Mutual Fund Operations

1. Mutual Fund Operations 23

2. Background on Mutual Funds • Mutual funds offer a way for small investors to diversify • In Dec/12, the number of mutual funds was 8,752 with assets ~ $13T (more MFs than there are individual stocks!) • Today about half of households own invest in mutual funds (1980 only 6% of households owned MFs). This will get bigger as more employers switch from defined benefit pensions to 401k-style plans.

3. Growth in Mutual Funds Note: The numbers shown here include money market funds. MF experienced tremendous growth until the turn of the century.

4. Background on Mutual Funds • Mutual fund itself is exempt from income taxation if it distributes 90 percent of taxable income to shareholders each year • Mutual funds adhere to a variety of federal (SEC) and state regulations • Prospectus must disclose relevant info to investors (see next slide)

5. Prospectus • Mutual fund prospectus 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 past five years • The exposure of the fund to various types of risk • Services the fund offers (e.g. check writing, funds transfer) • Fees that investors pay (expense ratios) • Name and tenure of manager • https://personal.vanguard.com/us/literature/prospectus

6. Determining NAV • Net asset value is the value per share, after expenses • Calculated once a day at 4pm ET by: • Determining the market value of all the securities in the fund • Adding interest or dividends and subtracting expenses for day • Dividing by the number of shares

7. Scandals • Late-trading: illegal practice of allowing purchase/sale of shares after 4pm (but stamped 4pm) to key investors who have an unfair chance to learn about market events after 4pm which will affect the NAV the next morning (e.g. earnings releases, lawsuits, world events, etc.) • Market-timing: allowing favored investors to make large trades into and out of the fund, based on international of other information believed to affect the NAV; not illegal per see but usually violates internal policies. E.g. Whistle-blower: Peter Scannell at Putnam. • SEC now strictly prohibits late trading and requires all funds to state a policy about market-timing. Peter Scannell

8. Mutual Fund Distributions Income from Interest & Dividends Capital Gains from the Sale of Securities in Fund (Called Capital Gain Distributions) Mutual Fund Price Appreciation (Unrealized gains/losses on security prices)

9. 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 • Balanced funds • Money market mutual funds • Family of funds offered by investment companies (Vanguard, Magellan, Putnam, American, United, etc.) • Investor able to allocate then transfer funds among funds

10. Distribution of Investment in Mutual Funds Source: Mutual Fund Fact Book.

11. Background on Mutual Funds • Management of mutual funds • Managers invest in a portfolio of securities that meet the objectives of the fund • Management costs paid by fees, usually less than 2% of total assets per year • Managers adjust the composition of portfolios in response to market and economic conditions • Fund may rise or fall with the manager (manager may leave or die) • Manager not so important for index funds

12. Background on Mutual Funds • Expenses • Fees include mgmt, record-keeping, and clerical fees • Expense ratio = annual expenses/fund NAV • Investor should compare expense ratios • SEC requires that all funds disclose average fees • 12b-1 Fees: Active marketing expenses (pay brokers to recommend fund) • controversy over 12b-1 fees being passed on unethically • Loads • Front-end load or sales commission (usually 3-8.5%) • Back-end load or redemption fee

13. How the Accumulated Value Can be Affected by Expenses (Assume Initial Investment of $10,000 and a Return before Expenses of 9.2%)

14. Background on Mutual Funds • Corporate control by mutual funds • Mutual funds are large shareholders in companies whose stock they hold (Fidelity controls 5% of stock traded on NYSE; it owns controlling share in more than 700 corporations) • 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 shares • Some mutual funds are now not only asking the corps they own for good returns but also for good citizenship (environment, etc.)

15. Load versus No-Load Mutual Funds • Classification refers to whether or not there is a sales charge • 12b-1 expenses are “loads” used by no-load funds • Load funds • Promoted by registered representatives of brokerage firms who get a commission • Investors pay the sales charge, usually 3%-8.5%

16. Open-End versus Closed-End Funds • Closed-end funds (not common; e.g. ETFs) • Mutual fund does not trade the shares they sell—similar to direct common stock investment; rather investors must trade shares on an exchange • Value of shares changes with market conditions • Open-end “mutual” funds (very common) • Willing to repurchase investor shares at any time • Number of shares outstanding changes constantly • NAV determined by fund daily at 4pm

17. 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

18. Stock Mutual Fund Categories • Growth and income funds (sometimes called balanced funds) try to offer growth but with some stability of income • International funds invests in non-US securities • A global mutual fund invests in U.S. stocks as well as foreign stocks

19. Stock Mutual Fund Categories • Specialty funds focus on a particular industry or characteristic such as high-tech, precious medals or socially conscious funds • Index funds are designed to simply match the performance of an existing stock index • Advantages include: (1) low management fee, (2) low turnover and resulting transaction costs, (3) tax deferral, (4) performance not tied to one manager • Multifund funds invest in a portfolio of different mutual funds • More diversified (Vanguard’s STAR fund, 9 different fds) • Involves higher expenses (double management fees)

20. Growth in the Number of Stock Funds and Bond Funds

21. Investment in Bond and Stock Mutual Funds

22. Distribution of Aggregate Mutual Fund Assets

23. Bond Funds • Income bond funds attract investors who are • Interested in periodic interest income over long-term • Tax-free funds in muni’s for high tax bracket investors • High-yield or junk bond funds • International and global bond funds • 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. Mutual Fund Types • Asset allocation funds • Funds that contain a variety of investments • Composition among stocks, bonds and money market securities is based on manager’s expectations • Can have retirement target date funds which automatically shift allocation as you age (Vanguard’s funds targeting retirement in 2020, 2030, 2040, 2050 etc.)

