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  • 1. CHAPTER 20 INVESTMENT COMPANIES CHAPTER OVERVIEW AND LEARNING OBJECTIVES  Investment companies or funds are very diverse financial institutions that tend to serve as a financial intermediary between personal investors and direct capital market securities, such as stocks and bonds.  Note the difference between closed-end and open-end funds or mutual funds and the many areas where the market has responded to the financial investment needs of the public.  Money market mutual funds and tax-sheltered funds quickly became popular when regulatory constraints prevented existing institutions and contracts from responding to investor needs.  Self-directed pension plans, such as the popular 401k, frequently use mutual funds for investments. Can you anticipate the next popular type of investment company? Hedge funds, popular in the late 1990’s and covered in this chapter, were the last. See, there are still opportunities and money to be made!  Hedge funds, generally unregulated investment funds for high net worth, “sophisticated” investors, have attracted considerable interest in the late 1990's. With high returns that provide large investors more diversification, hedge funds of today do not hedge but invest aggressively where investment managers estimate there are security market inefficiencies, such as differential pricing between related securities.  The classic hedge fund tended toward arbitrage activities, thus in many ways, contributing to market efficiency. This can be termed the “extreme sport” of investment management! CAREER PLANNING NOTE: BENEFITS OF ESTABLISHING PERSONAL GOALS In an earlier Career Planning Note, the relationship between values, goals, plans, and decisions was discussed. Decisions should be based on plans directed toward goals which are consistent with your value system. Establishing personal goals and objectives takes time and effort, and many people cannot see how goals may help them. Here is a list of "benefits" or reasons why establishing a values-goals- plan-decision orientation can help you. The benefits of goal setting are neither mystical nor hazy. There are real and significant benefits to be gained from establishing personal goals. 1. Goal setting improves your self-image. It improves you today and makes you better prepared for tomorrow. 2. Goal setting makes you aware of your strengths which can be used to overcome obstacles and provide solutions to problems. 252
  • 2. 3. Goal setting makes you aware of your weaknesses. 4. Goal setting gives you a sense of past victories which provides the stimulus for present successes. 5. Written goals help you visualize, act, and then make things happen. 6. Goal setting gives you a sense of direction. 7. Goal setting forces you to set priorities and thus be very specific as to what you seek. 8. Goal setting defines reality and separates it from wishful thinking. 9. Goal setting makes you responsible for your own life. It forces you to define and establish in concrete form your system of values. 10. Goals serve as criteria to sharpen decision making. Decisions are always made in the light of some criteria or standards. If the standards have not been defined, decisions will often be made to satisfy the demand of immediate pressures. READING THE WALL STREET JOURNAL: TRACKING THE FUNDS Every three months, The Wall Street Journal publishes a quarterly review of mutual fund performance. You can use this information to identify the best and worst performing mutual funds over the previous three months. In addition, the mutual fund report includes articles on recent trends and issues of concern to mutual fund managers and investors. TOPIC OUTLINE AND KEY TERMS I. Investment Companies A. History of Investment Companies 1. Investment companies were first started in Belgium in 1822. 2. Early U.S. investment companies a. Began at end of 1800s b. Closed-end companies c. First mutual fund in 1924 d. Declines in Great Depression e. Regulations enhanced confidence f. Growth very rapid in 1945 to 1965 period as the stock market performed well. g. Inflation, high interest rates, and poor stock market performance hurt growth in 1970s. 3. New types of funds post 1970s a. Municipal bonds funds - tax-free income b. Government security funds - safety c. Money market funds - safety and high rates with inverse yield curve. d. Exchange traded Funds (ETFs) – represent indices. 253
  • 3. B. Description of Investment Companies 1. Purchase direct, long term, capital market securities and issue indirect, liquid, small denomination securities, called shares. 2. Investment companies offer the financial investor the following services/advantages: a. Risk intermediation by investing in a diversified portfolio of assets. b. Denomination intermediation by issuing shares in smaller denominations than the direct securities purchased. c. Marketability for their shares. d. Economies of scale in investment management and transaction costs. Value of shares is called Net Asset Value (NAV): NAV = ( MV Assets − MVLiabilities ) # of shares outstanding C. Types of Investment Companies. 1. The many types of investment companies can be classified by organizational differences, fees charged to investors, and methods of buying and selling fund shares. 