Chapter 8 Investment Co.

1. Chapter 8 Investment Co. • indirect investment • types • fees • objectives • regulation • ETFs

2. I. Indirect investment • investment co. • pools investor funds • purchases & manages portfolio • direct investments • investors • own shares of portfolio • indirect investment

3. advantages • diversification & asset choice • small amount of capital • professional management • lower transactions costs • trading • information

4. disadvantages • lack of control over portfolio • choice of assets • tax consequences of trading • lack of voting rights • that come w/ common stock

5. II. Types Open-end funds (mutual funds) sell new shares, redeem existing shares • # shares changes over time

6. portfolio value - liabilities NAV = • share price based on NAV # shares outstanding • NAV computed at close of day • NAV changes with price of assets in portfolio

7. growth of mutual funds • less than 600 1980 • over 8000 today ($6.2 trillion) • assets concentrated with largest funds • why? • growth of 401(k)s, IRAs • demographics (baby boomers)

8. Closed-end funds • < 500 funds ($130 billion) • fixed # shares initially issued • no later sales or redemptions • # of shares is fixed • shares bought and sold in secondary market • price depends on supply & demand

9. share price & NAV • price < NAV -- trading at a discount • price > NAV -- trading at a premium • many closed end fund shares trade a a discount

10. Unit Trusts • # shares fixed • typically invest in bonds • portfolio is fixed: no active trading • fixed termination date

11. III. Mutual fund fees • sale charges • operating expenses

12. Sales charges • funds originally sold 2 ways: • sales force, w/ commission -- front-end load (8.5% max) -- pay when purchase shares -- back-end load (8.5% max) -- pay when redeem shares -- level loads (.75% max) -- annual fee

13. buy funds directly -- no sales charge -- no load funds • today many distribution channels • fund supermarkets • fund families • “distribution is king”

14. Operating Expenses • management fee • distribution fees • 12b-1 fees (SEC rule) • 1% max (100 basis pts.) • cover marketing costs • other • trading, records, auditing

15. All fees • NASD, SEC set some limits on fees • most funds charge much less • average • actively managed funds: 1.44% • index funds: .4%

16. impact of fees • $10,000, 10% annual return, 20 yrs. • if fees 1.5% annually, • $49,725 • if fees .5% annually, • $60,858

17. IV. Fund Objectives • funds differ in • types of assets • investment goals

18. Equity funds • income funds • stocks w/ high, stable dividends • growth funds • stock w/ high expected capital gains • growth/income funds

19. value funds • “bargain” stocks -- low PE ratio -- high book-to-value ratio • sector funds • stocks in specific industry • health care, biotech, financial, electronics

20. market capitalization • small/mid/large cap funds • stocks based on size of company -- value of total shares outstanding • international/global • international stock portfolio or • stock in particular region

21. index funds • match performance of stock index -- S&P 500, Wilshire 5000 • hold portfolio the matches index • passive strategy -- match, not beat, the market’s average return • lower expenses

22. index fund returns slightly below index return • operating expenses • must hold some cash to redeem shares

23. why I like indexing • 1990-99 • S&P 500 index outperformed 76% of all actively managed stock funds

24. Bond funds • U.S. Government • Investment grade corporate • bond ratings BBB or above • High yield corporate • junk bonds (rated below BBB) • Municipal bonds • tax exempt interest

25. Money Market • share price = $1, check-writing • general taxable • U.S. Government • tax-exempt

26. Stocks & Bonds • balanced funds • hybrid funds • asset allocation funds • 529 plans for college

27. Fund Families • one investment company • many different funds • Fidelity, Vanguard, Strong, Janus • 400 families • top ten hold over 40% of assets

28. look at some top funds • http://quicktake.morningstar.com/Fund/Snapshot.asp?Country=USA&Symbol=FGRIX • http://quicktake.morningstar.com/Fund/Snapshot.asp?Country=USA&Symbol=VWLTX • http://quicktake.morningstar.com/Fund/Snapshot.asp?Country=USA&Symbol=VFINX • http://quicktake.morningstar.com/Fund/Snapshot.asp?Country=USA&Symbol=FSPHX

29. V. Regulation • SEC is main regulator • disclosure rules • fees • insider trading • “truth in advertising” -- returns & risks -- name and objective of fund

30. NASD is industry self-regulator • sales practices • commissions, fees • taxation • investment co. distributes 90% of income annually • fund shareholders taxed on gains -- even if gains are reinvested -- dividends no longer taxable

31. taxation trap • as share holders redeem shares • funds sells assets to raise cash • remaining share holders face tax liability

32. VI. Exchange-traded funds (ETFs) • like index funds & closed-end fund • shares traded on exchange • trade continually, not just at closing NAV • swap large blocks of stock for ETF shares • price is always close to NAV

33. ETF tax advantage • mutual funds • other investors sell shares, -- trigger tax liability for remaining share holders • ETFs • tax liability only for seller • swap shares for underlying portfolio