Mutual Fund

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• Mutual Fund
• Operations

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Background on Mutual Funds
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Background on Mutual Funds

• Mutual funds offer a way for small investors to
  diversify and achieve economies of scale
• In 2013, the number of mutual funds was 8,974,
  with net assets 15T (more MFs exist than
  individual stocks!)
• Today about half of households own invest in
  mutual funds (1980 only 5 of households owned
  MFs). This will get bigger as more employers
  switch from defined benefit pensions to
  401k-style plans.

http//www.icifactbook.org/fb_ch6.html
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Growth in Mutual Funds
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Growth in Mutual Funds
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Background on Mutual Funds

• Mutual fund itself is exempt from income taxation
  if it distributes 90 percent of taxable income to
  shareholders each year
• Mutual funds adhere to a variety of federal (SEC)
  and state regulations
• Prospectus must disclose relevant info to
  investors (see next slide)

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Prospectus

• Mutual fund prospectus includes
• The minimum amount of investment required
• The investment objective of the fund
• The return on the fund over the past year, the
  past three years and the past five years
• The exposure of the fund to various types of risk
• Services the fund offers (e.g. check writing,
  funds transfer)
• Fees that investors pay (expense ratios)
• Name and tenure of manager
• https//personal.vanguard.com/us/literature/prospe
  ctus

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Determining NAV

• Net asset value is the value per share, after
  expenses
• Calculated once a day at 4pm ET by
• Determining the market value of all the
  securities in the fund
• Adding interest or dividends and subtracting
  expenses for day
• Dividing by the number of shares

Description Market Value
Stock Bonds (market value) 30B
Cash 0.5B
Less Liabilities 0.3B
Total Net Asset Value 30.2B
Divided by 10M shares O/S NAV 3.20
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Scandals

• Late-trading illegal practice of allowing
  purchase/sale of shares after 4pm (but stamped
  4pm) to key investors who have an unfair chance
  to learn about market events after 4pm which will
  affect the NAV the next day (e.g. earnings
  releases, lawsuits, world events, etc.)
• Market-timing allowing favored investors to make
  large trades in and out of the fund, based on
  international of other information believed to
  affect the NAV not illegal, per see, but usually
  violates internal policies. E.g. Whistle-blower
  Peter Scannell at Putnam.
• SEC now strictly prohibits late trading and
  requires all funds to state a policy about
  market-timing.

Peter Scannell
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Mutual Fund Distributions
Income from Interest Dividends
Capital Gains from the Sale of Securities in
Fund (Called Capital Gain Distributions)
Mutual Fund Price Appreciation (Unrealized
gains/losses on security prices)
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Background on Mutual Funds

• Mutual fund classifications depend on the type of
  securities the fund invests in and can include
• Stock or equity mutual funds
• Bond mutual funds
• Balanced funds
• Money market mutual funds
• Family of funds offered by investment companies
  (Vanguard, Magellan, Putnam, American, United,
  etc.)
• Investor able to allocate then transfer among
  funds

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Composition of Investments in Mutual Funds
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Background on Mutual Funds

• Management of mutual funds
• Managers invest in a portfolio of securities that
  meet the objectives of the fund
• Management costs paid by fees, usually less than
  2 of total assets per year
• Managers adjust the composition of portfolios in
  response to market and economic conditions
• Fund may rise or fall with the manager (manager
  may leave or die)
• Manager not so important for index funds

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Background on Mutual Funds

• Expenses
• Fees include mgmt, record-keeping, and clerical
  fees
• Expense ratio annual expenses/fund NAV
• Investor should compare expense ratios
• SEC requires that all funds disclose average fees
  
• 12b-1 Fees Active marketing expenses (pay
  brokers to recommend fund)
• controversy over 12b-1 fees being passed on
  unethically
• Loads
• Front-end load or sales commission (usually
  3-8.5)
• Back-end load or redemption fee

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How the Accumulated Value Can be Affected by
Expenses (Assume Initial Investment of 10,000
and a Return before Expenses of 9.2)
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Background on Mutual Funds

• Corporate control by mutual funds
• Mutual funds are large shareholders in companies
  whose stock they hold (Fidelity controls 5 of
  stock traded on NYSE it owns controlling share
  in more than 700 corporations)
• Managers may serve on the board of directors of
  companies in which the fund invests
• Companies try to satisfy mutual fund managers in
  order to keep them from selling their shares
• Some mutual funds are now not only asking the
  corps they own for good returns but also for good
  citizenship (environment, etc.)

