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 companiesB. Open end investment companies

2. Unmanaged companiesA. 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 fundsFurther 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 security’s 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 yearPast 5 Years Past 10 years• -10% 8.5% 180.5%