automatic systems to add & withdraw from your account. buy sell online?

Disadvantages

1. Lower than market performance
   
   1. on average, most mutual funds under-perform the market
   2. A top-performing actively managed fund might do well in the first few years. It achieves above-average returns, which attracts more investors. Then the assets of the fund grow too large to manage as well as they were managed in the past, and returns begin to shift from above-average to below-average.
   3. By the time most investors discover a top-performing mutual fund, they’ve missed the above-average returns. You rarely capture the best returns because you’ve invested based primarily on past performance.
2. Costs
   
   1. Ongoing annual fees to keep you invested in the fund.
   2. Transaction fees paid when you buy or sell shares in a fund (also known as loads).
3. Narrow Specialization
   
   1. Many funds have become very narrow in specialization or segmentation. The result is less diversification
4. Systematic Risk
   
   1. Mutual Funds won’t protect against systematic risk
5. Taxes
   
   1. When mutual funds sell securities within their portfolios for a profit, the majority of the capital gain is distributed to the shareholders. There is a lack of control of the holding period, so the distributed gains can have more short-term gains (which are taxed as income) than long-term gains (which are taxed at a lower fixed percentage)
   2. When it comes to distributions, the difference between ordinary income and capital gains has nothing to do with how long you have owned shares in a mutual fund, but rather how long that fund has held an individual investment within its portfolio.
6. Unrealized Capital Gain
   
   1. When you buy a fund, you are essentially buying someone else’s tax liability. The difference between the market value of the stocks currently held by the fund, and what the fund paid for the stock (the fund’s basis) is known as “unrealized capital gain.” This data, along with fund turnover (how often a fund trades its securities) information, will be a fairly good predictor of realized capital gains, as described under the tax disadvantage, above. The very nature of a mutual fund necessarily means that the newest shareholders will subsidize the capital gain taxes for the longer-term shareholders
7. Style Drift
   
   1. Over time, the internal fund managers who make asset allocation and security selection decisions, may deviate from the stated fund’s objective
8. Poor Estate Planning
   
   1. Mutual funds do not lend themselves for basic estate planning issues such as giving your highly appreciated assets away, and selling losers for tax breaks
9. Transaction Price
   
   1. Can only buy or sell at a price at the end of the trading day. This can be a huge disadvantage in a rapidly moving market

Question 17

Tax Treatment Strategies under Mutual Funds

Answer 17

1. Consider the timing of fund purchases and sales relative to distributions?
   
   1. Year-end fund distributions apply to all shareholders equally, so if you buy shares in a fund just before the distribution occurs, you’ll have to pay tax on any gains incurred from shares throughout the entire year, well before you owned the shares. This could have a significant tax impact.
   2. Selling a fund prior to the distribution will generally result in more capital gain or less loss than if you sell the shares after the distribution, if you only take into account market price changes reflecting the distribution. Selling shares after the distribution usually will yield less gain or more loss.
   3. If you are considering a purchase or sale around the time of a distribution, there are many other factors to consider, including the size of the dividend relative to the size of your expected investment and how the transaction may fit in your overall tax strategy. Consult a tax or other advisor regarding your specific situation.
2. Consider the fund’s turnover rate?
   
   1. Since a capital gain must be reported each time a purchase or sale of shares is made, funds that trade securities in and out very frequently may be apt to accumulate more taxable gains. Additionally, trading fees associated with this activity may also increase costs, cutting into net earnings.
   2. Fidelity offers Index Funds, which tend to have lower turnover than actively managed funds. You can also use the Fund Evaluator in Mutual Funds Research and include turnover as a factor in your search criteria (located in the advanced criteria under Fund Management).
   3. Again, taxes are only one of many factors you should consider when choosing a mutual fund. Consult a tax or other advisor regarding your specific situation.

Question 18

Closed-End Funds?

What is the relationship of NAV and closed-end funds?

Answer 18

Initial offer of a SET number of shares that are then traded exclusively in the secondary market

Although their value is also based on the fund’s NAV, the actual price of the fund is determined by supply and demand, so it can trade at prices above or below the value of its holdings.

Question 19

Closed-End Fund vs. Closed Fund

Answer 19

Don’t confuse a closed-end fund with a “closed fund,” which is an open-end fund that no longer accepts new investors.

Question 20

Expense Ratio

EXAMPLE:

Let’s say you own a mutual fund that is valued at $10 per share. It has a gross return of 10%, meaning its total investment return was $1 per share. If there were no fees, the fund share would be valued at $11, but the fund manager deducts 1% in fees, so your actual investment return is…

What has a higher expense ratio:

1. Actively Managed funds vs. Passive or Index Funds?
2. International Funds vs. Domestic Funds?
3. Small-Cap Funds vs. Large-Cap Funds?
4. NOTES
   
   1. Different companies charge different expense ratios for similar funds…always need to check yourself.
   2. When comparing fund fees, keep the items above in mind. It doesn’t make sense to compare the fund fee on a U.S. large-cap fund to one on an international fund. That is not an apples-to-apples comparison.

Answer 20

IN EVERY SINGLE MUTUAL FUND

It costs money to run a mutual fund. Some funds cost more to operate than others. Regardless of the cost, all mutual funds have a fee referred to as an expense ratio, or sometimes called a management fee or an operating expense. This fee is deducted from the total assets of the fund before your share price is determined. Like many other fees and expenses related to mutual funds, the expense ratio does not represent a charge that is directly payable by the investor. Instead, the expenses are taken from the mutual fund assets.

