Chapter 4 investments mutual funds and other investment companies

Managed Investment Companies Open-end funds : A fund that issues or redeems its shares at net asset value.. Managed Investment Companies Open-End and Closed-End Funds: Key Differences

Chapter 4

Mutual Funds and Other Investment Companies

4.1 Investment Companies

Investment Companies

 Financial intermediates that collect funds from individual investors and invest those funds in a wide range of securities or other assets

• Used as a basis for valuation of investment company shares

- Selling new shares

- Redeeming existing shares

• Calculation

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g Outstandin Shares

s Liabilitie Assets

of Value Market

NAV calculation

ABC Fund ($Millions except NAV)

Market Value Securities

+ Cash & Receivables

$605.00 20.00

$ 30.25

Services of Investment Companies

a Administration & record keeping

: Issue periodic status reports, keeping track of capital gains distributions, dividends, investments, and redemptions

b Diversification and divisibility

: By pooling their money, investment companies enable investors to hold fractional shares of many different securities

c Professional management

: Lower research costs, Portfolio managed according to specific objectives, and Professionals to find undervalued securities

d Lower transaction costs

: Achieve substantial savings on brokerage fees and commissions

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4.2 Types of Investment Companies

Unit Investment Trusts (UITs)

- Pools of money invested in a portfolio that is fixed for the life of the fund

- Unmanaged, fixed composition portfolios

- Any interest and/or dividends are

distributed immediately to trust certificate

holders

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Managed Investment Companies

- Managed, usually changing composition portfolio.

- The fund's board of directors typically hires an investment advisor to select and manage the f und assets according to some specific goal(s) set by the board and any regulatory requirements

- The investment advisor usually creates the fund and selects the investments Most funds are

of this type

Managed Investment Companies

 Open-end funds

: A fund that issues or redeems its shares at net asset value.

- When investors in open-end funds wish to cash out their

shares, they sell them back to the fund at NVA

- Commonly call mutual funds

 Closed-end funds

: A fund that do not redeem or issue shares

- Investors in closed-end funds who wish to cash out must sell

their shares to other investors

- Shares of close-end funds are traded on organized exchanges

and can be purchased through brokers just like other common

stock

- Prices therefore can differ from NAV

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Managed Investment Companies

 Open-End and Closed-End Funds: Key Differences

• Shares Outstanding

- Closed-end: No change unless new stock offered

- Open-end: Changes when new shares are sold or old shares are redeemed

• Pricing

- Open-end: Fund share price = Net asset value (NAV)

- Closed-end: Fund share price may trade at premium or discount to NAV

Figure 4.1 Closed-End Mutual Funds

Fund NAV Mkt Price Prem/Disc % 52 Wk Return %

Adams Express Company (ADX) 12.89 11.11 −13.81 26.13

Advent/Clay Enhcd G&I (LCM) 12.16 11.58 −4.77 23.52

BlackRock Equity Div (BDV) 10.65 10.03 −5.82 27.39

BlackRock Str Eq Div Achv (BDT) 11.8 10.68 −9.49 26.17

Cohen & Steers CE Oppty (FOF) 14.64 13.46 −8.06 25.17

Cohen & Steers Dvd Mjrs (DVM) 14.70 13.82 −5.99 49.28

Eaton Vance Tax Div Inc (EVT) 18.75 17.19 −8.32 29.89

Gabelli Div & Inc Tr (GDV) 18.64 16.58 −11.05 43.52

Gabelli Equity Trust (GAB) 6.08 6.10 0.33 48.48

General Amer Investors (GAM) 32.71 28.26 −13.60 30.93

Guggenheim Enh Eq Inc (GPM) 9.58 9.65 0.73 38.93

Other Investment Organizations

- Similar to closed end fund Invest in real estate and real estate loans

- Highly leveraged for most of them, a debt ratio of 70%

- Equity trusts invests in real estate directly

- Mortgage trusts invest in mortgage and construction loans

- Similar to mutual funds, but not registered and not subject to SEC regulations.

