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A common concern for small investors is the difficulty of purchasing a diversified group of assets in order to minimize risk. However, for small investors, the cost of diversification may be prohibitive. For example, most bonds have face values of $1,000 and are sold in blocks of five units. The typical trading unit of stock listed on an exchange is 100 shares. Trading smaller blocks of stock is disproportionately more expensive. Thus, investors with a few thousand dollars could wind up placing all their eggs in one basket.
Without diversification the risk of loss can be high. Statistically it is more common for one stock to produce a significant loss than for a portfolio of 50 different stocks to all show a loss. In the multistock portfolio, “winners” tend to cancel out “losers,” and portfolio performance tends to emulate that of the overall stock market.

Investors with limited funds can diversify by purchasing shares in an investment company. An investment company is a corporation or trust through which investors pool their capital to achieve the benefits of diversification and management of their investments. Shares in such a pool represent ownership in many different companies-often in different industry groups. In addition to providing “instant” diversification, these shares are readily tradable or redeemable. Shares in an investment company represent an interest in all the assets of the company. As the market value of those assets fluctuates, so does the value of the shares.

The two most common types of investment companies are
management companies and unit trusts.

Management Companies

The portfolio of securities in these companies is managed on behalf of the shareholders with specific goals in mind. These objectives are described in the investment company’s prospectus, which also lists the securities actually held by the fund when the prospectus was issued.

Funds can be structured for “aggressive growth,” “income,” “growth and income,” “tax-exempt income,” etc. Moreover some investment companies narrow the focus of their activities to investments in specific industry groups, such as information science and medical technology. There are over 500 investment companies to choose from. Thus, it is not difficult for planners to find several with objectives that correspond to those of a particular client.
There are two types of management companies: closed end
and open end.

Closed end. Closed-end companies have a fixed number of shares outstanding that trade in the OTC market. Closed-end funds fluctuate in value and are usually redeemed for a price below the value of the net assets.

Open end. Open-end companies-or mutual funds-are so named because they make a continuous offering of new shares to the public. As capital comes in from the sale of new shares, it is invested by the fund’s managers.

Unlike those of closed-end companies, mutual fund shares do not trade on exchanges or in the OTC market. Rather, shares are redeemed by selling them back to the fund-usually at the net asset value (NAV). The NAV is simply the market value of the fund’s assets, less liabilities, expressed on a per-share basis. Securities regulations require that redemption requests be honored within seven days.

In addition to the current value of the shares, it is important to look at a fund’s long-term performance. The prospectus usually includes 10-years of financial data. Of course, for newer funds, a shorter period is listed. To determine performance, start with the fund’s NAV for the period and add net income. Then add the gain or subtract the losses. Any distributions from realized capital gains should be subtracted. The result is the NAV for the end of the period. This figure can be compared to the NAV for each year to determine profit or loss. Table 9.3 provides an example of NAV calculation for a mutual fund.

The example shows the NAV at the beginning of 1983 as $11.05 and an ending value of $12.49, for an increase of 13.03 percent. In 1984, the beginning NAV was $12.49 and the ending NAV was $12.08, for a loss in NAV of 3.28 percent.
Load and no-load funds. Some mutual funds include a load, or sales charge, for the purchase of shares. The maximum allowable charge is 8.5 percent of the offering price (the price at which the client purchases the shares). With no-load funds, no such charge is involved. To date, there is no statistical information indicating that load funds outperform no-load funds. In the financial press, price quotes for mutual funds are usually shown as follows:

Investors could have purchased shares of A Fund for $10 per share. These shares have a net asset value of $9.15. The difference between the cost and NAV figures is the 8.5 percent sales charge ($10 less 8.5% _$9.15). The C Fund is a no-load fund because there is no sales charge. Thus, the NAV and offering price are the same.

Other fees
When selecting funds, planners should be cognizant of withdrawal charges and redemption fees that are taken out of the proceeds of some funds, both load and no-load when they are redeemed.

Recently a new fee, known as 12b-1, has been charged. This fee stems from a 1980 Securities and Exchange Commission (SEC) ruling that allows a mutual fund to use assets to pay for distribution or sales expenses, such as advertising or mailing material to customers. The SEC has not placed a limit on the percentage involved. Currently 12b-1 funds charge fees ranging from 1 percent to over 2 percent.

Some critics conclude that existing shareholders are financing the growth of 12b-1 funds. The concern of others is the fact that no separate expense category is listed in the prospectus of such funds. So checking for this hidden fee is not easy. However, future SEC regulations may change how the fee is shown.
All mutual funds charge a management fee, usually in the range of .05 percent to 1 percent of the total assets of the fund. This fee is a major source of revenues to the investment companies. In return, shareholders receive professional selection and management of a portfolio of securities, safekeeping of certificates, and regular reports and distributions.

Mutual fund selection
When selecting a mutual fund for a particular client, the planner has two tasks: (1) determining which funds have objectives and risk characteristics that match those of the client; and (2) selecting from this limited group of candidates the ones most likely to perform well in the future. It is the second of these tasks that presents the greater challenge to the planner.

When selecting stock, the characteristics and earnings prospects of particular firms are analyzed. Mutual fund selection comes down to finding those money managers who are better than others at trading securities. Picking mutual funds is like going to a race where bets are placed on the jockeys, not on the horses l
In making decisions about the future, it is often necessary to look to the past. The historical performance of individual funds are documented in several places. Lipper Analytical Services, the Weisenberger Report, the United Mutual Fund Selector, and the Standard & Poor’s Stock Guide all track performance over many years. But some funds are so new that past data are not helpful. Also, successful fund managers often move from employer to employer; this information is never available through regular sources.

Dollar-cost averaging. Besides the obvious benefits of professional management and shareholder services, mutual funds make regular investing of modest amounts both convenient and possible. In this sense they are useful to clients whose financial plans call for channeling discretionary funds into a pool for longterm accumulation. Clients who can discipline themselves to channel funds in this way find mutual funds a fairly painless way to build an investment portfolio over time. Such systematic investing results in dollar-cost averaging. Fund share prices fluct,uate over time. So committing a fixed dollar amount to purchasing shares on a regular basis results in an average purchase price somewhere between the highs and lows. For instance, when share prices are at $10, a $100 purchase adds 10 shares to the portfolio; when prices are at $5, a$100 purchase adds 20 shares. The investor then has 30 shares at an average price of $6.66.

As mentioned, there is a second type of investment company. These companies issue redeemable shares that represent an undivided interest in a fixed portfolio of specific assets and are called unit investment trusts. They are similar to mutual funds in that monies generated through the sale of shares are used to acquire specific assets. Mutual funds, however, are managedi.e., securities in the funds are traded in response to economic conditions. Unit trusts make no attempt to manage assets, except in unusual situations. Typically, a unit trust will buy a stated portfolio of securities and deposit them with a trustee.

Securities placed in this type of trust include GNMAs, corporate and municipal bonds, preferred stocks, and equity ownership in real estate. The fixed-interest securities are of course, sensitive to interest-rate fluctuations. For example, as interest rates decrease, the value of a unit trust holding bonds will increase and vice versa. Interest and dividends are paid out periodically to unit holders according to their share of ownership. The unit investment trust terminates when the last asset matures.

This entry was posted on Monday, August 21st, 2006 at 5:14 am and is filed under Economy, Investment. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.