Chapter Five: Nonbank Finance

5.1 Insurance Companies

Insurance companies are in the business of assuming risk on behalf of their
customers in exchange for a fee, called a premium. Insurance companies make a
profit by charging premiums that are sufficient to pay the expected claims to the
company plus a profit. Why do people pay for insurance when they know that over
the lifetime of their policy, they will probably pay more in premiums than the
expected amount of any loss they will suffer? Because most people are risk-averse:
They would rather pay a certainty equivalent (the insurance premium) than accept
the gamble that they will lose their house or their car. Thus, it is because people are
risk-averse that they prefer to buy insurance and know with certainty what their
wealth will be (their current wealth minus the insurance premium) than to incur the
risk and run the chance that their wealth may fall.
Consider how people’s lives would change if insurance were not available. Instead of
knowing that the insurance company would help if an emergency occurred, everyone
would have to set aside reserves. These reserves could not be invested long-term
but would have to be kept in an extremely liquid form. Furthermore, people would be
constantly worried that their reserves would be inadequate to pay for catastrophic
events such as the loss of their house to fire, the theft of their car, or the death of the
family breadwinner. Insurance allows
us the peace of mind that a single event can have only a limited financial impact on
our lives.
Fundamentals of Insurance

Although there are many types of insurance and insurance companies, all insurance
is subject to several basic principles.

1. There must be a relationship between the insured (the party covered by insurance)
and the beneficiary (the party who receives the payment should a loss occur). In
addition, the beneficiary must be someone who may suffer potential harm. For
example, you could not take out a policy on your neighbour’s teenage driver
because you are unlikely to suffer harm if the teenager gets into an accident. The
reason for this rule is that insurance companies do not want people to buy
policies as a way of gambling.
2. The insured must provide full and accurate information to the insurance company.

3. The insured is not to profit as a result of insurance coverage.

4. If a third party compensates the insured for the loss, the insurance company’s
obligation is reduced by the amount of the compensation.

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5. The insurance company must have a large number of insureds so that the risk
can be spread out among many different policies.
6. The loss must be quantifiable. For example, an oil company could not buy a
policy on an unexplored oil field.
7. The insurance company must be able to compute the probability of the loss
occurring.

The purpose of these principles is to maintain the integrity of the insurance process.
Without them, people may be tempted to use insurance companies to gamble or
speculate on future events. Taken to an extreme, this behavior could undermine the
ability of insurance companies to protect persons in real need. In addition, these
principles provide a way to spread the risk among many policies and to establish a
price for each policy that will provide an expectation of a profitable return.

Despite following these guidelines, insurance companies suffer greatly from the
problems of asymmetric information.
Adverse Selection and Moral Hazard in Insurance

Recall that adverse selection occurs when the individuals most likely to benefit from
a transaction are the ones who most actively seek out the transaction and are thus
most likely to be selected. We discussed adverse selection in the context of
borrowers with the worst credit being the ones who most actively seek loans. The
problem also occurs in the insurance market. Who is more likely to apply for health
insurance, someone who is seldom sick or someone with chronic health problems?
Who is more likely to buy flood insurance, someone who lives on a mountain or
someone who lives in a river valley?
In both cases, the party more likely to suffer a loss is the party likely to seek
insurance. The implication of adverse selection is that loss probability statistics
gathered for the entire population may not accurately reflect the loss potential for
the persons who actually want to buy policies.
The adverse selection problem raises the issue of which policies an insurance
company should accept. Because someone in poor health is more likely to buy a
supplemental health insurance policy than someone in perfect health, we might
predict that insurance companies should turn down anyone who applies. Since this
does not happen, insurance companies must have found alternative solutions. For
example, most insurance companies require physical exams and may examine
previous medical records before issuing a health or life insurance policy. If some
previous illness is found to be a factor in the person’s health, the company may issue
the policy but exclude this pre-existing condition. Insurance firms often offer better
rates to insure groups of people, such as everyone working at a particular business,
because

