1. Mutual Funds and Other Investment Companies Chapter 4 Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

2. 4-2 4.1 Investment Companies

3. 4-3 Services of Investment Companies a.Administration & record keeping  Tax purposes Low cost reinvestment Low cost additional investment, DCA Low cost switching between fund families Some funds may allow check writing privileges

4. 4-4 Services of Investment Companies b.Diversification  c.Professional management  d.Reduced transaction costs e.Investing for retirement: Most funds can be set up as an IRA Lower research costs Portfolio managed according to specific objectives Professionals to find undervalued securities and/or engage in asset allocation strategies Low cost, instant diversification

5. 4-5 4.2 Types of Investment Companies

6. 4-6 Organizational Forms Unit Investment Trusts (UITs): unmanaged, fixed composition portfolios  Any interest and/or dividends are distributed immediately to trust certificate holders.  Provide diversification within one sector or area and low cost entry.  Often levered, rates of return can be extreme.

7. 4-7 Organizational Forms A managed investment company (mutual fund) may be  Open end –shares are bought from the fund and redeemed by the fund or  Closed end –shares are bought and sold among investors in the marketplace (NASDAQ or an exchange) and the fund itself is not involved.

8. 4-8 Differences in Open & Closed End Most funds are open end: The advantage of the open end form is  The disadvantage of the open end form is  Liquidity for the investor Fund’s ability to grow (advantage for the fund or sponsor) The need to keep a cash reserve Vulnerable to panics

9. 4-9 Other Investment Organizations –Commingled funds Partnerships of investors that pool their funds. Designed for trusts or larger retirement accounts to get professional management for a fee. Operates similar to a mutual fund. –REITs Similar to closed end fund. Invest in real estate and real estate loans. Equity trusts purchase real estate. Mortgage trusts invest in mortgage and construction loans.

10. 4-10 Other Investment Organizations Cont. –Hedge Funds Similar to mutual funds, but not registered and not subject to SEC regulations. Available to institutional and high net worth investors Can pursue investment strategies that are not allowed for mutual funds. – Grew from about $50 billion in 1990 to about $2 trillion in 2008.

11. 4-11 4.3 Mutual Funds

12. 4-12 Net Asset Value Used as a basis for valuation of investment company shares –Selling new shares –Redeeming existing shares Calculation

13. 4-13 Open-End and Closed-End Funds: Key Differences Shares Outstanding  Closed-end: no change unless new stock is offered  Open-end: changes when new shares are sold or old shares are redeemed Pricing  Open-end: Fund share price = Net Asset Value (NAV)  Closed-end: Fund share price may trade at a premium or discount to NAV

14. 4-14 NAV calculation ABC Fund ($Millions except NAV) Market Value Securities + Cash & Receivables - Current Liabilities NAV Total  # Fund Shares NAV $550.00 75.00 (20.00) $605.00 20.00 $ 30.25 Most Mutual Funds have little or no Long Term Debt

15. 4-15 How Funds Are Sold Directly marketed – Sales force distributed – You find them May avoid front end load Front end load is an up front cost (fee) to purchase a share of a mutual fund. Recommended by a broker or planner Usually will have a front end load May be revenue sharing on sales force distributed Potential conflict of interest

16. 4-16 Potential Conflicts of Interest: Revenue Sharing  Brokers put investors in funds that may that ____________________________  Mutual funds could direct trading _____________________  Revenue sharing is _________ but it must be ________ to the investor may not be the most appropriate to higher cost brokers not illegal disclosed

17. 4-17 Different Funds based on Investment Objectives & Styles 1. Domestic Stock Funds a. Aggressive Growth, Growth, Growth & Income, Value, etc b. Large Cap, Mid Cap, Small Cap, etc 2. Index - passively managed a. Borad market, Industry, International, etc 3. Fixed Income a. Government(s), Corporate bonds, etc 4. International a. Stocks, Bonds, Emerging Markets, etc 5. Money market funds

18. 4-18 Table 4.1 U.S. Mutual Funds by Investment Classification, 2008

19. 4-19 Trading Scandal with Mutual Funds  Late trading: allowing some investors to purchase or sell after NAV has been determined for the day  Market timing: allowing investors to buy or sell on stale net asset values –International: fund NAV may be based on prices in foreign markets which close at different times. A U.S. mutual fund specializing in Japanese stocks may create an exploitable opportunity since the Japanese markets close before ours, at which time the fund’s NAV will be set. If the U.S. markets subsequently go up late in the day, probably Japanese stocks will go up the next day, driving up NAV for the fund the next day.

