20 Pooled, Derivative & Insurance Products Practice Questions & Answers

1. 1. An adviser compares two registered investment companies. Fund A continuously offers new redeemable shares priced at the next computed net asset value; Fund B sold a fixed number of shares in a single offering and now trades on an exchange. Which statement about Fund B is correct?

   • A.It must redeem its outstanding shares at net asset value within seven days of a written request.
   • B.It may issue preferred stock or bonds as senior securities and use that leverage in its portfolio.✓ Answer
   • C.Its exchange price is set each business day at net asset value plus any applicable sales charge.
   • D.It must keep a registration statement effective because it offers new shares on a continuous basis.

   Fund B is a closed-end management company. Under the Investment Company Act of 1940 a closed-end fund issues a fixed number of shares that are not redeemable, and those shares trade in the secondary market at a price set by supply and demand that may be a premium or a discount to net asset value. Unlike an open-end fund, a closed-end fund may issue senior securities such as preferred stock and bonds and use that leverage in the portfolio.

   Source: Investment Company Act of 1940, Sections 4(2) and 18Report a problem with this question

2. 2. An index ETF and an index mutual fund track the same benchmark, yet over many years the ETF distributes far less in capital gains to its shareholders. Which mechanism best explains that difference?

   • A.An exchange-traded fund is not subject to the requirement that realized net capital gains be distributed.
   • B.Gains realized inside an exchange-traded fund are taxed at the fund level and are not passed through.
   • C.Shareholders who sell an exchange-traded fund on an exchange defer all gains until the fund is liquidated.
   • D.Shares are created and redeemed in kind by authorized participants, so appreciated holdings are seldom sold.✓ Answer

   ETF shares are created and redeemed in large creation units exchanged in kind for baskets of securities with authorized participants, so the fund rarely has to sell appreciated positions to raise cash for redemptions. Fewer realized gains means fewer taxable capital gains distributions. The ETF is still a regulated investment company and must distribute the gains it does realize.

   Source: SEC Rule 6c-11 under the Investment Company Act of 1940 (exchange-traded funds); IRC Subchapter MReport a problem with this question

3. 3. A client is offered shares of a public non-traded REIT and compares them with an exchange-listed REIT that owns similar properties. Which statement about the non-traded REIT is correct?

   • A.Its per-share value is an appraisal-based estimate and exit depends on a limited repurchase plan.✓ Answer
   • B.Its shares may be sold only to qualified purchasers because the offering is not listed on an exchange.
   • C.Its distributions are guaranteed by the sponsor and cannot be suspended while the offering is open.
   • D.Its shares trade at a discount to net asset value whenever demand for commercial property weakens.

   A non-traded REIT has no secondary market and therefore no market price: the sponsor publishes an estimated per-share value derived from appraisals, and an investor who needs cash normally depends on a limited, discretionary share repurchase program. Up-front sales and offering costs are far higher than a brokerage commission, and distributions are not guaranteed and are sometimes paid from offering proceeds or borrowings.

   Source: SEC Office of Investor Education and Advocacy, Investor Bulletin: Non-Traded REITsReport a problem with this question

4. 4. A hedge fund admits more than 100 beneficial owners, requires every investor to be a qualified purchaser, and does not register as an investment company. Which statement explains the basis for that structure?

   • A.It falls outside the Act because each investor meets the accredited investor test in Regulation D.
   • B.It relies on an exclusion that caps beneficial owners at 100 regardless of investor sophistication.
   • C.It falls outside the Act because its adviser is registered with the SEC and reports for the fund.
   • D.It relies on an exclusion with no ceiling on the number of owners but limited to qualified purchasers.✓ Answer

   Section 3(c)(1) excludes a fund whose outstanding securities are beneficially owned by not more than 100 persons, while Section 3(c)(7) excludes a fund all of whose owners are qualified purchasers and imposes no comparable cap on the number of owners. Accredited investor status under Regulation D governs the private offering of the interests, not the fund's status under the Investment Company Act.

