Companies: Mutual Funds

invEsTmEnT ComPAniEs: oRigins And TERminology

Investment companies are not a recent development but
were established in Britain during the 1860s. Initially,
these investment companies were referred to as trusts
because the securities were held in trust for the firms
stockholders. These firms issued a specified number of
shares and used the funds that were obtained through
the sale of the stock to acquire shares of other firms.
Today, the descendants of these companies are referred
to as closed-end investment companies because the
number of shares is fixed
(i.e., closed to new investors).
Whereas the first trusts offered a specific number of
shares, the most common type of investment company
today does not. Instead, the number of shares varies as
investors buy more shares from the trust or sell them
back to the trust. This open-end investment company is
commonly called a mutual fund. Such funds started in
1924 when
Massachusetts Investor Trust offered new shares and
redeemed (i.e., bought) existing shares on demand by
stockholders.
closed-end investment company

An investment company with a fixed number of shares that

are bought and sold in the secondary securities markets.
open-end investment company
A mutual fund; an investment company from which
investors buy shares and to which they resell them.
mutual fund
An open-end investment company.
Mutual Funds
Mutual funds are investment companies whose shares are
not traded in the secondary markets like stocks and
bonds. Instead, an investor purchases shares directly
from the fund at the net asset value plus any applicable
sales charge, which is called a load fee or load charge or
simply load. After receiving the cash, the mutual fund
issues new shares and purchases assets with the newly
acquired funds.
The Portofolios of Mutual fund company
The portfolios of investment companies may be
diversified or specialized, such as the money market
mutual funds covered. The more traditional funds may be
classified by investment type or investment style.
Investment type refers to the class or type of securities
the fund acquires, such as income-producing bonds.
Investment style refers to the funds investment
philosophy or strategy. Possible styles include the size of
the firms acquired by the fund or the approach used to
select securities.
Specialized mutual Funds
A variety of funds have developed that have moved away
from this concept of diversification and the reduction of
risk. Instead of offering investors a cross section of
American business, many funds have been created to
offer investors specialized investments. For example, a
mutual fund may be limited to investments in the
securities of a particular sector of the economy (e.g.,
Fidelity Select Multimedia) or a particular industry, such
as gold (e.g., INVESCO Gold). There are also funds
thatnspecialize in a particular type of security, such as
bonds (e.g., American General Bond Fund).

Money Market mutual Funds

As the name implies, money market mutual funds are
investment companies that acquire money market
instruments, which are short-term securities issued by
banks, nonbank corporations, and governments. Money
market mutual funds specialize solely in short-term
assets and provide investors with an alternative to
savings and time deposits offered by banks. Money
market mutual funds thus compete directly with
commercial banks and other depository institutions for
the deposits of savers, while regular mutual funds offer
an alternative means to own stocks and bonds.
money market mutual funds
Mutual funds that specialize in shortterm securities.
money market instruments
Short-term securities, such as Treasury bills, negotiable
certificates of deposit, or commercial paper.
U.S. Treasury bill
The safest short-term security is the U.S. Treasury bill
(commonly referred to as a T-bill), which is issued by the
federal government. Prior to the political confrontations
over the federal budget in 1995 and 2011, there was no
question that the federal government would retire the
principal and pay the interest on its obligations.

Negotiable certificate of deposit (jumbo CDs)

A certificate of deposit in which the rate and the term are
individually negotiated by the bank and the lender and
which may be bought and sold.

Large American banks with foreign operations also issue

Eurodollar certificates of deposit (Eurodollar CDs).
These CDs are similar to domestic negotiable CDs except
they are issued either by the branches of domestic banks
located abroad or by foreign banks. Eurodollar CDs are
denominated in dollars (instead of a foreign currency) and
are actively traded, especially in London, which is the
center of the Eurodollar CD market.
Commercial paper is a promissory note (i.e., debt)
issued by a corporation as an alternative to borrowing
funds from commercial banks. Only firms with excellent
credit ratings are able to sell commercial paper; hence,
the risk of default is small, and the repayment of principal
is virtually assured. Once again, the term is short, so
there is little risk from an investment in commercial
paper.
A repurchase agreement (or repo) is a sale of a
security in which the seller agrees to buy back
(repurchase) the security at a specified price at a
specified date. Repos are usually executed using federal
government securities, and the repurchase price is higher
than the initial sale price.
Bankers acceptances are short-term promissory notes
guaranteed by a bank. These acceptances arise through
international trade. Suppose a firm ships goods abroad
and receives a draft drawn on a specific bank that
promises payment after two months. If the firm does not
want to wait for payment, it can take the draft to a
commercial bank for acceptance. Once the bank accepts
the draft, the draft may be sold.
Tax anticipation notes are issued by states or
municipalities to finance current operations before tax
revenues are received. As the taxes are collected, the
proceeds are used to retire the debt. Similar notes are
issued in anticipation of revenues from future bond issues
and other sources, such as revenue sharing from the
federal government.

TaxATion
Investment companies do not pay income and capital
gains taxes. Instead, applicable taxes are paid by
shareholders. Distributions from mutual funds (and
closed-end investment companies) are specified as
income or capital gains on the 1099 forms sent to each
shareholder so the investor knows the proper
classification of the distributions for tax purposes. In
addition, sales of fund shares are subject to capital gains
taxes. While the fund will include sales on the 1099, the
cost basis of the shares, which is necessary to determine
capital gains or losses, is each investors responsibility.
A mutual fund cannot know its stockholders tax brackets,
and it reports returns on a before-tax basis. Even if the
fund reports returns on an after-tax basis, the tax rates
used may not be applicable for all investors. For this
reason, individuals may not be able to compare their
realized, after-tax return with the return reported by the
fund.
Hidden Capital gains
The individual mutual fund can have built into its portfolio
the potential for a considerable tax liability that may not
be obvious to the investor. In some cases this liability
may fall on investors who do not experience the gains.
This potential tax liability is the result of the fund
experiencing paper profits on its portfolio (i.e., profits that
have not been realized). As long as the gains are not
realized, there will be no taxation, which only occurs once
the investment company sells the appreciated assets and
thus realizes the capital gain.
Year-End Distributions and Income Taxation
Distributions from mutual funds are subject to income or
capital gains taxation. Most mutual funds make two
distributions. The first is a six-month income distribution.
Asecond and year-end distribution consists of both
income and capital gains.
Tax Efficiency
Mutual fund fees obviously affect an investors return.
Load charges, operating expenses, 12b-1 fees, and
commissions paid by the fund reduce the return the
investorm earns. While funds with lower fees may be
preferred, there are reasons why some fees are larger
and the increased expense is justified.