Investments: Analysis and Behavior

Chapter 16- Mutual Funds

©2008 McGraw-Hill/Irwin

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Learning Objectives

Understand the structure and pricing of mutual funds Remember the differences between open-end, closed-

end and exchange traded funds Recognize the impact of expenses and taxes on fund

returns Assess mutual fund performance Know various types of mutual funds

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Mutual Funds An investment company that issues its portfolio shares to investors.

Money from shareholders are pooled and invested in a wide range of stocks, bonds, or money market securities. Managed by professional managers

Each investor shares proportionately in the income and investment gains and losses, as well as the brokerage expenses and management fees.

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1. Types of Mutual Funds

Open-end Funds Closed-end Funds Exchange Traded Funds (ETF)

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Open-End Funds

An open-end investment company is commonly called an open-end fund.

A mutual fund has no limit on the size of the fund or the number of shares outstanding.

Mutual fund shares are not sold to other investors. Instead, they are redeemed by the fund management.

The value of a mutual fund share is called its net asset value.

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Open-End Investment Companies

Insert Figure 21-1 here.

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Closed-End Funds

A closed-end fund has a fixed number of shares.When the market price exceeds its NAV, selling

at a premium, otherwise, selling at a discount Buy and sell like a stock.The pricing of closed-end fund shares is a

financial puzzle - they usually sell at a discount to their net asset value (NAV).

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Exchange Traded Funds (ETFs)

Exchange traded fund (ETF) is a form of closed-end fund, embedded with some features of an open-end fundTraded like a stock at stock exchangesShare price is very close to its NAVShares are redeemable!!

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2. Important mutual fund terms

Net Asset Value (NAV) Fees

Load: Expense ratio: 12b-1 fee:

Alpha Beta

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Net asset Value NAV: per share value of a mutual fund’s investment

holding.

Example

A mutual fund has $100 mil in assets and $3 mil in short term liabilities. 10.765 mil shares outstanding. What is the NAV?

Solution

($100 mil - $3 mil) / 10.765 mil = $9.0107 per share

gOutstandin Shares of #

sLiabilitie Portfolio Assets of ValueMarket NAV

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Types of Mutual Funds Objective Funds Hold Growth Potential Income Potential Stability

Money Market Funds          

Taxable money market Current income stability of principal

Cash investments None Moderate Very high

Tax-exempt money market

Tax-free income, stability of principal

Municipal cash investments None Moderate Very high

Bond Funds          

Taxable bond Current income Wide range of government and/or corporate bonds

None Moderate to high Low to moderate

Tax-exempt bond Tax-free income Wide range of municipal bonds None Moderate to high Low to moderate

Common Stock Funds          

Balanced Current income capital growth

Stocks and bonds Moderate Moderate to high Low to moderate

Equity income   High-yielding stocks, convertible bonds

Moderate to high Moderate Low to moderate

Value funds   Low P/E, P/B stocks Moderate to high Low to moderate Low to moderate

Growth and income   Dividend-paying stocks Moderate to high Low to moderate Low to moderate

Domestic growth Capital growth U.S. stocks with high potential for growth

High Very low Low

International growth   Stocks of companies outside U.S.

High Very low to low Very low

Aggressive growth Aggressive growth of capital

Stocks with very high potential for growth

Very high Very low Very low

Small cap   Stocks of small companies Very high Very low Very low

Specialized   Stocks of industry sectors High to very high Very low to moderate

Very low to low

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1) Load and No-Load Load funds is a sales charge.

If paid at the time of purchase, the fee is a front-end load.

If levied when shares are sold, the fee is a back-end load, or contingent deferred sales charge.

A no-load fund charges no sales commission.

Fees

Most mutual funds separate their charges into a number of categories.

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The Investment Company Industry : Fees

Insert Figure 21-2 here.

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Expense Ratio

Annual fee charges are calculated by a fund’s expense ratio, which is the fund’s total expenses expressed as a percentage of the fund’s assets. (range from 0.2% to 2%)management fee : includes salaries and

bonus paid to fund managers 12-b fees: advertising costs on to the

accountholders Other fees

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Expense Ratio

A mutual fund could have several classes of shares with different fee combinations.

Studies indicate thatExpense ratio is normally lowest for money

market mutual funds and highest for international stock funds

Tend to be lowest for large, liquid fundsThe lower the expense ratio, the better the

fund performance.

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The Investment Company Industry : Fees

Insert Figure 21-3 here.

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Fund A Fund B Fund C

Shareholder Transaction Expenses

Sales load imposed on purchases None None 4.75%

Sales load imposed on reinvested dividends None None 4.75

Redemption fees None None None

Exchange fees None None None

Annual Fund Operating Expenses

Management and administrative expenses 0.22% 0.60% 0.70%

Investment advisory expenses 0.02 — —

12b-1 marketing fees — 0.30 —

Marketing and distribution costs 0.02 — —

Miscellaneous expenses 0.03 0.32 0.26

Total Operating Expenses 0.29% 1.22% 0.96%

Expenses on a $10,000 Investment

1 year $ 30 $ 124 $ 587

3 years 93 387 823

5 years 163 670 1,077

10 years 368 1,477 1,805

Table 16.4A. Typical fee tables found in three different mutual fund prospectuses

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B. The impact of equity mutual fund costs on long-term investor returns.

