Transcript Document
24
Mutual Fund
Operations
1
Chapter Objectives
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
2
Background on Mutual Funds
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
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
3
Background on Mutual Funds
Mutual funds adhere to a variety of federal
and state regulations
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
4
Background on Mutual Funds
Mutual fund prospectus information includes:
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
Check writing
Telephone or Internet funds transfer
Management fees incurred that investors pay
5
Background on Mutual Funds
Estimating the net asset value
Net asset value is the value per share
Estimated daily
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
6
Mutual Fund Distributions
Earned Income from Dividends or Coupon Payments
Capital Gains from the Sale of Securities in Fund
Mutual Fund Price Appreciation
7
Background on Mutual Funds
Mutual fund classifications depend on the
type of securities the fund invests in and can
include
Stock or equity mutual funds
Bond mutual funds
Money market mutual funds
Family of funds offered by investment
companies
Investor able to allocate then transfer funds
among funds
8
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%
9
Background on Mutual Funds
Management of mutual funds
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
10
Background on Mutual Funds
Expenses
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
11
Background on Mutual Funds
Corporate control by mutual funds
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
12
Load versus No-Load Mutual
Funds
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
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
13
Open-End versus Closed-End
Funds
Closed-end funds
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
Willing to repurchase investor shares at any time
Number of shares outstanding does not remain constant
NAV determined by fund daily
14
Stock Mutual Fund Categories
Growth funds for investors who want high
returns with moderate risk
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
High but unproven growth potential stocks
Higher risk
15
Stock Mutual Fund Categories
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
Returns affected by stock prices
Returns also affected by foreign exchange rates
A global mutual fund invests in some U.S.
stocks
16
Stock Mutual Fund Categories
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
More diversified
Involves higher expenses
17
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
18
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
19
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%
20
Bond Fund Investment Objectives
Risks of bond funds
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
Interested in periodic income since prices are
volatile
Plan to hold the fund long term
21
Bond Fund Investment Objectives
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
International bond funds contain bonds issued by
governments or corporations from other countries
Global funds may contain both U.S. and foreign
bonds
22
Bond Fund Investment Objectives
Maturity classifications
Interest rate sensitivity depends on the maturity of
bonds
Funds are typically segmented based on maturity
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
23
Bond Fund Investment Objectives
Asset allocation funds
Funds that contain a variety of investments
Composition among stocks, bonds and money
market securities is based on manager’s
expectations
24
Growth and Size of Mutual Funds
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
25
Performance of Stock Mutual
Funds
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
26
Performance of Stock Mutual
Funds
Change in market conditions
Close relationship between performance and
market conditions
Change in sector conditions
Depends on the focus of the fund
Index funds
Asian funds
Change in management ability includes both
managers’ skills and operating efficiency
27
Performance of Stock Mutual
Funds
Performance of closed-end stock funds
Driven by the same factors that influence openended funds
Fixed supply of the fund’s shares
Additional issues
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
28
Performance of Bond Mutual
Funds
Performance of bond mutual funds as shown
in the model below
PERF= f ( Rf, RP, CLASS, MANAB)
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
29
Performance of Bond Mutual
Funds
Change in the risk free rate
Bond prices are inversely related to the risk- free
rate
When rates decline, most bond funds perform
well
Change in the risk premium
If required risk premiums increase, bond prices
fall
Linked to economic condition:
Risk premiums increase in recessions
Risk premiums decrease in boom times as investors
buy riskier investments
30
Performance of Bond Mutual
Funds
Impact of the bond fund’s classification
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
31
Performance of Mutual Funds
Investors should diversify among different
kinds of funds to reduce volatility
Research on stock mutual fund performance
Using return only is not valid
Mutual funds typically do not outperform the
market
Evaluate mutual fund expenses
Research on bond mutual funds
Bond mutual funds underperform bond indexes
Investors should look for low expense bond funds
32
Money Market Funds
Money market funds are portfolios of shortterm assets
Can include check-writing privileges for investors
Number of checks per month may be restricted
Shareholders get periodic statements
Liquid, “cash” balance for investor
33
Money Market Funds
Asset composition of money market funds
Individual funds concentrate in assets that reflect
the fund’s objective
Money market securities of varying maturity
Maturity of money market funds
Varies over time with market conditons
Risk increases with term
34
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%
35
Money Market Funds
Risk of money market funds
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
Consistent positive returns over time
Lower credit risk
Lower interest rate risk
36
Money Market Funds
Management of money market funds
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
37
Money Market Funds
Regulation of money market funds
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
38
Hedge Funds
Financial problems experienced by LongTerm Capital Management (LTCM)
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
39
Real Estate Investment Trusts
A real estate investment trust or REIT is a
closed-end mutual fund that invests in real
estate or mortgages
Classifications
Equity REIT
Mortgage REIT
Hybrid of the two
Sometimes seen as an inflation hedge
Performance influenced by interest rates and
area real estate performance
40
Other Issues
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
Reduces transactions costs
Increases market integration
41