Investments: Analysis and Behavior

Chapter 16- Mutual Funds

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Learning Objectives

Understand the structure and pricing of mutual funds Know the advantages and disadvantages of buying mutual

funds Be able to assess mutual fund performance Assess mutual fund manager incentives Recognize the impact of taxable distributions on fund

returns

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Mutual Funds An investment company that issues portfolio shares to investors. Money from shareholders invested in a wide range of stocks, bonds, or

money market securities.– Managed by professional managers

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

Open end fund: # of shares issued solely depends on investor demand.– Bought and sold directly through the investment company (not an

exchange)

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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

Table 16.1 Types of Mutual Funds

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Sources of Information Morningstar.com: provide unbiased

data and analysis and candid editorial commentary (www.morningstar.com)

Lipper Inc.: a provider of data and analysis on the investment company business (www.lipperweb.com)

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

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Mutual Fund Advantages Broad diversification

– Diversified stock funds hold large and small company stocks broadly spread across industries and economic sectors

– Diversified bond funds hold bonds with different maturities, coupon, and credit quality

Ability to retain professional investment management at a reasonable cost.

Investor convenience Many offer a “fund family” with lots

of investment options.

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Mutual Fund Disadvantages Volatility can be significant

Diversification doesn’t protect investors from the risk of loss from an overall decline in financial markets.

Mutual fund regulation doesn’t eliminate the risk of an investment falling in value.

High management fees and sales commissionsSome funds charge very high management fees.Some funds charge very sales commissions.

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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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Mutual fund expenses

Operating expense ratio: total of investment advisory fees and costs of legal and accounting services, etc., expressed as a percentage of the fund’s average net assets (range from 0.2% to 2%)

– Lowest for money market mutual funds and highest for international stock funds

– Tend to be lowest for large, liquid funds Load charges: one time sales commissions

– Front-end loads (charged at the time of purchase)

– Back-end loads (charged at the time of sales of shares)

– Low-end funds: sales fee ranging from 1% to 3%

– 12b-1 fees: marketing and distribution costs

– No-load funds: fund without front-end or back-end load charges

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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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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 16.3 Yahoo! Finance Gives Detailed Information about Mutual Fund Style and Fees

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Figure 16.4 Dreyfus Appreciation Fund Performance from Yahoo! Finance

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Figure 16.4 Dreyfus Appreciation Fund Performance from Yahoo! Finance (cont.)

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Figure 16.4 Dreyfus Appreciation Fund Performance from Yahoo! Finance (cont.)

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Hedge Funds

Like mutual funds, hedge funds allow investors to pool financial resources.

Typically organized as partnership and available only to the wealthiest investors.

Flexibility to use speculative investment strategies, subject to limited oversight.– High fees (2% of assets plus 20% of returns is common.)

Hedgefund.net tracks nearly 3,000 hedgefunds

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Table 16.7 Hedge Funds Differ From Mutual Funds in a Number of Ways

Mutual Funds Hedge Funds

Who Invests 92 million Americans own mutual fund shares. The only qualification for investing is having the minimum investment to open an account with a fund company ‑‑ often $1,000 or less.

Only sophisticated, high net worth investors are eligible to invest. The typical investor is a wealthy individual or an institution such as an endowment or foundation. A minimum investment of $1 million or more is required.

Fees Mutual fund shareholders pay, on average, an annual expense ratio of roughly 1.5% of assets. Load charges can increase this to 2.5% to 5% per year. Funds must disclose fees and expenses in detail. Sales charges and other distribution fees are subject to specific regulatory limits.

Hedge fund investors often pay a portfolio management fee of 1% to 2% of net assets, plus a performance-based fee that can run as high as 10% per year, depending upon performance. Fees are not subject to specific regulatory limits.

InvestmentPractices

Securities laws restrict a mutual fund's ability to leverage, or borrow against the value of securities in its portfolio. Funds that use options, futures, forward contracts, and short selling must "cover" their positions with cash reserves or other liquid securities. Investment policies must be fully disclosed to investors.

Leveraging strategies are hallmarks of hedge funds. Investment policies do not have to be disclosed, even to investors in the fund.

Pricing andLiquidity

Mutual funds must value their portfolio securities and compute their share daily. They generally must also allow shareholders to redeem shares on at least a daily basis.

There are no specific rules on valuation or pricing. As a result, hedge fund investors may be unable to determine the value of their investment at any given time. In addition, new investors typically must pledge to keep their money in a hedge fund for at least one year.

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Taxes on distributions

Shareholders pay taxes on dividends and capital gains distributions.

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.