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Chapter 4 Chapter 4 Mutual Funds Mutual Funds

Chapter 4 Mutual Funds Mutual Funds

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Page 1: Chapter 4 Mutual Funds Mutual Funds

Chapter 4Chapter 4

Mutual FundsMutual Funds

Page 2: Chapter 4 Mutual Funds Mutual Funds

Mutual FundsMutual Funds

Our goal in this chapter is to understand Our goal in this chapter is to understand the different types of mutual funds, their the different types of mutual funds, their risks and returnsrisks and returns

Page 3: Chapter 4 Mutual Funds Mutual Funds

Staggering StatsStaggering Stats

In 1980, 5 million Americans owned In 1980, 5 million Americans owned mutual fundsmutual funds

By 2001By 200193 million Americans owned mutual funds93 million Americans owned mutual fundsMutual fund assets totaled $7 trillionMutual fund assets totaled $7 trillion

Yes, that’s $7,000,000,000,000Yes, that’s $7,000,000,000,000

**As of October 2007, $12.3 trillionAs of October 2007, $12.3 trillion

Page 4: Chapter 4 Mutual Funds Mutual Funds

Stocks vs. Mutual FundsStocks vs. Mutual Funds

$10,000 invested in $10,000 invested in individual stocksindividual stocks Pay commissions on Pay commissions on

each stock purchasedeach stock purchased Possible difficulty in Possible difficulty in

diversificationdiversification

$10,000 invested in a $10,000 invested in a mutual fundsmutual funds Pay bundled expenses Pay bundled expenses

through the fund for through the fund for active managementactive management

DiversificationDiversification

Page 5: Chapter 4 Mutual Funds Mutual Funds

Mutual FundsMutual Funds

Mutual funds are Mutual funds are Financial IntermediariesFinancial Intermediaries Investment companies that pool the funds of a Investment companies that pool the funds of a

large group of investorslarge group of investorsManaged by fund managers who make the Managed by fund managers who make the

buying and selling decisionsbuying and selling decisions

Page 6: Chapter 4 Mutual Funds Mutual Funds

Organization and CreationOrganization and Creation

A mutual fund is a corporationA mutual fund is a corporationOwned by shareholdersOwned by shareholders

Created by investment advisory firmsCreated by investment advisory firmsFirms earn fees for managing mutual fundsFirms earn fees for managing mutual funds

Page 7: Chapter 4 Mutual Funds Mutual Funds

Investment CompaniesInvestment CompaniesRecord keepingRecord keeping

Periodic status reports are issuedPeriodic status reports are issued

Diversification and divisibilityDiversification and divisibilityInvestors can hold fractional shares of many Investors can hold fractional shares of many

stocksstocks

Professional managementProfessional managementAnalysts and port. managers looking for superior Analysts and port. managers looking for superior

investment resultsinvestment results

Lower transactions costsLower transactions costsBlock trading saves money on brokerage fees and Block trading saves money on brokerage fees and

commissionscommissions

Page 8: Chapter 4 Mutual Funds Mutual Funds

Investment Companies and Fund Investment Companies and Fund TypesTypes

Investment company – business that Investment company – business that specializes in pooling funds from individual specializes in pooling funds from individual investors and making investmentsinvestors and making investments

Page 9: Chapter 4 Mutual Funds Mutual Funds

Investment Company Investment Company ClassificationsClassifications

Unit Investment TrustsUnit Investment TrustsNot actively managedNot actively managed Invest in relatively uniform types of assetsInvest in relatively uniform types of assets

ORORManaged Investment CompaniesManaged Investment Companies

Actively managedActively managed

Page 10: Chapter 4 Mutual Funds Mutual Funds

Investment Companies and Fund Investment Companies and Fund TypesTypes

Investment companies

Open-end funds Closed-end funds

Money market funds Long-term funds

Stock funds

Bond funds

Blended funds

Page 11: Chapter 4 Mutual Funds Mutual Funds

Investment Companies and Fund Investment Companies and Fund TypesTypes

Open EndOpen End Issue and redeem Issue and redeem

shares at their net shares at their net asset value (NAV)asset value (NAV)

NAV = (market value NAV = (market value of assets - of assets - liabilities)/shares liabilities)/shares outstandingoutstanding

Offering price may Offering price may exceed NAV b/c of a exceed NAV b/c of a “load”“load”

Closed EndClosed End Do not issue or Do not issue or

redeem sharesredeem shares must buy or sell must buy or sell

shares to other shares to other investors (many traded investors (many traded at NYSE)at NYSE)

Usually sell at a Usually sell at a discountdiscount

Can be traded all dayCan be traded all day Can be traded on Can be traded on

marginmargin

Page 12: Chapter 4 Mutual Funds Mutual Funds

Investment Companies and Fund Investment Companies and Fund TypesTypes

Net asset value (NAV) is the value of the Net asset value (NAV) is the value of the assets held by a mutual fund, divided by assets held by a mutual fund, divided by the number of sharesthe number of sharesShares in an open-end fund are worth their Shares in an open-end fund are worth their