Example:

0.89 cents instead of the full $1, and after fees, your share is worth $10.89.

Higher Expense Ratio:

1. Actively Managed Funds
   
   1. This is because an actively managed fund is conducting ongoing research trying to determine the best securities to own. This research costs more, but statistics show you don’t get what you pay for.
2. International Funds
   
   1. It costs more to purchase investments that are traded outside of the U.S. This higher cost is passed along in the form of higher expense ratios
3. Small-Cap Funds
   
   1. It costs more to buy and sell small stocks than large ones. This higher cost is passed along in the form of higher expense ratios.

Question 21

What are the basics of Front-End Loads?

What is the percentage paid?

What class of shares charges Front-End Loads in Mutual Funds?

When is the front-end load fee waived?

What is the relationship between the expense ratio between Mutual Funds A-Share and other classes of shares?

Answer 21

The term most often applies to mutual fund investments, but may also apply to insurance policies or annuities. The front-end load is deducted from the initial deposit, or purchase funds and, as a result, lowers the amount of money actually going into the investment product OR raises the total amount required

• Let’s say you are buying a fund that is valued at $10 per share and has a 5% front-end sales charge or load. You will pay approximately $10.52 for each share purchased, as a 5% sales fee will be added on to the initial purchase price of your shares
• To illustrate how the load works let’s say an investor invests $10,000 in the AGTHX fund. They will pay a front-end load of 5.75%, or $575. The remaining $9,425 is used to purchase shares of the mutual fund at the current share net asset value (NAV) price.

Percentage Paid?

1. The percentage paid for the front-end load varies among investment companies but typically falls within a range of 3.75% to 5.75%. Lower front-end loads are found in bond mutual funds, annuities, and life insurance policies. Higher sales charges are assessed for equity-based mutual funds

Mutual Fund Class of Shares?

1. Class A Shares

Waiver?

1. With a front-end load fund, if your total investment amount exceeds a threshold amount and you are willing to invest it all into the same fund family, you may qualify for what is called a “breakpoint,” or a lower upfront fee
2. Generally, the sales charge on a load mutual fund is waived if such a fund is included as an investment option in a retirement plan such as a 401(k).

Expense Ratio:

1. For instance, front-end loads eliminate the need to continually pay additional fees and commissions as time progresses, allowing the capital to grow unimpeded over the long-term. Mutual fund A-shares—the class that carries front-end loads—pay lower expense ratios than other shares pay.
2. Expense ratios are the annual management and marketing fees.

Question 22

What is a No-Load Mutual Fund?

Answer 22

Mutual funds that do not charge loads are known as no-load mutual funds.

Funds without front- or back-end sales charges. Purchased directly by investors or through advisors. The typical no-load fund does not carry any letters after its name, though no-load share classes are sometimes tagged as “retail” or “investor” shares. No-load means an investor will not pay a broker to buy and sell their shares, they are able to execute the trades on their own. Typically, the maximum front load is 0%, the maximum deferred load is 0%, the maximum 12b-1 fee is between 0 and 100 bps, and the investment minimum is $2,500 or less.

How Much Does a No-Load Mutual Fund Cost?

1. No-load mutual funds may be free of sales charges (loads), but they do have costs.
2. All share classes of funds—load or no load—carry fees that are paid out of the fund’s assets to the fund’s investment advisors (as opposed to paying the advisor/broker who sells the fund).
3. The bottom line is that no-load funds are almost always preferred over loaded funds. Just be sure that your no-load funds’ expense ratios are below average.

Question 23

What are the characteristics of Class A shares?

Answer 23

Funds that have lower investment minimums and carry a front-load to pay the advisors’ sales commission.

This charge comes right off the top of the investment.

A shares are usually the most cost-effective for long term investors who are using a commission-based broker to transact.

Typically,

1. the maximum front load is between 4% and 5.75%,
2. the maximum deferred load is zero,
3. the maximum 12b-1 fee is between 0 and 50 bps and
4. the investment minimum is $2,500 or less

When do you buy Class A shares?

1. Use A shares for long-term (more than 8 years), especially if you can get a break on the front-load for making a large purchase.
   
   1. Now that you know A share funds charge a front-load with each purchase, you won’t want to make frequent purchases, such as with a systematic investment plan, with this share class because you’ll be hit with a charge of up to 5.00% every time you buy shares. Better to do one big purchase if you can get the discount on front-load charges.
2. Although A share funds have front loads averaging around 5.00%, their expenses are low after that.
3. Therefore, a lump sum investment held for a long period, such as 5 to 10 years or more, would be well-suited for an A share fund

Question 24

What are the characteristics of an Adv shares?

Answer 24

Funds typically purchased through advisors, but generally requiring a higher minimum investment. Known as Adv Advisor. Typically, the maximum front load is 0%, the maximum deferred load is 0%, the maximum 12b-1 fee is between 0 and 50 bps, and the investment minimum is $2,500 or less.

Question 25

What are the characteristics of Class B Shares?

Answer 25

Funds that have lower investment minimums and carry a deferred-load sales charge, also called a surrender charge.

