Mutual Funds

1
Mutual Funds

• Definition Financial intermediary through which
  savers pool their monies for collective
  investment, primarily in publicly trades
  securities.
• A fund is mutual in the sense that all of its
  returns minus its expenses, are shared by its
  shareholders.

2
Mutual Funds

• Returns consist of dividends, realized and
  unrealized capital gains (losses)
• Expenses consist of advisory fee for servicing
  the shareholders, annual fee for distribution
  (12b-1)

3
Mutual Funds Vs. Individual Securities

• Objective is to maximize return with minimum
  risk
• Efficient Market hypothesis and undervalued
  securities
• Mean reversion in the equity market

4
Mutual Funds Vs. Individual Securities

• Individual securities have two main sources of
  risk alpha and beta.
• Alpha - company specific risk usually accounts
  for 50-70 of securitys price volatility
• Beta - market risk accounts for 30-50 of price
  volatility.

5
Bond Funds Vs. Individual Bonds

• Investors are focused on income stream
• To receive income, investors can buy individual
  bonds - T-bonds, agency bonds, corp. bonds,
  municipal bonds, and hold to their maturity.
  Receive periodic fixed interest payment and
  principal at maturity.

6
Bond Funds Vs. Individual Bonds

• Alternatively, receive income stream by buying a
  diversified bond mutual fund. No fixed interest
  payment nor an obligation to pay principal at
  maturity.
• Higher minimum requirements for individual bonds
  (usually 25,000 T-bonds 1,000). Lot size is
  usually 100,000. One 25,000 bond lacks
  diversification.

7
Bond Funds Vs. Individual Bonds

• Cost 2 - 4 of value.
• Bond mutual fund minimum As low as 1,000. Can
  redeem fund on any business day. Do not have to
  hold till maturity.
• Fund offers more diversification. Offer
  convenient services, such as monthly income
  payments, compared to quarterly or semi-annually
  for individual bonds

8
Benefits of Investing in Mutual Funds

• Diversification Typically lowers ? global fund
  may also lower ?
• Professional Management Professional
  qualifications (CFA) access to company
  executives in house research team, wall street
  research.
• Lower Transaction Costs Lower admn. cost,
  savings on record keeping, better execution of
  securities.
• Convenience Automatic deposits/ withdrawal, tax
  reporting, retirement planning, educational
  materials.

9
Disadvantages of Investing in Mutual Funds

• Need to pay fees/expenses even when fund performs
  poorly
• Increased diversification may prevent the chance
  of hitting the jackpot from one security
• Online trading and security research on the
  internet have reduced the advantage of cost and
  research access
• Less control over securities portfolio and
  therefore timing of realized capital gains for
  tax purposes.

10
What Investors Need to Know?

• Structure and working of a typical fund
• Roles of various entities involved in operating a
  fund.
• Fund Manager, Custodian, distributor, etc.
• Minimum investment requirement
• Fees and Expenses
• Services provided to the shareholders
• Performance measurements

11
Investment Objectives and Risks of Stock and Bond
Funds

• Investor must clearly evaluate his/her own goals.
• What is the purpose of the investment?
• What is the time horizon?
• What is your risk tolerance?

12
Mutual Fund Investment Objectives

• A funds objective is established when the fund
  is created. Objective can be changed with a
  majority vote of the shareholders.
• A funds objective denotes the type of assets a
  fund manger will buy or sell such as
• primary method by which the manager seeks to
  generate value for shareholders (capital
  appreciation, dividend payment, interest income,
  etc.)

13
Mutual Fund Investment Objectives

• the class or classes of assets (stocks, bonds,
  money market securities) and types of securities
  (growth stoc, income stock, municipal bonds,
  corporate bonds, etc.)
• Reasons for proliferation of fund objectives
• Competition - sponsors imitating successful
  funds by competitors
• Shareholder retention - sponsors profit from
  higher

14
Mutual Fund Investment Objectives

• retention of shareholders. Greater variety of
  objectives offer the likelihood of customers
  staying within the same fund family
• Refinement of investment objective - splicing
  allows investor with a specific risk tolerance
  and time horizon to invest in appropriate fund.
• Greater variety allows investors a broader arena
  for optimizing returns, but makes selecting a
  fund that is suitable to investment goal more
  complex.

