1.1.1.1.1Chapter Seventeen
Investment Companies
1.1.1.2 I. Chapter Outline
1. Investment Companies: Chapter Overview
2. Size, Structure, and Composition of the Mutual Fund Industry
a. Historical Trends
b. Different Types of Mutual Funds
c. Other Types of Investment Company Funds
3. Mutual Fund Returns and Costs
a. Mutual Fund Prospectuses and Objectives
b. Investor Returns from Mutual Fund Ownership
c. Mutual Fund Costs
4. Mutual Fund Balance Sheets and Recent Trends
a. Long-Term Mutual Funds
b. Money Market Mutual Funds
5. Mutual Fund Regulation
6. Mutual Fund Global Issues
7. Hedge Funds
a. Types of Hedge Funds
b. Fees on Hedge Funds
c. Offshore Hedge Funds
d. Regulation of Hedge Funds
II. Learning Goals
1. Examine how and why the mutual fund industry has grown through time.
2. Distinguish between long-term mutual funds and money market mutual funds.
3. Distinguish between open-end mutual funds, closed-end funds, and unit investment funds.
4. Understand what is contained in a mutual fund prospectus.
5. Calculate the net asset value of and the return on a mutual fund investment.
6. Identify the main regulators of mutual funds.
7. Examine trends in the dollar value of mutual funds outstanding globally.
8. Know what a hedge fund is.
1.1.1.3 III. Chapter in Perspective
Mutual funds pool investors’ funds and invest in money or capital market instruments, and
sometimes derivatives. They allow investors to gain diversification and professional
management according to specific published objectives at low cost. Money market mutual
funds provide denomination intermediation to investors as most money market securities have
denominations that are too large for individual savers to afford. They also offer higher rates of
return than bank accounts. Recall from Chapter 1 that investors desire to place some of their
funds in less liquid, higher earning accounts to fund long term goals. Long term mutual funds
provide investors a low cost means to gain exposure to high return markets while eliminating
most diversifiable risk. The strong stock market of the 1990s brought record increases in both the
level of mutual fund assets and the numbers of funds. The poorer stock market performance of
the early 2000s however, slowed and even reversed the trend of mutual fund growth. From the
end of 2001 to June 2002, industry assets declined about $340 billion due to fund withdrawals
and declining equity values. Growth returned to the industry in 2003 and 2004 with better stock
market returns. In 2005 and 2006 net new cash flows in equity funds were $135.6 and $159.4
billion respectively before dropping off to $92.4 billion in 2007. Hedge funds grew rapidly after
generating very high returns in the 1990s and early 2000s. However, the financial crisis in the
late 2000s led to the largest decline in mutual fund industry assets ever. Assets fell $2.4 trillion to
$9,602.6 billion, a 20% drop in 2008. Industry assets in 2010 recovered to $11,267.0 billion.
Similarly net new cash flows in 2008 were -$233.9 billion, the worst in recent times. Equity
funds had the worst outflows overall while inflows to the much safer government bond funds
actually increased during the crisis. Even in 2013 the amount of funds invested in equity in long
term funds had not yet recovered even though losses from incurred during the crisis had been
recovered.
