1. Mutual Fund Operations24
Mutual Fund
Operations

2. Chapter Objectives Explain the concept of mutual fund operation
Explain various types of mutual funds
Describe the various types of stock and bond mutual funds
Describe the characteristics of money market funds

3. Background on Mutual Funds
Mutual funds offer a way for small investors to diversify when they could not do so on their own with the purchases of individual stocks
Comparison to depository institutions
Like depository institutions, mutual funds repackage proceeds from individuals to make investments
Bank deposits are a liability contract, but a mutual fund represents partial ownership
No federal insurance with mutual fund shares

4. Background on Mutual Funds
Mutual funds adhere to a variety of federal and state regulations
Securities and Exchange Commission (SEC) regulates
Funds must register and provide a prospectus to investors
Disclosure since 1993 of manager’s name and length of time employed in that position
Mutual fund itself is exempt from income taxation if fund distributes 90 percent of taxable income

5. Background on Mutual Funds
Mutual fund prospectus information includes:
The minimum amount of investment required
The investment objective of the fund
The return on the fund over the past year, the past three years and the the past five years
The exposure of the fund to various types of risk
Services the fund offers
Check writing
Telephone or Internet funds transfer
Management fees incurred that investors pay

6. Background on Mutual Funds
Estimating the net asset value
Net asset value is the value per share
Estimated daily
Determine the market value of all the securities in the fund
Any interest or dividends added in
Expenses subtracted
Divide by the number of shares
Dividends lower NAV
NAV quotes

7. Mutual Fund Distributions
Earned Income from Dividends or Coupon Payments
Capital Gains from the Sale of Securities in Fund
Mutual Fund Price Appreciation

8. Background on Mutual Funds
Mutual fund classifications depend on the type of securities the fund invests in and can include
Stock or equity mutual funds
Bond mutual funds
Money market mutual funds
Family of funds offered by investment companies
Investor able to allocate then transfer funds among funds

9. Exhibit 24.2 Distribution of Investment in Mutual Fundsy a r k t F u d s $ 1 , 8 4 5 b i l 2 7 % S t o c k F u n d s $ 3 , 9 6 2 b i l 5 7 % H y b r i d F u n s $ 3 4 9 l o 5 % B o n d F u s $ 8 b i l 1 %

10. Background on Mutual Funds
Management of mutual funds
Managers invest in a portfolio of securities to meet the objectives of the fund
Cover management costs with fees which are typically around one percent of total assets per year
Managers adjust the composition of their portfolios in response to market and economic conditions

11. Background on Mutual Funds
Expenses
Fees include management plus record-keeping and clerical fees
Expense ratio = annual expenses/fund NAV
Passed on to investors since NAV is reduced by fees
Investor should compare expense ratios
Active marketing expenses and compensation increases expenses—12b-1 expenses

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

13. Load versus No-Load Mutual Funds
Classification refers to whether or not there is a sales charge
No-load means funds are promoted, bought and sold directly via the mutual fund
Load funds
Promoted by registered representatives of brokerage firms who get a commission
Investors pay the sales charge
12b-1 expenses are “loads” used by no-load funds

14. Open-End versus Closed-End Funds
Mutual fund does not repurchase the shares they sell—similar to direct common stock investment
Investors must sell shares on an exchange
Number of outstanding shares is constant
Value of shares related to expectations of portfolio and determined in market
Open-end “mutual” funds
Willing to repurchase investor shares at any time
Number of shares outstanding does not remain constant
NAV determined by fund daily

15. Stock Mutual Fund Categories
Growth funds for investors who want high returns with moderate risk
Mutual fund invests in companies that are expected to grow at a higher than average rate
Generate an increase in investment value rather than steady income
Capital appreciation or aggressive growth funds
High but unproven growth potential stocks
Higher risk

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

17. Stock Mutual Fund Categories
Internet funds focus on investments in Internet companies
Specialty funds focus on a group of companies sharing a particular characteristic
Index funds are designed to simply match the performance of an existing stock index
Multifund funds invest in a portfolio of different mutual funds
More diversified
Involves higher expenses

18. Exhibit 24.3 Growth in Number of Equity and Bond Funds8 B o n d F u n d s 7 6 S t o c k F u n d s 5 4 3 2 1 1 9 7 8 1 9 8 5 1 9 9 1 9 9 5 1 9 9 9 2 1 Y e a r

19. Exhibit 24.4 Investment in Bond and Stock Mutual Funds5 B o n d F u n d s 4 S t o c k F u n d s 3 2 1 1 9 8 5 1 9 8 6 1 9 8 7 1 9 8 8 1 9 8 9 1 9 9 1 9 9 1 1 9 9 2 1 9 9 3 1 9 9 4 1 9 9 5 1 9 9 6 1 9 9 7 1 9 9 8 1 9 9 9 2 Y e a r

20. Exhibit 24.5 Distribution of Aggregate Mutual Fund Assetsc p a l B o d $ 2 6 9 5 % L o n g - T e r m U . S G v ’ t $ 3 9 B i l 6 % C a s h $ 2 7 B i l o n 5 % C o m n S t c k $ 3 , 8 2 B i l 7 6 % C o r p a t e B n d s $ 3 4 9 i l 7 % P r e f d S t o c k $ 2 8 B i l n 1 %

