CHAPTER TWENTY-THREE 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
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 )/NSOt

where NAVt is the firms net asset value MVAt is the market value of firms assets LIABt is the dollar value of firms liabilities
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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 FORMATION
sponsor purchases a specific set of securities the securities are deposited with trustee firm sells redeemable trust certificates to the public all income received by trustee paid out to certificate holders

MAJOR TYPES OF INVESTMENT COMPANIES

UNIT INVESTMENT TRUST
LIFE SPANS
from 6 months to 20 years

SECONDARY MARKET
investor may sell the shares back to the trust a 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 directors management company is hired annual management fees vary from .5 to 1% of the average market value of the companys total assets

MAJOR TYPES OF INVESTMENT COMPANIES

CLOSED-END INVESTMENT COMPANY
FEATURES
shares are traded on an exchange unlimited life dividends received paid out to shareholders can issue shares to raise additional funds

quotations
market prices published daily NAV 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

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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
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MUTUAL FUNDS
AVERAGE RETURN
Benchmark portfolio used tom compare the performance of the investment company Composition of the benchmark portfolio
a 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
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MUTUAL FUNDS
AVERAGE RETURN
Style Analysis
used to derive appropriate benchmark

Ex Post Alpha Derived

formula:

p = arp - arbp
where ar p = the average return on portfolio p ar = average return on the
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MUTUAL FUNDS

p = arp - arbp
If p > 0, the portfolio has performed well

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EVALUATING MUTUAL FUNDS

PROFESSIONAL SERVICES
MORNINGSTAR
is 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
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EVALUATING MUTUAL FUNDS

PROFESSIONAL SERVICES
MORNINGSTAR
is the most often used service

CAVEATS RE. MORNINGSTAR:

their approach to the quest for abnormal returns is not clearly revealed use of peer group comparisons has several serious shortcomings
some funds may be restricted by their stated objectives as to what they can purchase
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EVALUATING MUTUAL FUNDS

PROFESSIONAL SERVICES
MORNINGSTAR
is 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

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