1. Mutual Funds and Other Investment Companies
Chapter 4
Mutual Funds and Other
Investment Companies

2. Mutual Funds and Other Investment Companies
“Take calculated risks. That is quite different from being rash.”
– George S. Patton

3. Learning Objectives
You are probably going to be a mutual fund investor very soon, so you should definitely know the following:
The different types of mutual funds.
How mutual funds operate.
How to find information about how mutual funds have performed.
The workings of Exchange Traded Funds (ETFs) and hedge funds.

4. Mutual Funds: Overview
Our goal in this chapter is to understand the different types of mutual funds, their risks, and their returns.
Around 1980, 5 million Americans owned mutual funds.
However, by mid-2012, 90.4 million Americans in 52.3 million households owned mutual funds.
In 2011 investors added $24 billion in net new funds to mutual funds.
In 2011, mutual fund assets totaled $11.6 trillion.

5. Mutual Funds: Overview, Cont.
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.

6. Advantages of Mutual Fund Investing
Diversification
A mutual fund is a portfolio, or basket, of securities.
As you will learn later, holding a diversified portfolio helps you reduce risk.
Diversification does not eliminate risk.
Professional Management
Professional money managers make decision of when to add or remove particular securities from the mutual fund.
This means that you, as the investor, do not have to make these crucial decisions.
Minimum Initial Investment
Most mutual funds have a minimum initial purchase of $2,500, but some are as low as $1,000 or even $250 in some cases.
After your initial purchase, subsequent purchases are sometimes as low as $50.
Of course, these amounts vary from fund to fund.

7. Drawbacks of Mutual Fund Investing
Risk
Mutual fund values, unlike a bank deposit, can fall and be worth less than your initial investment.
No government or private agency guarantees the value of a mutual fund.
Costs
investing in mutual funds entails fees and expenses that do not usually accrue when purchasing individual securities directly.
We detail most of these costs later in the chapter.
Taxes
You will pay taxes on distributions (dividends and capital gains) from the mutual fund.
You will pay taxes on profits you make when you sell mutual fund shares.

8. Investment Companies and Fund Types, I.
An Investment company is business that specializes in pooling funds from individual investors and making investments.
An Open-end fund is an investment company that stands ready to buy and sell shares in itself to investors, at any time.
A Closed-end fund is an investment company with a fixed number of shares that are bought and sold by investors, only in the open market.
Sometimes, if an open-end fund gets too big, it will not take in new investors.
It will, however, take more money from its current investors.
Of course, current investors can withdraw money from the fund.

9. Investment Companies and Fund Types, II.

10. Investment Companies and Fund Types, III.
Net asset value (NAV) is the value of the assets held by a mutual fund, divided by the number of shares.
Shares in an open-end fund are worth their NAV, because the fund stands ready to redeem their shares at any time.
In contrast, share value of closed-end funds may differ from their NAV.

11. 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 (say Fidelity Investments) or brokerage firms with investment advisory operations (say Merrill Lynch).
Investment advisory firms earn fees for managing mutual funds.

12. Mutual Fund Operations Taxation of Investment Companies
A “regulated investment company” does not have to pay taxes on its investment income.
To qualify, an investment company must:
Hold almost all its assets as investments in stocks, bonds, and other securities
Use no more than 5% of its assets when acquiring a particular security
Pass through all realized investment income to fund shareholders

13. 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.

14. Mutual Fund Costs and Fees Types of Expenses and Fees
Sales charges or “loads”
Front-end loads are charges levied on purchases.
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. 0.25% is most common
Management fees:
Usually range from 0.25% to 1.50% of the funds total assets each year.
Are usually based on fund size and/or performance.
Trading costs
Not reported directly
Funds must report "turnover," which is related to the amount of trading.
The higher the turnover, the more trading has occurred in the fund.
The more trading, the higher the trading costs.

15. Mutual Fund Costs and Fees Expense Reporting
Mutual funds are required to report expenses in a fairly standardized way in their prospectus.
Shareholder transaction expenses - loads and deferred sales charges.
Fund operating expenses - management and 12b-1 fees, legal, accounting, and reporting costs, director fees.
Funds report a hypothetical example showing total expenses paid by investors per $10,000 invested.

16. Example: Fee Table

17. Mutual Fund Costs and Fees Why Pay Loads and Fees?
After all, many good no-load funds exist.
But, you may want a fund run by a particular manager. All such funds are load funds.
Or, you may want a specialized type of fund.
Perhaps one that specialized in Italian companies
Loads and fees for specialized funds tend to be higher, because there is little competition among them.

18. Short-Term Funds, I.
Short-term funds are collectively known as money market mutual funds.
Money market mutual funds (MMMFs) are mutual funds specializing in money market instruments.
MMMFs maintain a $1.00 net asset value to make them resemble bank accounts.
There is no guarantee that the net asset value will be $1.00 or more.
A Net Asset Value for a MMMF under $1.00 results in the term, “breaking the buck.”
Following the Crash of 2008, a few MMMF “broke the buck.”
Depending on the type of securities purchased, MMMFs can be either taxable or tax-exempt.

