1. Principles of Investing FIN 330
Chapter 6 Mutual Funds Investment Companies
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2. Student Learning Objectives
What are mutual funds?
Open-end vs. closed-end funds
Alternatives: UIT, REIT, RELP, REMIC
Selecting a mutual fund
Managing mutual fund investments
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3. Forming a Mutual Fund
Investment company forms the fund and advertises its investment objectives, fees, and fund manager.
Interested parties buy shares (of beneficial interest) at a preset price (NAV).
Fund manager then invests the proceeds of the share sale in a variety of stocks.
Thereafter, NAV set by stock prices
Value of mutual fund assets minus liabilities divided by number of outstanding shares
Regulatory requirements for Investment Companies
Must distribute
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4. Types of Mutual Funds Open-end
Investment Company stands ready to buy and sell
Price based on NAV (sales charge possible)
Active or Passive management
May have multiple classes (fee schedules)
Closed-end
One time issuance of shares
Shares publicly traded
Tend to trade at a discount to NAV
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5. Types of Mutual Funds Stock Funds (common, preferred)
Bond Funds (short-, intermediate- or long-term)
Balanced Funds (stocks and bonds)
Taxable vs. Tax “free”
Index Funds (SP500, Nasdaq, Russell, Wilshire )
Sector Funds (Energy, Utility, Transportation)
Global Funds (Europe, Far East, Emerging)
Exchange Traded Funds (ETF)
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6. Types of Mutual Funds Asset Allocation Socially Responsible
Money Market
REITs and RELPs
Real estate applications: commercial, residential
Unit investment trusts
Unmanaged
Self-liquidating
Largely consist of short-term debt securities
Hedge funds
Typically organized as offshore limited partnerships for qualified investors
Maximum investment flexibility
Variable annuities
Mutual fund type of instrument originating at insurance companies
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7. ICIFactBook.Org
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8. Fund Operating Details
Distribution Requirements
IRS (Subchapter M) requires funds to distribute no less than 90% of interest and dividends received.
The same applies to “net” realized capital gains
Realized = result of buying and selling
Load Charges
Most funds are no-load
Sales charges may vary according to fund
Front-end vs. Back-end (tied to holding period or class)
Sales charges tend to discourage timing or frequent trading
May also involve break-points
Management (Advisory) Fees, 12b-1 Fees
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9. Fund Operating Details
Distribution (sales)
Direct marketing (Vanguard, Fidelity, etc., websites)
Sales Force
Broker-Dealers
Financial Planners
Retirement fund jobbers (Planco Div of HIG)
Prospectus Requirements
Investor purchase must be followed by receipt of fund prospectus
Annual reports required, may receive quarterly reports
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10. Pros & Cons of Mutual Funds
Professional portfolio management
Diversification (risk reduction)
Convenience
Record keeping
Other factors
Examples: liquidity, minimal investment requirements, regulation
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11. Pros & Cons of Mutual Funds
Management fees, expenses, and loads for load funds reduce their returns.
Large investors, such as mutual funds, sometimes adversely affect the market when they trade.
Institutions usually restrict their analysis to a small percentage of traded stocks (i.e., the larger ones).
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12. Net Asset Value (NAV)
Per-share market value of mutual fund’s portfolio:
NAV = (total assets – total liabilities)  number of shares outstanding
Forms of Return
Price Appreciation: Increase in NAV
Dividends and Interest: Pass-through of dividends and interest received on portfolio
Regular dividend
Capital Gain Distribution: Payment of net capital gain recognized by fund during year
Reinvestment Strategies: auto-reinvest, cash distribution
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13. Load Charges
Contingent deferred sales charge (CDSC) is a back-end load that declines over time
Back-end loads discourage trading by investors
Front-end loads compensate the broker
No-load funds tend to be most popular
Share Class Structure
Class A: Usually large front-end load, and minimal or no 12b-1 fee . Best if plan long holding period
Class B: Back-end load and 12b-1 fees, usually convertible to Class A after load waived
Class C: Minimal or no front-end or back-end load, but substantial 12b-1 fee. Best if plan short holding period
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14. Operating Expenses
Management or advisory fees and other operating expenses
12b -1 fees cover distribution costs
Paid out of investment income as percent of NAV
Compare loads and operating expenses for varying time periods in evaluating funds
No evidence that higher fees or load charges bring superior performance
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15. Performance and taxes
Mutual funds are not taxed directly on income or capital gains as these are passed on to the shareholders
Returns can be broken down into distributions and change in NAV
Portfolio turnover relates to higher capital gains distributions and unrealized capital gains
Don’t purchase just before a distribution
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16. Managing Fund Investments
Passive versus active
Personal objectives may change over time
Dollar-cost averaging results from investing equal dollar amounts at regular intervals
Can be beneficial when prices fluctuate, but…
if prices continually rise, buying more earlier is better
Rebalancing Investment Portfolio
Adjusting allocations to desired risk-return target
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17. Regulations and Taxation
The SEC regulates U. S. fund operations through Mutual Fund Act of 1940.
