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Mutual Fund Operations(24)

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Mutual Fund Operations(24)

  1. 1. 24 Mutual Fund Operations
  2. 2. Chapter Objectives <ul><li>Explain the concept of mutual fund operation </li></ul><ul><li>Explain various types of mutual funds </li></ul><ul><li>Describe the various types of stock and bond mutual funds </li></ul><ul><li>Describe the characteristics of money market funds </li></ul>
  3. 3. 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 liability contract, but a mutual fund represents partial ownership </li></ul></ul><ul><ul><li>No federal insurance with mutual fund shares </li></ul></ul>
  4. 4. Background on Mutual Funds <ul><li>Mutual funds adhere to a variety of federal and state regulations </li></ul><ul><ul><li>Securities and Exchange Commission (SEC) regulates </li></ul></ul><ul><ul><li>Funds must register and provide a prospectus to investors </li></ul></ul><ul><ul><li>Disclosure since 1993 of manager’s name and length of time employed in that position </li></ul></ul><ul><li>Mutual fund itself is exempt from income taxation if fund distributes 90 percent of taxable income </li></ul>
  5. 5. Background on Mutual Funds <ul><li>Mutual fund prospectus information includes: </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 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 </li></ul></ul><ul><ul><ul><li>Check writing </li></ul></ul></ul><ul><ul><ul><li>Telephone or Internet funds transfer </li></ul></ul></ul><ul><ul><li>Management fees incurred that investors pay </li></ul></ul>
  6. 6. Background on Mutual Funds <ul><li>Estimating the net asset value </li></ul><ul><ul><li>Net asset value is the value per share </li></ul></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>Any interest or dividends added in </li></ul></ul></ul><ul><ul><ul><li>Expenses subtracted </li></ul></ul></ul><ul><ul><ul><li>Divide by the number of shares </li></ul></ul></ul><ul><ul><ul><li>Dividends lower NAV </li></ul></ul></ul><ul><ul><ul><li>NAV quotes </li></ul></ul></ul>
  7. 7. Mutual Fund Distributions Mutual Fund Price Appreciation Capital Gains from the Sale of Securities in Fund Earned Income from Dividends or Coupon Payments
  8. 8. Background on Mutual Funds <ul><li>Mutual fund classifications depend on the type of securities the fund invests in and can include </li></ul><ul><ul><li>Stock or equity mutual funds </li></ul></ul><ul><ul><li>Bond mutual funds </li></ul></ul><ul><ul><li>Money market mutual funds </li></ul></ul><ul><li>Family of funds offered by investment companies </li></ul><ul><ul><li>Investor able to allocate then transfer funds among funds </li></ul></ul>
  9. 9. Exhibit 24.2 Distribution of Investment in Mutual Funds S t o c k F u n d s $ 3 , 9 6 2 b i l l i o n 5 7 % B o n d F u n d s $ 8 0 8 b i l l i o n 1 1 % H y b r i d F u n d s $ 3 4 9 b i l l i o n 5 % M o n e y M a r k e t F u n d s $ 1 , 8 4 5 b i l l i o n 2 7 %
  10. 10. Background on Mutual Funds <ul><li>Management of mutual funds </li></ul><ul><ul><li>Managers invest in a portfolio of securities to meet the objectives of the fund </li></ul></ul><ul><ul><li>Cover management costs with fees which are typically around one percent of total assets per year </li></ul></ul><ul><ul><li>Managers adjust the composition of their portfolios in response to market and economic conditions </li></ul></ul>
  11. 11. Background on Mutual Funds <ul><li>Expenses </li></ul><ul><ul><li>Fees include management plus record-keeping and clerical fees </li></ul></ul><ul><ul><li>Expense ratio = annual expenses/fund NAV </li></ul></ul><ul><ul><li>Passed on to investors since NAV is reduced by fees </li></ul></ul><ul><ul><li>Investor should compare expense ratios </li></ul></ul><ul><li>Active marketing expenses and compensation increases expenses—12b-1 expenses </li></ul>
  12. 12. Background on Mutual Funds <ul><li>Corporate control by mutual funds </li></ul><ul><ul><li>Mutual funds are large shareholders in companies whose stock they hold </li></ul></ul><ul><ul><li>Managers may serve on the board of directors of companies in which the fund invests </li></ul></ul><ul><ul><li>Companies try to satisfy mutual fund managers in order to keep them from selling their stake in the firm </li></ul></ul>
  13. 13. Load versus No-Load Mutual Funds <ul><li>Classification refers to whether or not there is a sales charge </li></ul><ul><li>No-load means funds are promoted, bought and sold directly via the mutual fund </li></ul><ul><li>Load funds </li></ul><ul><ul><li>Promoted by registered representatives of brokerage firms who get a commission </li></ul></ul><ul><ul><li>Investors pay the sales charge </li></ul></ul><ul><ul><li>12b-1 expenses are “loads” used by no-load funds </li></ul></ul>