2. Closed-end Investment Companies. a. Have a fixed number of shares outstanding like any publicly traded corporation. b. Shares are traded and priced in the market. c. The net asset value (NAV) and the market value of the shares are determined separately. d. Closed-end fund shares sometimes sell at a 10%-20% discount off the NAV up to a 10% premium. e. Size of discount varies by type of closed-end fund – equity versus bond funds, domestic vs. global equity funds. [See Exhibit 20.1]. f. Discounts could be due to a variety of reasons including poor management, tax considerations, and market demand. g. The majority of closed-end funds are either bond funds or global equity funds. [See Exhibit 20.2] 3. Open-end Investment Companies or Mutual Funds. a. Most common – dominate asset holdings. b. Stand ready to buy or sell their shares at the current market price of assets, i.e., at NAV. c. No limit to the number of shares issued. d. With a continuous source of cash flow, liquidity costs due to forced sales of securities are minimized. e. Load funds – investor pays a sales commission when shares are purchased from brokers (front-end load) or redeemed (back-end load). f. No-load funds-no initial sales fees, but management, back-end, and other charges may be levied for services provided. 4. Exchange-Traded Funds(ETF) a. First introduced in 1989 by Toronto Stock Exchange 254
  • 4. b. Similar to closed-end funds c. Shares traded on organized exchanges d. Tremendous growth since 2000. [See Exhibit 20.3] e. ETF shares traded for portfolio of stock—no large premiums or discounts on ETF shares because of arbitrage activities. f. Many ETF track specific stock index. [See Exhibit 20.4] g. Tax advantage, low expense ratios, ease of buying/selling, and ease of tracking prices. 5. Investment Trust or Unit Trust. a. Assets are not actively managed – buy and hold strategy! b. Provide small denomination claims against a diversified, fixed portfolio of securities. c. No active secondary market, but trust sponsors usually will repurchase shares at NAV, less a commission. D. Importance of Investment Companies 1. Investment funds’ popularity with investors increased dramatically since 1990. 2. By year-end 2003, 8120 mutual funds exist in the U.S. holding a total of over $10.4 trillion in assets. [See Exhibit 20.6] 3. Multiple reasons exist for this tremendous growth. a. Variety of new offerings b. Development of IRAs and Roth IRAs. c. Shift in the type of private pension plans from defined benefit to defined contribution. d. Increased investment in the markets by baby boomers. e. Booming economy and low inflation leading to record returns in the stock markets. f. primary vehicle for retirement savings. E. Investment composition of investment funds varies with economic conditions. 1. Cash Holdings – Short-term liquid assets a. Hold more cash items when interest rates rising and high. b. Reduce short-term securities, buy long term when rates are at peak and falling. 2. Delayed redemption and paid-in-kind redemption policies, along with bank lines of credit have reduced the proportion of cash held. 3. Shift to equity funds in the late 1990s – 49% of all assets held by mutual funds. 4. Composition varied over time. [See Exhibit 20.7] F. Types of Mutual Funds 1. Growth & Income Funds a. They seek a balance between capital gains and current income. b. Mostly invest in highly rated companies’ stock. c. Ideal for investors who are looking for some income, but would also want to invest in growth stocks. 2. Growth Funds a. The objective of growth funds is to invest in industries and companies that are not mature and are still experiencing sizable growth. 255
  • 5. b. Investors looking for a higher return and a moderate risk are attracted to such funds. c. Focus is on capital appreciation rather than steady income so investors’ outlook needs to be long-term. 3. Capital Appreciation Funds or Aggressive Growth Funds a. These are similar to growth funds in their outlook, but are more risky because they focus on emerging industries and unproven firms. b. Investors trade off a very high return potential for high risk. 4. Balanced Funds a. Such funds are a hybrid portfolio of growth stocks and fixed-income securities. b. The proportion of each determines the level of return for each fund. c. Generates higher proportion of income than growth and income funds and are less volatile. d. Investors who have a few more years to retirement and are typically in their early 50s are attracted to such funds. 5. Income Funds a. Income funds invest in bonds that provide steady coupon cash flows and are quite varied in their risk level. Income funds could be made up of a portfolio of entirely corporate bonds (risky) or a portfolio of entirely Treasury issues (no default risk) or of mortgage-backed securities. b. Income funds are exposed to default risk and interest rate risk. c. Such income funds are attractive to retirees as the income stream of fund’s instruments provides them with necessary income. 6. Specialty Funds. a. Additionally, there exist different types of specialized funds like tax- exempt funds, global funds, asset allocation funds, sector funds, and index funds. G. Mutual Fund Families 1. Mutual fund managing companies market a variety of types of mutual funds to investors, called families of funds. 2. The intent is to provide an opportunity to change risk, asset, term and other investment profiles without changing mutual fund companies or retirement account manager. 3. Funds may be moved from fund to fund at nominal charges. 4. Other services may include: a. discount brokerage service – purchase/sale of individual direct securities, such as stocks and bonds. b. Transaction Accounts – check writing and/or debit card relationship to mutual fund. H. Regulation of Mutual Funds-SEC and States 1. Regulation relates to adequate required disclosure, adequate diversification, sales practices, and management practices. [See People & Events Exhibit] 2. Federal laws a. Securities Act of 1933 b. SEC Act of 1934 c. Investment Company Act of 1940 and 1970 256
