Chap-4

Report
Mutual Funds and Other
Investment Companies
Bodie, Kane, and Marcus
Essentials of Investments,
9th Edition
McGraw-Hill/Irwin
4
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
4.1 Investment Companies
• Functions
• Record keeping and administration
• Diversification and divisibility
• Professional management
• Lower transaction costs
• Definitions
• Investment company: Financial intermediaries
• Net asset value (NAV): Assets minus liabilities
per share
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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
• Open-end fund: Issues or redeems shares at
net value
• Closed-end fund: Shares can’t be redeemed,
are traded at prices different than NAV
• Load: Sales commission charged on mutual
fund
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4.2 Types of Investment Companies
• Open-End and Closed-End Funds: Key
Differences
• Shares Outstanding
• Closed-end: No change unless new stock offered
• Open-end: Changes when new shares are sold or old
shares are redeemed
• Pricing
• Open-end: Fund share price = Net asset value (NAV)
• Closed-end: Fund share price may trade at premium or
discount to NAV
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Figure 4.1 Closed-End Mutual Funds
Fund
NAV
Adams Express Company (ADX)
12.89
11.11
−13.81
26.13
Advent/Clay Enhcd G&I (LCM)
12.16
11.58
−4.77
23.52
BlackRock Equity Div (BDV)
10.65
10.03
−5.82
27.39
BlackRock Str Eq Div Achv (BDT)
11.8
10.68
−9.49
26.17
Cohen & Steers CE Oppty (FOF)
14.64
13.46
−8.06
25.17
Cohen & Steers Dvd Mjrs (DVM)
14.70
13.82
−5.99
49.28
Eaton Vance Tax Div Inc (EVT)
18.75
17.19
−8.32
29.89
Gabelli Div & Inc Tr (GDV)
18.64
16.58
−11.05
43.52
Gabelli Equity Trust (GAB)
6.08
6.10
0.33
48.48
General Amer Investors (GAM)
32.71
28.26
−13.60
30.93
Guggenheim Enh Eq Inc (GPM)
9.58
9.65
0.73
38.93
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Mkt Price Prem/Disc % 52 Wk Return %
54-5
4.2 Types of Investment Companies
• Other Investment Organizations
• Commingled Funds
• Partnership of investors pooling funds; designed for
trusts/larger retirement accounts to get professional
management for fee
• Real Estate Investment Trusts (REITs)
• Similar to closed-end funds, invests in real estate/real
estate loans
• Hedge Funds
• Private speculative investment pool, exempt from
SEC regulation
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4.3 Mutual Funds
• Investment Policies
• Money market funds
• Commercial paper, repurchase agreements, CDs
• Equity funds
• Invest in stock, some fixed-income, or other securities
• Specialized sector funds
• Concentrate on particular industry
• Bond funds
• Specialize in fixed-income (bonds) sector
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4.3 Mutual Funds
• Investment Policies
• International funds
• Global funds invest in securities worldwide,
including U.S.
• International funds invest outside U.S.
• Regional funds focus on particular part of world
• Emerging market funds invest in developing
nations
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4.3 Mutual Funds
• Investment Policies
• Balanced funds
• Hold both equities and fixed-income securities in stable
proportion
• Life-cycle funds: Asset mix ranges from aggressive to
conservative
• Static allocation funds maintain stable mix across
stocks and bonds
• Targeted maturity funds become more conservative
as investor ages
• Funds of funds: Mutual funds that primarily invest in
other mutual funds
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4.3 Mutual Funds
• Investment Policies
• Asset allocation and flexible funds
• Stocks and bonds—proportion varies according to
market forecast
• Index funds
• Try to match performance of broad market index
• Buy shares in securities included in particular index in
proportion to security’s representation in index
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Table 4.1 U.S. Mutual Funds by Investment Classification
Assets ($ billion)
Percent of Total Assets
Number of Funds
Equity Funds
Capital appreciation focus
World/international
Total return
Total equity funds
2,912
1,660
1,950
6,522
24.2%
13.8%
16.2%
54.2%
3,037
968
762
4,767
Bond Funds
Corporate
High yield
World
Government
Strategic income
Single-state municipal
National municipal
Total bond funds
301
157
84
203
560
156
218
1,679
2.5%
1.3%
0.7%
1.7%
4.7%
1.3%
1.8%
14.0%
293
206
122
301
370
451
224
1,967
713
5.9%
488
2,642
465
3,107
22.0%
3.9%
25.8%
548
259
807
12,021
100.0%
8,029
Hybrid (bond/stock) funds
Money market funds
Taxable
Tax-exempt
Total money market funds
Total
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4.4 Costs of Investing in Mutual Funds
• Fee Structure
• Operating expenses: Costs incurred by mutual
fund in operating portfolio
• Front-end load: Commission or sales charge
paid when purchasing shares
• Back-end load: “Exit” fee incurred when selling
shares
• 12b-1 charges: Annual fees charged by mutual
fund to pay for marketing/distribution costs
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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 expense
ratios
• Compare costs with Morningstar
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4.4 Costs of Investing in Mutual Funds
• 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 expenses of
marketing the fund; it 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
• Avoiding the Load
• Choose different class of fund shares
Notes:
a Depending on size of investment.
b Depending on years until holdings are sold.
c Including service fee of .25%.
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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 
NAV 1  NAV 0  Income  Capital gains distributi
on
NAV 0
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Table 4.2 Impact of Costs on Investment Performance
Notes: Fund A is no-load with .5% expense ratio, Fund B is no-load with
1.5% total expense ratio, and Fund C has an 8% load on purchases and
a 1% expense ratio. Gross return on all funds is 12% per year before
expenses.
* After front-end load, if any.
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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
• Portfolio turnover may affect 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
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4.6 Exchange-Traded Funds
• Exchange-Traded Funds: Offshoots of
mutual funds that allow investors to trade
index portfolios
• Potential Advantages
• Trade continuously throughout day
• Can be sold or purchased on margin
• Potentially lower tax rates
• Lower costs (no marketing, lower fund
expenses)
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4.6 Exchange-Traded Funds
• Potential Disadvantages
• Small deviations from NAV possible
• Brokerage commission to buy ETF
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Table 4.3 ETF Sponsors and Products
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Figure 4.2 Assets in ETFs
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Figure 4.3 Investment Company Assets under Management, 2010 ($
Billion)
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4.7 Mutual Fund Investment Performance
• On average, mutual fund performance less
than broad market performance
• Evidence suggests some persistence in
positive performance over certain horizons
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Figure 4.4 Average Returns on Diversified Equity Funds
vs. Wilshire 5000 Index
50%
40%
30%
Rate of return (%)
20%
10%
0%
-10%
-20%
-30%
-40%
Diversified equity funds
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2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
1979
1978
1977
1976
1975
1974
1973
1972
1971
-50%
Wilshire return
264-26
Table 4.4 Consistency of Investment Results
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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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Sample Problems
4-29
Problem 1
NAV is $10.70 Front-end load is 6%
Every dollar paid results in only ____
$.94 going
toward purchase of shares.
Offer price =
NAV =
1 - load
$10.70 =
1-.06
$11.38
4-30
Problem 2
Offer price $12.30 Front-end load is 5%
$.95
Every dollar paid results in only ____
going toward purchase of shares.
NAV
= offer price x (1- load)
= $12.30 x 0.95
= $11.69
4-31
Problem 3
NAV = (Market Value of Assets – Liabilities)  Shares Outstanding
A. (200,000)x($35) = $ 7,000,000
Liabilities
B. (300,000)x($40) = $12,000,000
$30,000
C. (400,000)x($20) = $ 8,000,000
D. (600,000)x($25) = $15,000,000
Shares Outstanding
$42,000,000
4,000,000
$42,000,000 – $30,000 = $10.49 = NAV
4,000,000
4-32
Problem 4
Turnover rate = Value of stocks sold and replaced
Market Value Assets
MVA = $42M
Value of stocks sold = (600,000x$25)= $15,000,000
or
Value of stocks purchased = (200kx$50)+(200kx$25) = $15,000,000
Market Value Assets = $42,000,000
$15,000,000 = 0.357
$42,000,000
Average holding period?
or 35.7%
AHP = 0.5 x 1/Turnover
= 0.5 x 1/0.357 = 1.4 yrs
4-33
Problem 5
a.
The empirical research suggests that past performance
is not highly predictive of future performance, especially
for better performing funds. There may be some
tendency for the fund to perform better than average
next year, but it is unlikely that the fund will be in the top
10%.
b.
Evidence suggests that bad performance is more likely
to persist. Probably related to high fund costs or high
turnover rates. Excessive costs are detrimental to a
fund’s returns.
4-34
Problem 6




