INVESTMENT COMPANIES

Practical Investment Management

Robert A. Strong

CHAPTER TWENTY-ONE

South-Western / Thomson Learning © 2004 21 - 2

Outline

The Investment Company Industry Open-End Investment Companies Closed-End Investment Companies Regulation Fees

Selecting a Mutual Fund Rationale Eligibility Interpreting Past Performance Types of Funds

South-Western / Thomson Learning © 2004 21 - 3

Outline

Information Sources Company Information Commercial Services

South-Western / Thomson Learning © 2004 21 - 4

The Investment Company Industry

The investment company industryis a significant portion of the financial landscape in the United States.

The automatic diversification and professionalmanagement provided by mutual funds make it simple for even the smallest investor to participate in the capital markets.

There are two types of investment companies:open-end funds and closed-end funds.

South-Western / Thomson Learning © 2004 21 - 5

Open-End Investment Companies

An open-end investment company is commonly called a mutual fund.

A mutual fund has no limit on the size of the fund or the number of shares outstanding.

The value of a mutual fund share is called its net asset value.

Mutual fund shares are not sold in the traditional sense. Instead, they are redeemed by the fund management.

South-Western / Thomson Learning © 2004 21 - 6

Open-End Investment Companies

Insert Figure 21-1 here.

South-Western / Thomson Learning © 2004 21 - 7

Open-End Investment Companies

Upon opening an account with a mutual fund, the investor must select from among several options.

Some common options are : - automatic reinvestment option - automatic monthly investment plan - limit order option - periodic payment option - telephone redemption option - switching option

South-Western / Thomson Learning © 2004 21 - 8

Closed-End Investment Companies

A closed-end investment company has a fixed number of shares.

Investors buy and sell these shares on an exchange just like shares of stock.

The pricing of closed-end fund shares is a financial puzzle - they usually sell at a discount to their net asset value.

South-Western / Thomson Learning © 2004 21 - 9

The Investment Company Industry : Regulation

Almost all mutual funds choose toorganize as a regulated investment company, so that any tax liability on capital gains and income can be passed on to the accountholders.

The Investment Company Act of 1940 provides the potential investor with some degree of protection from misleading advertising or incomplete investment information.

South-Western / Thomson Learning © 2004 21 - 10

The Investment Company Industry : Regulation

The Investment Company Amendments Act of 1970 serves primarily to clarify legal points. It mandates that the fund manager and the board of directors be held to fiduciary standards in their actions.

Many states have their own version of the Securities and Exchange Commission. Today, these blue sky laws function largely to inform investors of the suitability of certain proposed investments.

South-Western / Thomson Learning © 2004 21 - 11

The National Securities Markets Improvement Act of 1996 sought to largely eliminate Federal and state regulatory overlap. The principal effects include lower registration fees, lower broker-dealer margin fees, and ensuring that a fund’s name is consistent with its objective.

The Investment Company Industry : Regulation

South-Western / Thomson Learning © 2004 21 - 12

Load and No-Load

Load funds have a salesforce and the shareholders have to pay a sales charge. If paid at the time of purchase, the fee is a front-end load. If levied when shares are sold, the fee is a back-end load, or contingent deferred sales charge. A no-load fund charges no sales commission.

The Investment Company Industry : Fees

Most mutual funds separate their charges into a number of categories.

South-Western / Thomson Learning © 2004 21 - 13

The Investment Company Industry : Fees

Insert Figure 21-2 here.

South-Western / Thomson Learning © 2004 21 - 14

The Investment Company Industry : Fees

Certain expenses such as the management fee are associated with operating a mutual fund. These fees are measured by the fund’s expense ratio, which is the fund’s total expenses expressed as a percentage of the fund’s assets.

Note that within the same fund, there may be several classes of shares with different fee combinations. Their relative merits depend on how long the investor anticipates keeping the investment.

South-Western / Thomson Learning © 2004 21 - 15

The Investment Company Industry : Fees

Insert Figure 21-3 here.

South-Western / Thomson Learning © 2004 21 - 16

The Investment Company Industry : Fees

The annual 12b-1 fees permit the fund manager to pass certain advertising costs on to the accountholders.

A trailing commission is an annual fee paid to a broker, sometimes independent of the level of activity in the account or its size.

Other fees include fund transfer charges, custodian fees, low-balance fees, account opening or closing fees etc.

Studies indicate that the lower the expense ratio, the better the fund performance.

South-Western / Thomson Learning © 2004 21 - 17

Selecting A Mutual Fund

Rationale : Mutual funds provide automatic diversification, professional management, and convenience.

Eligibility : One need only consider funds whose requirements, such as the minimum initial investment, are satisfied.

Interpreting Past Performance : Buying last year’s best performing mutual funds is seldom a winning strategy.

South-Western / Thomson Learning © 2004 21 - 18

Selecting A Mutual Fund

before-load(gross) return

change innet asset

value

capital gainsdistributions

incomedistributions

beginning net asset value

+ +

=

after-load(net) return

change innet asset

value

capital gainsdistributions

incomedistributions

beginning net asset value

+ + -

=

loadfee

With a mutual fund, return comes from the change in net asset value, capital gains distributions, and income distributions.

