Investments, 8 th edition Bodie, Kane and Marcus Slides by Susan Hine McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. CHAPTER 4 Mutual Funds and Other Investment Companies

4-2 Investment Companies -Collecting funds from individuals -Investing in a big portfolio -How it works Investment company forms portfolio Sells investors shares in the portfolio investors have claim to the portfolio, proportional to their number of shares

4-3 Investment Companies These companies perform several important functions for investors: –Administration & record keeping: capital gains, dividends and so on –Diversification & divisibility:i.e. by pooling of assets –Professional management: security analysts etc. –Reduced transaction costs

4-4 Net Asset Value Used as a basis for valuation of investment company shares for –Selling new shares –Redeeming existing shares( buying back) Calculation: NAV= Market Value of Assets - Liabilities Shares Outstanding

4-5 Types of Investment Companies Unit Investment Trusts: pool of money invested in portfolio; its portfolio is fixed, unmanaged. -Brokerage firm buys and forms portfolio -Sells shares in that trust called units or redeemable trust certificates -All money from portfolio is distributed to share holders by trustee, i.e. company which manages portfolio e.g. -Trust bourght portfolio for $ 5 million -Sells 5,000 shares at $1,030 per share -3% premium per share obtained by trustee

4-6 Types of Investment Companies Managed Investment Companies; portfolio is managed Board of directors, elected by shareholders, hires management company for fee of 0.2 to 1.5% of assets value - Open-End (called mutual funds) Open-end: shares redeemed, new shares issued at NAV; shares outstanding change when new shares are issued or old shares are redeemed Priced at Net Asset Value(NAV)

4-7 Types of Investment Companies - Closed-End Not redeemed, no new share issue No change in shares outstanding Shares traded on organized exchanges and can be sold and bought at market price (unlike open-end mutual funds shares) May be priced at Premium or discount to NAV Fig 4.1 MKT PRICE: share price PREM/DISC %: (Price-NAV)/NAV 52 WEEK RETURN: based on percentage price change + dividend

4-8 Figure 4.1 Closed-End Mutual Funds

4-9 Types of Investment Companies Puzzle of divergence of share price and NAV Puzzle of issue price of share above NAV Naturally, mutual fund share not traded on organized exchages

4-10 Types of Invest. Companies Continued Other investment organizations Not as organized as investment companies but similar to them in function -Commingled funds: units are issued (like shares). Like open-end, they're trades at NAV. e.g. money market fund, bond fund, common stock fund often offered by Bank or insurance company -Real estate investment trusts (REITs): equity trust, mortgage trust -Like closed-end, issuing shares and investing in real estates or mortgages -usu., bank or insurance company forms REIT and serves as trust manager and earns fee

4-11 Types of Invest. Companies Continued -Hedge funds -Like mutual funds but private partnership so under minimal SEC regulation -can make heavy use of risky, profitable assets -very often initial lock-ups

4-12 Mutual Funds—Investment Policies Money Market Funds Equity Funds -Sector Funds, Income or Growth Fund Bond Funds, often specializing by types Balanced Funds, across all secrities International(global, regional, emerging market) Asset Allocation and Flexible; like balanced but vary much in portfolios Index, forms portfolio of index

4-13 Table 4.1 U.S. Mutual Funds by Investment Classification

4-14 How Funds Are Sold Direct-marketed funds; mails, phone, internet etc. Sales force distributed: brokers, advisers on commission -Revenue sharing on sales force –Potential conflicts of interest Financial Supermarkets; sell shares of many funds

4-15 Costs of Investing in Mutual Funds Fee Structure –Operating expenses; cost of operating portfolio, inc. administration and advisory cost –Front-end load:when you buy a share –Back-end load:when you redeem a share 12 b-1 charges, authorized by SEC, up to 1% of average NAV per year distribution costs paid by the fund Alternative to a load Funds offer several combination of above fees

4-16 Fees and Mutual Fund Returns

4-17 Fees and Mutual Fund Returns: An Example Initial NAV = $20 Income distributions of $.15 Capital gain distributions of $.05 Ending NAV = $20.10:

4-18 Table 4.2 Impacts of Costs on Investment Performance

4-19 Trading Scandal with Mutual Funds -Every day, calculates NAV at the close of the market. -All orders of the day are executed at that NAV after the close of the market. Late trading – allowing some investors to buy or sell after market closes and NAV fixed Market timing – allowing investors to buy or sell on stale NAV after the lose of the regional markets in International funds (e.g.Japanese) Why allow? Management fee for big investment Net effect is to transfer value from other shareholders to privileged traders –Reduction in the rate of return of the mutual fund

4-20 Potential Reforms Strict 4:00 PM cutoff with late orders executed the following trading day Fair value pricing: in NAV, adjust prices of securities of closed markets to reflect impact of prices of securities in still open markets Imposition of redemption fees of more than 2% for shares sold within a week of buy, paid directly to funds not to management company

4-21 Taxation on Mutual Fund Income Pass-through status under the U.S. tax code i.e. taxes are paid only by investor, not by fund High turnover(replacement of assets in the fund) leads to high tax inefficiency Last decade turnover: 60% in equity funds, 2% in index funds

4-22 Exchange Traded Funds ETF allow investors to trade index portfolios like shares of stock (continuous price quote) Examples – Spider (for S&P 500), Diamond (for DJIA), Cube(for NASDAQ 100), WEBS(World equity benchmark shares) Potential advantages –Lower taxes; redeem many→fund sells securities→capital gain tax –Trade continuously +short sale, buying on margin –Lower costs; for fund doesn’t market to investors, who buy from brokers. So low management fees Potential disadvantages –Prices can depart by small amounts from NAV

4-23 Table 4.3 EFT Sponsors and Products

4-24 Mutual Fund Investment Performance: A First Look Evidence shows that average mutual fund performance is generally less than broad market performance But there are good managers and bad managers. Then, do the former perform consistently well? Hence the following test. Evidence that performance is consistent from one period to the next is suggestive but inconclusive. Table 4.4

4-25 Figure 4.2 Diversified Equity Funds versus Wilshire 5000 Index

4-26 Table 4.4 Consistency of Investment Results

4-27 Information on Mutual Funds Prospectus+Statement of additional information (SAI) Wiesenberger’s Investment Companies Morningstar ( Yahoo (biz.yahoo.com/funds)biz.yahoo.com/funds Investment Company Institute ( Directory of Mutual Funds