  • 6. 3. Mutual funds are not taxed on income and capital gains– owners of shares are. I. Mutual Fund Fee Structures 1. Sales fees or loads as a per cent of net asset value (NAV). a. front-end b. back-end or redemption fee 2. Marketing Expenses or “12b-1” fees a. subtracted from funds assets each year. b. maximum of 1% of average net assets per year. c, higher with higher portfolio turnover (commissions) 3. Management or advisory fees paid to fund managers. a. level of fees not related to investment performance. b. read prospectus for fees vary. 4. Exchange fees when funds are transferred from one fund to another in a family of funds. 5. Account maintenance fees J. Determining Mutual Fund Values 1. Value of investments divided by number of shares is net asset value (NAV). 2. Load fund cost equals NAV plus percentage load. 3. Redemption value is NAV unless redemption fee. II. Hedge Funds A. Traditional hedge funds participated in arbitrage activities to exploit market inefficiencies 1. Market arbitrage is the simultaneous buying and selling of a security or derivative of the security to exploit market pricing differentials. One can take a “hedged”, limited risk position, or speculative positions, based on estimating price differentials and trends. 2. Arbitrage activities included: a. fixed-income arbitrage in long (buy) and short (sell) where pricing differentials exists, such as breaks in the yield curve. b. index arbitrage serves to capture pricing differences between an index derivative and the underlying securities. c. closed-end fund arbitrage attempts to capture the price differential between the securities of a closed-end investment fund and the net asset value (share price) of the fund. d. convertible arbitrage attempts to capture pricing differentials between a convertible bond and the stock of the company, especially as the stock price approaches the conversion value. B. Hedge funds, using sophisticated forecasting models, may also take very aggressive, speculative positions, attempting to exploit pricing and informational market inefficiencies. 1. Large net worth investors seek diversification benefits and high potential return, while mutual fund managers seek high investment management fees. 257
  • 7. 2. Aggressive strategies may include domestic hedge strategies seeking short-term value opportunities in a variety of equities, commodities, real estate, etc. a. global hedge strategies focus on a variety of investments in specific areas or economies of the world. b. global macro strategies estimate major changes in economic conditions, especially external impacts of central banks, etc. C. Hedge Funds Differ From Mutual Funds 1. Hedge funds avoid SEC regulation by concentrating on a few, high net worth investors. 2. Organized as limited partnerships, the fund manager is the general partner; the investors the limited partners. a. limited disclosure–no SEC monitored prospectus. b. very high investment minimums. c. wide latitude in establishing investment strategies and changing strategy as needed. d. may use speculative short selling, leverage, etc. e. fees for investment management higher than mutual funds. f. incentive fees common, but not permitted with mutual funds. D. Hedge Fund Performance. 1. Short sell strategies performed well in mid 1990's. 2. Hedge funds have not outperformed the S&P 500. [See Exhibit 20.9] III. Money Market Mutual Funds (MMMF) A. Description 1. Short-term money market investments 2. Provide excellent liquidity for investors 3. High quality and high yield when yield curve is inverse 4. Compete with bank deposits B. Initial growth spurred by bank Regulation Q. 1. When market rates were above Regulation Q maximum deposit rates, MMMF grew rapidly. [See Exhibit 20.10] 2. Banks were able to compete after the 1982 Depository Institutions Act when they were permitted to offer insured, Money Market Deposit Accounts (MMDA) whose rates were not capped. C. New Services of MMMF after 1982 1. Tax exempt MMMF 2. Family of funds 3. Brokerage service 4. Insurance on share accounts 5. Transactional convenience – check-writing capability or debit cards. 258
