Mutual Funds

1. Mutual Funds Strategy Follows Structure

2. Overview Markets & Mutual Funds Players and Terminology Government oversight Fund structures Fund expenses

3. What is a Market? • A human invention for our collective use • No central control- it’s a distributed network. • It sets prices, distributes investment risk and provides capital to future business among a willing group of participants who want to maximize gain and minimize risk.

4. Price vs. Value • Markets clear goods from the market place by auction- buy and sell • No two investors have the same information so they never value an item identically and this creates price differences • Price exists at the moment of completed sale of an item- an arbitrarily agreed upon value. Low quality/high volume prices discounted High quality/low volume prices at a premium

5. Why have Mutual Funds? • A mutual fund provides small investors with the same diversification and professional management of investment available to a wealthy investor. • In 1822 the first investment company formed by King of Netherlands. A group of wealthy, interested people pooled their money to invest primarily in securities, thereby sharing the risk and rewards.

6. Owner/Shareholders Fund Company Portfolio of Securities hires Stock 1 Wealthy Investor Stock 2 Stock 3 Stock 4 Fund Management Stock 5 Stock 6 Stock 7 Stock 8 Stock 9 Stock 10 Capital NAV = $100 / 1 shareholder =$100 Stock 1 Stock 2 Stock 3 Fund Management Stock 4 Stock 5 Stock 6 Stock 7 Stock 8 Stock 9 Stock 10 10 investors NAV = $100 / 10 shareholder =$10

7. Terminology Trust 1) A legal arrangement in which an individual (the trustor) gives fiduciary control of property to a person or institution (the trustee) for the benefit of beneficiaries. 2) A monopolistic corporation, prior to the enactment of antitrust laws.

8. Pooled Investment Vehicles • Investment Trusts(British late 1800’s) • Investment Companies (regulation- incorporated) • Investment Funds (America in 1920s) Mutual Investment Funds Mutual Funds • Closed End Funds • Open End Funds • Unit Investment Trusts (Money market funds) • Fixed Trusts • Exchange Traded Funds (ETF) • Hedge Funds • <100 shareholders or knowledgeable, wealthy investors $MM

9. Fund Abuses of 1880s • Lack of Disclosure • Insufficient portfolio diversification • Excessive leverage by borrowing through: • Issue of senior securities • Funds engaging in underwriting and non investment activities • Issue cheap “founder’s shares” to funds promoters

10. Closed End Funds • Do not offer new shares continuously. To buy in, you must find an current shareholder willing to sell their shares. 2) Fund shares of portfolio traded in market at more or less than liquidation value of the portfolio of securities $100 portfolio of 5 shares, each share = $20 if selling for $23, premium is $3 if selling for $18, discount is $2

11. Open End Funds • Offer redemption of shares at any time. Receive proceeds based on current value of portfolio at the end of the day. • Continuously offer new shares to investors

12. Exchange Traded Funds ETFs always bundle together the individual securities that are in an particular index of virtually any industry or sector of a market. ETF’s track that index and can be traded like a stock Institutional investor purchases a pre-specified basket of securities. A creation unit of ETF is produced that the investor then can sell or hold their at anytime of day like a stock share. Retail investors buy an interest in the unit. The first ETF created was the Standard and Poor's Deposit Receipt (SPDR, pronounced "Spider") in 1993. SPDRs gave investors an easy way to track the S&P 500 without buying an index fund. On NASDAQ, it was “Qubes” for QQQQ ticket symbol

13. Advice -Trust but Verify • Investment Adviser (Counsel) / Trust Services of Banks Conservative, Competent, Defensive For investors with >$5M; Substantial annual fees Registered Investment Adviser (RIA) –is listed with SEC and in states they do work. They manage assets worth >25 M and >100 clients. Should provide a Part II Form ADV which summarizes background and fees. • Financial Services Advisers Newsletters & Statistical Information Standard & Poor, Moody’s, Morningstar; Subscription fees

14. Advice -Trust but Verify • Brokerage (Wire) Houses / Firms • Stockbroker must be member of a SEC registered exchange (NYSE,NASDAQ, Regional or Int’l Exchanges) • broker/dealer is any individual or firm in the business of buying and selling securities for itself and others • When acting as a broker, a broker/dealer executes orders on behalf of his/her client. • When acting as a dealer, a broker/dealer executes trades for his/her firm's own account. • Securities bought for the firm's own account may be sold to clients or other firms, or become a part of the firm's holdings.

15. Advice -Trust but Verify Individuals who work for broker-dealers: sales personnel whom most people call brokers are technically known as registered representatives (RR). • When a RR suggests that you buy or sell a particular security, they must have reason to believe that the recommendation is suitable for you based on a host of factors, including your income, portfolio, and overall financial situation, your tolerance for risk, and your stated investment objectives. • The products they can sell depend on SEC licenses they hold. A RR with a Series 6 license can sell only mutual funds, variable annuities, and similar products. A RR with a Series 7 license can sell a broader array of securities.

16. Advice -Trust but Verify Individuals who work for broker-dealers: Financial Analyst /Security Analyst • Performs detailed studies of individual securities and forms a judgment on their value as a stock price forecast (not business analysis) • No formal requirements for training but generally have a business school training or equivalent. Often CFA • Usually only speak to institutional or wealthy investors directly

17. Advice -Trust but Verify Investment Banker/Firm • Supplies new capital for expansion of industry • Engages in originating, underwriting, and selling new issues of securities • Normally sells to professional investor who is prudent and shrewd.

