1. Investments: Analysis and Behavior Chapter 16- Mutual Funds

2. 16-2 Learning Objectives  Understand the structure and pricing of mutual funds  Know the advantages and disadvantages of buying mutual funds  Be able to assess mutual fund performance  Assess mutual fund manager incentives  Recognize the impact of taxable distributions on fund returns

3. 16-3 Mutual Funds  An investment company that issues portfolio shares to investors.  Money from shareholders invested in a wide range of stocks, bonds, or money market securities. –Managed by professional managers  Each investor shares proportionately in portfolio income and investment gains and losses, as well as the brokerage expenses and management fees.  Open end fund: # of shares issued solely depends on investor demand. –Bought and sold directly through the investment company (not an exchange)

4. 16-4 Net asset Value  NAV: per share value of a mutual fund’s investment holding. Example A mutual fund has $100 mil in assets and $3 mil in short term liabilities. 10.765 mil shares outstanding. What is the NAV? Solution ($100 mil - $3 mil)/10.765 mil = $9.0107 per share

5. 16-5 Types of Mutual Funds ObjectiveFunds HoldGrowth PotentialIncome PotentialStability Money Market Funds Taxable money marketCurrent income stability of principal Cash investmentsNoneModerateVery high Tax-exempt money market Tax-free income, stability of principal Municipal cash investmentsNoneModerateVery high Bond Funds Taxable bondCurrent incomeWide range of government and/or corporate bonds NoneModerate to highLow to moderate Tax-exempt bondTax-free incomeWide range of municipal bondsNoneModerate to highLow to moderate Common Stock Funds BalancedCurrent income capital growth Stocks and bondsModerateModerate to highLow to moderate Equity income High-yielding stocks, convertible bonds Moderate to highModerateLow to moderate Value funds Low P/E, P/B stocksModerate to highLow to moderate Growth and income Dividend-paying stocksModerate to highLow to moderate Domestic growthCapital growthU.S. stocks with high potential for growth HighVery lowLow International growth Stocks of companies outside U.S. HighVery low to lowVery low Aggressive growthAggressive growth of capital Stocks with very high potential for growth Very highVery low Small cap Stocks of small companiesVery highVery low Specialized Stocks of industry sectorsHigh to very highVery low to moderate Very low to low Table 16.1 Types of Mutual Funds

6. 16-6 Sources of Information  Morningstar.com: provide unbiased data and analysis and candid editorial commentary (www.morningstar.com) Morningstar.comwww.morningstar.com  Lipper Inc.: a provider of data and analysis on the investment company business (www.lipperweb.com)www.lipperweb.com  Vanguard Group: providing competitive investment performance and the lowest operating expenses (www.vanguard.com)www.vanguard.com

7. 16-7 Mutual Fund Advantages  Broad diversification –Diversified stock funds hold large and small company stocks broadly spread across industries and economic sectors –Diversified bond funds hold bonds with different maturities, coupon, and credit quality Ability to retain professional investment management at a reasonable cost. Investor convenience  Many offer a “fund family” with lots of investment options.

8. 16-8 Mutual Fund Disadvantages Volatility can be significant  Diversification doesn’t protect investors from the risk of loss from an overall decline in financial markets.  Mutual fund regulation doesn’t eliminate the risk of an investment falling in value. High management fees and sales commissions  Some funds charge very high management fees.  Some funds charge very sales commissions.

9. 16-9

10. 16-10 Sources of Investment Returns  Total Return: dividend and interest income,and realized and unrealized appreciation  Income distribution: interest and dividend income after expenses.  Capital gains unrealized until the fund sells the shares (Unrealized capital gains)  The realized capital gains are paid out to shareholders at the end of the year (capital gains distributions)

11. 16-11 Mutual fund expenses  Operating expense ratio: total of investment advisory fees and costs of legal and accounting services, etc., expressed as a percentage of the fund’s average net assets (range from 0.2% to 2%) –Lowest for money market mutual funds and highest for international stock funds –Tend to be lowest for large, liquid funds  Load charges: one time sales commissions –Front-end loads (charged at the time of purchase) –Back-end loads (charged at the time of sales of shares) –Low-end funds: sales fee ranging from 1% to 3% –12b-1 fees: marketing and distribution costs –No-load funds: fund without front-end or back-end load charges

