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Mutual Funds – Why so popular?

Easy ways to achieve diversification, even for small investors

Reduced transaction costs (e.g., brokerage fees)

Delegation of asset selection and management

An easy way to ratably invest

Alternatives to traditional savings and checking accounts through money market mutual funds

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Mutual Funds – Why so popular?

Example 1: You are considering investing $ 100 in stocks.

How many shares can you buy?

Price ($/share) Number of Shares Citigroup $ 20/share $100/($20/sh) = 5 shares GE $ 33.33/share $100/($33.33/sh) = 3

shares Exxon $ 75/share $100/($75/sh) = 1 share

( + brokerage fees @ $ 10 / trade = 1 trade*$10 = $10. )

-------- You just buy one of the above companies.

-------- You cannot invest in all 3 companies because you cannot buy fractions of shares of common stock.

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Mutual Funds – Why so popular?Example 2: You & 8 of your closest friends form an

investment pool, each investing $ 100 in stocks. Your pool decides to invest equally (on a $ basis) in each of the 3 companies. How many shares can your pool buy? (9 people x $100 each = $900. $300 per company.)

How many shares can you buy?

Price ($/share) Number of Shares Citigroup $ 20/share $300/($20/sh) = 15 shares GE $ 33.33/share $300/($33.33/sh) = 9

shares Exxon $ 75/share $300/($75/sh) = 4 shares

( + brokerage fees @ $ 10 / trade = 3 trades * $10 = $30.$30/9 people = $3.33 per person. )

You’ve diversified stocks and reduced commissions. Your $100 is 33.3% Citi, 33.3% GE, & 33.3% Exxon.

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Mutual Funds --- prices are quoted as “NAV”

Net Asset Value (“NAV”)

Used as a basis for valuation of investment company shares

Used to determine your cost when you buy shares Used to determine how much you receive when

you sell (“redeem”) your shares NAV is calculated at the end of each trading day. Calculated as:

NAV = Market Value of Assets - Liabilities

Shares Outstanding

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Mutual Funds --- prices are quoted as “NAV”

Note – in our Example 2, number of mutual fund shares is different from number of shares of common stock. When we created our pool with our 8 friends, we would

define how many “mutual fund shares” we had Say we said our pool was 90 shares and therefore each

of us received 10 shares ( = 90 shares / 9 people) The NAV of our mutual fund would be:

NAV = Market Value of Assets - Liabilities

Shares Outstanding

= ( $15x20)+($33.33x9)+($75x4) 90

= $ 10.( Note --- the mutual fund holds 33 shares of common

stock.)

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Mutual Funds: advantages of ratably investing Suppose you save $100 each month in you mutual fund

Mutual funds let you buy fractions of shares. Although the fund is down 1.3% = [(9.87-10)/10]=

[(9.87/10)-1], your investment is only down [(60.5944*9.87)/600]-

1= 0.29%.

Change from prior

month NAV NAVInvestment per month

Number of shares you

buy

$10.00 $100.00 10.0000

2% 10.20$ $100.00 9.8039

-3% 9.89$ $100.00 10.1071

-4% 9.50$ $100.00 10.5283

5% 9.97$ $100.00 10.0269

-1% 9.87$ $100.00 10.1282

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Open-End versus Closed-End Funds Open-End

Sold at Net Asset Value (NAV) Changes in number of mutual fund’s shares outstanding

when new shares are sold or old shares are redeemed

Closed-End Trade on organized exchanges through brokers like

comon stock Sold at premium or discount to NAV No change in number of mutual fund’s shares

outstanding unless new shares are offered Similar to “REITs” Typically, these deal with illiquid securities or private

investments.

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Wide Variety of Mutual Funds are offered

Each mutual fund must have a prospectus that states its objectives

Example: a fund’s objective might be to replicate the returns of the S&P 500 index

Management companies manage a family of mutual funds. Some examples include: Fidelity Vanguard Putnam Dreyfus

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Mutual Fund Fees

Front-end load: a commission you pay when you buy into the fund

Back-end load: a commission you pay when you exit the fund

Operating expenses: costs to operate the fund, such as salaries and trading commissions

12 b-1 charges: annual charges for marketing and distribution costs

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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

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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)

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Problem 3

NAV = (Market Value of Assets – Liabilities) Shares OutstandingA. (200,000)x($35) = $ 7,000,000B. (300,000)x($40) = $12,000,000C. (400,000)x($20) = $ 8,000,000D. (600,000)x($25) = $15,000,000

