What is Investment Company? Advantages, Types

What is Investment Company?

An investment company is a company whose main business is holding securities of other companies purely for investment purposes. The investment company invests money on behalf of its shareholders who in turn share in the profits and losses. Generally, an investment company is a company (corporation, business trust, partnership, or Limited Liability Company) that issues securities and is primarily engaged in the business of investing in securities.

An investment company invests the money it receives from investors on a collective basis, and each investor shares in the profits and losses in proportion to the investor’s interest in the investment company. The performance of the investment company will be based on the performance of the securities and other assets that the investment.

Investment companies are business entities, both privately and publicly owned, who invest in large blocks of securities of diverse firms, and to obtain its capital from issues of shares or units. Investment companies give small investors the advantage of full-time professional investment management and a very much wider spread of risk that it would have been otherwise possible.

Advantages of Investment Companies

For an individual there are two type of advantages to investing in such companies instead of investing directly in the financial assets. Specifically, the advantages arise from:

Economies of Scale

In terms of economies of scale, the individual could buy stocks in odd lots and thus have a diversified portfolio. However, the brokerage commissions on odd lot transactions are relatively high. Alternatively, the individual could purchase round lots, but would only be able to afford a few different securities.

Unfortunately, the individual would then be giving up the benefits of owing a well-diversified portfolio. In order to receive the benefit of both diversification and substantially reduced brokerage commissions, the individual could invest in the shares of an investment company. This is because economies of scale make it possible for an investment company to provide diversification at a lower cost of investment than would be incurred by a small investor.

Professional Management

In terms of professional management, the individual investing directly in the stock market would have to go through all the details of investing, including making all buying and selling decisions as well as keeping records of all transactions for tax purposes. In doing so, the individual would have to be continually on the lookout for mispriced securities in an attempt to find undervalued ones for the purchase, while selling any that were found to be overvalued.

Simultaneously the individual would have to keep track of the overall risk level of the portfolio so that it did not deviate from some desired level. However, by purchasing shares of an investment company, the individual can turn over all these details to a professional money manager.

Types of Investment Companies

They are divided into three major types:

  1. Open-End Funds: It is also called mutual funds which have a floating number of issued shares, and sell or redeem their shares at their current net asset value (NAV);

  2. Closed-End Funds: Also called investment trusts. They can sell only a fixed number of shares which are traded on stock exchanges, usually at a discount to their net asset value; and

  3. Unit Investment Trusts: Also called unit trusts. They sell their redeemable securities called units which represent interests in the securities held by the trust in its investment portfolio. A unit holder is not a shareholder in a unit trust.

Each type of investment companies has its own unique features. For example, mutual fund and UIT shares are “redeemable” meaning that when investors want to sell their shares, they sell them back to the fund or trust, or to a broker acting for the fund or trust, at their approximate net asset value. Closed-end fund shares, on the other hand, generally are not redeemable.

Instead, when closed-end fund investors want to sell their shares, they generally sell them to other investors on the secondary market, at a price determined by the market. In addition, there are variations within each type of investment company, such as stock funds, bond funds, money market funds, index funds, interval funds, and Exchange Traded Funds (ETFs).

Open End investment Company

An Open-End investment company distributes and redeems securities it issues. The most common open-end management companies are mutual fund companies which sell and redeem shares at the net asset value per share. An investor in an open-end fund essentially pools his/her money with other investors in order to attain economies of scale, professional management, etc.

This differs from a closed-end fund which has a limited number of shares available. Unlike with open-end funds, an investor in a closed- end fund typically sells his/her shares on the open market to another investor instead of back to the fund company.

Concept of Mutual Fund

A mutual fund is a managed group of owned securities of several corporations. These corporations receive dividends on the shares that they hold and realize capital gains or losses on their securities traded. Investors purchase shares in the mutual as if it was an individual security. After paying operating costs, the earnings (dividends, capital gains or loses ) of the mutual fund are distributed to the investors, in proportion to the amount of money invested. Investors hope that a loss on one holding will be made up by a gain on another.

A mutual fund may be either an open-end or a closed-end fund. An open-end mutual fund does not have a set number of shares; it may be considered as a fluid capital stock. The number of shares changes as investors buys or sell their shares. Investors are able to buy and sell their shares of the company at any time for a market price.

However the open-end market price is influenced greatly by the fund managers. On the other hand, closed-end mutual fund has a fixed number of shares and the value of the shares fluctuates with the market. But with close-end funds, the fund manager has less influence because the price of the underlining owned securities has greater influence.

Net Asset Value (NAV)

Net asset value (NAV) represents a fund’s per share market value. This is the price at which investors buy (“bid price”) fund shares from a fund company and sell them (“redemption price”) to a fund company. It is derived by dividing the total value of all the cash and securities in a fund’s portfolio, less any liabilities, by the number of shares outstanding. An NAV computation is undertaken once at the end of each trading day based on the closing market prices of the portfolio’s securities.

For example, if a fund has assets of $50 million and liabilities of $10 million, it would have a NAV of $40 million. This number is important to investors because it is from NAV that the price per unit of a fund is calculated. By dividing the NAV of a fund by the number of outstanding units, you are left with the price per unit. In our example, if the fund had 4 million shares outstanding, the price-per-share value would be $40 million divided by 4 million, which equals $10.

