Mutual Funds and Other

Investment Companies

Bodie, Kane, and Marcus

Essentials of Investments,
4
9th Edition

McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
 Chapter Objectives
• Identifying key differences between open-end and
closed-end investment companies
• Understanding the advantages of investing in funds
rather than investing directly in individual securities
• Describing the expenses associated with investment in
mutual funds, calculate net asset value and fund returns
and identify the major types of investment policies of
mutual funds
• Describing services provided by mutual funds and be
able to identify sources of information on investment
companies

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 Chapter Outline
• Investment Companies
• Types of Investment Companies
• Mutual Funds
• Costs of Investing in Mutual Fund
• Exchange Traded Funds
• Mutual Fund Investment Performance: A First
Look
• Information on Mutual Funds

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 4.1 Investment Companies
• Functions
• Record keeping and administration
• Diversification and divisibility
• Professional management
• Lower transaction costs
• Definitions
• Investment company: Financial intermediaries
• Net asset value (NAV): Assets minus liabilities per share
• NAV = (Market value of assets – liabilities)/ Shares
outstanding
•
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 4.2 Types of Investment Companies
• Two types of Investment companies: Unit Investment
Trust and Managed Investment Companies
• Unit Investment Trusts
• Money pooled from many investors is invested in
portfolio fixed for life of fund
• Sponsor buy a portfolio and deposited into a trust– sell
unit of trust (redeemable trust certificates)
• Income and principal are paid out by trustees; investor
may sell back to trustees for NAV
• Often set up for fixed-income securities
• Unmanaged – lower fees than managed funds
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 4.2 Types of Investment Companies
• Managed Investment Companies
• Open-end fund: stand ready to issues or
redeems shares at net asset value
• Closed-end fund: Shares can’t be redeemed,
are traded at prices could different than NAV

• Load: Sales commission charged on mutual

fund (aka. open-end fund)

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 4.2 Types of 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 (mostly discount)

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 Figure 4.1 Closed-End 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

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 4.2 Types of Investment Companies
• Other Investment Organizations
• Commingled Funds
• Partnership of investors pooling funds; designed for
trusts/larger retirement accounts to get professional
management for fee. Similar to open-end funds
• Real Estate Investment Trusts (REITs)
• Similar to closed-end funds, invests in real estate/real
estate loans
• Hedge Funds
• Private speculative investment pool, exempt from
SEC regulation;
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 4.3 Mutual Funds
• Mutual Funds is a common name of an open-end
funds
• Trade once a day when the NAV is calculated

• Investment Policies
• Each mutual fund has a specified investment policy
(decribled in the fund’s prospectus)
• Should be aware that large differences exist between
different funds within the same category.
• Should never invest in any particular fund without
reading and understanding the prospectus.
• Can obtain advice from a broker or planner
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 4.3 Mutual Funds
• Money Market Funds
• Invest in money market securities (commercial papers,
repurchase agreements, or CDs)
• NAV fixed at $1.00
• No capital gains or losses, just income distributions
• Providing some income while maintaining safety of
principal. They earn more than bank accounts with little
additional risk

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 4.3 Mutual Funds
• Domestic Stock Funds
• Aggressive Growth
• Sector, Small Cap Growth, Mid Cap Growth

• Growth
• Large Cap Growth

• Growth & Income

• Small, Medium, Large, Blend or Small, Medium, Large, Value

• Notes:
- Specialized Sector funds focus in a particular industry

- Income: high dividend yields

- Growth: capital gain

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 4.3 Mutual Funds
• Bond Funds (fixed income funds) Focus on
income and current yield more so than capital gains. Low
capital loss but high inflation risk
• Federal Government
• Short, Intermediate, Long Term
• Inflation Protected
• Corporate
• Ultrashort, Short, Intermediate, Long Term
• High Yield, Multisector
• Emerging Market
• Bank Loans
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 4.3 Mutual Funds
• Index Funds: duplicate the performance of an
index or market sector. Low cost. For Efficient
market believers
• Broad market
• Industry or market subset
• International market
• Size subset

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 4.3 Mutual Funds
• International Funds
• Global funds invest in securities worldwide,
including U.S.
• International funds invest outside U.S.
• Regional funds focus on particular part of world
• Emerging market funds invest in developing
nations

