BUFN 722 ch-5 Mutual Funds
Overview  <ul><li>In this segment ... Mutual Funds: </li></ul><ul><ul><li>Activities of mutual funds </li></ul></ul><ul><u...
Mutual Funds <ul><li>Open-ended </li></ul><ul><li>Closed-end </li></ul><ul><li>End of 2000:  </li></ul><ul><ul><li>More th...
Size, structure and composition <ul><ul><li>First mutual fund: Boston, 1924. </li></ul></ul><ul><ul><li>Slow growth, initi...
Size, Structure and Composition <ul><ul><li>By asset size, mutual fund industry second most important FI group. </li></ul>...
Types of Mutual Funds <ul><li>Long-term funds (71.0% of assets, 2000) </li></ul><ul><ul><li>Bond and income funds. </li></...
Number of Mutual Funds
Overview of Mutual Funds <ul><ul><li>Objectives (and adherence to stated objectives), rates of return and risk characteris...
Returns to Mutual Funds <ul><ul><li>Income and dividends of underlying portfolio. </li></ul></ul><ul><ul><li>Capital gains...
Types of Funds <ul><ul><li>Open-ended funds: contrast with most corporate securities traded on stock exchanges. </li></ul>...
Mutual Fund Costs <ul><li>Two types of fees: </li></ul><ul><ul><li>Sales loads </li></ul></ul><ul><ul><ul><li>Generally, n...
Mutual Fund Share Quotes <ul><li>Quotes include: </li></ul><ul><ul><li>Fund name, Objective, Minimum investment required, ...
Balance Sheet and Trends <ul><li>Money Market Funds </li></ul><ul><ul><li>Key assets are short-term securities (consistent...
Balance Sheet and Trends <ul><li>Long-term Funds </li></ul><ul><ul><li>Stocks comprise over 72.8 % of asset portfolios in ...
Regulation <ul><ul><li>One of the most closely regulated among non-depository FIs. </li></ul></ul><ul><ul><li>Primary regu...
Legislation <ul><ul><li>Securities Act 1933, 1934 </li></ul></ul><ul><ul><li>Investment Advisers Act, 1940. </li></ul></ul...
Mutual Funds Overview <ul><li>Mutual funds are financial intermediaries that pool the financial resources of investors and...
Investment company - economic motivation <ul><li>Investment company is financial intermediary that pools funds of market p...
Background on Mutual Funds <ul><li>Mutual funds offer a way for small investors to diversify when they could not do so on ...
Investment Co - Mutual Fund <ul><li>continuously stand ready to sell new shares to public  & redeem outstanding shares  on...
Historical Trends <ul><li>First mutual fund established in 1924 </li></ul><ul><li>Advent of money market mutual funds in 1...
Growth of the Mutual Fund Market
Types of Mutual Funds <ul><li>Long Term </li></ul><ul><ul><li>Equity funds - funds consisting of common and preferred stoc...
Mutual Fund Prospectuses and Objectives <ul><li>Regulations require mutual fund managers to specify the investment objecti...
Background on Mutual Funds <ul><li>Information contained in a prospectus </li></ul><ul><ul><li>The minimum amount of inves...
Investor Returns from Mutual Fund Ownership <ul><li>The return for the investor reflects three aspects of the underlying p...
Calculation of NAV Calculation of NAV on an Open-End Mutual Fund NAV  =  Total market value of assets under management Num...
Open-End versus Closed-End Funds <ul><li>Closed-end funds </li></ul><ul><ul><li>Do not repurchase the shares they sell </l...
Mutual Fund Costs <ul><li>Mutual funds charge shareholders a price or fee </li></ul><ul><li>Two types of fees are incurred...
Assets in MMMFs, 1999 Q2 (in $B)
Regulation <ul><li>This industry is heavily regulated to protect investors </li></ul><ul><li>SEC is the primary regulator ...
<ul><li>III.  Investment Companies </li></ul><ul><li>  Investment firms offer investment expertise and portfolio  </li></u...
<ul><ul><li>C.  Investment Management Companies </li></ul></ul><ul><ul><ul><li>Investment management companies are none of...
<ul><ul><li>D.  Regulations Applicable to All Investment Companies </li></ul></ul><ul><ul><ul><li>The SEC is responsible f...
Investment Company <ul><ul><li>E.  The Size of Investment Company Business </li></ul></ul><ul><ul><ul><li>At the end of 19...
<ul><ul><li>F.  Money Market Funds </li></ul></ul><ul><ul><ul><li>Money market funds made their appearance in 1972 to expl...
Benefit of ETF (exchange traded funds) <ul><li>Convenience – desired market exposure in a single trade </li></ul><ul><li>L...
Tax efficiency of ETF <ul><li>Structural  - “In-kind” distribution of low cost basis stock to institutional creation / red...
Potential Costs & Constraints of ETF <ul><li>There are several potential constraints and costs of ETFs. </li></ul><ul><li>...
Structure of ETFs <ul><li>Unit Investment Trust (UIT)  </li></ul><ul><li>-  Examples: S&P 500 SPDR (SPY), Nasdaq-100 Trust...
Large EFT (1/25/02) <ul><li>  assets ($) </li></ul><ul><li>SPY SPDR (S&P depository receipts) 29,243,887,050 </li></ul><ul...
Registered Investment Company (RIC) Rules <ul><li>1.No security greater than 25% of the Fund, measured quarterly </li></ul...
What’s new in ETFs? <ul><li>Fixed income ETFs – applications have been filed with the SEC  - problems related to liquidity...
Exchange traded fund glossary <ul><li>Closed end fund: A type of mutual fund. Like ETFs,  closed-end  funds differ from  o...
ETF glossary, cont. <ul><li>HOLDRs Holding company depository receipts, a type of  ETF  marketed by Merrill Lynch. Unlike ...
