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Samenvatting - Investment Analysis & Portfolio Managment (B3T2102)
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Literatuur samenvatting Investment Analysis & Portfolio management
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The investment landscapeChapter 4: mutual funds and other investment companies
If you do not wish to actively buy and sell individual securities on your own, you can invest in stocks,
bonds or other financial assets through a mutual fund. Mutual funds are a means of combining or
pooling the funds of a large group of investors. The buy and sell decisions for the resulting pool are
then made by a fund manager, who is compensated for the service provided.
One of the reasons for the proliferation of mutual funds is that they have become, on a basic level,
consumer products. They are created and marketed to the public in ways that are intended to
promote buyer appeal.
Investing in mutual funds offers many advantages. Three of these are diversification, professional
management, and the size of the initial investment. When you invest in a mutual fund, you are
investing in a portfolio, or basket, of securities. Holding a diversified portfolio helps you reduce risk. A
mutual fund might invest in hundreds (or thousands) of securities. If the value of one of them falls to
zero, this decline will have a small impact on the mutual fund value. Diversification helps you reduce
risk, but diversification does not eliminate risk. It is still possible for you to lose money when you
invest in a mutual fund. Also, not all mutual funds are diversified.
Professional money managers make investment decisions for mutual funds: the mutual fund manager
makes the decision of when to add or remove particular securities from the mutual fund. This means
that you, as the investor holding the mutual fund, do not have to make these crucial decisions.
Most mutual funds have a minimum initial purchase of $2,500, but some of $1,000 or $250.
There are also drawbacks of mutual funds: risk, costs and taxes. The value of your mutual fund
investment could fall and be worth less than your initial investment. There is a cost to diversification.
Diversification greatly reduces the risk of loss from holding one (or a few) securities. However, by
spreading your investments over many securities, you limit your chances for large returns if one of
these securities increases dramatically in value.
Investing in mutual funds entails fees and expenses that do not usually accrue when purchasing
individual securities directly.
When you invest in a mutual fund, you will pay federal income tax on distributions (dividend and
capital gains) made by the mutual fund, and on profits you make when you sell mutual fund shares.
At the most basic level, a company
that pools funds obtained from
individual investors and invests them
is called an investment company. In
other words, an investment company
is a business that specializes in
managing financial assets for
individual investors. All mutual funds
are investment companies, but not
,all investment companies are mutual funds.
There are two fundamental types of investment companies: open-end funds and closed-end funds.
Whenever you invest in a mutual fund, you do so by buying shares in the fund. However, how shares
are bought and sold depends on which type of fund you are considering.
With an open-end fund, the fund itself will sell new shares to anyone wishing to buy and will
redeem shares from anyone wishing to sell. When an investor wishes to buy open-end fund shares,
the fund issues them and then invests the money received. When someone wishes to sell open-end
fund shares, the fund sells some of its assets and uses the cash to redeem the shares. As a result,
with an open-end fund, the number of shares outstanding fluctuates over time.
With a closed-end fund, the number of shares is fixed and never changes. If you want to buy shares,
you must buy them from another investor. Similarly, if you wish to sell shares that you own, you must
sell them to another investor.
Thus, the key difference is that, with a closed-end fund, the fund itself does not buy or sell shares. In
fact, shares in closed-end funds are listed on stock exchanges like ordinary shares of stock, where
their shares are bought and sold in the same way. Open-end funds are much more popular among
individual investors than closed-end funds.
The distinction between the two types are not always clear-cut. For example, some open-end funds
‘close their doors’ to new investors. The typical reason for this decision is fund size. If the fund gets
too large, exercising effective control over the fund’s investments will be difficult for the fund
managers. When an open-end fund no longer accepts new investors, existing investors generally can
continue to add money to the fund. Existing investors can also withdraw money from the fund.
Strictly speaking, the term mutual fund refers only to an open-end investment company.
A mutual fund’s net asset value is an important consideration. Net asset value is calculated by taking
the total value of the assets held by the fund less any liabilities and then dividing by the number of
outstanding shares. With one important exception, the net asset value of a mutual fund will change
essentially every day because the value of the assets held by the fund fluctuates. The one exception
concerns money market mutual funds.
An open-end fund will generally redeem or buy back shares at any time. The price you will receive for
shares you sell is the net asset value. Because the fund stands ready to redeem shares at any time,
shares in an open-end fund are always worth their net asset value. In contrast, because the shares of
closed-end funds are bought and sold in the stock markets, their share prices at any point in time may
or may not be equal to their net asset value.
A mutual fund is a corporation and thus owned by its shareholders. The shareholders elect a board of
directors; the board of directors is responsible for hiring a manager to oversee the fund’s operations.
Although mutual funds often belong to a larger family of funds, every fund is a separate company
owned by its shareholders.
Most mutual funds are created by investment advisory firms, which are businesses that specialize in
managing mutual funds. Investment advisory firms are also called mutual fund companies -> create
mutual funds because they wish to manage them to earn fees. A typical management fee might be
,0.5% of the total assets in the fund per year. Thus, there is a large significant economic incentive to
create funds and attract investors to them.
