Chapter 10
Investment Companies
Types of Investment Companies
• Open-end
– Mutual fund
– Price based on NAV
• Closed-end
– Stock publicly traded
• Dual purpose investment company
– two classes of shares
• REITs and RELPs
– Real estate applications
(continued)
Types of Investment Companies
(continued)
• Unit investment trusts
– Unmanaged
– Self-liquidating
– Largely consisting of short-term debt securities
• Hedge funds
– Typically organized as offshore limited partnerships for
qualified investors
– Maximum investment flexibility
• Variable annuities
– Mutual fund type of instrument originating at insurance
companies
Net Asset Value (NAV)
• Per-share market value of mutual fund’s
portfolio:
NAV = (total assets – total liabilities) 
number of shares outstanding
Fair-Value Pricing
• Problem created by asynchronous closing of
markets
• SEC mandated solution
• funds should use what they believe is the
appropriate price of securities with stale
prices, rather than the official close
Types of Mutual Funds
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Common stock funds
Hybrid funds
Bond funds
Money market funds
Others
Common Stock Fund
• Mutual fund that holds portfolio primarily consisting
of common stocks and perhaps a small number of
preferred stocks
• Subcategories include investments in:
– conservative (defensive) stocks
– growth stocks
– aggressive growth stocks
– foreign stocks
Hybrid Fund
• Mutual fund that owns portfolio of bonds,
stocks, and other investment instruments.
• Subcategories include
– balanced funds
– growth and income funds
Bond Fund
• Mutual fund that owns portfolio of bonds.
Subcategories include funds that invest in:
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U.S. government issues
Municipal issues
Corporate issues
Low-quality (junk) bonds
• Subcategories can be short-term (up to 5
years), intermediate-term (5 to 10 years), or
long-term (10 or more years) bonds
Money Market Mutual Fund
• Mutual fund that invests in short-term,
highly liquid securities—that is, primarily
or exclusively money market securities
– Taxable
– Tax-Exempt
Index Fund
• Mutual fund that owns a portfolio of either
common stock or bonds that replicates a major
market index, such as the S&P 500 or Lehman
Brothers Aggregate Bond Index
• Index funds are low-cost funds that are especially
useful in passive investment strategies in which
the investor is satisfied to match performance of
index.
Specialty Fund
• Mutual fund designed for investors who
seek special investment opportunities.
• Examples include:
– Sector or industry funds such as gold
related stocks
– Regional stocks such as sunbelt
– Gimmick funds such as race car related
stocks
International Funds
• Mutual fund that specializes in investments
outside the U.S. and helps investor to
further diversify his or her portfolio
• May specialize in
– Specific countries
– Regions such as Pacific Rim
Global Fund
• Mutual fund that invests in U.S. and foreign
markets
• General philosophy:
– We live in global economy and capital should
flow toward regions that offer optimal riskreturn combinations.
Asset Allocation Fund
• Mutual fund that allows managers
considerable flexibility in allocating
portfolio among three major asset categories
—stocks, bonds, and money market
instruments—as market conditions change
Life-cycle Fund
• Appeals to investors in specific stages of
life
• Retirement date funds
• Two approaches
– Specific securities
– Fund of funds
Socially Responsible Fund
• Mutual fund that invests only in corporations or
other entities that maintain social and/or ethical
principles consistent with those specified by fund.
• Example:
– Fund may elect not to invest in any company that
produces tobacco products or other products associated
with potential health hazards.
Forms of Return
• Price Appreciation: Increase in NAV
• Dividends and Interest: Pass-through of
dividends and interest received on portfolio
– Regular dividend
• Capital Gain Distribution: Payment of net
capital gain recognized by fund during year
Reinvestment Strategies
• Reinvest regular & CG distribution
– Makes most sense in a qualified account
• Reinvest CG distribution & take regular as
cash distribution
– Concept of “not touching the principal”
• Reinvest regular & take CG as cash
– Rarely suggested
• Same tax treatment on all
Family of Funds
• Group of mutual funds owned and marketed
by same company
• Advantages:
– Exchange privilege
– Convenience of dealing with one
company
Load
• Selling fee applied to mutual fund purchase,
similar to commission
• Maximum load charge = 8.5%
• Based on gross purchase price
– $1,000 purchase means $915 invested if
maximum load
(continued)
Load (continued)
• Many funds have breakpoints for load
charges
• Rights of accumulation
• Letter of intent
• Back-end load (contingent deferred sales
charge)
Price of a Load Share
PL =
where PL =
L =
NAV/(1 – L)
ask price including load
load percentage
Operating Expenses
• Investment advisory fee
• 12b-1 fee
– trail commission or trailer
• Brokerage fees
– Measured by portfolio turnover ratio
• Other Fees
– Examples: exchange fees, account maintenance
fees, reinvestment loads
Switching
• Money moved from one fund to another
– Both inter- and intra- familty exchanges
• If intra-family & paid load on initial
purchase, waived on switch if second fund
is also a load fund
Classes of Shares
• 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
Distribution Systems
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direct marketing
captive sales force
broker-dealers
financial planners
Advantages of Mutual Funds
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Professional portfolio management
Diversification (risk reduction)
Convenience
Record keeping
Other factors
– Examples: liquidity, minimal investment
requirements, regulation
Disadvantages of Mutual Funds
• 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).