20. 4-20 Potential Reforms  Strict _____________ with late orders executed the following trading day  ________________ with net asset values being adjusted for trading in open markets  Imposition of __________________________________ 4:00 PM cutoff Fair value pricing redemption fees on holdings < 1 week

21. 4-21 4.4 Costs of Investing in Mutual Funds

22. 4-22 Costs of Investing in Mutual Funds Fee Structure – Operating expenses – 12 b-1 charges – Front-end load Back-end load (contingent), (redemption fee) Buying and selling commissions, administrative expenses and advisory fees for the managers Marketing costs paid by the fundholders Alternative to a load, but assessed annually Maximum is 1% of assets

23. 4-23 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 –Why pay a load charge? –Funds with high expenses tend to be poorer performers. 12 b-1 charges should be added to expense ratios Costs found in the fund prospectus and may be compared via Morningstar

24. 4-24 NAV and the Effective Load Cost to initially purchase one share of a load fund = NAV + front-end load (%) (if any).  Stated Loads typically range from ________  If you invest $10,000 in a fund with an 8.5% front-end load, you actually acquire shares worth $9,150; the other $850 goes to the broker. The load is designed to offset expenses of marketing the fund and goes to the broker who sells the fund to the investor.  The effective load is greater than the stated load: In the above example, the actual % commission cost (effective load) is: –$850 / $9150 = 9.3%; which is > stated load. 0 to 8.5%

25. 4-25 Costs of Investing in Mutual Funds  Avoiding the load: –Can sometimes choose different class of fund shares. –Best alternative may depend on _______________________________________. amount invested and expected holding period

26. 4-26 Costs of Investing in Mutual Funds Expense ratios:  Funds charge annual operating expenses and annual advisory or management fees against the NAV. –Expense ratios are calculated as Annual Expenses / Average NAV –A "well managed" fund probably should have an expense ratio of less than ___.  All costs and charges must be revealed in the fund's prospectus. 2%

27. 4-27 Amount initially invested = Amount after gross return = Amount after fees = Net rate of return = In MF prospectus and annual reports the MF returns are net of operating expenses, 12b-1 fees and commissions, but the returns do not include loads. Converting gross pretax returns to net pretax returns: $10,000 – (0.06 x $10,000) = $9,400 $9,400 x 1.175 = $11,045 $11,045 - (0.0135 x $11,045) = $10,895.89* ($10,895.89 - $10,000) / $10,000 = 8.96% *This example calculates expenses using ending NAV.

28. 4-28 HPR on mutual funds Dist = Distribution All distributions are taxable, even if reinvested in the fund. Do not buy into a MF just before its distribution date (usually near the end of the year or quarter).

29. 4-29 4.5 Taxation of Mutual Fund Income

30. 4-30 General Tax Rules The fund itself is not taxed as long as –Fund meets certain diversification requirements –Fund distributes virtually all income earned (less fees and expenses) to fund shareholders The investor is taxed on capital gain and dividend distributions at the investor’s appropriate tax rate. Distribution requirements imply that portfolio turnover may affect an investor’s tax liability.

31. 4-31 Taxes and Mutual Funds  _______________________ can be structured to take advantage of taxes while mutual funds cannot  High turnover leads to _________________  More disclosure on taxes was required ________ Investor directed portfolios greater tax liability in 2002 After-tax returns now reported in prospectus For more information on taxes see: IRS Publication 564: Mutual Fund Distributions

32. 4-32 Implications of Fund Turnover  The fund itself pays commission costs on purchases and sales of portfolio holdings, which are charged against NAV. –  The turnover rate is measured as the ______________ _____________ in a year divided by the ____________ __________. These commissions are lower than what you and I pay. Total commission expenses are higher if the portfolio has higher turnover. total asset value bought or sold average total asset value

33. 4-33 Implications of Fund Turnover  For example, if a fund had an average total asset value of $10 million, and $6 million of securities were bought or sold that year the turnover rate was ____  Can you figure the average security holding period from the turnover ratio?  Turnover rates vary from ______________ per year. 300%  Average holding period or AHP  AHP = 0.5 x (1 / turnover ratio)  AHP = 0.5 x (1 / 0.60) = 0.83 years 60%.

34. 4-34 4.6 Exchange Traded Funds

35. 4-35 Exchange Traded Funds ETFs allow investors to trade index portfolios like shares of stock Examples: Potential advantages – – Trade continuously throughout the day Can be sold short or purchased on margin Potentially lower taxes No fund redemptions Large investors can exchange their ETF shares for shares in the underlying portfolio Lower costs (No marketing; lower fund expenses) SPDRs and Diamonds, Cubes, WEBS

36. 4-36 Exchange Traded Funds Potential disadvantages  Small deviations from NAV are possible Must pay a brokerage commission to buy an ETF but a no load index fund may be purchased online for no commission.