18. Advice -Trust but Verify • “Financial planners” Come from a variety of backgrounds and offer a variety of services. They could be brokers or investment advisers, insurance agents or practicing accountants—or they have no financial credentials at all. Some will examine your entire financial picture and help you develop a detailed plan for achieving your financial goals. Others will recommend only the products they sell, which may give you a limited range of choices. * CFP Certified Financial Planner * CFA Chartered Financial Analyst

19. Government Regulation of Abuses • 1924 First American open end mutual funds created • 1929 American Market Crash • Securities Act of 1933 “Truth in Securities” Law • Fund must provide prospectus with financial, management, and information to investors. Laws for selling fraudulent securities made • Securities Act of 1934 • Creates the Securities and Exchange Commission (SEC) with authority over securities industry to oversee, regulate, register clearing agencies, brokerage firms, transfer agent and SRO (self regulating organizations) like NYSE, AMEX, and later NASDAQ. • Revenue Act of 1936 • Investment companies pass through dividends to shareholders who pay tax. To prevent speculation no more than 30% of fund’s gross income could be derived from sale of securities held less than 3 months. Company could hold no more than 5% of assets in one company.

20. Government Regulation of Abuses • Investment Advisers Act of 1940 • Individuals and firms dealing in advice for compensation must register with the SEC. (amended 1996- 25M under management to register) • Investment Company Act of 1940 • Company must provide information to investors about their investment policies and financial condition upon original sale and then regular basis • Securities Investor Protection Act of 1970 • Establishes Securities Investor Protection Corporation (SPIC) to protect investors from a failed brokerage firm. If cash or securities are missing from an account (except fraudulent securities) most investors get their money back. • Securities Act Amendments of 1975 • SEC directed to establish National Market System for OTC Trading

21. Government Regulation of Abuses • 1976 SEC rule change- lifted federal law prohibiting tax exempt mutual funds by allowing dividend pass through on municipal funds • 1980 SEC rule change- 12b-1 rule. • Funds allowed to pay for distribution expenses out of funds. Old shareholders now paying for newly added shareholders. • Insider Trading Sanctions Act of 1984 • SEC can fine insider trading to triple of profits • Insider Trading Act of 1988 • More punishments for insider trading and pay for whistleblower • Sarbanes-Oxley Act of 2002 • Creates the public company accounting oversight board. The auditing profession is not to engage in fraud.

22. Typical Mutual Fund Complex Board of Directors/ Trustees Officers Shareholders Mutual Fund Investment Adviser Attorney/Legal Independent Public Accountant Principal Underwriter Transfer Agent Custodian Administrator

23. External Management Company Runs the fund for a fee • Covers office costs • Hires investment adviser • Handles distribution services • Commissions & fees paid to broker-dealers for selling fund shares • Marketing services- branding, direct mail, literature, promotions • Custodial • Operations: account tracking and maintenance, compliance, prospectus printed • Administration • bookkeeping, banking, insurance, forecasting,

24. Capital flow in a Mutual Fund Shares redeemed Shareholders & Shares purchased Capital gains paid out Mutual Fund Assets Management Fee 1-1.5% annual Dividend (stocks) Portfolio trading costs from turnover~ 0.25-3% Interest (bonds) Realized capital gains from securities sold Commissions, loads & 12b-1 fees Expenses not covered By Mgmt fee

25. Mutual Ownership Structurevs.Traditional Corporate Structure Mutual Traditional Mgmt. Co. Shareholders Fund Shareholders own own Management Company Mutual Funds controls own Mutual Funds Management Company own Fund Shareholders Bogle p. 376

26. Purchasing Funds • Direct purchase • From Salespeople (Broker, RR) Method determines how they get paid • A shares- Front end load. Charge up to 8.5% of sale Breakpoints for larger investments • B shares- Back end surrender charges. 12b-1 fees • If investor sold shares before commission paid off, usually at 1.5% to fund annually, get charged for commission & interest • C shares- Back end load. Pay charges after redeem • D shares- 1% paid to salesperson each year

27. Expense Ratios for Portfolios 1999 low avg high Equity MF 0.2% 1.5% 2.2% Balanced MF 0.2% 1.4% 1.8% Bond MF 0.2% 1.1% 1.5% Pension Fund 0.3% 0.7% 1.0% Bogle

28. 2008 Expense Ratios Avg Avg Vanguard Industry Active Funds 0.23% 1.32% Index Funds 0.18% 0.95% ETF 0.15 0.60% Barron’s, 1/12/2009, Market Funds 4Q08, p2

29. Book References • Common sense on mutual funds: New imperatives for the intelligent investor; John C. Bogle, 2000 • The rise of mutual funds: an insider’s view; Matthew P. Fink, 2008 • Stop wasting your wealth in mutual funds; Separately managed Accounts: the smart alternativ, Don F. Wilkinson, 2005. • How markets really work; Joel Kurtzman, 2002 • Complete guide to online investing: everything you need to know explained simply; Michelle Dawn Hooper, 2008 • Against the gods: the remarkable story of risk; Peter L. Bernstein, 1996