Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

McGraw-Hill/Irwin
CHAPTER 4
Mutual Funds and Other
Investment Companies
KIND REMINDERS:
HW#1 is due on Sep. 19
th.
No late assignment will be accepted.
The assignment has to be typed and submitted through Moodle
Link.
HW#2 will be posted on Moodle. It will not be graded and you
dont need to submit your solution. But you will benefit in the
exams by putting some efforts to solve those problems.
The registration deadline for the simulation trading game is
Sep.21
st
and the game will start from Sep.22
nd
.
Please contact the TA if you havent registered for the
Tutorial section!
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OUTLINE
Types of investment companies
---Unit investment trust( unmanaged)
---Managed investment companies (open-end, closed-end)
Mutual Funds
---Different kinds of mutual funds
---How funds are sold
---Costs of investing in mutual funds
---Taxation of mutual fund income
---Mutual fund investment performance: a first look
---Information on mutual funds
Exchanged-traded funds(ETFs)
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INVESTMENT COMPANIES
Financial intermediaries that collect funds
from individual investors and invest in a
wide range of securities or other assets.
Provide a mechanism for small investors
to team up to obtain the benefits of large-
scale investing.
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INVESTMENT COMPANIES
Services provided:
Administration & record keeping
---issue periodic status reports, keeping track of capital gains distributions,
dividends, investments, and redemptions, reinvestment of dividend and
interest income for shareholders
Diversification & divisibility
--- investors can hold many kinds of different securities
Professional management
---support full-time staffs of security analysis
---portfolio managers who attempt to achieve superior investment results
for the investors
Reduced transaction costs
---trade large blocks of securities substantial savings on brokerage fees
and commissions
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NET ASSET VALUE
Investors buy shares in investment companies.
Ownership is proportional to the number of
shares purchased.
The value of each share is called Net Asset
Value or NAV.
Calculation:
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NET ASSET VALUE: EXAMPLE 4.1
Consider a mutual fund that manages a portfolio
of securities worth $120 million.
Suppose the fund owes $4 million to its
investment advisers and owes another $1 million
for rent, wages due, and miscellaneous
expenses.
The fund has 5 million shares outstanding.
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TYPES OF INVESTMENT COMPANIES
Unit Investment Trusts (unmanaged)
Managed Investment Companies
open-end companies (mutual funds
or unit trusts in some countries)
closed-end companies
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TYPES OF INVESTMENT COMPANIES
Unit Investment Trusts
unmanagedthe portfolio composition is fixed for the
life of the fund.
tend to invest in relatively uniform types of assets. ex:
municipal bonds, corporate bonds.
Sponsor(selects and assembles the securities to be
included in the fund)deposits securities into a trust
and sells shares or units to the public with a premium
Trustee keeps the securities, maintains unitholder
records, and performs all accounting and tax reporting
for the portfolio.
Lost market share to mutual funds---total assets have
declined from $105 billion in 1990 to $29 billion in 2009.
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TYPES OF INVESTMENT COMPANIES
Managed Investment Companies
Open-End funds
Fund issues new shares when investors buy and
redeems shares when investors cash out
Priced at Net Asset Value (NAV)
Do not trade on exchanges
Investors buy and liquidate through the investment
company at net asset value
Mutual Funds are known as Unit Trusts in some
countries such as Singapore, Malaysia, and Australia
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TYPES OF INVESTMENT COMPANIES
Managed Investment Companies
Closed-End funds
No change in shares outstanding; old investors
cash out by selling to new investors
Can be purchased through broker just like
common stock
Can be traded on exchanges
Therefore, their prices can differ from NAV---
priced at premium or discount to NAV
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TYPES OF INVESTMENT COMPANIES
Other Investment Organizations
---not formally organized or regulated as
investment companies
---but serve similar functions
---three important ones are:
Commingled funds
Real estate investment trusts(REITs)
Hedge Funds
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TYPES OF INVESTMENT COMPANIES
Commingled funds
--partnerships of investors that pool funds
--typical partners might be trust or retirement accounts
with portfolios much larger than those of most
individual investors, but too small to manage on a
separate basis.
