1. 4 4 C h a p t e r Mutual Funds second edition Fundamentals of Investments Valuation & Management Charles J. Corrado Bradford D. Jordan McGraw Hill / IrwinSlides by Yee-Tien (Ted) Fu

2.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 2 Mutual Funds Our goal in this chapter is to understand the different types of mutual funds, their risks, and returns. Goal  Investors added $363 billion in net new funds to mutual funds in 1999, and by the end of the year, mutual fund assets totaled $6.85 trillion. These were estimated to be owned by 83 million Americans.

3.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 3 Investment companies and fund types  At the most basic levels. A company that pools funds obtained from individual investors and invests them is called an investment company  An investment company is a business that specializes in managing financial assets for individual investors.  All mutual funds are in fact investment companies, however not all investment companies are mutual funds.

4.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 4 Mutual Funds  Mutual funds are simply a means of combining or pooling the funds of a large group of investors.  The buy and sell decisions for the resulting pool are then made by a fund manager, who is compensated for the service provided.  Like commercial banks and life insurance companies, mutual funds are a form of financial intermediary.

5.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 5 Open-End Versus Closed-End Fund  There are two types of investment companies, open end funds and closed end funds.  With an open end fund, the fund itself will sell new shares to anyone wishing to buy and will redeem shares from anyone wishing to sell.  As a result with an open end fund, the number of shares outstanding fluctuates through time  With a closed end, the number of shares is fixed and never changes, if you want to buy shares, you can buy them from another investor.

6.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 6 Open-End Versus Closed-End Fund  Strictly, speaking the term mutual fund actually refers only to an open end investment company.

7.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 7 Investment Companies and Fund Types Investment company A business that specializes in pooling funds from individual investors and investing them. Closed-end fund An investment company with a fixed number of shares that are bought and sold only in the open stock market. Open-end fund An investment company that stands ready to buy and sell shares at any time.

8. Investment Companies and Fund Types 4 - 8 @2002 by the McGraw- Hill Companies Inc.All rights reserved. McGraw Hill / Irwin

9.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 9 Investment Companies and Fund Types  Shares in an open-end fund are worth their NAV, because the fund stands ready to redeem their shares at any time.  In contrast, the shares of closed-end funds may or may not be equal to their NAV. Net asset value The value of the assets held by a mutual fund, divided by the number of shares. Abbreviated NAV.

10.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 10 Mutual Fund Operations Organization and Creation  A mutual fund is simply a corporation. It is owned by shareholders, who elect a board of directors.  The board of director is responsible for hiring a manager to oversee the fund’s operations  Most mutual funds are created by investment advisory firms( which are businesses that specialize in managing mutual funds) or brokerage firms with investment advisory operations

11.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 11 Mutual Fund Operations  These firms wish to manage the funds to earn fees.  Investment advisory firms are also called mutual fund companies, such firms have additional operations such as discount brokerages and other financial services.

12.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 12 Mutual Fund Operations  Regulated investment company doesn’t pay taxes on its investment income. The fund passes through all realized investment income to fund shareholders who then pay taxes on these distributions as though they owned the securities.

13.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 13 Mutual Fund Operations Taxation of Investment Companies  An investment company that  holds almost all its assets as investments in stocks, bonds, and other securities,  uses no more than 5% of its assets when acquiring a particular security, and  passes through all realized investment income to fund shareholders, is treated as a “regulated investment company” for tax purposes and does not need to pay taxes on its investment income.

14.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 14 Mutual Fund Operations The Fund Prospectus and Annual Report  Mutual funds are required by law to supply a prospectus to any investor who wishes to purchase shares.  Mutual funds must also provide an annual report to their shareholders.  The prospectus and annual report contain financial statement along with information concerning the fund’s expenses, gains and losses, objectives ----

15.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 15 Mutual Fund Costs and Fees Types of Expenses and Fees  Sales charges or “loads.” many mutual funds charge a fee whenever shares are purchased. * Funds that charge loads are called load funds, funds that have no such charges are called no- load funds. *Front-end loads are charges levied on purchases, while back-end loads are charges levied on redemptions. (CDSC)

16.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 16 Mutual Fund Costs and Fees  When you purchase shares in a load fund, you pay a price excess of the net asset value called the offering price.  The difference between the offering price and the net asset value is the load.  Shares in no-load funds are sold at the net asset value  Front end loads are expressed as a percentage of the offering price, not the net asset value

17.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 17 Mutual Fund Costs and Fees  12b-1 fees. SEC Rule 12b-1 allows funds to spend up to 1% of fund assets annually to cover distribution and marketing costs. Funds that market directly to the public may use 12b- 1 fees to pay for advertising and direct mailing costs Mutual funds with no front end or back end loads or minimal 12b-1 fees are often called pure( No loads funds) to distinguish them from the Not so pure funds that may have no loads but still charge the fees.

