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