Mutual Funds and Other Investment Companies Chapter 4 Mutual Funds and Other Investment Companies McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

4.1 Investment Companies

Services of Investment Companies Administration & record keeping Tax purposes Low cost reinvestment Low cost additional investment, DCA Low cost switching between fund families Some funds may allow check writing privileges Immediate advantages Administer and keep track of all of your investments in one location. Keeps track of all of your distributions both capital gains and dividends. Will allow you to easily reinvest any distributions Allows for easy diversification. Difficult for small investors to do when buying securities on there own. Allows small investor to hold a fraction of a share in a company. Knowledgeable management of your portfolio. These managers generally have an MBA and plenty of experience trading securities. Economies of scale allow for reduced transaction costs.

Services of Investment Companies Diversification Professional management Reduced transaction costs Investing for retirement: Most funds can be set up as an IRA Low cost, instant diversification Lower research costs Portfolio managed according to specific objectives Professionals to find undervalued securities and/or engage in asset allocation strategies Immediate advantages Administer and keep track of all of your investments in one location. Keeps track of all of your distributions both capital gains and dividends. Will allow you to easily reinvest any distributions Allows for easy diversification. Difficult for small investors to do when buying securities on there own. Allows small investor to hold a fraction of a share in a company. Knowledgeable management of your portfolio. These managers generally have an MBA and plenty of experience trading securities. Economies of scale allow for reduced transaction costs.

4.2 Types of Investment Companies

Organizational Forms Unit Investment Trusts (UITs): unmanaged, fixed composition portfolios Any interest and/or dividends are distributed immediately to trust certificate holders. Provide diversification within one sector or area and low cost entry. Often levered, rates of return can be extreme.

Organizational Forms Managed Investment Companies: Managed, usually changing composition portfolio. ___________________________________ The fund's board of directors typically hires an investment advisor to select and manage the fund assets according to some specific goal(s) set by the board and any regulatory requirements. The investment advisor usually creates the fund and selects the investments. Most funds are of this type. More commonly known as a ‘mutual fund’

Organizational Forms A managed investment company (mutual fund) may be Open end shares are bought from the fund and redeemed by the fund or Closed end shares are bought and sold among investors in the marketplace (NASDAQ or an exchange) and the fund itself is not involved.

Closed End Mutual Funds

Differences in Open & Closed End Most funds are open end: The advantage of the open end form is The disadvantage of the open end form is Liquidity for the investor Fund’s ability to grow (advantage for the fund or sponsor) About 90% of investment company assets are held in mutual funds. For various reasons, actively managed mutual funds don't invest all the money at their disposal, but instead maintain cash balances of approximately 8%. Source: The Fool The need to keep a cash reserve Vulnerable to panics

Other Investment Organizations Commingled funds Partnerships of investors that pool their funds. Designed for trusts or larger retirement accounts to get professional management for a fee. Operates similar to a mutual fund. REITs Similar to closed end fund. Invest in real estate and real estate loans. Equity trusts purchase real estate. Mortgage trusts invest in mortgage and construction loans. Unit Trust- Fixed portfolio for the life of the fund, “unmanaged” portfolios. Managed Investment Company: A management team manages a portfolio for a fee.Open-End: This is the typical mutual fund an investor will buy. Here the fund issues or redeems shares at net asset value (NAV) For this reason cannot trade during day. Put in order during day. At end of day buy or sell at NAV price. Closed End funds trade like stocks on an exchange. Price can differ from NAV. Some trade at a premium and many trade at a discount. See p. 102 Commingled Funds: Similar to mutual fund. Designed for trusts or large retirement accounts to get professional management for a fee. Real Estate Investment Trusts: Similar to closed end fund. Invest in real estate and real estate loans. Equity trusts in real estate. Mortgage trusts in mortgage and construction loans Hedge Fund: Similar to Mutual Funds, but not registered and not subject to SEC regs. Rich investors. Can pursue investment strategies that are not allowed for mutual funds.

Other Investment Organizations Cont. Hedge Funds Similar to mutual funds, but not registered and not subject to SEC regulations. Available to institutional and high net worth investors Can pursue investment strategies that are not allowed for mutual funds. Incentive fees may be as high as 20% of profits! Began dropping mid-2008 on due to credit crisis. Grew from about $50 billion in 1990 to about $2 trillion in 2008.

