1. Chapter 10 Investment Companies Mutual Fund Characteristics Other Pooled Investments Managing Fund Investments

2. Student Learning Objectives

What are mutual funds?

Open-end vs. closed-end funds

UIT, REIT, RELP, REMIC

Selecting a mutual fund

Managing mutual fund investments

3. Forming a Mutual Fund

Investment company forms the fund and advertises its investment objectives, fees, and fund manager.

Interested parties buy shares (of beneficial interest) at a preset price (NAV).

Fund manager then invests the proceeds of the share sale in a variety of stocks.

Thereafter, NAV set by stock prices

• Value of mutual fund assets minus liabilities divided by number of outstanding shares

Regulatory requirements for Investment Companies

• Must distribute

4. Types of Mutual Funds

Open-end

• Investment Company stands ready to buy and sell

• Price based on NAV (sales charge possible)

• Active or Passive management

• May have multiple classes (fee schedules)

Closed-end

• One time issuance of shares

• Shares publicly traded

• Tend to trade at a discount to NAV

5. Types of Mutual Funds

Stock Funds (common, preferred)

Bond Funds (short-, intermediate- or long-term)

Balanced Funds (stocks and bonds)

Taxable vs. Tax free

Index Funds (SP500, Nasdaq, Russell, Wilshire )

Sector Funds (Energy, Utility, Transportation)

Global Funds (Europe, Far East, Emerging)

Exchange Traded Funds (ETF)

6. Types of Mutual Funds

Asset Allocation

Socially Responsible

Money Market

REITs and RELPs

• Real estate applications: commercial, residential

Unit investment trusts

• Unmanaged

• Self-liquidating

• Largely consist of short-term debt securities

Hedge funds

• Typically organized as offshore limited partnerships for qualified investors

• Maximum investment flexibility

Variable annuities

• Mutual fund type of instrument originating at insurance companies

7. 8. Fund Operating Details

Distribution Requirements

• IRS (Subchapter M) requires funds to distribute no less than 90% of interest and dividends received.

• The same applies to net realized capital gains

• • Realized = result of buying and selling

Load Charges

• Most funds areno-load

• Sales charges may vary according to fund

• • Front-end vs. Back-end (tied to holding period or class)

• • Sales charges tend to discourage timing or frequent trading

• • May also involve break-points

Management (Advisory) Fees, 12b-1 Fees

9. Fund Operating Details

Distribution (sales)

• Direct marketing (Vanguard, Fidelity, etc., websites)

• Sales Force

• Broker-Dealers

• Financial Planners

• Retirement fundjobbers(Planco Div of HIG)

Prospectus Requirements

• Investor purchase must be followed by receipt of fund prospectus

• Annual reports required, may receive quarterly reports

10. Pros & Cons of Mutual Funds

Pros

• Professional portfolio management

• Diversification (risk reduction)

• Convenience

• Record keeping

• Other factors

• • Examples: liquidity, minimal investment requirements, regulation

11. Pros & Cons of Mutual Funds

Cons

• Management fees, expenses, and loads for load funds reduce their returns.

• Large investors, such as mutual funds, sometimes adversely affect the market when they trade.

• Institutions usually restrict their analysis to a small percentage of traded stocks (i.e., the larger ones).

12. Net Asset Value (NAV)

Per-share market value of mutual funds portfolio:

NAV = (total assets total liabilities) number of shares outstanding

Forms of Return

• Price Appreciation:Increase in NAV

• Dividends and Interest:Pass-through of dividends and interest received on portfolio

• • Regular dividend

• Capital Gain Distribution:Payment of net capital gain recognized by fund during year

• Reinvestment Strategies: auto-reinvest, cash distribution

13. Load Charges

Contingent deferred sales charge (CDSC)is a back-end load that declines over time

Back-end loads discourage trading by investors

Front-end loads compensate the broker

No-load funds tend to be most popular

Share Class Structure

• Class A:Usually large front-end load, and minimal or no 12b-1 fee . Best if plan long holding period

• Class B:Back-end load and 12b-1 fees, usually convertible to Class A after load waived

• Class C:Minimal or no front-end or back-end load, but substantial 12b-1 fee. Best if plan short holding period

14. Operating Expenses

Management or advisory fees and other operating expenses

• 12b -1 fees cover distribution costs

Paid out of investment income as percent of NAV

Compare loads and operating expenses for varying time periods in evaluating funds

