Department of Banking and Finance SPRING 2007-08 Mutual Funds and Other Investment Companies by...

Department of Banking and Finance

SPRING 2007-08

Mutual Funds and Other Investment Mutual Funds and Other Investment CompaniesCompanies

by

Asst. Prof. Sami Fethi

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Investment Management © 2005 Sami Fethi, EMU, All Right Reserved.

Ch 4 : Mutual fund

Mutual FundsMutual Funds

Mutual fuds are firms that manage pools of individual investor money.

The objectives of mutual funds is to invest such shares that the income generated by the funds.

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Ch 4 : Mutual fund

Investment CompaniesInvestment Companies

These companies are financial intermediaries that collect funds from indivudual investors and invest those funds in a potetially wide range of securities or other assets.

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Ch 4 : Mutual fund

Investment CompaniesInvestment Companies

Pooling of assets is the key idea behind investment companies.

Each investor has a claim to the Porfolio established by the investment company in proportion to the amount invested.

These companies thus provide a mechanism for small investors to team up to obtain the benefits of large-scale investing.

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Ch 4 : Mutual fund

Services of Investment Companies Services of Investment Companies

Investment companies perform several

important function for their investors:Administration & record keepingDiversification & divisibilityProfessional managementReduced transaction costs

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Ch 4 : Mutual fund

Administration & record keepingAdministration & record keeping

Investment companies issue periodic status reports, keeping track of capital gains distributions, dividends, investments, and redemptions, and they may reinvest dividend and interest income for shareholders.

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Ch 4 : Mutual fund

Diversification & divisibilityDiversification & divisibility

By pooling their money, investment companies enable investors to hold fractional shares of many different securities. They can act as large investors even if any individual shareholder cannot.

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Ch 4 : Mutual fund

Professional managementProfessional management

Most, but not all, investment companies have full-time staffs of security analysts and portfolio managers who attempt to achieve superior investment results for their investors.

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Ch 4 : Mutual fund

Reduced transaction costsReduced transaction costs

Investment companies can achieve substantial saving on brokerage fees and commissions due to the large blocks of securities.

Investment companies also need to divide claims to these assets among those investors as they pool the assets of individual investors.

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Ch 4 : Mutual fund

Net Asset ValueNet Asset ValueInvestor buy shares in investment

companies, and ownership is proportional to the number of shares purchased. The value of each share is called the net asset value or NAV.

NAV equals assets minus liabilities expressed on a per-share basis:

NAV= Market value of assets- Liabilities/ Share outstanding

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Ch 4 : Mutual fund

NAVNAV

dingoutsSharesLiabilitieAssetsValueMarketNAV

tan

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Ch 4 : Mutual fund

Example 1Example 1

Consider a mutual fund that manages a portfolio of securities worth $ 120 mn. Assume that the fund owes $ 4 mn to its investment advisers and owes another +$ 1 mn for rent, wages due and miscellanous expenses. The fund has $ 5 mn shareholders. What is the net asset value of the portfolio?

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Ch 4 : Mutual fund

Answers 1Answers 1

NAV= (120-5)/5= $ 23 per share

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Ch 4 : Mutual fund

Example 2Example 2

The composition of X fund portfolio is as follows:

Stock Share Price

A 200000 $ 35

B 300000 40

C 400000 20

D 600000 25

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Ch 4 : Mutual fund

Example 2Example 2 cont… cont…

The fund has not borrowed any funds, but its management fee with the porfolio manager currently total $ 30000. There are also $ 4 mn shares outstanding.

What was the NAV?

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Ch 4 : Mutual fund

Answers 2Answers 2

MVA= Share x PriceMVA=(A=7mn)+(B=12mn)+(C=8mn)+

(D=15mn)MVA Total=42mnNAV=$ 42mn-$ 30000/$ 4mnNAV=$ 10.4930000=0.03

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Ch 4 : Mutual fund

Types of Investment OrganizationsTypes of Investment Organizations

Unit TrustsManaged Investment Companies

– Open-End– Closed-End

Other investment organizations– Commingled funds– REITs– Hedge Funds

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Ch 4 : Mutual fund

Unit Investment TrustUnit Investment Trust

Investment companies can be classifed as either unit investment trusts or managed investment companies.

