CHAPTER 7 CHAPTER 7

INVESTMENT COMPANIES INVESTMENT COMPANIES

AND EXCHANGE-TRADED FUNDS AND EXCHANGE-TRADED FUNDS
TYPE OF INVESTMENT COMPANIES
Open-End Funds (Mutual Funds)
More popularly known as mutual funds. As open-end funds they stand ready to buy and redeem
shares at a price based on net asset value, which is total asset value less liabilities. Prices are
quoted on a bid/offer basis. For a no-load fund the bid/offer prices will be the same. he net asset
value !"A#$ per share equals the market value of the portfolio minus the liabilities of the mutual
fund divided by the number of shares owned by the mutual fund investors.
here are several important characteristics of open-end or mutual fund. First, investors in mutual
funds own a pro rata share of the overall portfolio. %econd, the investment mana&er actively
mana&es the portfolio. hird, the share price is the "A#. Fourth, the "A# is determined only once
each day, at the close of the day.
'n the case of a load fund the offer price will e(ceed the bid price by the amount of a sales
commission char&ed upon purchases of shares. %ome funds have back-end loads, wherein
commissions are char&ed upon redemption of funds within a few years. )thers, known as %ection
*+b-* funds, char&e a small percenta&e of assets annually to cover sales costs. 'n any case, all
funds earn small percenta&e annual fees to cover administrative costs. hese funds comprise the
third lar&est &roup of financial institutions, behind banks and insurance companies.
Closed-End Funds
hese funds issue a limited number of shares and are very similar to shares of common stock.
hey are then sold on the open market like other securities. 'nvestors pay a broker,s commission.
he "A# of closed-ended funds is determined by supply and demand. he market price of these
shares may thus differ from net asset value, often at a discount from it. he discount results from
lar&e ta( liabilities on capital &ains that swell the net asset value, while investors are pricin& future
after-ta( distributions. Premiums can result because such funds often have ine(pensive access to
overseas stocks.
-nder the Investment Company Act of 1940, closed-end funds are capitali.ed only once. hey
make an 'P), and then their shares are traded on the secondary market, /ust like any corporate
stock.
he relatively new exchange traded funds (ETFs) pose a threat to both mutual funds and
closed-end funds. 0Fs are essentially hybrid closed-end vehicles, which trade on e(chan&es but
typically trade very close to "A#.
Unit Trusts
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A unit trust is similar to a closed-end fund in that the number of unit certificates is fi(ed. hey
are different from closed-end funds in the followin&. First, they typically invest in bonds. %econd,
they do not trade. hird, a fi(ed amount of securities is assembled with a defined termination date.
he ma/or benefit of such funds is lower operatin& costs due to the absence of tradin&.
FUND SALES CHARGES AND ANNUAL OPERATING EXPENSES
here are two types of costs borne by investors in mutual funds. he first is shareholders fee,
usually called the sales char&e. his type of char&e is related to the way the fund is sold and
distributed. he second cost is the annual fund operatin& e(pense usually called the e(pense ratio,
which covers the fund2s e(penses. he lar&est of which is for investin& mana&ements. )ther
e(penses include primarily the cost of, *$ custody +$ the transfer a&ent cost, 3$ independence
public accountant fee, and 4$ directors, fee. he sum of annual mana&ement fee, the annual
distribution fee and other e(penses is called the e(pense ratio.
Sales Charge
%ales char&es on mutual funds are related to their method of distribution. he two types of
distribution were sales force and direct. %ales force occurs via an intermediary a&ent. 5irect
distribution takes place without an intermediary. Funds with no sales char&es are called no-load
mutual funds. %ome have speculated that load funds would eventually disappear, but the trend
has &one the other way. Amon& the recent adaptations of the sales load are back-end loads.
Annual Operating Expenses (Expense Ratio)
he operatin& e(pense, also called the e(pense ratio, is debited annually from the investor,s fund
balance by the fund sponsor. )peratin& e(penses are deducted from "A# and therefore reduce the
reported return. he mana&ement fee, also called the investment advisory fee, is the fee char&ed
by the investment advisor for mana&in& a fund,s portfolio. 'n *678, the %09 approved the
imposition of a fi(ed annual fee, called the 12b-1 fee, which intended to cover distribution costs.