1.1.1.4 IV. Key Concepts and Definitions to Communicate to Students
Equity funds Open-end mutual fund
Bond funds Closed-end investment company
Hybrid funds Real Estate Investment Trust (REIT)
Money market mutual funds Load fund
Marked to market No-load fund
Net asset value (NAV) 12b-1 fee
Hedge funds Tax exempt funds
Capital gains distributions Dividend distributions
Mutual fund share classes Performance fees
Risky arbitrage Directional trading
1.1.1.5 V. Teaching Notes
1. Investment Companies: Chapter Overview
Open end mutual funds sell shares to the public and redeem them from the public. Thus,
liquidity is never a concern to fund shareholders.1 The mutual fund pools the cash received and
invests in securities in line with the fund’s stated objective. Because the funds invest in large
amounts, they are able to negotiate very low transaction costs. Thus, small investors (and even
many institutional investors) are able to obtain diversified portfolios on more favorable terms
than they could achieve on their own. Mutual funds provide other services to investors as well
including:
Free exchange of investment between a mutual fund company’s funds
Automatic periodic investment and reinvestment of fund distributions
Check writing privileges on certain funds type (MMMF and bond funds)
Automatic withdrawals
Record keeping for tax purposes
2. Size, Structure, and Composition of the Mutual Fund Industry
a. Historical Trends
Mutual funds are the second largest type of financial intermediary in the U.S. beyond only
depository institutions. Although mutual funds have been around since the 1920s, as recently as
1970 there were only 361 funds with $50 billion in total industry assets. In 2013 there were
7,707 mutual funds with total net assets of $15,015.2 billion. There has been a huge increase in
the number of accounts since 1990, although all numbers fell during the crisis. Part of the
growth in mutual funds has been driven by the growth in retirement funds under management by
the mutual fund industry. Retirement funds grew from $4.0 trillion in assets in 1990 to over $20
trillion in 2013. Mutual funds manage about 25% of this total. Much of the growth in this market
has come from so called institutional funds, which are funds that manage retirement plans for a
company’s employees. New innovations in retirement focused funds include target date (aka
lifecycle) funds and lifestyle (aka target risk) funds. The former employs asset allocation among
a group of funds that reduce risk as the target retirement date nears. The latter employs a
constant level of risk.
Money market mutual funds (MMMFs) grew in the 1970s due to Regulation Q. Regulation Q
limited the rate of interest banks could pay on their deposits and rising open market rates induced
investors to seek higher returns in money market mutual funds. Tax exempt funds grew rapidly
in the 1980s as taxes owed climbed, and bond and equity funds grew tremendously rapidly with
the bull markets of the 1980s and 90s. Mutual funds are now the second largest financial
intermediary, and if their rate of growth continues, they will soon overtake banks as the country’s
largest intermediary. As a result of the rapid growth, commercial banks, insurers and other
institutions have also begun operating investment management funds. There are generally low
entry barriers into the fund industry. The twenty five largest funds however manage 73% of
industry assets indicating that there are large economies of scale in fund expenses that promote
large size.
b. Different Types of Mutual Funds
1 This risk is borne by the fund and requires the fund to hold larger cash balances than they
would otherwise.
2013
Categor
y
Billions $
Percen
t Percent
Total Net Assets $ 13,045.23
Equity
Capital apprecia!on 2,619.28 20.1%
World equity 1,613.85 12.4%
Total return 1,701.17 13.0%
Total equity 5,934.30 45.5%
Total hybrid 991 7.6%
Bond
Corporate bond 517.14 4.0%
High-yield bond 265.86 2.0%
World bond 329.61 2.5%
Government bond 298.27 2.3%
Strategic income 1,436.67 11.0%
State municipal 177.53 1.4%
Na!onal municipal 401.32 3.1%
Total bond 3,426.40 26.3%
Money Market
Taxable funds 2,406.10 18.4%
Tax-exempt funds 287.43 2.2%
Total money market $ 2,693.53 20.6%
100.0%
Major types of funds include:
Long term funds (79.4% of mutual fund assets 2013)
Equity funds: Primarily hold common and preferred stock (45.5%)
Bond funds: Primarily hold fixed income securities with maturities over 1 year (26.3%)
Hybrid funds: Blends of equity and bond funds. (7.6%)
Tax exempt funds: Funds that specialize in investing in tax exempt securities
Short term funds (20.6% of mutual fund assets in 2013)
Money market mutual funds: Funds that invest in securities with 1 year maturity or
less.
Tax exempt money market mutual funds
In 2013 long term funds comprised about 79% of total funds, after falling to as low as 59.1% in
prior years due to the crisis in the economy. The money market fund share actually grew to about
40% during the crisis, in part because the Fed temporarily insured all money fund accounts.
Over the longer term, the split between long term and short term funds used to be about 60:40,
but stronger equity bull markets and increased education about equity investments increased
holdings in long term funds, particularly equities.
Individual investors held about 57.3% of long term funds in 2013 and 38.4% of short term funds.
Investors in MMMFs give up deposit insurance, but usually gain higher rates of return. This is
probably a safe bet to gain a slightly higher rate of return as only one MMMF has ever failed.