4.3 Mutual Funds

Net Asset Value Used as a basis for valuation of investment company shares Selling new shares Redeeming existing shares Calculation At the end of each day a NAV is calculated for the fund. In mutual funds this is the value used to buy or sell your shares.

Open-End and Closed-End Funds: Key Differences Shares Outstanding Closed-end: no change unless new stock is offered Open-end: changes when new shares are sold or old shares are redeemed Pricing Open-end: Fund share price = Net Asset Value (NAV) Closed-end: Fund share price may trade at a premium or discount to NAV Since closed end is like stock cannot redeem, must sell to another investor. Can only increase shares outstanding by having a new issue of more shares.

NAV calculation ABC Fund ($Millions except NAV) Market Value Securities + Cash & Receivables - Current Liabilities NAV Total  # Fund Shares NAV Most Mutual Funds have little or no Long Term Debt $550.00 75.00 (20.00) $605.00 20.00 $ 30.25 Investment company act of 1940 limits ability of mutual funds (MF) to employ leverage without tax disadvantage.

How Funds Are Sold Directly marketed Sales force distributed You find them May avoid front end load Front end load is an up front cost (fee) to purchase a share of a mutual fund. About ½ of funds are directly marketed. Revenue sharing: Fund company pays the broker for preferential treatment when making investment recommendations. Recommended by a broker or planner Usually will have a front end load May be revenue sharing on sales force distributed Potential conflict of interest

Potential Conflicts of Interest: Revenue Sharing Brokers put investors in funds that may that ____________________________ Mutual funds could direct trading _____________________ Revenue sharing is _________ but it must be ________ to the investor may not be the most appropriate to higher cost brokers not illegal disclosed

How Funds Are Sold Financial supermarkets E.G., Charles Schwab Avoid a direct load, but may cost you more in expenses Low cost switching even between fund families and easier to interpret record keeping

Funds & Investment Objectives Domestic Stock Funds Aggressive Growth Growth Growth & Income Countercyclical Sector, Small Cap Growth, Mid Cap Growth* Investment characteristics Focus on capital gains, low income High turnover Substantial potential for capital loss Large Cap Growth Small, Med, Large Blend Small, Med, Large Value Small Cap < $1 billion (Hot Topic (Ticker HOTT)), Mid Cap $1-$5 billion, (Barnes and Noble) Large Cap > $5 bill (GE) Each mutual fund has a specified investment policy. Money Market fund: Invests in money market securities. Allows easy access to this market. Fixed Income- Invests in the fixed income sector. Equity- Primarily in stocks. Income funds (high dividend yields) Growth ( higher risk low yields) Balance and Income-Try to act like a fund for an individuals entire portfolio. (well rounded mix) Asset Allocation: Similar to Bal & Income, but weigh sectors based on manager forecasts (riskier) Index Funds ( Passively managed portfolio replicating an index. Specialized sector funds (Industry or geography specific. This section draws heavily from ideas in “A Random Walk Down Wall Street,” by Burton Malkeil Compatible Investor Goals Long time horizon Financial ability to remain in the markets Ability to handle losses Bear Market *Morningstar fund definitions

Funds & Investment Objectives Index Funds Broad market Industry or market sector International market Size subset Investment characteristics Goal is to duplicate the performance of an index or market sector. Low turnover, low expenses Compatible Investor Goals Investors who believe in ‘efficient markets’ and are seeking market returns with minimal expenses and turnover. Stock funds still require ability to handle risk and staying power.