No evidence that higher fees or load charges bring superior performance

15. Performance and taxes

Mutual funds are not taxed directly on income or capital gains as these are passed on to the shareholders

Returns can be broken down into distributions and change in NAV

Portfolio turnover relates to higher capital gains distributions and unrealized capital gains

Dont purchase just before a distribution

16. Managing Fund Investments

Passive versus active

Personal objectives may change over time

Dollar-cost averaging results from investing equal dollar amounts at regular intervals

• Can be beneficial when prices fluctuate, but

• if prices continually rise, buying more earlier is better

Rebalancing Investment Portfolio

• Adjusting allocations to desiredrisk-return target

17. Regulations and Taxation

The SEC regulates U. S. fund operations through Mutual Fund Act of 1940.

State approval is also required to sell shares

Most funds are taxed asregulated investment companies :

• All investment income must be distributed to shareholders each year

• All tax liability falls to individual shareholders

18. Mutual Fund Services

Automatic reinvestment of distributions

Automatic investment plans

Check writing (money market funds)

Exchange privileges within fund families

Periodic statements

19. Why Mutual Funds?

Positives

• Professional management

• Diversification

• Convenience

• Marketability

• Ease of exchange

Negatives

• Most funds under perform the indexes

• Fund performance depends on fund manager and market conditions

20. Special Issues in Closed-End Funds

No prospectus to traders

May have tax liabilities (liquidation)

May be leveraged (additional risk)

May have liquidity problems (thinly traded)

Possibility of conversion to open-end

Different distribution structures (managed)

Tends to trade at less than NAV

21. Real Estate Investment Companies

Real Estate Investment Trust (REIT)

• Min of 75% invested in RE

• Required to pay out 90% of income

• Equity REITs: income producing

• Mortgage REITs: making loans

• Hybrids

Real estate Limited Partnerships (RELP)

• More complex tax rules

• May have a liquidation time set

• May involve sales charges

• Many sell at discounts

22. Real Estate Investment Companies

RE Mortgage Investment Conduits (REMIC)

• Created by breaking up interest and principal streams

• Different maturity packs to match investor needs

• Bear Stearnswasmajor player in this market (> JPM)

23. Unit Investment Trust

Debt

• Funds invested in bonds

• Bond UIT have fixed lives.

• Purpose: provide known income stream

Equity

• Funds invested in Equities

• All have termination date: liquidation > distribution

Pros and Cons

• Negligible fees, tax efficient, convenient

• Sales charges, lack of marketability

24. Exchange Traded Funds

Alternative to Mutual Funds

• No minimum holding period

• Can mimic indexes, sector, countries, etc.

• Many are very liquid 51 traded more than 500,000 shares (April, 2008), another 60 at least 100,000 shares

• Even more are thinly traded: 259 ETF had daily volumes under 100,000 shares (April, 2008)

• Marginable

• Able to sell short

25. Other Investment Vehicles

Hedge Funds

• Multiple fronts

• • Derivatives: options and futures

• • Stocks and bonds

• • International

• Costly and Risky

• Performance suspect backfilling

• Losses can be significant e.g. LTCM

Variable Annuities

• Industry is still evolving trying to increase returns

26. Other Investment Vehicles

Pooled Portfolios

• Operating or holding companies:Some operating or holding companies hold such large portfolios that their performances are more closely related to their security holdings than to their operations.

• Partnerships:Some investment companies choose the partnership form, often a limited partnership, because of its greater flexibility and/or tax advantages.

• Blind pools:Investors bankroll enterprises whose purposes will later be revealed; these pools are sometimes involved in takeover financing.

27. Selecting and Evaluating Funds

Evaluate Historic Performance

• Against a benchmark like the S&P 500 over time

• Morningstar or Weisenberger publications

Assess Future Performance

• Some believe that past performance is a poor predictor since funds do not (over the long term) post better risk-adjusted performance than the broad market averages

• Others feel that past performance is a reasonable, though imperfect, predictor because past performance reflects more than mere luck

28. Selecting and Evaluating Funds

Evaluate services offered by the fund

• Redemptions

• Automatic dividend reinvestment

• Advisory services

Examine fees and expenses

• Load charges

• Operating expenses

Third Party Evaluations

• Morningstar