NAVNAVShares of closed-end funds may differ from Shares of closed-end funds may differ from

their NAVtheir NAV

Page 13: Chapter 4 Mutual Funds Mutual Funds

Short-Term FundsShort-Term Funds

Money market mutual funds (MMMFs)Money market mutual funds (MMMFs)Specialize in money market instrumentsSpecialize in money market instrumentsMaintain a $1.00 NAV to resemble bank Maintain a $1.00 NAV to resemble bank

accountsaccountsCan be taxable or tax-exemptCan be taxable or tax-exempt

Page 14: Chapter 4 Mutual Funds Mutual Funds

Stock FundsStock Funds

Capital appreciation and dividend incomeCapital appreciation and dividend incomeCapital appreciationCapital appreciationGrowthGrowthGrowth and IncomeGrowth and IncomeEquity incomeEquity income

Company sizeCompany sizeSmall capSmall capMid-capMid-capLarge capLarge cap

Page 15: Chapter 4 Mutual Funds Mutual Funds

Stock FundsStock Funds

InternationalInternationalGlobalGlobalEmerging marketsEmerging markets

Sector FundsSector FundsBiotechnologyBiotechnology InternetInternetEnergyEnergy

Page 16: Chapter 4 Mutual Funds Mutual Funds

Stock FundsStock Funds

Other FundsOther Funds Index fundsIndex fundsSocially conscience fundsSocially conscience fundsSin fundsSin fundsTax-managed fundsTax-managed funds

Page 17: Chapter 4 Mutual Funds Mutual Funds

Bond FundsBond Funds

Government debtGovernment debtCorporate debtCorporate debtTax-plannedTax-planned

Page 18: Chapter 4 Mutual Funds Mutual Funds

Stock and Bond FundsStock and Bond Funds

Funds that do not invest exclusively in Funds that do not invest exclusively in either stocks or bondseither stocks or bondsBalanced fundsBalanced funds

Weighting of assets may be restrictedWeighting of assets may be restrictedAsset allocation fundsAsset allocation funds

Freedom in allocation between stocks and bondsFreedom in allocation between stocks and bondsConvertible fundsConvertible funds

Bonds and preferred stock that converts to Bonds and preferred stock that converts to common stockcommon stock

Income fundsIncome funds

Page 19: Chapter 4 Mutual Funds Mutual Funds

ValuationValuation

Valuation is based on the net asset valueValuation is based on the net asset valueNAV is the value of each share in an NAV is the value of each share in an

investment companyinvestment company

NAV = NAV = Market value of assets less liabilitiesMarket value of assets less liabilities

Shares outstandingShares outstanding

Page 20: Chapter 4 Mutual Funds Mutual Funds

Fund ValuationFund Valuation

Given the data below, calculate the NAV Given the data below, calculate the NAV for the fund below (#s in millions)for the fund below (#s in millions)AssetsAssets LiabilitiesLiabilities

$13,857$13,857 $1,522$1,522

Shares outstanding: 313Shares outstanding: 313

NAV =NAV =

Page 21: Chapter 4 Mutual Funds Mutual Funds

Fund Rates of ReturnFund Rates of Return

You invested in a mutual fund with a $20 You invested in a mutual fund with a $20 NAV. At the end of the year, the NAV rose NAV. At the end of the year, the NAV rose 8%. A dividend of $0.20 was paid. What 8%. A dividend of $0.20 was paid. What is the rate of return on your fund?is the rate of return on your fund?

NAVNAV11 - NAV - NAV00 + Income/Div. Distributions + Income/Div. Distributions

NAVNAV00

Page 22: Chapter 4 Mutual Funds Mutual Funds

Taxation of Investment CompaniesTaxation of Investment Companies

A “regulated investment company” does A “regulated investment company” does not pay taxes on its investment incomenot pay taxes on its investment income

To qualify:To qualify:Almost all assets in stocks, bonds and other Almost all assets in stocks, bonds and other

securitiessecuritiesMaintain a 50% diversified portfolio and use Maintain a 50% diversified portfolio and use

<5% of its assets when acquiring a particular <5% of its assets when acquiring a particular securitysecurity

Pass through all realized investment income Pass through all realized investment income to fund shareholdersto fund shareholders

Page 23: Chapter 4 Mutual Funds Mutual Funds

Fund Prospectus and Annual Fund Prospectus and Annual ReportReport

Legally required to supply a prospectusLegally required to supply a prospectus

Must provide annual report to Must provide annual report to shareholdersshareholders

