INDIRECT INVESTMENT - MUTUAL FUNDS Dr. BALAMURUGAN MUTHURAMAN Chapter

MUTUAL FUNDS Definition: Financial intermediary through which savers pool their monies for collective investment, primarily in publicly trades securities. A fund is “mutual” in the sense that all of its returns minus its expenses, are shared by its shareholders. Returns consist of dividends, realized and unrealized capital gains (losses) Expenses consist of advisory fee for servicing the shareholders, annual fee for distribution (12b-1)

SEEKING HIGHER RETURNS Objective is to maximize return with minimum risk Efficient Market hypothesis and undervalued securities Behavioral Finance Mean reversion in the equity market Individual securities have two main sources of risk: alpha and beta

DEFINITIONS FOR RETURNS Return = Interest or Dividends +/- Price Change Initial Investment Risk = Variation (or range) of possible returns Goal => Maximize return and minimize risk

SEEKING HIGHER RETURNS Random walk – No predictable relationship between past changes and future changes in stock prices – Based on extensive empirical studies

SEEKING HIGHER RETURNS Efficient Market Hypothesis (EMH) – Theory regarding information content of market prices – May explain random walk studies – Paradox of EMH and value of research Behavioural finance – Most investors do not behave perfectly rationally, but are influenced by psychological factors

REDUCING PORTFOLIO RISK Alpha risk Alpha - company specific risk usually accounts for 50%-70% of security’s price volatility; can be reduced by diversification Beta risk – Beta - market risk accounts for 30%-50% of price volatility. – Stock market risk; cannot be reduced by diversification

BENEFITS OF INVESTING IN MUTUAL FUNDS Diversification :Typically lowers  ; global fund may also lower  Professional Management: Professional qualifications (CFA); access to company executives; in house research team, wall street research. Lower Transaction Costs: Lower admn. cost, savings on record keeping, better execution of securities. Convenience: Automatic deposits/ withdrawal, tax reporting, retirement planning, educational materials

BENEFITS OF INVESTING IN MUTUAL FUNDS Higher minimum requirements for individual bonds (usually $25,000; T-bonds $1,000). Lot size is usually $100,000. One $25,000 bond lacks diversification. Cost : 2% - 4% of value. Bond mutual fund minimum: As low as $1,000. Can redeem fund on any business day. Do not have to hold till maturity. Fund offers more diversification. Offer convenient services, such as monthly income payments, compared to quarterly or semi-annually for individual bonds Similar advantages for stock funds

DISADVANTAGES OF INVESTING IN MUTUAL FUNDS Need to pay fees/expenses even when fund performs poorly Increased diversification may prevent the chance of “hitting the jackpot” from one security Online trading and security research on the internet have reduced the advantage of cost and research access Less control over securities portfolio and therefore timing of realized capital gains for tax purposes

POPULAR WAYS TO PURCHASE INDIVIDUAL SECURITIES On-line trading Separate account – Portfolio of individual securities managed separately by a bank, broker, or financial adviser – Account minimums lowered for consultant – Pre-packaged model portfolios – “Baskets” available through the internet

STRUCTURE OF A MUTUAL FUND

MUTUAL FUND COMPLEX Shareholders (Savers) Management Company Distribution Transfer Agency Broker Stock Funds Fixed Income Funds Money Market Funds

STRUCTURE OF A COMMERCIAL BANK

MUTUAL FUND VERSUS BANK DEPOSIT Mutual FundBank Deposit Rate of ReturnTracks T-bill closely but usually higher because of credit risk Does not track T-bill closely; longer maturity results in higher rate TimeRedemptions daily MMDA: allows limited daily withdrawals CDs: penalty for early withdrawal LiquidityHighly liquid CDs: funds “locked-up” for fixed period DiversificationNo more than 5% in any one issuer Generally cannot loan more than 15% to one borrower

Mutual FundBank Deposit Risk95% must be in highest rated paper; average 90-day security maturity; no FDIC insurance Loans subject to credit review; try to match asset maturity to liabilities; FDIC insurance ($100K) CapitalManagement company, not fund, has capital; no regulatory requirement or guarantee Banks must have capital meeting meeting regulatory requirements; FDIC guarantees deposits ($100K limit) TaxMay offer tax-exempt interest to shareholders May not offer tax-exempt interest to depositors FeesFee income from management contract Primarily spread income from principal risk MUTUAL FUND VERSUS BANK DEPOSIT