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24Mutual Fund

Operations

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Chapter Objectives Explain the concept of mutual fund operation Explain various types of mutual funds Describe the various types of stock and bond

mutual funds Describe the characteristics of money market

funds

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Background on Mutual Funds Mutual funds offer a way for small investors to

diversify when they could not do so on their own with the purchases of individual stocks

Comparison to depository institutions Like depository institutions, mutual funds repackage

proceeds from individuals to make investments Bank deposits are a liability contract, but a mutual

fund represents partial ownership No federal insurance with mutual fund shares

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Background on Mutual Funds Mutual funds adhere to a variety of federal and

state regulations Securities and Exchange Commission (SEC) regulates Funds must register and provide a prospectus to

investors Disclosure since 1993 of manager’s name and length

of time employed in that position Mutual fund itself is exempt from income

taxation if fund distributes 90 percent of taxable income

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Background on Mutual Funds Mutual fund prospectus information includes:

The minimum amount of investment required The investment objective of the fund The return on the fund over the past year, the past three

years and the the past five years The exposure of the fund to various types of risk Services the fund offers

Check writing Telephone or Internet funds transfer

Management fees incurred that investors pay

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Background on Mutual Funds Estimating the net asset value

Net asset value is the value per share Estimated daily

Determine the market value of all the securities in the fund

Any interest or dividends added in Expenses subtracted Divide by the number of shares Dividends lower NAV NAV quotes

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Mutual Fund Distributions

Mutual Fund Price Appreciation

Capital Gains from the Sale of Securities in Fund

Earned Income from Dividends or Coupon Payments

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Background on Mutual Funds Mutual fund classifications depend on the type

of securities the fund invests in and can include Stock or equity mutual funds Bond mutual funds Money market mutual funds

Family of funds offered by investment companies Investor able to allocate then transfer funds among

funds

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Exhibit 24.2 Distribution of Investment in Mutual Funds

Stock Funds$3,962 billion

57%

Bond Funds$808 billion

11%

Hybrid Funds$349 billion

5%

MoneyMarket Funds$1,845 billion

27%

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Background on Mutual Funds Management of mutual funds

Managers invest in a portfolio of securities to meet the objectives of the fund

Cover management costs with fees which are typically around one percent of total assets per year

Managers adjust the composition of their portfolios in response to market and economic conditions

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Background on Mutual Funds Expenses

Fees include management plus record-keeping and clerical fees

Expense ratio = annual expenses/fund NAV Passed on to investors since NAV is reduced by

fees Investor should compare expense ratios

Active marketing expenses and compensation increases expenses—12b-1 expenses

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Background on Mutual Funds Corporate control by mutual funds

Mutual funds are large shareholders in companies whose stock they hold

Managers may serve on the board of directors of companies in which the fund invests

Companies try to satisfy mutual fund managers in order to keep them from selling their stake in the firm

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Load versus No-Load Mutual Funds Classification refers to whether or not there is a

sales charge No-load means funds are promoted, bought and

sold directly via the mutual fund Load funds

Promoted by registered representatives of brokerage firms who get a commission

Investors pay the sales charge 12b-1 expenses are “loads” used by no-load funds

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Open-End versus Closed-End Funds Closed-end funds

Mutual fund does not repurchase the shares they sell—similar to direct common stock investment

Investors must sell shares on an exchange Number of outstanding shares is constant Value of shares related to expectations of portfolio and

determined in market Open-end “mutual” funds

Willing to repurchase investor shares at any time Number of shares outstanding does not remain constant NAV determined by fund daily

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Stock Mutual Fund Categories Growth funds for investors who want high

returns with moderate risk Mutual fund invests in companies that are expected

to grow at a higher than average rate Generate an increase in investment value rather than

steady income Capital appreciation or aggressive growth funds

High but unproven growth potential stocks Higher risk

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Stock Mutual Fund Categories Growth and income funds try to offer growth

but with some stability of income International and global funds allow investment

in foreign securities without the costs involved in purchasing and monitoring individual stocks Returns affected by stock prices Returns also affected by foreign exchange rates

A global mutual fund invests in some U.S. stocks

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Stock Mutual Fund Categories Internet funds focus on investments in Internet

companies Specialty funds focus on a group of companies

sharing a particular characteristic Index funds are designed to simply match the

performance of an existing stock index Multifund funds invest in a portfolio of different

mutual funds More diversified Involves higher expenses

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Exhibit 24.3 Growth in Number of Equity and Bond Funds

Year

0

1000

2000

3000

4000

5000

6000

7000

8000

Bond Funds

S tock Funds

200119991995199019851978

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Exhibit 24.4 Investment in Bond and Stock Mutual Funds

Year

0

1000

2000

3000

4000

5000

Bond Funds

Stock F unds

2000199919981997199619951994199319921991199019891988198719861985

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Exhibit 24.5 Distribution of Aggregate Mutual Fund Assets

Common Stock$3,882 Billion

76%

Municipal Bond$269 Billion

5%Long-Term U.S. Gov’t

$309 Billion6%

Cash$277 Billion

5%

Corporate Bonds$349 Billion

7%

Preferred Stock$28 Billion

1%

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Bond Fund Investment Objectives Risks of bond funds

