Mutual Funds and Other Investment Companies

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Mutual Funds and Other Investment Companies

  1. 1. Mutual Funds and Other Investment Companies B, K & M Chapter 4
  2. 2. Investment Companies <ul><li>Financial intermediaries that collect money from individual investors and invest these funds in a wide range of securities or other assets </li></ul><ul><li>Perform important functions for individual investors including: </li></ul><ul><ul><ul><ul><li>Diversification and Divisibility </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Lower Transaction Fees </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Record Keeping and Administration </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Professional Management </li></ul></ul></ul></ul>
  3. 3. Investment Companies <ul><li>Value of each share is called the Net Asset Value or NAV (equals assets minus liabilities expressed on a per-share basis): </li></ul>
  4. 4. Types of Investment Companies <ul><li>Open-end Investment Companies </li></ul><ul><ul><ul><li>- Commonly known as Mutual Funds </li></ul></ul></ul><ul><ul><ul><li>- Stands ready to redeem or issue shares at NAV </li></ul></ul></ul><ul><ul><ul><li>- May have “front-load” or “rear-end” sales charges (capped at 8.5% by NASD) </li></ul></ul></ul><ul><ul><ul><li>- Number of shares constantly changes </li></ul></ul></ul>
  5. 5. Types of Investment Companies <ul><li>Closed-end Funds </li></ul><ul><ul><ul><li>- Number of shares is fixed - Does not redeem or issue shares </li></ul></ul></ul><ul><ul><ul><li>- Typically, newly issued shares sell for a premium over the NAV </li></ul></ul></ul><ul><ul><ul><li>- Shortly after being issued, many shares sell at a discount from NAV </li></ul></ul></ul><ul><ul><ul><li>- A puzzle that much recent financial research has focused on </li></ul></ul></ul><ul><ul><ul><li>- Usually traded on organized exchanges </li></ul></ul></ul>
  6. 6. Types of Investment Companies <ul><li>Unit Investment Trusts </li></ul><ul><ul><ul><li>- Pools of money invested in a portfolio that is fixed for the life of the fund </li></ul></ul></ul><ul><ul><ul><li>- Units (also called redeemable trust certificates) sold by a sponsor (brokerage firm) to individual investors </li></ul></ul></ul><ul><ul><ul><li>- Most unit trusts hold fixed-income securities (bonds, etc.) and expire at their maturity </li></ul></ul></ul><ul><ul><ul><li>- Most unit investment trusts are invested in tax-exempt securities (municipal bonds) </li></ul></ul></ul><ul><ul><ul><li>- Individuals may sell units back to trustee at NAV </li></ul></ul></ul>
  7. 7. Types of Investment Companies <ul><li>Commingled Funds </li></ul><ul><ul><ul><li>- Used by trust departments among others </li></ul></ul></ul><ul><ul><ul><li>- Partnership of investors that pool their funds with a management firm (e.g., bank) </li></ul></ul></ul><ul><ul><ul><li>- Similar to open-end funds except units are traded rather than shares </li></ul></ul></ul>
  8. 8. Types of Investment Companies <ul><li>Real Estate Investment Trusts (REITs) </li></ul><ul><ul><ul><li>- Similar to a closed-end fund </li></ul></ul></ul><ul><ul><ul><li>- Invest in real estate or loans secured by real estate </li></ul></ul></ul><ul><ul><ul><li>- Exempt from taxes as long as at least 95% of their taxable income is distributed to shareholders; however, these distributions (dividends) are taxable as personal income </li></ul></ul></ul>
  9. 9. Mutual Funds Types <ul><li>Money Market Funds </li></ul><ul><li>Equity Funds: </li></ul><ul><ul><ul><ul><li>Maximum Capital Gain </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Growth </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Growth and Income </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Income </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Income and Security </li></ul></ul></ul></ul>
  10. 10. Mutual Funds Types <ul><li>Fixed-Income Funds </li></ul><ul><li>Balanced and Income Funds </li></ul><ul><li>Asset Allocation Funds </li></ul><ul><li>Index Funds </li></ul><ul><li>Special Sector Funds </li></ul><ul><li>International Funds </li></ul>
  11. 11. Mutual Fund Returns
  12. 12. Taxation of Mutual Fund Income <ul><li>Granted “pass-through status” (i.e., taxes paid by investor in the fund, but not by the fund itself) if the fund meets certain requirements including : </li></ul><ul><ul><ul><ul><li>At least 90% of all income is distributed to shareholders (in order to avoid “excise tax”, fund must distribute 98% of income in the calendar year in which it was earned) </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Fund receives less than 30% of its gross income from sale of securities held for less than three months </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Fund must meet diversification criteria </li></ul></ul></ul></ul>
  13. 13. Mutual Fund Performance Benchmark <ul><li>Benchmark for the performance of equity fund managers is the rate of return on the Wilshire 5000 Index (a value-weighted index of about 7000 stocks that trade on the NYSE and Amex stock exchanges, and the Nasdaq stock market </li></ul><ul><li>Useful benchmark to evaluate professional fund managers because it corresponds to a simple passive investment strategy; however, an imperfect comparison due to: </li></ul><ul><ul><ul><ul><li>Risk Differential : the risk of the Wilshire 5000 Index may differ significantly from the risk of a specific fund </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Expenses : a specific fund will incur expenses (e.g., transaction costs, etc.) that the Wilshire 5000 Index is not exposed to </li></ul></ul></ul></ul>
  14. 14. Mutual Fund Performance Benchmark <ul><li>Over the past two decades, passively managed (indexed) equity funds would have outperformed the average actively managed fund </li></ul>
  15. 15. Mutual Fund Performance Benchmark <ul><li>Is superior performance in a given year random (based on luck) or consistent (due to skill of fund manager)? </li></ul><ul><ul><ul><li>Goetzmann and Ibbotson (1994) : using an equity fund sample from 1976-85, find that at least a portion of mutual fund returns can be attributed to manager skill </li></ul></ul></ul><ul><ul><ul><li>Malkiel (1995) : using an equity fund sample from 1971-91 and dividing the time horizon by decade (i.e., into the 1970s and the 1980s), finds that manager skill explains a portion of the 1970s’ results, but not the 1980s </li></ul></ul></ul>

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