Mutual Fund Operations

CHAPTER
24
Mutual Fund Operations
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
Copyright 2002 Thomson Publishing. All rights reserved.
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
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 managers 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
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

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

Exhibit 24.2 Distribution of Investment in Mutual Funds
Money Market Funds $1,845 billion 27% Stock Funds $3,962 billion 57%
Hybrid Funds $349 billion 5%
Bond Funds $808 billion 11%
Management of mutual funds

Managers invest in a portfolio of securities to meet the objectives of the fund Managers adjust the composition of their portfolios in response to market and economic conditions
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 expenses12b-1 expenses

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
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
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 Willing to repurchase investor shares at any time Number of shares outstanding does not remain constant NAV determined by fund daily
Open-end mutual funds

Types of Loads
Front end load is paid only once, at the time you invest money in a mutual fund. Back end load is a withdrawal fee assessed when you withdraw money from mutual fund.

12b-1 Fees, a distribution fee in reference to SEC rule 12b-1. Funds have used the proceeds from 12b-1 fees to pay commissions to brokers whose clients invested in fund.
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

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


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
Exhibit 24.3 Growth in Number of Equity and Bond Funds

8000 7000
Bond Funds
6000
Stock Funds
5000
4000
3000
2000
1000
0 1978 1985 1990 1995 1999 2001
Year
Exhibit 24.4 Investment in Bond and Stock Mutual Funds

5000 Bond Funds 4000
Stock Funds
3000
2000
1000
0 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
Year
Exhibit 24.5 Distribution of Aggregate Mutual Fund Assets

Municipal Bond $269 Billion Long-Term U.S. Govt 5% $309 Billion 6% Cash $277 Billion 5%
Corporate Bonds $349 Billion 7% Preferred Stock $28 Billion 1% Common Stock $3,882 Billion 76%
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

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
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
Asset allocation funds

Funds that contain a variety of investments Composition among stocks, bonds and money market securities is based on managers expectations
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 funds sector MANAB = The ability of the funds management
Change in market conditions
Close relationship between performance and market conditions Depends on the focus of the fund
Index
Change in sector conditions
funds Asian funds
Change in management ability includes both managers skills and operating efficiency
Performance of closed-end stock funds

Driven by the same factors that influence openended funds Fixed supply of the funds shares Additional issues
Performance
is affected by changes in the premium or discount relative to NAV If the funds premium increases relative to NAV, return to fund holders increases
Performance of Bond Mutual Funds
Performance of bond mutual funds as shown in the model below PERF= f ( Rf, RP, CLASS, MANAB)
PERF = Performance Rf = Risk free interest rates RP =Risk premium CLASS =the classification of the bond fund MANAB = The ability of the bond funds management
Where:
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
Impact of the bond funds 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
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
Money Market Funds
Money market funds are portfolios of shortterm 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
Money Market Funds
Asset composition of money market funds

Individual funds concentrate in assets that reflect the funds objective Money market securities of varying maturity
Maturity of money market funds

Varies over time with market conditons Risk increases with term
Exhibit 24.7 Composition of Money Market Fund Assets
Other $303 billion 20% U.S. Treasury Securities $91 billion 6%
Commercial Paper $620 billion 41%
Other U.S. Securities $189 billion 13%
Repurchase Agreements $186 billion 12%
CDs $123 billion 8%

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
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
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
Hedge Funds
Financial problems experienced by LongTerm 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

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
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

Mutual Fund Operations

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CHAPTER

Mutual Fund Operations

Copyright 2002 Thomson Publishing. All rights reserved.

Background on Mutual Funds

Copyright 2002 Thomson Publishing. All rights reserved.

Background on Mutual Funds

Mutual funds adhere to a variety of federal and state regulations

Background on Mutual Funds

Mutual fund prospectus information includes:

writing Telephone or Internet funds transfer

Management fees incurred that investors pay

Background on Mutual Funds

Estimating the net asset value

the market value of all the securities in the

Mutual Fund Distributions

Earned Income from Dividends or Coupon Payments

Capital Gains from the Sale of Securities in Fund

Mutual Fund Price Appreciation

Copyright 2002 Thomson Publishing. All rights reserved.

Background on Mutual Funds

Family of funds offered by investment companies

Investor able to allocate then transfer funds among funds

Exhibit 24.2 Distribution of Investment in Mutual Funds

Hybrid Funds $349 billion 5%

Bond Funds $808 billion 11%

Copyright 2002 Thomson Publishing. All rights reserved.

Background on Mutual Funds

Management of mutual funds

Copyright 2002 Thomson Publishing. All rights reserved.

Background on Mutual Funds

Active marketing expenses and compensation increases expenses12b-1 expenses

Background on Mutual Funds

Corporate control by mutual funds

Copyright 2002 Thomson Publishing. All rights reserved.

Load versus No-Load Mutual Funds

Copyright 2002 Thomson Publishing. All rights reserved.

Open-End versus Closed-End Funds

Open-end mutual funds

Stock Mutual Fund Categories

Capital appreciation or aggressive growth funds

Copyright 2002 Thomson Publishing. All rights reserved.

Stock Mutual Fund Categories

A global mutual fund invests in some U.S. stocks

Stock Mutual Fund Categories

More diversified Involves higher expenses

Copyright 2002 Thomson Publishing. All rights reserved.

Exhibit 24.3 Growth in Number of Equity and Bond Funds

0 1978 1985 1990 1995 1999 2001

Copyright 2002 Thomson Publishing. All rights reserved.

Exhibit 24.4 Investment in Bond and Stock Mutual Funds

Copyright 2002 Thomson Publishing. All rights reserved.

Exhibit 24.5 Distribution of Aggregate Mutual Fund Assets

Copyright 2002 Thomson Publishing. All rights reserved.

Bond Fund Investment Objectives

Risks of bond funds

Copyright 2002 Thomson Publishing. All rights reserved.

Bond Fund Investment Objectives

Copyright 2002 Thomson Publishing. All rights reserved.

Bond Fund Investment Objectives

Copyright 2002 Thomson Publishing. All rights reserved.

Bond Fund Investment Objectives

Asset allocation funds

Copyright 2002 Thomson Publishing. All rights reserved.

Performance of Stock Mutual Funds