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Chapter 4. MUTUAL FUNDS AND OTHER MANAGED INVESTMENTS. Chapter 4 Questions. What is a mutual fund? How does one compute the net asset value (NAV)? What expenses and changes might a mutual fund investor face?
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Chapter 4 MUTUAL FUNDS AND OTHER MANAGED INVESTMENTS
Chapter 4 Questions • What is a mutual fund? • How does one compute the net asset value (NAV)? • What expenses and changes might a mutual fund investor face? • What does research on mutual fund performance tell about fund expenses, portfolio turnover, and returns?
Chapter 4 Questions • What is a good procedure for determining which mutual funds to purchase? • When might it be appropriate to sell shares in a mutual fund? • What are the similarities between mutual funds and some other managed investments?
Mutual Fund Growth • Mutual funds have become very popular investment vehicles. • Nearly $7 trillion in total assets in 2002. • Total assets have grown 600% since 1990.
What is a mutual fund? • Mutual funds are open-end investment companies. • The fund sells shares to the public and invests the proceeds in a pool of funds, which are jointly owned by the fund’s investors.
Computing Net Asset Value • For investors, the performance of their investment depends on what happens to the fund’s per share value, or net asset value (NAV). NAV= Market Value of Assets – Liabilities Number of Shares Outstanding
Mutual Fund Management • Most funds are started by investment management companies who hire the fund manager to make investment decisions. • Fidelity, Vanguard, etc. • Usually offer many different funds and allow investors to switch between funds. • Funds (open-end) sell additional shares to those who want to invest, redeem shares at the NAV (less any fees) to those who want to sell their shares.
Why invest with mutual funds? • Liquidity • Funds buy and sell their own shares quickly, even if fund investments are illiquid • Diversification • Small minimum investment buys a typically well-diversified investment • Professional management and record-keeping • Expertise and services
Why invest with mutual funds? • Choice and flexibility • Families of funds offer a variety of investments to match investor needs • Indexing • Some funds track a broad market index which insures that investors will earn the “market return” • Increasingly popular mutual fund alternative
Mutual Fund Drawbacks • Active trading contributes to high costs which lower fund returns • Tax consequences can be a disadvantage • Tax impacts of asset trading are passed through to investors • Tax bill can be large even when the NAV falls
Mutual Fund Returns Three sources of return: • Income distributions (ID) • Bond interest, stock dividends • Capital gain distributions (CGD) • Realized gains/losses from selling assets • Changes in NAV (DNAV) • From unrealized gains/losses from assets
Mutual Fund Returns Return = (ID + CGD + DNAV)/Beg.NAV • By dividing the sum of the three components of dollar returns by the beginning NAV, we have the mutual fund’s holding period return. • Most mutual funds allow investors to either receive distributions in cash or to reinvest in additional shares.
Types of Mutual Funds • Funds can be classified according to the type of security in which they invest • Stock Funds • Taxable Bond Funds • Municipal Bond Funds • Stock and Bond Funds • Money Market Funds
Common Stock Funds • Most popular type of fund • Wide variety with different objectives and levels of risk • Growth • Industry or sector funds • Geographic areas • International or Global • Equity Index funds
Taxable Bond Funds • Generally seek to generate current income with limited risk • Can vary by maturity • Short-term, Intermediate-term, Long-term • Can vary by type of bond • Government • Corporate • Mortgage-backed • International/Global • Bond Index funds
Municipal Bond Funds • Provide investors with income exempt from Federal taxation • Often concentrate on single states to avoid state income taxation as well
Stock and Bond Funds • Seek to provide a combination of income and value appreciation. • Different names • Balanced funds • Blended funds • Flexible funds
Money Market Funds • Provide safe, current income with high liquidity • Invest in money market securities • T-bills, Bank CD’s, Commercial paper, etc. • NAV stays at $1; income either paid out or reinvested daily • Provide an alternative to bank deposits, but not FDIC insured
Mutual Fund Innovations • Life-stage funds • Offer different mixes of securities based on the age of the investor • Supermarket funds • Offer a wide variety of funds with “one-stop” fund shopping • Transfer services between funds • Expenses/fees can be high
Mutual Fund Prospectus • Must be available to investors and should be review by investors. • Contains: • Fund’s investment objective • Investment strategy • Principal risks faced by investors • Recent investment performance • Expenses and fees • Lots of other detailed information
