Topic_4 = Mutual_Funds_and_Investment_Companies

Course Information

  • Course Title: FINC 335

  • Topic: Investments

  • Focus: Mutual Funds and Investment Companies

  • Instructor: An Qin

  • Institution: Loyola University Chicago

  • Semester: Spring 2026

Review of Securities Markets

  • Key Questions:

    • How do firms issue securities?

    • What are IPOs and SEOs?

    • How are securities traded?

    • What are different types of exchanges?

    • What are trading costs?

    • What is margin trading?

  • Definitions:

    • Initial Margin: The amount of equity an investor must put up when buying on margin.

    • Maintenance Margin: The minimum account balance an investor must maintain before the broker will require further deposits.

    • Margin Call: A demand by a broker that an investor deposits further cash or securities to cover possible losses.

    • Leverage: The use of borrowed funds to increase one’s investment.

    • Short Sales: Selling a security that the seller does not own, with the intention to repurchase it later at a lower price.

    • Regulation of Securities Markets: Overview of the guidelines and rules governing securities trading.

Agenda

  • Main Topics:

    • Mutual Funds and Investment Companies:

    • Definition and purpose of investment companies.

    • Types of investment companies: unit investment trusts, managed investment companies, closed-end funds, open-end funds (mutual funds).

    • Investment strategies and costs of using investment companies.

    • Exchange-Traded Funds (ETFs).

Investment Companies Overview

  • Definition: Investment companies are financial intermediaries that collect funds from individual investors and allocate those funds into a wide array of securities.

  • Benefits of Investment Companies:

    • Record Keeping and Administration: Efficient management of investor records.

    • Diversification and Divisibility: Enables smaller investors to diversify their portfolios efficiently.

    • Professional Management: Expert management of investment portfolios.

    • Lower Transaction Costs: Economies of scale reduce costs for individual investors.

Shares of Investment Companies

  • Net Asset Value (NAV): The total value of the assets minus liabilities divided by the number of shares outstanding.

    • Formula: NAV=racAssets−LiabilitiesSharesextoutstandingNAV = rac{Assets - Liabilities}{Shares ext{ outstanding}}

    • Example: For ABCD Growth Fund:

    • Assets: $900,000

    • Liabilities: $100,000

    • Shares Outstanding: 50,000

    • NAV Calculation: NAV=rac900,000−100,00050,000=rac800,00050,000=16NAV = rac{900,000 - 100,000}{50,000} = rac{800,000}{50,000} = 16

    • NAV = $16

Types of Investment Companies

Unit Investment Trust

  • Characteristics: Unmanaged, fixed portfolio of uniformly invested assets.

  • Management Fees: Typically lower due to lack of active management.

  • Market Share Trends: Declining from $105 billion in 1990 to $51 billion in 2010.

Managed Investment Companies

  • Open-End Funds:

    • Definition: Issues or redeems shares at NAV.

    • Pricing of Shares: Based on NAV.

  • Closed-End Funds:

    • Definition: Shares are traded but cannot be redeemed at NAV.

    • Pricing of Shares: May trade at a discount to NAV.

    • Load Fees: Sales commission charged on mutual funds.

Open-End vs. Closed-End Funds

  • Open-End Funds:

    • Trading: Occurs at the close of the day based on NAV.

    • Shares Outstanding: Changes daily with new sales and redemptions of shares.

  • Closed-End Funds:

    • Trading: Takes place on stock exchanges where shares are bought and sold among investors.

    • Shares Outstanding: Remains constant; transactions occur in the secondary market.

  • Pricing Differences:

    • Open-end share price = NAV + load.

    • Closed-end typically trades at a discount to NAV.

Other Investment Companies

Commingled Funds

  • Definition: Partnerships where investors pool funds for investment purposes.

  • Target Users: Trusts and retirement accounts seeking professional management for a fee.

Real Estate Investment Trusts (REITs)

  • Types:

    • Equity Trusts: Invest directly in real estate.

    • Mortgage Trusts: Invest in mortgage and construction loans.

  • Financial Structure: Generally highly leveraged, around 70% debt.

Hedge Funds

  • Definition: Private partnerships that engage in speculative investment pooling.

  • Regulatory Exemptions: Generally free from many SEC regulations.

  • Growth Statistics: From $50 billion in 1990 to nearly $2 trillion in 2011.

Mutual Funds

  • Definition: A common type of open-end fund, dominant in the U.S. investment landscape.

  • Market Share: Approximately 90% of investment company assets.

  • Asset AUM: Almost $18 trillion in U.S. mutual fund industry (as of early 2019).

  • Investment Types:

    • International Funds: Invest solely in foreign assets.

    • Global Funds: Invest in both domestic (U.S.) and international markets.

Exercise on NAV Calculation

  • Example Fund: Advantage Mutual Fund

    • Assets: $180 million

    • Liabilities: $30 million

    • Shares Outstanding: 1 million

  • NAV Calculation: NAV=rac180,000,000−30,000,0001,000,000=rac150,000,0001,000,000=150NAV = rac{180,000,000 - 30,000,000}{1,000,000} = rac{150,000,000}{1,000,000} = 150

  • Impact of Redemption: If an investor redeems 100,000 shares, the NAV and shares outstanding will adjust accordingly, requiring recalculation of the new NAV.

