chapter 4: investment companies. definition: financial intermediaries that collect funds from...
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CHAPTER 4: INVESTMENT COMPANIES
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Definition: financial intermediaries that collect funds from individual investors and invest those funds in a potentially wide range of securities
Administration & record keeping◦ issue periodic status reports, keeping track of capital gain
distributions, dividends, investments, and redemption Diversification & divisibility: diversify portfolios
and investors can buy fractional shares of many different securities
Professional management: full-time staffs of security analysts and portfolio managers
Reduced transaction costs: can achieve substantial savings on brokerage fees and commissions because of large transactions
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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
Example: Consider a mutual fund that manages a portfolio of securities worth $120 mil. Suppose the fund owes $4 mil to its investment advisers and owes another $1mil for rent, wages and other expenses. The fund has 5mil shares outstanding. What is NAV of the fund
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4.2 TYPES OF INVESTMENT COMPANIES
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Pools of money from many investors that is invested in a portfolio fixed for the life of the fund
Little active management Example: invest in municipal bond,
corporate bond
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Hire managers to manage portfolio Open-End
◦ stand ready to redeem or issue shares at their net asset value. If investors in open-end funds want to cash out shares, they sell back to the fund at NAV
Closed-End◦ Funds cannot issue or redeem shares. Investors
who want to cash out must sell shares to other investors
◦ Sold at premium or discount to NAV◦ Shares of close-end fund are traded on organized
exchanges just like other common stocks.
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◦ Commingled funds partnership of investors that pool their funds. Similar to
open-end fund. Example: trust or retirement account that have portfolios much larger than those of most individual investors but still too small to warrant managing on a separate basis
◦ REITs: similar to closed-end fund but invest in real estate or loans secured by real estate
◦ Hedge Funds like mutual fund: hedge fund allows private investors to
pool assets to be invested by a fund manager Unlike mutual fund: hedge fund are commonly
structured as private partnerships and are not subject to many SEC regulations
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4.3 MUTUAL FUNDS
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mutual fund is a common name for open-end investment company. Account for >90% of investment company asset.
Described in the prospectus Management companies manage a family
of mutual funds. Some examples include:◦ Fidelity◦ Vanguard◦ Putnam ◦ Dreyfus
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Money Market: invest in money market securities.
Equity: invest in stocks◦ Income fund and growth fund
Specialized Sector: sector funds Bond: invest in bond
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Balanced Funds: hold both equities and fixed income securities in relatively stable proportions to meet needs of individual investors
Asset Allocation and Flexible: similar to balance funds but the proportion can change according to managers’ forecasts
Indexed: match performance of a broad market index. Example: Vanguard 500 Index Fund International
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4.4 COSTS OF INVESTING IN MUTUAL FUNDS
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Fee Structure◦ Front-end load: commission or sale charge
paid when purchasing the shares◦ Back-end load: redemption or exit fee
incurred when you sell shares. Operating expenses 12 b-1 charges
distribution costs paid by the fund Alternative to a load
Fees and performance
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1 0
0
NAV NAV Income and capital gain distributionsRate of return =
NAV
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Initial NAV = $20Income distributions of $.15Capital gain distributions of $.05Ending NAV = $20.10:
$20.10 - $20.00 + $.15 + $.05Rate of Return = 1.5%
$20.00
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Example: you purchased 1000 shares of the New Fund at a price of $20 at the beginning of the year. You paid a front-end load of 4%. The securities in which the fund invests increase in value by 12% during the year. The fund’s expense ratio is 1.2%. What is your rate of return on the fund if you sell your shares at the end of the year.
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4.6 EXCHANGE-TRADED FUNDS
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ETF allow investors to trade index portfolios like shares of stock
Examples – SPDRs, Diamonds, and WEBS Potential advantages
◦ Trade continuously ◦ Lower taxes ◦ Lower costs
Potential disadvantages◦ mispricing◦ broker fees
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4.7 MUTUAL FUND INVESTMENT PERFORMANCE: A FIRST LOOK
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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
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4.8 INFORMATION ON MUTUAL FUNDS
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Wiesenberger’s Investment Companies Morningstar (www.morningstar.com) Yahoo (finance.yahoo.com/funds) Investment Company Institute Popular press Investment services