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Cite advantages and disadvantages of investing with an

> investment company rather than buying securities directly.

Contrast open-end mutual funds with closed-end funds and

> unit investment trusts.

Define net asset value and measure the rate of return on a

> mutual fund.

Classify mutual funds according to investment style.

Demonstrate the impact of expenses and turnover on
mutual fund investment performance.

Bodie’Kane’Marcus: I. Elements of Investments 4. Mutual Funds and Other © The McGraw’Hill
Essentials of Investments, Investment Companies Companies, 2003
Fifth Edition

Related Websites
These sites give information on exchange-traded funds
(ETFs). IndexFunds.com has an excellent screening
http://moneycentral.msn.com/investor/research/ program that allows you to compare index funds with
fundwelcome.asp?Funds=1 ETFs in terms of expense ratios.
http://www.bloomberg.com/money/mutual/index. http://www.vanguard.com
The above sites have general and specific information
These sites are examples of specific mutual fund
on mutual funds. The Morningstar site has a section
organization websites.
dedicated to exchange-traded funds.

he previous chapter provided an introduction to the mechanics of trading secu-

T rities and the structure of the markets in which securities trade. Increasingly,
however, individual investors are choosing not to trade securities directly for
their own accounts. Instead, they direct their funds to investment companies that pur-
chase securities on their behalf. The most important of these financial intermediaries
are mutual funds, which are currently owned by about one-half of U.S. households.
Other types of investment companies, such as unit investment trusts and closed-end
funds, also merit distinctions.
We begin the chapter by describing and comparing the various types of invest-
ment companies available to investors”unit investment trusts, closed-end investment
companies, and open-end investment companies, more commonly known as mutual
funds. We devote most of our attention to mutual funds, examining the functions of
such funds, their investment styles and policies, and the costs of investing in these
Next, we take a first look at the investment performance of these funds. We con-
sider the impact of expenses and turnover on net performance and examine the ex-
tent to which performance is consistent from one period to the next. In other words,
will the mutual funds that were the best past performers be the best future perform-
ers? Finally, we discuss sources of information on mutual funds and consider in detail
the information provided in the most comprehensive guide, Morningstar™s Mutual
Fund Sourcebook.
Bodie’Kane’Marcus: I. Elements of Investments 4. Mutual Funds and Other © The McGraw’Hill
Essentials of Investments, Investment Companies Companies, 2003
Fifth Edition

100 Part ONE Elements of Investments

Investment companies are financial intermediaries that collect funds from individual in-
vestors and invest those funds in a potentially wide range of securities or other assets. Pooling
of assets is the key idea behind investment companies. Each investor has a claim to the port-
folio established by the investment company in proportion to the amount invested. These com-
intermediaries that
panies thus provide a mechanism for small investors to “team up” to obtain the benefits of
invest the funds of
individual investors large-scale investing.
in securities or Investment companies perform several important functions for their investors:
other assets.
1. Record keeping and administration. Investment companies issue periodic status reports,
keeping track of capital gains distributions, dividends, investments, and redemptions,
and they may reinvest dividend and interest income for shareholders.
2. Diversification and divisibility. By pooling their money, investment companies enable
investors to hold fractional shares of many different securities. They can act as large
investors even if any individual shareholder cannot.
3. Professional management. Most, but not all, investment companies have full-time staffs
of security analysts and portfolio managers who attempt to achieve superior investment
results for their investors.
4. Lower transaction costs. Because they trade large blocks of securities, investment
companies can achieve substantial savings on brokerage fees and commissions.
While all investment companies pool the assets of individual investors, they also need to
divide claims to those assets among those investors. Investors buy shares in investment com-
panies, and ownership is proportional to the number of shares purchased. The value of each
share is called the net asset value, or NAV. Net asset value equals assets minus liabilities ex-
net asset value
pressed on a per-share basis:
Assets minus Market value of assets minus liabilities
Net asset value
liabilities expressed
Shares outstanding
on a per-share basis.
Consider a mutual fund that manages a portfolio of securities worth $120 million. Suppose
the fund owes $4 million to its investment advisers and owes another $1 million for rent,
wages due, and miscellaneous expenses. The fund has 5 million shareholders. Then
$120 million $5 million
Net asset value $23 per share
5 million shares

1. Consider these data from the December 2000 balance sheet of the Growth Index
mutual fund sponsored by the Vanguard Group. (All values are in millions.) What
CHECK was the net asset value of the portfolio?

Assets: $14,754
Liabilities: $ 1,934
Shares: 419.4

In the United States, investment companies are classified by the Investment Company Act of
1940 as either unit investment trusts or managed investment companies. The portfolios of unit
investment trusts are essentially fixed and thus are called “unmanaged.” In contrast, managed
Bodie’Kane’Marcus: I. Elements of Investments 4. Mutual Funds and Other © The McGraw’Hill
Essentials of Investments, Investment Companies Companies, 2003
Fifth Edition

4 Mutual Funds and Other Investment Companies

companies are so named because securities in their investment portfolios continually are
bought and sold: The portfolios are managed. Managed companies are further classified as ei-
ther closed-end or open-end. Open-end companies are what we commonly call mutual funds.

