1. Mutual Funds and Other Investment Companies
Chapter Four
Mutual Funds and Other Investment Companies
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2. Chapter Overview Types of investment companies Mutual funds: Functions
Investment styles and policies
Investment costs
Performance
Sources of information

3. Investment Companies
Pool funds of individual investors and invest in a wide range of securities or other assets
Services provided:
Record keeping and administration
Diversification and divisibility
Professional management
Lower transaction costs
What is a mutual fund
What are the advantages? (3)

4. Net Asset Value
Net Asset Value (NAV) is the value of each share in the investment company
Calculation:
Market Value of Assets - Liabilities
Shares Outstanding

5. Types of Investment Companies
Unit Trusts
Fixed portfolio of uniform assets
Unmanaged
Total assets have declined from $105 billion in 1990 to $60 billion in 2012

6. Types of Investment Companies
Managed Investment Companies
Open-End
Fund issues new shares when investors buy in and redeems shares when investors cash out
Priced at Net Asset Value (NAV)
Closed-End
No change in shares outstanding; old investors cash out by selling to new investors
Priced at premium or discount to NAV
When we talk about mutual funds we are talking mostly about Managed Investment Companies.
In particular Open-end funds.

7. Types of Investment Companies
Other investment organizations
Commingled funds
REITs
Hedge Funds

8. Mutual Funds Money market Equity Sector Bond International
Balanced and funds of funds
Asset allocation and flexible
Index

9. 4.3 Mutual Funds Investment Policies International funds
Global funds invest in securities worldwide, including U.S.
International funds invest outside U.S.
Regional funds focus on particular part of world
Emerging market funds invest in developing nations

10. 4.3 Mutual Funds Investment Policies Balanced funds
Hold both equities and fixed-income securities in stable proportion
Life-cycle funds: Asset mix ranges from aggressive to conservative
Static allocation funds maintain stable mix across stocks and bonds
Targeted maturity funds become more conservative as investor ages
Funds of funds: Mutual funds that primarily invest in other mutual funds

11. 4.3 Mutual Funds Investment Policies
Asset allocation and flexible funds
Stocks and bonds—proportion varies according to market forecast
Index funds
Try to match performance of broad market index
Buy shares in securities included in particular index in proportion to security’s representation in index

12. Mutual Funds How Funds Are Sold Direct-marketed funds
Sales-force distributed
Revenue sharing on sales force distributed
Potential conflicts of interest
Financial supermarkets

13. Costs of Investing in Mutual Funds
Fee Structure:
Operating expenses
Front-end load
Back-end load
12 b-1 charge
Fees must be disclosed in the prospectus
Share classes with different fee combinations
Let’s reorder these
Loads – fees to buy
Front load
Back load
CDSC
Operating fees
Operating fees – mgt fees
12b-1 – marketing fees

14. Example 4.2: Fees for Various Classes

15. Fees and Mutual Fund Returns
Example:
Initial NAV = $20
Income distributions of $.15
Capital gain distributions of $.05
Ending NAV = $20.10

16. 4.4 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
Funds with high expenses tend to be poorer performers
12b-1 charges should be added to expense ratios
Compare costs with Morningstar

17. 4.4 Costs of Investing in Mutual Funds
NAV and Effective Load
Cost to initially purchase one share of load fund = NAV + Front-end load (%) (if any)
Stated loads typically range from 0 to 8.5%
Load is designed to offset expenses of marketing the fund; it goes to broker who sells fund to investor
Effective load greater than stated load

18. Table 4.2 Impacts of Costs on Investment Performance
This is not realistic.
No load funds have no load but usually a larger expense ratio
Class B shares typically have the same higher expense ratio as Class C, but it drops when the shares get to about 8 years.
Class A shares have a load, but a lower expense ratio.
Rarely do mutual funds have an 8% load. In fact if they did they would have to provide documentation etc.
Load funds range from the 3 to 5.75 range.
Let’s say you can by a class C fund and pay 1.75% forever.
A class A share of the same fund has a 5% load but a 1% fee forever.
Which would you rather have is you were saving for retirement?
Let’s say you want to retire in 30 years?
5 / .75 = 6.6 years

19. Taxation of Mutual Fund Income
Pass-through status under the U.S. tax code
Taxes are paid only by the investor
Fund investors do not control the timing of the sales of securities from the portfolio
High portfolio turnover leads to tax inefficiency
Average turnover = 60%

20. 4.5 Taxation of Mutual Fund Income
Implications of Fund Turnover
Fund pays commission costs on portfolio purchases and sales—charged against NAV
Turnover rate measured as annual total asset value bought or sold in a year divided by average total asset value

21. Exchange Traded Funds Examples: “spiders,” “diamonds,” and “cubes”
Potential advantages:
Trade continuously like stocks
Can be sold short or purchased on margin
Lower costs
Tax efficient
Potential disadvantages:
Prices can depart from NAV
Must be purchased from a broker

22. Figure 4.2 Growth of U.S. ETFs over Time

23. Figure 4.3 Investment Company Assets Under Management, 2011 ($ Billion) 

24. Mutual Fund Investment Performance
Performance of actively managed funds:
Below the return on the Wilshire index in 25 of the 41 years from 1971 to 2011
Evidence for persistent superior performance (due to skill and not just good luck) is weak, but suggestive
Bad performance is more likely to persist

25. Figure 4.4 Diversified Equity Funds versus Wilshire 5000 Index
Shows lower returns in general.
True.
But what if we create portfolios of mutual funds?
Can we create portfolios that will earn higher returns and / or lower risk than the market?

26. Information on Mutual Funds
Fund’s prospectus describes:
Investment objectives
Fund investment adviser and portfolio manager
Fees and costs
Statement of Additional Information (SAI)
Fund’s annual report

27. Information on Mutual Funds
Morningstar (
Yahoo (biz.yahoo.com/funds)
Investment Company Institute (
Directory of Mutual Funds