CHAPTER 7

INVESTMENT COMPANIES
AND EXCHANGE-TRADED FUNDS
TYPE OF INVESTMENT COMPANIES

Open-End Funds (Mutual Funds)

More popularly known as mutual funds. As open-end funds they stand ready to buy and redeem
shares at a price based on net asset value, which is total asset value less liabilities. Prices are
quoted on a bid/offer basis. For a no-load fund the bid/offer prices will be the same. The net
asset value (NAV) per share equals the market value of the portfolio minus the liabilities of the
mutual fund divided by the number of shares owned by the mutual fund investors.

There are several important characteristics of open-end or mutual fund. First, investors in mutual
funds own a pro rata share of the overall portfolio. Second, the investment manager actively
manages the portfolio. Third, the share price is the NAV. Fourth, the NAV is determined only
once each day, at the close of the day.

In the case of a load fund the offer price will exceed the bid price by the amount of a sales
commission charged upon purchases of shares. Some funds have back-end loads, wherein
commissions are charged upon redemption of funds within a few years. Others, known as
Section 12b-1 funds, charge a small percentage of assets annually to cover sales costs. In any
case, all funds earn small percentage annual fees to cover administrative costs. These funds
comprise the third largest group of financial institutions, behind banks and insurance companies.

Closed-End Funds

These funds issue a limited number of shares and are very similar to shares of common stock.
They are then sold on the open market like other securities. Investors pay a broker’s commission.
The NAV of closed-ended funds is determined by supply and demand. The market price of these
shares may thus differ from net asset value, often at a discount from it. The discount results from
large tax liabilities on capital gains that swell the net asset value, while investors are pricing
future after-tax distributions. Premiums can result because such funds often have inexpensive
access to overseas stocks.

Under the Investment Company Act of 1940, closed-end funds are capitalized only once. They
make an IPO, and then their shares are traded on the secondary market, just like any corporate
stock.

The relatively new exchange traded funds (ETFs) pose a threat to both mutual funds and
closed-end funds. ETFs are essentially hybrid closed-end vehicles, which trade on exchanges but

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typically trade very close to NAV.

Unit Trusts

A unit trust is similar to a closed-end fund in that the number of unit certificates is fixed. They
are different from closed-end funds in the following. First, they typically invest in bonds.
Second, they do not trade. Third, a fixed amount of securities is assembled with a defined
termination date. The major benefit of such funds is lower operating costs due to the absence of
trading.

FUND SALES CHARGES AND ANNUAL OPERATING EXPENSES

There are two types of costs borne by investors in mutual funds. The first is shareholders fee,
usually called the sales charge. This type of charge is related to the way the fund is sold and
distributed. The second cost is the annual fund operating expense usually called the expense
ratio, which covers the fund's expenses. The largest of which is for investing managements.
Other expenses include primarily the cost of, 1) custody 2) the transfer agent cost, 3)
independence public accountant fee, and 4) directors’ fee. The sum of annual management fee,
the annual distribution fee and other expenses is called the expense ratio.

Sales Charge

Sales charges on mutual funds are related to their method of distribution. The two types of
distribution were sales force and direct. Sales force occurs via an intermediary agent. Direct
distribution takes place without an intermediary. Funds with no sales charges are called no-load
mutual funds. Some have speculated that load funds would eventually disappear, but the trend
has gone the other way. Among the recent adaptations of the sales load are back-end loads.

Annual Operating Expenses (Expense Ratio)

The operating expense, also called the expense ratio, is debited annually from the investor’s fund
balance by the fund sponsor. Operating expenses are deducted from NAV and therefore reduce
the reported return. The management fee, also called the investment advisory fee, is the fee
charged by the investment advisor for managing a fund’s portfolio. In 1980, the SEC approved
the imposition of a fixed annual fee, called the 12b-1 fee, which intended to cover distribution
costs. Such 12b-1 fees are now imposed by many mutual funds.

Multiple Share Classes

Share classes were first offered in 1989 following the SEC’s approval of multiple share class.
Initially share classes were used primarily by sales-force funds to offer alternatives to front-end
load as a means of compensating brokers. Later, some of the funds used additional share classes
as a means of offering the same fund or portfolio through alternative distribution channels in
which some fund expenses varied by channel.

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ECONOMIC MOTIVATIONS FOR FUNDS

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. They provide at least one of the
following six economic functions: (1) risk reduction via diversification, (2) lower costs of
contracting and processing information, (3) professional portfolio management, (4) liquidity, (5)
variety, (6) payments mechanism.