ETF glossary, cont. <ul><li>Premium to NAV  Unlike regular  open-end  mutual funds, which are bought and sold directly fro...
Stock Mutual Fund Categories <ul><li>Growth funds for investors who want high returns with moderate risk </li></ul><ul><ul...
Stock Mutual Fund Categories <ul><li>Internet funds focus on investments in Internet companies </li></ul><ul><li>Specialty...
Bond Fund Investment Objectives <ul><li>Risks in bond funds </li></ul><ul><ul><li>Interest rate risk </li></ul></ul><ul><u...
Bond Fund Investment Objectives <ul><li>Tax-free funds for high tax bracket investors (can be structured to be state incom...
Bond Fund Investment Objectives <ul><li>Maturity classifications </li></ul><ul><ul><li>Interest rate sensitivity depends o...
Hedge Funds* <ul><li>Not technically mutual funds </li></ul><ul><ul><li>Not subject to SEC regulation </li></ul></ul><ul><...
Hedge Funds <ul><li>Financial problems experienced by Long-Term Capital Management (LTCM) </li></ul><ul><ul><li>Hedge fund...
Real Estate Investment Trusts <ul><li>A real estate investment trust or REIT is a closed-end mutual fund that invests in r...
Investment co - Unit trust <ul><li># of unit certificates is fixed (~closed end) </li></ul><ul><li>differences unit trust ...
Web Resources <ul><li>For information on the performance of mutual funds, visit: </li></ul><ul><li>Morningstar  www.mornin...
How can one start a mutual fund? <ul><li>You must file a registration document with the SEC that complies with the Investm...
Global Issues <ul><li>Worldwide growth in mutual fund investment not as great as in the U.S. </li></ul><ul><ul><li>$1,626 ...
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  1. 1. BUFN 722 ch-5 Mutual Funds
  2. 2. Overview <ul><li>In this segment ... Mutual Funds: </li></ul><ul><ul><li>Activities of mutual funds </li></ul></ul><ul><ul><li>Size, structure and composition </li></ul></ul><ul><ul><li>Balance sheets and recent trends </li></ul></ul><ul><ul><li>Regulation of mutual funds </li></ul></ul><ul><ul><li>Global issues </li></ul></ul><ul><ul><li>Hedge funds* </li></ul></ul>
  3. 3. Mutual Funds <ul><li>Open-ended </li></ul><ul><li>Closed-end </li></ul><ul><li>End of 2000: </li></ul><ul><ul><li>More than 7,100 stock and bonds mutual companies. </li></ul></ul><ul><ul><li>Total assets of $5.12 trillion. </li></ul></ul><ul><ul><li>8,200 firms and $6.97 trillion if money market mutual funds included </li></ul></ul>
  4. 4. Size, structure and composition <ul><ul><li>First mutual fund: Boston, 1924. </li></ul></ul><ul><ul><li>Slow growth, initially. </li></ul></ul><ul><ul><li>Advent of money market mutual funds, 1972. </li></ul></ul><ul><ul><ul><li>Regulation Q. </li></ul></ul></ul><ul><ul><li>Total assets in stock and bond mutual funds: </li></ul></ul><ul><ul><ul><li>1940: $0.4 billion. </li></ul></ul></ul><ul><ul><ul><li>1990: $568.5 billion </li></ul></ul></ul><ul><ul><ul><li>2000: $5,120.0 billion. </li></ul></ul></ul>
  5. 5. Size, Structure and Composition <ul><ul><li>By asset size, mutual fund industry second most important FI group. </li></ul></ul><ul><ul><li>Recent inroads by commercial banks and insurance companies </li></ul></ul><ul><ul><ul><li>Mellon purchase of Dreyfus </li></ul></ul></ul><ul><ul><ul><li>State Farm (9,000 agents) </li></ul></ul></ul>
  6. 6. Types of Mutual Funds <ul><li>Long-term funds (71.0% of assets, 2000) </li></ul><ul><ul><li>Bond and income funds. </li></ul></ul><ul><ul><li>Equity funds. </li></ul></ul><ul><ul><li>Hybrid </li></ul></ul><ul><li>Short-term funds (29.0% of assets, 2000) </li></ul><ul><ul><li>Taxable and tax-exempt MMMFs </li></ul></ul><ul><ul><li>Generally higher returns than bank deposits but uninsured. </li></ul></ul>
  7. 7. Number of Mutual Funds
  8. 8. Overview of Mutual Funds <ul><ul><li>Objectives (and adherence to stated objectives), rates of return and risk characteristics vary. </li></ul></ul><ul><li>Examples: </li></ul><ul><ul><li>Aggressive growth funds </li></ul></ul><ul><ul><li>Growth funds </li></ul></ul><ul><ul><li>Precious metals </li></ul></ul><ul><ul><li>World </li></ul></ul>
  9. 9. Returns to Mutual Funds <ul><ul><li>Income and dividends of underlying portfolio. </li></ul></ul><ul><ul><li>Capital gains on trades by mutual fund management. </li></ul></ul><ul><ul><li>Capital appreciation in values of assets held in the portfolio. </li></ul></ul><ul><ul><ul><li>Marked-to-market. </li></ul></ul></ul><ul><ul><ul><li>Net-asset value (NAV). </li></ul></ul></ul>
  10. 10. Types of Funds <ul><ul><li>Open-ended funds: contrast with most corporate securities traded on stock exchanges. </li></ul></ul><ul><ul><li>Closed-end investment companies: </li></ul></ul><ul><ul><li>Fixed number of shares </li></ul></ul><ul><ul><ul><li>Example: REITs. </li></ul></ul></ul><ul><ul><ul><li>May trade at premium or discount. </li></ul></ul></ul><ul><ul><li>Load versus no-load funds. </li></ul></ul>
  11. 11. Mutual Fund Costs <ul><li>Two types of fees: </li></ul><ul><ul><li>Sales loads </li></ul></ul><ul><ul><ul><li>Generally, negative effect on performance outweighs benefits </li></ul></ul></ul><ul><ul><li>Fund operating expenses </li></ul></ul><ul><ul><ul><li>Management fee </li></ul></ul></ul><ul><ul><ul><li>12b-1 fees </li></ul></ul></ul>
  12. 12. Mutual Fund Share Quotes <ul><li>Quotes include: </li></ul><ul><ul><li>Fund name, Objective, Minimum investment required, Asset size, Maximum initial and exit sales charges, Annual expenses, NAV, Dividends , Quarterly earnings, </li></ul></ul><ul><ul><li>One-through five-year rating (A through E). </li></ul></ul>
