Lou Rouselle – chap 4 - finance 1

Essentials of investments

Chapter 4 – Mutual Funds and Other Investment Companies

1. Investment Companies

Investment Companies= Financial intermediaries that invest the funds of individual investors in securities or
other assets.

Investment companies perform several important functions for their investors:

1. Record keeping and administration.

2. Diversification and divisibility.
3. Professional management.
4. Lower transaction costs.

Investment companies also need to divide claims to those assets among those investors. The value of each share
= Net asset value (expressed on a per-share basis).

𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡𝑠 − 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

𝑁𝑒𝑡 𝑎𝑠𝑠𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 =
𝑆ℎ𝑎𝑟𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔

2. Types of Investment Companies

Investment companies are classified: Unit investment trust or managed investment companies

Unit investment trust= Money from many investors that is invested in a portfolio fixed for the life of the fund
(unmanaged=passive).

• A sponsor buys a portfolio, then sells to the public shares = redeemable trust certificates
• All income or payments of principal from the portfolio are paid out by the fund’s trustees to the
shareholders.
• Trusts tend to invest in relatively uniform assets as municipal bonds or corporate bonds.

Managed investment companies= the one for which securities are bought and sold continually.

• A mutual will hire an outside portfolio manager.

• There are two types of managed companies: Closed-end or open-end companies

Open-end fund= A fund that issues or redeems its shares at net asset value; also called mutual funds. Its price
cannot fall below NAV.

Closed-end fund= Shares may not be redeemed but instead are traded at prices that can differ from net asset
value.

Load= a sales commission charged on a mutual fund.

Other Investment Organizations, not formally organized or regulated:

• Commingled funds are partnerships of investors that pool funds.

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- The management firm that organizes the partnership manages the fund for a fee.
- The fund offers units which are bought & sold at NAV.
• Real Investment Trusts (REITs) are similar to a closed end fund.
- REITs invest in real estate (equity trusts) or loans (mortgage trusts) secured by real estate.
- Most of them are highly leveraged.
• Hedge fund A private investment pool, open to wealthy or institutional investors
- that is largely exempt from SEC regulation
- can pursue more speculative policies than mutual funds.
- Invest in a wide range of investment (currency speculation, convertible bonds, distressed firms).

3. Mutual Funds

Mutual fund is the common name for an open-end investment company. Each mutual finds has a specified
investment policy, which is described in the fund’s prospectus.

Some important fund types:

▪ Money market funds: These funds investment in money market securities such as commercial paper,
repurchase agreement, or certificates of deposit.
- Average maturity is usually a bit more than a month.
- Net asset value is fixed at 1$.
- No tax implications
- Government funds hold short-term US Treasury or agency securities. Whereas, prime funds also
hold other money market instruments (commercial papers).
▪ Equity funds: They invest primarily in stock.
- Stock funds tend to be classified by their emphasis on capital appreciation versus current income.
- Income funds hold shares with high dividend yields, Growth funds focus on capital gains (typically
riskier)
▪ Specialized sector funds: Some equity funds, called sector funds, concentrate on a particular industry.
▪ Bond funds: Specialize in the fixed-income sector
- sector in which there is room for specialization
▪ International funds.
- Global funds invest securities worldwide, including US.
- International funds invest in securities outside the US.
- Regional funds invest on a particular part of the world.
▪ Balanced funds. Mix of equities & fixed-income securities.
- Life-cycle funds: mix varies from aggressive to conservative.
- Many balanced funds are in fact funds of funds = Mutual funds that primarily invest in shares of
other mutual funds.
▪ Asset allocation and flexible funds. These are similar to balanced funds, but vary the proportion in each
market in accord with the portfolio manager’s forecast of the relative performance sector - not
designed to be low risk.
▪ Index funds. Try to match the performance of a broad market index.
- low cost and passive
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How funds are sold

They are generally marketed to the public either by the fund underwriter (via phone, mail, internet) or indirectly
through brokers acting on behalf of the underwriter.

Many funds also are sold trough “financial supermarkets’ that can sell shares in funds of many complexes.

4. Costs of Investing in Mutual Funds

Fee structure

When an investor chooses a mutual fund -> consider the fund’s stated investment policy + past performance +
management fees and other expenses

Four general classes of fees

1. Operating Expenses: these include administrative expenses and advisory fees. No explicit bill but the
expenses are periodically deducted from the assets of the funds.
2. Front-end load: A front-end load is a commission or sales charge paid when you purchase the shares.
May not exceed 8.5%.
3. Back-end Load: A back-end load is a redemption, or “exit,” fee incurred when you sell your shares. Also
known as “contingent deferred sales loads”.
4. 12b-1 fees: Annual fees charged by a mutual fund to pay for marketing and distribution costs.

