INVESTMENT COMPANIES

Chapter 8
Types of Investment Companies
● Open-End Funds: These funds, more popularly
referred to as mutual funds, continually stand ready to
sell new shares to the public and to redeem their
outstanding shares on demand at a price equal to an
appropriate share of the value of their portfolio, which
is computed daily at the close of the market.
Types of Investment Companies
● Open-End Funds: A mutual fund’s share price is based on its
net asset value per share, which is found by subtracting from
the market value of the portfolio the mutual fund’s liabilities
and then dividing by the number of mutual fund shares
outstanding.
NAV Example: suppose that a mutual fund with 10 million
shares outstanding has a portfolio with a market value of $215
million and liabilities of $15 million. The net asset value per
share is $20 [($215 million - $15 million) divided by 10
million].
Types of Investment Companies
● Open-End Funds: The share price is quoted on a
bid-offer basis. The offer price is the price at which the
mutual fund will sell the shares. It is equal to the net
asset value per share plus any sales commission that the
mutual fund may charge. The sales commission is
referred to as a “load”.
● Closed-End Funds: Close-end funds sell shares like any
other corporation but usually do not redeem their
shares.
Types of Investment Companies
● Closed-End Funds: Shares of close-end funds sell on
either an organized exchange or in the over-the-counter
market. Investors who wish to purchase closed-end
funds must pay a brokerage commission at the time of
purchase and again at the time of sale.
The price of a share in a close-end fund is determined
by supply and demand, so the price can fall below or
rise above the net asset value per share.
Types of Investment Companies
● Closed-End Funds: Shares selling below NAV are said
to be “trading at a discount”, while shares with prices
above NAV are “trading at a premium”.
An interesting feature of close-end funds is that
investors bear the substantial cost of underwriting the
issuance of the funds’ share. The proceeds that the
managers of the fund have to invest equal the total paid
by initial buyers of the shares minus all costs of
issuance.
Types of Investment Companies
● Closed-End Funds: The high commissions are strong
incentives for retail brokers to recommend these
shares to their customers who are retail (individual)
investors.
● Unit Trusts: A unit trust is similar to a close-end fund
in that the number of unit certificates is fixed. Unit
trusts typically invest in bonds, and they differ in
several ways from both mutual funds and close-end
funds.
Types of Investment Companies
● Unit Trusts: First, there is no active trading of the
bonds in the portfolio of the unit trust. Once the unit
trust is assembled by the sponsor (usually a brokerage
firm or bond underwriter) and turned over to a trustee,
the trustee holds all the bonds until they are redeemed
by the issuer.
Types of Investment Companies
● Unit Trusts: Second, unit trust have a fixed
termination date, while mutual funds and close-end
funds do not.
Third, unlike the mutual fund and close-end fund
investor, the unit trust investor knows that the
portfolio consists of a specific collection of bonds and
has no concern that the trustee will alter the portfolio.
Economic Functions
An investment company is a financial intermediary because it pools
the funds of market participants and uses those funds to buy a
portfolio of securities. Also recall the special role in the financial
markets played by financial intermediaries. They provide at least
one of the following four economic functions:
1. Maturity intermediation: An investor with a short-term
investment horizon wishing to invest in either stocks or debt
obligations with a maturity grater than the planned investment
horizon faces the risk that the securities may have to be sold at a
time when their market value is lass than the price paid.
Economic Functions
1. Maturity intermediation: This is true even with
mutual funds because the net asset value per share will
fluctuate with market conditions. Consequently,
maturity intermediation is not an economic function
provided by the fund.
2. Risk Reduction via diversification: By investing in a
fund, an investor can obtain broad-based ownership of a
sufficient number of securities either within a sector of
the financial market or across market sectors to reduce
portfolio risk.
Economic Functions
2. Risk Reduction via diversification: While an
individual investor may be able to acquire a
broad-based portfolio of securities, the degree of
diversification will be limited by the amount
available to invest. By investing in the investment
company, however, the investor can effectively
achieve the benefits of diversification at lower cost
even if the amount of money available to invest is
not large.
Economic Functions
3. Lower costs of contracting and information
processing: There are reduced costs of contracting and
information processing because an investor purchases
the services of a presumably skilled financial advisor at
less cost than if the investor directly negotiated with
such an advisor. The advisory fee is lower because of the
larger size of assets managed, as well as the reduced
costs of searching for an investment manager and
obtaining information about the securities.
Economic Functions
3. Lower costs of contracting and information processing:
Also, the cost of transacting in the securities are reduced
because a fund has more clout in negotiating transactions
costs, and custodial fees and bookkeeping costs are less for a
fund than for an individual investor.
4. A payments mechanism: Finally, money market funds
generally provide payment services by allowing investors to
write checks drawn on the fund, although this facility is
limited in various ways.