1. © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Mutual Funds Chapter 5 K. R. Stanton

2. McGraw-Hill/Irwin -2 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin 5-2 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Overview  In this segment... Mutual Funds: Activities of mutual funds Size, structure and composition Balance sheets and recent trends Regulation of mutual funds Global issues Hedge funds*

3. McGraw-Hill/Irwin -3 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin 5-3 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Mutual Funds  Open-ended  Closed-end  End of 2003: More than 7,100 stock and bond mutual companies. Total assets of $5.36 trillion. 8,200 firms and $7.41 trillion if money market mutual funds included  Slower rate of growth in the industry in early 2000s than in 1990s

4. McGraw-Hill/Irwin -4 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin 5-4 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Size, structure and composition First mutual fund: Boston, 1924. Slow growth, initially. Advent of money market mutual funds, 1972.  Regulation Q. Total assets in stock and bond mutual funds:  1940: $0.4 billion.  1990: $1,065.2 billion  2003: $7,414.1 billion.

5. McGraw-Hill/Irwin -5 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin 5-5 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Size, Structure and Composition By asset size, mutual fund industry second most important FI group. Recent inroads by commercial banks and insurance companies  Mellon purchase of Dreyfus  State Farm (9,000 agents)  As of 2004, insurance companies managed approximately 14% of mutual fund assets

6. McGraw-Hill/Irwin -6 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin 5-6 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Types of Mutual Funds  Long-term funds 74.3% of assets, 1999 2002, long-term funds dropped to 62.1% of assets, losing ground to MMMFs  Types of Long-term Funds: Bond and income funds. Equity funds. Hybrid.

7. McGraw-Hill/Irwin -7 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin 5-7 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Types of Mutual Funds  Short-term funds 25.7% of assets, 1999. 30.2% of assets, 2002. Taxable and tax-exempt MMMFs Generally higher returns than bank deposits but uninsured.  Impact of low interest rates during early 2000s

8. McGraw-Hill/Irwin -8 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin 5-8 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Number of Mutual Funds

9. McGraw-Hill/Irwin -9 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin 5-9 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Overview of Mutual Funds Objectives (and adherence to stated objectives), rates of return and risk characteristics vary.  Examples: Capital appreciation funds Growth funds High-yield bond World equity Corporate bond

10. McGraw-Hill/Irwin -10 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin 5-10 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Returns to Mutual Funds Income and dividends of underlying portfolio. Capital gains on trades by mutual fund management. Capital appreciation in values of assets held in the portfolio.  Marked-to-market.  Net-asset value (NAV).

11. McGraw-Hill/Irwin -11 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin 5-11 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Web Resources  For information on the performance of mutual funds, visit: Morningstar www.morningstar.comwww.morningstar.com

12. McGraw-Hill/Irwin -12 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin 5-12 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Types of Funds Open-ended funds: contrast with most corporate securities traded on stock exchanges. Closed-end investment companies: Fixed number of shares  Example: REITs.  May trade at premium or discount. Load versus no-load funds.

13. McGraw-Hill/Irwin -13 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin 5-13 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Mutual Fund Costs  Two types of fees: Sales loads  Generally, negative effect on performance outweighs benefits Fund operating expenses  Management fee  12b-1 fees

14. McGraw-Hill/Irwin -14 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin 5-14 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Mutual Fund Share Quotes  Quotes include: Fund NAV, Fund name, Objective, one-month through ten-year return and rating (A through E), Maximum initial charges, and Annual expenses.

15. McGraw-Hill/Irwin -15 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin 5-15 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Balance Sheet and Trends  Money Market Funds Key assets are short-term securities (consistent with deposit-like nature)  2003: $1,395.9 billion (69.2% of total assets) Many have share values fixed at $1 and adjust number of shares owned by the investor.

16. McGraw-Hill/Irwin -16 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin 5-16 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Balance Sheet and Trends  Long-term Funds Stocks comprised over 65.6 % of asset portfolios in 2000. Credit market instruments 32.3% of asset portfolios Shift to U.S. Treasuries, municipal bonds etc. when equity markets not performing as well.

17. McGraw-Hill/Irwin -17 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin 5-17 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Regulation One of the most closely regulated among non- depository FIs. Primary regulator: SEC  Emphasis on full disclosure and anti-fraud measures to protect small investors.  NASD supervises mutual fund share distributions.

18. McGraw-Hill/Irwin -18 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin 5-18 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Regulatory Changes  Prosecutions in light of trading abuses in early 2000s. Market timing Late trading Directed brokerage Improper fee assessments  Changes include: SEC requirements for independent board members; reporting and disclosure requirements

19. McGraw-Hill/Irwin -19 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin 5-19 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Legislation Securities Act 1933, 1934 Investment Advisers Act, 1940. Insider Trading and Securities Fraud Enforcement Act of 1988. Market Reform Act of 1990  Allows SEC to halt trading and introduce circuit breakers. National Securities Markets Improvement Act of 1996.  Exempts mutual fund sellers from state securities regulatory oversight.

20. McGraw-Hill/Irwin -20 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin 5-20 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Pertinent Websites American Banker www.americanbanker.comwww.americanbanker.com American Funds www.americanfunds.comwww.americanfunds.com Federal Reserve www.federalreserve.govwww.federalreserve.gov Fidelity Investments www.fidelity.comwww.fidelity.com Investment Company Institute www.ici.orgwww.ici.org Morningstar, Inc. www.morningstar.comwww.morningstar.com SEC: www.sec.govwww.sec.gov NASD: www.nasd.comwww.nasd.com Vanguard www.vanguard.comwww.vanguard.com Wall Street Journal www.wsj.comwww.wsj.com

21. McGraw-Hill/Irwin -21 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin 5-21 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Global Issues  Worldwide growth in mutual fund investment not as great as in the U.S. $1.626 trillion in 1992 to $6.543 trillion in 2003  Over 300% growth compared to 350% in U.S. Larger returns in U.S.stock markets Greatest development in countries with most developed markets Opportunities from declining Japanese markets Efforts to reduce barriers for U.S. mutual fund sponsors  China and other Asian countries

22. McGraw-Hill/Irwin -22 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin 5-22 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Hedge Funds*  Not technically mutual funds Not subject to SEC regulation Organized as limited partnership  Small number of sophisticated investors Common feature is use of leverage  High returns in 1990s

23. McGraw-Hill/Irwin -23 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin 5-23 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Hedge Funds*  Near collapse of Long-Term Capital Management $3.6 billion bailout 2003 SEC scrutiny of hedge funds Scandals such as Canary Capital Partners involving trades with mutual funds