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Mutual Funds and


Periodic reports on capital gains, dividends, investments, and redemption ... Individual investors' sentiment. NAV. Premium or discount to NAV. Pricing ... – PowerPoint PPT presentation

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Title: Mutual Funds and

Chapter 4
  • Mutual Funds and
  • Other Investment Companies

Services of Investment Companies
  • Administration record keeping
  • Periodic reports on capital gains, dividends,
    investments, and redemption
  • Diversification divisibility
  • Each investor has a claim to the portfolio in
    proportion to his investment
  • Professional management
  • Full-time staffs of security analysts and
    portfolio managers
  • Reduced transaction costs

Net Asset Value
  • Value of each share of a mutual fund
  • Used as a basis for valuation of mutual funds,
    e.g., when selling new shares or redeeming
    existing shares
  • Market Value of Assets - Liabilities
  • Shares Outstanding
  • (Example) A mutual fund with 5 mil shares
  • Portfolio of securities 120 mil
  • Investment advisory fees payable 4 mil
  • Other Liab. (rent, wages due, expenses) 1
  • NAV (120 5) / 5 23 per share

Types of Investment Companies
  • Investment Company Act of 1940
  • Unit Investment Trusts
  • Investment portfolios are fixed and unmanaged
    (lower operating expenses than actively managed
  • Managed Investment Companies
  • Closed-End vs. Open-End Funds
  • Discount puzzle of closed-end funds
  • Various commissions (sales, management,
    performance fees, etc.)
  • Unrealized capital gains and taxes
  • Individual investors sentiment

Other investment Organizations
  • Similar functions, but not formally regulated as
    investment companies
  • Commingled funds
  • Similar to open-end funds, and units are offered
  • Money market fund, bond fund, etc, by a bank or
    insurance company
  • REITs
  • Similar to closed-end funds
  • Investing in real estate (Equity trusts) or
    mortgage loans (Mortgage trusts)
  • Hedge Funds
  • Private investment pool, not subject to SEC
  • Heavy use of derivatives, short sales, and
    leverage, speculating on convergence of valuation
    differences across two sections

Investment Policies
  • Investment policies of mutual funds are described
    in prospectus
  • Get a free prospectus for many mutual funds at
  • http//
  • Various kinds of investment policies (styles)
  • Money Market Funds
  • Fixed Income Funds
  • Balanced Income Funds
  • Equity Funds
  • Index Funds passive strategy, tracking a broad
    market index
  • Asset Allocation Funds actively engaged in
    market timing and forecasting
  • Specialized Sector Funds industry-specific or
    international stocks

Costs of Investing in Mutual Funds
  • Front-end vs. Back-end load
  • Front-end load sales commission paid at time of
    purchase (about 6)
  • No-load funds no front-end sales charges
  • Back-end load redemption fee at time of
    redemption (about 6, and gradually lowers every
  • Operating expenses
  • Administrative expenses and advisory fees paid to
    the investment manager (0.2 to 2 of total
  • Periodically deducted from the fund assets
  • 12 b-1 charges
  • Annual fees charged by a fund manager to pay for
    marketing and distribution costs of annual
    reports and prospectuses, and sales broker
    commissions (limited to 1 of a funds average
    net assets per year)
  • Annually deducted from the fund assets
  • Different classes of shares have different fee
  • Allow investors to choose the best combination of
    fees, depending on their investment horizons.

Mutual Funds Returns, Fees, and Taxes
  • Rate of return before fund expenses
  • (NAV1 NAV0 Dividend and capital gain
    distributions) / NAV0
  • Fund expenses affect the returns
  • Front-end or back-end loads, operating expenses,
    and 12b-1 charges are periodically deducted from
    fund assets, having substantial negative effects
    on the rate of return
  • Costs incurred in soft dollars are difficult to
  • High trading commissions will eventually reduce
    fund returns
  • The pass-through status of fund income
  • If at least 90 of all income is distributed to
    shareholders, and
  • less than 30 of its income comes from the sale
    of securities held for less than three months
  • Then, investors (but not the fund) pay income
    taxes at their own tax rate
  • It may be a disadvantage since it is difficult to
    control when to realize capital gains and how to
    manage tax liabilities
  • Such a tax management issue is irrelevant if a
    mutual fund is held in a tax-deferred retirement
    account such as an IRA or 401(k) account

Exchange Traded Funds
  • A variant of mutual funds that allow investors to
    trade index portfolios like shares of stock
  • Examples SPDRs and Webs
  • Potential advantages
  • Trade continuously, and can be sold short or
    bought on margin
  • Tax advantage over mutual funds
  • Redeemable for shares of stocks in the portfolio
    without selling them, thus not triggering capital
    gains taxes
  • Investor can buy ETFs through brokers (save sales
  • Lower management fees, 0.090.18
  • Potential disadvantages
  • Sometimes depart from the NAV, giving arbitrage
  • Trading incurs brokerage fee and bid-ask spreads

Mutual Fund Performance
  • Choice of an appropriate benchmark is difficult
  • Must have similar risk characteristics
  • A simple comparison with Wilshire 5000 index (Fig
  • The index has outperformed the median managers in
    more years during 1972-2001, and the average
    difference of annualized compound returns is
    1.09 (12.20 vs. 11.11)
  • This margin could have reduced to 0.79 for
    passively managed low-cost index fund, and thus,
    passive index fund would have outperformed
    actively managed funds
  • Repeated winners?
  • Tab 4.4 shows that 62 of initial winners repeats
    in the following period, which is consistent with
    at least some part of a funds performance is a
    function of skill as opposed to luck
  • Bad performance is more likely to persist than
    good performance due to high turnover ratios and
    expense ratios

Sources of Information on Mutual Funds
  • Prospectus
  • Is required to contain investment objectives,
    policies, risks, fee table, portfolio managers,
  • Two other sources
  • Statement of Additional Information (Part B of
    Prospectus), and Annual Report show portfolio
    composition, financial statements, etc.
  • Which funds to choose?
  • Morningstars Mutual Fund Sourcebook
  • Wiesenbergers Investment Companies
  • Investment Company Institutes Directory of
    Mutual Funds

Recent Fraud in Mutual Fund Industry
  • Late trading or market timing is discouraged
    or prohibited
  • Mutual fund companies state in their prospectuses
    that they discourage or prohibit "late trading"
    and "market timing" by large investors. However,
    mutual fund managers were found to permit certain
    companies to conduct such trades in exchange for
    payments and other inducements.
  • http//
  • http//
  • http// (fraud
    investigation documents)
  • Late trading involves purchasing mutual fund
    shares at the 4 pm price after the market closes,
    a practice which is illegal, and like allowing
    betting on a horse race after the horses have
    crossed the finish line.
  • Market timing is a short-term, "in and out"
    trading of mutual fund shares. It is designed to
    exploit market inefficiencies by buying mutual
    fund shares at the stale NAV, and realizing a
    profit later when selling them.
  • Typically, funds limit the number of round trips
    an investor can make during a 12-month period,
    and allow exchanges from one fund to another
    within the same fund family several times a year
    for a low or no fee.