Chapter 4Chapter 4

MUTUAL FUNDS AND OTHER MUTUAL FUNDS AND OTHER MANAGED INVESTMENTSMANAGED INVESTMENTS

Chapter 4 QuestionsChapter 4 Questions

•• What is a mutual fund?What is a mutual fund?•• How is the net asset value (NAV) computed?How is the net asset value (NAV) computed?•• What expenses and changes might a mutual What expenses and changes might a mutual

fund investor face?fund investor face?•• What does research on mutual fund What does research on mutual fund

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

Chapter 4 QuestionsChapter 4 Questions

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

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

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

Mutual Fund GrowthMutual Fund Growth

•• Mutual funds have Mutual funds have become very become very popular investment popular investment vehicles.vehicles.

•• Nearly $7.5 trillion in Nearly $7.5 trillion in total assets in 2004.total assets in 2004.

•• Total assets have Total assets have grown 600% since grown 600% since 1990.1990.

What is a mutual fund?What is a mutual fund?

•• Mutual funds are openMutual funds are open--end investment end investment companies.companies.

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

Computing Net Asset ValueComputing Net Asset Value

•• For investors, the performance of their For investors, the performance of their investment depends on what happens investment depends on what happens to the fundto the fund’’s per share value, or net s per share value, or net asset value (NAV).asset value (NAV).

NAV= NAV= Market Value of Assets Market Value of Assets –– LiabilitiesLiabilitiesNumber of Shares OutstandingNumber of Shares Outstanding

Mutual Fund ManagementMutual Fund Management

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

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

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

Why invest with mutual Why invest with mutual funds?funds?

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

if fund investments are illiquidif fund investments are illiquid

•• DiversificationDiversification–– Small minimum investment buys a typically wellSmall minimum investment buys a typically well--

diversified investmentdiversified investment

•• Professional management and recordProfessional management and record-- keepingkeeping–– Expertise and servicesExpertise and services

Why invest with mutual Why invest with mutual funds?funds?

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

investments to match investor needsinvestments to match investor needs•• IndexingIndexing

–– Some funds track a broad market index Some funds track a broad market index which insures that investors will earn the which insures that investors will earn the ““market returnmarket return””

–– Increasingly popular mutual fund Increasingly popular mutual fund alternativealternative

Mutual Fund DrawbacksMutual Fund Drawbacks

•• Active trading contributes to high costs Active trading contributes to high costs which lower fund returns (Turnover)which lower fund returns (Turnover)

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

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

fallsfalls

Mutual Fund ReturnsMutual Fund Returns

Three sources of return:Three sources of return:•• Income distributions (ID)Income distributions (ID)

–– Bond interest, stock dividendsBond interest, stock dividends•• Capital gain distributions (CGD)Capital gain distributions (CGD)

–– Realized gains/losses from selling assetsRealized gains/losses from selling assets

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

Mutual Fund ReturnsMutual Fund Returns

Return = (ID + CGD + Return = (ID + CGD + ΔΔNAV)/Beg.NAVNAV)/Beg.NAV•• By dividing the sum of the three By dividing the sum of the three

components of dollar returns by the components of dollar returns by the beginning NAV, we have the mutual beginning NAV, we have the mutual fundfund’’s holding period return.s holding period return.

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

Types of Mutual FundsTypes of Mutual Funds

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

Common Stock FundsCommon Stock Funds

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

and levels of riskand levels of risk–– GrowthGrowth–– Industry or sector fundsIndustry or sector funds–– Geographic areasGeographic areas–– International or GlobalInternational or Global–– Equity Index fundsEquity Index funds

Taxable Bond FundsTaxable Bond Funds

•• Generally seek to generate current income Generally seek to generate current income with limited riskwith limited risk

•• Can vary by maturityCan vary by maturity–– ShortShort--term, Intermediateterm, Intermediate--term, Longterm, Long--termterm

•• Can vary by type of bondCan vary by type of bond–– GovernmentGovernment–– CorporateCorporate–– MortgageMortgage--backedbacked–– International/GlobalInternational/Global–– Bond Index fundsBond Index funds

Municipal Bond FundsMunicipal Bond Funds

•• Provide investors Provide investors with income exempt with income exempt from Federal from Federal taxationtaxation

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

Stock and Bond FundsStock and Bond Funds

•• Seek to provide a combination of Seek to provide a combination of income and value appreciation.income and value appreciation.

