1. CHAPTER 19 Investment Companies Copyright© 2012 John Wiley & Sons, Inc.

2. 2 History of Investment Companies Investment companies were first started in Belgium in 1822. Early U.S. investment companies Began at end of 1800s Closed-end companies First mutual fund in 1924 Declines in Great Depression Regulations enhanced confidence Growth very rapid in 1945 to 1965 period as the stock market performed well Inflation, high interest rates, and poor market performance hurt growth in 1970s Copyright© 2012 John Wiley & Sons, Inc.

3. 3 History of Investment Companies (continued) New types of funds after 1970s Municipal bonds funds - tax-free income Government security funds - safety Money market funds - safety and liquidity Exchange-Traded Funds (ETFs) – represent indices Copyright© 2012 John Wiley & Sons, Inc.

4. 4 Importance of Investment Companies Investments in mutual funds exploded in the 1990s because Many new funds were developed. Individual Retirement Accounts (IRAs) were developed. The shift of many pension plans from defined benefit to defined contribution plans (401k). Increased investment by baby boomers. The high rates of return on common stocks. Copyright© 2012 John Wiley & Sons, Inc.

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6. 6 Investment Funds Purchase direct, long-term, capital market securities and issue indirect, liquid, small denomination shares. Investment funds provide to the financial investor: Risk intermediation by investing in a diversified portfolio of assets. Denomination intermediation by requiring small minimum investments. Liquidity for IF shares. Economies of scale in investment management and transaction costs. Copyright© 2012 John Wiley & Sons, Inc.

7. 7 Regulation of Mutual Funds - SEC and States Regulation relates to adequate required disclosure, adequate diversification, sales practices, and management practices. Federal laws Securities Act of 1933 SEC Act of 1934 Investment Company Act of 1940 National Securities Markets Improvement Act of 1996 Mutual funds are not taxed on income and capital gains - owners of shares are. Copyright© 2012 John Wiley & Sons, Inc.

8. 8 Net Asset Value (NAV) Value of shares is called Net Asset Value (NAV) Copyright© 2012 John Wiley & Sons, Inc.

9. 9 Open-End Mutual Funds Are most common; dominate asset holdings. Mutual funds stand ready to buy (redeem) or sell their shares at NAV. No limit to the number of shares issued. Copyright© 2012 John Wiley & Sons, Inc.

10. 10 Investment composition of mutual funds Composition varies with economy Cash Holdings - Short-term liquid assets Hold more cash items when interest rates rising and high Reduce short-term securities, buy long-term when rates are at peak and falling Delayed redemption and paid-in-kind redemption policies, along with bank lines of credit have reduced the proportion of cash held Composition varied over time Copyright© 2012 John Wiley & Sons, Inc.

11. Portfolio Holdings of Long-Term U.S. Mutual Funds 11 Copyright© 2012 John Wiley & Sons, Inc.

12. Types of Mutual Funds 12 Copyright© 2012 John Wiley & Sons, Inc.

13. Equity Funds Primarily invest in stocks. There are many types of equity funds: Growth and income funds Growth funds Aggressive growth funds Income-equity funds International and global equity funds Specialized funds Index funds 13 Copyright© 2012 John Wiley & Sons, Inc.

14. Bond Funds Types of bond funds: Corporate Bond Funds High-Yield Bond Funds Global and International Bond Funds Government Bond Funds Strategic Income Bond Funds Municipal Bond Funds 14 Copyright© 2012 John Wiley & Sons, Inc.

15. Hybrid Funds Hybrid funds invest in both stocks and bonds. Types of hybrid funds are - Asset Allocation Funds: Change their stock and bond weights over time as market conditions change. Balanced Funds: Invest in both stocks and bonds and in relatively constant proportions. 15 Copyright© 2012 John Wiley & Sons, Inc.

16. 16 Money Market Mutual Funds (MMMFs) Short-term money market investments. Provide excellent liquidity for investors. High quality and high yield when yield curve is inverse. Compete with bank deposits. Copyright© 2012 John Wiley & Sons, Inc.

17. 17 Growth of MMMFs & Regulation Q When market rates were above Regulation Q maximum for bank deposit rates, MMMFs grew rapidly (1970s and early 1980s). Banks were able to compete after the 1982 Depository Institutions Act when they were permitted to offer insured, Money Market Deposit Accounts (MMDAs). MMMFs offer higher yields than bank MMDAs. MMMFs are not insured by FDIC. Copyright© 2012 John Wiley & Sons, Inc.

18. 18 MMMFs’ role in the economy Around $2 trillion under management. Transactional convenience: Check writing privileges, debit cards, wire transfers Compete with bank deposits MMMFs that invest in tax-exempt securities pass through interest payments that are exempt from federal (and possibly state) income taxes. Interest earned on bank deposits is fully taxable. Copyright© 2012 John Wiley & Sons, Inc.

