Chapter 4 Outline - Summary Essentials of Investments PDF

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Chapter 4 Outline Mutual Find and Other Investment Companies

Investment Companies -

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Investment companies are financial intermediaries that invest the funds of individual investors in securities or other assets Pooling of assets is the key idea behind investment companies Investment companies perform several important functions: o Record keeping and administration o Diversification and divisibility o Professional management o Lower transaction costs (because investment companies trade large blocks of securities, they save on brokerage fees and commissions) Investors buy shares in investment companies, and ownership is proportional to the number of shares purchased. o The value of each share is called the Net Asset Value (NAV) o NAV= (market value of assets- liabilities) / shares outstanding o If a mutual fund managers a portfolio worth 120 million, and owes 4 million to advisors and another 1 million for rent and wages due, and the fund has 5 million shares, the NAV= (120 mil – 5 mil) / 5 mil = $23/share There are two main types of Investment Companies o Unit Investment Trusts  These trusts are money pooled from many investors that is invested in a portfolio fixed for the life of the fund  A brokerage firm buys a portfolio of securities which are deposited into a trust. It then sells public shares, or units, called redeemable trust certificates  These are unmanaged, not very active funds  These trusts are usually made up of one particular type of asset  Sponsors of unit trusts earn their profit by selling shares in the trust at a premium to the cost of acquiring the underlying assets  Investors who wish to liquidate their holdings of a unit investment trust may sell the shares back to the trustee for NAV o Managed Investment Companies: Closed-end and Open-end funds  Open-end fund (mutual fund) is a fund that issues or redeems its shares at net asset value  They stand ready to redeem or issue shares at their NAV, although purchases and redemptions involve sales charges  When investors wish to cash out their shares, they sell them back to the fund at NAV

The offering price will exceed NAV is the fund carries a load. A load is a sales commission charged on a mutual fund.  Open-end funds do not trade on organized exchanges. Buying and selling happens directly through the investor and the investment company  Closed-end fund is a fund where shares may not be redeemed, but instead are traded at prices that can differ from NAV  Investors who wish to cash out must sell their shares to other investors on an organized exchange. These shares can be purchased through brokers just like other common stock.  Their prices differ from NAV. The premium or discount is the percentage difference between the price and NAV: (Price-NAV)/NAV  Example: Black Rock equity dividend (BDV) Real Estate Investment Trusts (REITs) o Similar to a closed-end fund. They invest in real estate or loans secured by real estate. Equity trusts and mortgage trusts Hedge Funds o Like mutual funds (open-ended), hedge funds are vehicles that allow private investors to pool assets to be invested by a fund manager o A hedge fund is a private investment pool, open to wealthy or institutional investors, that is exempt from SEC regulation and can therefore pursue more speculative policies than mutual funds o “Lock-ups” : periods of several years where investments can not be withdrawn 

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Mutual Funds -

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Common name for an open-ended investment company Each mutual fund has a specified investment policy, which is described in the fund’s prospectus. Management companies (Vangaurd, Fidelity, etc) manage a collection of funds under one umbrella, making it easy for investors to allocate assets across market sectors and to switch assets across funds while still benefitting from centralized recordkeeping Money Market Funds o Invest money in market securities such as commercial paper or CDs. Short maturities. NAV is fixed at $1 so that there are no tax implications such as capital gains or losses associate with redemption of shares Equity Funds o Invest primarily in stock but may also hold fixed-income or other types of securities. Income funds tend to hold shares of firms with high dividend yields that provide high current income. Growth funds are

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willing to forgo current income, focusing instead on prospects for capital gain Bond Funds o Fixed-income sector o Various funds will concentrate in corporate bonds, treasury bonds, mortgage-backed securities, or municipal (tax free) bonds Funds of funds are mutual funds that primarily invest in shares of other mutual funds Index fund o Tries to match the performance of a broad market index. o Passive investment strategy

Costs of Investing in Funds -

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Operating expenses are the costs incurred by the mutual fund in operating the portfolio, including administrative expenses an advisory fees paid to the investment manager. They range from .2-2% o The expenses are periodically deducted from the assets of the fund. o Shareholders pay for these expenses through the reduced value of the portfolio In addition to operating expenses, most funds assess fees to pay for marketing and distribution costs o Front-end load is a commission or sales charge paid when you purchase the shares. These charges are used primarily to pay the brokers who sell the funds o Back-end load is a redemption or “exit” fee incurred when you sell your shares. Typically, funds that impose back-end loads start them at 5 or 6% and reduce them by one percentage point for every year the funds are left invested. o 12b-1 charges are annual fees charged by a mutual fund to pay for marketing and distribution costs  Class A shares have front-end loads and a small 12b-1 fee around .25%  Class B shares rely on larger 12b-1 fees, commonly 1%, and often charge a modest back end load. If an investor holds a class B share for a long time, they will often convert into Class A shares  Class C share generally rely on 12b-1 fees and back-end loads. These shares usually do not convert to class A. o Loads are only paid once for each purchase, whereas 12b-1 fees are paid annually Rate of Return = (NAV1- NAV0 + Income and capital gain distributions) / NAV 0 o This ignores any commissions such as front-end loads In terms of taxation, investment returns of mutual funds are granted “passthrough status” under the U.S. tax code, meaning that taxes are paid only by the investor in the mutual fund, not by the fund itself.

o A fund’s short term cap gains, long-term cap gains, and dividends are passed through to investors as though the investor earned the income directly o A fund with a high portfolio turnover rate can be particularly “tax inefficient”. Turnover is the ratio of the trading activity of a portfolio to the assets of the portfolio

Exchange Traded Funds -

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ETFs are offshoots of mutual funds first introduced in 1993 that allow investors to trade index portfolios just as they do shares of stock Unlike mutual funds, which can be bought or sold only at the end of the day when NAV is calculated, investors could trade ETFs throughout the day. Barclay’s Global Investors was log the market leader in the ETF market, using the product name iShares. The firm sponsors many ETFs including broad U.S. equity indexes, broad international and single-country funds, and U.S. and global industry sector funds. Leveraged ETFs have daily returns that are a targeted multiple of the returns on an index. ETFs offer several advantages over mutual funds: o A mutual fund’s NAV is quoted and therefore investors can buy or sell their shares in the fund only once a day whereas ETFs trade continuously o ETFs can be sold short or purchased on margin o They offer potential tax advantage o When large traders wish to redeem their position in the ETF, redemptions are satisfied with shares of stock in the underlying portfolio. A redemption does not trigger a stock sale by the fund sponsor o The ability of large investors to redeem ETFs for a portfolio of stocks constituting the index, or to exchange a portfolio of stocks for shares in the corresponding ETF, ensures that the price of an ETF cannot depart for long from the NAV of that portfolio. o ETFs are cheaper than mutual funds. Reduction in expenses means lower fees. However, ETFs must be purchased from brokers for a fee. Investors also incur a bid-ask spread when purchasing an ETF. o When markets are not working properly, it can be hard to measure the NAV of the ETF portfolio, especially for ETFs that track less liquid assets. And, reinforcing this problem, some ETFs may be supported by only a small number of dealers. If they drop out of the market during a period of turmoil, prices may swing wildly....