University of California, Merced Professor Jason Lee ECO 163 Economics of Investments Chapter 4 Lecture otes I. Investment Companies
A. Introduction
Definition: Investment companies are financial intermediaries that collect funds from individual investors and invest the funds in securities and assets.
• Each investor in an investment company has a claim on the portfolio of assets in proportion to the amount invested.
Investment companies serve the following functions:
1. Allow individual investors to achieve diversification by pooling resources with other investors. 2. Provide professional management of the portfolio of assets. 3. Provide administrative duties and record keeping. 4. Lowers transaction costs for investors.
Definition: et Asset Value ( AV) is the value of each share in the investment company.
Value of Assets - Liabilites NAV = Number of Shares
Example: Assets = $3,035.74 million Liabilities = $83.08 million Shares = 281.69 million
NAV = [($3035.74 - $83.08)/(281.69)] = $10.48
B. Types of Investment Companies
1. Unit Investment Trusts Definition: A unit investment trust pools money from investors to purchase a portfolio of assets that is fixed for the life of the fund.
• Unit investment trusts are unmanaged once established. • Investors purchase shares or “units” in the trust that are called redeemable trust certificates. • Investors may sell shares back to the trust at the NAV. • Has declined in popularity over time. 2. Managed Investment Companies There are two types of managed investment companies: open end funds and closed end funds.
Definition: Open end funds are managed investment companies that allow investors to redeem (sell) their shares back to the fund at the NAV.
• Open-end funds do not trade on exchanges (such as the NYSE). Instead investors buy and sells shares directly through the investment company at the NAV.
Definition: Closed end funds are managed investment companies that do not allow the redemption of shares.
• Closed-end funds do trade on exchanges (like stocks). If an investor wishes to sell their shares it must find another investor who wishes to purchase the shares.
3. Commingled Funds
Definition: Commingled funds are partnerships of investors that pool funds. A management firm manages the fund for a fee. Partnerships generally consist of a few large investors.
4. Real Estate Investment Trusts (REITs)
Definition: A real estate investment trust (REITs) is a fund that invest in real estate or mortgage loans. There are two types of REITS: Equity Trusts and Mortgage Trusts Definition: Equity Trusts are funds that invest directly in real estate. Definition: Mortgage Trusts are funds that invest in mortgage or construction loans.
• REITs are established by banks, mortgage companies or insurance companies who manage the funds for a fee.
5. Hedge Funds
Definition: A hedge fund is similar to a mutual fund in that private investors’ assets are pooled together to be invested by the fund manager.
• Hedge funds are typically open only to wealthy investors. • Structured as a private partnership. Not subject to SEC regulation. • Usually have a “lock-up” restriction which prevents investors from withdrawing assets for several years after investment. • Due to the lack of regulations, hedge fund managers are able to use investment strategies not available to mutual funds (invest in derivatives, short sales, etc…) • Has experienced significant recent growth.
II. Mutual Funds
The most common form of investment company are mutual funds. Approximately 90% of assets that are invested in investment companies are invested with mutual funds. There are over 9000 mutual funds. Two of the largest mutual fund companies are Vanguard and Fidelity.
A. Investment Policies
• Each mutual fund has a specified investment policy that is outlined by the prospectus.
Investment policies dictate what type of assets a mutual fund will hold and they fall under the following broad categories:
1. Money Market Funds
Definition: Money market mutual funds are funds that are investment in money market securities (t-bills, commercial paper, repurchase agreements, CDs).
• The average maturity of assets held by these funds is 1 month. • These funds offer check-writing features (usually $250 minimum check) • NAV fixed at $1 per share
2. Equity Funds
Definition: Equity mutual funds are funds that are invested primarily in equities.
• Equity funds are divided into two categories income funds (funds that focus on firms that have high dividend yields) and growth funds (funds that focus on firms that have the greatest prospect of capital gains). Growth funds are riskier than income funds. • Despite its name, equity funds still hold cash or money market assets. Typically approximately 5% of its assets are held in cash or money market assets for the possibility of share redemption.
3. Sector Funds
Definition: Sector funds are equity funds that have a concentration on a particular industry.
• Sector funds may have a focus on biotech, utility, finance, etc…
4. Bond Funds
Definition: Bond funds are funds that specialize in the fixed income (bond) sector. • There is a great variety of bond funds. Some bond funds focus solely on treasury bonds, others on municipal bonds and others on high yield corporate bonds (junk bonds). Thus there is a significant range in terms of risk with bond funds.
5. International Funds
Definition: International funds are funds that have an international focus.
