1. Chapter 10 Investment Companies

2. 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)

3. 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

4. Net Asset Value (NAV) Per-share market value of mutual fund’s portfolio: NAV = (total assets – total liabilities)  number of shares outstanding

5. 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

6. Types of Mutual Funds Common stock funds Hybrid funds Bond funds Money market funds Others

7. 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

8. Hybrid Fund Mutual fund that owns portfolio of bonds, stocks, and other investment instruments. Subcategories include –balanced funds –growth and income funds

9. Bond Fund Mutual fund that owns portfolio of bonds. Subcategories include funds that invest in: –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

10. 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

11. 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.

12. 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

13. 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

14. 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 risk- return combinations.

15. 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

16. Life-cycle Fund Appeals to investors in specific stages of life Retirement date funds Two approaches –Specific securities –Fund of funds

17. 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.

18. 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

19. 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

20. Family of Funds Group of mutual funds owned and marketed by same company Advantages: –Exchange privilege –Convenience of dealing with one company

21. 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)

22. Load (continued) Many funds have breakpoints for load charges Rights of accumulation Letter of intent Back-end load (contingent deferred sales charge)

23. Price of a Load Share P L =NAV/(1 – L) where P L =ask price including load L=load percentage

24. 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

25. 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

26. 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

27. Distribution Systems direct marketing captive sales force broker-dealers financial planners

28. Advantages of Mutual Funds Professional portfolio management Diversification (risk reduction) Convenience Record keeping Other factors –Examples: liquidity, minimal investment requirements, regulation

29. 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).

30. Prospectus the fund’s investment objectives the fund’s investment policies general information about risks tables showing the loads and other expenses additional information

31. Governance Like any other corporation –Inside director –Outside director Funds where directors have more money invested do better!

32. 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

33. 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

34. 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

35. 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)

36. 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

37. 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

38. Advantages of UITs Convenience Low cost for holding diversified portfolio Stable portfolio Tax efficiency No or minimal management fees

39. Disadvantages of UITs May not find UIT to match investment goal Front-end loads can be hefty Lack of resale market

40. Exchange Traded Funds Portfolio mimics a specified index Creation units

41. ETFs: Advantages over Index Funds Traded on daily basis like any other stock Can buy on margin Low management fees Extremely tax efficient Likely to track index more closely

42. 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

43. 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

44. 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

45. 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.

46. 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

47. 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

48. 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

49. 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