Chapter 14
Investment Companies
And Mutual Funds
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Chapter 14
Outline
Questions to be answered:
• What are the different ways that professional
asset management firms can be organized?
• How has the structure of the asset
management industry changed over time?
• How are managers at investment advisory
firms compensated?
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Chapter 14
Outline
• Who manages the investment company portfolio and
how are its managers compensated?
• How do you compute the net asset value (NAV) for an
investment company?
• What is the difference between closed-end and openend investment companies?
• What is the difference between the NAV and market
price for a closed-end fund?
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Chapter 14
Outline
• What are load fees, 12b-1 fees, and management fees
and how do they influence investment company
performance?
• What are the two major means of fund distribution
and what has been the trend for each approach?
• Given the breakdown of all funds by investment
objectives, which groups have experienced relative
growth or decline?
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Chapter 14
Outline
• Given a desire to have a personal portfolio manager
perform certain functions for you, how do investment
companies help fulfill this need?
• What are the ethical dilemmas involved in the
professional asset management industry?
• What has been the risk-adjusted performance of
mutual funds relative to alternative market indexes?
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The Asset Management Industry:
Structure and Evolution
1. Contract directly with a management and
advisory firm
relationship with client
assets under management (AUM)
separate accounts
customized
2. Commingling of investment capital of
several clients in an investment company
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What is an Investment Company?
• An investment company invests a pool of funds
belonging to many individuals in a portfolio of
individual investments such as stocks and bonds
• The total market value of all investments divided
by the number of fund shares outstanding is the
net asset value (NAV)
• Portfolio management is handled by an
investment management company
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Types Of Funds
• Open-End Funds
– Mutual funds (MFs)
• Closed -End Funds
– Investment trusts
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Closed-End Funds
• Developed in Europe 1820s
• No Additional Shares Issued
• Easier to Manage
– No liquidity requirement
• Shares Trade on Secondary Market
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Pricing Of Closed-End Funds
• NAV
• CMP
• Premium or Discount
CMP – NAV
= + Premium or - Discount
NAV
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Reasons For Premium
Or Discount
• Unrealized Capital Appreciation
• Management Fees and Transfer Costs
• Performance of the Fund
• Turnover
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Open-End Funds
• Load and No-Load Funds
• Prospectus
– Required by law to be provided to investors
• Family of Funds
• Growth of Mutual Funds
– See next slide
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Growth Of Mutual Funds (MFs)
4000
3500
3000
2500
Growth in $millions
Total Assets
2000
1500
1000
500
0
1940 1950 1960 1970 1980 1990 1996
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Growth Of MFs
7000
6000
5000
4000
Growth in Number of
Funds
3000
2000
1000
0
1940 1950 1960 1970 1980 1990 1996
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Closed-End Versus Open-End
Investment Companies
• Closed-end investment company
– Stock trades on secondary market
– Net asset value (NAV) is determined twice daily, but market
price determined by supply and demand
– Discounts from NAV can be opportunities
• Closed-end fund index
• Open-end investment companies
– Mutual funds
– Sell and repurchase shares at NAV
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Benefits Of Investing In MFs
• Diversification
• Professional
• Checking Accounts
• Switching Fund
Management
• Reduced Trading
Costs
• Systematic
Accumulation and
Withdrawal Plans
Services
• Security Custody and
Bookkeeping
• Increasing an
Economy’s Capital
Supply
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Costs Of Investing In MFs
• Load
• Management Fees
• Suboptimal
• 12b-1 Fees
• Transaction Costs
• Higher Income Tax
Investment
• Accounting,
Distribution, and
Other Costs
Rate
• Disadvantage of Being
too Big
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Mutual Fund Costs
• Load versus no-load open-end funds
– Load funds charge sales commission up to 8.5% of
NAV, but usually not a redemption fee
– No-load imposes no initial sales charge, so it sells
shares at NAV, but may charge a small redemption
fee of 1/2%
– Low-load imposes a front-end sales charge in the
3% range
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Types of Investment Companies
Based on Portfolio Objectives
• Common stock funds
– General Equity
– Specialized Equity
– World Equity
• Balanced funds
•…
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Types of Investment Companies
Based on Portfolio Objectives
• Taxable bond funds
– Convertible Securities
– Dual Purpose
– Loan Participations
– Bond
– World Income
• Municipal bond funds
– National Municipal
– Single State Municipal
• Money market funds
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Global Investment Companies
• Foreign funds
– International funds
– Global funds
• Fund categories, regions, countries
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•
•
•
•
•
•
•
•
•
•
•
•
Sources of Information
About Mutual Funds
The Wall Street Journal
Barron’s - weekly and quarterly
Investment Companies
Mutual Funds Update
Mutual Funds Report
Closed-end Weekly Review
FundEdge
Management Results
Forbes
Business Week - “Mutual Fund Scoreboard”
Morningstar Mutual Funds
Value Line
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Ethics and Regulation in the Professional
Asset Management Industry
• Agency - looking out for the interest of another
• Asset management industry is based on handling
•
•
•
•
•
someone else’s money
Investment Company Act of 1940
Securities Act of 1933
Securities Exchange Act of 1934
Investment Advisors Act of 1940
ERISA (1974) - Prudent man rule
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Ethics and Regulation in the Professional
Asset Management Industry
• Association for Investment Management and
Research (AIMR) has a Code of Ethics and
Standards of Professional Conduct
• Chartered Financial Analyst (CFA)
• Compensation dilemma - incentives and risk
• Soft dollars
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Performance of Investment Companies
• Below average returns for actively managed
equity and bond funds
• Do a fund’s objectives matter?
– Positive relationship between stated objectives
and risk measures
• Do managers generally outperform the
market?
– Results are more consistent in shorter time
periods
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Your Portfolio Manager
1. Determine your risk-return preferences and develop a
portfolio that is consistent with them
2. Diversify your portfolio to eliminate unsystematic risk
3. Maintain your portfolio diversification and your desired risk
class while allowing flexibility so you could shift between
alternative investment instruments as desired
4. Attempt to achieve a risk-adjusted performance that is
superior to aggregate market performance
5. Administer the account, keep records of costs, provide
timely information for tax purposes, and reinvest dividends
if desired
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Structuring a Stock Portfolio: The Objective

