CHAPTER 4: INVESTMENT
COMPANIES
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Definition: financial intermediaries that collect
funds from individual investors and invest those
funds in a potentially wide range of securities
Administration & record keeping
◦ issue periodic status reports, keeping track of capital gain
distributions, dividends, investments, and redemption
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Diversification & divisibility: diversify portfolios and
investors can buy fractional shares of many
different securities
Professional management: full-time staffs of
security analysts and portfolio managers
Reduced transaction costs: can achieve substantial
savings on brokerage fees and commissions
because of large transactions
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Net Asset Value
◦ Used as a basis for valuation of investment
company shares
◦ Selling new shares
◦ Redeeming existing shares
Calculation:
Market Value of Assets - Liabilities
Shares Outstanding
Example: Consider a mutual fund that manages a portfolio of
securities worth $120 mil. Suppose the fund owes $4 mil to
its investment advisers and owes another $1mil for rent,
wages and other expenses. The fund has 5mil shares
outstanding. What is NAV of the fund
4.2 TYPES OF INVESTMENT COMPANIES
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Pools of money from many investors that is
invested in a portfolio fixed for the life of the
fund
Little active management
Example: invest in municipal bond, corporate
bond
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Hire managers to manage portfolio
Open-End
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Closed-End
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◦ stand ready to redeem or issue shares at their net
asset value. If investors in open-end funds want to
cash out shares, they sell back to the fund at NAV
◦ Funds cannot issue or redeem shares. Investors
who want to cash out must sell shares to other
investors
◦ Sold at premium or discount to NAV
◦ Shares of close-end fund are traded on organized
exchanges just like other common stocks.
◦ Commingled funds
 partnership of investors that pool their funds. Similar
to open-end fund. Example: trust or retirement
account that have portfolios much larger than those
of most individual investors but still too small to
warrant managing on a separate basis
◦ REITs: similar to closed-end fund but invest in
real estate or loans secured by real estate
◦ Hedge Funds
 like mutual fund: hedge fund allows private investors
to pool assets to be invested by a fund manager
 Unlike mutual fund: hedge fund are commonly
structured as private partnerships and are not subject
to many SEC regulations
4.3 MUTUAL FUNDS
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mutual fund is a common name for openend investment company. Account for >90%
of investment company asset.
Described in the prospectus
Management companies manage a family of
mutual funds. Some examples include:
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Fidelity
Vanguard
Putnam
Dreyfus
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Money Market: invest in money market
securities.
Equity: invest in stocks
◦ Income fund and growth fund
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Specialized Sector: sector funds
Bond: invest in bond
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Balanced Funds: hold both equities and
fixed income securities in relatively
stable proportions to meet needs of
individual investors
Asset Allocation and Flexible: similar to
balance funds but the proportion can
change according to managers’ forecasts
Indexed: match performance of a broad
market index. Example: Vanguard 500
Index Fund International
4.4 COSTS OF INVESTING IN
MUTUAL FUNDS
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Fee Structure
◦ Front-end load: commission or sale charge
paid when purchasing the shares
◦ Back-end load: redemption or exit fee
incurred when you sell shares.
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Operating expenses
12 b-1 charges
 distribution costs paid by the fund
 Alternative to a load
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Fees and performance
NAV1  NAV0  Income and capital gain distributions
Rate of return =
NAV0
Initial NAV = $20
Income distributions of $.15
Capital gain distributions of $.05
Ending NAV = $20.10:
$20.10 - $20.00 + $.15 + $.05
Rate of Return =
 1.5%
$20.00
Example: you purchased 1000 shares of the
New Fund at a price of $20 at the beginning of
the year. You paid a front-end load of 4%. The
securities in which the fund invests increase in
value by 12% during the year. The fund’s
expense ratio is 1.2%. What is your rate of
return on the fund if you sell your shares at
the end of the year.
4.6 EXCHANGE-TRADED FUNDS
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ETF allow investors to trade index
portfolios like shares of stock
Examples – SPDRs, Diamonds, and WEBS
Potential advantages
◦ Trade continuously
◦ Lower taxes
◦ Lower costs
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Potential disadvantages
◦ mispricing
◦ broker fees
4.7 MUTUAL FUND INVESTMENT
PERFORMANCE: A FIRST LOOK
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Evidence shows that average mutual fund
performance is generally less than broad
market performance
Evidence suggests that over certain
horizons some persistence in positive
performance
◦ Evidence is not conclusive
◦ Some inconsistencies
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4.8 INFORMATION ON MUTUAL FUNDS
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Wiesenberger’s Investment Companies
Morningstar (www.morningstar.com)
Yahoo (finance.yahoo.com/funds)
Investment Company Institute
Popular press
Investment services