chapter 16

Investments: Analysis and BehaviorChapter 16- Mutual Funds

2008 McGraw-Hill/Irwin

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Learning ObjectivesUnderstand the structure and pricing of mutual fundsKnow the advantages and disadvantages of buying mutual fundsBe able to assess mutual fund performanceAssess mutual fund manager incentivesRecognize the impact of taxable distributions on fund returns

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Mutual FundsAn investment company that issues its portfolio shares to investors.

Money from shareholders are pooled and invested in a wide range of stocks, bonds, or money market securities.Managed by professional managers

Each investor shares proportionately in the income and investment gains and losses, as well as the brokerage expenses and management fees.

Open end fund: # of shares issued solely depends on investor demandBought and sold directly through the investment company (not an exchange)

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Net asset Value NAV: per share value of a mutual funds investment holding.

Example A mutual fund has $100 mil in assets and $3 mil in short term liabilities. 10.765 mil shares outstanding. What is the NAV?Solution ($100 mil - $3 mil) / 10.765 mil = $9.0107 per share

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Types of Mutual Funds ObjectiveFunds HoldGrowth PotentialIncome PotentialStabilityMoney Market FundsTaxable money marketCurrent income stability of principalCash investmentsNoneModerateVery highTax-exempt money marketTax-free income, stability of principalMunicipal cash investmentsNoneModerateVery highBond FundsTaxable bondCurrent incomeWide range of government and/or corporate bondsNoneModerate to highLow to moderateTax-exempt bondTax-free incomeWide range of municipal bondsNoneModerate to highLow to moderateCommon Stock FundsBalancedCurrent income capital growthStocks and bondsModerateModerate to highLow to moderateEquity incomeHigh-yielding stocks, convertible bondsModerate to highModerateLow to moderateValue fundsLow P/E, P/B stocksModerate to highLow to moderateLow to moderateGrowth and incomeDividend-paying stocksModerate to highLow to moderateLow to moderateDomestic growthCapital growthU.S. stocks with high potential for growthHighVery lowLowInternational growthStocks of companies outside U.S.HighVery low to lowVery lowAggressive growthAggressive growth of capitalStocks with very high potential for growthVery highVery lowVery lowSmall capStocks of small companiesVery highVery lowVery lowSpecializedStocks of industry sectorsHigh to very highVery low to moderateVery low to low

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Sources of InformationLipper Inc.: leading provider of data and analysis on the investment company business ( www.lipperweb.com )Morningstar.com: provide unbiased data and analysis and candid editorial commentary (www.morningstar.com) Vanguard Group: providing competitive investment performance and lowest operating expenses ( www.vanguard.com )

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Mutual Fund AdvantagesBroad diversificationDiversified stock funds hold large and small company stocks broadly spread across industries and economic sectorsDiversified bond funds hold bonds with different maturities, coupon, and credit qualityAbility to retain professional investment management at a reasonable cost Investor convenience Many offer fund family

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Mutual Fund DisadvantagesHigh management fees and sales commissionsNo-load funds Volatility can be significantDiversification doesnt protect investors from the risk of loss from an overall decline in financial marketsMutual fund regulation doesnt eliminate the risk of an investment falling in value

