Chapter 8 Investment Co.Chapter 8 Investment Co.Chapter 8 Investment Co.Chapter 8 Investment Co.

• indirect investment

• types

• fees

• objectives

• regulation

• ETFs

• indirect investment

• types

• fees

• objectives

• regulation

• ETFs

I. Indirect investmentI. Indirect investmentI. Indirect investmentI. Indirect investment

• investment co. pools investor funds purchases & manages portfolio direct investments

• investors own shares of portfolio indirect investment

• investment co. pools investor funds purchases & manages portfolio direct investments

• investors own shares of portfolio indirect investment

advantagesadvantagesadvantagesadvantages

• diversification & asset choice small amount of capital

• professional management

• lower transactions costs trading information

• diversification & asset choice small amount of capital

• professional management

• lower transactions costs trading information

disadvantagesdisadvantagesdisadvantagesdisadvantages

• lack of control over portfolio choice of assets tax consequences of trading

• lack of voting rights that come w/ common stock

• lack of control over portfolio choice of assets tax consequences of trading

• lack of voting rights that come w/ common stock

II. TypesII. TypesII. TypesII. Types

sell new shares, redeem existing shares # shares changes over time

sell new shares, redeem existing shares # shares changes over time

Open-end funds (mutual funds)Open-end funds (mutual funds)Open-end funds (mutual funds)Open-end funds (mutual funds)

• share price based on NAV• share price based on NAV

NAV computed at close of day NAV changes with price of assets in portfolio

NAV computed at close of day NAV changes with price of assets in portfolio

NAV =portfolio value - liabilities

# shares outstanding

growth of mutual fundsgrowth of mutual fundsgrowth of mutual fundsgrowth of mutual funds

• less than 600 1980

• over 8000 today ($6.2 trillion) assets concentrated with largest

funds

• why? growth of 401(k)s, IRAs demographics (baby boomers)

• less than 600 1980

• over 8000 today ($6.2 trillion) assets concentrated with largest

funds

• why? growth of 401(k)s, IRAs demographics (baby boomers)

Closed-end fundsClosed-end fundsClosed-end fundsClosed-end funds

• < 500 funds ($130 billion)

• fixed # shares initially issued no later sales or redemptions # of shares is fixed

• shares bought and sold in secondary market price depends on supply & demand

• < 500 funds ($130 billion)

• fixed # shares initially issued no later sales or redemptions # of shares is fixed

• shares bought and sold in secondary market price depends on supply & demand

• share price & NAV price < NAV

-- trading at a discount price > NAV

-- trading at a premium

• many closed end fund shares trade a a discount

• share price & NAV price < NAV

-- trading at a discount price > NAV

-- trading at a premium

• many closed end fund shares trade a a discount

Unit TrustsUnit TrustsUnit TrustsUnit Trusts

• # shares fixed

• typically invest in bonds

• portfolio is fixed: no active trading

• fixed termination date

• # shares fixed

• typically invest in bonds

• portfolio is fixed: no active trading

• fixed termination date

III. Mutual fund feesIII. Mutual fund feesIII. Mutual fund feesIII. Mutual fund fees

• sale charges

• operating expenses• sale charges

• operating expenses

Sales chargesSales chargesSales chargesSales charges

• funds originally sold 2 ways: sales force, w/ commission

-- front-end load (8.5% max)

-- pay when purchase shares

-- back-end load (8.5% max)

-- pay when redeem shares

-- level loads (.75% max)

-- annual fee

• funds originally sold 2 ways: sales force, w/ commission

-- front-end load (8.5% max)

-- pay when purchase shares

-- back-end load (8.5% max)

-- pay when redeem shares

-- level loads (.75% max)

-- annual fee

buy funds directly

-- no sales charge

-- no load funds

• today many distribution channels fund supermarkets fund families “distribution is king”

buy funds directly

-- no sales charge

-- no load funds

• today many distribution channels fund supermarkets fund families “distribution is king”

Operating ExpensesOperating ExpensesOperating ExpensesOperating Expenses

• management fee

• distribution fees 12b-1 fees (SEC rule) 1% max (100 basis pts.) cover marketing costs

• other trading, records, auditing

• management fee

• distribution fees 12b-1 fees (SEC rule) 1% max (100 basis pts.) cover marketing costs

• other trading, records, auditing

All feesAll feesAll feesAll fees

• NASD, SEC set some limits on fees most funds charge much less

• average actively managed funds: 1.44% index funds: .4%

• NASD, SEC set some limits on fees most funds charge much less

• average actively managed funds: 1.44% index funds: .4%

impact of feesimpact of feesimpact of feesimpact of fees

• $10,000, 10% annual return, 20 yrs.

• if fees 1.5% annually, $49,725

• if fees .5% annually, $60,858

• $10,000, 10% annual return, 20 yrs.

