1. Chapter 4 MUTUAL FUNDS AND OTHER MANAGED INVESTMENTS

2. Chapter 4 Questions What is a mutual fund?What is a mutual fund? How is the net asset value (NAV) computed?How is the net asset value (NAV) computed? What expenses and changes might a mutual fund investor face?What expenses and changes might a mutual fund investor face? What does research on mutual fund performance reveal about fund expenses, portfolio turnover, and returns?What does research on mutual fund performance reveal about fund expenses, portfolio turnover, and returns?

3. Chapter 4 Questions What is a good procedure for determining which mutual funds to purchase?What is a good procedure for determining which mutual funds to purchase? When might it be appropriate to sell shares in a mutual fund?When might it be appropriate to sell shares in a mutual fund? What are the similarities and differences between mutual funds and other managed investments?What are the similarities and differences between mutual funds and other managed investments?

4. Mutual Fund Growth Mutual funds have become very popular investment vehicles.Mutual funds have become very popular investment vehicles. Nearly $7.5 trillion in total assets in 2004.Nearly $7.5 trillion in total assets in 2004. Total assets have grown 600% since 1990.Total assets have grown 600% since 1990.

5. What is a mutual fund? Mutual funds are open-end investment companies.Mutual funds are open-end investment companies. The fund sells shares to the public and invests the proceeds in a pool of funds, which are jointly owned by the fund’s investors.The fund sells shares to the public and invests the proceeds in a pool of funds, which are jointly owned by the fund’s investors.

6. Computing Net Asset Value For investors, the performance of their investment depends on what happens to the fund’s per share value, or net asset value (NAV).For investors, the performance of their investment depends on what happens to the fund’s per share value, or net asset value (NAV). NAV= Market Value of Assets – Liabilities Number of Shares Outstanding Number of Shares Outstanding

7. Mutual Fund Management Most funds are started by investment management companies who hire the fund manager to make investment decisions.Most funds are started by investment management companies who hire the fund manager to make investment decisions. –Fidelity, Vanguard, etc. Usually offer many different funds and allow investors to switch between funds.Usually offer many different funds and allow investors to switch between funds. Funds (open-end) sell additional shares to those who want to invest, redeem shares at the NAV (less any fees) to those who want to sell their shares.Funds (open-end) sell additional shares to those who want to invest, redeem shares at the NAV (less any fees) to those who want to sell their shares.

8. Why invest with mutual funds? LiquidityLiquidity –Funds buy and sell their own shares quickly, even if fund investments are illiquid DiversificationDiversification –Small minimum investment buys a typically well- diversified investment Professional management and record- keepingProfessional management and record- keeping –Expertise and services

9. Why invest with mutual funds? Choice and flexibilityChoice and flexibility –Families of funds offer a variety of investments to match investor needs IndexingIndexing –Some funds track a broad market index which insures that investors will earn the “market return” –Increasingly popular mutual fund alternative

10. Mutual Fund Drawbacks Active trading contributes to high costs which lower fund returns (Turnover)Active trading contributes to high costs which lower fund returns (Turnover) Tax consequences can be a disadvantageTax consequences can be a disadvantage –Tax impacts of asset trading are passed through to investors –Tax bill can be large even when the NAV falls

11. Mutual Fund Returns Three sources of return: Income distributions (ID)Income distributions (ID) –Bond interest, stock dividends Capital gain distributions (CGD)Capital gain distributions (CGD) –Realized gains/losses from selling assets Changes in NAV (  NAV)Changes in NAV (  NAV) –From unrealized gains/losses from assets

12. Mutual Fund Returns Return = (ID + CGD +  NAV)/Beg.NAV By dividing the sum of the three components of dollar returns by the beginning NAV, we have the mutual fund’s holding period return.By dividing the sum of the three components of dollar returns by the beginning NAV, we have the mutual fund’s holding period return. Most mutual funds allow investors to either receive distributions in cash or to reinvest in additional shares.Most mutual funds allow investors to either receive distributions in cash or to reinvest in additional shares.

