1. Chapter 4 Mutual Funds

2. Learning Objectives You are probably going to be a mutual fund investor very soon, so you should definitely know the following: 1.The different types of mutual funds. 2.How mutual funds operate. 3.How to find information about how mutual funds have performed. 4.The workings of Exchange Traded Funds (ETF). 2

3. MUTUAL FUND, OVERVIEW 4-3

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 2010, 89 million Americans in 51 million households owned mutual funds. –In 2009 investors added $390 billion in net new funds to mutual funds. –In 2009, mutual fund assets totaled $11.1 trillion. 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. 4

5. Mutual Funds: Overview, Cont. Mutual funds are simply a means of combining or pooling the funds of a large group of investors. –You are investing in a portfolio, or basket, of securities. –With only $2,000 to invest, you can easily own shares in MSFT, MCD, IBM, and others. The buy and sell decisions for the resulting pool are then made by a fund manager, who is compensated for the service provided. –Indirect investing: You have someone else “pick” stocks for you. They are created and marketed to the public in ways that are intended to promote buyer appeal: diversification, “value” and “growth” strategy, large-cap and small-cap strategy, etc. Like commercial banks and life insurance companies, mutual funds are a form of financial intermediary because they provide indirect access to financial markets for individual investors. Mutual funds are increasingly important for YOU because soon you will be investing on them through employee pension plan or retirement account. 5

6. Mutual Funds: Overview, Cont. Advantages o Diversification o Professional management o Minimum initial investment – as low as $1,000 or $2,500 Drawbacks o Risk – You could “lose” money unlike bank deposits. o Costs – Some professional managers charge a hefty fee. o Taxes – You will pay federal income tax on distributions (dividends and capital gains made by the fund) and profits you make when you sell mutual funs shares. 6

7. Investment Companies and Fund Types, I. An Investment company is business that specializes in pooling funds from individual investors and making investments. –All mutual funds are in fact investment company, but not all investment companies are mutual funds. An Open-end fund is an investment company that stands ready to buy and sell shares in itself to investors, at any time. –Issuance: The fund simply issues new shares and then invest the money received. –Redemption: The fund sells some of its assets and uses the cash to redeem the shares. –As a result, the number of shares outstanding fluctuates through time. –More popular. 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. –You must buy (or sell) from (or to) another investor. –Listed in stock exchanges just like any other ordinary stocks. 7

8. Mutual Funds Some open-end funds “close their doors” to new investors become a closed-end fund if a fund becomes “too big.” Strictly speaking, the term “mutual fund” actually refers only to an open-end investment company. Therefore, the phrase, “open-end mutual fund” is an unnecessary repetition, or restatement. Investment companies are now generally called mutual funds. Several well-known mutual funds in U.S. include Fidelity, Vanguard, State Street Global Advisor, and others. 8

9. Investment Companies and Fund Types, II. 9

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12. Investment Companies and Fund Types, III. Net asset value (NAV) is the value of the assets held by a mutual fund less any liabilities, divided by the number of shares. Notice that this measure of the rate of return ignores any commissions such as front-end loads paid to purchase the fund. NAV changes every day because the value of the assets held by the fund changes every day. 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. Market Value of Assets - Liabilities Shares Outstanding 12

13. Fees and Mutual Fund Returns: An Example Initial NAV = $20 Income distributions of $.15 Capital gain distributions of $.05 Ending NAV = $20.10: 13

14. 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 or Charles Schwab). Investment advisory firms earn fees for managing mutual funds. Although mutual funds often belong to a large “family” of funds, every fund is a separate company owned by its shareholders. In theory, the directors of a mutual fund in a particular family, acting on behalf of the fund shareholders, could vote to fire the investment advisory firm and hire a different one, but in reality, this rarely occurs. 14

15. Ten Largest Mutual Fund Companies By Assets 1The Vanguard Group $957 BillionThe Vanguard Group 2 American Funds $931.5 BillionAmerican Funds 3 Fidelity $717 BillionFidelity 4 Barclays Global Investors $287 BillionBarclays Global Investors 5 Franklin Templeton Investments $256.7 BillionFranklin Templeton Investments 6 Pimco Funds $218.7 BillionPimco Funds 7 T Rowe Price Investments $192.1 BillionT Rowe Price Investments 8 State Street Global Investors $176.8 BillionState Street Global Investors 9 Oppenheimer Funds $129.9 BillionOppenheimer Funds 10 Dodge & Cox $118.2 BillionDodge & Cox 15

