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					 Chapter 4
Mutual Funds




               1
              Understand the benefits and
                   costs of mutual funds
What services do investment organizations offer?
   –   Administration & record keeping
   –   Diversification & divisibility
   –   Professional management
   –   Reduced transaction costs




                                                   2
               Unit Investment Trusts
 Are pools of money invested in a portfolio that is
  fixed for the life of the fund.
 To form a unit trust, a sponsor, typically a brokerage
  firm, buys a portfolio of securities which are
  deposited into trust.
 It then sells to the public shares, or ―units,‖ in the trust,
  called redeemable trust certificates.
 There is little active management of a unit investment
  trust because once established, the portfolio
  composition is fixed; hence these trusts are referred to
  as unmanaged.
                                                           3
              Unit Investment Trusts

 Sponsors of unit investment trusts earn their profits by
  selling shares in the trust at a premium to the cost of
  acquiring the underlying assets.
 Investors who wish to liquidate their holdings of a
  unit investment trust may sell the shares back to the
  trustee for net asset value. The trustees can either sell
  enough securities from the asset portfolio to obtain the
  cash necessary to pay the investor, or they may
  instead sell the shares to a new investor (again at a
  slight premium to net asset value).

                                                        4
       Managed Investment Companies

 There are two types of managed companies: closed-
  end and open-end.
 In both cases, the fund’s board of directors, which is
  elected by shareholders, hires a management company
  to manage the portfolio for an annual fee that typically
  ranges from .2% to 1.5% of assets.




                                                       5
   Open-End and Closed-End Funds: Key
              Differences
• Shares Outstanding
   – Closed-end:
       No change unless new stock is offered
       Traded on organized exchange and can be purchased through
        brokers like other common stock
   – Open-end:
       Changes when new shares are sold or old shares are redeemed
       When investors in open-end fund wish to cash out their shares, they
        sell them back to the fund.
• Pricing
   – Open-end: Net Asset Value (NAV)
   – Closed-end: Premium or discount to NAV
                                                                        6
        Two Puzzles Related to Close-end

   A close-end fund is sold at a discount from net asset
    value.
    – The difference between the market price of the fund and the
      fund’s NAV would represent the per-share increases in the
      wealth of the fund’s investors.
   While many close-ends sell at a discount from net
    asset value, the price s of these funds when originally
    issued are typically above NAV.



                                                              7
          Other Investment Organization

   Commingled funds
    – Commingled funds are partnerships of investors that pool
      their funds.
    – The management firm that organizes the partnership, for
      example, a bank or insurance company, manages the funds
      for a fee.
   Real Estate Investment Trusts (REITs)
    – A REIT is similar to a closed-end fund.
    – REITs invest in real estate or loans secured by real estate.
    – REITs generally are established by banks, insurance
      companies, or mortgage companies, which then serve as
      investment managers to earn a fee.

                                                                 8
            Other Investment Organization

   Hedge funds
    – Hedge funds are not registered as mutual funds and are not
        subject to SEC regulation.
    –   They typically are open only to wealthy or institutional
        investors.
    –   Heavy use of derivatives, short sales, and leverage.
    –   Hedge funds typically attempt to exploit temporary
        misalignments in security valuations.
    –   Because the funds often operate with considerable
        leverage, returns can be quite volatile.


                                                                   9
                           Mutual Funds
   Open-end investment companies
    – Fidelity, Vanguard, Putnam, and Dreyfus
   Investment policies
    – Money Market funds
    – Equity Funds
          Income funds-dividend yields
          Growth funds-capital gains
    – Fixed-Income Finds
    – Balance and Income Funds
    – Asset Allocation Funds
          Market Timing
    – Index Funds
    – Specialized Sector Funds
                                                10
             Benefits of Mutual Funds

 Benefits
  – Free individuals from the many administrative burdens of
    owning individual securities
      Proxies, capital gains recognition, etc.
  – Offer professional management
  – Offer (generally) economies of scale and lower trading costs
  – Offer other services