• if fees 1.5% annually, $49,725

• if fees .5% annually, $60,858

IV. Fund ObjectivesIV. Fund ObjectivesIV. Fund ObjectivesIV. Fund Objectives

• funds differ in types of assets investment goals

• funds differ in types of assets investment goals

Equity fundsEquity fundsEquity fundsEquity funds

• income funds stocks w/ high, stable dividends

• growth funds stock w/ high expected capital

gains

• growth/income funds

• income funds stocks w/ high, stable dividends

• growth funds stock w/ high expected capital

gains

• growth/income funds

• value funds “bargain” stocks

-- low PE ratio

-- high book-to-value ratio

• sector funds stocks in specific industry health care, biotech, financial,

electronics

• value funds “bargain” stocks

-- low PE ratio

-- high book-to-value ratio

• sector funds stocks in specific industry health care, biotech, financial,

electronics

• market capitalization small/mid/large cap funds stocks based on size of company

-- value of total shares outstanding

• international/global international stock portfolio or stock in particular region

• market capitalization small/mid/large cap funds stocks based on size of company

-- value of total shares outstanding

• international/global international stock portfolio or stock in particular region

• index funds match performance of stock index

-- S&P 500, Wilshire 5000 hold portfolio the matches index passive strategy

-- match, not beat, the market’s average return

lower expenses

• index funds match performance of stock index

-- S&P 500, Wilshire 5000 hold portfolio the matches index passive strategy

-- match, not beat, the market’s average return

lower expenses

• index fund returns slightly below index return operating expenses must hold some cash to redeem

shares

• index fund returns slightly below index return operating expenses must hold some cash to redeem

shares

why I like indexingwhy I like indexingwhy I like indexingwhy I like indexing

• 1990-99 S&P 500 index outperformed 76%

of all actively managed stock funds

• 1990-99 S&P 500 index outperformed 76%

of all actively managed stock funds

Bond fundsBond fundsBond fundsBond funds

• U.S. Government

• Investment grade corporate bond ratings BBB or above

• High yield corporate junk bonds (rated below BBB)

• Municipal bonds tax exempt interest

• U.S. Government

• Investment grade corporate bond ratings BBB or above

• High yield corporate junk bonds (rated below BBB)

• Municipal bonds tax exempt interest

Money MarketMoney MarketMoney MarketMoney Market

• share price = $1, check-writing

• general taxable

• U.S. Government

• tax-exempt

• share price = $1, check-writing

• general taxable

• U.S. Government

• tax-exempt

Stocks & BondsStocks & BondsStocks & BondsStocks & Bonds

• balanced funds

• hybrid funds

• asset allocation funds 529 plans for college

• balanced funds

• hybrid funds

• asset allocation funds 529 plans for college

Fund FamiliesFund FamiliesFund FamiliesFund Families

• one investment company

• many different funds

• Fidelity, Vanguard, Strong, Janus

• 400 families top ten hold over 40% of assets

• one investment company

• many different funds

• Fidelity, Vanguard, Strong, Janus

• 400 families top ten hold over 40% of assets

look at some top fundslook at some top fundslook at some top fundslook at some top funds

• http://quicktake.morningstar.com/Fund/Snapshot.asp?Country=USA&Symbol=FGRIX

• http://quicktake.morningstar.com/Fund/Snapshot.asp?Country=USA&Symbol=VWLTX

• http://quicktake.morningstar.com/Fund/Snapshot.asp?Country=USA&Symbol=VFINX

• http://quicktake.morningstar.com/Fund/Snapshot.asp?Country=USA&Symbol=FSPHX

• http://quicktake.morningstar.com/Fund/Snapshot.asp?Country=USA&Symbol=FGRIX

• http://quicktake.morningstar.com/Fund/Snapshot.asp?Country=USA&Symbol=VWLTX

• http://quicktake.morningstar.com/Fund/Snapshot.asp?Country=USA&Symbol=VFINX

• http://quicktake.morningstar.com/Fund/Snapshot.asp?Country=USA&Symbol=FSPHX

V. RegulationV. RegulationV. RegulationV. Regulation

• SEC is main regulator disclosure rules fees insider trading “truth in advertising”

-- returns & risks

-- name and objective of fund

• SEC is main regulator disclosure rules fees insider trading “truth in advertising”

-- returns & risks

-- name and objective of fund

• NASD is industry self-regulator sales practices commissions, fees

• taxation investment co. distributes 90% of

income annually fund shareholders taxed on gains

-- even if gains are reinvested

-- dividends no longer taxable

• NASD is industry self-regulator sales practices commissions, fees

• taxation investment co. distributes 90% of

income annually fund shareholders taxed on gains

-- even if gains are reinvested

-- dividends no longer taxable

taxation traptaxation traptaxation traptaxation trap

• as share holders redeem shares funds sells assets to raise cash remaining share holders face tax

liability

• as share holders redeem shares funds sells assets to raise cash remaining share holders face tax

liability

VI. Exchange-traded funds (ETFs)VI. Exchange-traded funds (ETFs)VI. Exchange-traded funds (ETFs)VI. Exchange-traded funds (ETFs)

• like index funds & closed-end fund

• shares traded on exchange

• trade continually, not just at closing NAV

• swap large blocks of stock for ETF shares price is always close to NAV

• like index funds & closed-end fund

• shares traded on exchange

• trade continually, not just at closing NAV

• swap large blocks of stock for ETF shares price is always close to NAV

ETF tax advantageETF tax advantageETF tax advantageETF tax advantage

• mutual funds other investors sell shares,

-- trigger tax liability for remaining share holders

• ETFs tax liability only for seller swap shares for underlying portfolio

• mutual funds other investors sell shares,

-- trigger tax liability for remaining share holders

• ETFs tax liability only for seller swap shares for underlying portfolio