Chapter 4 - Mutual Funds and Other Investment Companies

Question 1

What are investment companies?

Answer 1

Financial intermediaries that collect funds from individual investors and invest those funds in a potentially wide range of securities or other assets. Pooling is key - allows small investors to team up to obtain benefits of large scale investing.

Question 2

What functions do investment companies provide? (4)

Answer 2

1. Record keeping and administration - periodic status reports, tracking capital gains distributions, dividends etc.
2. Diversification and divisibility - by pooling, investment companies enable investors to hold fractional shares of many different companies
3. Professional management - investment companies support full time staffs who attempt to achieve superior returns.
4. Lower transaction costs - because they trade large blocks of securities, they can obtain substantial transactional savings.

Question 3

What is a unit investment trust?

Answer 3

A pool of money invested into a portfolio that is fixed for the life of the fund. - little active management as once established the portfolio is fixed, hence thee trusts are ‘unmanaged’ or ‘passive’ - commonly invest in bonds

Question 4

Difference between open-end and closed-end funds?

Answer 4

Open-end funds stand ready to redeem or issue shares at NAV. When investors wish to cash out their shares they sell them back to the fund at NAV.
Closed-end funds do not redeem or issue shares. Investors in closed-end funds are traded on organisational exchanges and can be purchased through brokers. - prices can therefore differ from NAV

Question 5

What are the three ‘other’ investment organisations?

Answer 5

1. Commingled funds
2. Real Estate Investment Trusts (REITS)
3. Hedge Funds

Question 6

What is a Commingled fund?

Answer 6

Partnerships of investors that pool funds. Management firm organises the partnerships e.g. bank or insurance company manages for a fee. Typically partners are true or retirement accounts, with portfolios much larger than most individual investors, but still too small to warrant managing on a separate basis. Similar to open-end mutual funds, but instead of shares, offers units, which are bought and sold at NAV. Examples: money market, bond common stock fund.

Question 7

What is a REIT?

Answer 7

Similar to closed-end fund - these invest in real estate or loans secured by real estate. Besides issuing shares, capital is raised by borrowing from banks and issuing bonds or mortgages. Often highly leveraged. Two types- equity trusts, which invest in real estate directly, and mortgage trusts - invest in mortgage and construction loans.

Question 8

What is a Hedge fund?

Answer 8

Similar to mutual funds, however usually structured as private partnerships and thus only subject to minimal SEC regulation. Typically only open to wealthy investors, of whom often are required to agree to “lock-ups” (periods in which the investments cannot be withdrawn). This allows hedge funds to invest in illiquid assets, without worrying about demands of redemption. - empowered to invest in wide range of investments - such as derivatives, distressed firms, currency speculation conv bonds etc.

Question 9

What do money-market funds consist of?

Answer 9

Commercial paper, repurchase agreements, or certificates of despot (CDs)

Question 10

What do Equity Funds consist of?

Answer 10

Primarily stock - may also hold fixed income or other types of security. Commonly hold 4-5% in money market securities for liquidity.
Classified by emphasis on capital appreciation vs current income.
Income funds tend to hold shares of firms with consistently high dividend yields.
Growth funds are willing to forgo current income, focusing instead on the prospects for capital gains

Question 11

What is a sector fund?

Answer 11

Concentrates primarily on particular industries.

Question 12

What is a bond fund?

Answer 12

Specialise in fixed-income securities.

Question 13

What is an index fund?

Answer 13

Tries to match the performance of a broad market index. Tracks weightings of indexes such as SP 500 and mimics composition

Question 14

How are funds sold?

Answer 14

Either directly by fund underwriter or indirectly through brokers acting on behalf of underwriter. Mostly through sales forces. Broker or financial advisors receive commission for selling shares to investors. Investors who reply on brokers should be aware of conflicts of interest. This can arrive from practice called “revenue sharing” in which fund companies pay brokerage firms for preferential treatment when making investment recommendations.
Also sold through “financial supermarkets” .

Question 15

Fee structures - operating expenses?

Answer 15

Costs incurred by mutual fund in operating the portfolio, including administrative expenses and advisory fees paid to the investment manager. Usually expressed as a percentage of total assets under management (0.2-2%). Shareholders pay for this through reduced value of portfolio. Distribution and marketing fees may also apply.

Question 16

Fee structures - Front-end load?

Answer 16

A commission or sale charge paid when you purchase the shares. Usually paid to brokers - may not exceed 8.5% - in practice rarely higher than 6%.

Question 17

Fee structures - Back-end load?

Answer 17

Redemption or “exit” fee incurred when you sell your shares. Typically start at 5-6% and reduce by 1% each year you hold the investment. More commonly known as “contingent deferred sales charges”.

Question 18

Fee Structures - 12b-1 Charges?

Answer 18

Can use fund assets to pay for distribution costs such as advertising, promotional literature including annual reports and prospectuses, and commissions paid to brokers who sell the fund to investors. Funds may use 12b-1 charges instead of, or in addition to, front-end loads to generate fees with which to pay brokers. Investors not explicitly billed for these fees- deducted from value of fund. limited to 1% of funds net assets per year.

Question 19

What is the taxation of a mutual fund?

Answer 19

Pass-through status- the fund itself does not pay taxation on profits, rather, the investor pays taxation on distributed profits.