B shares are typically not the most economical choice because their expense ratios that are paid year after year are typically higher than A shares.

An investor may pay a charge when selling shares of the fund if they are redeemed before specified time periods, typically within five years. The sales charge decreases with the time invested such that the surrender charge is higher in year one than it is in year five.

Typically:

1. the maximum front load is 0%,
2. the maximum deferred load is between 4% and 5%,
3. the maximum 12b-1 fee is between 75 and 100 bps, and
4. the investment minimum is $2,500 or less.

When do you buy Class B shares?

1. B shares are a good choice for the long-term investor who wants to invest frequently (i.e., dollar-cost averaging)
   
   1. Class C shares charge what is called a “level load,” which is typically a flat 1.00% per year. This may seem like less than a 5.00% front-load but over a long period of time, C shares cost more than other share classes.
   2. Now that you know A share funds charge a front-load with each purchase, you won’t want to make frequent purchases, such as with a systematic investment plan, with this share class because you’ll be hit with a charge of up to 5.00% every time you buy shares.

Question 26

What are the characteristics of Class C Shares?

Answer 26

Funds that have lower investment minimums and carry a level-load structure.

This sales charge is typically a recurring fee of 1% that is used on an annual basis to compensate advisors.

C shares do not include a front-end sales charge, but their expense ratio is typically higher than B shares.

Typically,

1. the maximum front load is 0% and occasionally 1%,
2. the maximum deferred load is 1% and occasionally 0%,
3. the maximum 12b-1 fees is between 75 and 100 bps, and
4. the investment minimum is $2,500 or less.

When to buy Class C Shares?

1. In general use C shares for short-term (less than 3 years)
   
   1. lass C shares charge what is called a “level load,” which is typically a flat 1.00% per year. This may seem like less than a 5.00% front-load but over a long period of time, C shares cost more than other share classes.

Question 27

What are the characteristics of class D shares?

Answer 27

Funds that have lower investment minimums and carry a level-load structure.

This sales charge is typically a recurring fee of 1% that is used on an annual basis to compensate advisors.

D shares are typically carried by broker-sold fund shops. These are usually noload shares that are available through mutual fund supermarkets such as Charles Schwab or TD Ameritrade. Although there are no front-end or back-end loads with D shares, an investor will typically be charged a transaction fee to buy into this share class.

Typically,

1. the maximum front load is 0%,
2. the maximum deferred load is 0% and occasionally 1%,
3. the maximum 12b-1 fee is 0% and occasionally between 1 and 50 bps, and t
4. the investment minimum is $2,000 or more.

Question 28

What are the characteristics of Institutional shares?

Answer 28

Funds typically purchased by large institutional buyers, such as pension plans.

These share classes are typically only offered to investors who invest $1 million or more.

Invariably, institutional shares have the lowest expenses in the mutual fund universe.

Typically, the maximum front load is 0%, the maximum deferred load is 0%, the maximum 12b-1 fee is 0%, and the investment minimum is $25,000 or more. Also known as I or Y shares

Question 29

Morningstar Share Class - Type M

Answer 29

Typically, M shares carry lower front-end loads than A shares and are available to investors with larger initial investments.

Typically

1. the maximum front load is either 0% or between 1% and 3.5%,
2. the maximum deferred load is 0%,
3. the maximum 12b-1 fee is sometimes 0% and sometimes between 25 bps and 100 bps, and
4. the investment minimum is $50,000 or more.

Question 30

What are the characteristics of Inv share class?

Answer 30

Investor share classes can be purchased by individual investors, so there is usually no front or deferred load charged.

However, investment minimums may be slightly higher. Also known as Investor or Investment.

Typically,

1. the maximum front load is 0%,
2. the maximum deferred load is 0%,
3. the maximum 12b-1 fee is sometimes 0% and sometimes between 1bp and 25 bps, and
4. the investment minimum is $10,000 or less

Question 31

What are the characteristics of N class shares?

Answer 31

Typically, N shares are available to investors with larger initial investments.

Many also charge a 12b-1 fee.

Typically,

1. the maximum front load is 0%,
2. the maximum deferred load is 0%,
3. the maximum 12b-1 fee is between 25 and 50 bps, and
4. the investment minimum is $50,000 or more

Question 32

What are the characteristics of No-Load shares

Answer 32

Funds without front- or back-end sales charges. Purchased directly by investors or through advisors. The typical no-load fund does not carry any letters after its name, though no-load share classes are sometimes tagged as “retail” or “investor” shares. No-load means an investor will not pay a broker to buy and sell their shares, they are able to execute the trades on their own. Typically, the maximum front load is 0%, the maximum deferred load is 0%, the maximum 12b-1 fee is between 0 and 100 bps, and the investment minimum is $2,500 or less.

Question 33

Funds not elsewhere classified

Answer 33

Funds not elsewhere classified. This category contains fewer than 5% of all U.S. funds. Also know as most other share class letters. The maximum front load, the maximum deferred load, the maximum 12b-1 fee, and the investment minimum all vary widely.

Question 34

What are the characteristics of Retirement class shares?

Answer 34

Funds available through retirement plans. R share classes are purchased by retirement plan participants, usually without any sales loads.

The fees that these funds charge range widely.