Unit investment trusts: They are essentially fixed and thus are called unmanaged.

More specifically, a unit trust is a pool of funds invested in a portfolio that is fixed for the life of the fund.

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Ch 4 : Mutual fund

Unit Investment TrustUnit Investment Trust

Sells to the public shares or unit in trust. These are called redeemable trust certificates.

Due to the portfolio composition is fixed, these trusts are referred to as unmanaged.

The trust life is dependent on the maturity of securities.

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Ch 4 : Mutual fund

Management Investment CompaniesManagement Investment CompaniesThere are two types of managed companies: closed-end and open-end.In both cases, the fund’s board of directors

which is elected by shareholders hires a management company to sort the portfolio out for an annual fee that typically ranges from 0.2% to 1.5% of assets.

This type of company in many cases is the firm that organized the fund.

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Ch 4 : Mutual fund

Open-end and closed-end fundsOpen-end and closed-end funds

A fund that issues or redeems shares at their net asset value (NAV). When investors in open-end fund wish to cash out their shares, they sell back to fund at NAV.

A fund that do not issue or redeem shares. Investors in closed-end fund who wish to cash out must sell their shares to other investors. Shares in this type of fund are traded at prices that differ from NAV. This can be purchased through brokers just like other common stock.

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Ch 4 : Mutual fund

Open-end and closed-end fundsOpen-end and closed-end funds cont… cont…Since the shares in closed-end funds are

required in second market, prices for such shares are commonly at premiums or discounted from the underlying NAV.

When discussing premiums or discounts on closed-end funds, it is worth to emphasize the fact that the NAVs are generally reported on weekly basis. For such investment companies the premiums and discounts from the reported NAV are accurate for closing prices on the reporting day.

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Ch 4 : Mutual fund

Open-End and Closed-End Funds: Key Open-End and Closed-End Funds: Key DifferencesDifferences

Shares OutstandingClosed-end: no change unless new stock is

offeredOpen-end: changes when new shares are

sold or old shares are redeemedPricingOpen-end: Net Asset Value (NAV)Closed-end: Premium or discount to NAV

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Ch 4 : Mutual fund

Offering Price and loadOffering Price and load

In contrast to closed-end funds, the price of opened-end funds cannot fall below NAV. Because these funds stand ready to redeem shares at NAV. However, the offering price can exceed NAV, if the fund carries a load.

A Load- a sales commission charged on a mutual fund.

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Ch 4 : Mutual fund

Example 3Example 3

An open-end fund has a net value asset of $ 10.70 per share. It is sold wıth a load of 6%. What is the offering price?

Offering price=NAV/(1-load)10.70/(1-0.06)11.38

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Ch 4 : Mutual fund

Example 4Example 4

Would you expect a typical open-end fixed-income mutual fund to have higher or lower operating expenses than a fixed income unit investment trust?

The unit investment trust should have lower operating expenses. Because the investment trust portfolio is fixed once the trust is established, it does not have to pay portfolio managers to constantly monitor and rebalance the portfolio as perceived needs or opportunities change.

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Ch 4 : Mutual fund

Other Investment OrganizationOther Investment Organization

Commingled funds REITs

- Real Estate Investment Trust Hedge Funds

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Ch 4 : Mutual fund

Commingled FundsCommingled Funds

This type of funds are partnerships for investors that pool their funds. The management firm that organizes the partnership, for example, a bank or insurance company manages the funds for a fee.

They are similar in firm to open-end mutual funds and are commonly used in trust accounts for which investors do not have large enough pools of funds to warrant individual management.

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Ch 4 : Mutual fund

Real Estate Investment TrustsReal Estate Investment Trusts

• They are investment vehicles that are similar to closed-end funds in that they invest in real estate or in bonds secured by real estate. REITs provide financial leverage (with debt ratio of 70%) and offer an investor the possibily to invest in real estate with professional management.