Fund A Fund B Fund C

Initial investment $ 10,000 $10,000 $10,000

Day 1 10,000 10,000 9,525

5 years 18,189 17,451 16,186

10 years 33,084 30,565 29,689

15 years 60,178 53,145 52,416

20 years 109,458 92,743 92,539

Gross return 13.00% 13.00% 13.00%

Operating expenses 0.29% 1.22% 0.96%

Net return 12.71% 11.78% 12.04%

Fund A : typical cost efficient index fundFund B : conventional no-load stock mutual fundFund C : low-load stock mutual fund with less than typical annual operating expenses

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Figure 16.2 Impact of Costs and Taxes on 10% Return

$0

$500

$1,000

$1,500

$2,000

$2,500

$3,000

$3,500

$4,000

$4,500

$5,000

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40

Years

En

din

g V

alu

e

10% Return, no cost

10% Return, 1% cost

10% Return, 1% cost, 30% taxes

$4,526

$3,141

$1,152

Begin w ith $100

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Sources of Investment Returns

Total Return: dividend and interest income and realized and unrealized appreciation Income distribution: interest and dividend income after

expenses. Capital gains unrealized until the fund sells the shares

(Unrealized capital gains) The realized capital gains are paid out to shareholders at the

end of the year (capital gains distributions)

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Taxes

Shareholders pay taxes due once income dividends and capital gains distributions are received.

All income and capital gains distributions are generally subject to income taxes. Municipal bond or US T-securities interest income exempt

from federal taxes, but capital gains are taxable.

Turnover rate: expressed as a percentage of the fund’s average assets (average turnover rate for stock mutual fund: 79%)

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Selecting A Mutual Fund

before-load(gross) return

change innet asset

value

capital gainsdistributions

incomedistributions

beginning net asset value

+ +

=

after-load(net) return

change innet asset

value

capital gainsdistributions

incomedistributions

beginning net asset value

+ + -

=

loadfee

With a mutual fund, return comes from the change in net asset value, capital gains distributions, and income distributions.

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3. Fund Performance

Using ranking tools or portfolio evaluation tools (alpha, Sharp ratio, and Treynor measure)

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Style boxes

Value Strategy(Score <1.75)

Blend(1.75 Score

2.25)

Growth Strategy(Score > 2.25)

Large-cap (Top 5%)

S & P 500Benchmark

Mid-cap(Next 15%)

Wilshire 4500Benchmark

Small-cap(Bottom 80%)

Russell 2000Benchmark

• Characterize mutual funds by market capitalization (large, mid, and small cap)• Next, determine how cheap or expensive portfolio holdings are relative to the overall market using P/E and P/B ratios (Value, Blend and Growth)

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4. Selecting A Mutual Fund : Types of Funds

Insert Figure 21-4 here.

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Money market funds invest in short-term government securities and sometimes in short-term corporate securities. They are used primarily as a temporary cash haven.

Bond funds invest in fixed income securities. They vary widely, and have no common maturity date to simultaneously return the components to their par value.

Stock funds vary widely in their risk and price behavior. They are classified as growth or value, and as large-cap or small-cap.

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A balanced fund is a mixture of stocks and fixed income securities. It forces discipline on the fund manager.

An international fund is limited to buying securities registered outside the country where it is sold, while a global fund can invest anywhere in the world.

A fund of funds invests only in other mutual funds. Its diversification is good, but its expense ratio tends to be higher than that of the typical mutual fund.

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Sector : Such funds invest in specific market sectors, such as physical commodities or stocks closely tied to natural resources e.g. oil, forest products, and gold.

An index fund may be a stock or bond fund that tries to behave exactly like the market. A stock index fund, for instance, may seek to mirror the performance of the Standard & Poor’s 500 stock index.

Investors should determine their investment objective first, and then choose an appropriate fund or group of funds.

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Insert Table 21-2 here.

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Information Sources : Company Information The prospectus is a legal document

describing the operation of the fund, its management, and the fees accountholders must pay.

One important item in the prospectus is the fund’s portfolio turnover rate. A higher rate usually means higher expenses.

The Statement of Additional Information is required by the SEC, although it is generally only sent to accountholders upon their request. It is a more detailed version of the prospectus.

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Review

ConceptsOpen-end fund, closed-end fund, ETF load charge, NAV, 12-b fees, expense ratio,

alpha

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Sources of Information Lipper Inc.: leading provider of data and

analysis on the investment company business ( www.lipperweb.com )

Morningstar.com: provide unbiased data and analysis and candid editorial commentary (www.morningstar.com)

Vanguard Group: providing competitive investment performance and lowest operating expenses ( www.vanguard.com )