ON THE MONEY: Investment basics: Investment companies

  • Posted: Sunday, November 10, 2013 12:01 a.m.

There are essentially two major classifications of investment companies: management companies and unit investment trusts. Management companies are either “open-end” or “closed-end”, and open-end companies are better known as mutual funds. A mutual fund is the best known type of Investment Company, and all mutual funds are regulated under the Investment Company Act of 1940.

Unit Investment Trusts, or unit trusts, are registered investment companies that buy and hold a fixed portfolio of income producing stocks, bonds, or other securities. These UIT’s, as they are known, are attractive to an investor who wants diversification, low expenses and an initial portfolio choice, but not ongoing portfolio management. A UIT does not have an actively managed investment portfolio, rather it is akin to “set it and forget it.” The investments of the trust are divided into units, which are sold to investors. No earnings of the underlying investments are retained by the UIT, but rather are paid out proportionately to the investors. UIT’s are different from other investment companies, since there is a stated date for termination of the trust. Prior to the termination date, investors have the option to redeem their units for the net asset value or to resell their units on the secondary market. At the actual termination date of the trust, all investors receive their proportionate share of the net assets of the trust, and the trust is then terminated.

Closed-end investment companies are not mutual funds; rather, they are investment companies that issue a fixed number of shares in closed-end funds. These shares are traded on a stock exchange or in the over-the-counter market. So then, if an investor wants to purchase shares of a closed-end company, he or she must do by finding a willing seller, and conversely, the only way to sell these shares is to find a willing buyer. Assets of the closed-end fund are actively managed according to the fund’s investment objectives and policies. The fund assets may be invested in stocks, bonds, or a combination. Just like other publicly trades securities, the market price of closed- end fund shares fluctuate based on supply and demand.

Open-ended investment companies are mutual funds, and the federal law requires them to redeem (or buy back) any outstanding shares at any time based on a shareholder’s request, and at a price based on the current values of the fund’s net assets, or NAV. This value is determined by dividing the current market values of the fund’s assets, minus liabilities, divided by the total number of outstanding shares. The price at which an investor may purchase shares of the fund is equal to the NAV, plus any applicable front-end sales charge.

Mutual funds are usually managed externally by third parties, rather than having internal employees managing the company. Shareholders of mutual funds have very specific voting rights, which include the right to elect directors. Shareholders may often be called upon to approve material changes in the terms of the fund’s contract with its investment adviser, who manages the fund’s assets.

Mutual funds are often attractive investment vehicles for tax-qualified retirement plans, such as an IRA, since any taxes that would otherwise be due each year are deferred until the funds are withdrawn at retirement time. Moreover, mutual funds provide a great deal more diversification than any one investor would be able to arrange by investing in individual stocks. Finally, each mutual fund has its unique investment philosophy which will enable investors to pick those funds that best suit them.

Mutual funds come in three different share classes: A, B and C shares. Each class has different fees along with different sales and expense charges. Class A shares usually have a front-end sales charge, which means that a certain percentage of your invested dollars will be used to pay a sales charge at the time of purchase. These front-end charges are only levied when shares are purchased. Class A shares may also impose an asset-based sales charge, but these charges are generally lower than those levied by other share types. A Class A mutual fund may also offer discounts, known as breakpoints, on the front-end sales charge if you: Make a large purchase; already hold mutual funds by the same fund family; and/or commit to purchasing additional shares on a recurring basis over time.

Class B shares do not usually have a front-end sales charge, so the full dollar amount you deposit is invested immediately. These Class B shares do, however, have asset-based sales charges which may be higher than those of Class A shares. Also, Class B shares usually have contingent deferred sales charges (CSDC), which are levied when you sell your shares. The CSDC usually reduces over time, and once it is eliminated, Class B shares often convert into Class A shares, which will provide you with the lower asset-based sales and expense charges of Class A shares. Class C shares usually have no front-end charges, but their asset-based charges are typically higher than are those of Class A or Class B shares. Also, Class C shares will usually impose a CSDC, if you sell your shares within a short time of purchase, usually one year. These shares do not convert into Class A shares, so their asset-based expenses are not usually reduced over time. Choosing which class of mutual fund shares you should purchase deserves careful attention. Certainly you should take into consideration the size of your purchase, the time span over which you are planning to invest, and what other mutual funds you currently own. If you plan on purchasing a large amount of shares, buying Class A shares may be best, since the asset-based sales charges are less, and your purchase may qualify for a discount. Other considerations are breakpoints, rights of accumulation, letters of intent, and family discounts. Be sure to discuss all of these points with your financial professional prior to any purchase.

Greg Roberts is a certified financial planner with 35 years of financial and estate planning experience. Got a financial planning question for Greg? You may email him at greg@lifesolutionsonline.net.

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