Chapter 4Chapter 4
Mutual FundsMutual Funds
Mutual FundsMutual Funds
Our goal in this chapter is to understand Our goal in this chapter is to understand the different types of mutual funds, their the different types of mutual funds, their risks and returnsrisks and returns
Staggering StatsStaggering Stats
In 1980, 5 million Americans owned In 1980, 5 million Americans owned mutual fundsmutual funds
By 2001By 200193 million Americans owned mutual funds93 million Americans owned mutual fundsMutual fund assets totaled $7 trillionMutual fund assets totaled $7 trillion
Yes, that’s $7,000,000,000,000Yes, that’s $7,000,000,000,000
**As of October 2007, $12.3 trillionAs of October 2007, $12.3 trillion
Stocks vs. Mutual FundsStocks vs. Mutual Funds
$10,000 invested in $10,000 invested in individual stocksindividual stocks Pay commissions on Pay commissions on
each stock purchasedeach stock purchased Possible difficulty in Possible difficulty in
diversificationdiversification
$10,000 invested in a $10,000 invested in a mutual fundsmutual funds Pay bundled expenses Pay bundled expenses
through the fund for through the fund for active managementactive management
DiversificationDiversification
Mutual FundsMutual Funds
Mutual funds are Mutual funds are Financial IntermediariesFinancial Intermediaries Investment companies that pool the funds of a Investment companies that pool the funds of a
large group of investorslarge group of investorsManaged by fund managers who make the Managed by fund managers who make the
buying and selling decisionsbuying and selling decisions
Organization and CreationOrganization and Creation
A mutual fund is a corporationA mutual fund is a corporationOwned by shareholdersOwned by shareholders
Created by investment advisory firmsCreated by investment advisory firmsFirms earn fees for managing mutual fundsFirms earn fees for managing mutual funds
Investment CompaniesInvestment CompaniesRecord keepingRecord keeping
Periodic status reports are issuedPeriodic status reports are issued
Diversification and divisibilityDiversification and divisibilityInvestors can hold fractional shares of many Investors can hold fractional shares of many
stocksstocks
Professional managementProfessional managementAnalysts and port. managers looking for superior Analysts and port. managers looking for superior
investment resultsinvestment results
Lower transactions costsLower transactions costsBlock trading saves money on brokerage fees and Block trading saves money on brokerage fees and
commissionscommissions
Investment Companies and Fund Investment Companies and Fund TypesTypes
Investment company – business that Investment company – business that specializes in pooling funds from individual specializes in pooling funds from individual investors and making investmentsinvestors and making investments
Investment Company Investment Company ClassificationsClassifications
Unit Investment TrustsUnit Investment TrustsNot actively managedNot actively managed Invest in relatively uniform types of assetsInvest in relatively uniform types of assets
ORORManaged Investment CompaniesManaged Investment Companies
Actively managedActively managed
Investment Companies and Fund Investment Companies and Fund TypesTypes
Investment companies
Open-end funds Closed-end funds
Money market funds Long-term funds
Stock funds
Bond funds
Blended funds
Investment Companies and Fund Investment Companies and Fund TypesTypes
Open EndOpen End Issue and redeem Issue and redeem
shares at their net shares at their net asset value (NAV)asset value (NAV)
NAV = (market value NAV = (market value of assets - of assets - liabilities)/shares liabilities)/shares outstandingoutstanding
Offering price may Offering price may exceed NAV b/c of a exceed NAV b/c of a “load”“load”
Closed EndClosed End Do not issue or Do not issue or
redeem sharesredeem shares must buy or sell must buy or sell
shares to other shares to other investors (many traded investors (many traded at NYSE)at NYSE)
Usually sell at a Usually sell at a discountdiscount
Can be traded all dayCan be traded all day Can be traded on Can be traded on
marginmargin
Investment Companies and Fund Investment Companies and Fund TypesTypes
Net asset value (NAV) is the value of the Net asset value (NAV) is the value of the assets held by a mutual fund, divided by assets held by a mutual fund, divided by the number of sharesthe number of sharesShares in an open-end fund are worth their Shares in an open-end fund are worth their
NAVNAVShares of closed-end funds may differ from Shares of closed-end funds may differ from
their NAVtheir NAV
Short-Term FundsShort-Term Funds