Some R shares are ultra-low-cost, while others bundle in the record-keeping and other administrative costs associated with running the plan.

Typically,

1. the maximum front load is 0%,
2. the maximum deferred load is 0%,
3. the maximum 12b-1 fee is between 25 and 50 bps, and
4. the investment minimum varies. Also known as K and J shares

Question 35

What are the characteristics of Class S shares?

Answer 35

S shares are former no-load share classes that have been closed to new investors.

If an investor would like to buy into one of those funds for the first time, they will have to go through a broker and opt for the A, B, or C share class.

S share classes are similar to noload funds in that there is usually no front or deferred load charged. However, investment minimums may be slightly higher.

Typically,

1. the maximum front load is 0%,
2. the maximum deferred load is 0%,
3. the maximum 12b-1 fee is 0%, and
4. the investment minimum is $2,000 or more.
5. Also known as Z shares.

Question 36

What are the characteristics of Class T shares?

Answer 36

Typically, T shares carry lower front-end loads than A shares and are available to investors with larger initial investments.

Typically,

1. the maximum front load is 0% but sometimes between 3% and 4.75%,
2. the maximum deferred load is 0%,
3. the maximum 12b-1 fee is sometimes 0% and sometimes between 25 bps and 50 bps, and
4. the investment minimum is $2,000 or more.

To prepare for the DOL fiduciary rule, asset managers are making adaptations to support fiduciary standards. T shares look to become an industry fixture with a standard, maximum sales charge across all fund categories of 2.5% and a 0.25% 12b-1 fee. By having a standard fee, advisors won’t be financially incentivized to recommend one mutual fund over another. This should make it far easier for wealth management firms to manage conflicts.

Question 37

What are back end loads?

Answer 37

Also called contingent deferred sales charges, backloads are charged only when you sell the fund. These charges can also be 5% or more, but the load percentage is usually reduced in increments over several years until the load amount reaches zero. Mutual funds with back loads will usually be Share Class B funds, which are normally identified by the letter ‘B’ at the end of the fund name.

Question 38

What are level loads

Answer 38

These loads are neither charged at purchase, nor at the sale of the mutual fund. Instead, there is an ongoing “level” percentage, such as 1.00%, that the investor pays to the mutual fund company. Like front-end loads and back-end loads, level loads are not fees paid directly out of the investor’s pocket, nor are they “billed” to the investor. Instead, with level loads, the fee reduces the net return of the investor. For example, if a level load fund charging 1.00% has a total return before fees of 10%, the investor will get a net return of 9%. Mutual funds with level loads will usually be Share Class C funds, which are normally identified by the letter ‘C’ at the end of the fund name.

Question 39

12(b)1 Fee, Service Fee, or Distribution Fee

Answer 39

A 12b-1 fee is an annual marketing or distribution fee on a mutual fund. The 12b-1 fee is considered to be an operational expense and, as such, is included in a fund’s expense ratio. It is generally between 0.25% and 0.75% (the maximum allowed) of a fund’s net assets. The fee gets its name from a section of the Investment Company Act of 1940..

If you purchase a “C share” mutual fund it will typically have an extra 1% 12(b)1 fee, in addition to an expense ratio. Just like the expense ratio, this service fee will be deducted out of the total fund assets before your share price is determined.

Example: Let’s say you own a C share that is valued at $10 per share. It has a gross return for the year of 10%, meaning its total investment return was $1 per share. The fund manager deducts 1% in fees, so your actual investment return is .89 cents instead of the full $1.

Two Distinct Charges in 12b-1 Fees:

1. the distribution and marketing fee - capped at 0.75% annually
2. the service fee - capped at 0.25%

Class A - C

1. Class A shares, which usually charge a front-end load but no back-end load, may come with a reduced 12b-1 expense but normally don’t come with the maximum 1% fee.
2. Class B shares, which typically carry no front-end but charge a back-end load that decreases as time passes, often come with a 12b-1 fee.
3. Class C shares usually have the greatest likelihood of carrying the maximum 1% 12b-1 fee.
4. The presence of a 12b-1 fee frequently pushes the overall expense ratio on a fund to above 2%.

What are Class 12b-1 Fees used for?

1. The distribution fee covers marketing and paying brokers who sells shares.
2. They also go toward advertising the fund and mailing fund literature and prospectuses to clients.
3. Shareholder service fees, another form, specifically pay for the fund to hire people to answer investor inquiries and distribute information when necessary, though these fees may be required without the adoption of a 12b-1 plan.
4. Another category of fees that can be charged is known as “other expenses.” Other expenses can include costs associated with legal, accounting and administrative services.
5. They may also pay for transfer agent and custodial fees.

Question 40

Rank the expense ratio based on the fund category of the following:

Large-Cap Stock Funds

Mid-Cap Stock Funds

Small-Cap Stock Funds

Foreign Stock Funds

S&P 500 Index Funds

Bond Funds

Answer 40

Here is a breakdown and comparison of average expense ratios you can expect, based on fund category:

1. Foreign Stock Funds: 1.50%
2. Small-Cap Stock Funds: 1.40%
3. Mid-Cap Stock Funds: 1.35%
4. Large-Cap Stock Funds: 1.25%
5. Bond Funds: 0.90%
6. S&P 500 Index Funds: 0.15%

Question 41

What is the maximum load charge?