13. Types of Mutual Funds Funds can be classified according to the type of security in which they investFunds can be classified according to the type of security in which they invest –Stock Funds –Taxable Bond Funds –Municipal Bond Funds –Stock and Bond Funds –Money Market Funds

14. Common Stock Funds Most popular type of fundMost popular type of fund Wide variety with different objectives and levels of riskWide variety with different objectives and levels of risk –Growth –Industry or sector funds –Geographic areas –International or Global –Equity Index funds

15. Taxable Bond Funds Generally seek to generate current income with limited riskGenerally seek to generate current income with limited risk Can vary by maturityCan vary by maturity –Short-term, Intermediate-term, Long-term Can vary by type of bondCan vary by type of bond –Government –Corporate –Mortgage-backed –International/Global –Bond Index funds

16. Municipal Bond Funds Provide investors with income exempt from Federal taxationProvide investors with income exempt from Federal taxation Often concentrate on single states to avoid state income taxation as wellOften concentrate on single states to avoid state income taxation as well

17. Stock and Bond Funds Seek to provide a combination of income and value appreciation.Seek to provide a combination of income and value appreciation. Different namesDifferent names –Balanced funds –Blended funds –Flexible funds

18. Money Market Funds Provide safe, current income with high liquidityProvide safe, current income with high liquidity Invest in money market securitiesInvest in money market securities –T-bills, Bank CD’s, Commercial paper, etc. NAV stays at $1; income either paid out or reinvested dailyNAV stays at $1; income either paid out or reinvested daily Provide an alternative to bank deposits, but not FDIC insuredProvide an alternative to bank deposits, but not FDIC insured

19. Mutual Fund Innovations Life-stage fundsLife-stage funds –Offer different mixes of securities based on the age of the investor Supermarket fundsSupermarket funds –Offer a wide variety of funds with “one- stop” fund shopping –Transfer services between funds –Expenses/fees can be high

20. Mutual Fund Prospectus Must be available to investors and should be review by investors.Must be available to investors and should be review by investors. Contains:Contains: –Fund’s investment objective –Investment strategy –Principal risks faced by investors –Recent investment performance –Expenses and fees –Lots of other detailed information

21. Mutual Fund Expenses and Considerations LoadsLoads –Commission to the broker to financial advisor who sold the fund to the investor –For load funds, the offer price is the fund’s NAV less the load (while no-load funds are sold at their NAV) –Load range from around 3% (low-load) to 8.5% 12b-1 Fees12b-1 Fees –Fees deducted from the asset value of the fund to cover marketing expenses –An alternative to loads

22. Mutual Fund Expenses and Considerations Deferred Sales LoadsDeferred Sales Loads –Redemption charges when fund shares are sold (rather than when purchased) –Often high (5-7%) if shares are sold within the first year, but then fall over time, perhaps even disappearing eventually Share ClassesShare Classes –Many funds offer several different classes of shares (A-B-C) with different fee structures –Best choice usually depends of investment horizon

23. Mutual Fund Expenses and Considerations Management FeesManagement Fees –Fees deducted from the fund’s asset value to compensate the fund managers –Some adjust fees according to the fund’s performance Expense ratioExpense ratio –Adding all fees and calculating expenses as a percentage of the fund’s asset

24. Mutual Fund Expenses and Considerations Portfolio TurnoverPortfolio Turnover –Not an explicit cost, but very important determinant of shareholder returns –Trading costs rise with turnover –In order for high turnover to pay off, fund managers must be successful in their active trading strategies Sources of InformationSources of Information –Wall Street Journal, Business Week –Morningstar Fund history, tax efficiency, risk analysisFund history, tax efficiency, risk analysis

25. Mutual Fund Return and Risk Performance Return Performance On a risk-adjusted basis, portfolio managers seem to out-perform the market before expenses, but net returns are below the market indexOn a risk-adjusted basis, portfolio managers seem to out-perform the market before expenses, but net returns are below the market index Some above-average performers over short time horizons, but such performance is not generally sustained (just luck?)Some above-average performers over short time horizons, but such performance is not generally sustained (just luck?) These results help to explain the growing popularity of index fundsThese results help to explain the growing popularity of index funds

26. Mutual Fund Return and Risk Performance Risk Performance While returns are not consistent, risk isWhile returns are not consistent, risk is Objectives lead to strategies that lead to varying degrees of investment risksObjectives lead to strategies that lead to varying degrees of investment risks Return is positively related to the level of riskReturn is positively related to the level of risk Risk is therefore an important considerationRisk is therefore an important consideration Style Consistency Style-shifting funds earn less on averageStyle-shifting funds earn less on average