•• Different namesDifferent names–– Balanced fundsBalanced funds–– Blended fundsBlended funds–– Flexible fundsFlexible funds

Money Market FundsMoney Market Funds

•• Provide safe, current income with high Provide safe, current income with high liquidityliquidity

•• Invest in money market securitiesInvest in money market securities–– TT--bills, Bank CDbills, Bank CD’’s, Commercial paper, etc.s, Commercial paper, etc.

•• NAV stays at $1; income either paid out NAV stays at $1; income either paid out or reinvested dailyor reinvested daily

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

Mutual Fund InnovationsMutual Fund Innovations

•• LifeLife--stage fundsstage funds–– Offer different mixes of securities based on Offer different mixes of securities based on

the age of the investorthe age of the investor•• Supermarket fundsSupermarket funds

–– Offer a wide variety of funds with Offer a wide variety of funds with ““oneone-- stopstop”” fund shoppingfund shopping

–– Transfer services between fundsTransfer services between funds–– Expenses/fees can be highExpenses/fees can be high

Mutual Fund ProspectusMutual Fund Prospectus

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

•• Contains:Contains:–– FundFund’’s investment objectives investment objective–– Investment strategyInvestment strategy–– Principal risks faced by investorsPrincipal risks faced by investors–– Recent investment performanceRecent investment performance–– Expenses and feesExpenses and fees–– Lots of other detailed informationLots of other detailed information

Mutual Fund Expenses and Mutual Fund Expenses and ConsiderationsConsiderations

•• LoadsLoads–– Commission to the broker to financial advisor who Commission to the broker to financial advisor who

sold the fund to the investorsold the fund to the investor–– For load funds, the offer price is the fundFor load funds, the offer price is the fund’’s NAV s NAV

less the load (while noless the load (while no--load funds are sold at their load funds are sold at their NAV)NAV)

–– Load range from around 3% (lowLoad range from around 3% (low--load) to 8.5%load) to 8.5%•• 12b12b--1 Fees1 Fees

–– Fees deducted from the asset value of the fund to Fees deducted from the asset value of the fund to cover marketing expensescover marketing expenses

–– An alternative to loadsAn alternative to loads

Mutual Fund Expenses and Mutual Fund Expenses and ConsiderationsConsiderations

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

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

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

•• Share ClassesShare Classes–– Many funds offer several different classes of Many funds offer several different classes of

shares (Ashares (A--BB--C) with different fee structuresC) with different fee structures–– Best choice usually depends of investment Best choice usually depends of investment

horizonhorizon

Mutual Fund Expenses and Mutual Fund Expenses and ConsiderationsConsiderations

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

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

performanceperformance•• Expense ratioExpense ratio

–– Adding all fees and calculating expenses Adding all fees and calculating expenses as a percentage of the fundas a percentage of the fund’’s assets asset

Mutual Fund Expenses and Mutual Fund Expenses and ConsiderationsConsiderations

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

determinant of shareholder returnsdeterminant of shareholder returns–– Trading costs rise with turnoverTrading costs rise with turnover–– In order for high turnover to pay off, fund In order for high turnover to pay off, fund

managers must be successful in their active managers must be successful in their active trading strategiestrading strategies

•• Sources of InformationSources of Information–– Wall Street Journal, Business WeekWall Street Journal, Business Week–– MorningstarMorningstar

•• Fund history, tax efficiency, risk analysisFund history, tax efficiency, risk analysis

Mutual Fund Return and Risk Mutual Fund Return and Risk PerformancePerformance

Return PerformanceReturn Performance•• On a riskOn a risk--adjusted basis, portfolio managers adjusted basis, portfolio managers

seem to outseem to out--perform the market before perform the market before expenses, but net returns are below the expenses, but net returns are below the market indexmarket index

