McGraw-Hill/Irwin

CHAPTER 4

Mutual Funds and Other Investment Companies

© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

4.1 INVESTMENT COMPANIES

4-2

Investment Companies Investment companies are financial intermediaries that collect funds from individuals and invest those funds in a wide variety of securities and other assets. Functions include: Administration & record keeping Diversification & divisibility Professional management Reduced transaction costs 4-3

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 4-4

4.2 TYPES OF INVESTMENT COMPANIES

4-5

Unit Trusts Pools of money fixed for the life of the fund Little active management 4-6

Managed Investment Companies: Open-End and Closed-End Open-End – Sold at Net Asset Value (NAV) – Number of outstanding shares changes when new shares are sold or old shares are redeemed Closed-End – Sold at premium or discount to NAV – No change in outstanding shares unless new stock is offered 4-7

Figure 4.1 Closed-End Mutual Funds 4-8

Other Investment Organizations – Commingled funds: partnerships of investors pooling their funds.

– REITs: similar to closed-end fund; invests in real estate or loans secured by real estate. Equity trusts invest directly in real estate Mortgage trusts invests in mortgage and construction loans – Hedge Funds: usually structured as private partnership; escapes many SEC regulations. Typically only open to ‘wealthy’ or institutional investors. Lock-up provisions (sometimes 1 year) Compensation to manager usualy based on sharing profits.

4-9

4.3 MUTUAL FUNDS

4-10

Investment Policies Described in the prospectus Management companies manage a family of mutual funds. Some examples include: – Fidelity – Vanguard – Putnam – Dreyfus 4-11

Types of Mutual Funds Money Market: invest in commercial paper, repurchase agreements, certificates of deposit. Try to maintain NAV of $1 per share. Equity: invest in stocks Specialized Sector Bond: invest in bonds 4-12

Types of Mutual Funds Balanced Funds: Hold both equities and fixed-income securities Asset Allocation and Flexible: Change mix of equities/bonds depending on manager’s view of market. Market timing occurs.

Indexed International: duh… 4-13

Table 4.1 Mutual Funds by Investment Classification 4-14

How Funds Are Sold Directly marketed: e.g. Vanguard Sales force distributed: e.g. American Funds Revenue sharing on sales force distributed funds: funds pay fee to brokerage for preferential mention – Potential conflicts of interest – It must be disclosed to the investor Financial supermarkets 4-15

4.4 COSTS OF INVESTING IN MUTUAL FUNDS

4-16

Fee Structure Fee Structure – Front-end load: commission or sales charge paid when you purchase the fund – Back-end load: commission or sales charge paid when you sell the fund Operating expenses: admin costs, advisory fees 12 b-1 charges – distribution costs paid by the fund – Alternative to a load Fees and performance 4-17

Example 4.1 From Text 4-18

Fees and Mutual Fund Returns 4-19

Fees and Mutual Fund Returns: An Example

Initial NAV = $20 Income distributions of $.15

Capital gain distributions of $.05

Ending NAV = $20.10:

4-20

Table 4.2 Impacts of Costs on Investment Performance 4-21

Trading Scandal with Mutual Funds Late trading – allowing some investors to purchase or sell after the market closes Market timing – allowing investors to buy or sell on stale net asset values – International Net effect is to transfer value from other shareholders to privileged traders – Reduction in the rate of return of the mutual fund 4-22

Potential Reforms Strict 4:00 PM cutoff with late orders executed the following trading day Fair value pricing with net asset values being adjusted for trading in open markets Imposition of redemption fees 4-23

4.5 TAXATION OF MUTUAL FUND INCOME

4-24

Taxation of Mutual Fund Income Investor directed portfolios can be structured to take advantage of taxes while mutual funds cannot High turnover leads to tax inefficiency More disclosure on taxes was required in 2000 4-25

4.6 EXCHANGE-TRADED FUNDS

4-26

Exchange Traded Funds ETF allow investors to trade index portfolios like shares of stock Examples – SPDRs (Standard & Poor’s Depository Receipt), Diamonds (DJIA ETF), and WEBS (World Equity Benchmark Shares) Potential advantages – Trade continuously – Lower taxes – Lower costs Potential disadvantages – Price can depart (slightly) from NAV – Purchase requires payment of broker’s fee plus bid/ask spread 4-27

4.7 MUTUAL FUND INVESTMENT PERFORMANCE: A FIRST LOOK

4-28

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 4-29

Figure 4.2 Diversified Equity Funds Versus Wilshire 5000 Index 4-30

Table 4.4 Consistency of Investment Results 4-31

4.8 INFORMATION ON MUTUAL FUNDS

4-32

Sources of Information Wiesenberger’s Investment Companies Morningstar (www.morningstar.com) Yahoo (finance.yahoo.com/funds) Investment Company Institute Popular press Investment services 4-33