Chapter 15

Learning Objectives (part 1 of 3) Distinguish between the different types of investment companies. Explain the different types of fees and charges associated with investment companies. Compute the Net Asset Value of a share. Explain the source of dividend and capital gain distributions.

Learning Objectives (part 2 of 3) Analyze how various fees affect one’s rate of return Decide which of two funds to purchase. Compute the capital gain or loss on the sale of any mutual fund shares. Discuss various criteria for selecting a mutual fund

Learning Objectives (part 3 of 3) Describe an index fund and explain its advantages. Analyze a prospectus. Distinguish between closed-end funds, unit investment trusts, and DPICs.

Advantages of investing in an investment company Instant diversification (unless a sector fund) Professional management Multitude of objectives and strategies to choose from Convenient for “small” portfolios Convenient for incremental investments

Types of Investment Companies Investment Club Open-end (Mutual Funds) Closed-end REITs DPICs Unit investment trusts

Description of mutual funds Open-end investment company Shares can only be bought from the company as newly issued shares Shares can only be sold back to the company as redemptions Purchases and redemptions based on NAV, which is computed at the end of trading each day & all trades done after close

Net Asset Value Measures each investor’s claim on the investment company’s portfolio if the portfolio were liquidated at current prices and all liabilities paid off NAV = (Market Value of Portfolio – Liabilities) # of invest. comp. shares outstanding

Cash distributions (1 of 2) For tax exempt status, investment companies must pass through most of their income to their shareholders Dividend distributions A distribution of dividends and/or interest received by securities held in the portfolio May be as rarely as annually, or as frequently as monthly Taxed as dividend income to the investor

Cash distributions (2 of 2) Capital Gain distribution At least once per year (usually in January) Sum up all the gains and losses from trades during the prior year (including any capital loss carry-forward If a net gain, distributed (and taxed as capital gains for the recipients) If a net loss, carried forward (no direct tax benefit to the investor)

Fees & Charges Load fee Front-end Back-end Management fee 12b-1 charges Commissions (implicit in trading)

Impact of fees & Charges The average investment company always under performs the market due to the fees Management fee & 12b-1 fees a direct reduction to one’s return Impact of load fees depends on how long a fund is held

Deciding between two funds Should only compare funds with the same objectives Tradeoffs might include: Load vs. lower management fees Load vs. 12b-1 charges More growth prospects vs. higher income

Cost basis for mutual funds (1 of 2) If no reinvestment has occurred, then cost basis is what was paid for shares If any reinvestment made, or new shares purchased, then knowledge of cost basis requires good record keeping

Cost basis for mutual funds (2 of 2) If sell only part of holdings, then must decide methodology to assign cost basis for shares sold Average cost (add up total paid for shares and divide by number of shares held) LIFO (Last in, first out): minimizes taxes if prices rising FIFO (First in, first out)

Criteria for selecting a mutual fund (1 of 2) Select a fund whose investment objective matches your objective for this particular investment. Seek to minimize fees & charges No loads preferred over loads Avoid funds with 12b-1 fees Seek low management fees Seek low portfolio turnover ratios

Criteria for selecting a mutual fund (2 of 2) Ignore funds which consistently underperform their peer group Do not be attracted to funds which tout top performance Funds always select the one time period which makes them look best Research shows past performance is of little value in predicting future performance

Index Funds (1 of 2) Linked to an index Could be a market index such as S&P 500 Could be a sector index Although will never be a top performer within a category, will rarely be below average Lower volatility than typical fund

Index Funds (2 of 2) Have most attractive attributes Usually no-loads Usually no 12b-1 fees Low management fees Low trading activity (so minimal commissions paid and few capital gain distributions)

Prospectus Must be given to all new investors (as purchases represent the issuance of new shares) Look for: Fund objectives Management fee Description of other fees (loads & 12b-1 charges)

Closed-end funds Fund usually created by company selling its shares in a single offering. After that, no new shares created and no redemptions allowed Market price rarely equals NAV Usually trades at a discount Some believe closed-end funds trading at substantial discounts are a great bargain

Unit Investment Trusts (1 of 2) Can be a stock or bond fund Shares sold in a single offering (like closed end funds) Portfolio is pre-defined when shares are sold Little trading in shares (always plan to hold shares until trust extinguished)

Unit Investment Trusts (2 of 2) Bond fund Bonds usually newly issued & usually municipals Trust extinguished when bonds mature Stock fund Portfolio has an objective (e.g., dogs of the Dow) Trust has maturity date when portfolio liquidated and investors paid off

Dual Purpose Investment Companies Issues two classes of shares Income share (analogous to preferred stock): has a promised yield Capital Appreciation Share (analogous to common stock) Income shares have a maturity date, at which time company dissolves or evolves to closed end fund