12. 16-12 Fund AFund BFund C Shareholder Transaction Expenses Sales load imposed on purchasesNone 4.75% Sales load imposed on reinvested dividendsNone 4.75 Redemption feesNone Exchange feesNone Annual Fund Operating Expenses Management and administrative expenses0.22%0.60%0.70% Investment advisory expenses0.02—— 12b-1 marketing fees—0.30— Marketing and distribution costs0.02—— Miscellaneous expenses0.030.320.26 Total Operating Expenses0.29%1.22%0.96% Expenses on a $10,000 Investment 1 year$ 30$ 124$ 587 3 years93387823 5 years1636701,077 10 years3681,4771,805 Table 16.4 A. Typical fee tables found in three different mutual fund prospectuses

13. 16-13 The impact of equity mutual fund costs on long-term investor returns. Fund AFund BFund C Initial investment$ 10,000 Day 110,000 9,525 5 years18,18917,45116,186 10 years33,08430,56529,689 15 years60,17853,14552,416 20 years109,45892,74392,539 Gross return13.00% Operating expenses0.29%1.22%0.96% Net return12.71%11.78%12.04% Fund A : typical cost efficient index fund Fund B : conventional no-load stock mutual fund Fund C : low-load stock mutual fund with less than typical annual operating expenses

14. 16-14 Figure 16.3 Yahoo! Finance Gives Detailed Information about Mutual Fund Style and Fees

15. 16-15 Figure 16.4 Dreyfus Appreciation Fund Performance from Yahoo! Finance

16. 16-16 Figure 16.4 Dreyfus Appreciation Fund Performance from Yahoo! Finance (cont.)

17. 16-17 Figure 16.4 Dreyfus Appreciation Fund Performance from Yahoo! Finance (cont.)

18. 16-18 Hedge Funds  Like mutual funds, hedge funds allow investors to pool financial resources.  Typically organized as partnership and available only to the wealthiest investors.  Flexibility to use speculative investment strategies, subject to limited oversight. –High fees (2% of assets plus 20% of returns is common.)  Hedgefund.net tracks nearly 3,000 hedgefunds Hedgefund.net

19. 16-19 Table 16.7 Hedge Funds Differ From Mutual Funds in a Number of Ways Mutual FundsHedge Funds Who Invests92 million Americans own mutual fund shares. The only qualification for investing is having the minimum investment to open an account with a fund company ‑‑ often $1,000 or less. Only sophisticated, high net worth investors are eligible to invest. The typical investor is a wealthy individual or an institution such as an endowment or foundation. A minimum investment of $1 million or more is required. FeesMutual fund shareholders pay, on average, an annual expense ratio of roughly 1.5% of assets. Load charges can increase this to 2.5% to 5% per year. Funds must disclose fees and expenses in detail. Sales charges and other distribution fees are subject to specific regulatory limits. Hedge fund investors often pay a portfolio management fee of 1% to 2% of net assets, plus a performance-based fee that can run as high as 10% per year, depending upon performance. Fees are not subject to specific regulatory limits. Investment Practices Securities laws restrict a mutual fund's ability to leverage, or borrow against the value of securities in its portfolio. Funds that use options, futures, forward contracts, and short selling must "cover" their positions with cash reserves or other liquid securities. Investment policies must be fully disclosed to investors. Leveraging strategies are hallmarks of hedge funds. Investment policies do not have to be disclosed, even to investors in the fund. Pricing and Liquidity Mutual funds must value their portfolio securities and compute their share daily. They generally must also allow shareholders to redeem shares on at least a daily basis. There are no specific rules on valuation or pricing. As a result, hedge fund investors may be unable to determine the value of their investment at any given time. In addition, new investors typically must pledge to keep their money in a hedge fund for at least one year.

20. 16-20 Taxes on distributions  Shareholders pay taxes on dividends and capital gains distributions.  Income and capital gains distributions are generally subject to income taxes. – Municipal bond or US T-securities interest income exempt from federal taxes, but capital gains are taxable.