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Chapter 4 Mutual Funds and Other Investment Companies Mc. Graw-Hill/Irwin Copyright © 2010 by Chapter 4 Mutual Funds and Other Investment Companies Mc. Graw-Hill/Irwin Copyright © 2010 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

4. 1 Investment Companies 4 -2 4. 1 Investment Companies 4 -2

Services of Investment Companies a. Administration & record keeping v Tax purposes v Low Services of Investment Companies a. Administration & record keeping v Tax purposes v Low cost reinvestment v Low cost additional investment, DCA Low cost switching between fund v families v Some funds may allow check writing privileges 4 -3

Services of Investment Companies b. Diversification § Low cost, instant diversification c. Professional management Services of Investment Companies b. Diversification § Low cost, instant diversification c. Professional management § Lower research costs § Portfolio managed according to specific objectives § Professionals to find undervalued securities and/or engage in asset allocation strategies d. Reduced transaction costs e. Investing for retirement: Most funds can be set up as an IRA 4 -4

4. 2 Types of Investment Companies 4 -5 4. 2 Types of Investment Companies 4 -5

Organizational Forms Unit Investment Trusts (UITs): unmanaged, fixed composition portfolios v Any interest and/or Organizational Forms Unit Investment Trusts (UITs): unmanaged, fixed composition portfolios v Any interest and/or dividends are distributed immediately to trust certificate holders. v Provide diversification within one sector or area and low cost entry. v Often levered, rates of return can be extreme. 4 -6

Organizational Forms Managed Investment Companies: Managed, usually changing composition portfolio. v __________________ More commonly Organizational Forms Managed Investment Companies: Managed, usually changing composition portfolio. v __________________ More commonly known as a ‘mutual fund’ v The fund's board of directors typically hires an investment advisor to select and manage the fund assets according to some specific goal(s) set by the board any regulatory requirements. v The investment advisor usually creates the fund and selects the investments. Most funds are of this type. 4 -7

Organizational Forms A managed investment company (mutual fund) may be v Open end – Organizational Forms A managed investment company (mutual fund) may be v Open end – shares are bought from the fund and redeemed by the fund or v Closed end – shares are bought and sold among investors in the marketplace (NASDAQ or an exchange) and the fund itself is not involved. 4 -8

Closed End Mutual Funds 4 -9 Closed End Mutual Funds 4 -9

Differences in Open & Closed End Most funds are open end: The advantage of Differences in Open & Closed End Most funds are open end: The advantage of the open end form is v. Liquidity for the investor v. Fund’s ability to grow (advantage for the fund or sponsor) The disadvantage of the open end form is v v The need to keep a cash reserve Vulnerable to panics 4 -10

Other Investment Organizations – Commingled funds • Partnerships of investors that pool their funds. Other Investment Organizations – Commingled funds • Partnerships of investors that pool their funds. Designed for trusts or larger retirement accounts to get professional management for a fee. Operates similar to a mutual fund. – REITs • Similar to closed end fund. Invest in real estate and real estate loans. Equity trusts purchase real estate. Mortgage trusts invest in mortgage and construction loans. 4 -11

Other Investment Organizations Cont. – Hedge Funds • Similar to mutual funds, but not Other Investment Organizations Cont. – Hedge Funds • Similar to mutual funds, but not registered and not subject to SEC regulations. • Available to institutional and high net worth investors • Can pursue investment strategies that are not Grew from about $50 billion in 1990 to about $2 allowed for 2008. funds. mutual trillion in – 4 -12

4. 3 Mutual Funds 4 -13 4. 3 Mutual Funds 4 -13

Net Asset Value Used as a basis for valuation of investment company shares – Net Asset Value Used as a basis for valuation of investment company shares – Selling new shares – Redeeming existing shares Calculation 4 -14

Open-End and Closed-End Funds: Key Differences Shares Outstanding v Closed-end: no change unless new Open-End and Closed-End Funds: Key Differences Shares Outstanding v Closed-end: no change unless new stock is offered v Open-end: changes when new shares are sold or old shares are redeemed Pricing v Open-end: Fund share price = Net Asset Value (NAV) v Closed-end: Fund share price may trade at a premium or discount to NAV 4 -15

NAV calculation ABC Fund ($Millions except NAV) Market Value Securities + Cash & Receivables NAV calculation ABC Fund ($Millions except NAV) Market Value Securities + Cash & Receivables - Current Liabilities NAV Total # Fund Shares NAV $550. 00 75. 00 (20. 00) $605. 00 Most Mutual Funds have little or no Long Term Debt 20. 00 $ 30. 25 4 -16

