Transcript Document

24
Mutual Fund
Operations
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Chapter Objectives
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Explain the concept of mutual fund operation
Explain various types of mutual funds
Describe the various types of stock and bond
mutual funds
Describe the characteristics of money market
funds
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Background on Mutual Funds
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Mutual funds offer a way for small investors
to diversify when they could not do so on
their own with the purchases of individual
stocks
Comparison to depository institutions
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Like depository institutions, mutual funds
repackage proceeds from individuals to make
investments
Bank deposits are a liability contract, but a
mutual fund represents partial ownership
No federal insurance with mutual fund shares
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Background on Mutual Funds
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Mutual funds adhere to a variety of federal
and state regulations
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Securities and Exchange Commission (SEC)
regulates
Funds must register and provide a prospectus to
investors
Disclosure since 1993 of manager’s name and
length of time employed in that position
Mutual fund itself is exempt from income
taxation if fund distributes 90 percent of
taxable income
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Background on Mutual Funds
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Mutual fund prospectus information includes:
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The minimum amount of investment required
The investment objective of the fund
The return on the fund over the past year, the past
three years and the the past five years
The exposure of the fund to various types of risk
Services the fund offers
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Check writing
Telephone or Internet funds transfer
Management fees incurred that investors pay
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Background on Mutual Funds
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Estimating the net asset value
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Net asset value is the value per share
Estimated daily
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Determine the market value of all the securities in the
fund
Any interest or dividends added in
Expenses subtracted
Divide by the number of shares
Dividends lower NAV
NAV quotes
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Mutual Fund Distributions
Earned Income from Dividends or Coupon Payments
Capital Gains from the Sale of Securities in Fund
Mutual Fund Price Appreciation
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Background on Mutual Funds
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Mutual fund classifications depend on the
type of securities the fund invests in and can
include
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Stock or equity mutual funds
Bond mutual funds
Money market mutual funds
Family of funds offered by investment
companies
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Investor able to allocate then transfer funds
among funds
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Exhibit 24.2 Distribution of
Investment in Mutual Funds
Money
Market Funds
$1,845 billion
27%
Hybrid Funds
$349 billion
5%
Stock Funds
$3,962 billion
57%
Bond Funds
$808 billion
11%
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Background on Mutual Funds
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Management of mutual funds
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Managers invest in a portfolio of securities to
meet the objectives of the fund
Cover management costs with fees which are
typically around one percent of total assets per
year
Managers adjust the composition of their
portfolios in response to market and economic
conditions
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Background on Mutual Funds
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Expenses
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Fees include management plus record-keeping
and clerical fees
Expense ratio = annual expenses/fund NAV
Passed on to investors since NAV is reduced by
fees
Investor should compare expense ratios
Active marketing expenses and compensation
increases expenses—12b-1 expenses
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Background on Mutual Funds
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Corporate control by mutual funds
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Mutual funds are large shareholders in companies
whose stock they hold
Managers may serve on the board of directors of
companies in which the fund invests
Companies try to satisfy mutual fund managers in
order to keep them from selling their stake in the
firm
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Load versus No-Load Mutual
Funds
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Classification refers to whether or not there is
a sales charge
No-load means funds are promoted, bought
and sold directly via the mutual fund
Load funds
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Promoted by registered representatives of
brokerage firms who get a commission
Investors pay the sales charge
12b-1 expenses are “loads” used by no-load funds
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Open-End versus Closed-End
Funds
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Closed-end funds
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Mutual fund does not repurchase the shares they sell—
similar to direct common stock investment
Investors must sell shares on an exchange
Number of outstanding shares is constant
Value of shares related to expectations of portfolio and
determined in market
Open-end “mutual” funds
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Willing to repurchase investor shares at any time
Number of shares outstanding does not remain constant
NAV determined by fund daily
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Stock Mutual Fund Categories
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Growth funds for investors who want high
returns with moderate risk
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Mutual fund invests in companies that are
expected to grow at a higher than average rate
Generate an increase in investment value rather
than steady income
Capital appreciation or aggressive growth
funds
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High but unproven growth potential stocks
Higher risk
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Stock Mutual Fund Categories
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Growth and income funds try to offer growth
but with some stability of income
International and global funds allow
investment in foreign securities without the
costs involved in purchasing and monitoring
individual stocks
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Returns affected by stock prices
Returns also affected by foreign exchange rates
A global mutual fund invests in some U.S.
