Download II. How to Read a Mutual Fund Prospectus

Chapter 4: Mutual Funds
I.
Mutual Fund Basics
A regulated investment company pools and invests the funds of individuals with
common investment objectives in the financial securities of other companies.
Shareholders indirectly own the securities held by the fund and share proportionally
in the earnings of the company through capital gains and distribution of dividends.
Registered with the S.E.C.
Regulated under the Investment Company Act of 1940
(Note: Hedge Funds are NOT regulated)
The company is a conduit: all earnings and dividends are distributed, thus avoiding
taxes at the company level.
Established by the fund sponsor, and operated and managed by an investment
company hired by the sponsor. The investment company is compensated by various
fees and charges levied on the “shareholders” of the fund.
The Investment Company Institute monitors and helps develop policies, laws or
regulations that need to be adapted in order to promote the growth of the mutual
fund industry under Federal regulations.
2016 ICI Factbook!
Its membership includes open-end investment companies ("mutual funds") and
closed-end investment companies.
A.
Advantages of Mutual Funds
-
Low cost diversification
Costless switching within a family of funds
Professional management and record keeping
Pooled resources lowers fees & trading costs
Public information: Kipplinger’s, Morningstar, Value Line, Lipper
Analytical
FIN 330: Chapter 4, page 1
B.
Open-end Fund
Most common type of Investment Company
Shares are purchased directly from (or sold directly to) the fund
Share price is typically at net asset value (NAV) or at NAV plus load
NAV
=
(P x Q)/N
NAV is computed at the end of the trading day (4:00 p.m. ET). Any shares bought
or sold on that day are traded at the price, or the “offer price” which is NAV plus
load
Late day trading, trading after hours at the closing price, is illegal
The number of shares outstanding varies each day, depending on demand
The open-end fund always stands ready to buy or sell shares on demand at any time
of the day (the price will be the 4:00pm EST price)
FIN 330: Chapter 4, page 2
C.
Closed-end Fund
A “closed-end” fund is less popular than the open-end type
Shares trade like stock on the stock exchanges and over-the-counter (OTC)
Only a fixed number of shares are issued and the price of these shares is determined
by supply and demand and is not necessarily tied to the value of the securities held
by the fund
Historically, these funds often sell at prices below N.A.V., which indicates that
fund investors are not valuing the assets at their full value.
Various explanations have been proposed but none adequately justify the “deep
discounts” on many closed-end funds:
Stocks in the fund are “illiquid”
Accumulated tax liability for funds with large capital gains
Investors have less flexibility in timing their tax exposure in a fund
Managers may not add value
Disadvantages of closed-end funds include:
Because the closed-end share price are determined by supply and demand, out-offavor funds find prices falling below N.A.V. This makes it harder to sell
closed-end shares than to sell open-end shares.
-Shares from closed-end funds need to be purchased through a broker, like
corporate stock. Thus, commissions must be paid to buy the shares.
While shares are initially sold at a premium over N.A.V. (to cover startup
expenses), most fall below N.A.V. after the IPO.
FIN 330: Chapter 4, page 3
Closed End Fund Discount
For buyers, the opportunity to purchase a fund at a discount is a
key advantage of the closed-end structure. If a fund performs
well, investors may push the share price to a premium, or at least
a narrower discount. Thus shareholders reap the benefits not only
of the fund's NAV advance, but the exaggerated effects of its
market-price movement.
Central Securities CET is an example of a strong performer that
saw its price move from a discount to a premium--and then back
to a discount.
http://news.morningstar.com/doc/article/0,1,3549,00.html
FIN 330: Chapter 4, page 4
http://seekingalpha.com/article/115839-closed-end-funds-taking-it-on-the-chin
Midway through 2008, we looked at the closed-end funds that trade at the highest discounts to
their net assets. But the discounts we saw then pale in comparison to the discounts we see now.
Consider the largest discounts according to The Closed-End Fund Association ((CEFA)) now
versus six months ago.
We also saw that near the end of 2008, the median discount for closed-end funds rose
dramatically, so the rise in discounts we see in the table above shouldn't come as a large surprise.
Of course, this doesn't mean these funds are automatic buys. While investors may appreciate the
fact that they can buy assets for a discount in the form of closed-end funds, they should always
do their homework (i.e. read the fund's quarterly reports) to ensure they understand what they are
buying. For example, if fund holdings are out of date (due to declines in market value) or
illiquid, the book value may not be an accurate assessment of the value of the fund's underlying
holdings.
