Chapter 10

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 fund’s 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 securities—that 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 S&P 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 instruments—as 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

29. 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).

30. Prospectus • the fund’s investment objectives • the fund’s 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 PMAopened 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 client’s objectives & risk tolerance • Third party evaluations • Fees & Expenses • Diversification/concentration • Experience, qualifications, and longevity of the fund’s 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