Mutual Fund Operations

1. Mutual Fund Operations 24

2. Chapter Objectives • Explain the concept of mutual fund operation • Explain various types of mutual funds • Describe the various types of stock and bond mutual funds • Describe the characteristics of money market funds

3. Background on Mutual Funds • Mutual funds offer a way for small investors to diversify when they could not do so on their own with the purchases of individual stocks • Comparison to depository institutions • Like depository institutions, mutual funds repackage proceeds from individuals to make investments • Bank deposits are a liability contract, but a mutual fund represents partial ownership • No federal insurance with mutual fund shares

4. Background on Mutual Funds • Mutual funds adhere to a variety of federal and state regulations • Securities and Exchange Commission (SEC) regulates • Funds must register and provide a prospectus to investors • Disclosure since 1993 of manager’s name and length of time employed in that position • Mutual fund itself is exempt from income taxation if fund distributes 90 percent of taxable income

5. Background on Mutual Funds • Mutual fund prospectus information includes: • The minimum amount of investment required • The investment objective of the fund • The return on the fund over the past year, the past three years and the the past five years • The exposure of the fund to various types of risk • Services the fund offers • Check writing • Telephone or Internet funds transfer • Management fees incurred that investors pay

6. Background on Mutual Funds • Estimating the net asset value • Net asset value is the value per share • Estimated daily • Determine the market value of all the securities in the fund • Any interest or dividends added in • Expenses subtracted • Divide by the number of shares • Dividends lower NAV • NAV quotes

7. Mutual Fund Distributions Earned Income from Dividends or Coupon Payments Capital Gains from the Sale of Securities in Fund Mutual Fund Price Appreciation

8. Background on Mutual Funds • Mutual fund classifications depend on the type of securities the fund invests in and can include • Stock or equity mutual funds • Bond mutual funds • Money market mutual funds • Family of funds offered by investment companies • Investor able to allocate then transfer funds among funds

9. M o n e y M a r k e t F u n d s $ 1 , 8 4 5 b i l l i o n 2 7 % S t o c k F u n d s $ 3 , 9 6 2 b i l l i o n 5 7 % H y b r i d F u n d s $ 3 4 9 b i l l i o n 5 % B o n d F u n d s $ 8 0 8 b i l l i o n 1 1 % Exhibit 24.2 Distribution of Investment in Mutual Funds

10. Background on Mutual Funds • Management of mutual funds • Managers invest in a portfolio of securities to meet the objectives of the fund • Cover management costs with fees which are typically around one percent of total assets per year • Managers adjust the composition of their portfolios in response to market and economic conditions

11. Background on Mutual Funds • Expenses • Fees include management plus record-keeping and clerical fees • Expense ratio = annual expenses/fund NAV • Passed on to investors since NAV is reduced by fees • Investor should compare expense ratios • Active marketing expenses and compensation increases expenses—12b-1 expenses

12. Background on Mutual Funds • Corporate control by mutual funds • Mutual funds are large shareholders in companies whose stock they hold • Managers may serve on the board of directors of companies in which the fund invests • Companies try to satisfy mutual fund managers in order to keep them from selling their stake in the firm

13. Load versus No-Load Mutual Funds • Classification refers to whether or not there is a sales charge • No-load means funds are promoted, bought and sold directly via the mutual fund • Load funds • Promoted by registered representatives of brokerage firms who get a commission • Investors pay the sales charge • 12b-1 expenses are “loads” used by no-load funds

14. Open-End versus Closed-End Funds • Closed-end funds • Mutual fund does not repurchase the shares they sell—similar to direct common stock investment • Investors must sell shares on an exchange • Number of outstanding shares is constant • Value of shares related to expectations of portfolio and determined in market • Open-end “mutual” funds • Willing to repurchase investor shares at any time • Number of shares outstanding does not remain constant • NAV determined by fund daily

15. Stock Mutual Fund Categories • Growth funds for investors who want high returns with moderate risk • Mutual fund invests in companies that are expected to grow at a higher than average rate • Generate an increase in investment value rather than steady income • Capital appreciation or aggressive growth funds • High but unproven growth potential stocks • Higher risk

