CHAPTER 4

Mutual Funds and Other

Investment Companies

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McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
 Investment Companies
• Pool funds of individual investors and invest
in a wide range of securities or other assets.
• Services provided:
– Administration & record keeping
– Diversification & divisibility
– Professional management
– Reduced transaction costs

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 Net Asset Value - Calculation

Net Asset Value (NAV) =

Market Value of Assets - Liabilities

Number of Shares Outstanding

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 Types of Investment Companies
• According to Investment Company Act of
1940:
• Unit Investment Trusts
• Managed Investment Companies
– Closed-end
– Open-end (aka Mutual Funds)

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 Types of Investment Companies
• Unit Trusts
– Fixed portfolio of uniform assets
– Unmanaged
– Cash out by selling back to Trustee, which will
disinvest or find new buyer
– Total assets have declined from $105bn in 1990
to $29bn in 2009 (recovered to ~60bn in 2012)
Q. When was the first one created?
1868: created to give smaller investors access to the new
stock markets of the USA. Also used to bankroll expansion
(such as railway lines) in the New World, hence names such
as Foreign & Colonial. Many were formed in Scotland, still a
centre of investment trusts.
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 Types of Investment Companies
Managed Investment Companies
• Closed-End
– No change in shares outstanding; old investors
cash out by selling to new investors
– Priced at premium or discount to NAV
• Open-End (Mutual Funds)
– Fund issues new shares when investors buy in,
and redeems shares when investors cash out
– Priced at Net Asset Value (NAV)
– Transactions are executed after market closes
and NAV is computed (more about this later)
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 Types of Investment Companies
• Other investment organizations
– Commingled funds: partnership of investors
that pool money. Resemble mutual funds (units
instead of shares).
– REITs: similar to closed-end fund. Most are
leveraged. Equity and Mortgage trusts.
– Hedge Funds: pools of assets actively managed.
Lock-up periods. Leverage and risk. More later in
the textbook.

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 Mutual Funds types
• Money Market
• Equity
• Sector
• Bond
• International
• Balanced and funds of funds
• Asset Allocation and Flexible
• Index

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Table 4.1 - U.S. Mutual Funds by Investment
Table 4.1 U.S. Mutual Funds by Investment
Classification (Investm. Company Inst. 2009)

Classification

9
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 Table 4.1 U.S. Mutual Funds by
Table 4.1 - U.S. Mutual Funds by Investment
Classification (Investm. Company Inst. 2012)

Investment Classification

10
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 Mutual Funds Market

(Year-end 2011)
Source: http://www.icifactbook.org/fb_ch2.html
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 Mutual Funds Market

(Year-end 2013)
Source: http://www.icifactbook.org/fb_ch2.html
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Mutual Funds Flows
($bn)

Source: http://www.icifactbook.org/fb_ch2.html
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 How Funds Are Sold
• Direct-marketed funds (mail, phone, internet)
• Sales force distributed (about half)
– Revenue sharing on sales force distributed
(you ultimately pay for it)
– Potential conflicts of interest
– SEC: “Must tell prospective investors”
• Financial Supermarkets
– No charge, but fee split with MF company
– Unified reporting

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Costs of Investing in Mutual Funds
• Fee Structure – Four types:
1. Operating expenses
2. Front-end load
3. Back-end load (contingent deferred sales fee)
4. 12 b-1 charge (From SEC rule #, includes misc.
costs, broker commissions)
• Fees must be disclosed in the prospectus
• Share classes with different fee combinations

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Example 4.2: Fees for Various Classes
(Dreyfus Worldwide Growth Fund)

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Fees and Mutual Fund Returns example
• Initial NAV = $20
• Income distributions of $0.15
• Capital gain distributions of $0.05
• Ending NAV = $20.10:

N A V1  N A V 0  Incom e  C apital G ain

R 
N A V0

$20.10 - $20.00 + $.15 + $.05

Rate of Return =  1.5%
$20.00
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Table 4.2 Impacts of Costs on
Investment Performance

All grow 12% p.a.

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 Late Trading and Market Timing
• Late trading – accepting buy or sell orders
after the market closes and NAV is
determined
• Market timing – rapid in-and-out trading on
stale net asset values
• Net effect is to transfer value from ordinary
shareholders to privileged traders
Q. Why should MF managers allow this?

• Mutual funds penalized for improper trading.

New rules to prevent these practices
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 Taxation of Mutual Fund Income
• Pass-through status under the U.S. tax code
– Taxes are paid only by the investor (you)
– Fund investors do not control the timing of the
sales of securities from the portfolio
Q. What is the tax difference between short and long
term capital gain(loss)?
• Turnover = fraction of portfolio replaced
• High portfolio turnover (60% on average) leads to
tax inefficiency

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 Exchange Traded Funds (ETFs)
• Examples: “spiders”, “diamonds” and “cubes”
• Potential advantages:
– Trade continuously like stocks
– Can be sold short or purchased on margin
– Lower costs
– Tax efficient
• Potential disadvantages:
– Prices can depart by small amounts from NAV
– Must be purchased from a broker

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 Total Net Assets, Number of ETFs
$bn, year-end 2002-2013

Source: http://www.icifactbook.org/fb_ch3.html
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Fig 4.2 Growth of U.S. ETFs, per type
1,000,000
Bond
900,000
Commodities
800,000
Global/int'l equity
ETF assets ($ million)

700,000

600,000
U.S. equity: sector

500,000
U.S. equity: broad index

400,000

300,000

200,000

100,000

0
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

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Mutual Fund Investment Performance:
A First Look
• Performance of actively managed funds:
– below the return on the Wilshire index in 23 of
the 41 years from 1971 to 2011
– Evidence for persistent superior performance
(due to skill, and not just good luck) is weak, but
suggestive
– Bad performance more likely to persist

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 Figure 4.4 Diversified Equity Funds versus
Wilshire 5000 Index (see here)
40% Active funds Wilshire 5000

30%

20%
Rate of Return

10%

0%

-10%

-20%

-30%

-40%
1971

1975

1979

1983

1987

1991

1995

1999

2003

2007

2011
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 Information on Mutual Funds
• Fund’s prospectus describes:
– investment objectives
– Fund investment adviser and portfolio manager
– Fees and costs
• Statement of Additional Information (SAI)
– List of securities, etc. You must ask for it.
– aka Something Always Ignored
• Fund’s annual report

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 Information on Mutual Funds
• Wiesenberger’s Investment Companies
• Morningstar (www.morningstar.com)
• Yahoo (biz.yahoo.com/funds)
• Investment Company Institute (www.ici.org)
• Directory of Mutual Funds

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Table 4.3 ETF Sponsors and Products

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Let’s move to the next chapter

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