1. 4 Mutual Funds and Other Investment Companies Bodie, Kane, and Marcus
Essentials of Investments, 9th Edition

2. 4.1 Investment Companies Functions Definitions
Record keeping and administration
Diversification and divisibility
Professional management
Lower transaction costs
Definitions
Investment company: Financial intermediaries
Net asset value (NAV): Assets minus liabilities per share

3. 4.2 Types of Investment Companies
Unit Investment Trusts
Money pooled from many investors is invested in portfolio fixed for life of fund
Managed Investment Companies
Open-end fund: Issues or redeems shares at net value
Closed-end fund: Shares can’t be redeemed, are traded at prices different than NAV
Load: Sales commission charged on mutual fund

4. 4.2 Types of Investment Companies
Open-End and Closed-End Funds: Key Differences
Shares Outstanding
Closed-end: No change unless new stock offered
Open-end: Changes when new shares are sold or old shares are redeemed
Pricing
Open-end: Fund share price = Net asset value (NAV)
Closed-end: Fund share price may trade at premium or discount to NAV

5. Figure 4.1 Closed-End Mutual Funds
NAV
Mkt Price
Prem/Disc %
52 Wk Return %
Adams Express Company (ADX)
12.89
11.11
−13.81
26.13
Advent/Clay Enhcd G&I (LCM)
12.16
11.58
−4.77
23.52
BlackRock Equity Div (BDV)
10.65
10.03
−5.82
27.39
BlackRock Str Eq Div Achv (BDT)
11.8
10.68
−9.49
26.17
Cohen & Steers CE Oppty (FOF)
14.64
13.46
−8.06
25.17
Cohen & Steers Dvd Mjrs (DVM)
14.70
13.82
−5.99
49.28
Eaton Vance Tax Div Inc (EVT)
18.75
17.19
−8.32
29.89
Gabelli Div & Inc Tr (GDV)
18.64
16.58
−11.05
43.52
Gabelli Equity Trust (GAB)
6.08
6.10
0.33
48.48
General Amer Investors (GAM)
32.71
28.26
−13.60
30.93
Guggenheim Enh Eq Inc (GPM)
9.58
9.65
0.73
38.93

6. 4.2 Types of Investment Companies
Other Investment Organizations
Commingled Funds
Partnership of investors pooling funds; designed for trusts/larger retirement accounts to get professional management for fee
Real Estate Investment Trusts (REITs)
Similar to closed-end funds, invests in real estate/real estate loans
Hedge Funds
Private speculative investment pool, exempt from SEC regulation

7. 4.3 Mutual Funds Investment Policies Money market funds Equity funds
Commercial paper, repurchase agreements, CDs
Equity funds
Invest in stock, some fixed-income, or other securities
Specialized sector funds
Concentrate on particular industry
Bond funds
Specialize in fixed-income (bonds) sector

8. 4.3 Mutual Funds Investment Policies International funds
Global funds invest in securities worldwide, including U.S.
International funds invest outside U.S.
Regional funds focus on particular part of world
Emerging market funds invest in developing nations

9. 4.3 Mutual Funds Investment Policies Balanced funds
Hold both equities and fixed-income securities in stable proportion
Life-cycle funds: Asset mix ranges from aggressive to conservative
Static allocation funds maintain stable mix across stocks and bonds
Targeted maturity funds become more conservative as investor ages
Funds of funds: Mutual funds that primarily invest in other mutual funds

10. 4.3 Mutual Funds Investment Policies
Asset allocation and flexible funds
Stocks and bonds—proportion varies according to market forecast
Index funds
Try to match performance of broad market index
Buy shares in securities included in particular index in proportion to security’s representation in index

