Open-end funds and exchange traded funds
Open-end investment companies, aka mutual funds, are one of the more commonly dealt with securities in the real world and test world. We need to make sure to go through and review some additional parts of mutual funds. Much of this should be a review from previous exams you’ve had, but just in case, we will cover it.
Share classes
There are 3 main types of share classes mutual fund companies sell, and an additional related one, that is not sold the same way, but can be tested with the other 3.
A-shares are the front-end load share class. The sales charge is levied when the shares are purchased. They have a front-end sales charge. A-shares are the primary share class sold, suitable for continuous contributions, or larger amounts of money, both for the long term. A-shares benefit from breakpoints, rights of accumulation, and letters of intent which we will discuss later.
B-shares are the back-end load share class. The contingent deferred sales charge (CDSC) is assessed at redemption, not at purchase, and it declines each year the shares are held until it reaches 0%, at which point the shares automatically convert to A-shares free of charge. In the modern world, they are not really sold anymore, as they are far more expensive to the client, with no real added benefit. Although unsuitable in the real world, test world may ask you for suitability, and the idea is for small amounts of money for a long time. If the client “has $5000 to invest for 10-20 years, and they know they will have no additional money to invest, what should you choose”. That would be B-shares, but in the real world, they likely should have it in savings as opposed to a long-term investment.
C-shares are the level load share class. The sales charge is reflected in the highest annual fee. They have no front-end or back-end sales charge, and therefore are bought and sold at NAV, but with the highest annual fees, they get expensive fast. They are suitable for short-term, 1-3 years (potentially 4-5 in rare situations) investments. Due to the “buy at NAV sell at NAV” making it look like there are no costs, and therefore good to trade, many C-shares have a small surrender charge in their first 6-months or a year to discourage people from day-trading, or simply short-term trading mutual fund C-shares.
No-load funds don’t assess a sales charge, and are sold differently than the others. No-load funds are purchased directly from the issuer, and are typically used by investment advisors in brokerage accounts where they charge a management fee instead of a commission. A fund may be described as “no-load” only if it has no front-end or deferred sales charge and its total asset-based charges - 12b-1 fees plus any service fees combined - don’t exceed 0.25%, or 25 basis points, under FINRA Rule 2341. There’s no built-in compensation for a representative to help with the sale.
Breakpoints, letters of intent, and rights of accumulation
These will apply to within a specific fund family; ABC growth fund and ABC income fund would combine, but ABC growth fund and DEF growth fund would not. They must be available to all investors fairly, and cannot be discriminated against.
Breakpoints are “bulk discount” purchase discount. Similar how if you purchase 1 custom shirt, of 10 custom shirts, or 100, or 1,000, the total price is going up, but the price you’re paying per shirt is going down. That is the “bulk purchase discount”, clients get with breakpoints. The more they invest, once they pass certain specified dollar amounts, they will get a lower sales charge.
Example: Breakpoint schedule
Contribution Sales fee Under $25,000 5% $25,000 to under $250,000 4% $250,000 to under $1,000,000 3% $1,000,000 or more 2%
If the client invests $20,000, that’s 5%, so $1000 would be the fee. If the client invests $200,000, that is 4%, so that is $8000 in fees. Obviously, the total fees went up, but the “bulk discount”, is that they invested 10 times the money, but only have 8 times the fees, not 10 times the fees.
Letters of intent are for people who want a breakpoint, but can’t make it immediately. They can be backdated up to 3 months, and are good for 13 months from when they started. If the client invests $10,000 today, they’d have 13 months to raise the additional $15,000 in new money to hit the $25,000 breakpoint. They will be given the discount on that initial $10k, and if they don’t meet the breakpoint, the account will simply be adjusted to reflect what they should have paid. If instead the client gave you $5,000 2 months ago, and told you they would not have the additional money in 13 months to hit $25,000, so they are charged the normal breakpoint, today they change their mind. We can backdate it up to 3 months, including that $5k from 2 months ago, so they need $20k more, and let’s say they give us another $10k today, so they would need to provide the remaining $10k, (5+10+10=25), within 11 months. They have 11 months because the 13 months started 2 months ago when we backdated the letter of intent.
Letters of intent are only new money. Can combine with other family members living in the same house. Growth does not help with LOIs, unlike the next reduction benefit.
Rights of accumulation are for reaching breakpoints over a long period of time. If letters of intent can be thought of as a “bulk quantity” discount, rights of accumulation can be thought of as a “loyalty discount”. A client who has been investing for a long time, eventually will hit the break point level, and then future contributions will be given the new discounted breakpoint level. One of the things to recognize is if any contribution would bring the total account value, or total contributions of new money into the account, either at or above the breakpoint value, the entire contribution is given the discount; “if any penny crosses a breakpoint, all the pennies cross the breakpoint”.