Funds & Investment Objectives Balanced funds Allocation Funds Target Date Funds World, moderate, conservative Convertibles Near term (to 2014), Intermediate (2015-2029), Long term (2030+) Investment characteristics Hold both stocks and bonds, allocations may vary over time Turnover varies Higher income, lower capital gains & lower potential for capital loss Compatible Investor Goals Intermediate to long time horizon Willing to face higher tax liability Some ability to handle losses

Funds & Investment Objectives Fixed Income funds Federal Government Corporate Investment characteristics Focus on income and current yield Lower potential for capital loss, inflation risk higher Short, Intermediate, Long Inflation Protected Ultrashort, Short, Intermediate, Long High Yield, Multisector Emerging Markets, World Bank Loans Compatible Investor Goals Short to moderate time horizon okay Understand tax liability Adds diversification, income and safety

Funds & Investment Objectives Investment characteristics Risk varies, but can be high, FX exposure Expense ratios can be high Substantial potential for capital loss International Stock Funds Foreign Global or World Geographic region Emerging markets Size and Value/Growth Size and Value/Growth Compatible Investor Goals Longer time horizon Investor seeking diversification and/or higher returns Ability to remain in the markets & handle losses

Funds & Investment Objectives Investment characteristics Focus on safety of principal and income Earn more than on bank accounts with little additional risk Money market funds Taxable Tax Exempt Compatible Investor Goals Short time horizon Add stability to a portfolio Potentially large opportunity losses & inflation risk MMMF: NAV is fixed at $1, so no cg or cl, just income distirbutions.

Table 4.1 U.S. Mutual Funds by Investment Classification, 2008

Trading Scandal with Mutual Funds Late trading: allowing some investors to purchase or sell after NAV has been determined for the day Market timing: allowing investors to buy or sell on stale net asset values International: fund NAV may be based on prices in foreign markets which close at different times. A U.S. mutual fund specializing in Japanese stocks may create an exploitable opportunity since the Japanese markets close before ours, at which time the fund’s NAV will be set. If the U.S. markets subsequently go up late in the day, probably Japanese stocks will go up the next day, driving up NAV for the fund the next day. Late Trading: At 4:00 pm the markets close and NAV is figured at $50 / share. Good news comes out at 4:30. When trading resumes tomorrow the fund assets will increase and NAV will go up. Late trading: Allow certain fund investors to buy at $50 after markets have closed. This is illegal. Market timing is a variation on the same theme that exploits different closing times of foreign markets (see the example on the slide) This one is not illegal.

Trading Scandal with Mutual Funds Net effect? Transfer wealth from existing owners to the new purchasers or sellers At 4:00 pm NAV the markets close and NAV is figured at $50 / share. Good news comes out at 4:30. When trading resumes tomorrow the fund assets will increase and NAV will go up. Late trading: Allow certain fund investors to buy at $50 after markets have closed. This is illegal. Market timing is a variation on the same theme.

Potential Reforms Strict _____________ with late orders executed the following trading day ________________ with net asset values being adjusted for trading in open markets Imposition of __________________________________ 4:00 PM cutoff Fair value pricing Funds paid > $1.65 billion to settle allegations. Mutual fund board director must now be independent of fund sponsor Fair value: If there is a big move in the U.S. for example we may adjust up the market value of the foreign holdings in the closed markets. redemption fees on holdings < 1 week

4.4 Costs of Investing in Mutual Funds

Costs of Investing in Mutual Funds Fee Structure Operating expenses 12 b-1 charges Front-end load Back-end load (contingent), (redemption fee) Buying and selling commissions, administrative expenses and advisory fees for the managers 12b-1 max used to be 1.25%. Actually now 0.75%, but you can have a service fee of 0.25%. In mutual fund quotes, r = redemption fee, p means there is a 12b-1 fee and T means there are both. Quotes do not identify front end loads. Front-End. A commission or sales charge paid when you buy into a fund. Generally given to the broker who sells the fund. Rip-off Back-End. Redemption or exit fee. These may be more useful since there are costs to all investors when investors cash out of the fund. Operating expenses- Buying and selling commissions, Administrative Expenses and advisory fees for the managers. 12 b-1 Annual fees to pay for marketing and distribution costs. Fact is that these fees can have a huge effect on your annual returns. High fees generally lower returns. Marketing costs paid by the fundholders Alternative to a load, but assessed annually Maximum is 1% of assets

Costs of Investing in Mutual Funds Fees, loads and performance Gross performance of load funds is statistically identical to gross performance of no load funds Why pay a load charge? Funds with high expenses tend to be poorer performers. 12 b-1 charges should be added to expense ratios Costs found in the fund prospectus and may be compared via Morningstar Harder to avoid than you might think. 12b-1 is increasingly prevalent.