--investors benefit from economies of scale trading
costs are reduced.
--the management firm that organizes the partnership
manage the funds for a fee.
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TYPES OF INVESTMENT COMPANIES
Real estate investment trusts(REITs)
--similar to a closed-end fund.
--invest in real estate or loans secured by real estate.
--Equity trusts: invest in real estate directly
--Mortgage trusts: invest primarily in mortgage and
construction loans
--can raise capital by issuing shares, borrowing from
banks, and issuing bonds or mortgages.
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TYPES OF INVESTMENT COMPANIES
Hedge Funds
--for private investors to pool assets
--typically only open to wealthy and institutional investors
--subject to less regulation
--many require investors to agree to initial lock-ups,
periods as long as several years in which investment can
not be withdrawn
--managers can pursue relatively risky investment
strategies such as short sales, derivatives, currency
speculation, merger arbitrage and so on
--enjoyed great growth over the last several years: assets
growing from $50 billion in 1990 to $2 trillion in mid-2008
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MUTUAL FUNDS: OPEN-END INVESTMENT COMPANIES
Dominant investment company today
Accounting for 90% of investment company assets.
Assets under management: $11.6 trillion in U.S.
mutual funds at the end of 2011, $12.2 trillion in non-
U.S. mutual funds
More than 7500 mutual funds in the U.S., over 16000
mutual funds in the Asia-Pacific region.
Management companies manage a family of mutual
funds.
Well-known Management companies. Ex: Fidelity,
Vanguard, Putnam investments.
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MUTUAL FUNDS
Funds are commonly classified into the following
groups based on investment style:
Money Market
Equity
Sector
Bond
Balanced
Asset Allocation and Flexible
Index
International
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MUTUAL FUNDS
Money Market
--invest in money market securities (short term, low risk)
--ex: commercial paper, repurchase agreements, certificates of
deposit
Equity
-- invest primarily in stock
--may also hold fixed-income or other types of securities
--commonly will hold about 4% to 5% of total assets in money
market securities to provide liquidity to meet potential redemption
of shares
--income funds: hold shares of firms with consistently high
dividend yields.
--growth funds: hold stocks with potentially high capital gains
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MUTUAL FUNDS
Sector
-- concentrate on a particular industry
-- such as: biotechnology, energy, precious metals, telecommunications
Bond
-- invest in fixed-income securities
-- such as: corporate bonds, Treasury bonds, mortgage-backed securities
or municipal bonds
International
-- invest in securities of firms outside of the home country.
-- Global funds: invest in securities worldwide.
-- Regional funds: concentrate on a particular part of the world
-- Emerging market funds: invest in companies in developing nations
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MUTUAL FUNDS
Balanced
-- hold both equities and fixed-income securities in
relatively stable proportions
Asset Allocation and Flexible
--hold both stocks and bonds
--the proportion allocated to each market vary dramatically,
depending on the portfolio managers forecast of the
relative performance of each market.
--engage in market-timing.
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MUTUAL FUNDS
Index Fund
-- buys shares in securities included in a particular
index in proportion to each securitys representation in
that index
-- ex: Vanguard 500 index fund: replicates the
composition of the Standard & Poors 500 stock price
index, which is a value-weighted index.
-- the funds buys shares in each S&P 500 company in
proportion to the market value of that companys
outstanding equity.
-- good for small investors to pursue a passive
investment strategy: invest without engaging in security
analysis
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HOW FUNDS ARE SOLD
Direct-marketed funds
--sold through the mail, offices, phone, internet
--investors contact the fund directly to purchase shares
Sales force
--brokers or financial advisers receive a commission for selling shares to
investors
Revenue sharing: fund companies pay the brokerage firm for preferential
treatment when making investment recommendations
Potential conflicts of interest: recommend mutual funds not based on the
interest of clients
---SEC requires brokerage firms to explicitly reveal any compensation or
other incentives they receive to sell a particular fund
Financial Supermarkets
-- sell shares in funds of many complexes
-- instead of getting a commission, the supermarket splits management fees with
the mutual fund company. Mutual fund might raise the management fee to adjust
for this commission cost.