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Load versus No-Load Mutual Funds

• Classification refers to whether or not there is
  a sales charge
• 12b-1 expenses are loads used by no-load funds
• Load funds
• Promoted by registered representatives of
  brokerage firms who get a commission
• Investors pay the sales charge, usually 3-8.5

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Open-End versus Closed-End Funds

• Closed-end funds (not common e.g. ETFs)
• Mutual fund does not trade the shares they
  sellsimilar to direct common stock investment
  rather investors must trade shares on an exchange
• Value of shares changes with market conditions
• Open-end mutual funds (very common)
• Willing to repurchase investor shares at any time
• Number of shares outstanding changes constantly
• NAV determined by fund daily at 4pm

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Stock Mutual Fund Categories

• Growth funds for investors who want high returns
  with moderate risk
• Mutual fund invests in companies that are
  expected to grow at a higher than average rate
• Generate an increase in investment value rather
  than steady income
• Capital appreciation or aggressive growth funds
• High but unproven growth potential stocks
• Higher risk

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Stock Mutual Fund Categories

• Growth and income funds (sometimes called
  balanced funds) try to offer growth but with some
  stability of income
• International funds invests in non-US securities
• A global mutual fund invests in U.S. stocks as
  well as foreign stocks

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Stock Mutual Fund Categories

• Specialty funds focus on a particular industry or
  characteristic such as high-tech, precious medals
  or socially conscious funds
• Index funds are designed to simply match the
  performance of an existing stock index
• Advantages include (1) low management fee, (2)
  low turnover and resulting transaction costs, (3)
  tax deferral, (4) performance not tied to one
  manager
• Multifund funds invest in a portfolio of
  different mutual funds
• More diversified (Vanguards STAR fund, 9
  different fds)
• Involves higher expenses (double management fees)

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Growth in the Number of Stock Funds and Bond Funds
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Investment in Bond and Stock Mutual Funds
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Distribution of Aggregate Mutual Fund Assets
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Bond Funds

• Income bond funds attract investors who are
• Interested in periodic interest income over
  long-term
• Tax-free funds in munis for high tax bracket
  investors
• High-yield or junk bond funds
• International and global bond funds
• Maturity classifications
• Interest rate sensitivity depends on the maturity
  of bonds
• Funds are typically segmented based on maturity
• Intermediate-term funds invest in bonds with 5 to
  10 years remaining to maturity
• Long-term funds invest in maturities of 15 to 30
  years

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Mutual Fund Types

• Asset allocation funds
• Funds that contain a variety of investments
• Composition among stocks, bonds and money market
  securities is based on managers expectations
• Can have retirement target date funds which
  automatically shift allocation as you age
  (Vanguards funds targeting retirement in 2020,
  2030, 2040, 2050 etc.)

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Performance of Mutual Funds

• Investors should diversify among different kinds
  of funds to reduce volatility
• Research on stock mutual fund performance
• Mutual funds typically do not outperform the
  market (indices)
• Evaluate mutual fund expenses
• Go with index funds, says Mr. Toews!
• Research on bond mutual funds
• Bond mutual funds underperform bond indexes
• Investors should look for low expense bond funds

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Money Market Funds

• Money market funds are portfolios of short-term
  assets
• Can include check-writing privileges for
  investors
• Number of checks per month usually restricted
• Shareholders get periodic statements
• Liquid, cash balance for investor
• Lower interest-rate risk, inflation risk, default
  risk, liquidity risk but lower return as well

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Growth in Money Market Fund Assets
Taxable
Non-Taxable
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Composition of Taxable Money Market Fund Assets
in Aggregate
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Weighted Average Maturity of MM Fund Assets
If interest rates are expected to increase, you
would want to shorten the average maturity . . .
And vice versa
Source 2007 Mutual Fund Fact Book.
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Exchange-Traded Funds (ETFs)

