1. ©2007, The McGraw-Hill Companies, All Rights Reserved 17-1 McGraw-Hill/Irwin Chapter Seventeen Mutual Funds

2. ©2007, The McGraw-Hill Companies, All Rights Reserved 17-2 McGraw-Hill/Irwin Mutual Funds Overview  Mutual funds pool investors’ funds and invest in money or capital market instruments, and sometimes derivatives.  They allow investors to gain diversification and professional management according to specific published objectives at low cost.  Mutual funds pool investors’ funds and invest in money or capital market instruments, and sometimes derivatives.  They allow investors to gain diversification and professional management according to specific published objectives at low cost.

3. ©2007, The McGraw-Hill Companies, All Rights Reserved 17-3 McGraw-Hill/Irwin 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

4. ©2007, The McGraw-Hill Companies, All Rights Reserved 17-4 McGraw-Hill/Irwin Growth of the Mutual Fund Market

5. ©2007, The McGraw-Hill Companies, All Rights Reserved 17-5 McGraw-Hill/Irwin Financial Assets of Major Financial Intermediaries, 1990 and 2004 ($Tns)

6. ©2007, The McGraw-Hill Companies, All Rights Reserved 17-6 McGraw-Hill/Irwin Types of Mutual Funds Long term funds 1.Equity funds: Primarily hold common and preferred stock 2.Bond funds: Primarily hold fixed income securities with maturities over 1 year 3.Hybrid funds: Blends of equity and bond funds. 4.Tax exempt funds: Funds that specialize in investing in tax exempt securities Long term funds 1.Equity funds: Primarily hold common and preferred stock 2.Bond funds: Primarily hold fixed income securities with maturities over 1 year 3.Hybrid funds: Blends of equity and bond funds. 4.Tax exempt funds: Funds that specialize in investing in tax exempt securities

7. ©2007, The McGraw-Hill Companies, All Rights Reserved 17-7 McGraw-Hill/Irwin Long term funds 5. Index funds; Funds that attempt to mimic the performance of a given index, because they do not actively engage in timing and stock selection they generally have lower expense ratios than other funds. –These have now grown to 25% of long term funds. –Investing in an index fund is a form of passive investing. –The primary advantage to such a strategy is the lower management expense ratio on an index fund. 5. Index funds; Funds that attempt to mimic the performance of a given index, because they do not actively engage in timing and stock selection they generally have lower expense ratios than other funds. –These have now grown to 25% of long term funds. –Investing in an index fund is a form of passive investing. –The primary advantage to such a strategy is the lower management expense ratio on an index fund.

8. ©2007, The McGraw-Hill Companies, All Rights Reserved 17-8 McGraw-Hill/Irwin Long term funds 6.Exchange traded funds (ETF): A variant of index funds that are traded on an exchange. The advantage of an ETF is that it can be traded throughout the day at continuously updated prices. ETFs can be purchased on margin and sold short, unlike index funds. There are no capital gains distributions to add to tax liabilitiy in a given year either. These features allow for better hedging and arbitrage strategies. Examples include SPDRs on the AMEX and Vanguard’s Large-Cap VIPERS funds. 6.Exchange traded funds (ETF): A variant of index funds that are traded on an exchange. The advantage of an ETF is that it can be traded throughout the day at continuously updated prices. ETFs can be purchased on margin and sold short, unlike index funds. There are no capital gains distributions to add to tax liabilitiy in a given year either. These features allow for better hedging and arbitrage strategies. Examples include SPDRs on the AMEX and Vanguard’s Large-Cap VIPERS funds.

9. ©2007, The McGraw-Hill Companies, All Rights Reserved 17-9 McGraw-Hill/Irwin Short term funds 1.Money market mutual funds: –Funds that invest in securities with 1 year maturity or less 1.Money market mutual funds: –Funds that invest in securities with 1 year maturity or less

10. ©2007, The McGraw-Hill Companies, All Rights Reserved 17-10 McGraw-Hill/Irwin Number of Mutual Funds, 1980, 1990, 2004

11. ©2007, The McGraw-Hill Companies, All Rights Reserved 17-11 McGraw-Hill/Irwin Mutual Fund Prospectuses and Objectives Regulations require mutual fund managers to specify the investment objectives of their funds in a prospectus The prospectus includes a list of the securities that the fund holds and the investment objectives 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 The prospectus includes a list of the securities that the fund holds and the investment objectives As of 1998, SEC requires key sections of a fund prospectus to be written in ‘plain’ English

12. ©2007, The McGraw-Hill Companies, All Rights Reserved 17-12 McGraw-Hill/Irwin Investor Returns from Mutual Fund Ownership 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 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

13. ©2007, The McGraw-Hill Companies, All Rights Reserved 17-13 McGraw-Hill/Irwin Mutual Funds Open End funds Closed-End Funds Open End funds Closed-End Funds

14. ©2007, The McGraw-Hill Companies, All Rights Reserved 17-14 McGraw-Hill/Irwin Open End funds ready to buy and sell shares at a price based on net asset value (NAV) NAV per share equals the market value of the portfolio minus the liabilities of the mutual fund divided by the number of shares owned by the mutual fund investors. ready to buy and sell shares at a price based on net asset value (NAV) NAV per share equals the market value of the portfolio minus the liabilities of the mutual fund divided by the number of shares owned by the mutual fund investors.

