Transcript Slide 1
Chapter 23
Mutual Fund Operations
Financial Markets and Institutions
, 7e, Jeff Madura Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.
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Chapter Outline
Background on mutual funds Stock mutual fund categories Bond fund categories Growth and size of mutual funds Performance of mutual funds Money market funds
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Background on Mutual Funds
Mutual funds: Serve as a financial intermediary by pooling investments by individual investors and using the funds to accommodate financing needs by governments and corporations in the primary market Frequently invest in securities in the secondary market Provide an important service for individuals who wish to invest funds and diversify Offer liquidity if they are willing to repurchase an investor’s shares upon request
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Background on Mutual Funds (cont’d)
Types of funds Open-end funds: Are open to investment from investors at any time Allow investors to purchase or redeem shares at any time Have a constantly changing number of shares Maintain some cash in case redemptions exceed investments Consist of many different categories to satisfy investors’ investment needs
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Background on Mutual Funds (cont’d)
Closed-end funds: Do not repurchase shares they sell Require investors to sell the shares on a stock exchange Have a constant number of outstanding shares Have an asset size that is about 1/40 th of the asset size of open-end funds Focus primarily on bonds and other debt securities
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Background on Mutual Funds (cont’d)
Exchange-traded funds: Are designed to mimic particular stock indexes and are traded on a stock exchange Differ from open-end funds in that their shares are traded on an exchange, and their share price changes throughout the day Consist of a fixed number of shares Are not actively managed Have become very popular in recent years
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Background on Mutual Funds (cont’d)
Hedge funds: Sell shares to wealthy individuals and financial institutions and use the proceeds to invest in securities Differ from open-end funds because: They require a much larger initial investment They may not always accept additional investments or accommodate redemption They are unregulated and provide very limited information to prospective investors
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Background on Mutual Funds (cont’d)
Comparison to depository institutions Mutual funds repackage the proceeds from individuals to make various types of investments Investing in mutual funds represents partial ownership Investors share the gains or losses generated by the fund
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Growth and Size of Mutual Funds (cont’d)
Distribution of Aggregate Mutual Fund Assets 9% 5% 9% 6% 71% Common and Preferred Stock Municipal Bond Treasury Bonds Liquid Assets Corporate Bonds 9
Background on Mutual Funds (cont’d)
Distributions to shareholders Mutual funds generate returns to shareholders in three ways: They pass on earned income as dividend payments They distribute capital gains resulting from the sale of securities within the fund Mutual fund share price appreciation Mutual fund classifications Stock mutual funds, bond mutual funds, or money market mutual funds (see next slide)
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Background on Mutual Funds (cont’d)
Expenses incurred by shareholders Mutual funds pass their expenses on to their shareholders Expenses can be compared among mutual funds by comparing the expense ratio Equal to annual expenses per share divided by the NAV The higher the expense ratio, the lower the return for a given level of performance Mutual funds with lower expense ratios tend to outperform others with similar objectives
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Background on Mutual Funds (cont’d)
Expenses incurred by shareholders (cont’d) Expenses include: Compensation to the portfolio managers and other employees Record-keeping and clerical fees Marketing fees 12b-1 fees cover advertising expenses or compensate brokerage firms that advised their clients to invest in that fund
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Background on Mutual Funds (cont’d)
Sales load
Load funds
have a sales charge Promoted by brokerage firms who earn a sales charge between 3 and 8.5 percent Investors pay the sales charge through the difference between the bid and ask prices of the load fund
Front-end load
versus
back-end load 13
Background on Mutual Funds (cont’d)
Sales load (cont’d)
No-load funds
are promoted strictly by the mutual fund of concern Preferred by investors who feel capable of making their own investment decisions Recently, some small no-load funds have become load funds because they could not attract sufficient investors
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Background on Mutual Funds (cont’d)
Corporate control by mutual funds Large mutual funds can exert control over the management of firms because they are commonly a firm’s largest shareholders e.g., Fidelity is the largest shareholder of more than 700 firms Portfolio managers of many funds serve on the board of directors of various firms Many firms discuss any major policy changes with analysts and portfolio managers of funds to convince them that the change will have a favorable effect
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Stock Mutual Fund Categories
Growth funds
are composed of stocks of maturing companies that are expected to grow at a high rate The primary objective is to increase investment value
Capital appreciation funds
are composed of stocks that have high growth potential but may be unproven Suited to investors who are willing to risk a possible loss in value
Growth and income funds
provide potential for capital appreciation with some stability in income
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Stock Mutual Fund Categories (cont’d)
International and global funds International funds invest in foreign securities Returns on international funds are affected by the foreign companies’ stock prices and the movements of the currencies that denominate the stocks Global funds include some U.S. stocks
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Stock Mutual Fund Categories (cont’d)
Specialty funds
focus on a group of companies sharing a particular characteristic e.g., energy or banking
Index funds
are designed to match the performance of an existing stock index e.g., Vanguard 500
Multifund funds
invest in a portfolio of different mutual funds to achieve more diversification
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Bond Fund Categories
Income funds
are composed of bonds that offer periodic coupon payments and vary in exposure to risk Corporate bonds are subject to credit risk, Treasury bonds are not Bonds backed by government agencies are less risky than corporate bonds Tax-free funds contain municipal bonds Allows investors in high tax-brackets to avoid taxes while maintaining a low degree of credit risk
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INFORMATION IN PROSPECTUS
MIN AMOUNT OF INVESTMENT REQUIRED INVESTMENT OBJECTIVE RETURN ON FUND OVER PAST YEAR, PAST THREE YEARS AND PAST 5 YEARS EXPOSURE OF FUND TO VARIOUS RISKS
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SERVICES OFFERED BY MUTUAL FUND FEES INCURRED BY FUND WHICH IS PASSED ON TO UNIT HOLDERS.