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COSTS OF INVESTING IN MUTUAL FUNDS
Fee Structure: Four types
Operating expenses
-- administrative expenses and advisory fees paid to the investment manager.
-- ranging from 0.2% to 2% of the total assets under management
-- the expenses are deducted from the assets of the fund
Front-end load
-- primarily used to pay the commission of brokers who sell the funds
-- typically, less than 6% of your investment
-- reduce the amount of money invested
Back-end load
-- exit fee when you sell your shares.
--Typically starts from 5% or 6% and decreases by 1% each year
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COSTS OF INVESTING IN MUTUAL FUNDS
Fee Structure: Four types
12 b-1 charge (in the U.S.)
-- used to pay for distribution costs such as advertising, and most
important, commissions: limited to 1% of a funds average net assets per
year.
-- paid annually
-- the fees are deducted from the assets of the fund should be added to
operating expenses to calculate the true annual expense ratio of the
fund
SEC requires fees must be disclosed in the prospectus
Many funds offer classes with different fee
combinations, but represent ownership in the same
portfolio of securities: Class A, Class B, Class C
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FEES AND MUTUAL FUND RETURNS
The rate of return on an investment in a mutual fund
= (change of net asset value + income distributions +
capital gains distributions)/initial net asset value
This measure ignores any commissions such as
front-end loads paid to purchase the fund.
Moreover, the return is affected by the funds
expenses and 12b-1 fees.
This expenses are deducted from the portfolio, which
reduces the net asset value.
The rate of return of the fund == gross return on the
underlying portfolio minus the total expense ratio
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FEES AND MUTUAL FUND RETURNS:
EXAMPLE 1
Initial NAV = $20
Income distributions = $.15
Capital gain distributions = $.05
Ending NAV = $20.10:
$20.10 - $20.00 + $.15 + $.05
Rate of Return = 1.5%
$20.00

1 0
0
NAV NAV Income and capital gain distributions
Rate of return =
NAV

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A mutual fund had NAV per share of $16.75 on January 1, 2009.
On December 31 of the same year the fund's rate of return for the
year was 26.6%.
Income distributions were $1.79 and the fund had capital gain
distributions of $2.80.
Without considering taxes and transactions costs, what ending NAV
would you calculate?
A. $17.44
B. $13.28
C. $14.96
D. $17.25
E. $16.62
26.6% = (P $16.75 + $1.79 + $2.80)/$16.75;
P = $16.615
FEES AND MUTUAL FUND RETURNS: EXAMPLE 2
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FEES AND NET RETURNS: EXAMPLE 3
Consider a fund with $100 million in assets at the start of the year and
with 10 million shares outstanding. Suppose the share number does not
change.
The fund invests in a portfolio of stocks that provides no income but
increases in value by 10%.
The expense ratio, including 12b-1 fees, is 1%.
What is the rate of return for an investor in the fund?
Initial NAV = $100 million/10 million shares = $10 per share
without the expenses, the fund assets grow to $100*(1+10%) =$110
millionNAV = $110M/10 million shares = $11per share
without the expenses, the rate of return = (11-10)/10=10%
1% expense ratio $100m*1% =$1m is deducted from the fund to pay
the fees the portfolio net worth $109 million
NAV = $109m/10 million shares = $10.9 per share
with expenses, the rate of return = (10.9-10)/10 = 9%
10% -1% = gross return on the underlying portfolio total expense
ratio
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FEES AND NET RETURNS: EXAMPLE 4
The Equity Fund sells Class A shares with a front-end load of 4%.
Class B shares with 12b-1 fees of 0.5% annually as well as back-end load fees
that start at 5% and fall by 1% for each full year the investor holds the
portfolio( until the fifth year).
