Mutual Funds

1

• Chapter 4
• Mutual Funds

2
Understand the benefits and costs of mutual funds

• What services do investment organizations offer?
• Administration record keeping
• Diversification divisibility
• Professional management
• Reduced transaction costs

3
Unit Investment Trusts

• Are pools of money invested in a portfolio that
  is fixed for the life of the fund.
• To form a unit trust, a sponsor, typically a
  brokerage firm, buys a portfolio of securities
  which are deposited into trust.
• It then sells to the public shares, or units,
  in the trust, called redeemable trust
  certificates.
• There is little active management of a unit
  investment trust because once established, the
  portfolio composition is fixed hence these
  trusts are referred to as unmanaged.

4
Unit Investment Trusts

• Sponsors of unit investment trusts earn their
  profits by selling shares in the trust at a
  premium to the cost of acquiring the underlying
  assets.
• Investors who wish to liquidate their holdings of
  a unit investment trust may sell the shares back
  to the trustee for net asset value. The trustees
  can either sell enough securities from the asset
  portfolio to obtain the cash necessary to pay the
  investor, or they may instead sell the shares to
  a new investor (again at a slight premium to net
  asset value).

5
Managed Investment Companies

• There are two types of managed companies
  closed-end and open-end.
• In both cases, the funds board of directors,
  which is elected by shareholders, hires a
  management company to manage the portfolio for an
  annual fee that typically ranges from .2 to 1.5
  of assets.

6
Open-End and Closed-End Funds Key Differences

• Shares Outstanding
• Closed-end
• No change unless new stock is offered
• Traded on organized exchange and can be purchased
  through brokers like other common stock
• Open-end
• Changes when new shares are sold or old shares
  are redeemed
• When investors in open-end fund wish to cash out
  their shares, they sell them back to the fund.
• Pricing
• Open-end Net Asset Value (NAV)
• Closed-end Premium or discount to NAV

7
Two Puzzles Related to Close-end

• A close-end fund is sold at a discount from net
  asset value.
• The difference between the market price of the
  fund and the funds NAV would represent the
  per-share increases in the wealth of the funds
  investors.
• While many close-ends sell at a discount from net
  asset value, the price s of these funds when
  originally issued are typically above NAV.

8
Other Investment Organization

• Commingled funds
• Commingled funds are partnerships of investors
  that pool their funds.
• The management firm that organizes the
  partnership, for example, a bank or insurance
  company, manages the funds for a fee.
• Real Estate Investment Trusts (REITs)
• A REIT is similar to a closed-end fund.
• REITs invest in real estate or loans secured by
  real estate.
• REITs generally are established by banks,
  insurance companies, or mortgage companies, which
  then serve as investment managers to earn a fee.

9
Other Investment Organization

• Hedge funds
• Hedge funds are not registered as mutual funds
  and are not subject to SEC regulation.
• They typically are open only to wealthy or
  institutional investors.
• Heavy use of derivatives, short sales, and
  leverage.
• Hedge funds typically attempt to exploit
  temporary misalignments in security valuations.
• Because the funds often operate with considerable
  leverage, returns can be quite volatile.

10
Mutual Funds

• Open-end investment companies
• Fidelity, Vanguard, Putnam, and Dreyfus
• Investment policies
• Money Market funds
• Equity Funds
• Income funds-dividend yields
• Growth funds-capital gains
• Fixed-Income Finds
• Balance and Income Funds
• Asset Allocation Funds
• Market Timing
• Index Funds
• Specialized Sector Funds

11
Benefits of Mutual Funds

• Benefits
• Free individuals from the many administrative
  burdens of owning individual securities
• Proxies, capital gains recognition, etc.
• Offer professional management
• Offer (generally) economies of scale and lower
  trading costs
• Offer other services

12
Costs of Mutual Funds

• Costs
• High management and other fees
• Front-end loads, back-end loads, 12b-1 fees
• Cannot control timing of recognizing capital
  gains
• Income earned is not taxed at the level of the
  fund, but at your rate. You pay these taxes
• Existing shareholders subsidize new investors
• It costs roughly .50-1.0 to get new funds
  invested (i.e., the pooling problem)
• Performance of actively-managed mutual funds lags
  passive benchmarks
• Mutual fund performance has under-performed
  passive indexing over the past 10 years

13
Index Mutual Funds

• From 1970-1998, the average mutual funds have
  returned 12.44 versus 13.99 for the Wilshire
  5000
• Index funds (either mutual or exchange traded)
  have
• Lower turnover (3 year versus 50-200 for
  managed funds)
• Lower management fees (10-20 basis points/year
  versus 50-150 for managed funds)
• More tax efficient
• While there are good managers, you need to
  evaluate prospective mutual funds and managers
  carefully
• While good managers are hard to find, generally
  poor managers are easier spot and to avoiddo
  it!!!!

14
Exchange-Traded Funds (ETF)

• Index portfolio
• The first ETF was the SPDR-SP 500 index
• Other ETFs
• Diamonds-Dow Jones Industrial Average
• Qubes (QQQ)-Nasdaq 100 index
• WEBS-World Equity Benchmark Shares
• Investors can trade ETF through out the day, just
  like any other share of stock.

15
Exchange-Traded Funds (ETF)

• Advantages
• ETFs trade continuously. ETFs can be sold short
  or purchased on margin.
• Offer a potential tax advantage over mutual
  funds.
• Cheaper than mutual funds
• SP 500 ETF(0.09) vs SP 500 index mutual fund
  (0.18)
• Disadvantage
• There is the possibility that their prices can
  depart by small amounts from net asset value.
• ETFs must be purchased from brokers for a fee.