As an initial approximation, your return equals the return on
the shares minus the total of the expense ratio and purchase
costs:
•
Return  12%  1.2%  4% = 6.8%
But the precise return is less than this because the 4% load is
paid up front, not at the end of the year.
To purchase the shares, you would have had to invest:
•
$20,000 / (1  0.04) = $20,833
The shares net increase in value (12%  1.2%) from $20,000 to:
•
$20,000  (1.12  0.012) = $22,160
The rate of return is:
($22,160  $20,833) / $20,833 = 6.37%
4-35
Problem 7
a.
Sell after 4 years: Suppose you have $1000 to invest. The
$940 net of the front-end
initial investment in Class A shares is ____
load. After 4 years, your portfolio will be worth:
$940  (1.10)4 = $1,376.25
Class B shares allow you to invest the full $1,000, but your
investment performance net of 12b-1 fees will be only 9.5%,
and you will pay a 1% back-end load fee if you sell after 4
years.
Your redemption value after 4 years will be:
$1,000  (1.095)4 x 0.99 = $1,423.28
Class B shares are the better choice if your horizon is 4 years.
4-36
Problem 7 Cont.
b.
Sell after 15 years:
With a 15-year horizon, the Class A shares will be worth:
$940  (1.10)15 = $3,926.61
For the Class B shares, there is no back-end load in this case
since the horizon is greater than 5 years. Therefore, the value
of the Class B shares will be: N x LN [1.10 / 1.095]
$1,000  (1.095)15 = $3,901.32
At this longer horizon, Class A shares are the better choice.
Why?
4-37
Problem 8

Suppose that finishing in the top half of all portfolio
managers is purely luck, and that the probability of
doing so in any year is exactly 50%.

Then the probability that any particular manager would
finish in the top half of the sample five years in a row is
0.505 = 0.03125.

We would then expect to find that [350  0.03125]  11
managers finish in the top half for each of the five
consecutive years.
4-38
Problem 9
Trading costs will reduce the portfolio return by
(0.4%)x(0.50)= 0.2%
Over many years of savings these costs can greatly
reduce the value of your portfolio.
Remember also that the high turnover rate can have tax
consequences that further reduces your after-tax return.
4-39

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