4
Mutual Funds
Learning Objectives
1. The different types of mutual funds.
2. How mutual funds operate.
3. How to find information about how mutual
funds have performed.
4. The workings of Exchange Traded Funds.
4-2
Mutual Funds: Overview
• Around 1980, 5 million Americans owned
mutual funds.
• By 2007, 96 million Americans in 55 million
households owned mutual funds.
• In 2006 investors added $474 billion in net
new funds to mutual funds.
• In 2006, mutual fund assets totaled $10.4
trillion.
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Mutual Funds:
• A means of combining or pooling the
funds of a large group of investors
• Buy and sell decisions made by a fund
manager, who is compensated for
the service provided
• A financial intermediary
4-4
Mutual Fund Basics
• Advantages
• Diversification
• Professional management
• Minimum investment
• Drawbacks
• Risk
• Costs
• Taxes
• Distributions and profits
4-5
Investment Companies
and Fund Types, I
• Investment company = business that specializes in
pooling funds from individual investors and
making investments.
• Open-end fund = an investment company that
stands ready to buy and sell shares in itself to
investors, at any time.
• Closed-end fund = an investment company with a
fixed number of shares that are bought and sold
by investors, only in the open market.
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Investment Companies
and Fund Types, II
Investment Companies
Open-end Funds
Money Market
Funds
Closed-end Funds
Long-term
Funds
Stock Funds
Bonds Funds
Blended
Funds
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Investment Companies
and Fund Types, III
• Net asset value (NAV) is the value of the assets
held by a mutual fund, divided by the number of
shares.
• Shares in an open-end fund are worth their NAV,
because the fund stands ready to redeem their
shares at any time.
• In contrast, share value of closed-end funds may
differ from their NAV.
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Net Asset Value
• Net asset value (NAV):
• Assets under Management (AUM) = the value of the assets
held by the fund
NAV = AUM/Shares outstanding
• Open-end fund share value = NAV
• Closed-end fund share value may ≠ NAV.
• ABC fund reports $56 billion in assets under
management and 750 million shares outstanding
• NAV = $56 billion /750 million = $74.67 per share
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4-9
Mutual Fund Operations
Organization and Creation
• Mutual fund = Corporation
• Owned by shareholders
• Shareholders elect a board of directors
• Must supply a prospectus to any interested investor
• Annual report to their shareholders
• Most created by:
• Investment advisory firms (Fidelity Investments)
• Brokerage firms with investment advisory operations (Merrill
Lynch)
• Investment advisory firms earn fees for managing mutual funds.
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Taxation of Investment Companies
• A “regulated investment company” does not have to
pay taxes on its investment income.
• To qualify, an investment company must:
•
Hold almost all its assets as investments in stocks,
bonds, and other securities,
• Use no more than 5% of its assets when acquiring a
particular security, and
• Pass through all realized investment income to fund
shareholders
4-11
4-11
Mutual Fund Operations
The Fund Prospectus and Annual
Report
• Mutual funds are required by law to supply a
prospectus to any investor who wishes to
purchase shares.
• Mutual funds must also provide an annual
report to their shareholders.
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The Fund Prospectus
• Shareholder fees
• Loads or sales charges
• Deferred sales charges (CDSC)
• Back-end load
• Annual Operating Expenses
• Management fee
• 12b-1 fee
• Other expenses
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4-13
Sales charge or “Load”
• “Load” = difference between NAV and offering or
redemption price
• “Front-end loads” or load funds; levied on purchases
• “Back-end loads” or “contingent deferred sales
charges” = CDSC; levied on redemptions
• Example:
The AGC fund has a net asset value (NAV) of $47.
On the same day the offering price is quoted as $50.
• AGC is a load fund since NAV ≠ Offering price
• The load = $50 - $47 = $3.00
• Load percentage = $3/47 = 6.38%
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4-14
12b-1 and Management Fees
• 12b-1 fees
• SEC Rule 12b-1 allows funds to spend up to 1% of
fund assets annually to cover distribution and
marketing costs.
• Typically 0.75 – 1.0 % of fund assets per year
• Management Fees
• Usually range from 0.25% to 1.00% of the fund’s total
assets each year.
• Usually based on fund size and/or performance.
JM5e_Ch04_15
4-15
Mutual Fund Costs and Fees
Types of Expenses and Fees
• Trading costs
• Not reported directly
• Funds must report "turnover," which is related
to the amount of trading.
• The higher the turnover, the more trading has
occurred in the fund.
• The more trading, the higher the trading costs.
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Trading Costs & Turnover
• “Turnover”
• Measures trading
• A turnover ratio = 1.0  fund has, in effect, sold off
its entire portfolio and replaced in once during the
year.
• Example:
• Suppose a fund had average daily assets under
management of $150 million.
• During the past year, the fund bought $85 million
of assets and sold $90 million.
