2. Copyright © 2003 South-Western/Thomson Learning All rights reserved. Chapter 8 Investment Companies

3. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Investment Companies Two Types Closed-end Open-end (commonly called a mutual fund)

4. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Important General Information Net asset value (NAV) - the value of a share Taxation - pass through vehicles Professional management Portfolio diversification Growth in mutual funds

5. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Closed-end Investment Companies Have a fixed capital structure Shares are bought and sold in the secondary markets Shares may sell for a premium or discount from NAV Tendency for shares to sell at a discount from NAV

6. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Sources of Return to the Investor Income distributed in the form of dividends Capital gains distributions Appreciation in the NAV Change in the discount/premium

7. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Open-end Investment Companies - Mutual Funds Have a variable capital structure Shares are bought and sold from the mutual fund Shares cannot sell for a discount from NAV

8. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. The Load Fee Charged to investor when the shares are purchased Compensates the sales person (i.e., is analogous to brokerage commissions for buying securities)

9. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. The Load Fee Varies with dollar amount purchased Load expenses mean investors pay a premium over the fund's NAV

10. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. No-load Mutual Fund Mutual fund without a sales charge

11. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Other Fees and Expenses Early withdrawal fees (or exit fees) Management fees Operating expenses 12b-1 fees

12. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Mutual Fund Portfolios May be classified by –type of investment –investment style

13. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Types of Investments Growth funds Balanced funds Income funds Growth and income funds Specialized funds

14. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Specialized Funds Sector funds Bond funds Index funds Tax-exempt bond funds Single country or regional funds Exchange - traded - funds

15. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Investment Styles Large cap Mid-size cap Small cap Growth Value

16. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Capitalization Total market value of a company’s stock

17. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Growth A strategy designed to identify companies that offer exceptional opportunity for capital appreciation

18. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Value A strategy designed to identify companies whose stock price appears to be below some estimate of the firm's intrinsic value Stocks that are undervalued

19. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Advantages Offered by Funds Diversification Professional management Custodial and other services

20. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Returns Advantages do not necessarily include superior returns Tendency to underperform the market Returns in an efficient market context

21. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Factors that Affect Returns Expenses Fees –load fees and exit fees –12b-1 fees Movements in the market

22. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Before and After - Tax Returns Fund returns are before tax Shareholders pay applicable taxes Shareholders realize after-tax returns

23. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Performance Evaluation CAPM as a theoretical basis for comparison Market benchmark used in the CAPM is often the S&P 500 stock index

24. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Performance Evaluation

25. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Performance Evaluation Figure indicates the return that should be earned for each level of risk

26. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Composite Performance Measures: The Jensen Index a = r p - [r f + (r m - r f ) beta] The alpha measures whether the actual return exceeds the return that should have been earned based on the CAPM

27. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. The Composite Performance Measures: The Treynor Index r p - r f beta Standardizes the return in excess of the risk-free return by the portfolio's beta

28. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. The Composite Performance Measures: The Treynor Index Uses the portfolio's volatility as the measure of risk Assumes that the portfolio is well diversified, so the beta (which measures systematic risk only) is the appropriate measure of risk

29. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. The Composite Performance Measures: The Sharpe Index r p - r f standard deviation Standardizes the return in excess of the risk-free return by the portfolio's standard deviation Uses the portfolio's variability as the measure of risk

30. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. The Composite Performance Measures: The Sharpe Index Does not assume that the portfolio is well diversified Standard deviation (which measures total risk) is the appropriate measure of risk

31. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Comparing Realized Returns to Market Returns

32. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Comparing Realized Returns to Market Returns If the realized return lies above the security market line, performance exceeded the market return on a risk- adjusted basis If the realized return lies below the security market line, performance was inferior to the market return on a risk- adjusted basis

33. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Comparing Realized Returns to Market Returns Absolute returns do not necessarily indicate inferior or superior returns (Compare points X and Y)

34. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. The Benchmark Problem The comparisons use an aggregate measure of the market The composition of many portfolios are not comparable to the market Examples would be specialized funds or global funds