Download Direct marketing of funds

Mutual Funds
• Definition
• Risk and Return Relationship
• Pros and Cons of Investing in Mutual Funds
• Structure of a Mutual Fund and a Commercial Bank
• History of Mutual Funds
• Challenges Facing the Industry
Copyright © Houghton Mifflin Company. All rights reserved.
1–0
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)
Copyright © Houghton Mifflin Company. All rights reserved.
1–1
Seeking Higher Returns
• Objective is to maximize return with minimum
risk
• Efficient Market hypothesis and undervalued
securities
• Behavioral Finance
• Mean reversion in the equity market
• Individual securities have two main sources
of risk: alpha and beta.
Copyright © Houghton Mifflin Company. All rights reserved.
1–2
Definitions for Returns
• Return = Interest or Dividends +/- Price Change
Initial Investment
• Risk = Variation (or range) of possible returns
• Goal => Maximize return and minimize risk
Copyright © Houghton Mifflin Company. All rights reserved.
1–3
Seeking Higher Returns
(for Same Risks)
• Random walk
– No predictable relationship between past
changes and future changes in stock
prices
– Based on extensive empirical studies
Copyright © Houghton Mifflin Company. All rights reserved.
1–4
Seeking Higher Returns
(for Same Risks) (cont.)
• 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
Copyright © Houghton Mifflin Company. All rights reserved.
1–5
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
Copyright © Houghton Mifflin Company. All rights reserved.
1–6
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, tax
reporting, retirement planning, educational materials.
Copyright © Houghton Mifflin Company. All rights reserved.
1–7
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
Copyright © Houghton Mifflin Company. All rights reserved.
1–8
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.
Copyright © Houghton Mifflin Company. All rights reserved.
1–9
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
or rep wraps
– Pre-packaged model portfolios
– “Baskets” available through the internet
Copyright © Houghton Mifflin Company. All rights reserved.
1–10
Assets of Mutual Funds
1985–2000
$ Billion
$6,967 B
7,000
6,000
Money Market
Funds
5,000
4,000
3,000
2,000
Stock and
Bond Funds
1,000
0
1985
1987
1989
1991
1993
1995
1997
1999
Source: Investment Company Institute (ICI)
Copyright © Houghton Mifflin Company. All rights reserved.
1–11
Growth of Financial
Intermediaries*
$ Billions
7,000
Mutual Funds
6,000
Commercial
Banks
5,000
4,000
Life Insurance
3,000
2,000
Savings /
Credit Unions
1,000
0
1990R
1992R
1994
1996
1998
2000
* Excludes bank-administered trusts and closed-end investment companies
Source: Federal Reserve Board, Federal Financial Institutions Examination Council, ICI
Copyright © Houghton Mifflin Company. All rights reserved.
1–12
Structure of a Mutual Fund
Copyright © Houghton Mifflin Company. All rights reserved.
1–13
Mutual Fund Complex
Stock Funds
Shareholders
(Savers)
Fixed Income
Funds
Money Market
Funds
Management
Company
Broker
Distribution
Transfer
Agency
Copyright © Houghton Mifflin Company. All rights reserved.
1–14
Structure of a
Commercial Bank
Copyright © Houghton Mifflin Company. All rights reserved.
1–15
MM Fund Versus
Bank Deposit
MM 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 Generally cannot loan more
issuer
than 15% to one borrower
• Rate of Return
Copyright © Houghton Mifflin Company. All rights reserved.
1–16
MM Fund Versus
Bank Deposit (cont.)
MM Fund
Bank Deposit
• Risk
95% must be in highest rated
paper; average 90-day security
maturity; no FDIC insurance
Loans subject to credit review;
try to match asset maturity to
liabilities; FDIC insurance
($100K)
• Capital
Management company, not
fund, has capital; no regulatory
requirement or guarantee
Banks must have capital
meeting meeting regulatory
requirements; 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
contract
Copyright © Houghton Mifflin Company. All rights reserved.
Primarily spread income from
principal risk
1–17
History of Mutual Funds
• 1940: Investment Company Act
– established standards for fund promotion,
reporting, product pricing, and portfolio
investing.
• 1950-60s: Industry experience growth.
• 1970s: Stock market declined. Difficult to sell
stock fund. Investors interested in short-term
or income-oriented investments
Copyright © Houghton Mifflin Company. All rights reserved.
1–18
History of Mutual Funds (Cont’d)
• 1970s: Money market funds were created
and became the savior of the industry.
• 1980s: High interest rate atmosphere. Banks
were legally prevented from paying more than
4% - 5% interest. MM assets exceeded either
stock or bond fund assets.
• 1990s: Spectacular growth in mutual fund
industry. $800b in 1987 to $5t in 1999.
Copyright © Houghton Mifflin Company. All rights reserved.
1–19
History of Mutual Funds (Cont’d)
• Factors behind the rapid growth:
– Bull market in U.S. stock.
– Tax-advantaged retirement vehicles
– attractive mutual fund products
– enhanced services to fund shareholders.
• Distribution channels & pricing structures:
– Broker - Dealers are the traditional distribution
channel
Copyright © Houghton Mifflin Company. All rights reserved.
1–20
History of Mutual Funds (Cont’d)
– Front-end load declined from 81/2% in 1960 to
~4% now.
– Currently broker-dealer may charge ‘back-end’
load. The load declines based on the length of
investment.
– Annual distribution fee 12b-1paid by the fund to
the distributor. Range is from 25 bp to 75bp.
Copyright © Houghton Mifflin Company. All rights reserved.
1–21
History of Mutual Funds (Cont’d)
• Direct marketing of funds:
– MMF spurred direct marketing
– ‘no-load’ funds. Charges are low- around
2%-3% and 12b-1 around 25bp.
• Retirement Plan:
– Attractive service providers to plan
sponsors of 401(k) and other defined
contribution plans.
Copyright © Houghton Mifflin Company. All rights reserved.
1–22
History of Mutual Funds (Cont’d)
– Employees can choose to contribute in specific
funds. Fund Co provides disclosure documents
and educational materials to each employee.
– In most cases sales loads may be waved and
service fees may be negotiated .
Banks and Insurance Cos :
– Glass-Steagall prohibition? Banks found ways to
offer their own or other’s funds to their customers.
– Insurance Co- joint venture with funds to offer
variable annuities
Copyright © Houghton Mifflin Company. All rights reserved.
1–23