Lecture 4 MUTUAL FUNDS`

Indirect investing Investing indirectly refers to the buying and selling of the shares of investment companies Instead of buying and selling shares themselves, inventors can give their money to investment companies that manage the money for them by investing in shares and bonds An investment company is a financial service organization that sells shares in itself to the public and uses the funds to invest in a portfolio of securities

Types of investment companies Types of investment companies: 1. Managed companies A. Closed end investment companies B. Open end investment companies 2. Unmanaged companies A. Index portfolio

Closed end investment companies Closed end investment company does not sell additional shares of its own stock after initial public offering The shares of a closed-end fund trade in the secondary markets Shares prices are determined by demand and supply forces in the secondary market

Advantages of Close End Buying at a discount Shares of closed end funds sometimes sell at a discount to their underlying NAV, which may give investors who buy shares at a discount the opportunity to enhance their overall investment return. The discount may not narrow over time, however, and short-term trading entails greater risks. Leverage potential Closed-end funds can use leverage (borrowing funds for additional investments) to amplify investment performance by producing outsized gains or enhancing earnings. Funds can use leverage in two ways: borrow capital or issue preferred shares. If borrowing costs are lower than the net long-term interest rates earned by the portfolio and the markets are rising, then fund shareholders will see greater returns than they would had the fund not used leverage Stable pool of capital With a fixed number of shares, closed end funds don't have to keep cash on hand or sell securities in a declining market to meet shareholder redemptions. Managers can remain fully invested and invest in securities with longer time horizons, which may result in higher yields and returns for investors.

Disadvantages Fees and Expenses Active management, means more fees and expenses taken out of the fund. Because the fees are higher, Shareholders must pay higher fees and must also pay brokerage commissions when they buy and sell closed-end shares. This puts closed-ends at a disadvantage to open-end "no load" mutual funds, which don't charge upfront sales commissions. Leverage Closed-end funds often borrow money to increase their assets and boost returns. Leverage can be both an advantage and a disadvantage because it magnifies both gains and losses

Continue… Discount vs. Premium A closed-end fund’s shares have two sets of values: current price and net asset value, or NAV. Current price is what the shares are currently trading for on an exchange; NAV is what the fund’s assets are worth at current market prices. The NAV per share is calculated daily by dividing a fund’s total assets by the number of shares outstanding; the current price is set by the market. As a result, the current price can be more or less than the NAV. If CP < NAV = the shares are said to be trading at a discount. If CP > NAV = the shares are said to be trading at a premium. Buying closed-end fund shares at a 10 percent discount is essentially paying 90 cents for a dollar’s worth of stocks or bonds and is obviously to your advantage. Buying closed-end fund shares at a premium does not make much sense because you are overpaying for the market value of stocks or bonds.

Open end investment company Also known as mutual funds, Market capitalization of these companies change constantly as new investors buy additional shares and some existing shareholders sell back their shares to the company Mutual funds shares can be purchased either directly from the company through mail or telephone Or from a sales agent

Net Asset Value Investors purchase new shares and redeem existing shares at the net asset value (NAV) NAV is computed daily by calculating the total market value of the investments, subtracting liabilities and dividing it by the number of shares outstanding

Advantages of mutual funds Record keeping Company keeps track of capital gains, dividends, investments Diversification and divisibility By pooling their money, investment companies enable investors to hold fractional shares of many different securities Professional management Lower transaction costs