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the adverse selection problem is then avoided.
In addition to the adverse selection problem, moral hazard plagues the insurance
industry. Moral hazard occurs when the insured fails to take proper precautions to
avoid losses because losses are covered by insurance. For example, moral hazard
may cause you not to lock your car doors if you will be reimbursed by insurance if
the car is stolen.
One way that insurance companies combat moral hazard is by requiring a deductible.
A deductible is the amount of any loss that must be paid by the insured before the
insurance company will pay anything. For example, if new auto covers cost Br
200,000 and the auto owner has Br20,000 deductibles, the owner will pay the first Br
20,000 of the loss and the insurance company will pay Br 180,000. In addition to
deductibles, there may be other terms in the insurance contract aimed at reducing
risk. For example, a business insured against fire may be required to install and
maintain a sprinkler system on its premises to reduce the loss should a fire occur.
Although contract terms and deductibles help with the moral hazard problem, these
issues remain a constant difficulty for insurance companies.

Selling Insurance

Another problem common to insurance companies is that people often fail to seek
as much insurance as they actually need. Human nature tends to cause people to
ignore their mortality, for example. For this reason, insurance, unlike many banking
services, does not sell itself. Instead, insurance companies must hire large sales
forces to sell their products. The expense of marketing may account for up to 20% of
the total cost of a policy. A good sales force can convince people to buy insurance
coverage that they never would have pursued on their own yet may need.
Insurance is unique in that agents sell a product that commits the company to a risk.
The relationship between the agent and the company varies: Independent agents
may sell insurance for a number of different companies. They do not have any
particular loyalty to any one firm and simply try to find the best product for their
customer.
Exclusive agents sell the insurance products for only one insurance company. Most
agents, whether independent or exclusive, are compensated by being paid a
commission. The agents themselves are usually not at all concerned with the level of
risk of any one policy because they have little to lose if a loss occurs. (Rarely are
commissions influenced by the claims submitted by an agent’s customers.) To keep
control of the risk that agents are incurring on behalf of the company, insurance
companies employ underwriters, people who review and sign off on each policy an
agent writes and who have the authority to turn down a policy if they deem the risk
unacceptable. If underwriters have questions about the quality of customers, they
may order an independent inspector to review the property being insured or request
additional medical information. A final decision to accept the policy may depend on

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the inspector’s report.
Types of Insurance

Insurance is classified by which type of undesirable event is insured. The most

common types are life insurance and property and casualty insurance. In its simplest
form, life insurance provides income for the heirs of the deceased. Many insurance
companies offer policies that provide retirement benefits as well as life insurance. In
this case, the premium combines the cost of the life insurance with a savings
program. The cost of life insurance depends on such factors as the age of the
insured, average life expectancies, the health and lifestyle of the insured (whether
the insured smokes, engages in a dangerous hobby such as skydiving, and so on),
and the insurance company’s operating costs.

Property and casualty insurance protects property (houses, cars, boats, and so on)
against losses due to accidents, fire, disasters, and other calamities. Marine
insurance, for example, which insures against the loss of a ship and its cargo, is the
oldest form of insurance, predating even life insurance. Property and casualty
policies tend to be short-term contracts subject to frequent renewal. Another
significant distinction between life insurance policies and property and casualty
policies is that the latter do not have a savings component. Property and casualty
premiums are based simply on the probability of sustaining the loss. That is why car
insurance premiums are higher if a driver has had speeding tickets, has caused
accidents, or lives in a high-crime area. Each of these events increases the likelihood
that the insurance company will have to pay a claim.

1. Life Insurance
Life is assumed to unfold in a predictable sequence: You work for a number of years
while saving for retirement; then you retire, live off the fruits of your earlier labor, and
die at a ripe old age. The problem is that you could die too young and not have time
to provide for your loved ones, or you could live too long and run out of retirement
assets. Either option is very unappealing to most people. The purpose of life
insurance is to relieve some of the concern associated with either eventuality.
Although insurance cannot make you comfortable with the idea of a premature death,
it can at least allow you the peace of mind that comes with knowing that you have
provided for your heirs. Life insurance companies also want to help people save for
their retirement. In this way, the insurance company provides for the customer’s
whole life.

