Chapter
Mutual Funds and Other
4 Investment Companies
Bodie, Kane, and Marcus
Essentials of Investments
Tenth Edition
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
• A professional investment firm that manages a
portfolio for an annual fee
• Load: Sales commission charged on mutual
fund
• Open-end or Closed-end fund
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4.2 Types of Investment Companies: Open vs. Closed
Open-End Funds Closed-End Funds
Shares Outstanding Change when new No change unless new
shares are sold or old stock is offered
shares are redeemed
Pricing Fund Share Price = Net Fund Share Price may
Asset Value (NAV) trade at a premium or
discount to NAV
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4.2 Types of Investment Companies: Other
Investment Organization Characteristics
Partnership of investors pooling
funds; designed for trusts/larger
Commingled Funds retirement accounts to get
professional management for a fee
Real Estate Investment Similar to closed-end funds; invests
Trust (REITs) in real estate/real estate loans
Private investment pools; exempt
from SEC regulation. Can be
Hedge Funds speculative in nature
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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
Stocks concentrated in a particular industry
Equity Sector Funds
Specialize in fixed-income (bond) sector
Bond Funds
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
Assets: ($ bil.) Percent of Total Assets Number of Funds
Equity Funds
Capital appreciation focus $1,725 11.5% 1,329
World/international 2,034 13.5% 1,345
Total return 4,004 26.7% 1,866
Total equity funds $7,764 51.7% 4,540
Bond Funds
Investment grade $1,451 9.7% 594
High yield 412 2.7% 225
World 339 2.3% 270
Government 239 1.6% 214
Multisector 327 2.2% 143
Single-state municipal 145 1.0% 331
National municipal 353 2.4% 229
Total bond funds $3,265 21.7% 2,006
Hybrid (bond/stock) funds $1,270 8.5% 606
Money market funds
Taxable $2,448 16.3% 382
Tax-exempt 271 1.8% 173
Total money market funds $2,718 18.1% 555
Total $15,018 100.0% 7,707
Source: 2014 Mutual Fund Fact Book
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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
Commission or sales charge paid when purchasing
Front-end Load
shares
Back-end load “Exit” fee incurred when shares
Annual fees charged by mutual fund to pay for
12b-1 charges
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 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 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
• Fees and Mutual Fund Returns
• Soft dollars: Value of research services
brokerage house provides “free of charge” in
exchange for business
NAV1 NAV 0 Income Capital gains distributi on
Rate of return
NAV 0
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Table 4.2 Costs on Investment Performance: Example
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 investor to trade index portfolios
Potential Advantages Potential Disadvantages
Trade Continuously throughout the day Small deviations from NAV possible
Can be sold or purchased on margin Brokerage commission to buy ETF
Potentially lower tax rates
Lower costs (no marketing, lower fund
expenses)
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Figure 4.2 Assets in ETFs
1,800,000
1,600,000
Bond
Commodities
1,400,000
Global/int'l equity
U.S. equity: sector
ETF assets ($ million)
1,200,000
U.S. equity: broad index
1,000,000
800,000
600,000
400,000
200,000
0
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Source: Investment Company Institute, 2010-2014 Investment Company Fact Books
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Figure 4.3 Investment Company Assets under Management, 2013
($ Billion)
279 87
1,675
Mutual funds
Exchange-traded funds
Closed-end funds
Unit investment trusts
15,018
Source: Investment Company Institute, 2014 Investment Company Fact Book
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4.7 Mutual Fund Investment Performance: Figure 4.4
• On average, mutual fund performance less than
broad market performance
40%
30%
20%
10%
Rate of return (%)
0%
-10%
-20% Active funds
Wilshire 5000
-30%
-40%
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1983
1986
2001
2003
2004
2005
2006
2007
2009
2012
1982
1984
1985
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2002
2008
2010
2011
2013
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4.7 Mutual Fund Investment Performance Persistence
• Evidence suggests some persistence in positive
performance over certain horizons
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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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