Chapter 4 Mutual Funds and Other Investment Companies
Investments 10th edition by Bodie Kane Marcus
4.1) Investment Companies
Investment companies => Are financial intermediaries that collect funds from individual investors and
invest those funds in a potentially wide range of securities or other assets.
Pooling of assets is the key idea behind investment companies. Each investor has a claim to the portfolio
established by the investment company in proportion to the amount invested. These companies thus
provide a mechanism for small investors to “team up” to obtain the benefits of large scale-investing.
Investment companies perform several important functions for their investors:
1. Record keeping and administration
2. Diversification and divisibility
a. They can act as large investors even if any individual shareholder cannot.
3. Professional management
4. Lower transaction costs
While all investment companies pool assets of individual investors, they also need to divide claims to
those assets among those investors. Investors buy shares in investment companies, and ownership is
proportional to the number of shares purchased. The value of each share ts called the net asset value
(NAV).
Example:
Consider these data from the March 2018 balance sheet of Vanguard's Growth and Income Fund. What
was the net asset value of the fund?
- Assets: $ 2,846.80 million
- Liabilities: $ 19.46 million
- Shares: 60.69 million
2,846.80 million -19.46 million / 60.69 million = $ 46.91 per share
4.2) Types of investment companies
Types of investment companies:
- Unit Investment Trust => Are pools of money invested in a portfolio that is fixed for the life of
the fund. Trust tend to invest in relatively uniform types of assets: for example, one trust may
invest in municipal bonds, another in corporate bonds. The uniformity of the portfolio is
consistent with the lack of active management.
- Managed Investment Companies => Securities in their investment portfolios are continually
bought and sold: The portfolios are managed. There are two types of managed companies:
o Closed end => 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 closed-end funds
are traded on organized exchanges and can be purchased through brokers just like
other common stock: their prices, therefore, can differ from NAV.
o Open end => Stand ready to redeem or issue shares at their net asset value (although
both purchases and redemptions may involve sale charges). When investors in open-
end funds wish to “cash out” their share, they sell them back to the fund at NAV.
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- Commingled Funds => Commingled funds are partnerships of investors that pool funds. The
management firm that organizes the partnership, for example, a bank or insurance company,
manages the funds for a fee.
- Real Estate Investment Trusts => Similar to closed-end fund, invest in real estate or loans
secured by real estate;
- Hedge funds => Are vehicles that allow private investors to pool assets to be invested by a
fund manager. Unlike mutual funds, however, hedge funds are commonly structured as
private partnerships and thus subject to only minimal SEC regulation.
Open-end versus closes-end mutual funds
Shares outstanding
- Closed end: No changes unless new stock is offered
- Open end: Changes when new shares are sold or old shares are redeemed.
Pricing
- Closed end: premium/discount to NAV
- Open end: NAV
4.3) Mutual Funds
Mutual Funds => are the common name for open-end investment companies.
Each mutual fund has a specified investment policy, which is described in the fund's prospectus.
Different type of funds:
- Money market funds (These funds invest in money market securities such as commercial paper,
repurchase agreements, or certificates of deposit)
- Equity funds (invest primarily in stock)
- Sector funds (concentrate on particular industry such as biotechnology, utilities, energy, or
telecommunications.)
- Bond funds (fixed income sector For example, various funds will concentrate on corporate bonds,
Treasury bonds, mortgage backed securities, or municipal (tax-free) bonds.)
- Balanced funds (Some funds are designed to be candidates for an individual’s entire investment
portfolio. These balanced funds hold both equities and fixed-income securities in relatively stable
proportions.)
-Asset allocation and flexible funds (similar to balanced funds, hold stock and bonds)
- Index funds (tries to match the performance of a broad market index)
- International funds (international focus - invest in securities of firms located outside the United States.)
How Funds Are Sold-
Mutual funds are generally marketed to the public either directly by the fund underwriter or indirectly
through brokers acting on behalf of the underwriter. Direct-marketed funds are sold through the mail,
various offices of the fund, over the phone, or, more so, over the Internet. Investors contact the fund
directly to purchase shares.
4.4) Costs of investing in mutual funds
An individual investor choosing a mutual fund should consider not only the fund’s stated investment
policy and past performance but also its management fees and other expenses.
- Front-end load => A commission or sales charge paid when you purchase the shares. (smaller
than 8.5%)
- Back-end load => A redemption, or “exit”, fee incurred when you sell your shares. (start at 5-
6%, decrease with years invested)
- Operating expenses => Operating expenses are the costs incurred by the mutual fund in
operating the portfolio, including administrative expenses and advisory fees paid to the
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investment manager (0.2-2%) paid through reduced value of the portfolio.
-12 b-1 charges => Pay for the distribution costs such as advertising, promotional literature
and commission paid to the brokers who sell the funds to investors. (limited to 1% of fund's
avg. net assets per year)
Fees and Mutual Fund Returns- The rate of return on an investment in a mutual fund is measured as the
increase or decrease in net asset value plus income distributions such as dividends or distributions of
capital gains, all expressed as a fraction of net asset value at the beginning of the investment period. If we
denote the net asset value at the start and end of the period as NAV 0 and NAV 1, respectively then:
For example, if a fund has an initial NAV of $20 at the start of the month, makes income distributions of
$.15 and capital gain distributions of $.05, and ends the month with NAV of $20.10, the monthly rate of
return is computed as
4.6) Exchange-traded funds (ETFs)
Exchange traded funds are highly preferred when investing for the long term. Since they have low fees.
First introduced in 1993, are offshoots of mutual funds that allow investors to trade index portfolios just
as they do shares of stock.
4.7) A First Look at Fund Performance
- Empirical evidence shows that average mutual fund performance is generally less than broad
market performance
- Evidence that performance is consistent from one period to the next is suggestive but
Inconclusive
- Results
o Most funds underperform
o Not fair comparison because of costs
- Adjusted Benchmark: Wilshire 5000 with passive management costs considered.
o The majority of funds still under-perform
Consistency of fund performance
- If you look at the funds that perform well (50% best performing funds) and compare
them with the bottom one. And also compare them in the next period, 62% out of the
funds are part of the top 50 again, onby 629%. 38% have moved to the bottom half
- There is some shifting going on.
Evidence suggests that some firms show consistent stronger performance.
A. Depends on the time period
B. Depends on measurement interval
