Mutual Funds and Other

Investment Companies

Chapter 4

Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

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4.1 Investment Companies

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Services of Investment Companies

a. Administration & record keeping

Tax purposes

Low cost reinvestment

Low cost additional investment, DCA

Low cost switching between fund families

Some funds may allow check writing privileges

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Services of Investment Companiesb. Diversification

c. Professional management

d. Reduced transaction costs

e. Investing for retirement: Most funds can be set up as an IRA

Lower research costs

Portfolio managed according to specific objectives

Professionals to find undervalued securities and/or engage in asset allocation strategies

Low cost, instant diversification

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4.2 Types of Investment Companies

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Organizational FormsUnit Investment Trusts (UITs): unmanaged, fixed composition portfolios

Any interest and/or dividends are distributed immediately to trust certificate holders.

Provide diversification within one sector or area and low cost entry.

Often levered, rates of return can be extreme.

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Organizational FormsA managed investment company (mutual fund) may be

Open end– shares are bought from the fund and redeemed by

the fund or

Closed end

– shares are bought and sold among investors in the marketplace (NASDAQ or an exchange) and the fund itself is not involved.

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Differences in Open & Closed EndMost funds are open end:

The advantage of the open end form is

The disadvantage of the open end form is

Liquidity for the investor

Fund’s ability to grow (advantage for the fund or sponsor)

The need to keep a cash reserve

Vulnerable to panics

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Other Investment Organizations

– Commingled funds• Partnerships of investors that pool their funds.

Designed for trusts or larger retirement accounts to get professional management for a fee. Operates similar to a mutual fund.

– REITs• Similar to closed end fund. Invest in real estate and

real estate loans.Equity trusts purchase real estate.

Mortgage trusts invest in mortgage and construction loans.

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Other Investment Organizations Cont.

– Hedge Funds• Similar to mutual funds, but not registered and

not subject to SEC regulations.• Available to institutional and high net worth

investors• Can pursue investment strategies that are not

allowed for mutual funds. – Grew from about $50 billion in 1990 to about $2

trillion in 2008.

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4.3 Mutual Funds

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Net Asset Value

Used as a basis for valuation of investment company shares– Selling new shares– Redeeming existing shares

Calculation

goutstandin shares Fund

sLiabilitie Fund AssetsFund of ValueMarketNAV

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Open-End and Closed-End Funds: Key Differences

Shares OutstandingClosed-end: no change unless new stock is

offeredOpen-end: changes when new shares are sold or

old shares are redeemed

PricingOpen-end: Fund share price = Net Asset Value

(NAV)Closed-end: Fund share price may trade at a

premium or discount to NAV

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NAV calculation

ABC Fund ($Millions except NAV)

Market Value Securities

+ Cash & Receivables

- Current Liabilities

NAV Total

# Fund Shares

NAV

$550.00

75.00

(20.00)

$605.00

20.00

$ 30.25

Most Mutual Funds have little or no Long Term Debt

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How Funds Are Sold

Directly marketed– –

•

Sales force distributed– – –

•

You find them

May avoid front end load

Front end load is an up front cost (fee) to purchase a share of a mutual fund.

Recommended by a broker or planner

Usually will have a front end load

May be revenue sharing on sales force distributed

Potential conflict of interest

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Potential Conflicts of Interest: Revenue Sharing

Brokers put investors in funds that may that ____________________________

Mutual funds could direct trading _____________________

Revenue sharing is _________ but it must be ________ to the investor

may not be the most appropriate

to higher cost brokers

not illegal

disclosed

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Different Funds based on Investment Objectives & Styles

1. Domestic Stock Funds

a. Aggressive Growth, Growth, Growth & Income, Value, etc

b. Large Cap, Mid Cap, Small Cap, etc

2. Index - passively managed

a. Borad market, Industry, International, etc

3. Fixed Income

a. Government(s), Corporate bonds, etc

4. International

a. Stocks, Bonds, Emerging Markets, etc

5. Money market funds

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Table 4.1 U.S. Mutual Funds by Investment Classification, 2008

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Trading Scandal with Mutual FundsLate trading:

allowing some investors to purchase or sell after NAV has been determined for the day

Market timing: allowing investors to buy or sell on stale net asset values– International: fund NAV may be based on prices in

foreign markets which close at different times. A U.S. mutual fund specializing in Japanese stocks may create an exploitable opportunity since the Japanese markets close before ours, at which time the fund’s NAV will be set.

If the U.S. markets subsequently go up late in the day, probably Japanese stocks will go up the next day, driving up NAV for the fund the next day.