  13. 13. Balance Sheet and Trends <ul><li>Money Market Funds </li></ul><ul><ul><li>Key assets are short-term securities (consistent with deposit-like nature) </li></ul></ul><ul><ul><ul><li>2000: $1,303.9 billion (71.9% of total assets) </li></ul></ul></ul><ul><ul><li>Many have share values fixed at $1 and adjust number of shares owned by the investor. </li></ul></ul>
  14. 14. Balance Sheet and Trends <ul><li>Long-term Funds </li></ul><ul><ul><li>Stocks comprise over 72.8 % of asset portfolios in 2000. </li></ul></ul><ul><ul><li>Shift to U.S. Treasuries, municipal bonds etc. when equity markets not performing as well. </li></ul></ul>
  15. 15. Regulation <ul><ul><li>One of the most closely regulated among non-depository FIs. </li></ul></ul><ul><ul><li>Primary regulator: SEC </li></ul></ul><ul><ul><ul><li>Emphasis on full disclosure and anti-fraud measures to protect small investors. </li></ul></ul></ul><ul><ul><ul><li>NASD supervises mutual fund share distributions. </li></ul></ul></ul>
  16. 16. Legislation <ul><ul><li>Securities Act 1933, 1934 </li></ul></ul><ul><ul><li>Investment Advisers Act, 1940. </li></ul></ul><ul><ul><li>Insider Trading and Securities Fraud Enforcement Act of 1988. </li></ul></ul><ul><ul><li>Market Reform Act of 1990 </li></ul></ul><ul><ul><ul><li>Allows SEC to halt trading and introduce circuit breakers. </li></ul></ul></ul><ul><ul><li>National Securities Markets Improvement Act of 1996. </li></ul></ul><ul><ul><ul><li>Exempts mutual fund sellers from state securities regulatory oversight. </li></ul></ul></ul>
  17. 17. Mutual Funds Overview <ul><li>Mutual funds are financial intermediaries that pool the financial resources of investors and invest those resources in diversified portfolios of assets </li></ul><ul><li>Enjoy economies of scale by incurring lower transaction costs and commissions </li></ul><ul><li>Shareholder services offered include free exchanges of investments between a company’s funds, automatic investing, check-writing, automatic reinvestment of dividends, and automatic withdrawals </li></ul><ul><li>As of January 2000, more than 7,800 mutual funds held total assets of $6.8 trillion </li></ul>
  18. 18. Investment company - economic motivation <ul><li>Investment company is financial intermediary that pools funds of market participants & uses funds to buy a portfolio of securities </li></ul><ul><li>perform 5 economic functions </li></ul><ul><ul><li>maturity intermediation </li></ul></ul><ul><ul><li>risk reduction via diversification </li></ul></ul><ul><ul><li>denomination intermediation </li></ul></ul><ul><ul><li>lower costs of contracting & information processing </li></ul></ul><ul><ul><li>payments mechanism </li></ul></ul>
  19. 19. Background on Mutual Funds <ul><li>Mutual funds offer a way for small investors to diversify when they could not do so on their own with the purchases of individual stocks </li></ul><ul><li>Comparison to depository institutions </li></ul><ul><ul><li>Like depository institutions, mutual funds repackage proceeds from individuals to make investments </li></ul></ul><ul><ul><li>Bank deposits are a form of credit but a mutual fund represents partial ownership </li></ul></ul>
  20. 20. Investment Co - Mutual Fund <ul><li>continuously stand ready to sell new shares to public & redeem outstanding shares on demand at a price equal to the net asset value (NAV), which is computed daily at close of market . NAV = total asset value minus liabilities </li></ul><ul><ul><li>price quoted on bid-offer basis. Offer price = NAV per share + any sales commission (sales commission called “load”) </li></ul></ul><ul><ul><li>no-load - not charge commission - Vanguard </li></ul></ul><ul><ul><li>back-end load - fee to sell (redeem) shares </li></ul></ul><ul><ul><li>12b-1 fund charge < 1.25% of avg.. daily fund assets each year to cover costs of selling shares </li></ul></ul>
  21. 21. Historical Trends <ul><li>First mutual fund established in 1924 </li></ul><ul><li>Advent of money market mutual funds in 1972 as investors looked for ways to earn market rates on short-term funds </li></ul><ul><li>Tax-exempt money market mutual funds introduced in 1979 </li></ul><ul><li>Special-purpose equity, bond, emerging market, and derivative funds exploded on the scene during the 1990’s bull market </li></ul>
  22. 22. Growth of the Mutual Fund Market
  23. 23. Types of Mutual Funds <ul><li>Long Term </li></ul><ul><ul><li>Equity funds - funds consisting of common and preferred stock securities </li></ul></ul><ul><ul><li>Bond funds - funds consisting of fixed-income capital market debt securities </li></ul></ul><ul><ul><li>Hybrid funds - funds consisting of stock and bond securities </li></ul></ul><ul><li>Short Term </li></ul><ul><ul><li>Money market mutual funds - funds consisting of various mixtures of money market securities </li></ul></ul>
  24. 24. Mutual Fund Prospectuses and Objectives <ul><li>Regulations require mutual fund managers to specify the investment objectives of their funds in a prospectus available to potential investors </li></ul><ul><li>The prospectus includes a list of the securities that the fund holds and the investment objectives (i.e., aggressive growth funds, high-growth and high-risk securities) </li></ul><ul><li>The SEC is proposing an initiative to require mutual funds to disclose more information about their return risk as well as the returns themselves to better enable investors to compare </li></ul>
