Transcript The North Carolina Department of the Secretary of State

Investment Products &
Client File Review
2010 NASAA Investment Adviser Training
Dallas, TX
____________________
Presented by:
Darren D. Kearns CFP®
Introduction / Topics to be Covered
Investments as they relate to the examination
process (interview & exam modules)
 Investment types, vehicles, and details
 Investment strategies, analysis & suitability
 Investment terminology
 Areas of abuse
 NASAA Modules
 Red flags

Types of Investments

Debt - Represents money borrowed that
must be repaid, generally having a fixed
amount, a specific maturity, and usually a
specific rate of interest or an original
purchase discount

Equities - Represents ownership shares of
an asset

Alternative - All others (Options, Futures,
Real Estate, Limited Partnerships, Direct
Participation Programs)
Types of Debt
 CD’s
- Redeemable debt obligation
issued by a bank or other depository
institutions
 Commercial Paper - Usually low-risk
debt issued by large corporations
usually with strong credit. Issued in
large amounts with short maturities
Types of Debt (cont’d)
 Bonds
– Corporate
– Municipal
– Federal
– Government Agencies (government
sponsored)
Equity Securities

Represents ownership shares of an asset
(such as a corporation)
– Individual Stocks
» Common Stock
» Preferred Stock
Mutual Funds
Used by investors who have neither the
resources nor the time to manage a
portfolio on their own effectively
 Ownership of these pooled portfolios is
subdivided into shares or units
representing ownership of a fraction of
the pooled portfolio
 The share price is called Net Asset
Value (NAV)

Mutual Funds

Marketed two ways
– No-load funds - Sold directly to fund’s investors
» Example: Fidelity, Vanguard, Schwab
– Load funds - Sold through an agent (registered
representative). Primarily sold as A, B & C shares
» Example: Van Kampen, American Funds, AIM

What are 12b-1 fees? - Named after an SEC rule,
these fees are not directly paid but taken out of funds
assets annually to cover costs of marketing and
distributing the fund. These fees are paid to the
salesperson
Types of Load Funds

A Shares - Front end load (5.75%)
– Client purchases $10,000 of American Funds
Growth Fund of America Class A
» $9,425 goes to purchase shares in mutual fund
» Agent receives commission of 5% ($500)
» 12b-1 fee is lower – .25% annually
» Annual operating expenses is .65%
 Offers
breakpoints on commission when large amounts are
purchased
 Front end load can also be reduced by signing a letter of
intent or with rights of accumulation
Types of Load Funds

B Shares - Contingent deferred sales charge
(CDSC) if sold during the first five years
– Client purchases $10,000 of American Funds
Growth Fund of America Class B
» $10,000 goes to purchase shares in mutual fund
» If client sells in first 5 years a CDSC is charged
 CDSC
declines for each of first 5 years from 5% to 1.5%
» One-time commission of 5% ($500)
» Annual operating expense is 1.36% annually
» 12b-1 fee is higher - 1% annually
B
shares convert to A shares after 8 years
Types of Load Funds

C Shares - Contingent deferred sales
charge (CDSC) if sold during 1st year
– Client purchases $10,000 of American Funds
Growth Fund of America Class C
» $10,000 goes to purchase shares in mutual
fund (sold in 1st year client is charged a 1% fee)
» One-time commission of 1% ($100) and ongoing annual fee of 1%
» 12b-1 fee is 1% annually
»Annual operating expenses is 1.41% annually
Cost of Ownership for $50,000 in the
American Funds - Growth Fund of America
A Shares
B Shares
C Shares
1-year
$52,090
$51,658
$53,631
3-years
$61,989
$61.542
$63,447
5-years
$73,769
$73,551
$74,365
10-years
$113,965
$112,746
$110,602
*Based on $50,000 investment and 9.80% annual growth
*Class B share automatically converts to A share after 8 years
*Class C share automatically converts to A share after 10 years
FINRA Mutual Fund Expense Analyzer Website:
http://apps.finra.org/fundanalyzer/1/fa.aspx
Cost of Ownership for $100,00 Investment in
American Funds – Growth Fund of America
A Shares B Shares C Shares
1-year
$105,271 $103,317 $107,263
3-years
$125,276 $123,084 $126,893
5-years
$149,082 $147,102 $148,730
10-years $230,316 $225,493 $221,205
*Based on $100,000 investment and 9.80% annual growth
*Class B share automatically converts to A share after 8 years
*Class C share automatically converts to A share after 10 years
FINRA Mutual Fund Expense Analyzer Website:
http://apps.finra.org/fundanalyzer/1/fa.aspx
Mutual Fund Abuses

