Ch04 mutual funds


Published on

this is a brief description and beginner knowledge abt mutual funds

Published in: Economy & Finance, Business
  • Be the first to comment

  • Be the first to like this

No Downloads
Total views
On SlideShare
From Embeds
Number of Embeds
Embeds 0
No embeds

No notes for slide

Ch04 mutual funds

  1. 1. Chapter 4 Mutual Funds and Other Investment Companies
  2. 2. Services of Investment Companies <ul><li>Administration & record keeping </li></ul><ul><ul><li>Periodic reports on capital gains, dividends, investments, and redemption </li></ul></ul><ul><li>Diversification & divisibility </li></ul><ul><ul><li>Each investor has a claim to the portfolio in proportion to his investment </li></ul></ul><ul><li>Professional management </li></ul><ul><ul><li>Full-time staffs of security analysts and portfolio managers </li></ul></ul><ul><li>Reduced transaction costs </li></ul>
  3. 3. Net Asset Value <ul><li>Value of each share of a mutual fund </li></ul><ul><ul><li>Used as a basis for valuation of mutual funds, e.g., when selling new shares or redeeming existing shares </li></ul></ul><ul><li>Market Value of Assets - Liabilities </li></ul><ul><li> Shares Outstanding </li></ul><ul><ul><li>(Example) A mutual fund with 5 mil shares: </li></ul></ul><ul><ul><li>Portfolio of securities $120 mil </li></ul></ul><ul><ul><li>Investment advisory fees payable $ 4 mil </li></ul></ul><ul><ul><li>Other Liab. (rent, wages due, expenses) $ 1 mil </li></ul></ul><ul><ul><li>NAV = (120 – 5) / 5 = $23 per share </li></ul></ul>
  4. 4. Types of Investment Companies <ul><li>Investment Company Act of 1940 </li></ul><ul><ul><li>Unit Investment Trusts </li></ul></ul><ul><ul><ul><li>Investment portfolios are fixed and unmanaged (lower operating expenses than actively managed funds) </li></ul></ul></ul><ul><ul><li>Managed Investment Companies </li></ul></ul><ul><ul><ul><li>Closed-End vs. Open-End Funds </li></ul></ul></ul><ul><ul><ul><li>Discount puzzle of closed-end funds: </li></ul></ul></ul><ul><ul><ul><ul><li>Various commissions (sales, management, performance fees, etc.) </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Unrealized capital gains and taxes </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Individual investors’ sentiment </li></ul></ul></ul></ul>NAV Premium or discount to NAV Pricing Changes daily as new shares are sold or old shares are redeemed No change unless new share is offered Shares outstanding Can redeem or issue its shares at NAV, but not listed on exchanges Cannot redeem its shares, but traded on stock exchanges Redemption of shares Open-end Closed-end
  5. 5. Other investment Organizations <ul><li>Similar functions, but not formally regulated as investment companies </li></ul><ul><li>Commingled funds </li></ul><ul><ul><li>Similar to open-end funds, and units are offered </li></ul></ul><ul><ul><li>Money market fund, bond fund, etc, by a bank or insurance company </li></ul></ul><ul><li>REITs </li></ul><ul><ul><li>Similar to closed-end funds </li></ul></ul><ul><ul><li>Investing in real estate (Equity trusts) or mortgage loans (Mortgage trusts) </li></ul></ul><ul><li>Hedge Funds </li></ul><ul><ul><li>Private investment pool, not subject to SEC regulation </li></ul></ul><ul><ul><li>Heavy use of derivatives, short sales, and leverage, speculating on convergence of valuation differences across two sections </li></ul></ul>
  6. 6. Investment Policies <ul><li>Investment policies of mutual funds are described in prospectus </li></ul><ul><ul><li>Get a free prospectus for many mutual funds at </li></ul></ul><ul><ul><li> </li></ul></ul><ul><li>Various kinds of investment policies (styles) </li></ul><ul><ul><li>Money Market Funds </li></ul></ul><ul><ul><li>Fixed Income Funds </li></ul></ul><ul><ul><li>Balanced & Income Funds </li></ul></ul><ul><ul><li>Equity Funds </li></ul></ul><ul><ul><li>Index Funds: passive strategy, tracking a broad market index </li></ul></ul><ul><ul><li>Asset Allocation Funds: actively engaged in market timing and forecasting </li></ul></ul><ul><ul><li>Specialized Sector Funds: industry-specific or international stocks </li></ul></ul>
  7. 7. Costs of Investing in Mutual Funds <ul><li>Front-end vs. Back-end load </li></ul><ul><ul><li>Front-end load: sales commission paid at time of purchase (about 6%) </li></ul></ul><ul><ul><ul><li>No-load funds: no front-end sales charges </li></ul></ul></ul><ul><ul><li>Back-end load: redemption fee at time of redemption (about 6%, and gradually lowers every year) </li></ul></ul><ul><li>Operating expenses </li></ul><ul><ul><li>Administrative expenses and advisory fees paid to the investment manager (0.2% to 2% of total assets) </li></ul></ul><ul><ul><li>Periodically deducted from the fund assets </li></ul></ul><ul><li>12 b-1 charges </li></ul><ul><ul><li>Annual fees charged by a fund manager to pay for marketing and distribution costs of annual reports and prospectuses, and sales broker commissions (limited to 1% of a fund’s average net assets per year) </li></ul></ul><ul><ul><li>Annually deducted from the fund assets </li></ul></ul><ul><li>Different classes of shares have different fee structures </li></ul><ul><ul><li>Allow investors to choose the best combination of fees, depending on their investment horizons. </li></ul></ul>
