004 15 Investment Companies

1

Boğaziçi UniversityInvestment Analysis and Portfolio Management

Investment Companies

Attila Odabaşı

• Outline:• Advantages and disadvantages of investing with an

investment company• Open-end mutual funds , Closed-end funds and unit

investment trusts• Net Asset Value, • Mutual fund types• Impact of expenses and turnover on mutual fund

investment• Other funds

2

Services of Investment Companies

Important functions of investment companies for their investments:a. Professional managementb. Diversificationc. Lower transaction costsd. Administration & record keepinge. Liquidityf. Investing for retirement (IRA in USA,

similar structures in Turkey)

3

What are They?

• A company that brings together a group of people and invests their money in stocks, bonds and other securities.

• Each investor owns shares, which represent a portion of the holdings of the fun.

4

Organizational Forms

Mutual Funds: Managed Investment Companies: Mostly, active portfolio management.

The fund's board of directors typically hires an investment advisor to select and manage the fund assets according to some specific goal(s) set by the board and any regulatory requirements.

The investment advisor usually creates the fund and selects the investments. Most funds are of this type.

5

Organizational FormsOpen end

– shares are bought from and redeemed by the mutual fund company

– There is no limit to the number of available shares, the fund can continue to create new shares as needed

– A portfolio may be affected if a significant number of shares is redeemed quickly; need to make trades to meet the cash demand

– Priced once per day at the close of business– Price is equal to Net Asset Value (NAV)

6


Closed end– Launched through an IPO– Fixed number of shares are issued; money

raised is invested according to the fund’s mandate

– Closed-end fund configured into a stock and traded in the secondary market

– Closed-end funds are actively managed– Fund share price may trade at a premium

or discount to NAV

7

Net Asset Value

• Used as a basis for valuation of investment company shares– Selling new shares– Redeeming existing shares

Calculation:

goutstandin shares Fund

sLiabilitie Fund AssetsFund of ValueMarketNAV

8

NAV calculation

ABC Fund ($Millions except NAV)

Market Value Securities+ Cash & Receivables- Current Liabilities NAV Total # Fund Shares

NAV

$550.00

75.00(20.00)$605.0

0 20.00

$ 30.25

Most Mutual Funds have little or no Long Term Debt

99

Mutual Fund Types• Money market funds• Bond/Income funds• Balanced funds

Objective: to provide a balanced mixture of safety, income and capital appreciation

• Asset allocation funds• Equity funds

Maximum capital gain Growth Growth & income Income Income & security

• Index funds• Specialized sector funds

10

Cost of Investing in Mutual Funds

• Biggets problem with mutual funds. These costs eat into your return.

• Fee Structure:– Ongoing yearly fees to keep you ivested in the

fund– Transaction fees paid when you buy or sell

shares in a fund (loads)

11


• Operating Expenses: – Management fee (0,5% - 1% of assets

on average)– Administrative Expenses – 12-b1 Fee (USA), for advertising and promoting

the fund• On the whole, expense ratios range from

0.2% (index funds) to as high as 2%.• Are high fees worth it?

12


• Loads are just fees that a fund uses to compensate brokers or other salespeople.

• Don’t buy funds with loads!– Front-end loads:

• A commission or sales charge paid when you buy into a fund. Generally given to the broker who sells the fund. Rip-off

– Redemption fee, back hand load (also known as deferred sales charges)• Paid if you sell a fund within a certain time

frame.

13

NAV and the Effective Load

Cost to initially purchase one share of a load fund = NAV + front-end load (%) (if any).

Assume that stated front load is 5%, If you invest $10,000 in a fund with an 5% front-

end load, you actually acquire shares worth $9,500; the other $500 goes to the broker.

The effective load is greater than the stated load: In the above example, the actual % commission cost (effective load) is:– $500 / $9500 = 5.26%;

14

Costs of Investing in Mutual Funds

Expense ratios:Funds charge annual operating expenses

and annual advisory or management fees against the NAV.– Expense ratio:

Annual Expenses / Average NAV

– A "well managed" fund probably should have an expense ratio of less than 2%.

All costs and charges must be revealed in the fund's prospectus.

15

HPR on mutual funds

where Dist = Distribution

• Rate of return measured as the increase or decrease in NAV plus income distributions,

• From this gross return the expenses should be deducted to get to net return.

• Mutual funds pass through investment income to investors as they become due.

Buy

DistDistBuySell

NAV

DivCGNAVNAVHPR

16

4-16

Fees and Mutual Fund Returns:An Example

Initial NAV = $20Income distributions of $.15Capital gain distributions of

$.05Ending NAV = $20.10:

$20.10 - $20.00 + $.15 + $.05Rate of Return = 1.5%

$20.00

1 0

0

NAV NAV Income and capital gain distributionsRate of return =

NAV

17

Amount initially invested = $10,000 – (0.06 x $10,000) = $9,400

Amount after gross return = $9,400 x 1.175 = $11,045

Amount after fees = $11,045 - (0.0135 x $11,045) = $10,895.89*

Net rate of return = ($10,895.89 - $10,000) / $10,000 = 8.96%

Converting gross pretax returns to net pretax returns:ThisThis year you invested $10,000 in a mutual fund with a year you invested $10,000 in a mutual fund with a 6% load (one time fee) and estimated annual expenses of 6% load (one time fee) and estimated annual expenses of 1.35%. The gross return is 17.5%. What is your return 1.35%. The gross return is 17.5%. What is your return net of loads and expenses?net of loads and expenses?

18

Ex: Impacts of Costs on Investment Performance

Conclusions? Optimal choice fee structure is

• Time and investment-size dependent

19

Implications of Fund Turnover

• The turnover rate is measured as the total asset value bought or sold in a year divided by the average total asset value.

• Lately, average turnover ratio is around 60%

• High turnover means that capital gains or losses are realized constantly, hence the investor can not time the realizations to manage his tax obligations.

20

Exchange Traded Funds

• ETF trade like a stock and look like a mutual fund.

• Examples: SPDRs, iSHares, VIPERs, QQQQ

• They originally tracked an underlying market

index

• Now there various ETFs

• Management Style: Passively managed portfolios

• Low fees

• Tutorials:• http://

www.investopedia.com/university/all/exchangetradedfunds/

http://www.investopedia.com/university/all/exchangetradedfunds/



21

Exchange Traded Funds

• Potential advantages: • Trade continuously throughout the day• Can be sold short or purchased on margin• Potentially lower taxes

• No fund redemptions• Large investors can exchange their ETF

shares for shares in the underlying portfolio• Lower costs (No marketing; lower fund

expenses)

• Potential disadvantages:– Small deviations from NAV are possible– Must pay a brokerage commission to buy an

ETF

22

ETF Sponsors and Products

23


Unit Investment Trusts (UITs): unmanaged, fixed composition portfolios

Any interest and/or dividends are distributed immediately to trust certificate holders.

Provide diversification within one sector or area and low cost entry.

Often levered, rates of return can be extreme.

24

Other Investment Organizations

–REITs

• Similar to closed end fund. Invest in real estate and real estate loans.–Equity trusts purchase real estate.–Mortgage trusts invest in mortgage

and construction loans.

25

Other Investment Organizations Cont.

– Hedge Funds• Similar to mutual funds, but not registered

and not subject to SEC regulations.• Available to institutional and high net worth

investors• Can pursue investment strategies that are

not allowed for mutual funds. • Grew from about $50 billion in 1990 to about

$2 trillion in 2008.

Documents

004 15 Investment Companies