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Figure 16.2

100100100

110109106.3

121118.81112.9969

133.1129.5029120.1157047

146.41141.158161127.6829940961

161.051153.86239549135.7270227242

177.1561167.7100110841144.2778251558

194.87171182.8039120817153.3673281406

214.358881199.256264169163.0294698134

235.7947691217.1893279442173.3003264117

259.37424601236.7363674592184.2182469756

285.311670611258.0426405305195.8239965351

313.8428376721281.2664781783208.1609083168

345.2271214393306.5804612143221.2750455408

379.7498335832334.1727027236235.2153734098

417.7248169416364.2482459688250.0339419347

459.4972986357397.0305881059265.7860802765

505.4470284993432.7633410355282.530603334

555.9917313492471.7120417287300.330031344

611.5909044841514.1661254842319.2508233187

672.7499949326560.4410767778339.3636251877

740.0249944258610.8807736878360.7435335746

814.0274938684665.8600433197383.4703761898

895.4302432552725.7874472185407.6290098897

984.9732675808791.1083174682433.3096375128

1083.4705943388862.3080660403460.6081446761

1191.8176537727939.9157919839489.6264577907

1310.999419151024.5082132625520.4729246315

1442.0993610651116.7139524561553.2627188833

1586.30929717151217.2182081772588.1182701729

1744.94022688861326.7678469131625.1697211938

1919.43424957751446.1769531353664.555413629

2111.37767453531576.3328789175706.4224046877

2322.51544198881718.2028380201750.927016183

2554.76698618771872.8410934419798.2354182025

2810.24368480642041.3967918516848.5242495493

3091.26805328712225.1225031183901.9812772709

3400.39485861582425.3835283989958.8060977389

3740.43434447742643.66804595481019.2108818965

4114.47777892512881.59817009081083.421167456

4525.92555681763140.94200539891151.6767010057

$4,526

$3,141

$1,152

Begin with $100

10% Return, no cost

10% Return, 1% cost

10% Return, 1% cost, 30% taxes

Years

Ending Value

Figure 16.2 Impact of Costs and Taxes on 10% Return

Data

Year10% Return, no cost10% Return, 1% cost10% Return, 1% cost, 30% taxes

0100100100

1110109106

2121119113

3133130120

4146141128

5161154136

6177168144

7195183153

8214199163

9236217173

10259237184

11285258196

12314281208

13345307221

14380334235

15418364250

16459397266

17505433283

18556472300

19612514319

20673560339

21740611361

22814666383

23895726408

24985791433

251083862461

261192940490

2713111025520

2814421117553

2915861217588

3017451327625

3119191446665

3221111576706

3323231718751

3425551873798

3528102041849

3630912225902

3734002425959

38374026441019

39411428821083

40452631411152

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Sources of Investment ReturnsTotal Return: dividend and interest income and realized and unrealized appreciation

Income distribution: interest and dividend income after expenses.

Capital gains unrealized until the fund sells the shares (Unrealized capital gains)

The realized capital gains are paid out to shareholders at the end of the year (capital gains distributions)

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Mutual fund expensesOperating expense ratio: total of investment advisory fees and costs of legal and accounting services, etc., expressed as a percentage of the funds average net assets (range from 0.2% to 2%)Lowest for money market mutual fund and highest for international stock fundsTend to be lowest for large, liquid funds Load charges: one time sales commissionsFront-end loads (charged at the time of purchase)Back-end loads (charged at the time of sales of shares) Low-end funds: sales fee ranging from 1% to 3%12b-1 fees: marketing and distribution costsNo-load funds: fund without front-end or back-end load charges

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Table 16.4A. Typical fee tables found in three different mutual fund prospectuses

Fund AFund BFund CShareholder Transaction ExpensesSales load imposed on purchasesNoneNone4.75%Sales load imposed on reinvested dividendsNoneNone4.75 Redemption feesNoneNoneNoneExchange feesNoneNoneNoneAnnual Fund Operating ExpensesManagement and administrative expenses0.22%0.60%0.70%Investment advisory expenses0.02 12b-1 marketing fees 0.30 Marketing and distribution costs0.02 Miscellaneous expenses0.03 0.32 0.26 Total Operating Expenses0.29%1.22%0.96%Expenses on a $10,000 Investment1 year$ 30$ 124$ 5873 years933878235 years1636701,07710 years3681,4771,805

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B. The impact of equity mutual fund costs on long-term investor returns.

Fund A : typical cost efficient index fundFund B : conventional no-load stock mutual fundFund C : low-load stock mutual fund with less than typical annual operating expenses

Fund AFund BFund CInitial investment$ 10,000$10,000$10,000Day 110,00010,0009,5255 years18,18917,45116,18610 years33,08430,56529,68915 years60,17853,14552,41620 years109,45892,74392,539Gross return13.00%13.00%13.00%Operating expenses0.29%1.22%0.96%Net return12.71%11.78%12.04%

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Style boxes Characterize mutual funds by market capitalization (large, mid, and small cap) Next, determine how cheap or expensive portfolio holdings are relative to the overall market using P/E and P/B ratios (Value, Blend and Growth)

Value Strategy(Score 2.25) Large-cap (Top 5%)S & P 500BenchmarkMid-cap(Next 15%)Wilshire 4500BenchmarkSmall-cap(Bottom 80%)Russell 2000Benchmark

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Mutual Fund OrganizationMutual fund shareholders: own mutual funds, elect the board of directors

Majority of the directors must be independent directors

Investment advisor: manages the day-to-day operations

Principal underwriter, administrator, transfer agent, custodian, and independent public accountant

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Evaluating Fund PerformanceUsing ranking tools or portfolio evaluation tools (alpha, Sharp ratio, and Treynor measure)

20 categories in domestic equity mutual funds, 14 in international equity funds, 12 in fixed income and 17 in municipal bond funds

