How to understand mutual funds
What is the philosophy of the investment company?
An investment company is organized either as a corporation or as a trust. The money from individual investors is then pooled into a single account and used to purchase securities that are most likely to help the investment firm achieve its goals. All investors jointly own the portfolio created by these mutual funds, and each investor has an undivided interest in the securities. No shareholder has a right or claim that exceeds the rights or claims of any other shareholder, regardless of the size of the investment. Investment firms offer retail investors the option of having their money managed by professionals who would otherwise only offer their services to large institutions. Through diversification, the investor can participate in future growth or income generated by the large number of different securities contained in the portfolio. Both diversification and professional management must contribute significantly to the achievement of the objectives set by the investment company. There are many other features and benefits that can be offered to investors which will be discussed later in this chapter.
What are the different types of investment companies?
All offers from investment companies are subject to the Securities Act of 1933, which requires the investment company to register with the Securities Exchange Commission (SEC) and issue a prospectus to all buyers. Investment companies are also subject to the Investment Companies Act 1940, which sets out guidelines on how investment companies are to operate. The 1940 Investment Companies Act divides investment companies into three different types:
- Company with insured capital
- Mutual funds (UIT)
- Management investment company (UCITS)
What is a company with insured capital / certificates with insured capital?
An investor can enter into a contract with an issuer of a nominal value certificate to commit to receiving a specified or fixed amount of money (the nominal value) on a specified future date. In exchange for this future sum, the investor must deposit an agreed lump sum or make installments over time. Face value certificates are rarely issued these days, as most of the tax benefits that investing once offered have been lost due to changes in tax laws.
What is a Unit Investment Trust (UIT)?
A mutual fund (UIT) will invest either in a fixed portfolio of securities or in a non-fixed portfolio of securities. A fixed ITU will traditionally invest in a large block of government or municipal debt. The bonds will be held to maturity and the proceeds will be distributed to ITU investors. Once the product is distributed to investors, ITU will have achieved its purpose and cease to exist. A non-fixed ITU, also known as a contractual plan, will purchase units of mutual funds in order to achieve a stated goal. Both types of ITU are organized as a trust and function as a holding company for the portfolio. ITUs are not actively managed and do not have a board of investment advisers. Both types of ITU issue units or shares of beneficial interest to investors, which represent an undivided interest in the underlying securities portfolio. ITUs need to maintain a secondary market for units or shares to provide some liquidity to investors.
What are management investment companies (mutual funds)?
A management investment company employs an investment advisor to manage a diversified portfolio of securities designed to achieve its stated investment objective. The management company can be organized either as a public limited company or as a public limited company. The main difference between an open-ended company and a closed-end company is the way shares are bought and sold. A variable capital company offers new shares to any investor who wishes to invest. This is called a continuous primary supply. As the supply of new shares is continuous, the capitalization of the open-ended fund is unlimited. In other words, an open-ended fund can raise as much money as investors are willing to invest. An open-ended fund must buy back its own shares from investors who wish to buy them back. There is no secondary market for shares of open-ended mutual funds. Shares must be purchased from the fund company and redeemed from the fund company. A closed-end fund offers common stocks to investors through an initial public offering (IPO), just like a stock. Its capitalization is limited to the number of authorized shares approved for sale. The shares of the closed-end fund will trade in the secondary market through investor-to-investor transactions on the stock exchange or in the over-the-counter (OTC) market, just like ordinary shares.
What is the difference between an open-end fund and a closed-end fund?
While open and closed-end funds are designed to meet their stated investment objective, the way they operate is different. The following is a side-by-side comparison of the important features of open and closed-end funds and shows how these features differ between fund types:
|Characteristic||Open end||Closed end|
|Capitalization||Unlimited continuous primary offer||Single fixed offer via IPO|
|The investor can buy||Whole and fractional shares||Full shares only|
|Titles offered||Common shares only||Common and preferred shares and debt securities|
| The shares are bought
|Shares are bought from the fund company and redeemed from the fund company||Shares can only be purchased from the fund company during the IPO, then secondary market transactions between investors|
|Share price||The actions are valued by formula:
NAV + SC = POP
|Shares are valued according to supply and demand|
|Shareholder rights||Dividends and voting||Dividends, voting rights and pre-emption|
What is the difference between a diversified fund and an undiversified fund?
Investors in a mutual fund will achieve diversification through their investment in the fund. However, in order to determine whether the fund itself is a diversified fund, the fund must meet certain requirements. The Investment Company Act of 1940 set out an asset allocation model that must be followed in order for the fund to be called a diversified mutual fund. It is known as the 75-5-10 test and the requirements are as follows:
75% – 75% of the fund’s assets must be invested in securities of other issuers. Cash and cash equivalents are recognized in the 75%. A cash equivalent can be a treasury bill or a money market instrument.
5% – The investment company cannot invest more than 5% of its assets in the same company.
ten% – The investment company may not hold more than 10% of the shares with voting rights in circulation of a company.
The XYZ fund is marketed as a diversified mutual fund. Its net assets are $ 10,000,000,000 and the investment advisor thinks ABC Company would be a great business to acquire for $ 300,000,000. Since XYZ markets itself as a diversified mutual fund, it would not be allowed to buy the company even if the price of $ 300,000,000 would be less than 5% of the fund’s assets. The investment company must meet both the 5% asset and 10% ownership diversification requirements in order to continue to market itself as a diversified mutual fund.