Chapter 4

MUTUAL FUNDS AND OTHER MANAGED INVESTMENTS

Chapter 4 Questions

What is a mutual fund?How does one compute the net asset value (NAV)?What expenses and changes might a mutual fund investor face?What does research on mutual fund performance tell about fund expenses, portfolio turnover, and returns?

Chapter 4 Questions

What is a good procedure for determining which mutual funds to purchase?When might it be appropriate to sell shares in a mutual fund?What are the similarities between mutual funds and some other managed investments?

Mutual Fund Growth

Mutual funds have become very popular investment vehicles.

Nearly $7 trillion in total assets in 2002.

Total assets have grown 600% since 1990.

What is a mutual fund?

Mutual funds are open-end investment companies.

The fund sells shares to the public and invests the proceeds in a pool of funds, which are jointly owned by the fund’s investors.

Computing Net Asset Value

For investors, the performance of their investment depends on what happens to the fund’s per share value, or net asset value (NAV).

NAV= Market Value of Assets – Liabilities

Number of Shares Outstanding

Mutual Fund Management

Most funds are started by investment management companies who hire the fund manager to make investment decisions. Fidelity, Vanguard, etc.

Usually offer many different funds and allow investors to switch between funds.Funds (open-end) sell additional shares to those who want to invest, redeem shares at the NAV (less any fees) to those who want to sell their shares.

Why invest with mutual funds?

Liquidity Funds buy and sell their own shares quickly, even

if fund investments are illiquid

Diversification Small minimum investment buys a typically well-

diversified investment

Professional management and record-keeping Expertise and services

Why invest with mutual funds?

Choice and flexibilityFamilies of funds offer a variety of

investments to match investor needs

IndexingSome funds track a broad market index

which insures that investors will earn the “market return”

Increasingly popular mutual fund alternative

Mutual Fund Drawbacks

Active trading contributes to high costs which lower fund returns

Tax consequences can be a disadvantageTax impacts of asset trading are passed

through to investorsTax bill can be large even when the NAV

falls

Mutual Fund Returns

Three sources of return:

Income distributions (ID)Bond interest, stock dividends

Capital gain distributions (CGD)Realized gains/losses from selling assets

Changes in NAV (NAV)From unrealized gains/losses from assets

Mutual Fund Returns

Return = (ID + CGD + NAV)/Beg.NAVBy dividing the sum of the three components of dollar returns by the beginning NAV, we have the mutual fund’s holding period return.Most mutual funds allow investors to either receive distributions in cash or to reinvest in additional shares.

Types of Mutual Funds

Funds can be classified according to the type of security in which they investStock FundsTaxable Bond FundsMunicipal Bond FundsStock and Bond FundsMoney Market Funds

Common Stock Funds

Most popular type of fundWide variety with different objectives and levels of riskGrowth Industry or sector fundsGeographic areas International or GlobalEquity Index funds

Taxable Bond Funds

Generally seek to generate current income with limited riskCan vary by maturity Short-term, Intermediate-term, Long-term

Can vary by type of bond Government Corporate Mortgage-backed International/Global Bond Index funds

Municipal Bond Funds

Provide investors with income exempt from Federal taxation

Often concentrate on single states to avoid state income taxation as well

Stock and Bond Funds

Seek to provide a combination of income and value appreciation.

Different namesBalanced fundsBlended fundsFlexible funds

Money Market Funds

Provide safe, current income with high liquidityInvest in money market securitiesT-bills, Bank CD’s, Commercial paper, etc.

NAV stays at $1; income either paid out or reinvested dailyProvide an alternative to bank deposits, but not FDIC insured

Mutual Fund Innovations

Life-stage fundsOffer different mixes of securities based on

the age of the investor

Supermarket fundsOffer a wide variety of funds with “one-

stop” fund shoppingTransfer services between fundsExpenses/fees can be high

Mutual Fund Prospectus

Must be available to investors and should be review by investors.

