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Chapter 5Mutual Funds

Chapter outline• Investment companies and fund types• Mutual fund operations• Mutual fund costs and fees• Short-term funds• Long-term funds• Mutual fund performance• Closed-end funds, exchange traded

funds, and hedge funds• Registered retirement savings plans• Income trusts

Chapter Objective

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

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Investment Companies Fund Types An Investment company is a business that specializes in pooling funds

from individual investors and making investments. 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. A Closed-end fund is an investment company with a fixed number of shares

that are bought and sold by investors, only in the open market. An Open-end fund is an investment company that stands ready to buy and

sell shares in itself to investors, at any time. Sometimes, if an open-end fund gets too big, it will not take in new

investors. It will, however, take more money from its current investors. Of course, current investors can withdraw money from the fund.

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Investment Companies and Fund Types

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Investment Companies and Fund Types

Net asset value (NAV) is the value of the assets held by a mutual fund, divided by the number of shares.

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

In contrast, share value of closed-end funds may differ from their NAV.

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Mutual Fund Operations 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 (say Fidelity Investments), or brokerage firms with investment advisory operations.

Investment advisory firms earn fees for managing mutual funds.

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.

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Mutual Fund Costs and Fees Sales charges or “loads”

Front-end loads are charges levied on purchases. Back-end loads are charges levied on redemptions.

Management fees: Usually range from 0.5% to 2% of the funds total assets each year. Are usually based on fund size and/or performance.

Trading costs Not reported directly Funds must report "turnover," which is related to the amount of trading. The higher the turnover, the more trading has occurred in the fund. The more trading, the higher the trading costs.

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Mutual Fund Costs and Fees

Mutual funds are required to report expenses in a fairly standardized way in their prospectus. Shareholder transaction expenses - loads and deferred sales

charges. Fund operating expenses - management and 12b-1 fees, legal,

accounting, and reporting costs, director fees. After all, many good no-load funds exist. But, you may want a fund run by a particular manager. All such

funds are load funds. Or, you may want a specialized type of fund.

Perhaps one that specialized in Italian companies Loads and fees for specialized funds tend to be higher, because

there is little competition among them.

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Short-Term Funds, Short-term funds are collectively known as money market mutual

funds. Money market mutual funds (MMMFs) are mutual funds

specializing in money market instruments. MMMFs maintain a $1.00 (in the US) or $10.00 (in Canada) net asset value

to make them resemble bank accounts. There is no guarantee that the net asset value will be $1.00 or more.

A Net Asset Value for a MMMF under $1.00 results in the term, “breaking the buck.”

Following the Crash of 2008, a few MMMF “broke the buck.” 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 CDIC protection.

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Long-Term Funds

There are many different types of long-term funds, i.e., funds that invest in long-term securities.

Historically, mutual funds were classified as stock funds, bond funds, or income funds.

Nowadays, the investment objective of the fund is the major determinant of the fund type.

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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

Small company Mid-cap Large

Some stock fund invest internationally.

Global International Region Country Emerging markets

Sector funds specialize in specific sectors of the economy, such as:

Biotechnology Internet Energy

Other fund types include: Index funds Social conscience, or “green,”

funds “Sin” funds (i.e., tobacco,

liquor, gaming) Tax managed funds

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Bond Funds

Bond funds may be distinguished by their Maturity range Credit quality Taxability Bond type Issuing country

Bond fund types include: Short-term and intermediate-term funds General funds High-yield funds Mortgage funds World funds Insured 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

Target Date Funds (also known as Lifecycle Funds) The asset allocation chosen by target date funds is based on the

anticipated retirement date of the investors holding the fund. If a company offers a Target Date 2040 Fund, the fund is for people

planning to retire in about 2040. In 2011, say, this fund would have a large equity exposure. In 2039, say, this fund would have a large bond exposure.

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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).

Growth stocks are those considered more likely to grow their businesses.

Value stocks are those that look to be relatively undervalued.

Mutual Fund Objectives : Recent Developments

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Mutual Fund Objectives 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

Size

Style

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Mutual Fund Objectives

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Mutual Fund Performance Mutual fund performance is very closely tracked by a number of

organizations. Financial publications of all types periodically provide mutual fund

data. The Globe Fund site is particularly valuable for fund investors. www.morningstar.ca has a “Fund Selector” that provides

performance information 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.