16. Ten Largest Mutual Funds 16

17. Mutual Fund Operations Taxation of Investment Companies A “regulated investment company” does not have to pay taxes on its investment income. Instead, the fund passes through all realized investment income to fund shareholders, who then pay taxes on these distributions as though they owned the securities directly. The pass-through feature is an important disadvantage of owning mutual fund because investors cannot time capital gains/losses to efficiently manage tax liabilities. 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 (diversification rule), and – Pass through all realized investment income to fund shareholders 17

18. 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. –Prospectus contains investment objectives, investment strategy, fee and expenses, performance information and others. Mutual funds must also provide an annual report to their shareholders. 18

19. 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. –Load in $ = offering price – NAV, or load in % = load in $ / offering price –Vary from 2% to 9%, on average, 5% is typical. –Why pay load when there are plenty of no-load fund available? 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 range from 0.25% to 1.00% of the fund’s 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. 19

20. Examples 20

21. 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. –Hypothetical example showing the total expenses paid by investors through time per $10,000 invested. 21

22. Example: Fee Table 22

23. 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. Then, those funds you want may be 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. 23

24. 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. –Depending on the type of securities purchased, MMMFs can be either taxable or tax-exempt. 24

25. 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. 25

26. 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 income funds. Today, the investment objective of the fund is the major determinant of the fund type. 26

27. 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 funds invest in different parts of the world. –Global : includes world plus U.S. –International: includes world but no U.S. –Regional –Country –Emerging markets 27

28. Stock Funds, II. Sector funds specialize in specific sectors of the economy, such as: –Biotechnology –Internet –Energy Other fund types include: –Index funds: very important –Social conscience, or “green,” funds –“Sin” funds (i.e., tobacco, liquor, gaming) –Tax-managed funds 28

29. 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 29

30. 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. 30

31. Mutual Fund Objectives: Recent Developments, I. 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 31

32. 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. 32

33. Mutual Fund Objectives 33

34. Mutual Fund Selection ( www.morningstar.com) www.morningstar.com 34

35. 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. www.morningstar.com has a “Fund Selector” that provides performance informationwww.morningstar.com 35

36. Mutual Fund Performance: Yardsticks 36

37. Mutual Fund Performance: Online Version of The Wall Street Journal, I. Note the fund with symbol: FBGRX Mutual fund ticker symbols are usually alphanumeric and end with the letter X to differentiate them from stock symbols. 37

38. Mutual Fund Performance: Online Version of The Wall Street Journal, II Result of clicking on “BluCh” 38

39. 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. Ratings by reputable research firm such as Morningstar are as good indicator for the future performance as anyone’s guess. 39

40. Past Performance is No Guarantee of Future Results! 40

41. Closed Funds Sometimes a fund will choose to close. This 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 may feel that the incoming cash is more than the fund can invest profitably. –Funds that close often reopen at a later date. 41

42. 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. 42

43. Mutual Fund Performance: Closed-End Funds 43

44. 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. –Example: Suppose a closed-end fund owns $100 million worth of stocks. It has 10 million shares outstanding, so the NAV is clearly $10. However, the share is sold at, say, $9. (9-10)/10 = -10% Despite a great deal of academic research, the closed- end fund discount phenomenon remains largely unexplained. 44

45. Exchange Traded Funds, ETFs An exchange traded fund, or ETF, –A relatively recent innovation – since 1993. –Is basically an index fund but it is not a mutual 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 www.amex.com.www.amex.com –SPY, DIA, QQQQ, VNQ, EWZ, EFA, FXI, and others Major sponsors include Barclays Global Investors, State Street Global Advisor, PowerShares, Vanguard, and others. 45

46. ETFs An ETF sponsors files a plan with the SEC. Arranges to set aside the shares representing the basket of securities that forms the ETF index. These few million shares are placed into a trust. Create an unit shares that represent claims on the bundles of shares held in the trust. These unit shares are then traded in exchanges. ETF is like an index fund but not exactly a mutual fund because –It can be short. –It can have options. –Actually traded like a closed-end fund. –Can be bought and sold during the day. –Generally have very low expense:.10% or one-tenth of 1 percent. –Must pay a commission. 46