The basic products of life insurance companies are life insurance proper, disability
insurance, annuities, and health insurance. Life insurance pays off if you die,
protecting those who depend on your continued earnings. As mentioned, the person
who receives the insurance payment after you die is called the beneficiary of the
policy. Disability insurance replaces part of your income should you become unable

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to continue working due to illness or an accident.
An annuity is an insurance product that will help if you live longer than you expect.
For an initial fixed sum or stream of payments, the insurance company agrees to pay
you a fixed amount for as long as you live. If you live a short life, the insurance
company pays out less than expected. Conversely, if you live unusually long, the
insurance company may pay out much more than expected. Notice one curiosity
among these various types of insurance: Although predicting any one individual’s life
expectancy or probability of being disabled is very difficult, when many people are
insured, the actual amount to be paid out by the
insurance company can be predicted very accurately.
The law of large numbers says that when many people are insured, the probability
distribution of the losses will assume a normal probability distribution, a distribution
that allows accurate predictions. This distribution is important: Because insurance
companies insure so many millions of people, the law of large numbers tends to
make the company’s predictions quite accurate and allows companies to price the
policies so that they can earn a profit.
Life insurance policies protect against an interruption in the family’s stream of
income. The broad categories of life insurance products are term, whole life, and
universal life.

Term Life The simplest form of life insurance is the term insurance policy, which
pays out if the insured dies while the policy is in force. This form of policy contains
no savings element. Once the policy period expires, there are no residual benefits. As
the insured ages, the probability of death increases, so the cost of the policy rises.

Some term policies fix the premiums for a set number of years, usually five or ten.
Alternatively, decreasing term policies have a constant premium, but the amount of
the insurance coverage declines each year.
Term policies have been historically hard to sell because once they expire, the
policyholder has nothing to show for the premium paid. This problem is solved with
whole life policies.

Whole Life A whole life insurance policy pays a death benefit if the policyholder dies.
Whole life policies usually require the insured to pay a level premium for the duration
of the policy. In the beginning, the insured pays more than if a term policy had been
purchased. This overpayment accumulates as a cash value that can be borrowed by
the insured at reasonable rates.

Survivorship benefits also contribute to the accumulated cash values. When

members of the insured pool die, any remaining cash values are divided among the
survivors. If the policyholder lives until the policy matures, it can be surrendered for

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its cash value. This cash value can be used to purchase an annuity. In this way, the
whole life policy is advertised as covering the insured for the duration of his or her
life.
Universal Life Universal life policies combine the benefits of the term policy with
those of the whole life policy. The major benefit of the universal life policy is that the
cash value
accumulates at a much higher rate.
The universal life policy is structured to have two parts, one for the term life
insurance and one for savings. One important advantage that universal life policies
have over many alternative investment plans is that the interest earned on the
savings portion of the account is tax-exempt until withdrawn. To keep this
favourable tax treatment, the cash value of the policy cannot exceed the death
benefit.
Annuities If we think of term life insurance as insuring against death, the annuity can
be viewed as insuring against life. One risk people have is outliving their retirement
funds. If they live longer than they projected when they initially retired, they could
spend all of their money and end up in poverty. One way to avoid this outcome is by
purchasing annuities. Once an annuity has been purchased for a fixed amount, it
makes payments as long as the beneficiary lives.
Annuities are particularly susceptible to the adverse selection problem. When people
retire, they know more about their life expectancy than the insurance company
knows. People who are in good health, have a family history of longevity, and have
attended to their health all of their lives are more likely to live longer and hence to
want to buy an annuity more than people in poor or average health. To avoid this
problem, insurance companies tend to price individual annuities expensively.

Most annuities are sold to members of large groups where all employees covered by
a particular pension plan automatically receive their benefit distribution by
purchasing an annuity from the insurance company. Because the annuity is
automatic, the adverse selection problem is eliminated.