Answer 41

Percentage Load cannot exceed 8.5% of the amount invested

Question 42

Money Market Funds

Answer 42

Maximum maturity of underlying investment = 13 months

Average maturity of all investments in a money market fund = less than 90 days

Typical investments inside a money market fund might be

1. US Treasury issues,
2. short-term corporate paper, and
3. CDs that present an extremely low risk of default.

Benefits:

1. typically liquid - usually get your money out within a few business days.
2. take advantage of rising interest rates by keeping your money in an investment that will adjust to the markets
3. A lot of institutions allow you to write checks to withdraw your funds from a money market fund
4. Therefore, you get the advantages of dividend earnings as well as easy access to your cash

Risks:

1. First, a money market fund is technically a security
2. The fund managers attempt to keep the share price constant at $1/share. However, there is no guarantee that the share price will stay at $1/share. If the share price goes down, you can lose some or all of your principal
3. The U.S. Securities and Exchange Commission notes that “While investor losses in money market funds have been rare, they are possible.”
   
   1. In return for this risk, you should earn a greater return on your cash than you’d expect from an FDIC insured savings account.
4. Not FDIC insured
5. Variable Rates
   
   1. In other words, you don’t know how much you’ll earn on your investment next month
6. For example, common stock returns average out to 8 percent to 10 percent over time, while money market mutual funds come in at only 2 percent to 3 percent on average. Over long periods of time, inflation can eat away at your returns, and you might be better served with higher-yielding investments.

Expenses:

1. Management Fee of .25% - 1%
2. Load
   
   1. usually no load charges

Question 43

Money Market Funds vs. Money Market Accounts

Answer 43

The former are sponsored by fund companies and carry no guarantee of principal, while the latter are interest-earning savings accounts offered by financial institutions, with limited transaction privileges and insured by the Federal Deposit Insurance Corporation (FDIC).

A money market account usually pays a higher interest rate than a bank savings account, but a slightly lower interest rate than a CD or the total return of a money market fund.

Money Market Deposit Accounts

1. Higher minimum balance than passbook accounts
2. Restrictions on the number of withdrawals the account holder may take over a given period
3. Trade-off
   
   1. Less liquidity than typical checking account
   2. More liquid than bonds

Question 44

Bonds Mutual Funds vs. Bonds

What is the fundamental difference between bonds and bond mutual funds?

Answer 44

Bond Mutual funds

1. The managers then purchase and sell bonds based on economic and market activity.
2. Managers also have to sell funds to meet redemptions (withdrawals) of investors
3. RARELY hold bonds until Maturity

Fundamental Difference between Bonds and Bond Mutual Funds:

1. However, a bond mutual fund can gain or lose value, expressed as net asset value (NAV), because the fund manager(s) often sell the underlying bonds in the fund prior to maturity. Therefore, bond funds can lose value. This is a fundamental difference between individual bonds and bond mutual funds
2. Consequently, an ill-timed purchase can mean that an investor will have to sell the fund at a lower share price than they originally paid since - with the exception of target maturity funds - the vast majority of funds don’t mature at par on a specific date like an individual bond. This means that even though a fund may be invested in securities that mature at their original value, the fund itself does not

Worst Case Scenario:

In 2008, for example, the fallout from the financial crisis caused many high-yield bonds portfolios to lose between 30-40% of their value.

Benefits of Bond Funds:

1. On the plus side, funds offer greater diversification than most investors can achieve through individual bonds. Bond funds are also professionally managed, which relieves the individual investors from having to make decisions on their own. Finally, funds are typically easier to purchase and manage than individual bonds.

Question 45

Taxable Equivalent Yield

Answer 45

Taxable Equivalent Yield = Tax Free Yield / (1 - marginal tax rate)

Question 46

Bond Mutual Funds vs. Bond ETFs

Answer 46

What is a Bond ETF?

1. A bond ETF offers bonds in a stocklike wrapper. Though these investment vehicles hold bonds and only bonds, they trade on exchanges like stocks. With ETFs, therefore, investors can get the safety of bonds with the flexibility exchange-trading can provide.

Bond ETF vs. Bond Mutual Fund?

1. Tradability
   
   1. ETF shares trade at any time during the trading day
   2. ETF shares can be bought on margin AND sell them short
   3. Mutual funds are traded once a day AFTER market hours
   4. Mutual funds cannot be bought on margin NOR sell them short
2. Transparency
   
   1. ETFs are more transparent than mutual funds
   2. ETF managers publish a complete listing of their holdings daily.
   3. Mutual funds publish holdings once a quarter
3. Total Costs
   
   1. Bond ETFs tend to be cheaper than their mutual funds. Why? Because there is less work involved in running an ETF.
4. Commissions
   
   1. Every time you buy and sell shares of an ETF, you incur a trading commission. If you regularly invest small amounts of money, such as through regular paycheck contributions to a retirement account, those commissions can quickly add up. Although several commission-free ETF trading platforms have emerged in recent years, you should still check your brokerage’s rules before investing.
   2. Mutual Funds may be Load-Funds
5. Bid/Ask Spreads
   
   1. Every time you buy and sell shares of an ETF, you incur a trading commission. If you regularly invest small amounts of money, such as through regular paycheck contributions to a retirement account, those commissions can quickly add up. Although several commission-free ETF trading platforms have emerged in recent years, you should still check your brokerage’s rules before investing.
6. Premiums/Discounts
   