%uch *+b-* fees are now imposed by many mutual funds.
Multiple Share Classes
%hare classes were first offered in *676 followin& the %09,s approval of multiple share class.
'nitially share classes were used primarily by sales-force funds to offer alternatives to front-end
load as a means of compensatin& brokers. :ater, some of the funds used additional share classes
as a means of offerin& the same fund or portfolio throu&h alternative distribution channels in
which some fund e(penses varied by channel.
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ECONOMIC MOTIVATIONS FOR FUNDS
An investment company is a financial intermediary because it pools the funds of market
participants and uses those funds to buy a portfolio of securities. hey provide at least one of the
followin& si( economic functions; !*$ risk reduction via diversification, !+$ lower costs of
contractin& and processin& information, !3$ professional portfolio mana&ement, !4$ liquidity, !<$
variety, !=$ payments mechanism.
TYPES OF FUNDS BY INVESTMENT OB1ECTIVE
'nvestment funds tend to have a variety of investment objectives. 'n &eneral, there are stock
funds, bond funds, money market funds and others. hey seek to accommodate a wide ran&e of
desires and needs, amon& them income, capital &ains, &rowth, and income. %ome funds speciali.e
by securities, e(amples of which are inde(ed funds, &overnment bond funds, municipal bond
funds, corporate bond funds, money market mutual funds, and balanced funds--combination of
bonds and stocks.
CONCEPT OF FAMILY OF FUNDS
"ow many mana&ement companies offer investors a choice of numerous funds. %ome firms
provide a choice of funds and ob/ectives. 9han&in& from one to the other to reflect chan&in&
needs can then be accomplished at low or no cost to the investor. he funds in a family usually
include choices ran&in& from money market funds to &lobal funds, and funds devoted to particular
industries such as medical technolo&y or &old minin& companies. 9oncentration in the mutual
funds industry continues to increase.
INVESTMENT VEHICLES FOR MUTUAL FUNDS
Mutual funds may be included in different investment vehicles. An investment vehicle can be a
non-qualified vehicle because it does not quality for ta( advanta&es. he same fund can also be
included in a retirement plan such as 48*!k$, >oth 48*!k$, '>A or >oth '>A. hese retirement
plans are called qualified plans.
MUTUAL FUND COSTS
From *678 to +88=, the measure of mutual fund costs declined from +.3+? to *.81? for stock
funds and from +.8<? to 8.74? for bond funds. here were three reasons for this decline. First,
loads in &eneral declined. %econd, no-load mutual funds &rew. hird, mutual fund e(penses have
also declined due to economies of scale and intense competition.
TAXATION OF MUTUAL FUNDS
Mutual funds must distribute at least 68? of their net investments income earned, e(clusive of
reali.ed capital &ains or losses to shareholders to be considered a re&ulated investment company
!>'9$ and, thus not be required to pay ta(es at the fund level prior to distribution to shareholders.
9onsequently, funds make these distributions. 9apital &ains distributions must occur annually, and
typically occur late durin& the calendar year. "ew investors in the fund may assume a ta( liability
even thou&h they have no &ains. he investors must also pay ordinary income ta(es on
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distribution of income.
REGULATION OF FUNDS
All investment companies are re&ulated under the 'nvestment 9ompany Act of *648. hey must
re&ister with the %09 and file periodic reports. "o ta(es are levied on funds, which distribute
68? of their income. here are minimum diversification and liquidity requirements as well as
ma(imum fees that can be applied. 9urrently under consideration is a proposal allowin& less
redemption over a quarter, thus permittin& funds to hold smaller proportions of liquid assets.
Amon& the recent %09 priorities, which directly affect mutual funds, are;
*. >eportin& after ta(es.
+. More complete reportin& fee.
3. More accurate and consistent reportin& of investment performance.
4. >equirin& fund investment practices to be more consistent with the name of a fund to
more accurately reflect their investment ob/ectives.