FIN 330: Chapter 4, page 5
II.
How to Read a Mutual Fund Prospectus
Fees and Expenses
A.
Loads
A “load” is a sales fee charged to the investor and paid to the broker who handles
the sale
A typical load (sales charge) is around 5%, meaning that a $100 investment will
buy only $95 worth of the mutual fund, with $5 going to compensate the broker
A load can be assessed when the share is purchased (front-end load) or when the
shares are sold (back-end or deferred load)
Many funds have graduated back-end loads that are reduced the longer the shares
are held and typically become zero at around six years
Mutual fund companies often issue different shares classes on the same underlying
assets
Share classes usually differ according to the load or sales fee charged. Thus,
depending on the investor’s investment time frame, they can choose the class that
will minimize these costs
Typically,
Class A has a front-end load and low (or no) 12b-1 fee
Class B, a graduated, deferred load and 12b-1 fee
Class C, higher 12b-1 fees, no load
Although shares with front-end loads may seem the least attractive, low expense
ratios may enhance your investment over the long term.
The key thing when considering fund fees is your time horizon.
FIN 330: Chapter 4, page 6
B.
Operating Expenses: 12b-1 Fees
Annual charges allowed by the SEC (1980) for marketing and distribution costs.
These annual charges are justified to cover costs for on-going “maintenance” of the
fund and to encourage brokers to continue to service existing clients
The maximum by law is .75% for marketing and distribution,
and .25% to compensate brokers
These charges are considered by some (many?) critics as an insidious means of
assessing additional fees on customers and are particularly objectionable since they
are charged every year, rather than just once like sales loads
C.
Operating Expenses: Management fees
Annual charges based on the value of the assets under management.
Average fees typically range from around 0.20% for index funds to 1.5% or higher
for aggressively managed stock funds.
Operating expenses (management fees and 12b-1 fees) are deducted directly from
the NAV when calculating the return, for the Fund.
Return
=
NAV1 – NAV0 + distributions
NAV0
Loads, transfer fees (exchanges between accounts), and account maintenance fees
are deducted directly from the investor’s account.
FIN 330: Chapter 4, page 7
D.
Return
Time-weighted return: Links intra-period returns geometrically
Date
Cash Flow Balance
Beg.
1,150
-----1,100
$ 80
1,180
-----1,220
$100
1,320
End
1,380
7/1
7/31
8/1
8/31
9/1
9/30
Period 1:
V1/V0
=
1+R1 =
Period 2:
V2/V1
=
1+R2 =
Period 3:
V3/V2
=
1+R3 =
Average return
=
Dollar-weighted return: Computes the IRR
$1,150
(1+r)0
+
$80
(1+r)1
+
$100
(1+r)2
=
$1,380
(1+r)3
$1,150
(1+r)0
+
$80
(1+r)1
+
$100
(1+r)2
-
$1,380
(1+r)3
-
=
0
If fund managers can control cash inflows and outflows, the dollarweighted method is appropriate.
FIN 330: Chapter 4, page 8
Comparing the time-weighted and dollar-weighted methods
A fund earns 20% in 1995, 20% in 1996 and –20% in 1997.
The fund starts with $1 million in 1995, then attracts $1 million of additional funds
in 1996, and finally another $8 million in 1997.
Compute the average annual rate of return.
Time-weighted:
Geometric average = [(1 +r)(1+r)(1+r)] 1/3 – 1
G
=
[(1.2)(1.2)(.8)]1/3 – 1
=
.0483 =
4.83%
Dollar-weighted:
$1(1.2)
=
+
=
1.2
1.0
2.2(1.2)
=
+
=
2.64
8.00
10.64(0.8)
$8.512mil
(1+r)3
$1mil +
(1+r)0
$1mil +
(1+r)1
$8mil (1+r)2
IRR =
- .1187
=
=
8.512 = ending balance
-11.87%
FIN 330: Chapter 4, page 9
III.
Benchmarking
A.
Fund Objective/Category
The objective is stated in the mutual fund prospectus, as required by law
It describes the investment goals and the asset types that the fund will specialize in.