State approval is also required to sell shares
Most funds are taxed as regulated investment companies:
All investment income must be distributed to shareholders each year
All tax liability falls to individual shareholders
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18. Mutual Fund Services Automatic reinvestment of distributions
Automatic investment plans
Check writing (money market funds)
Exchange privileges within fund families
Periodic statements
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19. Why Mutual Funds? Positives Negatives Professional management
Diversification
Convenience
Marketability
Ease of exchange
Negatives
Most funds under perform the indexes
Fund performance depends on fund manager and market conditions
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20. Special Issues in Closed-End Funds
No prospectus to traders
May have tax liabilities (liquidation)
May be leveraged (additional risk)
May have liquidity problems (thinly traded)
Possibility of conversion to open-end
Different distribution structures (managed)
Tends to trade at less than NAV
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21. Real Estate Investment Companies
Real Estate Investment Trust (REIT)
Min of 75% invested in RE
Required to pay out 90% of income
Equity REITs: income producing
Mortgage REITs: making loans
Hybrids
Real estate Limited Partnerships (RELP)
More complex tax rules
May have a liquidation time set
May involve sales charges
Many sell at discounts
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22. Real Estate Investment Companies
RE Mortgage Investment Conduits (REMIC)
Created by breaking up interest and principal streams
Different maturity packs to match investor needs
Bear Stearns was major player in this market (> JPM)
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23. Unit Investment Trust Debt Equity Pros and Cons
Funds invested in bonds
Bond UIT have fixed lives.
Purpose: provide known income stream
Equity
Funds invested in Equities
All have termination date: liquidation > distribution
Pros and Cons
Negligible fees, tax efficient, convenient
Sales charges, lack of marketability
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24. Exchange Traded Funds Alternative to Mutual Funds
No minimum holding period
Can mimic indexes, sector, countries, etc.
Many are very liquid – 51 traded more than 500,000 shares (April, 2008), another 60 at least 100,000 shares
Even more are thinly traded: 259 ETF had daily volumes under 100,000 shares (April, 2008)
Marginable
Able to sell short
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25. Other Investment Vehicles
Hedge Funds
Multiple fronts
Derivatives: options and futures
Stocks and bonds
International
Costly and Risky
Performance suspect – backfilling
Losses can be significant – e.g. LTCM
Variable Annuities
Industry is still evolving – trying to increase returns
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26. Other Investment Vehicles
Pooled Portfolios
Operating or holding companies: Some operating or holding companies hold such large portfolios that their performances are more closely related to their security holdings than to their operations.
Partnerships: Some investment companies choose the partnership form, often a limited partnership, because of its greater flexibility and/or tax advantages.
Blind pools: Investors bankroll enterprises whose purposes will later be revealed; these pools are sometimes involved in takeover financing.
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27. Selecting and Evaluating Funds
Evaluate Historic Performance
Against a benchmark like the S&P 500 over time
Morningstar or Weisenberger publications
Assess Future Performance
Some believe that past performance is a poor predictor since funds do not (over the long term) post better risk-adjusted performance than the broad market averages
Others feel that past performance is a reasonable, though imperfect, predictor because past performance reflects more than mere luck
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28. Selecting and Evaluating Funds
Evaluate services offered by the fund
Redemptions
Automatic dividend reinvestment
Advisory services
Examine fees and expenses
Load charges
Operating expenses
Third Party Evaluations
Morningstar
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