   Source: Investment Company Act of 1940, Sections 3(c)(1) and 3(c)(7)Report a problem with this question

5. 5. A client purchased shares of an equity mutual fund four months ago. The fund now makes a capital gains distribution arising from stocks the fund itself had held for several years. How is that distribution taxed to the client?

   • A.As a return of capital, because the gain arose before he ever purchased the fund shares.
   • B.As a short-term capital gain, because he has owned the fund shares for less than one year.
   • C.As a long-term capital gain, because the character is set by the fund's own holding period.✓ Answer
   • D.As ordinary income, because every distribution from a regulated investment company is ordinary.

   Under the conduit rules of Subchapter M, a regulated investment company passes its realized net long-term capital gains through to shareholders as long-term capital gains no matter how long the shareholder has owned the fund shares. The fund's holding period in the underlying securities fixes the character of the distribution, and a fund can never pass a loss through to its shareholders.

   Source: IRC Subchapter M, Section 852(b)(3)Report a problem with this question

6. 6. A client with $50,000 to invest tells his adviser to buy an equity mutual fund two days before its scheduled year-end capital gains distribution so that he captures the payout. What should the adviser explain?

   • A.Buying before the record date makes the distribution tax-free, since the gains arose before he invested.
   • B.Waiting until after the distribution would forfeit a payment he is entitled to and cut his total return.
   • C.Reinvesting the distribution in new shares defers the tax until the fund position is eventually sold.
   • D.Buying just before the distribution creates a tax bill with no economic gain, since the price drops.✓ Answer

   Buying a dividend gives the investor no economic benefit: the fund's net asset value falls by the amount distributed, so the client simply receives part of his own investment back and owes current tax on it in a taxable account. Waiting until after the distribution date avoids a taxable event that adds nothing to total return.

   Source: IRC Section 852; SEC Office of Investor Education and Advocacy guidance on mutual fund distributionsReport a problem with this question

7. 7. A client holds an equity mutual fund in a taxable account and has elected to reinvest all dividend and capital gains distributions in additional shares. Which statement is correct?

   • A.The reinvested amounts are taxable in the year paid but leave his cost basis unchanged.
   • B.The reinvested amounts are a return of capital that reduces his cost basis in the fund.
   • C.The reinvested amounts are taxable in the year paid and add to his cost basis in the fund.✓ Answer
   • D.The reinvested amounts are tax-deferred until the shares bought with them are eventually sold.

   Reinvestment is a matter of form, not substance: the distribution is constructively received and is taxed in the year it is paid whether or not the shareholder takes cash. Because tax has already been paid on those dollars, the reinvested amount is added to basis, and failing to track that is what causes investors to be taxed twice on the same money at redemption.

   Source: IRC Section 852 and Section 1012 (basis of mutual fund shares)Report a problem with this question

8. 8. Two clients each agree to take delivery of a commodity in six months. One uses an exchange-traded futures contract; the other uses a forward negotiated directly with the producer. Which statement correctly contrasts the two?

   • A.The futures contract is standardized and cleared with daily margin, while the forward carries credit risk.✓ Answer
   • B.The forward is standardized and marked to market daily, while the futures contract settles at maturity.
   • C.The futures contract binds only the seller, while the forward binds both parties to perform at maturity.
   • D.Both give the buyer a right rather than an obligation to take delivery, and differ only in where they trade.

   A futures contract is a standardized, exchange-traded obligation whose performance is guaranteed by a clearinghouse, with positions marked to market and margined every day. A forward is a privately negotiated, customized contract that settles at maturity with no clearinghouse behind it, so each side bears the other's credit risk and the position is illiquid. Unlike options, both instruments obligate both parties.

   Source: Commodity Exchange Act; NASAA Series 65 Test Specifications, derivative securities (definitions)Report a problem with this question

9. 9. A corporation issues bonds with warrants attached. Separately, an investor buys a listed call option on that corporation's stock. Which statement correctly contrasts the two instruments?

