A Presentation on Mutual Funds

Questions to start with

• What is a mutual fund?• How does one compute the net asset value

(NAV)?• What expenses and charges might a mutual

fund investor face?• What does research on mutual fund

performance tell about fund expenses, portfolio turnover, and returns?

Questions to start with

• What is a good procedure for determining which mutual funds to purchase?

• When might it be appropriate to sell shares in a mutual fund?

• What are the similarities between mutual funds and some other managed investments?

Mutual Fund Growth

• Mutual funds have become very popular investment vehicles.

• Nearly $7 trillion in total assets in 2000 vs $13 trillion in NYSE in 2002.

• Total assets have grown 600% since 1990.

What is a mutual fund?

• Mutual funds are open-end investment companies.

• The fund sells shares to the public and invests the proceeds in a pool of funds, which are jointly owned by the fund’s investors.

Computing Net Asset Value• For investors, the performance of their investment

depends on what happens to the fund’s per share value, or net asset value (NAV).

NAV= Market Value of Assets – Liabilities Number of Shares OutstandingNAV1=NAV0+All Incomes-All Distributed

Example: NAV0=Rs.100, Distributed 1) Net Realized Gains=Rs.2 and 2) Net Investment Income=Re.1.

NAV1= Rs.100-Rs.2-Re.1=Rs.97

Mutual Fund Management

• Most funds are started by investment management companies who hire the fund manager to make investment decisions.– Fidelity, Vanguard, etc.

• Usually offer many different funds and allow investors to switch between funds.

• Funds (open-end) sell additional shares to those who want to invest, redeem shares at the NAV (less any fees) to those who want to sell their shares.

Why invest with mutual funds?

• Liquidity– Funds buy and sell their own shares quickly, even if

fund investments are illiquid

• Diversification– Small minimum investment buys a typically well-

diversified investment

• Professional management and record-keeping– Expertise and services

Why invest with mutual funds?

• Choice and flexibility– Families of funds offer a variety of investments

to match investor needs

• Indexing– Some funds track a broad market index which

insures that investors will earn the “market return”

– Increasingly popular mutual fund alternative

Mutual Fund Drawbacks

• Active trading contributes to high costs which lower fund returns

• Tax consequences can be a disadvantage– Tax impacts of asset trading are passed through

to investors– Tax bill can be large even when the NAV falls

Mutual Fund Returns

Three sources of return:

• Income distributions (ID)– Bond interest, stock dividends

• Capital gain distributions (CGD)– Realized gains/losses from selling assets

• Changes in NAV (∆NAV)– From unrealized gains/losses from assets

Mutual Fund Returns

Return = (ID + CGD –Payments + ∆NAV)/Beg.NAV

• Ex. NAV0=Rs.35,NAV1=Rs.35.2, Net Realized Gain Rs.2, Net Investment Income =Rs..5. Return= (2+.5+35.2-35)/35=7.714%

• Most mutual funds allow investors to either receive distributions in cash or to reinvest in additional shares.

Types of Mutual Funds

• Funds can be classified according to the type of security in which they invest– Stock Funds– Taxable Bond Funds– Municipal Bond Funds– Stock and Bond Funds– Money Market Funds

Common Stock Funds

• Most popular type of fund• Wide variety with different objectives and

levels of risk– Growth– Industry or sector funds– Geographic areas– International or Global– Equity Index funds

Taxable Bond Funds

• Generally seek to generate current income with limited risk

• Can vary by maturity– Short-term, Intermediate-term, Long-term

• Can vary by type of bond– Government– Corporate– Mortgage-backed– International/Global– Bond Index funds

Municipal Bond Funds

• Provide investors with income exempt from Federal taxation

• Often concentrate on single states to avoid state income taxation as well

Stock and Bond Funds• Seek to provide a combination of income and

value appreciation.• Different names

– Balanced funds (60% equity+40% of debt securities) Goal: to conserve principal, by maintaining a balanced portfolio of both stocks and bonds

– Blended funds: Mutipurpose funds(e.g., balanced target maturity, convertible securities that invest in both stocks and bonds

– Flexible funds: Flexible income, flexible portfolio, global flexible and income funds, that invest in both stocks and bonds

Money Market Funds

• Provide safe, current income with high liquidity

• Invest in money market securities– T-bills, Bank CD’s, Commercial paper, etc.