                                                            11
                Costs of Mutual Funds
 Costs
  – High management and other fees
      Front-end loads, back-end loads, 12b-1 fees
  – Cannot control timing of recognizing capital gains
      Income earned is not taxed at the level of the fund, but at your rate.
       You pay these taxes
  – Existing shareholders subsidize new investors
      It costs roughly .50-1.0% to get new funds invested (i.e., the pooling
       problem)
  – Performance of actively-managed mutual funds lags passive
    benchmarks
      Mutual fund performance has under-performed passive indexing
       over the past 10 years
                                                                          12
                   Index Mutual Funds

• From 1970-1998, the average mutual funds have returned
  12.44% versus 13.99% for the Wilshire 5000
   – Index funds (either mutual or exchange traded) have:
        Lower turnover (~3% year versus 50-200% for managed funds)
        Lower management fees (10-20 basis points/year versus 50-150 for
         managed funds)
        More tax efficient
   – While there are good managers, you need to evaluate
     prospective mutual funds and managers carefully
        While good managers are hard to find, generally poor managers are
         easier spot and to avoid—do it!!!!



                                                                      13
          Exchange-Traded Funds (ETF)

 Index portfolio
 The first ETF was the SPDR-S&P 500 index
 Other ETFs
    – Diamonds-Dow Jones Industrial Average
    – Qubes (QQQ)-Nasdaq 100 index
    – WEBS-World Equity Benchmark Shares
   Investors can trade ETF through out the day, just like
    any other share of stock.



                                                        14
           Exchange-Traded Funds (ETF)

   Advantages
    – ETFs trade continuously. ETFs can be sold short or
      purchased on margin.
    – Offer a potential tax advantage over mutual funds.
    – Cheaper than mutual funds
          S&P 500 ETF(0.09%) vs S&P 500 index mutual fund (0.18%)
   Disadvantage
    – There is the possibility that their prices can depart by small
      amounts from net asset value.
    – ETFs must be purchased from brokers for a fee.


                                                                     15
            Mutual Fund Calculations
• How is Net Asset Value calculated?
  Used as a basis for valuation of investment
  company shares
         • Selling new shares
         • Redeeming existing shares
• Calculation
  Market Value of Assets - Liabilities
         Shares Outstanding


                                                16
Understand the Impact of Costs on Investing
   Mutual Fund Costs
    – Fee Structure
        Front-end load / Back-end load
    – Operating expenses
        Management fees
    – 12 b-1 charges
        Distribution costs paid by the fund to cover marketing expenses
         (why should you pay for marketing expenses?)
    – Taxes Inefficient
        Higher turnover means that capital gains or losses are being realized
         constantly, and therefore that the investor cannot time the
         realizations to manage his or her overall tax obligation.You are
         taxes on all capital gains (turnover) and dividends
                                                                        17
                 Reality Check on Costs

Methodology:
   Took all large-cap stocks that have been around for 10 years
      or more, ranked them by annual operating expenses, and
      compared the lowest and highest–cost groups
Results:
   Lowest cost funds outperformed their expensive counterparts
      by 1.8-2.3% per year.
       On $50,000, 10% instead of 8% over 10 years equates to $21,741 or
        43% of your original investment
          Implications -- Invest in the low-cost area!
               Source: Walter Updegrave, Money Magazine




                                                                      18
  Problem 4-4: Calculating Fund Net Asset
                  Values
• The composition of the Fingroup Fund is :
       Stock   Shares (000)   Price   Value ($mn)
      A        200            $35      $7
      B        300             40      12
      C        400             20        8
      D        600             25       15
       Total                            $42
   – With $30,000 in accrued management fees unpaid, and 4
     million share outstanding, what is the current net asset value?




                                                               19
                Problem 4-4 Answer

• NAV = Total Assets less liabilities
•        shares outstanding

     ($42,000,000 – $30,000) = $10.49
           4,000,000




                                        20
     Problem 4-8: Calculating Discounts / Premiums on
                    Closed End Funds

             1/1/01          12/31/01
•   NAV $12.00.                $12.10
•   Price 2% premium          7% discount
•   Distributions                 1.50
•   What was the rate of return to the investor in 2001?
•   What would have been the rate of return in an open
    ended fund holding the same securities?




