Boazii University

Investment Analysis and Portfolio Management

Investment Companies
Attila Odaba
Outline:
Advantages and disadvantages of investing with an investment
company
Open-end mutual funds , Closed-end funds and unit investment
trusts
Net Asset Value,
Mutual fund types
Impact of expenses and turnover on mutual fund investment
Other funds
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Services of Investment Companies

Important functions of investment companies for
their investments:
a. Professional management
b. Diversification
c. Lower transaction costs
d. Administration & record keeping
e. Liquidity
f. Investing for retirement (IRA in USA,
similar structures in Turkey)

What are They?

A company that brings together a group of
people and invests their money in stocks,
bonds and other securities.
Each investor owns shares, which represent a
portion of the holdings of the fun.

Organizational Forms
Mutual Funds: Managed Investment

Companies: Mostly, active portfolio management.

The fund's board of directors typically hires an
investment advisor to select and manage the fund
assets according to some specific goal(s) set by the
board and any regulatory requirements.
The investment advisor usually creates the fund
and selects the investments. Most funds are of
this type.
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Organizational Forms
Open end
shares are bought from and redeemed by the
mutual fund company
There is no limit to the number of available
shares, the fund can continue to create new
shares as needed
A portfolio may be affected if a significant
number of shares is redeemed quickly; need to
make trades to meet the cash demand
Priced once per day at the close of business
Price is equal to Net Asset Value (NAV)
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Organizational Forms
Closed end
Launched through an IPO
Fixed number of shares are issued; money
raised is invested according to the funds
mandate
Closed-end fund configured into a stock and
traded in the secondary market
Closed-end funds are actively managed
Fund share price may trade at a premium or
discount to NAV

Net Asset Value

Used as a basis for valuation of
investment company shares
Selling new shares
Redeeming existing shares

Calculation:
Market Value of Fund Assets Fund Liabilitie s
NAV
Fund shares outstandin g
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NAV calculation
NAV)

ABC Fund ($Millions except

Market Value Securities

+ Cash & Receivables
- Current Liabilities
NAV Total
# Fund Shares
NAV

$550.00
75.00
(20.00)
$605.00
20.00
$ 30.25

Most Mutual
Funds have little
or no Long Term
Debt

Mutual Fund Types

Money market funds
Bond/Income funds
Balanced funds
Objective: to provide a balanced mixture of safety,
income and capital appreciation
Asset allocation funds
Equity funds
Maximum capital gain
Growth
Growth & income
Income
Income & security

Index funds
Specialized sector funds

Cost of Investing in Mutual Funds

Biggets problem with mutual funds. These
costs eat into your return.
Fee Structure:

Ongoing yearly fees to keep you ivested in the fund

Transaction fees paid when you buy or sell shares
in a fund (loads)

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Cost of Investing in Mutual Funds

Operating Expenses:
Management fee (0,5% - 1% of assets on
average)
Administrative Expenses

12-b1 Fee (USA), for advertising and promoting the

fund

On the whole, expense ratios range from 0.2%

(index funds) to as high as 2%.
Are high fees worth it?

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Cost of Investing in Mutual Funds

Loads are just fees that a fund uses to
compensate brokers or other salespeople.
Dont buy funds with loads!
Front-end loads:

A commission or sales charge paid when you buy

into a fund. Generally given to the broker who
sells the fund. Rip-off

Redemption fee, back hand load (also known

as deferred sales charges)
Paid if you sell a fund within a certain time
frame.

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NAV and the Effective Load

Cost to initially purchase one share of a load fund =
NAV + front-end load (%) (if any).
Assume that stated front load is 5%,
If you invest $10,000 in a fund with an 5% front-end
load, you actually acquire shares worth $9,500; the
other $500 goes to the broker.
The effective load is greater than the stated load: In
the above example, the actual % commission cost
(effective load) is:
$500 / $9500 = 5.26%;
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Costs of Investing in Mutual Funds

Expense ratios:

Funds charge annual operating expenses and

annual advisory or management fees against the
NAV.
Expense ratio:
Annual Expenses / Average NAV

A "well managed" fund probably should have an

expense ratio of less than 2%.

All costs and charges must be revealed in the

fund's prospectus.
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HPR on mutual funds

HPR

NAV Sell NAVBuy CG Dist Div Dist

NAVBuy

where Dist = Distribution

Rate of return measured as the increase or

decrease in NAV plus income distributions,
From this gross return the expenses should be
deducted to get to net return.
Mutual funds pass through investment income
to investors as they become due.
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4-16

Fees and Mutual Fund Returns:

An Example
Initial NAV = $20
Income distributions of $.15
Capital gain distributions of $.05
Ending NAV = $20.10:

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Converting gross pretax returns to

net pretax returns:

Amount initially invested = $10,000 (0.06 x $10,000) = $9,400

Amount after gross return = $9,400 x 1.175 = $11,045
Amount after fees = $11,045 - (0.0135 x $11,045) = $10,895.89*
Net rate of return = ($10,895.89 - $10,000) / $10,000 = 8.96%

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Ex: Impacts of Costs on Investment

Performance

Conclusions?

Optimal choice fee structure is

Time and investment-size dependent

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Implications of Fund Turnover

The turnover rate is measured as the total asset
value bought or sold in a year divided by the
average total asset value.
Lately, average turnover ratio is around 60%
High turnover means that capital gains or losses
are realized constantly, hence the investor can
not time the realizations to manage his tax
obligations.

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Exchange Traded Funds

ETF trade like a stock and look like a mutual fund.
Examples: SPDRs, iSHares, VIPERs, QQQQ
They originally tracked an underlying market index
Now there various ETFs
Management Style: Passively managed portfolios
Low fees
Tutorials:

http://www.investopedia.com/university/all/exchangetradedfunds/

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Exchange Traded Funds

Potential advantages:

Trade continuously throughout the day

Can be sold short or purchased on margin
Potentially lower taxes
No fund redemptions
Large investors can exchange their ETF shares
for shares in the underlying portfolio
Lower costs (No marketing; lower fund expenses)

Potential disadvantages:

Small deviations from NAV are possible

Must pay a brokerage commission to buy an ETF
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ETF Sponsors and Products

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Organizational Forms
Unit Investment Trusts (UITs): unmanaged,
fixed composition portfolios
Any interest and/or dividends are distributed
immediately to trust certificate holders.
Provide diversification within one sector or
area and low cost entry.
Often levered, rates of return can be extreme.
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Other Investment Organizations

REITs

Similar to closed end fund. Invest in real

estate and real estate loans.
Equity trusts purchase real estate.
Mortgage trusts invest in mortgage
and construction loans.

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Other Investment Organizations

Cont.
Hedge Funds

Similar to mutual funds, but not registered and

not subject to SEC regulations.
Available to institutional and high net worth
investors
Can pursue investment strategies that are not
allowed for mutual funds.
Grew from about $50 billion in 1990 to about $2
trillion in 2008.

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