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 4.3 Mutual Funds
• Balanced funds
• Hold both equities and fixed-income securities in stable
proportion
• Life-cycle funds: Asset mix ranges from aggressive to
conservative
• Static allocation funds maintain stable mix across
stocks and bonds
• Targeted maturity funds become more conservative
as investor ages
• Funds of funds: Mutual funds that primarily invest in
other mutual funds

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 Table 4.1 U.S. Mutual Funds by Investment Classification
Assets ($ billion) Percent of Total Assets Number of Funds
Equity Funds
Capital appreciation focus 2,912 24.2% 3,037
World/international 1,660 13.8% 968
Total return 1,950 16.2% 762
Total equity funds 6,522 54.2% 4,767
Bond Funds
Corporate 301 2.5% 293
High yield 157 1.3% 206
World 84 0.7% 122
Government 203 1.7% 301
Strategic income 560 4.7% 370
Single-state municipal 156 1.3% 451
National municipal 218 1.8% 224
Total bond funds 1,679 14.0% 1,967

Hybrid (bond/stock) funds 713 5.9% 488

Money market funds
Taxable 2,642 22.0% 548
Tax-exempt 465 3.9% 259
Total money market funds 3,107 25.8% 807

Total 12,021 100.0% 8,029

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 4.4 Costs of Investing in Mutual Funds
• Fee Structure
• Operating expenses: Costs incurred by mutual
fund in operating portfolio
• Front-end load: Commission or sales charge
paid when purchasing shares
• Back-end load: “Exit” fee incurred when selling
shares
• 12b-1 charges: Annual fees charged by mutual
fund to pay for marketing/distribution costs

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 4.4 Costs of Investing in Mutual Funds
• Fees, Loads, and Performance
• Gross performance of load funds is statistically
identical to gross performance of no-load funds
• Funds with high expenses tend to be poorer
performers
• 12b-1 charges should be added to expense
ratios
• Compare costs with Morningstar

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 4.4 Costs of Investing in Mutual Funds
• NAV and Effective Load
• Cost to initially purchase one share of load fund
= NAV + Front-end load (%) (if any)
• Stated loads typically range from 0 to 8.5%
• Load is designed to offset expenses of
marketing the fund; it goes to broker who sells
fund to investor
• Effective load greater than stated load

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 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%.

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 4.4 Costs of Investing in Mutual Funds
• Fees and Mutual Fund Returns
• Soft dollars: Value of research services
brokerage house provides “free of charge” in
exchange for business

NAV1 - NAV0 + Income + Capital gains distribution

−
Rate of return =
NAV0

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 Table 4.2 Impact of Costs on Investment Performance

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.
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 4.5 Taxation of Mutual Fund Income
• General Tax Rules
• Fund not taxed if diversified and income
distributed
• Investor taxed on capital gain and dividend
distributions
• Turnover: Ratio of trading activity to assets of
portfolio
• Portfolio turnover may affect investor’s tax
liability

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 4.5 Taxation of Mutual Fund Income
• Implications of Fund Turnover
• Fund pays commission costs on portfolio purchases
and sales—charged against NAV
• Turnover rate measured as annual total asset value
bought or sold in a year divided by average total asset
value
• For example, if a fund had an average total asset value
of $10 million and $6 million of securities were bought
or sold that year the turnover rate was 60%.
• Average holding period or AHP
• AHP = 0.5 x (1 / turnover ratio)
• AHP = 0.5 x (1 / 0.60) = 0.83 years
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 4.6 Exchange-Traded Funds
• Exchange-Traded Funds: Offshoots of
mutual funds that allow investors to trade
index portfolios
• Potential Advantages
• Trade continuously throughout day
• Can be sold short or purchased on margin
• Potentially lower tax rates
• Lower costs (no marketing, lower fund
expenses)

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 4.6 Exchange-Traded Funds
• Potential Disadvantages
• Small price deviations from NAV possible
• Brokerage commission to buy ETF

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 Table 4.3 ETF Sponsors and Products

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4.7 Mutual Fund Investment Performance
• On average, mutual fund performance less
than broad market performance
• Evidence suggests some persistence in
positive performance over certain horizons
• There is some evidence that funds with
higher expense ratios are more likely to be
poorer performers

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 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

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 Exercises
• Problem Sets: Basic questions (1- 10)

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