How Funds Are Sold Directly marketed – You find them – May avoid front How Funds Are Sold Directly marketed – You find them – May avoid front end load • Front end load is an up front cost (fee) to purchase a share of a mutual fund. Sales force distributed – Recommended by a broker or planner – Usually will have a front end load – May be revenue sharing on sales force distributed Potential conflict of interest 4 -17

Potential Conflicts of Interest: Revenue Sharing v. Brokers put investors in funds that may Potential Conflicts of Interest: Revenue Sharing v. Brokers put investors in funds that may not be the most appropriate ______________ v. Mutual funds could direct trading to higher cost brokers ___________ not illegal v. Revenue sharing is _____ but it must be disclosed ____ to the investor 4 -18

How Funds Are Sold Financial supermarkets – E. G. , Charles Schwab Avoid a How Funds Are Sold Financial supermarkets – E. G. , Charles Schwab Avoid a direct load, but may cost you more in expenses Low cost switching even between fund families and easier to interpret record keeping 4 -19

Funds & Investment Objectives 1. Domestic Stock Funds a. Aggressive Growth Sector, Small Cap Funds & Investment Objectives 1. Domestic Stock Funds a. Aggressive Growth Sector, Small Cap Growth, Mid Cap Growth* i. b. Growth i. Large Cap Growth c. Growth & Income Investment characteristics • Focus on capital gains, low income • High turnover i. Small, Med, Large Blend • Substantial potential for ii. Small, Med, Large Value capital loss Compatible Investor Goals d. Countercyclical i. Bear Market *Morningstar fund definitions • Long time horizon • Financial ability to remain in the markets • Ability to handle losses 4 -20

Funds & Investment Objectives 2. Index Funds a. b. c. d. Broad market Industry Funds & Investment Objectives 2. Index Funds a. b. c. d. Broad market Industry or market sector International market Size subset Investment characteristics Compatible Investor Goals • Goal is to duplicate the performance of an index or market sector. • Investors who believe in ‘efficient markets’ and are seeking market returns with minimal expenses and turnover. • Low turnover, low expenses • Stock funds still require ability to handle risk and staying power. 4 -21

Funds & Investment Objectives 3. Balanced funds World, Funds a. Allocation moderate, conservative i. Funds & Investment Objectives 3. Balanced funds World, Funds a. Allocation moderate, conservative i. ii. Convertibles Near term (to 2014), Intermediate (2015 -2029), b. Target Date Funds Long term (2030+) Investment characteristics i. Compatible Investor Goals • Hold both stocks and bonds, • Intermediate to long time horizon • Willing to face higher tax liability • Some ability to handle losses allocations may vary over time • Turnover varies • Higher income, lower capital gains & lower potential for capital loss 4 -22

Funds & Investment Objectives 4. Fixed Income funds a. Short, Intermediate, Long Federal Government Funds & Investment Objectives 4. Fixed Income funds a. Short, Intermediate, Long Federal Government i. Inflation Protected ii. b. Corporate. Short, Ultrashort, i. Intermediate, Long High Yield, Multisector ii. Emerging Markets, World iii. Bank Loans iv. Investment characteristics • Focus on income and current yield • Lower potential for capital loss, inflation risk higher Compatible Investor Goals • Short to moderate time horizon okay • Understand tax liability • Adds diversification, income and safety 4 -23

Funds & Investment Objectives Investment characteristics 5. International Stock Funds a. Size and Value/Growth Funds & Investment Objectives Investment characteristics 5. International Stock Funds a. Size and Value/Growth Foreign i. b. Size andor World Global Value/Growth i. • Risk varies, but can be high, FX exposure • Expense ratios can be high • Substantial potential for capital loss Compatible Investor Goals c. Geographic region • d. Emerging markets Longer time horizon • Investor seeking diversification and/or higher returns • Ability to remain in the markets & handle losses 4 -24

Funds & Investment Objectives Investment characteristics 6. Money market funds a. Taxable b. Tax Funds & Investment Objectives Investment characteristics 6. Money market funds a. Taxable b. Tax Exempt • Focus on safety of principal and income • Earn more than on bank accounts with little additional risk Compatible Investor Goals • Short time horizon • Add stability to a portfolio • Potentially large opportunity losses & inflation risk 4 -25

Table 4. 1 U. S. Mutual Funds by Investment Classification, 2008 4 -26 Table 4. 1 U. S. Mutual Funds by Investment Classification, 2008 4 -26

