Download Mutual funds

Chapter Seventeen
Mutual Funds
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Mutual Funds Overview
 Mutual funds pool investors’ funds and invest in
money or capital market instruments, and
sometimes derivatives.
 They allow investors to gain diversification and
professional management according to specific
published objectives at low cost.
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Historical Trends
 First mutual fund established in 1924
 Advent of money market mutual funds in 1972
as investors looked for ways to earn market
rates on short-term funds
 Tax-exempt money market mutual funds
introduced in 1979
 Special-purpose equity, bond, emerging market,
and derivative funds exploded on the scene
during the 1990’s bull market
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Growth of the Mutual Fund Market
300000
9000
8000
250000
7000
200000
6000
5000
150000
4000
100000
3000
2000
50000
1000
0
0
1950
1960
1970
Accounts
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1980
1990
2000
Assets ($ Bn.)
17-4
2001
2002
2003
2004
No. of Funds
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Financial Assets of Major Financial
Intermediaries, 1990 and 2004 ($Tns)
9
8
7
6
5
1990
2004
4
3
2
1
0
Commercial Mutual
Banks
Funds
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Private Insurance
Gov.
Pension Companies Pension
Funds
Funds
17-5
Savings
Inst.
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Types of Mutual Funds
Long term funds
1. Equity funds:
• Primarily hold common and preferred stock
2. Bond funds:
• Primarily hold fixed income securities with
maturities over 1 year
3. Hybrid funds:
• Blends of equity and bond funds.
4. Tax exempt funds:
• Funds that specialize in investing in tax
exempt securities
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Long term funds
5. Index funds;
•
Funds that attempt to mimic the performance of
a given index, because they do not actively engage
in timing and stock selection they generally have
lower expense ratios than other funds.
–
These have now grown to 25% of long term funds.
–
Investing in an index fund is a form of passive
investing.
–
The primary advantage to such a strategy is the
lower management expense ratio on an index fund.
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Long term funds
6. Exchange traded funds (ETF):
• A variant of index funds that are traded on an
exchange.
• The advantage of an ETF is that it can be traded
throughout the day at continuously updated prices.
• ETFs can be purchased on margin and sold short,
unlike index funds.
• There are no capital gains distributions to add to
tax liabilitiy in a given year either.
• These features allow for better hedging and
arbitrage strategies.
• Examples include SPDRs on the AMEX and
Vanguard’s Large-Cap VIPERS funds.
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Short term funds
1. Money market mutual funds:
–
Funds that invest in securities with 1 year
maturity or less
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Number of Mutual Funds, 1980, 1990, 2004
5000
4500
4000
3500
3000
2500
2000
1500
1000
500
0
1980
1990
2000
2004
Equity
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Hybrid
Bond
17-10
Tax.
Money
Market
Tax.-Ex.
Money
Market
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Mutual Fund Prospectuses and Objectives
• Regulations require mutual fund managers to specify
the investment objectives of their funds in a
prospectus
• The prospectus includes a list of the securities that the
fund holds and the investment objectives
• As of 1998, SEC requires key sections of a fund
prospectus to be written in ‘plain’ English
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Investor Returns from Mutual Fund
Ownership
• The return for the investor reflects three
aspects of the underlying portfolio of mutual
fund assets
– portfolio earns income and dividends on those
assets
– experiences capital gains sells an asset at a
higher price
– capital appreciation in the underlying values
of its existing assets adds to the value of
mutual fund shares
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Mutual Funds
• Open End funds
• Closed-End Funds
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Open End funds
• ready to buy and sell shares at a price based
on net asset value (NAV)
• NAV per share equals the market value of the
portfolio minus the liabilities of the mutual
fund divided by the number of shares owned
by the mutual fund investors.
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Open-End Funds
Five important characteristics
First, investors own a pro rata share of the overall
portfolio.
Second, investment manager of the fund actively manages
the portfolio.
Third, the value or the price of each share of portfolio
is called the NAV and equals market value of the
portfolio minus liabilities / numbers of shares owned
by the fund investors.
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Open-End Funds
• Fourth, the NAV is determined once at each
day either at beginning of the day or close of
the day.
