Q. What is an investment company?
A. An investment company is a vehicle of indirect investment, where investors funds and pooled, used to purchase a portfolio of assets, and the investors own shares in the portfolio.

I. Advantages and Disadvantages of indirect investment

• advantages
• diversification and wider range of asset choice with a small amount of capital
• professional management (although this is no guarantee of superior performance)
• lower transactions costs (lower trading costs, lower information costs due to economies of scale)
• disadvantages
• lack of control over the investment portfolio
• tax consequences to buying and selling assets in the portfolio
• lack of voting rights (that typically come with direct ownership of common stock)

• Open-end funds or mutual funds
• sell new shares and redeem existing shares
• # shares grows and shrinks over time with new sales and redemptions
• what price?
• based of the NAV = (total value of portfolio - liabilities)/# shares outstanding
• NAV computed at close of each day
• NAV changes as prices of portfolio assets change
• about 8000 mutual funds in operation ($6.3 trillion) in 2002 (up from < 600 in 1980)
• households own 90% of assets
• due in part to growth of 401(k)s and IRAs (pension funds)
• concentrated
• many small funds, but a few very large funds
• Closed-end funds
• new shares initially issued, then no new shares are sold and no redemption of shares
• # of shares remain fixed
• initial shareholders bear the cost of the issuing the shares
• shares are bought and sold in secondary market
• NAV may be greater than or less than the share price, depending on supply and demand
• NAV > share price
• shares trading at discount
• share of many closed end funds perpetually trade at a discount, which is a big drawback to these types of funds
• NAV < share price
• shares trading at a premium
• why?  fund may offer expertise in little-known market
• < 500 closed-end funds ($130 billion)
• Unit Trusts
• # shares are fixed
• typically invest in bonds
• fixed portfolio with no active trading (low operating costs)
• fixed termination date
• more common in Europe than in U.S.

• Sales Charges
• originally funds sold in 2 ways
• through sales force, receiving commission
• sales charge known as a load
• front-end load (8.5% max)
• fee deducted from amount invested
• back-end load (8.5% max)
• fee imposed when shares are redeemed
• level loads (.75% max)
• fee imposed each year
• directly from the mutual fund
• no-load funds
• no sales charge
• today there are many distribution channels
• supermarkets of no load funds
• fund families often sell funds of other companies as well
• with large # of funds, "distribution is king"
• Operating Expenses
• management fee  (for portfolio manager)
• distribution fees
• 12b-1 fee  SEC rule
• cost of marketing, advertising
• 1% cap
• other expenses
• trading costs
• transferring funds
• auditing fees
• SEC, NASD set some limits on certain fees (most funds charge much less)
• measured by expense ratio = expenses/assets
• average for actively managed funds = 1.44%
• average for index funds = .4%
• fees add up!  example:  $10,000, 10% annual return for 20 years
• 1.5% expense ratio, $49,725
• .5% expense ratio, $60, 858

• how funds vary with respect to type of assets, the characteristic of these assets, and investment goals
• Equity funds
• income funds--target stocks with high and stable dividends
• growth funds--target stocks with high expected capital gains (price appreciation)
• the key word here is "expected". most growth funds will not meet their objective
• growth/income funds combine both categories and have been top performers
• value funds -- target "bargain" stocks with low PE ratios, high book-to-value ratios
• sector funds--target stocks in a specific industry, such as technology, health care, financial
• small cap/mid cap/large cap funds--target stocks based on the size of the company, as measured by market capitalization (the value of the total shares outstanding)
• international/global funds
• aim to develop an internationally diversified portfolio of stocks OR target stocks in particular region of the world
• index funds--aim to match average market performance, as measure by some stock market index
• S&P 500 (Vanguard 500), Wiltshire 5000, Russell 2000
• most of these funds fall just below the index return due to fees and cash holdings
• represents a passive strategy of matching average performance rather than active strategy of trying to earn returns above the market average
• a note in favor of index funds:  from 1990-99, 76% of actively managed funds failed to do better than the S&P 500 index
• Bonds
• U.S. Government
• Investment Grade Corporate
• High Yield Corporate
• Municipal Bonds (tax exempt interest)
• Money Market
• maturity of assets is less than 1 year
• general taxable
• U.S. Government
• tax-exempt
• these funds typically come with check writing privileges
• Balanced , hybrid, and asset allocation funds invest in both stocks and bonds
• certain investment companies offer many funds with different objectives, known as a family of funds
• Fidelity, Vanguard, 20^th Century, Strong, Janus are examples
• over 400 fund families but top 10 fund families hold over 40% of mutual funds assets

• SEC is main regulator
• rules about disclosure ("Plain English")
• fees
• insider trading
• "truth in advertising":  about returns and risks, about name & objectives of fund
• NASD sets rules for it members on acceptable sales practices and commissions
• investment co. are exempt from tax on gains if they distribute 90% of their income to shareholders annually
• shareholders are taxed on capital gains (unless the fund is in a tax-sheltered account)
• even if reinvest the distribution
• shareholders have no control over tax liability
• if other shareholders redeem shares, mutual funds will sell assets, triggering tax liabilities to other investors

• Features that are like index mutual funds and like closed end funds
• traded on an exchange
• purchases/sales  trigger commissions
• traded continually at current prices, not just at end-of-day NAV
• large blocks of shares of stock may be traded for shares of ETFs; this keeps the ETF share price close to the NAV
• Tax liability advantage
• when other investors sell shares, does not trigger liability for remaining investors
• trading ETF shares for blocks of stock does not trigger tax liability