16-2 Learning Objectives Understand the structure and pricing of mutual funds Remember the differences between open-end, closed- end and exchange traded funds Recognize the impact of expenses and taxes on fund returns Assess mutual fund performance Know various types of mutual funds
16-3 Mutual Funds An investment company that issues its portfolio shares to investors. Money from shareholders are pooled and invested in a wide range of stocks, bonds, or money market securities. Managed by professional managers Each investor shares proportionately in the income and investment gains and losses, as well as the brokerage expenses and management fees.
16-5 Open-End Funds An open-end investment company is commonly called an open-end fund. A mutual fund has no limit on the size of the fund or the number of shares outstanding. Mutual fund shares are not sold to other investors. Instead, they are redeemed by the fund management. The value of a mutual fund share is called its net asset value.
16-7 Closed-End Funds A closed-end fund has a fixed number of shares. When the market price exceeds its NAV, selling at a premium, otherwise, selling at a discount Buy and sell like a stock. The pricing of closed-end fund shares is a financial puzzle - they usually sell at a discount to their net asset value (NAV).
16-8 Exchange Traded Funds (ETFs) Exchange traded fund (ETF) is a form of closed-end fund, embedded with some features of an open-end fund Traded like a stock at stock exchanges Share price is very close to its NAV Shares are redeemable!!
Important mutual fund terms Net Asset Value (NAV) Fees Load: Expense ratio: 12b-1 fee: Alpha Beta
16-10 Net asset Value NAV: per share value of a mutual fund’s investment holding. Example A mutual fund has $100 mil in assets and $3 mil in short term liabilities mil shares outstanding. What is the NAV? Solution ($100 mil - $3 mil) / mil = $ per share
16-11 Types of Mutual Funds ObjectiveFunds HoldGrowth PotentialIncome PotentialStability Money Market Funds Taxable money marketCurrent income stability of principal Cash investmentsNoneModerateVery high Tax-exempt money market Tax-free income, stability of principal Municipal cash investmentsNoneModerateVery high Bond Funds Taxable bondCurrent incomeWide range of government and/or corporate bonds NoneModerate to highLow to moderate Tax-exempt bondTax-free incomeWide range of municipal bondsNoneModerate to highLow to moderate Common Stock Funds BalancedCurrent income capital growth Stocks and bondsModerateModerate to highLow to moderate Equity income High-yielding stocks, convertible bonds Moderate to highModerateLow to moderate Value funds Low P/E, P/B stocksModerate to highLow to moderate Growth and income Dividend-paying stocksModerate to highLow to moderate Domestic growthCapital growthU.S. stocks with high potential for growth HighVery lowLow International growth Stocks of companies outside U.S. HighVery low to lowVery low Aggressive growthAggressive growth of capital Stocks with very high potential for growth Very highVery low Small cap Stocks of small companiesVery highVery low Specialized Stocks of industry sectorsHigh to very highVery low to moderate Very low to low
) Load and No-Load Load funds is a sales charge. If paid at the time of purchase, the fee is a front-end load. If levied when shares are sold, the fee is a back-end load, or contingent deferred sales charge. A no-load fund charges no sales commission. Fees Most mutual funds separate their charges into a number of categories.
16-13 The Investment Company Industry : Fees Insert Figure 21-2 here.
16-14 Expense Ratio Annual fee charges are calculated by a fund’s expense ratio, which is the fund’s total expenses expressed as a percentage of the fund’s assets. (range from 0.2% to 2%) management fee : includes salaries and bonus paid to fund managers 12-b fees: advertising costs on to the accountholders Other fees
16-15 Expense Ratio A mutual fund could have several classes of shares with different fee combinations. Studies indicate that Expense ratio is normally lowest for money market mutual funds and highest for international stock funds Tend to be lowest for large, liquid funds The lower the expense ratio, the better the fund performance.
16-16 The Investment Company Industry : Fees Insert Figure 21-3 here.
