1. Mutual Funds and Other Investment Companies Chapter 4

2. Services of Investment Companies b.Diversification  c.Professional management (good/bad) d.Reduced transaction costs (tax, reinvest) e.Investing for retirement: Most funds can be set up as an IRA Low cost, instant diversification 4-2

3. 4.2 Types of Investment Companies Unit Investment Trusts (UITs): unmanaged, fixed composition portfolios  Any interest and/or dividends are distributed immediately to trust certificate holders.  Provide diversification within one sector or area and low cost entry.  Often levered, rates of return can be extreme. 4-3

4. Managed Investment Companies: Managed, usually changing composition portfolio.  ___________________________________  The fund's board of directors typically hires an investment advisor to select and manage the fund assets according to some specific goal(s) set by the board and any regulatory requirements.  The investment advisor usually creates the fund and selects the investments. Most funds are of this type. More commonly known as a ‘mutual fund’ 4-4

5. Organizational Forms A managed investment company (mutual fund) may be  Open end –shares are bought from the fund and redeemed by the fund or  Closed end (e.g. ETF) –shares are bought and sold among investors in the marketplace (NASDAQ or an exchange) and the fund itself is not involved. 4-5

6. Other Investment Organizations –Commingled funds Partnerships of investors that pool their funds. Designed for trusts or larger retirement accounts to get professional management for a fee. Operates similar to a mutual fund. –REITs Similar to closed end fund. Invest in real estate and real estate loans. Equity trusts purchase real estate. Mortgage trusts invest in mortgage and construction loans. 4-6

7. Other Investment Organizations Cont. –Hedge Funds Similar to mutual funds, but not registered and not subject to SEC regulations. Available to institutional and high net worth investors Can pursue investment strategies that are not allowed for mutual funds. – Grew from about $50 billion in 1990 to about $2 trillion in 2008. 4-7

8. Net Asset Value Used as a basis for valuation of investment company shares –Selling new shares –Redeeming existing shares No Calculation for the course as they are published 4-8

9. Open-End and Closed-End Funds: Key Differences Shares Outstanding  Closed-end: no change unless new stock is 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 a premium or discount to NAV 4-9

10. How Funds Are Sold Directly marketed – Sales force distributed – You find them May avoid front end load Front end load is an up front cost (fee) to purchase a share of a mutual fund. Recommended by a broker or planner Usually will have a front end load May be revenue sharing on sales force distributed Potential conflict of interest 4-10

11. Funds Screener (e.g. Yahoo, WSJ, MorningStar) 1.Domestic Stock Funds 2.Index Funds, e.g. Vanguard 4-11 Investment characteristics Goal is to duplicate the performance of an index or market sector.Goal is to duplicate the performance of an index or market sector. Low turnover, low expensesLow turnover, low expenses Compatible Investor Goals Investors who believe in ‘efficient markets’ and are seeking market returns with minimal expenses and turnover.Investors who believe in ‘efficient markets’ and are seeking market returns with minimal expenses and turnover. Stock funds still require ability to handle risk and staying power.Stock funds still require ability to handle risk and staying power.

12. Funds & Investment Objectives 3.Balanced funds a.Allocation Funds i. ii. b.Target Date Funds i. World, moderate, conservative Convertibles Near term (to 2014), Intermediate (2015-2029), Long term (2030+) 4-12

13. Funds & Investment Objectives 4.Fixed Income funds 5.International Stock Funds (country fund, discount phenomenon) 6.Money market funds 4-13

14. 4.4 Costs of Investing in Mutual Funds 4-14

15. Costs of Investing in Mutual Funds Fee Structure – Operating expenses – 12 b-1 charges – Front-end load Back-end load (contingent), (redemption fee) Buying and selling commissions, administrative expenses and advisory fees for the managers Marketing costs paid by the fundholders Alternative to a load, but assessed annually Maximum is 1% of assets 4-15

16. NAV and the Effective Load Cost to initially purchase one share of a load fund = NAV + front-end load (%) (if any).  Stated Loads typically range from ________  If you invest $10,000 in a fund with an 8.5% front-end load, you actually acquire shares worth $9,150; the other $850 goes to the broker. The load is designed to offset expenses of marketing the fund and goes to the broker who sells the fund to the investor.  The effective load is greater than the stated load: In the above example, the actual % commission cost (effective load) is: –$850 / $9150 = 9.3%; which is > stated load. 0 to 8.5% 4-16

17. Costs of Investing in Mutual Funds Expense ratios:  Funds charge annual operating expenses and annual advisory or management fees against the NAV. –Expense ratios are calculated as Annual Expenses / Average NAV –A "well managed" fund probably should have an expense ratio of less than ___.  All costs and charges must be revealed in the fund's prospectus. 2% 4-17

18. 4.5 Taxation of Mutual Fund Income 4-18 The fund itself is not taxed as long as –Fund meets certain diversification requirements –Fund distributes virtually all income earned (less fees and expenses) to fund shareholders The investor is taxed on capital gain and dividend distributions at the investor’s appropriate tax rate. Distribution requirements imply that portfolio turnover may affect an investor’s tax liability.

19. 4.6 Exchange Traded Funds ETFs allow investors to trade index portfolios like shares of stock Examples: Potential advantages – – Trade continuously throughout the day Can be sold short or purchased on margin Potentially lower taxes No fund redemptions Large investors can exchange their ETF shares for shares in the underlying portfolio Lower costs (No marketing; lower fund expenses) SPDRs, Diamonds, &Cubes; iShares 4-19

20. 4.8 Information Sources on Mutual Funds  Wiesenberger’s Investment Companies  Morningstar (www.morningstar.com)  Fund prospectus (a must read)  Yahoo  Wall Street Journal  Investment Company Institute (www.ici.org)  AAII  Brokers  Background information: “A Random Walk Down Wall Street,” by Burton Malkeil 4-20