• Turnover = $85m/$150m = 0.567
JM5e_Ch04_17
4-17
Mutual Fund Costs and Fees
Expense Reporting
• Mutual funds are required to report expenses
in a fairly standardized way in their
prospectus.
• Shareholder transaction expenses - loads and
deferred sales charges
• Fund operating expenses - management and
12b-1 fees, legal, accounting, and reporting
costs, director fees
• Hypothetical example showing the total expenses
paid by investors through time per $10,000
invested
4-18
Example: Fee Table
4-19
Mutual Fund Costs and Fees
Why Pay Loads and Fees?
• After all, many good no-load funds exist.
• But, you may want a fund run by a particular
manager. All such funds are load funds.
• Or, you may want a specialized type of fund.
• Perhaps one that specialized in Italian companies
• Loads and fees for specialized funds tend to be higher,
because there is little competition among them.
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Investment Companies & Fund Types
Investment Companies
Open-end Funds
Money Market
Funds
Closed-end Funds
Long-term
Funds
Stock Funds
Bonds Funds
Blended
Funds
JM5e_Ch04_21
4-21
Short-Term Funds
• Money market mutual funds (MMMFs)
• Specialize in money market instruments
• Maintain a $1.00 NAV to resemble bank accounts
• “Breaking the Buck” - 1994
• Can be either taxable or tax-exempt
• Banks offer “money market” deposit accounts
(MMDAs)
• Offers FDIC protection
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Investment Companies & Fund Types
Investment Companies
Open-end Funds
Money Market
Funds
Closed-end Funds
Long-term
Funds
Stock Funds
Bonds Funds
Blended
Funds
•Historically, mutual funds were classified as stock funds, bond funds, or
income funds.
•Today, the investment objective = major determinant of fund type
JM5e_Ch04_23
4-23
Stock Funds
Long-term
Funds
Stock Funds
Bonds Funds
Blended
Funds
Capital appreciation
Growth
Growth and Income
Price growth vs.
Dividend Income
Equity income
Small-cap
Mid-cap
Company Size
Large -cap
Global
International
% U.S. vs.
International
Sector funds
Economic Sectors
JM5e_Ch04_24
4-24
Stock Funds
Long-term
Funds
Stock Funds
Bonds Funds
Capital appreciation
Growth
Growth and Income
Price growth vs.
Dividend Income
Equity income
Blended
Funds
Some stock funds
trade off capital
appreciation and
dividend income.
Small-cap
Mid-cap
Company Size
Large -cap
Global
International
% U.S. vs.
International
Sector funds
Economic Sectors
JM5e_Ch04_25
4-25
Stock Funds
Long-term
Funds
Stock Funds
Bonds Funds
Blended
Funds
Capital appreciation
Growth
Growth and Income
Price growth vs.
Dividend Income
Equity income
Small-cap
Mid-cap
Company Size
Large -cap
Global
International
% U.S. vs.
International
Sector funds
Economic Sectors
Some stock funds
focus on
companies in a
particular size
range
JM5e_Ch04_26
4-26
Stock Funds
Long-term
Funds
Stock Funds
Bonds Funds
Blended
Funds
Capital appreciation
Growth
Growth and Income
Price growth vs.
Dividend Income
Equity income
Small-cap
Mid-cap
Company Size
Large -cap
Global
International
% U.S. vs.
International
Sector funds
Economic Sectors
Some stock fund
invest
internationally.
•Global
•International
•Region
•Country
•Emerging
markets
JM5e_Ch04_27
4-27
Stock Funds
Long-term
Funds
Stock Funds
Bonds Funds
Blended
Funds
Capital appreciation
Growth
Growth and Income
Price growth vs.
Dividend Income
Equity income
Small-cap
Mid-cap
Large -cap
Global
International
Sector funds
Company Size
Sector funds
specialize in specific
sectors of the economy:
% U.S. vs.
•Biotechnology
International
•Internet
Economic Sectors
•Energy
JM5e_Ch04_28
4-28
Special Interest Stock Funds
• Index funds
• Social conscience fund
• “Sin” funds (i.e., tobacco, liquor,
gaming)
• Tax-managed funds
JM5e_Ch04_29
4-29
Bond Funds
Long-term
Funds
Stock Funds
Bonds Funds
Maturity range
Credit quality
Taxabiity
Type of bond
Country
Blended
Funds
Bond fund types include:
• Short-term funds
• Intermediate-term funds
• General funds
• High-yield funds
• Mortgage funds
• World funds
• Insured funds
• Single-state municipal
funds
JM5e_Ch04_30
4-30
Blended Funds
Long-term
Funds
Stock Funds
Bonds Funds
“Blended” or “Hybrid” Funds:
Funds that do not invest
exclusively in either stocks or
bonds.
