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Investment Analysis and Portfolio Management

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Investment Analysis & Portfolio Management (FIN630)
Lesson # 20
Investing Indirectly:
Indirect investing in this discussion usually refers to the buying and selling of the shares of
investment companies' that, in turn, hold portfolios of securities. Most of our attention is
focused on investment-companies, arid mutual funds in particular, because of their
importance to investors. However, we will conclude the chapter with a discussion of
Exchange-Traded Funds (ETFs), which represent a bridge between direct and indirect in
vesting. Investors buy ETFs like any other stock, but many ETFs can be compared to
index mutual funds.
The decision of whether to invest directly or indirectly is an important one that all investors
should think about carefully. Because-each alternative has possible advantages arid
disadvantages, it is not necessarily easy to choose one over the other. Investors can be,
active investors, investing directly, or passive investors, investing indirectly. Of course, they
can do both at the same time, and many individuals do exactly that!
An investment company such as a mutual fund is a clear alternative for an investor seeking
to own-stocks and bonds. Rather .than purchase securities and manage a portfolio, investors'
can, in effect, indirectly invest by turning their money over to an investment company
which will do all the work and make all the decisions (for a fee,-of course). Investors who
purchase shares of a particular portfolio managed by an investment company
The primary difference is that the investment company stands between the investors and the
portfolio of securities, Although technical qualifications exist, the point about indirect
investing is that investors gain and lose through the investment company's activities in the
same manner that they would gain and lose from holding a portfolio directly. The
differences are the, costs (any sales charges plus the management fee) and the benefits
which consist of additional services gained from the investment company, such as
recordkeeping and check-writing privileges.
The line between direct and indirect investing is becoming blurred. For example,
investors can invest indirectly by investing directly-- 'that is, they can buy various mutual
funds through their brokerage accounts. This is explained at the end of the chapter when we
discuss fund "supermarkets." And, as noted above, ETFs have characteristics of both direct
and indirect investing.
What Is An Investment Company?
An investment company is a financial service organization that sells shares in it to the
public and uses the funds it raises to invest in a portfolio of securities such as money market
instruments or stocks and bonds. By pooling the funds of thousands of investors, a widely
diversified portfolio of financial assets can be purchased and the investment company can
offer its owners (shareholders) a variety of services.
A regulated investment company can elect to pay no federal taxes on any distribution of
dividends, interest, and realized capital gains to its shareholders. The investment company
acts as a conduit, "flowing through" these distributions to stockholders who pay their own
marginal tax, rates on them. In effect, fund shareholders are treated as if they held the
Investment Analysis & Portfolio Management (FIN630)
securities in the fund's portfolio. Shareholders pay the same taxes they would pay if they
owned the shares directly.
Fund taxation is unique with income taxed only once when it is received by its shareholders.
A funds short-term gains and other earnings are taxed to shareholders as ordinary income,
whereas its long-term capital gains are taxed to shareholders as" long-term, capital gains.
Tax-exempt income received by a fund is generally tax exempt to the shareholder.
Investment companies are required by the Investment Company Act of 1940 to register with
the Securities and Exchange Commission (SEC). This detailed regulatory statute contains
numerous provisions designed to protect shareholders. Both federal and state laws require
appropriate disclosures to investors.
It is important to note that investment companies are not insured or guaranteed by any
government agency or by any financial institution from which an investor may obtain
shares. These are risky investments, losses to, investors can and do occur (just think 2000 to
2002), and investment companies' promotional materials state this clearly.
Types of Investment Companies:
All investment companies begin by selling shares in themselves to the public. The proceeds
are then used to buy a portfolio of securities. Most investment companies are managed
companies, offering professional management of the portfolio as one of the benefits. One
less well-known type of Investment Company is unmanaged. We begin here with the
unmanaged type and then discuss the two types of managed investment companies. After
we consider each of the three types, we focus on mutual funds, the most popular type of
investment company by far for the typical' individual investor.