15. ©2007, The McGraw-Hill Companies, All Rights Reserved 17-15 McGraw-Hill/Irwin Open-End Funds Five important characteristics First, investors own a pro rata share of the overall portfolio. Second, investment manager of the fund actively manages the portfolio. Third, the value or the price of each share of portfolio is called the NAV and equals market value of the portfolio minus liabilities / numbers of shares owned by the fund investors. Five important characteristics First, investors own a pro rata share of the overall portfolio. Second, investment manager of the fund actively manages the portfolio. Third, the value or the price of each share of portfolio is called the NAV and equals market value of the portfolio minus liabilities / numbers of shares owned by the fund investors.

16. ©2007, The McGraw-Hill Companies, All Rights Reserved 17-16 McGraw-Hill/Irwin Open-End Funds Fourth, the NAV is determined once at each day either at beginning of the day or close of the day. Fifthly, All new investments into the fund and withdrawals are priced at a closing price or NAV. Fourth, the NAV is determined once at each day either at beginning of the day or close of the day. Fifthly, All new investments into the fund and withdrawals are priced at a closing price or NAV.

17. ©2007, The McGraw-Hill Companies, All Rights Reserved 17-17 McGraw-Hill/Irwin Example Net asset value = (Total assets minus liabilities) / numbers of shares A NAV = 1,050,000 – 50,000 = $100 10,000 B NAV= 2,100,000 – 0 = $210 10,000 Net asset value = (Total assets minus liabilities) / numbers of shares A NAV = 1,050,000 – 50,000 = $100 10,000 B NAV= 2,100,000 – 0 = $210 10,000

18. ©2007, The McGraw-Hill Companies, All Rights Reserved 17-18 McGraw-Hill/Irwin Calculation of NAV; Classes of Funds NAV = Total market value of assets under management Number of mutual fund shares outstanding NAV = Total market value of assets under management Number of mutual fund shares outstanding

19. ©2007, The McGraw-Hill Companies, All Rights Reserved 17-19 McGraw-Hill/Irwin Closed-End Funds Specialized investment companies with a fixed supply of o/s shares but invest in assets and securities of other firms.

20. ©2007, The McGraw-Hill Companies, All Rights Reserved 17-20 McGraw-Hill/Irwin Closed-End Funds  Issue a limited number of shares and are very similar to shares of common stock  Investors pay a broker’s commission.  NAV of closed-ended funds is determined by supply and demand.  Discounts or premiums  discount results from large tax liabilities on capital gains  Premiums can result because such funds often have inexpensive access to overseas stocks.  Issue a limited number of shares and are very similar to shares of common stock  Investors pay a broker’s commission.  NAV of closed-ended funds is determined by supply and demand.  Discounts or premiums  discount results from large tax liabilities on capital gains  Premiums can result because such funds often have inexpensive access to overseas stocks.

21. ©2007, The McGraw-Hill Companies, All Rights Reserved 17-21 McGraw-Hill/Irwin Mutual Fund Costs Mutual funds charge shareholders a price or fee Two types of fees are incurred by investors –Load versus No-load Funds Load fund No-load fund –Fund Operating Expenses Mutual funds charge shareholders a price or fee Two types of fees are incurred by investors –Load versus No-load Funds Load fund No-load fund –Fund Operating Expenses

22. ©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Mutual Fund Expenses Types of Costs – Shareholder fee or sales charge – Operating expense or expense ratio Types of Costs – Shareholder fee or sales charge – Operating expense or expense ratio Types of Loads –Front end load –Back end load –Level load

23. ©2007, The McGraw-Hill Companies, All Rights Reserved 17-23 McGraw-Hill/Irwin Types of Costs Shareholder fee or sales charge – related to the way the fund is sold and distributed – Two types of sales charges and distribution –Sales force Distribution (Active approach) – Direct Distribution (Passive approach) Shareholder fee or sales charge – related to the way the fund is sold and distributed – Two types of sales charges and distribution –Sales force Distribution (Active approach) – Direct Distribution (Passive approach)

24. ©2007, The McGraw-Hill Companies, All Rights Reserved 17-24 McGraw-Hill/Irwin Types of Costs Sales force Distribution – takes place through intermediaries like agents, brokers, or any other entity. – This is an active approach. – The sales person has to approach the client – The fund is typically sold not bought. Sales force Distribution – takes place through intermediaries like agents, brokers, or any other entity. – This is an active approach. – The sales person has to approach the client – The fund is typically sold not bought.