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Mutual Fund Performance

Mutual Fund Performance: Online Version of The Wall Street Journal

Note the fund with symbol: FBGRX

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Mutual Fund Performance: Online Version of The Wall Street Journal

Result of clicking on “BluCh”19

Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson

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.

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Mutual Fund Performance: Cautions

Sometimes a fund will choose to close.

This means that the fund will no longer sell shares to new investors.

The use of the word “close” here should not be confused with “closed-end.”

The number of shares in a closed fund can still fluctuate as existing owners buy and sell.

Why would a fund choose to close?

When a fund grows rapidly, the fund manager may feel that the incoming cash is more

than the fund can invest profitably.

Funds that close often reopen at a later date.

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Closed Funds

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Closed-End Fund Performance

A closed-end fund has a fixed number of shares. These shares are traded on stock exchanges.

There are about 600 closed-end funds that have their shares listed on stock exchanges.

There are about 8,000 long-term open-end mutual funds. Most closed-end funds sell at a discount relative to their

net asset values. The discount is sometimes substantial. The typical discount fluctuates over time.

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

Mutual Fund Performance: Closed-End Funds

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Exchange Traded Funds An exchange traded fund, or ETF,

Is basically an index fund. 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. A well-known ETF is the “Standard and Poor’s

Depositary Receipt” or SPDR. This ETF mimics the S&P 500 index. It is commonly called “spider.“ Another well-known ETF mimics the Dow Jones—it is called

"Diamond.” A list of ETFs can be found at www.amex.com.

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Exchange Traded Funds, Performance

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A particularly interesting, but potentially dangerous, ETF growth area is in leveraged ETFs. The fund managers of a leveraged ETF create a portfolio designed

to provide a return that tracks the underlying index. But, by also using derivative contracts, the managers can magnify,

or leverage, the return on the underlying. The Fund Manager can also use derivatives to generate returns

opposite, or inverse, of the index return. Leveraged funds are designed to have twice the return on an index,

say the S&P 500. In other words, if the S&P 500 return on a given day is one

percent, the leveraged fund should provide a return of two percent.

The danger is that leverage works both ways. Losses are also magnified by two. 26

Leveraged ETFs

Levered ETFs seem to track their underlying indexes on a short-term basis, i.e., day by day.

Over longer periods of time, however, their performance is probably not what you would expect.

For example, trading in leveraged ETFs offered by Rydex, a reputable firm, began on November 7, 2007. The Long Fund (RSU) was designed to earn twice the S&P 500

index return. The Inverse Fund (RSW) was designed to earn the opposite of twice

the S&P 500 Index return. Over the next two years, the S&P 500 lost -22.4 percent.

Given its objective, the RSU fund should have lost -44.8 percent. The inverse fund, RSW, should have gained 44.8 percent. Over this two-year period, however, the RSU lost -56.5 percent, and

the inverse fund, the RSW, lost -7.3%. How is such a result possible? 27

Leveraged ETFs

The answer lies in average versus geometric returns (and not with Rydex). Recall that geometric returns are lower than arithmetic returns Volatility fuels the difference. Both Rydex leveraged funds add extra volatility to the series of S&P 500

index returns. As a result, returns from any leveraged funds will be less than expected.

Example: Consider a week during which the S&P500 earns daily returns of 1, -2, 2, 1, and 3 percent, respectively.

The arithmetic average is 1%. The geometric average is just slightly less, 0.986%. This difference seems trivial.

Consider the returns, however, for a twice-leveraged fund. The arithmetic average is exactly double, 2%. The geometric average, however, is [(1.02)(0.96)(1.04)(1.02)(1.06)](1/5) – 1

= .0194, or 1.94%. Six basis points tracking error in one week.

The longer the holding period and/or the more volatile the underlying index, the less accurate a leveraged fund will be in tracking its stated objective. 28

Leveraged ETFs

Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson

Introduced in mid-2006 by Barclays Bank.

To investors, ETNs look like ETFs.

However, ETNs are unsecured debt—so, unlike holders of ETFs, holders of ETNs do have default risk.

ETNs provide investors with exposure to commodities, but without the leveraged risk of futures contracts.

Handy web source: www.ipathetn.com 29

Exchange-Traded Notes

Like mutual funds, hedge funds collect pools of money from investors. Like mutual funds, hedge funds in the US are generally required to

register with the SEC. But: Hedge funds are not required to maintain any particular degree of

diversification or liquidity. Hedge fund managers have considerably more freedom to follow

various investment strategies, or styles. Investing in hedge funds is not suitable for the all investors.

