1. Fundamentals of Investments4
C h a p t e r
Mutual Funds
Fundamentals of Investments
Valuation & Management
second edition
Charles J. Corrado Bradford D. Jordan
McGraw Hill / Irwin
Slides by Yee-Tien (Ted) Fu

2. Mutual Funds
Our goal in this chapter is to understand the different types of mutual funds, their risks, and returns.
Goal
Investors added $363 billion in net new funds to mutual funds in 1999, and by the end of the year, mutual fund assets totaled $6.85 trillion. These were estimated to be owned by 83 million Americans.

3. Investment companies and fund types
At the most basic levels. A company that pools funds obtained from individual investors and invests them is called an investment company
An investment company is a business that specializes in managing financial assets for individual investors.
All mutual funds are in fact investment companies, however not all investment companies are mutual funds.

4. Mutual Funds
Mutual funds are simply a means of combining or pooling the funds of a large group of investors.
The buy and sell decisions for the resulting pool are then made by a fund manager, who is compensated for the service provided.
Like commercial banks and life insurance companies, mutual funds are a form of financial intermediary.

5. Open-End Versus Closed-End Fund
There are two types of investment companies, open end funds and closed end funds.
With an open end fund, the fund itself will sell new shares to anyone wishing to buy and will redeem shares from anyone wishing to sell.
As a result with an open end fund , the number of shares outstanding fluctuates through time
With a closed end, the number of shares is fixed and never changes, if you want to buy shares, you can buy them from another investor.

6. Open-End Versus Closed-End Fund
Strictly, speaking the term mutual fund actually refers only to an open end investment company.

7. Investment Companies and Fund Types
Investment company
A business that specializes in pooling funds from individual investors and investing them.
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.

8. Investment Companies and Fund Types
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Investment Companies and Fund Types
McGraw Hill / Irwin
@2002 by the McGraw- Hill Companies Inc.All rights reserved.

9. Investment Companies and Fund Types
Net asset value
The value of the assets held by a mutual fund, divided by the number of shares. Abbreviated NAV.
Shares in an open-end fund are worth their NAV, because the fund stands ready to redeem their shares at any time.
In contrast, the shares of closed-end funds may or may not be equal to their NAV.

10. Mutual Fund Operations
Organization and Creation
A mutual fund is simply a corporation. It is owned by shareholders, who elect a board of directors.
The board of director is responsible for hiring a manager to oversee the fund’s operations
Most mutual funds are created by investment advisory firms( which are businesses that specialize in managing mutual funds) or brokerage firms with investment advisory operations

11. Mutual Fund Operations
These firms wish to manage the funds to earn fees.
Investment advisory firms are also called mutual fund companies, such firms have additional operations such as discount brokerages and other financial services.

12. Mutual Fund Operations
Regulated investment company doesn’t pay taxes on its investment income. The fund passes through all realized investment income to fund shareholders who then pay taxes on these distributions as though they owned the securities.

13. Mutual Fund Operations
Taxation of Investment Companies
An investment company that
holds almost all its assets as investments in stocks, bonds, and other securities,
uses no more than 5% of its assets when acquiring a particular security, and
passes through all realized investment income to fund shareholders,
is treated as a “regulated investment company” for tax purposes and does not need to pay taxes on its investment income.

14. Mutual Fund Operations
The Fund Prospectus and Annual Report
Mutual funds are required by law to supply a prospectus to any investor who wishes to purchase shares.
Mutual funds must also provide an annual report to their shareholders.
The prospectus and annual report contain financial statement along with information concerning the fund’s expenses, gains and losses, objectives ----

15. Mutual Fund Costs and Fees
Types of Expenses and Fees
Sales charges or “loads.” many mutual funds charge a fee whenever shares are purchased.
* Funds that charge loads are called load funds, funds that have no such charges are called no-load funds.
*Front-end loads are charges levied on purchases, while back-end loads are charges levied on redemptions. (CDSC)

16. Mutual Fund Costs and Fees
When you purchase shares in a load fund , you pay a price excess of the net asset value called the offering price.
The difference between the offering price and the net asset value is the load.
Shares in no-load funds are sold at the net asset value
Front end loads are expressed as a percentage of the offering price, not the net asset value

17. Mutual Fund Costs and Fees
12b-1 fees. SEC Rule 12b-1 allows funds to spend up to 1% of fund assets annually to cover distribution and marketing costs.
Funds that market directly to the public may use 12b-1 fees to pay for advertising and direct mailing costs
Mutual funds with no front end or back end loads or minimal 12b-1 fees are often called pure( No loads funds) to distinguish them from the Not so pure funds that may have no loads but still charge the fees.

18. Mutual Fund Costs and Fees
Types of Expenses and Fees …continued
Management fees. Usually based on fund size, performance, etc.
Trading costs. This is related to the fund’s turnover.
* Turnover is a measure of how much trading a fund does, its calculated as the lesser of the fund total purchases or sales during a year, divided by the average daily assets

19. Mutual Fund Costs and Fees
Expense Reporting
Mutual funds are required to report expenses in a fairly standardized way in the prospectus.
Shareholder transaction expenses - loads and deferred sales charges.
Fund operating expenses - management and 12b-1 fees, legal, accounting, and reporting costs, director fees.
Hypothetical example showing the total expense you would pay over time per $10,000 invested.