Individual participation in mutual funds is becoming more widespread as financial education
increases and interest in the stock market continues. The primary reason most people hold
mutual funds is to provide supplemental retirement income. The bull markets of the 1990s, the
low transactions costs of purchasing shares, the diversification achieved, and the other services
provided by funds are major reasons behind their rapid growth. Fund growth slowed with the
poorer stock markets of the early part of the century, but growth in market value of long term
funds from 2002 to 2004 was 22% per year. Money market fund growth was -8% per year over
the same time period. Long term funds grew to 75.4% in 2006 as the stock market performed
well before falling back in 2007 as the mortgage market effects spilled over into stocks and other
long term investments. In 2007 and 2008 flows to these funds increased before declining as the
economy recovered and more investors began seeking higher yields. Low rates of return
continue to deter investment in MMMFs.
c. Other types of investment companies
Closed end funds: Closed end investment companies have a fixed number of shares
outstanding and do not issue new shares or redeem shares from investors. These shares are
traded like stocks and may be exchange listed. Closed end funds are either created as a closed
end company, as most unit investment trusts are, or they are former mutual funds that have
decided to close to new investors, such as Fidelity’s Magellan Fund. Unlike mutual fund shares,
closed end fund shares may trade at a premium or a discount to the NAV of the fund. Empirical
evidence has presented no convincing reason why fund discounts and premiums exist. In 2013
there was $265 billion invested in 602 closed end funds.
Unit investment trusts (UITs), such as the popular real estate investment trusts (REITs), may
be levered and can have extreme rates of return. UITs are fixed composition funds that may hold
up to 20 to 25 investments, but the portfolio composition is static and the fund has a fixed
termination/liquidation date. As of 2013 there were about $72 billion invested in 5,787 UITs.
3. Mutual Fund Returns and Costs
a. Mutual Fund Prospectuses and Objectives
Mutual funds are required to publish the specific objectives of the fund in the prospectus (a
formal summary of a proposed investment). No investor should invest in a fund without
carefully reading the prospectus. The prospectus will contain historical return information,
usually for 1 year, 3 year and 5 year periods and perhaps longer. The prospectus must also show
historical fees and the effect of those fees on a given investment over time.
Teaching Tip: The reader should be aware that a prospectus, while containing necessary
information for the investor, is basically a marketing tool. For instance, one rarely finds much
about risk in a prospectus and the funds will often tout the period that makes the returns appear
the best.
Teaching Tip: Fund objectives and appropriate goals (major categories only): See
www.morningstar.com, www.ici.org, and Malkeil, B., A Random Walk Down Wall Street, W.W.
Norton Press 1990. Much of the following material is drawn from Malkeil’s book.
Fund Type
Aggressive Growth
Fund Objective
Common stock fund, stressing picking stocks with unrecognized growth, usually small firms or
sector funds, high turnover, higher beta or stocks, little or no dividend income. These funds
have substantial potential for capital loss. Sector funds, small and mid cap growth funds may fit
into this category. There are also some bear market funds that invest counter-cyclically.
Compatible Investor Goal(s)
Long time horizon, willing and able to take substantial risk in hope of high returns, high ability
to remain in the markets regardless of economic conditions.
Growth
Fund Objective
Common stock fund, stressing picking some stocks with unrecognized growth, and some stocks
that pay moderate to substantial dividends, moderate to high turnover, higher beta stocks, only
moderate dividend income. These funds also have substantial potential for capital loss. Large
cap growth funds are an example in this category
Compatible Investor Goal(s)
Long time horizon, willing and able to take substantial risk in hope of high returns, high ability
to remain in the markets regardless of economic conditions.
Growth & Income
Fund Objective
Basically a common stock fund, probably with some bonds, stressing picking some stocks with
unrecognized growth, and some stable stocks that pay substantial dividends as well as coupon
bearing bonds, moderate turnover, fund beta at or near the ‘market’, generally higher dividend
income. There is a substantial potential for capital loss in adverse economic conditions. All size
blend and value funds may fit into this category.
Compatible Investor Goal(s)
Those with a moderate to long time horizon, willing and able to take risk in hope of higher
returns, moderate ability to remain in the markets regardless of economic conditions.