18.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 18 Mutual Fund Costs and Fees Types of Expenses and Fees …continued  Management fees. Usually based on fund size, performance, etc.  Trading costs. This is related to the fund’s turnover. * Turnover is a measure of how much trading a fund does, its calculated as the lesser of the fund total purchases or sales during a year, divided by the average daily assets

19.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 19 Mutual Fund Costs and Fees Expense Reporting  Mutual funds are required to report expenses in a fairly standardized way in the prospectus.  Shareholder transaction expenses - loads and deferred sales charges.  Fund operating expenses - management and 12b-1 fees, legal, accounting, and reporting costs, director fees.  Hypothetical example showing the total expense you would pay over time per $10,000 invested.

20. Mutual Fund Costs & Fees 4 - 20 McGraw Hill / Irwin

21.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 21 Mutual Fund Costs and Fees Why Pay Loads and Fees?  You may want a fund run by a particular manager, and all such funds are load funds.  You want a specialized type of fund. Loads and fees for such funds tend to be higher as there is little competition among them.

22.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 22 Short term funds  Mutual funds are divided into two major groups, short term funds and long term funds  Short term funds are known as money market mutual funds  Long term funds include everything that’s not a money market fund.

23.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 23 Short-Term Funds  Short-term funds are collectively known as money market mutual funds, or MMMFs.  MMMFs always maintain a $1 net asset value to make them resemble bank accounts.  Depending on the type of securities purchased, MMMFs can be either taxable or tax-exempt. Money market mutual fund A mutual fund specializing in money market instruments.

24.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 24 Short-Term Funds  Most banks offer what are called “money market” deposit accounts, or MMDAs, which are much like MMMFs.  The distinction is that a bank money market account is a bank deposit and offers FDIC protection.

25.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 25 Money market mutual funds  Most money market funds invest in high quality, low risk instruments with maturity of less than 90 days.  As a result, they have relatively little risk. However, some buy riskier assets or have longer maturities than others, so they don’t all carry equally low risk

26.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 26 Money market fund accounting  A unique feature of money market funds is that their net asset value are always 1$/share.  A money market fund sets the number of shares equal to the fund’s assets  ( breaking the buck) is used to describe dropping below 1$ in net asset value

27.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 27 Taxes and money market fund  Money market funds are either taxable or tax- exempt, taxable funds are more common  Non taxable money market funds therefore buy only these types of tax exempt securities

28.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 28 Long-Term Funds  A fund’s objective is the major determinant of the fund type.  Historically, mutual funds were classified as stock, bond, or income funds. However, it is becoming increasingly difficult to do so. Stock, bond, or income?

29.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 29 Stock Funds  Some stock funds trade off capital appreciation and dividend income.  Capital appreciation, growth, growth and income, equity income.  Some stock funds focus on companies in a particular size range.  Small company, midcap.  Some fund groups invest internationally.  Global, international, region, country, emerging markets.

30.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 30 Stock Funds  Sector funds specialize in specific sectors of the economy.  Other fund types include index funds, social conscience funds, and tax-managed funds.

31.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 31 Bond Funds  Bond funds may be distinguished by their  maturity range,  credit quality,  taxability,  bond type, and  issuing country.  Bond fund types include short-term and intermediate-term funds, general funds, high- yield funds, mortgage funds, world funds, insured funds, single-state municipal funds.

32.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 32 Taxable and Municipal bond funds  There are five characteristics that distinguish bond fund: 1.Maturity range: from quite short (2 years) to quite long (25-30 years). 2.Credit quality: some bonds are safer than the others in the possibility of defaults. US bonds have no default risk so called junk bonds have significant default risk 3.Taxability: Municipal bond funds buy only bonds that are free from federal income tax

33.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 33 Taxable and Municipal bond funds 4. Type of bond: some funds specialize in particular types of fixed income securities such as mortgages 5. Country: most bond funds buy only domestic issues, but some buy foreign company and government issues

34.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 34 Short-term and intermediate-term funds  There are two fund types focus on bonds in a specific maturity range, short term maturities are generally considered to be less than five years, intermediate term would be less than ten years.  Credit quality may vary from one bond to another.