TYPES OF FUNDS BY INVESTMENT OBJECTIVE

Investment funds tend to have a variety of investment objectives. In general, there are stock
funds, bond funds, money market funds and others. They seek to accommodate a wide range of
desires and needs, among them income, capital gains, growth, and income. Some funds
specialize by securities, examples of which are indexed funds, government bond funds,
municipal bond funds, corporate bond funds, money market mutual funds, and balanced
funds--combination of bonds and stocks.

CONCEPT OF FAMILY OF FUNDS

Now many management companies offer investors a choice of numerous funds. Some firms
provide a choice of funds and objectives. Changing from one to the other to reflect changing
needs can then be accomplished at low or no cost to the investor. The funds in a family usually
include choices ranging from money market funds to global funds, and funds devoted to
particular industries such as medical technology or gold mining companies. Concentration in the
mutual funds industry continues to increase.

INVESTMENT VEHICLES FOR MUTUAL FUNDS

Mutual funds may be included in different investment vehicles. An investment vehicle can be a
non-qualified vehicle because it does not quality for tax advantages. The same fund can also be
included in a retirement plan such as 401(k), Roth 401(k), IRA or Roth IRA. These retirement
plans are called qualified plans.

MUTUAL FUND COSTS

From 1980 to 2006, the measure of mutual fund costs declined from 2.32% to 1.07% for stock
funds and from 2.05% to 0.84% for bond funds. There were three reasons for this decline. First,
loads in general declined. Second, no-load mutual funds grew. Third, mutual fund expenses have
also declined due to economies of scale and intense competition.

TAXATION OF MUTUAL FUNDS

Mutual funds must distribute at least 90% of their net investments income earned, exclusive of
realized capital gains or losses to shareholders to be considered a regulated investment company
(RIC) and, thus not be required to pay taxes at the fund level prior to distribution to shareholders.

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Consequently, funds make these distributions. Capital gains distributions must occur annually,
and typically occur late during the calendar year. New investors in the fund may assume a tax
liability even though they have no gains. The investors must also pay ordinary income taxes on
distribution of income.

REGULATION OF FUNDS

All investment companies are regulated under the Investment Company Act of 1940. They must
register with the SEC and file periodic reports. No taxes are levied on funds, which distribute
90% of their income. There are minimum diversification and liquidity requirements as well as
maximum fees that can be applied. Currently under consideration is a proposal allowing less
redemption over a quarter, thus permitting funds to hold smaller proportions of liquid assets.

Among the recent SEC priorities, which directly affect mutual funds, are:

1. Reporting after taxes.

2. More complete reporting fee.
3. More accurate and consistent reporting of investment performance.
4. Requiring fund investment practices to be more consistent with the name of a fund to
more accurately reflect their investment objectives.
5. Disclosing portfolio practices such as "window dressing".
6. Various rules to increase the effectiveness of independent fund boards.

STRUCTURE OF A FUND

A mutual fund organization is structured as follows: (1) board of directors, (2) mutual fund, (3)
investment advisor, (4) distributor, (5) other service providers. The role of the board of
directors is to represent the fund shareholders. External advisers are called subadvisers, and they
are used because (1) to develop a fund in an area in which the fund family has no expertise, (2)
to improve performance, (3) to increase assets under management, (4) to obtain an attractive
manager at a reasonable cost.

RECENT CHANGES IN THE MUTUAL FUND INDUSTRY

Distribution Channels

Traditionally, funds were sold direct or through a sales force. However, funds have moved
increasingly to nontraditional sources of sales.

Supermarkets: The organizer of a supermarket, like Charles Schwab, offers funds from a
number of different mutual fund families.

Wrap programs: Wrap accounts are managed accounts, typically mutual funds or ETFs,
wrapped in a service package. The service provided is often asset allocation counsel, i.e., advice
on the mix of managed funds or ETFs.

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Fee-based financial advisors: Fee-based financial advisors are independent financial planners
who charge a fee rather than a transaction charge for investment services. These fees are
typically a percentage of assets under management or alternatively an hourly fee or a fixed
retainer.

Variable annuities: Variable annuities represent another distribution channel.

Changes in the Costs of Purchasing Mutual Funds

The purchase cost of mutual funds has declined significantly. In general, load funds responded to
the competition of no-load funds by lowering distribution cost.

Mix and Match

The investors’ demands for choice and convenience, and also the distributors’ need to appear
objective, have motivated essentially all institutional users of funds and distribution
organizations to offer funds from other fund families in addition to their own.

Domestic Acquisitions in the US Funds Market

There merger and acquisition business in the US asset management business has been active. The
US asset management business continues to grow and consolidate across the various types of
asset management firms.

