U.S.

Government and Agency Underwritings: Treasury Auctions: Overview

The U.S. Government sells its debt through yield auctions conducted by the Federal Reserve. 4 week, 13 week, and 26 week Treasury Bills are auctioned weekly and 52 week TBills are auctioned monthly. Treasury Notes, Treasury Bonds, TIPS and STRIPS are auctioned monthly. Both competitive and non-competitive bids are accepted at the auctions. Competitive bids specify a yield; and the lowest yield bids win (lowest interest cost to the government). Non-competitive bids do not specify a yield, and are always filled at the average yield of the winning competitive bids.

Treasury Auctions: Settlement

The weekly Treasury Bill auction is held on either Monday or Tuesday. Settlement (delivery of the Treasury Bills to the winners and payment) is on the Thursday of that week.

Primary Purchasers

The primary purchasers at the weekly auctions are the primary government dealers (the larger commercial banks and broker-dealers), as well as investment companies which are buying the securities for the funds that they manage

Pricing

Agency securities are typically sold at par via the selling group. The selling group earns a selling concession on each bond sold, so the agency receives par less the selling concession on each bond sold.

Competitive Bid

Primary U.S. Government dealers are obligated to place competitive bids at each Treasury auction. Competitive bids specify a dollar amount of securities desired and the yield that is bid. Competitive bids are filled from lowest yield on up, until the government sells the desired amount of securities. Thus, the higher bidders (higher yield equals higher interest cost to the government) lose.

Non-Competitive Bid

Smaller purchasers such as secondary dealers and individuals, place non-competitive bids at the weekly auction. Non-competitive bids are guaranteed to be filled. The dollar amount of non-competitive bids is tallied prior to the auction, and this amount is reserved out of the auction. The remaining amount of securities to be sold are awarded by competitive bid, from lowest yield on up. After the auction, the average of the winning competitive bid yield is computed, and the non-competitive bids are filled at the average winning yield.

Bid Dollar Limits

The minimum non-competitive bid is for one $100 face amount Treasury Bill. The maximum non-competitive bid is for $5,000,000 face amount of Treasury Bills. The minimum competitive bid is for $5,000,000 face amount of Treasury Bills. There is no maximum competitive bid amount.

Agency Securities Underwritings: Overview

Unlike Treasury securities that are sold via competitive bid yield auction, agencies sell their debt through selling groups on a negotiated basis. The members of the selling group are appointed by the agency, and typically are the primary U.S. Government dealers.

Overview: Types of Investment Companies

The Investment Company Act of 1940 defines 3 different types of investment companies: These are:
o o o

Face Amount Certificate Company Unit Investment Trust Management Company

Management Companies: Subclassifications

Management companies have an investment adviser that "manages" the fund's portfolio to meet its investment objective Management companies can be either: Open-end management companies; or Closed-end management companies An open-end management company continuously issues and redeems its own shares; this is a "mutual fund"
o o

A closed-end management company has a 1 time stock issuance and "closes" its books to new shareholders; the shares are listed on an exchange and trade like any other stock

Management Companies: Open End Fund Characteristics

Open-end management companies hire an investment adviser to manage the fund in accordance with the fund's investment objective Such funds are commonly known as mutual funds Open-end management companies continuously issue and redeem their own shares Every day, the fund computes its aggregate net asset value; and net asset value per common share If a person wishes to buy shares, he or she buys at that day's closing Net Asset Value (plus a sales charge, if one is assessed); and the fund issues the new shares to that investor If a person wishes to redeem, the shares are sold back to the fund at that day's closing Net Asset Value Note that the shares are always bought from the fund; and redeemed with the fund. There is no trading of mutual fund shares

Closed End Fund Terminology

A closed-end management company has a 1 time stock issuance and its books are closed to new investors

After the initial public offering, the shares of a closed-end fund are listed on an exchange or NASDAQ, and trade like any other stock (this company is in the business of making profitable investments for its shareholders) Since this type of management company is traded like any other stock, a closed-end fund is commonly known as a "publicly traded fund" (remember that open-end mutual funds do not trade)

