Investments: Analysis

and Behavior
Chapter 16- Mutual Funds

2008 McGraw-Hill/Irwin

Learning Objectives

Understand the structure and pricing of mutual funds

Know the advantages and disadvantages of buying
mutual funds
Be able to assess mutual fund performance
Assess mutual fund manager incentives
Recognize the impact of taxable distributions on fund
returns

16-2

Mutual Funds

An investment company that issues its portfolio shares to investors.

Money from shareholders are pooled and invested in a wide range of

stocks, bonds, or money market securities.

Managed by professional managers

Each investor shares proportionately in the income and investment

gains and losses, as well as the brokerage expenses and
management fees.

Open end fund: # of shares issued solely depends on investor

demand

Bought and sold directly through the investment company (not an

exchange)

16-3

Net asset Value

NAV: per share value of a mutual funds investment

holding.
Market Value of Assets Portfolio Liabilities
NAV
# of Shares Outstanding

Example
A mutual fund has $100 mil in assets and $3 mil in short
term liabilities. 10.765 mil shares outstanding. What is
the NAV?
Solution
($100 mil - $3 mil) / 10.765 mil = $9.0107 per share

16-4

Types of Mutual Funds

Objective

Funds Hold

Growth Potential

Income Potential

Stability

Money Market Funds

Taxable money market

Current income
stability of principal

Cash investments

None

Moderate

Very high

Tax-exempt money
market

Tax-free income,
stability of principal

Municipal cash investments

None

Moderate

Very high

Taxable bond

Current income

Wide range of government

and/or corporate bonds

None

Moderate to high

Low to moderate

Tax-exempt bond

Tax-free income

Wide range of municipal bonds

None

Moderate to high

Low to moderate

Current income
capital growth

Stocks and bonds

Moderate

Moderate to high

Low to moderate

Equity income

High-yielding stocks,
convertible bonds

Moderate to high

Moderate

Low to moderate

Value funds

Low P/E, P/B stocks

Moderate to high

Low to moderate

Low to moderate

Growth and income

Dividend-paying stocks

Moderate to high

Low to moderate

Low to moderate

U.S. stocks with high potential

for growth

High

Very low

Low

Stocks of companies outside

U.S.

High

Very low to low

Very low

Stocks with very high potential

for growth

Very high

Very low

Very low

Small cap

Stocks of small companies

Very high

Very low

Very low

Specialized

Stocks of industry sectors

High to very high

Very low to
moderate

Very low to low

Bond Funds

Common Stock Funds

Balanced

Domestic growth

Capital growth

International growth
Aggressive growth

Aggressive growth
of capital

16-5

Sources of Information

Lipper Inc.: leading provider of

data and analysis on the
investment company business (
www.lipperweb.com )
Morningstar.com: provide
unbiased data and analysis and
candid editorial commentary (
www.morningstar.com)
Vanguard Group: providing
competitive investment
performance and lowest
operating expenses (
www.vanguard.com )
16-6

Mutual Fund Advantages

Broad diversification

Diversified stock funds hold large and small company stocks

broadly spread across industries and economic sectors
Diversified bond funds hold bonds with different maturities,
coupon, and credit quality

Ability to retain professional

investment management at a
reasonable cost
Investor convenience

Many offer fund family

16-7

Mutual Fund Disadvantages

Volatility can be significant

Diversification

doesnt protect investors from the

risk of loss from an overall decline in financial
markets
Mutual fund regulation doesnt eliminate the risk of
an investment falling in value

High management fees

and sales commissions
No-load

funds

16-8

16-9

Sources of Investment Returns

Total Return: dividend and interest income and realized and

unrealized appreciation

Income distribution: interest and dividend income after

expenses.

