Mutual Funds and Other Investment

CompaniesCHAPTER 4

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Types of Investment Companies• Unit Investment Trusts

• Managed Investment Companies– Open-End (Mutual Funds)– Closed-End

• Other investment organizations– REITs– Hedge Funds

Services of Investment Companies

• Administration & record keeping

• __________________________

• Professional management

• Divisibility

• Low transaction costs

Net Asset Value

• NAV is basis for valuation of investment company shares:– Selling new shares– Redeeming existing shares

NAV equals:

Mkt Val of Assets - Liabilities

Shares Outstanding

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Investment Companies

• Investment companies are exempt from _________________________________.

• Investors pay income tax on income from investment companies.

• Funds with high turnover result in high taxes (low tax efficiency).

• Purchasing a mutual fund late in the year can result in taxes on earnings you did not receive.

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Unit Investment Trusts

• A unit investment trust invests in a fixed pool of securities for a predetermined period of time. At the end of that time, assets are sold and investors receive NAV.

Open-End and Closed-End Funds: 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: Price set in stock market, at

premium or discount to NAV

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Types of Investment Organizations

REIT: ______________________________

Equity REIT: invests in real estate

Mortgage REIT: invests in mortgages

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Types of Investment Organizations

Hedge Funds: little regulation

Limited to high net worth investors:

Net worth > $5 mil

Income > $200K

Annual fees are typically ______ of assets plus _______ of profit

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Mutual Fund Types

• Mutual Funds can be classified by the assets held:– Money Market – Fixed Income– Equity– Balance & Income – Index – Specialized Sector

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Investment Policies

Index funds (including most Exchange Traded Funds, or ETFs) are not actively managed; they simply match an index

Actively managed funds attempt to increase returns by market timing (asset allocation funds) and/or security selection

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Exchange Traded Funds• ETFs are closed-end funds

• Examples - SPDRs and Webs

• Potential advantages– Trade continuously – Lower taxes – Lower fees

• Potential disadvantages– Must pay brokerage commission – Price can differ from NAV

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Mutual Fund Types

• Equity fund by investment objective– Aggressive growth– Growth– Growth & income– Equity income

Table 4.1 Classification of U.S. Mutual Funds

How Funds Are Sold

• Directly marketed

• Sales force distributed

• Revenue sharing on sales force distributed funds– Potential conflicts of interest

• Financial supermarkets (Schwab’s OneSource)

Potential Conflicts of Interest - Revenue Sharing

• Brokers put investors in funds that may not be the most appropriate

• Mutual funds could direct trading to higher cost brokers

• Revenue sharing is not illegal but should be disclosed to the investor

Costs of Investing in Mutual Funds

• Fee Structure– Front-end load (up to 8.5%)– Back-end load (up to 6%)

• Operating expenses• 12 b-1 charges (up to 1% of assets

annually)– distribution costs paid by the fund– Alternative to a load

• Fees and performance

Table 4.2 Impacts of Costs on Investment Performance

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

Table 4.4 Consistency of Investment Results

Sources of Information on Mutual Funds

• Morningstar (www.morningstar.com)

• Value Line Mutual Fund Survey

• Wiesenberger’s Investment Companies

• Yahoo (finance.yahoo.com/funds)

• Investment Company Institute

• Popular press (Business Week, Barron’s)

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How to Pick a Mutual Fund

• In comparing mutual funds, look for:– Matches your investment ________________

and _______________ tolerance– Good _____________________________ for

several years– Same portfolio manager– No ______________– Low ______________ (including 12b-1)– Tax efficiency (unless IRA or 401k)