stocks
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Stock Mutual Fund Categories
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Internet funds focus on investments in
Internet companies
Specialty funds focus on a group of
companies sharing a particular characteristic
Index funds are designed to simply match the
performance of an existing stock index
Multifund funds invest in a portfolio of
different mutual funds
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More diversified
Involves higher expenses
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Exhibit 24.3 Growth in Number of
Equity and Bond Funds
8000
Bond Funds
7000
Stock Funds
6000
5000
4000
3000
2000
1000
0
1978
1985
1990
1995
Year
1999
2001
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Exhibit 24.4 Investment in Bond
and Stock Mutual Funds
5000
Bond Funds
4000
Stock Funds
3000
2000
1000
0
1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
Year
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Exhibit 24.5 Distribution of
Aggregate Mutual Fund Assets
Municipal Bond
$269 Billion
Long-Term U.S. Gov’t
5%
$309 Billion
6%
Cash
$277 Billion
5%
Corporate Bonds
$349 Billion
7%
Preferred Stock
$28 Billion
1%
Common Stock
$3,882 Billion
76%
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Bond Fund Investment Objectives
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Risks of bond funds
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Interest rate risk
Credit risk
Tax implications of bond fund investments
Income bond funds vary in terms their
exposure to credit risk and focus on periodic
coupon payments and attract investors who
are
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Interested in periodic income since prices are
volatile
Plan to hold the fund long term
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Bond Fund Investment Objectives
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Tax-free funds for high tax bracket investors
High-yield or junk bond funds invest in bonds
with a high risk of default
International and global bond funds
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International bond funds contain bonds issued by
governments or corporations from other countries
Global funds may contain both U.S. and foreign
bonds
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Bond Fund Investment Objectives
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Maturity classifications
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Interest rate sensitivity depends on the maturity of
bonds
Funds are typically segmented based on maturity
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Intermediate-term funds invest in bonds with 5 to 10
years remaining to maturity
Long-term funds invest in maturities of 15 to 30 years
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Bond Fund Investment Objectives
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Asset allocation funds
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Funds that contain a variety of investments
Composition among stocks, bonds and money
market securities is based on manager’s
expectations
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Growth and Size of Mutual Funds
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Volume and mix in the kind of funds varies
over time
Overall investment via mutual funds much
higher in recent years
New kinds of funds target customers with
different risk preferences
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Performance of Stock Mutual
Funds
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Both investors and managers closely monitor
performance as modeled by the equation below
 PERF= f ( MKT,  SECTOR,  MANAB)
Where:
PERF = Performance
MKT = General stock market conditions
SECTOR = Conditions in the fund’s sector
MANAB = The ability of the fund’s management
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Performance of Stock Mutual
Funds
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Change in market conditions
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Close relationship between performance and
market conditions
Change in sector conditions
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Depends on the focus of the fund
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Index funds
Asian funds
Change in management ability includes both
managers’ skills and operating efficiency
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Performance of Stock Mutual
Funds
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Performance of closed-end stock funds
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Driven by the same factors that influence openended funds
Fixed supply of the fund’s shares
Additional issues
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Performance is affected by changes in the premium or
discount relative to NAV
If the fund’s premium increases relative to NAV,
return to fund holders increases
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Performance of Bond Mutual
Funds
Performance of bond mutual funds as shown
in the model below
 PERF= f ( Rf,  RP,  CLASS,  MANAB)
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Where:
PERF = Performance
Rf = Risk free interest rates
RP =Risk premium
CLASS =the classification of the bond fund
MANAB = The ability of the bond fund’s management
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Performance of Bond Mutual
Funds
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Change in the risk free rate
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Bond prices are inversely related to the risk- free
rate
When rates decline, most bond funds perform
well
Change in the risk premium
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If required risk premiums increase, bond prices
fall
Linked to economic condition:
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Risk premiums increase in recessions
Risk premiums decrease in boom times as investors
buy riskier investments
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Performance of Bond Mutual
Funds
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Impact of the bond fund’s classification
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Some funds target a specific risk or maturity
Classification may have more impact than any
other factor
Change in management abilities
Performance of closed-end bond funds is
affected by all of the other factors and
changes in the premium or discount
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Performance of Mutual Funds
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Investors should diversify among different
kinds of funds to reduce volatility
Research on stock mutual fund performance
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Using return only is not valid
Mutual funds typically do not outperform the
market
Evaluate mutual fund expenses
Research on bond mutual funds
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Bond mutual funds underperform bond indexes
Investors should look for low expense bond funds
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Money Market Funds
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Money market funds are portfolios of shortterm assets
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Can include check-writing privileges for investors
Number of checks per month may be restricted
Shareholders get periodic statements
Liquid, “cash” balance for investor
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Money Market Funds
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Asset composition of money market funds
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Individual funds concentrate in assets that reflect
the fund’s objective
Money market securities of varying maturity
Maturity of money market funds
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Varies over time with market conditons
Risk increases with term
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Exhibit 24.7 Composition of
Money Market Fund Assets
U.S. Treasury
Securities
$91 billion
6%
Other
$303 billion
20%
Other U.S. Securities
$189 billion
13%
Repurchase
Agreements
$186 billion
12%
Commercial Paper
$620 billion
41%
CDs
$123 billion
8%
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Money Market Funds
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Risk of money market funds
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Credit risk minimized by the short-term nature of
maturities
Returns for money market funds fall as interest
rates in the economy fall
Expected returns are low relative to stock and
bond funds
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Consistent positive returns over time
Lower credit risk
Lower interest rate risk
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Money Market Funds
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Management of money market funds
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Managers try to maintain the overall objective of
the fund
Manage the composition of the assets
Investors have a variety of choices when it comes
to money market funds
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Money Market Funds
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Regulation of money market funds
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Securities Act of 1933 requires that funds provide
full information to investors via a prospectus
Investment Company Act of 1940 contains
restrictions to prevent conflicts of interest
between investors and mangers
Funds are exempt from tax if 90% of earnings
are distributed to shareholders
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Hedge Funds
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Financial problems experienced by LongTerm Capital Management (LTCM)
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Hedge funds sell shares to wealthy investors and
financial institutions
Historically unregulated
Invest in derivatives, sell stock short, and
combine borrowing to magnify returns
LTCM experienced problems when risky
investments lost money
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Real Estate Investment Trusts
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A real estate investment trust or REIT is a
closed-end mutual fund that invests in real
estate or mortgages
Classifications
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Equity REIT
Mortgage REIT
Hybrid of the two
Sometimes seen as an inflation hedge
Performance influenced by interest rates and
area real estate performance
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Other Issues
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Mutual funds interact with banks, savings
institutions, finance companies, securities
firms, insurance companies, and pension
funds
Mutual funds typically use all the various
financial markets including money, bond,
mortgage, stock, futures, options, and swap
markets
Globalization is facilitated by mutual funds
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Reduces transactions costs
Increases market integration
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