Chapter - 4
INDIRECT INVESTMENT MUTUAL FUNDS
Dr. BALAMURUGAN MUTHURAMAN
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MUTUAL FUNDS
Definition: Financial intermediary through which savers pool
their monies for collective investment, primarily in publicly
trades securities.
A fund is “mutual” in the sense that all of its returns minus its
expenses, are shared by its shareholders.
Returns consist of dividends, realized and unrealized capital gains
(losses)
Expenses consist of advisory fee for servicing the shareholders,
annual fee for distribution (12b-1)
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SEEKING HIGHER RETURNS
Objective is to maximize return with minimum risk
Efficient Market
securities
hypothesis
and
undervalued
Behavioral Finance
Mean reversion in the equity market
Individual securities have two main sources of risk:
alpha and beta.
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DEFINITIONS FOR RETURNS
Return =
Interest or Dividends +/- Price Change
Initial Investment
Risk = Variation (or range) of possible returns
Goal => Maximize return and minimize risk
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SEEKING HIGHER RETURNS
• Random walk
– No predictable relationship between past changes
and future changes in stock prices
– Based on extensive empirical studies
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SEEKING HIGHER RETURNS
• Efficient Market Hypothesis (EMH)
– Theory regarding information content of market
prices
– May explain random walk studies
– Paradox of EMH and value of research
• Behavioural finance
– Most investors do not behave perfectly rationally,
but are influenced by psychological factors
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REDUCING PORTFOLIO RISK
• Alpha risk
• Alpha - company specific risk usually accounts for 50%-70% of
security’s price volatility;
• can be reduced by diversification
• Beta risk
– Beta - market risk accounts for 30%-50% of price volatility.
– Stock market risk; cannot be reduced by diversification
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BENEFITS OF INVESTING IN
MUTUAL FUNDS
• Diversification :Typically lowers ; global fund may also
lower 
• Professional Management: Professional qualifications
(CFA); access to company executives; in house research team,
wall street research.
• Lower Transaction Costs: Lower admn. cost, savings on
record keeping, better execution of securities.
• Convenience: Automatic deposits/ withdrawal,
reporting, retirement planning, educational materials.
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BENEFITS OF INVESTING IN
MUTUAL FUNDS
• Higher minimum requirements for individual bonds (usually
$25,000; T-bonds $1,000). Lot size is usually $100,000. One
$25,000 bond lacks diversification.
•Cost : 2% - 4% of value.
•Bond mutual fund minimum: As low as $1,000. Can redeem
fund on any business day. Do not have to hold till maturity.
•Fund offers more diversification. Offer convenient services,
such as monthly income payments, compared to quarterly or
semi-annually for individual bonds
•Similar advantages for stock funds
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DISADVANTAGES OF
INVESTING IN MUTUAL FUNDS
•Need to pay fees/expenses even when fund performs poorly
•Increased diversification may prevent the chance of “hitting the
jackpot” from one security
•Online trading and security research on the internet have
reduced the advantage of cost and research access
•Less control over securities portfolio and therefore timing of
realized capital gains for tax purposes.
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POPULAR WAYS TO PURCHASE
INDIVIDUAL SECURITIES
• On-line trading
• Separate account
– Portfolio of individual securities managed
separately by a bank, broker, or financial adviser
– Account minimums lowered for consultant
– Pre-packaged model portfolios
– “Baskets” available through the internet
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STRUCTURE OF A
MUTUAL FUND
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MUTUAL FUND COMPLEX
Stock Funds
Shareholders
(Savers)
Fixed Income
Funds
Management
Company
Money Market
Funds
Broker
Distribution
Transfer
Agency
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STRUCTURE OF A
COMMERCIAL BANK
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MUTUAL FUND VERSUS BANK DEPOSIT
Mutual Fund
Bank Deposit
Tracks T-bill closely but
usually higher because of
credit risk
Does not track T-bill closely;
longer maturity results in higher
rate
• Time
Redemptions daily
MMDA: allows limited daily
withdrawals
CDs: penalty for early
withdrawal
• Liquidity
Highly liquid
CDs: funds “locked-up” for
fixed period
• Diversification
No more than 5% in any one
issuer
Generally cannot loan more
than 15% to one borrower
• Rate of Return
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MUTUAL FUND VERSUS BANK DEPOSIT
Mutual Fund
Bank Deposit
• Risk
95% must be in highest rated Loans subject to credit review;
paper; average 90-day security try to match asset maturity to
maturity; no FDIC insurance
liabilities;
FDIC
insurance
($100K)
• Capital
Management company, not fund, Banks must have capital meeting
has capital; no regulatory meeting regulatory requirements;
requirement or guarantee
FDIC
guarantees
deposits
($100K limit)
• Tax
May offer tax-exempt interest to May not offer tax-exempt
shareholders
interest to depositors
• Fees
Fee income from management Primarily spread income from
contract
principal risk
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