  25. 25. Background on Mutual Funds <ul><li>Information contained in a prospectus </li></ul><ul><ul><li>The minimum amount of investment required </li></ul></ul><ul><ul><li>The investment objective of the fund </li></ul></ul><ul><ul><li>The return on the fund over the past year, the past three years and the past five years </li></ul></ul><ul><ul><li>The exposure of the fund to various types of risk </li></ul></ul><ul><ul><li>Services the fund offers (e.g., check writing, telephone transfer, etc.) </li></ul></ul><ul><ul><li>The fees incurred and passed on to investors </li></ul></ul>
  26. 26. Investor Returns from Mutual Fund Ownership <ul><li>The return for the investor reflects three aspects of the underlying portfolio of mutual fund assets </li></ul><ul><ul><li>portfolio earns income and dividends on those assets </li></ul></ul><ul><ul><li>experiences capital gains sells an asset at a higher price </li></ul></ul><ul><ul><li>capital appreciation in the underlying values of its existing assets adds to the value of mutual fund shares </li></ul></ul><ul><li>Marked to market - asset and balance sheet values adjusted to reflect current market prices </li></ul><ul><li>NAV - the net asset value of a mutual fund -- equal to the market value of the assets in the mutual fund portfolio divided by number of shares outstanding </li></ul><ul><ul><li>Estimated daily </li></ul></ul><ul><ul><ul><li>Determine the market value of all the securities in the fund </li></ul></ul></ul><ul><ul><ul><li>Add interest or dividends; subtracted expenses </li></ul></ul></ul><ul><ul><ul><li>Divide by the number of shares </li></ul></ul></ul>
  27. 27. Calculation of NAV Calculation of NAV on an Open-End Mutual Fund NAV = Total market value of assets under management Number of mutual fund shares outstanding Open-end mutual fund - a fund for which the supply of shares is not fixed but can increase or decrease daily with purchases and redemptions of shares Closed-end investment companies - specialized investment companies that have a fixed supply of outstanding shares but invest in the securities and assets of other firms REIT - a closed-end investment company that specializes in investing in mortgages, property, or real estate shares
  28. 28. Open-End versus Closed-End Funds <ul><li>Closed-end funds </li></ul><ul><ul><li>Do not repurchase the shares they sell </li></ul></ul><ul><ul><li>Investors must sell shares on an exchange </li></ul></ul><ul><ul><li>Number of outstanding shares is constant </li></ul></ul><ul><li>Open-end funds </li></ul><ul><ul><li>Willing to repurchase investor shares at any time </li></ul></ul><ul><ul><li>Number of shares outstanding does not remain constant </li></ul></ul>
  29. 29. Mutual Fund Costs <ul><li>Mutual funds charge shareholders a price or fee </li></ul><ul><li>Two types of fees are incurred by investors </li></ul><ul><ul><li>Load versus No-load Funds </li></ul></ul><ul><ul><ul><li>Load fund - a mutual fund with an up-front sales or commission charge that the investor must pay </li></ul></ul></ul><ul><ul><ul><li>No-load fund - a mutual fund that does not charge up-front sales or commission charges on the sale of mutual fund shares to investors </li></ul></ul></ul><ul><ul><li>Fund Operating Costs </li></ul></ul><ul><ul><ul><li>annual fees charged to cover all fund level expenses experienced as a percent of fund assets </li></ul></ul></ul>
  30. 30. Assets in MMMFs, 1999 Q2 (in $B)
  31. 31. Regulation <ul><li>This industry is heavily regulated to protect investors </li></ul><ul><li>SEC is the primary regulator </li></ul><ul><ul><li>Securities Act of 1933 requires a mutual fund to file a registration statement with the SEC </li></ul></ul><ul><ul><li>Securities Exchange Act of 1934 makes the purchase and sale of mutual fund shares subject to various antifraud provisions and appointed the National Association of Securities Dealers (NASD) to supervise </li></ul></ul><ul><ul><li>Investment Advisers Act and Investment Company Act of 1940 established rules to prevent conflicts of interest, fraud, and excessive fees or charges </li></ul></ul><ul><ul><li>Insider Trading and Securities Fraud Enforcement Act of 1988 requires mutual funds to develop mechanisms and procedures to avoid insider trading abuses </li></ul></ul><ul><ul><li>Market Reform Act of 1990 allowed the SEC to introduce circuit breakers </li></ul></ul><ul><ul><li>NSMIA of 1996 also applies to mutual funds </li></ul></ul>
  32. 32. <ul><li>III. Investment Companies </li></ul><ul><li> Investment firms offer investment expertise and portfolio </li></ul><ul><li> diversification. </li></ul><ul><ul><li>A. Face-Amount Certificate Companies </li></ul></ul><ul><ul><ul><li>These companies issue certificates which promise a specific amount on the maturity date. </li></ul></ul></ul><ul><ul><ul><li>The investor makes periodic payments. </li></ul></ul></ul><ul><ul><ul><li>These firms are not subject to depository regulatory structure and are not insured. </li></ul></ul></ul><ul><ul><li>B. Unit Investment Trusts </li></ul></ul><ul><ul><ul><li>This is an investment vehicle which issues redeemable units of securities. </li></ul></ul></ul>
  33. 33. <ul><ul><li>C. Investment Management Companies </li></ul></ul><ul><ul><ul><li>Investment management companies are none of the above. These firms are also called mutual funds. </li></ul></ul></ul><ul><ul><ul><li>Closed-end funds have a fixed number of shares. Shares are traded at prices above or below asset value. </li></ul></ul></ul><ul><ul><ul><li>The number of shares of an open-end company varies as new shares are sold and other shares are redeemed. Shares are redeemed at net asset value. </li></ul></ul></ul><ul><ul><ul><li>Open-end funds have total assets 20 times greater than closed-end funds. </li></ul></ul></ul><ul><ul><ul><li>They are mutual firms that rely on a sponsor or promoter to be established and have a complex organizational structure. </li></ul></ul></ul><ul><ul><ul><li>The board of directors is responsible for overseeing contractors as: </li></ul></ul></ul><ul><ul><ul><li>- investment advisor - fund administrator - transfer agent - custodian </li></ul></ul></ul>
