CHAPTER TWENTYONE

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CHAPTER TWENTY-ONE

• INVESTMENT COMPANIES

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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

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• 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

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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
• NSOt is the number of shares outstanding

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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

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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

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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

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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

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MAJOR TYPES OF INVESTMENT COMPANIES

• OPEN-ENDED INVESTMENT COMPANIES
• most known as mutual funds
• continuously offer new shares to the public
• capitalization is open

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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. SP500)
• 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
• ap arp - arbp
• where ar p the average return on portfolio p
• arbp average return on the benchmark

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MUTUAL FUNDS

• ap arp - arbp
• If ap gt 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 SP500 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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• END OF CHAPTER 21