25. Performance of Mutual Funds • Investors should diversify among different kinds of funds to reduce volatility • Research on stock mutual fund performance • Mutual funds typically do not outperform the market (indices) • Evaluate mutual fund expenses • Go with index funds, says Mr. Toews! • Research on bond mutual funds • Bond mutual funds underperform bond indexes • Investors should look for low expense bond funds

26. Money Market Funds • Money market funds are portfolios of short-term assets • Can include check-writing privileges for investors • Number of checks per month usually restricted • Shareholders get periodic statements • Liquid, “cash” balance for investor • Lower interest-rate risk, inflation risk, default risk, liquidity risk: but lower return as well

27. Growth in Money Market Fund Assets Taxable Non-Taxable

28. Composition of Taxable Money Market Fund Assets in Aggregate

29. Weighted Average Maturity of Money Market Fund Assets If interest rates are expected to increase, you would want to shorten the average maturity . . . And vice versa Source: 2007 Mutual Fund Fact Book.

30. Exchange-Traded Funds (ETFs) • Designed to mimic particular stock indexes and are traded on a stock exchange just like stocks. • E.g. Nasdaq100 Cubes (QQQ); S&P500 Spiders (SPY), and DJIA Diamonds (DIA) • Exchange-traded funds have become very popular in recent years because they are an efficient way for investors to invest in a particular stock index. • Disadvantage: each purchase must be executed through the exchange where they are traded, which incurs broker fees. According to John Bogle, founder of Vanguard, ETFs allow games to be played (speculation, short-selling, etc.) which is no way to invest for the long-term. • Advantages: may be purchased on margin, sold short, hedged & bundled; are tax efficient (pay only capital gains tax and only when sold); have low minimum investment compared to mutual funds

31. Venture Capital Funds Venture Capital Funds • Venture capital (VC) funds use money that they receive from wealthy individuals and some institutional investors to invest mostly in start-up companies. • Invested monies are pooled and used to create a diversified equity portfolio. • Venture capital funds tend to focus on technology firms, which have the potential for high returns but also exhibit a high level of risk. • A VC fund typically plans to exit from its original investment in a business within about four to seven years.

32. Private Equity Funds • Private equity funds pool money provided by individual and institutional investors and buy majority (or entire) stakes in businesses (e.g. Mitt Romney, Bain Capital, and Staples). • When a private equity fund purchases a business, it assumes control and is able to restructure the business in a manner that will improve its performance. • The potential to capitalize on inefficiencies has attracted much investment in private equity and has led to the creation of many new private equity funds.

33. Hedge Funds • A mutual fund for rich people (net worth $1 million) & financial institutions; began as a “hedge” against risk; today, the opposite • Invest in derivatives, sell stock short, and incur high leverage • 4000+ hedge funds with some $2T in market value • Traditionally unregulated (rich can look after themselves) • Charge high fees (e.g. 20% of return + 2% mgmt fee) to the extent that low-cost index funds are often better choice to investor over L/T • SEC started regulating hedge funds in 2006 by banning advertising • Because hedge funds can affect systemic risk, Dodd-Frank Act of 2010 brings serious regulation: • Must register w/ SEC, disclose financial data, including commissions • Commercial banks can’t invest more 3% of capital in a hedge, PE, or REIT • Investors in hedge funds must have at least $1M net worth, joint with spouse, on average over 4-years (not including home). $1M will adjust to inflation every five years.

34. Hedge Funds • Long-Term Capital Management Hedge Fund, 1998 • Founded by John Meriwether of Salomon Brothers, and team of physicists, mathematicians, computer specialists, and Nobel Prize winning economists, Merton & Scholes!!! Used complicated quantitative models to try to maximize return. • Had long position in risky bonds and short position in AAA bonds, betting spread would decline, but Russian bond default made spread bigger. Caused a liquidity crisis, and LTCM lost 40% of value. Federal Reserve decided it was too big too fail. Required $3.6B bailout by NY Fed, a bunch of banks and security firms (including Warren Buffet!) • Bernard Madoff, 2009 • Ran the largest Ponzi scheme ever in his hedge fund; investors lost as much as $50B; Madoff sentenced to 150 years • Was using $$ from new investors to pay consistent high returns to old investors; many market experts were suspicious of this; one even complained to the SEC, which did nothing

35. 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 (invest directly in properties) • Mortgage REIT (invest in loans secured by property) • Hybrid of the two • Sometimes seen as an inflation hedge • Performance influenced by interest rates and area real estate values (not so hot right now)