                                                        21
                       Answer 4-8

• Price 1/1/01        $12.00 x (1 + .02) = 12.24
• Price 12/31/01      $12.10 x (1 - .07) = 11.25

   – Return (CEF) = (11.25 -12.24 + 1.50)/ 12.24 = 4.2%
   – Return (OEF) = ($12.10 - 12.00 + 1.50)/12.00 = 13.3%




                                                            22
      Problem 4-12: Fund Performance

• A. Impressive Fund had an excellent investment
  performance last year, with portfolio returns that
  placed it in the top 10% of all fund with the same
  investment policy. Do you expect it to be a top
  performed next year? Why or why not?
• B. Suppose instead that Impressive Fund was among
  the poorest performers in its comparison group.
  Would you be more or less likely to believe its
  relative performance will persist into the following
  year? Why?

                                                    23
        Consistency of Investment Results

                            Successive Period Performance
Initial Period Performace   Top Half        Bottom Half
A. Goetzmann and Ibbotson study
Top half                    62.0%           38.0%
Bottom half                 36.6%           63.4%
B. Malkiel study, 1970s
Top half                    65.1%           34.9%
Bottom half                 35.5%           64.5%
C. Malkiel study, 1980s
Top half                    51.7%           48.3%
Bottom half                 47.5%           52.5%

                                                       24
        Consistency of Fund Performance

Do some mutual funds consistently outperform?
 Evidence suggests that some funds show consistent
  stronger performance.
    – Depends on measurement interval
    – Depends on time period
   Evidence shows consistent poor performance.




                                                  25
                    Answer 4-12

• A. Empirical research indicates that past performance
  is not highly predictive of future
  performance, especially for better performing funds.
  While there is some tendency, it is unlikely to repeat
  the top 10% achievement.
• B. The evidence is more suggestive of a tendency for
  bad performance to persist. This is probably related to
  fund costs and turnover rates. So if your fund is
  among the poorest performers, I would be concerned
  that its performance would persist.

                                                     26
Problem 4-17: Calculating Fund Costs with Different
               Classes of Shares

        Fund      Front-load 12B-1 fees Redemption
• Class A            6%             -            -
• Class B            -             0.5%         5%*
          –                       *(declines 1% a year
                                         for 5 years)
       Both funds return 10% net of operating expenses
• If you hold the funds for 4 years, which is the better
  investment (assume $1,000 to invest)?
• If you hold the funds for 15 years?


                                                          27
                Problem 4-17 Answer

• 4 Years
      Class A = (1000 x (1 - .06)) x (1.10)4 = $1,376.25
      Class B = ((1000 x (1 + (.10 – 0.05))4 ) * (1 - .01)
              = $1,437.66 x .99 = $1,423.28
         – Class B is better for 4 years
• 15 Years
      Class A = (1000 x (1 - .06)) x (1.10)15 = $3,926.61
      Class B = ((1000 x (1 + (.10 – 0.05))15 = $3,901.32
         • Class A is better for 15 years




                                                              28
      Problem 4-20: Transactions Costs

• A. Suppose that every time a fund manager trades
  stock, transactions costs such as commissions and bid-
  asked spread amount to 40 basis points (0.4%) of the
  value of the trade. If the portfolio turnover rate is
  50%, by how much is the total return of the portfolio
  reduced by trading costs?
• B. How much if the turnover is 150%? What does
  this mean to an active manager?



                                                    29
               Problem 4-20 Answer

• A. While the book says that trading costs will reduce
  portfolio returns by 0.4% x .50 = .2%, the reality is
  that turnover is on both sides, buying and selling
   – .4% x .50 for sales     = .20%
   – .4% x .50 for purchases = .20%
   –        Total              .40%
• B. .4% x 1.5% x 2 = 1.20% The active manager must
  obtain returns of 1.2% just to offset the expense of
  turnover versus an index fund. That is tough to do!!!


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