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Chapter 4
Mutual Funds and Other Investment
Companies
Slides
4-1. Chapter 4
4-2. Mutual Funds and Other Investment Companies
4-3. Learning Objectives
4-4. Mutual Funds: Overview
4-5. Mutual Funds: Overview, Cont.
4-6. Advantages of Mutual Fund Investing
4-7. Drawbacks of Mutual Fund Investing
4-8. Investment Companies and Fund Types, I.
4-9. Investment Companies and Fund Types, II.
4-10. Investment Companies and Fund Types, III.
4-11. Mutual Fund Operations Organization and Creation
4-12. Mutual Fund Operations Taxation of Investment Companies
4-13. Mutual Fund Operations The Fund Prospectus and Annual Report
4-14. Mutual Fund Costs and Fees Types of Expenses and Fees
4-15. Mutual Fund Costs and Fees Expense Reporting
4-16. Example: Fee Table
4-17. Mutual Fund Costs and Fees Why Pay Loads and Fees?
4-18. Short-Term Funds, I.
4-19. Taxes and Money Market Funds Money market funds are either taxable or
tax-exempt.
4-20. Short-Term Funds, II.
4-21. Long-Term Funds
4-22. Stock Funds, I.
4-23. Stock Funds, II.
4-24. Bond Funds
4-25. Stock and Bond Funds
4-26. Mutual Fund Objectives: Recent Developments, I.
4-27. Mutual Fund Objectives: Recent Developments, II.
4-28. Mutual Fund Objectives
4-29. Mutual Fund Performance
4-30. Mutual Fund Selection
4-31. Mutual Fund Performance: Yardsticks
4-32. Mutual Fund Performance: Online Version of The Wall Street Journal, I.
4-33. Mutual Fund Performance: Cautions
4-34. Closed Funds
4-35. Closed-End Funds
4-36. Mutual Fund Performance: Closed-End Funds
4-37. The Closed-End Funds Discount
4-38. Exchange Traded Funds, ETFs
4-39. Exchange Traded Funds, Performance
4-40. Leveraged ETFs, I.
4-41. Leveraged ETFs, II.
4-42. Leveraged ETFs, III.
4-43. Exchange Traded Notes, ETNs
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Mutual Funds and Other Investment Companies 4-2
4-44. Hedge Funds, Overview
4-45. Hedge Fund Fees
4-46. Some Common Hedge Fund Investment Styles, I.
4-47. Some Common Hedge Fund Investment Styles, II.
4-48. Hedge Funds, Conclusion
4-49. Useful Internet Sites
4-50. Chapter Review, I.
4-51. Chapter Review, II.
Chapter Organization
4.1 Advantages and Drawbacks of Mutual Fund Investing
A. Advantages
B. Drawbacks
4.2 Investment Companies and Fund Types
A. Open-End versus Closed-End Funds
B. Net Asset Value
4.3 Mutual Fund Operations
A. Mutual Fund Organization and Creation
B. Taxation of Investment Companies
C. The Fund Prospectus and Annual Report
D. Mutual Fund Transactions
4.2 Mutual Fund Costs and Fees
A. Types of Expenses and Fees
B. Expense Reporting
C. Why Pay Loads and Fees?
D. The Impact of Fees on Portfolio Values
4.3 Short-Term Funds
A. Money Market Mutual Funds
B. Money Market Deposit Accounts
4.4 Long-Term Funds
A. Stock Funds
B. Taxable and Municipal Bond Funds
C. Stock and Bond Funds
D. Mutual Fund Objectives: Recent Developments
4.7 Mutual Fund Performance
A. Mutual Fund Performance Information
B. How Useful are Fund Performance Ratings?
4.8 Closed-End Funds, Exchange-Traded Funds, and Hedge Funds
A. Closed-End Funds Performance Information
B. The Closed-End Fund Discount Mystery
C. Exchange-Traded Funds
D. Hedge Funds
4.3 Summary and Conclusions
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Mutual Funds and Other Investment Companies 4-3
Selected Web Sites
www.ici.org (reference for mutual fund facts and figures)
www.vanguard.com (example of major fund family website)
www.fidelity.com (website of largest investment advisory firm in US)
www.mfea.com (reference for info on thousands of funds)
www.morningstar.com (one of the best mutual fund reference sites)
www.ussif.org (reference for “social conscience” funds)
www.domini.com (reference for “social conscience” funds)
www.usamutuals.com (reference for “vice” funds)
www.hedgeworld.com (reference for hedge fund information)
www.turnkeyhedgefunds.com (reference to start your own hedge fund)
Annotated Chapter Outline
4.1 Advantages and Drawbacks of Mutual Fund Investing
A. Advantages
Diversification, professional management, and the low required size of the initial
investment are among the advantages to investing in mutual funds.