Closed End Fund Characteristics

Closed-end management companies have an investment adviser that manages the fund in accordance with the fund's investment objective Closed-end funds have a 1 time stock issuance; and then the books of the fund are closed to new investment; thus such a fund does not continuously issue and redeem its own shares Investors who like the fund will buy the shares on an exchange, as they would any other stock Investors who dislike the fund will sell the shares on an exchange, as they would any other stock

Open End vs Closed End - Capital Structure

Open-end management companies (mutual funds) continuously issue and redeem their own shares Mutual funds can only issue common stock Shares are issued at the next computed Net Asset Value (plus a sales charge, if any) Shares are redeemed at the next computed Net Asset Value (less a redemption fee, if any) There is no trading of mutual fund shares Closed-end management companies (publicly traded funds) have a 1 time stock issuance and the fund closes its books to new investment After the initial public offering, the shares are listed on an exchange and trade like any other stock The only way for a closed-end fund to raise additional capital is for the fund to issue subscription rights to the existing common shareholders; or for the fund to issue preferred stock or bonds An investor buys the common shares of a publicly traded fund at the market price, which can be lower, higher, or the same as Net Asset Value An investor sells the common shares of a publicly traded fund at the market price, which can be lower, higher, or the same as Net Asset Value

Closed End Fund - Share Pricing

An investor buys the common shares of a publicly traded fund at the market price, which can be lower, higher, or the same as Net Asset Value; in addition the investor must pay a commission for having the trade executed An investor sells the common shares of a publicly traded fund at the market price, which can be lower, higher, or the same as Net Asset Value; in addition the investor must pay a commission for having the trade executed

Overview: Fixed Unit Investment Trusts

A Fixed Unit Investment Trust consists of a fixed portfolio of securities that are selected by the trust sponsor, transferred into trust, and sold to investors Each investor buys an interest in the trust called a trust "unit" - hence the name unit investment trust Unit investment trusts are typically bond trusts, where the investor buys a unit of a broadly diversified fixed bond portfolio Trust units typically sell for $1,000 minimum, so investors can achieve diversification with a small dollar investment, as compared to buying individual bonds

Overview: Participating Unit Investment Trusts

Participating Unit investment Trusts are the structure for a variable annuity contract A Participating Unit Investment Trust establishes a separate investment account to buy shares of a designated mutual fund Each investor buys an interest in the separate account, termed an "accumulation unit" The "accumulation" unit value is tied to the Net Asset Value of the mutual fund held in the separate account The amount of the annuity to be received is based upon the performance of the mutual fund shares held in the separate account

Summary: Redeemable vs Negotiable Investment Companies

Open-end management company shares are redeemable with the sponsor; there is no trading of open-end funds (mutual funds) Closed-end management company shares are negotiable; they trade in the market like any other stock Closed-end management company shares are not redeemable Unit investment trusts are redeemable with the sponsor; they are not negotiable (tradeable)

Summary: Marginable Investment Company Securities

Initial public offerings of registered securities cannot be purchased on margin Because every mutual fund share is newly issued, these cannot be purchased on margin Initial public offerings of closed-end fund shares cannot be purchased on margin Once closed-end fund shares are listed and trade on an exchange, they become marginable after 30 days Under a Federal Reserve Board letter ruling, mutual fund shares may be margined once they have been held for 30 days

Structure: Custodian Bank

The primary function of the custodian bank is to safekeep all of the investments of the fund The custodian bank can also act as the transfer agent for the fund; and as the paying agent for the fund For these functions, the custodian bank is paid a custodial fee

Types: Index Fund

An index fund matches the composition and weighting of its portfolio to a widely followed index such as the Standard and Poor's 500 Index; or the Value Line Index In order to equal the performance of the index, the index fund must actually outperform the index by a small margin to pay for the running of the fund (management fees; brokerage expenses, etc.) This is typically done by using index option writing strategies to enhance income Such funds typically have much lower expenses than actively managed funds, since there is no need to spend major time and money researching potential investments the investments are defined by the composition of the index being tracked

Buying Mutual Funds: Maximum Sales Charge Percentage

FINRA regulates the sale of mutual funds Under FINRA rules, the maximum sales charge that may be imposed by a mutual fund is 8 1/2% of the Public Offering Price Note that the maximum sales charge is based on a percentage of the Public Offering Price; not as a percentage of Net Asset Value

