Chapter 8
Investment Companies
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Investment Companies
Two Types
• Closed-end
• Open-end (commonly called a
mutual fund)
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Important General Information
• Net asset value (NAV) - the value
of a share
• Taxation - pass through vehicles
• Professional management
• Portfolio diversification
• Growth in mutual funds
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Closed-end Investment
Companies
• Have a fixed capital structure
• Shares are bought and sold in the
secondary markets
• Shares may sell for a premium or
discount from NAV
• Tendency for shares to sell at a
discount from NAV
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Sources of Return to the
Investor
• Income distributed in the form of
dividends
• Capital gains distributions
• Appreciation in the NAV
• Change in the discount/premium
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Open-end Investment
Companies - Mutual Funds
• Have a variable capital structure
• Shares are bought and sold from
the mutual fund
• Shares cannot sell for a discount
from NAV
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The Load Fee
• Charged to investor when the
shares are purchased
• Compensates the sales person
(i.e., is analogous to brokerage
commissions for buying securities)
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The Load Fee
• Varies with dollar amount
purchased
• Load expenses mean investors pay
a premium over the fund's NAV
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No-load Mutual Fund
• Mutual fund without a sales charge
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Other Fees and Expenses
• Early withdrawal fees (or exit fees)
• Management fees
• Operating expenses
• 12b-1 fees
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Mutual Fund Portfolios
• May be classified by
–type of investment
–investment style
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Types of Investments
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Growth funds
Balanced funds
Income funds
Growth and income funds
Specialized funds
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Specialized Funds
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Sector funds
Bond funds
Index funds
Tax-exempt bond funds
Single country or regional funds
Exchange - traded - funds
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Investment Styles
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Large cap
Mid-size cap
Small cap
Growth
Value
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Capitalization
• Total market value of a company’s
stock
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Growth
• A strategy designed to identify
companies that offer exceptional
opportunity for capital appreciation
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Value
• A strategy designed to identify
companies whose stock price
appears to be below some estimate
of the firm's intrinsic value
• Stocks that are undervalued
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Advantages Offered by Funds
• Diversification
• Professional management
• Custodial and other services
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Returns
• Advantages do not necessarily
include superior returns
• Tendency to underperform the market
• Returns in an efficient market context
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Factors that Affect Returns
• Expenses
• Fees
–load fees and exit fees
–12b-1 fees
• Movements in the market
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Before and After - Tax Returns
• Fund returns are before tax
• Shareholders pay applicable taxes
• Shareholders realize after-tax
returns
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Performance Evaluation
• CAPM as a theoretical basis for
comparison
• Market benchmark used in the
CAPM is often the S&P 500 stock
index
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Performance Evaluation
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Performance Evaluation
• Figure indicates the return that
should be earned for each level of
risk
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Composite Performance
Measures: The Jensen Index
• a = rp - [rf + (rm - rf) beta]
• The alpha measures whether the
actual return exceeds the return
that should have been earned
based on the CAPM
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The Composite Performance
Measures: The Treynor Index
• rp - rf
beta
• Standardizes the return in excess
of the risk-free return by the
portfolio's beta
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The Composite Performance
Measures: The Treynor Index
• Uses the portfolio's volatility as the
measure of risk
• Assumes that the portfolio is well
diversified, so the beta (which
measures systematic risk only) is
the appropriate measure of risk
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The Composite Performance
Measures: The Sharpe Index
• rp - rf
standard deviation
• Standardizes the return in excess
of the risk-free return by the
portfolio's standard deviation
• Uses the portfolio's variability as
the measure of risk
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The Composite Performance
Measures: The Sharpe Index
• Does not assume that the portfolio
is well diversified
• Standard deviation (which
measures total risk) is the
appropriate measure of risk
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Comparing Realized Returns
to Market Returns
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Comparing Realized Returns
to Market Returns
• If the realized return lies above the
security market line, performance
exceeded the market return on a riskadjusted basis
• If the realized return lies below the
security market line, performance was
inferior to the market return on a riskadjusted basis
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Comparing Realized Returns
to Market Returns
• Absolute returns do not necessarily
indicate inferior or superior returns
(Compare points X and Y)
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The Benchmark Problem
• The comparisons use an aggregate
measure of the market
• The composition of many portfolios
are not comparable to the market
• Examples would be specialized
funds or global funds
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