Assets and Liabilities of Life Insurance Companies Life insurance companies

derive funds from two sources. First, they receive premiums that represent future
obligations that must be met when the insured dies. Second, they receive premiums
paid into pension funds managed by the life insurance company. These funds are
long-term in nature.
Since life insurance liabilities are predictable and long-term, life insurance
companies can invest in long-term assets.
2. Health Insurance

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Individual health insurance coverage is very vulnerable to adverse selection
problems. People who know that they are likely to become ill are the most likely to
seek health insurance coverage. This causes individual health insurance to be very
expensive. Most policies are offered through company-sponsored programs in which
the company pays all or part of the employee’s policy premium. Most life insurance
companies also offer health insurance. Health insurance premiums may account for
a significant portion of total premium income.
3. Property and Casualty Insurance
Property and casualty insurance was the earliest form of insurance. It began in the
Middle Ages when merchants sent ships off to foreign ports to trade. A merchant,
though willing to accept the risk that the trading might not turn a profit, was often
unwilling to accept the risk that the ship might sink or be captured by pirates. To
reduce such risks, merchants began to band together and insure each other’s ships
against loss. The process became more sophisticated as time went on, and
insurance policies were written that were then traded in the major commercial
centers of the time.
Property and Casualty Insurance Today Property and casualty insurance protects
against losses from fire, theft, storm, explosion, and even neglect. Property
insurance protects businesses and owners from the impact of risk associated with
owning property. This includes replacement and loss of earnings from income
producing property as well as financial losses to owners of residential property.

Casualty insurance (or liability insurance) protects against liability for harm the
insured may cause to others as a result of product failure or accidents. For example,
part of your car insurance is property insurance (which pays if your car is damaged)
and part is casualty insurance (which pays if you cause an accident). Property and
casualty insurance is different from life insurance. First, policies tend to be short-
term, usually for one year or less. Second, whereas life insurance is limited to
insuring against one event, property and casualty companies insure against many
different events. Finally, the amount of the potential loss is much more difficult to
predict than for life insurance. These characteristics cause property and casualty
companies to hold more liquid assets than those of life insurance companies. The
wide range of losses means that property and casualty firms must maintain
substantial liquidity. Property insurance can be provided in either named-peril
policies or open peril policies. Named-peril policies insure against loss only from
perils that are specifically named in the policy, whereas open-peril policies insure
against all perils except those specifically excluded by the policy. For example, many
homeowners in low-lying areas are required to buy flood insurance. This insurance
covers only losses due to flooding, so it is a named-peril policy. A homeowner’s
insurance policy, which protects the house from fire, hurricane, tornado, and other
damage, is an example of an open-peril policy.

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Casualty or liability insurance protects against financial losses because of a claim of
negligence. Liability insurance is bought not only by manufacturers who might be
sued because of product defects but also by many types of professionals, including
physicians, lawyers, and building contractors. Whereas the risk exposure in property
insurance policies is relatively easy to predict, since it is usually limited to the value
of the property, liability risk exposure is much more difficult to determine.
Reinsurance One way that insurance companies may reduce their risk exposure is to
obtain reinsurance. Reinsurance allocates a portion of the risk to another company
in exchange for a portion of the premium. Reinsurance allows insurance companies
to write larger policies because a portion of the policy is actually held by another firm.
Smaller insurance firms obtain reinsurance more frequently than large firms. You
can think of it as insurance for the insurance company.

Since the originator of the policy usually has more to lose than the reinsurer, the
moral hazard and adverse selection problems are small. This means that little
specific information about the risk being reinsured is required. As a result of the
simplified information requirements, the reinsurance market consists of relatively
standardized contracts.
Credit Default Swaps

A CDS is insurance against default on a financial instrument, usually some kind of

securitized bond. Typically, the holder of debt will buy a CDS from an investment or
insurance company, such as AIG to shift the risk of default to a third party. When the
probability of default is low, the cost of the CDS is similarly low. By lowering the risk
of these insured bonds with default insurance, the market price of the bonds would
increase.
Monoline Insurance Instead of providing credit insurance with CDSs, an insurance
company may supply it directly, just as with any insurance policy. However,
insurance regulations do not allow property/casualty insurance companies, life
insurance companies, or insurance companies with multiple lines of business to
underwrite credit insurance. Monoline insurance companies, which specialize in
credit insurance alone, are therefore the only insurance companies that are allowed
to provide insurance that guarantees the timely repayment of bond principal and
interest when a debt issuer defaults.