   • A.The warrant is issued by the corporation and dilutes holders on exercise; the listed call comes from the OCC.✓ Answer
   • B.The warrant is issued by the Options Clearing Corporation; the listed call is created by the corporation.
   • C.The warrant's exercise price is set below the market price of the stock at the time the bonds are issued.
   • D.The warrant usually expires within a few months, while the listed call routinely runs for several years.

   A warrant is a long-term instrument issued by the company itself, normally with an exercise price above the market price when it is attached to a bond as a sweetener, and exercising it makes the company issue new shares that dilute existing holders. A listed equity option is standardized and is issued and guaranteed by the Options Clearing Corporation; exercise moves existing shares and dilutes no one. Rights, not warrants, are short-lived and priced below the market.

   Source: NASAA Series 65 Test Specifications, derivative securities (definitions); Options Clearing Corporation, Characteristics and Risks of Standardized OptionsReport a problem with this question

10. 10. A client asks an investment adviser representative about adding exchange-traded corn futures contracts to a speculative portion of her portfolio. Which statement about those contracts is correct?

    • A.They are securities under state law, so a prospectus must be delivered before the client may trade them.
    • B.They are securities because their value is derived from an underlying asset, just as listed options are.
    • C.They are generally not securities, and trading in them is regulated by the CFTC rather than by the SEC.✓ Answer
    • D.They are exempt securities, so no antifraud provision reaches statements made when they are sold.

    Commodity futures contracts are generally not securities: the Commodity Futures Trading Commission regulates the futures markets, while the SEC and the state administrators regulate securities. Listed options on securities, by contrast, are securities. The distinction determines which regulator, which registration requirement and which disclosure regime apply to a recommendation.

    Source: Commodity Exchange Act; Securities Exchange Act of 1934, Section 3(a)(10)Report a problem with this question

11. 11. An adviser reviews two option contracts held by a client: one is American style and the other is European style. Which statement correctly states the difference between them?

    • A.The American-style contract trades only on U.S. exchanges, and the European style only on foreign markets.
    • B.The American-style contract may be exercised any time before expiration, the European style only at expiry.✓ Answer
    • C.The American-style contract settles by delivering shares, and the European style always settles in cash.
    • D.The American-style contract may be exercised only on its expiration date, and the European style at any time.

    Exercise style is a matter of timing only. The holder of an American-style option may exercise it at any time from purchase through expiration, while a European-style option may be exercised only at expiration. Whether a contract settles in cash or in shares, and the market on which it trades, are separate features that do not define the style.

    Source: Options Clearing Corporation, Characteristics and Risks of Standardized Options (exercise styles)Report a problem with this question

12. 12. A bank offers a client a five-year principal protected market-linked note whose return tracks a stock index up to a stated cap. Which statement should the adviser make about the note?

    • A.The protection is a promise of the issuing bank, so the client takes issuer credit risk for a capped return.✓ Answer
    • B.The note can be sold back to the issuer at par at any time, so its liquidity resembles a money market fund.
    • C.The note pays the whole index return above a floor, so it behaves much like an insured index fund would.
    • D.The principal protection is backed by federal deposit insurance because the issuer is a commercial bank.

    A structured note is an unsecured debt obligation of the issuer with a derivative embedded in it. The protection is only as good as the issuer's ability to pay, it is not covered by deposit insurance, the upside is limited by the cap and the participation terms, and there is little or no secondary market before maturity.

    Source: SEC Office of Investor Education and Advocacy, Investor Bulletin: Structured NotesReport a problem with this question

13. 13. A client with a large salary and a portfolio of dividend-paying stocks invests in an oil and gas limited partnership. His Schedule K-1 for the year reports a substantial loss. How may he use that loss?