27. Mutual Fund Return and Risk Performance Fees and expenses: Do higher fees pay off? Investment performance is no better (and perhaps worse) for load funds vs. no-loadInvestment performance is no better (and perhaps worse) for load funds vs. no-load Expenses lower returns in predictable ways – lower expense funds give better returnsExpenses lower returns in predictable ways – lower expense funds give better returns Turnover affects returns in several ways, including taxes – high turnover means more short-term realized gainsTurnover affects returns in several ways, including taxes – high turnover means more short-term realized gains Tax efficiency is an important consideration – after-tax returns tend to be less for high turnover fundsTax efficiency is an important consideration – after-tax returns tend to be less for high turnover funds

28. Mutual Fund Investment StrategiesMutual Fund Investment Strategies Choose in funds consistent with your objectives, constraints, and tax situation.Choose in funds consistent with your objectives, constraints, and tax situation. Consider index funds for a large portion of your fund portfolio.Consider index funds for a large portion of your fund portfolio. When possible, invest in no-load funds with below-average expense and turnover ratios.When possible, invest in no-load funds with below-average expense and turnover ratios. Invest at least 10-20% in international or global funds.Invest at least 10-20% in international or global funds. Own funds in different asset classes and consider life-cycle investing.Own funds in different asset classes and consider life-cycle investing.

29. Mutual Fund Investment StrategiesMutual Fund Investment Strategies If you actively manage your portfolio, consider the past year’s “hot funds.”If you actively manage your portfolio, consider the past year’s “hot funds.” Do not attempt to time the market; timing strategies add little except costs and risk.Do not attempt to time the market; timing strategies add little except costs and risk. Use dollar cost averaging by investing a set dollar amount each month.Use dollar cost averaging by investing a set dollar amount each month. Avoid investing money shortly before the capital gain distribution dates (prospectus).Avoid investing money shortly before the capital gain distribution dates (prospectus). Do not own too many funds. You will get average returns with high expenses.Do not own too many funds. You will get average returns with high expenses.

30. When should you sell a mutual fund? Personal considerationsPersonal considerations –Portfolio rebalancing points due to life cycle considerations Be aware of the quick trigger, selling on the first dip in NAV; think long-termBe aware of the quick trigger, selling on the first dip in NAV; think long-term Be aware of capital gains with selling fund sharesBe aware of capital gains with selling fund shares Fund considerationsFund considerations –Change in portfolio manager –Change in investment style –Fund is growing “too large” or “too fast” –Persistent bad performance

31. Mutual Fund Scandals Market timing, late trading, miscalculating load fees, soft dollar commissionsMarket timing, late trading, miscalculating load fees, soft dollar commissions Benefit fund managers, hurt long-term shareholdersBenefit fund managers, hurt long-term shareholders Rule changes to combat abuses initiated by the SECRule changes to combat abuses initiated by the SEC

32. Other Managed Investments Closed-end investment companies Shares trade like stock rather than being bought and sold from the fundShares trade like stock rather than being bought and sold from the fund Number of shares are fixedNumber of shares are fixed Often sell at a discount from NAV (a puzzle for modern finance)Often sell at a discount from NAV (a puzzle for modern finance) Often a means of investing in a pool of assets from a foreign countryOften a means of investing in a pool of assets from a foreign country

33. Other Managed Investments Exchange-traded funds (EFTs) Relatively new, yet very popularRelatively new, yet very popular Like closed-end funds, they trade like individual stocksLike closed-end funds, they trade like individual stocks Passively managed to mirror a market index, both broad and narrowPassively managed to mirror a market index, both broad and narrow Low expenses, but do involve brokerage commissionsLow expenses, but do involve brokerage commissions Tax and liquidity concernsTax and liquidity concerns

34. Other Managed Investments Variable Annuities Many offered by insurance companiesMany offered by insurance companies Offers investors with choices of investments with tax-deferred growthOffers investors with choices of investments with tax-deferred growth Insurance product: payment in the case of death or else retirement income streamInsurance product: payment in the case of death or else retirement income stream Expenses for both fund management and to pay for insurance, so fees tend to be much higher than with mutual fundsExpenses for both fund management and to pay for insurance, so fees tend to be much higher than with mutual funds Income stream taxed as regular incomeIncome stream taxed as regular income