Power Point Slides for:

Financial Institutions, Markets, and

Money, 9th Edition

Authors: Kidwell, Blackwell, Whidbee &

Peterson

Prepared by: Babu G. Baradwaj, Towson University

and
Lanny R. Martindale, Texas A&M University

Copyright© 2006 John Wiley & Sons, Inc. 1

CHAPTER 20

Investment
Companies
 History of Investment Companies
Investment companies were first started in
Belgium in 1822.
Early U.S. investment companies
Began at end of 1800s
Closed-end companies
First mutual fund in 1924
Declines in Great Depression
Regulations enhanced confidence
Growth very rapid in 1945 to 1965 period as the stock
market performed well.
Inflation, high interest rates, and poor market
performance hurt growth in 1970s.

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 History of Investment Companies (continued)

New types of funds post 1970s

Municipal bonds funds - tax-free income
Government security funds - safety
Money market funds - safety and high rates
with inverse yield curve.
Exchange traded Funds (ETFs) – represents
indices.

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Investment Funds
Purchase direct, long term, capital market
securities and issue indirect, liquid, small
denomination securities, called shares.
(IF) offer the financial investor the following:
Provide risk intermediation by investing in a diversified
portfolio of assets.
Provide denomination intermediation by issuing shares
in smaller denominations than the direct securities
purchased.
Provide marketability for IF shares.
Offer economies of scale in investment management
and transaction costs.

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 Net Asset Value (NAV)

Value of shares is called Net Asset Value

(NAV)

NAV 
 MV Assets  MV Liabilities 
# of shares outstanding

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 Closed-end Investment Companies
Have a fixed number of shares outstanding
like any publicly traded corporation.
Shares are traded and priced in the market.
Market value of close- end fund shares sells
at a 10%-20% discount off the NAV.

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 Closed-end Investment Companies

Size of discount varies by type of closed-

end fund – equity versus bond funds,
domestic vs. global equity funds. [See
Exhibit 20.1].
Discounts could be due to a variety of
reasons including poor management, tax
considerations, and market demand.
The majority of closed-end funds are either
bond funds or global equity funds. [See
Exhibit 20.2]
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Closed End Funds

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 Open-end Investment Companies

Most common and dominates asset

holdings.
Mutual funds stand ready to buy(redeem) or
sell their shares at the current market price
of assets - net asset value.
No limit to the number of shares issued.

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 Exchange-Traded Funds (ETF)
First introduced in 1989 at Toronto Stock
Exchange
Shares traded on organized exchanges like
closed-end funds
Created with deposit of portfolio of stock.
Tremendous growth since 2000.

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 Exchange-Traded Funds (ETF)
Redemptions in form of stock portfolio
Most track stock index – SPDRs,
DIAMONDS, etc.
ETF shares traded for portfolio of stock—
no large premiums or discounts on ETF
shares because of arbitrage activities.
Tax advantage, low expense ratios, ease of
buying/selling and ease of tracking prices.

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Assets of ETFs

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No. of ETFs – Exhibit 20.3 (continued)

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Selected ETFs on the AMEX

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 Investment Trust or Unit Trust.
Assets are not actively managed.
Provide small denomination share claims against a
diversified, fixed portfolio of securities.
Trust sponsors usually will repurchase shares at
net asset value, less a commission.

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 Importance of Investment Companies
Investments in mutual funds exploded in the
1990s because
Many new funds were developed.
Individual Retirement Accounts (IRAs) were
developed.
The shift of many pension plans from defined benefit to
defined contribution plans(401k).
Increased investment by baby boomers.
The high rates of return available on common stocks.
Primary vehicle for retirement savings.
By year-end 2003, 8126 mutual funds exist in the
U.S. holding a total of over $7.0 trillion in assets.
[See Exhibit 20.5]
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Growth of Mutual Funds

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 Investment composition of investment funds

Composition varies with economy

Cash Holdings - Short-term liquid assets
Hold more cash items when interest rates rising and
high
Reduce short-term securities, buy long term when rates
are at peak and falling
Delayed redemption and paid-in-kind redemption
policies, along with bank lines of credit have reduced
the proportion of cash held.
Shift to equity funds in the late 1990s – 49% of all
assets held by mutual funds.
Composition varied over time. [See Exhibit 20.6]

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 Types of Investment Funds

Growth and income funds

Growth funds
Aggressive growth funds
Balanced funds
Income funds
Specialty funds.
Global
Tax-exempt
Sector
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 Types of Investment Funds
Growth & Income Funds
They seek a balance between capital gains and current
income.
Mostly invest in highly rated companies’ stock.
Ideal for investors who are looking for some income,
but would also want to invest in growth stocks.
Growth Funds
The objective of growth funds is to invest in industries
and companies that are not mature and are still
experiencing sizable growth.
Investors looking for a higher return and a moderate
risk are attracted to such funds.
Focus is on capital appreciation rather than steady
income so investors’ outlook needs to be long-term.

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 Types of Investment Funds
Aggressive Growth Funds
These are similar to growth funds in their
outlook, but are more risky because they focus
on emerging industries and unproven firms.
Investors trade off a very high return potential
for high risk.

