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Mutual Funds

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Learning Objectives

1. The different types of mutual funds.

2. How mutual funds operate.

3. How to find information about how mutual funds have performed.

4. The workings of Exchange Traded Funds.

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Mutual Funds: Overview

• Around 1980, 5 million Americans owned mutual funds.

• By 2007, 96 million Americans in 55 million households owned mutual funds.

• In 2006 investors added $474 billion in net new funds to mutual funds.

• In 2006, mutual fund assets totaled $10.4 trillion.

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Mutual Funds:

• A means of combining or pooling the funds of a large group of investors

• Buy and sell decisions made by a fund manager, who is compensated for the service provided

• A financial intermediary

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Mutual Fund Basics• Advantages

• Diversification• Professional management• Minimum investment

• Drawbacks• Risk• Costs• Taxes

• Distributions and profits

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Investment Companies and Fund Types, I

• Investment company = business that specializes in pooling funds from individual investors and making investments.

• Open-end fund = an investment company that stands ready to buy and sell shares in itself to investors, at any time.

• Closed-end fund = an investment company with a fixed number of shares that are bought and

sold by investors, only in the open market.

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Investment Companies and Fund Types, II

Money Market Funds

Long-term Funds

Stock Funds Bonds FundsBlended Funds

Open-end Funds

Investment Companies

Closed-end Funds

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Investment Companies and Fund Types, III

• Net asset value (NAV) is the value of the assets held by a mutual fund, divided by the number of shares.

• Shares in an open-end fund are worth their NAV, because the fund stands ready to redeem their shares at any time.

• In contrast, share value of closed-end funds may differ from their NAV.

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Net Asset Value• Net asset value (NAV):

• Assets under Management (AUM) = the value of the assets held by the fund

NAV = AUM/Shares outstanding

• Open-end fund share value = NAV• Closed-end fund share value may ≠ NAV.

• ABC fund reports $56 billion in assets under management and 750 million shares outstanding• NAV = $56 billion /750 million = $74.67 per share

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Mutual Fund OperationsOrganization and Creation

• Mutual fund = Corporation• Owned by shareholders• Shareholders elect a board of directors• Must supply a prospectus to any interested investor • Annual report to their shareholders

• Most created by:• Investment advisory firms (Fidelity Investments)• Brokerage firms with investment advisory operations (Merrill

Lynch)

• Investment advisory firms earn fees for managing mutual funds.

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Taxation of Investment Companies

• A “regulated investment company” does not have to pay taxes on its investment income.

• To qualify, an investment company must:• Hold almost all its assets as investments in stocks, bonds,

and other securities,• Use no more than 5% of its assets when acquiring a

particular security, and• Pass through all realized investment income to fund

shareholders

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Mutual Fund OperationsThe Fund Prospectus and Annual Report

• Mutual funds are required by law to supply a prospectus to any investor who wishes to purchase shares.

• Mutual funds must also provide an annual report to their shareholders.

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• Shareholder fees • Loads or sales charges• Deferred sales charges (CDSC)• Back-end load

• Annual Operating Expenses• Management fee• 12b-1 fee• Other expenses

The Fund Prospectus

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Sales charge or “Load”• “Load” = difference between NAV and offering or

redemption price• “Front-end loads” or load funds; levied on purchases• “Back-end loads” or “contingent deferred sales

charges” = CDSC; levied on redemptions• Example:

The AGC fund has a net asset value (NAV) of $47.On the same day the offering price is quoted as $50.• AGC is a load fund since NAV ≠ Offering price• The load = $50 - $47 = $3.00 • Load percentage = $3/47 = 6.38%

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• 12b-1 fees • SEC Rule 12b-1 allows funds to spend up to 1% of

fund assets annually to cover distribution and marketing costs.

• Typically 0.75 – 1.0 % of fund assets per year

• Management Fees• Usually range from 0.25% to 1.00% of the fund’s total

assets each year. • Usually based on fund size and/or performance.

12b-1 and Management Fees

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Mutual Fund Costs and FeesTypes of Expenses and Fees

• Trading costs • Not reported directly• Funds must report "turnover," which is related

to the amount of trading.• The higher the turnover, the more trading has

occurred in the fund.• The more trading, the higher the trading costs.

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• “Turnover” • Measures trading • A turnover ratio = 1.0 fund has, in effect, sold

off its entire portfolio and replaced in once during the year.