• -Equity-invest real estate• -mortgage trust-invest in mortgage construction

load.

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Ch 4 : Mutual fund

Hedge FundsHedge Funds

Like mutual funds, hedge funds are vehicles that allow private investors to pool assets to be invested by a fund manager, however they are not registered as mutual funds. They are open only to wealthy or institutional investors.

As hedge funds are only lightly regulated, their managers can pursue investment strategies that are not open to mutual fund managers (i.e. Heavy use of derivatives, short sales and leverage). They have more speculative polies than mutual funds.

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Ch 4 : Mutual fund

Mutual FundsMutual Funds This type of fund is the common name for an

open-end investment company and they have a specified investment policy.

i.e. Money market mutual funds hold the short-term, low-risk instruments of the money market whereas bonds funds hold fixed-income securities. These types of funds can be classified by investment policy.

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Ch 4 : Mutual fund

Investment PoliciesInvestment Policies

Money Market Fixed IncomeEquityBalance & Income Asset AllocationIndexed Specialized Sector

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Ch 4 : Mutual fund

Money MarketMoney Market

This kind of fund invest in money market securities. They usually provide check writing features and NAV is fixed at $ 1 per share, hence there are no tax implications such as capital gains or loses association with redemption of share.

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Ch 4 : Mutual fund

Fixed income or BondFixed income or Bond

As the name itself suggests, these funds specialize in the fixed-income sector. In this sector, however, there is considerable room for specialization. i.e. Various funds concentrate on corporate bonds, Treasury bond, morgage-backed securities or municipal bonds due to free-tax.

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Ch 4 : Mutual fund

EquityEquityEquity funds invest primarily in stock,

although they may, at the porfolio manager’s discretion, also hold fixed-income or other types of securities. This type of funds will hold about 5% of total assets in money market securities to provide the liquidity necessary to meet potential redemption of shares.

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Ch 4 : Mutual fund

EquityEquity

Income Funds: tend to hold share shares of firms with high dividend yields that provide high current income.

Growth Funds: are willing to forgo current income focusing instead on prospects for capital gains.

Growth funds are riskier and respond far more dramatically to change in economic conditions then income funds.

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Ch 4 : Mutual fund

Balanced and Income fundsBalanced and Income funds

They are based on individual’s entire investment, holding both equities and fixed-income securities in relatively stable proportions.

Balanced funds minimize investment risks whereas income funds maintain current income and long-term growth.

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Ch 4 : Mutual fund

Asset allocationAsset allocation

They are similar to balanced funds in that hold both stocks and bonds.

Assets allocation funds may vary the proportions allocated to each market in accord with the portfolio manager’s forecast of the relative performance of each sector, however, they are not desingned to be low-risk investment vehicles.

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Ch 4 : Mutual fund

Index FundsIndex Funds

They have intention to match the performance of a broad market index.

These funds buy shares in securities included in a particular index in proportion to the security’s representation in that index.

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Ch 4 : Mutual fund

Specialized Sector FundsSpecialized Sector Funds

This kind of fund concentrates on a particular industry.

i.e. Biotechnology or telecomunications.

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Ch 4 : Mutual fund

Costs of Investing in Mutual FundsCosts of Investing in Mutual Funds

Fee Structure– Front-end load– Back-end load

Operating expenses12 b-1 charges

– distribution costs paid by the fund– Alternative to a load

Fees and performance

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Ch 4 : Mutual fund

Fee StructureFee Structure

Fee Structure

- An individual investor choosing a mutual fund should consider not only the fund’s stated investment policy and past performance, but also its management fees and other expenses.

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Ch 4 : Mutual fund

Front-end load and Back-end loadFront-end load and Back-end load

– Front-end load– A Front-end load is a commission or

sales charge paid by when you purchase the share.

Funds with a front-end load initially reduce the investment amount.