15
Types of Mutual Funds


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Types of Mutual Funds (Money Market)

• MONEY MARKET FUNDS Invests in high quality, low
  risk, short-term debt securities (T-bills,
  bankers acceptance, negotiable CDs, etc.).
• Low risk of default and high liquidity. Managers
  are limited to buying short-term securities rated
  investment grade by Moodys and SP.
• Attempts to maintain NAV of the fund at 1 per
  share achieve this by purchasing debt securities
  that are trading at a discount to their face
  value.

17
Types of Mutual Funds (Money Market)

• Interest accrues daily
• Money market funds are neither insured nor
  guaranteed by the U.S. Government. Funds are not
  insured by the FDIC.
• Like other securities, MMF are insured by
  Securities Investor Protection Corporation
  (SIPC). SIPC is a government sponsored private
  corporation that provides limited protection (up
  to 100,000) for customer if their broker/dealer
  goes bankrupt.

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Types of Mutual Funds (Money Market)

• Five Basic Types Of Money Market Funds
• 1.GOVT SECURITIES MONEY MARKET FUNDS
• Invests in T-bills, T-notes, and agency
  securities
• 90 days or less to maturity
• Income earned is subject to federal income tax
  but may be exempt from state and local taxes
• Considered to be the safest type of MMF.

19
Types of Mutual Funds (Money Market)

• 2. U.S. TREASURY MONEY MARKET FUND
• Invests only in U.S. government securities
  issued directly by the U.S. Treasury with short
  term maturity
• Agency securities are not included
• Income earned is subject to federal taxes, but
  exempt from state and local taxes.

20
Types of Mutual Funds (Money Market)

• 3. TAXABLE MONEY MARKET FUND
• Invests in bank obligations such as, negotiable
  CDs, short-term debt obligations traded between
  institutions. Agency securities are not included
  
• Income earned is subject to federal , state and
  local taxes.

21
Types of Mutual Funds (Tax Exempt Money Market)

• 4. NATIONAL TAX EXEMPT MONEY MARKET FUND
• 75 of its assets is invested in high quality
  debt securities issued by municipality.
• 90 days or less to maturity
• Income earned is exempt from federal income
  taxes, but is subject to state and local taxes

22
Types of Mutual Funds (Tax Exempt Money Market)

• 5 SINGLE STAT, DOUBLE TAX EXEMPT MONEY MARKET
  FUND
• Invests in municipal securities issued by a
  single state
• Income earned is exempt from federal and state
  taxes, but may be subject to local taxes.

23
Types of Mutual Funds (Equity Funds)

• EQUITY FUNDS invest primarily in common stocks
• Returns are generated through capital gains and
  dividend yields
• Portfolio manager selects stocks whose profile
  matches the funds investment objective
• Stocks are categorized based on features, such
  as dividend history, potential for capital gains,
  asset size, cyclical nature of the stock, etc.

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Types of Mutual Funds (Categories of Common
Stocks)

• Basic Categories of Common Stocks
• Blue Chip - large and most successful public
  companies (IBM, GE, DuPont, ) ability to
  maintain and grow profits, as well as increase
  dividends over a long period time through
  different market conditions.
• Establish Growth - large in asset size stocks
  traded over several years steady increase in
  sales and earnings and therefore stock price
  most pay

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Types of Mutual Funds (Categories of Common
Stocks)

• little or no dividends (Microsoft Coca-Cola,
  McDonalds, ).
• Returns are generated from price increase price
  volatility is greater than Blue Chips.
• Income Stocks - pay a higher percentage of
  earnings as dividends (utility companies)
  investors adhere to buy-hold philosophy less
  volatile than the market.

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Types of Mutual Funds (Categories of Common
Stocks)

• Emerging Growth Stocks - little or no track
  record of steady growth of sales and earnings
  growth and earnings potentials have recently been
  recognized investors (e-commerce, internet,
  biotech,) pay no dividends have commercially
  viable product if successful, considerable
  fortune to be made.
• Defensive Stocks - share prices are less
  adversely affected during declines in the
  economy, yet offers a reasonable rate of return
  when the economy is doing well.