Money market mutual funds (MMMFs)Money market mutual funds (MMMFs)Specialize in money market instrumentsSpecialize in money market instrumentsMaintain a $1.00 NAV to resemble bank Maintain a $1.00 NAV to resemble bank
accountsaccountsCan be taxable or tax-exemptCan be taxable or tax-exempt
Stock FundsStock Funds
Capital appreciation and dividend incomeCapital appreciation and dividend incomeCapital appreciationCapital appreciationGrowthGrowthGrowth and IncomeGrowth and IncomeEquity incomeEquity income
Company sizeCompany sizeSmall capSmall capMid-capMid-capLarge capLarge cap
Stock FundsStock Funds
InternationalInternationalGlobalGlobalEmerging marketsEmerging markets
Sector FundsSector FundsBiotechnologyBiotechnology InternetInternetEnergyEnergy
Stock FundsStock Funds
Other FundsOther Funds Index fundsIndex fundsSocially conscience fundsSocially conscience fundsSin fundsSin fundsTax-managed fundsTax-managed funds
Bond FundsBond Funds
Government debtGovernment debtCorporate debtCorporate debtTax-plannedTax-planned
Stock and Bond FundsStock and Bond Funds
Funds that do not invest exclusively in Funds that do not invest exclusively in either stocks or bondseither stocks or bondsBalanced fundsBalanced funds
Weighting of assets may be restrictedWeighting of assets may be restrictedAsset allocation fundsAsset allocation funds
Freedom in allocation between stocks and bondsFreedom in allocation between stocks and bondsConvertible fundsConvertible funds
Bonds and preferred stock that converts to Bonds and preferred stock that converts to common stockcommon stock
Income fundsIncome funds
ValuationValuation
Valuation is based on the net asset valueValuation is based on the net asset valueNAV is the value of each share in an NAV is the value of each share in an
investment companyinvestment company
NAV = NAV = Market value of assets less liabilitiesMarket value of assets less liabilities
Shares outstandingShares outstanding
Fund ValuationFund Valuation
Given the data below, calculate the NAV Given the data below, calculate the NAV for the fund below (#s in millions)for the fund below (#s in millions)AssetsAssets LiabilitiesLiabilities
$13,857$13,857 $1,522$1,522
Shares outstanding: 313Shares outstanding: 313
NAV =NAV =
Fund Rates of ReturnFund Rates of Return
You invested in a mutual fund with a $20 You invested in a mutual fund with a $20 NAV. At the end of the year, the NAV rose NAV. At the end of the year, the NAV rose 8%. A dividend of $0.20 was paid. What 8%. A dividend of $0.20 was paid. What is the rate of return on your fund?is the rate of return on your fund?
NAVNAV11 - NAV - NAV00 + Income/Div. Distributions + Income/Div. Distributions
NAVNAV00
Taxation of Investment CompaniesTaxation of Investment Companies
A “regulated investment company” does A “regulated investment company” does not pay taxes on its investment incomenot pay taxes on its investment income
To qualify:To qualify:Almost all assets in stocks, bonds and other Almost all assets in stocks, bonds and other
securitiessecuritiesMaintain a 50% diversified portfolio and use Maintain a 50% diversified portfolio and use
<5% of its assets when acquiring a particular <5% of its assets when acquiring a particular securitysecurity
Pass through all realized investment income Pass through all realized investment income to fund shareholdersto fund shareholders
Fund Prospectus and Annual Fund Prospectus and Annual ReportReport
Legally required to supply a prospectusLegally required to supply a prospectus
Must provide annual report to Must provide annual report to shareholdersshareholders
Types of Expenses and FeesTypes of Expenses and Fees
Sales charges or “loads”Sales charges or “loads”Front-end load - charged on purchaseFront-end load - charged on purchaseBack-end load – charged on redemptionBack-end load – charged on redemption
12b-1 fees12b-1 feesMarketing and distributionMarketing and distributionSEC rule allows funds to spend up to 1%SEC rule allows funds to spend up to 1%
Management feesManagement feesTrading costsTrading costs
Types of Expenses and FeesTypes of Expenses and Fees
Management feesManagement feesRange from 0.25%-1% of total assets each Range from 0.25%-1% of total assets each
yearyearUsually tied to fund size or performanceUsually tied to fund size or performance
Trading costsTrading costsNot reported directlyNot reported directlyTurnover must be reportedTurnover must be reported Increase as turnover increasesIncrease as turnover increases
Trading and TurnoverTrading and Turnover
Your mutual fund holds the securities Your mutual fund holds the securities below:below:
If the manager replaces Stocks B and D If the manager replaces Stocks B and D with shares of a new Stock, E, what is with shares of a new Stock, E, what is the turnover rate?the turnover rate?