- Available to institutional and high net worth investors.

- Usually require investors to agree to initial “lock-ups”.

- Can pursue investment strategies that are not allowed for mutual funds.

EX) Heavy use of derivatives, short sales, and leverage

- Grew from about $50 billion in 1990 to about $2 trillion in 2011.

4.3 Mutual Funds

 The common name for an open-end investment company

 The dominant investment company, 90% of investment company assets in the U.S

 Assets under management in the U.S mutual fund industry were closely $12 trillion in early 2011

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4.3 Mutual Funds

 Investment Policies

• Money market funds

- Commercial paper, repurchase agreements, CDs

• Equity funds

- Invest in stock, some fixed-income, or other securities

• Specialized sector funds

- Concentrate on particular industry

• Bond funds

- Specialize in fixed-income (bonds) sector

4.3 Mutual Funds

 Investment Policies

• International funds

- Global funds invest in securities worldwide

- International funds invest outside U.S

- Regional funds focus on particular part of world

- Emerging market funds invest in developing nations

- Funds of funds: Mutual funds that primarily invest

in other mutual funds

4.3 Mutual Funds

 Investment Policies

• Asset allocation and flexible funds

- Stocks and bonds—proportion varies according to market forecast

• Index funds

- Try to match performance of broad market index

- Buy shares in securities included in particular index

in proportion to security’s representation in index

Table 4.1 U.S Mutual Funds by Investment Classification

Assets ($ billion) Percent of Total Assets Number of Funds

Money market funds

4.4 Costs of Investing in Mutual Funds

- SEC allows the managers of so-called 12b-1 funds to use fund assets to pay

for distribution and marketing costs such as advertising and promotional

literature.

4.4 Costs of Investing in Mutual Funds

• Avoiding the Load

- Choose different class of fund shares

Notes:

a Depending on size of investment.

b Depending on years until holdings are sold.

c Including service fee of 25%.

4.4 Costs of Investing in Mutual Funds

• Fees and Mutual Fund Returns

(This measure of the rate of return ignores any commission.)

• E.G.) Initial NAV = $20, Income distributions = $0.15

Capital gains = $0.05, NAV at the end = $20.10

 Rate of return = 1.5%

0

01

NAV

on distributi gains

Capital Income

NAV

NAV return

of

=

Table 4.2 Impact of Costs on Investment Performance

: An investor who starts which $10,000 and three funds with an annual 12% return

on investment before fees but with different fee structures

Notes: Fund A is no-load with 5% expense ratio, Fund B is no-load with 1.5% total expense ratio, and Fund C has an 8% load on purchases and a 1% expense ratio Gross return on all funds is 12% per year before expenses.

* After front-end load, if any.

4.6 Exchange Traded Funds

 Offshoots of mutual funds that allow investors to trade index portfolios like shares of stock

 Potential advantages

• Unlike mutual funds, trade continuously throughout the day

• Can be sold short or purchased on margin

• Potentially lower taxes

• Lower costs (No marketing; lower fund expenses

 Potential disadvantages

• Small deviations from NAV are possible because ETFs trade as securities

• Must pay a brokerage commission such as bid-ask spread to buy an ETF

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Table 4.3 ETF Sponsors and Products

Figure 4.2 Assets in ETFs

Figure 4.3 Investment Company Assets under Management, 2010 ($ Billion)

4.7 First Look at Mutual Fund Performance

• On average, mutual fund performance less than broad market performance

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Figure 4.4 Average Returns on Diversified Equity Funds vs Wilshire 5000 Ind

4.8 Information on Mutual Funds

 Sources of Information on Mutual Funds

• Morningstar (www.morningstar.com)

• Fund prospectus

• Yahoo!

• The Wall Street Journal

• Investment Company Institute (www.ici.org)

• American Institute of Individual Investors

• Brokers