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1 CHAPTER 6 INVESTMENT COMPANIES: MUTUAL FUNDS By Dr. M. Metghalchi Investment Companies = take the proceeds of individual investors & reinvest them in other securities. They provide the following services (Rational for Investment Companies): •Administration & record keeping •Diversification & divisibility •Professional management •Reduced transaction costs All mutual funds are investment companies but all investment companies are not mutual funds. For example a Hedge fund is a type of investment company but is not a mutual fund because they are not really regulated like mutual funds. Another example of an investment company that is not a mutual fund is Unit Investment Trusts : portfolio is fixed for the life of the Trust, Mostly Fixed income. No active management in this case, they are called Unmanaged. A trustee (a bank or trust company) organizes the investment company. However, for simplicity we will call all investment companies as mutual funds Investment companies, which include mutual funds, receive special tax treatment provided they distribute the income they receive and capital gains they realize. Mutual funds collect dividends and interest on their investments and then distribute the income to stockholders. Any applicable taxes are paid by the fund's stockholders as part of the tax on their incomes. Net Asset Value (NAV) Used as a basis for valuation of investment company shares. They sell new shares at NAV They redeeming existing shares at NAV Calculation of NAV:
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2 The net asset value is equal to the current value of the securities owned by the fund minus any liabilities divided by the number of shares outstanding NAV = ( Market Value of Assets – Liabilities)/Shares Outstanding Example: Consider a mutual fund with $200 million in assets at the start of the year and with 10 million shares outstanding and no liability. The fund invests in a portfolio of stocks that provides dividend income at the end of the year of $2 million. The stocks included in the fund’s portfolio increase in price by 8%, but no securities are sold and there are no capital gains distributions. The fund charges 12b-1 fees of 1 %, which are deducted from portfolio assets at year-end. What is the NAV at the start and end of the year? What is the rate of return of the fund? SOLUTION: Start of the year NAV = $200m/ 10 m =$20 Dividends per share = $2M/10 M = $0.20 End of the year NAV is based on the 8% price gain, less the 1% 12b-1 fee: End of year NAV = $20 × (1.08) × (1 – 0.01) = $21.384 Rate of return = 20 $ 20 . 0 $ 20 $ 384 . 21 $ + = 0.0792 = 7.92% We usually have two types of Mutual Funds (MF). Closed end and open-end mutual funds. In both cases, the board of directors of the fund (elected by shareholders) hire management companies to manage the fund’s portfolio for a fee (.2% to 1.5% per annum). This fee is part of operating expenses of the fund. Usually, management of the fund is the firm that organizes the Fund. Example: Fidelity both organizes & manages.
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