Investments: Analysis and Behavior Chapter 16- Mutual Funds ©2008 McGraw-Hill/Irwin
Learning Objectives <ul><li>Understand the structure and pricing of mutual funds </li></ul><ul><li>Know the advantages and...
Mutual Funds <ul><li>An investment company that issues its portfolio shares to investors.  </li></ul><ul><li>Money from sh...
Net asset Value   <ul><li>NAV: per share value of a mutual fund’s investment holding.  </li></ul><ul><li>Example   </li></...
Very low to low Very low to moderate High to very high Stocks of industry sectors   Specialized Very low Very low Very hig...
Sources of Information <ul><li>Lipper Inc.:  leading provider of data and analysis on the investment company business (  w...
Mutual Fund Advantages <ul><li>Broad diversification </li></ul><ul><ul><li>Diversified stock funds hold large and small co...
Mutual Fund Disadvantages <ul><li>High management fees and sales commissions </li></ul><ul><ul><li>No-load funds  </li></u...
 
Sources of Investment Returns <ul><li>Total Return: dividend and interest income and realized and unrealized appreciation ...
Mutual fund expenses <ul><li>Operating expense ratio: total of investment advisory fees and costs of legal and accounting ...
Table 16.4 A. Typical fee tables found in three different mutual fund prospectuses  1,805 1,477 368 10 years 1,077 670 163...
B.  The impact of equity mutual fund costs on long-term investor returns. Fund A : typical cost efficient index fund Fund ...
Style boxes <ul><li>Characterize mutual funds by market capitalization (large, mid, and small cap) </li></ul><ul><li>Next,...
 
Mutual Fund Organization <ul><li>Mutual fund shareholders: own mutual funds, elect the board of directors </li></ul><ul><l...
Evaluating Fund Performance <ul><li>Using ranking tools or portfolio evaluation tools (alpha, Sharp ratio, and Treynor mea...
Top 10 U.S. Domestic Funds Based on 3 Year Return   -- 22.6 43.3% 25.4 6.7 6.7 Fidelity Adv Lev Co;   Ins FLVIX    Mid-Cap...
 
 
 
Exchange-Trade Funds (ETFs) <ul><li>Tradable shares in baskets of stocks that closely track broad market averages, market ...
Closed-End Funds <ul><li>Issues a fixed number of shares at a given point in time </li></ul><ul><li>Collect money from inv...
Hedge Funds <ul><li>Like mutual funds, a means for groups of investors to pool financial resources </li></ul><ul><li>Typic...
Table 16.6  Hedge Funds Differ From Mutual Funds in a Number of Ways There are no specific rules on valuation or pricing. ...
Taxes on distributions <ul><li>Shareholders pay taxes due once income dividends and capital gains distributions are receiv...
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  1. 1. Investments: Analysis and Behavior Chapter 16- Mutual Funds ©2008 McGraw-Hill/Irwin
  2. 2. Learning Objectives <ul><li>Understand the structure and pricing of mutual funds </li></ul><ul><li>Know the advantages and disadvantages of buying mutual funds </li></ul><ul><li>Be able to assess mutual fund performance </li></ul><ul><li>Assess mutual fund manager incentives </li></ul><ul><li>Recognize the impact of taxable distributions on fund returns </li></ul>
  3. 3. Mutual Funds <ul><li>An investment company that issues its portfolio shares to investors. </li></ul><ul><li>Money from shareholders are pooled and invested in a wide range of stocks, bonds, or money market securities. </li></ul><ul><ul><li>Managed by professional managers </li></ul></ul><ul><li>Each investor shares proportionately in the income and investment gains and losses, as well as the brokerage expenses and management fees. </li></ul><ul><li>Open end fund: # of shares issued solely depends on investor demand </li></ul><ul><ul><li>Bought and sold directly through the investment company (not an exchange) </li></ul></ul>
  4. 4. Net asset Value <ul><li>NAV: per share value of a mutual fund’s investment holding. </li></ul><ul><li>Example </li></ul><ul><li>A mutual fund has $100 mil in assets and $3 mil in short term liabilities. 10.765 mil shares outstanding. What is the NAV? </li></ul><ul><li>Solution </li></ul><ul><li>($100 mil - $3 mil) / 10.765 mil = $9.0107 per share </li></ul>
