1. Investments Vicentiu Covrig 1 Mutual Funds ( chapter 4)

2. Investments Vicentiu Covrig 2 What is a mutual fund? Mutual funds are open-end investment companies. The fund sells shares to the public and invests the proceeds in a pool of funds, which are jointly owned by the fund’s investors Most funds are started by investment management companies who hire the fund manager to make investment decisions. - Fidelity, Vanguard, etc. Usually offer many different funds and allow investors to switch between funds. Funds (open-end) sell additional shares to those who want to invest, redeem shares at the NAV (less any fees) to those who want to sell their shares.

3. Investments Vicentiu Covrig 3 Computing Net Asset Value For investors, the performance of their investment depends on what happens to the fund’s per share value, or net asset value (NAV). NAV= Market Value of Assets – Liabilities Number of Shares Outstanding

4. Investments Vicentiu Covrig 4 Why invest with mutual funds? Diversification Professional management and record-keeping Low capital requirement Liquidity Indexing Choice and flexibility Access to illiquid markets Access to non-traditional trading strategies

5. Investments Vicentiu Covrig 5 Mutual Fund Drawbacks Some funds have very high expenses Active trading contributes to high costs which lower fund returns Tax consequences can be a disadvantage - Tax impacts of asset trading are passed through to investors - Tax bill can be large even when the NAV falls

6. Investments Vicentiu Covrig 6 Mutual Fund Returns Three sources of return: Income distributions (ID) - Bond interest, stock dividends Capital gain distributions (CGD) - Realized gains/losses from selling assets Changes in NAV (  NAV) - From unrealized gains/losses from assets Most mutual funds allow investors to either receive distributions in cash or to reinvest in additional shares.

7. Investments Vicentiu Covrig 7 Types of Mutual Funds Funds can be classified according to the fund objective that is based on the type of securities in which they invest - Stock Funds - Taxable Bond Funds - Municipal Bond Funds - Blend:Stock and Bond Funds - Money Market Funds - International - Global

8. Investments Vicentiu Covrig 8 Type of mutual funds (based on organization) Open-end Close-end: - Shares trade like stock rather than being bought and sold from the fund -Number of shares are fixed - Often sell at a discount from NAV (a puzzle for modern finance) ETF (Exchange-traded)

9. Investments Vicentiu Covrig 9 Exchange Traded Funds Are traded securities; entails commission costs Each ETF is a claim on a trust that holds a specified pool of assets (e.g. S&P500 index components) Examples:SPDRS,WEBS,HOLDERS Advantages: Liquidity Taxes Can be purchased on margin or sell short ETF are appropriate for short-term investors and the ones who buy in large lots

10. Investments Vicentiu Covrig 10 Mutual Fund Prospectus Must be available to investors and should be review by investors. Contains: - Fund’s investment objective - Investment strategy - Principal risks faced by investors - Recent investment performance - Expenses and fees - Lots of other detailed information

11. Investments Vicentiu Covrig 11 Mutual Fund Expenses Loads - For load funds, the offer price is the fund’s NAV less the load (while no- load funds are sold at their NAV) - Load range from around 3% (low-load) to 8.5% 12b-1 Fees - Fees deducted from the asset value of the fund to cover marketing expenses Deferred Sales Loads - Redemption charges when fund shares are sold (rather than when purchased) Share Classes - Many funds offer several different classes of shares (A-B-C) with different fee structures

12. Investments Vicentiu Covrig 12 Mutual Fund Expenses Management Fees - Fees deducted from the fund’s asset value to compensate the fund managers Expense ratio - Adding all fees and calculating expenses as a percentage of the fund’s asset

13. Investments Vicentiu Covrig 13 Mutual funds: Performance On a risk-adjusted basis, the average stock fund under-performs market averages While portfolio managers seem to out-perform the market before expenses, net returns are below the market index There is some evidence of short-term performance persistence Weak evidence that high turnover decreases the performance Investment performance is no better (and perhaps worse) for load funds vs. no-load

14. Investments Vicentiu Covrig 14 Mutual Fund Investment Strategies Choose in funds consistent with your objectives, constraints, and tax situation. Consider index funds for a large portion of your fund portfolio. When possible, invest in no-load funds with below-average expense and turnover ratios. Invest at least 10-20% in international or global funds. Own funds in different asset classes and consider life-cycle investing Use dollar cost averaging by investing a set dollar amount each month Avoid investing money shortly before the capital gain distribution dates (prospectus)

15. Investments Vicentiu Covrig 15 Morningstar rating Created in 1984 to provide comprehensive assessment of mutual funds The star system was not meant to predict future performance 5* - the top 20% of the funds 1* the bottom 20%

16. Investments Vicentiu Covrig 16 Hedge Funds Considerable confusion exists concerning hedge funds – what they are (and are not) and how they work Hedge funds are privately organized, pooled investment vehicle with no restrictions in terms of investment strategies, asset classes and use of leverage Many of them registered off-shore for tax and regulatory reasons Can’t have more than 100 “accredited” investors or 500 “super- accredited” investors Accredited investor: net worth > 1 million or income of $200,000 in each of the past two years Super-Accredited investor: net worth > 5 million

17. Investments Vicentiu Covrig 17 Hedge Funds Are not allowed to advertise broadly and engage in “ general solicitation” to the investing public Charge 1-2% of assets under management and 20-25% of profits First hedge fund on record, Jones Hedge Fund, was established in 1949 He hedged the US equity market risk and focused on stock selection By 2004, more than 10,000 funds in existence world-wide Common features: - shorting - leverage - concentration Do they all hedge?

18. Investments Vicentiu Covrig 18 Learning objectives What is mutual fund? Know the advantages and drawbacks of investing in a mutual fund. What is NAV? Know the sources of returns in a mutual fund Discuss the expenses of a mutual fund. Know the types of mutual funds based on objective Know the differences between mutual funds, closed-end funds and exchange traded funds. Why one might invest in the last two type of funds? What do we know about the mutual fund performance? Know the investment strategies discussed in the text Recommended exercises: Questions 1 -13; 17-19