Contains: Fund’s investment objective Investment strategy Principal risks faced by investors Recent investment performance Expenses and fees Lots of other detailed information

Mutual Fund Expenses and Considerations

Loads Commission to the broker to financial advisor who

sold the fund to the investor For load funds, the offer price is the fund’s NAV

less the load (while no-load funds are sold at their NAV)

Load range from around 3% (low-load) to 8.5%

12b-1 Fees Fees deducted from the asset value of the fund to

cover marketing expenses An alternative to loads

Mutual Fund Expenses and Considerations

Deferred Sales Loads Redemption charges when fund shares are sold

(rather than when purchased) Often high (5-7%) if shares are sold within the first

year, but then fall over time, perhaps even disappearing eventually

Share Classes Many funds offer several different classes of

shares (A-B-C) with different fee structures Best choice usually depends of investment horizon

Mutual Fund Expenses and Considerations

Management FeesFees deducted from the fund’s asset value

to compensate the fund managersSome adjust fees according to the fund’s

performance

Expense ratioAdding all fees and calculating expenses

as a percentage of the fund’s asset

Mutual Fund Expenses and Considerations

Portfolio Turnover Not an explicit cost, but very important determinant

of shareholder returns Trading costs rise with turnover In order for high turnover to pay off, fund managers

must be successful in their active trading strategies

Sources of Information Wall Street Journal, Business Week Morningstar

Fund history, tax efficiency, risk analysis

Mutual Fund Return and Risk Performance

Return PerformanceOn a risk-adjusted basis, the average stock fund under-performs market averagesWhile portfolio managers seem to out-perform the market before expenses, net returns are below the market indexSome above-average performers over short time horizons, but such performance is not generally sustained (just luck?)These results help to explain the growing popularity of index funds

Mutual Fund Return and Risk Performance

Risk PerformanceWhile returns are not consistent, risk isObjectives lead to strategies that lead to varying degrees of investment risksReturn is positively related to the level of riskRisk is therefore an important consideration

Mutual Fund Return and Risk Performance

Fees and expenses: Do higher fees pay off?Investment performance is no better (and perhaps worse) for load funds vs. no-loadExpenses lower returns in predictable ways – lower expense funds give better returnsTurnover affects returns in several ways, including taxes – high turnover means more short-term realized gainsTax efficiency is an important consideration – after-tax returns may be 30-40% less than pre-tax

•Mutual Fund Investment Strategies

Choose in funds consistent with your objectives, constraints, and tax situation.Consider index funds for a large portion of your fund portfolio.When possible, invest in no-load funds with below-average expense and turnover ratios.Invest at least 10-20% in international or global funds.Own funds in different asset classes and consider life-cycle investing.

•Mutual Fund Investment Strategies

If you actively manage your portfolio, consider the past year’s “hot funds.”Do not attempt to time the market; timing strategies add little except costs and risk.Use dollar cost averaging by investing a set dollar amount each month.Avoid investing money shortly before the capital gain distribution dates (prospectus).Do not own too many funds. You will get average returns with high expenses.

When should you sell a mutual fund?

Personal considerations Portfolio rebalancing points due to life cycle

considerations Be aware of the quick trigger, selling on the first dip in

NAV; think long-term Be aware of capital gains with selling fund shares

Fund considerations Change in portfolio manager Change in investment style Fund is growing “too large” or “too fast” Persistent bad performance

Other Managed Investments

Closed-end investment companiesShares trade like stock rather than being bought and sold from the fundNumber of shares are fixedOften sell at a discount from NAV (a puzzle for modern finance)Often a means of investing in a pool of assets from a foreign country

Other Managed Investments

Exchange-traded funds (EFTs)Relatively new, yet very popularLike closed-end funds, they trade like individual stocksPassively managed to mirror a market index, both broad and narrowLow expenses, but do involve brokerage commissionsTax and liquidity concerns

Other Managed Investments

Variable AnnuitiesMany offered by insurance companiesOffers investors with choices of investments with tax-deferred growthInsurance product: payment in the case of death or else retirement income streamExpenses for both fund management and to pay for insurance, so fees tend to be much higher than with mutual fundsIncome stream taxed as regular income