Comparison: Mutual Funds vs. Hedge Funds

Mutual Funds

Hedge Funds

Transparency: Public info on portfolios

Limited info to investors

Number of Investors: Unlimited

Less than 100 investors, high minimums

Strategies: Limited short selling etc.

No limitations on strategies

Liquidity: Redeem on demand

Multiple year lock-up

Fee Structure: 0.5%-2% fixed

1%-2% fixed + 20% incentive fee

Investment Policies

Different Types of Investment Funds:

  • Money Market Funds:

    • Invest primarily in commercial paper, certificates of deposit, etc.

    • Maintain a fixed NAV of $1 and often have check-writing features.

  • Equity Funds:

    • Primarily invest in stocks but may also include fixed income and maintain some liquidity in money market securities.

  • Specialized Sector Funds:

    • Focus on particular industries.

  • Bond Funds:

    • Specialize in fixed-income securities based on type or issuer risk.

  • International Funds:

    • Focus on investments in specific global regions or either developing or developed markets.

  • Balanced Funds:

    • Make strategic asset allocation decisions.

  • Life-Cycle and Targeted-Maturity Funds:

    • Aim for specific future dates.

  • Index Funds:

    • Attempt to replicate market index performance.

Fee Structure of Mutual Funds

  • Types of Fees Associated with Investing:

    • Operating Expenses: Include administrative costs and fees to fund managers.

    • Front-End Load: Sales charge upon purchase of shares.

    • Back-End Load: Fees incurred when selling shares.

    • 12b-1 Charges: Annual fees for marketing and distribution.

Costs and Returns

  • Return Calculation Formula: Return=racNAV<em>1−NAV</em>0+IncomeNAV0Return = rac{NAV<em>1 - NAV</em>0 + Income}{NAV_0}

  • Costs Included in Return Calculation:

    • Operating expenses

    • 12b-1 expenses

  • Costs Excluded from Calculation:

    • Front-end load fees

    • Back-end load fees

Example of Costs and Returns

  • Example Fund: Excelsior Mutual Fund

    • Assets: $200 million

    • Shares Outstanding: 10 million

    • Dividend Income: $2 million with 8% price appreciation.

    • 12b-1 Fee: 1%, deducted annually.

NAV at Year-End Calculation:
NAV<em>end=NAV</em>0imes(1+extPriceGain)imes(1−ext12b−1fee)NAV<em>{end} = NAV</em>0 imes (1+ ext{Price Gain}) imes (1- ext{12b-1 fee})
NAVend=20imes(1.08)imes(0.99)=21.384NAV_{end} = 20 imes (1.08) imes (0.99) = 21.384

  • Rate of Return Calculation:
    RateextofReturn=racDividends+(NAV<em>end−NAV</em>0)NAV0=rac0.20+21.384−2020Rate ext{ of }Return = rac{Dividends + (NAV<em>{end} - NAV</em>0)}{NAV_0} = rac{0.20 + 21.384 - 20}{20}

Turnover Rate Calculation

  • Formula: TurnoverextRate=racTotalextAssetTransactedAverageextAssetsTurnover ext{ Rate} = rac{Total ext{ Asset Transacted}}{Average ext{ Assets}}

  • Implications of High Turnover: May lead to frequent capital gains/losses and potential tax complications for investors.

  • Example Calculation:

    • Assets: $80 million

    • Annual Transactions amount: $20 million.

    • Turnover Rate: Turnover ext{ Rate} = rac{20,000,000}{80,000,000} = 0.25 ext{ or } 25 ext{%}

Turnover and Taxes

  • Investor Portfolio Example: Portfolio worth $1 million; sells 1,000 shares of Intel at $160 and buys 2,000 shares of PayPal at $80.

  • Turnover Rate Calculation: Turnover = rac{Purchased ext{ Value}}{Total ext{ Portfolio Value}} = rac{160,000}{1,000,000} = 0.16 ext{ or } 16 ext{%}

  • Tax Implications:

    • Original Purchase Price of Intel: $120/share.

    • Capital Gain Tax Rate: 25%.

    • Tax Owed Calculation:
      Tax=1,000imes(160−120)imes0.25=10,000Tax = 1,000 imes (160-120) imes 0.25 = 10,000

Exchange-Traded Funds (ETFs)

  • Definition: Investment products similar to mutual funds that enable trading in index portfolios at any time during trading hours unlike mutual funds.

  • Popular Examples:

    • SPDR: Mimics S&P 500.

    • DIA: Based on Dow Jones Industrial Average.

    • QQQ: Tracks NASDAQ 100 index.

    • WEBS: Shares in international equity indices.

Advantages of ETFs

  • Continuous trading throughout the day.

  • Can be sold short or bought on margin.

  • Generally lower management expenses than mutual funds.

Disadvantages of ETFs

  • Possible small deviations from NAV.

  • May incur brokerage commissions to purchase ETFs.

Assets in ETFs

  • Statistics on ETF Assets (in millions):

    • Bond: $900,000

    • Commodities: $800,000

    • U.S. equity (broad index): $700,000

    • U.S. equity (sector): $600,000

    • Global/international equity: $500,000

    • Years Covered: From 1998 to 2010, showcasing growth in ETF assets over time.