Blended
Funds
Balanced funds
Asset Allocation funds
Convertible funds
Income funds
JM5e_Ch04_31
4-31
Mutual Fund Objectives:
Recent Developments, I
• A mutual fund “style” box is a way of visually
representing a fund’s investment focus by
placing the fund into one of nine boxes:
Value
Style
Blend
Growth
Size
Large
Medium
Small
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Mutual Fund Objectives:
Recent Developments, II
• Recent trend = classifying a mutual fund’s objective
based on its actual holdings.
• For example, the Wall Street Journal classifies most
general purpose funds based on the market “cap” of
the stocks they hold, and also on whether the fund
tends to invest in “growth” or “value” stocks (or
both).
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Mutual
Fund
Objectives
4-34
Mutual Fund
Selection
(www.morningstar.com)
4-35
Mutual Fund Performance
• Mutual fund performance is very closely
tracked by a number of organizations.
• Financial publications of all types periodically
provide mutual fund data.
• The Wall Street Journal is particularly timely
print source.
• www.morningstar.com has a “Fund Selector”
that provides performance information
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Mutual Fund
Performance:
Yardsticks
4-37
Mutual Fund
Performance:
Online Version of
The Wall Street
Journal, I
Note the fund with symbol: FBGRX
4-38
Mutual Fund Performance:
Online Version of The Wall Street
Journal, II
Result of clicking on “BluCh”
4-39
Mutual Fund Performance:
Cautions
• While looking at historical returns, the
riskiness of the various fund categories
should also be considered.
• Whether historical performance is useful in
predicting future performance is a subject of
ongoing debate.
• Some of the poorest-performing funds are
those with very high costs.
4-40
Closed Funds
• A “closed” fund is NOT a “closed-end” fund
• “Closed” = the fund will no longer sell shares to
new investors
• When a fund grows rapidly, the fund manager
may feel that the incoming cash is more than the
fund can invest profitably
• Funds that close often reopen at a later date
• The number of shares in a closed fund can still
fluctuate as existing owners buy and sell.
4-41
Closed Funds
• Why would a fund choose to close?
• When a fund grows rapidly, the fund
manager may feel that the incoming cash is
more than the fund can invest profitably.
• Funds that close often reopen at a later
date.
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Closed-End Funds
• A closed-end fund has a fixed number of
shares.
• These shares are traded on stock
exchanges.
• There are about 600 closed-end funds that have
their shares listed on U.S. Stock Exchanges.
• There are about 8,000 long-term open-end mutual
funds.
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Mutual Fund
Performance
Closed-End
Funds
4-44
The Closed-End Funds Discount
• Most closed-end funds sell at a discount
relative to their net asset values.
• The discount is sometimes substantial.
• The typical discount fluctuates over time.
• Despite a great deal of academic
research, the closed-end fund discount
phenomenon remains largely unexplained.
4-45
ETFs
• ETFs = Exchange Traded Funds
• Index funds that trade on exchanges like
stock:
• Spiders (SPDR)
• Diamonds (DIA)
• Cubes (QQQQ)
• A list of ETFs can be found at www.amex.com
JM5e_Ch04_46
4-46
Exchange
Traded
Funds:
Performance
4-47
Exchange Traded Notes, ETNs
• Introduced in mid-2006 by Barclays Bank.
• To investors, ETNs look like ETFs:
• ETNs are unsecured debt
• Unlike holders of ETFs, holders of ETNs do have
default risk.
• ETNs provide investors with exposure to
commodities, but without the leveraged risk
of futures contracts.
• Handy web source: www.ipathetn.com
4-48
Hedge Funds
• Hedge funds ≈ mutual funds that are free to
pursue any investment style
• Very little disclosure or regulation requirements
• Not required to maintain any particular
degree of diversification or liquidity
• Hedge fund managers have considerably
more freedom to follow various investment
strategies, or styles.
JM5e_Ch04_49
4-49
Hedge Funds
• Offered only to “sophisticated", usually very
wealthy investors.
• Minimum investment = $50,000 to $1 million
• Hedge fund fees:
• General management fee = 1-2% of fund
assets
• Performance fee = 20-40% of profits
• “Fund of Funds”
JM5e_Ch04_50
4-50
Useful Internet Sites
•
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www.ici.org (mutual fund facts and figures)
www.vanguard.com (example of a major fund family website)
www.fidelity.com (largest investment advisory firm in US)
www.mfea.com (information on thousands of funds)
www.morningstar.com (one of the best mutual fund sites)
www.domini.com (more “social conscience” funds)
www.vicefund.com (“vice” funds)
www.amex.com (exchange traded funds)
www.ishares.com (more on exchange traded funds)
www.ipathetn.com (all about ETNs)
www.hedgeworld.com (hedge fund information)
www.hedgefundcenter.com (more hedge fund information)
www.turnkeyhedgefunds.com (how to start your own hedge fund)
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