19. Short-Term Funds, II.
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. Long-Term Funds
There are many different types of long-term funds, i.e., funds that invest in long-term securities.
Historically, mutual funds were classified as stock funds, bond funds, or balanced funds.
Today, the investment objective of the fund is the major determinant of the fund type.

21. Stock Funds, I.
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
Mid-cap
Large-cap
Some stock fund invest internationally.
Global
International
Region
Country
Emerging markets

22. Stock Funds, II.
Sector funds specialize in specific sectors of the economy:
Biotechnology
Internet
Energy
Other fund types include:
Index funds
Social conscience, or “green,” funds
“Sin” funds (i.e., tobacco, liquor, gaming)
Tax-managed funds

23. Bond Funds Bond funds may be distinguished by their
Maturity range
Credit quality
Taxability
Bond type
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

24. 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
Target Date Funds (also known as Lifecycle Funds)
The asset allocation chosen by target date funds is based on the anticipated retirement date of the investors holding the fund.
If a company offers a Target Date 2040 Fund, the fund is for people planning to retire in about 2040.
In 2014, say, this fund would have a large equity exposure.
In 2039, say, this fund would have a large bond exposure.

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

26. Mutual Fund Objectives: Recent Developments, II.
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
whether the fund tends to invest in “growth” or “value” stocks (or both).
Growth stocks are those considered more likely to grow their businesses.
Value stocks are those that look to be relatively undervalued.

27. Mutual Fund Objectives

28. Mutual Fund Performance
Mutual fund performance is very closely tracked by a number of organizations.
Financial publications of all types periodically provide mutual fund data.
The Wall Street Journal is particularly timely print source.
has a “Fund Selector” that provides performance information.

29. Mutual Fund Selection (www.morningstar.com)
Our Screen: domestic stock fund; small-cap growth; low expenses; no loads

30. Mutual Fund Perfaormance: Yardsticks

31. Mutual Fund Performance: Online Version of The Wall Street Journal, I.
Note the fund with symbol: FBGRX

32. Result by clicking on “BluCh”
Mutual Fund Performance: Online Version of The Wall Street Journal, II.
Result by clicking on “BluCh”

33. Mutual Fund Performance: Cautions
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 Funds Sometimes a fund will choose to close.
Choosing to close means that the fund will no longer sell shares to new investors.
The use of the word “close” here should not be confused with “closed-end.”
The number of shares in a closed fund can still fluctuate as existing owners buy and sell.
Why would a fund choose to close?
When a fund grows rapidly, the fund manager might feel that the incoming cash is more than the fund can invest profitably.
Funds that close often reopen at a later date.

35. Closed-End Funds A closed-end fund has a fixed number of shares.
These shares are traded on stock exchanges.
There are about 600 closed-end funds that have their shares listed on U.S. Stock Exchanges.
There are about 8,000 long-term open-end mutual funds.

36. Mutual Fund Performance: Closed-End Funds

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

38. Exchange Traded Funds, ETFs
An exchange traded fund, or ETF,
Is basically an index fund.
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.
A well-known ETF is the “Standard and Poor’s Depositary Receipt” or SPDR.
This ETF mimics the S&P 500 index.
It is commonly called “spider."
Another well-known ETF mimics the Dow Jones—it is called "Diamond."
A list of ETFs can be found at

39. Exchange Traded Funds, Performance

40. Leveraged ETFs, I.
A particularly interesting, but potentially dangerous, ETF growth area is in leveraged ETFs.
The fund managers of a leveraged ETF create a portfolio designed to provide a return that tracks the underlying index.
But, by also using derivative contracts, the managers can magnify, or leverage, the return on the underlying.
The Fund Manager can also use derivatives to generate returns opposite, or inverse, of the index return.
Leveraged funds are designed to have twice the return on an index, say the S&P 500.
In other words, if the S&P 500 return on a given day is one percent, the leveraged fund should provide a return of two percent.
The danger is that leverage works both ways. Losses are also magnified by two.

41. Leveraged ETFs, II.
Levered ETFs seem to track their underlying indexes on a short-term basis, i.e., day by day.
Over longer periods of time, however, their performance is probably not what you would expect.
For example, trading in leveraged ETFs offered by Rydex, a reputable firm, began on November 7, 2007.
The Long Fund (RSU) was designed to earn twice the S&P 500 index return.
The Inverse Fund (RSW) was designed to earn the opposite of twice the S&P 500 Index return.
Over the next two years, the S&P 500 lost percent.
Given its objective, the RSU fund should have lost percent.
The inverse fund, RSW, should have gained 44.8 percent.
Over this two-year period, however, the RSU lost percent, and the inverse fund, the RSW, lost -7.3%.
How is such a result possible?

