Transcript Chapter 16 Mutual Funds

Investments: Analysis
and Behavior
Chapter 16- Mutual Funds
©2008 McGraw-Hill/Irwin
Learning Objectives





Understand the structure and pricing of mutual funds
Remember the differences between open-end, closedend and exchange traded funds
Recognize the impact of expenses and taxes on fund
returns
Assess mutual fund performance
Know various types of mutual funds
16-2
Mutual Funds

An investment company that issues its portfolio shares to investors.

Money from shareholders are pooled and invested in a wide range of
stocks, bonds, or money market securities.


Managed by professional managers
Each investor shares proportionately in the income and investment
gains and losses, as well as the brokerage expenses and
management fees.
16-3
1. Types of Mutual Funds



Open-end Funds
Closed-end Funds
Exchange Traded Funds (ETF)
16-4
Open-End Funds
An open-end investment company is
commonly called an open-end fund.
 A mutual fund has no limit on the size of
the fund or the number of shares
outstanding.
 Mutual fund shares are not sold to other
investors. Instead, they are redeemed by
the fund management.
 The value of a mutual fund share is
called its net asset value.

16-5
Open-End Investment Companies
Insert Figure 21-1 here.
16-6
Closed-End Funds

A closed-end fund has a fixed number of
shares.
 When
the market price exceeds its NAV,
selling at a premium, otherwise, selling at a
discount
 Buy and sell like a stock.
 The pricing of closed-end fund shares is a
financial puzzle - they usually sell at a
discount to their net asset value (NAV).
16-7
Exchange Traded Funds (ETFs)

Exchange traded fund (ETF) is a form of
closed-end fund, embedded with some
features of an open-end fund
 Traded
like a stock at stock exchanges
 Share price is very close to its NAV
 Shares are redeemable!!
16-8
2. Important mutual fund terms


Net Asset Value (NAV)
Fees

Load:
 Expense ratio:
 12b-1 fee:


Alpha
Beta
16-9
Net asset Value

NAV: per share value of a mutual fund’s investment
holding.
MarketValue of Assets  PortfolioLiabilities
NAV 
# of Shares Outstanding
Example
A mutual fund has $100 mil in assets and $3 mil in short
term liabilities. 10.765 mil shares outstanding. What is
the NAV?
Solution
($100 mil - $3 mil) / 10.765 mil = $9.0107 per share
16-10
Types of Mutual Funds
Objective
Funds Hold
Growth Potential
Income Potential
Stability
Money Market Funds
Taxable money market
Current income
stability of principal
Cash investments
None
Moderate
Very high
Tax-exempt money
market
Tax-free income,
stability of principal
Municipal cash investments
None
Moderate
Very high
Taxable bond
Current income
Wide range of government
and/or corporate bonds
None
Moderate to high
Low to moderate
Tax-exempt bond
Tax-free income
Wide range of municipal bonds
None
Moderate to high
Low to moderate
Current income
capital growth
Stocks and bonds
Moderate
Moderate to high
Low to moderate
Equity income
High-yielding stocks,
convertible bonds
Moderate to high
Moderate
Low to moderate
Value funds
Low P/E, P/B stocks
Moderate to high
Low to moderate
Low to moderate
Growth and income
Dividend-paying stocks
Moderate to high
Low to moderate
Low to moderate
U.S. stocks with high potential
for growth
High
Very low
Low
Stocks of companies outside
U.S.
High
Very low to low
Very low
Stocks with very high potential
for growth
Very high
Very low
Very low
Small cap
Stocks of small companies
Very high
Very low
Very low
Specialized
Stocks of industry sectors
High to very high
Very low to
moderate
Very low to low
Bond Funds
Common Stock Funds
Balanced
Domestic growth
Capital growth
International growth
Aggressive growth
Aggressive growth
of capital
16-11
Fees

Most mutual funds separate their
charges into a number of categories.
1) Load and No-Load
Load funds is a sales charge.
 If
paid at the time of purchase, the fee is a
front-end load.
 If levied when shares are sold, the fee is a
back-end load, or contingent deferred sales
charge.
 A no-load fund charges no sales commission.
16-12
The Investment Company Industry : Fees
Insert Figure 21-2 here.
16-13
Expense Ratio

Annual fee charges are calculated by a
fund’s expense ratio, which is the fund’s
total expenses expressed as a percentage
of the fund’s assets. (range from 0.2% to 2%)
 management
fee : includes salaries and
bonus paid to fund managers
 12-b fees: advertising costs on to the
accountholders
 Other fees
16-14
Expense Ratio
A mutual fund could have several
classes of shares with different fee
combinations.
 Studies indicate that

