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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
Chapter 10

Investment Companies

types of 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


types of investment companies continued
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
net asset value nav
Net Asset Value (NAV)
  • Per-share market value of mutual fund’s portfolio:

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

fair value pricing
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
types of mutual funds
Types of Mutual Funds
  • Common stock funds
  • Hybrid funds
  • Bond funds
  • Money market funds
  • Others
common stock fund
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
hybrid fund
Hybrid Fund
  • Mutual fund that owns portfolio of bonds, stocks, and other investment instruments.
  • Subcategories include
    • balanced funds
    • growth and income funds
bond fund
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
money market mutual fund
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
index fund
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.
specialty fund
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
international funds
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
global fund
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.
asset allocation fund
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
life cycle fund
Life-cycle Fund
  • Appeals to investors in specific stages of life
  • Retirement date funds
  • Two approaches
    • Specific securities
    • Fund of funds
socially responsible fund
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.
forms of return
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
reinvestment strategies
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
family of funds
Family of Funds
  • Group of mutual funds owned and marketed by same company
  • Advantages:
    • Exchange privilege
    • Convenience of dealing with one company
  • 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


load continued
Load (continued)
  • Many funds have breakpoints for load charges
  • Rights of accumulation
  • Letter of intent
  • Back-end load (contingent deferred sales charge)
price of a load share
Price of a Load Share

PL = NAV/(1 – L)

where PL = ask price including load

L = load percentage

operating expenses
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
  • 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
classes of shares
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
distribution systems
Distribution Systems
  •  direct marketing
  • captive sales force
  • broker-dealers
  • financial planners
advantages of mutual funds
Advantages of Mutual Funds
  • Professional portfolio management
  • Diversification (risk reduction)
  • Convenience
  • Record keeping
  • Other factors
    • Examples: liquidity, minimal investment requirements, regulation
disadvantages of mutual funds
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).
  • the fund’s investment objectives
  • the fund’s investment policies
  • general information about risks
  • tables showing the loads and other expenses
  • additional information
  • Like any other corporation
    • Inside director
    • Outside director
  • Funds where directors have more money invested do better!
closed end companies
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
managed distribution policy
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
dual purpose investment companies
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
reits relps remics
  • 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


reits relps remics continued
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
unit investment trusts uits
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
advantages of uits
Advantages of UITs
  • Convenience
  • Low cost for holding diversified portfolio
  • Stable portfolio
  • Tax efficiency
  • No or minimal management fees
disadvantages of uits
Disadvantages of UITs
  • May not find UIT to match investment goal
  • Front-end loads can be hefty
  • Lack of resale market
exchange traded funds
Exchange Traded Funds
  • Portfolio mimics a specified index
  • Creation units
etfs advantages over index funds
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
index funds advantages over etfs
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
hedge funds
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
variable annuities
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
alternative ways of organizing pooled portfolios
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.
smas and pmas
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
selecting a mutual fund
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
when to sell a fund
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
why funds underperform the market
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