1. Copyright © Houghton Mifflin Company. All rights reserved. 1–01–0 Mutual Funds Definition Risk and Return Relationship Pros and Cons of Investing in Mutual Funds Structure of a Mutual Fund and a Commercial Bank History of Mutual Funds Challenges Facing the Industry

2. Copyright © Houghton Mifflin Company. All rights reserved. 1–11–1 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)

3. Copyright © Houghton Mifflin Company. All rights reserved. 1–21–2 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.

4. Copyright © Houghton Mifflin Company. All rights reserved. 1–31–3 Definitions for Returns Return = Interest or Dividends +/- Price Change Initial Investment Risk = Variation (or range) of possible returns Goal => Maximize return and minimize risk

5. Copyright © Houghton Mifflin Company. All rights reserved. 1–41–4 Seeking Higher Returns (for Same Risks) Random walk –No predictable relationship between past changes and future changes in stock prices –Based on extensive empirical studies

6. Copyright © Houghton Mifflin Company. All rights reserved. 1–51–5 Seeking Higher Returns (for Same Risks) (cont.) 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

7. Copyright © Houghton Mifflin Company. All rights reserved. 1–61–6 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

8. Copyright © Houghton Mifflin Company. All rights reserved. 1–71–7 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.

9. Copyright © Houghton Mifflin Company. All rights reserved. 1–81–8 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

10. Copyright © Houghton Mifflin Company. All rights reserved. 1–91–9 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.

11. Copyright © Houghton Mifflin Company. All rights reserved. 1–10 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 or rep wraps –Pre-packaged model portfolios –“Baskets” available through the internet

12. Copyright © Houghton Mifflin Company. All rights reserved. 1–11 Assets of Mutual Funds 1985–2000 $ Billion Source: Investment Company Institute (ICI) $6,967 B

13. Copyright © Houghton Mifflin Company. All rights reserved. 1–12 Growth of Financial Intermediaries* $ Billions * Excludes bank-administered trusts and closed-end investment companies Source: Federal Reserve Board, Federal Financial Institutions Examination Council, ICI

14. Copyright © Houghton Mifflin Company. All rights reserved. 1–13 Structure of a Mutual Fund

15. Copyright © Houghton Mifflin Company. All rights reserved. 1–14 Mutual Fund Complex Shareholders (Savers) Management Company Distribution Transfer Agency Broker Stock Funds Fixed Income Funds Money Market Funds

16. Copyright © Houghton Mifflin Company. All rights reserved. 1–15 Structure of a Commercial Bank

17. Copyright © Houghton Mifflin Company. All rights reserved. 1–16 MM Fund Versus Bank Deposit MM 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

18. Copyright © Houghton Mifflin Company. All rights reserved. 1–17 MM Fund Versus Bank Deposit (cont.) MM 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

19. Copyright © Houghton Mifflin Company. All rights reserved. 1–18 History of Mutual Funds 1940: Investment Company Act –established standards for fund promotion, reporting, product pricing, and portfolio investing. 1950-60s: Industry experience growth. 1970s: Stock market declined. Difficult to sell stock fund. Investors interested in short-term or income-oriented investments

20. Copyright © Houghton Mifflin Company. All rights reserved. 1–19 History of Mutual Funds (Cont’d) 1970s: Money market funds were created and became the savior of the industry. 1980s: High interest rate atmosphere. Banks were legally prevented from paying more than 4% - 5% interest. MM assets exceeded either stock or bond fund assets. 1990s: Spectacular growth in mutual fund industry. $800b in 1987 to $5t in 1999.

21. Copyright © Houghton Mifflin Company. All rights reserved. 1–20 History of Mutual Funds (Cont’d) Factors behind the rapid growth: –Bull market in U.S. stock. –Tax-advantaged retirement vehicles –attractive mutual fund products –enhanced services to fund shareholders. Distribution channels & pricing structures: –Broker - Dealers are the traditional distribution channel

22. Copyright © Houghton Mifflin Company. All rights reserved. 1–21 History of Mutual Funds (Cont’d) –Front-end load declined from 81/2% in 1960 to ~4% now. –Currently broker-dealer may charge ‘back-end’ load. The load declines based on the length of investment. –Annual distribution fee 12b-1paid by the fund to the distributor. Range is from 25 bp to 75bp.

23. Copyright © Houghton Mifflin Company. All rights reserved. 1–22 History of Mutual Funds (Cont’d) Direct marketing of funds: –MMF spurred direct marketing –‘no-load’ funds. Charges are low- around 2%-3% and 12b-1 around 25bp. Retirement Plan: –Attractive service providers to plan sponsors of 401(k) and other defined contribution plans.

24. Copyright © Houghton Mifflin Company. All rights reserved. 1–23 History of Mutual Funds (Cont’d) –Employees can choose to contribute in specific funds. Fund Co provides disclosure documents and educational materials to each employee. –In most cases sales loads may be waved and service fees may be negotiated. Banks and Insurance Cos : – Glass-Steagall prohibition? Banks found ways to offer their own or other’s funds to their customers. –Insurance Co- joint venture with funds to offer variable annuities