11. Table 4.1 U.S. Mutual Funds by Investment Classification
Assets ($ billion)
Percent of Total Assets
Number of Funds
Equity Funds
Capital appreciation focus
2,912
24.2%
3,037
World/international
1,660
13.8%
968
Total return
1,950
16.2%
762
Total equity funds
6,522
54.2%
4,767
Bond Funds
Corporate
301
2.5%
293
High yield
157
1.3%
206
World 84
0.7%
122
Government
203
1.7%
Strategic income
560
4.7%
370
Single-state municipal
156
451
National municipal
218
1.8%
224
Total bond funds
1,679
14.0%
1,967
Hybrid (bond/stock) funds
713
5.9%
488
Money market funds
Taxable
2,642
22.0%
548
Tax-exempt
465
3.9%
259
Total money market funds
3,107
25.8%
807
Total
12,021
100.0%
8,029

12. 4.4 Costs of Investing in Mutual Funds
Fee Structure
Operating expenses: Costs incurred by mutual fund in operating portfolio
Front-end load: Commission or sales charge paid when purchasing shares
Back-end load: “Exit” fee incurred when selling shares
12b-1 charges: Annual fees charged by mutual fund to pay for marketing/distribution costs

13. 4.4 Costs of Investing in Mutual Funds
Fees, Loads, and Performance
Gross performance of load funds is statistically identical to gross performance of no-load funds
Funds with high expenses tend to be poorer performers
12b-1 charges should be added to expense ratios
Compare costs with Morningstar

14. 4.4 Costs of Investing in Mutual Funds
NAV and Effective Load
Cost to initially purchase one share of load fund = NAV + Front-end load (%) (if any)
Stated loads typically range from 0 to 8.5%
Load is designed to offset expenses of marketing the fund; it goes to broker who sells fund to investor
Effective load greater than stated load

15. 4.4 Costs of Investing in Mutual Funds
Avoiding the Load
Choose different class of fund shares
Notes:
a Depending on size of investment.
b Depending on years until holdings are sold.
c Including service fee of .25%.

16. 4.4 Costs of Investing in Mutual Funds
Fees and Mutual Fund Returns
Soft dollars: Value of research services brokerage house provides “free of charge” in exchange for business

17. Table 4.2 Impact of Costs on Investment Performance
Notes: Fund A is no-load with .5% expense ratio, Fund B is no-load with 1.5% total expense ratio, and Fund C has an 8% load on purchases and a 1% expense ratio. Gross return on all funds is 12% per year before expenses.
* After front-end load, if any.

18. 4.5 Taxation of Mutual Fund Income
General Tax Rules
Fund not taxed if diversified and income distributed
Investor taxed on capital gain and dividend distributions
Turnover: Ratio of trading activity to assets of portfolio
Portfolio turnover may affect investor’s tax liability

19. 4.5 Taxation of Mutual Fund Income
Implications of Fund Turnover
Fund pays commission costs on portfolio purchases and sales—charged against NAV
Turnover rate measured as annual total asset value bought or sold in a year divided by average total asset value

20. 4.6 Exchange-Traded Funds
Exchange-Traded Funds: Offshoots of mutual funds that allow investors to trade index portfolios
Potential Advantages
Trade continuously throughout day
Can be sold or purchased on margin
Potentially lower tax rates
Lower costs (no marketing, lower fund expenses)

21. 4.6 Exchange-Traded Funds
Potential Disadvantages
Small deviations from NAV possible
Brokerage commission to buy ETF

22. Table 4.3 ETF Sponsors and Products

23. Figure 4.2 Assets in ETFs

24. Figure 4.3 Investment Company Assets under Management, 2010 ($ Billion)

25. 4.7 Mutual Fund Investment Performance
On average, mutual fund performance less than broad market performance
Evidence suggests some persistence in positive performance over certain horizons

26. Figure 4. 4 Average Returns on Diversified Equity Funds vs
Figure 4.4 Average Returns on Diversified Equity Funds vs. Wilshire 5000 Index

27. Table 4.4 Consistency of Investment Results

28. 4.8 Information on Mutual Funds
Sources of Information on Mutual Funds
Morningstar (
Fund prospectus
Yahoo!
The Wall Street Journal
Investment Company Institute (
American Institute of Individual Investors
Brokers

29. Sample Problems
4-29

30. Problem 1
NAV is $10.70 Front-end load is 6% Every dollar paid results in only ____ going toward purchase of shares. Offer price =
$.94
NAV =
1 - load
$10.70 =
1-.06
$11.38
4-30

