Chapter 17 Mutual Funds Chapter Outline Mutual Funds

Chapter 17 Mutual Funds

Chapter Outline Mutual Funds: Chapter Overview Size, Structure and Composition of the Industry Balance Sheets and Recent Trends Regulation Global Issues

Mutual Funds Are financial intermediaries that pool the financial resources of investors and invest them in portfolio assets (diversified) Open end mutual funds Liquidity Objective other services At year-end 2004, more than 8, 800 mutual funds held total assets of $8. 11 trillion

Size, Structure and Composition of the Industry Historical trends: Although mutual funds have been around since the 1920 s, from the 1970 s onward mutual funds enjoyed rapid growth. Money market mutual funds (MMMFs) Tax exempt funds Special-purpose equity, bond, emerging market, and derivative funds second largest financial intermediary, low entry barriers large economies of scale in fund expenses

Growth of the Mutual Fund Market

Financial Assets of Major Financial Intermediaries, 1990 and 2004 ($Tns) Mutual Funds Insurance Saving Institutions

Different Types of Mutual Funds Long term funds Short term funds

Long term funds: Long term funds (74% of mutual fund assets 2004) Equity funds Bond funds Hybrid funds Tax exempt funds Index funds Exchange traded funds (ETF

Number of Mutual Funds, 1980, 1990, 2004

Short term funds (26% of mutual fund assets in 2004) Money market mutual funds Tax exempt money market mutual funds In 2004 long term funds comprised slightly over 74% of total funds (26% short term), after falling as low as 65% in prior years due to the weakness in the stock market and low long term rates in the early part of the decade. 60: 40, but the equity bull markets of the 1990 s led to increased interest in long term funds

The major holders of both types of funds are individual investors Investing in MMMFs The primary reason most people hold mutual funds is to provide supplemental retirement income: Fund growth slowed with the poorer stock markets of the early part of the century

Mutual Fund Prospectuses and Objectives: prospectus

Fund Type Aggressive Growth: Fund Objective Compatible Investor Goal(s

Growth: Fund Compatible Investor Goal(s

Growth & Income Fund Objective Compatible Investor Goal(s)

Index Fund Objective Compatible Investor Goal(s)

Balanced Fund Objective Compatible Investor Goal(s)

Income Fund Objective Compatible Investor Goal(s)

Money Market Fund Objective Compatible Investor Goal(s)

statements are generalities and many variations exist within a fund category.

Profile of Typical Mutual Fund Owner About 48% of households own mutual funds Most mutual fund owners are long term investors, with 49% making their first purchase before 1990 median age investor is 48 are employed, married and have a working spouse About 80% of fund holders invest in some equities median investment is $48, 000 and the median number of funds held is four Although many people now check their fund’s performance over the Internet, the majority do not conduct buy/sell transactions on-line

Investor Returns from Mutual Fund Ownership 1. Appreciation in the value of the mutual fund’s shares 2. Dividend distributions 3. Capital gains distributions NAV turnover rate average holding period of securities within the fund: 0. 5 (1 / annual turnover ratio)

disadvantage of the open end nature of mutual funds bankruptcy Limited debt

Calculation of NAV; Classes of Funds Calculation of NAV on an Open-End Mutual Fund NAV = Total market value of assets under management Number of mutual fund shares outstanding

Examples NAV on an open-end MF: 15, 000 shares outstanding 1, 000 shares @$37. 75 (Sears) 2, 000 shares @ $43. 70 (Roebuck) 4, 500 shares @ $ 46. 67 (Exxon/Mobile) Increase: $45, $48, and $50 respectively NAV on Open-End MF ($13. 01) when # shares increases ($14. 40) Add 1, 000 investors buying one share of MF above, invest at today’s NAV of $13. 01: invest 344 in Sears Same increases as above: NAV becomes $14. 47

Closed end investment companies have a fixed number of shares outstanding and do not issue new shares or redeem shares from investors. a premium or discount Example: REIT

Mutual Fund Costs: two types Sales load Fund operating expenses

Load vs no load fund Load charge: No load funds Some funds charge back end loads instead of or in addition to front end loads. different classes holding period contingent back end loads

Class A shares Class B shares Class C shares

Class A shares entail the highest cost The real cost of a front end load If you have $1, 000 to invest and you place your money in a fund with a 5% front end load you get an investment worth $950. So you pay a commission of $50 which gives a commission rate of $50 / $950 or 5. 26%.

12 b-1 fees: The hidden load.

Expenses: A "well managed" fund probably should have an expense ratio of less than 2%. The effect of loads and fees on returns: This year you invested $10, 000 in a mutual fund with a 6% load (one time fee) and estimated annual expenses of 1. 35%. Fees are charged against average assets for the year. The gross return is 11. 5%. What is your return net of loads and expenses? Amount initially invested = $10, 000 – (0. 06 $10, 000) = $9, 400 Amount after gross return = $9, 400 1. 115 = $10, 481 Average asset value for year = ($10, 481 + $9, 400) / 2 = $9, 940. 50 Fees = $9, 940. 50 * 0. 0135 = $134. 20 Ending amount after fees = $10, 481 - $134. 20 = $10, 346. 80 Net rate of return (first year) = ($10, 346. 80 / $10, 000) – 1 = 3. 47% In the mutual fund prospectus and annual reports the fund returns presented are net of operating expenses, 12 b-1 fees and commissions, but the reported returns do not include loads

Text Example Invest $10, 000 Commission 4% Operating expenses 0. 85% Return 5% Annual operating expenses = av NAV * Annual operating expenses (9, 600+ 9, 600(1. 05))/2*0. 0085=83. 64 Value of invst yr 1= 9600*1. 05 -83. 64=9996. 36 Return = 9996. 36/10000 -1=-0. 04%

Mutual Fund Share Quotes: Mutual fund quotes are similar to stock quotes. Fund returns are also ranked within the investment objective. WSJ rankings do not include any measure of risk. Morningstar rankings include an adjustment for fund risk and thus are probably better rankings to use. most studies show that rankings are not predictive of future performance so care must be used in interpreting any ranking scheme

Balance Sheets and Recent Trends Long Term Funds In 2004 equity investments were 68% of total funds invested in long term funds. Investments in corporate and foreign bonds comprised 11. 5%, U. S. government and agency securities made up 11. 3%. , municipal investments were 5. 4%. The percentages of debt and equity however can vary widely over different market conditions. Market timing funds (also called asset allocation funds) are designed to vary the amount of money in the different asset classes according to forecasts of performance.

Money Market Funds In 2004 MMMFs held 21% in open market paper, 13. 9% in agencies, 16. 9% in municipals and 12. 7% in repos. Most money market funds maintain a constant NAV of $1. 00. As interest is earned an investor is credited with more shares

Regulation SEC is the primary regulator major acts regulating mutual funds include the banking and securities acts of 1933 and 1934 and the Investment Company Act of 1940, requiring mutual funds to meet disclosure requirements similar to public issues of debt and equity, and introduced many anti-fraud procedures and limits on fees Newer laws such as the Insider Trading and Securities Fraud Enforcement Act of 1988 required funds to develop mechanisms to avoid insider trading abuses and the Market Reform Act of 1990 allowed the SEC to introduce circuit breakers. More recently, the National Securities Markets Improvements Act (NSMIA) of 1996 exempts mutual fund sellers from most state oversight