Example:
“Long-term capital gain with low income and low tax
exposure”
“Capital appreciation with income and emphasis on
preservation of value”
Typical classifications identifying different fund objectives:
Stock Funds: Aggressive Growth, Growth, Growth and Income
Bond Funds: Investment Grade, Speculative-Grade, etc.
Balanced Funds: Stocks and Bonds (growth with income)
Specialty Funds: Gold, Sector,
International-Diversified, International-Specialized, Global
Each classification has a meaning within the industry and provides clues as to the
assets types that will be included in the fund
MORNINGSTAR SCREEN
Growth vs Value 1
Growth vs Value 2
FIN 330: Chapter 4, page 10
Example of Mutual Fund Objectives/Categories:
A fund's investment objective will usually seek capital gains (gains from the sale of
securities), income (interest and dividends earned on the securities) or a
combination of both.
Money Market: A money market fund seeks safety of principal by investing in
high quality, short-term securities. This type of fund is designed with the aim that
an investor's principal should not decrease in value. There is no guarantee, how
ever, that this will always be the case. A money market fund seeks to provide a
regular distribution of income which is determined by short-term interest rates.
Growth: A growth fund invests primarily in the common stock of well established
companies. This type of fund may invest for long-term capital gains and is not
intended for an investor who seeks income.
Aggressive Growth: Like a growth fund, an aggressive growth fund will invest
primarily in common stock for long-term capital gains. An aggressive growth fund
may invest in the common stock of small companies, out-of-favor companies or
companies in new industries. It, therefore, has a higher degree of risk than a basic
growth fund.
Income: An income fund invests in either corporate, govern ment, or municipal
debt securities. A debt security is an obligation which pays interest on a regular
basis. Hence, this type of fund is designed for investors who desire periodic income
payments. There are, however, substantial differ ences and varying degrees of risk
among income funds depending on the credit quality of the debt issuer, the maturity
of the debt instrument, and prevailing interest rates.
High Income: This category of income fund seeks to achieve a high degree of
income by investing a material portion of its portfolio in below investment grade
debt securities or junk bonds. These funds have a high degree of risk and should be
purchased by investors who can incur the risk of loss of principal.
Balanced: A balanced fund, as the name implies, invests for both growth and
income. The fund will invest in both equity and debt securities. A balanced fund
seeks to provide long-term growth through its equity component as well as income
to be generated by the portfolio's debt securities.
http://www.sec.state.ma.us/sct/sctprs/prsamf/amfidx.htm
FIN 330: Chapter 4, page 11
B.
Fund style
Investment style typically refers to the type of company in which the fund invests
Equity fund styles generally extent along two axis: Growth/value & Size
“Small-cap, growth” indicates that the fund invests in small, riskier companies that
are looking for exceptional growth in earnings and price appreciation
“Small-cap, value” style would look for small companies that are (temporarily) out
of favor and selling at low prices: low P/E, low price-to-sales ratio, and low priceto-book ratio
Size
Large
Med
Small
Value
Blend
Growth
Style
Equity Fund
Fixed income styles also extend along two axis: credit quality and duration
Credit Quality
High
Medium
Low
Low Medium High
Interest Rate Sensitivity
FIN 330: Chapter 4, page 12
Turnover rate
A fund’s turnover rate is an indication of how often the fund trades and reflects
how aggressively the fund managers are managing the fund
A high turnover rate implies higher costs (transactions and management fees) and
lower tax efficiency
Investors should be wary of funds with excessive turnover, since historically it is
very difficult for professional managers to consistently “beat the market”
Low turnover rates (< .30) indicates a more passive investing strategy, while high
rates (>1.00) indicates active investing
Passive Investing
Index funds promote this strategy. In the long-term, few funds beat the index
Most of the difference in fund performance is related to asset allocation: how much
is invested in broad asset classes such as equities, bonds, and cash
Active Investing
Active managers who consistently beat their benchmarks by 1-2 percentage points
are considered exceptional
Sector rotation and market timing involves moving funds between sectors
(industries) or asset classes based on economic forecasts
The proper role of active portfolio managers involves active examination of
primary and secondary information sources
Fund managers often “follow the herd”
Tax Efficiency
Tax efficiency compares pretax to post-tax returns. A tax-efficient fund defers
capital gains, and avoids investing in income generating assets.
FIN 330: Chapter 4, page 13