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
• Diversification and divisibility
• Professional management
• Lower transaction costs
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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
• A sponsor, typically a brokerage firm, buys a
portfolio of securities, which are deposited into
a trust.
• Sell to the public shares, or “unit,” in the trust,
called redeemable trust certificates.
• All income and payments of principal from the
portfolio are paid out by the fund’s trustees (a
bank or trust company) to the shareholders.
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4.2 Types of Investment Companies
• Unit Investment Trusts
• Little active management
• Invest in relatively uniform types of assets
• Profit earned by sponsors: sell shares in the
trust at a premium to the cost of acquiring the
underlying assets. E.g., $5 million of assets
may sell 5,000 shares to the public at a price of
$1,030 per share.
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4.2 Types of Investment Companies
• Managed Investment Companies
• A professional investment firm that manages a
portfolio for an annual fee
• Load: Sales commission
• Open-end or Closed-end fund
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4.2 Types of Investment Companies: Open vs. Closed
• Open-end fund
• A fund that issues or redeems its shares at net
asset value.
• Closed-end fund
• Share may not be redeemed or issued
• Investors “cash out” by selling their shares to
other investors in organized exchanges
• Trading prices can differ from net asset value
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4.2 Types of Investment Companies: Open vs. Closed
• Commingled Funds
• Partnership of investors pooling fund
• For trusts/larger retirement accounts
• Professional management for a fee
• Real Estate Investment Trusts (REITS)
• Similar to closed-end funds
• Invests in real estate (equity trusts) /real estate
loans (mortgage trusts)
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4.2 Types of Investment Companies: Open vs. Closed
• Hedge Funds
• Private investment pools
• Exempt from SEC regulation
• Open only to wealthy or institutional investors
• Initial “lock-up” periods: ability to invest in illiquid
assets
• Can be speculative in nature: heavy use of
derivatives, short sales, and leverage
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4.3 Mutual Funds: Investment Policies
Investment Policy Characteristics
Money Market Mutual Fund Commercial Paper, Repurchase Agreements, CDs
(MMMF)
Stocks, money market securities
Equity Funds
Income funds versus growth funds
Stocks concentrated in a particular industry
Equity Sector Funds
Specialize in fixed-income (bond) sector: corporate
Bond Funds bonds, T-bonds, mortgage-backed securities,
municipal bonds
World wide securities, including the U.S.A.
Global Funds
World wide securities, excluding the U.S.A.
International Funds
Foreign securities concentrated in certain regions
International Regional Funds
Securities from developing nations
Emerging Markets Funds
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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 securities
Asset Allocation/Flexible Funds —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
Costs incurred by mutual fund in operating portfolio,
Operating Expenses including administrative expenses and advisory fees
Investors are not explicitly billed
Commission or sales charge paid when purchasing shares
Effectively reduce the amount of money invested.
Example: Each $1,000 paid for a fund with a 6% load
Front-end Load incurs a sales charge of $60 and fund investment of only
$940. Break even requires the cumulative returns of 6.4%
of net investment ($$60/$940 = 6.4%)
Back-end load “Exit” fee incurred when selling shares
Annual fees charged by mutual fund to pay for
marketing/distribution costs such as advertising,
promotional literature including annual reports and
12b-1 charges prospectuses, and commissions paid to brokers who sell
the fund to investors
Investors are not explicitly billed
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4.4 Costs of Investing in Mutual Funds
• Fees, Loads, and Performance
• Gross performance of load funds is statistically
identical to gross performance of no-load funds
• Funds with high expenses tend to be poorer
performers
• 12b-1 charges should be added to operating
expenses to obtain the true annual expense
ratio of the fund
• Compare costs with Morningstar
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Example 4.1: Fees
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4.4 Costs of Investing in Mutual Funds
• Fees and Mutual Fund Returns
• Soft dollars: The value of research services that
brokerage house provides “free of charge” in
exchange for investment manager’s business
• The stockbroker effectively returns part of the
high trading commission to the fund.
• Funds with extensive soft-dollar arrangements
may report artificially low expense ratios to the
public.
• The impact of the higher trading commissions
shows up in net investment performance.
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Returns of Investing in Mutual Funds
• Rate of return = the increase or decrease in
net asset value plus income distributions
such as dividends or distributions of capital
gains expressed as a fraction of net asset
value at the beginning of the investment
period.