This pricing system for the trading of shares in a mutual fund differs significantly from that of common stock issued by a company listed on a stock exchange. In this instance, a company issues a finite number of shares through an initial public offering (IPO), and possibly subsequent additional offerings, which then trade in the secondary market. In this market, stock prices are set by market forces of supply and demand. The pricing system for stocks is based solely on market sentiment.

In the context of mutual funds, NAV per share is computed once a day based on the closing market prices of the securities in the fund’s portfolio. All mutual funds’ buy and sell orders are processed at the NAV of the trade date.

However, investors must wait until the following day to get the trade price. Mutual funds pay out virtually all of their income and capital gains. As a result, changes in NAV are not the best gauge of mutual fund performance, which is best measured by annual total return. Because ETFs and closed-end funds trade like stocks, their shares trade at market value, which can be a dollar value above (trading at a premium) or below (trading at a discount) NAV.

Role of AMFI (Association Mutual Fund in India)

The Association of Mutual Funds in India (AMFI) is dedicated to developing the Indian Mutual Fund Industry on professional, healthy and ethical lines and to enhance and maintain standards in all areas with a view to protecting and promoting the interests of mutual funds and their unitholders.

Closed End Fund

A closed-end fund (CEF) is a publicly-traded security that offers its shareholders partial ownership in an underlying portfolio of assets.

Closed-end funds initially raise capital through an initial public offering. They then use the proceeds to invest in a basket of securities. The term “closed-end” refers to the fact that once the initial shares are issued, the fund is basically “closed” to new investors wishing to purchase shares from the company. Instead, buying and selling takes place between individual investors.

Investment companies are classified as either closed-end or open-end, depending on the fund’s redemption feature. Closed-end funds do not redeem investors’ shares — shares are bought and sold at market prices on an exchange. Open-end funds, also known as mutual funds, directly buy and sell investor shares at net asset value (NAV). NAV is simply the fund assets minus fund liabilities.

Similar to common stocks, closed-end funds usually trade on one of the major U.S. exchanges. However, unlike regular stocks, they represent a share of a specialized portfolio managed by a group of investment advisors. These managers typically concentrate on a specific industry, country, or sector. Management strategies are explained in a closed-end fund’s prospectus, which should be reviewed thoroughly before investing.

Closed-end funds typically invest in more speculative investments than open-end mutual funds, and they sometimes invest in illiquid assets or alternative asset classes. For example, Closed Fund XYZ may specialize in buying and selling mortgage-backed securities (MBS). MBS are generally not available to individuals, so if you want exposure to them, you can buy shares of Closed Fund XYZ.

One important aspect of closed-end funds is that their share price can deviate substantially from their NAV. If the shares are trading at a higher price than the fund’s NAV, they are said to be trading at a premium. Conversely, a fund with a share price lower than its NAV is said to be trading at a discount. Closed-end funds that trade at substantial discounts to their NAV may offer compelling opportunities for investors to pick up good assets on the cheap.

Closed-end funds can be an easy way for an individual to invest in a piece of a diversified portfolio. Like open-end funds, these securities allow individual investors an opportunity to invest in a wide range of assets, industries, countries, etc. They also allow the individual investor a chance to invest in highly specialized and sometimes speculative instruments that would otherwise be off-limits or unavaible.

Before purchasing, it is important to understand any sales fees and management expenses, which are listed and explained in the fund’s prospectus. Fees vary from fund to fund and can eat away at your total return.

  • Closed-end investment company’s do not continuously offer shares to the public. Capital is raised by rights offerings, to existing shareholders.

  • Closed-end companies can influence the net asset value, but this is not of great concern to investors.

  • Closed-end companies are permitted to invest in unlisted securities, which may not have a liquid market.

  • Closed-end companies are not required to buy its shares back from investors upon request.

  • Portfolios of closed-end companies are managed by separateinvestment advisers, who do not benefit from the continuous buying and selling of the funds assets, like mutual funds.

  • Investors should carefully read all of a fund’s available information, including its prospectus, and most recent shareholder report, before putting assets into a closed- end fund

Unit Investment Trusts (UITs)

Unit investment trusts (UITs) are registered investment companies with some characteristics of mutual funds and some of the closed-end funds. Like closed-end funds, however, UITs typically issue only a specific, fixed number of shares.

A UIT typically issues redeemable securities or units like a mutual fund, which means that the UIT will buy back an investor’s units at the investor’s request, at their approximate net asset value (or NAV). Some exchange-traded funds (ETFs) are structured as UITs.

  • A UIT typically will make a one-time public offering of only a specific, fixed number of units like closed-end funds. Many UIT sponsors, however, will maintain a secondary market, which allows owners of UIT units to sell them back to the sponsors and allows other investors to buy UIT units from the sponsors.

  • A UIT will have a termination date (a date when the UIT will terminate and dissolve) that is established when the UIT is created (although some may terminate more than fifty years after they are created).

    In the case of a UIT investing in bonds, for example, the termination date may be determined by the maturity date of the bond investments. When a UIT terminates, any remaining investment portfolio securities are sold and the proceeds are paid to the investors.

  • A UIT does not actively trade its investment portfolio. That is, a UIT buys a relatively fixed portfolio of securities (for example, five, ten, or twenty specific stocks or bonds), and holds them with little or no change for the life of the UIT.

    Because the investment portfolio of a UIT generally is fixed, investors know more or less what they are investing in for the duration of their investment. Investors will find the portfolio securities held by the UIT listed in its prospectus.

A UIT does not have a board of directors, corporate officers, or an investment adviser to render advice during the life of the trust.

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