• Designed to mimic particular stock indexes and
  are traded on a stock exchange just like stocks.
• E.g. Nasdaq100 Cubes (QQQ) SP500 Spiders (SPY),
  and DJIA Diamonds (DIA)
• Exchange-traded funds have become very popular in
  recent years because they are an efficient way
  for investors to invest in a particular stock
  index.
• Disadvantage each purchase must be executed
  through the exchange where they are traded, which
  incurs broker fees. According to John Bogle,
  founder of Vanguard, ETFs allow games to be
  played (speculation, short-selling, etc.) which
  is no way to invest for the long-term.
• Advantages may be purchased on margin, sold
  short, hedged bundled are tax efficient (pay
  only capital gains tax and only when sold) have
  low minimum investment compared to mutual funds

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Venture Capital Funds

• Venture Capital Funds
• Venture capital (VC) funds use money that they
  receive from wealthy individuals and some
  institutional investors to invest mostly in
  start-up companies.
• Invested monies are pooled and used to create a
  diversified equity portfolio.
• Venture capital funds tend to focus on technology
  firms, which have the potential for high returns
  but also exhibit a high level of risk.
• A VC fund typically plans to exit from its
  original investment in a business within about
  four to seven years.

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Private Equity Funds

• Private equity funds pool money provided by
  individual and institutional investors and buy
  majority (or entire) stakes in businesses (e.g.
  Mitt Romney, Bain Capital, and Staples).
• When a private equity fund purchases a business,
  it assumes control and is able to restructure the
  business in a manner that will improve its
  performance.
• The potential to capitalize on inefficiencies has
  attracted much investment in private equity and
  has led to the creation of many new private
  equity funds.

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Hedge Funds

• A mutual fund for rich people (net worth 1
  million) financial institutions began as a
  hedge against risk today, the opposite
• Invest in derivatives, sell stock short, and
  incur high leverage
• 4000 hedge funds with some 2T in market value
• Traditionally unregulated (rich can look after
  themselves)
• Charge high fees (e.g. 20 of return 2 mgmt
  fee) to the extent that low-cost index funds are
  often better choice to investor over L/T
• SEC started regulating hedge funds in 2006 by
  banning advertising
• Because hedge funds can affect systemic risk,
  Dodd-Frank Act of 2010 brings serious regulation
• Must register w/ SEC, disclose financial data,
  including commissions
• Commercial banks cant invest more 3 of capital
  in a hedge or PE fund or REIT
• Investors in hedge funds must have at least 1M
  net worth, joint with spouse, on average over
  4-years (not including home). 1M will adjust to
  inflation every five years.

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Hedge Funds

• Long-Term Capital Management Hedge Fund, 1998
• Founded by John Meriwether of Salomon Brothers,
  and team of physicists, mathematicians, computer
  specialists, and Nobel Prize winning economists,
  Merton Scholes!!! Used complicated
  quantitative models to try to maximize return.
• Had long position in risky bonds and short
  position in AAA bonds, betting spread would
  decline, but Russian bond default made spread
  bigger. Caused a liquidity crisis, and LTCM lost
  40 of value. Federal Reserve decided it was too
  big too fail. Required 3.6B bailout by NY Fed,
  a bunch of banks and security firms (including
  Warren Buffet!)
• Bernard Madoff, 2009
• Ran the largest Ponzi scheme ever in his hedge
  fund investors lost as much as 50B Madoff
  sentenced to 150 years
• Was using from new investors to pay consistent
  high returns to old investors many market
  experts were suspicious of this one even
  complained to the SEC, which did nothing

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Real Estate Investment Trusts

• A real estate investment trust or REIT is a
  closed-end mutual fund that invests in real
  estate or mortgages
• Classifications
• Equity REIT (invest directly in properties)
• Mortgage REIT (invest in loans secured by
  property)
• Hybrid of the two
• Sometimes seen as an inflation hedge
• Performance influenced by interest rates and area
  real estate values (not so hot right now)