Series 66 – Uniform Combined State Law Exam Key Study Note Set Two

Duration is a measure of a bond’s price sensitivity to changes in interest rates. A higher duration indicates greater price volatility for a given change in interest rates. Modified duration provides an estimate of the percentage price change for a 1% change in yield. Key assumptions include parallel shifts in the yield curve, which rarely occur in reality. The calculation of duration relies on discounted cash flow analysis, considering the timing and size of future coupon payments and the principal repayment. It’s crucial to understand that duration is an approximation, and its accuracy decreases as the magnitude of interest rate changes increases. Furthermore, duration assumes that the bond’s yield-to-maturity accurately reflects its risk. FINRA Rule 2210 governs communications with the public and requires that any discussion of bond yields and risks be fair and balanced.

Strategic asset allocation involves setting target asset allocation percentages based on a client’s long-term goals, risk tolerance, and time horizon. It’s a passive approach that aims to maintain a consistent portfolio mix over time. Tactical asset allocation, on the other hand, is an active strategy that involves making short-term adjustments to asset allocation in response to perceived market opportunities or risks. An IAR implementing strategic allocation would regularly rebalance the portfolio back to its target allocations. For tactical allocation, the IAR would actively overweight or underweight certain asset classes based on economic forecasts or market trends. The Uniform Prudent Investor Act requires fiduciaries to act with reasonable care, skill, and caution, and diversification is a key element of prudent investing. Any tactical shifts should be well-researched and documented, aligning with the client’s investment policy statement.

A C-corporation is taxed as a separate entity, meaning its profits are taxed at the corporate level, and then again when distributed to shareholders as dividends (double taxation). An S-corporation, however, is a pass-through entity, where profits and losses are passed through directly to the owners’ individual income tax returns, avoiding double taxation. This distinction significantly impacts the tax liabilities of business owners. For a small business owner, the choice between a C-corp and S-corp depends on factors like anticipated profitability, owner compensation, and long-term business goals. An S-corp is often preferred for smaller businesses with active owner-operators due to the avoidance of double taxation. However, a C-corp might be advantageous for businesses seeking to retain earnings for future growth or attract venture capital. Investment advisors must understand these tax implications to provide suitable advice, as outlined in the Investment Advisers Act of 1940, which requires them to act in the best interest of their clients.

“Per stirpes,” Latin for “by branch,” is a method of distributing assets to beneficiaries in estate planning. If a primary beneficiary dies before the testator (the person making the will), the deceased beneficiary’s share is passed down to their descendants equally. For example, if a testator has two children, A and B, and A predeceases the testator, A’s share would be divided equally among A’s children. If “per capita” were used instead, all surviving beneficiaries (including A’s children and B) would share equally. The use of per stirpes ensures that each branch of the family receives an equal share of the estate, regardless of whether the original beneficiary is alive. This is particularly important in blended families or situations where there are multiple generations of potential beneficiaries. Estate planning documents should clearly define the intended distribution method to avoid ambiguity and potential legal challenges. State laws governing wills and trusts vary, so it’s crucial to consult with an estate planning attorney.

Time-weighted return (TWR) measures the performance of an investment portfolio over a period of time, isolating the impact of the portfolio manager’s decisions. It neutralizes the effects of cash flows into and out of the portfolio. Dollar-weighted return (DWR), also known as the internal rate of return (IRR), measures the return earned by the investor, taking into account the timing and size of cash flows. TWR is generally considered a more accurate measure of a portfolio manager’s performance because it removes the influence of investor decisions regarding contributions and withdrawals. DWR, on the other hand, reflects the actual return experienced by the investor, which can be significantly different from the manager’s performance if large cash flows occur at opportune or inopportune times. The CFA Institute’s Global Investment Performance Standards (GIPS) emphasize the use of TWR for performance reporting to ensure comparability across different portfolios and managers.

The “duty of care” standard requires investment advisers to act with reasonable diligence, competence, and skill when providing investment advice. This means conducting thorough research, understanding the client’s financial situation and objectives, and making recommendations that are suitable and in their best interest. The Uniform Securities Act, particularly sections dealing with unethical business practices, reinforces this duty by prohibiting fraudulent or deceptive conduct. When recommending complex or alternative investments, the duty of care is heightened. Advisers must have a comprehensive understanding of the investment’s risks, features, and potential impact on the client’s portfolio. They must also ensure that the client understands these aspects before making a recommendation. Failure to adequately assess and disclose the risks of complex investments can lead to liability for breach of fiduciary duty. NASAA Model Rule 204-3(a) emphasizes the importance of disclosing all material facts about the advisory relationship, including potential conflicts of interest.

“Selling away” refers to the practice of an agent of a broker-dealer engaging in securities transactions outside the scope of their employment with the firm, without the firm’s knowledge or approval. This is a serious violation of securities regulations and ethical standards. The agent is potentially liable for violating anti-fraud provisions of the Securities Exchange Act of 1934 and state securities laws. Ethically, it breaches the agent’s duty to the broker-dealer and potentially exposes clients to unsuitable investments or fraud. Broker-dealers have a supervisory responsibility to prevent and detect selling away. This includes implementing reasonable procedures to monitor agents’ activities, such as reviewing customer complaints, monitoring personal securities transactions, and conducting regular audits. Failure to adequately supervise agents can result in sanctions against the broker-dealer by regulatory authorities like FINRA and state securities administrators. FINRA Rule 3110 outlines supervisory responsibilities, emphasizing the need for written supervisory procedures and regular reviews of business activities.