Index
Fund Objective
Duplicate performance of some index such as the S&P500. These are funds that attempt to
mimic the performance of a given index, because they do not actively engage in timing and stock
selection they generally have lower expense ratios than other funds.2 In 2013 there were 373
index funds managing about $1.3 trillion in assets. Like all stock funds there is substantial
chance of capital loss during adverse economic conditions. These funds have very low turnover
and low expenses. There are index funds that mimic performance of the entire market while
some funds are designed to give returns similar to an industry or market sector, including
different size sectors such as small caps, mid caps, etc. There are also various international index
funds available now. Exchange traded funds (ETF) are a variant of index funds that are traded
2The average expense ratio for Vanguard funds is 0.19%, considerably below expense ratios for
managed portfolio which average about 1.3%.
on an exchange. In 2013 there were about $1,465 billion invested in ETFs. The advantage of an
ETF is that it can be traded throughout the day at continuously updated prices. ETFs can be
purchased on margin and sold short, unlike index funds. There are no capital gains distributions
to add to tax liability in a given year either. These features allow for better hedging and arbitrage
strategies. Examples include SPDRs on the AMEX and Vanguard’s Large-Cap VIPERS funds.3
Compatible Investor Goal(s)
Investors with a moderate to long time horizon that are willing and able to take risks in return for
yields comparable to the ‘market’. Investors are often those who believe in efficient markets with
staying power to ride out tough economic times.
Balanced
Fund Objective
Approximately equal proportions of stocks and bonds although this varies with market
conditions; they are usually very well diversified. The stocks are usually “blue-chip” type with
established dividend records. Bonds are usually high grade with substantial coupons, the fund
focus is typically (but not always) on current income. Some may have substantial international
investments for diversification purposes. The fund’s beta is usually below the ‘market’, with
generally high dividend and interest income. Investors face moderate potential for capital loss in
adverse economic conditions. A special type of balanced funds called Target Date funds have
now developed that are designed for investors who will retire within the given target date. As
investors age they normally want to reduce the risk of their investments. These funds do this
automatically as the target date approaches.
Compatible Investor Goal(s)
Those with a moderate time horizon, willing and able to take moderate risk in return for higher
current income, and have some ability to remain in the markets regardless of economic
conditions.
Income
Fund Objective
Primarily higher current yield, fixed income securities, mostly bonds. Bonds are usually high
grade with substantial coupons; the objective is usually to generate maximum current income.
The fund beta is normally substantially below the ‘market’, and the fund normally generates high
interest income. There is some potential for capital loss in adverse economic conditions.
Inflation risk can be severe and taxes can significantly erode returns.
Compatible Investor Goal(s)
Those with a moderate time horizon, willing and able to take moderate risk in return for higher
current income, investors are often those who need the investment income for living expenses.
Money Market
Fund Objective
Lower yielding fixed income securities. Most fund investments will have a maturity less than or
equal to 1 year. The fund objective is to provide a rate of return superior to bank investments
while minimizing chance of capital loss. There is little risk of capital loss.
Compatible Investor Goal(s)
3 SPDRs mimic the S&P500, and VIPERS track an index of large capitalization stocks.
Investors with a short to moderate time horizon, who are unwilling or unable to take much risk in
return for moderate to low yields. Investors are often those who need the investment income for
living expenses and cannot afford to risk capital losses, or the funds may be used as a ‘parking
space’ for a short time. There are potentially large opportunity losses on these investments if
held for a long time period.
These statements are generalities and many variations exist within a fund category. For instance,
it is entirely possible to find a growth fund with greater risk than an aggressive growth fund.
See Morningstar for more specific fund objective definitions. Growth funds have been among
the most popular in recent years.
About 53.8 million households (44.4%) owned mutual funds in 2013. The median age investor is
51 although two-thirds are between ages 35 and 64. They are employed, married and have a
working spouse. About 79% of fund holders invest in some equities. The median investment is
$80,000 and the median number of funds held is four. Although many people now check their
fund’s performance over the Internet, the majority do not conduct buy/sell transactions on-line.
b. Investor Returns from Mutual Fund Ownership
Returns come from three sources:
1. Appreciation in the value of the mutual fund’s shares due to unrecognized gains in the fund’s
underlying assets. These are usually marked to market daily. The value of a mutual fund
share is its net asset value (NAV). The NAV is equal to the total value of the fund’s holdings
less any liabilities divided by the number of mutual fund shares outstanding. Mutual funds
are open ended, meaning that investors buy shares directly from the fund and the fund
redeems their shares upon demand. NOTE: It is important to understand that NAV is set as
of 4:00 PM EST each business day.