Unit Investment Trusts:
An alternative form of. Investment Company that deviates from the normal managed type is
the unit -investment trust, (OIT), which typically is an unmanaged, fixed-income security
portfolio put together by a sponsor and handled by an independent trustee. Redeemable trust
certificates representing claims against the assets, of the trust are sold to investors at net
asset value plus a small commission. All interest (or dividends) and principal repayments
are distributed to the holders of the certificates. Most unit investment trusts hold either
equities or tax-exempt securities. The assets are almost always kept unchanged, and the trust
ceases to exist when the bonds mature, although it is possible to redeem units of the trust.
In general, unit investment trusts are designed to be bought and held, with capital
preservation as a major objective. They enable 'investors to gain diversification, provide
professional, management that takes care of all the details, permit the purchase of securities
by (he trust at a cheaper; price than, if purchased individually, and ensure minimum
operating costs.. If conditions change, however, investors lose the ability to make rapid,
inexpensive, or costless changes in their positions.
Closed-End Investment Companies:
One of the two types of managed investment companies, the closed-end investment
company, usually sells no additional shares of its own stock after the initial public offering.
Therefore, their capitalizations are fixed, unless a new public offering is made.
The shares of a closed-end fund trade in the secondary markets (e.g., on the-exchanges)
exactly like any other stock.10 To buy and sell, investors use their brokers, paying
Investment Analysis & Portfolio Management (FIN630)
(receiving) the current price at which the shares are selling plus (less) broker age
Open-End Investment Companies (Mutual Funds):
Open-end investment companies, the most familiar type of managed company are popularly
referred to as mutual funds and continue to sell shares to investors after the initial sale of
shares that starts the fund. The capitalization of an .open-end investment company is
continually changing--that is, it is open-ended--as new investors buy additional shares and
some existing shareholders cash in .by selling their shares back to the company.
Mutual funds typically are purchased either:
1. Directly from a fund company, using mail or telephone, or at the company's office
2. Indirectly from a sales agent, including securities firms, banks, life insurance
companies, and financial planners.
Mutual funds may be affiliated with an underwriter, -which usually has an exclusive right
to distribute shares to investors: Most underwriters distribute shares through broker/dealer
Mutual funds are either corporations or business trusts typically formed by an investment
advisory firm that selects the/board of trustees (directors) for the company. The trustees, in
turn, hire a separate management company, normally the investment advisory firm, to
manage the fund. The management company is contracted by the investment company to
perform necessary research and to manage the portfolio, as well as to handle the
administrative chores, for which it receives a fee.
Major Types of Mutual Funds:
The general range of mutual funds arrayed along a return-risk spectrum. As we can see',
money market funds are on the lower end; and bond funds and balanced funds (which hold
both bonds and stocks) are in the middle. Stock funds are on the upper-end of the risk-return
There are two major types of mutual funds:
1. Money market mutual funds
2. Stock (also called equity) funds and bond & income funds
These types of funds parallel of money markets and capital markets. Money market funds
concentrate on short-term investing by holding portfolios of money market assets, whereas
stock funds and bond & income funds concentrate on longer term investing by holding
mostly capital market assets. We will discuss each of these two types of mutual funds in
Money Market Funds:
A major innovation in the investment company industry has been the creation, and subse-
quent phenomenal growth, of money market funds (MMFs), which are open-end investment
companies whose portfolios consist of m6ney market instruments. Created in 1974, when
interest rates were at record-high levels, MMFs grew rapidly as investors sought to earn
Investment Analysis & Portfolio Management (FIN630)
these high short-term rates. However,-with- the deregulation of the thrift institutions,
competition has increased dramatically for investors' short-term savings. Money market
deposit accounts (MMDAs) pay competitive money market rates and are insured, and
therefore have attracted large amounts of funds. Nevertheless in August 2002, money
market mutual fund assets approximated $2.3 trillion.
