Chapter 3: Indirect Investing

CHAPTER OVERVIEW

Chapter 3, covering indirect investing, is a logical sequence to Chapter 2, which focused on direct purchases and sales of assets by investors. Furthermore, investment companies warrant a separate chapter. The importance of investment companies, primarily mutual funds, to investors in the 1990s is obvious, and it continues to increase in the 21st Century. For most investors, investment companies in some form are an integral part of their investing activities. This material deserves emphasis as a separate chapter where the relevant issues can be read and studied as a unified package.

It is also important that investment companies be studied early on in an investments course because of the many references to mutual fund investing that are likely to occur. Students should be exposed to this material early, and make use of it during the course. It may often be the case that term papers or term projects will involve mutual funds and/or other investment companies.

Chapter 3 begins by showing how households have increasingly turned to indirect investing through pension funds and mutual funds. Some discussion of financial intermediation may be appropriate at this point. The dramatic growth in mutual fund assets is illustrated with a graph.

The process of investing indirectly through investment companies is explained and illustrated with a graph. The increasing movement toward “fund superstores” at brokerage houses, thereby combining direct investing with indirect investing, is mentioned.

The basic concept of an investment company is discussed in terms of how it is organized, regulated, and operated. This is followed by a discussion of the three types of investment companies: unit investment trusts, closed-end funds, and open-end funds. Included here is a discussion and illustration of net asset value.

25

Mutual funds receive primary emphasis in Chapter 3 because that is the type of investment company most frequently owned. Money market funds are discussed first, followed by equity and bond & income funds. The types of mutual funds are considered, using the objectives defined by the Investment Company Institute. Value funds and growth funds are considered, and the dramatic growth of all mutual funds is discussed.

The details of indirect investing are considered next. What is involved when buying a mutual fund or closed-end fund in terms of how to do it, the expenses involved, and so forth?

Investment company performance is analyzed in Chapter 3, although a detailed discussion of return and risk measures does not occur until Chapter 6. Performance is explained using actual data for one fund. The consistency of mutual fund performance is explored.

The Eighth Edition contains a discussion of exchange-traded funds because of their emerging importance. Some detail is provided on the differences between ETFs and mutual funds, as well as closed-end funds.

Investing internationally through investment companies is analyzed because many investors are interested in international diversification.

CHAPTER OBJECTIVES

To emphasize the important alternative for all investors of indirect investing, and how it fits in most investors' overall plans when investing.

To explain the various types of investment companies, including how they operate, objectives, expenses, and so forth.

To discuss important issues such as fund performance and how to use funds to invest internationally.

To discuss important new developments in this area, primarily exchange-traded funds.

26

MAJOR CHAPTER HEADINGS [Contents]

[Introduction explains increasing importance of indirect investing to households--the rising ownership of pension fund assets and mutual fund shares]

Investing Indirectly

[diagram showing direct and indirect investing; rise of indirect purchase of investment companies in brokerage accounts]

What Is An Investment Company?

[how organized, regulated, and operated]

Types of Investment Companies

Unit Investment Trusts[definition, characteristics]

Closed-End Investment Companies[characteristics]

Open-End Investment Companies (Mutual Funds)[how organized and operated; net asset value description and calculation; examples using a Fidelity fund; minimum investment requirements]

Major Types of Mutual Funds

Money Market Funds[description; characteristics; holdings]

Equity and Bond and Income Funds[description; objectives of these funds; growth funds and value funds; growth of these funds]

The Growth in Mutual Funds[growth in number of funds; changing distribution of assets by type of fund]

27

The Mechanics of Investing Indirectly

Closed-End Funds[discounts and premiums]

Mutual Funds[load funds, no-load funds, and low-load funds; fees, such as 12b-1; management fee]

Investment Company Performance

[total return; cumulative total return; average annual return--explanation and examples]

Benchmarks

[different funds use different benchmarks]

How Important Are Expenses? [expenses are increasing and investors should be aware]

Consistency of Performance[the controversy continues]

Investing Internationally Through Investment Companies

[international funds; global funds; single-country funds]

New Developments in International Investing[passively managed country funds, WEBS and CountryBaskets]

Exchange-Traded Funds (ETFs)

[mechanics; types; how they work]

Distinguishing Among ETFs, Closed-End Funds, and Mutual Funds

The Future of Indirect Investing

[fund supermarkets offered by brokerage houses]

28

Appendix 3-A Obtaining Information on Investment Companies

Daily and Weekly Price and Performance Information

Obtaining Information About Investment Companies

POINTS TO NOTE ABOUT CHAPTER 3

Tables and Figures

There are no tables in Chapter 3.