NAV and the Effective Load Cost to initially purchase one share of a load fund = NAV + front-end load (%) (if any). Stated Loads typically range from ________ If you invest $10,000 in a fund with an 8.5% front-end load, you actually acquire shares worth $9,150; the other $850 goes to the broker. The load is designed to offset expenses of marketing the fund and goes to the broker who sells the fund to the investor. The effective load is greater than the stated load: In the above example, the actual % commission cost (effective load) is: $850 / $9150 = 9.3%; which is > stated load. 0 to 8.5% This is usually a round trip commission that has been in effect prepaid. 8.5% is the regulatory maximum, but rare to see anything over 6%. Load charges are larger than round trip commissions on stocks.

Costs of Investing in Mutual Funds Avoiding the load: Can sometimes choose different class of fund shares. Best alternative may depend on _______________________________________. Harder to avoid than you might think. 12b-1 is increasingly prevalent. amount invested and expected holding period

Costs of Investing in Mutual Funds Expense ratios: Funds charge annual operating expenses and annual advisory or management fees against the NAV. Expense ratios are calculated as Annual Expenses / Average NAV A "well managed" fund probably should have an expense ratio of less than ___. All costs and charges must be revealed in the fund's prospectus. NOTE: Book examples and mine use EOP NAV to calculate expenses Harder to avoid than you might think. 12b-1 is increasingly prevalent. 2%

Converting gross pretax returns to net pretax returns: Amount initially invested = Amount after gross return = Amount after fees = Net rate of return = In MF prospectus and annual reports the MF returns are net of operating expenses, 12b-1 fees and commissions, but the returns do not include loads. $10,000 – (0.06 x $10,000) = $9,400 $9,400 x 1.175 = $11,045 $11,045 - (0.0135 x $11,045) = $10,895.89* ($10,895.89 - $10,000) / $10,000 = 8.96% This example takes expense ratio off of ending NAV. * This example calculates expenses using ending NAV.

Table 4.2 Impacts of Costs on Investment Performance Tough to figure actual expense ratio with soft dollar commissions P. 109, supposedly will be used less now. Conclusions? Optimal choice fee structure is Time dependent Investment size dependent

HPR on mutual funds Dist = Distribution All distributions are taxable, even if reinvested in the fund. Do not buy into a MF just before its distribution date (usually near the end of the year or quarter). HPR = Holding period return (remind them)

4.5 Taxation of Mutual Fund Income

General Tax Rules The fund itself is not taxed as long as Fund meets certain diversification requirements Fund distributes virtually all income earned (less fees and expenses) to fund shareholders The investor is taxed on capital gain and dividend distributions at the investor’s appropriate tax rate. Distribution requirements imply that portfolio turnover may affect an investor’s tax liability.

Taxes and Mutual Funds Investor directed portfolios _______________________ can be structured to take advantage of taxes while mutual funds cannot High turnover leads to _________________ More disclosure on taxes was required ________ Investor directed portfolios greater tax liability in 2002 After-tax returns now reported in prospectus Table in the prospectus shows the effects of taxes on our investment Disclosure of mutual fund after-tax returns SEC rule requiring all mutual funds to state explicitly their after-tax returns in their prospectuses, starting February 15, 2002. (The Fool) For more information on taxes see: IRS Publication 564: Mutual Fund Distributions

Implications of Fund Turnover The fund itself pays commission costs on purchases and sales of portfolio holdings, which are charged against NAV. The turnover rate is measured as the ______________ _____________ in a year divided by the ____________ __________. These commissions are lower than what you and I pay. Total commission expenses are higher if the portfolio has higher turnover. total asset value bought or sold average total asset value

Implications of Fund Turnover For example, if a fund had an average total asset value of $10 million, and $6 million of securities were bought or sold that year the turnover rate was ____ Can you figure the average security holding period from the turnover ratio? Turnover rates vary from ______________ per year. 60%. Average holding period or AHP AHP = 0.5 x (1 / turnover ratio) AHP = 0.5 x (1 / 0.60) = 0.83 years If the fund's annual turnover is 50%, the average holding period is 1 year. For 100% turnover, the average holding period is 1/2 year. Take 0.5 x (1 / turnover) to get the average holding period. < 5% to > 300%

