Chapter 20
The Mutual Fund Industry
The Growth of Mutual Funds
The First Mutual Funds
Benefits of Mutual Funds
Ownership of Mutual Funds
Mutual Fund Structure
Open- Versus Closed-End Funds
Organizational Structure
Case: Calculating a Mutual Fund’s Net Asset Value
Investment Objective Classes
Equity Funds
Bond Funds
Hybrid Funds
Money Market Funds
Index Funds
Fee Structure of Investment Funds
Regulation of Mutual Funds
Hedge Funds
Mini-Case Box: The Long-Term Capital Debacle
Conflicts of Interest in the Mutual Fund Industry
Sources of Conflicts of Interest
Mutual Fund Abuses
Conflicts of Interest Box: Many Mutual Funds are Caught Ignoring Ethical Standards
Conflicts of Interest Box: SEC Survey Reports Mutual Fund Abuses Widespread
Government Response to Abuses
◼ Overview and Teaching Tips
Mutual funds have grown rapidly over the last two decades. Their growth has been partly fueled by increases
in the number of investors who are responsible for managing their own retirement. The increased liquidity
and diversification they provide, among other factors, have also been important. There are currently over
7596 separate mutual funds with $13 trillion in net assets.
Mutual funds can be organized as either open or closed end funds. Closed end funds issue stock in the
fund at an initial offering and do not accept additional funds. Most new funds are organized as open end
118 Mishkin/Eakins • Financial Markets and Institutions, Eighth Edition
funds and issue additional shares when new money is received. The net asset value (NAV) of the shares is
computed each day. All trades conducted that day are at the NAV.
The primary classes of mutual funds are stock funds, bond funds, hybrid funds, and money market funds.
Stock and bond funds can be either actively managed by investment managers or can be structured as
index funds that mimic the behavior of some index, such as the S&P 500.
Hedge funds attempt to earn returns by trading on deviations between historical security relationships and
current market conditions. These funds are not available to small investors.
The mutual fund industry has been subject to widely publicized scandals for violating SEC regulations and
internal policy. Most abuses centered on market timing and late trading by investors receiving privileged
treatment in exchange for large deposits with the funds. Conflicts of interest created by fee structures that
reward investment managers more for total assets than for returns are partly responsible.
Points to emphasize: Review Table 1, Figure 1, and Figure 6 in the context of the market decline in 2000.
Discuss how the profitability of the market affects this industry.
The case Net Asset Value discusses the calculation of the NAV. A useful exercise is to show how changes
in market values of the assets can change the NAV. Several homework problems are provided to let
students practice computing NAV.
The chapter details a number of recent high profile conflict of interest cases. These provide an excellent
opportunity to address ethical issues faced by mutual fund managers. Discuss the motivations that lead to
the abuses and alternative organizational structures that would reduce these problems. Include in the
discussion the long term implication to the industry of continued conflict of interest abuse.
◼ Answers to End-of-Chapter Questions
2. Liquidity intermediation is allowing investors to redeem their shares at any time, despite long-term
holdings.
3. You may be willing to pay fees for a mutual fund to provide liquidity intermediation, denomination
5. Investors have different objectives, goals, and tastes in securities. Mutual funds attempt to offer a
6. Index funds are not actively managed. They simply hold the stocks in the index. They usually have
significantly lower fees than actively managed funds.
8. A deferred load is a fee charged when money is withdrawn from a fund. They are usually 5% and fall
120 Mishkin/Eakins • Financial Markets and Institutions, Eighth Edition
Based on the new information, NAV is:
$1,920 $255,900 $90,832 $618,148 $13,530 $5,353.40
NAV 5,000
$197.14/share.
+ + + + +
=
=
$25,000 buys 126.813 shares.
If sale prices are used, the investor buys 128.034 shares. $25,000 enters the fund. After
2. A mutual fund charges a 5% upfront load plus reports an expense ratio of 1.34%. If an investor plans
on holding a fund for 30 years, what is the average annual fee, as a percent, paid by the investor?
3. A mutual fund offers “A” shares which have a 5% upfront load and an expense ratio of 0.76%. The
fund also offers “B” shares which have a 3% backend load and an expense ratio of 0.87%. Which
shares make more sense for an investor looking over an 18 year horizon?
4. A mutual fund reported year-end total assets of $1,508 million and an expense ratio of 0.90%. What
total fees is the fund charging each year?
5. A $1 million fund is charging a back-end load of 1%, 12b-1 fees of 1%, and an expense ratio of 1.9%.
Prior to deducting expenses, what must the fund value be at the end of the year for investors to
break even?
Solution: With the backend load, the fund value must be (after expenses):
6. On January 1st, a mutual fund has the following assets and prices at 4:00 p.m.:
Stock
Shares owned
1
1,000
2
5,000
3
1,000
4
10,000
5
3,000
Chapter 20: The Mutual Fund Industry 121
Calculate the net asset value (NAV) for the fund. Assume that 8,000 shares are outstanding for the fund.
Solution:
$1,970 $241,300 $26,440 $674,900 $7,770
NAV $119.05/share
8,000
+ + + +
==
7. An investor sends the fund a check for $50,000. If there is no front-end load, calculate the new number
of shares and price/share. Assume the manager purchases 1,800 shares of stock 3, and the rest is held
as cash.
Solution: With the $50,000, the value of the fund is now $952,380 + 50,000 = $1,002,380. Shares are
sold at a price of $119.05, or 420 new shares. There are now 8,420 shares outstanding.
The new fund looks like:
Stock
Shares owned
Price
1
1,000
$ 1.97
2
5,000
$48.26
3
2,800
$26.44
4
10,000
$67.49
5
3,000
$ 2.59
cash
n.a.
$ 2408
8. On January 2nd, the prices at 4:00 PM are:
Stock
Shares owned
Price
1
1,000
$ 2.03
2
5,000
$51.37
3
2,800
$29.08
4
10,000
$67.19
5
3,000
$ 4.42
cash
n.a.
$ 2408
Calculate the net asset value (NAV) for the fund.
8,420
9. Assume the new investor then sells the 420 shares. What is his profit? What is the annualized return?
The fund sells 800 shares of stock 4 to raise the needed funds.
122 Mishkin/Eakins • Financial Markets and Institutions, Eighth Edition
The new fund is:
Stock
Shares owned
Price
1
1,000
$ 2.03
2
5,000
$ 51.37
3
2,800
$ 29.08
4
9,200
$ 67.19
5
3,000
$ 4.42
cash
n.a.
$4,886.40
10. To discourage short-term investing in its fund, the fund now charges a 5% upfront load and a 2%
backend load. The same investor decides to put $50,000 back into the fund. Calculate the new
number of shares outstanding. Assume the fund manager buys back as many round-lot shares of
stock 4 with the cash.
11. On January 3rd, the prices at 4:00 PM are:
Stock
Shares owned
Price
1
1,000
$ 1.92
2
5,000
$ 51.18
3
2,800
$ 29.08
4
9,900
$ 67.19
5
3,000
$ 4.51
cash
n.a.
$5,353.40
Calculate the new NAV.
Solution:
$1,920 $255,900 $81,424 $665,181 $13,530 $5,353.40
NAV $121.98/share
8,389.09
+ + + + +
==
12. Unhappy with the results, the new investor then sells the 389.09 shares. What is his profit? What is
the new fund value?