  5. 5. Very low to low Very low to moderate High to very high Stocks of industry sectors   Specialized Very low Very low Very high Stocks of small companies   Small cap Very low Very low Very high Stocks with very high potential for growth Aggressive growth of capital Aggressive growth Very low Very low to low High Stocks of companies outside U.S.   International growth Low Very low High U.S. stocks with high potential for growth Capital growth Domestic growth Low to moderate Low to moderate Moderate to high Dividend-paying stocks   Growth and income Low to moderate Low to moderate Moderate to high Low P/E, P/B stocks   Value funds Low to moderate Moderate Moderate to high High-yielding stocks, convertible bonds   Equity income Low to moderate Moderate to high Moderate Stocks and bonds Current income capital growth Balanced           Common Stock Funds Low to moderate Moderate to high None Wide range of municipal bonds Tax-free income Tax-exempt bond Low to moderate Moderate to high None Wide range of government and/or corporate bonds Current income Taxable bond           Bond Funds Very high Moderate None Municipal cash investments Tax-free income, stability of principal Tax-exempt money market Very high Moderate None Cash investments Current income stability of principal Taxable money market           Money Market Funds Stability Income Potential Growth Potential Funds Hold Objective Types of Mutual Funds
  6. 6. Sources of Information <ul><li>Lipper Inc.: leading provider of data and analysis on the investment company business ( www.lipperweb.com ) </li></ul><ul><li>Morningstar.com: provide unbiased data and analysis and candid editorial commentary ( www.morningstar.com ) </li></ul><ul><li>Vanguard Group: providing competitive investment performance and lowest operating expenses ( www.vanguard.com ) </li></ul>
  7. 7. Mutual Fund Advantages <ul><li>Broad diversification </li></ul><ul><ul><li>Diversified stock funds hold large and small company stocks broadly spread across industries and economic sectors </li></ul></ul><ul><ul><li>Diversified bond funds hold bonds with different maturities, coupon, and credit quality </li></ul></ul><ul><li>Ability to retain professional investment management at a reasonable cost </li></ul><ul><li>Investor convenience </li></ul><ul><ul><li>Many offer “fund family” </li></ul></ul>
  8. 8. Mutual Fund Disadvantages <ul><li>High management fees and sales commissions </li></ul><ul><ul><li>No-load funds </li></ul></ul><ul><li>Volatility can be significant </li></ul><ul><ul><li>Diversification doesn’t protect investors from the risk of loss from an overall decline in financial markets </li></ul></ul><ul><ul><li>Mutual fund regulation doesn’t eliminate the risk of an investment falling in value </li></ul></ul>
  9. 10. Sources of Investment Returns <ul><li>Total Return: dividend and interest income and realized and unrealized appreciation </li></ul><ul><li>Income distribution: interest and dividend income after expenses. </li></ul><ul><li>Capital gains unrealized until the fund sells the shares (Unrealized capital gains) </li></ul><ul><li>The realized capital gains are paid out to shareholders at the end of the year (capital gains distributions) </li></ul>
  10. 11. Mutual fund expenses <ul><li>Operating expense ratio: total of investment advisory fees and costs of legal and accounting services, etc., expressed as a percentage of the fund’s average net assets (range from 0.2% to 2%) </li></ul><ul><ul><li>Lowest for money market mutual fund and highest for international stock funds </li></ul></ul><ul><ul><li>Tend to be lowest for large, liquid funds </li></ul></ul><ul><li>Load charges: one time sales commissions </li></ul><ul><ul><li>Front-end loads (charged at the time of purchase) </li></ul></ul><ul><ul><li>Back-end loads (charged at the time of sales of shares) </li></ul></ul><ul><ul><li>Low-end funds: sales fee ranging from 1% to 3% </li></ul></ul><ul><ul><li>12b-1 fees: marketing and distribution costs </li></ul></ul><ul><ul><li>No-load funds: fund without front-end or back-end load charges </li></ul></ul>