4.6 Exchange Traded Funds

Exchange Traded Funds ETFs allow investors to trade index portfolios like shares of stock Examples: Potential advantages SPDRs and Diamonds, Cubes, WEBS Trade continuously throughout the day Can be sold short or purchased on margin Potentially lower taxes No fund redemptions Large investors can exchange their ETF shares for shares in the underlying portfolio Lower costs (No marketing; lower fund expenses) Relatively new way of investing in an index portfolio. The price of a unit of the SPDR should equal the value of the S&P500 / 10. SPDR = Standard and Poor’s Depository Receipt, DIA or Diamonds are DJIA, Cubes or QQQ based on the Nasdaq 100, WEBS = World Equity Benchmark shares Can trade throughout the trading day. Do not have to wait for the end of the day NAV. Mutual funds redemptions can trigger asset sales that generate tax liability Lower taxes The exchange by large investors is non-taxable Taxes: Mutual funds often must pay capital gains taxes when many investors cash out of the fund since the fund must sell securities to payout to the investors. ETF shares are merely sold to another investor! Mutual Funds can limit this problem by putting on short-term trading expenses to minimize short-horizon investors in the fund. Less marketing = Less management fees. Broker fees, bid-ask spread Ability of large investors to exchange shares for share in the underlying portfolio creates arbitrage strategies that helps ensure the ETF value does not stray far from "NAV"

Exchange Traded Funds Potential disadvantages Small deviations from NAV are possible Must pay a brokerage commission to buy an ETF but a no load index fund may be purchased online for no commission. Relatively new way of investing in an index portfolio. SPDR = Standard and Poor’s Depository Receipt, DIA or Diamonds are DJIA, Cubes or QQQ based on the Nasdaq 100, WEBS = World Equity Benchmark shares Can trade throughout the trading day. Do not have to wait for the end of the day NAV. Mutual funds redemptions can trigger asset sales that generate tax liability Lower taxes The exchange by large investors is non-taxable Taxes: Mutual funds often must pay capital gains taxes when many investors cash out of the fund since the fund must sell securities to payout to the investors. ETF shares are merely sold to another investor! Mutual Funds can limit this problem by putting on short-term trading expenses to minimize short-horizon investors in the fund. Less marketing = Less management fees. Broker fees, bid-ask spread

Table 4.3 ETF Sponsors and Products Not in notes MCSI is a typo, should be MSCI

Figure 4.2 Growth in ETF Assets

4.7 Mutual Fund Investment Performance: A First Look

First Look at Mutual Fund Performance Evidence shows that average mutual fund performance is generally ________ broad market performance Evidence suggests that over certain horizons ________________ in positive performance Evidence is _____________ less than some persistence not conclusive Some inconsistencies

First Look at Mutual Fund Performance Consistency of performance of mutual funds NOTE: The majority of the persistent poor performers had higher expense ratios than the norm. What does that tell us? Conclusion? Historical performance is not necessarily a good predictor of future performance.

Figure 4.3 Diversified Equity Funds versus Wilshire 5000 Index Lipper: Fund average; Wilshire is unmanaged index return

4.8 Information on Mutual Funds

Sources of Information on Mutual Funds Wiesenberger’s Investment Companies Morningstar (www.morningstar.com) Fund prospectus (a must read) Yahoo Wall Street Journal Investment Company Institute (www.ici.org) AAII Brokers Background information: “A Random Walk Down Wall Street,” by Burton Malkeil WSJ online, Schwab and Morningstar provide links to fund prospectus (biz.yahoo.com / funds)

Figure 4.4 Morningstar Report Be careful with using the ratings. newer evidence indicates they aren’t very useful at predicting future winners, actually poor ratings do have some predictive ability, but not good ratings (star ratings).