42. Leveraged ETFs, III.
The answer lies in average versus geometric returns (and not with Rydex).
Recall that geometric returns are lower than arithmetic returns
Volatility fuels the difference.
Both Rydex leveraged funds add extra volatility to the series of S&P 500 index returns.
As a result, returns from any leveraged funds will be less than expected.
Example: Consider a week during which the S&P500 earns daily returns of 1, - 2, 2, 1, and 3 percent, respectively.
The arithmetic average is 1%.
The geometric average is just slightly less, 0.986%.
This difference seems trivial.
Consider the returns, however, for a twice-leveraged fund.
The arithmetic average is exactly double, 2%.
The geometric average, however, is [(1.02)(0.96)(1.04)(1.02)(1.06)](1/5) – 1 = .0194, or 1.94%.
Six basis points tracking error in one week.
The longer the holding period and/or the more volatile the underlying index, the less accurate a leveraged fund will be in tracking its stated objective.

43. Exchange Traded Notes, ETNs
Introduced in mid-2006 by Barclays Bank.
To investors, ETNs look like ETFs.
However, ETNs are unsecured debt—so, unlike holders of ETFs, holders of ETNs do have default risk.
ETNs provide investors with exposure to commodities, but without the leveraged risk of futures contracts.
Handy web source:

44. Hedge Funds, Overview
Like mutual funds, hedge funds collect pools of money from investors.
Like mutual funds, hedge funds are generally required to register with the SEC. But:
Hedge funds are not required to maintain any particular degree of diversification or liquidity.
Hedge fund managers have considerably more freedom to follow various investment strategies, or styles.
Investing in hedge funds is not suitable for the all investors.
Hedge funds accept only “qualified” (or accredited) investors.
To be considered a qualified investor, you need to fulfill one of these conditions:
You must be an institution or an individual investor with a net worth of about $1 million.
You must have a recurring annual income of over $200,000.

45. Hedge Fund Fees
Most common fee structure is 2/20, but many others exist.
A short way to say that the manager charges an annual 2% management fee and retains 20% of the hedge fund profits.
To prevent the fund from being manipulated by its managers, many fee structures include hurdles for the manager to meet.
A common example is called a “high-water mark.”
When a hedge fund fee structure includes a high-water mark, the manager will receive performance fees only when the fund value is higher than its previous highest value.
Why do hedge fund investors willingly pay high fees?
Obvious answer: returns earned are high enough to provide a reasonable return.
Some experts opine that hedge fund returns net of fees are about the same as the overall stock market return.
If these experts are correct, why would anyone invest in a hedge fund instead of a market index fund? The answer lies in the principle of diversification.

46. Some Common Hedge Fund Investment Styles, I.
Market Neutral. Goal: offset risk with opposite positions in pairs of securities.
These hedge funds are also called long-short funds.
Properly constructed, the resulting portfolio makes money regardless of how the overall market performs.
Hence the name “market neutral.”
Expected Volatility: Low.
Arbitrage. Goal: identify a mispricing in relationships between securities that theoretically should not exist.
These hedge fund managers look at pricing relationships for securities offered by the same company, or for investments across time or countries.
Distressed Securities. Goal: Buy securities that are being offered at deep discounts resulting from company-specific or sector-wide distress.
For example, a manager of distressed securities fund might buy securities of firms facing bankruptcy.
Expected Volatility: Low to moderate.

47. Some Common Hedge Fund Investment Styles, II.
Macro. Goal: These hedge fund managers attempt to profit from changes in global economies brought about by governmental policies that affect interest rates interest rates, currencies, or commodity prices.
Macro fund managers often use leverage and derivative securities to increase the impact of market moves.
Expected Volatility: High.
Short Selling. Goal: Managers of a pure short hedge fund only short sell.
In addition, these managers use leverage through the use of margin.
Expected Volatility: High
Market Timing. Goal: Managers of these hedge funds attempt to identify trends in particular sectors or overall global markets.
These managers often take concentrated positions and generally use leverage to increase the fund’s exposure to predicted movements.

48. Hedge Funds, Conclusion
As you can see, hedge fund managers employ many approaches, and each has its own risk level.
The lesson?
Suppose you make your millions and become a qualified hedge fund investor
You still have your work cut out trying to identify the best hedge fund for your portfolio.
Suppose you just cannot decide?
You might want to use a “Fund of Funds.”
These investment companies invest in hedge funds.
Note: There is an additional, and significant, layer of fees heaped onto the already hefty hedge fund fees.

49. Useful Internet Sites www.ici.org (mutual fund facts and figures)
(example of a major fund family website)
(website of largest investment advisory firm in US)
(information on thousands of funds)
(one of the best mutual fund sites)
(more “social conscience” funds)
(“vice” funds)
(more on exchange traded funds)
(all about ETNs)
(hedge fund information)
(more hedge fund information)
(want to start your own hedge fund?)
jmdinvestments.blogspot.com (reference for recent financial information)

50. Chapter Review, I. 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
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

51. Chapter Review, II. 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?
Closed-End Funds, Exchange Traded Funds, and Hedge Funds
Closed-End Funds Performance Information
The Closed-End Fund Discount Mystery
Exchange Traded Funds
Leveraged Funds
Exchange Traded Notes
Hedge Funds and their Investment Styles