Chapter 8 Investment Co.
• indirect investment
• types
• fees
• objectives
• regulation
• ETFs
I. Indirect investment
• investment co.
•
 pools investor funds
 purchases & manages portfolio
 direct investments
investors
 own shares of portfolio
 indirect investment
advantages
• diversification & asset choice
•
•
 small amount of capital
professional management
lower transactions costs
 trading
 information
disadvantages
• lack of control over portfolio
•
 choice of assets
 tax consequences of trading
lack of voting rights
 that come w/ common stock
II. Types
Open-end funds (mutual funds)
sell new shares, redeem existing
shares
 # shares changes over time
• share price based on NAV
NAV =
portfolio value - liabilities
# shares outstanding
 NAV computed at close of day
 NAV changes with price of assets
in portfolio
growth of mutual funds
• less than 600 1980
• over 8000 today ($6.2 trillion)
•
 assets concentrated with largest
funds
why?
 growth of 401(k)s, IRAs
 demographics (baby boomers)
Closed-end funds
• < 500 funds ($130 billion)
• fixed # shares initially issued
•
 no later sales or redemptions
 # of shares is fixed
shares bought and sold in
secondary market
 price depends on supply &
demand
• share price & NAV
•
 price < NAV
-- trading at a discount
 price > NAV
-- trading at a premium
many closed end fund shares trade a
a discount
Unit Trusts
• # shares fixed
• typically invest in bonds
• portfolio is fixed: no active trading
• fixed termination date
III. Mutual fund fees
• sale charges
• operating expenses
Sales charges
• funds originally sold 2 ways:
 sales force, w/ commission
-- front-end load (8.5% max)
-- pay when purchase shares
-- back-end load (8.5% max)
-- pay when redeem shares
-- level loads (.75% max)
-- annual fee
•
 buy funds directly
-- no sales charge
-- no load funds
today many distribution channels
 fund supermarkets
 fund families
 “distribution is king”
Operating Expenses
• management fee
• distribution fees
•
 12b-1 fees (SEC rule)
 1% max (100 basis pts.)
 cover marketing costs
other
 trading, records, auditing
All fees
• NASD, SEC set some limits on fees
•
 most funds charge much less
average
 actively managed funds: 1.44%
 index funds: .4%
impact of fees
• $10,000, 10% annual return, 20 yrs.
• if fees 1.5% annually,
•
 $49,725
if fees .5% annually,
 $60,858
IV. Fund Objectives
• funds differ in
 types of assets
 investment goals
Equity funds
• income funds
•
•
 stocks w/ high, stable dividends
growth funds
 stock w/ high expected capital
gains
growth/income funds
• value funds
•
 “bargain” stocks
-- low PE ratio
-- high book-to-value ratio
sector funds
 stocks in specific industry
 health care, biotech, financial,
electronics
• market capitalization
•
 small/mid/large cap funds
 stocks based on size of company
-- value of total shares outstanding
international/global
 international stock portfolio or
 stock in particular region
• index funds
 match performance of stock index
-- S&P 500, Wilshire 5000
 hold portfolio the matches index
 passive strategy
-- match, not beat, the market’s
average return
 lower expenses
• index fund returns slightly below
index return
 operating expenses
 must hold some cash to redeem
shares
why I like indexing
• 1990-99
 S&P 500 index outperformed 76%
of all actively managed stock
funds
Bond funds
• U.S. Government
• Investment grade corporate
•
•
 bond ratings BBB or above
High yield corporate
 junk bonds (rated below BBB)
Municipal bonds
 tax exempt interest
Money Market
• share price = $1, check-writing
• general taxable
• U.S. Government
• tax-exempt
Stocks & Bonds
• balanced funds
• hybrid funds
• asset allocation funds
 529 plans for college
Fund Families
• one investment company
• many different funds
• Fidelity, Vanguard, Strong, Janus
• 400 families
 top ten hold over 40% of assets
look at some top funds
•
•
•
•
http://quicktake.morningstar.com/Fund/Snapsho
t.asp?Country=USA&Symbol=FGRIX
http://quicktake.morningstar.com/Fund/Snapsho
t.asp?Country=USA&Symbol=VWLTX
http://quicktake.morningstar.com/Fund/Snapsho
t.asp?Country=USA&Symbol=VFINX
http://quicktake.morningstar.com/Fund/Snapsho
t.asp?Country=USA&Symbol=FSPHX
V. Regulation
• SEC is main regulator
 disclosure rules
 fees
 insider trading
 “truth in advertising”
-- returns & risks
-- name and objective of fund
• NASD is industry self-regulator
•
 sales practices
 commissions, fees
taxation
 investment co. distributes 90% of
income annually
 fund shareholders taxed on gains
-- even if gains are reinvested
-- dividends no longer taxable
taxation trap
• as share holders redeem shares
 funds sells assets to raise cash
 remaining share holders face tax
liability
VI. Exchange-traded funds (ETFs)
• like index funds & closed-end fund
• shares traded on exchange
• trade continually, not just at closing
•
NAV
swap large blocks of stock for ETF
shares
 price is always close to NAV
ETF tax advantage
• mutual funds
•
 other investors sell shares,
-- trigger tax liability for remaining
share holders
ETFs
 tax liability only for seller
 swap shares for underlying
portfolio