Lecture 18 Mutual Funds

Net Asset Value NAV = net asset value MVA = market value of assets L = funds liabilities NSO = number of shares outstanding

Sales Charges “Front-end” load—commission paid when shares are purchased. Load fees range from 0% to 8.5%. Some funds charge load fees on reinvested dividends! The fund’s prospectus may say “Dividend reinvested at offering price.”

Sales Charges “Back-end” load—a contingent deferred sales charge. Starts at 5 or 6%. Decreases by 1% per year. Load charges are ignored when a fund’s performance is reported. Historical performance of load and no-load funds.

Sales Charges 12b-1 charges. Covers distribution costs and commissions paid to brokers. Annual charge of 0.25% to 1.00% of fund’s assets. Some funds that are closed to new investors continue to charge 12b-1 fees!

Sales Charges Comparison of three funds. Fund A—6% “front-end” load fee. Fund B—6% “back-end” load fee that decreases by 1% per year. Fund C—No “front-end” load fee, a 1% annual 12b-1 fee and a “back- end” load fee that starts at 5% and decreases by 1% per month.

Sales Charges Some mutual funds have several classes of stock. Class A may have a “front-end” load fee of 5%. Class B may have a 12b-1 fee of 1% per year and a back-end load fee that begins at 5% and decreases by 1% per year.

Sales Charges Transaction and redemption charges. Paid when fund shares are purchased, liquidated, or exchanged into shares of another fund. Usually 1% of net asset value. Paid to fund rather than fund’s sponsors or sales representative.

Expense Ratios Investment advisory fees. Administrative expenses. Other operating expenses. 12b-1 fees. What counts is fund’s expense ratio which vary from 0.2% to 2.5%. A fund’s expense ratio is a key determinant of performance.

Invisible Costs Transaction costs associated with the fund buying and selling securities. Commissions: 0.1% to 0.5% Bid-Ask spreads: 0.125% to 6.0%. Price impact of a large block trade. Average transaction cost is estimated to be about 0.6%.

Invisible Costs A fund’s annual portfolio turnover is A fund’s transaction cost can be estimated by multiplying the fund’s annual portfolio turnover by 2 and then multiplying by the average transaction cost of 0.6%.

Taxes To maintain a tax-free status a fund must distribute at least 90% of its dividends and realized capital gains each year. Funds with high annual portfolio turnover realize more capital gains.

Taxes If you purchase a mutual fund just prior to the distribution of dividends or capital gains, you will pay taxes on income that you did not earn. Unrealized capital gains are a potential tax liability. Unrealized capital loses are a potential tax savings.

Performance Annual geometric rates of return from 1970 to Wilshire 5000 index 12.36% S&P500 index12.42% Lipper General Equity Fund Average11.08%

Performance Returns on market indexes ignore expenses. Expense ratio of Vanguard’s Wilshire 5000 Index Fund is about 0.25%. The turnover ratio is about 3%. The overall costs would be about 0.30%.

Performance Malkiel’s estimates of Jensen’s alpha. r i – r f =  + (r M - r f ) + e Wilshire 5000 p-value Net return-0.93% 7.5% Gross return 0.18% 71.1% S&P500 p-value Net return-3.20% 0.0% Gross return-2.03% 0.1%

Performance Elton, Gruber, Das and Hlavka r i – r f =  +   (r M - r f ) +  S (r S – r f ) +  D (r D – r f ) + e r M —return on S&P500 index. r S —return on a small stock index. r D —return on a bond index.  is negative, though generally not statistically significant.

Performance About 60% of above average funds in one year remain above average over the next 3 years. About 75% of below average funds in one year remain below average over the next 3 years.

Performance Persistence in relative performance across fund managers is: Mainly due to expenses and transaction costs, Concentrated at the extremes of best and worst performers.