Trading Scandal with Mutual Funds v Late trading: allowing some investors to purchase or Trading Scandal with Mutual Funds v Late trading: allowing some investors to purchase or sell after NAV has been determined for the day v Market timing: allowing investors to buy or sell on stale net asset values – International: fund NAV may be based on prices in foreign markets which close at different times. A U. S. mutual fund specializing in Japanese stocks may create an exploitable opportunity since the Japanese markets close before ours, at which time the fund’s NAV will be set. If the U. S. markets subsequently go up late in the day, probably Japanese stocks will go up the next day, driving up NAV for the 4 -27

Trading Scandal with Mutual Funds v. Net effect? – Transfer wealth from existing owners Trading Scandal with Mutual Funds v. Net effect? – Transfer wealth from existing owners to the new purchasers or sellers 4 -28

Potential Reforms 4: 00 PM cutoff v. Strict _______ with late orders executed the Potential Reforms 4: 00 PM cutoff v. Strict _______ with late orders executed the following trading day Fair value pricing v________ with net asset values being adjusted for trading in open markets v. Imposition of redemption fees on holdings < 1 week _________________ 4 -29

4. 4 Costs of Investing in Mutual Funds 4 -30 4. 4 Costs of Investing in Mutual Funds 4 -30

Costs of Investing in Mutual Funds Fee Structure – Front-end load – Back-end load Costs of Investing in Mutual Funds Fee Structure – Front-end load – Back-end load (contingent), (redemption fee) Operating expenses – Buying and selling commissions, administrative expenses and advisory fees for the managers 12 b-1 charges – Marketing costs paid by the fundholders – Alternative to a load, but assessed annually – Maximum is 1% of assets 4 -31

Costs of Investing in Mutual Funds Fees, loads and performance – Gross performance of Costs of Investing in Mutual Funds Fees, loads and performance – Gross performance of load funds is statistically identical to gross performance of no load funds – Why pay a load charge? – Funds with high expenses tend to be poorer performers. • 12 b-1 charges should be added to expense ratios • Costs found in the fund prospectus and may be 4 -32

NAV and the Effective Load Cost to initially purchase one share of a load NAV and the Effective Load Cost to initially purchase one share of a load fund = NAV + front-end load (%) (if any). 0 to 8. 5% v Stated Loads typically range from ____ v If you invest $10, 000 in a fund with an 8. 5% front-end load, you actually acquire shares worth $9, 150; the other $850 goes to the broker. The load is designed to offset expenses of marketing the fund and goes to the broker who sells the fund to the investor. v The effective load is greater than the stated load: In the above example, the actual % commission cost (effective load) is: – $850 / $9150 = 9. 3%; which is > stated load. 4 -33

Costs of Investing in Mutual Funds v. Avoiding the load: – Can sometimes choose Costs of Investing in Mutual Funds v. Avoiding the load: – Can sometimes choose different class of fund shares. – Best alternative may depend on amount invested and expected holding period ____________________. 4 -34

Costs of Investing in Mutual Funds Expense ratios: v. Funds charge annual operating expenses Costs of Investing in Mutual Funds Expense ratios: v. Funds charge annual operating expenses and annual advisory or management fees against the NAV. – Expense ratios are calculated as Annual Expenses / Average NAV – A "well managed" fund probably should have an 2 expense ratio of less than ___. % v. All costs and charges must be revealed in the fund's prospectus. 4 -35

Converting gross pretax returns to net pretax returns: Amount initially invested = $10, 000 Converting gross pretax returns to net pretax returns: Amount initially invested = $10, 000 – (0. 06 x $10, 000) = $9, 400 Amount after gross return =$9, 400 x 1. 175 = $11, 045 Amount after fees = $11, 045 - (0. 0135 x $11, 045) = $10, 895. 89* Net rate of return = ($10, 895. 89 - $10, 000) / $10, 000 = 8. 96% In MF prospectus and annual reports the MF returns are net of operating expenses, 12 b-1 fees and commissions, but the returns do not include loads. * This example calculates expenses using ending NAV. 4 -36

Table 4. 2 Impacts of Costs on Investment Performance Conclusions? Optimal choice fee structure Table 4. 2 Impacts of Costs on Investment Performance Conclusions? Optimal choice fee structure is • Time dependent • Investment size dependent 4 -37

HPR on mutual funds Dist = Distribution All distributions are taxable, even if reinvested HPR on mutual funds Dist = Distribution All distributions are taxable, even if reinvested in the fund. Do not buy into a MF just before its distribution date (usually near the end of the year or quarter). 4 -38

