Lecture 4

MUTUAL FUNDS`

Indirect investing
Investing indirectly refers to the buying and
selling of the shares of investment companies
Instead of buying and selling shares
themselves, inventors can give their money
to investment companies that manage the
money for them by investing in shares and
bonds
An investment company is a financial service
organization that sells shares in itself to the
public and uses the funds to invest in a
portfolio of securities

Types of investment
companies
Types of investment companies:
1. Managed companies
A. Closed end investment companies
B. Open end investment companies
2. Unmanaged companies
A. Index portfolio

Closed end investment

companies
Closed end investment company
does not sell additional shares of its
own stock after initial public offering
The shares of a closed-end fund
trade in the secondary markets
Shares prices are determined by
demand and supply forces in the
secondary market

Advantages of Close End

Buying at a discount
Shares of closed end funds sometimes sell at a discount to their underlying
NAV, which may give investors who buy shares at a discount the opportunity
to enhance their overall investment return. The discount may not narrow over
time, however, and short-term trading entails greater risks.
Leverage potential
Closed end fund managers can elect to issue senior securities or borrow
money to leverage their fund's investments to potentially enhance yields and
returns to investors, particularly with fixed income closed end funds.
Stable pool of capital
With a fixed number of shares, closed end funds don't have to keep cash on
hand or sell securities in a declining market to meet shareholder redemptions.
Managers can remain fully invested and invest in securities with longer time
horizons, which may result in higher yields and returns for investors.

Open end investment

company
Also known as mutual funds,
Market capitalization of these companies
change constantly as new investors buy
additional shares and some existing
shareholders sell back their shares to the
company
Mutual funds shares can be purchased
either directly from the company through
mail or telephone Or from a sales agent

Net Asset value

Investors purchase new shares and
redeem existing shares at the net
asset value (NAV)
NAV is computed daily by calculating
the total market value of the
investments, subtracting liabilities
and dividing it by the number of
shares outstanding

Advantages of mutual funds

Record keeping
Company keeps track of capital gains,
dividends, investments

Diversification and divisibility

By pooling their money, investment
companies enable investors to hold
fractional shares of many different
securities

Professional management
Lower transaction costs

Major types of mutual funds

There are two major types of mutual
funds
Money market mutual funds
Stock funds and bond and income funds
Further mutual funds can classified on the
basis of risk and return

Types of mutual funds

1. Money market funds
These funds invest in money market
securities
They usually offer check writing features
They are low risk and low return funds
They provide the chance to earn the
going rate in the money market with
diversification advantage

 2. Bond Funds
These fund specialize in fixed income
sector
Within bond funds, there exists many
categories
Funds may specialize in government
bonds, or corporate bonds
Or they specialize in bonds of different
maturities

3. Hybrid Funds
Includes both bonds and equity funds
They are also called balanced funds
The main objective is to preserve
capital and earn a return
Have a bit higher risk than the bond
funds because of investment in
equity

 4. Equity funds
All investment is made in common stocks
Within equity funds, there can be growth
funds or income funds
Growth funds have investment in stocks
that have good growth potential (usually
small firms)
Income funds have investment in stocks
that provide consistent flow of
income(usually large firms)

 5. Sector funds
Some industries perform well in one stage
of business cycle and others perform well
in the other stages of business cycle
An investment company may have a
mutual fund that specialize only one in
sector
For example, a mutual fund may invest
only in oil stocks

 6. Index funds
An index fund tries to match the
performance of a broad market index
The fund buys shares in securities in the
proportion to the securitys
representation in the index
It is an unmanaged fund and hence a
low cost
Investors following passive strategy will
invest in index fund

Mutual Funds returns

Mutual funds returns are expressed in
total returns i.e. dividends and capital
gains as a percentage of initial
investment
A cumulative total return measures the
actual performance over a stated period
of time, 1 year, 3 years or 10 years
For example, a fund gave returns:
Past 1 year Past 5 Years Past 10 years
-10% 8.5%
180.5%