FIN5401 Investments

Chapter 4 Mutual Funds and Other Investment Companies

Fei Fang GSOM

Fall 2019 Clark University

1 Investment companies
Investment companies are financial intermediaries that collect funds from individual in-
vestors and invest those funds in a potentially wide range of securities or other assets.

• Pool funds of (mostly) individual investors

• Invest in a wide range of securities or other assets

• Services provided:

– Record keeping and administration

– Diversification and divisibility
– Professional management
– Lower transaction costs

Net asset value (NAV)

• NAV is the value of each share in the investment company

• Calculation:
Market value of assets - Liabilities
Shares outstanding
CONCEPT CHECK 4.1
Consider these data from the March 2016 balance sheet of Vanguard’s Growth and Income
Fund. What was the net asset value of the fund?

Assets: $5,986.0 million

Liabilities: $118.5 million
Shares: 148.36 million

$5,986.0−$118.5
N AV = 148.36 = $39.55

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2 Types of Investment companies
2.1 Unit investment trusts

• Fixed portfolio of uniform assets

• Unmanaged

• Sponsors of unit investment trusts earn their profit by selling shares in the trust at a
premium to the cost of acquiring the underlying assets.

• Investors who wish to liquidate their holdings of a unit investment trust may sell the
shares back to the trustee for net asset value.

• Declined from $105 billion in 1990 to $94 billion in 2016

2.2 Managed investment companies

• Open-end

– Issues shares when investors buy; redeems shares when investors sell
– Priced at NAV

• Closed-end

– Shares outstanding stay (relatively) constant; investors cash out by selling to new
investors
– Priced at premium or discount to NAV

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2.3 Other investment organizations - after class reading (will not be tested)

• Commingled funds: Partnerships of investors that pool funds together

• Real estate investment trusts (REITs): Similar to closed-end funds; invest in real estate
or loans secured by real estate

• Hedge funds: Commonly structured as private partnerships (and thus subject to only
minimal SEC regulation)

3 Mutual funds
Mutual funds are the common name for open-end investment companies.

• Each mutual fund has a specified investment policy, which is described in the fund’s
prospectus.

• Management companies manage a family, or “complex” of mutual funds. They organize

an entire collection of funds and then collect a management fee for operating them.

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 Mutual funds - Investment policies

• Money market funds: Invest in money market securities such as commercial paper,
repurchase agreements, or certificates of deposit

• Equity funds

• Sector funds: Concentrate on a particular sector/industry

• Bond funds

• International funds: Invest in securities of firms located outside the United States

• Balanced funds: Invest in both equities and fixed-income securities in relatively stable
proportions

• Funds of funds: Invest primarily in shares of other mutual funds

• Asset allocation and flexible funds

• Index funds

Mutual funds - How funds are sold

• Direct-marketed funds

• Sales-force (broker or financial advisers) distributed

– receive a commission for selling shares to investors.

– Potential conflicts of interest

• Financial supermarkets

– sell shares in funds of many complexes.

– the broker splits management fees with the mutual fund company.

4 Costs of investing in mutual funds

• Fee Structure:

1. Operating expenses
2. Front-end load
3. Back-end load
4. 12 b-1 charge

• Fees must be disclosed in the prospectus

– Share classes with different fee combinations

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 Fees and mutual fund returns
NAV1 − NAV0 + Income + Capital gain
R=
NAV0

• Example:

– Initial NAV = $20

– Income distributions of $0.15
– Capital gain distributions of $0.05
– Ending NAV = $20.10

$20.10 − $20.00 + $0.15 + $0.05

R= = 0.015 or 1.5%
$20.00
Notice that this measure of the rate of return ignores any commissions such as front-end
loads paid to purchase the fund.

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5 Taxation of mutual fund income
• Pass-through status under the U.S. tax code

– Taxes are paid only by the investor

– Fund investors do not control the timing of the sales of securities from the portfolio

• Turnover and Taxes

– Turnover is the ratio of the trading activity of a portfolio to the assets of the
portfolio. It measures the fraction of the portfolio that is “replaced” each year.

CONCEPT CHECK 4.3

An investor’s portfolio currently is worth $1 million. During the year, the investor sells
500 shares of FedEx at a price of $160 per share and 3,200 shares of Cisco at a price of $25
per share. The proceeds are used to buy 1,000 shares of IBM at $160 per share.

a. What is the portfolio turnover rate?

b. If the shares in FedEx originally were purchased for $140 each and those in Cisco were
purchased for $20, and the investor’s tax rate on capital gains income is 20%, how much extra
will the investor owe on this year’s taxes as a result of these transactions?

Solution:
Turnover ratio = 1,000×$160
$1,000,000 = 16%
Ralized capital gains are $20 × 500 = $10, 000 for FedEx and $5 × 3, 200 = $16, 000 on
Cisco. The tax owed on the capital gain is therefore .20 × $26, 000 = $5, 200

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H
Table 1: ETFs vs Mutual Funds
ETFs Mutual Funds
Trade continuously on an intra-day basis like stocks can only be traded at the end of the day
Prices can depart from NAV trade at NAV
Must be purchased from a broker can be purchased directly from the funds
Higher transaction costs Lower transaction costs
Low expense ratio comparably high expense ratio
Can be sold short or purchased on margin can not be sold short or purchased on margin

6 Exchange traded funds (ETFs)

• An exchange-traded fund (ETF) is a collection of securities - such as stocks - that tracks
an underlying index.

• Close-end

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