Figure 3-1 shows assets of mutual funds for selected years. The dramatic growth in assets is obvious.

Figure 3-2 illustrates the difference between direct investing and indirect investing. The important point here is that indirect investing accomplishes the same things as direct investing.

Figure 3-3 shows basic information for a few closed-end funds. Illustrated are net asset value and market price, and the discounts and premiums that result.

Figure 3-4 shows the minimum investment requirements for mutual funds. These are, all in all, quite low and illustrate that most investors can invest by using mutual funds.

Figure 3-5 shows the major investment objectives of mutual funds. This allows us to organize mutual funds by objective.

Figure 3-6 shows a “style map” for Fidelity’s Equity-Income fund. This map shows at a glance the types of securities a fund invests in—for this fund, large cap, value stocks.

Figure 3-7 shows the assets of stock and bond & income funds over time. Equity funds constitute about 60 percent of the total assets in this category, and have enjoyed recent rapid growth.

Box Inserts

29

Box 3-1 discusses fund taxes. This issue has been in the news quite a lot lately. More and more investors are concerned about the tax efficiency of inefficiency of their mutual funds after what happened in 2000 when a number of funds made very large capital gains distributions even as their NAVs declined sharply in the market drop.

30

ANSWERS TO END-OF-CHAPTER QUESTIONS

3-1. Indirect investing involves the purchase and sale ofinvestment company shares. Since investment companies hold portfolios of securities, an investor owning investment company shares indirectly owns a pro-rata share of a portfolio of securities.

3-2. An investment company is a financial corporation organized for the purpose of investing in securities, based on specific objectives.

• Open-end investment companies (mutual funds) continually sell and redeem their shares, based on investor demands. Shareowners deal directly with the company.

• Closed-end investment companies have a fixed capitalization, and their shares trade on exchanges or over-the-counter.

3-3. A money market fund is an investment company formed

to invest in a portfolio of short-term, highly liquid, low risk money market instruments. Interest is earned daily, and shares can be sold at anytime. There are no sales commissions or redemption fees.

Most money market mutual funds hold a substantial part of their assets in the form of Treasury bills because of their safety and liquidity. In effect, these funds are doing for investors what they could do for themselves if they had enough funds to purchase Treasury bills and earn the going risk-free rate of return directly.

Money market funds have appealed to investors seeking to earn the often-attractive rates being paid on money market instruments but who could not afford the large minimum initial investments required. Liquidity is excellent, and safety has been no problem although an investor’s funds are uninsured. Fund expenses are very low. In addition, most money market funds offer check writing privileges (often with some minimum amount constraint).

The creation of the money market deposit accounts at financial institutions has lessened the appeal of

money market funds. MMDAs are insured, and locally available.

3-4. A closed-end fund selling at a discount is technically worth more dead than alive in the sense that if investors could take over the fund, they could liquidate the portfolio and enjoy a gain. Think of a closed-end selling at a 20 percent discount. If assets could be bought for $0.80 on the dollar and liquidated at face value, in principle a nice gain could be realized. Of course, attempts to take over a fund would likely drive the price up and reduce some, or all, of the potential gain.

3-5. A regulated investment company can elect to pay no federal taxes by “flowing through” distributions of dividends, interest, and realized capital gains to shareholders who pay their own marginal tax rates on these distributions.

3-6. Benefits of money market funds include:

(a) current money market rates can be earned(b) securities with high minimum denominations,

which most investors could not purchase, are held by these funds on behalf of shareholders

(c) diversification(d) check-writing privileges--investors continue

to earn interest until the check actually clears

(e) shares are quickly redeemable by wire (f) no sales charge or redemption charge

(g) interest is earned and credited daily

A possible disadvantage is that these funds are not insured.

The money market deposit accounts (MMDAs) offered by banks and other financial institutions are a close substitute for a money market fund.

3-7. The board of directors of an investment company must specify the objective that the company will pursue in its investment policy. The company will try to follow a consistent investment policy, given its objective.

(a) common stock funds: aggressive growth, growth, growth and income, international, and precious metals

(b) balanced funds: hold both bonds and stocks

(c) bond and income funds: income funds, bond funds, municipal bond funds and option/income funds

(d) specialized funds: index funds, dual-purpose funds, and unit investment trusts.