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Potential ReformsStrict _____________ with late orders

executed the following trading day

________________ with net asset values being adjusted for trading in open markets

Imposition of __________________________________

4:00 PM cutoff

Fair value pricing

redemption fees on holdings < 1 week

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4.4 Costs of Investing in Mutual Funds

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Costs of Investing in Mutual FundsFee Structure

–

–

Operating expenses–

12 b-1 charges–

–

–

Front-end load

Back-end load (contingent), (redemption fee)

Buying and selling commissions, administrative expenses and advisory fees for the managers

Marketing costs paid by the fundholders

Alternative to a load, but assessed annually

Maximum is 1% of assets

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Costs of Investing in Mutual Funds

Fees, loads and performance– Gross performance of load funds is

statistically identical to gross performance of no load funds

– Why pay a load charge?

– Funds with high expenses tend to be poorer performers.

• 12 b-1 charges should be added to expense ratios• Costs found in the fund prospectus and may be

compared via Morningstar

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NAV and the Effective LoadCost to initially purchase one share of a load fund = NAV + front-end load (%) (if any).

Stated Loads typically range from ________ If you invest $10,000 in a fund with an 8.5% front-end load,

you actually acquire shares worth $9,150; the other $850 goes to the broker.

The load is designed to offset expenses of marketing the fund and goes to the broker who sells the fund to the investor.

The effective load is greater than the stated load: In the above example, the actual % commission cost (effective load) is:

– $850 / $9150 = 9.3%; which is > stated load.

0 to 8.5%

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Costs of Investing in Mutual Funds

Avoiding the load:– Can sometimes choose different class of

fund shares.

– Best alternative may depend on _______________________________________.amount invested and expected holding period

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Costs of Investing in Mutual FundsExpense ratios:Funds charge annual operating expenses and

annual advisory or management fees against the NAV.– Expense ratios are calculated as

Annual Expenses / Average NAV

– A "well managed" fund probably should have an expense ratio of less than ___.

All costs and charges must be revealed in the fund's prospectus.

2%

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Amount initially invested =

Amount after gross return =

Amount after fees =

Net rate of return =

In MF prospectus and annual reports the MF returns are net of operating expenses, 12b-1 fees and commissions, but the returns do not include loads.

Converting gross pretax returns to net pretax returns:

$10,000 – (0.06 x $10,000) = $9,400

$9,400 x 1.175 = $11,045

$11,045 - (0.0135 x $11,045) = $10,895.89*

($10,895.89 - $10,000) / $10,000 = 8.96%

ThisThis year you invested $10,000 in a mutual fund with a year you invested $10,000 in a mutual fund with a 6% load (one time fee) and estimated annual expenses of 6% load (one time fee) and estimated annual expenses of 1.35%. The gross return is 17.5%. What is your return 1.35%. The gross return is 17.5%. What is your return net of loads and expenses?net of loads and expenses?

* This example calculates expenses using ending NAV.

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HPR on mutual funds

Dist = Distribution

All distributions are taxable, even if reinvested in the fund.

Do not buy into a MF just before its distribution date (usually near the end of the year or quarter).

Buy

DistDistBuySell

NAV

DivCGNAVNAVHPR

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4.5 Taxation of Mutual Fund Income

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General Tax RulesThe fund itself is not taxed as long as

– Fund meets certain diversification requirements– Fund distributes virtually all income earned

(less fees and expenses) to fund shareholders

The investor is taxed on capital gain and dividend distributions at the investor’s appropriate tax rate.

Distribution requirements imply that portfolio turnover may affect an investor’s tax liability.

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Taxes and Mutual Funds

_______________________ can be structured to take advantage of taxes while mutual funds cannot

High turnover leads to _________________

More disclosure on taxes was required ________

Investor directed portfolios

greater tax liability

in 2002

After-tax returns now reported in prospectus

For more information on taxes see:

IRS Publication 564: Mutual Fund Distributions

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Implications of Fund Turnover

The fund itself pays commission costs on purchases and sales of portfolio holdings, which are charged against NAV. –

–

The turnover rate is measured as the ______________ _____________ in a year divided by the ____________ __________.

These commissions are lower than what you and I pay.

Total commission expenses are higher if the portfolio has higher turnover.

total asset valuebought or sold average totalasset value

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Implications of Fund Turnover

For example, if a fund had an average total asset value of $10 million, and $6 million of securities were bought or sold that year the turnover rate was ____

Can you figure the average security holding period from the turnover ratio?

Turnover rates vary from ______________ per year.< 5% to > 300%

Average holding period or AHP AHP = 0.5 x (1 / turnover ratio) AHP = 0.5 x (1 / 0.60) = 0.83 years

60%.

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4.6 Exchange Traded Funds

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Exchange Traded Funds

ETFs allow investors to trade index portfolios like shares of stock

Examples:

Potential advantages– – –

• •

–

Trade continuously throughout the day

Can be sold short or purchased on margin

Potentially lower taxes

No fund redemptions

Large investors can exchange their ETF shares for shares in the underlying portfolio

Lower costs (No marketing; lower fund expenses)

SPDRs and Diamonds, Cubes, WEBS

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Exchange Traded Funds

Potential disadvantages

Small deviations from NAV are possible

Must pay a brokerage commission to buy an ETF but a no load index fund may be purchased online for no commission.

