Chapter 04 – Mutual Funds and Other Investment Companies
CHAPTER FOUR
MUTUAL FUNDS AND OTHER INVESTMENT COMPANIES
CHAPTER OVERVIEW
This chapter describes the various types of investment companies and mutual funds; discusses
services provided by mutual funds; and provides information on expenses and loads associated
with investment in investment companies. Investment policies of different funds are described
and sources of information on investment companies are identified.
LEARNING OBJECTIVES
After studying this chapter the students should be able to identify key differences between open-
end and closed-end investment companies and understand the advantages of investing in funds
rather than investing directly in individual securities. Students should be able to describe the
expenses associated with investment in mutual funds, calculate net asset value and fund returns
CHAPTER OUTLINE
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 trade securities at lower costs because of the size of the trades and because they are trading
2. Types of Investment Companies
Chapter 04 – Mutual Funds and Other Investment Companies
PPT 4-3 through PPT 4-5
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
maintain cash balances of approximately 8%. (Source: The Fool)
A unit trust is a pool of funds invested in a portfolio that is fixed for the life of the fund. Trusts
are often set up for fixed-income securities. The trust life is dependent on the maturity of the
securities.
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
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 real estate (mortgage trusts). REITs employ financial leverage and offer an investor the
possibility to invest in real estate with professional management.
Hedge funds pool funds of private investors. They are only open to wealthy and institutional
investors. Some have initial ‘lock–up’ periods (minimum time before capital can be withdrawn.
Hedge funds engage in short selling, risk arbitrage and other derivatives. Some may have been
3. Mutual Funds
PPT 4-6 through PPT 4-8
Chapter 04 – Mutual Funds and Other Investment Companies
Net Asset Value (NAV) is used as a basis for valuation of investment company shares and it may
be calculated as follows:
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
Sample NAV calculation
ABC Fund ($Millions except NAV)
Market Value Securities $550.00
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
load is an up -front cost (fee) to purchase a share of a mutual fund. Some funds may have a
back-end load and or a 12b-1 fee instead of or in addition to the front-end load. These other
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
Chapter 04 – Mutual Funds and Other Investment Companies
Funds and Investment Objectives
(This section relies on Morningstar’s definitions of fund types and the analysis relies heavily on
Burton Malkeil’s work in “A Random Walk Down Wall Street.”) Investment funds follow
policy general policy guidelines and may be roughly grouped according to the type of fund.
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
i. Size and Value/Growth
b. Global or World
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
income distributions. These funds provide some income while maintaining safety of principal.
They earn more than bank accounts with little additional risk, although during the financial
crisis, two (out of thousands) “broke the buck” or failed.
Trading Scandals
Late trading allowed some investors to purchase or sell fund shares after the NAV had been
determined for the day. (NAVs are established once per day at the end of trading.) Market
timing is allowing investors to buy or sell on stale net asset values based on information from
international markets. For example a fund NAV may be based on prices in foreign markets
4. Costs of Investing in Mutual Fund
PPT 4-9 through PPT 4-13
Funds with a front-end load initially reduce the investment amount. This makes the cost of a
front-end load higher and investors who feel comfortable picking their own funds should pick a
no-load fund. If the investor’s choice is between a front-end load or a 12b-1 fee the choice is
less clear cut. A 12b-1 fee is a different way to assess a front-load charge. In a front load the
5. Taxation of Mutual Funds
PPT 4-14 through PPT 4-15
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
fund shareholders. The investor is taxed on capital gain and dividend distributions at the
investor’s appropriate tax rate. The distribution requirements imply that portfolio turnover may
affect an investor’s tax liability. The fund itself pays commission costs on purchases and sales of
portfolio holdings, which are charged against NAV although these commissions are lower than
what you and I pay. Nevertheless, total commission expenses are higher if the portfolio has
higher turnover.
6. Exchange Traded Funds
PPT 4-16 through PPT 4-18
Exchange Traded Funds have become popular and offer investors alternatives to traditional
7. Mutual Fund Investment Performance: A First Look
PPT 4-19 through PPT 4-20
Chapter 04 – Mutual Funds and Other Investment Companies
The evidence on mutual fund performance does not show a consistent superior performance to
broad market indexes. Evidence shows a tendency for some persistence in superior performance
8. Information on Mutual Funds
PPT 4-21
A partial list of sources of information on mutual funds appears in PPT 4-28. As the popularity