Investment Companies

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 funds
  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 securitiesthat 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 SP 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 instrumentsas 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

• PL NAV/(1 L)
•  
• where PL 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

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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).

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Prospectus

• the funds investment objectives
• the funds 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 clients objectives risk tolerance
• Third party evaluations
• Fees Expenses
• Diversification/concentration
• Experience, qualifications, and longevity of the
  funds 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