Chapter

Mutual Funds and Other

4 Investment Companies

Bodie, Kane, and Marcus

Essentials of Investments
12th Edition

© 2022 McGraw Hill. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitted without the prior written consent of McGraw Hill.
 4.1 Investment Companies 1

Investment companies.
• Financial intermediaries that invest the funds of individual
investors in securities or other assets.

Net asset value (NAV).

• Assets minus liabilities per share.

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 4.1 Investment Companies 2

Functions:
• Record keeping and administration.
• Diversification and divisibility.
• Professional management.
• Lower transaction costs.

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 4.2 Types of Investment Companies
Unit Investment Trusts.
• Money pooled from many investors is invested in portfolio
fixed for life of fund.

Managed Investment Companies:

• A professional investment firm that manages a portfolio for
an annual fee.
• Load: Sales commission.
• Open-end or Closed-end fund.

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 4.2 Types of Investment Companies: Open versus
Closed 1

Open-end fund.
• A fund that issues or redeems its shares at net asset
value.

Closed-end fund.
• Share may not be redeemed.
• Are traded at prices that can differ from net asset value.

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 4.2 Types of Investment Companies: Open versus
Closed 2

Commingled Funds:
• Partnership of investors pooling fund.
• For trusts/larger retirement accounts.
• Professional management for a fee.

Real Estate Investment Trusts (REITS).

• Similar to closed-end funds.
• Invests in real estate/real estate loans.

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 4.2 Types of Investment Companies: Open versus
Closed 3

Hedge Funds:
• Private investment pools.
• Exempt from SEC regulation.
• Can be speculative in nature.

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 4.3 Mutual Funds: Investment Policies

Investment Policy Characteristics

Money Market Mutual Fund (MMMF) Commercial Paper, Repurchase Agreements, C Ds
Equity Funds Stocks, Some fixed-income or other securities
Equity Sector Funds Stocks concentrated in a particular industry
Bond Funds Specialize in fixed-income (bond) sector
Global Funds World wide securities, including the U.S.A.
International Funds World wide securities, excluding the U.S.A.
International Regional Funds Foreign securities concentrated in certain regions
Emerging Markets Funds Securities from developing nations

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 4.3 Mutual Funds: Investment Policies Continued

Investment Policy Characteristics

Balanced Fund: Hold both equities and fixed-income securities
Hold both equities and fixed-income securities
Life Cycle Fund: Static Allocation
stable proportions
Targeted maturity funds become more
Life Cycle Fund: Targeted-Maturity
conservative as investor ages
Hold both equities and fixed-income securities—
Asset Allocation/Flexible Funds proportion varies according to market forecast
(market timing)
Try to match performance of broad market index;
Index Funds Buy shares in proportion to security’s
representation in index
Mutual funds that primarily invest in other mutual
Fund of Funds
funds

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 Table 4.1 U.S. Mutual Funds by Investment
Classification 1

Assets ($ billion) Percent of Total Assets Number of Funds

Equity Funds
Capital appreciation focus $ 1,942 11.0% 1,319
World/international 2,426 13.7% 1,527
Total return 4,857 27.4% 1,907
Total equity funds $ 9,225 52.1% 4,753
Bond Funds
Investment grade $ 1,845 10.4% 604
High yield 331 1.9% 247
World 494 2.8% 362
Government 299 1.7% 193
Multisector 418 2.4% 211
Single-state municipal 158 0.9% 293
National municipal 518 2.9% 264
Total bond funds 4,062 22.9% 2,174

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 Table 4.1 U.S. Mutual Funds by Investment
Classification 2

Assets ($ billion) Percent of Total Assets Number of Funds

Hybrid (bond/stock) funds $ 1,383 7.8% 783
Money market funds
Taxable $ 2,892 16.3% 287
Tax-exempt 145 0.8% 81
Total money market funds 3,037 17.2% 368
Total $17,707 100.0% 8,078

Note: Column sums subject to rounding error.

Source: 2019 Investment Company Fact Book, Investment Company Institute.

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 4.4 Costs of Investing in Mutual Funds: Fee
Structure

Fee Structure Definition

Operating Expenses Costs incurred by mutual fund in operating portfolio
Front-end Load Commission or sales charge paid when purchasing shares
Back-end load “Exit” fee incurred when shares
Annual fees charged by mutual fund to pay for
12b-1 charges
marketing/distribution costs

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 4.4 Costs of Investing in Mutual Funds 1

Fees, Loads, and Performance.

