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)

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)

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

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

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

• Common stock funds

• Hybrid funds

• Bond funds

• Money market funds

• Others

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

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

• Subcategories include

– balanced funds

– growth and income funds

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

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

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

• 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

• 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

• 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

• 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

• Appeals to investors in specific stages of life

• Retirement date funds

• Two approaches– Specific securities– Fund of funds

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

• 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

• 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

• Group of mutual funds owned and marketed by same company

• Advantages:

– Exchange privilege

– Convenience of dealing with one company

Load

• 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

(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

PL = NAV/(1 – L)

 

where PL = ask price including load

L = load percentage

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

Switching

• 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

• 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

•  direct marketing

• captive sales force

• broker-dealers

• financial planners

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

• 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).

Prospectus

• the fund’s investment objectives

• the fund’s investment policies

• general information about risks

• tables showing the loads and other expenses

• additional information

Governance

• Like any other corporation– Inside director– Outside director

• Funds where directors have more money invested do better!

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

• 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

• 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

(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)

• 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

• Convenience

• Low cost for holding diversified portfolio

• Stable portfolio

• Tax efficiency

• No or minimal management fees

Disadvantages of UITs

• May not find UIT to match investment goal

• Front-end loads can be hefty

• Lack of resale market

Exchange Traded Funds

• Portfolio mimics a specified index

• Creation units

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

• 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

• 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

• 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

• 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

• Separately managed accounts & privately managed accounts– An SMA is a PMA opened 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

• 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

• 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

• 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