 Hello and welcome to the session. This is Professor Farhad in which we would look at investment companies, a topic that's covered in an essential or principles of investment course, whether undergraduate or graduate. As always, I would like to remind you to connect with me on LinkedIn if you haven't done so. YouTube is where you would need to subscribe. I have 1,700 plus accounting, auditing, tax, finance, as well as Excel tutorial. If you like my lectures, please like them, share them, put them in playlists. If they benefit you, it means they might benefit other people. Connect with me on Instagram. On my website, farhadlectures.com, you will find additional resources to supplement and complement your accounting as well as your finance, CPA, CFA, CMA exams. I strongly suggest you check out my website. Today, we're going to be talking about investment companies. The first thing we want to know is the act that govern the investment companies. So in the US, investment companies are classified under the Investment Company Act of 1940. And they're classified under basically two major categories, either a unit investment trust, which is kind of an unmanaged trust, or a managed investment trust, or a managed investment companies. Under the managed investment companies, we have two types. We have close end and open end. Now, it's very important. We're going to be talking about those two, referring to them a lot in this session. So you want to make sure you understand what is a close end and open end investment companies. Let's start by looking at unit investment trust. And unit investment trust is this category here. The first category, unit investment trust. Let me just highlight it, unit investment trust. And under unit investment trust, investors will pull their money and they invest in a portfolio that is fixed for life of the life of the fund. So notice here, it's fixed. It's not managed. That's one of the characteristics of the investment fund. So a brokerage firm, basically it's called a sponsor. They will buy a portfolio of securities, a bunch of securities, which are deposited in a trust. So they buy them, they put them in that trust. And what happens is the investors will buy shares of that trust. So the portfolio composition is stable. So once that portfolio is established, it's basically it's not managed. For example, they might have municipal bond or corporate bond in that portfolio, but it's a stable. Okay, because of that management fees can be lower. Why? Because you are not constantly managing. It's stable. It's fixed. It's not actively managed. And that's why you might be able to save some money with these funds. Then this fund will sell to the public shares or unit in the trust called redeemable trust certificate. So once the trust is established, you sell those shares to the public and you call them units. All income and payment of principle from the portfolio are paid out by the fund, usually a bank to the shareholders. If there's any payment, that's a sum of interest, any distribution, they're paid to the shareholders, the people that own those units. Now, also the sponsor earned their profit, earned their profit by selling shares in a trust at a premium to the cost acquired. So what they do first is they buy securities, they buy securities, a bunch of portfolio, then they sell them. So if they invested $1,000, they may sell those securities as at $1,050 making the profit of $50. So this is how they make their profit. For example, a trust that has purchased 5 million worth of assets may break those assets. They put those assets first in the trust, then they sell 5,000 shares to the public at a price of $1,030. So basically what it costs them is $1,000 per share. They sell them at $1,030. The $30 here is the profit that the broker or the sponsor of this unit investment trust makes. So this is how they make their money. So basically here, 3% premium. So the 3% is the fee for establishing the trust. Obviously they have to make money that's, you know, they're not going to create the trust for free. Now, you have to understand that those type of trust are not as popular and actually they're going down in popularity. So it's not the most type of investment vehicle, the most popular investment vehicle. So notice they went from $105 billion to $85 billion. It means they are going down. Now another type of investment companies are managed investment trust companies. You remember we said there is unit investment and we said those are basically unmanaged. Those will be managed. Now under the managed investment trust, we have two types. We have the open end and we have the closed end. Now we're going to talk about each one of them separately. Start with the open end. A fund that is issued or redeemed at its net asset value at the NAV. So when they issue it, they determine the NAV. Now if you don't know what the NAV is, please look at the prior recording. You know what the NAV is. Then when you sell it or when they buy it, it's traded at the NAV. So when investor wishes to cash out their shares, they can sell them back at the NAV. The price of open ended fund cannot fall below the NAV. So you can get the NAV. You can get whatever the NAV is computed. This is the open ended fund. So it's very important to understand that when it says open ended, it's traded at NAV. When we talk about close ended fund, it's different. Here the shares may not be redeemed, but instead they are traded at prices that can differ from the NAV. So if you have an open ended fund, you could go back to the fund and say, look, I want to cash out. What is the NAV today? Close end fund, you can go back and tell them I want my money. You can sell your fund, but what's going to happen is you would sell it at market because it's traded at market. So it's very important every time I refer. This is more similar to an open ended. It means it's redeemed at NAV, close ended. When you go back to sell it, you don't know how much you're going to sell it for. It's basically sold on the market. Now both funds, they have a board of directors, which it reaches elected by the shareholders. They hire a management company to manage the portfolio. Typically they charge them 0.2 to 1.5% of the asset. That's the fee that the management company will earn. And the management company is the firm that organized the fund. They put it all together. Now there's something called load. You know what a load is? It's a sales commission charge on a mutual fund. Here we're talking about whether it's closed end or open ended. You might have a fee. The fee is called a load. So this is the management, managed investment companies. Again, managed investment companies. Very important to understand. They could be open ended or closed ended. You need to know the features. Other investment