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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