35.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 35 General funds  For both taxable and municipal bonds, funds in this category simply don’t specialize in any particular way, credit quality and maturities differ from one bond to another.  High-Yield fund: specialize in low credit quality issues, such issues have higher yields because of the risk, as a result high yield funds can be quite volatile.

36.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 36 Mortgages funds  A number of funds specialize in so called mortgages backed securities such as GNMA ( government national mortgage association, referred to as “ Ginnie Mae”, there are no municipal mortgage backed securities so there are all taxable bond funds.  World fund: a relatively limited number of taxable funds to invest worldwide. Some specialize in only government issues, others buy a variety of non US issues, these are all taxable bond funds

37.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 37 Insured funds  This is a type of municipal bond fund, municipal bond issuers frequently purchase insurance that guarantees the bond’s payment will be made, such bonds have very little possibility of default.  Single state municipal funds: such funds are important in large states such as California and other high tax states, this classification refers only to long term funds, short and intermediate single state funds are classified with other maturity based municipal funds.

38.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 38 Stock and Bond Funds  Funds that do not invest exclusively in either stocks or bonds are often called “blended” or “hybrid” funds.  Examples include balanced funds, asset allocation funds, convertible funds, income funds.

39.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 39 Stock and bond funds  Balanced fund: there is a fixed split between stocks and bonds. They emphasize relatively safe, high quality investments, such funds provide a kind of one stop shopping for fund investors.  Asset allocation funds: two types of funds carry this label, the first is an extended version of a balanced fund, such fund holds relatively fix proportion investments in stocks, bonds, money market instrument and real estate.

40.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 40 Stock and bond funds  The other type of asset allocation fund is often called a flexible portfolio fund, here the fund can hold up to 100% in stocks, bonds, money market instruments. These funds try to time the market.  Convertible funds : meaning that can be swapped for a fixed number of shares of stock at the option of the bondholder.  Income fund: generating dividend and coupon income on its investments.

41.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 41 Mutual Fund Objectives: Recent Developments  In recent years, there has been a trend toward classifying a mutual fund’s objective based on its actual holdings.  For example, the Wall Street Journal classifies most general purpose funds based on the market “cap” of the stocks they hold, and also on whether the fund tends to invest in “growth” or “value” stocks (or both).

42. Mutual Fund Objectives: Recent Developments 4 - 42

43.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 43 Mutual Fund Objectives: Recent Developments  A mutual fund “style” box is a way of visually representing a fund’s investment focus by placing the fund into one of nine boxes: GrowthBlendValue Large Medium Small Size Style

44.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 44 Mutual Fund Performance  Mutual fund performance is very closely tracked by a number of organizations.

45. Mutual Fund Performance 4 - 45

46. Mutual Fund Performance 4 - 46

47.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 47 Mutual Fund Performance  While looking at historical returns, the riskiness of the various fund categories should also be considered.  Whether historical performance is useful in predicting future performance is a subject of ongoing debate.  Some of the poorest-performing funds are those with very high costs.

48. Closed-End Funds & Exchange Traded Funds 4 - 48 McGraw Hill / Irwin

49.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 49 Closed-End Funds & Exchange Traded Funds  Most closed-end funds sell at a discount relative to their net asset values, and the discount is sometimes substantial. The typical discount also fluctuates over time  Despite a great deal of research, the closed-end fund discount phenomenon remains largely unexplained.

50.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 50 Closed-End Funds & Exchange Traded Funds  An exchange traded fund, or ETF, is basically an index fund, except that it trades like a closed-end fund (without the discount phenomenon).  An area where ETFs seem to have an edge over the more traditional index funds is the more specialized indexes.

51.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 51 Chapter Review  Investment Companies and Fund Types  Open-End versus Closed-End Funds  Net Asset Value  Mutual Fund Operations  Mutual Fund Organization and Creation  Taxation of Investment Companies  The Fund Prospectus and Annual Report

52.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 52 Chapter Review  Mutual Fund Costs and Fees  Types of Expenses and Fees  Expense Reporting  Why Pay Loads and Fees?  Short-Term Funds  Money Market Mutual Funds  Money Market Deposit Accounts

53.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 53 Chapter Review  Long-Term Funds  Stock Funds  Taxable and Municipal Bond Funds  Stock and Bond Funds  Mutual Fund Objectives: Recent Developments  Mutual Fund Performance  Mutual Fund Performance Information  How Useful are Fund Performance Ratings?

54.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 54 Chapter Review  Closed-End Funds and Exchange Traded Funds  Closed-End Funds Performance Information  The Closed-End Fund Discount Mystery  Exchange Traded Funds