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Bond Fund Categories (cont’d)
High-yield (junk) bond funds
consist of at least two thirds of bonds rated below Baa by Moody’s or BBB by S&P International and global bond funds International funds contain bonds issued by corporations or governments based in other countries Global bond funds contain U.S. as well as foreign bonds Foreign bonds are subject to credit risk, interest rate risk, and exchange rate risk
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Bond Fund Categories (cont’d)
Maturity classifications Bond funds are commonly segmented according to the maturities of the bonds they contain Intermediate-term bonds invest in bonds with 5 to 10 years remaining to maturity Long-term bond funds contain bonds with 15 to 30 years until maturity Long-term bonds have more interest rate risk Asset allocation funds contain a variety of investments such as stocks, bonds, and money market securities Portfolio managers adjust the compositions of these funds in response to expectations
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Growth and Size of Mutual Funds
The number of stock and bond funds is substantially larger today than it was during the 1980s Growth funds, income funds, international and global funds, and long-term municipal bond funds are the most popular types of bonds (see next slide) Growth and income funds are the most popular when measured according to total assets Common stocks are clearly the dominant asset maintained by mutual funds
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Performance of Mutual Funds (cont’d)
Research on stock mutual fund performance The performance should be compared to a market index and risk should be considered Most studies find that mutual funds do not outperform the market, especially when accounting for the type of securities that the fund invests in Even when returns are adjusted for risk, mutual funds fail to outperform the market
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Performance of Mutual Funds (cont’d)
Research on bond mutual fund performance In general, bond funds underperform bond indexes Generally, bond mutual funds with higher expense ratios generate lower returns Past performance does generally not serve as a useful indicator for future performance
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Money Market Funds
Money market funds: Are portfolios of money market instruments constructed and managed by investment companies Allow investors to participate for as little as $1,000 Usually allow check-writing privileges Send periodic account statements to their shareholders Send shareholders periodic updates on any changes in the asset portfolio composition Sell some of their assets when redemptions exceed sales
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Money Market Funds (cont’d)
Asset composition of money market funds Commercial paper dominates, followed by Treasury and other U.S. securities (see next slide) During recessionary periods, the proportion of Treasury bills normally increases Each individual MMF is concentrated in whatever assets reflect its objectives
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Money Market Funds (cont’d)
Maturity of money market funds The average maturity is determined by individual asset maturities, weighted according to their relative value In the mid-1970s, the average maturity was relatively long By the late 1970s, average maturity had declined to less than half During the 1980s, the average maturity was about 40 days The average maturity has generally increased since the 1980s
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Money Market Funds (cont’d)
Risk of money market funds Credit risk is low, with the exception of commercial paper defaults Money market securities are not too sensitive to movements in market interest rates Expected returns on MMFs are low because of: Low credit risk Low interest rate risk Consistently positive returns
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Hedge Funds
Sell shares to wealthy individuals and financial institutions and use the proceeds to invest in securities Have historically been unregulated but are not allowed to advertise Are usually organized as limited partnerships May allow investors to withdraw their investments but require advance notice of 30 days or more Often invest in derivative securities, sell short, or use borrowed funds along with equity investments Strive for high returns but also have a very high degree of risk
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Hedge Funds (cont’d)
Hedge fund fees Management fees usually range from 1 to 2 percent of the investment per year Incentive fees (usually 20 percent) are based on the return of the fund Regulation Hedge funds are not regulated
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Real Estate Investment Trusts
A real estate investment trust (REIT)
: Is a closed-end mutual fund that invests in real estate or mortgages Allows small investors to participate with a low minimum investment Generates income by passing through rents on real estate or interest payments on mortgages Can typically be sold on a stock exchange Can be either classified as an
equity REIT
, a
mortgage REIT
, or a hybrid
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Globalization through Mutual Funds
International and global mutual funds have facilitated international capital flows and helped create a global securities market Can reduce excessive transaction costs Increase the degree of integration among stock markets European countries have recently agreed to allow their respective mutual fund shares to be sold across their borders Due to NAFTA, qualified companies are allowed to sell mutual fund shares in Mexico
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