16
Mutual Fund Calculations

• How is Net Asset Value calculated?
• Used as a basis for valuation of investment
  company shares
• Selling new shares
• Redeeming existing shares
• Calculation
• Market Value of Assets - Liabilities
• Shares Outstanding

17
Understand the Impact of Costs on Investing

• Mutual Fund Costs
• Fee Structure
• Front-end load / Back-end load
• Operating expenses
• Management fees
• 12 b-1 charges
• Distribution costs paid by the fund to cover
  marketing expenses (why should you pay for
  marketing expenses?)
• Taxes Inefficient
• Higher turnover means that capital gains or
  losses are being realized constantly, and
  therefore that the investor cannot time the
  realizations to manage his or her overall tax
  obligation.You are taxes on all capital gains
  (turnover) and dividends

18
Reality Check on Costs

• Methodology
• Took all large-cap stocks that have been around
  for 10 years or more, ranked them by annual
  operating expenses, and compared the lowest and
  highestcost groups
• Results
• Lowest cost funds outperformed their expensive
  counterparts by 1.8-2.3 per year.
• On 50,000, 10 instead of 8 over 10 years
  equates to 21,741 or 43 of your original
  investment
• Implications -- Invest in the low-cost area!
• Source Walter Updegrave, Money Magazine

19
Problem 4-4 Calculating Fund Net Asset Values

• The composition of the Fingroup Fund is
• Stock Shares (000) Price Value
  (mn)
• A 200 35
  7
• B 300 40
  12
• C 400 20
  8
• D 600 25
  15
• Total
  42
• With 30,000 in accrued management fees unpaid,
  and 4 million share outstanding, what is the
  current net asset value?

20
Problem 4-4 Answer

• NAV Total Assets less liabilities
• shares outstanding
• (42,000,000 30,000) 10.49
• 4,000,000

21
Problem 4-8 Calculating Discounts / Premiums on
Closed End Funds

• 1/1/01 12/31/01
• NAV 12.00. 12.10
• Price 2 premium 7 discount
• Distributions 1.50
• What was the rate of return to the investor in
  2001?
• What would have been the rate of return in an
  open ended fund holding the same securities?

22
Answer 4-8

• Price 1/1/01 12.00 x (1 .02) 12.24
• Price 12/31/01 12.10 x (1 - .07) 11.25
• Return (CEF) (11.25 -12.24 1.50)/ 12.24
  4.2
• Return (OEF) (12.10 - 12.00 1.50)/12.00
  13.3

23
Problem 4-12 Fund Performance

• A. Impressive Fund had an excellent investment
  performance last year, with portfolio returns
  that placed it in the top 10 of all fund with
  the same investment policy. Do you expect it to
  be a top performed next year? Why or why not?
• B. Suppose instead that Impressive Fund was
  among the poorest performers in its comparison
  group. Would you be more or less likely to
  believe its relative performance will persist
  into the following year? Why?

24
Consistency of Investment Results

• Successive Period Performance
• Initial Period Performace Top Half Bottom Half
• A. Goetzmann and Ibbotson study
• Top half 62.0 38.0
• Bottom half 36.6 63.4
• B. Malkiel study, 1970s
• Top half 65.1 34.9
• Bottom half 35.5 64.5
• C. Malkiel study, 1980s
• Top half 51.7 48.3
• Bottom half 47.5 52.5

25
Consistency of Fund Performance

• Do some mutual funds consistently outperform?
• Evidence suggests that some funds show consistent
  stronger performance.
• Depends on measurement interval
• Depends on time period
• Evidence shows consistent poor performance.

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Answer 4-12

• A. Empirical research indicates that past
  performance is not highly predictive of future
  performance, especially for better performing
  funds. While there is some tendency, it is
  unlikely to repeat the top 10 achievement.
• B. The evidence is more suggestive of a tendency
  for bad performance to persist. This is probably
  related to fund costs and turnover rates. So if
  your fund is among the poorest performers, I
  would be concerned that its performance would
  persist.

27
Problem 4-17 Calculating Fund Costs with
Different Classes of Shares

• Fund Front-load 12B-1 fees Redemption
• Class A 6 -
  -
• Class B - 0.5 5
  
• 
  (declines 1 a year for 5 years)
• Both funds return 10 net of operating expenses
• If you hold the funds for 4 years, which is the
  better investment (assume 1,000 to invest)?
• If you hold the funds for 15 years?

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Problem 4-17 Answer

• 4 Years
• Class A (1000 x (1 - .06)) x (1.10)4
  1,376.25
• Class B ((1000 x (1 (.10 0.05))4 ) (1 -
  .01)
• 1,437.66 x .99 1,423.28
• Class B is better for 4 years
• 15 Years
• Class A (1000 x (1 - .06)) x (1.10)15
  3,926.61
• Class B ((1000 x (1 (.10 0.05))15
  3,901.32
• Class A is better for 15 years

29
Problem 4-20 Transactions Costs

• A. Suppose that every time a fund manager trades
  stock, transactions costs such as commissions and
  bid-asked spread amount to 40 basis points (0.4)
  of the value of the trade. If the portfolio
  turnover rate is 50, by how much is the total
  return of the portfolio reduced by trading costs?
• B. How much if the turnover is 150? What does
  this mean to an active manager?

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Problem 4-20 Answer

• A. While the book says that trading costs will
  reduce portfolio returns by 0.4 x .50 .2, the
  reality is that turnover is on both sides, buying
  and selling
• .4 x .50 for sales .20
• .4 x .50 for purchases .20
• Total .40
• B. .4 x 1.5 x 2 1.20 The active manager
  must obtain returns of 1.2 just to offset the
  expense of turnover versus an index fund. That
  is tough to do!!!