Chapter 04 – Mutual Funds and Other Investment Companies
CHAPTER FOUR
MUTUAL FUNDS AND OTHER INVESTMENT COMPANIES
CHAPTER OVERVIEW
1. Investment Companies
PPT 4-2
Key services provided by investment companies include elements of services that are related to
scale factors such as reducing transaction costs, diversification and divisibility. Mutual funds can
2. Types of Investment Companies
PPT 4-3 through PPT 4-6
While the largest category of investment organization is managed investment companies, other
vehicles exist. About 90% of investment company assets are held in mutual funds. For various
reasons, actively managed mutual funds don’t invest all the money at their disposal, but instead
Chapter 04 – Mutual Funds and Other Investment Companies
The key differences between open-end and closed-end funds are displayed in PPT 4-4. Since the
shares in closed-end funds are acquired in secondary markets, prices for such shares may differ
from the underlying net asset value (NAV). Closed end fund shares may trade at a premium or a
unrealized tax gains in the fund or the discounts may exist to offset lower liquidity.
Commingled funds are partnerships for investors that pool their funds. Commingled funds are
commonly used in trust accounts for which investors do not have large enough pools of funds to
warrant separate management. REITs (Real Estate Investment Trusts) are investment vehicles
that are similar to closed-end funds. They invest in real estate (equity trust) or in loans secured by
involved in excessive naked short selling. Naked short selling (see Chapter 3 for more detail on
short sales) is short selling shares you don’t have. With most stocks held in street name it may be
possible to sell more stock than actually exists, exerting downward pressure on a share’s price.
This is far more likely to be a serious problem for smaller firms than firms with a large public
float. Most hedge funds are registered as private partnerships and thus avoid SEC regulation.
3. Mutual Funds
PPT 4-7 through PPT 4-11
Net Asset Value (NAV) is used as a basis for valuation of investment company shares and it may
be calculated as follows:
More differences between Open-End and Closed-End Funds
Closed-end: Fund share price may trade at a premium or discount to NAV
Sample NAV calculation
ABC Fund ($Millions except NAV)
Market Value Securities $550.00
+ Cash & Receivables 75.00
¸ # Fund Shares 20.00
NAV $ 30.25
How Funds Are Sold
About half of the funds are ‘Sales force distributed.’ This means that brokers and planners
recommend the funds to investors. These funds will typically have a front-end load. A front-end
their own. These funds should not have a front-end load although they may have a back-end load
or even in some cases a 12b-1 charge.
Potential Conflicts of Interest: Revenue Sharing
Brokers put investors in funds that may that may not be appropriate for the investor.
Mutual funds could direct trading to higher-cost brokers because the broker recommends
Some funds are sold in financial supermarkets such as at Charles Schwab. Investors can purchase
load funds from Schwab or others without paying the load. However there is no free lunch, the
fund may charge higher expenses to offset. Nevertheless investors often get the benefit of low–
cost switching even between fund families and easier to interpret record keeping when investing
this way.
category. An investor should never invest in any particular fund without reading and
understanding the prospectus. If one is willing to pay a load charge the investor can obtain advice
from a broker or planner.
1. Domestic Stock Funds
a. Aggressive Growth
i. Sector, Small Cap Growth, Mid Cap Growth
b. Growth
2. Index funds
a. Broad market
b. Industry or market subset
3. Balanced funds
a. Allocation funds
i. World, moderate, conservative
ii. Convertibles
4. Fixed Income Funds
a. Federal Government
i. Short, Intermediate, Long Term
ii. Inflation Protected
5. International Stock Funds
a. Foreign
4-4
6. Money Market Funds
a. Taxable
b. Tax Exempt
Money market funds have their NAV fixed at $1.00. There are no capital gains or losses, just
redemption fees may be imposed on short-term holding periods under one week. In aggregate,
funds paid more than $1.65 billion to settle these claims.
4. Costs of Investing in Mutual Fund
PPT 4-12 through PPT 4-17
4-5
Chapter 04 – Mutual Funds and Other Investment Companies
against the NAV of the fund, in effect, all investors share in paying the 12b-1 fee. The 12b-1 fee is
an annual assessment that an investor must pay as long as they are invested in the fund; whereas
the front load is a one-time fee. Hence if investors plan on holding the mutual fund for a
sufficiently long time the front-end load may be preferable to a 12b-1, even though the front load
reduces the invested amount.
exit fee or the back-end load to become smaller with longer investment periods. This is called a
holding period contingent fee.
When comparing expense ratios on funds, the 12 b-1 charges should be added to the fund
expenses since the 12b-1 fees represent an annual charge. Operating expenses that are reported
may not fully reflect operating costs because of soft-dollar payments. Some brokerage houses
Several examples of the effects of expense are provided in the PowerPoint.
5. Taxation of Mutual Funds
PPT 4-18 through PPT 4-19
Mutual funds are not taxed as long as the fund meets certain diversification requirements and the
fund distributes virtually all income earned, including capital gains, (less fees and expenses) to
Turnover rates vary from under 5% to well over 300% per year.
Investor-directed portfolios can take advantage of tax consequences and time when to take
taxable gains, while investment in most mutual funds cannot be structured to take advantage of
specific tax considerations. High turnover may lead to higher taxes and result in greater expenses
6. Exchange Traded Funds
PPT 4-20 through PPT 4-24
7. Mutual Fund Investment Performance: A First Look
PPT 4-25 through PPT 4-27
8. Information on Mutual Funds
PPT 4-28
A partial list of sources of information on mutual funds appears in PPT 4-28. As the popularity of