Chapter 10 All Rights Reserved
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Transcript of Chapter 10 All Rights Reserved
- 1. Chapter 10 Investment Companies Mutual Fund Characteristics Other Pooled Investments Managing Fund Investments
2. Student Learning Objectives
- What are mutual funds?
- Open-end vs. closed-end funds
- UIT, REIT, RELP, REMIC
- Selecting a mutual fund
- Managing mutual fund investments
3. Forming a Mutual Fund
- Investment company forms the fund and advertises its investment objectives, fees, and fund manager.
- Interested parties buy shares (of beneficial interest) at a preset price (NAV).
- Fund manager then invests the proceeds of the share sale in a variety of stocks.
- Thereafter, NAV set by stock prices
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- Value of mutual fund assets minus liabilities divided by number of outstanding shares
- Regulatory requirements for Investment Companies
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- Must distribute
4. Types of Mutual Funds
- Open-end
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- Investment Company stands ready to buy and sell
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- Price based on NAV (sales charge possible)
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- Active or Passive management
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- May have multiple classes (fee schedules)
- Closed-end
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- One time issuance of shares
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- Shares publicly traded
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- Tend to trade at a discount to NAV
5. Types of Mutual Funds
- Stock Funds (common, preferred)
- Bond Funds (short-, intermediate- or long-term)
- Balanced Funds (stocks and bonds)
- Taxable vs. Tax free
- Index Funds (SP500, Nasdaq, Russell, Wilshire )
- Sector Funds (Energy, Utility, Transportation)
- Global Funds (Europe, Far East, Emerging)
- Exchange Traded Funds (ETF)
6. Types of Mutual Funds
- Asset Allocation
- Socially Responsible
- Money Market
- REITs and RELPs
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- Real estate applications: commercial, residential
- Unit investment trusts
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- Unmanaged
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- Self-liquidating
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- Largely consist of short-term debt securities
- Hedge funds
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- Typically organized as offshore limited partnerships for qualified investors
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- Maximum investment flexibility
- Variable annuities
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- Mutual fund type of instrument originating at insurance companies
7. 8. Fund Operating Details
- Distribution Requirements
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- IRS (Subchapter M) requires funds to distribute no less than 90% of interest and dividends received.
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- The same applies to net realized capital gains
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- Realized = result of buying and selling
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- Load Charges
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- Most funds areno-load
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- Sales charges may vary according to fund
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- Front-end vs. Back-end (tied to holding period or class)
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- Sales charges tend to discourage timing or frequent trading
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- May also involve break-points
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- Management (Advisory) Fees, 12b-1 Fees
9. Fund Operating Details
- Distribution (sales)
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- Direct marketing (Vanguard, Fidelity, etc., websites)
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- Sales Force
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- Broker-Dealers
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- Financial Planners
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- Retirement fundjobbers(Planco Div of HIG)
- Prospectus Requirements
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- Investor purchase must be followed by receipt of fund prospectus
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- Annual reports required, may receive quarterly reports
10. Pros & Cons of Mutual Funds
- Pros
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- Professional portfolio management
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- Diversification (risk reduction)
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- Convenience
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- Record keeping
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- Other factors
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- Examples: liquidity, minimal investment requirements, regulation
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11. Pros & Cons of Mutual Funds
- Cons
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- Management fees, expenses, and loads for load funds reduce their returns.
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- Large investors, such as mutual funds, sometimes adversely affect the market when they trade.
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- Institutions usually restrict their analysis to a small percentage of traded stocks (i.e., the larger ones).
12. Net Asset Value (NAV)
- Per-share market value of mutual funds portfolio:
- NAV = (total assets total liabilities) number of shares outstanding
- Forms of Return
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- Price Appreciation:Increase in NAV
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- Dividends and Interest:Pass-through of dividends and interest received on portfolio
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- Regular dividend
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- Capital Gain Distribution:Payment of net capital gain recognized by fund during year
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- Reinvestment Strategies: auto-reinvest, cash distribution
13. Load Charges
- Contingent deferred sales charge (CDSC)is a back-end load that declines over time
- Back-end loads discourage trading by investors
- Front-end loads compensate the broker
- No-load funds tend to be most popular
- Share Class Structure
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- Class A:Usually large front-end load, and minimal or no 12b-1 fee . Best if plan long holding period
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- Class B:Back-end load and 12b-1 fees, usually convertible to Class A after load waived
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- Class C:Minimal or no front-end or back-end load, but substantial 12b-1 fee. Best if plan short holding period
14. Operating Expenses
- Management or advisory fees and other operating expenses
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- 12b -1 fees cover distribution costs
- Paid out of investment income as percent of NAV
- Compare loads and operating expenses for varying time periods in evaluating funds
- No evidence that higher fees or load charges bring superior performance
15. Performance and taxes
- Mutual funds are not taxed directly on income or capital gains as these are passed on to the shareholders
- Returns can be broken down into distributions and change in NAV
- Portfolio turnover relates to higher capital gains distributions and unrealized capital gains
- Dont purchase just before a distribution
16. Managing Fund Investments
- Passive versus active
- Personal objectives may change over time
- Dollar-cost averaging results from investing equal dollar amounts at regular intervals
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- Can be beneficial when prices fluctuate, but
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- if prices continually rise, buying more earlier is better
- Rebalancing Investment Portfolio
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- Adjusting allocations to desiredrisk-return target
17. Regulations and Taxation
- The SEC regulates U. S. fund operations through Mutual Fund Act of 1940.
