1. Chapter 2 How Mutual Funds Work Instructor: IFTEKHAR AMIN CHOWDHURY Mutual Fund Management (GA31203) Semester II, Session 2013/2014 SPKAL, UMSKAL

2. Session Overview (1) Each mutual fund is a separate corporation. Investors buy and sell fund shares directly from the fund itself at net asset value (NAV). Mutual funds qualify for pass-through tax treatment. Funds generally don’t have employees; they hire other firms to perform needed services. Mutual funds are governed by strict ethical standards. Instructor: IFTEKHAR AMIN CHOWDHURY Mutual Fund Management (GA31203) Semester II, Session 2013/2014 SPKAL, UMSKAL

3. Session Overview (2) Alternatives to mutual funds include: –Direct ownership of securities through a brokerage, trust or separately-managed account. –Other commingled investment vehicles, such as closed-end funds, exchange-traded funds, unit investment trusts and hedge funds. Instructor: IFTEKHAR AMIN CHOWDHURY Mutual Fund Management (GA31203) Semester II, Session 2013/2014 SPKAL, UMSKAL

4. Key Legislation Securities Act of 1933 –Regulates the sale of securities. Securities Exchange Act of 1934 –Regulates reporting by corporations. –Established the SEC. Investment Company Act of 1940 (“the 1940 Act”) –Regulates mutual funds. Investment Advisers Act of 1940 –Regulates some investment managers, including the managers of mutual funds. Instructor: IFTEKHAR AMIN CHOWDHURY Mutual Fund Management (GA31203) Semester II, Session 2013/2014 SPKAL, UMSKAL

5. Buying and Selling Fund Shares Fund Each fund is a separate corporation, called a (registered) investment company. Issues Shares The fund issues shares to the public at net asset value (NAV). Each share represents proportional ownership of fund assets. Investors Investors put their money into the fund by buying shares and becoming fund shareholders. Investors can sell their shares back to the fund at NAV. Instructor: IFTEKHAR AMIN CHOWDHURY Mutual Fund Management (GA31203) Semester II, Session 2013/2014 SPKAL, UMSKAL

6. Net Asset Value (NAV) Assets minus Liabilities Number of shares outstanding Net Asset Value (NAV) NAV is computed at the end of every business day. Investors may sell their shares back to the fund (or redeem) at the end of every business day. Instructor: IFTEKHAR AMIN CHOWDHURY Mutual Fund Management (GA31203) Semester II, Session 2013/2014 SPKAL, UMSKAL

7. Buying and Selling Fund Shares To ensure that funds have the ability to raise cash quickly to pay redeeming shareholders, the 1940 Act requires that funds: –Limit borrowings. –Limit holdings of illiquid securities. In addition, most funds meet the 1940 Act tests for diversification and: –Limit holdings in a single security. –Limit percentage ownership of the shares of a single company. Instructor: IFTEKHAR AMIN CHOWDHURY Mutual Fund Management (GA31203) Semester II, Session 2013/2014 SPKAL, UMSKAL

8. Pass-Through Tax Status Fund Earns interest and dividend income from investments. May sell investments at a gain or loss. Pays no taxes if it meets certain tests. Distributes Income Pays out a proportionate share of its dividend and interest income and net capital gains to each shareholder. Shareholder Pays taxes on distributions from the fund. Instructor: IFTEKHAR AMIN CHOWDHURY Mutual Fund Management (GA31203) Semester II, Session 2013/2014 SPKAL, UMSKAL

9. IRS Tests To qualify for pass-through tax status, the IRS requires that funds: –Limit holdings in a single security.* –Limit percentage ownership of the shares of a single company.* –Distribute almost all income and net realized capital gains annually. –Earn most of their income from investing in securities and currencies. *IRS test is slightly different from similar 1940 Act test. Instructor: IFTEKHAR AMIN CHOWDHURY Mutual Fund Management (GA31203) Semester II, Session 2013/2014 SPKAL, UMSKAL

10. A Virtual Corporation Mutual funds generally don’t have employees. –Instead, they hire other firms to provide needed services for a fee. –The fund signs contracts with these service providers. Each fund has a board of directors which: –Is elected by fund shareholders through a proxy vote. –Negotiates contracts with service providers. –Monitors potential conflicts of interest. –Must have a majority of independent or disinterested directors. Instructor: IFTEKHAR AMIN CHOWDHURY Mutual Fund Management (GA31203) Semester II, Session 2013/2014 SPKAL, UMSKAL

11. The Management Contract The most important contract is with the management company which: –Creates the fund. –Lends its brand name to the fund family or fund complex. –Serves as investment adviser and is responsible for investment management of the fund’s portfolio. Instructor: IFTEKHAR AMIN CHOWDHURY Mutual Fund Management (GA31203) Semester II, Session 2013/2014 SPKAL, UMSKAL

12. The Gartenberg Standard A board’s review of the management contract is governed by the Gartenberg standard. This legal standard suggests that directors consider: –The nature and quality of services provided. –The profitability of the fund to the adviser. –Any fallout benefits to the adviser (i.e., indirect profits). –The extent of economies of scale as the fund grows. –Fees charged on comparable funds. –The independence and conscientiousness of the directors. The Supreme Court recently reaffirmed the Gartenberg standard in the Jones v. Harris case. Instructor: IFTEKHAR AMIN CHOWDHURY Mutual Fund Management (GA31203) Semester II, Session 2013/2014 SPKAL, UMSKAL

