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CHAPTER TWENTY-ONEINVESTMENT COMPANIESINVESTMENT COMPANIESINVESTMENT COMPANIES DEFINITION: a type of financial intermediary who obtain funds from investing to use in purchase of financial assetsinvestors receive certain rights in exchangeINVESTMENT COMPANIESAdvantages to the Individual Investoreconomies of scalehigher volume purchases, lower commission rateprovides diversificationprofessional managementmanager is a professional seeking mispriced securities full timeNET ASSET VALUEKEY CONCEPT FOR INVESTMENT COMPANIESNet Asset Value (NAV)NAVt = (MVAt - LIABt )/NSOtwhereNAVt is the firms net asset valueMVAt is the market value of firms assetsLIABt is the dollar value of firms liabilitiesNSOt is the number of shares outstandingMAJOR TYPES OF INVESTMENT COMPANIESUNIT INVESTMENT TRUSTDEFINITION: an investment company that owns a fixed set of securities for the life of the companyFORMATIONsponsor purchases a specific set of securitiesthe securities are deposited with trusteefirm sells redeemable trust certificates to the publicall income received by trustee paid out to certificate holdersMAJOR TYPES OF INVESTMENT COMPANIESUNIT INVESTMENT TRUSTLIFE SPANSfrom 6 months to 20 yearsSECONDARY MARKETinvestor may sell the shares back to the trusta secondary market may be maintained by the sponsor of the trustMAJOR TYPES OF INVESTMENT COMPANIESMANAGED COMPANIESWHAT ARE THEY?organized as corporations with a board of directorsmanagement company is hiredannual management fees vary from .5 to 1% of the average market value of the companys total assetsMAJOR TYPES OF INVESTMENT COMPANIESCLOSED-END INVESTMENT COMPANYFEATURESshares are traded on an exchange unlimited lifedividends received paid out to shareholderscan issue shares to raise additional fundsquotationsmarket prices published dailyNAV published weeklyMAJOR TYPES OF INVESTMENT COMPANIESOPEN-ENDED INVESTMENT COMPANIESmost known as mutual fundscontinuously offer new shares to the publiccapitalization is openMUTUAL FUNDSMUTUAL FUND TAXATIONre. the investment company:no corporate income tax liability ifit pays at least 90% of its net income to shareholderTwo kinds of payments to investors:one for incomeanother for net capital gains realizedMUTUAL FUNDSMUTUAL FUND PERFORMANCECALCULATING RETURNS:Formula:rt = {(NAVt- NAVt-1) +It + Gt}/ NAVt-1where rt = return at time t It = income Gt = capital gain distribution at time tMUTUAL FUNDSAVERAGE RETURNBenchmark portfolio used tom compare the performance of the investment companyComposition of the benchmark portfolioa market index is chosen (e.g. S&P500)a risk-free asset chosen (e.g. T-bills)an index to account for the difference in performance is chosenallows for high to low book-to-market price stocksMUTUAL FUNDSAVERAGE RETURNStyle Analysisused to derive appropriate benchmarkEx Post Alpha Derivedformula:ap = arp - arbpwhere ar p = the average return on portfolio parbp = average return on the benchmarkMUTUAL FUNDSap = arp - arbpIf ap > 0, the portfolio has performed wellEVALUATING MUTUAL FUNDSPROFESSIONAL SERVICESMORNINGSTARis the most often used serviceCAVEATS RE. MORNINGSTAR:performance comparisons using S&P500 for all equity and bond fundsmay not be appropriate for certain types of fundse.g. a fund mostly invested in NASDAQ stocks does not compare EVALUATING MUTUAL FUNDSPROFESSIONAL SERVICESMORNINGSTARis the most often used serviceCAVEATS RE. MORNINGSTAR:their approach to the quest for abnormal returns is not clearly revealeduse of peer group comparisons has several serious shortcomingssome funds may be restricted by their stated objectives as to what they can purchaseEVALUATING MUTUAL FUNDSPROFESSIONAL SERVICESMORNINGSTARis the most often used serviceCAVEATS RE. MORNINGSTAR:survivorship biasthe tendency for poorly performing funds to go out of business and leave the peer groupEND OF CHAPTER 21