<. 5isclosin& portfolio practices such as @window dressin&@.
=. #arious rules to increase the effectiveness of independent fund boards.
STRUCTURE OF A FUND
A mutual fund or&ani.ation is structured as follows; !*$ board of directors, !+$ mutual fund, !3$
investment advisor, !4$ distributor, !<$ other service providers. he role of the board of directors
is to represent the fund shareholders. 0(ternal advisers are called subadvisers, and they are used
because !*$ to develop a fund in an area in which the fund family has no e(pertise, !+$ to improve
performance, !3$ to increase assets under mana&ement, !4$ to obtain an attractive mana&er at a
reasonable cost.
RECENT CHANGES IN THE MUTUAL FUND INDUSTRY
Distribution Channels
raditionally, funds were sold direct or throu&h a sales force. Aowever, funds have moved
increasin&ly to nontraditional sources of sales.
Supermarkets: he or&ani.er of a supermarket, like 9harles %chwab, offers funds from a number
of different mutual fund families.
Wrap programs: Brap accounts are mana&ed accounts, typically mutual funds or 0Fs,
wrapped in a service packa&e. he service provided is often asset allocation counsel, i.e., advice
on the mi( of mana&ed funds or 0Fs.
Fee-based financial advisors: Fee-based financial advisors are independent financial planners
who char&e a fee rather than a transaction char&e for investment services. hese fees are typically
a percenta&e of assets under mana&ement or alternatively an hourly fee or a fi(ed retainer.
Variable annuities: #ariable annuities represent another distribution channel.
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Changes in the Costs of Purchasing Mutual Funds
he purchase cost of mutual funds has declined si&nificantly. 'n &eneral, load funds responded to
the competition of no-load funds by lowerin& distribution cost.
Mix and Match
he investors, demands for choice and convenience, and also the distributors, need to appear
ob/ective, have motivated essentially all institutional users of funds and distribution or&ani.ations
to offer funds from other fund families in addition to their own.
Domestic Acquisitions in the US Funds Market
here mer&er and acquisition business in the -% asset mana&ement business has been active. he
-% asset mana&ement business continues to &row and consolidate across the various types of
asset mana&ement firms.
Internationalization of the US Funds Business
he combination of a -% fund company and international asset mana&er could occur in either two
directions, i.e., with either bein& the acquirer. Cut the dominant direction has been the acquisition
of -% funds by international institutions.
EXCHANGE TRADED FUNDS
Bhile mutual funds have become very popular with investors, they are often critici.ed for two
reasons. First, mutual funds shares are priced at, and can be transacted only at the end of day
!closin&$ price. he second relates, to ta(es and the investors, control over ta(es. Bithdrawals by
some shareholders may cause ta(able reali.ed capital &ain for shareholders who maintain their
positions.
9losed-end funds trade all durin& the day on stock e(chan&e, but there is often a difference
between the "A# and the price of the closed-end funds. Coth mutual funds and closed-end funds
are similar in that they are instruments based on the portfolio of their securities, but closed-end
funds are transacted continuously throu&hout the day.
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An investment that embodies a combination of the desirable aspects of mutual funds !open-end
funds$ and closed-end funds is the exchange-traded fund (ETF). hese are mostly inde( funds.
hey are traded on an e(chan&e, and they are like open-end funds in that the number of shares can
chan&e.
ETC Creation/Redemption Process
For 09s, individuals do not deal directly with the provider of the 0F. hat privile&e is reserved
for a few very lar&e investors called authorized participants (AP) who are arbitra&ers.
Authori.ed participants are mainly lar&e institutional traders who have contractual a&reements
with 0F funds. hey are the only investors who may create or redeem shares of an 0F with the
0F sponsor and then only in lar&e specified quantities called creation/redemption units. hese
unit si.es ran&e from appro(imately <8,888 to *88,888 0F shares.
