Chapter 10 All Rights Reserved


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  • Chapter 10 All Rights Reserved

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