Investments: Analysis and Behavior

1. Investments: Analysis and Behavior Chapter 16- Mutual Funds ©2008 McGraw-Hill/Irwin

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. Mutual Funds • An investment company that issues its portfolio shares to investors. • Money from shareholders are pooled and invested in a wide range of stocks, bonds, or money market securities. • Managed by professional managers • Each investor shares proportionately in the 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. 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

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

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 “fund family”

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 • No-load funds

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. 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 fund 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. Table 16.4 A. Typical fee tables found in three different mutual fund prospectuses

13. B. The impact of equity mutual fund costs on long-term investor returns. 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. Style boxes • Characterize mutual funds by market capitalization (large, mid, and small cap) • Next, determine how cheap or expensive portfolio holdings are relative to the • overall market using P/E and P/B ratios (Value, Blend and Growth)

16. Mutual Fund Organization • Mutual fund shareholders: own mutual funds, elect the board of directors • Majority of the directors must be independent directors • Investment advisor: manages the day-to-day operations • Principal underwriter, administrator, transfer agent, custodian, and independent public accountant

17. Evaluating Fund Performance • Using ranking tools or portfolio evaluation tools (alpha, Sharp ratio, and Treynor measure) • 20 categories in domestic equity mutual funds, 14 in international equity funds, 12 in fixed income and 17 in municipal bond funds

18. Top 10 U.S. Domestic Funds Based on 3 Year Return

22. Exchange-Trade Funds (ETFs) • Tradable shares in baskets of stocks that closely track broad market averages, market sectors, or major stock markets from around the world. • Tradable shares in baskets of stocks that closely track broad market averages, market sectors, or major stock markets from around the world. • Standard and Poor’s Depository Receipts (SPY), “spiders”: closely track S&P 500 Index • Diamonds (DIA): track Dow Jones Industrial Average • QQQQ: track Nasdaq 100 Index • Select Sector SPDRs: unbundled S&P Index to give investors ownership in a particular market sector or group of industries. • Barclays Global Investors: offer “iShares” – internationally indexed

23. Closed-End Funds • Issues a fixed number of shares at a given point in time • Collect money from investors through and IPO and use this money to invest in securities. • # of securities are fixed at the time of IPO. • When the market price exceeds its NAV, selling at a premium, otherwise, selling at a discount (closed-end funds typically sell at a discount) • Suited to specialized investing in small or illiquid markets * Assets are Net Assets, expressed in Millions, and exclude leveraged capital (preferred stock, debt, etc.).

24. Hedge Funds • Like mutual funds, a means for groups of investors to pool financial resources • Typically organized as partnership arrangement available only to the wealthiest investors • Flexibility to use speculative investment strategies • Subject to only limited oversight.

25. Table 16.6 Hedge Funds Differ From Mutual Funds in a Number of Ways

26. Taxes on distributions • Shareholders pay taxes due once income dividends and capital gains distributions are received. • All 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. • Turnover rate: expressed as a percentage of the fund’s average assets (average turnover rate for stock mutual fund: 79%)