Mutual Funds and Other Investment Companies

4.1 Investment Companies

1) Investment Company

Investment Company: A financial intermediary that collects money from investors and invests it in securities or other assets.

Each investor owns a proportional claim on the investment company’s portfolio.

2) Benefits of Investment Companies

Diversification: The distribution of investments across many assets to reduce security-specific risk.

Professional Management: The use of professional analysts and portfolio managers to select and manage investments.

Divisibility: The ability of small investors to obtain fractional ownership of a large portfolio.

Record Keeping and Administration: The management of transactions, distributions, taxes, and account reports on behalf of investors.

Lower Transaction Costs: Cost savings obtained by trading securities in large quantities.

3) Net Asset Value

Net Asset Value (NAV): The market value of a fund’s assets minus its liabilities, expressed on a per-share basis.

Let $A$ be the market value of the fund’s assets, $L$ be its liabilities, and $N$ be the number of shares outstanding.

$$\mathrm{NAV} = \frac{A-L}{N}.$$

NAV represents the underlying value of one share of the investment company.

4.2 Types of Investment Companies

1) Unit Investment Trust

Unit Investment Trust: An investment company that holds a fixed portfolio for the life of the fund.

The portfolio is generally unmanaged after it is established.

Redeemable Trust Certificate: A unit representing proportional ownership of a unit investment trust.

Investors may redeem their units for a value based on the trust’s NAV.

2) Managed Investment Company

Managed Investment Company: An investment company whose portfolio is actively managed.

Managed investment companies are classified as open-end or closed-end funds.

3) Open-End Fund

Open-End Fund: A fund that issues new shares and redeems existing shares at NAV.

An open-end fund is commonly called a mutual fund.

The number of shares outstanding changes as investors purchase and redeem shares.

4) Closed-End Fund

Closed-End Fund: A fund with shares that trade among investors in a secondary market.

The fund does not normally issue or redeem shares after its initial offering.

Because closed-end fund shares trade in the market, their market price may differ from NAV.

5) Premium and Discount to NAV

Let $P$ be the market price of a closed-end fund share.

Premium to NAV: A condition in which the market price is greater than NAV.

$$P>\mathrm{NAV}.$$

Discount to NAV: A condition in which the market price is less than NAV.

$$P<\mathrm{NAV}.$$

The percentage premium or discount is

$$\text{Premium or Discount} = \frac{P-\mathrm{NAV}}{\mathrm{NAV}}.$$

A positive value represents a premium, while a negative value represents a discount.

6) Other Investment Organizations

Commingled Fund: A pooled investment fund generally offered to trusts, retirement accounts, or institutional investors.

Real Estate Investment Trust (REIT): An investment organization that invests in real estate or real-estate loans.

Equity REIT: A REIT that owns and manages real property.

Mortgage REIT: A REIT that invests primarily in mortgages and real-estate loans.

Hedge Fund: A privately organized investment pool that generally serves wealthy or institutional investors and may use flexible, complex, or leveraged strategies.

Fund of Funds: A fund that invests primarily in shares of other investment funds.

4.3 Mutual Funds

1) Mutual Fund

Mutual Fund: An open-end investment company that pools investor money in a professionally managed portfolio.

Investors purchase and redeem mutual-fund shares through the fund at NAV.

2) Money Market Fund

Money Market Fund: A mutual fund that invests in short-term, liquid, and relatively low-risk money market instruments.

Money market funds generally attempt to maintain a stable NAV.

3) Equity Fund

Equity Fund: A mutual fund that invests primarily in common stocks.

Income Fund: An equity fund that emphasizes stocks providing relatively high dividend income.

Growth Fund: An equity fund that emphasizes companies with high expected growth and capital appreciation.

Sector Fund: A fund that concentrates its investments in a particular industry or economic sector.

Sector funds provide less diversification than broad-market equity funds.

4) Bond Fund

Bond Fund: A mutual fund that invests primarily in fixed-income securities.

Bond funds may specialize by issuer, maturity, credit risk, or tax treatment.

5) International Funds

Global Fund: A fund that invests throughout the world, including the investor’s domestic market.

International Fund: A fund that invests primarily outside the investor’s domestic market.

Regional Fund: A fund that concentrates on a particular geographic region.

Emerging-Market Fund: A fund that invests in securities issued in developing economies.

6) Balanced and Life-Cycle Funds

Balanced Fund: A fund that maintains a portfolio containing both stocks and bonds.

Life-Cycle Fund: A balanced fund designed for investors with a particular age, risk level, or investment horizon.