Capital gains unrealized until the fund sells the shares

(Unrealized capital gains)

The realized capital gains are paid out to shareholders at the

end of the year (capital gains distributions)
16-10

Mutual fund expenses

Operating expense ratio: total of investment advisory

fees and costs of legal and accounting services, etc.,
expressed as a percentage of the funds average net
assets (range from 0.2% to 2%)
Lowest for money market mutual fund and highest
for international stock funds
Tend to be lowest for large, liquid funds
Load charges: one time sales commissions
Front-end loads (charged at the time of purchase)
Back-end loads (charged at the time of sales of
shares)
Low-end funds: sales fee ranging from 1% to 3%
12b-1 fees: marketing and distribution costs
No-load funds: fund without front-end or back-end
load charges

16-11

Table 16.4
A. Typical fee tables found in three different mutual fund prospectuses
Fund A

Fund B

Fund C

Sales load imposed on purchases

None

None

4.75%

Sales load imposed on reinvested dividends

None

None

4.75

Redemption fees

None

None

None

Exchange fees

None

None

None

Management and administrative expenses

0.22%

0.60%

0.70%

Investment advisory expenses

0.02

0.30

Marketing and distribution costs

0.02

Miscellaneous expenses

0.03

0.32

0.26

Total Operating Expenses

0.29%

1.22%

0.96%

1 year

$ 30

$ 124

$ 587

3 years

93

387

823

5 years

163

670

1,077

10 years

368

1,477

Shareholder Transaction Expenses

Annual Fund Operating Expenses

12b-1 marketing fees

Expenses on a $10,000 Investment

1,805 16-12

B. The impact of equity mutual fund costs on long-term investor returns.

Fund A

Fund B

Fund C

$ 10,000

$10,000

$10,000

Day 1

10,000

10,000

9,525

5 years

18,189

17,451

16,186

10 years

33,084

30,565

29,689

15 years

60,178

53,145

52,416

20 years

109,458

92,743

92,539

Gross return

13.00%

13.00%

13.00%

0.29%

1.22%

0.96%

12.71%

11.78%

12.04%

Initial investment

Operating expenses
Net return

Fund A : typical cost efficient index fund

Fund B : conventional no-load stock mutual fund
Fund C : low-load stock mutual fund with less than typical annual operating
expenses
16-13

Style boxes
Value Strategy
(Score <1.75)

Blend
(1.75 Score
2.25)

Large-cap
(Top 5%)

S & P 500
Benchmark

Mid-cap
(Next 15%)

Wilshire 4500
Benchmark

Small-cap
(Bottom 80%)

Russell 2000
Benchmark

Growth Strategy
(Score > 2.25)

Characterize mutual funds by market capitalization (large, mid, and small cap)
Next, determine how cheap or expensive portfolio holdings are relative to the
overall market using P/E and P/B ratios (Value, Blend and Growth)

16-14

16-15

Mutual Fund Organization

Mutual fund shareholders: own mutual

funds, elect the board of directors

Majority of the directors must be

independent directors

Investment advisor: manages the dayto-day operations

Principal underwriter, administrator,

transfer agent, custodian, and
independent public accountant
16-16

Evaluating Fund Performance

Using ranking tools or portfolio evaluation

tools (alpha, Sharp ratio, and Treynor
measure)

20 categories in domestic equity mutual

funds, 14 in international equity funds, 12 in
fixed income and 17 in municipal bond funds

16-17

Top 10 U.S. Domestic Funds Based on 3 Year Return

Fund Name: Classification

1 Mon.

YTD

1 Year

3 Year

5 Year

10 Year

Pacific Adv: Small Cp;A

PASMXSmall-Cap Value

16.8

16.8

27.8

49.2%

19.3

12.1

ProFunds: UltraSm-Cap;Inv
UAPIXSmall-Cap Core

17.7

17.7

29.3

49.2%

6.4

--

Pacific Adv: Small Cp;C

PGSCXSmall-Cap Value

16.6

16.6

26.7

48.0%

18.0

--

ProFunds: UltraSm-Cap;Svc
UAPSXSmall-Cap Core

17.6

17.6

28.0

47.7%

5.4

--

Schneider Sm Cap Val

SCMVXSmall-Cap Value

5.1

5.1

22.4

46.8%

22.3

--

ProFunds: UltraMidCap;Inv
UMPIXMid-Cap Core

11.6

11.6

39.7

45.6%

7.6

--

Hodges Fund
HDPMXMulti-Cap Core

9.8

9.8

33.3

45.0%

14.5

13.6

Fidelity Lvrgd Co Stk

FLVCXMid-Cap Core

6.9

6.9

26.1

44.4%

22.4

--

ProFunds: UltraMidCap;Svc
UMPSXMid-Cap Core

11.5

11.5

38.2

44.1%

6.6

--

Fidelity Adv Lev Co; Ins

FLVIXMid-Cap Value

6.7

6.7

25.4

43.3%

22.6

--

16-18

16-19

16-20

16-21

Exchange-Trade Funds (ETFs)

