1. Mutual Funds and Other Investment Companies Chapter 4 Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

2. 4-2 4.1 Investment Companies

3. 4-3 Services of Investment Companies a.Administration & record keeping  Tax purposes Low cost reinvestment Low cost additional investment, DCA Low cost switching between fund families Some funds may allow check writing privileges

4. 4-4 Services of Investment Companies b.Diversification  c.Professional management  d.Reduced transaction costs e.Investing for retirement: Most funds can be set up as an IRA Lower research costs Portfolio managed according to specific objectives Professionals to find undervalued securities and/or engage in asset allocation strategies Low cost, instant diversification

5. 4-5 4.2 Types of Investment Companies

6. 4-6 Organizational Forms Unit Investment Trusts (UITs): unmanaged, fixed composition portfolios  Any interest and/or dividends are distributed immediately to trust certificate holders.  Provide diversification within one sector or area and low cost entry.  Often levered, rates of return can be extreme.

7. 4-7 Organizational Forms Managed Investment Companies: Managed, usually changing composition portfolio.  ___________________________________  The fund's board of directors typically hires an investment advisor to select and manage the fund assets according to some specific goal(s) set by the board and any regulatory requirements.  The investment advisor usually creates the fund and selects the investments. Most funds are of this type. More commonly known as a ‘mutual fund’

8. 4-8 Organizational Forms A managed investment company (mutual fund) may be  Open end –shares are bought from the fund and redeemed by the fund or  Closed end –shares are bought and sold among investors in the marketplace (NASDAQ or an exchange) and the fund itself is not involved.

9. 4-9 Closed End Mutual Funds

10. 4-10 Differences in Open & Closed End Most funds are open end: The advantage of the open end form is  The disadvantage of the open end form is  Liquidity for the investor Fund’s ability to grow (advantage for the fund or sponsor) The need to keep a cash reserve Vulnerable to panics

11. 4-11 Other Investment Organizations –Commingled funds Partnerships of investors that pool their funds. Designed for trusts or larger retirement accounts to get professional management for a fee. Operates similar to a mutual fund. –REITs Similar to closed end fund. Invest in real estate and real estate loans. Equity trusts purchase real estate. Mortgage trusts invest in mortgage and construction loans.

12. 4-12 Other Investment Organizations Cont. –Hedge Funds Similar to mutual funds, but not registered and not subject to SEC regulations. Available to institutional and high net worth investors Can pursue investment strategies that are not allowed for mutual funds. – Grew from about $50 billion in 1990 to about $2 trillion in 2008.

13. 4-13 4.3 Mutual Funds

14. 4-14 Net Asset Value Used as a basis for valuation of investment company shares –Selling new shares –Redeeming existing shares Calculation

15. 4-15 Open-End and Closed-End Funds: Key Differences Shares Outstanding  Closed-end: no change unless new stock is offered  Open-end: changes when new shares are sold or old shares are redeemed Pricing  Open-end: Fund share price = Net Asset Value (NAV)  Closed-end: Fund share price may trade at a premium or discount to NAV

16. 4-16 NAV calculation ABC Fund ($Millions except NAV) Market Value Securities + Cash & Receivables - Current Liabilities NAV Total  # Fund Shares NAV $550.00 75.00 (20.00) $605.00 20.00 $ 30.25 Most Mutual Funds have little or no Long Term Debt

17. 4-17 How Funds Are Sold Directly marketed – Sales force distributed – You find them May avoid front end load Front end load is an up front cost (fee) to purchase a share of a mutual fund. Recommended by a broker or planner Usually will have a front end load May be revenue sharing on sales force distributed Potential conflict of interest

18. 4-18 Potential Conflicts of Interest: Revenue Sharing  Brokers put investors in funds that may that ____________________________  Mutual funds could direct trading _____________________  Revenue sharing is _________ but it must be ________ to the investor may not be the most appropriate to higher cost brokers not illegal disclosed

