Mutual Funds and Other Investment Companies

1. Mutual Funds and Other Investment Companies P.V. Viswanath For a First Course in INvestments

2. Learning Goals • What are investment companies? • What are the different kinds of investment companies? • What are the different kinds of mutual funds? • How are they sold? • What are exchange-traded funds?

3. Functions of Investment Companies • Record keeping and administration • Diversification and divisibility • Professional management • Active portfolio management • Tax minimization • Lower transaction costs

4. Types of Investment Companies • Unit Investment Trusts • Closed-end Mutual Funds where there is no trading in the underlying assets • Managed Investment Companies • Open-end funds (mutual funds) • Closed-end funds • Commingled funds • These are similar to mutual funds, but they are not open to all investors and hence have less regulation and disclosure • REITs • Corporate entities investing in real estate that pay out 90% of their income; in return they don’t have to pay corporate taxes • Hedge funds • Mutual funds that are structured as private partnerships and have minimal SEC regulation

5. Types of Mutual Funds • Money Market Funds • Equity Funds • Sector Funds • Concentrate on a particular sector • Bond Funds • International Funds • Invest in securities of firms located outside the US • Balanced Funds • Hold stocks and bonds; meant to be an individual’s entire portfolio • Life cycle funds take the investor’s age into account • Asset Allocation Funds and Flexible Funds • Index Funds

6. How Funds are Sold • Directly by the Fund Underwriter/Distributor, who • Creates prospectus for the fund • Develops marketing campaigns (tv, internet, magazine) • Sells the shares directly to the public • Provides a wholesale market to reach a larger number of investors • Indirectly through brokers or financial advisers • Funds pay brokers for preferential treatment when making investment recommendations – revenue sharing. Note conflict of interest! • Fund Supermarkets

7. Costs of Investing in Mutual Funds • Operating Expenses • Front-End Load • Back-End • 12b-1 charges • Soft dollars • A portfolio manager earns soft dollar credits with a brokerage firm by directing the fund’s trades to that broker. On the basis of these credits, the broker will pay for some of the fund’s expenses. Purchases made with soft dollars are not included in the fund’s expenses, so funds with soft-dollar arrangements may report artificially low expense ratios. However, the fund may have paid the broker needlessly high commissions; alternatively the broker may not provide good execution. This will show up in lower returns. But this signal is much noisier.. • Late Trading • The practice of allowing some traders to buy or sell after the market has closed and the NAV has been established – these traders can then time the market. • Tax inefficient trading • Unnecessary generation of capital gains, which are passed on investors and causes them to lose out on the timing option.

8. What’s an ETF (Exchange Traded Funds)? • Issues (or redeems) creation units in exchange for the deposit (or delivery) of basket assets the current value of which is disseminated per share by a national securities exchange at regular intervals during the trading day; • Identifies itself as an ETF in any sales literature; • Issues shares that are approved for listing and trading on a securities exchange; • Discloses each business day on its publicly available web site the prior business day's net asset value and closing market price of the fund's shares, and the premium or discount of the closing market price against the net asset value of the fund's shares as a percentage of net asset value; and • Either is an index fund, or discloses each business day on its publicly available web site the identities and weighting of the component securities and other assets held by the fund.

9. More on ETFs vs Mutual Funds • An ETF is similar to an open-ended fund in some ways – for example, there can be withdrawals from the fund and there can be additions to the fund. However, the way in which this happens is crucially different. • With an open-ended fund, investors sell back to the fund or invest additional money with the fund, which then buys additional shares. • With an ETF, investors buy from or sell shares to other investors. Addition to or reduction of the size of the fund occurs when entities called Authorized Participants (AP) exchange ETF shares for the shares of the financial assets (stocks in a stock ETF) that underlie the ETF. They buy or sell these financial assets in the open market. • The actions of these APs ensures that the ETF trading price is close to the NAV of the fund. This happens directly with an open-ended mutual fund because the fund stands ready to buy or sell at the NAV.

10. More on ETFs vs MFs • An ETF allows investors to trade during the day, while an investor in an open-ended mutual fund (MF) can only buy or sell at the end-of-day price. • ETF investors have relatively high transactions costs (brokerage fees) because their trades are likely to be small. In a MF, the fund does the trading and can do it more cheaply. • However, since an MF has to trade large amounts, market impact costs could be high; ETF trades don’t have this problem. However, an investor disinvesting from an MF doesn’t bear this cost because s/he gets the NAV. In other words, a MF investor buys illiquidity insurance, which is spread out among all the MF investors. • However this insurance is not valuable for the long-term investor who only trades infrequently. Hence, in equilibrium, MFs may have short-term investors, while ETFs may have long-term investors. • On the other hand, investors who believe they have above-average proficiency in short-term market timing would want to use ETFs. (The evidence suggests that most such investors have incorrect beliefs.)

11. More on ETFs vs MFs • According to an Economist article (Jan 2010), the average expense ratio for ETFs was 0.31% at the end of 2009, while it was about 0.78 for index-tracking MFs.