In principle, the directors of a mutual fund in a particular family, acting on behalf of the fund
shareholders, could vote to fire the investment advisory firm and hire a different one. As a practical
matter, this rarely occurs. Part of the reason is that the directors are originally appointed by the fund’s
founder, and they are routinely re-elected. Unhappy shareholders generally vote with their feet: they
sell their shares and invest elsewhere.
As long as an investment company meets certain rules set by the IRS, it is treated as a regulated
investment company for tax purposes. This is important because a regulated investment company
does not pay taxes on its investment income. Instead, the fund passes through all realized investment
income to fund shareholders, who then pay taxes on these distributions as though they owned the
securities directly. Essentially, the fund acts as a conduit, funneling gains and losses to fund owners.
To qualify as a regulated investment company, the fund must follow three basic rules. The first rule is
that it must in fact be an investment company holding almost all of its assets as investments in
stocks, bonds and other securities. The second rule limits the fun to using no more than 5% of its
assets when acquiring a particular security. This is a diversification rule. The third rule is that the fund
must pass through all realized investment income to fund shareholders.
Mutual funds are required by law to produce a document known as prospectus, which is supplied to
any investor wishing to purchase shares. Mutual funds also provide an annual report to their
shareholders. The annual report and the prospectus, which are sometimes combined, contain
financial statements along with specific information concerning the fund’s expenses, gains and
losses, holdings, objectives and management.
Fund companies have thousands of individual investors. For closed-end funds, this fact is of little
consequence because investor transactions take place in the secondary market. For an open-end
fund, however, on a given day, the fund company could receive thousands of buy and sell orders for
each of its mutual funds. To reduce the cost and complexity of dealing with so many transactions,
fund companies accrue all transactions until the end of the day. That way, they can net out fund
inflows and outflows and thereby reduce the number of transactions they have to make in the market
on a given day. This clearing process is one reason why mutual funds are not attractive to active
investors such as day traders.
Another unique feature of mutual fund investing is how an investor would specify the amount he or
she wishes to purchase. When you buy and sell stocks, you generally enter the number of shares you
wish to purchase or sell, which in turn determines the amount you will pay or receive. With mutual
funds, however, investors enter the dollar amount that they wish to purchase. Based on the NAV at
the time, this in turn determines the number of shares the investor will receive. Because investor
amounts and fund NAVs are not always nice round numbers, investors often end up holding fractional
shares.
, All mutual funds have various expenses that are paid by the fund’s shareholders. These expenses
can vary considerably from fund to fund, and one of the most important considerations in evaluating a
fund is its expense structure. All else the same, lower expenses are preferred.
There are four types of expenses or fees associated with buying and owning mutual fund shares:
1. Sales charges or “loads”
2. 12b-1 fees
3. Management fees
4. Trading costs
Many mutual funds charge a fee whenever shares are purchased. These fees are generally called
front-end loads. Funds that charge loads are called load funds. Funds that have no such charges are
called no-load funds. When you purchase shares in a load fund, you pay a price in excess of the net
asset value, called the offering price. The difference between the offering price and the net asset
value is the load. Shares in no-load funds are sold at net asset value.
Front-end loads can range as high as 8.5%, but 5% would be more typical. Some funds with
front-end loads in the 2-3% range are described as low-load funds.
Front-end loads are expressed as a percentage of the offering price, not the net asset value.
Some funds have “back-end” loads, which are charges levied on redemptions. These loads are often
called contingent deferred sales charges (CDSC). The CDSC usually declines through time.
Different loads are typically designated with letters. For example, front-end loads are often known as
A-shares. Back-end loads are designated as B-shares, and level loads are called C-shares. With the
back-end and level loads, the fund companies often increase other fees associated with the fund. As
it happens, B-shares appear to be a dying breed and have mostly disappeared.
Mutual funds are allowed to use a portion of the fund’s assets to cover distribution and shareholder
service costs. Funds that market directly to the public may use 12b-1 fees to pay for advertising and
direct mailing costs. Funds that rely on brokers and other sales force personnel often use 12b-1 fees
to provide compensation for their services. Frequently, 12b-1 fees are used in conjunction with a
CSDC. Such funds will often have no front-end load, but they efficiently make it up through these
other costs. Such funds may look like no-load funds, but they are really load funds in disguise. Mutual
funds with no front-end or back-end loads and no or minimal 12b-1 fees are often called “pure”
no-load funds to distinguish them from the “not-so-pure” funds that may have no loads but still
charge hefty 12b-1 fees.
As compensation for managing a fund, the fund company receives a management fee. The
management fee is generally charged as a percentage of assets held. Rather than reporting all the
fees separately, fund companies often report their expense ratio: an all-inclusive fee percent that
includes both 12b-1 fees and management fees, as well as any other administrative or operating
costs.
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