• Fifthly, All new investments into the fund and
withdrawals are priced at a closing price or
NAV.
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Example
Net asset value =
(Total assets minus liabilities) / numbers of
shares
A
NAV = 1,050,000 – 50,000 = $100
10,000
B
NAV = 2,100,000 – 0 = $210
10,000
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Calculation of NAV; Classes of Funds
NAV =
Total market value of assets under management
Number of mutual fund shares outstanding
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Closed-End Funds
Specialized investment companies with a
fixed supply of o/s shares but invest in
assets and securities of other firms.
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Closed-End Funds
 Issue a limited number of shares and are very similar
to shares of common stock
 Investors pay a broker’s commission.
 NAV of closed-ended funds is determined by supply
and demand.
 Discounts or premiums
 discount results from large tax liabilities on capital
gains
 Premiums can result because such funds often have
inexpensive access to overseas stocks.
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Mutual Fund Costs
• Mutual funds charge shareholders a price or
fee
• Two types of fees are incurred by investors
– Load versus No-load Funds
• Load fund
• No-load fund
– Fund Operating Expenses
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Mutual Fund Expenses
• Types of Costs
•
– Shareholder fee or
sales charge
– Operating expense or
expense ratio
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Types of Loads
– Front end load
– Back end load
– Level load
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Types of Costs
Shareholder fee or sales charge
– related to the way the fund is sold and
distributed
– Two types of sales charges and
distribution
– Sales force Distribution (Active approach)
– Direct Distribution (Passive approach)
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Types of Costs
• Sales force Distribution
– takes place through intermediaries like
agents, brokers, or any other entity.
– This is an active approach.
– The sales person has to approach the
client
– The fund is typically sold not bought.
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Types of Costs
• Direct Distribution
– No intermediary is involved.
– Direct sale from company to investor.
– The investor has to approach the company.
– This is a passive approach.
– The fund is typically bought not sold.
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Types of Costs
Operating expense or expense ratio
– for investment managements
– Other expenses include primarily the cost of,
• 1) custody
• 2) the transfer agent cost,
• 3) independence public accountant fee, and
• 4) directors’ fee.
Sum of annual management’s fee, the annual
distribution fee and other expenses is called the
expense ratio.
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Loads
Load
– is a sales charge for the agent-distributed
fund.
Front end load
– The load is deducted initially at the time of
purchase of fund.
Back-end load
– wherein commissions are charged upon
redemption of funds.
Level load
– Imposed uniformly each year.
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The hidden load
Section 12b-1 funds/fee
– Charge a small percentage of assets annually
to cover sales costs
– Is a fixed annual fee
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Regulation
• The MUTUAL FUNDS are heavily
regulated to protect investors
• SEC is the primary regulator
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Assets in MMMFs, 2004 (in $B)
Total financial assets
Foreign deposits
Checkable deposits and
currency
Time and savings deposits
Security RPs
Credit and Market instruments
Open-market paper
Treasury
Agency
Municipal securities
Corporate and foreign bonds
Miscellaneous assets
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$1,879.9
75.4
0.6
174.1
239.2
1,260.8
395.3
96.4
262.2
318.8
188.1
129.7
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Hedge Funds
– They take the funds from individuals and institutions
and invest on their behalf.
– Can take position in derivative markets
– Invest in risky activities.
– Are free from regulations
– Can work within the country and abroad.
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Hedge Funds
 An aggressively managed portfolio of investments;
 the goal of generating high returns;
 Legally, hedge funds are open to a limited number of
investors and require a very large initial minimum
investment.
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Hedge Funds
 Investments in hedge funds are illiquid as they often
require investors keep their money in the fund for at
least one year.
 You can think of hedge funds as mutual funds for the
super rich.
 They are similar to mutual funds in that investments
are pooled and professionally managed, but differ in
that the fund has far more flexibility in its investment
strategies.
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Hedge Funds
– Offer opportunities to investors without a
legal cover
– Attract by offering good returns
– Can borrow money unlike mutual funds
– Liquidity is a problem, limited possibility of
withdrawal
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