  • 8. IV. Real Estate Investment Trusts (REIT) 1. Closed-end investment funds selling shares and investing in real estate related assets. a. Own income property b. Acquire mortgages c. Finance real estate development and construction d. Acquire and lease property 2. Regulated under federal Real Estate Investment Act of 1960 and state regulation 3. Exempt from federal income tax under specific rules 4. Grew rapidly in the inflationary boom period of the late 1960s and early 1970s, then the bubble burst a. High interest rates of 1973 or 1974 b. Financed short (commercial paper) and invested long in rising rate environment c. A real estate recession caused many REIT failures. d. REITs total assets peaked in 1974 and thereafter declined until 1984. 5. REITs rebounded with low interest rates and real estate revival of 1984 and low interest rate periods. 6. REITs are exempt from federal income tax is they accrue a minimum of 75% of income from real estate investments and pay 90% of their net income to shareholders. COMPLETION QUESTIONS 1. _______ ________ funds are traded on organized exchanges. 2. Mutual fund _________ offer a variety of mutual funds to investors. 3. _______ funds are investment funds for high net worth investors. 4. Open-end investment companies, called , issue to investors and invest in a variety of financial assets. 5. Mutual funds offer investors two important services: and . 6. pool investor funds and invest in specific financial assets for a specified period. 7. When mutual fund cash holdings are high, interest rates are (high/low), the inflation is usually (high/low), and interest rates are expected to (increase/decrease) in the near term. 8. When investors sell their mutual funds shares, the purchases them. 9. Mutual fund redemption fees are levied when one _______ his/her shares. 10. A REIT is a _____-end investment company that invests in real estate. 259
  • 9. TRUE/FALSE QUESTIONS T F 1. When shares of a closed-end investment fund are sold, another investor purchases them. T F 2. Money market mutual funds lost their competitiveness with banks when Regulation Q was phased out. T F 3. Unit investment trusts, while actively managed like mutual funds, have much shorter lives. T F 4. If interest rates are expected to fall very soon, the bond mutual fund manager is likely to have a high cash position. T F 5. The cost per share of a mutual fund with a 3% load is the NAV less the 3% load. T F 6. Bond mutual funds have more interest rate risk than comparable unit investment trusts. T F 7. The largest investment category for mutual funds as a whole is common stock. T F 8. Hedge funds are typically organized as limited partnerships with the fund manager as the general partner. T F 9. Hedge funds have been popular diversification investments for high wealth investors. T F 10. Exchange-traded funds receive a portfolio of stock as payment for fund shares and redeem the shares with a portfolio of stocks. T F 11. Balanced funds generate higher proportion of income than growth and income funds and are less volatile. T F 12. Market arbitrage by hedge funds is the simultaneous buying and selling of a security or derivative of the security to exploit market pricing differentials. T F 13. When purchasing load mutual fund, the NAV includes the load charge for purchasing the mutual funds. T F 14. Money market mutual funds invest in commercial paper, large bank CDs, and short-term government securities. T F 15. Unit investment trusts have a high security turnover rate, increasing their costs over equivalent mutual funds. 260
  • 10. MULTIPLE-CHOICE QUESTIONS 1. Investment funds provide investors all of the following except: a. diversification. b. contractual rate of return. c. professional advice. d. small minimum investment. 2. Investment funds a. are adaptive organizations which have responded well to economic conditions and investor needs. b. are slow to react to needs because of severe regulation. c. have shifted from one investment fad to another without attending to investor needs. d. serve the large institutional investor. 3. Unit investment trusts provide all of the following advantages to investors except: a. diversification b. professional organization and investment selection c. no-load mutual fund d. closed-end investment company. 4. One may find the shares of which of the following traded on the national exchanges? a. MMMF b. open-end investment company c. no-load mutual fund d. closed-end investment company e. none of the above 5. Which one of the following is not actively managed? a. load mutual funds b. unit investment trusts c. REITs d. MMMFs 6. Money market mutual funds managed by investment banking/brokerage firms compete directly with bank a. DDAs. b. large time deposits. c. MMDAs. d. small savings accounts. 7. The major investment of money market mutual funds is a. commercial paper and bankers' acceptances. b. bank CDs. c. U.S. government securities. d. cash. 261
