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Chapter 4 Chapter 4 Presentation Transcript

  • Chapter 4 MUTUAL FUNDS AND OTHER MANAGED INVESTMENTS
  • Chapter 4 Questions
    • What is a mutual fund?
    • How does one compute the net asset value (NAV)?
    • What expenses and changes might a mutual fund investor face?
    • What does research on mutual fund performance tell about fund expenses, portfolio turnover, and returns?
  • Chapter 4 Questions
    • What is a good procedure for determining which mutual funds to purchase?
    • When might it be appropriate to sell shares in a mutual fund?
    • What are the similarities between mutual funds and some other managed investments?
    View slide
  • Mutual Fund Growth
    • Mutual funds have become very popular investment vehicles.
    • Nearly $7 trillion in total assets in 2002.
    • Total assets have grown 600% since 1990.
    View slide
  • What is a mutual fund?
    • Mutual funds are open-end investment companies.
    • The fund sells shares to the public and invests the proceeds in a pool of funds, which are jointly owned by the fund’s investors.
  • Computing Net Asset Value
    • For investors, the performance of their investment depends on what happens to the fund’s per share value, or net asset value (NAV).
    • NAV= Market Value of Assets – Liabilities
    • Number of Shares Outstanding
  • Mutual Fund Management
    • Most funds are started by investment management companies who hire the fund manager to make investment decisions.
      • Fidelity, Vanguard, etc.
    • Usually offer many different funds and allow investors to switch between funds.
    • Funds (open-end) sell additional shares to those who want to invest, redeem shares at the NAV (less any fees) to those who want to sell their shares.
  • Why invest with mutual funds?
    • Liquidity
      • Funds buy and sell their own shares quickly, even if fund investments are illiquid
    • Diversification
      • Small minimum investment buys a typically well-diversified investment
    • Professional management and record-keeping
      • Expertise and services
  • Why invest with mutual funds?
    • Choice and flexibility
      • Families of funds offer a variety of investments to match investor needs
    • Indexing
      • Some funds track a broad market index which insures that investors will earn the “market return”
      • Increasingly popular mutual fund alternative
  • Mutual Fund Drawbacks
    • Active trading contributes to high costs which lower fund returns
    • Tax consequences can be a disadvantage
      • Tax impacts of asset trading are passed through to investors
      • Tax bill can be large even when the NAV falls
  • Mutual Fund Returns
    • Three sources of return:
    • Income distributions (ID)
      • Bond interest, stock dividends
    • Capital gain distributions (CGD)
      • Realized gains/losses from selling assets
    • Changes in NAV (  NAV)
      • From unrealized gains/losses from assets
  • Mutual Fund Returns
    • Return = (ID + CGD +  NAV)/Beg.NAV
    • By dividing the sum of the three components of dollar returns by the beginning NAV, we have the mutual fund’s holding period return.
    • Most mutual funds allow investors to either receive distributions in cash or to reinvest in additional shares.
  • Types of Mutual Funds
    • Funds can be classified according to the type of security in which they invest
      • Stock Funds
      • Taxable Bond Funds
      • Municipal Bond Funds
      • Stock and Bond Funds
      • Money Market Funds
  • Common Stock Funds
    • Most popular type of fund
    • Wide variety with different objectives and levels of risk
      • Growth
      • Industry or sector funds
      • Geographic areas
      • International or Global
      • Equity Index funds
  • Taxable Bond Funds
    • Generally seek to generate current income with limited risk
    • Can vary by maturity
      • Short-term, Intermediate-term, Long-term
    • Can vary by type of bond
      • Government
      • Corporate
      • Mortgage-backed
      • International/Global
      • Bond Index funds
  • Municipal Bond Funds
    • Provide investors with income exempt from Federal taxation
    • Often concentrate on single states to avoid state income taxation as well
  • Stock and Bond Funds
    • Seek to provide a combination of income and value appreciation.
    • Different names
      • Balanced funds
      • Blended funds
      • Flexible funds
  • Money Market Funds
    • Provide safe, current income with high liquidity
    • Invest in money market securities
      • T-bills, Bank CD’s, Commercial paper, etc.
    • NAV stays at $1; income either paid out or reinvested daily
    • Provide an alternative to bank deposits, but not FDIC insured
  • Mutual Fund Innovations
    • Life-stage funds
      • Offer different mixes of securities based on the age of the investor
    • Supermarket funds
      • Offer a wide variety of funds with “one-stop” fund shopping
      • Transfer services between funds
      • Expenses/fees can be high
  • Mutual Fund Prospectus
    • Must be available to investors and should be review by investors.
