Chapter 10
Investment Companies
Mutual Fund Characteristics
Other Pooled Investments
Managing Fund Investments
Chapter 10
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Student Learning Objectives
What are mutual funds?
 Open-end vs. closed-end funds
 UIT, REIT, RELP, REMIC
 Selecting a mutual fund
 Managing mutual fund investments
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Forming a Mutual Fund
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Investment company forms the fund and advertises its
investment objectives, fees, and fund manager.
Interested parties buy shares (of beneficial interest) at a
preset price (NAV).
Fund manager then invests the proceeds of the share sale
in a variety of stocks.
Thereafter, NAV set by stock prices
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Value of mutual fund assets minus liabilities divided by number
of outstanding shares
Regulatory requirements for Investment Companies
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Chapter 10
Must distribute
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Types of Mutual Funds
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Open-end
 Investment Company stands ready to buy and sell
 Price based on NAV (sales charge possible)
 Active or Passive management
 May have multiple classes (fee schedules)
Closed-end
 One time issuance of shares
 Shares publicly traded
 Tend to trade at a discount to NAV
Chapter 10
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Types of Mutual Funds
Stock Funds (common, preferred)
 Bond Funds (short-, intermediate- or long-term)
 Balanced Funds (stocks and bonds)
 Taxable vs. Tax “free”
 Index Funds (SP500, Nasdaq, Russell, Wilshire )
 Sector Funds (Energy, Utility, Transportation)
 Global Funds (Europe, Far East, Emerging)
 Exchange Traded Funds (ETF)
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Types of Mutual Funds
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Asset Allocation
Socially Responsible
Money Market
REITs and RELPs
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Unit investment trusts
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Unmanaged
Self-liquidating
Largely consist of short-term debt securities
Hedge funds
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Real estate applications: commercial, residential
Typically organized as offshore limited partnerships for qualified
investors
Maximum investment flexibility
Variable annuities
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Chapter 10
Mutual fund type of instrument originating at insurance companies
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Investm ent Com pany Assets
Year-End 1995 - 2008
www.icifactbook.org
14000
12000
Open-End
ETF
$ (Billions)
10000
Closed-end
UIT
8000
6000
4000
2000
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2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
0
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Fund Operating Details
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Distribution Requirements
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IRS (Subchapter M) requires funds to distribute no less than 90%
of interest and dividends received.
The same applies to “net” realized capital gains
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Load Charges
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Most funds are no-load
Sales charges may vary according to fund
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Realized = result of buying and selling
Front-end vs. Back-end (tied to holding period or class)
Sales charges tend to discourage timing or frequent trading
May also involve break-points
Management (Advisory) Fees, 12b-1 Fees
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Fund Operating Details
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Distribution (sales)
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Direct marketing (Vanguard, Fidelity, etc., websites)
Sales Force
Broker-Dealers
Financial Planners
Retirement fund jobbers (Planco Div of HIG)
Prospectus Requirements
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Chapter 10
Investor purchase must be followed by receipt of fund
prospectus
Annual reports required, may receive quarterly reports
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Pros & Cons of Mutual Funds
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Pros
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Professional portfolio management
Diversification (risk reduction)
Convenience
Record keeping
Other factors
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Examples: liquidity, minimal investment requirements,
regulation
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Pros & Cons of Mutual Funds
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Cons
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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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Net Asset Value (NAV)
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Per-share market value of mutual fund’s portfolio:
NAV = (total assets – total liabilities) 
number of shares outstanding
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Forms of Return
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Price Appreciation: Increase in NAV
Dividends and Interest: Pass-through of dividends and interest
received on portfolio
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Regular dividend
Capital Gain Distribution: Payment of net capital gain recognized
by fund during year
Reinvestment Strategies: auto-reinvest, cash distribution
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Load Charges
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Contingent deferred sales charge (CDSC) is a back-end
load that declines over time
Back-end loads discourage trading by investors
Front-end loads compensate the broker
No-load funds tend to be most popular
Share Class Structure
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Chapter 10
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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Operating Expenses
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Management or advisory fees and other
operating expenses
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12b -1 fees cover distribution costs
Paid out of investment income as percent of
NAV
 Compare loads and operating expenses for
varying time periods in evaluating funds
 No evidence that higher fees or load charges
bring superior performance
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Chapter 10
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Performance and taxes
Mutual funds are not taxed directly on income or
capital gains as these are passed on to the
shareholders
 Returns can be broken down into distributions
and change in NAV
 Portfolio turnover relates to higher capital gains
distributions and unrealized capital gains
 Don’t purchase just before a distribution
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Chapter 10
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Managing Fund Investments
Passive versus active
 Personal objectives may change over time
 Dollar-cost averaging results from investing
equal dollar amounts at regular intervals
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Can be beneficial when prices fluctuate, but…
if prices continually rise, buying more earlier is better
Rebalancing Investment Portfolio
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Chapter 10
Adjusting allocations to desired risk-return target
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Regulations and Taxation
The SEC regulates U. S. fund operations through
Mutual Fund Act of 1940.
