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is $9. If management pays out dividends received from the shares as they come in, then the
dividend yield to those that hold the same portfolio through the closed-end fund will be $1/$9,
or 11.1%.
Variations on closed-end funds are interval closed-end funds and discretionary closed-end
funds. Interval closed-end funds may purchase from 5 to 25% of outstanding shares from
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investors at intervals of 3, 6, or 12 months. Discretionary closed-end funds may purchase any
or all of outstanding shares from investors, but no more frequently than once every two years.
The repurchase of shares for either of these funds takes place at net asset value plus a repur-
chase fee that may not exceed 2%.
In contrast to closed-end funds, the price of open-end funds cannot fall below NAV, be-
cause these funds stand ready to redeem shares at NAV. The offering price will exceed NAV,
however, if the fund carries a load. A load is, in effect, a sales charge, which is paid to the load
seller. Load funds are sold by securities brokers and directly by mutual fund groups. A sales commission
Unlike closed-end funds, open-end mutual funds do not trade on organized exchanges. In- charged on a
stead, investors simply buy shares from and liquidate through the investment company at net mutual fund.
asset value. Thus, the number of outstanding shares of these funds changes daily.

Other Investment Organizations
There are intermediaries not formally organized or regulated as investment companies that
nevertheless serve functions similar to investment companies. Among the more important are
commingled funds, real estate investment trusts, and hedge funds.

Commingled funds Commingled funds are partnerships of investors that pool their
funds. The management firm that organizes the partnership, for example, a bank or insurance
company, manages the funds for a fee. Typical partners in a commingled fund might be trust
or retirement accounts which have portfolios that are much larger than those of most individ-
ual investors but are still too small to warrant managing on a separate basis.
Commingled funds are similar in form to open-end mutual funds. Instead of shares, though,
the fund offers units, which are bought and sold at net asset value. A bank or insurance com-
pany may offer an array of different commingled funds from which trust or retirement
accounts can choose. Examples are a money market fund, a bond fund, and a common
stock fund.

Real Estate Investment Trusts (REITs) A REIT is similar to a closed-end fund.
REITs invest in real estate or loans secured by real estate. Besides issuing shares, they raise
capital by borrowing from banks and issuing bonds or mortgages. Most of them are highly
leveraged, with a typical debt ratio of 70%.
There are two principal kinds of REITs. Equity trusts invest in real estate directly, whereas
mortgage trusts invest primarily in mortgage and construction loans. REITs generally are es-
tablished by banks, insurance companies, or mortgage companies, which then serve as invest-
ment managers to earn a fee.
REITs are exempt from taxes as long as at least 95% of their taxable income is distributed
to shareholders. For shareholders, however, the dividends are taxable as personal income.

Hedge funds Like mutual funds, hedge funds are vehicles that allow private investors hedge fund
to pool assets to be invested by a fund manager. However, hedge funds are not registered as A private investment
mutual funds and are not subject to SEC regulation. They typically are open only to wealthy pool, open to wealthy
or institutional investors. As hedge funds are only lightly regulated, their managers can pursue or institutional
investors, that is
investment strategies that are not open to mutual fund managers, for example, heavy use of de-
exempt from SEC
rivatives, short sales, and leverage.
regulation and can
Hedge funds typically attempt to exploit temporary misalignments in security valuations. therefore pursue
For example, if the yield on mortgage-backed securities seems abnormally high compared to more speculative
that on Treasury bonds, the hedge fund would buy mortgage-backed and short sell Treasury policies than
mutual funds.
securities. Notice that the fund is not betting on broad movement in the entire bond market; it
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104 Part ONE Elements of Investments


