CHAPTER TWENTY-ONE

INVESTMENT COMPANIES

INVESTMENT COMPANIES INVESTMENT COMPANIES

DEFINITION: a type of financial intermediary who obtain funds from investing to use in purchase of financial assets•investors receive certain rights in

exchange

INVESTMENT COMPANIES•Advantages to the Individual Investor

economies of scale– higher volume purchases, lower commission

rate– provides diversification

professional management– manager is a professional seeking mispriced

securities full time

NET ASSET VALUE KEY CONCEPT FOR INVESTMENT

COMPANIES•Net Asset Value (NAV)NAVt = (MVAt - LIABt )/NSOtwhere NAVt is the firm’s net asset valueMVAt is the market value of firm’s assetsLIABt is the dollar value of firm’s liabilitiesNSOt is the number of shares outstanding

MAJOR TYPES OF INVESTMENT COMPANIES UNIT INVESTMENT TRUST

•DEFINITION: an investment company that owns a fixed set of securities for the life of the company

•FORMATIONsponsor purchases a specific set of securitiesthe securities are deposited with trusteefirm sells redeemable trust certificates to the publicall income received by trustee paid out to

certificate holders

MAJOR TYPES OF INVESTMENT COMPANIES UNIT INVESTMENT TRUST

•LIFE SPANSfrom 6 months to 20 years

•SECONDARY MARKETinvestor may sell the shares back to the

trusta secondary market may be maintained

by the sponsor of the trust

MAJOR TYPES OF INVESTMENT COMPANIES MANAGED COMPANIES

•WHAT ARE THEY?organized as corporations with a board

of directorsmanagement company is hiredannual management fees vary from .5 to

1% of the average market value of the company’s total assets

MAJOR TYPES OF INVESTMENT COMPANIES CLOSED-END INVESTMENT COMPANY

•FEATURESshares are traded on an exchange unlimited lifedividends received paid out to shareholderscan issue shares to raise additional funds

•quotationsmarket prices published dailyNAV published weekly

MAJOR TYPES OF INVESTMENT COMPANIES OPEN-ENDED INVESTMENT

COMPANIES•most known as mutual funds•continuously offer new shares to the

public•capitalization is open

MUTUAL FUNDS MUTUAL FUND TAXATION

•re. the investment company:no corporate income tax liability if

– it pays at least 90% of its net income to shareholder

– Two kinds of payments to investors:• one for income• another for net capital gains realized

MUTUAL FUNDS MUTUAL FUND PERFORMANCE

•CALCULATING RETURNS:Formula:rt = {(NAVt- NAVt-1) +It + Gt}/ NAVt-1

where rt = return at time t It = income Gt = capital gain distribution at time t

MUTUAL FUNDS AVERAGE RETURN

•Benchmark portfolio used tom compare the performance of the investment company

•Composition of the benchmark portfolioa market index is chosen (e.g. S&P500)a risk-free asset chosen (e.g. T-bills)an index to account for the difference in

performance is chosen– allows for high to low book-to-market price stocks

MUTUAL FUNDS AVERAGE RETURN

•Style Analysisused to derive appropriate benchmark

•Ex Post Alpha Derivedformula:parp - arbpwhere ar p = the average return on portfolio p

arbp = average return on the benchmark

MUTUAL FUNDS

parp - arbp

•If p > 0, the portfolio has performed well

EVALUATING MUTUAL FUNDS PROFESSIONAL SERVICES

•MORNINGSTARis the most often used service

•CAVEATS RE. MORNINGSTAR:performance comparisons using S&P500

for all equity and bond funds– may not be appropriate for certain types of

funds– e.g. a fund mostly invested in NASDAQ stocks

does not compare

EVALUATING MUTUAL FUNDS PROFESSIONAL SERVICES

•MORNINGSTARis the most often used service

•CAVEATS RE. MORNINGSTAR:their approach to the quest for abnormal

returns is not clearly revealeduse of peer group comparisons has several

serious shortcomings– some funds may be restricted by their stated

objectives as to what they can purchase

EVALUATING MUTUAL FUNDS PROFESSIONAL SERVICES

•MORNINGSTARis the most often used service

•CAVEATS RE. MORNINGSTAR:survivorship bias

– the tendency for poorly performing funds to go out of business and leave the peer group

END OF CHAPTER 21