20. Mutual Fund Costs & Fees
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McGraw Hill / Irwin

21. Mutual Fund Costs and Fees
Why Pay Loads and Fees?
You may want a fund run by a particular manager, and all such funds are load funds.
You want a specialized type of fund. Loads and fees for such funds tend to be higher as there is little competition among them.

22. Short term funds
Mutual funds are divided into two major groups, short term funds and long term funds
Short term funds are known as money market mutual funds
Long term funds include everything that’s not a money market fund.

23. Short-Term Funds Money market mutual fund
A mutual fund specializing in money market instruments.
Short-term funds are collectively known as money market mutual funds, or MMMFs.
MMMFs always maintain a $1 net asset value to make them resemble bank accounts.
Depending on the type of securities purchased, MMMFs can be either taxable or tax-exempt.

24. Short-Term Funds
Most banks offer what are called “money market” deposit accounts, or MMDAs, which are much like MMMFs.
The distinction is that a bank money market account is a bank deposit and offers FDIC protection.

25. Money market mutual funds
Most money market funds invest in high quality , low risk instruments with maturity of less than 90 days.
As a result , they have relatively little risk. However, some buy riskier assets or have longer maturities than others, so they don’t all carry equally low risk

26. Money market fund accounting
A unique feature of money market funds is that their net asset value are always 1$/share.
A money market fund sets the number of shares equal to the fund’s assets
( breaking the buck) is used to describe dropping below 1$ in net asset value

27. Taxes and money market fund
Money market funds are either taxable or tax-exempt , taxable funds are more common
Non taxable money market funds therefore buy only these types of tax exempt securities

28. Long-Term Funds
A fund’s objective is the major determinant of the fund type.
Historically, mutual funds were classified as stock, bond, or income funds. However, it is becoming increasingly difficult to do so.
Stock, bond,
or income?

29. Stock Funds
Some stock funds trade off capital appreciation and dividend income.
Capital appreciation, growth, growth and income, equity income.
Some stock funds focus on companies in a particular size range.
Small company, midcap.
Some fund groups invest internationally.
Global, international, region, country, emerging markets.

30. Stock Funds
Sector funds specialize in specific sectors of the economy.
Other fund types include index funds, social conscience funds, and tax-managed funds.

31. Bond Funds
Bond funds may be distinguished by their  maturity range ,  credit quality,  taxability,  bond type, and  issuing 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.

32. Stock and Bond Funds
Funds that do not invest exclusively in either stocks or bonds are often called “blended” or “hybrid” funds.
Examples include balanced funds, asset allocation funds, convertible funds, income funds.

33. Mutual Fund Objectives: Recent Developments
In recent years, there has been a trend toward classifying a mutual fund’s objective based on its actual holdings.
For example, the Wall Street Journal classifies most general purpose funds based on the market “cap” of the stocks they hold, and also on whether the fund tends to invest in “growth” or “value” stocks (or both).

34. Mutual Fund Objectives: Recent Developments
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Mutual Fund Objectives: Recent Developments

35. Mutual Fund Objectives: Recent Developments
A mutual fund “style” box is a way of visually representing a fund’s investment focus by placing the fund into one of nine boxes:
Growth
Blend
Value
Large
Medium
Small
Size
Style

36. Mutual Fund Performance
Mutual fund performance is very closely tracked by a number of organizations.

37. Mutual Fund Performance
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Mutual Fund Performance

38. Mutual Fund Performance
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Mutual Fund Performance

39. Mutual Fund Performance
While looking at historical returns, the riskiness of the various fund categories should also be considered.
Whether historical performance is useful in predicting future performance is a subject of ongoing debate.
Some of the poorest-performing funds are those with very high costs.

40. Closed-End Funds & Exchange Traded Funds
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Closed-End Funds & Exchange Traded Funds
McGraw Hill / Irwin

41. Closed-End Funds & Exchange Traded Funds
Most closed-end funds sell at a discount relative to their net asset values, and the discount is sometimes substantial. The typical discount also fluctuates over time
Despite a great deal of research, the closed-end fund discount phenomenon remains largely unexplained.

42. Closed-End Funds & Exchange Traded Funds
An exchange traded fund, or ETF, is basically an index fund, except that it trades like a closed-end fund (without the discount phenomenon).
An area where ETFs seem to have an edge over the more traditional index funds is the more specialized indexes.

43. Chapter Review Investment Companies and Fund Types
Open-End versus Closed-End Funds
Net Asset Value
Mutual Fund Operations
Mutual Fund Organization and Creation
Taxation of Investment Companies
The Fund Prospectus and Annual Report

44. Chapter Review Mutual Fund Costs and Fees Short-Term Funds
Types of Expenses and Fees
Expense Reporting
Why Pay Loads and Fees?
Short-Term Funds
Money Market Mutual Funds
Money Market Deposit Accounts

45. Chapter Review Long-Term Funds Mutual Fund Performance Stock Funds
Taxable and Municipal Bond Funds
Stock and Bond Funds
Mutual Fund Objectives: Recent Developments
Mutual Fund Performance
Mutual Fund Performance Information
How Useful are Fund Performance Ratings?

46. Chapter Review Closed-End Funds and Exchange Traded Funds
Closed-End Funds Performance Information
The Closed-End Fund Discount Mystery
Exchange Traded Funds