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Mutual Funds

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Title: 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


16
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.


18
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.


24
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


25
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.


26
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.


27
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.


28
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.


33
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.
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