Example: Rights of accumulation
Over several years, a client has grown their account value to exactly $20,000, and now wants to contribute $10,000. Using the breakpoint schedule above, the breakpoint is at $25,000, and since the contribution crosses it, the entire contribution is charged 4%; none of it is charged 5%. A $5,000 contribution would reach the breakpoint exactly, so all $5,000 would also be charged 4%. A client planning to contribute $4,999 should be told that one more dollar reaches the lower charge.
Mutual fund additional facts
Dividend reinvestment is a strong benefit in mutual fund investing. Most mutual funds will make dividends and capital gains distributions to their clients, and this allows them to invest those distributions back into the fund at NAV, and avoid any sales charge. The distribution is taxable the year received, and therefore, the reinvested dividends being taxed the year received will increase the cost basis of the investment.
Mutual fund redemption is another strong benefit of mutual funds; there is always someone who will give your clients their money when they need or want it. Mutual funds must calculate their NAV at least once daily, Monday through Friday, at the time set by the fund’s board of directors; some do it more often. Clients can redeem their shares on any business day, and the fund has at most 7 days to give them their money. The next calculated NAV, after the redemption request has been made, is the price the client will receive, less any potential surrender charges.
As both the total net assets, and the outstanding shares can change daily, NAV can change daily. Recognize that is net assets. Net assets are total assets - liabilities. Test takers have reported seeing the test ask to calculate NAV giving the student both net assets and liabilities, and students subtract the liabilities from net assets, meaning they are accidentally subtracting twice. If they give you total assets, subtract liabilities, if they give you net, they’ve already subtracted liabilities.
Exchange traded funds
Exchange traded funds (ETFs) are registered under the Investment Company Act of 1940, usually as open-end management companies (a smaller number are organized as unit investment trusts). Unlike a mutual fund, which is only bought and sold at the next-calculated NAV, an ETF trades on an exchange throughout the day at whatever market price buyers and sellers agree to.
That market price stays close to the ETF’s NAV because large institutional firms called authorized participants create and redeem big blocks of ETF shares, called creation units, directly with the fund by exchanging a basket of the underlying securities for ETF shares, or the reverse.
Additional mutual funds rules
FINRA Rule 2341 limits the sales charges, including the breakpoint schedules, of the mutual funds member firms may sell; the percentages below all come from that rule.
An asset-based sales charge, like the standard 12b-1 in many mutual funds, is a sales charge that is deducted from the net assets of the company, and does not include any service fees.
Service fees are continuing charges, often paid as part of 12b-1 fees, paid out of fund assets for personal service to shareholders and maintenance of their accounts - not compensation for selling shares.
Investment companies without an asset-based sales charge can charge at most 8.5% provided they offer rights of accumulation and breakpoints. If ROA are not offered, the maximum is 8% of offering price. FINRA has guidelines here as well for breakpoints. A maximum of 7.75% on purchases of $10k or more, and maximum of 6.25% on $25k or more, or either a maximum of 7.5% on purchases of $15k or more and maximum of 6.25% on $25k again. If breakpoints are not at least that good, then the maximum is 7.75% if ROA are available, and 7.25% if they are not. A fund without an asset-based sales charge that pays a service fee is limited to a maximum of 7.25%.
Investment companies with an asset-based sales charge are capped in two ways. Across the fund, the asset-based, front-end, and deferred sales charges combined may not exceed 7.25% of the fund’s total new gross sales (plus interest) if it pays no service fee, or 6.25% if it does. And no single purchase’s front-end or deferred sales charge may exceed that same 7.25% or 6.25%.
In the end, sales charges cannot be excessive. Member firms may not sell mutual funds that have excessive fees. If the asset-based charges are in excess of 0.75% or 75 basis points they can’t be sold. There is an additional 0.25% or 25 basis points that can be in service fees, but above that, would also be prohibited from being sold.
Unethical actions involving mutual funds
Breakpoint sales are when we sell mutual funds right below a breakpoint. Think about the previous breakpoints; if a client invests $24k they are charged 5%, $25k would be 4%. Doing the math that is a sales charge of $1200 on the $24,000 and $1000 on the $25,000. This produces a larger commission for the representative, which is precisely why breakpoints must be disclosed. Clients cannot borrow money, and we cannot suggest they do, in order to meet a breakpoint, but if they are that close, a letter of intent is certainly appropriate.
Switching is simply the mutual fund term for churning. Moving money within the same family, from ABC growth when the client is young to ABC income when the client reaches retirement, is done without sales charge. It is still a taxable sale of the ABC growth shares: any gain over their cost basis is taxed in the year of the exchange. Recommending the client instead move from ABC growth to DEF income would incur a new sales charge, and thus give the representative a commission bonus. There are times this is appropriate, but only if ABC really didn’t have a good alternative, very poor management, or similar type problems. Trying to chase #1 in the class, is definitely a very bad reason to switch mutual funds.
Sales contests are a common thing in this industry. Brokerage firms may run them, but not on sales of a specific fund or of proprietary funds, and for retail customers Regulation Best Interest also bars contests on one type of security within a limited period. A reward tempts representatives to sell what earns the bonus, not what is best for the client.