  34. 34. <ul><ul><li>D. Regulations Applicable to All Investment Companies </li></ul></ul><ul><ul><ul><li>The SEC is responsible for the investment company industry. </li></ul></ul></ul><ul><ul><ul><li>Customers are protected by the Security Investor Protection Corporation (SIPC). </li></ul></ul></ul><ul><ul><ul><li>Under Subchapter M of the Internal Revenue Code, if a fund distributes capital gains and dividend income, it is not taxed, but owners are subject to taxation. </li></ul></ul></ul>
  35. 35. Investment Company <ul><ul><li>E. The Size of Investment Company Business </li></ul></ul><ul><ul><ul><li>At the end of 1998, there were 7,314 different mutual funds in the U.S. Fund families have become increasingly important. </li></ul></ul></ul><ul><ul><ul><li>The past two decades saw massive growth in the mutual fund sector. From 1980 to 1993 the number of accounts grew from 12 million to 200 million, while assets rose from $135 billion to over $5.5 trillion. </li></ul></ul></ul>
  36. 36. <ul><ul><li>F. Money Market Funds </li></ul></ul><ul><ul><ul><li>Money market funds made their appearance in 1972 to exploit interest rate ceilings on deposits. </li></ul></ul></ul><ul><ul><ul><li>Money market funds invest in high quality, short-term money market instruments. </li></ul></ul></ul><ul><ul><ul><li>Money market funds are not backed by federal deposit insurance. </li></ul></ul></ul><ul><ul><li>G. Performance of Mutual Funds </li></ul></ul><ul><ul><ul><li>Mutual funds offer the investor ease of diversification. </li></ul></ul></ul><ul><ul><ul><li>Most studies have shown that mutual funds on average perform no better than portfolios based upon random selection. </li></ul></ul></ul><ul><ul><ul><li>Expenses associated with funds vary substantially. In addition, expense categories differ: front-end loads, 12b1, fees, and annual expenses charged by subcontractors. </li></ul></ul></ul><ul><ul><li>H. Exchange Traded Funds </li></ul></ul><ul><ul><ul><li>Mimics the price performance and dividend yield of a basket of stocks. </li></ul></ul></ul><ul><ul><ul><li>Trades like a regular stock on a listed exchange; trades in the secondary securities market at negotiated prices. </li></ul></ul></ul><ul><ul><ul><li>Examples: S&P 500 SPDR (SPY), Nasdaq-100 Trust (QQQ), </li></ul></ul></ul>
  37. 37. Benefit of ETF (exchange traded funds) <ul><li>Convenience – desired market exposure in a single trade </li></ul><ul><li>Liquidity – underlying institutional market provides arbitrage </li></ul><ul><li>Diversification and variety - broad based market indexes - market capitalization strata - sector and industry - style (value / growth) - international </li></ul><ul><li>Trading Advantages – trade intraday, marginable, shortable </li></ul><ul><li>Tax Efficiency – generally minimize taxable events to shareholders </li></ul><ul><li>Generally lower management fees compared to active mutual funds or index mutual funds means better net returns to shareholders </li></ul>
  38. 38. Tax efficiency of ETF <ul><li>Structural - “In-kind” distribution of low cost basis stock to institutional creation / redemption units - this tax efficiency is just like other RICs today (index mutual funds and UITs) - greatly affected by structure of underlying stock index </li></ul><ul><li>Strategic - Tax Loss Harvesting </li></ul><ul><li>There are two broad reasons why ETFs offer tax efficiency: structural and strategic. The first is that they share an “in-kind” redemption process similar to index mutual funds today. This feature enables the fund manager to distribute low cost basis stock to institutional shareholders in the fund. Secondly, they can offer the ability to tax loss harvest. This means that an investor can collect tax losses in individual stocks and replace them with a similar performing ETF . </li></ul>
  39. 39. Potential Costs & Constraints of ETF <ul><li>There are several potential constraints and costs of ETFs. </li></ul><ul><li>When you own ETFs, you must pay management fees. They are not free to own. </li></ul><ul><li>There are brokerage costs associated with transacting in ETFs. </li></ul><ul><li>They can still pay capital gains distributions, although these tend to be lower than mutual funds. </li></ul><ul><li>Liquidity is a concern in thinly-traded ETFs. </li></ul><ul><li>The most popular ETFs are the most liquid equity investments in the world. </li></ul><ul><li>Some funds have restrictions that do not permit them to hold other funds. ETFs will likely not exactly meet the performance of their benchmark – the degree of error is called “phantom tracking error”. </li></ul>
  40. 40. Structure of ETFs <ul><li>Unit Investment Trust (UIT) </li></ul><ul><li>- Examples: S&P 500 SPDR (SPY), Nasdaq-100 Trust (QQQ), S&P 400 </li></ul><ul><ul><li>Midcap SPDR (MDY), Select Sector SPDRs </li></ul></ul><ul><li>Open-Ended Mutual Fund (1940 Investment Company Act Fund) - </li></ul><ul><ul><li>Examples: iShares, VIPERs </li></ul></ul><ul><li>Grantor Trusts </li></ul><ul><ul><li>- Examples: Merrill Lynch HOLDRs - Not technically ETFs </li></ul></ul><ul><ul><li>There are three broad classes of ETF structure. </li></ul></ul><ul><ul><li>UITs are the older, more established funds, like the various SPDRs. </li></ul></ul><ul><ul><li>Almost all newer versions of ETFs will come to market in an open-ended mutual fund form, like the iShares and Vanguard’s VIPERs. </li></ul></ul><ul><ul><li>Grantor Trusts like Merrill’s HOLDRs are not technically ETFs, but they do share many features in common. </li></ul></ul>
