Mutual Funds

Strategy Follows Structure

Overview

Markets & Mutual Funds

Players and Terminology

Government oversight

Fund structures

Fund expenses

What is a Market?

• A human invention for our collective use

• No central control- it’s a distributed network.

• It sets prices, distributes investment risk and provides capital to future business among a willing group of participants who want to maximize gain and minimize risk.

Price vs. Value• Markets clear goods from the market place by

auction- buy and sell• No two investors have the same information so

they never value an item identically and this creates price differences

• Price exists at the moment of completed sale of an item- an arbitrarily agreed upon value.

Low quality/high volume prices discounted

High quality/low volume prices at a premium

Why have Mutual Funds?

• A mutual fund provides small investors

with the same diversification and professional management of investment available to a wealthy investor.

• In 1822 the first investment company formed by King of Netherlands. A group of wealthy, interested people pooled their money to invest primarily in securities, thereby sharing the risk and rewards.

WealthyInvestor

10 investors

Capital

Fund Management

Fund Management

Fund CompanyOwner/Shareholders

Stock 3

Stock 4

Stock 5

Stock 6

Stock 7

Stock 8

Stock 9

Stock 10

Portfolio of Securities

NAV = $100 / 1 shareholder =$100

NAV = $100 / 10 shareholder =$10

Stock 2

Stock 1

Stock 3

Stock 4

Stock 5

Stock 6

Stock 7

Stock 8

Stock 9

Stock 10

Stock 2

Stock 1

hires

Terminology

Trust

1) A legal arrangement in which an individual (the trustor) gives fiduciary control of property to a person or institution (the trustee) for the benefit of beneficiaries.

2) A monopolistic corporation, prior to the enactment of antitrust laws.

Pooled Investment Vehicles• Investment Trusts (British late 1800’s)• Investment Companies (regulation-

incorporated)

• Investment Funds (America in 1920s) Mutual Investment Funds Mutual Funds

– Closed End Funds– Open End Funds– Unit Investment Trusts (Money market funds)– Fixed Trusts– Exchange Traded Funds (ETF)– Hedge Funds

• <100 shareholders or knowledgeable, wealthy investors $MM

Fund Abuses of 1880s

• Lack of Disclosure

• Insufficient portfolio diversification

• Excessive leverage by borrowing through:– Issue of senior securities– Funds engaging in underwriting and non investment activities– Issue cheap “founder’s shares” to funds promoters

Closed End Funds

1) Do not offer new shares continuously.

To buy in, you must find an current shareholder willing to sell their shares.

2) Fund shares of portfolio traded in market at more or less than liquidation value of the portfolio of securities

$100 portfolio of 5 shares, each share = $20

if selling for $23, premium is $3

if selling for $18, discount is $2

Open End Funds

1) Offer redemption of shares at any time. Receive proceeds based on current value of portfolio at the end of the day.

2) Continuously offer new shares to investors

Exchange Traded Funds

ETFs always bundle together the individual securities that are in an particular index of virtually any industry or sector of a market. ETF’s track that index and can be traded like a stock

Institutional investor purchases a pre-specified basket of securities. A creation unit of ETF is produced that the investor then can sell or hold their at anytime of day like a stock share. Retail investors buy an interest in the unit.

The first ETF created was the Standard and Poor's Deposit Receipt (SPDR, pronounced "Spider") in 1993. SPDRs gave investors an easy way to track the S&P 500 without buying an index fund. On NASDAQ, it was “Qubes” for QQQQ ticket symbol

Advice -Trust but Verify• Investment Adviser (Counsel) /

Trust Services of BanksConservative, Competent, Defensive

For investors with >$5M; Substantial annual feesRegistered Investment Adviser (RIA) – is listed with SEC and in states they do work. They manage assets worth >25 M and >100 clients. Should provide a Part II Form ADV which summarizes background and

fees.

• Financial Services Advisers

Newsletters & Statistical Information Standard & Poor, Moody’s, Morningstar;

Subscription fees

Advice -Trust but Verify• Brokerage (Wire) Houses / Firms

– Stockbroker must be member of a SEC registered exchange (NYSE,NASDAQ, Regional or Int’l Exchanges)

– broker/dealer is any individual or firm in the business of buying and selling securities for itself and others

– When acting as a broker, a broker/dealer executes orders on behalf of his/her client.

– When acting as a dealer, a broker/dealer executes trades for his/her firm's own account.

– Securities bought for the firm's own account may be sold to clients or other firms, or become a part of the firm's holdings.

Advice -Trust but VerifyIndividuals who work for broker-dealers:

sales personnel whom most people call brokers are technically known as registered representatives (RR).

• When a RR suggests that you buy or sell a particular security, they must have reason to believe that the recommendation is suitable for you based on a host of factors, including your income, portfolio, and overall financial situation, your tolerance for risk, and your stated investment objectives.

• The products they can sell depend on SEC licenses they hold. A RR with a Series 6 license can sell only mutual funds, variable annuities, and similar products.

A RR with a Series 7 license can sell a broader array of securities.

Advice -Trust but VerifyIndividuals who work for broker-dealers:

Financial Analyst /Security Analyst

• Performs detailed studies of individual securities and forms a judgment on their value as a stock price forecast (not business analysis)

• No formal requirements for training but generally have a business school training or equivalent. Often CFA

• Usually only speak to institutional or wealthy investors directly

Advice -Trust but Verify

Investment Banker/Firm

• Supplies new capital for expansion of industry

• Engages in originating, underwriting, and selling new issues of securities

• Normally sells to professional investor who is prudent and shrewd.

