1. McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter Seventeen Mutual Funds

2. McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter Outline 1.Overview 2.Types of Mutual Funds 3.Evaluate Mutual Funds 4.Regulation 1.Overview 2.Types of Mutual Funds 3.Evaluate Mutual Funds 4.Regulation

3. McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Growth of the Mutual Fund Market

4. McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 1. Mutual Funds Overview Mutual funds are financial intermediaries that pool the financial resources of investors and invest those resources in diversified portfolios of assets Enjoy economies of scale by incurring lower transaction costs and commissions Shareholder services offered include free exchanges of investments between a company’s funds, automatic investing, check-writing, automatic reinvestment of dividends, and automatic withdrawals At year-end 2004, more than 8,800 mutual funds held total assets of $8.11 trillion Mutual funds are financial intermediaries that pool the financial resources of investors and invest those resources in diversified portfolios of assets Enjoy economies of scale by incurring lower transaction costs and commissions Shareholder services offered include free exchanges of investments between a company’s funds, automatic investing, check-writing, automatic reinvestment of dividends, and automatic withdrawals At year-end 2004, more than 8,800 mutual funds held total assets of $8.11 trillion

5. McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Historical Trends First mutual fund established in 1924 Advent of money market mutual funds in 1972 as investors looked for ways to earn market rates on short-term funds Tax-exempt money market mutual funds introduced in 1979 Special-purpose equity, bond, emerging market, and derivative funds exploded on the scene during the 1990’s bull market First mutual fund established in 1924 Advent of money market mutual funds in 1972 as investors looked for ways to earn market rates on short-term funds Tax-exempt money market mutual funds introduced in 1979 Special-purpose equity, bond, emerging market, and derivative funds exploded on the scene during the 1990’s bull market

6. McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Financial Assets of Major Financial Intermediaries, 1990 and 2004 ($Tns)

7. McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 2. Types of Mutual Funds Long Term –Equity funds - funds consisting of common and preferred stock securities –Bond funds - funds consisting of fixed-income capital market debt securities –Hybrid funds - funds consisting of stock and bond securities Short Term –Money market mutual funds – invest in taxable or tax-exempt money market securities (with maturity of less that one year) Long Term –Equity funds - funds consisting of common and preferred stock securities –Bond funds - funds consisting of fixed-income capital market debt securities –Hybrid funds - funds consisting of stock and bond securities Short Term –Money market mutual funds – invest in taxable or tax-exempt money market securities (with maturity of less that one year)

8. McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Number of Mutual Funds, 1980, 1990, 2004

9. McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Mutual Fund Prospectuses and Objectives Regulations require mutual fund managers to specify the investment objectives of their funds in a prospectus available to potential investors The prospectus includes a list of the securities that the fund holds and the investment objectives (e.g., aggressive growth funds invest in the equities of high-growth and high-risk firms) As of 1998, SEC requires key sections of a fund prospectus to be written in ‘plain’ English Regulations require mutual fund managers to specify the investment objectives of their funds in a prospectus available to potential investors The prospectus includes a list of the securities that the fund holds and the investment objectives (e.g., aggressive growth funds invest in the equities of high-growth and high-risk firms) As of 1998, SEC requires key sections of a fund prospectus to be written in ‘plain’ English

10. McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 3. Evaluation 1.Returns, NAV 2.Performance 3.Costs 4.Index Funds 1.Returns, NAV 2.Performance 3.Costs 4.Index Funds

11. McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 3.1 Investor Returns The return for the investor reflects three aspects of the underlying portfolio of mutual fund assets –portfolio earns income and dividends on those assets –experiences capital gains sells an asset at a higher price –capital appreciation in the underlying values of its existing assets adds to the value of mutual fund shares Daily marking to market - asset and balance sheet values are adjusted to reflect current market prices NAV - the net asset value of a mutual fund -- equal to the market value of the assets in the mutual fund portfolio divided by number of shares outstanding The return for the investor reflects three aspects of the underlying portfolio of mutual fund assets –portfolio earns income and dividends on those assets –experiences capital gains sells an asset at a higher price –capital appreciation in the underlying values of its existing assets adds to the value of mutual fund shares Daily marking to market - asset and balance sheet values are adjusted to reflect current market prices NAV - the net asset value of a mutual fund -- equal to the market value of the assets in the mutual fund portfolio divided by number of shares outstanding

12. McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Calculation of NAV Calculation of NAV on an Open-End Mutual Fund NAV = Total market value of assets under management Number of mutual fund shares outstanding Calculation of NAV on an Open-End Mutual Fund NAV = Total market value of assets under management Number of mutual fund shares outstanding

13. Classes of Funds Open-end mutual fund - a fund for which the supply of shares is not fixed but can increase or decrease daily with purchases and redemptions of shares Closed-end investment companies - investment companies that have a fixed supply of outstanding shares. Shares trade in the stock market throughout the trading day. –REIT: a closed-end investment company that specializes in investing in mortgages, property, or real estate shares Open-end mutual fund - a fund for which the supply of shares is not fixed but can increase or decrease daily with purchases and redemptions of shares Closed-end investment companies - investment companies that have a fixed supply of outstanding shares. Shares trade in the stock market throughout the trading day. –REIT: a closed-end investment company that specializes in investing in mortgages, property, or real estate shares

14. McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Example: Open-end Fund (p.496) 1,000 Sears, Roebuck shares; price =$37.75 2,000 Mobil Oil shares; price =$43.70 1,500 Household International shares; price =$46.67 # of outstanding shares for the fund = 15,000 NAV = (1,000× $37.75+ 2,000 × $43.70+ 1,500 × $46.67)/(15,000) = $13.01 Prices increase: Sears, Roebuck - $45; Mobil Oil - $48; Household International - $50 NAV = (1,000× $45+ 2,000 × $48+ 1,500 × $50)/(15,000) = $14.4 1,000 Sears, Roebuck shares; price =$37.75 2,000 Mobil Oil shares; price =$43.70 1,500 Household International shares; price =$46.67 # of outstanding shares for the fund = 15,000 NAV = (1,000× $37.75+ 2,000 × $43.70+ 1,500 × $46.67)/(15,000) = $13.01 Prices increase: Sears, Roebuck - $45; Mobil Oil - $48; Household International - $50 NAV = (1,000× $45+ 2,000 × $48+ 1,500 × $50)/(15,000) = $14.4

15. McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Example: Open-end Fund 1,000 new mutual fund shares are sold @ $13,010 and the proceeds from sale are used to buy 344 shares of Sears at $37.75 ($13,010/ $37.75 = 344). After the purchase, the mutual fund has the following assets 1,344 Sears, Roebuck shares; price =$45 2,000 Mobil Oil shares; price =$48 1,500 Household International shares; price =$50 # of outstanding shares for the fund = 16,000 NAV = (1,344× $45+ 2,000 × $48+ 4,779 × $50)/16,000 = $14.47 1,000 new mutual fund shares are sold @ $13,010 and the proceeds from sale are used to buy 344 shares of Sears at $37.75 ($13,010/ $37.75 = 344). After the purchase, the mutual fund has the following assets 1,344 Sears, Roebuck shares; price =$45 2,000 Mobil Oil shares; price =$48 1,500 Household International shares; price =$50 # of outstanding shares for the fund = 16,000 NAV = (1,344× $45+ 2,000 × $48+ 4,779 × $50)/16,000 = $14.47

16. McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Closed-End Fund Trading at Premium # of outstanding shares for the fund = 50 Market price per fund share = $20 Market value of the fund’s asset portfolio = $800 Market value of one fund share (NAV) = $16 AssetsLiabilities & Equity Market value of assets $800of fund shares$1,000 Premium$200(50×$20) # of outstanding shares for the fund = 50 Market price per fund share = $20 Market value of the fund’s asset portfolio = $800 Market value of one fund share (NAV) = $16 AssetsLiabilities & Equity Market value of assets $800of fund shares$1,000 Premium$200(50×$20)

17. McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Closed-End Fund Trading at Discount # of outstanding shares for the fund = 100 Market price per one fund share = $25 Market value of the fund’s asset portfolio = $3,000 Market value of one fund share (NAV) = $30 AssetsLiabilities & Equity Market value of assets $3,000of fund shares$2,500 Discount-$500(100×$25) # of outstanding shares for the fund = 100 Market price per one fund share = $25 Market value of the fund’s asset portfolio = $3,000 Market value of one fund share (NAV) = $30 AssetsLiabilities & Equity Market value of assets $3,000of fund shares$2,500 Discount-$500(100×$25)

18. 3.2 Mutual Fund Performance The average mutual fund does not beat the market. At best, they perform well enough to offset costs. Most studies find they don’t even do that. While a few funds do better than the market, they are no more than could be expected from pure chance. Little evidence that winners repeat. However, some evidence that losers repeat. The average mutual fund does not beat the market. At best, they perform well enough to offset costs. Most studies find they don’t even do that. While a few funds do better than the market, they are no more than could be expected from pure chance. Little evidence that winners repeat. However, some evidence that losers repeat.

19. McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 3.3 Mutual Fund Costs Two types of fees are incurred by investors –Load versus No-load Funds Load fund - a mutual fund with an up-front sales or commission charge that the investor must pay No-load fund - a mutual fund that does not charge up-front sales or commission charges on the sale of mutual fund shares to investors –Fund Operating Costs annual fees charged to cover all fund level expenses experienced as a percent of fund assets 12b-1 fees: fees relating to the distribution costs of mutual fund shares Two types of fees are incurred by investors –Load versus No-load Funds Load fund - a mutual fund with an up-front sales or commission charge that the investor must pay No-load fund - a mutual fund that does not charge up-front sales or commission charges on the sale of mutual fund shares to investors –Fund Operating Costs annual fees charged to cover all fund level expenses experienced as a percent of fund assets 12b-1 fees: fees relating to the distribution costs of mutual fund shares

20. 3.4 Index Funds Mutual Funds that attempt to duplicate the performance of a market index Examples of indices: –S&P 500 –Wilshire 5000 (total market) –Bond market –International stock market Advantages –Low fees –Above average performance Mutual Funds that attempt to duplicate the performance of a market index Examples of indices: –S&P 500 –Wilshire 5000 (total market) –Bond market –International stock market Advantages –Low fees –Above average performance

21. McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Assets in MMMFs, 2004 (in $B)

22. McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 4. Regulation This industry is heavily regulated to protect investors SEC is the primary regulator –Securities Act of 1933 requires a mutual fund to file a registration statement with the SEC –Securities Exchange Act of 1934 makes the purchase and sale of mutual fund shares subject to various antifraud provisions and appointed the National Association of Securities Dealers (NASD) to supervise –Investment Advisers Act and Investment Company Act of 1940 established rules to prevent conflicts of interest, fraud, and excessive fees –Insider Trading and Securities Fraud Enforcement Act of 1988 requires mutual funds to develop mechanisms and procedures to avoid insider trading abuses –Market Reform Act of 1990 allows the SEC to introduce circuit breakers –NSMIA of 1996 also applies to mutual funds This industry is heavily regulated to protect investors SEC is the primary regulator –Securities Act of 1933 requires a mutual fund to file a registration statement with the SEC –Securities Exchange Act of 1934 makes the purchase and sale of mutual fund shares subject to various antifraud provisions and appointed the National Association of Securities Dealers (NASD) to supervise –Investment Advisers Act and Investment Company Act of 1940 established rules to prevent conflicts of interest, fraud, and excessive fees –Insider Trading and Securities Fraud Enforcement Act of 1988 requires mutual funds to develop mechanisms and procedures to avoid insider trading abuses –Market Reform Act of 1990 allows the SEC to introduce circuit breakers –NSMIA of 1996 also applies to mutual funds