CHAPTER 4 MUTUAL FUNDS AND OTHER INVESTMENT COMPANIES

4-1

Outline of the Chapter

Investment Companies Types of Investment Companies Mutual Funds Costs of Investing in Mutual Funds

Mutual Fund Investment Performance

4-2

Investment Companies
Investment companies: financial intermediaries that collect funds from individual investors and invest those funds in a potentially wide range of securities or other assets. These companies perform several important functions for investors:
Administration & record keeping
Diversification & divisibility Professional management Reduced transaction costs
4-3

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

4-4

Types of Investment Companies

Unit Trusts Managed Investment Companies Open-End Open-end: shares outstanding change when new shares are sold or old shares are redeemed Priced at Net Asset Value(NAV) Closed-End no change in shares outstanding unless new stock is offered Priced at Premium or discount to NAV
4-5

Types of Investment Companies Continued

Other investment organizations
Commingled funds
Partnerships of investors that pool their funds. Similar in form to open-end mutual funds.

REITs
Similar to a closed-end fund Invest in real estate or loans secured by real estate.

Hedge Funds
Vehicles that allow private investors to pool assets to be invested by a fund manager.
4-6

Mutual FundsInvestment Policies

Open-end investment companies
Money Market Equity Sector Bond Balanced Asset Allocation and Flexible Index International

4-7

How Funds Are Sold

Direct-marketed funds Sales force distributed Revenue sharing on sales force distributed Potential conflicts of interest

Financial Supermarkets

4-8

Costs of Investing in Mutual Funds

Fee Structure
Operating expenses: costs incurred by the mutual fund in operating the portfolio, including admisitrative expenses and advisory fees paid to the investment manager Front-end load: commission or sales charge paid when you purchase the shares Back-end load: redemption or exit fee incurred when you sell your shares

4-9

Costs of Investing in Mutual Funds

12 b-1 charges Distribution costs paid by the fund Funds may use 12b-1 charges instead of or in addition to pront-end loads to generate the fees with which to pay brokers Not explicitly billed, the fees are deducted from the assets of the fund Should be added to operating expenses to obtain the true annual expense of the fund
4-10

Fees and Mutual Fund Returns

NAV1 NAV0 Income and capital gain distributions Rate of return = NAV0
Rate of return= gross return- total expense ratio

4-11

Table 4.2 Impacts of Costs on Investment Performance

4-12

Trading Scandal with Mutual Funds

Late trading allowing some investors to purchase or sell later than other investors Market timing allowing investors to buy or sell on stale net asset values International Net effect is to transfer value from other shareholders to privileged traders Reduction in the rate of return of the mutual fund
4-13

Potential Reforms
Strict 4:00 PM cutoff with late orders executed the following trading day Fair value pricing with net asset values being adjusted for trading in open markets Imposition of redemption fees

4-14

Exchange Traded Funds

ETF allow investors to trade index portfolios like shares of stock Examples SPDRs Unlike mutual funds, investors can trade trade them throughout the day. Potential advantages Lower taxes Trade continuously Lower costs Potential disadvantages Prices can depart by small amounts from NAV Brokers fee
4-15

Table 4.3 EFT Sponsors and Products

4-16

Mutual Fund Investment Performance: A First Look

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

4-17

Figure 4.2 Diversified Equity Funds versus Wilshire 5000 Index

4-18

Table 4.4 Consistency of Investment Results

4-19