$42,000,000$42,000,000 – $30,000 = $10.49 = NAV

4,000,000

Shares Outstanding4,000,000

Liabilities$30,000

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Problem 4

Turnover rate = Value of stocks sold and replaced Market Value Assets

Value of stocks sold = (600,000x$25)= $15,000,000 or

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

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Types of Mutual Funds

Money Market Equity

Examples: Value, Growth, Large cap, Small cap, Green

Specialized Sector Examples: Energy, Health Care

Bond Balanced Funds Asset Allocation and Flexible Indexed

Examples: S&P 500,Wilshire 5000 International

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Lots of info about mutual funds at the ICI web sitehttp://members.ici.org/aboutici.do

About ICI

The Investment Company Institute is the national association of U.S. investment companies, including mutual funds, closed-end funds, exchange-traded funds (ETFs) and unit investment trusts (UITs). ICI seeks to encourage adherence to high ethical standards, promote public understanding, and otherwise advance the interests of funds, their shareholders, directors, and advisers. Members of ICI manage total assets of $15.7 trillion and serve more than 90 million shareholders.

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U.S. Mutual Fund Combined Assets http://www.ici.org/research/stats/trends/trends_09_13

R=Revised data

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Data from ICI web sitehttp://www.icifactbook.org/fb_ch1.html#investment

Individual and Household OwnershipHouseholds are the largest group of investors in funds, and registered investment companies managed 23 percent of households’ financial assets at year-end 2012, up slightly from 2011 (Figure 1.2). As households have increased their reliance on funds over the past decade, their demand for directly held equities has decreased (Figure 1.3). Household demand for directly held bonds has been weak since the financial crisis, and household assets in directly held bonds fell by $51 billion in 2012. In contrast, households made net investments in registered investment companies in 10 of the past 11 years. Households invested an average of $349 billion each year, on net, in long-term registered investment companies versus average annual sales, on net, of $230 billion in directly held equities and bonds.

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Data from ICI web site http://www.icifactbook.org/fb_ch1.html#investment

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Institutional Ownership

Businesses and other institutional investors also rely on funds. Many institutions use money market funds to manage a portion of their cash and short-term assets. Nonfinancial businesses held 21 percent of their cash in money market funds at year-end 2012. Institutional investors also have contributed to the growing demand for ETFs. Investment managers, including mutual funds and pension funds, use ETFs to manage liquidity. This strategy allows them to help manage their investor flows and remain fully invested in the market. Asset managers also use ETFs as part of their investment strategies, including as a hedge for their exposure to equity markets.

Data from ICI web sitehttp://www.icifactbook.org/fb_ch1.html#investment

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Mutual Funds – Survivorship Bias

Tremendous growth in number of mutual fund: ~ 2,900 mutual funds in 1990 ~ 8,000 mutual funds in 1999.

Wall Street Journal article ( 7/23/2002 ) “Fewer Funds Have Positive Streaks”:

As of June 30, 2002, only 790 U.S. stock funds had been around for at least 10 years.

Among these, only 11 beat the S&P 500 Index, posted positive gains for at least 10 consecutive calendar years, and had the same manager “at the helm”.

Where have the mutual funds from 1990 gone?

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Mutual Funds – Survivorship Bias (continued)

Wall Street Journal article ( 7/10/2002 ) “Rewriting History: How Mutual Funds Hide Mistakes by Closing Bad Performers”:

Vanguard founder John Boggle: "6 ½% of stock funds are killed off each year, double the failure rate of a few years ago. 2/3 will be gone in 10 years. When a fund is killed off, it’s expunged from

historical records. Survivorship bias: As poor-performers are killed off,

the average of the surviving funds look better. Examples:

$135 M Berger New Generation (- 3.2%/yr) merged into $35 M Berger Mid Cap Growth (+ 15.5%/yr).

$354 M Credit Suisse Focus (- 2.2%/yr) merged into $29 M Credit Suisse Equity (+ 5.7%/yr).

(The SEC sometimes allows these “minnow-swallows-the-whale”. Under SEC guidelines, the surviving fund is allowed to use the record of whichever predecessor fund it most closely resembles. )

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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.

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Exchange-Traded Funds (“ETFs”)http://finance.yahoo.com/q/hl?s=XLE+Holdings

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http://www.nasdaq.com/investing/etfs/what-are-ETFs.aspx

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ETFs http://en.wikipedia.org/wiki/Exchange-traded_fundStructure

ETFs offer public investors an undivided interest in a pool of securities, and other assets and thus are similar in many ways to traditional mutual funds, except that shares in an ETF can be bought and sold throughout the day like stocks on a securities exchange through a broker-dealer.

Unlike traditional mutual funds, ETFs do not sell or redeem their individual shares at net asset value, or NAV. Instead, financial institutions (the broker-dealers) purchase and redeem ETF shares directly from the ETF, but only in large blocks, varying in size by ETF from 25,000 to 200,000 shares, called "creation units".

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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%

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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 = $1,376.25Class 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

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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

$3,901.32N x LN [1.10 / 1.095]N x LN [1.10 / 1.095]

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