44THE PREVIOUS CHAPTER introduced you to the mechanics of trading securities and the structure of the markets in which securities trade. Commonly, however, individual inves-tors do not trade securities directly for their own accounts. Instead, they direct their funds to investment companies that purchase secu-rities on their behalf. The most important of these financial intermediaries are open-end investment companies, more commonly known as mutual funds, to which we devote most of this chapter. We also touch briefly on other types of investment companies such as unit investment trusts, hedge funds, and closed-end funds. We begin the chap-ter by describing and comparing the various types of investment companies available to investors. We then examine the functions of mutual funds, their investment styles and pol-icies, and the costs of investing in these funds. Next we take a first look at the investment performance of these funds. We consider the impact of expenses and turnover on net per-formance and examine the extent to which performance is consistent from one period to the next. In other words, will the mutual funds that were the best past performers be the best future performers? Finally, we dis-cuss sources of information on mutual funds, and we consider in detail the information provided in the most comprehensive guide, Morningstar’s Mutual Fund Sourcebook.Mutual Funds and Other Investment Companies CHAPTER FOUR PART I 4.1 Investment Companies Investment companies are financial intermediaries that collect funds from individual investors and invest those funds in a potentially wide range of securities or other assets. Pooling of assets is the key idea behind investment companies. Each investor has a claim to the portfolio established by the investment company in proportion to the amount invested. These companies thus provide a mechanism for small investors to “team up” to obtain the benefits of large-scale investing. Investment companies perform several important functions for their investors: 1 . Record keeping and administration. Investment companies issue periodic status reports, keeping track of capital gains distributions, dividends, investments, and redemptions, and they may reinvest dividend and interest income for shareholders. bod30700_ch04_092-116.indd 926/21/10 12:22 PM
CHAPTER 4 Mutual Funds and Other Investment Companies 93 2. Diversification and divisibility. By pooling their money, investment companies enable investors to hold fractional shares of many different securities. They can act as large investors even if any individual shareholder cannot. 3. Professional management. Investment companies can support full-time staffs of security analysts and portfolio managers who attempt to achieve superior invest-ment results for their investors. 4. Lower transaction costs. Because they trade large blocks of securities, investment companies can achieve substantial savings on brokerage fees and commissions. While all investment companies pool assets of individual investors, they also need to divide claims to those assets among those investors. Investors buy shares in investment companies, and ownership is proportional to the number of shares purchased. The value of each share is called the net asset value, or N AV. Net asset value equals assets minus liabilities expressed on a per-share basis: Net asset value5Market value of assets minus liabilitiesShares outstandingExample 4.1 Net Asset Value Consider a mutual fund that manages a portfolio of securities worth $120 million. Suppose the fund owes $4 million to its investment advisers and owes another $1 million for rent, wages due, and miscellaneous expenses. The fund has 5 million shares outstanding. Net asset value5$120 million2$5 million5 million shares5$23 per share CONCEPT CHECK 1 Consider these data from the March 2009 balance sheet of Vanguard’s Global Equity Fund. What was the net asset value of the fund?Assets: $3,035.74 million Liabilities: $ 83.08 million Shares: 281.69 million 4.2 Types of Investment Companies In the United States, investment companies are classified by the Investment Company Act of 1940 as either unit investment trusts or managed investment companies. The portfolios of unit investment trusts are essentially fixed and thus are called “unmanaged.” In contrast, man-aged companies are so named because securities in their investment portfolios continually are bought and sold: The portfolios are managed. Managed companies are further classified as either closed-end or open-end. Open-end companies are what we commonly call mutual funds. Unit Investment Trusts Unit investment trusts are pools of money invested in a portfolio that is fixed for the life of the fund. To form a unit investment trust, a sponsor, typically a brokerage firm, buys a bod30700_ch04_092-116.indd 936/21/10 12:22 PM