47. ETF Sponsors and Products 4-47

48. Exchange Traded Funds, Performance 48

49. 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. 49

50. 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 -22.4 percent. –Given its objective, the RSU fund should have lost -44.8 percent. –The inverse fund, RSW, should have gained 44.8 percent. –Over this two-year period, however, the RSU lost -56.5 percent, and the inverse fund, the RSW, lost -7.3%. How is such a result possible? 50

51. 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. 51

52. 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: www.ipathetn.comwww.ipathetn.com 52

53. Hedge Funds Like mutual funds, hedge funds collect pools of money from investors. –Some funds are limited to no more than 50-100 “high net worth investors.” 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: 1.You must be an institution or an individual investor with a net worth of about $1 million. 2.You must have a recurring annual income of over $200,000. Traditionally. Hedge funds were only lightly regulated. Despite protests from the hedge fund industry, the SEC recently initiated some regulations. 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. Hedge fund fees: –General management fee of 1-2% of fund assets –Excessive performance fee of 20-40% of profits 53

54. 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. 54

55. 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. –Expected Volatility: Low. 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. 55

56. 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. –Expected Volatility: High 56

57. 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. 57

58. Useful Internet Sites www.ici.org (mutual fund facts and figures)www.ici.org www.vanguard.com (example of a major fund family website)www.vanguard.com www.fidelity.com (website of largest investment advisory firm in US)www.fidelity.com www.mfea.com (information on thousands of funds)www.mfea.com www.morningstar.com (one of the best mutual fund sites)www.morningstar.com www.domini.com (more “social conscience” funds)www.domini.com www.vicefund.com (“vice” funds)www.vicefund.com www.amex.com (exchange traded funds)www.amex.com www.ishares.com (more on exchange traded funds)www.ishares.com www.ipathetn.com (all about ETNs)www.ipathetn.com www.hedgeworld.com (hedge fund information)www.hedgeworld.com www.hedgefundcenter.com (more hedge fund information)www.hedgefundcenter.com www.turnkeyhedgefunds.com (how to start your own hedge fund)www.turnkeyhedgefunds.com 58

59. 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 59

60. Chapter Review, II. 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? Closed-End Funds, Exchange Traded Funds, and Hedge Funds –Closed-End Funds Performance Information –The Closed-End Fund Discount Mystery –Exchange Traded Funds –Hedge Funds 60

61. A contingent deferred sales charge is a back-end load which is imposed when shares of some mutual funds are sold. A) True B) False 61

62. A mutual fund is owned by the investment advisory firm which manages the fund. A) True B) False 62

63. Mutual funds are only permitted to invest in U.S. securities. A) True B) False 63

64. The net asset value (NAV) of a mutual fund is equal to the: A) market value of the assets divided by the number of shares outstanding. B) cost of the assets minus the liabilities. C) market value of the assets minus the liabilities. D) (cost of the assets minus the liabilities) divided by the number of shares outstanding. E) (market value of the assets minus the liabilities) divided by the number of shares outstanding. 64

65. Each prospective investor in a mutual fund must be supplied with a(n): A) trust certificate. B) stock certificate. C) tax report. D) investment advisory report. E) prospectus. 65

66. A fund has an offering price of $43.60 and a front-end load of 4.5 percent. What is the NAV? A) $40.16 B) $41.64 C) $44.09 D) $45.78 E) $46.03 66

67. The Oliver Mutual Fund had average net assets of $111 million for the year. It bought $13 million worth of securities and sold $11 million worth. What is the fund's turnover rate? A) 8.54 times B) 8.67 times C) 9.25 times D) 10.00 times E) 0.0991 times 67

68. When an open-end fund closes, the: A) fund is converting into a closed-end fund B) final prices for the trading day are being calculated C) fund ceases operations. D) fund refuses to accept any new investors. E) fund is finished trading for the day. 68

69. If you want to find a fund which invests only in companies which are environmentally friendly, you should refer to the category of funds which are classified as _____ funds. A) income B) index C) social conscience D) sector E) emerging markets 69