Charles P' Jones, Investments: Analysis and Management,

1
Indirect Investing

• Chapter 3
• Charles P. Jones, Investments Analysis and
  Management,
• Ninth Edition, John Wiley Sons
• Prepared by
• G.D. Koppenhaver, Iowa State University
• Additional Information by Axel Grossmann

2
Indirect Investing

• Alternative to direct investment in or ownership
  of securities
• Refers to buying and selling the shares of
  intermediaries (investment companies) that hold
  portfolios of securities
• Investors are purchasing an ownership interest in
  that portfolio of securities
• They are entitled to
• Pro rate share of dividends, interest, and
  capital gains
• Shareholders also pay expenses

3
Investment Companies

• Financial firm that sells shares to the public
  and uses the proceeds to invest in marketable
  securities
• Acts as conduit for distribution of dividends,
  interest, and realized gains
• Can elect to pay no federal taxes on
  distributions
• Shareholders pay tax as if they own securities
  directly
• Offers professional management, diversification
• Not insured or guaranteed
• Required to register with the SEC

4
Company Types

• Unit investment trusts (UIT)
• Put together by a sponsor and handled by an
  independent trustee
• Typically holds an unmanaged, fixed-income
  portfolio
• Assets not actively traded once purchased
• Trust ceases to exist when securities mature
• Passive investment
• At cheap price

5
Company Types

• Closed-end investment companies
• (Closed-end Funds)
• No additional shares sold after initial public
  offering
• Capitalization is fixed (closed-end)
• Traded like any other stock
• Share prices determined by supply and demand in
  the secondary market
• Price may not equal Net Asset Value of the shares
• Net Asset Value Total market value of the
  security portfolio divided by total shares

6
Company Types

• Open-end investment companies
• (Mutual Funds)
• Shares continue to be sold to the public at NAV
  after initial sale that capitalizes the company
• Shares may be sold back to company at NAV
• Company size constantly changes (open-ended)
• Most popular form of investment company
• Two thirds of all mutual funds require 1,000 or
  less as minimum investment

7
Company Types

• Open-end investment companies
• Mutual funds are corporations or business trusts
• Formed by an investment advisory firm (IAF)
• IAF selects a board of trustees (directors)
• Trustees hire management company, which manages
  the fund (usually IAF)

8
Mutual Fund Categories (see page 60)

• Money market mutual funds (MMFs)
• Less risk
• Less expected return
• Invest in portfolio of money market securities
• Taxable money market funds
• Treasury Bills
• Negotiable CDs
• Commercial papers
• etc
• Tax-exempt money market funds
• Short-term municipal secuirties
• State tax-exempt MMFs

9
Mutual Fund Categories

• Average maturity 1 to 2 month
• Regulation limit 90 days
• Investors pay a management fee but not a sales or
  redemption charge (load)
• Interest is earned and credited daily
• Usually no capital gains and losses
• Not insured by the federal government

10
Mutual Fund Categories

• Equity, bond, and income mutual funds
• More risk
• More expected return
• invest in portfolio of securities consistent with
  the objectives of the fund
• Objectives set by the companys board
• Disclosure of objectives to investors
• 18 major categories of investment objectives

11
Mutual Fund Categories

• Equity, bond, and income mutual funds
• Some Objectives
• Only capital gains (equity)
• Capital gains and income (equity with dividends)
• International companies
• Mix of equity, fixed-income and derivatives
• Taxable bonds
• Corporate, global, government bond funds
• Tax-free bonds
• State municipal, national municipal bond funds

12
Equity Funds

• Other categories
• Large cap, mid cap, small cap, value and growth.
• Most equity funds are either
• Value funds, which invest in undervalued stocks
  as determined by fundamental financial analysis
• Growth funds, which invest in stocks of firms
  expected to show future rapid earnings growth

13
Equity Funds
https//flagship.vanguard.com/VGApp/hnw/FundsStock
sOverview
14
Cost Considerations

• Closed-end fund
• prices may be at a discount or premium to NAV
• NAV gt market price selling at discount
• NAV lt market price selling at premium
• On average closed-end funds sold at 11 discount
• Reasons for premium/discount
• Transaction cost
• Future fund managers performance
• Investor sentiment (Foreign Closed-end funds)

15
Cost Considerations

• Mutual funds
• Load funds (charge a sales fee)
• Load charge goes to investment company or brokers
• Depending on the class
• charge a front-end fee (load) to cover the costs
  of selling the fund to investors (around 5)
• a redemption (back-end) fee
• distribution fee (called 12b-1 fee)
• management fee
• All fees must be stated in the mutual fund
  prospectus

16
Cost Considerations

• distribution fee (called 12b-1 fee)
• Imposed by half of all funds
• Covers distribution, marketing and advertising
  expenses
• Existing shareholders benefit if new shareholders
  are attracted (spreading overhead)

17
Cost Considerations

• Classes of shares
• Class A
• Front-end fee (sales load)
• Maybe small annual distribution fee
• Class B
• Annual distribution fee (around 1)
• Back-end fee (redemption fee)
• Declines and disappears over time (5 to 6 years)
• Convertible into class A shares

18
Cost Considerations

• Class C
• Like class B but not convertible into class A
  shares
• Distribution fee is not reduced and continues on
  and on.
• Load funds
• See example 3-12 page 68

19
Cost Considerations

• On a 1,000 purchase of a class A load mutual
  fund, with a 5.2 load fee, an investor would pay
  52 commission, acquiring only 948 in shares.
• On a 1,000 purchase of a class B load mutual
  fund, an investor would acquire 1,000 in shares.
  
• The sales charge is simply being deferred

20
Cost Considerations

• No-load funds
• Purchased at NAV directly from the investment
  company
• No sales force expense to cover
• no sales fee, no redemption fee, no distribution
  fee
• Investors must seek out funds
• How is investment company compensated
• An annual operating expense paid out of fund
  income

21
Performance

• Reported on a regular basis in the popular press
• Measured over a given time period as a percent of
  initial investment
• Total returns include reinvested dividends and
  capital gains
• Average annual return reflects the mean compound
  growth rate of investment over a given time period

22
Performance

• Example

23
Performance

• Benchmarks
• E.g. SP500
• Importance of Expenses
• Class B share with 4.77 annual return, expense
  ratio 2.17
• Net return only 2.6
• Consistency of Performance
• Does past performance matter?
• Only few managed mutual funds beat the market
• Index Funds (passive funds)
• Replicate the market (e.g. SP500)
• Lower expenses unmanaged

24
International Funds

• Some mutual funds specialize in international
  securities
• US investors can participate in emerging market
  economies
• International funds or global funds emphasize
  international stocks
• Single-country funds concentrate assets
• Actively or passively managed

25
Exchange-Traded Funds

• Basket of stocks that tracks the value of a
  sector, investment style, or market as a whole
• Some characteristics of index mutual funds and
  closed-end funds
• Passive in nature
• Trades throughout the day on an exchange
• ETFs can be sold and bought any time during the
  trading day (mutual funds are only priced once a
  day)
• ETFs like stocks can be bought on margins and can
  be sold short
• Lower operating expenses than mutual funds, but
  brokerage fees
• Bond and equity indexes traded
• Tax efficient control over capital gains
  distributions
• http//www.vanguard.com/jumppage/vipers/

26
New Directions in Funds

• Mutual fund supermarkets
• Various mutual fund families can be purchased
  through a single source
• Brokerage account may provide access
• Supermarket managers earn fee
• On-line investment services
• Internet used to provide mutual fund information
  and make transactions