    • Contains:
      • Fund’s investment objective
      • Investment strategy
      • Principal risks faced by investors
      • Recent investment performance
      • Expenses and fees
      • Lots of other detailed information
  • Mutual Fund Expenses and Considerations
    • Loads
      • Commission to the broker to financial advisor who sold the fund to the investor
      • For load funds, the offer price is the fund’s NAV less the load (while no-load funds are sold at their NAV)
      • Load range from around 3% (low-load) to 8.5%
    • 12b-1 Fees
      • Fees deducted from the asset value of the fund to cover marketing expenses
      • An alternative to loads
  • Mutual Fund Expenses and Considerations
    • Deferred Sales Loads
      • Redemption charges when fund shares are sold (rather than when purchased)
      • Often high (5-7%) if shares are sold within the first year, but then fall over time, perhaps even disappearing eventually
    • Share Classes
      • Many funds offer several different classes of shares (A-B-C) with different fee structures
      • Best choice usually depends of investment horizon
  • Mutual Fund Expenses and Considerations
    • Management Fees
      • Fees deducted from the fund’s asset value to compensate the fund managers
      • Some adjust fees according to the fund’s performance
    • Expense ratio
      • Adding all fees and calculating expenses as a percentage of the fund’s asset
  • Mutual Fund Expenses and Considerations
    • Portfolio Turnover
      • Not an explicit cost, but very important determinant of shareholder returns
      • Trading costs rise with turnover
      • In order for high turnover to pay off, fund managers must be successful in their active trading strategies
    • Sources of Information
      • Wall Street Journal, Business Week
      • Morningstar
        • Fund history, tax efficiency, risk analysis
  • Mutual Fund Return and Risk Performance
    • Return Performance
    • On a risk-adjusted basis, the average stock fund under-performs market averages
    • While portfolio managers seem to out-perform the market before expenses, net returns are below the market index
    • Some above-average performers over short time horizons, but such performance is not generally sustained (just luck?)
    • These results help to explain the growing popularity of index funds
  • Mutual Fund Return and Risk Performance
    • Risk Performance
    • While returns are not consistent, risk is
    • Objectives lead to strategies that lead to varying degrees of investment risks
    • Return is positively related to the level of risk
    • Risk is therefore an important consideration
  • Mutual Fund Return and Risk Performance
    • Fees and expenses: Do higher fees pay off?
    • Investment performance is no better (and perhaps worse) for load funds vs. no-load
    • Expenses lower returns in predictable ways – lower expense funds give better returns
    • Turnover affects returns in several ways, including taxes – high turnover means more short-term realized gains
    • Tax efficiency is an important consideration – after-tax returns may be 30-40% less than pre-tax
    • Mutual Fund Investment Strategies
    • Choose in funds consistent with your objectives, constraints, and tax situation.
    • Consider index funds for a large portion of your fund portfolio.
    • When possible, invest in no-load funds with below-average expense and turnover ratios.
    • Invest at least 10-20% in international or global funds.
    • Own funds in different asset classes and consider life-cycle investing.
    • Mutual Fund Investment Strategies
    • If you actively manage your portfolio, consider the past year’s “hot funds.”
    • Do not attempt to time the market; timing strategies add little except costs and risk.
    • Use dollar cost averaging by investing a set dollar amount each month.
    • Avoid investing money shortly before the capital gain distribution dates (prospectus).
    • Do not own too many funds. You will get average returns with high expenses.
  • When should you sell a mutual fund?
    • Personal considerations
      • Portfolio rebalancing points due to life cycle considerations
        • Be aware of the quick trigger, selling on the first dip in NAV; think long-term
        • Be aware of capital gains with selling fund shares
    • Fund considerations
      • Change in portfolio manager
      • Change in investment style
      • Fund is growing “too large” or “too fast”
      • Persistent bad performance
  • Other Managed Investments
    • Closed-end investment companies
    • Shares trade like stock rather than being bought and sold from the fund
    • Number of shares are fixed
    • Often sell at a discount from NAV (a puzzle for modern finance)
    • Often a means of investing in a pool of assets from a foreign country
  • Other Managed Investments
    • Exchange-traded funds (EFTs)
    • Relatively new, yet very popular
    • Like closed-end funds, they trade like individual stocks
    • Passively managed to mirror a market index, both broad and narrow
    • Low expenses, but do involve brokerage commissions
    • Tax and liquidity concerns
  • Other Managed Investments
    • Variable Annuities
    • Many offered by insurance companies
    • Offers investors with choices of investments with tax-deferred growth
    • Insurance product: payment in the case of death or else retirement income stream
    • Expenses for both fund management and to pay for insurance, so fees tend to be much higher than with mutual funds
    • Income stream taxed as regular income