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Lecture 18

Lecture 18. Mutual Funds. Net Asset Value. NAV = net asset value MVA = market value of assets L = funds liabilities NSO = number of shares outstanding. Sales Charges. “Front-end” load—commission paid when shares are purchased. Load fees range from 0% to 8.5%.

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Lecture 18

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  1. Lecture 18 Mutual Funds

  2. Net Asset Value • NAV = net asset value • MVA = market value of assets • L = funds liabilities • NSO = number of shares outstanding

  3. Sales Charges • “Front-end” load—commission paid when shares are purchased. • Load fees range from 0% to 8.5%. • Some funds charge load fees on reinvested dividends! • The fund’s prospectus may say “Dividend reinvested at offering price.”

  4. Sales Charges • “Back-end” load—a contingent deferred sales charge. • Starts at 5 or 6%. • Decreases by 1% per year. • Load charges are ignored when a fund’s performance is reported. • Historical performance of load and no-load funds.

  5. Sales Charges • 12b-1 charges. • Covers distribution costs and commissions paid to brokers. • Annual charge of 0.25% to 1.00% of fund’s assets. • Some funds that are closed to new investors continue to charge 12b-1 fees!

  6. Sales Charges • Comparison of three funds. • Fund A—6% “front-end” load fee. • Fund B—6% “back-end” load fee that decreases by 1% per year. • Fund C—No “front-end” load fee, a 1% annual 12b-1 fee and a “back-end” load fee that starts at 5% and decreases by 1% per month.

  7. Sales Charges • Some mutual funds have several classes of stock. • Class A may have a “front-end” load fee of 5%. • Class B may have a 12b-1 fee of 1% per year and a back-end load fee that begins at 5% and decreases by 1% per year.

  8. Sales Charges • Transaction and redemption charges. • Paid when fund shares are purchased, liquidated, or exchanged into shares of another fund. • Usually 1% of net asset value. • Paid to fund rather than fund’s sponsors or sales representative.

  9. Expense Ratios • Investment advisory fees. • Administrative expenses. • Other operating expenses. • 12b-1 fees. • What counts is fund’s expense ratio which vary from 0.2% to 2.5%. • A fund’s expense ratio is a key determinant of performance.

  10. Invisible Costs • Transaction costs associated with the fund buying and selling securities. • Commissions: 0.1% to 0.5% • Bid-Ask spreads: 0.125% to 6.0%. • Price impact of a large block trade. • Average transaction cost is estimated to be about 0.6%.

  11. Invisible Costs A fund’s annual portfolio turnover is A fund’s transaction cost can be estimated by multiplying the fund’s annual portfolio turnover by 2 and then multiplying by the average transaction cost of 0.6%.

  12. Taxes • To maintain a tax-free status a fund must distribute at least 90% of its dividends and realized capital gains each year. • Funds with high annual portfolio turnover realize more capital gains.

  13. Taxes • If you purchase a mutual fund just prior to the distribution of dividends or capital gains, you will pay taxes on income that you did not earn. • Unrealized capital gains are a potential tax liability. • Unrealized capital loses are a potential tax savings.

  14. Performance • Annual geometric rates of return from 1970 to 1996. • Wilshire 5000 index 12.36% • S&P500 index 12.42% • Lipper General Equity Fund Average 11.08%

  15. Performance • Returns on market indexes ignore expenses. • Expense ratio of Vanguard’s Wilshire 5000 Index Fund is about 0.25%. • The turnover ratio is about 3%. • The overall costs would be about 0.30%.

  16. Performance • Malkiel’s estimates of Jensen’s alpha.ri – rf = a + b(rM - rf) + e • Wilshire 5000 a p-value Net return -0.93% 7.5% Gross return 0.18% 71.1%S&P500 a p-value Net return -3.20% 0.0% Gross return -2.03% 0.1%

  17. Performance • Elton, Gruber, Das and Hlavkari – rf = a + bM(rM - rf) + bS(rS – rf) + bD(rD – rf) + e • rM—return on S&P500 index. • rS—return on a small stock index. • rD—return on a bond index. • a is negative, though generally not statistically significant.

  18. Performance • About 60% of above average funds in one year remain above average over the next 3 years. • About 75% of below average funds in one year remain below average over the next 3 years.

  19. Performance • Persistence in relative performance across fund managers is: • Mainly due to expenses and transaction costs, • Concentrated at the extremes of best and worst performers.

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