Mutual Fund Expenses and Considerations • Loads • Commission to the broker to financial advisor who sold the fund to the investor • For load funds, the offer price is the fund’s NAV less the load (while no-load funds are sold at their NAV) • Load range from around 3% (low-load) to 8.5% • 12b-1 Fees • Fees deducted from the asset value of the fund to cover marketing expenses • An alternative to loads
Mutual Fund Expenses and Considerations • Deferred Sales Loads • Redemption charges when fund shares are sold (rather than when purchased) • Often high (5-7%) if shares are sold within the first year, but then fall over time, perhaps even disappearing eventually • Share Classes • Many funds offer several different classes of shares (A-B-C) with different fee structures • Best choice usually depends of investment horizon
Mutual Fund Expenses and Considerations • Management Fees • Fees deducted from the fund’s asset value to compensate the fund managers • Some adjust fees according to the fund’s performance • Expense ratio • Adding all fees and calculating expenses as a percentage of the fund’s asset
Mutual Fund Expenses and Considerations • Portfolio Turnover • Not an explicit cost, but very important determinant of shareholder returns • Trading costs rise with turnover • In order for high turnover to pay off, fund managers must be successful in their active trading strategies • Sources of Information • Wall Street Journal, Business Week • Morningstar • Fund history, tax efficiency, risk analysis
Mutual Fund Return and Risk Performance Return Performance • On a risk-adjusted basis, the average stock fund under-performs market averages • While portfolio managers seem to out-perform the market before expenses, net returns are below the market index • Some above-average performers over short time horizons, but such performance is not generally sustained (just luck?) • These results help to explain the growing popularity of index funds
Mutual Fund Return and Risk Performance Risk Performance • While returns are not consistent, risk is • Objectives lead to strategies that lead to varying degrees of investment risks • Return is positively related to the level of risk • Risk is therefore an important consideration
Mutual Fund Return and Risk Performance Fees and expenses: Do higher fees pay off? • Investment performance is no better (and perhaps worse) for load funds vs. no-load • Expenses lower returns in predictable ways – lower expense funds give better returns • Turnover affects returns in several ways, including taxes – high turnover means more short-term realized gains • Tax efficiency is an important consideration – after-tax returns may be 30-40% less than pre-tax
Mutual Fund Investment Strategies • Choose in funds consistent with your objectives, constraints, and tax situation. • Consider index funds for a large portion of your fund portfolio. • When possible, invest in no-load funds with below-average expense and turnover ratios. • Invest at least 10-20% in international or global funds. • Own funds in different asset classes and consider life-cycle investing.
Mutual Fund Investment Strategies • If you actively manage your portfolio, consider the past year’s “hot funds.” • Do not attempt to time the market; timing strategies add little except costs and risk. • Use dollar cost averaging by investing a set dollar amount each month. • Avoid investing money shortly before the capital gain distribution dates (prospectus). • Do not own too many funds. You will get average returns with high expenses.
When should you sell a mutual fund? • Personal considerations • Portfolio rebalancing points due to life cycle considerations • Be aware of the quick trigger, selling on the first dip in NAV; think long-term • Be aware of capital gains with selling fund shares • Fund considerations • Change in portfolio manager • Change in investment style • Fund is growing “too large” or “too fast” • Persistent bad performance
Other Managed Investments Closed-end investment companies • Shares trade like stock rather than being bought and sold from the fund • Number of shares are fixed • Often sell at a discount from NAV (a puzzle for modern finance) • Often a means of investing in a pool of assets from a foreign country
Other Managed Investments Exchange-traded funds (EFTs) • Relatively new, yet very popular • Like closed-end funds, they trade like individual stocks • Passively managed to mirror a market index, both broad and narrow • Low expenses, but do involve brokerage commissions • Tax and liquidity concerns
Other Managed Investments Variable Annuities • Many offered by insurance companies • Offers investors with choices of investments with tax-deferred growth • Insurance product: payment in the case of death or else retirement income stream • Expenses for both fund management and to pay for insurance, so fees tend to be much higher than with mutual funds • Income stream taxed as regular income