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

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

Mutual Fund Return and Risk Mutual Fund Return and Risk PerformancePerformance

Risk PerformanceRisk Performance•• While returns are not consistent, risk isWhile returns are not consistent, risk is•• Objectives lead to strategies that lead to Objectives lead to strategies that lead to

varying degrees of investment risksvarying degrees of investment risks•• Return is positively related to the level of riskReturn is positively related to the level of risk•• Risk is therefore an important considerationRisk is therefore an important considerationStyle ConsistencyStyle Consistency•• StyleStyle--shifting funds earn less on averageshifting funds earn less on average

Mutual Fund Return and Risk Mutual Fund Return and Risk PerformancePerformance

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

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

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

including taxes including taxes –– high turnover means more high turnover means more shortshort--term realized gainsterm realized gains

•• Tax efficiency is an important consideration Tax efficiency is an important consideration –– afterafter--tax returns tend to be less for high tax returns tend to be less for high turnover fundsturnover funds

••Mutual Fund Investment Mutual Fund Investment StrategiesStrategies

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

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

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

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

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

••Mutual Fund Investment Mutual Fund Investment StrategiesStrategies

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

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

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

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

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

When should you sell a When should you sell a mutual fund?mutual fund?

•• Personal considerationsPersonal considerations–– Portfolio rebalancing points due to life cycle Portfolio rebalancing points due to life cycle

considerationsconsiderations•• Be aware of the quick trigger, selling on the first dip in Be aware of the quick trigger, selling on the first dip in

NAV; think longNAV; think long--termterm•• Be aware of capital gains with selling fund sharesBe aware of capital gains with selling fund shares

•• Fund considerationsFund considerations–– Change in portfolio managerChange in portfolio manager–– Change in investment styleChange in investment style–– Fund is growing Fund is growing ““too largetoo large”” or or ““too fasttoo fast””–– Persistent bad performancePersistent bad performance

Mutual Fund ScandalsMutual Fund Scandals

•• Market timing, late trading, Market timing, late trading, miscalculating load fees, soft dollar miscalculating load fees, soft dollar commissionscommissions

•• Benefit fund managers, hurt longBenefit fund managers, hurt long--term term shareholdersshareholders

•• Rule changes to combat abuses Rule changes to combat abuses initiated by the SECinitiated by the SEC

Other Managed InvestmentsOther Managed Investments

ClosedClosed--end investment companiesend investment companies•• Shares trade like stock rather than Shares trade like stock rather than

being bought and sold from the fundbeing bought and sold from the fund•• Number of shares are fixedNumber of shares are fixed•• Often sell at a discount from NAV (a Often sell at a discount from NAV (a

puzzle for modern finance)puzzle for modern finance)•• Often a means of investing in a pool of Often a means of investing in a pool of

assets from a foreign countryassets from a foreign country

Other Managed InvestmentsOther Managed Investments

ExchangeExchange--traded funds (traded funds (EFTsEFTs))•• Relatively new, yet very popularRelatively new, yet very popular•• Like closedLike closed--end funds, they trade like end funds, they trade like

individual stocksindividual stocks•• Passively managed to mirror a market index, Passively managed to mirror a market index,

both broad and narrowboth broad and narrow•• Low expenses, but do involve brokerage Low expenses, but do involve brokerage

commissionscommissions•• Tax and liquidity concernsTax and liquidity concerns

Other Managed InvestmentsOther Managed Investments

Variable AnnuitiesVariable Annuities•• Many offered by insurance companiesMany offered by insurance companies•• Offers investors with choices of investments Offers investors with choices of investments

with taxwith tax--deferred growthdeferred growth•• Insurance product: payment in the case of Insurance product: payment in the case of

death or else retirement income streamdeath or else retirement income stream•• Expenses for both fund management and to Expenses for both fund management and to

pay for insurance, so fees tend to be much pay for insurance, so fees tend to be much higher than with mutual fundshigher than with mutual funds

•• Income stream taxed as regular incomeIncome stream taxed as regular income