  14. 14. Open-End versus Closed-End Funds <ul><li>Closed-end funds </li></ul><ul><ul><li>Mutual fund does not repurchase the shares they sell—similar to direct common stock investment </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><ul><li>Value of shares related to expectations of portfolio and determined in market </li></ul></ul><ul><li>Open-end “mutual” 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><ul><ul><li>NAV determined by fund daily </li></ul></ul>
  15. 15. Stock Mutual Fund Categories <ul><li>Growth funds for investors who want high returns with moderate risk </li></ul><ul><ul><li>Mutual fund invests in companies that are expected 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>
  16. 16. Stock Mutual Fund Categories <ul><li>Growth and income funds try to offer growth but with some stability of income </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 </li></ul>
  17. 17. 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>
  18. 18. Exhibit 24.3 Growth in Number of Equity and Bond Funds Y e a r 0 1 0 0 0 2 0 0 0 3 0 0 0 4 0 0 0 5 0 0 0 6 0 0 0 7 0 0 0 8 0 0 0 B o n d F u n d s S t o c k F u n d s 2 0 0 1 1 9 9 9 1 9 9 5 1 9 9 0 1 9 8 5 1 9 7 8
  19. 19. Exhibit 24.4 Investment in Bond and Stock Mutual Funds Y e a r 0 1 0 0 0 2 0 0 0 3 0 0 0 4 0 0 0 5 0 0 0 B o n d F u n d s S t o c k F u n d s 2 0 0 0 1 9 9 9 1 9 9 8 1 9 9 7 1 9 9 6 1 9 9 5 1 9 9 4 1 9 9 3 1 9 9 2 1 9 9 1 1 9 9 0 1 9 8 9 1 9 8 8 1 9 8 7 1 9 8 6 1 9 8 5
  20. 20. Exhibit 24.5 Distribution of Aggregate Mutual Fund Assets C o m m o n S t o c k $ 3 , 8 8 2 B i l l i o n 7 6 % M u n i c i p a l B o n d $ 2 6 9 B i l l i o n 5 % L o n g - T e r m U . S . G o v ’ t $ 3 0 9 B i l l i o n 6 % C a s h $ 2 7 7 B i l l i o n 5 % C o r p o r a t e B o n d s $ 3 4 9 B i l l i o n 7 % P r e f e r r e d S t o c k $ 2 8 B i l l i o n 1 %
  21. 21. Bond Fund Investment Objectives <ul><li>Risks of 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 bond 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>
  22. 22. Bond Fund Investment Objectives <ul><li>Tax-free funds for high tax bracket investors </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>
  23. 23. 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>
  24. 24. Bond Fund Investment Objectives <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>
  25. 25. Growth and Size of Mutual Funds <ul><li>Volume and mix in the kind of funds varies over time </li></ul><ul><li>Overall investment via mutual funds much higher in recent years </li></ul><ul><li>New kinds of funds target customers with different risk preferences </li></ul>
  26. 26. Performance of Stock Mutual Funds <ul><li>Both investors and managers closely monitor performance as modeled by the equation below </li></ul>PERF = Performance SECTOR = Conditions in the fund’s sector Where:  PERF= f (  MKT,  SECTOR,  MANAB) MKT = General stock market conditions MANAB = The ability of the fund’s management
  27. 27. Performance of Stock Mutual Funds <ul><li>Change in market conditions </li></ul><ul><ul><li>Close relationship between performance and market conditions </li></ul></ul><ul><li>Change in sector conditions </li></ul><ul><ul><li>Depends on the focus of the fund </li></ul></ul><ul><ul><ul><li>Index funds </li></ul></ul></ul><ul><ul><ul><li>Asian funds </li></ul></ul></ul><ul><li>Change in management ability includes both managers’ skills and operating efficiency </li></ul>
  28. 28. Performance of Stock Mutual Funds <ul><li>Performance of closed-end stock funds </li></ul><ul><ul><li>Driven by the same factors that influence open-ended funds </li></ul></ul><ul><ul><li>Fixed supply of the fund’s shares </li></ul></ul><ul><ul><li>Additional issues </li></ul></ul><ul><ul><ul><li>Performance is affected by changes in the premium or discount relative to NAV </li></ul></ul></ul><ul><ul><ul><li>If the fund’s premium increases relative to NAV, return to fund holders increases </li></ul></ul></ul>
  29. 29. Performance of Bond Mutual Funds <ul><li>Performance of bond mutual funds as shown in the model below </li></ul> PERF= f (  R f ,  RP,  CLASS,  MANAB) PERF = Performance RP =Risk premium Where: R f = Risk free interest rates CLASS =the classification of the bond fund MANAB = The ability of the bond fund’s management