  8. 8. Mutual Funds Returns, Fees, and Taxes <ul><li>Rate of return before fund expenses </li></ul><ul><ul><li>= (NAV 1 – NAV 0 + Dividend and capital gain distributions) / NAV 0 </li></ul></ul><ul><li>Fund expenses affect the returns </li></ul><ul><ul><li>Front-end or back-end loads, operating expenses, and 12b-1 charges are periodically deducted from fund assets, having substantial negative effects on the rate of return </li></ul></ul><ul><ul><li>Costs incurred in “soft dollars” are difficult to measure </li></ul></ul><ul><ul><ul><li>High trading commissions will eventually reduce fund returns </li></ul></ul></ul><ul><li>The “pass-through” status of fund income </li></ul><ul><ul><li>If at least 90% of all income is distributed to shareholders, and </li></ul></ul><ul><ul><li>less than 30% of its income comes from the sale of securities held for less than three months </li></ul></ul><ul><ul><ul><li>Then, investors (but not the fund) pay income taxes at their own tax rate </li></ul></ul></ul><ul><ul><li>It may be a disadvantage since it is difficult to control when to realize capital gains and how to manage tax liabilities </li></ul></ul><ul><ul><ul><li>Such a tax management issue is irrelevant if a mutual fund is held in a tax-deferred retirement account such as an IRA or 401(k) account </li></ul></ul></ul>
  9. 9. Exchange Traded Funds <ul><li>A variant of mutual funds that allow investors to trade index portfolios like shares of stock </li></ul><ul><ul><li>Examples: SPDRs and Webs </li></ul></ul><ul><li>Potential advantages </li></ul><ul><ul><li>Trade continuously, and can be sold short or bought on margin </li></ul></ul><ul><ul><li>Tax advantage over mutual funds </li></ul></ul><ul><ul><ul><li>Redeemable for shares of stocks in the portfolio without selling them, thus not triggering capital gains taxes </li></ul></ul></ul><ul><ul><li>Investor can buy ETFs through brokers (save sales charges) </li></ul></ul><ul><ul><li>Lower management fees, 0.09%~0.18% </li></ul></ul><ul><li>Potential disadvantages </li></ul><ul><ul><li>Sometimes depart from the NAV, giving arbitrage opportunities </li></ul></ul><ul><ul><li>Trading incurs brokerage fee and bid-ask spreads </li></ul></ul>
  10. 10. Mutual Fund Performance <ul><li>Choice of an appropriate benchmark is difficult </li></ul><ul><ul><li>Must have similar risk characteristics </li></ul></ul><ul><li>A simple comparison with Wilshire 5000 index (Fig 4.3) </li></ul><ul><ul><li>The index has outperformed the median managers in more years during 1972-2001, and the average difference of annualized compound returns is 1.09% (12.20% vs. 11.11%) </li></ul></ul><ul><ul><li>This margin could have reduced to 0.79% for passively managed low-cost index fund, and thus, passive index fund would have outperformed actively managed funds </li></ul></ul><ul><li>Repeated winners? </li></ul><ul><ul><li>Tab 4.4 shows that 62% of initial winners repeats in the following period, which is consistent with at least some part of a fund’s performance is a function of skill as opposed to luck </li></ul></ul><ul><ul><ul><li>Bad performance is more likely to persist than good performance due to high turnover ratios and expense ratios </li></ul></ul></ul>
  11. 11. Sources of Information on Mutual Funds <ul><li>Prospectus </li></ul><ul><ul><li>Is required to contain investment objectives, policies, risks, fee table, portfolio managers, etc. </li></ul></ul><ul><li>Two other sources </li></ul><ul><ul><li>Statement of Additional Information (Part B of Prospectus), and Annual Report show portfolio composition, financial statements, etc. </li></ul></ul><ul><li>Which funds to choose? </li></ul><ul><ul><li>Morningstar’s Mutual Fund Sourcebook </li></ul></ul><ul><ul><li>Wiesenberger’s Investment Companies </li></ul></ul><ul><ul><li>Investment Company Institute’s Directory of Mutual Funds </li></ul></ul>
  12. 12. Recent Fraud in Mutual Fund Industry <ul><li>“ Late trading” or “market timing” is discouraged or prohibited </li></ul><ul><ul><li>Mutual fund companies state in their prospectuses that they discourage or prohibit &quot; late trading &quot; and &quot; market timing &quot; by large investors. However, mutual fund managers were found to permit certain companies to conduct such trades in exchange for payments and other inducements. </li></ul></ul><ul><ul><ul><li> </li></ul></ul></ul><ul><ul><ul><li> </li></ul></ul></ul><ul><ul><ul><li>http:// (fraud investigation documents) </li></ul></ul></ul><ul><ul><li>Late trading involves purchasing mutual fund shares at the 4 pm price after the market closes, a practice which is illegal, and like allowing betting on a horse race after the horses have crossed the finish line. </li></ul></ul><ul><ul><li>Market timing is a short-term, &quot;in and out&quot; trading of mutual fund shares. It is designed to exploit market inefficiencies by buying mutual fund shares at the stale NAV, and realizing a profit later when selling them. </li></ul></ul><ul><ul><li>Typically, funds limit the number of round trips an investor can make during a 12-month period, and allow exchanges from one fund to another within the same fund family several times a year for a low or no fee. </li></ul></ul>