1 Chapter 23 Mutual Fund Operations © 2001 South-Western College Publishing Company

2 Background on Mutual Funds nMutual funds offer a way for small investors to diversify when they could not do so on their own with the purchases of individual stocks nComparison to depository institutions 4Like depository institutions, mutual funds repackage proceeds from individuals to make investments 4Bank deposits are a form of credit but a mutual fund represents partial ownership

3 Background on Mutual Funds nMutual funds adhere to a variety of federal and state regulations 4Securities and Exchange Commission (SEC) regulates - SEC Act Disclosure since 1993 of manager’s name and length of time employed in that position 4Funds must register and provide a prospectus to investors 4Investment Company Act of 1940 contains restrictions to prevent conflicts of interest between investors and mangers 4Exempt from tax if fund distributes 90 percent of taxable income

4 Background on Mutual Funds nInformation contained in a prospectus 4The minimum amount of investment required 4The investment objective of the fund 4The return on the fund over the past year, the past three years and the the past five years 4The exposure of the fund to various types of risk 4Services the fund offers 4The fees incurred and passed on to investors

5 Background on Mutual Funds nDistributions to shareholders or returns to stockholders can take three forms 4Pass on any earned income from dividend or coupon payments as a dividend 4Distribute the capital gains from the sale of securities in the fund 4Mutual fund price appreciation As market price goes up, NAV increase Shareholders benefit if they sell shares

6 Background on Mutual Funds nMutual fund classifications depend on the type of securities the fund invests in and can include 4Stock or equity mutual funds 4Bond mutual funds 4Money market mutual funds nMany investment companies offer a family of funds to meet the needs of diverse customer preferences

7 Background on Mutual Funds nManagement of mutual funds 4Managers invest in a portfolio of securities to meet the needs of investors 4Cover management costs with fees which are typically less than one percent of total assets per year 4Managers adjust the composition of their portfolios in response to market and economic conditions

8 Background on Mutual Funds nExpenses 4Fees include management plus record- keeping and clerical fees 4Passed on to investors since NAV is reduced by fees 4Compare expense ratios nA fund’s emphasis on marketing in order to attract more investors may not enhance performance because fees increase

9 Background on Mutual Funds nCorporate control by mutual funds 4Mutual funds are large shareholders in companies whose stock they hold 4Managers may serve on the board of directors of companies in which the fund invests 4Companies try to satisfy mutual fund managers in order to keep them from selling their stake in the firm

10 Stock Mutual Fund Categories nGrowth funds for investors who want high returns with moderate risk 4Invest in companies that expect to grow at a higher than average rate 4Generate an increase in investment value rather than steady income nCapital appreciation or aggressive growth funds 4High but unproven growth potential stocks 4Higher risk

11 Stock Mutual Fund Categories nGrowth and income funds try to offer growth but with some stability of income nInternational and global funds allow investment in foreign securities without the costs involved in purchasing and monitoring individual stocks 4Returns affected by stock prices 4Returns also affected by foreign exchange rates nA global mutual fund invests in some U.S. stocks

12 Stock Mutual Fund Categories nInternet funds focus on investments in Internet companies nSpecialty funds focus on a group of companies sharing a particular characteristic nIndex funds are designed to simply match the performance of an existing stock index nMultifund funds invest in a portfolio of different mutual funds 4More diversified 4Involves higher expenses

13 Bond Fund Investment Objectives nRisks in bond funds 4Interest rate risk 4Credit risk nTax implications of bond fund investments nIncome funds vary in terms their exposure to credit risk and focus on periodic coupon payments and attract investors who are 4Interested in periodic income since prices are volatile 4Plan to hold the fund long term

14 Bond Fund Investment Objectives nTax-free funds for high tax bracket investors nHigh-yield or junk bond funds invest in bonds with a high risk of default nInternational and global bond funds 4International bond funds contain bonds issued by governments or corporations from other countries 4Global funds may contain both U.S. and foreign bonds

15 Bond Fund Investment Objectives nMaturity classifications 4Interest rate sensitivity depends on the maturity of bonds 4Funds are typically segmented based on maturity Intermediate-term funds invest in bonds with 5 to 10 years remaining to maturity Long-term funds invest in maturities of 15 to 30 years

16 Bond Fund Investment Objectives nAsset allocation funds 4Funds that contain a variety of investments 4Composition among stocks, bonds and money market securities is based on manager’s expectations

17 Performance of Mutual Funds nInvestors should diversify among different kinds of funds to reduce volatility nResearch on stock mutual fund performance 4Using return only is not valid 4Mutual funds typically do not outperform the market 4Include risk and expenses nResearch on bond mutual funds

18 Money Market Funds nMoney market funds are portfolios of short-term assets 4Can include check-writing privileges for investors 4Number of checks per month may be restricted 4Shareholders get periodic statements 4Liquid