Page 24: Chapter 4 Mutual Funds Mutual Funds

Types of Expenses and FeesTypes of Expenses and Fees

Sales charges or “loads”Sales charges or “loads”Front-end load - charged on purchaseFront-end load - charged on purchaseBack-end load – charged on redemptionBack-end load – charged on redemption

12b-1 fees12b-1 feesMarketing and distributionMarketing and distributionSEC rule allows funds to spend up to 1%SEC rule allows funds to spend up to 1%

Management feesManagement feesTrading costsTrading costs

Page 25: Chapter 4 Mutual Funds Mutual Funds

Types of Expenses and FeesTypes of Expenses and Fees

Management feesManagement feesRange from 0.25%-1% of total assets each Range from 0.25%-1% of total assets each

yearyearUsually tied to fund size or performanceUsually tied to fund size or performance

Trading costsTrading costsNot reported directlyNot reported directlyTurnover must be reportedTurnover must be reported Increase as turnover increasesIncrease as turnover increases

Page 26: Chapter 4 Mutual Funds Mutual Funds

Trading and TurnoverTrading and Turnover

Your mutual fund holds the securities Your mutual fund holds the securities below:below:

If the manager replaces Stocks B and D If the manager replaces Stocks B and D with shares of a new Stock, E, what is with shares of a new Stock, E, what is the turnover rate?the turnover rate?

Stock Shares PriceA 200,000 35$ 7,000,000.00$ B 300,000 40$ 12,000,000.00$ C 400,000 20$ 8,000,000.00$ D 600,000 25$ 15,000,000.00$

Page 27: Chapter 4 Mutual Funds Mutual Funds

Expense ReportingExpense Reporting

Required to report expenses in a Required to report expenses in a standardized waystandardized wayShareholder transaction expensesShareholder transaction expenses

Loads and deferred sales chargesLoads and deferred sales charges

Fund operating expensesFund operating expensesManagement and 12b-1 feesManagement and 12b-1 feesAccounting, legal, reporting and director feesAccounting, legal, reporting and director fees

Hypothetical example showing total expenses Hypothetical example showing total expenses paid over time per $10,000 investedpaid over time per $10,000 invested

Page 28: Chapter 4 Mutual Funds Mutual Funds

How do “loads” affect your investment?How do “loads” affect your investment?

Fee structure on your investment (assuming Fee structure on your investment (assuming a 12% annual rate of return before expenses)a 12% annual rate of return before expenses) Fund A - No load, .5% operating expenses, no 12b-1Fund A - No load, .5% operating expenses, no 12b-1 Fund B - No load, 1% operating expenses, .5% 12b-1Fund B - No load, 1% operating expenses, .5% 12b-1 Fund C - 8% load, 1% operating expense, no 12b-1Fund C - 8% load, 1% operating expense, no 12b-1

Fund A Fund B Fund CInitial Inv. 10,000 10,000 9,200 5 yrs 17,234 16,474 15,502 10 yrs 29,699 27,141 26,123 15 yrs 51,183 44,713 44,018

Page 29: Chapter 4 Mutual Funds Mutual Funds

Why Pay Loads and Fees?Why Pay Loads and Fees?

Many good no-load funds existMany good no-load funds existMany bad load funds existMany bad load funds existYou may wish to invest inYou may wish to invest in

A fund with a specific managerA fund with a specific manager

A fund that specializes in foreign companiesA fund that specializes in foreign companies

Page 30: Chapter 4 Mutual Funds Mutual Funds

Exchange Traded FundsExchange Traded Funds

Price movements are based on the value of the Price movements are based on the value of the underlying indexunderlying index Only operating expensesOnly operating expenses

Do not require active managementDo not require active management Subject to the bid-ask spreadSubject to the bid-ask spread Closed-end funds, can be traded all dayClosed-end funds, can be traded all day Must be purchased from brokers for a feeMust be purchased from brokers for a fee

Popular ETFsPopular ETFs SpiderSpider DiamondsDiamonds CubesCubes

Page 31: Chapter 4 Mutual Funds Mutual Funds

Why Trade with ETFs?Why Trade with ETFs?

Mutual fundsMutual funds Receive cash from Receive cash from

investors and buys investors and buys stocks with cashstocks with cash

Sells stocks to obtain Sells stocks to obtain cash when investor cash when investor redeems sharesredeems shares

Trade only at NAV as Trade only at NAV as priced at the end of priced at the end of each trading dayeach trading day

ETFsETFs Create shares by Create shares by

depositing a portfolio depositing a portfolio of shares matching of shares matching indexindex

Margin eligibilityMargin eligibility Tradable throughout Tradable throughout

the daythe day

Page 32: Chapter 4 Mutual Funds Mutual Funds

Quick QuizQuick Quiz

Why do people invest in mutual funds?Why do people invest in mutual funds?What is the difference between a load and What is the difference between a load and

a fee?a fee?What is an ETF?What is an ETF?