  • 11. 8. Hedge funds often seek to take advantage of market inefficiencies such as: a. high transaction costs. b. pricing differentials between derivative contracts and the underlying security. c. technological developments aiding informational efficiencies. d. similar prices in different geographic locations. 9. In what area below are hedge funds similar to mutual funds? a. required SEC registration. b. open to all investors. c. large minimum investment amounts. d. fund managers are managers, not investors 10. All but one of the following are advantages of exchange-traded funds: a. tax advantages b. high return; low risk c. low expense ratio d. ease of buying and selling 11. The price of a mutual fund share is a. the sum of the value of mutual fund shares divided by the number of corporate shares held. b. the net asset value or the number of shares issued divided by the number of corporate shares owned. c. the net asset value or the value of assets divided by shares issued. d. the net asset value or the number of shares of corporate stock held divided into the total value of the stock portfolio. 12. Real estate investment trusts are ________ investment companies that tend to prosper when a. open-end; when interest rates are low. b. open-end; when interest rates are high. c. closed-end; when interest rates are low. d. closed-end; when interest rates are high 13. The majority of securities owned by open-ended mutual funds are: a. real, physical assets. b. money market securities. c. capital market securities. d. safe, low-risk government securities. 14. Which type of investment companies allows shareholders to cash in their shares at their present asset value? a. unit investment trusts b. open-end investment companies c. closed-end investment companies d. none of the above 15. The key advantage of a mutual funds families is a. the ability to diversify an investment portfolio. b. the ability to add funds on a regular basis such as with a 401K retirement plan. c. the ability to shift quickly from one type of mutual funds to another with little or no cost. d. the ability to shift from one mutual funds management company to another. 262
  • 12. SOLUTIONS TO COMPLETION QUESTIONS 1. Exchange-traded 2. families 3. Hedge 4. mutual funds; shares 5. diversification; professional expertise 6. unit investment trusts 7. high; high, decrease 8. mutual fund 9. sells 10. closed SOLUTIONS TO TRUE-FALSE QUESTIONS 1. T Investors purchase them initially and all subsequent sell/buy transactions are between investors. 2. F MMMF did lose market share in early 1983, but came back with a variety of new financial services and have remained competitive with banks. 3. F Unit investment trusts are not “actively managed.” 4. T When interest rates fall, long-term, capital market securities will be purchased. 5. F The cost is the net asset value plus 3% of the NAV. 6. T There are no redemptions for unit investment trusts and the bonds are held to maturity. Mutual funds often must redeem shares, financed by selling bonds at a price below the purchase price. 7. T Common stock is the largest asset category of mutual funds. 8. T A limited partnership must have one general partner with unlimited liability. Hedge fund investors are usually limited liability limited partners. 9. T Hedge fund returns have had lower correlations with the returns of other areas of investment, so they are used to diversify or lower total risk of a high wealth investor. 263
  • 13. 10. T Exchange-traded funds are created with a deposit of a portfolio of stocks and likewise, redeemed. 11. T Balanced funds generate higher proportion of income than growth and income funds and are less volatile. 12. T Hedge funds arbitrage markets by the simultaneous buying and selling of a security or derivative of the security to exploit market pricing differentials. 13. F The NAV does not include the load charge for purchasing the mutual funds. It is the per share value of the difference between the mutual fund’s market value of its assets and its liabilities. 14. T Money market mutual funds invest in commercial paper, large bank CDs, and short-term government securities. 15. F Unit investment trusts have little (if any) security turnover rate, thus, having lower costs than equivalent mutual funds. SOLUTIONS TO MULTIPLE-CHOICE QUESTIONS 1. b The finite number of shares are traded among investors, not purchased/sold by the fund, such as open-end mutual funds. 2. a Relatively unregulated funds can and have adapted quickly to investor needs. 3. d All of the above. 4. d Several closed-end investment companies are listed. Investors trade existing securities. 5. b Unit investment trusts are carefully set up, but are not usually "actively" managed. 6. c MMDAs are market interest insured savings accounts and, thus far, have been the closest competitor to MMMFs. Stay tuned!! 7. a The higher yielding money market securities. 8. b The arbitrage activities attempt to take advantage of market price differentials of derivatives and their underlying asset. Such activities enhances market efficiency. 9. d Hedge funds are unregulated investment funds with large investments from deep pocket investors. Professional fund managers, like mutual funds, are “manager,” not investors. 10. b In financial markets, there are not free lunches, especially high returns on a low risk investment. 11. c. The share price of a mutual fund is the net asset value (NAV) or the value of assets divided by shares issued. 264
  • 14. 12. c REITs are closed-end funds that tend to do when interest rates are low and real estate does well. 13. c The majority of securities owned by open-ended mutual funds are: capital market securities or long –term securities. 14. b Open-end investment companies or mutual funds allows shareholders to cash in their shares at their present asset value or NAV. 15. c Mutual fund families give investors the ability to shift quickly from one type of mutual funds to another with little or no cost and without rolling over 401K monies. 265