13. Service Providers The distributor sells fund shares to the public. The transfer agent keeps track of shareholder positions and provides customer service. Links with investors The custodian holds the securities in the fund’s portfolio. The fund accountant maintains the fund’s books and records and computes the NAV nightly. Portfolio administration Legal counsel. Auditor. Professional services The fund also signs contracts with firms that provide: Instructor: IFTEKHAR AMIN CHOWDHURY Mutual Fund Management (GA31203) Semester II, Session 2013/2014 SPKAL, UMSKAL

14. Service Provider Relationships Some of these services are provided by firms affiliated with the management company. –Others are provided by independent firms. Typical Service Provider Relationships Instructor: IFTEKHAR AMIN CHOWDHURY Mutual Fund Management (GA31203) Semester II, Session 2013/2014 SPKAL, UMSKAL

15. Ethical Standards Managers of mutual funds are fiduciaries. –They must use their expertise to advance their clients’ interests and many not gain personally at their clients’ expense. –They must present all material facts to their clients and disclose any conflicts of interests. Managers of mutual funds are registered investment advisers. –They must register with the SEC as required by the Investment Advisers Act of 1940. –The SEC requires that they have a written code of ethics. Instructor: IFTEKHAR AMIN CHOWDHURY Mutual Fund Management (GA31203) Semester II, Session 2013/2014 SPKAL, UMSKAL

16. Components of a Registered Investment Adviser’s Code of Ethics (1) General statement about expected standard of business conduct. At minimum, must comply with all relevant laws and regulations. May require avoiding appearance of impropriety. Standards of business conduct To prevent insider trading. Protection of material nonpublic information Instructor: IFTEKHAR AMIN CHOWDHURY Mutual Fund Management (GA31203) Semester II, Session 2013/2014 SPKAL, UMSKAL

17. Components of a Registered Investment Adviser’s Code of Ethics (2) Apply to access persons with access to information about the fund’s trading. Requires pre-clearance of personal trading. Prohibits certain trades. Limits on personal securities trading Usually applies to gifts both given and received. Limits on gifts and entertainment Requires prompt reporting of violations. The Chief Compliance Officer has responsibility for enforcing the code. Violations of the code Instructor: IFTEKHAR AMIN CHOWDHURY Mutual Fund Management (GA31203) Semester II, Session 2013/2014 SPKAL, UMSKAL

18. Alternatives to Mutual Funds Alternatives to mutual funds include: –Direct ownership of securities. –Other commingled investment vehicles. Instructor: IFTEKHAR AMIN CHOWDHURY Mutual Fund Management (GA31203) Semester II, Session 2013/2014 SPKAL, UMSKAL

19. Direct Ownership of Securities Options for direct ownership of securities include: Brokerage account –Investor has high degree of control. –Costs vary widely. Trust account –For high net worth individuals. –High customer service level. Separately managed account (SMA) –Uses technology to adapt model portfolio selected by an investment professional to an individual account. –Can be customized to limited extent. Instructor: IFTEKHAR AMIN CHOWDHURY Mutual Fund Management (GA31203) Semester II, Session 2013/2014 SPKAL, UMSKAL

20. Commingled Investment Vehicles (1) Open-end mutual funds –Permit investors to redeem shares every day. Closed-end mutual funds –Sell shares only once. –List shares for trading on a stock exchange; price determined by supply and demand. –Do not redeem shares daily; instead, investors buy/sell on exchange, often for less than NAV. –Have declined in popularity. Instructor: IFTEKHAR AMIN CHOWDHURY Mutual Fund Management (GA31203) Semester II, Session 2013/2014 SPKAL, UMSKAL

21. Commingled Investment Vehicles (2) Exchange-traded funds –Shares listed for trading on a stock exchange; price determined by supply and demand. –Adjust the number of shares outstanding so that the market price remains close to NAV. –Are tax-efficient. –Are growing in popularity. Instructor: IFTEKHAR AMIN CHOWDHURY Mutual Fund Management (GA31203) Semester II, Session 2013/2014 SPKAL, UMSKAL

22. Commingled Investment Vehicles (3) Unit investment trusts –Don’t hire an investment manager; a UIT buys a portfolio of securities at creation, then holds it until the trust liquidates on a set date. –Investors can redeem shares at NAV, but they can also sell on the open market or wait for trust to liquidate. –Don’t have a board of directors. –Are low-cost. –Have declined in popularity. Instructor: IFTEKHAR AMIN CHOWDHURY Mutual Fund Management (GA31203) Semester II, Session 2013/2014 SPKAL, UMSKAL

23. Commingled Investment Vehicles (4)S Hedge funds –Aren’t required to register with the SEC, unlike the other commingled vehicles discussed. –Usually structured as limited partnerships. –Limit investor ability to redeem. –Use aggressive investing techniques and are not subject to investment restrictions. –Generally don’t have a board of directors. Instructor: IFTEKHAR AMIN CHOWDHURY Mutual Fund Management (GA31203) Semester II, Session 2013/2014 SPKAL, UMSKAL

24. Commingled Investment Vehicles FeatureMutual Fund (Open- End) Closed- End Fund Exchange- Traded Fund Unit Investment Trust Hedge Fund Daily redemptions at NAV XOpen market sale XNo Pass-through tax status XXXXX Ongoing professional management XXXNoX Supervision by independent directors XXXNo Instructor: IFTEKHAR AMIN CHOWDHURY Mutual Fund Management (GA31203) Semester II, Session 2013/2014 SPKAL, UMSKAL