P.V. VISWANATH
FOR A FIRST COURSE IN INVESTMENTS
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 What are investment companies?
 What are the different kinds of investment
companies?
 What are the different kinds of mutual funds?
 How are they sold?
 What are exchange-traded funds?
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 Record keeping and administration
 Diversification and divisibility
 Professional management
 Active portfolio management
 Tax minimization
 Lower transaction costs
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 Unit Investment Trusts
 Closed-end Mutual Funds where there is no trading in the
underlying assets
 Managed Investment Companies
 Open-end funds (mutual funds)
 Closed-end funds
 Commingled funds
 These are similar to mutual funds, but they are not open to all
investors and hence have less regulation and disclosure
 REITs
 Corporate entities investing in real estate that pay out 90% of
their income; in return they don’t have to pay corporate taxes
 Hedge funds
 Mutual funds that are structured as private partnerships and have
minimal SEC regulation
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 Money Market Funds
 Equity Funds
 Sector Funds
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Concentrate on a particular sector
 Bond Funds
 International Funds
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Invest in securities of firms located outside the US
 Balanced Funds
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Hold stocks and bonds; meant to be an individual’s entire portfolio
Life cycle funds take the investor’s age into account
 Asset Allocation Funds and Flexible Funds
 Index Funds
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 Directly by the Fund Underwriter/Distributor, who
 Creates prospectus for the fund
 Develops marketing campaigns (tv, internet, magazine)
 Sells the shares directly to the public
 Provides a wholesale market to reach a larger number of
investors
 Indirectly through brokers or financial advisers
 Funds pay brokers for preferential treatment when making
investment recommendations – revenue sharing. Note conflict
of interest!
 Fund Supermarkets
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Operating Expenses
Front-End Load
Back-End
12b-1 charges
Soft dollars
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A portfolio manager earns soft dollar credits with a brokerage firm by directing the
fund’s trades to that broker. On the basis of these credits, the broker will pay for
some of the fund’s expenses. Purchases made with soft dollars are not included in
the fund’s expenses, so funds with soft-dollar arrangements may report artificially
low expense ratios. However, the fund may have paid the broker needlessly high
commissions; alternatively the broker may not provide good execution. This will
show up in lower returns. But this signal is much noisier..
 Late Trading
 The practice of allowing some traders to buy or sell after the market has closed and
the NAV has been established – these traders can then time the market.
 Tax inefficient trading
 Unnecessary generation of capital gains, which are passed on investors and causes
them to lose out on the timing option.
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 Issues (or redeems) creation units in exchange for the deposit
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(or delivery) of basket assets the current value of which is
disseminated per share by a national securities exchange at
regular intervals during the trading day;
Identifies itself as an ETF in any sales literature;
Issues shares that are approved for listing and trading on a
securities exchange;
Discloses each business day on its publicly available web site
the prior business day's net asset value and closing market
price of the fund's shares, and the premium or discount of the
closing market price against the net asset value of the fund's
shares as a percentage of net asset value; and
Either is an index fund, or discloses each business day on its
publicly available web site the identities and weighting of the
component securities and other assets held by the fund.
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 An ETF is similar to an open-ended fund in some ways – for
example, there can be withdrawals from the fund and there
can be additions to the fund. However, the way in which this
happens is crucially different.
 With an open-ended fund, investors sell back to the fund or
invest additional money with the fund, which then buys
additional shares.
 With an ETF, investors buy from or sell shares to other
investors. Addition to or reduction of the size of the fund
occurs when entities called Authorized Participants (AP)
exchange ETF shares for the shares of the financial assets
(stocks in a stock ETF) that underlie the ETF. They buy or sell
these financial assets in the open market.
 The actions of these APs ensures that the ETF trading price is
close to the NAV of the fund. This happens directly with an
open-ended mutual fund because the fund stands ready to buy
or sell at the NAV.
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 An ETF allows investors to trade during the day, while an investor
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in an open-ended mutual fund (MF) can only buy or sell at the endof-day price.
ETF investors have relatively high transactions costs (brokerage
fees) because their trades are likely to be small. In a MF, the fund
does the trading and can do it more cheaply.
However, since an MF has to trade large amounts, market impact
costs could be high; ETF trades don’t have this problem. However,
an investor disinvesting from an MF doesn’t bear this cost because
s/he gets the NAV. In other words, a MF investor buys illiquidity
insurance, which is spread out among all the MF investors.
However this insurance is not valuable for the long-term investor
who only trades infrequently. Hence, in equilibrium, MFs may have
short-term investors, while ETFs may have long-term investors.
On the other hand, investors who believe they have above-average
proficiency in short-term market timing would want to use ETFs.
(The evidence suggests that most such investors have incorrect
beliefs.)
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 According to an Economist article (Jan 2010), the
average expense ratio for ETFs was 0.31% at the end
of 2009, while it was about 0.78 for index-tracking
MFs.