CHAPTER 4: INVESTMENT COMPANIES

1. CHAPTER 4: INVESTMENT COMPANIES

2. 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

3. Investment Companies:Net Asset Value • 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. 4.2 TYPES OF INVESTMENT COMPANIES

5. Unit Trusts • 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

6. Managed Investment Companies:Open-End and Closed-End • 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.

7. Figure 4.1 Closed-End Mutual Funds

8. Other Investment Organizations • 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

9. 4.3 MUTUAL FUNDS

10. Investment Policies • 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

11. Types of Mutual Funds • Money Market: invest in money market securities. • Equity: invest in stocks • Income fund and growth fund • Specialized Sector: sector funds • Bond: invest in bond

12. Types of Mutual Funds • 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

13. Table 4.1 Mutual Funds by Investment Classification

14. 4.4 COSTS OF INVESTING IN MUTUAL FUNDS

15. Fee Structure • 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

16. Example 4.1 From Text

17. Fees and Mutual Fund Returns

18. Fees and Mutual Fund Returns:An Example Initial NAV = $20 Income distributions of $.15 Capital gain distributions of $.05 Ending NAV = $20.10:

19. Fee Structure 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.

20. Table 4.2 Impacts of Costs on Investment Performance

21. 4.6 EXCHANGE-TRADED FUNDS

22. 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

23. Table 4.3 EFT Sponsors and Products

24. 4.7 MUTUAL FUND INVESTMENT PERFORMANCE: A FIRST LOOK

25. Mutual Fund Performance • 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

26. Figure 4.2 Diversified Equity Funds Versus Wilshire 5000 Index

27. Figure 4.3 Percentage of Funds Below Wilshire 5000

28. Table 4.4 Consistency of Investment Results

29. 4.8 INFORMATION ON MUTUAL FUNDS

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