16. Stock Mutual Fund Categories • Growth and income funds try to offer growth but with some stability of income • International and global funds allow investment in foreign securities without the costs involved in purchasing and monitoring individual stocks • Returns affected by stock prices • Returns also affected by foreign exchange rates • A global mutual fund invests in some U.S. stocks

17. Stock Mutual Fund Categories • Internet funds focus on investments in Internet companies • Specialty funds focus on a group of companies sharing a particular characteristic • Index funds are designed to simply match the performance of an existing stock index • Multifund funds invest in a portfolio of different mutual funds • More diversified • Involves higher expenses

18. Exhibit 24.3 Growth in Number of Equity and Bond Funds 8 0 0 0 B o n d F u n d s 7 0 0 0 S t o c k F u n d s 6 0 0 0 5 0 0 0 4 0 0 0 3 0 0 0 2 0 0 0 1 0 0 0 0 1 9 7 8 1 9 8 5 1 9 9 0 1 9 9 5 1 9 9 9 2 0 0 1 Y e a r

19. Exhibit 24.4 Investment in Bond and Stock Mutual Funds 5 0 0 0 B o n d F u n d s 4 0 0 0 S t o c k F u n d s 3 0 0 0 2 0 0 0 1 0 0 0 0 1 9 8 6 1 9 8 7 1 9 8 8 1 9 8 9 1 9 9 0 1 9 9 1 1 9 9 2 1 9 9 3 1 9 9 4 1 9 9 5 1 9 9 6 1 9 9 7 1 9 9 8 1 9 9 9 2 0 0 0 1 9 8 5 Y e a r

20. M u n i c i p a l B o n d $ 2 6 9 B i l l i o n L o n g - T e r m U . S . G o v ’ t 5 % $ 3 0 9 B i l l i o n 6 % C a s h $ 2 7 7 B i l l i o n 5 % C o r p o r a t e B o n d s $ 3 4 9 B i l l i o n 7 % P r e f e r r e d S t o c k $ 2 8 B i l l i o n 1 % C o m m o n S t o c k $ 3 , 8 8 2 B i l l i o n 7 6 % Exhibit 24.5 Distribution of Aggregate Mutual Fund Assets

21. Bond Fund Investment Objectives • Risks of bond funds • Interest rate risk • Credit risk • Tax implications of bond fund investments • Income bond funds vary in terms their exposure to credit risk and focus on periodic coupon payments and attract investors who are • Interested in periodic income since prices are volatile • Plan to hold the fund long term

22. Bond Fund Investment Objectives • Tax-free funds for high tax bracket investors • High-yield or junk bond funds invest in bonds with a high risk of default • International and global bond funds • International bond funds contain bonds issued by governments or corporations from other countries • Global funds may contain both U.S. and foreign bonds

23. Bond Fund Investment Objectives • Maturity classifications • Interest rate sensitivity depends on the maturity of bonds • Funds are typically segmented based on maturity • Intermediate-term funds invest in bonds with 5 to 10 years remaining to maturity • Long-term funds invest in maturities of 15 to 30 years

24. Bond Fund Investment Objectives • Asset allocation funds • Funds that contain a variety of investments • Composition among stocks, bonds and money market securities is based on manager’s expectations

25. Growth and Size of Mutual Funds • Volume and mix in the kind of funds varies over time • Overall investment via mutual funds much higher in recent years • New kinds of funds target customers with different risk preferences

26. Performance of Stock Mutual Funds • Both investors and managers closely monitor performance as modeled by the equation below  PERF= f ( MKT,  SECTOR, MANAB) Where: PERF= Performance MKT = General stock market conditions SECTOR = Conditions in the fund’s sector MANAB = The ability of the fund’s management

27. Performance of Stock Mutual Funds • Change in market conditions • Close relationship between performance and market conditions • Change in sector conditions • Depends on the focus of the fund • Index funds • Asian funds • Change in management ability includes both managers’ skills and operating efficiency