– Back-end load– A Back-end load is a redemption fee

incurred when you sell your share.

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Ch 4 : Mutual fund

Operating expensesOperating expenses

Operating expenses: are the costs incurred by the mutual fund in operating the portfolio, including administrative expenses and advisory fees paid to the investment manager. These expenses usually expressed as a percentage of total assets under management, may range from 0.2% to 2%.

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Ch 4 : Mutual fund

12 b-1 charges12 b-1 charges

12 b-1 chargesAnnual fees charged by a mutual fund to

pay for marketing and distribution costs.– distribution costs paid by the fund– Alternative to a load

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Ch 4 : Mutual fund

Fees and Mutual Fund ReturnsFees and Mutual Fund Returns

The rate of return on an investment in a mutual fund is measured as the increase or decrease in NAV plus income distribution such as dividends or distributions of capital gains expressed as a fraction of NAV at the beginning of the investment period. We can denote the NAV at the start and final period as NAVo and NAV1 respectively.

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Ch 4 : Mutual fund

Rate of ReturnRate of Return

ROR=(NAV1-NAVo+I+CGD)/(NAVo)

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Ch 4 : Mutual fund

Example-RORExample-RORIf a fund has an initial NAV of £20 at the

start of the month, makes income distributions of $ 0.15 and capital gain distributions of $ 0.05, and ends the month with NAV of $ 20.10. What is the rate of return?

ROR=(20.10-20.00+0.15+0.05)/20.00ROR=0.015 or 1.5%

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Ch 4 : Mutual fund

Example-12b-1 FeeExample-12b-1 FeeThe Equity fund sells class A shares with a

front-end load of 4% and class B shares with 12b-1 fees of 0.5 % annually as well as back-end load fees that start at 5% and fall by 1% for each full year the investor holds the portfolio until the fifth year. Assume ROR on the fund portfolio net of operating expenses is 10% annually. What will be the value of a $ 10,000 investment in class A and B shares if the shares are sold (a) 1 year, (b) 4 years, (c) 10 years and which fee structure provide higher proceeds?

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Ch 4 : Mutual fund

Solution-12b-1 FeeSolution-12b-1 Fee Inv in Class A is (10,000x4)/100=400 Class A after 4% commission 10,000-400= 9600 Investment grow with 10% earn, 9600x (1.10)n

1 year: $ 10,560 4 year: 14,055.36 10 year : 24,899.93 After 12b-1, net return is 9.5% Investment grow with the following 10,000 (1.095)n (1-percentage exit fee) Year 1 (1-0.04): $ 10,512 year 4 (1-0.01): 14,232.89 Year 10: 24,782.28

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Ch 4 : Mutual fund

CommentCommentIn one year time, the class A shares are

better choice. The front-end and back-end loads are equal, however the class A shares do not have to pay the 12b-1 fees.

For four years, the class B shares dominate because the front-end of the class A shares is more costly than the 12b-1 fees.

For 10 years, class A dominatesIn this case, one time front-end load is less

expensive than the continuing 12b-1 fees.

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Ch 4 : Mutual fund

Taxation of Mutual Fund IncomeTaxation of Mutual Fund Income

Income earned on mutual fund portfolios is not taxed at the level of the fund. Instead, as long as the fund meets certain requirements for pass-through status, the income is treated as being earned by the investors in the fund. This means that taxes are paid by investors, not by the fund itself.

Tax inefficient: a fund with a high portfolio turnover rate can be particularly tax inefficient.

Turnover: the ratio of the trading activity of a portfolio to the assets of the portfolio.

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Ch 4 : Mutual fund

ExampleExample

An investor’s portfolio currently is worth $ 1 million. The investor sells 1000 shares of Microsoft at a price of $ 80 per share and 2000 shares of ford at a price of $ 40 per share. The aim is to buy 1600 shares of IBM at $ 100 per share.

A) What was the portfolio turn over rate? B) If the shares in Microsoft and Ford were

purchased $ 70 and $ 35 respectively and tax rate on capital income is 20%, how much extra will investor owe taxes as a result of these transactions?