5.2 Pension Funds

A pension plan is an asset pool that accumulates over an individual’s working years
and is paid out during the nonworking years.
Types of Pensions

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Pension plans can be categorized in several ways. They may be defined-benefit or
defined-contribution plans, and they may be public or private.

1. Defined-Benefit Pension Plans

Under a defined-benefit plan, the plan sponsor promises the employees a specific
benefit when they retire. The payout is usually determined with a formula that uses
the number of years worked and the employee’s final salary. For example, a pension
benefit may be calculated by the following formula:

In this case, if a worker had been employed for 35 years and the average wages
during the last three years were Br 50,000, the annual pension benefit would be
0.02 x Br 50,000 x 35 = Br 35,000 per year
The defined-benefit plan puts the burden on the employer to provide adequate funds
to ensure that the agreed payments can be made. External audits of pension plans
are required to determine whether sufficient funds have been contributed by the
company. If sufficient funds are set aside by the firm for this purpose, the plan is
fully funded. If more than enough funds are available, the plan is overfunded.
Often, insufficient funds are available and the fund is underfunded. For example, if
Abebe contributes Br 100 per year into his pension plan and the interest rate is 10%,
after 10 years, the contributions and their interest earnings would be worth Br
1,753.2. If the defined benefit on his pension plan is Br 1,753 or less after 10 years,
the plan is fully funded because his contributions and earnings will cover this
payment in full. But if the defined benefit is Br 2,000, the plan is underfunded
because his contributions and earnings do not cover this amount. Underfunding is
most common when the employer fails to contribute adequately to the plan.
Surprisingly, it is not illegal for a firm to sponsor an underfunded plan.
2. Defined-Contribution Pension Plans
As the name implies, instead of defining what the pension plan will pay, defined-
contribution plans specify only what will be contributed to the fund. The retirement
benefits are entirely dependent on the earnings of the fund. Corporate sponsors of
defined-contribution plans usually put a fixed percentage of each employee’s wages
into the pension fund each pay period. In some instances, the employee also
contributes to the plan. An insurance company or fund manager acts as trustee and
invests the fund’s assets. Frequently, employees are allowed to specify how the
funds in their individual accounts will be invested. For example, an employee who is
a conservative investor may prefer government securities, while one who is a more
aggressive investor may prefer to have his or her retirement funds invested in
corporate stock. When the employee retires, the balance in the pension account can
be transferred into an annuity or some other form of distribution.

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Defined-contribution pension plans are becoming increasingly popular. Many
existing defined-benefit plans are converting to this form, and virtually all new plans
are established as defined-contribution. One reason the defined-contribution plan is
becoming so popular is that the onus is put on the employee rather than the
employer to look out for the pension plan’s performance. This reduces the liability of
the employer. One problem is that plan participants may not understand the need to
diversify their holdings. For example, many firms actively encourage employees to
invest in company stock. The firm’s motivation is to better align employee interest
with that of stockholders. The downside is that employees suffer twice should the
firm fail. First, they lose their jobs, and second, their retirement portfolios evaporate.
The collapse of Enron Inc. brought this issue forcibly to the public’s attention.
Another problem with defined-contribution plans is that many employees are not
familiar enough with investments to make wise long-term choices.
Private and Public Pension Plans

Private pension plans, sponsored by employers, groups, and individuals, have grown
rapidly as people have become more concerned about the viability of Social Security
and more sophisticated about preparing for retirement. In the past, private pension
plans invested mostly in government securities and corporate bonds. Although these
instruments are still important pension plan assets, corporate stocks, mortgages,
open
market paper, and time deposits now play a significant role.
An alternative to privately sponsored pension plans are the public plans, though
in many cases there is very little difference between the two. A public pension plan
is one that is sponsored by a governmental body. The public plan in Ethiopia is the
Social Security. The amount of the Social Security benefits a retiree receives is
based on the person’s earnings history.