28. Performance of Stock Mutual Funds • Performance of closed-end stock funds • Driven by the same factors that influence open-ended funds • Fixed supply of the fund’s shares • Additional issues • Performance is affected by changes in the premium or discount relative to NAV • If the fund’s premium increases relative to NAV, return to fund holders increases

29. Performance of Bond Mutual Funds • Performance of bond mutual funds as shown in the model below  PERF= f (Rf,  RP,  CLASS,  MANAB) Where: PERF= Performance Rf= Risk free interest rates RP =Risk premium CLASS =the classification of the bond fund MANAB = The ability of the bond fund’s management

30. Performance of Bond Mutual Funds • Change in the risk free rate • Bond prices are inversely related to the risk- free rate • When rates decline, most bond funds perform well • Change in the risk premium • If required risk premiums increase, bond prices fall • Linked to economic condition: • Risk premiums increase in recessions • Risk premiums decrease in boom times as investors buy riskier investments

31. Performance of Bond Mutual Funds • Impact of the bond fund’s classification • Some funds target a specific risk or maturity • Classification may have more impact than any other factor • Change in management abilities • Performance of closed-end bond funds is affected by all of the other factors and changes in the premium or discount

32. Performance of Mutual Funds • Investors should diversify among different kinds of funds to reduce volatility • Research on stock mutual fund performance • Using return only is not valid • Mutual funds typically do not outperform the market • Evaluate mutual fund expenses • Research on bond mutual funds • Bond mutual funds underperform bond indexes • Investors should look for low expense bond funds

33. Money Market Funds • Money market funds are portfolios of short-term assets • Can include check-writing privileges for investors • Number of checks per month may be restricted • Shareholders get periodic statements • Liquid, “cash” balance for investor

34. Money Market Funds • Asset composition of money market funds • Individual funds concentrate in assets that reflect the fund’s objective • Money market securities of varying maturity • Maturity of money market funds • Varies over time with market conditons • Risk increases with term

35. O t h e r $ 3 0 3 b i l l i o n 2 0 % U . S . T r e a s u r y S e c u r i t i e s $ 9 1 b i l l i o n C o m m e r c i a l P a p e r 6 % $ 6 2 0 b i l l i o n 4 1 % O t h e r U . S . S e c u r i t i e s $ 1 8 9 b i l l i o n 1 3 % R e p u r c h a s e C D s A g r e e m e n t s $ 1 2 3 b i l l i o n $ 1 8 6 b i l l i o n 8 % 1 2 % Exhibit 24.7 Composition of Money Market Fund Assets

36. Money Market Funds • Risk of money market funds • Credit risk minimized by the short-term nature of maturities • Returns for money market funds fall as interest rates in the economy fall • Expected returns are low relative to stock and bond funds • Consistent positive returns over time • Lower credit risk • Lower interest rate risk

37. Money Market Funds • Management of money market funds • Managers try to maintain the overall objective of the fund • Manage the composition of the assets • Investors have a variety of choices when it comes to money market funds

38. Money Market Funds • Regulation of money market funds • Securities Act of 1933 requires that funds provide full information to investors via a prospectus • Investment Company Act of 1940 contains restrictions to prevent conflicts of interest between investors and mangers • Funds are exempt from tax if 90% of earnings are distributed to shareholders

39. Hedge Funds • Financial problems experienced by Long-Term Capital Management (LTCM) • Hedge funds sell shares to wealthy investors and financial institutions • Historically unregulated • Invest in derivatives, sell stock short, and combine borrowing to magnify returns • LTCM experienced problems when risky investments lost money

40. Real Estate Investment Trusts • A real estate investment trust or REIT is a closed-end mutual fund that invests in real estate or mortgages • Classifications • Equity REIT • Mortgage REIT • Hybrid of the two • Sometimes seen as an inflation hedge • Performance influenced by interest rates and area real estate performance

41. Other Issues • Mutual funds interact with banks, savings institutions, finance companies, securities firms, insurance companies, and pension funds • Mutual funds typically use all the various financial markets including money, bond, mortgage, stock, futures, options, and swap markets • Globalization is facilitated by mutual funds • Reduces transactions costs • Increases market integration