   1. When you buy or sell a mutual fund, you always transact exactly at the fund’s stated net asset value (NAV). ETF prices, however, are influenced by share supply and demand. Though mechanisms exist to keep ETF share prices in line with NAV, they’re not always perfect, and sometimes an ETF may trade at high premiums or discounts to NAV.
7. Active Management
   
   1. Whether a bond ETF or a mutual fund is right for you depends on your goals, of course, but also on your philosophy.
   2. If you believe in the power of active management, then there’s likely a mutual fund option with your name on it. Active bond funds remain a relatively new idea in the ETF space, and while some big-name managers troll the ETF waters, the choices pale in comparison to those found in mutual fund land.

In times of Distress?

• Mutual fund devotees often point out that during times of market distress, bond ETFs may trade with large premiums and discounts. It’s true, but that doesn’t mean bond mutual funds are better. In fact, unless you’re a panic seller, during volatile times, bond mutual fund investors may be worse off.
• Without an official exchange, there’s no single agreed-upon price for the value of any particular bond. In fact, many bonds don’t even trade daily; certain types of municipal bonds, for example, can go weeks or even months between trades
• Mutual fund and ETF managers rely on bond pricing services, which estimate the value of individual bonds based on reported trades, trading desk surveys, matrix models and so on. It’s not a sure thing, of course. But it’s a good guess

1. Mutual Funds
   
   1. Bond mutual funds guarantee the ability to buy and sell exactly at NAV in times of market stress. That’s a good thing. Buying and selling exactly at NAV shields shareholders who want to exit during times of market stress from the true costs of liquidating that portfolio. But what about the shareholders who don’t sell?
   2. Buy-and-hold bond mutual fund investors subsidize the costs of investors who leave. To fill a redemption request, mutual fund managers must give the exiting investor cash equal in value to NAV. In normal markets, the fund would just sell bonds to come up with the cash. But in stressed markets, that’s harder to pull off. As the APs have already discovered, it’s not possible to sell the underlying bonds for the prices, given by the pricing service. Therefore, mutual funds often have to sell more bonds than the NAV’s worth to make up the difference. The shareholders who stay are the ones to absorb that cost. Plus, because funds process redemptions overnight, funds must keep cash on hand—creating cash drag on returns—or maintain a credit facility, which shows up as a fund expense. Thus, buy-and-hold bond mutual fund investors are often penalized for staying in their fund during periods of market stress.
2. ETFs
   
   1. Unlike a mutual fund, whose share price is always its NAV, an ETF’s share price may drift from its NAV due to market supply and demand. Premiums develop when prices rise above NAV, and discounts develop when prices fall below NAV
   2. But there’s a natural mechanism in place to keep an ETF’s share price and NAV aligned: arbitrage.
      
      1. A special class of institutional investors known as “authorized participants” (APs) have the ability to create or destroy shares of an ETF at any time. Should an ETF’s share price dip below its NAV, APs can make money on the difference by buying up shares of the ETF on the open market and trading them in to the issuer for an “in kind” exchange of the underlying bonds. To profit, the AP simply needs to liquidate those bonds. Likewise, if an ETF’s share price rises above NAV, APs can buy up the individual bonds and trade them in for ETF shares. Arbitrage creates a natural buying or selling pressure that tends to keep an ETF’s share price and NAV from drifting too far from each other.
   3. In stressed or illiquid markets, an ETF’s price may be below its reported NAV by a lot, or for a long period of time. When that happens, it essentially means APs and market makers think the bond pricing service is wrong, and that they’re overestimating prices for the fund’s underlying bonds. In other words, the APs don’t believe they can actually liquidate the underlying bonds for their reported values. For ETF investors, this means the ETF price falls to a discount to its NAV. (The reverse is true for any premiums that may arise.)

Question 47

ETF Taxation vs. Mutual Funds

Answer 47

Main Reason ETFs are more tax efficient than Mutual Funds

1. One of the main reasons ETFs are more tax efficient is due to the fact they generally create fewer taxable events than most mutual funds. The overwhelming majority of ETFs only sell holdings when the elements that compose their underlying index change. A significantly lower portfolio turnover rate means significantly fewer taxable gain incidents. Some actively traded equity mutual funds have turnover rates higher than 100%. In contrast, the average turnover rate for an ETF is less than 10%.
2. EXCEPTIONS?
   
   1. In respect to this aspect of ETFs versus mutual funds, ETFs that aim to mirror the performance of specialized, nontraditional indexes or are constructed using proprietary criteria for portfolio selections, may have notably higher turnover rates. However, the turnover rate is still, in all likelihood, lower than the average for mutual funds.

Big Structural Difference

1. Mutual Funds = The way this happens is if other investors in the mutual fund decide to sell, or redeem, a substantial amount of shares, the odds are the fund manager is forced to sell part of the mutual fund’s holdings to have sufficient cash to pay for the shares being redeemed. This selling of portfolio holdings most likely results in some level of capital gains being realized and those gains are then passed on to fund shareholders who are liable for the taxes due on the realized gains.
2. ETFs = ETF shares do not work that way. Because of the way ETFs work, securities in the ETF portfolio are exchanged “in-kind” for fund shares, and new fund shares are created through an in-kind exchange for securities. Thus, securities are regularly returned at a low-cost basis and received at a higher cost basis. When securities are sold for rebalancing with a changing index, this translates into, officially at least, a smaller profit showing, and therefore a lower taxable capital gain amount than is the case for a mutual fund engaging in essentially the same type of transaction.