5.3 Mutual Funds

Suppose that you decide that you want to begin investing for retirement. You would
probably want to hold some money in a diversified portfolio of stocks. You might
want to put some money in bonds. You might even want to hold stock in some
foreign companies. Now suppose your budget will only let you invest Br 25 per week.
How are you going to build this retirement fund? You will probably not want to buy
individual stocks, and with only Br 25 to spend at a time, you will not be able to buy
bonds. The solution to your problem is to invest in mutual funds.
Mutual funds pool the resources of many small investors by selling them shares in
the fund and using the proceeds to buy securities. Through the asset transformation
process of issuing shares in small denominations and buying large blocks of
securities, mutual funds can take advantage of volume discounts on brokerage
commissions and can purchase diversified portfolios of securities. Mutual funds
allow small investors to obtain the benefits of lower
transaction costs in purchasing securities and to take advantage of a reduction in
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risk by diversifying their portfolios.
The Growth of Mutual Funds
The First Mutual Funds
The origins of mutual funds can be traced back to the mid to late 1800s in England
and Scotland. Investment companies were formed that pooled the funds of investors
with modest resources and used the money to invest in a number of different
securities. These investment companies became more popular when they began
investing in the economic growth of the United States, mostly by purchasing
American railroad bonds.
The first fund in which new shares were issued as new money was invested—the
dominant structure seen today—was introduced in Boston in 1824. This fund allowed
for continuous offering of shares, the ability to cash out of the fund at any time, and
a set of restrictions on investments aimed at protecting investors from losses.

The stock market crash of 1929 set mutual fund growth back for several decades
because small investors distrusted stock investments generally and mutual funds in
particular.

Benefits of Mutual Funds

There are five principal benefits that attract investors to mutual funds:
1. Liquidity intermediation
2. Denomination intermediation
3. Diversification
4. Cost advantages
5. Managerial expertise

Liquidity intermediation means that investors can convert their investments into
cash quickly and at a low cost. If you buy a CD or a bond, there can be early
redemption penalties or transaction fees imposed if you need your funds before the
securities mature. Additionally, if you bought a Br10,000 CD, you must redeem the
whole security even if you only require Br 5,000 to meet your current needs. Mutual
funds allow investors to buy and redeem at any time and in any amount. Some funds
are designed specially to meet short-term transaction requirements and have no
fees associated with redemption, whereas others are designed for longer-term
investment and may have redemption fees if they are held only a short time.

Denomination intermediation allows small investors access to securities they would

be unable to purchase without the mutual fund. For example, most money market
securities are only available in large denominations, often in excess of $100,000. By
pooling money, the mutual fund can purchase these securities on behalf of investors.
Diversification is an important advantage to investing in mutual funds. Your risk can
be lowered by holding a portfolio of diversified securities rather than a limited
number. Small investors buying stocks individually may find it difficult to acquire

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enough securities in enough different industries to capture this benefit. Additionally,
mutual funds provide a low-cost way to diversify into foreign stocks.
Significant cost advantages may accrue to mutual fund investors. Institutional
investors negotiate much lower transaction fees than are available to individual
investors. Additionally, large block trades of 100,000 shares or more trade according
to a different fee structure than do smaller trades. By buying securities through a
mutual fund, investors can share in these lower fees.
One of the main features that has driven mutual fund growth has been access to
managerial expertise. Many investors prefer to rely on professional money
managers to select their stocks. The failure of mutual funds to post greater-than-
average returns should not come as a surprise given the existing market efficiency.
Still, the financial markets remain something of a mystery to a large number of
investors. These investors are willing to pay fees to let someone else choose their
stocks.
The increase in the number of defined-contribution pension plans has also been a
factor in mutual fund growth. In the past, most pension plans either invested on
behalf of the employee and guaranteed a return or required employees to invest in
company stock. Now, most new pension plans require the employee to invest his or
her own pension dollars. With pension investments being made every payday, the
mutual fund provides the perfect pension conduit.
Mutual Fund Structure

Mutual fund companies frequently offer a number of separate mutual funds. They
are called complexes and are defined as a group of funds under substantially
common management, composed of one or more families of funds. The advantage
to investors of fund complexes is that investments can usually be transferred among
different funds within a family very easily and quickly. Additionally, account
information can be summarized by the complex to help investors keep their assets
organized.
In this section we will look at how mutual funds are structured and at the types of
investments the funds hold.