B. Drawbacks
Three in particular are risk, costs, and taxes.
4.2 Investment Companies and Fund Types
Investment company: A business that specializes in pooling funds from
individual investors and investing them.
All mutual funds are investment companies, but not all investment companies are
mutual funds.
A. Open-End versus Closed-End Funds
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Mutual Funds and Other Investment Companies 4-4
Open-end fund: An investment company that stands ready to buy and sell
shares at any time.
Closed-end fund: An investment company with a fixed number of shares
that are bought and sold only in the open stock market.
The difference is in how the shares are bought and sold. A closed-end fund does
not buy or sell shares; the shares are listed on organized exchanges. In an open-
end fund, the fund issues new shares and invests the money received. When an
investor sells shares, the fund sells some of its assets and uses the cash to
redeem shares.
Sometimes an open-end fund will choose to close, meaning that the fund will no
longer sell shares to new investors. The use of the word “close” here should not
be confused with “closed-end,” because the number of shares can still fluctuate
as existing owners buy and sell. Why would a fund choose to close? It usually
happens when a fund grows so rapidly (due to good past performance) that the
fund manager feels that the incoming cash is more than the fund can invest
profitably. When this occurs, the fund in question is usually a small-cap fund, but
large-cap funds have also closed on occasion. Funds that close may reopen at a
later date.
B. Net Asset Value
Net asset value (NAV): The value of the assets held by a mutual fund
less any liabilities divided by the number of shares.
The NAV of a mutual fund changes daily and the shares are always worth their
NAV. Because shares of closed-end funds are traded in the markets, their share
price may not be equal to their NAV.
4.3 Mutual Fund Operations
A. Mutual Fund Organization and Creation
A mutual fund is a corporation owned by its shareholders, who elect the board of
directors. Although there are many "families" of funds, each fund is a separate
company. The funds are usually created by investment advisory firms, which earn
the management fees. A typical management fee is 0.75%.
B. Taxation of Investment Companies
Investment companies are treated as "regulated investment companies" for tax
purposes, as long as they meet the following rules:
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Mutual Funds and Other Investment Companies 4-5
Almost all assets must be held in stocks, bonds, and other securities.
No more than 5% may be initially invested in a particular security.
The fund must pass through all realized investment income to shareholders.
C. The Fund Prospectus and Annual Report
Mutual funds must provide a prospectus to any investor wanting to purchase
shares. They must also provide an annual report to shareholders. The fees
charged by a mutual fund are disclosed in their prospectus. These days, you can
find the prospectus of many mutual funds on-line.
D. Mutual Fund Transactions
To limit the impact of new deposits and redemptions, mutual funds follow the
practice of clearing all transactions at the end of the trading day. This prevents
day trading in mutual funds.
Also, funds trade by identifying the dollar amount to be purchased, not the
number of shares.
4.4 Mutual Fund Costs and Fees
A. Types of Expenses and Fees
Front-end load: A sales charge levied on purchases of shares in some
mutual funds.
12b-1 fees: Named for the SEC Rule 12b-1, which allows funds to spend
up to 1% of fund assets annually to cover distribution and shareholder
service costs.
Turnover: A measure of how much trading a fund does, calculated as the
lesser of total purchase or sales during a year divided by average daily
assets.
There are four basic fees or expenses associated with mutual funds:
Sales charges or "loads"
12b-1 fees
Management fees
Trading costs
If a fund charges a fee when shares are purchased, they are called load funds. If
they don't charge a fee, they are no-load funds. For a load fund, the investor
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Mutual Funds and Other Investment Companies 4-6
pays the offering price, which is more than the NAV. The excess is the load. No-
load funds are sold at NAV. There are also low-load funds.
Other funds have either a back-end load or a level load charged each period.
They may also have a contingent deferred sales charge (CDSC), which is a
back-end load that declines over time as an incentive for the investor to hold the
shares. Redemption fees are charged on sales that occur within a stated time
period, but these are more like trading costs than loads.
12b-1 fees are named for the SEC rule that permits them and allows the fund to
use a portion of the fund's assets to cover distribution and marketing costs.
These fees are typically 0.25% to 1.0%. Many low cost funds will charge 0%.