Internationalization of the US Funds Business

The combination of a US fund company and international asset manager could occur in either
two directions, i.e., with either being the acquirer. But the dominant direction has been the
acquisition of US funds by international institutions.

EXCHANGE TRADED FUNDS

While mutual funds have become very popular with investors, they are often criticized for two
reasons. First, mutual funds shares are priced at, and can be transacted only at the end of day
(closing) price. The second relates’ to taxes and the investors’ control over taxes. Withdrawals
by some shareholders may cause taxable realized capital gain for shareholders who maintain
their positions.

Closed-end funds trade all during the day on stock exchange, but there is often a difference
between the NAV and the price of the closed-end funds. Both mutual funds and closed-end funds
are similar in that they are instruments based on the portfolio of their securities, but closed-end
funds are transacted continuously throughout the day.

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An investment that embodies a combination of the desirable aspects of mutual funds (open-end
funds) and closed-end funds is the exchange-traded fund (ETF). These are mostly index funds.
They are traded on an exchange, and they are like open-end funds in that the number of shares
can change.

ETC Creation/Redemption Process

For ETCs, individuals do not deal directly with the provider of the ETF. That privilege is
reserved for a few very large investors called authorized participants (AP) who are arbitragers.
Authorized participants are mainly large institutional traders who have contractual agreements
with ETF funds. They are the only investors who may create or redeem shares of an ETF with
the ETF sponsor and then only in large specified quantities called creation/redemption units.
These unit sizes range from approximately 50,000 to 100,000 ETF shares.

ETF Sponsors

Like mutual funds, ETFs require a company to sponsor them. The ETF sponsor must (1) develop
the index, (2) retain the authorized participants, (3) provide seed capital to initiate the ETF, (4)
advertise and market the ETF, (5) engage in other activities.

Mutual Funds versus ETFs: Their Relative Advantages

The following are ETF advantages. Mutual funds are priced only once a day. But ETFs are
traded on an exchange and so there is continuous pricing. Both passive mutual funds and ETFs
have low fees, but ETF fees tend to be somewhat lower. All ETFs trade on an exchange and
incur commission. As to taxes, mutual funds may lead to capital gains taxes for investors who do
not even liquidate their fund. Because of the unique structure of ETFs, ETFs can fund
redemptions by in-kind transfers without selling their holdings, which have no tax consequences.

Mutual funds have the following advantages. While ETFs have been exclusively passive or
indexes, mutual fund families offer many types of active funds as well as passive funds.
Additionally, no-load mutual funds, both active and passive, permit transactions with no loads or
commissions.

Separately Managed Accounts

Many high net worth people object to mutual funds because (1) lack of control over taxes, (2)
lack of any input into investment decision, (3) absence of services. The use of separately
managed accounts responds to all these limitations of mutual funds.

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 ANSWERS TO QUESTIONS FOR CHAPTER 7
(Questions are in bold print followed by answers.)

1. An investment company has $1.05 million of assets, $50,000 of liabilities, and 10,000
shares outstanding.
a. What is its NAV?
b. Suppose the fund pays off its liabilities while at the same time the value of its assets
double. How many shares will a deposit of $5,000 receive?

a. Net asset value = (Total assets minus liabilities) / numbers of shares

= 1,050,000 – 50,000 = $100
10,000

b. Net asset value = 2,100,000 – 0 = $210

10,000
No of shares = 5000 = 23.81 shares.
210

2. “The NAV of an open-end fund is determined continuously throughout the trading day.”
Explain why you agree or disagree with this statement.

Disagree. NAV of open-ended fund is the closing price of the day.

3. What are closed-end funds?

These funds issue a limited number of shares, are sold on the open market.

4. Why do some closed-end funds use leverage to raise more funds rather than issue new
shares like mutual funds?

Under the 1940 Act, these funds are capitalized only once. The number of shares is fixed. Thus
many funds become leveraged to raise more funds without issuing new (additional) shares.

5. Why might the price of a share of a closed-end fund diverge from its NAV?

The price of closed-end funds may differ from NAV (often at a discount) because the fund has a
large built-in tax liabilities and investors are discounting the share’s price for future tax
liabilities. Leverage may be another factor for price below NAV.

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6. What is the difference between a unit trust and a closed-end fund?

With a unit trust a number of securities are assembled in a portfolio package and held for a
specified number of years and then liquidated. The charges are low since there is no trading of
securities or redemption prior to maturity.