- State approval is also required to sell shares
- Most funds are taxed asregulated investment companies :
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- All investment income must be distributed to shareholders each year
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- All tax liability falls to individual shareholders
18. Mutual Fund Services
- Automatic reinvestment of distributions
- Automatic investment plans
- Check writing (money market funds)
- Exchange privileges within fund families
- Periodic statements
19. Why Mutual Funds?
- Positives
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- Professional management
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- Diversification
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- Convenience
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- Marketability
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- Ease of exchange
- Negatives
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- Most funds under perform the indexes
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- Fund performance depends on fund manager and market conditions
20. Special Issues in Closed-End Funds
- No prospectus to traders
- May have tax liabilities (liquidation)
- May be leveraged (additional risk)
- May have liquidity problems (thinly traded)
- Possibility of conversion to open-end
- Different distribution structures (managed)
- Tends to trade at less than NAV
21. Real Estate Investment Companies
- Real Estate Investment Trust (REIT)
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- Min of 75% invested in RE
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- Required to pay out 90% of income
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- Equity REITs: income producing
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- Mortgage REITs: making loans
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- Hybrids
- Real estate Limited Partnerships (RELP)
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- More complex tax rules
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- May have a liquidation time set
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- May involve sales charges
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- Many sell at discounts
22. Real Estate Investment Companies
- RE Mortgage Investment Conduits (REMIC)
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- Created by breaking up interest and principal streams
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- Different maturity packs to match investor needs
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- Bear Stearnswasmajor player in this market (> JPM)
23. Unit Investment Trust
- Debt
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- Funds invested in bonds
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- Bond UIT have fixed lives.
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- Purpose: provide known income stream
- Equity
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- Funds invested in Equities
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- All have termination date: liquidation > distribution
- Pros and Cons
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- Negligible fees, tax efficient, convenient
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- Sales charges, lack of marketability
24. Exchange Traded Funds
- Alternative to Mutual Funds
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- No minimum holding period
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- Can mimic indexes, sector, countries, etc.
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- Many are very liquid 51 traded more than 500,000 shares (April, 2008), another 60 at least 100,000 shares
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- Even more are thinly traded: 259 ETF had daily volumes under 100,000 shares (April, 2008)
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- Marginable
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- Able to sell short
25. Other Investment Vehicles
- Hedge Funds
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- Multiple fronts
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- Derivatives: options and futures
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- Stocks and bonds
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- International
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- Costly and Risky
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- Performance suspect backfilling
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- Losses can be significant e.g. LTCM
- Variable Annuities
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- Industry is still evolving trying to increase returns
26. Other Investment Vehicles
- Pooled Portfolios
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- Operating or holding companies:Some operating or holding companies hold such large portfolios that their performances are more closely related to their security holdings than to their operations.
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- Partnerships:Some investment companies choose the partnership form, often a limited partnership, because of its greater flexibility and/or tax advantages.
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- Blind pools:Investors bankroll enterprises whose purposes will later be revealed; these pools are sometimes involved in takeover financing.
27. Selecting and Evaluating Funds
- Evaluate Historic Performance
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- Against a benchmark like the S&P 500 over time
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- Morningstar or Weisenberger publications
- Assess Future Performance
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- Some believe that past performance is a poor predictor since funds do not (over the long term) post better risk-adjusted performance than the broad market averages
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- Others feel that past performance is a reasonable, though imperfect, predictor because past performance reflects more than mere luck
28. Selecting and Evaluating Funds
- Evaluate services offered by the fund
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- Redemptions
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- Automatic dividend reinvestment
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- Advisory services
- Examine fees and expenses
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- Load charges
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- Operating expenses
- Third Party Evaluations
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- Morningstar