19. 19 MMMFs’ Holdings Copyright© 2012 John Wiley & Sons, Inc.

20. Relative Sizes of Mutual Funds 20 Copyright© 2012 John Wiley & Sons, Inc.

21. 21 Mutual Fund Fees Load funds - investor pays a sales commission when shares are purchased from brokers. No-load funds - no initial sales fees, but other charges (back-end load-contingent deferred sales charge, or redemption fees) may be levied. 12b-1 fees - an annual fee levied against fund assets by some funds. Management or advisory fees. Exchange fees and account maintenance fees. Copyright© 2012 John Wiley & Sons, Inc.

22. 22 Mutual Fund Families Mutual fund managing companies that market a variety of mutual funds to investors. Money may be moved from fund to fund at nominal charges. Investors can change risk profile, asset class, term, and other investment characteristics without much hassle. Copyright© 2012 John Wiley & Sons, Inc.

23. 23 Mutual Fund Families (concluded) Other services may include: Discount brokerage service - purchase/sale of individual direct securities, such as stocks and bonds. Liquidity services – checks and/or debit cards tied to mutual fund balances. Pension fund management - for businesses. Copyright© 2012 John Wiley & Sons, Inc.

24. 24 Closed-End Mutual Funds Have a fixed number of shares outstanding like any publicly traded corporation. Shares are traded and priced in the market. Closed-end fund shares may sell at a premium or (more often) at a discount to NAV. Sometimes as much as 10%-20% below NAV. Copyright© 2012 John Wiley & Sons, Inc.

25. 25 Closed-End Mutual Funds Size of discount varies by type of closed- end fund – equity versus bond funds, domestic versus global equity funds. Discounts could be due to a variety of reasons including poor management, tax considerations, and market demand. The majority of closed-end funds are either bond funds or global equity funds. Copyright© 2012 John Wiley & Sons, Inc.

26. 26 Closed-End Funds Copyright© 2012 John Wiley & Sons, Inc.

27. 27 Exchange-Traded Funds (ETFs) First introduced in U.S. in 1993. Tremendous growth since 2000. Shares traded on organized exchanges like closed- end funds. Have a unique creation and redemption feature that prevents large premiums or discounts from the NAV. Redemptions in form of stock portfolio. Most ETFs track a stock index – SPDR, etc. Tax advantage, low expense ratios, ease of buying/selling, and ease of tracking prices. Copyright© 2012 John Wiley & Sons, Inc.

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29. 29 Investment Trusts or Unit Investment Trusts Assets are not actively managed. Provide small denomination share claims against a diversified, fixed portfolio of securities. Trust sponsors usually will repurchase shares at net asset value, less a commission. Copyright© 2012 John Wiley & Sons, Inc.

30. 30 Hedge Funds Investment pools that use a combination of market philosophies and analytical techniques. Seek to develop financial models to identify, evaluate, and execute trading decisions. Typically are limited partnerships. The goal is providing consistent, above market returns while reducing the risk of loss. Copyright© 2012 John Wiley & Sons, Inc.

31. 31 Hedge Funds differ from Mutual Funds Hedge funds Used to be private, unregistered investment pools open to a limited number of accredited investors. As a result of Dodd-Frank act, hedge funds with more than $150 million in assets must register with the SEC. Pay managers based on their performance. Mutual funds Are heavily regulated investment pools registered with the SEC and open to all investors. Pay managers a fee that is percentage of the assets under management. Copyright© 2012 John Wiley & Sons, Inc.

32. 32 Hedge Fund Investment Strategies Traditional hedge fund strategies include: Global macro Market neutral Sector Short selling Arbitrage hedge fund strategies include: Fixed-Income Index Closed-End Fund Convertible Copyright© 2012 John Wiley & Sons, Inc.

33. 33 Hedge Fund Investment Strategies, cont. Event-driven hedge fund strategies include: Risk arbitrage Distressed securities Special situations Copyright© 2012 John Wiley & Sons, Inc.

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35. 35 Real Estate Investment Trusts (REITs) An investment fund selling shares and investing in real estate related assets. They: own income property; acquire mortgages; finance real estate development and construction; acquire and lease property. Copyright© 2012 John Wiley & Sons, Inc.

36. 36 Real Estate Investment Trusts (REITs) Regulated under federal Real Estate Investment Act of 1960 and state regulation. REITs are exempt from federal income tax if they accrue a minimum of 75% of income from real estate investments and pay 90% of their net income to shareholders. Grew rapidly in the inflationary boom period of the late 1960s and early 1970s, then the bubble burst. Financed short (commercial paper) and invested long in rising rate environment. Copyright© 2012 John Wiley & Sons, Inc.

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38. 38 Copyright© 2012 John Wiley & Sons, Inc.