Investment Companies

This section describes Investment Companies and discusses origin and terminology, closed and open-ended mutual funds, exchange traded funds and the implication of taxes and fees.

Origins and Terminology

The investment companies in the 1800s resembled the closed end funds of today featuring a fixed number of shares. The current open ended mutual funds with unlimited number of shares were were first established in the 1920s when bank trustees pooled their client’s funds to share risk.

The rationale for investment companies was simple and appealing:

  • advantage of professional management
  • benefit of ownership in a diversified portfolio
  • potential savings in commissions
  • custodial services

In the last twenty years, a new fund type, exchange traded funds (ETFs), have become popular.  Their development is driven by the popularity of index investing with its passive approach.  The ETFs combine the diversity of mutual funds with continuous trading of closed end funds at low cost.

Closed End Funds

Predating mutual funds, closed end funds have the characteristics similar to stocks and bonds traded in the security markets. Because of the limited number of shares, you have to buy the shares of an existing holder.

Typically, closed end funds trade at a premium or discount to its underlying net asset value. The reasons for the spread are unclear but many think it has to do with taxation. This spread is used as a guide for buying and selling the shares.

Closed end investors earn a return by

  • collecting dividends and interest
  • realizing gains of underlying asset price appreciation
  • realizing the rise of the share price relative to the underlying net asset value, in other words narrowing the discount or widening the premium.

Mutual Funds

Open ended funds are similar to closed ended ones except they don’t trade on a secondary exchange. They trade exactly at net asset value and have additional fees such as

  • front and back end loads
  • marketing fees
  • other administrative expensesInvestment Companies

The MF portfolios of investment companies may be diversified or specialized. Most are classified according to type such as

  • income growth- focus on providing current income
  • growth- focus on capital appreciation
  • special situations- focus on speculative investments
  • balanced-  hold both stocks and bonds

Even within each class, there may be different focuses ranging from

  • market capitalization
  • riskier versus less risky
  • foreign versus domestic

Another distinction involves a growth versus value approach to picking the stocks.

Exchanged Traded Funds

An ETF, or exchange traded fund, is a marketable security which tracks

  • an index
  • a commodity
  • bonds
  • a basket of assets like an index fund

Unlike mutual funds, an ETF trades like a common stock on a stock exchange. This ability gives you flexibility to buy and sell throughout the day, rather than only buying on the mutual fund closing price. ETFs experience price changes throughout the day as they are bought and sold. ETFs typically have higher daily liquidity and lower fees than mutual fund shares, making them an attractive alternative for individual investors

When large investors or market makers, known as authorized participants, notice an imbalance between the price of the ETF and the aggregate of the prices of the underlying securities the ETF tracks (or they need to fill a large order of ETFs for a customer), they essentially swap the underlying stocks or bonds for shares of the ETF, or vice versa.

This transfer in (or out) of the fund is known as “in-kind” and limits the tax consequences for the fund by allowing it to constantly raise its cost basis of individual securities by swapping out the securities with the largest built-in gains first (swaps as opposed to sales don’t realize the gains). In the event the fund needs to sell securities itself, maintaining a high basis would limit its tax liability. Non-ETF mutual funds don’t have this luxury.

You can establish limit orders, enter stop loss orders, buy on margin and short the shares but SCM doesn’t engage in these types of orders for your portfolio. Currently, SCM’s ETF’s management style is a variation on index funds. We use ETFs with alternate weighting schemes, rather than the traditional market-capitalization method.

Return Earned

In addition to the advantages of funds listed above, you may not have the time, desire or expertise to manage your assets. The administrative and custodial services enhances the appeal of a professionally managed fund. However, their services may not be unique and can be obtained elsewhere for less cost such as SCM.

The professional management is no guarantee the funds will outperform the market.  In fact, many studies show the performance of the managed funds was not significantly different than an unmanaged portfolio of similar assets. The shortfall is usually explained by the higher fees of an actively managed fund.

The general conclusion appears to be investments in mutual funds do not offer superior returns. Fund performance may also vary during rising and falling markets. These conclusions explain the rise of passive ETFs.

Impact of Taxes and Fees

The conclusions in this last section were in reference to the aggregate but individual investors experience a different return than the fund due taxation and fees. The MF’s reported returns are before taxes and load charges.Investment Companies

MF earnings and capital gains are not taxed at the fund level. Each one of the MF shareholders have different tax considerations. The shareholder pays the tax triggered by gains realized by the fund and also taxed on distribution.

Management fees, commissions to brokers for executing the fund’s trades and 12b-1 fess are paid from the fund’s income before determining the fund’s earnings available to shareholders. 12b-1 fees are marketing costs paid out the fund’s earnings and don’t benefit existing shareholders. These fees affect the investor’s realized return and increase the difficulty of comparing the performance reported by the fund and the return actually realized by the investor.

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The material presented on this Investment Companies section and other Investment Basics sections are adapted from Dave’s lecture notes for the Investments for Professionals course taught at UCLA 1998-2005 and three decades of practical experience. See our Site Credits page for reference sources.