31. Problem 2
Offer price $12.30 Front-end load is 5% Every dollar paid results in only ____ going toward purchase of shares. NAV = = $12.30 x 0.95 = $11.69
$.95
offer price x (1- load)
4-31

32. Problem 3
NAV = (Market Value of Assets – Liabilities)  Shares Outstanding A. (200,000)x($35) = $ 7,000,000 B. (300,000)x($40) = $12,000,000 C. (400,000)x($20) = $ 8,000,000 D. (600,000)x($25) = $15,000,000 $42,000,000 $42,000,000 – $30,000 = $10.49 = NAV 4,000,000
Liabilities
$30,000
Shares Outstanding
4,000,000
4-32

33. Problem 4 AHP = 0.5 x 1/Turnover
Turnover rate = Value of stocks sold and replaced Market Value Assets Value of stocks sold = (600,000x$25)= $15,000,000 or Value of stocks purchased = (200kx$50)+(200kx$25) = $15,000,000 $15,000,000 = or 35.7% $42,000,000 Average holding period?
MVA = $42M
Market Value Assets = $42,000,000
AHP = 0.5 x 1/Turnover
= 0.5 x 1/0.357 = 1.4 yrs
4-33

34. Problem 5
The empirical research suggests that past performance is not highly predictive of future performance, especially for better performing funds. There may be some tendency for the fund to perform better than average next year, but it is unlikely that the fund will be in the top 10%.
Evidence suggests that bad performance is more likely to persist. Probably related to high fund costs or high turnover rates. Excessive costs are detrimental to a fund’s returns.
4-34

35. Problem 6
As an initial approximation, your return equals the return on the shares minus the total of the expense ratio and purchase costs:
Return  12%  1.2%  4% = 6.8%
But the precise return is less than this because the 4% load is paid up front, not at the end of the year.
To purchase the shares, you would have had to invest:
$20,000 / (1  0.04) = $20,833
The shares net increase in value (12%  1.2%) from $20,000 to:
$20,000  (1.12  0.012) = $22,160
The rate of return is:
($22,160  $20,833) / $20,833 = 6.37%
4-35

36. Problem 7
Sell after 4 years: Suppose you have $1000 to invest. The initial investment in Class A shares is ____ net of the front-end load. After 4 years, your portfolio will be worth:
$940  (1.10)4 = $1,376.25
Class B shares allow you to invest the full $1,000, but your investment performance net of 12b-1 fees will be only 9.5%, and you will pay a 1% back-end load fee if you sell after 4 years.
Your redemption value after 4 years will be:
$1,000  (1.095)4 x 0.99 = $1,423.28
Class B shares are the better choice if your horizon is 4 years.
$940
4-36

37. Problem 7 Cont.
Sell after 15 years:
With a 15-year horizon, the Class A shares will be worth:
$940  (1.10)15 =
For the Class B shares, there is no back-end load in this case since the horizon is greater than 5 years. Therefore, the value of the Class B shares will be:
$1,000  (1.095)15 =
At this longer horizon, Class A shares are the better choice. Why?
$3,926.61
The effect of Class B's 0.5% 12b-1 fees cumulates over time and finally overwhelms the 6% load charged to Class A investors.
N x LN [1.10 / 1.095]
$3,901.32
4-37

38. Problem 8
Suppose that finishing in the top half of all portfolio managers is purely luck, and that the probability of doing so in any year is exactly 50%.
Then the probability that any particular manager would finish in the top half of the sample five years in a row is =
We would then expect to find that [350  ]  11 managers finish in the top half for each of the five consecutive years.
Thus, we should not conclude that the consistent performance after five years is proof of skill. We would expect to find eleven managers exhibiting precisely this level of "consistency" even if performance is due solely to luck.
4-38

39. Problem 9 Trading costs will reduce the portfolio return by
(0.4%)x(0.50)= 0.2%
Over many years of savings these costs can greatly reduce the value of your portfolio.
Remember also that the high turnover rate can have tax consequences that further reduces your after-tax return.
4-39