What Is An Investment Company

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Investment Analysis & Portfolio Management (FIN630)

Lesson # 20

INDIRECT INVESTING

Investing Indirectly:

Indirect investing in this discussion usually refers to the buying and selling of the shares of

investment companies' that, in turn, hold portfolios of securities. Most of our attention is

focused on investment-companies, arid mutual funds in particular, because of their

importance to investors. However, we will conclude the chapter with a discussion of

Exchange-Traded Funds (ETFs), which represent a bridge between direct and indirect in

vesting. Investors buy ETFs like any other stock, but many ETFs can be compared to

index mutual funds.

The decision of whether to invest directly or indirectly is an important one that all investors

should think about carefully. Because-each alternative has possible advantages arid

disadvantages, it is not necessarily easy to choose one over the other. Investors can be,

active investors, investing directly, or passive investors, investing indirectly. Of course, they

can do both at the same time, and many individuals do exactly that!

An investment company such as a mutual fund is a clear alternative for an investor seeking

to own-stocks and bonds. Rather .than purchase securities and manage a portfolio, investors'

can, in effect, indirectly invest by turning their money over to an investment company

which will do all the work and make all the decisions (for a fee,-of course). Investors who

purchase shares of a particular portfolio managed by an investment company

The primary difference is that the investment company stands between the investors and the

portfolio of securities, Although technical qualifications exist, the point about indirect

investing is that investors gain and lose through the investment company's activities in the

same manner that they would gain and lose from holding a portfolio directly. The

differences are the, costs (any sales charges plus the management fee) and the benefits

which consist of additional services gained from the investment company, such as

recordkeeping and check-writing privileges.

The line between direct and indirect investing is becoming blurred. For example,

investors can invest indirectly by investing directly-- 'that is, they can buy various mutual

funds through their brokerage accounts. This is explained at the end of the chapter when we

discuss fund "supermarkets." And, as noted above, ETFs have characteristics of both direct

and indirect investing.

What Is An Investment Company?

An investment company is a financial service organization that sells shares in it to the

public and uses the funds it raises to invest in a portfolio of securities such as money market

instruments or stocks and bonds. By pooling the funds of thousands of investors, a widely

diversified portfolio of financial assets can be purchased and the investment company can

offer its owners (shareholders) a variety of services.

A regulated investment company can elect to pay no federal taxes on any distribution of

dividends, interest, and realized capital gains to its shareholders. The investment company

acts as a conduit, "flowing through" these distributions to stockholders who pay their own

marginal tax, rates on them. In effect, fund shareholders are treated as if they held the

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securities in the fund's portfolio. Shareholders pay the same taxes they would pay if they

owned the shares directly.

Fund taxation is unique with income taxed only once when it is received by its shareholders.

A funds short-term gains and other earnings are taxed to shareholders as ordinary income,

whereas its long-term capital gains are taxed to shareholders as" long-term, capital gains.

Tax-exempt income received by a fund is generally tax exempt to the shareholder.

Investment companies are required by the Investment Company Act of 1940 to register with

the Securities and Exchange Commission (SEC). This detailed regulatory statute contains

numerous provisions designed to protect shareholders. Both federal and state laws require

appropriate disclosures to investors.

It is important to note that investment companies are not insured or guaranteed by any

government agency or by any financial institution from which an investor may obtain

shares. These are risky investments, losses to, investors can and do occur (just think 2000 to

2002), and investment companies' promotional materials state this clearly.

Types of Investment Companies:

All investment companies begin by selling shares in themselves to the public. The proceeds

are then used to buy a portfolio of securities. Most investment companies are managed

companies, offering professional management of the portfolio as one of the benefits. One

less well-known type of Investment Company is unmanaged. We begin here with the

unmanaged type and then discuss the two types of managed investment companies. After

we consider each of the three types, we focus on mutual funds, the most popular type of

investment company by far for the typical' individual investor.

Unit Investment Trusts:

An alternative form of. Investment Company that deviates from the normal managed type is

the unit -investment trust, (OIT), which typically is an unmanaged, fixed-income security

portfolio put together by a sponsor and handled by an independent trustee. Redeemable trust

certificates representing claims against the assets, of the trust are sold to investors at net

asset value plus a small commission. All interest (or dividends) and principal repayments

are distributed to the holders of the certificates. Most unit investment trusts hold either

equities or tax-exempt securities. The assets are almost always kept unchanged, and the trust

ceases to exist when the bonds mature, although it is possible to redeem units of the trust.

In general, unit investment trusts are designed to be bought and held, with capital

preservation as a major objective. They enable 'investors to gain diversification, provide

professional, management that takes care of all the details, permit the purchase of securities

by (he trust at a cheaper; price than, if purchased individually, and ensure minimum

operating costs.. If conditions change, however, investors lose the ability to make rapid,

inexpensive, or costless changes in their positions.

Closed-End Investment Companies:

One of the two types of managed investment companies, the closed-end investment

company, usually sells no additional shares of its own stock after the initial public offering.

Therefore, their capitalizations are fixed, unless a new public offering is made.

The shares of a closed-end fund trade in the secondary markets (e.g., on the-exchanges)

exactly like any other stock.10 To buy and sell, investors use their brokers, paying

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(receiving) the current price at which the shares are selling plus (less) broker age

commissions.

Open-End Investment Companies (Mutual Funds):

Open-end investment companies, the most familiar type of managed company are popularly

referred to as mutual funds and continue to sell shares to investors after the initial sale of

shares that starts the fund. The capitalization of an .open-end investment company is

continually changing--that is, it is open-ended--as new investors buy additional shares and

some existing shareholders cash in .by selling their shares back to the company.

Mutual funds typically are purchased either:

1. Directly from a fund company, using mail or telephone, or at the company's office

locations.