  11. 12. Table 16.4 A. Typical fee tables found in three different mutual fund prospectuses 1,805 1,477 368 10 years 1,077 670 163 5 years 823 387 93 3 years $ 587 $ 124 $ 30 1 year Expenses on a $10,000 Investment 0.96% 1.22% 0.29% Total Operating Expenses 0.26 0.32 0.03 Miscellaneous expenses — — 0.02 Marketing and distribution costs — 0.30 — 12b-1 marketing fees — — 0.02 Investment advisory expenses 0.70% 0.60% 0.22% Management and administrative expenses Annual Fund Operating Expenses None None None Exchange fees None None None Redemption fees 4.75 None None Sales load imposed on reinvested dividends 4.75% None None Sales load imposed on purchases Shareholder Transaction Expenses Fund C Fund B Fund A
  12. 13. B. The impact of equity mutual fund costs on long-term investor returns. Fund A : typical cost efficient index fund Fund B : conventional no-load stock mutual fund Fund C : low-load stock mutual fund with less than typical annual operating expenses 12.04% 11.78% 12.71% Net return 0.96% 1.22% 0.29% Operating expenses 13.00% 13.00% 13.00% Gross return 92,539 92,743 109,458 20 years 52,416 53,145 60,178 15 years 29,689 30,565 33,084 10 years 16,186 17,451 18,189 5 years 9,525 10,000 10,000 Day 1 $10,000 $10,000 $ 10,000 Initial investment Fund C Fund B Fund A
  13. 14. Style boxes <ul><li>Characterize mutual funds by market capitalization (large, mid, and small cap) </li></ul><ul><li>Next, determine how cheap or expensive portfolio holdings are relative to the </li></ul><ul><li>overall market using P/E and P/B ratios (Value, Blend and Growth) </li></ul>Russell 2000 Benchmark Small-cap (Bottom 80%) Wilshire 4500 Benchmark Mid-cap (Next 15%) S & P 500 Benchmark Large-cap (Top 5%) Growth Strategy (Score > 2.25) Blend (1.75  Score  2.25) Value Strategy (Score <1.75)
  14. 16. Mutual Fund Organization <ul><li>Mutual fund shareholders: own mutual funds, elect the board of directors </li></ul><ul><li>Majority of the directors must be independent directors </li></ul><ul><li>Investment advisor: manages the day-to-day operations </li></ul><ul><li>Principal underwriter, administrator, transfer agent, custodian, and independent public accountant </li></ul>
  15. 17. Evaluating Fund Performance <ul><li>Using ranking tools or portfolio evaluation tools (alpha, Sharp ratio, and Treynor measure) </li></ul><ul><li>20 categories in domestic equity mutual funds, 14 in international equity funds, 12 in fixed income and 17 in municipal bond funds </li></ul>
  16. 18. Top 10 U.S. Domestic Funds Based on 3 Year Return -- 22.6 43.3% 25.4 6.7 6.7 Fidelity Adv Lev Co; Ins FLVIX    Mid-Cap Value -- 6.6 44.1% 38.2 11.5 11.5 ProFunds: UltraMidCap;Svc UMPSX    Mid-Cap Core -- 22.4 44.4% 26.1 6.9 6.9 Fidelity Lvrgd Co Stk FLVCX    Mid-Cap Core 13.6 14.5 45.0% 33.3 9.8 9.8 Hodges Fund HDPMX    Multi-Cap Core -- 7.6 45.6% 39.7 11.6 11.6 ProFunds: UltraMidCap;Inv UMPIX    Mid-Cap Core -- 22.3 46.8% 22.4 5.1 5.1 Schneider Sm Cap Val SCMVX    Small-Cap Value -- 5.4 47.7% 28.0 17.6 17.6 ProFunds: UltraSm-Cap;Svc UAPSX    Small-Cap Core -- 18.0 48.0% 26.7 16.6 16.6 Pacific Adv: Small Cp;C PGSCX    Small-Cap Value -- 6.4 49.2% 29.3 17.7 17.7 ProFunds: UltraSm-Cap;Inv UAPIX    Small-Cap Core 12.1 19.3 49.2% 27.8 16.8 16.8 Pacific Adv: Small Cp;A PASMX    Small-Cap Value 10 Year 5 Year 3 Year 1 Year YTD 1 Mon. Fund Name: Classification
  17. 22. Exchange-Trade Funds (ETFs) <ul><li>Tradable shares in baskets of stocks that closely track broad market averages, market sectors, or major stock markets from around the world. </li></ul><ul><li>Standard and Poor’s Depository Receipts (SPY), “spiders”: closely track S&P 500 Index </li></ul><ul><li>Diamonds (DIA): track Dow Jones Industrial Average </li></ul><ul><li>QQQQ: track Nasdaq 100 Index </li></ul><ul><li>Select Sector SPDRs: unbundled S&P Index to give investors ownership in a particular market sector or group of industries. </li></ul><ul><li>Barclays Global Investors: offer “iShares” – internationally indexed </li></ul><ul><li>Tradable shares in baskets of stocks that closely track broad market averages, market sectors, or major stock markets from around the world. </li></ul>
