Investments:
Theory and Applications
Mark Hirschey
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Chapter 15
Investment
Management: Mutual
Funds
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ASSESSING STOCK FUND RISK
Portfolio Characteristics
 Common stock investors look to the company’s
annual report to shareholders, 10-k report to
SEC, and fund prospectus for free information
about:




company assets
earnings
management
strategy
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ASSESSING STOCK FUND RISK
Portfolio Characteristics
 Mutual Fund Investors look to the fund’s annual
report to shareholders and its prospectus for
information about:

The fund’s portfolio holdings

Helps clarify the fund’s investment policies (value stocks,
growth stocks, U.S. Treasuries)

Level of concentration in the portfolio

Historical rates of return / performance

Management

Investment philosophy
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ASSESSING STOCK FUND RISK
Portfolio Characteristics
 When evaluating mutual funds, performance is always
the bottom line. However, it’s important to view
performance in “relative” terms:

Relative to: an appropriate benchmark index and against
peer group competitor funds that have similar objectives
and policies

Yahoo! Finance Mutual Funds
– Investment philosophy
– Relative performance
– Fees and expenses
 Must track performance over time to get a clear picture
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ALPHA, BETA & R2
 Under CAPM, the Security Market Line (SML)
shows relation between expected rate of return and
systematic risk

E(Rp) = RF + ßP(RM – RF)

ßP is beta measure of portfolio systematic (market) risk

Risk premium for typical mutual fund should be ßP times
as great as the market risk premium.
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ALPHA, BETA & R2
 For any given mutual fund portfolio, the following equation can
be used to identify any abnormal risk-adjusted performance:

E(Rp) - RF = P + ßP(RM – RF)

 signifies annual return on the portfolio that cannot be
tied to volatility in overall market
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ALPHA, BETA & R2

If 

is > 0 and significant:
a mutual fund portfolio has returned positive risk-adjusted
performance to its shareholders, indicating superior
historical portfolio manager performance


performance is better than the expectation derived from the CAPM
– the fund has earned an abnormal return
Market-beating performance can be due to superior:

Selectivity: stock-picking ability (the selection of stocks with
exceptionally good risk/reward characteristics)
– Warren Buffett, Fidelity’s Peter Lynch, and global investor John
Templeton

Market Timing: punctual purchase and sale of securities
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ALPHA, BETA & R2
 If  is < 0 and significant, the mutual fund has
underperformed the market on a risk-adjusted basis,
and inferior historical performance is demonstrated.
Possibly due to:

Bad stock picking

Bad market timing

Excessive operating expenses tied with:

extravagant portfolio manager compensation or

unreasonably high portfolio turnover
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ALPHA, BETA & R2
 R2 measures the degree to which volatility of a fund’s
return is explained by volatility in the overall market

The lower the R2, the more fund performance
depends on the fund manager’s timing and stock
selection

If a stock fund has a low R2, it’s hard to predict
how the fund will perform compared with the
overall stock market
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Risk-Adjusted Performance
 , , and R2 aren’t very useful in depicting
risk/reward ratio for mutual funds over time
 Sharpe Ratio:

Risk premium earned relative to total risk

Reward-to-variability measure (RVAR)

RVAR - Ranks portfolios according to the risk
premium earned relative to total risk using SD(RP)
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Risk-Adjusted Performance
 Treynor Ratio:

Risk premium earned relative to systematic risk

Reward-to-volatility measure (RVOL)

RVOL – ranks portfolios according to the risk
premium earned relative to systematic risk using
ßP
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Bond Fund Investing
Why Bonds?
 Bonds are part of many
people’s and institutional
investors’ portfolios.
 Stable income (coupon
payments)
 Diversification
 Tax-exempt municipal
bond income
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Advantages of Investing
in Individual Bonds
 Advantages of Individual Bond Investing (not a
mutual fund):

Great confidence in a given bond issuer to make all
promised interest payments and to repay principal in full at
maturity
 Choose when to buy or sell, retaining control over the
timing and amount of any taxable capital gains or losses
 Avoid paying fees for professional management or record
keeping, and thus receive all the income
 Assurance that the value of a given bond investment will
pay in full on a certain date so that it can be targeted to pay
for anticipated living expenses or an expected cost such as
college
tuition.
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Advantages of Investing
in Individual Bonds
 When bonds of different maturity dates are
purchased to meet specific expenses, a
technique called laddering is used.
 However, brokerage commissions are incurred
when buying or selling individual bonds

Exception: U.S. Treasury securities my be
purchased without commissions through the
Treasury Direct program of the Federal Reserve
System
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Advantages of Bond
Funds
 Investors may choose to have interest income
automatically reinvested
 Appealing to small investors with limited
amounts to invest: 3k for a portfolio or 1k for
an IRA
 Can purchase additional fund shares in amounts
far smaller than the cost of an individual bond.

