4 4 C h a p t e r Mutual Funds second edition Fundamentals of Investments Valuation & Management...

44C h a p t e r

Mutual FundsMutual Funds

second edition

Fundamentals

of InvestmentsValuation & Management

Charles J. Corrado Bradford D. Jordan

McGraw Hill / Irwin Slides by Yee-Tien (Ted) Fu

2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Mutual Funds

Our goal in this chapter is to understand the different types of mutual funds, their risks, and returns.

Goal

Investors added $363 billion in net new funds to mutual funds in 1999, and by the end of the year, mutual fund assets totaled $6.85 trillion. These were estimated to be owned by

83 million Americans.


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Investment companies and fund types

At the most basic levels. A company that pools funds obtained from individual investors and invests them is called an investment company

An investment company is a business that specializes in managing financial assets for individual investors.

All mutual funds are in fact investment companies, however not all investment companies are mutual funds.


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Mutual Funds

Mutual funds are simply a means of combining or pooling the funds of a large group of investors.

The buy and sell decisions for the resulting pool are then made by a fund manager, who is compensated for the service provided.

Like commercial banks and life insurance companies, mutual funds are a form of financial intermediary.


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Open-End Versus Closed-End Fund

There are two types of investment companies, open end funds and closed end funds.

With an open end fund, the fund itself will sell new shares to anyone wishing to buy and will redeem shares from anyone wishing to sell.

As a result with an open end fund , the number of shares outstanding fluctuates through time

With a closed end, the number of shares is fixed and never changes, if you want to buy shares, you can buy them from another investor.


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Open-End Versus Closed-End Fund

Strictly, speaking the term mutual fund actually refers only to an open end investment company.


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Investment Companies and Fund Types

Investment companyA business that specializes in pooling funds from individual investors and investing them.

Closed-end fundAn investment company with a fixed number of shares that are bought and sold only in the open stock market.

Open-end fundAn investment company that stands ready to buy and sell shares at any time.


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@2002 by the McGraw- Hill Companies Inc.All rights reserved.McGraw Hill / Irwin


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

In contrast, the shares of closed-end funds may or may not be equal to their NAV.

Net asset valueThe value of the assets held by a mutual fund, divided by the number of shares. Abbreviated NAV.


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Mutual Fund Operations

Organization and Creation A mutual fund is simply a corporation. It is owned

by shareholders, who elect a board of directors. The board of director is responsible for hiring a

manager to oversee the fund’s operations Most mutual funds are created by investment

advisory firms( which are businesses that specialize in managing mutual funds) or brokerage firms with investment advisory operations


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These firms wish to manage the funds to earn fees.

Investment advisory firms are also called mutual fund companies, such firms have additional operations such as discount brokerages and other financial services.


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Regulated investment company doesn’t pay taxes on its investment income. The fund passes through all realized investment income to fund shareholders who then pay taxes on these distributions as though they owned the securities.


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Taxation of Investment Companies An investment company that

holds almost all its assets as investments in stocks, bonds, and other securities,

uses no more than 5% of its assets when acquiring a particular security, and

passes through all realized investment income to fund shareholders,

is treated as a “regulated investment company” for tax purposes and does not need to pay taxes on its investment income.


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The 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.

The prospectus and annual report contain financial statement along with information concerning the fund’s expenses, gains and losses, objectives ----


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Mutual Fund Costs and Fees

Types of Expenses and FeesSales charges or “loads.” many mutual funds

charge a fee whenever shares are purchased.

* Funds that charge loads are called load funds, funds that have no such charges are called no-load funds.

*Front-end loads are charges levied on purchases, while back-end loads are charges levied on redemptions. (CDSC)


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When you purchase shares in a load fund , you pay a price excess of the net asset value called the offering price.

The difference between the offering price and the net asset value is the load.

Shares in no-load funds are sold at the net asset value

Front end loads are expressed as a percentage of the offering price, not the net asset value


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Mutual Fund Costs and Fees 12b-1 fees. SEC Rule 12b-1 allows funds to spend up

to 1% of fund assets annually to cover distribution and marketing costs.

• Funds that market directly to the public may use 12b-1 fees to pay for advertising and direct mailing costs

• Mutual funds with no front end or back end loads or minimal 12b-1 fees are often called pure( No loads funds) to distinguish them from the Not so pure funds that may have no loads but still charge the fees.


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Mutual Fund Costs and FeesTypes of Expenses and Fees …continued

Management fees. Usually based on fund size, performance, etc. Trading costs. This is related to the fund’s turnover.