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

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

23. Bond Fund Investment Objectives
Maturity classifications
Interest rate sensitivity depends on the maturity of bonds
Funds 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

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

25. Growth and Size of Mutual Funds
Volume and mix in the kind of funds varies over time
Overall investment via mutual funds much higher in recent years
New kinds of funds target customers with different risk preferences

26. Performance of Stock Mutual Funds
Both investors and managers closely monitor performance as modeled by the equation below
 PERF= f ( MKT,  SECTOR,  MANAB)
Where:
PERF = Performance
MKT = General stock market conditions
SECTOR = Conditions in the fund’s sector
MANAB = The ability of the fund’s management

27. Performance of Stock Mutual Funds
Change in market conditions
Close relationship between performance and market conditions
Change in sector conditions
Depends on the focus of the fund
Index funds
Asian funds
Change in management ability includes both managers’ skills and operating efficiency

28. Performance of Stock Mutual Funds
Performance of closed-end stock funds
Driven by the same factors that influence open-ended funds
Fixed supply of the fund’s shares
Additional issues
Performance is affected by changes in the premium or discount relative to NAV
If the fund’s premium increases relative to NAV, return to fund holders increases

29. Performance of Bond Mutual Funds
Performance of bond mutual funds as shown in the model below
 PERF= f ( Rf,  RP,  CLASS,  MANAB)
Where:
PERF = Performance
Rf = Risk free interest rates
RP =Risk premium
CLASS =the classification of the bond fund
MANAB = The ability of the bond fund’s management

30. Performance of Bond Mutual Funds
Change in the risk free rate
Bond prices are inversely related to the risk- free rate
When rates decline, most bond funds perform well
Change in the risk premium
If required risk premiums increase, bond prices fall
Linked to economic condition:
Risk premiums increase in recessions
Risk premiums decrease in boom times as investors buy riskier investments

31. Performance of Bond Mutual Funds
Impact of the bond fund’s classification
Some funds target a specific risk or maturity
Classification may have more impact than any other factor
Change in management abilities
Performance of closed-end bond funds is affected by all of the other factors and changes in the premium or discount

32. Performance of Mutual Funds
Investors should diversify among different kinds of funds to reduce volatility
Research on stock mutual fund performance
Using return only is not valid
Mutual funds typically do not outperform the market
Evaluate mutual fund expenses
Research on bond mutual funds
Bond mutual funds underperform bond indexes
Investors should look for low expense bond funds

33. Money Market Funds
Money market funds are portfolios of short-term assets
Can include check-writing privileges for investors
Number of checks per month may be restricted
Shareholders get periodic statements
Liquid, “cash” balance for investor

34. Money Market Funds Asset composition of money market funds
Individual funds concentrate in assets that reflect the fund’s objective
Money market securities of varying maturity
Maturity of money market funds
Varies over time with market conditons
Risk increases with term

35. Exhibit 24.7 Composition of Money Market Fund Assets$ 3 b i l o n 2 % C o m e r c i a l P p $ 6 2 b n 4 1 % U . S T r e a s u y c i t $ 9 1 b l o n 6 % O t h e r U . S c u i s $ 1 8 9 b l o n 3 % R e p u r c h a s A g m n t $ 1 8 6 b i l o 2 % C D s $ 1 2 3 b i l o n 8 %

36. Money Market Funds Risk of money market funds
Credit risk minimized by the short-term nature of maturities
Returns for money market funds fall as interest rates in the economy fall
Expected returns are low relative to stock and bond funds
Consistent positive returns over time
Lower credit risk
Lower interest rate risk

37. Money Market Funds Management of money market funds
Managers try to maintain the overall objective of the fund
Manage the composition of the assets
Investors have a variety of choices when it comes to money market funds

38. Money Market Funds Regulation of money market funds
Securities Act of 1933 requires that funds provide full information to investors via a prospectus
Investment Company Act of 1940 contains restrictions to prevent conflicts of interest between investors and mangers
Funds are exempt from tax if 90% of earnings are distributed to shareholders

39. Hedge Funds
Financial problems experienced by Long-Term Capital Management (LTCM)
Hedge funds sell shares to wealthy investors and financial institutions
Historically unregulated
Invest in derivatives, sell stock short, and combine borrowing to magnify returns
LTCM experienced problems when risky investments lost money

40. Real Estate Investment Trusts
A real estate investment trust or REIT is a closed-end mutual fund that invests in real estate or mortgages
Classifications
Equity REIT
Mortgage REIT
Hybrid of the two
Sometimes seen as an inflation hedge
Performance influenced by interest rates and area real estate performance

41. Other Issues
Mutual funds interact with banks, savings institutions, finance companies, securities firms, insurance companies, and pension funds
Mutual funds typically use all the various financial markets including money, bond, mortgage, stock, futures, options, and swap markets
Globalization is facilitated by mutual funds
Reduces transactions costs
Increases market integration