 Expense
ratio is normally lowest for money
market mutual funds and highest for
international stock funds
 Tend to be lowest for large, liquid funds
 The lower the expense ratio, the better the
fund performance.
16-15
The Investment Company Industry : Fees
Insert Figure 21-3 here.
16-16
Table 16.4
A. Typical fee tables found in three different mutual fund prospectuses
Fund A
Fund B
Fund C
Sales load imposed on purchases
None
None
4.75%
Sales load imposed on reinvested dividends
None
None
4.75
Redemption fees
None
None
None
Exchange fees
None
None
None
0.22%
0.60%
0.70%
0.02
—
—
—
0.30
—
Marketing and distribution costs
0.02
—
—
Miscellaneous expenses
0.03
0.32
0.26
0.29%
1.22%
0.96%
1 year
$ 30
$ 124
$ 587
3 years
93
387
823
5 years
163
670
1,077
10 years
368
1,477
Shareholder Transaction Expenses
Annual Fund Operating Expenses
Management and administrative expenses
Investment advisory expenses
12b-1 marketing fees
Total Operating Expenses
Expenses on a $10,000 Investment
1,805 16-17
B. The impact of equity mutual fund costs on long-term investor returns.
Fund A
Fund B
Fund C
$ 10,000
$10,000
$10,000
Day 1
10,000
10,000
9,525
5 years
18,189
17,451
16,186
10 years
33,084
30,565
29,689
15 years
60,178
53,145
52,416
20 years
109,458
92,743
92,539
Gross return
13.00%
13.00%
13.00%
0.29%
1.22%
0.96%
12.71%
11.78%
12.04%
Initial investment
Operating expenses
Net return
Fund A : typical cost efficient index fund
Fund B : conventional no-load stock mutual fund
Fund C : low-load stock mutual fund with less than typical annual operating
expenses
16-18
Figure 16.2 Impact of Costs and Taxes on 10% Return
$5,000
$4,526
$4,500
$4,000
$3,500
Ending Value
10% Return, no cost
$3,141
10% Return, 1% cost
$3,000
10% Return, 1% cost, 30% taxes
$2,500
$2,000
$1,500
$1,152
$1,000
$500
Begin w ith $100
$0
0
1
2
3
4
5
6
7
8
9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40
Years
16-19
Sources of Investment Returns

Total Return: dividend and interest income and realized
and unrealized appreciation



Income distribution: interest and dividend income after
expenses.
Capital gains unrealized until the fund sells the shares
(Unrealized capital gains)
The realized capital gains are paid out to shareholders at the
end of the year (capital gains distributions)
16-20
Taxes

Shareholders pay taxes due once income dividends
and capital gains distributions are received.

All income and capital gains distributions are
generally subject to income taxes.


Municipal bond or US T-securities interest income exempt
from federal taxes, but capital gains are taxable.
Turnover rate: expressed as a percentage of the
fund’s average assets (average turnover rate for stock
mutual fund: 79%)
16-21
Selecting A Mutual Fund

With a mutual fund, return comes from the change in
net asset value, capital gains distributions, and income
distributions.
change in capital gains
income
net asset +
+
distributions distributions
value
before-load
(gross) return =
beginning net asset value
change in capital gains
income - load
net asset +
+
distributions distributions fee
value
after-load
(net) return =
beginning net asset value
16-22
16-23
3. Fund Performance

Using ranking tools or portfolio evaluation
tools (alpha, Sharp ratio, and Treynor
measure)
16-24
Style boxes
Value Strategy
(Score <1.75)
Blend
(1.75  Score 
2.25)
Large-cap
(Top 5%)
S & P 500
Benchmark
Mid-cap
(Next 15%)
Wilshire 4500
Benchmark
Small-cap
(Bottom 80%)
Russell 2000
Benchmark
Growth Strategy
(Score > 2.25)
• Characterize mutual funds by market capitalization (large, mid, and small cap)
• Next, determine how cheap or expensive portfolio holdings are relative to the
overall market using P/E and P/B ratios (Value, Blend and Growth)
16-25
4. Selecting A Mutual Fund : Types of Funds
Insert Figure 21-4 here.
16-26

Money market funds invest in short-term
government securities and sometimes in shortterm corporate securities. They are used
primarily as a temporary cash haven.

Bond funds invest in fixed income securities.
They vary widely, and have no common maturity
date to simultaneously return the components to
their par value.

Stock funds vary widely in their risk and price
behavior. They are classified as growth or value,
and as large-cap or small-cap.
16-27

A balanced fund is a mixture of stocks and
fixed income securities. It forces discipline on
the fund manager.

An international fund is limited to buying
securities registered outside the country where
it is sold, while a global fund can invest
anywhere in the world.

A fund of funds invests only in other mutual
funds. Its diversification is good, but its
expense ratio tends to be higher than that of
the typical mutual fund.
16-28



Sector : Such funds invest in specific market
sectors, such as physical commodities or stocks
closely tied to natural resources e.g. oil, forest
products, and gold.
An index fund may be a stock or bond fund that
tries to behave exactly like the market. A stock
index fund, for instance, may seek to mirror the
performance of the Standard & Poor’s 500 stock
index.
Investors should determine their investment
objective first, and then choose an appropriate
fund or group of funds.
16-29
Insert Table 21-2 here.
16-30
Information Sources : Company Information



The prospectus is a legal document
describing the operation of the fund, its
management, and the fees
accountholders must pay.
One important item in the prospectus is the
fund’s portfolio turnover rate. A higher rate
usually means higher expenses.
The Statement of Additional Information is
required by the SEC, although it is generally only
sent to accountholders upon their request. It is a
more detailed version of the prospectus.
16-31
Review

Concepts
 Open-end
fund, closed-end fund, ETF
 load charge, NAV, 12-b fees, expense ratio,
alpha
16-32
Sources of Information



Lipper Inc.: leading provider of data and
analysis on the investment company business
( www.lipperweb.com )
Morningstar.com: provide unbiased data and
analysis and candid editorial commentary
(www.morningstar.com)
Vanguard Group: providing competitive
investment performance and lowest operating
expenses ( www.vanguard.com )
16-33