Money market funds can be divided into taxable funds and tax-exempt funds.
Approximately 85 percent of these assets are in taxable funds. Investors in higher tax
brackets should carefully compare the taxable equivalent yield on tax-exempt money market
funds with that available on taxable funds because the tax-exempt funds often provide an
Taxable MMFs hold assets such as Treasury bills, negotiable certificates of deposit (CDs),
and prime commercial paper. Some funds hold only bills, whereas others hold various
mixtures. Commercial paper typically accounts for 40 to 50 percent of the total assets held
by these funds, with Treasury bills, governmental agency securities, domestic and foreign
bank obligations, and repurchase agreements rounding out" the portfolios. The average
maturity of money market portfolios ranges from approximately one to twp months. SEC
regulations limit the maximum average maturity of money funds to 90 days.
Stock Funds and Bond A Income Funds:
The board of directors (trustees) of an investment company must specify the objective that
the company will pursue in its investment policy! The companies try to follow a consistent
investment policy according to their specified objective. Investors purchase mutual funds on
the basis of their objectives.
The Investment Company Institute, a well-known organization that represents the
investment company industry, uses multiple major categories of investment objectives, most
of which are for equity and bond, & income funds (the remainder are-for money market
funds as previously explained).
Mutual Funds:
Some mutual funds use a sales force to reach investors, with shares being available from
brokers, insurances agents, and financial planners. In an alternative form of distribution
called direct marketing, the company uses advertising and direct mailing to appeal to
investors. About 60 percent of all stock, bond; and income fund sales are made by funds
using a sales force.
Mutual funds can be subdivided into:
1. Load funds (those that charge a sales fee)
No-load funds (those that do not charge a sales fee)
Measures of Fund Performance:
Throughout this text we will use total return to measure the return from any financial asset,
including a mutual fund. Total return for a mutual fund includes reinvested dividends and
capital gains, and therefore includes all of the ways investors make money from financial
Investment Analysis & Portfolio Management (FIN630)
assets. It instated as a percentage or a decimal, and can cover any time periods-one month,
one year, or multiple years.
A cumulative total return measures the actual cumulative performance over a stated
period of time, such as the past 3, 5 and 10 years. This allows die investor to assess total
performance over some stated period of time.
Investing Internationally Through Investment Companies:
The mutual fund Industry has become a global industry. Open-end funds around the world
have grown rapidly, including emerging market economies. Worldwide assets as of mid-
2002 were approximately $11.6 trillion. About 42 percent of worldwide mutual future assets
were invested in equity funds and another 26 percent in money market funds.
Aggregate mutual fund assets in Europe amount to about one-third of the world total. .In
Latin America, roughly one of every 200 people owns a mutual fund (compare to one in
three in the United States). In Japan, mutual fund assets approximate one-half trillion
dollars. In early 1999, there were more than 41,000 funds worldwide.
U.S. investors can invest internationally by buying and selling both mutual funds and
closed-end funds whose shares are traded on exchanges. Funds that specialize in
international securities have become both numerous and well known in recent years.
1. So-called international funds tend to-concentrate primarily on international stocks.
In one recent year, Fidelity Overseas Fund was roughly one-third invested in Europe
and one-third in the Pacific Basin, whereas Kemper International had roughly one-
sixth of its assets in each of three areas, the United Kingdom, Germany, and Japan.
2. Global funds tend to keep a minimum of 25 percent of their-assets in the United
States. For example, in one recent year, Templeton World Fund had over 60 percent
of its assets in the United States and small positions in Australia and Canada.
Most mutual funds that offer "international" investing invest primarily in non U.S. stocks,
thereby exposing investors to foreign markets, which may behave differently from U.S.
markets. However; investors may also be exposed to currency risks. An alternative
approach to international investing is to seek international exposure by investing in U.S.
companies with strong earnings abroad, which is a natural extension of the globalization