37. 4-37 Table 4.3 ETF Sponsors and Products

38. 4-38 4.7 Mutual Fund Investment Performance: A First Look

39. 4-39 First Look at Mutual Fund Performance  Evidence shows that average mutual fund performance is generally ________ broad market performance  Evidence suggests that over certain horizons ________________ in positive performance –Evidence is _____________ – less than some persistence not conclusive Some inconsistencies

40. 4-40 4.8 Information on Mutual Funds

41. 4-41 Sources of Information on Mutual Funds  Wiesenberger’s Investment Companies  Morningstar (www.morningstar.com)  Fund prospectus (a must read)  Yahoo  Wall Street Journal  Investment Company Institute (www.ici.org)  AAII  Brokers  Background information: “A Random Walk Down Wall Street,” by Burton Malkeil

42. 4-42 Figure 4.4 Morningstar Report

43. 4-43 Morningstar Report Cont.

44. 4-44 Sample Problems

45. 4-45 Problem 1 NAV is $10.70 Front-end load is 6% Every dollar paid results in only ____ going toward purchase of shares. Offer price = $.94 NAV = 1 - load $10.70 = 1-.06 $11.38

46. 4-46 Problem 2 Offer price $12.30 Front-end load is 5% Every dollar paid results in only ____ going toward purchase of shares. NAV = = $12.30 x 0.95 = $11.69 $.95 offer price x (1- load)

47. 4-47 Problem 3 NAV = (Market Value of Assets – Liabilities)  Shares Outstanding A. (200,000)x($35)=$ 7,000,000 B. (300,000)x($40)=$12,000,000 C. (400,000)x($20)= $ 8,000,000 D. (600,000)x($25)= $15,000,000 $42,000,000 $42,000,000 – $30,000 = $10.49 = NAV 4,000,000 Shares Outstanding 4,000,000 Liabilities $30,000

48. 4-48 Problem 4 Turnover rate = Value of stocks sold and replaced Market Value Assets Value of stocks sold = (600,000x$25)= $15,000,000or Value of stocks purchased = (200kx$50)+(200kx$25) = $15,000,000 $15,000,000 = 0.357 or 35.7% $42,000,000 Average holding period? Market Value Assets = $42,000,000 AHP = 0.5 x 1/Turnover = 0.5 x 1/0.357 = 1.4 yrs MVA = $42M

49. 4-49 Problem 5 a.The empirical research suggests that past performance is not highly predictive of future performance, especially for better performing funds. There may be some tendency for the fund to perform better than average next year, but it is unlikely that the fund will be in the top 10%. b.Evidence suggests that bad performance is more likely to persist. Probably related to high fund costs or high turnover rates. Excessive costs are detrimental to a fund’s returns.

50. 4-50 Problem 6  As an initial approximation, your return equals the return on the shares minus the total of the expense ratio and purchase costs: –Return  12%  1.2%  4% = 6.8%  But the precise return is less than this because the 4% load is paid up front, not at the end of the year. To purchase the shares, you would have had to invest: –$20,000 / (1  0.04) = $20,833  The shares net increase in value (12%  1.2%) from $20,000 to: –$20,000  (1.12  0.012) = $22,160  The rate of return is: ($22,160  $20,833) / $20,833 = 6.37%

51. 4-51 Problem 7 a.Sell after 4 years: Suppose you have $1000 to invest. The initial investment in Class A shares is ____ net of the front-end load. After 4 years, your portfolio will be worth: $940  (1.10) 4 = $1,376.25 Class B shares allow you to invest the full $1,000, but your investment performance net of 12b-1 fees will be only 9.5%, and you will pay a 1% back-end load fee if you sell after 4 years. Your redemption value after 4 years will be: $1,000  (1.095) 4 x 0.99 = $1,423.28 Class B shares are the better choice if your horizon is 4 years. $940

52. 4-52 Problem 7 Cont. b.Sell after 15 years: With a 15-year horizon, the Class A shares will be worth: $940  (1.10) 15 = For the Class B shares, there is no back-end load in this case since the horizon is greater than 5 years. Therefore, the value of the Class B shares will be: $1,000  (1.095) 15 = At this longer horizon, Class A shares are the better choice. Why? $3,926.61 $3,901.32 N x LN [1.10 / 1.095]

53. 4-53 Problem 8  Suppose that finishing in the top half of all portfolio managers is purely luck, and that the probability of doing so in any year is exactly 50%.  Then the probability that any particular manager would finish in the top half of the sample five years in a row is 0.50 5 = 0.03125.  We would then expect to find that [350  0.03125]  11 managers finish in the top half for each of the five consecutive years.

54. 4-54 Problem 9 Trading costs will reduce the portfolio return by (0.4%)x(0.50)= 0.2%  Over many years of savings these costs can greatly reduce the value of your portfolio.  Remember also that the high turnover rate can have tax consequences that further reduces your after-tax return.