Chapter 10
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Chapter 10. Investment Companies. Types of Investment Companies. Open-end Mutual fund Price based on NAV Closed-end Stock publicly traded Dual purpose investment company two classes of shares REITs and RELPs Real estate applications (continued).

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Chapter 10 l.jpg
Chapter 10

Investment Companies

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Types of Investment Companies

  • Open-end

    • Mutual fund

    • Price based on NAV

  • Closed-end

    • Stock publicly traded

  • Dual purpose investment company

    • two classes of shares

  • REITs and RELPs

    • Real estate applications


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Types of Investment Companies (continued)

  • Unit investment trusts

    • Unmanaged

    • Self-liquidating

    • Largely consisting of short-term debt securities

  • Hedge funds

    • Typically organized as offshore limited partnerships for qualified investors

    • Maximum investment flexibility

  • Variable annuities

    • Mutual fund type of instrument originating at insurance companies

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Net Asset Value (NAV)

  • Per-share market value of mutual fund’s portfolio:

    NAV = (total assets – total liabilities)  number of shares outstanding

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Fair-Value Pricing

  • Problem created by asynchronous closing of markets

  • SEC mandated solution

  • funds should use what they believe is the appropriate price of securities with stale prices, rather than the official close

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Types of Mutual Funds

  • Common stock funds

  • Hybrid funds

  • Bond funds

  • Money market funds

  • Others

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Common Stock Fund

  • Mutual fund that holds portfolio primarily consisting of common stocks and perhaps a small number of preferred stocks

  • Subcategories include investments in:

    • conservative (defensive) stocks

    • growth stocks

    • aggressive growth stocks

    • foreign stocks

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Hybrid Fund

  • Mutual fund that owns portfolio of bonds, stocks, and other investment instruments.

  • Subcategories include

    • balanced funds

    • growth and income funds

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Bond Fund

  • Mutual fund that owns portfolio of bonds. Subcategories include funds that invest in:

    • U.S. government issues

    • Municipal issues

    • Corporate issues

    • Low-quality (junk) bonds

  • Subcategories can be short-term (up to 5 years), intermediate-term (5 to 10 years), or long-term (10 or more years) bonds

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Money Market Mutual Fund

  • Mutual fund that invests in short-term, highly liquid securities—that is, primarily or exclusively money market securities

    • Taxable

    • Tax-Exempt

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Index Fund

  • Mutual fund that owns a portfolio of either common stock or bonds that replicates a major market index, such as the S&P 500 or Lehman Brothers Aggregate Bond Index

  • Index funds are low-cost funds that are especially useful in passive investment strategies in which the investor is satisfied to match performance of index.

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Specialty Fund

  • Mutual fund designed for investors who seek special investment opportunities.

  • Examples include:

    • Sector or industry funds such as gold related stocks

    • Regional stocks such as sunbelt

    • Gimmick funds such as race car related stocks

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International Funds

  • Mutual fund that specializes in investments outside the U.S. and helps investor to further diversify his or her portfolio

  • May specialize in

    • Specific countries

    • Regions such as Pacific Rim

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Global Fund

  • Mutual fund that invests in U.S. and foreign markets

  • General philosophy:

    • We live in global economy and capital should flow toward regions that offer optimal risk-return combinations.

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Asset Allocation Fund

  • Mutual fund that allows managers considerable flexibility in allocating portfolio among three major asset categories —stocks, bonds, and money market instruments—as market conditions change

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Life-cycle Fund

  • Appeals to investors in specific stages of life

  • Retirement date funds

  • Two approaches

    • Specific securities

    • Fund of funds

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Socially Responsible Fund

  • Mutual fund that invests only in corporations or other entities that maintain social and/or ethical principles consistent with those specified by fund.

  • Example:

    • Fund may elect not to invest in any company that produces tobacco products or other products associated with potential health hazards.

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Forms of Return

  • Price Appreciation: Increase in NAV

  • Dividends and Interest: Pass-through of dividends and interest received on portfolio

    • Regular dividend

  • Capital Gain Distribution: Payment of net capital gain recognized by fund during year

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Reinvestment Strategies

  • Reinvest regular & CG distribution

    • Makes most sense in a qualified account

  • Reinvest CG distribution & take regular as cash distribution

    • Concept of “not touching the principal”

  • Reinvest regular & take CG as cash

    • Rarely suggested

  • Same tax treatment on all

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Family of Funds

  • Group of mutual funds owned and marketed by same company

  • Advantages:

    • Exchange privilege

    • Convenience of dealing with one company

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  • Selling fee applied to mutual fund purchase, similar to commission

  • Maximum load charge = 8.5%

  • Based on gross purchase price

    • $1,000 purchase means $915 invested if maximum load


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Load (continued)

  • Many funds have breakpoints for load charges

  • Rights of accumulation

  • Letter of intent

  • Back-end load (contingent deferred sales charge)

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Price of a Load Share

PL = NAV/(1 – L)

where PL = ask price including load

L = load percentage

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Operating Expenses

  • Investment advisory fee

  • 12b-1 fee

    • trail commission or trailer

  • Brokerage fees

    • Measured by portfolio turnover ratio

  • Other Fees

    • Examples: exchange fees, account maintenance fees, reinvestment loads

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  • Money moved from one fund to another

    • Both inter- and intra- familty exchanges

  • If intra-family & paid load on initial purchase, waived on switch if second fund is also a load fund