The choice between paying a load and paying 12b-1 fees depend on your expected time horizon. 12b-1 are paid
annually, whereas loads are paid only once at the purchase.

Many funds offer “classes” which represent ownership in the same portfolio of securities but with different
combinations fees.

Fees and Mutual Fund Returns

The rate of return on an investment in mutual funds:

𝑁𝐴𝑉1 − 𝑁𝐴𝑉0 + 𝐼𝑛𝑐𝑜𝑚𝑒 𝑎𝑛𝑑 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑔𝑎𝑖𝑛 𝑑𝑖𝑠𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛𝑠

𝑅𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 =
𝑁𝐴𝑉0

The rate of return is affected by the fund’s expenses & 12b-1 fees as they are periodically deducted from the
portfolio, reducing the NAV.

Difficult for the investor in a mutual funds to measure true expenses accurately due to: Soft dollars= The value
of research services that brokerage houses provide “free of charge” in exchange for the investment manager’s
business.

5. Taxation of Mutual Fund Income

Investment returns of mutual funds are granted “pass-through status” under the U.S. tax code = taxes are paid
only by the investor in the mutual fund, not by the fund itself.

The pass-through of investment income has one important disadvantage for individual investors. If you manage
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your own portfolio, you decide when to realize capital gains and losses on any security; therefore, you can time
those realizations to efficiently manage your tax liabilities.

Turnover= The ratio of the trading portfolio to the assets of the portfolio.

➢ high turnover portfolio can be “tax inefficient” = capital losses and gains are realised constantly, not
time to manage the overall tax obligation.

6. Exchange-Traded Funds

Exchange traded funds= Offshoots of mutual funds that allow investors to trade entire portfolios such as shares
of stock.

Some new ETF products have been devised:

(1) lever- aged ETFs, with daily returns that are a targeted multiple of the returns on an index
(2) inverse ETFs, which move in the opposite direction to an index.
(3) actively managed ETF funds that, like actively managed mutual funds, attempt to outperform market
indexes.
(4) synthetic ETFs such as exchange-traded notes (ETNs) or exchange-traded vehicles (ETVs). These are
nominally debt securities, but with payoffs linked to the performance of an index. Often that index
measures the performance of an illiquid and thinly traded asset class, so the ETF gives the investor the
opportunity to add that asset class to his or her portfolio. However, rather than invest in those assets
directly, the ETF achieves this exposure by entering a “total return swap” with an investment bank in
which the bank agrees to pay the ETF the return on the index in exchange for a relatively fixed fee.

Advantages of EFTs Disadvantages

-trade continuously -ETFs must be purchased from brokers for a fee. Bid-
ask spread
-can be sold short or purchase on margin
-EFTs trade as securities, their prices can depart from
-potential tax advantage over mutual funds NAV, at least for short periods, and these
discrepancies can easily swamp the cost advantage
-when small investors wish to redeem their position
that ETFs otherwise offer.
in an EFT, they simply sell their shares to other
traders (not the case for large investors, redemptions -When markets are not working properly, it can be
can be satisfied with shares of stock in the underlying hard to measure the NAV of the ETF portfolio,
portfolio). especially for ETFs that track less liquid assets.

-The price of an ETF cannot depart for long from the

NAV of that portfolio.

-ETFs are also cheaper than mutual funds. Investors

who buy ETFs do so through brokers, rather than
buying directly from the fund.
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7. Mutual Fund Investment Performance: a First look

Individual investors take part of the asset allocation decision, but benefit from delegating management of the
portfolio to investment professionals.

Measuring the returns or the Benchmark of ETF is difficult.

8. Information on Mutual Fund

Where to find info on a mutual fund? In its prospectus.

Funds also provide info on themselves in 2 other sources

• The statement of additional information (SAI) = part B of the prospectus (you need to request it to
receive it)
• The fund’s annual report

The average rate of return of the average equity mutual fund in the last 46 years has been below that of a
passive index fund holding a portfolio to replicate a broad-based index like the S&P 500 or Wilshire 5000. Some
of the reasons for this disappointing record are

• the costs incurred by actively managed funds, such as the expense of conducting the research to guide
stock-picking activities
• trading costs due to higher portfolio turnover.

The record on the consistency of fund performance is mixed. In some sample periods, the better-performing
funds continue to perform well in the following periods; in other sample periods they do not.