CHAPTER 4: INVESTMENT COMPANIES

Definition: financial intermediaries that collect funds from individual investors and invest those funds in a potentially wide range of securities

Administration & record keeping◦ issue periodic status reports, keeping track of capital gain

distributions, dividends, investments, and redemption Diversification & divisibility: diversify portfolios

and investors can buy fractional shares of many different securities

Professional management: full-time staffs of security analysts and portfolio managers

Reduced transaction costs: can achieve substantial savings on brokerage fees and commissions because of large transactions

Net Asset Value◦ Used as a basis for valuation of investment company

shares◦ Selling new shares◦ Redeeming existing shares

Calculation:Market Value of Assets - Liabilities Shares Outstanding

Example: Consider a mutual fund that manages a portfolio of securities worth $120 mil. Suppose the fund owes $4 mil to its investment advisers and owes another $1mil for rent, wages and other expenses. The fund has 5mil shares outstanding. What is NAV of the fund

4.2 TYPES OF INVESTMENT COMPANIES

Pools of money from many investors that is invested in a portfolio fixed for the life of the fund

Little active management Example: invest in municipal bond,

corporate bond

Hire managers to manage portfolio Open-End

◦ stand ready to redeem or issue shares at their net asset value. If investors in open-end funds want to cash out shares, they sell back to the fund at NAV

Closed-End◦ Funds cannot issue or redeem shares. Investors

who want to cash out must sell shares to other investors

◦ Sold at premium or discount to NAV◦ Shares of close-end fund are traded on organized

exchanges just like other common stocks.

◦ Commingled funds partnership of investors that pool their funds. Similar to

open-end fund. Example: trust or retirement account that have portfolios much larger than those of most individual investors but still too small to warrant managing on a separate basis

◦ REITs: similar to closed-end fund but invest in real estate or loans secured by real estate

◦ Hedge Funds like mutual fund: hedge fund allows private investors to

pool assets to be invested by a fund manager Unlike mutual fund: hedge fund are commonly

structured as private partnerships and are not subject to many SEC regulations

4.3 MUTUAL FUNDS

mutual fund is a common name for open-end investment company. Account for >90% of investment company asset.

Described in the prospectus Management companies manage a family

of mutual funds. Some examples include:◦ Fidelity◦ Vanguard◦ Putnam ◦ Dreyfus

Money Market: invest in money market securities.

Equity: invest in stocks◦ Income fund and growth fund

Specialized Sector: sector funds Bond: invest in bond

Balanced Funds: hold both equities and fixed income securities in relatively stable proportions to meet needs of individual investors

Asset Allocation and Flexible: similar to balance funds but the proportion can change according to managers’ forecasts

Indexed: match performance of a broad market index. Example: Vanguard 500 Index Fund International

4.4 COSTS OF INVESTING IN MUTUAL FUNDS

Fee Structure◦ Front-end load: commission or sale charge

paid when purchasing the shares◦ Back-end load: redemption or exit fee

incurred when you sell shares. Operating expenses 12 b-1 charges

distribution costs paid by the fund Alternative to a load

Fees and performance

1 0

0

NAV NAV Income and capital gain distributionsRate of return =

NAV

Initial NAV = $20Income distributions of $.15Capital gain distributions of $.05Ending NAV = $20.10:

$20.10 - $20.00 + $.15 + $.05Rate of Return = 1.5%

$20.00

Example: you purchased 1000 shares of the New Fund at a price of $20 at the beginning of the year. You paid a front-end load of 4%. The securities in which the fund invests increase in value by 12% during the year. The fund’s expense ratio is 1.2%. What is your rate of return on the fund if you sell your shares at the end of the year.

4.6 EXCHANGE-TRADED FUNDS

ETF allow investors to trade index portfolios like shares of stock

Examples – SPDRs, Diamonds, and WEBS Potential advantages

◦ Trade continuously ◦ Lower taxes ◦ Lower costs

Potential disadvantages◦ mispricing◦ broker fees

4.7 MUTUAL FUND INVESTMENT PERFORMANCE: A FIRST LOOK

Evidence shows that average mutual fund performance is generally less than broad market performance

Evidence suggests that over certain horizons some persistence in positive performance◦ Evidence is not conclusive◦ Some inconsistencies

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4.8 INFORMATION ON MUTUAL FUNDS

Wiesenberger’s Investment Companies Morningstar (www.morningstar.com) Yahoo (finance.yahoo.com/funds) Investment Company Institute Popular press Investment services