• Gross performance of load funds is statistically identical to
gross performance of no-load funds.
• Funds with high expenses tend to be poorer performers.
• 12b-1 charges should be added to expense ratios.
• Compare costs with Morningstar.

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 Example 4.1: Fees
Here are fees for different classes of the Dreyfus High Yield Fund in
2019. Notice the trade-off between front-end loads and 12b-1 charges in
Class A versus Class C.

Class A Class B Class C

Front-end load 4.50% 0 0
Back-end load 0 1% 0
12b-1 fees 0.25% 1.0% 0
Expense ratio 0.7 0.7% 0.7

Notes:
a
Depending on size of investment. Starts at 4.5% for investments less than $50,000 and
tapers to zero for investments exceeding $1 million.
b
Depending on years until holdings are sold. Exit fee is 1% for shares redeemed within one
year of purchase.
c
Including annual service fee.

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 4.4 Costs of Investing in Mutual Funds HERE
NAV and Effective Load:
• Cost to initially purchase one share of load fund = NAV +
Front-end load (%) (if any).
• Stated loads typically range from 0 to 8.5%.
• Load is designed to offset marketing expenses.
• Goes to broker who sells fund to investor.
• Effective load greater than stated load.

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 4.4 Costs of Investing in Mutual Funds 2

Fees and Mutual Fund Returns.

• Soft dollars: Value of research services brokerage house
provides “free of charge” in exchange for business.
• Rate of Return:

NAV1  NAV 0  Income  Capital gains distributi on

Rate of return 
NAV 0

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 Table 4.2 Costs on Investment Performance: Example

Cumulative Proceeds
(all dividends reinvested)
Fund A Fund B Fund C
Initial investment* $10,000 $10,000 $ 9,400
5 years 15,923 15,211 14,596
10 years 25,354 23,136 22,665
15 years 40,371 35,192 35,194
20 years 64,282 53,529 54,649

Notes: Fund A is no load with 0.25% expense ratio, Fund B is no load with 1.25% total
expense ratio, and Fund C has a 6% load on purchases and a 0.8% expense ratio. Gross
return on all funds is 10% per year before expenses.
*After front-end load, if any.

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 4.5 Taxation of Mutual Fund Income 1

General Tax Rules:

• Fund not taxed if diversified and income distributed.
• Investor taxed on capital gain and dividend distributions.
• Turnover: Ratio of trading activity to assets of portfolio
(Turnover affects investor’s tax liability).

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 4.5 Taxation of Mutual Fund Income 2

Implications of Fund Turnover.

• Fund pays commission costs on portfolio purchases and
sales—charged against NAV.
• Turnover rate measured as annual total asset value
bought or sold in a year divided by average total asset
value.

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 4.6 Exchange-Traded Funds
Exchange-traded funds (ETFs).
• Offshoots of mutual funds that allow investors to trade
entire portfolios.
• Much like shares of stock.

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 Figure 4.2 Assets in ETFs

Access the text alternative for slide images.

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 Figure 4.3 Investment Company Assets under
Management

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 4.7 Mutual Fund Investment Performance: Figure 4.4
• Average MF performance < broad market performance.

Access the text alternative for slide images.

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 Table 4.3 Consistency of Investment Results
• Evidence suggests some persistence in positive
performance over certain horizons.
Percentage of Percentage Percentage
Percentage of
Number of 2-year of 3-year of 4-year
outperformers
top-half outperformers outperformer outperform
that perform in
performers that s that ers that
top half of
in 2014 outperform in outperform outperform
sample in 2015
2016 in 2017 in 2018
All domestic equity
1,120 43.8 46.5 55.3 84.1 0.1125
funds
Large-cap equity funds 440 46.8 40.3 57.8 83.3 0.1091
Small-cap equity funds 256 43.8 44.6 58.0 44.8 0.1133

Note: Performance values are for periods ending in September of each year.
Source: Berlinda Liu and Aye Soe, “Does Past Performance Matter? The Persistence
Scorecard,” S&P Dow Jones Indices, December 2018.

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 4.8 Information on Mutual Funds
Sources of Information on Mutual Funds:
• Morningstar (www.morningstar.com).
• Fund prospectus.
• Yahoo!
• The Wall Street Journal.
• Investment Company Institute (www.ici.org).
• American Institute of Individual Investors.
• Brokers.

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 End of Content

© 2022 McGraw Hill. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitted without the prior written consent of McGraw Hill. 26