buys one type of bond and sells another. By taking a long mortgage/short Treasury position,
the fund “hedges” its interest rate exposure, while making a bet on the relative valuation
across the two sectors. The idea is that when yield spreads converge back to their “normal” re-
lationship, the fund will profit from the realignment regardless of the general trend in the level
of interest rates. In this respect, it strives to be “market neutral,” which gives rise to the term
“hedge fund.”
Of course even if the fund™s position is market neutral, this does not mean that it is low risk.
The fund still is speculating on valuation differences across the two sectors, often taking a
very large position, and this decision can turn out to be right or wrong. Because the funds of-
ten operate with considerable leverage, returns can be quite volatile.
One of the major financial stories of 1998 was the collapse of Long-Term Capital Man-
agement (LTCM), probably the best-known hedge fund at the time. Among its many invest-
ments were several “convergence bets,” such as the mortgage-backed/Treasury spread we
have described. When Russia defaulted on some of its debts in August 1998, risk and liquid-
ity premiums increased, so that instead of converging, the yield spread between safe Trea-
suries and almost all other bonds widened. LTCM lost billions of dollars in August and
September of 1998; the fear was that given its extreme leverage, continued losses might more
than wipe out the firm™s capital and force it to default on its positions. Eventually, several Wall
Street firms contributed a total of about $3.5 billion to bail out the fund, in return receiving a
90% ownership stake in the firm.

4.3 MUTUAL FUNDS
Mutual fund is the common name for an open-end investment company. This is the dominant
investment company today, accounting for roughly 90% of investment company assets. Assets
under management in the mutual fund industry reached $7 trillion by year-end 2001.

Investment Policies
Each mutual fund has a specified investment policy, which is described in the fund™s pro-
spectus. For example, money market mutual funds hold the short-term, low-risk instruments
of the money market (see Chapter 2 for a review of these securities), while bond funds hold
fixed-income securities. Some funds have even more narrowly defined mandates. For exam-
ple, some bond funds will hold primarily Treasury bonds, others primarily mortgage-backed
securities.
Management companies manage a family, or “complex,” of mutual funds. They organize
an entire collection of funds and then collect a management fee for operating them. By man-
aging a collection of funds under one umbrella, these companies make it easy for investors to
allocate assets across market sectors and to switch assets across funds while still benefiting
from centralized record keeping. Some of the most well-known management companies are
Fidelity, Vanguard, Putnam, and Dreyfus. Each offers an array of open-end mutual funds with
different investment policies. There were over 8,000 mutual funds at the end of 2000, which
were offered by fewer than 500 fund complexes.
Some of the more important fund types, classified by investment policy, are discussed next.

Money market funds These funds invest in money market securities. They usually
offer check-writing features, and net asset value is fixed at $1 per share, so that there are no
tax implications such as capital gains or losses associated with redemption of shares.

Equity funds Equity funds invest primarily in stock, although they may, at the portfolio
manager™s discretion, also hold fixed-income or other types of securities. Funds commonly
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4 Mutual Funds and Other Investment Companies


will hold about 5% of total assets in money market securities to provide the liquidity neces-
sary to meet potential redemption of shares.
It is traditional to classify stock funds according to their emphasis on capital appreciation
versus current income. Thus income funds tend to hold shares of firms with high dividend
yields that provide high current income. Growth funds are willing to forgo current income, fo-
cusing instead on prospects for capital gains. While the classification of these funds is couched
in terms of income versus capital gains, it is worth noting that in practice the more relevant
distinction concerns the level of risk these funds assume. Growth stocks”and therefore
growth funds”are typically riskier and respond far more dramatically to changes in economic
conditions than do income funds.

Bond funds As the name suggests, these funds specialize in the fixed-income sector.
Within that sector, however, there is considerable room for specialization. For example, vari-
ous funds will concentrate on corporate bonds, Treasury bonds, mortgage-backed securities,
or municipal (tax-free) bonds. Indeed, some of the municipal bond funds will invest only in
bonds of a particular state (or even city!) in order to satisfy the investment desires of residents
of that state who wish to avoid local as well as federal taxes on the interest paid on the bonds.
Many funds also will specialize by the maturity of the securities, ranging from short-term to
intermediate to long-term, or by the credit risk of the issuer, ranging from very safe to high-
yield or “junk” bonds.

Balanced and income funds Some funds are designed to be candidates for an indi-
vidual™s entire investment portfolio. Therefore, they hold both equities and fixed-income se-
curities in relatively stable proportions. According to Wiesenberger, such funds are classified
as income or balanced funds. Income funds strive to maintain safety of principal consistent
with “as liberal a current income from investments as possible,” while balanced funds “mini-
mize investment risks so far as this is possible without unduly sacrificing possibilities for
long-term growth and current income.”