Morningstar Report Cont. WSJ online, Schwab and Morningstar provide links to fund prospectus

Sample Problems

Problem 1 NAV is $10.70 Front-end load is 6% Every dollar paid results in only ____ going toward purchase of shares. Offer price = $.94 NAV = 1 - load $10.70 = 1-.06 $11.38 58

Problem 2 Offer price $12.30 Front-end load is 5% Every dollar paid results in only ____ going toward purchase of shares. NAV = = $12.30 x 0.95 = $11.69 $.95 offer price x (1- load) 59

Problem 3 NAV = (Market Value of Assets – Liabilities)  Shares Outstanding A. (200,000)x($35) = $ 7,000,000 B. (300,000)x($40) = $12,000,000 C. (400,000)x($20) = $ 8,000,000 D. (600,000)x($25) = $15,000,000 $42,000,000 $42,000,000 – $30,000 = $10.49 = NAV 4,000,000 Liabilities $30,000 Shares Outstanding 4,000,000 60

Problem 4 AHP = 0.5 x 1/Turnover Turnover rate = Value of stocks sold and replaced Market Value Assets Value of stocks sold = (600,000x$25)= $15,000,000 or Value of stocks purchased = (200kx$50)+(200kx$25) = $15,000,000 $15,000,000 = 0.357 or 35.7% $42,000,000 Average holding period? MVA = $42M Market Value Assets = $42,000,000 AHP = 0.5 x 1/Turnover = 0.5 x 1/0.357 = 1.4 yrs 61

Problem 5 The empirical research suggests that past performance is not highly predictive of future performance, especially for better performing funds. There may be some tendency for the fund to perform better than average next year, but it is unlikely that the fund will be in the top 10%. Evidence suggests that bad performance is more likely to persist. Probably related to high fund costs or high turnover rates. Excessive costs are detrimental to a fund’s returns. 62

Problem 6 As an initial approximation, your return equals the return on the shares minus the total of the expense ratio and purchase costs: Return  12%  1.2%  4% = 6.8% But the precise return is less than this because the 4% load is paid up front, not at the end of the year. To purchase the shares, you would have had to invest: $20,000 / (1  0.04) = $20,833 The shares net increase in value (12%  1.2%) from $20,000 to: $20,000  (1.12  0.012) = $22,160 The rate of return is: ($22,160  $20,833) / $20,833 = 6.37% 63

Problem 7 Sell after 4 years: Suppose you have $1000 to invest. The initial investment in Class A shares is ____ net of the front-end load. After 4 years, your portfolio will be worth: $940  (1.10)4 = $1,376.25 Class B shares allow you to invest the full $1,000, but your investment performance net of 12b-1 fees will be only 9.5%, and you will pay a 1% back-end load fee if you sell after 4 years. Your redemption value after 4 years will be: $1,000  (1.095)4 x 0.99 = $1,423.28 Class B shares are the better choice if your horizon is 4 years. $940 64

Problem 7 Cont. Sell after 15 years: With a 15-year horizon, the Class A shares will be worth: $940  (1.10)15 = For the Class B shares, there is no back-end load in this case since the horizon is greater than 5 years. Therefore, the value of the Class B shares will be: $1,000  (1.095)15 = At this longer horizon, Class A shares are the better choice. Why? What is the breakeven time? $940 x (1.10)N = $1,000 x (1.095)N [$1,000 / $940 ] = (1.10)N / (1.095)N 1.06383 = [1.10 / 1.095]N LN 1.06383 = LN [1.10 / 1.095]N LN 1.06383 = 0.061875 = N x 0.004556 N = 13.581 years $3,926.61 The effect of Class B's 0.5% 12b-1 fees cumulates over time and finally overwhelms the 6% load charged to Class A investors. N x LN [1.10 / 1.095] $3,901.32 65

Problem 8 Suppose that finishing in the top half of all portfolio managers is purely luck, and that the probability of doing so in any year is exactly 50%. Then the probability that any particular manager would finish in the top half of the sample five years in a row is 0.505 = 0.03125. We would then expect to find that [350  0.03125]  11 managers finish in the top half for each of the five consecutive years. Thus, we should not conclude that the consistent performance after five years is proof of skill. We would expect to find eleven managers exhibiting precisely this level of "consistency" even if performance is due solely to luck. 66

Problem 9 Trading costs will reduce the portfolio return by (0.4%)x(0.50)= 0.2% Over many years of savings these costs can greatly reduce the value of your portfolio. Remember also that the high turnover rate can have tax consequences that further reduces your after-tax return. 67