Lecture 18

Mutual Funds

Net Asset Value

NSOLMVA

NAV

NAV = net asset value MVA = market value of assets L = funds liabilities NSO = number of shares outstanding

Sales Charges

“Front-end” load—commission paid when shares are purchased.

Load fees range from 0% to 8.5%. Some funds charge load fees on

reinvested dividends! The fund’s prospectus may say

“Dividend reinvested at offering price.”

Sales Charges

“Back-end” load—a contingent deferred sales charge. Starts at 5 or 6%. Decreases by 1% per year.

Load charges are ignored when a fund’s performance is reported.

Historical performance of load and no-load funds.

Sales Charges

12b-1 charges. Covers distribution costs and

commissions paid to brokers. Annual charge of 0.25% to 1.00%

of fund’s assets. Some funds that are closed to new

investors continue to charge 12b-1 fees!

Sales Charges Comparison of three funds.

Fund A—6% “front-end” load fee. Fund B—6% “back-end” load fee

that decreases by 1% per year. Fund C—No “front-end” load fee, a

1% annual 12b-1 fee and a “back-end” load fee that starts at 5% and decreases by 1% per month.

Sales Charges

Some mutual funds have several classes of stock. Class A may have a “front-end”

load fee of 5%. Class B may have a 12b-1 fee of

1% per year and a back-end load fee that begins at 5% and decreases by 1% per year.

Sales Charges

Transaction and redemption charges. Paid when fund shares are

purchased, liquidated, or exchanged into shares of another fund.

Usually 1% of net asset value. Paid to fund rather than fund’s

sponsors or sales representative.

Expense Ratios

Investment advisory fees. Administrative expenses. Other operating expenses. 12b-1 fees. What counts is fund’s expense ratio

which vary from 0.2% to 2.5%. A fund’s expense ratio is a key

determinant of performance.

Invisible Costs

Transaction costs associated with the fund buying and selling securities. Commissions: 0.1% to 0.5% Bid-Ask spreads: 0.125% to 6.0%. Price impact of a large block trade. Average transaction cost is

estimated to be about 0.6%.

Invisible Costs

A fund’s annual portfolio turnover is

assets sfund' of valueAveragesalesor purchases of Minimum

A fund’s transaction cost can be estimated by multiplying the fund’s annual portfolio turnover by 2 and then multiplying by the average transaction cost of 0.6%.

Taxes

To maintain a tax-free status a fund must distribute at least 90% of its dividends and realized capital gains each year.

Funds with high annual portfolio turnover realize more capital gains.

Taxes

If you purchase a mutual fund just prior to the distribution of dividends or capital gains, you will pay taxes on income that you did not earn.

Unrealized capital gains are a potential tax liability.

Unrealized capital loses are a potential tax savings.

Performance

Annual geometric rates of return from 1970 to 1996. Wilshire 5000 index 12.36% S&P500 index 12.42% Lipper General Equity

Fund Average 11.08%

Performance

Returns on market indexes ignore expenses.

Expense ratio of Vanguard’s Wilshire 5000 Index Fund is about 0.25%.

The turnover ratio is about 3%. The overall costs would be about

0.30%.

Performance

Malkiel’s estimates of Jensen’s alpha.

ri – rf = + (rM - rf) + e

Wilshire 5000 p-value Net return -0.93% 7.5% Gross return 0.18% 71.1%S&P500 p-value Net return -3.20% 0.0% Gross return -2.03% 0.1%

Performance

Elton, Gruber, Das and Hlavka ri – rf = + (rM - rf) + S(rS – rf)

+ D(rD – rf) + e

rM—return on S&P500 index.

rS—return on a small stock index.

rD—return on a bond index. is negative, though generally not

statistically significant.

Performance

About 60% of above average funds in one year remain above average over the next 3 years.

About 75% of below average funds in one year remain below average over the next 3 years.

Performance

Persistence in relative performance across fund managers is: Mainly due to expenses and

transaction costs, Concentrated at the extremes of

best and worst performers.