• Example:• Suppose a fund had average daily assets under

management of $150 million.• During the past year, the fund bought $85 million

of assets and sold $90 million.• Turnover = $85m/$150m = 0.567

Trading Costs & Turnover

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Mutual Fund Costs and FeesExpense Reporting• Mutual funds are required to report expenses

in a fairly standardized way in their prospectus.• Shareholder transaction expenses - loads and

deferred sales charges• Fund operating expenses - management and

12b-1 fees, legal, accounting, and reporting costs, director fees

• Hypothetical example showing the total expenses paid by investors through time per $10,000

invested

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Example: Fee Table

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Mutual Fund Costs and FeesWhy Pay Loads and Fees?

• After all, many good no-load funds exist.

• But, you may want a fund run by a particular manager. All such funds are load funds.

• Or, you may want a specialized type of fund.• Perhaps one that specialized in Italian companies• Loads and fees for specialized funds tend to be higher,

because there is little competition among them.

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Investment Companies & Fund Types

Money Market Funds

Long-term Funds

Stock Funds Bonds FundsBlended Funds

Open-end Funds

Investment Companies

Closed-end Funds

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Short-Term Funds

• Money market mutual funds (MMMFs)• Specialize in money market instruments• Maintain a $1.00 NAV to resemble bank accounts

• “Breaking the Buck” - 1994

• Can be either taxable or tax-exempt

• Banks offer “money market” deposit accounts (MMDAs) • Offers FDIC protection

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Investment Companies & Fund Types

Money Market Funds

Long-term Funds

Stock Funds Bonds FundsBlended Funds

Open-end Funds

Investment Companies

Closed-end Funds

•Historically, mutual funds were classified as stock funds, bond funds, or income funds.

•Today, the investment objective = major determinant of fund type

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Stock FundsLong-term

Funds

Stock Funds Bonds FundsBlended Funds

Capital appreciation

Growth

Growth and Income

Equity income

Sector funds

Small-cap

Mid-cap

Global

International

Large -cap

Price growth vs. Dividend Income

% U.S. vs. International

Economic Sectors

Company Size

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Stock FundsLong-term

Funds

Stock Funds Bonds FundsBlended Funds

Price growth vs. Dividend Income

% U.S. vs. International

Economic Sectors

Company Size

Sector funds

Small-cap

Mid-cap

Global

International

Large -cap

Capital appreciation

Growth

Growth and Income

Equity income

Some stock funds trade off capital appreciation and dividend income.

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Stock FundsLong-term

Funds

Stock Funds Bonds FundsBlended Funds

Price growth vs. Dividend Income

% U.S. vs. International

Economic Sectors

Company Size

Sector funds

Small-cap

Mid-cap

Global

International

Large -cap

Capital appreciation

Growth

Growth and Income

Equity income

Some stock funds focus on companies in a particular size range

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Stock FundsLong-term

Funds

Stock Funds Bonds FundsBlended Funds

Price growth vs. Dividend Income

% U.S. vs. International

Economic Sectors

Company Size

Sector funds

Small-cap

Mid-cap

Global

International

Large -cap

Capital appreciation

Growth

Growth and Income

Equity income Some stock fund invest internationally.

•Global•International•Region•Country•Emerging markets

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Stock FundsLong-term

Funds

Stock Funds Bonds FundsBlended Funds

Price growth vs. Dividend Income

% U.S. vs. International

Economic Sectors

Company Size

Sector funds

Small-cap

Mid-cap

Global

International

Large -cap

Capital appreciation

Growth

Growth and Income

Equity income

Sector funds specialize in specific sectors of the economy:

•Biotechnology•Internet•Energy

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• Index funds• Social conscience fund• “Sin” funds (i.e., tobacco, liquor,

gaming)• Tax-managed funds

Special Interest Stock Funds

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Bond FundsLong-term

Funds

Stock Funds Bonds FundsBlended Funds

Maturity range

Credit quality

Taxabiity

Type of bond

Country

Bond fund types include: • Short-term funds• Intermediate-term funds• General funds• High-yield funds• Mortgage funds • World funds• Insured funds• Single-state municipal funds

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Blended FundsLong-term

Funds

Stock Funds Bonds FundsBlended Funds

Balanced funds

Asset Allocation funds

Income funds

Convertible funds

“Blended” or “Hybrid” Funds:

Funds that do not invest exclusively in either stocks or bonds.