Advice -Trust but Verify• “Financial planners” Come from a variety of backgrounds and offer a variety of

services. They could be brokers or investment advisers, insurance agents or practicing accountants—or they have no financial credentials at all.

Some will examine your entire financial picture and help you develop a detailed plan for achieving your financial goals.

Others will recommend only the products they sell, which may give you a limited range of choices.

* CFP Certified Financial Planner * CFA Chartered Financial Analyst

Government Regulation of Abuses

• 1924 First American open end mutual funds created 1929 American Market Crash• Securities Act of 1933 “Truth in Securities” Law

– Fund must provide prospectus with financial, management, and information to investors. Laws for selling fraudulent securities made

• Securities Act of 1934– Creates the Securities and Exchange Commission (SEC) with authority

over securities industry to oversee, regulate, register clearing agencies, brokerage firms, transfer agent and SRO (self regulating organizations) like NYSE, AMEX, and later NASDAQ.

• Revenue Act of 1936– Investment companies pass through dividends to shareholders who pay

tax. To prevent speculation no more than 30% of fund’s gross income could be derived from sale of securities held less than 3 months. Company could hold no more than 5% of assets in one company.

Government Regulation of Abuses

• Investment Advisers Act of 1940– Individuals and firms dealing in advice for compensation must register

with the SEC. (amended 1996- 25M under management to register)

• Investment Company Act of 1940– Company must provide information to investors about their investment

policies and financial condition upon original sale and then regular basis

• Securities Investor Protection Act of 1970– Establishes Securities Investor Protection Corporation (SPIC) to protect

investors from a failed brokerage firm. If cash or securities are missing from an account (except fraudulent securities) most investors get their money back.

• Securities Act Amendments of 1975– SEC directed to establish National Market System for OTC Trading

Government Regulation of Abuses

• 1976 SEC rule change- lifted federal law prohibiting tax exempt mutual funds by allowing dividend pass through on municipal funds

• 1980 SEC rule change- 12b-1 rule. – Funds allowed to pay for distribution expenses out of funds. Old

shareholders now paying for newly added shareholders.

• Insider Trading Sanctions Act of 1984– SEC can fine insider trading to triple of profits

• Insider Trading Act of 1988– More punishments for insider trading and pay for whistleblower

• Sarbanes-Oxley Act of 2002– Creates the public company accounting oversight board.

The auditing profession is not to engage in fraud.

Typical Mutual Fund Complex

Mutual Fund

Board of Directors/ Trustees

Shareholders

Investment Adviser

Principal Underwriter

Transfer Agent

Administrator

Custodian

Independent Public Accountant

Attorney/Legal

Officers

External Management Company

Runs the fund for a fee– Covers office costs – Hires investment adviser– Handles distribution services

• Commissions & fees paid to broker-dealers for selling fund shares

• Marketing services- branding, direct mail, literature, promotions

– Custodial• Operations: account tracking and maintenance, compliance,

prospectus printed

– Administration• bookkeeping, banking, insurance, forecasting,

Capital flow in a Mutual Fund

Mutual FundAssets

Shares redeemedShareholders & Shares purchased

Dividend (stocks)

Interest (bonds)

Realized capital gains from securities sold

Expenses not coveredBy Mgmt fee

Commissions, loads &12b-1 fees

Portfolio trading costs from turnover~ 0.25-3%

Management Fee 1-1.5% annual

Capital gains paid out

Mutual Ownership Structurevs.

Traditional Corporate Structure

ownFund Shareholders

Mutual

Mutual Funds

Mutual Funds

Management Company

Traditional

own

own

controls

own

Mgmt. Co. Shareholders

Management Company

Fund ShareholdersBogle p. 376

Purchasing Funds

• Direct purchase

• From Salespeople (Broker, RR)Method determines how they get paid

• A shares- Front end load. Charge up to 8.5% of sale

Breakpoints for larger investments• B shares- Back end surrender charges. 12b-1 fees

• If investor sold shares before commission paid off, usually at 1.5% to fund annually, get charged for commission & interest

• C shares- Back end load. Pay charges after redeem• D shares- 1% paid to salesperson each year

Expense Ratios for Portfolios 1999

low avg high

Equity MF 0.2% 1.5% 2.2%

Balanced MF 0.2% 1.4% 1.8%

Bond MF 0.2% 1.1% 1.5%

Pension Fund 0.3% 0.7% 1.0%

Bogle

2008 Expense Ratios

Avg Avg

Vanguard Industry

Active Funds 0.23% 1.32%

Index Funds 0.18% 0.95%

ETF 0.15 0.60%

Barron’s, 1/12/2009, Market Funds 4Q08, p2

Book References• Common sense on mutual funds: New imperatives for the intelligent

investor; John C. Bogle, 2000

• The rise of mutual funds: an insider’s view; Matthew P. Fink, 2008

• Stop wasting your wealth in mutual funds; Separately managed Accounts: the smart alternativ, Don F. Wilkinson, 2005.

• How markets really work; Joel Kurtzman, 2002

• Complete guide to online investing: everything you need to know explained simply; Michelle Dawn Hooper, 2008

• Against the gods: the remarkable story of risk; Peter L. Bernstein, 1996