  30. 30. Performance of Bond Mutual Funds <ul><li>Change in the risk free rate </li></ul><ul><ul><li>Bond prices are inversely related to the risk- free rate </li></ul></ul><ul><ul><li>When rates decline, most bond funds perform well </li></ul></ul><ul><li>Change in the risk premium </li></ul><ul><ul><li>If required risk premiums increase, bond prices fall </li></ul></ul><ul><ul><li>Linked to economic condition: </li></ul></ul><ul><ul><ul><li>Risk premiums increase in recessions </li></ul></ul></ul><ul><ul><ul><li>Risk premiums decrease in boom times as investors buy riskier investments </li></ul></ul></ul>
  31. 31. Performance of Bond Mutual Funds <ul><li>Impact of the bond fund’s classification </li></ul><ul><ul><li>Some funds target a specific risk or maturity </li></ul></ul><ul><ul><li>Classification may have more impact than any other factor </li></ul></ul><ul><li>Change in management abilities </li></ul><ul><li>Performance of closed-end bond funds is affected by all of the other factors and changes in the premium or discount </li></ul>
  32. 32. Performance of Mutual Funds <ul><li>Investors should diversify among different kinds of funds to reduce volatility </li></ul><ul><li>Research on stock mutual fund performance </li></ul><ul><ul><li>Using return only is not valid </li></ul></ul><ul><ul><li>Mutual funds typically do not outperform the market </li></ul></ul><ul><ul><li>Evaluate mutual fund expenses </li></ul></ul><ul><li>Research on bond mutual funds </li></ul><ul><ul><li>Bond mutual funds underperform bond indexes </li></ul></ul><ul><ul><li>Investors should look for low expense bond funds </li></ul></ul>
  33. 33. Money Market Funds <ul><li>Money market funds are portfolios of short-term assets </li></ul><ul><ul><li>Can include check-writing privileges for investors </li></ul></ul><ul><ul><li>Number of checks per month may be restricted </li></ul></ul><ul><ul><li>Shareholders get periodic statements </li></ul></ul><ul><ul><li>Liquid, “cash” balance for investor </li></ul></ul>
  34. 34. Money Market Funds <ul><li>Asset composition of money market funds </li></ul><ul><ul><li>Individual funds concentrate in assets that reflect the fund’s objective </li></ul></ul><ul><ul><li>Money market securities of varying maturity </li></ul></ul><ul><li>Maturity of money market funds </li></ul><ul><ul><li>Varies over time with market conditons </li></ul></ul><ul><ul><li>Risk increases with term </li></ul></ul>
  35. 35. Exhibit 24.7 Composition of Money Market Fund Assets U . S . T r e a s u r y S e c u r i t i e s $ 9 1 b i l l i o n 6 % O t h e r $ 3 0 3 b i l l i o n 2 0 % C o m m e r c i a l P a p e r $ 6 2 0 b i l l i o n 4 1 % C D s $ 1 2 3 b i l l i o n 8 % R e p u r c h a s e A g r e e m e n t s $ 1 8 6 b i l l i o n 1 2 % O t h e r U . S . S e c u r i t i e s $ 1 8 9 b i l l i o n 1 3 %
  36. 36. Money Market Funds <ul><li>Risk of money market funds </li></ul><ul><ul><li>Credit risk minimized by the short-term nature of maturities </li></ul></ul><ul><ul><li>Returns for money market funds fall as interest rates in the economy fall </li></ul></ul><ul><ul><li>Expected returns are low relative to stock and bond funds </li></ul></ul><ul><ul><ul><li>Consistent positive returns over time </li></ul></ul></ul><ul><ul><ul><li>Lower credit risk </li></ul></ul></ul><ul><ul><ul><li>Lower interest rate risk </li></ul></ul></ul>
  37. 37. Money Market Funds <ul><li>Management of money market funds </li></ul><ul><ul><li>Managers try to maintain the overall objective of the fund </li></ul></ul><ul><ul><li>Manage the composition of the assets </li></ul></ul><ul><ul><li>Investors have a variety of choices when it comes to money market funds </li></ul></ul>
  38. 38. Money Market Funds <ul><li>Regulation of money market funds </li></ul><ul><ul><li>Securities Act of 1933 requires that funds provide full information to investors via a prospectus </li></ul></ul><ul><ul><li>Investment Company Act of 1940 contains restrictions to prevent conflicts of interest between investors and mangers </li></ul></ul><ul><li>Funds are exempt from tax if 90% of earnings are distributed to shareholders </li></ul>
  39. 39. 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 </li></ul>
  40. 40. 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 </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 and area real estate performance </li></ul>
  41. 41. Other Issues <ul><li>Mutual funds interact with banks, savings institutions, finance companies, securities firms, insurance companies, and pension funds </li></ul><ul><li>Mutual funds typically use all the various financial markets including money, bond, mortgage, stock, futures, options, and swap markets </li></ul><ul><li>Globalization is facilitated by mutual funds </li></ul><ul><ul><li>Reduces transactions costs </li></ul></ul><ul><ul><li>Increases market integration </li></ul></ul>

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