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Mutual Fund Objectives: Recent Developments, I• A mutual fund “style” box is a way of visually

representing a fund’s investment focus by placing the fund into one of nine boxes:

GrowthBlendValue

Large

Medium

Small

Siz

e

Style

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Mutual Fund Objectives: Recent Developments, II

• Recent trend = classifying a mutual fund’s objective based on its actual holdings.

• For example, the Wall Street Journal classifies most general purpose funds based on the market “cap” of the stocks they hold, and also on whether the fund tends to invest in “growth” or “value” stocks (or both).

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Mutual Fund Objectives

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Mutual Fund Selection(www.morningstar.com)

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Mutual Fund Performance• Mutual fund performance is very closely

tracked by a number of organizations.• Financial publications of all types periodically

provide mutual fund data.• The Wall Street Journal is particularly timely

print source.• www.morningstar.com has a “Fund Selector”

that provides performance information

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Mutual Fund Performance: Yardsticks

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Mutual Fund Performance: Online Version of The Wall Street Journal, I

Note the fund with symbol: FBGRX

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Mutual Fund Performance: Online Version of The Wall Street Journal, II

Result of clicking on “BluCh”

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Mutual Fund Performance: Cautions

• While looking at historical returns, the riskiness of the various fund categories should also be considered.

• Whether historical performance is useful in predicting future performance is a subject of ongoing debate.

• Some of the poorest-performing funds are those with very high costs.

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Closed Funds

• A “closed” fund is NOT a “closed-end” fund• “Closed” = the fund will no longer sell shares to

new investors• When a fund grows rapidly, the fund manager

may feel that the incoming cash is more than the fund can invest profitably

• Funds that close often reopen at a later date • The number of shares in a closed fund can still

fluctuate as existing owners buy and sell.

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Closed Funds

• Why would a fund choose to close? • When a fund grows rapidly, the fund

manager may feel that the incoming cash is more than the fund can invest profitably.

• Funds that close often reopen at a later date.

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Closed-End Funds

• A closed-end fund has a fixed number of shares.

• These shares are traded on stock exchanges.• There are about 600 closed-end funds that have

their shares listed on U.S. Stock Exchanges.• There are about 8,000 long-term open-end mutual

funds.

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Mutual Fund Performance

Closed-End Funds

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The Closed-End Funds Discount

• Most closed-end funds sell at a discount relative to their net asset values.• The discount is sometimes substantial. • The typical discount fluctuates over time.

• Despite a great deal of academic research, the closed-end fund discount phenomenon remains largely unexplained.

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ETFs• ETFs = Exchange Traded Funds

• Index funds that trade on exchanges like stock:• Spiders (SPDR)• Diamonds (DIA) • Cubes (QQQQ)

• A list of ETFs can be found at www.amex.com

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Exchange Traded Funds:

Performance

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Exchange Traded Notes, ETNs

• Introduced in mid-2006 by Barclays Bank.• To investors, ETNs look like ETFs:

• ETNs are unsecured debt• Unlike holders of ETFs, holders of ETNs do have

default risk.

• ETNs provide investors with exposure to commodities, but without the leveraged risk of futures contracts.

• Handy web source: www.ipathetn.com

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Hedge Funds• Hedge funds ≈ mutual funds that are free to

pursue any investment style• Very little disclosure or regulation requirements

• Not required to maintain any particular degree of diversification or liquidity

• Hedge fund managers have considerably more freedom to follow various investment strategies, or styles.

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Hedge Funds• Offered only to “sophisticated", usually very

wealthy investors.• Minimum investment = $50,000 to $1 million

• Hedge fund fees:• General management fee = 1-2% of fund

assets• Performance fee = 20-40% of profits

• “Fund of Funds”

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Useful Internet Sites• www.ici.org (mutual fund facts and figures)• www.vanguard.com (example of a major fund family website)• www.fidelity.com (largest investment advisory firm in US)• www.mfea.com (information on thousands of funds)• www.morningstar.com (one of the best mutual fund sites)• www.domini.com (more “social conscience” funds)• www.vicefund.com (“vice” funds)• www.amex.com (exchange traded funds)• www.ishares.com (more on exchange traded funds)• www.ipathetn.com (all about ETNs)• www.hedgeworld.com (hedge fund information)• www.hedgefundcenter.com (more hedge fund information)• www.turnkeyhedgefunds.com (how to start your own hedge fund)