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 Types of Investment Funds

Balanced Funds
Such funds are a hybrid portfolio of growth stocks
and fixed-income securities.
The proportion of each determines the level of
return for each fund.
Generates higher proportion of income than
growth and income funds and are less volatile.
Investors who have a few more years to retirement
and are typically in their early 50s are attracted to
such funds.

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Types of Investment Funds
Income Funds
Income funds consist of bonds that provide steady
coupon cash flows and are quite varied in their risk
level.
Income funds could be made up of a portfolio of
entirely corporate bonds (risky) or a portfolio of
entirely Treasury issues (no default risk) or of
mortgage-backed securities.
Income funds are exposed to not only default risk,
but also to interest rate risk.
Such income funds are attractive to investors close
to retirement age as the income stream of fund’s
instruments provides them with necessary income.

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 Mutual Fund Families
Mutual fund managing companies market a
variety of types of mutual funds to investors,
called families of funds.
The intent is to provide an opportunity to change
risk, asset, term and other investment profiles
without changing mutual fund companies or
retirement account manager.
Funds may be switched from fund to fund at
nominal charges.

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 Mutual Fund Families (concluded)

Other services may include:

discount brokerage service - purchase/sale of
individual direct securities, such as stocks and
bonds.
Transaction Accounts - check writing and/or
debit card relationship to mutual fund.
Pension fund management for businesses

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 Regulation of Mutual Funds-SEC and States

Regulation relates to adequate required

disclosure, adequate diversification, sales
practices, and management practices. [See
People & Events Exhibit]
Federal laws
Securities Act of 1933
SEC Act of 1934
Investment Company Act of 1940 and 1970
Mutual funds income and capital gains are
not taxed-owners of shares are.

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 Mutual Fund Fee Structures
Load funds - investor pays a sales commission
when shares are purchased from brokers.
No-load funds - no initial sales fees, but other
charges (Bank-end load, contingent deferred sales
charge, or redemption fees) may be levied for
services provided.
12b-1 fees - an annual fee levied against fund
assets by some funds.
Management or advisory fees
Exchange fees and account maintenance fees.

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 Hedge Funds
Hedge funds comprise investment pools that use a
combination of market philosophies and analytical
techniques.
Hedge funds seek to develop financial models to
identify, evaluate, and execute trading decisions.
Hedge funds typically are organized as limited
partnerships.
The goal of a hedge fund is providing consistent,
above-market returns while reducing the risk of
loss.

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 Hedge Funds Differ from Mutual Funds
Hedge funds are private, unregistered investment
pools open to a limited number of accredited
investors.
Hedge fund managers receive a fee that is based
on their performance.
Mutual funds are heavily regulated investment
pools registered with the SEC that are open to all
investors.
Mutual fund managers receive a fee that is
percentage of the assets under management.

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 Hedge Fund Investment Strategies

Traditional hedge fund strategies include:

domestic hedge strategies.
global hedge strategies.
global macro strategies.
market neutral strategies.
sector strategies.
short strategies.

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 Arbitrage Hedge Fund Investment Strategies

Arbitrage hedge fund strategies include:

Fixed income arbitrage.
Index arbitrage.
Closed-end fund arbitrage.
Convertible arbitrage.

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 Event-driven Investment Strategies

Event-driven hedge fund strategies include:

Risk arbitrage.
Distressed securities.
Special situation.

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 Money Market Mutual Funds (MMMF)

Short-term money market investments.

Provide excellent liquidity for investors.
High quality and high yield when yield
curve is inverse.
Compete with bank deposits.

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 Growth of MMMFs & Reg. Q
When market rates were above Regulation Q
maximum deposit rates, MMMFs grew rapidly.
Banks were able to compete after the 1982
Depository Institutions Act when they were
permitted to offer insured, Money Market Deposit
Accounts (MMDA).
MMMF offer higher yields than bank MMDA’s?

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 MMMFs’ Role in the Economy
At year end 2001, MMMFs had peaked at over $2
trillion worth of shares outstanding and by 2003
declined to $1.763 billion.
MMMFs offer transactional conveniences that
make them very competitive with bank deposits.
Check writing privileges, debit cards, wire transfers,
sweep features.
MMMFs that invest in tax-exempt securities can
pass through interest payments that are exempt
from federal (and possibly state) income taxes.
Interest earned on bank deposits is fully taxable.
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Growth of MMMFs

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Real Estate Investment Trust (REIT)

An investment fund selling shares and

investing in real estate related assets
Own income property.
Acquire mortgages.
Finance real estate development and
construction.
Acquire and lease property.

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 Real Estate Investment Trust (REIT)
Regulated under federal Real Estate Investment
Act of 1960 and state regulation
REITs are exempt from federal income tax is they
accrue a minimum of 75% of income from real
estate investments and pay 90% of their net
income to shareholders.
Grew rapidly in the inflationary boom period of
the late 1960s and early 1970s, then the bubble
burst
Financed short (commercial paper) and invested
long in rising rate environment

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