Teaching Tip: Most mutual funds are limited in the amount of debt (liabilities) they can use.
Many unit trusts are not however. Leveraged funds have generally riskier rates of return and
have bankruptcy risk. A mutual fund should not technically go bankrupt (absent substantial
derivatives positions) because they owe only the market value of their holdings. However in
September 2008, Primary Reserve Fund- a money market mutual fund ‘broke the buck’ and had
its share value fall below the standard $1 due to losses on $785 million of commercial paper
issued by Lehman brothers. This led to contagion and a run on money funds with over $200
billion outflows over the next few days. The Treasury guaranteed payments on money funds for
one year to stop the runs. The insurance ran out September 19, 2009. You can track the resulting
change in flows in Text Figure 17-2.
Teaching Tip: A disadvantage of the open end nature of mutual funds is the need to hold a cash
reserve to handle redemptions from fund shareholders. Without cash reserves a mutual fund can
be forced to sell fund holdings to redeem shares. A dramatic case of this occurred in the crash of
October 1987. At the time funds held low cash reserves and were forced to sell to meet the very
large number of redemption orders. NOTE: In a more general sense, newer evidence on funds’
ability to profitably engage in stock selection indicates that fund managers may have some real
stock selection ability once we separate out liquidity trades from information trades of fund
managers. This implies a higher cost to the open end structure than we previously thought.
2. Dividend distributions: Distributions by the fund of dividend and interest income earned on
the fund’s underlying holdings. Funds are normally required to distribute at least 90% of
dividend and interest income earned.
3. Capital gains distributions: Recognized capital gain increases due to the fund’s selling of
shares result in capital gains distributions. Funds are normally required to distribute at least
90% of realized capital gains.
Distributions are normally paid quarterly or annually.
Teaching Tip: Investors will not normally wish to buy into a fund right before a distribution date.
Doing so will create taxable income from the distributions in the current tax year. The taxable
income will be offset by a capital loss on the mutual fund shares, but the loss will be
unrecognized until the individual sells the mutual fund shares.
Teaching Tip: Investors should choose a fund with a turnover rate that meets their goals,
particularly if the fund is not held in a tax sheltered vehicle. High turnover funds generate more
tax liabilities each year. Taking 0.5 (1 / annual turnover ratio) will give the average holding
period of securities within the fund. Turnover ratios are reported by Morningstar and in the fund
prospectus.
c. Mutual Fund Costs
Costs to a mutual fund investor (not all funds charge each type of fee).
Load charge: The load is usually a front end load, meaning that this fee is paid up front
when the investor buys shares in the fund. It is conceptually equivalent to a broker’s
commission. The maximum size load allowed is 8.5%, although very few funds (mostly
sector or international funds) charge loads over 5% today because of the competitiveness of
the mutual fund industry. In fact, the majority of funds now charge no load at all and the
amount of dollars invested in load funds is lees than invested in so called ‘no load’ funds. No
load funds are directly marketed, consequently, the investor must go looking for them.
Brokers sell load funds. Statistical performance of load funds is no better than the
performance of no load funds; thus, investors who use load funds are paying for the advice of
a broker as to what type of fund is appropriate for them, but there is no other return for
paying the load charge. Some funds charge back end loads instead of or in addition to front
end loads. In a back end load the investor pays the load when the shares are sold. This is
better than a front end load because in a front end load you earn nothing on the amount that
goes to the broker whereas that money could be invested for the holding period on a back end
load. If a fund has multiple class shares (and over half now do), the different classes usually
represent different methods of assessing the load charge. Some funds charge holding period
contingent back end loads such that the load is reduced if the investor leaves their money
with the fund for longer periods. Usually after five years the load is zero.