Semantics are important in any statement of
investment objectives.

The four main portfolio objectives are stability
of principal, income, growth of income, and
capital appreciation.

In a world with taxes, one dollar in capital
gains is worth more than one dollar in
income.

The overriding investment objective is utility
maximization.
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Relative Riskiness of Portfolio Objectives
20
18
capital appreciation
small
company
stocks
expected return
16
14
large company stocks
12
growth
of income
10
intermediateterm
8 government
bonds
6
long-term
corporate bonds
4 T-bills
inflation
2
stability
0 of principal
0
6
12
long-term
government bonds
income
18
24
standard deviation (%)
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30
36
Structuring a Stock Portfolio : Asset Allocation

An asset class refers to a broad category of
investments.

U.S. equities, foreign equities, bonds, and
cash are four widely used asset classes.

The relative distribution of funds across asset
classes is called asset allocation.
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Structuring a Stock Portfolio : Asset Allocation
Portfolio
attitude
toward risk
need for
return
individual choice
stocks
bonds
real
estate
ASSET
CLASSES
cash foreign
equities
asset class mix
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realized
return
and risk
with the
passage
of time
investment results
Structuring a Stock Portfolio: Categories of Stock

A blue chip stock usually has a
long history of uninterrupted dividends.

Income stocks are those that historically
have a higher-than-average payout ratio (the
proportion of net income after taxes paid as
a dividend).

A cyclical stock is one whose fortune is
directly tied to the state of the overall
national economy.
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Structuring a Stock Portfolio: Categories of Stock

A defensive stock is largely immune to
changes in the economy.

Growth stocks reinvest most of their
earnings rather than paying them out as
dividends and may be good candidates for
above-average returns.

A speculative stock has a high probability of
a loss and a small probability of a large
profit.

Penny stocks refer to unusually risky,
especially inexpensive shares.
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Structuring a Stock Portfolio :
Active vs. Passive Management

A strategy of passive management is one in
which, once established, the portfolio is
largely left alone.