  18. 23. Closed-End Funds <ul><li>Issues a fixed number of shares at a given point in time </li></ul><ul><li>Collect money from investors through and IPO and use this money to invest in securities. </li></ul><ul><li># of securities are fixed at the time of IPO. </li></ul><ul><li>When the market price exceeds its NAV, selling at a premium, otherwise, selling at a discount (closed-end funds typically sell at a discount) </li></ul><ul><li>Suited to specialized investing in small or illiquid markets </li></ul>* Assets are Net Assets, expressed in Millions, and exclude leveraged capital (preferred stock, debt, etc.). $214,736.69 Total Assets * : 693 Total number of closed-end funds (U.S. exchanges only): Value Statistic
  19. 24. Hedge Funds <ul><li>Like mutual funds, a means for groups of investors to pool financial resources </li></ul><ul><li>Typically organized as partnership arrangement available only to the wealthiest investors </li></ul><ul><li>Flexibility to use speculative investment strategies </li></ul><ul><li>Subject to only limited oversight. </li></ul>
  20. 25. Table 16.6 Hedge Funds Differ From Mutual Funds in a Number of Ways There are no specific rules on valuation or pricing. As a result, hedge fund investors may be unable to determine the value of their investment at any given time. In addition, new investors typically must pledge to keep their money in a hedge fund for at least one year. Mutual funds must value their portfolio securities and compute their share daily. They generally must also allow shareholders to redeem shares on at least a daily basis. Pricing and Liquidity Leveraging strategies are hallmarks of hedge funds. Investment policies do not have to be disclosed, even to investors in the fund. Securities laws restrict a mutual fund's ability to leverage, or borrow against the value of securities in its portfolio. Funds that use options , futures , forward contracts, and short selling must &quot;cover&quot; their positions with cash reserves or other liquid securities. Investment policies must be fully disclosed to investors. Investment Practices Hedge fund investors often pay a portfolio management fee of 1% to 2% of net assets, plus a performance-based fee that can run as high as 10% per year, depending upon performance. Fees are not subject to specific regulatory limits. Mutual fund shareholders pay, on average, an annual expense ratio of roughly 1.5% of assets. Load charges can increase this to 2.5% to 5% per year. Funds must disclose fees and expenses in detail. Sales charges and other distribution fees are subject to specific regulatory limits. Fees Only sophisticated, high net worth investors are eligible to invest. The typical investor is a wealthy individual or an institution such as an endowment or foundation. A minimum investment of $1 million or more is required. 92 million Americans own mutual fund shares. The only qualification for investing is having the minimum investment to open an account with a fund company ‑‑ often $1,000 or less. Who Invests Hedge Funds Mutual Funds
  21. 26. Taxes on distributions <ul><li>Shareholders pay taxes due once income dividends and capital gains distributions are received. </li></ul><ul><li>All income and capital gains distributions are generally subject to income taxes. </li></ul><ul><ul><li>Municipal bond or US T-securities interest income exempt from federal taxes, but capital gains are taxable. </li></ul></ul><ul><li>Turnover rate: expressed as a percentage of the fund’s average assets (average turnover rate for stock mutual fund: 79%) </li></ul>

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