Maximum Sales Charge - Conditions

In order for a fund to impose the maximum 8 1/2% sales charge permitted by FINRA, the fund must offer the following benefits: Breakpoints Letter of Intent Rights of Accumulation Breakpoints allow for a lowered sales charge, as larger dollar amounts of the fund are purchased
o o o

A Letter of Intent, once signed, gives the customer 13 months to complete a breakpoint Rights of accumulation allow the accumulated value in the fund to count towards a breakpoint on subsequent purchases

Breakpoints - Letter of Intent

If a customer does not have enough money immediately to qualify for a breakpoint, but intends to buy enough of the fund to qualify for a breakpoint within a 13 month period, then the customer can sign a Letter of Intent The Letter of Intent gives the customer 13 months maximum to complete the purchase(s) necessary to reach the breakpoint The extra shares purchased with the lower sales charge are held in escrow and are not released to the customer until the Letter of Intent is completed If a customer buys some shares at the full sales charge, and then decides to buy enough extra to qualify for the breakpoint, the customer can be given the breakpoint on the previous purchase because a Letter of Intent can be backdated for 90 days

Management Companies: Buying Mutual Funds: 12b-1 Fees

12b-1 fees are permitted under SEC Rule 12b-1. If a fund adopts a 12b-1 plan it may charge its existing shareholders for the cost of soliciting new investment to the fund. The "cost" of soliciting new investment also includes compensation to registered representatives selling the fund shares. The maximum annual 12b-1 fee is .75% of net assets per year under FINRA rules. If a fund imposes a 12b-1 fee, FINRA limits to maximum up-front sales charge to 7.25% instead of 8.50%.

Redeeming Mutual Funds: Redemption Fee

Mutual funds are permitted to charge a redemption fee, as long as front end sales loads and back end redemption fees do not exceed the FINRA permitted maximum sales charge percentage of 8 1/2% Redemption fees are expressed as a percentage of Net Asset Value If a customer redeems a mutual fund shares with a Net Asset Value of $10; and if the fund imposes a 1/2% redemption fee; then the customer will receive $9.95 upon redemption Redemption fees are not very prevalent

Redeeming Mutual Funds: Time Limit for Payment

Under the Investment Company Act of 1940, if a customer redeems mutual fund shares, the customer must be paid within 7 calendar days (1 week) Note that most funds remit payment upon redemption much more quickly than this

Buying / Redeeming Mutual Funds: Automatic Reinvestment

Mutual fund companies can allow for automatic reinvestment of distributions from the fund Funds distribute both dividends and capital gains If a fund has an automatic reinvestment plan, both dividends and capital gains are reinvested at Net Asset Value; thus no sales charges are imposed on reinvested monies

Publicly Traded Funds: Overview

A closed-end management company has a 1 time stock issuance and its books are closed to new investors After the initial public offering, the shares of a closed-end fund are listed on an exchange or NASDAQ, and trade like any other stock (this company is in the business of making profitable investments for its shareholders) Since this type of management company is traded like any other stock, a closed-end fund is commonly known as a "publicly traded fund" (remember that open-end mutual funds do not trade) Closed-end management companies have an investment adviser that manages the fund in accordance with the fund's investment objective Investors who like the fund will buy the shares on an exchange, as they would any other stock Investors who dislike the fund will sell the shares on an exchange, as they would any other stock
An investor buys the common shares of a publicly traded fund at the market price, which can be lower, higher, or the same as Net Asset Value; in addition the investor must pay a commission for having the trade executed Closed-end funds trade in the secondary market, and the market price can be the same as; lower than; or higher than Net Asset Value Closed-end funds trade at a discount to Net Asset Value when investors are pessimistic about the fund's prospects Closed-end funds trade at a premium to Net Asset Value when investors are optimistic about the fund's prospects

Exchange Traded Funds: Identification of Product

SPDRs are "Spiders"; DIAs are "DIAmonds"; QQQQs are "Qubes", an ETF Spiders are based on the Standard and Poor's 500 Index; DIAmonds are based on the Dow Jones Industrial Average; Qubes are based on the NASDAQ 100 Index