Subsequent purchases can be as low as $100
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Advantages of Bond
Funds
 Diversification – a fund may hold hundreds of different
issuers

The failure of any single issuer to make interest or principal
pmts has only a slight effect on the overall portfolio vs. a
potential catastrophic loss for the holder of the individual
bond in default
 Professional fund managers - are in a position to make
informed trading decisions with access to:



extensive research
market information
skilled securities traders
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Advantages of Bond
Funds
 Offer the advantage of ready liquidity

Shares in a bond mutual fund may be bought or sold
whenever an investor chooses via toll-free telephone
number or Internet
 Check writing redemption options
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Advantages of Bond
Funds
 However – there are a few disadvantages:

Dividend income payments tend to vary as the
fund buys and sells individual bonds

No fixed maturity date – funds sell off aging bonds
and by newer ones which may create unwanted
taxable capital gains

Must redeem a bond mutual fund investment at an
unknown price to receive funds

which may create realizable capital gain or loss
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Bond Fund Risks
 The value of a bond fund goes up and down with
changes in credit market conditions
 Bond funds can be just as risky as stock funds

The market value of bond funds decrease in value when
interest rates rise (but increase when interest rates fall)
 Interest Rate Risk – is the risk that a bond fund will rise or
fall in value due to changes in interest rates. (The longer a
bond fund’s average time to maturity, the greater the
interest rate risk.)
 Income risk – during periods of rising interest rates long
term bonds pay a lower coupon rate relative to new bond
issues. Additionally, the face value of the bonds drops
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which
would
produce
a byloss
on Inc.
sale.
Bond Fund Risks
 Call Risk: Chance of bond redemption when
doing so would be economically advantageous
to the issuer

If market rates have fallen or a bond issuer’s credit
rating has improved, bond issuers will refinance
their debt at a lower interest rate – bond holders
must reinvest at a lower yield
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Bond Fund Risks
 Prepayment Risk: Chance of mortgage-backed
security redemption

Ginnie Maes – when interest rates fall,
homeowners may pay off their mortgages early by
refinancing
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Bond Fund Risks
 Inflation risk – long-term bond investments lose
purchasing power as prices rise.

A serious concern to anyone relying on fixedincome coupon payments to pay “future” inflated
expenses

Over significant periods of time, the long-run
effects of inflation on the value of a bond portfolio
can be devastating
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Bond Fund Risks
 Individual Bond Investors can lose money if an
issuer defaults or if a bond’s credit rating is
reduced.
 However, because a mutual fund invests in
many bonds, the possibility that a single default
would significantly impair the investor’s overall
portfolio is greatly reduced.
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Specialized Funds
Exchange-Traded Funds (ETFs)
 Exchange-Traded Funds (ETFs): tradable shares that
represent proportional ownership in baskets of stocks
that closely track any one of a large number of market
indexes



Can be purchased any time the markets are open
Can be held for long term appreciation
Low fees and expenses
 Standard and Poor’s Depository Receipts (SPDRs –
called “Spiders”): ETFs that track the price
performance and dividend yield of the S&P 500 Index
(unit investment trusts or closed-end mutual funds)
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Exchange-Traded Funds (ETFs)
 DIAMONDS: ETFs that track the price performance
and dividend yield of the DJIA
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Exchange-Traded Funds (ETFs)
 QQQs: ETFs that track the price performance and
dividend yield of the Nasdaq 100 Index
 MidCap SPDRs: ETFs that track the price
performance and dividend yield of the S&P
MidCap 400 Index
 Select Sector SPDRs: ETFs that track the
price performance and dividend yield of
particular industry groups

unbundle the S&P 500 Index and give investors
ownership in a particular market sector or group
of industries
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Exchange-Traded Funds (ETFs)
 iShares: index shares (ETFs) created by
Barclay’s Global Investors
 ETFs and iShares:




Represent valuable investment vehicles for
long-term investors
Can serve as the core position in an
investor’s portfolio by giving diversified
exposure to one or more broad market
indices
Can compliment an existing core portfolio
Can make it easy to add international
exposure to domestic portfolios
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Closed-End Funds
 Closed-End Funds: Investment companies that issue
a fixed number of shares at a given point in time
 They collect money from investors through an
initial public offering (IPO) and use the money to
invest in securities
 The number of shares issued by the fund and the
dollar value of assets under management are fixed
at the time of the fund’s IPO
 Operate with a stable pool of money
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Closed-End Funds

Total assets under management grow or decline
depending on management’s investment success

A closed-end fund is a publicly traded investment
company on the exchanges or OTC market