4. 5 Taxation of Mutual Fund Income 4 -39 4. 5 Taxation of Mutual Fund Income 4 -39

General Tax Rules The fund itself is not taxed as long as – Fund General Tax Rules The fund itself is not taxed as long as – Fund meets certain diversification requirements – Fund distributes virtually all income earned (less fees and expenses) to fund shareholders The investor is taxed on capital gain and dividend distributions at the investor’s appropriate tax rate. Distribution requirements imply that portfolio turnover may affect an investor’s tax liability. 4 -40

Taxes and Mutual Funds v Investor directed portfolios can be structured to take ____________ Taxes and Mutual Funds v Investor directed portfolios can be structured to take ____________ advantage of taxes while mutual funds cannot greater tax liability v High turnover leads to _________ v More disclosure on taxes was required ____ in 2002 After-tax returns now reported in prospectus For more information on taxes see: IRS Publication 564: Mutual Fund Distributions 4 -41

Implications of Fund Turnover v The fund itself pays commission costs on purchases and Implications of Fund Turnover v The fund itself pays commission costs on purchases and sales of portfolio holdings, which are charged against NAV. –These commissions are lower than what you and I pay. –Total commission expenses are higher if the portfolio has higher turnover. v The turnover rate is measured as the total asset value _______ bought or sold in a year divided by the ______ average total _______ asset value _____. 4 -42

Implications of Fund Turnover v For example, if a fund had an average total Implications of Fund Turnover v For example, if a fund had an average total asset value of $10 million, and $6 million of securities were bought or sold that year the turnover rate was 60%. ____ v Can you figure the average security holding period from the turnover ratio? · Average holding period or AHP · AHP = 0. 5 x (1 / turnover ratio) · AHP = 0. 5 x (1 / 0. 60) = 0. 83 years < 5% to > 300% v Turnover rates vary from _______ per year. 4 -43

4. 6 Exchange Traded Funds 4 -44 4. 6 Exchange Traded Funds 4 -44

Exchange Traded Funds ETFs allow investors to trade index portfolios like shares of stock Exchange Traded Funds ETFs allow investors to trade index portfolios like shares of stock SPDRs and Diamonds, Cubes, WEBS Examples: Potential advantages Trade continuously throughout the day – Can be sold short or purchased on margin – Potentially lower taxes – No fund redemptions • Large investors can exchange their ETF shares • for shares in the underlying portfolio Lower costs (No marketing; lower fund expenses) – 4 -45

Exchange Traded Funds Potential disadvantages v Small deviations from NAV are possible v Must Exchange Traded Funds Potential disadvantages v Small deviations from NAV are possible v Must pay a brokerage commission to buy an ETF but a no load index fund may be purchased online for no commission. 4 -46

Table 4. 3 ETF Sponsors and Products 4 -47 Table 4. 3 ETF Sponsors and Products 4 -47

Figure 4. 2 Growth in ETF Assets 4 -48 Figure 4. 2 Growth in ETF Assets 4 -48

4. 7 Mutual Fund Investment Performance: A First Look 4 -49 4. 7 Mutual Fund Investment Performance: A First Look 4 -49

First Look at Mutual Fund Performance v Evidence shows that average mutual fund less First Look at Mutual Fund Performance v Evidence shows that average mutual fund less than performance is generally ____ broad market performance v Evidence suggests that over certain horizons some persistence ________ in positive performance – Evidence is _______ not conclusive – Some inconsistencies 4 -50

First Look at Mutual Fund Performance Consistency of performance of mutual funds Conclusion? Historical First Look at Mutual Fund Performance Consistency of performance of mutual funds Conclusion? Historical performance is not necessarily a good predictor of future performance. 4 -51

Figure 4. 3 Diversified Equity Funds versus Wilshire 5000 Index Lipper: Fund average; Wilshire Figure 4. 3 Diversified Equity Funds versus Wilshire 5000 Index Lipper: Fund average; Wilshire is unmanaged index return 4 -52

4. 8 Information on Mutual Funds 4 -53 4. 8 Information on Mutual Funds 4 -53

Sources of Information on Mutual Funds v Wiesenberger’s Investment Companies v Morningstar (www. morningstar. Sources of Information on Mutual Funds v Wiesenberger’s Investment Companies v Morningstar (www. morningstar. com) v Fund prospectus (a must read) v Yahoo v Wall Street Journal v Investment Company Institute (www. ici. org) v AAII v Brokers v Background information: “A Random Walk Down Wall Street, ” by Burton Malkeil 4 -54