NAV1 NAV0 Income Capital gains distributions
Rate of return
NAV0
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Returns of Investing in Mutual Funds
• Example 4.2
• Consider a fund with $100 million in assets at
the start of the year and with 10 million shares
outstanding.
• The fund invests in a portfolio of stocks that
provides no income but increase in value by
10%.
• The expense ratio, including 12b-1 fees, is 1%.
• What is the rate of return for an investor in the
fund?
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Returns of Investing in Mutual Funds
• The initial NAV equals $100 million/10 million
shares = $10 per share.
• In the absence of expense, fund assets would
grow to $110 million and NAV would grow to $11
per share, for a 10% rate of return.
• The expense ratio of the fund is 1%. Therefore,
$1 million will be deducted from the fund to pay
these fees, leaving the portfolio worth only $109
million, and NAV equal to $10.90.
• The rate of return on the fund is only 9%, which
equals the gross return on the underlying portfolio
minus the total expense ratio.
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Table 4.2 Costs on Investment Performance: Example
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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
• Turnover: Ratio of trading activity to assets of
portfolio (Turnover affects investor’s tax liability)
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4.5 Taxation of Mutual Fund Income
• Implications of Fund Turnover
• Fund pays commission costs on portfolio
purchases and sales—charged against NAV
• Turnover rate measured as annual total asset
value bought or sold in a year divided by
average total asset value
• Example: A $100 million portfolio with $50
million in sales of some securities and
purchases of other securities would have a
turnover rate of 50%
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4.6 Exchange-Traded Funds
• Exchange-traded funds (ETFs)
• Offshoots of mutual funds that allow investors to
trade entire portfolios
• Unlike mutual funds, which can be bought or
redeemed only at the end of the day when NAV
is calculated, investors could trade ETFs
throughout the day, just like any other share 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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Actively Managed ETFs
• Starting in 2008, the SEC granted approval
for so-called ‘actively managed’ ETFs with
other investment objectives.
• Focus on attributes such as value, growth,
dividend yield, liquidity, recent
performance, or volatility—called smart
beta funds (or factor-based funds) because
“beta” is often used as jargon for the
sensitivity to one or another factor
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Actively Managed ETFs
• If actively managed ETFs had to report
portfolio holdings on a daily basis,
competitors could take advantage of their
buying and selling programs.
• In 2014, the SEC gave permission to Eaton
Vance to offer an actively managed
“nontransparent” ETF that is required to
report its portfolio composition only once
each quarter, the same frequency at which
mutual funds disclose their portfolio
holdings.
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Advantages of ETFs over Mutual Funds
• ETFs trade continuously.
• A mutual fund’s net asset value is quoted—and
therefore, investors can buy and sell their
shares in the fund—only once a day.
• Like stocks, but unlike mutual funds, EFTs
can be sold short or purchases on margin.
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Advantages of ETFs over Mutual Funds
• ETFs offer a potential tax advantage over
mutual funds.
• When large numbers of mutual fund investors
redeem their shares, the fund must sell securities
to meet the redemptions. The sale can trigger
capital gains taxes, which are passed through to
and must be paid by the remaining shareholders.
• In contrast, when small investors wish to redeem
their position in an ETF they simply sell their
shares to other traders, with no need for the fund
to sell any of the underlying portfolio.
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Advantages of ETFs over Mutual Funds
• ETFs offer a potential tax advantage over
mutual funds.
• When large traders wish to redeem their
position in the ETF, redemptions are satisfied
with shares of stock in the underlying portfolio.
This redemption does not trigger a taxable
event.
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Advantages of ETFs over Mutual Funds
• 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 significantly from the NAV of that
portfolio.
• Any meaningful discrepancy would offer
arbitrage trading opportunities for these
large traders, which would quickly eliminate
the disparity.
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4.7 Mutual Fund Investment Performance: Figure 4.4
• Average MF performance < broad market performance
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Table 4.3 Consistency of Investment Results
• Evidence suggests some persistence in positive
performance over certain horizons
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Table 4.3 Consistency of Investment Results
• If performance were due entirely to skill,
with no randomness, we would expect to
see entries of 100% in each cell because
each above-average fund would continue
to be above average.
• If performance were purely random from
one year to the next, continued
outperformance would essentially be a coin
flip, and we would expect each entry to be
50%.
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4.8 Information on Mutual Funds
• Sources of Information on Mutual Funds
• Morningstar ([Link])
• Fund prospectus
• Yahoo!
• The Wall Street Journal
• Investment Company Institute ([Link])
• American Institute of Individual Investors
• Brokers
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