    • A.Against his dividend and interest income, which counts as passive income for this purpose.
    • B.Against his other passive income, with any unused amount carried forward to later years.✓ Answer
    • C.Against his salary for the current year, reducing his ordinary earned income dollar for dollar.
    • D.Against his capital gains first, with any remaining loss deducted from his ordinary income.

    A limited partnership is a flow-through vehicle, so income and loss reach the partner on a Schedule K-1, but a loss from a passive activity may offset only passive income. Wages are earned income and dividends and interest are portfolio income, so neither can be sheltered by the partnership loss, which is suspended and carried forward until there is passive income to absorb it.

    Source: IRC Section 469 (passive activity loss limitations)Report a problem with this question

14. 14. A client wants to hold physical gold bullion rather than a gold fund as an inflation hedge. Which statement should the adviser make about that position?

    • A.Bullion held longer than a year is taxed at the same preferential rate as a long-term gain on stock.
    • B.Bullion pays a small stream of interest that helps offset the cost of holding the metal over time.
    • C.Bullion pays no income, and the client bears storage, insurance and dealer spread costs while holding it.✓ Answer
    • D.Bullion prices follow the earnings outlook of the mining companies that produce and refine the metal.

    Precious metals produce no interest, dividends or earnings, so the entire return depends on what a later buyer will pay, while the holder keeps paying for vaulting, insurance and the spread between the dealer's bid and ask. Physical bullion is also treated as a collectible for federal tax purposes rather than qualifying for the ordinary long-term capital gain rate.

    Source: IRC Section 1(h) (collectibles gain); NASAA Series 65 Test Specifications, other assetsReport a problem with this question

15. 15. A representative wishes to recommend and sell variable annuity contracts. Which statement describes what the law requires for that product?

    • A.Only a securities registration is required, because the separate account is an investment company.
    • B.Both a securities registration and a state insurance license are required, and a prospectus is used.✓ Answer
    • C.Neither one is required where the insurer, not the contract owner, bears the separate account risk.
    • D.Only a state insurance license is required, because every annuity contract is an insurance product.

    A variable annuity shifts the investment risk to the contract owner, which makes it a security: the contract is registered under the Securities Act of 1933, the separate account funding it is registered as an investment company under the Investment Company Act of 1940, and it is sold with a prospectus. Because it is also an insurance contract, the person selling it needs a securities registration and a state insurance license. A fixed annuity, where the insurer bears the risk, is not a security.

    Source: SEC v. Variable Annuity Life Insurance Co., 359 U.S. 65 (1959); Securities Act of 1933; Investment Company Act of 1940Report a problem with this question

16. 16. A client owns a non-qualified deferred annuity with a large embedded gain and wants to move that value into a permanent life insurance policy without paying current tax. What should the adviser explain?

    • A.The transfer is taxable as ordinary income, because a tax-free exchange runs annuity to annuity only.✓ Answer
    • B.The transfer is tax-free up to the client's cost basis, and the balance is taxed as a long-term capital gain.
    • C.The transfer is tax-free if the client deposits the proceeds into the new policy within 60 days of receipt.
    • D.The transfer is tax-free under Section 1035 provided the insurer sends the funds straight to the new carrier.

    Section 1035 lets a life policy be exchanged for another life policy, an annuity or a qualified long-term care contract, and an annuity for another annuity, but it does not permit an annuity to be exchanged for life insurance. Surrendering the annuity therefore produces ordinary income on the gain. Even for a permitted exchange the carriers must transfer the funds directly, because constructive receipt by the owner destroys the tax-free treatment.

    Source: IRC Section 1035Report a problem with this question

17. 17. A 40-year-old client asks her adviser to fund her entire traditional IRA with a deferred variable annuity because she likes its tax deferral. How should the adviser respond?

