Chapter 7 – Investment Companies

BA 543 Financial Markets and Institutions

Chapter 7 – Investment Companies

Indirect Investing Shares of investment company fund represent

proportional ownership in portfolio Investment company is the listed owner of the

shares of the portfolio Investors in the company fund are the beneficiary

owners of the shares of the portfolio

Benefit -- Professional Management of Funds Shared costs across investors Diversification at a low cost

Chapter 7 – Investment Companies

Open-End Funds Number of shares vary based on purchases and sales of

shares by owners Company acts as the “broker” of all shares

Closed-End Funds Limited number of shares from charter Shares trade in secondary market after initial sale

Unit Trust Bond Portfolio – Related to Closed-End Fund Bonds held to maturity (exceptions for quality change) Fixed termination date Common in Europe but not U.S.

Chapter 7 – Investment Companies

Net Asset Value (NAV) Price of the shares of the investment company

fund NAV = (Value of Portfolio – Liabilities) / Shares Price fixed once daily at close of business

Trading in shares for open-end Purchases and sales by investment company Price is the NAV (minus load) at end of day

Examples of Trading Costs (Sales Charge) No Load – no charge, costs in operating charges Front-end Load (max is 8.5%, typical 2% - 3%) Back-end or Contingent Deferred Sales Charge

Chapter 7 – Investment Companies

Annual Operating Expenses (Expense Ratio) Services for Members

Management fees Distribution fees for marketing, agent compensation and

advertising (12b-1 fees, max is 1% of portfolio value) Other fees (accounting, custodial, legal, directors, etc.)

No-Loads cannot charge 12b-1 fees Why so popular?

Provide diversification, lower contracting costs, professional management, liquidity, payment mechanisms

Chapter 7 – Investment Companies

Taxing Mutual Funds Regulated Investment Company (RIC) must

distribute 90% of investment income Taxes not paid at the “fund” Taxes paid at the individual level on distributions Investors may “automatically” reinvest

distributions but still incur tax obligation Capital Gains distributions

Occur typically late in year Based on transactions that year

All shares are “taxed” regardless of holding period

Chapter 7 – Exchange Traded Funds

Do it yourself mutual funds These are ticker symbol “stocks” that match an

index and function like a closed-end fund Trade throughout the day at “current” index price Limit or market orders, stop-loss orders, shorted Have options trading on them

Arbitrageur keeps prices aligned between “stock” and underlying portfolio (aka authorized participants) and create and redeem units

First ETF was S&P 500 and symbol is SPY As of 2007 – 629 ETFs