CHAPTER 4 Mutual Funds

and Other
Investment
Companies

Investments, 8th edition

Bodie, Kane and Marcus

Slides by Susan Hine

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
 Investment Companies
-Collecting funds from individuals
-Investing in a big portfolio
-How it works
• Investment company forms portfolio
• Sells investors shares in the portfolio
• investors have claim to the portfolio,
proportional to their number of shares

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 Investment Companies
• These companies perform several important
functions for investors:
– Administration & record keeping: capital
gains, dividends and so on
– Diversification & divisibility: i.e. by pooling of
assets
– Professional management: security analysts
etc.
– Reduced transaction costs

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 Net Asset Value

• Used as a basis for valuation of investment

company shares for
– Selling new shares
– Redeeming existing shares( buying back)
Calculation: NAV=
Market Value of Assets - Liabilities
Shares Outstanding

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Types of Investment Companies
Unit Investment Trusts:
• pool of money invested in portfolio; its
portfolio is fixed, unmanaged.
• Brokerage firm buys and forms portfolio
• Sells shares in that trust called units or
redeemable trust certificates
• Trusts tend to invest in relatively uniform
types of assets.

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Types of Investment Companies
Unit Investment Trusts:
Sponsors of unit investment trust earn their profit
by selling shares in the trust at a premium to the
cost of acquiring the underlying assets. For
example:
- Trust brought portfolio for $ 5 million
- Sells 5,000 shares at $1,030 per share
- 3% premium per share obtained by trustee
which is the trustee’s fee for establishing the
trust.

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Types of Investment Companies
Managed Investment Companies:
Securities in their investment portfolios are
continually bought and sold. This portfolio is
managed.
• Board of directors, elected by shareholders,
hires management company for a fee.
• Managed companies are either closed-end
or open-end.

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 Types of Investment Companies
Managed Investment Companies:
Open-End (called mutual funds)
• Open-end: redeemed or issue new shares
at their NAV;
• shares outstanding change when new
shares are issued or old shares are
redeemed
• Priced at Net Asset Value(NAV)

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 Types of Investment Companies
Managed Investment Companies:
Closed-End
• Not redeemed, no new share are issued
• No change in shares outstanding
• Investors can cash out by selling their shares to
other investors.
• Shares are traded on organized exchanges and
can be sold and bought at market price (unlike
open-end mutual funds shares)
• May be priced at Premium or discount to NAV

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 Types of Investment Companies
Managed Investment Companies:
Open End Vs Closed-End
• In contrast to closed end funds, the price of
open-end funds can not fall below NAV, because
these funds stand ready to redeem shares at
NAV.
• Unlike closed end funds, open-end funds do not
trade on organized exchanges. Instead, investors
simply buy shares from and liquidate through the
investment company at net asset value.

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 Types of Investment Companies
• Other investment organizations
- Commingled funds
- Real estate investment trusts (REITs)
- Hedge Funds

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 Mutual Funds—Investment Policies
• Money Market Funds: These funds invest in money
market funds such as commercial paper, repurchase
agreement, or certificates of deposit. The average
maturity of these assets is a bit more than a month.
• Equity Funds: These funds invest primarily in stock,
although, they may also hold fixed income or other
types of securities.
Income funds tend to hold shares of firms with
consistently high dividend yields.
Growth funds are willing to forgo current income,
focusing instead on prospects for capital gains.

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 Mutual Funds—Investment Policies
Sector Funds: Some equity funds, called sector funds,
concentrate on a particular industry or in securities of
particular countries.
Bond Funds: These funds specialize in fixed income
sector. For example, various funds will concentrate on
corporate bonds, Treasury bonds, mortgage-backed
securities, etc.
• International Funds: Many funds have international
focus. Global funds invest in securities worldwide.
Regional Funds concentrate on a particular part of the
world.
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 Mutual Funds—Investment Policies
• Balanced Funds: Balanced funds hold both equities
and fixed income securities in relatively stable
proportions.
• Asset Allocation funds: These funds hold both stocks
and bonds (similar to balanced funds). However, asset
allocation funds can vary the proportion allocated to each
market in accordance with the Portfolio manager’s forecast
of the relative performance of each sector.
• Index Funds: Index funds buy shares in securities
included in a particular index in proportion to each security’s
representation in that index.
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 How Funds Are Sold
• Direct-marketed funds; mails, phone, internet
etc.
• Sales force distributed: brokers, advisers on
commission
- Revenue sharing on sales force
- Potential conflicts of interest
• Financial Supermarkets; sell shares of many
funds

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 Costs of Investing in Mutual Funds
• Fee Structure
– Operating expenses; cost of operating portfolio, inc.
administration and advisory cost
– Front-end load: when you buy a share
– Back-end load: when you redeem a share

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 Fees and Mutual Fund Returns
NAV1 - NAV0 + Income and capital gain distributions
Rate of return =
NAV0

90
80
70
60
50 East
40 West
30 North
20
10
0
1st Qtr 2nd Qtr 3rd Qtr 4th Qtr

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 Fees and Mutual Fund Returns:
An Example
Initial NAV = $20
Income distributions of $.15
Capital gain distributions of $.05
Ending NAV = $20.10:

$20.10 - $20.00 + $.15 + $.05

Rate of Return = = 1.5%
$20.00

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 Taxation on Mutual Fund Income

• Pass-through status under the U.S. tax code

i.e. taxes are paid only by investor, not by fund
• High turnover(replacement of assets in the
fund) leads to high tax inefficiency
• Last decade turnover: 60% in equity funds,
2% in index funds

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 Information on Mutual Funds

• Prospectus+Statement of additional
information (SAI)
• Wiesenberger’s Investment Companies
• Morningstar (www.morningstar.com)
• Yahoo (biz.yahoo.com/funds)
• Investment Company Institute (www.ici.org)
• Directory of Mutual Funds

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