19. 4-19 How Funds Are Sold Financial supermarkets –E.G., Charles Schwab Avoid a direct load, but may cost you more in expenses Low cost switching even between fund families and easier to interpret record keeping

20. 4-20 Funds & Investment Objectives 1.Domestic Stock Funds a.Aggressive Growth i. b.Growth i. c.Growth & Income i. ii. d.Countercyclical i. Investment characteristics Focus on capital gains, low income High turnover Substantial potential for capital loss Compatible Investor Goals Long time horizon Financial ability to remain in the markets Ability to handle losses * Morningstar fund definitions Sector, Small Cap Growth, Mid Cap Growth* Large Cap Growth Small, Med, Large Blend Small, Med, Large Value Bear Market

21. 4-21 Funds & Investment Objectives 2.Index Funds a. b. c. d. Investment characteristics Goal is to duplicate the performance of an index or market sector.Goal is to duplicate the performance of an index or market sector. Low turnover, low expensesLow turnover, low expenses Compatible Investor Goals Investors who believe in ‘efficient markets’ and are seeking market returns with minimal expenses and turnover.Investors who believe in ‘efficient markets’ and are seeking market returns with minimal expenses and turnover. Stock funds still require ability to handle risk and staying power.Stock funds still require ability to handle risk and staying power. Broad market Industry or market sector International market Size subset

22. 4-22 Funds & Investment Objectives 3.Balanced funds a.Allocation Funds i. ii. b.Target Date Funds i. Investment characteristics Hold both stocks and bonds, allocations may vary over timeHold both stocks and bonds, allocations may vary over time Turnover variesTurnover varies Higher income, lower capital gains & lower potential for capital lossHigher income, lower capital gains & lower potential for capital loss Compatible Investor Goals Intermediate to long time horizonIntermediate to long time horizon Willing to face higher tax liabilityWilling to face higher tax liability Some ability to handle lossesSome ability to handle losses World, moderate, conservative Convertibles Near term (to 2014), Intermediate (2015-2029), Long term (2030+)

23. 4-23 Funds & Investment Objectives 4.Fixed Income funds a.Federal Government i. ii. b.Corporate ii. iii. iv. Investment characteristics Focus on income and current yieldFocus on income and current yield Lower potential for capital loss, inflation risk higherLower potential for capital loss, inflation risk higher Compatible Investor Goals Short to moderate time horizon okayShort to moderate time horizon okay Understand tax liabilityUnderstand tax liability Adds diversification, income and safetyAdds diversification, income and safety Short, Intermediate, Long Inflation Protected Ultrashort, Short, Intermediate, Long High Yield, Multisector Emerging Markets, World Bank Loans

24. 4-24 Funds & Investment Objectives 5.International Stock Funds a.Foreign i. b.Global or World i. c.Geographic region d.Emerging markets Investment characteristics Risk varies, but can be high, FX exposureRisk varies, but can be high, FX exposure Expense ratios can be highExpense ratios can be high Substantial potential for capital lossSubstantial potential for capital loss Compatible Investor Goals Longer time horizonLonger time horizon Investor seeking diversification and/or higher returnsInvestor seeking diversification and/or higher returns Ability to remain in the markets & handle lossesAbility to remain in the markets & handle losses Size and Value/Growth

25. 4-25 Funds & Investment Objectives 6.Money market funds a.Taxable b.Tax Exempt Investment characteristics Focus on safety of principal and incomeFocus on safety of principal and income Earn more than on bank accounts with little additional riskEarn more than on bank accounts with little additional risk Compatible Investor Goals Short time horizonShort time horizon Add stability to a portfolioAdd stability to a portfolio Potentially large opportunity losses & inflation riskPotentially large opportunity losses & inflation risk

26. 4-26 Table 4.1 U.S. Mutual Funds by Investment Classification, 2008

27. 4-27 Trading Scandal with Mutual Funds  Late trading: allowing some investors to purchase or sell after NAV has been determined for the day  Market timing: allowing investors to buy or sell on stale net asset values –International: fund NAV may be based on prices in foreign markets which close at different times. A U.S. mutual fund specializing in Japanese stocks may create an exploitable opportunity since the Japanese markets close before ours, at which time the fund’s NAV will be set. If the U.S. markets subsequently go up late in the day, probably Japanese stocks will go up the next day, driving up NAV for the fund the next day.