Unit Investment Trusts
Unit investment trusts are pools of money invested in a portfolio that is fixed for the life of unit investment
the fund. To form a unit investment trust, a sponsor, typically a brokerage firm, buys a portfo- trusts
lio of securities which are deposited into a trust. It then sells to the public shares, or “units,” Money pooled from
in the trust, called redeemable trust certificates. All income and payments of principal from many investors that is
the portfolio are paid out by the fund™s trustees (a bank or trust company) to the shareholders. invested in a portfolio
fixed for the life of
There is little active management of a unit investment trust because once established, the
the fund.
portfolio composition is fixed; hence these trusts are referred to as unmanaged. Trusts tend to
invest in relatively uniform types of assets; for example, one trust may invest in municipal
bonds, another in corporate bonds. The uniformity of the portfolio is consistent with the lack
of active management. The trusts provide investors a vehicle to purchase a pool of one partic-
ular type of asset, which can be included in an overall portfolio as desired. The lack of active
management of the portfolio implies that management fees can be lower than those of man-
aged funds.
Sponsors of unit investment trusts earn their profit by selling shares in the trust at a pre-
mium to the cost of acquiring the underlying assets. For example, a trust that has purchased $5
million of assets may sell 5,000 shares to the public at a price of $1,030 per share, which (as-
suming the trust has no liabilities) represents a 3% premium over the net asset value of the se-
curities held by the trust. The 3% premium is the trustee™s fee for establishing the trust.
Investors who wish to liquidate their holdings of a unit investment trust may sell the shares
back to the trustee for net asset value. The trustees can either sell enough securities from the
asset portfolio to obtain the cash necessary to pay the investor, or they may instead sell the
shares to a new investor (again at a slight premium to net asset value).

Managed Investment Companies
There are two types of managed companies: closed-end and open-end. In both cases, the
fund™s board of directors, which is elected by shareholders, hires a management company to
manage the portfolio for an annual fee that typically ranges from .2% to 1.5% of assets. In
many cases the management company is the firm that organized the fund. For example, Fi-
delity Management and Research Corporation sponsors many Fidelity mutual funds and is re-
sponsible for managing the portfolios. It assesses a management fee on each Fidelity fund. In
other cases, a mutual fund will hire an outside portfolio manager. For example, Vanguard has
hired Wellington Management as the investment adviser for its Wellington Fund. Most man-
open-end funds
agement companies have contracts to manage several funds.
A fund that issues or
Open-end funds stand ready to redeem or issue shares at their net asset value (although
redeems its shares at
both purchases and redemptions may involve sales charges). When investors in open-end
net asset value.
funds wish to “cash out” their shares, they sell them back to the fund at NAV. In contrast,
closed-end funds do not redeem or issue shares. Investors in closed-end funds who wish to
closed-end funds
cash out must sell their shares to other investors. Shares of closed-end funds are traded on or-
A fund whose shares
ganized exchanges and can be purchased through brokers just like other common stock; their
are traded at prices
prices therefore can differ from NAV.
that can differ from
Figure 4.1 is a listing of closed-end funds from The Wall Street Journal. The first column net asset value.
after the name of the fund indicates the exchange on which the shares trade (A: Amex; C: Shares may not be
Chicago; N: NYSE; O: Nasdaq; T: Toronto; z: does not trade on an exchange). The next four redeemed at NAV.
Bodie’Kane’Marcus: I. Elements of Investments 4. Mutual Funds and Other © The McGraw’Hill
Essentials of Investments, Investment Companies Companies, 2003
Fifth Edition

102 Part ONE Elements of Investments

F I G U R E 4.1
mutual funds
Source: The Wall Street
Journal, November 19, 2001.
Reprinted by permission of
Dow Jones & Company, Inc.,
via Copyright Clearance
Center, Inc. © 2001 Dow
Jones & Company, Inc. All
Rights Reserved Worldwide.

columns give the fund™s most recent net asset value, the closing share price, the change in the
closing price from the previous day, and trading volume in round lots of 100 shares. The pre-
mium or discount is the percentage difference between price and NAV: (Price NAV)/NAV.
Notice that there are more funds selling at discounts to NAV (indicated by negative differ-
ences) than premiums. Finally, the annual dividend and the 52-week return based on the per-
centage change in share price plus dividend income is presented in the last two columns.
The common divergence of price from net asset value, often by wide margins, is a puzzle
that has yet to be fully explained. To see why this is a puzzle, consider a closed-end fund that
is selling at a discount from net asset value. If the fund were to sell all the assets in the port-
folio, it would realize proceeds equal to net asset value. The difference between the market
price of the fund and the fund™s NAV would represent the per-share increase in the wealth of
the fund™s investors. Despite this apparent profit opportunity, sizable discounts seem to persist
for long periods of time.
Interestingly, while many closed-end funds sell at a discount from net asset value, the
prices of these funds when originally issued are often above NAV. This is a further puzzle, as
it is hard to explain why investors would purchase these newly issued funds at a premium to
NAV when the shares tend to fall to a discount shortly after issue.
Many investors consider closed-end funds selling at a discount to NAV to be a bargain.
Even if the market price never rises to the level of NAV, the dividend yield on an investment
in the fund at this price would exceed the dividend yield on the same securities held outside
the fund. To see this, imagine a fund with an NAV of $10 per share holding a portfolio that
pays an annual dividend of $1 per share; that is, the dividend yield to investors that hold this
portfolio directly is 10%. Now suppose that the market price of a share of this closed-end fund


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