    • A.Funding the IRA this way makes the contract's death benefit payable to her heirs free of any income tax.
    • B.Funding the IRA this way turns her future withdrawals into long-term capital gain instead of ordinary income.
    • C.Funding the IRA this way stacks a second layer of tax deferral on top of the deferral the IRA gives her.
    • D.Funding the IRA this way adds fees and surrender charges for a tax deferral the account already provides.✓ Answer

    Tax deferral inside an IRA is already complete, so buying it a second time through an annuity's mortality and expense charge, administrative fees and surrender schedule pays for a benefit the client already has. That duplication is why an unexplained annuity-inside-an-IRA recommendation is treated as a suitability problem; the contract fits only if some other feature, such as a guaranteed lifetime income benefit, is what the client actually needs.

    Source: IRC Sections 72 and 408; NASAA Series 65 Test Specifications, insurance-based productsReport a problem with this question

18. 18. An insurer offers a fixed indexed annuity that credits interest by reference to an equity index, subject to a participation rate, a cap and a floor of zero percent. How does that contract work?

    • A.It credits the index return with dividends included, and the cap takes effect after the surrender period.
    • B.It credits the entire index return each year, and the insurer absorbs index declines in exchange for a fee.
    • C.It credits part of the index gain and nothing when the index falls, so a market loss does not cut principal.✓ Answer
    • D.It invests contract assets in a separate account, which is why the owner bears the investment risk.

    A participation rate and a cap limit how much of the index's movement is credited, and a floor of zero means a losing year simply credits nothing instead of reducing the accumulated value. The insurer bears the investment risk and holds the assets in its general account, which is why a traditional indexed annuity is regulated as an insurance product, while a registered index-linked annuity that exposes the owner to loss beyond a buffer is registered as a security.

    Source: NASAA Series 65 Test Specifications, insurance-based products (indexed annuities)Report a problem with this question

19. 19. A client with no dependents is about to annuitize her contract and wants the largest possible monthly payment for as long as she lives. Which settlement option provides it, and why?

    • A.Joint and last survivor, because the payments are spread over two lives rather than a single lifetime.
    • B.Straight life, because the payments cease at her death and nothing is guaranteed to any beneficiary.✓ Answer
    • C.Cash refund, because the unpaid balance goes back to the estate and the insurer holds a smaller reserve.
    • D.Life with a 20-year period certain, because the guarantee lets the insurer use a longer payout schedule.

    The more the insurer must guarantee to someone other than the annuitant, the smaller each payment becomes. A straight life option pays over one life only and stops at death with no residual guarantee, so it produces the largest payment, while a period certain, a refund feature or a second life all reduce it. The trade-off is that nothing passes to a beneficiary, which matters only where someone depends on the income.

    Source: IRC Section 72; NASAA Series 65 Test Specifications, insurance-based products (annuity settlement options)Report a problem with this question

20. 20. A client pays very large premiums into a newly issued whole life policy during its first years, and the policy fails the seven-pay test. How are later policy loans and withdrawals treated?

    • A.They are fully taxable, and the death benefit also loses its income-tax-free status at the insured's death.
    • B.They are tax-free up to basis, and any excess is a long-term capital gain when the policy is surrendered.
    • C.They stay income-tax-free, because cash value distributions come out of premiums paid before earnings.
    • D.Earnings are treated as coming out first as ordinary income, with a penalty possible before age 59 1/2.✓ Answer

    A policy that fails the seven-pay test becomes a modified endowment contract. Distributions from a MEC, including policy loans, are taxed last-in first-out, so gain comes out ahead of basis and is ordinary income, and a penalty applies to the taxable portion taken before age 59 1/2. The death benefit itself stays income-tax-free; only the living distributions change character.

    Source: IRC Section 7702A (modified endowment contracts); IRC Section 72(e) and 72(v)Report a problem with this question

Practice questions written from the NASAA Series 65 Test Specifications and the Uniform Securities Act. Not affiliated with or endorsed by NASAA, FINRA or Prometric. Dollar thresholds, fee figures and contribution limits change; where one matters the question supplies it. Confirm current requirements with NASAA before testing. NASAA exam content outline →