Packaged Products

Investment company types

The 1940 Act recognizes three types.

Face-amount certificate companies issue debt certificates promising a fixed sum at a fixed future date. They barely exist and appear only in the classification question.

Unit investment trusts hold a fixed, unmanaged portfolio. There is no board and no investment adviser, because there is nothing to decide once the portfolio is assembled. Units are redeemable and the trust has a termination date.

Management companies hold a managed portfolio under an investment adviser, and divide two ways: open-end or closed-end by capitalization, and diversified or non-diversified.

An open-end company — a mutual fund — continuously issues new shares and redeems them on demand, so the share count changes daily and every purchase is a purchase of newly issued shares sold with a prospectus.

A closed-end company issues a fixed number of shares in a one-time offering and does not redeem them. Investors who want out sell to other investors in the secondary market, at whatever price supply and demand produce — frequently at a discount to net asset value, sometimes at a premium. A closed-end fund trading at a discount is normal, not an error.

A diversified fund satisfies the 75-5-10 test: with respect to 75 percent of total assets, no more than 5 percent in any one issuer and no more than 10 percent of any issuer's voting securities. A non-diversified fund simply does not make that representation.

Mutual fund pricing and share classes

Net asset value per share is total assets minus total liabilities, divided by shares outstanding.

The public offering price is NAV plus the sales charge. Because the charge is quoted as a percentage of the offering price, POP equals NAV divided by one minus the sales charge percentage. The reverse calculation — the sales charge percentage — is POP minus NAV, over POP. For a no-load fund, NAV and POP are the same number.

Orders are executed under forward pricing: at the next computed net asset value after the order is received, not the last one. A representative who quotes this morning's NAV as the price is wrong.

Breakpoints reduce the sales charge at stated purchase levels. A letter of intent lets a customer get the lower charge immediately by committing to reach a breakpoint within thirteen months, and may be backdated up to ninety days. Rights of accumulation apply the lower charge based on holdings already owned plus the new money, with no time limit.

Share classes: Class A carries a front-end charge with low ongoing fees and offers breakpoints, so it suits large or long-term investments. Class C carries a level load with a permanently higher annual fee, which suits short holding periods and is expensive over long ones. Class B, with a declining contingent deferred sales charge, has largely disappeared.

The named violations: breakpoint sales — selling just below a breakpoint without telling the customer; selling dividends — urging a purchase before an ex-dividend date, which merely buys a tax liability; and switching between fund families without a documented reason, which incurs a new sales charge and destroys accumulated breakpoints.

A fund that distributes at least 90 percent of its net investment income is taxed as a conduit and the shareholder is taxed once. Capital gain distributions are long-term to the shareholder regardless of their own holding period, and reinvested distributions increase cost basis.

Exchange-traded products

An exchange-traded fund is a registered investment company whose shares trade on an exchange all day. Large institutions called authorized participants create and redeem shares in large blocks in exchange for baskets of the underlying securities, and the arbitrage that permits keeps the share price close to the value of the portfolio.

Compared with a mutual fund, an ETF trades intraday at market prices, can be bought on margin and sold short, generally carries a lower expense ratio, and is usually more tax-efficient — but the customer pays a commission or spread on each trade and can pay a premium or receive a discount to the portfolio's value.

Leveraged and inverse ETFs are designed to deliver a multiple or the inverse of an index's return over a single day and reset daily. Over longer periods the result can diverge sharply from the multiple of the index's return, so they are trading tools, not holdings.

An exchange-traded note is different in the way that matters: it is unsecured debt of the issuing bank promising an index-linked return, and it holds no assets at all. The holder carries the issuer's credit risk in full. An ETF holds a portfolio; an ETN holds a promise.

Variable contracts

A fixed annuity promises a stated return and the insurer bears the investment risk, so it is insurance and not a security. A variable annuity's value depends on a portfolio the contract holder selects, so the holder bears the risk and it is a security — sold only by someone holding both a securities registration and a state insurance licence.

Premiums go into a separate account, kept apart from the insurer's general account and divided into subaccounts. During the accumulation phase, payments buy accumulation units whose value moves with performance. At annuitization the holder receives a fixed number of annuity units; what changes thereafter is the value of each unit, which is why the payment varies.

Whether the payment rises or falls depends on how actual performance compares with the assumed interest rate built into the payout calculation. Above the AIR the payment rises, at it the payment stays the same, below it the payment falls — even if the account gained in absolute terms.

Payout options trade payment size against protection: life only pays most and stops at death; life with period certain, unit refund and joint and last survivor each pay less in exchange for continuing payments to someone.

Taxation: contributions to a non-qualified annuity are after-tax and create basis; growth is tax-deferred; withdrawals during accumulation come out earnings first — last in, first out — taxed as ordinary income, with a 10 percent penalty before age 59½. Section 1035 permits a tax-free exchange of one annuity for another.

Variable life insurance applies the same structure to a policy: the cash value fluctuates and is not guaranteed, while the death benefit varies above a guaranteed minimum.