Assume the rate of return on the fund portfolio net of operating expenses is
10% annually.
What will be the value of a $10,000 investment in Class A and Class B shares if
the shares are sold after (1) 1 year, (b) 4 year, (c) 10 years?
Which fee structure provides higher net proceeds at the end of each
investment horizon?
Front-end load = 4% for Class A shares net investment in Class A shares
after 4% is $10,000*(1-4%) = $9,600 .
If the fund earns a return of 10% without expenses. The investment will
grow after n years to $9,600 *(1+10%)^n.
The Class B shares have no frond-load net investment = $10,000.
However, Class B shares has 12b-1 fees of 0.5%return after expense =
10%-0.5% = 9.5%.
So the investment will grow after n years to $10,000*(1+9.5%)^n
Back-end load reduces the sales proceeds until the fifth year.
4%( at the end of the first year)..1%(at the end of the fourth year),..
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FEES AND NET RETURNS: EXAMPLE 4
Class A shares Class B shares
Horizon $9600*(1+10%)^n $10000*(1+9.5%)^n *(1-exit fee)
1 year $10,560 $10000*(1+9.5%)*(1- 4%) =$10,512
4 year $14,055 $10000*(1+9.5%)^4 *(1-1%)=$14,233
10 year $24,900 $10000*(1+9.5%)^10*(1-0)= $24,782
The Equity Fund sells Class A shares with a front-end load of 4%.
Class B shares with 12b-1 fees of 0.5% annually as well as back-end load fees
that start at 5% and fall by 1% for each full year the investor holds the
portfolio( until the fifth year).
Assume the rate of return on the fund portfolio net of operating expenses is
10% annually.
What will be the value of a $10,000 investment in Class A and Class B shares if
the shares are sold after (1) 1 year, (b) 4 year, (c) 10 years?
Which fee structure provides higher net proceeds at the end of each
investment horizon?
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FEES AND NET RETURNS: EXAMPLE 5
You purchased shares of a mutual fund at a price of $20 per share at the
beginning of the year
You paid a front-end load of 5.75%.
If the securities in which the fund invested increased in value by 11% during
the year.
the fund's expense ratio was 1.25%
your return if you sold the fund at the end of the year would be ________%.
Suppose the initial investment = S then S*(1-5.75%) is the net investment
amount : consider the front-end load.
The investment return of the fund is 11% without expense and the expense
ratio is 1.25%net investment return = 11%-1.25%
Profit/initial investment = [S*(1-5.75%) *(1+11%-1.25%)- S] /S = 3.44%
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LATE TRADING AND MARKET TIMING
Mutual funds calculate NAV at the end of each trading day. All buy
and sell orders arrived during the day are executed at that NAV. Some
funds calculates NAV several times daily.
Late trading accepting buy or sell orders after the market closes and
NAV is determined.
For example, some positive news is announced after 4:00, NAV would
be adjusted to reflex the news the next day.
Market timing rapid in-and-out trading on stale net asset values
For example, a fund specializes in Japanese stocks. Because of time-
zone differences, the Japanese market closes several hours earlier
than the U. S. market. But NAV is set based on the closing price of the
Japanese shares.. So it is fixed or stale.
If the U.S. market jumps while the Japanese market is closed, it is likely
that price of those Japanese shares will rise next day, so the NAV of
that fund share will rise next day.
A market timer can buy the fund in the U.S. today at its stale NAV and
make a profit the next day.
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TAXATION OF MUTUAL FUND INCOME
Pass-through status under the tax code in most
countries
Taxes are paid only by the investor, not by the fund
Fund investors do not control the timing of the sales of securities from the
portfolio reduces investors ability to engage in tax management
High portfolio turnover leads to tax inefficiency
-- Turnover is the ratio of the trading activity of a portfolio to the assets
of the portfolio.
-- It measures the fraction of the portfolio that is replaced each year.
-- High turnover means capital gains and losses are being realized
constantly.
--Index funds: can be as low as 2%, equity funds: around 60% in the last
decade.