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Table 4.3 ETF Sponsors and Products

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4.7 Mutual Fund Investment Performance: A First Look

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First Look at Mutual Fund Performance

Evidence shows that average mutual fund performance is generally ________ broad market performance

Evidence suggests that over certain horizons ________________ in positive performance– Evidence is _____________

–

less than

some persistence

not conclusive

Some inconsistencies

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4.8 Information on Mutual Funds

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Sources of Information on Mutual Funds

Wiesenberger’s Investment Companies Morningstar (www.morningstar.com) Fund prospectus (a must read) Yahoo Wall Street Journal Investment Company Institute (www.ici.org) AAII Brokers

Background information: “A Random Walk Down Wall Street,” by Burton Malkeil

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Figure 4.4 Morningstar Report

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Morningstar Report Cont.

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Sample Problems

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Problem 1

NAV is $10.70 Front-end load is 6%

Every dollar paid results in only ____ going toward purchase of shares.

Offer price =

$.94

NAV = 1 - load

$10.70 = 1-.06

$11.38

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Problem 2

Offer price $12.30 Front-end load is 5%

Every dollar paid results in only ____ going toward purchase of shares.

NAV =

= $12.30 x 0.95

= $11.69

$.95

offer price x (1- load)

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Problem 3

NAV = (Market Value of Assets – Liabilities) Shares Outstanding

A. (200,000)x($35) = $ 7,000,000

B. (300,000)x($40) = $12,000,000

C. (400,000)x($20) = $ 8,000,000

D. (600,000)x($25) = $15,000,000 $42,000,000

$42,000,000 – $30,000 = $10.49 = NAV4,000,000

Shares Outstanding

4,000,000

Liabilities

$30,000

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Problem 4

Turnover rate = Value of stocks sold and replaced Market Value Assets

Value of stocks sold = (600,000x$25)= $15,000,000 or

Value of stocks purchased = (200kx$50)+(200kx$25) = $15,000,000

$15,000,000 = 0.357 or 35.7%$42,000,000

Average holding period?

Market Value Assets = $42,000,000

AHP = 0.5 x 1/Turnover

= 0.5 x 1/0.357 = 1.4 yrs

MVA = $42M

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Problem 5

a. The empirical research suggests that past performance is not highly predictive of future performance, especially for better performing funds. There may be some tendency for the fund to perform better than average next year, but it is unlikely that the fund will be in the top 10%.

b. Evidence suggests that bad performance is more likely to persist. Probably related to high fund costs or high turnover rates. Excessive costs are detrimental to a

fund’s returns.

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Problem 6

As an initial approximation, your return equals the return on the shares minus the total of the expense ratio and purchase costs:– Return 12% 1.2% 4% = 6.8%

But the precise return is less than this because the 4% load is paid up front, not at the end of the year.

To purchase the shares, you would have had to invest:– $20,000 / (1 0.04) = $20,833

The shares net increase in value (12% 1.2%) from $20,000 to: – $20,000 (1.12 0.012) = $22,160

The rate of return is:

($22,160 $20,833) / $20,833 = 6.37%

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Problem 7

a. Sell after 4 years: Suppose you have $1000 to invest. The initial investment in Class A shares is ____ net of the front-end load. After 4 years, your portfolio will be worth:

$940 (1.10)4 = $1,376.25

Class B shares allow you to invest the full $1,000, but your investment performance net of 12b-1 fees will be only 9.5%, and you will pay a 1% back-end load fee if you sell after 4 years.

Your redemption value after 4 years will be:

$1,000 (1.095)4 x 0.99 = $1,423.28

Class B shares are the better choice if your horizon is 4 years.

$940

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Problem 7 Cont.

b. Sell after 15 years:

With a 15-year horizon, the Class A shares will be worth:

$940 (1.10)15 =

For the Class B shares, there is no back-end load in this case since the horizon is greater than 5 years. Therefore, the value of the Class B shares will be:

$1,000 (1.095)15 =

At this longer horizon, Class A shares are the better choice. Why?

$3,926.61

$3,901.32

N x LN [1.10 / 1.095]N x LN [1.10 / 1.095]

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Problem 8

Suppose that finishing in the top half of all portfolio managers is purely luck, and that the probability of doing so in any year is exactly 50%.

Then the probability that any particular manager would finish in the top half of the sample five years in a row is 0.505 = 0.03125.

We would then expect to find that [350 0.03125] 11 managers finish in the top half for each of the five consecutive

years.

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Problem 9

Trading costs will reduce the portfolio return by

(0.4%)x(0.50)= 0.2% Over many years of savings these costs can greatly

reduce the value of your portfolio.

Remember also that the high turnover rate can have tax consequences that further reduces your after-tax return.