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Types of Mutual Funds (Categories of Common
Stocks)

• Capitalization Current value of a publicly
  traded company ( shares at current market price)
• Large Cap current market value of 5 billion
  or more
• Mid-Cap current market value of between 1
  billion to 5 billion
• Small-Cap current market value of between 300
  million to 1 billion
• Micro-Cap current market value of 300 million
  or less.

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Equity Fund Objectives


29
Types of Mutual Funds (Equity Fund Objectives)

• AGGRESSIVE GROWTH invest in stocks whose market
  prices are expected to rise rapidly also invests
  in a single sector or industry employs
  speculative investment strategies, such as margin
  and selling short primary portfolio holdings in
• Emerging growth stocks
• mid cap stocks
• small cap stocks.
• IPO
• Tend to provide high gains during rally and steep
  drops during market declines high volatility.

30
Types of Mutual Funds (Equity Fund Objectives)

• CAPITAL APPRECIATION speculative in nature
  invest in stocks whose prices are expected to
  rise price increase may be due to increase in
  earnings expectation or purely demand/supply led.
• Investment horizon may be short-term or
  long-term relatively high turnover and therefore
  higher transaction costs.
• Employ speculative investment strategies, such
  as margin and options may also maintain large
  cash holding.
• High price volatility.

31
Types of Mutual Funds (Equity Fund Objectives)

• EQUIY INCOME primary objective is to provide
  current income.
• Portfolio consists of large cap, blue chip and
  defensive stocks that pay large dividends.
• Volatility moves in tandem with or lower than
  overall market.
• Low shareholder turnover during a downturn high
  dividend makes the yield higher as the share
  price declines.
• If stocks starts to pay low dividends, less
  incentive to hold on to the fund.

32
Types of Mutual Funds (Equity Fund Objectives)

• GROWTH primary objective is capital
  appreciation dividend payments are decidedly a
  secondary objective.
• Portfolio consists primarily of large cap and
  mid cap growth stocks may also contain a small
  percentage of emerging growth and small cap
  growth if the manager recognizes significant
  potential for growth.

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Types of Mutual Funds (Equity Fund Objectives)

• Volatility among growth funds varies widely
• Type of stock that the fund manager considers as
  a growth stock- Coca-Cola vs. Amazon.com. Both
  considered growth stock, but varied risk.
• Investment Style more speculative ( profiting
  from short-term gains) style leads to more
  volatility
• Important to read the fund prospectus carefully
  to determine the nature of risk involved.

34
Types of Mutual Funds (Equity Fund Objectives)

• GROWTH AND INCOME capital appreciation and
  current income are equally important.
• Portfolio consists of large cap, income and
  established-growth stocks stocks must have
  potential for growth and ability to pay steady
  and increasing dividends.
• The blend of growth and income stock creates a
  portfolio volatility that is less than the
  overall market.

35
Types of Mutual Funds (Equity Fund Objectives)

• INTERNATIONAL OR FOREIGN primary objective is
  capital appreciation from commons stock companies
  located outside the US dividend payments are not
  usually a consideration.
• Foreign funds are spliced in different ways
• Country/Region
• Diversified Emerging market
• Europe Fund
• Pacific Fund
• Latin America Fund

36
Types of Mutual Funds (Equity Fund Objectives)

• WHY INVEST IN FOREIGN STOCKS
• Foreign stocks constitute a greater percentage of
  the value of the worlds stock market than do US
  stocks
• Many foreign economies are in the early stages
  of development - opportunity for significant
  capital gains
• Portfolio Diversification - not all foreign
  markets move in tandem with the US market.

37
Types of Mutual Funds (Equity Fund Objectives)

• Risk of foreign funds varies depending on the
  type of fund and the period of investment. Expose
  to currency risk.
• Asset allocation models recommend 5 to 20 percent
  holding of foreign funds.

38
Types of Mutual Funds (Equity Fund Objectives)

• GLOBAL FUND invests in equity securities issued
  throughout the world maintains 25 - 50 of
  assets in US companies.
• Safe way to invest in international markets
• US multinationals pay dividends in dollars -
  investors are shielded form currency risk
• US multinationals shares are traded on the US
  stock markets performance closely follows the
  US market performance and not the foreign markets.

