Chapter

Mutual Funds and Other

4 Investment Companies

Bodie, Kane, and Marcus

Essentials of Investments
12th Edition
 4.1 Investment Companies

• Investment companies
• Financial intermediaries that invest the funds of
individual investors in securities or other assets

• Net asset value (NAV)

• Assets minus liabilities per share

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 4.1 Investment Companies
• Functions
• Record keeping and administration: Handle all paperwork,
transaction records, and reports for investors automatically,
saving time and effort.
• Diversification and divisibility: Allow investors to own a share
of a broad range of assets, reducing the impact of any single
asset's poor performance.
• Professional management: Expert managers select and
monitor the investments, so investors benefit from their
experience and research.
• Lower transaction costs: Trading as part of a large pooled
fund means each investor pays a much smaller share of the
buying and selling costs than if investing alone.
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 4.2 Types of Investment Companies
• Unit Investment Trusts
• Money pooled from many investors is invested in portfolio
fixed for life of fund
• Managed Investment Companies
• A professional investment firm that manages a portfolio
for an annual fee
• Load: Sales commission: This is a one-time fee or
commission paid to a broker or intermediary when you
buy (front-end load) or sell (back-end load) shares in a
mutual fund. It compensates the seller for their service
and advice and is charged as a percentage of your
investment amount.
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 4.2 Types of Investment Companies

Open-end or Closed-end fund: Open-end funds

issue and redeem shares at any time directly with
the fund at the fund’s net asset value (NAV),
allowing continuous investment and withdrawal.
Closed-end funds issue a fixed number of shares in
an initial public offering, and those shares are
traded on the stock exchange, sometimes at prices
different from the NAV.

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 4.2 Types of Investment Companies: Open vs. Closed

• Commingled Funds (‫)الصناديق المختلطة‬

• Partnership of investors pooling fund
• For trusts/larger retirement accounts
• Professional management for a fee

• Real Estate Investment Trusts (REITS)

• Invests in real estate/real estate loans

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 4.2 Types of Investment Companies: Open vs. Closed
Hedge Funds: These are investment funds that pool money from
high-net-worth individuals or institutional investors, seeking to
achieve high returns using various complex strategies.
• Private investment pools: Hedge funds are privately organized and
not offered to the general public; only accredited investors can
participate.
• Exempt from SEC regulation: Because they are private and target
select wealthy investors, hedge funds operate with fewer regulatory
constraints and disclosures than mutual funds or other public
funds.
• Can be speculative in nature: Hedge funds often use aggressive
and risky strategies, such as short selling, derivatives, and
leverage, aiming for high profits, which makes them more
speculative compared to traditional investments.
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 4.3 Mutual Funds: Investment Policies
Investment Policy Characteristics
Money Market Mutual Fund Commercial Paper, Repurchase Agreements, CDs
(MMMF)
Equity Funds Stocks, Some fixed-income or other securities

Equity Sector Funds Stocks concentrated in a particular industry

Bond Funds Specialize in fixed-income (bond) sector

Global Funds World wide securities, including the U.S.A.

International Funds World wide securities, excluding the U.S.A.

International Regional Funds Foreign securities concentrated in certain regions

Emerging Markets Funds Securities from developing nations

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4.3 Mutual Funds: Investment Policies (Continued)

Investment Policy Characteristics

Balanced Fund: Hold both equities and fixed-income securities
Hold both equities and fixed-income securities
Life Cycle Fund: Static Allocation
stable proportions
Life Cycle Fund: Targeted- Targeted maturity funds become more
Maturity conservative as investor ages
Hold both equities and fixed-income
Asset Allocation/Flexible Funds securities—proportion varies according to
market forecast (market timing)
Try to match performance of broad market
Index Funds index; Buy shares in proportion to security’s
representation in index
Mutual funds that primarily invest in other
Fund of Funds
mutual funds

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 Table 4.1 U.S. Mutual Funds by Investment Classification

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 4.4 Costs of Investing in Mutual Funds: Fee Structure

Fee Structure Definition

Operating Expenses Costs incurred by mutual fund in operating portfolio
Front-end Load Commission or sales charge paid when purchasing shares
“Exit” fee incurred when shares are sold or redeemed; the
Back-end load fee is deducted from the proceeds at the time of selling
the mutual fund shares.
Annual fees charged by mutual fund to pay for
12b-1 charges
marketing/distribution costs

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 Example 4.1: Fees

Comparison of investment funds in KSA:

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Nin2YTYtdmG2KfYr9mK2YIg2KfZhNin2LPYqtir2YXYp9ix2YrYqQ%3D%3D
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 4.4 Costs of Investing in Mutual Funds HERE

• NAV and Effective Load

• Cost to initially purchase one share of load fund
= NAV + Front-end load (%) (if any)
• Stated loads typically range from 0 to 8.5%
• Load is designed to offset marketing expenses
• Goes to broker who sells fund to investor
• Effective load greater than stated load

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 4.4 Costs of Investing in Mutual Funds

• Fees and Mutual Fund Returns

• Soft dollars: Value of research services
brokerage house provides “free of charge” in
exchange for business

• Rate of Return:

NAV1 − NAV0 + Income + Capital gains distribution

Rate of return =
NAV0

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 4.4 Costs of Investing in Mutual Funds
• Example Data
• Beginning net asset value (NAV₀): $20
• Ending net asset value (NAV₁): $22
• Income (dividends received per share): $0.50
• Capital gains distribution: $1.00
• Calculation
• Plug into the formula:
22−20+0.50+1.00 3.50
• 𝑅𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 = = = 0.175 𝑜𝑟 17.5%
20 20

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 Table 4.2 Costs on Investment Performance: Example

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 Table 4.2 Costs on Investment Performance: Example
Table 4.2 considers an investor who starts with $10,000 and can choose
between three funds that all earn an annual 10% return on investment
before fees but have different fee structures.
• The table shows the cumulative amount in each fund after several
investment horizons.
To find the average annual rate (CAGR):
25,354 1
𝐶𝐴𝐺𝑅(𝐴) = ( )10 −1 ≈ (2.5354)0.1 − 1 ≈ 0.0965 = 9.65% ≈ 10%
10,000
Based on the table, students should choose Fund A for the best outcome in
terms of both fees and returns. Fund A has the lowest expense ratio (0.25%),
no load fees, and delivers the highest cumulative proceeds over all periods—
especially over the long term (e.g., $64,282 after 20 years from an initial
$10,000 investment). High fees and sales charges, like those for Fund B (1.25%
expense ratio) and Fund C (6% front-end load plus 0.80% expense),
significantly reduce investment growth over time.
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 4.5 Taxation of Mutual Fund Income

• General Tax Rules

• Fund not taxed if diversified and income
distributed

• Investor taxed on capital gain and dividend

distributions

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 4.6 Exchange-Traded Funds

• Exchange-traded funds (ETFs)

• Offshoots of mutual funds that allow investors to
trade entire portfolios
• Much like shares of stock

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 Figure 4.2 Assets in ETFs

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 Figure 4.3 Investment Company Assets under Management

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 4.7 Mutual Fund Investment Performance: Figure 4.4
• Average MF performance < broad market performance

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 4.8 Information on Mutual Funds
• Sources of Information on Mutual Funds
• Morningstar (www.morningstar.com)
• Fund prospectus
• Yahoo!
• The Wall Street Journal
• Investment Company Institute (www.ici.org)
• American Institute of Individual Investors
• Brokers

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