Have a board of directors elected by shareholders

Offer a wide array of investment alternatives

Conventional mutual finds offer many of the same
advantages with more flexibility at lower costs
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Closed-End Funds
 Premium: when the market price per share for closed-
end funds exceeds the NAV

Shares sell at a premium to net asset value when investors
are unusually optimistic about the fund’s investment
prospects
 Discount: when the market price per share for a closed-
end fund is less than NAV

Closed-end mutual funds typically sell at a discount of 1520% because there is no implicit agreement on the part of
the fund advisor to redeem shares at net asset value and
they operate in relative obscurity
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Hedge funds
 Hedge Funds: investment partnerships that use
speculative investment techniques, such as
leverage and short selling, that are very risky and
commonly prohibited for mutual funds


Largely unregulated with little reliable information
about their operations
Typically organized as partnership arrangements
available only to sophisticated high-net-worth
individuals or institutions with a minimum of $1
million to invest
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Taxes
Taxes on Distributions
 Once income dividends and capital gains distributions
have been received by shareholders, they must pay any
taxes due when they file their income taxes with the
Internal Revenue Service (IRS)
 Income Dividends – are derived from all interest and
dividend income earned from the fund’s cash
investments, bonds, and stock positions
 The amount paid to shareholders is the fund’s net
income, after subtracting fund operating expenses.
 Fund net realized capital gains must be fully
distributed to shareholders in the same calendar year.
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Taxes on Distributions
 All income and capital gains distributions are generally
subject to local, state, and federal income taxes

Gains or losses on securities held one year or less before
sold or exchanged are categorized as short term capital
gains taxed at ordinary income tax rates
 Long-term capital gains on securities held more than one
year are taxable at a lower federal tax rate
 Mutual funds send out IRS Form 1099-DIV, which details
income dividends and capital gains distributions that must
be reported
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Taxes on Distributions

Before purchasing a fund, the buyer needs to know when
the fund plans to make its next distribution



If a shareholder owns shares on the fund’s record date, they will
receive a distribution.
When a mutual fund makes a distribution, its share price and net
asset value fall by the amount of the distribution.
Purchasing shares shortly before a distribution is made is called
“buying the dividend” and exposes the buyer to taxes on the
distribution received even though net asset value per share has
fallen and no true gain has been realized
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Influences on the Size
of Distributions
 Money market funds: pay dividends on
interest income that are fully taxable

Except in the case of low-yield funds that invest in
tax-exempt municipal bonds
 Bond funds: typically produce relatively high
levels of taxable income
 Stock funds: generate income from dividends
paid by common stocks held in the portfolio and
from capital gains on sales of stock
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Influences on the Size
of Distributions
 Frequent selling within a fund makes the fund more
likely to produce taxable distributions than a fund that
follows a “buy-and-hold” strategy
 Turnover Rate: Common measure of a mutual fund’s
trading activity

Funds with high turnover generate lots of short-term gains
and realized long-term gains and relatively higher taxes for
mutual fund shareholders.
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Influences on the Size
of Distributions
 The simple “buy-and-hold strategy” is a tax-
efficient means of building mutual fund
shareholder wealth
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Taxes on
Sales and Exchanges
 All capital gains from the sale of mutual fund
shares are taxable, even those from the sale of
shares in tax-exempt funds

Interest payments are tax-exempt not profit on sale
 Writing a check against an investment in a
short-term bond fund with a fluctuating share
price also triggers a sale of shares and may
expose the mutual fund investor to a tax on any
resulting capital gains
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Taxes on
Sales and Exchanges
 Mutual fund investors can use losses on the sale of
shares to:

fully offset other capital gains on mutual funds, stocks,
bonds, or other investments.

After capital gains have been fully offset, mutual fund
shareholders can use up to $3,000 of net capital losses to
offset ordinary income, such as salary or investment
income, in any year

Capital losses that exceed $3,000 in any year can be carried
forward to offset future capital gains and ordinary income
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Taxes on
Sales and Exchanges
 Wash Sale: when an investor redeems shares at a loss
and purchases shares in the same fund within 30 days


In the eyes of the IRS, there was no effective sale of shares,
and the investor may not be allowed to claim some or all of
the realized losses on the tax return
Note: Tax rules governing taxable gains and losses can be
complex, and individual investors may wish to consult with
a tax adviser or tax preparer for guidance in dealing with
these situations
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Answers to Selected
End of Chapter 15 Questions
and Suggested Study
 Study the following end-of-
 11. (c)
chapter questions:
 2. (b)
 4. (c)
 12. (d)
 5. (b)
 19. (d)
 6. (c)
 Read the Chapter
 7. (b)
 Read the Chapter
 9. (b)
“Summary”
 Review the Power Point
Presentation
 10. (d)
 13. (a)
 18. (d)
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