CHAPTER TWENTY-ONE

INVESTMENT COMPANIES

Practical Investment Management

Robert A. Strong
 Outline

 The Investment Company Industry

 Open-End Investment Companies
 Closed-End Investment Companies
 Regulation
 Fees
 Selecting a Mutual Fund
 Rationale
 Eligibility
 Interpreting Past Performance
 Types of Funds

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 Outline

 Information Sources
 Company Information
 Commercial Services

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 The Investment Company Industry
 The investment company industry
is a significant portion of the
financial landscape in the United
States.
 The automatic diversification and professional
management provided by mutual funds make
it simple for even the smallest investor to
participate in the capital markets.
 There are two types of investment companies:
open-end funds and closed-end funds.

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 Open-End Investment Companies
 An open-end investment company is
commonly called a mutual fund.
 A mutual fund has no limit on the size of
the fund or the number of shares
outstanding.
 The value of a mutual fund share is called
its net asset value.
 Mutual fund shares are not sold in the
traditional sense. Instead, they are
redeemed by the fund management.

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 Open-End Investment Companies

Insert Figure 21-1 here.

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 Open-End Investment Companies

 Upon opening an account with a mutual

fund, the investor must select from among
several options.
 Some common options are :
- automatic reinvestment option
- automatic monthly investment plan
- limit order option
- periodic payment option
- telephone redemption option
- switching option

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 Closed-End Investment Companies

 A closed-end investment company has a

fixed number of shares.
 Investors buy and sell these shares on an
exchange just like shares of stock.
 The pricing of closed-end fund shares is a
financial puzzle - they usually sell at a
discount to their net asset value.

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 The Investment Company Industry : Regulation

 Almost all mutual funds choose to

organize as a regulated investment
company, so that any tax liability
on capital gains and income can be
passed on to the accountholders.
 The Investment Company Act of 1940
provides the potential investor with some
degree of protection from misleading
advertising or incomplete investment
information.

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 The Investment Company Industry : Regulation

 The Investment Company Amendments Act

of 1970 serves primarily to clarify legal
points. It mandates that the fund manager
and the board of directors be held to
fiduciary standards in their actions.
 Many states have their own version of the
Securities and Exchange Commission.
Today, these blue sky laws function largely
to inform investors of the suitability of
certain proposed investments.

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 The Investment Company Industry : Regulation

 The National Securities Markets Improvement

Act of 1996 sought to largely eliminate Federal
and state regulatory overlap. The principal
effects include lower registration fees, lower
broker-dealer margin fees, and ensuring that a
fund’s name is consistent with its objective.

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 The Investment Company Industry : Fees
 Most mutual funds separate their
charges into a number of categories.

Load and No-Load

Load funds have a salesforce and the
shareholders have to pay a sales charge. If
paid at the time of purchase, the fee is a front-
end load. If levied when shares are sold, the
fee is a back-end load, or contingent deferred
sales charge. A no-load fund charges no sales
commission.

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 The Investment Company Industry : Fees

Insert Figure 21-2 here.

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 The Investment Company Industry : Fees
 Certain expenses such as the management
fee are associated with operating a mutual
fund. These fees are measured by the
fund’s expense ratio, which is the fund’s
total expenses expressed as a percentage
of the fund’s assets.
 Note that within the same fund, there may
be several classes of shares with different
fee combinations. Their relative merits
depend on how long the investor
anticipates keeping the investment.

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 The Investment Company Industry : Fees

Insert Figure 21-3 here.

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 The Investment Company Industry : Fees
 The annual 12b-1 fees permit the fund
manager to pass certain advertising costs
on to the accountholders.
 A trailing commission is an annual fee paid
to a broker, sometimes independent of the
level of activity in the account or its size.
 Other fees include fund transfer charges,
custodian fees, low-balance fees, account
opening or closing fees etc.
 Studies indicate that the lower the expense
ratio, the better the fund performance.

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 Selecting A Mutual Fund

 Rationale : Mutual funds provide automatic

diversification, professional management,
and convenience.
 Eligibility : One need only consider funds
whose requirements, such as the minimum
initial investment, are satisfied.
 Interpreting Past Performance : Buying last
year’s best performing mutual funds is
seldom a winning strategy.