Mutual fund switching
– Selling out of one company’s fund and
purchasing into a different company’s
fund to generate a commission

Mutual fund breakpoint
– Selling B or C Shares when A shares
would have earned the client a reduced
sales charge
– Buying in multiple lots at a price under
the breakpoint
Exchange Traded Fund (ETF)
An ETF is an investment vehicle traded on a
stock exchange
 An ETF holds assets such as stocks and trades at
the same price as the NAV of its underlying
assets
 Most ETF’s track an index like the S&P 500
(SPDR)
 ETF’s traditionally have been index funds, but
in 2008 the SEC began to authorize the creation
of actively-managed ETF’s

Annuities

Types of Annuities
– Fixed - An insurance contract in which the
insurance company makes fixed dollar
payments to the annuitant for the term of the
contract, usually until the annuitant dies
– Variable - An insurance contract in which the
insurance company makes variable dollar
payments to the annuitant which varies based
on the performance of underlying equity
investments
Variable Annuities
Typically purchased for benefit of tax
deferral or death benefit
 Offers a range of investment options in
sub-accounts
 Investment options are typically mutual
funds that invest in stocks and bonds
 Value of variable annuity will vary based
on performance of investments chosen

Benefits of Variable Annuities

Tax-deferred
– No taxes on income earned and gains realized
until you withdraw your money
» No benefit to having a variable annuity purchased in
a tax-advantaged retirement plan, such as 401(k)

Death benefit
– If owner dies before receiving payments then
beneficiary is guaranteed to received specified
amount
Variable Annuity Disclosures

Surrender charges
– 7-10 year surrender period

High cost of ownership
– Annual administrative fees
» Record keeping costs
– Mortality and expense risk fee
» The cost of insurance
– Management fees
» Indirectly paid to mutual fund for managing assets
1035 Exchanges

Allows for tax-free exchange from existing
variable annuity to a new variable annuity
– What to look for
» Was a surrender charge levied by the old
annuity company?
 Bonus feature can be marketed to induce
exchange and payment of surrender charge.
Annuity company can increase expenses to
pay for bonus feature
» What was reason for exchange?
Alternative Investments
Options
 Hedge Funds
 Futures
 Real Estate
 Direct Participation Programs

Options
A put, call, warrant, right or other security
giving the holder the right but not the
obligation to purchase or sell a security at a
set price for a specified period
 Highly speculative – Magnifies gains and
losses
 BP Option

Hedge Funds
An aggressively managed portfolio of
investments that uses advanced investment
strategies such as leverage, long, short and
derivative positions in both domestic and
international markets with the goal of
generating high returns
 Legally, hedge funds are most often set up
as private investment partnerships that
are open to a limited number of investors
and require a very large initial minimum
investment

Futures


A financial contract obligating the buyer
to purchase an asset (or the seller to sell an asset),
such as a physical commodity or a financial
instrument, at a predetermined future date and
price. The futures markets are characterized by
the ability to use very high leverage relative to
stock markets
Futures can be used either to hedge or to speculate
on the price movement of the underlying asset
Real Estate
Real Estate Investment Trust (REITs) - A
security that sells like a stock on the major
exchanges and invests in real estate directly,
either through properties or mortgages
 REITs receive special tax considerations
and typically offer investors high yields, as
well as a highly liquid method of investing
in real estate

Direct Participation Programs (DPPs)

A business venture designed to let
investors participate directly in the cash
flow and tax benefits of the underlying
investment. DPPs are generally passive
investments that invest in real estate or
energy-related ventures
Investment Strategies
Long-term - Buy & hold
Short-term – Daytrade
Margin - Borrow money to purchase
investments (leverage investments)
Option Writing - Generates Income
Shorting - Sell a security you do not own in
hopes price declines and you make a profit





•
Naked short selling is illegal practice of shorting
stocks and failing to deliver the shares shorted
Type of Analysis - Fundamental
–
–
–
–
Macroeconomic analysis – Business Cycle
Industry analysis – Sector rotation
Company analysis – Financial position
(balance sheet, income statement), earnings
per share, book value
Mutual fund analysis – Review of mutual
fund performance based on statistical data
Type of Analysis - Technical