39
Types of Mutual Funds (Equity Fund Objectives)

• Fund Volatility volatility depends on the
  mixture of foreign and US equities. As high as
  75 of assets can be held in foreign equities.
  Depending on the mixture, the fund volatility may
  track or move opposite to the US markets.

40
Types of Mutual Funds (Equity Fund Objectives)

• SECTOR FUND primary objective is capital
  appreciation.
• Portfolio consists of stocks of companies of a
  single industry/sector/geographical region.
• RISK is high - specialized concentration can
  produce spectacular returns and losses. Example
  investment in Telecom or Internet sectors in
  1999-2000 vs. 2001-03.

41
Types of Mutual Funds (Equity Fund Objectives)

• Popular Sector Funds
• Communications
• Financial Services
• Health Care
• Natural Resources
• Precious Metals
• Real Estate
• Technology
• Utilities

42
Types of Mutual Funds (Bond Fund Objectives)

• BOND FUNDS considered to be safer than stock
  funds. Attracts conservative investors with low
  risk tolerance.
• Historically, returns are less than stock funds.
  Principal source of return is interest payments
  with limited potential for capital gains.
• Market price of bonds do not increase as
  companys sales and earnings grow bond prices
  are inversely related to interest rates.

43
Types of Bond Funds


44
Types of Bond Funds


45
Types of Mutual Funds (Bond Fund Objectives)

• BOND FUND objectives are defined using criteria
  such as
• Types of bonds - corporate, government, yankee
  (dollar denominated, issued in the US by foreign
  corp. or govt), euro (dollar denominated, issued
  outside the US), etc.
• Bond rating
• Average length of maturity
• Taxation of interest income from bonds - taxable
  or tax exempt fund.

46
Types of Mutual Funds (Bond Fund Objectives)

• BOND FUNDS considered to be safer than stock
  funds. Attracts conservative investors with low
  risk tolerance.
• Historically, returns are less than stock funds.
  Principal source of return is interest payments
  with limited potential for capital gains.
• Market price of bonds do not increase as
  companys sales and earnings grow bond prices
  are inversely related to interest rates.

47
Types of Mutual Funds (Taxable Bond Fund
Objectives)

• CORPORATE BOND FUNDS invest primarily in US
  issued corporate bonds, but may invest in debt
  securities issued by foreign corporations. Fixed
  income securities include
• Debentures unsecured bonds
• Mortgage bonds secured by real estate and
  property
• Equipment Truest Certificates (ETC) secured by
  the equipment of the issuers. Airlines use ETCs
  extensively.

48
Types of Mutual Funds (Taxable Bond Fund
Objectives)

• CORPORATE BOND FUNDS are further categorized
  as
• General Corp Bond Fund buys only investment
  grade bonds of US based corp. (Aaa -Baa/AAA-BBB)
• High Quality Corporate Bond Fund majority of
  assets are invested in bonds rated A or better
  manager tries to maintain a rating of Aa or AA
  among all bonds

49
Types of Mutual Funds (Taxable Bond Fund
Objectives)

• High Yield Corporate Bond Fund majority of
  assets are invested in bonds rated BB of Ba, or
  lower.
• Interest income from these securities are
  taxable at the federal, state and local levels.

50
Types of Mutual Funds (Govt Bond Fund
Objectives)

• GOVERNMENT BOND FUNDS invest in long-term debt
  securities issued by the US govt or by its
  agencies (GNMA, SLMA). Agency securities are not
  backed by the govt but the agency itself. Agency
  securities are as safe as the US govt issues.
• Interest income from US govt bonds are subject
  to federal taxes, but are exempt from state and
  local taxes.
• Taxation of agency issues vary - Mortgage backed
  securities are fully taxed all other issues are
  taxed as govt issues.

51
Types of Mutual Funds (Govt Bond Fund
Objectives)

• TYPES OF GOVERNMENT BOND FUNDS include
• Adjustable Rate Mortgage fund majority of
  assets are invested in mortgage backed securities
  (GNMA, FNMA, FHLMC) secured by pool of adjustable
  rate mortgages.
• General Government Bond Fund invests in
  T-notes, T-bonds, STRIPS, TIPS, mortgage backed
  securities and other US government and agency
  securities.

