Practice investment management pim3 ch21

CHAPTER TWENTY-ONE INVESTMENT COMPANIES Practical Investment Management Robert A Strong Outline  The Investment Company Industry     Open-End Investment Companies Closed-End Investment Companies Regulation Fees  Selecting a Mutual Fund     Rationale Eligibility Interpreting Past Performance Types of Funds South-Western / Thomson Learning © 2004 21 - Outline  Information Sources  Company Information  Commercial Services South-Western / Thomson Learning © 2004 21 - The Investment Company Industry  The investment company industry is a significant portion of the financial landscape in the United States  The automatic diversification and professional management provided by mutual funds make it simple for even the smallest investor to participate in the capital markets  There are two types of investment companies: open-end funds and closed-end funds South-Western / Thomson Learning © 2004 21 - Open-End Investment Companies  An open-end investment company is commonly called a mutual fund  A mutual fund has no limit on the size of the fund or the number of shares outstanding  The value of a mutual fund share is called its net asset value  Mutual fund shares are not sold in the traditional sense Instead, they are redeemed by the fund management South-Western / Thomson Learning © 2004 21 - Open-End Investment Companies Insert Figure 21-1 here South-Western / Thomson Learning © 2004 21 - Open-End Investment Companies  Upon opening an account with a mutual fund, the investor must select from among several options  Some common options are : - automatic reinvestment option - automatic monthly investment plan - limit order option - periodic payment option - telephone redemption option - switching option South-Western / Thomson Learning © 2004 21 - Closed-End Investment Companies  A closed-end investment company has a fixed number of shares  Investors buy and sell these shares on an exchange just like shares of stock  The pricing of closed-end fund shares is a financial puzzle - they usually sell at a discount to their net asset value South-Western / Thomson Learning © 2004 21 - The Investment Company Industry : Regulation  Almost all mutual funds choose to organize as a regulated investment company, so that any tax liability on capital gains and income can be passed on to the accountholders  The Investment Company Act of 1940 provides the potential investor with some degree of protection from misleading advertising or incomplete investment information South-Western / Thomson Learning © 2004 21 - The Investment Company Industry : Regulation  The Investment Company Amendments Act of 1970 serves primarily to clarify legal points It mandates that the fund manager and the board of directors be held to fiduciary standards in their actions  Many states have their own version of the Securities and Exchange Commission Today, these blue sky laws function largely to inform investors of the suitability of certain proposed investments South-Western / Thomson Learning © 2004 21 - 10 Selecting A Mutual Fund : Types of Funds Insert Table 21-2 here South-Western / Thomson Learning © 2004 21 - 23 Information Sources : Company Information  The prospectus is a legal document describing the operation of the fund, its management, and the fees accountholders must pay  One important item in the prospectus is the fund’s portfolio turnover rate A higher rate usually means higher expenses  The Statement of Additional Information is required by the SEC, although it is generally only sent to accountholders upon their request It is a more detailed version of the prospectus South-Western / Thomson Learning © 2004 21 - 24 Information Sources : Commercial Services  Most public libraries carry some reference material, such as the Morningstar Mutual Funds and the Thomson Financial Investment Company Survey  The internet is also a good source  Several periodicals like Forbes, Fortune and BusinessWeek provide excellent coverage of the investment company industry  Some organizations like the Investment Company Institute also publish some educational material for the public South-Western / Thomson Learning © 2004 21 - 25 Review  The Investment Company Industry      Open-End Investment Companies Closed-End Investment Companies Regulation Fees Selecting a Mutual Fund     Rationale Eligibility Interpreting Past Performance Types of Funds South-Western / Thomson Learning © 2004 21 - 26 Review  Information Sources   Company Information Commercial Services South-Western / Thomson Learning © 2004 21 - 27 Appendix: Tax Considerations  Municipal securities Interest on a municipal bond is exempt from federal tax  An in-state municipal bond is not subject to state income tax  South-Western / Thomson Learning © 2004 21 - 28 Appendix: Tax Considerations  Taxable equivalent yield: the yield a taxable security would have to offer to provide the same after-tax return, including the effects of federal, state, and local taxes Taxable equivalent yield = Rtaxfree - [(Rstate + Rlocal )(1 − R federal ) + R federal ] South-Western / Thomson Learning © 2004 21 - 29 Appendix: Tax Considerations  Deeply discounted securities:  If the discount exceeds 0.25% multiplied by the remaining years until maturity, the IRS considers the municipal bond to be deeply discounted South-Western / Thomson Learning © 2004 21 - 30 Appendix: Tax Considerations  Treasury Securities  Treasury security interest is exempt from state and local income taxes South-Western / Thomson Learning © 2004 21 - 31 Appendix: Tax Considerations  Preferred Stock:  Most preferred stock owned by other corporations  Corporations can avoid paying taxes on 70% of their dividend income from portfolio investments Dividend Price = Rate of Return South-Western / Thomson Learning © 2004 21 - 32 Appendix: Tax Considerations  Reductions in the capital gains tax increases the attractiveness of growth stocks and growth mutual funds South-Western / Thomson Learning © 2004 21 - 33 Appendix: Special Considerations with Mutual Funds Distributions Income and capital gains distributions Reinvested dividends Return of capital distribution Cost Methods Average cost method FIFO Specific identification method Commissions South-Western / Thomson Learning © 2004 21 - 34 Mutual Fund Account Activity South-Western / Thomson Learning © 2004 21 - 35 Appendix: Tax Swaps Tax swaps with bonds Tax swaps with mutual funds South-Western / Thomson Learning © 2004 21 - 36 Sample Bond Data South-Western / Thomson Learning © 2004 21 - 37 ...Outline  The Investment Company Industry     Open-End Investment Companies Closed-End Investment Companies Regulation Fees  Selecting a Mutual... The Investment Company Industry  The investment company industry is a significant portion of the financial landscape in the United States  The automatic diversification and professional management. .. There are two types of investment companies: open-end funds and closed-end funds South-Western / Thomson Learning © 2004 21 - Open-End Investment Companies  An open-end investment company is