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Top 10 U.S. Domestic Funds Based on 3 Year Return

Fund Name: Classification1 Mon.YTD1 Year3 Year5 Year10 YearPacific Adv: Small Cp;A PASMXSmall-Cap Value16.816.827.849.2%19.312.1ProFunds: UltraSm-Cap;Inv UAPIXSmall-Cap Core17.717.729.349.2%6.4--Pacific Adv: Small Cp;C PGSCXSmall-Cap Value16.616.626.748.0%18.0--ProFunds: UltraSm-Cap;Svc UAPSXSmall-Cap Core17.617.628.047.7%5.4--Schneider Sm Cap Val SCMVXSmall-Cap Value5.15.122.446.8%22.3--ProFunds: UltraMidCap;Inv UMPIXMid-Cap Core11.611.639.745.6%7.6--Hodges Fund HDPMXMulti-Cap Core9.89.833.345.0%14.513.6Fidelity Lvrgd Co Stk FLVCXMid-Cap Core6.96.926.144.4%22.4--ProFunds: UltraMidCap;Svc UMPSXMid-Cap Core11.511.538.244.1%6.6--Fidelity Adv Lev Co; Ins FLVIXMid-Cap Value6.76.725.443.3%22.6--

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Exchange-Trade Funds (ETFs)Tradable shares in baskets of stocks that closely track broad market averages, market sectors, or major stock markets from around the world. Standard and Poors Depository Receipts (SPY), spiders: closely track S&P 500 IndexDiamonds (DIA): track Dow Jones Industrial AverageQQQQ: track Nasdaq 100 Index Select Sector SPDRs: unbundled S&P Index to give investors ownership in a particular market sector or group of industries. Barclays Global Investors: offer iShares internationally indexedTradable shares in baskets of stocks that closely track broad market averages, market sectors, or major stock markets from around the world.

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Closed-End FundsIssues a fixed number of shares at a given point in time

Collect money from investors through and IPO and use this money to invest in securities.

# of securities are fixed at the time of IPO.

When the market price exceeds its NAV, selling at a premium, otherwise, selling at a discount (closed-end funds typically sell at a discount)

Suited to specialized investing in small or illiquid markets * Assets are Net Assets, expressed in Millions, and exclude leveraged capital (preferred stock, debt, etc.).

StatisticValueTotal number of closed-end funds (U.S. exchanges only):693Total Assets*:$214,736.69

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Hedge FundsLike mutual funds, a means for groups of investors to pool financial resources

Typically organized as partnership arrangement available only to the wealthiest investors

Flexibility to use speculative investment strategies

Subject to only limited oversight.

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Table 16.6 Hedge Funds Differ From Mutual Funds in a Number of Ways

Mutual FundsHedge FundsWho Invests92 million Americans own mutual fund shares. The only qualification for investing is having the minimum investment to open an account with a fund company often $1,000 or less.Only sophisticated, high net worth investors are eligible to invest. The typical investor is a wealthy individual or an institution such as an endowment or foundation. A minimum investment of $1 million or more is required.FeesMutual fund shareholders pay, on average, an annual expense ratio of roughly 1.5% of assets. Load charges can increase this to 2.5% to 5% per year. Funds must disclose fees and expenses in detail. Sales charges and other distribution fees are subject to specific regulatory limits.Hedge fund investors often pay a portfolio management fee of 1% to 2% of net assets, plus a performance-based fee that can run as high as 10% per year, depending upon performance. Fees are not subject to specific regulatory limits.InvestmentPracticesSecurities laws restrict a mutual fund's ability to leverage, or borrow against the value of securities in its portfolio. Funds that use options, futures, forward contracts, and short selling must "cover" their positions with cash reserves or other liquid securities. Investment policies must be fully disclosed to investors.Leveraging strategies are hallmarks of hedge funds. Investment policies do not have to be disclosed, even to investors in the fund.Pricing andLiquidityMutual funds must value their portfolio securities and compute their share daily. They generally must also allow shareholders to redeem shares on at least a daily basis.There are no specific rules on valuation or pricing. As a result, hedge fund investors may be unable to determine the value of their investment at any given time. In addition, new investors typically must pledge to keep their money in a hedge fund for at least one year.

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Taxes on distributionsShareholders pay taxes due once income dividends and capital gains distributions are received.

All income and capital gains distributions are generally subject to income taxes. Municipal bond or US T-securities interest income exempt from federal taxes, but capital gains are taxable.

Turnover rate: expressed as a percentage of the funds average assets (average turnover rate for stock mutual fund: 79%)