FINA 4310Spring 2002

Chapter 4: Mutual Funds and Other Investment Companies

Investment Companies

Unit Investment Trusts

Managed Investment CompaniesOpen-end funds (Mutual Funds)

Closed-end funds

Real Estate Investment Trusts (REITs)

Exchange-Traded Funds (ETFs)

Commingled Funds

Hedge Funds

Unit Investment Trusts

Portfolio is fixed for the life of the trust

Fixed-Income UITGovernment securities

Corporate bond

Municipal bond

International bond

Equity UIT

Mutual Funds

Open-end fundsInvest by sending money directly to the fundNew units are created as new money flows inUnits retired as money flows outGo in and out at Net Asset Value (NAV)

Management companies – “Families”FidelityVanguard Many Others

Types of Mutual Funds

Equity Funds

Fixed-Income Funds

Money Market Funds

Balanced Funds

Asset Allocation Funds

Index Funds

Specialized Funds

Equity Mutual FundsAggressive Growth/Capital Appreciation

Small companies/Narrow market sectors

GrowthFirms with good revenue & earnings potential

Blend (Growth and Income)Combination of Growth and Value Stocks

Value Profitable, Dividend-paying stocksStocks with low P/E ratios

Balanced Funds

Invests in both equities and fixed income securities

Proportion of stocks and bonds fairly stable over time

Designed to be an investor’s entire portfolio

Example: ARK Balanced Fund

Asset Allocation Fund

Like Balanced Funds, hold both stocks and bonds

Proportion of stocks vs. bonds varies substantially over time

Manager tries to increase returns by timing the market

Example: Preferred Asset Allocation Fund

Index Funds

Passive Management

Goal is to match the performance of a benchmark index

Low expenses

Most Popular Benchmark: S&P 500 Index

Example: Vanguard Index Funds

Specialized Funds

Focus on a particular sector or industryReal Estate

Technology

Health Care

Utilities

Financial Services

Closed-end Funds

Do not create or redeem shares

After initial offering, shares trade on secondary market

To invest, buy shares on the exchange

May trade above or below NAVAbove: Premium

Below: Discount

Real Estate Investment Trusts

Like a closed-end fundBuy it on an exchange

Equity REITSBuy investment property

Mortgage TrustsBuy mortgage loans

Exchange-traded Funds

Like closed-end funds, they trade on an exchangeLike index funds, they tend to be passively managedA variety of legal forms:

Unit Investment Trusts (SPDRs, HOLDRs)Open-end Mutual funds (iShares)Traditional mutual fund share class (Vipers)

Commingled Funds

Partnerships of investors that pool their funds

Similar to open-end mutual fund

Typically, small institutional investorsMost commonly pension plans

Larger than typical individual investor

Too small to warrant individual management

Hedge Funds

Limited partnership of investorsAccredited investors (high net worth)

Restricted to 499 partners

Cannot advertise

Less regulated than mutual funds• Manager has freedom to follow a wider variety of

investment strategies

• fewer reporting requirements

Mutual Fund Fees

Front-end load

Back-end load

12b-1 charges

Operating Expenses

Broker Commissions

Front-end Load

This is a sales charge, or “commission” charged to enter a fund

Paid as a percentage of investment

Can be as large as 8.5%

Rarely higher than 6.25%

Often much lower, down to zero

“No Load Fund” means no front-end load

Back-end LoadAlso called:

Redemption FeeContingent Deferred Sales Charge

This is a fee charged when you exit the fundCharged in percentage termsSome funds have no back-end loadIf they do, it often drops off gradually to zero the longer you hold the fundDiscourages investors with short horizons

12b-1 charges

Managers can use up to 1% of the fund’s assets each year to pay for...

AdvertisingAnnual reports and prospectusesCommissions paid to brokers

Because these fees come straight from the fund’s assets, they are “hidden” costs to the investor

Operating Expenses

Administrative Expenses

Advisory fees paid to manager

Should be less than 2% per year

Again, this comes out of the funds assets. (You don’t see them explicitly, but pay for them in the form of lower returns)

Measured by “expense ratio”

Brokerage Commissions

If your broker does not have an arrangement with the mutual fund management company, they will charge you a commission to invest for you.

But, you do not need to go through a broker at all. You can buy (and redeem) shares directly from the mutual fund.

Classes of Mutual Fund shares

One fund can have multiple classes with different fees

Class A: Front-end load

Class B: Back-end load and 12b-1

Class C: Higher 12b-1 fees

Investor class and premium class sharesExample: Vanguard “Admiral” Shares