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Investment and Portfolio Management

Lecture 2 – Part B - Chapter: 4

Mutual Funds and Other Investment Companies

Topic Overview:

-Investment Companies: Roles and Types

-Mutual Fund:
• Types
• Investment Policies
• Costs and Returns
-ETFs
Overview

• Even though various trading mechanisms are available to investors,

individual investors do not often trade securities directly for their own
accounts.
• They direct their funds to investment companies that purchase
securities on their behalf.
• Most important of these are mutual funds.

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Investment Companies
• Financial intermediaries that pool and invest the funds of individual investors
in securities or other assets
• Services provided:
• Record keeping and administration
• Diversification and divisibility
• Professional management
• Lower transaction costs

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Calculating value of shares
• Investors buy shares in investment companies
• Balance sheet structure

Assets Equity and liabilities

Portfolio of securities invested in XXX Equity XXX
Liabilities XXX

• The value of each share is called Net Asset Value (NAV)

Market Value of Assets − Liabilities

𝑁𝐴𝑉 =
Shares Outstanding

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Types of investment companies: Unit Investment
Trusts

Unit Investment
Trusts

Managed
Investment
Investment
Companies
Companies
Other
Investment
Organizations

– Unit investment trusts are pools of money invested in a portfolio that is fixed
for the life of the fund
– Unmanaged
– Declined from $105 billion (1990) to $85 billion (2017)

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Types of investment companies: Managed Investment Companies

Unit Investment
Trusts
Open-end funds
Managed
Investment
Investment
Companies
Companies Closed-end
Other funds
Investment
Organizations

▪ Open-End
– Stand ready to redeem or issue shares at the NAV
– Priced at Net Asset Value (NAV)
▪ Closed-End
– Do not redeem or issue shares
– Shares outstanding constant; investors cash out by selling to new investors
– Priced at premium or discount to NAV

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 Types of investment companies: Other Investment Companies

• Commingled funds
Unit Investment
Trusts – Partnerships of investors that
pool funds
Investment
Managed
Commingled • REITs
Investment
Companies Funds – Similar to a closed-end fund
Companies

Other – Equity versus mortgage trusts

Investment REITs • Hedge funds
Organizations
– Vehicles that allow private
investors to pool assets to be
Hedge Funds
invested by a fund manager

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 Mutual Funds
• Common name for open-end investment companies
• Dominant investment company today
• Accounts for 87% of investment company assets
• Assets under management (early 2018)
• U.S. – $18.7t
• Non-U.S. – $25t

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Mutual Funds: Investment Policies

• Money market funds

• Invest in money market securities such as commercial paper, repurchase
agreements, or CDs
• Equity funds
• Invest primarily in stock
• Sector funds
• Concentrate on a particular industry or country
• Bond funds
• Specialize in the fixed-income sector
• International funds
• Global, international, regional, and emerging market

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Mutual Funds: Investment Policies

• Balanced funds
• Designed to be candidates for an individual’s entire investment portfolio;
hold both equities and fixed-income securities in relatively stable
proportions
• Asset allocation and flexible funds
• Hold both stocks and bonds
• Engaged in market timing; not designed to be low-risk
• Index funds
• Tries to match the performance of a broad market index

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U.S. Mutual funds by investment classification

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 Costs of investing in mutual funds
• Fee Structure:
1. Operating expenses
2. Front-end load – commission paid when you buy
3. Back-end load – commission paid when you sell
4. 12 b-1 charge – e.g. commissions paid to brokers who sells the fund to
investors
• Fees must be disclosed in the prospectus

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 Mutual Fund Returns
• Formula:
NAV1 − NAV0 + Income + Capital Gain
R=
NAV0
• Example
• Initial NAV = $20
• Income distributions of $0.15 (e.g. dividends received by the fund and
distributed to shareholders)
• Capital gain distributions of $0.05 (e.g. capital gains earned by the fund
and distributed to shareholders)
• Ending NAV = $20.10

$20.10 − $20.00 + $.15 + $.05

R= = .015 or 1.5%
$20.00

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Tax implications of mutual fund investing
• “Pass-through status” under the U.S. tax code
• Taxes are paid only by the investor, not by the fund itself
• Disadvantage is that fund investors do not control the timing of the sales of
securities from the portfolio, reducing their ability to engage in tax
management
▪ High portfolio turnover rate can be particularly “tax inefficient”
▪ Turnover ratio: The fraction of the portfolio that is replaced each year
– A $100m portfolio with $50m sales and purchases of securities has a
turnover ratio of 50%.

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Exchange Traded Funds (ETF)
• ETFs are offshoots of mutual funds that allow investors to trade index
portfolios just as they do shares of stock
• Examples: “spiders,” “diamonds,” “cubes,” and “WEBS”
• Potential advantages
• Trade continuously like stocks
• Can be sold short or purchased on margin
• Cheaper than mutual funds
• Tax efficient
• Potential disadvantages
• Prices can depart from NAV
• Must be purchased from a broker (for a fee)

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Investment company assets under management, 2018 ($ billion)

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 Performance of Mutual Funds
• Wilshire 5000 index is used as a benchmark for the performance of equity
fund managers
• Wilshire 5000 outperformed average return on diversified equity funds in 29
of the 48 years from 1971 to 2018

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