Prospectus
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the fund’s investment objectives
the fund’s investment policies
general information about risks
tables showing the loads and other expenses
additional information
Governance
• Like any other corporation
– Inside director
– Outside director
• Funds where directors have more money
invested do better!
Closed-End Companies
• Trade in secondary market (exchanges or OTC)
– No prospectur
• Rarely trades at NAV
– Usually at discount, but occasionally at premium
• Embedded tax liabilities
• Some of holdings may not be marketable
• Conversion to open-end form
– May produce windfall gains for investors
– Sometimes have exit fees for those redeeming
immediately after conversion
Managed Distribution Policy
• A guaranteed cash distribution based on
NAV at start of year
– Provided even if have to return principal
– Provides sense of safety because of guarantee
of cash payout each year
Dual Purpose Investment
Companies
• Two classes of shares
– Income share (like a preferred stock)
– Capital Appreciation share
• Termination date of fund
– Portfolio liquidated
– Income share paid off at par
– Residual goes to capital appreciation shares
REITs, RELPs, & REMICs
• Equity REIT: real estate investment trust
that invests in office buildings, apartments,
hotels, shopping malls, and other real estate
ventures
• Mortgage REIT: real estate investment
trust that holds construction loans and/or
mortgage loans
(continued)
REITs, RELPs, & REMICs
(continued)
• Hybrid REIT: real estate investment trust
that is combination of equity and mortgage
investments
• RELP: type of investment organized as
limited partnership that invests directly in
real estate properties
• REMIC: Real estate mortgage investment
conduits
Unit Investment Trusts (UITs)
• Unmanaged, self-liquidating
• Most UITs are debt (primarily short-term) but
some are equity (may have liquidation date for
portfolio)
• Some UITs are equity
– Liquidation date
– Example: Dogs of the Dow portfolios
Advantages of UITs
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Convenience
Low cost for holding diversified portfolio
Stable portfolio
Tax efficiency
No or minimal management fees
Disadvantages of UITs
• May not find UIT to match investment goal
• Front-end loads can be hefty
• Lack of resale market
Exchange Traded Funds
• Portfolio mimics a specified index
• Creation units
ETFs: Advantages over Index Funds
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Traded on daily basis like any other stock
Can buy on margin
Low management fees
Extremely tax efficient
Likely to track index more closely
Index Funds: Advantages over ETFs
• Most are no-loads
• ETFs trade on bid-ask spread, in addition to
commission
• Always trade at NAV, ETFs sometimes
trade at a slight discount
Hedge Funds
• Pooled portfolio instrument organized for
maximum investment flexibility
– Typically invest in derivatives, sell short, use
leverage, and invest internationally
– Take substantial risks, seeking correspondingly
large rewards
– Typically organized as limited partnerships and
allow only “qualified investors” to participate
Variable Annuities
• Purchased from insurance company
– Account separate from assets of the insurance
company
– Can be variable during the accumulation period
or the payout period
– Considered securities under federal law
• Assets accumulate on a tax-deferred basis
Alternative Ways of Organizing
Pooled Portfolios
• 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.
SMAs and PMAs
• Separately managed accounts & privately
managed accounts
– An SMA is a PMA opened through a broker or
financial advisor who uses pooled money to
buy individual assets
– About 80% of SMAs sold via major brokerage
firms
– A mutual fund with personalized holdings
Selecting a Mutual Fund
• First step, identify appropriate category
based on client’s objectives & risk tolerance
• Third party evaluations
• Fees & Expenses
• Diversification/concentration
• Experience, qualifications, and longevity of
the fund’s manager
When to Sell a Fund
• Style Drift
• Significant change in asset allocation
• Extended poor performance (esp. if
associated with high fees)
– Should look at least at 3-year record
Why Funds Underperform the
Market
• Hold a large part of the market & have a fee
structure
• Other institutional investors have the same
advantages
• Have some cash holdings due to cash
inflows & outflows