Tradable shares in baskets of stocks that closely

track broad market averages, market sectors, or
major stock markets from around the world.

Tradable shares in baskets of stocks that closely

track broad market averages, market sectors, or
major stock markets from around the world.
Standard and Poors Depository Receipts (SPY),
spiders: closely track S&P 500 Index
Diamonds (DIA): track Dow Jones Industrial
Average
QQQQ: track Nasdaq 100 Index
Select Sector SPDRs: unbundled S&P Index to
give investors ownership in a particular market
sector or group of industries.
Barclays Global Investors: offer iShares
internationally indexed
16-22

Closed-End Funds

Issues a fixed number of shares at a given point in time

Collect money from investors through and IPO and use this money to
invest in securities.

# of securities are fixed at the time of IPO.

When the market price exceeds its NAV, selling at a premium,

otherwise, selling at a discount (closed-end funds typically sell at a
discount)

Suited to specialized investing in small or illiquid markets

Statistic
Total number of closed-end funds
(U.S. exchanges only):
Total Assets*:
* Assets are Net Assets, expressed in Millions, and exclude leveraged capital (preferred stock, debt, etc.).

Value
693
$214,736.69

16-23

Hedge Funds

Like mutual funds, a means for groups of

investors to pool financial resources

Typically organized as partnership

arrangement available only to the
wealthiest investors

Flexibility to use speculative investment

strategies

Subject to only limited oversight.

16-24

Table 16.6 Hedge Funds Differ From Mutual Funds in a Number of Ways
Mutual Funds

Hedge Funds

Who Invests

92 million Americans own mutual fund shares. The

only qualification for investing is having the
minimum investment to open an account with a fund
company often $1,000 or less.

Only sophisticated, high net worth investors are

eligible to invest. The typical investor is a
wealthy individual or an institution such as an
endowment or foundation. A minimum
investment of $1 million or more is required.

Fees

Mutual fund shareholders pay, on average, an annual

expense ratio of roughly 1.5% of assets. Load
charges can increase this to 2.5% to 5% per year.
Funds must disclose fees and expenses in detail.
Sales charges and other distribution fees are subject
to specific regulatory limits.

Hedge fund investors often pay a portfolio

management fee of 1% to 2% of net assets, plus
a performance-based fee that can run as high as
10% per year, depending upon performance.
Fees are not subject to specific regulatory limits.

Investment
Practices

Securities laws restrict a mutual fund's ability to

leverage, or borrow against the value of securities in
its portfolio. Funds that use options, futures, forward
contracts, and short selling must "cover" their
positions with cash reserves or other liquid securities.
Investment policies must be fully disclosed to
investors.

Leveraging strategies are hallmarks of hedge

funds. Investment policies do not have to be
disclosed, even to investors in the fund.

Pricing and
Liquidity

Mutual funds must value their portfolio securities and

compute their share daily. They generally must also
allow shareholders to redeem shares on at least a
daily basis.

There are no specific rules on valuation or

pricing. As a result, hedge fund investors may
be unable to determine the value of their
investment at any given time. In addition, new
investors typically must pledge to keep their
money in a hedge fund for at least one year.

16-25

Taxes on distributions

Shareholders pay taxes due once income

dividends and capital gains distributions
are received.

All income and capital gains distributions

are generally subject to income taxes.

Municipal bond or US T-securities interest

income exempt from federal taxes, but capital
gains are taxable.

Turnover rate: expressed as a percentage

of the funds average assets (average
turnover rate for stock mutual fund: 79%)
16-26