16-17 Fund AFund BFund C Shareholder Transaction Expenses Sales load imposed on purchasesNone 4.75% Sales load imposed on reinvested dividendsNone 4.75 Redemption feesNone Exchange feesNone Annual Fund Operating Expenses Management and administrative expenses0.22%0.60%0.70% Investment advisory expenses0.02—— 12b-1 marketing fees—0.30— Marketing and distribution costs0.02—— Miscellaneous expenses Total Operating Expenses0.29%1.22%0.96% Expenses on a $10,000 Investment 1 year$ 30$ 124$ years years , years3681,4771,805 Table 16.4 A. Typical fee tables found in three different mutual fund prospectuses
16-18 B. The impact of equity mutual fund costs on long-term investor returns. Fund AFund BFund C Initial investment$ 10,000 Day 110,000 9,525 5 years18,18917,45116, years33,08430,56529, years60,17853,14552, years109,45892,74392,539 Gross return13.00% Operating expenses0.29%1.22%0.96% Net return12.71%11.78%12.04% Fund A : typical cost efficient index fund Fund B : conventional no-load stock mutual fund Fund C : low-load stock mutual fund with less than typical annual operating expenses
16-20 Sources of Investment Returns Total Return: dividend and interest income and realized and unrealized appreciation Income distribution: interest and dividend income after expenses. Capital gains unrealized until the fund sells the shares (Unrealized capital gains) The realized capital gains are paid out to shareholders at the end of the year (capital gains distributions)
16-21 Taxes Shareholders pay taxes due once income dividends and capital gains distributions are received. All income and capital gains distributions are generally subject to income taxes. Municipal bond or US T-securities interest income exempt from federal taxes, but capital gains are taxable. Turnover rate: expressed as a percentage of the fund’s average assets (average turnover rate for stock mutual fund: 79%)
16-22 Selecting A Mutual Fund before-load (gross) return change in net asset value capital gains distributions income distributions beginning net asset value + = after-load (net) return change in net asset value capital gains distributions income distributions beginning net asset value = load fee With a mutual fund, return comes from the change in net asset value, capital gains distributions, and income distributions.
Fund Performance Using ranking tools or portfolio evaluation tools (alpha, Sharp ratio, and Treynor measure)
16-25 Style boxes Value Strategy (Score <1.75) Blend (1.75 Score 2.25) Growth Strategy (Score > 2.25) Large-cap (Top 5%) S & P 500 Benchmark Mid-cap (Next 15%) Wilshire 4500 Benchmark Small-cap (Bottom 80%) Russell 2000 Benchmark Characterize mutual funds by market capitalization (large, mid, and small cap) Next, determine how cheap or expensive portfolio holdings are relative to the overall market using P/E and P/B ratios (Value, Blend and Growth)
Selecting A Mutual Fund : Types of Funds Insert Figure 21-4 here.
16-27 Money market funds invest in short-term government securities and sometimes in short- term corporate securities. They are used primarily as a temporary cash haven. Bond funds invest in fixed income securities. They vary widely, and have no common maturity date to simultaneously return the components to their par value. Stock funds vary widely in their risk and price behavior. They are classified as growth or value, and as large-cap or small-cap.
16-28 A balanced fund is a mixture of stocks and fixed income securities. It forces discipline on the fund manager. An international fund is limited to buying securities registered outside the country where it is sold, while a global fund can invest anywhere in the world. A fund of funds invests only in other mutual funds. Its diversification is good, but its expense ratio tends to be higher than that of the typical mutual fund.
16-29 Sector : Such funds invest in specific market sectors, such as physical commodities or stocks closely tied to natural resources e.g. oil, forest products, and gold. An index fund may be a stock or bond fund that tries to behave exactly like the market. A stock index fund, for instance, may seek to mirror the performance of the Standard & Poor’s 500 stock index. Investors should determine their investment objective first, and then choose an appropriate fund or group of funds.
16-30 Insert Table 21-2 here.
16-31 Information Sources : Company Information The prospectus is a legal document describing the operation of the fund, its management, and the fees accountholders must pay. One important item in the prospectus is the fund’s portfolio turnover rate. A higher rate usually means higher expenses. The Statement of Additional Information is required by the SEC, although it is generally only sent to accountholders upon their request. It is a more detailed version of the prospectus.
16-33 Sources of Information Lipper Inc.: leading provider of data and analysis on the investment company business ( )www.lipperweb.com Morningstar.com: provide unbiased data and analysis and candid editorial commentary (www.morningstar.com)www.morningstar.com Vanguard Group: providing competitive investment performance and lowest operating expenses ( )www.vanguard.com