Slides_Fundamentals of Investments - Chapter 4 doc

All rights reserved.McGraw Hill / Irwin Mutual Fund Operations The Fund Prospectus and Annual Report Š Mutual funds are required by law to supply a prospectus to any investor who wishes

Mutual Funds

Our goal in this chapter is to understand the different types of mutual funds, their risks, and returns

Goal

Š 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

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Mutual Funds

Š Mutual funds are simply a means of combining

or pooling the funds of a large group of investors

Š The buy and sell decisions for the resulting

pool are then made by a fund manager, who is compensated for the service provided

Š Like commercial banks and life insurance

companies, mutual funds are a form of financial intermediary

Investment Companies and Fund Types

Open-end fund

An investment company that stands ready to buy and sell shares at any time

Investment Companies and Fund Types

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Investment Companies and Fund Types

Š Shares in an open-end fund are worth their

NAV, because the fund stands ready to redeem their shares at any time

Š 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

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Work the Web

 For mutual fund facts and figures,

visit:

http://www.ici.org

Mutual Fund Operations

Organization and Creation

Š A mutual fund is simply a corporation It is

owned by shareholders, who elect a board of directors

Š Most mutual funds are created by investment

advisory firms (such as Fidelity Investments),

or brokerage firms with investment advisory operations (such as Merrill Lynch)

Š These firms wish to manage the funds to earn fees

© 2002 by The McGraw-Hill Companies, Inc All rights reserved.

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Work the Web

 All the major fund families have

websites Try, for example:

http://www.vanguard.com

Mutual Fund Operations

Taxation of Investment Companies

Š An investment company that

c holds almost all its assets as investments in stocks, bonds, and other securities,

d uses no more than 5% of its assets when acquiring

a particular security, and

e 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

© 2002 by The McGraw-Hill Companies, Inc All rights reserved.

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Mutual Fund Operations

The Fund Prospectus and Annual Report

Š Mutual funds are required by law to supply a

prospectus to any investor who wishes to purchase shares

Š Mutual funds must also provide an annual

report to their shareholders

Mutual Fund Costs and Fees

Types of Expenses and Fees

cSales charges or “loads.” Front-end loads are charges levied on purchases, while back-end loads are charges levied on redemptions

d12b-1 fees SEC Rule 12b-1 allows funds to

spend up to 1% of fund assets annually to cover distribution and marketing costs

eManagement fees Usually based on fund size, performance, etc

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Mutual Fund Costs and Fees

Types of Expenses and Fees …continued

fTrading costs This is related to the fund’s

turnover

Mutual Fund Costs and Fees

Expense Reporting

Š Mutual funds are required to report expenses

in a fairly standardized way in the prospectus

c Shareholder transaction expenses - loads and deferred sales charges.

d Fund operating expenses - management and 12b-1 fees, legal, accounting, and reporting costs,

director fees.

e Hypothetical example showing the total expense you would pay over time per $10,000 invested.

Mutual Fund

Costs & Fees

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Work the Web

 Prospectuses are increasingly available

online To see some examples, visit:

© 2002 by The McGraw-Hill Companies, Inc All rights reserved.

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Mutual Fund Costs and Fees

Why Pay Loads and Fees?

Š You may want a fund run by a particular

manager, and all such funds are load funds

Š You want a specialized type of fund Loads

and fees for such funds tend to be higher as there is little competition among them

Short-Term Funds

Š Short-term funds are collectively known as

money market mutual funds, or MMMFs

Š MMMFs always maintain a $1 net asset value

to make them resemble bank accounts

Š 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

© 2002 by The McGraw-Hill Companies, Inc All rights reserved.

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Short-Term Funds

Š Most banks offer what are called “money

market” deposit accounts, or MMDAs, which are much like MMMFs

Š The distinction is that a bank money market

account is a bank deposit and offers FDIC protection

Work the Web

 For information on thousands of

funds, including MMMFs, visit:

http://www.mfea.com

© 2002 by The McGraw-Hill Companies, Inc All rights reserved.

