1. CHAPTER
TWENTY-THREE
INVESTMENT COMPANIES
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2. 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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3. 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
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4. NET ASSET VALUE
• KEY CONCEPT FOR INVESTMENT
COMPANIES
– Net Asset Value (NAV)
NAVt = (MVAt - LIABt )/NSOt
where NAVt is the firm’s net asset value
MVAt is the market value of firm’s assets
LIABt is the dollar value of firm’s liabilities
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5. 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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6. 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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7. 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 company’s total assets
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8. 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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9. 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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10. 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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11. 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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12. 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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13. MUTUAL FUNDS
• AVERAGE RETURN
– Style Analysis
• used to derive appropriate benchmark
– Ex Post Alpha Derived
• formula:
αp = arp - arbp
where ar p = the average return on portfolio p
arbp = average return on the benchmark
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14. MUTUAL FUNDS
αp = arp - arbp
If αp > 0, the portfolio has performed well
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15. 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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16. 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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17. 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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