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Ch 4 : Mutual fund

SolutionSolution

a) Turnover is $ 160,000 per $ 1 mn =16%b) Realized Capital gain = $ 10x1000=

10000 on Microsoft and $ 5x2000=$ 10000 on ford.

Tax owed on the capital gains is therefore

0.20x $ 20000=$ 4000.

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Ch 4 : Mutual fund

Exchange Traded FundsExchange Traded Funds ETF allow investors to trade index portfolios like

shares of stock Examples - SPDRs (S&P 500) and Webs Potential advantages

– Trade continuously – Lower taxes – Lower costs

Potential disadvantages– Higher costs (price deviation from NAV)

– Brokers’ fee

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Ch 4 : Mutual fund

SPDRs and WebsSPDRs and Webs

The first ETF was the spider, a nickname for SPDR or standard & Poor’s Depository Receipt, which is a unit trust holding a portfolio matching the S&P 500 index.

Spiders give a rise to many similar products such as Diamonds (Dow Jones Industrial Average)- DIA, Cubes (Nasdaq 100 index)-QQQ and WEB (World Equity Benchmark Shares which are shares in portfolios of foreign stock market indexes).

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Ch 4 : Mutual fund

Exchange Traded FundsExchange Traded Funds

Exchange Traded Funds have become popular and offer investors alternatives to traditional mutual funds.

ETFs allow investors to trade portfolios of indexes as individual shares of stock. A wide variety of indexes, both international and domestic can be traded.

Some advantages include lower taxes and costs as well as the ability to trade the index portfolios intra-day. Potential disadvantages include price deviation from NAV and payment of brokerage fees to trade the funds.

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Ch 4 : Mutual fund

Problem1-ch 4Problem1-ch 4

Consider a mutual fund with $200 mn in assets at the start of the year and with 10mn shares outstanding. The fund invests in a portfolio of stocks that provides dividend income at the end of the year of $ 2mn. The stocks included in the fund’s portfolio increase in price 8%, but no securities are sold and there are no capital gains distributions. The fund charges 12b-1 fees of 1%, which deducted from portfolio assets at year-end.

a) what is NAV at the start and end of the year? b) What is the ROR for an investor in the fund?

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Ch 4 : Mutual fund

Answer 1-chAnswer 1-ch

a) Start of year NAV = $20 Dividends per share = $0.20 End of year NAV is based on the 8% price gain,

less the 1% 12b-1 fee: End of year NAV = $20 (1.08) (1 – 0.01) =

$21.384 b) Rate of return = ($21.384-$20+$0.20)/$20=

0.0792 = 7.92%

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Ch 4 : Mutual fund

Problem 2- ch 4Problem 2- ch 4

You purchased 500 shares of the new fund at a price of $45 per share at the beginning of the year. You paid a front-end load of 6%. The securities in which the fund invests increase in value by 14% during the year. The Fund’s expense ratio is 1.4%.

a) What is your ROR on the fund if you sell your shares at the end of the year?

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Ch 4 : Mutual fund

Answer 2- ch 4Answer 2- ch 4 As an initial approximation, your return equals the

return on the shares minus the total of the expense ratio and purchase costs: (14% 1.4% 6%) = 6.6%

But the precise return is less than this because the 6% load is paid up front, not at the end of the year.To purchase the shares, you would have had to invest: [$22,500/(1 .06)] = $23,936. The shares increase in value from $22,500 to: [$22,500 (1.14 0.014)] = $25,335. The rate of return is: [(25,335 23,936)/23,936] = 5.84%

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Ch 4 : Mutual fund

Sources of Information on Mutual FundsSources of Information on Mutual Funds

Wiesenberger’s Investment CompaniesMorningstarInvestment Company InstitutePopular pressInvestment services

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Ch 4 : Mutual fund

The EndThe End

Thanks

Department of Banking and Finance SPRING 2007-08 Mutual Funds and Other Investment Companies by...

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