Investment Companies
by
Charles Lamson
Investment companies are financial intermediaries that raise funds from many small investors by selling shares in the company. The funds are then pooled together and used to purchase financial securities. Investment companies reduce risk for individual investors by purchasing hundreds or even thousands of different securities. This allows individual investors to diversify to a much greater extent than they would be able to by purchasing individual securities on their own. In addition, because large blocks of securities are bought and sold, the investment company can take advantage of volume discounts, and the transactions costs per share are less than if smaller amounts of securities were purchased or sold. Investors share in the gains and losses proportionally to the size of their investment.
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Open-End and Closed-End Companies
Investment companies may be open-end or closed-end. An open-end fund continually sells new shares to the public, or buys outstanding shares from the public at a price equal to the net asset value. The net asset value per share is found by subtracting the liabilities of the mutual fund from the market value of the securities that the fund owns and dividing the difference by the outstanding number of shares.
The vast majority of investment companies are open-end companies called mutual funds. Mutual funds that deal in money market instruments with an original maturity of one year or less are called money market mutual funds. They issue more shares as investors demand them. Because they buy and sell their own shares, mutual fund shares are not traded on organized exchanges. Mutual funds sell their own new shares to investors and stand ready to buy back outstanding shares.
Closed-end investment companies sell shares like other corporations, but usually do not buy back outstanding shares. Once the sale of a limited number of shares is completed, the fund is closed to new purchases, but the shares may be traded like shares of stock on organized exchanges. Because the price of a share of a closed-end fund is determined by supply and demand, it can differ from the net asset value.
Load and No-Load Companies
Some investment companies require that a load, or sales commission, be paid to a broker to buy into a fund. By law, the law cannot exceed 8.5 percent of the investment. No load funds are purchased directly from the mutual fund company without a broker or a sales commission.
Both load and no-load companies deduct a percentage from the net asset value each year to administer the funds. The fees are usually in the range of 0.2 to 1.5 percent. A fund may also deduct a 12b-1 (named for the SEC regulation that authorizes the fee) for marketing and advertising expenses. Finally there can be a redemption fee, called a back-end load, to sell the investment company shares. An investor should know all of the fees before investing in a fund.
Types of Mutual Funds
Often many types of mutual funds are offered by a single investment company. Investors can own several different funds within one investment company. They can choose the funds they prefer depending on their investment needs. Investors can also move funds in and out of various funds within one company at a relatively low cost. Some of the better-known and larger investment companies that you may have heard of are Fidelity, Vanguard, American Fund, Putnam, Janis, Franklin, and T., Rowe Price.
Investment companies also create new companies that invest in several mutual funds. In reality, the investor purchases a fund of funds. For example, Vanguard's STAR fund invests in nine different Vanguard funds. In general 60 to 70 percent of investments are held in stock funds, 20 to 30 percent in bond funds, and 10 to 20 percent in money market mutual funds. The advantages to investors are that they achieve much greater diversification than if they invested in only one mutual fund and they save the time and effort of investing in several different mutual funds on their own. A disadvantage is that costs can be high because both the individual funds and the fund of funds fees.
Recap
Investment companies are financial intermediaries that pool the funds of many investors to invest in several hundred or even thousands of stocks. For any given investment, investment companies offer great safety and more diversification than offered by investing in one or a few stocks. Money market funds invest in financial instruments with an original maturity of one year or less. Some mutual funds invest in bonds or some combination of both stocks and bonds. An open-end fund continually sells new shares or buys shares from the public at the net asset value and is called a mutual fund. Closed-end investment companies sell a limited number of shares that may be traded on the open market and on organized exchanges. The value of open-end funds (mutual funds) greatly exceeds that of closed-end investment companies. The price of closed-end investment companies is determined by supply and demand and can differ from the net asset value. Mutual funds and closed-end investment companies can be either load or no-load funds.
*SOURCE: THE FINANCIAL SYSTEM & THE ECONOMY, 3RD ED., 2003, MAUREEN BURTON & RAY LOMBRA, PGS. 357-360*
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