Management fees range from 0.25% to 1.0% of fund assets annually. Mutual
funds also have brokerage expense from trading, so funds with high turnover
would typically have much higher trading costs.
Lecture Tip: The importance of mutual funds’ fees and expenses should be
emphasized to students. Front-end and back-end loads can add a considerable
cost to the cost of a fund, especially when one considers the lost compounding of
the investment. Interestingly, when comparing a front-end load to a back-end
load the cost is the same. A simple numerical example will show that the total
final wealth will be identical for front-end load and back-end load funds, when the
load is the same percentage. Research has also shown that management fees
and trading costs can impose a severe penalty on fund returns. Finally, beware of
12b-1 fees! This annual charge can turn out to be much higher than a front-end
load over time. Would you rather pay a 5% front-end load or a 1% 12b-1 fee
every year for ten years?
B. Expense Reporting
Mutual funds are required to report their expenses in a standardized way in the
prospectus and annual report. One item that is difficult to detect is "soft dollars,"
which can increase trading costs.
C. Why Pay Loads and Fees?
Because there are many no-load funds currently available, why would an investor
consider a load fund? It may be that you want a certain fund, a specific fund
manager, or a sector fund. Most specialized or sector funds require a load.
D. The Impact of Fees on Portfolio Values
A fee of 1 percent does not seem that impactful, but this compounds over
multiple years. For someone investing over a 40 year period, a loss of 1 percent
to fees each year can reduce the final portfolio value by as much as 25 percent.
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Mutual Funds and Other Investment Companies 4-7
4.5 Short-Term Funds
A. Money Market Mutual Funds
Money market mutual fund (MMMF): A mutual fund specializing in
money market instruments.
Introduced in the 1970's, money market funds have grown to more than $2.7
trillion in assets by 2015.They generally invest in high-quality low-risk instruments
with maturities of less than 90 days, although some funds do invest in riskier
assets with longer maturities. Net asset values are “always” $1 per share. This
allows MMMF's to resemble bank accounts. It is possible for the NAV to drop
below $1 per share if the fund has financial difficulties. MMMF's are either
taxable or tax-exempt. Tax-exempt funds have much lower interest rates or
yields.
B. Money Market Deposit Accounts
Banks offer money market deposit accounts (MMDA).They are similar to
MMMF's, although MMDA's offer FDIC protection, whereas MMMF's do not.
4.6 Long-Term Funds
While there are many types of long-term funds, historically funds were classified
as stock, bond, or balanced funds. Now there are many classifications. Investors
should carefully investigate the holdings of a fund because the stated investment
objective may not concur with the actual portfolio holdings of a fund.
A. Stock Funds
Capital Appreciation versus Income
Capital appreciation
Growth
Growth and income
Equity income
Company Size-Based Funds
Small company
Midcap
Large company
International Funds
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Mutual Funds and Other Investment Companies 4-8
Global
International
Sector Funds
Other Fund Types and Issues
Index funds
Social conscience funds
Tax-managed funds
B. Taxable and Municipal Bond Funds
Most bond funds invest in corporate and government securities. There are five
characteristics that distinguish bond funds:
Maturity range
Credit quality
Taxability
Type of bond
Country
Bond fund types include:
Short-Term and Intermediate-Term Funds
General Funds
High-Yield Funds
Mortgage Funds
World Funds
Insured Funds
Single-State Municipal Funds
C. Stock and Bond Funds
Stock and bond funds invest in both types of securities, and are also called
"blended" or "hybrid" funds. Fund types include:
Balanced Funds
Asset Allocation Funds
Convertible Funds
Income Funds
Target Date (Lifecycle) Funds
D. Mutual Fund Objectives: Recent Developments
A mutual fund’s stated objective may not be all that informative. In recent years,
there has been a trend toward classifying a mutual fund’s objective based on its
actual holdings.
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Mutual Funds and Other Investment Companies 4-9
Most general-purpose funds (as opposed to specialized types such as sector
funds) are classified based on the market “cap” of the stocks they hold (small,
midsize, or large) and also on whether the fund tends to invest in either “growth”
or “value” stocks (or both).
The mutual fund “style” box is an increasingly common sight. A style box is a way
of visually representing a fund’s investment focus by placing the fund into one of
nine boxes like this:
STYLE
SIZE
Value Blend Growth
Large
Medium
Small
As shown, this particular fund focuses on large-cap, value stocks. These newer
mutual fund objectives are also useful for screening mutual funds. We have
included a Work the Web box to show how many Web sites have mutual fund
selectors that allow you to find funds with particular characteristics.