3-8. A unit investment trust is an unmanaged portfolio handled by an independent trustee, while investment companies are actively managed. The sponsor maintains a secondary market for the trust for those wishing to sell, while investment company shares are traded, or redeemed, more actively. The assets in the portfolio of a trust are seldom changed, a situation completely different from an investment company which pursues a more active management strategy.

3-9. The net asset value (NAV) for any investment company share is computed daily by calculating the total market value of the securities in the portfolio, subtracting any trade payables, and dividing by the number of investment company fund shares currently outstanding.

3-10. A pure intermediary refers to the concept of achieving the same objective that an investor could achieve directly in terms of owning a portfolio. That is, a mutual owns a portfolio of stocks which, in principle, investors could own directly. The fund passes on to the investors the same dividends and capital gains that they could earn themselves through direct investing (less fund expenses).

3-11. Investors might prefer a closed-end fund because it could be bought on an exchange, through a broker, like any other stock. Thus, it would be added to the portfolio like any other security, and when it came time to sell all that would be required would be a call to the broker. Also, an investor might feel there is an advantage to buying a closed-end fund at

a discount, because a narrowing of the discount would lead to a gain for the investor. Finally, a particular closed-end fund might appeal to an investor better than the open-end funds that are available because of the closed-end fund’s particular focus, managers, expenses, past record, and so forth.

3-12. 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. On the other hand, 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.

3-13. A cumulative total return measures the actual performance over a stated period of time, such as the past 3, 5 or 10 years. Standard practice in the mutual fund industry is to calculate and present the average annual return, a hypothetical rate of return that, if achieved annually, would have produced the same cumulative total return if performance had been constant over the entire period. The average annual return is a geometric mean (discussed in Chapter 6) and reflects the compound rate of growth at which money grew over time.

3-14. A value fund generally seeks to find stocks that are cheap on the basis of standard fundamental analysis yardsticks, such as earnings, book value, and dividend yield.

Growth funds, on the other hand, seek to find companies that are expected to show rapid future growth in earnings, even if current earnings are poor or, possibly, nonexistent.

3-15. Unit investment trusts are considered to be passive investments because they are designed to be bought and held, with capital preservation as a major

objective. They are, by and large, unmanaged investment companies.

3-16. Mutual fund shares are typically purchased directly from the investment company that operates the fund. The investor contacts the company, obtains a prospectus and application, and buys and sells shares by mail and phone. Alternatively, mutual funds can be purchased 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 firms.

3-17. When the investor is ready to sell the shares of Equity-Income Fund, he or she would contact Fidelity by phone or mail and instruct Fidelity to sell the shares. The company is obligated to do so under normal circumstances at the NAV prevailing at the time of sale.

3-18. Since 1986 Equity funds as a percentage of total fund assets doubled to about 45 percent. Taxable Money Market funds declined from about 32 percent of total fund assets to approximately 22 percent. The percentage of assets held in Bond and Income funds also declined. In the mid-1990s, investors were clearly emphasizing Equity funds.

3-19. Mutual funds are corporations 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 firm.

3-20. Mutual funds involve investment risk because they hold risky financial assets such as stocks and bonds. However, mutual funds are able to reduce risk, relative to many investors, by holding a diversified portfolio of securities. Proper diversification may require 30 or more stocks, which many individual investors cannot achieve through direct investing.

3-21. The “load” refers to the sales charge. A no-load fund has no sales charge, while a load fund has a sales charge, which may often be as much as 5-6 percent. A low-load fund has a lower sales charge, often 2 percent or 3 percent.

3-22. Passively managed country funds are geared to match a major stock index of a particular country. Each of these offerings will typically be almost fully invested, have little turnover, and offer significantly reduced expenses to shareholders.

Morgan Stanley has created World Equity Benchmark Shares (WEBS) which track a pre-designated index (one of Morgan Stanley’s international capital indices) for each of 17 countries. These are closed-end funds, and trade on the Amex.

Deutsche Morgan Grenfell has created CountryBaskets, designed to replicate the Financial Times/Standard & Poor’s Actuaries World Indices. These are available for each of nine countries. Unlike WEBS, which attempt to match the performance of a particular index without owning all of the stocks in the index, CountryBaskets own every stock in the index for that country.

3-23. Once an investor buys a particular fund within an investment company, such as Vanguard or Fidelity, he or she can easily sell the shares of that fund and purchase shares of another fund within the same organization. This can be done by phone or mail.