1. 4 4 C h a p t e r Mutual Funds second edition Fundamentals of Investments Valuation & Management Charles J. Corrado Bradford D. Jordan McGraw Hill / IrwinSlides by Yee-Tien (Ted) Fu

2.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 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.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 3 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.

4.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 4 Investment Companies and Fund Types Investment company A business that specializes in pooling funds from individual investors and investing them. Closed-end fund An investment company with a fixed number of shares that are bought and sold only in the open stock market. Open-end fund An investment company that stands ready to buy and sell shares at any time.

5. Investment Companies and Fund Types 4 - 5 @2002 by the McGraw- Hill Companies Inc.All rights reserved. McGraw Hill / Irwin

6.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 6 Investment Companies and Fund Types  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. Net asset value The value of the assets held by a mutual fund, divided by the number of shares. Abbreviated NAV.

7.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 7 Work the Web  For mutual fund facts and figures, visit:  http://www.ici.org http://www.ici.org

8.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 8 Mutual Fund Operations Organization and Creation  A mutual fund is simply a corporation. It is owned by shareholders, who elect a board of directors.  Most mutual funds are created by investment advisory firms (such as Fidelity Investments), or brokerage firms with investment advisory operations (such as Merrill Lynch).  These firms wish to manage the funds to earn fees.

9.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 9 Work the Web  All the major fund families have websites. Try, for example:  http://www.vanguard.com http://www.vanguard.com

10.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 10 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.

11.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 11 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.

12.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 12 Mutual Fund Costs and Fees Types of Expenses and Fees  Sales charges or “loads.” Front-end loads are charges levied on purchases, while back-end loads are charges levied on redemptions.  12b-1 fees. SEC Rule 12b-1 allows funds to spend up to 1% of fund assets annually to cover distribution and marketing costs.  Management fees. Usually based on fund size, performance, etc.

13.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 13 Mutual Fund Costs and Fees Types of Expenses and Fees …continued  Trading costs. This is related to the fund’s turnover.

14.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 14 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.

15. Mutual Fund Costs & Fees 4 - 15 McGraw Hill / Irwin

16.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 16 Work the Web  Prospectuses are increasingly available online. To see some examples, visit:  http://www.fidelity.com http://www.fidelity.com  To see a fund that really discloses information, try:  http://www.ipsfunds.com http://www.ipsfunds.com Check out the “plain language” risk disclosure!

17.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 17 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.

18.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 18 Short-Term Funds  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. Money market mutual fund A mutual fund specializing in money market instruments.

19.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 19 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.

20.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 20 Work the Web  For information on thousands of funds, including MMMFs, visit:  http://www.mfea.com http://www.mfea.com

21.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 21 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?

22.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 22 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.

23.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 23 Stock Funds  Sector funds specialize in specific sectors of the economy.  Other fund types include index funds, social conscience funds, and tax-managed funds.

24.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 24 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.

25.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 25 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.

26.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 26 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).

27. Mutual Fund Objectives: Recent Developments 4 - 27

28.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 28 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: GrowthBlendValue Large Medium Small Size Style

29.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 29 Work the Web  One of the best mutual fund sites is:  http://www.morningstar.com http://www.morningstar.com Try picking some funds using their “Fund Selector.”  To learn more about “social conscience” funds, visit:  http://www.socialinvest.org http://www.socialinvest.org  http://www.domini.com http://www.domini.com

30.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 30 Mutual Fund Performance  Mutual fund performance is very closely tracked by a number of organizations.

31. Mutual Fund Performance 4 - 31

32. Mutual Fund Performance 4 - 32

33.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 33 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.

34. Closed-End Funds & Exchange Traded Funds 4 - 34 McGraw Hill / Irwin

35.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 35 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.

36.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 36 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.

37.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 37 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

38.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 38 Chapter Review  Mutual Fund Costs and Fees  Types of Expenses and Fees  Expense Reporting  Why Pay Loads and Fees?  Short-Term Funds  Money Market Mutual Funds  Money Market Deposit Accounts

39.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 39 Chapter Review  Long-Term Funds  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?

40.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 40 Chapter Review  Closed-End Funds and Exchange Traded Funds  Closed-End Funds Performance Information  The Closed-End Fund Discount Mystery  Exchange Traded Funds