Phantom Mutual Fund Gains

1. For shareholders who have invested in the fund for quite some time, the gain in the NAV of their shares since buying into the fund may more than compensate for any resulting tax liability. However, newer shareholders who have only recently bought into the fund experience the unfortunate circumstance of being taxed on gains that were of little or no benefit to them.
2. Thus the term, phantom gains.

Question 48

ETN vs. ETF

Answer 48

What is an ETN?

1. ETNs are structured investment products that are issued by a major bank or provider as senior debt notes
2. When an investor purchases an ETN, he or she is purchasing a debt product similar to a bond. The terms of the debt contract are determined by the structure of the ETN. When an investor purchases an ETF, he is purchasing an asset like stock or index. Because ETNs are backed by a bank with a high credit rating, they are pretty secure products. However, the notes are not without credit risk, just a lower level.

Types of ETNs?

1. As of today, there are four major types of ETNs. According to Barclays, the premier ETN provider, there are commodity, currency, emerging market, and strategy ETNs.
   
   1. Commodity ETNs include categories such as energy, oil, and metals
   2. Currency ETNS include the euro, the British pound, and the Japanese Yen
   3. Emerging Market ETNs include the India Index ETN
   4. Strategy ETNs linked to the performance of the S&P 500 Buy/Write Index

How They’re Taxed

1. Just like ETFs, ETNs have a tax advantage. Any profits on the purchase or sale of the note are not realized until the actual closing transaction, which is when capital gain taxes are incurred. However, in the case of commodity ETFs, the tax advantage isn’t as prevalent since capital gain taxes are incurred when rolling commodity futures. In the case of commodity ETNs, that is not an issue

Do ETNs Have Tracking Errors?

1. The short answer is no. ETNs are treated as prepaid contracts, which eliminates any tracking errors. An investor who owns a note is promised a contracted rate of return by the issuing bank. With an ETF, the funds are designed to emulate an index (without trying to outperform) however, it does not always go according to plan. That difference is known as an ETF tracking error

Risks Involved

1. The biggest risk of an ETN is the credit risk
2. The other risk is associated with liquidity. There are a lot more ETFs in the investing world than ETNs. At least as of now. That means trading in and out of ETN positions may not be as easy. If you need to close or open an ETN, there may be some difficulty due to lack of trading volume.

Considering ETNs for Your Portfolio

1. Before you make any investment, we stress conducting your due diligence and thoroughly analyzing your research. One way to start is by watching how ETNs perform. Here are some ETNs you can keep an eye on
   
   1. GSC - GS Connect S&P GSCI Enhanced Commodity Total Return Strategy Index ETN
   2. ERO - iPath EUR/USD Exchange Rate ETN
   3. AYT - Barclays Global Emerging Market Strategy (GEMS) Asia 8 Index ETN
2. And keep in mind that while ETNs may be attractive, they do have their risks. As do all investments, so make sure you research each note thoroughly before making any trades. Watch how they react to different market conditions. Understand what is in each note, especially the leveraged and inverse ETNs, which typically contain derivatives

Question 49

What does a Balanced Fund provide?

Answer 49

A balanced fund often promises a one-stop shop by investing in a mix of stocks and bonds, and even ultra-safe investments like money market securities. The key is balance – a balanced mutual fund doesn’t swing for the fences for performance, seeking to provide a return that, over time, blends the returns of stocks and bonds.

A balanced fund typically holds about 50% to 70% of its assets in stocks, with the remainder made up of bonds and cash-like investments. There is no universal definition, as funds differ dramatically between managers.

1. Case in point: The Vanguard Balanced Index Fund held about 59% of its assets in stocks, and about 40% of its assets in bonds and other fixed income products. The remaining 1% was held in cash.
2. Alternatively, the American Funds American Balanced Fund held 56% of its assets in stock, and about 33% of its assets in bonds. The remainder – more than 10% of the fund’s assets – was “invested” in cash and cash equivalents.

Advantages:

1. The main draw of a balanced fund is convenience. Instead of buying a collection of funds, you can theoretically achieve diversification by investing in just one balanced fund. Likewise, you can put your full faith in a single asset manager to pick the best investments across all investment types, from stocks to bonds, and occasionally, even commodities. (Depending on your perspective, a go-anywhere mandate for a mutual fund manager may or may not be a benefit as much as a potential problem.)
2. In retirement a balanced fund allows you to take systematic withdrawals while maintaining an appropriate asset allocation easily. This approach may work well for those who have one account to draw from, such as $100,000 in an IRA where they want to take out $400 a month.