• NAV stays at Re.1; income either paid out or reinvested daily

• Provide an alternative to bank deposits, but not FDIC insured

Mutual Fund Innovations

• Life-stage funds– Offer different mixes of securities based on the

age of the investor

• Supermarket funds– Offer a wide variety of funds with “one-stop”

fund shopping– Transfer services between funds– Expenses/fees can be high

Mutual Fund Prospectus

• Must be available to investors and should be review by investors.

• Contains:– Fund’s investment objective– Investment strategy– Principal risks faced by investors– Recent investment performance– Expenses and fees– Lots of other detailed information

Mutual Fund Expenses and Considerations

• Loads– Commission to the broker to financial advisor who sold

the fund to the investor– For load funds, the offer price is the fund’s NAV plus

the load (while no-load funds are sold at their NAV)– Ex. 4% load with NAV Rs.96, buy at Rs.100– Load range from around 3% (low-load) to 8.5%

• 12b-1 Fees: pay to the distributor (.25%-.75% )+ .25% servicing charge in some cases)– Fees deducted from the asset value of the fund to cover

marketing expenses– An alternative to loads

• Offering Price= NAV/(1-load %).– Investing Rs.1,000 in a load MF with 7% and

expected return of 10%,– Rs.value=1000(1-.07)(1.10)=1023 (2.3%

growth)– Investing Rs.1,000 no load MF with 8% return

and 2% redemption fee,– Rs.value=1000(1-0)(1.08)(1-.02)= 1058.4

(5.84% growth)– Rs.35.4 Difference

Mutual Fund Expenses and Considerations

• Deferred Sales Loads– Redemption charges when fund shares are sold (rather

than when purchased)– Often high (5-7%) if shares are sold within the first

year, but then fall over time, perhaps even disappearing eventually

• Share Classes– Many funds offer several different classes of shares (A-

B-C) with different fee structures– Best choice usually depends of investment horizon

Mutual Fund Expenses and Considerations

• Management Fees– Fees deducted from the fund’s asset value to

compensate the fund managers– Some adjust fees according to the fund’s

performance

• Expense ratio– Adding all fees and calculating expenses as a

percentage of the fund’s asset

*Mutual Fund Expenses and Considerations

• Portfolio Turnover– Not an explicit cost, but very important determinant of

shareholder returns– Trading costs rise with turnover– In order for high turnover to pay off, fund managers

must be successful in their active trading strategies

• Sources of Information– Wall Street Journal, Business Week– Morningstar

• Fund history, tax efficiency, risk analysis

Holding Period for a Portfolio

• Portfolio Turnover

• Holding Period = 12 months/(Portfolio Turnover%)

• Ex Turnover 125%=>12/1.25=9.6 month

Mutual Fund Return and Risk Performance

Return Performance• On a risk-adjusted basis, the average stock fund

under-performs market averages• While portfolio managers seem to out-perform the

market before expenses, net returns are below the market index

• Some above-average performers over short time horizons, but such performance is not generally sustained (just luck?)

• These results help to explain the growing popularity of index funds

Mutual Fund Return and Risk Performance

Risk Performance

• While returns are not consistent, risk is

• Objectives lead to strategies that lead to varying degrees of investment risks

• Return is positively related to the level of risk

• Risk is therefore an important consideration

Mutual Fund Return and Risk Performance

Fees and expenses: Do higher fees pay off?• Investment performance is no better (and perhaps

worse) for load funds vs. no-load• Expenses lower returns in predictable ways –

lower expense funds give better returns• Turnover affects returns in several ways, including

taxes – high turnover means more short-term realized gains

• Tax efficiency is an important consideration – after-tax returns may be 30-40% less than pre-tax

•Mutual Fund Investment Strategies

• Choose in funds consistent with your objectives, constraints, and tax situation.

• Consider index funds for a large portion of your fund portfolio.

• When possible, invest in no-load funds with below-average expense and turnover ratios.

• Invest at least 10-20% in international or global funds.

• Own funds in different asset classes and consider life-cycle investing.

•Mutual Fund Investment Strategies

• If you actively manage your portfolio, consider the past year’s “hot funds.”

• Do not attempt to time the market; timing strategies add little except costs and risk.

• Use dollar cost averaging by investing a set dollar amount each month.

• Avoid investing money shortly before the capital gain distribution dates (prospectus).

• Do not own too many funds. You will get average returns with high expenses.

When should you sell a mutual fund?

• Personal considerations– Portfolio rebalancing points due to life cycle

considerations• Be aware of the quick trigger, selling on the first dip in NAV;

think long-term• Be aware of capital gains with selling fund shares

• Fund considerations– Change in portfolio manager– Change in investment style– Fund is growing “too large” or “too fast”– Persistent bad performance.