Interest rate risk Credit risk

Tax implications of bond fund investments Income bond funds vary in terms their exposure

to credit risk and focus on periodic coupon payments and attract investors who are Interested in periodic income since prices are volatile Plan to hold the fund long term

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Bond Fund Investment Objectives Tax-free funds for high tax bracket investors High-yield or junk bond funds invest in bonds

with a high risk of default International and global bond funds

International bond funds contain bonds issued by governments or corporations from other countries

Global funds may contain both U.S. and foreign bonds

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Bond Fund Investment Objectives Maturity classifications

Interest rate sensitivity depends on the maturity of bonds

Funds are typically segmented based on maturity Intermediate-term funds invest in bonds with 5 to 10

years remaining to maturity Long-term funds invest in maturities of 15 to 30 years

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Bond Fund Investment Objectives Asset allocation funds

Funds that contain a variety of investments Composition among stocks, bonds and money

market securities is based on manager’s expectations

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Growth and Size of Mutual Funds Volume and mix in the kind of funds varies

over time Overall investment via mutual funds much

higher in recent years New kinds of funds target customers with

different risk preferences

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Performance of Stock Mutual Funds Both investors and managers closely monitor

performance as modeled by the equation below

PERF = Performance

SECTOR = Conditions in the fund’s sector

Where:

PERF= f ( MKT, SECTOR, MANAB)

MKT = General stock market conditions

MANAB = The ability of the fund’s management

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Performance of Stock Mutual Funds Change in market conditions

Close relationship between performance and market conditions

Change in sector conditions Depends on the focus of the fund

Index funds Asian funds

Change in management ability includes both managers’ skills and operating efficiency

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Performance of Stock Mutual Funds Performance of closed-end stock funds

Driven by the same factors that influence open-ended funds

Fixed supply of the fund’s shares Additional issues

Performance is affected by changes in the premium or discount relative to NAV

If the fund’s premium increases relative to NAV, return to fund holders increases

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Performance of Bond Mutual Funds Performance of bond mutual funds as shown

in the model below PERF= f ( Rf, RP, CLASS, MANAB)

PERF = Performance

RP =Risk premium

Where:

Rf = Risk free interest rates

CLASS =the classification of the bond fund

MANAB = The ability of the bond fund’s management

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Performance of Bond Mutual Funds Change in the risk free rate

Bond prices are inversely related to the risk- free rate

When rates decline, most bond funds perform well Change in the risk premium

If required risk premiums increase, bond prices fall Linked to economic condition:

Risk premiums increase in recessions Risk premiums decrease in boom times as investors buy

riskier investments

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Performance of Bond Mutual Funds Impact of the bond fund’s classification

Some funds target a specific risk or maturity Classification may have more impact than any

other factor Change in management abilities Performance of closed-end bond funds is

affected by all of the other factors and changes in the premium or discount

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Performance of Mutual Funds Investors should diversify among different kinds

of funds to reduce volatility Research on stock mutual fund performance

Using return only is not valid Mutual funds typically do not outperform the market Evaluate mutual fund expenses

Research on bond mutual funds Bond mutual funds underperform bond indexes Investors should look for low expense bond funds

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Money Market Funds Money market funds are portfolios of short-

term assets Can include check-writing privileges for investors Number of checks per month may be restricted Shareholders get periodic statements Liquid, “cash” balance for investor

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Money Market Funds Asset composition of money market funds

Individual funds concentrate in assets that reflect the fund’s objective

Money market securities of varying maturity Maturity of money market funds

Varies over time with market conditons Risk increases with term

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Exhibit 24.7 Composition of Money Market Fund Assets

U.S. TreasurySecurities$91 billion

6%

Other$303 billion

20%

Commercial Paper$620 billion

41%

CDs$123 billion

8%

RepurchaseAgreements$186 billion

12%

Other U.S. Securities$189 billion

13%

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Money Market Funds Risk of money market funds

Credit risk minimized by the short-term nature of maturities

Returns for money market funds fall as interest rates in the economy fall

Expected returns are low relative to stock and bond funds Consistent positive returns over time Lower credit risk Lower interest rate risk

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Money Market Funds Management of money market funds

Managers try to maintain the overall objective of the fund

Manage the composition of the assets Investors have a variety of choices when it comes

to money market funds

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Money Market Funds Regulation of money market funds

Securities Act of 1933 requires that funds provide full information to investors via a prospectus

Investment Company Act of 1940 contains restrictions to prevent conflicts of interest between investors and mangers

Funds are exempt from tax if 90% of earnings are distributed to shareholders

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Hedge Funds Financial problems experienced by Long-Term

Capital Management (LTCM) Hedge funds sell shares to wealthy investors and

financial institutions Historically unregulated Invest in derivatives, sell stock short, and combine

borrowing to magnify returns LTCM experienced problems when risky

investments lost money

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Real Estate Investment Trusts A real estate investment trust or REIT is a closed-

end mutual fund that invests in real estate or mortgages

Classifications Equity REIT Mortgage REIT Hybrid of the two

Sometimes seen as an inflation hedge Performance influenced by interest rates and area

real estate performance

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Other Issues Mutual funds interact with banks, savings

institutions, finance companies, securities firms, insurance companies, and pension funds

Mutual funds typically use all the various financial markets including money, bond, mortgage, stock, futures, options, and swap markets

Globalization is facilitated by mutual funds Reduces transactions costs Increases market integration