2. Indirectly from a sales agent, including securities firms, banks, life insurance

companies, and financial planners.

Mutual funds may be affiliated with an underwriter, -which usually has an exclusive right

to distribute shares to investors: Most underwriters distribute shares through broker/dealer

firms.

Mutual funds are either corporations or business trusts typically formed by an investment

advisory firm that selects the/board of trustees (directors) for the company. The trustees, in

turn, hire a separate management company, normally the investment advisory firm, to

manage the fund. The management company is contracted by the investment company to

perform necessary research and to manage the portfolio, as well as to handle the

administrative chores, for which it receives a fee.

Major Types of Mutual Funds:

The general range of mutual funds arrayed along a return-risk spectrum. As we can see',

money market funds are on the lower end; and bond funds and balanced funds (which hold

both bonds and stocks) are in the middle. Stock funds are on the upper-end of the risk-return

spectrum.

There are two major types of mutual funds:

1. Money market mutual funds

2. Stock (also called equity) funds and bond & income funds

These types of funds parallel of money markets and capital markets. Money market funds

concentrate on short-term investing by holding portfolios of money market assets, whereas

stock funds and bond & income funds concentrate on longer term investing by holding

mostly capital market assets. We will discuss each of these two types of mutual funds in

turn.

Money Market Funds:

A major innovation in the investment company industry has been the creation, and subse-

quent phenomenal growth, of money market funds (MMFs), which are open-end investment

companies whose portfolios consist of m6ney market instruments. Created in 1974, when

interest rates were at record-high levels, MMFs grew rapidly as investors sought to earn

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these high short-term rates. However,-with- the deregulation of the thrift institutions,

competition has increased dramatically for investors' short-term savings. Money market

deposit accounts (MMDAs) pay competitive money market rates and are insured, and

therefore have attracted large amounts of funds. Nevertheless in August 2002, money

market mutual fund assets approximated $2.3 trillion.

Money market funds can be divided into taxable funds and tax-exempt funds.

Approximately 85 percent of these assets are in taxable funds. Investors in higher tax

brackets should carefully compare the taxable equivalent yield on tax-exempt money market

funds with that available on taxable funds because the tax-exempt funds often provide an

edge.

Taxable MMFs hold assets such as Treasury bills, negotiable certificates of deposit (CDs),

and prime commercial paper. Some funds hold only bills, whereas others hold various

mixtures. Commercial paper typically accounts for 40 to 50 percent of the total assets held

by these funds, with Treasury bills, governmental agency securities, domestic and foreign

bank obligations, and repurchase agreements rounding out" the portfolios. The average

maturity of money market portfolios ranges from approximately one to twp months. SEC

regulations limit the maximum average maturity of money funds to 90 days.

Stock Funds and Bond A Income Funds:

The board of directors (trustees) of an investment company must specify the objective that

the company will pursue in its investment policy! The companies try to follow a consistent

investment policy according to their specified objective. Investors purchase mutual funds on

the basis of their objectives.

The Investment Company Institute, a well-known organization that represents the

investment company industry, uses multiple major categories of investment objectives, most

of which are for equity and bond, & income funds (the remainder are-for money market

funds as previously explained).

Mutual Funds:

Some mutual funds use a sales force to reach investors, with shares being available from

brokers, insurances agents, and financial planners. In an alternative form of distribution

called direct marketing, the company uses advertising and direct mailing to appeal to

investors. About 60 percent of all stock, bond; and income fund sales are made by funds

using a sales force.

Mutual funds can be subdivided into:

1. Load funds (those that charge a sales fee)

No-load funds (those that do not charge a sales fee)

INVESTMENT COMPANY PERFORMANCE:

Measures of Fund Performance:

Throughout this text we will use total return to measure the return from any financial asset,

including a mutual fund. Total return for a mutual fund includes reinvested dividends and

capital gains, and therefore includes all of the ways investors make money from financial

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assets. It instated as a percentage or a decimal, and can cover any time periods-one month,

one year, or multiple years.

A cumulative total return measures the actual cumulative performance over a stated

period of time, such as the past 3, 5 and 10 years. This allows die investor to assess total

performance over some stated period of time.

Investing Internationally Through Investment Companies:

The mutual fund Industry has become a global industry. Open-end funds around the world

have grown rapidly, including emerging market economies. Worldwide assets as of mid-

2002 were approximately $11.6 trillion. About 42 percent of worldwide mutual future assets

were invested in equity funds and another 26 percent in money market funds.

Aggregate mutual fund assets in Europe amount to about one-third of the world total. .In

Latin America, roughly one of every 200 people owns a mutual fund (compare to one in

three in the United States). In Japan, mutual fund assets approximate one-half trillion

dollars. In early 1999, there were more than 41,000 funds worldwide.

U.S. investors can invest internationally by buying and selling both mutual funds and

closed-end funds whose shares are traded on exchanges. Funds that specialize in

international securities have become both numerous and well known in recent years.

1. So-called international funds tend to-concentrate primarily on international stocks.

In one recent year, Fidelity Overseas Fund was roughly one-third invested in Europe

and one-third in the Pacific Basin, whereas Kemper International had roughly one-

sixth of its assets in each of three areas, the United Kingdom, Germany, and Japan.

2. Global funds tend to keep a minimum of 25 percent of their-assets in the United

States. For example, in one recent year, Templeton World Fund had over 60 percent

of its assets in the United States and small positions in Australia and Canada.

Most mutual funds that offer "international" investing invest primarily in non U.S. stocks,

thereby exposing investors to foreign markets, which may behave differently from U.S.

markets. However; investors may also be exposed to currency risks. An alternative

approach to international investing is to seek international exposure by investing in U.S.

companies with strong earnings abroad, which is a natural extension of the globalization

concept.

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