  41. 41. Large EFT (1/25/02) <ul><li> assets ($) </li></ul><ul><li>SPY SPDR (S&P depository receipts) 29,243,887,050 </li></ul><ul><li>QQQ Nasdaq 100 trust 21,183,511,000 </li></ul><ul><li>MDY Midcap SPDRs 5,116,628,480 </li></ul><ul><li>IW iShares S&P 500 3,672,825,000 </li></ul><ul><li>DIA Diamond Trust DJIA 3,154,245,600 </li></ul><ul><li>IWM iShares Russell 2000 2,215,580,000 </li></ul><ul><li>VTI Vanguard total index VIPERS 1,443,932,000 </li></ul><ul><li>XLK Technology select SPDR 1,415,931,000 </li></ul><ul><li>IW iShares Russell 3000 1,297,088,000 </li></ul><ul><li>EFA iShares MSCI EAFE 992,440,000 </li></ul>
  42. 42. Registered Investment Company (RIC) Rules <ul><li>1.No security greater than 25% of the Fund, measured quarterly </li></ul><ul><li>2.The 5/50 Rule: All securities greater than 5% cannot sum to be greater than 50% of the Fund. </li></ul><ul><li>Penalties are onerous </li></ul><ul><li>Examples of rebalancing problems: iShares Sweden (EWD) – Ericsson iShares Canada (EWC) – Nortel </li></ul><ul><li>What are the RIC rules? </li></ul><ul><li>There are two. </li></ul><ul><li>The first rule is that no security can be greater than 25% of the fund. </li></ul><ul><li>Also, if you sum the securities that represent more than 5% of the fund, they cannot sum to more than 50%. </li></ul><ul><li>The penalties are onerous. Fund companies can violate 33% of their net income to the IRS. </li></ul><ul><li>Here are two examples of large cap stocks that disrupted RIC rules in several international funds. iShares Sweden (EWD) – Ericsson iShares Canada (EWC) – Nortel </li></ul>
  43. 43. What’s new in ETFs? <ul><li>Fixed income ETFs – applications have been filed with the SEC - problems related to liquidity and credit risk of underlying issues </li></ul><ul><li>Actively Managed ETFs – SEC has floated a Concept paper - problems related to transparency </li></ul><ul><li>What’s new in ETFs? Fixed income ETFs are due “in short order”, according to the SEC. </li></ul><ul><li>There are some serious issues to get resolved related to liquidity and the credit risk of the underlying securities in the fund. </li></ul><ul><li>The SEC is now considering proposals for actively managed ETFs. </li></ul><ul><li>There are tremendous problems here related to transparency. </li></ul><ul><li>How can the institutional market know how to deal with the NAV? </li></ul>
  44. 44. Exchange traded fund glossary <ul><li>Closed end fund: A type of mutual fund. Like ETFs, closed-end funds differ from open-end mutual funds in that they trade throughout the day over an exchange. Unlike ETFs, however, they have no mechanism to prevent them from trading at substantial premiums or discounts to their net asset values. </li></ul><ul><li>Commission The fee you pay a broker to buy or sell a security, such as a stock or an ETF , for your account. The charge is typically assessed on a per-trade basis. You do not need to pay a commission to buy or sell no-load, open-end mutual funds, giving them a cost-advantage over ETFs for investors who plan to invest regular sums of money or who trade frequently. </li></ul><ul><li>Creation Unit The smallest block of ETF shares that can be bought or sold from the fund company at net asset value, usually 50,000. These are only bought and sold &quot;in-kind.&quot; For example, when you sell one, you receive a portfolio of securities that approximates the ETF's holdings, not cash. Creation units' size means that only market makers and institutions can afford to buy or sell them. All other investors can buy or sell ETF shares in any size lot at the market price, rather than at NAV , over an exchange. </li></ul><ul><li>DIAMONDs Shares in an ETF , Diamonds Trust Series I, that track the Dow Jones Industrial Average. The fund is structured as a unit investment trust . Discount to NAV Unlike regular open-end mutual funds, which are bought and sold directly from the fund company at the net asset value (NAV) of their portfolio securities, ETFs and closed-end funds trade at prices determined by the market forces of supply and demand. A fund that trades at a price less than its NAV is said to trade at a discount to its NAV . </li></ul><ul><li>Exchange-traded fund (ETF) The broad class of funds, excluding closed-end funds, which trade throughout the day over an exchange. ETFs have low annual expenses, but you must pay commissions to trade them. ETFs do not redeem shares for cash, and thus do not need to sell securities (possibly realizing capital gains) to pay investors who redeem their shares. They are typically more tax-efficient than mutual funds. Unlike closed-end funds, ETFs market prices usually closely track their NAVs . Most ETFs are index funds. </li></ul><ul><li>Expense ratio The annual fee that all funds or ETFs charge their shareholders, expressed as a percentage of the fund's average daily net assets. This ratio includes such items as the management fee, trustee's fee, license fee, and 12b-1 fee, among others. It does not include the commissions you must pay to buy and sell ETF shares, or the costs incurred by the fund in trading its securities. HOLDRs do not express their fees as expense ratios , but instead charge a flat quarterly fee per 100 shares. </li></ul>
