Mutual Funds and Other Investment Companies

B, K & M Chapter 4

Benefits of Investment Companies

• Administration & record keeping• Diversification & divisibility• Professional management• Reduced transaction costs

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

# of Shares Outstanding

Types of Investment Companies

• Unit Investment Trusts• Pools of money invested in a portfolio that

is fixed for the life of the fund• Little active management involved• Steadily lost market share to mutual funds

in recently years

Types of Investment Companies• Managed Investment Companies

• Open-End fund: stand ready to redeem or issue shares at their net asset value (NAV)

• Closed-End fund: are traded much like shares of common stock. They do not issue or redeem shares at NAV, and often trade at a discount or surplus NAV.

*Key Differences*Shares Outstanding• Closed-end: no change unless new stock is offered• Open-end: changes when new shares are sold or old shares are

redeemed

Pricing• Open-end: Net Asset Value (NAV)• Closed-end: Premium or discount to NAV

Figure 4.1 Closed-End Mutual Funds

Types of Investment Companies

• Other investment organizations• Commingled funds• Real Estate Investment Trusts (REITs)• Hedge Funds

Figure 4.2 Listing of Mutual Fund Quotations

Investment Policies

• Money Market • Equity• Specialized Sector• Bond• Balance & Income • Asset Allocation• Indexed • International

Table 4.1 Classification of U.S. Mutual Funds

How Funds Are Sold

• Directly marketed• Sales force distributed• Revenue sharing on sales force

distributed• Potential conflicts of interest

• Financial supermarkets

Potential Conflicts of Interest - Revenue Sharing• Brokers put investors in funds that may

that may not be the most appropriate• Mutual funds could direct trading to

higher cost brokers• Revenue sharing is not illegal but it must

be disclosed to the investor

Costs of Investing in Mutual Funds

• Fee Structure• Front-end load• Back-end load

• Operating expenses• 12 b-1 charges

• These fees are named after the SEC rule that permits funds to pay for distribution costs such as advertising, promotional literature and, most importantly, commissions to brokers out of fund assets

• Are deducted from the fund’s assets• Fees can have an important impact on fund

performance

Taxes on Mutual Funds

• 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

First Look at 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

Figure 4.3 Percentage of Funds Below Wilshire 5000

Sources of Information on Mutual Funds

• Wiesenberger’s Investment Companies• Morningstar (www.morningstar.com)• Yahoo (biz.yahoo.com/funds)• Investment Company Institute• Popular press• Investment services