1. Open-Versus Closed-End Funds

Mutual funds are structured in two ways. The first funds were what are now called
closed-end funds. In a closed-end fund, a fixed number of nonredeemable shares are
sold at an initial offering and are then traded in the over-the-counter market like
common stock. The market price of these shares fluctuates with the value of the
assets held by the funds. The market value of the shares may be above or below the
value of the assets held by the fund, depending on the market’s assessment of how
likely managers are to pick stocks that will increase fund value.

The problem with closed-end funds is that once shares have been sold, the fund

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cannot take in any more investment dollars. Thus, to grow the fund managers must
start a whole new fund. The advantage of closed-end funds to managers is that
investors cannot make withdrawals. The only way investors have of getting money
out of their investment in the fund is to sell shares.

Today, the closed-end fund has been largely replaced with the open-end fund.
Investors can contribute to an open-end fund at any time. The fund simply increases
the number of shares outstanding. Another feature of open-end funds is that the
fund agrees to buy back shares from investors at any time. Each day the fund’s net
asset value is computed based on the number of shares outstanding and the net
assets of the fund. All shares bought and sold that day are traded at the same net
asset value.
Open-end mutual funds have a couple of advantages that have contributed to the
growth of mutual funds. First, because the fund agrees to redeem shares at any time,
the investment is very liquid. This liquidity intermediation has great value to investors.
Second, the open-end structure allows mutual funds to grow unchecked. As long as
investors want to put money into the fund, it can expand to accommodate them.
Organizational Structure
Regardless of whether a fund is organized as a closed-or an open-end fund, it will
have the same basic organizational structure. The investors in the fund are the
shareholders. In the same way that shareholders of corporations receive the residual
income of a company, the shareholders of a mutual fund receive the earnings, after
expenses, of the mutual fund.
The board of directors oversees the fund’s activities and sets policy. They are also
responsible for appointing the investment advisor, usually a separate company, to
manage the portfolio of investments and a principal underwriter, who sells the fund
shares.
The investment advisors manage the fund in accordance with the fund’s stated
objectives and policies. The investment advisors actually pick the securities that will
be held by the fund and make both buy and sell decisions. It is their expertise that
determines the success of the fund.
In addition to the investment advisors, the fund will contract with other firms to
provide additional services. These will include underwriters, transfer agents, and
custodians. Contracts will also be arranged with an independent public accountant.
Large funds may arrange for some of these functions to be done in-house, whereas
other funds will use all outside companies.
Investment Objective Classes
Four primary classes of mutual funds are available to investors. They are (1) stock
funds (also called equity funds), (2) bond funds, (3) hybrid funds, and (4) money
market funds.

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 1. Equity Funds
Equity funds share a common theme in that they all invest in stock. After that, they
can have very different objectives.
2. Bond Funds
Strategic income bonds are the most popular and invest in a combination of
corporate bonds to provide a high level of current income. The quality of the bonds in
these funds will often be lower than in some other classes, but their yields will be
higher. Investors are trading safety for greater returns. Corporate bond funds, the
next most popular fund type, invest primarily in high-grade corporate bonds.
Government bonds are also popular. These are essentially default risk-free, but will
have relatively low returns. Bonds are not as risky as stocks, and so it is not usually
as important that investors diversify across a large number of different bonds.
Additionally, it is relatively easy to buy and sell bonds through the secondary market.
As a result, it is not surprising that bond mutual funds hold only about a third of the
assets held by stock mutual funds. Still, many investors value the liquidity
intervention and automatic reinvestment features provided by bond mutual funds.
3. Hybrid Funds
Hybrid funds combine stocks and bonds into one fund. The idea is to provide an
investment that diversifies across different types of securities as well as across
different issuers of a particular type of security. Thus, if an investor found a hybrid
fund that held the percentage of stocks and bonds he wanted, he could own just one
fund instead of several. Despite this apparent convenience, most investors still
prefer to choose separate funds.
4. Money Market Funds
Customers who had MMMF accounts could simply direct the broker to take funds
out of this account to buy stocks or to deposit funds in this account when they sold
securities. All MMMFs are open-end investment funds that invest only in money
market securities. Most funds do not charge investors any fee for purchasing or
redeeming shares.
An important feature of MMMFs is that many have check-writing privileges. They
often do not charge a fee for writing checks or have any minimum check amount as
long as the balance in the account is above the stated level. This convenience, along
with market interest rates, makes the accounts very popular with small investors.
The money invested in MMMFs is in turn invested in money market instruments.
Commercial paper and certificates of deposit are by far the largest component of
these
funds, followed by treasury securities and repurchase agreements.
Fee Structure of Investment Funds