South-Western / Thomson Learning © 2004 21 - 19

Selecting A Mutual Fund : Types of Funds

Insert Figure 21-4 here.

South-Western / Thomson Learning © 2004 21 - 20

Selecting A Mutual Fund : Types of Funds

Money market funds invest in short-term government securities and sometimes in short-term corporate securities. They are used primarily as a temporary cash haven.

Bond funds invest in fixed income securities. They vary widely, and have no common maturity date to simultaneously return the components to their par value.

Stock funds vary widely in their risk and price behavior. They are classified as growth or value, and as large-cap or small-cap.

South-Western / Thomson Learning © 2004 21 - 21

Selecting A Mutual Fund : Types of Funds

A balanced fund is a mixture of stocks and fixed income securities. It forces discipline on the fund manager.

An international fund is limited to buying securities registered outside the country where it is sold, while a global fund can invest anywhere in the world.

A fund of funds invests only in other mutual funds. Its diversification is good, but its expense ratio tends to be higher than that of the typical mutual fund.

South-Western / Thomson Learning © 2004 21 - 22

Selecting A Mutual Fund : Types of Funds

Sector : Such funds invest in specific market sectors, such as physical commodities or stocks closely tied to natural resources e.g. oil, forest products, and gold.

An index fund may be a stock or bond fund that tries to behave exactly like the market. A stock index fund, for instance, may seek to mirror the performance of the Standard & Poor’s 500 stock index.

Investors should determine their investment objective first, and then choose an appropriate fund or group of funds.

South-Western / Thomson Learning © 2004 21 - 23

Selecting A Mutual Fund : Types of Funds

Insert Table 21-2 here.

South-Western / Thomson Learning © 2004 21 - 24

Information Sources : Company Information The prospectus is a legal document

describing the operation of the fund, its management, and the fees accountholders must pay.

One important item in the prospectus is the fund’s portfolio turnover rate. A higher rate usually means higher expenses.

The Statement of Additional Information is required by the SEC, although it is generally only sent to accountholders upon their request. It is a more detailed version of the prospectus.

South-Western / Thomson Learning © 2004 21 - 25

Information Sources : Commercial Services Most public libraries carry some

reference material, such as the Morningstar Mutual Funds and the Thomson Financial Investment Company Survey.

The internet is also a good source. Several periodicals like Forbes, Fortune and

BusinessWeek provide excellent coverage of the investment company industry.

Some organizations like the Investment Company Institute also publish some educational material for the public.

South-Western / Thomson Learning © 2004 21 - 26

Review

The Investment Company Industry Open-End Investment Companies Closed-End Investment Companies Regulation Fees

Selecting a Mutual Fund Rationale Eligibility Interpreting Past Performance Types of Funds

South-Western / Thomson Learning © 2004 21 - 27

Review

Information Sources Company Information Commercial Services

South-Western / Thomson Learning © 2004 21 - 28

Appendix: Tax Considerations

Municipal securities Interest on a municipal bond is exempt

from federal tax. An in-state municipal bond is not

subject to state income tax.

South-Western / Thomson Learning © 2004 21 - 29

Appendix: Tax Considerations

Taxable equivalent yield: the yield a taxable security would have to offer to provide the same after-tax return, including the effects of federal, state, and local taxes

]R)R)(1R[(R-1

R

yield equivalentTaxable

federalfederallocalstate

taxfree

South-Western / Thomson Learning © 2004 21 - 30

Appendix: Tax Considerations

Deeply discounted securities:

If the discount exceeds 0.25% multiplied by the remaining years until maturity, the IRS considers the municipal bond to be deeply discounted.

South-Western / Thomson Learning © 2004 21 - 31

Appendix: Tax Considerations

Treasury SecuritiesTreasury security interest is exempt from

state and local income taxes.

South-Western / Thomson Learning © 2004 21 - 32

Appendix: Tax Considerations

Preferred Stock:Most preferred stock owned by other

corporationsCorporations can avoid paying taxes on 70%

of their dividend income from portfolio investments

Return of Rate

Dividend Price

South-Western / Thomson Learning © 2004 21 - 33

Appendix: Tax Considerations

Reductions in the capital gains tax increases the attractiveness of growth stocks and growth mutual funds.

South-Western / Thomson Learning © 2004 21 - 34

Appendix: Special Considerations with Mutual Funds

DistributionsIncome and capital gains distributionsReinvested dividendsReturn of capital distribution

Cost MethodsAverage cost methodFIFOSpecific identification methodCommissions

South-Western / Thomson Learning © 2004 21 - 35

Mutual Fund Account Activity

South-Western / Thomson Learning © 2004 21 - 36

Appendix: Tax Swaps

Tax swaps with bondsTax swaps with mutual funds

South-Western / Thomson Learning © 2004 21 - 37

Sample Bond Data