 State approval is also required to sell shares
 Most funds are taxed as regulated investment
companies:
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Chapter 10
All investment income must be distributed to
shareholders each year
All tax liability falls to individual shareholders
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Mutual Fund Services
Automatic reinvestment of distributions
 Automatic investment plans
 Check writing (money market funds)
 Exchange privileges within fund families
 Periodic statements
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Chapter 10
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Why Mutual Funds?
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Positives
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Professional management
Diversification
Convenience
Marketability
Ease of exchange
Negatives
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Chapter 10
Most funds under perform the indexes
Fund performance depends on fund manager and
market conditions
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Special Issues in Closed-End Funds
No prospectus to traders
 May have tax liabilities (liquidation)
 May be leveraged (additional risk)
 May have liquidity problems (thinly traded)
 Possibility of conversion to open-end
 Different distribution structures (managed)
 Tends to trade at less than NAV
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Chapter 10
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Real Estate Investment Companies
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Real Estate Investment Trust (REIT)
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Min of 75% invested in RE
Required to pay out 90% of income
Equity REITs: income producing
Mortgage REITs: making loans
Hybrids
Real estate Limited Partnerships (RELP)
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More complex tax rules
May have a liquidation time set
May involve sales charges
Many sell at discounts
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Real Estate Investment Companies
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RE Mortgage Investment Conduits (REMIC)
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Chapter 10
Created by breaking up interest and principal streams
Different maturity packs to match investor needs
Bear Stearns was major player in this market (> JPM)
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Unit Investment Trust
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Debt
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Equity
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Funds invested in bonds
Bond UIT have fixed lives.
Purpose: provide known income stream
Funds invested in Equities
All have termination date: liquidation > distribution
Pros and Cons
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Negligible fees, tax efficient, convenient
Sales charges, lack of marketability
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Exchange Traded Funds
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Alternative to Mutual Funds
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No minimum holding period
Can mimic indexes, sector, countries, etc.
Many are very liquid – 51 traded more than 500,000
shares (April, 2008), another 60 at least 100,000 shares
Even more are thinly traded: 259 ETF had daily
volumes under 100,000 shares (April, 2008)
Marginable
Able to sell short
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Other Investment Vehicles
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Hedge Funds
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Multiple fronts
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Derivatives: options and futures
Stocks and bonds
International
Costly and Risky
Performance suspect – backfilling
Losses can be significant – e.g. LTCM
Variable Annuities
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Chapter 10
Industry is still evolving – trying to increase returns
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Other Investment Vehicles
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Pooled Portfolios
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Chapter 10
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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Selecting and Evaluating Funds
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Evaluate Historic Performance
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Against a benchmark like the S&P 500 over time
Morningstar or Weisenberger publications
Assess Future Performance
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Chapter 10
Some believe that past performance is a poor
predictor since funds do not (over the long term)
post better risk-adjusted performance than the broad
market averages
Others feel that past performance is a reasonable,
though imperfect, predictor because past
performance reflects more than mere luck
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Selecting and Evaluating Funds
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Evaluate services offered by the fund
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Examine fees and expenses
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Redemptions
Automatic dividend reinvestment
Advisory services
Load charges
Operating expenses
Third Party Evaluations
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Chapter 10
Morningstar
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