  45. 45. ETF glossary, cont. <ul><li>HOLDRs Holding company depository receipts, a type of ETF marketed by Merrill Lynch. Unlike other ETFs , HOLDRs can only be bought and sold in 100-share increments. HOLDRs do not have creation units like other ETFs , but investors may exchange 100 shares of a HOLDR for its underlying stocks at any time. Existing HOLDRs focus on narrow industry groups. Each initially owns 20 stocks, but they are unmanaged, and so can become more concentrated due to mergers, or the disparate performance of their holdings. </li></ul><ul><li>iShares A group of ETFs advised and marketed by Barclays Global Investors. iShares are structured as open-end mutual funds. </li></ul><ul><li>Market return The total return of an ETF based on its market price at the beginning and end of the holding period. This may be different from the ETF's NAV return. The market return is the return actually earned by ETF investors, except for those who hold creation units . </li></ul><ul><li>Market price The price of an ETF as determined by the market forces of supply and demand. Unlike regular open-end mutual funds, which are always bought and sold at NAV , the market price may differ from NAV . Most ETFs typically trade at market prices near their NAVs . </li></ul><ul><li>Net asset value (NAV) The value of each share of a fund as determined by the value of its underlying holdings, including any cash in the portfolio. NAV is calculated by dividing a fund's total net assets by its number of shares outstanding. Shares in regular open-end mutual funds are bought and sold at NAV , but shares in ETFs (with the exception of creation units ) are bought and sold at the market price, which can differ from NAV . NAV return The total return of an ETF , based on its NAV at the beginning and end of the holding period. This may be different from the ETF's market return . The market return , not the NAV return, is the return actually earned by ETF investors, except for creation units . </li></ul><ul><li>Open-end fund The typical mutual-fund structure, and one used by several groups of ETFs , including iShare s and Select Sector Spiders. This structure allows the funds to reinvest their dividends immediately, which could permit them to hold slightly less cash than ETFs that are structured as unit investment trusts . </li></ul>
  46. 46. ETF glossary, cont. <ul><li>Premium to NAV Unlike regular open-end mutual funds, which are bought and sold directly from the fund company at the net asset value (NAV) of their portfolio securities, ETFs and closed-end funds trade at prices determined by the market forces of supply and demand. A fund that trades at a price higher than its NAV is said to trade at a premium to its NAV . </li></ul><ul><li>Qubes (QQQ) The Nasdaq-100 tracking stock, an ETF that tracks the technology-laden Nasdaq-100 index. The popular name, Qubes, derives from the ETF's ticker symbol, QQQ. Qubes are structured as unit investment trusts . Qubes are by far the most heavily traded ETF . </li></ul><ul><li>Spiders SPDRs, or Standard & Poors' Depository Receipts. A group of ETFs that track a variety of Standard & Poors' indexes. SPDR Trust, Series 1, usually referred to as &quot;Spiders,&quot; tracks the S&P 500 index. Select Sector SPDRs track various sector indices that carve up the S&P 500 index into separate industry groups. SPDR Trust, Series 1 is structured as a unit investment trust , but Select Sector SPDRs are open-end funds. </li></ul><ul><li>StreetTracks A group of ETFs managed by State Street Global Advisors. These ETFs track various indexes, including Dow Jones style-specific and global indexes, technology indexes from Morgan Stanley Dean Witter, and the Wilshire REIT index. StreetTracks are open-end funds , not unit investment trusts , and trade on the American Stock Exchange. </li></ul><ul><li>Unit investment trust A structure used by some ETFs . One important difference between this format and the open-end fund format is that the latter allows ETFs to reinvest dividends immediately, while the former does not. This could result in ETFs that use the unit investment trust structure having a slight cash drag on their performance. </li></ul><ul><li>VIPERs Vanguard Index Participation Receipts ETF versions of several Vanguard index funds. VIPERs are structured as share classes of existing open-end funds. The only VIPER currently available is the Vanguard Total Stock Market VIPER, but Vanguard plans to launch others. </li></ul>
  47. 47. Stock Mutual Fund Categories <ul><li>Growth funds for investors who want high returns with moderate risk </li></ul><ul><ul><li>Invest in companies that expect to grow at a higher than average rate </li></ul></ul><ul><ul><li>Generate an increase in investment value rather than steady income </li></ul></ul><ul><li>Capital appreciation or aggressive growth funds </li></ul><ul><ul><li>High but unproven growth potential stocks </li></ul></ul><ul><ul><li>Higher risk </li></ul></ul><ul><li>Growth and income funds try to offer growth but with some stability of income (dividends) </li></ul><ul><li>International and global funds allow investment in foreign securities without the costs involved in purchasing and monitoring individual stocks </li></ul><ul><ul><li>Returns affected by stock prices </li></ul></ul><ul><ul><li>Returns also affected by foreign exchange rates </li></ul></ul><ul><li>A global mutual fund invests in some U.S. stocks as well as foreign </li></ul>