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 Selecting A Mutual Fund
 With a mutual fund, return comes from the
change in net asset value, capital gains
distributions, and income distributions.

change in capital gains income

net asset + distributions + distributions
before-load value
(gross) return = beginning net asset value

change in capital gains income - load

net asset + distributions +distributions
value fee
after-load
(net) return = beginning net asset value

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 Selecting A Mutual Fund : Types of Funds

Insert Figure 21-4 here.

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 Selecting A Mutual Fund : Types of Funds
 Money market funds invest in short-term
government securities and sometimes in
short-term corporate securities. They are
used primarily as a temporary cash haven.
 Bond funds invest in fixed income securities.
They vary widely, and have no common
maturity date to simultaneously return the
components to their par value.
 Stock funds vary widely in their risk and
price behavior. They are classified as growth
or value, and as large-cap or small-cap.

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 Selecting A Mutual Fund : Types of Funds
 A balanced fund is a mixture of stocks and
fixed income securities. It forces discipline
on the fund manager.
 An international fund is limited to buying
securities registered outside the country
where it is sold, while a global fund can
invest anywhere in the world.
 A fund of funds invests only in other
mutual funds. Its diversification is good,
but its expense ratio tends to be higher
than that of the typical mutual fund.

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 Selecting A Mutual Fund : Types of Funds
 Sector : Such funds invest in specific market
sectors, such as physical commodities or
stocks closely tied to natural resources e.g.
oil, forest products, and gold.
 An index fund may be a stock or bond fund
that tries to behave exactly like the market. A
stock index fund, for instance, may seek to
mirror the performance of the Standard &
Poor’s 500 stock index.
 Investors should determine their investment
objective first, and then choose an
appropriate fund or group of funds.

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 Selecting A Mutual Fund : Types of Funds

Insert Table 21-2 here.

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 Information Sources : Company Information
 The prospectus is a legal document
describing the operation of the fund,
its management, and the fees
accountholders must pay.
 One important item in the prospectus is the
fund’s portfolio turnover rate. A higher rate
usually means higher expenses.
 The Statement of Additional Information is
required by the SEC, although it is generally
only sent to accountholders upon their
request. It is a more detailed version of the
prospectus.

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 Information Sources : Commercial Services
 Most public libraries carry some
reference material, such as the
Morningstar Mutual Funds and the
Thomson Financial Investment
Company Survey.
 The internet is also a good source.
 Several periodicals like Forbes, Fortune and
BusinessWeek provide excellent coverage of
the investment company industry.
 Some organizations like the Investment
Company Institute also publish some
educational material for the public.

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 Review
 The Investment Company Industry
 Open-End Investment Companies
 Closed-End Investment Companies
 Regulation
 Fees
 Selecting a Mutual Fund
 Rationale
 Eligibility
 Interpreting Past Performance
 Types of Funds

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 Review

 Information Sources
 Company Information
 Commercial Services

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 Appendix: Tax Considerations

 Municipal securities
 Interest on a municipal bond is exempt
from federal tax.
 An in-state municipal bond is not
subject to state income tax.

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 Appendix: Tax Considerations
 Taxable equivalent yield: the yield a taxable
security would have to offer to provide the
same after-tax return, including the effects
of federal, state, and local taxes

Taxable equivalent yield =

Rtaxfree
1 - [(Rstate + Rlocal )(1 − R federal ) + R federal ]

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 Appendix: Tax Considerations

 Deeply discounted securities:

 If the discount exceeds 0.25% multiplied

by the remaining years until maturity, the
IRS considers the municipal bond to be
deeply discounted.

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 Appendix: Tax Considerations

 Treasury Securities
 Treasury security interest is exempt from
state and local income taxes.

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 Appendix: Tax Considerations

 Preferred Stock:
 Most preferred stock owned by other
corporations
 Corporations can avoid paying taxes on 70%
of their dividend income from portfolio
investments

Dividend
Price =
Rate of Return

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 Appendix: Tax Considerations

 Reductions in the capital gains tax

increases the attractiveness of growth
stocks and growth mutual funds.

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 Appendix: Special Considerations
with Mutual Funds
Distributions
Income
and capital gains distributions
Reinvested dividends
Return of capital distribution
Cost Methods
Average cost method
FIFO
Specific identification method
Commissions

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 Mutual Fund Account Activity

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 Appendix: Tax Swaps

Tax swaps with bonds

Tax swaps with mutual funds

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 Sample Bond Data

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