Stock Shares PriceA 200,000 35$ 7,000,000.00$ B 300,000 40$ 12,000,000.00$ C 400,000 20$ 8,000,000.00$ D 600,000 25$ 15,000,000.00$
Expense ReportingExpense Reporting
Required to report expenses in a Required to report expenses in a standardized waystandardized wayShareholder transaction expensesShareholder transaction expenses
Loads and deferred sales chargesLoads and deferred sales charges
Fund operating expensesFund operating expensesManagement and 12b-1 feesManagement and 12b-1 feesAccounting, legal, reporting and director feesAccounting, legal, reporting and director fees
Hypothetical example showing total expenses Hypothetical example showing total expenses paid over time per $10,000 investedpaid over time per $10,000 invested
How do “loads” affect your investment?How do “loads” affect your investment?
Fee structure on your investment (assuming Fee structure on your investment (assuming a 12% annual rate of return before expenses)a 12% annual rate of return before expenses) Fund A - No load, .5% operating expenses, no 12b-1Fund A - No load, .5% operating expenses, no 12b-1 Fund B - No load, 1% operating expenses, .5% 12b-1Fund B - No load, 1% operating expenses, .5% 12b-1 Fund C - 8% load, 1% operating expense, no 12b-1Fund C - 8% load, 1% operating expense, no 12b-1
Fund A Fund B Fund CInitial Inv. 10,000 10,000 9,200 5 yrs 17,234 16,474 15,502 10 yrs 29,699 27,141 26,123 15 yrs 51,183 44,713 44,018
Why Pay Loads and Fees?Why Pay Loads and Fees?
Many good no-load funds existMany good no-load funds existMany bad load funds existMany bad load funds existYou may wish to invest inYou may wish to invest in
A fund with a specific managerA fund with a specific manager
A fund that specializes in foreign companiesA fund that specializes in foreign companies
Exchange Traded FundsExchange Traded Funds
Price movements are based on the value of the Price movements are based on the value of the underlying indexunderlying index Only operating expensesOnly operating expenses
Do not require active managementDo not require active management Subject to the bid-ask spreadSubject to the bid-ask spread Closed-end funds, can be traded all dayClosed-end funds, can be traded all day Must be purchased from brokers for a feeMust be purchased from brokers for a fee
Popular ETFsPopular ETFs SpiderSpider DiamondsDiamonds CubesCubes
Why Trade with ETFs?Why Trade with ETFs?
Mutual fundsMutual funds Receive cash from Receive cash from
investors and buys investors and buys stocks with cashstocks with cash
Sells stocks to obtain Sells stocks to obtain cash when investor cash when investor redeems sharesredeems shares
Trade only at NAV as Trade only at NAV as priced at the end of priced at the end of each trading dayeach trading day
ETFsETFs Create shares by Create shares by
depositing a portfolio depositing a portfolio of shares matching of shares matching indexindex
Margin eligibilityMargin eligibility Tradable throughout Tradable throughout
the daythe day
Quick QuizQuick Quiz
Why do people invest in mutual funds?Why do people invest in mutual funds?What is the difference between a load and What is the difference between a load and
a fee?a fee?What is an ETF?What is an ETF?
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