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.

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

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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.

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

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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.

Investment Companies and Fund Types

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

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Investment Companies and Fund Types

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.

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

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Work the Web

For mutual fund facts and figures, visit:http://www.ici.org

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

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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.

Most mutual funds are created by investment advisory firms (such as Fidelity Investments), or brokerage firms with investment advisory operations (such as Merrill Lynch).

These firms wish to manage the funds to earn fees.

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

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Work the Web

All the major fund families have websites. Try, for example:http://www.vanguard.com

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

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Mutual Fund Operations

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.

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

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Mutual Fund Operations

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.

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

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Mutual Fund Costs and Fees

Types of Expenses and FeesSales charges or “loads.” Front-end loads are

charges levied on purchases, while back-end loads are charges levied on redemptions.

12b-1 fees. SEC Rule 12b-1 allows funds to spend up to 1% of fund assets annually to cover distribution and marketing costs.

Management fees. Usually based on fund size, performance, etc.

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Mutual Fund Costs and Fees

Types of Expenses and Fees …continued

Trading costs. This is related to the fund’s turnover.

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Mutual Fund Costs and Fees

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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Work the Web

Prospectuses are increasingly available online. To see some examples, visit:http://www.fidelity.com

To see a fund that really discloses information, try:http://www.ipsfunds.com

Check out the “plain language” risk disclosure!

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

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Mutual Fund Costs and Fees

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.

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

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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.

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

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Work the Web

For information on thousands of funds, including MMMFs, visit:http://www.mfea.com

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

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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.

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

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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.

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

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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.

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

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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).

Mutual Fund Objectives: Recent Developments

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Mutual Fund Objectives: Recent Developments

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

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

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Work the Web

One of the best mutual fund sites is:http://www.morningstar.comTry picking some funds using their

“Fund Selector.”

To learn more about “social conscience” funds, visit:http://www.socialinvest.orghttp://www.domini.com

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

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Mutual Fund Performance

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

Mutual Fund Performance

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Mutual Fund Performance

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Mutual Fund Performance

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.

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

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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.

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

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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

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

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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

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

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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?

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

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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