Taxation and Mutual Funds

Let's take a look at a question about mutual fund taxation . . .

All of the following are taxable in relation to a mutual fund investment except
A. undistributed capital gains
B. unrealized capital gains
C. reinvested capital gains distributions
D. capital gains distributions from a tax-exempt municipal bond fund

EXPLANATION: a surprising fact about capital gains that a mutual fund portfolio manager realizes is that even if they're not paid out to shareholders, the shareholders are taxed on their fair share of the gains. If the fund does distribute capital gains, the investor is taxed whether she cashes the check or reinvests automatically. And, municipal bonds are subject to capital gains taxes just like other securities. Of course, if a capital gain is "unrealized," there is no capital gain.



ANSWER: b

Net Asset Value

Net Asset Value in a mutual fund seems to annoy a large number of Series 7 candidates, so let's take a closer look. Here is a rather difficult practice question on the concept:

The Pacesetter Equity Income Fund holds large positions in exactly 10 common stock issues. This week 5 of the holdings distributed dividend payments of $10,000 each. Therefore, which of the following statements is true?
a. the NAV remains unchanged if proportionally more purchase orders come in versus redemptions
b. the NAV remains unchanged due to dividend distributions
c. the NAV will rise unless market values decline by more than the dividends distributed
d. the NAV remains unchanged unless redemptions outweigh purchase orders for the fund shares

EXPLANATION: NAV is figured before anybody buys or sells shares of the fund on a particular trading day. The buyers are not bidding competitively on a fixed number of shares--the fund creates new shares for the buyers and converts the sellers' shares to an equal amount of cash. Purchases and redemptions have no effect whatsoever on NAV. On the other hand, if $50,000 of cash money comes into the mutual fund portfolio, that makes the assets of the fund rise. The only way the NAV could go down that day is if the market values of the securities dropped by more than $50,000.



ANSWER: c

Mutual Fund A, B, C shares

When you recommend mutual funds to investors, part of your suitability obligation is to help determine the proper share class. An investor with, say, $100,000 and a long time horizon should be purchasing A-shares. She will knock down the front-end sales charge with her quantity purchase, and her expenses going forward will be significantly lower than on B- and C-shares. B-shares are suitable for an investor with a long time horizon and a smaller amount to invest. This investor will avoid the front-end sales charge, and as long as she holds the shares 6 or 7 years, the back-end sales charge will go away, and then her shares will convert to A-shares with their lower operating expenses. She will pay higher operating expenses, but due to her small amount of $ to invest, she couldn't reach a breakpoint on A-shares, anyway. This is her best option. C-shares charge high operating expenses, and, unlike B-shares, these things do not convert to A-shares. So, they are generally for investors with a short time horizon. We don't want to keep hitting them with high annual expenses for very long, but if the investor will only hold the shares, say, three years, C-shares are ideal. No need to hit her up with a big front-end sales charge if she's only going to hold the fund a few years. As long as the investment is under, say, $500,000, C-shares will be suitable for a short-term investment. And that implies that a larger investment--even over the short-term--would be more suitable in A-shares, since the front-end load would be knocked down so low and then the investor would also enjoy the low operating expenses going forward. In other words, it's freaking complicated. And that's why many firms end up getting fined millions of dollars and returning millions of dollars to over-charged customers. They don't have adequate training and supervision in place. The rep's don't know enough about the various share classes, or maybe--just maybe--they prefer making the highest compensation possible, regardless of what's best for the customer. When you read the news release at the link below, please know that I am absolutely not bashing Wachovia here--heck, I'm a Wells Fargo shareholder (they own them now), and I also sell a lot of Pass the 7(c) books, DVD's etc. to Wachovia employees all across the country. Every firm out there could provide us with dozens of similar fines and mishaps--the securities industry is complicated. No one can stay on the right side of the regulatory line all the time. I don't see a need to explain the UIT angle, since the FINRA news release does such an excellent job of bringing up the testable points. Check out the news release at : http://www.finra.org/Newsroom/NewsReleases/2009/P117836