For example
Class A shares pay a front end load, and usually incur a small 12b-1 fee (see below)
Class B shares have no front load, but incur a back end load and a larger 12b-1 fee; after a
set period of time such as 6-8 years, the Class B shares convert to Class A and thus incur the
smaller 12b-1 fee.
Class C shares have no front load, and a back end load is incurred only if shares are sold
within a set number of years. These shares do not normally convert to Class A and carry the
full 12b-1 fee for the entire time they are held.
Teaching Tip: This means investors face tradeoffs in determining which class of fund share to
purchase. The best choice will depend on the terms of the fund, the expected time the investor
will stay in the fund and in some cases the amount of money invested. Normally, Class A
shares entail the highest cost because less money is invested with the front load deduction. The
real cost of a front end load is actually worse than the stated load. If you have $1,000 to invest
and you place your money in a fund with a 5% front end load you get an investment worth $950.
So you pay a commission of $50 which gives a commission rate of $50 / $950 or 5.26%. For
longer expected holding periods the investor may be better off with Class B shares rather than
Class C shares because of the reduced 12b-1 fee after the conversion.
The demand for no load funds has been increasing and discount (and other) brokers offer
investors services where the investor can buy and sell mutual funds shares offered by different
mutual funds sponsors without incurring any load charges. Brokers are compensated by a
portion of the 12b-1 fees.
Teaching Tip: The American Association of Individual Investors (AAII) publishes a low cost
book annually titled, “The Individual Investor’s Guide to Low Load Mutual Funds.” Low load is
4% or less. A searchable database is also available. The best source of mutual fund data is
probably Morningstar, which provides its Principia product at a reasonable cost.
12b-1 fees: The hidden load. For some reason the SEC allows funds to assess what is called a
12b-1 fee in lieu of (or in addition to) a front end load. With a front end load the investor
purchasing the fund shares pays all of the commission. In a 12b-1 plan the load is assessed on all
the fund’s shareholders. This makes the load amount (%) appear smaller. Marketing and
servicing costs can be no more than 0.25% per year and management fees are limited to 0.75%
per year; thus the maximum 12b-1 charge is 1% per year. A no-load fund can charge a 12b-1 fee
of no more than 0.25% and still advertise as a no load fund. As noted the maximum for load
funds is 1%. The assessed fee may vary with the class of shares chosen as discussed above.
Operating Expenses: Fund managers’ expenses and profits are generated by the operating
expenses that are assessed to the fund.
Total costs of investing in mutual funds declined in the 1990s and costs are likely to continue to
drop.
Teaching Tip: The effect of loads and fees on returns
This year you invested $10,000 in a mutual fund with a 6% load (one time fee) and estimated
annual expenses of 1.35%. Fees are charged against average assets for the year. The gross
return is 11.5%. What is your return net of loads and expenses?
Amount initially invested = $10,000 – (0.06 $10,000) = $9,400
Amount after gross return = $9,400 1.115 = $10,481
Average asset value for year = ($10,481 + $9,400) / 2 = $9,940.50
Fees = $9,940.50 * 0.0135 = $134.20
Ending amount after fees = $10,481 – $134.20 = $10,346.80
Net rate of return (first year) = ($10,346.80 / $10,000) – 1 = 3.47%
Teaching Tip: Fees are assessed on average assets, but for simplicity I often have students use
year end assets. In the mutual fund prospectus and annual reports the fund returns presented are
net of operating expenses, 12b-1 fees and commissions, but the reported returns do not include
loads.
In 2013 average fees and expenses paid by mutual fund investors were 0.77% on stock funds
and 0.61% on bond funds. These expenses have continued to fall (see below):
Average fund expenses/yr Equity funds Bond funds
1990 1.98% 1.89%
2004 1.18% 0.92%
2009 0.99% 0.75%
2012 0.77% 0.61%
Mutual fund quotes are similar to stock quotes. The Wall Street Journal for instance provides
NAV, investment objective, expense ratio, and load charges if any. Fund returns are also ranked
within the investment objective. Morningstar rankings include an adjustment for fund risk and
thus are probably better rankings to use. Nevertheless, most studies show that rankings are not
predictive of future performance so care must be used in interpreting any ranking scheme.