• What is a mutual fund? • How does one compute the net asset value (NAV)? • What expenses and charges might a mutual fund investor face? • What does research on mutual fund performance tell about fund expenses, portfolio turnover, and returns? Questions to start with • 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 2000 vs $13 trillion in NYSE 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 NAV1=NAV0+All Incomes-All Distributed Example: NAV0=Rs.100, Distributed 1) Net Realized Gains=Rs.2 and 2) Net Investment Income=Re.1. NAV1= Rs.100-Rs.2-Re.1=Rs.97 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 (∆NAV) – From unrealized gains/losses from assets Mutual Fund Returns Return = (ID + CGD –Payments + ∆ NAV)/Beg.NAV • Ex. NAV0=Rs.35,NAV1=Rs.35.2, Net Realized Gain Rs.2, Net Investment Income =Rs..5. Return= (2+.5+35.2-35)/35=7.714% • 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 (60% equity+40% of debt securities) Goal: to conserve principal, by maintaining a balanced portfolio of both stocks and bonds – Blended funds: Mutipurpose funds(e.g., balanced target maturity, convertible securities that invest in both stocks and bonds – Flexible funds: Flexible income, flexible portfolio, global flexible and income funds, that invest in both stocks and bonds 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 Re.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 plus the load (while no-load funds are sold at their NAV) – Ex. 4% load with NAV Rs.96, buy at Rs.100 – Load range from around 3% (low-load) to 8.5% • 12b-1 Fees: pay to the distributor (.25%-.75% )+ .25% servicing charge in some cases) – Fees deducted from the asset value of the fund to cover marketing expenses – An alternative to loads • Offering Price= NAV/(1-load %). – Investing Rs.1,000 in a load MF with 7% and expected return of 10%, – Rs.value=1000(1-.07)(1.10)=1023 (2.3% growth) – Investing Rs.1,000 no load MF with 8% return and 2% redemption fee, – Rs.value=1000(1-0)(1.08)(1-.02)= 1058.4 (5.84% growth) – Rs.35.4 Difference 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 Holding Period for a Portfolio • Portfolio Turnover • Holding Period = 12 months/(Portfolio Turnover%) • Ex Turnover 125%=>12/1.25=9.6 month 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.