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A mutual fund had average daily assets of $2.0 billion in 2009. The
fund sold $500 million worth of stock and purchased $500 million
worth of stock during the year. The fund's turnover ratio is ___.
A. 27.5%
B. 12%
C. 15%
D. 25%
E. 20%
Turnover measures the fraction of the portfolio that is replaced
each year.
500,000,000/2,000,000,000 = 25%
EXAMPLE: TURNOVER
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YouTube video on mutual fund:
http://www.youtube.com/watch?v=07E1hFlyg-o
4-39
EXCHANGE TRADED FUNDS
An investment fund traded on stock exchanges, much like stocks.
Most ETFs track an index, such as a stock index or bond index.
Ex: spiders(S&P500), diamonds (DJIA) and cubes(NASDAQ 100
index)
potential advantages over conventional mutual fund:
can be traded continuously, while you can only buy or sell mutual fund
once a day since mutual fund compute NAV at the end of each trading day
can be sold short or purchased on margin
lower costs than mutual fund: investors buy ETFs through brokers not
directly from funds ETF saves the cost of marketing itself to small
investors reduction in expenses leads to lower management fees for
ETFs
Tax efficient: For mutual fund: investors redeem shares fund must sell
securities from the portfolio capital gain taxes are passed to remaining
shareholders; For ETFs, small investors can sell the shares to other
investors and fund has no need to sell securities, thus avoid passing
capital gain taxes.
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EXCHANGE TRADED FUNDS
An investment fund traded on stock exchanges, much like stocks.
Most ETFs track an index, such as a stock index or bond index.
Ex: spiders(S&P500), diamonds (DJIA) and cubes(NASDAQ
100 index)
potential disadvantages over conventional mutual fund:
ETFs trade as securities Prices can depart by small
amounts from NAVif you purchase the ETF share with a
price higher than NAV, then the cost advantage of ETF can
easily be swamped over mutual fund since you can purchase
mutual fund with NAV
ETFs must be purchased from brokers for a fee, while mutual
fund can be bought with no expense from no front-end load
fund.
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MUTUAL FUND INVESTMENT PERFORMANCE: A FIRST LOOK
Performance of actively managed funds:
Performance of actively managed equity fund VS.
Performance of a passively managed portfolio that
replicates a broad index of the stock market Wilshire
5000 index?
Wilshire 5000 index is a value-weighted index of all actively
traded U.S. stocks.
It is a simple passive investment strategy.
Average return on diversified equity funds was below the return
on the Wilshire 5000 index in 23 of the 39 years from 1971 to 2009
The average annual return on the index was 11.9%, 1% greater
than the average annual return of the average mutual fund.
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MUTUAL FUND INVESTMENT PERFORMANCE: A FIRST LOOK
Performance of actively managed funds:
Whether managers with good performance in one year
are likely to repeat that performance in a following year?
That is, is superior performance in any particular year
due to luck, and therefore random, or due to skill, and
therefore consistent from year to year?
Studies in the 1970s show that part of a funds performance is a function of
skill as opposed to luck.
However, the pattern of persistence in performance disappears in 1980s.
Evidence for persistent superior performance (due to skill and not just
good luck) is weak, and suggestive, not inconclusive.
Other studies suggest that bad performance is more likely to persist than
good performance
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INFORMATION ON MUTUAL FUNDS
Funds prospectus describes:
investment objectives and policies
Fund investment adviser and portfolio manager
Fees and costs
Funds annual report
Portfolio composition
Financial statements
Discussion of the factors that affected the fund performance
during the last reporting period.
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INFORMATION ON MUTUAL FUNDS/UNIT TRUSTS
Wiesenbergers Investment Companies
Morningstar (www.morningstar.com)
--- Mutual Fund Sourcebook
Yahoo Finance (finance.yahoo.com/funds)
Investment Company Institute (www.ici.org)
--- publishes an annual Directory of mutual
funds with infor on fees and contact
numbers
Fundsupermart.com
http://www.fundsupermart.com