Figure 4. 4 Morningstar Report 4 -55 Figure 4. 4 Morningstar Report 4 -55

Morningstar Report Cont. 4 -56 Morningstar Report Cont. 4 -56

Sample Problems 4 -57 Sample Problems 4 -57

Problem 1 NAV is $10. 70 Front-end load is 6% Every dollar paid results Problem 1 NAV is $10. 70 Front-end load is 6% Every dollar paid results in only ____ going $. 94 toward purchase of shares. Offer price = NAV = 1 - load $10. 70 = 1 -. 06 $11. 38 4 -58

Problem 2 Offer price $12. 30 Front-end load is 5% $. 95 Every dollar Problem 2 Offer price $12. 30 Front-end load is 5% $. 95 Every dollar paid results in only ____ going toward purchase of shares. NAV = offer price x (1 - load) = $12. 30 x 0. 95 = $11. 69 4 -59

Problem 3 NAV = (Market Value of Assets – Liabilities) Shares Outstanding A. (200, Problem 3 NAV = (Market Value of Assets – Liabilities) Shares Outstanding A. (200, 000)x($35) = $ 7, 000 Liabilities B. (300, 000)x($40) = $12, 000 $30, 000 C. (400, 000)x($20) = $ 8, 000 D. (600, 000)x($25) = $15, 000 Shares Outstanding $42, 000 4, 000 $42, 000 – $30, 000 = $10. 49 = NAV 4, 000 4 -60

Problem 4 Turnover rate = Value of stocks sold and replaced Market Value Assets Problem 4 Turnover rate = Value of stocks sold and replaced Market Value Assets MVA = $42 M Value of stocks sold = (600, 000 x$25)= $15, 000 or Value of stocks purchased = (200 kx$50)+(200 kx$25) = $15, 000 Market Value Assets = $42, 000 $15, 000 = 0. 357 $42, 000 Average holding period? or 35. 7% AHP = 0. 5 x 1/Turnover = 0. 5 x 1/0. 357 = 1. 4 yrs 4 -61

Problem 5 a. The empirical research suggests that past performance is not highly predictive 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. 4 -62

Problem 6 v As an initial approximation, your return equals the return on the Problem 6 v 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% v 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 v The shares net increase in value (12% 1. 2%) from $20, 000 to: – $20, 000 (1. 12 0. 012) = $22, 160 v The rate of return is: ($22, 160 $20, 833) / $20, 833 = 6. 37% 4 -63

Problem 7 a. Sell after 4 years: Suppose you have $1000 to invest. The Problem 7 a. Sell after 4 years: Suppose you have $1000 to invest. The initial investment in Class A shares is $940 net of the front-end ____ load. After 4 years, your portfolio will be worth: $940 (1. 10)4 = $1, 376. 25 Class B shares allow you to invest the full $1, 000, but your investment performance net of 12 b-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. 4 -64

Problem 7 Cont. b. Sell after 15 years: What is the breakeven time? With Problem 7 Cont. b. Sell after 15 years: What is the breakeven time? With a 15 -year horizon, the Class A shares will be worth: N $940 x (1. 10)N = $1, 000 x (1. 095) $940 (1. 10)15 = $3, 926. 61 [$1, 000 / $940 ] = (1. 10)N / (1. 095)N 1. 06383 back-end 1. 095]in this case = [1. 10 / load N For the Class B shares, there is no since the horizon is greater LN 1. 06383 = LN [1. 10 / 1. 095]value than 5 years. Therefore, the N of the Class B shares will be: 1. 06383 = N x LN [1. 10 / 1. 095] LN 0. 061875 = N x 0. 004556 $1, 000 (1. 095)15 = $3, 901. 32 N = 13. 581 years At this longer horizon, Class A shares are the better choice. Why? 4 -65

Problem 8 v Suppose that finishing in the top half of all portfolio managers Problem 8 v Suppose that finishing in the top half of all portfolio managers is purely luck, and that the probability of doing so in any year is exactly 50%. v Then the probability that any particular manager would finish in the top half of the sample five years in a row is 0. 505 = 0. 03125. v We would then expect to find that [350 0. 03125] 11 managers finish in the top half for each of the five consecutive years. 4 -66

Problem 9 Trading costs will reduce the portfolio return by (0. 4%)x(0. 50)= 0. Problem 9 Trading costs will reduce the portfolio return by (0. 4%)x(0. 50)= 0. 2% v Over many years of savings these costs can greatly reduce the value of your portfolio. v Remember also that the high turnover rate can have tax consequences that further reduces your after-tax return. 4 -67