25. ©2007, The McGraw-Hill Companies, All Rights Reserved 17-25 McGraw-Hill/Irwin Types of Costs Direct Distribution – No intermediary is involved. – Direct sale from company to investor. – The investor has to approach the company. – This is a passive approach. – The fund is typically bought not sold. Direct Distribution – No intermediary is involved. – Direct sale from company to investor. – The investor has to approach the company. – This is a passive approach. – The fund is typically bought not sold.

26. ©2007, The McGraw-Hill Companies, All Rights Reserved 17-26 McGraw-Hill/Irwin Types of Costs Operating expense or expense ratio – for investment managements –Other expenses include primarily the cost of, 1) custody 2) the transfer agent cost, 3) independence public accountant fee, and 4) directors’ fee. Sum of annual management’s fee, the annual distribution fee and other expenses is called the expense ratio. Operating expense or expense ratio – for investment managements –Other expenses include primarily the cost of, 1) custody 2) the transfer agent cost, 3) independence public accountant fee, and 4) directors’ fee. Sum of annual management’s fee, the annual distribution fee and other expenses is called the expense ratio.

27. ©2007, The McGraw-Hill Companies, All Rights Reserved 17-27 McGraw-Hill/Irwin Loads Load – is a sales charge for the agent-distributed fund. Front end load – The load is deducted initially at the time of purchase of fund. Back-end load – wherein commissions are charged upon redemption of funds. Level load – Imposed uniformly each year. Load – is a sales charge for the agent-distributed fund. Front end load – The load is deducted initially at the time of purchase of fund. Back-end load – wherein commissions are charged upon redemption of funds. Level load – Imposed uniformly each year.

28. ©2007, The McGraw-Hill Companies, All Rights Reserved 17-28 McGraw-Hill/Irwin The hidden load Section 12b-1 funds/fee – Charge a small percentage of assets annually to cover sales costs – Is a fixed annual fee Section 12b-1 funds/fee – Charge a small percentage of assets annually to cover sales costs – Is a fixed annual fee

29. ©2007, The McGraw-Hill Companies, All Rights Reserved 17-29 McGraw-Hill/Irwin Regulation The MUTUAL FUNDS are heavily regulated to protect investors SEC is the primary regulator The MUTUAL FUNDS are heavily regulated to protect investors SEC is the primary regulator

30. ©2007, The McGraw-Hill Companies, All Rights Reserved 17-30 McGraw-Hill/Irwin Assets in MMMFs, 2004 (in $B)

31. ©2007, The McGraw-Hill Companies, All Rights Reserved 17-31 McGraw-Hill/Irwin Hedge Funds –They take the funds from individuals and institutions and invest on their behalf. –Can take position in derivative markets –Invest in risky activities. –Are free from regulations –Can work within the country and abroad. –They take the funds from individuals and institutions and invest on their behalf. –Can take position in derivative markets –Invest in risky activities. –Are free from regulations –Can work within the country and abroad.

32. ©2007, The McGraw-Hill Companies, All Rights Reserved 17-32 McGraw-Hill/Irwin Hedge Funds An aggressively managed portfolio of investments; the goal of generating high returns; Legally, hedge funds are open to a limited number of investors and require a very large initial minimum investment. An aggressively managed portfolio of investments; the goal of generating high returns; Legally, hedge funds are open to a limited number of investors and require a very large initial minimum investment.

33. ©2007, The McGraw-Hill Companies, All Rights Reserved 17-33 McGraw-Hill/Irwin Hedge Funds Investments in hedge funds are illiquid as they often require investors keep their money in the fund for at least one year. You can think of hedge funds as mutual funds for the super rich. They are similar to mutual funds in that investments are pooled and professionally managed, but differ in that the fund has far more flexibility in its investment strategies. Investments in hedge funds are illiquid as they often require investors keep their money in the fund for at least one year. You can think of hedge funds as mutual funds for the super rich. They are similar to mutual funds in that investments are pooled and professionally managed, but differ in that the fund has far more flexibility in its investment strategies.

34. ©2007, The McGraw-Hill Companies, All Rights Reserved 17-34 McGraw-Hill/Irwin Hedge Funds –Offer opportunities to investors without a legal cover –Attract by offering good returns –Can borrow money unlike mutual funds –Liquidity is a problem, limited possibility of withdrawal –Offer opportunities to investors without a legal cover –Attract by offering good returns –Can borrow money unlike mutual funds –Liquidity is a problem, limited possibility of withdrawal