978-1259720697 Chapter 4 Lecture Note

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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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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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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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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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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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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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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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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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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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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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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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