* Turnover is a measure of how much trading a fund does, its calculated as the lesser of the fund total purchases or sales during a year, divided by the average daily assets


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Expense Reporting Mutual funds are required to report expenses

in a fairly standardized way in the 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 expense you would pay over time per $10,000 invested.

Mutual Fund Costs & Fees

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Why Pay Loads and Fees? You may want a fund run by a particular

manager, and all such funds are load funds. You want a specialized type of fund. Loads

and fees for such funds tend to be higher as there is little competition among them.


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Short term funds

Mutual funds are divided into two major groups, short term funds and long term funds

Short term funds are known as money market mutual funds

Long term funds include everything that’s not a money market fund.


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Short-Term Funds

Short-term funds are collectively known as money market mutual funds, or MMMFs.

MMMFs always maintain a $1 net asset value to make them resemble bank accounts.

Depending on the type of securities purchased, MMMFs can be either taxable or tax-exempt.

Money market mutual fundA mutual fund specializing in money market instruments.


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Short-Term Funds

Most banks offer what are called “money market” deposit accounts, or MMDAs, which are much like MMMFs.

The distinction is that a bank money market account is a bank deposit and offers FDIC protection.


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Money market mutual funds

Most money market funds invest in high quality , low risk instruments with maturity of less than 90 days.

As a result , they have relatively little risk. However, some buy riskier assets or have longer maturities than others, so they don’t all carry equally low risk


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Money market fund accounting

A unique feature of money market funds is that their net asset value are always 1$/share.

A money market fund sets the number of shares equal to the fund’s assets

( breaking the buck) is used to describe dropping below 1$ in net asset value


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Taxes and money market fund

Money market funds are either taxable or tax-exempt , taxable funds are more common

Non taxable money market funds therefore buy only these types of tax exempt securities


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Long-Term Funds

A fund’s objective is the major determinant of the fund type.

Historically, mutual funds were classified as stock, bond, or income funds. However, it is becoming increasingly difficult to do so.

Stock, bond,or income?


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Stock Funds

Some stock funds trade off capital appreciation and dividend income. Capital appreciation, growth, growth and income,

equity income.

Some stock funds focus on companies in a particular size range. Small company, midcap.

Some fund groups invest internationally. Global, international, region, country, emerging

markets.


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Stock Funds

Sector funds specialize in specific sectors of the economy.

Other fund types include index funds, social conscience funds, and tax-managed funds.


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Bond Funds

Bond funds may be distinguished by their

maturity range , credit quality,

taxability, bond type, and issuing country.

Bond fund types include short-term and intermediate-term funds, general funds, high-yield funds, mortgage funds, world funds, insured funds, single-state municipal funds.


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Stock and Bond Funds

Funds that do not invest exclusively in either stocks or bonds are often called “blended” or “hybrid” funds.

Examples include balanced funds, asset allocation funds, convertible funds, income funds.


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Mutual Fund Objectives: Recent Developments

In recent years, there has been a trend toward 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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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 Performance

Mutual fund performance is very closely tracked by a number of organizations.


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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.

Closed-End Funds & Exchange

Traded Funds

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Closed-End Funds & Exchange Traded Funds

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

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


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Closed-End Funds & Exchange Traded Funds

An exchange traded fund, or ETF, is basically an index fund, except that it trades like a closed-end fund (without the discount phenomenon).

An area where ETFs seem to have an edge over the more traditional index funds is the more specialized indexes.


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Chapter Review

Investment Companies and Fund Types Open-End versus Closed-End Funds Net Asset Value

Mutual Fund Operations Mutual Fund Organization and Creation Taxation of Investment Companies The Fund Prospectus and Annual Report


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Chapter Review

Mutual Fund Costs and Fees Types of Expenses and Fees Expense Reporting Why Pay Loads and Fees?

Short-Term Funds Money Market Mutual Funds Money Market Deposit Accounts


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Chapter Review

Long-Term Funds Stock Funds Taxable and Municipal Bond Funds Stock and Bond Funds Mutual Fund Objectives: Recent Developments

Mutual Fund Performance Mutual Fund Performance Information How Useful are Fund Performance Ratings?


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Chapter Review

Closed-End Funds and Exchange Traded Funds Closed-End Funds Performance Information The Closed-End Fund Discount Mystery Exchange Traded Funds

4 4 C h a p t e r Mutual Funds second edition Fundamentals of Investments Valuation & Management...

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