Disadvantages

1. Sometimes the fees in a balanced fund will be a bit higher than if you choose your individual index funds because the fund management team is doing the work of selecting the underlying mix of stocks and bonds and changing it as needed.
2. Within the balanced fund, you cannot choose how much is in what type of stocks, such as international, small cap, large cap; or what type of bonds, such as government, corporate or high yields. Of course, the whole point of the balanced fund is that someone else is making those asset class choices for you.
3. As your portfolio size grows larger during your accumulation phase, if you have investments across numerous different types of accounts it may make sense to locate certain investment types, such as bonds, within your tax-deferred retirement accounts, while locating stocks in your non-retirement brokerage accounts. You cannot do this with a balanced fund as the same fund owns both bonds and stocks.
4. No Bond Ladder - In your retirement phase, if you have a larger portfolio size and numerous types of accounts, you may want to use a bond ladder so that the bond portion of your portfolio lines up in each account with the number of withdrawals you will need from that account. You will not be able to do this with a balanced fund.

Question 50

What are Flexible Income Funds?

Answer 50

Flexible funds can be U.S. regulated or offshore funds. These funds give the portfolio manager broad latitude for making portfolio investments. As a result they are highly susceptible to style drift and may employ macro strategies such as sector rotation or macro hedging. Investors in these funds will often invest based on the expertise of high-profile managers rather than specific market segment allocations

Mutual funds usually are pegged to a particular style box, such as large-cap growth or small-cap value, which helps them to reach a specific audience of investors. Flexible funds do not follow this standard approach, making due diligence even more important for investors.

The Fidelity Magellan Fund is one of the most well known flexible funds, thanks in part to Peter Lynch, who advocated a flexible investment strategy while managing the fund in the 1980s and early 1990s. The Fund has continued to carry forward a flexible investing style in its investment strategy with its subsequent portfolio managers.

Question 51

Asset Allocation Fund?

Answer 51

An asset allocation fund is a fund that provides investors with a diversified portfolio of investments across various asset classes. The asset allocation of the fund can be fixed or variable among a mix of asset classes. Popular asset categories for asset allocation funds include stocks, bonds and cash equivalents

Asset allocation funds were developed from modern portfolio theory. Modern portfolio theory shows that investors can achieve optimal returns by investing in a diversified portfolio of investments included in an efficient frontier. The standard applications of modern portfolio theory investing include an efficient frontier of stocks, bonds, and cash equivalents. Furthermore, modern portfolio theory outlines how a portfolio can vary its asset mix to tailor to the risk tolerance of the investor.

One of the most common types of asset allocation funds is a “balanced fund.” A balanced fund implies a balanced allocation of equities and fixed income, such as 60% stocks and 40% bonds. Investors will find numerous funds deploying the 60/40 mix as it has become a popular standardized strategy for investors seeking broad market diversification. Asset allocation funds also offer varying levels of diversification based on risk tolerance. Investors seeking additional investing categories beyond just 60/40 will find many options, including conservative allocation funds, moderate allocation funds and aggressive alloca­tion funds.

“Life-cycle” or “target-date” funds, usually used in retirement planning, are also considered a type of asset allocation fund. These funds are managed with a targeted mix of asset classes that starts out with a higher risk-return position and gradually becomes less risky as the fund nears its targeted utilization date

Question 52

Asset Allocation vs. Diversification

Answer 52

Asset allocation

• is the most basic and important component of investing. An asset allocation is simply the percentage of your portfolio invested in stocks, bonds, and cash. Your asset allocation is the primary determinate of how risky your investment portfolio is. Stocks are the most aggressive investment, bonds are a middle-of-the-road option, and cash is the safest way to invest your money. Of course, the higher the risk of your portfolio, the higher the return you should expect.

Diversification

• A well-devised asset allocation does not ensure you are appropriately diversified, however. For example, if you have determined that you should have 60% of your investments in stocks, you shouldn’t invest that full 60% in one stock
• In fact, you shouldn’t have the bulk of your investments in the same investment category (large cap, mid cap, small cap, international, growth or value, or different sectors of the economy).
• Diversification applies not only to stocks, but also to the bond side of your portfolio. Many people invest solely in U.S. corporate bonds, but they should be rounding out their portfolio and reducing risk by also investing in U.S. Government bonds and international bonds.

Question 53

Index Funds vs. ETFs

Answer 53

Both index funds and ETFs fall under the heading of “indexing.” Both involve investing in an underlying benchmark index. The primary reason for indexing is that index funds and ETFs can often beat actively managed funds in the long run

Unlike actively managed funds, indexing relies on what the investment industry refers to as a passive investing strategy. Passive investments are not designed to outperform the market or a particular benchmark index, and this removes manager risk—the risk or inevitable eventuality that a money manager will make a mistake and end up losing to a benchmark index

Differences between Index Funds and ETFs

1. Expense Ratio
   
   1. Lower expense ratios can provide a slight edge in returns over index funds for an investor, at least in theory. ETFs can have higher trading costs, however.
2. Commisison
   
   1. Let’s say that you have a brokerage account at Vanguard Investments. You’ll pay a trading fee of around $7 if you want to trade an ETF, whereas a Vanguard index fund tracking the same index might have no transaction fee or commission.
3. Tradability
   
   1. But the primary difference is that index funds are mutual funds and ETFs are traded like stocks. The price at which you might buy or sell a mutual fund isn’t really a price—it’s the net asset value (NAV) of the underlying securities. And you’ll trade at the fund’s NAV at the end of the trading day
   2. If stock prices rise or fall during the day, you have no control over the timing of execution of the trade. You get what you get at the end of the day, for better or worse.