The Uniform Securities Act (USA) defines an “agent” as any individual who represents a broker-dealer or issuer in effecting or attempting to effect purchases or sales of securities. It’s crucial to understand that this definition is broad and encompasses various activities. Registration as an agent is generally required when an individual solicits orders, negotiates transactions, or provides investment advice on behalf of a broker-dealer. However, there are exclusions. For example, individuals who represent issuers in certain exempt transactions or with specified exempt securities may not be required to register. State securities laws, guided by the USA, mandate registration to protect investors by ensuring that individuals dealing with the public have met certain competency and ethical standards. NASAA provides guidance on interpreting these provisions. The specific requirements and exclusions can vary by state, so it’s essential to consult the specific state’s securities laws and regulations.

“Soft dollars” refer to the practice where an investment adviser uses client brokerage commissions to pay for research and other services that benefit the adviser. Section 28(e) of the Securities Exchange Act of 1934 provides a safe harbor, allowing advisers to pay more than the lowest available commission rate if they determine in good faith that the commission is reasonable in relation to the value of the brokerage and research services received. However, this safe harbor is not a blanket exemption. The services must provide a direct benefit to the adviser’s clients. Under the Investment Advisers Act of 1940, advisers must disclose their soft dollar practices to clients. Form ADV Part 2A requires detailed disclosure of the types of products, research, and services received in exchange for brokerage commissions. This disclosure must be specific enough for clients to understand the potential conflicts of interest. Failure to adequately disclose soft dollar arrangements can result in regulatory action, as it violates the adviser’s fiduciary duty to act in the best interests of their clients.

Strategic asset allocation involves setting target asset allocations based on a client’s long-term financial goals, risk tolerance, and time horizon. This approach emphasizes maintaining a consistent asset mix over time, rebalancing the portfolio periodically to stay aligned with the target allocations. It’s a passive approach suited for investors with a long-term focus and a desire for stable, predictable returns. Tactical asset allocation, on the other hand, is a more active strategy that involves making short-term adjustments to asset allocations based on market conditions and economic forecasts. The goal is to capitalize on perceived market inefficiencies and generate higher returns. This approach is more suitable for investors with a higher risk tolerance and a willingness to actively manage their portfolios. The key difference lies in the time horizon and the level of active management. Strategic allocation is long-term and passive, while tactical allocation is short-term and active. The choice between the two depends on the client’s individual circumstances and preferences.

“Selling away” refers to the prohibited practice of an agent of a broker-dealer engaging in securities transactions outside the scope of their employment with the firm, without the knowledge or approval of the broker-dealer. This is a serious violation of securities regulations, as it circumvents the broker-dealer’s supervisory responsibilities and exposes clients to potential risks, including unregistered securities, fraud, and unsuitable investments. The Uniform Securities Act (USA) prohibits agents from engaging in such activities. Broker-dealers have a duty to supervise their agents and prevent selling away. To prevent and detect this activity, broker-dealers should implement robust supervisory procedures, including: (1) conducting background checks on new agents, (2) monitoring agents’ outside business activities, (3) reviewing customer complaints and account activity for suspicious patterns, (4) providing training to agents on the firm’s policies and procedures, and (5) establishing a system for reporting and investigating potential instances of selling away. Failure to adequately supervise agents can result in disciplinary action by state securities regulators.

The Investment Company Act of 1940 imposes significant regulations on the fee structures and costs of pooled investments, particularly mutual funds and ETFs, to protect investors. The Act requires clear and transparent disclosure of all fees and expenses, including management fees, 12b-1 fees (marketing and distribution expenses), and other operating expenses. Mutual funds must provide a prospectus that details these costs, allowing investors to make informed decisions. ETFs, while also subject to the 1940 Act, have different cost structures. They typically have lower expense ratios than actively managed mutual funds due to their passive investment strategies. However, investors also incur brokerage commissions when buying and selling ETF shares. The Act also addresses potential conflicts of interest related to fees, such as excessive advisory fees. Section 36(b) of the Act allows shareholders to sue investment advisers for breach of fiduciary duty if they believe the advisory fees are excessive. These regulations aim to ensure that investors are not unfairly burdened by high costs and that fund managers act in the best interests of shareholders.

Modern Portfolio Theory (MPT) is a framework for constructing investment portfolios that maximizes expected return for a given level of risk. Its key assumptions include: (1) investors are rational and risk-averse, (2) markets are efficient, and (3) asset returns are normally distributed. MPT uses statistical measures like expected return, standard deviation (risk), and correlation to create an efficient frontier, representing portfolios that offer the highest expected return for each level of risk. MPT guides portfolio construction by encouraging diversification across asset classes with low correlations to reduce overall portfolio risk. However, MPT has limitations in real-world application. The assumption of normally distributed returns is often violated, as markets can experience extreme events (fat tails). Also, investors are not always rational, and behavioral biases can influence investment decisions. Furthermore, market efficiency is debatable, and some investors believe they can outperform the market through active management. Despite these limitations, MPT provides a valuable framework for understanding risk and return and constructing diversified portfolios.

Leveraged funds aim to deliver a multiple (e.g., 2x or 3x) of the daily return of an underlying index or benchmark. Inverse funds, also known as “short” funds, seek to deliver the opposite of the daily return of an underlying index. These funds use derivatives and other strategies to achieve their objectives. While they can offer the potential for amplified gains, they also carry significant risks. Due to the daily reset, their performance can deviate significantly from the multiple or inverse of the underlying index over longer periods, especially in volatile markets. They are generally unsuitable for buy-and-hold investors. When recommending leveraged or inverse funds, advisors must provide clear and prominent disclosures about their risks, including the potential for significant losses and the impact of daily compounding. Suitability considerations are paramount. These products are generally suitable only for sophisticated investors with a high risk tolerance, a thorough understanding of their mechanics, and a short-term investment horizon. Advisors must document their suitability analysis and ensure that clients understand the risks before investing. FINRA Regulatory Notice 09-31 provides guidance on the sale of leveraged and inverse ETFs.