Hedge funds accept only “qualified” (or accredited) investors. To be considered a qualified investor, you need to fulfill one of

these conditions:1. You must be an institution or an individual investor with a net

worth of about a million dollars.2. You must have a recurring annual income of over $200,000.

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Hedge Funds, Overview

Most common fee structure is 2/20, but many others exist. A short way to say that the manager charges an annual 2%

management fee and retains 20% of the hedge fund profits. To prevent the fund from being manipulated by its managers, many fee

structures include hurdles for the manager to meet. A common example is called a “high-water mark.” When a hedge fund fee structure includes a high-water mark, the

manager will receive performance fees only when the fund value is higher than its previous highest value.

Why do hedge fund investors willingly pay high fees? Obvious answer: returns earned are high enough to provide a

reasonable return. Some experts opine that hedge fund returns net of fees are about the

same as the overall stock market return. If these experts are correct, why would anyone invest in a hedge fund

instead of a market index fund? The answer lies in the principle of diversification.

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Hedge Fund Fees

Some Common Hedge Fund Investment StylesMarket Neutral. Goal: offset risk with opposite positions in pairs of

securities. These hedge funds are also called long-short funds. Properly constructed, the resulting portfolio makes money regardless

of how the overall market performs. Hence the name “market neutral.” Expected Volatility: Low.

Arbitrage. Goal: identify a mispricing in relationships between securities that theoretically should not exist.

These hedge fund managers look at pricing relationships for securities offered by the same company, or for investments across time or countries.

Expected Volatility: Low.Distressed Securities. Goal: Buy securities that are being offered at deep

discounts resulting from company-specific or sector-wide distress. For example, a manager of distressed securities fund might buy

securities of firms facing bankruptcy. Expected Volatility: Low to moderate.

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Some Common Hedge Fund Investment Styles

Macro. Goal: These hedge fund managers attempt to profit from changes in global economies brought about by governmental policies that affect interest rates interest rates, currencies, or commodity prices. Macro fund managers often use leverage and derivative securities to

increase the impact of market moves. Expected Volatility: High.

Short Selling. Goal: Managers of a pure short hedge fund only short sell. In addition, these managers use leverage through the use of margin. Expected Volatility: High

Market Timing. Goal: Managers of these hedge funds attempt to identify trends in particular sectors or overall global markets. These managers often take concentrated positions and generally use

leverage to increase the fund’s exposure to predicted movements. Expected Volatility: High

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As you can see, hedge fund managers employ many approaches, and each has its own risk level.

The lesson? Suppose you make your millions and become a qualified hedge fund

investor You still have your work cut out trying to identify the best hedge fund

for your portfolio. Suppose you just cannot decide?

You might want to use a “Fund of Funds.” These investment companies invest in hedge funds. Note: There is an additional, and significant, layer of fees heaped onto

the already hefty hedge fund fees.

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Hedge Funds

Registered Retirement Savings Plan (RRSP)

Every year more and more Canadians choose to invest in registered retirement savings plans as part of their long-term investment portfolios.

The registered retirement savings plan is, as its name suggests, a retirement plan.

Investors can open an RRSP account and contribute throughout the year.

All contributions are tax deductible; thus, investors can use their contributions to these plans to reduce their income taxes.

As long as their savings stay in the plan, investors do not pay tax. Once they withdraw their money, however, they do pay tax.

RRSP funds can be invested in stocks, bonds, and mutual funds. Canadian investors choose mutual funds as the most popular RRSP

investment option. 35

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Income Trusts

Income trusts are created as asset-holding companies.

A trust creates units and offers these units to the public in exchange for money.

In Canada income trusts enjoy tax advantages. Recently, income trusts became very popular

because of tax deduction and tax referral of cash distributions.

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Useful Internet Sites www.ici.org (reference for mutual fund facts and figures) www.globefund.com (reference for mutual funds and their rankings) www.vanguard.com (example of major fund family website) www.manulife.ca (website of major mutual fund families) www.mfea.com (reference for info on thousands of funds) www.morningstar.ca (reference for one of the best mutual fund sites) www.vicefund.com (reference for “vice” funds) www.socialinvest.org (reference for “social conscience” funds) www.hedgefundworld.com (reference for hedge fund information) www.turnkeyhedgefunds.com (reference to start your own hedge fund) www.cra-arc.gc.ca (reference for tax policy regarding RRSP www.globeinvestor.com (reference for income trusts