MUTUAL FUNDS AND OTHER MANAGED INVESTMENTS

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Chapter 4

• MUTUAL FUNDS AND OTHER MANAGED INVESTMENTS

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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?

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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?

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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.

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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 funds investors.

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Computing Net Asset Value

• For investors, the performance of their
  investment depends on what happens to the funds
  per share value, or net asset value (NAV).
• NAV Market Value of Assets Liabilities
• Number of Shares Outstanding

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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.

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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

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Why invest with mutual funds?

• Choice and flexibility
• Families of funds offer a variety of investments
  to match investor needs
• Indexing
• Some funds track a broad market index which
  insures that investors will earn the market
  return
• Increasingly popular mutual fund alternative

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Mutual Fund Drawbacks

• Active trading contributes to high costs which
  lower fund returns
• Tax consequences can be a disadvantage
• Tax impacts of asset trading are passed through
  to investors
• Tax bill can be large even when the NAV falls

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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 (DNAV)
• From unrealized gains/losses from assets

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Mutual Fund Returns

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

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Types of Mutual Funds

• Funds can be classified according to the type of
  security in which they invest
• Stock Funds
• Taxable Bond Funds
• Municipal Bond Funds
• Stock and Bond Funds
• Money Market Funds

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Common Stock Funds

• Most popular type of fund
• Wide variety with different objectives and levels
  of risk
• Growth
• Industry or sector funds
• Geographic areas
• International or Global
• Equity Index funds

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Taxable Bond Funds

• Generally seek to generate current income with
  limited risk
• Can vary by maturity
• Short-term, Intermediate-term, Long-term
• Can vary by type of bond
• Government
• Corporate
• Mortgage-backed
• International/Global
• Bond Index funds

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Municipal Bond Funds

• Provide investors with income exempt from Federal
  taxation
• Often concentrate on single states to avoid state
  income taxation as well

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Stock and Bond Funds

• Seek to provide a combination of income and value
  appreciation.
• Different names
• Balanced funds
• Blended funds
• Flexible funds

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Money Market Funds

• Provide safe, current income with high liquidity
• Invest in money market securities
• T-bills, Bank CDs, Commercial paper, etc.
• NAV stays at 1 income either paid out or
  reinvested daily
• Provide an alternative to bank deposits, but not
  FDIC insured

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Mutual Fund Innovations

• Life-stage funds
• Offer different mixes of securities based on the
  age of the investor
• Supermarket funds
• Offer a wide variety of funds with one-stop
  fund shopping
• Transfer services between funds
• Expenses/fees can be high

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Mutual Fund Prospectus

• Must be available to investors and should be
  review by investors.
• Contains
• Funds investment objective
• Investment strategy
• Principal risks faced by investors
• Recent investment performance
• Expenses and fees
• Lots of other detailed information

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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 funds 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

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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

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Mutual Fund Expenses and Considerations

• Management Fees
• Fees deducted from the funds asset value to
  compensate the fund managers
• Some adjust fees according to the funds
  performance
• Expense ratio
• Adding all fees and calculating expenses as a
  percentage of the funds asset

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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

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Mutual Fund Return and Risk Performance

• Return Performance
• On a risk-adjusted basis, the average stock fund
  under-performs market averages
• While portfolio managers seem to out-perform the
  market before expenses, net returns are below the
  market index
• Some 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

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Mutual Fund Return and Risk Performance

• Risk Performance
• While returns are not consistent, risk is
• Objectives lead to strategies that lead to
  varying degrees of investment risks
• Return is positively related to the level of risk
• Risk is therefore an important consideration

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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-load
• Expenses lower returns in predictable ways
  lower expense funds give better returns
• Turnover affects returns in several ways,
  including taxes high turnover means more
  short-term realized gains
• Tax efficiency is an important consideration
  after-tax returns may be 30-40 less than pre-tax

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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.

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Mutual Fund Investment Strategies

• If you actively manage your portfolio, consider
  the past years 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.

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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

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Other Managed Investments

• Closed-end investment companies
• Shares trade like stock rather than being bought
  and sold from the fund
• Number of shares are fixed
• Often 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

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Other Managed Investments

• Exchange-traded funds (EFTs)
• Relatively new, yet very popular
• Like closed-end funds, they trade like individual
  stocks
• Passively managed to mirror a market index, both
  broad and narrow
• Low expenses, but do involve brokerage
  commissions
• Tax and liquidity concerns

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Other Managed Investments

• Variable Annuities
• Many offered by insurance companies
• Offers investors with choices of investments with
  tax-deferred growth
• Insurance product payment in the case of death
  or else retirement income stream
• Expenses for both fund management and to pay for
  insurance, so fees tend to be much higher than
  with mutual funds
• Income stream taxed as regular income