Asset allocation funds These funds are similar to balanced funds in that they hold
both stocks and bonds. However, asset allocation funds may dramatically vary the proportions
allocated to each market in accord with the portfolio manager™s forecast of the relative per-
formance of each sector. Hence, these funds are engaged in market timing and are not de-
signed to be low-risk investment vehicles.

Index funds An index fund tries to match the performance of a broad market index. The
fund buys shares in securities included in a particular index in proportion to the security™s rep-
resentation in that index. For example, the Vanguard 500 Index Fund is a mutual fund that
replicates the composition of the Standard & Poor™s 500 stock price index. Because the S&P
500 is a value-weighted index, the fund buys shares in each S&P 500 company in proportion
to the market value of that company™s outstanding equity. Investment in an index fund is a
low-cost way for small investors to pursue a passive investment strategy”that is, to invest
without engaging in security analysis. Of course, index funds can be tied to nonequity indexes
as well. For example, Vanguard offers a bond index fund and a real estate index fund.

Specialized sector funds Some funds concentrate on a particular industry. For exam-
ple, Fidelity markets dozens of “select funds,” each of which invests in specific industry such
as biotechnology, utilities, precious metals, or telecommunications. Other funds specialize in
securities of particular countries.
Table 4.1 breaks down the number of mutual funds by investment orientation as of the end
of 2001. Figure 4.2 is part of the listings for mutual funds from The Wall Street Journal.
Bodie’Kane’Marcus: I. Elements of Investments 4. Mutual Funds and Other © The McGraw’Hill
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Fifth Edition




106 Part ONE Elements of Investments


Assets % of
TA B L E 4.1 ($ billion) Total
Classification of
Common Stock
mutual funds,
December 2001 Aggressive growth $ 576.2 8.3%
Growth 1,047.5 15.0
Growth & income 1,066.6 15.3
Equity income 125.4 1.8
International 415.1 6.0
Emerging markets 13.7 0.2
Sector funds 173.6 2.5
Total equity funds $3,418.1 49.0%
Bond Funds
Corporate, investment grade $ 161.0 2.3%
Corporate, high yield 94.3 1.4
Government & agency 90.9 1.3
Mortgage-backed 73.4 1.1
Global bond funds 19.0 0.3
Strategic income 191.6 2.7
Municipal single state 141.0 2.0
Municipal general 154.0 2.2
Total bond funds $ 925.2 13.3%
Mixed (hybrid) Asset Classes
Balanced $ 231.1 3.3%
Asset allocation & flexible 115.3 1.7
Total hybrid funds $ 346.3 5.0%
Money Market
Taxable $2,012.9 28.9%
Tax-free 272.4 3.9
Total money market funds $2,285.3 32.8%
Total $6,974.9 100.0%

Note: Column sums subject to rounding error.
Source: Mutual Fund Fact Book, Investment Company Institute, 2002.




Notice that the funds are organized by the fund family. For example, funds sponsored by the
Vanguard Group comprise most of the figure. The first two columns after the name of each
fund present the net asset value of the fund and the change in NAV from the previous day. The
last column is the year-to-date return on the fund.
Often the fund name describes its investment policy. For example, Vanguard™s GNMA fund
invests in mortgage-backed securities, the municipal intermediate fund (MuInt) invests in
intermediate-term municipal bonds, and the high-yield corporate bond fund (HYCor) invests
in large part in speculative grade, or “junk,” bonds with high yields. You can see that Vanguard
offers about 20 index funds, including portfolios indexed to the bond market (TotBd), the
Wilshire 5000 Index (TotSt), the Russell 2000 Index of small firms (SmCap), as well as
European- and Pacific Basin-indexed portfolios (Europe and Pacific). However, names of
common stock funds frequently reflect little or nothing about their investment policies. Ex-
amples are Vanguard™s Windsor and Wellington funds.
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4 Mutual Funds and Other Investment Companies




F I G U R E 4.2
Listing of mutual
fund quotations
Source: The Wall Street
Journal, November 15,

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