Exchange Traded Funds: Other Major Products

The American Stock Exchange trades a large variety of index funds under the name "I-Shares" (Index Shares) I-shares are based on portfolios of stocks by industry sector, by country, or by market capitalization Another successful AMEX product is the "DIAmond" - traded under the symbol DIA, this is the Dow Jones Industrial Average Index ETF NASDAQ, as opposed to AMEX, trades the QQQQ - NASDAQ 100 ETF (Note the QQQQ used to trade on the AMEX under the symbol "QQQ", but no longer does so) Note that because of the tremendous popularity and success of ETFs, the NYSE and NASDAQ have created their own versions of ETFs to compete

Exchange Traded Funds: Features

Exchange Traded Funds (ETFs) trade like any other stock ETFs can be bought and sold at the prevailing market price, plus a commission ETFs can be bought on margin and can be sold short

Exchange Traded Funds: Comparison to ETNs

An ETN is an Exchange Traded Note. It is a type of structured product offered by banks that gives a return tied to a benchmark index. The note is a debt of the bank, and is backed by the faith and credit of the issuing bank. ETNs are listed on an exchange and trade, so they have minimal marketability risk. In comparison, a regular structured product is non-negotiable and, if redeemed prior to maturity, imposes an early-redemption penalty. ETNs make no interest or dividend payments. Their value grows as they are held based on the growth of the benchmark index, with any gain at sale or redemption currently taxed at capital gains rates. Thus, they are tax-advantaged as compared to other structured debt products. An ETF is an Exchange Traded Fund. It is an investment company that owns an underlying portfolio of securities. The shares of the ETF are listed and trade. ETFs have little marketability risk and they do not suffer from the credit risk issue of ETNs. However, as with any negotiable security, they still have market risk (the risk of a general market price decline).

Exchange Traded Funds: Summary

Purchasers of ETFs are required to get either a Prospectus or a Product Description summarizing key information about the ETF. Characterized by cost efficiency because expense ratios are very low; and tax efficiency, because capital gains arent distributed annually, like with mutual funds. Any gain on ETF shares is taxed when the shares are sold.

Management Companies: Fund Analysis: Management Fee

The annual management fee paid to the investment adviser is based on a percentage of net assets Typical management fees are 1/2% to 1% of net assets annually The management fee is the largest expense of running a mutual fund. Note that actively managed funds have much higher management fees than passively managed index funds.

Management Companies: Fund Taxation: Subchapter M

If an investment company is "regulated" under Subchapter M of the Internal Revenue Code, then the fund pays no tax on the net income that is distributed to shareholders; the tax liability is the responsibility of the shareholders The shareholders receive Net Investment Income as a dividend distribution; and receive capital gains as a capital gains distribution; and include this on their individual tax returns For an investment company to be regulated under Subchapter M, it must distribute at least 90% of Net Investment Income to shareholders

Management Companies: Fund Taxation: Regulated Fund Holding Tax Exempt Securities

If an investment company is "regulated" under Subchapter M of the Internal Revenue Code, then the fund pays no tax on the net income that is distributed to shareholders; the tax liability is the responsibility of the shareholders However, the taxation on any distributions is based upon the type of securities held in the fund portfolio
o

if a fund holds corporate bonds, the income distributions are taxable at both the Federal and State levels, since the interest income from corporate bonds is fully taxable if a fund holds U.S. Government bonds, the income distributions are taxable at the Federal level, but not the State level, since the interest income from U.S. Government bonds is subject to Federal tax, but is exempt from State and Local tax if a fund holds municipal bonds, the income distributions are exempt from Federal tax, and are also exempt from State and Local tax if purchased by a resident of that State

Management Companies: Fund Taxation: Tax Consequence of Switching Within a Fund Family

If an investor "switches" funds within a family, the Internal Revenue Service views this as the sale or one fund; and the purchase of another fund On the liquidating sale, there can be a taxable capital gain; or a tax deductible capital loss The only way to avoid taxation is a "like kind exchange" - where the shares of one fund are sold; and reinvested into another very similar fund - for example, selling the shares of a money fund, and reinvesting the proceeds into another money fund (not, say, a growth fund or income fund)