4.7 Mutual Fund Performance
A. Mutual Fund Performance Information
There are many sources of mutual fund performance information, including:
Morningstar, the Wall Street Journal, and Value-Line. There are also many web
sites that provide mutual fund information. Several of these web sites are noted
at the beginning of this chapter.
Lecture Tip: It is very useful to walk through the Wall Street Journal mutual fund
information with students. It is important to point out the differences between load
and no-load funds, the meaning of the abbreviations, the performance ratings,
and the many choices of funds from various families of funds.
Lecture Tip: We will return to performance measurement in Chapter 13, where
we discuss such important metrics as alphas and Sharpe Ratios, which are very
important for mutual fund performance analysis.
B. How Useful are Fund Performance Ratings?
Lecture Tip: When reviewing the performance ratings, the instructor should point
out that the best performing fund this year may have performed very poorly over
the past five years (or visa versa). These historical performance measures are
not necessarily good predictors of future performance. Also, the riskiest funds
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Mutual Funds and Other Investment Companies 4-10
may do the best during a rising market, but they will probably perform the poorest
during a declining market. Funds are continually changing the fund manager as
well. This information may take additional research to uncover.
4.8 Closed-End Funds, Exchange-Traded Funds, and Hedge Funds
A. Closed-End Funds Performance Information
Remember, closed-end funds offer a fixed number of shares, and these shares
are bought and sold on the open market. The closed-end fund quotes are listed
with the other common and preferred stock listings contained in the stock tables
for established exchanges, such as the NYSE. The closed-end fund quotes have
"Fd" as part of the name and do not have P/E ratios listed.
B. The Closed-End Fund Discount Mystery
Because shares in closed-end funds trade in the marketplace, share prices
typically differ from the NAV. Interestingly, most closed-end funds trade at a
discount from NAV. This appears to allow investors to buy stock at a discount
through closed-end funds. This discount also fluctuates over time, sometimes it is
very wide, and at other times it almost disappears. If an investor interprets funds
trading at a large discount as a good investment, this may not be the case. For
the investor to profit, the discount must narrow. Occasionally closed-end funds
will sell at a premium to NAV. This is similar to a front-end load.
Closed-end funds are initially sold to the public as an IPO, and the price is equal
to the fund's NAV. Since the fund promoter is paid a fee "right off the top," the
fund will likely start selling at a discount. Therefore, newly offered closed-end
funds are generally not good investments.
C. Exchange-Traded Funds
Exchange traded funds (commonly called ETFs) are a relatively recent
innovation. They began about 1993, but their growth mushroomed in the late
1990s. As of 2015, there were over 1,400 ETFs trading.
Basically, an ETF is an index fund. When an investor buys an ETF, the investor
owns a basket of securities. A well-known ETF is the “Standard and Poor’s
Depositary Receipt” or SPDR. This ETF is the S&P 500 index, and it is commonly
called “spider.” An ETF that represents the Dow Jones Industrial Average is
commonly called “diamond.”
ETFs trade like a closed-end fund. They can be traded intra-daily, and can be
sold short. They generally have low fund expenses, but investors must pay
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Mutual Funds and Other Investment Companies 4-11
commissions when they are purchased and sold. However, due to redemption
units, they generally trade close to NAV.
Leveraged ETFs are a relatively recent addition to those available. These
generally track the intended benchmark (at 2X or negative 2X, or more) over very
short periods (i.e., daily). However, over longer periods both fund types
experience lower returns than would be expected since the added volatility of the
leveraged funds reduces the compounded returns.
D. Hedge Funds
Hedge funds are like mutual funds, in that a hedge fund manager has a pool of
money obtained from investors. Unlike mutual funds, however, hedge funds are
not required to register with the Securities and Exchange Commission. Also,
hedge funds are not required to maintain any particular degree of diversification
or liquidity. Basically, hedge fund managers have considerable freedom to follow
various investment strategies. Investors in hedge funds generally must qualify as
“financially sophisticated” investors.
The fee structure generally includes a management fee (often around 2%) and a
performance fee, generally 20% of profits. However, the performance fee is
subject to a high water mark to prevent manipulation.
Types of hedge funds include: market neutral (long/short), arbitrage, distressed,
macro, short, and market timing. Each brings its own approach and level of risk.
Fund of funds have become popular, but the downside is the added layer of fees,
which generally drags on performance.
4.9 Summary and Conclusions
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