Mutual Funds: An Indirect Route to the Market

1. Mutual Funds: An Indirect Route to the Market Gitman-Joehnk Chapter 13

2. Key Concepts • Distinction between investing in a mutual fund and investing directly in securities • pooled diversification • closed-end vs.open-end funds • load Vs.. no-load funds • 12(b)-1 fees and other charges • classification of mutual fund types by fund objectives

3. variety of fund services available to investors • choosing funds consistent with investment objectives • computing the holding period return and approximate yield of a mutual fund

4. I. Mutual funds allow investors to own securities indirectly A. Mutual fund as a financial intermediary 1. Key benefits include pooled diversification professional management low initial investment special services such as automatic reinvestment of dividends

5. 2. Key drawbacks include: load charge (may reduce front-end contributions) management fees of from .5 to 1.75% (or higher) are common performance has not been better than market averages

6. B. Each mutual fund has several contributors: 1. management company - usually the fund’s creator 2. investment advisor - usually an employee of the mgt. co. 3. distributor - sells the mutual fund shares to the public 4. custodian - safeguards fund assets and securities, usually a bank or trust co. 5. transfer agent - maintains shareholder records

7. C. Classification and Characteristics of Mutual Funds 1. open-end investment cos. are true mutual funds -account for 90% of all MF assets -have no limit on the number of issued shares -purchase and sale of MF shares are made with the MF -current market value or net asset value,( NAV), plus any commissions represents the purchase or sale price of a MF share

8. 2. Closed-end funds operate with a fixed number of shares outstanding -have a capital structure like ordinary corporation -shares trade in the market for common stock -CEF shares often trade at a discount to (occasionally at a premium) NAV

9. 3. unit investment trust - holds a portfolio of securities which, once selected, is unmanaged -portfolio is assembled and shares sold -portfolio is usually bonds of 10 to 15 years maturity -income is paid periodically and the trust is liquidated when the securities mature

10. 4. Load funds - charge a commission for the purchase(front-end)and/or sale or redemption (back-end) of MF shares -brokers prefer to sell load funds investors may need to contact no-load funds on their own -commissions of 7 to 8.25% are common -performance of load funds has been no better than that of no-load MFs -low-load funds are now appearing -some funds also charge a 12(b)-1 annual assessment for marketing and distribution expenses

11. 5. No-load funds do not charge a commission for the purchase or sale of MF shares -some do charge 12(b)-1 fees 6. All MF are subject to management fees of between .5 and 1.75% per year -these charges are levied regardless of the fund’s performance -commissions and security transactions taxes also apply -all expenses and costs associated with the MF are required to be provided in an easy to read format

12. II. Major classification of Mutual Funds by Type A. Based on MF Objectives 1. growth funds - objective is capital gains viewed as long-term investment vehicles for moderately aggressive investors who seek wealth accumulation 2. Aggressive growth (performance) funds - highly speculative MF, objective is high returns from capital gains. vehicles for aggressive investors willing to accept high risk

13. 3. Equity income fund - primary objective is current income from interest and/ or dividends. more conservative, with moderate level of risk 4. Balanced fund - objective is income and long-term capital gains maintain higher % of funds in bonds than equity-income funds 5. Growth and income fund - objective focusing more on growth or capital gains and less on current income

14. 6. Bond funds - designated to generate income through investment in portfolios of various bond issues. Focus on high quality government bonds, corporates, and/or municipals eliminates most default risk but interest rate risk remains. 7. Money Market Funds - offer ownership in a portfolio of short-term. money market securities. Low risk, highly liquid investment funds

15. 8. Index funds - buy and hold a portfolio of stocks or bonds equivalent to the composition of a leading market index produces market performance, as measured by that index, with low management costs 9. Sector funds - tend to limit their holdings to one or more segments (industries) of the capital market

16. 10. Asset Allocation funds - spread investors’ funds across stocks and bonds and money market securities Designed for investors who want to hire fund managers not only to select individual securities but also to make strategic decisions on how to allocate money among the various sectors of the money and capital markets 11. International funds - only acquire securities of foreign firms. A variant, the global fund, would also include securities of US companies

17. III. Other Mutual Fund Services A. Automatic investment and reinvestment plans 1. investor makes an agreement to invest a certain amount with the fund each period 2. dividend and /or capital gains income is used to purchase additional shares of the mutual fund

18. B. Withdrawal plans for regular income payments 1. may be fixed-dollar withdrawals 2. set number of shares to be liquidated each period C. Conversion privileges for investors interested in changing among a variety of funds 1. at no or low cost, a family of MFs will allow an investor to transfer money among company funds 2. for tax purposes this represents a sale and purchase so taxes will be due at that time

19. 4. Retirement programs such as Keoghs and IRAs can be serviced by MFs

20. IV. Approach to MF Investing A. 3 Common investment uses of MF 1. accumulation of wealth for future needs 2. storehouse of value, i.e..... MFs allow for the preservation of capital and current income -particularly attractive 3. speculation and short-term trading not a common use due to long-term nature of MF investing

21. B. Selection of specific MFs out of 6,000+ available 1. examine fund specifics (many eliminated) -investment objectives -intended use of fund -range of services offered -manner of fund operation -historical performance of fund should provide a small set of MF that have objectives, performance, and services that are reasonably consistent with the investor’s preferences

22. 2. final step is elimination of funds by closer comparison of costs and performance returns over time performance in up and down markets load Vs.. no-load management fees levels of dividends and capital gains distributions consistency of management

23. V. Rates of Return and Investment Performance of MF A. ROR on MF are just as important as for individual investments 1. sources of returns dividend income capital gains distributions changes in MF share price or NAV 2. for open-ended funds the price of a MF share and NAV are the same except for commissions

24. 3. for close-ended funds the price and NAV may not be equal P>NAV premium P<NAV discount, most likely changes in the premium or discount are a source of return unique to CEFs changes in the premium or disc. for a CEF are reflected in the price of the CEF fund

25. B. Computing Returns on MF 1. HPR - holding period return for MF performance assume all current income and capital distributions occur within the same year

26. HPR measure appropriate if all distributions are reinvested in the fund:

27. HPR is not appropriate if performance is to be measured over a period exceeding a year. Approximate yield is a better measure.

28. Most MF are diversified and have reduced or eliminated buiness and financial risk. MFs still face market risk the MF’s mgt. practices may affect the fund’s level of risk MFs face interest rate risk, most importantly for MF with bonds in their portfolio Securities in the portfolio are still subject to interest rate ris, market risk and purchasing power or inflation risk.