  48. 48. Stock Mutual Fund Categories <ul><li>Internet funds focus on investments in Internet companies </li></ul><ul><li>Specialty funds focus on a group of companies sharing a particular characteristic </li></ul><ul><li>Index funds are designed to simply match the performance of an existing stock index </li></ul><ul><li>Multifund funds invest in a portfolio of different mutual funds </li></ul><ul><ul><li>More diversified </li></ul></ul><ul><ul><li>Involves higher expenses </li></ul></ul>
  49. 49. Bond Fund Investment Objectives <ul><li>Risks in bond funds </li></ul><ul><ul><li>Interest rate risk </li></ul></ul><ul><ul><li>Credit risk </li></ul></ul><ul><li>Tax implications of bond fund investments </li></ul><ul><li>Income funds vary in terms their exposure to credit risk and focus on periodic coupon payments and attract investors who are </li></ul><ul><ul><li>Interested in periodic income since prices are volatile </li></ul></ul><ul><ul><li>Plan to hold the fund long term </li></ul></ul>
  50. 50. Bond Fund Investment Objectives <ul><li>Tax-free funds for high tax bracket investors (can be structured to be state income tax-free as well as federal) </li></ul><ul><li>High-yield or junk bond funds invest in bonds with a high risk of default </li></ul><ul><li>International and global bond funds </li></ul><ul><ul><li>International bond funds contain bonds issued by governments or corporations from other countries </li></ul></ul><ul><ul><li>Global funds may contain both U.S. and foreign bonds </li></ul></ul>
  51. 51. Bond Fund Investment Objectives <ul><li>Maturity classifications </li></ul><ul><ul><li>Interest rate sensitivity depends on the maturity of bonds </li></ul></ul><ul><ul><li>Funds are typically segmented based on maturity </li></ul></ul><ul><ul><ul><li>Intermediate-term funds invest in bonds with 5 to 10 years remaining to maturity </li></ul></ul></ul><ul><ul><ul><li>Long-term funds invest in maturities of 15 to 30 years </li></ul></ul></ul><ul><li>Asset allocation funds </li></ul><ul><ul><li>Funds that contain a variety of investments </li></ul></ul><ul><ul><li>Composition among stocks, bonds and money market securities is based on manager’s expectations </li></ul></ul>
  52. 52. Hedge Funds* <ul><li>Not technically mutual funds </li></ul><ul><ul><li>Not subject to SEC regulation </li></ul></ul><ul><ul><li>Organized as limited partnership </li></ul></ul><ul><ul><li>Common feature is use of leverage </li></ul></ul><ul><li>High returns in 1990s </li></ul><ul><li>Near collapse of Long-Term Capital Management </li></ul><ul><ul><li>$3.6 billion bailout </li></ul></ul>
  53. 53. Hedge Funds <ul><li>Financial problems experienced by Long-Term Capital Management (LTCM) </li></ul><ul><ul><li>Hedge funds sell shares to wealthy investors and financial institutions </li></ul></ul><ul><ul><li>Historically unregulated </li></ul></ul><ul><ul><li>Invest in derivatives, sell stock short and combine borrowing to magnify returns </li></ul></ul><ul><li>LTCM experienced problems when risky investments lost money - rescue 1998 </li></ul><ul><li>financial leverage - in 1998, $5 bil. in equity & $150 bil. in debt to support $150 bil.portfolio; overall leverage higher than 25:1 because of derivative positions. </li></ul>
  54. 54. Real Estate Investment Trusts <ul><li>A real estate investment trust or REIT is a closed-end mutual fund that invests in real estate or mortgages </li></ul><ul><li>Classifications </li></ul><ul><ul><li>Equity REIT (real estate) </li></ul></ul><ul><ul><li>Mortgage REIT </li></ul></ul><ul><ul><li>Hybrid of the two </li></ul></ul><ul><li>Sometimes seen as an inflation hedge </li></ul><ul><li>Performance influenced by interest rates </li></ul>
  55. 55. Investment co - Unit trust <ul><li># of unit certificates is fixed (~closed end) </li></ul><ul><li>differences unit trust vs. closed & open-end funds </li></ul><ul><ul><li>no active trading of bonds in portfolio </li></ul></ul><ul><ul><li>fixed termination date </li></ul></ul><ul><ul><li>investor knows that the portfolio consists of specific collection of bonds; trustee will NOT alter portfolio </li></ul></ul>
  56. 56. Web Resources <ul><li>For information on the performance of mutual funds, visit: </li></ul><ul><li>Morningstar www.morningstar.com </li></ul><ul><li>Other information on mutual funds, </li></ul><ul><li>Investment Company Institute www.ici.org </li></ul><ul><li>Lipper analytical http://www.lipperweb.com/ </li></ul><ul><li>http://www.vanguard.com/ http://www32.fidelity.com/ </li></ul><ul><li>For details of regulation of securities firms and investment banks, visit: </li></ul><ul><li>SEC: www.sec.gov </li></ul><ul><li>NASD: www.nasd.com </li></ul>
  57. 57. How can one start a mutual fund? <ul><li>You must file a registration document with the SEC that complies with the Investment Company Act of 1940.  All open-ended mutual funds are considered ’40 Act Funds.  The SEC site has some information.  There are dozens of registration statements on file in the EDGAR system.  These documents are almost always filed with considerable legal assistance.  There is a list of filing statements and forms on the SEC website. SEC: www.sec.gov </li></ul>
  58. 58. Global Issues <ul><li>Worldwide growth in mutual fund investment not as great as in the U.S. </li></ul><ul><ul><li>$1,626 trillion in 1992 to $4,833 trillion in 2000 </li></ul></ul><ul><ul><ul><li>200% growth compared to 340% in U.S. </li></ul></ul></ul><ul><ul><li>Larger returns in U.S.stock markets </li></ul></ul><ul><ul><li>Greatest development in countries with most developed markets </li></ul></ul><ul><ul><li>Opportunities from declining Japanese markets </li></ul></ul>
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