Mutual Funds and Other Investment Companies Chapter Four Mutual Funds and Other Investment Companies Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter Overview Types of investment companies Mutual funds: Functions Investment styles and policies Investment costs Performance Sources of information

Investment Companies Pool funds of individual investors and invest in a wide range of securities or other assets Services provided: Record keeping and administration Diversification and divisibility Professional management Lower transaction costs What is a mutual fund What are the advantages? (3)

Net Asset Value Net Asset Value (NAV) is the value of each share in the investment company Calculation: Market Value of Assets - Liabilities Shares Outstanding

Types of Investment Companies Unit Trusts Fixed portfolio of uniform assets Unmanaged Total assets have declined from $105 billion in 1990 to $60 billion in 2012

Types of Investment Companies Managed Investment Companies Open-End Fund issues new shares when investors buy in and redeems shares when investors cash out Priced at Net Asset Value (NAV) Closed-End No change in shares outstanding; old investors cash out by selling to new investors Priced at premium or discount to NAV When we talk about mutual funds we are talking mostly about Managed Investment Companies. In particular Open-end funds.

Types of Investment Companies Other investment organizations Commingled funds REITs Hedge Funds

Mutual Funds Money market Equity Sector Bond International Balanced and funds of funds Asset allocation and flexible Index

4.3 Mutual Funds Investment Policies International funds Global funds invest in securities worldwide, including U.S. International funds invest outside U.S. Regional funds focus on particular part of world Emerging market funds invest in developing nations

4.3 Mutual Funds Investment Policies Balanced funds Hold both equities and fixed-income securities in stable proportion Life-cycle funds: Asset mix ranges from aggressive to conservative Static allocation funds maintain stable mix across stocks and bonds Targeted maturity funds become more conservative as investor ages Funds of funds: Mutual funds that primarily invest in other mutual funds

4.3 Mutual Funds Investment Policies Asset allocation and flexible funds Stocks and bonds—proportion varies according to market forecast Index funds Try to match performance of broad market index Buy shares in securities included in particular index in proportion to security’s representation in index

Mutual Funds How Funds Are Sold Direct-marketed funds Sales-force distributed Revenue sharing on sales force distributed Potential conflicts of interest Financial supermarkets

Costs of Investing in Mutual Funds Fee Structure: Operating expenses Front-end load Back-end load 12 b-1 charge Fees must be disclosed in the prospectus Share classes with different fee combinations Let’s reorder these Loads – fees to buy Front load Back load CDSC Operating fees Operating fees – mgt fees 12b-1 – marketing fees

Example 4.2: Fees for Various Classes

Fees and Mutual Fund Returns Example: Initial NAV = $20 Income distributions of $.15 Capital gain distributions of $.05 Ending NAV = $20.10

4.4 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 Funds with high expenses tend to be poorer performers 12b-1 charges should be added to expense ratios Compare costs with Morningstar

4.4 Costs of Investing in Mutual Funds NAV and Effective Load Cost to initially purchase one share of load fund = NAV + Front-end load (%) (if any) Stated loads typically range from 0 to 8.5% Load is designed to offset expenses of marketing the fund; it goes to broker who sells fund to investor Effective load greater than stated load

Table 4.2 Impacts of Costs on Investment Performance This is not realistic. No load funds have no load but usually a larger expense ratio Class B shares typically have the same higher expense ratio as Class C, but it drops when the shares get to about 8 years. Class A shares have a load, but a lower expense ratio. Rarely do mutual funds have an 8% load. In fact if they did they would have to provide documentation etc. Load funds range from the 3 to 5.75 range. Let’s say you can by a class C fund and pay 1.75% forever. A class A share of the same fund has a 5% load but a 1% fee forever. Which would you rather have is you were saving for retirement? Let’s say you want to retire in 30 years? 5 / .75 = 6.6 years

Taxation of Mutual Fund Income Pass-through status under the U.S. tax code Taxes are paid only by the investor Fund investors do not control the timing of the sales of securities from the portfolio High portfolio turnover leads to tax inefficiency Average turnover = 60%

4.5 Taxation of Mutual Fund Income Implications of Fund Turnover Fund pays commission costs on portfolio purchases and sales—charged against NAV Turnover rate measured as annual total asset value bought or sold in a year divided by average total asset value

Exchange Traded Funds Examples: “spiders,” “diamonds,” and “cubes” Potential advantages: Trade continuously like stocks Can be sold short or purchased on margin Lower costs Tax efficient Potential disadvantages: Prices can depart from NAV Must be purchased from a broker

Figure 4.2 Growth of U.S. ETFs over Time

Figure 4.3 Investment Company Assets Under Management, 2011 ($ Billion) 

Mutual Fund Investment Performance Performance of actively managed funds: Below the return on the Wilshire index in 25 of the 41 years from 1971 to 2011 Evidence for persistent superior performance (due to skill and not just good luck) is weak, but suggestive Bad performance is more likely to persist

Figure 4.4 Diversified Equity Funds versus Wilshire 5000 Index Shows lower returns in general. True. But what if we create portfolios of mutual funds? Can we create portfolios that will earn higher returns and / or lower risk than the market?

Information on Mutual Funds Fund’s prospectus describes: Investment objectives Fund investment adviser and portfolio manager Fees and costs Statement of Additional Information (SAI) Fund’s annual report

Information on Mutual Funds Morningstar (www.morningstar.com) Yahoo (biz.yahoo.com/funds) Investment Company Institute (www.ici.org) Directory of Mutual Funds