An active management policy, in contrast, is
one in which the composition of the portfolio
is dynamic.
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Index Funds
• Replicate a Given Index
– S&P 500 index
• Holds No Cash
• Sell Stock
– When investors redeem shares
• No Telephone Sales
• Redemption Fee
– Time factor
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Ranking Global Fund
Performance
• Forbes Global Stock Fund Composite
• Blended Domestic and Foreign Index
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Portfolio Project Notes:
The Portfolio Management Process
The Portfolio Management Process
1. Policy statement - Focus: Investor’s short-term and longterm needs, familiarity with capital market history, and
expectations
2. Examine current and project financial, economic,
political, and social conditions - Focus: Short-term and
intermediate-term expected conditions to use in
constructing a specific portfolio
3. Implement the plan by constructing the portfolio - Focus:
Meet the investor’s needs at the minimum risk levels
4. Feedback loop: Monitor and update investor needs,
environmental conditions, portfolio performance
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The Portfolio Management Process
1. Policy statement
– specifies investment goals and
acceptable risk levels
– should be reviewed periodically
– guides all investment decisions
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The Portfolio Management Process
2. Study current financial and
economic conditions and forecast
future trends
– determine strategies to meet goals
– requires monitoring and updates
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The Portfolio Management Process
3. Construct the portfolio
– allocate available funds to meet
goals and minimize investor’s risks
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The Portfolio Management Process
4. Monitor and update
– revise policy statement as needed
– modify investment strategy
accordingly
– evaluate portfolio performance
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The Need For A Policy Statement
• Understand and articulate realistic investor
goals
– needs, objectives, and constraints
– financial markets and risks of investing
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Constructing A Policy Statement
• What are the real risks of an adverse
financial outcome, especially in the short
run?
• What probable emotional reactions will I
have to an adverse financial outcome?
• How knowledgeable am I about investments
and markets?
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Constructing A Policy Statement
• What other capital or income sources do I
have? How important is this particular
portfolio to my overall financial position?
• What, if any, legal restrictions may affect
my investment needs?
• What, if any, unanticipated consequences of
interim fluctuations in portfolio value might
affect my investment policy?
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Standards For Evaluating
Portfolio Performance
• Benchmark portfolio
– risk and return
• Matches risk preferences and
investment needs
– analysis of risk tolerance
– return objective goals
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Realistic Investor Goals
• Capital preservation
– minimize risk of real loss
– strongly risk-averse or funds needed soon
• Capital appreciation
– capital gains to provide real growth over time for future
need
– aggressive strategy with accepted risk
• Current income
– generate spendable funds
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Realistic Investor Goals
• Total return
– capital gains and income reinvestment
– moderate risk exposure
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Investment Constraints
• Liquidity needs
– near-term goals
• Time horizon
– longer time horizon favors risk acceptability
– short time horizon favors less risky investments
because losses are harder to overcome in a short
time frame
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Investment Constraints
• Tax concerns
– interest and dividends taxed at investor’s
marginal tax rate
– capital gains may be unrealized
– basis and gain or loss realized
– revisions to capital gains tax rates
– tradeoff with diversification needs for
employer’s stock holdings
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Investment Constraints
• Tax concerns (continued)
– interest on municipal bonds exempt from
federal income tax and from state of issue
– interest on federal securities exempt from state
income tax
– contributions to an IRA may qualify as
deductible from taxable income
– tax deferral considerations - compounding
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Effect of Tax Deferral on
Investor Wealth over Time
Figure 2.5
Investment
Value
$10,063
8% Tax
Deferred
$5,365
5.76%
After Tax
Return
$1,000
0
10
20 Inc.
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Time
30 years
Legal and Regulatory Factors
• Limitations or penalties on withdrawals
• Fiduciary responsibilities “prudent man” rule
• Investment laws prohibit insider trading
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Unique Needs and Preferences
• Personal preferences - socially conscious
investments
• Time constraints or expertise for managing the
portfolio may require professional management
• Large investment in employer may require
consideration of diversification needs and realistic
liquidity
• Institutional investors needs
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Constructing the Policy Statement
• Objectives - risk and return
• Constraints - liquidity, time horizon, tax
factors, legal and regulatory constraints, and
unique needs and preferences
• Developing a plan depends on
understanding the relationship between risk
and return and the importance of
diversification
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The Importance
of Asset Allocation
• An investment strategy is based on four
decisions
– What asset classes to consider for investment
– What normal or policy weights to assign to each
eligible class
– The allowable allocation ranges based on policy
weights
– What specific securities to purchase for the
portfolio
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The Importance
of Asset Allocation
• Most (85% to 95%) of the overall
investment return is due to the first two
decisions, not the selection of individual
investments
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Returns and Risk of Different
Asset Classes
• Higher returns compensate for risk
• Policy statements must provide risk
guidelines
• Measuring risk by standard deviation of
returns over time indicates stocks are more
risky than T-bills
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Returns and Risk of Different
Asset Classes
• Measuring risk by probability of not
meeting your investment return objective
indicates risk of equities is small and risk of
T-bills is large because of different expected
returns
• Focusing only on return variability ignores
reinvestment risk
• Changes in returns from year to year
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Asset Allocation Summary
• Policy statement determines types of assets
to include in portfolio
• Asset allocation determines portfolio return
more than stock selection
• Over long time periods sizable allocation to
equity will improve results
• Risk of a strategy depends on the investor’s
goals and time horizon
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Asset Allocation and
Cultural Differences
• Social, political, and tax environments
• U.S. institutional investors average 45%
allocation in equities
• In the United Kingdom, equities make up
72% of assets
• In Germany, equities are 11%
• In Japan, equities are 24% of assets
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Summary
• Develop an investment policy statement
– Identify investment needs, risk tolerance, and
familiarity with capital markets
– Identify objectives and constraints
– Investment plans are enhanced by accurate
formulation of a policy statement
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Summary
• Asset allocation determines long-run returns
and risk
– Success depends on construction of the policy
statement
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