organizations, they are intermediaries that are not formally organized or regulated as investment companies, but they work the same way as an investment companies. You could have commingled funds, real estate investment trust, which is REIT and hatch funds. And we're going to talk about each one of them very briefly, starting with commingled funds. Here what they do, partnerships, they pull their funds together. So the owners are partnership, not necessarily individual. So the management firm that organized the partnership managed the fund for a fee. Obviously, you have to have someone that's going to manage a fund and they're going to manage it for a fee either in a bank or an insurance company. So typically, typically the partners in a commingled fund, they could be trust or retirement account that have portfolio that's much larger than most individual investors. So you're a little bigger than individual investor, but you are still too small to have your own management company on a separate basis. So what you do is you commingle your funds together. All these partners, they commingled the funds and it's called a commingled funds. It's similar to an open and mutual fund. What does that mean? It's mean it's sold at NAV. So when we say commingled fund, it's open and it's sold and bought at NAV. Each unit is sold and bought at net asset value. Again, if you don't know what net asset value, please go to the prior recording. And a bank or an insurance company may offer an array of different commingled fund, a money market fund, a bond fund or a common stock fund. So you have different type of funds. So this is what commingled funds are. When you think of real estate investment trust, think of real estate. Think of real estate. You're investing in real estate. This is similar to close-ended fund. Again, what this close-ended fund means, it means it's traded. The NAV is not really relevant. You could invest in real estate or loan secured by real estate. And we're going to look at both type of REIT in a second. Besides issuing shares, they can raise capital by borrowing money from banks and issuing bonds or mortgages. So that's also how they can raise money for those real estate investment trust. Most of them are highly leveraged. It means they use that to finance themselves. Now, there's a lot of tax implication for REIT. We'll talk about them in a separate session. But REIT are very, you know, they get a favorable tax treatment if you distribute all the dividend. Basically, if all the profit is distributed, the dividend is treated favorably. It's not taxed for tax purposes. And there are two types of REIT. Actually, we kind of talked about them here, real estate and loan secured. One is called equity trust. Those, they invest in real estate and the physical structure directly. Those are equity trust. And you have mortgage trust. Here, what they do is they invest in mortgages and construction loans. So they basically finance the transaction. They don't invest in the mortar and bricks. They don't invest in the physical asset. REIT are generally established by bank, insurance company or mortgage company. Then these investment companies, banks or mortgage companies, they serve as an investment manager again to earn a fee. So that's every, every time you create a fund, you have to make money out of that fund. Otherwise, why would you take all this time to do your research, put the fund together to earn a fee? That's how they earn the fee. Sometimes the fee is, most of the time it's a percentage of the, a percentage of the asset. And sometimes it's based on profit. Like for hedge funds, what they do is based on the profit and they take a higher percentage. In other words, I don't get paid if I don't make money when it comes to hedge funds. Hedge funds, it's a private investment pool. Private means, you know, it's not open to the public. And it's open usually to wealthy or institutional investors. And it's usually organized under a private partnership. So hedge fund is usually a private partnership and it's exempt from the SEC. So simply put, when you think of mutual fund, think of wealthy individual, individual who are, who has a lot of money or institutional investors. Now, because they are a partnership, they are exempt from SEC. It means the SEC does not regulate, does not, does not look over their shoulder. And because of that, that's going to give them more room to invest in speculative policies, speculative investments than a mutual fund. So they're not restricted in that sense. And oftentimes what happens when you invest in a mutual fund, you might have a lock up period. And what's a lock up period? It means the investors agree to give their money and forget about it for several years, maybe two years, one years. They will, you know, it's the agreement between you and the hedge fund. Now, why would they do that? Because hedge funds, what they do sometime is they invest in unliquid assets. It means asset, it's going to take some time to pay off. So if you give them your money and six months later, you come back and say, I want my money back. Well, that's not going to work for the hedge fund because they made that investment and they think it's going to pay off in three years. And it's going to pay a lot, but you have to wait. Okay. So that's why they have a lock up period. And if you watch that movie, I told you about the big short, the big short about the financial crisis. The hedge fund manager, what he did is he triggered that call because there was a lock up period for the investors. So what they did, he told the investors, you cannot take your money because there is a lock up period. So this is what it gives them managers for this mutual fund. They can pursue an investment strategies that's not open to typical mutual fund managers. They can invest in derivatives in short sales. This is basically what the big short is about. They basically shorted the real estate market indirectly, leverage derivatives, the stress firms, currency speculation, convertible bonds, immersion market, immersion arbitrage, and so on. So they have a lot of rooms to invest in different speculative investments. And they are popular. They are very popular vehicles. Again, you're talking about wealthy and institutional investors. For example, in the 1990, they were around 50 billion. Now there are, by 2017, we have $4 trillion invested in hedge funds. And we'll get to discuss this later on in a separate chapter. In the next session, we would look specifically at mutual funds because most people invest in mutual funds. We look at their characteristics, their fees, their taxation. If you like this recording, please like it, share it, put it in playlists. Don't forget to visit my website farhatlectures.com and please stay safe, study hard. Good luck.