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Classes of Shares

  • Class A: Usually large front-end load, and minimal or no 12b-1 fee

    • Best if plan long holding period

  • Class B: Back-end load and 12b-1 fees, usually convertible to Class A after load waived

  • Class C: Minimal or no front-end or back-end load, but substantial 12b-1 fee

    • Best if plan short holding period

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Distribution Systems

  •  direct marketing

  • captive sales force

  • broker-dealers

  • financial planners

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Advantages of Mutual Funds

  • Professional portfolio management

  • Diversification (risk reduction)

  • Convenience

  • Record keeping

  • Other factors

    • Examples: liquidity, minimal investment requirements, regulation

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Disadvantages of Mutual Funds

  • Management fees, expenses, and loads for load funds reduce their returns.

  • Large investors, such as mutual funds, sometimes adversely affect the market when they trade.

  • Institutions usually restrict their analysis to a small percentage of traded stocks (i.e., the larger ones).

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  • the fund’s investment objectives

  • the fund’s investment policies

  • general information about risks

  • tables showing the loads and other expenses

  • additional information

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  • Like any other corporation

    • Inside director

    • Outside director

  • Funds where directors have more money invested do better!

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Closed-End Companies

  • Trade in secondary market (exchanges or OTC)

    • No prospectur

  • Rarely trades at NAV

    • Usually at discount, but occasionally at premium

  • Embedded tax liabilities

  • Some of holdings may not be marketable

  • Conversion to open-end form

    • May produce windfall gains for investors

    • Sometimes have exit fees for those redeeming immediately after conversion

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Managed Distribution Policy

  • A guaranteed cash distribution based on NAV at start of year

    • Provided even if have to return principal

    • Provides sense of safety because of guarantee of cash payout each year

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Dual Purpose Investment Companies

  • Two classes of shares

    • Income share (like a preferred stock)

    • Capital Appreciation share

  • Termination date of fund

    • Portfolio liquidated

    • Income share paid off at par

    • Residual goes to capital appreciation shares

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  • Equity REIT: real estate investment trust that invests in office buildings, apartments, hotels, shopping malls, and other real estate ventures

  • Mortgage REIT: real estate investment trust that holds construction loans and/or mortgage loans


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REITs, RELPs, & REMICs(continued)

  • Hybrid REIT: real estate investment trust that is combination of equity and mortgage investments

  • RELP: type of investment organized as limited partnership that invests directly in real estate properties

  • REMIC: Real estate mortgage investment conduits

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Unit Investment Trusts (UITs)

  • Unmanaged, self-liquidating

  • Most UITs are debt (primarily short-term) but some are equity (may have liquidation date for portfolio)

  • Some UITs are equity

    • Liquidation date

    • Example: Dogs of the Dow portfolios

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Advantages of UITs

  • Convenience

  • Low cost for holding diversified portfolio

  • Stable portfolio

  • Tax efficiency

  • No or minimal management fees

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Disadvantages of UITs

  • May not find UIT to match investment goal

  • Front-end loads can be hefty

  • Lack of resale market

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Exchange Traded Funds

  • Portfolio mimics a specified index

  • Creation units

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ETFs: Advantages over Index Funds

  • Traded on daily basis like any other stock

  • Can buy on margin

  • Low management fees

  • Extremely tax efficient

  • Likely to track index more closely

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Index Funds: Advantages over ETFs

  • Most are no-loads

  • ETFs trade on bid-ask spread, in addition to commission

  • Always trade at NAV, ETFs sometimes trade at a slight discount

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Hedge Funds

  • Pooled portfolio instrument organized for maximum investment flexibility

    • Typically invest in derivatives, sell short, use leverage, and invest internationally

    • Take substantial risks, seeking correspondingly large rewards

    • Typically organized as limited partnerships and allow only “qualified investors” to participate

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Variable Annuities

  • Purchased from insurance company

    • Account separate from assets of the insurance company

    • Can be variable during the accumulation period or the payout period

    • Considered securities under federal law

  • Assets accumulate on a tax-deferred basis

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Alternative Ways of Organizing Pooled Portfolios

  • Operating or holding companies: Some operating or holding companies hold such large portfolios that their performances are more closely related to their security holdings than to their operations.

  • Partnerships: Some investment companies choose the partnership form, often a limited partnership, because of its greater flexibility and/or tax advantages.

  • Blind pools: Investors bankroll enterprises whose purposes will later be revealed; these pools are sometimes involved in takeover financing.

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SMAs and PMAs

  • Separately managed accounts & privately managed accounts

    • An SMA is a PMAopened through a broker or financial advisor who uses pooled money to buy individual assets

    • About 80% of SMAs sold via major brokerage firms

    • A mutual fund with personalized holdings

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Selecting a Mutual Fund

  • First step, identify appropriate category based on client’s objectives & risk tolerance

  • Third party evaluations

  • Fees & Expenses

  • Diversification/concentration

  • Experience, qualifications, and longevity of the fund’s manager

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When to Sell a Fund

  • Style Drift

  • Significant change in asset allocation

  • Extended poor performance (esp. if associated with high fees)

    • Should look at least at 3-year record

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Why Funds Underperform the Market

  • Hold a large part of the market & have a fee structure

  • Other institutional investors have the same advantages

  • Have some cash holdings due to cash inflows & outflows