ETF Sponsors
:ike mutual funds, 0Fs require a company to sponsor them. he 0F sponsor must !*$ develop
the inde(, !+$ retain the authori.ed participants, !3$ provide seed capital to initiate the 0F, !4$
advertise and market the 0F, !<$ en&a&e in other activities.
Mutual Funds versus ETFs: Their Relative Advantages
he followin& are 0F advanta&es. Mutual funds are priced only once a day. Cut 0Fs are traded
on an e(chan&e and so there is continuous pricin&. Coth passive mutual funds and 0Fs have low
fees, but 0F fees tend to be somewhat lower. All 0Fs trade on an e(chan&e and incur
commission. As to ta(es, mutual funds may lead to capital &ains ta(es for investors who do not
even liquidate their fund. Cecause of the unique structure of 0Fs, 0Fs can fund redemptions by
in-kind transfers without sellin& their holdin&s, which have no ta( consequences.
Mutual funds have the followin& advanta&es. Bhile 0Fs have been e(clusively passive or
inde(es, mutual fund families offer many types of active funds as well as passive funds.
Additionally, no-load mutual funds, both active and passive, permit transactions with no loads or
commissions.
Separately Managed Accounts
Many hi&h net worth people ob/ect to mutual funds because !*$ lack of control over ta(es, !+$
lack of any input into investment decision, !3$ absence of services. he use of separately
managed accounts responds to all these limitations of mutual funds.

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ANSWERS TO QUESTIONS FOR CHAPTER 7
!Questions are in bold print followed by answers.$
1. An investment company has $1.05 million of assets, $50,000 of liabilities, and 10,000
shares outstanding.
a. What is its NAV?
b. Suppose the fund pays off its liabilities while at the same time the value of its assets
double. How many shares will a deposit of $5,000 receive?
a. "et asset value D !otal assets minus liabilities$ / numbers of shares
D *,8<8,888 E <8,888 D F*88
*8,888
b. "et asset value D +,*88,888 E 8 D F+*8
*8,888
"o of shares D <888 D +3.7* shares.
+*8
2. ~The NAV of an open-end fund is determined continuously throughout the trading day.
Explain why you agree or disagree with this statement.
5isa&ree. "A# of open-ended fund is the closin& price of the day.
3. What are closed-end funds?
hese funds issue a limited number of shares, are sold on the open market.
4. Why do some closed-end funds use leverage to raise more funds rather than issue new
shares like mutual funds?
-nder the *648 Act, these funds are capitali.ed only once. he number of shares is fi(ed. hus
many funds become levera&ed to raise more funds without issuin& new !additional$ shares.
5. Why might the price of a share of a closed-end fund diverge from its NAV?
he price of closed-end funds may differ from "A# !often at a discount$ because the fund has a
lar&e built-in ta( liabilities and investors are discountin& the share,s price for future ta( liabilities.
:evera&e may be another factor for price below "A#.
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6. What is the difference between a unit trust and a closed-end fund?
Bith a unit trust a number of securities are assembled in a portfolio packa&e and held for a
specified number of years and then liquidated. he char&es are low since there is no tradin& of
securities or redemption prior to maturity.
7.
a. Describe the following: front-end load, back-end load, level load, 12b-l fee,
management fee.
b. Is there a limit on the fees that a mutual fund may charge?
a. Cack-end load funds char&e sales fees upon redemption within a period of a few years.
Front end is commissioned char&ed up front of the time of sale. A level load is amount of sales
commission a fund may char&e. A *+b-* fund is a no-load fund that char&es an annual sales fee
of around *.<? annually.
b. Ges the security rule specifies these fees.
8. Why do mutual funds have different classes of shares?
5ifferent classes of shares offered by mutual funds is determined by the needs of the investors and
their risk preferences. 't permits the distributor and its client to select the type of load they prefer.
9. What is an index fund?
An inde( fund e.&. Fidelity Ma&ellan and #an&uard %HP <88 are mutual funds, which invests in
stocks included in %HP <88, and aim to achieve its performance to the benchmark %HP<88
returns.