Target-Date Fund: A life-cycle fund that gradually shifts toward more conservative assets as its target date approaches.

7) Asset Allocation Fund

Asset Allocation Fund: A fund that changes its allocation among asset classes according to the manager’s market outlook.

Its asset proportions may change substantially over time.

8) Index Fund

Index Fund: A fund designed to reproduce the performance of a specified market index.

Index funds use passive management and generally have low expenses and low portfolio turnover.

4.4 Costs of Investing in Mutual Funds

1) Operating Expenses

Operating Expenses: The administrative, advisory, and management costs incurred in operating a fund.

These expenses are deducted from fund assets and reduce NAV.

Expense Ratio: Annual operating expenses expressed as a proportion of average fund assets.

Let $E$ be annual operating expenses and $A$ be average net assets.

$$\text{Expense Ratio} = \frac{E}{A}.$$

2) Loads

Load: A sales commission charged when mutual-fund shares are purchased or redeemed.

Front-End Load: A sales charge paid when fund shares are purchased.

Let $I$ be the investor’s initial payment and $f$ be the front-end load rate.

The amount actually invested is

$$I_{\mathrm{net}} = I(1-f).$$

Back-End Load: A sales charge paid when fund shares are redeemed.

It is also called a contingent deferred sales charge.

No-Load Fund: A mutual fund that does not charge a front-end or back-end sales commission.

3) 12b-1 Fees

12b-1 Fee: An annual fee deducted from fund assets to pay for marketing and distribution expenses.

Because it is charged repeatedly, a 12b-1 fee can substantially reduce long-term returns.

4) Share Classes

Class A Shares: Fund shares that commonly charge a front-end load and a relatively small annual 12b-1 fee.

Class C Shares: Fund shares that commonly charge a higher annual 12b-1 fee and may impose a back-end load.

Institutional Shares: Shares offered to institutional investors, generally with low expenses and no sales load.

5) Soft Dollars

Soft Dollars: Research or other services provided by a broker in exchange for receiving the fund’s trading business.

Soft-dollar costs appear through higher trading commissions rather than directly in the reported expense ratio.

6) Mutual Fund Return

Let $\mathrm{NAV}_0$ be the beginning NAV, $\mathrm{NAV}_1$ be the ending NAV, $D$ be income distributions, and $G$ be capital-gain distributions.

The mutual fund’s holding-period return is

$$r = \frac{\mathrm{NAV}_1-\mathrm{NAV}_0+D+G} {\mathrm{NAV}_0}.$$

This return includes changes in NAV and distributions received during the period.

It does not automatically account for a sales load paid directly by the investor.

7) Gross and Net Return

Gross Portfolio Return: The return earned by the fund’s underlying investments before fund expenses.

Net Fund Return: The return remaining for investors after operating expenses and recurring fees.

If $r_g$ is the gross portfolio return and $e$ is the total expense ratio, then approximately

$$r_{\mathrm{net}} = r_g-e.$$

Even small annual expenses can cause a large reduction in long-term compounded wealth.

4.5 Taxation of Mutual Fund Income

1) Pass-Through Status

Pass-Through Status: A tax treatment under which qualifying fund income is taxed at the investor level rather than at both the fund and investor levels.

Interest, dividends, and realized capital gains are passed through to shareholders.

2) Capital-Gain Distribution

Capital-Gain Distribution: A payment to shareholders representing capital gains realized by the fund.

An investor may owe tax on the distribution even when the investor did not personally sell fund shares.

3) Portfolio Turnover

Portfolio Turnover: The proportion of a fund’s portfolio that is replaced through trading during a period.

Let $S$ be the value of securities sold or purchased, using the smaller value, and let $A$ be average net assets.

$$\text{Turnover Rate} = \frac{S}{A}.$$

High turnover generally increases transaction costs and taxable capital-gain distributions.

Tax Efficiency: The ability of an investment to minimize or defer taxable distributions.

Low-turnover index funds are generally more tax-efficient than frequently traded active funds.

4.6 Exchange-Traded Funds

1) Exchange-Traded Fund

Exchange-Traded Fund (ETF): An investment fund whose shares trade on a securities exchange like ordinary stock.

Many ETFs are designed to track a market index.

2) ETF Characteristics

Intraday Trading: ETF shares can be bought or sold throughout the trading day.

Market Price: The price at which an ETF share trades in the market.

An ETF’s market price may temporarily differ from its NAV.

Creation and Redemption: The process through which large financial institutions exchange baskets of securities for large blocks of ETF shares.