28. 4-28 Trading Scandal with Mutual Funds  Net effect? –Transfer wealth from existing owners to the new purchasers or sellers

29. 4-29 Potential Reforms  Strict _____________ with late orders executed the following trading day  ________________ with net asset values being adjusted for trading in open markets  Imposition of __________________________________ 4:00 PM cutoff Fair value pricing redemption fees on holdings < 1 week

30. 4-30 4.4 Costs of Investing in Mutual Funds

31. 4-31 Costs of Investing in Mutual Funds Fee Structure – Operating expenses – 12 b-1 charges – Front-end load Back-end load (contingent), (redemption fee) Buying and selling commissions, administrative expenses and advisory fees for the managers Marketing costs paid by the fundholders Alternative to a load, but assessed annually Maximum is 1% of assets

32. 4-32 Costs of Investing in Mutual Funds Fees, loads and performance –Gross performance of load funds is statistically identical to gross performance of no load funds –Why pay a load charge? –Funds with high expenses tend to be poorer performers. 12 b-1 charges should be added to expense ratios Costs found in the fund prospectus and may be compared via Morningstar

33. 4-33 NAV and the Effective Load Cost to initially purchase one share of a load fund = NAV + front-end load (%) (if any).  Stated Loads typically range from ________  If you invest $10,000 in a fund with an 8.5% front-end load, you actually acquire shares worth $9,150; the other $850 goes to the broker. The load is designed to offset expenses of marketing the fund and goes to the broker who sells the fund to the investor.  The effective load is greater than the stated load: In the above example, the actual % commission cost (effective load) is: –$850 / $9150 = 9.3%; which is > stated load. 0 to 8.5%

34. 4-34 Costs of Investing in Mutual Funds  Avoiding the load: –Can sometimes choose different class of fund shares. –Best alternative may depend on _______________________________________. amount invested and expected holding period

35. 4-35 Costs of Investing in Mutual Funds Expense ratios:  Funds charge annual operating expenses and annual advisory or management fees against the NAV. –Expense ratios are calculated as Annual Expenses / Average NAV –A "well managed" fund probably should have an expense ratio of less than ___.  All costs and charges must be revealed in the fund's prospectus. 2%

36. 4-36 Amount initially invested = Amount after gross return = Amount after fees = Net rate of return = In MF prospectus and annual reports the MF returns are net of operating expenses, 12b-1 fees and commissions, but the returns do not include loads. Converting gross pretax returns to net pretax returns: $10,000 – (0.06 x $10,000) = $9,400 $9,400 x 1.175 = $11,045 $11,045 - (0.0135 x $11,045) = $10,895.89* ($10,895.89 - $10,000) / $10,000 = 8.96% *This example calculates expenses using ending NAV.

37. 4-37 Table 4.2 Impacts of Costs on Investment Performance Conclusions? Optimal choice fee structure is Time dependent Investment size dependent

38. 4-38 HPR on mutual funds Dist = Distribution All distributions are taxable, even if reinvested in the fund. Do not buy into a MF just before its distribution date (usually near the end of the year or quarter).

39. 4-39 4.5 Taxation of Mutual Fund Income

40. 4-40 General Tax Rules The fund itself is not taxed as long as –Fund meets certain diversification requirements –Fund distributes virtually all income earned (less fees and expenses) to fund shareholders The investor is taxed on capital gain and dividend distributions at the investor’s appropriate tax rate. Distribution requirements imply that portfolio turnover may affect an investor’s tax liability.