Seeks to time trades by assessing
psychological state of the market
– Types of charts – Bar, line, candle charts &
point-and-figure charts
Bar Chart
Point and Figure Chart
Dartboard Theory of Investing
Sources of Investment Information

News Papers & Periodicals
– Wall Street Journal, Business Week, Money

Mutual Fund Research
– Morning Star – Principia
– Lipper

The Web
– www.stockcharts.com,
www.finance.yahoo.com, www.thestreet.com

Company Analysis
– Standard & Poors, Moody’s, Value Line
Suitability

Has the Investment Adviser determined the
client’s suitability?
– Has the client completed a risk tolerance &
objective questionnaire?
– Has a client profile been completed?
– Have they been periodically updated?
– Is the Investment Adviser doing due diligence in
ascertaining client’s wants and needs?
– Proper asset allocation requires a determination of
the client’s risk tolerance

Efficient Frontier
Suitability (cont’d)
Aggressive Asset Allocation
Debt
15%
Cash
5%
Equity
80%
Sample Asset Allocation
Suitability (cont’d)
Moderate Asset Allocation
Cash
25%
Equity
40%
Debt
35%
Sample Asset Allocation
Suitability (cont’d)
Conservative Asset Allocation
Equity
20%
Cash
30%
Debt
50%
Sample Asset Allocation
Equity Allocation
International
20%
Large Cap
Growth
20%
Small Cap
Value
10%
Small Cap
Growth
10%
Large Cap
Value
20%
Mid Cap Value
10%
Mid Cap
Growth
10%
Suitability (cont’d)





Do the investments in client account match the
client’s suitability (risk tolerance & time horizon)?
Ask Adviser “Why did you recommend this
investment?”
Check client files for profile of the client as well
as basis for what is recommended and determine
whether profiles are regularly updated?
Annuities – Is an annuity suitable? Are
investments in sub-accounts suitable? Are riders
suitable?
Mutual Fund – Is the class of fund sold suitable
and appropriate for client’s needs and objectives?
Investment Adviser Interview
Module Questionnaire
– Products Section: What types of products does the firm
recommend?
» Equity Securities



BP PLC - BP
Cree Research – CREE
General Electric - GE
» Corporate Debt Securities


Credit Suisse High Yield Bond Fund
General Electric Corporate Bond 30 yr 6%
» Federal, state, or municipal securities


Wake County Revenue Bond 6 ½%
New Jersey Municpal Bond Fund
» Mutual Funds


Van Kampen Equity Growth A - VEGAX
Fidelity Select Technology - FSPTX
Investment Adviser Interview
Module Questionnaire (cont’d)
– Variable Products (Annuities or Variable Life)
» Fidelity Personal Retirement annuity
– Wrap Programs
» Raymond James Freedom Account
– 3rd Party Money Managers
» Brinker Capital
– Insurance (Life, Health, Long Term Care, Property/Casualty)
– Options
– Futures
Investment Adviser Interview
Module Questionnaire (cont’d)
– Pooled Investment vehicles (Hedge Fund)
» Highbridge Capital Management, LLC – $21 billion in management
» Bridgewater Associates, Inc. - $43.6 billion in management
– Limited Partnerships
» Armadillo Oil Wells, LP
– Promissory Notes
» 10% promissory note
– Viaticals, Life Settlements
» Viatical settlement provider
– Proprietary Products
» Offerings
» LLC’s
– Other
» Exchange Traded Fund
Investment Adviser Interview
Module Questionnaire (cont’d)

Product Comments:
– Make notes about a unique product and note which account it is in

Does the firm provide advice not involving securities? If yes, describe.
– “We offer estate planning advice”
– “We provide insurance advice”
– “We provide real estate advice”

What are the firm’s investment strategy, analysis, and research methods?
– Investment strategy should be based on client’s needs and objectives
– Analysis – Fundamental and/or technical
– Research methods – Proprietary research, Morningstar, third-party (Standard and Poors,
Moody’s, etc)
Investment Adviser Exam Module
– Investment Activities Section (page 4 of module)
– Does it appear that the adviser’s actual research and analysis
methods, investment policies, and securities selection are
determined and carried out in accordance with the client
agreement and/or the advisers disclosure brochure?
»
»
»
»
»
»
Review Investment policy statement if used
Review client contract
Review client file (notes, risk tolerance questionnaire)
Review client statements
Review Form ADV and advertising
Ask questions
Questions?
Thank You