10.
a. What is meant by a target-date fund?
b. What is the motivation for the creation of such a fund?
a. ar&et date funds are mutual funds that base their asset allocations on a specific date, the
assumed retirement date for the investor, and then rebalance to a more conservative allocation
as that date approaches.
b. hese funds are desi&ned to be Ione-si.e-fits-allJ portfolios for investors with a &iven number
of years to retirement.
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11. What are the costs incurred by a mutual fund?
9osts typically incurred by an investment company !Mutual fund$ include advisory fees,
sellin&/marketin& e(penses, custodial/accountin& fees, and transactions costs. here are two types
of costs borne by investors in mutual funds. he first is shareholder fee, usually called the sales
char&e. his type of char&e is related to the way the fund is sold or distributed. he second cost is
the annual fund operatin& e(pense usually called the e(pense ratio, which covers the fund,s
e(penses. he lar&est of which is for investin& mana&ements.
12. Why might the investor in a mutual fund be faced with a potential tax liability arising
from capital gains even though the investor did not benefit from such a gain?
'nvestor in a closed fund is faced with a potential ta( &ain on capital &ains that swell the net asset
value. he investor is pricin& future-ta( distributions.
13. Does an investment company provide any economic function that individual investors
cannot provide for themselves on their own? Explain your answer.
Ges. An investment company provides risk reduction throu&h diversification and lower costs of
transactions and information processin&, which is hardly to come by an individual investor.
14. Why might a family of funds hire subadvisors for some of its funds?
hey are used because !*$ to develop a fund in an area in which the fund family has no e(pertise,
!+$ to improve performance, !3$ to increase assets under mana&ement, !4$ to obtain an attractive
mana&er at a reasonable cost.
15.
a. How can a fund qualify as a regulated investment company?
b. What is the benefit in gaming this status?
a. A re&ulated investment company must provide information on its fees and its ob/ectives. 't
must file financial reports and indicate amount of income distributed.
b. A re&ulated investment company is e(empt from ta(ation on all its ordinary and capital &ains
income as lon& as at least 68? of these funds are distributed to the stockholders. %uch
distributions are then ta(able to the stockholders.
16. What is an ETF?
An e(chan&ed traded fund is a new investment vehicle that is similar to mutual funds but trade
like a stock on an e(chan&e. he price is determined continuously rather than the closin& price
e.&. KKK.
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17. What are the advantages of an ETF relative to open-end and closed-end investment
companies?
As said earlier, price is continuously chan&in& durin& the tradin& period.
18. Explain the role of the authorized participant in an ETF.
he role of the authori.ed participants is to en&a&e in arbitra&e transactions that maintain the
market price of the 0F as compared to an inde( portfolio.
19. Why is tracking error important for an ETF?
%ince 0Fs are based on passive inde(es where value is represented by the "A#, investors in
0Fs e(pect their return to be equal to that of the portfolio,s "A#. :ar&e trackin& error s are bad
for 0Fs because it undermines the investor,s e(pectation.
20. Comment on the following statement: ~Exchange traded funds are typically actively
managed funds.
%ince they are mostly inde( funds, they are passively mana&ed.
21. Briefly describe the following in the context of mutual funds:
a. supermarket
b. wrap program
c. segregated managed accounts
d. family of funds
a. %upermarkets; he introduction of the first mutual fund supermarket in *66+ by 9harles
%chwab H 9o. introduced its One Source service. hese supermarkets allow investors to
purchase funds from participatin& companies without investors havin& to contact each fund
company.
b. Brap pro&ram; Brap accounts are mana&ed accounts, typically mutual funds IwrappedJ in a
service packa&e. he service provided is often asset allocation counselL that is advice on the
mi( of mana&ed funds.
c. %e&re&ated mana&ed accounts; are in response to individuals who ob/ect to mutual funds
because of their lack of control over ta(es and other investment decisions. Many investors
with medium-si.e portfolio are utili.in& se&re&ated accounts.
d. Family of funds; 'n the -.%. system, a family of funds consists of an investment company that
offers several different funds. 'n Mapan the family fund allows investors to buy new certificates
in a &roupin& of e(istin& unit trusts.
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