FINA 4310

Spring 2002
Chapter 4: Mutual Funds and Other Investment Companies

Investment Companies
Unit Investment Trusts Managed Investment Companies
Open-end funds (Mutual Funds) Closed-end funds

Real Estate Investment Trusts (REITs) Exchange-Traded Funds (ETFs) Commingled Funds Hedge Funds

Unit Investment Trusts

Portfolio is fixed for the life of the trust Fixed-Income UIT
Government securities Corporate bond Municipal bond International bond

Equity UIT

Mutual Funds
Open-end funds
Invest by sending money directly to the fund New units are created as new money flows in Units retired as money flows out Go in and out at Net Asset Value (NAV)

Management companies Families

Fidelity Vanguard

Many Others

Types of Mutual Funds

Equity Funds Fixed-Income Funds Money Market Funds Balanced Funds Asset Allocation Funds Index Funds Specialized Funds

Equity Mutual Funds

Aggressive Growth/Capital Appreciation
Small companies/Narrow market sectors

Growth
Firms with good revenue & earnings potential

Blend (Growth and Income)

Combination of Growth and Value Stocks

Value
Profitable, Dividend-paying stocks Stocks with low P/E ratios

Balanced Funds
Invests in both equities and fixed income securities Proportion of stocks and bonds fairly stable over time Designed to be an investors entire portfolio Example: ARK Balanced Fund

Asset Allocation Fund

Like Balanced Funds, hold both stocks and bonds Proportion of stocks vs. bonds varies substantially over time Manager tries to increase returns by timing the market Example: Preferred Asset Allocation Fund

Index Funds
Passive Management Goal is to match the performance of a benchmark index Low expenses Most Popular Benchmark: S&P 500 Index Example: Vanguard Index Funds

Specialized Funds
Focus on a particular sector or industry
Real Estate Technology Health Care Utilities Financial Services

Closed-end Funds
Do not create or redeem shares After initial offering, shares trade on secondary market To invest, buy shares on the exchange May trade above or below NAV
Above: Premium Below: Discount

Real Estate Investment Trusts

Like a closed-end fund
Buy it on an exchange

Equity REITS
Buy investment property

Mortgage Trusts
Buy mortgage loans

Exchange-traded Funds
Like closed-end funds, they trade on an exchange Like index funds, they tend to be passively managed A variety of legal forms:
Unit Investment Trusts (SPDRs, HOLDRs) Open-end Mutual funds (iShares) Traditional mutual fund share class (Vipers)

Commingled Funds
Partnerships of investors that pool their funds Similar to open-end mutual fund Typically, small institutional investors
Most commonly pension plans Larger than typical individual investor Too small to warrant individual management

Hedge Funds
Limited partnership of investors
Accredited investors (high net worth) Restricted to 499 partners Cannot advertise Less regulated than mutual funds
Manager has freedom to follow a wider variety of investment strategies fewer reporting requirements

Mutual Fund Fees

Front-end load Back-end load 12b-1 charges Operating Expenses Broker Commissions

Front-end Load
This is a sales charge, or commission charged to enter a fund Paid as a percentage of investment Can be as large as 8.5% Rarely higher than 6.25% Often much lower, down to zero No Load Fund means no front-end load

Back-end Load
Also called:
Redemption Fee Contingent Deferred Sales Charge

This is a fee charged when you exit the fund Charged in percentage terms Some funds have no back-end load If they do, it often drops off gradually to zero the longer you hold the fund Discourages investors with short horizons

12b-1 charges
Managers can use up to 1% of the funds assets each year to pay for...
Advertising Annual reports and prospectuses Commissions paid to brokers

Because these fees come straight from the funds assets, they are hidden costs to the investor

Operating Expenses
Administrative Expenses Advisory fees paid to manager Should be less than 2% per year Again, this comes out of the funds assets. (You dont see them explicitly, but pay for them in the form of lower returns) Measured by expense ratio

Brokerage Commissions
If your broker does not have an arrangement with the mutual fund management company, they will charge you a commission to invest for you. But, you do not need to go through a broker at all. You can buy (and redeem) shares directly from the mutual fund.

Classes of Mutual Fund shares

One fund can have multiple classes with different fees
Class A: Front-end load Class B: Back-end load and 12b-1 Class C: Higher 12b-1 fees

Investor class and premium class shares

Example: Vanguard Admiral Shares