This process generally keeps the ETF’s market price close to NAV.

3) ETF Advantages

Low Expenses: Many index ETFs have relatively low expense ratios.

Tax Efficiency: ETF creation and redemption can reduce taxable capital-gain distributions.

Trading Flexibility: ETFs can be traded intraday, sold short, purchased on margin, and used with limit orders.

4) ETF Costs and Risks

Brokerage Cost: Investors may pay commissions when purchasing or selling ETF shares.

Bid-Ask Spread: ETF investors incur the difference between the market bid and ask prices.

Tracking Error: The difference between an ETF’s return and the return of its benchmark index.

Price Deviation: A temporary difference between an ETF’s market price and its NAV.

ETFs holding illiquid assets may experience larger price deviations during market stress.

5) ETFs versus Mutual Funds

Mutual Fund: Purchased or redeemed through the fund at end-of-day NAV.

ETF: Traded between investors throughout the day at a market price.

Mutual funds provide direct transactions at NAV, while ETFs provide greater trading flexibility.

4.7 Mutual Fund Investment Performance

1) Performance Benchmark

Performance Benchmark: A market index or portfolio used as a standard for evaluating investment performance.

A fund should be compared with a benchmark having a similar investment policy and risk level.

2) Active and Passive Performance

Active Fund: A fund whose manager selects securities in an attempt to outperform a benchmark.

Passive Fund: A fund that attempts to reproduce the performance of a market index.

On average, actively managed funds tend to underperform comparable index funds after expenses.

3) Risk-Adjusted Performance

Risk-Adjusted Performance: Investment performance evaluated after accounting for the amount and type of risk taken.

A higher raw return does not necessarily indicate superior management if the fund assumed greater risk.

4) Performance Persistence

Performance Persistence: The tendency of a fund’s past performance to continue in future periods.

Past mutual-fund performance generally has limited ability to predict future performance.

5) Survivorship Bias

Survivorship Bias: The distortion created when performance data include surviving funds but exclude funds that closed or merged.

Excluding failed funds makes historical fund performance appear better than it actually was.

4.8 Information on Mutual Funds

1) Fund Prospectus

Fund Prospectus: A disclosure document describing a fund’s objectives, policies, risks, fees, and historical performance.

Investors should examine the prospectus before purchasing fund shares.

2) Investment Objective

Investment Objective: The financial goal that guides a fund’s investment strategy.

Examples include capital growth, current income, capital preservation, and total return.

3) Morningstar Style Box

Morningstar Style Box: A classification system that describes an equity fund using company size and investment style.

Company size is classified as large, medium, or small.

Investment style is classified as value, blend, or growth.

Value Stock: A stock with a relatively low market price compared with earnings, book value, sales, cash flow, or dividends.

Growth Stock: A stock with a relatively high market price based on expectations of rapid future growth.

4) Important Fund Information

Asset Allocation: The proportions of fund assets invested in different asset classes.

Top Holdings: The securities representing the largest positions in a fund.

Sector Allocation: The distribution of a fund’s investments across industries.

Historical Return: The return earned by a fund during previous periods.

Fund Rating: An evaluation of a fund based on historical return, risk, expenses, or other criteria.

A high historical rating does not guarantee superior future performance.

Summary

• Investment companies pool investor money and provide diversification, professional management, administration, and lower transaction costs.
• NAV equals a fund’s assets minus liabilities divided by its shares outstanding.
• A unit investment trust holds a mostly fixed portfolio, while a managed investment company changes its holdings over time.
• Open-end funds issue and redeem shares at NAV, while closed-end fund shares trade in the secondary market.
• Closed-end fund prices may trade at a premium or discount to NAV.
• A mutual fund is an open-end investment company.
• Mutual funds are classified by investment policy, including money market, equity, bond, balanced, international, sector, and index funds.
• Index funds use passive management to track a benchmark at relatively low cost.
• Mutual-fund costs include operating expenses, front-end loads, back-end loads, and 12b-1 fees.
• Fund expenses are deducted from fund assets and reduce the investor’s return.
• Mutual-fund return consists of the change in NAV plus income and capital-gain distributions.
• High portfolio turnover increases trading costs and may reduce tax efficiency.
• ETFs trade throughout the day like stocks, while mutual funds transact at end-of-day NAV.
• ETF investors may incur commissions, bid-ask spreads, tracking error, and temporary deviations from NAV.
• Active funds must outperform their benchmarks by enough to cover their higher expenses.
• Past fund performance and ratings have limited power to predict future results.