1. CHAPTER TWENTY-ONE INVESTMENT COMPANIES

2. n 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

3. n INVESTMENT COMPANIES Advantages to the Individual Investor 3 economies of scale – higher volume purchases, lower commission rate – provides diversification 3 professional management – manager is a professional seeking mispriced securities full time

4. NET ASSET VALUE n KEY CONCEPT FOR INVESTMENT COMPANIES Net Asset Value (NAV) NAV t = (MVA t - LIAB t )/NSO t whereNAV t is the firm’s net asset value MVA t is the market value of firm’s assets LIAB t is the dollar value of firm’s liabilities NSO t is the number of shares outstanding

5. MAJOR TYPES OF INVESTMENT COMPANIES n UNIT INVESTMENT TRUST DEFINITION: an investment company that owns a fixed set of securities for the life of the company FORMATION 3 sponsor purchases a specific set of securities 3 the securities are deposited with trustee 3 firm sells redeemable trust certificates to the public 3 all income received by trustee paid out to certificate holders

6. MAJOR TYPES OF INVESTMENT COMPANIES n UNIT INVESTMENT TRUST LIFE SPANS 3 from 6 months to 20 years SECONDARY MARKET 3 investor may sell the shares back to the trust 3 a secondary market may be maintained by the sponsor of the trust

7. MAJOR TYPES OF INVESTMENT COMPANIES n MANAGED COMPANIES WHAT ARE THEY? 3 organized as corporations with a board of directors 3 management company is hired 3 annual management fees vary from.5 to 1% of the average market value of the company’s total assets

8. MAJOR TYPES OF INVESTMENT COMPANIES n CLOSED-END INVESTMENT COMPANY FEATURES 3 shares are traded on an exchange 3 unlimited life 3 dividends received paid out to shareholders 3 can issue shares to raise additional funds quotations 3 market prices published daily 3 NAV published weekly

9. MAJOR TYPES OF INVESTMENT COMPANIES n OPEN-ENDED INVESTMENT COMPANIES most known as mutual funds continuously offer new shares to the public capitalization is open

10. MUTUAL FUNDS n MUTUAL FUND TAXATION re. the investment company: 3 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

11. MUTUAL FUNDS n MUTUAL FUND PERFORMANCE CALCULATING RETURNS: 3 Formula: r t = {(NAV t - NAV t-1 ) +I t + G t }/ NAV t-1 where r t = return at time t I t = income G t = capital gain distribution at time t

12. MUTUAL FUNDS n AVERAGE RETURN Benchmark portfolio used tom compare the performance of the investment company Composition of the benchmark portfolio 3 a market index is chosen (e.g. S&P500) 3 a risk-free asset chosen (e.g. T-bills) 3 an index to account for the difference in performance is chosen – allows for high to low book-to-market price stocks

13. MUTUAL FUNDS n AVERAGE RETURN Style Analysis 3 used to derive appropriate benchmark Ex Post Alpha Derived 3 formula:  p  ar p - ar bp where ar p = the average return on portfolio p ar bp = average return on the benchmark

14. MUTUAL FUNDS  p  ar p - ar bp If  p > 0, the portfolio has performed well

15. EVALUATING MUTUAL FUNDS n PROFESSIONAL SERVICES MORNINGSTAR 3 is the most often used service CAVEATS RE. MORNINGSTAR: 3 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

16. EVALUATING MUTUAL FUNDS n PROFESSIONAL SERVICES MORNINGSTAR 3 is the most often used service CAVEATS RE. MORNINGSTAR: 3 their approach to the quest for abnormal returns is not clearly revealed 3 use of peer group comparisons has several serious shortcomings – some funds may be restricted by their stated objectives as to what they can purchase

17. EVALUATING MUTUAL FUNDS n PROFESSIONAL SERVICES MORNINGSTAR 3 is the most often used service CAVEATS RE. MORNINGSTAR: 3 survivorship bias – the tendency for poorly performing funds to go out of business and leave the peer group

18. END OF CHAPTER 21