• Global funds are funds that invest in securities worldwide (including the U.S.) • International funds are funds that invest in securities located outside the U.S. • Regional funds are funds that concentrate on a particular part of the world. • Emerging market funds are funds that invest in companies in developing nations.
6. Balanced Funds
Definition: Balanced funds are funds that hold both equities and fixed income assets in their portfolio.
• Balanced funds are sometimes called life cycle funds because balance funds range in asset mix between equities and fixed income. Some balanced funds are more heavily weighted with equities (aggressive fund for younger investors or those that have a higher risk tolerance). Other balanced funds are more heavily weighted with fixed income (less risky fund for older investors or more risk adverse investors).
7. Asset Allocation Funds
Definition: Asset Allocation funds are like balanced funds, however, the fund manager has the ability to change the allocation mix between equities and fixed income based on the manager’s forecast of the relative performance of each sector.
• Asset allocation funds are riskier form of balanced funds.
8. Index funds
Definition: An index fund tries to match the performance of a broad market index.
• The fund buys shares in securities that are included in the particular index that is being tracked. Shares are bought exactly in the same proportion as its weight in the index. • Index funds are popular with investors who prefer a low cost passive investment strategy. III. Costs of Investing in Mutual Funds
A. Fees
• Mutual funds incur operating expenses (administrative expenses as well as fees to the investment manager). These operating expenses can range between 0.2% to 2% of total assets under management. • Shareholders do not pay these expenses directly, rather they are periodically deducted from the fund’s assets which lowers the portfolio value.
Definition: Front end load is a commission or sales charge that is paid when you purchase the mutual fund shares.
• The front-end load may not exceed 8.5% of the purchase value. • o load mutual funds are funds that has no front-end sales charge.
Definition: Back end load is a fee that is incurred when the investor sells the shares.
• Typically back-end load fees fall the longer the funds have been invested.
Definition: 12b 1 fees are charges that pay for advertising, promotional literature, prospectus and commissions paid to brokers who sell the fund to investors. B. Calculating the Rate of Return of a Mutual Fund
• NAV is calculated at the end of each trading day. All buy and sell orders received during the trading day are executed at the NAV following the close of the market (4pm E.S.T).
Let NAV 0 = net asset value at the beginning of the period Let NAV 1 = net asset value at the end of the period
− + + NAV1 NAV0 Income Distribution Capital Gain Distrtibution Rate of Return = x 100% NAV0
Example: Suppose that
NAV 0 = $20; NAV 1 = $20.10; income distribution = 0.15; capital gain distribution = 0.05
Rate of Return = [($20.10 - $20.00 + 0.15 + 0.05)/$20.00] x 100 % = 1.5%
C. Taxation of Mutual Fund Income
• As long as all the income (short-term capital gains, long-term capital gains, and dividends) are distributed entirely to shareholders, then the mutual fund does not have to pay any taxes. • It is the investor who receives the “pass through” income that is responsible for paying the investment income taxes. • One factor that can affect the amount of taxes that is paid by the investor is the turnover ratio . Definition: The turnover ratio is the amount of trading activity of a portfolio relative to the assets in the portfolio.
• A high turnover ratio implies that there is more realized capital gains which will increase the tax obligation. IV. Exchange Traded Funds (ETFs)
Definition: Exchange traded funds are a type of index mutual funds that trade on an exchange like stocks.
• ETFs track a market index or an industry index. • Unlike mutual funds that can only be bought and sold once per day (at the end of the trading day), ETFs can be bought and sold continuously throughout the trading day. • ETFs can be sold short and purchased on the margin. • Another difference between an ETF and a mutual fund is when a mutual fund investor wishes to sell (redeem) his shares to the mutual fund, the fund may be required to sell some assets to raise the necessary funds to pay off the investor. This may lead to capital gains and tax consequences for the fund investors. However, if an ETF shareholder wishes to sell her shares, they don’t redeem the shares to the mutual fund but rather sell the shares to another investor. The fund does not have to sell assets (and face tax obligations) as a result of an investor wishing to sell their position. V. Managed Fund Performance
• An important question for mutual fund investor is how do mutual fund managers perform relative to some benchmark index. Does an active fund manager outperform the general market? • One way to compare is to look at the historical performance of a group of diversified equity funds vs. the returns for the Wilshire Index (recall this is the broadest stock market index). It turns out that the average annual return for the Wilshire Index is slightly higher than the returns for the equity funds. • Some mutual funds tout their recent performance suggesting they are able to outperform their peers. Are such claims justified or could it just be due to luck? One way to test this is to look at returns of top funds from one year to the next. If the managers have skill then we would expect that an outperforming fund one year will also outperform the following year. There is inconclusive evidence to suggest that any such pattern exists.