Chapter 4

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Chapter 4

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

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