7.
a. Describe the following: front-end load, back-end load, level load, 12b-l fee,
management fee.
b. Is there a limit on the fees that a mutual fund may charge?

a. Back-end load funds charge sales fees upon redemption within a period of a few years.
Front end is commissioned charged up front of the time of sale. A level load is amount of
sales commission a fund may charge. A 12b-1 fund is a no-load fund that charges an annual
sales fee of around 1.5% annually.
b. Yes the security rule specifies these fees.

8. Why do mutual funds have different classes of shares?

Different classes of shares offered by mutual funds is determined by the needs of the investors
and their risk preferences. It permits the distributor and its client to select the type of load they
prefer.

9. What is an index fund?

An index fund e.g. Fidelity Magellan and Vanguard S&P 500 are mutual funds, which invests in
stocks included in S&P 500, and aim to achieve its performance to the benchmark S&P500
returns.

10.
a. What is meant by a target-date fund?
b. What is the motivation for the creation of such a fund?

a. Target date funds are mutual funds that base their asset allocations on a specific date, the
assumed retirement date for the investor, and then rebalance to a more conservative
allocation as that date approaches.

b. These funds are designed to be “one-size-fits-all” portfolios for investors with a given
number of years to retirement.

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11. What are the costs incurred by a mutual fund?

Costs typically incurred by an investment company (Mutual fund) include advisory fees,
selling/marketing expenses, custodial/accounting fees, and transactions costs. There are two
types of costs borne by investors in mutual funds. The first is shareholder fee, usually called the
sales charge. This type of charge is related to the way the fund is sold or distributed. The second
cost is the annual fund operating expense usually called the expense ratio, which covers the
fund’s expenses. The largest of which is for investing managements.

12. Why might the investor in a mutual fund be faced with a potential tax liability arising
from capital gains even though the investor did not benefit from such a gain?

Investor in a closed fund is faced with a potential tax gain on capital gains that swell the net asset
value. The investor is pricing future-tax distributions.

13. Does an investment company provide any economic function that individual investors
cannot provide for themselves on their own? Explain your answer.

Yes. An investment company provides risk reduction through diversification and lower costs of
transactions and information processing, which is hardly to come by an individual investor.

14. Why might a family of funds hire subadvisors for some of its funds?

They are used because (1) to develop a fund in an area in which the fund family has no expertise,
(2) to improve performance, (3) to increase assets under management, (4) to obtain an attractive
manager at a reasonable cost.

15.
a. How can a fund qualify as a regulated investment company?
b. What is the benefit in gaming this status?

a. A regulated investment company must provide information on its fees and its objectives. It
must file financial reports and indicate amount of income distributed.

b. A regulated investment company is exempt from taxation on all its ordinary and capital gains
income as long as at least 90% of these funds are distributed to the stockholders. Such
distributions are then taxable to the stockholders.

16. What is an ETF?

An exchanged traded fund is a new investment vehicle that is similar to mutual funds but trade
like a stock on an exchange. The price is determined continuously rather than the closing price
e.g. QQQ.

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17. What are the advantages of an ETF relative to open-end and closed-end investment
companies?

As said earlier, price is continuously changing during the trading period.

18. Explain the role of the authorized participant in an ETF.

The role of the authorized participants is to engage in arbitrage transactions that maintain the
market price of the ETF as compared to an index portfolio.

19. Why is tracking error important for an ETF?

Since ETFs are based on passive indexes where value is represented by the NAV, investors in
ETFs expect their return to be equal to that of the portfolio’s NAV. Large tracking error s are bad
for ETFs because it undermines the investor’s expectation.

20. Comment on the following statement: “Exchange traded funds are typically actively
managed funds.”

Since they are mostly index funds, they are passively managed.

21. Briefly describe the following in the context of mutual funds:

a. supermarket
b. wrap program
c. segregated managed accounts
d. family of funds

a. Supermarkets: The introduction of the first mutual fund supermarket in 1992 by Charles
Schwab & Co. introduced its One Source service. These supermarkets allow investors to
purchase funds from participating companies without investors having to contact each fund
company.

b. Wrap program: Wrap accounts are managed accounts, typically mutual funds “wrapped” in a
service package. The service provided is often asset allocation counsel; that is advice on the
mix of managed funds.

c. Segregated managed accounts: are in response to individuals who object to mutual funds
because of their lack of control over taxes and other investment decisions. Many investors
with medium-size portfolio are utilizing segregated accounts.

d. Family of funds: In the U.S. system, a family of funds consists of an investment company
that offers several different funds. In Japan the family fund allows investors to buy new
certificates in a grouping of existing unit trusts.

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