CHAPTER 4: MUTUAL FUNDS AND OTHER INVESTMENT
COMPANIES
CHAPTER OVERVIEW
This chapter describes the various types of investment companies and mutual funds. The chapter
discusses services, expenses, and loads associated with investing in mutual funds. It describes the
investment policies of different funds and lists sources of information on investment companies.
The chapter surveys the returns of mutual fund managers over time searching for consistency of
performance. Finally, it presents sources of information on mutual funds and considers in detail
the information provided in the most comprehensive guide, Morningstar’s Mutual Fund
Sourcebook.
LEARNING OBJECTIVES
After studying this chapter, the students should be able to identify key differences between open-
end and closed-end investment companies. Students should be able to describe the expenses
associated with investment in mutual funds and identify the major types of investment policies of
mutual funds. Students should be able to describe services provided by mutual funds and be able
to identify sources of information on investment companies.
PRESENTATION OF MATERIAL
4.1 Investment Companies (PowerPoint Slides 3–4)
Key services provided by investment companies are presented in this section. These include
services that are related to scale factors such as reducing transaction costs, diversification, and
divisibility. Mutual funds can trade securities at lower costs because of the size of the trades and
because they are trading larger dollar volumes with brokerage firms. Investment companies
perform several important functions for their investors such as record keeping and
administration. Diversification and divisibility, professional management, and lower transaction
costs. The concept of Net Asset Value (NAV), presented first here, is important for
understanding pricing and performance of investment companies.
4.2 Types of Investment Companies (PowerPoint Slides 5–7)
A unit investment trust is a pool of funds invested in a portfolio that is fixed for the life of the
fund. Trusts are often set up for fixed-income securities. The trust life is dependent on the
maturity of the securities. There are two types of managed investment companies: closed-end and
open-end. Since the shares in closed-end funds are acquired in secondary markets, prices for
such shares are commonly at premiums or discounted from the underlying net asset value.
Students should understand these differences when viewing quotes for closed-end funds in
Figure 4.1.
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Other types of investment companies include commingled funds, which are partnerships for
investors that pool their funds. Commingled funds are commonly used in trust accounts for
which investors do not have large enough pools of funds to warrant individual management.
REITs (Real Estate Investment Trusts) are investment vehicles that are similar to closed-end
funds but they invest in real estate or in loans secured by real estate. REITs often employ
financial leverage and offer an investor the possibility to invest in real estate with professional
management.
Like mutual funds, hedge funds are vehicles that allow private investors to pool assets to be
invested by a fund manager. Unlike mutual funds, however, hedge funds are commonly
structured as private partnerships and thus subject to only minimal SEC regulation. They
typically are open only to wealthy or institutional investors.
4.3 Mutual Funds (PowerPoint Slides 8–13)
The major types of mutual funds classified by investment policy are identified here. For
example, in the equity funds group, some funds emphasize growth while others emphasize
income. Within the money market group, some funds limit their investment to very short-term
U.S. Government securities while others may invest in securities with longer maturities and
greater risk of default. Some money market funds invest in derivatives. Table 4.1 shows the
breakdown by assets of mutual funds by investment classification in the United States.
Mutual funds can be marketed directly or sold through a sales force. Revenue sharing
agreements are often used by the industry and may create conflicts of interest. Mutual funds are
also sold through financial supermarkets individuals access a wide variety of funds in one
location.
4.4 Costs of Investing in Mutual Funds (PowerPoint Slides 14–17)
This section discusses issues relevant to costs associated with investing in mutual funds such as
operating expenses. Funds with a front-end load initially reduce the investment amount. A back-
end load or exit fee is charged when the shares are redeemed. It is common for an exit fee or the
back-end load to become smaller with longer investment periods. The 12b-1 charges on no-load
funds are an alternative to a load. When comparing expense ratios on funds, the 12b-1 charges
should be considered since they are funds that are not invested. Example 4.2 illustrates fees for
various classes. Operating expenses that are reported may not fully reflect operating costs
because of the issue of soft-dollar payments. Fees and mutual fund returns are discussed next
followed by Table 4.2 which illustrates how different free structures affect return over time. This
section also introduces the concept of soft dollars, which are not included in the fund’s expenses
resulting in artificially low expense ratios.
4.5 Taxation of Mutual Fund Income (PowerPoint Slide 18)
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McGraw Hill LLC.
Investor directed portfolios can take advantage of tax consequences but mutual fund investments
cannot be structured to take advantage of specific tax considerations. High turnover or the ratio
of trading activity to the assets of the portfolio leads to tax inefficiency.
4.6 Exchange Traded Funds (PowerPoint Slides 19–22)
Exchange Traded Funds have become popular and offer investors alternatives to traditional
mutual funds. Key aspects on ETFs are discussed in this section. ETFs allow investors to trade
portfolios of indexes as individual shares of stock. A wide variety of indexes, both international
and domestic can be traded. Some advantages include lower taxes and costs as well as the ability
to trade the index portfolios intra-day. Potential disadvantages include price deviation from NAV
and payment of brokerage fees to trade the funds. Figure 4.2 makes clear the significant number
of commodity, bond, and international ETFs.
4.7 Mutual Fund Investment Performance: A First Look (PowerPoint Slides 23–24)
The evidence on mutual fund performance does not show a consistent superior performance to
broad market indexes. Evidence shows a tendency for some persistence in superior performance
by funds but the evidence is far from conclusive. If you look at performance against broad
market indexes, most of the performance is less than broad investment portfolios. As Figure 4.4
shows, by illustrating the rates of return on actively managed equity funds versus Wilshire 5,000
index, over a long horizon, most funds underperform the broad market.
4.8 Information on Mutual Funds (PowerPoint Slides 25–26)
A partial list of sources of information on mutual funds appears in this section. As the popularity
of mutual funds has grown in recent years, nearly all major business publications feature some
reporting on performance of mutual funds. Morningstar’s website www.morningstar.com is an
excellent source of information as is Yahoo!’s website www.finance.yahoo.com/funds.
Excel Applications
Connect Integrated Excel models are available for a variety of learning outcomes in this chapter.
Please utilize the questions developed in Connect!
KEY TERMS
investment company closed-end fund 12b-1 fees
net asset value (NAV) load soft dollars
unit investment trust hedge fund turnover
open-end fund funds of funds exchange-traded funds
(ETFs)
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McGraw Hill LLC.