52
Types of Mutual Funds (Govt Bond Fund
Objectives)

• US Treasury Government Bond Fund all assets
  are invested in bonds and notes issued by the US
  government. One of the safest mutual funds
  available.

53
Types of Mutual Funds (Taxable Bond Fund
Objectives)

• INTERNATIONAL BOND FUNDS invest largely in debt
  securities issued by foreign corporations or
  governments denominated in foreign currencies
  attempts to earn income from interest payments
  and capital gains.
• Foreign securities are substantially more
  volatile than domestic debt exposed to currency
  risk.

54
Types of Mutual Funds (Taxable Bond Fund
Objectives)

• MULTI-SECTOR BOND FUNDS invest in long-term
  debt securities including government bonds,
  corporate bonds, foreign bonds, and eurobonds. It
  may also invest in high-yield (junk) bond issued
  by US based corporations.
• WORLD BOND FUNDS invest in long-tern debt
  securities around the globe large percentage of
  assets are invested in sovereign debt. Interest
  payments, and to a lesser extent, capital gains
  are the main sources of income.

55
Types of Mutual Funds (Tax Exempt Bond Fund
Objectives)

• NATIONAL TAX EXEMPT BOND FUND ( known as
  National Municipal Bond Fund) invests in
  long-term municipal debt securities of town,
  cities, states and municipalities in the US.
• Income consist primarily of interest payments
  interest is exempt from federal taxes subject to
  state and local taxes.

56
Types of Mutual Funds (Tax Exempt Bond Fund
Objectives)

• SINGLE STATE TAX EXEMPT BOND FUND consists of
  debt securities issued by and within one state.
  New York and California, because of the size of
  their bond issues are used most frequently.
• Interests are double tax exempt - exempt from
  federal and state taxes for resident of the
  single state. May also be triple tax exempt
  depending on the tax code of the local
  municipality.

57
Redeeming Fund Shares

• For front end load funds, especially with no
  contingent deferred charges, fund simply buys
  back shares at the NAV and distributes the
  proceeds.
• For back end load funds, all charges are
  deducted from the proceed. The amount of
  deduction is based on the number of shares sold.
  The percentage deduction is calculated by the
  lesser of
• a) the original purchase price of the shares, or
• b) the NAV at the time of redemption.

58
Redeeming Fund Shares

• Example of Redeeming a back end load fund
• 1000 shares purchased 3 years ago at NAV of
  13.0 back end load begins at 5 and declines by
  1 each year to 0 current NAV 20.20 want to
  sell 50 shares what is the back end load?
• Total proceed (20.20x50) 1,010
• Load based on original purchase price
  3x13x50 19.50
• Net Proceed (1,010 - 19.5) 990.50.

59
Redeeming Fund Shares

• Load based on NAV at the time of redemption
  3x20.20x50 30.30
• Net Proceed (1,010 - 30.30) 979.70.
• Therefore, use original purchase price basis.
• If current NAV 12.0
• Load 3x12.0x50 18.0
• Use current NAV method.

60
Deciding Which Shares to Redeem

• Redeeming funds share has tax implications
• If redemption results in capital gains, pay tax
  during the year when the transaction occurred
• capital loss can be used to offset gains on
  another security.
• Tax planning is an important part of
  redemption
• Decide which share of your holding will be sold,
  because it will determine
• Cost basis of current sale and
• Tax on current sale.

61
Redeeming Fund Shares

• Three methods of selecting the shares for
  redemption
• First In. First Out. Shares purchased first will
  be redeemed first.
• Average Cost The fund computes the average
  purchase price of the shares being sold becomes
  the cost basis.
• Specific Shares Specify broker specific shares
  you want to sell according to their cost basis
• Once a method is decided, it must be followed.

62
Redeeming Fund Shares

• Example of Redeeming a back end load fund
• 1000 shares purchased 3 years ago at NAV of
  13.0 back end load begins at 5 and declines by
  1 each year to 0 current NAV 20.20 want to
  sell 50 shares what is the back end load?
• Total proceed (20.20x50) 1,010
• Load based on original purchase price
  3x13x50 19.50
• Net Proceed (1,010 - 19.5) 990.50.