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All mutual fund accounts are subject to a variety of fees. One of the primary factors
that an investor should consider before choosing a mutual fund is the level of fees
the fund charges. The fees are taken out of portfolio income before it is passed on to
the investor. Since the investor is not directly charged the fees, many will not realize
that they have even been subtracted.
The usual fees charged by mutual funds are the following:
 A contingent deferred sales charge imposed at the time of redemption is an
alternative way to compensate financial professionals for their services. This
fee typically applies for the first few years of ownership and then disappears.
 A redemption fee is a back-end charge for redeeming shares. It is expressed as
a dollar amount or a percentage of the redemption price.
 An exchange fee may be charged when transferring money from one fund to
another within the same fund family.
 An account maintenance fee is charged by some funds to maintain low balance
accounts.
 Other fees, if any, are deducted from the fund’s assets to pay marketing and
advertising expenses or, more commonly, to compensate sales professionals.
Regulation of Mutual Funds
As part of government regulation, all funds must provide two types of documents
free of charge: a prospectus and a shareholder report. A mutual fund’s prospectus
describes the fund’s goals, fees and expenses, and investment strategies and risks;
it also gives information on how to buy and sell shares. Government requires a fund
to provide a full prospectus either before an investment or together with the
confirmation statement of an initial investment.

Annual and semi-annual shareholder reports discuss the fund’s recent performance
and include other important information, such as the fund’s financial statements. By
examining these reports, an investor can learn if a fund has been effective in meeting
the goals and investment strategies described in the fund’s prospectus. In addition,
investors are sent a yearly statement detailing the tax status of distributions
received from the fund. Mutual fund shareholders are taxed on the fund’s income
directly, as if the shareholders held the underlying securities themselves. Similarly,
any tax-exempt income received by a fund is generally passed on to the shareholders
as tax exempt.
Government may believe that independent directors play a critical role in the
governance of mutual funds. To this effect, it may adopt substantive rules designed
to enhance the independence of investment company directors and provide
investors with more information to assess directors’ independence. These rules
require that:

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  Independent directors constitute at least a majority of the fund’s board of
directors.

 Independent directors select and nominate other independent directors.

 Any legal counsel for the fund’s independent directors be an independent

legal counsel.
In addition, government rules may require that mutual funds publish extensive
information about directors, including their business experience and fund shares
held. This system of overseeing the interests of mutual fund shareholders may help
the industry avoid systemic problems and contribute significantly to public
confidence in mutual funds.
Conflicts of Interest in the Mutual Fund Industry
Many of the corporate governance breakdowns observed recently were due to the
principal–agent relationship. If these funds take advantage of investors or fail to
provide the returns they should, people will find themselves unable to retire or having
to scale back their retirement plans. No one argues that mutual funds can or should
guarantee any specific return. They should, however, treat all investors equally and
accurately disclose risk and fees. They must also follow the policies and rules they
publish as governing the management of each fund.
Sources of Conflicts of Interest

Conflicts of interest arise when there is asymmetric information and the principal’s
and agent’s interests are not closely aligned. The governance structure of mutual
funds creates such a situation. Investors in a mutual fund are the shareholders. They
elect directors, who are supposed to look out for their interest. The directors in turn
select investment advisors, who actually run the mutual fund. However, given the
large number of shareholders in the typical fund, there is a free-rider problem that
prevents them from monitoring either the directors or the investment advisers.

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