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Long-Term Funds

Š A fund’s objective is the major determinant of the fund type

Š Historically, mutual funds were classified as

stock, bond, or income funds However, it is becoming increasingly difficult to do so

Stock, bond,

or income?

Š Some stock funds focus on companies in a

particular size range

Î Small company, midcap.

Š Some fund groups invest internationally

Î Global, international, region, country, emerging markets.

© 2002 by The McGraw-Hill Companies, Inc All rights reserved.

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Stock Funds

Š Sector funds specialize in specific sectors of

the economy

Š Other fund types include index funds, social

conscience funds, and tax-managed funds

Bond Funds

Š Bond funds may be distinguished by their

c maturity range , d credit quality,

e taxability, f bond type, and g issuing country

Š Bond fund types include short-term and

intermediate-term funds, general funds, yield funds, mortgage funds, world funds,

high-insured funds, single-state municipal funds

© 2002 by The McGraw-Hill Companies, Inc All rights reserved.

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Stock and Bond Funds

Š Funds that do not invest exclusively in either

stocks or bonds are often called “blended” or

“hybrid” funds

Š Examples include balanced funds, asset

allocation funds, convertible funds, income funds

Mutual Fund Objectives: Recent Developments

Š In recent years, there has been a trend toward

classifying a mutual fund’s objective based on its actual holdings

Š 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)

Mutual Fund Objectives: Recent Developments

Mutual Fund Objectives: Recent Developments

Š 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:

Growth Blend

Value Large

Medium Small

Style

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Work the Web

 One of the best mutual fund sites is:

http://www.morningstar.com

Try picking some funds using their

“Fund Selector.”

 To learn more about “social

conscience” funds, visit:

http://www.socialinvest.org

http://www.domini.com

Mutual Fund Performance

Š Mutual fund performance is very closely

tracked by a number of organizations

Mutual Fund Performance

Mutual Fund Performance

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Mutual Fund Performance

Š While looking at historical returns, the

riskiness of the various fund categories should also be considered

Š Whether historical performance is useful in

predicting future performance is a subject of ongoing debate

Š Some of the poorest-performing funds are

those with very high costs

& Exchange

Traded Funds

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Closed-End Funds & Exchange Traded Funds

Š 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

Š Despite a great deal of research, the closed-end fund discount phenomenon remains largely

unexplained

Closed-End Funds & Exchange Traded Funds

Š An exchange traded fund, or ETF, is basically

an index fund, except that it trades like a closed-end fund (without the discount

phenomenon)

Š An area where ETFs seem to have an edge

over the more traditional index funds is the more specialized indexes

© 2002 by The McGraw-Hill Companies, Inc All rights reserved.

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Chapter Review

Š Investment Companies and Fund Types

Î Open-End versus Closed-End Funds

Î Net Asset Value

Š Mutual Fund Operations

Î Mutual Fund Organization and Creation

Î Taxation of Investment Companies

Î The Fund Prospectus and Annual Report

Chapter Review

Š Mutual Fund Costs and Fees

Î Types of Expenses and Fees

Î Expense Reporting

Î Why Pay Loads and Fees?

Š Short-Term Funds

Î Money Market Mutual Funds

Î Money Market Deposit Accounts

© 2002 by The McGraw-Hill Companies, Inc All rights reserved.

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Chapter Review

Š Long-Term Funds

Î Stock Funds

Î Taxable and Municipal Bond Funds

Î Stock and Bond Funds

Î Mutual Fund Objectives: Recent Developments

Š Mutual Fund Performance

Î Mutual Fund Performance Information

Î How Useful are Fund Performance Ratings?

Chapter Review

Š Closed-End Funds and Exchange Traded

Funds

Î Closed-End Funds Performance Information

Î The Closed-End Fund Discount Mystery

Î Exchange Traded Funds